Microeconomic Decision-Makers

Money & banking

Before goods can be exchanged efficiently, an economy needs something everyone will accept in return for them — which is exactly the role money plays, and exactly the service banks are built to manage.

Why barter fails

Without money, exchange relies on barter — trading one good directly for another. Barter needs a double coincidence of wants: each party must want exactly what the other offers, at the same time. A fisherman wanting shoes must find a shoemaker who wants fish that day. As an economy grows complex, this condition becomes rare, so money removes the need for it to occur at all.

The functions of money

Money performs four functions. As a medium of exchange, it is accepted in payment, replacing the need for a double coincidence of wants. As a unit of account, it gives every good a common measure of value. As a store of value, it can be held and spent later without losing its purchasing power (except under high inflation). As a standard of deferred payment, it lets debts be agreed today and settled at a fixed sum later.

Characteristics money must have

Money must be generally acceptable, durable (does not wear out or perish), portable, divisible (splits into smaller units), scarce (limited in supply, or it loses value), and uniform (every unit of the same value is identical, so it can be trusted without inspection).

Central banks and commercial banks

A central bank is a country’s own monetary authority, usually government-owned — it issues the currency, holds the government’s accounts, sets monetary policy, and is lender of last resort to commercial banks. A commercial bank is a profit-seeking bank that takes deposits from, and lends to, households and firms.

Households

Every household continuously divides its income between spending now, saving for later, and borrowing against future income — and five factors tilt that balance one way or another.

Income and the rate of interest

Higher disposable income raises spending, saving and the capacity to borrow, because a larger income leaves more available for each once necessities are covered. The rate of interest works in opposite directions on saving and borrowing: a higher rate rewards saving more generously, so households save more and borrow less; a lower rate does the reverse, since the cost of borrowing falls and the reward for saving shrinks.

Confidence

Confidence reflects how secure households feel about their income and jobs. Rising confidence pulls spending and borrowing up and saving down, because households feel less need for a financial buffer. Falling confidence — during a recession, for example — pushes households to build precautionary savings and cut back on spending and borrowing.

Age

Younger households, still building an income and often facing costs such as education or setting up a home, tend to save less and borrow more. Middle-aged households in their peak earning years tend to save more, often for retirement. Older, retired households typically draw down past savings rather than add to them, and spend more on healthcare.

Culture

Attitudes to saving and borrowing differ between societies. Cultures that place a high value on saving see households hold back a larger share of income even at the same income and interest rate; cultures more accepting of consumer credit see higher borrowing and spending at a comparable income.

Choosing work & wage determination

A job is chosen for more than its pay packet, but the wage itself is set the same way any other price is — by demand and supply, this time in the market for labour.

Wage and non-wage factors in choosing an occupation

Workers weigh wage factors — the pay on offer — against non-wage factors: security, hours, holiday, conditions, fringe benefits, promotion, and job satisfaction. A lower-paid job with strong security can be chosen over a higher-paid job without it, since workers value the whole package, not the wage alone.

How wages are determined

In a competitive labour market, the wage rate is set where demand for labour equals supply of labour, just as price is set in a product market. Demand for labour is a derived demand — it exists only because of demand for the good labour helps produce — and slopes downward. Supply of labour slopes upward: a higher wage draws more workers into the occupation.

Trade unions and bargaining power

A trade union negotiates collectively with employers over wages and conditions. A union that can call on many workers together — including strike action — has greater bargaining power than one worker alone, and can push the agreed wage above what an unorganised market would set.

National minimum wage & wage differences

A wage floor set by law, and the ordinary forces of demand and supply, can pull an occupation’s pay in the same direction — or in opposite ones.

A national minimum wage (NMW)

A government can set a national minimum wage — a legal floor below which employers may not pay. Set above the free-market equilibrium wage, it raises pay for those who remain employed, but by making labour more expensive it can reduce the quantity of labour firms demand, creating an excess supply of labour over the quantity firms are willing to hire — unemployment in that market.

Why wages differ between workers

Wages differ because of differences in the demand for and supply of labour in each occupation, the relative bargaining strength of workers, discrimination (for example between male and female workers doing comparable work), and government policy. These forces act differently depending on a worker’s skill level, the economic sector they work in, and whether they work in the private or public sector.

Mobility of labour & division of labour

How freely a worker can move between jobs or places decides whether a wage gap closes quickly — and specialising too narrowly can itself become a barrier to moving at all.

Mobility of labour

Occupational mobility is how easily a worker can retrain and move between jobs; it is reduced by the time and cost of training, and by restrictive licensing. Geographical mobility is how easily a worker can relocate for work; it is reduced by housing costs, family ties, and language or cultural barriers. Low mobility of either kind means wage differences between occupations or regions can persist, because workers cannot easily move to close the gap.

Division of labour

Division of labour is the specialisation of workers in a single task or a narrow part of the production process, rather than each worker completing a whole product alone.

Types of firms

Firms can be sorted in three different ways — by what they produce, who owns them, and how big they are — and each classification highlights a different trade-off.

Classifying firms by economic sector

A firm in the primary sector extracts or grows raw materials (farming, mining, fishing). A secondary-sector firm processes those raw materials into manufactured goods. A tertiary-sector firm provides a service (banking, retail, transport). Many large firms operate across more than one sector at once.

Public sector and private sector firms

A public sector firm is owned and controlled by the government, and typically aims to provide a service rather than maximise profit. A private sector firm is owned by individuals or shareholders, and typically aims to maximise profit — which tends to make private firms more cost-conscious and productive, though not always more attentive to social need.

Small firms versus large firms

Small firms trade these advantages away for flexibility — they can respond quickly to changing demand, offer a more personal service, and serve niche markets too small to interest a large competitor — but they normally cannot match a large firm’s access to finance or its economies of scale.

Mergers

A firm can grow on its own, or grow quickly by joining with another firm already in business — and the type of merger chosen shapes exactly what the combined firm stands to gain.

Internal and external growth

Internal (organic) growth comes from expanding using the firm’s own resources — reinvested profit, new outlets, or entry to new markets. External growth comes from combining with another firm: as a merger, where both firms agree to combine into a new firm, or a takeover, where one firm buys a controlling stake in another.

Types of merger

A horizontal merger joins two firms at the same stage of production in the same industry — two supermarket chains, for example — mainly to gain market share and economies of scale. A vertical merger joins firms at different stages of the same supply chain: backward vertical integration reaches toward a firm’s suppliers (a bakery merging with a flour mill); forward vertical integration reaches toward a firm’s customers (a flour mill merging with a bakery) — both aim to secure supply or distribution and cut out a middleman’s profit. A conglomerate merger joins firms in unrelated industries, mainly to spread risk across markets unlikely to decline at the same time.

Economies & diseconomies of scale

As a firm grows, its average cost of production usually falls for a while — then, past some point, starts rising again, and naming why is the whole of this topic.

Internal economies of scale

Internal economies arise from a firm’s own growth. Purchasing economies come from bulk-buying at a discount. Financial economies come from borrowing at lower rates as a larger, less risky borrower. Managerial economies come from affording specialist managers per department. Marketing economies come from spreading a fixed advertising cost over more units. Technical economies come from affording large-scale equipment. Risk-bearing economies come from spreading risk across markets.

Internal diseconomies of scale

Past some size, average cost can rise again. Management diseconomies arise when managers act in their own interest rather than the firm’s. Communication diseconomies arise when a large firm responds slowly. Geographical diseconomies arise when operations spread across distant sites.

External economies of scale

External economies come from growth of the whole industry, not the firm — a larger industry attracts ancillary suppliers, better transport links, and more skilled labour nearby, lowering every firm’s average cost.

Factor demand & production methods

Firms don’t want land, labour or capital for their own sake — they want them because of what those factors can produce, which is what makes factor demand different from ordinary demand.

What drives demand for a factor of production

A firm’s demand for a factor of production depends on three things: the demand for the good or service the factor helps produce (since factor demand is a derived demand), the price of that factor relative to substitute factors, and the factor’s availability and productivity. A rise in demand for a good raises demand for every factor used to produce it; a fall in a factor’s relative price, or a rise in its productivity, makes a firm want to use more of it.

Labour-intensive and capital-intensive production

Labour-intensive production uses proportionally more labour than capital; capital-intensive production uses proportionally more capital than labour. The choice depends on the nature of the product (mass-produced goods suit capital-intensive methods; customised goods suit labour-intensive methods), the relative cost of labour versus capital, the scale of production, and how much capital the firm can afford.

Production & productivity

An economy can produce more purely by using more resources, or it can produce more from the very same resources — and only the second of these is what economists mean by rising productivity.

Production versus productivity

Production is the total quantity of goods and services made in a given period. Productivity is output per unit of input in that period — most commonly, output per worker. An economy can raise production simply by employing more workers or using more land and capital, without any of them becoming more efficient; productivity rises only when the same quantity of resources produces more output than before.

Influences on production

Production rises and falls with the state of the economy — expanding in a boom and contracting in a recession — and with any change in the conditions of demand or supply for the goods being produced.

Influences on productivity

Productivity is raised chiefly by investment in better capital equipment, training that improves worker skill, innovation in products and processes, and competition, which pressures firms to use their resources more efficiently. A firm facing little competition has less pressure to improve productivity than one competing for every customer.

Investment and productivity

Higher investment raises productivity by equipping workers with better machinery, improving infrastructure, and funding training — all of which let the same workforce produce more. Falling investment has the opposite effect over time: capital equipment ages and becomes less efficient, and workers fall behind the skills a changing economy demands.

Costs: definitions & calculation

Before a firm can decide how much to produce, it needs to know exactly how its costs change as output changes — and that starts with four simple definitions.

Fixed, variable and total cost

Fixed costs (FC) do not change with output — rent, insurance, and management salaries must be paid whether the firm produces nothing or its maximum output. Variable costs (VC) rise directly with output — raw materials and the wages of production workers. Total cost (TC) is the sum of the two.

TC = FC + VC — measured in $.

Average costs

Dividing each cost by the quantity produced gives the cost per unit. Average fixed cost (AFC) is fixed cost divided by quantity — it falls continuously as output rises, because the same fixed cost is spread over more units. Average variable cost (AVC) is variable cost divided by quantity. Average total cost (ATC) is total cost divided by quantity, and is also the sum of AFC and AVC.

AFC = FC ÷ Q · AVC = VC ÷ Q · ATC = TC ÷ Q — measured in $ per unit.

Worked example: a workshop’s costs at two output levels

A furniture workshop has fixed costs of $400 per week. Producing 20 chairs this week costs $60 of materials and labour per chair.

Step 1. Variable cost = $60 × 20 chairs = $1,200. Step 2. Total cost = FC + VC = $400 + $1,200 = $1,600. Step 3. Average total cost = TC ÷ Q = $1,600 ÷ 20 = $80 per chair. ATC = $80 per chair at an output of 20.

Cost diagrams

Plotting cost against output turns the same four definitions into a single picture that shows exactly how a firm’s cost per unit changes as it produces more.

Reading the cost-curve diagram

Output is plotted on the horizontal axis and cost per unit on the vertical axis. AFC falls continuously across the diagram, since the same fixed cost is divided by a growing quantity. AVC and ATC are both U-shaped: they fall at low output as the fixed cost is spread more thinly and the firm produces more efficiently, then rise again at high output as variable cost per unit increases. Because ATC = AFC + AVC, the vertical gap between the ATC and AVC curves at any output is exactly AFC — and that gap narrows as output rises.

Why the curves fall and then rise

At low output, spreading fixed cost over more units, and using resources more efficiently, pulls both AVC and ATC down. Past some output, variable cost per unit starts to increase — extra workers may have less equipment to share, or overtime may be needed — pulling both curves back up. The lowest point of the ATC curve is the output at which the firm produces at its lowest possible cost per unit.

Revenue

Revenue is the other half of a firm’s profit calculation, and — unlike cost — it depends entirely on what happens outside the factory gate: how many units sell, and at what price.

Total revenue and average revenue

Total revenue (TR) is the total income from selling output — price multiplied by quantity sold. Average revenue (AR) is revenue per unit sold, found by dividing total revenue by quantity; since TR = price × quantity, average revenue is always equal to price when every unit sells at the same price.

TR = P × Q · AR = TR ÷ Q = P — measured in $ · $ per unit.

Worked example: revenue from a bakery’s daily sales

A bakery sells 150 loaves in a day at $4 each.

Step 1. Total revenue = price × quantity = $4 × 150 = $600. Step 2. Average revenue = TR ÷ Q = $600 ÷ 150 = $4 per loaf. Step 3. Average revenue equals the selling price, because every loaf sold at the same $4 price. TR = $600 · AR = $4 per loaf.

What changes a firm’s revenue

Total revenue rises when more units are sold at the same price, or when price rises without quantity sold falling by a greater proportion. Whether a price change raises or lowers revenue depends on the price elasticity of demand for the product: with inelastic demand, a price rise increases revenue because quantity falls proportionally less; with elastic demand, a price cut increases revenue because quantity rises proportionally more.

Objectives of firms

Not every firm is trying to do the same thing — and knowing which objective a firm is pursuing explains a great deal of its pricing, output and investment decisions.

Profit maximisation

Most firms aim to maximise profit — the gap between total revenue and total cost. Profit-maximising firms continuously look for ways to raise revenue or cut cost, since either raises the gap between them.

Profit = TR − TC — measured in $.

Growth, survival and social welfare

Some firms instead pursue growth — increasing market share, revenue, or number of employees — often to benefit from economies of scale, even at some short-term cost to profit. A new firm’s first objective is often simply survival: many new firms fail within their first year, so covering costs and staying in business takes priority over maximising profit. A firm with a social welfare objective accepts a lower profit than it could otherwise make, in order to pursue a social or environmental goal alongside — or instead of — profit.

Objectives change over time

A firm’s objective commonly shifts as it matures: a new firm focused on survival, once established, often shifts to growth to build market share, and only later shifts to profit maximisation once its position is secure enough to prioritise the gap between revenue and cost.

Types of markets

At one extreme, a market with a single firm can set almost any price it likes; at the other, a market with countless rivals leaves no single firm any power over price at all.

Characteristics of a competitive market

A competitive market has many buyers and sellers, so no single firm can influence the market price — each is a price taker. Firms can enter or leave freely, since barriers to entry are low, and products are broadly similar (homogeneous), so buyers switch readily between sellers.

Effect of a high number of firms

Characteristics of a monopoly market

A monopoly market is dominated by a single firm with significant market power, protected by high barriers to entry that keep rivals out. With no close substitute available, the monopolist has considerable control over price and output.

Effect of having only one firm