# Principles of Microeconomics Solved Paper 2021, Dibrugarh University B.Com 5th Sem Non-Hons

Dibrugarh University B. Com 5th Sem Solved Question Papers CBCS Pattern

5th SEM TDC PM (CBCS) GE 501

Principles of Microeconomics Solved Paper 2021

(Held in January/February, 2022)

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:       1×8=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:           4×4=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). 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 dead weight 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.

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.

(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:

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 Explanation:

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 super normal 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. The short period marginal cost and average cost curves are shown as SMC and SAC.  The sloping down average revenue and marginal revenue curves are shown as AR and MR. The equilibrium point is E where MR equals MC.  The equilibrium output is OM and the price is fixed OP.  The difference between average cost and average revenue is RQ.  The output is OM.  So, the super normal profit for the firm is shown by the rectangle PQRS. The firm by producing OM units of its commodity and selling it at a price of OP per unit realizes the maximum profit in the short run. Firms may also incur loss also which can be indicated in the following diagram. With the revenue curves and cost curves the firm comes to equilibrium at E1 where MR equals MC.  At this point the firm is making the minimum loss P1Q1R1S1 shown by the shaded rectangle.  The price is P1.   The firm incurs loss in the short run because average cost is high than average revenue.

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 super normal 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 super normal 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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