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What Is Microeconomics?

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Microeconomics Definition, Uses, and Concepts

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Microeconomics is the social science that studies the implications of incentives and decisions and how they affect the utilization and distribution of resources on an individual level. Microeconomics shows how and why different goods have different values. It addresses how individuals and businesses conduct and benefit from efficient production and exchange and how individuals can best coordinate and cooperate with each other.

Microeconomics provides a more detailed understanding of individuals, firms, and markets. Macroeconomics provides a more aggregate view of economies.

Key Takeaways

• Microeconomics studies the decisions of individuals and firms to allocate resources of production, exchange, and consumption.
• Microeconomics deals with prices and production in single markets and the interaction between markets.
• Microeconomics leaves the study of economy-wide aggregates to macroeconomics.
• Microeconomists form various types of models based on logic and observed human behavior and they test the models against real-world observations.

Investopedia / Tara Anand

Microeconomics is the study of what's likely to happen when individuals make choices in response to changes in incentives, prices, resources, or methods of production. These scenarios are also known as tendencies. Individuals are often grouped into microeconomic subgroups such as buyers, sellers , and business owners. These groups create the supply and demand for resources, using money and interest rates as pricing mechanisms for coordination.

The Uses of Microeconomics

Microeconomics can be applied in a positive or normative sense. Positive microeconomics describes economic behavior and explains what to expect if certain conditions change. It theorizes that consumers will tend to buy fewer cars than before if a manufacturer raises the prices of cars.

The price of copper will tend to increase if a major copper mine collapses in South America because supply is restricted. Positive microeconomics could help an investor see why Apple Inc. ( AAPL ) stock prices might fall if consumers buy fewer iPhones. It could also explain why a higher minimum wage might force The Wendy's Company ( WEN ) to hire fewer workers.

These explanations, conclusions, and predictions of positive microeconomics can then be applied normatively to prescribe what people, businesses, and governments should do to attain the most valuable or beneficial patterns of production, exchange, and consumption among market participants.

This extension of the implications of microeconomics from what is to what ought to be or what people ought to do also requires at least the implicit application of some sort of ethical or moral theory or principles and some form of utilitarianism .

Method of Microeconomics

Microeconomic study has historically been performed according to general equilibrium theory , developed by Léon Walras in "Elements of Pure Economics," and partial equilibrium theory, introduced by Alfred Marshall in "Principles of Economics."

The Marshallian and Walrasian methods fall under the larger umbrella of neoclassical microeconomics. Neoclassical economics focuses on how consumers and producers make rational choices to maximize their economic well-being, subject to the constraints of how much income and resources they have available.

Neoclassical economists make simplifying assumptions about markets such as perfect knowledge, infinite numbers of buyers and sellers, homogeneous goods, or static variable relationships to construct mathematical models of economic behavior.

These methods attempt to represent human behavior in functional mathematical language. This allows economists to develop mathematically testable models of individual markets. Neoclassicals believe in constructing measurable hypotheses about economic events and then using empirical evidence to determine which hypotheses work best.

They follow the “logical positivism” or “logical empiricism” branch of philosophy in this way. Microeconomics applies a range of research methods depending on the question being studied and the behaviors involved.

Basic Concepts of Microeconomics

The study of microeconomics involves several key concepts, including but not limited to:

• Incentives and behaviors : This addresses how people as individuals or in firms react to the situations with which they're confronted.
• Utility theory : Consumers will choose to purchase and consume a combination of goods that will maximize their happiness or “utility” subject to the constraint of how much income they have available to spend.
• Production theory : This is the study of production or the process of converting inputs into outputs. Producers seek to choose a combination of inputs and methods of combining them that will minimize costs to maximize their profits.
• Price theory : Utility and production theory interact to produce the theory of supply and demand which determines prices in a competitive market. Price theory concludes that the price demanded by consumers is the same as that supplied by producers in a perfectly competitive market. This results in economic equilibrium .

Where Is Microeconomics Used?

Microeconomics has a wide variety of uses. Policymakers may use microeconomics to understand the effect of setting a minimum wage or subsidizing the production of certain commodities. Businesses may use microeconomics to analyze pricing or production choices. Individuals may use it to assess purchasing and spending decisions.

What Is Utility in Microeconomics?

Utility refers to the degree of satisfaction that an individual receives when making an economic decision. The concept is important because decision-makers are often assumed to seek maximum utility when making choices within a market.

How Important Is Microeconomics in Our Daily Life?

Microeconomics is critical to daily life even in ways that may not be evident to those engaging in it. Take the case of someone who's looking to buy a car. Microeconomic principles play a central role in individual decision-making. They'll likely consider various incentives such as rebates or low interest rates when assessing whether to purchase a vehicle.

They'll probably select a make and model based on maximizing utility while also staying within their income constraints. A car company will have made similar microeconomic considerations in the production and supply of cars into the market.

Microeconomics is a field of study focused on the decision-making of individuals and firms within economies. It's in contrast with macroeconomics, a field that examines economies on a broader level.

Microeconomics may look at the incentives that influence individuals to make certain purchases, how they seek to maximize utility, and how they react to restraints.

Microeconomics for firms may look at how producers decide what to produce, in what quantities, and what inputs to use based on minimizing costs and maximizing profits. Microeconomists formulate various types of models based on logic and observed human behavior. They test the models against real-world observations.

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S.P.S. Chauhan, via Google Books. " Microeconomics: Theory and Applications, Part 2 ." Page 224.

Oregon State University. " Intermediate Economics, Chapter 2, Utility ."

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Principles of microeconomics, course description.

14.01 Principles of Microeconomics is an introductory undergraduate course that teaches the fundamentals of microeconomics. This course introduces microeconomic concepts and analysis, supply and demand analysis, theories of the firm and individual behavior, competition and monopoly, and welfare economics. Students will …

14.01 Principles of Microeconomics is an introductory undergraduate course that teaches the fundamentals of microeconomics. This course introduces microeconomic concepts and analysis, supply and demand analysis, theories of the firm and individual behavior, competition and monopoly, and welfare economics. Students will also be introduced to the use of microeconomic applications to address problems in current economic policy throughout the semester.

This course is a core subject in MIT’s undergraduate Energy Studies Minor . This Institute-wide program complements the deep expertise obtained in any major with a broad understanding of the interlinked realms of science, technology, and social sciences as they relate to energy and associated environmental challenges.

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This course has been designed for independent study. It includes all of the materials you will need to understand the concepts covered in this subject. The materials in this course include:

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Microeconomics

The study of how individuals and companies make choices regarding the allocation and utilization of resources

What is Microeconomics?

Microeconomics is the study of how individuals and companies make choices regarding the allocation and utilization of resources. It also studies how individuals and businesses coordinate and cooperate, and the subsequent effect on the price, demand, and supply. Microeconomics refers to the goods and services market and addresses economic and consumer concerns.

Why are seniors receiving discounts on public transportation systems? Why do flight tickets cost so much during the holiday season? Such questions are considered to be microeconomic, as they are focused on markets or individuals in an economy. Microeconomics also analyzes market failures where productive results are not achieved.

• Microeconomics deals with the study of how individuals and businesses determine how to distribute resources and how they interact.
• The supply and demand theory in microeconomics assumes that the market is perfect.
• Microeconomics uses various principles, such as the Law of Supply and Demand and the Theory of Consumer Demand, to predict the behavior of individuals and companies in situations involving financial or economic transactions.

Assumptions in Microeconomic Theory

• Microeconomic theory begins with a single objective analysis and individual utility maximization. To economists, rationality means an individual’s preferences are stable, total, and transitive.
• It assumes continuous preference relations to ensure that the utility function is differentiable when you compare two different economic outcomes.
• The microeconomic model of supply and demand assumes that the markets are perfect. It means that there are a large number of buyers and sellers in the market, and none of them can influence the price of products and services significantly. Nonetheless, in real-life cases, the principle fails when any buyer or seller controls prices.

Theories in Microeconomics

1. theory of consumer demand.

The theory of consumer demand relates goods and services consumption preference to consumption expenditure. Such a correlation provides a way for consumers, subject to budget constraints, to achieve a balance between expenses and preferences by optimizing utility.

2. Theory of Production Input Value

According to the production input value theory, the price of any item or product is determined by the number of resources spent to create it. Cost may include several of the production factors (including land, capital, or labor) and taxation . Technology may be regarded as either circulating capital (e.g., intermediate goods) or fixed capital (e.g., an industrial plant).

3. Production Theory

The production theory in microeconomics explains how businesses decide on the quantity of raw material to be used and the quantity of items to be produced and sold. It defines a relationship between the quantity of the commodities and production factors on the one hand, and the price of the commodities and production factors on the other.

4. Theory of Opportunity Cost

According to the opportunity cost theory, the value of the next best alternative available is the opportunity cost . It depends entirely on the valuation of the next best option and not on the number of options.

The Demand and Supply Model of Microeconomics

The demand and supply model of microeconomics explains the relationship between the quantity of a good or service that the producers are willing to produce and sell at different prices and the quantity that consumers are willing to buy at such prices. In a  market economy , price and quantity are considered basic measures to gauge the goods produced and exchanged.

Basic definitions

Demand : In microeconomics, demand is referred to as the quantity of product or service that the consumers are willing to purchase at a particular price level. The quantity demanded by the consumers also depends on their ability to pay.

Supply : In microeconomics, supply refers to the amount of product or service that the producers are willing to provide at a particular price level. Moreover, companies seek to maximize their profit; hence, they would manufacture and supply a larger quantity of products if they can be sold at higher prices.

Law of Demand and Supply

In microeconomics, the law of demand states that the quantity of commodities demanded by consumers varies inversely with prices of the commodities, all other factors being constant. This implies that if the price of any commodity increases, the demand for that commodity will decrease.

The law of supply states that an increase in the price of any commodity will lead to an increase in supply and vice versa, all other factors being constant. The producers attempt to maximize their profit by increasing the quantity when the price rises.

The point of intersection of the demand curve and supply curve is called the equilibrium point. At the equilibrium point, the price and quantity are respectively known as the equilibrium price (P*) and equilibrium quantity (Q*) . Due to a change in any of the economic or consumer factors, the market shifts away from the equilibrium point. However, the economy behaves accordingly to bring the market back to the equilibrium point.

Now, assume that the price of a certain commodity falls below P*. In such a case, the demand for that commodity will surge. The quantity supplied will not be enough to cater to the quantity demanded, resulting in excess demand or shortage. The producers will realize that they have an opportunity to sell whatever quantity they have at a higher price and make profits.

Consequently, the price will rise toward the equilibrium. Similarly, if the price of a commodity increases above P*, there will be a drop in quantity demanded. At the new price, the quantity supplied is more than the quantity demanded, which results in excess supply or surplus. The producers will eventually start selling at lower prices, causing an increase in demand, and the market will move towards the equilibrium point.

Structure of the Market

Market structure is determined by various aspects, such as the number of buyers and sellers in the market, the distribution of market shares between them, and how convenient it is for the companies to enter and leave the market.

1. Pure competition

Pure competition is a market structure in which numerous small firms compete against each other. The demand and supply determine the quantity of the commodities produced and the market prices. The firms cannot influence the prices, and the commodities produced by all the firms are identical.

2. Monopoly

In such a monopolistic market structure, there is a single company controlling the supply in the entire market. As there are no substitutes, the company reduces the quantity supplied, increases the price, and earns considerable profits.

3. Oligopoly

In an oligopoly , a few companies control the entire market. The companies can either compete or collaborate to raise prices and earn more profits.

4. Monopsony

A monopsony exists when only one buyer is controlling the demand for commodities, whereas there are many sellers in the market.

5. Oligopsony

An oligopsony exists when there are only a small number of buyers but many sellers. In such a market, the buyers exert more power than sellers, unlike oligopoly, where sellers control the market.

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Economic Definition of hypothesis . Defined.

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Term hypothesis Definition : A reasonable proposition about the workings of the world that's inspired or implied by a theory and which may or may not be true. An hypothesis is essentially a prediction made by a theory that can be compared with observations in the real world. Hypotheses usually take the form: "If A, the also B." The essence of the scientific method is to test, or verify, hypotheses against real world data. If supported by data over and over again, hypotheses become principles.

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Microeconomics Models and Theories

Microeconomics is concerned with the economic decisions and actions of individuals and firms.

Within the broad church of microeconomics, there are different theories that emphasise certain assumptions and expectations of economic behaviour. The most important theory is neo-classical theory, which places emphasis on free-markets and the assumption individuals are rational and seek to maximise utility. However, there are many critiques of the neo-classical model, arguing economics is more complex with issues of market failure and irrational behaviour.

Pre-classical microeconomic theory

Before, Adam Smith, economics was more disparate with no commanding overall theory. Philosophers like Aristotle and Plato made references to issues in economics such as division of labour. The dominant ideas, pre-classical economics, were based on theories of mercantilism – the idea a nation should try to accumulate gold.

Classical microeconomic theory

Classical microeconomic theory was developed by Adam Smith (Wealth of Nations, 1776) and later economists, such as David Ricardo The essential aspect of classical microeconomic theory include:

Determination of market price and output

Adam Smith mentioned the ‘ invisible hand of the market .’ He noted how when people act out of self-interest, markets tend to provide goods and services which are demanded by the population. It needed no central price setting, but market forces responded to changes in demand and supply, e.g. a shortage pushes up the price and causes demand to fall.

Smith also investigated topics such as the division of labour, specialisation and economies of scale.

The early classical economists emphasised the importance of costs to firms and consumers.

2. Utility maximisation

An important development of classical economics towards the end of the nineteenth century is the concept of utility maximisation. The concept of utility was developed by philosophers/economists – Jeremy Bentham and John Stuart Mill.

In microeconomic theory, it was believed a consumer will buy goods depending on the marginal utility (satisfaction) they get from the good. This theory assumes consumers are rational and seeking to maximise the satisfaction they get.

Neo-classical theory

Neo-classical theory is a modern re-interpretation of classical economics of the nineteenth century. Neo-classical theory places importance on markets, but developed new ideas, especially regarding utility and rational choice theory. Elements of neo-classical theory.

• Market distribution of goods and services.
• Rational choice theory. This is the idea individuals hold rational preferences and make rational choices; seeking to maximise their outcomes – be it profit, wages, consumption or investment.
• People act independently and make use of available information.
• Marginalism. In neo-classical economics, more emphasis was placed on concepts of marginal utility and marginal cost. We make choices depending on satisfaction we get from one extra unit of a good.

Economists such as Carl Menger, William Stanley Jevons and Marie-Esprit-Léon Walras. and Alfred Marshall developed ideas such as diminishing marginal utility .

Many of these neo-classical economic theories were brought together in Alfred Marshall’s very influential textbook, Principles of Economics. (1890)

• Note there is some blurring between classical economics and neo-classical economics.
• Neo-classical economics has also come to mean ‘orthodox economic theory. To a large extent, it has incorporated new developments in microeconomics, such as theories of market failure, market structure and econometrics.

Theories of Market failure

Neo-classical economics has become associated with a belief in the efficiency of markets. However, microeconomic theory has also incorporated the criticisms and limitations of free-markets.

• Monopoly . Adam Smith was well aware of the problem of monopolies and how firms could use their market power to set excessive prices.
• Imperfect competition . In the 1930s, Joan Robinson developed a model of imperfect competition, an awareness many markets were somewhere between monopoly and perfect competition often assumed in neo-classical economics.
• Externalities . Developed by Arthur C.Pigou in  The Economics of Welfare (1920) this is the awareness production and consumption decisions can have harmful (or positive) effects on third parties. Therefore, a free market can lead to overconsumption of demerit goods and negative externalities.
• Game theory . An awareness, decisions are not linear or simple, but the interdependence of agents influences what we decide to do.
• Behavioural economics

The most important trend in recent decades in economics is the greater emphasis placed on aspects of behavioural economics, which uses many insights from related fields such as psychology.

• Disputes rational choice theory. The essential element of behavioural economics is that it argues individual agents are often not rational and often do not seek to maximise utility.
• Behavioural economics examines how agents can be influenced by biases, and make decisions not predicted by neo-classical economic theory. Behavioural economics can explain the irrational exuberance of booms and busts.

Econometrics

In the post-war period, economics became increasingly mathematical with economists attempting to use mathematics to explain models and theories. Econometrics looks at economic data and seeks to extract simple relationships. The basic tool is the linear regression models and can be used to try and predict consumer spending and demand for labour.

Heterodox models of microeconomics

Heterodox models differ substantially from microeconomic foundations of neo-classical economics. Schools of thought include

Marxist economic theory

Karl Marx developed an alternative perspective on economics. He focused on the surplus value created under the capitalist economic system. To Marx, the invisible hand of the market would be better described as the invisible hand of capitalist exploitation of workers. Marx claimed workers did receive their full labour value but were compensated for their necessary labour only – enabling capitalists to profit from the surplus.

Institutional economics . The role of society and institutions in shaping economic behaviour. For example, Thomas Veblen looked at theories of ‘conspicuous consumption’ and noted how the desire for social status could drive much economic theory. Institutional economics could be seen as a forerunner for later behavioural economics.

Environmental economics Argues traditional economics wrongly places value on increasing output. The most important thing is creating a sustainable environment which maximises living standards.

Buddhist economics/non-profit goals . Like environmental economics, this questions the assumption higher incomes and higher output are desirable. The theory of hedonistic relativism suggests higher incomes do nothing to increase happiness levels, and traditional economics can encourage society to pursue materialistic goals which actually create more problems of stress, conflict and environmental degradation.

Some of the basic models you might find in A-Level economics

• Price Discrimination
• Perfect competition
• Price Mechanism
• Oligopoly and kinked demand curve
• Game Theory Pricing strategies
• Market failure

Theory n A model or framework (made up of a body of principles) to explain phenomena. The word ‘theory’ derives from the Greek word ‘theorein’, which means ‘to look at’.

• Difference between macroeconomics and microeconomics

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1.3 The Economists’ Tool Kit

Learning objectives.

• Explain how economists test hypotheses, develop economic theories, and use models in their analyses.
• Explain how the all-other-things unchanged (ceteris paribus) problem and the fallacy of false cause affect the testing of economic hypotheses and how economists try to overcome these problems.
• Distinguish between normative and positive statements.

Economics differs from other social sciences because of its emphasis on opportunity cost, the assumption of maximization in terms of one’s own self-interest, and the analysis of choices at the margin. But certainly much of the basic methodology of economics and many of its difficulties are common to every social science—indeed, to every science. This section explores the application of the scientific method to economics.

Researchers often examine relationships between variables. A variable is something whose value can change. By contrast, a constant is something whose value does not change. The speed at which a car is traveling is an example of a variable. The number of minutes in an hour is an example of a constant.

Research is generally conducted within a framework called the scientific method , a systematic set of procedures through which knowledge is created. In the scientific method, hypotheses are suggested and then tested. A hypothesis is an assertion of a relationship between two or more variables that could be proven to be false. A statement is not a hypothesis if no conceivable test could show it to be false. The statement “Plants like sunshine” is not a hypothesis; there is no way to test whether plants like sunshine or not, so it is impossible to prove the statement false. The statement “Increased solar radiation increases the rate of plant growth” is a hypothesis; experiments could be done to show the relationship between solar radiation and plant growth. If solar radiation were shown to be unrelated to plant growth or to retard plant growth, then the hypothesis would be demonstrated to be false.

If a test reveals that a particular hypothesis is false, then the hypothesis is rejected or modified. In the case of the hypothesis about solar radiation and plant growth, we would probably find that more sunlight increases plant growth over some range but that too much can actually retard plant growth. Such results would lead us to modify our hypothesis about the relationship between solar radiation and plant growth.

If the tests of a hypothesis yield results consistent with it, then further tests are conducted. A hypothesis that has not been rejected after widespread testing and that wins general acceptance is commonly called a theory . A theory that has been subjected to even more testing and that has won virtually universal acceptance becomes a law . We will examine two economic laws in the next two chapters.

Even a hypothesis that has achieved the status of a law cannot be proven true. There is always a possibility that someone may find a case that invalidates the hypothesis. That possibility means that nothing in economics, or in any other social science, or in any science, can ever be proven true. We can have great confidence in a particular proposition, but it is always a mistake to assert that it is “proven.”

Models in Economics

All scientific thought involves simplifications of reality. The real world is far too complex for the human mind—or the most powerful computer—to consider. Scientists use models instead. A model is a set of simplifying assumptions about some aspect of the real world. Models are always based on assumed conditions that are simpler than those of the real world, assumptions that are necessarily false. A model of the real world cannot be the real world.

We will encounter our first economic model in Chapter 35 “Appendix A: Graphs in Economics” . For that model, we will assume that an economy can produce only two goods. Then we will explore the model of demand and supply. One of the assumptions we will make there is that all the goods produced by firms in a particular market are identical. Of course, real economies and real markets are not that simple. Reality is never as simple as a model; one point of a model is to simplify the world to improve our understanding of it.

Economists often use graphs to represent economic models. The appendix to this chapter provides a quick, refresher course, if you think you need one, on understanding, building, and using graphs.

Models in economics also help us to generate hypotheses about the real world. In the next section, we will examine some of the problems we encounter in testing those hypotheses.

Testing Hypotheses in Economics

Here is a hypothesis suggested by the model of demand and supply: an increase in the price of gasoline will reduce the quantity of gasoline consumers demand. How might we test such a hypothesis?

Economists try to test hypotheses such as this one by observing actual behavior and using empirical (that is, real-world) data. The average retail price of gasoline in the United States rose from an average of $2.12 per gallon on May 22, 2005 to $2.88 per gallon on May 22, 2006. The number of gallons of gasoline consumed by U.S. motorists rose 0.3% during that period.

The small increase in the quantity of gasoline consumed by motorists as its price rose is inconsistent with the hypothesis that an increased price will lead to an reduction in the quantity demanded. Does that mean that we should dismiss the original hypothesis? On the contrary, we must be cautious in assessing this evidence. Several problems exist in interpreting any set of economic data. One problem is that several things may be changing at once; another is that the initial event may be unrelated to the event that follows. The next two sections examine these problems in detail.

The All-Other-Things-Unchanged Problem

The hypothesis that an increase in the price of gasoline produces a reduction in the quantity demanded by consumers carries with it the assumption that there are no other changes that might also affect consumer demand. A better statement of the hypothesis would be: An increase in the price of gasoline will reduce the quantity consumers demand, ceteris paribus. Ceteris paribus is a Latin phrase that means “all other things unchanged.”

But things changed between May 2005 and May 2006. Economic activity and incomes rose both in the United States and in many other countries, particularly China, and people with higher incomes are likely to buy more gasoline. Employment rose as well, and people with jobs use more gasoline as they drive to work. Population in the United States grew during the period. In short, many things happened during the period, all of which tended to increase the quantity of gasoline people purchased.

Our observation of the gasoline market between May 2005 and May 2006 did not offer a conclusive test of the hypothesis that an increase in the price of gasoline would lead to a reduction in the quantity demanded by consumers. Other things changed and affected gasoline consumption. Such problems are likely to affect any analysis of economic events. We cannot ask the world to stand still while we conduct experiments in economic phenomena. Economists employ a variety of statistical methods to allow them to isolate the impact of single events such as price changes, but they can never be certain that they have accurately isolated the impact of a single event in a world in which virtually everything is changing all the time.

In laboratory sciences such as chemistry and biology, it is relatively easy to conduct experiments in which only selected things change and all other factors are held constant. The economists’ laboratory is the real world; thus, economists do not generally have the luxury of conducting controlled experiments.

The Fallacy of False Cause

Hypotheses in economics typically specify a relationship in which a change in one variable causes another to change. We call the variable that responds to the change the dependent variable ; the variable that induces a change is called the independent variable . Sometimes the fact that two variables move together can suggest the false conclusion that one of the variables has acted as an independent variable that has caused the change we observe in the dependent variable.

Consider the following hypothesis: People wearing shorts cause warm weather. Certainly, we observe that more people wear shorts when the weather is warm. Presumably, though, it is the warm weather that causes people to wear shorts rather than the wearing of shorts that causes warm weather; it would be incorrect to infer from this that people cause warm weather by wearing shorts.

Reaching the incorrect conclusion that one event causes another because the two events tend to occur together is called the fallacy of false cause . The accompanying essay on baldness and heart disease suggests an example of this fallacy.

Because of the danger of the fallacy of false cause, economists use special statistical tests that are designed to determine whether changes in one thing actually do cause changes observed in another. Given the inability to perform controlled experiments, however, these tests do not always offer convincing evidence that persuades all economists that one thing does, in fact, cause changes in another.

In the case of gasoline prices and consumption between May 2005 and May 2006, there is good theoretical reason to believe the price increase should lead to a reduction in the quantity consumers demand. And economists have tested the hypothesis about price and the quantity demanded quite extensively. They have developed elaborate statistical tests aimed at ruling out problems of the fallacy of false cause. While we cannot prove that an increase in price will, ceteris paribus, lead to a reduction in the quantity consumers demand, we can have considerable confidence in the proposition.

Normative and Positive Statements

Two kinds of assertions in economics can be subjected to testing. We have already examined one, the hypothesis. Another testable assertion is a statement of fact, such as “It is raining outside” or “Microsoft is the largest producer of operating systems for personal computers in the world.” Like hypotheses, such assertions can be demonstrated to be false. Unlike hypotheses, they can also be shown to be correct. A statement of fact or a hypothesis is a positive statement .

Although people often disagree about positive statements, such disagreements can ultimately be resolved through investigation. There is another category of assertions, however, for which investigation can never resolve differences. A normative statement is one that makes a value judgment. Such a judgment is the opinion of the speaker; no one can “prove” that the statement is or is not correct. Here are some examples of normative statements in economics: “We ought to do more to help the poor.” “People in the United States should save more.” “Corporate profits are too high.” The statements are based on the values of the person who makes them. They cannot be proven false.

Because people have different values, normative statements often provoke disagreement. An economist whose values lead him or her to conclude that we should provide more help for the poor will disagree with one whose values lead to a conclusion that we should not. Because no test exists for these values, these two economists will continue to disagree, unless one persuades the other to adopt a different set of values. Many of the disagreements among economists are based on such differences in values and therefore are unlikely to be resolved.

Key Takeaways

• Economists try to employ the scientific method in their research.
• Scientists cannot prove a hypothesis to be true; they can only fail to prove it false.
• Economists, like other social scientists and scientists, use models to assist them in their analyses.
• Two problems inherent in tests of hypotheses in economics are the all-other-things-unchanged problem and the fallacy of false cause.
• Positive statements are factual and can be tested. Normative statements are value judgments that cannot be tested. Many of the disagreements among economists stem from differences in values.

Look again at the data in Table 1.1 “LSAT Scores and Undergraduate Majors” . Now consider the hypothesis: “Majoring in economics will result in a higher LSAT score.” Are the data given consistent with this hypothesis? Do the data prove that this hypothesis is correct? What fallacy might be involved in accepting the hypothesis?

Case in Point: Does Baldness Cause Heart Disease?

Mark Hunter – bald – CC BY-NC-ND 2.0.

A website called embarrassingproblems.com received the following email:

What did Dr. Margaret answer? Most importantly, she did not recommend that the questioner take drugs to treat his baldness, because doctors do not think that the baldness causes the heart disease. A more likely explanation for the association between baldness and heart disease is that both conditions are affected by an underlying factor. While noting that more research needs to be done, one hypothesis that Dr. Margaret offers is that higher testosterone levels might be triggering both the hair loss and the heart disease. The good news for people with early balding (which is really where the association with increased risk of heart disease has been observed) is that they have a signal that might lead them to be checked early on for heart disease.

Source: http://www.embarrassingproblems.com/problems/problempage230701.htm .

Answer to Try It! Problem

The data are consistent with the hypothesis, but it is never possible to prove that a hypothesis is correct. Accepting the hypothesis could involve the fallacy of false cause; students who major in economics may already have the analytical skills needed to do well on the exam.

Principles of Economics Copyright © 2016 by University of Minnesota is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License , except where otherwise noted.

Microeconomics

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• Hal R. Varian 2  

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Microeconomics is the study of individual economic units and their interactions. In includes the theory of the consumer, the producer, and the markets in which they are involved. Microeconomics is often contrasted with macroeconomics which is concerned with the behaviour of economic aggregates, such as aggregate consumption and production.

This chapter was originally published in The New Palgrave: A Dictionary of Economics , 1st edition, 1987. Edited by John Eatwell, Murray Milgate and Peter Newman

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Economic Science and Economics

Macroeconomics, origins and history of, bibliography.

Boulding K. 1948. Economic analysis. Revised ed. New York: Harper and Brothers.

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De Wolff, P. 1941. Income elasticity of demand, a micro-economic and a macroeconomic interpretation. Economic Journal 51: 140–145.

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Frisch, R. 1933. Propagation problems and impulse problems in dynamic economics. In Economic essays in honour of Gustav Cassel , ed. R. Frisch. London: Allen & Unwin.

Frisch, R. 1934. Some problems in economic macrodynamics. Econometrica 2: 189.

Keynes, J.M. 1936. The general theory of employment, interest and money . New York: Harcourt, Brace.

Klein, L. 1946. Macroeconomics and the theory of rational behavior. Econometrica 14: 93–108.

Leijonhufvud, A. 1968. On Keynesian economics and the economics of Keynes . New York: Oxford University Press.

Machlup, F. 1963. Micro- and macro-economics: Contested boundaries and claims of superiority. In Essays on economic semantics , ed. F. Machlup and M. Miller. Englewood Cliffs: Prentice-Hall.

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Varian, H.R. (1987). Microeconomics. In: The New Palgrave Dictionary of Economics. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-349-95121-5_1212-1

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Module 1: Economic Thinking

Economic models, learning objectives.

• Explain the characteristics and purpose of economic models

An economic model  is a simplified version of reality that allows us to observe, understand, and make predictions about economic behavior. The purpose of a model is to take a complex, real-world situation and pare it down to the essentials. If designed well, a model can give the analyst a better understanding of the situation and any related problems.

A good model is simple enough to be understood while complex enough to capture key information. Sometimes economists use the term theory  instead of model . Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical representation. Often, models are used to test theories. In this course, however, we will use the terms interchangeably.

Watch this video to get a better grasp on economic models and why they are useful to economists in making predictions about behavior.

Economic Models and Math

Economists use models as the primary tool for explaining or making predictions about economic issues and problems. For example, an economist might try to explain what caused the Great Recession in 2008, or she might try to predict how a personal income tax cut would affect automobile purchases.

Economic models can be represented using words or using mathematics. All of the important concepts in this course can be explained without math. That said, math is a tool that can be used to explore economic concepts in very helpful ways. You know the saying “A picture is worth a thousand words”? The same applies to graphs: they’re a very effective means of conveying information visually—without a thousand words. In addition to being a “picture,” a graph is also a math-based model.

The use of algebra is a specific way that economics express and explore economic models. Where graphs require you to “eyeball” a model, algebra can give you more precise answers to questions. For example, if a business puts their product on sale for 10% off the regular price, how much more will consumers buy? Similarly, using the algebraic formula for a line allows economists to find precise points on a graphs that help in interpreting how much of a good should be sold, or at what price.

Why would an economist use math when there are other ways of representing models, such as with text or narrative? Why would you use your fist to bang a nail, if you had a hammer? Math has certain advantages over text. It disciplines our thinking by making us specify exactly what we mean. You can get away with fuzzy thinking and vague approximations in your own mind, but not when you’re reducing a model to algebraic equations. At the same time, math has certain disadvantages. Mathematical models lack the nuances that can be found in narrative models. The point is that math is one tool, but it’s not the only tool or even always the best tool economists can use to work with economic models.

Examples of Models

Figure 1. A architectural model.

An architect who is designing a major office building will probably build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products that are rougher and less finished than the final product but can still demonstrate how the new product will work and look. Such models help people visualize a product (or a building) in a more complete, concrete way than they could without them.

Similarly, economic models offer a way to get a complete view or picture of an economic situation and understand how economic factors fit together.

A good model to start with in economics is the circular flow diagram (Figure 2, below). Such a diagram indicates that the economy consists of two groups, households and firms, which interact in two markets: the goods-and-services market  (also called the product market) , in which firms sell and households buy, and the labor market , in which households sell labor to business firms or other employees.

Figure 2. The Circular Flow Diagram.

Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies these distinctions in order to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for payments. The outer ring represents the two sides of the product market (which provides goods and services), in which households demand and firms supply. In addition, households (as workers) sell their labor to firms in return for wages, salaries, and benefits. This is shown in the inner circle, which represents the two sides of the labor market ,  in which households supply and firms demand. This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy.

We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, or interactions with the rest of the world (imports and exports). Economists reach for theories in much the same way as a carpenter might grab a tool. When economists identify an economic issue or problem, they sift through the available theories to see if they can find one that fits. Then they use the theory to give them insights about the issue or problem. In economics, theories are expressed in models as diagrams, graphs, or even as mathematical equations. Counter to what you might expect, economists don’t figure out the solution to a problem and then draw the graph. Instead, they use the graph to help them discover the answer. In this way, these graphs serve as models to make inferences about behavior.

At the introductory level, you can sometimes figure out the right answer without using a model, but if you keep studying economics, before too long you’ll encounter issues and problems whose solution will require graphs. Both micro and macroeconomics are explained in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn about several others.

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