Applications of Microeconomics
In this lesson, you’re expected to learn:
– the economic implications of competition, demand, and supply
– the economic implications of utility and labor economics
– how to perform a break-even analysis
The process by which businesses make decisions is as complex as the processes that characterize consumer decision-making.
A business draws upon microeconomic principles and data to make a variety of critical choices – any one of which could mean the success or failure of their enterprise.
What a business does with that information is decided by senior management. The major influences on their decisions may entail some or all of the following factors:
• what the competition is doing
• the state of the economy
• other variable and unknown factors
1) Economic Implications of Competition
Competition is the major mechanism of control in a free market system because it forces businesses and resource suppliers to make appropriate responses to changes in consumer wants and needs.
Use of scarce resources in a least cost and most efficient manner is good for all – buyers, sellers, resource suppliers, competition, and government.
Competition does more than guarantee responses to customer wants and needs.
It is competition that forces firms to adopt the most efficient production techniques. Inefficient and high-cost firms will eventually be eliminated from the industry.
Therefore, competition provides an environment conducive to technological advance.
Another benefit of competition is when businesses not only seek their own self-interest but also promote the public or social interest.
The key link between self-interest and public interest is the use of the least expensive combination of resources in producing a given output.
2) Economic Implications of Demand & Supply
To understand how demand and supply forces work, it’s important to understand the market in which they operate.
Markets assume a wide variety of forms: local, national, or international in scope; personal or impersonal actions by buyers and sellers; and small or large in size.
Determination of Equilibrium Price & Quantity
The equilibrium price and quantity for a product is determined by market demand and supply.
• Quantity supplied will exceed quantity demanded when a price is above the equilibrium price, resulting in a surplus of goods. This in turn reduces prices and increases consumption.
• Quantity demanded will exceed quantity supplied when the price is below the equilibrium price, resulting in a shortage of goods. This in turn increases prices and increases quantity supplied.
Three types of explanations exist to represent consumer behavior and the downward-sloping demand curve. These include income and substitution effects, the law of diminishing marginal utility, and indifference curves.
• Income effect indicates that, at a lower price, one can afford more of a good without giving up any alternative goods. The purchasing power of one’s money is increased due to lower prices.
• Substitution effect states that at a lower price, one has the incentive to substitute a cheaper good for similar goods that are now relatively more expensive.
• A budget line shows the various combinations of two products, which can be purchased with a given money income.
• An indifference curve shows all combinations of two products that will yield the same level of satisfaction or utility to the consumer. Hence, the consumer will be indifferent as to which combination is actually obtained.
• Wages are the price paid for the use of labor, where labor includes all blue- and white-collar workers, professionals, and owners of small businesses.
• Wage rate is the price paid for the use of units of labor service.
There are two basic types of wages: nominal (money) wages and real wages.
• Nominal wages are the amounts of money received per unit of time (hour, day, week, month, year).
• Real wages are the quantity of goods and services that can be obtained with nominal wages. Real wages depend on one’s nominal wages and the prices of the goods and services purchased. Thus, real wages are the purchasing power of nominal wages.
Profit at break-even is zero. Break-even is only possible if a firm’s prices are higher than its variable costs per unit. If so, then each unit of the product sold will generate some ‘contribution’ toward covering fixed costs.
It is the point at which a business’s sales have generated enough income to cover all of its fixed costs and expenses.
At that point, all of the business’s incoming revenue is profit as long as the expenses and costs are not increased and the sales amounts are not reduced.
At the BEP, Revenue = Variable Costs + Fixed Costs
One simple formula uses your fixed costs and gross profit margin to determine your break-even point:
Breakeven Point = Fixed Costs ÷ Gross Profit Margin *
The margin reflects the percentage of revenue that remains after the business pays all of its expenses. This represents the total profit after expenses.
Fixed costs exist regardless of how much you sell or don’t sell, and include expenses such as rent, wages, power, and insurance.
Breakeven Point = Fixed Costs ÷ Contribution Margin Contribution Margin is a product’s price minus all associated variable costs, resulting in the incremental profit earned for each unit sold. *
It helps to provide a dynamic view of the relationships between sales, costs, and profits.
For example, expressing break-even sales as a percentage of actual sales can give managers a chance to understand when to expect to break even (by linking the percent to when this percent of sales might occur).