MICRO ECONOMICS

CHAPTER-1

INTRODUCTION

I. Choose the correct answer (each question carries 1 mark)

1. The scarce resources of an economy have

(a) Competing usages (b) Single usages
(c) Unlimited usages (d) none of the above
Ans: (a) Competing usages
2. Which of the following in an example of micro economic study?
(a) National income (b) Consumer Behaviour
(c) Unemployment (d) Foreign trade
Ans: (b) Consumer behaviour
4. Central problems of an economy includes
(a) What to produce (b) How to produce
(c) For whom to produce (d) All of the above
Ans: (d) All of the above
5. Traditionally, the subject matter of economics has been studied under the following broad
branches.
(a) Micro and macro Economics (b) Positive and Normative
(c) Deductive and Inductive (d) None of the above
Ans: (a) Micro and Macro Economics.
II. Fill in the blanks (each questions carries 1 marks)
1. Scarcity of resources gives raise to.....................
Ans: Problem of choice
2. In a centrally planned economy all important decisions are made by ………………
Ans: Government
3. …………. is a set of arrangement where economic agents can freely exchange their endowments
with each other.
Ans: Market
4. In reality all economies are …………………..
Ans: Mixed Economies.
III. Match the following (each question carries 1 mark)

1. Market economy a. Government

2. Service of a Teacher b. Private
3. Centrally planned economy c. Skill
4. Positive economics d. Evaluate the Mechanism
5. Normative economics e. Functioning of Mechanism
Ans: 1-b; 2-c; 3-a; 4-e; 5-d;

IV. Answer the following questions in a sentence/word. (each question carries 1 mark)

1. Why does the problem of choice arise?

Ans: An economic problem arises because of limited resources, unlimited wants and alternative
uses of resources.
 2. What is market economy?
Ans: A market economy is that economy where economic decisions are undertaken on the basis of
market mechanism by the private entrepreneurs. It is also known as capitalistic economy.
3. What do you mean by centrally planned economy?
Ans: A planned economy is that economy where the economic activities are controlled by the
central Government.
4. Give the meaning of micro economics.
Micro economics studies small units of an economy.
5. What do you mean by positive economics?
The positive economics is the study of „what was‟ and „what is‟ under the given set of
circumstances. It deals with the scientific explanation of the working of the economy.
6. What is normative economics?
Ans: The Normative economics studies „what ought to be‟. It explains about „what should be and
should not be done‟.
V. Answer the following in 4 sentences. (each question carries 2 marks)

1. Mention the central problems of an economy.

Ans: The central problems of an economy are as follows:
a) What goods are to be produced and in what quantities?
b) How the goods are to be produced?
c) For whom the goods are to be produced?
2. Distinguish between Micro and Macro economics.

Micro Economics Macro Economics

 Micro Economics study in individual  Macro Economics study in aggregates
units  Its scope is wider
 Its scope is narrow  Follows lumping method
 Follows slicing method

5. Distinguish between positive and normative economics.

Positive Economics Normative Economics

 Here we study how the different  Here we try to understand whether the
mechanisms function different mechanisms are desirable or not
 It deals with the scientific explanation of  It explains about „what should be and
the working of the economy. should not be done‟.

6. What do you mean by production possibility set?

Ans: The collection of all possible combinations of the goods and services that can be produced
from a given amount of resources and a given stock of technological knowledge is called the
production possibility set of the economy.
7. What is opportunity cost?
Ans: An opportunity cost is the cost of having a little more of one good in terms of the amount of
the other good that has to be forgone. This is known as the opportunity cost of an additional unit of
the goods.
8. What is production possibility frontier?
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Ans: The production possibility frontier gives the combinations of two commodities (cotton and corn) that
can be produced when the resources of the economy are fully utilized. It is also called as Production
possibility curve (PPC) also known as transformation curve.

VI. Answer the following question in 12 sentences. (each question carries 4 mark)

1. Briefly explain how the family farm, weaver and Teacher can use their resources to fulfill
their needs in a simple economy.
Ans: People in the society need many goods and services in their everyday life including food,
clothing, shelter, transport facilities, postal services and various other services like that of teachers
and doctors. In fact, the list of goods and services that any individual needs is so large that no
individual in society has all the things he needs.
Every individual has some amount of only a few of the goods and services that he would
like to use. A family farm may own a plot of land, some grains, farming implements, may be a pair
of bullocks and also the labour services of the family members.
A weaver may have some yarn, some cotton and other instruments required for weaving
cloth.
The teacher in the local school has the skills required to impart education to the students.
Each of these decision making units can produce some goods or services by using the
resources that it has and use part of the produce to obtain the many other goods and services which
it needs.
For instance, the family farm can produce corn, use part of the produce for consumption
purposes and procure clothing, housing and various services in exchange for the rest of the
produce.
Similarly, the weaver can get the goods and services that he wants in exchange for the cloth
he produces in his yarn. The teacher can earn some money by teaching students in the school and
use the money for obtaining the goods and services that he wants.
Thus, each individual can use his resources o fulfill his needs. It is said that no individual
has unlimited resources compared to his needs. The quantity of corn that the family farm can
produce is limited by the quantity of resources it has and hence the amount of different goods and
services that it can procure in exchange of corn is also limited. As a result, the family is forced to
make a choice between the different goods and services that are available. It can have more of a
good or service only by giving up some amounts of other goods or services.
2. Briefly explain the production possibility frontier.
Ans: The production possibility frontier is a graphical representation of the combinations of two
commodities (cotton and wheat) that can be produced when the resources of the economy are fully
utilized. It is also called as Production possibility curve (PPC) also known as transformation curve.
It gives the combinations of cotton and wheat that can be produced when the resources of
the economy are fully utilized. The production possibility frontier can be explained with the help
of following table.

Combination Cotton Wheat

 A 10 0
B 8 1
C 5 2
D 2 3
E 0 4

As per the above table, if a country uses all its resources to grow cotton, it can grow a maximum of
10 units, which is shown in combination A. Similarly, if all the resources are used to grow wheat,
it can grow a maximum of 4 units of wheat. If the resources are to be used to grow both the
commodities, the combinations of B, C or D can be chosen.

This can be graphically represented as follows:

y
A
B
C
Cotton D

E
O Wheat x

In the above diagram, the combinations A to E, lying on the production possibility curve
represent that a country can produce both the commodities with the help of available resources and
technology. If the points lying strictly below the production possibility curve, it represents a
combination of cotton and wheat, that will be produced when all or some of the resources are
either underemployed or are utilized in a wasteful fashion.

3. Briefly explain the central problems of an economy.

Ans: An economic system or economy is a mechanism where the scarce resources are channelized
on priority to produce goods and services. These goods and services produced by all the sectors of
the economy determine the national income.
Generally, human wants are unlimited and resources to satisfy them are limited. If there
was a perfect match between human wants and availability of resources there would have been no
scarcity, no problem of choice and no economic problems at all. So, one has to select the most
essential want to be satisfied with limited resources. In economics, this problem is called „Problem
of Choice‟.
The problem of choice arising out of limited resources and unlimited wants is called
economic problem. Every economy whether developed or underdeveloped, Capitalistic or
socialistic or mixed economy, there will be three basic economic problems viz., What to produce,
How to produce and For whom to produce. Let us discuss in detail.

a) What to Produce i.e., what is to be produced and in what quantities:: Every country has to
decide which goods are to be produced and in what quantities. Whether more guns should be
produced or more foodgrains should be grown or whether more capital goods like machines,
tools, etc., should be produced or more consumer goods (electrical goods, daily usable products
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etc.) will be produced. What goods to be produced and in what quantity depends on the
economic system of the country. In socialistic economy, the Government decides and in
Capitalistic economy market forces decide and in mixed economy both the Government and
market forces provide solutions to this problem.
b) How to Produce i.e., how are goods produced?: There are various alternative techniques of
producing a product. For example, cotton cloth can be produced with either handloom or
power looms. Production of cloth with handloom requires more labour and production with
power loom use of more machines. It involves selection of technology to produce goods and
services.
There are two types of techniques of production viz., (a) Labour intensive technology and
(b) capital intensive technology.
The firm has to decide whether production be based on labour intensive or capital intensive
techniques. Obviously, the choice of technology would depend on the availability of different factors of
production (land, labour, capital) and their relative prices (rent, wages, interest).
c) For whom to produce i.e., for whom are the goods to be produced: Another important
decision which an economy has to take is for whom to produce. The economy cannot satisfy all
wants of all the people. Therefore, it has to decide who should get how much of the total output
of goods and services. The society has to decide about the shares of different groups of people-
poor, middle class and the rich, in the national output.

Thus, every economy faces the problem of allocating the scarce resources to the production
of different possible goods and services and of distributing the produced goods and services among
the individuals within the economy. The allocation of scarce resources and the distribution of the
final goods and services are the central problems of any economy.

4. Write a short note on a centrally planned economy.

Ans: A planned economy also called as socialistic economy is that economy where the economic
activities are controlled by the central Government. Here, the Government takes decisions about
the allocation of resources in accordance with objectives to attain economic and social welfare.
Example, Russia, China, North Korea etc.
In a centrally planned economy, the basic economic problems are solved as follows:
In centrally planned economy, the Government takes decisions about the allocation of resources in
accordance with the predetermined goals and objectives to attain maximum social welfare.
Government decides what to produce, how to produce and what prices are to be fixed.
 Regarding what to produce, the Government may produce those goods and services
which are most useful for its society.
 Regarding how to produce, the most suitable technique in production is adopted
whether labour intensive or capital intensive in accordance with the situation in the
economy.
 Regarding whom to produce, the goods and services are produced to those people who
are suffering from hunger though there is a loss.
 It gives importance to the quality of life rather than quantity of production.
 It focuses the resources on rapid economic development.

5. Write a short on market economy.

 Ans: A market economy also known as capitalistic economy is that economy in which the
economic decisions are undertaken on the basis of market mechanism by the private entrepreneurs.
It functions on demand and supply conditions. In USA, Japan, Autralia, UK and other countries we
can see Market Economic systems.
In market economy, private individuals own the factors of production. Here, the profit is
the main goal of business. There is least intervention of Government.
Price mechanism plays a major role in market economy. It is a balancing wheel of the
market mechanism. Prices coordinate decisions of the producers and consumers. The price is
determined by demand and supply in the market. No individual organization or Government is
responsible for the production and distribution or pricing of goods. All depend on market
mechanism.
Regarding basic problems of an economy, the problem of what to produce is solved on the
basis of demand and profit. The producers produce those products which bring more income.
The problem - how the goods are to be produced is determined by the competition among
different entrepreneurs. The select least cost combination of technology so that they can get more
returns with less cost.
In market economy, the problem of whom to produce is decided on the basis of purchasing
power of consumers. The producers produce commodities to the rich as they can afford to pay
more but poorer sections of the society are neglected.
In Market economy, profits and losses play a predominant role in growth and development
of every producer.

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CHAPTER-2

CONSUMER BEHAVIOUR

I Choose the correct answer

1. Utility is
a) Objective c) Both a and b
b) Subjective d) None of the above
Ans: (b) Subjective
2. The shape of an Indifference curve is normally
a) Convex to the origin c) Horizontal
b) Concave to the origin d) Vertical
Ans: (a) Convex to the origin
3. The consumption bundle that are available to the consumer depend on
a) Colour and shape c) Income and quality
b) Price and income d) None of the above
Ans: (b) Price and income
4. The equation of Budget line is
a) Px+p1x1=M c) P1x1+p2x2=M
b) M=P0X0+Px d) Y=Mx+C
Ans: c) P1x1+p2x2=M
5. The demand for these goods increases as income increases
a) Inferior goods c) Normal goods
b) Giffen goods d) None of the above
Ans: (c) Normal goods
6. A vertical demand curve is
a) Perfectly elastic c) Unitary elastic
b) Perfectly inelastic d) None of the above
Ans: (b) Perfectly inelastic
7. Ordinal utility analysis expresses utility in
a) Numbers c) Ranks
b) Returns d) awards
Ans: (c) Ranks

II Fill in the blanks

1. Wants satisfying capacity of commodity is ……………….
Ans: Utility
2. Two indifference curves never ……………….. each other.
Ans: Intersect
3. As income increases, the demand curve for normal goods shifts towards………………….
Ans: Rightward
 4. The demand for a good moves in the …………………….direction of its price
Ans: Opposite
5. Method of adding two individual demand curve is called as……………………
Ans: Horizontal summation

III Match the following

A B
1. Demand curve a) D(p)=a-bp
2. Linear Demand curve b) Downward sloping
3. Unitary elasticity of demand c) Pen and ink
4. Complementary goods d) A family of Indifference curve
5. Indifference map e) |ed|=1

Ans: 1-b; 2-a; 3-e; 4-c; 5-d;

IV Answer the following questions in a sentence or a word

1. What is budget line?
Ans: The line which consists of all bundles of goods cost exactly equal to the money
income of consumer is called budget line.
2. What do you mean cardinal utility analysis?
Ans: When the utility is measured in numbers like 1,2,3,4…., it is called as cardinal utility
analysis.
3. Give the meaning of marginal utility.
Ans: It is the additional utility derived by the consumer by consuming additional unit of a
commodity. It represents the utility of single unit.
4. What is utility?
Ans: Utility refers to the want-satisfying power of a commodity or a service.
5. Expand MRS.
Ans: Marginal Rate of Substitution.
6. What do you mean by indifference curve?
Ans: Indifference curve shows the different combinations of two goods in which the
consumer gets equal level of satisfaction.
7. What is demand?

Ans: The concept „demand‟ refers to the quantity of a good or service that a consumer is
willing and able to purchase at various prices, during a period of time.

V Answer the following in 4 sentences

1. What are the differences between budget line and budget set?

Budget Line Budget Set

 It represents different combinations of  It is a collection of all bundles
two goods which the consumer available to a consumer at the
consumes and whose prices are existing price at his given level of
exactly equal to his income. income.
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 It is also known as Price line.  It is also known as opportunity set

2. What do you mean by inferior goods? Give example.

Ans: The inferior goods are those goods for which the demand falls with the increase in
income of consumer. Here demand for such goods move in the opposite direction of the
income of the consumer. That is, there will be a negative relationship between income of
consumer and demand for inferior goods. Example: Low quality goods.

3. What is monotonic preference?

Ans: A consumer‟s preferences are said to monotonic if and only if between any two
bundles, the consumer prefers the bundle which has more of at least one of the goods and
no less of the other good as compared to the other bundle.
For instance, the consumer, between any bundles say (x1,x2) and (y1, y2), if (x1,x2)
has more of at least one of the goods and no less of the other good compared to (y1, y2) then
the consumer prefers (x1,x2) to (y1, y2). This is called monotonic preferences.
Here the consumer will not remain indifferent between two combinations of
commodities when he has an opportunity to have more quantity in one combination than
the other.

4. State the law of demand?

Ans: Law of Demand states that other things being equal, there is a negative relation
between demand for a commodity and its price.
In other words, when price of the commodity increases, demand for it falls and
when price of the commodity decreases, demand for it rises, other factors remaining the
constant.
5. Mention two different approaches which explain consumer behavior.
Ans:
a) Cardinal Utility Analysis – Law of Diminishing Marginal Utility
b) Ordinal Utility Analysis – Indifference Curve analysis
6. What do you mean by price elasticity of demand?
Ans: Price elasticity of demand is a measure of the responsiveness of the demand for a
good to changes in its price.
It is measured by using the following formula.
PED = Percentage change in demand for the good
Percentage change in price of the good

VI Answer the following questions in 12 sentences

1. Write the differences between total utility and marginal utility.

Total Utility Marginal Utility

 It is the aggregate utility derived by the  It is the additional utility derived by
consumer by consuming all the units. the consumer by consuming
  It represents utility of all the units additional unit
consumed.  It represents the utility of single unit.
 It may be symbolically written as
TUn=U1+U2+U3+U4………….Un.  It may be written as
 It increases in the beginning and later MUn=TUn-TUn-1.
decreases as the consumer consumes  It decreases from the beginning and
more and more units. becomes negative later.

2. Briefly explain the budget set with the help of a diagram.

Ans: The budget set is the collection of products that the consumer can buy with his
income at the prevailing market prices. The Budget set is also known as opportunity set. It
includes all the bundles (all possible combination of two goods) which the consumer can
purchase with his given level of income.
The budget equation can be written as follows:
P1X1 + P2 X2 ≤ M.
Consider, for example, a consumer who has Rs.20 and suppose, both the goods are
priced at Rs.5 and are available only in integral units. The bundles that this consumer can
afford to buy are; (0,0), (0,1), (0,2), (0,3), (0,4), (1,0), (1,1), (1,2), (1,3), (2,0), (2,1), (2,2),
(3,0), (3,1) and (4,0).
Among these bundles, (0,4), (1,3), (2,0), (2,2), (3,1) and (4,0) cost exactly Rs.20
and all the other bundles cost less than Rs.20.
If both the goods are perfectly divisible, the consumer‟s budget set would cosist of
all bundles (x1,x2) such that x1 and x2 are any numbers greater than or equal to 0 and P1X1
+ P2 X2 ≤ M.
The budget set can be represented in a diagram as follows:
Y

Mangoes

M/P2

P1X1 + P2 X2 =M.

O Banana M/P1 X

Quantity of bananas is measured along the horizontal axis and quantity of mangoes
is measured along the vertical axis. Any point in the diagram represents a bundle of the two
goods. The budget set consists of all points on or below the straight line having the
equation P1X1 + P2 X2 =M.
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3. Explain the derivation of slope of the budget line.

Ans: The slope of the budget line measures the quantity of change in one product required
per unit of change in another product along the budget line.
For example, the amount of change in mangoes required per unit of change in
bananas along the budget line is the derivation of slope of the budget line. It can be
represented in diagram as follows:

M/P2

(x1, x2)

Mangoes ∆x2

(x1 + ∆x1, x2+∆x2)

∆x1

O Banana M/P1 X

The absolute value of the slope of the budget line measures the rate at which the
consumer is able to substitute bananas for mangoes when she spends her entire budget.
Let us consider two points (x1, x2) and (x1 + ∆x1, x2+∆x2) on the budget line. It will
be as follows:

P1X1 + P2 X2 =M……………..(1)

P1 (x1 + ∆x1) + P2( x2+∆x2)=M …………(2)

Now subtracting (1) from (2), we get

P1∆x1+ P2∆x2=0…………….(3)

By rearranging terms in (3) we get

 ∆x2/∆x1 = -P1/P2 ....................(4).

Therefore, the slope of the budget line is -P1/P2. The means, the Indifference curve is negatively
sloped i.e., it slope downwards. An increase in the amount of bananas along the indifference curve is
associated with a decrease in the amount of mangoes.

4. Explain the indifference map with the diagram.

Ans: A family of indifference curves is called as indifference map. It refers to a set of
indifference curves for two commodities showing different levels of satisfaction. The
higher indifference curves show higher level of satisfaction and lower Indifference Curve
represent lower satisfaction. A rational consumer always chooses more of that product that
offers him a higher level of satisfaction which is represented in higher Indifference Curve.
It is also called „Monotonic preferences‟.
The consumer‟s preferences over all the bundles can be represented by a family of
indifference curves as shown in the following diagram.

Y
Mango

O Banana X
In the above diagram, we see the group of three indifference curves showing different
levels of satisfaction to the consumer. The arrow indicates that bundles on higher
indifference curves are preferred by the consumer to the bundles on lower indifference
curves.

5. Write the differences between substitutes and complements.

Substitute goods Complementary goods
 These are alternative goods available to  These are the goods which are consumed
satisfy our wants. together.
 If the price of a product increases, the  If the price of a product increases, the
demand for its substitute also increases. demand for its complementary good
 Example for substitute goods are Tea decreases.
and Coffee, Colgate and Pepsodant, etc.  Example for complementary goods are
 Here the demand curve shifts to the Pen and Ink, Shoes and socks etc
right in case of price rise.  Here the demand curve shifts to left in
 Price and demand move in same case of price rise.
direction.  Price and demand move in opposite
directions.
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6. Explain the differences between normal and inferior goods with examples.
Normal goods Inferior goods
 These are the goods for which the  These are the goods for which the
demand increases with the increase demand decreases with the increase
in the income of consumer. in the income of consumer.
 Example for normal goods are  Example for inferior goods are low
food, cloths, electronic goods, quality of goods like unbranded
luxury goods etc. products.
 There is positive relationship  There is inverse relationship
between income and demand. between income and demand.
 Here the demand curve shifts  Here the demand curve shifts
towards right if the income of towards left if the income of
consumer increases. consumer increases.

VII Answer the following questions in 20 sentences

1. Explain the law of diminishing marginal utility with the help of a table and diagram.

Introduction: One of the most important propositions of the cardinal utility approach to demand
was the Law of Diminishing Marginal Utility. German Economist Gossen was the first to explain
it. Therefore, it is called Gossen‟s First Law. But it was popularized by Prof.Alfred Marshall.

Definition:

According to Alfred Marshall, “The additional benefit which a person derives from a given
increase of a stock of a thing diminishes, other things being equal, with every increase in the stock
that he already has”.

This law simply tells us that, we obtain less and less utility from the successive units of a
commodity as we consume more and more of it.

This law has few assumptions like, size of the commodity should be uniform, consumption
should be continuous, no change in price, consumer behaves rationally, no change in tastes and
preferences of consumer and the utility is measured in cardinal numbers.

Explanation:

The basis of this law is that every want needs to be satisfied only upto a limit. After this
limit is reached the intensity of our want becomes zero. It is called complete satisfaction of the
want. Therefore, as we consume more and more units of a commodity to satisfy our need, the
intensity of our want for it becomes less and less. Therefore, the utility obtained from the
consumption of every unit of the commodity is less than that of the units consumed earlier. This
can be explained with the help of the following table. TU- Total Utility, U- Marginal Utility.

Units of TU MU
 Apples

1 40 40

2 70 30

3 90 20

4 100 10

5 100 0

6 90 -10

Suppose a man wants to consume apples and is hungry. In this condition, if he gets one
apple, he has very utility for it. Let us say that the measurement of this utility is equal to 40 utils.
Having eaten the first he will not remain so hungry as before. Therefore, if he consumes the
second apple he will have a lesser amount of utility from the second apple even if it was exactly
like first one. The utility he got from the second apple equals 30 units, the third and fourth apples
give him utility equal to 20 and 10 respectively. Now, if he is given the 5th apple he has no use for
it. That means the utility of the 5th apple to the consumer is zero. It is just possible that if he is
given the 6th apple for consumption, it may harm him. Here the utility will be negative ie., -10.
Therefore, we are clear that the additional utility of the successive apples to the consumer goes on
diminishing as he consumes more and more of it.

The Law of Diminishing Marginal Utility can be explained with the help of the following
diagram.

Y T (highest utility)

TU

Initial Utility

Utility

Satiety

No. of Apples MU

Negative Utility
 15

In the diagram the horizontal axis shows the units of apples and the vertical axis measures
the MU and TU obtained from the apple units. The total utility Curve will be increasing in the
beginning and later falls. The Marginal Utility curve is falling from left down to the right clearly
tells us that the satisfaction derived from the successive consumption of apples is falling.

The Marginal Utility of the first apple is known as initial utility. It is 40 utils. The
Marginal utility of the 5th apple is Zero. Therefore, this point is called the satiety point. The
Marginal Utility of the 6th apple is -10. So, it is called Negative utility and lies below the X axis.

2. Explain the features of Indifference curves with the help of diagrams.

Ans: The main features of Indifference curves are as follows:
a) Indifference curve slopes downwards from left to right: An indifference curve
slopes downwards from left to right because, the consumer in order to have more of
units of one commodity, he has to forego some units of other commodity. This can be
explained with the help of diagram.

Mangoes

(x1,x2)

∆x2

(x1 + ∆x1, x2+∆x2)

∆x1

O Banana X

Thus, according to above diagram, as long as the consumer is on the same indifference curve, an
increase in bananas must be compensated by a fall in quantity of mangoes. That means, an increase
in the amount of bananas along the indifference curve is always associated with a decrease in the
amount of mangoes.
b) Higher indifference curve gives greater level of utility: As long as marginal utility of a
commodity is positive, a consumer always prefers more of that commodity to increase his level of
satisfaction. This can be explained with the help of table and a diagram:
Combination Banana Mango
A 1 10
B 2 10
C 3 10
 Y
Mango

10 A B C
IC3

IC2
IC1
O 1 2 3 Banana X
Let us consider the different combinations of two goods bananas and mangoes A, B
and C in the above table and diagram. All the three combinations consist of same quantity
of mangoes but different quantities of bananas. As combination B has more bananas than
A, B will provide the consumer higher level of satisfaction than A. Therefore, B will lie on
higher indifference curve. Similarly, C has more bananas than B and therefore C will
provide higher level of satisfaction than B and also lie on higher indifference curve than B.
Thus higher indifference curves give greater level of utility.
c) Two indifference curves never intersect each other: The two indifference curves
never intersect with each other. This is because, if the two indifference curves intersect
each other, they will give conflicting results. This can be explained with the help of
diagram.

Mango

B IC2

C IC1

O Banana X

In the above diagram the two indifference curves have intersected with each
other. As points A and B lie on IC2, utilities derived from A and B are same. Similarly, as points A
and C lie on the same indifference curve IC1, the utilities are same. From this, it follows that utility
from points B and C are same. But this is clearly an absurd result as on B, the consumer gets a
greater number of mangoes with the same quantity of bananas. So the consumer is better off at
point B than at Point C. Thus, it is clear that intersecting indifference curves will lead to
conflicting results. Thus, two indifference curves cannot intersect each other.

3. Explain the optimal choice of consumer with the help of diagram.

 17

It is assumed that the consumer chooses her consumption bundle on the basis of her
taste and preferences over the bundles in the budget set. It is generally assumed that the
consumer has well defined preferences over the set of all possible bundles. She can
compare any two bundles. In other words, between any two bundles, she either prefers one
to the other or she is indifferent between the two goods.
It is further assumed that the consumer is a rational individual. A rational
individual clearly knows what is good or what is bad for her and in any given situation, she
always tries to achieve the best for herself. From the bundles which are available to her, a
rational consumer always chooses the one which gives her maximum satisfaction. The
consumer always tries to move to a point on the highest possible indifference curve given
her budget set.
Thus, the optimum point would be located on the budget line. A point below the
budget line cannot be the optimum. Compared to a point below the budget line, there is
always some point on the budget line which contains more of at least one of the goods and
no less of the other. Thus, the consumer‟s preferences are monotonic.
The point at which the budget line is tangent to one of the indifference curves
would be the optimum choice of consumer. This is because, the budget line other than the
point at which it touches the indifference curves lies on a lower indifference curve is
considered as inferior. So such a point cannot be the consumer‟s optimum. The optimum
bundle is located on the budget line at the point where the budget line is tangent to an
indifference curve.
This can be explained with the help of the following diagram.

Y
P
(x1,x2)
Mango

IC3
IC2
IC1
O Banana Q X
In the above diagram, PQ is budget line, IC1, IC2 and IC3 are indifference
curves showing different levels of satisfaction. Banana is measured in OX axis and Mango
is measured in OY axis.
The above diagram illustrates the consumer‟s optimal choice also known as consumer‟s
equilibrium. At (x1,x2), the budget line PQ is tangent to the indifference curve IC2. The
indifference curve just touching the budget line is the highest possible indifference curve
given the consumer‟s budget set. Bundles on the indifference curve above IC2 are not
affordable. Points on the indifference curve IC1 are certainly inferior to the points on the
IC2. Therefore, (x1,x2) is the consumer‟s optimum bundle.
4. Explain the movement along the demand curve and shift in demand curve with the
help of two diagrams.
It is important to note that the amount of a good that the consumer chooses depends on
the price of the good, the prices of other goods, income of the consumer and her tastes and
preferences. The demand function is a relation between the amount of the good and its
price when other things remain constant.

Movements along the Demand Curve: The demand curve is a graphical representation of
the demand function. At higher prices, the demand is less and at lower prices, the demand
is more. Thus, any change in the price leads to movements along the demand curve. This
can be shown in diagram as follows:

Price

O quantity X
On the other hand, changes in any of the other things like, income of consumer,
price of related goods (substitutes and complementary goods) and tastes and preferences,
lead to a shift in the demand curve. The following two diagrams depict the movement
along the demand curve and a shift in the demand curve.

Y
D D1

Price

D D1

O quantity X
 19

The above diagrams show movement along a demand curve and shift of a demand curve.
Diagram (a) depicts a movement along the demand curve and diagram (b) depicts a shift in the
demand curve.

5. Explain the market demand with the help of diagrams.

Ans: The market demand for a good at a particular price is the total demand for all
consumers taken together. The market demand for a good can be derived from the
individual demand curves. Suppose there are two consumers in the market. The market
demand curve can be explained in with the help of following diagrams:

Y Y D2
D1 price price

P P P
P1
P1 P1
D1 D2 DM

O q1 q1’ O q2 q2’ O q1+q2 q1’+q2’

quantity
In the above diagrams, D1 is demand curve of consumer 1 and D2 is the demand
curve of Consumer 2. Suppose at price P the demand of consumer 1 is „q1‟ and that of
consumer 2 is „q2‟ then the market demand of the good at P is q1+q2.
Suppose at price P1, the demand of consumer is 1 is q1‟ and that of consumer 2 is
q2‟. Then the market demand at P1 will be q1‟+ q2‟. So the market demand curve can be derived
as a horizontal summation of the individual demand curves.
Thus, the market demand for the good at each price can be derived by adding up the
demands of the two consumers at that price. If there are more than two consumers in the
market for a good, the market demand can be derived similarly.
VIII Assignment and project oriented question
1. A consumer wants to consume two goods. The Price of bananas is Rs.5 and price of
mangoes is Rs.10. The consumer income is Rs.40.
a) How much bananas can she consume if she spend her entire income on that good
b) How much mangoes can she consume if she spend her entire income on that good
c) Is the slope of budget line is downward or upward
d) Are the bundles on the budget line equal to the consumers’ income or not
e) If you want to have more of banana you have to give up mangoes. Is it true?

Ans: (a) 8 Bananas (40/5)

 (b) 4 Mangoes (40/10)

(c) Slope of budget line is downward.

(d) Yes, the bundles on the budget line are equal to the consumer‟s income.

(e) True. If we want to have more of banana we have to give up mangoes.

******

CHAPTER 3

PRODUCTION AND COST

I Choose the correct answer

1. The formula of production function is

a) q=f(L, K) c) Y=f(x)
b) q=d(p) d) None of the above.
Ans: (a) q=f(L, K)

2. In the short run, a firm

a) Can change all the inputs c) can keep inputs fixed
b) Cannot vary all the inputs d) None of the above
Ans: (b) Cannot vary all the inputs

3. The change in output per unit of the change in the input is called
a) Marginal product c) Total product
b) Average Product d) Product
Ans: (a) Marginal product

4. Cobb-Douglas production function is

a) q=(x, x) c) q= (x1α, x2β)
b) q=(x1, x2) d) q=(0)
Ans: c) q= (x1 , x2β)
α

5. TC=
a) TVC c) TFC+TVC
b) TFC d) AC + MC
Ans: c) TFC+TVC

II Fill the blanks

 21

1. In the long run, all inputs are ……………

Ans: Variable
2. …………..is defined as the output per unit of variable input.
Ans: Average Product
3. Marginal product and average product curves are …………in shape.
Ans: Inverse U
4. SMC curves cuts the AVC curve at the …………point of AVC curve from below.
Ans: Minimum
5. …………….is the set of all possible combinations of the two inputs that yield the same maximum
possible level of output.
Ans: Isoquant

III Match the following

A B
1. CRS a) ΔTC/Δq
2. SAC b) Long run Average cost
3. LRAC c) Short run Average cost
4. TFC+TVC= d) Constant returns to scale
5. SMC e) TC

Ans: 1 - (d); 2 - (c); 3 - (b); 4 – (e); 5 – (a)

IV Answer the following questions in a sentence or word

1. What do you meant by total product?

Ans: Total product is the relationship between a variable input and output when all other inputs are
held constant.
Suppose we vary a single input and keep all other inputs constant. Then for different levels
of that input, we get different levels of output. This relationship between the variable input and
output, keeping all other inputs constant, is often referred to as Total Product of the variable input.
2. What is Average product?
Ans: Average Product is defined as the output per unit of variable input. We calculate it as
APL=TPL/L.
3. Give the meaning of marginal product.
Ans: Marginal Product of an input is defined as the change in output per unit of change in the input
when all other inputs are held constant. It is the additional unit of output per additional unit of
variable input. It is calculated by dividing the change in output by change in input labour.
MPL = ∆TPL/∆L.
4. Write the meaning of cost function of the firm.
Ans: The cost function of the firm refers to the least cost of producing each level of output, given
prices of factors of production and technology.
5. What is total fixed cost?
 Ans: The cost that a firm incurs to employ fixed factors of production (inputs) is called as Total
Fixed Cost.
6. What is average fixed cost?
Ans: Average fixed cost is the cost per unit of fixed input. It is obtained by dividing the values of
the Total Fixed cost by output. The formula to calculate Average Fixed cost is
AFC = TFC/q.

V Answer the following questions in four sentences.

1. What is Isoquant?
Ans: An isoquant is the set of all possible combinations of the two inputs that yield the same
maximum possible level of output. Each isoquant represents a particular level of output and is
labelled with that amount of output. It is just an alternative way of representing the production
function.
2. Give the meaning of the concepts of short run and long run.
Ans: The concepts of short run and long run are defined as a period simply by looking at whether
all the inputs can be varied or not. It is not advisable to define short run and long run in terms of
days, months or years.
In the short run, at least one of the factor – labour or capital cannot be varied and therefore,
remains fixed. In order to vary the output level, the firm can vary only the other factor. The factor
that remains fixed is called the fixed factor and the other factor which the firm can vary is called
the variable factor.
In the long run, all factors of production can be varied. A firm in order to produce different
levels of output in the long run may vary both the inputs simultaneously. So, in the long there is no
fixed factor.
3. Mention the types of returns to scale.
Ans: The types of returns to scale are
(a) Constant Returns to Scale
(b) Increasing Returns to Scale
(c) Decreasing Returns to Scale
4. Name the short run costs.
Ans: The short run costs are: Total Fixed cost, Total Variable cost, Total Cost, Average Fixed
Cost, Average Variable Cost, Average Cost and Marginal Cost.
5. What are long costs?
Ans: There are two long run costs namely, (a) Long run Average Cost (b) Long run Marginal Cost.

VI Answer the following questions in 12 sentences.

1. Explain isoquant with the help of a diagram.

Ans: An isoquant is the set of all possible combinations of the two inputs that yield the same
maximum possible level of output. Each isoquant represents a particular level of output and is
labelled with that amount of output. It is just an alternative way of representing the production
function.
 23

The concept of isoquant can be explained with the help of following diagram:

Capital

K2

K1
q=q3
q=q2
q=q1
O L1 L2 L3 Labour X

The above diagram generalizes the concept of isoquant. In the above diagram, labour
is measured in OX axis and Capital is measured in OY axis. There are 3 isoquants for the three
output levels viz., q=q1, q=q2 and q=q3. Two input combinations (L1, K2) and (L2, K1) give us the
same level of output q1. If we fix capital at K1 and increase labour to L3, output increases and we
reach a higher isoquant q=q2. When Marginal products are positive, with greater amount of one
input, the same level of output can be produced only using lesser amount of the other. Therefore,
isoquants curves slope downwards from left to right (negatively sloped).

2. Explain TP, MP and AP with the example.

Ans: The TP – total product, MP- marginal product and AP – Average Product
Total Product:
Total product is the relationship between a variable input and output when all other inputs are held
constant. Suppose we vary a single input and keep all other inputs constant. Then for different
levels of that input, we get different levels of output. This relationship between the variable input
and output, keeping all other inputs constant, is often referred to as Total Product of the variable
input.
Average product
 Average Product is defined as the output per unit of variable input. We calculate it as APL=TPL/L,
where APL is the Average Product of Labour, TPL is the Total product of labour and L is the
amount of labour input used.
Marginal Product
Marginal Product of an input is defined as the change in output per unit of change in the input
when all other inputs are held constant. It is the additional unit of output per additional unit of
variable input. It is calculated by dividing the change in output by change in input labour.
MPL = ∆TPL/∆L.
The concepts of TP, AP and MP can be explained with the help of following table:

Labour TP MPL APL

0 0 - -
1 10 10 10
2 24 14 12
3 40 16 13.33
4 50 10 12.5
5 56 6 11.2
6 57 1 9.5
The above table shows the total product of labour, Marginal product of labour and Average
product of labour. The total product is also sometimes called as total return to or total physical
product of the variable input labour. The third column gives us a numerical example of Marginal
product of labour. The values in this column are obtained by dividing change in TP by change in
Labour. The last column gives us a numerical example of average product of labour. The values in
their column are obtained by dividing TP by Labour.
3. Write a brief note on returns to scale.
Ans: The returns to scale can happen only in the long run as both the factors (Labour and Capital)
can be changed. One special case in the long run occurs when both factors are increased by the
same proportion or factors are scaled up.
 Constant returns to scale: When a proportional increase in all inputs results in an increase
in output by the same proportion, the production function is said display constant returns to
scale.
 Increasing returns to scale: When proportional increase in all inputs results in an increase
in output by a larger proportion, the production function is said to display increasing
returns to scale.
 Decreasing returns to scale: When a proportional increase in all inputs results in an
increase in output by a smaller proportion, the production function is said to display
decreasing returns to scale.
For example, if in a production process, all inputs get doubled. As a result, if the
output gets doubled, the production function exhibits constant returns to scale, if output is
less than doubled, exhibits decreasing returns to scale and if is more than doubled, exhibits
increasing returns to scale.
4. Explain the long run costs.
 25

Ans: In the long run, all inputs are variable. There are no fixed costs, The total cost and the total
variable cost coincide in the long run. There are two types of long run costs. They are as follows:
a) Long Run Average Cost (LRAC): The long run average cost is the cost per unit of output
produced. It is obtained by dividing the Total Cost by the output produced. It can be calculated
as follows:
LRAC = TC/q
Where TC is Total cost and „q‟ is quantity of output produced.
b) Long Run Marginal Cost: The long run marginal cost is the change in total cost per unit of
change in output. When output changes in discrete units, then, if we increase production from
q1-1 to q1 units of output, the marginal cost of producing q1th unit will be measured as follows:
LRMC = (TC at q1 units) – (TC at q1-1 units) or LRMC = TCn – TCn-1
5. The following table gives the TP schedule of labour. Find the corresponding Average product
and marginal product schedules.
TPL 0 15 35 50 40 48
L 0 1 2 3 4 5
Ans: Calculation of Average Product (AP) and Marginal Product (MP). AP is obtained by dividing
TPL by Labour (L) and MP is obtained from TPL with the help of formula TCn – TCn-1
TPL L AP MP
0 0 0 -
15 1 15 15
35 2 17.5 20
50 3 16.66 15
40 4 10 -10
48 5 9.6 8

VII Answer the following questions in 20 sentences.

1. Explain the various short run costs.
The various short run costs are Total Cost, Total Fixed Cost, Total Variable Cost, Average Cost,
Average Fixed Cost, Average Variable Cost, and Marginal Cost. The following table shows the
various types of short run costs:
a) Total Fixed Cost (TFC):
It refers to the total money expenses incurred on all the fixed factors in the short run. TFC remains
constant at all levels of output. Therefore the total fixed cost curve is horizontal straight line to OX
axis above the origin which indicates that it is never zero.

TFC = TC-TVC

b) Total Variable Cost (TVC):

It refers to the total money expenses incurred on the variable factor inputs in the short-run.
Total variable cost is the direct cost of the output because it increases along with the output &
remains zero when the output is zero. So, the TVC curves starts from the origin & rises sharply in
the beginning, gradually in the middle & stretch again sharply in the end the nature of this slope is
in accordance with the law of variable proportion.

TVC = TC-TFC
 c) Total Cost (TC):
It is the aggregate money expenditure incurred by the firm on all the factors to produce a
given quantity of output. TC varies in the same proportion as total variable cost because the total
fixed cost is constant. The TC curve slope upwards from left to right, above the origin, indicating
that, it includes total fixed cost and total variable cost.

d) Average Fixed Cost (AFC):

It is the fixed cost per unit of output. In other words, it is average expenses incurred on a
single unit of output produced. AFC and output are inverse relation i.e. AFC will be higher
when the output level is less and as the output goes on increasing AFC starts reducing, when it
is represented in the diagram AFC curve will have a negative slope which falls very stiffly in
the beginning and later on becomes parallel to the X axis. .
The Average Fixed Cost is obtained by dividing Total Fixed Cost by Output.
AFC=TFC/Output.

e) Average Variable Cost (AVC):

It is a variable cost for per unit of output. It can be calculated by dividing total variable
cost by the total units of output. When this cost is graphically represented, we get a „U‟ shaped
AVC, which shows that the cost will be less as the number of units produced increase, this is
because as the number of variable inputs are added in a fixed plant the efficiency will increase and
vice versa.

AVC=TVC/Output or AVC=AC-AFC

f) Average Cost (AC): It is the cost per unit of output produced. It is obtained by dividing total
cost by the total output produced i.e. AC = TC/Q or it is also obtained by adding AFC & AVC.
If the AC is graphical represented we get U shaped curve because of the operation of law of
variable proportions. The short run AC curve is also called as „Plant Curves‟ because it
indicates the optimum utilization of a given plant (Industry) capacity.
g) Marginal Cost (MC): It is an additional cost incurred to produce an additional output. In other words
it is the net additions to the total cost when one more unit of output is produced.
MC = TCn-TCn-1 or ΔTC/Δq

(Where TCn = Total Cost of „n‟ selected unit of output and TCn-1 is Total cost of previous output,
ΔTC is change in total cost, Δq is change in quantity produced)

2. Explain the shapes of long run cost curves.

Ans: In the long run, all inputs are variable. There are no fixed costs, The total cost and the total
variable cost coincide in the long run. There are two types of long run costs. They are as follows:
c) Long Run Average Cost (LRAC): The long run average cost is the cost per unit of output
produced. It is obtained by dividing the Total Cost by the output produced. It can be calculated
as follows:
LRAC = TC/q
Where TC is Total cost and „q‟ is quantity of output produced.
 27

In a typical firm the Increasing Returns to scale is observed at the initial level of
production. This is then followed by the Constant Returns to Scale and then by the
Diminishing Returns to Scale. Accordingly, the LRAC curve is „U‟ shaped curve. Its
downward sloping part corresponds to Increasing Returns to Scale and upward rising part
corresponds to Decreasing Returns to scale. At the minimum point of the LRAC curve,
Constant returns to scale is observed.
d) Long Run Marginal Cost: The long run marginal cost is the change in total cost per unit of
change in output. When output changes in discrete units, then, if we increase production from
q1-1 to q1 units of output, the marginal cost of producing q1th unit will be measured as follows:
LRMC = (TC at q1 units) – (TC at q1-1 units) or LRMC = TCn – TCn-1
For the first unit of output, both LRMC and LRAC are the same. Then, as output increases,
LRAC initially falls, and then, after a certain point, it rises. As long as average cost is falling,
marginal cost must be less than the average cost. When the average cost is rising, marginal cost
must be greater than the average cost. LRMC curve is there a „U‟ shaped curve. It cuts the LRAC
curve from below at the minimum point of LRAC. The following diagram shows the shapes of the
long run marginal and the long run average cost curves for a typical firm.

LRMC
Y
Cost
LRAC
M

X
O q1 output
In the above diagram, LRAC reaches its minimum at q1. To the left of q1, LRAC is
falling and LRMC is less than the LRAC curve. To the right of q1, LRAC is rising and LRMC is
higher than LRAC.
3. Explain the shapes of TP, MP and AP curves.
Ans: Total Product(TP):
Total product is the relationship between a variable input and output when all other inputs are held
constant. Suppose we vary a single input and keep all other inputs constant. Then for different
levels of that input, we get different levels of output. This relationship between the variable input
and output, keeping all other inputs constant, is often referred to as Total Product of the variable
input.
The total product curve in the input-output plane is a positively sloped curve as follows:
Y
Output
 TPL
q1

O L Labour X
The above diagram shows the total product curve for labour. When all other inputs are held
constant, it shows the different output levels obtainable from different units of labour.
Labour is measured in OX axis and output is measured in OY axis. With L units of labour,
the firm can at most produce q1 units of output.

Average product (AP) and Marginal Product (MP):

Average Product is defined as the output per unit of variable input. We calculate it as APL=TPL/L,
where APL is the Average Product of Labour, TPL is the Total product of labour and L is the
amount of labour input used.
Marginal Product of an input is defined as the change in output per unit of change in the
input when all other inputs are held constant. It is the additional unit of output per additional unit
of variable input. It is calculated by dividing the change in output by change in input labour.
MPL = ∆TPL/∆L.
According to the law of variable proportions, the marginal product of an input initially rises
and then after a certain level of employment, it starts falling. The MP curve therefore, looks like an
inverse „U‟ shaped curve.
For the first unit of the variable input, one can easily check that the MP and the AP are
same. As the amount of input is increased, the MP rises. AP being the average of marginal
products also rises, but rises less than MP. Then after a point, the MP starts falling. However, as
long as the value of MP remains higher than the value of the AP, the AP continues to rise. Once
MP has fallen sufficiently, its value becomes less than the AP and the AP also starts falling. So AP
curve is also inverse „U‟ shaped.
This can be diagrammatically represented as follows:

Y P
Output

MPL APL

O L Labour X
 29

In the above diagram, MPL is marginal product of labour, APL is the average
product labour. As long as the AP increases, it must be the case that MP is greater than AP.
Otherwise, AP cannot rise. Similarly, when AP falls, MP has to be less than AP. It follows that MP
curve cuts AP curve from above at its maximum. In the diagram, AP is maximum at L. To the left
of L, AP is rising and MP is greater than AP. To the right of L, AP is falling and MP is less than
AP.

4. A firm’s SMC schedule is shown in the following table. TFC is Rs.100. find TVC, TC, AVC
and SAC schedules of the firm
Q 0 1 2 3 4 5 6
SMC - 500 300 200 300 500 800
Ans:
Q SMC TFC TVC TC AVC SAC
0 - 100 0 100 0 0
1 500 100 500 600 500 600
2 300 100 800 900 400 450
3 200 100 1000 1100 333.33 366.66
4 300 100 1300 1400 325 350
5 500 100 1800 1900 360 380
6 800 100 2600 2700 433.33 450
Note: TFC is given. TVC is obtained by adding SMC for each unit of output like 500 as it is taken,
then 500+300=800; 800+200(SMC)=1000 and so on. TC is TFC+TVC, AVC is TVC divided by
Q; and SAC is TC divided by Q.
5. Explain the law of variable proportions with the help of a diagram.
Ans: The law of variable proportions say that the Marginal product of a factor input initially rises
with the employment level. But after reaching a certain level of employment, it starts falling.
The law of variable proportions can be explained with the help of the following table and
diagram.

Labour TP MPL APL

0 0 - -
1 10 10 10
2 24 14 12
3 40 16 13.33
4 50 10 12.5
5 56 6 11.2
6 57 1 9.5
The above table shows the total product of labour, Marginal product of labour and Average
product of labour. The total product is also sometimes called as total return to or total physical
product of the variable input labour. The third column gives us a numerical example of Marginal
product of labour. The values in this column are obtained by dividing change in TP by change in
Labour. The last column gives us a numerical example of average product of labour. The values in
their column are obtained by dividing TP by Labour.
 If we plot the above table in graph, placing labor on X axis and output on Y axis, we get
the curves shown in the diagram below:

Y TP
Output

AP
MP X
O Labour
The TP increases as labour input increases. But the rate at which it increases is not
constant. An increase in labour from 1 to 2 increases TP by 10 units. An increase in labour from 2
to 3 increases TP by 12 units. The rate at which TP increases is shown by the MP. The MP first
increases (till 3 units of labour) and then begins to fall. This tendency of the MP to first increase
and then fall is called the law of variable proportions.
The law of variable proportions is also known as law of diminishing marginal product. It
occurs because of change in factor proportions. Factor proportions represent the ratio in which the
two inputs are combined to produce output. As we hold one factor fixed and keep the other
increasing, the factor proportions change. Initially, as we increase the amount of the variable input,
the factor proportions become more and more suitable for the production and marginal product
increases. But after a certain level of employment, the production process becomes too crowded
with the variable input.
In the above diagram, TP is Total Product curve which is increasing in different
proportions due the change in labour input. The AP and MP curves are increasing in the beginning
and decreasing later. But the change in MP is greater than AP.

VIII Assignment and project oriented questions.

1. Find the missing products of the following table.

Factor 1 TP MP1 AP1
0 0 0 0
1 10 - 10
2 24 - 12
 31

3 40 16 13.33
4 - 10 -
5 - 6 11.2
6 57 1 9.5

Ans:
Factor 1 TP MP1 AP1
0 0 0 0
1 10 10 10
2 24 14 12
3 40 16 13.33
4 50 10 12.5
5 56 6 11.2
6 57 1 9.5
Note: TP is summation of MP so 40+10=50; 50+6=56; 56+1=57; MP is TPn – TPn-1 so 10-0=10; 24-
10=14; AP is TP/q so 50/4=12.5;
 CHAPTER-4

THE THEORY OF FIRM UNDER PERFECT COMPETITION

I Choose the correct answer

1. The products in a perfect competition are

a) Heterogeneous products c) Luxury goods
b) Homogeneous products d) Necessary goods

Ans: (b) Homogeneous products

2. The increase in total revenue for a unit increase in the output is

a) Marginal Revenue c) Total Revenue
b) Average Revenue d) Fixed Revenue

Ans: (a) Marginal Revenue

3. The firm‟s profit is denoted by

a) ∑ b)Δ c) Φ d)π
Ans: d) π
4. When the supply curve is vertical, the elasticity of supply is
a) es=1 b) es=1 c) es=0 d) ex=∞
Ans: c) es=0
5. The revenue per unit of output of a firm is called as
a) TR b) MR c) AR d) None of these.

Ans: c) AR

II Fill in the blanks.

1. Price taking behavior is the single most distinguishing characteristic of ………………market
Ans: Perfect competitive market.
2. …………….is a tax that the Government imposes per unit sale of output.
Ans: Unit Tax
3. For a price taking firm Marginal Revenue is equal to……………………
 33

Ans: Market price

4. The point of minimum AVC where the SMC curve cuts the AVC curves is called as
……………………
Ans: Shut down point
5. …………………cost of some activity is the gain forgone from the second best activity.
Ans: Opportunity cost

III Match the following

A B
1. MR a) Perfect information
2. π= b) Zero profit
3. AR= c) ΔTR/Δq
4. Normal profit d) TR-TC
5. Perfect competition e) TR/Q

Ans: 1 – (c); 2 – (d); 3 – (e); 4 – (b); 5 – (a)

IV Answer the following questions in a sentence or a word

1. Define Marginal Revenue.

Ans: Marginal Revenue of a firm is defined as the increase in total revenue for a unit increase in
the firm‟s output.
It is obtained by dividing the Change in Total Revenue by Change in quantity.
2. To which side does a supply curve shift due to the technological progress?
Ans: The supply curve shifts to the right due to the technological progress.
3. Write the formula to calculate Average Revenue.
Ans: We calculate Average Revenue, by dividing Total revenue by the quantity sold. The
following formula is used:
AR = TR/q
4. What is normal profit?
Ans: The minimum level of profit that is needed to keep a firm in the existing business is called as
normal profit.
5. Give the meaning of super normal profit.
Ans: Profit that a firm earns over and above the normal profit is called as super normal profit.

V Answer the following questions in four sentences

1. Mention the conditions needed for profit by a firm under perfect competition.
Ans: The following conditions needed for profit by a firm under perfect competition:
 The Price P must be equal to MC
  Marginal cost must be non-decreasing at q0
 The firm to continue to produce, in the short run, price must be greater than the average
variable cost and in the long run, price must be greater than the average cost.
2. Give the meaning of shut down point.
Ans: In the short run, the shut down point is that point of minimum Average Variable Cost where
Short run Marginal Cost curve cuts the Average Variable Cost curve. In the long run, the shut
down point is the minimum of Long Run Average Cost Curve.
3. Write the meaning of opportunity cost with an example.
Ans: Opportunity cost of some activity is the gain foregone from the second best alternative
activity.
For example, you have Rs.10000 which you decide to invest in your family business. What is
the opportunity cost of your action? If you do not invest this money, you can either keep it in the
house safe which will give you zero return or you can deposit it in either bank A or bank B in
which case you get an interest at the rate of 20 percent or 10 percent respectively. So the maximum
benefit that you may get from other alternative activities is the interest from the bank A. But this
opportunity will no longer be there once you invest the money in your family business. The
opportunity cost of investing the money in your family business is therefore the amount of forgone
interest from the bank A.
4. Mention the two determinants of a firm’s supply curve.
Ans: The two determinants of a firm‟s supply curve are as follows:
(a) Technological progress
(b) Input prices.
5. Give the meaning of price elasticity of supply and write its formula.
Ans: The price elasticity of supply refers to the proportionate change in quantity supplied to a
proportionate change in price of a commodity.

PES= Percentage change in quantity supplied

Percentage change in price
= Δq/Δp x p/q

VI Answer the following questions in 12 sentences

1. Write a short note on profit maximization of a firm under the following conditions
a) P=MC
b) MC must be none decreasing at q0
Ans:
A firm always wishes to maximize its profit. The firm would like to identify the quantity q0, the
firm‟s profits are less than at q0. For profits to be maximum, the following conditions must hold at
q0 .
a) The price P must equal MC (P = MC): Profit is the difference between Total Revenue and
Total Cost. Both total revenue and total cost increase as output increases. As long as the
change in total revenue is greater than the change in total cost, profits will continue to increase.
 35

The change in total revenue per unit increase in output is the marginal revenue and the
change in total cost per unit increase in output is the marginal cost.
Therefore, we can conclude that as long as marginal revenue is greater than marginal cost,
profits are increasing and as long as marginal revenue is less than marginal cost, profits will
fall. It follows that for profits to be maximum, marginal revenue should be equal to marginal
cost.
For the perfectly competitive firm, we have established that the MR=P. So the firm‟s profit
maximizing output becomes the level of output at which P=MC.
b) Marginal cost must be non-decreasing at q0: It means that the marginal cost curve cannot
slope downwards at the profit maximizing output level. This can be explained with the help of
diagram:

Y MC

Price and

Marginal cost

O q1 q2 q3 q4 q5 q6 Output X

In the above diagram, at output levels q1 and q4 the market price is equal to the marginal cost.
However, at the output level q1 the marginal cost curve is downward sloping. The q1 is not profit
maximizing output level.
If we observe all output levels left to the q1 the market price is lower than the marginal cost. But
the firm‟s profit at an output level slightly smaller than q1 exceeds that corresponding to the output
level q1. Therefore, q1 cannot be a profit maximizing output level.

2. Explain the determinants of a firm’s supply curve.

Ans: A firm‟s marginal cost curve is a part of its marginal cost curve. Any factor that affects a firm‟s
marginal cost curve is a determinant of its supply curve. Following are the two factors determining a
firm‟s supply curve:

a) Technological Progress: The organizational innovation by the firm leads to more production of
output. That means, to produce a given level of output, the organizational innovation allows the
firm to use fewer units of inputs. It is expected that this will lower the firm‟s marginal cost at any
level of output, i.e., there is a rightward shift of the MC curve. As the firm‟s supply curve is
 essentially a segment of the MC curve, technological progress shifts the supply curve of the firm to
the right. At any given market price, the firm now supplies more quantity of output.
b) Input prices: A change in the prices of factors of production (inputs) also influences a firm‟s
supply curve. If the price of input (eg. wage) increases, the cost of production also increases. The
consequent increase in the firm‟s average cost at any level of output is usually accompanied by an
increase in the firm‟s marginal cost at any level of output which leads to upward shift of the MC
curve. That means, the firm‟s supply curve shifts to the left and the firm produces less quantity of
output.

3. Explain the features of perfect competition.

Ans: Perfect competition is a market where there will be existence of large number of buyers and sellers
dealing with homogenous products. It is a market with highest level competition.
i) Large number of sellers and sellers: The first condition which a perfectly competitive market must
satisfy is concerned with the sellers‟ side of the market. The market must have such a large number of
sellers that no one seller is able to dominate in the market. No single firm can influence the price of the
commodity. The sellers will be the firms producing the product for sale in the market. These firms must
be all relatively small as compared to the market as a whole. Their individual outputs should be just a
fraction of the total output in the market.

There must be such a large number of buyers that no one buyer is able to influence the market
price in any way. Each buyer should purchase just a fraction of the market supplies. Further the buyers
should have any kind of union or association so that they compete for the market demand on an individual
basis.

ii) Homogeneous products: Another prerequisite of perfect competition is that all the firms or sellers
must sell completely identical or homogeneous goods. Their products must be considered to be identical
by all the buyers in the market. There should not be any differentiation of products by sellers by way of
quality, colour, design, packing or other selling conditions of the product.

iii) Free Entry and Free exit for firms: Under perfect competition, there is absolutely no restriction on
entry of new firms in the industry or the exit of the firms from the industry which want to leave. This
condition must be satisfied especially for long period equilibrium of the industry.

If these four conditions are satisfied, the market is said to be purely competitive. In other words, a
market characterized by the presence of these four features is called purely competitive. For a market to
be perfect, some conditions of perfection of the market must also be fulfilled.

iv) Price Taker: The single distinguishing character of perfect competition is the price taking behaviour
of the firms. A price taking firm believes that if it sets a price above the market price, it will be unable to
sell any quantity of the good that it produces. On the other hand, if the firm set the price less than or equal
to the market price, the firm can sell as many units of the good as it wants sell. The firms in the perfect
competitive market are price takers. That means, the producers will continue to sell their goods and
services in the price existing in the market. Firms have no control over the price of the product.
 37

v) Information is perfect: Price taking is often thought to be a reasonable assumption when the market
has many firms and buyers have perfect information about the price prevailing in the market. Since all
firms produce the same good and all buyes are aware of the market price, the firm in question loses all its
buyers if it rises price.

4. Write about shut down point, Normal profit and Break Even Point.
Shut down point:
In the short run, the firm continues to produce as long as the price remains greater than or equal to the
minimum of AVC. Therefore, along the supply curve as we move down, the last price-output combination
at which the firm produces positive output is the point of minimum AVC where the SMC curve cuts the
AVC curve. Below this, there will be no production. This point is called the short run shut down point of
the firm.
However, in the long run, the shut down point is the minimum of LRAC curve.
Normal Profit:
The firm incurs explicit cost to acquire different kinds of inputs in the production process by paying
directly to their owners. For example, if a firm employs labour, it has to pay wages to them, if it uses some
raw materials, it has to buy them.
There may be some other kinds of inputs which the firm owns and therefore, does not to pay to
anybody for them. These inputs though do not involve any explicit cost, they involve some opportunity
cost to the firm. The firm instead of using these inputs in the current production process could have used
them for some other purpose and get some return. This forgone return is the opportunity cost to the firm.
The firm normally expects to earn a profit that along with the explicit costs can also cover the opportunity
costs.
Therefore, the profit level that is just enough to cover the explicit costs and opportunity costs of the
firm is called the normal profit. If a firm includes both its explicit cost and opportunity costs in the
calculation of total cost, the normal profit becomes that level of profit when total revenue equals total cost.

Break Even Point:

In the long run, the firm does not produce if it earns anything less than the normal profit. In the short
run, however, it may produce even if he profit is less than this level. The point on the supply curve at
which a firm earns normal profit is called the Break Even Point of the firm. The point of minimum
average cost at which the supply cure cuts the LRAC curve is therefore the break even point of the firm.

VII Answer the following questions in 20 sentences.

1. Explain the short run supply curve of a firm with the help of a diagram.
Ans: Supply of a firm refers to the quantity that it chooses to sell at a given price, given technology
and given prices of factors of production. Supply curve of a firm shows the levels of output that the
firm chooses to produce corresponding to different values of the market price by keeping technology
and prices of factors of production constant.
Short Run Supply Curve of a Firm:
 Let us derive a firm‟s short run supply curve. The derivation of supply curve can be split into two
parts viz., firm‟s profit maximizing output level when the market price is greater than or equal to
minimum Average Variable Cost and the firm‟s profit maximizing output level when the market price
is less than the minimum Average Variable Cost.
Case 1: Price or Average Revenue greater than or equal to the minimum AVC:
This can be explained with the help of the following diagram

Y
Price,
costs SMC

SAC
AVC
P1

P2

O q1 output X
If the market price is P1, which exceeds the minimum of AVC, the firm starts out by equating P1
with SMC on the rising part of the SMC curve which leads to the output level q1 . But the AVC at q1
does not exceed the market price P1. Thus, when the market price is P1, the firm‟s output level in the
short run is equal to q1.
Case -2: Price is less than minimum AVC: If the market price is P2 which is less than the minimum
AVC, at all positive output levels, AVC exceeds P2. In other words, it cannot be the case that the firm
supplies a positive output. So, if the market price is P2, the firm produces zero output.
Combining both the cases, we can conclude that a firm‟s short run supply curve is the rising part of
the Short Run Marginal curve from and above the minimum Average Variable Cost together with zero
output for all prices strictly less than the minimum AVC. This can be represented in the following
diagram:

Y Supply Curve (SMC)

Price,
costs
SAC
 39

AVC

O output X
In the above diagram, the short run supply curve of a firm, which is based on its short run marginal
cost curve and average variable cost is represented by the curve which rises from the minimum point
of AVC curve. The bold line represents the short run supply curve.

2. Explain TR and AR of a firm under perfect competition with diagram.

Ans: A firm earns revenue by selling the good that it produces in the market. Let the market price of a
unit of the good be „p‟. Let the „q‟ be the quantity of the good produced and sold by the firm at price
„p‟. Then the Total Revenue and Average Revenue can be discussed as follows:
Total Revenue (TR):
The total revenue is defined as the market price (p) of the good multiplied by the firm‟s output (q).
Then, TR= p x q.
In a perfectly competitive market, a firm views the market price „p‟ as given, With the market price
fixed at „p‟ the TR curve of a firm shows the relationship between its Total Revenue (y axis) and its
total output (x axis). The following diagram shows the Total Revenue Curve of a firm.

Y
Revenue
TR

O q1 Output X
There are three observations we must make. Firstly, when the output is zero, Total Revenue of the
firm is also zero. Therefore, TR curve passes through point O. Secondly, the TR increases as the
output goes up. Moreover, the equation TR= p x q is that of a straight line. This means that the TR
curve is an upward rising straight line. Thirdly, consider the slope of the straight line. When the
output is 1 unit (horizontal distance Oq1 in the above diagram), the Total Revenue (vertical height
Aq1) is px1=p. Therefore the slope of the straight line is Aq1/Oq1=p.
 Average Revenue:
The average revenue (AR) of a firm is defined as Total Revenue per unit of output. This can be
represented as follows:
AR=TR/q = p x q/q = p.
For a price taking firm, average revenue equals the market price. Diagrammatically the AR curve can
be represented as follows:

Y
Price

P Price Line

O Output X

In the above diagram, we plot the market price(y axis), for different values of a firm‟s output (x axis).
Since the market price is fixed at p, we obtain a horizontal straight line that cuts the y axis at a height
equal to p. This horizontal straight line is called the price line. The price line shows the relationship
between market price and the firm‟s output level. The vertical height of the price line is equal to the
market price p.The price line also depicts the demand curve facing a firm. Observe that the diagram
shows that the market price, p, is independent of a firm‟s output. This means that the firm can sell as
many units of the goods as it wants to sell at price p.

3. Explain market supply curve with the help of a diagram.

Ans: The market supply curve shows the output levels that firms in the market produce in aggregate
corresponding to different values of the market price.
For example, there are firm 1, firm 2, firm3 in the market. Suppose the price is fixed at p. Then the
output produced by these firms in aggregate will be supply of firm 1 + supply of firm 2 + supply of
firm 3. So, the market supply at price p is the summation of the supplies of individual firms at that
price.
 41

The supply curve geometrically with two firms in the market i.e., firm 1 and firm 2 is given below.
The two firms have different cost structures. Firm 1 will not produce anything if the market price is
less than P1 while firm 2 will not produce anything if the market price is less than P2. This can be
represented in the diagram:
Y (a) (b) (c)
S1 S2 Sm
P3

P2
P1

O q1 O q2 O qm output X

In the above diagram, output is measured in X axis and Price is measured in Y axis. The diagram (a)
is the supply curve of firm 1 (S1), diagram (b) is the supply curve of firm 2 (S2) and the diagram (c) is
the market supply curve (Sm). When the market price is below P1, both the firms do not produce the
goods. Hence the market supply will be zero. If the market price is greater than or equal to P1, but less
than P2, only firm 1 will produce the goods. In this range, the market supply curve coincides with the
supply curve of firm 1. If the market price is greater than or equal P2, both firms will have positive
output levels. If the price is P3, the firm 1 will supply q1 units of output and firm 2 supplies q2 units of
output. So, the market supply at price P3 is qm, where qm = q1 + q2. The market supply curve Sm is
obtained by taking a horizontal summation of the supply curves of the two firms in the market S1 and
S2.

VIII Assignment and project oriented questions.

1. Compute the total revenue, marginal revenue and average revenue schedules from the
following table when market price of each unit of goods is Rs.10.
Quantity TR MR AR
sold
0
1
2
3
4
5
6

Ans: Hint: For TR Multiply Price and Quantity (PxQ);

MR = TRn-TRn-1 and AR = TR/Q
Quantity TR MR AR
sold
 0 0 - -
1 10 10 10
2 20 10 10
3 30 10 10
4 40 10 10
5 50 10 10
6 60 10 10

********

CHAPTER 5

MARKET EQUILIBRIUM

I Choose the correct answer

1. In perfect competition buyers and sellers are

a) Price makers c) Price analysts
b) Price takers d) None of the above
Ans: (b) Price takers.
2. A situation where the plans of all consumers and firm in the market match.
a) Inequilibrium situation c) Maximisation situation
b) Equilibrium situation d) Partial Equilibrium situation
(b) Equilibrium situation
3. As a result of increase in the number of firms there is an increase in supply, then supply curve
a) Shifts towards left c) Shifts towards both sides
b) Shifts towards right d) None of the above
Ans: (b) Shifts towards right
4. The firms earn super normal profit as long as the price is greater than the minimum of
a) Marginal cost c) Average cost
b) Total cost d) Fixed cost
Ans: c) Average cost
5. The government imposing upper limit on the price of goods and services is called
a) Price ceiling c) Price floor
b) Selling price d) None of the above
Ans: (a) Price ceiling
6. The government imposed lower limit on the price of goods and service is called
a) Goods floor c) Price floor
 43

b) Service floor d) None of the above

Ans: c) Price floor

II Fill in the blanks

1. In a perfectly competitive market, equilibrium occurs when market demand …………market

supply
Ans: Equals
2. If the supply curve shifts rightward and demand curve shifts leftward equilibrium price will
be………………..
Ans: Decreasing
3. ……………is determined at the point where the demand for labour and supply of labour curves
intersect.
Ans: Wage
4. In labour market……………….are the suppliers of labour.
Ans: Households
5. Due to rightward shifts in both demand and supply curves the equilibrium price remains…………..
Ans: Unchanged (constant or same).
6. It is assumed that, in a perfectly competitive market an ……………………is at play.
Ans: Invisible hand

III Match the following

A B
1. Adam smith a) Attraction of new firms
2. Price ceiling b) Operation of invisible
3. Market equilibrium hand
4. Possibility of supernormal c) Lower limit on price
profit d) Upper limit on price
5. Price floor e) QD=QS
Ans: 1 – (b); 2 – (d); 3 – (e); 4 – (a); 5 – (c);

IV Answer the following questions

1. Define market equilibrium.

Ans: A market equilibrium is a situation where the plans of all consumers and firms in the market
match and the market clears. Here Quantity demanded is equal to Quantity supplied.
2. What is equilibrium price?
Ans: The price at which market reaches equilibrium is reached is called equilibrium price.
3. What is price ceiling?
Ans: The Government imposed upper limit on the price of a good or service is called price ceiling.
Example, price ceiling on necessary items like selected medicines, kerosene, wheat etc.
4. What is price floor?
 Ans: The Government imposed lower limit on the price that may be charged for a particular good
or service is called price floor. Example agricultural price support programmes and minimum
wage legislation.
5. Through which legislation, the government ensures that the wage rate of the labourers does
not fall below a particular level?
Ans: Minimum Wage Legislation (Minimum Wages Act)

V Answer the following questions in 4 sentences

1. Define equilibrium price and quantity.

Ans: Equilibrium price is the price at which equilibrium is reached in the market.
The equilibrium quantity is defined as the quantity which is bought and sold at equilibrium price.
Therefore price and quantity will be at equilibrium when
Qd (p*) = qs (p*)
p* denotes the equilibrium price and Qd (p*) and qs (p*) denote the market dmenad and market
supply respectively.
2. Write any two possible ways in which simultaneous shift of both demand and supply curve.
Ans: The simultaneous shifts can happen in four possible ways:
a) Both supply and demand curves shift rightwards.
b) Both supply and demand curves shift leftwards.
c) Supply curve shifts leftward and demand curve shifts rightward
d) Supply curve shifts rightward and demand curve shifts leftward.
3. What is marginal revenue product labour (MRPL)?
Ans: The extra output produced by one more unit of labour is its marginal product and by selling
each extra unit of output, the additional learning of the firm is the marginal revenue she gets from
that unit.
Therefore, for each extra unit of labour, she gets an additional benefit equal to marginal
revenue times marginal product is called as Marginal Revenue Product of Labour (MRP L).
MRPL = MR x MPL
MR - Marginal Revenue; MPL- Marginal productivity of Labour.
4. Distinguish between excess demand and excess supply.
Excess Demand Excess Supply
 It is situation where market demand  It is a situation where the market supply
exceeds the market supply. exceeds the market demand.
 Here the price of the product increases.  Here the price of the product decreases.
 Qd > Qs  Qs > Qd.
5. How wage is determined in the labour market?
Ans: The wage rate is determined at the point where the demand for labour and supply of labour
curves intersect. This is shown in the following diagram:

Y
 45

Wage SL

w E

DL

O L Labour (Hrs) X
In the above diagram, hours of labour is measured in X axis and Wage is measured in Y axis. SL is
labour supply curve and DL Labour demand curve. With an upward sloping supply curve and
downward sloping demand curve, the equilibrium wage rate is determined at the point where these
two curves intersect (point E). That means, the wage rate is determined at that point where the
labour that the households wish to supply is equal to the labour that the firms wish to hire.

VI Answer the following questions in 12 sentences.

1. What is the implication of free entry and exit of firm on market equilibrium? Briefly explain.
Ans: In perfect competitive market, it is assumed that there will be free entry and exit of firms.
This assumption implies that in equilibrium, no firm earns super normal profit or incurs loss by
remaining in production. Here, the equilibrium price will be equal to the minimum average cost of
the firms.
Let us discuss in detail why there will be no super normal profit or no loss to the firms.
Suppose, at the prevailing market price, each firm is earning super normal profit. The
possibility of earning supernormal profit will attract some new firms. As new firms enter the
market supply curve shifts rightward. However, demand remains same. This causes market price to
fall. As prices decrease, super normal profits will eventually extinct. At this point, with all firms in
the market earning normal profit.
Similarly, if the firms are incurring loss (less than normal profit) at the prevailing price,
some firms will exit. This will lead to an increase in price. Then the profits of each firm will
increase to the level of normal profit. At this point, no firm will want to leave since they will be
earning normal profit.
Therefore, with free entry and exit, each firm will always earn normal profit at the
prevailing market price.

2. Write a table to show the impact of simultaneous shifts on equilibrium.

Ans: The following table shows the impact of simultaneous shifts on equilibrium
Shift in Demand Shift in Supply Quantity Price
May increase,
Leftward Leftward Decreases decrease or remain
constant
May increase,
Rightward Rightward Increases decrease or remain
 constant
May increase,
Leftward Rightward decrease or remain Decreases
constant
May increase,
Rightward Leftward decrease or remain Increases
constant

3. Write a note on price ceiling.

Ans: The Government imposed upper limit on the price of a good or service is called price ceiling.
Price ceiling is generally imposed on necessary items like wheat, rice, kerosene, sugar and it is
fixed below the market determined price. It is fixed below the market price because, at market
determined price some sections of the population will not be able to afford these goods.

The effect of price ceiling on Market equilibrium can b explained with the help of following
diagram.
Y SS

Price

P*

Pc
DD

1 *
O qc q qc Quantity X
In the above diagram DD is market demand curve and SS is market supply curve. P* is the
equilibrium price and q* is the equilibrium quantity. When government imposes price ceiling at P c
1
which is lower than equilibrium price, there will be excess demand of qc qc. There will be
scarcity of goods.
Here, though the intention of the Government is to help the consumers, it could end up
creating shortage of products. In order to solve the scarcity of products, the Government may issue
ration coupons to the consumers so that no individual can buy more than a certain amount of a
product. This stipulated amount of a product sold through ration shops are called Fair Price Shops.

4. Write a note on Price Floor.

Ans. The Government imposed lower limit on the price that may be charged for a particular good
or service is called price floor. For certain goods and services, fall in price below a particular level
is not desirable and hence the Government sets minimum prices for these goods and services.
Example, agricultural price support programmes and the minimum wage legislation. The
Government may impose a lower limit on the purchase price for some of the agricultural goods
and the floor is normally set at a level higher than the market determined price for these goods.
 47

Similarly, through the minimum wage legislation, the Government ensures that the wage
rate of the labourers does not fall below a particular level and here again the minimum wage rate is
set above the equilibrium wage rate.
The Price floor can be explained with the help of following diagram
Y
SS
Pf

P*
Price
DD
`
1 *
O qf q qf Quantity X
In the above diagram DD is market demand curve and SS is market supply curve. P* is the
equilibrium price and q* is the equilibrium quantity. When government imposes price floor at Pf
1
which is higher than equilibrium price, there will be excess supply of qf qf. In order to support
producers the government needs to buy this excess supply and should take steps to find alternative
markets.

VII Answer the following questions in 20 sentences

1. Explain the simultaneous shifts of demand and supply curve in perfect competition with the
help of diagrams.
Ans: The simultaneous shifts can happen in four possible ways:
e) Both supply and demand curves shift rightwards.
f) Both supply and demand curves shift leftwards.
g) Supply curve shifts leftward and demand curve shifts rightward
h) Supply curve shifts rightward and demand curve shifts leftward.
The simultaneous shifts of demand and supply curve in perfect competition can be
represented in the following table:
Shift in Demand Shift in Supply Quantity Price
May increase,
Leftward Leftward Decreases decrease or remain
constant
May increase,
Rightward Rightward Increases decrease or remain
constant
May increase,
Leftward Rightward decrease or remain Decreases
constant
May increase,
Rightward Leftward decrease or remain Increases
constant
 In the above table, each row of the table describes the direction in which the equilibrium
price and quantity will change for each possible combination of the simultaneous shifts in demand
and supply curves. For instance, from the second row of the table, we can notice that due to a
rightward shift in both demand and supply curves, the equilibrium quantity increases invariably
but the equilibrium price may increase or decrease or remain constant.
The following diagrams depict the second and third cases of the above table:
(a) (b)
Y
SS0 Y
Price SS1 SS0
SS1
P E F P0 E

P1 F
DD1 DD0
DD0 DD1
O q q1 quantity X O q quantity X
In the above diagram (a) initially, the equilibrium is at E where the demand curve DD0 and
supply curve SS0 intersect. Here, both supply and demand curves shift rightward where the price
remains constant at P but the equilibrium quantity moves from q to q1.
Similarly, in diagram (b), the supply curve shifts rightward and demand curve shifts
leftward where the equilibrium quantity remains same but the equilibrium price decreases from P
to P1.
Therefore, the rightward shifts in both demand and supply curves leads to increase in the
equilibrium quantity and equilibrium price remaining constant. The equilibrium quantity remains
same and the price decreases if there is leftward shift in demand curve and a rightward shift in
supply curve.
2. Explain the market equilibrium with the fixed number of firms with the help of diagram.
Ans: Under perfect competition, market is said to be in equilibrium when quantity demanded is
equal to the quantity supplied. Here, with the help of market demand curve and market supply
curve we will determine where the market will be in equilibrium when the number of firms is
fixed.
This can be illustrated with the help of the following diagram:

Price SS
P2

P E

P1 DD

O q1 q 2 q q3 q4 Quantity
The above diagram illustrates equilibrium for a perfectly competitive market with a fixed
number of firms. SS is market supply curve and DD is market demand curve. The market supply
 49

curve SS shows how much of the commodity firms would wish to supply at different prices and
the demand curve DD tells us how much of the commodity, the consumer would be willing to
purchase at different prices.
At point E, the market supply curve intersects the market demand curve which denotes that
quantity demanded is equal to quantity supplied. At any other point, either there is excess supply
or there is excess demand.
OP is the equilibrium price and Oq is the equilibrium quantity. If the price is P1, the market
supply is q1 and market demand is q4. Therefore, there is excess demand in the market equal to
q1q4. Some consumers who are either unable to obtain the commodity at all or obtain it in
insufficient quantity will be willing to pay more than P1. The market price would tend to increase.
All other things remaining constant, when the price increases the demand falls and quantity
supplied rises. The market moves towards equilibrium where quantity demanded is equal to
quantity supplied. It happens at P where supply decisions match demand decisions.
If the price is P2, the market supply- q3 will exceed the market demand q2 which leads to
excess supply equal to q2q3. Some firms will not be able to sell quantity they want to sell.
Therefore, they will lower their price. All other things remaining constant, when the price falls,
quantity demanded rises and quantity supplied falls to equilibrium price P where the firms are able
to sell their desired output as market demand equals market supply at P. So, the P is the
equilibrium price and the corresponding quantity q is the equilibrium quantity.
3. Suppose the demand and supply curves of wheat are given by
qD=200-P and qS=120+P
a) Find the equilibrium price
b) Find the equilibrium quantity of demand and supply
c) Find the quantity of demand and supply when P is greater than equilibrium price
d) Find the quantity of demand and supply when P is lesser than equilibrium price.
Ans:

We know that Qd = Qs

The Demand and supply equations given qD=200-P and qS=120+P respectively.

For equilibrium For equilibrium Quantity Quantity of demand Quantity of demand

Price (P*) Demanded and Supplied and supply when P is and supply when P
greater than is less than
200-P = 120+P qD=200-P equilibrium price equilibrium price,
=200-40 If P=50 If P=30
= 200-P -120-P =160
qD=200-P qD=200-P
= 80 – 2P S
q =120+P =200-50 =200-30
=120+40 =150 =170
2p= 80 =160
P= 80/2 qS=120+P qS=120+P
qD=qS=160 =120+50 =120+30
i.e., P* = 40 =170 =150
So when P ˃ P* So when P ˂ P*
qS ˃ qD qD ˃ qS
 ****

CHAPTER-6

NON COMPETITIVE MARKETS

I Choose the correct answer

1. A market structure which produces heterogeneous products is called

a) Monopoly c) Perfect competition
b) Monopolistic competition d) None of the above
Ans: (b) Monopolistic competition
2. The change in TR due to the sale of an additional unit is called
a) Total Revenue c) Marginal revenue
b) Average Revenue d) Revenue
Ans: c) Marginal revenue
3. When the price elasticity of demand is more than one, MR has a
a) Negative value c) Constant value
b) Decreasing value d) Positive value
Ans: d) Positive value
4. Profit =
a) P x Q c) TFC + TVC
b) TR-TC d) TR/Q
Ans: (b) TR-TC

II Fill in the blanks

1. The monopoly firm‟s decision to sell a larger quantity is possible only at…………..
Ans: Lower prices.
2. Competitive behavior and competitive market structure are in general…………..related
Ans: Inversely
3. In monopoly market the goods which are sold have no………………..
Ans: Substitutes
4. TR=……………….
 51

Ans: P x q (price x quantity)

5. The revenue received by the firm per unit of commodity sold is called………………….
Ans: Average Revenue
6. With the zero production cost, when the total revenue of monopoly firm is maximum, the profit is
…………………..
Ans: Maximum
III Answer the following questions in a sentence or a word.
1. What is monopoly?
Ans: It is a market with single seller or firm with many buyers.
2. Give the meaning of monopolistic competition.
Ans: When the market structure has large number of firms, free entry and exit of firms and
differentiated goods, then it is called monopolistic competition.
OR
It is one of the imperfect competitive situations in which we can see large number of firms with
product differentiation.
3. Give the meaning of oligopoly market.
Ans: If the market consists of more than one seller but the number of sellers are few, then it is called
oligopoly market.
4. What is duopoly?
Ans: It is a special case of oligopoly where there are exactly two sellers or firms.

IV Answer the following questions in 4 sentences

1. State the meaning of average revenue and marginal revenue.

Ans: Marginal Revenue of a firm is defined as the increase in total revenue for a unit increase in
the firm‟s output. It is obtained by dividing the Change in Total Revenue (∆TR) by Change in
quantity (∆q). Thus,
MR = ∆TR/∆q.
Average Revenue: We calculate Average Revenue, by dividing Total revenue by the quantity
sold. The following formula used:
AR = TR/q
2. State the relationship between Marginal revenue and price elasticity of demand.
Ans: The values of Marginal Revenue have a relation with the price elasticity of demand. Price
elasticity of demand is more than 1 when the Marginal Revenue has a positive value and becomes
less than the unity (one) when Marginal Revenue has a negative value.
3. Write the meaning of monopolistic competition and give an example.
Ans: When the market structure has large number of firms, free entry and exit of firms and
differentiated goods, then it is called monopolistic competition.
For example, there is large number of soaps producing firms. But many of the soaps being
produced are associated with some brand name and are distinguishable from the other companies.
The consumer develops a preference for a particular brand of soap over time or becomes loyal to a
particular brand like some people always prefer Mysore Sandal Soap.
 4. Write the features of monopoly.
Ans:
 Existence of single seller or firm.
 No close substitutes.
 Barriers on entry of new firms.
 Firm is a Price maker and buyers are price takers.
 Uniform price or price discrimination.
 No difference between firm and industry.
 Perfect knowledge.

V Answer the following questions in 12 sentences.

1. Explain the market demand curve for a monopoly firm with the help of diagram.
Ans: The market demand curve shows the quantities that consumers as a whole are willing to
purchase at difference prices.
The market demand curve for a monopoly firm can be explained with the help of diagrams
follows:
Y
Price D
P0

P1

D
O q0 q1 quantity X
In the above diagram, price is measured in Y axis and quantity is measured X axis. If the market
price is at P0 consumers are willing to purchase the q0 quantity. If the market price is less i.e., P1,
consumers are willing to buy more quantity i.e., q1. That means, price in the market affects the
quantity demanded by the consumers.
Therefore, monopoly firm‟s decision to sell a larger quantity is possible only at a lower price.
If the monopoly firm brings a smaller quantity of the commodity into the market for sale it will be
able to sell at a higher price. Thus, for the monopoly firm, the price depends on the quantity of the
commodity sold.
For a monopoly firm, price is decreasing function of the quantity sold. So, the market demand
curve for a monopolist expresses the price that consumers are willing to pay for different quantities
supplied. This idea is reflected in the statement that the monopoly firm faces the downward
sloping market demand curve.

2. Calculate TR and MR from the following table.

Q 1 2 3 4 5 6 7 8 9 10
P 100 90 80 70 60 50 40 30 20 10

Ans:
 53

Q 1 2 3 4 5 6 7 8 9 10
P 100 90 80 70 60 50 40 30 20 10
TR 100 180 240 280 300 300 280 240 180 100
MR - 80 60 40 20 0 -20 -40 -60 -80
Hint: TR = P x Q; MR = TRn – TRn-1
3. Briefly explain the monopolistic competitive market.
Ans: Ans: When the market structure has large number of firms, free entry and exit of firms and
differentiated goods, then it is called monopolistic competition.
For example, there is large number of biscuits producing firms. But many of the biscuits
being produced are associated with some brand name and are distinguishable from the other
companies. The consumer develops a taste for a particular brand of biscuits over time or becomes
loyal to a particular brand and he may not immediately be willing to substitute it for another
biscuit. However, if the price difference becomes large, the consumer would be willing to choose a
biscuit of another brand which is of lower price.
Therefore, the demand curve faced by the firm in monopolistic competitive market is not
perfectly elastic. The demand curve faced by the firm is also not market demand curve. In
monopolistic competition, the firm expects increase in demand if it reduces the price. So, the
demand curve (AR curve) is downward sloping. The Marginal Revenue curve will be less than
Average revenue and is downward sloping.
The monopolistic competitive firm is also a profit maximiser. So it will increase production
as long as the addition to its total revenue is greater than the addition to its total costs. In other
words, the firm under monopolistic competition will produce the quantity that equates its marginal
revenue to its marginal cost. But, here, the firm produces less than the perfectly competitive firm.
This is because, given the lower output, the price of the commodity becomes higher than the price
under perfect competition.
The above situation exists in the short run. But in the long run, new firms may enter the
market. If the firms in the industry are receiving supernormal profit in the short run, this will
attract new firms. As new firms enter, some customers shift from existing firms to these new firms.
So, existing firms find that their demand curve has shifted leftward. This reduces firm‟s profits.
This continues till supernormal profits are wiped out and firms are making only normal profits.
On the other hand, if firms in the industry are facing losses in the short run, some firms
would stop producing (exit). The demand curve for existing firms would shift leftward. This would
lead to a higher price and higher profit. Entry or exit would stop once supernormal profits become
zero and this will be long run equilibrium under monopolistic competition.

4. Show the relationship between average revenue and marginal revenue of a monopoly market
with the help of diagrams.
Ans: Marginal Revenue of a firm is defined as the increase in total revenue for a unit increase in
the firm‟s output. It is obtained by dividing the Change in Total Revenue (∆TR) by Change in
quantity (∆q). Thus,
MR = ∆TR/∆q.
 Average Revenue: We calculate Average Revenue, by dividing Total revenue by the quantity
sold. The following formula used:
AR = TR/q
The relationship between AR and MR of a monopoly market can be shown with the help of
following diagrams:

AR,MR (a) AR,MR (b)

AR

AR
O output O Output
MR MR

The above diagram shows that the MR curve lies below the AR curve. That means, if the AR curve
is falling steeply, the MR curve is far below the AR curve. If the AR curve is less steep, the
vertical distance between the AR and MR curves is smaller. The diagram (a) shows a flatter AR
curve while diagram (b) shows a steeper AR curve. Therefore, for the same units of the
commodity, the difference between AR and MR in diagram (a) is less than the difference in
diagram (b).

5. Explain how the firms behave in oligopoly.

Ans: If the market of a particular commodity consists of a few number of sellers, the market
structure is termed oligopoly.
Given there are a few firms, each firm is relatively large when compared to the size of the
market. As a result each firm is in a position to affect the total supply in the market and thus
influence the market price.
For example, if a firm decides to double its output, the total supply in the market will
increase, causing the price to fall. This fall in price affects the profits of all firms in the industry.
Other firms will respond to such a move in order to protect their own profits, by taking fresh
decisions regarding how much to produce. Therefore the level of output in the industry, the level
of prices, and the profits are outcomes of how firms are interacting with each other.
 55

Case- 1: Firms could decide to collude with each other to maximize profits. Here the firms form a
cartel (an association) that acts as a monopoly. The quantity supplied collectively by the industry
and the price charged are the same as a single monopoly firm.
Case-2: The firms could decide to compete with each other. For example, a firm may lower its
price a little below the other firms, in order to attract away their customers. Certainly, the other
firms would retaliate by doing the same. So the market price keep falling.
In reality, cooperation of the kind that is needed to ensure a monopoly outcome is often
difficult to achieve in the real world. The firms may realize that competing fiercely by continuous
price cuts is harmful to their own profits.

VI Answer the following questions in 20 sentences.

6. Explain the short run equilibrium of a monopoly firm with the help of the simple case of zero
cost.
Ans: Every monopolist aims at maximizing profit. Here, we try to analyze the profit maximizing
behaviour to determine the quantity produced by a monopoly firm and price at which it is sold.
Let us imagine that there exists a village situated far way from other villages. In this
village, there is exactly one well from which water is available. All residents are completely
dependent for their water requirements on this well. The well is owned by one person who is able
to prevent others from drawing water from it except through purchase of water. The person who
purchases the water has to draw the water out of the well. The well owner is thus a monopolist
firm which bears zero cost in producing the good. We shall analyse this simple case of a
monopolist bearing zero costs to determine the amount of water sold and the price at which it is
sold.
The short run equilibrium of the monopolist with zero cost can be explained with the help
of the following diagram:
Y
TR, a (50)
AR,
MR, TR
Price

5
(profit) AR=D
O 10 Output
MR
In the above diagram, TR, AR and MR curves are revenue curves. The profit received by the firm
is equal to the revenue received by the firm minus the cost incurred. Since TC is zero, profit is
maximum when TR is maximum i.e.,50 (5x10). This occurs when output is of 10 units. This is the
 level when MR equals zero. The amount of profit is given the length of the vertical line segment
from „a‟ to the horizontal axis.
7. Explain the short run equilibrium of a monopolist firm, when the cost of production is
positive by using TR and TC curves with the help of diagram.
Ans: The short run equilibrium of a monopolist firm, when the cost of production is positive by
using TR and TC curves can be explained with the help of diagram as follows:

Y
TC
Revenue, cost, profit a
TR1 A TR

TC1 B b

O q2 q1 q0 q3 output X
Profit

In the above diagram Total Cost, Total Revenue and Profit curves are drawn. The profit received
by the firm equals the total revenue minus the total cost. In the diagram, if quantity q1 is produced,
the Total Revenue is TR1 and Total cost is TC1. The difference TR1 – TC1 is the profit received.
The same is depicted by the length of the line segment AB i.e., the vertical distance between the
TR and TC curves at q1 level of output.
If the output level is less than q2, the TC curve lies above the TR curve, i.e., TC is greater
than TR and therefore profit is negative and the firm makes losses. The same situation exists for
output levels greater than q3. Hence, the firm can make positive profits only at output levels
between q2 and q3 where TR curve lies above the TC curve. The monopoly firm will chose that
level of output which maximizes its profit. This would be level of output for which the vertical
distance between TR and TC is maximum and TR is above the TC i.e., TR – TC is maximum (the
vertical distance between ab). This occurs at the output level q0.
Therefore, the monopolist firm always produce profit maximum level of output q0 where
its TR is maximum and TC is minimum.

8. The market demand curve for a commodity and the total cost for a monopoly firm producing
the commodity is given by the schedule below. Use the information to calculate the following.
Quantity 0 1 2 3 4 5 6 7 8
Price 52 44 37 31 26 22 19 16 13
 57

Quantity 0 1 2 3 4 5 6 7 8
Total 10 60 90 100 102 105 109 115 125
cost

a) The MR and MC schedules

b) The quantity for which the MR and MC are equal
c) The equilibrium quantity of output and equilibrium price of the commodity
d) The total revenue, Total Cost, and Total profit in equilibrium

Ans:

Quantity Price TR MR TC MC
0 52 0 - 10 -
1 44 44 44 60 50
2 37 74 30 90 30
3 31 93 19 100 10
4 26 104 11 102 2
5 22 110 6 105 3
6 19 114 4 109 4
7 16 112 -2 115 6
8 13 104 -8 125 10
a) Quantity where MR and MC are equal is 6
b) Equilibrium quantity is 6 and Equilibrium price is 19
c) Total Revenue is 114 and Total cost is 109
d) Profit = TR-TC i.e., 114-109 = 5; therefore Profit=5.

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