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Microeconomics in a Nutshell

The terms optimum, maximum, and equilibrium play a key role in microeconomic analysis. Households are assumed to make “optimal” decisions when confronted by something that lies at the heart of a microeconomic problem: resolving a trade-off between alternative possibilities (e.g., get a little more of this and a little less of that, or vice versa). Optimality is achieved with regard to the decision maker’s single, ultimate goal – to maximize his/her personal utility. In a two-good environment (X and Y, for simplicity), a household determines the optimal amount of X to buy relative to Y when, because of a resource constraint (income or wealth), more of X can be obtained if and only if less of Y is obtained, and vice versa (more Y and less X). Having allocated its scarce resources optimally and, in so doing, having maximized utility, a household is in equilibrium. A firm makes two optimal decisions in order to achieve a single goal – the maximization of profits. In a two-input environment (again, we are keeping it simple), a firm maximizes profits by optimally combining L (let us call it labor) and C (let us call it physical capital) and producing an optimal quantity of its product (let us stay with X). When a firm has done this, it too is in equilibrium. A household’s utility-maximizing decisions are made with respect to tastes, income, and the prices of X and Y. An X-producing firm’s profit maximizing decisions are made with respect to technology, the price of the product it is producing (the price of X), and the prices of its factors of production (L and C). When numerous households are consuming X, when many firms are producing X, and when all households and all firms are in equilibrium, the market for X is in equilibrium. We can obtain this equilibrium with the use of a downward-sloping market demand curve to consume X and an upward-sloping market supply curve to produce X.

The intersection between these two curves identifies the equilibrium price of X and the quantity of X produced and consumed. Note the critical role played by the prices of X, Y, L, and C in enabling households and firms to achieve equilibrium. As we have already noted, price is a key variable in microeconomics. The price of X, for instance, is a guiding light since it signals what has to be given up in return for more X. Because we have assumed that many individuals consume X and that many firms produce X, we take the market for X to be perfectly competitive. Accordingly, no participant, on either the demand or the supply side, is big enough to individually affect the price of X. Thus, all participants, both households and firms, are price takers, and the price that each one of them faces is determined by all participants as they meet collectively in the marketplace for X.

While a theoretical, frictionless market equilibrium might not be fully achieved in a real-world marketplace, an unobservable equilibrium price nevertheless exerts a force that improves the quality of market outcomes. This force merits being understood. By way of analogy, one might think of the power of the Gulf Stream, a strong, deep-sea ocean current that brings warm water into the Atlantic Ocean from the Gulf of Mexico, moves up the Atlantic coast, and branches out to Europe. A ship crossing the Atlantic should take account of the Gulf Stream, but the vessel also has to contend with the winds, waves, and storms on the surface of the sea. One might equate the power of the Gulf Stream with the force exerted by an unobservable frictionless market equilibrium price and equate the wind, waves, and storms with frictions that buffet real-world, non-frictionless markets.

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