Introduction to Microeconomics
Introduction to Microeconomics Q#1: What do you understand by Economics? Solution: Lionel Robbins provided the most complete definition of economics. He wrote a book “Nature and significance of Economic science” in 1932 in which he defined economics as: “Economics is a science which studies human behavior as a relationship between unlimited wants and limited resources which have many uses. ” Following points are most important in this definition and explain why economics is said to be the science of scarcity and choice: 1.
Our wants are unlimited related to our resources. 2. Our resources are limited related to our wants. 3. Wants are unlimited but each want is different in its intensity. 4. Some wants are more intense (necessities) and some are less intense (comforts and luxuries). 5. Our resources can not fulfill all of our wants, so we have to make choices. 6. The choices we make are on the assumption that our resources have alternative uses. Q#2: Write a short note on Microeconomics and Macroeconomics. Solution:
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Microeconomics: Microeconomics is the study of small segments of an economy. It can be defined as: “Microeconomics is the study of how individuals and businesses make decisions about producing, exchanging, distributing and consuming particular goods and services and the interaction of those decisions in the market. ” It studies “individual” and “particular” business units, firms, industries, households, prices, wages and income. Thus, we can say it is the study of individual parts of the economy. E. g. hen we say that the price of a particular commodity should be reduced; a certain industry must be given special tax concession; Wages of labor working in shipyard industry must be increased; we are talking about Microeconomics or individual parts of the economy. Macroeconomics: The word “Macro” means large. It may be defined as: “Macroeconomics is the study of economics as a whole. It studies national income, total employment, aggregate income, total production and average prices. ” It studies economy in a broad way.
It takes into account the totality and aggregates of different performance variables like inflation (average price level), total employment, national income, GDP (Gross domestic product) to give the broader perspective of the economy. Q#3: What is the difference between ‘Quantity demanded’ and Change in Demand’? Solution: When price changes, the quantity demanded changes. The change in quantity demanded brings a movement along the demand curve. But, when the non-price factors change, there is a change in the demand curve or a shift in the demand curve. [pic] Factors of change in Demand (Non Price factors):
When the non-price factors or determinants of demand change, there is a change in the demand curve or a shift in the demand curve. These factors are as follows: Population: If the population of a country increases due to an increase in immigrants or an increase in birth rate, the demand of various kinds of goods will increase or vice versa. Changes in Tastes: Demand for a commodity may change due to change in tastes. For example, if people shift from motorbikes to cars for travel due to change in tastes, the demand for cars will increase and demand for motorbikes will decrease.
Changes in Income: When the disposable income increases, the purchasing power of people also increases and they demand more goods at the same price or even at a higher price. Conversely, decrease in income results in decrease in the purchasing power and hence demand also decreases. Price of Related Goods: In case of substitutes (The goods that can be used in place of other goods) like tea and coffee, if the price of the coffee decreases, the demand of coffee will increase and demand of tea will decrease.
In case of compliments (The goods that are used in combination with other goods) like cars and fuel, if the price of the fuel increases, the demand of cars will decrease and vice versa. Q#4: Explain the concept of Elasticity of Demand. Solution: Elasticity of Demand: Elasticity means responsiveness. Elasticity of demand means responsiveness of demand to a change in price. It measures how much the quantity demanded changes with a change in price. Price Elasticity of Demand: Price elasticity of demand is the responsiveness of the quantity demanded of a good to a change in its price.
It is defined as: “Responsiveness of quantity demanded to a change in price. ” It is the percentage change in quantity demanded divided by the percentage change in price. Mathematically, it can be expressed as: Ep = [pic] Degrees of Price Elasticity of Demand: We observe that for some commodities, the quantity demanded changes sharply with even a slight change in price. But, for some other commodities, a larger change in price doesn’t bring much change in quantity demanded. There are different degrees of price elasticity of demand for different products. Perfectly Elastic Demand:
When a small change in price results in quantity demanded dropping down to zero, the elasticity is said to be perfectly elastic. It occurs where there is perfect competition. [pic] Perfectly Inelastic Demand: When a change in price doesn’t affect quantity demanded at all and leaves it unchanged, the elasticity is said to be perfectly inelastic. The demand for too expensive or too economical goods is nearly perfectly inelastic. [pic] Unitary Elastic Demand: When the quantity demanded changes by exactly the same percentage as price, the demand is said to be unitary elastic.
For example, if a 10% decrease in price results in a 10% increase in quantity demanded, the elasticity of demand is unit elastic. [pic] Elastic Demand: When the quantity demanded increases by a higher percentage than price, the demand is said to be elastic. In other words, if a 1% change in price brings a more than 1% change in quantity demanded, the demand is said to be elastic. The elasticity of luxurious goods is usually elastic. The demand for products having close substitutes is also elastic. [pic] Inelastic Demand; When the quantity demanded increases by a lower percentage than price, the demand is said to be inelastic.
In other words, if a 1% change in price brings a less than 1% change in quantity demanded, the demand is said to be inelastic. The elasticity of necessities is usually inelastic because we need necessities most. The demand for products having no or fewer substitutes is also inelastic. [pic] ii) Cross elasticity of demand. Solution: The demand for many goods is affected by the prices of other goods. It is a common observation that various goods have close substitutes like coffee is a substitute of tea and mutton is a substitute of beef.
If a price of one substitute changes, the demand for the other substitute is also affected. The cross elasticity of demand measures this effect. It may be defined as: “Responsiveness of quantity demanded of one good (B) to a change in price of another good (A)” Mathematically, it can be expressed as: Eab = [pic] iii) Income Elasticity of Demand: Income is the most important non-price factor which affects the demand of a good. A rise in income when the price remains constant increases the purchasing power of a consumer and increases the demand.
Income elasticity of demand can be defined as: “Responsiveness of quantity demanded to a change in income. ” It is the percentage change in quantity demanded divided by the percentage change in income. Mathematically, it can be expressed as: Ey = [pic] Q#5: Explain any two methods of measuring elasticity of demand. Solution: There are two most commonly methods used to measure elasticity of demand. They are explained below: Point Elasticity Method: It may be defined as; “The measurement of elasticity at a point on the demand curve is called point elasticity. ”
The point elasticity method is used when we want to measure a small change in quantity demanded to a very small change in price. The formula for calculating point elasticity of demand is: = [pic] = [pic] = [pic] = [pic] Arc Elasticity of Demand: It may be defined as: “The measurement of elasticity between any two points on the demand curve. ” Arc elasticity method is used when we want to measure a large change in quantity demanded relative to a large change in price. It gives elasticity measurement between any two points lying on the demand curve irrespective of the distance between them.
Therefore, we can measure a large change in quantity demanded and price through this method. The formula for calculating Arc elasticity of demand is: = [pic] = [pic] Q#6: Define and Explain ‘Law of diminishing marginal Utility’. Solution: Law of diminishing marginal utility explains a basic fact of life that whenever we consume something in sequence, we get less satisfaction from it with each successive unit consumed. The law may be stated as: “The additional utility derived from consuming more quantities of a commodity diminishes with each additional unit of consumption. ” Explanation:
This law can be explained with a schedule and a graph. We take example of consumption of mangoes. The total utility and marginal utility derived from each unit of consumption is listed in the following schedule. The table shows that with each additional unit of mango consumed, the marginal utility or additional utility decreases. |Units of Mangoes |Total Utility |Marginal Utility | |0 |0 |0 | |1 7 |7 | |2 |11 |4 | |3 |13 |2 | |4 |14 |1 | |5 |14 |0 | |6 |13 |-1 | The total utility and marginal utility curves are graphically expressed as: [pic] The total utility is maximum when marginal utility is zero. Q#7: State and Explain Law of Equi-marginal utility Solution: We have limited resources and whenever we use limited resources to satisfy some of our unlimited wants, we want to gain maximum satisfaction.
Whenever we spent money on purchasing certain commodities at a price, we want to gain maximum satisfaction. The Law of Equi marginal utility helps in achieving this goal. It may be stated as: “We gain maximum satisfaction or utility from consuming a different set of commodities if the marginal utility per rupee spent on all commodities becomes equal”. Explanation: Law of Equi marginal utility can further be explained by taking a simple example. Suppose we want to consume money on video games and pizza. For simplicity, we suppose the price of one video game is Rs/- 6 and the price of one pizza is Rs/- 3. The total utility, marginal utility and marginal utility per rupee spent is listed in the following schedule for different sets of consumption. Video Games (Rs/- 6 each) |Pizza (Rs/- 3 each) | |Quantity |TU |MU |MU/Re spent |Quantity |TU |MU |MU/Re spent | |0 |0 |0 |0 |10 |291 |15 |5. 00 | |1 |50 |50 |8. 33 |8 |274 |17 |5. 67 | |2 |88 |38 |6. 33 |6 |255 |19 |6. 33 | |4 |150 |29 |4. 83 |2 |185 |42 |14. 00 | |5 |175 |25 |4. 17 |0 |0 |- |- | The table shows that if we purchase 2 video games and 6 pizzas, we will maximize satisfaction or utility i. e. 343 (88+255).
In no other combinations we can maximize utility because only by purchasing 2 video games and 6 pizzas, marginal utility per rupee spent is equal for both goods. Q#8: Write a brief note on the concept of short run and long run in economics. Solution: |Short Run |Long Run | |It is the time period in which at least the quantities of one |It is the time period in which the quantities of all the inputs | |input are fixed while the quantities of other inputs can be |(fixed or variable) can be increased. | |varied. | |
Q#9: What do you understand about ‘Laws of returns’? Solution: There are three law of returns i. e. 1. Law of increasing Returns. 2. Law of decreasing returns. 3. Law of constant returns. Law of Increasing Returns: It may be stated as: “Increasing the quantities of one input while keeping all other inputs constant, the total output increases with each unit of input added. ” Explanation: The law of increasing returns occurs when there are some unused fixed resources available. Therefore, increasing the variable factor yields more output at an increasing rate because some unused fixed resources are now utilized. This law can be explained by a schedule and a graph. Fixed Factor (Land) |Labor |Total Product |Marginal Product | |5 |1 |4 |4 | |5 |2 |10 |6 | |5 |3 |18 |8 | |5 |4 |28 |10 | |5 |5 |40 |12 | [pic] The graph based on the values in the schedule clearly shows that with additional hiring of labor, the total product is increasing at an increasing rate i. e. marginal product is increasing. Law of diminishing returns:
It may be stated as: “Increasing the quantities of one input while keeping all other inputs constant, the total output increases at a decreasing rate with each unit of input added. ” Explanation: The law of diminishing returns is the most important of all the laws of returns because it is applicable in both agriculture and industry. It prevails when fixed resources are used to their capacity. Adding variable inputs while fixed resources are kept constant, the productivity of each additional input or marginal product decreases. Therefore, increasing the variable factor yields more output at a decreasing rate. This law can be explained by a schedule and a graph. Fixed Factor (Land) |Labor |Total Product |Marginal Product | |5 |1 |20 |20 | |5 |2 |45 |25 | |5 |3 |65 |20 | |5 |4 |80 |15 | |5 |5 |90 |10 | [pic] Law of Constant Returns: It may be stated as: “Increasing the quantities of one input while keeping all other inputs constant, the total output increases at a constant rate with each unit of input added. ” Explanation:
The law of constant returns occurs for a very short period when the fixed resources available are used to their capacity. Therefore, increasing the variable factor yields more output at a constant rate but for a very short period. This law can be explained by a schedule and a graph. |Fixed Factor (Land) |Labor |Total Product |Marginal Product | |5 |1 |4 |4 | |5 |2 |8 |4 | |5 |3 |12 |4 |5 |4 |16 |4 | |5 |5 |20 |4 | [pic] Q#10: What do you know about ‘Law of Variable Proportions’? Solution: It was discovered that the three laws of returns are not different from each other; they are merely the three different stages of production. Therefore, they were combined in a one single law known as “Law of variable proportions. ” The laws of returns are the different stages of production. Initially with the increase in variable input, the firm experiences law of increasing returns and marginal product increases with each unit of input added.
After sometime, the firm experiences constant returns and marginal product remains constant. In the last stage of production, the firm experiences diminishing returns as fixed factors are used to their capacity and an increase in variable input give returns at a diminishing rate. The following graph explains the different stages of production in the working of law of variable proportions. It shows that with the increase in size of the firm, marginal product first increases, then remains constant for sometime and finally it decreases showing diminishing returns. [pic] Q#11: Write a short note on Fixed Costs and Variable Costs. Solution: Fixed Cost:
Fixed cost is the cost that is independent of the output level. It remains same at each level of Output. Changes in output level do not affect fixed cost. It is represented as a horizontal curve on the graph. Fixed cost curve is shown below: [pic] Average Fixed Cost: It is total fixed cost per unit of output. It always decreases with the increase in the level of output. With the increase in output, the fixed cost is distributed over many units. That is why; average fixed cost curve always decreases. Variable Cost It is cost of all the variable inputs per unit of output. It is proportional to the level of output. It increases as the output increases. At zero level of output, there is no variable cost.
It is represented as an upward sloping curve representing that it is proportional to the output. [pic] Average Variable Cost: It is total variable cost per unit of output. It decreases initially and then it starts to increase with the increase in output. It serves as a minimum compensation for the firm when it is incurring losses. The firm will shut down operations if it is not able to cover its average variable cost. Q#12: What do you understand by Economies of Scale? Solution: Economies of large scale production: The benefits obtained through large scale production are called economies of large scale production. There are several advantages of large scale production.
Broadly speaking, we divide these benefits as internal economies and external economies of large scale production. 1. Internal Economies: The economies of large scale production benefiting an organization’s internal structure are referred to as internal economies of large scale production. Some of the internal economies that firms enjoy through large scale production are as follows: a) Technical Economies: Advancement in technology is the most important tool to reduce cost of production and increase productivity. But, new and improved technology is introduced after heavy investment in research and development. A large scale producer can afford research and development spending and achieve increase in productivity which reduces cost of production. ) Administrative Economies: In a large scale firm, each major task is performed by a specialized department. Therefore, a businessman has to worry only about the policy matters because he can pass on the work to his supervisors who are specialized in managing a particular task better. c) Commercial Economies: A firm needs raw materials to produce output. A large scale firm needs more inputs to produce more outputs. It has to purchase raw materials in large quantities to produce more output. A large scale firm can obtain raw materials at a cheaper price if it buys them in large quantity. Therefore, cost of production decreases. d) Financial Economies:
To operate any business activity, a firm either small or large needs finance. A large scale firm has a generally greater reputation than a small scale firm. Because of its reputation, a large scale firm can obtain finance from banks and also purchase raw materials on credit. e) Risk Bearing Economies: No business is without a risk. To operate any business, one needs to take risk. But, taking risks also depends on risk bearing capability of a firm. A large scale producer or a firm has a greater risk bearing capacity than a small scale firm. It can take greater risks and run through a financial crisis because of adequate capital. 2. External Economies:
The economies of large scale production benefiting an organization’s external environment are referred to as external economies of large scale production. Some of the external economies that firms enjoy through large scale production are as follows: a) Reduced cost of production: Since a large scale firm can spend a huge amount on research and development, it has a better chance of achieving advancements in technology and reducing cost of production through increased productivity. Therefore, a large scale firm can reduce the price to increase the demand of its products and still earn a higher profit on its products. b) Establishment of supporting industries: A large scale firm can become its own supplier. It can produce equipments and raw materials itself which it purchases from other firms.
It can reduce the cost of production because a firm producing its own supplies will not have to pay “profit” to other firms. c) Establishment of subsidiary industries: A large scale producer can use wasted output to produce some useful by-products. This way, it will earn more profit and will be able to use its resources optimally. d) Availability of trained manpower: A large scale firm can hire more trained workers for each department because it can pay the higher salaries for getting specialized workers. But, the benefit obtained from specialization and division of labor is much more than the extra cost of hiring trained manpower. e) Better prospects of market leadership.
Since a large scale producer can reduce its cost of production, it can transfer this benefit to its customers by charging them a lower price. This way, it will be able to maintain better customer relationships and gaining the market share. Q#13: What do you understand by Diseconomies of Scale? Solution: The diseconomies are the disadvantages arising to a firm or a group of firms due to large scale production. Internal Diseconomies of Scale If a firm continues to grow beyond the optimum capacity, the economies of scale disappear and diseconomies will start operating. For instance, if the size of a firm increases, after a point, managing the firm becomes difficult which will increase the average cost of production of that firm.
This is known as internal diseconomies of scale. External Diseconomies of Scale If the size of the firm increases beyond a limit, it will create diseconomies in production which will be common for all firms in a locality. For instance, the growth of an industry in a particular area leads to high rents and high costs of utilities. These are the external diseconomies as this affects all the firms in the industry located in that particular region. Q#14: What do you mean by ‘Perfect Competition’, ‘Monopoly’, ‘Oligopoly’ and ‘Monopolistic Competition’? Solution: Perfect Competition • There are large number of buyers and sellers. • Buyers and sellers are price takers. Products are homogenous or identical with no differentiation. • There are no barriers to entry and exit. • Buyers and sellers are perfectly informed of the market conditions. Monopoly: ? There is only one seller. ? A single seller is a price setter. ? A single seller has a complete control over price. ? There are no close substitutes available. ? There are no competitors in the market. Oligopoly ? There are few producers. ? Products may be identical or differentiated. ? Producers have some control over price. ? Firms advertise their products to create demand for them. Monopolistic Competition ? There are a large number of sellers. ? Products are differentiated (either real or perceived differences). None of the sellers has a large share of the market. ? Sellers have some control over price. ? Firms advertise their products to create demand for them. Q#15: How equilibrium is attained in the short run under perfect competition? Solution: A firm under perfect competition faces a horizontal demand curve. It means that demand of its products is perfectly elastic. If it increases the price of its product by even a smaller quantity, the demand for its products will immediately drops down to zero. Since the products are homogenous and every firm is a price taker, the price remains constant and is equal to marginal revenue at each level of quantity sold. P = Average Revenue = Marginal revenue
The competitive firm will be in equilibrium at a point where its marginal cost is equal to marginal revenue. The firm’s equilibrium at different points determine whether the firm is incurring losses or earning profits and whether it should continue operations or shut down. Following cases determine the firm’s performance. Cases of Equilibrium: ? If the marginal revenue intersects marginal cost at a point above average cost, the competitive firm will enjoy supernormal profits. ? If the marginal revenue intersects marginal cost where it also equals average cost, the competitive firm will enjoy normal or zero economic profits (including seller’s compensation for efforts). If the marginal revenue intersects marginal cost at a point below average total cost but above average variable cost, the competitive firm is incurring losses but it will not shut down because it is able to cover the variable cost and a part of fixed cost. By shutting down at a point above average variable cost, it will incur a greater loss than continuing operations. ? If the marginal revenue intersects marginal cost at a point below average variable cost, it will minimize losses by shutting down. Short Run Equilibrium under Perfect Competition: [pic] Q#16: How does a firm reach to equilibrium point under ‘Perfect Competition’ in the long run? Solution:
A perfectly competitive firm in the long run is in equilibrium at a point where marginal revenue intersects marginal cost at a point where it also equals minimum average total cost. Therefore at this point, P = Marginal revenue = marginal Cost = Minimum Average Cost It also implies that in the long run, the firm can only survive if it can cover its minimum average total cost (variable as well as fixed). Therefore, zero economic profit point is the long run equilibrium point of a perfectly competitive firm. Long Run Equilibrium under Perfect Competition: [pic] Q#17: How equilibrium is attained under Monopoly? In Monopoly, ? There is only one seller. A single seller is a price setter. ? A single seller has a complete control over price. ? There are no close substitutes available. ? There are no competitors in the market. A monopolist can restrict output and produce much lower output even if Average Total Cost (ATC) is declining further. By restricting output due to non-availability of substitutes, the Monopolist can set its own price and has the most control over prices than any other competition. Green Rectangle is the economic profit region. Marginal Cost (MC) curve is a crooked J curve and the rising portion of MC is the supply curve. Average Total Cost (ATC) curve is a U-shaped curve.
Equilibrium takes place where MR=MC. Qm is the equilibrium level of output and Pm is the equilibrium level of price. [pic] Q#18: How equilibrium is attained under Oligopoly? In Oligopoly, ? There are few producers. ? Products may be identical or differentiated. ? Producers have some control over price. ? Firms advertise their products to create demand for them. Each firm in Oligopoly anticipates actions of its rivals when making strategic decisions. Decision making and choices in Oligopolistic Competition are interdependent. When firms in Oligopoly enter into a collusive agreement, they can generate monopoly like profits as shown in the following figure.
Rectangle ‘abcd’ is the profit region. Marginal Cost (MC) curve is a crooked J curve and the rising portion of MC is the supply curve. Average Total Cost (ATC) curve is a U-shaped curve. Equilibrium takes place where MR=MC. Q is the equilibrium level of output and P is the equilibrium level of price. [pic] Q#19: How equilibrium is attained under Monopoly? In Monopolistic Competition, ? There are a large number of sellers. ? Products are differentiated (either real or perceived differences). ? None of the sellers has a large share of the market. ? Sellers have some control over price. ? Firms advertise their products to create demand for them.
A monopolistically competitive firm confronts a downward-sloping demand curve for its output. Modest changes in the output or price of any single firm will have no perceptible influence on the sales of any other firm. The relative independence of monopolist competitors means that they don’t have to worry about retaliatory responses to every price or output change. Another characteristic of monopolistic competition is the presence of low barriers to entry. In the figure below, purple rectangle is the economic profit region. Marginal Cost (MC) curve is a crooked J curve and the rising portion of MC is the supply curve. Average Total Cost (ATC) curve is a U-shaped curve.
Equilibrium takes place where MR=MC. Qa is the equilibrium level of output and Pa is the equilibrium level of price. [pic] With low barriers to entry, new firms will enter the market if there is economic profit. Economic profit is the difference between total revenues and total economic costs (including explicit costs and implicit costs). When firms enter a monopolistically competitive industry, the market supply curve shifts to the right. The demand curves facing individual firms shift to the left. In the long run, there are no economic profits in monopolistic competition as shown in figure below. [pic] ———————– MICROECONOMICS