Micro Economics Solved Question Paper 2019 [Dibrugaru University B.Com 1st Sem CBCS Pattern]

The figures in the margin indicate full marks for the questions

1. Answer the following as directed:               1x8=8

a)The price of the commodity’ is a factor of demand function.  (Write True or False)

Ans: True, Price – Income – Taste – Preference are factors of demand functions.

b) Marginal revenue will be zero, if elasticity of demand is _______. (Less than one  / equal to one / greater than one / zero).  (Choose the correct answer)

Ans: equal to one

c)What is production function?

Ans:  Production function refers to the functional relationship between the quantity of a good producedand factors of production.

d) Under which form of market a firm is a price taker?

Ans: Perfectly competitive market

e) Total cost is the summation of

1) Total fixed cost and total variable cost.

2) Average cost and marginal cost.

3) Real cost and opportunity cost.

4) Selling cost and money cost. (Choose the correct answer)

Ans: Total fixed cost and total variable cost.

f) Which of the following economists is associated with monopolistic competition?

1) Adam Smith.

2) Keynes.

3) Chamberlin.

4) Marshall. (Choose the correct answer)

Ans: Chamberlin

g) In which market firms are mutually interdependent in determination of price of commodity?

1) Perfect competition.

2) Monopoly.

3) Monopolistic competition.

4) Oligopoly.          (Choose the correct answer)

Ans: Oligopoly

h) AR curve is also known as demand curve. (Fill in the blank)

2. Write short notes on the following (any four):               4x4=16

a) Income effect and income consumption curve.

b) Characteristics of isoquant curve.

c) Relationship between average cost and marginal cost.

d) Duopoly.

e) Producer’s surplus.

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Also Read: Microeconomics Question Paper Dibrugarh University

Microeconomics Question Paper 2019

Microeconomics Question Paper 2020

3. (a) What is price elasticity of demand? Examine the role of price elasticity of demand in decision-making of a firm.      4+7=11

Ans: 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.

These are three types of elasticity

1. Price elasticity

2. Income elasticity

3. Cross 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.

E_P=Proportionate change in quantity demanded/ Proportionate change in price

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 worker’s 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 bazaars. 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.

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

Or

(b) What is consumer’s equilibrium? Explain with the indifference curve and budget constraint how a consumer attains equilibrium.        3+8=11

Meaning of Consumer’s Equilibrium

Consumer’s equilibrium refers to a situation where in a consumer gets maximum satisfaction out of his limited income and he has no tendency to make any change in his existing expenditure. A consumer may find out with the help of indifference curve analysis as to how he should spend his limited income on the combination of different goods so that he gets maximum satisfaction.

Assumptions: Consumer’s equilibrium through utility analysis is based on the following assumptions:

1. Rational Consumer: Consumer is assumed to be rational. A rational consumer is one who is keen to get maximum satisfaction out of his limited income.

2. Cardinal Utility: Utility of every commodity can be measured in terms of cardinal numbers, such as, 1, 2, 3, 4 etc.

3. Independent Utility: It is assumed that the utility derived from one good is not depend on the utility derived from other goods.

4. Marginal Utility of money is constant.

Conditions of Consumer’s Equilibrium with the help of Indifference curve and Budget line

There are two conditions of consumer’s equilibrium with the help of indifference curve analysis:

(1) Budget Line or Price Line should be Tangent to Indifference Curve.

(a) Indifference Curve: An indifference curve is a curve which shows different combination of two commodities yielding equal satisfaction to the consumer. Supposing a consumer consumes two goods, namely apples and oranges. The following table and diagram indicates different combination of apples and oranges yielding equal satisfaction.

Combination of Apples &Oranges	Apples	Oranges
A	1	10
B	2	7
C	3	5
D	4	4

(b) Budget Line: The budget line is that line which shows all the different combinations of the two commodities that a consumer can purchase given his money income and the price of two commodities.

Explanation: Supposing a consumer has an income of Rs. 4 to be spent on apples and oranges. Price of oranges is Rs. 0.50 per orange and that of apple Rs. 1 per apple. With his given income and given prices of apples and oranges, the different combinations that a consumer can get of these two goods are shown in the following table and diagram:-

Income	Apples = Rs. 1.00	Oranges = Rs. 0.50
Four	0	8
Four	1	6
Four	2	4
Four	3	2
Four	4	0

(2) Indifference curve must be convex to the origin.

Consumer’s Equilibrium: Consumer’s equilibrium can be explained with the help of following diagram:

In this figure AB is the budget or price line. IC, IC, IC are the indifference curves. A consumer can buy any of the combinations, A, B, C, D and E of apples and oranges shown on the price line AB. Out of A, B, C, D and E combinations, the consumer will be in equilibrium at combination ‘D’ (4 oranges and 2 apples) because at this point price line is tangent to the indifference curve and indifference curve is convex to the point of the origin.

4. (a) Discuss laws of returns to scale. How are laws of returns to scale different from laws of variable proportions?          8+4=12

Laws of Return to Scale

It is a Long run concept. All factors of production are variable in the long period. No factor is a fixed factor. Accordingly, scale of production can be changed by changing the quantity of all factors.

According to Koutsoyiannis “The term returns to scale refers to the changes in output as all factors change by the same proportion.”

There are three aspects to Laws of Return to Scale:

a) Increasing Return to Scale.

b) Constant Returns to Scale.

c) Diminishing Returns to Scale.

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.

Constant Return to Scale: When inputs are increased in a given proportion and output increases in the same proportion, constant return to scale is said to prevail. For example, if inputs are increased by 25% and output also increases by 25%, the return to scale are said to be constant (= 1).This may be called homogeneous production function of the first degree.In case of constant returns to scale the average output remains constant. Constant returns to scale operate when the economies of the large scale production balance with the diseconomies.

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.

Difference between Laws of Variable Proportion and Laws of Returns to Scale

Basis	Laws of Variable Proportion	Laws of Returns to Scale
Meaning	Law of variable proportion shows the input-output relationship or production function with one variable factor, while other factors of production are kept constant.	Laws of return to scale shows the input output relationship where the behaviour of outputs as well as inputs are varied by the same proportion.
Stages	There are three stages: Negative, increasing and decreasing.	There are three stages: Increasing, decreasing and constant returns.
Time period	This law applies in the short run.	This law applies in the long run.
Prices	Prices are fixed in laws of variable proportion.	Prices are changeable in case of laws of returns to scale.
Technology	Technology is fixed and unchangeable.	Technology is changeable according to the need.

Or

(b) What are economies of scale? Discuss about internal economies and external economies.  2+10=12

Ans: 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.

Internal economies are further divided into:

a) Real Economies

b) Pecuniary Economies                               

Real economies are further divided into:

1. Labour Economies

2. Technical Economies

3. Inventory Economies

4. Selling or Marketing Economies

5. Managerial Economies

6. Transport and Storage Economies

External economies are further divided into:

1. Economies of Concentration

2. Economies of Information

3. Economies of Disintegration

4. Physical Factors

A.      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:

a)    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 –

1)    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.

2)    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:

a)    Economies of Increased Dimension.

b)   Economies of Linked Processes.

c)    Economies of the use of By-Product.

3)    Inventory Economies: A large size firm can enjoy several types of inventory economies; a big firm possesses large stocks of raw material.

4)    Selling or Marketing Economies: A firm producing a large scale also enjoys several marketing economies in respect of scale of this large output.

5)    Managerial Economies: A firm producing on large scale can engage efficient & talented managers.

6)    Transport and Storage Economies: A firm producing on large scale enjoys economies of transport & storage.

b) 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.

B.    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:

1)    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.

2)    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.

3)    Economies of Disintegration: when an industry develops, the firms engaged in its mutually agree to divide the production process among themselves.

4)    Physical factors: As the size of an industry expands, some physical factors may work to reduce the costs of all the firms working in the industry.

5. (a) Discuss the features of a perfectly competitive market. Explain how a firm under perfect competition attains equilibrium with normal profit, super normal profit and loss in the short-run.     4+7=11

Ans: Features of Perfectly Competitive Market

Different definitions given by different economists point out the distinct Assumptions/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. Perfect competition is characterized by:

1.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.

2.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.

3.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.

4. 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.

Equilibrium of the firm can be analysed in both short-run and long-run periods. A firm can earn the maximum profits in the short run or may incur the minimum loss. But in the long run, it can earn only normal profit.

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:

1) 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

2) 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.

3) Minimum Loss (AR < AC)

A firm in equilibrium may incur minimum loss when the average cost is more than 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 super normal profits, or normal profits or losses depending upon the price of the product.

Or

(b) Explain the effect of imposition of a specific tax on equilibrium price and output under perfect competition.       11

 

6. (a) Describe how a monopolist determines his profit-maximizing output and price in the long-run. How can monopoly power be measured?       8+3=11

Price – Output determination or monopoly equilibrium

In monopoly the average revenue curve will slope downwards. Further the marginal revenue per will also be falling and it will be steeper occupying a low level than the AR curve. The reason is since the AR is falling the extra units sold will be fetch less and lesser revenue in the market. In the case of perfect competition, both AR and MR is   the same horizontal line parallel to X access and equal to the price. But in monopoly, this is not so. The AR curve will be at a higher level sloping down, the MR curve will be at a lower level sloping down.

The principle of profit maximization is the same as that of perfect competition. The monopolist will maximize his net monopoly revenue by keeping the marginal cost and the marginal revenue at the same level. The following diagram illustrate monopoly equilibrium and price fixation. 

Where,

AR = Average Revenue

MR = Marginal Revenue

AC = Average Cost

MC = Marginal Cost

OM = Equilibrium Output

OP = Price

E = Equilibrium point where MR = MC

PQRS = Net Monopoly Revenue

With the AR curve falling and MR curve falling below it and cost curve, the Monopolist comes to the equilibrium at the point E where MR = MC and produces OM units of the commodity fixing the price at OP. at this price an output the monopolist realizes the maximum profit shown by the shaded area PQRS. In the diagram at OM output the Marginal revenue is greater than the marginal cost, but beyond OM, Marginal revenue is less than marginal cost. So equilibrium output is OM. This output OM can be sold in the market at a price OP according to the demand curve (AR curve). At this level of output the difference between average cost and average revenue is QR. The total profit is PQRS.

The monopolist firm has come to equilibrium and it is earning maximum profit. The equilibrium fall a short period is also for a long period under monopoly as there will not be any competitor entering the field.

Or

(b) What is price discrimination? Discuss the types of price discrimination with examples. Discuss the conditions of price discrimination.   2+6+3=11

Ans: Price discrimination

Price discrimination means the practice of selling the same commodity at different prices to different buyers. Under monopoly the producer usually restricts output and sells it at a higher price, thereby making maximum profit. If the monopolist charges different prices from different customers for the same commodity, it is called price discrimination or discriminating monopoly. The idea is to get from each customer whatever profits could be squeezed out of him depending on his ability to pay and intensity of demand. When a seller charges Rs.20 for a commodity from a customer A and Rs.22 for the same commodity from customer B, he is practicing price discrimination. Joan Robinson defines price discrimination as, “the act of selling the same article produce under a single control at different prices”. Price discrimination may also be defined as, “the sale of technically similar products at prices which are not proportional to marginal cost”.

Types of price discrimination

There are different types of price discrimination. They are

1. Personal discrimination: in personal discrimination, the monopolist will charge different prices from different customers on the basis of their ability to pay. Rich customers will be asked to pay more and poor customers to pay less. This is possible in specialized personal services of doctors and lawyers. If it is a commodity the discrimination will not be done openly but in a disguised manner. For e.g. the book of a famous Author can be sold in the market at different prices to different class of customers – deluxe edition is higher than the popular edition at a considerably lower price. Though the cost of producing deluxe edition is higher than the popular edition, the price fixed for the former will be very high than the price fixed for the latter. The content of the book is the same for which different customers pay the different prices. The deluxe edition will command a market among the richer class and it will have prestige value. Thus personal discrimination can be mad by making some superficial changes.

Similar principle of personal discrimination adopted in railways or transport organization. The upper class passengers pay more than the lower class for the same services rendered.

2. Place discrimination: monopolist having different markets in different regions may charge different prices for the same commodity in the different regions or localities. The locality in which his market is situated will be the criteria in fixing up the price. Suppose a monopolist has a shop in an aristocratic locality and also in a slum. He will charge higher prices in the former shop and lesser price in the slum shop on the understanding that aristocrats will not go for shopping in the slum. Generally, the extra price charge in an aristocratic locality will not be felt by the customers as this shop would cater to their extra needs such as ‘drive - in ‘facility, ‘door - delivery’ etc. sometimes the monopolist may charge lower prices in a foreign country than in the home market. This is also place discrimination. This method is adopted for “dumping” the goods in the foreign markets

3. Trade discrimination: this can also be called ‘use discrimination’. By this method, the monopolist will charge different price for the same commodity for different types of users to which the commodity is put to. For instance, electricity will be sold at cheaper rates for industrial establishments and charged at a higher rate for domestic consumption. Similarly, accessories like small springs, bolts, nuts, etc. will be charged at a higher price for automobiles and a lower price when the same material is used for bicycles and for domestic purposes.

Conditions necessary for price discrimination

1. Firm is a price maker: The firm must operate in imperfect competition; it must be a price maker with a downwardly sloping demand curve.

2. Separate markets: The firm must be able to separate markets and prevent resale. E.g. stopping an adults using a child’s ticket. Prevent business travellers from buying discount tickets.

3. Different elasticities of demand: Different consumer groups must have elasticities of demand. E.g. students with low income will be more price elastic and sensitive to price. Business travellers will have more inelastic demand.

4. Low admin costs: It must be relatively cheap to separate markets and implement price discrimination.

7. (a) Illustrate how a firm in monopolistic competition reaches its equilibrium in the short-run. Can economic efficiency be attained in monopolistic competition? Discuss.           7+4=11

Price determination under monopolistic competition

Price-output determination under monopolistic competition is governed by the cost and revenue curves of the firm. The cost curves are governed by laws of production. The revenue curves of the firm will not be very elastic, to be parallel to x-axis as in monopoly.  The average revenue curve of the firm under monopolistic competition will be a sloping down curve, the sloping being neither too steep nor too flat.  It will not be flat or parallel straight line because the firm may not have very elastic demand for its product.  The product is not homogenous but slightly different from that of other firms.  The firm cannot sell unlimited quantities at the established prices as the products of other firms are close substitutes if not perfect substitutes.  The curve will not be too steep because the demand under monopolistic condition will be much more sensitive to small changes in price as any fall in price could ensure more customers using the substitute product of other firms, similarly any rise in price will drive out many customers from the firm to go demanding other firms product.  Thus under monopolistic competition the AR curve will be fairly a sloping down curve and MR curve will be below it.

Equilibrium of the individual firm:

The monopolistic competitive firm will come to equilibrium on the same principle of equalizing MR and MC.  Each firm will choose that price that price and output where it will be maximizing its profit.  The following diagram shows the equilibrium of the individual firm in short period.

The short period marginal cost and average cost curves are shown as SMC and SAC.  The sloping down average revenue and marginal revenue curves are shown as AR and MR. The equilibrium point is E where MR equals MC. The equilibrium output is OM and the price is fixed OP.  The difference between average cost and average revenue is RQ.  The output is OM.  So, the super normal profit for the firm is shown by the rectangle PQRS. The firm by producing OM units of its commodity and selling it at a price of OP per unit realizes the maximum profit in the short run. Firms may also incur loss also which can be indicated in the following diagram.

 With the revenue curves and cost curves the firm comes to equilibrium at E¹ where MR equals MC.  At this point the firm is making the minimum loss P₁Q₁R₁S₁ shown by the shaded rectangle.  The price is P₁.   The firm incurs loss in the short run because average cost is high than average revenue.

Economic Efficiency

The different firms in monopolistic competition may be making either abnormal profits or losses in the short period depending on their costs and revenue curves.  The price of the commodity of the different firms will be different because the firm adopt individual price policy.  Based on consumer preferences of the product of the firm and the cost of production each firm will be fixing its price which may be different from the price of other firms. Old and long standing firms with established customers and goodwill will find high price advantageous.  The technique of production due to long experience may result in the cost position very comfortable.  So, established firms will be making abnormal profits in the short period.  Newly started firms may have to fix the price at a lower possible level to establish themselves.  The profit may not be very high.  It may even result in loss at the initial stages.  Thus in monopolistic competition firms may be making abnormal profit, normal profit or loss in the short period.  Firms making losses will keep the loss out at minimum and try to cover the average variable cost.

Or

(b) Why does price leadership sometimes evolve in oligopolistic markets? Explain how the price leader determines a profit-maximizing price.         4+7=11

Ans: Price Leadership and its importance under Oligopoly

Price leadership is a feature of oligopolistic situation. One firm assumes the role of a leader and fixes the price of a product or the entire industry. Price leadership can be seen when most or all of the firms in an industry decide to sell their product at a price fixed by one among them. The other firms in the industry follow this price.

These price followers simply accept the price fixed by the price leader and adjust their output to this price. The price leader may be the biggest firm in the industry or it may be a firm with the lowest cost of production. Its leadership may be established as a result of price-war in which it emerges as the winner. Independent pricing by each firm in the industry is rarely seen in the oligopolistic situation. Instead there will be some agreement among the various firms with regard to the price that is to be charged.

The agreement among these rival firms may be formal or informal. There may be a formal agreement among the various firms to follow the price fixed by a leader chosen from among them or there may be only an informal understanding among themselves.

Determination of Profit-maximizing price by Price Leader

The price and output decisions are illustrated in the above figure. Here it is assumed that there are only two firms A and B and firm A has a lower cost of production than B. These two firms are producing homogeneous products and are having equal share in the market.

Thus these firms face the same demand curve which will be half of the total market demand curve. DD is the demand curve facing each firm which is half of the total demand curve for the product. MR is the marginal revenue curve of each firm. MC, is the marginal cost curve of firm A and MC2 is the marginal cost curve of the firm B.

As the firm A has a lower cost of production than the firm B, MC, is drawn below MC2. If the price is fixed independently each firm will fix a price at which MC=MR. Then price of A would have been OP and B would have been OP.

But in the oligopolistic market the firm B cannot make maximum profit by fixing the price as OP, The firm B is to fix its price as OP, the price the low cost firm A has fixed. Firm B can sell its product only if it accepts its price as OP, the lower price. While A makes maximum profit, B is to be satisfied with a lower profit. Thus firm A is price leader and firm B has to follow it.

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