How do companies decide what price to charge for their sleek new gadgets? Why are some people willing to pay more for a product than others? How do your decisions play into how corporations price their products? The answer to all of these questions and many more is microeconomics. Read on to find out what microeconomics is and how it works.

Tutorial: Microeconomics 101

What Is It?
Microeconomics focuses on the role consumers and businesses play in the economy, with specific attention paid to how these two groups make decisions. These decisions include when a consumer purchases a good and for how much, or how a business determines the price it will charge for its product. Microeconomics examines smaller units of the overall economy; it is different than macroeconomics, which focuses primarily on the effects of interest rates, employment, output and exchange rates on governments and economies as a whole. Both microeconomics and macroeconomics examine the effects of actions in terms of supply and demand. (To learn more about supply and demand, see Economics Basics.)

Microeconomics breaks down into the following tenets:

  • Individuals make decisions based on the concept of utility. In other words, the decision made by the individual is supposed to increase that individual's happiness or satisfaction. This concept is called rational behavior or rational decision-making.
  • Businesses make decisions based on the competition they face in the market. The more competition a business faces, the less leeway it has in terms of pricing.
  • Both individuals and consumers take the opportunity cost of their actions into account when making their decisions.

Total and Marginal Utility
At the core of how a consumer makes a decision is the concept of individual benefit, also known as utility. The more benefit a consumer feels a product provides, the more that consumer is willing to pay for the product. Consumers often assign different levels of utility to different goods, creating different levels of demand. Consumers have the choice of purchasing any number of goods, so utility analysis often looks at marginal utility, which shows the satisfaction that one additional unit of a good brings. Total utility is the total satisfaction the consumption of a product brings to the consumer.

Utility can be difficult to measure and is even more difficult to aggregate in order to explain how all consumers will behave. After all, each consumer feels differently about a particular product. Take the following example:

Think of how much you like eating a particular food, such as pizza. While you might be really satisfied after one slice, that seventh slice of pizza makes your stomach hurt. In the case of you and pizza, you might say that the benefit (utility) that you receive from eating that seventh slice of pizza is not nearly as great as that of the first slice. Imagine that the value of eating that first slice of pizza is set to 14 (an arbitrary number chosen for the sake of illustration). Figure 1, below, shows that each additional slice of pizza you eat increases your total utility because you feel less hungry as you eat more. At the same time, because the hunger you feel decreases with each additional slice you consume, the marginal utility - the utility of each additional slice - also decreases.

Slices of Pizza Marginal Utility Total Utility
1 14 14
2 12 26
3 10 36
4 8 44
5 6 50
6 4 54
7 2 56
Figure 1

In graph form, Figures 2 and 3 would look like the following:

Figure 2
Figure 3

The decreasing satisfaction the consumer feels from additional units is referred to as the law of diminishing marginal utility. While the law of diminishing marginal utility isn't really a law in the strictest sense (there are exceptions), it does help illustrate how resources spent by a consumer, such as the extra dollar needed to buy that seventh piece of pizza, could have been better used elsewhere. For example, if you were given the choice of buying more pizza or buying a soda, you might decide to forgo another slice in order to have something to drink. Just as you were able to indicate in a chart how much each slice of pizza meant to you, you probably could also indicate how you felt about combinations of different amounts of soda and pizza. If you were to plot out this chart on a graph, you'd get an indifference curve, a diagram depicting equal levels of utility (satisfaction) for a consumer faced with various combinations of goods. Figure 4 shows the combinations of soda and pizza, which you would be equally happy with.

Figure 4

Opportunity Costs
When consumers or businesses make the decision to purchase or produce particular goods, they are doing so at the expense of buying or producing something else. This is referred to as the opportunity cost. If an individual decides to use a month's salary for a vacation instead of saving, the immediate benefit is the vacation on a sandy beach, but the opportunity cost is the money that could have accrued in that account in interest, as well as what could have been done with that money in the future.

When illustrating how opportunity costs influence decision making, economists use a graph called the production possibility frontier (PPF). Figure 5 shows the combinations of two goods that a company or economy can produce. Points within the curve (Point A) are considered inefficient because the maximum combination of the two goods is not reached, while points outside of the curve (Point B) cannot exist because they require a higher level of efficiency than what is currently possible. Points outside the curve can only be reached by an increase in resources or by improvements to technology. The curve represents maximum efficiency.

Figure 5

The graph represents the amount of two different goods that a firm can produce, but instead of always seeking to produce along the curve, a firm might choose to produce within the curve's boundaries. The firm's decision to produce less than what is efficient is determined by demand for the two types of goods. If the demand for goods is lower than what can be efficiently produced, then the firm is more likely to limit production. This decision is also influenced by the competition faced by the firm.

A well-known example of the PPF in practice is the "guns and butter" model, which shows the combinations of defense spending and civilian spending that a government can support. While the model itself oversimplifies the complex relationships between politics and economics, the general idea is that the more a government spends on defense, the less it can spend on non-defense items.

Market Failure and Competition
While the term "market failure" might conjure up images of unemployment or a massive economic depression, the meaning of the term is different. Market failure exists when the economy is unable to efficiently allocate resources. This can result in scarcity, a glut or a general mismatch between supply and demand. Market failure is frequently associated with the role that competition plays in the production of goods and services, but can also arise from asymmetric information or from a misjudgment in the effects of a particular action (referred to as externalities).

The level of competition a firm faces in a market, as well as how this determines consumer prices, is probably the more widely-referenced concept. There are four main types of competition:

  • Perfect Competition - A large number of firms produce a good, and a large number of buyers are in the market. Because so many firms are producing, there is little room for differentiation between products, and individual firms cannot affect prices because they have a low market share. There are few barriers to entry in the production of this good.
  • Monopolistic Competition - A large number of firms produce a good, but the firms are able to differentiate their products. There are also few barriers to entry.
  • Oligopoly - A relatively small number of firms produce a good, and each firm is able to differentiate its product from its competitors. Barriers to entry are relatively high.
  • Monopoly - One firm controls the market. The barriers to entry are very high because the firm controls the entire share of the market.

The price that a firm sets is determined by the competitiveness of its industry, and the firm's profits are judged by how well it balances costs to revenues. The more competitive the industry, the less choice the individual firm has when it sets its price. (To learn about how the economic system we now use was created, check out History of Capitalism.)

We can analyze the economy by examining how the decisions of individuals and firms alter the types of goods that are produced. Ultimately, it is the smallest segment of the market - the consumer - who determines the course of the economy by making choices that best fit the consumer's perception of cost and benefit.

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