Microeconomics and Macroeconomics
Chapter Three
Syllabus topic 1.1, "Difference between Micro and Macro Economics"
Pages 14 to 18 of 556
In one line
Microeconomics studies the individual parts of an economy, one household, one firm, one market; macroeconomics studies the economy as a whole, its total output, its total employment and its general level of prices.
In the wording a student can write in an exam: microeconomics is that branch of economics which analyses the behaviour of individual economic units, such as a consumer, a producer, a firm or a single market, and the determination of relative prices and the allocation of resources between uses; macroeconomics is that branch which analyses the economy in the aggregate, and is concerned with national income, total output, total employment, the general price level, the money supply and the balance of payments.
Where the two words come from
The words were introduced by the Norwegian economist Ragnar Frisch in 1933. Both are built from Greek: mikros meaning small and makros meaning large. The idea is older than the words. Adam Smith, David Ricardo and Alfred Marshall were writing about individual prices and markets, which is microeconomics; the systematic study of the whole economy as a single object began with John Maynard Keynes's General Theory of Employment, Interest and Money in 1936, written out of the Great Depression, which is why Keynes is usually called the father of modern macroeconomics.
The Depression is the reason the split was needed. Classical economics, working from individual markets, taught that unemployment would cure itself: if too many workers were unemployed, wages would fall and employers would hire them. Between 1929 and 1933 that did not happen, in country after country, for years. Keynes's answer was that a question about the whole economy cannot be answered by adding up answers about its parts.
The two nicknames, and what they teach
Microeconomics is often called price theory, because in it the price of one good relative to another does the explaining: why onions cost more than potatoes, why a lawyer's fee is higher than a clerk's. It works with relative prices.
Macroeconomics is often called income and employment theory, because it explains the size of the national income and the number of people at work. It works with the general price level, meaning the average of all prices, whose movement is inflation or deflation.
The distinctions table
This is the answer to MU's own question, and it is what an examiner marks.
| Microeconomics | Macroeconomics | |
|---|---|---|
| Unit of study | An individual household, firm, industry or market | The economy as a whole |
| Also called | Price theory | Income and employment theory |
| Central question | How are resources allocated between uses, and how is a relative price determined? | What determines total output, total employment and the general price level? |
| Chief variables | Individual demand and supply, price of one good, cost, revenue, wage of one kind of labour | National income, aggregate demand and aggregate supply, total employment, general price level, money supply, balance of payments |
| Method | Partial equilibrium: one market examined with the rest of the economy held constant | General equilibrium: the whole system examined together |
| Assumption it makes about the rest | Full employment of resources is often assumed | Full employment is the thing to be explained, not assumed |
| Typical policy question | Should this industry be regulated? What will a tax on this good do to its price? | Should the repo rate be cut? Is the fiscal deficit too large? |
| Associated with | Alfred Marshall and the classical and neoclassical writers | John Maynard Keynes, from 1936 |
| In this syllabus | Module I, topics 1.2 and 1.3 | Module I topics 1.4 to 1.6, and the whole of Modules II, III and IV |
Microeconomics and Macroeconomics
Why you cannot simply add the parts up: the fallacy of composition
This is the deepest point in the chapter and the one that most often appears as a short note question.
The fallacy of composition is the mistake of assuming that what is true of a part must be true of the whole. It is the reason macroeconomics had to be invented as a separate branch.
Example one, the paradox of thrift. If one household saves more, that household becomes better off. If every household saves more at once, total spending falls; falling spending means falling sales; falling sales mean lower output and fewer jobs; and with lower incomes the total amount actually saved may end up smaller than before. What is prudent for one is damaging for all.
Example two, wages. A single firm that cuts wages lowers its costs and can sell more. Every firm cutting wages at once lowers the incomes of the very people who buy the goods, so demand falls and the firms may end up selling less.
Example three, from outside economics. One person standing up at a cricket match sees better. Everybody standing up sees no better and is less comfortable.
The reverse mistake exists too and is called the fallacy of division: assuming that what is true of the whole must be true of each part. National income can rise in a year in which most people become poorer, if the gain is concentrated.
They are not rivals: the two are interdependent
An examiner sometimes asks whether the two branches are opposed. They are not, and the answer has two halves.
Macro rests on micro. Aggregate demand is the sum of the demands of individual households and firms. The general price level is an average of individual prices. Any macroeconomic proposition eventually has to be consistent with how individuals behave, which is what economists mean when they speak of the microeconomic foundations of macroeconomics.
Microeconomics and Macroeconomics
Micro rests on macro. No firm can plan without knowing what is happening to the whole economy. A monopolist's demand curve shifts when national income changes; a builder's costs shift when the interest rate does. A firm studied with the rest of the economy held constant is being studied under an assumption everybody knows is false, which is the standing limitation of partial equilibrium analysis.
The picture usually offered is that microeconomics examines the trees and macroeconomics examines the forest. Neither view alone tells you what is happening to the wood.
A worked example: one onion farmer and the price of onions
Sunil grows onions on two acres near Nashik. In a good monsoon his yield is heavy.
The micro question. With a heavy crop, the supply of onions in the Lasalgaon market rises. With demand unchanged, the price of onions falls. Sunil's revenue may fall even though his output rose, if demand for onions is inelastic, which is the trap explained in [Elasticity of Demand]. That is a complete microeconomic analysis: one market, one relative price, the rest of the economy held constant.
The macro question is a different question. Does a heavy onion crop reduce inflation? Now the unit is the general price level, not the price of onions. Onions have a weight in the consumer price index. A fall in their price pulls the index down by that weight, but only if other prices do not rise at the same time. If the monsoon also raised transport costs or if fuel prices rose that month, the index can rise while the onion price falls.
What the example shows. The same event answers two different questions, with two different units of study, two different methods, and two different sets of things held constant. Notice also the direction of influence: if the general price level rises sharply, the government may ban onion exports, which changes Sunil's market. Macro conditions feed back into the micro answer.
What beginners get wrong
"Micro means small quantities and macro means large ones." No. The subject of study is what differs, not the size of the number. The total sales of a single very large company are a microeconomic quantity. The average price of a matchbox across the country is a macroeconomic one.
"Micro is about firms, macro is about government." No. Macroeconomics studies household consumption and business investment too. Government is one of four sectors in [The Circular Flow of Income].
"They contradict each other." No. They answer different questions. Where they appear to contradict, the usual cause is the fallacy of composition.
Microeconomics and Macroeconomics
"Macro came first because it is more general." No. Micro is the older branch; macro was built later, out of the Depression.
Limits of each branch
Microeconomics assumes full employment far too readily, treats the rest of the economy as constant when it never is, and cannot answer questions about the economy as a whole. It also says nothing about growth over time.
Macroeconomics works with aggregates that hide their own composition. A stable general price level can conceal a sharp rise in food prices and a sharp fall in electronics prices, which matter very differently to a poor household. An average is not a description of anybody.
Quick revision
- Microeconomics studies individual units: a consumer, a firm, an industry, one market. Also called price theory. It works with relative prices and partial equilibrium.
- Macroeconomics studies the economy as a whole: national income, employment, the general price level, money and the balance of payments. Also called income and employment theory.
- The words were coined by Ragnar Frisch in 1933; the branch of macroeconomics was built by Keynes in the General Theory, 1936, out of the Great Depression.
- The fallacy of composition: what is true of a part need not be true of the whole. The paradox of thrift is the standard example. Its reverse is the fallacy of division.
- They are interdependent. Macro is built on micro behaviour; micro analysis holds macro conditions constant that in fact move.
- In this syllabus: Module I topics 1.2 and 1.3 are micro; topics 1.4 to 1.6 and Modules II, III and IV are macro.
Test yourself
1. Define microeconomics and macroeconomics, and name the economist who coined the two terms. Microeconomics analyses the behaviour of individual economic units, a consumer, a firm, an industry or a single market, and explains relative prices and the allocation of resources between uses. Macroeconomics analyses the economy in the aggregate and explains national income, total output, total employment, the general price level, the money supply and the balance of payments. Both words were introduced by Ragnar Frisch in 1933.
2. Give five points of difference between the two branches. Unit of study, an individual unit against the whole economy; alternative name, price theory against income and employment theory; central variables, relative prices and individual demand and supply against national income, aggregate demand and the general price level; method, partial equilibrium with other things held constant against general equilibrium; and treatment of employment, which micro usually assumes to be full and macro sets out to explain.
3. What is the fallacy of composition? Illustrate it. It is the error of inferring that what is true of a part is necessarily true of the whole. The paradox of thrift is the classic illustration: additional saving makes one household better off, but if all households save more at once, spending and therefore incomes fall, and total saving may end up lower than before. A second illustration is a wage cut, which helps one firm's sales and damages all firms' sales if every firm does it.
Microeconomics and Macroeconomics
4. Why did macroeconomics develop as a separate branch? Because classical reasoning built up from individual markets predicted that unemployment would cure itself through falling wages, and in the Great Depression of the 1930s it did not, for years together. Keynes argued in the General Theory of 1936 that questions about total output and total employment cannot be answered by adding up answers about single markets, because of effects like the fallacy of composition.
5. Are the two branches independent of each other? Explain. No. Macroeconomic aggregates are built out of individual behaviour, so every macroeconomic proposition must be consistent with how households and firms actually act. Conversely, microeconomic analysis holds constant things, national income, interest rates, the price level, that macroeconomic forces are constantly moving, so a partial equilibrium answer is only as good as that assumption. They are two levels of the same subject.
6. Classify these as micro or macro: the price of petrol in Mumbai; the rate of inflation; the wage of a welder; the fiscal deficit; the demand for a company's product. The price of petrol in one city, micro. The rate of inflation, macro, because it measures the general price level. The wage of a welder, micro, since it is one factor price. The fiscal deficit, macro. The demand for one company's product, micro.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.