What is Microeconomics

It is already apparent from this brief overview that the subject of economics is a very broad one. Just as the study of the physical world is divided into fields such as physics and chemistry, economics is likewise divided into fields comprised of closely related topics.

The two major fields of economics are microeconomics and macroeconomics. Since the second is the subject of this book, let's take a minute to review what microeconomics is about.

Microeconomics is the study of how markets function.

For example, how do the prices of airline tickets and the frequency of service to various airports get determined in the US economy? An airline decides whether to raise or lower fares, whether to add a flights between LA and Chicago, and whether to put a new 747 in service on the San Francisco to Honolulu route. Travelers respond by buying more or fewer trips. The airline's objective is to maximize profits, constrained by the rules of the game established and enforced by government. Travelers, in turn, hope to buy transportation at the lowest possible price with the best possible convenience and comfort.

The diffuse but very real arena in which such firms and their customers interact is called the marketplace. Physically, the marketplace for airline tickets is all the ticket counters and travel agencies where transactions take place. Conceptually, the market encompasses all the interactions between the economic agents that produce and consume air travel.

Prior to the late 1970's the prices of airline tickets, as well as the routes and airline could fly, were set by the federal government as a part of the regulation of air travel. Largely due to the urging of economists, the airline ticket market was deregulated so that airlines are now free to raise or lower fares and alter service to airports as they see it to be to their advantage to do so. Advocates of deregulation contended that freeing the air travel market would result in a more efficient allocation of resources within the airline industry, making society as a whole better off.

The term "resources" here means the factors of production, not just natural resources. The analysis of airline deregulation, the arguments for and against it, as well appraising its success or failure to date, are interesting and important problems in microeconomics.

In private enterprise economies it is primarily in the marketplace that the three fundamental economic decisions are made:

  • What will be produced?
  • How will it be produced?
  • Who will consume it?

For example, it is in the marketplace that society decides how many tennis rackets will be produced, whether they will be made in Ohio or in Taiwan, and which consumers will buy them. It was the remarkable insight of Adam Smith, pondering the workings of the British economy two centuries ago, that products and services are provided for the benefit of society mainly as a result of the pursuit of self interest by producers and consumers interacting in the marketplace rather than because of their good intentions.

Producers who supply what consumers demand are rewarded with higher profits, while those who do not are punished for wasting society's valuable land, labor and capital resources by suffering losses. In a famous passage in his book The Wealth of Nations, Smith wrote:

"It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."

Adam Smith realized that the market provides incentives for agents to behave in ways that generally improve economic welfare.

Microeconomists are also interested in studying ways in which markets fail to provide the proper incentives to allocate resources. This happens when an economic activity produces consequences for agents that are not a party to that activity. An example of such an externality is the air pollution. Unless there is a way to make agents pay for producing pollutants, they will tend to produce more of it than is good for society.

The design and cost-effectiveness of taxes and regulations to mitigate externalities is an important issue in microeconomics. A supplement entitled Review of the Principles of Microeconomics offers an introduction for students who have not encountered ‘Micro” before and for those who have taken a prior course but wish to get a firmer grasp of basic microeconomic principles, particularly those that will be used in this book.

Exercises 1.3

A. What are the three fundamental decisions that have to be made in any economic system? Discuss what those decisions are in the context of trips between San Francisco and Hong Kong. How has technology changed the outcomes of those decisions during the last half century?

B. Express in your own words Adam Smith's idea of what makes a private enterprise economy work.

C. Federal law requires that electric generating stations install scrubbers on their exhaust stacks to reduce emissions of certain compounds. Discuss why utilities might not install these scrubbers on their own, and how you might approach the question of whether such scrubbers should be required by law.

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