Microeconomics
Microeconomics
EQUILIBRIA AND THE PRICE SYSTEM
Microeconomics refers to the behavior of individual actors, using economic reasoning. Economic reasoning refers to the specification of individuals as purposeful decision makers. In economics, observed behaviors are typically interpreted as the outcomes of decision problems. At this level of abstraction, such a conceptualization of individuals is purely tautological. Microeconomic theories have content because of the way in which these decisions are specified; in other words, from the ways in which individuals are assumed to behave and from the description of the environment in which they function.
BASIC IDEAS
While the behavioral assumptions embodied in theoretical economic models vary widely, there are common elements that provide a heuristic description of individual decisions. First, agents are assumed to have preferences over the outcomes of their actions. By itself, this is again tautological until structure is placed on the preferences. In neoclassical economic theory, where preferences are defined over different commodity vectors, such as consumer durables to leisure, standard assumptions include: (1) completeness, the idea that an individual can compare all possible pairs of commodities and determine that which he or she prefers; and (2) transitivity, the idea that if an individual prefers commodity vector a to b and prefers b to c, then he or she will prefer a to c. These assumptions on preferences can, with certain technical assumptions, mean that individuals may be modeled as possessing utility functions; that is, that an individual acts “as if” there is a function that assigns numbers to different commodity bundles such that higher numbers are always preferred. While microeconomic environments typically start with utility functions, the reason for this is not a belief in their literal existence, but the fact that preference orderings may be represented by them.
Second, agents are assumed to face constraints. Simply put, an agent cannot choose the best of all possible outcomes. In the context of consumption, constraints are usually represented as a budget constraint, which requires that the expenditures required for a group of commodities are affordable. Constraints can be less transparent. In labor economics, when there is imperfect information about jobs, an unemployed worker can either choose among those jobs of which he or she is aware or alter the constraint by engaging in search.
Third, decisions are affected by an agent’s beliefs. The preferences that an agent has over outcomes will be mediated by his or her beliefs as to how these outcomes affect him or her. For example, if an individual is deciding on whether to attend college or begin work after graduating high school, this decision will be affected by his or her beliefs as to the trajectories of earned wages under the two scenarios. An obvious reason why beliefs and realizations may differ is time, where decisions are made today before their future consequences are known. While the baseline assumptions on beliefs in economics are some form of consistent beliefs such as rational expectations, recent research has stressed various forms of learning and adaptation, such as the 2001 work of George Evans and Seppo Honkapohja.
EQUILIBRIA AND THE PRICE SYSTEM
Individual decisions are made in larger contexts. Traditionally the context for microeconomics was that of markets, in which buyers and sellers transact commodities. General equilibrium theory represents the apex of the market-based approach to microeconomics, in which the individual behaviors of buyers and sellers is simultaneously considered. In the classical environment studied by Kenneth Arrow, Gerard Debreu, and Lionel McKenzie, the key feature linking these decisions is the presence of a common price for all buyers and sellers in a given market. In general equilibrium theory, classic questions include whether an equilibrium exists (that is, whether there is a set of prices such that aggregate demand and aggregate supply are equated in every market) and whether the equilibrium is Pareto Optimal (that is, whether the allocation of goods at an equilibrium is efficient in the sense that there is no other allocation where everyone is equally well off and at least one person better off).
In classical general equilibrium theory prices do not convey information; no one learns from prices. The classical theory has been extended to include an informational role for prices. This is of great importance as it addresses the question of how information is aggregated in a decentralized economy. As Friedrich Hayek wrote in a classic statement, “How can the combination of fragments of knowledge bring about results which, if they were to be brought about deliberately, would require a knowledge on the part of the directing mind which no single person can possess?” (Hayek 1948, p. 54). Hayek’s profound suggestion was that the price system aggregates information across agents in a way to produce collectively efficient allocations; modern microeconomic theory, pioneered by Sanford Grossman, has provided both a formalization and a description of the cases where this aggregation property does and does not hold. This is especially true for asset markets, where, as Grossman observed in 1989, a trader will wish to change his or her demand function for an asset evaluated at a particular price after observing that price cleared the market, in contrast to the standard formulation of a demand function in classical Walrasian general equilibrium theory.
Grossman’s own work shows that the extension of classical general equilibrium theory to include the informational role of prices leads to: (1) results that show how equilibrium prices aggregate private information held by individual traders and renders key portions of it publicly available to all traders; (2) results that help resolve key information paradoxes in efficient markets theory; and (3) results that show key distinctions between synthetic securities (e.g., those synthetic securities produced by program trading strategies) and real securities and the policy importance of this distinction. The importance of prices as conveyors of information originally arose in the context of debates, primarily between Hayek and Oskar Lange, on whether socialist economies could replicate the efficiency of capitalist ones; economists conjecture they are important in thinking about transition by postcommunist economies today.
In contrast to general equilibrium theory, game theory does not focus on the role of markets in adjudicating individual decisions or in the transmission of information in a world where agents take prices as given beyond their individual control, but rather examines how individuals choose strategies when others are also choosing strategies. In such environments, important institutional features include the specification of whether or not agents can communicate with one another and form contracts with one another. Game theory has proven particularly useful in understanding the consequences of imperfect competition; that is, cases where individual firms do not act as passive price takers.
APPLICATIONS
Virtually all forms of economic decisions have been studied using microeconomics, with particular attention to their implications for behaviors that are observed in equilibrium. One example of this is the analysis of decision making under uncertainty. In order to understand how, for example, financial markets price risk, it is necessary to specify how individual agents react to risk as well as the riskiness of assets that are available. When placed in an integrated general equilibrium framework that takes into account the informational role of prices, one has the basis for the theory of finance, which has provided a complete theory of how asset returns are interrelated. Celebrated results such as the capital asset pricing model, which describes how financial markets price risk and the Black-Scholes option pricing model, which relates the prices of a stock option to the price of the stock and the interest rate on risk free bonds, have proven to have great practical as well as scholarly value.
Much of the research in microeconomics since the 1970s has focused on the relaxation of the behavioral assumptions that are traditionally associated with neoclassical economic theory. A particularly important body of work is often referred to as information economics and explores the implications for imperfect and differential information for the functioning of market and nonmarket interactions. A classic example is George Akerlof’s 1970 analysis of the market for used cars when some cars are known by their owners to be lemons. Two ideas that emerge from this literature that are standard in the study of insurance and related markets are adverse selection (the idea that certain market arrangements influence the composition of market participants such as individuals who privately know they are ill being more likely to seek medical insurance but vendors of such insurance are unable to observe the health of the individual) and moral hazard (the idea that market arrangements can lead to undesirable behaviors, such as an insured person taking more risks because he or she has the insurance).
The newly influential school of behavioral economics has challenged many of the rationality assumptions that agents face. Behavioral economists have attempted both to document how actual behaviors deviate from traditional notions of rationality as well as to understand how these deviations can explain phenomena such as investment behavior. Recent work on social interactions has attempted to expand microeconomics to incorporate substantive sociological perspectives. A recent survey of this type of work and the related empirical measurement problems is produced in William Brock and Steven Durlauf’s article for the Handbook of Econometrics (2001).
In addition to efforts to expand the behavioral richness of microeconomics, research has attempted to apply microeconomic reasoning to new contexts; much of this was pioneered by Gary Becker. It is standard for economists to study decisions ranging from childbearing to religious behavior to crime using microeconomic reasoning. This work is sometimes regarded as “economic imperialism” but is perhaps better regarded as a recognition that purposeful decision making is not simply an economic concept but rather an important element of human nature. The notion of purposeful decision making that lies at the heart of microeconomics is compatible with the use of substantive ideas from psychology and sociology to enrich the specification of how these decisions are made.
An equally important development concerns the integration of microeconomics into macroeconomics. Modern macroeconomic theory, as exemplified in the work of Robert Lucas, Edward Prescott, and Thomas Sargent, has to a large extent been defined by the requirement that microeconomics provides the basis for macroeconomic modeling relationships. This integration has been of fundamental importance providing a coherent view of macroeconomic dynamics, including the role of expectations and intertemporal decision making in understanding the effects of macroeconomic policies. The integration of microeconomics and macroeconomics is not complete in the sense that issues of aggregation are typically ignored, but the importance of microeconomic reasoning in conditioning the modeling of macroeconomic relations is clear.
Finally, it is important to note that microeconomics has an extraordinarily active empirical side. Specific microeconomic theories are constantly being subjected to testing and evaluation. More generally, microeconomic reasoning has been used to strengthen the inferences drawn for what might appear initially as purely statistical questions, such as the effect of a job-training program on its participants. As exemplified in the work of James Heckman, microeconomic reasoning is required whenever one is interested in discussing causal aspects of individual behavior.
FURTHER READING
Neoclassical economic theory is comprehensively surveyed in Andreu Mas-Collel, Michael Whinston, and Jerry Green’s Microeconomic Theory (1995). J. Darrell Duffie’s Dynamic Asset Pricing Theory (2001) is a deep treatment of the modern theory of finance. Becker surveyed his fundamental contributions to the extension of neoclassical microeconomics to the study of the family and reproduced them in A Treatise on the Family (1993). Nancy Stokey, Robert Lucas, and Edward Prescott in Recursive Methods in Economic Dynamics (1989) and Thomas Sargent in Dynamic Macroeconomic Theory (1987) provide full coverage of the contemporary micro foundations of macroeconomics. Colin Camerer described the contemporary behavioral economics and contrasted it with more traditional approaches in his 2003 work. Heckman’s 2001 article is an overview of his scholarship and is in many ways a summary of the achievements of modern microeconometrics. In their book Microeconometrics (2005), A. Colin Cameron and Pravin Trivedi describe many statistical methods that have been employed to evaluate microeconomic data.
SEE ALSO Arrow-Debreu Model; Economics, Neoclassical; Game Theory; General Equilibrium; Macroeconomics; Microfoundations; Rationality
BIBLIOGRAPHY
Akerlof, George. 1970. The Market for Lemons: Quality Uncertainty and the Market Mechanism. Quarterly Journal of Economics 89: 488–500.
Becker, Gary. 1993. A Treatise on the Family. Enlarged ed. Cambridge, MA: Harvard University Press.
Brock, William, and Steven Durlauf. 2001. Interactions-Based Models. In Handbook of Econometrics. Vol. 5, ed. James Heckman and Edward Leamer, 3297–3380. Amsterdam: North Holland.
Camerer, Colin. 2003. Behavioral Game Theory: Experiments in Strategic Interaction. Princeton, NJ: Princeton University Press.
Cameron, A. Colin, and Pravin Trivedi. 2005. Microeconometrics: Methods and Applications. New York: Cambridge University Press.
Duffie, J. Darrell. 2001. Dynamic Asset Pricing Theory. 3rd ed. Princeton, NJ: Princeton University Press.
Evans, George, and Seppo Honkapohja. 2001. Learning and Expectations in Macroeconomics. Princeton, NJ: Princeton University Press.
Grossman, Sanford. 1989. The Informational Role of Prices. Cambridge: MIT Press.
Hayek, Friedrich. 1948. Individualism and Economic Order. Chicago: University of Chicago Press.
Heckman, James. 2001. Micro Data, Heterogeneity, and the Evaluation of Public Policy: Nobel Lecture. Journal of Political Economy 109: 673–748.
Mas-Collel, Andreu, Michael Whinston, and Jerry Green. 1995. Microeconomic Theory. New York: Oxford University Press.
Sargent, Thomas. 1987. Dynamic Macroeconomic Theory. Cambridge, MA: Harvard University Press.
Stokey, Nancy, Robert Lucas, and Edward Prescott. 1989. Recursive Methods in Economic Dynamics. Cambridge, MA: Harvard University Press.
William A. Brock
Steven N. Durlauf
microeconomics
mi·cro·ec·o·nom·ics / ˌmīkrōˌekəˈnämiks; -ˌēkə-/ • pl. n. [treated as sing.] the part of economics concerned with single factors and the effects of individual decisions.DERIVATIVES: mi·cro·ec·o·nom·ic adj.