Microeconomics
Economics — Grade 12 | Unit 2 | NEB Nepal
Table Of Contents
Introduction
Unit 2 of NEB Grade 12 Economics is the most analytically demanding unit in the course — covering market structures, revenue analysis, cost theory, price and output determination, and factor pricing. Building directly on the demand and supply analysis of Grade 11, it examines how firms and markets actually work: how different market structures (perfect competition, monopoly, monopolistic competition, and oligopoly) generate different prices and output levels, how costs behave as output changes, how firms determine their profit-maximizing output, and how the prices of factors of production (wages, rent, interest, profit) are determined. These concepts are the analytical foundation of modern microeconomics.
1. Market Structures
1.1 Concept of Market
A market is any arrangement — a physical place, a network, or a digital platform — through which buyers and sellers interact to exchange goods and services and determine prices.
According to Alfred Marshall, “A market is not a place but a region in which buyers and sellers are in such close communication with one another that the prices of the same goods tend to equality easily and quickly.”
According to Paul A. Samuelson, “A market is a mechanism by which buyers and sellers interact to determine prices and exchange goods and services.”
Markets are classified by the degree of competition — the number of buyers and sellers, the nature of the product, the ease of entry and exit, and the degree of information available to participants.
1.2 Perfect Competition
According to Alfred Marshall, “Perfect competition is a market structure in which there are many buyers and many sellers of a homogeneous product, perfect information, and free entry and exit — so that no single buyer or seller can influence the market price.”
According to E.H. Chamberlin, “Perfect competition is an ideal market structure in which conditions are such that the price of a commodity is determined by the forces of aggregate demand and aggregate supply — no individual buyer or seller having the power to influence price.”
Characteristics of perfect competition:
i. Large number of buyers and sellers: Each is so small relative to the market that none can individually influence the market price — all are price-takers.
ii. Homogeneous (identical) product: All sellers offer exactly the same product — buyers have no preference for one seller over another.
iii. Perfect information: All buyers and sellers have complete knowledge of prices, quality, and market conditions — no information advantage exists.
iv. Free entry and exit: Firms can enter and leave the industry without restriction or cost — no barriers to competition.
v. Perfect mobility of factors: Labour, capital, and other inputs can move freely between industries and locations — ensuring factor prices equalize across uses.
vi. No transportation costs: All buyers face identical prices regardless of location (a simplifying assumption).
Examples in Nepal: While no market is perfectly competitive in theory, Nepal’s agricultural markets — particularly for standardized commodities like rice, maize, and vegetables in wholesale markets — come closest to competitive conditions, with many small sellers offering similar products.
1.3 Imperfect Competition
Most real-world markets are imperfectly competitive — one or more of the conditions of perfect competition are violated. The NEB syllabus identifies three major forms of imperfect competition:
i. Monopoly
According to Paul A. Samuelson, “A monopoly is a market structure in which there is a single seller of a product with no close substitutes, and in which entry of new firms is blocked.”
According to Joan Robinson, “A monopoly is a firm which is the sole producer of a commodity for which there is no close substitute.”
Characteristics of monopoly:
- Single seller controls the entire market supply
- No close substitutes — the monopolist’s product is unique in its category
- Barriers to entry prevent competitors from entering (legal patents, economies of scale, resource control, government licence)
- The monopolist is a price-maker — sets price by choosing output level
- Demand curve facing the monopolist is the entire market demand curve (downward-sloping)
Sources of monopoly power:
- Legal monopoly: Government grants exclusive rights — Nepal Electricity Authority (NEA) historically had a legal monopoly on power distribution
- Natural monopoly: Economies of scale so large that one firm can supply the entire market at lower cost than multiple firms — utility networks (water, electricity transmission) are natural monopolies
- Resource monopoly: Control of an essential input — De Beers’ historical control of diamond mining
- Patent and copyright: Temporary legal protection for innovation
ii. Monopolistic Competition
According to E.H. Chamberlin, who developed the theory of monopolistic competition in his 1933 work The Theory of Monopolistic Competition, “Monopolistic competition is a market structure with many sellers, but each selling a differentiated product — each firm has a degree of monopoly power over its own product while facing competition from many close substitutes.”
According to Joan Robinson, who independently developed similar analysis, “Under monopolistic competition, each firm faces a downward-sloping demand curve for its particular variety of the product — but close substitutes exist, limiting the degree of monopoly power.”
Characteristics of monopolistic competition:
- Many sellers (like perfect competition)
- Differentiated products — similar but not identical (different brands, styles, qualities)
- Some degree of price-setting power due to product differentiation
- Free entry and exit in the long run
- Non-price competition (advertising, branding, quality improvement)
Examples in Nepal: Restaurants in Kathmandu (each offering a different menu and ambiance but competing for the same customers), clothing retailers, beauty salons, stationery shops — all exhibit monopolistic competition.
iii. Oligopoly
According to Paul A. Samuelson, “Oligopoly is a market structure in which a small number of firms produce the bulk of an industry’s output — few enough that the actions of each firm significantly affect the others and trigger reactions.”
According to William J. Baumol, “Oligopoly is a market characterized by mutual interdependence among firms — each firm must take into account the reactions of rivals when setting price or output.”
Characteristics of oligopoly:
- Few dominant sellers (typically 2–10 firms) controlling most of the market
- Products may be homogeneous (steel, cement) or differentiated (automobiles, mobile phones)
- High barriers to entry — economies of scale, capital requirements, brand loyalty
- Mutual interdependence: Each firm’s decisions affect rivals and triggers reactions — strategic behaviour is central
- Price rigidity — firms are reluctant to change prices because rivals will match price cuts but not price rises (kinked demand curve)
- Non-price competition — advertising, quality, service
Examples in Nepal: Nepal’s cement industry (dominated by a few large producers: Sarbottam, Shivam, Hongshi Shivam), the telecommunications market (Nepal Telecom and Ncell), and the commercial banking sector (a handful of large banks dominate).
1.4 Comparison of Market Structures
| Feature | Perfect Competition | Monopolistic Competition | Oligopoly | Monopoly |
|---|---|---|---|---|
| Number of sellers | Many | Many | Few | One |
| Product | Homogeneous | Differentiated | Homo. or diff. | Unique, no substitute |
| Entry/exit | Free | Free | Barriers | Blocked |
| Price control | None (price-taker) | Limited | Some | Full (price-maker) |
| Demand curve | Horizontal (perfectly elastic) | Downward-sloping (elastic) | Kinked | Downward-sloping |
| Examples | Agricultural wholesale | Restaurants, clothing | Cement, telecom | NEA (historically) |
2. Revenue Concepts
2.1 Total Revenue, Average Revenue, and Marginal Revenue
Revenue is the income a firm earns from selling its output.
Total Revenue (TR): The total amount received from selling a given quantity of output. Formula: TR = P × Q (Price × Quantity sold)
Average Revenue (AR): Revenue per unit sold. Formula: AR = TR / Q = P Note: Average revenue equals the price charged per unit. The AR curve is therefore identical to the demand curve facing the firm.
Marginal Revenue (MR): The additional revenue earned from selling one more unit of output. Formula: MR = ΔTR / ΔQ = dTR/dQ
According to Alfred Marshall, “Marginal revenue is the net revenue obtained by selling one additional unit — it is the change in total revenue resulting from a unit change in quantity sold.”
2.2 Revenue Curves Under Perfect Competition
Under perfect competition, the firm is a price-taker — it can sell any quantity at the market price P, but has no power to raise or lower that price.
TR under perfect competition: TR = P × Q — a straight line through the origin with slope = P (constant price). TR increases linearly with output.
AR under perfect competition: AR = P — a horizontal straight line at the market price. The AR curve is perfectly elastic (horizontal) — the firm can sell any quantity at price P, but nothing above P (buyers would go elsewhere).
MR under perfect competition: MR = P = AR — the additional revenue from each extra unit equals the constant market price. The MR curve coincides with the AR curve (both are the same horizontal line at price P).
Summary under perfect competition: AR = MR = P (constant, horizontal)
Numerical example: If market price P = Rs. 50:
| Q | TR = P×Q | AR = TR/Q | MR = ΔTR/ΔQ |
|---|---|---|---|
| 1 | 50 | 50 | 50 |
| 2 | 100 | 50 | 50 |
| 3 | 150 | 50 | 50 |
| 4 | 200 | 50 | 50 |
2.3 Revenue Curves Under Monopoly
Under monopoly, the firm faces the entire market demand curve — which is downward-sloping. To sell more units, the monopolist must lower the price on all units sold.
TR under monopoly: TR first rises (as quantity increases outweighs price falls), reaches a maximum, then falls (price falls outweigh quantity increases). TR is an inverted U-shaped curve.
AR under monopoly: AR = P — follows the downward-sloping demand curve. As more is sold, the price (and hence AR) falls.
MR under monopoly: MR falls faster than AR. When the demand curve is a straight line, the MR curve has the same price-axis intercept and twice the slope of the AR (demand) curve — it falls twice as fast.
Key relationship: MR = AR + Q(dAR/dQ). Since demand is downward-sloping (dAR/dQ < 0), MR < AR at all positive output levels.
Summary under monopoly: MR < AR (MR lies below the AR/demand curve at all positive quantities)
Numerical example: If demand is P = 100 − 10Q:
| Q | P (AR) | TR = P×Q | MR = ΔTR/ΔQ |
|---|---|---|---|
| 1 | 90 | 90 | 90 |
| 2 | 80 | 160 | 70 |
| 3 | 70 | 210 | 50 |
| 4 | 60 | 240 | 30 |
| 5 | 50 | 250 | 10 |
| 6 | 40 | 240 | −10 |
Note: TR is maximized at Q=5 where MR=0. Beyond Q=5, MR is negative and TR falls.
3. Cost Concepts and Cost Curves
3.1 Types of Costs
According to Alfred Marshall, “The costs of production of a commodity may be classed as the expenses which a manufacturer has to pay for the factors of production he employs.”
Explicit Costs (Accounting Costs): Direct monetary payments made to factors of production — wages paid to workers, rent paid for premises, interest on loans, payments for raw materials. These appear in the firm’s financial accounts.
Implicit Costs (Opportunity Costs): The opportunity cost of using resources owned by the firm itself — the owner’s time (foregone salary), capital invested in the firm (foregone interest or alternative investment return), and owned premises (foregone rental income).
Economic Cost = Explicit Costs + Implicit Costs
According to Paul Samuelson, “Economic cost includes both the explicit costs that appear in accounting statements and the implicit opportunity costs of resources owned and used by the firm.”
Fixed Costs (FC): Costs that do not change with output in the short run — rent, loan repayments, management salaries, insurance. Fixed costs are incurred even if output is zero.
Variable Costs (VC): Costs that change directly with output — raw materials, direct labour, fuel. Variable costs are zero when output is zero and rise as output increases.
Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC)
3.2 Short-Run Cost Curves
Total Fixed Cost (TFC): A horizontal straight line — constant at all output levels. Example: a Kathmandu restaurant’s monthly rent of Rs. 50,000 does not change whether it serves 50 or 500 customers.
Total Variable Cost (TVC): Rises from zero as output increases. Initially rises at a decreasing rate (as the law of increasing returns operates), then rises at an increasing rate (as diminishing returns set in). TVC is an S-shaped (sigmoid) curve.
Total Cost (TC): TC = TFC + TVC. TC has the same shape as TVC — an S-shaped curve shifted upward by the amount of TFC.
Average Fixed Cost (AFC): AFC = TFC / Q — continuously falls as output increases (fixed cost spread over more units). AFC approaches zero but never reaches it — a rectangular hyperbola.
Average Variable Cost (AVC): AVC = TVC / Q — falls initially (as productivity improves with scale), reaches a minimum, then rises (as diminishing returns increase variable cost per unit). U-shaped curve.
Average Total Cost (ATC or AC): ATC = TC / Q = AFC + AVC — U-shaped, but reaches its minimum at a higher output level than AVC (because AFC continues to fall as AVC rises, pulling ATC down longer).
Marginal Cost (MC): MC = ΔTC / ΔQ = dTC/dQ — the additional cost of producing one more unit. MC falls initially (increasing returns) and then rises (diminishing returns). MC intersects both AVC and ATC at their minimum points.
According to Alfred Marshall, “The marginal cost is the addition to total cost caused by producing one more unit of output. It is the most important cost concept for production decisions — a rational firm produces up to the point where marginal cost equals marginal revenue.”
Key relationships among cost curves:
- When MC < AVC, AVC is falling
- When MC = AVC, AVC is at its minimum
- When MC > AVC, AVC is rising
- The same relationship holds between MC and ATC
- AFC falls throughout — it never rises
- ATC = AVC + AFC at every output level
Numerical example:
| Q | TFC | TVC | TC | AFC | AVC | ATC | MC |
|---|---|---|---|---|---|---|---|
| 0 | 100 | 0 | 100 | — | — | — | — |
| 1 | 100 | 60 | 160 | 100 | 60 | 160 | 60 |
| 2 | 100 | 100 | 200 | 50 | 50 | 100 | 40 |
| 3 | 100 | 130 | 230 | 33 | 43 | 77 | 30 |
| 4 | 100 | 170 | 270 | 25 | 43 | 68 | 40 |
| 5 | 100 | 230 | 330 | 20 | 46 | 66 | 60 |
| 6 | 100 | 320 | 420 | 17 | 53 | 70 | 90 |
4. Theory of Price and Output Determination
4.1 The Profit Maximization Condition
According to Alfred Marshall, “A firm maximizes profit by producing the output at which marginal revenue equals marginal cost — provided the MC curve is rising (cutting MR from below) at that point.”
The universal profit-maximization rule: MR = MC
Intuition: If MR > MC, producing one more unit adds more to revenue than to cost — profit rises by increasing output. If MR < MC, producing one more unit costs more than it earns — profit rises by reducing output. At MR = MC, no change in output can increase profit.
4.2 Equilibrium Under Perfect Competition
Characteristics of the perfectly competitive firm:
- Price-taker: P = AR = MR (horizontal demand/revenue curve)
- Many identical firms producing the same product
- Free entry and exit determines long-run equilibrium
Short-Run Equilibrium (SR):
The firm maximizes profit where MR = MC. Since MR = P (price-taker), the condition becomes: P = MC.
At this output, the firm may earn:
- Supernormal (abnormal) profit: AR > ATC — price exceeds average total cost
- Normal profit: AR = ATC — price equals average total cost (zero economic profit)
- Loss: AR < ATC — price below average total cost
According to Alfred Marshall, “In the short run, a firm will continue to produce as long as price covers average variable cost — it can withstand losses up to the amount of fixed costs. If price falls below AVC, the firm shuts down because it cannot cover even its variable costs.”
Shut-down condition: P < AVC (short run)
Long-Run Equilibrium (LR):
In the long run, entry and exit eliminate abnormal profits and losses:
- If firms earn supernormal profit → new firms enter → supply increases → price falls → profit falls to normal
- If firms make losses → firms exit → supply decreases → price rises → losses eliminated
Long-run equilibrium condition: P = MR = MC = AR = ATC (minimum)
At long-run equilibrium:
- All firms earn only normal profit (zero economic profit)
- Price equals minimum average total cost — production is at maximum efficiency
- Consumer pays the lowest possible price — resources are allocated optimally
According to Joan Robinson, “Perfect competition produces the socially optimal allocation of resources in long-run equilibrium — price equals marginal cost (allocative efficiency) and output is at minimum average cost (productive efficiency).”
4.3 Equilibrium Under Monopoly
A monopoly faces a downward-sloping demand (AR) curve and an MR curve that lies below it. The monopolist is a price-maker — it chooses output to maximize profit and sets the price from the demand curve.
Profit-maximization under monopoly: Produce where MR = MC.
Steps to find monopoly equilibrium:
- Derive MR from TR (or from the demand function)
- Derive MC from TC
- Set MR = MC to find profit-maximizing output Q*
- Read the price P* from the demand (AR) curve at Q*
- Calculate profit: π = (AR − ATC) × Q*
Key features of monopoly equilibrium:
- Price (P) > Marginal Cost (MC) — allocative inefficiency (price exceeds the social cost of production)
- Price (P) > Minimum ATC is possible in the long run (barriers to entry prevent price from being competed down)
- Output is lower and price is higher than under perfect competition — the “deadweight welfare loss” of monopoly
- The monopolist can sustain supernormal profits in the long run (barriers to entry)
According to Paul Samuelson, “Monopoly misallocates resources — it restricts output below the socially efficient level and charges a price above marginal cost. The difference between the competitive and monopoly outcomes represents a deadweight welfare loss to society.”
Numerical example: Given demand P = 200 − 8Q and TC = 100 + 12Q²:
- TR = P × Q = (200 − 8Q)Q = 200Q − 8Q²
- MR = dTR/dQ = 200 − 16Q
- MC = dTC/dQ = 24Q
At MR = MC: 200 − 16Q = 24Q → 40Q = 200 → Q = 5* Price: P* = 200 − 8(5) = 200 − 40 = Rs. 160 TC = 100 + 12(25) = 100 + 300 = Rs. 400 TR = 160 × 5 = Rs. 800 Profit = TR − TC = 800 − 400 = Rs. 400
5. Factor Pricing
5.1 Concept of Factor Pricing
Factor pricing refers to the determination of the payments (rewards) made to factors of production — wages for labour, rent for land, interest for capital, and profit for entrepreneurship.
According to Alfred Marshall, “The theory of distribution is the theory of factor pricing — it explains how the national dividend is distributed among the factors of production that cooperate in creating it.”
According to Paul Samuelson, “Factor prices — wages, rent, interest, and profit — are determined in factor markets by the interaction of demand for and supply of each factor. The demand for a factor is a derived demand — it derives from the demand for the output the factor helps produce.”
5.2 Rent: Ricardian Theory
According to David Ricardo, the classical economist who first systematically analyzed rent: “Rent is that portion of the produce of the earth which is paid to the landlord for the use of the original and indestructible powers of the soil.”
Ricardo’s theory of rent rests on two observations:
- Land varies in fertility — some land is more productive than other land
- Land is fixed in total supply — more cannot be created when demand rises
Ricardian Rent arises because different pieces of land differ in productivity. When population and demand grow, progressively less fertile (marginal) land is brought into cultivation. The rent on superior land equals the surplus productivity over the marginal (no-rent) land.
According to Ricardo: “Rent is not the cause of high agricultural prices but the effect — high prices bring inferior land into cultivation, and the surplus of superior land over the margin of cultivation is captured as rent.”
Modern concept of economic rent: According to Alfred Marshall, economic rent is the surplus earned by any factor of production above its transfer earnings (the minimum amount needed to keep it in its current use). Marshall extended Ricardo’s analysis from land to all factors — any factor earning more than its next-best alternative earns “rent” in the economic sense.
Quasi-rent: Marshall introduced the concept of quasi-rent — the short-run surplus earned by fixed factors (machinery, specialized skills) — which disappears in the long run as supply adjusts.
5.3 Wages: Theories of Wages
Wages are the payment for labour — either money wages (nominal) or real wages (purchasing power of money wages).
Real Wages = Money Wages / Price Level
i. Subsistence Theory of Wages (Iron Law of Wages)
According to David Ricardo and Thomas Robert Malthus, wages in the long run tend toward the subsistence level — the minimum required to keep workers alive and reproducing. If wages rise above subsistence, workers have more children; the growing labour supply drives wages back down to subsistence.
Criticism: Wages in industrialized economies have risen far above subsistence — the theory was too pessimistic about the prospects for worker welfare.
ii. Wage Fund Theory
According to John Stuart Mill, “Wages depend on the proportion between the number of the labouring population and the capital or other funds devoted to the purchase of labour.” The total wage fund is fixed in the short run — the average wage is simply the wage fund divided by the number of workers.
Criticism: The wage fund is not independently fixed — it depends on prices, output, and profit expectations. Mill himself later acknowledged the theory’s limitations.
iii. Marginal Productivity Theory of Wages
According to Alfred Marshall, “Wages tend to equal the marginal product of labour — the addition to total output attributable to the last worker employed.” Employers hire workers up to the point where the value of the marginal product (VMP) equals the wage.
Formula: Wage = Value of Marginal Product of Labour (VMPL) = MPL × P
This is the modern standard theory of wage determination — integrated into the supply and demand analysis of the labour market.
5.4 Interest: Classical Theory
Interest is the payment for the use of capital — the reward for postponing consumption and providing funds for investment.
According to Alfred Marshall, “Interest is the price paid for the use of capital in any market. It is determined by the demand for and supply of capital.”
According to Irving Fisher, “Interest is the premium that borrowers must pay to lenders for the use of money — it compensates lenders for three things: the preference for present over future consumption (time preference), the risk of non-repayment, and the loss of purchasing power from inflation.”
Classical (Real) Theory of Interest (Marshall-Loanable Funds):
- Demand for capital comes from investors who borrow to finance productive investment — investment falls as interest rate rises
- Supply of capital comes from savers who lend their surplus income — saving rises as interest rate rises
- Equilibrium interest rate is determined where demand for (investment) equals supply of (saving) loanable funds
5.5 Profit: Theories of Profit
Profit is the residual income remaining after all other factors (land, labour, capital) have been paid their contractual rewards — the reward to the entrepreneur.
i. Risk-Bearing Theory of Profit
According to F.B. Hawley, “Profit is the reward for risk-bearing — entrepreneurs earn profit as compensation for the risk they accept in organizing production. The greater the risk, the higher the profit expected.”
ii. Uncertainty-Bearing Theory of Profit
According to Frank H. Knight, in his foundational work Risk, Uncertainty and Profit (1921), “Profit is the reward for bearing genuine uncertainty — not calculable risk (which can be insured against) but true uncertainty, where outcomes cannot be predicted with any probability. The entrepreneur who makes correct judgments under genuine uncertainty earns profit; those who make wrong judgments bear losses.”
Knight’s distinction between risk and uncertainty is fundamental: insurable risk can be hedged (fire insurance, motor insurance); genuine uncertainty cannot be insured and is the source of economic profit.
iii. Innovation Theory of Profit
According to Joseph Schumpeter, “Profit is the reward for innovation — the successful introduction of new products, new production methods, new markets, or new organizational forms. Innovation generates temporary monopoly profits that are eventually competed away as imitators enter — at which point the innovative entrepreneur must innovate again to maintain profitability.”
6. Microeconomics in the Nepali Context
i. Market structures in Nepal: Nepal’s markets exhibit all four structural types. Agricultural wholesale markets approximate perfect competition; urban retail food, clothing, and services exhibit monopolistic competition; cement, telecom, banking, and airlines exhibit oligopoly; and NEA historically operated as a legal monopoly in electricity distribution and transmission.
ii. Monopoly and NEA: Nepal Electricity Authority’s historical monopoly over electricity distribution resulted in high prices, poor service quality, and chronic under-investment — classic monopoly outcomes predicted by theory. The government’s gradual opening of generation to private independent power producers (IPPs) and the unbundling of generation from distribution are policy responses to the efficiency costs of monopoly.
iii. Cost structure of Nepali enterprises: Nepal’s manufacturing firms face high fixed costs relative to output — expensive imported machinery, rented premises, and management overheads — combined with low capacity utilization. This creates high average costs that make Nepali products uncompetitive against Indian and Chinese imports.
iv. Factor pricing in Nepal: Wages in Nepal’s formal sector are regulated by the Labour Act, 2074 BS (minimum wage: Rs. 17,300/month in 2024). Real wages vary significantly between formal and informal sectors, between skilled and unskilled workers, and between Kathmandu and remote areas. Land rents in Kathmandu have risen dramatically with urbanization. Interest rates set by Nepal Rastra Bank affect investment and the cost of capital across the economy.
v. Profit and entrepreneurship: Nepal’s entrepreneurial environment is constrained by regulatory complexity, limited access to finance, inadequate infrastructure, and small market size — factors that reduce the expected profit from innovation and investment. Addressing these constraints is central to Nepal’s economic development agenda.
Conclusion
Unit 2 provides the analytical tools for understanding how markets actually work — how prices are determined, how costs behave, how firms maximize profits, and how factor incomes are generated. These are not abstract theoretical exercises — they describe the real forces that determine the price of a mobile phone plan in Nepal, the wages paid to a factory worker in Birgunj, the rent charged for a shop in New Road, and the profit earned by a successful Nepali entrepreneur.
As Alfred Marshall observed, “The forces of supply and demand are merely the surface expression of much deeper forces — the forces of human wants, human effort, and the technical conditions of production that together determine economic outcomes.” Microeconomics gives us the tools to analyze these deeper forces with precision and insight.
Prepared for NEB Grade 12 Economics — Unit 2: Microeconomics Aligned with the National Curriculum Framework 2076, Curriculum Development Centre, Sanothimi, Bhaktapur
