by Marc Davis
In order to best understand how microeconomics applies to the real world, we'll go over the case of a car maker, General Motors (OTCBB:GMGMQ). Once, General Motors was among America's most profitable companies and a colossus of the automobile industry.
By 2008, GM had fallen on hard times, the victim of a slumping U.S. and global economy and a series of microeconomic decisions that turned out to be wrong. Trouble at the microeconomic level began for General Motors several years before its problems worsened in late 2008. As Japanese automaker Toyota (NYSE:TM) began steadily eating into GM's market share, GM did not meet its competition head-on.
Toyota made a cheaper car with better gas mileage that was of better overall quality, and was engineered for greater durability than its chief competitor, GM. Consumers naturally gravitated away from GM to Toyota and demand for the once-popular GM automobiles declined slowly and continually as Toyota and other Japanese cars won an ever-increasing share of the automobile market. (For further reading, check out Analyzing Auto Stocks.)
Although the general economy may also be responsible to some degree for GM's fall, which eventually led to its bankruptcy in 2009, several GM management decisions at the microeconomic level contributed to the problem.
First, prior to its bankruptcy, GM was selling eight different brands of cars – Buick, Cadillac, Chevrolet, GMC, Hummer, Pontiac, Saab and Saturn. The number of units manufactured for each of these brands represented too much output, a situation in which the marginal revenue is less than the marginal costs.
Second, as gasoline prices rose, spurred by rising oil prices, GM continued to build gas-guzzling SUVs and pick-up trucks, and failed to produce cars that kept pace with the high mileage-per-gallon vehicles produced by Toyota and other Japanese manufacturers. Despite the obvious decline in demand for automobiles that were not fuel-efficient, GM persisted in marketing them, reflecting a microeconomic decision of management that seemed to disregard data on consumer preferences.
Finally, in response to high consumer demand for fuel-efficient or alternative-energy vehicles, GM began developing hybrid vehicles, but only long after its competitors had brought them to the market.
GM's problems staggering debt and the costs of honoring contracts to provide pensions to its retirees and handsome health benefits and other costly benefits to its union-represented employees only contributed to its decline.
Too many microeconomic decisions at GM have apparently proved unsuccessful. The result was a bankruptcy filing for a firm that once made huge profits and reigned supreme over its industry.
On the success side of the microeconomic ledger are many companies whose top management made the right decisions as start-ups, or in their restructuring efforts in the face of changing market conditions. (For more on this see, Understanding Microeconomics or if you want to see how it affects the currency markets, check out our Forex Walkthrough.)
One typical success story is FedEx (NYSE:FDX). Founded in 1971, the service firm is now the world's largest express transportation company. Initially, FedEx had a simple but powerfully effective business strategy that was summed up in its early advertising slogan: "When it absolutely, positively has to be there overnight."
Frederick W. Smith, who founded FedEx, was aware of the growing consumer demand for prompt, dependable overnight delivery of packages and documents. Smith's microeconomic research in advance of starting his firm provided the data necessary to confirm an idea he first developed when he was studying economics at Yale.
Understanding Demand and Adaptation
In the early 1970s, the U.S. Postal Service was not as reliable as it would later become, and postal rates were increasing. Smith's unknown start-up firm would provide the service that the post office could not, at a reasonable price, and demand for Fed Ex service grew exponentially through the years.
As the firm matured, several new and critical price and technological challenges arose, which threatened FedEx's market share. These included the entry into the express carrier business of the U.S. Postal Service, Emory Airborne Freight and United Parcel Service of America (UPS), among others.
On the technological side, fax transmissions and emails could now deliver almost instantaneously what previously could only be delivered overnight. In response to this challenge, FedEx concentrated on items that could not be dispatched via phone lines or electronically and expanded into foreign markets. With its own fleet of aircraft, FedEx was an effective competitor against most of the other carriers, which used commercial flights for delivery.
These moves reflect simple microeconomic decisions - when demand declined for overnight deliveries of materials which could be sent via email or fax, the firm focused on other services, vigorously advertising what the market demanded at a competitive price.
In the slumping economy of late 2008, with consumer budgets and disposable income shrinking through job loss, the declining value of their investments, and a lack of consumer confidence, consumer decision-making took a new direction.
Consumer Spending During a Downturn
Consumer spending during the period of economic downturn that began in 2008 still expressed the microeconomic concepts of opportunity costs, cardinal utility and ordinal utility, which are used in decision-making in good economic times.
Opportunity costs, as discussed in a previous chapter, are the tradeoff concept. With a limited budget, a consumer may be able to afford two items he or she desires, but cannot buy both. Buying one rather than the other is the opportunity cost.
Suppose a consumer wants an expensive chocolate cake, a loaf of bread and a pound of sliced ham to make sandwiches for her school children. In a down economy the consumer on an abbreviated budget would likely chose the more practical purchases, the bread and ham. The cost for this decision - the opportunity cost - is the chocolate cake. (To learn more see, Economics Basics.)
The cardinal utility - in microeconomics, the numerical value of satisfaction to the consumer - may not be measurable. But the ordinal value, which only denotes consumer preference, without assigning actual numbers, is obvious. In hard times, consumers prefer the necessities.
This consumer preference for necessities and competitive pricing during a recessionary period was also demonstrated in a reported increase in brand switching and the use of discount coupons at supermarkets and other retailers. A consumer may prefer one brand of toothpaste at a certain price, but if a coupon for a different brand of toothpaste is offered at a significant discount, consumers may decide to buy the cheaper brand. (For further insight, see Advertising, Crocodiles and Moats.)
Micro Meets Macro
At this point, the principles of macroeconomics - the big-picture economy - came into play in the 2007-2009 recession. The Federal Reserve lowered the key interest rate to encourage borrowing. The federal government embarked on a costly but necessary rescue plan for the financial industry, and a plan to help home owners either facing default, or in default of their mortgages. (To learn more see, The Federal Reserve: Monetary Policy.)
The government also rescued certain mortgage firms and investment banks with infusions of cash, principally Fannie Mae and Freddie Mac, and JPMorgan Chase to purchase failing investment firm Bear Sterns.
Additionally, through a legislative act called The Troubled Assets Relief Program (commonly called "the bailout"), the federal government appropriated some $750 billion to buy toxic debt (non-performing or questionable debt) and to lend money to banks and other institutions to get the economy moving again. (For more on this, see Top 6 U.S. Government Financial Bailouts.)
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