Micro Economics Solved Question Paper 2022 [Dibrugaru University B.Com 1st Sem CBCS Pattern]

Micro Economics Solved Question Paper 2022 
[Dibrugaru University B.Com 1st Sem CBCS Pattern]

COMMERCE (Generic Elective)

Paper: GE – 101 (Microeconomics)

Full Marks: 80

Pass Marks: 32

Time: 3 hours

The figures in the margin indicate full marks for the questions

1. Choose the correct alternatives:                1 x 8=8

(a) AR and MR curves under perfect competitions are _______.

(1) parallel to X-axis.

(2) parallel to Y-axis.

(3) upward sloping.

(4) downward sloping.

(b) In case of inferior goods, the income elasticity of demand is _______.

(1) positive.

(2) negative.

(3) zero.

(4) infinity.

(c) At all points on a ‘ridge line’, the MP of a specific factor are _______.

(1) positive.

(2) zero.

(3) negative.

(4) infinity.

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

(1) Monopoly.

(2) Perfect competition.

(3) Monopolistic competition.

(4) Oligopoly.

(e) The ‘L’ shaped indifference curve signifies _______.

(1) substitutable goods.

(2) complementary goods.

(3) Both of the above.

(4) None of the above.

(f) The structure of the toothpaste industry in India is best described as

(1) perfectly competitive.

(2) monopoly.

(3) monopolistically competitive.

(4) oligopoly.

(g) Under price leadership, the leading firm may be

(1) low cost firm.

(2) dominant firm.

(3) most experienced firm.

(4) Any of the above.

(h) Public utility includes the supply of

(1) water.

(2) gas.

(3) electricity.

(4) All of the above.

2. Write short notes on (within 150 words each):             4 x 4=16

(a) Cash subsidy vs. Kind subsidy.

Ans: Cash subsidies refer to direct financial assistance provided to eligible recipients in the form of grants, vouchers, or direct payments. They offer flexibility as beneficiaries can use the funds for various purposes according to their needs. Cash subsidies provide targeted support and allow recipients to make their own purchasing decisions.

On the other hand, kind subsidies involve providing goods or services directly to the beneficiaries instead of cash. These subsidies are often in the form of essential items such as food, healthcare, housing, education, or transportation. Instead of receiving money, recipients receive specific goods or services that are deemed necessary for their well-being.

Kind subsidies aim to ensure that recipients have access to specific goods or services that may otherwise be unaffordable or inaccessible. By directly providing these items, kind subsidies can target specific needs or vulnerable populations. However, they may limit the flexibility and choices available to beneficiaries as the assistance is provided in a predetermined form.

(b) Learning curve.

Ans: Learning Curves: Learning curves, also known as experience curves, depict the relationship between the cumulative production quantity and the average cost per unit of production. They represent the idea that as cumulative production increases, the average cost per unit tends to decrease.

Learning curves are based on the concept of learning by doing, which suggests that as workers or firms gain experience and knowledge through repeated production, they become more efficient and effective, leading to cost reductions. This can be due to factors such as improved skills, streamlined processes, economies of scale, or technological advancements.

Learning curves have implications for cost estimation, pricing strategies, and production planning. They provide insights into the cost dynamics associated with cumulative production and help businesses forecast future costs, set competitive prices, and make decisions related to economies of scale and production ramp-up.

(c) Price discrimination.

Ans: 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”.

(d) Prisoner’s dilemma.

Ans: The Prisoner's Dilemma is a concept in game theory that illustrates a situation where two individuals, acting in their own self-interest, may not achieve the best outcome for themselves or for the group. It demonstrates the tension between cooperation and competition.

The scenario involves two suspects who have been arrested for a crime but are held in separate cells with no means of communication. The prosecutor offers each suspect a deal: if one confesses and implicates the other while the other remains silent, the one who confesses will receive a reduced sentence, and the one who remains silent will face a harsher penalty. If both suspects confess, they will receive moderate sentences, but if both remain silent, they will both face lighter sentences due to lack of evidence.

The dilemma arises from the conflicting choices the suspects face. If both suspects act in their own self-interest, they will confess, fearing that the other will confess and leave them with the harshest penalty. However, this leads to a suboptimal outcome as both receive moderate sentences, which are worse than the lighter sentences they could have received if they had both remained silent.

Also Read: Microeconomics Question Paper Dibrugarh University

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Microeconomics Question Paper 2020

3. (a) What is price elasticity of demand? What are the degrees of price elasticity of demand? Examine the role of price elasticity of demand in decision making of a firm. 2+4+8=14

Ans: 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

Various Degrees of Elasticity of Demand

Since the responsiveness of quantity demanded varies from commodity to commodity and from market to market, it is important to study the degrees of price elasticity. We can identify five degrees of elasticity. They are:

1. Perfectly elastic demand

2. Perfectly inelastic demand

3. Unitary elastic demand

4. Relatively elastic demand

5. Relatively inelastic demand

1. Perfectly elastic demand:

Perfectly elastic demand is the situation where a small change in price causes a substantial change in quantity demanded i.e. a slight decline in price causes an infinite increase in quantity demanded and a slight increase in price leads to demand contracting to zero. The demand is hypersensitive and the elasticity of demand is infinite.

2. Perfectly inelastic demand:

It is the situation where changes in price cause no change in quantity demanded. Quantity demanded is non-responsive or inelastic.

3. Unitary elastic demand:

It refers to that situation where a given proportionate change in price is accompanied by an equally proportionate change in quantity demanded. For example, if price changes by 10%, quantity demanded also changes by 10%. Ep= 10/10 = 1

4. Relatively elastic demand:

Demand is said to be relatively elastic when a given proportionate change in Price causes a more than proportionate change in quantity demanded.

5. Relatively Inelastic demand:

Demand is relatively inelastic when a given proportionate change in price causes a less than proportionate change in quantity demanded. Demand curve will be a very steep curve. Elasticity is less than 1. For example, if price changes by 20% quantity demanded changes by 10% Then Ep = 10/20 = .5     i.e.; Ep<1.

Of the five degrees of elasticity perfectly elastic and perfectly inelastic are extreme cases i.e. rarely found in actual life. Unitary elasticity, relatively elastic and relatively inelastic demand are the most widely used price elasticity.

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.

Or

(b) Explain the revealed preference theory with appropriate diagram. In what respects is the revealed preference theory superior to indifference curve analysis?                     10+4=14

Ans: The Revealed Preference Theory is an economic theory that suggests that the preferences of individuals can be inferred by observing their actual choices in the market. It was developed by economist Paul Samuelson in the 1930s as an alternative to the subjective utility theory.

According to the Revealed Preference Theory, an individual's preferences are revealed through the choices they make when faced with different options. It assumes that individuals are rational decision-makers who select the best available option from the set of feasible alternatives.

Suppose the consumer buys combination A rather than combination В. С or D. It means that he reveals his preference for combination A. He can do this for two reasons. First, combination A may be cheaper than the other combinations B, C, D. Seconds combination A may be dearer than others and even then he likes it more than other combinations. In such a situation, it can be said that A is revealed preferred to В, C, D or В, C, D are revealed inferior to A. This is explained in Figure 14.1.

Given the income and prices of the two goods X and Y. LM is the price-income line of the consumer. The triangle OLM is the area of choice for the consumer which shows the various combinations of X and Y on the given price- income situation LM. In other words, the consumer can choose any combination between A and В on the line LM or between С and D below this line.

If he chooses A, it is revealed preferred to B. Combinations С and D are revealed inferior to A because they are below the price-income line LM. But combination E is beyond the reach of the consumer being dearer for him because it lies above his price-income line LM. Therefore, A is revealed preferred to other combinations within and on the triangle OLM.

Revealed Preference Theory is considered superior to indifference curve analysis in certain respects:

Empirical Foundation: The Revealed Preference Theory is grounded in actual observations of consumer behaviour and choices in the market. It relies on real data, making it more empirically robust compared to the subjective assumptions and hypothetical constructs used in indifference curve analysis.

No Need for Cardinal Utility: The Revealed Preference Theory does not require assigning cardinal values to utility or measuring satisfaction quantitatively. It focuses solely on observing and analyzing choices, making it more practical and less reliant on subjective assumptions.

Non-reliance on Indifference Curves: While indifference curve analysis is based on the concept of indifference curves, the Revealed Preference Theory does not depend on these curves. Instead, it focuses on revealed choices and preference orderings directly, making it conceptually simpler and more intuitive.

Applicability to Non-standard Preferences: The Revealed Preference Theory can accommodate a wider range of preferences, including non-standard or non-conventional preferences. It is not limited to assumptions about convex preferences or strict monotonicity, allowing for more flexibility in analyzing real-world behaviour.

4. (a) What is a production isoquant curve? Discuss in what ways the least cost combination and output maximizing combination of factors are determined with the help of isoquant curve and isoclines.   2+12=14

Ans: 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.

The producer’s equilibrium refers to the situation in which a producer maximizes his profits. In other words, the producer is producing given amount of output with least cost combination of factors. The least cost combination of factors also called optimum combination of the factor or input. Optimum combination is that combination at which either:

a) The output derived from a given level of inputs is maximum OR

b) The cost of producing a given output is minimum.

For producer’s equilibrium or optimum combination, it must fulfill following two conditions as:

(i) At the point of equilibrium the iso-cost line must be tangent to isoquant curve.

(ii) At point of tangency i.e., iso-quant curve must be convex to the origin or MRTS_Lk must be falling.

The iso-cost line gives information regarding factor prices and financial resources of the firm.

With a given outlay and prices of two factors, the firm obtains least cost combination of factors, when the iso-cost line becomes tangent to an iso-product curve. Let us explain it with the following Fig. 15.

In Figure 15, P₁L₁ iso-cost line has become tangent to iso-product curve (representing 500 units of output) at point E. At this point, the slope of the iso-cost line is equal to the iso-product curve. The slope of the iso- product curve represents MRTS of labour for capital. The slope of the iso-cost line represents the price ratio of the two factors.

Slope of Iso-quant curve = Slope of Iso-cost curve

MRTS_Lk = – ∆L/∆L = MP_L/MP_K = P_L/P_K

[where ∆K → change in capital, ∆L → change in labour, MPL → Marginal Physical Product of Labour, MPk – Marginal Physical Product of capital, P_L Price of Labour, and P_K → Price of capital, MRTS_LK ⁼Marginal Rate of Technical Substitution of labour and capital.]

The firm employs OM units of labour and ON units of capital. The producing firm is in equilibrium. It obtains least cost combination of the two factors to produce 5 00 units of the commodity. The points such as H, K, R and S lie on higher iso-cost lines. They require a larger outlay, which is beyond the financial resources of the firm.

Or

(b) Discuss the relationship between short-term and long-term average cost curves. Explain the L shape of the LAC curve.                       8+6=14

Ans: The relationship between short-term and long-term average cost curves are covered under the following headings:

1. Fixed Factors and Diminishing Returns: In the short run, firms face fixed factors of production that cannot be easily adjusted, such as plant size and capital equipment. This leads to diminishing returns as more variable factors, like labour, are added. As the firm hires more workers, for example, there comes a point where the additional output gained from each additional worker diminishes. This leads to an upward-sloping short-run average cost (SAC) curve.

2. Flexibility and Optimization in the Long Run: In the long run, firms have the flexibility to adjust all factors of production, including capital equipment and plant size. This allows them to optimize their production process and achieve greater cost efficiency. Firms can choose the most cost-effective combination of inputs and take advantage of economies of scale. As output expands, they can spread fixed costs over a larger quantity of output, leading to lower average costs. This results in a downward-sloping long-run average cost (LAC) curve.

3. Scale Economies: The downward slope of the LAC curve reflects the presence of economies of scale. As production increases, firms can achieve cost savings through various mechanisms. These include better utilization of resources, increased specialization, purchasing economies, and improved technology. These scale economies result in decreasing average costs as output expands.

4. Optimal Scale and Diminishing Returns: However, as the firm continues to expand production beyond a certain point, it may experience diminishing returns to scale. This can be due to coordination challenges, increased management complexities, or diminishing returns to managerial efficiency. As a result, the LAC curve starts to rise, indicating increasing average costs in the long run.

The L shape of the LAC curve captures the transition from the initial downward slope due to economies of scale, reaching an optimal scale with constant returns to scale, and then turning upward due to diseconomies of scale. It represents the different stages of cost efficiency and inefficiency associated with varying levels of production in the long run. Firms strive to operate at the scale that corresponds to the lowest point on the LAC curve to achieve maximum cost efficiency and competitiveness.

5. (a) What is normal price? Discuss how the long term equilibrium of industry and firm is determined under perfect competition.                         2+12=14

Ans: Long-run Equilibrium of the Industry: In the long run, an industry is in equilibrium when its firms are earning normal profit. Long run equilibrium of the industry means that no new firm has a tendency to enter it not any old firm has a tendency to leave it. Long-run equilibrium is explained with the help of following diagram:

In this figure, DD is demand and SS is supply curve of the industry. Both intersect each other at point ‘E’. Thus E is the equilibrium point of the industry that determines OP as the equilibrium price. It indicates that firms are getting only normal profits.

Long-run Equilibrium of the Firm:

In the long-run, it is possible to make more adjustments than in the short-run. The firm can adjust its plant capacity and scale of operations to the changed circumstances. Therefore, all costs are vari­able. Firms must earn only normal profits. In case the price is above the long-run AC curve firms will be earning supernormal profits.

Attracted by them, new firms will enter the industry and supernormal profits will be competed away. If the price is below the LAC curve firms will be incurring losses. As a result, some of the firms will leave the industry so that no firm earns more than normal profits. Thus “in the long-run firms are in equilibrium when they have adjusted their plant so as to produce at the mini­mum point of their long-run AC curve, which is tangent (at this point) to the demand (AR) curve defined by the market price” so that they earn normal profits.

It’s Assumptions:This analysis is based on the following assumptions:

a)   Firms are free to enter into or leave the industry.

b)   All firms are of equal efficiency.

c)    All factors are homogeneous. They can be obtained at constant and uniform prices.

d)   Cost curves of firms are uniform.

e)   The plants of firm: are equal having given technology.

f)     All firms have perfect knowledge about price and output.

Determination:

Given these assumptions, each firm of the industry will be in the equilibrium in the following two conditions.

(1) In equilibrium, its short-run marginal cost (SMC) must equal to its long-run marginal cost (LMC) as well as its short-run average cost (SAC) and its long-run average cost (LAC) and both should be equal to MR=AR=P. Thus the first equilibrium condition is:

SMC = LMC = MR = AR = P = SAC = LAC at its minimum point, and

(2) LMC curve must cut MR curve from below.

Both these conditions of equilibrium are satisfied at point E in Figure 3 where SMC and LMC curves cut from below SAC and LAC curves at their minimum point E and SMC and LMC curves cut AR = MR curve from below. All curves meet at this point E and the firm produces OQ optimum quantity and sell it at OP price.

Since we assume equal costs of all the firms of industry, all firms will be in equilibrium m the long-run. At OP price a firm will have neither a tendency to leave nor enter the industry and all firms will earn normal profit.

Or

(b) Describe how a monopolist determines his profit maximizing output and price in the long run. How can monopoly power be measured?                  10+4=14

Ans: Long-run is that time period in which all the fixed and variable factors of production can be altered. The firm can change the size of plant and machinery and can determine the level of output to maximize its profit. Because of this, the firm does not suffer loss. Likewise, the entry of new firms is restricted somehow and the monopolist earns abnormal profit in the long run due to lack of competition. The following conditions must be fulfilled to attain equilibrium under monopoly in the long run:

i) MR must be equal to LMC.

ii) LMC must intersect MR from below.

The equilibrium of a monopoly, in the long run, can be graphically presented as follows:

In the above figure, LAC and LMC represent long-run average cost curve and Marginal cost curve. AR and MR represent Average and Marginal Revenue. The equilibrium point is determined at ‘E’ where LMC intersects MR from below. The equilibrium level of output is determined at OQ. The cost incurred is OC and the revenue earned is OP. Since revenue is higher than cost (AR> AC), the monopolist earns abnormal profit in the long-run.

Measurement of Monopoly Power

1. Concentration Ratio: Concentration ratio refers to the fraction of total market sales controlled by the largest group of sellers. The inclusion of the market shares of several firms in the concentration ratio rests upon the possibility that large firms will adopt a common price - output policy which may not be very different from the one they would adopt if they were under unified management. But here difficulty arises that they may not do so. Therefore, a high concentration ratio may be necessary for the exercise of monopoly power but it is not sufficient.

2. Profit-Rate as a Measure: J.S. Bain used profit-rate as a measure of monopoly power. By high profits, economists mean returns sufficiently in excess of all opportunity costs which potential new entrants desire for entering the industry. The size of super-normal profits which a firm is able to earn is an indication of its monopoly power. In perfect competition, a firm earns only normal profits. In monopoly, new entrants will not normally compete away monopoly profits. But there will be some level of profits at which new firms will find it worth taking the risk of trying to break the monopoly.

The stronger the monopolists position, the greater the profits he will be able to earn without attracting new rivals. In short, it is said that neither concentration ratio nor profit-rate are ideal measures of the degree of monopoly power, both are of some value nor both are widely used.

3. Lerner’s Measure: It is the oldest measure and is based on the difference between the price charged by the monopolist and his marginal cost. Bober gives the formula 1/E. Thus, degree of monopoly power varies inversely with the elasticity of demand for the commodity. However, the more commonly used formula is:

Degree of monopoly power = (P-MC) / P

Where P is price charged by the monopolist and MC his marginal cost.

In perfect competition,

P = MC and the formula (P-MC)/P gives zero answer indicating no monopoly power. If the monopolized product is a free good, MC = 0 and the formula registers unity. The index of monopoly power thus varies from zero to unity. Since monopolized goods are seldom free, monopoly power is seldom as high as unity.

 

6. (a) What factors cause the emergence of oligopoly? Explain the kinked demand curve analysis. Is there always price rigidity in kinked demand curve analysis?    4+8+2=14

Ans: “Oligopoly” is a term derived from two Greek words “Oligos” meaning a few “pollein” meaning to sell. Thus Oligopoly refers to that form of imperfect competition where there will be only few sellers producing either a homogenous product which are close substitutes but not perfect substitutes or similar products.

Cause of Emergence of Oligopoly

The main reasons which give rise to oligopoly are as follows:

1. Large Investment of Capital: The number of firms in an industry may be small due to the large requirements of capital. No entrepreneur will like to venture to invest large sums in an industry in which addition to output to the existing one may likely to depress prices. Further, the new entrant may also fear of provoking a price-war by the established firms in the industry. This is always true that in the midst of differentiated product, it is difficult to make a new product.

2. Control of Indispensable Resources: A few firms may control some indispensable resources which may enable them to secure several advantages in costs over all others. This enables them to operate profitably at a price at which others cannot survive.

3. Economies of Scale: If the productive capacity of few firms is large and are able to capture a greater percentage of the total available demand for the product in the market, there will then be a small number of firms in an industry. The firms in the industry with heavy investment using improved technology and reaping economies of scale in production, sales promotion etc. will complete and stay in the market. The firms using outdated machinery and old techniques of production will not be able to compete with the low unit’s costs producing firm and eventually wipe out from the industry. Oligopoly is, thus promoted due to the economies of scale.

4. Barriers to entry: In many oligopolies, the new firms cannot enter the industry as the big firms have ownership of patents or control over the essential raw material used in the production of an output. The heavy expenditure on the advertising by the oligopolistic industries may also be a financial barrier for the new firms to enter the industry.

5. Merger: If the new firms in the industry smell the danger of entry of new firms, they then immediately merge and formulate a joint policy in the pricing and production of the products. The joint action of a few big firms discourages the entry of new firms into the industry.

6. Mutual Interdependence: As the number of firms is small in an oligopolistic industry, therefore they keep a strict watch of the price charged by rival firms in the industry. The firm generally avoid price war and try to create conditions of mutual interdependence.

Kinked demand curve

Price rigidity under oligopoly is better explained by kinked demand curve. The kinked demand model represents a condition in which the firm has no incentive either to increase the price or to decrease the price but keep the price rigid at a particular level. The firm believes that the rival firms will not follow suit if it raises the price. But if it cuts down the price the rival firms will follow suit. Adding on this belief the firm maintains the present price. If it increases the price sales will be decreased automatically and that will prove advantages to the rivals who have not increased the price. If price reduction is restored, the rivals also would not improve appreciably. Hence to stick on to the present price is very expedient. Only in the event of any drastic changes in demand and cost conditions the firm could think of changing the price.

Under such a condition the demand curve of the firm, as anticipated by the firm would be kinked. This means that the curve will have a kink at the present price. The following diagram shows kinked demand curve.

In the figure the demand curves with a kink point P has been shown. P is the price at which the firm is selling the product by producing ON units. Above the price P the demand curve as anticipated by the firm is DP.  The curve is elastic. Below the price P the anticipated demand will be PB which is inelastic. This shows that when the firm increases the price above P and if all other firms maintain the old price, then the demand for the firms product would fall off. So the demand curve is highly elastic above P [DP portion]. The total revenue and profits of the firm would be reduced. The corresponding portion of marginal revenue curve is also shown in the figure [MR]. If the firm decreases the price the demand curve becomes much less [PB]. PB curve is inelastic because, the reduction in price will be followed by other firms and the sales may not increases appreciably, than what it is at the price P. as this level the marginal revenue curve is shown as MR, when the demand curve is positive. When the demand curve is PB the marginal revenue becomes negative. When there is no scope of better profit in either way, why should the firm think of changing the price from what it is.  (P) so the price PN as shown in the diagram becomes rigid.

The peculiarity of this figure is that there is gap or discontinuity in MR curve below the point of kink. KL shows the gap or extent of discontinuity between MR and MR₁. This gap will depend on the elasticity of demand above and below the kink.

The gap will be larger if the elasticity is greater above the kink and elasticity is also greater below the kink, price will not change oligopoly unless there is drastic change in demand and cost conditions.

The kinked demand curve theory of oligopoly explains the price rigidity but it does not explain how the price under oligopoly is determined. Moreover, this theory has little application to oligopoly with product differentiation. This method is not useful in case of price leadership or collusive oligopoly. Because of this complexities and variations and uncertainties a general theory of pricing under oligopoly is not possible.

Or

(b) Critically discuss the Baumol’s model of sales maximization with and without advertising.                      14

Ans: 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.

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.

Baumol's Model with Advertising:

In Baumol's model, advertising plays a crucial role in achieving sales maximization. Advertising can help firms attract more customers, increase brand awareness, and stimulate demand for their products or services. By investing in advertising, firms can differentiate themselves from competitors and capture a larger market share. This can lead to higher sales revenue and potentially higher profits in the long run.

However, the effectiveness of advertising in achieving sales maximization depends on various factors. Firstly, there is the issue of diminishing returns to advertising. Initially, increased advertising expenditure may lead to higher sales, but at some point, the marginal benefit of additional advertising diminishes. This means that there is an optimal level of advertising beyond which further investments may not generate significant returns.

Secondly, advertising costs money, and firms need to consider the trade-off between advertising expenditure and potential profits. If advertising expenses exceed the incremental revenue generated, it may lead to lower profitability or even losses. Thus, firms must carefully evaluate the cost-effectiveness of advertising campaigns and ensure that the benefits outweigh the costs.

Baumol's Model without Advertising:

In the absence of advertising, Baumol's model suggests that firms can still pursue sales maximization through other means. For example, firms can focus on price competition, product differentiation, or expanding their distribution networks. By offering competitive prices or unique products, firms can attract customers and gain a larger market share, leading to increased sales revenue.

However, without advertising, firms may face challenges in creating brand awareness and communicating the value of their products or services to potential customers. Advertising helps in building brand recognition, shaping consumer preferences, and creating a positive image of the firm. Without these marketing efforts, firms may struggle to differentiate themselves from competitors and may not be able to achieve maximum sales.

Moreover, in the absence of advertising, firms may rely more on price competition, which can lead to a race to the bottom in terms of pricing. This can erode profit margins and potentially harm the long-term sustainability of the firm.

Overall, while Baumol's model of sales maximization emphasizes the importance of increasing sales revenue, the role of advertising is crucial in achieving this goal. Advertising can help firms differentiate themselves, increase brand awareness, and stimulate demand. However, firms must carefully consider the costs and benefits of advertising and ensure that the investment is cost-effective. Without advertising, firms may face challenges in creating brand recognition and communicating their value proposition to customers. Ultimately, the effectiveness of sales maximization strategies, with or without advertising, depends on various factors such as market conditions, competitive dynamics, and consumer preferences.

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