2.3 Micro versus Macro Economics
As people get to know more about economics, it is gradually divided into two major aspects of study: microeconomics and macroeconomics. Although the two branches of economics are intertwined, they differ from each other in analysing content, scope and method. Microeconomics holds individuals such as households or enterprises as research subject and studies how they make decisions as well as how they interact in specific markets. The core of microeconomics is price theory. Some basic problems in the decision making process such as what, how, when, where, and for whom to produce are all in the study area of microeconomics. On the other hand, macroeconomics holds a country or an economic society as analysing subject and studies the economy-wide phenomena including unemployment, inflation, and economic growth. The core of macroeconomics is deciding theory of national income. In terms of analysing method, microeconomics portrays the behaviour of a rational economic man through explanation and logical deduction; whereas macroeconomics reveals the interior organism of economy depending on observing how various economic variables are related. That is to say, microeconomics majorly depends on deduction while macroeconomics is more likely to depend on induction (Begg & Fischer, 2009).
3.0 Demand and Supply Curves
In this part of the report, all the curves are assumed to be derived under the condition of perfect competition.
3.1 Individual & Market Demand Curve
Demand of an individual product shows how much of the product consumers are willing and able to buy as the price of the product changes and it is determined by a lot of factors including price of the product, consumers’ income, price of relative products, consumers’ preference and consumers’ anticipation of the product’s price. Among all of these factors, price of the product is the basic determining factor and is thus usually considered to be the only determinant. Therefore, a demand function can be achieved as Qd = f (P) where P is the price and Qd symbolises the product demand (Pindyck & Rubinfeld, 2005). Demand function demonstrates a kind of one-on-one relation between quantity and price, which can also be displayed by demand curve as exhibited below.
In the above diagram, the horizontal axle stands for the product quantity and the vertical axle stands for the product price. Joining the one-on-one combinations of price and quantity using a smooth curve, the individual demand curve is derived. As the price grows higher, the quantity demanded by consumers decrease.
The market demand curve for a product is derived through aggregating the individual demand curves and the total market demand meaning how much the economic society demands a certain kind of product or service is usually in the form of output. The total demand comprises consumer demand, investment demand, government demand and foreign demand. The total demand function defines the relation between quantity /income and price, meaning how much income the economic society needs at a certain level of price. The geometric display of total demand function in a coordinate system with X axle meaning quantity and Y axle meaning price is the market demand curve. Market demand curve portrays the equilibrium cost or income in relation to every level of price and the quantity /income also decreases as price increases (Mankiw, 2006).
3.2 A Firm’s Output Decision in the Short Run
In the short run, the producing scale of a firm is set and fixed, and the firm chooses the quantity or proportion of variable factors to come to the minimum of average cost. The Total Cost of the firm is composed of Fixed Cost and Variable Cost. The Average Fixed Cost = FC / Q, Average Variable Cost = VC / Q, Average Cost = TC / Q = AFC + AVC, Marginal Cost = dTC / dQ. The diagrams of these short-run costs are displayed as follows.
As shown, the curves of AVC, AC and MC all take the form of U, and the curve of AFC is right-bottom leaning toward the horizontal axle infinitely. To earn the maximum of profit, the firm sets its level of output where marginal revenue equals marginal cost as shown in the diagram below.
In the above diagram, to gain the maximum of profit or the minimum of loss, the firm will decide its output as determined by the intersection of MR curve and SMC curve. Thus, in the short run, the output of the firm is Q1 in the diagram and the shadow symbolises the maximum of profit earned. However, it is important to bear in mind that if Price line is tangent with SAC, the firm does not realise any excess profit or loss; whereas if Price line is below the lowest point of SAC, the firm realises the minimum of loss by applying the MR = SMC principle.
3.3 A Firm’s Output Decision in the Long Run
In the long run, neither the producing scale nor variable factors of the firm are set and fixed; and the firm looks for the best producing scale to realise its planned producing quantity. Once the scale is confirmed, the output decision turns to be a short-term decision. The Long-run Total Cost is how much the firm costs to produce a certain quantity in the long run, determined by both product quantity and firm scale. Besides, the Long-run Average Cost = LTC / Q, Long-run Marginal Cost = dLTC / dQ. LTC is the envelope of STC and they are tangent in the same shape. In the same way, LAC is the envelope of SAC and they are also tangent in the same shape of U as shown below.
In the long run, the market price is moderate and the firm decides its output by applying the LMC = MR principle when there is neither loss nor excess profit for the firm. In this market there are no new firms to enter or current firms to step out, contributing to a relative equilibrium in the market and a long-run equilibrium for the firm. Therefore, in perfect competition, the firm decides its long-run output at the point where MR = LMC = SMC = AR = LAC = SAC as shown below and the equilibrium output is Q1 along the horizontal axle.
3.4 Equilibrium Price and Equilibrium Quantity
In Western economics, the equilibrium price of a product is the price derived when the market demand quantity of this product equals its supply quantity, and the equal quantity of demand and supply at equilibrium price is equilibrium quantity (Samuelson & Nordhaus, 2004). Geometrically, the equilibrium of a product is achieved at the intersection of demand curve and supply curve of the product.
As shown in the diagram above, when price is P1, the supply quantity Q2 exceeds demand quantity Q1 and the market price is bound to fall. When price falls to P2, the demand quantity Q1 exceeds supply quantity Q2 and the market price will increase. Only when the price is Pe can the market demand equals supply at Qe. Thus, in this condition, equilibrium price is Pe and equilibrium quantity is Qe.
3.5 Effects of Excess Supply and Excess Demand on Market Equilibrium
Price is determined by the changes in both supply and demand, and any factor that will lead to demand or supply change results in equilibrium change. For instance, when excess supply is caused by decrease in price of producing materials or increase in output because of technology development, the supply curve moves to its right. And when people’s income or their preference toward the product increases, excess demand is achieved with the demand curve moving toward its right. The increase in supply and demand can be shown in the diagram below.
In this diagram, the previous equilibrium point is E. In the first case of excess supply, the supply curve moves from S0 to S1 and the demand curve remains as D0, making the new equilibrium point to the right-bottom of E at which point equilibrium price falls yet equilibrium quantity grows. New market equilibrium is achieved. Therefore, when the market demand is fixed, excess supply leads to lower equilibrium price and bigger equilibrium quantity. In the latter case of excess demand, the demand curve moves from D0 to D1 and the supply curve remains as S0, making the new equilibrium point to the upper-right of E at which point both equilibrium price and equilibrium quantity increase. New market equilibrium is achieved. In the light of this, when the market supply is fixed, excess demand results in higher equilibrium price and bigger equilibrium quantity (Samuelson & Nordhaus, 2004).
4.0 Market Structures
4.1 Perfect Competition
Perfect competition refers to the kind of competition that has no hindrances or obstacles and this market structure has four attributes. Firstly, there are a great number of buyers and sellers; secondly, resources are totally free to flow; thirdly, the products are of the same quality; lastly, all the economic subjects have complete information. In perfect competition, the industry price is determined by the industry demand and supply; however, for an individual firm, once the industry price is confirmed, the firm’s quantity has no impact on market price (Krugman, 2004). What’s more, as market price remains still, unit price of the product equals average revenue and marginal revenue of the product, so AR line, MR line and Demand line overlap each other for individual firm in a coordinate system. To achieve equilibrium in perfect competition, the firm applies the MR = MC principle. In the short run, if the market price is higher than Short-run Average Cost of the firm, excess profit can be obtained as shown in the diagram below.
If the market price is at the lowest point of SAC, the firm reaches a break-even point where there is no profit or loss for the firm in the short run as displayed below.
When the market price is lower than the lowest point of SAC, the firm makes a loss in the short run as shown. By applying MR = SMC, the firm can realize the minimum of loss which is the shadow in the diagram below.
In the diagram below, if the firm does not produce products, the loss is SFC. If the firm continues to produce by applying the MR = SMC principle, the minimum of loss equals SFC as the shadow. From the perspective of contribution to society, the firm should continue to produce as shown below.
In the last case, the market price is so low that the firm makes a loss of SFC if it does not produce products at all. However, the loss will be bigger than SFC wherever the firm chooses to produce products. In this event, the firm does not produce products any more. The diagram below portrays such event.
In the long run, all firms can adjust their producing factors according to market price until all of them are at the break-even point. The condition for the firm to realize long-run equilibrium in perfect competition is MR = LMC = AR = LAC as shown in the diagram below. In this diagram, the firm manufactures products according to MR = LMC and can achieve the maximum of profit symbolised by the shadow.
4.2 Oligopoly
In the market structure of oligopoly which lies between monopoly and perfect competition, only a few sellers offer consumers with similar or identical products. Besides, the entry barriers in oligopoly are quite high and the sellers rely on each other. The decision making of price and output in oligopoly is complicated as every firm’s output accounts for a large proportion in the industry and its change in output or price delivers far-reaching influence on its competitors and the whole industry. In the light of this, before an oligarch takes an action, it has to consider the likely impact of this action on other firms and their likely reaction so as to take the most favourable move (Stigler, 1964).
Cournot model is the earliest oligopoly model and is usually considered to be the starting point of oligopoly analysis. The model assumes that there are two oligarchs in the market in pursuit of the maximum of profit by producing identical or similar products; competition between the oligarchs is output competition rather than price competition and price is determined by output; the two oligarchs do not collude with each other; they decide their own output as that of the other is confirmed and the marginal cost is a constant (Shapiro, 1989). The diagram below demonstrates the Gournot model. With the assistance of Gournot model, the oligarchs can determine their equilibrium price and output so as to earn the maximum of profit.
5.0 Keynesian and Monetarist Schools of Thought
There has been heated debate between the two leading schools of thought in macroeconomics concerning the role of government which are respectively Keynesianism and Monetarism. Keynesians believe that government intervention can remarkably improve the operation of the economy. Monetarists hold that markets work best if left alone with the minimum of government interference (Blanchard, 2005).
5.1 Keynesian Economics
Applauding government intervention, Keynesians believe that free enterprise without government intervention does not cause full employment and unemployment is a big problem that needs a solution. Furthermore, with government spending and monetary policy, government should smooth out the business cycles. Subsequently, adequate information is available to take government action. The last but not the least, government spending can help stimulate efficient economic growth (Frank & Bernanke, 2007).
Keynesian Economics has always been criticized for that it can only be applied in times of crisis rather than in the long run. There is no denying that Keynesian Economics can help the government allocate resources to the most needed places efficiently in times of crisis and can succeed in delivering the economic society from crisis. However, if it is continued to be applied after the crisis, it is very likely to lead to damage of market system and erosion of liberty. On the one hand, Keynesian Economics is indeed useful in resolving crisis in the short run; on the other hand, it is not appropriate to be applied when the economic society is out of crisis, and that is indeed one of its limitations (wiseGEEK, 2010).
5.2 Monetarist Economics
Against government intervention, Monetarists think that free market economies are best in the long term even at the cost of unemployment. Secondly, they believe that inflation is the big evil; it is a tax on everyone. Thirdly, government intervention makes the economy worse off in the long run. Following that, available economic data are often inaccurate and too late for useful government inflation. The last but not the least, government spending is believed to crowd out efficient private activity (Frank & Bernanke, 2007). Monetarists believe that monetary policies can accomplish two tasks including preventing money from being a root of economic disorder and providing a sound and stable environment for economy. Therefore, Monetarists claim to adopt a constant growth rate of money when there is no inflation and they hold money supply as the only control indicator of monetary policies which exclude interest rates, credit flow, and reserve fund. Such policy is called unitary policy.
Monetarist Economics was once widely accepted and applied in some major capitalist countries such as USA and UK because it could tackle some existing social problems effectively then. For example, it claims to keep policies to be stable and continual so as not to turbulent economy; to emphasise the effect of monetary policies to keep appropriate money supply in the flow and suchlike. These measures contributed to the decrease in inflation degree for both UK and USA in the 1980s. Even in today’s world, these measures still play a part in some countries’ macro-control.
However, it can not be denied that Monetarist Economics has some weak points. For example, it considers money to be the only important policy and promotes unitary policy, which is way too extreme. Besides, this also leads to Monetarist Economics’ disregard of fiscal policies, being too one-sided (Virtual Economy Home Page, n.d.). In a word, when applying Monetarist Economics, both its contribution to alleviating inflation and side effects to economy should be considered. Only in this way can Monetarist Economics be applied rationally and reasonably.
6.0 References
Baumol, W.J. & Blinder, A.S. (2009). Economics: Principles & Policy. 11th ed. Mason: South Western Cengage Learning.
Begg, D.K.H. & Fischer, S. (2009). Economics. 9th ed. Dalian: Dongbei University of Finance & Economics Press.
Blanchard, O. (2005). Macroeconomics. 3rd ed. Beijing: Tsinghua University Press.
Frank, R.H. & Bernanke, B.S. (2004). Principles of Microeconomics. Beijing: Tsinghua University Press.
Frank, R.H. & Bernanke, B.S. (2007). Principles of Macroeconomics. 2nd ed. Beijing: Tsinghua University Press.
Krugman, P.R. (2004). International Economics: Theory and Policy. 6th ed. Beijing: Tsinghua University Press.
Mankiw, N.G. (2006). Principles of Economics. 3rd ed. Beijing Tsinghua University Press.
Pindyck, R.S. & Rubinfeld, D.L. (2005). Microeconomics. 6th ed. Beijing: Tsinghua University Press.
Samuelson, P.A. & Nordhaus, W.D. (2004). Microeconomics. Beijing: The People’s Post and Telecommunication Press.
Shapiro, C. (1989). Theories of Oligopoly Behavior. Handbook of Industrial Organization, 1989 (6). p. 329-414.
Stigler, G.L. (1964). A Theory of Oligopoly. The Journal of Political Economy, 72 (1). p. 44-61.
Virtual Economy Home Page. (n.d.) Monetarists Theory of Economics. [Online]. Available at: [accessed 23 February 2010]
WiseGEEK. (2010). What Is Keynesian Economics? [Online]. (Updated 17 February 2010) Available at: [accessed 23 February 2010]
