Part 3: A Question of Perspective – Macro and Microeconomics in Context

The previous blog in this series dealt with Indicators, all of which take a view of the economy as a whole. This aggregate approach can give useful information about global events and changes on a national scale, which, inevitably, will affect individual businesses. This is called Macroeconomics. The study, however, of the exact way in which these factors, and others, play out for those businesses and other entities, be they companies, markets, institutions or individuals, is called Microeconomics.

Macroeconomic Theory

Macroeconomists, in general, are concerned with modelling the economy as a whole, and specifically, with recommending policies that will increase production, reduce unemployment and avoid inflation. Each of these factors affects the growth of an economy. Periods of negative growth, known as recession, typically create adverse conditions for businesses and individuals alike, occasionally resulting in extended periods of poverty amongst the general population. This is clearly undesirable.

Broadly, speaking, therefore, macroeconomics involves the study of the following three basic quantities:

1. Output

Often used interchangeably with income. Since almost everything produced is eventually sold to make profit, output refers to the overall value of goods and services produced by an economy. The most common method for expressing this is Gross Domestic Product (GDP).

2. Inflation

A rapidly growing economy typically generates wealth for the people within it, which, in economic terms, means increasing the supply of money. As the money supply increases and people get richer, demand for specific goods and services also increases. This leads in turn to an increase in the price of those goods as retailers capitalise on people’s willingness to buy. When this process occurs across an entire economy, and all goods and services within it, it’s known as inflation. The net result is a reduction in real income (a typical Coincident Indicator) and an increase in uncertainty that can affect subsequent investment and growth. The reverse of inflation is deflation, which typically occurs in declining economies.

3. Unemployment

In an economic context, unemployment is defined as the percentage of workers in the labour force (that is, those in or actively searching for work) without jobs. Conventional unemployment refers to a situation where labour costs are too high to encourage businesses to employ more workers; frictional unemployment relates to the time it takes to find and apply for an available position; and structural unemployment refers to systemic issues that prevent individuals finding work – a mismatch between available jobs and the skillset of workers for example.

A certain amount of unemployment is inevitable in any economy, and even necessary, since the pool of unemployed individuals constitutes the supply of labour from which businesses draw their workforce. Too much, however, is clearly bad since it limits the money supply in the economy (see above).

In fact, too much or too little of any of these factors can be extremely detrimental to an economy (think of the position of Germany between the world wars where workers were forced to carry their weekly wage home in wheelbarrows; or Spain at the height of the credit crunch where more than one in four people were unemployed). From an economic perspective, the job of policy makers, often working at the national or ‘central’ bank, is to balance out inflation and deflation to avoid a situation of ‘overheating’ and/or recession, limit unemployment and create growth. This is achieved through analysis of data about the current state of the economy, and mathematical modelling of its future performance based on an understanding of how various factors like supply and demand, taxation and interest rates affect these three key variables on a national and global scale.

Microeconomic Theory

Microeconomics is the study of factors affecting the decision-making behaviour of individuals and so-called ‘low impacting organisations’ as they allocate limited (that is, scarce) resources. Traditionally, the study of ‘Economics’ meant only what we now know as Macroeconomics (see above), the study of the aggregate behaviour of large numbers of organisations acting together; but following the work of American Economist Robert Lucas and others towards the end of last century, it is now widely accepted that even Macroeconomic theory should be based on ‘micro-foundations’. The ‘Lucas Critique’ points out that traditional Macroeconomic theory incorporates policies imposed by regulatory bodies (like governments) into its models, and thus stands to give misleading information if these policies change. By this analysis, Microeconomics attempts to elicit the deep foundations of Macroeconomic phenomena by analysing the component parts that go to make it up.

Microeconomic theory is complex and multi-faceted, but certain key concepts and areas of enquiry can be identified. These include:

Supply and Demand

When demand for a particular product is high, retailers are able to charge a higher price for it. Conversely, when the supply of a product is plentiful and demand becomes satisfied, the price tends to fall. Thus, the supply of a particular good or service and the demand for it work together to affect the price in ways that can be mathematically determined. Most demand/supply systems will tend towards an equilibrium point where supply, demand and price remain stable.

Elasticity

In economics, Elasticity is defined as the response of one economic variable to changes in another variable, where the two are causally related. Price elasticity of demand, for example, gives the relationship between changes in demand and price for a given product. During the recent Iraq war, because of a restriction of supply, the price of crude oil rose to an all-time high of USD147 per barrel, with a resultant surge in petrol prices in the UK. Petrol consumption, however, remained relatively the same, illustrating that demand for petrol is relatively inelastic with respect to price. Luxury items like package holidays, for example, show more price elasticity.

Preference

Consumer preferences dictate what are known as consumption expenditures; that is, the amount of money spent on a particular product or service. Preferences can also be applied to businesses in the purchase of raw materials, support services and so on. Ultimately, it is preferences that determine the relationships between supply and demand, including elasticity (see above). In short, the concept of preference gets to the heart of the issue of resource allocation under conditions of scarcity, something that is central to microeconomic theory as a whole.

Production

Broadly speaking, production refers to the conversion of inputs, through a particular process or series of processes, into an output suitable for use, gifting or exchange. Even more broadly, the term may be applied to any activity that is not consumption. Microeconomics concerns itself largely with factors affecting production and specifically how price is determined by the cost of production.

Markets

A market is a physical or virtual space in which goods and services are exchanged and refers in part to the relationship between producers, suppliers and consumers. Various market types have been identified and are amenable to study by microeconomic theory. These include familiar forms like monopoly, where there is only one supplier; and perfect competition, where no single seller has a large enough market share to affect the price. As well as these, microeconomics concerns itself with more technical or obscure market forms like oligopsony, where there are a limited number of buyers; and natural monopoly, where through economies of scale, one supplier is able to meet the entire market demand at a lower cost than any other two of its competitors combined.

Because of its smaller scope, and the reducibility of many of these phenomena to more or less precise mathematical relationships, microeconomics tends to be more successful in its predictions than macroeconomics, for all that it lacks a broad predictive value. Microeconomic theory, therefore, has a wide range of applications in fields as diverse as industry, politics and health.

The next blog in this series deals with behavioural economics, which its advocates believe holds the key to understanding the behaviour of markets, and the economy as a whole.

Pointers

  • Macroeconomics is the ‘bigger picture’; the study of the economy as a whole which can provide useful information about global events and changes
  • Microeconomics analyses the component parts; the market behaviour of individuals and businesses, their decision-making behaviour and how they are affected by factors in the economy
  • Macroeconomists recommend policies that will increase production, reduce unemployment and avoid inflation, factors which affect the growth of an economy and individual businesses
  • Broadly, macroeconomics involves the study of three basic quantities: output (GDP), inflation and unemployment
  • Too much or too little of any of these factors can be extremely detrimental to an economy
  • The job of economic policy makers is to balance out inflation and deflation to avoid a situation of ‘overheating’ and/or recession, limit unemployment and create growth
  • This is achieved through analysis of data about the current state of the economy, and mathematical modelling of its future performance
  • Key concepts in microeconomic theory are: supply and demand, the level of elasticity in the price of goods and services, consumer preferences, production and markets
  • Because of its smaller scope, and the ability to reduce many of these concepts to precise mathematical relationships, microeconomics tends to be more successful in its predictions than macroeconomics
  • Microeconomic theory, therefore, has a wide range of applications in fields as diverse as industry, politics and health

Apr 14, 2015