Microeconomic analysis attempts to explain the behavior of individuals and organizations in a given economy. Before being able to understand macroeconomics, or national and global trends for indicators like Gross Domestic Product, it is helpful to know how economics works on a small scale. Microeconomics fills this purpose by providing analysis on a smaller scale. Simplified models and key definitions will help you to understand microeconomics.
Microeconomics examines the most basic of economic transactions by focusing on behavior by individuals. It is assumed that individuals always act with economic rationality; it is further surmised that companies make decisions that will maximize profits. You choose to work at a job, say in a grocery store. If you are the store manager, you may buy produce from the supplier who has the best fruits and vegetables at the lowest price. Your decision helps the store to become more profitable. The store attracts more customers, who are making the choice to shop at your store. The store owners may decide to open additional stores and sell stock in the company. Individual investors would choose to buy shares in the chain.
In turn, as an employee, you earn a salary. When you take your paycheck and buy things with it, this is also part of the microeconomic model. By spending the money you earned, you are basically stating that you value the goods and services you buy more than you value the money you earned. The basis of microeconomic analysis is the decisions of individuals--including those individuals who make up businesses and governments--making everyday choices.
Microeconomic analysis functions through modeling and by emphasizing interests. Microeconomic models are necessarily simplistic; although real-world markets are complex, with many different variables and competing firms, a microeconomic model may assume only two competing companies selling a solitary product, for example. Such simplification allows the observer to use microeconomics to better understand economic decision-making on a small scale.
The emphasis of interest is another hallmark of microeconomics. For instance, individuals make up a particular company. Yet the interests of management and other employees may be at odds, and both of those groups may have different interests from the company's shareholders. Although firms strive to align the goals of all involved, the individual decision-making component of microeconomics means that such consolidation of interests--and therefore, behaviors--is not always possible.
Microecnomics contains features that help to better explain the behavior of individuals and companies. Explanations of microeconomics are either positive (explaining what did or will happen) or normative (explaining what should happen). Economists therefore may explain the large increase in hotel and motel business in 2002 as the direct result of consumers using less air travel, due to the events of 9/11, a positive explanation. Likewise the prediction that health care costs will go down if pools of insured individuals increase is a normative explanation, microeconomic analysis that is a standard discussion of health care reform.
Demand measurements and game theory are two of the key concepts of microeconomic analysis. When studying the behavior of individuals and companies, you may focus on prices and how they are affected by supply and demand. One way to measure prices in this context is known as the "price elasticity of demand." Elasticity quantifies how the price of something, let's say gasoline, affects demand. In the U.S., gasoline is considered to be relatively price inelastic, meaning that consumers still purchase about the same amount regardless of the price. A microeconomic study might try to determine at what price per gallon demand for gas would actually start to decrease; public policy makers might use such a study to form the normative question of how to sustain an overall reduction in dependence on foreign oil.
Game theory is another microeconomic component, which addresses equality of outcomes. Two individuals may compete for a good at a variable price, as in the case of an auction. One individual ends up better off than the other by winning the auction. Game theory recognizes that microeconomic activity sometimes results in inequality.
Although microeconomic analysis often focuses on individual consumers and companies, governments also have a considerable affect on such studies. This is because governments influence the behavior of both individuals and companies (as well as other organizations, like nonprofits) by formulating tax policy. Taxes, and tariffs, in the case of imports, may dampen demand for certain goods or stimulate demand for competing goods. Public policy therefore must be considered in any comprehensive study of microeconomics, as lawmakers continue efforts to forge answers to normative questions and improve overall societal welfare.