Microeconomics is a branch of economics that studies the behavior of individual economic agents, or systems with a limited number of agents, in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms.

The microeconomic perspective focuses on parts of the economy: individuals, firms, and industries. Together with macroeconomics, which studies systems at an aggregate level, it constitutes the macro-category in which all disciplines related to the political economy can be grouped.

One of the main goals of studying microeconomics is to increase economic efficiency. It may have different forms and shapes, and it encompasses more than the industrial archetype of producing most output from least input: allocative efficiency, technical efficiency (X-inefficiency), and employment.

Basic concepts of microeconomics

The fundamentals of microeconomics originate from a basic human characteristic: unlimited desires with limited resources, while the available resources are allocated in a way that maximizes the overall benefit or happiness. The study of microeconomics involves several key concepts, including (but not limited to):

  • Consumer demand theory (utility theory – consumer choice)
  • Production theory and cost-of-production theory of value (price theory)
  • Opportunity cost
  • Industrial organization and market structure

Microeconomists study the many ways that markets can be structured, from perfect competition to monopolies, and the ways that production and prices will develop in these different types of markets.

Use and limits of microeconomic theory

Economics is concerned with the explanation and prediction of observed phenomena. Explanation and prediction are grounded in theories, which are used to explain observed phenomena, in terms of a set of rules and basic assumptions. The theory of the firm, for example, arises from a simple hypothesis: firms seek to maximize profit (although in some particular markets this is not always the case: for example, according to Baumol’s theory in monopolistic markets, firms might pursue the goal of maximizing total revenues, while maintaining the balanced budget of profit as a simple constraint under which not to exceed). The theory uses this assumption to explain how firms choose the amount of labor, capital, and raw materials to use for production, as well as the quantities of goods to produce. This theory also serves to explain how these choices depend on input prices and what price firms are able to obtain for their products.

Economic theories also serve as a prerequisite for making predictions. Thus, firm theory tells us whether a firm’s level of output will increase or decrease as a result of an increase in wages or a decrease in the price of raw materials. Using statistical and econometric techniques, the theory can then be used to build models, on which quantitative forecasts can then be based. A model is a mathematical representation, based on the economic theory of a firm, a market, or some other type of economic entity.

No theory is perfectly correct. Each one starts from basic assumptions or more or less reasonable or realistic approximations of reality. The usefulness and validity of a theory depend on the ability it has to explain and predict the set of real phenomena that we want to study. Given this goal, theories are continually compared (tested) with observations of reality; as a result of this comparison, they are often subject to modification and reformulation, and sometimes even rejection. The process of testing and reformulation is of primary importance to the development of economics as a science. In evaluating a theory, it is important to keep in mind that it is necessarily imperfect.