ECON 201 - Principles of Economics:

Phil Martinez, Economics

A Brief History of Microeconomic Theory


Contemporary microeconomics uses mathematical models to represent the ideal behavior of individual consumers and producers in a theoretical market. While these models rely upon the perfectly logical causal implications of mathematics, they are based upon and incorporate ideas that came before the use of modern mathematical modeling. Contemporary microeconomics has its roots in Adam Smith’s theory of the free market (c. mid 1770s) and in the Utilitarians’ theory of human behavior (c. mid 1800s).

Adam Smith and the Theory of the Free Market (c. mid 1700s)

In his book, An Inquiry into the Nature and Cause of the Wealth of Nations, Adam Smith constructed the theory of the free market. In this theory Smith attempts to explain how an unregulated (i.e.  “free”) market can generate new wealth and benefits to society that outstrip any previous economic system (i.e. feudalism) or any conceivable new economic system.

He theorized that in an unregulated (i.e. “free) market individuals are able to pursue their own self-interest.

The pursuit of self-interest generates economic competition. According to Smith's view, competition is generated in all markets throughout the economy. It is generated among consumers for access to employment and goods, among producers for access to resources and to markets, and between consumers and producers over the distribution of the benefits from transactions.

Competition in turn generates the independent adjustment of prices. If the quantity demanded of a good is greater the quantity supplied of the good the current market price, then market price will independently rise. If the quantity supplied of a good is greater the quantity demanded of the good the current market price, then market price will independently fall. The independent adjustment of prices is the most important process in the market mechanism, i.e. in the demand and supply process.

These independent price adjustments continue until an equilibrium is generated where the quantity demand of the good exactly equals the quantity supplied of the good at a single market price.

Smith concludes that when equlibrium occurs the market has achieved a series of beneficial results:

(i) Efficiency.

There are three different but inter-related concepts of efficiency all of which occur at equilibrium:
•    Economic Efficiency: producing the maximum economic (or financial) return from a given set of economic (or financial) resources), for example from a given amount of investment.

•    Productive Efficiency: producing the maximum output from a given set of productive resources (i.e. inputs). This means there is no waste or pollution occurring. Any residual (leftover) resources have no productive use and do no harm.

•    Allocative Efficiency: producing the optimal mix of outputs from society’s resources. All of society’s resources are being used to produce the most desired goods consistent with consumer’s preferences. There is no under-production or over-production of any good in the economy and every production process is efficient. So every resource is allocated to its best possible use.

(ii) Social Optimality

Adam Smith theorized that since individuals pursuing their self-interest in the unregulated market could freely enter into fair and balanced transactions (i.e. no one in the market had any power to manipulate prices or output, or force specific conditions on anyone else in the market) then each person was assured to gain the maximum benefit for themselves in every transaction that they entered. Otherwise they would not agree to the terms of the transaction. They would simply go on to a more beneficial transaction. Since everyone was engaged in such transactions the unregulated market would generate the maximum benefits for everyone partaking in the market. Society based upon an unregulated market would produce the maximum benefits.

                    Pareto Optimality. While this is a very reassuring theory (people everywhere have always wanted to believe that their society is the best even in the face of contrary evidence) economists have only been able to establish that the market is able to generate a Pareto Optimality. This occurs when no one can gain any additional benefits unless someone else in the economy loses some benefits. In other words, all of the benefits have been distributed. Every piece of the pie has been distributed to someone. The only way for a Pareto optimal situation to be improved upon is for the pie to grow larger and more becomes available to distribute.

The problem with Pareto Optimality is that it is an extremely weak concept of what is social best. In fact, it does not meet the basic concepts of democratic fairness, since it cannot distinguish a democracy as being better than a brutal dictatorship.

Imagine a country that produces $100,000 and has population of 100 people. The dictator receives $90,000 and hires and arms a military of 9 people to force the rest of the population to work. The military receives $1000 each. The remaining 90 people have $1000 to share between them. Note that not one worker can earn even $1 more unless someone else loses $1. Even taking a dollar from the dictator to give to a worker would not be considered a Pareto improvement since the dictator has to lose $1.

This an important point in understanding how Neoclassical microeconomic theory functions and how it has been misused.  The laissez-faire doctrine which argues that an unregulated market always produces a better result than a regulated market is, perhaps. the most common misapplication of Neoclassical microeconomic theory. The laissez-faire doctrine can only be shown to produce Pareto optimality not the broader concepts social optimality or democratic fairness.

(iii) Consumer Sovereignty

Smith concludes that at market equilibrium producers have produced only those goods most desired by demanders. The point is that producers do not choose what to produce leaving consumers only the choice of what to pick out of range of possibly less desired goods, for example production under the former Soviet system. Rather, producers respond to what consumers are willing and able to spend money on. Therefore, consumers determine what is most needed and desired for the society, and producers respond with the most efficient way to produce it.

(iv) Uniqueness

Smith’s theory of the free market concludes that there is only a single equilibrium – single most efficient, socially best, solution to any economic problem. 

Market Imperfections and Market Failures

Smith was aware of a couple of potential problems in the Free Market Theory. One area he was concerned about was the tendency for producers to try to collude to set prices to avoid competition.

"People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices."

Another area was what he called "public works", goods that were beneficial to be provided to the society as a whole but which no individual producer would have an incentive or ability to provide. For Smith these included roads, bridges, and public education.

Since Smith's time economists have come to analyze both of these areas and to identify a few others that Smith could not have known about. These characteristics of markets are now common and well understood. When they occur in actual markets
then the free market will fail to generate the beneficial outcomes. Additionally, when we alter the free market models to include these imperfect market conditions then the models generate results that more accurately reflect actual markets rather than ideal markets. That is the under these imperfect conditions the market will fail to acheive the efficient, optimal, unique equilibrium theorized by Smith. We classify these market conditions as market imperfections and market failures.

Market imperfections
occur when there is some inherent problem with the pricing function of the market. In this case the free market will produce the good at an equilibrioum price and quantity, however, that price and quantity will not be the efficient, optimal price and quantity. Categories of market imperfections are market power (i.e. monopoly, oligopoly, et cetera); externalities; and imperfect information. Smith's concern about price collusion in the comment above is an example of a market imperfection.

Market failures occur when the market is unable to produce a good or service at all under competitive conditions. With market failures the market is entirely unable to generate a price, or cannot generate a competitive price and ensure that they are paid by every consumer. When these conditions exist either the government must provide the goods directly, or the government must allow a private monopoly to produce the goods under heavy regulation and with guarantees of profit rates that approximate a competitive market.
The primary category of market failures is called public goods. Smith's "public works" - roads, bridges, public education - are examples of public goods.

Another area that our textbook (The Economy Today, Schiller) includes as a market failure is the issue of equity. The free market will not provide any goods for anyone who cannot pay the market price for the good. Additionally, the free market will not employ and provide an income to anyone who is not actively employed. Thus, the free market is guaranteed to starve to death all those who are unable to work and provide for their own care - orphans, disabled, mentally ill, seniors, et cetera. These conditions violate all modern standards of fairness (i.e. equity), especially in democracies. Thus, the free market cannot produce economic equity.

The Utilitarianian Theory of Human Behavior (c. mid 1800s)

The Utilitarians were a leading group of philiosphers of the mid 1800s who argued that there was a fundamental theory that exlained all human behavior. According to the Utilitarians all human behavior conformed to the "pleasure-pain principle". All human behavior was said to be motivated by the pursuit of pleasure and avoidance of pain. This became important to economic theory because it  was a specific  interpretation of Smith's claim that in an unregulated market people pursue their self-interest. Under the Utilitarians' interpretation "pursuing self-interest" meant seeking the maximum pleasure and minimum pain in all endeavors, or in economic terms, in all transactions.

The Marginalists, aka Neoclassicals, and Utility Maximization (c. late 1800s to present)

The Marginalists (now-a-days caled Neoclassicals) made the final step in translating Smith's Theory of the Free Market into a set of mathematical models. By recognizing that "seeking maximum pleasure and minimum pain" could be easily formulated as a calculus constrained maximization problem they began writing mathematical models (systems of equations) to represent the essence of Smith's Free Market Theory. They developed the mathematical methods and structure that are now used in most microeconomic theory.

(i) Utility Maximization

Specifically, they modelled all economic actors as making choices based upon seeking to maximize the utility (i.e. benefit) gained from their choices within the limits of their resources (budget, income, endowment).

Consumers are modelled as seeking to maximize the utility of their purchases limited by their budget (or income).

Producers are modelled as seeking to maximize profit limited by their technology.

Government is modelled as seeking to maximize total public benefit limited by its budget (or available resources).

Note that for producers we use slightly different terminology, the words "profit" and "technology". We do this only to be more specific. In the case of consumers we assume some theoretical benefit called "utility" since we cannot state precisely what consumers maybe trying to achieve with any specific choice or purchase. In the case of producers we can be more specific since producers must seek a profit in order to be successful. Similarly we use the term "technology" instead of "budget" to emphasize that a producer is making a decision based upon a specific production process or enterprise. A budget, or investment, or set of costs fund a production process but do not in themselves produce anything. They must first be spent on or invested in a productive process, which we call "technology".

(ii) Economic Rationality

When we model human decision-making behavior with mathematics we represent human behavior as being just as logical as the mathematics. We have little choice in this since mathematics is perfectly logical and internally consistent. Thus if we use mathematics to represent human choices we are necessarily limiting the choices to only the mathematically logical results. For example, while Sara might always prefer apple pie over cherry pie, she may occasionally choose a piece of cherry instead of the apple pie for random, emotional, unconscious, or other inconsistent reasons. This is not an option in mathematics. If 6 is greater than 5, then 6 must always be greater than 5 in all calculations. For this reason we model all of our economic decisionmakers in microeconomic models as being perfectly consistent (i.e. economically rational) in all their choices.

An "economically rational" person:
  • is a utility maximizer;
  •  and can rank or prioritize all of their preferences over all alternative goods or options.
So note that we have now translated Smith's idea of "individuals pursuing self-interest" into a mathematical model of "utility maximizers who prioritize all of the preferences".

“The theory of rational behavior is usually presented as a study of the principals upon which a rational man would act. This rational man...makes no errors in arithmetic, or logic, in attempting to achieve his clearly defined objectives...Every action is perfectly thought out; every risk is perfectly calculated.”

Harry Markowitz (the father of modern investment portfolio theory)

(iii) The Utility Maximization Model and Actual Behavior

It is important to remember that a model is not a description of actual phenomena, but a tool to help us think about the actual phenomena. Thus, a model can be unrealistic in many ways but still valuable in helping us to identify fundamental relationships, forces, tendencies, or possible outcomes of actual phenomena.

Given what we know about cognitive psychology, utility maximization is a ludicrous concept; equilibrium pretty foolish outside of financial markets; perfect competition a howler for most industries. The reason for making these assumptions is not that they are reasonable but that they seem to help us produce models that are helpful metaphors for things that we think happen in the real world.
                                               How I Work
                                               Paul Krugman, PhD
                                               Prof. of Economics & Int'l Affairs,
                                               Princeton University

(iv) Irrationality and Behavioral Economics

Just as market imperfections and market failures are common economic conditions that show free market theory to be an overally narrow model, contemporary psychology provides considerable evidence that humans do not behave nor make decisions like the free market theory assumes. In other words, the assumption of a a rational, perfectly logical, self-interested, maximizing decisionmaker is inaccurate. Economists who are attempting to analyze how people actually make decisions and to include this process in economic models and theory are called Behavioral Economists. One of the leading Behavioral Economists is Dan Ariely, author of Predictably Irrational (which I highly recommend for students interested in delving into current cutting edge economics). Below I've placed several video links to YouTube videos of Dr. Ariely explaining how humans actually make decisions and why the free market models of traditional free market theory are such poor tools.

Before you check out Dan's videos let me provide two explanatory points. First, as a young man Dan was an Israeli soldier and survived a bomb blast, which burned 70% of his body. This experience is relevant because it started him on this path of economic research, as he explains in one of the videos.

Secondly, when he states in the videos that "there are free lunches" he is criticising the Neoclassical assumption that the market always generates the efficient, optimal outcome. In Neoclassical economics we often state that "there are no free lunches", as short hand for saying all goods are properly priced, all costs are properly accounted for, and the free market produces at maximum efficiency. By claiming there are free lunches he is saying that by acknowledging that we are not rational, and changing our behavior to be more rational or implementing rules to make us behave rationally, we can actually increase efficiency without sacrificing any additional resources. More rational behavior results in less waste and error, so we get more output and more efficiency for the same resources used. There are free lunches.

Irrational Predictability, Dan Ariely,, 2008

Irrationality and Self-Control, Dan Ariely, TED Lecture, 2008

Cheating and Group Behavior, Dan Ariely, TED Lecture, 2009