Introduction to Microeconomics
Microeconomics studies individual units of an economy — consumers, households, and firms — and how they make choices under scarcity. This unit covers the scope and limitations of microeconomics, business economics, the production possibility curve, marginal analysis, and Mankiw's Ten Principles of Economics.
In this chapter
Definition and Meaning of Microeconomics
The word 'micro' has been derived from the Greek word 'mikros', which means small. Microeconomics is the branch of economics that deals with individual parts of an economy — consumers, households, and firms. It examines how consumers choose between goods and services, how workers choose between jobs, and how business firms decide what to produce, how to produce, how much to produce, and for whom to produce. The term 'micro' and 'macro' was first used by Ragnar Frisch in 1933.
Features of Microeconomics
Key Features
- Studies individual parts of an economy (consumers, firms, markets).
- Based on assumptions of full employment, partial equilibrium, and perfect competition.
- Major variables: relative price, individual demand and supply, output of a single firm.
- Also known as price theory because it studies how the price of a product is determined.
- Also known as the slicing method or microscopic analysis — like studying a particular tree of the whole forest.
- Applicable only in a free market economy.
Scope of Microeconomics
Five Branches of Microeconomics
- Theory of demand — consumer behaviour and demand determination.
- Theory of production and cost — how firms produce and what it costs.
- Theory of product pricing — pricing under different market structures.
- Theory of factor pricing — how rent, wages, interest, and profit are determined.
- Theory of economic welfare — efficiency and optimal resource allocation.
Microeconomics vs Macroeconomics
Comparison of Microeconomics and Macroeconomics
| Basis | Microeconomics | Macroeconomics |
|---|---|---|
| Meaning | Studies individual units | Studies economy as a whole |
| Deals with | Consumers, firms, markets | National income, output, employment |
| Central variable | Relative price | Aggregate income |
| Method | Slicing method | Aggregation method |
| Other name | Price theory | Income and employment theory |
| Example | Demand for rice in Kathmandu | Total GDP of Nepal |
Uses of Microeconomics
- Helps in understanding how the economy functions at the micro level — pricing, output, distribution.
- Useful for formulating economic policies such as taxation, subsidy, and price control.
- Provides tools for studying consumer behaviour and predicting demand for new products.
- Enables efficient allocation of scarce resources among alternative uses.
- Forms the basis of international trade theory — comparative advantage and gains from trade.
- Essential for welfare economics — measuring efficiency and equity.
- Provides the foundation for business and managerial decision-making.
Limitations of Microeconomics
- It is a static analysis — it assumes technology, tastes, and resources remain constant, which is unrealistic.
- It can lead to wrong conclusions when extended to the whole economy (fallacy of composition).
- Based on unrealistic assumptions such as full employment and perfect competition.
- Has limited scope — it cannot explain aggregate phenomena like inflation, recession, or unemployment.
- It largely ignores the role of government in the economy.
- Cannot fully explain externalities (pollution, public goods) without government intervention.
- Example: an individual saving more is good, but if everyone saves more, aggregate demand falls (paradox of thrift) — micro cannot capture this.
Nepal Example: Nepal Telecom Pricing
Nepal Telecom (NTC) and Ncell set different tariffs for different customer segments — students, businesses, rural callers. This is microeconomic price discrimination in action: NTC studies the demand of each customer segment (individual units) and sets call rates, data packs, and night packs accordingly. Likewise, a vegetable seller in Kalimati sets prices based on daily demand, supply, and perishability of each vegetable — micro-level decision making that macroeconomics cannot explain.
Business Economics (Managerial Economics)
Business economics is the branch of economics that uses economic principles and methods to solve business problems. Born in the 1950s, it is also called managerial economics or the economics of the firm. It applies economic theory (microeconomics and macroeconomics) and decision science tools (mathematical economics and econometrics) to solve managerial decision problems.
Scope of Business Economics
Areas Covered by Business Economics
- Demand analysis and forecasting — predicting future demand for products.
- Cost analysis — understanding cost behaviour for pricing and output decisions.
- Production and supply analysis — choosing the optimal input combination.
- Price determination — pricing under different market structures.
- Profit analysis — measuring, managing, and maximising profit.
- Capital management — investment decisions, capital budgeting, and cost of capital.
- Strategic decisions — entry, exit, expansion, and diversification.
Microeconomics vs Business Economics
Difference Between Microeconomics and Business Economics
| Basis | Microeconomics | Business Economics |
|---|---|---|
| Nature | Theoretical and positive | Applied and normative |
| Scope | Wide — entire price theory | Narrow — single firm's problems |
| Assumptions | Unrealistic (perfect competition) | Pragmatic (modified to suit firm) |
| Use of mathematics | Limited | Extensive (econometrics, OR) |
| Goal | Explain and predict market behaviour | Help managers make decisions |
| Audience | Students, researchers, policymakers | Business managers and executives |
Microeconomics in Business Decision Making
A Nepali tea exporter must decide how much tea to ship to Europe each month. Using microeconomic tools, the manager: (1) estimates demand elasticity for Nepali tea in Europe — if elastic, lower the price to raise revenue; (2) calculates the marginal cost of producing an extra kilogram; (3) sets output where MR = MC to maximise profit; (4) checks whether substitute prices (Indian, Sri Lankan tea) make Nepali tea more or less attractive. These are microeconomic decisions applied in real business.
Production Possibility Curve (PPC)
The production possibility curve (also called the production possibility frontier) is the locus of different combinations of any two goods that an economy can produce by fully and efficiently utilising its existing resources. It graphically illustrates the concepts of scarcity, choice, and opportunity cost. The PPC is concave to the origin because of increasing opportunity cost — resources are not equally suited to producing all goods.
Production Possibility Schedule (Cars vs Computers)
| Production Possibility | Cars ('00) | Computers ('00) | Opportunity Cost |
|---|---|---|---|
| A | 0 | 15 | — |
| B | 1 | 14 | 1 computer |
| C | 2 | 12 | 2 computers |
| D | 3 | 9 | 3 computers |
| E | 4 | 5 | 4 computers |
| F | 5 | 0 | 5 computers |
Why the PPC is Concave
Moving from A to F, each additional car costs more computers than the last. This increasing opportunity cost arises because resources specialise — the first resources shifted from computers to cars are those best suited to cars, so the sacrifice is small. Later, car production must draw resources better suited to computers, so the sacrifice grows.
Assumptions of PPC
Key Assumptions
- Only two goods are produced (e.g. rice and cloth) — simplifying assumption.
- Resources are fixed in quantity during the period of analysis.
- Resources are fully and efficiently employed — no waste, no unemployment.
- Technology remains constant — no innovation during the period.
- Resources are not perfectly adaptable to the production of both goods — this is why opportunity cost increases.
Shifts in PPC
The PPC shifts outward when the economy grows — due to an increase in resources (labour, capital, land) or technological progress. An inward shift occurs when resources are destroyed (war, natural disaster). A rotational shift happens when technology improves for only one good: e.g. if a new technology doubles rice productivity but not cloth, the PPC pivots outward on the rice axis but stays fixed on the cloth axis. Nepal's PPC shifts outward slowly because capital formation (investment) is modest and most workers remain in low-productivity agriculture.
PPC and Economic Growth
A country's long-run economic growth is shown by an outward-shifting PPC. In Nepal, investment in hydropower (Kalinchowk, Upper Tamakoshi), road networks, and education shifts the PPC outward by increasing both capital and labour productivity. Remittance income, however, mainly raises consumption rather than production capacity, so it has a limited effect on shifting the PPC outward.
Marginal Analysis
Marginal analysis is the study of the additional benefits of an activity compared to the additional costs incurred by the same activity. "Marginal" refers to the extra cost or extra benefit of the next unit. The most important use of marginal analysis in microeconomics is to determine the optimum level of output that maximises a firm's profit.
Marginal analysis — profit maximisation condition
Marginal vs Incremental Analysis
Difference Between Marginal and Incremental Analysis
| Basis | Marginal Analysis | Incremental Analysis |
|---|---|---|
| Unit of change | One unit at a time | A batch or lump change |
| Variables | Only variable cost/revenue changes | All costs/revenues affected by decision |
| Scope | Narrow — single variable | Broader — multiple variables |
| Typical use | Output pricing, factor employment | New product line, plant expansion |
| Example | Cost of one extra unit | Cost of opening a new branch |
Applications of Marginal Analysis
Where Marginal Analysis is Used
- Profit maximisation — produce until MR = MC.
- Cost minimisation — hire inputs until marginal product per rupee is equal across all inputs.
- Pricing — set price where marginal revenue equals marginal cost.
- Investment decisions — invest until marginal return equals marginal cost of capital.
- Government policy — set Pigouvian tax equal to marginal external cost.
- Labour hiring — hire workers until marginal revenue product equals wage.
Ten Principles of Economics (Mankiw)
Mankiw's Ten Principles
- 1. People face trade-offs — to get one thing, you must give up another.
- 2. The cost of something is what you give up to get it — opportunity cost.
- 3. Rational people think at the margin — decisions compare marginal benefit vs marginal cost.
- 4. People respond to incentives — behaviour changes when costs or benefits change.
- 5. Trade can make everyone better off — specialisation and exchange create gains.
- 6. Markets are usually a good way to organise economic activity — the invisible hand.
- 7. Governments can sometimes improve market outcomes — correct externalities and inequality.
- 8. A country's standard of living depends on its ability to produce — productivity matters.
- 9. Prices rise when the government prints too much money — inflation.
- 10. Society faces a short-run trade-off between inflation and unemployment — the Phillips curve.
Principles 1–4: How people make decisions. Principle 1 says every choice involves giving up something — for example, a student who chooses to study BBS gives up the salary they could have earned by working. Principle 2 introduces opportunity cost — the true cost of attending BBS is not only fees but also the foregone income. Principle 3 emphasises marginal thinking — a firm should produce one more unit only if marginal revenue exceeds marginal cost. Principle 4 explains incentives — when the Nepal government subsidised chemical fertilisers, farmers used more of them, boosting output.
- Principles 5–7: How people interact. Principle 5 — trade creates gains through specialisation: Nepal trades carpets and garments for machinery and electronics
- both sides gain. Principle 6 — markets coordinate activity through the price mechanism (Adam Smith's "invisible hand")
- prices signal scarcity and guide resources to their best use. Principle 7 — government can improve outcomes when markets fail (externalities, monopoly, inequality): e.g. Nepal's ban on plastic bags corrects a negative externality
- subsidies for rural electricity address unequal access.
- Principles 8–10: How the economy as a whole works. Principle 8 — productivity drives living standards
- Nepal's per-capita income is low partly because labour productivity in agriculture (which employs 60% of workers) is far below that of East Asian economies. Principle 9 — excessive money growth causes inflation
- when Nepal Rastra Bank expands money supply faster than output, prices rise (the post-COVID inflation spike). Principle 10 — short-run Phillips curve trade-off: expansionary policy can reduce unemployment temporarily but at the cost of higher inflation.
Nepal Example: Applying the Ten Principles
A farmer in Chitwan deciding whether to grow tomatoes or potatoes faces Principle 1 (trade-off) and Principle 2 (opportunity cost — the tomatoes given up). When she compares the extra income from one more ropani of tomatoes with the extra cost of seed and fertiliser, she uses Principle 3 (marginal thinking). When the government raises the subsidised fertiliser price, she uses less fertiliser — Principle 4 (incentives). She sells her produce at the Kalimati market, where buyers and sellers trade — Principle 5. The price she receives is set by supply and demand in that market — Principle 6.
Memory Aid
Group the Ten Principles into four categories: (1) How people make decisions — Principles 1–4; (2) How people interact — Principles 5–7; (3) How the economy as a whole works — Principles 8–10. This makes them much easier to remember.
Key Terms and Definitions / मुख्य शब्द र परिभाषा
- Microeconomics: The branch of economics that studies individual units — सूक्ष्मअर्थशास्त्र: अर्थतन्त्रका व्यक्तिगत एकाइको अध्ययन गर्ने अर्थशास्त्रको शाखा।
- Macroeconomics: Study of the economy as a whole — स्थूलअर्थशास्त्र: समग्र अर्थतन्त्रको अध्ययन।
- Business economics: Application of economic theory to business problems — व्यवसायिक अर्थशास्त्र: व्यावसायिक समस्यामा आर्थिक सिद्धान्तको प्रयोग।
- Scarcity: Limited resources vs unlimited wants — दुर्लभता: सीमित स्रोत बनाम असीमित आवश्यकता।
- Choice: Selecting one alternative over others — छनोट: एउटा विकल्प अन्यभन्दा रोज्नु।
- Opportunity cost: Value of the next-best alternative forgone — अवसर लागत: त्यागिएको अर्को उत्कृष्ट विकल्पको मूल्य।
- Production Possibility Curve (PPC): Locus of maximum output combinations of two goods — उत्पादन सम्भावना वक्र: दुई वस्तुका अधिकतम उत्पादन संयोजनको स्थान।
- Marginal analysis: Comparing marginal benefit and marginal cost — सीमान्त विश्लेषण: सीमान्त लाभ र सीमान्त लागत तुलना।
- Marginal utility: Extra satisfaction from one more unit — सीमान्त उपयोगिता: एक थप एकाइबाट थप सन्तुष्टि।
- Slicing method: Studying small individual units — स्लाइसिङ विधि: साना व्यक्तिगत एकाइ अध्ययन।
- Price theory: Another name for microeconomics — मूल्य सिद्धान्त: सूक्ष्मअर्थशास्त्रको अर्को नाम।
- Ceteris paribus: Other things remaining the same — अन्य कुरा समान: अन्य कुराहरू स्थिर रहने।
Practice Problem
An economy produces two goods: rice and cloth. Given the production possibilities below, calculate the opportunity cost of producing each additional unit of rice. | Option | Rice (qt) | Cloth (m) | | A | 0 | 100 | | B | 10 | 95 | | C | 20 | 85 | | D | 30 | 70 | | E | 40 | 50 | | F | 50 | 25 |
Practice Problem
A small Nepali village has 100 workers, each of whom can produce either 2 kg of tea per day OR 5 kg of rice per day. Draw the PPC for this village (max tea vs max rice) and answer: (a) what is the maximum tea it can produce? (b) what is the maximum rice? (c) what is the opportunity cost of 1 kg of tea in terms of rice? (d) what is the opportunity cost of 1 kg of rice in terms of tea?