Business Education: Basics of Microeconomics

Microeconomics
Microeconomics is the branch of economics that studies how individuals and small organizations act and make decisions. This includes how buyers, sellers, and their decisions affect supply and demand, price, and output. It not only covers the decisions buyers and sellers make but how they reach these decisions given limited resources, market failure, and perfect competition. It looks at preference relations, and the choices people can make. Microeconomics also covers supply and demand to see what affects them and how equilibrium can be reached. It also covers elasticity, consumer demand theory, theory and costs of production, and the types of markets such as perfect competition and monopolies. Additional topics include game theory, labor economics, economies of information, welfare economics, and opportunity costs.
One of the key assumptions of microeconomics is that individuals possess preferences. They may like brand A more than brand B. They also try to maximize their happiness while minimizing the cost. Essentially, people want to get as much happiness for as little as possible, due to limited resources. Another key assumption is that individuals must engage in competition for resources that are limited. Microeconomics also assumes that people typically make rational decisions. These assumptions make it easier to apply the theories of microeconomics and account for complex human behaviors.

Adam Smith's Theories of Microeconomics
Adam Smith (1723–1790) was a Scottish philosopher who is known as the founder of modern economics. He felt that, when people work in their own self-interest and get the products they need, the market will self-regulate and produce the best outcome for all. Supply and demand will come together if the market is just left to its own devices. This is known as the invisible hand. He promoted laissez-faire policies and was a free-market capitalist. In 1776, he published The Wealth of Nations, which describes self-regulation. Many economists used his theories as a springboard for their own work.

Elasticity
Elasticity refers to how one variable changes in response to another, such as how consumers respond to a change in a product. For instance, if the price of a product changes, will the demand change a lot or a little?

The price elasticity of demand can be calculated with the equation:

For instance, if the price of a good goes up by 50 percent and the quantity demanded goes down by 10 percent, then the price elasticity would be -10% / 50%, or 0.2 (technically there would be a negative sign, but this is usually discarded).

If the price elasticity is greater than one, then the demand is considered elastic. This means that there will be a greater change in quantity demanded than the percentage change in price. Thus a higher price will cause lower revenues, and a lower price can increase revenues. If the price elasticity is less than one, then it is inelastic and a percentage change in price corresponds to a smaller percentage change in demanded quantity. Thus a higher price equals higher revenue. A price elasticity equal to one means price changes won't affect revenue.

Scarcity
Scarcity refers to how there are limited resources for unlimited wants in people. This means resources must be carefully allocated because using them for one thing means giving up another. Resources that are scarce include land, labor, and capital. Scarcity can affect price. If something is scarce, then it can have higher prices. Scarcity can change, for instance, a crop may become less available due to weather conditions, and the price can vary with it. A good is considered scarce if there are fewer units available than the amount people want. Individuals and companies try to decide how best to allocate these limited resources for the maximum return.

Equilibrium
Equilibrium refers to when there are balanced economic forces. For a product, this is when demand is equal to supply. The spot where the demand curve and supply curve meet is the equilibrium price. The equilibrium price will not change on its own, but can change with the emergence of external factors. For instance, if consumer preferences change, then the demand might go down and thus the supply may rise. Due to this, a short time of disequilibrium might occur as the market adjusts. Subsequently, a new equilibrium price will emerge, and equilibrium will be reestablished. Equilibrium can also refer to other variables in economics. For instance, there may be an ideal interest rate for growth.

Opportunity Costs
Opportunity costs are what a company gives up when making a decision. For instance, if a company can make five laptops or five desktop computers with the same resources, and it chooses to make the laptops, then the opportunity cost will be the five desktops. When managers make decisions, they need to consider the opportunity costs of various paths to determine the best path. Sometimes what they give up may be more worthwhile than what they are making, and then they need to consider a path where they won't incur the opportunity cost.
Opportunity costs help determine which party has a comparative advantage. For instance, if a company can make 10 shirts in one hour or 20 pants in one hour, then the opportunity cost of the 10 shirts is the 20 pants and the opportunity cost of the 20 pants is 10 shirts. It has a comparative advantage with the pants because it has a lower opportunity cost.
The company that has the lowest opportunity cost for a product has a comparative advantage in that product. It makes sense to spend its resources making that product and purchase the other product elsewhere.

Supply and Demand
Supply is defined as how much of a good or service the market has to offer to buyers. The amount producers make changes based on many variables and is especially based on price. The law of supply states that the higher the price of a good, the more of it the producers are willing to make (with everything else being equal). If they will receive more money for a product, they will make more to increase their revenues. Demand is how much of a good or service buyers want. This also can vary due to price. The law of demand shows that the higher the price, the lower the demand (with everything else being equal). Buyers are willing to buy more of a product if it is cheaper. The supply and demand for a product or good can be shown in a graph by two intersecting lines.

Circular Flow Economic Model
The circular flow economic model shows a simplified way of how money and products make their way through the economy. It divides the parties as households and firms and shows two distinct markets: goods and services markets and factor markets, which represent the market for the factors of production such as land, labor, and capital. The goods and services market shows the finished product moving from the firms to the market and then to the households while money moves from the households to the market to the firms. In the factors of production market, everything is reversed. The households are the 'sellers'; for instance, they provide the labor. Thus, the factors of production move from the households to the market and to the firms. The firms pay for this, so the money moves from the firms to the market to the households in this part of the model. The money then flows through the households and firms, leaving a sustainable economy.

Factors Influencing Economic Change
Individual wants can influence economic change, as do the choices people make. The production of goods influences it. When production rises or falls for different reasons, the economy will be affected. Of course, competition plays a large part in the economy. Scarcity, or when items are in short supply, also plays a part. Prices can go up when this happens. The amount of consumption, the purchase of goods and services, influences the economy as well. All of these factors combine to contribute to economic change.

Effects of Supply and Demand on the Price of Goods
Demand and supply affect the price of goods. The price is where supply equals demand on the demand curve. If demand goes up and supply stays the same, then the price will rise. More people will be competing for the same number of products. Alternatively, if demand goes down and supply stays the same, then the price will go down because fewer people will want it. If supply goes up and demand stays the same, then the price will go down. There will be more products for the same demand. If supply goes down and demand stays the same, then the price will go up because there will be fewer products for the same demand.

Complements and Substitutes
A high supply on a related product can affect both products.
First, the higher supply on the related product will drive prices down for that related product. If the related product is a substitute (i.e., pens versus pencils) and the price has gone down, then buyers will move to that product and have less demand for the original product. When the demand goes down for the original product, the price will go down too. Thus, both prices may go down.

Margins
Marginal benefits describe the utility or satisfaction an individual gets from one more unit of a service or good. It is how much they will pay for that extra unit. Oftentimes this amount will go down with more units. For instance, someone may be willing to pay five dollars for a hair bow, but once she has bought five bows, she would only pay four dollars for another. Marginal costs describe how much it costs to make one more unit of something. Companies may use it to find the best level of production. Marginal utility refers to the satisfaction a consumer will get from one more unit.
This can be positive or negative. The law of diminishing returns refers to the fact that, as there is an increase in a factor of production (holding all other factors steady), eventually the per unit output of that factor will go down. For instance, if there is one cook in a busy kitchen, adding one more will make a big difference. Once you add 10 more cooks, however, then each additional one will not make as big a difference.

Perfect Competition
In the market structure of perfect competition, all companies make products that are exactly the same. They are identical, and because of this, no one firm has a large market share. The companies all have a small share. These firms do not have control over pricing. The buyers know the pricing for each firm as well as complete information regarding the product itself. There is complete freedom to enter or exit the market. Although there may be no one market that is exactly like this, some are close, such as agriculture. There are a lot of buyers and sellers in perfect competition, and supply and demand drive prices. The profit earned is modest and allows them to just stay in business because more firms enter when it rises.

Monopolistic Competition
Monopolistic competition is characterized by a market with many different producers that sell similar, although not identical, products.
It is a form of imperfect competition. They are not perfect substitutes because of their differences, but they are very similar. The differences may be in quality, branding, or another area. One example would be restaurants. There may be a hundred Italian restaurants in an area that all serve Italian food, but none of them serve the exact same products in the exact same place. The consumers understand this and will often make decisions based on factors other than price. There are often a lot of consumers, and no one business controls the pricing of the market. There are not a lot of barriers to entry, so many competitors can go into the market. These competitors have some market power and make their own decisions without regard to the market, but they also have imperfect information.

Oligopoly

An oligopoly occurs when there are only a small number of businesses supplying a certain product, meaning there is very limited competition. At times, this occurs when companies collude together to reduce competition and gain the ability to charge higher prices for their products.
Because there are so few competitors, companies are very aware of each other and will often make decisions based on the actions of the other companies.
Sometimes the companies try to collude, although this is illegal in some places. A cartel occurs when this collusion is formalized. Some oligopolies do feature fierce competition, however, and prices can be lower for it. An example is the cellular phone market, which has several large firms controlling most of the market.

Monopoly
A monopoly occurs when one company is the only provider of a product. Everyone who wants to receive that product or service must get it through the one entity. There is no competition and no reasonable substitute that consumers can purchase. Because the company is the only seller and does not have to compete, it can charge high prices for the product. If a consumer wants the product, he will have no choice but to pay whatever the company is asking.
A government may make them or they may form on their own. Many countries such as the United States have laws that restrict monopolies to promote healthy competition.

Effects of Competition
Competition affects the behavior of individual firms.
Individual firms that have to compete against others may be forced to lower their prices in order to stay competitive. They may also make decisions on location based on where competitors are located. For instance, they may strive to stay away from a very heavy competitor. With a lot of competition, consumers may get more of a choice of products and services. Each company may work hard to differentiate its product and make it unique to attract more of the market.
Consumers can benefit greatly from healthy competition.

Competitive Strategies
There are different competitive strategies that businesses employ to gain a competitive advantage. With cost leadership, a company charges less for the product to attract more customers. With penetration pricing, a business offers a low cost initially to get customers and then slowly raises it. With economy pricing, it strives to offer the lowest cost through the most basic items. With skimming, the initial price is high, but then it goes down to compete. In bundle pricing, a variety of products are offered together.
There are a wide variety of promotional pricing strategies such as percent off sales. There are many non-price competition strategies as well. One is differentiation, in which a company tries to produce a unique product. The differences may be real, or they may just appear to be real. They may offer features that are better or different than the competitors' products, or they may try to increase the quality of the product.
For instance, a phone manufacturer will try to produce innovative or higher quality features. Some strategies involve analyzing the market and customizing their strategy to different groups. These strategies may be used independently or in conjunction with each other.

Production
There are four main factors of production: land, labor, capital, and entrepreneurship. Land encompasses the natural resources used in the production of goods and services. Besides literal land, it also includes wood, farms, fisheries, metal, and other natural substances. Labor encompasses all human resources such as the workers in businesses with the exception of the entrepreneur. The entrepreneur is his or her own factor of production because it is his idea that will make the business happen. He uses the other resources to create a good or service that will be profitable.
He accepts the risks, reaps the rewards, and creates the business. The final factor of production is capital, which can be defined as either the money used to purchase the resources necessary for the business, or the large physical assets utilized in production such as vehicles, buildings, and equipment. These four factors of production can be combined to create a business.

Diminishing Returns
The law of diminishing returns refers to the concept that, as one factor of input is increased (while all others stay constant), eventually the marginal or incremental output will start to decrease. It is not that there will not be increased output (although at times this can occur) but that the incremental amount will not be as much. Take studying for example. The first hour you spend studying for a test will likely be very productive. You will be very motivated and will really remember what you've learned. By hour eight of continous studying, you'll likely be very tired and will not remember what you just went over. Each hour of studying produces less benefits, or returns, than the previous hour, until eventaully it is best to just go to bed. This law is true of many items as well as labor, and should be considered so that companies are not spending the resources to add an input that is not making a worthwhile difference in output.

Economies of Scale
With economies of scale, as the volume of output increases, it costs less per unit to produce it. This is true of a number of products, especially when overhead is high. For instance, a video game manufacturer might spend a lot of money to design, create, and program a video game. If they only make ten units of the game, the cost per unit would be very high. If instead they make 100,000 copies of the game, the cost of production per unit would be significantly less. This is true for products such as medications, which cost a lot to develop, but then may not cost a lot to produce.

Economies of Scope
Economies of scope is when it is cheaper to produce a range of products rather than just one. The company may be able to benefit from one function for both, such as the same marketing department. A company that makes toys may use the same advertisements to advertise similar but not identical products. Other major departments such as IT may be the same as well.
Also, the output of one might be used for another such as a company that produces chocolate chips and then also uses those to make chocolate chip cookies. Also, the company may be able to sell them near to each other such as a toy manufacturer that can sell the toys together.

Size of a Company and the Different Factors of Production
The size of a company can affect the cost of the different factors of production. For instance, a larger company may have more land or use more natural resources. Because they use so much, they may pay less for each unit; there is often a cheaper per-unit cost when things are bought in high numbers. Overall, they may pay more if they use more land. A larger company may have less difficulty attracting employees. Employees may be willing to take a lower salary knowing they will be working for such a large company. Of course, a bigger company will need more employees and some of these employees will be more skilled, higher-paid employees, which can increase the overall cost. A larger company is likely to need more in the way of capital and will therefore spend more money on that as well. Again, they may get pricing discounts, so it may be a lower per unit cost.