Micro-Economics

6 Marks Questions

1. Distinguish between a centrally planned economy and a market economy.

Points of Difference

Centrally Planned Economy

Market Economy

1 Ownership of factors of production

Factors of production are publically owned; i.e., public ownership.

Factors of production are privately owned.

2 Production motive

The motive of production is social welfare.

The main motive is profit making.

3 Governing factor The production is governed by planning mechanism; i.e. according to the government plans.

The production is governed by price mechanism; i.e., by demand and supply.

4 Income distribution

The degree of inequality of income is low.

There exists unequal distribution of income.

5 Government’s role

The main role is played by the government−from production to distribution.

The main role is played by private players. They decide what to produce, while the role of a government is limited to maintaining law and order in the nation.

2. Discuss about the Central Problems of an Economy.

Ans. Every economy has to face the problems of multiplicity of wants, scarcity of resources and problem of choice. These are known as central problems of an economy. Economic theory mostly revolves around them. These are explained as below:

i. What to produce?

With limited resources, every economy has to decide, what commodities are to be produced and in what quantities. The problem of choice is related to the production of goods and services. The guiding principle is to allocate resources in such a way as to maximize aggregate utility of the society.

ii. How to produce?

Second problem regarding allocation of resources is concerned with the selection of technique of production. Goods and services can be produced with two techniques (a) Labour intensive technique (b) Capital intensive technique.

However, optimum allocation of resources requires maximum possible quantity with least possible costs.

iii. For whom to produce?

Third important decision regarding allocation of resources is concerned with distribution of production or for whom it is to be produced. Gods and services are only produced for those who have purchasing power to buy them. Purchasing power infact depends upon the distribution of income. Therefore this problem is concerned with the distribution of income.

3. What do you understand by positive and normative economic analysis?

Ans. Positive economic analysis: Positive science is that science which deals with the things as they are. It helps us to know the cause and effect relationship of a particular phenomenon. Positive science only explains and explores the things in its pure form. It simply answers the qusetions-what, why and how, about an actual phenomenon.

Lionel Robbins considers economics as a pure science and writes, “Economics is neutral as regards the ends”. Economics has many examples to prove it as a positive science, such as it deals with price determination of a commodity and analysis of existing economic systems etc.

Examples:

i. India has 20% population living below poverty line.

ii. India is an over populated country with 121 crores of population.

Normative Economic Analysis: A normative science studies the thing ‘as they should be’. It makes the opinion known, as to how ‘the things ought to be’. Economists like Marshall, Pigou, Frazer etc. regard economics as a normative science. Instead of explaining the facts and circumstances, normative economist suggests aims and objectives for the economy and points out what ought to be done to achieve these aims and objectives.

Examples:

i. Minimum wages must be provided to labour so as to meet their basic needs.

ii. Agricultural income tax should be imposed upon rich farmers.

Chapter-2

Consumer’s Equilibrium

1. Give any six assumptions of equilibrium position of consumer under utility analysis.

Ans. Equilibrium position of a consumer under utility analysis is based on the following assumptions:

i. Utility can be measured in a cardinal numbers.

ii. Price measures the utility in terms of money. But the marginal utility of money is assumed to be constant.

iii. Consumer behaves rationally.

iv. Consumer has perfect knowledge regarding market condition.

v. Consumer’s income and prices of goods remain fixed.

vi. Goods are divisible.

Vii. Consumers tastes, habits and fashions remain constant.

2. How does the budget line change if the consumer’s income increases to Rs 40 but the prices remain unchanged?

.M2 = Rs 40

P1 = Rs 4

P2 = Rs 5

Initial equation of the budget line: 4x1 + 5x2 = 20

New equation of the budget line: 4x1 + 5x2 = 40

As M has increased, the consumer can now purchase more of both the goods and the budget line will shift parallelly outwards to A’B’ from

AB.

Horizontal intercept will be 

Vertical intercept will be 

The slope of the new budget line will be the same as that of the old budget line.

3. How does the budget line change if the price of good 2 decreases by a rupee but the price of good 1 and the consumer’s income remain unchanged?

P1 = Rs 4

P2 = Rs 5

M = Rs 20

Since the income and the price of good 1 are unchanged, the decrease in the price of good 2 will increase the vertical intercept of the budget line. The new budget line will also pivot outwards around the same horizontal intercept.

Horizontal intercept 

Vertical intercept 

Slope 

The slope of the new budget line will be more and the new budget line will be steeper than the original one.

4. Suppose a consumer wants to consume two goods that are available only in integer units. The two goods are equally priced at Rs 10 and

the consumer’s income is Rs 40.

(i) Write down all the bundles that are available to the consumer.

(ii) Among the bundles that are available to a consumer, identify those that cost will him/her exactly Rs 40.

(i) P1 = Rs 10

P2 = Rs 10

M = Rs 40

Budget set ⇒ P1x1 + P2x2 ≤ M

10x1 + 10x2 ≤ 40

The bundles that are available to the consumer should cost less than or equal to Rs 40.

Horizontal intercept 

Vertical intercept 

Slope 

The bundles in the shaded region (ΔAOB) are all available to the consumer, including the bundles lying on the line AB.

(0, 0) (0, 1) (0, 2) (0, 3) (0, 4)

(1, 0) (1, 1) (1, 2) (1, 3) (1, 4)

(2, 0) (2, 1) (2, 2) (2, 3) (2, 4)

(3, 0) (3, 1) (3, 2) (3, 3) (3, 4)

(4, 0) (4, 1) (4, 2) (4, 3) (4, 4)

(ii) The coordinates that lie on the line AB cost exactly the same as the income of the consumer. The bundles are as follows:

(0, 4), (1, 3), (2, 2), (3, 1), (4, 0)

Chapter-3

Theory of Demand

1. State three causes of leftward shift in demand curve.

Ans. Leftward shift in demand curve would mean a decrease in demand due to other factors rather than price. Following are the three factors that cause a decrease in demand;

i. Fall in income: hen income of the consumer falls, his purchasing power also falls by which demand decreases and it shifts leftwards.

ii. Rise in price of complementary goods: When price of complementary good rises say petrol price, demand for related good car will fall by which demand shift curve will shift leftward.

ii. Fall in price of substitute goods: When a price of substitute goods falls say Pepsi, people will shift to it and demand for Coke will fall by which demand for coke lifts leftward.

2. Consider a market where there are just two consumers and suppose their demands for the good are given as follows:

Calculate the market demand for the goods.

p d1 d2

1

2

3

4

5

6

9

8

7

6

5

4

24

20

18

16

14

12

p d1 d2 Market demand = D = d1 + d2

1

2

3

4

5

6

9

8

7

6

5

4

24

20

18

16

14

12

9 + 24 = 33

8 + 20 = 28

7 + 18 = 25

6 + 16 = 22

5 + 14 = 19

4 + 12 = 16

3. (i) What do you mean by substitutes? Give examples of two goods which are complements of each other.

Those goods that can be consumed in place of other goods are called substitute goods. Example: Tea and coffee are goods that can be substitutes for each other. If the price of tea increases, then the demand for tea will decrease and people will substitute coffee for tea, which will increase the demand for coffee.

The demand for a good moves in the same direction as the price of its substitutes.

Price of tea (PT) increases →Demand for tea (DT) decreases →Demand for coffee (DC) increases

(II) What do you mean by complements? Give examples of two goods which are complements of each other.?

Those goods that are consumed together are called complementary goods. Example: Tea and sugar. If the price of sugar increases, then it will lead to a decrease in the demand for tea. If the price of tea increases, then it will reduce the demand for sugar.

The demand for a good moves in the opposite direction of the price of its complementary goods. That is,

If the price of tea (PT) increases, then the demand for sugar (DS) decreases.

If the price of sugar (PS) increases, then the demand for tea (DT) decreases.

4. What are expectations of law of demand?

Ans. In certain cases, demand curve slopes upwards. In such a case law of demand does not hold good. These are known as expectations of law of demand. Some of them are mentioned as below:

i. Status Symbol Goods: Goods like diamond, jewellery, works of art, costly carpets, etc. are demanded by rich people because they confer prestige or appeal on them. Higher the price of such goods, greater would be demand for them.

ii. Change in future expectations: If prices are expected to rise in future, then people may buy more even if the existing prices are high. In such a case, law of demand does not hold good.

iii. Inferior goods: Those goods which are psychologically inferior for the consumer, he will demand less even at a lesser price and with a rise in purchasing power of the consumer.

iv. Necessaries of life: In case of necessaries of life, consumer does not demand more or less even with fall or increase in price.

v. Change in fashion or tastes: when there is unfavorable change in fashion or tastes, consumer will not buy more even at a lesser price. In such cases, law of demand does not hold good.

5. Explain the factors that affect the market demand of a commodity. (or)

Distinguish between increase in demand and expansion of demand (rise in quantity demanded). Use diagram.

ANS. Expansion demand due to price change and Increase in demand is due to other than price change. Previous one is movement along with same demand curve.

Later one is shifting ‘DD’.

Expansion due to price falls,

Increase demand due to

Income rise.

OR

Determinants of market demand: i) Price of the commodities, ii) Income of the consumers iii) Price of related goods and iv) Tastes and preferences of the market/ consumers (Give a brief explanation for each points

1. Explain total expenditure method of measuring price of elasticity of demand with the help of table.

Ans. While measuring price of elasticity of demand with total expenditure method there may be three possible situations.

(i) If total expenditure remains constant with a change in price Ed=1

(ii) If total expenditure increases with a fall in price and vice-versa Ed>1

(iii) If total expenditure decreases with a fall in price and vice-versa Ed<1Schedule showing price elasticity of demand with total expenditure method

Situations Price per unit (Rs.)

Quantity(kgs)

Total Expenditure Elasticity of demand (Ed)

1 105

1020

100100

Ed=1

2 105

1030

100150

Ed>1

3 105

1015

10075

Ed<1

2. Explain factors affecting the magnitude of price elasticity of demand.Ans. Following are the factors affecting the magnitude of price elasticity of demand:(i) Nature of the commodity: Commodities can be classified in three parts:A. Necessaries: Demand for necessaries (like salt) is highly inelastic.B. Comforts: Demand for comforts (like air-cooler) is moderately elastic.C. Luxuries: demand for luxuries (like ACs) is highly elastic.(ii) Availability of substitutes: Commodities which have substitutes their demand will be

elastic (like tea and coffee). The goods which have no substitutes (like liquor and cigarettes) have inelastic demand.

Chapter-4

ELASTICITY OF

DEMAND

(iii) Alternative uses of the commodity: If commodity can be used for different purposes, its demand will be elastic (like sugar, milk)

(iv) Price level: Higher the price, higher the elasticity of demand for a commodity.(v) Time period: In the short period demand will be less elastic because of consumption.(vi) Level of income: if income of a consumer will be very high or very low then elasticity of

demand will be inelastic and if income of a consumer will be at middle level then elasticity of demand will be elastic.

3. What is the importance of elasticity of demand?

Ans. The concept of elasticity of demand is of great practical importance. We can explain its importance in the following way:

(i) Importance to Finance Minister: The concept of price elasticity of demand is of great practical importance for Finance Minister. He would levy taxes on those goods which have an inelastic demand.

(ii) Importance to the Monopolist: The aim of the monopolist is to earn maximum profit. A monopolist will have to keep in mind the nature of demand of the good while fixing its price.

(iii) Importance in Pricing of Joint Products: Goods which are produced jointly are also priced according to their elasticity of demand.

(iv) Importance for Railways: Railways keep in mind the elasticity of demand while fixing the rates.

(v) Importance for the Electricity Board: Electricity Board keep in mind the elasticity of demand while fixing the rates.

(vi) Importance in International Trade: In the international trade that country earns more profit which imports those commodities which have more elastic demand. The commodities when are exported should have been elastic demand.

(vii) Importance in Formulation of Economic Policy: A knowledge of elasticity of demand is required by the state for formulating its economic policies.

4.Suppose there was a 4% decrease in the price of a good, and as a result, the expenditure on the good increased by 2%. What can you say about the elasticity of demand?

Percentage decrease in price = 4%

Increase in expenditure = 2%

ΔE= ΔP {q + (1 + ed)}

Since the price has decreased, the expenditure on the good will increase. This implies that the percentage of change in demand has increased more than the percentage decrease in price.

Thus, elasticity = 

The numerator is more than the denominator. This means that elasticity is more than 1. We can say that the small change in price has lead to a bigger change in demand, and as a result, the demand is elastic.

5. Explain price elasticity of demand.

Price elasticity of demand is the measure of the degree of responsiveness of the demand for a good to the changes in its price. It is defined as the percentage change in the demand for a good divided by the percentage change in its price.

Where,

ΔQ = Q2 − Q1, change in demand

ΔP = P2 − P1, change in demand

P = Initial price

Q = Initial quantity

1. Explain the meaning of increasing returns to a scale and decreasing returns to scale with the help of total physical product schedule.

Ans. (i) Increasing returns to scale refers to a situation when percentage increase in output is greater than percentage increase in all outputs.

Assumptions: Input ratio remains constant.

Schedule showing increasing returns to scale.

Labor (units) Capital (units) Physical Output (units)5 5 10010 10 300

It is clear from the table that when labor and capital are doubled (or are increased By 100%) remaining their ratio constant, physical output is more than double (increased by 200%). Hence the situation of increasing returns.

(ii) Decreasing returns to scale refers to a situation when percentage increases in output is less than percentage increase in all outputs.

Assumptions: Input ratio remains constant.

Schedule showing decreasing returns to scale.

Labor (units) Capital (units) Physical Output (units)5 5 10010 10 150

It is clear from the table that when labor and capital are doubled (or are increased By 100%) remaining their ratio constant, physical output increases only by 50% (from 100-150 units).Hence the situation of decreasing returns.

Chapter-5

Production Function

2. Explain the law of variable proportion with the help of total product and marginal product curves.

Ans.

Law of Variable Proportions- The law states that if we go on using more and more units of a variable factor (Labour) with a fixed factor( land , Capital) the total output initially increases at an increasing rate but beyond certain point, it increases at a diminishing rate and finally it falls.

This can be studied in three stages (I, II, and III) Total Physical Product (TPP) :- The total output of commodity at a particular level of employment of an input(Labour), Average Physical Product (APP):- Dividing the TPP by the number of inputs. Marginal Physical Product (MPP):- An addition made to the TPP by employing an additional unit of a variable input

TPP & MPP Relationship:- a) When MPP is positive, TPP increases at increasing rate (I stage) b) When MPP is zero, TPP is maximum,(II stage) c) When MPP is negative, TPP is falling(III stage) ( or)

(i) It means that TPP increases at an increasing rate and consequently MPP rises. It is due to (a) more efficient utilization of fixed input and (b) division of labour and specialisation due to increase in the quantity of variable input. (3)

(ii) It means output increasing in greater proportion than the increase in all input simultaneously and in the same proportion. It is due to (a) more division of labour leading to specialisation that increases productivity and(b) use of specialized machines.

3. What is meant by return to a factor? State the three phases of the law of variable proportion.

Ans. When a variable factor increases, given the quantity of fixed factors, the resultant increase in output is called return to a factor.

There are three phases of the law of variable proportions:

Phase I (Increasing Returns to a Factor). In this phase, we have increasing return to a factor. The Total Physical Product (TPP) increases at an increasing rate. Marginal Physical Product (MPP) is increasing. This phase ends at the point where MPP reaches at its highest point.

Phase II (Diminishing Returns to a Factor). In this phase, we have diminishing returns to a factor. The Total Physical Product (TPP) increases at a diminishing rate till it reaches the maximum point. Marginal Physical Product (MPP) is falling but is positive. This phase crucial because the firms would like to produce in this stage.

Phase III (Negative Returns to a Factor). This is the phase of negative returns. Here the total product (TP) starts downwards. Marginal product becomes negative and goes below x-axis.

LAB 1 2 3 4 5 6 7 8 9 10

TPP

(TP) 3 7 12 16 19 21 22 22 21 19

APP

(AP) 3 3.5 4 4 3.8 3.5 3.14 2.75 2.33 1.9

MPP

(MP) 3 4 5 4 3 2 1 0

-1 -2

4. State and explain the law of diminishing factor.

Ans. Returns to a factor relates to the behavior of total output as one variable input say labor is varied. It is a short run concept. There are three aspects of return to a factor:

(i) Increasing Returns to a Factor(ii) Constant Returns to a Factor(iii) Diminishing Returns to a Factor

Diminishing returns to a factor refers to a situation in which the total output tends to increase at the diminishing rate when additional units of the variable factor is combined with the fixed factors production.

Diminishing returns to a factor may occur due to following reasons:(i) Fixity of the factor: Fixity of factor is the principal cause that explains the

occurrence of the diminishing returns to a factor. As more and more units of the variable factor continues to be combined with the fixed factor, the latter gets over utilized. Hence the diminishing returns occurs.

(ii) Imperfect substitution. Factors of production are imperfect substitutes of each other. More and more of labour, for example, cannot be continuously used in place of additional capital. Accordingly, diminishing returns to the variable factor becomes inevitable.

5. The following table gives the average product schedule of labour. Find the total product and marginal product schedules. It is given that the total product is zero at zero level of labour employment.

L APL

1 2

2 3

3 4

4 4.25

5 4

6 3.5

L APL TPL = AP × L

1 2 2 × 1 = 2 2

2 3 3 × 2 = 6 6 − 2 = 4

3 4 4 × 3 = 12 12 − 6 = 6

4 4.25 4.25 × 4 = 17 17 − 12 = 5

5 4 4 × 5 = 20 20 − 17 = 3

6 3.5 3.5 × 6 = 21 21 − 20 = 1

1. Draw Average Total Cost, Average Variable Cost and Marginal Cost in a single diagram. Also explain the relation between marginal Cost and average cost with its help.

Ans.

Marginal cost is an additional made to total cost by producing an extra unit of output. It is expressed as:

MC = ΔTC÷ΔQ

Average cost is obtained by dividing the total cost by the units of output. It is expressed as:

AC = TC÷Q

MC affects AC. The relationship between MC and AC is as follows:

(i) When MC<AC, then AC falls.(ii) Hen MC=AC, then AC is constant or maximum.(iii) Hen MC>AC, then AC rises.(iv) MC curve always intersect AC curve at its minimum point.

Chapter-6

Concept of Cost

The following cost schedule and diagram illustrate the relationship:

Output (units) TC (Rs.) MC (Rs.) AC (rs.)

12345

59121621

54345

54.5444.2

2. Explain the relationship between ATC, AVC and MC with suitable illustration.

Ans.

Units TC ATC AVC MC

0 60 -- -- --

1 90 90 30 30

2 100 50 20 10

3 105 35 15 5

4 115 26.25 11.25 10

5 135 27 15 20

6 180 30 20 45

From 0 to 3 units when MC<Ac, AVC and MC fall and both Ac and AVC also decrease/fail.

When MC=AC, AVC both AC and AVC are minimum/constant.

From 4th to 6th unit, when MC>AC, AVC, MC rises and both AC and AVC also increase/rise.

3. What do the long run marginal cost and the average cost curves look like?

The long run marginal cost (LMC) and long run average cost (LAC) are U shaped curves. The reason behind them being U-shaped is due to the law of returns to scale. It is argued

that a firm generally experiences IRS during the initial period of production followed by CRS, and lastly by DRS. Consequently, both LAC and LMC are U-shaped curves. Due to IRS, as the output increases, LAC falls due to economies of scale. Then falling LAC experiences CRS at Q1 level of output which is also called the optimum capacity. Beyond Q1level of output, the firm experiences diseconomies of scale and if the firm continues to produce beyond Q1 level, the cost of production will rise.

4. What does the average fixed cost curve look like? Why does it look so?

Average fixed cost curve looks like a rectangular hyperbola. It is defined as the ratio of TFC to output. We know that TFC remains constant throughout all the output levels and as output increases, with TFC being constant, AFC decreases.

When output level is close to zero, AFC is infinitely large and by contrast when output level is very large, AFC tends to zero but never becomes zero. AFC can never be zero because it is a rectangular hyperbola and it never intersects the x-axis and thereby can never be equal to zero.

5. What do the short run marginal cost, average variable cost and short run average cost curves look like?

The short run marginal cost (SMC), average variable cost (AVC) and short run average cost (SAC) curves are all U-shaped curves. The reason behind the curves being U-shaped is the law of variable proportion. In the initial stages of production in the short run, due to increasing returns to labour, all the costs (average and marginal) fall. In addition to this in the short run MP of labour also increases, which implies that more output can be produced by per additional unit of labour, leading all the costs curves to fall. Subsequently with the advent of constant returns to labour, the cost curves become constant and reach their minimum point (representing the optimum combination of capital and labour). Beyond this optimum combination, additional units of labour increase the cost, and as MP of labour starts falling, the cost curve starts rising due to decreasing returns to labour.

1. Explain the relation between TR, AR and MR with the help of a table and diagram.

Ans. Total revenue is defined and given by: TR = p * q or AR * q

Average revenue is defined and given by: AR = TR÷q

Marginal revenue is defined and given by: MR = ΔTR÷Δq

Relationship between TR, AR and MR:

There is a close relationship between TR, AR and MR. the relationship among all the three concepts is illustrated by means of the following table and diagram:

q p TR= p * q MR AR123456

654321

6101212106

6420-2-4

654321

Chapter-7

Concept of Revenue

The above table and diagram show that TR will rise so long as MR is positive. TR is Maximum when MR is Zero. TR starts falling when MR becomes negative. AR is always positive.

2. Prepare a schedule based on imaginary data about TR, AR and MR assuming that the price is same at all levels of output.

Ans.

Quantity of output sold Price = AR TR MR0 10 0 01 10 10 10

2 10 20 103 10 30 104 10 40 105 10 50 10

3. Prepare an imaginary TR, AR and MR schedule in a market situation in which the firm is able to sell more only by reducing the price of the product.

Ans.

Units sold TR AR MR1 10 10 102 18 9 83 24 8 64 28 7 45 30 6 26 30 5 0

4. What is revenue of a firm? Give meaning of average revenue and marginal revenue. What happens to average revenue when marginal revenue is (i) greater than average revenue (ii) equal to average revenue (iii) less than revenue?

Ans. Revenue of a firm is defined as receipts from the sale of good. It is obtained by multiplying the quantity of the good sold and price per unit.

R = p * q

There are two concepts of revenue: AR and MR

AR is defined as revenue per unit of output sold. It is obtained by dividing TR by total output sold.

AR = TR÷q

MR is defined as an additional revenue from the sale of an additional unit of output. It is obtained as:

MR = ΔTR÷Δq

(i) When MR is greater than AR, Ar rises.(ii) When MR is equal to AR, AR is constant.(iii) When MR is less than AR, AR falls.

5. From the schedule provided below calculate the total revenue, demand curve and the price

elasticity of demand:

Quantity 1 2 3 4 5 6 7 8 9

Marginal Revenue 10 6 2 2 2 0 0 0 −5

Quantity MR TR AR

Ed = 

1 10 10 −

2 6 10 + 6 = 16

3 2 16 + 2 = 18

4 2 18 + 2 = 20

5 2 20 + 2 = 22

6 0 22 + 0 = 22

7 0 22

8 0 22

9 −5 22 − 5 = 17

1. Explain Producer’s Equilibrium with example.

. The producer of a good is in equilibrium at that level of output of the good at which he earns maximum profit. (1)

There are two conditions of producer.s equilibrium :

(i) The difference between TR and TC is maximum.

(ii.) Total profit falls if one more unit of output is produced. (2)

In the diagram, OQ is the equilibrium output with profit equal to AB = AQ . BQ. AB is the maximum vertical distance between TR and TC. If more than OQ output is produced total profits fall.

Total cost and total revenue schedule

Output

(Units)

TR TC Profit

1 10 15 5

2 18 12 6

3 24 21 3

4 28 32 4

2. Give example of producer’s equilibrium.

The producer will produce 2 units because his profits are maximum at this

level of output.

Chapter-8

Producer’s Equilibrium

The producer of a good is in equilibrium at that level of output of the good at which he earns maximum profit. (1)

There are two conditions of producer.s equilibrium :

(i) The difference between TR and TC is maximum.

(ii.) Total profit falls if one more unit of output is produced. (2)

In the diagram, OQ is the equilibrium output with profit equal to AB = AQ . BQ. AB is the maximum vertical distance between TR and TC. If more than OQ output is produced total profits fall.

Total cost and total revenue schedule

Output

(Units)

TR TC Profit

1 10 15 5

2 18 12 6

3 24 21 3

4 28 32 4

The producer will produce 2 units because his profits are maximum at this

level of output.

Explain briefly any two or three determinants of supply of a good.

Ans. Following are the factors that affect the supply of a commodity:

(i) Technological Changes: The supply of a commodity depends on the production technology used by the firm. If there is an improvement in the production technology used by the firm, the cost of production declines. Lower cost of production increases the supply of a commodity. The use of obsolete technology raises the cost of production increases in the supply of a commodity decreases.

(ii) Price of inputs: The supply of a good is also affected by a change in price of inputs used in the production of the good. If the price of inputs (wages of labour, price of raw material) goes up, the gross cost of production will rise and as a result the supply of the commodity decreases.

(iii) Price of other goods: The supply of a commodity depends upon the price of other goods. Suppose a farmer is growing wheat and rice. If the price of wheat rises, it will be probable for the farmer to grow more wheat. The farmer would withdraw some land and other resources from the production of rice and devote them to production of wheat. This will cause a decrease in the supply of rice, the price of wheat has not changed. The supply curve of rice shifts to the left.

1. Explain with the help of diagrams the effect of the following on the supply of a good:

(i) An improvement in technology

(ii) A rise in the price of inputs

(iv) Ans. Technological Changes: The supply of a commodity depends on the production technology used by the firm. If there is an improvement in the production technology used by the firm, the cost of production declines. Lower cost of production increases the supply of a commodity. The use of obsolete technology raises the cost of production increases in the supply of a commodity decreases.

Chapter-9

Supply and Elasticity of

Supply

(v) Price of inputs: The supply of a good is also affected by a change in price of inputs used in the production of the good. If the price of inputs (wages of labour, price of raw material) goes up, the gross cost of production will rise and as a result the supply of the commodity decreases.

4. Explain briefly any thee factors which leads to increase in supply.

Ans. 1. Technological changes : Technological advancement in the field of production lower the

marginal cost of production Since, MC curve is essentially the supply curve, technological

progress shifts supply curve to the right.

2.Input price changes :- Increase in the price of factor inputs leads to an decrease in supply & the supply

curve shifts to the left conversely, if the price of factor factor inputs decreases, the supply

increases and the supply curve shifts to the right.

3.Change in the excise tax rate : If product the marginal cost, which curve to the left. If the ensue duty decreases, the Mc would decrease and the supply curve would shift to the right.

4. Changes in the prices of related goods : An increase in the price of a substitute good in predictor shifts the supply curve of a good to the right, white a decrease in the price of a substitute good, would shift the supply curve of a good to the left

1. Explain the main features of monopolistic competition.

ANS. MONOPOLISTIC COMPETITION:-. A market situation in which competition

among the monopolies is seen for buying or selling differentiated product with freedom of entry and exists is known as monopolistic competition. It is also known as imperfect competition. Because both perfect competition and monopoly present.

Main features:- 1. There are large number of buyers and sellers in the market. 2. There is product differentiation. i.e., each firm produces a brand or variety of the same product and 3) there is free entry or exit of firm in the long run.4) Downward slopes elastic demand curve(AR and MR) and MR lies below AR 5) The equilibrium condition( profit maximization) is MR= RC and MC is rising

6) Selling cost;- To attract customers from other brand of a product to their own brands selling cost or advertisement cost incurred. 7) E.g. for monopolistic competition is toothpaste, soaps, lipstick etc.1) Large Number of sellers and sellers in imperfect competition.

2) There is a product differentiation 3) All the firms are price makers of their own product.4) Factors of production are mobile. Not rigid5) ) Price is greater than marginal cost6) ) ‘DD’ curve / AR and MR curves slopes down wards. (>1).7) There is Selling costs(Brief explanation with diagram of DD curve.

2. Explain how price is determined in a perfectly competitive market with fixed number of firms.

When the number of firms in a perfectly competitive market is fixed, the firms are operating in the short-run. The equilibrium price is determined by the intersection of

MR

market demand curve and supply curve. It is the price at which the market demand equals market supply.

In the given figure, if at any price above Pe, let us say Rs 12, there will be an excess supply, which will increase the competition among the sellers and they will reduce the price in order to sell more output. This causes a fall in the price, finally to Rs 8 (Pe), where the demand equals supply.

If at any price lower than Pe , let us say Rs 2, there will be an excess demand that will raise the competition among the buyers or consumers and they will be ready to pay higher price for the given output. This will increase the price to Rs 8 (equilibrium price), where the market will reach the equilibrium.

Thus, the invisible hands of market operate automatically whenever there exist excess demand and excess supply; ensuring equilibrium in the market.

3. Suppose the price at which the equilibrium is attained in exercise 5 is above the minimum average cost of the firms constituting the market. Now if we allow for free entry and exit of firms, how will the market price adjust to it?

If the equilibrium price (Rs 8) in the above figure (of Q-5) is above the minimum of average cost, then it implies that the firm is earning supernormal profits. This situation will attract new firms in the market. As the new firms enter, the industry supply of output will also increase. New firms will continue to enter the industry that will lead the price to fall until it becomes equal to the minimum of the average cost. Thus, the supernormal profits are wiped out and all the firms earn normal profits.

When the free entry and exit of firms is allowed, the equilibrium is determined by the intersection of demand curve and the ‘P = min AC’ line.

4. At what level of price do the firms in a perfectly competitive market supply when free entry and exit is allowed in the market? How is the equilibrium quantity determined in such a market?

In the long run, due to the free entry and exit of firms, all the firms earn zero economic profit or normal profit. They neither earn abnormal profits nor abnormal losses. Thus, the free entry and exit feature ensures that in the long run the equilibrium price will be equal to the minimum of average cost, irrespective of whether profits or losses are earned in the short run.

The equilibrium is determined by the intersection of consumers’ demand curve and the ‘P = min AC’ line. At equilibrium point E, quantity supplied by each firm is qe at the price (P).

5. How is the equilibrium number of firms determined in a market where entry and exist is permitted?

The characteristic of free entry and exit of firms ensures that all the firms in a perfect competitive market earn normal profit, i.e. the market price is always equal to the minimum of LAC. No new firm will be attracted to enter the market or no existing firm

will leave, if the price is equal to the minimum of LAC. Thus, the number of firms is determined by the equality of price and the minimum of LAC. The market equilibrium is determined by the intersection of market demand curve (D1D1) and the price line. The equilibrium price is P1and the equilibrium output is q1. At this equilibrium price, each firm supplies the same output q1f , as it is assumed that all the firms are identical. Therefore, at the equilibrium, the number of firms in the market is equal to the number of firms required to supply output q1at price P1, and each in turn supplying q1f amount at this price. That is

Where,

n = number of firms at market equilibrium

q1 = the equilibrium quantity demanded

q1f = the quantity of output supplied by each firm

6. How are equilibrium price and quantity affected when income of the consumers

(a) increase

(b) decrease

(a) Increase in income of consumers

If the number of firms is assumed to be fixed, then the increase in consumers’ income will lead the equilibrium price to rise.

Let us understand how it happens:

D1D1 and S1S1 represent the market demand and market supply respectively. The initial equilibrium occurs at E1, where the demand and the supply intersect each other. Due to the increase in consumers’ income, the demand curve will shift rightward parallelly while the supply curve will remain unchanged. Hence, there will be a situation of excess demand, equivalent to (qe − q1). Consequently, the price will rise due to excess demand. The price will continue to rise until it reaches E2 (new equilibrium), where D2D2 intersects the supply curve S1S1. The equilibrium price increases from Pe to P2 and the equilibrium output increases from qe to q2.

(b) Decrease in the income of consumers

The decrease in consumers’ income is depicted by leftward parallel shift of demand curve from D1D1 to D2 D2. Consequently, at the price Pe, there will be an execs supply (qe − q1), resulting the price to fall. At the new equilibrium (E2), where D2D2 intersect the supply curve, the equilibrium price falls from Pe to P2 and the equilibrium quantity falls from qe to q2.

7. Compare the effect of shift in the demand curve on the equilibrium when the number of firms in the market is fixed with the situation when entry-exit is permitted.

The above figure depicts the cases when the number of firms is fixed (in the short run) and when the number of firms is not fixed (in the long run). ‘P = min AC’ represents the long run price line, D1D1 and D2D2 represent the demands in the short run and the long run. The point E1 represents the initial equilibrium where the demand curve and the supply curve intersect each other. Now, let us suppose that the demand curve shifts under the assumption that the number of firms are fixed; thus, the new equilibrium will be at ES (in the short run), where the supply curve S1S1 and the new demand curve D2D2 intersect each other. The equilibrium price is Ps and equilibrium quantity is qs.

Now let us analyse the situation under the assumption of free entry and exit.

The increase in demand will shift the demand curve rightwards to D2D2. The new equilibrium will be at E2. It is the long run equilibrium with equilibrium price (P) = min AC and equilibrium quantity qL.

Therefore, on comparing both the cases, we find that when the firms are given the freedom of entry and exit, the equilibrium price remains same and the price is lower than the short run equilibrium price (Ps); whereas, the long run equilibrium quantity (qL) is more than that of the short run equilibrium (qs).

Similarly, for leftward demand shift, it can be noted that the short run equilibrium price (Ps) is less than the long run equilibrium price and the short run equilibrium quantity (qs) is less than the long run equilibrium quantity qL.

8. Explain through a diagram the effect of a rightward shift of both the demand and supply curves on equilibrium price and quantity.

(a) When demand and supply increase in the same proportion:

E1 is the initial equilibrium with equilibrium price P1 and equilibrium output q1.

Now, let us suppose that the demand increases to D2D2 and the supply increase to S2S2 by the same proportion. The new demand and new supply curve intersect at E2, which is the new equilibrium, with a new equilibrium output q2, but the same equilibrium price P1. Thus, an increase in the demand and the supply by the same proportion leaves the equilibrium price unchanged.

(b) When demand increases more than the increase in supply:

The original demand and supply curves intersect each other at E1 with initial equilibrium price P1 and initial equilibrium output q1.

Now, let us suppose that the demand increases and thereby the demand curve shifts to D2D2; the supply curve also shifts rightwards to S2S2. However, the increase in supply is less than the increase in demand. The new supply curve and the new demand curve intersect each other at point E2 with higher equilibrium price P2 and higher equilibrium output q2.

(c) When the increase in demand is less than the increase in supply:

Let the initial equilibrium be at E1 with the equilibrium price P1 and equilibrium output q1. Now, let us suppose that the demand increases to D2D2 and the supply increases to S2S2; where the increase in supply is more than that of demand. The new demand curve D2D2 and the new supply curve S2S2 intersect at E2. Thus, the greater increase in supply curve as compared to the demand curve will lead the equilibrium price to fall and equilibrium output to rise.

9. How are the equilibrium price and quantity affected when

(a) both demand and supply curves shift in the same direction?

(b) demand and supply curves shift in opposite directions?

(a) both demand and supply curves shift in the same direction

CasesEquilibrium

PriceEquilibrium

QuantityFigure

1) Increase in Dd =

Increase in supply

Unchanged Increases

2) Increase in Dd more

than increase SS

Increases Increases

3) Increase in Dd less

than increase in SS

Falls Increases

4) Decrease in Dd =

decrease in SS

Unchanged Falls

5) Decrease in Dd more

than decrease in

SS

Falls Falls

6) Decrease in Dd less

than decrease in

SS

Increases Falls

(b) demand and supply curves shift in opposite direction

Cases Equilibrium

Price

Equilibrium Quantity

Figure

1. Increase in Dd = decrease in SS

Increase Unchanged

2. Decrease in Dd = increase in SS

Unchanged Increase

3. Decrease in Dd < increase in supply

Decrease Increase

4. Decrease in Dd > increase in supply

Decrease Decrease

5. Increase in Dd < decrease in SS

Increase Decrease

6. Increase in Dd > decrease in SS

Increase Increase

10. Can you think of any commodity on which price ceiling is imposed in India? What may be the consequence of price-ceiling?

In India, there are many goods on which government has imposed price ceiling, in order to keep them available within the reach of the BPL (below poverty lime) people. These goods are kerosene, sugar, wheat, rice, etc.

The following are the consequences of price ceiling:

1) Excess demand − Due to artificially imposed price, cutting lower than the equilibrium price leads to the emergence of the problem of excess demand.

2) Fixed Quota − Each consumer gets a fixed quantity of good (as per the quota). The quantity often falls short of meeting the individual’s requirements. This further leads to the problem of shortage and the consumer remains unsatisfied.

3) Inferior goods − Often it has been found that the goods that are rationed are usually inferior goods and are adulterated.

4) Black marketing − the needs of a consumer remains unfulfilled as per the quota laid by the government. Consequently, some of the unsatisfied consumers get ready to pay higher price for the additional quantity. This leads to black-marketing and artificial shortage in the market.