Applied Economics

The circular flow of income shows how income and expenditure flow continuously between sectors of the economy. In a three-sector economy the sectors are households, firms and government.

Flows

1. Households to firms: consumption expenditure on goods and services ($C$).
2. Firms to households: payments for factor services (wages, rent, interest, profit), which form household income ($Y$).
3. Households to government: taxes ($T$). Households save ($S$) in financial markets.
4. Government to households and firms: government spending ($G$) on goods and services and transfer payments/subsidies.
5. Firms to government: business taxes; government buys goods from firms.
6. Financial market: saving of households flows to firms as investment ($I$).

Leakages and injections

• Leakages: saving $S$ and taxes $T$ (withdrawals from the flow).
• Injections: investment $I$ and government expenditure $G$ (additions to the flow).

Equilibrium condition: national income is stable when leakages equal injections:

$S + T = I + G$

Income identity:

$Y = C + I + G$

and from the income side $Y = C + S + T$. If injections exceed leakages, income rises; if leakages exceed injections, income falls.

Diagram description: households and firms are linked by two flows (factor services and goods/services, with matching money flows); the government and financial market sit in the middle, drawing taxes and saving out and putting expenditure and investment back in.

Under monopoly there is a single seller of a product with no close substitutes and with barriers to entry. The demand curve (AR) slopes downward and MR lies below AR. In the long run the monopolist can vary all factors, including plant size, so it adjusts the scale of plant to the most profitable level. Entry of new firms is blocked, so abnormal profit can persist even in the long run.

Conditions of long-run equilibrium

1. $LMC = MR$ (necessary condition).
2. LMC cuts MR from below (MC slope greater than MR slope), the second-order condition.
3. At the equilibrium output the short-run MC also equals MR, and SAC touches LAC, so the plant used is the optimum one for that output: $SMC = LMC = MR$ and $SAC = LAC$.

Explanation with diagram

Take quantity on the X-axis and price/cost/revenue on the Y-axis. Draw downward-sloping AR and MR curves, a U-shaped LAC with its LMC, and a SAC (with SMC) tangent to LAC at the output chosen.

• The monopolist produces where LMC cuts MR, at output $Q_M$.
• The price is read from the AR curve at $Q_M$, i.e. $P_M$.
• The average cost at $Q_M$ is $C$ (read from LAC = SAC).
• Abnormal profit per unit is $P_M - C$, so total profit is $\pi = (P_M - C)\times Q_M$
• This is the rectangle between the price line and the average-cost line.

Special features

• Price exceeds MC: $P > MR = MC$, which reflects monopoly power.
• A monopolist need not produce at the minimum point of LAC, so the plant may be underutilised (excess capacity) when demand is limited.
• A monopolist never operates on the inelastic part of the demand curve, because MR would be negative there. Equilibrium lies where $e > 1$.
• Since entry is barred, supernormal profit remains in the long run. If demand is so low that AR is below LAC at every output, the monopolist exits.

Hence the long-run monopoly equilibrium is at $LMC = MR$ with the optimum-size plant and with abnormal profit of $(AR - LAC)\times Q_M$.

Under perfect competition there are many buyers and sellers, a homogeneous product, free entry and exit, and perfect knowledge. Price is determined by the industry (market demand and market supply) and each firm takes it as given.

Long-run price determination

The long-run industry supply curve (LRS) intersects market demand (D) at the equilibrium price $P^*$ and output $Q^*$. The firm sells at $P^*$, so $AR = MR = P^*$ (a horizontal line).

Long-run equilibrium of the firm requires:

1. $MR = LMC$ (profit-maximising output), and LMC cuts MR from below.
2. $P = AR = LAC$ at the minimum point of LAC (zero economic profit).

Adjustment

• If price is above LAC, firms earn supernormal profit. New firms enter, industry supply rises, price falls and profit disappears.
• If price is below LAC, firms make losses. Some firms leave, supply falls, price rises until losses disappear.

Final position:

$P = AR = MR = LMC = LAC\ (\text{minimum})$

Each firm produces at the optimum scale (the lowest point of LAC), earns only normal profit, and the industry is stable with no tendency for entry or exit. The market price is therefore the minimum average cost, which gives allocative and productive efficiency.

Monopolistic competition has many sellers selling differentiated products, with free entry and exit. Each firm has some control over price, so its demand curve (AR) slopes downward and is fairly elastic, with MR below it.

Long-run equilibrium

Because entry is free, abnormal profit attracts new firms (and losses cause exit). This continues until each firm earns only normal profit. Equilibrium conditions:

1. $LMC = MR$ (and the SMC also equals MR at that output).
2. $AR = LAC$ (and $SAC$), i.e. the AR curve is tangent to the LAC curve at the output chosen.

Explanation with diagram

• If firms earn abnormal profit, new firms enter, the demand (AR) of each existing firm shifts left and becomes more elastic until it just touches LAC.
• If firms incur losses, some exit, and the AR of the rest shifts right until it touches LAC.
• At the tangency point $T$, the firm produces output $OQ$ where $MR = LMC$, and price $OP = AR = AC$.

$\text{Profit} = (AR - AC)\times Q = 0$

Features

• Only normal profit in the long run.
• The tangency lies on the falling part of LAC, so output is less than the minimum-cost output; the difference is excess capacity.
• Price exceeds MC ($P > MC$) and is higher than under perfect competition. The cost is the variety and choice consumers enjoy.

Economics is studied at two levels: microeconomics (the individual unit) and macroeconomics (the economy as a whole).

The two are complementary: the economy is the sum of its individual units, but what is true for one unit may not hold for the whole (the paradox of thrift).

Demand is the quantity of a good that a consumer is willing and able to buy at a given price, in a given period of time. Effective demand needs desire, ability to pay and willingness to pay.

Law of demand: other things remaining constant, the quantity demanded rises when price falls and falls when price rises (inverse relation), so $Q_d = f(P)$ and the demand curve slopes downward.

Determinants of demand

1. Price of the good: the higher the price, the lower the quantity demanded (movement along the curve).
2. Income of the consumer: for normal goods demand rises with income; for inferior goods it falls.
3. Prices of related goods: a rise in the price of a substitute (tea for coffee) raises demand; a rise in the price of a complement (petrol for cars) lowers it.
4. Tastes and preferences: fashion, habits and advertising shift demand.
5. Expectations: if prices are expected to rise, current demand rises.
6. Population size and composition: more people or a different age structure changes demand.
7. Distribution of income: more equal distribution increases demand for necessities.
8. Other factors: climate, government policy, taxes, credit availability.

Changes in price cause a movement along the demand curve (extension or contraction); changes in the other determinants shift the curve (increase or decrease in demand).

(a) Given $P_0 = 4$, $Q_0 = 80$, $Q_1 = 100$, so $\Delta Q = 20$; $e_d = -1$.

$e_d = \frac{\Delta Q}{\Delta P}\times\frac{P_0}{Q_0}$

$-1 = \frac{20}{\Delta P}\times\frac{4}{80} = \frac{1}{\Delta P}$

$\Delta P = -1$

New price $= 4 - 1 =$ Rs 3 per unit.

(b) Given $e_s = 5$, $P_0 = 5$, $P_1 = 6$, $Q_0 = 500$.

$\%\Delta P = \frac{1}{5}\times 100 = 20\%$

$\%\Delta Q = e_s\times\%\Delta P = 5\times 20\% = 100\%$

$\Delta Q = 500$

Quantity sold at Rs 6 $= 500 + 500 =$ 1000 units.

The price effect is the change in the quantity of a good purchased when its price changes, other things (income, tastes, other prices) remaining constant. Hicks and Slutsky showed that it can be split into two parts:

$\text{Price effect (PE)} = \text{Substitution effect (SE)} + \text{Income effect (IE)}$

Explanation (normal good X, fall in its price)

• The budget line rotates outward from $AB$ to $AB_1$ and the consumer moves from equilibrium $E_0$ on $IC_1$ to $E_1$ on $IC_2$. The line joining such points is the price-consumption curve (PCC). The total movement from $E_0$ to $E_1$ is the price effect.
• Substitution effect: when the price falls, X becomes relatively cheaper, so the consumer substitutes X for Y. To isolate this, real income is held constant by drawing an imaginary budget line $CD$ parallel to $AB_1$ and tangent to the original $IC_1$ at $E_s$. The move $E_0 \to E_s$ is the SE. It is always positive for a price fall (price and quantity move in opposite directions).
• Income effect: the fall in price raises real income. Moving from $E_s$ on $IC_1$ to $E_1$ on $IC_2$ is the IE. For a normal good it increases the purchases of X; for an inferior good it reduces them.

Cases

Hence the price effect is the combination of the substitution and income effects.

Average revenue (AR) is revenue per unit sold, $AR = TR/Q = P$. Marginal revenue (MR) is the addition to total revenue from selling one more unit, $MR = \Delta TR/\Delta Q$.

Relationship

1. Perfect competition: the firm is a price taker and the price is constant, so $AR = MR = P$. Both are one horizontal line.
2. Imperfect competition (monopoly, monopolistic competition): the AR curve (demand) slopes downward, and MR lies below AR, falling twice as fast for a straight-line demand curve.

For a linear AR curve $P = a - bQ$:

$TR = aQ - bQ^2,\qquad MR = a - 2bQ$

so the MR curve has the same intercept but double the slope, and cuts the quantity axis at half the distance of AR.

General relation:

$MR = AR\left(1 - \frac{1}{e}\right)$

where $e$ is the price elasticity of demand.

• If $e > 1$: MR is positive and TR rises as output rises.
• If $e = 1$: MR $= 0$ and TR is maximum.
• If $e < 1$: MR is negative and TR falls.

When AR falls, MR is less than AR; when AR is constant, MR $=$ AR; when AR rises, MR $>$ AR.

Money is anything generally accepted as a medium of exchange and a measure of value. Its functions are classified as:

A. Primary functions

1. Medium of exchange: money removes the double coincidence of wants in barter, so goods can be bought and sold through it.
2. Measure of value (unit of account): the values of all goods and services are expressed in a common unit, such as Rs, making comparison and accounting easy.

B. Secondary functions

1. Standard of deferred payments: loans, wages, rents and other future obligations are fixed and settled in money.
2. Store of value: money allows purchasing power to be saved and used later.
3. Transfer of value: value can be moved from place to place and person to person (for example, by selling property in one city and buying in another).

C. Contingent functions (extra): basis of the credit system, distribution of national income among factors, equalisation of marginal utilities, and the most liquid form of wealth.

Primary functions are the basic reasons money exists; secondary functions arise from and support them.

An indifference curve (IC) shows the different combinations of two goods that give the consumer the same level of satisfaction. All points on an IC are equally preferred.

Properties

1. Downward sloping (negative slope): to keep satisfaction constant, if the consumer takes more of X, he must give up some Y. An IC sloping upward would mean more of both goods gives the same satisfaction, which violates monotonicity.

2. Convex to the origin: the slope is the marginal rate of substitution:

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

MRS diminishes as the consumer gets more X, because the marginal utility of X falls and that of Y rises. A consumer is therefore willing to give up less and less Y for each additional unit of X.

3. Higher IC represents higher satisfaction: an IC further from the origin contains larger bundles, which are preferred.

4. ICs never intersect: if two ICs cut at a point, the bundles on them would give the same utility as the common point, which contradicts the fact that the higher IC gives more satisfaction (violates transitivity).

5. ICs do not touch either axis: a touching IC would mean the consumer buys only one good, but the analysis assumes he consumes both goods.

6. ICs are not necessarily parallel: their slopes depend on the MRS at each point, which varies.

7. Continuous and thick-free: ICs are smooth lines, not thick bands, because only one level of satisfaction exists on each.

Special cases: perfect substitutes give straight-line ICs; perfect complements give L-shaped ICs.

Macroeconomics (Ragnar Frisch, 1933) is the branch of economics that studies the economy as a whole by analysing aggregate variables such as national income, total employment, the general price level, aggregate consumption, saving and investment. It is also called income and employment theory.

Subject matter

1. Theory of national income: concepts, measurement and determinants of GDP, GNP, NNP and per capita income.
2. Theory of employment and output: determination of the level of employment, unemployment and output (Keynes' theory).
3. Theory of money and prices: supply of and demand for money, inflation, deflation and the price level.
4. Theory of economic growth and development: factors causing long-term growth of output.
5. Theory of international trade and payments: balance of trade, balance of payments, exchange rate.
6. Theory of public finance and macro policies: fiscal and monetary policy for stabilisation.
7. Theory of business cycles: causes of booms and depressions.

Importance: it helps the government formulate economic policy, explains the functioning of the whole economy, and aids in planning and the solution of problems like inflation and unemployment.

Price elasticity of demand measures the responsiveness of the quantity demanded to a change in price:

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

Point method (Marshall's geometric method)

The elasticity is measured at a single point on a linear demand curve using the formula:

$e_d = \frac{\text{Lower segment}}{\text{Upper segment}} = \frac{PB}{PA}$

where $P$ is the point on the demand line $AB$ (A on the price axis, B on the quantity axis), PB is the segment below the point and PA is the segment above it.

Values at different points

Thus elasticity falls steadily from infinity to zero as we move down a straight demand line. For a non-linear curve, a tangent is drawn at the point and the same formula is applied to the tangent.

Equivalent formula for a demand function: $e_d = \dfrac{dQ}{dP}\cdot\dfrac{P}{Q}$.

The income effect is the change in the quantity of a good purchased due to a change in the consumer's real income, with prices unchanged. In the indifference curve approach it is shown by the income-consumption curve (ICC).

Explanation

• With money income $M$ and prices $P_x$, $P_y$, the budget line is $P_xX + P_yY = M$. The consumer is in equilibrium where the budget line is tangent to an indifference curve ($MRS_{xy} = P_x/P_y$).
• When income rises, the budget line shifts outward and parallel (prices unchanged): $B_1 \to B_2 \to B_3$.
• Each new budget line is tangent to a higher indifference curve at $E_1, E_2, E_3$ ($IC_1 < IC_2 < IC_3$).
• Joining $E_1, E_2, E_3$ gives the ICC. The horizontal and vertical movement between points shows the income effect on X and Y.

Types

• Normal goods (X and Y): ICC slopes upward to the right; purchases of both rise with income, so the income effect is positive.
• Inferior good X: ICC bends backward; more income reduces the quantity of X bought, so the income effect is negative.
• Necessity vs luxury: if the ICC is steeper toward Y, X is a necessity; if flatter, X is a luxury.

The ICC also gives the Engel curve, relating income to quantity demanded.

Cost is the monetary expenditure incurred by a firm in producing a given level of output, including payments for all inputs used.

Types of cost

1. Explicit (money) cost: actual payments to outsiders, such as wages, rent, raw materials and interest.
2. Implicit cost: imputed value of the owner's own resources (own capital, land, labour). Economic cost = explicit + implicit.
3. Fixed cost (TFC): does not change with output (rent, insurance, machinery). It exists even at zero output.
4. Variable cost (TVC): varies directly with output (raw materials, wages of casual labour).
5. Total cost: $TC = TFC + TVC$.
6. Average costs:

$AFC = \frac{TFC}{Q},\quad AVC = \frac{TVC}{Q},\quad AC = \frac{TC}{Q} = AFC + AVC$

7. Marginal cost: the addition to total cost from one more unit of output.

$MC = \frac{\Delta TC}{\Delta Q} = TC_n - TC_{n-1}$

8. Opportunity cost: the value of the next best alternative forgone.
9. Social vs private cost: social cost includes external costs borne by society (pollution).
10. Short-run vs long-run cost: in the short run some costs are fixed; in the long run all costs are variable.

AC and MC curves are U-shaped because of the law of variable proportions; MC cuts AC at its minimum.

A monopolist is the sole seller of a product with no close substitutes and barriers to entry. Its demand curve (AR) slopes downward and MR lies below it.

Profit maximisation (MC-MR approach)

Profit $\pi = TR - TC$ is maximum when:

1. $MR = MC$ (necessary condition), and
2. MC cuts MR from below (slope of MC greater than slope of MR) (sufficient condition).

Reasoning: if $MR > MC$, producing one more unit adds more to revenue than to cost, so output should expand; if $MR < MC$, output should be reduced. The monopolist stops at $Q^*$ where $MR = MC$.

Price and profit: at $Q^*$ the price is read from the demand (AR) curve, $P^* > MR = MC$. If $AR > AC$ at $Q^*$:

$\text{Supernormal profit} = (P^* - AC)\times Q^*$

Because entry is blocked, this profit can persist even in the long run. In the short run the monopolist may also earn only normal profit ($AR = AC$) or bear a loss if $AR \ge AVC$ (it continues production as long as $P \ge AVC$).

Alternative (TR-TC approach): profit is greatest at the output where the vertical distance between TR and TC is maximum (where their slopes are equal).

Yes, economics is useful to a BCA student, both for personal decision-making and for the career a BCA graduate will follow.

1. Understanding markets: demand, supply, pricing and competition explain how software, hardware and IT services are priced and sold.
2. Cost and profit decisions: concepts of costs, break-even and marginal analysis help in project budgeting, outsourcing and make-or-buy decisions in IT firms.
3. Economics of information goods: network effects, high fixed cost and near-zero marginal cost explain why software and platform firms become monopolies or use freemium pricing.
4. Macro environment: inflation, interest rates, exchange rates and national income affect IT investment, imports of equipment and exports of IT services (important for Nepal's remittance and outsourcing economy).
5. Entrepreneurship: a start-up founder needs knowledge of market structure, elasticity and opportunity cost.
6. Policy awareness: understanding fiscal and monetary policy, taxes and trade policy helps interpret government decisions on digital economy and e-commerce.
7. Analytical skills: economic reasoning (trade-offs, incentives, cost-benefit analysis) improves decision-making in project management and system design.
8. Personal finance: budgeting, saving and investment choices.

Hence economics complements technical skills and prepares a BCA graduate to work in a business environment.

(a) Relation between AC and MC of a firm

AC is total cost per unit ($AC = TC/Q$) and MC is the addition to total cost from one extra unit ($MC = \Delta TC/\Delta Q$). Both are U-shaped in the short run because of the law of variable proportions.

• When $MC < AC$, AC falls.
• When $MC > AC$, AC rises.
• When $MC = AC$, AC is at its minimum; MC cuts AC from below at the minimum point of AC.
• MC reaches its minimum earlier than AC and rises faster.

This is the same arithmetic as the average and marginal marks of a student: a mark below the average pulls the average down, and one above it raises the average.

(b) Law of Diminishing Marginal Utility

Proposed by Gossen and Marshall: as a consumer consumes more units of a good, the marginal utility (MU) derived from each additional unit declines, other things remaining constant.

TU increases at a decreasing rate until MU $= 0$ (saturation point). It underlies the downward-sloping demand curve and the consumer's equilibrium ($MU_x/P_x = MU_y/P_y$).

Assumptions: homogeneous units, constant tastes, continuous consumption, rational consumer.

Monopolistic competition has many sellers offering differentiated (close substitute) products, with free entry and exit and some control over price through branding and advertising. The firm's demand curve (AR) slopes downward and is fairly elastic.

Short-run equilibrium of the firm

The firm maximises profit at the output where:

1. $MR = MC$, and
2. MC cuts MR from below.

At that output $Q^*$, the price $P^*$ is found on the AR (demand) curve. Depending on the position of AC relative to AR, three cases arise.

Case 1: Supernormal profit ($AR > AC$)

$\text{Profit} = (AR - AC)\times Q^*$

AC at $Q^*$ lies below price; the profit rectangle lies between $P^*$ and AC.

Case 2: Normal profit ($AR = AC$)

The AR curve is tangent to AC at $Q^*$; the firm covers all costs only.

Case 3: Loss ($AR < AC$)

$\text{Loss} = (AC - AR)\times Q^*$

The firm continues production in the short run if $AR \ge AVC$ (covers variable cost), else it shuts down.

Diagram description: downward-sloping AR, MR below it, U-shaped AC and MC with MC cutting AC at its minimum, equilibrium at $MR = MC$, vertical to AR to get price.

In the long run, supernormal profit attracts new firms and demand for each firm falls until only normal profit remains (tangency equilibrium).

The final product (value-added/output) method measures national income by adding up the market value of all final goods and services produced in the economy in a year. Only final goods are counted to avoid double counting of intermediate goods.

Steps

1. Classify the producing units into sectors: primary (agriculture, forestry, mining), secondary (manufacturing, construction) and tertiary (trade, banking, transport, services).
2. Estimate the gross value of output of each sector.
3. Deduct the value of intermediate consumption from each sector to get gross value added (GVA) at market prices.
4. Sum up GVA of all sectors to get GDP at market price:

$GDP_{MP} = \sum (\text{Value of output} - \text{Intermediate consumption})$

5. Deduct depreciation to get net product, add net factor income from abroad, and adjust for indirect taxes and subsidies:

$GNP_{MP} = GDP_{MP} + NFIA$

$NNP_{MP} = GNP_{MP} - \text{Depreciation}$

$NNP_{FC} = NNP_{MP} - \text{Indirect taxes} + \text{Subsidies} = \text{National income}$

Numerical illustration

Farmer sells wheat to a miller for Rs 100 (inputs nil), the miller sells flour to a baker for Rs 150, and the baker sells bread for Rs 200.

Value added: $100 + (150 - 100) + (200 - 150) = 200$, equal to the final value of bread (Rs 200). Adding all sales (450) would double-count.

Precautions: exclude second-hand goods, financial transactions and transfer payments; include the imputed value of self-consumed output and owner-occupied housing.

Micro studies the trees, macro studies the forest; both are interdependent.

Given: $P_x$: Rs 100 to Rs 200; $Q_y$: 500 to 400 units.

(a) The change is in the quantity demanded of a different commodity Y when the price of X changes. So this is the cross elasticity of demand ($\varepsilon_{Q_y,P_x}$).

(b)

$\varepsilon_{Q_y,P_x} = \frac{\Delta Q_y / Q_y}{\Delta P_x / P_x} = \frac{(400-500)/500}{(200-100)/100} = \frac{-0.20}{1} = -0.2$

(using initial values as base)

(c) The cross elasticity is negative: when the price of X rises, demand for Y falls. Hence X and Y are complementary goods (used together, like car and petrol). Since $|{-0.2}| < 1$, the complementarity is weak. (Positive cross elasticity would indicate substitutes; zero would indicate unrelated goods.)

The income effect is the change in the quantity demanded of a good caused by a change in the consumer's real income, with commodity prices and tastes unchanged.

Income-consumption curve (ICC)

The ICC is the locus of consumer equilibrium points obtained when the consumer's money income changes while prices of X and Y stay constant.

Derivation (both goods normal)

1. Take the initial budget line $B_1$ ($P_xX + P_yY = M_1$). It is tangent to indifference curve $IC_1$ at $E_1$, where $MRS_{xy} = P_x/P_y$.
2. If income rises to $M_2$ and $M_3$, the budget line shifts outward in parallel to $B_2$ and $B_3$ (same slope $-P_x/P_y$).
3. $B_2$ is tangent to higher curve $IC_2$ at $E_2$, and $B_3$ to $IC_3$ at $E_3$.
4. Joining $E_1, E_2, E_3$ gives the ICC.

Since both goods are normal, purchases of X and Y both rise as income rises, so the ICC slopes upward to the right (positive slope) and the income effect is positive for both goods. If income falls, the consumer moves down along the ICC.

Plotting income against the quantity of X (or Y) from the ICC gives the Engel curve.

Derivation of the long-run marginal cost (LMC) curve

In the long run all factors are variable. The firm can choose any plant size, and the long-run average cost (LAC) curve is the envelope of the short-run average cost curves ($SAC_1, SAC_2, SAC_3, \dots$).

Each SAC curve has a corresponding short-run marginal cost curve ($SMC$). The LMC is derived from them as follows:

1. At each output where a SAC curve is tangent to the LAC, the firm is using the optimal plant for that output, so $LMC = SMC$ at that output.
2. Draw perpendiculars from each tangency point to the horizontal axis; mark where they cut the corresponding SMC curve.
3. Join these points: the resulting smooth curve is the LMC.

LMC is U-shaped but flatter than SMC, because of economies and diseconomies of scale rather than the law of variable proportions.

Relationship between LMC and LAC

• When LAC is falling (economies of scale): $LMC < LAC$.
• When LAC is rising (diseconomies of scale): $LMC > LAC$.
• At the minimum of LAC (optimum scale): $LMC = LAC$; the LMC cuts LAC from below at its minimum point.

This is because LMC is the addition to long-run total cost; an addition lower than the average pulls the average down, and one above it pushes the average up. Also, at a tangency of SAC and LAC, $SMC = LMC$, and at the minimum LAC, $SAC = SMC = LAC = LMC$.

In perfect competition the firm is a price taker, so price $P$ is constant and $TR = P \times Q$ is a straight line through the origin. The firm maximises profit $\pi = TR - TC$.

TR-TC approach

• $TR$ is a straight upward line from the origin; $TC$ is an S-shaped curve starting from the positive TFC at zero output.
• Break-even points: $TR = TC$ at two outputs ($Q_1$ and $Q_2$). Between them $TR > TC$ (profit); outside them there are losses.
• Maximum profit occurs at the output where the vertical gap $TR - TC$ is greatest, i.e. where the slope of TC equals the slope of TR (tangent to TC parallel to TR), which means $MC = MR = P$. At this output the TC slope is rising (second-order condition).

$\pi_{max} = TR - TC \text{ at } Q^*$

• If TR is tangent to TC, the firm earns only normal profit.
• If TR lies below TC at all outputs, the firm makes a loss. It continues production in the short run if $TR \ge TVC$, otherwise it shuts down.

The firm is therefore in short-run equilibrium at $Q^*$ where profit is maximum, with $P = MR = MC$.

Inflation is a sustained rise in the general price level over time, reducing the purchasing power of money.

Causes

1. Demand-pull: aggregate demand outruns supply (excess money supply, stimulus spending, credit expansion, remittance-fuelled consumption).
2. Cost-push: higher wages, raw material and energy costs. Globally, the Russia-Ukraine war, oil and gas price shocks and supply chain disruptions after COVID-19 pushed up food and fuel prices.
3. Supply constraints: poor harvests, climate shocks, blockades, shipping delays.
4. Exchange rate depreciation: raises the price of imports (important for import-dependent economies such as Nepal, whose currency is pegged to the Indian rupee and imports from India).
5. Monetary expansion and large fiscal deficits.
6. Expectations of higher prices (wage-price spiral).

Adverse effects

1. Erodes purchasing power, hurting fixed-income groups (pensioners, salaried workers) and the poor.
2. Redistributes income from creditors and savers to debtors.
3. Discourages saving and encourages speculation and hoarding.
4. Raises production costs and uncertainty, reducing investment.
5. Worsens the balance of trade, making exports expensive.
6. Raises interest rates (central banks tighten policy), slowing growth and raising unemployment.
7. Social unrest and political instability, and higher poverty.

Remedies: tight monetary policy (higher policy rate, CRR), fiscal restraint, better supply chains and stock management, and price monitoring.

Money is a generally accepted medium of exchange. In a modern economy its functions are:

1. Medium of exchange: money removes the need for a double coincidence of wants, enabling smooth trade. Today this includes notes, coins, bank deposits and digital payments (e-wallets, mobile banking, QR payments).
2. Unit of account (measure of value): prices, wages, debts and national accounts are expressed in a common unit.
3. Store of value: purchasing power can be held for future use, though inflation weakens it.
4. Standard of deferred payment: loans, mortgages, bonds and contracts are written in terms of money.
5. Transfer of value: funds can be moved across places, even across countries (remittances).
6. Basis of credit: banks create credit on the basis of cash reserves, supporting investment.
7. Liquidity: money is the most liquid asset and provides financial security.
8. Distribution of income: it helps in rewarding factors of production (wages, rent, interest, profit).
9. Policy tool: control of the money supply lets the central bank manage inflation and growth.

Thus money makes exchange efficient, supports specialisation and the credit system, and is central to macroeconomic management.

Macroeconomics studies the economy as a whole (national income, employment, price level, growth, trade). Its main goals are:

1. Full employment: Making use of all available labour so that involuntary unemployment is minimised. Only frictional and structural unemployment (the natural rate) remains.
2. Price stability: Keeping inflation and deflation low and predictable, so that the value of money, savings and contracts are protected.
3. Economic growth: A sustained rise in real national income and per capita income, achieved through capital formation, technology and human capital.
4. Equitable distribution of income and wealth: Reducing poverty and inequality so that the benefits of growth reach all groups.
5. Balance of payments equilibrium: Avoiding persistent deficits so that foreign exchange reserves and the exchange rate remain stable.
6. Economic stability and efficient resource use: Reducing business-cycle fluctuations (boom and recession) and using resources efficiently and sustainably.

These goals may conflict (for example, the trade-off between inflation and unemployment), so policy makers use fiscal and monetary policy to balance them.

In the ordinal utility approach, a consumer is in equilibrium when he reaches the highest possible indifference curve given his income and the prices of goods. The analysis uses the indifference map and the budget line.

Assumptions: the consumer is rational; utility is ordinal (ranking only); indifference curves are convex to the origin; income and prices of X and Y are given; goods are homogeneous and divisible; the consumer has a consistent preference ordering.

Budget line: with income $M$ and prices $P_x, P_y$, $P_x X + P_y Y = M$ Its slope is $P_x/P_y$.

Equilibrium: Draw X on the horizontal axis and Y on the vertical axis, with several indifference curves $IC_1, IC_2, IC_3$ and one budget line $AB$.

• $IC_1$ cuts the budget line at two points, but a higher curve can still be reached, so these points are not equilibrium.
• $IC_3$ lies wholly above the budget line, so it is unattainable.
• $IC_2$ is tangent to $AB$ at point $E$. This is the highest attainable curve, and the consumer buys $X_0$ and $Y_0$.

Conditions

1. First order: the slope of the IC equals the slope of the budget line $MRS_{xy} = \frac{MU_x}{MU_y} = \frac{P_x}{P_y}$
2. Second order: the IC must be convex to the origin at the point of tangency, i.e. $MRS$ is diminishing.

If $MRS_{xy} > P_x/P_y$, the consumer gives up Y for X until equality is restored; if $MRS_{xy} < P_x/P_y$, the reverse happens. Equilibrium is therefore stable at $E$.

(i) Price elasticity of supply

Given $P_1 = 200,\ P_2 = 400,\ Q_1 = 400,\ Q_2 = 1200$.

$\Delta Q = 1200 - 400 = 800,\qquad \Delta P = 400 - 200 = 200$

$e_s = \frac{\Delta Q}{\Delta P}\times\frac{P_1}{Q_1} = \frac{800}{200}\times\frac{200}{400} = 4\times 0.5 = 2$

(Using the mid-point method: $e_s = \dfrac{800/800}{200/300} = 1.5$.)

(ii) Interpretation

$e_s = 2 > 1$, so supply is elastic. A 1% rise in price leads to a 2% rise in the quantity supplied. Equivalently, the 100% rise in price brought about a 200% rise in quantity supplied, so producers respond more than proportionately to a price change.

Under perfect competition, the firm is a price taker: price equals AR = MR, a horizontal line. A firm maximises profit at $MC = MR = P$ with MC rising. The short-run supply curve shows the quantity the firm will supply at each price, and it is derived from the firm's MC curve.

Derivation

Draw SAC, AVC and SMC. SMC cuts AVC and SAC at their minimum points.

• At price $P_1$ (equal to minimum AVC), MR$_1$ touches SMC at the shutdown point $S$. The firm just covers variable cost, so it is indifferent between producing $q_1$ and shutting down.
• At price $P_2$, SMC = MR$_2$ at $q_2$, where $P > AVC$ but $P < SAC$. The firm loses part of fixed cost but loses less than by closing, so it continues.
• At price $P_3$ (minimum SAC), $q_3$ is the break-even point (normal profit).
• At price $P_4$, SMC = MR$_4$ at $q_4$ and the firm earns abnormal profit.

Result

• At prices below minimum AVC, $P < AVC$, the firm shuts down and supplies zero.
• At prices at or above minimum AVC, the firm supplies the quantity at which $P = SMC$.

Hence the firm's short-run supply curve is the portion of the SMC curve lying above the minimum point of AVC. It slopes upward because of the law of diminishing returns (rising MC), showing a direct relation between price and quantity supplied. The industry short-run supply is the horizontal sum of the supply curves of all firms.

Balance of trade (BOT)

The balance of trade is the difference between the value of a country's visible exports (goods) and visible imports over a period: $BOT = \text{Value of exports of goods} - \text{Value of imports of goods}$

Types:

• Favourable (surplus) BOT: exports > imports.
• Unfavourable (deficit) BOT: imports > exports.
• Balanced BOT: exports = imports.

Balance of payments (BOP)

The balance of payments is a systematic record of all economic transactions between residents of a country and the rest of the world in a year. It is wider than BOT because it includes services, transfers and capital movements.

Its main accounts:

1. Current account: trade in goods, services (transport, tourism, insurance), income, and unilateral transfers such as remittances.
2. Capital account: transfers of capital and acquisition or disposal of non-produced assets.
3. Financial account: direct investment, portfolio investment, loans and changes in reserve assets.

Types of BOP position:

• Surplus: receipts exceed payments, adding to foreign reserves.
• Deficit: payments exceed receipts, reducing reserves or increasing borrowing.
• Equilibrium: receipts equal payments.

Accounting-wise, BOP always balances, but a disequilibrium shows in the autonomous items (current and capital accounts), and is financed by accommodating items (reserves).

A monopolist is the sole seller, so it faces the downward-sloping market demand curve (AR). MR lies below AR. In the short run it cannot change its fixed factors, so it can earn abnormal profit, normal profit or bear a loss.

Conditions of equilibrium (profit maximisation)

1. $MC = MR$
2. MC cuts MR from below (slope of MC > slope of MR).

Explanation with figure

On the diagram, draw the downward-sloping AR and MR curves, and U-shaped SAC and SMC curves.

• MC cuts MR at point $E$, giving the equilibrium output $Q_M$.
• Extending upward to AR at $Q_M$ gives the monopoly price $P_M$.
• The average cost at $Q_M$ is $C$.

Cases

• Abnormal profit: if $AR > AC$ at $Q_M$, $\text{Profit} = (P_M - C)\times Q_M$
• Normal profit: if AR is tangent to AC at $Q_M$.
• Loss: if $AR < AC$ at $Q_M$ but $AR \ge AVC$, the monopolist continues production in the short run and minimises loss. If $AR < AVC$, it shuts down.

Why not other outputs: if $MR > MC$ more output adds more revenue than cost; if $MR < MC$ output should be cut. So only at $MC = MR$ is profit at its maximum. Price is above MC, which marks monopoly power.

Definition

Microeconomics (from Greek mikros, small) 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 the prices of individual goods and factors. It is also called price theory. As Boulding put it, it is the study of particular firms, households, individual prices, wages, incomes and individual industries.

Issues of microeconomics

1. Theory of product pricing: how the price and output of a commodity are determined by demand and supply under different market structures.
2. Theory of consumer behaviour: how a consumer allocates income to maximise satisfaction (utility, indifference curves, demand).
3. Theory of production and costs: how a firm combines inputs, the laws of returns, and cost curves.
4. Theory of factor pricing: the determination of rent, wage, interest and profit.
5. Theory of welfare economics: efficient allocation of resources and the distribution of welfare.
6. Allocation of resources: the central problems of what, how and for whom to produce.

Income elasticity of demand: $E_Y = \frac{\Delta Q/Q}{\Delta M/M} = \frac{\Delta Q}{\Delta M}\times\frac{M}{Q}$

Income $M = 20000 \to 30000$, so $\Delta M = 10000$ (a 50% rise).

Good A: $Q = 12 \to 150$, $\Delta Q = 138$ $E_Y = \frac{138}{10000}\times\frac{20000}{12} = 23$

Good B: $Q = 10 \to 60$, $\Delta Q = 50$ $E_Y = \frac{50}{10000}\times\frac{20000}{10} = 10$

Good C: $Q = 4 \to 200$, $\Delta Q = 196$ $E_Y = \frac{196}{10000}\times\frac{20000}{4} = 98$

Interpretation: all three elasticities are positive and greater than 1, so A, B and C are normal goods with luxury (income-elastic) demand: demand rises more than proportionately to the income. Good C is the most income-elastic, followed by A and then B.

Law: Other things being equal, as a consumer consumes more units of a commodity, the additional utility (marginal utility) from each successive unit goes on decreasing. (Marshall)

$MU_n = TU_n - TU_{n-1}$

Numerical example (oranges)

MU falls from 20 to 0 as consumption rises. TU increases at a diminishing rate until it is maximum (60) when MU = 0 at the 6th unit; after that MU is negative and TU declines.

Assumptions: the units are homogeneous and of a standard size; consumption is continuous; the consumer's taste and income are constant; utility is cardinally measurable; no change in the consumer's mental condition.

Importance: it explains why the demand curve slopes downward and the principle of equi-marginal utility, and underlies value in use versus value in exchange and progressive taxation.

Average cost (AC): the cost per unit of output, obtained by dividing total cost by output. $AC = \frac{TC}{Q} = AFC + AVC$

Marginal cost (MC): the addition to total cost from producing one more unit of output. $MC = \frac{\Delta TC}{\Delta Q} = TC_n - TC_{n-1}$

Relationship between AC and MC (short run)

Both curves are U-shaped because of the law of variable proportions.

1. When AC is falling, MC is below AC ($MC < AC$). MC falls faster and reaches its minimum earlier than AC.
2. When AC is at its minimum, MC = AC. MC cuts AC at the lowest point of AC from below.
3. When AC is rising, MC is above AC ($MC > AC$).
4. MC may rise or fall even while AC moves in the opposite direction; AC changes only when MC pulls it, just as a marginal mark pulls up or down an average mark.

Example: a fall in AC from 10 to 9 happens when the extra unit costs less than 9. The same logic gives the rule above. So MC reaches its minimum before AC, and cuts AC at its minimum point.

A perfectly competitive firm is a price taker, so market price is fixed and $TR = P\times Q$ is a straight line from the origin whose slope equals price. The firm aims at maximum profit: $\pi = TR - TC$

TC-TR approach (figure)

Plot output on the X-axis and revenue/cost on the Y-axis: the TR line is a straight line through the origin, and TC starts above the origin (fixed cost) and rises, first at a decreasing rate and then at an increasing rate.

• TR and TC intersect at two points, $B_1$ and $B_2$, the break-even points. At these, profit is zero (normal profit).
• Between $B_1$ and $B_2$, TR is above TC, so profit exists.
• Profit is greatest where the vertical distance between TR and TC is at its maximum, i.e. where a tangent to TC is parallel to TR (same slope). That output is $Q_0$ (point $E$), and the maximum profit is $TR - TC$ at $Q_0$.
• Below $B_1$ and above $B_2$, the firm makes losses.

Conditions

• First order: slope of TR = slope of TC, i.e. $MR = MC$ (and $MR = P$).
• Second order: TC must be convex from below at that output (MC rising).

The firm therefore produces $Q_0$, where the gap TR - TC is greatest. In the short run it may suffer a loss, but continues as long as TR covers total variable cost.

The product (value-added) method measures national income as the sum of the market value of final goods and services produced in the economy in a year, avoiding double counting by counting only final goods or by summing the value added at each stage.

Steps

1. Divide the economy into producing sectors (agriculture, industry, services).
2. Find the value of output of each sector.
3. Deduct the value of intermediate consumption to get gross value added (GVA) for each sector.
4. Add the GVA of all sectors to get GDP at market prices; then $\text{NNP at factor cost} = GDP_{mp} - \text{Depreciation} - \text{Net indirect taxes} + \text{Net factor income from abroad}$

Example (bread)

The sum of value added (40 + 30 + 50 = Rs 120) equals the final value of bread, Rs 120. Adding sales (230) would double-count intermediate goods.

Precautions: exclude second-hand goods and financial transactions, include the value of self-consumed output and imputed rent, and exclude illegal activities.

(a) Functions of a commercial bank

Primary functions

1. Accepting deposits: current, savings, fixed (term) and recurring deposits.
2. Lending/advances: loans, overdrafts, cash credit and discounting of bills.
3. Credit creation: banks create deposits many times over their cash reserves, increasing the money supply.

Secondary (agency and general utility) functions

• Remittance of funds, collection of cheques and bills, payment of insurance premiums and bills on behalf of customers.
• Issue of drafts, letters of credit and guarantees; foreign exchange dealing.
• Safe custody of valuables (lockers); underwriting of shares; ATM, e-banking and mobile banking.

(c) Inflation

Inflation is a sustained and considerable rise in the general price level over a period, so that the purchasing power of money falls. It is measured by the rate of change of a price index such as the CPI: $\text{Inflation rate} = \frac{CPI_t - CPI_{t-1}}{CPI_{t-1}}\times 100$

Main types by cause: demand-pull (excess aggregate demand) and cost-push (rising wages or input costs). By speed: creeping, walking, running and hyperinflation.

Effects: it hurts fixed-income earners and creditors, benefits debtors and speculators, distorts savings and investment, and worsens the balance of payments. Remedies include monetary measures (a higher bank rate, CRR and open market sales), fiscal measures (lower government spending and higher taxes) and increased supply.

Under monopoly there is a single seller of a product with no close substitutes, and entry is blocked. The firm faces the market demand curve, so AR slopes downward and MR lies below AR (MR falls twice as fast with a linear demand: if $AR = a - bQ$, then $MR = a - 2bQ$). The monopolist is a price maker, but it can fix either price or output, not both independently.

Assumptions: one seller and entry barriers; profit maximisation; the firm cannot change fixed factors in the short run; the cost curves are the usual U-shaped SAC and SMC; no price discrimination.

Equilibrium conditions

1. $MC = MR$
2. MC cuts MR from below.

Determination of price and output (diagram)

Plot output on the X-axis and price/cost/revenue on the Y-axis, with AR, MR, SMC and SAC.

• MC cuts MR at $E$, giving the equilibrium output $OQ$.
• Price is taken from AR at $OQ$: $OP$.
• The average cost at $OQ$ is $OC$.

Possible outcomes in the short run

1. Abnormal profit when $AR > AC$: $\text{Profit} = (OP - OC)\times OQ$
2. Normal profit when $AR = AC$ (AR just touches SAC).
3. Loss when $AR < AC$, but $AR \ge AVC$: the firm continues to minimise the loss. If $AR < AVC$, it closes down.

Features of the result

• Price is above MC ($P > MR = MC$), so output is lower and price higher than under perfect competition.
• The monopolist always operates on the elastic part of demand ($e > 1$), since MR must be positive: $MR = P\left(1 - \frac{1}{e}\right)$
• There is no supply curve for a monopolist, because the output depends on both MC and the elasticity of demand.

Demand: the quantity of a commodity that a consumer is willing and able to buy at a given price during a given period, other things remaining the same. It requires desire, ability to pay and willingness to pay.

Price elasticity of demand ($e_d$): the degree of responsiveness of the quantity demanded to a change in price. $e_d = \frac{\%\ \text{change in quantity demanded}}{\%\ \text{change in price}} = \left|\frac{\Delta Q}{\Delta P}\times\frac{P}{Q}\right|$

Types

1. Perfectly elastic ($e_d = \infty$): a horizontal demand curve; at a given price any quantity is demanded, and a slight rise in price drops demand to zero.

2. Perfectly inelastic ($e_d = 0$): a vertical demand curve; the quantity demanded does not change at all with price.

3. Unitary elastic ($e_d = 1$): a rectangular hyperbola; the percentage change in quantity equals that in price, so total expenditure is constant. Example: $P$: Rs 10 to Rs 12 (+20%), $Q$: 100 to 80 (-20%), so $e_d = 1$.

4. Relatively elastic ($e_d > 1$): a flat demand curve; quantity changes by a greater proportion than price. Example: $P$: Rs 10 to Rs 11 (+10%), $Q$: 100 to 120 (-20%), so $e_d = 2$.

5. Relatively inelastic ($e_d < 1$): a steep demand curve; quantity changes by a smaller proportion than price. Example: $P$: Rs 10 to Rs 12 (+20%), $Q$: 100 to 90 (-10%), so $e_d = 0.5$.

Relation with total revenue

Necessities usually have inelastic demand and luxuries have elastic demand. Elasticity is also affected by the availability of substitutes, the share of income spent and the time period.

Price effect (PE) is the change in the consumer's equilibrium purchases of a good when its price changes, with money income, tastes and the prices of other goods held constant. In the indifference curve diagram, a fall in the price of X pivots the budget line outward on the X-axis (from $AB_1$ to $AB_2$, $AB_3$), and the consumer moves to a higher indifference curve. Joining the equilibrium points gives the price consumption curve (PCC).

The PE can be split into the substitution effect and the income effect (Hicks), and the shape of the PCC depends on the relation between the goods.

1. Substitute goods (e.g. tea and coffee)

Let X (tea) fall in price; Y (coffee) is a substitute. The budget line pivots from $AB_1$ to $AB_2$ and the equilibrium moves from $E_1$ to $E_2$ on higher curves.

• The consumer buys more X (it is now cheaper) and less Y, since X replaces Y.
• Therefore the PCC slopes downward (to the right), as X rises and Y falls.
• Cross elasticity of demand is positive.

2. Complementary goods (e.g. car and petrol, pen and ink)

When the price of X (cars) falls, the budget line pivots outward.

• The consumer buys more X and also more Y, because the two are used together.
• The PCC therefore slopes upward (to the right).
• Cross elasticity of demand is negative.

Decomposition

For a fall in the price of X: $PE = SE + IE$. The substitution effect is always negative (more X when it is cheaper). For a normal good the income effect reinforces it (real income rises), so the PE is strongly positive for the quantity of X. For the other good Y, the net effect depends on substitution (reduces Y) and complementarity (raises Y).

For the diagram, plot X on the horizontal and Y on the vertical axis, draw the budget lines $AB_1, AB_2, AB_3$ with tangent ICs $IC_1, IC_2, IC_3$, and join $E_1, E_2, E_3$ to obtain the PCC.

Indifference curve (IC): a curve showing all combinations of two goods that give the consumer equal satisfaction. Since every point gives the same utility, the consumer is indifferent among them. A set of ICs is an indifference map.

Along an IC, $\Delta U = MU_x\,\Delta X + MU_y\,\Delta Y = 0$, so the slope is $MRS_{xy} = -\frac{\Delta Y}{\Delta X} = \frac{MU_x}{MU_y}$

Properties

1. Slopes downward from left to right: to keep satisfaction constant, more of X means less of Y.
2. Convex to the origin: because the MRS diminishes as the consumer has more X and less Y; the consumer gives up less Y for each extra X.
3. Two ICs never intersect: intersection would imply two different utility levels at the same point, and violate transitivity.
4. Higher IC represents higher satisfaction: it contains more of at least one good (monotonicity).
5. ICs do not touch the axes: the consumer is assumed to buy both goods (interior combinations).
6. ICs need not be parallel, since the MRS varies from curve to curve; they are also not necessarily equidistant.

Illustration: for combinations A (1X, 12Y), B (2X, 8Y), C (3X, 5Y), D (4X, 3Y), MRS falls: 4, 3, 2.

Under imperfect competition (monopoly, monopolistic competition, oligopoly) the firm has some control over price, so it faces a downward-sloping demand curve.

Definitions

• $AR = \dfrac{TR}{Q} = P$
• $MR = \dfrac{\Delta TR}{\Delta Q}$

Relationship

1. AR slopes downward because to sell more, the firm must lower the price on all units.
2. MR is below AR at every output, since the lower price applies to all units and so the extra revenue from an additional unit is less than its price.
3. When AR falls, MR falls faster. For a linear demand $AR = a - bQ$: $TR = aQ - bQ^2,\quad MR = a - 2bQ$ so MR has the same intercept but twice the slope, and cuts the horizontal axis at half the output at which AR is zero.
4. When MR is positive, TR rises and $e > 1$; when $MR = 0$, TR is maximum and $e = 1$; when MR is negative, TR falls and $e < 1$.
5. Formula linking them: $MR = AR\left(1 - \frac{1}{e}\right)$

Example: $P = 10 - Q$. At $Q = 4$, $AR = 6$ and $MR = 10 - 8 = 2$, so $MR < AR$.

Only under perfect competition do they coincide ($AR = MR$, a horizontal line).

Central bank: the apex institution of a country's monetary and banking system that issues currency, controls the money supply and credit, and acts as banker to the government and the commercial banks. It does not aim at profit, and its main objective is monetary stability and economic growth. Example: Nepal Rastra Bank (NRB), established in 1956.

Functions

1. Currency issue: the sole authority to issue notes (note issue), ensuring uniformity and control of the money supply.
2. Banker, agent and adviser to the government: keeps government accounts, manages public debt, and advises on monetary and economic policy.
3. Banker to banks (custodian of cash reserves): commercial banks keep their reserves with it, and it acts as the lender of last resort.
4. Control of credit: through quantitative tools (bank rate, CRR, SLR, open market operations) and qualitative tools (margin requirements, credit rationing, moral suasion, selective controls).
5. Custodian of foreign exchange reserves: manages reserves and the exchange rate, and keeps the balance of payments in order.
6. Clearing house and supervision: settles inter-bank claims, and licenses, regulates and supervises banks and financial institutions.
7. Developmental functions: promotes financial inclusion and banking development.

Economics is divided into two broad branches, microeconomics and macroeconomics. This division was introduced by Ragnar Frisch.

1. Microeconomics

It studies the behaviour of individual economic units: a consumer, a firm or an industry, and the determination of the prices of individual commodities and factors. Its tools are demand and supply of a single good. Its chief parts are the theory of consumer behaviour, the theory of production and cost, and the theory of product and factor pricing. Diagram: a demand curve $D$ and supply curve $S$ intersecting at $E$ determine the equilibrium price $P^*$ and quantity $Q^*$ of a commodity.

2. Macroeconomics

It studies the economy as a whole, dealing with aggregates such as national income, total employment, general price level, money supply, savings and investment, growth and the balance of payments. Diagram: an aggregate demand curve $AD$ and an aggregate supply curve $AS$ meet at equilibrium giving the general price level $P$ and national output $Y$ (plotted as price level against real GDP).

Difference in brief

The two are interdependent: aggregate outcomes come from individual decisions and, conversely, the economy-wide situation affects individual units.

Demand function: $Q = 200 - 30P$ at $P = 4$.

Quantity demanded $Q = 200 - 30(4) = 80$

Price elasticity of demand $\frac{dQ}{dP} = -30$ $e_d = \left|\frac{dQ}{dP}\times\frac{P}{Q}\right| = 30\times\frac{4}{80} = 1.5$

Decision

Since $e_d = 1.5 > 1$, demand is elastic at this price. A price decrease raises total revenue, because the percentage rise in quantity exceeds the percentage fall in price.

Check: at $P = 4$, $TR = 4\times 80 =$ Rs 320. If price falls to Rs 3, $Q = 200 - 90 = 110$ and $TR = 3\times 110 =$ Rs 330, which is higher. If price rose to Rs 5, $Q = 50$ and $TR =$ Rs 250, which is lower.

So the price should be decreased (revenue is maximum at the unit-elastic point $P = 200/60 \approx$ Rs 3.33).

(a) Demand-pull inflation

It is a rise in the general price level caused by an excess of aggregate demand over the available aggregate supply ("too much money chasing too few goods"). It occurs when the economy is at or near full employment and output cannot rise quickly.

Causes: an increase in the money supply, government spending or credit; higher consumer spending, investment or exports; a fall in taxes; and increased income from remittances. The aggregate demand curve shifts right ($AD_1 \to AD_2$) along a steep AS curve, so the price level rises from $P_1$ to $P_2$ with little increase in output.

Remedies: tight monetary policy (higher interest rates, CRR), lower public spending, higher taxes, and a greater supply of goods.

(c) Price consumption curve (PCC)

The price consumption curve is the locus of the consumer's equilibrium points obtained when the price of one good (say X) changes while income, tastes and the price of the other good (Y) are constant. As the price of X falls, the budget line pivots outward and the consumer reaches higher indifference curves, with tangency points $E_1, E_2, E_3$. Joining these gives the PCC.

Shapes: for elastic demand for X the PCC slopes downward; for unit-elastic demand it is horizontal; for inelastic demand it slopes upward (backward). The PCC is used to derive the individual demand curve for X, by plotting the price of X against the quantity at each equilibrium.

Cartel: a formal agreement among independent firms in an oligopolistic industry to coordinate price and output (and sometimes market share) so as to act like a single monopolist. The purpose is to restrict competition and earn the maximum joint profit. An example is OPEC. Cartels may be of two kinds: a joint profit maximisation (centralised) cartel and a market-sharing cartel.

Pricing under a centralised cartel (joint profit maximisation)

Firms set up a central agency that determines the price, the total output and its allocation among members. The agency behaves like a multi-plant monopolist.

Steps (diagram)

1. Assume two firms, A and B, with marginal costs $MC_A$ and $MC_B$ and the market demand $D$ (AR) and its marginal revenue curve $MR$.
2. Sum $MC_A$ and $MC_B$ horizontally to get the industry marginal cost $\Sigma MC$.
3. The cartel's optimum is where $\Sigma MC = MR$ (point $E$), giving total output $Q$.
4. Price is read from the market demand curve at $Q$: $P$.
5. Draw a horizontal line from $E$ to the firms' MC curves to allocate output: each firm produces where its MC equals the common MR level: $MC_A = MC_B = MR$ giving outputs $Q_A$ and $Q_B$ with $Q_A + Q_B = Q$.

Joint profit: $\pi = (P - AC_A)Q_A + (P - AC_B)Q_B$

Features and difficulties

• Output allocation follows the MC rule rather than equal shares, so the low-cost firm produces more and may earn a larger profit; the high-cost firm can therefore demand a profit share (side payments).
• Each member is tempted to cheat by selling more at a price just below the cartel price (the price is above MC), which can break the cartel.
• Instability arises from the entry of new firms, differing costs and demand, and legal restrictions (cartels are illegal in many countries).

The result is the same as a monopoly outcome: lower output and a higher price than competition.