Principles of MicroEconomics Solved Question Paper 2021
[Dibrugarh University BCOM 5th SEM CBCS Pattern]
5th SEM TDC PM (CBCS) GE 501
COMMERCE (Generic Elective)
Paper: GE 501 (Principles
of Microeconomics)
Full Marks: 80
Pass Marks: 32
Time: 3 hours.
The figures in the margin
indicate full marks for the questions.
1. Answer the following as directed: 1x8=8
(a) The demand for a commodity is inversely related to the price of its substitutes. (Write True or False)
(b) If demand curve is parallel to Y-axis, the price elasticity of
demand is equal to unity/more than unity/less than unity/zero.
(Choose the correct answer)
(c) What is ordinal
measurement of utility?
Ans: Ordinal utility states that the satisfaction which a consumer
derives from the consumption of good or service cannot be expressed numerical
units.
(d) Define a price consumption
curve.
Ans: The price consumption curve shows the
quantity of goods a consumer is able to purchase when the price of the good
changes.
(e) Total cost is the summation of (Choose the correct answer)
(1)
Total
fixed cost and total variable cost.
(2) Average cost and marginal cost.
(3) Selling cost and money cost.
(4) Real cost and opportunity cost.
(f)
If two factors are perfectly
substitutes, the isoquant curve will be (Choose the correct answer)
(1) Negatively sloping convex curve.
(2)
Negatively
sloping straight line.
(3) Right-angled.
(4) None of the above.
(g) Under which form of market a firm is price taker? (Choose the correct answer)
(1) Monopoly.
(2)
Perfect
competition.
(3) Monopolistic competition.
(4) Oligopoly.
(h) Monopolistic competition and oligopoly are alike in terms of Control over price. (Fill in the blank)
2.
Write short notes on any four of the following: 4x4=16
(a) Determinants of price
elasticity of supply.
Ans: Factors influencing Price Elasticity of
Demand
1. Nature of commodity: Elasticity depends on whether
the commodity is a necessity, comfort or luxury. Necessities of life have
inelastic demand and comforts and luxuries have elastic demand.
2. Availability of substitutes: Goods with substitutes have
elastic demand and goods without substitutes have inelastic demand. For
example: coffee and tea are substitutes. If price of tea increases, people may
switch over to coffee. If price of coffee raises people may shift to tea. The
demand of salt is inelastic.
3. Uses of the commodity: Certain goods can be put to
many uses. Example – electricity. Such goods have elastic demand because as the
price decreases, they will be put to more uses.
4. Proportion of income spent on
commodity: For
some goods, consumers spend only a small part of their income. The demand will
be inelastic. For e.g.: - salt and matches
5. Price of goods: Generally cheap goods have
inelastic demand and expensive goods have elastic demand.
(b) Characteristics of indifference
curve.
Ans: An indifference curve shows the various
combination of two goods, which give the same total satisfaction to the
consumer. Four 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.
(c) Relationship between average
cost and marginal cost.
Ans: Relationship between AC and MC
We observe
the following relationship between AC and MC is –
a)
Both average cost and marginal
cost are obtained from total cost as under:
b)
When average cost falls with an
increase in output (upto q, level of output as shown marginal cost always
remains lower than average cost.
c)
When average cost is rising,
marginal cost remains above average cost. In other words, marginal cost rises
faster than average cost (beyond q1 level of output).
d) Marginal cost and average cost are equal when average cost in minimum (at q1 level of output).
(d) Dead-weight loss in
monopoly.
Ans: Monopoly market is one in which there is only one seller of
the product having no close substitutes to the commodities sold by the seller.
The seller has full control over the supply of that commodity and also he is
the price maker. There being only one firm, producing that product, there is no
difference between the firm and industry in case of monopoly.
In monopoly, demand and supply are out of
equilibrium which creates a market inefficiency. A monopoly creates a
deadweight loss by not supplying at a price where marginal costs equal to
demand. Monopolies supply at a quantity where MC=MR and then select the
corresponding quantity on the demand curve. Because of this, dead weight loss
is created because consumers are paying higher prices as compared to prices
they normally would have paid under perfectly competitive conditions. On the
other hand, Producers also lose out because they are not able to sell units which
they would be able to sell under perfectly competitive market conditions.
(e) Excess capacity in
monopolistic competition.
Ans: Excess capacity (or
unutilized capacity) occurs when a firm operates or is producing output at less
than the optimum level. It can happen when there is a
market recession or increased competition, where demand declines and
firms are forced to reduce capacity to decrease costs. Excess capacity is more
defined under monopolistic competition due to the nature of the market
structure. Unlike perfectly competitive markets where the demand curve is
horizontal, monopolistic competitive markets show a downward sloping demand
curve. The demand curve cannot be tangential to the LAC at its minimum point.
Conditions
of equilibrium are reached at E, where LMC = LAC at the minimum point of the
latter. Firms in monopolistic competition are likely to see excess capacity, as
there is no incentive to produce optimum output at a higher long-run marginal
cost (LMC) that is greater than marginal revenue (MR). Firms in monopolistic
competition operate below optimum capacity; hence, they are smaller in size,
large in terms of population, and work under conditions of excess capacity.
Firms
under monopolistic competition operate at the equilibrium point E1, where
output OQ1 is produced, and the demand curve is tangent to the LAC at point A.
It is the point where the LMC curve intercepts with the MR curve. Firms do not
operate at equilibrium (E), where the LMC curve intercepts the LAC curve at its
lowest point, and optimum output (OQ) is produced. Beyond OQ1, firms will start
making losses as LMC is greater than MR. Thus, excess capacity is created as
represented by Q1Q. The graph also reveals that in the long run, output is
lower, and price is higher under monopolistic competition, compared to
perfectly competitive markets where output is higher and price is lower.
3.
(a) Explain the relationship price of a commodity and its quantity supplied.
Discuss how market equilibrium is determined at the intersection of market
demand and market supply curves. 4+7=11
Ans: Law of Demand: The law of demand expresses the
functional relationship between price and quantity demanded. It is the most
important laws of economic theory which states that, other things being equal,
if price of a commodity falls, the quantity demanded of it will rise, and if
price of the commodity rises, its quantity demanded will decline. Thus,
according to the law of demand, there is inverse relationship between price and
quantity demanded. However, it should be remembered that the law is only an
indicative and not a quantitative statement. This means that it is not necessary
that such variation in demand be proportionate to the change in price.
Among the many
causal factors affecting demand, price is the most significant and the price-
quantity relationship called as the Law of Demand is stated by 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".
In simple words other things being equal, quantity demanded will be more at a lower price than at higher price. The law assumes that income, taste, fashion, prices of related goods, etc. remain the same in a given period.
A market is in equilibrium if at the
market price the quantity demanded is equal to the quantity supplied. The price
at which the quantity demanded is equal to the quantity supplied is called the
equilibrium price or market clearing price and the corresponding quantity is
the equilibrium quantity.
In a market, sellers,
who offer a good or service, interact with buyers, who do not possess the good
and want to acquire it. At each price the sellers decide how many units they
want to offer or supply at this price and the buyers decide how many units they
want to buy or demand. The quantity supplied will be higher, the higher the
market price of the good, whereas the quantity demanded will be lower, the
higher the market price of the good. At the price at which these two quantities
are identical, i.e., at the price at which the quantity demanded equals the
quantity supplied, the market is in equilibrium. In equilibrium there are no
buyers who would like to buy the good but cannot find a seller and there are no
sellers who would like to sell the good but are unable to find a buyer. This
means that at the equilibrium price the sellers are able to sell exactly the
quantity they want to sell at this price and the buyers are able to buy exactly
the quantity that they want to buy at this price.
If we know the
demand and supply in a particular market, we can easily find the market
equilibrium by looking for the price at which the quantity demanded is equal to
the quantity supplied. For example, suppose that in the market for pencils the
market demand is given by the linear demand function qD =
10 - p and the market supply is equal to qS = 2p - 2. In
equilibrium the number of pencils that the sellers want to sell has to be equal
to the number of pencils that the buyers want to buy, i.e., quantity supplied
has to be equal to the quantity demanded, qD = qS. For the
demand and supply function of our example this means: 10 - p = 2p - 2.
Now we only have to
solve p to find the equilibrium price which is equal to p* =
4. To find the corresponding quantity, we plug the equilibrium
price p* back into the supply or the demand function and obtain q* =
6. Thus, in our market for pencils the equilibrium price is equal to
4, and at this price the quantity exchanged is equal to 6 units.
This result is also
shown in the graph below. The market equilibrium in a perfectly competitive
market corresponds to the point of intersection of the supply curve and the
demand curve. On the x-axis we have the quantity q of the good or
service (in our case pencils) and on the y-axis the price p of the
good. The green line represents the demand curve and shows the quantity
demanded at each price (for the graph below the demand function is the same as
in the example qD = 10 - p). The blue line represents the supply
curve (also taken from the example above qS = 2p - 2) and
shows the quantity supplied at each price. At the equilibrium price p* =
4, the quantity demanded is equal to the quantity supplied (qD = qS = q* =
6).
The market equilibrium is also called
the competitive equilibrium, because it describes the allocation of goods and
services in a perfectly competitive market (see the term for Perfect
Competition). In a competitive market where buyers and sellers are price
takers, the equilibrium price (and thus marginal revenue) will be equal to
marginal costs and each firm makes a profit of zero. The intuition behind this
result is that in a perfectly competitive market without barriers to entry,
firms will enter as long as they can make a positive profit. As the number of
firms increases the market price decreases because otherwise the consumers do
not want to buy the additional quantities offered by the new firms. This
decreases profits until they reach zero and firms have no incentive to enter
the market anymore.
Or
(b)
What is price elasticity of demand? Examine the role of price elasticity of
demand in decision making of a firm. 3+8=11
Ans:
Price Elasticity of Demand: Price elasticity of demand may be defined as the degree of
responsiveness of quantity demanded of a commodity in response to change in its
price i.e. it measures how much a change in price of a good affects demand for
that good, all other factors remaining constant. It is calculated by dividing
the proportionate change in quantity demanded by the proportionate change in
price.
EP=
Proportionate change in quantity demanded/ Proportionate change in price
Importance of Elasticity of Demand
1. Determination
of price policy:
While fixing the
price of this product, a businessman has to consider the elasticity of demand
for the product. He should consider whether a lowering of price will stimulate
demand for his product, and if so to what extent and whether his profits will
also increase a result thereof.
2. Price
discrimination:
Price
discrimination refers to the act of selling the technically same products at
different prices to different section of consumers or in different in
sub-markets. The policy of price-discrimination is profitable to the monopolist
when elasticity of demand for his product is different in different
sub-markets. Those consumers whose demand is inelastic can be charged a higher
price than those with more elastic demand.
3. Shifting
of tax burden:
To what extent a
producer can shift the burden of indirect tax to the buyers by increasing price
of his product depends upon the degree of elasticity of demand. If the demand
is inelastic the larger part of the indirect tax can be shifted upon buyers by
increasing price. On the other hand, if the demand is elastic than the burden
of tax will be more on the producer.
4. Taxation
and subsidy policy:
The government can
impose higher taxes and collect more revenue if the demand for the commodity on
which a tax is to be levied is inelastic. On the other hand, in ease of a
commodity with elastic demand high tax rates may fail to bring in the required
revenue for the government. Govt., should provide subsidy on those goods whose
demand is elastic and in the production of the commodity the law of increasing
returns operates.
5. Importance
in international trade:
The concept of
elasticity of demand is of crucial importance in many aspects of international
trade. The success of the policy of devaluation to correct the adverse balance
of payment depends upon the elasticity of demand for exports and imports of the
country.
6. Importance
in the determination of factors prices:
Factor with an
inelastic demand can always command a higher price as compared to a factor with
relatively elastic demand. This helps the trade unions in knowing that where
they can easily get the wage rate increased. Bargaining capacity of trade
unions depend upon elasticity of demand for worker’s services.
7. Determination
of sale policy for supper markets:
Super Markets is a
market where in a variety of goods are sold by a single organization. These
items are generally of mass consumption. Therefore, the organization is
supposed to sell commodities at lower prices than charged by shopkeepers in the
other bazaars. Thus, the policy adopted is to charge a slightly lower price for
items whose demand is relatively elastic and the costs are covered by increased
sales.
8. Pricing
of joint supply products:
The goods that are
produced by a single production process are joint supply products. The cost of
production of these goods is also joint. Therefore, while determining the
prices of these products their elasticity of demand is considered.
9. Effect
of use of machines on employment:
The use of
machines may reduce the cost of production and price. If the demand of the
product is elastic, then the fall in price will increase demand significantly.
As a result of increased demand the production will also increase and more
workers will be employed.
10. Public
utilities:
The
nationalization of public utility services can also be justified with the help
of elasticity of demand. Demands for public utilities are generally inelastic
in nature. If the operation of such utilities is left in the hand of private
individuals, they may exploit the consumers by charging high prices.
11. Output
decisions:
The elasticity of
demand helps the businessman to decide about production. A businessman chooses
the optimum product- mix on the basis of elasticity of demand for various
products. The products having more elastic demand are preferred by the
businessmen. The sale of such products can be increased with a little reduction
in their prices.
From the above
discussion it is amply clear that price elasticity of demand is of great
significance in making business decisions.
4.
(a) What is consumer’s equilibrium? Explain how a consumer attains equilibrium
with the indifference curve and budget line. 4+8=12
Meaning of Consumer’s
Equilibrium
Consumer’s equilibrium refers to a situation where in a
consumer gets maximum satisfaction out of his limited income and he has no
tendency to make any change in his existing expenditure. A consumer may find
out with the help of indifference curve analysis as to how he should spend his
limited income on the combination of different goods so that he gets maximum
satisfaction.
Assumptions: Consumer’s equilibrium through utility analysis is based on the
following assumptions:
1. Rational
Consumer: Consumer is assumed to be rational. A rational consumer is one
who is keen to get maximum satisfaction out of his limited income.
2. Cardinal
Utility: Utility of every commodity can be measured in terms of cardinal
numbers, such as, 1, 2, 3, 4 etc.
3. Independent
Utility: It is assumed that the utility derived from one good is not depend
on the utility derived from other goods.
4. Marginal Utility of money is constant.
5. Fixed Income
and Price: It is assumed that the income of the consumer and the price of
the commodity remain fixed.
Conditions of Consumer’s
Equilibrium with the help of Indifference curve and Budget line
There are two conditions of consumer’s equilibrium with
the help of indifference curve analysis:
(1) Budget Line
or Price Line should be Tangent to Indifference Curve.
(a) Indifference
Curve: An indifference curve is a curve which shows
different combination of two commodities yielding equal satisfaction to the
consumer. Supposing a consumer consumes two goods, namely apples and oranges.
The following table and diagram indicates different combination of apples and
oranges yielding equal satisfaction.
|
Combination
of Apples & Oranges |
Apples
|
Oranges
|
|
A |
1 |
10 |
|
B |
2 |
7 |
|
C |
3 |
5 |
|
D |
4 |
4 |
(b) Budget Line: The budget line is that line which shows all the different
combinations of the two commodities that a consumer can purchase given his
money income and the price of two commodities.
Explanation: Supposing a consumer has an income of Rs. 4 to be spent on apples
and oranges. Price of oranges is
Rs. 0.50 per orange and that of apple Rs. 1 per apple. With his given
income and given prices of apples and oranges, the different combinations that
a consumer can get of these two goods are shown in the following table and
diagram:-
|
Income
|
Apples
= Rs. 1.00 |
Oranges
= Rs. 0.50 |
|
Four |
0 |
8 |
|
Four |
1 |
6 |
|
Four |
2 |
4 |
|
Four |
3 |
2 |
|
Four |
4 |
0 |
(2) Indifference
curve must be convex to the origin.
Consumer’s
Equilibrium: Consumer’s equilibrium can be
explained with the help of following diagram:
In this figure AB is the budget or price line. IC, IC,
IC are the indifference curves. A consumer can buy any of the combinations, A,
B, C, D and E of apples and oranges shown on the price line AB. Out of A, B, C,
D and E combinations, the consumer will be in equilibrium at combination ‘D’ (4
oranges and 2 apples) because at this point price line is tangent to the
indifference curve and indifference curve is convex to the point of the origin.
Or
(b)
Define income effect and substitution effect. Explain how price effect of a
commodity is decomposed into income effect and substitution effect. 4+8=12
Ans: Income Effect: The
income effect may be defined as the effect on the purchases of the consumer or
consumer’s equilibrium caused by change in his income, if relative prices
remain constant. The income effect can be studies under the following two types
of goods:
(1) Income Effect in Case of Normal Goods: Income
effect of normal goods is positive. It implies that the quantity demanded
increases with an increase in income and decrease with decrease in income.
(2) Income Effect in Case of Inferior Goods: Income
effect in case of inferior goods is negative. It implies that quantity demanded
decreases as income increases and quantity demanded increases as income
increases.
Substitution Effect: The substitution effect may be defined as the change in the purchase
of consumer or consumer’s equilibrium caused by changes in relative prices if
real income remains constants. If change in relative prices of the goods is
followed by change in the monetary income of the consumer in such a way that
his real income remains constant, then the consumer will substitute cheaper
good for the dearer good. Consequently, it will affect the quantity purchased
of both the goods. This effect is known as substitution effect.
How Income Effect and
Substitution Effect is separated from Price Effect?
We know when the price of a commodity changes, it has
two effects:
(1) There is a change in the real income of the
consumer leading to change in the consumption of the consumer. It is called
income effect.
|
Price Effect = Income
Effect + Substitution Effect |
There are two different approaches relating to the
separation of substitution effect and income effect given the price effect.
These are:
(A) The Hicksian
Approach: Hicksian approach for separation of substitution effect and
income effect is discussed considering following cases. It may be noted here
that substitution effect is always negative because of the negative slope of
the indifference curve; quantity demanded always increases as the price falls
and always decreases as the price rises. In contrast, income effect is positive
or negative depending in whether the goods are normal or inferior.
(i) Separation
of Substitution Effect and Income Effect for Normal Goods: Normal goods are
those goods whose substitution effect is negative but income effect is
positive. Indeed, substitution effect is always negative.
(a) Separation of Substitution and Income Effect for a
Normal Good in case of Price Rise: The
separation of substitution and income effect for a normal good in case of price
rise may be explained with the help of following figure:
This figure shows that the LM is the original budget
line. The consumer is in equilibrium at point B on indifference curve IC. He
purchases OQ units of apples. When the price of apples rises, the budget line
shifts inwards to LN. The consumer moves to a new equilibrium position at point
A on indifference curve IC1. At this point he purchases OS units of apples. The
price effect is indicated by the movement from B to A or by the reduction in
quantity demanded from OQ to OS. In other words, price effect = OQ-Os = SQ. An
increase in price of apples results in a decline in real income of the consumer
as indicated by the shifting of indifference curve IC to IC1. If the monetary
income of the consumer is increased to such an extent that he remains on his
original indifference curve IC or that his real income remains constant, the
new budget line will be RP. It is tangent to indifference curve IC at point C.
It is parallel to the budget line LN conforming to the new price ratio as
indicated by LN after the price of apples rises.
1) Substitution Effect is represented by the movement
from the original equilibrium point B to C, both point being situated on the
same indifference curve. The substitution effect is the reduction in the
quantity demanded of apples from OQ to OT. In other words, Substitution effect
= OQ-OT = TQ.
2) Income Effect is represented by the movement from
point C to A. In other words, it will be ST
Price Effect = SQ.
Substitution Effect = TQ.
Income Effect = ST.
Thus SQ (Price Effect) = TQ (Substitution effect) + ST
(Income Effect)
(b) Separation
of Substitution Effect and Income Effect in case of a Normal Good for a Price
Fall:
In this figure AB is the original budget line and IC
the original indifference curve. Consumer is in equilibrium at point E. When
price of apples falls while the price of oranges and the income of the consumer
remains constant then the new budget line shifts from AB to AC. The new budget
line touches higher indifference curve IC1 at point E1 which is the new
equilibrium of the consumer. Movement from equilibrium point E to new
equilibrium point E1 signifies the effect of changes in the prices of apples. Thus
price effect is MT. Fall in the price of apples means increase in the real
income of the consumer. If the monetary income of the consumer is reduced to
such an extent that he remains on his original indifference curve IC, new
budget line will be PH and new equilibrium point E2.
1) Substitution Effect: It is represented by the
movement from E to E2.
2) Income Effect is represented by the NT.
Price Effect = MT.
Substitution Effect = MN.
Income Effect = NT.
MT (Price Effect) = MN (Substitution Effect) + NT
(Income Effect)
(B) The
Slutsky’s Approach: The following figure explained with the help of
following figure:
In this figure, initially the consumer is in
equilibrium at point Q where budget line AB and indifference curve IC are
tangent to each other. Owing to the fall in the price of Apples, price line
shifts to the right to become AC. The consumer is now in equilibrium at point R
where IC1 and budget line AC are tangent to each other. Movement from Q to R
shows the change in quantity demanded of apples from OL to OM, which is price
effect (LM).
Slutsky isolates the substitution effect by withdrawing
from the consumer AS amount of money income. So that the real income of the
consumer remains constant in terms of the original combination of apples and
oranges indicated by point Q. Thus, a new budget line SS is drawn Parallel to
AC but passing through Q. New budget line SS is tangent to IC2 at point T which
emerges as the new point of equilibrium corresponding to reduced money income,
but constant real income of the consumer. At T the consumer demands ON amount
of apples compared to the OL amount at equilibrium Q. The difference is
substitution effect (LN).
Substitution Effect = LN.
Income Effect = NM.
Price Effect (LM) = Substitution Effect (LN) + Income
Effect (NM).
5.
(a) Discuss the law of variable proportions using an appropriate production. At
which stage, the producer stops his/her production? 9+2=11
Ans: The law of variable proportion is one of the
fundamental laws of economics. It is also known as the 'Law of Diminishing
Marginal Returns' or the 'Law of Diminishing Marginal Productivity.' This Law
of variable proportion shows the input-output relationship or production
function with one variable factor, i.e., a factor, which can be changed, while
other factors of production are kept constant.
In short-period when the output of a good is sought to be
increased by way of additional application of the variable factor, law of
variable proportions comes into operation. When the number of one factor is
increased while all other factors remain constant, then the proportion between
the factors is altered. On account of change in the proportion of factors there
will also be a change in total output at different rates. In economics, this
tendency is called Law of Variable Proportions. The law states that as the
proportion of factors is changed, the total production at first increases more
than proportionately, then equi-proportionately and finally less than
proportionately.
According to Samuelson, “The law states than an increase in some
inputs relative to other fixed input will, in a given state of technology,
cause total output to increase, but after a point the extra output resulting
from the same addition of extra inputs is likely to become less and less.”
Explanation of the Law of Variable
Proportion with the help of an example
Law
of variable proportion can be explained with the help of following table and
diagram:
|
Units of
Land |
Units of
Labour |
Total
Product |
Marginal
Product |
Average
Product |
|
1 |
1 |
2 |
2 |
2 |
|
1 |
2 |
5 |
3 |
2.5 |
|
1 |
3 |
9 |
4 |
3 |
|
1 |
4 |
12 |
3 |
3 |
|
End of the first State Beginning of the Second Stage |
||||
|
1 |
5 |
14 |
2 |
2.8 |
|
1 |
6 |
15 |
1 |
2.5 |
|
1 |
7 |
15 |
0 |
2.1 |
|
End of the Second Stage Beginning of the Third Stage |
||||
|
1 |
8 |
14 |
-1 |
1.7 |
From
the above Table and Diagrams drawn on the assumption that production obeys the
law of variable proportions, one can easily understand three stages of
production. These are elucidated in the following table:
Three Stages of Production
|
Stages |
Total
Product |
Marginal
Product |
Average
Product |
|
1st Stage |
Initially it increases at an increasing rate. Later at
diminishing rate. |
Initially increases and reaches the maximum point. The starts
decreasing. |
Increases and reaches its maximum point |
|
2nd Stage |
Increases at diminishing rate and reaches its maximum point. |
Decreases and becomes zero. |
After reaching its maximum begins to decrease. |
|
3rd Stage |
Begins to fall |
Becomes Negative. |
Continues to diminish. |
At
which stage, the producer stops his/her production?
Marginal
product of the variable factor being negative in stage 3, a producer can
always increase his output by reducing the amount of the variable factor. It is
thus clear that a rational producer will never be producing in stage 3.
Or
(b)
What are economies of scale? Distinguish between the internal and external
economies of scale. 2+9=11
Ans: Economies of Scale: Now-a-days, goods are produced on a
very large scale in modern factories. When the production is carried on a large
scale the producer derives a number of advantages or economies. These
advantages of large scale production are called economies of scale. This is the
reason why entrepreneurs try to expand the size of their factories. Marshall
divides the economies of scale into groups:
(i) Internal economies and
(ii) External economies.
Internal economies are further divided into:
a) Real Economies
b) Pecuniary Economies
Real economies are further divided into:
1. Labour Economies
2. Technical Economies
3. Inventory Economies
4. Selling or Marketing Economies
5. Managerial Economies
6. Transport and Storage Economies
External economies are further divided into:
1. Economies of Concentration
2. Economies of Information
3. Economies of Disintegration
4. Physical Factors
Difference between Internal and External Economies of Scale
|
Basis |
Internal Economies to Scale |
External economies to scale |
|
Meaning |
A
producer drives a number of advantages when he expands the size of his
factory. These advantages are called internal economies. |
When the
industry as a whole develops, every firm in the industry derives man
advantages. These advantages are called external economies. |
|
Benefits |
Internal
Economies are beneficial to a particular firm. |
External
economies are beneficial to all the firms working in an industry. |
|
Caused |
It is
caused due to specific change within a firm. |
It is
caused due to massive changes that happens in a particular industry. |
|
Long-Run
Average Cost (LRAC) |
In
internal economies to scale, there is a fall in LRAC when a firm expands its
output. |
In
external economies to scale, there is a fall in LRAC when the industry
expands it output. |
|
Reflected
as |
It
reflected as a movement along the LRAC curve. |
It is
Reflected as a shift of the LRAC curve |
|
Profits |
Due to
fall in cost, only one firm earns large profit in case of internal economies
of scale. |
All the
firms in an industry are affected due to external economies to scale. |
|
Types |
It is
divided into two categories: a) Real
Economies b)
Pecuniary Economies. Real
economies are further divided into: 1.
Labour Economies 2.
Technical Economies 3.
Inventory Economies 4.
Selling or Marketing Economies 5.
Managerial Economies 6. Transport and Storage
Economies |
It is
mainly divided into three categories: 1.
Economies of Concentration 2. Economies
of Information 3.
Economies of Disintegration
|
|
Economy |
It is
mainly suitable for developed economy. |
It is
mainly suitable for developing economies. |
6.
(a) Discuss the main features of a perfectly competitive market. Explain how a
firm under perfect competition attains equilibrium with normal profit,
super-normal profit and loss in the short run. 4+7=11
Ans: Features
of Perfect Competition
Different
definitions given by different economists point out the distinct
Assumptions/features of perfect competition. We can list various features which
point out that the form of a market is perfectly competitive. In other words,
there are some necessary conditions which must be satisfied if the market is to
be perfectly competitive. Perfect competition is characterized by:
1. Large number of small,
unorganized firms: The first condition which a perfectly competitive market
must satisfy is concerned with the seller’s side of the market. The market must
have such a large number of sellers that on one seller is able to dominate in
the market. No single firms can influence the price of the commodity. These
firms must be all relatively small as compared to the market as a whole. Their
individual outputs should be just a fraction of the total output in the market.
2. A large number of small,
unorganized buyers: On the buyer’s side the perfectly competitive market must
also satisfy this condition. There must be such a large number of buyers that
no one buyer is able to influence the market price in any way. Each buyer
should purchase just a fraction of the market supplies. Further the buyers
should not have any king of union or organization so that they compete for the
market demand on an individual basis.
3. Homogeneous products: Another
pre-requisite of perfect competition is that all the firms or sellers must sell
completely identical or homogeneous goods. Their products must be considered to
be identical by all the buyers in the market. There should not be any
differentiation of products by sellers by way of quality, variety, colour,
design, packing or other selling conditions of the product.
4. Free entry and free exit
for firms: Under
perfect competition, there is absolutely no restriction on entry of new firms
in the industry or the exit of the firms from the industry which want to leave
it. This condition must be satisfied especially for long period equilibrium of
the industry.
5. Perfect knowledge among
buyers and sellers about market conditions: Another pre-requisite of
perfect competition is that both buyers and sellers must be having perfect
knowledge about the conditions in which they are operating. Seller must know
the prices being quoted or charged by other sellers in the market from the
buyers. Similarly, buyers must know the prices being charged by different
sellers.
Short-run Equilibrium of the Firm
The short run is a
period of time in which the firm can vary its output by changing the variable
factors of production in order to earn maximum profits or to incur minimum
losses. The number of firms in the industry is fixed because neither the
existing firms can leave nor new firms can enter it. The firm is in equilibrium
when it is earning maximum profits as the difference between its total revenue
and total cost. A firm is short run equilibrium may face any of the three
situations:
1) Super Normal Profits (AR > AC):
A firm is
in equilibrium when its marginal cost is equal to marginal revenue and marginal
cost curve cuts marginal revenue from below. A firm is in equilibrium earns
super normal profit, when average revenue is more than its average cost. It can
also be explained with the help of following diagram:
In
this figure, output of the firm is shown on OX-axis and cost/revenue on
OY-axis. MC is the marginal cost and AC is average cost curve. PP is the
average revenue and marginal revenue curve (MR = AR). Supposing OP is the price
determined by the industry. At this price, firm’s equilibrium will be at point
E, where marginal cost is equal to marginal revenue and marginal cost curve
cuts marginal revenue curve from below.
Equilibrium
output is OM. At this output AR (price) = EM and AC = AM. Since AR (EM) > AC
(AM), firm is earning EA super normal profit per unit of output.
Per Unit super normal profit = EA
Total Super-Normal Profit = EABP
2) Normal Profits (AR = AC):
Normal profits
cover just the reward for entrepreneurial services and are included in the cost
of production. So that, a firm in equilibrium earns normal profits when its
average cost is equal to the average revenue i.e. AC = AR.
In this figure,
output of the firm is shown on OX-axis and cost/revenue on OY-axis. MC is the
marginal cost and AC is average cost curve. PP is the average revenue and
marginal revenue curve (MR = AR). Supposing OP is the price determined by the
industry. At this price, firm’s equilibrium will be at point E, where marginal
cost is equal to marginal revenue and marginal cost curve cuts marginal revenue
curve from below. The firm earns normal profits at equilibrium output because
its average cost and average revenue are equal.
Normal Profits =
MC = MR = AC = AR.
3) Minimum Loss (AR < AC)
A
firm in equilibrium may incur minimum loss when the average cost is more than
the average revenue and average revenue is equal to average variable cost. Even
if, the firm discontinues its production, in the short run, it will have to
bear the loss of fixed costs. Loss of fixed costs is the minimum loss of the
firm.
In this figure,
output of the firm is shown on OX-axis and cost/revenue on OY-axis. MC is the
marginal cost and AC is average cost curve. PP is the average revenue and
marginal revenue curve (MR = AR). Supposing OP is the price determined by the
industry. At this price, firm’s equilibrium will be at point E, where marginal
cost is equal to marginal revenue and marginal cost curve cuts marginal revenue
curve from below.
At equilibrium
point an (AC) is more than EN (AR). In other words, average cost is more than
average revenue by AE which represents per unit loss. As such firm’s total loss
is AEPB.
Per Unit Loss = AE
Total Loss = AEPB
From the above
discussion, we may conclude from the above discussion that in the short-run
each firm may be making either supernormal profits, or normal profits or losses
depending upon the price of the product.
Or
(b)
What is price discrimination? Discuss the type of price discrimination with
examples. Discuss the conditions of price discrimination. 2+6+3=11
Ans: Price discrimination: Price discrimination means the practice of
selling the same commodity at different prices to different buyers. Under
monopoly the producer usually restricts output and sells it at a higher price,
thereby making maximum profit. If the monopolist charges different prices from
different customers for the same commodity, it is called price discrimination
or discriminating monopoly. The idea is to get from each customer whatever
profits could be squeezed out of him depending on his ability to pay and
intensity of demand. When a seller charges Rs.20 for a commodity from a
customer A and Rs.22 for the same commodity from customer B, he is practicing
price discrimination. Joan Robinson defines price discrimination as, “the act
of selling the same article produce under a single control at different
prices”. Price discrimination may also be defined as, “the sale of technically
similar products at prices which are not proportional to marginal cost”.
Types of price discrimination
There
are different types of price discrimination. They are
1.
Personal discrimination: in personal discrimination,
the monopolist will charge different prices from different customers on the
basis of their ability to pay. Rich customers will be asked to pay more and
poor customers to pay less. This is possible in specialized personal services
of doctors and lawyers. If it is a commodity the discrimination will not be
done openly but in a disguised manner. For e.g. the book of a famous Author can
be sold in the market at different prices to different class of customers –
deluxe edition is higher than the popular edition at a considerably lower
price. Though the cost of producing deluxe edition is higher than the popular
edition, the price fixed for the former will be very high than the price fixed
for the latter. The content of the book is the same for which different
customers pay the different prices. The deluxe edition will command a market
among the richer class and it will have prestige value. Thus personal
discrimination can be mad by making some superficial changes.
Similar principle of personal
discrimination adopted in railways or transport organization. The upper class
passengers pay more than the lower class for the same services rendered.
2.
Place discrimination: monopolist having different
markets in different regions may charge different prices for the same commodity
in the different regions or localities. The locality in which his market is
situated will be the criteria in fixing up the price. Suppose a monopolist has
a shop in an aristocratic locality and also in a slum. He will charge higher
prices in the former shop and lesser price in the slum shop on the
understanding that aristocrats will not go for shopping in the slum. Generally,
the extra price charge in an aristocratic locality will not be felt by the
customers as this shop would cater to their extra needs such as ‘drive - in
‘facility, ‘door - delivery’ etc. sometimes the monopolist may charge lower
prices in a foreign country than in the home market. This is also place
discrimination. This method is adopted for “dumping” the goods in the foreign
markets
3.
Trade discrimination: this can also be called ‘use
discrimination’. By this method, the monopolist will charge different price for
the same commodity for different types of users to which the commodity is put
to. For instance, electricity will be sold at cheaper rates for industrial
establishments and charged at a higher rate for domestic consumption.
Similarly, accessories like small springs, bolts, nuts, etc. will be charged at
a higher price for automobiles and a lower price when the same material is used
for bicycles and for domestic purposes.
Conditions necessary for price
discrimination
1. Firm is a
price maker: The firm must operate in imperfect
competition; it must be a price maker with a downwardly sloping demand curve.
2. Separate
markets: The firm must be able to separate markets
and prevent resale. E.g. stopping an adults using a child’s ticket. Prevent
business travellers from buying discount tickets.
3. Different
elasticities of demand: Different consumer groups
must have elasticities of demand. E.g. students with low income will be more
price elastic and sensitive to price. Business travellers will have more
inelastic demand.
4. Low admin
costs: It must be relatively cheap to separate
markets and implement price discrimination.
7.
(a) Define monopolistic competition. Discuss the price-output determination
under monopolistic competition both in short and long run. 2+9=11
Ans: Monopolistic competition,
as the name itself implies, is a blend of monopoly and perfect
competition. It refers to the market
situation in which many producers produce and sell goods which are closely
related to each other and close substitutes but they are not identical. In this
respect each firm will have some monopoly at the same time the firm has to
compete in the market will other firms as they produce close substitutes. Also they are large number of sellers who
follow an independent price policy. Thus we can say that monopolistic
competition is an intermediate situation between perfect competition and
monopoly.
Price determination under
monopolistic competition
Price-output
determination under monopolistic competition is governed by the cost and
revenue curves of the firm. The cost
curves are governed by laws of production.
The revenue curves of the firm will not be very elastic, to be parallel
to x-axis as in monopoly. The average
revenue curve of the firm under monopolistic competition will be a sloping down
curve, the sloping being neither too steep nor too flat. It will not be flat or parallel straight line
because the firm may not have very elastic demand for its product. The product is not homogenous but slightly
different from that of other firms. The
firm cannot sell unlimited quantities at the established prices as the products
of other firms are close substitutes if not perfect substitutes. The curve will not be too steep because the
demand under monopolistic condition will be much more sensitive to small
changes in price as any fall in price could ensure more customers using the
substitute product of other firms, similarly any rise in price will drive out
many customers from the firm to go demanding other firms product. Thus under monopolistic competition the AR
curve will be fairly a sloping down curve and MR curve will be below it.
Equilibrium of the individual
firm in the short period:
The
monopolistic competitive firm will come to equilibrium on the same principle of
equalizing MR and MC. Each firm will
choose that price that price and output where it will be maximizing its
profit. The following diagram shows the
equilibrium of the individual firm in short period.
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|
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The
different firms in monopolistic competition may be making either abnormal
profits or losses in the short period depending on their costs and revenue
curves. The price of the commodity of
the different firms will be different because the firm adopt individual price
policy. Based on consumer preferences of
the product of the firm and the cost of production each firm will be fixing its
price which may be different from the price of other firms. Old and long standing firms with established
customers and goodwill will find high price advantageous. The technique of production due to long
experience may result in the cost position very comfortable. So, established firms will be making abnormal
profits in the short period. Newly
started firms may have to fix the price at a lower possible level to establish
themselves. The profit may not be very
high. It may even result in loss at the
initial stages. Thus in monopolistic
competition firms may be making abnormal profit, normal profit or loss in the
short period. Firms making losses will
keep the loss out at minimum and try to cover the average variable cost.
Individual
Firm’s Equilibrium in Long Run
In the preceding sections, we have discussed that in
the short run, firms can earn supernormal profits. However, in the long run,
there is a gradual decrease in the profits of the firms. This is because in the
long run, several new firms enter the market due to freedom of entry.
When these new firms start production the market supply
would increase and the price would fall. This would automatically increase the
level of competition in the market. Consequently, AR curve shifts from right to
left and supernormal profits are eliminated. The firms will be able to earn
normal profits only.
In the long run, the AR curve is more elastic than that
of in the short run. This is because of an increase in the number of substitute
products in the long-run. The long-run equilibrium of monopolistically
competitive firms is achieved when average revenue is equal to average cost. In
such a case, the firms receive normal profits.
Shows the long-run equilibrium position
under monopolistic competition.
In Fig. 3.5, P is the point at which AR curve touches
the average cost curve (LAC) as a tangent. P is regarded as the equilibrium
point at which the price level is MP (which is also equal to OP) and output is
OM.
In the present case average cost is equal to average
revenue that is MP. Therefore, in long run, the profit is normal. In the short
run, equilibrium is attained when marginal revenue is equal to marginal cost.
However, in the long run, both the conditions (MR = MC and AR = AC) must hold
to attain equilibrium.
Or
(b)
What is oligopoly? What are its characteristics? What factors cause the
emergence of oligopoly? 2+3+6=11
Ans: “Oligopoly”
is a term derived from two Greek words “Oligos” meaning a few “pollein” meaning
to sell. Thus Oligopoly refers to that form of imperfect competition where
there will be only few sellers producing either a homogenous product which are
close substitutes but not perfect substitutes or similar products.
There are only few
sellers of a product under oligopoly due to which actions taken by any
individual seller have a significant impact on other sellers. There is a
personalized competition under oligopoly. All firms act as rivals of each
other. The most important feature of oligopolistic market is interdependence in
decision making.
Oligopoly Examples
Perfect example of
Oligopoly in India is Indian Telecom Industry. In telecom industry, there are
only few sellers for example Reliance Jio, Airtel, BSNL, IDEA etc. All these
act as rivals of each other. Also when one company increases or decreases
tariff charges, this is also followed by other companies
Oligopoly Features
Following are the
features of oligopoly which distinguish it from other market structures:
1. Few Number of Sellers: Under Oligopoly, there are only
few sellers producing either a homogenous product which are close substitutes
but not perfect substitutes or similar products.
2. Interdependence of firms: The most striking feature of
Oligopoly market is the interdependence of the firms operating in similar
industry. Since the products of oligopolist are close substitute, the price and
output decisions of one will surely affect the other firm’s pricing and output
decision. The oligopolist has to take into account the actions and reactions of
his rivals while deciding his price and output policies.
3. Price rigidity: Another important feature of
oligopoly with product differentiation is price rigidity. The price will be
kept unchanged because any change in price by one oligopolist invites
retaliation and counter- action from others. So, the oligopolist normally
sticks to one price because they do not want to enter into price competition.
If an oligopolist reduces his price, his rivals will also do so and therefore,
it is not advantageous for the oligopolist to reduce the price.
4. Indeterminate demand curve: This feature is a natural
outcome of the first feature. No firm in Oligopoly can forecast the nature and
position of the demand curve with certainty. The firm cannot estimate the sales
when it decides to reduce the price of its product. Hence the demand curve
under oligopoly is indeterminate.
5. Group behaviour: Another important feature in
Oligopoly market is the conflicting attitudes of the firms. The firms under
oligopoly are interdependent and they know the importance of mutual
cooperation. Therefore, there is a tendency among them for collusion. Collusion
as well as competition prevailed in the monopolistic market leads to
uncertainty and indeterminateness.
6. Monopoly power: If there is product
differentiation, the firms enjoy some monopoly power because the firms are few
and each of them controls a large share of the market. Further, when firms
collude with each other, they can work together to raise the price and earn
some monopoly income.
7. Selling cost incurred in Advertising:
There is tough
competition between firms under oligopoly market. They can increase their sales
volume only through advertising or by providing better quality products.
Advertisement expenditure is used as an effective tool to shift the demand in
favour of the product.
Cause of Emergence of Oligopoly
The main reasons which give rise to oligopoly are as follows:
1. Large Investment of Capital: The number of firms in an
industry may be small due to the large requirements of capital. No entrepreneur
will like to venture to invest large sums in an industry in which addition to
output to the existing one may likely to depress prices. Further, the new
entrant may also fear of provoking a price-war by the established firms in the
industry. This is always true that in the midst of differentiated product, it
is difficult to make a new product.
2. Control of Indispensable Resources: A few firms may control some
indispensable resources which may enable them to secure several advantages in
costs over all others. This enables them to operate profitably at a price at
which others cannot survive.
3. Economies of Scale: If the productive capacity of few firms is large and are able to capture a greater percentage of the total available demand for the product in the market, there will then be a small number of firms in an industry. The firms in the industry with heavy investment using improved technology and reaping economies of scale in production, sales promotion etc. will complete and stay in the market. The firms using outdated machinery and old techniques of production will not be able to compete with the low unit’s costs producing firm and eventually wipe out from the industry. Oligopoly is, thus promoted due to the economies of scale.
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