Micro Economics Solved Question Paper 2021 (December)
Dibrugaru University B.Com 1st Sem CBCS Pattern
COMMERCE (Generic Elective)
Paper: G – 101 (Microeconomics)
Full Marks: 80
Pass Marks: 32
Time: 3 hours
In this Post You will get Micro Economics Solved Question Paper 2021 of Dibrugarh University BCOM 1st SEM CBCS Pattern.
The figures in the margin indicate full marks for the questions.
1. Fill in the blanks selecting correct alternatives: 1x8=8
The consumer is in equilibrium when
The Engel curve for an inferior good _______. (slopes downward / slopes upward / is a horizontal line)
The MC curve intersects AC curve, where AC is _______. (maximum / minimum / rising)
If two factors are perfect substitutes, the isoquant will be _______. (L-shaped / straight line / downward falling)
Laws of production does not include _______. (returns to scale / law of variable proportion / least-cost combination of factors)
During long run, the firms under perfect competition can earn only _______. (normal profit / supernormal profit / both normal and supernormal profits)
The first-order condition for maximization of profit of a firm is _______. (AC = AR / AC = MR / MC = MR)
Advertisement cost is a part of _______. (selling cost / MC / AC)
2. Write short notes on (within 150 words each): 4x4=16
a) Monopolistic competition vs. Oligopoly.
Ans: Difference between Monopolistic Competition and Oligopoly
1. Number of Buyers and Sellers
There is large number of buyers and sellers.
There is only few sellers and large number of buyers.
Competition amongst monopolists
Competition amongst the few sellers.
Products are different but close substitute of one another.
4. Entry or exit of firm
Freedom of entry or exit of firms into the market.
Blocked entry / threat to entry of new firms.
Demand is highly elastic.
b) Expansion path (with diagram).
Ans: Expansion Path: As financial resources of a firm increase, it would like to increase its output. The output can only be increased if there is no increase in the cost of the factors. In other words, the level of total output of a firm increase with increase in its financial resources.
By using different combinations of factors a firm can produce different levels of output. Optimum combinations of factors which will be used by the firm is known as Expansion Path. It is also called Scale-line.
In the words of Stonier and Hague, “Expansion path is that line which reflects least cost method of producing different levels of output.”
Expansion path can be explained with the help of Fig. 16. On OX-axis units of labour and on OY-axis units of capital are given.
The initial iso-cost line of the firm is AB. It is tangent to IQ at point E which is the initial equilibrium of the firm. Supposing the cost per unit of labour and capital remains unchanged and the financial resources of the firm increase.
As a result, firm’s new iso-cost-line shifts to the right as CD. New iso-cost line CD will be parallel to the initial iso-cost line. CD touches IQ1 at point E1 which will constitute the new equilibrium point. If the financial resources of the firm further increase, but cost of factors remaining the same, the new iso-cost line will be GH.
It will be tangent to Isoquants curve IQ2 at point E2 which will be the new equilibrium point of the firm. By joining together equilibrium points E, E1 and E2, one gets a line called scale-line or Expansion Path. It is because a firm expands its output or scale of production in conformity with this line.
c) Economies of scale.
Ans: 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
d) Social cost of production.
Ans: Social Cost of Production: The social cost of production extends beyond the private costs and incorporates the external costs or negative externalities imposed on society as a result of production activities. These costs are not directly accounted for or borne by the producer but are instead borne by third parties or society as a whole.
Negative externalities can arise in various forms, such as pollution, environmental degradation, congestion, health effects, or depletion of natural resources. For example, a manufacturing plant emitting pollutants that harm the surrounding community creates a social cost beyond the private cost borne by the firm.
The social cost reflects the full cost to society, including both private costs and the external costs imposed on others. It is important to consider social costs to capture the broader impact of production activities on society's well-being and to ensure efficient resource allocation.
3. (a) Explain with the help of suitable diagram how firms and industry under perfect competition attain equilibrium during short-run. (Within 500 words) 14
Ans: 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.
(b) What is price discrimination? Explain how a discriminatory monopolist determines prices for homogeneous products. (Within 500 words) 2+12=14
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”.
Pricing under discriminating monopoly:
Under simple monopoly the producer will charge the equilibrium price on the basis of total output and the marginal revenue and marginal cost will decide the equilibrium of the monopoly firm. In order to discrimination prices, the entire market will be divided into sub-markets on the basis of the elasticity of demand for the product. Only if the elasticity of demand is different, price discrimination will be profitable. After dividing the market, the producer has to decide the supply for each submarket. Here the decision of output for each sub – market depends on the equilibrium condition of each sub-market with the total cost condition and the revenue curves of the sub-market. The monopolist should decide two things on the basis of his cost and revenue curves.
how much the total output should produce
How the total output should be shared between the sub-markets and what prices should be charged in each of his sub-market.
For sake of simplicity, we shall take that a monopolist device his market, into sub-markets A and B and finds the AR curve different in these two. The following diagram illustrates the revenue curves of the two sub-markets A and B and the aggregate situation in the entire market under his control.
The sub-market A given on the extreme left AR, is the demand curve or the average revenue curve of the market. In sub-market B it is the demand curve or the average revenue curve of the market. Note that the elasticity of demand in these two sub-markets are different. In sub-market The demand curve shows inelastic in nature and in sub-market B the curve shows the elastic in nature. The two sub-markets respective marginal revenue curves are shown as MR1 and MR2 .which lie below the average revenue curve of the respective sub-market. The figure on the extreme rite shows the total market where the aggregate conditions of the revenue curves are shown. The total average revenue curves of the two sub-markets have been shown in the total market as AAR. Similarly, the aggregate of the two marginal revenue curves of the sub-markets has been shown as AMR. According to the figure AR1 + AR2 = AAR. MR1+MR2=AMR combined at various levels of output. Since the output is under single control the marginal cost curve in the aggregate figure. MC in the total market shows the marginal cost for the entire production. The level of production is determined at the point where MR=MC. In the total market the aggregate MR curve cuts the MC curve at E and the total output is determine at OM for the two sub-markets. How much of OM goes to each of these markets is found out by drawing from E a line parallel to X-axis. This line indicating marginal cost of output cuts the marginal revenue curves of the sub-markets at E2 and E1. at the point E1 the marginal revenue of the sub-market A and the marginal cost of production are equal. So the equilibrium condition in sub-market A lies at E1 where the quantity of commodity should be OM1. Similarly, the equilibrium point in sub-market B lies at the point E2 where the marginal cost level meets the marginal revenue level of that sub-market. The corresponding quantity of the commodity in sub-market B is OM2.
Therefore, quantity OM will be sold in sub-market A and quantity OM2 in the sub-market B. At the equilibrium point E1 in sub-market The price of the commodity will be P1M1 as at the level of equilibrium output the average revenue is P1M1. In submarket B, at the equilibrium output the average revenue P2 M2. So, the price of the commodity in that sub-market will be P2M2.
Thus the monopolist producing OM quantities in sub-market A at a price P1M1. He will sell OM2 quantity in sub-market B at a price P2M2. in the figure price is higher in sub-market A and lower in B. It has discriminated the two and charges different prices for the same commodity.
4. (a) What is oligopoly? What is ‘market cartel’ under oligopoly? Explain the price-output determination process with the help of Cournot’s model. (Within 500 words) 1+3+10=14
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.
Market Cartel: A market cartel refers to an arrangement or agreement between firms in an oligopoly market structure to coordinate their actions and behaviour in order to achieve mutual benefits. Cartels are typically formed by a small number of dominant firms within an industry who collaborate to manipulate market conditions and maximize their joint profits.
In a market cartel, member firms agree to coordinate their pricing, output levels, market shares, or other aspects of their business strategies. The aim is to reduce competition among themselves and act as a single entity to exert control over the market. Cartels often involve explicit agreements, such as formal contracts or informal understandings, among the participating firms.
Cournot’s duopoly model
Cournot duopoly, also called Cournot competition, is a model of imperfect competition in which two firms with identical cost functions compete with homogeneous products in a static setting. It was developed by Antoine A. Cournot in his “Researches into the Mathematical principles of the Theory of Wealth”, 1838. Cournot’s duopoly represented the creation of the study of oligopolies, more particularly duopolies, and expanded the analysis of market structures which, until then, had concentrated on the extremes: perfect competition and monopolies.
Cournot really invented the concept of game theory almost 100 years before John Nash, when he looked at the case of how businesses might behave in a duopoly. There are two firms operating in a limited market. Market production is: P(Q)=a-bQ, where Q=q1+q2 for two firms. Both companies will receive profits derived from a simultaneous decision made by both on how much to produce, and also based on their cost functions: TCi=C-qi.
In order to maximise, the first order condition will be:
And, if qi=qj, then both equal:
Therefore, the reaction functions (blue lines), where the key variable is the quantity set by the other firm, will take the following form:
What all this explains is a very basic principle. Both companies are vying for maximum benefits. These benefits are derived from both maximum sales volume (a larger share of the market) and higher prices (higher profitability). The problem stems from the fact that increasing profitability through higher prices can damage revenue by losing market share. What Cournot’s approach does is maximise both market share and profitability by defining optimum prices. This price will be the same for both companies, as otherwise the one with the lower price will obtain full market share, which makes this a Nash equilibrium, also known for this model the Cournot-Nash equilibrium.
If we consider isoprofit curves (those which show the combinations of quantities that will render the same profit to the firm, red curves) we can see that the equilibrium of the game is not Pareto efficient, since isoprofit curves are not tangent. The outcome is below that of perfect competition and therefore is not socially optimal, but it is better than the monopoly outcome.
Extending the model to more than two firms, we can observe that the equilibrium of the game gets closer to the perfect competition outcome as the number of firms increases, decreasing market concentration.
(b) What is break-even principle? Discuss critically the pricing policy of public utility undertakings. (Within 500 words) 2+12=14
Ans: The break-even principle is a concept in economics and business that focuses on determining the point at which a business or project neither makes a profit nor incurs a loss. It is the point where total revenue equals total costs, resulting in zero profit.
The break-even point is a crucial reference for businesses to assess the viability of a project or determine the level of sales needed to cover costs. It helps in making decisions regarding pricing, production levels, and overall profitability.
Pricing Policy of Public Utility undertakings
Price of a commodity is usually determined by two factors:
1) demand, and
This does not apply in the case of all goods and services supplied by the public utility undertakings. There are other considerations which play a more important role in fixing the price. In the case of public utility concerns, price is not fixed on the basis of cost involved in the production or supply of such services i.e. cost of service principle. It is determined on the basis of the purchasing capacity of the consumers, which is called the principle of what the traffic will bear.
As we know, the goods and services provided by public utility concerns are essential services or goods. These products or services are used by the poor and the rich alike, the rich can pay higher price to avail of these services, while the poor may not be able to pay for it if prices are fixed on cost basis. Hence the government takes care of and safeguards the interests of the poor by regulating the prices of such goods and services so that the poorer people may also be able to use them. Normally, the consumer would like to pay a fair price. But what is a fair price, is a question which cannot be easily answered. Determination of a fair price involves a number of considerations like cost of production, cost of supply, a reasonable rate of profit, paying capacity of the customers, changes in the general price level, and so on. Thus, price determination is not a simple matter. It is to be determined after due consideration and consultation with various interests. However, the following three broad aspects of the price policy of public utility undertakings can be kept in mind.
1) Promotional aspect: This aspect is concerned with the promotion of demand of the services provided by the public utility undertakings. Promotional aspect refers to increasing demand for the products or services. Promotion of demand is necessary to ensure full utilisation of the production capacity of the undertaking. This helps in spreading the overhead costs over large output. For example: the transport services such as roadways and railways issue monthly tickets (Season tickets) at concessional rates to a large number of regular passengers.
2) Price discrimination: As we know that the demand for the products of a public utility undertaking is elastic in some markets and inelastic in other markets. Take the case of transport services. In the case of general public or tourists the demand for bus service is elastic, since these persons do not depend upon public buses alone. They may hire three wheelers or taxis. But most of the regular office-goers or students depend mainly upon public buses only. For them the demand is inelastic. Here the undertakings have to charge less from the students and office-goers, and more from the tourists and the general public. Take another example of electric supply undertakings. They charge more for supply of electricity for domestic purposes than for agricultural purposes. In some cases, public utilities can demand lower price in one market and higher price in others, or may charge lower price from one category of consumers and higher price from the other category of consumer.
3) Social considerations: Some of the public utility undertakings touch everyday life of the people and are “affected with public interests”. In such cases the price of the product is not fixed purely on economic basis. Considerations of social welfare play an important role in the price fixation, Consumers with low incomes or poor people get the services at concessional or subsidised rates.
5. (a) Discuss the concept of price effect as a summation of income and substitution effect with appropriate diagram. (Within 500 words) 7+7=14
Ans: Price Effect: The price effect may be defined as the change in the consumption of goods when the price of either of the two goods changes while the price of the other goods and the income of the consumer remain constant.
According to Lipsey: “The price effect shows how much satisfaction of the consumer varies due to the change in the consumption of two goods as the price of one changes the price of the other and money income remains constant”.
Price effect can be explained with the help of following diagram:
In this figure IC is the original indifference curve and AB the original budget line and consumer is in equilibrium at point ‘E’. When the income of the consumer and the price of oranges remain constant but the price of apples falls, then new budget line assumes the shape of AD which touches higher indifference curve IC1 at point G, the new equilibrium point. In other words, demand for apples will increase from ON to OT i.e. by NT which is what we call “Price effect” of a fall in price. On the other hand, if the price of apples increases, other things remaining constant, the budget line will move inwards to AC. It touches indifference curve IC2 at new equilibrium point F. It shows that demand for apples will decrease from ON to OM i.e. by MN which represents price effect of a rise in price. By joining together different equilibrium points like E, F, G one gets price consumption curve (PCC).
How Income Effect and Substitution Effect is separated from Price Effect? Or Separation of Substitution Effect and Income 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
(2) Secondly, due to change in relative price, the consumer substitutes relatively cheaper good for relatively expensive good. It is called substitution effect. The combination of this income and substitution effect is called price effect. Thus:
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).
(b) What is price elasticity of demand? What are the factors that determine the value of elasticity of demand? Explain the concept of price-consumption curve (PCC) with appropriate diagram. (Within 500 words) 2+8+4=14
Ans: 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
Factors influencing Price Elasticity of Demand or Determinants 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.
6. Income of consumers: Very rich people have inelastic demand for goods and poor people have elastic demand. Because rich people will buy the commodity at all levels of prices where poor people there is a change in quantity of consumption according to change in price.
7. Time period: Elasticity would be more in the long run than in the short run. Because in the long run consumers can adjust their demand by switching over to cheaper substitutes. Production of cheaper substitutes is possible only in the long run.
8. Distribution of income and wealth in the society: If there is unequal distribution of income, the demand of commodities will be relatively inelastic. If the distribution of income and wealth in the society is equal, there will be elastic demand for commodities.
Price consumption curve, income consumption curve and Engel curve
The price consumption curve (PCC) is a graphical representation that shows the different combinations of two goods that a consumer can purchase at various price levels while keeping their total expenditure or income constant. It helps illustrate how changes in relative prices affect consumer choices and the resulting quantity demanded for each good.
To construct a price consumption curve, we consider two goods, usually referred to as good X and good Y. The vertical axis represents the price of good X, while the horizontal axis represents the quantity of good X that the consumer can afford to purchase given their income and the price of good Y.
Here's how the price consumption curve is derived:
1. Fixed Income: The consumer's income remains constant throughout the analysis. This means that as the prices of goods change, the consumer's purchasing power adjusts accordingly.
2. Budget Constraint: The budget constraint is represented by a straight line that shows the different combinations of goods X and Y that the consumer can purchase, given their fixed income and the prevailing prices. The slope of the budget constraint line is determined by the relative prices of the two goods.
3. Consumer Preferences: The consumer's preferences are represented by indifference curves, which reflect their level of satisfaction or utility. Indifference curves are typically convex and represent different levels of utility. Higher indifference curves represent higher levels of satisfaction.
4. Tangency Points: The optimal consumption bundle occurs at the points of tangency between the highest attainable indifference curve (subject to the budget constraint) and the budget constraint line. These points reflect the combination of goods that maximizes the consumer's utility given their income and prices.
By varying the price of good X while holding the price of good Y constant, we can trace out different tangency points and derive the price consumption curve. The curve represents the different quantities of good X that the consumer will choose to purchase at various price levels.
In Fig.8.38 price consumption curve (PCC) is sloping downward. Downward-sloping price consumption curve for good X means that as price of good X falls, the consumer purchases a larger quantity of good X and a smaller quantity of good Y. This is quite evident from Fig. 8.38. We obtain downward-sloping price consumption curve for good X when demand for it is elastic (i.e., price elasticity is greater than one). But downward sloping is one possible shape of price consumption curve. Price consumption curve can have other shapes also.
6. (a) What is marginal rate of technical substitution (MRTS)? Explain the concept of optimal combination of production of a firm with the help of isoquant and isocost lines for a given level of output. Discuss how ridgelines describe ‘economic region of production’. (Within 500 words) 2+10+2=14
Ans: The Marginal Rate of Technical Substitution (MRTS) is an economic concept that measures the rate at which one input can be substituted for another input while keeping the level of output constant. It quantifies the trade-off between two inputs in the production process.
Specifically, the MRTS represents the amount by which the quantity of one input can be reduced when an additional unit of another input is added, while maintaining the same level of output. It captures the rate of substitution between inputs and helps analyze the efficiency of resource allocation in production.
Producer’s Equilibrium or Optimal Combination of Factors or Least Cost Combination
The producer’s equilibrium refers to the situation in which a producer maximizes his profits. In other words, the producer is producing given amount of output with least cost combination of factors. The least cost combination of factors also called optimum combination of the factor or input. Optimum combination is that combination at which either:
a) The output derived from a given level of inputs is maximum OR
b) The cost of producing a given output is minimum.
For producer’s equilibrium or optimum combination, it must fulfill following two conditions as:
(i) At the point of equilibrium the iso-cost line must be tangent to isoquant curve.
(ii) At point of tangency i.e., iso-quant curve must be convex to the origin or MRTSLk must be falling.
The iso-cost line gives information regarding factor prices and financial resources of the firm.
With a given outlay and prices of two factors, the firm obtains least cost combination of factors, when the iso-cost line becomes tangent to an iso-product curve. Let us explain it with the following Fig. 15.
In Figure 15, P1L1 iso-cost line has become tangent to iso-product curve (representing 500 units of output) at point E. At this point, the slope of the iso-cost line is equal to the iso-product curve. The slope of the iso- product curve represents MRTS of labour for capital. The slope of the iso-cost line represents the price ratio of the two factors.
Slope of Iso-quant curve = Slope of Iso-cost curve
MRTSLk = – ∆L/∆L = MPL/MPK = PL/PK
[where ∆K → change in capital, ∆L → change in labour, MPL → Marginal Physical Product of Labour, MPk – Marginal Physical Product of capital, PL Price of Labour, and PK → Price of capital, MRTSLK =Marginal Rate of Technical Substitution of labour and capital.]
The firm employs OM units of labour and ON units of capital. The producing firm is in equilibrium. It obtains least cost combination of the two factors to produce 5 00 units of the commodity. The points such as H, K, R and S lie on higher iso-cost lines. They require a larger outlay, which is beyond the financial resources of the firm.
Ridgelines describe the concept of an economic region of production by highlighting the relationship between input combinations and output levels. They represent the highest achievable level of output for each combination of inputs. As we move along the ridgeline, the input mix changes while output remains constant. The ridgeline illustrates the efficient allocation of resources and helps identify the optimal combination of inputs that maximizes production in an economic region.
(b) What are ‘envelop curves’ and ‘learning curves’? Explain why a long-run average cost (LAC) curve is flatter than the short-run average cost (SAC) curve. (Within 500 words) 3+3+8=14
Ans: Envelop curves: Envelop curves, also known as transformation curves or production possibility frontiers, represent the boundary of feasible production combinations for a given set of resources and technology. They illustrate the maximum output that can be achieved for different combinations of inputs.
Envelop curves depict the trade-off between producing different goods or services. They demonstrate the efficient allocation of resources by showing the maximum output achievable when resources are fully utilized. Points on the envelop curve represent the most efficient combinations of inputs and output levels, while points inside the curve indicate inefficient utilization of resources.
Envelop curves are valuable tools for analyzing resource allocation, production efficiency, and trade-offs between different goods or services. They help businesses and policymakers understand the limits of production possibilities and make informed decisions regarding resource allocation and production planning.
Learning Curves: Learning curves, also known as experience curves, depict the relationship between the cumulative production quantity and the average cost per unit of production. They represent the idea that as cumulative production increases, the average cost per unit tends to decrease.
Learning curves are based on the concept of learning by doing, which suggests that as workers or firms gain experience and knowledge through repeated production, they become more efficient and effective, leading to cost reductions. This can be due to factors such as improved skills, streamlined processes, economies of scale, or technological advancements.
Learning curves have implications for cost estimation, pricing strategies, and production planning. They provide insights into the cost dynamics associated with cumulative production and help businesses forecast future costs, set competitive prices, and make decisions related to economies of scale and production ramp-up.
The difference in shape between the long-run average cost (LAC) curve and the short-run average cost (SAC) curve can be attributed to the presence of fixed factors of production in the short run versus the flexibility of adjusting all factors of production in the long run.
In the short run, certain factors of production, such as capital equipment and plant size, are fixed and cannot be easily adjusted. This leads to diminishing returns to variable factors of production, such as labor. As a result, the SAC curve initially declines due to increasing specialization and improved efficiency as more variable inputs are added. However, at a certain point, the diminishing returns set in, causing the SAC curve to start rising.
On the other hand, in the long run, firms have the flexibility to adjust all factors of production, including capital equipment and plant size. This allows them to optimize their production process based on the most cost-effective combination of inputs. With the ability to adjust all factors, the long-run average cost curve represents the most efficient cost structure achievable by the firm.
The LAC curve is flatter than the SAC curve due to several reasons:
1. Economies of Scale: In the long run, firms can take advantage of economies of scale, which refers to cost reductions as production levels increase. As output expands, firms can spread their fixed costs over a larger quantity of output, leading to lower average costs. This results in a flatter portion of the LAC curve.
2. Input Flexibility: In the long run, firms have the flexibility to choose the optimal combination of inputs to minimize costs. They can adjust their production scale, adopt more advanced technologies, and choose the most cost-efficient production techniques. This flexibility allows for greater cost optimization and leads to a flatter LAC curve.
3. Specialization and Learning: Over time, firms can benefit from increased specialization and learning effects in the long run. As firms gain experience and improve their production processes, they become more efficient and can lower their average costs. This leads to a flatter LAC curve as firms achieve greater efficiency through experience and learning.