INDIAN INSTITUTE OF MODERN MANAGEMENT (IIMM)

Registration No. :- IIMM/DH/1/2007/5516

Name :- Shekhar Sharma

ASSIGNMENT :-MANAGERIAL ECONOMICS

Answer 1. (a) Father of Economics Adam Smith Published his book in 1776: He described
economics as “The Science of wealth”. According to him “The acquisition of wealth is the main
objective of human activity. Therefore, it is necessary to study how wealth is produced. This is the
subject matter of the economics”. As this is a wealth oriented definition, thus it attracts many
critism.

Then came the definition of Alfred Marshall. He said “Political economy or

Economics is a study of means and actions in the ordinary business of life”. Marshal was criticized
for being restricted to the earning and spending class only. It did not answer the questions as to
How, Why and What etc.

There were many other definitions given by many economists, but the definition
given by Liouel Robbins in 1932 was a definition, which is accepted by most of the economists.
According to Robbins “Economics is the science which studies human behavior as a relationship
between ends and scarce means which have alternative uses”. Here ends refer to wants which are
considered to be unlimited. The use and allocation of scarce resources to production of goods and
services which will give maximize satisfaction. Scarcity of resources also compels us to decide how
the different goods & services would be produced.

Production Possibility curve (PPC)

This is a very basic tool but a very important one. We’ll use this tool to study the
about the problem of scarcity by using this tool. The problem of scarcity was given focused by
Prof. Samulson by using the production possibility curve of production possibility frontier.

Basic Assumptions or Production Possibility Curve:

1) There is full employment in the society which means all the four factors of production are fully
employed and there is no unemployment in the society.

2) The supply is limited which means that supply of factors are fixed and they can be reallocated or
shifted within limits among different uses.

3) Technology is constant which means that there is no innovations’ going in the society.

We can use this technique to illustrate the economizing problem with the help of an
imaginary table containing some of the alternative combinations of breads and sewing machines,
which the economy might choose.

Products A B C D E

Breads (in hundred thousand) 0 1 2 3 4

Sewing Machine (in Thousand) 10 9 7 4 0

Notes:

1. Four factors of production- Land, Labour, Capital and Enterprise.

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 A
B
C
8

U
6

Sewing Machine
4

0
1 2

2. Improvement in existing technology.

If we closely observe the data we find that we have two extremes here. The alternative A
and alternative E. At ‘A’ there is no production of bread which mean all the resources available the
production of only and only sewing machine. Same is the case with where there is production of
only bread. The ‘D’’B’ and ‘C’ are the combination of the two goods. The economy generally
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 adopts the ‘D’ ‘B’ or ‘C’ alternatives. As we move from ‘A’ to ‘E’ the economy changes the
combinations. When the society is moving from ‘A’ to ‘E’ the society is consuming one sewing
machine. At any point of time, a fully employed and fully producing economy must scarce; the
economy cannot have all the commodities at one time.

The above mentioned explanation can be explained graphically with the use of Production
Possibility Curve (PPC). The PPC represents shifting of resources from one production to another.

If a point falls on the Production Possibility Curve it means the factors of production are
fully employed.

If the production is taking place at point ‘U’ it means there’s under employment and there
are some unemployed factors in the society. Whereas if the production takes place at point ‘P’, it
shows the shortage of factors of production. Whereas if the economy wants to reach the point ‘P’ it
will have to increase the efficiency and production capacity of the factors of production.

Answer.1 (a) Micro and Macro Economics

Micro-Economics:

Definitions

The term ‘Micro’ has been derived from the greek word ‘mikros’ which means ‘small’. In
micro-economic approach, attention is concentrated on a very small part or the individual units.

Hanson terms it as “atomistic individualistic approach.”

Boulding has described micro-economics as the study of “The particular firms, particular
households, individual prices, wages, incomes, individual industries and particular commodities.”

Thus micro economics is the study of the behavior of individual consumer’s, individual
firm or workers. It studies, for example the motive of a business man in diverting his capital from
the cotton textile industry to the Weller industry or that of an individual producer for increasing the
production of commodity A rather than commodity B.

Scope of Micro Economics:

Micro-economic analysis explains the allocation of resources assuming that the total
resources are given. The following chart given of the view of the scope of micro-economics.

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 Micro-economic Analysis

Theory of Theory
Commodity Factor Pricing Welfare Economics
Pricing

Theory of Theory of Rent Interest Profit

Wages
Demand Supply

Macro-Economics: Definitions and Scope

The term ‘Macro’ has also been derived from another Greek word ‘Makros’ meaning large.
The word itself was coined in 1933 by Ragnar Frisch.

Macro-economics implies a study of economic aggregates or the wholes. The problems like
full employment, unemployment, economic stability and economic growth cannot be accurately
investigated through the examination of infinitesimally small units like individual consumers,
producers, workers or firms. The actions of a single employer cannot in any way, have a
perceptible impact upon the employment situation of a country. The production or investment by a
single firm is unlike to generate cyclical fluctuations. The proper analysis of such problem requires
an aggregated thinking. Full employment, economic growth and instability are concerned with the
entire economic system. Their analysis and solution in the right perspective can be possible only if
a macro approach and aggregative instruments of analysis and policy are employed.

Prof. Gardner Ackely states that Macro-economics “concerns itself with such variables as
the aggregate volume of output of an economy, with the extent to which its resources are
employed, with the size of national income, with the general price level.”

Hanson has interpreted macro-economics as “that branch of Economics which considers

relationship between large aggregates such as the volume of employment, total amount of saving
and investment, the national income, etc.’

Evolution of Macro-Economics

The depression of The 1930’s was not simply instrumental in the tumbling down of the
prices of securities and a consequent collapse of general economic activity; it pulled down even the
old structure of economic analysis. The world was forced upon the aggregates like national income,
aggregate output, expenditure, consumption, saving and investment.

Keyne’s General Theory has a tremendously decisive impact on the post-Keynesian

aggregative thinking. The main factors which contributed to the growth of aggregative in the
1930’s and which sustained the impetus for the development of such an approach were as follows:

(i) Technological break through reflected in mass production methods.

(ii) Continuous process of industrialization and urbanization in general.

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 (iii) Increasing complexity and multiplicity of the phenomena influencing the present day
economic life. The investigation of which requires more and more detailed information.

(iv) Extension of public sector in every economy and the resulting growing importance of the
role of government finance for growth, welfare and stability.

Answer.2(a) Managerial economics should be thought of as an applied branch of Micro economics,

which studies the topics which are of great interest and importance to a manager. These topics
involve components like demand, Supply, Production, Cost, revenue, Government regulations etc.
Good understanding of these topics is an important managerial talent, which helps the manager in
decision making and forecasting.

In general managerial economics can be used by the goal-oriented manager in two ways.
Firstly, given an existing economic environment, the Principles of managerial economics provider
a frame work or evaluating whether resources are being allocated efficiently. Secondly, the
principles of economics help in decision making. For example one reason to cut down in the
Labour cost could be because of larger use of the machinery.

Managerial economics is the application of economic analysis to evaluate business

decisions. It concentrates on the decision process, decision model and decision variables at the firm
level. The firm is viewed as a microeconomics unit located within as industry, which exists in the
context of a given socioeconomic environment of business.

Managerial economics is concerned with the economics behavior of the firm. It is assumed
that the firm maximizes profit. Profit is defined as the difference between revenue and costs. The
flow of revenue is determined by the demand conditions in the market, whereas the costs are
influenced by the supply conditions. Demand and supply interact with each other to determine
prices commodity prices in the product market structure perfect or imperfect, free or regulated,
buyer or seller etc. The firm placed in the context of a market environment, decides its economic
strategy and tactics, keeping in view its objectives and constraints. Tactical decisions are reflected
in the course of operational decision variables like price and, output, etc. , which affect the firm’s
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 level of profit. The firm can then evaluate its performance in terms of return on an investment
intended and achieved. The firm can estimate the element of risk and uncertainty, it is subject to
and through its decision making process the firm can formulate strategies to minimize such risk
through forecasting and forward planning.

Definitions:

There are many definitions of managerial economics, fun of them are as follows:

1) Prof. Spencer Siquelman

“Managerial economics deals with integration of economic theory with business practice
for the purpose of facilitating decision making and forward planning’.

2) Prof. Hague

“Managerial Economics is concerned with using logic of economics mathematics and

Statistics to provide effective ways of thinking about business decision problem”.

3) Mc Nair and Meriam

“Business economics & managerial consists of the use of economic”.

Answer.2(b) The demand for a product is the desire for that product backed by willingness as well as
ability to pay for it. It is always defined with reference to a particular time, place, price and given
values of other variables on which it depends.

Law of Demand

“Other things being equal, the higher the price of a commodity, the smaller is the quantity
demanded and smaller the price, larger is the quantity demand”.

Individual Demand Curve

With the given income individual selects that combination of goods and services that
maximized their personal satisfaction. We know that an individual distributes his income among
different demands. Generally we study demand for one good to understand the individual demand
curve.

The Demand Schedule

A demand curve considers only the price-demand relation, other things remaining the same.
This price-demand relationship can be illustrated in the form of a table called demand schedule and
the data from the table may be given a diagrammatic representation in the form of a curve.

Demand Curve

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 The graphical representation of individual or market demand schedule is known as demand
curve as shown below:

Demand Schedule

Px (in Rs.) Dx (in units)

2 12

3 10

4 8

5 6

6 4

It may be observed from the demand schedule and the demand curve above that the price of x and
the demand for x move in opposite directions.

Assumptions:

The Law of demand stands on some basic assumptions without which it losses its meaning.

1) No change in consumer’s income during the period or at the time of demand.

2) No change in fashion.

3) No change in technology.

4) No change in the price of substitute.

5) No change in consumer’s preference.

6) No change in government policy.

7) No change in weather conditions.

The Law of demand which says that there is a inverse relation between quantity and price
depends on the above assumptions.
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 Types of Demand

1) Direct and Derived Demands

Direct demand refers to demand for goods meant for final consumption. By contrast,
derives derived. For Example, the demand for cement is derived from the demand for housing.
Autonomous demand, on the other hand, is not derived or induced. All direct demand may be
loosely called autonomous. In the context of econometric estimates of demand, this distinction is
used to identify the determinates of demand.

2) Autonomous and Induced Demand

When the demand for a product is tied to the purchase of some parent product, its demand
is caved induced or derived. For Example, the demand for cement is derived from the demand for
housing. Autonomous demand, on the other hand, is not derived or induced. All direct demand may
be loosely called autonomous. In the context of econometric estimates of demand, this distinction
is used to identify the determinates of demand.

3) Perishable and Durable Goods Demand

Both consumer’s goods and producer’s goods are further classified into perishable, non-
durable, single use goods, durable, non-perishable, repeated use goods.

Non-durable goods meet immediate demand, but durable goods are designed to meet
current as well as future demand as they are used more than ones. When durable items are
purchased, they are considered to be an addition to stock of assets or wealth. Due to continuous
use, durables suffer depreciation and thus call for replacement. Thus the demand for durable goods
has two aspects replacement of old products, and expansion of total stock.

4) New Demand and Replacement Demand

If the purchase of an item is meant as an addition to stock, it is a new demand. If the

purchase of an item is meant for maintaining the old stock of capital/asset intact, it is replacement
demand. Such replacement expenditure is to overcome depreciation in the existing stock.

Answer.3(a) The Consumer’s Surplus

The concept of consumer’s was introduced by Marshall, who maintained that it can be
measured in monetary units.

Consumer surplus is equal to the difference between the amount of money that a consumer
actually pays to buy a certain quantity of a commodity x, and the amount that he would be willing
to pay for this quantity rather than do without it.

Graphically the consumer’s surplus may be found by his demand curve for commodity x
and the current market price, which, is assumed, he cannot affect by his purchases of this
commodity. Assume that the consumer’s demand for x is a straight line (AB in the fig. Below and
the market price is P. At this price consumer buy Q units of x and pays an amount (p) for it.
However, he would be willing to pay P1 for q1, P2 for q2, P3 for q3 and so on. The fact that the
price in the market is lower than the price he would be willing too pay for initial units of x implies
that is actual expenditure is less than he would willing to spend to acquire the quantity q. This
difference is the consumer’s surplus, and is the area of the triangle PAC in the fig. below.

8
Px

P1

P2

P3
C
P

Qx
O q1 q2 q3 q B

Thus, consumer surplus may be defined as the excess of utility or satisfaction obtained by
the consumer and is measured by the difference between what we are prepared to pay and what we
actually pay.

Consumer surplus = what one is prepared to pay - what one actually pays.

Or Consumer surplus = Total utility obtained – Total amount spent

Assumptions of Consumer Surplus

The Marshallian surplus is based on the following assumptions:

1) Marginal utility of money remains constant.

2) Utility of any particular commodity demands upon the quantity of that commodity alone, and is
not determined by the quantities of other related goods.

3) Incomes, tastes, fashions, etc. had no role in consumption pattern.

4) Since the Marshallian consumer’s surplus may be found by consumer’s demand curve for a
commodity, marshall assumed that all the assumptions that were applicable to the demand
curve were applied to the concept of consumer’s surplus also

5) Substitute goods were regrouped together as single commodity and hence were not taken into
consideration.

Difficulties in Measuring Consumer’s Surplus

1) The cardinal measurement of utility is difficult because it is close to impossible for a consumer
to say that the first unit of a commodity x gave him 10 units of satisfaction and the second unit
of the commodity gave him 5 units of satisfaction.

2) Marginal utility for the same commodity id different to different consumers. Marginal utility
for a particular commodity varies from person to person depending upon their income, tastes
and preferences.

3) Existence of substitutes: In the real world, a number of substitutes for a commodity exist, thus
making the work of measuring consumer’s surplus a complicated task.

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 4) Marshall based his concept of consumer’s surplus on the simplifying assumption that the
marginal utility of money is constant. As the consumer buys more and more units of a
commodity x, the amount of money with him diminishes, In this case, the marginal utility of
money is bound to increase rather than remain constant.

5) Lack of awareness of different price it is not possible for a consumer to be aware of the entire
demand schedule.

Answer.3(b) Definition

Demand forecasting is a specific type of forecasting, which enables the manger to

minimize element of risk and uncertainty. The likely future event has to be given form and content
in terms of projected course of variables, i.e. forecasting.

The manager can conceptualize the future in definite terms. If he is concerned with future
events in its order, intensity and duration, he can predict the future. If he is concerned with the
course in like of future variables like demand, price or profit, he can project the future.

Types of Forecasts

1) Economic and non-economic forecasts

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 ‘Social’, technological and ‘political’ forecasts are all examples of non-economic forecasts. For
example, one can forecast the crime rate, technological obsolescence, election result and so on.

2) Micro and Macro forecasts

Micro-forecasts are at firm level, e.g. a demand or sales forecast. On the other hand, macro-
forecasts are at the industry level or the economy level for e.g. five year plan projections.

3) Active and Passive forecasts

If the firm extrapolates the demand of previous years to yield the likely estimated demand for
the coming year, it is an example of passive forecast. If the firm, on the other hand, tries to
manipulate demand by changing price, product quality promotional effort, etc. Then it is an
example of active forecast.

4) Conditional and non-conditional forecasts

In ‘conditional’ forecasting, we estimate the likely impact of certain known or assumed

changes in the independent variable on the dependant variable.

‘Non-conditional’ forecasting, in contrast, requires the estimation of the changes in the

independent variables themselves.

5) Short-run and long-run forecasts

An important consideration in forecasting is the time span relevant for a particular problem,
which varies from problem to problem. In a long-term forecast, one has to consider long-term
changes in population, tastes, preferences of the buyers, technology, product life-cycle etc. By
contrast short-run forecasting concentrates on a few selected variables; here simple techniques
based on analysis of past experience and information give fairly accurate forecasts.

Steps in Demand Forecasting

1) Nature of forecast:

One should be clear about the uses of forecast data how it is related to forward planning and
corporate planning by the firm. Depending upon its use, one has to choose the type of forecast
short-run, active or passive, conditional or non-conditional etc.

2) Nature of product

The nature of the product for which one is attempting a demand forecasts has to be examined
carefully to establish whether the product is:

- consumer goods or producer goods

- perished or durable

- final or intermediate demand

- new demand or replacement demand etc.

For example, the demand for consumers, durables has two components new demand and
replacement demand. As more and more people purchase these goods, the market become saturated
where new demand declines and replacement demand rises. Buyer can delay replacement demand
depending upon their socioeconomic condition, price and availability of consumer credit.

Time element enters into demand forecasting with reference to the concept of ‘product life
cycle’. When a new product is introduced, sales will increase slowly as more and more people
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 come to know about it. If the product is success, the market will widen quickly and sales will
increase rapidly. As the market begins to get saturated and substitute products also get introduced,
sales will begin to taper off. The product life cycle curve is illustrated in fig. The forecasting of
demand for a product must consider the stage where the product belongs to.

Product Life Cycle Curve

Acceptance and growth

Introduction

Obsolescence and
Annual Demand

Petering off
decline
Saturation and
Maturity

3) Determinates of demand
Time
Depending on the nature of the product and nature of the forecasts, different determinants will
assume different degrees of importance in difference demand functions. In addition to own
price, related price, own income, disposable income and discretionary, related income,
advertisements, price expectations, etc. It is important to consider socio-psychological
determinates, specially demographic, sociological and psychological factors affecting demand.
Such factors are particularly important for long-run active forecasts.

4) Analysis of determinants (factors)

In an analysis of statistical demand functions, the explanatory factors determinants are

classified into

(a) Trend factors which affect demand over long-run

(b) Cyclical factors, whose effects on demand are periodic in nature

(c) Seasonal factors which are a little more certain compared to cyclical factors because there is
some regularity with regard to their occurrence, and

(d) Random factors, which create disturbance because they are erratic in nature, operation and
effects are not very orderly.

For a long-run demand forecast, trend factors are important but for a short-run demand
forecast, cyclical and seasonal are important.

5) Choice of techniques

The choice of technique has to be logical and appropriate. The choice depends on a number of
factors like the degree of accuracy required, reference period of the forecast, complexity of the

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 relationship postulated in the demand function, available time for forecasting exercise, size of
cost budget for the forecast etc.

6) Testing accuracy

Testing is needed to avoid or reduce the margin of error and thereby its validity for practical
decision making purpose.

Answer.4(a) Laws of variable proportion

The law of variable proportion is a Short-Run production function. Where some factors are
fixed and others variable, like a land may be fixed and Labour may be variable. Variable means its
quantity can be changed.

Statement of the law

“As equal increments of one point are added, the inputs of other productive services being
held, constant, beyond a certain point the resulting increments of product will decrease i.e. the
marginal product will diminish”. G Stigler.

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 The law of variable proportions is also known as “The law of diminishing returns” this law
refers to the amount of extra output secured by adding to a fixed input (or factor) more and more of
variable inputs. If, for example we add increasing quantities of some variable factors (say Labour)
to a fixed factor (say land) and as a result we get production more than proportionately, then it is
known as increasing returns to scale. When, however, the resulting production is in the same
proportion it is known as constant returns and when the output is less than the input it is the
decreasing returns of scale.

Assumption of the law

1) There is only one variable factor. All the others are constant.

2) The units of the variable factor are homogeneous in character.

3) It is possible to change the proportion in which the various factors are combined together.

4) The state of technology remains unchanged.

5) The time period is short.

Based on these assumptions we try to understand this law. Lets take a numerical example to
understand this law we assure that capital is fixed which is machinery here and the variable.

Units of Labour UL Total Product TP Marginal Product MP Avg. Product AP

1 80 80 80

2 170 90 85

3 270 100 90

4 368 98 92

5 430 62 86

6 480 50 80

7 504 24 72

8 504 0 63

9 495 -7 55

10 470 -25 47

Let us now understand this graphically this graph is not based on the figures given above.

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Marginal and Avg. Product

I stage

II
stage
III stage

AP

Labour MP
Total Product

II
stage
III stage TP

I stage

Labour

Lets now study the diagram stage wise-

Stage-I
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 TP till a point increases at a increasing rate. In the figure from origin to point F the TP is
increasing at a increasing rate. After F till the beginning of stage II it increases at a slower pace,
which means T.P. increases at diminishing rate. MP also rises accordingly and so dose the AP, MP
reaches the maximum point when there’s a influx in the TP and after reaching the maximum starts
falling. This happens because the factors are not being utilized to there full capacity. The Stage I
ends where AP curve reaches its highest and MP cuts AP at the highest. MP remains higher than AP
through out this Stage this is the ‘Increasing returns to Scale’.

Stage-II

In the Stage II TP continues to rise but at diminishing rate until it reaches its maximum.
This is the most important stage, which is also known as the ‘Operational Stage’. Where MP
behaviors like a demand curve for Labour in a firm. In this stage AP remains above MP. Any firm
will like to be in this stage because it is using its resources to fullest and to the best of its use. This
stage ends with TP maximum and MP as zero. AP still remains positive.

Stage-III

In the 3rd stage all the curves are falling TP, AP and MP where TP starts to fall at a
increasing rate. AP is also falling. There is one thing special about AP and that is that it’ll never
become negative. MP becomes negative this happens because due to too many variable factors the
efficiency of the fixed factor decreases.

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Answer.4(b) The Cost Function:

Both in the short run and in the long run, total cost is a multivariable function. That is, total
cost is determined by many factors.

Symbolically, we may write the long-run function as

C = f (X,T,Pf)

And the short run cost function as

C = (X,T,PfK)

Where

C = total cost

X = output

T = technology

K = prices of factors

Pf = fixed factor(s)

Cost curves imply cost is a function of output C= f(X),

Ceteris paribus: The clause ceteris paribus implies that all other factors which determine
cost are constant. If these factor change, their effect on costs is shown graphically by a shift of the
cost curve. This is the reason why determinants of cost other than output, are called shift factors.

Any point on a cost curve shows the minimum cost at which a certain level of output may
be produced. This is the optimality by the points of a cost curve.

Concepts of Costs

There are many types of concepts where costs are concered.

1) Money Cost

Cost is not a unique concept on the contrary there are various types of costs. The most accepted
is the money value or the money cost of production which means the total money involved in
production of a commodity. For example money spend on rent, machinery interests, salary of
the employee etc., from a producer’s point of view this is the most important cost concept.

2) Opportunity Cost

This is a very important concept in modern economic analysis. We can understand this concept
best by an example say if a person goes to market he has many things to buy he can buy a
watch or a book or a T.V. anything for that matter he’ll choose one out of all the items. Now at
the same time he foregoes other items. The cost of foregoing the other items in known as
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 opportunity cost. We could say that the alternative or opportunity cost of any factor in the
production of a particular commodity is the maximum amount which the factor could have
cared in some alternative use.

3) Real Cost

According to Marshall, the real cost of production of a commodity expressed not in terms of
money but in the efforts (of makers) and the sacrifices (of Entrepreneur) undergone in the
making of a commodity. Money is paid to the factors of production to compensate them for
their effort and sacrifice. Whether this money is adequate or not is entirely a different question
the main difficulty with this concept is that it is purely subjective and psychological.

4) Accounting Cost and Economic Costs

Accounting cost is also known as explicit costs or expenditure cost. We can say that these costs
are contractual payments which are paid to the factors of production which do not belong to the
employer himself. For example payments made for raw materials, Power, Light, and Wages.

Economic costs are also known as implicit costs or non-expenditure costs. This arises
in the case of those factors which are possessed and supplied by the employer himself. For
example, and employer may contribute his own land, his own capital and may work as the
manager of the firm. So he is entitled to. Interest and salary for himself.

5) Fixed Costs and Variable Costs

Variable costs refer to those factors which are variable in Short-Run. These costs naturally vary
with the changes in the level of output of the firm, increasing with an increase and diminishing
with a decrease in the output. For example if a firm plans to increase the number of labor it will
have to increase the expenditure or the salary of the workers. They are direct costs because all
the units produced by the firm depend directly upon them.

The supplementary or fixed costs are those costs which cannot be increased in Short-
Run even if employer wishes to do so. They are called fixed costs because they do not change
with every change in output, for example if the output is doubled, the rent of the land where the
firm is operating will not change. It is important for a firm to cover the variable costs.

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Answer.6.(b) The Cardinal Utility Theory

Definition:

In economics, utility is a measure of the relative happiness or satisfaction (gratification)

gained by consuming different bundles of goods and services. Given this measure, one may speak
meaningfully of increasing or decreasing utility, and thereby explain economic behavior in terms of
attempts to increase one's utility. The theoretical unit of measurement for utility is the util.

Utility is applied by economists in such constructs as the indifference curve, which plots
the combination of commodities that an individual or a society requires to maintain a given level of
satisfaction. Individual utility and social utility can be construed as the dependent variable of a
utility function (such as an indifference curve map) and a social welfare function respectively.
When coupled with production or commodity constraints, these functions can represent Pareto
efficiency, such as illustrated by Edgeworth boxes and contract curves. Such efficiency is a central
concept of welfare economics.

Economists distinguish between cardinal utility and ordinal utility. When cardinal utility is
used, the magnitude of utility differences is treated as an ethically or behaviorally significant
quantity. On the other hand, ordinal utility captures only ranking and not strength of preferences.
An important example of a cardinal utility is the probability of achieving some target.

Assumptions

1) Rationality: The consumer is rational. He aims at the maximization of his utility subject to the
constraint imposed by his given income.

2) Cardinal Utility: The utility of each commodity is measurable. Utility is a concept. Utility is
measured by the monetary units that the consumer is prepared to pay for another unit of the
commodity.

3) Constant marginal utility of money: This assumption is necessary if the unit is used as the
measure of utility. The essential feature of a standard unit of measurement is that it is constant.
If the marginal utility of money changes as income increase, the measuring- rod for utility
becomes like as elastic ruler, inappropriate for measurement.

4) Diminishing Marginal Utility: The utility from successive unit of a commodity diminishes. The
marginal utility of commodity diminishes as the consumer acquires larger quantities of it. This
is the axiom of diminishing marginal utility.

5) The total utility of a ‘basket of good’s depend on the quantities of the individual commodities.
If there are n commodities in the bundle with quantities x1, x2,--xn, the total utility is

U = f (x1,x2,--xn)

It is tempting when dealing with cardinal utility to aggregate utilities across persons. The
argument against this is that interpersonal comparisons of utility are suspect because there is no
good way to interpret how different people value consumption bundles.

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 When ordinal utilities are used, differences in utils are treated as ethically or behaviorally
meaningless: the utility values assigned encode a full behavioral ordering between members of a
choice set, but nothing about strength of preferences. In the above example, it would only be
possible to say that coffee is preferred to tea to water, but no more.

Answer.6.(C) Long Run Costs Curve

In the short-period the firm does not have enough time to change the scale or size of the
production unit or of the firm. But in long run there is no such problem because there is adequate
time for the manager to adjest the requirement. Therefore there are no fixed factors in the Long-
run. If suppose there is a increase in the demand for the product, there is time to increase the
production of the firm. In long run every thing is variable including management, labour or be it
machinery, when the scale of operations is changed, we need to draw a new short- run cost curve of
the firm, because the old cost curve becomes outdated due to change in the scale of operations.
That is why we have not one but many cost curve with past experience the firm will choose the
best short- run cost curve and implement in the long run.
We can thus draw a long- run average cost curve which will indicate the long- run cost of
producing each level of output or different scale of production.

1) Long Run Average Cost Curve (LAC)

LAC is the sum of various short- run cost curves depicting different production plan A at
different time periods. In the long run, all inputs (factors of production) are variable and firms
can enter or exit any industry or market. Consequently, a firm's output and costs are
unconstrained in the sense that the firm can produce any output level it chooses by employing
the needed quantities of inputs (such as labor and capital) and incurring the total costs of
producing that output level.
The Long Run Average Cost, LRAC, curve of a firm shows the minimum or lowest average
total cost at which a firm can produce any given level of output in the long run (when all inputs
are variable).
In the long run, a firm will use the level of capital (or other inputs that are fixed in the short
run) that can produce a given level of output at the lowest possible average cost. Consequently,
the LRAC curve is the envelope of the short run average total cost (SR ATC) curves, where
each SR ATC curve is defined by a specific quantity of capital (or other fixed input).

2) Long Run Marginal Cost Curve (LMC)

The LMC bears the same relation to the long run LAC that any SMC bears with SAC i.e.
LMC cuts LAC from down at the lowest point and till the LMC is lower than LAC it is profitable
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for the firm, but when the LMC goes above the LAC its indicates loss where as when LAC and
LMC intersect each other that is known as the equilibrium point. In the long run the point L2 will
be chosen from the figure given below:

Marginal Cost
MC is the calculation of the change in rate of total cost. It is the change in TC due to
additional unit of variable factor.

MC = ∆ TC

∆ Output

MC is a ‘u’ shaped curve. MFC (Marginal Fixed Cost) is zero that is why we don’t
study MFC this is because fixed cost is constant throughout the production period. Therefore
we take MVC = MC.

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Answer.6(d). Definition

In an oligopolistic market there are a small number of firms, so that sellers are
conscious of their interdependence. Thus each firm must take into account the rivals reactions.
The competition is not perfect, yet the rivalry among firms in high unless they make a
collusive agreement.

The products that the oligopolists produce may be homogenous (pure oligopoly) or
differentiated (differentiated oligopoly). The seller must guess the rivals reactions. Their
decisions depend on the ease of entry and the time lag, which they forecast to intervene
between own action and the rival’s reactions. Given that there is a very large number of
possible reactions of competitors, the behaviour of firms may assume various forms. Thus
there are various models of oligopolistic behaviour, each based on different reaction patterns of
rivals.

Oligopoly is a common market form. As a quantitative description of oligopoly, the

four-firm concentration ratio is often utilized. This measure expresses the market share of the
four largest firms in an industry as a percentage.

Oligopsony is a market form in which the number of buyers is small while the number
of sellers in theory could be large. This typically happens in markets for inputs where a small
number of firms are competing to obtain factors of production. This also involves strategic
interactions but of a different nature than when competing in the output market to sell a final
output. Oligopoly refers to the market for output while oligopsony refers to the market where
these firms are the buyers and not sellers (eg. a factor market). A market with a few sellers
(oligopoly) and a few buyers (oligopsony) is referred to as a bilateral oligopoly.

The Main Features

Its very important to study the feature or charaecteristic of oligopoly. How will you
recognize the oligopoly market? The following are the main feature.

1) Interdependence – The producers are interdependent on each other for decision making.
This is because the number of competitors are few so any change in the price, output,
product etc. by a firm can have some effect on the other producer.
2) Importance of advertising and selling cost – To occupy the bigger share of market the
producer plans a layout for advertising. For this various firms have to incur a good deal of
costs on advertising.
3) Group Behaviour – In this type of market the producers come together to take decisions in
every memebers common interest.

We can broadly devide oligoploy into two parts collusive and non collusive oligoploy is
the one in which the producers come together and determine a fixed price or output or share of
the market etc.

Non-collusive oligopoly is the one in which the competitor applies own managerial skills to
capture the market and is always alert of what the rival producer is planning.

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 Oligopolistic competition can give rise to a wide range of different outcomes. In some
situations, the firms may collude to raise prices and restrict production in the same way as a
monopoly. Where there is a formal agreement for such collusion, this is known as a cartel.

Answer.6(e) Definition

In economics, an isoquant (derived from quantity and the Greek word iso [meaning equal])
is a contour line drawn through the set of points at which the same quantity of output is produced
while changing the quantities of two or more inputs. Another way of defining the isoquant is a
curve that shows all possible quantities of inputs that result in the same level of output with a given
production function. While an indifference curve helps to answer the utility-maximizing problem
of consumers, the isoquant deals with the cost-minimization problem of producers. Isoquants are
typically drawn on capital-labor graphs, showing the tradeoff between capital and labor in the
production function, and the decreasing marginal returns of both inputs. Adding one input while
holding the other constant eventually leads to decreasing marginal output, and this is reflected in
the shape of the isoquant. A family of isoquants can be represented by an isoquant map, a graph
combining a number of isoquants, each representing a different quantity of output.

Isoquants are a geometric representation of the production function. The same level of
output can be produced by various combinations of factor inputs. Assuming continuous variation in
the possible combination of Labour and capital, we can draw a curve by plotting all these
alternative combinations for a given level of output. This curve which is the locus of all possible
combinations is called Isoquants or Iso-product curve.

Properties of Isoquants

(i) Each Isoquants corresponds to a specific level of output and shows different ways,
of technological efficiency, for producing that quantity of output.
(ii) The Isoquants are downward sloping and convex to the origin. The slope of an
Isoquants is significant because it indicates the rate at which factors K and L can be
substituted for each other while a constant level of output is maintained.
(iii) As we proceed north eastward from the origin, the output level corresponding to
each successive Isoquants increases, as a higher level of output usually required
greater amounts of the two inputs.
(iv) Two Isoquants do not interest each other as it is not possible to have two output
levels for a particular inputs combination.

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 An isoquant map where Q3 > Q2 > Q1. A typical choice of inputs would be labor for input
X and capital for input Y. More of input X, input Y, or both is required to move from isoquant Q1
to Q2, or from Q2 to Q3.

Answer.6(f) A Weber’s Deductive Theory of Location of Industries

Alfred Weber’s deductive theory of location of industries was presented in his book
“Theory of the location of industries in 1909”.

According to Weber, the economic reasons responsible for the location of industries are:

(i) Primary causes or regional factors, and

(ii) Secondary causes
(iii) Primary Causes of Regional Factors

According to Weber, the two unavoidable expenditures incurred by an industry are on Expenditure
on transport incurred by every firms is of two types.

Expenditure on transport incurred by every firms is of two types.

(a) Expenditure for transporting raw material to the site of the firm, and
(b) Expenditure incurred for transporting the finished products to the respective markets. An
industry should ideally be located where both the above expenditures are minimum.

Weber has further divided raw material into two categories based on its availability.

(a) “Ubiquitous” raw materials are those which are easily available at all places such as bricks,
cement etc. The industry requiring these factors may be started anywhere, keeping in mind the
proximity markets which reduce the cost on transport of its products.
(b) “Localized factors” or localized raw materials are those factors of production which are
available only at certain places such as coal, iron, oil, etc. Industries using these factors should
be started where these localized factors are available.

Weber further classified raw materials into (a) Pure and (b) Weight losing.

“Pure” raw materials (such as cotton woll etc.) When used in the manufacturing process do not
loose weight to any great extent. Industries using “pure” raw materials can be started anywhere.

“Weight Losing” raw materials (such as iron ore, coal, etc.) are substantially reduced in weight
when transformed into finished products. Industries using weight losing raw materials should be
started in the vicinity of the supply of raw material. Taking into account all the above mentioned
factors Weber prepared a “Material Index.”

The Material index given the proportion of the weight of finished product to the weight of
localized raw material:

Material Index = Weight of the raw material x 100

Weight of the finished product

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 The larger the material index the greater is the possibility of the industry being attracted
towards the supply of raw material and the smaller the value of the material index, the greater is
possibility of the industry being attracted towards the market.

The industry which is localized at a particular place on the basis of the material index may
be shifted from that place to any other place if the expenditure incurred on Labour is large. In such
case, the industry will shift and localize at a place where Labour cheap.

Weber put forth the concept “Labour Coefficient”. The Labour coefficient is based on the
“Labour Cost Index”. “Labour cost index” is the proportion of expenditure incurred on Labour and
the locational weight.

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