Economics refers to the use of finite resources to meet unlimited demands. Minipip does have a separate section on the basics of economics here. In this article, we’ll look at microeconomics. Although there are a variety of areas of economic research, most focus on the production, consumption, and transfer of wealth. The study of Economics can be broken down into two branches, Micro- and Macroeconomics. The latter takes a broader view of economic decision-making, often at the country level. The former looks in more detail at decision-making, often at an individual, household, or company level. British economist Lord Lionel Robbins states microeconomics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses. At its core, microeconomics observes the choices made by such individuals as a result of certain factors and circumstances. Through these observations, microeconomists look to make models to help predict future economic behaviour. Understanding how individuals act has many implications and uses, for example when creating macroeconomic policies at the government level. If a government knows how its population will act, it can influence its behaviour and, most commonly, spending. Before we look at such implications, we must learn about the crooks of microeconomic theory.

Microeconomists understand that they can never predict with 100% certainty what effect certain policies or events will have. Hence there is no one theory that rules over microeconomic thinking and economists must make assumptions when anticipating the behaviour of individuals. This is where microeconomics becomes more complex and conceptual, therefore we will spend time going through key vocabulary and concepts that will crop up in the next couple of articles.

Supply, Demand, and Equilibrium

The relationship between supply and demand is fundamental to microeconomics. Microeconomists want to know what happens when supply = demand (equilibrium), when supply is greater than demand, and vice versa. The significance of equilibrium, the point where supply = demand, is that this is where an economy is at its most efficient. Nothing needs to be changed on the supply side as demands are being met. Think of a supermarket that starts the day filled with items and at the end of the day has no stock left over and no one queueing outside. The demand of customers has been fully met and the supermarket has not got any leftover products. It is therefore not too farfetched to assume that individuals will strive to be in equilibrium and that they will react when they fall out of equilibrium. Sticking with the supermarket analogy, if the store constantly ends the day with too many tins of baked beans, it can figure that demand therefore has fallen. The store may decide to reduce the supply of baked beans, affecting the supply side of the equation, or reduce the price of baked beans, in an effort to increase demand.

Utility, Maximisation, and Utility Maximisation

Perhaps the most conceptual aspect of microeconomics is “utility”. Utility can be thought of as the pleasure an individual gets from making a certain decision. The happiness you feel from buying a new car or having money in a savings account is what macroeconomists call utility. Therefore, we assume an individual will always act in a way to maximise this, i.e. get the most pleasure out of any decision. For example, an individual faced with the choice of two apples for £3 or the same two apples for £2 should always take the second offer. They will receive the same amount of pleasure from the two apples in either scenario but will gain additional utility from spending £1 less. This is closely linked to the concept of opportunity cost, about which an article has already been written on Minipip. The conceptual nature of utility emerges when we try to measure it. At its essence, it is not measurable and differs from individual to individual. We cannot ascertain that the two apples will provide the same amount of utility to two individuals and so their choices may differ if we throw in a third choice, i.e. two oranges for £3. An individual may opt to spend more on the oranges if they prefer such a product. Finally, when we assume an individual will maximise their utility, we say that they are rational or acting rationally. Unfortunately, even with such a simple example, the assumption of utility maximisation is not that concrete, and we will explore why an individual might not make the decision they are expected to make as a result of asymmetric information.

Asymmetric Information

Asymmetric information adds more complexity to decision-making. Asymmetric information is the concept of two individuals entering into an agreement where one individual has more knowledge about the agreement than the other. Using the above example, we can see why an individual might opt for two apples for £3 rather than for £2. If the buyer does not know that the two apples are the exact same, they may believe that the higher price is indicative of higher quality. The individual may believe they will get more utility from “better quality” apples as they do not know they can get the exact same apples at a lower cost. In this scenario, they have not acted in the way that they are expected to. Asymmetric information becomes even more complex when applied to other real-world situations. The most common example of a market swarmed by asymmetric information is the insurance market. You may have wondered why insurance companies offer different rates to different people, for example, boys and girls. It is common for boys to pay higher rates of insurance than girls as they are expected to drive more erratically and require more frequent payouts. The insurance company charges these higher rates in an effort to protect itself against asymmetric information. We cannot guarantee that a male driver will require more payouts than a female driver, but if the insurance company can see that historically this is the case, it will charge higher rates to such customers. 

Application and Uses

Above is a classic microeconomic example, incorporating asymmetric information. There are of course many more real-life uses. As mentioned earlier, governments want to know what decisions their population will make to help influence macroeconomic policy, such as tax. It can also work the other way. If a government is receiving increasing pressure from certain industries, such as local farmers, they may implement policies to appease these lobbyists, for example, increasing tax on imported goods to induce spending on local products which will be comparatively cheaper in supermarkets. A real-life example of such a behaviour-inducing policy was the 'eat out to help out' scheme. After identifying a real threat to hospitality, the government implemented a policy to induce spending in this industry. By reducing VAT on certain products, consumers were influenced to spend at local bars and restaurants. 

In the next article, we will look at consumer theory, which ties nicely with utility maximisation and asymmetric information.