2013 ( May )
( General / Speciality )
Course : 202
( Business Economics )
Full Marks : 80
Time : 3 hours
1. Answer as directed: 1x8=8
(a) Defining the problems is one of the steps of business decision making process.(true/false)
Ans: TRUE
(b) Business Economics is specially associated with the business firms. (true/false)
Ans: True
(c) Demand for commodity means
- Desire for a commodity
- Need for a commodity
- Desire for a commodity backed by ability to pay for it
- Ability to pay for a commodity (choose the correct answer)
ANS: Desire for a commodity backed by ability to pay for it
(d) ‘Income of people’ is one of the factors determining market demand. (true/false)
Ans: TRUE
(e) If all factors of production would have been perfectly divisible, increasing return to scale would not have occurred. (true/false)
Ans: FALSE
(f) Isoquants, like indifference curves does not slop downwards from left to right. (true/false)
Ans: FALSE
(g) The price at which quantity demanded equals quantity supplied is called EQUILIBRIUM price.
(h) Which rule of revenue and cost is followed by the monopolist to earn maximum profit?
ANS: Monopolist can earn maximum profits when difference between TR and TC is maximum
2. Answer the following questions: 4x4=16
(a) What are the basic problems of an economic system?
Ans: Basic Problems of an economic system or Problems of business economics: The problem of scarcity of resources which arises before an individual consumer also arises collectively before an economy. On account of this problem and economy has to choose between the following:
(i) Which goods should be produced and in how much quantity?
(ii) What technique should be adopted for production?
(iii) For whom goods should be produced?
These three problems are known as the central problems or the basic problems of an economy. This is so because all other economic problems cluster around these problems. These problems arise in all economics whether it is a socialist economy like that of North Korea or a capitalist economy like that of America or a mixed economy like that of India. Similarly, they arise in developed and under-developed economics alike.
1. What to produce?
There are two aspects of this problem— firstly, which goods should be produced, and secondly, what should be the quantities of the goods that are to be produced. The first problem relates to the goods which are to be produced. In other words, what goods should be produced? An economy wants many things but all these cannot be produced with the available resources. Therefore, an economy has to choose what goods should be produced and what goods should not be. In other words, whether consumer goods should be produced or producer goods or whether general goods should be produced or capital goods or whether civil goods should be produced or defense goods. The second problem is what should be the quantities of the goods that are to be produced.
2. How to produce?
The second basic problem is which technique should be used for the production of given commodities. This problem arises because there are various techniques available for the production of a commodity such as, for the production of wheat, we may use either more of labour and less of capital or less of labour or more of capital. With the help of both these techniques, we can produce equal amount of wheat. Such possibilities exist relating to the production of other commodities also.
3. For whom to produce?
The main objective of producing a commodity in a country is its consumption by the people of the country. However, even after employing all the resources of a country, it is not possible to produce all the commodities which are required by the people. Therefore, an economy has to decide as to for whom goods should be produced. This problem is the problem of distribution of produced goods and services. Therefore, what goods should be consumed and by whom depends on how national product is distributed among various people.
(b) Mention four chief determinants of price elasticity of demand.
Ans: FACTORS INFLUENCING PRICE ELASTICITY OF DEMAND
1. Nature of commodity: Elasticity depends on whether the commodity is a necessity, comfort or luxury. Necessities of life have inelastic demand and comforts and luxuries have elastic demand.
2. Availability of substitutes: Goods with substitutes have elastic demand and goods without substitutes have inelastic demand. For example: coffee and tea are substitutes. If price of tea increases, people may switch over to coffee. If price of coffee raises people may shift to tea. The demand of salt is inelastic.
3. Uses of the commodity: Certain goods can be put to many uses. Example – electricity. Such goods have elastic demand because as the price decreases, they will be put to more uses.
4. Proportion of income spent on commodity: For some goods, consumers spend only a small part of their income. The demand will be inelastic. For e.g.: - salt and matches
5. Price of goods: Generally cheap goods have inelastic demand and expensive goods have elastic demand.
6. Income of consumers: Very rich people have inelastic demand for goods and poor people have elastic demand. Because rich people will buy the commodity at all levels of prices where poor people there is a change in quantity of consumption according to change in price.
(c) Discuss briefly four characteristics of isoquants.
Ans: Isoquants and its Properties
The word an isoquant is a locus of points, representing different combinations labour and capital .An isoquant Curve. ‘ISO’ is of Greek origin and means equal or same and ‘quant’ means quantity. An isoquant may be defined as a curve showing all the various combinations of two factors that can produce a given level of output. The isoquant shows- the whole range of alternative ways of producing- the same level of output. The modern economists are using isoquant, or ‘ISO’ product curves for determining the optimum factor combination to produce certain units of a commodity at the least cost.
Properties or Features of Isoquant
The following are the important properties of isoquants:
1. Isoquant is downward sloping to the right. This means that if more of one factor is used less of the other is needed for producing the same output.
2. A higher isoquant represents larger output.
3. No isoquants intersect or touch each other. If so it will mean that there will be a common point on the two curves. This further means that same amount of labour and capital can produce the two levels of output which is meaningless.
4. Isoquants need not be parallel to each other. It so happens because the rate of substitution in different isoquant schedules need not necessarily be equal. Usually they are found different and therefore, isoquants may not be parallel.
5. Isoquant is convex to the origin. This implies that the slope of the isoquant diminishes from left to right along the curve. This is because of the operation of the principle of diminishing marginal rate of technical substitution.
(d) What do you mean by minimum support price?
Ans: Minimum Support Price is the price at which government purchases crops from the farmers, whatever may be the price for the crops. Minimum Support Price is an important part of India’s agricultural price policy. The MSP helps to incentivize the framers and thus ensures adequate food grains production in the country. It gives sufficient remuneration to the farmers, provides food grains supply to buffer stocks and supports the food security programme through PDS and other programmes.
The minimum support prices are announced by the Government of India at the beginning of the sowing season for certain crops on the basis of the recommendations of the Commission for Agricultural Costs and Prices (CACP). Support prices generally affect farmers’ decisions indirectly, regarding land allocation to crops, quantity of the crops to be produced etc. It is in this angle that the MSP becomes a big incentive for the farmers to produce more quantity.
3. (a) What do you mean by business decision-making process? Discuss the various phases or steps of business decision-making process. 4+7=11
Ans: Decision Making - Introduction
Decision-making is an essential aspect of modern management. It is a primary function of management. A manager's major job is sound/rational decision-making. He takes hundreds of decisions consciously and subconsciously. Decision-making is the key part of manager's activities. Decisions are important as they determine both managerial and organisational actions. A decision may be defined as "a course of action which is consciously chosen from among a set of alternatives to achieve a desired result." It represents a well-balanced judgment and a commitment to action.
It is rightly said that the first important function of management is to take decisions on problems and situations. Decision-making pervades all managerial actions. It is a continuous process. Decision-making is an indispensable component of the management process itself.
The effectiveness of management depends on the quality of decision-making. In this sense, management is rightly described as decision-making process. According to R. C. Davis, "management is a decision-making process." Decision-making is an intellectual process which involves selection of one course of action out of many alternatives. Decision-making will be followed by second function of management called planning. The other elements which follow planning are many such as organising, directing, coordinating, controlling and motivating.
Decision-making has priority over planning function. According to Peter Drucker, it is the top management which is responsible for all strategic decisions such as the objectives of the business, capital expenditure decisions as well as such operating decisions as training of manpower and so on. Without such decisions, no action can take place and naturally the resources would remain idle and unproductive. The managerial decisions should be correct to the maximum extent possible. For this, scientific decision-making is essential.
Definitions of Decision-making
The Oxford Dictionary defines the term decision-making as "the action of carrying out or carrying into effect".
According to Trewatha & Newport, "Decision-making involves the selection of a course of action from among two or more possible alternatives in order to arrive at a solution for a given problem".
Steps Involved In Decision Making Process
Decision-making involves a number of steps which need to be taken in a logical manner. This is treated as a rational or scientific 'decision-making process' which is lengthy and time consuming. Such lengthy process needs to be followed in order to take rational/scientific/result oriented decisions. Drucker recommended the scientific method of decision-making which, according to him, involves the following six steps:
- Identifying the Problem: Identification of the real problem before a business enterprise is the first step in the process of decision-making. It is rightly said that a problem well-defined is a problem half-solved. Information relevant to the problem should be gathered so that critical analysis of the problem is possible. This is how the problem can be diagnosed. Clear distinction should be made between the problem and the symptoms which may cloud the real issue.
- Analyzing the Problem: After defining the problem, the next step in the decision-making process is to analyze the problem in depth. This is necessary to classify the problem in order to know who must take the decision and who must be informed about the decision taken. Here, the following four factors should be kept in mind:
- Futurity of the decision,
- The scope of its impact,
- Number of qualitative considerations involved, and
- Uniqueness of the decision.
- Collecting Relevant Data: After defining the problem and analyzing its nature, the next step is to obtain the relevant information/ data about it. There is information flood in the business world due to new developments in the field of information technology. All available information should be utilised fully for analysis of the problem.
- Developing Alternative Solutions: After the problem has been defined, diagnosed on the basis of relevant information, the manager has to determine available alternative courses of action that could be used to solve the problem at hand. Only realistic alternatives should be considered. It is equally important to take into account time and cost constraints and psychological barriers that will restrict that number of alternatives.
- Selecting the Best Solution: After preparing alternative solutions, the next step in the decision-making process is to select an alternative that seems to be most rational for solving the problem. The alternative thus selected must be communicated to those who are likely to be affected by it. Acceptance of the decision by group members is always desirable and useful for its effective implementation.
- Converting Decision into Action: After the selection of the best decision, the next step is to convert the selected decision into an effective action. Without such action, the decision will remain merely a declaration of good intentions. Here, the manager has to convert 'his decision into 'their decision' through his leadership.
- Ensuring Feedback: Feedback is the last step in the decision-making process. It is like checking the effectiveness of follow-up measures. Feedback is possible in the form of organised information, reports and personal observations. Feed back is necessary to decide whether the decision already taken should be continued or be modified in the light of changed conditions.
Every step in the decision-making process is important and needs proper consideration by managers. This facilitates accurate decision-making.
Or
(b) Discuss the relationship between Business Economics and Traditional Economics. 11
Ans: Ans: Managerial economics is the study of economic theories, logic and tools of economic analysis that are used in the process of business decision making. Economic theories and techniques of economic analysis are applied in analyze business problems, evaluate business options and opportunities with a view to arriving at an appropriate business decision. Managerial economics is thus constituted of that part of economic knowledge, logic theories and analytical tools that are used for rational business decision making.
Managerial economics is that subject which describes how economic analysis is used in taking business decisions. The purpose of Managerial Economics is to show how economic analysis can be used in formulating business policies.
Managerial economics is that discipline which uses economic concepts, principles and economic analysis in taking business decision and formulating future plans. It integrates economic theory with business practice for choosing business policies. Managerial economics lies on the borderline between economics and business management and bridges the gap between the two.
Definition of Managerial Economics:-
According to McNair and Meriam: “Managerial economics ……. Is the use of economics modes of thought to analyze business situation.”
According to Mansfield: “Managerial economics is concerned with the application of economic concepts and economics analysis to the problems of formulating rational decision making”.
Relationship between Managerial economics and Traditional economics
In the words of Haynes “The relation of managerial economics to economic theory is much like that of engineering to physics, or of medicine to biology or bacteriology. It is the relation of an applied field to the more fundamental but more abstract basic discipline from which it borrows concepts and analytical tools. The fundamental theoretical fields will no doubt on the long run make the greater contribution to the extension of human knowledge. But the applied fields involve the development of skills that are worthy of respect in themselves and that require specialized training. The practicing physician may not contribute much to the advance of biological theory but he plays an essential role in producing the fruits of progress in theory. The managerial economist stands in a similar relation to theory with perhaps the difference that the dichotomy between the pure and the “applied” is less clear in management than it is in medicine.”
Managerial economics has been defined as economics applied in decision-making. It is a special branch of economics bridging the gap between economic theory and managerial practice. The relationship between managerial economics and traditional economics is facilitated by considering the structure of traditional study. The traditional fields of economic study about theory, Micro economics focuses on individual consumers firms and industries. Macro economics focuses on aggregations of economics units, especially national economics. The emphasis on normative economics focuses on prescriptive statements that are established rules on the specified field. Positive economics focuses on description that describes that manner in which economics forces operate without attempting to state how they should operate. The focus of each field of study is sufficiently well defined to warrant the breakdown suggested.
Since each area of economics has some bearing on managerial decision making, managerial economics draws from them all. In practice, some are more relevant to the business firm that others and hence to managerial economics. Both micro-economics and macro-economics are important in managerial economics but the micro economic theory of the firm is especially significant. The theory of firm is the single most important element in managerial economics. However, because the individual firm is influenced by the general economy, that is domain of macro economics. Managerial economics is certainly on normative theory. We want to establish decision rules that will help managers attain the goals of their firm, agency or organization; this is the essence of the word normative. If managers are to establish valid decision rules, however, they must thoroughly know the environment in which they operate for this reason positive or descriptive economics is important.
Surveys conducted in various countries showed that business economists have found economic concepts such as price elasticity of demand, income elasticity of demand, opportunity casts, the multiplier, propensity to consume, marginal revenue products,. Speculative motive, production function, balanced growth, liquidity preference etc., quite useful and of frequent application. They have also found the following main areas of economics as useful in their works:
- Demand theory
- Theory of the firm-price and output
- Business financing
- Public Finance and Fiscal Policy
- Money and banking
- National income and Social accounting
- Theory of international trade, and
- Economics of developing countries.
4. (a) What is cross-elasticity of demand? Discuss the importance of cross-elasticity of demand in business decision making. 4+7=11
Ans: Cross elasticity: This measures the change in demand for a commodity due to change in price of another commodity.
ED= Percentage change in quantity demanded of commodity A/ Percentage change in price of commodity B
If the goods having substitutes the cross elasticity is positive i.e. an increase in the price of X will result in an increase in sales of Y. If the goods are complementary and increase in the price of one commodity will depress the demand for the other. So cross elasticity will be negative. If the goods are unrelated cross elasticity will be zero. Because however much the price of one commodity increased demand for the other will not be affected by that increase. There exist another two types of cross elasticity viz.
- Advertisement elasticity and
- Elasticity of price expectation.
Advertisement elasticity or Promotional elasticity: The expenditure n advertisement and other sales promotion activities does help in promoting sales, but not in the same degree at all levels of the total sales. The concept of advertisement elasticity is useful in determining the optimum level of advertisement expenditure. It may be defined as, “the responsiveness of demand t to changes in advertising or other promotional expenses”.
EA = Proportionate change in sales/ Proportionate change in advertising and other promotional expenditure
Elasticity of price expectations: The price expectation elasticity refers to the expected change in future price as a result of change in current price of a product.
EX = (△pf/ △pc) * (pc/pf)
Where Pc and Pf are current and future price. The coefficient ex gives the measure of expected percentage change in future price as a result of 1 percent change in present price. If ex > 1 it indicates the future change in price will be greater than the present change in price. If ex=1, it indicates that the future change in price will be equal to the change in current price. In ex > 1, the sellers will sell more in the future at higher prices.
Importance of Price Elasticity of Demand
The concept cross elasticity is very useful to producer and businessman to make pricing decision. The major importance of cross elasticity of demand is given below:
1. Classification of goods: Goods are classified into substitute and complementary. If cross elasticity of demand between any two goods is positive, the goods may be considered as substitute for each other. If the cross elasticity is greater, the good are closer substitute. If it is infinite, they are perfect substitute. If the cross elasticity of demand for any two related goods is negative, the two goods may be considered as complementary for each other. If the negative cross elasticity of demand is high, the degree of complementarily is also high.
2. Classification of Market: Market structure has been classified by Prof. Bayn on the basis of cross elasticity of demand. If the cross elasticity of demand is infinite, the market is perfectly competitive. If the cross elasticity is zero or almost zero, the market structure is monopoly. If the cross elasticity is high there is imperfect market.
3. Pricing Policy: Large firms produce different related goods. For example Nepal Liver Limited produces various brands of tooth paste & tooth brush. They are complementary goods. Similarly, Nepal Dairy Limited produces ice-cream of different flavor. Cross elasticity of demand helps firms to decide whether to increase price of related products or not.
4. Determination of boundaries between industries; Concept of cross elasticity of demand is useful in order to decide to which product should include in which industry. If related goods having negative cross elasticity (complementary goods), they belong to different industries. If the related goods having positive cross elasticity (substitute goods), they belong to one industry.
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(b) What is price elasticity of demand? Explain perfectly elasticity demand with the help of diagrams. 4+7=11
Ans: Elasticity of Demand: Demand is desire backed by willingness to pay and ability to pay i.e. a wish to have a commodity does not become demand. A person wishing to have a commodity should be willing to pay for it and should have ability to pay for it. Thus a desire becomes demand if it is backed by willingness to pay and ability to pay. Demand is meaningless unless it is stated with reference to a price.
Decisions regarding what to produce, how to produce and for whom to produce are taken on the basis of price signals coming from the market. The law of demand explains inverse relationship between price and quantity demanded. When price falls quantity demanded of that commodity will increase. The deficiency of law of demand is removed by the concept of elasticity of demand.
The term elasticity was developed by Alfred Marshall, and is used to measure the relationship between price and quantity demanded. The law states that the price of a commodity falls, the quantity demanded of that commodity will increase, i.e. it explains only the direction of change in demand and not the extent of change. This deficiency is removed by the concept of elasticity of demand.
Elasticity means responsiveness. Elasticity of demand refers to the responsiveness of quantity demanded of a commodity to change in its price.
According to E.K. Estham, “Elasticity of demand is a measure of the responsiveness of quantity demanded to a change in price”.
According to Muyers “Elasticity of demand is a measure of the relative change in the amount purchased in response to any change in price or a given demand curve”.
According to A.K. Cairncross “The elasticity of demand for a commodity it is the rate at which quantity bought changes as the price changes.”
Price Elasticity: Price elasticity of demand may be defined as the degree of responsiveness of quantity demanded of a commodity in response to change in its price i.e. it measures how much a change in price of a good affects demand for that good, all other factors remaining constant. It is calculated by dividing the proportionate change in quantity demanded by the proportionate change in price.
EP= Proportionate change in quantity demanded/ Proportionate change in price
Perfectly elastic demand
Perfectly elastic demand is the situation where a small change in price causes a substantial change in quantity demanded i.e. a slight decline in price causes an infinite increase in quantity demanded and a slight increase in price leads to demand contracting to zero. The demand is hypersensitive and the elasticity of demand is infinite.
5. (a) Discuss the causes of increasing return to scale and decreasing return to scale. 11
Ans: Increasing Returns to Scale: When inputs are increased in a given proportion and output increases in a greater proportion, the returns to scale are said to be increasing. In other words, proportionate increase in all factors of production results in a more than proportionate increase in output It is a case of increasing returns to scale. Thus, if by 100 percent increase in factors of production, output increases by 120 percent or more, it will be an instance of increasing returns to scale.
If the industry is enjoying increasing returns, then its marginal product increases. As the output expands, marginal costs come down. The price of the product also comes down.
Decreasing Returns to Sale: Decreasing returns to scale is otherwise known as the law of diminishing returns. This is an important law of production. If the firm continues to expand beyond the stage of constant returns, the stage of diminishing returns to scale will start operate. A proportionate increase in all inputs results in less than proportionate increase in output, the returns to scale is said to be decreasing. For example, if inputs are increased by 20%, but output increases by only 10%, ( = < 1), it is a case of decreasing return to scale. Decreasing return to scale implies increasing costs to scale.
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(b) Discuss about internal economies and external economies. 11
Ans: Internal and External Economies
Now-a-days, goods are produced on a very large scale in modern factories. When the production is carried on a large scale the producer derives a number of advantages or economies. These advantages of large scale production are called economies of scale. This is the reason why entrepreneurs try to expand the size of their factories. Marshall divides the economies of scale into groups – (i) internal economies and (ii) external economies.
Economies of Scale
Internal Economies External Economies
Real Economies Pecuniary Economies 
1. Economies of Concentration
2. Economies of Information
3. Economies of Disintegration
1. Labour Economies
2. Technical Economies
3. Inventory Economies
4. Selling or Marketing Economies
5. Managerial Economies
6. Transport and Storage Economies
- Internal Economies: Internal Economies: A producer drives a number of advantages when he expands the size of his factory. These advantages are called internal economies. They arise because of increase in the scale of production (i.e. output that can be produced). These are secured only by the firm expanding its size. They are dependent on the efficiency of the organizer and his resources. So internal economies are those advantages which are obtained by a producer when he increases or expands the size of his firm. Internal economies are divided into various classes as follows. When a firm increases its scale of production it enjoys several economies. These economies are called internal economies.
Types of Internal Economies: There are two types of internal economies:
- Real Economies: Real economies are those which are associated with a reduction in the physical quantity of inputs, raw materials, various types of labour and various types of capital. Real economies can be of six types –
- Labour Economies or Specialization: Specialization means to perform just one task repeatedly which makes the labour highly efficient in its performance. This adds to the productivity and efficiency of the labour.
- Technical Economies: Technical economies are those economies which are related with the fixed capital that includes all types of machines & plants. Technical economies are of three types:
- Economies of Increased Dimension.
- Economies of Linked Processes.
- Economies of the use of By-Product.
- Inventory Economies: A large size firm can enjoy several types of inventory economies; a big firm possesses large stocks of raw material.
- Selling or Marketing Economies: A firm producing a large scale also enjoys several marketing economies in respect of scale of this large output.
- Managerial Economies: A firm producing on large scale can engage efficient & talented managers.
- Transport and Storage Economies: A firm producing on large scale enjoys economies of transport & storage.
- Pecuniary Economies: Pecuniary economies are economies realized from playing lower prices for the factors used in the production and distribution of the product due to bulk-buying by the firm as its size increases.
- External Economies: When the number of factories producing the same commodity like sugar increases, we say that the particular industry (sugar industry) has developed. When the industry as a whole develops, every firm in the industry derives man advantages. These advantages are called external economies. They are enjoyed by all the firms in the industry. They are not the property or monopoly of any firm. The following are the main types of external economies:
- Economies of Concentration: When several firms of an industry establish themselves at one place, then they enjoy many benefits together, e.g. availability of developed means of communications and transport, trained labour, by products, development of new inventions pertaining to that industry etc.
- Economies of Information: When the number of firms in an industry increase, then it becomes possible for them to have concerted efforts and collective activities.
- Economies of Disintegration: when an industry develops, the firms engaged in its mutually agree to divide the production process among themselves.
6. (a) Explain Baumol’s sales maximization hypothesis as an objective of modern business firm. 11
Ans: Baumol’s Hypothesis of Sales Revenue Maximisation: Baumol’s theory of sales maximisation is an alternative theory of firm’s behaviour. The basic premise of his theory is that sales maximisation, rather than profit maximisation, is the plausible goal of the business firms. The separation of ownership from management, characteristic of the modern firm, gives discretion to the managers to pursue goals which maximise their own utility and deviate from profit maximisation, which is the desirable goal of owners.
Given this discretion, Baumol argues that sales maximisation seems the most reasonable goal of managers. From his experience as a consultant to large firms, Baumol found that managers are preoccupied with maximisation of the sales rather than profits. Several reasons seem to explain this attitude of the top management.
Firstly, there is evidence that salaries and other (slack) earnings of top managers are correlated more closely with sales than with profits.
Secondly, the banks and other financial institutions keep a close eye on the sales of firms and are more willing to finance firms with large and growing sales.
Thirdly, personnel problems are handled more satisfactorily when sales are growing. The employees at all levels can be given higher earnings and better terms of work in general.
Fourthly, large sales, growing over time, give prestige to the managers, while large profits go into the pockets of shareholders.
Implications (or Superiority) of the Theory:
Baumol’s sales maximisation theory has some important implications which make it superior to the profit maximisation model of the firm.
1. The sales maximising firm prefers larger sales to profits. Since it maximises its revenue when MR is zero, it will charge lower prices than that charged by the profit maximising firm.
2. It follows from the above that the sales maximising output will be larger than the profit maximising output.
3. The sales maximiser would spend more on advertising in order to earn larger revenue than the profit maximiser subject to the minimum profit constraint.
4. There may be a conflict between pricing in the short run and the long run. In the short run when output cannot be increased, revenue can be increased by raising the price. But in the long run, it would be in the interest of the sales maximisation firm to keep the price low in order to compete more effectively for a large share of the market and thus earn more revenue.
Criticisms: Baumol’s sales maximisation model is not free from certain weaknesses.
1. Rosenberg has criticised the use of the profit constant for sales maximisation by Baumol. Rosenberg has shown that it is difficult to specify exactly the relevant profit constraint for a firm.
2. According to Shepherd, under oligopoly a firm faces a kinked demand curve and if the kink is large enough, total revenue and profits would be the maximum at the same level of output. So both the sales maximiser and the profit maximiser would not be producing different levels of output.
3. The model does not show how equilibrium in an industry, in which all firms are sales maximisers, will be attained. Baumol does not establish the relationship between the firm and industry.
4. In the case of multiproducts, Baumol has argued that revenue and profit maximisation yield the same results. But Williamson has shown that sales maximisation yields different results from profit maximisation.
5. Another weakness of this model is that it ignores the interdependence of the prices of oligopolistic firms.
6. The model fails to explain “observed market situations in which price are kept for considerable time periods in the range of inelastic demand.”
7. The model ignores not only actual competition, but also the threat of potential competition from rival oligopolistic firms.
8. Prof. Hall in his analysis of 500 firms came to the conclusion that firms do not operate in accordance with the objective of sales maximisation.
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(b) State the features of a perfectly competitive market. Explain the conditions of short-run equilibrium of a firm under perfect competition. 5+6=11
Ans: Features of Perfect Competition: Different definitions given by different economists point out the distinct features of perfect competition. We can list various features which point out that the form of a market is perfectly competitive. In other words, there are some necessary conditions which must be satisfied if the market is to be perfectly competitive. We can explain these below:
- Large number of small, unorganized firms: The first condition which a perfectly competitive market must satisfy is concerned with the seller’s side of the market. The market must have such a large number of sellers that on one seller is able to dominate in the market. No single firms can influence the price of the commodity. 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.
- A large number of small, unorganized buyers: On the buyer’s side the perfectly competitive market must also satisfy this condition. 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 not have any king of union or organization so that they compete for the market demand on an individual basis.
- Homogeneous products: Another pre-requisite 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, variety, colour, design, packing or other selling conditions of the product.
- 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 it. This condition must be satisfied especially for long period equilibrium of the industry.
- Perfect knowledge among buyers and sellers about market conditions: Another pre-requisite of perfect competition is that both buyers and sellers must be having perfect knowledge about the conditions in which they are operating. Seller must know the prices being quoted or charged by other sellers in the market from the buyers. Similarly buyers must know the prices being charged by different sellers.
Short-run Equilibrium of the Firm:
The short run is a period of time in which the firm can vary its output by changing the variable factors of production in order to earn maximum profits or to incur minimum losses. The number of firms in the industry is fixed because neither the existing firms can leave nor new firms can enter it. The firm is in equilibrium when it is earning maximum profits as the difference between its total revenue and total cost. A firm is short run equilibrium may face any of the three situations:-
- Super Normal Profits (AR > AC): A firm is in equilibrium when its marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue from below. A firm is in equilibrium earns super normal profit, when average revenue is more than its average cost. It can also be explained with the help of following diagram:
In this figure, output of the firm is shown on OX-axis and cost/revenue on OY-axis. MC is the marginal cost and AC is average cost curve. PP is the average revenue and marginal revenue curve (MR = AR). Supposing OP is the price determined by the industry. At this price, firm’s equilibrium will be at point E, where marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue curve from below.
Equilibrium output is OM. At this output AR (price) = EM and AC = AM. Since AR (EM) > AC (AM), firm is earning EA super normal profit per unit of output.
Per Unit super normal profit = EA
Total Super-Normal Profit = EABP
- Normal Profits (AR = AC):- Normal profits cover just the reward for entrepreneurial services and are included in the cost of production. So that, a firm in equilibrium earns normal profits when its average cost is equal to the average revenue i.e. AC = AR.
In this figure, output of the firm is shown on OX-axis and cost/revenue on OY-axis. MC is the marginal cost and AC is average cost curve. PP is the average revenue and marginal revenue curve (MR = AR). Supposing OP is the price determined by the industry. At this price, firm’s equilibrium will be at point E, where marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue curve from below. The firm earns normal profits at equilibrium output because its average cost and average revenue are equal.
Normal Profits = MC = MR = AC = AR.
- Minimum Loss (AR < AC):- A firm in equilibrium may incur minimum loss when the average cost is more then the average revenue and average revenue is equal to average variable cost. Even if, the firm discontinues its production, in the short run, it will have to bear the loss of fixed costs. Loss of fixed costs is the minimum loss of the firm.
In this figure, output of the firm is shown on OX-axis and cost/revenue on OY-axis. MC is the marginal cost and AC is average cost curve. PP is the average revenue and marginal revenue curve (MR = AR). Supposing OP is the price determined by the industry. At this price, firm’s equilibrium will be at point E, where marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue curve from below.
At equilibrium point An (AC) is more than EN (AR). In other words, average cost is more then average revenue by AE which represents per unit loss. As such firm’s total loss is AEPB.
Per Unit Loss = AE
Total Loss = AEPB
From the above discussion, We may conclude from the above discussion that in the short-run each firm may be making either supernormal profits, or normal profits or losses depending upon the price of the product.
7. (a) How does a businessman fix his equilibrium price in monopoly market? For the fiction of this price, what are the influences of different factors? Discuss. Out of Syllabus
Or
(b) What is meant by price leadership? Discuss how the oligopolists determine price with the help of price leadership. Out of Syllabus