Unit 3 Business Economics PYQ’s 17th Oct 2020 Shift 2

The correct answer is – MR = MC

The profit-maximizing choice for a perfectly competitive firm will occur at the level of output where marginal revenue is equal to marginal cost, that is, where MR = MC.

Hence Option2 is correct

Key Points

Profit maximization is assumed to be the dominant goal of a typical firm. This means selling a quantity of a good or service or fixing a price, where total revenue (TR) is at its greatest above total cost (TC).

Marginal revenue is the additional revenue gained from selling one more unit of output.

Profit is the difference between total revenues and total costs.

The profit-maximizing rule for a perfectly competitive firm is to produce the level of output where marginal revenue equals marginal cost.

The correct answer is – Shortage of the commodity and black marketing

Key Points

• When a price ceiling is set below the equilibrium price, quantity demanded will exceed quantity supplied, and excess demand or shortages will result. When a price floor is set above the equilibrium price, the quantity supplied will exceed the quantity demanded, and excess supply or surpluses will result.
• The Shortage of the commodity and black marketing economy drives out legitimate industries that can’t compete with the lower costs of illegal operations. Some black market players deliberately create shortages in legal goods to force people to purchase from them. The tax-free nature of the black market means the government loses revenue.

Additional Information

• Commodity Glut an excessive quantity i.e. oversupply a glut of the commodity on the market.
• The incidence, or burden, of a tax, falls both on the consumers and producers of the taxed goods. If demand is more inelastic than supply, consumers bear most of the tax burden. But, if supply is more inelastic than demand, sellers bear most of the tax burden.
• Exports are goods and services that are produced in one country and sold to buyers in another. Exports, along with imports, make up international trade.

The correct answer is – Elastic

For a decline in price, Total Revenue (TR) increases if demand is elastic.

Key Points

Total revenue is price multiplied by quantity demanded (TR = P x Qd).

If demand is elastic at a given price level, then a company should cut its price, the percentage drop in price will result in an even larger percentage increase in the quantity sold—thus raising total revenue.

Important Points

However, if demand is inelastic at the original quantity level, then the company raises its prices, the percentage increase in price will result in a smaller percentage decrease in the quantity sold—and total revenue will rise.

Zero elasticity refers to the extreme case in which a percentage change in price, no matter how large, results in zero change in quantity. Constant unitary elasticity in either a supply or demand curve refers to a situation where a price change of one percent results in a quantity change of one percent.

A unitary elasticity means that a given percentage change in price leads to an equal percentage change in quantity demanded or supplied.

The correct answer is – Snob effect

When consumers seek to be different and exclusive by demanding less of a commodity as more people consume it. This phenomenon is known as the Snob effect.

Key Points

Snob effect

• It is a phenomenon described in microeconomics as a situation where the demand for a certain good by individuals of a higher income level is inversely related to its demand by those of a lower income level.
• The “snob effect” contrasts most other microeconomic models, in that the demand curve can have a positive slope, rather than the typical negatively sloped demand curve of normal goods.

Additional Information

Bandwagon effect

• The bandwagon effect is when people start doing something because everybody else seems to be doing it.
• The bandwagon effect can be attributed to psychological, social, and economic factors.
• The bandwagon effect originates in politics, where people vote for the candidate who appears to have the most support because they want to be part of the majority.

Substitution effect

• It is the decrease in sales for a product that can be attributed to consumers switching to cheaper alternatives when its price rises.
• A product may lose market share for many reasons, but the substitution effect is purely a reflection of frugality. If a brand raises its price, some consumers will select a cheaper alternative.

Price effect

• It is a concept that looks at the effect of market prices on consumer demand.
• The price effect can be an important analysis for businesses in setting the offering price of their goods and services.
• In general, when prices rise, buyers will typically buy less and vice versa when prices fall.

The correct answer is – Deadweight loss

Sub – optimal allocation of resources under monopoly to cause social welfare loss is often inferred as Deadweight loss.

Key Points

The deadweight loss is the potential gains that did not go to the producer or the consumer. As a result of the deadweight loss, the combined surplus (wealth) of the monopoly and the consumers is less than that obtained by consumers in a competitive market.

Additional Information

Resource allocation is the assignment of available resources to various uses. In the context of an entire economy, resources can be allocated by various means, such as markets, or planning. Allocation drift increases when the company or the economy is on a high growth path and declines when the growth rate slows down or during the period of recession.

Monopoly Loss The monopoly pricing creates a deadweight loss because the firm forgoes transactions with the consumers. Monopolies can become inefficient and less innovative over time because they do not have to compete with other producers in a marketplace. In the case of monopolies, abuse of power can lead to market failure.

Opportunity loss refers to the difference between the optimal profit or payoff for a given state of nature and the actual payoff received for a particular decision. In other words, it is the amount lost by not picking the best alternative in a given outcome.

The correct answer is – Adam Smith

The invisible hand, metaphor, introduced by the 18th-century Scottish philosopher and economist Adam Smith in 1759, characterizes the mechanisms through which beneficial social and economic outcomes may arise from the accumulated self-interested actions of individuals, none of whom intends to bring about such outcomes.

Key Points

• Smith argued against mercantilism and was a major proponent of laissez-faire economic policies.
• In his first book, “The Theory of Moral Sentiments,” Smith proposed the idea of an invisible hand—the tendency of free markets to regulate themselves by means of competition, supply and demand, and self-interest.

• The Theory Of Moral Sentiments was a real scientific breakthrough.
• It shows that our moral ideas and actions are a product of our very nature as social creatures.
• It argues that this social psychology is a better guide to moral action than is the reason.

The correct answer is – C and D only

A shutdown point is a concept in managerial economics that suggests that a business should at least stop production temporarily and close its door because its no longer profitable to sustain its operations.

Key Points

The three main factors that help in determining a shutdown point of a business:

• How much variable cost of operations goes into producing a good or service.
• The marginal revenue received from that good or service.
• The type of goods and services provided by the firm.

For a one-product firm, whenever the marginal revenue drops below marginal variable costs, the shutdown point occurs.

For a multi-product firm, whenever the average marginal revenue received drops below the average variable cost of operations, the shutdown point occurs.

A firm might reach its shutdown point for reasons that range from standard diminishing marginal returns to declining market prices for its merchandise.

Therefore, the average marginal revenue received and the average variable cost of operations are sufficient to determine the shutdown point of a multi-commodity firm in the short-run.

Important Points

To summarize, if:

• price > minimum average cost, then firm stays in business [refer (a) diagram]
• price < minimum average cost, then firm shuts down [refer (b) diagram].

The correct answer is – a-ii, b-i, c-iv, d-iii

A list and definition of different types of economic costs.

1. Sunk Cost

• Sunk costs are those which have already been incurred and which are unrecoverable.
• In business, sunk costs are typically not included in consideration when making future decisions, as they are seen as irrelevant to current and future budgetary concerns.
• Sunk costs are in contrast to relevant costs, which are future costs that have yet to be incurred.

2. Marginal Cost

• Marginal cost can help an organization optimize its production through economies of scale.
• Marginal cost is the change in the total cost that arises when the quantity produced is incremented by one unit; that is, it is the cost of producing one more unit of a good.
• A company that is looking to maximize its profits will produce up to the point where marginal cost (MC) equals marginal revenue (MR).
• Fixed costs are constant regardless of production levels, so higher production leads to a lower fixed cost per unit as the total is allocated over more units.
• Variable costs change based on production levels, so producing more units will add more variable costs.

3. Investment Cost

• The cost of an investment includes acquisition charges such as brokerage, fees and duties.
• If an investment is acquired in exchange, or part exchange, for another asset, the acquisition cost of an investment is determined by reference to the fair value of the asset given up.

4. Implicit cost

• An implicit cost is a cost that exists without the exchange of cash and is not recorded for accounting purposes.
• Implicit costs represent the loss of income but do not represent a loss of profit.
• These costs are in contrast to explicit costs, which represent money exchanged or the use of tangible resources by a company.

Therefore, the correct match is:

Hence option1 is correct

The correct answer is – A and B only

Utility maximization refers to the concept that individuals and firms seek to get the highest satisfaction from their economic decisions.

Key Points

The change in a consumer’s consumption of a good in response to an income-compensated price change is called the substitution effect. The substitution effect always involves a change in consumption in a direction opposite that of the price change.

• When a consumer is maximizing utility, the ratio of marginal utility to price is the same for all goods.
• For a consumer who purchases only two goods, price reduction increases the extra utility per rupee available from the good whose price has fallen; a consumer’s purchasing power will increase and thus purchase more of it.
• An income-compensated price increase reduces the extra utility per rupee from the good; the consumer will purchase less of it.
• In other words, when the price of a good falls, people react to the lower price by substituting or switching toward that good, buying more of it and less of other goods, if we artificially hold the consumer’s ability to buy goods constantly.
• Total utility is the aggregate summation of satisfaction that a consumer receives through the consumption of goods or services.
• When the price of goods decreases, the rate of consumption will increase i.e. the consumer’s total utility will increase as well.

Therefore, Statements A and B only are correct.

The correct answer is – A and C only

Monopolistic competition is a type of imperfect competition in which many firms offer products and services that are similar to each other but are not perfect substitutes.

Key Points

In a monopolistic competitive market:

• All firms have the same but a relatively low degree of market power.
• There are many firms offering similar but not identical products.
• There is easy entry and exit of firms in the market.
• These firms have little power to set short supply and raise prices to increase profit.
• The firms are small relative to the total market as there are many number of firms present providing goods and services in the market.
• Heavy advertisement and marketing are done by the firms of this market.
• Buyers and sellers have imperfect information.

Therefore, statements A and C only hold the truth about the monopolistically competitive market.

The correct answer is – B and C only

Price discrimination is a selling strategy that charges different prices for the same product or service from different customers. In price discrimination, the seller places different customers into groups based on certain attributes and then charges each group a different price.

Key Points

Three factors to successfully practice price discrimination:

1. The firm must possess market power.
2. The firm must be able to recognize differences in demand or must be able to control supply.
3. The firm must have the ability to prevent the resale of the product from one buyer to another.

Therefore, Statements B and C only hold the truth to successfully practice price discrimination.

Additional Information

Types of Price Discrimination:

• First-degree price discrimination: the monopoly seller of a good or service must know the absolute maximum price that every consumer would be willing to pay.
• Second-degree price discrimination: the price of a good or service differs according to the quantity demanded.
• Third-degree price discrimination: the price differs according to consumer attributes like age, location, gender, economic or social status, etc.

The correct answer is – a-iii, b-iv, c-ii, d-i

Market Structures:

“Market structures” refer to the different market characteristics that determine relations between sellers to each another, of sellers to buyers and more. There are four basic types of market structures.

Key Points

Perfect Competition

• All firms sell an identical product (the product is a “commodity” or “homogeneous”).
• All firms are price takers (they cannot influence the market price of their products).
• Market share has no influence on prices.
• Buyers have complete or “perfect” information—in the past, present, and future—about the product being sold and the prices charged by each firm.
• Resources for such labor are perfectly mobile.
• Firms can enter or exit the market without cost.

Monopoly

• Competitors are not able to enter the market as there are high barriers to entry.
• There is only one seller in the market, meaning the company becomes the same as the industry it serves.
• The company that operates the monopoly decides the price of the product that it will sell without any competition keeping its prices in check. As a result, monopolies can raise prices at will.
• A monopoly often can produce at a lower cost than smaller companies. Monopolies can buy huge quantities of inventory, for example, usually a volume discount. As a result, a monopoly can lower its prices so much that smaller competitors can’t survive.

Monopolistic Competition

• It occurs when an industry has many firms offering products that are similar but not identical.
• Unlike a monopoly, these firms have little power to set curtail supply or raise prices to increase profits.
• Firms in monopolistic competition typically try to differentiate their products in order to achieve above-market returns.
• Heavy advertising and marketing are common among firms in monopolistic competition and some economists criticize this as wasteful.

Oligopoly:

• Oligopoly is when a small number of firms collude, either explicitly or tacitly, to restrict output and/or fix prices, in order to achieve above normal market returns.
• Economic, legal, and technological factors can contribute to the formation and maintenance, or dissolution, of oligopolies.
• Government policy can discourage or encourage oligopolistic behavior, and firms in mixed economies often seek government blessing for ways to limit competition.

Therefore, the correct match is:

The correct answer is – Both A and R are correct and R is NOT the correct explanation of A

Key Points

Equilibrium:

Where, D = demand curve, S = supply curve, P = price of commodity, Q = quantity demanded and supplied, P0 = equilibrium price, A = excess demand, B = excess supply.

• In the above diagram, when the price of a commodity is above equilibrium price then the supply will be more than demand and when the price of a commodity is below equilibrium price then the demand will be more than supply.
• These both are disequilibrium prices of a commodity.
• The equilibrium price of a commodity is the price at which the quantity demanded of the commodity equals the quantity supplied i.e. P0.
• In the absence of external influences, the price of a commodity will not change.
• Equilibrium is a state in which market supply and demand balance each other and as a result, price becomes stable.
• Equilibrium is the condition, once determined tends to persist in time only when the behavior of agents is consistent, a dynamic process governs equilibrium outcome, and there is no incentive for agents to change behavior.

Therefore, both A and R are correct and R is NOT the correct explanation of A.