In This Chapter

Getting to grips with the main points of microeconomics

Dealing with an imperfect world

Microeconomics is a huge area of study, and no one can do the entire subject justice in one book — all of your authors are proud owners of entire shelves full of microeconomic textbooks. You can, however, take away many of the most important core ideas of microeconomics from this book.

So without more ado, here are ten important points to remember from this book.

Respecting Choice

All microeconomics is built on the idea that consumers and producers make choices about what to make or what to buy. As a result, economists tend to have a healthy respect for choice itself. People value things in different ways, and economists want to look at the consequences of, rather than the reasons for, those values. You only get to know what value people place on something after they choose it — or as economists say, you get to know people’s preferences when they have chosen (they also say that there are as many valuations as people).

Trade is possible because people value things differently. The desire to trade creates the need for a means to trade things — a market.

In a famous paper, “The Economic Organization of a Prisoner of War Camp,” Richard Radford, an economist interred in a POW camp, described the need for a means to trade in detail. Starting with Red Cross packages, prisoners traded allowances with each other to make themselves better off. For instance, Gurkhas, being strict Hindus, were only too happy to trade meat for other goods. At first, these trades were done by bartering goods directly, but eventually, through evolution and without anyone making an overall strategic decision, the camps alighted on using tobacco rations as currency — a simple form of money. At this point, very simply, the POWs had created a market.

The result of properly functioning markets is, over the long run, the betterment of everyone. The market relies on people choosing, and economists generally prefer an allocative mechanism that allows people to choose — for instance, by designing mechanisms that let people choose within a framework — as opposed to coming in and preventing or prescribing choice.

Pricing a Good: Difficult but not Impossible

In several situations, a market has difficulty pricing a good. One case is when the marginal cost of the good is at or near zero — a competitive market ends up with no one being able to price above zero and everyone scrambling around for other ways to make money. Public goods — such as street lighting, public parks, or even law enforcement — are another case, one made worse by the impossibility of excluding people who haven’t paid for these services from using them (check out Chapter 14).

But just because a market finding a competitively sustainable solution is difficult, that doesn’t mean it’s impossible. For instance, television broadcasts can be distributed to an extra person at zero marginal cost. In this industry, firms found a way to price something else — advertising — effectively using programming as a lure to sell viewers’ attention to advertisers. Another possibility is selling “membership” to a club as a way of getting access — in essence, a subscription model.

People are essentially creative in such situations. When they come up against an unfavorable economic situation, they try to find solutions to get around the problem. Economists have great respect for this creativity, which is one reason why they want to see what can be achieved without intervening, before coming up with ways to intervene.

Competing on Price or Quality

In a perfectly competitive market, competition is only ever on price, which is always forced down to the marginal cost of production for the marginal firm. But in many market structures, competing on price is tough, and firms have an incentive to focus on other dimensions of their product.

If you start in monopolistic competition (see Chapter 13) — which is a common market structure — you can see why. If you compete on price, over the long run, the price gets pushed down to average cost, and the firm doesn’t make profits. The alternative is to change your focus and try to make your product different or distinctive from the other competitors and, in so doing, make nonzero profits. However, you need to invest to do that, and if you’re investing in keeping the product different or better, you’re using resources that you could’ve spent on getting costs down.

This problem is one reason why firms tend to choose either to be the lowest-cost competitor or a high-quality competitor. The alternative is generally pleasing neither to people who want things cheap nor to those who want good quality.

Seeking Real Markets’ Unique Features

This book discusses lots of ways in which markets are structured, and the economic literature contains many more. What they all have in common are the basic assumptions about what people may do — whether deciding to produce or consume — in those markets. But in reality, markets do have unique and distinctive features — such as, for example, in health care — that often vary from place to place and product to product.

When economists come across distinctive features, they explore the differences between that market and a more generic one. Sometimes they propose ways to make such markets more productive or efficient. Most importantly, economists look very carefully at why a particular market exhibits those features before they rush in and call it a market failure. Instead, they ask a number of questions: Is the market like that because people value things in a particular way? Is a distortion involved, such as a tax or a subsidy? Are there very high sunk costs?

Generic models form a starting point for comparison. Economists aren’t trying to say a given market should be exactly like this or that.

Beating the Market in the Long Run is Very Difficult

The phrase you can’t beat the market is the kind of saying that drives economists to distraction. For a start, when transaction costs are high, a market in many cases is not the most efficient organizational design. Plus, it’s just not realistic to suggest, for instance, that all firms should abandon management structures and replace them with internal markets. Firms are market-facing on the outside, but above a certain size, many of the jobs in a given company aren’t involved in dealing with market transactions. Professors don’t offer their classes at market-clearing prices. When economists say that you can’t beat the market, they’re pointing out that we know that markets can be shown to achieve the highest level of efficiency. In a general equilibrium model (see Chapter 12), for example, the contract curve of best choices relies on people being able to trade their way to their highest level of utility. But that doesn’t mean that doing so is feasible — general equilibrium rests on some strong assumptions. Nor does it mean that a market in every instance is practical. In the Renaissance, Italian city-states hired private armies called condottieri. But they had great difficulty ensuring that condottieri followed orders — in some cases, the soldiers just came in and took over the city. The fact that few places would prefer a mercenary army today is no coincidence.

Having said all that, always be skeptical of people’s claims that they can make long-run profits — and therefore, if you’re an investor, returns — greater than the average of those in the market they’re in. Why? Well, if they could, someone would come in and compete them away. If we can persuade you to take one piece of advice from us, it’s this: Watch your wallet when anyone claims to be able to beat the market in the long run.

Knowing a Tradeoff Always Exists Somewhere

The economist’s model of consumer behavior is called a constrained optimization — because ultimately you’re trying to do your best given that you can’t have everything (see Chapter 5). As a result, at some point you have to choose between one option and another because you can’t have both.

As long as things are scarce, you have to make choices. To an economist, this is just a fact of life, and you may as well complain about gravity as about scarcity. That means that getting your best level of utility is always about trading off one thing for another.

A similar situation happens when you try to balance efficiency and fairness. Now, in the short run a society can be so far away from peak efficiency and complete fairness that a gain in both is possible. But if you’re at the constraint or very near it, trying to prioritize equity leads to a fall in efficiency unless you can do it by lump-sum transfers — which again may not be practical.

A good rule for looking at the world is that if you see a free lunch, ask who’s paying for it: If you’re not, someone else probably is. When a product seems free — as it does for some Internet services, especially in social media, check whether the product is actually you — or more accurately, your personal information that has a value to whoever is offering the service “free.”

Arguing about the Next Best Thing

Throughout the book, we look at the optimal decision for people or firms (Chapters 2–8) or society (Chapter 12 especially) to make. Here’s a little problem though: As Mick Jagger sang, you can’t always get what you want. Microeconomics has some advice for you though. An economic principle, the Theory of the Second Best, reminds us that if you can’t get the optimal solution, then there may be second-best alternatives.

Suppose, for instance, that a polluting monopoly produces your electricity — imagine that electricity can only be made using smoggy coal. Then, if you’re a policy maker and you act to counteract the monopoly, you increase output and produce more smog. So, your best choice under the circumstances isn’t immediately clear. Should you increase production, by dealing with the market inefficiency of monopoly, or mitigate the pollution while keeping the monopoly in place?

Although getting the optimal isn’t possible, you can certainly argue about what the next best thing is. Economists recommend that you look carefully at the inefficiency and the external cost in this situation before coming up with a solution.

When you hear politicians arguing about what to do, remember that often the argument isn’t about what the best thing is, but which of several “practical” options is the second best. You can then choose, on the basis of your investigations, and sometimes on which party you want to support.

Using Markets Isn’t Always Costless

Even though economists generally prefer free exchange — and therefore markets — as their way of achieving goals, using those markets isn’t always costless. Sometimes, an unaccounted cost falls upon another person — an external cost — and sometimes there are costs associated with just finding the person to trade with — transactions costs.

To an economist, the key question is what makes those costs as low as possible? The answer isn’t as simple as just saying that a market inevitably keeps those costs at the lowest possible level, because using the market may not be as “free” as a standard textbook implies.

If, for instance, a hundred painters of varying quality work in your town, and you don’t know any of them because you’ve just moved there, how can you know which one to hire to paint your house? You probably spend a fair amount of time looking for one, getting recommendations on their reliability, quality, and likelihood of leaving your house a mess. These activities are all costs, and they all come about precisely because you’re using a market to find the person.

Economists have two pieces of advice here:

• Think carefully about where the inevitable costs of using a market fall.
• Seek out the opportunities that always exist for entrepreneurs with good ideas for reducing transactions costs for buyers and sellers.

Believing that Competition is Good — Usually

Any time a market isn’t perfectly competitive, the firms in the industry are getting a greater share of the gains from trade. As a result, they always have an interest in preventing another firm from coming in and competing away the gains. They may erect barriers to do so — including advertising, investing in things that involve sunk costs, and making their product or brand different or unique in the consumer’s eye.

These tactics can prevent a rival, even one producing at a lower cost, from competing and taking away some market share. Consumers lose out because the incumbent producers produce less, for higher cost, and take more of the surplus. For this reason, economists look carefully at barriers to market entry and work to get them down as low as possible in the long run.

But that isn’t the whole story. There are times when economists give two cheers to markets that aren’t competitive. For example, a monopolist doesn’t compete with itself, which can mean that you can get a better range of product diversity when there is less competition.

Research in Australia, for instance, suggested that in order to get a different genre of television programming than the prevalent soaps in a prime-time slot, the market would require five TV channels, because the first four competing for viewers would find that making soaps was the best strategy. A monopolist, however, could instead produce a different genre for each channel, because that maximizes the profit from each “slice” of the market.

Suppose that 80 percent of Australia liked soaps in that time slot. Then the first channel would produce soaps, hoping to get 80 percent of the market. The second would also (two channels competing for 80 percent of the market would get around 40 percent each). So would the third and fourth (because 80 divided by 4 is 20 percent). It’s not until you get to the fifth channel that the expected share of the market from producing something different matches the expected share from producing soaps.

In some markets, competition costs too much because it means that competitors can’t produce at a big enough scale. In others — for example, Internet search — competition can’t happen because the market has a winner-takes-all feature. The more people using a search engine, the better the search engine. But if a possibility exists of getting a result from a competitive market, many economists take it as the best option.

Getting Cooperation and Organization in the World

Economics often gets a bad rap because the assumed behavior of individuals in economics seems selfish, because the model of people and firms seems to make a priority of individual benefit, and even because the model of an individual making decisions doesn’t try to reproduce many of the features people think of as essential. But in fact economists are the world’s greatest optimists. Why? Well, economic models are built from no greater assumption than that people follow their own interests — and in so doing, create firms, organizations, production, and consumption, and all the things that make the world go round!

You may disagree that this world is ideal — many people do. But what’s remarkable to the economist is that even if you don’t expect people to follow what Abraham Lincoln called “the better angels of our nature,” you still get cooperation as people get together and form companies, and people following their own interests create and trade in markets.