E.C.O.-6 Economic Theory

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2 ASSIGNMENT SOLUTIONS GUIDE ( ) E.C.O.-6 Economic Theory Disclaimer/Special Note: These are just the sample of the Answers/Solutions to some of the Questions given in the Assignments. These Sample Answers/Solutions are prepared by rivate Teacher/Tutors/Authors for the help and guidance of the student to get an idea of how he/she can answer the Questions given the Assignments. We do not claim 100% accuracy of these sample answers as these are based on the knowledge and capability of rivate Teacher/Tutor. Sample answers may be seen as the Guide/Help for the reference to prepare the answers of the Questions given in the assignment. As these solutions and answers are prepared by the private teacher/tutor so the chances of error or mistake cannot be denied. Any Omission or Error is highly regretted though every care has been taken while preparing these Sample Answers/ Solutions. lease consult your own Teacher/Tutor before you prepare a articular Answer and for up-to-date and exact information, data and solution. Student should must read and refer the official study material provided by the university. N Attempt all the questions. Units M.U. of x MU of y MU of z Q. 1. Describe the law of equi-marginal utility. Explain it with the help of a diagram. How does consumer attain equlibrium? Ans. The Law of Equi-Marginal Utility: This law gives to a very difficult question that is In what way should a person allocate his limited resources among different uses so as to maximize the total utility derived from consumption. Consumer s equilibrium is said to be established when the consumer has allocated his resources among the various users so that his total utility will be maximum and he has no motivation for change. The Law of Equiy: Marginal utility states that a consumer will reach the stage of equilibrium when the marginal utilities of the various commodities that he consumes are equal. According to Marshall, if a person has a thing which he can put to several uses, he will distribute it among these uses in such a way that it has the same marginal utility in all. Explanation: A consumer buys an variety of goods like food, clothing, jewellery, etc., the more he gets of one good the less he will buy the another good because of his limited money at disposal. Now the marginal utility of the good declines with increased purchases; marginal utility of other goods would be high; so the consumer would gain by substituting among goods with higher marginal utility for goods with lower marginal utility. The process of substitution shall continue until he arrives at the optimum combination which gives him maximum total utility We assume that each of the commodity costs Re. 1 each. In order to reach the equilibrium the consumer should that combination where MU x = MU y = MU z. This situation can be attained when consumer buys the following combination [2x + 4y + 4z] for Rs. 10. At this stage the derived total utility equals to (10 +8) + ( ) + ( )= 115 utils. This is the maximum utility he can derive from the given money. 2

3 Modern View of Law of the Equi-marginal Utility The major disadvantage of classical view is their assumption that prices of all the commodities are same, which is not possible. So a new concept was given by modern economist called as Law of roportional Marginal Utility. According to this the two factors that influence the consumer behaviour are: (a) The marginal utility of the various goods to be consumed. (b) The prices of various goods. This law states that consumer will be in equilibrium where marginal utility of money expenditure on all goods consumed is the same. The marginal utility of expenditure on a good equals the marginal utility of a good divided by the price of the good. In order to be in equilibrium, the ratio of marginal utility of good to its price is equal to the ratio of marginal utility of good Y to its price and so on. Symbolically, MU x x N = MU y y = MU z z = Marginal Utility of Money Quantity MU x x Ratio MU y y Ratio MU z z Ratio rice Y MU x / x Z 0 x 1 x 2 MU x 1 Y H x 1 J MU x 3 K x 3 MUx 3 x 3 x q 1 q 2 q 3 Quantity Limitations of the Law (a) Assumption of rationality is not practical because individuals do not prefer to make such arithmetical calculations and experiments. 3

4 (b) Ignorance on the part of the consumer always results in other equilibrium position. They are not aware of substitute goods and accept whatever is made available. (c) Because of habits and fashion trends consumer goes for non-economic considerations rather than by economic considerations. (d) Goods are indivisible. (e) Assumption is that there is a particular time period during which consumer makes his purchases, while there are many commodities of durable nature having long duration time period. (f) Utility can not be measured cardinally. (g) Utility is not additive. Q. 2. What do you mean by Elascity of Demand? How would you measure the rice Elasticity of Demand? Ans. Elasticity of Demand: Demand for a good depends upon its price, income of the consumer and price of related goods. Demand function tells us about the direction of change in demand in response to a change in any of its determinants, it however does not tell anything about the magnitude of change. Elasticity of demand therefore defines the degree of responsiveness of demand to a change in any of its determinants is called elasticity of demand. Since there are three quantifiable determinants of demand: (a) rice of a commodity, (b) rice of related commodities, (c) Level of income, we have three different concepts of elasticity of demand. rice Elasticity of Demand Ordinarily known as elasticity of demand is the degree of responsiveness of the demand for a commodity to a change in its price. It is defined as the ratio of the percentage in the quantity demanded to a change in price. Symbolically, N Inelastic or less than unitary elastic, E d < 1 Total expenditure increases Total expenditure decreases E d = % Change in Quantity Demanded % Change in rice It measures how much the quantity demanded of a good changes when its price changes. rice elasticity denotes the ratio at which the demand contracts with a rise in price and extends with a fall in price. Because of negative slope of the demand curve, the price and quantity will always change in opposite directions. One change will be positive and other will be negative. However the custom is to ignore the negative sign and discuss the absolute level of the price elasticity. Measurement of rice Elasticity of Demand There are various methods of measuring price elasticity of demand: (a) Total Outlay Method, (b) ercentage Method, (c) oint Elasticity Method. (a) Total Outlay Method Or Expenditure Method: According to this method in order to measure the elasticity of demand it is essential to know the direction in which the total expenditure has changed as result of change in price of commodity. How Total Expenditure Changes? rice Elasticity of Demand rice Increases rice Decreases Unitary elastic No change in expenditure No change in expenditure Elastic or greater than unitary. E d >1 Total expenditure decreases Total expenditure increases 4

5 Following table shows the effect of change in price on elasticity of demand: Total Expenditure Method rice of Quantity Total Change in Total Expenditure Elasticity of Demand Commodity urchased Expenditure Total expenditure unchanged. Unitary elastic Total expenditure increases Greater than unitary when price decreases, and total elastic expenditure increases when N price decreases Total expenditure increases Less than unitary R N M o Y when price increases and total expenditure decreases when price decreases. S T D A Total Expenditure E > 1 E < 1 E = 1 elastic In the figure total expenditure is shown on -axis and price on Y-axis. Line ST shows total expenditure BC part shows unitary elasticity. It points that when there is price change from OM to ON, then there is no change in expenditure from MC = NB (= MC). TB part shows the greater than unitary elasticity. When price rises from ON to OR, total expenditure comes down from NB to RA. It means it moves in opposite direction. SC part shows less than unitary elasticity. When prices falls from OM to O, then total expenditure also comes down from MC to D. It means they are moving in the same direction. (b) ercentage Method: In this method, the percentage change in demand and percentage change in price are compared. 5

6 e p = ercentage Change in Demand ercentage Change in rice In this method, three values of ep can be obtained. viz., e p = 1, e p > 1, e p > If 5% change in price leads to exactly 5% change in demand, i.e. percentage change in demand is equal to percentage change in price, e = 1, it is a case of unit elasticity. 2. If percentage change in demand is greater than percentage change in price, e > 1, it means the demand is elastic. 3. If percentage change in demand is less than percentage change in price that in price, e < 1, it means the demand is inelastic. Q. 3. What do you understand by production possibility curve? Illustrate it with the help of a suitable example. Ans. The roduction ossibility Curve: We know that with the availability of limited resources producing everything is not possible and it demands for setting of priorities regard to what to produce or not. The economy therefore has to choose between alternative combination of goods and services. Let us know how to Nproduction possibility curve helps in choosing out the best combination. A production possibility frontier (F), or transformation curve, is a graph that shows the different rates of production of two goods and/or services that can be produced efficiently during a given period of time with limited quantity of productive resources, or factors of production. Assumptions: The concept of C is based upon the following assumptions: The quantity of factors of production is fixed although they can be transferred from one good to another up to a limited extent. Available factors are fully utilized in the economy or there is no wastage and underutilization of resources. Technique of production is constant and is not possible to change it. To make the study simple we assume only two goods or two sets of goods that are to be produced in economy. roperties or Nature of roduction ossibility Curve C slopes downward: It slopes downward from left to right because under the given situation of full employment it is not possible to increase the production of both goods. roduction of one good is compromised if the production of other is increased. C is concave to the point of origin: This is because of existence of concept of opportunity cost and implication of phenomena of increasing opportunity cost. Opportunity cost of producing each additional unit of one good tends to increase in terms of loss of producing another good. Illustration: Suppose an economy decides to produce only two goods namely petrol and diesel from its available resources. If all the factors of production are used for production of petrol only then 10,000 barrels can be produced and in the similar situation if only diesel be produced then 15,000 barrels can be produced. If economy produces both then various combinations of both can be produced with the available and limited resources. Given table shows the various combinations of petrol and diesel: Goods roduction ossibilities A B C D E etrol (in barrels) Diesel (in barrels) The schedule shows that if production is carried out under combination A, then barrels of petrol can be produced alone and if production is obtained under combination E, then barrels of diesel can be produced. Besides these there are many other combinations of production of petrol and diesel. The schedule shows that if production is carried out under combination A, then barrels of petrol can be 6

7 produced alone and if production is obtained under combination E, then barrels of diesel can be produced alone. Besides these there are many other combinations of production of petrol and diesel. Q. 4. Explain a firm s shorts period equilibrium under perfect competition with the help of suitable diagram. Ans. Short run is that time period in which there are both variable and fixed factors of production. Only quantity of variable factors can be changed, but not of the fixed factors. Short run equilibrium of a firm is attained at a level of output which satisfies the following two conditions: 1. MC = MR 2. MC cuts MR from below. When a firm is in short run equilibrium, a perfectly competitive firm may find itself in any of the following conditions: (a) It suffers loss. (b) It earns profit. (c) It breaks even. 1. It Earns rofit: A firm earns profit if at the equilibrium level of output; its average revenue (AR) is more than its (AC). From the figure we conclude Nthat Equilibrium oint = E (MR = MC) Equilibrium Output = OQ Average Revenue = QE Average Cost = QK Therefore profit per unit = QK QE = EK Total rofit = EK OQ = Area EKT Revenue/Cost B O Y Super Normal rofit AR > AC E M A Output MC AC AR = MR 2. It Breaks Even: A firm breaks even when at the equilibrium level of output; its average revenue (AR) is equal to (AC). Average Revenue = QE Average Cost = QE Therefore the firms break-even (no profit and no loss). 7

8 Y MC AC Revenue Cost AR = MR Normal rofit O M Output 3. It Suffers Loss: A Nfirm incurs loss if at the equilibrium level of output; its average cost (AC) is more than the average revenue (AR) or the market price. From the figure we can see that Equilibrium point = E (MR = MC) Equilibrium output = OQ Average revenue = QE Average cost = QK Therefore loss per unit = QK QE = EK Total loss = EK OQ = Area EKT Shut down point for a perfect competitive firm: We know that at the point where AC > AR, then firm incurs losses. But the question is that at this point whether the firm should continue to produce or should it shut down? We know that total cost of any firm consist of fixed cost and variable cost. Fixed cost once incurred, cannot be recovered even if firms shuts down. Therefore the decision depends upon the behaviour of variable cost. A firm will continue to produce if at the equilibrium level of output the Average Revenue of the firm is more than the Average Variable Cost. It means AR > AVC. Otherwise the firm will shut down. The firm will not produce at the equilibrium output where Average Variable Cost is more than the Average Revenue. If it produces and sells at the market price QE, it suffers additional loss of EF in addition to loss of fixed cost. But if the equilibrium level of output where AVC = OQ, whereas AR = QE. By continuing the production, the firm not only recovers not only whole of its variable cost, but in addition also recovers a part of their fixed cost. Its total losses would be less if it continues production than if it were to close down its operations. Y Loss MC ACAVC Revenue / Cost B 1 A E K Shut down oint AR = MR AR = MR M N Output 8

9 Q. 5. Write short notes on the following: (a) Cardinal approach to utility (b) Quas rest (c) Extension of demand (d) Competitive wages Ans. Cardinal approach to utility: According to this approach, the utility is measurable and can be expressed in quantitative terms. Cardinal utility approach is also known as classical approach because it was presented by classical economists. In cardinal approach, utility is stated or measured in what is known as utils. These are the measurements of utility, although in real terms they are not like the standard units of measurements like miles, kilometres, metres and so on. The cardinal utility approach focuses on the independent utility derived from a product and hence any dependency is avoided. To put in other words, the utility that a consumer gets from a product is on the basis of consumption of that product only and not through interdependence of any another product. Thus, cardinal numbers are used here to get an idea about the utility. One needs to remember that the utils are derived from utility, which helps in understanding how choices are made by the consumers. Quas rest: It is the additional income earned by factors other than land, whose supply is fixed in the short period. In the short run the land earns rent because its supply is scarce and even the supply man made means of production is also scarce, so the income from these sources is as if rent. But it is not called rent because in the long-run their supply can be increased according to increased demand. Quasi rent is not available in the long run because in the long run, all costs are variable costs and must be covered by the prevailing price. Since long-run price is equal to variable costs, question of quasi rent does not arise. Thus the income of manmade means of production in the short run is like rent but in the long run it is not rent. Thus concept of quasi rent can be applied to the income of any factor of production whose supply is fixed in the short period. Quasi Rent = Total Revenue Total Variable Cost N Cost / Revenue 2 1 Q Uasi Rant A D B Output 1QQ 1 Q 2 MC AVC In figure units of output are shown on O-axis and cost/price on OY-axis. MC is marginal cost curve and AVC is average variable cost curve. At O price, output is OQ and firm is in equilibrium. Since price is equal to average variable cost, the firm is not getting any quasi rent. If price increases to O 1 (AQ 1 ), then the firm will produce OQ 1 amount of output. rice of OQ 1 output is AQ 1 which is more than average variable cost (BQ 1 ) by AB. Thus, the firm will earn AB (AQ 1 BQ 1 ) quasi rent per unit. Total quasi rent will be ABT 1. Similarly, if price rises to O 2 (= DQ 2 ), then quasi rent is also determined by demand. (c) Extension of Demand: When larger quantity of a commodity is demanded at a lower price, it is called extension in demand. In the change in quantity demanded because of change in price only and other factors remaining constant. There is upward movement in the same demand curve. It is a function of movement along a demand curve. C 9

10 D 1 rice 2 D O Q 1 Q Q 2 Fig. : Extension of Demand Competitive Wages: A competitive wage is one that is in line with what other industry employers offer workers for the same jobs. Competitive wages refers more to the efforts of employers to attract workers through industrystandard wages. In some cases, industry employers must pay above-minimum wages to compete with others for the limited supply of workers. In a pure market economy, the level of worker supply and employer demand dictates the typical pay for a given Njob. In unskilled or less-skilled jobs in some sectors, the minimum wage is the standard starting pay for workers because employer competition isn t very high relative to the availability of labourers. Employers usually pay more competitive wages to attract more skilled workers. Additionally, demand for certain types of work impacts pay. Fast food restaurants and big box retailers in many communities promote competitive wages to attract workers disinterested in these work settings at minimum wage levels. 10

Chapter 1- Introduction

Chapter 1- Introduction A SIMPLE ECONOMY Central PROBLEMS OF AN ECONOMY: scarcity of resources problem of choice Every society has to decide on how to use its scarce resources. Production, exchange and