Microeconomics is the study of the behaviour of individuals and small impacting organisations in making decisions on the allocation of limited resources. The modern field of microeconomics arose as an effort of neoclassical economics school of thought to put economic ideas into mathematical mode.
Origins
Microeconomics descends philosophically from Utilitarianism and mathematically from the work of Daniel Bernoulli.
Utilitarianism
Utilitarianism as a distinct ethical position only emerged in the 18th century, usually credited to Jeremy Bentham, but there were earlier writers, such as Epicurus who presented similar theories. Bentham's An Introduction to the Principles of Morals and Legislation (1780) begins by defining the principle of utility:
He also defined how pleasure can be measured:
A list of utilitarians also includes James Mill, Stuart Mill and William Paley.
Expected utility
Daniel Bernoulli wrote in 1738 this about risk:
He states that as an individual wealth increases so will his utility increase in inverse proportion to quantity of goods already possessed. This is called diminishing marginal utility in microeconomics textbooks. He also describes the following problem.
This is referred to in the literature as the St. Petersburg paradox.
Traditional marginalism
An early attempt of mathematizing economics was made by Antoine Augustine Cournot in Researches on the Mathematical Principles of the Theory of Wealth (1838): he described mathematically the law of demand, monopoly, and the spring water duopoly that now bears his name. Later, William Stanley Jevons's Theory of Political Economy (1871), Carl Menger's Principles of Economics (1871), and Léon Walras's Elements of Pure Economics: Or the theory of social wealth (1874–77) gave way to what was called the Marginal Revolution. Some common ideas behind those works were models or arguments characterized by rational economic agents maximising utility under a budget constraint. This arose as a necessity of arguing against the labour theory of value associated with classical economists such as Adam Smith, David Ricardo and Karl Marx, although the theory itself can traced back to earlier writers. Walras also went as far as developing the concept of general equilibrium of an economy.
Smith published The Wealth of Nations in 1776, his emphasis being on the labour saving function of money:A. Smith, The Wealth of Nations, 1776, Book I, Chapter V, Of the Real and Nominal Price of Commodities, or of their price in labour, and their price in money
Regarding value, Smith wrote:A. Smith, The Wealth of Nations, 1776, Book I, Chapter IV, Of the Origin and Use of Money
A labour theory of value can be understood as a theory that argues that economic value is determined by the amount of socially necessary labour time: this can be found in the theorization of RicardoD. Ricardo, On the Principles of Political Economy and Taxation, 1817, Chapter I, On Value who said "If the quantity of labour realized in commodities, regulate their exchangeable value, every increase of the quantity of labour must augment the value of that commodity on which it is exercised, as every diminution must lower it." and MarxK. Marx, Capital, 1867, Chapter I, Commodities who said "A use-value, or useful article, therefore, has value only because human labour in the abstract has been embodied or materialised in it. How, then, is the magnitude of this value to be measured? Plainly, by the quantity of the value-creating substance, the labour, contained in the article. The quantity of labour, however, is measured by its duration, and labour-time in its turn finds its standard in weeks, days, and hours.". A subjective theory of value on the other hand derives value from subjective preferences.
Carl Menger, born in Galicia and considered by Hayek as the founder of the Austrian school of economics, distinguished goods in consumption goods (first order goods) and means of production (higher-order goods). He said:C. Menger, Principles of Economics, 1871, Chapter I: The general theory of the good
Jevons could be considered a follower of Bentham, as can be read in his commentary upon the paradox of value:W. S. Jevons, The theory of political economy, 1871, Chapter II: Theory of Pleasure and Pain
Alfred Marshall's textbook, Principles of Economics was first published in 1890 and became the dominant textbook in England for a generation. His main point was that Jevons went too far in emphasising utility as an attempt to explain prices over costs of production. In the book he writes:A.Marshall, Principles of Economics, 1920, APPENDIX I, RICARDO’S THEORY OF VALUE
In the same appendix he further states:
Marshall's idea of solving the controversy was that the demand curve could be derived by aggregating individual consumer demand curves, which were themselves based on the consumer problem of maximising utility. The supply curve could be derived by superimposing a representative firm supply curves for the factors of production and then market equilibrium would be given by the intersection of demand and supply curves. He also introduced the notion of different market periods: mainly short run and long run. This set of ideas gave way to what economists call perfect competition, now found in the standard microeconomics texts, even though Marshall himself had stated:A.Marshall, Principles of Economics, 1920, BOOK VI, CHAPTER II: PRELIMINARY SURVEY OF DISTRIBUTION, CONTINUED.
Marshall also discussed how income affects consumption:A.Marshall, Principles of Economics, 1920, BOOK III, CHAPTER VI: VALUE AND UTILITY.
This exception is called in microeconomics textbooks the consumption of a Giffen Good.
Production and costs
An early formulation of the concept of production functions is due to Johann Heinrich von Thünen, which presented an exponential version of it. The standard Cobb–Douglas production function found in microeconomics textbooks refers to a collaborative paper between Charles Cobb and Paul Douglas published in 1928 in which they analyzed U.S. manufacturing data (1899-1922) using this function as the basis of a regression analysis for estimating the relationship between inputs (labour and capital) and output (product), discussing the problem using the concept of marginal productivity, the authors concluded:
The mathematical form of the Cobb–Douglas function can be found in the prior work of Wicksell, Thünen, and Turgot.
Jacob Viner presented an early procedure for constructing cost curves in his "Cost Curves and Supply Curves" (1931), Reprinted in the paper was an attempt to reconcile two streams of thought when dealing with this issue at the time: the idea that supplies of factors of production were given and independent of rate of remuneration (Austrian School) or dependent on rate of remuneration (English School, that is followers of Marshall). Viner argued that, "The differences between the two schools would not affect qualitatively the character of the findings," more specifically, "...that this concern is not of sufficient importance to bring about any change in the prices of the factors as a result of a change in its output."
In Viner's terminology—now considered standard—the short run is a period long enough to permit any desired output change that is technologically possible without altering the scale of the plant—but is not long enough to adjust the scale of the plant. He arbitrarily assumes that all factors can, for the short run, be classified in two groups: those necessarily fixed in amount, and those freely variable. Scale of plant is the size of the group of factors that are fixed in amount in the short-run, and each scale is quantitatively indicated by the amount of output that can be produced at the lowest average cost possible at that scale. Costs associated with the fixed factors are fixed costs. Those associated with the variable factors are direct costs. Note that fixed costs are fixed only in their aggregate amounts, and vary with output in their amount per unit, while direct costs vary in their aggregate amount as output varies, as well as in their amount per unit. The spreading of overhead is therefore a short-run phenomenon and not to be confused with the long-run.
He explains that if the law of diminishing returns holds that output per unit of variable factor falls as total output rises, and that if the prices of the factors remain constant—then average direct costs increase with output. Also, if atomistic competition prevails—that is, the individual firm output won't affect product prices—then the individual firm short-run supply curve equals the short run marginal cost curve. In the long run, the supply curve for industry can be constructed by summing individual marginal cost curves abscissas. He also explains that: Internal economies of scale are primarily a long-run phenomenon and are due either to reductions in the technical coefficients of production (technical economies=increasing productivity by improved organisation or methods of production) or to discounts resulting from larger size (pecuniary economies). Internal diseconomies of scale can be avoided by increasing industry output by increasing the number of plants without increasing the scale of the plant. External economies of scale are also either technical or pecuniary, but in this case are due to the aggregate behaviour of the industry, and refer to the size of output of the industry as a whole. External diseconomies of scale may occur if as industry output rises the unit price of factors and materials rises as well due to increasing competition for inputs with other industries. It should be made clear that these long-run results only hold if producer are rational actors, that is able to optimise their production so as to have an optimal scale of plant.
Imperfect competition and game theory In 1929 Harold Hotelling published "Stability in Competition" addressing the problem of instability in the classic Cournout model: Bertrand criticized it for lacking equilibrium for prices as independent variables and Edgeworth constructed a dual monopoly model with correlated demand with also lacked stability. Hotteling proposed that demand typically varied continuously for relative prices, not discontinuously as suggested by the later authors.
Following Sraffa he argued for "the existence with reference to each seller of groups who will deal with him instead of his competitors in spite of difference in price", he also noticed that traditional models that presumed the uniqueness of price in the market only made sense if the commodity was standardized and the market was a point: akin to a temperature model in physics, discontinuity in heat transfer (price changes) inside a body (market) would lead to instability. To show the point he built a model of market located over a line with two sellers in each extreme of the line, in this case maximizing profit for both sellers leads to a stable equilibrium. From this model also follows that if a seller is to choose the location of his store so as to maximize his profit, he will place his store the closest to his competitor: "the sharper competition with his rival is offset by the greater number of buyers he has an advantage". He also argues that clustering of stores is wasteful from the point of view of transportation costs and that public interest would dictate more spatial dispersion.