Introduction:

Microeconomics aims to cover every aspects of our economic life. This report will discuss, evaluate and assess the usefulness and limitations of microeconomic theories in reaching that aim. Microeconomics is “The study of choices that individuals make and the way these choices will interact in given markets” (Parkin et al. 2012, p.2) or put more simply, microeconomics is the allocation of scarce resources. There are a number of objectives of microeconomics, the foremost being; Equity, Efficiency, Growth and Stability. This report will examine the commonly used theories of; Indifference analysis, Game Theory and the market structure of Oligopoly; analysing the benefits and drawbacks and how they are applied in the real world.

Indifference Curve Analysis:

To answer questions about individual decision making indifference curve analysis is applied. Before looking at this model it is necessary to assume that the individual satisfies the four axioms of rational preference formulated by Savage (1954). These are; completeness, more is better, transitivity and convexity. Sugden (1991 p.761) describes these as “Preferences over acts, where acts are made up of consequences.”

A rational consumer will of course spend their money on the mix of products that give them most pleasure (Read 2007, p.45). However this will vary for each consumer, because each consumer will have different preferences. The consumer is constrained financially by their exogenous income to only be able to purchase bundles of goods X and Y on or below their budget line. This line does not always have to be straight, and in everyday applications it often is not. This is true with perfect compliments such as right and left shoes, the budget constraint will be stepped because a consumer will not gain much “util” (benefit) from having significantly more right shoes than left. An indifference curve is a graph showing a combination of two different goods that give the consumer equal satisfaction. There are four main properties of an indifference curve; it is ubiquitous, downward sloping, cannot cross and cannot become less steep. The marginal rate of substitution is the rate at which the consumer is willing to exchange one bundle, for another along the indifference curve (this is equal to the value of the slope). Diminishing marginal rate of substitution explains why the line is curved as seen in figure 1 (Perloff, 2012). The consumer will take any allocation of resources along each indifference curve (I₁, I₂, I₃). Their utility is optimal where the indifference curve meets the budget constraint. It can be observed that I₂ is tangent to the budget constraint at point ‘e’ therefore that is the rational and optimal choice, although I₁ does also intersect part of the budget constraint (points ‘a’ and ‘c’), the equilibrium of goods will be less desirable. Therefore that leaves I₂ as the rational choice. However indifference curve analysis does not take into account the consumers preference to save instead of spend. This could cause point ‘d’ to be the most desirable option.