Modern microeconomics is an examination of the purchasing behavior of individuals and separate businesses that evolved from the economic practice of price theory, which was a fundamental aspect of economic theories along with monetary policy as of the early 1940s. It looks at what motivates the behavior of individuals and businesses in making purchases, which directly affects supply and demand, and then these individual behavior observations are grouped together to gain a broader perspective of economic activity. Microeconomics does not, however, expand this analysis to include larger economic influences on a national or global scale such as analysis of gross domestic product (GDP) figures.
When modern microeconomics looks at markets, its primary concern is what influences buyers and sellers on a one-on-one basis, as this overall behavior is what drives prices and output, or productivity, within markets. Since it is a bottom-up approach to economic theory, its most applicable value is for start-up businesses and individual consumers who are looking to gain access to a particular market or purchase goods or services at an optimal value for the price. This is where modern microeconomics is a direct descendent of price theory, which is a broad attempt to understand the intrinsic monetary value that human beings place on particular goods and services.
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While the principles that modern microeconomics are founded upon may appear simple, such as calculating supply-and-demand figures on a local level and scaling them up for a broader perspective, the actual determination of human reasoning that goes into establishing price is a difficult one to quantify. The 18th century Scottish pioneer of economic theory, Adam Smith, noted this problem as far back as 1776 with the Diamond-Water Paradox. The Diamond-Water Paradox asks the perplexing question of why human beings place such little monetary value on water and such a high value on diamonds, when water is essential for life and, for the average human being, diamonds have virtually no practical value whatsoever.
Early price theory, therefore, recognized the fact that prices in a market are based on two different types of valuation by aggregate actions of people in society. Goods either have a value in use, such as with water, or a value in exchange, which diamonds hold at a very compact, high level. The exchange value of a good is also largely based on the amount of labor that is required to obtain it, which gives rare items that are hard to obtain even with intense labor a high value by individuals. Labor is the underpinning of price theory and modern microeconomics, as it determines the relative scarcity or abundance of all limited resources, and labor itself can be a limited resource that is factored into the calculations.
After determining established prices for individual purchases and the underlying causes for levels in price, modern microeconomics must also try to understand the strength of the market to support a particular price. It does this by looking at the availability of overall resources and labor and how efficiently they are allocated to production. The practice of modern microeconomics, therefore, has microfoundations that it builds data from using individual motivations, but it also must use broader factors of product pricing to understand how efficient and stable a market is.
One of the core values of modern microeconomics is that it can predict a market failure before macroeconomics or national economic policy ever sees it coming on the horizon. This is due to the fact that modern microeconomics looks for underlying principles that balance supply and demand outside of the control of government forces. Where efficiency is not present in either production, consumption, or distribution, it is a strong indicator that prices and markets are subject to rapid change.
Some weaknesses of microeconomics, however, include that it assumes markets and competition are rational environments that seek a natural equilibrium. The assumptions of price fluctuation are also based on the idea of full employment and that larger influences like trade barriers have no direct impact on the local level. As of 2011, attempts to overcome such limitations involve creating increasingly complex computer models of microeconomic activity that fit the reality of price fluctuations as closely as possible.