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Microeconomics Principles and Theories Essay

How the neoclassical Consumer Theory and the Theory of the Firm predict that competitive behaviour in all markets results into Pareto Efficient allocations

Neoclassical consumer theory uses the conventional model of economics of consumer behavior. The model which is often used is based on the consumer as a knowledgeable decision maker. The model optimises the consumer’s contentment with purchases through reasoned analysis of utility and value (Foss, 1993, p. 143). There is increase in market competition as a result of change in consumer behaviour. The increased flow of information raises the level of awareness among consumers; entrepreneurs must continuously develop innovative ideas in order to satisfy the contemporary consumer.

Neoclassical Theory and Consumer Preferences

The neoclassical consumer theory holds that there is a negative correlation between an item’s attached value and its price. Hence, when the price of the product or good decreases in a given economy; consumers benefit from buying more of that good. On the other hand, when the price of the good increases; consumers make less purchases. Intertic (2012) contends that from the economics point of view; consumers make their purchases by choice. Intertic assertion is similar to the one Becker support. He cites that understanding of consumer preferences fixes resource allocation by the firm creating a Pareto effect (Becker1962, p. 7).

Consumer’s and Elasticity of Demand

The strength with which consumers shift their demand for a particular product with regard to price change explains what Intertic (2012) refers to as the “elasticity of demand”. Elasticity of demand occurs when the consumer- demand declines drastically as a result of increase in price. In such a case, the demand for the goods in question is said to be elastic, and can lead to the Pareto effect (Becker, 1962, p. 7).

However, insignificant shifts in consumer demand result in inelastic demand. In his view, Intertic (2012), elasticity is a key cause that alters consumer demand and eventually redefines their preferences. Consumer demands are driven by other significant underpinnings which eventually affect their decision making capacity. Hence, a keen observation of the idea shows that consumers are “rational decision making agents” (Becker, 1962, p. 9). They are motivated in seeking the best or the highest level of satisfaction, which Becker (1962, p. 10) refers to as utility.

Utility Needs

Consumer needs revolve around their utility as well as specific assumptions that the purchased goods offer. This, according to Heiner (1983, p. 562) shows that the advantage to be gained from a specific good is not only driven by its price, but also by the subjective sensitivity of the consumer towards it.

According to Foss (1993, p. 137), consumers rank their preferences on sets of available alternatives. This aspect allows them to decide either to buy or not. Their preferences cause them to select goods or services that provide them with the best utility functions. Heiner (1983, p. 566) describes the level consumer benefit from the utility function as utility maximization; that is, the demands of the consumers are motivated by their expected gain on the utilities.

Demsetz (1968, p. 37) points out that consumers have many needs and wants. However, they have limited resources to satisfy all needs and wants. This, therefore, calls for selective satisfaction of needs and wants in order of importance and urgency (Foss, 1993, p. 139).

Firm Theory and Market Competition

Marshall (1961, p. 67) cites that the firm theory presents different economic theories that help predict the characteristics of a firm, company or a corporation. The theory looks at aspects of market relationship, existence, structure and behaviour. Marshall (1961, p. 76) also notes that a firm sprouts as a substitute system to address the challenge of market price mechanism. This occurs when the firm is more prudent to produce products in a non-market setting.

For instance, in a labour market, a firm may consider it costly or even challenging to involve in production when it requires recruiting, and dismissing workers based on the prevailing supply and demand situations (Heiner, 1983, p. 577). Similarly, employees may consider it expensive looking for alternative employment in other firms. In this case, the firm has to balance the needs of the market and its production activities to ensure the resources available are appropriately used to yield the projected results.

On the other hand, Heiner (1983, p. 570) points out that firms are involved in a long-term agreement with its workers to reduce costs. In cases where a firm is involved in adjusting its workforce, it may cause alterations in the pay structure as well as the production cost of the firm. This ultimately fixes competition in production, establishing the Pareto effect of resource allocation.

Demands of Labour Market

Demsetz (1968, p. 39) points out that the theory of the firm is determined by the demand conditions of the labour market. The demand for labour is a derived demand; this suggests that it is compelled by the demand for goods or services (Heiner, 1983, p. 573). Demand for labour is supported by factors such as; how strong or how productive labour is used in creating a product or a service and the market value of the product produced (Becker, 1962, p. 7). These factors fix how resources are allocated in producing quality products to meet the market needs.

Firm Short- run Production Function

The firm production function is a relationship that links resources and their matching outputs. This means that when labour is tied to a fixed amount of capital, the products increase by reducing amounts, causing a decline (Arestis and Sawyer, 1998, p. 190). Many firms do not subject their products to competitive markets; rather, they sell them under imperfect competitive conditions. Hence, most of them are “monopolistic” competitive sellers (Economic Welfare Analysis, 2012). This claim is felt when a firm fixes its price without external influence, it has a monopoly power. The firm practising this behaviour establishes a Pareto effect, hence, allowing it to devise ways of allocating resources efficiently in various areas which address goods on a short –term basis (Intertic, 2012).

Transaction processing

Economic Welfare Analysis (2012) cites that consumers plan their production in firms when they observe the transaction cost of overseeing production through a process such as market exchange. Arestis and Sawyer (1998, p. 188) point out that the impact of transaction lies in explaining the consistency of a firm on return to scale rather than increasing returns to scale. Transaction cost has a bigger impact on resource allocation because the firm has to define transaction process.

This can be in terms of pragmatic and attuned ideas of substitution at the margin and applying economic evaluation tools (Demsetz, 1968, p. 45). The firm’s involvement with the market is beyond its scope. However, the internal allocation of resources can be controlled by the firm itself. In this respect, a firm is able to achieve efficiency through allocating resources to areas which are most needed (Economic Welfare Analysis, 2012).

Firm and Determination of Production

Various factors may influence the firm in making decisions and determining its eventual cause of action. Arestis and Sawyer (1998, p. 182) contend that if the firm makes a wise decision, it is guaranteed sustained business practices that enhance production and at the same time reduce the production costs. Arestis and Sawyer (1998, p. 184) cite that the main reason why firms exist is to earn profits while reducing the costs. A firm which is competitively involved in producing smaller productions of the products supplied to the market; its output usually does not have a great impact on the market.

Economic Welfare Analysis (2012) points out that in such scenarios, a firm does not have price mark of its product. The firm operating in such condition is referred to as the “price taker” because the price it establishes in the market is the final price it will receive for its output (Economic Welfare Analysis, 2012). A case where price does not change with output is a feature of a competitive firm and establishes a Pareto effect of allocating resources efficiently.

Determination of Market price

The Economist (2012) notes that market demand and market supply are important in determining market price. This is because the connection between the quantity and price demanded, and the quantity and the price supplied are opposite; that is, the difference is created when the price at which the quantity demanded and the quantity supplied are the same. Buyers and sellers are satisfied at this price because there is no shortage or supply, making the market “clear” (The Economist 2012).

In a market which is competitive, this happens when some producers may reduce or cut their prices to retain or attract consumers, resulting in price cuts. At low price, the quantity being demanded increases than the quantity available for sale (Becker, 1962, p. 9). This situation causes competition among the consumers in view of obtaining the desired goods; hence increasing the price. The price at which quantities are demanded is equal to the quantities supplied at that particular price. When this occurs, it establishes what Maskin (1999, p. 25) refers to as the equilibrium price. This price persists until some aspects in the economy occur to change the underlying demand or supply conditions.

Also, Maskin (1999, p. 24) points out that in a free competitive market, price fluctuates and swings towards an equilibrium position. The price remains static at equilibrium unless the underlying conditions of supply and demand are destabilized. This happens in circumstances where a consumer preference keeps on changing (The Economist, 2012). As earlier demonstrated, the equilibrium price created in the product market is the price which each firm uses to adjust its output, Demsetz (1968, p. 40) notes that no explanation is expected that the present market price will provide a specific firm more revenues to cover its costs of production. Further, Maskin (1999, p. 26) shows that in the short run, a firm may operate at a loss rather than closing down, however, in the long-run, a firm may abandon the industry if they cannot produce a normal return.

Normative Theory of Equilibrium

According to Camerer (1997, p. 169) economists are interested in analyzing the world of economy market and drawing conclusion based on the findings. The Economist (2012) indicates that the knowledge behind efficiency is to support the well-being of the society. It helps the economy understand the merits associated with the market dynamism, analyze the economic model in the real world and provide justification why some economies want to change their economic institutions to encourage efficiency.

The efficiency of an economy is important in promoting growth and development, hence, Boland (1981, p. 1032) indicate that it comprises various requirements which need to be fulfilled. Some of these requirements are efficiency established when goods are traded in a manner that no additional beneficial trade is obtained, the production efficiency which eliminates waste of resources in producing goods and the production mix. On the last point, the mix of goods the economy produces reflect the preferences of consumers in that economy (Economic Welfare Analysis, 2012).

The potential difficulties posed by: The axioms or assumptions concerning consumers and producers

The behavioral axioms common with consumer theory claim that consumers devise ways of maximizing utility. For example, in a typical economic practice, this process of maximizing utility is known as “rational” behaviour of consumers or the decision makers (Boland, 1981, p. 1034). Consumers tend to reap from the utility function anchored on a budgetary control. In this case, it is assumed consumers will choose the “best package” of services or goods they are able to pay for (Boland, 1981, p. 1036).

The axioms created by consumers are that they assume preferences are absolute. Consumers base their decisions on the axioms that they understand their preferences (Economic Welfare Analysis 2012). Thus, this assertion allows them to make undemanding, but sound evaluation between two options of goods available. Hence, it is implicit that if the customer is allowed to choose two consumption options, let’s say A and B, and each has a different assortment of goods, consumers may unequivocally decide if they prefer B to A, A to B (Camerer, 1997, p. 168).

According to Loewenstein (1987, p. 565) assumptions are of the view that goods are available in all quantities. Hence, it is implicit that consumers may opt to purchase any goods that they like. Though this assumption makes the model less explicit, it acknowledges supporting ease in computing processes involved in consumer choice theory (Loewenstein, 1987, p. 567).

Use value

Also, Maskin (1999, p. 28) indicates that the use value is important in assumption. He explains that any labour-product has a value and a use value. When it is traded as a commodity in a market, it provides an exchange value in money-price. He also cites that commodities traded have a general utility; meaning that consumers want them.

The usefulness of the concept of Pareto Efficiency as a metric in the analysis of social welfare

Pareto Optimality

Pareto optimality plays a significant role in shaping social welfare initiatives (Economic Welfare Analysis 2012). It designates that at least, it makes a person better without making others worse. In economy, it designates allocating resources if no other allocation prevails or exists, hence, a person is better off and at least everyone feels satisfied. Loewenstein (1987, p. 569) indicates that this condition is achieved when consumers maximize utility, competition prevails, information is available for rational decision making and when producers maximize on profits (Loewenstein, 1987, p. 568). When these conditions prevail, economists use the concept of Pareto Efficiency as a metric in the analysis of social welfare.

Similarly, when a free market exists and is not interfered with by the government, Pareto optimality is achieved automatically, provided that consumption and production decisions do not involve substantial ecological disamenities.

The Economist (2012) cites that in a situation where imperfect market conditions are supported and environmental disamenities practised on a large scale, the Pareto efficiency is faced by major challenges. Therefore, it needs remedial measures such as; emission rights or pollution taxes to restore market efficiency (Maskin, 1999, p. 29).

Also, Pareto efficiency plays a key role as a metric in analyzing social welfare. Maskin(1999, p. 30) explains that the first theorem of the social welfare illustrates that producers and consumers are both price takers. Hence, it is viewed, based on this theory, that the equilibrium allocation leads to Pareto effect. This also happens in an economy which is competitive (Economic Welfare Analysis 2012). A competitive economy automatically allocates resources efficiently as more consumers maximize on their utility.

Similarly, Camerer (1997) shows that the theory of welfare indicates that, in any market practicing Pareto effect; economies have set of prices that create a competitive equilibrium. Hence, competitive economy can be used in other theories such as the game theory as a benchmark in evaluating social welfare (Economic Welfare Analysis, 2012).


Arestis, P and Sawyer, M 1998, “Keynesian Economic Policies for the New Millennium.” The Economic Journal, Vol. 108,no. 8, pp. 181-95.

Becker, GS 1962,” Irrational behaviour and economic theory,”The Journal of Political Economy, Vol.70,pp. 1-13.

Boland, L 1981, “On the futility of criticizing the neoclassical maximization hypothesis.” American Economic Review, Vol.71, pp. 1031-1036.

Camerer, C.F., 1997, “Progress in behavioral game theory.”Journal of Economic Perspectives, Vol.11, pp. 167-188.

Demsetz, H1968, “The Cost of Transacting.” Quarterly Journal of Economics, Vol. 82, pp. 33-53.

Economic Welfare Analysis 2012, . Web.

Foss, NJ 1993, “Theories of the firm: contractual and competence perspectives.”Journal of Evolutionary Economics, Vol.3, pp. 127-144.

Heiner, RA 1983, “The origin of predictable behavior.”American Economic Review, Vol. 73,pp. 560-595.

.Intertic 2012, International Think-Tank on Innovation and Competition. Web.

Loewenstein, G 1987, “Anticipation and the valuation of delayed consumption.”The Economic Journal ,Vol.97, pp. 666-684.

Maskin, E 1999, “Nash Equilibrium and Welfare Optimality,” Review of Economic Studies, Vol.66 no.5, pp.23-38.

Marshall, A 1961, Principles of Economics. Ninth (variorum) edition,MacMillan and Company, London.

The Economist 2012, Pareto Efficiency. Web.

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