Microeconomics is the study of how individuals and businesses make choices on how to best use limited resources. The field interests investors as individual consumer spending accounts for about two-thirds of the U.S. economy. Microeconomics and macroeconomics (the study of the larger aggregate economy) together make up the two main branches of economics.
So how do the principles of microeconomics affect everyday life? Most people have a limited amount of time and money. They cannot buy or do everything they want, so they make calculated microeconomic decisions on how to use limited resources to maximize personal satisfaction. Similarly, a business also has limited time and money. Businesses also make decisions that result in the best outcome for the business which may be to maximize profit.
- Microeconomics uses a set of fundamental principles to make predictions about how individuals behave in certain situations involving economic or financial transactions.
- These principles include the law of supply and demand, opportunity costs, and utility maximization.
- Here, we use the common example of renting an apartment in order to illustrate these important concepts of microeconomics in everyday life.
Some Principles of Microeconomics
Microeconomics uses certain basic principles to explain how individuals and businesses make decisions. One of these basic principles of microeconomics is that individuals make decisions to maximize their satisfaction. In microeconomics, this is called maximizing utility.
Another economic principle that comes into play as consumers make decisions is an opportunity cost. When an individual makes a decision, she also calculates the cost of forgoing the next best alternative. For instance, if you use your frequent flier miles to take a trip to the Bahamas, you will no longer be able to redeem the miles for cash. The missed cash is an opportunity cost.
Diminishing marginal utility, another economic input, describes the general consumer experience that the more you consume of something, the lower the satisfaction you get. For instance, when you eat one burger you may feel very satisfied. But if you eat a second burger, you may feel a lesser amount of satisfaction than with the first burger.
Two other important economic principles are supply and demand as it appears in the market. Market supply refers to the total amount of a certain good or service available on the market to consumers, while market demand refers to the total demand for the good or service. The interplay of supply and demand helps determine prices for a product or service, with higher demand and limited supply typically making for higher prices.
Example: Renting an Apartment
To help understand how microeconomics affects everyday life, let’s study the process of renting an apartment. In a city like New York, there is a limited supply of housing and high demand. Going by the principles of microeconomics, that’s why housing costs in New York are high.
To rent an apartment, first, you must determine a budget. For this, you will have to take into account your income and how much money you are looking to spend on housing, in such a way as to maximize your utility or satisfaction. If you allocate too much of your income to rent, you will not have a lot of money left for other expenses. Thus, you will have to decide what is the most amount of money you are willing to part with, what amenities you must have in your apartment and acceptable neighborhoods. It’s about maximizing utility.
Based on all the above factors, you set a budget to get the most satisfaction for the least possible rent. You will not pay more than you have to in order to get what you want. Considering that in this supply-constrained market there are others also interested in renting the apartments that are more in demand, you might find that you will have to increase your budget. To do this, you will have to cut down on spending in another area, like entertainment, travel, or eating out. That is the opportunity cost of finding the right apartment.
Similarly, a landlord will seek to rent an apartment at the highest price possible, since her motivation generally is to get the best return by renting out the apartment. In setting the rent, she would have to take into account the demand for the apartment and the neighborhood. If there are enough potential renters interested in the apartment, she would set a higher rent. If she were to set the rent too high, compared to what other landlords in the neighborhood are charging for comparable apartments, she would find that renters are not interested. The business owner, in this case, the landlord, also makes decisions based on supply and demand.
And while she would attract a larger pool of prospective renters by setting a rent that is lower than what other neighborhood landlords are charging for comparable apartments, she would be missing out on some rental income which will not maximize her utility. Thus, both you and the landlord will make decisions to get the best outcome for yourselves given the constraints you face.
The Bottom Line
In a capitalist economy, both consumers and businesses make thousands of big and small decisions each year guided by the principles of microeconomics. Consumers seek to maximize their satisfaction when they go out and shop for anything from paper towels to apartments, houses, and cars. Businesses set prices and make other decisions based on microeconomics. The prices that consumers will pay depends on the supply of a good, as well as how much others are willing to pay for it.