The price elasticity of demand for a good is − 0.4. If its price increases by 5 percentage, by what percentage will its demand fall? Calculate.
Ed = percentage change in quantity demanded / Percentage change in price
Ed = -0.4
% change in price = 5
Hence, -0.4 = percentage change in quantity demanded / 5
Percentage change in quantity demanded = -0.4 * 5 = -2
Thus, when the price of good increase by 5%, the quantity demanded falls by 2%.
Explain the Law of Variables Proportions with the help of total product and marginal product curves.
The law of variable proportions state that as the quantity of one factor is increased, keeping the other factors fixed, the marginal product of that factor will eventually decline. This means that up to the use of a certain amount of variable factor, marginal product of the factor may increase and after a certain stage it starts diminishing.
Assumptions of Law of Variable Proportions:
1. Constant State of Technology: First, the state of technology is assumed to be given and unchanged. If there is improvement in the technology, then the marginal product may rise instead of diminishing.
2. Fixed Amount of Other Factors: Secondly, there must be some inputs whose quantity is kept fixed. It is only in this way that we can alter the factor proportions and know its effects on output. The law does not apply if all factors are proportionately varied.
3. Possibility of Varying the Factor proportions: Thirdly, the law is based upon the possibility of varying the proportions in which the various factors can be combined to produce a product. The law does not apply if the factors must be used in fixed proportions to yield a product.
Behaviour of TP
|I||Stage of increasing return||TP increases at an increasing rate till F||From o to point F|
|II||Stage of diminishing return||Increases at a decreasing rate and attains maximum at H||From F to point H|
|III||Stage of negative return||TP starts to fall||From H onwards|
The whole production phase can be distinguished into three different production stages.
IstStage: Increasing Returns to a Factor
This stages starts from the origin point O and continues till the point of inflexion (F) on the TP curve. During this phase, TP increases at an increasing rate and is also accompanied by rising MP curve. The MP curve attains its maximum point corresponding to the point of inflexion. Throughout this stage, AP continues to rise
IIndStage: Diminishing Returns to a Factor
This stage starts from point F and continues till point H on the TP curve. During this stage, the TP increases but at a decreasing rate and attains its maximum point at H, where it remains constant. On the other hand, the MP curve continues to fall and cuts AP from its maximum point S, where MP equals AP. When TP attains its maximum point, corresponding to it, MP becomes zero. AP, in this stage initially rises, attains its maximum point at S and thereafter starts falling
IIIrdStage: Negative Returns to a Factor
This stage begins from the point H on the TP curve. Throughout this point, TP curve is falling and MP curve is negative. Simultaneously, the AP curve continues to fall and approaches the x-axis (but does not touch it).
Explain the relationship between prices of other goods and demand for the given period.
Price of Other Goods and Demand for the given Good:
Quantity demanded of a good depends on the price of other goods (i.e. related goods). Any two goods are considered to be related to each other, when the demand for one good changes in response to the change in the price of the other good. The related goods can be classified into following two categories.
A. Substitute Goods:
Substitute goods refer to those goods that can be consumed in place of each other. In other words, they can be substituted for each other. For example, tea and coffee, Colgate and CLOSE UP, Cello pens and Reynolds pen, etc. In case of substitute goods, if the price of one good increase, the consumer shifts his demand to the other (substitute) good i.e. rise in the price of one good result in a rise in the demand of the other good and vice-versa.
For example, if price of tea increases, then the demand for tea will decrease. As a result, consumers will shift their consumption towards coffee and the demand for coffee will increase. It should be noted that the demand for a good moves in the same direction as that of the price of its substitute.
B. Complementary Goods:
Complementary goods refer to those goods that are consumed together. The joint consumption of these goods satisfies wants of the consumer. For example: Tea and sugar, ink pen and ink, printer and paper, etc.
In case of complementary goods, if the price of one good increases then a consumer reduces his demand for the complementary good as well, i.e. a rise in the price of one good results in a fall in demand of the other good and vice-versa.
For example, sugar and tea are complementary goods. Since, sugar and tea consumed together, so a rise in price of tea reduces the demand for sugar and vice-versa. It should be noted that demand for a good moves in the opposite direction of the price of its complementary goods.
Production in an economy is below its potential due to unemployment. Government starts employment generation schemes. Explain its effect using production possibilities curve.
As initially, the production in the economy is below its potential due to unemployment, this suggests that the economy is operating at a point below the Production Possibility curve (PPC). As the government starts employment generation schemes, the unemployed resources get utilised. In a situation of full employment the economy would move to a point on the PPC.
Consider the example of the economy producing two goods- consumer goods and capital goods. Suppose AB is the Production Possibility Curve (PPC) depicting full-employment of resources.
Initially, suppose the economy is at point I (which is below the PPC) where, the economy is below the potential level. As employment in the economy rises, the economy starts moving at a point towards the PPC. At full employment, it will reach a point on the PPC such as point D.
Explain “large number of buyers and sellers” features of a perfectly competitive market.
The number of buyers and sellers operating under perfect competition is very high. As the number of individual sellers very large, an individual seller cannot fix the price. Similarly no single buyer can fix the price or change it by his action. Even if he increases or reduces demand, it does not make any effect on the total demand in the market. Price of a product is determined by the interaction of total demand and total supply in the market. Hence every seller and buyer under perfect competition is a price taker and not a price maker.
Explain the conditions of producer’s equilibrium with the help of a numerical example.
Equilibrium refers to a state of rest when no change is required. A producer is said to be in equilibrium when it has no inclination to expand or to contract its output. This state either reflects maximum profits or minimum losses. The conditions of producer's equilibrium can be explained through the MR-MC approach. In this approach, the producer attains equilibrium where the following two conditions are fulfilled.
(i) MR = MC:
As long as MC is less than MR, it is profitable for the producer to go on producing more because it adds to its profits. He stops producing more only when MC becomes equal to MR.
(ii) MC is greater than MR after MC = MR output level:
When MC is greater than MR after equilibrium, it means producing more will lead to decline in profits.
|Units of Output||MR||MC|
Explain consumer’s equilibrium with the help of Indifference Curve Analysis.
Consumer equilibrium refers to a situation, in which a consumer derives maximum satisfaction, with no intention to change it and subject to given prices and his given income. The point of maximum satisfaction is achieved by studying indifference map and budget line together. On an indifference map, higher indifference curve represents a higher level of satisfaction than any lower indifference curve. So, a consumer always tries to remain at the highest possible indifference curve, subject to his budget constraint.
Conditions of Consumer’s Equilibrium:
The consumer’s equilibrium under the indifference curve theory must meet the following two conditions:
(i) MRSXY = Ratio of prices or PX/PY:
Let the two goods be X and Y. The first condition for consumer’s equilibrium is that
MRSXY = PX/PY
(a) If MRSXY > PX/PY, it means that the consumer is willing to pay more for X than the price prevailing in the market. As a result, the consumer buys more of X. As a result, MRS falls till it becomes equal to the ratio of prices and the equilibrium is established.
(b). If MRSXY < PX/PY, it means that the consumer is willing to pay less for X than the price prevailing in the market. It induces the consumer to buys less of X and more of Y. As a result, MRS rises till it becomes equal to the ratio of prices and the equilibrium is established.
(ii) MRS continuously falls:
The second condition for consumer’s equilibrium is that MRS must be diminishing at the point of equilibrium, i.e. the indifference curve must be convex to the origin at the point of equilibrium. Unless MRS continuously falls, the equilibrium cannot be established.
Thus, both the conditions need to be fulfilled for a consumer to be in equilibrium.
In Fig, IC1, IC2 and IC3 are the three indifference curves and AB is the budget line. With the constraint of budget line, the highest indifference curve, which a consumer can reach, is IC2. The budget line is tangent to indifference curve IC2 at point ‘E’. This is the point of consumer equilibrium, where the consumer purchases OM quantity of commodity ‘X’ and ON quantity of commodity ‘Y. All other points on the budget line to the left or right of point ‘E’ will lie on lower indifference curves and thus indicate a lower level of satisfaction.
Thus, we can conclude that if the consumer is consuming any bundle other than the optimum one, then he would rearrange his consumption bundle in such a manner that the equality between the MRS and the price ratio is established and he attains the state of equilibrium.
Explain any two factors that affect the price elasticity of demand. Give suitable examples.
The following are the two factors that affect the price elasticity of demand.
1. Availability of substitutes:
Demand for a commodity with large number of substitutes will be more elastic. The reason is that even a small rise in its prices will induce the buyers to go for its substitutes. For example, a rise in the price of Pepsi encourages buyers to buy Coke and vice-versa.
Thus, availability of close substitutes makes the demand sensitive to change in the prices. On the other hand, commodities with few or no substitutes like wheat and salt have less price elasticity of demand.
2. Number of Uses:
If the commodity under consideration has several uses, then its demand will be elastic. When price of such a commodity increases, then it is generally put to only more urgent uses and, as a result, its demand falls. When the prices fall, then it is used for satisfying even less urgent needs and demand rises.
For example, electricity is a multiple-use commodity. Fall in its price will result in substantial increase in its demand, particularly in those uses (like AC, Heat convector, etc.), where it was not employed formerly due to its high price. On the other hand, a commodity with no or few alternative uses has less elastic demand.
Giving reasons, state whether the following statements are true or false.
A monopolist can sell any quantity he likes at a price.
False, a monopolist cannot sell any quantity he likes at a price because the monopolist controls only the supply and not the demand. A monopolist can only determine one of two things. It has to be either price or quantity; this is because there is a fixed price consumers are willing to pay for a given quantity. As a result a monopolist can only charge the price corresponding to the specific quantity he has set otherwise the goods he has produced won’t be sold. This is because he has no control over the quantity that he can sell in the market. Rather, it depends on the buyers that what quantity of output they want to purchase at the price fixed by the monopolist. If the monopolist fixes a higher price, then lesser quantity of the output will be demanded and lesser quantity will be sold in the market. On the other hand, if he fixes a lower price, then higher quantity of the good will be sold.
True, when equilibrium price of a good is less than its market price then there will be competition among the sellers. At a price lower than market price, there will be more supply. This is explained with the help of the following diagram.
In the above diagram, point E is the equilibrium point, where the market demand curve DD and the market supply curve SS intersects each other. At this point the equilibrium price is OP and the equilibrium quantity is OQe
Now, suppose the market price is OPo, the equilibrium price is less than the market price. At this price the market demand is OQd and the market supply is OQs. Clearly, market supply is more than the market demand. So, there exists a situation of excess supply. Due to excess supply, there will exist competition among the sellers.