by Marc Davis
As early as the 18th century, economists were studying the decision-making processes of consumers, a principal concern of microeconomics. Swiss mathematician Nicholas Bernoulli (1695-1726) proposed an extensive theory of how consumers make their buying choices in what was perhaps the first written explanation of how this often mysterious and always complex process works.
According to Bernoulli's theory, consumers make buying decisions based on the expected results of their purchases. Consumers are assumed to be rational thinkers who are able to forecast with reasonable accuracy the hopefully satisfactory consequences of what they buy. They select to purchase, among the choices available, the product or service they believe will provide maximum satisfaction or well-being.
For some 200 years beginning in the mid-1700s, the dominant economic theory was Adam's Smith's laissez-faire (French for "leave alone" or "let do") approach to the economy, which advocated a government hands-off policy regarding free markets and the machinery of capitalism. The laissez-faire theory argues that an economy functions best when the "invisible hand" of self-interest is allowed to operate freely, without government intervention.
Smith and Marshall
Scottish-born Smith (1723-1790) wrote in his book, "Wealth of Nations," that if the government does not tamper with the economy, a nation's resources will be most efficiently used, free-market problems will correct themselves and a country's welfare and best interests will be served. (For further reading on Adam Smith see, Adam Smith: the Father of Economics.)
Smith's views on the economy prevailed through two centuries, but in the late 19th and early 20the century, the ideas of Alfred Marshall (1842-1924), a London-born economist, had a major impact on economic thought.
In Marshall's book, "Principles of Economics, Vol. 1." published in 1890, he proposed, as Bernoulli had three centuries earlier, the study of consumer decision making. Marshall proposed a new idea as well - the study of specific, individual markets and firms, as a means of understanding the dynamics of economics. Marshall also formulated the concepts of consumer utility, price elasticity of demand and the demand curve, all of which will be discussed in the following chapter.
At the time of Marshall's death, John Maynard Keynes (1883-1946), who would become the most influential economist of the 20th century starting in the 1930s, was already at work on his revolutionary ideas about government management of the economy.
Born in Cambridge, England, Keynes' contributions to economic theory have guided the thinking and policy-making of central bankers and government economists for decades, both globally and in the U.S. (To learn more see, Can Keynesian Economics Reduce Boom-Bust Cycles?)
So much of U.S. monetary policy, the setting of key interest rates, government spending to stimulate the economy, support of private enterprise through various measures, tax policy and government borrowing through the issuance of Treasury bonds, bills and notes, have been influenced by the revolutionary ideas of Keynes, which he introduced in his books and essays.
What all these concepts had in common was their advocacy of government management of the economy. Keynes advocated government intervention into free markets and into the general economy when market crises warranted, an unprecedented idea when proposed during the Great Depression. (For more on this read, What Caused The Great Depression?)
Government spending to stimulate an economy, a Keynesian idea, was used during the Depression to put unemployed people to work, thus providing cash to millions of consumers to buy the country's products and services. Most of Keynes' views were the exact opposites of Adam Smith's. An economy, for optimum functioning, must be managed by government, Keynes wrote. (For related reading, see The Federal Reserve.)
Thus was born the modern science of macroeconomics – the big picture view of the economy – evolving in large part from what came to be called Keynesian economic theory. These are among the tools of microeconomics, and their principles, along with others, are still employed today by economists who specialize in this area.
Keynes' policies, to varying degrees, have been, and continue to be, employed with generally successful results worldwide in almost all modern capitalist economies. If and when economic problems occur, many economists often attribute them to some misapplication or non-application of a Keynesian principle.
While Keynesian economic theory was being applied in most of the world's major economies, the new concept of microeconomics, pioneered by Marshall, was also taking hold in economic circles. The study of smaller, more focused aspects of the economy, which previously were not given major importance, was fast becoming an integral part of the entire economic picture. (For further information on past economists, read How Influential Economists Changed Our History.)
Microeconomics had practical appeal to economists because it sought to understand the most basic machinery of an economic system: consumer decision-making and spending patterns, and the decision-making processes of individual businesses.
The study of consumer decision-making reveals how the price of products and services affects demand, how consumer satisfaction – although not precisely measurable – works in the decision-making process, and provides useful information to businesses selling products and services to these consumers.
The decision-making processes of a business would include how much to make of a certain product and how to price these products to compete in the marketplace against other similar products. The same decision-making dynamic is true of any business that sells services rather than products.
Although economics is a broad continuum of all the factors - both large and small - that make up an economy, microeconomics does not take into direct account what macroeconomics considers.
Macroeconomics is concerned principally with government spending, personal income taxes, corporate taxes, capital gains taxes and other taxes; the key interest rates set by the Federal Reserve, the banking system and other economic factors such as consumer confidence, unemployment or gross national product, which may influence the entire economy. (For more on macroeconomics read, Macroeconomic Analysis.)
Economics, like all sciences, is continually evolving, with new ideas being introduced regularly, and old ideas being refined, revised, and rethought.
Some 200 years after Bernoulli's theory was first introduced, it was expanded upon by Hungarian John von Neumann (1903-1957), and Austrian Oskar Morgenstern (1920-1976). A more detailed and nuanced theory than Bernoulli's and Marshall's emerged from their collaboration, which they called utility theory. The theory was elaborated in their book, "Theory of Games and Economic Behavior," published in 1944.
In the 1950s, Herbert A. Simon (1916-2001), a 1978 Nobel Memorial Prize-winner in economics, introduced a simpler theory of consumer behavior called "satisficing". The satisficing theory contends that when consumers find what they want, they then abandon the quest and decision-making processes, and buy the product or service which seems to them as "good enough." (For more on the Nobel Memorial Prize, read Nobel Winners Are Economic Prizes.)
And so the history of microeconomics continues to unfold, awaiting perhaps another Bernoulli, Adam Smith, Alfred Marshall, or John Maynard Keynes, to provide it with some new, revolutionary ideas.
Microeconomics: Assumptions and Utility
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