# Microeconomics

Microeconomics (literally, very small economics) is the study of the economic behaviour of individual consumers, firms, and industries and the distribution of production and income among them. It considers individuals both as suppliers of labour and capital and as the ultimate consumers of the final product. It analyzes firms both as suppliers of products and as consumers of labour and capital.

Microeconomics seeks to analyze the market form or other types of mechanisms that establish relative prices amongst goods and services and/or allocates society's resources amongst their many alternative uses.

Fundamental concepts in microeconomics
Scarcity - Opportunity cost - Supply and demand - Elasticity - Consumer and producer surplus - Aggregation of individual demand to total, or market, demand

Consumer theory
Consumer Theory - Preference - Indifference curve - Utility - Marginal utility - Income

Industrial organization
Market form - Perfect competition - Monopoly - Monopolistic competition - Oligopoly - Concentration ratio - Herfindahl index

Financial economics
Efficient markets theory - Financial economics - Finance - Risk

## Applications and Complications

The simplest way to estimate the opportunity cost of any single economic decision is to consider, "What is the next best alternative choice that could be made?" (This is even though most economic decisions involve multiple alternatives.) The opportunity cost of paying for college this semester could be the ability to make car payments. The opportunity cost of a vacation in the Bahamas could be the down payment money for a house.

Note that opportunity cost is not the sum of the available alternatives, but rather of benefit of the best alternative of them. The opportunity cost of the city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money that could have been made from selling the land, or the loss of any of the various other possible uses -- but not all of these in aggregate.

It is important, as individuals and as societies, to compare the opportunity costs associated with various courses of action. However, some opportunities may be difficult to compare along all relevant dimensions.

Economists often try to use the market price of each alternative to measure opportunity cost. This method, however, presents a considerable difficulty, since many alternatives do not have a market price. It is very difficult to agree on a way to place a dollar value on a wide variety of intangible assets. How does one calculate the cost in dollars, pounds, euros, or yen for the loss of clean air, or the loss of seaside views, or the loss of pedestrian access to a shopping center, or the loss of an untouched virgin forest? Since their costs are difficult to quantify, intangible values associated with opportunity cost can easily be overlooked or ignored.

To overcome this difficulty, economists have identified certain opportunity costs as spillover costs (or external costs). If a chemical producer dumps its waste products into a river, the company has effectively shifted part of the cost of its production onto those living downstream who like to fish. If a billboard company blocks the seaside view of passers-by, some of its gain in advertising revenue is being paid by the passers-by who enjoy natural vistas, instead of by the company's advertisers.

Typically, spillover costs are imposed by a narrower group (often called a special interest group) which benefits more quantifiably and more concretely, and they are borne by a wider group -- perhaps even the public at large -- which pays less quantifiably and less concretely. For this reason, spillover costs are most often controlled by politics and government regulation rather than by markets. Regulations against pollution and building codes restricting billboard locations are examples.

Special interest groups, with a particular political or financial gain in mind, usually find incentives to underestimate or ignore the opportunity costs associated with their activities or agendas (especially when the opportunity costs are spillover costs, that can be imposed upon others), but at times such groups find incentives to overestimate them.

Another difficulty in fixing opportunity cost exists on the macroeconomic level, and is empirical in nature. Discovering the real effect of a change in production of butter specific to the production of guns in an economy as large and multifarious as, say, that of the United States, would be nightmarishly complex.

For that reason, opportunity cost is usually figured within some specific budget of resources. For example, "If the state spends $200 million more on highways it will have$200 million less to spend on schools." Or, "If our company invests $10 million in R+D, it can't give a$1 million Christmas bonus to each of its top ten executives." Or, "If I buy fifty lottery tickets, I won't have these two twenties and one ten left in my wallet for groceries."

Although opportunity cost can be hard to quantify, its effect is universal and very real on the individual level. The principle behind the economic concept of opportunity cost applies to all decisions, not just economic ones. The word "decide" comes from the Latin decidere, meaning "to cut off"; being the prefix de plus the root caedere, "to cut". By definition, any decision that is made cuts off other decisions that could have been made. If one makes a right turn at an intersection, she or he precludes the possibility of having made a left turn. And so forth.

Since the work of the Austrian economist Friedrich von Wieser, opportunity cost has been seen as the foundation of the marginal theory of value.

## An Eternal Truth?

Many see the concept of opportunity cost as one of the very few profound "eternal truths of economics," a result of the universal nature of scarcity as the Economic Problem. A classic illustration of the concept (posed by Otto von Bismarck) envisions an imaginary economy capable of producing only two products: Guns and Butter (i.e. military goods versus civilian goods). If all the resources of this economy were used to produce guns, let's imagine that 100,000 guns could be produced. If, instead, all the resources were used to produce butter, let's imagine that 100,000,000 units of butter could be produced.

So, should this economy's resources be used in practice to produce 50,000,000 units of butter, there will be an opportunity cost in terms of guns. Instead of the 100,000 guns the economy could have produced, it may now only be able to produce 50,000. Conversely, should this economy's resources be used in practice to produce 75,000 guns, there will be an opportunity cost in terms of butter. Instead of the 100,000,000 units of butter the economy could have produced, it may now only be able to produce 25,000,000.

the guns and butter PPF
The graph that depicts opportunity cost between any two given items produced by a given economy is known in economics as the production possibility frontier or curve or "PPF." The curve describing this frontier is not straight, but is curved outward away from the axes to reflect the higher marginal costs that become inevitable due to diminishing returns at the extremes. In the real world, the point on the graph that describes the two given items' position will always lie somewhere well within the frontier (as shown), due to the resources used by all the other goods and services that the given economy produces. However, in the imaginary economy discussed above which produces only guns and butter, the economy will be operating on the PPF (as shown by the arrow) if all resources (inputs) are fully utilized and used most appropriately (efficiently). The exact combination of guns and butter produced depends on the mechanisms used to decide the allocation of resources (i.e., some combination of markets, government, tradition, and community democracy).

This choice can also change. But any move upward or to the right along the PPF involves an opportunity cost. (Scarcity means that cannot go above or the right of the PPF.) Any increase in gun production (a move upward) would reduce the amount of butter that can be produced, while increase in civilian production (moving to the right) would reduce the economy's ability to produce military products. On the PPF, scarcity and opportunity cost prevail.

Others argue that while it is true for most individuals that most or even all choices incur some sort of opportunity cost (i.e., that something is being given up), the concept of opportunity cost does not always apply when viewed from the societal level. Suppose that the economy starts with large amounts of unused capital equipment and unemployed labor, as in the United States (and many other countries) in 1939. In that case, the "guns and butter" economy is inside its PPF (and not due to the production of other outputs). In this situation, it is possible to raise the employment of both capital goods and labor, raising the production of both military goods and civilian goods. In fact, the U.S. did exactly this at the onset of World War II.

This is an example of "Keynesian inefficiency" being solved by increasing aggregate demand. More generally, if inputs are either underemployed or inappropriately employed, the production of both guns and butter can be increased by abolishing inefficiency. In the graph, the economy moves from the "inefficient points" inside the PPF to the PPF itself.

Unfortunately, we may not always be able to get this "free lunch" because special interests often oppose such policies. They may impose institutional opportunity costs that represent more than natural or technological scarcity. Thus, we may see a price that represents political, economic, or social power rather than opportunity cost.

The position of the PPF is not static. It shifts outward (upward and/or to the right) when an economy’s ability to produce increases, i.e., an increase in the aggregate number of guns and butter that can be produced. This can happen if the availability of resources (factors of production) increases, or if technology or management skills improve. Few if any of these changes are "free": for example, increasing the amount of capital goods requires sacrifice of current consumption. Thus, there is a clear opportunity cost. Some shifts may be inexpensive, however, as with some technological change.

The PPF shifts inward when an economy’s ability to produce decreases, reflecting a decrease in the aggregate number of military and civilian goods that can be produced. This is possible due to some major disaster, such as hurricanes or military invasion. The PPF of the Roman Empire probably shifted inward due to the "barbarian" invasions and the end of regular law and order.

File:Supply-demand-P.png
The supply and demand model describes how prices vary as a result of a balance between product availability at each price (supply) and the desires of those with purchasing power at each price (demand). The graph depicts an increase in demand from D1 to D2 along with the consequent increase in price and quantity required to reach a new market-clearing equilibrium point on the supply curve (S).

In microeconomic theory, the partial equilibrium supply and demand economic model originally developed by Alfred Marshall attempts to describe, explain, and predict changes in the price and quantity of goods sold in competitive markets. The model is only a first approximation for describing an imperfectly competitive market. It formalizes the theories used by some economists before Marshall and is one of the most fundamental models of some modern economic schools, widely used as a basic building block in a wide range of more detailed economic models and theories. The theory of supply and demand is important for some economic schools' understanding of a market economy in that it is an explanation of the mechanism by which many resource allocation decisions are made. However, unlike general equilibrium models, supply schedules in this partial equilibrium model are fixed by unexplained forces.

## Assumptions and definitions

The theory of supply and demand usually assumes that markets are perfectly competitive. This implies that there are many buyers and sellers in the market and none of them have the capacity to influence the price of the good. In many real-life transactions, the assumption fails because some individual buyers or sellers or groups of buyers or sellers do have enough ability to influence prices. Quite often a sophisticated analysis is required to understand the demand-supply equation of a good. However, the theory works well in simple situations.

Mainstream economics does not assume a priori that markets are preferable to other forms of social organization. In fact, much analysis is devoted to cases where so-called market failures lead to resource allocation that is suboptimal by some standard. In such cases, economists may attempt to find policies that will avoid waste; directly by government control, indirectly by regulation that induces market participants to act in a manner consistent with optimal welfare, or by creating "missing" markets to enable efficient trading where none had previously existed. This is studied in the field of collective action.

### Demand

Demand is that quantity of a good that consumers are not only willing to buy but also have the capacity to buy at the given price. For example, a consumer may be willing to purchase 2 lb of potatoes if the price is $0.75 per lb. However, the same consumer may be willing to purchase only 1 lb if the price is$1.00 per lb. A demand schedule can be constructed that shows the quantity demanded at each given price. It can be represented on a graph as a line or curve by plotting the quantity demanded at each price. It can also be described mathematically by a demand equation. The main determinants of the quantity one is willing to purchase will typically be the price of the good, one's level of income, personal tastes, the price of substitute goods, and the price of complementary goods.

The shape of the aggregated demand curve can be convex or concave, possibly depending on income distribution, as shown in this paper: http://www.economicswebinstitute.org/essays/consumers.htm

### Supply

Supply is the quantity that producers are willing to produce at a given market price. For example, the potato grower may be willing to sell 1 million lb of potatoes if the price is $0.75 per lb and substantially more if the market price is$0.90 per lb. The main determinants of supply will be the market price of the good and the cost of producing it. In fact, supply curves are constructed from the firm's long-run cost schedule.

## Simple supply and demand curves

Mainstream economic theory centers on creating a series of supply and demand relationships, describing them as equations, and then adjusting for factors which produce "stickiness" between supply and demand. Analysis is then done to see what "trade offs" are made in the "market", which is the negotiation between sellers and buyers. Analysis is done as to what point the ability of sellers to sell becomes less useful than other opportunities. This is related to "marginal" costs, or the price to produce the last unit that can be sold profitably, versus the chance of using the same effort to engage in some other activity.

File:Simple supply and demand.png
Graph of simple supply and demand curves

The slope of the demand curve (downward to the right) indicates that a greater quantity will be demanded when the price is lower. On the other hand, the slope of the supply curve (upward to the right) tells us that as the price goes up, producers are willing to produce more goods. The point where these curves intersect is the equilibrium point. At a price of P producers will be willing to supply Q units per period of time and buyers will demand the same quantity. P in this example, is the equilibrating price that equates supply with demand.

In the figures, straight lines are drawn instead of the more general curves. This is typical in analysis looking at the simplified relationships between supply and demand because the shape of the curve does not change the general relationships and lessons of the supply and demand theory. The shape of the curves far away from the equilibrium point are less likely to be important because they do not affect the market clearing price and will not affect it unless large shifts in the supply or demand occur. So straight lines for supply and demand with the proper slope will convey most of the information the model can offer. In any case, the exact shape of the curve is not easy to determine for a given market. The general shape of the curve, especially its slope near the equilibrium point, does however have an impact on how a market will adjust to changes in demand or supply. (See the below section on elasticity.)

It should be noted that on supply and demand curves both are drawn as a function of price. Neither is represented as a function of the other. Rather the two functions interact in a manner that is representative of market outcomes. The curves also imply a somewhat neutral means of measuring price. In practice any currency or commodity used to measure price is also the subject of supply and demand.

### Effects of being away from the equilibrium point

Consider how prices and quantities not at the equilibrium point tend to move towards the equilibrium. Assume that some organization (say government or industry cartel) has the ability to set prices. If the price is set too high, such as at P1 in the diagram to the right, then the quantity produced will be Qs. The quantity demanded will be Qd. Since the quantity demanded is less than the quantity supplied there will be an oversupply (also called surplus or excess supply). On the other hand, if the price is set too low, then too little will be produced to meet demand at that price. This will cause an undersupply problem (also called a shortage).

Now assume that individual firms have the ability to alter the quantities supplied and the price they are willing to accept, and consumers have the ability to alter the quantities that they demand and the amount they are willing to pay. Businesses and consumers will respond by adjusting their price (and quantity) levels and this will eventually restore the quantity and the price to the equilibrium.

In the case of too high a price and oversupply (seen in the diagram at the left), the profit-maximizing businesses will soon have too much excess inventory, so they will lower prices (from P1 to P) to reduce this. Quantity supplied will be reduced from Qs to Q and the oversupply will be eliminated. In the case of too low a price and undersupply, consumers will likely compete to obtain the good at the low price, but since more consumers would like to buy the good at the price that is too low, the profit-maximizing firm would raise the price to the highest they can, which is the equilibrium point. In each case, the actions of independent market participants cause the quantity and price to move towards the equilibrium point.

## Demand curve shifts

When more people want something, the quantity demanded at all prices will tend to increase. This can be referred to as an increase in demand. The increase in demand could also come from changing tastes, where the same consumers desire more of the same good than they previously did. Increased demand can be represented on the graph as the curve being shifted right, because at each price point, a greater quantity is demanded. An example of this would be more people suddenly wanting more coffee. This will cause the demand curve to shift from the initial curve D0 to the new curve D1. This raises the equilibrium price from P0 to the higher P1. This raises the equilibrium quantity from Q0 to the higher Q1. In this situation, we say that there has been an increase in demand which has caused an extension in supply.

Conversely, if the demand decreases, the opposite happens. If the demand starts at D1 and then decreases to D0, the price will decrease and the quantity supplied will decrease—a contraction in supply. Notice that this is purely an effect of demand changing. The quantity supplied at each price is the same as before the demand shift (at both Q0 and Q1). The reason that the equilibrium quantity and price are different is the demand is different.

## Supply curve shifts

When the suppliers' costs change the supply curve will shift. For example, assume that someone invents a better way of growing wheat so that the amount of wheat that can be grown for a given cost will increase. Producers will be willing to supply more wheat at every price and this shifts the supply curve S0 to the right, to S1—an increase in supply. This causes the equilibrium price to decrease from P0 to P1. The equilibrium quantity increases from Q0 to Q1 as the quantity demanded increases at the new lower prices. Notice that in the case of a supply curve shift, the price and the quantity move in opposite directions.

Conversely, if the quantity supplied decreases, the opposite happens. If the supply curve starts at S1 and then shifts to S0, the equilibrium price will increase and the quantity will decrease. Notice that this is purely an effect of supply changing. The quantity demanded at each price is the same as before the supply shift (at both Q0 and Q1). The reason that the equilibrium quantity and price are different is the supply is different.

## Market 'clearance'

The market "clears" at the point where all the supply and demand at a given price balance. That is, the amount of a commodity available at a given price equals the amount that buyers are willing to purchase at that price. It is assumed that there is a process that will result in the market reaching this point, but exactly what the process is in a real situation is an ongoing subject of research. Markets which do not clear will react in some way, either by a change in price, or in the amount produced, or in the amount demanded. Graphically the situation can be represented by two curves: one showing the price-quantity combinations buyers will pay for, or the demand curve; and one showing the combinations sellers will sell for, or the supply curve. The market clears where the two are in equilibrium, that is, where the curves intersect. In a general equilibrium model, all markets in all goods clear simultaneously and the "price" can be described entirely in terms of tradeoffs with other goods. For a century most economists believed in Say's Law, which states that markets, as a whole, would always clear and thus be in balance.

## Elasticity

Main article: Elasticity (economics)

An important concept in understanding supply and demand theory is elasticity. In this context, it refers to how supply and demand change in response to various stimuli. One way of defining elasticity is the percentage change in one variable divided by the percentage change in another variable (known as arch elasticity because it calculates the elasticity over a range of values, in contrast with point elasticity that uses differential calculus to determine the elasticity at a specific point). Thus it is a measure of relative changes.

Often, it is useful to know how the quantity supplied or demanded will change when the price changes. This is known as the price elasticity of demand and the price elasticity of supply. If a monopolist decides to increase the price of their product, how will this affect their sales revenue? Will the increased unit price offset the likely decrease in sales volume? If a government imposes a tax on a good, thereby increasing the effective price, how will this affect the quantity demanded?

If you do not wish to calculate elasticity, a simpler technique is to look at the slope of the curve. Unfortunately, this has units of measurement of quantity over monetary unit (for example, liters per euro, or battleships per million yen), which is not a convenient measure to use for most purposes. So, for example, if you wanted to compare the effect of a price change of gasoline in Europe versus the United States, there is a complicated conversion between gallons per dollar and liters per euro. This is one of the reasons why economists often use relative changes in percentages, or elasticity. Another reason is that elasticity is more than just the slope of the function: It is the slope of a function in a coordinate space, that is, a line with a constant slope will have different elasticity at various points.

Let's do an example calculation. We have said that one way of calculating elasticity is the percentage change in quantity over the percentage change in price. So, if the price moves from $1.00 to$1.05, and the quantity supplied goes from 100 pens to 102 pens, the slope is 2/0.05 or 40 pens per dollar. Since the elasticity depends on the percentages, the quantity of pens increased by 2%, and the price increased by 5%, so the elasticity is 2/5 or 0.4.

Since the changes are in percentages, changing the unit of measurement or the currency will not affect the elasticity. If the quantity demanded or supplied changes a lot when the price changes a little, it is said to be elastic. If the quantity changes little when the prices changes a lot, it is said to be inelastic. An example of perfectly inelastic supply, or zero elasticity, is represented as a vertical supply curve. (See that section below)

Elasticity in relation to variables other than price can also be considered. One of the most common to consider is income. How would the demand for a good change if income increased or decreased? This is known as the income elasticity of demand. For example, how much would the demand for a luxury car increase if average income increased by 10%? If it is positive, this increase in demand would be represented on a graph by a positive shift in the demand curve, because at all price levels, a greater quantity of luxury cars would be demanded.

Another elasticity that is sometimes considered is the cross elasticity of demand, which measures the responsiveness of the quantity demanded of a good to a change in the price of another good. This is often considered when looking at the relative changes in demand when studying complement and substitute goods. Complement goods are goods that are typically utilized together, where if one is consumed, usually the other is also. Substitute goods are those where one can be substituted for the other, and if the price of one good rises, one may purchase less of it and instead purchase its substitute.

Cross elasticity of demand is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For an example with a complement good, if, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, the cross elasticity of demand would be −20%/10% or, −2.

## Vertical supply curve

It is sometimes the case that the supply curve is vertical: that is the quantity supplied is fixed, no matter what the market price. For example, the amount of land in the world can be considered fixed. In this case, no matter how much someone would be willing to pay for a piece of land, the extra cannot be created. Also, even if no one wanted all the land, it still would exist. These conditions create a vertical supply curve, giving it zero elasticity (i.e., no matter how large the change in price, the quantity supplied will not change).

In the short run near vertical supply curves are even more common. For example, if the Super Bowl is next week, increasing the number of seats in the stadium is almost impossible. The supply of tickets for the game can be considered vertical in this case. If the organizers of this event underestimated demand, then it may very well be the case that the price that they set is below the equilibrium price. In this case there will likely be people who paid the lower price who only value the ticket at that price, and people who could not get tickets, even though they would be willing to pay more. If some of the people who value the tickets less sell them to people who are willing to pay more (i.e., scalp the tickets), then the effective price will rise to the equilibrium price.

The graph below illustrates a vertical supply curve. When the demand 1 is in effect, the price will be p1. When demand 2 is occurring, the price will be p2. Notice that at both values the quantity is Q. Since the supply is fixed, any shifts in demand will only affect price.

## Other market forms

In a situation in which there are many buyers but a single monopoly supplier that can adjust the supply or price of a good at will, the monopolist will adjust the price so that his profit is maximized given the amount that is demanded at that price. This price will be higher than in a competitive market. A similar analysis using supply and demand can be applied when a good has a single buyer, a monopsony, but many sellers.

Where there are both few buyers or few sellers, the theory of supply and demand cannot be applied because both decisions of the buyers and sellers are interdependent—changes in supply can affect demand and vice versa. Game theory can be used to analyze this kind of situation. (See also oligopoly.)

The supply curve does not have to be linear. However, if the supply is from a profit-maximizing firm, it can be proven that supply curves are not downward sloping (i.e., if the price increases, the quantity supplied will not decrease). Supply curves from profit-maximizing firms can be vertical, horizontal or upward sloping. While it is possible for industry supply curves to be downward sloping, supply curves for individual firms are never downward sloping.

Standard microeconomic assumptions cannot be used to prove that the demand curve is downward sloping. However, despite years of searching, no generally agreed upon example of a good that has an upward-sloping demand curve has been found (also known as a giffen good). Non-economists sometimes think that certain goods would have such a curve. For example, some people will buy a luxury car because it is expensive. In this case the good demanded is actually prestige, and not a car, so when the price of the luxury car decreases, it is actually changing the amount of prestige so the demand is not decreasing since it is a different good (see Veblen good). Even with downward-sloping demand curves, it is possible that an increase in income may lead to a decrease in demand for a particular good, probably due to the existence of more attractive alternatives which become affordable: a good with this property is known as an inferior good.

## An example: Supply and demand in a 6-person economy

Supply and demand can be thought of in terms of individual people interacting at a market. Suppose the following six people participate in this simplified economy:

• Alice is willing to pay $10 for a sack of potatoes. • Bob is willing to pay$20 for a sack of potatoes.
• Cathy is willing to pay $30 for a sack of potatoes. • Dan is willing to sell a sack of potatoes for$5.
• Emily is willing to sell a sack of potatoes for $15. • Fred is willing to sell a sack of potatoes for$25.

There are many possible trades that would be mutually agreeable to both people, but not all of them will happen. For example, Cathy and Fred would be interested in trading with each other for any price between $25 and$30. If the price is above $30, Cathy is not interested, since the price is too high. If the price is below$25, Fred is not interested, since the price is too low. However, at the market Cathy will discover that there are other sellers willing to sell at well below $25, so she will not trade with Fred at all. In an efficient market, each seller will get as high a price as possible, and each buyer will get as low a price as possible. Imagine that Cathy and Fred are bartering over the price. Fred offers$25 for a sack of potatoes. Before Cathy can agree, Emily offers a sack of potatoes for $24. Fred is not willing to sell at$24, so he drops out. At this point, Dan offers to sell for $12. Emily won't sell for that amount so it looks like the deal might go through. At this point Bob steps in and offers$14. Now we have two people willing to pay $14 for a sack of potatoes (Cathy and Bob), but only one person (Dan) willing to sell for$14. Cathy notices this and doesn't want to lose a good deal, so she offers Dan $16 for his potatoes. Now Emily also offers to sell for$16, so there are two buyers and two sellers at that price (note that they could have settled on any price between $15 and$20), and the bartering can stop. But what about Fred and Alice? Well, Fred and Alice are not willing to trade with each other, since Alice is only willing to pay $10 and Fred will not sell for any amount under$25. Alice can't outbid Cathy or Bob to purchase from Dan, so Alice will not be able to get a trade with them. Fred can't underbid Dan or Emily, so he will not be able to get a trade with Cathy. In other words, a stable equilibrium has been reached.

A supply and demand graph could also be drawn from this. The demand would be:

• 1 person is willing to pay $30 (Cathy). • 2 people are willing to pay$20 (Cathy and Bob).
• 3 people are willing to pay $10 (Cathy, Bob, and Alice). The supply would be: • 1 person is willing to sell for$5 (Dan).
• 2 people are willing to sell for $15 (Dan and Emily). • 3 people are willing to sell for$25 (Dan, Emily, and Fred).

Supply and demand match when the quantity traded is two sacks and the price is between $15 and$20. Whether Dan sells to Cathy, and Emily to Bob, or the other way round, and what precisely is the price agreed cannot be determined. This is the only limitation of this simple model. When considering the full assumptions of perfect competition the price would be fully determined, since there would be enough participants to determine the price. For example, if the "last trade" was between someone willing to sell at $15.50 and someone willing to pay$15.51, then the price could be determined to the penny. As more participants enter, the more likely there will be a close bracketing of the equilibrium price.

It is important to note that this example violates the assumption of perfect competition in that there are a limited number of market participants. However, this simplification shows how the equilibrium price and quantity can be determined in an easily understood situation. The results are similar when unlimited market participants and the other assumptions of perfect competition are considered.

## Decision making

Much of economics assumes that individuals seek to maximize their happiness or utility; however, whether they rationally attempt to optimize their well-being given available information is a source of much debate. In this view, which underpins much of economic writing, individuals make choices between alternatives based on their estimation of which will yield the best results. Many important economic ideas, such as the "efficient market hypothesis", rest on this view of decision making.

However, this framework, once called "homo economicus", has for decades been the focus of unease even by those who apply it. Milton Friedman once defended the idea by saying that inaccurate assumptions could produce accurate results. Alfred Marshall was careful to differentiate the tendency to maximize happiness with maximizing economic well-being. The limits of rationality have been the subject of intense study, for example, Herbert Simon's model for "bounded rationality", which was awarded a Nobel Prize in 1978. More recently, irrational behavior and imperfect information have increasingly been the subject of formal modeling, often referred to as behavioral economics, for which Daniel Kahneman won a Nobel Prize in 2002. An example is the growing field of behavioral finance, which combines previous theory with cognitive psychology.

The new model of information and decision making focuses on asymmetrical information, when some participants have key facts that others do not, and on decision making based not on the economic pressures but on the decisions of other economic actors. Asymmetrical information and behavioral dynamics lead to different conclusions: in a world of asymmetrical information, markets are generally not efficient, and inefficiencies grow up as means of hedging against information. While not yet universally accepted, it is increasingly influential in policy, for example, the writing of Joseph Stiglitz and financial modeling.

## History of supply and demand

Attempts to determine how supply and demand interact began with Adam Smith's The Wealth of Nations, first published in 1776. In this book, he mostly assumed that the supply price was fixed but that the demand would increase or decrease as the price decreased or increased. David Ricardo in 1817 published the book Principles of Political Economy and Taxation, in which the first idea of an economic model was proposed. In this, he more rigorously laid down the idea of the assumptions that were used to build his ideas of supply and demand.

During the late 19th century the marginalist school of thought emerged. This field mainly was started by Stanley Jevons, Carl Menger, and Léon Walras. The key idea was that the price was set by the most expensive price, that is, the price at the margin. This was a substantial change from Adam Smith's thoughts on determining the supply price.

Finally, most of the basics of the modern school theory of supply and demand were finalized by Alfred Marshall and Léon Walras, when they combined the ideas about supply and the ideas about demand and began looking at the equilibrium point where the two curves crossed. They also began looking at the effect of markets on each other. Since the late 19th century, the theory of supply and demand has mainly been unchanged. Most of the work has been in examining the exceptions to the model (like oligarchy, transaction costs, non-rationality).

## Criticism of Marshall's theory of supply and demand

Marshall's theory of supply and demand runs counter to the ideas of economists from Adam Smith and David Ricardo through the creation of the marginalist school of thought. Although Marshall's theories are dominant in elite universities today, not everyone has taken the fork in the road that he and the marginalists proposed. One theory counter to Marshall is that price is already known in a commodity before it reaches the market, negating his idea that some abstract market is conveying price information. The only thing the market communicates is whether or not an object is exchangeable or not (in which case it would change from an object to a commodity). This would mean that the producer creates the goods without already having customers—blindly producing, hoping that someone will buy them (buy meaning exchange money for the commodities). Modern producers often have market studies prepared well in advance of production decisions; however, misallocation of factors of production can still occur.

Keynesian economics also runs counter to the theory of supply and demand. In Keynesian theory, prices can become "sticky" or resistant to change, especially in the case of price decreases. This leads to a market failure. Modern supporters of Keynes, such as Paul Krugman, have noted this in recent history, such as when the Boston housing market dried up in the early 1990s, with neither buyers nor sellers willing to exchange at the price equilibrium.

Gregory Mankiw's work on the irrationality of actors in the markets also undermines Marshall's simplistic view of the forces involved in supply and demand.

## Progressive and regressive taxation

An important feature of tax systems is whether they are flat (the percentage does not depend on the base, hence the tax is proportional to how much you earn, have, or spend), regressive (the more you have the lower the tax rate), or progressive (the more you have the higher the tax rate). Progressive taxes reduce the tax burden of people with smaller incomes, since they take a smaller percentage of their income. Regressive taxes are less common but not unknown.

## Direct and indirect taxation

Taxes are sometimes referred to as direct or indirect. The meaning of these terms can vary in different contexts, which can sometimes lead to confusion. In economics, direct taxes refer to those taxes that are collected from the people or organizations on whom they are ostensibly imposed. For example, income taxes are collected from the person who earns the income. By contrast, indirect taxes are collected from someone other than the person ostensibly responsible for paying the taxes.

From whom a tax is collected is a matter of law. However, who pays the tax is determined by the market place and is found by comparing the price of the good (including tax) after the tax is imposed to the price of the good before the tax was imposed. For example, suppose the price of gas in the U.S., without taxes, were $2.00 per gallon. Suppose the U.S. government imposes a tax of$0.50 per gallon on the gas. Forces of demand and supply will determine how that $0.50 tax burden is distributed among the buyers and sellers. For example, it is possible that the price of gas, after the tax, might be$2.40. In such a case, buyers would be paying $0.40 of the tax while the sellers would be paying$0.10 of the tax.

In law, the terms may have different meanings. In US constitutional law, for instance, direct taxes refer to poll taxes and property taxes, which are based on simple existence or ownership. Indirect taxes are imposed on rights, privileges, and activities. Thus, a tax on the sale of property would be considered an indirect tax, whereas the tax on simply owning the property itself would be a direct tax.

The distinction can be subtle, but it is important under US law, since the United States Constitution formerly required that direct taxes be apportioned according to population. That is, if one state had twice the population of another state, then the direct tax revenue from that state must be exactly twice that from the other state. In 1895, the US Supreme Court interpreted the income tax as a direct tax when applied to income from property, and struck down the tax as a result. The federal government then had no income tax until the Sixteenth Amendment was ratified, which removed the apportionment requirement for income taxes.

## Economics of taxation

File:TaxGraph1.jpg
Figure 1: Equilibrium

Figure 1 indicates a good without any government interference. This good could represent anything from apples to zippers. At this equilibrium quantity Q1 of the good are sold at price P1. The consumer and producer surplus are both high.

File:TaxGraph2.jpg
Figure 2: With a tax

Figure 2 shows the introduction of a very simple tax. The tax charges a flat fee whenever a consumer wishes to purchase the good. The price thus rises to P2, and since fewer consumers wish to purchase the good at the higher price, the quantity produced falls to Q2. The government receives the amount of the tax for each unit sold, and this amounts to the region shown in grey. This is the amount of revenue the government receives for this tax.

Note that in this situation the price of the good to consumers only increases by half the amount of the tax, the other half of the tax is borne by the producer. Thus both consumer and producer surpluses shrink by equal amounts. For many goods this is not the case. Who bears the cost of the tax is determined by the elasticity of the good. For inelastic goods like cigarettes, and gasoline almost all of the tax is paid by the consumer.

File:TaxGraph3.jpg
Figure 3: Net Societal Loss

The tax is not a simple transfer of wealth from producers and consumers to government. A permanent loss of surplus occurs, shown in orange. This loss is often called dead weight loss which is is a permanent loss to sociey as if some of the goods (Q1 to Q2) were destroyed.

However, because this model greatly simplifies the economics of taxation, governments must weigh many other factors when choosing a tax system. The size of the dead weight loss usually increases exponentially with regards to the size of the tax meaning a broad small tax (sales tax) would normally have less negative impact than a narrow large tax (taxing a particular good heavily).

## Types of taxes

### Income tax

Income tax is commonly a progressive tax because the tax rate increases with increasing income. For this reason, it is generally advocated by those who think that taxation should be borne more by the rich than by the poor, even to the point of serving as a form of social redistribution. Some critics characterize this tax as a form of punishment for economic productivity. Other critics charge that income taxation is inherently socially intrusive because enforcement requires the government to collect large amounts of information about business and personal affairs, much of which is considered proprietary and confidential.

The crucial invention permitting the reliable collection of high income taxes was direct withholding of taxes from payrolls by employers; this works because most people in modern societies are salaried workers. This reduces the perceived burden of the tax, because employees never handle the money. Direct withholding also discourages cheating, because it requires the collaboration of employers, and as there are fewer employers than employees, the government's enforcement efforts can be deployed more effectively. However, direct withdrawal also has some drawbacks: it puts part of the burden of processing taxes on the employer, and it also complicates matters when the employee is in a situation where he or she should pay significantly less or more than what is expected from its salary (because of tax-deductible expenses, or side revenues). Direct withholding is the method of collection of choice in most countries implementing income taxes, with the exception of France, where direct withholding is periodically discussed, but has so far not been implemented.

Where income tax is not collected at source, it may become easier to cheat by lying about one's affairs. The government may then require that employers report the amounts they pay to employees.

Income tax, in addition to income, generally takes into account a variety of factors. Certain expenses, such as work-related expenses, donations to charities etc..., may be tax-deductible: that is, they are subtracted from the taxable revenue. Investments in some impoverished areas or industrial sectors may be encouraged through tax breaks (reduced rates). Donations to charities may be partly subtracted from the tax, in an original form of subsidy. Because of various exemptions, rebates etc..., income tax codes tend to be complicated. In some countries such as the United States, individuals often hire the service of a tax accountant so as to find the best way to reduce their tax.

Income tax fraud is a problem in most, if not all, countries implementing an income tax. Either one fails to declare income, or declares nonexistent expenses. Failure to declare income is especially easy for non-salaried work, especially those paid in cash. Tax enforcement authorities fight tax fraud using various methods, nowadays with the help of computer databases. They may, for instance, look for discrepancies between declared revenue and expenses along time. Tax enforcement authorities then target individuals for a tax audit – a more or less detailed review of the income and tax-deductible expenses of the individual.

Income tax may be collected from legal entities (e.g., companies) as well as natural persons (individuals), although, in some cases, the income tax on legal entities is levied on a slightly different basis than the income tax on individuals and may be called, in the case of income tax on companies, a corporation tax or a corporate income tax.

### Retirement tax

Some countries with social security systems, which provide income to retired workers, fund those systems with specific dedicated taxes. These often differ from comprehensive income taxes in that they are levied only on specific sources of income, generally wages and salary (in which case they are called payroll taxes). A further difference is that the total amount of the taxes paid by or on behalf of a worker is typically considered in the calculation of the retirement benefits to which that worker is entitled. Examples of retirement taxes include the FICA tax, a payroll tax that is collected from employers and employees in the United States to fund the country's Social Security system; and the National Insurance Contributions (NICs) collected from employers and employees in the United Kingdom to fund the country's national insurance system.

These taxes are sometimes regressive in their immediate effect. For example, in the United States, each worker, whatever his or her income, pays at the same rate up to a specified cap, but income over the cap is not taxed. A further regressive feature is that such taxes often exclude investment earnings and other forms of income that are more likely to be received by the wealthy. The regressive effect is somewhat offset, however, by the eventual benefit payments, which typically replace a higher percentage of a lower-paid worker's pre-retirement income.

### Capital gains tax

A capital gain tax is the tax levied of the profit realised upon the sale of an asset. In many cases, the amount of a capital gain is treated as income and subject to the marginal rate of income tax.

If such a tax is levied on inherited property then it can act as a de facto probate or inheritance tax.

### Corporation tax

Corporation tax is a tax on corporate earnings (and often includes capital gains) of a company. Earnings are generally considered gross revenue less expenses. However, corporate expenses that relate to capital expenditures are rarely deducted in full (such as the entire cost of a company truck) and are often deducted over the useful life of the asset purchase. Generally, industrialized countries also use a regressive rate of tax upon corporate income.

### Poll tax

A poll tax, also called a per capita tax, or capitation tax, is a tax that levies a set amount per individual. The earliest tax mentioned in the Bible of a half-shekel per annum from each adult Jew (Ex. 30:11-16) was a form of poll tax. Poll taxes are regressive, since they take the same amount of money (and hence, a higher proportion of income) for poorer individuals as for richer individuals. Poll taxes are difficult to cheat.

### Excises

Unlike an ad valorem tax, an excise is not a function of the value the product being taxed. Excise taxes are based on the quantity, not the value, of product purchased. For example, in the United States, the Federal government imposes an excise tax of 18.4 cents per US gallon (4.86 ¢/L) of gasoline, while state governments levy an additional 8 to 28 cents per US gallon.

#### Purposes and effects of excises

Excises on particular commodities are frequently hypothecated. For example, a fuel excise is often used to pay for public transportation, especially roads and bridges and for the protection of the environment. A special form of hypothecation arises where an excise is used to compensate a party to a transaction for alleged uncontrollable abuse: for example, a blank media tax is a tax on recordable media such as CD-Rs, whose proceeds are typically allocated to copyright holders. Critics charge that such taxes tax blindly those who make legitimate and illegitimate usages of the products; for instance, a person or corporation using CD-R's for data archival should not have to subsidize the producers of popular music.

Excises (or exemptions from them) are also used to modify consumption patterns. For example, a high alcohol excise is used to discourage alcohol consumption, relative to other goods. This may be combined with hypothecation if the proceeds are then used to pay for the costs of treating illness caused by alcohol abuse. Similar taxes may exist on tobacco, pornography, etc..., and they may be collectively referred to as sin taxes. A carbon tax is a tax on the consumption of carbon-based non-renewable fuels, such as petrol, diesel-fuel, jet fuels and natural gas. The object is to reduce the release of carbon into the atmosphere. In the UK, vehicle excise duty is an annual tax on vehicle ownership.

### Sales tax

Sales taxes are a form of excise levied when a commodity is sold to its final consumer. They are generally held to discourage retail sales. The question of whether they are generally progressive or regressive is a subject of much current debate. People with higher incomes spend a lower proportion of them, so a flat-rate sales tax will tend to be regressive. It is therefore common to exempt food, utilities and other necessities from sales taxes, since poor people spend a higher proportion of their incomes on these commodities, so such exemptions would make the tax more progressive. The classic way of cheating on sales tax is to ask a merchant or service provider for a cash discount. The merchant pockets the cash and writes off the merchandise to shrinkage and the state fails to get the tax.

### Tariffs

An import or export tariff (also called customs duty or impost) is a charge for the movement of goods through a political border. Tariffs discourage trade, and they may be used by governments to protect domestic industries. A proportion of tariff revenues is often hypothecated to pay government to maintain a navy or border police. The classic way of cheating a tariff is smuggling.

A value added tax (sometimes called a goods and services tax, as in Australia and Canada) applies the equivalent of a sales tax to every operation that creates value. To give an example, sheet steel is imported by a machine manufacturer. That manufacturer will pay the VAT on the purchase price, remitting that amount to the government. The manufacturer will then transform the steel into a machine, selling the machine for a higher price to a wholesale distributor. The manufacturer will collect the VAT on the higher price, but will remit to the government only the excess related to the "value added" (the price over the cost of the sheet steel). The wholesale distributor will then continue the process, charging the retail distributor the VAT on the entire price to the retailer, but remitting only the amount related to the distribution markup to the government. The last VAT amount is paid by the eventual retail customer who cannot recover any of the previously paid VAT. Economic theorists have argued that this minimises the market distortion resulting from the tax, compared to a sales tax. However, VAT is held by some to discourage production.

VAT was historically used when a sales tax or excise tax was uncollectible. For example, a 30% sales tax is so often cheated that most of the retail economy will go off the books. By collecting the tax at each production level, and requiring the previous production level to collect the next level tax in order to recover the VAT previously paid by that production level, the theory is that the entire economy helps in the enforcement. In reality, forged invoices and the like demonstrate that tax evaders will always attempt to cheat the system.

### Property taxes

A property tax is usually levied on the value of property owned, usually real estate. Property taxes may be charged on a recurrent basis, or upon a certain event.

A common type of property tax is an annual charge on the ownership of real estate, where the tax base is the supposed value of the property. For a period of over 150 years from 1695 a window tax was levied in England, with the result that you can still see listed buildings with windows bricked up [1] in order to save their owner's money. A similar tax existed in France, with similar results.

The two most common type of event driven property taxes are stamp duty, charged upon change of ownership, and inheritance tax, which is imposed in many countries on the estates of the deceased.

In contrast with a tax on real estate, a land value tax is levied only on the unimproved value of the land.

When real estate is held by a higher government unit or some other entity not subject to taxation by the local government, the taxing authority may receive a payment in lieu of taxes to compensate it for some or all of the foregone tax revenue.

### Transfer taxes

Historically, in many countries, a contract needed to have a stamp affixed to make it valid. The charge for the stamp was either a fixed amount or a percentage of the value of the transaction. In most countries the stamp has been abolished but stamp duty remains. Stamp duty is levied in the UK on the purchase of shares and securities, the issue of bearer instruments, and certain partnership transactions. Its modern derivatives, stamp duty reserve tax and stamp duty land tax, are respectively charged on transactions involving securities and land. Stamp duty has the effect of discouraging speculative purchases of assets by decreasing liquidity. Taxes on currency transactions are known as Tobin taxes.

### Inheritance tax

Some believe that inheritance taxes do not have any harmful effect on the economy and may even be beneficial as they encourage consumer spending by the elderly. However, they are also believed to discourage productivity and to disrupt the continuity of family-owned businesses.

### Wealth (net worth) tax

Main article: wealth (net worth) tax

Some countries' governments will require declaration of the tax payers' balance sheet (assets and liabilities), and from that ask for a tax on net worth (assets minus liabilities), as a percentage of the net worth, or a percentage of the net worth exceeding a certain level. The tax is in place for both "natural" and in some cases legal "persons".

### Personal property tax

In many jurisdictions (including many American states), there is a general tax levied periodically on residents who own personal property within the jurisdiction. Vehicle and boat registration fees are subsets of this kind of tax.

Usually, the tax is designed with blanket coverage but with large exceptions for obvious things like food and clothing. Household goods are exempt as long as they are kept or used within the household. However, any otherwise non-exempt object can lose its exemption if regularly kept outside the household. Thus, tax collectors often monitor newspaper articles for stories about wealthy people who have lent art to museums for public display, because the artworks have then become subject to personal property tax. And if an artwork had to be sent to another state for some touch-ups, it may have become subject to personal property tax in that state as well.

## Who pays

In the United States, the Congressional Budget Office produces a number of reports on the share of all federal taxes paid by taxpayers of various income levels. Their data for 2002 shows the following: (Table 2)

• The top 1% of taxpayers by income pay 33% of all individual income taxes, and 22.7% of all federal taxes.
• The top 5% of taxpayers pay 54.5% of all individual income taxes, and 38.5% of all federal taxes.
• The top 10% of taxpayers pay 67.4% of all individual income taxes, and 50% of all federal taxes.
• The top quintile pays 82.5% of all individual income taxes, and 65.3% of all federal taxes.

Their numbers also show, that when broken down by quintile, the social insurance taxes are regressive on an effective tax rate basis only for the highest quintile, though that quintile pays the largest share of social insurance taxes (44%). (Table 1)

## Historical taxation levels

Quite a few records of the government tax collection in Europe since at least the 17th century are still available today. But the taxation levels are hard to compare to the size and flow of the economy since production numbers are not as readily available. The government expenditures and revenue in France during the 17th century went from about 20 million livres in 1600 to about 60 million livres in 1650 to about 150 million livres in 1700 when the government debt had reached 1.6 billion livres.

The taxation as a percentage of production of final goods may have reached 15%-20% during the 17th century in places like, France, the Netherlands, and Scandinavia. During the war filled years of the eighteenth and early nineteenth century tax rates in Europe increased dramatically as war became more expensive and governments became more centralized and adept at gathering taxes. This increase was greatest in England, Peter Mathias and Patrick O'Brien found that the tax burden increased by 85% over this period. Another study confirmed this number, finding that per capita tax revenues had grown almost six-fold over the eighteenth century, but that steady economic growth had made the real burden on each individual only double over this period before the industrial revolution. Average tax rates were higher in Britain than France the years before the French Revolution, but they were mostly placed on international trade. In France the taxes were lower but the burden was mainly on landowners, individuals, and internal trade and thus created far more resentment.

Taxation as a percentage of GDP is today (2003) 56.1% in Denmark, 54.5% in France, 49.0% in the Euro area, 42.6% in the United Kingdom, 35.7% in the United States, 35.2% in The Republic of Ireland, and among all OECD members an average of 40.7%. (OECD national accounts) (Forbes magazine)

### Historical forms of taxation

In monetary economies prior to fiat banking, a critical form of taxation was seigniorage, the tax on the creation of money. Seigniorage has been replaced by central banking.

Other obsolete forms of taxation include:

• scutage - paid in lieu of military service; strictly speaking a commutation of a non-tax obligation rather than a tax as such, but functioning as a tax in practice
• tallage - a tax on feudal dependents
• tithe - a tax, or more precisely a tax-like payment, (one tenth of one's earnings or agricultural produce), paid to the Church (and thus too specific to be a tax in strict technical terms even though appearing as one to the payer)
• Aids - During feudal times Aids was a type of tax or due paid by a vassal to his lord.
• Danegeld - medieval land tax originally raised to pay off raiding Danes and later used to fund military expenditures.
• Carucate - tax which replaced the danegeld in England.
• Tax Farming - the principle of assigning the responsibility for tax revenue collection to private citizens or groups.

Some principalities taxed windows, doors or cabinets to reduce consumption of imported glass and hardware. Armoires, hutches and wardrobes were invented to evade taxes on doors and cabinets.

Today the most complicated taxation-system is the German one. Three quarters of the world's taxation-literature refers to the German system. There are 118 laws, 185 forms and 96000 regulations (only one comment to taxation covers 2671 pages). The administration spends 3.7 billion Euro just to collect income tax.

## Morality of taxation

Many say that activities funded by taxes are beneficial to society and that progressive taxation used in most modern countries is a net benefit to the majority of the population. Others disagree. But as payment of tax is not optional, some people hold that taxation is tantamount to theft. This view is most common among political schools of thought such as libertarianism and anarcho-capitalism, which accuse governments of levying taxes through a system of coercion. However most libertarians, particularly minarchists, recommend taxation as a necessary evil as long as only enough money is taken as is necessary for a government to maximize the protection of liberty.

Many maintain that taxation is not theft since government is the party performing the act, and moreover that if there is a democracy in place, then it is society as a whole that decides (through the government) what the level and form of taxation is. The American Revolution's "No taxation without representation" slogan took this view. Others assert that the moral stature of any act, such as slavery or the taking of a person's property without his consent, is not contingent upon its legality or who is performing it or whether a majority approves of it.

There are several justifications that are offered for compulsory taxation. Taxation of business is justified with the claim that business necessarily involves use of publicly established and maintained economic infrastructure, and businesses are in effect charged for this use. Compulsory taxation of individuals, such as income tax, is based on similar arguments to those for universality of law, territorial sovereignty, and the social contract.bg:Микроикономика cs:Mikroekonomie de:Mikroökonomie et:Mikroökonoomika el:Μικροοικονομία es:Microeconomía eo:Mikroekonomiko fr:Micro-économie ko:미시경제학 it:Microeconomia ka:მიკროეკონომიკა hu:Mikroökonómia nl:Micro-economie ja:ミクロ経済学 no:Mikroøkonomi pl:Mikroekonomia pt:Microeconomia ro:Microeconomie ru:Микроэкономика simple:Microeconomics sk:Mikroekonómia sr:Микроекономија sv:Mikroekonomi tr:Mikroekonomi zh:微观经济学

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