Unit 3 Business Economics PYQ’s 6th Dec 2019 Shift 2

The following are the explanation for the correct match:

In the case consumers equilibrium to be explained through an ordinal approach, when there are two commodities with their prices given and with limited income of the consumer, the following information is required in the correct sequence:

1. Indifference Map:

• J.R Hicks used the concept of the Indifference curve to analyze consumer behaviour. A consumer-facing choice between a large number of bundles of two goods tries to maximise his satisfaction by choosing a combination which gives him maximum utility.
• An indifference schedule is a table which represents various combinations of two goods, which yield equal satisfaction to consumer.
• The graphical presentation of the Indifference schedule is known as the Indifference curve.
• A diagram showing different indifference curves corresponding to different indifference schedules of the consumer is an indifference map. In other words, a set or family of indifference curves is an indifference map.

2. Price line/budget line:

• The budget line is a graphical delineation of all feasible combinations of two commodities that can be bought with provided income and cost so that the price of each of these combinations is equivalent to the monetary earnings of the customer.

• In economics, a budget constraint represents all the combinations of goods and services that a consumer may purchase given current prices within his or her given income.
• Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices.

3. Equality of the slopes of IC and budget line:

• Note that the equilibrium quantities are those for which the slope of the indifference curve equals the slope of the budget line—that is, where the marginal rate of substitution equals the price ratio.
• Now suppose that the level of the individual’s income increases without any change in prices. More of both commodities can now be consumed and the price ratio does not change, so the budget line shifts outward with the new budget line being parallel to the original one.
• The level of utility increases from U0 to U1 and the individual’s consumption of the two goods increases to X1 and Y1 .
• At this point we must keep in mind that the indifference map below Figure assumes that both X and Y are normal goods—that is, that indifference curve U1 is tangent to the new higher budget line at a point to the right of output level X0.
• In the case where X is an inferior good, this tangency would be to the left of output level X0 and the quantity demanded of commodity X would decline as a result of the increase in income.

Therefore, the correct sequence is b) → a) → d) → c).

Assertion (A): In the case of short-run cost behavior, MC curve intersects AC curve at its minimum

Explanation:

Costs in the short run

1. Short-run cost curves tend to be U shaped because of diminishing returns.
2. In the short run, capital is fixed. After a certain point, increasing extra workers leads to declining productivity. Therefore, as you employ more workers the marginal cost increases.
3. Because the short-run marginal cost curve is sloped like this, mathematically the average cost curve will be U-shaped. Initially, average costs fall. But, when marginal cost is above the average cost, then the average cost starts to rise.
4. Marginal cost always passes through the lowest point of the average cost curve.

Therefore, from the above explanation Assertion (A) is true.

Reason (R): While AC continues to decrease, MC begins to rise. Also, when AC is at its minimum, it is neither increasing nor decreasing. It is constant when AC is constant, it is equal to MC at the point of intersection

Explanation:

when MC < AC, AC falls

When MC = AC, AC is constant and its minimum point

When MC > AC, AC rises

1. When MC is less than AC, AC falls with an increase in the output, i.e. till 3 units of output.
2. When MC is equal to AC, i.e. when MC and AC curves intersect each other at point A, AC is constant and at its minimum point.
3. When MC is more than AC, AC rises with an increase in output, i.e. from 5 units of output.
4. Thereafter, both AC and MC rise, but MC increases at a faster rate as compared to AC. As a result, MC curve is steeper as compared to AC curve.

Therefore, from the above explanation, Reason (R) is correct, and R) is the correct explanation of A).

Statement I: On every point on the straight-line demand curve, the point elasticities are all equal

Statement II: On every point on the rectangular hyperbola shaped demand curve, the point elasticities are not equal

Both the above statements are incorrect.

The explanation for Statement I:

ELASTICITY AND DEMAND SLOPE: The slope of a straight-line demand curve, one with a constant slope, has constantly changing elasticity. It includes all five elasticity alternatives–perfectly elastic, relatively elastic, unit elastic, relatively inelastic, and perfectly inelastic. No two points on a straight-line demand curve have the same elasticity.

The explanation for Statement II:

Rectangular hyperbola is a curve under which all rectangular areas are equal. When the elasticity of demand is equal to unity (ed = 1) at all points of the demand curve, then the demand curve is a rectangular hyperbola.

Short Run Average Costs: While the total cost of production helps firms understand the overall expenses incurred, the average costs help identify the expenditures involved in manufacturing a single unit.

1. Average Fixed Cost (AFC)

• The average fixed cost is the total fixed cost divided by the number of units produced.
• AFC is the fixed cost per unit of output.

2. Average Variable Cost (AVC)

• The second aspect of short-run average costs is an average variable cost.
• The average variable cost is the total variable cost divided by the number of units produced.
• AVC is the variable cost per unit of output.

3. Average Total Cost (ATC)

• The average total cost is the sum of the average variable cost and the average fixed costs. That is,
• ATC = AFC + AVC
• In other words, it is the total cost divided by the number of units produced.

The diagram below shows the AFC, AVC, ATC, and Marginal Costs (MC) curves:

It is important to note that the behavior of the ATC curve depends upon that of the AVC and AFC curves. Observe that:

• In the beginning, both AVC and AFC curves fall. Hence, the ATC curve falls as well.
• Next, the AVC curve starts rising, but the AFC curve is still falling. Hence, the ATC curve continues to fall. This is because, during this phase, the fall in the AFC curve is greater than the rise in the AVC curve.
• As the output rises further, the AVC curve rises sharply. This offsets the fall in the AFC curve. Hence, the ATC curve falls initially and then rises.

From the above explanation, the correct statement are as follows:

(a) In the short-run, Δ TFC = 0, therefore Δ TC = Δ TVC = MC

(b) If decrease in AFC < increase in AVC, then AC increases

(c) If decrease in AFC = increase in AVC, AC remains constant

(d) If decrease in AFC > increase in AVC, then AC decreases

Thus, Option A is correct.

a) A simple monopoly firm always earns supernormal profit- False

Explanation: A Monopoly firm does not always earn supernormal profits. The condition of earning supernormal profits or abnormal profits is if a firm’s average cost of production is less than the average revenue from the production for the corresponding output.

A monopoly firm’s equilibrium in the short run is:

1. Normal profits, when the average cost is equal to average revenue (AC = AR).
2. Losses, when the average cost is more than the average revenue (AC > AR).
3. Supernormal profits when average cost is less than the average revenue (AC < AR).

So, it is not always that a monopoly firm will enjoy supernormal profits. In the long run, if the supernormal profits continue it will attract other producers to enter the market, and the monopoly will lose these profits and may have to shut down its production if it incurs losses.

b) Sweezy’s kinked demand curve model is the best-known model explaining relatively more satisfactory behavior of oligopoly firm for price rigidity- True

Explanation: The kinked demand curve model seeks to explain the reason for price rigidity under oligopolistic market situations. A kinked demand curve represents the behavior pattern of oligopolistic organizations in which rival organizations lower down the prices to secure their market share, but restrict an increase in the prices.

c) A perfectly competitive firm is the price – taker- True

Explanation: A perfectly competitive firm is known as a price taker because the pressure of competing firms forces them to accept the prevailing equilibrium price in the market. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors.

d) Firms under monopolistic competition earn only normal profits- False

Explanation:

• In monopolistic competition, there is partial allowance of entry and exit of firms.
• Therefore, when there are super-normal profits in the market the new firms tend to enter the market to get the benefit of such profits due to which the supply of the commodity is increased and price falls.
• When there is a super-normal loss in the market the new firms tend to exit the market to avoid such losses due to which the supply of the commodity is decreased and price increases respectively.
• Due to these entry and exit mechanism, the firms in the market only earn normal profits in the long run.

Therefore, Option 3 is the correct option.

Constant Elasticity Substitution Function: The CES production function is a neoclassical production function that displays constant elasticity of substitution. In other words, the production technology has a constant percentage change in factor (e.g. labor and capital) proportions due to a percentage change in the marginal rate of technical substitution. The two factors (capital, labor) CES production function introduced by Solow, and later made popular by Arrow, Chenery, Minhas, and Solow are:

Q = A[αK^−β + (1 − α)L^−β]^−1/β  or  Q = A[αL^−β + (1 − α)K^−β]^−1/β

When A > 0, 0 < α < 1 and β > -1

Where L = Labour, K = Capital, and A, α, and β are three parameters.

Key Points

As its name suggests, the CES production function exhibits constant elasticity of substitution between capital and labor. Leontief, linear, and Cobb–Douglas functions are special cases of the CES production function.

Important Points

That is,

If β approaches 1, we have a linear or perfect substitute function;

If β approaches zero in the limit, we get the Cobb–Douglas production function;

If β approaches negative infinity, we get the Leontief or perfect complements production function.

‘Maximization of firm’s growth rate subject to managerial and financial constraints’ as one of the important alternative objectives of the especially large business corporations was pleaded by Robin Marris.

Key Points

1. Robin Marris suggested an alternative objective of ‘Maximization of firm’s growth rate’.
2. According to Marris, managers have their own goals other than profit maximization, which is the goal of shareholders or owners.
3. This dual objective can be achieved only by maximization of the firm’s growth rate.

Cardinal utility analysis is the oldest theory of demand which provides an explanation of consumer’s demand for a product and derives the law of demand which establishes an inverse relationship between price and quantity demanded of a product.

The analysis of consumer behavior seeks to answer two questions.

1. Firstly, how does a consumer decide the optimum quantity of a good that he/she selects to consume?
2. Secondly, how the disposable income is allocated by the consumer for different goods so that he/she maximizes the utility?

The cardinal utility approach answers these two questions on the basis of the following assumptions:

1. Rationality:

• Assumes that a consumer is rational and satisfies his/her wants in order of his/her preferences. Therefore, he/she firstly prefers to purchase those goods which yield the highest utility and lastly those that provide the lowest utility.

2. Limited Money Income:

• Refers to one of the important assumptions of the cardinal utility approach. According to this approach, a consumer has a limited amount of income to be expended on goods selected by him/her for consumption. Therefore, in such a case when there is an objective of utility maximization along with limited income, he/she selects those goods whose consumption is unavoidable.

3. Maximization of Satisfaction:

• This implies that every rational consumer strives to maximize his/her satisfaction from the limited income.

4. Utility is Measurable:

• Assumes that utility is cardinally measurable. Therefore, the utility of one unit of good equals the units of money that a consumer is willing to pay, which means that 1 util = 1 unit of money.

5. Diminishing Marginal Utility:

• Constitutes the basis for consumer behavior analysis. The utility gained falls as more and more units of a good are consumed.

6. Constant Marginal Utility of Money:

• Implies that whatever the level of income, the MU of money remains the same. According to this assumption, money is used as a measure of utility.

7. Utility is Additive:

• Implies that utility is not only cardinally measurable but can be added together to obtain the total utility. For instance, a consumer consumes X1, X2, and X3 units of good X and derives U1, U2, and U3 utils, respectively.

Therefore, from the above explanation, diminishing marginal utility of money is not the appropriate assumption considered under the theory of consumer behavior on the cardinal utility approach.