Dibrugarh University Solved Question Papers: Business Economics (May' 2015)

2015 (May)

(General / Speciality)

The figures in the margin indicate full marks for the questions

(New Course)

Answer the following as directed : 1x8=8

Elasticity of demand at the midpoint of a straight line demand curve is >1 / 1 / <1. (Choose the correct answer.)
Perfectly inelastic demand curve is parallel / vertical to the vertical axis. (Choose the correct answer.)
An assumption to the law of supply is ‘there will be no change in input prices’. (State True or False)
Production function shows the physical relationship between FACTOR INPUTS and THE QUANTITY OF OUTPUT. (Fill in the blanks)
Internal economies are enjoyed by a business firm due to a decrease / increase in its scale of operation. (Choose the correct answer)
Under perfectly competitive market AR is not equal MR. (State True or False)
The short-run supply curve of a firm under perfect competition always slopes downward / upward. (Choose the correct answer)
Market price in a long-run / short-run / very short-run price. (Choose the correct answer)

Write on the following in brief : 4x4=16

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.

Therefore, every economy faces the problem as to how resources should be combined for the production of a given commodity. The goods would be produced employing those methods and techniques, whereby the output may be the maximum and cost of production be the minimum.

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.

All the three central problems arise because resources are scarce. Had resources been unlimited, these problems would not have arisen. For example, in the event of resources being unlimited, we could have produced each and every thing we had wanted, we could have used any technique and we could have produced for each and everybody.

4. The problem of efficient use of resources: An economy has to face the problem of efficiently using its resources. Production can be increased even by improving the use of resources. Resources will be deemed to be better utilised when by reallocating them in various uses, production of a commodity can be increased without adversely affecting the production of other commodities.

Cross-elasticity of demand: 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”.

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.

△pf / pf △pf pc

△pc/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.

Properties of isoquants.

Ans: 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.

6. No isoquant can touch either axis. If an isoquant touches X axis then it would mean that without using any labour the firm can produce output with the help of capital alone. If an isoquant touches Y axis, it would mean that without using any capital the firm can produce output with the help of labour alone. This is impossible.

Normal profit and supernormal profit.

Ans: 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.

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.

(a) Discuss the nature and scope of business economics. 14

Ans: Nature or Characteristics of Managerial Economics:-

Managerial Economics is a Science: Managerial economics is a science because it establishes relationship between causes and effects. It studies the effects of a change in price of a commodity factors and forces on the demand of a particular product. It also studies the effects and implications of the plans, policies and programmes of a firm on its sales and profit.
Managerial Economics is an Art: Managerial economics may also be called an art. Because it also develops the best way of doing things. It helps management in the best and most efficient utilization of limited economic resources of the firm.
Managerial Economics is a Micro Economics: Entire study of economics may be divided into two segments – Macro economics and Micro economics. Managerial economics is mainly micro-economics. Micro economics is the study of the behaviour and problems of individual economic unit. In managerial economics unit of study is firm or business organization and an individual industry. It is the problem of business firms such as problem of forecasting demand, cost of production, pricing, profit planning, capital, management etc.
Managerial Economics is the Economics of firms: Managerial economics largely use that body of economic concepts and principles which is known as ‘Theory of the Firm’ or ‘Economics of the Firm’.
Managerial Economics uses Macro economic Analysis: Managerial economics also uses macro-economics to analysis and understand the general business environment in which the business firm must operate. Business management must have the adequate knowledge of external forces that affect the business of the firm. The important macro-factors that affect the firm are trends in national income and expenditure, business cycle, economic policies of the government, trends in foreign trade etc.
Managerial Economics is Pragmatic: It is concerned with practical problems and results. It has nothing to do with abstract economic theory which has no practical application to solve the problems faced by business firms.
Managerial Economics is Normative Science: There are two types of science – Normative Science and Positive Science. Positive science studies what is being done. Normative science studies what should be done. From this point of view, it can be concluded that managerial economics is normative science because its suggests what should be done under particular circumstances.
Aims at helping the management: Managerial economics aims at supporting the management in taking corrective decisions and charting plans and policies for future.
Prescriptive rather than descriptive: Managerial economics is a normative and applied discipline. It suggests the application of economic principles with regard to policy formulation, decision-making and future planning. It not only describes the goals of an organisation but also prescribes the means of achieving these goals.

Scope of Managerial Economics

Managerial economics is the application of economics theories in the process of decision making and formulation of future plans. The management will have to analyze the business problems that are faced by the firm. Thus, the principles relating to following topics constitute the scope of subject matter of managerial economics.

Demand Analysis: A business firm is in an economic organization which is engaged in transforming productive resources into goods that are to be sold in the market. A major part of managerial decision-making depends on accurate estimates of demand. A forecast of future sales serves as a guide to management for preparing production schedules and employing resources. It will help management to maintain or strengthen its market position and profit base. Demand analysis also identifies a number of other factors influencing the demand for a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics.
Cost Analysis: Cost estimates are most useful for management decision. The different factors that cause variations in cost estimates should be given due consideration for planning purpose. There is the element of uncertainty of cost as other factor influencing cost are either uncontrollable or not always known.
Pricing Practices and Policies: As price gives income to the firm, it constitutes as the most important field of Managerial Economics. The success of a business firm depends very much on the correctness of the price decision taken by it. The various aspects that are deal under it cover the price determination in various market forms, pricing policies, pricing method, different pricing, productive pricing and price forecasting.
Profit Management:- The chief purpose of a business firm is to earn the maximum profit. There is always an element of uncertainty about profits because of variation in cost and revenue. It knowledge about the future were perfect, profit analysis would have been very easy task. But in this world of uncertainty expectations are not always realized. Hence profit planning and its measurement constitute the most difficult area of managerial economics. Under profit management we study nature and management of profit, profit policies and techniques of profit planning like Break Even Analysis.
Capital Management:- The problems relating to firm’s capital investments are perhaps the most complex and the troublesome. Capital management implies planning and control of capital expenditure. The main topics deal with under capital management is cost of capital, rate of return and selection of projects.
Analysis of Business Environment: The environmental factors influence the working and performance of a business undertaking. Therefore, the managers will have to consider the environmental factors in the process of decision-making. The factors which constitute economic environment of a country include the following factors:

Economic System of the Country.
Business Cycles.
Fluctuations in National Income and National Production.
Industrial Policy of the Government.
Trade and Fiscal Policy of the Government.
Taxation Policy.
Licensing Policy etc.
Political Environment.
Social Factors.
Trend in labour and capital markets.

Inventory Management: It refers to stock of raw materials which a firm keeps. If it is high, capital is unproductively tide up which might, if stock of inventory is reduced, be used for other productive purpose . On the other hand, if the level of inventory is low, production will be hampered. Hence, managerial economics with methods such as ABC analysis a simple simulation exercise and some mathematical models with a view to minimize inventory cost.
Advertising: Managerial economics helps in determining the total advertising cost and budget, the measuring of economic effects of advertising and form an integral part of decision making and forward planning.
Resource Allocation: Managerial economics with the help of advanced tools such as linear programming are used to arrive at the best course of action for the maximum use of the available resources and its substitutes.
Risk and Uncertainty Analysis: As business firm have to operate under conditions of risk and uncertainty both decision making and forward planning becomes difficult. Hence managerial economics helps the business firm in decision making and formulating plans on the basis of past data, current information and future prediction.

(b) Explain the working of price mechanism. Discuss whether price mechanism can be ensure maximum social welfare. 10+4=14

Ans: Price Mechanism

Price mechanism refers to the system where the forces of demand and supply determine the prices of commodities and the changes therein. It is the buyers and sellers who actually determine the price of a commodity. Price mechanism is the outcome of the free play of market forces of demand and supply. However, sometimes the government controls the price mechanism to make commodities affordable for the poor people too. For example, the Government of India recently passed an order to decontrol the prices of diesel and remove it from the jurisdiction of the government. Now the prices will be determined by the demand from consumers and supply from the oil companies.

Role of price mechanism:

The price mechanism solves the problem of allocation of resources which is associated with what ,how and for whom to produce.

1. What to produce?

In a free market economy, producers are guided by profit motive. When price of a commodity increases with the increase in demand, the profits increase and this would encourage the production of this commodity. Producers would shift resources from the production of other commodities to this commodity. Therefore, the price mechanism would automatically solve the problem what to produce.

2. How to produce?

It is the question of choice of production technique. There are generally two techniques of production available:

Labour-intensive technique (in which more of labour is used than capital)
Capital-intensive technique (in which more of capital is used than labour)

If capital is available at a lower rate, firms adopt capital-intensive technique of production. If labour is available at lower rate, firms adopt labour intensive techniques. Therefore, it is the price of labour or the price of capital that will help the producer in deciding whether they should choose capital intensive or labour intensive technique.

3. For whom to produce?

In a market economy, the producers must produce for those who have the ability and willingness to pay the highest price. The income of the consumers determines the ability to pay ie; there is a direct relationship between income and consumption pattern. Hence, both the ability and willingness to pay determines who gets the available commodities.

4. Fuller Utilization of the factors

It is through price-mechanism that fuller utilization of the factors is attained in a capitalist economy .Volume of full employment depends upon the volume of production which in its turn, depends upon the level of investment. Amount of investment depends upon saving. Equality between saving and investment is brought about by change in price of capital i.e.; rate of interest. If at any given time, total savings are large and condition of unemployment prevails in the economy ,the rate of interest will fall. Due to fall in the rate of interest there will be increase in investment. Increase in investment will result into increase in production and the condition of less than fuller utilization of the factors will become possible. Classical economists were of the view that under condition of less than full employment of labour, price of labour, i.e; wage will fall. Fall in wage rate will stimulate demand and condition of full employment of labour will be achieved . In this way, price mechanism will help to achieve fuller utilization of the factors.

Maximum social advantage cannot be obtained due to the following limitations of price mechanism:

(1) Imperfection of completion: the working of the price mechanism assumes the existence of perfect completion in the economic system. But in practice, perfect completion does not exist; instead monopolistic forces prevail in many industries. These reduce supply and raise prices which are against the interests of the consumers.

(2) Loss of consumer’s sovereignty: it is stated that under market mechanism the consumers enjoyed complete freedom in choice of goods and services. Producers produced those goods and services that are demanded by the consumers. But in the real world consumer’s sovereignty is limited. For instance the demand of consumer is influenced by advertisement, personal selling social customs etc. Further there is in inequality of incomes among people and consequently the market demand but only the demand of well to do consumers.

(3) Elimination of completion: price mechanism is to encourage completion. But according to critics it is price mechanism itself that accounts for the elimination completion. In their desire of profit, competing firms attempt to eliminate is rightly said that “Monopoly is the mechanism of completion and at the same time its logical conclusion.” It is the negation of all the values for which market mechanism stands.

(4) Unequal Distribution of Income: the price mechanism through completion brings huge profits to big producers, the landlords, the entrepreneurs and the traders who accumulate vast amount of wealth and luxury the poor live in poverty and squalor.

(5) Non-utilization if resources: the price mechanism fails to employ the country’s resources fully. Free and cut throat competition, inequalities of income distribution over production and consequent depression lead to wastage also, as frivolous luxury goods are produced poor. Similarly natural resources are exploited for the short-run effect on the economy, for example soil erosion occurs when forests of timber are cut down by greedy contractors.

(6) Ignores social goods: price mechanism mainly takes into account individual wants but does not provide for social goods and social overheads like education, health, care, transport & communication services. These goods and services needed for the overall economic growth of the system may not be provided/produced by private individuals. This is because in such industries, huge investments are required; having there is a need for some intervention from some entity to overcome this limitation of the price mechanism.

(7) Ignores social cost: While determining his cost of production the producers include only the private cost of production (the price paid to factors of production and other inputs). He fails to include the social costs (e.g. air, water, and noise pollution) on his production process. Since social costs are not included in the market price, the producer produces an output which is larger than desirable.

The above shortcoming of price mechanism have led the free enterprise economics of West to modify the capital system by regulating and controlling the institutions of private property and freedom of enterprise to serve the best interests of the community at large.

(a) Explain the concept of income elasticity of demand. Discuss the importance of income elasticity of demand concept in business economics. 8+6=14

Ans: Income elasticity: Income elasticity of demand measures how much a change in income affects demand for that commodity if the price and other factors remains constant.

EY= Proportionate change in quantity demanded/ Proportionate change in income

A product with an income elasticity of more than one will experience a growth in demand that is higher than growth in consumer’s income. Luxury goods tend to have relatively high income elasticity. Low quality goods have negative income elasticities, as people stop buying them when they can afford to.

There are three types of income elasticity:

Zero income elasticity – Here a change in income will have no effect of quantity demanded. For example: - salt, matches, cigarettes.

Negative income elasticity – Here an increase in income leads to a decrease in quantity demanded. This happens in inferior goods.

Positive income elasticity – In this an increase in income will leads to an increase in quantity demanded. For most goods income elasticity is positive.

Importance of Income Elasticity of Demand

1. Determination of price policy: While fixing the price of this product, a businessman has to consider the income elasticity of demand for the product. He should consider whether high income will stimulate demand for his product, and if so to what extent and whether his profits will also increase a result thereof.

2. Price discrimination: Price discrimination refers to the act of selling the technically same products at different prices to different section of consumers or in different in sub-markets. The policy of price-discrimination is profitable to the monopolist when income elasticity of demand for his product is different in different sub-markets.

3. Importance in international trade: The concept of income elasticity of demand is of crucial importance in many aspects of international trade. The success of the policy of devaluation to correct the adverse balance of payment depends upon the income elasticity of demand for exports and imports of the country.

4. Importance in the determination of factors prices: Factor with an inelastic demand can always command a higher price as compared to a factor with relatively elastic demand. This helps the trade unions in knowing that where they can easily get the wage rate increased. Bargaining capacity of trade unions depend upon elasticity of demand for workers services.

5. Determination of sale policy for supper markets: Super Markets is a market where in a variety of goods are sold by a single organization. These items are generally of mass consumption. Therefore, the organization is supposed to sell commodities at lower prices than charged by shopkeepers in the other bazars. Thus, the policy adopted is to charge a slightly lower price for items whose demand is relatively elastic and the costs are covered by increased sales.

6. Pricing of joint supply products: The goods that are produced by a single production process are joint supply products. The cost of production of these goods is also joint. Therefore, while determining the prices of these products their income elasticity of demand is considered.

7. Effect of use of machines on employment: The use of machines may reduce the cost of production and price. If the demand of the product is elastic then the fall in price will increase demand significantly. As a result of increased demand the production will also increase and more workers will be employed.

8. Public utilities: The nationalization of public utility services can also be justified with the help of income elasticity of demand. Demand for public utilities are generally inelastic in nature. If the operation of such utilities is left in the hand of private individuals, they may exploit the consumers by charging high prices.

From the above discussion it is amply clear that income elasticity of demand is of great significance in making business decisions.

(b) What are factors that determine price elasticity of demand? What role does price elasticity of demand play in the decision-making by business firms? 8+6=14

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 eg: - 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.

7. Time period: Elasticity would be more in the long run than in the short run. Because in the long run consumers can adjust their demand by switching over to cheaper substitutes. Production of cheaper substitutes is possible only in the long run.

8. Distribution of income and wealth in the society: If there is unequal distribution of income, the demand of commodities will be relatively inelastic. If the distribution of income and wealth in the society is equal there will be elastic demand for commodities.

Role and Importance of Elasticity of Demand

1. Determination of price policy: While fixing the price of this product, a businessman has to consider the elasticity of demand for the product. He should consider whether a lowering of price will stimulate demand for his product, and if so to what extent and whether his profits will also increase a result thereof.

2. Price discrimination: Price discrimination refers to the act of selling the technically same products at different prices to different section of consumers or in different in sub-markets. The policy of price-discrimination is profitable to the monopolist when elasticity of demand for his product is different in different sub-markets. Those consumers whose demand is inelastic can be charged a higher price than those with more elastic demand.

3. Shifting of tax burden: To what extent a producer can shift the burden of indirect tax to the buyers by increasing price of his product depends upon the degree of elasticity of demand. If the demand is inelastic the larger part of the indirect tax can be shifted upon buyers by increasing price. On the other hand if the demand is elastic than the burden of tax will be more on the producer.

4. Taxation and subsidy policy: The government can impose higher taxes and collect more revenue if the demand for the commodity on which a tax is to be levied is inelastic. On the other hand, in ease of a commodity with elastic demand high tax rates may fail to bring in the required revenue for the government. Govt., should provide subsidy on those goods whose demand is elastic and in the production of the commodity the law of increasing returns operates.

5. Importance in international trade: The concept of elasticity of demand is of crucial importance in many aspects of international trade. The success of the policy of devaluation to correct the adverse balance of payment depends upon the elasticity of demand for exports and imports of the country.

6. Importance in the determination of factors prices: Factor with an inelastic demand can always command a higher price as compared to a factor with relatively elastic demand. This helps the trade unions in knowing that where they can easily get the wage rate increased. Bargaining capacity of trade unions depend upon elasticity of demand for workers services.

7. Determination of sale policy for supper markets: Super Markets is a market where in a variety of goods are sold by a single organization. These items are generally of mass consumption. Therefore, the organization is supposed to sell commodities at lower prices than charged by shopkeepers in the other bazars. Thus, the policy adopted is to charge a slightly lower price for items whose demand is relatively elastic and the costs are covered by increased sales.

8. Pricing of joint supply products: The goods that are produced by a single production process are joint supply products. The cost of production of these goods is also joint. Therefore, while determining the prices of these products their elasticity of demand is considered.

(a) Explain the law of variable proportions with suitable diagram. In which stage a rational producer will seek to produce? 10+4=14

Ans: Law of Variable Proportion

Meaning: The law of variable proportion is one of the fundamental laws of economics. It is also known as the 'Law of Diminishing Marginal Returns' or the 'Law of Diminishing Marginal Productivity.' This Law of variable proportion shows the input-output relationship or production function with one variable factor, i.e., a factor, which can be changed, while other factors of production are kept constant.

In short-period when the output of a good is sought to be increased by way of additional application of the variable factor, law of variable proportions comes into operation. When the number of one factor is increased while all other factors remain constant, then the proportion between the factors is altered. On account of change in the proportion of factors there will also be a change in total output at different rates. In economics, this tendency is called Law of Variable Proportions. The law stats that as the proportion of factors is changed, the total production at first increases more than proportionately, then equi-proportionately and finally less than proportionately.

According to Samuelson, “The law states than an increase in some inputs relative to other fixed input will, in a given state of technology, cause total output to increase, but after a point the extra output resulting from the same addition of extra inputs is likely to become less and less.”

Assumptions: The law of variable proportions functions is based on following assumptions:

Constant technology: The technology is assumed to be constant because technological changes will result into rise of marginal and average product.
Snort-run: The law operates in the short-run because it is here that some factors are fixed and others are variable. In the long-run, all factors are variable.
Homogeneous input: The variable input employed is homogeneous or identical in amount and quality.
Use of varying amount of variable factor: It is possible to use various amounts of a variable factor on the fixed factors of production.

Explanation of the Law: Law of variable proportion can be explained with the help of following table and diagram:

Units of Land	Units of Labour	Total Product	Marginal Product	Average Product
1	1	2	2	2
1	2	5	3	2.5
1	3	9	4	3
1	4	12	3	3
End of the first State Beginning of the Second Stage
1	5	14	2	2.8
1	6	15	1	2.5
1	7	15	0	2.1
End of the Second Stage Beginning of the Third Stage
1	8	14	-1	1.7

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Explanation: From the above Table and Diagrams drawn on the assumption that production obeys the law of variable proportions, one can easily discern three stages of production. These are elucidated in the following table:

Three States of Production

States	Total Product	Marginal Product	Average Product
1. Stage	Initially it increases at an increasing rate. Later at diminishing rate.	Initially increases and reaches the maximum point. The starts decreasing.	Increases and reaches its maximum point
2. Stage	Increases at diminishing rate and reaches its maximum point.	Decreases and becomes zero.	After reaching its maximum begins to decrease.
3. Stage	Begins to fall	Becomes Negative.	Continues to diminish.

Causes of Applicability: Main causes accounting for the application of the law of variable proportions are as follows:

Under utilization of Fixed Factor: In the initial stage of production, fixed factor of production like land or machine is under-utilized. More units of variable factor, like labour are needed for its proper utilization. Thus, as a result of employment of additional units of variable factor there is proper utilization of fixe factor. Consequently, total production begins to increase.
Fixed Factors of production: The principal cause of the operation of this law is that some of the factors of production are fixed during the short period. When the fixed factor is used with variable factor, then its ratio if compared to variable factor falls. Production is the result of the cooperation of all factors. Consequently, marginal return of the variable factor begins to diminish.
Optimum Production: After making the optimum use of a fixed factor if it is combined with increasing units of variable factor, then the marginal return of such variable factor begins to diminish.
Imperfect Substitute: It is the imperfect substitution of factors that is mainly responsible for the operation of the law of diminishing returns. One factor cannot be used in place of the other factor. Consequently, when fixed and variable factors are not combined in an appropriate ratio, the marginal return of the variable factors begins to diminish.

Postponement of the Law: Postponement of the law of variable proportions is possible under the following conditions:

Improvement in Technique of Production: Operation of the law can be postponed if along with the increase in variable factors technique of production is improved.
Perfect Substitute: The law can also be postponed if factors of production are made perfect substitutes, i.e. when one factor can be substituted for the other.

(b) Discuss the internal and external economies of a business firm. 14

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.

(a) Explain Baumol’s sales revenue maximization hypothesis and mention some of the criticisms leveled against it. 9+5=14

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.

(b) Discuss the features of perfectly competitive market. Explain the process of price output determination in the short-run under such market. 5+6=14

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.
Perfect mobility: Another feature of perfect competition is that goods and services as well as resources are perfectly mobile between firms. Factors of production can freely move from one occupation to another and from one place to another. There is no barrier on their movement. No one has monopoly or control over the factors of production. Goods can be sold to a place where their prices are the highest. There should not be any kind of limitation on the mobility of resources.
Absence of transport cost: Another feature of perfect competition is that all the firms have equal access to the market. Price of the product is not affected by the cost of transportation of goods. In other words, we can say that the market price charged by different sellers does not differ due to location of different sellers in the market. Thus, there is complete absence of transport cost of the product from one part of the market to other.
Absence of selling cost: Under conditions of perfect competition, there is no need of selling costs. We know that under perfect competition, goods are completely homogeneous. Price of the product is also the same for a single product. Firms have no control over the price of the product. When they cannot change the price and when their goods are completely similar, firms need not make any expenditure on publicity and advertisement.

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.

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.

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.

(Old Course)

Full Marks: 80

Pass Marks: 32

Answer the following as directed : 1x8=8

Business Economics is micro / macro economics in nature. (Choose the correct answer)
The mechanism of price determination by the free play of forces of demand and supply is knows as PRICE mechanism. ( Fill in the blank )
The marginal rate of technical substitution increases as more and more of one input is substituted for the other input. ( State True or False ) DECREASES
A firm under perfect competition can / cannot determine the price. (Choose the correct answer)
Very short-run price is knows as normal price. (State True or False) MARKET PRICE
A firm under perfect competition in the long-run earns only NORMAL profit. (Fill in the blank)
Price discrimination will be profitable only when the monopolist funds that the price elasticity of demand for his product is different in the different markets. ( State True or False )
When the firms under oligopoly reach and understanding in price and output determination, it is knows as pure oligopoly / collusive oligopoly. ( Choose the correct answer )

Write on the following in brief : 4x4=16

a) Relationship between business 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.

(b) Isoquants: 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.

c) Price discrimination.

d) Baumol’s sales revenue maximization hypothesis: 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.

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.

(a) Discuss the characteristics and scope of business economics. 6+5=11

Ans: Nature or Characteristics of Managerial Economics:-

Managerial Economics is a Science: Managerial economics is a science because it establishes relationship between causes and effects. It studies the effects of a change in price of a commodity factors and forces on the demand of a particular product. It also studies the effects and implications of the plans, policies and programmes of a firm on its sales and profit.
Managerial Economics is an Art: Managerial economics may also be called an art. Because it also develops the best way of doing things. It helps management in the best and most efficient utilization of limited economic resources of the firm.
Managerial Economics is a Micro Economics: Entire study of economics may be divided into two segments – Macro economics and Micro economics. Managerial economics is mainly micro-economics. Micro economics is the study of the behaviour and problems of individual economic unit. In managerial economics unit of study is firm or business organization and an individual industry. It is the problem of business firms such as problem of forecasting demand, cost of production, pricing, profit planning, capital, management etc.
Managerial Economics is the Economics of firms: Managerial economics largely use that body of economic concepts and principles which is known as ‘Theory of the Firm’ or ‘Economics of the Firm’.
Managerial Economics uses Macro economic Analysis: Managerial economics also uses macro-economics to analysis and understand the general business environment in which the business firm must operate. Business management must have the adequate knowledge of external forces that affect the business of the firm. The important macro-factors that affect the firm are trends in national income and expenditure, business cycle, economic policies of the government, trends in foreign trade etc.
Managerial Economics is Pragmatic: It is concerned with practical problems and results. It has nothing to do with abstract economic theory which has no practical application to solve the problems faced by business firms.
Managerial Economics is Normative Science: There are two types of science – Normative Science and Positive Science. Positive science studies what is being done. Normative science studies what should be done. From this point of view, it can be concluded that managerial economics is normative science because its suggests what should be done under particular circumstances.
Aims at helping the management: Managerial economics aims at supporting the management in taking corrective decisions and charting plans and policies for future.
Prescriptive rather than descriptive: Managerial economics is a normative and applied discipline. It suggests the application of economic principles with regard to policy formulation, decision-making and future planning. It not only describes the goals of an organisation but also prescribes the means of achieving these goals.

Scope of Managerial Economics

Demand Analysis: A business firm is in an economic organization which is engaged in transforming productive resources into goods that are to be sold in the market. A major part of managerial decision-making depends on accurate estimates of demand. A forecast of future sales serves as a guide to management for preparing production schedules and employing resources. It will help management to maintain or strengthen its market position and profit base. Demand analysis also identifies a number of other factors influencing the demand for a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics.
Cost Analysis: Cost estimates are most useful for management decision. The different factors that cause variations in cost estimates should be given due consideration for planning purpose. There is the element of uncertainty of cost as other factor influencing cost are either uncontrollable or not always known.
Pricing Practices and Policies: As price gives income to the firm, it constitutes as the most important field of Managerial Economics. The success of a business firm depends very much on the correctness of the price decision taken by it. The various aspects that are deal under it cover the price determination in various market forms, pricing policies, pricing method, different pricing, productive pricing and price forecasting.
Profit Management:- The chief purpose of a business firm is to earn the maximum profit. There is always an element of uncertainty about profits because of variation in cost and revenue. It knowledge about the future were perfect, profit analysis would have been very easy task. But in this world of uncertainty expectations are not always realized. Hence profit planning and its measurement constitute the most difficult area of managerial economics. Under profit management we study nature and management of profit, profit policies and techniques of profit planning like Break Even Analysis.
Capital Management:- The problems relating to firm’s capital investments are perhaps the most complex and the troublesome. Capital management implies planning and control of capital expenditure. The main topics deal with under capital management is cost of capital, rate of return and selection of projects.
Analysis of Business Environment: The environmental factors influence the working and performance of a business undertaking. Therefore, the managers will have to consider the environmental factors in the process of decision-making. The factors which constitute economic environment of a country include the following factors:

Economic System of the Country.
Business Cycles.
Fluctuations in National Income and National Production.
Industrial Policy of the Government.
Trade and Fiscal Policy of the Government.
Taxation Policy.
Licensing Policy etc.
Political Environment.
Social Factors.
Trend in labour and capital markets.

Inventory Management: It refers to stock of raw materials which a firm keeps. If it is high, capital is unproductively tide up which might, if stock of inventory is reduced, be used for other productive purpose . On the other hand, if the level of inventory is low, production will be hampered. Hence, managerial economics with methods such as ABC analysis a simple simulation exercise and some mathematical models with a view to minimize inventory cost.
Advertising: Managerial economics helps in determining the total advertising cost and budget, the measuring of economic effects of advertising and form an integral part of decision making and forward planning.
Resource Allocation: Managerial economics with the help of advanced tools such as linear programming are used to arrive at the best course of action for the maximum use of the available resources and its substitutes.
Risk and Uncertainty Analysis: As business firm have to operate under conditions of risk and uncertainty both decision making and forward planning becomes difficult. Hence managerial economics helps the business firm in decision making and formulating plans on the basis of past data, current information and future prediction.

(b) Discuss the basic problems of an economic system. Explain how are the basic problems solved through the price mechanism. 6+5=11

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?

1. What to produce?

2. How to produce?

3. For whom to produce?

5. The problem of fuller employment of resources: In many economies, especially in developing economies, there is a tendency towards under-utilisation of resources. Resources lying idle or not being utilised fully is a recurring problem in many economies. This problem is particularly acute in labour-abundant economies like that of India where large scale unemployment exists. In many economies, a vital resource like land too remains under-utilised. Resources being relatively scarce, they should not be allowed to remain idle as it is a waste.

6. The Problem of Growth: The last problem is of growth. Every economy strives to increase its production for increasing standards of living of its people. Economic growth of a country depends upon the fact as to what extent; it can increase its resources. This problem is not confined to developing economies alone. It is also faced by developed economies which strive for increasing their resources in order to increase the material comforts of their technically advanced societies

Price mechanism help in solving basic problems in business economics in the following way

Role of price mechanism:

The price mechanism solves the problem of allocation of resources which is associated with what ,how and for whom to produce.

1. What to produce?

2. How to produce?

It is the question of choice of production technique. There are generally two techniques of production available:

Labour-intensive technique (in which more of labour is used than capital)
Capital-intensive technique (in which more of capital is used than labour)

3. For whom to produce?

4. Fuller Utilization of the factors

It is through price-mechanism that fuller utilization of the factors is attained in a capitalist economy .Volume of full employment depends upon the volume of production which in its turn, depends upon the level of investment. Amount of investment depends upon saving. Equality between saving and investment is brought about by change in price of capital ie; rate of interest. If at any given time, total savings are large and condition of unemployment prevails in the economy ,the rate of interest will fall. Due to fall in the rate of interest there will be increase in investment. Increase in investment will result into increase in production and the condition of less than fuller utilization of the factors will become possible. Classical economists were of the view that under condition of less than full employment of labour, price of labour, i.e; wage will fall. Fall in wage rate will stimulate demand and condition of full employment of labour will be achieved . In this way, price mechanism will help to achieve fuller utilization of the factors.

(a) What is meant by price elasticity of demand? How is the price elasticity of demand measured on a linear demand curve? 3+8=11

Ans: MEANING AND DEFINITION 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.”

Measurement of Elasticity of Demand

Elasticity of demand can be measured through three popular methods. These methods are:

1. Percentage method or Arithmetic method

2. Total Outlay method

3. Graphic method or point method.

4. ARC Method

5. Revenue Method

1. Percentage method: According to this method elasticity is estimated by dividing the percentage change in amount demanded by the percentage change in price of the commodity.

ep = [Percentage change in demand / Percentage change in price]

In this method, three values of ‘ep’ can be obtained. Viz., ep = 1, ep > 1, ep > 1.

If 5% change in price leads to exactly 5% change in demand, i.e. percentage change in demand is equal to percentage change in price , e = 1, it is a case of unit elasticity.

If percentage change in demand is greater than percentage change in price, e > 1, it means the demand is elastic.

If percentage change in demand is less than that in price, e > 1, meaning thereby the demand is inelastic.

2. Total Outlay Method: The elasticity of demand can be measured by considering the changes in price and the consequent changes in demand causing changes in the total amount spent on the goods. The change in price changes the demand for a commodity which in turn changes the total expenditure of the consumer or total revenue of the seller.

If a given change in price fails to bring about any change in the total outlay, it is the case of unit elasticity. It means if the total revenue (price x Quantity bought) remains the same in spite of a change in price, ‘ep’ is said to be equal to 1

If price and total revenue are inversely related, i.e., if total revenue falls with rise in price or rises with fall in price, demand is said to be elastic or e > 1.

When price and total revenue are directly related, i.e. if total revenue rises with a rise in price and falls with a fall in price, the demand is said to be inelastic pr e < 1.

3. Graphic method or Point method: Graphic method is otherwise known as point method or Geometric method. According to this method elasticity of demand is measured on different points on a straight line demand curve. The price elasticity of demand at a point on a straight line is equal to the lower segment of the demand curve divided by upper segment of the demand curve.

4. ARC method: The concept of ARC elasticity was provided by Dalton and than it was further developed by Lerner. This method for the measurement of price elasticity of demand is applied when the change in price is somewhat large or the price elasticity over an ARC of demand is provided. ARC elasticity of demand is the elasticity between distinct points on the demand curve. It is an increase of average responsiveness to price change shown by a demand curve. Any two points on demand curve make an ARC.

5. Revenue Method: Mrs. Joan Robinson has given this method. She says that elasticity of demand can be measured with the help of average revenue and marginal revenue.

(b) Define cross-elasticity of demand. Discuss its importance in business economics. 5+6=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

Advertisement elasticity and
Elasticity of price expectation.

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)

Importance of Cross 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.

(a) State the assumptions of the law of diminishing returns. Explain the theory with the help of suitable diagram. 3+8=11

Assumptions: The law of variable proportions functions is based on following assumptions:

Constant technology: The technology is assumed to be constant because technological changes will result into rise of marginal and average product.
Snort-run: The law operates in the short-run because it is here that some factors are fixed and others are variable. In the long-run, all factors are variable.
Homogeneous input: The variable input employed is homogeneous or identical in amount and quality.
Use of varying amount of variable factor: It is possible to use various amounts of a variable factor on the fixed factors of production.

Explanation of the Law: Law of variable proportion can be explained with the help of following table and diagram:

Units of Land	Units of Labour	Total Product	Marginal Product	Average Product
1	1	2	2	2
1	2	5	3	2.5
1	3	9	4	3
1	4	12	3	3
End of the first State Beginning of the Second Stage
1	5	14	2	2.8
1	6	15	1	2.5
1	7	15	0	2.1
End of the Second Stage Beginning of the Third Stage
1	8	14	-1	1.7

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Three States of Production

States	Total Product	Marginal Product	Average Product
1. Stage	Initially it increases at an increasing rate. Later at diminishing rate.	Initially increases and reaches the maximum point. The starts decreasing.	Increases and reaches its maximum point
2. Stage	Increases at diminishing rate and reaches its maximum point.	Decreases and becomes zero.	After reaching its maximum begins to decrease.
3. Stage	Begins to fall	Becomes Negative.	Continues to diminish.

Causes of Applicability: Main causes accounting for the application of the law of variable proportions are as follows:

Under utilization of Fixed Factor: In the initial stage of production, fixed factor of production like land or machine is under-utilized. More units of variable factor, like labour are needed for its proper utilization. Thus, as a result of employment of additional units of variable factor there is proper utilization of fixe factor. Consequently, total production begins to increase.
Fixed Factors of production: The principal cause of the operation of this law is that some of the factors of production are fixed during the short period. When the fixed factor is used with variable factor, then its ratio if compared to variable factor falls. Production is the result of the cooperation of all factors. Consequently, marginal return of the variable factor begins to diminish.
Optimum Production: After making the optimum use of a fixed factor if it is combined with increasing units of variable factor, then the marginal return of such variable factor begins to diminish.
Imperfect Substitute: It is the imperfect substitution of factors that is mainly responsible for the operation of the law of diminishing returns. One factor cannot be used in place of the other factor. Consequently, when fixed and variable factors are not combined in an appropriate ratio, the marginal return of the variable factors begins to diminish.

Postponement of the Law: Postponement of the law of variable proportions is possible under the following conditions:

Improvement in Technique of Production: Operation of the law can be postponed if along with the increase in variable factors technique of production is improved.
Perfect Substitute: The law can also be postponed if factors of production are made perfect substitutes, i.e. when one factor can be substituted for the other.

(b) Discuss the internal economies and diseconomies of a business firm. 8+3=11

Ans: Internal and 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.

(a) Explain the profit maximization objective of business firms. On what grounds it has been criticized in recent times? 8+4=12

Ans: Main Objectives - Profit Maximisation Goal of a Business Firm

According to traditional economic theory profit maximisation is the sole objective of business firms. The traditional theory suggests a number of reasons as to why does a firm want to maximize profits. All these reasons essentially fall into the following categories:

Traditional economic theory assumes that the firm is owner-managed, and therefore maximizing profit would imply maximizing the income of the owner; Owner would like to have adequate return for his activity as an entrepreneur.
Firm may pursue goals other than profit-maximisation, but they can achieve these subsidiary goals much easier if they aim for profit maximisation.

Under perfect competition individual firms have to maximize their profits at price determined by industry. Under imperfect competition firms search their profit maximizing price output as they are price makers. The profit can be defined as the difference between total revenue and total cost. i.e. Profit = Total Revenue – Total Cost.

A firm will maximize its profit at that level of output at which the difference between total revenue and total cost is maximum. Generally conventional price theory determines profit maximizing price-output in terms of marginal cost and marginal revenue.

Marginal Revenue: Marginal revenue is the addition to total revenue from the sale of an additional unit of a commodity.

Marginal Cost: Marginal cost is the addition to total cost from the production of an additional unit of a commodity.

The two profit maximizing conditions are:

1. MC = MR: - We take first condition

If MC < MR total profits are not maximized because firm will earn more profits by increasing output.
If MC > MR the level of total profit is being reduced and firm can increase profit by decreasing production.
If MC = MR the profits could not increase either by increasing or decreasing output and hence profits are maximized.
MC cuts MR from below: - Now we take the second condition. The second condition of profit maximisation requires that MC be rising at the point of its intersection with the MR curve.

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Criticism of profit Maximisation Approach:

The real world business environment is more complex than what convention theory of firm thought. The modern business firms face lot of risk and uncertainty. Long-run survival is more important than short-run profit.
The other objectives such as – sales maximisation, growth rate maximisation etc. describe real business behavior more accurately.
Profit maximisation objective cannot be realized without the exact measurement of marginal cost and marginal revenue.
Profits are not only measure of firm’s efficiency.
Profit maximisation assumption may require expansion of business which means more risks. But firms may prefer less profit instead of bearing additional uncertainties.

(b) What are the features of perfect competition? Explain how is the price outputs determined under such market in the short –run. 4+8=12

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:

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:

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.

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.

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

(a) Discuss the differences between monopoly and perfect competition. Explain how are the price and output determined under monopoly. 3+8=11

(b) Discuss the characteristics of oligopoly. Explain the price output determination process under ‘price leadership’ in oligopoly. 3+8=11

Dibrugarh University Solved Question Papers: Business Economics (May' 2015)

Posted by Kumar Nirmal Prasad

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Dibrugarh University Solved Question Papers: Business Economics (May' 2015)

Posted by Kumar Nirmal Prasad

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