## ECO401 Economics 29 May 2010

Elastic supply means relatively small changes in price causes relatively larger changes in quantity supplied. An elastic supply has a value greater than one (the negative value is ignored).

Inelastic supply means relatively large changes in price causes relatively smaller changes in quantity supplied. An inelastic supply has a value of elasticity less than one (the negative value is ignored).

The principle of equi marginal utility states that a person will derive a maximum level of Total Utility from consuming a particular bundle of goods when the utility derived from the last dollar spent on each good is the same OR the ratio of marginal utility to price of all the commodities should be equal to each other.

MUa = MUb = MUc = .

Pa Pb PC

Optimal point of consumption is that point where consumer surplus becomes zero. Consumer surplus is the difference between the price that consumer wants to pay and the price that he actually pays i.e. CS= Marginal Utility - Price. If marginal utility is greater than price, consumption will increase causing Marginal Utility to fall until it equals price, and vice versa.

Rational choice is the optimal choice. Consumers can decide about the rational decision by using cost and benefit analysis. Rational choice is a choice where individuals try to make the most efficient decisions possible in an environment of scarce resources. As people want to maximize their utility with limited resources, this is a rational choice for consumers.

Supply of food varies from time to time and according to the demand. Daily market supply of food like vegetables and fruits is fixed because these are perishable goods and go bad at the day end. However, foods like wheat and rice etc can be stored for some time period so its supply is not fixed and may vary according to the market demand.

In price floor, the government sets the minimum price to support a desired commodity or service in a society. At price floor, buyers are in equilibrium, but sellers are not. Sellers would like to sell more quantity, but buyers are not willing to buy all that quantity. To prevent the adjustment process from causing price to fall, government may buy the surplus.

In price ceiling, the government sets the maximum price limit to ensure that prices dont rise above that limit. Due to imposition of this limit, buyers want to buy more but sellers do not like the ceiling price so they dont provide the required supply in the market. Because buyers cannot buy as much as they would like at the legal price, buyers will be out of equilibrium.Equilibrium can take place if market forces of demand and supply works and push the price upward but it does not work due to government intervention.

For quizzes :

When there is increase in income, demand for inferior goods will decrease and demand curve will shift leftward.
When there is decrease in price of substitute, demand will decrease and demand curve will shift leftward.
When there is increase in income, demand for inferior goods will decrease and demand curve will shift leftward.
When there is decrease in price of substitute, demand will decrease and demand curve will shift leftward.

DIAMOND-WATER PARADOX is in the context of marginal utility. Water and diamond are very different in value. Water is extremely used thing while diamonds are not much used. The price of diamond is very high while the price of water is very low. Since water is used widely so its marginal utility is very low. And diamonds are used very rarely so its marginal utility is very high. On supply side, water is abundant so has low value and diamond is scarce so has very high value.

Water is a necessity, human beings cannot even survive without water, whereas diamonds are luxurious good not necessity. Yet water had a very small price, and diamonds have very large price.

For most people, water is sufficiently abundant whereas diamonds are in much more restricted supply thats why water is cheap and diamonds are expensive.

Risk Hedging means technique to avoid the risk.

Example: Insurance companies operate under the principle of law of large numbers. An insurance company collects the premium from the people. They also diversify the risk.

In the presence of asymmetric information, an insurance company has to contend with the problems of adverse selection (people who want to buy insurance are also the most risky customers; an ex-ante problem) and moral hazard (once a person is insured his behavior might become more rash; an ex-post problem).

Ex-ante concept
It is a neo-Latin word which means "before the event.

Ex-post concept
It is a Latin word which means "after the fact".

There are two sides: demand side and supply side.

According to supply side, the value of a good is determined by the labor content that is used to produce the good.

According to demand side, the value of a good is determined by its marginal utility.

Normal goods:
If the price of good falls, the consumers purchasing power increases, income effect reinforces the substitution effect.

Giffen goods:

If the price of good falls, the consumers purchasing power increases. But if the income effect for an inferior good is sufficiently strong, the consumer will buy less of the good when it becomes less expensive.

There are no hard and fast examples of normal goods, inferior goods and Giffen goods. It depends on the consumers taste and preferences. One thing might be normal for one person but inferior for another person. For example, wine may be normal for non Muslims but inferior for Muslims. Some people prefer mutton so it is a normal good for them or might be they consider chicken as inferior good. So it all depends on consumers tastes. Giffen good is also a category of inferior good.

The Income Consumption Curve (ICC)

The income consumption curve (ICC) can be used to derive the Engel Curve, which shows the relationship between income and quantity demanded.

Price Consumption Curve (PCC)

The price consumption curve (PCC) traces out the optimal choice of consumption at different prices. The PCC can be used to derive the demand curve, which shows the relationship between price & quantity demanded.

MPP = APP , APP does not change

MPP > APP , APP upward

MPP < APP , APP down

This is the relationship between Average Physical Product and Marginal Physical Product. If you see the graph of Average Physical Product and Marginal Physical Product then you will find that:

 If the marginal physical product equals the average physical product, the average physical product will not change.

 If the marginal physical product is above the average physical product, the average physical product will rise.

 If the marginal physical product is below the average physical product, the average physical product will fall(end)

Isocost or Budget Line

The concept of isocost is similar to the budget line developed in indifference curve analysis. It is a line, which captures all the different combinations of inputs that the firm can afford to hire.

Isoquant is the combination of inputs that provide the same level of output.

The slope of an isoquant is called marginal rate of technical substitution (MRTS). MRTS is the amount of one factor, e.g. capital, that can be replaced by a one unit increase in the other factor e.g. labor, if output is to be held constant.

Marginal cost is the change in total cost resulting from a change in the quantity of output produced by a firm.

Economies of scale arise when firms become bigger and bigger then their costs per unit of output fall. This could be because of larger more efficient plants, financial economies, more efficient specialized labour, bulk discounts on purchases etc.

Diseconomies of scale are the forces that cause larger firms to produce goods and services at increased per-unit costs.

If output increases by that same proportional change then there are constant returns to scale. If output increases by less than that proportional change, there are decreasing returns to scale. If output increases by more than that proportion, there are increasing returns to scale.

Average total cost (ATC) is total cost per unit of output, it can be found by dividing total cost (TC) by the quantity of output (Q).

ATC = TC/Q

Average variable cost (AVC)
AVC is an economics term to describe the total cost a firm can vary (labor, etc.) divided by the total units of output.
AVC = TVC/Q

Price taker:

A firm that does not have the ability to influence market price is a price-taker. In perfect competition, the firm is price taker. There are large number of buyers and sellers and firm can not influence on the market price. Price is set by the forces of demand and supply

Price maker:

A firm that influences the market price by how much it produces can be called a price-maker orprice-setter. In Monopoly, firm is price maker. A monopoly or a firm within monopolistic competition that has the power to influence the price it charges as the good it produces does not have perfect substitutes. A monopoly is a price maker as it holds a large amount of power over the price it charges.

Total Revenue & Total Cost approach

According to this approach, profit is maximized at that point where the difference between total revenue & total cost is maximum.

Marginal Revenue & Marginal Cost APPROACH
According to this approach, profit is maximized at the point where MC=MR.

If there is decrease in demand, there will be leftward / downward shift in demand curve.
If there is increase in demand, there will be rightward / upward / outward shift in demand curve.
For convenience, just remember that rightward shift for increase in demand and supply and leftward shift for decrease in demand and supply.

Profit Maximization:
Firms are interested in profit maximization. Profit is the difference between total revenue & total cost. Higher the difference, higher is the level of profit. There are two approaches of profit maximization. One is Total Revenue and Total Cost approach and the other is Marginal Revenue and Marginal Cost approach.

Production Possibility Frontier (PPF):
A production possibility frontier (PPF) is a graph or curve that shows the maximum level of output that can efficiently be produced with limited productive resources.

The law of demand states that if the price of a certain commodity rises, its quantity demanded will go down, and vice-versa.

The condition for consumer's equilibrium is expressed as ..Consumer's equilibrium occurs at the point where budget line is tangent to the indifference curve.

Law of Diminishing Marginal Utility
This law states that as more of a good is consumed, eventually each additional unit of the good provides less additional utility and marginal utility derived from the consumption of good decreases.

Substitution effect of a price change is negative in case of normal goods. If price of a good increases then consumers moves towards its substitutes and consume those substitutes goods and will reduce the quantity of that goods whose price rose. So substitution effect is also negative.

Income effect / real Income effect of a price change is negative in case of normal goods. If price of any good increases, real income of consumer falls and he will consume less of that good. Since as price increases, real income decreases, purchasing power of consumers decreases so income effect of a price change is negative for normal goods.

The term is Budget deficit. It is a situation when government expenditures are greater than the revenues.

Law of Diminishing Marginal Utility
This law states that as more of a good is consumed, eventually each additional unit of the good provides less additional utility and marginal utility derived from the consumption of good decreases.
The law of diminishing marginal utility helps explains the negative slope of the demand curve and the law of demand. Marginal utility curve is negatively sloped.
For example the initial cup of tea in the morning meets a large need and provides a large amount of satisfaction (utility). But as we consume another cup of tea, the satisfaction derived from the 2nd cup will be less than the 1stcup and so on.

For two goods x and y the concave shape of PPF shows the increasing opportunity cost.
1. What effect is working when the price of a good falls and consumers tend to buy it instead of other goods?
A. the substitution effect.
B. the ceteris paribus effect.
C. the total price effect.
D. the income effect.

2:- Suppose the demand for good Z goes up when the price of good Y goes down. We can say that goods Z and Y are

A. Perfect substitutes.
B. Unrelated goods.
C. Complements.
D. Substitutes.

3:-If the demand for coffee decreases as income decreases, coffee is

A. a normal good.
B. a complementary good.
C. An inferior good.
D. a substitute good.

4:-When the decrease in the price of one good causes the demand for another good to decrease, the goods are

A. Complements.
B. Normal.
C. Inferior.
D. Substitutes.

5:- The price of apples falls by 5% and quantity demanded increases by 6%. Demand for apples is:

A. Inelastic.
B. Perfectly inelastic.
C. Elastic.
D. Perfectly elastic.

6:- The price of bread increases by 22% and the quantity of bread demanded falls by 25%. This indicates that demand for bread is

A. Elastic.
B. Inelastic.
C. unitarily elastic
D. perfectly elastic

Question:-
what are sources of inefficiency in monopolistic competition?

what is the effect of the fact that price exceeds marginal cost, Excess Capacity and Product Diversity on this efficiency?

There are two sources of inefficiency in monopolistic competition:

1. At its optimum output, monopolistic competitive firm charges a price that exceeds marginal costs. The monopolistic competitive firm maximizes profits where Marginal Revenue = Marginal Cost. Since the monopolistic competitive firms demand curve is downward sloping, this means that the firm is charging a price that exceeds marginal costs.

2. Monopolistic competitive firm operate with excess capacity. It means that the firm's profit maximizing output is less than the output associated with minimum average cost.

Due to the fact that price exceeds marginal cost, there will be excess capacity.

Price elasticity of demand is:-

Ratio of the percentage change in quantity demanded to the percentage change in price.
Risk is when an outcome may or may not occur but its probability is known while
Uncertainty is when an outcome may or may not occur but its probability is not known.
( 'ceteris paribus' meaning 'all else equal )
Opportunity cost: what we forgo, or give up, when we make a choice or a decision

Question:-If the income elasticity of demand is 1/2, the good An inferior good or luxury good?

Answer:-If the sign of income elasticity of demand is positive, the good is normal and if sign is negative, the good is inferior.
Price floor results in excess supply or surplus of the product.
If cross price elasticity is positive then the goods are considered as substitutes.
Quantity demand will decrease as price increase. Demand curve will remains constant.
Will Costs determine Firm's behavior ?? yes

The term ex-ante means "before the event e.g. in the financial world, the ex-ante return is the expected return of an investment portfolio. Ex-post means after the fact

An explicit collusion is a formal, usually secret, collusion agreement among competing firms in an industry designed to control the market, raise the market price, and otherwise act like a monopoly. Explicit collusion is also known as overt collusion. The distinguishing feature of explicit collusion is a formal agreement whereas no formal explicit agreement is involved in tacit collusion.

Explicit collusion usually occurs in oligopolistic firms whereas tacit collusion is best understood in the context of a duopoly and the concept of Game Theory (namely, Nash Equilibrium).

Similarities of oligopoly with other market structures:

Oligopoly is similar to monopoly in the sense that there are a small number of firms (about 2-20) in the market and as such barriers to entry exist. It is similar to perfect competition in the sense that firms compete with each other which may result in prices very similar to those that would obtain under perfect competition. It is similar to monopolistic competition since there is a possibility of having differentiated products.

Difference of oligopoly with other market structures:

It is different with other market structures because there are few participants in this type of market, each Oligopolist is aware of the actions of the others. The decisions of one firm influence the other firms. This causes Oligopolistic markets and industries to be at the highest risk for collusion. It is not possible to identify any single equilibrium in oligopoly. Reason for that is the firms are interdependent.
At any point on the indifference curve, the slope is equal to the marginal rate of substitution.
if the income elasticity of demand is 1/2, the good is ? Normal good.
Price discrimination is the practice of charging different prices from different people for the same product.

QUESTION:does an income consumption curve another name for income demand curve?

ANS:Yes. Income consumption curve is a curve that shows the relationship between income and demand. Normally as income rises, so demand rises also, but it can happen, as in the case of low value goods, that when income rises demand falls as purchasers switch to higher-priced products.
Preference, Transitivity, Completeness and Convexity all are the properties of indifference curve.

QUESTION:when the firm doesnt produce any output , is total cost zero?

ANS: Total cost = Fixed cost + Variable cost
Total cost will not be zero in case of no output produced, because fixed cost always exist whether output produced or not. Variable cost will be zero if output is zero.

QUES:
for a shoe manufacturer which cost is fixed and which is variable?

cost of leather
wear and tear on machinery?

ANS:

Cost of leather = Variable cost
Fee paid to advertising agency = Variable cost
Wear and tear on machinery = Depreciation
cateris paribus means other things being remaining the same.
A rational person will always select on the basis of marginal benefit is greater than marginal cost.
Monopolists typically produce fewer goods and sell them at a higher price than under perfect competition, resulting in abnormal and sustained profit.
change in total revenue divided by one unit change in output is called marginal revenue.
The indifference curves are convex to the origin. This is due to the concept of the diminishing marginal rate of substitution between the two goods. If we consider indifference map, the higher indifference curve shows higher level of utility or satisfaction.
Negatively correlated means negative relationship.
Uncorrelated means no relationship.
A duopoly refers to a market condition in which two companies have control over the market while producing similar product. Duopoly is similar to monopolies in which only one company controls the market and oligopolies in which more than two companies are allowed to trade in the market.

Relationship between APP and MPP

 If the marginal physical product equals the average physical product, the average physical product will not change.
 If the marginal physical product is above the average physical product, the average physical product will rise.
 If the marginal physical product is below the average physical product, the average physical product will fall.

The slope is defined as: Rise / Run.
Rise = Vertical distance between any two points on the line.
Run = Horizontal distance between any two points on the line.

Curve is the graphical representation of tables / schedules. If demand schedule is represented graphically, it is known as demand curve. The slope of demand curve is negative or downward.

Oligopoly

In this market structure, there are a small number of firms (about 2-20) in the market and there are also barriers to entry.
A monopolist can make super normal, profits even in long run because there is no easy entry fo other firms as in the case of perfect competition therefore a monopolist can maintain her high price even in the long run.
Monopoly is the market structure where there is single seller. A monopolist has the ability to influence the market price. He is a price maker.

Super normal profit:-Profit = Revenue  cost.
Super normal profit is the profit where the positive difference between revenue and cost is maximum. Firm earns super normal profits in short run where revenue is greater than the cost, in long run it earns normal profit where revenue is equal to cost.
Super normal profit is only possible in the short run not in the long run. An industry is earning super normal profit in the short run. Due to the attraction of this super normal profit, other new firms enter in the market. These new firms also produce products; supply of the product increases in the market, so the price goes down, profit squeezes and profit share is divided among all the firms so profit share of each firm reduces, so each firm earns normal profit in the long run.

Ques: if the price of houses and the number of houses purchased both rise over the course of the year then what will be effect on demand demand curve, supply and house construction costs?

Ans: It means that demand of houses has increased. People want to purchase houses irrespective of the increase in prices.

Question. if there are only two goods A and B,if more of good A is always preferred to less, and if less of good B is always preferred to more, then what happens to Indifference curves of both?

Ans: Indifference curve will be downward sloping and convex to the origin.
Elastic demand means relatively small changes in price causes relatively larger changes in quantity demanded. An elastic demand has a value greater than one (the negative value is ignored).
Inelastic demand means relatively large changes in price causes relatively smaller changes in quantity demanded. An inelastic demand has a value of elasticity less than one (the negative value is ignored).

Question: A person with a diminishing marginal utility of income what is he said?

Ans: The degree of risk aversion increases as your income level falls, due to diminishing marginal utility of income.
Income effect of a price change is negative in case of normal goods. If price of any good increases, real income of consumer falls and he will consume less of that good. Since as price increases, real income decreases, purchasing power of consumers decreases so income effect of a price change is negative for normal goods.
In elasticity, minus sign is ignored. We just see the value which is greater than 1 is elastic and which is less than 1 is inelastic. If elasticity is 3 which is greater than 1, it is elastic. If elasticity is 0.3 which is less than 1, it is said to be inelastic.

Question No: 35 ( Marks: 3 )
Why the monopolists produce lower quantities at higher prices compared to perfectly competitive firms?

Ans:

1) Large initial fixed cost is involved
2) Product differentiation or drabd loyalty
3) Monopolistic controls the supply of key factors of production

Question No: 36 ( Marks: 5 )
Write down any five situations in which cartel can survive?

Ans:
1) Cartel can survive when number of firms is small.
2) When the collusion is tacit or hidden not explicit.
3) The products are homogeneous.
4) Industry is sable
5) There is opening among the firms regarding their production process.
6) Governments strictness in implementing antitrust law.

Question No: 37 ( Marks: 5 )
Differentiate between external economies of scale and external diseconomies of scale with the help of examples.

Ans:
External economies: These are the benefits which are accured to any firm in the presence of other firms. For example setting of credit information bureaus by bank , advertising by industry such as rival industry.
Discovery of new techniques.

This type of economy occurs when an industry is heavily concentrated in a particular area.
Economies is available to all firms for example construction of roads

External diseconomies of scale :
These are the forces which causes the large firms to produce goods and services at increased per unit costs
This type of scale occurs when an industry grows larger and shortage of skilled laor taking place and shortage of raw materials are the types of external diseconomies.
When a firm become large then supervision of workers become difficult and problem is created for management is taking place which cause adverse effect on efficiency.

Risk loving is the person who wants to take the risk.
Risk averse is a person who avoids taking the risk.
Risk neutral is a person that is indifferent about taking the risk or not taking the risk.

Question:- What would the risk neutral person, risk averse person and risk loving person do in the following cases?

o If Odds Ratio > 1

o If Odds Ratio = 1

o If Odds Ratio < 1

1) For risk neutral person
o If Odds Ratio > 1, then he will definitely buy
o If Odds Ratio = 1, then he will be indifferent
o If Odds Ratio < 1, then he might not buy as OR < 1

2) For risk averse person
o If Odds Ratio > 1, then in this case as well he might decide not to buy.
o If Odds Ratio = 1, then he will definitely not buy
o If Odds Ratio < 1, then he will definitely not buy

3) For risk loving person
o If Odds Ratio > 1, then he will definitely buy
o If Odds Ratio = 1, then he will definitely buy

· If Odds Ratio < 1, then in this case as well he might decide to buy.

Question :-
C. You toss a coin, if head comes, you are given Rs. 200 and if tail comes, you have to pay Rs. 200. Will you play this game or not? Give your answer with brief explanation