1

+3 Economics 1st Semester qqq 1

DEMAND AND CONSUMER

BEHAVIOUR UNIT
Concept of demand: demand function, law of demand, derivation of
individual and market demand curves, shifting of the demand curve,
elasticity of demand, Consumer behavior, Marshallian utility approach and
Indifference Curve approach; utility maximization conditions. Income-
Consumption Curve (ICC) and Price-Consumption Curve (PCC).

PART - I
(1 Mark each)
MULTIPLE CHOICE :
Choose the correct answer from the given atternatives.
(a) When marginal utility diminishes, total utility.
(i) diminishes (ii) increases
(iii) remains constant (iv) None of the above
Ans : (ii) increases
(b) The constumer stops consumption as the point where marinas utility is
(i) greater than price (ii) less than price
(iii) equal to price (iv) None of the above
Ans : (iii) equal to price
(c) The later of equimarginal utility is otherwise knows as the law of
(i) Substitution (ii) Maximum satisfaction
(iii) Consumer’s equilibrium
(iv) All of the above
Ans : (i) Substitution
(d) ‘Change in demand occur’s due to the change in
(i) income (ii) price of related goods
(iii) taste and preforence (iv) all of the above
Ans : (iv) all of the above
(e) Incase of perfect substitutes, the elasticity of demand is
(i) zero (ii) infinite
(iii) greater than one (iv) less than one
Ans : (ii) infinite
 2 qqq EXCELLENT

(f) When a given change in price results in an equal and proportionate ‘change in quantity
demanded’ the elasticity of demand is equal to
(i) one (ii) greater than one
(iii) less than one (iv) zero
Ans : (i) one
(g) If a commodity has good substitutes, its demand is said to be
(i) more elastic (ii) less elastic
(iii) perfectly elastic (iv) None of the above
Ans : (i) more elastic
(h) The marginal utility curve is
(i) down ward sloping (ii) upword sloping
(iii) vertical (iv) horisental
Ans : (i) down ward sloping
(i) In case of giffen goods the demand curfe is
(i) down ward sloping (ii) upword sloping
(iii) vertical (iv) horisental
Ans : (ii) upword sloping
(j) The demand for basic necessaries is
(i) elastic (ii) inelastic
(iii) unitary elastic (iv) perfectly elastic
Ans : (ii) inelastic
(k) The change in quantity demanded occuers due to the change in
(i) income (ii) price
(iii) taste (iv) price of related goods
Ans : (ii) price
(l) Demand in Economics means
(i) Amount needed by consumer
(ii) Amount available in the marke
(iii) desire backed by willingness and capacity to pay
(iv) Amount produced by the firm.
Ans : a
(m) Elasticity of demand means
(i) Tendency of the demand to change due to pressure
(ii) Rate of change indemand due to a given change in price
(iii) capacity of demand to increase
(iv) None of the above
Ans : (ii) Rate of change indemand due to a given change in price
 +3 Economics 1st Semester qqq 3

(n) What does the right word shift of the demand curve indicate ?
(i) Expansion of demand (ii) Contraction of demand
(iii) Rise in demand (iv) Fall in demand
Ans : (iii) Rise in demand
(o) What is the shape of perfectly elastic demand curve ?
(i) Harizental (ii) Upword sloping
(iii) Vertical (iv) Rectangular hyperbola
Ans : (i) Harizental
WRITE THE ANSWER IN ONE SENTENCES IN EACH CASE.
(a) What in consumption ?
Ans : Using up to utility of a good for the satisfaction of human wants.
(b) What is utility ?
Ans : Want satisfying power of a particular commodity is called utility.
(c) What is total utility ?
Ans : Sum of utilities of a given amount of commodity is called total utility.
(d) What is marginal utility ?
Ans : Addition to total utility by consuming one more unit of good.
(e) What in the meaning of Law of Deminisheing Marginal utility ?
Ans : The marginal utility goes on diminishing as we consume ore and more of a com-
modity.
(f) What is law of equi-marginal utility ?
Ans : The consumer spends his limited moniy income on various goods insuch a man-
ner that the marginal utility of last unit of money spent in each good is equal. The consumer
gets maximum sutisfaction out of it.
(g) What is demand ?
Ans : It refers to the quantity of a commodity purchased in the market at a price and at
a point of time.
(h) Write the deter minants of demand.
Ans : Price, encome, taste and habits, prices of related goods, climate, population,
income distribution etc. are the determinants of demand.
(i) What is the meaning of law of Demand ?
Ans : Law of demand states that other things remaining constant, more is demanded at
high price than at a lower price.
(j) What is Demand Schedule ?
Ans : It is the list of quantities demanded at various possible prices.
(k) What is the meaning of Demand curve ?
Ans : Demand curve is the graphic representation of law of demand and it slopes
downwords to the right.
(l) Write the causes of downword sloping of Demand curve.
Ans : The causes of downword sloping of Demand curve are operation of deminishing
marginal utility, Income effect, substition effect and arrival of marginal consumers.
 4 qqq EXCELLENT

(m) What is market demand ?

Ans : It refers to the total demand at a given price and at a given time by all the buyers
in the market.
(n) Why the demand curve shifts to the right or left ?
Ans : Price remaining constance when non-price determinants change, demand curve
shifts to the right or left.
(o) What is change in quantity demanded ?
Ans : When only due to the change in price, the consumer moves from one point to
another point in the in the same demand curve, it is called change in quantity demanded.
(p) What is price Elasticity of Demand ?
Ans : The degree of responsiveness of demand to change in price is called price Elas-
ticity of demand.
(q) What is Relatively elastic demand ?
Ans : When a given change in price produces a more than proportionate change in
quantity demanded, it is called relatively elastic demand.
(r) What is the meaning of unitary elastic demand ?
Ans : Unitary elastic demand is found in a situation when a given change in price pro-
duces an equal proportionate change in quality demanded.
(s) What is perfectly elastic demand ?
Ans : Demand is said to be perfectly elastic when a very small change in price pro-
duces an infinite chnage in quantity demanded.
(t) What is perfectly elastic demant ?
Ans : Demand is said to be relatively inelastic when a given change in price produces a
less than propor tionate change in quantity demanded.
(u) What is the meaning of inelastic demand ?
Ans : A perfeetly inelastic demand is one in which a change in price produces no
change in quantity demanded.
(v) What is Giffen goods ?
Ans : Giffen goods are inferior goods when the law of demand does not hold good.
(w) What is change is demand ?
Ans : Price remaing constant, when non-price determinants change it is called change
in demand.
FILL IN THE BLANKS :
(a) It is the for a commodity which can be called as demand.
Ans : effective desire.
(b) Other thing remaining wastant the higher the price of a commodity, the smaller is the
quantity demanded and lower is the price the the quantity demanded.
Ans : larger
(c) Demand schedule is a of various quantities of a commodity which a consumer
is willing to purchase at different alternent at prices.
Ans : list
 +3 Economics 1st Semester qqq 5

(d) Demand curve is the of the law of demand.

Ans : graphic representation
(e) The law of demand is nothing but a reflection of the .
Ans : law of deminishing marginal utility.
(f) Giffen goods are where the law of demand does not holdgood.
Ans : inferior goods.
(g) There are certain goods which are demanded by the rich to satisfy their sense of varity
is goods.
Ans : prestige goods
(h) The law of demand does not operate in case of very whose consumption can
neither be postponed or substituted other goods.
Ans : essential goods
(i) The market demand corve is based in the .
Ans : market demand scheduls
(j) Market demand refers to the for a commodity by all the buyers present in the
market.
Ans : Total demand
(k) Market demand schedule is derived by the individual demand schedules of all
buyers present in the market.
Ans : adding
(l) Market demand curve is the of market demand schedule.
Ans : graphic representation
(m) Other non-price determinants remainding constant when price changes it is called .
Ans : change in quantity demanded
(n) occurs when non-price deter minants change, price remaining constant.
Ans : change in demand
(o) Incase of change in demand, the demand curve shifts to the or
Ans : right, left
(p) Price elasticity of demand may be defined as the of demand to a gives change
in price.
Ans : degree of responsivness
(q) Incase of perfectly inelastic demand price elasticity of demand is equal to
Ans : zero
(r) When a given change in price produces a less than propertionate change in quantity
demanded demand is said to be .
Ans : relatively inelastic
(s) Incase of relatively inelastic demand, demand curve is relatively .
Ans : stup
 6 qqq EXCELLENT

(t) When a given change in price produces an equal proportionate change in quantity
demanded is called .
Ans : unitary elastic demand
(u) Incase of unitary elastic demand, the demand curve becomes a .
Ans : rectangular hypebola
(v) Incase of perfectly elastic demand, demand curve is a parelled to the x-axis.
Ans : Horizontal straight line
(w) Demand for necessities is .
Ans : inelastic
(x) Demand for tea is .
Ans : more elastic
(y) The demand for a good is if it has several atternative use.
Ans : elastic
(z) Change is demand occurs due to the change in .
Ans : price
(z1) In case of perfectly demand, the value of price elasticity of demand is equal to .
Ans : zero.
(z2) The demand for match box is .
Ans : Inelastic
(z3) The demand for luxury is .
Ans : elastic
(z4) If a commodity has no substitute, its elasticity of demand is than one.
Ans : less
(z5) Demand in Economics means desire backed by willingness and
Ans : capacity to pay
(z6) Elasticity of demand means rate of change in demand due to a give .
Ans : change in price
(z7) In case of giffen goods the demand curve is .
Ans : upward sloping
PART - II
Short Questions and Answer (2 Marks each)
(a) What is unitary elasticity of demand ?
Ans : Unitary elastic demand is found in stituation when a given change in price pro-
duces an equal propertimate change in quantity demanded. In this case change in price is
exactly equal to the change in quantity demanded and the price elasticity is equal to 1.
(b) What is Relatively elastic demand ?
Ans : demand is said to be relatively elastic when a given change in price produces a
more than propertionate change in quantity demanded. Here the price elasticity of demand is
greater than one.
(c) Whet is perfectly elastic demand ?
Ans : Demand is said to be perfectly elastic when a very small change in price produces
an infinite change in quantity demanded. Here the price elasticity of demand is equal to infinite.
 +3 Economics 1st Semester qqq 7

(d) What is meaning of Relatively inelastic demand ?

Ans : demand is said to be relatively inelastic when a given change in price produces a
less than proportionate change in quantity demanded. Here the price elasticity of demand
becomes less than 1.
(e) What is perfectly inelastic demand ?
Ans : A perfectly inelastic demand is one in which a change in price produces no
change in quantity demanded. In this case the price elasticity of demand is equal to zero.
(f) What is price elasticity of demand ?
Ans : price elasticity of demand may be defined at the degrees of responsiveness of
demand to a given change in price. It measures the ratio of the proportionte change in quantity
purchased of a commodity to the proportionate change in price.
(g) What is change in quantity demanded ?
Ans : “Change in quantity demanded occurs when price changes other non-price de-
terminants remaing constant” A change in quantity demanded can be measured along the
demand curve.
(h) What is change in demand ?
Ans : It occurs when non-price determinants change, price remaining constant. In case
of change in demand, the demand curve shifts to the right or lift.
(i) What is the meaning of Giffen goods ?
Ans : Giffen goods are inferior goods where the law of demand does not hold good. In
cas of this good, when price rises, demand for this good rises and when price of theis falls,
demand for this good asofalls.
(j) What is market demand schedule ?
Ans : Market demand schedule is a list of various quantities of a commodity which all
the consumers in the markets are willing to purchase at different alternative prices. It is de-
rived by adding the individual demand schedules of all buyers present in the market.
(k) What is Market Demand curve ?
Ans : The market demand curve is based on the market demand schedule. Market
demand curve is the graphic representation of market demand schedule.
(l) What is prestige goods ?
Ans : Prestige goods are demanded by the rich to satisfy their sense of varity. Ex-
amples of such goods are diamonds, jewels, costly ornaments and sarces.
(m) What is later of demand ?
Ans : Later of demand states that otherthing remaining constant, the higher the price of
a commodity the smaller is the quantity demanded and lawer is the
(n) What is price consumption curve for a good ?
Ans : The price – consumption curve (PCC) indicates the various amounts of a com-
modity bought by a consumer when its price changes. The marshallian demand curve also
shows the different amounts of a good demanded by the consumer at various prices, other
things remaining the same consumer at variours prices, other things remaining the same.
 8 qqq EXCELLENT

(o) What is income consumption curve and Enges curve.

Ans : In economics and particularly in consumer choice theory, the income consump-
tion curve is a curve in a graph in which the quantities of two goods are plotted on the two
axes, the curve is the locus of points showing the consumption bundles chosen at each of
various levels of income.
(p) What are the condition for utility maximization ?
Ans : Economics concept that when making a purchase decisim, a consumer attempts
to get the greatest value poisssible from expenditure of least amount of money. His or her
objective is to maximize the total value derived from the available money.
(q) What is ICC and PCC ?
Ans : An Ice has similar principles to that of a PCC. It is a company which has the
power to establish in corporated cells as part of its corporate structure and, live a PCC, it
may comprise of any number of cells. Unline cells within a PCC, each cell of an ICCis a
separately incorporated legal entity, as is the ICC itself.
(r) What is ordinal utility approach ?
Ans : Ordinal utilityApproach :This means that the utility can be ranked qualitatively.The
ordinal utility approch differs from the cordinalutility approach calso called classical theory ? in
the sense that the satisfaction derived from various comodities cannot be measured objectively.
PART - III
Short Questions and Answer (3 Marks each)
(a) What is Giffen goods ?
Ans : Giffen goods are inferior goods where the law of demand doesnot hold good. Sir
Robert Giffen found in the 19th century that the people of Ireland were so poor that they
spent the major part of their income on bread and potato and a very small part on superior
goods like meat. When price of bread rose, people purchased more of bread and when its
price fell, they purchased less of bread and divert their income for superior goods like fish and
meat. This is what we called the Giffen parndox. Therefore in case of Giffen goods the law of
demand does not hold good.
(b) What is meaning of Income effect of price change ?
Ans : When price of a good falls, real income of the consumer rises. If the consumer
has Rs 15 and price percanit of apply is Rs. 5, then he can purchase same 3 units, the
consumer will spend Rs. 3×3 = Rs. 9. This leaves a surplus of Rs. 6 with the consumer. Thus
a fall inprice has the same effect of increase inmoney income and hence is know as the income
effect of a price reduction. The consumer can purchase some more units of the good with the
surplus income released through the fall in price. Therefore when price falls amount purch\ased
increases. When price rises, the consumer’s real income falls. This reduces his expenditure on
the good leading to the fall indemand.
(c) What is relatively elastic demand ?
Ans : Demand is said to be relatively elastic when a given change in price produces a
more than proportionate change in quantity demanded. For example when price falls by 20%
and demand rises by 50% (more than 20%), then it is a case of relatively elastic demand.
 +3 Economics 1st Semester qqq 9

Relatively elastic demand - PNG

In above figure fall in price is P1P2 and rise in demand is Q1Q2. Since rise in demand
Q1Q2, is greater than the fall in price P1P2, it is called relatively elastic demand, Here the price
elasticity of demand is greater than one.
(d) What is change in Demand ?
Ans : Change in demand causes the demand curve to shift. The demand for a com-
modity is determined by many facturs other than price. These facturs are income, taste, and
habits, price of related goods, incomedistribution, climatic and wether conditions etc. It any
me or more factors undergoes a change, demand changes. This is called change in demand.
For example price of cold drinks remaining constant, if winter changes into summer, then
demand for cold drinks will rise. Here demand changes not due to the changes in price but
due to the factors other than price. This leads to the shift of demand curve to the right.
(e) What is change in quantity demanded ?
Ans : Change in quantity demanded occurs when other things remaing constant, only
price change. This is what we have studied in law of demand. Here demand curve doesnot
shift but the consumer moves from one point to another point in the same demand curve. This
is also called expansion or contraction of demand. It is single valued function depending only
in price.
(f) Wht is price elasticity of demand ?
Ans : Price elasticity of demand may be defind to a given change in price. According to
manshall, “the elasticity (or responsiveness) of demand in a market in great or small according
as the amount demanded increases much or little for a given fall in price and diminishes much
or little for a given rise in price”. It measures the ratio of the proportionate change in quantity
purchased of a commodity to the proportionate change in price.
 10 qqq EXCELLENT

(g) What is Market demand schedule ?

Ans : Market demand schedule is a list of various quantities of a commodity which all
the constumers in the markets are willing to purchase at different atternative prices. It is
derived by adding the individual demand schedules of all buyers present in the market. The
market demand curve is based in the market demand schedule. Thus the market demand
schedue, like the individual demand schedule depicts the inverse relation between price and
quantity demanded.
(h) What is Demand schedule ?
Ans : Demand schedule is a list of various quantities of a commodity which a consumer
is willing to purchase at different alternative prices. This shows the inverse relation between
price and quantity demanded of a commodity.
PART - IV
LONG QUESTIONS WITH ANSWERS (7 Marks Each)
Q.1. What is demand ? Explain the deter minants of Demand.
Ans : To common man, demand means desire for a commodity. But mere desire for a
commodity is not demand in economics. It is the ‘effective desire’ for a commodity which an
be called as demand. ‘Effective desire’ has two important characteristics, viz, (i) ability to pay
for the commodity and (ii) willingness to pay for the commodity. If the consumer has no
monetary ability to pay for the commodity, then desire connot be demand. A beggar’s desire
for a horse is not demand because he does not have the ability to pay for the horse. Again if
the consumer has the ability but does not have the willingness to part with the money, then also
desire cannot be demand. Thus if the consumer has the willingness and ability to pay for the
commodity, then this desire can be transformed into demand.
Definition of demand :
The demand for any commodity at a given price is the quantity of it which will bought
per unit of time at that price.
This difinition underlines two important things. First, demand is always at a price. If we
say demand for fish in puri market is 5 quintals, it is meaningless when it is said that demand
for fish in puri market is 5 quintals when the price per kg of fish is Rs 50, it becomes reasoable.
Secondly, demand mush be referred to a time period, say a day, a week or a month. In the
above example when we say that demand for fish in puri market is 5 quintals per day when
price per kg of fish is Rs. 50, it gives us a complete meaning of demand.
Determinats of Demand :
Demand for a commodity is governed by several factors live prices of related com-
modities, taste of the consumer and the live. Change is demand occurs when any one of the
above factors undergoes a change. To know the influence of any one factor, we have to keep
all other factors constant. For example in law of demand we only change the price keeping all
other factos constant to know the influence of price on demand. But in real world, demand is
influenced by so many factors. In symbolic form, this can be represented as follows :
Dx = f(Px, y, Py, Pz, T, L, G)
 +3 Economics 1st Semester qqq 11

where ‘Dx’ stands for demand for a definite good ‘x’

Px = price of good ‘x’
y = Income of the consumer
Py = price of the substitute product ‘Y’
Pz = price of the complementary good ‘Z’
T = Taste of the consumer
L = Population
G = govt. policy
f = functional relation.
The factors which gover demand except price are discussed below.
(1) Income of the consumer :
Price of the good remaining unchanged if consumer’s income changes then demand for
the good also undergoes a change. In most of the goods, income and demand are directly
related. That means as income rises, demand for the good also rises and vice verse. But in
case of in case of inferior goods. in come and demand are inversity rises. This was first
observed by sir Rober Giffen of Ireland in 19th century. When income of the industrial work-
ers rose, workers demanded less of potato and brend and purchased more of milk fish and
vegetables. Thus in case of inferior goods the effect of income on demandin negative
(2) Taste and Preference :
Taste and preference of the consumer also affect demand for a commodity. When a
commodity goes out of fashion, its demand falls. Similarly when a person changes his taste
from vegetarian to non-vegetarian from, his demand for fish and meat will rise. Now-a-days,
due to the advertisement by mass medin, the taste and fushion of the consumers are changing
rapidly which affect demand accordingly.
(3) Prices of related goods :
Goods are related either as substitutes or as complementaines. Tea and coffee and
substitutes where as scorter and petrol are complementaries. In case of subsittues life teac
and coffee, the change in prices of tea affects the demand for coffee. If price of tea rises, the
demand for coffee will rise because people will divert their attention to a superior hot drink.
Similary when price of scooter falls. demand for scooter will increase and at the sametime
demand for petrol will rise. Therefore demand for a good is influenced by the change in
prices of related goods.
(4) Population :
The size, composition and growth of population in a country affect the over all demand
for various goods and services. When growth of population takes place, the absolute number
of consumers rises. This ......... to rise in demand for basic necessities like food, clothing
medicine, shelter etc. A full in population growth will have opposite effect on demand. Again
the age and sex composition of population will also affect demand. A rise in proportion of
children will lead to the rise in demand for baby food, toys and chocolates. Similarly if female
out numbers male, then demand for skirt will rise and demand for shirt will full.
 12 qqq EXCELLENT

(5) Climate :
A change in climatic condition will affect the demand for a good. For example demand
for cold drink goes up in summar. When summer changes to winter, its demand drasticaly
fulls. Demand for cotton clothes rises in summer but demand for woollen garments increases
in winter. Thererfore change is senson and weather condition affect the demand for a particu-
lar comodity.
(6) State of economic activity :
The demand for a good is incluenced by the state of economic activity in the country.
During depression, the demand for goods and services fall. During the prosperity phase when
income, emplayment and investment rise demand rises. During this period the expectation of
the people regarding future undergoes a change rapidly affecting demand.
(7) Disstribution of Income :
Distribution of income and wealth in the society in an important factor affecting de-
mand. A change in distribution of income in favour of the poor will raise overall demand for
goods and services. This is because poor people consume more from their increased income
than the rich. Similarly welfare programme undertaken by the Govt in the form of free educa-
tion and health, widow & orphan allowances etc. raise the purchasing power of the poor
affecting demand favourably.
(8) Taxation policy of the Govt :
Taxation policy has a dual role to play in affecting the over all demand for the goods and
services in the economy. On one had it affects other hand, it affects price of the products. A
steeply progressive direct tax reduces income of the people particularly the rich which may
reduce their demand for luxury goods. Similarly high indirect tax live sales tax, excise duties
etc. will raise the price of the products reducing their demand. If Govt. impases high tariff on
imports. then demand for forecign goods will fall.
(9) Advartisement and sales promotion activity :
Now -a-days the firms incur heavy expenditure on advertisement and sales promotion
activities. These costs of the firm are called selling cost which is different from production
cost. Production casts are incurred to meet a given demand while selling costs are incurred to
secure a demand. Publicity and advertisement through mass media and sales promotion ac-
tivities thus influence consumer’s preforence pattern resulting in increase in demand.
(10) Demanstration effect in consumption :
Maintaining a higher standard of living in comparison to income by imitating the pros-
perous neighbour is know as demonstration effect in consumption. Due to this effect people
demand more than their requirements by following the standard of living of others. This is
more relevant for the under developed countries whose consumption pattern is influenced by
the life style of the people of the rich countries.
Q.2. Explain the law of demand ? What are its exceptions ?
Ans : The law of demand states that. Other things remaining constant the higher the
price of a commodity, the smaller is the quantity demanded and lower is the price, the larger
the quantity demanded. In other words, demand for a commodity varies inversely with price.
 +3 Economics 1st Semester qqq 13

Symbolically
1
Dx 
Px
Where Dx stands for quantity demanded of commodity ‘x’
Px = price of commodity ‘x’
1
Px
= Inverse of price of ‘x’
 = proportional relation
Assumptions :
The law of demand is based on the following assumptions :
1. The consumer is a rational being.
2. His teste and preference remain constant.
3. Income of the consumer remains constant.
4. Price of related goods like substitutes and complmentaries remach unchanged.
5. The size and composition of population remain constant.
6. The distribution of income and wealth is given and remains constant.
7. Climatic and weather conditions remain unchanged.
Explanation of the Law :
The law of demand states a common experience of all buyers in the market. People
genegally purchase more of a commodity when it is cheaper and less of a commodity when it
is cheaper and less of a commodity when it is dearer. We can explain this Phenomenon with
the help of a demand schedule and a demand curve.
Demand schedule is a list of various quantities of a commodity which a consumer is
willing to purchase at different alternative prices. The following table shows the monthly indi-
vidual demand schedute for apples.
Table
Individual demand schedule
Price of apple Quantity demanded
per kg in Rs in kg
50 5
40 10
35 12
30 15
20 20
In the above table we have depictud the demand for apples per month by an individual
consumer. When price per kg. of apple was Rs. 50 the consumer bays 5 kg apples. When
price falls to Rs. 40, consumer’s demand rises to l0 kg. When price further falls from Rs. 40
to Rs. 35, his demand for apples rises from 10 to 12 kg and soon. This shows the inverse
relation between price and quantity demanded of a commodity.
 14 qqq EXCELLENT

Diagrammatic representation :
The law of demand can also be explained
diagrammatically with the help of a demand
curve. Demand curve is the graphic represen-
tation of the law of demand.
In the above diagram, we have
meansured price on y - axis and quantity on x-
axis. Plotting the values from table and joining
the price– quantity combinations, we get a
downward sloping curve DD1. know as the
demand curve. The curve represents the same
thing that when prie falls, demand rises, and
vice versa. For example when price falls from
OP1 to OP2 in y- axis, quantity demandded rises
from OQ1 to OQ2 in x-axis. To put the samething in other way, when price rises from OP1 to
OP2 in y-axis, quantity demanded falls from OQ2 to OQ1 in x-axiz. Thus it follows from the
diagram that price and quantity demanded are inversely related.
Causes of the operation of the law :
Economists have advanced the following reasons to answer the question.
(1) Law of Diminishing Marginal Utility :
The operation of law of demand can be explained on the basis of the law of diminishing
marginal utility. The law states that as more of a commodity is purchased, its marginal utility to
the consumer will be less and less. Therefore the consumer while purchasing the commodity
values less and less the additional units of the commodity. So we will purrchase more only it
price falls. Thus the law of demand is nothing but a reflection of the law of diminishing mar-
ginal utility.
(2) Income effect :
When price of a good falls, real income of the consumer rises. If the consumer has Rs.
15 and price per unit of apple is Rs. 5 then we can purchase same 3 units, the consumer will
spend Rs 3 × 3 = Rs. 9. This leaves a surplus of Rs. 6 with the consumer. Thus a fall in price
has the same effect of increase in money income and hence is known as the income effect of
a price reduction. Therefore when price falls amount purchased increases. When price rises,
the consumer’s real income falls.
(3) Substitution effect :
Anather effect of a change in price of a good is the substitution effect. When price of a
good falls, other things remaining constant, the good becomes will substitutes the cheaper
goods for the castlier goods so that he will gain. If the price of fish falls, the consumer to some
extent will subsitute it for meat leading to the rise in demand for fish.
 +3 Economics 1st Semester qqq 15

(4) Change in the number of consumers :

With the change in price of a good, number of consumers willing to purchase the com-
modity also changes. For example, when price fall, the consumers who were in the borderline
of their ability can now come to the market to buy it as it is now affordable to them. The
existing consumers will no doubt purchase more. The combined result is the rise in quantity
demanded as price falls.
Exception to the law :
Exceptions to the law of demand have discussed below :
(1) Giffen goods :
Giffen goods are inferior goods where the law of demand does not hold good. Sir
Robert Giffen found in the 19th century that the people of Ireland were so poor that they
spent the major part of their income on bread and potato and a very small part on superior
goods like meat. When price of bread rose, people purchased more of bread and when its
price fell, they purchased less of bread and divert their income for superior goods like fish and
meat. This is called Giffen paradox. Theirfore incase of Giffen goods, the law of demand
does not hold good.
(2) Prestige goods :
There are certain goods which are demanded by the rich to satisfy their sense of varity.
Examples of such goods are diamonds, jewels, costly ornaments and sarees etc. The rich
people use these goods for purposes of show and distinction. Higher is the price, greater is
the prestige value of the commodity and they demand more of it.
(3) Essential goods :
The law of demand does not operate incase of very essential goods whose consump-
tion can neither be post poned (life saring drugs). They are so indispensable that an rise in
price does not lead to their fall demand.
(4) Expectations of Price change :
During the period of rising prices, people’s expectations of future change may lead to
the rise in demand for goods and services. This is because people expect that prices will
further rise. Similarly when trackers notify to go on strike, prices start rising before the actual
strike begins. Though prices are rising. People purchase more to hourd because of change
expectation.
Q.3. What is Market demand curve ? Explain the Derivation of market demand
curve ?
Ans : Market demand refers to the total demand for a commodity at a given price and
at a given time by all the buyers present in the mearket. The market demand curve is based on
the market demand schedule.
Market demand schedule is a list of various quantities of a cokmmodity which all the
consumers in the markets are willing to purchase at different atternative prices. It is derived by
adding the individual demand schedules of all buyerts present in the market. We have derived
 16 qqq EXCELLENT

the market demand schedule from the individual demand schedules. We have assumed that
the market consists of two buyers ‘A’ and ‘B’
Market demand schedule for apples perday.
Price per Quantity Quantity Total Market
kg in Rs purchased purchased demand
by ‘A’ in kg by ‘A’ in kg A + B in kg
(1) (2) (3) (4)
15 10 20 30
18 8 18 26
20 6 15 21
22 4 12 16
24 2 10 12
The above table shows the individual demand schedules of ‘A’ and ‘B’ and so also the
market demand schedul e. columan (1) represents the price of apple per kg, column (2) and
(3) represent the demand for apples by ‘A’ & ‘B’ respectively. In column (4), We have
derived the total market demand through the summation of quantities indicated in column (2)
and (3). When price per kg of apple is Rs.15, A’s demand is 10 kg. and B’s demand is 20kg.
Total market demand is 10+20=30kg. When price rises to Rs. 18, the respective demand of
‘A’ and ‘B’ is 8 and 18 kg of apples. Total demand is 8+18=26kg. and soon. This shows that
as price rises, demand of apples fall. Thus the market demand schedule, live the individual
demand schedule depicts the invarse relation between price and quantity demanded.
Derivation of Market demand curve :
Market demand curve is the graphic representation of market demnad schedule. It can
be drawn by directly taking the price– quantity combinations as indicated by column 1 and 4
in the above schedule. It can also be derived through the harizental addition of the individual
demand curves. In the following diagram we have derived the market demand curve on the
basis of data given is table.
 +3 Economics 1st Semester qqq 17

In the above figure, we have derived the market demand curve. Fig (a) represents the
individual demand curve for apples of ‘A’ and fig (b) represents that of ‘B’ Fig (c) indicates
athe market demand curve DM which has been drived from the harizontal summation of
individual demand curves DA and DB. When price of apple was OP1, A’s demand was OM1
and B’s demand was ON1. Total market demand at the same price became OM1 + ON1 =
OQ1. This price quantity combination, (i.e. OQ1 quantity at OP1 price) gives us a point E1
on the market demand curve DM in fig (c). Similarly by taking other price- quantity combina-
tions, we can find out other points like E2 and soon. By joining the points E1 and E2 e get a
curve which is called the market demand curve in fig. (c) The market demand curve like the
individual demand curve slopes downwards to the right. It confirms the marshallian law of
demand that when price falls demand rises and vice versa.
Q.4. What is Elasticity of Demand ? Draw the various degree of it with diagrammes.
Ans : Price elasticity of demand is the ratio of percentage change in quanity demanded
to the percentage change in price. In otherwords, price elasticity of demand is a measure of
the relative change in quantity purchased of a good in response to a relative change in its
price. It is, thus, a rate at which the demand changes to the given change in price. So, it means
the rate or the degree of response in demand to the change in price. Thus, the co-efficient of
price - elasticity of demand can be expressed as under :
Proportionate change in Demand
Ed = Proportionate change in Price

Symbolically :
q p q p
Ed =  
q p q p

q p q p
Ed =   
q p p q

Degrees of price Elasticity :

Different commodities have different price elasticities. Some commodities have more
elastic demand while others have relative elastic demand. However, some particular values of
elasticity of demand have been explained as under.
(1) Perfectly Elastic Demand :
Perfectly elastic demand is said to happen when a little change in price leads to an
infinite change in quantity demanded. In such a case the shape of the demand curve will be
horizontal straight line as shown in figure.
 18 qqq EXCELLENT

The above figure shows that at the ruling price OP the demand is infinite. A slight rise in
price will contract the demand to zero. A slight fall in price will attract more consumers but the
elasticity of demand will remain infinite, ed =  .
(2) Perfectly Inelastic demand :
Perfectly inelastic demand is opposite to perfectly elastic demand. Under the perfectly
inelastic demand, irrespective of any rise or fall in price of a commodity, the quantity de-
manded remains the same. The elasticity of demand in this case will be equal to zero (ed=0)

In this above diagram DD shows the perfectly inelastic demand. At price OP, the quan-
tity demanded is OQ. Now, the price falls to OP1, from OP, the demand remains the same.
Similarly, if the price rises to OP2 the demand still remains the same.
 +3 Economics 1st Semester qqq 19

(3) Unitary Elastic Demand :

The demand is said to be unitary elastic when a given proportionate change in the price
level brings about an equal propertionate change in quantity demanded. The numberical of
unitary elastic demand is exactly one i.e, ed = 1. Marshall callsitk unit elastic.

Ed = 1

In this above figure DD damand curve represents unitary elastic demand. This demand
curve is called rectangular hyperbola. When price is OP, the quantity demanded is OQ1.
Now price falls to OP1 the quantity demanded increases to OQ2. Here PP1 = QQ1
(4) Relatively Elastic Demand :
Relatively elastic demand refers to a situation in which a small change in price leads to
a big change in quantity demanded. In such a case elasticity of demand is said to be more than
one (ed > 1). This has been shown in following figure.

Ed > 1
 20 qqq EXCELLENT

In this figure DD is the demand curve which indicates that when price is OP the quantity
demanded is OQ1. Now the price falls from OP to OP1, the quantity demanded increases
from OQ1 to OQ2 i.e quantity demanded changes more than change in price.
(5) Relatively Inelastic Demand :
Under the relatively inelastic demand, a given percentage change in price produces a
relatively less percentage change in quantity demanded. In such a case elasticity of demand is
said to be less than one (ed < 1). It has been shown in following figure.

Ed < 1

Q.5. What is meant by Elalsticity of Demand. Explain factors that determine

elasticity of demand of a commodity.
Ans : Price elasticity of demand is the ratio of percentage change in quantity demanded
to the percentage change in price. In otherwords, price elasticity of demand is a measure of
the relative change in quantity purchased of a good in response to a relative change in its price.
So it means the rate or the degree of response in demand to the change in price. Thus the co-
efficent of price elasticity of demand can be expressed as. under :
Proportionate change in Demand
Ed = Proportionate change in Price
Facters Determineing Elasticity of Demand :
The factors that determines elasticity of demand are numberless. But the most impor-
tant among them are the nature, uses and prices of related goods and the level of income.
They are stated below.
(1) Nature of the commodity :
Generally all commodities can be divided into three categories.
(i) Necessaries of life : For necessories of life the demand is inlastic because people
buy the required amount of goods whatever their price. For example, necessaries such
as rice, salt, cloth are purchased whether they are dear or cheap.
 +3 Economics 1st Semester qqq 21

(ii) Conventional Necessaries : The demand for convential necessaries is less elastic or
inelastic. People are aceustomed to the use of goods like intoxicants which they pur-
chase at any price. For example, drunkards consider opium and wine almost as a
necessity as food and water. Therefore, they buy the same amount even when their
prices are higher and highest.
(iii) Luxury commodities : The demand for luxury is usually elastic as people buy more of
them at a lower price and less at a higher price. For example, the demand of luxuries
line silk, perfumes and or naments increases at a lower price and diminishes at a higher
price. Here, we must keep in mind that luxury is a relative term, which varies from
person to person, place to place and from time to time. For example, what is a luxury
to a poor man is a necessity to the rich. The luxury of the past may become a necessary
of today. Similarly a commodity which is a necessity to one class many be luxury to
another. Hence the elasticity of demand in such cases should have to be carefully ex-
pressed.
(2) Substitudes :
Demand is elastic for those goods which have substitutes and inelastic for those goods
which have no substitutes. The availability of substitutes, thus, determines the elasticity of
demand. For instance, tea and coffee are substitutes. The change in the price of tea affects the
demand for coffee. Hence, the demand for coffee and ten is elastic.
(3) Number of Uses :
Elasticity of demand for any commodity depends on its number of uses. Demand is
elastic, if a commodity has more uses and inelastic it it has only one use. As coal has multiple
uses, if its price fulls, it will be demanded more for cooking, henting, industrial purposes etc.
But if its price rises, minimum will be demanded for every purpose.
(4) Post ponement :
Demand is more elastic for goods the use of which can be postponed. For example, if
the price of silk rises, its consumption can be postponed. The demand for silk is, therefore,
elastic. Demand is inelastic for those goods the use of which is urgent and therefore, cannot be
postponed. The use of can not be pur. Hence, the demand for onedicines is inelastic.
(5) Row materials and finished Goods :
The demand for raw materials is inelastic but the demand for finished goods is elastic.
For instance, raw cotton has inelastic demand but cloth has elastic demand. In the same way,
petrol has inelastic demand but car it self has only elastic demand.
(6) Price level :
The demand is elastic for moerate prices but inelastic for lower and higher prices. The
rich and poor donot bother about the prices of the goods that they buy. For example, rich buy
Benaras silk and diamands etc. at any price. But the poor buy coarse rice, cloth etc. what
ever their prices are.
(7) Income level :
The demand is inelastic for higherand lower income groups and elastic for middle in-
come groups. The rich people with their higher income do not bother about the price. They
 22 qqq EXCELLENT

may continue to buy the same amount whatever the price. The poor people with lower
icomes buy always only the minimum requirements and therefore, they are induced neither to
buy more at a lower price norless at a higher price. The middle income group is sensitive to
the change in price. Thus, they buy more at a lower price and less at higher price.
(8) Habits :
If consumers are habituated of some commudities, the demand for such commodities
will be usually inelastic. It is because that the consumer will use them even their prices to up.
For example, a smoker generally, doesnot smoke less when the price of cigarette goesup.
(9) Properties of Experditure :
The elasticity of demand for a commodity also depends as to how much part of income
is spent on that porticular commodity. The demand for such commodities where a small part
of income is spent, elasticity of demand is very elastic.
(10) Time :
The demand for a commodity is always related to some period of time. This implies that
elasticity of demand varies with the length of time periods. In case of long period, elasticity of
demand will be elastic while in the short period, it will be inelastic. This is due to the fact that
during short period, generally demand does not change immediately due to price changes.
Moreover, changing of habits and changing of equipments are not easy. However, it is pos-
sible in the long period.
(11) Distribution of Income :
If the income is uniformly distributed in the society, a small change in price will effect the
demand of the whole society and the demand will be elastic. In case of unequal distribution of
income and wealth, a change in price will hardly influence the poor section of the society and
the demand will be relatively inelastic.
(12) Influence of consumer’s surplus :
There is relationship between elasticity of demand and consumer’s surplus. Generally,
necessaries provide us more consumers surplus. Whenever consummer’s surplus is high, the
margin between the actual price and potential price is high and the consumer does not change
the demand so long the price increases within the margin. Hence, the elasticity of demand
varies inversely.
Q.6. Explain price Elasticity of demand. What are the different methods of measur-
ing elasticity of demand.
Ans : Price elasticity of demand is the ratio of percentage change in quantity demanded
to the percentage change in price. In other words, price elasticity of demand is a measure of
the relative change in quantity purchased of a good in response to a relative change in its price.
So it means the rate or the degree of response in demand to the change in price. Thus, the co-
efficient of price elasticity.
Measure of Price Elasticity of Demand :
(1) Total Expenditure Method :
Dr. Marshall has envolved the total expenditure method to measure the price elasticity
of demand. According to this method. elasticity of demand can be measured by considering
 +3 Economics 1st Semester qqq 23

the change in price and the subsequent change in the total quantity of goods purchased and
the total amount of money spent on it.
Total outlay = price × Quantity Demanded.
There are three possibilities :
(i) If with a fall in price (demand increases) the total expenditure increases or with a rise in
price (demand falls), the total expenditure falls, in that case the elasticity of demand is
greater than one i.e Ed > 1
(ii) It with a rise or fall in the price the total expenditure remains the same, the demand will
be unitary elastic or Ed = 1.
(iii) If with a full in price (Demand rises), the total expenditure also falls, and with a rise
inprice (Demand falls) the total expenditure also rises, the demand is said to be less
elastic or elasticity of demand is less than one (Ed < 1)
This can be expressed with the help of achart.
Price Total outlay Nature of Elasticity
(A) Increases (P) Decreases (TE) Ed > 1
Decreases (P) Increases (TE) More Elastic
(B) Increases (P) Constant ( TE ) Ed = 1
Decreases (P) Constant ( TE ) Unitary elastic
(C) Increases (P) Increases (TE) Ed < 1
Decreases (P) Decreases (TE) less elastic
(2) Proportimate Method :
According to this method, “price elasticity of demand is the ratio of percentage change
in the amount demaned to the percentage change in price of the commodity.” Its formula is as
under :
Proportionate change in Demand
Ed = Proportionate change in Price

Change in quantity demanded

= Amount demanded before change

Change in price
= price before change

The algebric equation for this formula is

Q
Q Q P Q P
Ed =    
P Q P P Q
P
 24 qqq EXCELLENT

(3) Point Method :

This method has now become very popu-
lar method of measuring elasticity. In this we take
a straightline demand curve, which connects the
demand curve with both the axes of OX and
OY.
In this diagram OX axis represents the
quantity demanded and OY axis represents price.
Rs is a straight line demand curve. Initially, price
is OP or QA and OQ or PA is the initial de-
mand. AT OP1 new price the demand is OQ1.
At point R elasticity of demand can be
measured with the following for mula.
Ed =
Change in Demand Change in Price
Ed = 
Original Demand Original Pr ice

QQ ' PP ' CB CA
E  or 
OQ OP OQ AQ

CB AQ CB AQ
= OQ  CA  CA  OQ

Since ACB and AQS are similar triangless, therefore, the propertion of their sides
will be equal as
CB QS

CA AQ
This can be written as under :
QS AQ QS
 
AQ OQ OQ

QS
By deleting AQ, from both sides, elasticity of demand is equal to OQ

Since AQS and RPA are similar, the ratio of their sides will also be equal. Therefore
QS PA

AS AS
QS AS
or, 
PA AR
 +3 Economics 1st Semester qqq 25

QS AS

OQ AR

AS Lower Segment
mean Upper Segment
AR
The elasticity of demand may not be same at all points on a curve.
(4) Arc Elasticity of Demand :
According to watson, “Arc elasticity is the elasticity at the mid point of an arc of demand
curve.” This method of measuring elasticity of demand is also known as. “Average Elasticity.”
p1  p 2
In this method, we use rather than P. Thus, we apply rather than q. The formula arc
2
elasticity of demand is as follows.
Change in Demand
Arc Elasticity of Demand (EA) = Original Demand  Near demand

Change in Pr ice
Original Pr ice  Near Price
Arc Elasticity of Demand in notation from can be expressed as :
Q  Q1 P  P1
E 
Q  Q1 P  P1
Where Q = Original quantity demanded
Q1 = New quantity demanded
P1 = Original Price
P2 = New price.
(5) Revenue Method :
Mrs Joan Robinson has given this method. She says that elasticity of demand can be
measured with the help of average revenue and marginal revenue. Therefore, sale proceeds
that a firm obtains by selling its products is called its revenue. However, when total revenue is
divided by the number of units sold, we got average revenue. On the contrary, when addition
is made to the total revenue by the sale of one more unit of the commodity is called marginal
revenue. Therefore the formula to measure elasticity of demand can be written as,
A
Ed =
AM
Q.7. Discuss Marshall’s cardinal utility Analysis Vs Indifference curve Analysis.
Ans : Barring the views of some economists like Dennis Roberson, W.B. Armstrong,
F.H. kinght, it is now widely believed that indifference curve analysis makes a difinite
improvement upon the Marshallian cordinal utility analysis.
 26 qqq EXCELLENT

It has been asserted that where as marshallian cardinal utility analysis assumes ‘too
much’ it explains ‘too little’. On the other mand, the indifferent curve analysis explains explains
more by taking fewer as well as less restrictive assumptions.
It may be noted that there are some similarities in these two theories of demand. First,
both these theories assume that consumers are rational and therefore try to maximise utility or
satisfaction. second, both these theories use psychological or introspective method to explain
consumer’s behaviour.
Thirdly, both these theories of demand assume in some from diminishing morginal utility
or desire for a commodity as a consumer takes more units of the commodity. In this connection
it is generally believed that the principle of diminishing marginal rate of substitution rate of
substitution is similar to the law of diminishing marginal utility of Marshallian cardinal utility
analysis.
Sapariority of Indifference curve analysis :
After having pointed out the similarities between the two types of analysis we now turn
to study the difference between the two and to show how for indifference curve analysis is
superior to the Marshallian cardinal utility analysis.
(1) Ordinal Vs. Cardinal Measurability of Utility :
In the first place, Marshall assumes utility to be cardinally measureable. In other words,
he believes that, utility is quantitiable both in principle and in actual practices. According to
theis the consumer is able to assign a specific amount to the unility obtained by him from the
consumption of a certain amount of a good or a combination of goods.
Further, the amounts of utility can be manipulated in the same manner as weights, lengths,
heights, etc. In otherwords, the utilities can be componed and added, suppose, for unstance,
utility which a consumer gets from a unit of good A is equal to 15, and from a unit of good B
equal to 45.
We can then say that the consumer prefers B three times as strongly as A and the utility
obtained by the consumer from the combination containing one unit of each good is equal to
60. Like wise, even the difference between the utilities obtained from the various goods can
be so compared as to enable as to say A is preferred to B twice as much as.
(2) Analysis of demand without Assuming constant Marginal Utility of Money :
Another distinet improvement made by indifference curve technique is that unline Marshall
it explains consumer’s behaviour and derives demand theorm without the assumption of
constant marginal utility of money.
As has alrendy been seen, Marshall assumed that the marginal utility of money remained
constant when there occurred a change in the price of a good. In other words, “the Marshallian
demand theoreis cannot genuinely be derived from the marginal utility hypothesis except in
one commodity model with contradicting the assumption of constant marginal utility of money.
(3) Greater Insight into price effect :
The superiority of indifference curve analysis further lies in the fact that it makes greater
insight in to the effect of price change on the demand for a good by distingushing between
income and substitation effects. The endifference teennique splits up the price effect enalytically
 +3 Economics 1st Semester qqq 27

into its two component parts substitution effect and income effect. The distinction between the
income effect and the substitution effect of a price change enables us to gain a better
understanding of the effect of a price change on the demand for a good.
In indifference curve analysis, income effect is separated from the substitution effect of
the price change by the methods of compensating variation in income and equvalent variation
in income’. But by assuming constant marginal utility of money marshall ignoned the income
effect of a price change
(4) Deriving a more general and adequate ‘Demand Theoram’ :
A distinct advantage of the teennique of dividing the effect of a price change into income
and the substitution effects implayed by the indifference curve analysis is the it enables as to
enunciate a more general and a more inclusive theoreun of demand than the marshallian law of
demand.
(5) Significance of a price change in terms of Income and welfare Increments :
Another dostinct improvement of Hicks–Allen ordinal theory is that through it the
welfareconsequences of a change in price can be translated into these of a change in income.
As seen above, a fall in the price of a good enables the consumer to shift from a lower to a
higher level of welfare.
Likemise, arise in the price of the good world couse the consumer to shift down to a
lower indifference curve and therfare to a lower level of welfare. This means that a full in price
of a good causes a change in consumers welfare exactly as the rise in income would do.
(6) Hypotheris of Independent Utilities Given Up :
Marshall’s cardinal utility analysis is based upon the hypothesis of independent utilities.
This means that the utility which the consumer derives from any commodity is a function of the
quantity of that commodity and of that commodity alone.
In other words, the utility obtained by the consumer from a c ommadity is independent
of that derived from any other . By assuming independent utilities Marshall completely by
passed the relation of substitution and complementarity between commodities.
But this is quite contrary to the common cases found in the real world. In the real world,
it is found that as a result of the fall in price of a commodity the demand for some commodities
expands while the demand for others contracts.
(7) Analising consumer’s demand with less Restrictive and FewerAssumptions :
It has been shown above that both the Hicks – Allen indifference curve theory theory
and Marshall’s cardinal theory arrive at the same condition for consumer’s equilibrium. Hicks–
Allen condition for consumber’s equilibrium, that is, MRs must be equal to the price ratio
amounts to the some thing as marshall’s proportionality rule of consumers equilibrium. But
even hare indifference curvis ordinal approch is an improvement upon the marshall’s cardinal
theory in so far as the former arrives at the same euqilibrium condition withless restrictive and
fewer assumptions.
Critique of Indifference curve Analysis :
Indifference curve analysis has come in for criticism on several grounds. In the first
place, it is argued that the indifference curve approch for avoiding the difficulty of measuring
 28 qqq EXCELLENT

utility quantitatively is forced to make unrealistic assumption that the consumer possesses
complete knowledge of all his scale of preferenes or indifference map.
The indifference curve approch, so to say, falls from the frying pan into the fire. The
indifference curve analysis invisages a consumber who carries in his hend innu....... rable
possible combinations of goods and relative preferences in respect of them.
Q.8. What is income Effect ? Explain Income consumption curve.
Ans : With a given money income to spend on goods, given prince of the two goods
and given an indifference map, the consumer will be in equilibrium at a point on an indifference
map. We are now interested in knowing how the consumer will react in regard to his purchas
is of the goods when his money income changes, prices of the goods and his tastes and
preferences remaining unchanged. Income effect shows this reaction of the consumer. Thus,
the income effect means the change in consumer’s purchases of the goods as a resuls of a
change in his money income. Income effect is illustrated.

With given prices and a given money income as indicated by the price line P,L, the
consumer is initially in equilibrium at Q1 on the indifference curve IC1 and is having OM, of X
and ON, of Y. Now suppose that income of te consumer increases. With his increased in-
come, he would be able to purchase larger quantities of both the goods. As a result, price line
will shift upward and will be parallel to the original price line P1L1, Let us assume that the
consumer’s money income increases by such an amount that the new price line is P2L2, buy
the superior goods which are aften more expensive. Hence as they become richer and can
afford to buy more expensive goods they switch to the consumption of superior and better
quality goods. For instance, most of the people in India consider chaapest common food
 +3 Economics 1st Semester qqq 29

grains such as Maize, Jawar, Bajra as inferior goods and therefore when their income rises
they shift to the consumption of superior varieties of food grains like wheat and rice. Similarly,
most of Indian people regard vanaspati Ghee to be inferior and therefore as they become
richer, they reduce its consumption and use “Desi Ghee” instead.
In case of inferior goods, indifference map would be such as to yeild income consump-
tion curve which either slopes backword or downward to the right.
It would be noticed from the following two figures that income effect becomes negative
only after a point. It signifies that only at higher ranges of income, some goods become inferior
goods and up to a point changes in their consumption behave live those of normal goods. In
figure (A) income consumption curve (ICC) slopes backword (upward to the lift) i.e, bends
towards the y-axis. This shows good x to be an inferior good, since beyond point Q2, income
effect is negative for good X and as a result its quantity demanded falls as income inereases.
In figure (B) income consumption curve (ICC) slopes dewnward to the right beyond
point Q2 i.e, bends towards X –axis. This signifies that good Y is inferior good because as
beyond point Q2, income effect is negative for good Y and as a result its quantity demanded
falls as income increases. It follows from that the income consumption curve can have various
possible shapes. With price line P2L2 the consumer is in equilibrium at Q2 on indifference IC2
and is buying OM2 of X and ON2 of Y. Thus, as a result of the increase in his income the
consumer buys more quantity of both the goods. Since he is on the higher indifference curve
IC2 he will be better off than before i.e, his satisfaction will increase. If his income increases
further so that the price line shifts to P3L3, the consumer is in equilibrium at Q3 on indifference
curve IC3 and is having greater quantity of both the goods than at Q2. consequently, his
satisfaction further increases. In the above figure the consumer’s equilibrium is shown at a still
further higher leves of income and it will be seen that the consumer is in equilibrium at Q4 on
indifference curve IC4 when the price line shifts to P4 L4. As the consumer’s income increases,
he switches to higher indifference curves and as a consequence enjoys higher levels of satis-
faction.
 30 qqq EXCELLENT

If now various points Q1, Q2, Q3 and Q4 showing consumer’s equilibrium at various
levels of income are connected together, we will get what is called Income consumption curve
(ICC). Income consumption curve is thus the locus of equilibrium points at various levels of
consumber’s income. Income consumption curve traces out the income effect on the quantity
consumed of the goods.
Income effect can either be positive or negative. Income effect for a good is said to be
negative when with the increases in his income, the consumer raduces his consumption of the
good. Such goods for which income effect is negative are called Inferior goods. This is be-
cause the goods whose consumption falls as the income of the consumer rises are considered
to be some way ‘inferior’ by the consumer and therefore he substitutes superior goods for
them when his income rises. When with the increase in his income, the consumer begins to
consume superior goods, the consumption or quantity purchased by him of the inferior goods
falls. When the people are poor, they cannot afford to.
If the income effect is positive for both the goods X and Y, the income consumption
curve will slope upward to the right. But upward sloping income consumption curve will slope
upward to the right for various goods may be of different slopes.

In the above figure income consumption curves with varying slopes, are all sloping
upward to the right and therefore indicate both goods to be normal goods having positive
income effect. If the income effect is negative income consumption curve will slope backward
to the life.


 2
+3 Economics 1st Semester qqq 31

PRODUCTION AND COST

UNIT
Production function: Short-run and Long-run; Total Product, Average
Product and Marginal Product, Law of returns to a variable factor, Law
of Returns to Scale; Concepts of Iso-quant and iso-cost line; Cost:
Accounting and Economic Costs; Social and Private Costs; Short-run
and Long-run Costs; Relation between Average and Marginal.

PART - I
(1 Mark each)
MULTIPLE CHOICE :
Q.1. Choose the correct answer from the given atternatives.
(a) The utility created by a tailor is colled
(i) place utility (ii) Time utility
(iii) From utility (iv) Service utility
Ans : (iii) From utility
(b) The law of diminishing regurns is otherwise. called the law of
(i) increasing cost (ii) constant cost
(iii) diminishing cost (iv) None of the above
Ans : (i) increasing cost
(c) When marginal cost is less then average cost, average cost
(i) falls (ii) Increases
(iii) remains constant (iv) None of the above
Ans : (i) falls
(d) The SAC curve takes the shape of
(i) Rectangular hyperbola (ii) u.stape
(iii) vertical (iv) herizontal
Ans : (ii) u.stape
(e) Cost of raw material is
(i) variable cost (ii) fixed cost
(iii) overhead cost (iv) None of the above
Ans : (i) variable cost
 32 qqq EXCELLENT

(f) Wages paid to hired labour in a firm is

(i) explicit cost (ii) implicit cost
(iii) real cost (iv) None of the above
Ans : (i) explicit cost
(g) Which of the following is not a fixed cost ?
(i) cost of machine (ii) Salary of the manager
(iii) cost of the factory building (iv) payment for raw materials
Ans : (iv) payment for raw materials
(h) Oppertunity cost is
(i) expenses incurred in available opportunity
(ii) Income foregone in next best alternative
(iii) expenses of a producer
(iv) None of the above
Ans : (ii) Income foregone in next best alternative
(i) What is the value of marginal cost of production if total cost of production of 10 unit is
100 and that of II units of output is 140 ?
(i) 10 (ii) 14 (iii) 140 (iv) None of the above
Ans : (iii) 140
(j) Cost per unit of output is called
(i) Average cost (ii) Total cost
(iii) Marginal cost (iv) Fixed cost
Ans : (i) Average cost
(k) cost of entrepreneur’s self-owned resources
(i) Explicit cost (ii) Implicit cost
(iii) Marginal cost (iv) Average cost
Ans : (ii) Implicit cost
(l) It is the cost of next best alternative foregone.
(i) Real cost (ii) Money cost
(iii) Oppertunit cost (iv) Fixed cost
Ans : (iii) Oppertunit cost
(m) Addition made to tatal cost is called
(i) Marginal cost (ii) Real cost
(iii) Total cost (iv) None of the above
Ans : (i) Marginal cost
(n) The pain and sacrifice made by factors is called
(i) Money cost (ii) Real cost
(iii) Fixed cost (iv) Variable cost
Ans : (ii) Real cost
 +3 Economics 1st Semester qqq 33

(o) Expenditure incurred in terms of meney to produce a given output is called–

(i) Real cost (ii) Money cost
(iii) Fixed cost (iv) Variable cost
Ans : (ii) Money cost
(p) Creation of utility having an exchange value is called–
(i) consumption (ii) Production
(iii) Destruction (iv) None of the above
Ans : (ii) Production
(q) It is the amount of total output produced perunit of time by all factors inputs is called–
(i) Total product (ii) Average product
(iii) Average product (iv) None of the above
Ans : (i) Total product
(r) It is the output produced per unit of a given variable factor is called–
(i) Total product (ii) Average product
(iii) Marginal product (iv) None of the above
Ans : (ii) Average product
(s) It is addition to total product is called–
(i) Average product (ii) Marginal product
(iii) Total product (iv) None of the above
Ans : (ii) Marginal product
(t) The functional relation between inputs and output is called–
(i) production (ii) production function
(iii) Factors of production (iv) None of the above
Ans : (ii) production function
(u) Any commodity or service which helps in further production of wealth is called–
(i) production (ii) Factors of production
(iii) production function (iv) None of the above
Ans : (ii) Factors of production
(v) It is an operational time period in which the output of a firm can be varied by changing
all factors is called–
(i) Short run (ii) Long run
(iii) None of the above
Ans : (ii) Long run
(w) It is an operational time period in which the output of a firm can be varied by changing
variable factor is called.
(i) Short run (ii) Long run
(iii) None of the above
Ans : (iii) None of the above
 34 qqq EXCELLENT

PART - II
Short Questions and Answer (2 Marks each)
Q.2. Write the answer in one sentences in each case.
(a) What is marginal product ?
Ans : It is addition made to total product by explaying one more unit of a variable
facter.
MPn = TPn – TPn-1
where MP = Marginal product
n = any real number
TP
MP =
V
(b) What is average product ?
Ans : It refers to the output per unit of a given variable factor. By dividing the total
product by the quantity of the variable factor. We get average product symbolically.
TP
AP =
V
(c) What is total product ?
Ans : Total product may be defined as the amount of aggregate output produced per
unit of time by all factor inputs. In the shorrun, total product increases with the increase of
variable factors line labour and ra..... materials. Thus : TP = f (v)
(d) What is production ?
Ans : production can be defined as any economic activity resulting in addition or creation
of utilities. That means the process of creation of utility having an exchange value is called
production.
(e) What is facters of production ?
Ans : Anything that helps in the production of goods and services is called a factors of
production. Loard and and services is called a factors of Labour are called primary or original
factors of production as they constitute the basis of economic activity.
(f) What is production function ?
Ans : The functional relation that exists between input and output is called production
function is a teenical relation. It terms mathematical equation, the relation. ship can be expressed
as follows.
(g) What is shortrun ?
Ans : Short-run refers an operational time period in which the output of a firm can be
varied by changing the variable factors only. Fixed facter line factory building, machining
cannot be changed during this period.
 +3 Economics 1st Semester qqq 35

(h) What is Long run ?

Ans : Long run is an operational time period in which the output of firm can be varied
by changing all factors.
(i) What is fixed factor ?
Ans : Fixed factors are thase which remain unchanged as putput of the firm changes in
the short run. In otherwords as a firm increases or decreases its output in the short run, fixed
factor remain constant.
(j) What is variable factor ?
Ans : variable factor are thase factor inputs which change with the change of putput in
the shortrun. Raw materials, labour, fuel, power etc. are the examples of variable factors.
(k) What is cost of production ?
Ans : Expenditure incurred, by a firm to produce a given output is known as the cost of
production. Factor, must be paid in the form of rent, wages, interest and normal profit. These
costitute the cost of production of a firm.
(l) What is Money cast ?
Ans : Expenditure incurred by the firm in terms of money on hiring various factors of
production to produce a given output is knows as money cast. It is also called nominal cast of
production.
(m) What is Real cost ?
Ans : In the production process, the factors of production recive their remuneration
because they undergo different types of pain, sacrifice and hardship. Therefore realcost is the
sum total of pain, sacrifice, and tail undergone in producing a community by the different
factors of production.
(n) What is opportunity Cost ?
Ans : The opportunity cost is otherwise known as the alternative cost. The oppertunity
cost of any good is the next best alternative good that is sacrificed.
(o) What is fixed cost ?
Ans : Fixed costs refer to those expenditures incuvered by the firm which remain
unchanged irrespective of the firm which remain unchanged irrespective of the leves of output.
Expenditures on plant and equipmant. insurance premium, salaries of managerial staff. license
fees etc are the examples of fixed costs.
(p) What is variable cost ?
Ans : Variable cost refers to those cost of production which change with the change of
output of the firm. Wages of labour, payments for raw materials, power, fuel etc. are the
examples of variable factor.
(q) What is short-run costs ?
Ans : In short-period, total cost of production in divided into fixed cost and variable
cost. In order to carry on production in the short-run, the firm must cover the variable cost.
 36 qqq EXCELLENT

(r) What is average cost ?

Ans : Average cost is the cost per unit of output. It is calculated by dividing total cost
with the number of units of output produced. Average cost is of two types (1) Average fixed
cost (2) Average variable cost.
(s) What is Average fixed cost ?
Ans : It is the total fixed cast divided by the number of units of output produced. It
progressively declines as output goes on increasing in the short-run.
(t) What is Average variable cost ?
Ans : It is the total variable cost divided by the number of units of output produced. It
first falls and after reaching a minimum point rises.
(u) What is marginal cost ?
Ans : The addition mode to the total cost by producing one more unit of output is
known as marginalcost.
PART - III
Short Questions and Answer (3 Marks each)
Q.3. Write the answer in one sentences in each case.
(a) What is factors of production ?
Ans : Creation of uticility having an exchange value is called production.
(b) What is factors of production ?
Ans : Any commodity or service which helps in further production of wealth is called a
factor of production.
(c) What is production function ?
Ans : The functional relation between inputs and output is called production faction.
(d) What is shortrun production function ?
Ans : Short-run production function refers to the law of variable propertions.
(e) What is short run production function ?
Ans : Long-run production function refers to the law of return to scale.
(f) What is fixed factors ?
Ans : Fixed factors donot change with the change of the output of the firm in the short-
run.
(g) What is variable factors ?
Ans : Variable factors change with the change of output inthe short-run like labour, raw
material etc.
(h) What is Total product ?
Ans : It is the amount of total output produced per unit of time by all factors inputs.
(i) What is Average product ?
Ans : It is the output produced perunit of a given variable factor.
 +3 Economics 1st Semester qqq 37

(j) What is marginal product ?

Ans : It is addtion made to total product by emplaying on more unit of a variable factor.
(k) What is the meaning of Law of variable proportions ?
Ans : Keeping other factors constant if we vary equal quantities of a variable factor,
the marginal product after a point will begin to decline.
(l) What is Money cost ?
Ans : Expenditure incurred in terms of money to produce a given output is called
money cost.
(m) When does a production function satisfy constant returns to scale ?
Ans : Production function satisfly constant returns, when MP becommes zero and TP
reaches its maximum print.
(n) When does a production function satisfy increasing returns to scale ?
Ans : A production function satisfy increasing returns when every additional variable
factur adds more and more to the total output.
(o) When does a production function satisfy decreasing returns to scale ?
Ans : A production function satisfy decreasing return when every additional variable
factor adds lesser and lesser amount of output.
(p) What is cost of production ?
Ans : The functional relationship between cost and quantityproduced isterned as cost
function.
(q) What is Average fixed cost ?
Ans : It refers to the per unit fixed cost of production calculated as AVC =
(r) What is Average variable cost ?
Ans : It is the total variable cost divided by the number of units of output produced.
(s) What is marginal cost ?
Ans : The addition made to the total cost by producing one more unit of output in
known as marginal cost.
(t) Can there be come fixed cost in the longrun ? If not, Why ?
Ans : No, there are no fixed costs in the long-run as all the factors are variabloe fixed
cost exists only in the short-run.
(u) What does the average fixed cost curve look like ? Why does it look so ?
Ans : The average fixed cost curve looks like a rectangular hyperbola. It happens
because same amount of fixed cost is divided by increasing output.
(v) What do the shortrun marginal cost, average variable cost and shortrun average
cost curves look like ?
Ans : The curves of short-run marginal cost, average variable cost and average cost
are V shaped.
 38 qqq EXCELLENT

(w) Whe does the SMC curve cut theAVC at the minimum point of theAVC curve ?
Ans : It is only when AVC is constant and at its minimum point, that SMC is equal to
AVC. Therefore, SMC curve cuts AVC curve at its minimum points.
(x) At which point does the SMC curve cut the SAC curve ?
Ans : SMC curve cuts the SAC curve at its minimum point.
(y) Why is marginal cost higher than average cost ?
Ans : Marginal cast is the increase in cost causess by producing one more unit of the
good. The marginal cost curve is U shaped because initially when a firm increases its output,
total costs, as well as variable costs, starts to increase at a diminishing rate.
(z) What is ISO costline ?
Ans : The isocost line is an important component when analysing producer’s behaviour.
In simple words, an isocost line represents a combination of inputs which all cost the same
amount.
(z1) What is ISO costline ?
Ans : The isocost line is a that shows all the combinations of inputs that yeild the same
level of output.
(z2) What is Economic cost ?
Ans : Economic cost is the sum of explicit cost and implicit cost.
(z3) What is accounting cost ?
Ans : Those cost are recorded in accounts register is known as accounting cost.
PART - IV
Long Questions With Answers (7 Marks Each)
Q.1. Explain the law of variable proportion with the help of table and diagram. Give
the essential conditions for its applicability.
Ans : Law of variable proportions occupies an important place in economic theory.
Keeping other factors fixed, the law explains the production function with one factor variable.
In the short run when output of a commodity is sought to be increased, the law of variable
propertions comes into operation.
According to samuelson: “An increase in some inputs relative to other fixed inputs will
in a given state of technology cause output to increase, but after a point the extra output
resulting from the same additions of extra inputs will become less and less.”
Assumptions :
Law of variable proportions is based on following assumptions :
(i) Constant Technology :
The state of technology is assumed to be given and constant. It there is an improvement
in technology the production function will move upward.
 +3 Economics 1st Semester qqq 39

(ii) Factor proportions are variable. The law assumes that factor proportions are variable.
If factors of production are to be combined in a fixed proportion the law has no validity.
(iii) Homogeneous factor units :
The units of variable factor are homogeneous. Each unit is identical in quality and amount
with every other unit.
(iv) Short - run. The law operates in the short-run when it is not possible to vary all factor
linputs.
Explanation of the law :
In order to understand the law of variable proportions we take the example of agriculture.
Suppose, and and labour are the only two factors of production. By keeping land as a fixed
factor, the production of variable factor i.e, labour can be shown with the help of the following
table
Table
Units of Units of Total Average Marginal
Land labour production production production
10Acres 0 – – –
,,
,,
,,
,,
1
2
3
4
20
50
90
120
20
25
30
30
20
30
40
30
} 1st
stage

,,
,,
,,
5
6
7
140
150
150
28
25
21.3
}
20 2nd
10 stage
0
,, 8 140 17.5 –10 } 3rd
stage

From the table It is clear that there are three stages of the law of variable proportion. In
the first stage average production increases as there are more and more does of labour and
capital exployed with fixed factors (land). We see that total product, average product and
marginal product incrdases average product and marginal product increases up to 40 units.
Later on both start decreasing becouse proportion of workers to land was sulficient and land
is not properly used. This is the end of the first stage.
The second stage starts from where the first stage ends or where AP = MP. In this
stage, average product and marginal product start falling.
We should note that marginal product falls at a faster rate than the average product.
Here total product increases at a dissinishing rate. It is also maximum at 70 units of labour
where marginal product becomes zero while average product is never zero or negative. The
 40 qqq EXCELLENT

third stage begins where second stage ends. This starts from 8th unit. Here marginal product
is negative and total product falls but average produt is still positive. All this stage, any additional
does leads to positive nuisance because additional does leas to negative marginal product.

In this diagram, X - asix measures the quantity of the variable facter and Y - axis
measures the total product. The diagram indicates, How the total product, average product
and marginal product changes as a result of increase in the quantity of one factor to a fixed
quantity of other factors.
The total product curve will usually first increase at an increasing rate, then at a decreasing
rate until it reaches an absolute maximum, and finally the rate of increase becomes zero and
then the total product curve starts declining, since MP is negative. Average and marginal
product curves also rise and then decline, marginal product curve starts declining earlier than
the average product.
Sense all the curves rise to a maximum and then decline, it can be said that, a low of diminishing
regurns applies to the total product, the average product, and the marginal product curve.
Three stages of the Law of variable proportions :
First Stage :
First stage starts in which average product continues to increase and reaches a maximum.
The marginal product curve is greater than average product and marginal product curve reaches
its maximum withen this stage. Besides, the marginal product first increases and then decreases
in this stage but still remains positive.
The total product curve increases at an increasing rate into this region, i.e upto the point
F. This is known as the stage of increasing return. From the point F m-words the total product
curve increases but at a deminishing rate upto the poin K.
 +3 Economics 1st Semester qqq 41

Thus, at the end of state 1, average product reaches its maximum and becomes equal
to the marginal product. The state 1 is known as the stage of increasing returns because the
average product (AP) of the variable input increases throughout this stage and reaches its
maximum.
Second Stage :
The second stage ends at the point it, where total product curve (TP) reaches its maximum
and marginal product becomes zero. The stage II is generally called as the stage of diminishing
regurns, since the average product (AP) and marginal product (MP) both decline throughout
this stage but remain positive.
Third Stage :
Third stage starts after the employment of OQ2 units of variable factor. If any unit of
variable factor is addes to this amount, it will have a negative marginal productivity.
The additional units of variable factor will reduce production instead of increasing Thus,
the cost of production will also be increased, since total production actually falls as more
labour is used. This is the stage in which MP is negative and the AP continues to decline and
the total product (TP) also falls. This stage in known as the stage of negetive reterns since MP
of the variable factor is negative.
Q.2. Explain the law of return to scale with diagram.
Ans : In the longrun all factors of production are variable. No factor is fixed. Accordingly,
the scale of production can be changed by changing the quantity of all factors of production.
Definition :
According to Leibhafsky, “Returns toscale relates to the behariour of total output as all
inputs are varied and is a long run concept.”
Returns to scale are of the following three types :
(1) Increasing Returns to scale
(2) Constant Returns to scale
(3) Diminishing Returns to scale
Explanation :
In the long run, output can be increased by increasing all factors in the same proportion.
Generally, laws of returns to scale refer to an increase in output due to increase in all factors in
the same proportion. Such an increase is called returns to scale.
suppose, initially production function is as follows :
P = f (L, K)
Now, if both the factors of production i.e., labour and capital are increased in same
proportion i.e, x, production function will be rewritten as,
P1 = f (xL, xK)
1. If P1 increases in the same proportion as the increase in factors of production i.e,
P1
= x, it will be constant returns to scale.
P
 42 qqq EXCELLENT

P1
2. If P1 increases less than proportionate increase in the factors of production i.e. < x,
P
it will be diminishing returns to scale.
P1
3. If P1 increases morethan proportionate increase in the factors of production, i.e, > x,
P
it will be increasing returns to scale. REturns to scale can be shown with the help of
table.
Table showing different stages of returns to scale.
Units Units %age increase Total % age Returns
Of of in labour & product increase to
Labour capital capital in TP scale
1 3 – 10 –
2
3
9
9
100%
50%
30
60
200%
100% } Increasing

4
5
12
15
33%
25%
80
100
33%
25% } Constant
6
7
18
21
20%
16.6%
120
130
10%
8.3%
} Decreasing

The above stated table explains the following three stages of returns to scale.
1) Increasing Returns to scale :
In creasing returns to scale or
diminishing cost refers a situation when all
factors of production are increased, output
increases at a higher rate. It means if all
inputs are deuble output will also increase
at the faster rate than double. Hence, it is
said to be increasing returns to scale.
This increase is due to many reasons
like division of labour, specialization and
other external economics of scale.
Increasing returns to scale can be
illustrated with help of a diagram.
In the above figure, OX axis
represents increase in labour and capital while OY axis shows increase in output. When
labour and capital increases from Q to Q1, output also increases from P to P1which is higher
than the factors of production i.e.labour and capital.
 +3 Economics 1st Semester qqq 43

2) Diminishing Returns to scale :

Diminishing returns or increasing costs
refer to that production situation, where if
all the factors of production are increased
in a given proportion. output increases in a
smaller proootion. It means, if inputs are
doubled. Output will be less than doubled.
If 20 percent increase in labour and capital
is following by to percent increase in output,
then it is an instance of diminishing returns
to scale is that internal and external and
economics are less than internal and external
dis economics. It is clear from diagram.
In this above diagram, diminishing
Units of Labour and Capital
returns to scale has been shown. On ox axis,
labour and capital are given while on OY axis, output. When factors of production increases
from Q to Q, but as a result increase in output i.e, P to P1 is less. we see that increase in
factors of production is more and increase in production is comparatively less, thus deminishing
returns to scale apply.
3) Constant Returns to scale :
Constant returns to scale or constant
cost refers to the production situation in
which output increases exactly in the same
proportion in which factors of production
are increased. In simple terms, if factors of
production are doubled output will also be
doubled. In this case internal and external
economics are exactly equal to internal and
external economics are exactly equal to
internal and external diseconomics. This
situation arises when after reaching a certain
leves of production, economics of scale are
balanced by diseconomices of scale. This is
known as homogeneous production function.
Cobb-Douglas linear homogenous
production function is a good example of
this kind. This is shownin diagram.
In figure 10, we see that increase in factors of production i.e. labour and capital are
equal to the proportion of output increase. Therefore, the result is constant returns to scale.
 44 qqq EXCELLENT

Q.3. What is Iso-cost line ? Explain it with diagram.

The iso-cost line is similar to the price or badget line of the difference curve analysis. It
is the line which shows the various combinations of factors that will result in the same level of
total cost. It refers to those different combinations of two factors that afirm can obtain at the
same cost. Just as there are various iso quant curves, so there are various isocost lines,
corresponding to different levels of total output.
Isocost line may be defined as the line which shows different possible combinations of
two factors that the producer can afford to buy given his total expenditure to be incurred on
these factors and price of the factors.
Explanation :
The concept of iso-cost line can be expained with the help of the following table and
diagram. Suppose the producer’s budge for the purchase of labour and capital is fixed at
Rs.1000. Further suppose that a unit of labour cost the producer Rs. 10 while a unit of capital
Rs.20.
Toble. Alternative Factor combination.
Labour Lp = Rs.10 Labour Lk = Rs.10 Total
(1) (2) Expenditure (3)
10 0 100
0 5 100
4 3 100
2 4 100
From the table cited above, the producer can adopt the following option.
(i) Sepending all the money on the
purchase of labours, he can hire
 100 
10 units of labour   10 
 10 
(ii) Spending all the money on the
capital he may buy 5 units of
capital.
(iii) Spending the money on both
labour and capital, he can choose
between various possible
combinations of labour and capital
such (4, 3) (2, 4) etc.
Labou is given on OX - axis and
capital on OY-axis. The points A, B, C
and D convey the different combinations
 +3 Economics 1st Semester qqq 45

of two factors, capital and labour which can be purchased by spending Rs.100. Point A
indicates 5 units of capitalk and no unit of labour, while point D represents 10 units of labour
and no unit of capital. Point B indicates 4 units of capital and 2 units of labour. Like wise, point
c represents 4 units of labour and 3 units of capital.
ISOcost curves :
After knowing the nature of iso quants which represent the output posibilities of firm
from a given combination of two points. We further extend in to the prices of the inputs as
represented on the isoquant map by the isocost curves. These curves are also known as
outlay line, price lines, input, price lines, factor-cost lines, constant–outlay lines, etc. Each iso-
cost curve represents the different combination of two inputs that a firm can buy for a given
sum of money at the given price of each input.

In above figure (A) shows three isocost curves each represents a total outlay of 50, 75
and 100 respectively. The firm can here OC of capital or OD of labour with Rs. 75. OC is 2/
3 of OD which means that the price of a unit of labour is 1... times less than that of a unit of unit
of capital. The line CD represents the price ratio of capital and labour. Prices of factors
remaining the same, if the total outlay is raised, the isocost curve will shift upward to the right
as EF parallel to CD, and if the total outlay is reduced it will shift downwards to the lift as AB.
The isocosts are straight lines because factor price remain the same whatever the outlay of the
firm on the two factors. The isocost curves represent the locus of all combinations of the two
input factors which result in the same total cost. If the unit cost of labour (L) is W and the unit
of cost of capital (c) is r, then the total cost : TC = WL + rc. The slope of the isocost line is the
ratio of prices of labour and capital i.e. W / r.
 46 qqq EXCELLENT

The point whre the isocost line is tangent to an isoquant shows the least cost combination
of the two factors for producing a given output. If all points of tangency like LMN are joined
by a line, it is known as an output factor curve or least outlay curve or the expansion path of
a firm. It shows how the proportions of the two factors used might be changed as the firm
expands. For example in figure (A) the proportions of capital and labour used to produce 200
(1Q1) units of the product are different from the proportions of these factors used to produce
300 (1Q2) units or 100 unit at the lowest cost.
Like the price – income line in the indifference curve analysis, a relative cheapening of
one of the factors to that of another will extend the isocost line to the right. If one of the factors
become relatively dearer, the isocost line will contract inward to the lift. Given the price of
capital, if the price of labour falls, the isocost line EF in panes (B) of figure will extend to the
right as EG and if the price of labour rises, the isocost line EF will contract in ward to the lift
as EH, if the equilibrium L, M, and N are joined by a line. It will be called the price – factor
curve.
Q.4. What is production Function ? Discuss the features of production function.
Ans : In simple words, production function refers to the functional relationship between
the quantity of a good produced (output) and factors of production (inputs). In this way,
production function reflects how much output we can expect if we have so much of labour
and so much of capital as well as of labour etc. In other words we can say that production
function is an indicator of the physical relationship betweeen the inputs and output of a firm.
The production function of a firm depends on the state of technology. With way development
in technology the production function or the firm undergues a change. The new production
function brought about by developing technology displays same inputs and more output or the
same output with lesser inputs. Some times a new production function of the firm may be
adverse as it takes more inputs to produce the same output.
Mathematically, such a basic relationship between inputs and outputs may be express as :
Q = f (L, C, N)
Q = Quantity of output
L = Labour
C = Capital
N = Land.
Hence, the live of output (Q), depends on the quantities of different inputs (L, C, N....)
available to the firm. In the simplest case, where there are only two inputs, Labour (L) and
capital (C) and one output (Q), the production function becomes.
Q = f (L, C)
Thus, from the above definition, we can conclude that production function shows for a
given state of technological knowledge, the ration between physical quantities of inputs and
outputs achieved per period of time.
 +3 Economics 1st Semester qqq 47

Features of Production Function :

Production function presumes the following main features :
1) Substitutability : The factors of production or inputs are substitutes of one another
which make it possible to vary the total output by changing the quantity of one or a few
inputs, while the quantities of all other inputs are held constant. It is the substitutability of
the factors of production that gives rise to the laws of variable proportions.
2) Complementarity : The factors of production are also complementary to one another,
that is the two or more inputs if the quantity of either of the inputs used in the production
process is zero. The principles of returns to scale is another manifestation of
complementarity of inputs as it reveals that the quantity of all inputs are to be increased
simultaneously in order to attain a higher scale of total output.
3) Specificity : It reveals that the inputs are specific to the product in of a particular
product. Machines, and euqipments, specialised workers and raw materials are of few
examples of the specificity of factors of production. The specificity may not be complete
as factors may be used for production of other commodition too. This reveals that in
the production process none of the factor can be ignored and in some cases ignorance
to even slightest extent is not possible if the factors are perfectly specific.
Production involves time, hence, the way the inputs are combined is determined to a
large extent by the time period under consideration. In the production function, variation in
total output buy verying the quantities of all inputs is possible only in the longrun where as the
variation in total output by varying the quanity simple input may be possible even in the shortrun.
Q.5. Discuss about Total product, Average product and Marginal product.
Ans : Production function : – The function that explains the relationship between
physicalinputs and physical output (final output) is called the production function. WE normally
denote the production function in the form.
Q = f (X1 , X2)
where Q represents the final output and X1 and X2 are inputs or factors of production.
Total product : In simple terms we can define Total product as the total volume or amount of
final output produced by a firm using given inputs in a given period of time.
Marginal product :
The additional output produced as a result of employing an additional unit of the variable
factor input is called the marginal product. Thus, we can an say that marginal product is the
addition to total product when an extra factor input in used.
Marginal product = change in output / change in input. Thus, it can also besaid that
Total product is the summation of marginal products at defferent input levels.
Average product :
It is defined as the output per unit of factor inputs or the average of the total product per
unit of input and can be calculated by dividing the total product by the inputs. Average product
= Total product / units of variable factor input.
 48 qqq EXCELLENT

Relationship between marginal product and total product :

The law of variable propertions is used to explain the relation ship between total product
and marginal product. It shates that when only one variable factor input is allowed to increase
and all other inputs are kept constant, the following can be observed.
When the marginal product (MP) increases, the total product is also increasing at an
increasing rate. This gives the total product curve a convex shape in the begining as variable
factor inputs increase. This continues to the point where the MP curve reaches its maximum.
When the MPdeclines but remains positive, the total product is increasing but at a
decreasing rate. This ends the Total product curve a concare shape after the point of inflextion.
This continues until the total product curve reaches its maximum, when the MP is declining
and negative, the total product declines.
When the MP becomes zero, Total product reaches its maximum.
Relationship between Average product and marginal product. There exists an interesting
relationship betweenAverage product and marginal product. we can summarize in as under :
When Average product is rising, marginal product lies above Average product.
When average product is declining, marginal product lies below Average product.
At the maximum of Average products, marginal and average product equal each other.
Q.6. Differences Between Accounting costs and Economic costs.
Ans : Expenditure incurred by the firm in terms of money on hiring various factors of
production to produce a given output is known as money cost. It is also called nominal cost of
production. It includes wages and salaries paid in terms of money, cost of raw materials,
power and fuel charges, rent of factory premises interest changes on borrowed funds, insurance
premimum, taxes like excise duties, license fees, cost of transport etc. Thus money cost is the
total monetary outlay of the firm for producing a given output.
The above list of items included in money cost is an explicit payment made by the firm.
These are recorded expenditures during the process of production. It is also known as accunting
cost or explicit cost as these costs enter into accountant’s register. Gross profit is calculated
by deducting accounting cost from the total reve.........
In addition to the explicit money cost, economists are interested in another type of cost
called implicit cost. Implicit costs are the cost of entrepreneours own capital invested in business,
wages of his management etc. In other words, the entrepreneur may have imployed his own
resources in the production process for which no formal payments are mode and hence these
costs do not find their way into the accountant’s register. But economists consider these costs
to be bona fide costs. These costs are calculated on their imputed values. For example the
entre preneur may have his own lard emplayed inthe production process for which normal
payment is made to the entrepreneur. But if the producer had rented his land to somebody, he
would have earned rent at the market determined rate. This is called imputed rent.
Thus implicit cost is the cost of entrepreneur’s self-owned and self-employed resources.
Economic cost is the sum of explicit cost (accountry cost) and implicit to cost.
 +3 Economics 1st Semester qqq 49

Components of Accounting cost :

Accounting costs are the explicit costs, also known hard costs that are sun as money
out of your bank account that you need to run your business. These are production costs,
lease payments, marketing budgets and pay roll. In other words, these are the realcosts in
manufacturing, markting and delivering your products.
Explicit costs have a monetary value and are easily identified on a book keeper’s ledger.
Accounting costs are generally real-time costs that are deducted from revenues in any given
accounting period.
Components of Economic costs :
Economic costs include the same explicit costs that accounting costs use in calculations,
but economic costs also include implicit costs. Implicit costs are those values that are not
listed on the ledger, and they are assumed by the business to utilize resources. The idea with
implicit costs is that the business could make more by using an esset in a different, more
traditional fastion.
Cost Method use :
Accounting costs are used as a very traditional means to determine a company’s financial
health. As a business owner, yor want to know what meney is coming in and what funding gets
applied to which expense. This is why accounting costs are very popular when determining
the financial health of the company. Accounting costs are used in reporting taxes.
Economic costs are still very valuable to a business. because they determine long term
strate gies. Economic costs provide a high-level overview of what the company is really
valued at and what is could be valued at.

 3
50 qqq EXCELLENT

PERFECT COMPETITION
Concept of Perfectly Competitive market: Assumptions, Profit
maximization conditions; Related concepts of Total Revenue, UNIT
Average Revenue and Marginal Revenue, Short-run and Long-
run equilibrium of a firm; determination of short-run supply
curve of a firm, measuring producer surplus under perfect
competition.

PART - I
(1 Mark each)
FILL IN THE BLANKS :
1. ___________ competition a market structure characterized by a large number
of small firms such that no single firm can affect the market price or quantity
exchanged. ___________ competitive firms are price takers.
Ans. Perfect, Perfectly
2. They set a production level based on the ___________ determined in the
market.
Ans. price
3. There are no barriers to entry into or exit out of in the ___________
competition market.
Ans. Perfect
4. Firms produce homogeneous, identical, units of output that are not branded
in the ___________ competition market.
Ans. Perfect
5. No single firm can influence the market price, or market conditions in the
___________ competition market.
Ans. Perfect
6. The key assumption of Perfect Competition is motivate by ___________
maximization.
Ans. profit
7. Profit is maximised where the positive gap between Total Revenue and Total
cost is the ___________.
Ans.maximum
8. ___________ cost industry is an industry with a negatively-sloped long-run
industry supply curve.
Ans. Decreasing
9. ___________ Cost Industry is an industry with a positively-sloped long-run
industry supply curve.
Ans. Increasing
 +3 Economics 1st Semester qqq 51

10. ___________ Cost Industry is an industry with a horizontal long-run industry

supply curve.
Ans. Constant
11. The ___________ curve for a firm tells us how much output the firm is willing
to bring to market at different prices.
Ans. supply
12. ___________ Surplus is used to measure the welfare of a group of firms who
sell a particular product at a particular price.
Ans. Producer
13. ___________ surplus is defined as the difference between what producers
actually receive when selling a product and the amount they would be willing
to accept for a unit of the good.
Ans. Producer
14. An industry with a ___________ sloped long-run industry supply curve that
results because expansion of the industry causes lower production cost and
resource prices.
Ans. negatively
15. A ___________ industry occurs because the entry of new firms, prompted by
an increase in demand, causes the long-run average cost curve of each firm
to shift downward, which decreases the minimum efficient scale of production.
Ans. decreasing-cost
16. An ___________ industry occurs because the entry of new firms, prompted
by an increase in demand, causes the long-run average supply curve of each
firm to shift upward, which increases the minimum efficient scale of production.
Ans. increasing-cost
17. A ___________ industry occurs because the entry of new firms, prompted by
an increase in demand, does not affect the long-run average cost curve of
individual firms, which means the minimum efficient scale of production does
not change.
Ans. constant-cost
18. A perfectly competitive firm is presumed to shutdown production and produce
no output in the short run, if price is ___________ than average variable cost.
Ans. less
19. The ___________ is supposed to be a period sufficiently long to allow changes
to be made both in the size of the plant and in the number of firms in the
industry.
Ans. long-run
20. In the ___________ period, an increase in demand is met by over-using the
existing plant.
Ans. short
52 qqq EXCELLENT

21. A firm is in ___________ when it is satisfied with its existing level of output.
Ans. equilibrium
22. According to ___________, “Where profits are maximized, we say the firm is
in equilibrium”.
Ans. R A. Bilas
23. ___________ profits refer to pure profits which are a surplus above the average
cost of production.
Ans. Maximum
24. Under conditions of ___________ competition, the MR curve of a firm
coincides with its AR curve.
Ans. perfect
25. ___________ revenue is the revenue obtained from the last unit sold.
Ans.Marginal
26. ___________ revenue is computed by taking the change in total revenue
divided by the change in quantity.
Ans. Marginal
27. ___________ means a positive gain generated from business operations or
investment after subtracting all expenses or costs.
Ans. Profit
28. ___________ refers to the income obtained by a firm through the sale of
goods at different prices.
Ans. revenue
29. The income earned by a seller or producer after selling the output is called
the ___________ revenue.
Ans. total
30. ___________ revenue is the multiple of price and output.
Ans. total
31. ___________ revenue at any output is equal to price per unit multiplied by
quantity sold.”
Ans. Total
32. ___________ revenue refers to the revenue obtained by the seller by selling
the per unit commodity.
Ans. Average
33. ___________ revenue is obtained by dividing the total revenue by total output.
Ans. Average
34. ___________ revenue is the net revenue obtained by selling an additional
unit of the commodity.
Ans. Marginal
35. ___________ revenue is the change in total revenue which results from the
sale of one more or one less unit of output.”
Ans. Marginal
 +3 Economics 1st Semester qqq 53

ANSWER IN ONE WORD

1. Which competition is a market structure characterized by a large number of
small firms such that no single firm can affect the market price or quantity
exchanged.
Ans. Perfect competition
2. Where the competitive firms are price takers.
Ans. Perfect competition
3. In which market, there are no barriers to entry into or exit out.
Ans. Perfect competition
4. What is the key assumption of Perfect Competition
Ans. Profit maximization
5. When the Profit is maximised
Ans. Profit is maximised when the positive gap between Total Revenue and Total cost
is the maximum.
6. Which cost industry is an industry with a negatively-sloped long-run industry
supply curve
Ans. Decreasing cost industry
7. Which Cost Industry is an industry with a positively-sloped long-run industry
supply curve
Ans. Increasing cost industry
8. Which Cost Industry is an industry with a horizontal long-run industry supply
curve
Ans. Constant cost industry
9. Which curve for a firm tells us how much output the firm is willing to bring to
market at different prices.
Ans. The supply curve
10. What is used to measure the welfare of a group of firms who sell a particular
product at a particular price.
Ans. Producer Surplus
11. What is the difference between what producers actually receive when selling
a product and the amount they would be willing to accept for a unit of the
good.
Ans. Producer surplus
12. When a perfectly competitive firm is presumed to shutdown production
Ans. If price is less than average variable cost
13. Which period is supposed to be a period sufficiently long to allow changes to
be made both in the size of the plant and in the number of firms in the industry.
Ans. The long-run period
 54 qqq EXCELLENT

14. Which period, an increase in demand is met by over-using the existing plant.
Ans. Short period
15. When a firm is in equilibrium
Ans. When it is satisfied with its existing level of output.
16. Which type of profits refer to pure profits which are a surplus above the average
cost of production.
Ans. Maximum profit
17. When the MR curve of a firm coincides with its AR curve.
Ans. Under perfect competition
18. Which revenue is obtained from the last unit sold.
Ans. Marginal Revenue
19. Which revenue is computed by taking the change in total revenue divided by
the change in quantity?
Ans. Marginal Revenue
20. What a positive gain generated from business operations or investment after
subtracting all expenses or costs.
Ans. Profit
21. What refers to the income obtained by a firm through the sale of goods at
different prices.
Ans. Revenue
22. What is the income earned by a seller or producer after selling the output is
called
Ans. Total revenue
23. Which revenue refers to the revenue obtained by the seller by selling the per
unit commodity
Ans. Average
24. Which revenue is the net revenue obtained by selling an additional unit of the
commodity.
Ans. Marginal revenue
PART - II
Short Questions and Answer (2 Marks each)
1. Define perfect competition?
Ans. Perfect competition a market structure characterized by a large number of small
firms such that no single firm can affect the market price or quantity exchanged. Perfectly
competitive firms are price takers. They set a production level based on the price determined
in the market.

2. What are the conditions of short run equilibrium under perfect competition?
Ans. The key assumption of Perfect Competition is that a perfectly competitive firm, is
motivate by profit maximization. The firm chooses to produce the quantity of output that
 +3 Economics 1st Semester qqq 55

generates highest possible level of profit, based on price, market demand, cost conditions,
production technology.
3. What are the conditions of short run equilibrium under perfect competition?
Ans. The key assumption of Perfect Competition is that a perfectly competitive firm, is
motivate by profit maximization. The firm chooses to produce the quantity of output that
generates highest possible level of profit, based on price, market demand, cost conditions,
production technology.
4. What are the weaknesses of pure competition?
Ans. The main weakness of pure competition theory is that perfect competition does
not exist in reality. In addition to having many comparable sellers, many comparable buyers,
and a homogeneous product, a market must have perfect information to be perfectly competitive.
5. What does the supply curve for a firm tell?
Ans. The supply curve for a firm tells us how much output the firm is willing to bring to
market at different prices. But a firm with market power looks at the demand curve that it
faces and then chooses a point on that curve (a price and a quantity).
6. What is Producer Surplus?
Ans. Producer Surplus is used to measure the welfare of a group of firms who sell a
particular product at a particular price. Producer surplus is defined as the difference
between what producers actually receive when selling a product and the amount they
would be willing to accept for a unit of the good.
7. What is decreasing cost industries?
Ans. A decreasing-cost industry occurs because the entry of new firms, prompted by
an increase in demand, causes the long-run average cost curve of each firm to shift downward,
which decreases the minimum efficient scale of production.
8. What is increasing cost industries?
Ans. An increasing-cost industry occurs because the entry of new firms, prompted by
an increase in demand, causes the long-run average supply curve of each firm to shift upward,
which increases the minimum efficient scale of production.
9. What are constant cost industries?
Ans. A constant-cost industry occurs because the entry of new firms, prompted by an
increase in demand, does not affect the long-run average cost curve of individual firms, which
means the minimum efficient scale of production does not change.
10. What is Price taker?
Ans. No single firm can influence the market price, or market conditions. The single
firm is said to be a price taker, taking its price from the whole industry.
11. What is Short run Equilibrium?
Ans. Two conditions are to be satisfied to identify equilibrium in the short run. a. MC
should be equal to MR b. MC curve should cut MR curve from below.
 56 qqq EXCELLENT

12. Define Shut down point?

Ans. A perfectly competitive firm is presumed to shutdown production and produce no
output in the short run, if price is less than average variable cost
13. Define Constant-Cost Industry?
Ans. An industry with a horizontal long-run industry supply curve that results because
expansion of the industry causes no change in production cost or resource prices.
14. Define Decreasing-Cost Industry?
Ans. An industry with a negatively-sloped long-run industry supply curve that results
because expansion of the industry causes lower production cost and resource prices.
15. Define Increasing-Cost Industry?
Ans. An industry with a positively-sloped long-run industry supply curve that results
because expansion of the industry causes higher production cost and resource prices.
16. What is a long-run period?
Ans. The long-run is supposed to be a period sufficiently long to allow changes to be
made both in the size of the plant and in the number of firms in the industry.
17. What is a short period?
Ans. In the short period, an increase in demand is met by over-using the existing plant,
in the long-run, it will be met not only by the expansion of the plants of the existing firms but
also by the entry into the industry of new firms.
18. Define equilibrium of a firm?
Ans. A firm is in equilibrium when it is satisfied with its existing level of output. The firm
wills, in this situation produce the level of output which brings in greatest profit or smallest
loss. When this situation is reached, the firm is said to be in equilibrium.
19. When the firm maximises its profits?
Ans. Maximum profits refer to pure profits which are a surplus above the average cost
of production. It is the amount left with the entrepreneur after he has made payments to all
factors of production, including his wages of management.
20. What is Profit Maximisation?
Ans. Profit maximisation is an assumption of classical economics. One can easily
understand the logic of pursuing profit maximisation. Profits enable greater wages and dividends
for the entrepreneurs who set up the company.
21. What is Profit Satisfying.
Ans. The owners wish to maximise profits, but the workers and managers don’t. The
owners’ shareholders have a stake in the firm’s profits, but workers often do not. Therefore,
workers have little incentive to maximise profits.
22. Define Marginal Revenue?
Ans. Marginal revenue is the revenue obtained from the last unit sold. This is computed
by taking the change in total revenue divided by the change in quantity.
 +3 Economics 1st Semester qqq 57

23. Define profit?

Ans. Profit simply means a positive gain generated from business operations or investment
after subtracting all expenses or costs. In economic terms profit is defined as a reward received
by an entrepreneur by combining all the factors of production to serve the need of individuals
in the economy faced with uncertainties.
24. Define Revenue?
Ans. The term revenue refers to the income obtained by a firm through the sale of
goods at different prices. In the words of Dooley, ‘the revenue of a firm is its sales, receipts or
income’. The revenue concepts are concerned with Total Revenue, Average Revenue and
Marginal Revenue.
25. What is Total Revenue:
Ans. The income earned by a seller or producer after selling the output is called the
total revenue. In fact, total revenue is the multiple of price and output. The behavior of total
revenue depends on the market where the firm produces or sells. “Total revenue is the sum of
all sales, receipts or income of a firm.”
26. What is Average Revenue:
Ans. Average revenue refers to the revenue obtained by the seller by selling the per unit
commodity. It is obtained by dividing the total revenue by total output. “The average revenue
curve shows that the price of the firm’s product is the same at each level of output.”
27. What is Marginal Revenue:
Ans. Marginal revenue is the net revenue obtained by selling an additional unit of the
commodity. “Marginal revenue is the change in total revenue which results from the sale of
one more or one less unit of output.” Ferguson. Thus, marginal revenue is the addition made
to the total revenue by selling one more unit of the good.
28. What is Producer Surplus?
Ans. Producer surplus (PS) is defined as the difference between the actual amount a
producer receives (market price) by selling a given quantity of a commodity and the minimum
amount that he expects to receive for the same quantity of a commodity (indicated by the
marginal cost of production) to cover the cost of production.
PART - III
Short Questions and Answer (3 Marks each)
1. Define perfect competition?
Ans. Perfect competition a market structure characterized by a large number of small
firms such that no single firm can affect the market price or quantity exchanged. Perfectly
competitive firms are price takers. They set a production level based on the price determined
in the market. If the market price changes, then the firm re-evaluates its production decision.
This means that the short-run marginal cost curve of the firm is its short run supply curve.
 58 qqq EXCELLENT

2. What are the features of perfect competition?

Ans. There is perfect knowledge, with no information failure or time lags. Knowledge
is freely available to all participants, which means that risk-taking is minimal and the role of the
entrepreneur is limited.
a) There are no barriers to entry into or exit out of the market.
b) Firms produce homogeneous, identical, units of output that are not branded.
c) Each unit of input, such as units of labour, are also homogeneous.
d) No single firm can influence the market price, or market conditions. The single firm is
said to be a price taker, taking its price from the whole industry.
e) There are a very large numbers of firms in the market.
f) There is no need for government regulation, except to make markets more competitive.
3. What are the conditions of short run equilibrium under perfect competition?
Ans. The key assumption of Perfect Competition is that a perfectly competitive firm, is
motivate by profit maximization. The firm chooses to produce the quantity of output that
generates highest possible level of profit, based on price, market demand, cost conditions,
production technology. Three conditions are to be satisfied for long run equilibrium under
perfect competition.
a) Marginal Cost= Marginal Revenue (MC=MR)
b) MC should Cut MR curve from below
c) Average Revenue should be equal to Average Total cost(AR=ATC)
4. What are the conditions of short run equilibrium under perfect competition?
Ans. The key assumption of Perfect Competition is that a perfectly competitive firm, is
motivate by profit maximization. The firm chooses to produce the quantity of output that
generates highest possible level of profit, based on price, market demand, cost conditions,
production technology. It is possible to identify the short run equilibrium using TR and TC
approach and MC and MR approach. Profit is maximised where the positive gap between
Total Revenue and Total cost is the maximum. So, two conditions are to be satisfied to
identify equilibrium in the short run.
a) MC should be equal to MR
b) MC curve should cut MR curve from below.
5. What is the nature of supply curve under perfect competition?
Ans. Perfect competition a market structure characterized by a large number of small
firms such that no single firm can affect the market price or quantity exchanged. Perfectly If
the market price changes, then the firm re-evaluates its production decision. This means that
the upper portion of the short-run marginal cost curve of the firm is its short-run supply curve.
a) Decreasing cost industry: An industry with a negatively-sloped long-run industry supply
curve
b) Increasing-Cost Industry: An industry with a positively-sloped long-run industry supply
curve
c) Constant-Cost Industry: An industry with a horizontal long-run industry supply curve
 +3 Economics 1st Semester qqq 59

6. What are the weaknesses of pure competition?

Ans. The main weakness of pure competition theory is that perfect competition does
not exist in reality. In addition to having many comparable sellers, many comparable buyers,
and a homogeneous product, a market must have perfect information to be perfectly competitive.
7. What does the supply curve for a firm tell?
Ans. The supply curve for a firm tells us how much output the firm is willing to bring to
market at different prices. But a firm with market power looks at the demand curve that it
faces and then chooses a point on that curve (a price and a quantity).
8. What is Producer Surplus?
Ans. Producer Surplus is used to measure the welfare of a group of firms who sell a
particular product at a particular price. Producer surplus is defined as the difference between
what producers actually receive when selling a product and the amount they would be willing
to accept for a unit of the good.
9. What is decreasing cost industries?
Ans. An industry with a negatively-sloped long-run industry supply curve that results
because expansion of the industry causes lower production cost and resource prices. A
decreasing-cost industry occurs because the entry of new firms, prompted by an increase in
demand, causes the long-run average cost curve of each firm to shift downward, which
decreases the minimum efficient scale of production.
10. What is increasing cost industries?
Ans. An industry with a positively-sloped long-run industry supply curve that results
because expansion of the industry causes higher production cost and resource prices. An
increasing-cost industry occurs because the entry of new firms, prompted by an increase in
demand, causes the long-run average supply curve of each firm to shift upward, which increases
the minimum efficient scale of production.
11. What are constant cost industries?
Ans. An industry with a horizontal long-run industry supply curve that results because
expansion of the industry causes no change in production cost or resource prices. A constant-
cost industry occurs because the entry of new firms, prompted by an increase in demand,
does not affect the long-run average cost curve of individual firms, which means the minimum
efficient scale of production does not change.
12. What is Long run equilibrium of a firm and industry?
Ans. Three conditions are to be satisfied for long run equilibrium under perfect
competition.
a) Marginal Cost= Marginal Revenue (MC=MR),
b) MC should Cut MR curve from below, and
c) Average Revenue should be equal to Average Total cost(AR=ATC)
13. Define Shut down point?
Ans. A perfectly competitive firm is presumed to shutdown production and produce no
output in the short run, if price is less than average variable cost
 60 qqq EXCELLENT

14. Define Constant-Cost Industry?

Ans. An industry with a horizontal long-run industry supply curve that results because
expansion of the industry causes no change in production cost or resource prices.
15. Define Decreasing-Cost Industry?
Ans. An industry with a negatively-sloped long-run industry supply curve that results
because expansion of the industry causes lower production cost and resource prices.
16. Define Increasing-Cost Industry?
Ans. An industry with a positively-sloped long-run industry supply curve that results
because expansion of the industry causes higher production cost and resource prices.
17. What is a long-run and short period?
Ans. The long-run is supposed to be a period sufficiently long to allow changes to be
made both in the size of the plant and in the number of firms in the industry. Whereas in the
short period, an increase in demand is met by over-using the existing plant, in the long-run, it
will be met not only by the expansion of the plants of the existing firms but also by the entry
into the industry of new firms.
18. Define equilibrium of a firm?
Ans. A firm is in equilibrium when it is satisfied with its existing level of output. The firm
wills, in this situation produce the level of output which brings in greatest profit or smallest
loss. When this situation is reached, the firm is said to be in equilibrium. According to Prof. R
A. Bilas, “Where profits are maximized, we say the firm is in equilibrium”.
19. What are the conditions of the equilibrium of a firm?
Ans. A firm is said to be in equilibrium when it satisfies the following conditions:
a) The first condition for the equilibrium of the firm is that its profit should be maximum.
b) Marginal cost should be equal to marginal revenue.
c) MC must cut MR from below.
20. When the firm maximises its profits?
Ans. The firm maximises its profits when it satisfies the two rules. MC = MR and the
MC curve cuts the MR curve from below. Maximum profits refer to pure profits which are a
surplus above the average cost of production. It is the amount left with the entrepreneur after
he has made payments to all factors of production, including his wages of management.
21. Explain the profit Maximisation under Perfect Competition
Ans. Under perfect competition, the firm is one among a large number of producers. It
cannot influence the market price of the product. It is the price-taker and quantity-adjuster. It
can only decide about the output to be sold at the market price. Therefore, under conditions
of perfect competition, the MR curve of a firm coincides with its AR curve. The MR curve is
horizontal to the X-axis because the price is set by the market and the firm sells its output at
that price. The firm is, thus, in equilibrium when MC = MR = AR (Price).
22. What is Profit Maximisation?
Ans. Profit maximisation is an assumption of classical economics. One can easily
understand the logic of pursuing profit maximisation. Profits enable greater wages and dividends
 +3 Economics 1st Semester qqq 61

for the entrepreneurs who set up the company. Profit can be used to finance investment in
expanding the company. Profit provides a fall back for difficult times. In practice, there are
several occasions where firms will not pursue profit maximisation.
23. What is Profit Satisfying
Ans. The owners wish to maximise profits, but the workers and managers don’t. The
owners’ shareholders have a stake in the firm’s profits, but workers often do not. Therefore,
workers have little incentive to maximise profits. Workers make enough profits to keep their
jobs, but then pursue other objectives such as enjoying work.
24. What are the limitations of Profit Maximisation
Ans. In the real world, it is not so easy to know exactly your marginal revenue and the
marginal cost of last goods sold. For example, it is difficult for firms to know the price elasticity
of demand for their good – which determines the MR. It also depends on how other firms
react. If they increase the price, and other firms follow, demand may be inelastic. But, if they
are the only firm to increase the price, demand will be elastic and game theory.
25. Define Marginal Revenue?
Ans. Marginal revenue is the revenue obtained from the last unit sold. This is computed
by taking the change in total revenue divided by the change in quantity.
MR = Change in TR / Change in Q
26. Define profit?
Ans. Profit simply means a positive gain generated from business operations or investment
after subtracting all expenses or costs. In economic terms profit is defined as a reward received
by an entrepreneur by combining all the factors of production to serve the need of individuals
in the economy faced with uncertainties.
27. Define Total Revenue:
Ans. The income earned by a seller or producer after selling the output is called the
total revenue. In fact, total revenue is the multiple of price and output. The behavior of total
revenue depends on the market where the firm produces or sells. “Total revenue is the sum of
all sales, receipts or income of a firm.” Total revenue may be defined as the “product of
planned sales (output) and expected selling price.” “Total revenue at any output is equal to
price per unit multiplied by quantity sold.”
28. Define Average Revenue:
Ans. Average revenue refers to the revenue obtained by the seller by selling the per unit
commodity. It is obtained by dividing the total revenue by total output. “The average revenue
curve shows that the price of the firm’s product is the same at each level of output.”
29. Define Marginal Revenue:
Ans. Marginal revenue is the net revenue obtained by selling an additional unit of the
commodity. “Marginal revenue is the change in total revenue which results from the sale of
one more or one less unit of output.” Ferguson. Thus, marginal revenue is the addition made
to the total revenue by selling one more unit of the good. In algebraic terms, marginal revenue
is the net addition to the total revenue by selling n units of a commodity instead of n – 1.
 62 qqq EXCELLENT

30. What is Producer Surplus?

Ans. Producer surplus (PS) is defined as the difference between the actual amount a
producer receives (market price) by selling a given quantity of a commodity and the minimum
amount that he expects to receive for the same quantity of a commodity (indicated by the
marginal cost of production) to cover the cost of production. In other words, it is the excess
of money receipts of a producer over the minimum supply price at which he is willing to sell
rather than forgo the sale. It is given by area above the supply curve and below the market
price just as the consumer surplus (CS) is measured by the area below the consumer demand
curve and above the market price.
PART - IV
LONG QUESTIONS WITH ANSWERS (7 Marks Each)
Q.1. What is perfect competition? What are the features of perfect competition?
Explain short run and long run equilibrium of Perfect competition?
Ans. Perfect competition a market structure characterized by a large number of small
firms such that no single firm can affect the market price or quantity exchanged. Perfectly
competitive firms are price takers. They set a production level based on the price determined
in the market. If the market price changes, then the firm re-evaluates its production decision.
This means that the short-run marginal cost curve of the firm is its short-run supply curve.
Basic Features of perfect competition
1) Large Number of Small Firms: A perfectly competitive industry contains a large
number of small firms, each of which is relatively small compared to the overall size of
the market. This ensures that no single firm can influence market price or quantity. If
one firm decides to double its output or stop producing entirely, the market is unaffected.
The price does not change and there is no remarkable change in the quantity exchanged
in the market. No single firm can influence the market price, or market conditions.
The single firm is said to be a price taker, taking its price from the whole industry.
2) Identical Products (Homogenous product): Each firm in a perfectly competitive
market sells an identical product, what is often termed “homogeneous goods.” The
essential result of this feature is that the buyers are unable to identify any difference
among them. There are no brand names or distinguishing features that differentiate
products.
3) Perfect Mobility of Factors and Products: Under perfect competition, products
as well as resources are freely mobile within the market. It normally results in the
existence of same price for same products throughout the market.
4) Freedom to Entry and Exit of firms: Perfectly competitive firms are free to enter
and exit an industry. They are not restricted by government rules and regulations, start
up cost, or other entry. Likewise, a perfectly competitive firm is not prevented from
 +3 Economics 1st Semester qqq 63

leaving an industry as is the case for government-regulated public utilities. This ultimately
results in the existence of normal profit in the long run.
5) Perfect Knowledge: There exists perfect knowledge in the market. Buyers are
completely aware of sellers’ prices, such that one firm cannot sell its good at a higher
price than other firms. Each seller also has complete information about the prices
charged by other sellers. Perfect knowledge also extends to technology. No firm can
produce its good faster, better, or cheaper because of special knowledge of Information
6) No Externalities: There are assumed to be no externalities, that is no external costs
or benefits.
7) Normal profits in the long run: Firms can only make normal profits in the long run,
but they can make abnormal profits in the short run.
Derivation of Average Revenue curve (AR) and Marginal Revenue curve of a firm
The single firm takes its price from the industry, and is, consequently, referred to as a
price taker. The industry is composed of all firms in the industry and the market price is where
market demand is equal to market supply. Each single firm must charge this price and cannot
diverge from it. It means that a firm is able to sell its entire quantity at the existing market price
which is determined by the market through demand and supply. So Demand curve faced by a
firm is parallel to quantity axis. The derivation of AR and MR is shown in the following figure.

In the above figure, Segment 1 is shown the price determination of the market under
perfect competition. It happens through the free interaction of demand and supply. The market
determined price is OP. It is followed by the firm and the firm can sell their entire output at the
existing market price OP. So their AR and MR curve are parallel to X axis. Here Industry
fixes the price (price maker) and firm follows that Price is the (price taker).
Perfect Competition in the Short run
The key assumption of Perfect Competition is that a perfectly competitive firm, like
any other firm, is motivate by profit maximization. The firm chooses to produce the quantity of
 64 qqq EXCELLENT

output that generates highest possible level of profit, based on price, market demand, cost
conditions, production technology. It is possible to identify the short run equilibrium using TR
and TC approach and MC and MR approach. Profit is maximised where the positive gap
between Total Revenue and Total cost is the maximum.
The process of identifying short run equilibrium through MC and MR is shown in the
diagram below.

In the figure, MC= MR at two points. The first point is not the equilibrium point
because at this stage the firm starts earning profit and the firm has not reached to its optimum
output.
So, two conditions are to be satisfied to identify equilibrium in the short run.
a) MC should be equal to MR
b) MC curve should cut MR curve from below.
Such a point is identified at point E and it is the equilibrium point where the firm is
producing OM level of output.
Abnormal Profit and Loss Positions of a Firm under Perfect Competition in the Short Run
There are chances to a firm to earn abnormal profit. In the short run supernormal
profits are possible, but in the long run new firms are attracted into the industry, because of no
barriers to entry, perfect knowledge and an opportunity to expand output. Here also two
important conditions are to be satisfied to attain short run equilibrium under perfectly competitive
firms. They are:
1. Marginal Cost= Marginal Revenue (MC=MR)
2. MC should Cut MR curve from below.
 +3 Economics 1st Semester qqq 65

The condition of earning supernormal profit is explained in the following figure:

At profit maximisation, equilibrium point is attained at point E where, MC = MR, and

the firm is producing output OM and price is OP. At this stage:
1) AR = ME
2) AC= MB
3) Since AR > AC, the firm is gaining abnormal profit.
4) Profit per unit = ME – MB = EB
5) Total abnormal profit of the firm at OQ output = OM x AB = PEBC (Shaded area).
As new firms enter the market, demand for the existing firm’s products becomes
more elastic and the demand curve shifts to the left, driving down price. Eventually, all super-
normal profits are eroded away.
Perfect Competition in the Short Run
In the short run, there is a possibility of loss
also to a firm under perfect competition. Such a case
is demonstrated in the following figure:
The equilibrium point is attained at point E
where, MC = MR, and the firm is producing output
OM and price is OP. At this stage:
1) AR = ME
2) AC= MA
3) Since AR < AC, the firm is suffering loss.
4) Loss per unit = MA – ME = AE
5) Total loss of the firm at OQ output = OM x AE = ABPE.(the shaded area)
A loss suffering firm will try to reduce its cost condition and if they succeed in it, they
will continue in the market. If not they will have to leave the industry in the long run. As loss
suffering firms leave the market the long run supply will be affected and it will shift leftward
which increases the price in the long run. So they will start earning normal profit in the long run.
Eventually, all loss will be covered and the firm starts to earn normal profit in the long run.
 66 qqq EXCELLENT

Q.2. What is perfect competition? What are the features of perfect competition?
Explain short run and long run equilibrium of Perfect competition?
Ans. Perfect competition a market structure characterized by a large number of small
firms such that no single firm can affect the market price or quantity exchanged. Perfectly
competitive firms are price takers. They set a production level based on the price determined
in the market. If the market price changes, then the firm re-evaluates its production decision.
This means that the short-run marginal cost curve of the firm is its short-run supply curve.
Basic Characteristics of Perfect Competition
1. There is perfect knowledge, with no information failure or time lags. Knowledge is
freely available to all participants, which means that risk-taking is minimal and the role
of the entrepreneur is limited.
2. There are no barriers to entry into or exit out of the market.
3. Firms produce homogeneous, identical, units of output that are not branded.
4. Each unit of input, such as units of labour, are also homogeneous.
5. No single firm can influence the market price, or market conditions. The single firm is
said to be a price taker, taking its price from the whole industry.
6. There are a very large numbers of firms in the market.
7. There is no need for government regulation, except to make markets more competitive.
8. There are assumed to be no externalities that are no external costs or benefits.
9. Firms can only make normal profits in the long run, but they can make abnormal
profits in the short run.
Perfect Competition in the Long Run
The freedom to enter and to leave the industry in a perfectly competitive market will
lead to changes in the supply of the products in the market. Abnormal profit of the existing firm
in the short run will attract new firms to the industry. Similarly firms suffering with loss will
leave the industry. Therefore, in the long run all the existing firms will earn only normal profit.
Three conditions are to be satisfied for long run equilibrium under perfect competition:
1. Marginal Cost= Marginal Revenue (MC=MR)
2. MC should Cut MR curve from below
3. Average Revenue should be equal to Average Total cost(AR=ATC)
The normal profit of firm in the long run is demonstrated in the figure below.
The equilibrium point is attained at point E where MC = MR, and the firm is producing
output OM and price is OP. At this stage:
AR = ME
AC= ME
Since AR = AC, the firm is earning only normal profit
Hence the three conditions of equilibrium for the long run are satisfied. Since the firm
is earning normal profit, it has no tendency to change its scale of operation. It is clear from the
figure that in the long run, with all inputs variable, a perfectly competitive industry reaches
 +3 Economics 1st Semester qqq 67

equilibrium at the output that achieves the

minimum efficient scale, that is, the minimum of
the long run average cost curve. This is achieved
through a two-fold adjustment process:
a) The first of the folds is entry and exit of
firms into and out of the industry. This
ensures that firms earn zero economic
profit and that price is equal to average
cost.
b) The second of the folds is the pursuit of
profit maximization by each firm in the
industry. This ensures that firms produce
the quantity of output that equates price
(and marginal revenue) with short-run and long-run marginal cost.
The end result of this long-run adjustment is a multi-faceted equilibrium condition
shown below which is possible only in perfect competition: P = AR = MR = MC = LRMC =
ATC = LRAC
This condition means that the market price (which is also equal to a firm’s average
revenue and marginal revenue) is equal to marginal cost (both short run and long run) and
average cost (both short run and long run). With price equal to marginal cost, each firm is
maximizing profit and has no reason to adjust the quantity of output or factory size. With price
equal to average cost, each firm in the industry earns only a normal profit. Economic profit is
zero and there are no economic losses, meaning no firm is inclined to enter or exit the industry.
Is it a Real Market Condition
Very few markets or industries in the real world are perfectly competitive. For example,
how homogeneous is the output of real firms, given that even the smallest of firms working in
manufacturing or services try to differentiate their product. Although unrealistic, it is still a
useful model in two respects.
a. Many primary and commodity markets, such as coffee and tea, exhibit many of the
characteristics of perfect competition, such as the number of individual producers that
exist, and their inability to influence market price.
b. For other markets in manufacturing and services, the model is a useful yardstick by which
economists and regulators can evaluate levels of competition that exist in real markets.
Q.3. Explain the long-run supply curve of the industry under perfect competition?
Ans. In the long run the firms can change their capital equipment and the other fixed
factors and also the number of firms can vary in response to changes in the demand for a
commodity. In the long run, when new firms can enter and old ones can leave the industry the
firm is in equilibrium at the minimum point of the long-run average cost curve, where the long-
run marginal cost curve inter- sects it. Thus a firm under perfect competition in the long-run
equilibrium is forced to produce only at one point of the long-run marginal cost curve at which
it cuts the average cost curve. Price in the long run is equal to both long-run marginal cost and
minimum average cost.
 68 qqq EXCELLENT

Therefore, the firm in the long run will produce and supply an output indicated by the
minimum point of its long-run average cost curve, that is, its optimum size. Of course, this
optimum size of the firm may change with the change in the number of firms in the industry. The
long-run supply in the industry will be determined by the changes in the optimum size of the
firms (that is, long-run supply of output by individual firms) but mainly by the variation in the
number of firms in the industry.
It should be noted that long-run supply curve is defined as the supply by the existing
as well potential firms in the industry in the long run. A little reflection will show that the long-
run supply curve of the industry cannot be the lateral summation of the long-run marginal cost
curves of a given number of firms. This is because of three reasons:
a) Firstly, as explained above, whole of the long-run marginal cost curve does not constitute
the long-run supply curve of an individual firm only one point of the long-run marginal
cost curve at which it cuts the average cost curve (that is, the minimum point of the
average cost curve) constitutes long-run supply of the individual firm.
b) Secondly, the number of firms varies at different prices or demand conditions in the
long run.
c) Thirdly, we cannot sum up any existing long-run marginal cost curves of the firms to
obtain the long-run supply curve of the industry because with the expansion of the
industry in the long run cost curves of the firms shift due to the emergence of external
economics and diseconomies. In order to know the output supplied by the firms of an
industry in the long run, we need to know the position or level of the cost curves of the
firms as well as number of firms in the industry at a given demand and price of the
product.
External economies and diseconomies are those which are realised by all firms in an
industry as a result of the expansion of the industry as a whole. The creation of external
economies by an expanding industry will shift the cost curves of the firms downward. On the
other hand, the creation of external diseconomies will shift the cost curves of the firms
downward. Whether a given industry will experience upward or downward shift in the cost
curves depends upon the net or combined effect of the external economies and diseconomies.
When with the expansion of an industry the external economies out-weight the external
diseconomies, so that there are net external economies cost curves of the firms will shift
downward. On the other hand, if with the expansion of an industry external diseconomies are
stronger than the external economies so that there are net external diseconomies, cost curves
of the firms will shift upward. In brief, main examples of external econo- mies which an expanding
industry may reap are:
a. The availability of tools machinery, raw mate- rials etc., at lower prices,
b. Discovery and diffusion of a superior technical knowledge, and
c. Economic use of the waste-products.
 +3 Economics 1st Semester qqq 69

With the growth of an industry some raw materials, tools capital equipment etc. may
become available because some specialised subsidiary and correlated firms may be set up
which produce them on a large scale at lower cost per unit and are therefore in a position to
supply them at lower prices. Further, as the industry expands, trade journals may appear
which help in dis- covering and spreading technical knowledge. Again, with the growth of an
industry some specialised firms may come into existence which works up its waste products.
The industry can then sell them at good price. There is every possibility of external economies
to be reaped when a young industry grows in a new territory.
On the contrary, when a well-established and good-sized industry expands further, it
may expe- rience external diseconomies. As more firms enter the industry, competition among
them may push up the prices of scarce raw materials, skilled labour and other specialised
inputs. Moreover, the additional units of productive inputs being obtained by the industry may
be less efficient than the previous ones. All these external diseconomies will raise the average
and marginal cost curves of the firms.
We thus see that external economies and diseconomies play a vital role in shaping the
long-run supply of an industry. Whether a particular industry on expansion will experience the
phenomenon of rising costs or falling costs or constant costs will depend upon the net result of
external econo- mies and diseconomies.The long-run supply curve of perfectly competitive
industry will therefore have different shapes depending upon whether the industry in
question is a:
a. Constant cost indus- try,
b. Increasing cost industry;
c. Decreasing cost industry.
It follows from above that at a given price the quantity supplied by an industry in the
long run will be determined by the optimum output of a firm in the long run (i.e., output
corresponding to minimum long-run average cost) multiplied by the number of firms in the
industry at that price. With the change in the price of the product following a change in demand
conditions, the number of firms in the industry will change and also the cost curves of the firms
will shift on account of the creation of external economies and diseconomies. As a result, the
quantity supplied by the industry will change at a new price. The long-run supply curve of the
industry may either be sloping upward or be a horizontal straight line, or be sloping downward
depending upon whether the industry in question is increasing cost, constant cost, or decreasing
cost.
Q.4. Explains how the short run and long run equilibrium of firm determined?
Ans. A firm is in equilibrium when it is satisfied with its existing level of output. The firm
wills, in this situation produce the level of output which brings in greatest profit or smallest
loss. When this situation is reached, the firm is said to be in equilibrium. According to Prof. R
A. Bilas, “Where profits are maximized, we say the firm is in equilibrium”. Similarly Prof.
 70 qqq EXCELLENT

Meyers says, “The individual firm will be in equilibrium with respect to output at the point of
maximum net returns.”
A. Determination of Short Run Equilibrium of the Firm
Short-run refers to that period in which fixed factors remaining unchanged the firms in
order to incur maximum profits can vary their output by changing the variable factors like
labour, raw material etc. In the short period, it is not necessary that the firms must earn
super- normal or normal profits but even the firms may have to sustain the losses.
A firm may earn supernormal profits because in the short run, firms cannot enter the
industry. Moreover, a firm may suffer losses, because in the short run, may not step up
production even when price of the product falls. In case, it stops production temporarily, it
will have to bear the loss of fixed cost which will constitute the minimum losses of the firm.
However, all the above stated possibilities have been explained as under:
a. Supernormal Profits: A firm is said to be in equilibrium when its marginal cost is
equal to marginal revenue and marginal cost curve cuts the marginal revenue curve
from below. A firm in equilibrium enjoys supernormal profits if average revenue exceeds
marginal cost.
b. Normal Profit: Normal profits refer to those profits where the average cost of the
firm equals the average revenue. These profits cover just the reward for entrepreneurial
services and are included in the cost of production. It can be shown with the help of a
figure.
c. Minimum Losses: A firm in equilibrium incurs losses when it does not cover the
average cost. In other words, when average revenue falls short of average cost, the
firm has to sustain losses.
d. Shut Down Point: Simple question is why firms continue producing the product if
they are making losses. In the short run, the firms cannot go out of the industry by
disposing off the plant. Why do they not shut down? It is because they cannot change
the fixed factors and they have to face fixed costs even if the firm is shut down.
The firm can avoid only variable costs but it has to bear the fixed costs whether to
produce or not. The firm will continue producing till the price covers the average variable
cost. If the price covers some part of the average fixed costs besides the variable costs, the
producer will continue producing. Thus the firm will continue producing so long as price
exceeds average variable cost.
B. Determination of Long Run Equilibrium of the Firm
Long run refers to that period in which the producer can change its supply by changing
all the factors of production. In other words, the producer has the sufficient time to adjust their
supplies according to the changed demand conditions.
Moreover, new firms can also enter and existing firms can leave the industry. In the
long-run, the firm is said to be in equilibrium when marginal cost is equal to price. Besides it,
the firm under perfect competition to be in equilibrium-price must be equal to average cost.
 +3 Economics 1st Semester qqq 71

Generally, in the long run, firm in equilibrium earns normal profits. If the firms happen to earn
the super normal profits in the long period, the existing firms will increase their production.
Lured by super normal profits some new firms will enter into the industry. The total
supply of the product will increase and the price falls down. Thus, due to fall in price the firms
will get normal profits. In case price of the product is less than the average cost, the firms
would make losses. These losses would induce some firms to leave the industry. Consequently
the output of the industry will fall which will raise the price, hence, the firms will begin to earn
normal profits. Lured by these super normal profits, the existing firms will increase their
production capacity, thus, the new firms will enter the industry. As a result of the entry of the
new firms supply of the product will increase which will lead to a fall in price.
Q.5. Define profit? Explain types and functions of profit?
Ans. The term profit has distinct meaning for different people, such as businessmen,
accountants, policymakers, workers and economists. Profit simply means a positive gain
generated from business operations or investment after subtracting all expenses or costs. In
economic terms profit is defined as a reward received by an entrepreneur by combining all the
factors of production to serve the need of individuals in the economy faced with uncertainties.
In a layman language, profit refers to an income that flow to investor. In accountancy, profit
implies excess of revenue over all paid-out costs. Profit in economics is termed as a pure
profit or economic profit or just profit.
Profit differs from the return in three respects namely:
1. Profit is a residual income, while return is a total revenue
2. Profits may be negative, whereas returns, such as wages and interest are always
positive
3. Profits have greater fluctuations than returns
According to modern economists, profits are the rewards of purely entrepreneurial
functions. According to Thomas S.E., “pure profit is a payment made exclusively for bearing
risk. The essential function of the entrepreneur is considered to be something which only he
can perform. This something cannot be the task of management, for managers can be hired,
nor can it be any other function which the entrepreneur can delegate. Hence, it is contended
that the entrepreneur receives a profit as a reward for assuming final responsibility, a
responsibility that cannot be shifted on the shoulders of anyone else.”
For understanding the profit as a business objective, you need to learn two most
important concepts, such as economic profit and accounting profit.
Types of Profit:
Different people have described profit differently. Individuals have associated profit
with additional income revenue, and reward. However, none of the description of profit is
said to be right or wrong; it only depends on the field which the word profit is described. On
the basis of fields, profit can be classified into two types, which are explained as follows:
 72 qqq EXCELLENT

i. Accounting Profit:
It refers to the total earnings of an organization. It is a return that is calculated as a
difference between revenue and costs, including both manufacturing and overhead expenses.
The costs are generally explicit costs, which refer to cash payments made by the organization
to outsiders for its goods and services. In other words, explicit costs can be defined as
payments incurred by an organization in return for labor, material, plant, advertisements, and
machinery. The accounting profit is calculated as :
Accounting Profit= TR-(W + R + I + M) = TR- Explicit Costs
TR = Total Revenue
W = Wages and Salaries
R = Rent
I = Interest
M = Cost of Materials
The accounting profit is used for determining the taxable income of an organization and
assessing its financial stability. Let us take an example of accounting profit. Suppose that the
total revenue earned by an organization is Rs. 2, 50,000. Its explicit costs are equal to Rs. 10,
000. The accounting profit equals = Rs. 2, 50,000 – Rs. 10,000 = Rs. 2, 40,000. It is to be
noted that the accounting profit is also called gross profit. When depreciation and government
taxes are deducted from the gross profit, we get the net profit.
ii. Economic Profit:
Takes into account both explicit costs and implicit costs or imputed costs. Implicit that
is foregone which an entrepreneur can gain from the next best alternative use of resources.
Thus, implicit costs are also known as opportunity cost. The examples of implicit costs are
rents on own land, salary of proprietor, and interest on entrepreneur’s own investment.
Let us understand the concept of economic profit. Suppose an individual A is undertaking his
own business manager in an organization. In such a case, he sacrifices his salary as a manager
because of his business. This loss of salary will opportunity cost for him from his own business.
The economic profit is calculated as: Economic profit = Total revenue-(Explicit costs + implicit
costs)
Alternatively, economic profit can be defined as follows: Pure profit = Accounting
profit-(opportunity cost + unauthorized payments, such as bribes). Economic profit is not
always positive; it can also be negative, which is called economic loss. Economic profit indicates
that resources of a business are efficiently utilized, whereas economic loss indicates that business
resources can be better employed elsewhere.
Q.6. Do firms maximise profits? Explain with an example?
Ans. Profit maximisation is an assumption of classical economics. One can easily
understand the logic of pursuing profit maximisation. Profits enable greater wages and dividends
for the entrepreneurs who set up the company. Profit can be used to finance investment in
expanding the company. Profit provides a fall back for difficult times. In practice, there are
several occasions where firms will not pursue profit maximisation.
 +3 Economics 1st Semester qqq 73

1. Profit Satisfying: The owners wish to maximise profits, but the workers and
managers don’t. The owners’ shareholders have a stake in the firm’s profits, but workers
often do not. Therefore, workers have little incentive to maximise profits. Workers make
enough profits to keep their jobs, but then pursue other objectives such as enjoying work.
2. Increasing market share: Often firms seem to be most concerned with increasing
their market share. This could be labeled sales maximisation. The benefits of increasing market
share include:
3. Economies of scale: Increased market share enables more monopoly power and
therefore greater chance to set higher prices in the future. For example, firms like Walmart/
Asda have claimed their objective is to pursue sales maximisation and increase market share,
even at the expense of lower profits. Amazon has based its growth on aiming to capture
market share rather than maximise profits. The willingness of shareholders to accept low
profit can vary with the industry. For example, with IT/internet firms like Amazon, shareholders
have proved more willing to tolerate low dividends and seek market penetration with the
potential for more profit in the future. Non-IT firms in ‘old’ industries often find that shareholders
are less tolerant of low profit.
4. Non-economic motives : Humans don’t always make decisions on financial/
economic motives. They may consider issues such as Society, Environment, Welfare of workers
and stakeholders, e.g. a firm may be reluctant to lay off workers – even if it does help increase
profits.
Q.7. Describe the profit maximisation theory under perfect competition and
monopoly markets with the diagrams?
Ans. The main objective of a business firm is profit maximisation. The firm maximises
its profits when it satisfies the two rules. MC = MR and the MC curve cuts the MR curve
from below Maximum profits refer to pure profits which are a surplus above the average cost
of production. It is the amount left with the entrepreneur after he has made payments to all
factors of production, including his wages of management. In other words, it is a residual
income over and above his normal profits.
 74 qqq EXCELLENT

Assumptions: The profit maximisation theory is based on the following assumptions:

1. The objective of the firm is to maximise its profits where profits are the difference
between the firm’s revenue and costs.
2. The entrepreneur is the sole owner of the firm.
3. Tastes and habits of consumers are given and constant.
4. Techniques of production are given.
5. The firm produces a single, perfectly divisible and standardised commodity.
6. The firm has complete knowledge about the amount of output which can be sold at
each price.
7. The firm’s own demand and costs are known with certainty.
8. New firms can enter the industry only in the long run. Entry of firms in the short run is
not possible.
9. The firm maximises its profits over some time-horizon.
10. Profits are maximized both in the short run and the long run.
Given these assumptions, the profit maximising model of the firm can be shown under
perfect competition and monopoly.
A. Profit Maximisation under Perfect Competition:
Under perfect competition, the firm is one among a large number of producers. It
cannot influence the market price of the product. It is the price-taker and quantity-adjuster. It
can only decide about the output to be sold at the market price. Therefore, under conditions
of perfect competition, the MR curve of a firm coincides with its AR curve. The MR curve is
horizontal to the X-axis because the price is set by the market and the firm sells its output at
that price.The firm is, thus, in equilibrium when MC = MR = AR (Price). The equilibrium of
the profit maximisation firm under perfect competition is shown in the following figure Where
the MC curve cuts the MR curve first at point A.
It satisfies the condition of MC = MR, but it is not a point of maximum profits because
after point A, the MC curve is below the MR curve. It does not pay the firm to produce the
minimum output when it can earn larger profits by producing beyond OM.
It will, however, stop further production when it reaches the OM1 level of output where
the firm satisfies both conditions of equilibrium. If it has any plans to produce more than OM1it
will be incurring losses, for the marginal cost exceeds the marginal revenue after the equilibrium
point B. Thus the firm maximises its profits at M1B price and at the output level OM1.
B. Profit Maximisation under Monopoly:
There being one seller of the product under monopoly, the monopoly firm is the industry
itself. Therefore, the demand curve for its product is downward sloping to the right, given the
tastes and incomes of its customers. It is a price-maker which can set the price to its maximum
advantage. But it does not mean that the firm can set both price and output. It can do either of
the two things. If the firm selects its output level, its price is determined by the market demand
for its product. Or, if it sets the price for its product, its output is determined by what consumers
 +3 Economics 1st Semester qqq 75

will take at that price. In any situation, the ultimate aim of the monopoly firm is to maximise its
profits. The conditions for equilibrium of the monopoly firm are (1) MC = MR< AR (Price),
and (2) the MC curve cuts the MR curve from below.

In the above Figure, the profit maximising level of output is OQ and the profit
maximisation price is OP (=QA). If more than OQ output is produced, MC will be higher
than MR, and the level of profit will fall. If cost and demand conditions remain the same, the
firm has no incentive to change its price and output. The firm is said to be in equilibrium.
Criticism of the Profit Maximisation Theory:
The profit maximisation theory has been severely criticised by economists on the following
grounds:
1. Profits uncertain : The principle of profit maximisation assumes that firms are certain
about the levels of their maximum profits. But profits are most uncertain for they accrue from
the difference between the receipt of revenues and incurring of costs in the future. It is, therefore,
not possible for firms to maximise their profits under conditions of uncertainty.
2. No relevance to internal organisation: This objective of the firm bears little or no
direct relevance to the internal organisation of firms. For instance, some managers incur
expenditures apparently in excess of those that would maximise wealth or profits of the owners
of the firm. Managers of corporations are observed to emphasize growth of total assets of the
firm and its sales as objectives of managerial actions. Also managers of firms undertake cost
reducing, efficiency increasing campaigns when demand falls.
3. No perfect knowledge: The profit maximisation hypothesis is based on the
assumption that all firms have perfect knowledge not only about their own costs and revenues
but also of other firms. But, in reality, firms do not possess sufficient and accurate knowledge
about the conditions under which they operate. At the most they may have knowledge about
their own costs of production, but they can never be definite about the market demand curve.
 76 qqq EXCELLENT

They always operate under conditions of uncertainty and the profit maximisation theory is
weak in that it assumes that firms are certain about everything.
4. Empirical evidence vague: The empirical evidence on profit maximisation is vague.
Most firms do not rank profits as the major goal. The working of modem firms is so complex
that they do not think merely about profit maximisation. Their main problems are of control
and management. The function of managing these firms is performed by managers and
shareholders rather than by the entrepreneurs. They are more interested in their emoluments
and dividends respectively. Since there is substantial separation of ownership from control in
modern firms, they are not operated so as to maximise profits.
5. Firms do not bother about MC and MR: It is asserted that the real world firms
do not bother about the calculation of marginal revenue and marginal cost. Most of them are
not even aware of the two terms. Others do not know the demand and marginal revenue
curves faced by them.
6. Still others do not possess adequate information about their cost structure.
Empirical evidence by Hall and Hitch shows that businessman have not heard of marginal cost
and marginal revenue. After all, they are not greedy calculating machines.
7. Principle of average-cost maximises profits: Hall and Hitch found that firms do
not apply the rule of equality of MC and MR to maximise short run profits. Rather, they aim at
the maximisation of profits in the long run. For this, they do not apply the marginalistic rule but
they fix their prices on the average cost principle. According to this principle, price equals
AVC+AFC+ profit margin (usually 10%). Thus the main aim of the profit maximising firm is to
set a price on the average cost principle and sell its output at that price.
8. Static theory: The neo-classical theory of the firm is static in nature. The theory
does not tell the duration of either the short period or the long period. The time-horizon of the
neo-classical firm consists of identical and independent time-periods. Decisions are considered
as independent of the time-period. This is a serious weakness of the profit maximisation
theory. In fact, decisions are ‘temporally interdependent’. It means that decisions in any one
period are affected by decisions in past periods which will, in turn, influence the future decisions
of the firm. This interdependence has been ignored by the neo-classical theory of the firm.
9. Not applicable to oligopoly firm: As a matter of fact, the profit maximisation
objective has been retained for the perfectly competitive, or monopolistic, or monopolistic
competitive firm in economic theory. But it has been abandoned in the case of the oligopoly
firm because of the criticisms levelled against it. Hence the different objectives that have been
put forth by economists in the theory of the firm relate to the oligopoly or duopoly firm.
10. Varied Objectives: The basis of the difference between the objectives of the neo-
classical firm and the modern corporation arises from the fact that the profit maximisation
objective relates to the entrepreneurial behaviour while modern corporations are motivated
by different objectives because of the separate roles of shareholders and managers. In the
latter, shareholders have practically no influence over the actions of the managers.
 +3 Economics 1st Semester qqq 77

Q.8. Explain with an example the shut down price in a short run period?
Ans. The shut down price is the minimum price a business needs to justify remaining
in the market in the short run. A business needs to make at least normal profit in the long run
to justify remaining in an industry but in the short run a firm will continue to produce as long as
total revenue covers total variable costs or price per unit > or equal to average variable cost
(AR = AVC). This is called the short-run shutdown price. The reason for this is as follows:
A business’s fixed costs must be paid regardless of the level of output. If we make an
assumption that these costs cannot be recovered if the firm shuts down then the loss per unit
would be greater if the firm were to shut down, provided variable costs are covered.

Average revenue (AR) and marginal revenue curves (MR) lies below average cost, so
whatever output produced, the business faces making a loss i.e. P<AC
At price P1 and output Q1 (where marginal revenue equals marginal cost), the firm
would shut down as price is less than AVC. The loss per unit of producing is distance AC. No
contribution is made to fixed costs. If the firm shuts down production the loss per unit will
equal the fixed cost per unit AB. In the short-run, provided that the price is greater than or
equal to P2, the business can justify continuing to produce.
Q.9. Discuss how entry and exit of firms lead to zero profits in the long run?
Ans. The line between the short run and the long run cannot be defined precisely with
a stopwatch, or even with a calendar. It varies according to the specific business. The distinction
we’ll use to distinguish between the short run and the long run in this article is therefore more
technical—in the short run, firms cannot change the usage of fixed inputs, while in the long run,
the firm can adjust all factors of production. In a competitive market, profits are a red cape
that incites businesses to charge. If a business is making a profit in the short run, it has an
incentive to expand existing factories or to build new ones. New firms may start production as
well. When new firms enter the industry in response to increased industry profits, it is
called entry.
 78 qqq EXCELLENT

Losses are the black thundercloud that causes businesses to flee. If a business is making
losses in the short run, it will either keep limping along or just shut down, depending on
whether its revenues are covering its variable costs. But in the long run, firms that are facing
losses will shut down at least some of their output, and some firms will cease production
altogether. The long-run process of reducing production in response to a sustained pattern of
losses is called exit.
No perfectly competitive firm acting alone can affect the market price. However, the
combination of many firms entering or exiting the market will affect overall supply in the
market. In turn, a shift in supply for the market as a whole will affect the market price. Entry
and exit to and from the market are the driving forces behind a process that—in the long
run—pushes the price down to minimum average total costs so that all firms are earning a zero
profit.
To understand how short-run profits for a perfectly competitive firm will evaporate in
the long run, imagine the following situation. The market is in long-run equilibrium, where all
firms earn zero economic profits producing the output level where \text{P} = \text{MR} =
\text{MC}P=MR=MCP, equals, M, R, equals, M, C and \text{P} = \text{AC}P=ACP,
equals, A, C. No firm has an incentive to enter or leave the market.
Let’s say that the product’s demand then increases, causing the market price to go up.
The existing firms in the industry are now facing a higher price than before, so they will increase
production to the new output level where \text{P} = \text{MR} = \text{MC}P=MR=MCP,
equals, M, R, equals, M, C.
This will temporarily make the market price rise above the average cost curve, and
therefore, the existing firms in the market will now be earning economic profits. However,
these economic profits attract other firms to enter the market. Entry of many new firms
causes the market supply curve to shift to the right. As the supply curve shifts to the right,
the market price starts decreasing, causing economic profits to fall for new and existing
firms. As long as there are still profits in the market, entry will continue to shift supply to
the right. This shift will stop whenever the market price is driven down to the zero-profit
level, where no firm is earning economic profits.
Short-run losses also fade away when we consider the reverse of the process
described above. Say that the market is in long-run equilibrium. Now imagine that demand
decreases, causing the market price to start falling. The existing firms in the industry are
now facing a lower price than before. Since this new price is below the average cost curve,
the firms will now be making economic losses.
Some firms will continue producing where the new \text{P} = \text{MR} =
\text{MC}P=MR=MCP, equals, M, R, equals, M, C as long as they are able to cover
their average variable costs. Some firms, however, will not be able to cover their average
variable costs; these firms will need to shut down immediately so that they only incur fixed
costs, minimizing their losses.
 +3 Economics 1st Semester qqq 79

Exit of many firms causes the market supply curve to shift to the left. As the supply
curve shifts to the left, the market price starts rising, and economic losses start to be lower.
This process ends whenever the market price rises to the zero-profit level, where the existing
firms are no longer losing money and are at zero profits again.
Thus, while a perfectly competitive firm can earn profits in the short run, in the long run
the process of entry will push down prices until they reach the zero-profit level. On the other
hand, while a perfectly competitive firm may earn losses in the short run, firms will not
continuously lose money. Firms making losses are able to escape from their fixed costs, and
their exit from the market will push the price back up to the zero-profit level in the long run.
This process of entry and exit will drive the price in perfectly competitive markets in the long
run to the zero-profit point at the bottom of the AC curve, where marginal cost crosses
average cost.
Q.10. Define Revenue? Examine the types of Revenue?
Ans. The term revenue refers to the income obtained by a firm through the sale of
goods at different prices. In the words of Dooley, ‘the revenue of a firm is its sales, receipts or
income’. The revenue concepts are concerned with Total Revenue, Average Revenue and
Marginal Revenue.
Total Revenue:
The income earned by a seller or producer after selling the output is called the total
revenue. In fact, total revenue is the multiple of price and output. The behavior of total revenue
depends on the market where the firm produces or sells. “Total revenue is the sum of all sales,
receipts or income of a firm.” Total revenue may be defined as the “product of planned sales
(output) and expected selling price.” “Total revenue at any output is equal to price per unit
multiplied by quantity sold.”
Average Revenue:
Average revenue refers to the revenue obtained by the seller by selling the per unit
commodity. It is obtained by dividing the total revenue by total output. “The average revenue
curve shows that the price of the firm’s product is the same at each level of output.”
TR
Thus : AR = Q
where AR = Average Revenue
TR = Total Revenue
Q = Output
According to McDonnell, "Average Revenue is the per unit revenue received from the
sale of one unit of a commodity."
TR = Price × Output
TR = Pq
Pq
AR = q = P
and P = f(Q) is an average curve which shows that price is a function of quantity
demanded. It is also a demand curve.
 80 qqq EXCELLENT

Marginal Revenue:
Marginal revenue is the net revenue obtained by selling an additional unit of the
commodity. “Marginal revenue is the change in total revenue which results from the sale of
one more or one less unit of output.” Ferguson. Thus, marginal revenue is the addition made
to the total revenue by selling one more unit of the good. In algebraic terms, marginal revenue
is the net addition to the total revenue by selling n units of a commodity instead of n – 1.
TR
Thus : AR = Q
MRn = TRn – TRn–1
whereas TRn = Toral Revenue of ‘n’ units
TRn–1 = Total Revenue from (n – 1) units
MR(nth) = Marginal revenue from nth unit
n = Any given number
Total Revenue, Average Revenue and Marginal Revenue:
The relationship between TR, AR and MR can be expressed with the help of a table

From the table we can draw the idea that as the price falls from Rs. 10 to Re. 1, the
output sold increases from 1 to 10. Total revenue increases from 10 to 30, at 5 units. However,
at 6th unit it becomes constant and ultimately starts falling at next unit i.e. 7th. In the same way,
when AR falls, MR falls more and becomes zero at 6th unit and then negative. Therefore, it is
clear that when AR falls, MR also falls more than that of AR: TR increases initially at a
diminishing rate, it reaches maximum and then starts falling.
Q.10. What is Producer Surplus in Case of a Firm and Market under Perfect
Competition?
Ans. Producer surplus (PS) is defined as the difference between the actual amount a
producer receives (market price) by selling a given quantity of a commodity and the minimum
amount that he expects to receive for the same quantity of a commodity (indicated by the
marginal cost of production) to cover the cost of production. In other words, it is the excess
of money receipts of a producer over the minimum supply price at which he is willing to sell
rather than forgo the sale. It is given by area above the supply curve and below the market
price just as the consumer surplus (CS) is measured by the area below the consumer demand
curve and above the market price.
As per definition, Producer Surplus = Revenue – Variable Cost
 +3 Economics 1st Semester qqq 81

Profit = Revenue – (Fixed Cost + Variable Cost) = Producer Surplus – Fixed Cost
In the short run, since fixed cost is positive, producer surplus exceeds profit. But, in the
long run, when fixed cost vanishes, producer surplus equals profit.
.....Producer Surplus for a Firm:

This Figure illustrates producer surplus for a firm in the competitive industry. Here, the
profit maximising point is ‘E’ where price equals marginal cost. The profit maximising output is
OQ, sold at OP price. The producer surplus is shown by the shaded area in the figure, i.e.,
area above the supply (MC) curve and below firm’s demand curve till profit maximising level
of output OQ. It is equal to the difference between revenue OPEQ and variable cost OABQ.
Producer Surplus for a Market :

Producer surplus for a market is obtained by summing up the producer surplus of all the
firms as shown in the Figurebelow by the shaded area. Here, higher cost firms have less
producer surplus and lower cost firms have more. When price falls below the minimum of the
most efficient firm (the one having the lowest minimum of AVC), no output will be supplied in
the market.


 4
82 qqq EXCELLENT

IMPERFECT COMPETITION
UNIT
Concept of Monopoly: Sources of monopoly power; Short-run and Long-run
equilibrium of a monopoly firm; Price discrimination; Social Cost of Monopoly
(concept only). Monopolistic Competition : Concept of Imperfectly Competitive
market; Monopolistic Competition: Features and examples; Oligopoly: Non-
Collusive Oligopoly: Sweezy’s Kinked demand Curve Model, Collusive Oligopoly:
Cartel (concept with example) Learning Outcomes: The students would be able
to apply tools of consumer behaviour and firm theory to business situations.

PART - I
(1 Mark each)
FILL IN THE BLANKS :
1. A ___________ is an industry with a single firm in which the entry of new
firms is blocked. Such a market has only one seller but has many buyers.
Ans. monopoly
2. The ___________ is the market and completely controls the amount of output
offered for sale.
Ans. monopolist
3. ___________ refers to the practice of selling the same product at different
prices to different buyers.
Ans. Price discrimination
4. Price discrimination of ___________ is also known as perfect price
discrimination because this involves maximum possible exploitation of each
buyer in the interest of seller’s profits.
Ans. first degree
5. In price discrimination of ___________ degree buyers are divided into different
groups and from each group a different price is charged which is the lowest
demand price of that group.
Ans. second
6. Price discrimination of ___________ degree is said to occur when the seller
divides his buyers into two or more than two sub-markets or groups and charges
different price in each submarket.
Ans. third
7. ___________ curve is named after a 19th century German statistician
Christian Lorenz Ernst Engel, who developed it for the first time.
Ans. Engel
 +3 Economics 1st Semester qqq 83

8. ___________ means that when income elasticity of demand is positive, price

elasticity of demand is negative.
Ans. Preference axiom
9. In the traditional theory of the firm, the long run cost curve is called
___________, because it envelops the short run curves.
Ans. envelop curve
10. ___________ is a situation in which actual production is less than what is
achievable or optimal for a firm.
Ans. Excess capacity
11. The level of utilization of the plant which firms consider as normal is called
the ___________ factor of the plant.
Ans. load
12. ___________ costs refer to the expenses incurred on marketing, sales
promotion and advertisement of the product.
Ans. Selling
13. ___________ is that form of imperfect competition where there are a few
firms in the market producing either homogenous or differentiated products.
Ans. Oligopoly
14. A ___________ is a price discrimination technique in which the price of a
product or service is composed of two parts - a lump-sum fee as well as a per-
unit charge.
Ans. two-part tariff
15. ___________ refers to selling more than one product at a single price.
Ans. Bundling
16. ___________ refers to a market in which there is only a single buyer.
Ans. Monopsony
17. ___________ monopoly is a market with only one seller and only one buyer.
Ans. Bilateral
18. ___________ monopolies occur when a single firm is able to serve the entire
market demand at a lower cost than any combination of two or more smaller
firms.
Ans. Natural
19. In 1838, ___________ introduced a simple model of duopolies that remains
the standard model for oligopolistic competition.
Ans. Augustin Cournot
20. The ____________ market provides a means by which employers find the
labour they need.
Ans. labour
21. There is an ____________ relationship between the demand for labour and
the wage rate that a business needs to pay as they take on more workers.
Ans. inverse
84 qqq EXCELLENT

22. ___________ monopoly may be defined as an industry with a single firm that
produces a product for which there are no close substitutes and in which
significant barriers to entry prevent other firms from entering the industry to
compete for profits.
Ans. Pure
23. In reality ___________ monopoly is rare.
Ans. pure
24. ___________ is an international price discrimination in which an exporter firm
sells a portion of its output in a foreign market at a very low price and the
remaining output at a high price in the home market.
Ans. Dumping
25. ___________ competition a market structure characterized by a large number
of small firms such that no single firm can affect the market price or quantity
exchanged. Perfectly competitive firms are ___________[price] takers.
Ans. Perfect
26. A perfectly competitive firm, is motivate by ___________ maximization.
Ans. profit
27. A ___________ is a tax of a fixed amount that has to be paid by everyone
(every firm in the industry) regardless of the level of his or her (its) income
(production).
Ans. lump sum tax
28. A ___________ industry occurs because the entry of new firms, prompted by
an increase in demand, causes the long-run average cost curve of each firm to
shift downward, which decreases the minimum efficient scale of production.
Ans. decreasing-cost
29. An industry with a ___________ long-run industry supply curve that results
because expansion of the industry causes no change in production cost or
resource prices.
Ans. horizontal
30. A ___________ is an industry with a single firm in which the entry of new
firms is blocked. Such a market has only one seller but has many buyers.
Ans. monopoly
31. The ___________ is the market and completely controls the amount of output
offered for sale.
Ans. monopolist
32. ___________ refers to the practice of selling the same product at different
prices to different buyers.
Ans. Price discrimination
 +3 Economics 1st Semester qqq 85

33. Price discrimination of ___________ is also known as perfect price

discrimination because this involves maximum possible exploitation of each
buyer in the interest of seller’s profits.
Ans. first degree
34. In price discrimination of ___________ degree buyers are divided into different
groups and from each group a different price is charged which is the lowest
demand price of that group.
Ans. second
35. Price discrimination of ___________ degree is said to occur when the seller
divides his buyers into two or more than two sub-markets or groups and charges
different price in each submarket.
Ans. third
36. ___________ curve is named after a 19th century German statistician
Christian Lorenz Ernst Engel, who developed it for the first time.
Ans. Engel
37. ___________ means that when income elasticity of demand is positive, price
elasticity of demand is negative.
Ans. Preference axiom
38. In the traditional theory of the firm, the long run cost curve is called
___________, because it envelops the short run curves.
Ans. envelop curve
39. ___________ is a situation in which actual production is less than what is
achievable or optimal for a firm.
Ans. Excess capacity
40. The level of utilization of the plant which firms consider as normal is called
the ___________ factor of the plant.
Ans. load
41. ___________ costs refer to the expenses incurred on marketing, sales
promotion and advertisement of the product.
Ans. Selling
42. ___________ is that form of imperfect competition where there are a few
firms in the market producing either homogenous or differentiated products.
Ans. Oligopoly
43. A ___________ is a price discrimination technique in which the price of a
product or service is composed of two parts - a lump-sum fee as well as a per-
unit charge.
Ans. two-part tariff
 86 qqq EXCELLENT

44. ___________ refers to selling more than one product at a single price.
Ans. Bundling
45. ___________ refers to a market in which there is only a single buyer.
Ans. Monopsony
46. ___________ monopoly is a market with only one seller and only one buyer.
Ans. Bilateral
47. ___________ monopolies occur when a single firm is able to serve the entire
market demand at a lower cost than any combination of two or more smaller
firms.
Ans. Natural
48. In 1838, ___________ introduced a simple model of duopolies that remains
the standard model for oligopolistic competition.
Ans. Augustin Cournot
ANSWER IN ONE WORD
1. Name an industry with a single firm in which the entry of new firms is blocked.
Such a market has only one seller but has many buyers.
Ans. Monopoly industry
2. Who is the market and completely controls the amount of output offered for
sale.
Ans. The monopolist
3. What refers to the practice of selling the same product at different prices to
different buyers.
Ans. Price discrimination
4. What is also known as perfect price discrimination because this involves
maximum possible exploitation of each buyer in the interest of seller’s profits.
Ans. Price discrimination of first degree
5. What is buyers are divided into different groups and from each group a
different price is charged which is the lowest demand price of that group.
Ans. Price discrimination of second degree
6. What is said to occur when the seller divides his buyers into two or more than
two sub-markets or groups and charges different price in each submarket.
Ans. Price discrimination of third degree
7. Which curve is named after a 19th century German statistician Christian
Lorenz Ernst Engel, who developed it for the first time
Ans. Engel curve
 +3 Economics 1st Semester qqq 87

8. What is called when income elasticity of demand is positive, price elasticity of

demand is negative.
Ans. Preference axiom
9. What is called when it envelops the short run curves.
Ans. Envelop curve
10. What is a situation in which actual production is less than what is achievable
or optimal for a firm?
Ans. Excess capacity
11. What is the level of utilization of the plant which firms consider as normal?
Ans. The load factor of the plant
12. Which costs refer to the expenses incurred on marketing, sales promotion
and advertisement of the product.
Ans. Selling costs
13. What is that form of imperfect competition where there are a few firms in the
market producing either homogenous or differentiated products.
Ans. Oligopoly
14. What is a price discrimination technique in which the price of a product or
service is composed of two parts - a lump-sum fee as well as a per-unit charge.
Ans. A two-part tariff
15. What is refers to selling more than one product at a single price.
Ans. Bundling
16. What refers to a market in which there is only a single buyer.
Ans. Monopsony
17. Which is a market with only one seller and only one buyer.
Ans. Bilateral monopoly
18. Which monopoly occur when a single firm is able to serve the entire market
demand at a lower cost than any combination of two or more smaller firms.
Ans. Natural monopolies
19. Who introduced a simple model of duopolies that remains the standard model
for oligopolistic competition.
Ans. Augustin Cournot
20. What type of relationship between the demand for labour and the wage rate
that a business needs to pay as they take on more workers.
Ans. Inverse relationship
21. What is an industry with a single firm that produces a product for which there
are no close substitutes and in which significant barriers to entry prevent
other firms from entering the industry to compete for profits.
Ans. Pure monopoly
 88 qqq EXCELLENT

22. What is an international price discrimination in which an exporter firm sells a

portion of its output in a foreign market at a very low price and the remaining
output at a high price in the home market.
Ans. Dumping
23. Which market structure characterized by a large number of small firms such
that no single firm can affect the market price or quantity exchanged.
Ans. Perfect competition
24. Which competitive firm, is motivate by profit maximization.
Ans. A perfectly competitive
25. Which tax of a fixed amount that has to be paid by everyone (every firm in
the industry) regardless of the level of his or her (its) income (production).
Ans. A lump sum tax
26. Which industry occurs because the entry of new firms, prompted by an increase
in demand, causes the long-run average cost curve of each firm to shift
downward, which decreases the minimum efficient scale of production.
Ans. A decreasing-cost industry
27. In which industry the supply curve that results because expansion of the
industry causes no change in production cost or resource prices.
Ans. Horizontal long-run industry
28. Name the market that completely controls the amount of output offered for
sale.
Ans. Monopolist market
29. What refers to the practice of selling the same product at different prices to
different buyers.
Ans. Price discrimination
PART - II
Short Questions and Answer (2 Marks each)
1. Monopsony
Ans. Monopsony is similar to monopoly in many regards. A monopolistic market has
one seller and many competitive buyers. A monopsonistic market has one buyer and many
competitive sellers. Thus monopsony refers to a market in which there is only a single buyer.
2. Bilateral Monopoly
Ans. Bilateral monopoly is a market with only one seller and only one buyer. It is not
possible for the seller to behave as a monopolist and the buyer to behave as a monopsonist at
the same time. Bilateral monopoly is rare. Markets in which a few producers have some
monopoly power and sell to a few buyers who have some monopsony power are more
common.
 +3 Economics 1st Semester qqq 89

3. Sources of Monopoly
Ans. The important source or causes of monopoly are the following:
a) Monopoly granted by the government
b) Large Economies of Scale
c) Control of an essential or valuable input into production process:
4. Natural Monopoly
Ans. A natural monopoly is a firm that can produce the entire output of the market at a
cost that is lower than what it would be if there were several firms. If a firm is natural monopoly,
it is more efficient to let it serve the entire market rather than have serial competing firms. For
a natural monopoly, the average total cost continues to shrink as output increases.
5. Monopolistically competitive markets
Ans. Monopolistically competitive markets exhibit the following characteristics:
a) There are usually a large numbers of independent firms competing in the market.
b) Each firm makes independent decisions about price and output, based on its product,
its market, and its costs of production.
6. Examples of monopolistic competition
Ans. Examples of monopolistic competition can be found in every high street.
Monopolistically competitive firms are most common in industries where differentiation is
possible, such as: (a) The restaurant business. (b) Hotels and pubs, (c) General specialist
retailing, and (d) Consumer services, such as hairdressing
7. Oligopoly
Ans. The term oligopoly is derived from two Greek words “oligos” meaning few and
“pollen” meaning to sell. Oligopoly is that form of imperfect competition where there are a few
firms in the market producing either homogenous or differentiated products. In other words,
an oligopoly is a market structure in which a few firms dominate. When a market is shared
between a few firms, it is said to be highly concentrated.
8. Cournot Duopoly
Ans. In 1838, Augustin Cournot introduced a simple model of duopolies that remains
the standard model for oligopolistic competition. Here the two firms A & B produce
homogeneous and indistinguishable goods. There are no other firms in the market and no new
firm can enter into the market.
9. Kinked demand curve
Ans. Many explanations have been given of this price rigidity under oligopoly and most
popular explanation is the so-called kinked demand curve hypothesis. The kinked demand
curve hypothesis was put forward independently by Paul M. Sweezy, an American economist,
and by Hall and Hitch, Oxford economists. It is for explaining price and output under oligopoly
with product differentiation, that economists often use the kinked demand curve hypothesis.
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10 Why Monopolist is interested in Maximum Profits and not in Maximum

Price?
Ans. Because monopolist can manipulate output and price so it is often alleged that
a monopolist “will charge the highest price he can get”. It is generally believed that prices
under free competition are lower than under monopoly. This is clearly a misguided assertion.
10. What is Regulated Monopoly
Ans. Government and public authorities run these monopolies directly or impose
price ceilings, which are not too low from monopoly price. This saves the consumers from
having to pay high monopoly prices. This limits monopoly power.
11. When the monopolist maximizes his short-run profits
Ans. The monopolist maximizes his short-run profits if the following two conditions
are fulfilled: Firstly, the MC is equal to the MR. Secondly, the slope of MC is greater than
the slope of the MR at the point of intersection.
12. Discrimination of First Degree
Ans. In first degree, price discrimination the monopolist charge different prices for
every unit of commodity. It means he charges the price accordingly, to extract entire
amount of consumers surplus. Mrs. Joan Robinson refers to this kind of discrimination as
Perfect Discrimination.
13. Second Degree Price Discrimination
Ans. In second degree, price discrimination the monopolist charges different prices
for a specific quantity or block of output. It means monopolist will sell one block of product
at one price and another block at lower price. Second degree price discrimination is more
common than first degree price discrimination.
14. Third Degree Price Discrimination
Ans. In third degree price discrimination the price charged by monopolist is different
in different market of same commodity. The division of whole market into the two or more
than two submarkets is essential for third degree price discrimination. The third degree
price discrimination is most common in practice.
15. What is the Social Cost of Monopoly?
Ans. An important difference between monopoly and perfect competition is that
whereas under per- fect competition allocation of resources is optimum and therefore social
welfare is maximum, under monopoly resources are misallocated causing loss of social
welfare.
16. What is an ‘Imperfect Competition’?
Ans. Imperfect competition is a competitive market situation where there are many
sellers, but they are selling heterogeneous (dissimilar) goods as opposed to the perfect
competitive market scenario. As the name suggests, competitive markets that are imperfect
in nature. Imperfect competition is the real world competition.
 +3 Economics 1st Semester qqq 91

17. What is Monopolistic Competition

Ans. The word Monopoly has been derived from Greek word Mono + Poly. Mono
means single and Poly means producer. Therefore, Monopoly means single producer.
18. What is Oligopoly?
Ans. An oligopoly is an industry which is dominated by a few firms. In this market,
there are a few firms which sell homogeneous or differentiated products. Also, as there are
few sellers in the market, every seller influences the behavior of the other firms and other firms
influence it. Oligopoly is either perfect or imperfect/differentiated. In India, some examples of
an oligopolistic market are automobiles, cement, steel, aluminum, etc.
19. What is Collusive and non collusive oligopoly
Ans. Collusive oligopoly is a market situation wherein the firms cooperate with each
other in determining price or output or both. A non-collusive oligopoly refers to a market
situation where the firms compete with each other rather than cooperating.
PART - III
Short Questions and Answer (3 Marks each)
1. What is the meaning of Monopoly
Ans. A monopoly is an industry with a single firm in which the entry of new firms
is blocked. Such a market has only one seller but has many buyers. The monopolist is the
market and completely controls the amount of output offered for sale.
2. How monopoly power measured
Ans. The important distinction between perfectly competitive firm and a firm with
monopoly power is that; For the competitive firm price equals marginal cost: for the firm with
monopoly power, price exceeds marginal cost. Therefore the natural way to measure monopoly
power is to examine the extent to which the profit-maximizing price exceeds marginal cost.
3. What is Price Discrimination or Discriminating Monopoly?
Ans. Price discrimination refers to the practice of selling the same product at different
prices to different buyers. A seller makes price discrimination between different buyers when
it is both possible and profitable for him to do so. If the manufacturer of a refrigerator of a
given variety sells it at Rs. 8000 to one buyer and at Rs. 8200 to another buyer (all conditions
of sale and delivery being the same in two cases), he is practicing price discrimination.
4. What is Price Discrimination of First Degree?
Ans. Price discrimination of first degree is also known as perfect price discrimination
because this involves maximum possible exploitation of each buyer in the interest of seller’s
profits. Price discrimination of first degree is said to occur when the monopolist is able to sell
each separate unit of the output at a different price. That is perfect price discrimination occurs
when a firm charges the maximum amount that buyers are willing to pay for each unit.
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5. What is Price Discrimination of Second Degree?

Ans. In price discrimination of second degree buyers are divided into different groups
and from each group a different price is charged which is the lowest demand price of that
group.
6. What is Price Discrimination of Third Degree?
Ans. Price discrimination of third degree is said to occur when the seller divides his
buyers into two or more than two sub-markets or groups and charges different price in each
submarket. The price charged in a sub-market need not be the lowest demand price of that
sub-market or group.
7. Point out the Features of monopoly
a) One Seller and Large Number of Buyers
b) No Close Substitutes
c) Difficulty of Entry of New Firms
d) Monopoly is also an Industry
e) Price Maker
8. Point out why does a monopoly business arise?
Ans. Monopoly is a market situation in which there is only one seller of a product with
barriers to entry of others. The followings are the causes behind the development of monopolies:
1. Firstly, the size of the market or the nature of production may be such that it does not
permit the setting up of more than one firm in the industry.
2. Secondly, control or ownership over crucial raw materials or knowledge of a low cost
production technique may allow monopoly business to stay.
3. Thirdly, patents, copyrights and trade- marks allow a monopolist to produce a specified
commodity. This prevents other firms from producing the good without the permission
of the patent-holder or the copyright-holder.
4. Finally, the government may protect the monopolist by creating tariff wall with the
objective of eliminating foreign competition.
9. Point out the methods of controlling monopoly?
Ans. Monopoly is known as a great social evil because the monopolist charges high
price. Under this system, there is no rival competitor, and sells lesser output but earns more
profit. It increases inequality of income. Thus, many steps are suggested regulating
monopoly. There are three methods of controlling monopoly. These are:
a) By regulation through taxation.
b) By regulation of conditions of monopoly, as in case of natural and regulated monopolies
(MC pricing).
c) By anti-monopoly laws and policies to prevent unfair price discrimination amongst
different consumers (Peak load pricing).
 +3 Economics 1st Semester qqq 93

10. What is Specific Tax

Specific taxes are commodity taxes like excise duty and sales tax. Excise duty are
levied on production while sale tax on sales. The effects of a specific tax are stated below:
1. Output sold reduces.
2. Price charged increases; consumers have to share the burden of the specific tax.
3. Profit reduces.
4. To what extent, the monopolist will shift the burden of a per unit tax to the consumer. It
depends on the elasticity of his supply and demand for his product.
11. What is Lump Sum Tax
Ans. Sometimes, the government levies a lump sum tax on monopolists. A tax such as
a profit tax or license fee are imposed on a firm regardless of its level of output. It is treated as
a fixed cost and hence, does not enter the monopolist’s MC. The effects of lump sum tax are;
1. Output sold remains unchanged
2. Price remains unchanged
3. Profit reduces
4. Incidence of a lump sum tax is completely on the sellers and the buyers will escape from
the burden.
12. What is Peak Load Pricing:
Ans. This is a case of price discrimination peak and off-peak supplies at different
prices. Some examples are, electricity has different demand curves at different times during
the day. When demand is more, it is called peak period, when less the off-peak period.
Hotels at hill stations have peak period in summer and off-peak period in monsoon. Demand
for woolens is more in winter (peak period) and less in summer (off- peak period).
13. Point out the Advantages of Peak Load Pricing
Ans. The advantages of peak load pricing are stated below:
1. It ensures efficient distribution of the use of electricity between the peak and off-peak
periods. Net gain occurs when electricity is used lesser in the peak-period and more in
the off-peak period. The efficiency gains from peak load pricing largely depend on the
ability and willingness of electricity consumers to reduce its use in the peak-period.
2. While choosing the scale of operation, when we turn from short-run to long-run, the
electric supply company must keep in mind the capacity needed to meet the peak
period demand. It saves cost and adds to efficiency gain from peak load pricing.
14. Point out the disadvantages of Peak Load Pricing
Ans. Peak load pricing have the following disadvantages:
1. Such businesses whose electricity demand is mainly in the peak period and who find it
difficult to shift its use to the off-peak period will be harmed as they have to pay higher
prices.
2. Peak load pricing necessitates the installation of different types of meters for peak
period and off-peak period consumption of electricity.
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15. Point out the measures taken to control monopoly in economy

Ans. The following are some of the measures taken by Governments to control monopoly
in economy.
1. Many countries of the world have enacted legislation to curb monopolies. In India
the Monopolistic and Restrictive Trade Practices Act, 1969 was enacted to prevent
monopolies. But legislation has had only a limited success in reducing the negative
impact of monopolies.
2. Competition ensures efficiency of firms and results in better quality, lower price and
variety of choice to consumers. Therefore measures are taken to promote fair competition
and prohibit unfair commercial practices.
3. Unity is strength. Consumers unite and form consumers associations to protect and
promote their interests. The consumer associations can fight against unfair trade practices,
exploitation etc.,
16. What is Discriminating Monopoly?
Ans. Price discrimination exists when the same product is sold at different prices to
different buyers. The cost of production is either the same or it differs but not as much as the
difference in the charged price. The product is basically same, it may have slight difference.
(For example, different binding of same book; different location of seats in a theatre; different
seats in an aircraft or a train, etc.).
17. Point out conditions, necessary for the implementation of price discrimination
Ans. The necessary conditions, which must be fulfilled for the implementation of price
discrimination are the following: (i) The market must be divided into submarkets with different
price elasticities. ; (ii) There must be effective separations of the submarkets, so that no
reselling can take place from a low-price market to a high price market. These conditions
show why price discrimination is easier to apply with commodities like electricity, and services
(Like services of a doctor, etc.), which are consumed by buyer and cannot be resold.
18. Name the types of Price discrimination
Ans. Price discrimination may be (a) personal, (b) local, or (c) according to trade or
use:
(a) Personal: It is personal when different prices are charged for different persons.
(b) Local: It is local when the price varies according to locality.
(c) According to Trade or Use: It is according to trade or use when different prices are
charged for different uses to which the commodity is put, for example, electricity is
supplied at cheaper rates for domestic than for commercial purposes.
19. Point out the Conditions of Price-Discrimination
Ans. There are three main types of situation:
(a) When consumers have certain preferences or prejudices. Certain consumers usually
have the irrational feeling that they are paying higher prices for a good because it is of a
 +3 Economics 1st Semester qqq 95

better quality, although actually it may be of the same quality. Sometimes, the price
differences may be so small that consumers do not consider it worthwhile to bother
about such differences.
(b) When the nature of the good is such as makes it possible for the monopolist to charge
different prices. This happens particularly when the good in question is a direct service.
(c) When consumers are separated by distance or tariff barriers. A good may be sold in
one town for Rs.1 and in another town for Rs.2. Similarly, the monopolist can charge
higher prices in a city with greater distance or a country levying heavy import duty.
20. Point out the preconditions for the Price Discrimination under Monopoly?
Ans. Price discrimination exists when the same product is sold at different prices to
different buyers. The cost of production is either the same or it differs but not as much as the
difference in the charged price. Price discrimination is only possible when the following
preconditions are fulfilled:
(1) Single Seller or Producer of a Commodity
(2) Two Separate Markets.
(3) Different Elasticity of Demand
(4) Laziness or Ignorance of Buyers
21. Point out the Characteristics of Imperfect Competition
Ans. Imperfect competition is a competitive market situation where there are many
sellers, but they are selling heterogeneous (dissimilar) goods as opposed to the perfect
competitive market scenario. Under imperfect competition, there are large number of buyers
and sellers. Each seller can follow its own price-output policy. Each producer produces the
differentiated product, which are close substitutes of each other. Thus, the demand curve
under monopolistic competition is highly elastic.
22. Name the forms of imperfect competition?
Ans. Imperfect competition is a competitive market situation where there are many
sellers, but they are selling heterogeneous (dissimilar) goods as opposed to the perfect
competitive market scenario. The different forms are: 1. Oligopoly 2. Duopoly 3. Monopolistic
Competition.
23. Define Oligopoly
Ans. Oligopoly is a market situation in which there are a few firms selling homogeneous
or differentiated products. It is difficult to pinpoint the number of firms in the Oligopolist
market. There may be three, four or five firms. It is also known as competition among the few.
An oligopoly industry produces either a homogeneous product or heterogeneous products.
The former is called pure or perfect oligopoly and the latter is called imperfect or differentiated
oligopoly.
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24. Point out the Characteristics of Oligopoly

Ans. Following are the characteristics of Oligopoly:
1. In oligopoly there are few sellers or producers. Each seller produces a major share of
the product.
2. There is recognised inter-dependence among the sellers in the oligopolistic market.
3. Oligopolist firms spend much on adver- tisement and customer services.
25. Define Duopoly
Ans. Duopoly means such type of business in which there are two sellers, selling either
a homogeneous product or a differentiated product. These two sellers enjoy among themselves
a monopoly in the sale of the product produced by them. Both the sellers are completely
independent and no agreement exists between them. Even though they are independent, a
change in the price and output of one will affect the other, and may set a chain of reactions. A
seller may however assume that his rival is unaffected by what he does, in that case he takes
only his own direct influence on the price.
26. What is the Monopolistic Competition
Ans. Monopolistic competition is a market structure which combines elements of
monopoly and competitive markets. Essentially a monopolistic competitive market is one with
freedom of entry and exit, but firms can differentiate their products. Therefore, they have an
inelastic demand curve and so they can set prices. However, because there is freedom of
entry, supernormal profits will encourage more firms to enter the market leading to normal
profits in the long term.
27. Point out the Monopolistic Competition
Ans. A monopolistic competitive industry has the following features:
1. Many firms and Freedom of entry and exit of the firms
2. Firms produce differentiated products.
3. Firms have price inelastic demand; they are price makers because the good is highly
differentiated
4. Firms make normal profits in the long run but could make supernormal profits in the
short term
5. Firms are allocatively and productively inefficient.
28. Name some examples of monopolistic competition
1. Restaurants – restaurants compete on quality of food as much as price. Product
differentiation is a key element of the business. There are relatively low barriers to entry
in setting up a new restaurant.
2. Hairdressers. A service which will give firms a reputation for the quality of their hair-
cutting.
3. Clothing. Designer label clothes are about the brand and product differentiation
 +3 Economics 1st Semester qqq 97

4. TV programmes – globalisation has increased the diversity of tv programmes from

networks around the world. Consumers can choose between domestic channels but
also imports from other countries and new services, such as Netflix.
29. Point out the limitations of the model of monopolistic competition
1. Some firms will be better at brand differentiation and therefore, in the real world, they
will be able to make supernormal profit.
2. New firms will not be seen as a close substitute.
3. There is considerable overlap with oligopoly – except the model of monopolistic
competition assumes no barriers to entry. In the real world, there are likely to be at least
some barriers to entry
4. If a firm has strong brand loyalty and product differentiation – this itself becomes a
barrier to entry. A new firm can’t easily capture the brand loyalty.
5. Many industries, we may describe as monopolistically competitive are very profitable,
so the assumption of normal profits is too simplistic.
30. Point out the Characteristics of Oligopoly
Ans. The characteristics of Oligopoly are:
1. Under Oligopoly, there are a few large firms although the exact number of firms is
undefined..
2. Under Oligopoly, a firm can earn super-normal profits in the long run as there are
barriers to entry like patents, licenses, control over crucial raw materials, etc. These
barriers prevent the entry of new firms into the industry.
3. Firms try to avoid price competition due to the fear of price wars and hence depend on
non-price methods like advertising, after sales services, warranties, etc. This ensures
that firms can influence demand and build brand recognition.
4. Under Oligopoly, since a few firms hold a significant share in the total output of the
industry, each firm is affected by the price and output decisions of rival firms.
5. Under oligopoly, the products of the firms are either homogeneous or differentiated.
31. What is the behavior of the firms under Oligopoly
Ans. Based on the objectives of the firms, the magnitude of barriers to entry and the
nature of government regulation, there are different possible outcomes in relation to a firm’s
behavior under Oligopoly. These are: Stable prices, Price wars and Collusion for higher prices.
Further, Oligopoly can either be collusive or non-collusive. Collusive oligopoly is a market
situation wherein the firms cooperate with each other in determining price or output or both. A
non-collusive oligopoly refers to a market situation where the firms compete with each other
rather than cooperating. Non-Collusive Oligopoly-Sweezy’s Kinked Demand Curve
Model (Price-Rigidity). Usually, in Oligopolistic markets, there are many price rigidities. In
1939, Paul Sweezy used an unconventional demand curve – the kinked demand curve to
explain these rigidities.
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32. What is Sweezy’s Kinked Demand Curve Model?

Ans. Usually, in Oligopolistic markets, there are many price rigidities. In 1939, Paul
Sweezy used an unconventional demand curve – the kinked demand curve to explain these
rigidities. It is assumed that firms behave in a two-fold manner in reaction to a price change by
a rival firm. In simple words, firms follow price cuts by a rival company but not price increases.
So, if a seller increases the price of his product, his rivals do not follow the price increase.
Therefore, the market share of the firm reduces significantly as a result of the price rise. On the
other hand, if a seller reduces the price of his product, then the rivals also reduce their price to
bring it at par with the price reduction of the firm.
33. How profits are shared among firms?
Ans. Profits are allocated on basis of:
(1) Individual outputs,
(2) Historical market shares,
(3) Production capacity of firms and
(4) Bargaining power of individual firms.
PART - IV
LONG QUESTIONS WITH ANSWERS (7 Marks Each)
Q.1. What is monopoly? Explain its features and criticism?
Ans. The word monopoly has been derived from the combination of two words i.e.,
‘Mono’ and ‘Poly’. Mono refers to a single and poly to control. In this way, monopoly refers
to a market situation in which there is only one seller of a commodity. There are no close
substitutes for the commodity it produces and there are barriers to entry. The single producer
may be in the form of individual owner or a single partnership or a joint stock company. In
other words, under monopoly there is no difference between firm and industry. Monopolist
has full control over the supply of commodity. Having control over the supply of the commodity
he possesses the market power to set the price. Thus, as a single seller, monopolist may be a
king without a crown. If there is to be monopoly, the cross elasticity of demand between the
product of the monopolist and the product of any other seller must be very small.
Definitions:
1. “Pure monopoly is represented by a market situation in which there is a single seller of
a product for which there are no substitutes; this single seller is unaffected by and does
not affect the prices and outputs of other products sold in the economy.” Bilas
2. “Monopoly is a market situation in which there is a single seller. There are no close
substitutes of the commodity it produces, there are barriers to entry”. -Koutsoyiannis
3. “Under pure monopoly there is a single seller in the market. The monopolist demand is
market demand. The monopolist is a price-maker. Pure monopoly suggests no substitute
situation”. -A. J. Braff
 +3 Economics 1st Semester qqq 99

4. “A pure monopoly exists when there is only one producer in the market. There are no
dire competitions.” -Ferguson
5. “Pure or absolute monopoly exists when a single firm is the sole producer for a product
for which there are no close substitutes.” -McConnel
Features:
We may state the features of monopoly as:
1. One Seller and Large Number of Buyers: The monopolist’s firm is the only firm; it is an
industry. But the number of buyers is assumed to be large.
2. No Close Substitutes: There shall not be any close substitutes for the product sold by
the monopolist. The cross elasticity of demand between the product of the monopolist
and others must be negligible or zero.
3. Difficulty of Entry of New Firms: There are either natural or artificial restrictions on the
entry of firms into the industry, even when the firm is making abnormal profits.
4. Monopoly is also an Industry: Under monopoly there is only one firm which constitutes
the industry. Difference between firm and industry comes to an end.
5. Price Maker: Under monopoly, monopolist has full control over the supply of the
commodity. But due to large number of buyers, demand of any one buyer constitutes
an infinitely small part of the total demand. Therefore, buyers have to pay the price
fixed by the monopolist.
Misconceptions Concerning Monopoly Pricing:
1. Monopolist is nterested in Maximum Profits and not in Maximum Price: Because
monopolist can manipulate output and price so it is often alleged that a monopolist “will
charge the highest price he can get”. It is generally believed that prices under free
competition are lower than under monopoly. This is clearly a misguided assertion. Under
certain conditions, things may be altogether different. As explained in the previous table
and diagram, there are many prices above the one he charges but the monopolist shuns
them for the simple reason that they entail a smaller than maximum profits.
2. Maximum Total Profits and not Maximum Profit per Unit: The monopolist seeks maximum
total profits, not maximum per unit profits. The profits per units may be higher at higher
price but the total profits will be higher at lower price. It is; therefore, better to sell more
at a lower price than to sell less at a higher price.
3. Economies of Scale: The monopolist may enjoy certain economies like a better and
cheaper utilization of by-products, cheaper raw material, better and cheaper methods
of production, lower cost of advertisement and so on than under free competition.
Evidently, the monopolist may be able to charge prices lower than under free competition.
4. Law of Increasing Returns: If the commodity is produced under the Law of Increasing
Returns, the monopolist may be producing more at lower costs and selling at lower
prices. This policy may help him to earn higher total revenue. The consumer may also
buy larger output at lower prices.
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Q.2. Point out why does a monopoly business arise?

Ans. ‘Monopoly refers to a market situation where one firm or a group of firms which
are combined to have a control over the supply of the product. “ In other words, Monopoly
is a market situation in which there is only one seller of a product with barriers to entry of
others. The product has no close substitutes. The cross elasticity of demand with every other
product is very low. This means that no other firms produce a similar product. Thus, the
Monopoly firm is itself an industry. The followings are the causes behind the development of
monopolies:
1. Firstly, the size of the market or the nature of production may be such that it does not
permit the setting up of more than one firm in the industry. In particular, economies of
scale are so important that only one firm can produce entire output. If this particular
firm is capable of producing goods at lower average cost compared to two or more
firms, the market creates ‘natural monopoly’. For instance, a minibus in a particular
route carries 30 passengers per round trip. Suppose there are 300 passengers in a day.
Thus, 5 buses are required to be employed to transport 300 people daily. But all the 5
bus owners may find it unprofitable to serve the same route. In other words, it is the
narrowness of the market that prevents all the buses to run profitably. If, instead, one
bus owner is given the route permit, he could make profit. A monopoly firm with a very
large minimum efficient scale can deliver services at lower average cost. This case is
known as natural monopoly. Usually, the government behaves as a natural monopolist
who undertakes the production of public utilities, like electricity generation, railways,
etc. Because of indivisibilities of inputs of public goods, the government enjoys the
power of a natural monopolist.
2. Secondly, control or ownership over crucial raw materials or knowledge of a low cost
production technique may allow monopoly business to stay. Such control over the
resources often discourages other firms to start new business, thereby shutting out
competition. Or it may exhibit decreasing marginal costs over a wide range of output
levels due to ownership of unique resources or the possession of unique managerial
talent.
3. Thirdly, patents, copyrights and trade- marks allow a monopolist to produce a specified
commodity. This prevents other firms from producing the good without the permission
of the patent-holder or the copyright-holder. In other words, the source of monopoly
power is some sort ‘control over intellectual property’, that is, ‘property over
inventions or expressions’. In view of this, patent right is given to the monopoly
inventor that may guarantee an exclusive market power.
Finally, the government may protect the monopolist by creating tariff wall with the
objective of eliminating foreign competition. A high tariff discourages new firms to start new
business. Anyway, for the existence of a monopoly firm or industry, there must be barriers to
entry.
 +3 Economics 1st Semester qqq 101

Q.3. Examine the methods of controlling monopoly?

Ans. Monopoly is known as a great social evil because the monopolist charges high
price. Monopolist does not produce at full capacity and resorts to price discrimination. Under
this system, there is no rival competitor, and sells lesser output but earns more profit. It
increases inequality of income. Thus, many steps are suggested regulating monopoly. There
are three methods of controlling monopoly. These are :
d) By regulation through taxation.
e) By regulation of conditions of monopoly, as in case of natural and regulated monopolies
(MC pricing).
f) By anti-monopoly laws and policies to prevent unfair price discrimination amongst
different consumers (Peak load pricing).
Let us discuss all the three methods:
1. Regulations through Taxation:
Imposition of tax: The Govt. can regulate monopoly through taxation. Govt. can levy a
tax per unit of output (Specific Tax) or impose a lump sum tax irrespective to its output.
1st Case: Imposition of a Specific Tax:
Specific taxes are commodity taxes like excise duty and sales tax. Excise duty are
levied on production while sale tax on sales. The effects of a specific tax are stated below:
5. Output sold reduces.
6. Price charged increases; consumers have to share the burden of the specific tax.
7. Profit reduces.
8. To what extent, the monopolist will shift the burden of a per unit tax to the consumer. It
depends on the elasticity of his supply and demand for his product.
2nd Case: Imposition of Lump Sum Tax:
Sometimes, the government levies a lump sum tax on monopolists. A tax such as a
profit tax or license fee are imposed on a firm regardless of its level of output. It is treated as
a fixed cost and hence, does not enter the monopolist’s MC. The effects of lump sum tax are;
5. Output sold remains unchanged
6. Price remains unchanged
7. Profit reduces
8. Incidence of a lump sum tax is completely on the sellers and the buyers will escape from
the burden.
2. Marginal Cost Pricing or Price Regulation or Regulated Monopoly:
The term “public utilities” is applied to such essential services such as water supply,
power supply, passenger transport facilities, communication facilities and railway facility. These
services should be made available to the society at reasonable prices. Most public utility firms
are natural monopolies and are also called as regulated monopolies.
 102 qqq EXCELLENT

Government and public authorities run these monopolies directly or impose price ceilings,
which are not too low from monopoly price. This saves the consumers from having to pay
high monopoly prices. This limits monopoly power.
3. Peak Load Pricing:
This is a case of price discrimination peak and off-peak supplies at different prices.
Some examples are, electricity has different demand curves at different times during the day.
When demand is more, it is called peak period, when less the off-peak period. Hotels at hill
stations have peak period in summer and off-peak period in monsoon. Demand for woolens
is more in winter (peak period) and less in summer (off- peak period). The traffic rush on
roads is more after office hours. Weekend rush to amusement parks is another example of
peak period. Hence, whenever the demand for a good is not the same in the two time periods
and the cost to produce also differs, it is beneficial for the monopolist to charge different
prices in the two periods The cost is higher in peak period because resources are pushed
much harder to produce more in peak period.
Advantages of Peak Load Pricing (Over Uniform Pricing): The advantages of
peak load pricing are stated below:
3. It ensures efficient distribution of the use of electricity between the peak and off-peak
periods. Net gain occurs when electricity is used lesser in the peak-period and more in
the off-peak period. The efficiency gains from peak load pricing largely depend on the
ability and willingness of electricity consumers to reduce its use in the peak-period.
4. While choosing the scale of operation, when we turn from short-run to long-run, the
electric supply company must keep in mind the capacity needed to meet the peak
period demand. It saves cost and adds to efficiency gain from peak load pricing.
Disadvantages of Peak Load Pricing: Peak load pricing have the following disadvantages:
3. Such businesses whose electricity demand is mainly in the peak period and who find it
difficult to shift its use to the off-peak period will be harmed as they have to pay higher
prices.
4. Peak load pricing necessitates the installation of different types of meters for peak
period and off-peak period consumption of electricity.
Q.4. Examine the public policy towards controlling the growth of Monopoly market?
Ans. Monopolies are not helpful for the social and economic development of a country.
They result in concentration of economic power, profiteering and growth of unfair trade practices
such as hoarding and black marketing. Monopolies create entry barriers, try to eliminate
competitors and prevent the entry of new firms. Consumer’s interests are greatly affected
because of the growth of monopolies. They are forced to pay high prices for sub standard
products as they do not have any other choice. Monopolies are able to influence the economic
policy of the country to suit their interests. This they achieve by bribing the political class. The
interests of the monopoly business gain precedence over the national interest. Such actions
 +3 Economics 1st Semester qqq 103

affect growth and development of the economy. Therefore governments all over the world try
to prevent and control monopolies in the national interest.
Measures taken to control monopoly in economy
The following are some of the measures taken by Governments to control monopoly in
economy.
4. Anti monopoly legislation: Many countries of the world have enacted legislation to curb
monopolies. In India the Monopolistic and Restrictive Trade Practices Act, 1969 was
enacted to prevent monopolies. But legislation has had only a limited success in reducing
the negative impact of monopolies.
5. Promoting fair competition: Competition ensures efficiency of firms and results in better
quality, lower price and variety of choice to consumers. Therefore measures are taken
to promote fair competition and prohibit unfair commercial practices. In India, the
government has set up the Competition Commission to promote competition in all sectors
of business.
6. Consumer associations: Unity is strength. Consumers unite and form consumers
associations to protect and promote their interests. The consumer associations can
fight against unfair trade practices, exploitation etc., In the developed countries, especially
in the US, the consumer associations are very strong. In India, the consumer movement
is not so strong because of lack of awareness among consumers regarding their rights.
7. Media publicity: Unfair and exploitative practices of combinations should be given wide
publicity in media. Since media enjoys wide reach, it would create awareness among
consumers about the wrongful acts of combinations. Such negative publicity would
affect the sales and profitability of monopolistic combinations and would force them to
adopt ethical business practices.
8. Governmental action: According to the noted economist, Joan Robinson, the government
should impose taxes and provide subsidies.
Q.5. What is Equilibrium of the Monopolist? Explain the Short-Run and Long-
Run Equilibrium?
Ans. Short-run equilibrium:
The monopolist maximizes his short-run profits if the following two conditions are fulfilled
Firstly, the MC is equal to the MR. Secondly, the slope of MC is greater than the slope of the
MR at the point of intersection. In the following figure the equilibrium of the monopolist is
defined by point, at which the MC intersects the MR curve from below. Thus both conditions
for equilibrium are fulfilled. Price is PM and the quantity is XM. The monopolist realizes
excess profits equal to the shaded area APM CB. Note that the price is higher than the MR.
In pure competition the firm is a price-taker, so that its only decision is output
determination. The monopolist is faced by two decisions: setting his price and his output.
However, given the downward-sloping demand curve, the two decisions are interdependent.
 104 qqq EXCELLENT

The monopolist will either set his price and sell the amount that the market will take at
it, or he will produce the output defined by the intersection of MC and MR, which will be sold
at the corresponding price, P. The monopolist cannot decide independently both the quantity
and the price at which he wants to sell it. The crucial condition for the maximization of the
monopolist’s profit is the equality of his MC and the MR, provided that the MC cuts the MR
from below.
Formal derivation of the equilibrium of the monopolist
Given the demand function
X = g(P)
which may be solved for P
P = f1(X)
and given the cost function
C = f2(X)
The monopolist aims at the maximisation of his profit
 =R–C
(a) The first-order condition for maximum profit 

0
X
 R C
  0
X X X
R C
or, 
X X
that is MR = MC
(b) The second-order condition for maximum profit
 2
0
X 2
 +3 Economics 1st Semester qqq 105

 2   2 R  2C
  0
X 2 X 2 X 2

 2 R  2C
or, 
X 2 X 2

 slope   slope 
that is of MR   of MC 
   
A numerical example
Given the demand curve of the monopolist
X = 50 – 0.5P
which may be solved for P
P = 100 – 2X
Given the cost function of the monopolist
C = 50 + 40X
The goal of the monpolist is to maximise profit
  RC
(i) We first find the MR
R = XP = X(100 – 2X)
R = 100X – 2X2
R
MR = = 100 – 4X
X
(ii) We next find the MC
C = 50 + 40X
C
MC = = 40
X
(iii) We equate MR and MC
MR = MC
100 – 4X = 40
X = 15
(iv) The monopolist's price is found by substituting X = 15 into the demand-price equation
P = 100 – 2X = 70
(v) The profit is
 = R – C = 1050 – 650 = 400
 106 qqq EXCELLENT

This profit is the maximum possible, since the second-order condition is satisfied :
(a) from
C
 40
X

 2C
we have 0
X 2
(b) from
R
 100  4 X
X

2 R
we have  4
X 2
Clearly –4 < 0.
We may now re-examine the statement that there is no unique supply curve for the
monopolist derived from his MC. Given his MC, the same quantity may be offered at different
prices depending on the price elasticity of demand. Graphically this is shown in the following
figure. The quantity X will be sold at price P1 if demand is D1, while the same quantity X will
be sold at price P2 if demand is D2.

Thus there is no unique relationship between price and quantity. Similarly, given the MC
of the monopolist, various quan- tities may be supplied at any one price, depending on the
market demand and the corresponding MR curve. In figure below, we depict such a situation.
The cost conditions are represented by the MC curve. Given the costs of the monopolist, he
would supply 0X1, if the market demand is D1, while at the same price, P, he would supply
only 0X2 if the market demand is D2.
 +3 Economics 1st Semester qqq 107

B. long-run equilibrium:

In the long run the monopolist has the time to expand his plant, or to use his existing
plant at any level which will maximize his profit. With entry blocked, however, it is not necessary
for the monopolist to reach an optimal scale (that is, to build up his plant until he reaches the
minimum point of the LAC). Neither is there any guarantee that he will use his existing plant at
optimum capacity. What is certain is that the monopolist will not stay in business if he makes
losses in the long run.
He will most probably continue to earn supernormal profits even in the long run, given
that entry is barred. However, the size of his plant and the degree of utilization of any given
plant size depend entirely on the market demand. He may reach the optimal scale (minimum
point of LAC) or remain at suboptimal scale (falling part of his LAC) or surpass the optimal
scale (expand beyond the minimum LAC) depending on the market conditions.

In the next figure we depict the case in which the market size does not permit the
monopolist to expand to the minimum point of LAC. In this case not only is his plant of
suboptimal size (in the sense that the full economies of scale are not exhausted) but also the
existing plant is underutilized. This is because to the left of the minimum point of the LAC the
 108 qqq EXCELLENT

SRAC is tangent to the LAC at its falling part, and also because the short-run MC must be
equal to the LRMC. This occurs at e, while the minimum LAC is at b and the optimal use of
the existing plant is at a. Since it is utilized at the level e’, there is excess capacity.

In this figure we depict the case where the size of the market is so large that the
monop- olist, in order to maximize his output, must build a plant larger than the optimal and
overutilise it. This is because to the right of the minimum point of the LAC the SRAC and the
LAC are tangent at a point of their positive slope, and also because the SRMC must be equal
to the LAC. Thus the plant that maximizes the monopolist’s profits leads to higher costs for
two reasons firstly because it is larger than the optimal size, and secondly because it is
overutilised. This is often the case with public utility companies operating at national level.

Finally in this figure we show the case in which the market size is just large enough to
permit the monopolist to build the optimal plant and use it at full capacity. It should be clear
that which of the above situations will emerge in any particular case depends on the size of the
market (given the technology of the monopolist). There is no certainty that in the long run the
 +3 Economics 1st Semester qqq 109

monopolist will reach the optimal scale, as is the case in a purely competitive market. In
monopoly there are no market forces similar to those in pure competition which lead the firms
to operate at optimum plant size (and utilize it at its full capacity) in the long run.
Q.6. Examine how does a Monopolist Reach Equilibrium?
Ans. Perfect competition is compatible only with increasing cost situation, In other
words, a perfectly competitive firm reaches equili- brium only when MC is rising. A competitive
firm never reaches equilibrium when MC is falling (i.e., when the firm operates under decreasing
cost condition) or when MC is constant (i.e., constant cost condition). Thus, perfect competition
and decreasing cost or constant costs are incompatible. Only under increasing cost i.e., only
when MC is rising, are the conditions for equilibrium (i.e., MC = MR and MC must be rising)
are satisfied. However, a monopolist may reach equilibrium not only when MC is rising but
also in cases where MC is falling or constant.
He will most probably continue to earn supernormal profits even in the long run, given
that entry is barred. However, the size of his plant and the degree of utilization of any given
plant size depend entirely on the market demand. He may reach the optimal scale (minimum
point of LAC) or remain at suboptimal scale (falling part of his LAC) or surpass the optimal
scale (expand beyond the minimum LAC) depending on the market conditions.
In the following figure we depict the case in which the market size does not permit the
monopolist to expand to the minimum point of LAC. In this case not only is his plant of
suboptimal size (in the sense that the full economies of scale are not exhausted) but also the
existing plant is underutilized. This is because to the left of the minimum point of the LAC the
SRAC is tangent to the LAC at its falling part, and also because the short-run MC must be
equal to the LRMC. This occurs at e, while the minimum LAC is at b and the optimal use of
the existing plant is at a. Since it is utilized at the level e’, there is excess capacity.
In figure 6.6 we depict the case where the size of the market is so large that the
monop- olist, in order to maximize his output, must build a plant larger than the optimal and
overutilise it. This is because to the right of the minimum point of the LAC the SRAC and the
LAC are tangent at a point of their positive slope, and also because the SRMC must be equal
to the LAC. Thus the plant that maximizes the monopolist’s profits leads to higher costs for
two reasons firstly because it is larger than the optimal size, and secondly because it is
overutilised. This is often the case with public utility companies operating at national level.
Finally in this figure we show the case in which the market size is just large enough to
permit the monopolist to build the optimal plant and use it at full capacity.
It should be clear that which of the above situations will emerge in any particular case
depends on the size of the market (given the technology of the monopolist). There is no
certainty that in the long run the monopolist will reach the optimal scale, as is the case in a
purely competitive market. In monopoly there are no market forces similar to those in pure
competition which lead the firms to operate at optimum plant size (and utilize it at its full
capacity) in the long run.
 110 qqq EXCELLENT

Q.7. What is Discriminating Monopoly? Explain the Degrees of Price

Discrimination?
Ans. Price discrimination exists when the same product is sold at different prices to
different buyers. The cost of production is either the same or it differs but not as much as the
difference in the charged price. The product is basically same, it may have slight difference.
(For example, different binding of same book; different location of seats in a theatre; different
seats in an aircraft or a train, etc.). Here, we will concentrate on the typical case of an identical
product, produced at the same cost, which is sold at different prices, depending on the
preference of the buyers, income, location and the ease of availability of substitutes. These
factors give rise to demand curves with different elasticities in the various sectors of the market
of a firm. It is also common to charge different prices for the same product at different time
periods.
The necessary conditions, which must be fulfilled for the implementation of price
discrimination are the following: (i) The market must be divided into submarkets with different
price elasticities. ; (ii) There must be effective separations of the submarkets, so that no
reselling can take place from a low-price market to a high price market. These conditions
show why price discrimination is easier to apply with commodities like electricity, and services
(Like services of a doctor, etc.), which are consumed by buyer and cannot be resold.
Price discrimination may be (a) personal, (b) local, or (c) according to trade or use:
(a) Personal: It is personal when different prices are charged for different persons.
(b) Local: It is local when the price varies according to locality.
(c) According to Trade or Use: It is according to trade or use when different prices are
charged for different uses to which the commodity is put, for example, electricity is
supplied at cheaper rates for domestic than for commercial purposes.
Some monopolists used product differentiation for price discrimination by means of
special labels, wrappers, packing, etc. For example, the perfume manufacturers discriminate
prices of the same fragrance by packing it with different labels or brands.
Conditions of Price-Discrimination:
There are three main types of situation:
(a) When consumers have certain preferences or prejudices. Certain consumers usually
have the irrational feeling that they are paying higher prices for a good because it is of a
better quality, although actually it may be of the same quality. Sometimes, the price
differences may be so small that consumers do not consider it worthwhile to bother
about such differences.
(b) When the nature of the good is such as makes it possible for the monopolist to charge
different prices. This happens particularly when the good in question is a direct service.
(c) When consumers are separated by distance or tariff barriers. A good may be sold in
one town for Rs.1 and in another town for Rs.2. Similarly, the monopolist can charge
higher prices in a city with greater distance or a country levying heavy import duty.
 +3 Economics 1st Semester qqq 111

Degrees of Price Discrimination:

(i) Discrimination of First Degree: In first degree, price discrimination the monopolist
charge different prices for every unit of commodity. It means he charges the price accordingly,
to extract entire amount of consumers surplus. Mrs. Joan Robinson refers to this kind of
discrimination as Perfect Discrimination.
(ii) Second Degree Price Discrimination: In second degree, price discrimination
the monopolist charges different prices for a specific quantity or block of output. It means
monopolist will sell one block of product at one price and another block at lower price.
Second degree price discrimination is more common than first degree price discrimination.
(iii) Third Degree Price Discrimination: In third degree price discrimination the
price charged by monopolist is different in different market of same commodity. The division
of whole market into the two or more than two submarkets is essential for third degree price
discrimination. The third degree price discrimination is most common in practice.
Q.8. Describe the preconditions for the Price Discrimination under Monopoly?
Ans. Price discrimination exists when the same product is sold at different prices to
different buyers. The cost of production is either the same or it differs but not as much as the
difference in the charged price. The product is basically same, it may have slight difference.
(For example, different binding of same book; different location of seats in a theatre; different
seats in an aircraft or a train, etc.). Here, we will concentrate on the typical case of an identical
product, produced at the same cost, which is sold at different prices, depending on the
preference of the buyers, income, location and the ease of availability of substitutes. These
factors give rise to demand curves with different elasticities in the various sectors of the market
of a firm. It is also common to charge different prices for the same product at different time
periods. Price discrimination is only possible when the following preconditions are fulfilled:
(1) Single Seller or Producer of a Commodity: Price discrimination is only possible under
the monopoly market structure where there is a single seller or producer of a commodity
or service. In other types of market structure it is not possible.
(2) Two Separate Markets: Price discrimination presupposes that there should be two
separate markets in which such a product or commodity is being sold. They should not
be adjacent to each other.
(3) Different Elasticity of Demand: Price discrimination presupposes that the elasticity of
demand for the product should be different in both the markets. The monopoly firm will
then be able to fix a higher price in the market in which the elasticity of demand is
inelastic and fix a lower price in the market having elasticity of demand more elastic.
(4) Nature of the Product: The nature of commodity or service should be such that it may
not be re-sold otherwise price discrimination will not be possible. Professionals charge
different prices from different customers for their services. For example, doctors and
lawyers are in this category of price discrimination. A poor patient cannot transfer the
services rendered to him by a doctor to a rich patient.
 112 qqq EXCELLENT

(5) Laziness or Ignorance of Buyers: When buyers are lazy and they do not know the
market conditions then the monopolist will charge different prices for his product or
service from different buyers. Sometimes customers are lazy and they do not bother
about the slight difference in the price of a product or service.
(6) Supply or Sale on Order: Price discrimination is also possible only when a single seller
or producer of a product supplies or sells his product on order.
(7) Legal Acceptance: When a monopoly firm has legal sanction from the government to
sell its product at different prices then the price discrimination is possible. For example,
RSEB has legal sanction from the government to charge different prices for the use of
electricity in agricultural sector and industrial sector.
(8) Varying Preferences and Habits of Consumers: Price discrimination is also possible
when consumers have different preferences and habits for the consumption of a product
or service. The product can be sold in different forms and different prices can be charged
for the same product. For example, a book is supplied to library in hardbound while the
same book is sold in paperback to the students. The different prices for the same book
is charged by the publisher.
(9) Different Uses: Price discrimination is also possible when the users of a service or
product have different uses. For example, Indian Railways charge different freight rates
for coal and silver.
(10) Tariff Charges: Price discrimination is also possible due to tariff restrictions. We sell our
product at higher prices in domestic market but the same product is sold at lower
prices in international market because of tariff barriers.
(11) Different Transport Charges: When there are different transport charges in different
regions then the seller of a product or service will charge different prices from different
buyers.
(12) Busy and Slack Working Hours: Some services or products are used by the buyers or
customers. Such service may have busy working hours as well as slack working hours.
A monopolist can charge high prices and low prices as per the working hours from
different customers. For example, telephone charges for STD or ISD will be high in
busy working hours (day service) while it will be low in slack working hours (night
service).
This practice of charging lower price in the foreign market is termed as dumping. In the
domestic market the elasticity of demand is less and therefore price charged is higher as
compared to the foreign market where the elasticity of demand is higher. Dumping of this form
which is the most usual is referred to as the Persistent dumping. Another form of dumping is
the Predatory dumping. This form of dumping is unfair because under this situation the producer
deliberately sells the product in a foreign country at a lower price in order to eliminate the
competitors and gain control of the foreign market.
 +3 Economics 1st Semester qqq 113

Q.9. Explain the Social Cost of Monopoly?

Ans. An important difference between monopoly and perfect competition is that whereas
under per- fect competition allocation of resources is optimum and therefore social welfare is
maximum, under monopoly resources are misallocated causing loss of social welfare. When a
product is produced and sold under conditions of monopoly, the monopolist gains at the expense
of consum- ers, for they have to pay a price higher than marginal cost of production. This results
in loss of consumers’ welfare. Which is greater? Monopolist’s gain or consumers’ loss. To
measure welfare gain or loss some economists have used the concept of consumer’s surplus.
Consumer’s surplus, is the surplus of price which consumers are prepared to pay for a
commodity over and above what they actually pay for it. The dead-weight loss in consumer’s
welfare due to mo- nopoly can be shown through this Figure where TD is the demand curve
for the monopolist product MR is the corresponding marginal revenue curve. It is assumed
that the industry is a constant cost industry so that av- erage cost (AC) remains the same as
output is increased and marginal cost is equal to it.
Under perfect competition firms equate price with marginal cost and industry’s output
is determined by demand for and supply of the prod- uct. Since we are considering a constant
cost industry, a horizontal line (AC=MC) is the supply curve of the industry. It will be seen
from this Figure that under perfect competition price determined is equal to QK (or OPc) and
output OQ is being produced. Firms will be equating price 0Pcwith their marginal cost. The
consumer surplus enjoyed by the
consumers is equal to the area TKPC.
It may be noted that consumer surplus
reflects social welfare as it is excess of
what consumers are willing to pay (that
is, the utility that they obtain) over and
above what they actually pay.
Now, the monopolist would not
produce OPc output as he equates
marginal revenue (MR) with marginal
cost (MC) to maximise his profits. It
will be seen from Fig. 26.12 that
marginal revenue and marginal cost are
equal at output level OM. Therefore Fig. Dead-weight Loss or Social Cost of Monopoly
the monopolist will produce OM output
and charge ML or OPm price. Thus,
monopolist has restricted output to OM and raised price to OPm.
As a result monopolist makes profits equal to the area PmLEPc. On the other hand, as
a result of rise in price to Pm, the consumers’ surplus has been reduced to the area TLPm and
they suffer a loss of consumer surplus equal to the area PcKLPm. Thus there is a redistribution
 114 qqq EXCELLENT

of income from consumers to the monopolist, but it is important to note that loss of consumer
surplus PcKLPm which is greater than the profits made by the monopolist by the area of
triangle LKE.
The loss in consumer surplus can be divided into two components. First part is the
profits equal to the area PmLEPc made by the monopolist at the expense of the consumers.
This component of loss in consumer surplus is suffered by those who are still purchasing the
product.
The second component of the loss of consumer surplus is equal to the area of triangle
LKE which is due to allocative ineffi- ciency caused by the monopolist by reducing output of
the product and raising its price. This second component of loss in consumer surplus as
measured by the area of triangle LKE is called dead-weight loss of welfare caused by the
monopolist.
This represents social cost of monopoly. It will be seen from the above Figure that price
which the last existing consumer is willing to pay for Mth unit is ML while the marginal cost
which has to be incurred by the society is ME and therefore from Mth unit, consumer enjoys
consumer surplus equal to EL.
In other words, consumer values the product more than the opportunity cost of production
as measured by the marginal cost (MC). Likewise, the price which the consumers are willing
to pay for additional MQ units exceeds the marginal cost (MC) to the society and therefore
generates additional consumer surplus. Thus, the social welfare or consumer surplus would
be increased if output is extended to the point Q. It will be seen from Figure 26.12 that
consumers would gain additional consumer surplus equal to the area of triangle LKE if output
is increased to OQ.
But monopolist would not extend output to point Q because his profits are maximised
at OM output. Since for extra units from M to Q, marginal cost exceeds marginal revenue of
the monopolist, he will not produce them. But from the social point of view, the extension of
output to the point Q is desirable as it increases consumer surplus gained by the consumers.
Thus, monopoly causes a net loss of consumer welfare equal to area of triangle LKE.
This is called a dead weight loss of welfare because though consumers suffer a loss of welfare,
no one else, not even monopolist, gains from it. This is loss of welfare caused by allocative
inefficiency of the monopoly. It may be noted that the gain of profits by the monopolist equal
to the area PmLEPc has been made possible by the loss of consumer surplus of those who
are still purchasing the OM quantity of the product.
Q.10. What is an ‘Imperfect Competition’? Examine the characteristics of imperfect
competition?
Ans. Imperfect competition is a competitive market situation where there are many sellers,
but they are selling heterogeneous (dissimilar) goods as opposed to the perfect competitive
market scenario. As the name suggests, competitive markets that are imperfect in nature.
Imperfect competition is the real world competition. Today some of the industries and
sellers follow it to earn surplus profits. In this market scenario, the seller enjoys the luxury of
 +3 Economics 1st Semester qqq 115

influencing the price in order to earn more profits.If a seller is selling a non identical good in the
market, then he can raise the prices and earn profits. High profits attract other sellers to enter
the market and sellers, who are incurring losses, can very easily exit the market.
Characteristics of Imperfect Competition
Under imperfect competition, there are large number of buyers and sellers. Each seller
can follow its own price-output policy. Each producer produces the differentiated product,
which are close substitutes of each other. Thus, the demand curve under monopolistic
competition is highly elastic.
1. Large number of Sellers and Buyers: There are large numbers of sellers in the market.
All these firms are small sized. It means that each firm produces or sells such an
insignificant portion of the total output or sale that it cannot influence the market price
by its individual action. No firm can affect the sales of any other firm either by increasing
or reducing its output; so there is no reaction from other firms. Every firm acts
independently without bothering about the reactions of its rivals. There are a large
number of buyers and none of them can affect price by his individual action.
2. Product Differentiation: Another important characteristic is product differentiation. The
product of each seller may be similar to, but not identical with the product of other
sellers in the industry. For example, a packet of Verka butter may be similar in kind to
another packet of Vita butter, but because of the idea that there are differences, real or
imaginary, in the quality of these two products, each buyer may have a definite preference
for the one rather than for the other. As a result, each firm will have a group of buyers
who prefer, for one reason or another, the product of that particular firm.
3. Selling Costs: Another important characteristic of the monopolistic competition is
existence of selling costs. Since there is product differentiation and products are close
substitutes, selling costs are important to persuade buyers to change their preferences,
so as to raise their demand for a given article. Under monopolistic competition,
advertisement is not only persuasive but also informatory because a large number of
firms are operating in the market and buyer’s knowledge about the market is not perfect.
4. Free Entry and exit of Firms: Firms under monopolistic competition are free to join and
leave the industry at any time they like to. The implication of this characteristic is that by
entering freely into the market, the firms can produce close substitutes and increase the
supply of commodity in the market. Similarly, the firm commands such a meager amount
of resources that in the event of losses, they may easily quit the market.
5. Price-makers: In the monopolistic competitive market, each firm is a price-maker as it
can determine the price of its own brand of the product.
6. Blend of Competition and Monopoly: In this market, each firm has a monopoly power
over its product as it would not lose all customers if it raises the price as its product is
not perfect substitute of other brands. At the same time, there is an element of competition
because the consumers treat the different firms’ products as close substitutes. Hence, if
a firm raises the price of its brand, it would lose some customers to other brands.
 116 qqq EXCELLENT

Q.11. Explain the different Forms of Imperfect Competition?

Ans. Imperfect competition is a competitive market situation where there are many
sellers, but they are selling heterogeneous (dissimilar) goods as opposed to the perfect
competitive market scenario. As the name suggests, competitive markets that are imperfect in
nature.
Imperfect competition is the real world competition. Today some of the industries and
sellers follow it to earn surplus profits. In this market scenario, the seller enjoys the luxury of
influencing the price in order to earn more profits. If a seller is selling a non identical good in
the market, then he can raise the prices and earn profits. High profits attract other sellers to
enter the market and sellers, who are incurring losses, can very easily exit the market. The
different forms are: 1. Oligopoly 2. Duopoly 3. Monopolistic Competition.
1. Oligopoly: Oligopoly is a market situation in which there are a few firms selling
homogeneous or differentiated products. It is difficult to pinpoint the number of firms in the
Oligopolist market. There may be three, four or five firms. It is also known as competition
among the few. An oligopoly industry produces either a homogeneous product or
heterogeneous products. The former is called pure or perfect oligopoly and the latter is called
imperfect or differentiated oligopoly.
Characteristics of Oligopoly:
Following are the characteristics of Oligopoly:
1. Few Sellers: In oligopoly there are few sellers or producers. Each seller produces a
major share of the product.
2. Mutual Inter-dependence: There is recognised inter-dependence among the sellers in
the oligopolistic market. Each oligopolist firm knows that changes in its price advertising,
products etc. may lead to counter-moves by rivals. When the sellers are less in number,
each produces a considerable fraction of the total output of the industry and can have a
noticeable effect on market conditions.
3. Entry and Exit of Firms Difficult: Because there is keen competition in an oligopolistic
industry, there are no barriers to entry into or exit from it. However, in the long rim there
are some types of barriers to entry which tend to restrain new firms from entering the
industry.
4. Heavy Expenditure on Advertisement: Oligopolist firms spend much on adver- tisement
and customer services. As Professor Baumol has written—”Under oligopoly adverting
can become a life and death matter.”
For example: If all oligopolists continue to spend a lot on advertising their products
and one seller does not match up with them, he will find his customers gradually going in for his
rival’s product. Further, it can be said that “the different firms of an oligopolistic industry are all
in the same boat. If one rocks the boat, others will be affected and in all probability will know
the identity of the responsible firms and can retaliate.”
 +3 Economics 1st Semester qqq 117

2. Duopoly: Duopoly means such type of business in which there are two sellers,
selling either a homogeneous product or a differentiated product. These two sellers enjoy
among themselves a monopoly in the sale of the product produced by them. Both the sellers
are completely independent and no agreement exists between them.
Even though they are independent, a change in the price and output of one will affect
the other, and may set a chain of reactions. A seller may however assume that his rival is
unaffected by what he does, in that case he takes only his own direct influence on the price.
3. Monopolistic Competition: The word Monopoly has been derived from Greek
word Mono + Poly. Mono means single and Poly means producer. Therefore, Monopoly
means single producer.
Q.12. Describe the Monopolistic Competition with an examples?
Ans. Monopolistic competition is a market structure which combines elements of
monopoly and competitive markets. Essentially a monopolistic competitive market is one with
freedom of entry and exit, but firms can differentiate their products. Therefore, they have an
inelastic demand curve and so they can set prices. However, because there is freedom of
entry, supernormal profits will encourage more firms to enter the market leading to normal
profits in the long term. A monopolistic competitive industry has the following features:
6. Many firms.
7. Freedom of entry and exit.
8. Firms produce differentiated products.
9. Firms have price inelastic demand; they are price makers because the good is highly
differentiated
10. Firms make normal profits in the long run but could make supernormal profits in the
short term
11. Firms are allocatively and productively inefficient.
Monopolistic competition short run
In the short run, the diagram for
monopolistic competition is the same as for
a monopoly. The firm maximises profit
where MR=MC. This is at output Q1 and
price P1, leading to supernormal profit
Monopolistic competition long run
Demand curve shifts to the left due
to new firms entering the market. In the
long-run, supernormal profit encourages
new firms to enter. This reduces demand
for existing firms and leads to normal
profit. I
 118 qqq EXCELLENT

Efficiency of firms in monopolistic competition

1. Allocative inefficient. The above diagrams show a price set above marginal cost
2. Productive inefficiency. The above diagram shows a firm not producing on the lowest
point of AC curve
3. Dynamic efficiency. This is possible as firms have profit to invest in research and
development.
4. X-efficiency. This is possible as the firm does face competitive pressures to cut cost
and provide better products.
Examples of monopolistic competition
5. Restaurants – restaurants compete on quality of food as much as price. Product
differentiation is a key element of the business. There are relatively low barriers to entry
in setting up a new restaurant.
6. Hairdressers. A service which will give firms a reputation for the quality of their hair-
cutting.
7. Clothing. Designer label clothes are about the brand and product differentiation
8. TV programmes – globalisation has increased the diversity of tv programmes from
networks around the world. Consumers can choose between domestic channels but
also imports from other countries and new services, such as Netflix.
Limitations of the model of monopolistic competition
6. Some firms will be better at brand differentiation and therefore, in the real world, they
will be able to make supernormal profit.
7. New firms will not be seen as a close substitute.
8. There is considerable overlap with oligopoly – except the model of monopolistic
competition assumes no barriers to entry. In the real world, there are likely to be at least
some barriers to entry
 +3 Economics 1st Semester qqq 119

9. If a firm has strong brand loyalty and product differentiation – this itself becomes a
barrier to entry. A new firm can’t easily capture the brand loyalty.
10. Many industries, we may describe as monopolistically competitive are very profitable,
so the assumption of normal profits is too simplistic.
Q.13. What is Oligopoly? Examine it with an example?
Ans. An oligopoly is an industry which is dominated by a few firms. In this market,
there are a few firms which sell homogeneous or differentiated products. Also, as there are
few sellers in the market, every seller influences the behavior of the other firms and other firms
influence it. Oligopoly is either perfect or imperfect/differentiated. In India, some examples of
an oligopolistic market are automobiles, cement, steel, aluminum, etc.
Characteristics of Oligopoly
The characteristics of Oligopoly are:
6. Few firms: Under Oligopoly, there are a few large firms although the exact number of
firms is undefined. Also, there is severe competition since each firm produces a significant
portion of the total output.
7. Barriers to Entry: Under Oligopoly, a firm can earn super-normal profits in the long
run as there are barriers to entry like patents, licenses, control over crucial raw materials,
etc. These barriers prevent the entry of new firms into the industry.
8. Non-Price Competition: Firms try to avoid price competition due to the fear of price
wars and hence depend on non-price methods like advertising, after
sales services, warranties, etc. This ensures that firms can influence demand and build
brand recognition.
9. Interdependence: Under Oligopoly, since a few firms hold a significant share in the
total output of the industry, each firm is affected by the price and output decisions of
rival firms. Therefore, there is a lot of interdependence among firms in an oligopoly.
Hence, a firm takes into account the action and reaction of its competing firms while
determining its price and output levels.
10. Nature of the Product: Under oligopoly, the products of the firms are either
homogeneous or differentiated.
11. Selling Costs: Since firms try to avoid price competition and there is a huge
interdependence among firms, selling costs are highly important for competing against
rival firms for a larger market share.
12. No unique pattern of pricing behavior: Under Oligopoly, firms want to act
independently and earn maximum profits on one hand and cooperate with rivals to
remove uncertainty on the other hand. Depending on their motives, situations in real-life
can vary making predicting the pattern of pricing behavior among firms impossible. The
firms can compete or collude with other firms which can lead to different pricing situations.
 120 qqq EXCELLENT

13. Indeterminateness of the Demand Curve: Unlike other market structures, under
Oligopoly, it is not possible to determine the demand curve of a firm. This is because on
one hand, there is a huge interdependence among rivals. And on the other hand there is
uncertainty regarding the reaction of the rivals. The rivals can react in different ways
when a firm changes its price and that makes the demand curve indeterminate.
Firms behavior under Oligopoly:
Based on the objectives of the firms, the magnitude of barriers to entry and the nature
of government regulation, there are different possible outcomes in relation to a firm’s behavior
under Oligopoly. These are: Stable prices, Price wars and Collusion for higher prices.
Further, Oligopoly can either be collusive or non-collusive. Collusive oligopoly is a market
situation wherein the firms cooperate with each other in determining price or output or both. A
non-collusive oligopoly refers to a market situation where the firms compete with each other
rather than cooperating. Non-Collusive Oligopoly-Sweezy’s Kinked Demand Curve
Model (Price-Rigidity). Usually, in Oligopolistic markets, there are many price rigidities. In
1939, Paul Sweezy used an unconventional demand curve – the kinked demand curve to
explain these rigidities.
Q.14. Describe in brief the Sweezy’s Kinked Demand Curve Model (Price-Rigidity)
with examples?
Ans. Usually, in Oligopolistic markets, there are many price rigidities. In 1939, Paul
Sweezy used an unconventional demand curve – the kinked demand curve to explain these
rigidities.
Reason for the kink in the demand curve
1. It is assumed that firms behave in a two-fold manner in reaction to a price change by a
rival firm. In simple words, firms follow price cuts by a rival company but not price
increases. So, if a seller increases the price of his product, his rivals do not follow the
price increase.
2. Therefore, the market share of the firm reduces significantly as a result of the price rise.
On the other hand, if a seller reduces the price of his product, then the rivals also reduce
their price to bring it at par with the price reduction of the firm.
3. This ensures that they prevent their market share from falling. Once the rivals react, the
firm lowering the price first cannot gain from the price cut.
Why the price rigidity?
As can be seen above, a firm cannot gain or lose by changing its price from the prevailing
price in the market. In both cases, there is no increase in demand for the firm which changes
its price. Hence, firms stick to the same price over time leading to price rigidity under oligopoly.
Kinked-Demand Curve Model
In the figure above, KPD is the is the kinked-demand curve and OP0 is the prevailing
price in the oligopoly market for the OR product of one seller. Starting from point P,
 +3 Economics 1st Semester qqq 121

corresponding to the point OP1, any increase

in price above it will considerably reduce his
sales as his rivals will not follow his price
increase.
This is because the KP portion of the
curve is elastic and the corresponding portion
of the MR curve (KA) is positive. Therefore,
any price increase will not just reduce the total
sales but also his total revenue and profit. On
the other hand, if the seller reduces the price of
the product below OPQ (or P), his rivals will
also reduce their prices.
However, even if his sales increase, his profits would be less than before. This is because
the PD portion of the curve below P is less elastic and the corresponding part of the marginal
revenue curve below R is negative. Therefore, in both price-raising and price-reducing situations,
the seller is the loser. He will stick to the prevailing market price OP0 which remains rigid.
Working of the kinked-demand curve
Let’s analyze the effect of changes in cost and demand conditions on price stability in
the oligopolistic market. Let’s suppose that the prevailing price in the market is OP0. Therefore,
if one seller increases the price above OP0 and the rival sellers don’t and keep the prices of
their products at OP, then it will lead to the product becoming costlier than the others.
Subsequently, the demand for the costlier product will fall significantly. This is seen in the
demand curve of a firm for any price above OP0 or the KP section of the curve, is relatively
elastic. The high elasticity reduces the demand significantly as a result of the price increase.
On the other hand, if the seller reduces the price below OP0, the rivals also follow the price
cut to prevent their demand from falling. This is seen in the demand curve of a firm for any
price below OP0 or the PD segment of the curve is relatively inelastic. The low elasticity does
not increase the demand significantly as a result of the price cut.
This asymmetrical behavioral pattern results in a kink in the demand curve and hence
there is price rigidity in oligopoly markets. The prices remain rigid at the kink (point P). In
other words, the price will remain sticky at OP0 and the output = OR at this price. Due to the
difference in the elasticities, the MR curve becomes discontinuous corresponding to the point
of change in elasticity of the demand curve. The kink represents this. At the output < OR, the
demand curve is KP and the corresponding MR curve is KA. For output > OR, the demand
curve is PD and the corresponding MR curve is BMR.
Q.15. Describe the Collusive Oligopoly in Economics with Diagram?
Ans. When there is product differentiation, i.e., differentiated oligop- oly, two or few
sellers may recognise that their prices are closely interre- lated. Since each firm is a price-
 122 qqq EXCELLENT

searcher, each will guess and learn from experience that as and when it cuts its price, its rivals
tend to match or even exceed such a price cut. The consequence: a continuous price war,
which will come to a halt as soon as few sellers feel that they are on the same boat. In the past
oligopolists used to form cartels or trusts. Of late, this strategy has become ineffective due to
the enactment of anti-trust laws everywhere. In reality the oligopolists hesitate to charge too
high a price because that may tempt new rivals to enter the industry. They would, of course,
charge a price higher than the purely competitive one but with necessary modera- tion lest new
firms should be attracted into the industry.
The most typical form of collusion where firms join hands to gain the advantages of
monopoly is a cartel. A cartel is a formal agreement among firms regarding pricing and/or
market sharing. Firms often get together and set prices so as to maximize total industry profits.
This collusive oligopoly resembles monopoly and extracts the maxi- mum amount of profits
from customers. If a cartel has absolute control over its members as is true of the OPEC, it
can operate as a monopoly. To illustrate, consider Fig. 7 below.

Price/output determination for a cartel

The marginal cost curves of each firm are summed horizontally to derive an industry
marginal cost curve. The profit-maximizing output and equilibrium price (P0) are determined
simultaneously by equating the cartel’s total marginal cost with the industry marginal revenue
curve. Now each individual firm can easily find its output by equating its marginal cost to the
pre-determined industry profit-maximizing marginal cost level.
How profits are shared among firms?
Profits are allocated on basis of:
(1) Individual outputs,
(2) Historical market shares,
(3) Production capacity of firms and
(4) Bargaining power of individual firms.
 +3 Economics 1st Semester qqq 123

However, cartel arrangements do not last for long due to:

(1) Changing products,
(2) Entry of new firms into the industry and
(3) Disagreement among the members.
But subversion of the cartel by an individual firm is highly elastic provided it can lower
its prices without other cartel members learning of this action and retaliating.
Q.16. Discuss the Non-Collusive Oligopoly according to Sweezy’s Kinked Demand
Curve Model?
Ans. One of the important features of oligopoly market is price rigidity. And to explain
the price rigidity in this market, conventional demand curve is not used. The idea of using a
non-conventional demand curve to represent non-collusive oligopoly (i.e., where sellers
compete with their rivals) was best explained by Paul Sweezy in 1939. Sweezy uses kinked
demand curve to describe price rigidity in oligopoly market structure. The kink in the demand
curve stems from the asymmetric behavioural pattern of sellers. If a seller increases the price
of his product, the rival sellers will not follow him so that the first seller loses a considerable
amount of sales. In other words, every price increase will go unnoticed by rivals.

On the other hand, if one firm reduces the price of its product other firms will follow the
first firm so that they must not lose customers. In other words, every price will be matched by an
equivalent price cut. As a result, the benefit of price cut by the first firm will be inconsiderable. As
a result of this behavioural pattern, the demand curve will be kinked at the ruling market price.
Suppose, the prevailing price of an oligopoly product in the market is QE or OP of Fig.
5.19. If one seller increases the price above OP, rival sellers will keep the prices of their
 124 qqq EXCELLENT

products at OP. As a result of high price charged by the firm, buyers will shift to products of
other sellers who have kept their prices at the old level. Consequently, sales of the first seller
will drop considerably.
That is why demand curve in this zone (dE) is relatively elastic. On the other hand, if a
seller reduces the price of his product below QE, others will follow him so that demand for
their products does not decline. Thus, demand curve in this region (i.e., ED) is relatively
inelastic. This behavioural pattern thus explains why prices are inflexible in the oligopoly market
— even if demand and costs change.
The kink in the demand curve at point E results in a discontinuous MR curve.
The MR curve has two segments :
1. At output less than OQ the MR curve (i.e., dA) will correspond to DE portion of AR
curve, and, for output larger than OQ, the MR curve (i.e., BMR) will correspond to the
demand curve ED. Thus, discontinuity in MR curve occurs between points A and B. In
other words, between these two points, MR curve is vertical.
2. Equilibrium is achieved when MC curve passes through the discontinuous portion of
the MR curve. Thus the equilibrium output is OQ, to be sold at a price OP.
3. Suppose, costs rise. As a result, MC curve will shift up from MC1 to MC2. The resulting
price and output remain unchanged at OP and OQ, respectively. This fact explains
stickiness of prices. In other words, in oligopolistic industries price is more stable than
costs.
4. At first sight, the model seems to be attractive since it explains the behaviour of firms
realistically. But the model has certain limitations. Firstly, it does not explain how the
ruling price is determined. It explains that the demand curve has a kink at the ruling
price.
5. In this sense, it is not a theory of pricing. Secondly, price rigidity conclusion is not
always tenable. Empirical evidence suggests that higher costs force a further price rise
above the kink. Despite these limitations, the model is popular among textbook authors.


 +3 Economics 1st Semester qqq 125

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[1st Semester] Generic Elective - 1
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 +3 Economics 1st Semester qqq 127

CONTENT
+3 MICRO ECONOMICS
GENERIC ELECTIVE - 1
No. Topics Page
Unit: I Demand and Consumer behaviour 1-30
Concept of demand: demand function, law of demand, derivation of individual
and market demand curves, shifting of the demand curve, elasticity of demand,
Consumer behavior, Marshallian utility approach and Indifference Curve
approach; utility maximization conditions. Income-Consumption Curve (ICC)
and Price-Consumption Curve (PCC).
Unit: II Production and Cost 31-49
Production function: Short-run and Long-run; Total Product, Average Product
and Marginal Product, Law of returns to a variable factor, Law of Returns to
Scale; Concepts of Iso-quant and iso-cost line; Cost: Accounting and Economic
Costs; Social and Private Costs; Short-run and Long-run Costs; Relation
between Average and Marginal.
Unit: III Perfect Competition 50-81
Concept of Perfectly Competitive market: Assumptions, Profit maximization
conditions; Related concepts of Total Revenue, Average Revenue and Marginal
Revenue, Short-run and Long- run equilibrium of a firm; determination of short-
run supply curve of a firm, measuring producer surplus under perfect competition
Unit: IV Imperfect Competition Monopoly 82-124
Concept of Monopoly: Sources of monopoly power; Short-run and Long-run
equilibrium of a monopoly firm; Price discrimination; Social Cost of Monopoly
(concept only).
Monopolistic Competition
Concept of Imperfectly Competitive market; Monopolistic Competition:
Features and examples; Oligopoly: Non-Collusive Oligopoly: Sweezy’s Kinked
demand Curve Model, Collusive Oligopoly: Cartel (concept with example)
Learning Outcomes: The students would be able to apply tools of consumer
behaviour and firm theory to business situations.


128 qqq EXCELLENT

SYLLABUS
(GE – 1)
MICRO ECONOMICS
Objective: Objective of the course is to acquaint the students with the concepts of
microeconomics dealing with consumer behavior. The course also makes the student
understand the supply side of the market through the production and cost behavior of firms.
Unit: I Demand and Consumer behaviour
Concept of demand: demand function, law of demand, derivation of individual
and market demand curves, shifting of the demand curve, elasticity of demand,
Consumer behavior, Marshallian utility approach and Indifference Curve
approach; utility maximization conditions. Income-Consumption Curve (ICC)
and Price-Consumption Curve (PCC)
Unit: II Production and Cost
Production function: Short-run and Long-run; Total Product, Average Product
and Marginal Product, Law of returns to a variable factor, Law of Returns to
Scale; Concepts of Iso-quant and iso-cost line; Cost: Accounting and Economic
Costs; Social and Private Costs; Short-run and Long-run Costs; Relation
between Average and Marginal
Unit: III Perfect Competition
Concept of Perfectly Competitive market: Assumptions, Profit maximization
conditions; Related concepts of Total Revenue, Average Revenue and Marginal
Revenue, Short-run and Long- run equilibrium of a firm; determination of short-
run supply curve of a firm, measuring producer surplus under perfect competition
Unit: IV Imperfect Competition Monopoly
Concept of Monopoly: Sources of monopoly power; Short-run and Long-run
equilibrium of a monopoly firm; Price discrimination; Social Cost of Monopoly
(concept only).
Monopolistic Competition
Concept of Imperfectly Competitive market; Monopolistic Competition:
Features and examples; Oligopoly: Non-Collusive Oligopoly: Sweezy’s Kinked
demand Curve Model, Collusive Oligopoly: Cartel (concept with example)
Learning Outcomes: The students would be able to apply tools of consumer
behaviour and firm theory to business situations.