We’ve talked about economics already, it’s time to talk about one of the two main branches of economics, microeconomics. The other branch is macroeconomics. The prefix “micro” originates from the land of Zeus, Athena, and Hercules – Greece. Micro means small. Coupled with “economics” microeconomics is the study of how consumers and businesses make decisions with limited resources. For example, a company may be able to make widgets or gizmos, but they can’t make both. Which is the better choice? This is in contrast with macroeconomics which focuses on such topics as inflation, employment, and GDP.

Supply and Demand:

Though the field is broad, much of microeconomics can be summed up in 3 words, “Supply and Demand”. Such simple and well known words carry so much weight in the world of commerce. Supply and demand is the idea that changing the value of one variable changes the value of the other one. For example if GM makes 1,000 Corvette ZR1s (a $100,000 vehicle) they can expect demand for that supply to be high. However if they produce 100,000 of these Corvettes demand for that supply may be low. Mostly because not enough people can afford the car.

The rules of supply and demand allow microeconomists to establish other factors in business like appropriate pricing. GM initially priced the ZR1 at just over $100,000 because it was a performance bargain at that price point and they were fairly certain they could sell their entire production run without much trouble. As it turns out demand has been so high for the ZR1 that GM has increased the price by a couple of percentage points to pad the bottom line (which they need to do). Of course it works the opposite way too. Sometimes a vehicle is priced too high, and GM has to cut the price with incentives and rebates in order to get them off dealer lots. Decreasing the price usually increases demand. This can be a failure of appropriately determining the demand for their supply or perhaps the wrong pricing strategy all together.

Pricing strategy is often determined by competitors, which is another important component of microeconomics. You have to know your competitors and understand what may be complementary products or substitute products to your own product (or service). Complementary products are those that may be manufactured or sold with your own product. A complementary product to GM’s Pontiac G8 Sedan would be a Tom Tom navigation system. This is because the G8 does not have a navigation system available. GM could perhaps work with Tom Tom to sell units at the dealership. A substitute product to the Pontiac G8 would be the Dodge Charger because they compete at the same price point and offer similar features. GM would need to make sure they do not price the G8 so high that they drive buyers to the Charger.

Market Failure:

Another concept of microeconomics is the study of market failures. This isn’t necessarily failures like the finance industry from 2007-2009, but any situation that might disrupt a perfectly competitive market. Many times the focus is on areas where the resulting market no longer serves the public interest. One such example is the market monopoly in which a single business controls the majority of the market. Microsoft for many years had a monopoly on the operating system market and for the most part still does. This can, but not always, allow the business to set prices regardless of competition, bully vendors and consumers, and even lever their influence in policy decisions. Much study has gone into the impact of a monopoly on an industry to see if it hurts the end-user and if the government needs to step in, which they have done many times. If two or three companies control an industry, this is known as an oligopoly. The beer industry in the United States is an oligopoly of Miller, Coors, and Anheuser-Busch with their respective brands.

Sometimes a concept known as an externality leads to market failures. There are two kinds of externalities, good ones and bad ones. Externalities are byproducts of economic transactions that are not accounted for in the transaction. A good externality is the resulting pollination of flowers vital to an ecosystem by a beekeeper. If we were to account for this externality the government might provide a subsidy to encourage the behavior further. The most well-known bad externality is pollution, which is often regulated but not priced. The promotion of a carbon tax would price this externality into the production processes that make pollution. Microeconomists study externalities to see how they impact those that benefit/suffer from them and suggest appropriate regulation to encourage/discourage externailites. If not properly monitored these externalities can hurt people, business, or the industry itself.

Opportunity Cost

Perhaps the most fascinating idea of microeconomics is opportunity cost. This term has found its way into personal finance, which is a good thing. Opportunity cost is the value of an alternative when faced with mutually exclusive options. Mutually exclusive basically means you can’t do both. You can’t have ice cream and cookies, only one (at least according to Mom). One of the most often cited examples of opportunity cost is graduate school. Say I wanted to get an MBA from the Emory University. The cost of getting this MBA is estimated to be $82,000 over the 2-year period. However in order to enter this program I would need to quit my full-time job. If that job payed $50,000 a year I would be giving up another $100,000 in salary to go to school. That $100,000 is the opportunity cost. Knowing the opportunity cost can help make better decisions. It’s not always about money. If Mom is in charge the opportunity cost of eating ice cream is being able to eat cookies.

So microeconomics isn’t as small as its name might suggest. Macroeconomics always gets the headlines because their work impacts everyone with headlines of inflation, interest rates, and unemployment. But there are probably more microeconomists than macros. This is because just about every major business employs teams of microeconomists to scrutinize their business models and make the best recommendations. When you think about the hundreds of industries with thousands of companies, the demand for microeconomics suddenly becomes apparent. These are the “get your hands dirty” economists, the ones that can actually get fired for being wrong, and arguably much more important to the economy than macroeconomists. That’s an opinion of course, but it’s my opinion which is of course important.

Photo: vinduhl

By The Weakonomist

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categories: economics