UNIT – I

ECONOMY& CENTRAL

PROBLEMS OF AN ECONOMY

Q.1 Define an economy.Ans. An economy is a system in which and by which people get a living to satisfy their wants through the process of production, distribution and exchange.

Q.2 Define an economic problem.Ans. The problem of choice arising from the use of limited means to the satisfaction of various ends (wants) is known as an economic problem.

Q.3Why does an economic problem arise ?Ans. An economic problem arises due to the following reasons :-i. Human wants are unlimited and recurring in nature :Human wants are endless i.e. they are unlimited as we satisfy a want many more crop up. This goes endlessly in the economy. Also as we fulfill one particular want, at a particular time it again recurs. ii. Different priorities :All human wants are not equally important, they differ in intensity and urgency, this fact enables a man to arrange his wants in order of preference and make a choice in order of urgency.

iii. Limited resources/Means :An economy requires resources (land, labour, capital, etc.) to produce goods and services. Unfortunately, resources are limited in relation to their demand. If economy’s resources were as unlimited as wants there would have been no need to make choices. Scarcity is the root cause of economic problem. iv. Means have alternate uses :Resources are not only limited but can be put to alternative uses. Same resource can be used for different purposes. For eg :- A plot of land can be used for farming, for play-ground or for constructing dewelling units. A resource once used for a purpose cannot be used for other purposes. Therefore, an economy is faced constantly with problem of choice.

Q.4 Explain the central problems of an economy.

Ans. Following are the central problems of an

economy :-

i.What to produce ?

ii.How to produce ?

iii.For whom to produce ?

The above problems are called central problems

because they are common to all types of economics,

these problems can be explained as follows :-

i. What to produce ?Ans. A major problem before a country is to decide what commodities should be produced and in what quantities with the limited resources at her command. There are many types of goods that a country needs. Hence it has to make a choice among different types of goods.Eg :a. Choice between consumption goods and capital goods. (foods) (machines)b. Choice between Mass consumption goods and luxury goods.

(wage goods)c. Choice between war goods and civil goods.

ii. How to produce ?Ans. This problem deals with the manner in which goods and services should be produced, its concerned with the choice of technique of production, this problem arises because there is more than one possible way in which goods and services can be produced the problem deals with deciding between labour intensive technique and capital intensive technique of production. Therefore most efficient technique is to be selected. Most efficient technique is the one which uses least amount of scarce resources.

iii. For whom to produce ?Ans. This problem deals with the distribution of national income, it tries to answer the problem of distribution of national income among various individuals and factors of production. An economy faces a problem of how the income generated in the form of rent, wages, interest and profit be distributed among different factors of production or how the income generated be distributed among different individuals constituting the society.

Q.5 What is production possibility curve or production possibility frontier?

Ans. A curve which shows all possible combinations of two goods that an economy can produce with full utilization of given resources and state of technology is known as production possibility curve or production possibility Frontier.It is also called as transformation curve.

Production possibility Good X Good YA 0 15B 1 14C 2 12D 3 9E 4 5F 5 0Assumptions:

i.The amount of resources in the economy is fixed.ii.The technology is given and unchanged.iii.The resources are efficient and fully employediv.All resources are not equally efficient or uniformly efficient in production of all goods.

Q.6 Explain the terms opportunity cost and marginal opportunity cost.Ans. Opportunity Cost:The opportunity cost for a commodity is the amount of other commodity that has been forgone in order to produce the first. In other words, it is the cost of forgone alternative or the cost of next best alternative.Marginal opportunity cost:Marginal opportunity cost for a commodity is the amount of other good which has to be given up in order to produce an additional unit of the given commodity.In terms of Marginal Rate of Transformation (MRT) it is defined as a ratio of no. of units of a good sacrificed to produce an additional unit of the other good in a two goods economy.

Q.7 Why the shape of production possibility curve is concave to the origin?Ans. PPC is concave to the origin because of increasing marginal opportunity cost, as more and more of a good is produced factors producing it become marginally less and less productive and hence we sacrifice more and more quantity of the former good in order to increase the production of the given good by one unit. This happens due to our assumption that all resources are not uniformly efficient in production. It means most resources in the beginning are equally efficient but as we go on producing more and more of a given commodity, we may find it difficult to have equally efficient resource, and then there is no option but to transfer only the less and less efficient resource for production of a given commodity. Therefore, in order to produce each additional unit of good X we have to sacrifice resources engaged in the production of good Y at an increasing rate.

Q.8 Show economic growth, fuller utilization of resources and underutilization of

resources with the help of production possibility curve.

Q.9 Distinguish between:Ans.a) Market Economy and Planned Economyb) Positive Economics and Normative Economicsc) Micro Economics and Macro Economics

a) Market Economy Planned Economy

1 Market economics are those in which economic activities are left to the free play of the market forces.

1 These are those economics in which the course of economic activities is decided by some central authority.

2 There is no interference by the govt. regarding what to produce how to produce or how much to consume.

2 A central authority decides the overall basket of goods and services that people can consume.

3 It is a free economy. 3 It is not a free economy.

b) Positive Economics Normative Economics

1 The positive statements describe what was, what is and what would be under given circumstances. We can find out the degree of truth in such statements.

1 Normative economics or statements describe ‘what ought to be’. Its objective is to determine the norms and aims.

2 These statements do not pass any value judgement (or issue of debate)

2 These statements pronounce value judgement.

3 A positive statement does not offer any suggestions about facts.

3 A normative statement offer suggestions to solve the problem.

c) Micro Economics Macro Economics

1 Micro economics studies economic relationships or economic problems at the level of an individual, an individual firm, an individual household or an individual consumer.

1 Macro economics studies economic relationships or economic problems at the level of the economy as a whole.

2 It is basically concerned with determination of output and price for an individual firm or industry.

2 It is basically concerned with determination of aggregate output and general price level in the economy as a whole.

3 Study of microeconomics assumes that macro variables remain constant eg. it is assumed that aggregate output is given while we are studying determination of output and price of an individual form or industry.

3 Study of macroeconomics assumes that micro variables remain constant eg. it is assumed that distribution of income remains constant when we are studying the level of output in the economy.

UNIT – IVFORMS OF

MARKET

Q.1 Define the term Market.Ans. Market refers to a structure in which buyers and sellers negotiate over the exchange of a well defined commodity and remain in close contact with each other.Economists have classified market into different forms on the basis of different degrees of competition like:1) Perfect Competition1)Monopoly2)Monopolistic/imperfect competition.3)Oligopoly

Q.2 Define Perfect Competition and explain its features.

Ans. Perfect Competition is a market situation in which there are large no. of buyers and sellers, firms sell a homogenous (identical) product and there is free entry and exit of the firms in the market.Features:1) Large no. of buyers and sellers.There are a large no. of buyers and sellers of the commodity in the market, each buyer and seller is too small in relation to the market such that it cannot have any perceptible influence (visibly experienced) on the price of a commodity.

2) Homogenous product: Products sold in the market are homogenous i.e. they are identical in all respects like quality, colour, size, weight etc. As a result a buyer cannot distinguish between the outputs of one firm with that of another and is therefore indifferent towards a particular firm from which he buys.

3) Perfect Mobility:There is perfect mobility of factors of

production both geographically (one place to other) and occupationally (from one job to other). The factors are free to enter an industry if considered profitable and leave the industry when remuneration (return) is inadequate.

4) Perfect Knowledge:

There is complete and perfect

knowledge on the part of buyers and

sellers. They are fully aware of the prices

and cost prevailing in different parts of the

market.

5) Perfectly Elastic AR and Marginal Revenue MR Curves:In perfect competition, a firm can sell any amount of output at a given market piece, it means firms additional revenue (MR) from sale of every additional unit of the commodity will be just equal to the market price (Average Revenue).Hence AR and MR become equal (AR = MR)

6) Firms are price takers:Each firm is so small compared to the market, that no single firm can influence the market price thus homogenous product and existence of large no. of firms in this form of market induce the firms to keep the same price for

their product. Every firm accepts the market price determined by the whole industry and

therefore it is a price taker and not a price maker.

Q.3 Explain the meaning and features of monopoly.

Ans. Monopoly refers to that form of market wherein there is a single firm producing a commodity for which there is no close substitutes.Features:1) Single producer:There is a single firm producing the commodity in the market in such a market form there is no difference between the firm and the industry.

2) No close substitutes:The necessary condition for

monopoly to exist is that there should be no close substitutes of the commodity in the market. The cross elasticity of demand for the output of the firm, the price of every other firms product is zero.

3) Barrier’s to the entry:

The entry in the industry is completely prohibited or made impossible legally or mutually. If new firms are admitted into the industry, the monopoly itself breaks down.

4) Independent price policy:Monopolist firm can adopt independent price policy, i.e. it can increase or decrease price of a commodity as it likes. Monopoly firm has a downward sloping average revenue curve. The slope of the AR curve clearly indicates that a monopoly firm sells more at a lower price and is a price maker.

5) Price Discrimination:

It is possible under the conditions of monopoly it implies that a monopolist firm can sell its product at different prices to different customers.

6) Downward sloping AR and MR curves:A monopoly firm is like an industry and faces a downward sloping demand curve for its product i.e. it has to lower its price to sell more. The marginal revenue curve remains below the AR curve as MR < AR.

Q.4 Define and explain the features of monopolistic/imperfect competition.

Ans. It refers to a market situation in which there are many firms which sell closely related but differentiated products.

It has following features:1) Many Sellers:There is large no. of firms producing the commodity and supplying it in the market. Each firm supplies a small percentage of total supply of the product. As a result firms are in a position to marginally influence the price of their products due to their brand names.

2) Product Differentiation:

Each firm produces a unique brand of the same product which can be differentiated from brands of other firms. Products are not the same but are closely similar to each other. They can be differentiated on the basis of brand names, colour, quality, quantity, shape etc. The aim of the firm is to win over customers by product differentiation.

3) Free entry and exit of firms:New firms can enter the market if found profitable. Similarly inefficient firms already operating in the market are free to quit the market if they incur losses. Every firm is free to enter into the industry and come out of the industry as and when it wishes.

4) Selling Cost:Selling cost are the expenses which are incurred for promoting sales or for inducing customers to buy the product of a particular brand. This cost involves cost of advertisement, free sampling, salaries of salesmen etc.

5) Influence of Price:Each firm has an influence on the price of the commodity, as every firm has the monopoly over the production of its product. It is free to determine the price of its commodity on the basis of degree of consumer’s preference for its product and extent of competition from close substitutes.

6) AR and MR Curves:AR and MR curves in monopolistic competition are downward sloping because more units of a product can be sold by reducing price. MR curve is below the AR curve because increase in AR implies decrease in MR.

Q.5 Define Oligopoly and explain its features.Ans. It is a form of the market in which there are a few big sellers of a commodity and a large number of buyers. There is a severe competition in the market.Features:1) A Few Firms:

A few firms, but large in size, dominate the market for a commodity. Each firm commands a significant share of the market.2) Large Number of Buyers:

There a large number of buyers of a commodity. The number is so large that no individual buyer can impact market price of product.

3) High Degree of Interdependence:There is a high degree of interdependence between the firms. Price and output policy of one firm significantly impacts the price and output policy of one firm significantly impacts the price and output policy of the rival firms in the market.4) Barriers:There are various barriers to the entry of new firms. These barriers are almost similar to those under monopoly. Entry of new firms is extremely difficult.

5) Not Possible to Determine Firm’s Demand:It is not possible to determine firm’s demand

curve under oligopoly. Simply because it is not possible to predict change in price. When a firm lowers its price, demand for its product may not increase, because the rival firms may also lower the price.

6) Formation of Cartels:With a view to avoid competition, firms may

form a cartel. It is a formal agreement among the firms to avoid competition. It is a situation of collusive oligopoly under it, output quotas and prices are fixed. Sometimes, leading firm in the market is accepted by the cartel as the ‘Price Leader’. All firms in the cartel choose the same price as set by the price leaders.

Q.6 What happens to profit in long run when there is free entry and exit?

Ans.The freedom of entry or exit feature implies that no firm can earn above normal profits in the long run. It means each firm earns just the normal profit. It happens so because the existing firms which are earning above normal profits face competition with the new firms. New firms enter the industry and increase the supply. Consequently, price comes down and above normal profits go away.

Q.7 What happens to loss in long run when there is free entry and exit in the

market?Ans.The feature of freedom of entry and exit implies in the long run no firm incurs loss. It means that each firm earns just normal profit. This happens because the existing firms which are incurring losses, some of them will leave the industry. Consequently, supply will decrease, prices will go up and losses will be wiped out. Thus, ultimately firms will earn just normal profit in the long run and there will be no losses.

Q.8 Distinguish between:

Ans.a) Perfect Competition and Monopolyb) Perfect Competition and Monopolistic Competitionc) Monopoly and Monopolistic Competition

a) Perfect Competition Monopoly1 There are large nos. of firms in the

market and no single firm can influence the market price.

1 There is only one firm in the market and has the power to influence the market price.

2 A firm cannot adopt independent price policy; it is price taker and not a price maker.

2 A monopolist firm can have independent price policy, it is a price maker.

3 There is full freedom of entry and exit of the firms in the long run. Hence a firm can get only normal profits in the long run.

3 There is restriction on the entry of firms hence a firm can earn supernormal profit even in long run.

4 Price discrimination is not possible i.e. a firm charges same price from all customers.

4 Price discrimination is possible. A firm charges different prices from different customers.

5 AR – MR curves are one and the same and parallel to x-axis.

5 AR – MR curves are downward slopping. MR curve always remains below AR curve.

b) Perfect Competition Monopolistic Competition

1 Large no. of buyers and sellers 1 Many sellers and buyers2 They produce homogeneous

product2 They produce differentiated product

3 They have perfect knowledge of market conditions

3 They have imperfect knowledge of market conditions

4 They have perfect mobility 4 They have imperfect mobility5 AR – MR curves are parallel to

x-axis.5 MR curves is below the below AR curve.

c) Monopoly Monopolistic Competition1 Large no of sellers and buyers

are not there. Only one seller but large no. of buyers.

1 Large no. of sellers and buyers are there.

2 Homogeneous or differentiated product.

2 Product is closely related but differentiated.

3 Selling cost is not required. 3 Selling costs are very significant.4 Entry of firms is not possible. 4 Entry of firms are not possible with

absolute freedom.

5 Full control over price. 5 Partial control over price.

Q.9 Explain the basis of Market Classification.Ans.1) Number of Buyers and Sellers:When there is a large number of buyers and sellers of homogeneous commodity, it is a situation of perfect competition. When there is a large number of buyers and sellers but the commodity is not homogeneous, it is a situation of monopolistic competition.When there is one seller but a large number of buyers of a commodity, it is a situation of monopoly.

2) Nature of Commodity:It is a perfectly competitive market; commodity should be homogeneous, while in monopolistic competition, the commodity is always differentiated. In monopoly, the product may or may not be homogeneous.

3) Degree of Price Control:Perfect competition is said to exist when the producer has no control over price. In contrast, the monopolist has full control over price. Monopolistic competition has partial control over price.

4) Knowledge of the Market:In case of perfect competition, buyers and sellers have perfect knowledge of the market. In other forms of market, there is imperfect knowledge.

5) Mobility of Factors:Perfect mobility of the factors is another unique competition. It is not an essential feature of other forms of market.

PRICE DETERMINATI

ON UNDER PERFECT

COMPETITION

Q.1 Define Equilibrium, Equilibrium Price and Equilibrium Quantity.Ans. Equilibrium:It is a state from where there is no net tendency to move, it means that at the point of equilibrium forces that determined it are balanced.Equilibrium Price:The price at which market demand is equal to market supply is called Equilibrium Price.Equilibrium Quantity:The quantity demanded and supplied at Equilibrium Price is called Equilibrium Quantity.

Q.2 How is Equilibrium Price determined under perfect competition?Ans. Equilibrium price is determined by the interaction of the forces of market demand and market supply under perfect competition. It is determined at the point where market supply equals market demand.

In the above diagram we observe that when market price is more than the equilibrium price, supply becomes greater than the demand. It creates the situation of excess supply.  As a result, there is competition among sellers and the price starts declining. This continues till market price becomes equal to equilibrium price.

Similarly, when market price is less than the equilibrium price, demand becomes greater than supply. It creates the situation of excess demand. As a result competition among buyer’s price starts rising till it becomes equal to equilibrium price.In this manner, equilibrium price is determined at a point where there is no tendency for demand and supply to change.

Q.3 Draw proper diagrams to show the effect of change in demand on equilibrium price and equilibrium quantity when supply (remains constant) curve is given.Ans. i) When supply curve is given and demand increases:

ii) When supply curve is given and demand decreases.

Q.4 Show the effect of change in supply, when the demand curve is given (on equilibrium price and equilibrium quantity)

Ans. i) When demand curve is given and supply increases.

ii) When demand curve is given and supply decreases.

Q.5 Show the effect on equilibrium price and equilibrium quantity when both demand and supply decrease simultaneously.Ans. There are three conditions when both demand and supply decrease simultaneously. i) When demand decreases in a greater proportion then the decrease in supply.

ii) When decrease in supply is greater than decrease in demand.

iii) When decrease in demand is equal to the decrease in supply

Q.6 Show the effect on equilibrium price when both demand and supply increase simultaneously.Ans. i) When the demand increases in a greater proportion than the increase in supply.

ii) When the supply increases in a greater proportion than the increase in demand.

iii) When the demand and supply increases in the same proportion

ii) When demand decreases in greater proportion than increase in demand.

iii) When demand decreases and supply increases in equal proportion.

Q.8 Show the effect on equilibrium price when demand increases and supply decreases.Ans.i) Demand increases in a greater proportion than decrease in supply.

ii) Demand increases in smaller proportion as compared to decrease in supply.

iii) Demand increases and supply decreases in same proportion.

Q.9 Show the effect on equilibrium price when demand changes.Ans. 1. * Supply is perfectly elastic.

2. * Supply is perfectly inelastic.

*When demand changes and supply is perfectly inelastic.

Q.10 Show the effect on equilibrium price when supply changes and demand is either:Ans. 1. * perfectly elastic * perfectly inelastic

2) Qty. remains const. with se in supply price ses and with ses in supply price ses.

Thank You !