Long Answers

1. Firms maximize profit where marginal cost equals marginal revenue (MC = MR).Using a diagram explain why this is the case. In economics, profit maximization is the (short run) process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenuetotal cost method relies on the fact that profit equals revenue minus cost, and the marginal revenuemarginal cost method is based on the fact that total profit in a perfectly competitive market reaches its maximum point where marginal revenue equals marginal cost. Basic definitions Any costs incurred by a firm may be classed into two groups: fixed costs and variable costs. Fixed costs are incurred by the business at any level of output, including zero output. These may include equipment maintenance, rent, wages, and general upkeep. Variable costs change with the level of output, increasing as more product is generated. Materials consumed during production often have the largest impact on this category. Fixed cost and variable cost, combined, equal to total cost Revenue is the amount of money that a company receives from its normal business activities, usually from the sale of goods and services (as opposed to monies from security sales such as equity shares or debt issuances). Marginal cost and revenue, depending on whether the calculus approach is taken or not, are defined as either the change in cost or revenue as each additional unit is produced, or the derivative of cost or revenue with respect to quantity output. It may also be defined as the addition to total cost or revenue as output increase by a single unit. For instance, taking the first definition, if it costs a firm 400 USD to produce 5 units and 480 USD to produce 6, the marginal cost of the sixth unit is approximately 80 dollars, although this is more accurately stated as the marginal cost of the 5.5th unit due to linear interpolation. Calculus is capable of providing more accurate answers if regression equations can be provided. Total revenue - total cost method

Profit Maximization - The Totals Approach To obtain the profit maximising output quantity, we start by recognizing that profit is equal to total revenue (TR) minus total cost (TC). Given a table of costs and revenues at each quantity, we can either compute equations or plot the data directly on a graph. Finding the profit-maximizing output is as simple as finding the output at which profit reaches its maximum. That is represented by output Q in the diagram. There are two graphical ways of determining that Q is optimal. First, the profit curve is at its maximum at this point (A). Secondly, at the point (B) the tangent on the total cost curve (TC) is parallel to the total revenue curve (TR), meaning that the surplus of revenue net of costs (B,C) is at its greatest. Because total revenue minus total costs is equal to profit, the line segment C,B is equal in length to the line segment A,Q. Computing the price at which to sell the product requires knowledge of the firm's demand curve. The price at which quantity demanded equals profit-maximizing output is the optimum price to sell the product. Marginal revenue-marginal cost method

Profit maximization using the marginal approach

An alternative argument says that for each unit sold, marginal profit (M) equals marginal revenue (MR) minus marginal cost (MC). Then, if marginal revenue is greater than marginal cost, marginal profit is positive, and if marginal revenue is less than marginal cost, marginal profit is negative. When marginal revenue equals marginal cost, marginal profit is zero.[1] Since total profit increases when marginal profit is positive and total profit decreases when marginal profit is negative, it must reach a maximum where marginal profit is zero - or where marginal cost equals marginal revenue. If there are two points where this occurs, maximum profit is achieved where the producer has collected positive profit up until the intersection of MR and MC (where zero profit is collected), but would not continue to after, as opposed to vice versa, which represents a profit minimum.[1] In calculus terms, the correct intersection of MC and MR will occur when:[1]

The intersection of MR and MC is shown in the next diagram as point A. If the industry is perfectly competitive (as is assumed in the diagram), the firm faces a demand curve (D) that is identical to its Marginal revenue curve (MR), and this is a horizontal line at a price determined by industry supply and demand. Average total costs are represented by curve ATC. Total economic profit are represented by area P,A,B,C. The optimum quantity (Q) is the same as the optimum quantity (Q) in the first diagram. 2. What is Cartel? A cartel is defined as a group of firms that gets together to make output and price decisions. The conditions that give rise to an oligopolistic market are also conducive to the formation of a cartel; in particular, cartels tend to arise in markets where there are few firms and each firm has a significant share of the market. In the U.S., cartels are illegal; however, internationally, there are no restrictions on cartel formation. The organization of petroleum-exporting countries (OPEC) is perhaps the best-known example of an international cartel; OPEC members meet regularly to decide how much oil each member of the cartel will be allowed to produce. Why are most cartel doomed to failure in the long run if they use their cartel power? Analysis demonstrates that a cartel is an inherently unstable form of operation. If the joint pooling of assets in a common cause proves in the long run to be profitable for each of the individual members of the cartel, then they will act formally to merge into one large firm. The cartel then disappears in the merger. On the other hand, if the joint action proves unprofitable for one or more members, the dissatisfied firm or firms will break away from the cartel, and, as we shall see, any such independent action almost always destroys the cartel. The cartel form, therefore, is bound to be highly evanescent and unstable. If joint action is the most efficient and profitable course for each member, a merger will soon take place. The very fact that each member firm retains its potential independence in the cartel means that a breakup could take place at any time. The cartel will have to assign production totals and quotas to each of the member firms. This is likely to lead first to a

good deal of bicker-ing among the firms over the assignment of quotas, with each member attempting to gain a larger share of the assignment. Whatever basis quotas are assigned on will necessarily be arbi-trary and will always be subject to challenge by one or more members. In a merger, or in the formation of one corporation, the stockholders, by majority vote, form a decision-making organ-ization. In the case of a cartel, however, disputes arise among independent owning entities. Particularly likely to be restive under the imposed joint action will be the more efficient producers, who will be eager to expand their business rather than be fettered by shackles and quotas to provide shelter for their less efficient competitors. Clearly, the more efficient firms will be the ones to break up the cartel. This will be increasingly true as time goes on and conditions change from the time the cartel was first formed. The quotas, the jealously made agreements that formerly seemed plausible to all, now be-come intolerable restrictions for the more efficient firms, and the cartel soon breaks up; for once one firm breaks away, expands output and cuts prices, the others must follow. If the cartel does not break up from within, it is even more likely to do so from without. To the extent that it has earned unusual monopoly profits, outside firms and outside producers will enter the same field of production. Outsiders, in short, rush in to take advantage of the higher profits. But once one strong competitor arises to challenge it, the cartel is doomed. For as the firms in the cartel are bound by production quotas, they must watch new competitors expand and take away sales from them at an accelerating rate. As a result, the cartel must break up under the pressure of the newcomers competition. Or In oligopoly, the firms compete with one another rather than collude. Colluding or collusion means jointly deciding the total output for the industry and the market price, and formulating an allocation rule as to who will produce how much. If the firms do collude, collectively they behave like a monopoly or a cartel. A cartel essentially raises the price of the product by restricting output. Under the cartel, the total (monopoly) profits are higher than the sum of the profits in oligopoly competition (irrespective of the form of oligopoly competition). The quota system dictating who produces how much is devised such that every member (firm) of the cartel is better off (that is, enjoys higher profit), compared to oligopoly competition. Yet the firms do not collude or form cartels on regular basis as colluding or forming a business cartel is illegal in many countries because of its anticompetitive (high-price) effects, which hurt the consumers. However, for products that are primarily exported by a country, there is no such concern because higher prices would hit the consumers in the foreign countries, not the domestic consumers. This is why, over time, many cartels have come up typically in international markets. OPEC is, of course, the best example. But cartels have been formed in many products including steel and vitamin. However, there is an inherent problem with any cartel, even if it may be legal a member of a cartel has an incentive to cheat and secretly break the already agreed upon cartel rules. This can be understood by using fowling figure. The MC curve denotes the marginal cost curve of a cartel member. Suppose the cartel has fixed the price of the product at p r, which is presumably higher than the price that would prevail under oligopoly competition. Such a

high price is made sustainable by following a production (an export) quota rule in which each member is asked to produce a limited quantity (less than what it would have produced in oligopoly competition). Let this quantity or quota for the member in question be yr. In the cartel regime, this members total revenues are thus equal to the area 0p rCyr. Its total costs are measured by the area under the MC curve, equal to the area 0AByr. Hence, profits are equal to the area ABCpr. Suppose this is the original situationthere is a cartel, in which the member firms are charging the price pr, and each member is producing a limited quantity, with yr being the output of a particular member firm. Now observe that as long as the market price is given at pr, the particular firm we are looking at can actually increase its output and sale up to yC and make higher profits because if the market price is given, it is equal to MR and is over the output range 0 to yC, with MR > MC. Indeed, at the output level yC, the firms profits will be equal to ADpr, which is greater than ABCpr. The implication is that this member-firm will have an incentive to break the cartel rules, over-produce and make greater profits. Of course, once the cheater sells more, there will be dow nward pressure on the market price. This will be felt by the rest of the cartel members (who are honest to the cartel) because they will face difficulty in selling their quota output at the cartel price pr (since there is more quantity in the market than beforethanks to the cheater). Whether the cheater is identified or not, others will come to infer that someone among them has broken the rules. Hence there would be strong possibility is that the cartel is abandoned and the industry reverts to oligopoly competition.

3. What is Production Function? Definition and Explanation:

Production of goods requires resources or inputs. These inputs are called factors of production named as land, labor, capital and organization. A rational producer is always interested that he should get the maximum output from the set of resources or inputs available to him. He would like to combine these inputs in a technical efficient manner so that he obtains maximum desired output of goods. The relationship between the inputs and the resulting output is described as production function. A production function shows the relationship between the amounts of factors used and the amount of output generated per period of time. Formula: It can be expressed in algebraic form as under: X = f (a1, a2 ,........, an) This equation tells us the quantity of the product X which can be produced by the given quantities of inputs (lands labor, capital) that are used in the process of production. Here it may be noted that production function shows only the maximum amount of output which can be produced from given inputs. It is because production function includes only efficient production process. The analysis of production function is generally carried with reference to time period which is called short period and long period. In the short run, production function is explained with one variable factor and other factors of productions are held constant. We have called this production function as the Law of Variable Proportions or the Law of Diminishing returns. In the long run, production function is explained by assuming all the factors of production as variable. There are no fixed inputs in the long run. Here the production function is called the Law of Returns according to the scale of production. As it is difficult to handle more than two variables in graph, we therefore, explain the Law of Returns according to scale of production by assuming only two inputs i.e., capital and labor and study how output responds to their use. Managerial use of production function? In microeconomics, a production function asserts that the maximum output of a technologically-determined production process is a mathematical production of input factors of production. Considering the set of all technically feasible combinations of output and inputs, only the combinations encompassing a maximum output for a specified set of inputs would constitute the production function. Alternatively, a production function can be defined as the specification of the minimum input requirements needed to produce designated quantities of output, given available technology. It is usually presumed that unique production functions can be constructed for every production technology. By assuming that the maximum output technologically possible from a given set of inputs is achieved, economists using a production function in analysis are abstracting away from the engineering and managerial problems inherently associated with a particular production

process. The engineering and managerial problems of technical efficiency are assumed to be solved, so that analysis can focus on the problems of allocative efficiency. The firm is assumed to be making allocative choices concerning how much of each input factor to use, given the price of the factor and the technological determinants represented by the production function. A decision frame, in which one or more inputs are held constant, may be used; for example, capital may be assumed to be fixed or constant in the short run, and only labour variable, while in the long run, both capital and labour factors are variable, but the production function itself remains fixed, while in the very long run, the firm may face even a choice of technologies, represented by various, possible production functions. The relationship of output to inputs is non-monetary, that is, a production function relates physical inputs to physical outputs, and prices and costs are not considered. But, the production function is not a full model of the production process: it deliberately abstracts away from essential and inherent aspects of physical production processes, including error, entropy or waste. Moreover, production functions do not ordinarily model the business processes, either, ignoring the role of management, of sunk cost investments and the relation of fixed overhead to variable costs. The primary purpose of the production function is to address allocative efficiency in the use of factor inputs in production and the resulting distribution of income to those factors. Under certain assumptions, the production function can be used to derive a marginal product for each factor, which implies an ideal division of the income generated from output into an income due to each input factor of production. 4. Opportunity cost principle Opportunity costs are cash outflows prevented by taking one course of action instead of another. They include returns, which the entrepreneur could have earned in alternative use of his services and capital. The concept of opportunity cost occupies a very important place in modern economic analysis. The opportunity costs or alternative costs are the return from the second best use of the firms resources which the firm forgoes in order to avail itself of the return from the best use of the resources. To take an example, a farmer who is producing wheat can also produce potatoes with the same factors. Therefore, the opportunity cost of a quintal of wheat is the amount of the output of potatoes given up. Thus we find that opportunity cost of anything is the next best alternative that could be produced instead by the same factors or by an equivalent group of factors, costing the same amount of money. Two points must be noted in this definition. Firstly, the opportunity cost of anything is only the next best alternative foregone. Secondly, in the above definition is the addition of the qualification or by an equivalent group of factors costing the same amount of money. The alternative or opportunity cost of a good can be given a money value. In order to produce a good the producer has to employ various factors of production and have to pay them sufficient prices to get their services. These factors have alternative uses. The factor must be paid at least the price they are able to obtain in the alternative uses. Suppose a businessman can buy either a washing machine or a press machine with his

limited resources and suppose that he can earn annually Rs. 40,000 and 60,000 respectively from the two alternatives. A rational businessman will certainly buy a press machine that gives him a higher return. But, in the process of earning Rs. 60,000 he has foregone the opportunity to earn Rs. 40,000 annually from the washing machine. Thus, Rs. 40,000 is his opportunity cost or alternative cost. The difference between actual and opportunity costs is called economic rent or economic rent or economic profit. For example, economic profit from press machine in the above case is Rs.60,000 Rs. 4000 = Rs. 20,000. So long as economic profit is above zero, it is rational to invest resources in press machine.

5. Distinguish between Movement along the Demand Curve and Shift of the Demand Curve. OR What are the factors which can cause a S hift in the Demand Curve OR Movement Vs Shifts of Demand Curve:

Changes in demand for a commodity can be shown through the demand curve in two ways: (1) Movement Along the Demand Curve and (2) Shifts of the Demand Curve. (1) Movement Along the Demand Curve: Demand is a multivariable function. If income and other determinants of demand such as tastes of the consumers, changes in prices of related goods, income distribution, etc., remain constant and there is a change only in price of the commodity, then we move along the same demand curve. In this case, the demand curve remains unchanged. When, as a result of change in price, the quantity demanded increases or decreases, it is technically called extension and contraction in demand. The demand curve, which represents various price quantity has a negative slope. Whenever there is a change in the quantity demanded of a good due to change, in its price, there is a movement from one point price quantity combination to another on the same demand curve. Such a movement from one point price quantity combination to another along the same demand curve is shown in figure. Diagram/Figure:

Here the price of a commodity falls from $8 to $2. As a result, therefore, the quantity demanded increases from 100 units to 400 units per unit of time. There is extension in demand by 300 units. This movement is from one point price quantity combination (a) to another point (b) along a given demand curve. On the other hand, if the price of a good rises from $2 to $8, there is contraction in demand by 300 units. We, thus, see that as a result of change in the price of a good, the consumer moves along the given demand curve. The demand curve remains the same and does not change its position. The movement along the demand curve is designated as change in quantity demanded. (2) Shifts in Demand Curve: Demand, as we know, is determined by many factors. When there is a change in demand due to one or more than one factors other than price, results in the shift of demand curve. For example, if the level of income in community rises, other factors remaining the same, the demand for the goods increases. Consumers demand more goods at each price per period (rise or Increase in demand). The demand curve shifts upward from the original demand curve indicating that consumers at each price purchase more units of commodity per unit of time. If there is a fall in the disposable income of the consumers or rise in the prices of close substitute of a good or decline in consumer taste or non-availability of good on credit, etc, etc., there is a reduction in demand (fall or decrease in demand). The fall or decrease in demand shifts the demand curve from the original demand curve to the left. The lower demand curve shows that consumers are able and willing to buy less of the good at each price than before. Schedule: Pdx ($) Qdx Rise in Qdx Fall in Qdx

12 6 4 Diagram/Figure:

100 250 500

300 500 600

50 200 300

In this figure, the original demand curve is DD/. At a price of $12 per unit, consumers purchase 100 units. When price falls to$4 per unit, the quantity demanded increases to 500 units per unit of time. Let us assume now that level of income increases in a community. Now consumers demand 300 units of the commodity at price of $12 per unit and 600 at price of $4 per unit. As a result, there is an upward shift of the demand curve DD2. In case the community income falls, there is then decrease in demand at price of $12 per unit. The quantity demanded of a good falls to 50 units. It is 300 units at price of $4 unit per period of time. There is a downward shift of the demand to the left of the original demand curve. Summing Up: (i) Extension in demand is due to reduction in price. (ii) Increase in demand occurs due to changes in factors other than price. (iii) Contraction in demand is the result of a rise in the price commodity. (iv) A decrease in demand follows a change in factors other than price.

(v) Changes in demand both increase and decrease are represent shifts in the demand curve. (vi) Changes in the quantity demanded are represented by move along the same demand curve. 6. What are the factors which can cause a Shift in the Demand Curve Demand shifters Changes in disposable income Changes in tastes and preferences - tastes and preferences are assumed to be fixed in the short-run. This assumption of fixed preferences is a necessary condition for aggregation of individual demand curves to derive market demand. Changes in expectations. Changes in the prices of related goods (substitutes and complements) Population size and composition Changes that decrease demand Some circumstances which can cause the demand curve to shift in include: decrease in price of a substitute increase in price of a complement decrease in income if good is normal good increase in income if good is inferior good

Factors affecting market demand Market or aggregate demand is the summation of individual demand curves. In addition to the factors which can affect individual demand there are three factors that can affect market demand (cause the market demand curve to shift): a change in the number of consumers, a change in the distribution of tastes among consumers, a change in the distribution of income among consumers with different tastes.

7. J.M Keynes (British Economist) What was the solution suggested by John Maynard Keynes to deal with the Great Depression of 1929? What are the ideas of Keynes which can be utilized to tackle the Global Recession of 2008-2009? In what region of Short Run Aggregate supply curve will Keynes Prescription work? What is the prescription of J.M Keynes for smoothening business cycle?

Ans.

Keynesian economics is an economic theory named after John Maynard Keynes, a British economist who lived from 1883 to 1946. He is most well-known for his simple explanation for the cause of the Great Depression. His economic theory was based on a circular flow of money, which refers to the idea that when spending increases in an economy, earnings also increase, which can lead to even more spending and

earnings. Keynes' ideas spawned numerous interventionist economic policies during the Great Depression. In Keynes' theory, one person's spending goes towards another person's earnings, and when that person spends his or her earnings, he or she is, in effect, supporting another person's earnings. This cycle continues on and helps support a normal, functioning economy. When the Great Depression hit, people's natural reaction was to hoard their money. Under Keynes' theory, this stopped the circular flow of money, keeping the economy at a standstill. Keynes' solution to this poor economic state was to "prime the pump." He argued that the government should step in to increase spending, either by increasing the money supply or by actually buying things itself. During the Great Depression, however, this was not a popular solution. It is said, however, that the massive defence spending that United States president Franklin Delano Roosevelt initiated helped revive the U.S. economy. Keynesian economics advocates for the public sector to step in to assist the economy generally, which is a significant departure from popular economic thought that preceded it laissez-faire capitalism. Laissez-faire capitalism supported the exclusion of the public sector in the market. The belief was that an unfettered market would achieve balance on its own. Keynesian economics warns against the practice of too much saving and not enough consumption, or spending, in an economy. It also supports considerable redistribution of wealth, when needed. Keynesian economics further concludes that there is a pragmatic reason for the massive redistribution of wealth: if the poorer segments of society are given sums of money, they will likely spend it, rather than save it, thus promoting economic growth. Another central idea of Keynesian economics is that trends in the macroeconomic level can disproportionately influence consumer behaviour at the micro-level. The neoclassical synthesis Keynesian approach explained unemployment in terms of wage rigidity, but did not relate the analysis to optimizing micro foundations. The new Keynesian approach tries to develop Keynesian economics to address this problem. An early branch of this approach merely introduced fixed prices and wages into the standard micro-founded general equilibrium model, examining disequilibrium situations in which actual transactions occurred at the short side of the market and the effects of such deviations from market clearing in one market spilled over into other markets. Another branch of the approach responded directly to the monetarist and rational expectations approaches, introducing wage price stickiness (such as staggered or sticky wage adjustment) into models with rational expectations to show that it is complete wage flexibility, rather than the assumption about expectations, that produced the policy ineffectiveness result. A final, and most popular new Keynesian branch, provided optimizing micro foundations to wage, price, and interest rate rigidity. Efficiency wages (which prevent the wage from falling when unemployment exists because of its adverse effect on labour efficiency) and wage

bargaining, imperfect competition and the menu costs of price changes, and asymmetric information in credit markets have been used to explain these rigidities. Some models, such as those that distinguish the role of insiders and outsiders in the wage determination process, imply that aggregate demand changes can have longterm effects on output due to what are called hysteresis effects. While some new Keynesian models imply involuntary unemployment in equilibrium, others do not, but imply only that aggregate demand policies can have effects on output. In the wake of the financial crisis of 20072010 the free market consensus began to attract negative comment even by mainstream opinion formers from the economic right, leading to a reassessment or even reversal of normative judgments on a number of topics. The Keynesian view receiving most attention has been fiscal stimulus. In late 2008 and 2009 fiscal stimulus packages were widely launched across the world, with packages in G20 countries averaging at about 2% of GDP, with a ratio of public spending to tax cuts of about 2:1. The stimulus in Europe was notably smaller than for other large G20 countries. Other areas where opinion has shifted back towards a Keynesian perspective include: Global trade imbalances. Keynes placed great importance on avoiding large trade deficits or surpluses, but following the Keynesian displacement an influential view in the West was that governments need not be concerned about them. From late 2008 imbalances are once again widely seen as an area for government concern. In October 2010 the US suggested a possible plan to address global imbalances, with targets to limit current account surpluses similar to those proposed by Keynes at Bretton Woods. Capital Controls. Keynes strongly favoured the use of controls to restrain international capital movement, especially short term speculative flows. During 2009 and 2010 capital controls have once again came to be seen as an acceptable part of a governments macroeconomic policy toolkit, though institutions like the IMF still caution against overuse. In contrast to stimulus policies, the return to favour of capital controls still had momentum as of late 2011.

Scepticism concerning the role of maths in academic economics and in economic decision making. While the resurgence has seen no general reversal of opinion on the utility of complex math, there have been numerous calls for a broadening of economics to make further use of disciplines other than maths. In the practical spheres of banking and finance, there have been warnings against over reliance on mathematical models, which have been held up as one of the contributing causes of the 2008 2009 crises. 8. Profit Maximization OR Explain what is meant by the term profit maximization in economic theory and how it can be achieved. Explain why Profit gets maximized at the point where MR0=MC?

Related Questions:

Write brief note on alternative objectives of forms, besides the objective of profit maximization. Besides profit Maximization business firms have other goals like sales maximization, growth maximization, managers utility maximization etc. Discuss. In normal & formal economic theory we can often assume profit maximization. In reality, the firms do not maximize profit , in fact they cannot What are the alternatives to the hypothesis of profit maximization? How far would it be correct to prefer satisficing as an alternative to profit maximization?

Ans.

Profit maximization is the (short run) process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenuetotal cost method relies on the fact that profit equals revenue minus cost, and the marginal revenuemarginal cost method is based on the fact that total profit in a perfectly competitive market reaches its maximum point where marginal revenue equals marginal cost. Let the firm think of producing one more unit than what it has been doing so far. If it finds that the increase in costs to produce the extra unit is less than the increase due to the extra unit, it will produce one more unit becomes its revenue increases more than its costs by doing so and its profits increase. After increasing the output by one unit, the firm may consider producing another extra unit. If it finds that the increase in revenue due to second additional unit is more than the increase in costs due to that second additional unit, the firm will decide to produce the second extra unit because its profit increases. It will go on increasing its output so long as the latest unit adds to profit because the marginal revenue from the extra unit is higher the marginal cost of the extra unit. When will it stop further increasing output by one more unit. It will stop, if it finds that the latest extra unit adds to costs as much as it adds to revenue. Thus it stops increasing output at that level of output where its marginal cost equals its marginal revenue.

Again, if the firm finds that the mc>mr, it knows that the latest extra unit of output has added more to the total costs than it has added to the revenue. By reducing the output by one unit, the firm saves more costs than it loses in revenue. Thus its profits increase by reducing one unit from the output. Even at the lower output level, the firm will again check whether by reducing output by one more unit again the total costs reduces by an amount more than the loss in revenue due to reduction of further one unit of output. Thus so long as mc>mr, it pays if the firm goes on reducing output. When will the firm stop? It will stop at that level of output at which the reduction in costs on the latest unit of output is just equal to the reduction in the revenue on the latest output. This again means he stops where mr= mc.

The underlying assumption is that the marginal costs increases as output is increased and further increased. Profit is maximized where marginal profit is zero. Any increase or decrease in output from this peak level will cause marginal profit to be equal to zero. Marginal profit is zero, when marginal revenue equal marginal costs. marginal cost is the change in total costs due to a small (one unit) change in output level., while marginal revenue is the change in total revenue due to a small (one unit) change in output. Alternatives to profit maximization theories The standard neo-classical assumption is that a business seeks to maximise profits from producing and selling an output in a market. However there are other objectives firms might decide to pursue and this has implications for price, output and economic welfare. A second point is that it is difficult for firms to identify their profit maximizing output, as they cannot accurately calculate marginal revenue and marginal costs. Traditional economic theory assumes there is a single goal. Behavioural economists argue differently Any corporation is an organization with various groups - Employees - Managers - Shareholders - Customers Each of these groups is likely to have different objectives or goals. The dominant group at any moment in time can give greater emphasis to their own objectives - for example the main price and output decisions may be taken at local level by managers - with shareholders taking only a distant view of the company's performance and strategy. Satisfying Maximizing behavior may be replaced by satisfying - I.e. setting minimum acceptable levels of achievement. The domestic and international Equity and Bond markets may play an important role in monitoring the performance of managers in a company when companies are under-performing set against the performance of other businesses in a market, there may be downward pressure on the share price, raising the threat of a contested takeover bid by a rival firm. A firm may be under pressure to reduce prices to consumers if it has made large profits and may choose to do this in order to stop an investigation by the Competition Commission or to improve its image with customers. Alternatively, the firm may reward workers with higher wages in order to stop industrial action.

Sales Revenue Maximization This objective was initially developed by the work of Baumol (1959). Baumol's research focused on the behaviour of manager-controlled businesses - where the day-to-day decisions taken by managers are divorced from the shareholders (the owners of the business). Baumol argued that annual salaries and other perks might be more closely correlated with total sales revenue rather than bottom line profits. An alternative view was put forward by Williamson (1963), who built a model based on the concept of managerial satisfaction (utility). This can be enhanced by success in raising sales revenue. Total revenue is maximised when marginal revenue = zero. The shareholders of a business may introduce a constraint on the price and output decisions of managers this is known as constrained sales revenue maximization. They may introduce a minimum profit constraint designed to underpin the market valuation of their shares and maintain a dividend (a share of the company's profits). Limit Pricing Firms may adopt predatory pricing policies by lowering prices to a level that would force any new firms entering the industry to operate at a loss. This would allow firms to sustain a monopoly position in a market. 9. Write brief note on degrees of Price discrimination OR Price Discrimination - Short Note Ans. Price discrimination is the practice of one retailer, wholesaler, or manufacturer charging different prices for the same items to different customer. This is a widespread practice that does not necessarily imply negative discrimination. Price discrimination, as it is now understood, is separated into degrees. First, second and third degree price discrimination exist and apply to different pricing methods used by companies. Much depends on the understanding of the market in segments, and also the consumers ability to pay a higher or lower price, called elasticity of demand. A person who might pay more for an item is thought to have a low elasticity of demand. Another person who will not pay as much has a high elasticity of demand. First-degree price discrimination occurs when identical goods are sold at different prices to each individual consumer. Obviously, the seller is not always going to be able to identify who is willing to pay more for certain items, but when he or she can, his profit increases. You can see this type of price discrimination in the sale of both new and used cars. People will pay different prices for cars with identical features, and the salesperson must attempt to

gauge the maximum price at which the car can be sold. This type of price discrimination often includes a bargaining aspect, where the consumer attempts to negotiate a lower price. Second-degree price discrimination refers to companies charging lower prices for higher quantities. In companies where a client orders in bulk and is able to purchase a high number of the same items at once, the client may get a discounted rate. This rate would not apply to a client who only orders a few items at a time. In retail stores, second-degree price discrimination often exists. A reduced price may be offered if you buy two t-shirts instead of just one. This form helps to get rid of merchandise and generate more revenue for a company. Third degree price discrimination is based on understanding the market, and occurs with great frequency. Group of People: This type takes many different forms, but in all cases attempts to derive the most sales from each segmented group of consumers. For example, senior citizens are considered a group, and are often offered discounts at movie theatres, for transportation, in restaurants, and even in retail stores where seniors may have a senior day each week that allows them to take a discount on merchandise. Students are another segmented group that may be offered lower prices. Both seniors and students have a higher elasticity of demand and can generally afford to pay less than the average worker. Geography: In this case a supplier charges for instance a different price in different countries. The price difference is only partially driven by different local costs. The main driver is the willingness and ability of the local population to pay for the product.

Market segmentation may also evaluate the socio-economic aspects of an area when considering elasticity of demand. Its not uncommon to see retail grocery stores o ffer differing prices in an area where the retailer knows he can get more money for a product. Alternately, where only one chain store exists in a certain location, retail grocery stores might offer higher prices because people have no alternative place to shop. Another form of third degree price discrimination is temporary discounts for airfares that are meant to increase business. These discounts could be seasonal, and designed to promote the company. Those in urban areas may pay more for flights or hotel rooms than those in rural areas.

10.Oligopoly Explain the relevant economic models of oligopoly, which explain the following 2 oligopoly market conditions: a) Emergence of price war and war for market share b) Price being sticky for some products in oligopoly market Game theory and its application in oligopoly market. Why is the behavior of firms in oligopoly difficult to predict?

Explain the nature and characteristics of oligopoly market structure. Give at least an example of oligopoly existing in any one industry in India How is the price and output decision taken by a firm operating in an industry, which has a few large producers/sellers? (Oligopoly)

Ans: An oligopoly is a market dominated by a few producers, each of which has control over the market. It is an industry where there is a high level of market concentration. However, oligopoly is best defined by the conduct (or behaviour) of firms within a market rather than its market structure. Normally an oligopoly exists when the top five firms in the market account for more than 60% of total market demand/sales. The three most important characteristics of oligopoly are: (1) an industry dominated by a small number of large firms, (2) firms sell either identical or differentiated products, and (3) the industry has significant barriers to entry. Small Number of Large Firms The most important characteristic of oligopoly is an industry dominated by a small number of large firms, each of which is relatively large compared to the overall size of the market. This characteristics gives each of the relatively large firms substantial market control. While each firm does not have as much market control as monopoly, it definitely has more than a monopolistically competitive firm. The total number of firms in an oligopolistic industry is not the key consideration. A oligopoly firm actually can have a large number of firms, approaching that of any monopolistically competitive industry. However, the distinguishing feature is that a few of the firms are relatively large compared to the overall market. A given industry with a thousand firms, for example, is considered oligopolistic if the top five firms produce half of the industry's total output. Identical or Differentiate Products Some oligopolistic industries produce identical products, like perfect competition in this regard, while others produce differentiated products, more like monopolistic competition. In actuality it points out that oligopolistic industries come in two varieties. Identical Product Oligopoly: This type of oligopoly tends to process raw materials or produce intermediate goods that are used as inputs by other industries. Notable examples are petroleum, steel, and aluminum. Differentiate Product Oligopoly: This type of oligopoly tends to focus on goods sold for personal consumption. The key is that people have different wants and needs and thus enjoy variety. A few examples of differentiated oligopolistic industries include automobiles, household detergents, and computers. Barriers to Entry Firms in an oligopolistic industry attain and retain market control through barriers to entry. The most noted entry barriers are: (1) exclusive resource ownership, (2) patents and copyrights, (3) other government restrictions, and (4) high start-up cost.

Barriers to entry are the key characteristic that separates oligopoly from monopolistic competition on the continuum of market structures. With few if any barriers to entry, firms can enter a monopolistically competitive industry when existing firms receive economic profit. This diminishes the market control of any given firm. However, with substantial entry barriers found in oligopoly, firms cannot enter the industry as easily and thus existing firms maintain greater market control. Oligopoly theory makes heavy use of game theory to model the behaviour of oligopolies: Stackelberg's duopoly. In this model the firms move sequentially . Cournot's duopoly. In this model the firms simultaneously choose quantities Bertrand's oligopoly. In this model the firms simultaneously choose prices Demand curve

Above the kink, demand is relatively elastic because all other firms prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to produce at point E which is the equilibrium point and, incidentally, the kink point. In an oligopoly, firms operate under imperfect competition and a kinked demand curve which reflects inelasticity below market price and elasticity above market price, the product or service firms offer, are differentiated and barriers to entry are strong. Following from the fierce price competitiveness created by this sticky-upward demand curve, firms utilize nonprice competition in order to accrue greater revenue and market share. "Kinked" demand curves are similar to traditional demand curves, as they are downwardsloping. They are distinguished by a hypothesized convex bend with a discontinuity at the bend - the "kink." Therefore, the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue curve. Price leadership is something that economists refer as a game of follow-the-leader, it is a pricing strategy that one leading or dominant company perhaps the one that owns the biggest market share sets the price for the whole industry and others will follow. Companies are sometimes matching the prices with the biggest company. This oligopoly model is very common. Oligopoly is a market structure even though is much more difficult to evaluate when compared to other market structures, is very common in todays society and as we move on in new century and companies are getting bigger and more powerful every day, with the vision of global market it is certain that this market structure is going to be in the future world market a dominant market structure.

11. Business Cycle

In simple terms, Business Cycle can be defined as the recurring and fluctuating levels of economic activity that an economy experiences over a long period of time. The term business cycle (or economic cycle) refers to economy-wide fluctuations in production or economic activity over several months or years. These fluctuations occur around a long-term growth trend. Business cycles are usually measured by considering the growth rate of real gross domestic product. Despite being termed cycles, these fluctuations in economic activity do not follow a mechanical or predictable periodic pattern. The National Bureau of Economic Research (NBER), founded in New York in 1920, pioneered research into understanding the repetitive sequences that underlie business cycles. In general, a business cycle describes changes in the demand-side of the economy as measured by GDP, where: GDP = C + I + G + NX Over time, GDP does not remain constant and will change for many reasons, economic and non-economic. Economic reasons include changes in government policies such as taxes and interest rates. The non-economic reasons are too many to even consider listing, but include factors such as war, drought, natural and man-made disasters A business cycle is not a regular, predictable, or repeating phenomenon like the swing of the pendulum of a clock. Its timing is random and, to a large degrees, unpredictable. A business cycle is identified as a sequence of four phases: 1) An expansion is where the economy is experiencing positive and increasing economic output. Employment tends to increase (unemployment falls) and there is upward pressure placed on prices (inflation rises) as output rises. 2) A peak is reached when the economy has produced the greatest amount of output. At this point employment is generally at or near its highest level (unemployment is at its lowest level: usually below the full employment rate of approximately 5%) and prices tend to rise more rapidly (inflation accelerates). 3) Following the peak is a recession, or contraction. During this phase output actually decreases (the rate of growth becomes negative); unemployment begins to rise and the inflationary pressure on prices fades In America, due to government involvement, prices usually don't fall, but the rate of inflation decreases). The low point of the cycle occurs next. 4) The low point of the cycle occurs next. This is known as a trough and unemployment tends to be at its peak and production at its low point. There is very little upward pressure on prices and in some cases there is downward pressure on prices (deflation).

In recent years economic theory has moved towards the study of economic fluctuation rather than a 'business cycle though some economists use the phrase 'business cycle' as convenient shorthand. Dating of Business Cycles and Growth Rate Cycles in the Indian Economy For India, Chitre (1982) had initially determined a set of growth cycle dates.Following the classical NBER procedure, Dua and Banerji (1999) later determined business cycle and growth rate cycle dates for the Indian economy. These dates were further revised and reported in Dua and Banerji (2004). Recession: In this context, it is important to understand something of the mechanism that drives a business cycle. A recession occurs when a decline however initiated or instigated occurs in some measure of aggregate economic activity and causes cascading declines in the other key measures of activity. Thus, when a dip in sales causes a drop in production, triggering declines in employment and income, which in turn feedback into a further fall in sales, a vicious cycle results and a recession ensues.This domino effect of the transmission of economic weakness from sales to output to employment to income, feeding back into further weakness in all of these measures in turn, is what characterizes a recessionary downturn Keynesian According to Keynesian economics, fluctuations in aggregate demand cause the economy to come to short run equilibrium at levels that are different from the full employment rate of output. These fluctuations express themselves as the observed business cycles. Keynesian models do not necessarily imply periodic business cycles. However, simple Keynesian models involving the interaction of the Keynesian multiplier and accelerator give rise to cyclical responses to initial shocks. Paul Samuelson's "oscillator model"[21] is supposed to account for business cycles thanks to the multiplier and the accelerator. The amplitude of the variations in economic output depends on the level of the investment, for investment

determines the level of aggregate output (multiplier), and is determined by aggregate demand (accelerator). In the Keynesian tradition, Richard Goodwin accounts for cycles in output by the distribution of income between business profits and workers wages. The fluctuations in wages are almost the same as in the level of employment (wage cycle lags one period behind the employment cycle), for when the economy is at high employment, workers are able to demand rises in wages, whereas in periods of high unemployment, wages tend to fall. According to Goodwin, when unemployment and business profits rise, the output rises.

12.Capital Budgeting Capital budgeting is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures. It is also known as Investment Appraisal. Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. Capital budgeting is basically concerned with the justification of capital expenditures. Importance of Capital Budgeting: Capital budgeting decisions are of paramount importance in financial decision. So it needs special care on account of the following reasons: 1. Long-term Implications: A capital budgeting decision has its effect over a long time span and inevitably affects the companys future cost structure and growth. A wrong decision can prove disastrous for the long-term survival of firm. On the other hand, lack of investment in asset would influence the competitive position of the firm. So the capital budgeting decisions determine the future destiny of the company. 2. Involvement of large amount of funds: Capital budgeting decisions need substantial amount of capital outlay. This underlines the need for thoughtful, wise and correct decisions as an incorrect decision would not only result in losses but also prevent the firm from earning profit from other investments which could not be undertaken. 3. Irreversible decisions: Capital budgeting decisions in most of the cases are irreversible because it is difficult to find a market for such assets. The only way out will be scrap the capital assets so acquired and incur heavy losses. 4. Risk and uncertainty: Capital budgeting decision is surrounded by great number of uncertainties. Investment is present and investment is future. The future is uncertain and

full of risks. Longer the period of project, greater may be the risk and uncertainty. The estimates about cost, revenues and profits may not come true. 5. Difficult to make: Capital budgeting decision making is a difficult and complicated exercise for the management. These decisions require an overall assessment of future events which are uncertain. It is really a marathon job to estimate the future benefits and cost correctly in quantitative terms subject to the uncertainties caused by economic-political social and technological factors. The problems in capital budgeting decisions may be as follows: a) Future uncertainty: Capital budgeting decisions involve long term commitments. However there is lot of uncertainty in the long term. The uncertainty may be with reference to cost of the project, future expected returns, future competition, legal provisions, political situation etc. b) Time Element: The implications of a Capital Budgeting decision are scattered over a long period. The cost and the benefits of a decision may occur at different points of time. The cost of a project is incurred immediately. However, the investment is recovered over a number of years. The future benefits have to be adjusted to make them comparable with the cost. Longer the time period involved, greater would be the uncertainty. c) Difficulty in Quantification of impact: The finance manager may face difficulties in measuring the cost and benefits of projects in quantitative terms. For example, the new products proposed to be launched by a firm may result in increase or decrease in sales of other products already being sold by the same firm. It is very difficult to ascertain the extent of impact as the sales of other products may also be influenced by factors other than the launch of the new products.

13.Explain the concept of Ceteris Paribus. OR Short Note on Ceteris Paribus

Ans: This is a Latin term. It means everything else being equal. Ceteris Paribus is a concept that economists use to define cause-and-effect relationships that are isolated from external factors. Suppose, for example, that Apple Computer decides to lower the price of its popular iPod device. Economists would assert that this would increase the demand for iPods. But this statement ignores other factors. Suppose that at the same time, Microsoft releases a cool new product that competes directly with the iPod. If the Microsoft product is successful, the demand for iPods could decrease--- even though Apple has lowered the price of iPods. On the other hand, suppose that the decrease in the price of iPods coincides with an economic downturn. This too could result in a lower demand for iPods, despite the lower price. So how do economists deal with all these outside issues? They assume ceteris paribus, and focus their analysis only on two closely related factors. Otherwise, it

would be impossible to establish any economic theory, because economists would have to account for every possible outside factor that could interfere with a given cause-and-effect relationship For example, if the price of petrol rose, you would expect more people use public transport, ceteris paribus. However, everything else may not remain equal. e.g. Cost of cars might go down even though cost of petrol went up, etc. Economists need to use this as a benchmark to understand how two different factors relate to each other. A lot of the time economists speak hypothetically about different subjects in economics. Hope this helps Ceteris paribus is an essential feature of the scientific method and economic analysis. Implementing the ceteris paribus assumption makes it possible to isolate the effect one factor has on another in the derivation and testing of hypotheses and principles. Scientific Method The scientific method seeks to explain the way the world works by testing and verifying hypothesized cause-and-effect relations. Such relations take the form of "If A, then B." Or that "Event A causes event B." To identify the connection between A and B it is essential that only A and B change. If event A is hypothesized to cause event B, then other possible events C, D, and E, which might affect B, cannot be allowed to change, cannot be allowed to influence B. Consider a basic economic principle, the law of demand. This law states that quantity demanded is inversely related to demand price. Or stated in other terms, an increase in demand price causes a decrease in quantity demanded. Suppose, for example, that focus is on the demand for hot fudge sundaes, particular the law of demand for hot fudge sundaes. The amount of hot fudge sundaes that buyers are willing and able to purchase, however, can be influenced by factors other than the price of hot fudge sundaes, including income, preferences, or the prices of other goods. Demand Price Changes: Suppose that the price of hot fudge sundaes increases from $2 to $3. The law of demand indicates that the quantity demanded of hot fudge sundaes should decrease. Quantity Demanded Changes: If the quantity demanded of hot fudge sundaes decreases, then this provides (presumably) confirmation of the law of demand. But what if the quantity demanded increases? Does this refute the law of demand? Other Factors: The law of demand cannot be confirmed or refuted if other factors that also influence hot fudge sundae demand also change. Suppose hot fudge sundae buyers have more income, which they are inclined to spend on hot fudge sundaes. Additionally, suppose the price of yogurt cones (a substitute for hot fudge sundaes) increases, prompting potential yogurt cones buyers to purchase hot fudge sundaes instead. With these other factors also changing, testing the cause-and-effect connection between demand price and quantity demanded is impossible. It is not possible to say for certain if the change in the quantity demanded of hot fudge sundaes is caused by

the higher price of hot fudge sundaes or by the change in buyers' income or by the change in the price of yogurt cones. Using the scientific method to derive, test, and verify hypotheses, requires the ceteris paribus assumption, that other factors be kept constant. Economic Analysis Although other factors are initially held constant with the ceteris paribus assumption, they are not necessarily held constant forever. A critical aspect of economic analysis is to systematically relax the ceteris paribus assumption. In so doing, the specific effect of each ceteris paribus factor can be identified and analyzed. Much like a chemist adds one chemical at a time to a mixture to determine the resulting reaction, an economist relaxes one ceteris paribus assumption at a time to observe the results. Consider once again the demand for hot fudge sundaes. Once the law of demand is identified and combined with the supply of hot fudge sundaes, then the hot fudge sundae market can be analyzed. The equilibrium price and equilibrium quantity can be identified. This equilibrium, however, is based on the ceteris paribus assumption. In particular, other demand factors, such as buyers' income, preferences, and other prices, are held unchanged in the identification of the equilibrium. What happens to the price and quantity of hot fudge sundaes should one of these ceteris paribus factors change? Suppose, for example, that buyers have more income. By relaxing the ceteris paribus assumption of constant income, the effect of an increase in buyers' income on the hot fudge sundae market can be analyzed. The effect of other ceteris paribus factors can subsequently be analyzed as well, one by one. This systematic analytical approach can provide a great deal of insight into the operation of the hot fudge sundae market. 14. Elaborate how the concept of Consumer Surplus is useful to a business manager in his decision making. Consumer Surplus is defined as the total willingness to pay for a product minus the total payment for the product. The concept of consumers surplus was introduced by Alfred Marshall. According to him: A consumer is generally willing to pay more for a given quantity of good than what he actually pays at the price prevailing in the market". For example, you go to the market for the purchase of a pen. You are mentally prepared to pay $25 for the pen which the seller has shown to you. He offers the pen for $10 only. You immediately purchase the pen and say thank you. You were willing to pay $25 for the pen but you are delighted to get it for $10 only. Consumers surplus is the difference between the maximum amount a consumer is willing to pay for the good and the price he actually pays for the good. In our example given above, the consumers surplus is $15 ($25 $10).

If we are talking about good x, for example, and px and x stand respectively for the price and the quantity demanded of this good, the total payment for good x is simply price quantity demanded = pxx. The total willingness to pay for good x is defined as the total utility obtained from consuming x, measured in terms of money. It is the maximum amount that the consumer is willing to pay for the product. From the marginal utility theory,remember that this is measured by the area under the marginal utility (in terms of money). Further, this curve is same as the demand curve for the product. Hence the total willingness to pay is equal to the area under the demand curve. Turning to Figure 5.1(a), if px = p0 and the consumer is demanding x0, her total illingness to pay is equal to the area 0ABx0. Similarly, if px = p1 and the consumer demands x1, the total willingness to pay equals the area 0ACx1.We are now ready to compute consumer surplus. If the price is p0, for instance, the total willingness to pay = 0ABx0, while the total payment is equal to the area 0p0 0x0 = 0p0Bx0. Thus the consumer surplus = 0ABx0 0p0Bx0 = p0AB. By similar calculation, at the price p1, the consumer surplus is equal to p1AC. In general, we then say that the consumer surplus equals the area under a demand curve over and above the line representing the price. For example, in panel (b) of Figure 4.23, the shaded area shows the consumer surplus at the price p0. Using consumer surplus, we can measure the change in welfare due to a price change. If for example the price of good x increases from p0 to p1, the change in consumer surplus is simply the difference between the consumer surpluses associated with p0 and p1. In Figure 5.1(a), this is equal to p0AB p1AC = p0p1CB. The negative sign reflects a welfare loss due to a price increase, which is expected. In absolute value, the change in the consumer surplus equals the area between the two respective price lines.

Importance of Consumers Surplus: The concept of consumers surplus has both theoretical as well as practical importance. (i) Theoretical importance: The idea of consumers surplus reveals the benefits which we derive from our purchase of the commodity in the market. For example, when we purchase salt, or a match box, we are willing to pay the amount much higher than their market value. For example, a consumer would be willing to pay $10 for a match box rather than go without it but he actually pay Re one only on the purchase of a match box. Consumers surplus on the purchase of match box thus is $ 9.0. (ii) Practical importance: A monopolist can charge higher price for his product if the consumers are enjoying large consumers surplus on the use of his product. (iii) The inhabitants of a country derive consumer's surplus when they import commodities from abroad. They are usually prepared to pay more for than what they actually pay. (iv) A finance minister imposes taxes of the commodities yielding consumer's surplus.

(v) An entrepreneur before investing capital in a project evaluates the consumer's surplus to be derived from it. If the benefits to the obtained are greater than the costs, the investment is undertaken. Criticism: The Marshallian concept of consumers surplus has been severally criticized by modern economists Allen and Hicks. According to them, the concept is based on assumptions which are unwarranted. Utility, according to them, is a psychological feeling. It cannot be exactly measured in term of money. In Marshallian analysis, the marginal utility of money is assumed to remain constant. The fact is that when a consumer spends money on goods, his income decreases and the marginal utility of money to him rises. Analysis ignores this basic fact. Consumers surplus is said to be imaginary as it assumes that utilities derived from various goods are independent. In real life, this is not true. The fact is that utilities derived from various goods are independent. Measurement of Consumers Surplus with the Help of In difference Curves (Hicksian Method): Professor J.R. Hicks, has explained the concept of consumer surplus with the help of indifference curve technique . According to Hicks when there is fall in the price of a commodity, it has two main effects: First, the consumer can purchase more of the good whose price has fallen. Secondly, he can purchase the same quantity of the good as he was buying before but with a lesser amount of money. He spares some money in the bargain. This is a form of rise in the real income of the consumer. Diagram/Figure: The Hicksian method of measuring consumers surplus is now explained with the help of diagram below.

In figure 3.20 commodity X is measured on OX axis and money income of an individual on OY axis. We assume here that a consumer does not know the price of the commodity X and has OR quantity of money. The indifference curve IC1 represents various combinations of income and X of commodity X which yield the same level of satisfaction to the consumer. The indifference curve IC1 originates from point R. It shows the stage when the consumer retains all of his income and zero units of commodity for a given level of the utility. The consumer moves down along the curve IC 1. The consumer at point P buys OT amount of commodity X and has OE amount of money income. In other words, the consumer is ready to sacrifice RE amount of money for getting OT units of commodity X. We now assume that the consumer is informed of the price of commodity X. The RL is the budget line. The budget line touches the indifference curve IC2 at point N which is the point of equilibrium. The consumer now has the OT commodity of X and OF amount of income. He gives up RF amount of money to buy OT units of commodity X. Previously he was ready to pay RE amount of income which is higher than the amount he pays now. We infer from this that RE RF i.e., FE is the consumer surplus. FE is the difference between the amount of income the consumer was willing to pay and what he actually pays. The surplus has also shifted the consumer on the higher level of satisfaction from IC1 to IC2

15.What are the essential features of a perfectly competitive market? Illustrate a firm making a short- run loss. Why is this situation unlikely to persist in the long run? OR Perfectly competitive market in the short run allows even the less efficient to survive for some time. Discuss. OR Which of the following industries would you say is close to being perfectly competitive market and why: Brewing and wine making, taxi driving, Airlines, copper mining, Potato Farming, Car Manufacturing

Ans: Perfect competition or a perfectly competitive industry is defined by the following characteristics: A) - The product is homogeneous (i.e., they are perfect substitutes). (1). Competition in a market where products are differentiated (e.g., mineral water, owing to chemical and marketing differences) is not as keen as that in a market where products are homogeneous. (2). Generally, prices for differentiated products are different.

B) - There are many buyers, each of whom purchases a quantity that is small relative to the market. (1). In a market where some buyers have market power, different buyers pay different prices: The buyers with market power get lower prices. 2). Where some buyers have market power, it is not possible to construct the market demand curve as the buyers with market power can affect the going price. C) There are many sellers, each of whom supplies a quantity that is small relative to the market. (1). Where some sellers have market power, it is not possible to construct market supply curve as the sellers with market power can affect the going price. D). New buyers and sellers can enter freely, and existing buyers and sellers can exit freely. There are no technological, regulatory or legal barriers. (1). With free entry and exit, the market price cannot stay above a seller's average cost for very long. (2). If the market price is above a sellers average cost, new sellers will enter, add to the market supply, and bring down the price. E) All buyers and all sellers have equal information about market conditions (e.g., prices, substitutes, and technology). (1). Markets where there are differences in information among buyers, among sellers, or between buyers and sellers, are not as competitive as those where all buyers and sellers have equal information. Consider, for instance, wheat or onions. Each of these is a very homogeneous Productsame or identical everywhere (unlike cars that come in various Designs, quality and so on). The same is true of leather footballs or cooking gas. In general, by a very homogeneous or identical product, we refer to a very standardised item for which inherent quality differences are minimal; which does not come in different designs; and on which consumers do not have different perceptions. As for more examples of which goods are homogeneous and which goods are not, various computer-related items are fast becoming standardised items these days, which was not true 20 years ago. ACD RW drive, for example, is almost the same everywhere in the world with minimal quality differences among different brands. In contrast, TVs are available in different sizes, features and looks. They are certainly not homogeneous. Different types of cotton shirts may have the same quality but their styles may be different so that they are not necessarily homogeneous from the perspective of consumers. Sometimes, products like toothpaste or lipstick may be basically the same, but due to the effect of advertising, consumers see them differently and their perception matters. Such products are not considered homogeneous from the viewpoint of economic analysis. The important implication of a product being homogeneous is that all firms producing and selling it have to charge the same price. This is because, between two firms, if one charges a higher price than the other, no one will buy from the former.1 Given that a product is homogeneous, the existence of a large number of firms implies that each firm is very small compared to the whole market. Thus no single firm can influence the price. In other words, a firm in a perfectly competitive industry is a price takerit takes

the market price as given. We can say that the market price is exogenous to any individual firm. This is another way of saying that in a perfectly competitive market, no single firm possesses any market power.2 The last feature leads to a simple relationship between a firms output and a firms total revenue (TR), equal to total money generated from sales. By definition, TR = price (p) quantity sold or produced (y).3 Since p is given to the firm, its total revenue must equal p 1 if one unit is sold, p 2 if two units are sold and so on. Plotting these points against the output we obtain the total revenue curve, as shown in Figure 10.1. It is a ray from the origin with a slope equal to p everywhere because p is given to the firm.4 A decrease or an increase in p rotates this curve clockwise or anti-clockwise respectively. By now you might guess that with any total, there is always a marginal and an average. This is true here. We define marginal revenue (MR) as addition to the total revenue from one extra unit produced and sold. In Figure 10.1 notice by how much TR increases as one extra unit is produced. As output is increased from 0 to 1, MR = p 0 = p. Similarly, if output increases from 1 unit to 2 units, MR = 2p p = p. Thus, under perfect competition, MR = p. This is because p is exogenous to a firm.5 We now define average revenue (AR) as TR/output. Since TR = py, we have AR = py/y = p. Thus AR = p. Note that this has nothing to do with p being given to a firm. It holds in competitive and non-competitive markets. As you will see shortly, it will be useful to have another graph called the price line, defined as a plot of price facing a competitive firm against its output. However, since p is exogenous to the firm it is simply a flat line as shown in Figure 10.2. From the price line we can measure the total revenue. If, for instance, the output = y1, TR = 0p0 0y1 = the area 0p0A1y1. Similarly at y = y2, the total revenue equals the area 0p0A2y2 and so on. Hence , the (rectangular) area under the price line measures total revenue for a perfectly competitive firm. Sometimes the price line is referred to as the demand curve facing a competitive firm in the sense that irrespective of how much a firm wants to sell or equivalently how much the consumers are buying from the firm, the price they are paying does not change.6 We note that this demand curve facing a firm has price elasticity, equal to .

16. Define Price elasticity of demand and Income elasticity of demand / Discuss the concept of price elasticity of demand & income elasticity of demand / What do you understand by price elasticity of demand? Write short note on Income elasticity of demand.
Ans:

Price Elasticity of demand Price Elasticity of Demand is predominantly used in economic analysis; it is alternatively referred to as Elasticity of Demand. Price Elasticity of demand is the degree of responsiveness of demand to a change in its price. In technical terms it is the ratio of the percentage change in demand to the percentage change in price.

Thus, Ep = Percentage change in quantity demanded/Percentage change in price A measure of the responsiveness of the quantity demanded of a good to a change in its price. It is calculated as:

In mathematical terms it can be represented as: Ep = (q/p) (p/q) From the definition it follows that 1. When percentage change in quantity demanded is greater than the percentage change in price then, price elasticity will be greater than one and in this case demand is said to be elastic. 2. When percentage change in quantity demanded is less than the percentage change in price then, price elasticity will be less than one and in this case demand is said to be inelastic. 3. When percentage change in quantity demanded is equal to the percentage change in price then price elasticity will be equal to one and in this case demand is said to be unit elastic Determinants of Price Elasticity of Demand: There are number of factors which determine the price elasticity of demand. 1. Close Substitutes: if close substitutes are available then there is a tendency to shift from one product to another when the price increases and demand is said to be elastic. For example, demand for two brands of tea. If the price of one brand A increases then the demand for the other brand B increases. In other words greater the possibility of substitution greater the elasticity 2. Proportion of income spent: Secondly how much of the income is spent on a commodity by the consumer. Greater the proportion of income spent on the commodity greater will be the elasticity. 3. Utility: The number of uses to which the commodity can be put is important factor determining elasticity. If the commodity can be put to many uses then the elasticity will be greater. 4. Consumption: If two commodities are consumed jointly then increase in the price of one will reduce the demand for both.

5. Time: Time element has an important role to play in determining the elasticity of demand. Demand is more elastic if time involved is long. In the short run, it is difficult to substitute one commodity for another. 6. Cost: Cost of switching between different products and service. There may be significant transaction costs involved in switching. In this case demand tends to be relatively inelastic. For example, mobile phone service providers may include penalty clauses in their contracts. 7. Payment Bearer: Who makes the payment, where the purchaser does not directly pay for the good they consume, such as perks enjoyed by employees, demand is likely to be more inelastic. 8. The degree of necessity or whether the good is a luxury: goods and services deemed by consumers to be necessities tend to have an inelastic demand whereas luxuries will tend to have a more elastic demand because consumers can make do without luxuries when their budgets are stretched. I.e. in an economic recession we can cut back on discretionary items of spending 9. Brand Loyalty: An attachment to a certain brand either out of tradition or because of propriety barriers can override sensitivity to price changes, resulting in more inelastic.

Income Elasticity of Demand Income elasticity of demand refers to the degree of responsiveness of demand to a change in the income level. From the definition it follows that E y= Percentage change in quantity demanded /Percentage change in income A measure of the relationship between a change in income and a change in quantity of a good demanded:

In mathematical terms it can be represented as: Ey = (q/y) (y/q)

Relationship between nature of commodities and income elasticity

Normal good: Normal goods have positive income elasticity of demand. If with an increase

in the income there is an increase in the demand for the good, we refer to this as positive income elasticity of demand. The increase could be large or small. Hence when the increase is such that percentage change in demand is less than the percentage change in income (income elasticity being greater than zero but less than one) it represents a necessary good(0<Ey<1).However if the percentage increase in demand is more than percentage increase in income then such commodities are considered as luxury goods(Ey>1).
Inferior goods: Inferior goods have negative income elasticity of demand. If with an

increase in the income there is a decrease in the demand for the good, we refers to this as negative income elasticity of demand (Ey<0). When the income of the consumer increases he finds it below his dignity to purchase some goods and hence when his income increases he prefers to consume less of the goods he used to purchase earlier or opts for some other

good which according to him has a better position and are consumed by people belonging to the higher income group.
Superior Good: A superior good exists if a relatively small increase in income causes a

relatively large increase in demand. This is seen as a positive value for the income elasticity of demand greater than 1, or a coefficient of elasticity of N > 1. Although some goods might intuitively appear to be normal, inferior, or superior goods, economists generally let income elasticity calculations make the actual determination. This is especially important in that a particularly good might be normal for one buyer, inferior for another, and superior for a third. Income elasticity of demand varies across product range. Further over a long run period with changes in the taste and preference and consumers perception of commodities elasticity of demand is likely to change. A product which was a luxury at one point of time becomes a necessity today. Consider the market for foreign travel. A few decades ago, long distance foreign travel was regarded as a luxury. Now as real price levels have come down and incomes have grown, a large number of people are travelling to different places for a short or long period.