A Practical Guide to Microeconomics

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 does individual demand determine how corporations price their products? The study of microeconomics focuses on the role consumers and businesses play in the economy.

What Is Microeconomics?

The choices consumers and businesses make help drive the economy. These decisions include consumer purchases for goods and at what price or how a business determines how much to charge for its product. The tenets of microeconomics include:

• Individuals make decisions based on utility, where using a good or service will increase the individual's happiness or satisfaction.
• Businesses make decisions based on the competition in the market. The more competition a business faces, the less leeway it has in pricing.
• Individuals and consumers consider opportunity costs when making decisions.

Microeconomics differs from macroeconomics, the study of the effects of interest rates, employment, output, and exchange rates on governments and aggregate economies. Both microeconomics and macroeconomics examine the actions in terms of supply and demand.

Marginal vs. Total Utility

Consumers choose goods and services based on the benefit or utility the item provides. The more utility a product gives, the more a consumer is willing to pay. Consumers often assign different levels of utility to goods, creating varying levels of demand.

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 a product brings to the consumer. Utility can be difficult to measure. While a consumer may be satisfied after eating one slice of pizza, a seventh slice of pizza may cause the consumer to feel sick. The benefit (utility) received from eating a seventh slice of pizza is less than that of the first.

Each additional slice of pizza increases total utility because the consumer feels less hungry as they eat more. Because the hunger decreases with each additional slice, the marginal utility—the utility of each additional slice—decreases.

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

Notice the difference that total utility and marginal utility create.

Opportunity Costs

When consumers or businesses purchase or produce particular goods, they forego buying or producing something else. This is referred to as the opportunity cost. If an individual uses a month's salary for a vacation instead of saving, the opportunity cost is the interest that could have accrued in the savings account. Economists use software to graph the production possibility frontier (PPF). Figure 5 shows the combinations of two goods a company or economy can produce.

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 the demand for the two goods.

If the demand for goods is lower than what can be efficiently produced, then the firm is more likely to limit production. Efficiency occurs when a company reduces waste to produce a given number of goods or services. This decision is also influenced by competition.

Competition

When the economy is unable to efficiently allocate resources, market failure occurs. 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. 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 can produce, there is little room for differentiation between products, and individual firms cannot affect prices due to 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 differentiate their products. There are few barriers to entry.
• Oligopoly: A relatively small number of firms produce a good, and each firm differentiates 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 dictates the entire market share.

The Bottom Line

Microeconomics is the study of what happens when individuals make choices in response to changes in incentives, prices, resources, competition, or production. The smallest segment of the market - the consumer—helps determine the course of the economy by making choices that best fit the consumer's perception of cost and benefit.