Distinguishing micro- and macroeconomics

WHAT IS MICROECONOMICS?

Microeconomics can be variously defined as:

Study of group behavior in individual markets (Frank, Robert H., Microeconomics and Behavior, 2nd ed., 1994).

Study of the role of markets in which property rights are exchanged, and contracts and coalitions are formed to enable greater production and resolution of conflicts of interest (Alchian, Armen and William Allen, W, Exchange and Production, 3rd ed., 1983).

“Price theory.” Many textbooks equate microeconomics with “price theory,” which at its core is a theoretical answer to the question: what determines the price of a good? The answer is usually given as: “supply and demand,” so that microeconomics is the study of what determines supply and demand. But of course, supply and demand do not exist in a vacuum; in fact they intersect in something called “a market,” which is of course a place where people who sell meet people who buy.

When we consider that those who sell are “firms” and those who buy are “households,” we can say that microeconomics is the study of how households and firms make decisions and how they interact in markets.

The textbook definitions suggest the thematic areas of microeconomics, and some of its sub-disciplines:

supply and demand (markets as its intersection)

incentives (what drives behavior – utility or profit maximization for consumers or producers)

market failures (which arise when there are no property rights, and when there are transaction and information costs)

o Game theory is a sub-discipline in microeconomics which is often used to analyze market failures (most famous example: the so-called prisoners’ dilemma)

o Public choice is another sub-discipline which studies the economics of democracy.

o Institutional economics is yet another sub-discipline which focuses on how economic institutions work.

gasoline-supply-demand

WHAT IS MACROECONOMICS?

Macroeconomics is, like microeconomics, susceptible of many (equivalent) definitions.

One way to define macroeconomics is to say that it is the economics of the national economy. At one point, I told you that the economy is the “social institutions” for production and consumption, based on Stigler’s definition of economics. Here, the word “national economy” does not refer to such social institutions. Instead it refers to the economy in terms of aggregates, as measured by national or global product or income, employment, and monetary and credit aggregates. Hence, macroeconomics is the study of aggregate figures, based on a concept of the national economy in terms of three markets (goods and services, labor, and money or credit).

In one textbook (Mankiw), macroeconomics is defined as “a study of economy-wide phenomena.” Thus, it deals with such topics as unemployment and inflation, the effect of government activity (taxes, expenditures, subsidies) on the economy, and the exchange rate.

Parkin defines macroeconomics as the study of the national and global economy, focusing on inflation, employment, aggregate (national or global) income and production.

Sicat does not seem to have given an explicit definition of macroeconomics, though it may be inferred that he thinks of macroeconomics as a branch of economics that seeks to explain national income and monetary aggregates, inflation, unemployment, and the business cycle.

Important work in macroeconomics is that of giving this field its own foundations from microeconomics. Thus, the foundations of macro and micro are the same.

HOW DO MICROECONOMICS AND MACROECONOMICS DIFFER FROM EACH OTHER?

Some textbooks give an analogy for distinguishing macroeconomics from microeconomics: the former deals with aggregate behavior (the “forest”), while the latter deals with individual behavior (the “trees”).

Microeconomics attempts to answer the so-called “big” economic questions relating to the goods that are produced and, of course, consumed: what to produce, how to produce them, who will consume, and what are the prices of these goods. Macroeconomics attempts to explain why there is unemployment, why the national economy goes through a boom-and-bust cycle, and what causes the value of money to fall because of price and wage inflation.

I submit that the real distinction between microeconomics and macroeconomics is with respect to an important assumption – one relating to whether prices and wages are flexible or fixed. In microeconomics, the focus is on market equilibrium, and normally, prices and wages are thought (or assumed) to be flexible and determined by the market. In macroeconomics, it is assumed that prices and wages are “fixed” outside the market (they are said to be “rigid”), and the macroeconomist looks at the interaction of labor as consuming households, on the one hand, and firms as employers and producers, on the other hand. In practice, this price rigidity assumption is held valid only during unemployment. In times of “excess demand,” macro models allow for price and wage flexibility – upward.

FOUNDATIONS OF MICROECONOMICS

The following are the fundamental concepts of microeconomics:

1. Scarcity and opportunity cost, which are twin concepts. Scarcity means a choice has to be made. The “opportunity cost” of a choice is what you give up by not making that choice. Recall that opportunity cost is the next best alternative.

Scarce good: A good that is scarce necessarily has an opportunity cost. What is the opportunity cost of P100 of load? It is what you can buy with P100 (say, a meal at the cafeteria for 2 people; or 200 pages of copying at the copy center).

What is a free good? It is a good which you can consume without giving up anything else as a result. “Free-ness” depends on the point of view. It may be free to individuals, but it is not free for society. An example is information. It is free to individuals who receive it because as you “consume” information, you don’t destroy it; you can pass it on, and it doesn’t result in a loss in your ability to derive happiness from the information. But the originator of the information – the researcher or news reporter – needs to be paid for producing the information; society as a whole will have to pay for that, otherwise it will not be produced (see property rights below).

A good may be free because it is so abundant, that there is not enough demand to use it all up. Example: sunlight, moonlight, starlight, and salt water on the high seas. [Quaere: If you couldn’t see, would you consider sunlight a good?]

There is a statement, often attributed to economists: “There is no free lunch.” Why is that true? Answer: Some things appear to be free because it is offered to you as such. But usually, there is a price to pay, at some later time. In other words, there is an opportunity cost to the lunch, because, well good food and wine, and pretty tablecloths are not exactly free goods.

What about the statement that “The best things in life are free”? Is it really? What is the opportunity cost of “love”?

2. Rational choice means thinking at the margin. Averages don’t matter. The last unit does, whether it is the last one chosen or the last one given up. Recall that being rational is not the same as being “reasonable.”

3. Incentives matter in the sense that there are costs and benefits that drive rational behavior. Incentives generally can help to explain why airline food is not as good as food on earth, or why you can seldom find large-denomination money (or big bills) on the sidewalk.

4. Property rights are part of the incentive structure of an economy based on voluntary exchange (markets). A market cannot exist without property rights.

5. Transactions and information costs make a difference in how buyers and sellers might bargain with each other.

6. Efficiency and the production possibility curve (PPC): a process or rule is efficient, or a situation is in a state of efficiency, if, we cannot make any person better off without making another worse off. Efficiency also means that resources are put to their best use, i.e., we use resources to produce the goods we value the most. It also means that if we fix the amount of production of a given good, we will arrange resources and use them to produce the most that we can of another good. The concept of the production possibility curve illustrates how we can determine efficient from inefficient outcomes. Production on the PPC is efficient, whereas production at points “below” the PPC is inefficient. Production “above” the PPC is an impossibility

SAMPLE OF THE FINDINGS OF MICROECONOMICS

The following are some interesting (possibly controversial) results or conclusions from microeconomics:

Inefficiency is usually due to market failure, or to situations when a normal market process is impeded by some circumstances, such as the fact that the good in question is a public good, the presence of monopoly, or when there are unusual transactions costs that hinder bargaining.

Another cause of inefficiency is the use of the “wrong” social institution (dictatorship or regulation), when a market would have worked well enough.

The legal rule on abortions determines the crime rate (Levitt’s hypothesis). If you allow abortion, you lower crime. This leads to the surprising conclusion that an “immoral” society has less crime than a “moral” or righteous society.

If you strictly enforce the anti-drug laws, you increase the crime rate. This is true if the demand for drugs is inelastic (which appears to be the case).

Traffic problems arise from over-use of the roads, which is a variant of an economic model called The Tragedy of the Commons. One solution is to reduce the number of pedicabs, and this may actually be easy to implement if the collective income of all pedicab drivers will increase as their number declines, leaving enough extra to “buy out” those who hesitate to find other means of livelihood. A more general solution is to charge road users a fee during peak or congested hours of road use.

Even if we assume that firms attempt to maximize profits, in the long run, competitive forces in a market economy will drive profits down to zero (or to “normal” business profit). The process by which firms seek to maximize profits is the engine of “efficiency” of an economy. In other words, “greed” is good! Without such greed, or human self-interest, the social arrangements for producing and consuming private goods would be inefficient.

( Silliman lecture, revised June 23, 2008)

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2 thoughts on “Distinguishing micro- and macroeconomics

  1. If you take the micro perspective, policy is to encourage wage and price flexibility. If you take the macro, policy is for government to intervene with expansionary expenditures and/or provision of liquidity. There is usually an assumption that the micro fix takes time, while the macro fix is in the short run. Keynes said that in the long run, “we’re all dead!”

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