Microeconomics is a subset of economics that focuses on the actions of the individual participants in the economy, including individual consumers and businesses.
Unlike macroeconomics, which focuses on understanding and modeling collective behavior, microeconomics is the study of the decision-making process of individual entities within an economy. The branch of microeconomics that focuses on individual household consumption is called consumer theory, and the branch that covers business output is called producer theory. According to microeconomic theory, consumers act to maximize the utility of goods and services they purchase, whereas producers act to maximize profits.
Microeconomics is based mainly on the model of supply and demand. The model of supply and demand is simply a measure of the number of goods and services producers are willing to produce and sell at different prices and the quantity consumers are willing to purchase at those same prices. Supply, demand and price are three key variables in economics.
Demand is the quantity of a good or service consumers are willing or able to buy at a particular price. Likewise, supply is the amount of a good or service a producer is willing or able to sell at a particular price. According to the law of supply and demand, demand for a commodity varies inversely with its price if all other factors are consistent. In other words, the higher the price of a commodity, the lower the demand.
By plotting curves of supply and demand for a good or service at different price points, economists can predict how an individual consumer or producer will respond to a particular set of economic circumstances. The price at which the supply curve intersects the demand curve represents the equilibrium price and equilibrium quantity. Changing economic conditions may shift the market away from this theoretical equilibrium point, but individual actors within the economy will act to bring the market back toward the equilibrium point by increasing and decreasing production and consumption.
Macroeconomics is the study of the economy as a whole, including broad factors such as employment, gross domestic product and inflation. Microeconomics focuses on particular markets and individual actors within those markets, including supply and demand interactions for specific goods and services.
Macroeconomic studies tend to focus on a specific country, region or government. Microeconomic studies usually target particular industries or markets, such as the auto market, the oil and gas industry, or the travel industry.
There are at least seven general principles of economics that are central to microeconomic analysis.
- Supply and demand. Price, supply and demand are all related, and consumers and producers will behave in a way to bring these factors toward equilibrium.
- Opportunity cost. Consumers have limited resources and unlimited choices of how to spend their money. Opportunity cost is the cost associated with a consumer spending money in a manner that is less than optimal. In other words, when a consumer buys a particular good or service, all the other mutually exclusive purchases the consumer chose not to make represent the opportunity cost, often described as the cost of missing out.
- Law of diminishing marginal utility. This law states that the more of a product or service a consumer purchases at once, the less demand there will be for more of the same product or service. For example, a hungry consumer may pay $50 for a 16-ounce steak at a restaurant, but it's unlikely that they will be willing to pay for a second steak at the same price on the same night.
- Giffen goods. Giffen goods are non-luxury items, such as bread, wheat and gasoline, for which demand tends to rise as prices rise.
- Veblen goods. Veblen goods are luxury items considered socioeconomic status symbols, such as sports cars, jewelry and yachts, for which demand tends to rise as prices rise.
- Income and elasticity. Elasticity measures the change in demand for a product or service as its price changes. There is a positive correlation between a consumer's income and demand for superior goods and services.
- Substitution and elasticity. When the price of a good or service gets so high consumers can no longer afford it, they will often purchase a cheaper alternative.
Microeconomics principles can be applied to understand common household or business budget decisions and financial situations. Homebuyers comparing interest rates on mortgages, an individual shopper choosing one brand or product over another, a business investing in capital goods to expand its business, and two businesses competing for customers in the same market are all examples of situations that can be studied and modeled based on microeconomic principles.
Economists also use microeconomic principles to predict how demand for a product or service will be affected by a price change or how much a company may dial back production as input costs rise.
Nobel Prize laureate and Norwegian economist Ragnar Frisch first discussed "micro-dynamic" and "macro-dynamic" economic analysis in 1933. In 1942, economist Joseph Alois Schumpeter came up with the idea of creative destruction, stating that old and outdated products and firms will be replaced by newer ones. In 1957, economist Gary S. Becker published a groundbreaking microeconomic analysis suggesting discrimination against minority groups is economically harmful to the majority group. Other famous microeconomic thinkers include Alfred Marshall, Ronald Coase, Elinor Ostrom, William Vickrey, George Akerlof, Joseph Stiglitz, William Baumol, and Arthur Cecil Pigou.
Microeconomics is important to investors when making decisions on where to put money. Macroeconomic factors such as rising interest rates or declining GDP can bring down the valuations of most stocks in the market. However, the relative valuations of different market sectors and different stocks within a single sector or industry are often dictated by microeconomic principles. For example, the war in Ukraine disrupted the global supply of Russian oil, leading to higher U.S. oil prices and soaring oil stocks – even as much of the rest of the stock market dropped.
- Granularity. In contrast to macroeconomics, microeconomics provides investors and economists with a more detailed, nuanced understanding of what's happening in the economy at the sector, industry or company level. By understanding the decisions of individual consumers and producers, economists can extrapolate that behavior to model shifting economic dynamics on a much larger scale.
- Corporate decision-making. Businesses use microeconomics to make decisions about which products or services to produce, what prices to charge and how much they should produce.
- Consumer research. Consciously or unconsciously, consumers use principles of microeconomics to balance their budgets or even choose which products and brands they purchase at the grocery store.
- Assumed rationality. Some of the theories of microeconomics assume producers and consumers are rational actors, but there are times they act irrationally. During periods of market bubbles and panics, prices and demand can skyrocket or plummet based more on psychology and emotion rather than on changes in supply.
- Assumed efficiency. Microeconomics principles also assume a market is efficient, which is not always the case. In the event of a monopoly, for example, one entity controls the entire market supply and can set artificially high prices regardless of supply and demand.
- Narrow focus. For investors, focusing too much on the microeconomics of a company or sector can lead to blind spots when it comes to the big picture. A company may have the best microeconomic metrics within its industry, but its stock price will likely still drop if a deteriorating macroeconomic environment triggers an economic recession.
