Microeconomics explained in simple terms

Microeconomics is the branch of economics that studies the behaviour of individual economic actors, such as households and firms, and how they make decisions regarding the allocation of their limited resources. 

It is concerned with issues such as the determination of prices, the distribution of income, and the level of production, and seeks to understand how these factors are influenced by market forces and government policies.

Law of supply and demand

One of the key concepts in microeconomics is the law of supply and demand, which is a fundamental principle that explains the relationship between the quantity of a good or service that is available and the price at which it is sold. The law of supply and demand states that, all else being equal, an increase in the supply of a good or service will lead to a decrease in the price, while a decrease in the supply will lead to an increase in the price. This relationship is represented by the supply and demand curve, which shows the relationship between the quantity of a good or service and the corresponding price.

The law of supply and demand can be affected by a number of factors, including the cost of production, technological change, and the expectations of firms and consumers. For example, if the cost of producing a good or service decreases, firms may be able to increase the quantity supplied at each price, leading to a shift in the supply curve to the right. Similarly, if consumers expect the price of a good or service to increase in the future, they may be more likely to purchase it now, leading to an increase in the demand for the good or service and a shift in the demand curve to the right.

The intersection of the supply and demand curves determines the market equilibrium price and quantity, which is the price at which the quantity demanded is equal to the quantity supplied. If the price is above the equilibrium price, there will be a surplus of the good or service, as the quantity supplied is greater than the quantity demanded. If the price is below the equilibrium price, there will be a shortage of the good or service, as the quantity demanded is greater than the quantity supplied. Market forces such as competition among firms and the actions of consumers help to ensure that the market moves towards the equilibrium price and quantity over time.

Elasticity

Another important concept in microeconomics is elasticity, which refers to the degree to which a change in the price of a good or service affects the quantity demanded or supplied. There are several types of elasticity, including price elasticity of demand, which measures the responsiveness of the quantity demanded to a change in price, and price elasticity of supply, which measures the responsiveness of the quantity supplied to a change in price. Elasticity can be calculated using the formula: elasticity = (% change in quantity)/(% change in price).

Elasticity is an important factor in determining the impact of changes in prices on quantities, and can help to inform pricing decisions and government policies. For example, if the price elasticity of demand for a good or service is high, this means that a small change in the price will lead to a large change in the quantity demanded, and the good or service may be considered to be elastic. 

Conversely, if the price elasticity of demand is low, this means that a small change in the price will lead to a small change in the quantity demanded, and the good or service may be considered to be inelastic. Similarly, if the price elasticity of supply is high, this means that a small change in the price will lead to a large change in the quantity supplied, and the good or service may be considered to be elastic. Conversely, if the price elasticity of supply is low, this means that a small change in the price will lead to a small change in the quantity supplied, and the good or service may be considered to be inelastic.

Elasticity can vary depending on the nature of the good or service and the availability of substitutes. For example, goods or services that are necessities or have few substitutes may be more inelastic, as consumers are less likely to change their consumption patterns in response to price changes. Conversely, goods or services that are luxuries or have many substitutes may be more elastic, as consumers are more likely to adjust their consumption patterns in response to price changes.

Competition

Microeconomics also studies different market structures, which are the characteristics of a market that determine the degree of competition among firms. The four main types of market structures are perfect competition, monopolistic competition, oligopoly, and monopoly.

In perfect competition, there are many buyers and sellers in the market, and the goods or services being offered are homogeneous. Firms in a perfectly competitive market are price takers, as they have no control over the price at which their goods or services are sold, and must accept the market price. Perfect competition can lead to efficient outcomes, as firms have an incentive to produce at the lowest cost and consumers have an incentive to purchase the lowest-priced goods or services. However, perfect competition is rare in the real world, as it requires a large number of firms and a high degree of transparency and information.

In monopolistic competition, there are many buyers and sellers in the market, but the goods or services being offered are differentiated, meaning that they are not perfect substitutes. Firms in a monopolistically competitive market have some control over the price at which their goods or services are sold, as they can differentiate their products and charge a premium for them. Monopolistic competition can lead to efficient outcomes, as firms still have an incentive to produce at the lowest cost and consumers have an option to choose from a variety of differentiated products. However, monopolistic competition can also lead to suboptimal outcomes, as firms may have an incentive to engage in non-price competition such as advertising, which can increase costs and reduce consumer welfare.

In an oligopoly, there are a few firms in the market, and the goods or services being offered may be homogeneous or differentiated. Firms in an oligopoly have a significant degree of control over the price at which their goods or services are sold, as they can coordinate their actions and influence the market price. Oligopoly can lead to suboptimal outcomes, as firms may have an incentive to collude or engage in price discrimination in order to maximize profits.

In a monopoly, there is only one firm in the market, and the firm has complete control over the price at which its goods or services are sold. Monopoly can lead to suboptimal outcomes, as the firm has an incentive to restrict production and charge a higher price in order to maximize profits. However, monopoly can also lead to efficient outcomes in certain circumstances, such as when there are high fixed costs or significant economies of scale.

Role of government

In addition to market forces, microeconomics also examines the role of government policies in shaping economic outcomes. Governments can use a variety of tools, such as taxes, subsidies, and regulations, to influence the behaviour of firms and households and achieve policy objectives. For example, a government may impose a tax on a particular good in order to reduce the quantity consumed, or may provide a subsidy to a particular industry in order to increase the quantity produced.

Government policies can also affect the distribution of income and wealth, as they can influence the distribution of tax burdens and transfer payments. For example, progressive taxation, which imposes a higher tax rate on higher levels of income, can be used to reduce income inequality, while regressive taxation, which imposes a lower tax rate on higher levels of income, can increase income inequality. Transfer payments, such as welfare benefits or pension payments, can also be used to redistribute income and mitigate poverty.

In summary

Microeconomics is a fascinating and complex field of study, and is essential for understanding the behaviour of individual economic actors and the factors that influence prices, production, and distribution. It provides a framework for analyzing the trade-offs and incentives that shape economic decision making, and helps to inform policy decisions and the design of markets. While microeconomics can help to explain and predict many economic phenomena, it is important to recognize that it is based on a number of assumptions and simplifications, and may not always capture the complexity and nuance of real-world situations.