Microeconomic Theory

Microeconomic theory is a branch of economics that focuses on the behavior of individual consumers and firms within specific markets. It provides a framework for analyzing key concepts such as demand, supply, and market equilibrium, which are essential for understanding how goods and services are allocated in an economy. Central to this theory are the laws of supply and demand, which illuminate the relationships between price and quantity; the law of demand suggests that as prices rise, the quantity demanded typically falls, while the law of supply indicates that higher prices generally lead to an increase in the quantity supplied.

In microeconomic analysis, several foundational assumptions, such as rational behavior and the concept of ceteris paribus (holding other factors constant), guide the study of economic interactions. The theory also addresses the implications of scarcity and opportunity cost, emphasizing that choices must be made when resources are limited. Additionally, microeconomics examines how various determinants, including consumer preferences and resource prices, affect demand and supply dynamics. By exploring these components, microeconomic theory equips individuals with the analytical tools to navigate economic challenges and understand market functions.

Published in: 2021

By: Hoagland, Steven R.

Subject Terms

Microeconomic Theory

Abstract

Microeconomic theory prepares individuals for analyzing demand, supply, and equilibrium under certain assumptions. A study of economic theory involves recognizing explicit forms of assumptions and elevating our sensitivity to other assumptions encountered in our daily pursuits at work, play, and/or study. Far beyond the simplicities afforded by assumptions, however, are the law of demand and the law of supply. As the reader of this essay will see, both laws inform us of a specific relationship between price and quantity. More importantly, supply and demand when taken together help describe equilibrium and portray the dynamics between equilibrium price and quantity. This essay attempts to convey a vast array of concepts, models, and views that undergraduate students will encounter in a study of microeconomics. The essay also recognizes some obstacles to learning that students are likely to encounter during their studies of the discipline.

Overview

Microeconomic theory provides a conceptual foundation for analyzing demand, supply, and equilibrium in addition to other interrelated topics. Let us begin with a brief overview of how those concepts fit together from within an overarching theoretical framework. Consider first that theory is a mental abstraction consisting of a set of principles, methods, and models. In general, those models of economic theory and behavior contain an array of variables and interrelationships. In essence, variables and relationships set forth by a theory help us to simplify reality by breaking it down into manageable pieces and by subscribing to some key underlying assumptions.

A discussion of assumptions will follow in the section ahead. Models present us with a framework for organizing key pieces of information. Keep in mind that a model, moreover, is a tool that enables us to simplify reality and to summarize key hypotheses and relationships. Theories provide a basis with which to formulate those hypotheses. By nature, hypotheses convey information about what we can expect to observe in terms of how one or more variables relate to a key variable in accordance with theory. Scientists and researchers use theories and test hypotheses in order to generate knowledge and information from a limited amount of data. Some hypothesized relationships become truths after a long period of confirmation and/or of acceptance by a profession; eventually, they become laws. Two laws central to the study of microeconomic theory are the law of supply and the law of demand, which will receive ample attention in the text ahead.

Textbooks also devote a considerable amount of content to these two laws, expanding them into several hundred pages on demand and supply. Readers of this essay will find references to economics textbooks with which the essay author is most familiar (Arnold, 2016; Guell, 2009; McConnell, Brue, & Flynn, 2016) given their use in introductory courses. The reader of this essay may find benefit in knowing that the first eight or so chapters of most principles of economics textbooks provide a firm foundation for the study the economic theory. Specifically, Issues in Economics Today, the text book authored by Guell, is a valuable resource to any introductory level course in economics; particularly those courses designated for the non-business major or individuals in the major exploration phase of their academic pursuits.

Guell (2009) defines microeconomics as "[t]hat part of the discipline of economics that deals with individual markets and firms." This essay, which takes the form of a scholarly application and integration of theory, extends that definition and describes how individuals and firms create and interact in markets. Consider another yet deeper, perhaps more salient description of microeconomics, as found in Pearce (1992, pp. 276-277). According to Pearce, the term microeconomics is engaged to "describe those parts of economic analysis whose concern is the behaviour of individual units, in particular, consumers and firms" and that analysis "of individual behaviour concentrates on consumer demand theory" and "analysis of firm behaviour concentrates on production decisions and price theory." In other words, theories of consumer demand and prices coupled with analyses of individual and firm behavior comprise microeconomic theory.

The reader should have a sense by now that consumers and firms are two groups about which we can offer some generalizations. Microeconomic theory comprises a theory on consumers and a theory on firms from which we can simplify reality and deal with most of its complexities. In addition, the reader should be mindful that economic models consist of three highly interactive components: Consumers, businesses, and markets. The next section begins with a set of assumptions that are necessary in covering and learning economics.

Application

Assumptions

Ceteris Paribus. Assumptions are sometimes implicit and at other times are explicit; elevating sensitivity to either form is beneficial in a life of work, play, and study. A number of assumptions are applicable to an in-depth study of economics. Foremost among those three assumptions is the ceteris paribus assumption. Its literal translation from Latin into English means "all else is held constant." Anyone examining economics will discover that a wide array of relationships exists, which makes it necessary to consider as few as possible.

Rational Actors. Next is the assumption in microeconomic theory that individuals (primarily consumers and producers) behave rationally and choose to maximize their own self-interest. As strange as this may sound, those behaviors and choices serve a major function in the betterment of society according to an economics perspective. This second assumption means that consumers and producers have full and immediate access to perfect information relevant to their decisions.

Collective Implications. A third assumption is that those agents engage in transactions through which no individual or group brings an inordinate amount of influence to an exchange decision. In essence, this assumption carries the notion that an exchange between a buyer and a seller yields benefits and/or costs to them whereby third parties incur the same set of benefits and/or costs. Actions of individuals can affect larger society whether in a good or a bad manner; for the sake of brevity, this author invites those who want to learn more about that societal dimension to explore topics such as welfare economics and macroeconomics by considering the entries found in the suggested readings list near the end of this essay.

The Economic Problem. The aforementioned assumptions enable us to study economics and to recognize some key tenets of an economic perspective on the world with which we interact. Economics is all about scarcity. In terms of our own behaviors, most of us truly have unlimited wants and face limited resources. Our attempt to reconcile between those wants and resources gives rise to a major problem: The economic problem. A reason for studying economics is to alleviate that problem.

Opportunity Cost. Scarcity forces us to make choices and each decision presents us with a trade off or an opportunity cost. We can measure the value of our decisions in terms of the value of the forgone alternative. For example, the opportunity cost of reading this essay is the value you place on whatever it is that you might prefer to be doing when it is the next best alternative to reading this essay. Economic valuations of opportunity costs help consumers to decide how to allocate scarce resources (time, money, etc.). Likewise, business owners and entrepreneurs usually have a minimum profit rate in mind for the enterprise they operate, which typically coincides with that for the industry in question. If the actual profit rate fails to meet expectations, those operators can choose another industry where they can pursue whatever may be considered a normal rate of profit.

Price. By extension, the costs of conducting business include the normal rate of profit. This means that an enterprise must receive a price for their goods and services that covers profit and explicit costs. Price needs to become an agreement between a seller and a buyer of those goods and services. The seller or supplier will provide some amount at each price within a given range of prices and the buyer or consumer will purchase some amount at each price within a given range. In essence, price is a mechanism that is said to clear the market because buyers and sellers arrive at a price for which is agreeable between them.

Let us begin with the demand or consumer side of the situation. This article and many economists subscribe to the view that a good or service becomes available because of consumer demand. In brief, suppliers provide and offer goods and services, but the consumer ultimately decides whether to pay the asking price. The next two sections describe the relationships between prices and quantities beginning with the demand side and ending with the supply side.

Demand

The Law of Demand. The law of demand informs us that an inverse or negative relationship exists between price and quantity demanded. In other words, consumers demand less (more) of a good or service when its price rises (falls). Individual demand schedules are estimates of how many units of that good or service a specific consumer is willing and able to purchase over a period at a given price. On a graph, price is plotted on the vertical axis and quantity on the horizontal axis. In addition, a change in price corresponds with a change in quantity demanded. Note that a change in demand is movement along the demand curve.

Willingness & Ability to Pay. In terms of whether there is an increase or a decrease in demand and a corresponding shift in the demand curve, keep in mind that willingness and ability to pay the price are key considerations. The hypothetical amount of benefit or utility that originates from a quantity creates a willingness on the part of a consumer to buy; discussion of utility is forthcoming. Likewise, income level translates into a consumer's ability to pay the price. As one considers various price-quantity combinations comprising a demand schedule, willingness and ability run through the set of five factors. Furthermore, it is important to keep in mind that we hold constant willingness and ability to pay and several related factors unless specific information suggests otherwise.

Determinants of Demand. Known as determinants, a change in one or more of five factors will influence whether a consumer wants greater or smaller amounts of units at any given price. The difference between a change in demand and a change in quantity demanded bears worth repeating because it is a major stumbling block that is common amongst students in introductory economics courses. The five factors or determinants that shift a demand curve are as follows: The number of buyers; the prices of related goods; consumer income; consumer expectations; and consumer tastes and preferences. It is worthwhile here to summarize each item in that list of five.

First, population size determines the number of buyers.
Second, goods for which quantities demanded change when the price of another good changes or when incomes change are considered related goods; for example, one can really compare apples and oranges in terms of the effect of relative prices on the quantities demanded of fruit.
Third, a change in consumer income can directly influence the purchase quantity at any given price.
Fourth, consumer expectations, perspectives, or views about the present or future economic situation will influence whether they make a purchase or postpone it.
Last, consumer tastes and preferences determine popularity of a good or service; all the variations in today's caffeinated beverages serve as one example.

Before entering a discussion of utility for which consumer preferences and willingness to pay are foundational, brief coverage of how individual level demand translates into market level demand is necessary. Taking into account the aforementioned set of factors, an individual consumer will have a demand schedule that illustrates the various price and quantity combinations for any good or service under consideration. Furthermore, those individual schedules are brought together to construct the market demand for a specific good or service. This entails aggregating the quantities in those individual level demand schedules or curves, which again correspond with prices, for all consumers in the market for a specific good or service. Economists refer to that process as horizontal summation across demand schedules. Now that we understand the mechanics in constructing market demand schedules from individual schedules and the five factors in shifting the demand curve, our attention shifts to a few more details represented by a demand curve.

Theory of Consumer Choice & Behavior. Incomes, budgets, prices, quantity, and utility woven together are the essential ingredients in a demand recipe. First steps in the process require a draw from many of the basics introduced above. Let us start by acknowledging consumer tastes and preferences as a factor that tends to forge market trends; the want of diversity in caffeinated beverage consumption, for instance. It is important to note that a difference exists between wants and needs; food, clothing, and shelter are the most basic needs and they are readily identifiable.

Two questions for which answers, aside from being elusive, will likely vary among individuals: What is it that you want? How much of it is enough? When, where, and why do you want whatever it may be? Satisfaction from having the good or the service is a plausible answer for the why question, but all the other questions and more remain. In the study and the practice of economics, there is an attempt to resolve the problems stemming from these questions and from unlimited wants and limited or scarce resources.

Consumer Equilibrium. Consumers must make choices in the context of those wants and resources. Preferences suggest what the consumer wants to do, with income going only so far within that set of choices. Budget constraints suggest what is affordable. Crude economic rationality reminds us that we strive to maximize benefits subject to the budget constraint. In other words, as economic agents, consumers do the best with what they have at any given moment; arrival at consumer equilibrium is imminent.

Consumer equilibrium is a point at which consumers achieve the greatest benefit in the face of current budget constraint. The underlying assumption is that more is better than less whether concerning an income level and/or a physical quantity. Consumers can get more of something with higher incomes and more of that something translates into greater satisfaction levels in an absolute sense.

Marginal Utility. Total satisfaction increases to certain level that corresponds with each unit consumers are able and willing to attain. However, it is necessary to depart from examining the total amount by taking into consideration the incremental amount of a change in that total. At issue is the precise change in an amount of satisfaction that results from consuming one more physical unit; note that economists use satisfaction and utility interchangeably. Marginal utility is the change in utility that comes from consuming one more unit.

Consider a favorite beverage or food item. Maybe it is pizza. That first slice of pizza tastes so good, the second almost as fine, and the third or fourth or fifth is probably a little less satisfying than the previous slices. Somewhere along the way in consuming that pizza pie, the consumer is likely to encounter regrets; eat one slice too many. At that point of saturation, economists report that marginal utility drops to zero. Before then, however, marginal utility increases but at a decreasing rate. That is the Law of Diminishing Marginal Utility in operation, upfront and real. Perhaps we have reached the saturation point regarding the demand side of microeconomic theory, its laws, and now we find ourselves with a thirst for knowledge on the other side of that theory. The next section of this essay summarizes laws and key relationships relevant to supply.

Supply. The law of supply dictates that a direct or positive relationship exists between price and quantity supplied. In other words, producers supply less (more) of good or service when its price falls (rises). Supply schedules are estimates of how many units of that good or service a specific producer is willing and able to supply over a period at a given price. As is the case with demand, a graph of that schedule plots price on the vertical axis and quantity on the horizontal axis. Likewise, changes in quantity supplied are movements along the supply curve.

Willingness and ability also influence whether there is an increase or decrease in supply and a corresponding shift in the supply curve. In this instance, willingness to supply given quantities at a given price is a function of the expected level of profit and ability to supply is a function of costs. Furthermore, five factors or determinants can influence the price-quantity combinations comprising a supply schedule.

The five determinants—or curve shifters—of supply are as follows:

The number of sellers;
The prices of resources or inputs;
Productivity;
Technological state;
Expected future price of product.

Profit levels typically determine the number of sellers in a market. When those actual levels rise above (fall below) the normal level, new firms will enter (exit) the market thus increasing (decreasing) the supply of that good or service. One will notice openings of new stores or retail outlets in a geographic area when profit exceeds the normal level; caffeinated beverages are illustrative again. An increase (decrease) in the price of raw inputs such as wages for labor will raise (lower) the costs of doing business thereby prompting a decrease (increase) in supply. Productivity represents the amount of output that a worker can provide in any given work day or eight hour period. An increase (decrease) in productivity will result in an increase (decrease) in supply. The amount and/or state of technology also influences the supply curve and worker productivity. State of the art machines, computers, and so forth will boost worker productivity and company output levels; antiquated, obsolete, and worn out technology detracts from output and productivity. Producer pessimism and optimism come to bear on the supply level as well. When business leaders expect prices to rise (fall), they will take actions to increase (decrease) current supply levels thereby indirectly effecting unemployment levels.

Taking into consideration all those determinants, readers need to know there is a point at which businesses will cease or continue. To be a viable operating entity, a business must be able to cover payroll and make payments on their buildings and equipment. It will shut down if prices are too low to cover payroll. Consequently, the market supply curve is an aggregation of individual supply schedules, but only for those quantities corresponding with prices higher than the level of insolvency; again, production will cease when price fails to cover payroll costs. For the sake of brevity, this author needs to refer students and other interested parties to textbooks for detailed coverage of several cost types (as well as their mathematical and graphical natures) and of revenues. Speaking in terms of basic theory, when price is above the level of business failure, horizontal summation applies just as it does on the demand side of a market. The essay will now shift attention to microeconomic theory.

Market Equilibrium. This section brings together supply and demand for an initial brief description of equilibrium and a subsequent portrayal of changes in equilibrium price and quantity; the latter requires a change in demand and/or supply. The supply and demand model is an essential component in economics, especially in economic systems driven by capitalistic market forces.

A market in this context is a place in which consumers and producers come together to exchange a specific good or service; the market for caffeinated drinks, for instance. The supply curve intersects the demand curve creating a market equilibrium point. The market price is what economists refer to as "clearing the market," which means buyers and sellers agree to exchange dollars and quantities. The quantity associated with that market or equilibrium price is the equilibrium quantity. Recall the five determinants of demand and of supply; we are holding them constant for the moment by assumption.

For sake of examination, let us relax the ceteris paribus assumption and imagine that consumers become more optimistic about the future status of our nation's economy. In essence, they become more willing to purchase more at prevailing prices. This results in an increase, or a rightward shift in demand. Consequently, equilibrium price and equilibrium quantity arrive at a level higher than the previous level.

A sketch of this increase in demand would result in a graph or model featuring a new demand curve, parallel to the old curve that intersects the supply curve at a higher point. By altering any one determinant at a time, it would be possible to view the changes of graphic results in comparison to those above.

Microeconomics covers a lot of ground given its focus on markets and the integral roles of producers, consumers, and organizations. This essay attempts to convey a vast array of concepts, models, and views which undergraduate students will encounter in a study of microeconomics.

Terms & Concepts

Ceteris paribus: An underlying assumption of economics; translation from Latin into English means all else is held constant.

Consumer equilibrium: Occurs when the marginal utility per dollar spent for one item equals that for all other items.

Demand: The amount of a good or service an individual consumer or a group of consumers wants at a given price.

Demand curve: A graphical representation illustrating the negative or inverse relationship between price and quantity demanded.

Demand schedule: The actual quantities that consumers are willing and able to purchase at various prices.

Law of diminishing marginal utility: Key principle suggesting that total utility or satisfaction increases at decreasing rate as more units are consumed.

Economic problem: Occurs as a result of unlimited wants and scarce resources; forms basis for studying economics.

Market equilibrium: The price and quantity associated with the intersection of the demand and supply curve reflecting alignments among consumers and producers on an item's price and quantity.

Law of demand: Specifies the inverse or negative relationship that exists between an item's demand quantity and its price; quantity and price move in opposite directions.

Law of supply: Specifies the direct or positive relationship that exists between an item's demand quantity and its price; quantity and price move in same direction.

Marginal utility: The additional satisfaction an individual receives from the consumption of one additional amount of an item.

Market: A virtual space where consumers and producers interact while exchanging a specific item in accordance with their demand and supply schedules.

Opportunity cost: The hypothetical value or benefit of the foregone or next best alternative in a set of decisions.

Producers: Firms that supply or provide goods or services desired by consumers.

Quantity demanded: The amount of goods or services that consumers desire at given prices.

Quantity supplied: The amount of goods or services that suppliers are willing and able to produce at given prices.

Scarcity: Resources including time, money, effort, and so forth are limited and subject to depletion or extinction.

Supply: The amount of a good or service an individual producer or a group of producers will provide at a given price.

Supply curve: A graphical representation illustrating the positive or direct relationship between price and quantity supplied.

Supply schedule: The actual quantities that producers are willing and able to purchase at various prices.

Total utility: The total amount of satisfaction a consumer gains from the consumption of a good or a service.

Bibliography

Arnold, R. A. (2016). Economics (12th ed.) Boston: Cengage Learning.

Caballero, R. J., Cowan, K. N., Engel, E. A., & Micco, A. (2013). Effective labor regulation and microeconomic flexibility. Journal of Development Economics, 101, 92-104. Retrieved October 31, 2013, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86395650&site=ehost-live

Guell, R.C. (2009). Issues in economics today (5th ed.). Boston, MA: McGraw-Hill Irwin.

Irmak, C., Wakslak, C. J., & Trope, Y. (2013). Selling the forest, buying the trees: The effect of construal level on seller-buyer price discrepancy. Journal of Consumer Research, 40, 284-297. Retrieved October 31, 2013, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89022202&site=ehost-live

McConnell, C. R., Brue, S. L., & Flynn, S. M. (2016). Economics: Principles, problems, and policies (21st ed.). Dubuque, IA: McGraw-Hill Education.

Pearce, D. W. (Ed.). (1992). The MIT dictionary of modern economics. Cambridge, MA: MIT Press.

Microeconomic Theory

On this Page

Subject Terms

Microeconomic Theory

Abstract

Overview

Application

Assumptions

Demand

Terms & Concepts

Bibliography

Suggested Reading