Applied Economics

Microeconomics

Microeconomics is the branch of economics that studies the economic behaviour of individual units such as a consumer, a household, a firm or an industry, and the determination of prices of goods and factors in particular markets. The word "micro" means small. It is also called price theory.

Scope

1. Theory of product pricing: Demand and supply, consumer behaviour (utility, indifference curves), production and cost, and price and output under perfect competition, monopoly, monopolistic competition and oligopoly.
2. Theory of factor pricing: Determination of rent, wages, interest and profit.
3. Theory of economic welfare: Allocation of resources, efficiency and welfare (Pareto optimality).

Methods used are partial equilibrium and general equilibrium analysis.

Importance

1. Understanding the working of a free-market economy: Shows how prices coordinate decisions of consumers and producers.
2. Efficient allocation of resources: Explains how scarce resources are allocated among alternative uses.
3. Business decisions: Helps firms in demand forecasting, pricing, cost control and output decisions.
4. Consumer decisions: Explains how consumers maximize satisfaction.
5. Factor incomes and distribution: Explains the determination of wages, rent, interest and profit.
6. Government policy: Basis for taxes, subsidies, price controls and regulation of monopoly.
7. International trade: Explains gains from trade and exchange rates.
8. Foundation of macroeconomics and welfare economics.

Limitation: it assumes full employment and ignores the economy as a whole (fallacy of composition).

Indifference curve

An indifference curve (IC) is the locus of all combinations of two goods that give the consumer the same level of satisfaction. Since all points give equal satisfaction, the consumer is indifferent among them.

Properties

1. Slopes downward from left to right: more of one good requires less of the other.
2. Convex to the origin, due to the diminishing marginal rate of substitution (MRS).
3. Two ICs never intersect.
4. A higher IC represents a higher level of satisfaction.

$MRS_{xy} = \frac{\Delta Y}{\Delta X} = \frac{MU_x}{MU_y}$

Consumer's equilibrium

Assumptions: the consumer is rational, has a given money income $M$, prices $P_x$ and $P_y$ are constant, the goods are divisible, and preferences are consistent.

The budget (price) line is $P_x X + P_y Y = M$ with slope $-\dfrac{P_x}{P_y}$.

The consumer maximizes satisfaction by reaching the highest IC attainable with the budget line. Equilibrium is at the point where the budget line is tangent to an indifference curve (point E). Here:

$\text{Slope of IC} = \text{Slope of budget line} \Rightarrow MRS_{xy} = \frac{P_x}{P_y}$ or equivalently $\frac{MU_x}{P_x} = \frac{MU_y}{P_y}$

Conditions:

1. First-order (necessary): $MRS_{xy} = P_x/P_y$ (tangency).
2. Second-order (sufficient): The IC must be convex to the origin (MRS diminishing) at the point of equilibrium.

Explanation: At a point where the budget line cuts an IC (say point A), $MRS > P_x/P_y$ (or less), meaning the consumer is willing to give up more of one good than the market requires, so by moving along the budget line he reaches a higher IC. This continues until tangency at E. Points on higher ICs are unattainable (beyond the budget), and lower ICs give lower satisfaction. Hence E is the unique equilibrium, where the consumer buys quantities $X^*$ and $Y^*$.

Price elasticity of demand

Price elasticity of demand measures the degree of responsiveness of quantity demanded to a change in the price of the good.

$e_p = \frac{\%\ \text{change in quantity demanded}}{\%\ \text{change in price}} = \frac{\Delta Q}{Q}\div\frac{\Delta P}{P}$

It is conventionally interpreted in absolute value: $e>1$ elastic, $e=1$ unitary, $e<1$ inelastic.

From B to C (price rises from Rs 20,000 to Rs 30,000; demand falls from 4,000 to 3,000 kg)

$\%\Delta Q = \frac{3000-4000}{4000}\times100 = -25\%,\qquad \%\Delta P = \frac{30000-20000}{20000}\times100 = 50\%$ $e_p = \frac{-25}{50} = -0.5,\quad |e_p| = 0.5 < 1$ Demand is inelastic.

From C to B (price falls from Rs 30,000 to Rs 20,000; demand rises from 3,000 to 4,000 kg)

$\%\Delta Q = \frac{4000-3000}{3000}\times100 = 33.33\%,\qquad \%\Delta P = \frac{20000-30000}{30000}\times100 = -33.33\%$ $e_p = \frac{33.33}{-33.33} = -1,\quad |e_p| = 1$ Demand is unitary elastic.

The two values differ because the percentage change depends on the base point (starting value).

Opportunity cost

Opportunity cost is the value of the next best alternative that is given up when a choice is made. Because resources are scarce and have alternative uses, the real cost of using a resource for one purpose is the benefit forgone from its best alternative use. For example, if a farmer uses land to grow wheat instead of rice, the income from rice is the opportunity cost.

Cost function: $C = 10 + 6Q - 0.9Q^2 + 0.05Q^3$, at $Q=5$.

TFC is the constant term, independent of output: $TFC = 10$

TVC at $Q=5$: $TVC = 6(5) - 0.9(25) + 0.05(125) = 30 - 22.5 + 6.25 = 13.75$

TC $= 10 + 13.75 = 23.75$

AFC: $AFC = \frac{TFC}{Q} = \frac{10}{5} = 2$

AVC: $AVC = \frac{TVC}{Q} = \frac{13.75}{5} = 2.75$

AC (ATC): $AC = \frac{TC}{Q} = \frac{23.75}{5} = 4.75 \quad(= AFC + AVC = 2 + 2.75)$

MC: $MC = \frac{dC}{dQ} = 6 - 1.8Q + 0.15Q^2 = 6 - 9 + 3.75 = 0.75$

Producer's equilibrium means the position in which a producer, for a given level of output, uses the combination of inputs that gives the lowest possible cost (least-cost combination). It is analysed with isoquants and isocost lines.

Tools

• Isoquant: Curve showing all combinations of labour (L) and capital (K) producing the same output. It is downward sloping and convex to the origin. Its slope is the marginal rate of technical substitution: $MRTS_{LK} = -\frac{\Delta K}{\Delta L} = \frac{MP_L}{MP_K}$
• Isocost line: Shows all combinations of L and K that cost the same total amount: $C = wL + rK$ where $w$ is wage rate and $r$ the price of capital. Slope $= -\dfrac{w}{r}$. Its position is shifted by a change in total outlay, and its slope by a change in input price ratio.

Assumptions: Two inputs; given prices of inputs; the producer is rational and wants to minimize cost; a given output level; perfect divisibility of inputs.

Equilibrium (cost minimization for a given output)

The producer picks the lowest isocost line that touches the given isoquant. This is at the point of tangency (E) between the isoquant and the isocost line.

At E: $\text{Slope of isoquant} = \text{Slope of isocost}$ $MRTS_{LK} = \frac{MP_L}{MP_K} = \frac{w}{r}$ or $\frac{MP_L}{w} = \frac{MP_K}{r}$

That is, the marginal product per rupee spent on each input must be equal.

Second-order condition: The isoquant must be convex to the origin at E (MRTS diminishing).

Explanation: At a point on a higher isocost line, the same output could be produced at lower cost, so it is not minimum cost. At a point where the isocost line cuts the isoquant, the producer can move along the isoquant to a lower isocost line. Only at tangency can cost be reduced no further. Hence the equilibrium input combination is $(L^*, K^*)$ at minimum total cost.

Market equilibrium

Market equilibrium is the situation where the quantity demanded of a good equals the quantity supplied at a particular price, so there is no tendency for price to change. The price at which $Q_d = Q_s$ is the equilibrium price, and the quantity is the equilibrium quantity. If price is above it, a surplus pushes price down; if below it, a shortage pushes price up.

Short-run equilibrium of a perfectly competitive firm

Features of perfect competition: many buyers and sellers, homogeneous product, free entry and exit (in the long run), perfect knowledge, and the firm is a price taker. Hence the firm's demand curve is horizontal at market price, and $AR = MR = P$

In the short run, the firm adjusts only variable inputs; the number of firms is fixed.

Conditions for equilibrium (profit maximization):

1. $MC = MR$ (and so $MC = P$).
2. MC must cut MR from below, i.e., MC is rising at the equilibrium output.

If $MC<MR$ the firm can raise profit by producing more; if $MC>MR$ it should cut output.

Possible situations in the short run

1. Supernormal profit: If price (AR) is greater than average cost (AC) at equilibrium output, the firm earns abnormal profit $= (AR - AC)\times Q$.
2. Normal profit (break-even): If $P = AC$ (MC cuts AC at its minimum), the firm earns only normal profit.
3. Loss minimization: If $AVC < P < AC$, the firm incurs a loss but covers all variable cost and part of fixed cost, so it continues to produce in the short run.
4. Shut-down point: If $P < AVC$, the firm cannot cover variable cost, so it shuts down; the loss equals fixed cost. The firm's short-run supply curve is the part of the MC curve above minimum AVC.

Thus, in the short run, a competitive firm is in equilibrium at the output where $P = MC$ with MC rising, and earns profit, normal profit or loss according to the relation between price and average cost.

GDP versus GNP

Gross Domestic Product (GDP) is the market value of all final goods and services produced within the geographical boundary of a country in a year, irrespective of whether produced by nationals or foreigners.

Gross National Product (GNP) is the market value of all final goods and services produced by the nationals (residents) of a country in a year, whether inside or outside the country.

$GNP = GDP + \text{Net Factor Income from Abroad (NFIA)}$ $NFIA = \text{income earned by nationals abroad} - \text{income earned by foreigners in the country}$

Difficulties in measuring national income in developing countries like Nepal

1. Large non-monetized sector: Subsistence farming and household production are not sold in markets and are hard to value.
2. Unorganized and informal sector: Many small businesses lack records.
3. Illiteracy and lack of accounts: Producers do not keep proper records.
4. Inadequate and unreliable statistics: Weak data collection and limited staff.
5. Subsistence agriculture and self-consumption are difficult to estimate.
6. Black market and illegal activities, tax evasion, and unreported income (including informal remittance).
7. Non-marketed services, such as household work, unpaid family labour.
8. Occupational specialization is limited: People have multiple occupations, so double counting is likely.
9. Price fluctuations and inflation, and a difficulty in choosing base year prices.
10. Remittance and border trade: Informal transactions with India and migrant workers' income are hard to measure.
11. Lack of skilled personnel and resources for national accounting.

Principle of effective demand

J. M. Keynes (General Theory, 1936) argued that the level of employment in the economy depends on the level of effective demand, and not on wage flexibility as the classical economists claimed. Effective demand is the level of aggregate demand at the point where it equals aggregate supply; it determines the equilibrium level of output and employment.

Aggregate supply price (ASP): The total amount of money that all entrepreneurs must receive from the sale of output at a given level of employment (N) to induce them to provide that employment. ASP rises as employment rises, so the aggregate supply curve slopes upward.

Aggregate demand price (ADP): The total amount of money which entrepreneurs expect to receive from the sale of output produced by a given number of workers. It rises with employment, but less than proportionately, because as income rises consumption increases by less than the income (MPC < 1).

Effective demand: The point where ADP = ASP. At this point entrepreneurs' expected profit is maximum, so they have no incentive to change employment.

• If ADP > ASP at a given N, entrepreneurs expect profits and expand employment.
• If ADP < ASP, they expect losses and cut employment.
• So equilibrium employment is at the intersection (E), where $ADP = ASP$.

Aggregate demand has components: $AD = C + I + G + (X - M)$

Implications

1. Employment depends on effective demand: $N = f(ED)$.
2. Because consumption grows less than income, a gap emerges, which can be filled only by investment. If investment is insufficient, effective demand falls short of full employment level, and the economy settles at equilibrium with involuntary unemployment.
3. Hence full employment is not automatic; Keynes rejected Say's Law ("supply creates its own demand").
4. Remedy: raise effective demand through increased government spending, investment and consumption (fiscal and monetary measures).

Criticism: It is a short-run theory, does not explain the long-run, neglects supply constraints and inflation, and is less suited to developing countries with structural unemployment.

Propensity to save

The propensity to save is the relationship between saving and income, i.e., the portion of income that is not consumed.

• Average propensity to save (APS) $= \dfrac{S}{Y}$
• Marginal propensity to save (MPS) $= \dfrac{\Delta S}{\Delta Y}$

Since income is either consumed or saved: $APC + APS = 1,\qquad MPC + MPS = 1$

Saving rises as income rises; the saving function is $S = -a + sY$, where $s$ is MPS.

Paradox of thrift

The paradox of thrift, a Keynesian idea, states that if all people try to save more at the same time, the total amount of saving in the economy will not increase and may even fall, and national income and employment will fall.

Explanation

1. In ordinary life, thrift (saving) is a virtue and increases an individual's wealth.
2. But when everybody increases saving, consumption demand falls.
3. Fall in consumption reduces aggregate demand, so firms' sales and output fall, and employment and income decline.
4. With lower income, people's ability to save falls. Equilibrium saving is determined by the investment level ($S = I$), so if investment does not rise, the total saving cannot increase; the equilibrium income falls by (multiplier × the fall in consumption).

Example: if MPS rises, the multiplier $k = \dfrac{1}{MPS}$ falls and income decreases; with unchanged investment, saving remains equal to investment but income is lower.

Importance and limitations

• It shows the difference between micro-level and macro-level behaviour (fallacy of composition).
• It matters in a depression, where more spending, not more saving, is needed.
• It does not hold at full employment, where more saving can finance more investment and growth (as in developing countries like Nepal, which need higher savings).

Exchange rate

The exchange rate is the price of one country's currency expressed in terms of another country's currency, e.g., NPR per US dollar (Rs 133 = US$ 1). It links the price levels of different countries and affects trade and capital flows.

Determination of the exchange rate

1. Demand and supply approach (free floating rate)

• Demand for foreign exchange comes from imports of goods and services, foreign travel and education, investment abroad, and debt repayment. The demand curve slopes downward: when the foreign currency becomes cheaper, imports rise.
• Supply of foreign exchange comes from exports, remittances, tourism receipts, foreign investment and aid. The supply curve slopes upward: when the price of foreign currency rises, exports become cheaper and more earn.
• The equilibrium exchange rate is at the intersection of demand and supply curves, where quantity demanded equals quantity supplied.
• If demand for dollars rises (more imports), the dollar appreciates and the rupee depreciates; if supply rises (higher remittance), the rupee appreciates.

2. Purchasing power parity (PPP) The exchange rate between two currencies tends to equal the ratio of their price levels: $E = \frac{P_d}{P_f}$ A country with higher inflation will see its currency depreciate.

3. Balance of payments approach: A deficit raises demand for foreign currency and depreciates the currency; a surplus appreciates it.

Other factors: interest rate differences, inflation, speculation, political stability, capital flows, and central bank intervention.

Fixed (pegged) exchange rate system: The rate is fixed by the government/central bank, as in Nepal's peg of the rupee to the Indian rupee (INR 1 = NPR 1.6). The central bank buys and sells foreign exchange to maintain the rate; under managed floating, the rate is influenced but not fixed.

Fiscal policy

Fiscal policy is the government's policy regarding taxation, public expenditure and public borrowing (public debt) used to influence the level of economic activity, income, employment and prices in the economy. It is presented through the annual budget.

Instruments: taxes, public expenditure, public debt, and the budget (surplus, balanced or deficit).

Objectives

1. Economic growth: Public investment in infrastructure, energy, education and health and tax incentives to promote savings and investment.
2. Full employment: Raising public spending and giving incentives to create jobs.
3. Price stability: Controlling inflation by reducing spending or raising taxes (contractionary), and checking deflation by increasing spending and cutting taxes (expansionary).
4. Equitable distribution of income and wealth: Progressive taxation, subsidies and social security transfers to reduce inequality and poverty.
5. Resource mobilization: Raising revenue (tax and non-tax) for development.
6. Balance of payments equilibrium: Export promotion, import duties and incentives to reduce deficits.
7. Capital formation: Encouraging savings and investment.
8. Regional balance: Directing public funds towards backward regions.
9. Economic stability: Using counter-cyclical policy over the business cycle.
10. Reducing unemployment and poverty; providing public goods and merit goods.

Challenges of the Nepalese economy

1. Low growth and productivity: Growth is volatile and weak; agriculture is mostly subsistence-based and employs a large share of the population.
2. Poverty and inequality: A large number remains poor; regional and social disparities persist.
3. Unemployment and brain drain: Lack of jobs forces youth to migrate; the economy depends heavily on remittance.
4. Trade deficit: Imports far exceed exports, and the country depends on India for trade and transit.
5. Weak infrastructure: Inadequate roads, power distribution, transport and irrigation.
6. Low capital formation and investment: Low savings, low FDI, and slow capital expenditure by government.
7. Political instability and weak governance: Frequent changes of governments, corruption, and implementation problems after federalism.
8. Dependence on foreign aid and remittance.
9. Natural disasters and climate change: Earthquake, flood and landslides.
10. Underdeveloped industrial sector and a limited skilled workforce; inadequate technology.
11. Landlocked geography.

Prospects

1. Hydropower potential: About 83,000 MW potential; scope for export of electricity.
2. Tourism: Himalayas, culture and religious sites offer large scope for employment and foreign exchange.
3. Agriculture and agro-processing: Organic products, herbs, tea, cardamom, and commercial farming.
4. Demographic dividend: Large young population that can be skilled and productive.
5. Remittance and its productive use.
6. ICT and service sector growth, including start-ups and digital payments.
7. Geographic position between India and China (Belt and Road, trade links).
8. Mineral and natural resources, and forestry.
9. Federalism and economic reform, private sector and FDI-friendly policies, and potential graduation from the LDC status.
10. Financial sector expansion.

With political stability, good governance and proper utilisation of resources, Nepal can attain high and inclusive growth.

Factor pricing (theory of distribution) explains how the prices of factors of production, that is, rent for land, wages for labour, interest for capital and profit for entrepreneurship, are determined. These prices are the incomes of the factor owners and determine the functional distribution of national income.

Features

• Factor prices are determined, like commodity prices, by demand and supply in the factor market.
• Demand for a factor is a derived demand, dependent on demand for the final product, and based on its productivity. The firm hires a factor up to the point where $MRP = MFC \quad(\text{or } VMP = w \text{ in perfect competition})$
• Supply of factors depends on the factor's availability, willingness to work or save, and the cost.

Theories: Rent: Ricardian and modern theory. Wages: subsistence, wage fund, marginal productivity, bargaining. Interest: classical, loanable funds, liquidity preference. Profit: risk-bearing, innovation, dynamic theories.

The marginal productivity theory states that each factor is paid in accordance with its marginal contribution to output.

The multiplier, introduced by R. F. Kahn and developed by Keynes, shows that an initial change in autonomous spending (investment) leads to a larger, multiple change in national income.

$k = \frac{\Delta Y}{\Delta I}$

Since the rise in income is repeatedly re-spent according to the marginal propensity to consume (MPC), the multiplier is $k = \frac{1}{1-MPC} = \frac{1}{MPS}$

Example: If MPC = 0.8, then $k = \dfrac{1}{1-0.8} = 5$. An increase in investment of Rs 100 crore raises income by Rs 500 crore (100 + 80 + 64 + ... = 500).

Working: Investment spending becomes income of some people, who spend a fraction (MPC) of it, which becomes income of others, and so on in a chain.

The larger the MPC, the larger the multiplier.

Assumptions: Excess capacity and unemployed resources, constant MPC, closed economy, no time lag, and constant prices.

Limits (leakages): saving, taxes, imports, and inflation reduce the multiplier. With taxes and imports: $k = \dfrac{1}{1-MPC(1-t)+m}$.

Importance: It explains the large effect of public investment on income and employment, and supports fiscal policy and public works in recession. It also works in reverse (a fall in investment lowers income by a multiple).

A trade (business) cycle is the recurring fluctuation in the level of economic activity (output, income, employment and prices) over a period of years. It has four phases.

1. Expansion (recovery/prosperity): Output, employment, income, demand, investment and profits increase; credit expands; prices rise moderately; optimism grows.
2. Peak (boom): The economy reaches its highest level of activity; full employment, high demand, rising costs and inflation, shortage of resources and rising interest rates. Growth begins to slow.
3. Contraction (recession): Demand falls, firms cut production and investment, unemployment rises, profits decline and prices fall; credit tightens. A prolonged and deep recession is a depression.
4. Trough (depression): The lowest point; very high unemployment, low income and demand, idle capacity, low prices and interest rates, and pessimism.

After the trough, low costs and interest rates and pent-up demand encourage investment, and recovery begins, starting the next cycle.

The cycle is not regular in length or intensity. Stabilisation requires monetary and fiscal policy.