Economics Terms A-Z - The most important terms in economics.

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Economics Terms A-Z

Microeconomics

By , reviewed by Tom McKenzie

Microeconomics, one of the two main branches of economics, studies the choices made by individuals. This can be a consumer, a single business, or even a household. The decisions that these individuals make with their limited resources and time are modeled and used for a wide variety of real-world applications. The insight gained from these studies helps to inform macroeconomic models of the labor market, industries, international trade, and how the economy works. 

The fundamentals of microeconomics are generally agreed upon by modern economists. The field is used to examine supply and demand in specific markets to find if they are perfectly competitive or not, describe how monopolies behave, determine socially optimal outcomes and what may prevent them, examine individuals’ optimal strategies in theory, outline costs and benefits of certain actions, and much more.

Once certain assumptions are made, a mathematical model of human (or firm, or market) behavior can be built. This is the bread and butter of many microeconomists' work. With a model’s help, they can perform hypothesis testing on ideas, just like a scientist would do in a field like physics. Then, it's possible to learn how to best allocate resources, restore market equilibrium, predict behavior, and more.

But, that does not mean the field is already “solved”. Classic microeconomic assumptions usually include the idea that humans are fully rational, utility maximizing, and have perfect information to make optimal decisions. This “rational economic man” can be distilled into a formula of behavior, using math to build a model.

Sadly, these classic assumptions are often not realistic. People almost never have perfect information. And, they have many subconscious biases that could prevent them from making an optimal choice. Moreover, sometimes people just make mistakes!

If these assumptions are not realistic, where did they come from, and why were they widely used? The answer requires a very brief history lesson. First, Adam Smith’s classic Wealth of Nations was published in 1776. It introduced some key concepts, many of which became foundational to microeconomics. An example is the idea that individuals seeking their own self-interest allowed markets to function efficiently via the “invisible hand”.

A century later, three important figures built on Smith’s and other’s work, leading to what we call the “Marginal Revolution”. These economists were William Jevons, Leon Walras, and Carl Menger. Their works introduced the concepts of general equilibrium and partial equilibrium, which are still taught today. (General equilibrium describes equilibrium theory in the entire economy, while partial equilibrium only deals with one market at a time).

Then, Alfred Marshall built on their work with his Principles of Economics in 1890. This book was important because it introduced rigorous mathematics into economics and launched those methods into the mainstream. Soon after, Vilfredo Pareto (namesake of Pareto efficiency) made major contributions to consumer theory that led to the formation of welfare economics.

The work of these economists rested on the assumptions that human behavior could be modeled with math and studied. This is where the key assumptions of rationality, perfect information, and utility maximization came in. Without them, the basic models of microeconomics wouldn’t be able to be written as equations.

Suggested Opportunities

However, these assumptions were never intended to completely describe reality. Even Alfred Marshall himself stated that economics was closer to meteorology than to other natural sciences, because human behavior is hard to predict. Part of the reason these assumptions proliferated is because they simplified the math. This was important as economists at the time had to do their quantitative work by hand, and complicated models become intractable very quickly.

In the present era, technology has allowed economists to build and study more complicated models with computer algorithms and econometric software. Problems that could take earlier economists hours or days to solve might take us only a few minutes to do now. Thus, we have more ability and freedom to re-examine these classical assumptions, perhaps to replace them with better ones.

That is exactly what newer sub-disciplines like behavioral economics are doing to the field. Economists are able to challenge some of those classic but outdated assumptions and try to update old models with new findings. These new insights and theories seek to improve our models so they better represent the real world.

Thus, key areas of study and research for a modern microeconomist can vary. They include public economics, game theory, contract theory, behavioral economics, income inequality, industrial organization, and more. The common thread among these research areas is that they are grounded in the decision-making of individual economic agents.

Further Reading

Gregory Mankiw’s Principles of Economics is a lauded and well-known introduction into economics for new students. It’s a large book, but written in clear language with plenty of examples that paint a picture of economic concepts in action. It includes chapters on macroeconomic concepts too, but those build off of the microeconomics concepts that earlier chapters present. It makes a great introduction for any student curious about economics topics at a beginner-friendly level.

Additionally, The Wealth of Nations is a famous work of economics literature; even laymen know the name and understand that it is somehow important. Adam Smith, through this book, established the foundations for economics as a discipline. He introduced several concepts that form the basis of microeconomics today, including theories of competition, prices, and people seeking their own self-interest. Smith's ideas are used as a guide even among those modern economists who reject some of the stringent mathematical modeling that microeconomics developed.

However, the original work is quite dense and difficult for a modern reader. To get around this problem, the Adam Smith Institute’s Eamonn Butler has written a modern translation of Adam Smith’s writings, The Condensed Wealth of Nations. Any student of economics would benefit from the read.

Good to Know

Aspiring microeconomists will have to be familiar with the basics of economic theory, naturally. Microeconomics also makes heavy use of mathematical optimization problems, so an understanding of derivatives and basic calculus is necessary. Knowledge of statistics topics, particularly hypothesis testing, is also very useful. And, studying logic puzzles may help an aspiring student prepare for game theory and industrial organization topics.

Also, employment opportunities for microeconomists are more similar to macroeconomists than one might think at first. Often, government agencies, think tanks, and research organizations will make use of both micro- and macroeconomists, as the skillsets are complementary but not interchangeable. A microeconomist might be needed to design a specific regulation or government policy, for instance, that a macroeconomist may be ill-suited for.