Economics for Business

Microeconomics studies the behaviour of individual consumers, firms and markets, and its central question is how prices are determined. The price of a product is set by the demand of consumers and the supply of producers, and the price of a factor such as wage, rent or interest is set in the factor market in the same way. Prices guide the allocation of scarce resources, so the theory of how they are determined is the core of microeconomics. That is why it is called price theory.

Four determinants of supply:

1. Price of the good itself (the main determinant: a higher price means a larger quantity supplied).
2. Prices of inputs or cost of production (wages, raw materials, rent).
3. State of technology (better technology lowers cost and raises supply).
4. Government policy: taxes and subsidies.

Other determinants include the prices of related goods, the number of sellers and expectations about future prices.

Economic efficiency means using scarce resources so that the maximum possible output or satisfaction is obtained at the lowest cost, with no waste. It has two parts: productive efficiency (output is produced at the lowest possible cost) and allocative efficiency (resources are used to produce the goods that consumers value most, so that price equals marginal cost). It is reached when no one can be made better off without making someone else worse off (Pareto efficiency).

Properties of an isoquant (equal product curve):

1. It slopes downward from left to right, because more of one input needs less of the other to keep output constant.
2. It is convex to the origin, because the marginal rate of technical substitution diminishes.
3. Two isoquants never intersect.
4. A higher isoquant represents a higher level of output.
5. It does not touch either axis (when both inputs are needed to produce the good).

Advertisement elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in the advertising expenditure on it.

$E_A = \frac{\%\ \text{change in quantity demanded}}{\%\ \text{change in advertising expenditure}} = \frac{\Delta Q}{\Delta A} \times \frac{A}{Q}$

It is normally positive, and a larger value means advertising is more effective in raising sales.

The isocost line $rK + wL = C$ shows all combinations of capital and labour that a firm can buy with a given total cost.

• $C$ is the total cost (budget or outlay) of the firm.
• $r$ is the price per unit of capital (rental rate) and $K$ is the quantity of capital.
• $w$ is the price per unit of labour (wage rate) and $L$ is the quantity of labour.
• The slope of the line is $-w/r$ (with $K$ on the vertical axis, slope $= -\dfrac{w}{r}$), the ratio of input prices.

An exchange rate is the price of one country's currency in terms of another currency, i.e. the rate at which one currency can be exchanged for another. For example, if US$ 1 = Rs 133, the exchange rate between the US dollar and the Nepali rupee is 133 rupees per dollar. It links domestic and foreign prices and affects exports, imports and the balance of payments.

A linear demand curve has the form $Q_d = a - bP$, where $a$ is the autonomous demand (the quantity demanded when price is zero) and $b$ is the slope.

With $a = 5$ and $b = 3$:

$Q_d = 5 - 3P$

The negative sign shows that quantity demanded falls as price rises.

Four causes of a shift in the supply curve:

1. Change in input prices: a rise in the price of raw materials or wages shifts supply to the left, and a fall shifts it to the right.
2. Change in technology: improved technology lowers the cost of production and shifts supply to the right.
3. Government policy: taxes reduce supply (left shift), subsidies raise it (right shift).
4. Number of sellers: entry of new firms shifts supply to the right, and exit shifts it to the left.

Prices of related goods, weather (for agricultural goods) and expectations also cause shifts.

Scarcity means that resources (land, labour, capital, entrepreneurship) are limited in supply while human wants are unlimited. Because all wants cannot be satisfied with the available resources, people, firms and governments must choose among alternatives, and every choice involves an opportunity cost. Scarcity is the basic reason why economics exists.

Total revenue is $TR = P \times Q$. When price changes, quantity changes in the opposite direction, so the effect on revenue depends on the price elasticity of demand ($e_d$).

• Elastic demand: the percentage change in quantity is larger than the percentage change in price, so price and total revenue move in opposite directions.
• Unitary elasticity: the two changes are equal and offset each other, so total revenue is constant and is at its maximum.
• Inelastic demand: the percentage change in quantity is smaller than the percentage change in price, so price and total revenue move in the same direction.

In terms of marginal revenue, $MR = P\left(1 - \dfrac{1}{e_d}\right)$, which is positive when $e_d > 1$, zero when $e_d = 1$ and negative when $e_d < 1$. A firm should therefore raise price when demand is inelastic and lower price when demand is elastic.

Using the income approach, corporate profit is the sum of corporate profit tax, retained earnings and dividends:

$150 + 115 + 450 = 715$

National income (net domestic income at factor cost):

$800 + 60 + 175 + 200 + 715 = 1{,}950$

GDP at factor cost = national income + capital consumption allowance

$1{,}950 + 80 = \text{Rs } 2{,}030 \text{ billion}$

GDP at market price = GDP at factor cost + indirect taxes $-$ subsidies

$2{,}030 + 250 - 30 = \text{Rs } 2{,}250 \text{ billion}$

(Net factor income from abroad is not given, so it is taken as zero.)

(a) Demand and supply schedule

$Q_d = 500 - 5P$ and $Q_s = 100 + 5P$

(b) Elasticities at equilibrium

Equilibrium: $Q_d = Q_s$

$500 - 5P = 100 + 5P \Rightarrow 10P = 400 \Rightarrow P = 40, \quad Q = 300$

$e_d = \frac{dQ_d}{dP} \times \frac{P}{Q} = -5 \times \frac{40}{300} = -0.67$

$e_s = \frac{dQ_s}{dP} \times \frac{P}{Q} = 5 \times \frac{40}{300} = 0.67$

At equilibrium price Rs 40, the absolute value of price elasticity of demand is 0.67 and that of supply is 0.67; both are inelastic.

Accounting profit is total revenue minus explicit costs, i.e. the actual money payments recorded in the books (wages, raw materials, rent, interest, depreciation).

$\text{Accounting profit} = TR - \text{Explicit costs}$

Economic profit is total revenue minus both explicit and implicit costs. Implicit costs are the opportunity costs of the owner's own resources (own capital, own land or building, own time), including normal profit.

$\text{Economic profit} = TR - (\text{Explicit costs} + \text{Implicit costs})$

Example: Ram runs a shop with sales of Rs 1,000,000 and pays explicit costs of Rs 600,000. He could have earned Rs 300,000 as a salary elsewhere, and his own capital of Rs 2,000,000 in the shop could earn Rs 100,000 of interest.

• Accounting profit $= 1{,}000{,}000 - 600{,}000 =$ Rs 400,000.
• Implicit costs $= 300{,}000 + 100{,}000 =$ Rs 400,000.
• Economic profit $= 400{,}000 - 400{,}000 = 0$, so he earns only normal profit.

Accounting profit is always larger than economic profit when implicit costs exist. Economic profit is the better guide for deciding whether to stay in or leave an industry.

Macroeconomics studies the economy as a whole, dealing with aggregates such as national income, total employment, the general price level and total investment. Its scope covers the following.

1. Theory of national income: measurement of GDP, GNP and national income and their determinants, and the study of economic growth and business cycles.
2. Theory of employment: the causes of unemployment and the factors determining the level of output and employment (aggregate demand and supply, consumption and investment).
3. Theory of money and prices: the demand for and supply of money, inflation and deflation, and the working of monetary policy.
4. Public finance and fiscal policy: government spending, taxation and public debt, and their effect on output, employment and prices.
5. International trade and payments: exports, imports, balance of payments and exchange rates.
6. Economic growth and development: the factors that raise a country's output over time.
7. Macroeconomic policy: the design of monetary, fiscal and trade policies to achieve full employment, price stability, growth and a favourable balance of payments.

Quantitative (general) instruments of monetary policy control the total volume of credit and money supply in the economy without regard to its use. The central bank (Nepal Rastra Bank) uses the following.

1. Bank rate policy: the bank rate is the rate at which the central bank lends to commercial banks. To restrict credit it raises the rate, which raises commercial banks' lending rates and reduces borrowing. To expand credit it lowers the rate.
2. Open market operations: the central bank buys or sells government securities in the market. Selling securities withdraws money from the banks and reduces credit, and buying securities adds to bank reserves and expands credit.
3. Cash reserve ratio (CRR): the percentage of deposits that banks must keep with the central bank. A higher CRR reduces the funds available for lending, and a lower CRR increases them.
4. Statutory liquidity ratio (SLR): the share of deposits that banks must hold in liquid assets such as cash and government securities. Raising it limits credit expansion, and lowering it increases lending capacity.
5. Repo and reverse repo operations: the central bank lends to banks against securities (repo) or borrows from them (reverse repo), adding to or absorbing liquidity in the short term.

The firm maximizes output $Q = 100K^{1/2}L^{1/2}$ subject to the cost constraint $40K + 50L = 1000$.

At the optimum, $\dfrac{MP_L}{MP_K} = \dfrac{w}{r}$.

$MP_L = 50K^{1/2}L^{-1/2}, \quad MP_K = 50K^{-1/2}L^{1/2}$

$\frac{MP_L}{MP_K} = \frac{K}{L} = \frac{50}{40} \Rightarrow K = 1.25L$

Substitute in the cost constraint:

$40(1.25L) + 50L = 1000 \Rightarrow 100L = 1000 \Rightarrow L = 10$

$K = 1.25 \times 10 = 12.5$

Output:

$Q = 100\sqrt{12.5 \times 10} = 100\sqrt{125} \approx 1{,}118$

The firm should use 10 units of labour and 12.5 units of capital, producing about 1,118 units of output.

Determination of equilibrium price

In a competitive market the price is determined by the interaction of market demand and market supply. Demand is a decreasing function of price and supply is an increasing function of price.

• At a price above equilibrium, quantity supplied exceeds quantity demanded (surplus), so sellers lower the price.
• At a price below equilibrium, quantity demanded exceeds quantity supplied (shortage), so buyers bid the price up.
• The price at which $Q_d = Q_s$ is the equilibrium price, and the quantity traded at that price is the equilibrium quantity. The market clears and there is no tendency for change.

Numerical illustration: with $Q_d = 500 - 5P$ and $Q_s = 100 + 5P$, setting $Q_d = Q_s$ gives $P = 40$ and $Q = 300$.

Effect of a simultaneous increase in demand and supply

Both curves shift to the right, so the equilibrium quantity certainly rises. The effect on price depends on the relative size of the shifts.

Explanation:

• If demand rises more, the rise in demand is not fully matched by the extra supply, so the price goes up.
• If the shifts are equal, the surplus created by extra supply is exactly absorbed by the extra demand, so the price stays the same.
• If supply rises more, the extra supply exceeds the extra demand, so the price falls.

Example: with the demand $Q_d = 600 - 5P$ and supply $Q_s = 200 + 5P$, the equilibrium is $P = 40$, $Q = 400$, which is both a higher quantity and an unchanged price compared with the initial $P = 40$, $Q = 300$, because both curves moved by 100 units.

Conclusion: a simultaneous increase in demand and supply raises the equilibrium quantity, while the equilibrium price may rise, remain unchanged or fall depending on which shift is larger.

Inflation is a sustained rise in the general price level. It arises either from excess aggregate demand (demand-pull) or from rising costs of production (cost-push). In Nepal both types operate, and imported inflation from India is an additional strong factor.

Demand-pull factors

• Remittance inflow: Remittance is more than 20% of GDP. It raises household income and consumption faster than domestic output, so demand for goods, housing and land pulls prices up.
• Expansionary monetary policy and credit growth: Rapid growth of money supply and bank lending (especially for real estate, imports and consumption) raises spending.
• Government expenditure: Large recurrent spending, salary increases and election-time spending raise aggregate demand while capital spending is often delayed.
• Population growth and urbanisation: More consumers, particularly in Kathmandu Valley, increase demand for food, housing and transport.
• Supply shortage of output: Weak agriculture and industry cannot meet rising demand, so excess demand turns into price rises.

Cost-push factors

• Rising import prices and the INR peg: Nepal's currency is pegged to the Indian rupee and about two-thirds of imports come from India, so Indian inflation is transferred to Nepal.
• Petroleum prices: Nepal imports all petroleum products. Increases in NOC's fuel prices raise transport and production costs of almost every good.
• Wage increases: Higher minimum wages and salaries raise unit labour cost without matching productivity growth.
• Supply disruptions and syndicates: Strikes (bandhs), blockades, poor roads, landslides, transport syndicates and hoarding by traders raise the cost of distribution, especially for vegetables and foodgrains.
• Taxes and depreciation: Higher customs and excise duties, VAT and any depreciation of the rupee increase the cost of imported inputs.
• Electricity and input costs: Load-shedding in the past, and the high cost of fertiliser, seeds and credit, raise production cost.

Conclusion

In Nepal inflation is mostly cost-push and imported in nature (India's prices, fuel, transport and supply bottlenecks), reinforced by demand-pull from remittance-fuelled consumption and credit expansion. Controlling it needs better supply management, improved domestic production and transport, along with prudent monetary and fiscal policy.

Take 2019 as the base year.

(a) Nominal GDP = $\sum P_t Q_t$ (current prices); Real GDP = $\sum P_{2019} Q_t$ (base-year prices).

$\text{GDP deflator}=\frac{\text{Nominal GDP}}{\text{Real GDP}}\times 100$

• 2019: 100
• 2020: $1{,}070{,}000/970{,}000\times100=110.31$
• 2021: $1{,}123{,}000/975{,}000\times100=115.18$
• 2022: $1{,}067{,}500/1{,}002{,}500\times100=106.48$

$\text{Inflation rate}=\frac{D_t-D_{t-1}}{D_{t-1}}\times100$

• 2020: $(110.31-100)/100=10.31\%$
• 2021: $(115.18-110.31)/110.31=4.42\%$
• 2022: $(106.48-115.18)/115.18=-7.55\%$ (i.e. a fall in the price level, deflation)

(b) Nominal GDP can rise merely because prices rise, even if no more goods are produced. Real GDP values output at constant prices, so it removes the effect of inflation and measures the actual volume of goods and services available. Welfare depends on the quantity of goods people can consume, so changes in real GDP show true changes in living standards. For example, nominal GDP rose from Rs 937,500 to Rs 1,067,500 (13.9%) between 2019 and 2022, but real GDP rose only from Rs 937,500 to Rs 1,002,500 (6.9%).

(a) With TFC = Rs 300: $TC=TFC+TVC$, $AFC=TFC/Q$, $AVC=TVC/Q$, $AC=TC/Q$, $MC=\Delta TC/\Delta Q$.

(b) Average cost is the sum of the two components: $AC=AFC+AVC$. In the schedule, at $Q=4$: $75+32=107$; at $Q=8$: $37.5+90=127.5$.

• AFC falls continuously as output rises because the fixed cost of Rs 300 is spread over more units (300 to 37.5).
• AVC first falls (40 to 32), reaches its minimum at Q = 3-4, then rises because of diminishing returns (up to 90).
• AC is U-shaped. It falls while the fall in AFC dominates, is minimum at Q = 5 (Rs 100), and then rises as the rise in AVC outweighs the fall in AFC. The gap between AC and AVC is AFC, which shrinks as output grows, so AVC approaches AC.
• MC cuts AVC and AC at their minimum points (MC = 32 at Q = 4 equals AVC minimum; MC crosses AC near Q = 5).

(c) Graph with output on the X-axis and cost on the Y-axis:

• TFC is a horizontal line at Rs 300.
• TVC starts from the origin (0, 0) and rises: slowly at first, then rapidly (0, 40, 72, 96, 128, 200, 320, 496, 720).
• TC starts at Rs 300 on the Y-axis and is the TVC curve shifted up by 300 (300, 340, ... 1020).

Relation: $TC=TFC+TVC$. The vertical distance between TC and TVC is constant at Rs 300 (equal to TFC) at every output level, so the two curves are parallel, and they have the same slope (equal to MC) at each output.

(a) Examples of price discrimination:

• Public transport: Different fares for students, senior citizens and disabled persons (concessions); different fares for peak and off-peak seasons (for example, higher bus fares during Dashain and Tihar); different fares for AC and ordinary services or for tourist and local routes.
• Education: Scholarships and fee discounts for girls, Dalits, students from remote areas or meritorious students; different tuition fees for national and foreign students; lower fees for children of staff or siblings.

It is largely justifiable. These practices improve equity and access, since low-income, vulnerable and deserving groups can use the service at a lower price, while those with greater ability to pay cross-subsidise them. It also increases total use and revenue of the provider. It becomes unjustifiable if it discriminates by arbitrary reasons, or if fares are raised unreasonably high during peak periods.

(b) Price discrimination in telecommunication is mostly justifiable, but it needs regulation.

• Justification: Telecommunication has high fixed costs and low marginal cost per user. Different packages (prepaid and postpaid, data packs, night-time offers, student packs, bulk and corporate rates, international and domestic calls) let companies serve more customers, raise capacity use and recover fixed costs. Consumers can choose the plan which suits their use, and low-income users benefit from cheaper small packs.
• Criticism: Charging high prices from consumers with inelastic demand (for example, in remote areas with a single provider, or for international roaming) transfers consumer surplus to the firm. Hidden conditions, short validity and unclear tariffs can confuse users. Therefore, the Nepal Telecommunications Authority should regulate tariffs, keep the information transparent, and prevent abuse of dominant position.

(c) The government endorses price discrimination because:

• It promotes equity: households and the poor pay lower rates for essential services such as electricity and water, while industries and commercial users pay higher rates, so they cross-subsidise others.
• It helps public utilities (natural monopolies like NEA, KUKL) to recover costs and earn enough revenue to run and expand services.
• It encourages the efficient use of resources: higher charges for higher consumption (a block tariff) discourage wastage, and lower charges for exports or industry promote production.
• It supports social and development goals, such as access for students, senior citizens and the disabled, and encourages priority sectors (for example, agriculture, export industries).

(d) Business firms follow wage discrimination because:

• Workers differ in skill, education, experience, productivity and responsibility, so firms pay according to the value of the work.
• The supply of labour differs among labour markets: scarce skills command higher wages, while abundant unskilled labour is paid less.
• Firms try to reduce labour cost and increase profit by paying a lower wage to groups with less bargaining power or fewer alternatives (for example, women, young or informal workers).
• Different wages by location, risk of work or time of work (night shift, overtime) compensate for different working conditions.
• It acts as an incentive: higher wages for better performers motivate others to improve.

Discrimination based on gender, caste or ethnicity is unjust and illegal, whereas differences based on productivity are justified.