Macroeconomics examines the economy as a whole. It answers questions such as:
- What causes the economy to grow over time?
- What causes short-run fluctuations in the economy?
- What influences the various economic indicators and how do those indicators affect economic performance?
One Must Understand Microeconomics to Understand Macroeconomics
Macroeconomics considers the larger picture, or how all of these decisions sum together. An understanding of microeconomics is crucial to understand macroeconomics. To understand why a change in interest rates leads to changes in real GDP, we need to understand how lower interest rates influence decisions, such as the decision of how much to save, at the firm or household level. Once we understand how an individual, on average, will change their behavior we will then understand the large scale relationships in an economy.
Like most definitions in economics, there are various competing definitions of the term Macroeconomics. According to WordReference.com, “Macroeconomics is the branch of economics concerned with aggregates, such as national income, consumption, and investment.”
What Is Microeconomics?
Roughly speaking, microeconomics deals with economics decisions made at a low, or micro, level. More precisely, I would define microeconomics as “the analysis of the decisions made by individuals and groups, the factors that affect those decisions, and how those decisions effect others”.
Microeconomic decisions by both firms and individuals are motivated by cost and benefit considerations. Costs can be either in terms of financial costs such as average fixed costs and total variable costs or they can be in terms of opportunity costs, which consider alternatives foregone.
Microeconomists consider questions such as “What determines how much a consumer will save?”, “How much should a firm produce, given the strategies their competitors are using” and “Why do people buy both insurance and lottery tickets?”
The Economist’s Dictionary of Economics defines Microeconomics as “The study of economics at the level of individual consumers, groups of consumers, or firms… The general concern of microeconomics is the efficient allocation of scarce resources between alternative uses but more specifically it involves the determination of price through the optimizing behaviour of economic agents, with consumers maximizing utility and firms maximizing profit.”
Example of a Microeconomic Question
How does the change of a price of good influence a family’s purchasing decisions? If my wages rise, will I be inclined to work more hours or less hours? Contrast this with Macroeconomics, which deals with questions of a large scope, such as how does a change in interest rates influence national savings?
Microeconomics Versus Macroeconomics
According to comedian P.J. O’Rourke, “microeconomics concerns things that economists are specifically wrong about, while macroeconomics concerns things economists are wrong about generally. Or to be more technical, microeconomics is about money you don’t have, and macroeconomics is about money the government is out of.” This is probably closer to the truth than economists would like, but let’s examine the distinction in more detail.
Those who have studied Latin know that the prefix “micro-“ means “small,” so it shouldn’t be surprising that microeconomics is the study of small economic units. The field of microeconomics is concerned with things like:
- Consumer decision making and utility maximization
- Firm production and profit maximization
- Individual market equilibrium
- Effects of government regulation on individual markets
- Externalities and other market side effects
Macroeconomics can be thought of as the “big picture” version of economics. Rather than analyzing individual markets, macroeconomics focuses on aggregate production and consumption in an economy. Some topics that macroeconomists study are:
- The effects of general taxes such as income and sales taxes on output and prices
- The causes of economic upswings and downturns
- The effects of monetary and fiscal policy on economic health
- How interest rates are determined
- Why some economies grow faster than others
The Relationship Between Microeconomics and Macroeconomics
There is an obvious relationship between microeconomics and macroeconomics in that aggregate production and consumption levels are the result of choices made by individual households and firms, and some macroeconomic models explicitly make this connection.
Most of the economic topics covered on television and in newspapers are of the macroeconomic variety, but it’s important to remember that economics is about more than just trying to figure out when the economy is going to improve and what the RBI is doing with interest rates.