A brief guide to understanding Microeconomics
Prices of goods and assets in the economy always keep changing. It is surprising that bitcoin is now trading for over $50,000, and the Dow Jones industrial average, as well as the S&P 500 are on record highs. These are just three examples of what has changed in the last few years; there are countless other assets that have grown in value. However, there is always risk involved in investing, and successful investors and businesses always do a detailed analysis before making any decisions.
Since investors and corporations make their own choices, microeconomics is applicable to investing because it studies how individuals make choices related to changes in certain variables, such as prices and resources. In fact, microeconomics is the study of individuals, households and firms’ behavior in decision making and allocation of resources. It generally applies to markets of goods and services and deals with individual and economic issues. It may not be used to predict where index-funds will be in the next few months or how the inflation rate would be in a country twelve months from now, but it can identify which corporations are most likely to use their resources efficiently and generate higher returns.
Whether it be for investing or market prediction, the main objective of microeconomics is the allocation of resources and to maintain efficiency in the economy.
Assumptions in Microeconomics
Assumptions are conditions made before a microeconomic analysis is made. These assumptions are sometimes used for simplification and some are even criticized for being unrealistic. The following are five key economic assumptions:
- Scarcity: The gap between the limited number of resources present on planet Earth and the unlimited desire to have more. To meet human needs, decisions must be made regularly in order to manage the availability of resources to meet human needs.
- Trade-offs: Due to scarcity, choices have to be made in order to forgo a benefit or opportunity. However, trade-offs come with a cost; making one choice means losing something else.
- Self-interest: This assumption refers to the behavior of individuals as producers and consumers. Ideally, a consumer seeks the most satisfaction and value from the money exchanged. On the other hand, an ideal producer is concerned with maximizing profit. As Milton Friedman said, “the sole purpose of a business is to generate profits for its shareholders.”
- Costs and benefits: Decisions are made by comparing the costs and benefits of every choice made by a trade-off.
- Graphs: Present detailed numerical data to make it easier to observe patterns. Makes any data compact and readable, and helps represent visual connections and relationships. The supply-demand graph is a great example of an economic graph.
This is one of the most important concepts in microeconomics. The word marginal in this case means additional. How much additional revenue will an additional worker generate for a business? More workers do not always mean more or faster productivity. This is why the additional cost of hiring the workers is always compared to the additional revenue they might generate. As discussed before, consumers always look for more satisfaction when buying goods and services; this is also called utility. Now what comes under utility is the Law of Diminishing Marginal Utility, which is essentially the law of decreasing additional satisfaction. The more times a consumer uses a particular service, the more amount of satisfaction drops.