Maximum Marks: 100

Attempt all the questions:

1. Explain the exceptions to the Law of demand using the distinction between substitution and income effects. (20)

Ans: Exceptions to the Law of Demand: There are some exceptions to this Law. Many times people behave contrary to what expect according to this law. In these exceptional cases, the demand curve is positively sloped Sir Francis Giffen was the first to propose an important exception to this Law. Similarly, other exceptional cases have been found. These are as under.

1. Special type of Inferior goods or Giffen goods. There are some commodities consumption which are inferior from the consumer's viewpoint. There are others which are superior. Sir Giffen pointed out to the economist, Marshall, that in the case of English workers the Law of Demand does not apply to bread. He could practically. Price of bread its amount demanded was reduced rather than being more than before. Marshall admitted that this was an exceptional case to the Law of Demand. It is now clear as to why the English workers behaved contrary to the Law of Demand. They had two main items of consumption: (1) Bread, (2) Meat. As the price of bread fell in the market, they could purchase the same amount of bread with less money. The money income saved thereby was not spent on purchasing more bread. Rather it was spent on purchasing more of meat, a superior commodity for the English workers. In short, there was no Substitution Effect in favour of bread. The Income Effect of the fall in price of bread was also in favour of meat. This reduced the demand for bread as its price went down. Therefore, bread was a special type of inferior good whose amount demanded changed directly with change in its price and not inversely as expected from the Law of Demand. In India, such foodgrains as jowar and bajra are Giffen goods, wheat and rice being the superior goods.

2. Articles of distinction. This exception was first explained by the American economist, Veblen. According to him, the demand for articles of distinction like diamonds and, jewellery is more when their price is high. This is because a rich man's desire for distinction is satisfied better when the articles of distinction are highly-priced and the poorer man cannot buy them. In short, there is a income effect on these products. On the other hand, the demand for articles of distinction falls with a fall in their price and rich man looks for some other precious items hence there is a substitution effect.

3. Expectation of rise and fall in price in future. There are many commodities whose prices are expected to go down or rise in future. In such eases consumers may behave opposite to the law of demand. If people expect a rise in price in future, they will rush to purchase more of the commodity at the present price. If they expect the price to fall, they will purchase less of the commodity to derive benefit from the fall in price later on. In this case there is not income and substitution effect but consumers want to take the advantage of price rise in future.

4. Ignorance on the part of consumers about quality. It happens many times that consumer’s judge the quality of a commodity from its price. In such cases, a lower-price commodity may be considered inferior and purchasers buy lesser amount of it. But when its price is more they consider it to be superior and may purchase more of the commodity than before. Benham has cited the case of a book whose price during the First World War was 101/2 Shilling. It did not sell much. After the war, the same book was reprinted and priced at £ . This time the book was completely sold out because people considered it important from its high price. The list of exceptions given above is not complete. There are some other cases also where the assumptions of this law are not found to be applicable entirely.

2. What is the meaning of the term 'Monopoly'? In what way does it differ from perfect competition? (20)

Ans.: Monopoly: A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity. This contrasts with a monophony which relates to a single entity’s control of a market to purchases a good or service, and with oligopoly which consists of a few sellers dominating a market.

Definition of ‘Monopoly’

A market structure characterized by a single seller, selling a unique product in the market. In a monopoly market, the seller faces no completion, as he is the sole seller of goods with no close substitute.

Difference: Following points make clear difference between both the competitions:

1.    Output and Price: Under perfect competition price is equal to marginal cost at the equilibrium output. While under monopoly, the price is greater than average cost.

2.    Equilibrium: Under perfect competition equilibrium is possible only when MR=MC and MC cuts the MR curve from below. But under simple monopoly, equilibrium can be realized whether marginal cost is rising, constant or falling.

3.    Entry: Under perfect competition, there exist no restrictions on the entry or exit of firs into the industry. Under simple monopoly, there are strong barriers on the entry and exit of firms.

4.    Discrimination: Under simple monopoly, a monopolist can charge different prices from the different groups of buyers. But, in the perfectly competitive market, it is absent by definition.

5.    Profits: The difference between price and marginal cost under monopoly results in super-normal profits to the monopolist. Under perfect competition, a firm in the long run enjoys only normal profits.

6.    Supply Curve of Firm: Under perfect competition, supply curve can be known. It is so because all firms can sell desired quantity at the prevailing price. Moreover, there is no price discrimination. Under monopoly, supply curve cannot be known. MC curve is not the supply curve of the monopolist.

7.    Slope of Demand Curve: Under perfect competition, demand curve is perfectly elastic. It is due to the existence of large number of firms. Price of the product is determined by the industry and each firm has to accept that price. On the other hand, under monopoly, average revenue curve slopes downward. AR and MR curves are separate from each other. Price is determined by the monopolist.

8.    Goals of Firms: Under perfect competition and monopoly the firm aims at to maximize its profits. The firm which aims at to maximize its profits is known as rational firm.

9.    Comparison of Price: Monopoly price is higher than perfect competition price. In long period, under perfect competition, price is equal to average cost.

10. Comparison of Output: Perfect competition output is higher than monopoly price. Under perfect competition the firm is in equilibrium at AR=MR=AC=MC are equal.

3. What do you understand by production possibility curve? Illustrate it with the help of a suitable example. (20)

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Ans: Production possibility curve: An allocation of the scarce resources of the economy gives rise to a particular combination of different goods and services. With the given amount of resources it is possible to allocate the resources in many different ways and thereby leading to different possible combinations of goods and services. The collection of all possible combinations of goods service that can be produced from a given amount of resources and technology is called the production possibility set of the economy. When this production possibility set graphed, it is called production possibility frontier or production possibility curve. There is maximum limit (or boundary) to the amount of goods and services which an economy can produce with full and efficient use of its available resources and given technology. That is why PPC is called production possibility frontier.

Example: Let us suppose that with given resources and technology, an economy can produce only two goods namely cloth and wheat.

Table 1.1 Production Possibilities of Cloth and Wheat

Production Possibilities


(in thousand meters)


(in thousand quintals)

Marginal Opportunity Cost of Cloth (in wheat)






























The above table and Fig 1.1 indicate that with the given resources and technology, the economy can produce maximum either 5 thousand meters of cloth or 15 thousand quintals of wheat or any other combination of the two goods, like B (1 thousand meters of cloth and 14 thousand quintals of wheat), C (2 thousand meters of cloth and 12 thousand quintals of wheat) or E (4 thousand meters of cloth and 5 thousand quintals of wheat) etc. The economy has to choose out of these various production possibilities. If more of the resources are used in the production of wheat, fewer resources are available for the production of cloth and vice-versa. Thus there is always a cost of having a little more of one good in terms to the amount of the other goods that has to be sacrificed. This called opportunity cost. See Column (4) in is the above table. When this table is represented diagrammatically, we obtain a production possibility curve AF as shown in the figure. PPC is also called opportunity cost curve as at measures opportunity cost of one good in terms of alternative good given up. Suppose that society is producing at point C in Fig. 1.1. It indicates production of 2 thousand meters of cloth and 12 thousand quintals of wheat. Now if the society needs more of cloth, say, 3 thousand meters, it will have to give up 3 thousand quintals of wheat. In other words, 3 thousand quintals of wheat is the opportunity cost of 1 thousand meters of cloth. A production possibility curve depicts all possible combinations of two commodities which can be produced in a country with its given resources and technology.

Assumptions: The concept of production possibility curve is based on the following assumptions.

(i)        The resources available are fixed.

(ii)      The technology remains unchanged.

(iii)     The resources are fully and efficiently employed

(iv)    The resources are not equally efficient in the production of all goods. Thus if resources are transferred from production of one good to another, the cost of production increases.

 4. What is long-run cost curve? Why is short-run Average Cost Curve U-shaped? (20)

Ans: The term long term means a period of time within which all the factors of production varies. In long term all the costs are variable and concept of fixed cost does not arise. In microeconomics analysis, long run cost curve refers to a cost function which represents the total cost incurred of all goods manufactured of a long period of time. Long run cost depicts the minimum cost incurred in production of given level of output. It is drawn to shows the relationship between average total cost and output at a fixed price to minimise average total cost. Long run costs are always u shaped if it is drawn after calculating average. Average cost is calculated by dividing total cost by total output produced.

AC curve is depicted in Fig. 7.6. It is U-shaped due to operation of law of variable proportions. Remember, increasing returns imply diminishing costs, constant returns mean constant costs and diminishing returns imply increasing costs. As output is increased. AC first falls, reaches its minimum and then rises. Hence, AC curve becomes U-shaped. Minimum point of AC curve indicates lowest per unit cost of production.

Why short-run average cost is U-Shaped?

In the short-run period, the average cost (AC) curve is U shaped due to the law of variable proportions. This states that as more and more units of a variable factor are applied to the same fixed factor, initially, the total product would increase but would eventually come down. Therefore, initially cost is less and eventually it is more. Generally, price and output has inverse relationship.

This is due to-

a. Increasing returns-

                1. Optimum utilization of fixed factor,

                2. Division of work as per specialization.

b. Negative returns-

                1. Perturbed input-output ratio.

                2. Management problems.

Short run and Long run Average Cost curves are both U shaped. However, both are so shaped due to quite different reasons.

In the short run, we have some fixed factor of production, which limits the production capacity of the firm. When more and more units of variable factor is employed to the given level of fixed factor,

First MP of variable factor rises – Marginal Cost (MC) falls

Then it results in Diminishing returns to the variable factor after a certain limit. MP falls – MC rises.

LRAC falls due to rising economies of scale, it drops to the minimum point and then rises again as economies of scale falls and becomes diseconomies of scale at very high levels of output.

5. Write short notes on the following:

(a)Opportunity cost

(b)Quasi Rent

(c) Consumer's surplus

(d)Indifference curves

Ans: (a) Opportunity Cost: The opportunity cost of anything is the next best alternative that could be produced instead by the same factors or by costing the same amount of money. Since productive resources are limited, if they are used in the production of one commodity they are not available for the production of another. So, the opportunity cost of commodity is the alternative scarified in order to obtain it. For example, a farmer is cultivating rice on a piece of land and earning Rs. 1,500. If he would have cultivated wheat then he could earn Rs. 1,000 on the same piece of land. Therefore, Rs. 500 is the opportunity cost of producing rice as opportunity cost is defined as cost of forgone alternatives.

(b) Quasi Rent: Alfred Marshall, the English economist, gave the concept of ‘quasi-rent’. The concept is used for the surplus craned by the man-made factors which are in short supply, i.e., the factors other than land. These factors are fixed or inelastic in supply in the short run. Examples or these are man-made machines. So, by quasi-rent, Marshall meant the income derived from machines and other appliances of production made by man.

Marshall defined quasi-rent for a firm as the excess of total revenue over total variable cost. There are two types of factors of production in the short run one type is fixed and the others are variable. In the short run, fixed costs (of fixed factors) are constant. The quantity of the variable factors depends on the size of production. We know that for a firm under competition, there is a shut down point in the short run, a time period in which the firm must cover at least variable costs. If the market price is less than these costs, no producer would stay in production. Therefore, Marshall concluded that the excess earning which a factor earns over and above. Its variable cost in the short run can be called quasi-rent. But in the long run, this type of rent is not earned because both the fixed as well as variable costs are to be covered by the market price. We can say that,

Quasi-Rent = Total Revenue – Total variable costs.

(c) Consumer’s Surplus: Consumer surplus can be simply defined as the difference between willingness of the consumers to pay for a commodity and the actual amount paid by him for that commodity. If one consumer ready to pay Rs. 50 for a cup of coffee but can get it for Rs. 30, consumer surplus in this case will be Rs. 20. This concept is based on marginal utility theory which is the additional satisfaction of consumer by consuming one additional unit. Consumer surplus is related with price elasticity of demand. In case of perfectly elastic demand, consumer surplus is zero because the price which consumer is willing to pay matches the market price of the product. In case of inelastic demand, consumer surplus is very high.

(d) Indifference curve: An indifference curve is a curve which shows the various combinations of two goods, which give the same total satisfaction to the consumer. The indifference curve analysis is built upon the following assumptions:

1)    Two Goods: It is assumed that consumer buys only two goods. This assumption is made because a graph has only two axes. Therefore, only two goods can be represented one on each axis. 

2)    Rationality: Like Marshall’s utility analysis, indifference curve analysis also assumes consumer’s rationality. According to Hicks, consumer acts rationally and aims at the maximization of utility, given his income and market prices of the commodities.

3)    Utility is Ordinal: Indifference curve analysis has abandoned the concept of cardinal utility and instead has adopted the concept of ordinal utility. According to this analysis, utility is a psychic entity and therefore cannot be measured in cardinal terms.

4)    More is better: A consumer always prefers more of any good to less of it. Such preferences are called monotonic preferences. It is assumed that consumer had not reached the satiety point.

Some of the features of indifference curve are as follows:

a)    Indifference curve slopes downward from left to right.

b)   Higher indifference curve represents higher level of satisfaction.

c)    No two indifference curve cut each other.

d)   Indifference curve are convex to the origin due to diminishing marginal rate of substitution.

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