Microeconomics

The third major component of microeconomic theory is the theory of how markets operate to bring about an equilibrium between demand and supply. This theory describes how markets operate under different degrees of competition. This is not too difficult in markets with a pure monopoly, but such cases are rare. For example, the supply of electricity in any region is usually provided by a single monopoly supplier, but some threat of competition from alternative sources of energy—such as gas or oil—usually exists and can constrain the profit-maximization behavior of a monopolist, particularly in the longer term. When a market is dominated by a few major suppliers—conditions of oligopoly prevail—the theory of market equilibrium employs game theory, a way of analyzing competitive situations in which two or more opponents pursue conflicting goals.

The three components of microeconomics—demand, supply, and market equilibrium—provide a foundation for almost any branch of economics. For example, an economist working in public finance who wants to analyze the effects of imposing a tax (a macroeconomic strategy) must use microeconomic models to show how the tax will affect supply, demand, and price, and hence the revenue that it may generate or how it will affect the supply of factors of production. An income tax might discourage the supply of labor and a profits tax might discourage the level of investment. Similarly, the main theorems of welfare economics rely on microeconomic assumptions concerning the workings of markets.