Microeconomics
Economics — Grade 11 | Unit 2 | NEB Nepal
Table Of Contents
Introduction
Microeconomics is the branch of economics that examines how individual economic units — consumers, households, and firms — make decisions and how their interactions in markets determine prices and quantities. Unit 2 of NEB Grade 11 Economics covers four interconnected topics: demand and supply (including market equilibrium), elasticity, consumer behaviour (utility theory), and the theory of production. These are among the most analytically rich and examination-important topics in the entire Grade 11 course, and they form the foundation for understanding how markets work in Nepal and everywhere else.
1. Demand and Supply
1.1 Demand
Meaning of Demand
Demand is the quantity of a good or service that consumers are willing and able to purchase at various prices during a given period of time, all other factors remaining constant.
According to Alfred Marshall, “The demand for a thing is a schedule of the amounts of it that would be bought per unit of time at various prices.”
According to Paul A. Samuelson, “Effective demand means the desire for a commodity backed by the ability and willingness to pay for it.”
The word “effective” is critical — demand requires both the desire to buy and the ability to pay. A person who wants to buy a car but cannot afford one has no effective demand for cars.
The Law of Demand
According to Alfred Marshall, “The greater the amount to be sold, the smaller must be the price at which it is offered in order that it may find purchasers; or in other words, the amount demanded increases with a fall in price and diminishes with a rise in price.”
The law of demand states: other things being equal (ceteris paribus), when the price of a good rises, the quantity demanded falls; when the price falls, the quantity demanded rises. There is an inverse (negative) relationship between price and quantity demanded.
Reasons for the inverse relationship:
- Substitution effect: When a good’s price rises, it becomes relatively more expensive than substitutes — consumers switch to cheaper alternatives
- Income effect: A price rise reduces consumers’ real purchasing power — they can afford less of the good
- Law of Diminishing Marginal Utility: As more units are consumed, each additional unit gives less satisfaction — consumers are only willing to pay less for additional units
Demand Schedule and Demand Curve: A demand schedule is a table showing quantities demanded at different prices. When plotted on a graph (price on vertical axis, quantity on horizontal axis), it produces a downward-sloping demand curve.
Determinants of Demand (Factors Shifting the Demand Curve)
Changes in these factors shift the entire demand curve (not just a movement along it):
i. Income of consumers: As income rises, demand for normal goods increases; demand for inferior goods decreases.
ii. Prices of related goods:
- Substitute goods: If the price of tea rises, demand for coffee increases
- Complementary goods: If the price of vehicles rises, demand for petrol falls
iii. Tastes and preferences: Fashion, advertising, and changing preferences shift demand. Nepal’s growing preference for packaged food over traditional products reflects changing tastes.
iv. Population size and composition: A larger or younger population increases demand. Nepal’s urbanization is shifting demand patterns significantly.
v. Expectations: If consumers expect prices to rise in future, they buy more now.
vi. Government policies: Taxes, subsidies, and regulations affect demand.
1.2 Supply
Meaning of Supply
Supply is the quantity of a good or service that producers are willing and able to offer for sale at various prices during a given period, other things remaining constant.
According to Alfred Marshall, “The supply of a commodity is the schedule of amounts that would be offered for sale at various prices.”
The Law of Supply
The law of supply states: other things being equal, when the price of a good rises, the quantity supplied increases; when the price falls, the quantity supplied decreases. There is a direct (positive) relationship between price and quantity supplied.
Reason: Higher prices make production more profitable — existing firms expand output and new firms enter the market. Lower prices reduce profitability — firms contract output or exit.
Determinants of Supply (Factors Shifting the Supply Curve)
i. Cost of production: If input costs (wages, raw materials, energy) rise, supply decreases — the supply curve shifts left.
ii. Technology: Improvements in technology reduce production costs and increase supply. Nepal’s improved milling technology has increased rice supply.
iii. Prices of related goods: If the price of a substitute good in production rises, producers switch to producing that good, reducing supply of the original.
iv. Government policies: Taxes increase production costs (reduce supply); subsidies reduce costs (increase supply).
v. Natural factors: In Nepal, monsoon variability is a major determinant of agricultural supply — good rains increase supply; drought or flood reduces it.
vi. Number of producers: More producers in the market increases supply.
vii. Expectations of future prices: If producers expect prices to rise, they may withhold supply now.
1.3 Market Equilibrium
According to Alfred Marshall, “Equilibrium is the point at which the quantity demanded by buyers exactly equals the quantity supplied by sellers — at the equilibrium price, the market clears.”
According to Paul Samuelson, “The equilibrium price is the price that equates quantity demanded with quantity supplied — it is the price at which the market is in balance, with neither excess demand nor excess supply.”
At equilibrium:
- Quantity demanded = Quantity supplied
- The market clears — there is no unsatisfied demand or unsold surplus
- There is no tendency for price to change (unless an external factor shifts demand or supply)
Disequilibrium conditions:
Excess Demand (Shortage): When price is below equilibrium — quantity demanded exceeds quantity supplied. Buyers compete to obtain the limited supply, bidding price upward toward equilibrium.
Excess Supply (Surplus): When price is above equilibrium — quantity supplied exceeds quantity demanded. Sellers compete to dispose of surplus stock, cutting prices downward toward equilibrium.
Market equilibrium in Nepal: Nepal’s vegetable markets illustrate equilibrium dynamics clearly — in the off-season, when supply from hill farms is low, vegetable prices rise; at harvest time when supply increases, prices fall. The price mechanism continuously adjusts toward equilibrium.
2. Elasticity of Demand and Supply
2.1 Concept of Elasticity
According to Alfred Marshall, “The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price.”
Elasticity measures the responsiveness or sensitivity of one variable (quantity demanded or supplied) to a change in another variable (price, income, or price of related goods). It is expressed as a ratio — the percentage change in quantity divided by the percentage change in the determining variable.
2.2 Price Elasticity of Demand (PED)
Price elasticity of demand measures how sensitive the quantity demanded of a good is to a change in its own price.
Formula: PED = % Change in Quantity Demanded / % Change in Price
Types of Price Elasticity of Demand:
| Type | PED Value | Meaning | Example |
|---|---|---|---|
| Perfectly elastic | PED = ∞ | Any price rise → demand drops to zero | Hypothetical; near-perfect in some commodity markets |
| Elastic | PED > 1 | % change in Qd > % change in price | Luxury goods, tourism services |
| Unitary elastic | PED = 1 | % change in Qd = % change in price | Some manufactured goods |
| Inelastic | PED < 1 | % change in Qd < % change in price | Rice, salt, medicines |
| Perfectly inelastic | PED = 0 | Price change → no change in demand | Life-saving medicines (in short run) |
Factors Determining Price Elasticity of Demand:
i. Availability of substitutes: Goods with many close substitutes are more elastic — consumers switch easily when price rises. Example: one brand of bottled water vs. another. Goods with few substitutes are inelastic — necessities like kerosene in rural Nepal.
ii. Nature of the good: Necessities (rice, salt, medicines) tend to be inelastic — consumers must buy them regardless of price. Luxuries (tourism, jewellery) tend to be elastic.
iii. Proportion of income spent: Goods that absorb a large proportion of income (vehicles, houses) are more elastic — price changes have a large impact on affordability. Goods that absorb little income (salt, matches) are inelastic.
iv. Time period: Demand is more elastic in the long run — consumers have more time to adjust, find substitutes, or change habits. In the short run, demand is more inelastic.
v. Number of uses: Goods with many uses are more elastic — when price rises, the good is reserved for its most important uses and demand for less important uses drops.
2.3 Income Elasticity of Demand (YED)
Income elasticity measures the responsiveness of demand to a change in consumer income.
Formula: YED = % Change in Quantity Demanded / % Change in Income
- Positive YED (Normal goods): Demand rises with income
- YED > 1: Luxury goods — demand rises faster than income (holidays, cars)
- 0 < YED < 1: Necessities — demand rises slower than income (basic food)
- Negative YED (Inferior goods): Demand falls as income rises (low-quality rice, public transport)
2.4 Cross Elasticity of Demand (XED)
Cross elasticity measures the responsiveness of demand for one good to a change in the price of another good.
Formula: XED = % Change in Quantity Demanded of Good A / % Change in Price of Good B
- Positive XED: Substitute goods — when price of B rises, demand for A rises (tea and coffee)
- Negative XED: Complementary goods — when price of B rises, demand for A falls (vehicles and fuel)
- Zero XED: Unrelated goods — price of B has no effect on demand for A
2.5 Price Elasticity of Supply (PES)
According to Alfred Marshall, “The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good.”
Formula: PES = % Change in Quantity Supplied / % Change in Price
Factors Determining Price Elasticity of Supply:
i. Time period: Supply is most elastic in the long run — producers have time to build new capacity, hire more workers, and source more materials. In the very short run (market period), supply may be perfectly inelastic.
ii. Nature of the good: Agricultural goods are relatively inelastic in supply (production cycles cannot be changed quickly); manufactured goods are more elastic (production can be scaled more easily).
iii. Availability of raw materials and factors of production: If factors can be easily obtained, supply is more elastic.
iv. Spare capacity: Industries with spare production capacity can increase supply quickly (elastic); those operating at full capacity cannot (inelastic).
v. Mobility of factors: If labour and capital can be easily shifted between uses, supply is more elastic.
3. Consumer Behaviour
3.1 Utility: Meaning and Types
Utility is the satisfaction or pleasure that a consumer derives from consuming a good or service.
According to Jeremy Bentham, the founder of utilitarian philosophy, “Utility is that property in any object whereby it tends to produce benefit, advantage, pleasure, good, or happiness, or to prevent the happening of mischief, pain, evil, or unhappiness.”
According to Alfred Marshall, “Utility is the want-satisfying power of a commodity. The utility of a thing to a person is its power to satisfy one of his desires.”
Types of utility:
- Form utility: Created by changing the physical form of a good (cotton → cloth)
- Place utility: Created by moving goods to where they are needed (vegetables from Mustang to Kathmandu)
- Time utility: Created by storing goods until they are needed (stored grain during off-season)
- Possession utility: Created by transferring ownership (selling a house)
3.2 Cardinal Utility Analysis: Total Utility and Marginal Utility
The cardinal approach to consumer behaviour, developed by the classical economists, assumes that utility can be measured numerically — in units called “utils.”
Total Utility (TU): The total satisfaction obtained from consuming all units of a good over a given period.
Marginal Utility (MU): The additional satisfaction gained from consuming one more unit of a good.
Formula: MU = Change in TU / Change in Quantity = ΔTU / ΔQ
Relationship between TU and MU:
- When MU is positive, TU is rising
- When MU = 0, TU is at its maximum (point of satiety)
- When MU becomes negative (disutility), TU begins to fall
| Units consumed | Total Utility (TU) | Marginal Utility (MU) |
|---|---|---|
| 0 | 0 | — |
| 1 | 10 | 10 |
| 2 | 18 | 8 |
| 3 | 24 | 6 |
| 4 | 28 | 4 |
| 5 | 28 | 0 (satiety point) |
| 6 | 26 | -2 (disutility) |
3.3 Law of Diminishing Marginal Utility (Gossen’s First Law)
According to Alfred Marshall, “The additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has.”
According to H.H. Gossen, who first formulated this law, “The magnitude of one and the same pleasure diminishes continuously as we proceed to satisfy that pleasure without interruption until satisfaction is reached.”
Statement of the law: As a consumer consumes successive units of a commodity, the marginal utility derived from each additional unit goes on declining, provided the consumption of other goods remains constant and there is no change in the consumer’s tastes and preferences.
Assumptions of the law:
- Cardinal measurement of utility is possible
- Continuous consumption of the commodity
- No change in consumer’s tastes and preferences
- Each unit consumed is of the same quality and size
- Sufficient time period so that the law can operate
Limitations of the law:
- Does not apply to rare collectibles, knowledge, or hobbies (the more you have, the more you want)
- Does not apply to addictive goods (alcohol, tobacco) in some cases
- Assumes homogeneous units — may not hold if units differ in quality
Applications in Nepal: The law explains why Nepal’s vegetable sellers lower prices as the day progresses — the marginal utility to buyers of additional vegetables diminishes; sellers must offer lower prices to attract buyers for the remaining stock.
3.4 Law of Substitution (Gossen’s Second Law / Law of Equi-Marginal Utility)
According to Alfred Marshall, “If a person has a thing which he can put to several uses, he will distribute it among these uses in such a way that it has the same marginal utility in all. For if it had a greater marginal utility in one use than another, he would gain by taking away some of it from the second use and applying it to the first.”
Statement of the law: A consumer maximizes utility when they allocate their income among different goods so that the marginal utility per rupee spent is equal for all goods purchased.
Condition for consumer equilibrium:
MUx/Px = MUy/Py = MUz/Pz = … = MU of money (λ)
Where MUx is the marginal utility of good X and Px is its price.
Explanation: If the marginal utility per rupee of good X exceeds that of good Y, the consumer can increase total utility by spending more on X and less on Y — until the ratios are equalized.
Example in Nepal: A student with limited pocket money deciding how to allocate between food, transport, and stationery will unconsciously equalize the marginal utility per rupee across these expenditures. If the last rupee spent on food gives more satisfaction than the last rupee on transport, they will spend more on food and less on transport until the marginal utility ratios equalize.
3.5 Consumer’s Surplus
According to Alfred Marshall, who introduced the concept, “The excess of the price which a consumer would be willing to pay rather than go without the thing, over that which he actually does pay, is the economic measure of this surplus satisfaction. It may be called Consumer’s Surplus.”
Consumer’s Surplus = Maximum price willing to pay − Actual market price paid
Example: If a student is willing to pay Rs. 50 for a pen but the market price is Rs. 30, the consumer’s surplus is Rs. 20 — the “bargain” the student enjoys.
Applications: Consumer’s surplus is used to evaluate the welfare effects of price changes and taxes. When a government imposes a tax that raises the price of essential goods (kerosene, flour), it reduces consumer’s surplus — this is part of the welfare cost of the tax.
3.6 Producer’s Surplus
According to Alfred Marshall, “Producer’s surplus is the gain which the producer makes over and above the minimum amount at which he would be willing to supply the good. It is the difference between the actual price received and the minimum price the producer would have accepted.”
Producer’s Surplus = Actual market price received − Minimum price willing to accept (supply price)
Total Surplus = Consumer’s Surplus + Producer’s Surplus
Total surplus measures the total economic welfare generated by a market transaction — the combined benefit to buyers and sellers from trading. Markets in competitive equilibrium maximize total surplus.
4. Theory of Production
4.1 Production and Production Function
Production is the process of transforming inputs (factors of production — land, labour, capital, entrepreneurship) into outputs (goods and services).
According to Alfred Marshall, “Production is any activity that creates utility — it is not merely the physical transformation of matter, but any activity that increases the want-satisfying power of goods and services.”
The Production Function describes the mathematical relationship between the quantity of inputs used and the maximum quantity of output that can be produced with given technology.
According to Paul Samuelson, “The production function is a technical relationship that shows the maximum output attainable from any given combination of inputs, for a given state of technology.”
Expressed mathematically: Q = f(L, K, N, E)
Where Q = output, L = labour, K = capital, N = land, E = entrepreneurship
Short Run vs. Long Run:
- Short Run: The period during which at least one factor of production is fixed (cannot be changed). In the short run, a firm can change variable inputs (labour) but not fixed inputs (plant size, capital equipment).
- Long Run: The period during which all factors of production can be varied. In the long run, the firm can change its entire scale of operations — plant size, capital, and labour are all variable.
4.2 Total Product, Average Product, and Marginal Product
These three product concepts describe output as a variable input (typically labour) is added to fixed inputs (capital, land) in the short run.
Total Product (TP): The total output produced when a given quantity of the variable input is combined with fixed inputs.
Average Product (AP): Output per unit of the variable input. Formula: AP = TP / L (where L = units of labour)
Marginal Product (MP): The additional output produced by employing one more unit of the variable input. Formula: MP = ΔTP / ΔL
Relationship between TP, AP, and MP:
- When MP > AP, AP is rising
- When MP = AP, AP is at its maximum
- When MP < AP, AP is falling
- When MP = 0, TP is at its maximum
- When MP becomes negative, TP falls
| Labour (L) | Total Product (TP) | Average Product (AP) | Marginal Product (MP) |
|---|---|---|---|
| 0 | 0 | — | — |
| 1 | 10 | 10 | 10 |
| 2 | 22 | 11 | 12 |
| 3 | 30 | 10 | 8 |
| 4 | 36 | 9 | 6 |
| 5 | 40 | 8 | 4 |
| 6 | 40 | 6.7 | 0 |
| 7 | 38 | 5.4 | -2 |
4.3 Law of Variable Proportions (Law of Diminishing Returns)
According to Alfred Marshall, “An increase in the capital and labour applied in the cultivation of land causes in general a less than proportionate increase in the amount of produce raised, unless it happens to coincide with an improvement in the arts of agriculture.”
According to Paul Samuelson, “The law of diminishing returns states that as we increase the quantity of one input, with all other inputs held constant, the marginal product of the variable input will eventually decline.”
Statement of the law: As successive units of a variable factor (labour) are added to a fixed factor (land or capital), the marginal product of the variable factor first increases, then reaches a maximum, and eventually decreases — assuming technology remains constant.
Three stages of the law:
Stage I (Increasing Returns): MP is rising; TP increases at an increasing rate. This occurs because the fixed factor is underutilized — adding variable inputs increases efficiency. Firms should not stop in Stage I.
Stage II (Diminishing Returns): MP is declining but positive; TP continues to rise but at a decreasing rate. This is the economically relevant stage — rational producers operate here.
Stage III (Negative Returns): MP becomes negative; TP falls. The variable factor has been over-applied relative to the fixed factor — adding more labour actually reduces output. No rational firm operates in Stage III.
Assumptions of the law:
- At least one factor remains fixed (short run)
- Technology remains constant
- Variable factor units are homogeneous (of equal quality)
Application in Nepal: Nepal’s agricultural sector vividly demonstrates the law of variable proportions. Nepal’s hill farms — where land is the fixed factor — exhibit diminishing returns to labour: as more family members work the same terraced field, each additional worker adds progressively less to the harvest.
4.4 Law of Returns to Scale
According to Paul Samuelson, “Returns to scale refers to the changes in output when all inputs are changed in the same proportion in the long run.”
The law of returns to scale applies in the long run — when all factors can be varied simultaneously. It examines what happens to output when all inputs are increased by the same proportion.
Three types of returns to scale:
i. Increasing Returns to Scale (IRS): Output increases by a greater proportion than the increase in inputs.
- Example: Doubling all inputs more than doubles output
- Causes: Specialization, indivisibilities, economies of scale
- According to Adam Smith, increasing returns arise from specialization and division of labour — as scale increases, workers specialize in narrower tasks and become more efficient.
ii. Constant Returns to Scale (CRS): Output increases by exactly the same proportion as the increase in inputs.
- Example: Doubling all inputs exactly doubles output
- Occurs when economies of scale are exhausted but diseconomies have not yet set in
iii. Decreasing Returns to Scale (DRS): Output increases by a smaller proportion than the increase in inputs.
- Example: Doubling all inputs less than doubles output
- Causes: Managerial inefficiency, coordination problems, input scarcity at larger scales
- According to Alfred Marshall, decreasing returns to scale in large organizations arise from the difficulty of coordinating increasingly complex operations.
Comparison: Law of Variable Proportions vs. Law of Returns to Scale
| Basis | Law of Variable Proportions | Law of Returns to Scale |
|---|---|---|
| Time period | Short run | Long run |
| Inputs changed | One variable input | All inputs simultaneously |
| Other inputs | Fixed | All variable |
| Direction | One input varies; others fixed | All inputs increase proportionally |
| Result | Three stages (increasing, diminishing, negative returns) | Three types (IRS, CRS, DRS) |
5. Microeconomics in the Nepali Context
i. Demand and Supply in Nepal’s Markets: Nepal’s markets exhibit all the features analysed in this unit. Agricultural produce markets show strong seasonal supply fluctuations. The Kathmandu real estate market demonstrates inelastic demand (limited substitutes for urban land) and restricted supply (geographic constraints). The tourism market shows highly elastic demand in response to safety concerns and income levels of source markets.
ii. Price Elasticity and Government Policy: Nepal’s government regularly adjusts taxes and subsidies on essential goods — kerosene, LPG, fertilizers. The effectiveness of these policies depends on price elasticity of demand: if demand for subsidized goods is inelastic, subsidies transfer income to consumers; if elastic, price reductions significantly boost consumption.
iii. Consumer Behaviour in Nepal: Nepal’s rapidly urbanizing middle class shows patterns consistent with normal good theory — as income rises, demand for processed food, private transport, and education increases. Remittance income has been a major driver of rising consumer demand across Nepal’s hill and mountain districts.
iv. Agricultural Production: The law of variable proportions is directly visible in Nepal’s hill agriculture — fragmented smallholdings with inadequate capital investment result in diminishing returns to labour. Agricultural productivity improvement requires addressing the fixed-factor constraint — through better seeds, irrigation, mechanization, and land consolidation.
v. Industrial Scale: Nepal’s small manufacturing sector — carpet and garment factories in Kathmandu Valley, cement plants in the Terai — is beginning to experience economies of scale as it grows. Understanding returns to scale is essential for Nepal’s industrial policy — determining which industries benefit from consolidation and scale versus which function better at small scale.
Conclusion
Microeconomics provides the analytical tools for understanding how individual economic decisions produce market outcomes — how the interaction of millions of consumers and producers, each pursuing their own interests, generates the prices, quantities, and welfare outcomes observed in Nepal’s diverse markets. The law of demand, the concept of elasticity, utility theory, and the theory of production are not abstract academic constructs — they describe the real forces that determine why a dal bhat meal costs what it costs in Thamel, why apple prices in Kathmandu’s markets vary seasonally, and why Nepal’s hill farmers struggle to increase output despite working harder.
As Alfred Marshall observed, “Economics is a study of men as they live and move and think in the ordinary business of life.” The microeconomic tools in this unit bring that study to the level of individual decisions — the most fundamental level at which economic life is actually lived.
Prepared for NEB Grade 11 Economics — Unit 2: Microeconomics Aligned with the National Curriculum Framework 2076, Curriculum Development Centre, Sanothimi, Bhaktapur
