Ever wonder why some companies can raise prices without hurting demand and others must keep them low to remain competitive? It’s a matter of microeconomics.
Microeconomics explains why businesses and customers behave the way they do. Understanding this economic theory helps business owners improve productivity, make pricing decisions and increase profits.
In this article, you’ll learn about microeconomics and its key concepts, how to define your market and how to apply microeconomic principles to your business.
Microeconomics definition: Microeconomics is the study of individual behavior within an economy. It analyzes why consumers, households and businesses take specific actions and how economic decisions like incentives and price increases impact the economy and create externalities. (Externalities are indirect costs to third parties not involved in the initial action. For example, air pollution is an externality of driving a car).
Many microeconomic theories study the impact of decisions and incentives on the supply and demand model.
For example, a small business owner can use microeconomic principles to analyze the impact of a price increase on customer demand.
According to the law of supply and demand, demand will fall if prices rise, all other things being equal. Conversely, demand will increase if prices fall.
This graph from the Federal Reserve Bank of St. Louis shows the relationship between the supply curve and demand curve:
In the real world, you can see this concept in action with things like gas prices.
When gas prices rise, fewer people go to the pumps. People drive less, and the demand for gas falls.
When gas prices fall, demand rises because consumers are more willing to take the car than catch public transport.
The point on the graph where supply perfectly meets demand is called price equilibrium or general equilibrium.
Microeconomics is a way for business owners to understand how their decisions may impact economic outcomes.
Microeconomics is closely related to the field of study known as macroeconomics. While both are forms of analysis to help understand economic outcomes, there are some differences.
Microeconomics vs macroeconomics
Microeconomics studies the interactions among individuals and businesses. Macroeconomics, on the other hand, examines collective behavior within an entire economy.
It analyzes factors such as international trade, unemployment, inflation and GDP. It also studies national and international policies related to these issues and major financial events such as market failures or financial crises.
For example, if a government imposes tariffs, business owners would use macroeconomic principles to estimate the impact on their business.
Here’s a table that showcases the differences between the two social sciences:
Microeconomics | Macroeconomics |
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Note: Microeconomics also analyzes the impact of public policy on public goods, but this occurs at a smaller scale – often at the industry or business level. For instance, you can use microeconomics to analyze the impact of an increase in sales tax on a particular industry.
These two economic theories work together to help you understand the economy as a whole. For example, you can use macroeconomics to see how global factors like inflation will impact your market and microeconomics to make decisions about specific products or hires.
Analyzing your microeconomic market
Your market structure determines consumer and corporate behavior. If you want to predict how consumers will react to your decisions, you must factor market type into your calculations.
Here are the most common microeconomic markets:
Perfect competition
Perfect competition, also called “pure competition”, is a market where many small companies compete equally.
Businesses can easily enter and exit a perfectly competitive market and sell similar goods. Individual companies can’t influence prices. There’s no information asymmetry, either. Consumers are aware of the location and prices of every seller.
Note: Perfect competition markets exist only in theory. However, they help you compare other market structures. All of the markets below are examples of imperfect markets.
Monopoly
In a monopoly, a single company controls supply. No other businesses can enter the market, and the monopoly owner can set any price they wish.
This situation rarely happens in reality, but it is not unheard of. Utilities often fall into this category. For example, in North Carolina, Duke Energy operates a state-granted monopoly. Residents can only purchase electricity from a single local supplier.
Note: Many countries, like the US and the UK, define monopolies differently for legislative reasons. In these cases, monopolies occur when one company has a specific share of the market – typically around 70%–75%.
Monopolistic competition
Monopolistic competition occurs when many firms offer similar but not identical products. The market’s barriers to entry are low, and businesses compete on product differentiation, pricing and marketing.
Most consumer markets have monopolistic competition. For example, restaurants offer similar products and differentiate themselves through branding, customer service and price.
In monopolistic competition markets, demand is often very responsive to price. For example, companies can reduce prices to increase demand and gain market share. Big box retailers use this tactic to force smaller competitors that can’t compete on price out of business.
Oligopoly
In an oligopoly, a handful of companies control the market. The firms are interdependent – meaning the actions of one impact the actions of others – and they can choose to collaborate or compete.
OPEC is an example of an oligopoly. The oil-producing countries of Iran, Iraq, Kuwait, Saudi Arabia and Venezuela, among others, control a large percentage of the world’s oil supply. They coordinate the supply of oil to ensure a strong return.
Note: The minimum number of participants in an oligopoly is two. A two-party oligopoly is called a duopoly. There are several global duopolies, the most well-known being Coca-Cola and Pepsi.
Contestable markets
A contestable market is one with low barriers to entry, in which existing businesses face pressure to keep price levels low.
The constant risk of new entrants means existing businesses focus on boosting sales rather than profit maximization. If existing businesses are too profitable, newcomers can easily undercut them.
Examples of contestable markets include low-cost airlines, grocery stores and coffee shops. A contestable market doesn’t stop big brands from forming, but consumer choice will always exist.
Note: It’s harder for existing businesses to consolidate power and form a monopoly in contestable markets. Even if a monopoly does form, it’s in the monopoly’s interest to keep prices low to stay competitive.
Monopsony
In a monopsony, there is one buyer and many sellers. The buyer has all the power. They set the demand and control the price. Sellers have little influence and no incentive to innovate.
Businesses are monopsony employers if they’re the major supplier of jobs in a local area. This power lets them set wages and working conditions as long as they comply with regulations like minimum wages.
Some experts consider Amazon a monopsony in the retail book market because its purchasing power allows it to dictate market factors like price and product differentiation.
Oligopsony
An oligopsony is a market with a small number of buyers and a large number of sellers. The buyers hold significant control, allowing them to dictate prices, often to the detriment of sellers.
Many agricultural markets are oligopsonies. In the cocoa market, for example, three companies – Cargill, Archer Daniels Midland and Barry Callebaut – buy the majority of cocoa beans from small farmers in the third world.
What are the advantages and challenges of microeconomics?
Microeconomics helps business owners analyze customer behavior, predict the impact of incentives like a sales promotion and decide how to allocate resources.
Several benefits make this method of analysis particularly useful, including:
Insight into specific behavior. Microeconomics’ granular detail analyzes the behavior of specific individuals and businesses. For example, you can zero in on your existing customers’ buying patterns rather than studying the patterns of consumers in general.
Improved resource allocation. It highlights how business owners can best spend resources. For example, you can use microeconomics insights to decide how to distribute your marketing budget between channels.
Optimized pricing. Microeconomic theory helps you set the highest prices that demand will support. For instance, you can determine how much of the cost of inflation you can pass on to customers before they start buying fewer goods.
While microeconomics offers several advantages, there are also challenges to consider. These include:
Limited scope. Microeconomics only analyzes one business or market, not the wider economy, so your view can become narrow.
Lack of aggregate data. The theory doesn’t take macroeconomic information into account. You’ll need to incorporate both theories to achieve a broader analysis.
Assumption based. Microeconomics relies on simplistic assumptions – such as consumers behaving rationally – which don’t always hold true in the real world.
Here’s a table summarizing the benefits and drawbacks:
Benefits | Challenges |
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Bear these challenges in mind when using microeconomic analysis to inform your decisions.
For example, rather than relying on economic theory alone, test the impact of a price increase on a single product line in the short run before implementing the change across your entire offering.
How to apply the principles of microeconomics to your business
You’ll need to learn the fundamental principles to apply microeconomics to your day-to-day business decisions.
Here are four ways these principles of economics can help you quickly analyze decisions and predict outcomes.
1. Optimize pricing with price elasticity of demand
Price elasticity of demand measures the change in demand for a product compared to a change in its price. If a price increase significantly changes demand, then demand is elastic. If the change in demand is small, demand is inelastic.
Understanding your product’s price elasticity of demand will show you how much you can raise prices without impacting demand.
If you’ve previously changed the price of your product, you can use your sales data to calculate the change in demand. You can then use the following formula to calculate elasticity:
Price elasticity = percentage change in demand/percentage change in price
Your answer will tell you how elastic your price is, as shown in the following table:
Calculation | Type of elasticity |
More than 1 | Elastic (significant change in demand) |
Less than 1 | Inelastic (slight change in demand) |
0 | Perfectly inelastic (no change in demand) |
Imagine you raised prices by 10% at the start of 2023. Comparing Q1 2023 to Q1 2022, sales data shows that demand fell by 5%.
The elasticity of demand for your product is 0.05/0.10 = 0.5.
The result means your product is inelastic. Even when prices rise, consumer buying habits will remain roughly the same.
Essential items like medicine tend to be price inelastic, whereas luxury goods are usually price elastic. Consumers can’t go without medicine, even if prices rise, but they’ll forgo a European vacation.
2. Make better decisions by calculating opportunity cost
Consumers don’t have unlimited resources. When someone chooses between several mutually exclusive options, the opportunity cost is the value of the next best alternative.
Imagine you buy a new electric car. You’re choosing from several brands: a Tesla (your favorite option), a Kia (your second favorite) and a Hyundai (your third choice). If you choose the Tesla, your opportunity cost is the Kia – it’s the next best option you don’t choose.
Every business decision has an opportunity cost. For instance, if you have a limited marketing budget, the opportunity cost of investing in a digital marketing campaign might be the cost of forgoing a direct response campaign.
If you determine that digital marketing will generate $10,000 in new business and a direct response campaign will generate $5,000, then digital marketing is the best choice.
You can also use opportunity cost to compare different options, from purchasing a new piece of machinery to hiring new salespeople. The key to making better decisions is to compare the expected returns of a decision and prioritize accordingly.
3. Improve your product offering with the law of diminishing marginal utility
This economic principle states that additional satisfaction from a product decreases as consumption increases.
For example, a consumer might enjoy one ice cream sundae. However, they probably won’t enjoy eating a second sundae in the same sitting and might entirely dislike eating a third.
Understanding how the law of diminishing marginal utility impacts your business can help you diversify your product offering. For example, if you find consumers get significantly less value from repeated purchases of one product, offer a diverse range of products they’ll continue to buy.
Apple is an excellent example of this. Most consumers don’t need several iPhones but are happy to buy an iPhone, iPad and MacBook from the Apple Store.
The diverse offerings keep satisfied customers coming back for more.
Note: You can also apply this theory to structure your workforce. For example, a small business with a dozen employees will benefit from hiring an HR manager. Hiring a second may be beneficial if the company doubles in size, but it probably won’t see a marginal benefit from hiring a third until they have over 100 employees.
4. Create positive outcomes with incentives
In microeconomics, an incentive is a financial motivation that influences decision-making. Real-world incentives include the following:
Bonuses | Incentivize employees to work hard and hit sales targets |
Tax reductions | Incentivize businesses to invest in areas like research and development |
Subsidies | Incentivize consumers to purchase a specific product, like an electric car |
Use incentives to boost employee productivity, improve customer service and increase consumer demand for goods.
How to stay informed on economic trends and analysis
Keeping up with the latest financial and economic news is essential to applying microeconomic principles to your business.
The sooner you know about changes in economic factors like unemployment levels, government incentives or tax increases, the quicker you can calculate their impact on supply and demand.
Regularly browse dedicated publications like the following to get a high-level overview:
CNBC
Bloomberg
MarketWatch
Yahoo Finance
Learners looking for more detailed analysis can listen to finance and economic podcasts. For example, EconTalk is an award-winning weekly podcast that analyzes trending macro- and microeconomic factors. Planet Money regularly explores microeconomic issues and trends.
You can also create customized Google Alerts to get updates on a particular topic. For instance, you can set up a Google Alert for each of your competitors to stay informed about product launches, sales promotions and anything else that may impact your business and market.
Use Pipedrive alongside microeconomics for better business decisions
You don’t need to be an economist to make smart business decisions, but you need access to the right data. A Business Intelligence reporting tool can collect, analyze and present key information through charts, graphs and dashboards.
Pipedrive, for example, is an affordable and powerful choice for collecting and analyzing sales, marketing, customer and productivity data. Use Pipedrive’s Insights feature to:
Forecast revenue to better allocate marketing resources
Run performance reports to measure rep productivity and make hiring decisions
Create conversion reports to track campaign performance
You can tailor everything to your needs. For example, create customizable dashboards that track your most important KPIs.
Your data is always accessible. Pipedrive stores everything in the cloud, so you never have to search through dozens of spreadsheets again.
Final thoughts
Economic metrics are essential in helping small business owners understand their market, price products competitively and make hiring and resource allocation decisions.
Apply microeconomics principles more successfully using high-quality data. Use Pipedrive to collect and analyze business intelligence data. It provides automated insights, customizable reports and forecasting tools. Try Pipedrive free for 14 days.
