- Microeconomics focuses on individual economic actors in allocating resources and making choices.
- Each economic actor is rational and makes decisions based on marginal analysis.
- Producers and consumers interact in the market, forming supply-demand forces.
- The supply-demand interaction produces an equilibrium price and quantity, representing the best possible outcome for them.
- However, such market mechanisms do not always work, and market failures arise.
What is Microeconomics?
Microeconomics is a branch of economics focusing on individual economic agents. It is different from macroeconomics, another branch. The latter studies the economic agents in the aggregate. It focuses on the overall economic performance.
Microeconomics gives you insight into what are the consumers’ and producers’ goals? How do they decide to allocate resources? How do they maximize satisfaction and profit? How do they interact in the market? Economists also explain how external interventions, such as governments, affect market outcomes.
Demand, supply, and market are the main topics. Economists then detail how supply and demand arise? How do they produce the best results for consumers and producers? And what if the results do not match the ideal model?
Guide To Understanding Economics
Why is Microeconomics Important?
Microeconomic knowledge is useful in our daily life. For example, if you are a marketer, it helps you set the right price to maximize profit.
If you are an investor, microeconomics helps you assess the effectiveness of a company’s strategy. For example, you want to determine if a company can increase revenue by cutting prices. What will happen to the demand? Will the company sell more, more than the percentage cut price?
What Topics Are Covered In Microeconomics?
In general, microeconomics addresses two main concepts: supply and demand. Economists then break it down into several topics to answer the following questions:
- What is the goal of individual consuming goods and services?
- What is the goal of business offers goods and services?
- How do consumers and producers make decisions to allocate their resources and achieve their goals?
- How do both supply and demand interact in the market?
- How do companies compete with each other?
- Do their interactions result in an efficient allocation of economic resources?
- Why is resource allocation inefficient in some markets?
- Should the government intervene in the market? What is the impact?
Economists assume we are rational economic beings. In a sense, we seek to maximize our interests in allocating resources. For example, as consumers, we seek to maximize the utility of consuming goods and services. Meanwhile, as business owners, we strive to maximize profits from selling our products and services.
Because we face scarcity, allocation requires us to make choices. We may not take all the alternative options; some we don’t choose. From there, opportunity costs arise. It represents the next best alternative to the choices we make.
In addition, microeconomics relies on ceteris paribus assumptions. The microeconomic phenomenon is complex. It requires simplification to explain. Economists then focus on the most important, one or two variables. Next, they isolate the other factors’ effects beyond what is being described. Finally, they consider other factors constant, unchanging, or ceteris paribus.
Economists assume consumers aim to obtain satisfaction when consuming goods and services. So then, they introduced the theory of consumer choice. It describes how they satisfy their needs and wants and how they make decisions in allocating resources.
Consumers inherently have unlimited wants. However, they have limited resources. Their budget is not enough to buy all the goods and services they want. So, they have to make a decision on which item to choose, according to their budget.
- Consumer choice – Selecting or making decisions about which goods and services to choose.
- Consumption bundles – Items selected to satisfy needs and wants. Also known as the consumption basket.
Economists use three assumptions to explain consumer choice.
- Complete preferences. If faced with two bundles of product choices, a consumer can state which bundle is preferred.
- Transitive preferences. Take a simple example. A consumer compares three different bundles: A, B, and C. Each contains a combination of several products. Say he prefers A over B. Then, over C, he prefers B. So, we can conclude he prefers A over C.
- Nonsatiation. Consumers would rather have more of a good than have less because they are not at the maximum level of utility.
Economists introduce the term “utility” as a measure of satisfaction from consuming goods and services.
- Total utility means the total satisfaction obtained, measured in units of utils.
- The utility function is used to represent the satisfaction value for each combination of goods. The general function is U = f(Q1, Q2, …, Qn), indicating utility is a function of the quantity (Q) of various goods, from 1 to n.
Marginal utility represents the additional satisfaction gained from consuming one more unit. It is equal to the change in total utility divided by the change in the quantity consumed.
- Most goods provide diminishing marginal satisfaction.
- The law of diminishing marginal utility says, “the satisfaction obtained from consuming the next unit will be less than the utility obtained from consuming the last unit.”
- For example, each extra plate will give you less satisfaction when you eat because you are getting fuller.
- This law is important in explaining why the demand curve is downward sloping – we are willing to pay a lower price for each additional unit consumed.
Utility maximization – a consumer chooses what gives him the greatest total utility (highest satisfaction). Therefore, he had to spend his limited money on the best things, giving him the most marginal utility per dollar.
- The utility-maximization rule states: “utility is maximized when the marginal utility per dollar spent on all items equals the available budget.”
Which bundle is the most satisfying? Which one fits within the available budget? Economists answer both in indifference curves and budget lines. Then, the point of tangency between the two curves determines the consumer equilibrium.
The indifference curve shows the various potential consumption bundles to choose from because they produce equal utility. In practice, a bundle should contain various combinations of goods or services. But, economists usually use two goods to simplify the explanation, say good X and good Y.
- Points A, B, and C give the same satisfaction, although good X and Y proportions are different.
- Say a consumer chooses bundle A. He is willing to replace some of Y with good X and chooses bundle C with the same satisfaction.
- The marginal rate of substitution is the rate at which a consumer is willing to substitute one good for another and remain equally satisfied. It is represented by the slope at each point on the indifference curve.
Is the bundle selected only one?
- An indifference curve map shows a collection of indifference curves. Each curve has a different total utility level. The curve on the right/higher gives higher total satisfaction than the one on the left.
Having decided on the best potential bundles to choose from, now, consumers are looking at their money. Are the bundles within their budget? Economists then explain another topic, budget constraints.
The budget constraint represents the resources (money) owned by consumers. It limits the consumption bundle they can buy. Also known as income constraints.
Consumers may have many bundles to choose from. But, in the end, it all depends on the income. And, in total, the value of all the selected goods does not exceed their income.
- The budget line shows the different combinations of two items they can buy on their available budget. Along the curve, consumers spend all their income on these two goods.
Now, which bundle is right and within the budget?
Consumer equilibrium occurs when utility is maximum and within budget. That is, a consumer chooses the right bundle. And it’s still within his budget limit. In a graph, it is reached when the indifference curve is tangent to the budget line. Beyond that point, satisfaction may be higher, but budget is not enough. Or the bundle doesn’t maximize the available budget.
The price effect tells you what happens when the price of an item changes? Why, when it goes down (up), the quantity demanded to go up (down) as the law of demand said? Are there items that violate the law?
If the price of an item changes, it has two effects:
- Substitution effect
- Income effect
The substitution effect represents the change in quantity demanded caused by the change in its price relative to the price of another good. The income effect is related to the consumer’s real income.
Normal goods are positively related to consumer income (positive income elasticity). Higher incomes increase the demand for them. If their price drops:
- The substitution effect is positive. Demand increases because consumers switch from substitute products and ask for normal goods because they are relatively cheaper.
- The income effect is positive. Because prices are lower, they can buy more for the same amount of money (real income rises), so demand increases.
The positive income effect and the positive substitution effect reinforce each other. Thus, the demand for normal goods increases. The curve is downward sloping.
Inferior goods have a negative income elasticity. If income rises, consumers decrease demand for them and vice versa. If their price drops:
- The substitution effect is positive. Consumers switch from substitute products.
- The income effect is negative. Consumers’ real income rises, demand falls.
The negative income effect is partially offset by the positive substitution effect. As a result, demand increases but not significantly (less elastic). The demand curve remains downward sloping.
Giffen goods are a specific case of inferior goods. So, an increase in income reduces the demand for them. If their price drops:
- The substitution effect is positive. Giffen goods consumption increases as consumers switch from substitute products.
- The income effect is negative. A fall in prices increases real incomes, reducing the demand for them.
The negative income effect outweighs the positive substitution effect. Thus, the demand for Giffen goods will fall when the price falls. As a result, they have an upward or positive slope of the demand curve, violating the law of demand.
Veblen goods are goods where an increase in price causes an increase in demand for them. They have an upward-sloping demand curve, violating the law of demand. Increased price causes an increase in demand.
Higher prices increase utility because they convey a higher status as in demand for luxury goods. Because of this, some consumers like them and are eager to buy when prices go up.
The theory of the firm discusses how companies use factors of production to achieve their goals. Like consumers, producers also have limited resources. Therefore, they have to make economic decisions in allocating resources.
Economists assume the company’s goal is to maximize profits. Therefore, the company strives to generate as much profit as possible. It is achieved when marginal cost equals marginal revenue (MC = MR).
In practice, apart from maximizing profit, other goals may be:
- Revenue maximization. The company tries to generate as much revenue as possible. For this reason, they choose to produce at the output level where marginal revenue is zero (MR = 0).
- Satisficing. They are trying to get enough profit instead of maximum. They focus on pragmatic efforts and achieving at least a predetermined level of profit.
- Corporate social responsibility. The company strives to balance the goals of profit, people, and the environment. They follow a set of ethical guidelines on how to conduct their business.
Profit points to the difference between total revenue and total cost. In microeconomics, economists focus on economic profit, not accounting profit. So, you will not see it in the company’s financial statements.
To maximize profit, the company must record the highest positive difference between total revenue and total cost.
Total revenue is the amount of money the company receives from selling the product. It equals the selling price per unit times the quantity sold.
Total cost is the amount paid/incurred to acquire the resource. It refers to the total economic costs, which consist of implicit costs and explicit costs.
- Implicit costs point to the opportunity costs of the resources currently used by the firm. They do not involve direct monetary payments. For example, a company buys office space. Rent is the opportunity cost if it is the next best alternative.
- Explicit costs represent monetary payments to acquire resources. Examples are the payment of wages to workers and payments of raw materials to suppliers. Also known as accounting cost.
Accounting profit equals total revenue minus total accounting cost. Also called net profit, net earnings, or net income. If total revenue is less than the total accounting cost, the company records an accounting loss.
- Accounting profit = Total revenue – Total accounting cost
- Accounting profit = Total revenue – Total explicit cost
Economic profit points to the difference between total revenue and total economic cost. If the total economic cost exceeds the total revenue, the company bears the economic loss.
- Economic profit = Total revenue – Total economic cost
- Economic profit = Total revenue – Total explicit cost – Total implicit cost
- Economic profit = Accounting profit – Total implicit cost
Normal profit is when economic profit is equal to zero.
- Economic profit = 0
- Accounting profit = Total implicit cost
- Total revenue – Total explicit cost = Total implicit cost
Production is the activity of processing inputs and converting them into outputs, which can be:
- Final output – for final use without further processing.
- Intermediate output – for further processing.
Inputs are resources used to produce goods and services. We also call them factors of production, factor inputs, or resources. They include:
Furthermore, economists divide the production period into two: the short run and the long run.
- Short run is when at least one production factor is assumed to be in constant supply, namely capital, for example, production machinery. Firms can only increase production by using more variable factors such as labor.
- Long run is the period when all input factors are variable. Firms can scale their operations by using more inputs, for example buying new machines.
Production decisions affect revenues and costs, and ultimately, profits. Companies must minimize costs to get maximum profit. Thus, they must ensure resources are used at their highest usage. In addition, production decisions also affect how much total output they can sell.
Total product (TP) is the maximum output produced by a firm using available inputs.
- Average product (AP) represents the output per unit of input used. Assume the input is labor. You calculate it by dividing the total output by the total labor employed. It measures labor productivity and shows how much output each worker produces.
- Marginal product (MP) refers to the extra output produced by adding one factor of input, assuming all other factors of production remain constant. To calculate the marginal product of labor, you divide the change in the total product by the change in total labor. Also known as a marginal return.
The marginal product can be positive, zero, or negative. Each has an effect on the company’s total output.
- Increasing marginal product is when the marginal product is positive (MP>1) and at an increasing rate. Total output increases at a higher percentage than the percentage increase in inputs. Also known as increasing marginal return.
- Decreasing marginal product is when the marginal product is positive (MP>1) but at a decreasing rate. The extra output from each additional input is lower than before. Also known as decreasing marginal return or diminishing marginal return.
- Zero marginal product is when an additional input does not produce additional output. It represents the optimum point of production (MP=0). Also known as zero marginal return.
- Negative marginal product is when an additional input reduces the total output (MP<0). Also known as a negative marginal return.
Revenue is the total payment received by the company from selling goods and services. Companies use it to pay suppliers, including wages, raw materials, interest on loans, and dividends.
- Total revenue (TR) is equal to the selling price of the product per unit times the volume sold (TR = P x Q). It is equal to the average selling price times the quantity sold if selling various products at different prices.
- Average revenue (AR) is revenue per unit sold. It is equal to total revenue divided by total output (AR = TR/Q). If the company charges a single price for all products, it will be equal to the selling price of the product.
- Marginal revenue (MR) is the extra revenue from selling one more unit. It equals the change in total revenue divided by the change in total output (MR = ΔTR / ΔQ).
- Marginal revenue product (MRP) measures the increase in total revenue from selling the additional output generated by the last unit of input factor used. It is equal to the change in total revenue divided by the change in labor employed for labor.
Costs fall into two categories based on their nature. I mean, how do they change when the company changes the output. They are fixed costs and variable costs.
Fixed costs don’t vary directly with the output level. So, if output goes up, they don’t change. And, if output falls, they also don’t change. But, when production equals zero, the company still has to bear it.
- Total fixed cost (TFC) sums all fixed costs such as machinery, equipment, rental payments, and property taxes, including all opportunity costs.
- Average fixed cost (AFC) represents the fixed cost per unit of output. It is equal to total fixed cost divided by total output (AFC = TC/Q).
Variable costs vary directly with the level of output. They go up when production goes up and fall when production goes down. But, if the outputs are equal to zero, they are also equal to zero.
- Total variable cost (TVC) sums all variable costs such as raw materials and packaging. It equals the variable cost per unit times the total output.
- Average variable cost (AVC) represents the variable cost per unit of output. It is equal to the total variable cost divided by total output (AVC = TVC/Q).
Total cost (TC) is the cost incurred by the company to produce total output. It equals total variable cost plus total fixed cost (TC = TFC + TVC).
- Average cost (average total cost or ATC) represents the cost of producing one unit of output. Also known as unit cost. To get it, divide the total cost by the total output (ATC = TC/Q) or add up the average fixed cost by the average variable cost (ATC = AFC + AVC)
- Marginal cost (MC) means the extra cost of producing one more unit of output. You calculate it by dividing the change in total cost by the change in total output (MC = ΔTC / ΔQ).
Short-run costs are costs when at least one input factor is fixed, namely capital such as production machinery. So, the company incurs fixed and variable costs.
Long-run average cost (LRAC) is the cost per unit at different output levels when all input factors are variable. In other words, no fixed costs are in the long run. The points along the LRAC curve indicate the minimum unit cost that a firm would incur to produce a given production level if it could change all factors of production.
- Economies of scale are when the LRAC decreases as output increases. Also known as increasing returns to scale.
- Minimum efficient scale refers to the lowest output at which the firm can minimize LRAC. It is the lowest point in the LRAC curve.
- Diseconomies of scale are conditions in which LRAC increases as output increases. It occurs after production reaches the minimum efficient scale.
- Constant returns to scale are when LRAC is constant as output increases. When a firm varies the size of its plant, the average total cost will also change proportionally. When a firm increases all factor inputs by 10%, output increases by 10%.
The LRAC above is about how a company’s costs change in the long run. It produces what we call internal economies of scale and internal diseconomies of scale. Cost reduction only applies to one company.
Furthermore, what happens to costs in the long run for all firms in the market as their industry gets bigger? Finally, let’s discuss external economies of scale and external diseconomies of scale.
- External economies of scale occur when long-run average costs fall due to factors beyond a firm’s control. It happens to all companies in the market. They experience a decrease in costs as the industry’s output increases.
- External diseconomies of scale are the opposite of external economies of scale. All firms face an increase in long-run average costs as the industry’s output increases.
The long-run industry supply curve shows us the relationship between the quantity supplied in the industry for different prices. It considers all possible adjustments, including changes in plant size by firms and the firm’s entry or exit to and from the market. Such adjustments contribute to whether or not all firms earn economic profits.
Under perfect competition, for example, when the demand for industry increases, prices rise. Companies enjoy economic profits. The incumbents then increase output to earn a higher income. On the other hand, it also attracts new players to enter. Eventually, industrial output increases, bringing prices down to a level at which economic profit is eliminated.
- Decreasing-cost industries – The long-term supply curve is downward sloping. The entry of new firms lowers costs for all firms. They can lower prices because they incur lower resource costs. Take the personal computer industry, for example. Increased output in the industry allows manufacturers to buy semiconductors cheaper. On the other hand, semiconductor companies face increasing demand, prompting them to increase economies of scale and invest in technological innovation.
- Constant‐cost industries – The long-run supply curve is horizontal (perfectly elastic). The entry and exit of the company do not affect the cost of production.
- Increasing‐cost industries – The long-term supply curve is upward sloping. Increased supply raises all firms’ production costs. For example, the increasing demand for the property industry in a city increases the cost of land. All companies have to pay more to buy land to develop as a project.
Demand represents the quantity consumers are willing and able to buy at a given price. It arises when consumers have the desire and resources to buy. So if they have the money but don’t want the product, it doesn’t generate demand. Likewise, if they have a desire but no money, it does not lead to demand.
- Individual demand comes from an individual. The curve is essentially a marginal benefit curve.
- Market demand equals the sum of all individual demands.
The law of demand tells us “the quantity demanded is negatively related to the price of the good.” If price rises, quantity demanded falls, ceteris paribus. And, if the price declines, the quantity demanded increases.
Then, the demand function converts the law of demand into a mathematical formula. The quantity demanded (Qd) is expressed as a function of the price (P). In a simple linear function, it is:
Qd = a – bP
Let’s convert the above into a curve. A demand curve line in a two-dimensional graph illustrates the relationship between quantity demanded and price.
- the y-axis represents price (P)
- the x-axis represents the quantity (Qd)
The curve shows a negative relationship between quantity demanded and price. The points along the line of the curve indicate the quantity demanded each possible price.
Since the y-axis is price and the x-axis is quantity, it means that price is a function of quantity demanded. So, we have to invert the above function to get the demand curve.
The inverse demand function is useful for knowing the slope of the curve. The demand curve is based on this function, not the demand function.
- Move P in the demand function above to the left of the “equal sign (=)” and Qd to its right. So, you get the following inverse query function:
P = (a/b) – (1/b) * Qd
- The slope of the demand curve is “-(1/b)” in the above equation, not “-b” in the demand function.
Furthermore, the negative slope of the demand curve is explained by the law of diminishing marginal utility. The utility represents satisfaction from consuming goods and services. Marginal means additional.
- Marginal utility represents the additional satisfaction a consumer gets from consuming one more unit.
- Each additional consumption provides decreased satisfaction. Say, when you eat a meal, each subsequent addition makes you even more full.
- Because marginal utility decreases for each additional consumption, consumers will increase consumption only if the price is lower than before.
What are the determinants of demand?
Change in the quantity demanded for a good occurs when its price changes. If the price rises, the quantity demanded falls. If it falls, the quantity demanded increases.
- Changes in quantity demanded occur along the demand curve (for example, from point A to B).
Changes in the demand for a good occur due to changes in determinants other than its price. They can be:
- Consumer income
- Price of complementary goods
- Price of substitute goods
- Number of consumers in the market
- Tastes and preferences
If they change, the curve shifts to the right or to the left. For example, from a curve at point A to a curve at point C.
Supply is the quantity producers are willing and able to sell at a given price, ceteris paribus.
- Individual supply comes from a producer. The curve is essentially a marginal cost curve.
- Market supply comes from the output of all producers in the market.
The law of supply tells us “the quantity supplied is positively related to the price.” If the price increases, the quantity supplied increases. Conversely, a decrease in price causes a decrease in the quantity supplied, ceteris paribus.
The supply function represents the law. As with demand, the quantity supplied (Qs) is expressed as a function of price (P). In a simple linear function, we write into the following mathematical equation:
Qs = a + bP
The supply curve represents the supply function above. But, again, it uses price as the y-axis and quantity as the x-axis. So, price is a function of quantity supplied. Therefore, we must find the inverse supply function.
The inverse supply function expresses price as a function of quantity. The steps are the same as the previous demand curve. And the slope of the curve is “1/b”, not “b” in the supply function.
P = (1/b)*Qs – (a/b)
The supply curve’s positive slope reflects producers are willing to supply output as long as the price is at least equal to marginal cost. The greater the positive difference between the two, the greater the willingness to supply.
- Marginal cost is higher for each additional output due to diminishing marginal returns – also known as diminishing marginal product.
- Marginal return is the extra output the firm gets when it adds one more input.
- The law of diminishing marginal return states, “the additional output for each extra input used is decreasing.”
- In the short run, producers can only add variable inputs such as labor. Meanwhile, fixed input factors, such as machines, do not change.
- Under the law, the addition of new workers only results in lower additional output than the previous new workers. At the same time, variable costs (labor wages) increase in proportion to output.
- As a result, additional costs (ΔTC) increase faster than additional outputs (ΔQ) – marginal costs (ΔTC/ΔQ) increase.
What are the determinants of supply?
A change in the quantity supplied of a good occurs when its price changes.
- The quantity supplied moves along the curve.
- For example, it occurs from point A to point B. The quantity increases from Q1 to Q2 if the price increases from P1 to P2.
Changes in supply for a good occur due to factors other than changes in its price. They include:
- Production costs such as raw material prices and wages
- Number of companies
- Future price expectations
If they change, the curve shifts to the right or to the left. In the graph, it occurs, for example, from a curve at point B to a curve at point C.
Equilibrium in a competitive market
A competitive market has many producers and consumers. Each has no power to dictate the market. And market supply forces work in the best interests of producers and, likewise, market demand for consumers.
What is equilibrium?
Equilibrium is when two forces, such as supply and demand, are in balance. When it is reached, it tends not to change. This is because no alternative has a better outcome for either force.
Market equilibrium occurs if the quantity supplied equals the quantity demanded. In the curve, you can find it at the point where the supply curve and the demand curve intersect. It represents the best outcomes (price and quantity) for both producers and consumers. Neither has any incentive to try to change prices.
- The equilibrium quantity represents the quantity at which both agree on a given price.
- The equilibrium price represents the best price at which both agree to supply and demand the goods.
The market price functions as signals and incentives. Companies and consumers must make decisions when market conditions change. Price changes serve as an incentive and signal to both of them to take action. It becomes the basis for them to make economic decisions.
- When prices fall, it incentivizes consumers to increase demand. Instead, it signals producers to lower supply.
- When prices rise, it incentivizes producers to increase supply. For consumers, it is a signal to lower demand.
- Signal and incentive functions are important for the market mechanism to work.
The market mechanism is the tendency of the market to reach its new equilibrium when there is disequilibrium – the quantity demanded is not equal to the quantity supplied. It may occur above or below the equilibrium point.
- It works if there is no external intervention. Supply and demand will change until consumers and producers agree on price and quantity.
Excess supply arises if the price is above the equilibrium point. As a result, the quantity supplied (Qs1)exceeds the quantity demanded (Qd1). Also known as surplus.
- Prices tend to be pushed down because more of a good is being supplied than demanded.
- It is an incentive for consumers to boost demand. On the other hand, it becomes a signal for producers to reduce supply.
- Increased demand and decreased supply continue until a new equilibrium is reached.
Excess demand occurs when the price is below the equilibrium point. As a result, the market faces a shortage because the quantity demanded (Qd1) exceeds the supply (Qs1). Also known as shortfall or shortage.
- Prices tend to be pushed up.
- It gives a signal for consumers to reduce demand. On the other hand, it incentivizes producers to increase output.
- Decreased demand and increased supply continue until the market reaches a new equilibrium.
Economic surplus represents the economic well-being consumers and producers obtain when transacting in the market voluntarily. Also known as total surplus, or total welfare.
- It equals consumer surplus plus producer surplus.
- If the supply curve is steeper, more surplus is captured by producers.
- If the demand curve is steeper, more surplus is captured by consumers.
- It is maximal if the market is in competitive market equilibrium.
- If there is intervention, the market can be in disequilibrium, reducing economic well-being.
Consumer surplus is the difference between the market price and the consumers’ reservation price, the highest price at which consumers demand the product.
- It represents the total well-being the consumer gains.
- They pay less than they are willing and able to pay.
Producer surplus represents the difference between the market price and the producer’s reservation price, the lowest price they are willing to accept to supply the product.
- It represents the total welfare obtained by the producer.
- They benefit from supplying goods to the market at a higher price than they are willing to accept.
Allocative efficiency occurs when price equals marginal cost (P = MC). Then, it is reached at competitive market equilibrium, where the economic surplus is maximum.
- The allocation of resources provides maximum benefits to consumers and producers.
- Total well-being is maximized.
- No other price and quantity can achieve a greater total surplus.
Deadweight loss occurs when the market price is not at the competitive market equilibrium price. It represents a loss of economic well-being – a reduced producer surplus or a reduced consumer surplus.
- A deadweight loss arises due to market failures, for example, due to price or tax controls by governments.
- Economic welfare is completely lost – it is not transferred to producers, consumers, or the government (tax, for example).
- The market does not allocate resources to their best use.
An auction market is a place where products are offered to the public through a formal and competitive bidding process. That is one way to find the equilibrium price. There are several types of auctions.
A common-value auction is an auction in which the item has the same value for all bidders. But, they do not know its exact value. Each of them estimates its value, and it varies. The value is known after the auction is completed and the price is disclosed.
A private-value auction is an auction in which the actual value of the item is subjective. It depends on each bidder. Painting auctions are a good example. What is the actual value of a painting? It depends on how much they value it. There is no right or wrong because paintings have no fixed price.
An ascending price auction is an auction in which participants publicly disclose their bids. The auctioneer begins bidding at a certain price. Then, if someone bids higher, the price goes up. This continues until no one bids higher. The winner is the highest bidder and pays that amount.
A sealed-bid auction is an auction in which all bids are made simultaneously in a sealed envelope. The auctioneer then opens the envelope and announces the winner. There are two types of the price paid: first-price sealed-bid auction and second-price sealed-bid auction (or Vickrey auction).
- Under a first-price sealed-bid auction, the winner is the highest bidder and pays as much as he bids. It can invoke a winner’s curse, in which the winner pays more than the actual value of the item being auctioned off.
- Under a second-price sealed-bid auction, the winner is the highest bidder but pays the second-highest bid price. So, that wasn’t the price he bargained for.
Descending price (or Dutch auction) is an auction in which the auctioneer starts at a high price, usually for items sold per unit. The winning bidder can buy as many units as he wants at that price. If the unit is still available, the auctioneer then lowers the price. This continues until all items are sold.
Elasticity measures how responsive a variable when its determinant variables change, like the demand for a product with its price. The calculation is relatively easy. Divide the percentage change in the main variable by the percentage change in the determining variable.
Microeconomics usually deals with the following types:
- Own-price elasticity of demand
- Cross-price elasticity of demand
- Income elasticity of demand
- Price elasticity of supply
Own-price elasticity of demand (PED) uses the variable quantity demanded an item and its price. First, get the percentage change in quantity demanded. Then, divide it with the percentage change in price. Ignore the negative sign (see the law of demand).
- Perfectly inelastic demand (PED = 0). Price changes have no impact on the quantity demanded.
- Inelastic demand (0 < PED < 1). If the price changes by 5%, the quantity demanded changes by less than 5% but above 0%.
- Unit elastic demand (PED = 1). If the price changes 5%, the quantity demanded changes 5%.
- Elastic demand (1 < PED < ∞). If the price changes by 5%, the quantity demanded changes by more than 5%.
- Perfectly elastic demand (PED = ∞). The change in quantity demanded is infinite even if the percentage change in price is zero.
Cross-price elasticity of demand (XED) measures how sensitive the demand for good X when the price of the related good (good Y) changes. First, get the percentage change in the quantity demanded of good X. Divide it by the percentage change in the good Y’s price.
- Substitute goods (XED > 0). If the price of good Y increases, the demand for good X increases. They replace each other like Coca-cola and Pepsi.
- Complementary goods (XED < 0). If the price of good Y increases, the demand for good X decreases. They are consumed in conjunction with other items, such as ink cartridges with printers.
Income elasticity of demand (YED) shows how responsive the demand for a good is if consumer income changes. First, get the percentage change in demand. Then, divide that by the percentage change in income.
- Luxury goods (YED > 1). They are income elastic. Their demand is sensitive to changes in consumer income. If income rises by 5%, demand increases by more than 5%.
- Necessities (0 < YED < 1). They are income inelastic. Their demand is less responsive to changes in consumer income. If income rises by 5%, demand increases by less than 1%.
- Inferior goods (YED < 0). A rise in income causes their demand to fall.
- Luxury goods + Necessities = Normal goods. Their demand increases when income increases. Conversely, a decrease in income reduces demand.
Price elasticity of supply (PES) measures how sensitive the quantity supplied of a good is to changes in its price. First, calculate the percentage change in quantity supplied. Then, divide that by the percentage change in price.
- Perfectly inelastic supply (PES = 0). Price changes do not affect the quantity supplied.
- Inelastic supply (0 < PES < 1). If the price changes by 5%, the quantity supplied changes by less than 5% but above 0%.
- Unit elastic supply (PES = 1). If the price changes 5%, the quantity supplied changes 5%.
- Elastic supply (1 < PES < ∞). If the price changes by 5%, the quantity supplied changes by more than 5%.
- Perfectly elastic supply (PES = ∞). Any price change will cause the quantity supplied to be infinity, even if it is zero.
Point elasticity is calculated using one point as the divisor. Under this method, the elasticity values will differ when using different points for the same demand curve. But, supposedly, both are the same.
Arc elasticity overcomes the weakness of point elasticity. It uses the midpoint as a divisor. In addition to overcoming inconsistencies in point elasticity, this method is also useful when no general function defines the relationship between two variables.
Government intervention refers to deliberate actions by the government to influence the market. It may prevent markets from functioning freely and lead to inefficiencies in allocating resources, leading to government failure. Taxes and price controls are examples.
Policies do not provide better results or improve conditions. In fact, even worse, it might lead to new failures. Some reasons include political corruption, rent-seeking, principal-agent problems, and special interest effects.
Price control is government intervention by setting legal prices for goods and services. It aims to protect one of the economic actors, consumers or producers. The equilibrium price is considered too high or too low, to the detriment of one of them. The two types are price ceiling and price floor.
The price ceiling refers to the maximum price allowed by the government to be charged for goods or services. The government considers the market price for a good or service too high. Thus, the government imposes it and sets it below market equilibrium. Sellers can’t sell at a price higher than it.
Rent control is an example. Landlords can not demand payment higher than the rent determined by the government. It aims to maintain affordability.
But, it results in market failure because the market is in disequilibrium. More goods are demanded than supplied, so the market faces a shortage.
Such a situation is likely to give rise to a black market. Producers will secretly offer goods to those who are willing to pay a higher price.
The price floor refers to the legal minimum price for selling goods or services. The government considers the market price too low. Thus, the government imposes a price floor and sets it above the competitive market equilibrium price. It aims to protect suppliers from a too-low price.
Because prices are above equilibrium, the market faces more goods and services being supplied than demanded. As a result, it leads to excess supply.
The minimum wage is an example. In the labor market, supply comes from households. Meanwhile, demand comes from companies. Assuming it’s too high than it should be, the company is reluctant to hire more workers.
Taxes are government levies to the private sector. It can be collected directly from the taxpayer or indirectly.
- Direct tax is levied on the profit or income of the taxpayer. Examples are income taxes, capital gains taxes, and corporate taxes.
- Indirect tax is levied on products. Examples are sales tax or value-added tax.
How are indirect taxes levied? There are two ways:
- Specific tax – collected as a fixed amount of money per unit. For example, the tax on a product is $10 per ton.
- Ad valorem tax – levied as a percentage of a good’s price, for example, at 10% of the price.
What is the impact of taxes on producers and consumers?
Tax burden refers to the total welfare loss due to taxation. It is also interpreted as the amount of tax paid by the taxpayer.
Tax incidence is about how the tax burden is borne and shared between consumers and producers.
- Consumers bear most of the tax burden if supply is more elastic than demand.
- Producers bear most of the tax burden if demand is more elastic than supply.
Subsidies are payments to producers per unit of output. It aims to encourage more production, lower selling prices, or make producers more competitive, for example, in international markets.
- Market supply increases.
- Now, businesses produce more at a lower price for each quantity.
- The supply curve shifts to the right.
Subsidies may ameliorate market failures, particularly those caused by underconsumption. But, it also carries a significant opportunity cost. For example, the government spends a lot of money on subsidies in a market, which, in fact, could be allocated to other, more vital expenditures.
Market failure occurs when the market does not allocate resources efficiently. The market is not in perfect competition equilibrium. It leads to overallocation or underallocation of resources. Too much or not enough of a good is produced or consumed.
- Government intervention such as through price and tax controls
- Externalities resulting from consumption and production activities
- Insufficient production of public goods
- Asymmetric information because one party knows better than the other
- Abuse of monopoly power under imperfect competition
Externalities are side effects or consequences of an economic activity borne by third parties, not those who participate directly. It may be positive and generate benefits, or negative and generate costs.
Such benefits and costs should ideally be taken into account in making economic decisions. But, often, it is not. As a result, it leads to market failure, and marginal social benefits are unequal to marginal social costs.
- Marginal external benefit (MEB) – Additional benefit to a third party when one more output unit is consumed or produced. It represents the benefits of positive externalities of consumption such as education or production such as technological innovation.
- Marginal private benefit (MPB) – Additional benefit obtained by an individual when consuming one more unit. It is the marginal benefit if there are no externalities.
- Marginal external cost (MEC) – Additional cost charged to a third party when one more good is consumed or produced. They are costs resulting from negative externalities of consumption such as fossil fuels used by consumers or production such as waste by companies.
- Marginal private cost (MPC) – Additional cost incurred by a business when it produces one more unit of output. It is the marginal cost if there are no externalities.
- Marginal social benefit – Marginal private benefit plus marginal external benefit (MPB + MEB).
- Marginal social cost – Marginal private cost plus marginal external cost (MPC + MEC).
Negative externalities incur costs to third parties without any compensation being paid. Therefore, they lead to a situation where the marginal social cost is greater than the marginal private cost.
- Demerit goods – Goods whose consumption raises external costs. They are considered unwanted by society and overproduced by the market. Cigarettes, alcohol, and illegal drugs are examples.
- Greenhouse gases – Harming society at large because they cause pollution. The impact may not only be felt in a country but also globally through the global warming effects.
Taxation, government regulations, and tradable emissions permits are among the ways to reduce problems caused by negative externalities.
- Tradable emissions permits are licenses to determine the maximum level of emissions produced by a company. Suppose they push the pollutant level lower than the level set by the permit. In that case, they can sell the additional permit on the market. On the other hand, if they need to emit more pollutants than the prescribed level, they can buy more permits in the market.
Positive externalities generate benefits to third parties without having to pay for them. Thus, they result in the marginal social benefit exceeding the marginal private benefit.
- Merit goods – Goods whose consumption positively impacts and is desired by society but is not provided by the free market. Examples are basic education and basic health care.
- Technological innovation – Benefits are enjoyed by companies developing technology and society, and other companies.
Governments seek to encourage positive externalities in several ways, including subsidies, legislation, or advertising to influence behavior. It may also be through direct procurement, such as by building health and education facilities.
The Coase theorem states some externalities can be resolved through negotiations between the affected parties without government intervention. Therefore, it is possible, as long as the transaction fees are low enough. In addition, property rights must also be well defined, and the market operates under perfect competition.
Insufficient public goods
Goods are divided into four categories based on the following two characteristics:
- Rivalrous – consumption by one person reduces its availability to another.
- Excludability – the producer’s ability to prevent non-payers from obtaining goods.
|Rivalrous||Private goods||Common goods|
|Non-rivalrous||Club goods||Public goods|
- Private goods – rivalrous and excludable. Their consumption by one person reduces availability to another. Producers can also charge prices, so they can exclude non-payers. Your everyday items like clothes, shoes, bags, smartphones are examples.
- Club goods – excludable and non-rivalrous. Even if it is used by one person, it does not reduce the availability for others. But, to get these items, not everyone can do it. Producers can exclude non-payers by setting a price. A good example is a cinema, where you pay to enjoy it and can not prevent others from benefiting the same.
- Common goods – rivalrous and non-excludable. One person’s consumption reduces their availability to another. But, producers cannot prevent non-payers from consuming them. Wood in the forest, fish in the sea, and metallic minerals are examples – they are also called common access resources.
- Public goods are goods with non-rivalry and non-excludability characteristics. Consumption by one person does not reduce their availability to another. And suppliers cannot exclude anyone from getting goods and services, whether payers or non-payers. Examples are street lighting, national defense, lighthouses, and courts.
Free riders refer to those who benefit from public goods but do not pay for them. For example, everyone has protection from the police, whether they pay taxes or not.
- The free-rider problem causes private companies to be unwilling to provide public goods – unprofitable.
- The government can solve this by providing its own public goods using taxes.
Common-access resources, for example, common goods. They are owned by no one, have no price, and are available for anyone to use.
Take the example of wood in the forest. Since it’s free, everyone can cut it down. But, if some people cut down, its supply decreases for others. And if everyone does it, deforestation takes place rapidly. It gives rise to what we call the tragedy of the commons.
Several ways are to address this, for example, through legislation, cap and trade schemes, carbon taxes, and funding for green technologies.
- Cap and trade schemes set limits on the number of pollutants a company can legally emit and allow it to trade on the open market. The company sells (exchanges) its emission reductions to other companies whose emissions exceed the permissible limits.
- Carbon taxes are levied on carbon-based products such as oil, natural gas, and coal, contributing to greenhouse gas emissions. Taxes are expected to reduce the demand for them.
Asymmetric information occurs when one party has better information than the other in a transaction. Those with more access to information try to maximize their own profits.
For example, sellers may have more information about their products than buyers. They then charge higher than the fair market price to the detriment of consumers.
In other cases, the curator (buyer) knows more about the value of the antique than the owner. Therefore, he tried to bid a lower price than he should have. The owner, not knowing the true value of the item, took it for granted.
Information asymmetry can lead to market failure. This is because the price doesn’t reflect the equilibrium price.
Abuse of monopoly power
Monopoly power refers to the firm’s ability to raise prices above marginal cost. In other words, the firm can charge a higher price than the perfectly competitive equilibrium price. And we can measure it with the Lerner index.
Under perfect competition, firms do not have monopoly power. It exists only in imperfect competition, where firms can do so through differentiation or market dominance.
Solution: The government can prevent the abuse of monopoly power by several means, such as antitrust laws and trade and investment liberalization. Both are important to promote more competition, reduce the monopoly power of a company.
Another way is through nationalization (as opposed to privatization). The government buys the company and puts it under control. Now, the government decides how much the product will sell for. This method is common for strategic industries.
Market structure is the arrangement and relationship between elements in a market. It has an impact on competition and profitability. It affects whether the company can preserve long-term economic profit or not.
The four market structures discussed are perfect competition, monopolistic competition, oligopoly, and monopoly. The last three we call imperfect competition. Each serves many consumers. However, they differ in:
- Number of producers and their sizes
- Barriers to market entry and exit
- Pricing power
- Product characteristics offered
- Competition basis
- Availability of substitution
Here are several terms you may come across when learning about market structure:
Barriers to entry are any barriers for new players to enter the market. The new firm entry increases market supply, lowers market selling prices, and lowers profitability.
- Strategic barriers are built by incumbent players, for example, through predatory pricing.
- Structural barriers are due to the nature of business industries, such as significant economies of scale.
Barriers to exit also affect market profitability. If the exit barrier is high, it causes less efficient firms to stay in the market. Pressure on profitability is also even higher if barriers to entry are low because market supply is difficult to reduce.
Pricing power refers to a company’s ability to raise prices without reducing demand for its products. The more price power a company has, the easier it is to raise prices.
Differentiated products serve the same needs but in different ways. Some may be relatively similar to each other, thus acting as close substitutes.
- Homogeneous products are considered identical by consumers. They are standardized and act as perfect substitutes for each other under perfect competition.
Non-price competition is when companies outperform each other through non-price variables, such as features, quality, image, warranty, customer service, and advertising. Branding is also important for building a product’s brand image and making it easier for consumers to identify the product, making demand more price inelastic.
- Price competition is when a company tries to beat competitors by offering lower prices. That could lead to a price war.
Excess capacity occurs when demand is insufficient to make production capacity operate optimally. It leaves production facilities idle when demand is low.
Perfect competition or competitive market is a theoretical market structure in which firms act as price takers.
- Many companies operate in the market. They are similar in size and relatively small compared to market size.
- Each company offers identical products for sale. They are homogeneous products and are perfect substitutes for each other.
- Entry and exit barriers are minimal. Firms are easy to enter and exit in response to market profitability.
- The company has no pricing power. They are only price takers, taking the market price as their selling price.
- There is perfect information in the market. Producers and consumers have full and equal access to market information such as prices, product quality, benefits, market demand, or supply.
- There is no non-price competition. Consumers buy only for price reasons, for no other reason because the product is homogeneous.
Profit maximization. In the short run, firms in perfectly competitive markets can earn an economic profit, normal profit, or economic loss, depending on the position of the demand curve relative to average costs.
- Economic profit: if the price is higher than average cost (P>AVC)
- Normal profit: if price equals average cost (P=AVC)
- Economic loss: if the price is less than average cost (P<AVC)
But, in the long run, the company will only earn normal profits.
- When a company earns an economic profit, it attracts new players to enter, increasing supply and lowering prices. Profits go down.
- Conversely, if it loses, some companies will leave the market. It reduces the supply and raises prices. Prices rise until normal profits are earned by all remaining firms.
The shutdown point is a critical point at which a company decides whether to close its business or not.
- In the short run, it is the point at which average revenue equals average variable cost (AR = AVC). Under perfect competition, price equals average revenue (P = AR). Thus, if prices are below average variable costs, the firm closes.
- In the long run, it is when price equals long-run average cost (P = LRAC). When prices are lower, companies close and exit the market.
Efficiency measures how well we use resources at their maximum potential. Allocative efficiency and productive efficiency are achieved under perfect competition.
- Allocative efficiency – firms produce at the point where average revenue (price) equals marginal cost (P=MC).
- Productive efficiency – the company produces the product at the lowest possible unit cost, i.e., at the minimum average total cost.
Firms have absolute market power over the price, output’s quantity and quality in a monopoly market.
- There is only a single firm (monopolist) in the market. Thus, the firm’s output and selling price represent market output and price.
- Significant market entry barriers. The monopolist does not face the new competitor threat.
- Products are highly differentiated and have no close substitutes. Consumers find it difficult to find alternative products, forcing them to buy company products.
- The company has significant pricing power. Apart from being the sole supplier, the monopolist also does not face the threat of new entrants and substitutes.
- The firm acts as a price maker and can determine the price by itself.
Various factors give rise to the monopoly, including control over important production sources, government authorization (such as natural monopolies), patents or copyrights, and network effects.
Profit maximization. This is achieved when the firm produces output at a marginal cost equal to marginal revenue (MC = MR). The monopolist can profit in both the short and long term because new firms cannot enter the market. In pursuit of maximum profit, there is neither allocative nor productive efficiency.
In some industries, such as electricity and telecommunications, a monopoly is a viable option. These industries have significant fixed-cost structures. For this reason, they require significant economies of scale to lower average costs, and therefore, prices.
Such an industry is feasible with only a few, even one player. In this way, producers can achieve more significant economies of scale to lower average costs and selling prices. However, to reduce the abuse of monopoly power, they are usually under the ownership or tightly regulated by the government.
X-inefficiency occurs when the firm has no incentive to control production costs. The lack of competition in a monopoly market leaves firms with no incentive to lower costs and innovate. Finally, they are inefficient in allocating resources.
Price discrimination is a pricing practice in which companies charge different consumers with different prices for the same good.
- First-degree price discrimination – Sets the price according to the reservation price of each customer, the maximum price they are willing to pay. Also known as perfect price discrimination.
- Second-degree price discrimination – Discriminates in price based on the quantity purchased.
- Third-degree price discrimination – Discriminates in price based on non-price and non-volume variables such as education or employment.
This market is similar to perfect competition. It consists of many companies, and their business sizes are relatively similar. In addition, however, the company has some market power.
- Many companies operate in markets of relatively uniform size. They cannot influence the market through production volume.
- The products offered by each company are similar but not identical. They act as close substitutes for each other.
- Firms compete through a non-price strategy. They differentiate products through aspects such as advertising.
- Entry and exit barriers are low. Thus, prices change as players enter and leave in response to market profitability.
- Firms have some degree of pricing power. They can sell the product above marginal cost.
Profit maximization. The firm operates at a marginal cost equal to marginal revenue. The company may earn economic profit in the short run. But, because the barriers to entry are low, it will only amount to normal profits in the long run as new companies enter the market and lower prices.
Allocative and productive efficiency is not achieved under a monopolistically competitive market, both in the short and long term.
An oligopoly is a market structure with a few players with a small number of firms dominating the market.
- There are few companies with varying business sizes.
- Firms offer differentiated or homogeneous products (as in the petroleum market), which act as close substitutes.
- There are high entry and exit barriers.
- Firms enjoy substantial pricing power.
- Competition is generally based on non-price strategies such as quality, features, and marketing. Price competition is considered rare, although it is possible, especially when they offer a homogeneous product.
There are several models to explain pricing strategies and how firms compete in oligopoly markets.
A kinked demand curve is a curve with two slopes. Players respond asymmetrically. If a company lowers its price, competitors will follow. However, if the price increases, competitors will not follow suit. Also called the pricing interdependence model.
The Cournot model assumes that firms produce homogeneous goods. Each firm treats the competitors’ output as fixed. In other words, they assume competitors do not change the current output. And all firms decide simultaneously about how much to produce.
- In the duopoly model, when the firm operates at its profit-maximizing production level, the quantity and price equilibrium lies between a monopoly market and perfect competition.
Nash equilibrium is the result of game theory when each player plays their dominant strategy simultaneously. They have no reason to change behavior and choose reward maximizing actions with the actions of other players in mind. However, they ignored the effect their actions had on other players’ rewards.
- The game theory concerns optimal decision-making when all players are considered rational. Each acts strategically by anticipating the possible actions and reactions of its competitors.
Bertrand competition explains that each firm competes on price rather than quantity. They produce homogeneous goods. Thus, the switching costs are low. No reason is for consumers to prefer one product over another except for price reasons.
- Equilibrium is reached when the firm charges a price equal to its unit cost. When a company charges a higher price, consumers will switch to another competitor.
The Stackelberg model assumes that companies make decisions sequentially. So first, one firm determines its output. Then other companies followed suit. Also known as the dominant firm model.
Strategic behavior is the company’s action to maximize its own economic interests by taking into account the expected reaction of competitors. Companies may also try to take action to influence the future behavior of other companies.
Collusion occurs when two or more companies act together to reduce competition in the market.
- Tacit collusion – companies coordinate prices by looking at each other without involving a formal agreement, for example, through price leadership.
- Formal collusion – the company agrees on a price by making a formal agreement, usually signed in secret without going public.
A cartel is a special case of formal collusion, in which firms coordinate explicitly to influence market prices. It is communicated openly to the public. The Organization of the Petroleum Exporting Countries (OPEC) is a good example.
Identify market structure
The concentration ratio measures market power by several players, for example, the four largest players. It is calculated by adding up their market share.
The Herfindahl‐Hirschman index adds up the square of each firm’s market share. It ranges from 0 (perfect competition) to 10,000 (monopoly).