Economics analysis for Business mid semester test

Assignment 1

In

Economics analysis for Business

MBA - 51023

Shyamalie Jayakody - FGS/02/25/01/2009/022

Master of Business Administration

University of Kelaniya
2009/2010 – 4th Batch

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I. 1) Discuss whether economics is a science or an art or having the features of both
fields.

Cultural economics, or the Economics of the Arts, is generally thought to have been created
de novo in the last four decades. The essays included in this volume show that both
economists and artists were doing "cultural economics" for centuries, in the same way that
Moliere's Bourgeois Gentilhomme had been speaking prose without knowing it. To be precise,
artists were practicing much better economics than economists themselves were able to
understand.

At heart, economics is the study of how people make decisions. As such, no matter how
mathematical the basic principles of economics may be, it is inherently based on something

Dirty and imprecise the actions of irrational people.Any model that tries to predict or explain
the behavior of people will, by definition, have error. When it comes to interpreting what is
acceptable error and what is flawed theory may come down to more art than science, because.
at some point, standered errors and the statistic scan only go so far.

Quantity demands for a certain commodity vary due to difference reasons given in the
economics.
QdX = f(PX,PO,Y,T)

QdX = Quantity demand for commodity X

PX = Price of X
PO = Price of the other commodity
Y = Consumer Income
T = Consumer Taste

Consider all variables remain same (Ceteris Paribus) other than PX .

QdX = f(PX)

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Science is a systematized body of knowledge ascertainable by observation and experiments. It
is a body of generalizations, principles, theories or laws which traces out a casual relationship
between cause and effect. Economics is, in this sense, a science. For it has generalizations
which establish relationship between cause and effect. A definite result is expected to follow
from a particular cause in economics like all other sciences.

Economists face very serious difficulties to test their theories because of the complexity of the
subject matter and because of the presence of a lot of disturbances. So, as Housman asserts,
they are right in trusting more in the implications deduced from the theory's axioms than in
the negative results which may emerge from empirical testing. It is very rare to see a theory
disregarded because of an apparent disconfirmation

If economics is a science, the obvious question is why did so few economists not predict the
current crisis? The answer is that many economists had great confidence in their theories of
efficient market hypothesis and didn’t feel the house price rises of 2000-2006 was a boom,
but based on underlying fundamentals. In October of 2008.

Economic is a science which studies human behavior as a relationship between ends and
scarce means which have alternative uses.

Many people doubt whether economics can be considered as science. This sort of doubts does
not exist, for instance, with respect to physics or chemistry.

The main conclusion is that economics is a science inasmuch as it formulates falsifiable

theories. However, the peculiarity that distinguishes it from, for instance, natural sciences, is
that theories, in most cases, cannot actually in practice be falsified.

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11) Briefly discuss how the scope of Economics has expanded under the welfare and
scarcity schools of economic thought.

Fundamentally a study of scarcity and of the problems to which scarcity gives rise” They do
not enter into the controversy whether economics concerned with the administration of scares
resources”. And also similarly it says a study of the economical allocation of scare physical
and human means (resources) among competing ends.

This welfare and scarcity is not possible to say with precision which is better than the other.
And also it says to define it as a study of mankind in the ordinary business of life is surely too
broad. To define it as the study of mankind in the ordinary business of life is surely too broad.
To define it as the study of material wealth is too narrow. This study it as the study of that part
of human activity subject to the measuring rod of money is again too narrow.

This definition gave a new direction to the study of economics. As,

• A Social Science
• Study of Man
• Wealth as a Means Of Material Well Being
• Economics and Welfare
• Materiality
• Normative Outlook
Economics is what economics do. How ever the truth is that keeping in view the present day
trend of establishing welfare states in the world, the welfare definitions’ are more scientific. A
satisfactory definition must combine both these conceptions of economics. We may define
economics as a social science concerned with the proper use and allocation of resources for
the achievement and maintenance of growth with stability.

Like its nature, the scope of economics is a vexed question and economists differ widely in
their views. The continuous growth in the subject matter of economics has led to divergent
views about the scope of economics.

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iii). a) Distinguish between the Deductive reasoning and Inductive reasoning

Inductive Reasoning Deductive reasoning

Inductive reasoning is a type of reasoning that Deductive reasoning is based on laws or general
involves moving from a set of specific facts to a principles. People using deductive reasoning
general conclusion. It can also be seen as a form apply a general principle to a specific example.
of theory-building, in which specific facts are Deductive arguments are said to be valid or
used to create a theory that explains invalid, never true or false. Ex: All men are
relationships between the facts and allows mortal
prediction of future knowledge. Socrates is a man
(Therefore,) Socrates is mortal

It clearly shows the difference as inductive While deductive reasoning starts with a general
reasoning starts with empirical observations of rule, then applies that rule to a specific instance.
specific phenomena, then establishes a general
rule to fit the observed facts

It is start from generalization and goes to a In this we observe a specific problem carefully
specific solution. and then come to conclusion

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b) Distinguish between the Static analysis and comparative static analysis

Static analysis comparative static analysis

Economic statics concern itself with the This analysis compares two or different static
simultaneous and instantaneous or timeless equilibrium situations. Under the comparative
adjustment of economic variables. For example, static model we compare only these two
demand and supply, output and prices of equilibrium levels. We do not study the
goods are assumed to be instantaneously processes, path of changing from one
adjusted. Also, there is neither past nor equilibrium level to the other equilibrium.
future in the static state.

. Comparative statics is commonly used to study changes in supply and demand when
analyzing a single market. In the following graph (A), comparative static shows an increase in
demand causing a rise in price & quantity. Comparing two equilibrium states, comparative
static analyzing doesn’t describe how the increase actually occurs. The term 'comparative
statics' it is more commonly used in relation to microeconomics than to macroeconomics.

Graph (A)
Price
S

P2

P1

Q 1 Q2 D1 D2 Quantity

Q 2.
a). Demand Supply Figures are in thousands

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 1 2/15 16

1 -2/15 0

a) Equilibrium price and quantity using Carmer’s Method.

Equilibrium price=PE=X1
Equilibrium quantity=QE=X2

X1=IA1I/IAI

X2=IA2I/IAI

A= 1 2/15
1 -2/15

A1= 16 2/15
0 -2/15

A2= 1 16
1 0

So;

IAI = I -2/15-2/15 I = I -4/15 I = 4/15

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IA1I = I -32/15 I = 32/15

IA2I = I -16 I = 16
So;

PE= X1=IA1I/IAI=(32/15)/(4/15)=8
QE= X2=IA2/IAI=16/(4/15)=60

b) 1 2/15 16  Demand Curve

1 -2/15 0  Supply Curve

So; Quantity Demand QDX=(240-15P)/2

P-2/15Q=0

P+2/15Q=16
So; Quantity Demand QDX=(240-15P)/2

P-2/15Q=0

So; Quantity Supply QSX=15P/2

PX QDX QSX
0 120 0

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 1 112.5 7.5
2 105 15
3 97.5 22.5
4 90 30
5 82.5 37.5
6 75 45
7 67.5 52.5
8 60 60
9 52.5 67.5
10 45 75
11 37.5 82.5
12 30 90
13 22.5 97.5
14 15 105
15 7.5 112.5
16 0 120

c) A Supply

E
PE

B Demand

QE
The way that how consumer and producer surpluses can arise, and show how they can
be affected by market interventions such as imposing price ceiling and price controls,
If the demand is less than the equilibrium, customers are willing to pay more than the
equilibrium price. When incomes to market scenario the market customers are pay only
the equilibrium price.

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So the consumer surplus is the difference between the maximum total price a consumer
would be willing to pay for the amount he buys and the actual total. If someone is
willing to pay more than the actual price, their benefit in a transaction is how much
they saved when they didn't pay that price.
The consumer Surplus area would be as

AEPE = CONSUMER SURPLUS

When we consider the supply less situation than the equilibrium, suppliers price is less
than the equilibrium price. When it comes to market from there also supplier can get a
equilibrium price.
So the producer surplus is the difference between what producers are willing and able
to supply a good for and the price they actually receive. From BEPE in the diagram
shows the level of producers surplus in the supply curve.

BEPE above the supply curve and below the market price in the above diagram.
A Supply
BEPE = C Producer’s Surplus

E
D
PE

Price Ceiling
G
F

B Demand
10

Q1 QE Q2
 When it’s comes to government imposing taxes the effect is different

price ceiling is below the market's equilibrium price, as shown by the solid line in the
above graph.

producer surplus get reduce = BFG

On the other hand customer surplus increase and it can be shown as the area of GFCA.
On this type of situation quantity supply reduce to Q1 as shown in the diagram, but the
quantity demand is increase to Q2. So there is shortage of (Q2-Q1) in the

Market. Due to that black market can be create.

A Supply
C Price Control
G Maximu
E
D H
PE

B Demand
11

Q1 QE Q2
 A different effect occurs when the government's imposed price control is above the
market's equilibrium price, as shown by the solid line in the above graph. At this stage
the producer surplus get increase. It becomes the area of BHG. On the other hand
customer surplus reduce and it can be shown as the area of CAG. On this type of
situation quantity supply increase to Q2 as shown in the diagram, but the quantity
demand is reduce to Q1. So there is excess supply of (Q2-Q1) in the market. So the
excess supply is needs to be handled by the government by means of subsidies.

d) Suppose that the top management of your firm purposes

increasing the price of this product from Rs.8 to Rs.10 per unit with a
view to increase the sales income. As a MBA qualified consultant to
the firm, advice the management of the possible outcomes of this
proposal. (Hint: calculating arc elasticity of demand may be useful).

eP=(∆Q/∆P)*((P1+P2)/(Q1+Q2))

As in the diagram 2.b. When P1 = 8  Q1 = 60

P2 = 10  Q2 = 45

∆Q = 45-60 = -15
∆P = 10-8 = 2

eP = (∆Q/∆P)*((P1+P2)/(Q1+Q2))
= (-15/2)*((8+10)/(60+45))
= -0.8571 < 1

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 Here the situation is inelastic. So the when increasing the price of the commodity,
supplier can increase his income also.

This is called essential commodity.

Question - 03

I. Why consumer behavior is important for taking managerial decisions.

Understanding customer needs and wants is a continuing challenge for managers in the 21st
century. Focusing on the customer is the key contribution of marketing to business practice.
From this it gives how customers make decisions as consumers. This innovative text also
explains how managers can influence consumer decision making in the marketplace. end users
of the product or service supplied are consumers . Base on the income, taste and the other
requirement of the customer, they buy certain product or services. According to the demand of
the customer, suppliers put their product or service to the market. After that customers buy
products comparing price of the product, price of the substitute product, income, taste and the
other factors and requirement they have. The suppliers main target is to maximize the profit.
The main attractor of the market is supplier. Everything thing is depend on him. The supplier
understand the market well. The main objective is to understand the customer and the market
well. If not it really hard to survive in the highly competitive market.

(II) utility means satisfaction which a consumer derive from commodities and services by
purchasing different units of money.

Cardinal Utility Approach Ordinal Utility Approach

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cardinal utility means satisfaction that can
ordinal
be utility refers to satisfaction cannot be
measured in numbers such as 1,2,and 3. measurable in numbers.
The concept of Cardinal Utility was Ordinal Utility means giving the rank to the
used by Marshal to define Consumer's utility derived by the consumption of goods
Equilibrium. Cardinal Utility means and services. This Concept was given by
consumer could measure the satisfaction J.R. Hicks. This is more realistic and better
derived by the consumption of any than cardinal utility. This is totally based
goods or services in terms of number on Introspection.
and unit of that measurement is Utils or the
Money
The cardinal utility emphasize on the size of
Thethe
ordinal utility emphasize on
difference between two bundles of goods.
Ordering/rank bundles of goods.

The way consumer can be equilibrium when he buys;

. This information is usually put together on a graph called an indifference map. One of
these is shown below.

Good B

E I3
E I2
I1

A Good A

Each indifference curve represents various quantities of two goods or services which
jointly give the same total level of utility to the consumer. The further a curve from the
origin, the greater the level of utility. The slope of the curve (the marginal rate of
substitution of A for B – MRSAB) shows the rate at which the individual trades off good A
against good B. The curve is convex to the origin due to diminishing marginal utility. In
this approach equilibrium is “E” The usual assumptions about a rational economic human

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 have to hold for the indifference curve approach to work. It can also be shown that
indifference curves (an ordinal approach) give the same results as cardinal utility theory.
Consumers will consume until the ratios between the marginal utility and the prices of all
goods and services will be equal (the equi marginal principle).

Based on the cardinal utility approach explains how a consumer can be equilibrium
when he buys;
a. One commodity and b) a basket of commodities.

one commodity

The main objective of a rational consume is to maximize the total utility or

satisfaction derived from spending personal income. This objective is reached and
the consumer is said to be in equilibrium.

Quantity of Total Utility Marginal

chocolate (TUI) Utility
(MUI)
(QI)
0 0
1 10 10 MUI > PI
2 18 8 MUI > PI
3 24 6 MUI > PI
4 28 4 MUI = PI
5 30 2 MUI < PI
6 30 0 MUI < PI
7 28 -2 MUI < PI

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 We can see how a consumer is taking a decision when he buys a particular product.
Suppose the product is chocolate

Assume price of a chocolate is Rs. 4/-

Above table shows the consumption of various alternative quantities of commodity ‘I’
(chocolate), per unit of time. MUI obtained by subtracting two successive value of TUI.

MUI > PI (buying)

MUI = PI (consumer become equilibrium)

MUI < PI (not buying)

Equilibrium MUI = PI(Mum) where Mum is Marginal utility of money

Assume Mum=1 then MUI=PI(1)

MUI=PI

The above situation is related to a case of buying one product and based on that detail we
can derive consumer demand as follows.

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b) A basket of commodities

We suppose when consumer goes to the market and buys basket of goods, In that
case we will have to see how consumer becomes equilibrium. He becomes
equilibrium when following conditions are satisfied.

MUX/PX = MUY/PY = ……= MUn/Pn first condition

PXQX+PYQY+……….+PnQn=M second condition

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 M is amount of money consumer expect of buying goods.

Pn is the price of product ‘n’

Qn is the quantity be buy from product ‘n’

In this case for consumer becomes to equilibrium when the above 2 conditions met.
First condition says that he has selected combination of commodities in such a way
that last rupee is spent of each commodity gives in similar utilities or similar marginal
utility. Thus he is not going to have further selection, which that choice of basket of
goods he fully satisfied. Second condition states that, at that time he is expense that
entire amount of money (M).

Q MUX MUY
3 1
1 16 11
4 1
2 14 10
6 2
3 12 9
2
4 10 8
5
5 8 7
5
6 6 6
7 4 5
8 2 4

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We suppose price of commodity X is PX=Rs. 2/-

Price of commodity Y is PY=Rs.1/-

and M=Rs. 12/-

MUX/PX = MUY/PY = ……= MUn/Pn

12/2 = 6/1

2x3 + 1x6 =M = 12

The above situation is known as equi-marginal utility situation.

III. a) PX = 10
PY = 10
B=M=100

Assume the entire budget is spent for X; QX = M/PX

=100/10
=10

Assume the entire budget is spent for Y; QY = M/PY

=100/10
=10

Ea=Equilibrium related to question ‘a’

At this stage customer buy 5 units of X and 5 units of Y.

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 b) When PX = 10
PY = 5
B=M=100

Assume the entire budget is spent for X; QX = M/PX

=100/5
=20

Assume the entire budget is spent for Y; QY = M/PY

=100/10
=10

Eb=Equilibrium related to question ‘a’

At this stage customer buy 9 units of X and 5.5 units of Y.

c) Based on substitution and income effects explain why consumers

very often demand more units from a commodity whose price has
reduced and sometimes demand less from it.

If the price reduce consumer tends to by more from it thinking that is cheaper. That means he
substitute cheaper product to other product. This substitute effect (SE) is always positive.

The other effect (income effect – IE) behaves differently. When the price of a product reduces, it
real income increases. Therefore thinking that he is more rich he my buy more from this particular
product. If so due to positive SE and also due to positive IE he buys more units from that
particular product which price gone down.

Assume that due to the higher income effect (consumer are wealthier), the demand for the one
product may reduce. In such situation also due to positive SE consumer buy little more from that
product.

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 If good X is inferior, income effect is negative. A rise in real income will
cause the demand for good X to fall.

Y
A

D e g
I1

f
I0
X0 X2B X1 E C X

The substitution effect of a fall in PX increases demand for X from 0X0 to 0X1.
The rise in real income, shown by the parallel rightward shift of the budget
line from DE to AC changes the position of the consumer equilibrium from
point f to g. the quantity demanded of X falls from 0X1 to 0X2. The substitution
effect (X0X1) is partly neutralized by income effect (X2X1). The total rise in
quantity demanded is from 0X0 to 0X2.

If good X is “Giffen” good, negative income effect which decreases quantity

demanded is more than the substitution effect which increases the quantity
demanded.

A
g
I1
D
e

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 f
I0
X3 X2 X1 E C X

While substitution effect increases quantity demanded from 0X0 to 0X1,

income effect decreases quantity demanded from 0X1 to 0X2. The income
effect is so strong that it outweighs the substitution effect. The result is a fall
in quantity demanded from 0X1 to 0X2 following a fall in PX.

(4) (a) Suppose that the following table gives you partial labor
productivity data arising from a short run manufacturing production
function.

Labour 0 1 2 3 4 5 6 7 8 9
Total 0 2 5 9 12 14 15 15 14 12
production
of labour
(TP)

The reason why this data has been recognized as the data of partial labour productivity.
Partial productivity concept of labour contribution is not taken into consideration in that ways.
This measurement does not give 100% correct picture. Total productivity labour is a variable
factor.

By looking at TPL columns in the given table we can identify two spaces or 3 stages of
production.

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Hence there is a agricultural function and also this might be manufacturing production
function and service production functions. There are increasing returns up to 8. From 8-9
there are decreasing data. The diminishing returns are there in 4-7. The law of diminishing
returns operate in short run. It reduces in negatively downward sloping.

Labour TPL APL MPL

0 0 0
2
1 2 2
b) 1) 3
2 5 2.5
4
3 9 3
3
4 12 3
2
5 14 2.8
1
6 15 2.5
0
7 15 2.14
-1
23
8 14 1.75
-2
9 12 1.33
1)

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111)
Identify the best strategies that you can adopt under each stage of
production as a MBA qualified production manager for the firm.

We can identify 3 different stages in the above diagram (4.b.I.). Stage-I goes from the origin to the
point where the APL is maximum. Stage-II goes from the point where APL maximum to the point
where MPL is zero. Stage-III covers the range over which the MPL is negative.

Do not operate in the stage-III, even with the free labour, because it would be possible to increase
total output using less labour than the existence. So if the organization operates at the stage-III, it
should move to the origin by reducing labour.

At the stage-I since the APL and MPL increases producer need to increase the labour. So when the firm
become to the stage-II we observe decrease in APL and MPL, but he values are positive. So the firm
need to operate at this stage since the firm can obtain maximum profit at that stage. So stage-II is the
equilibrium stage.

1V) Briefly discuss how the producer’s freedom of deciding the employment level is
constrained theoretically and practically in the short run, particularly in the SriLankan
labour market.

Production is a process, and as such it occurs through time and space. Because it is a flow
concept production is measured as a “rate of output per period of time”. There are three
aspects to production processes:

1. the quantity of the good or service produced,

2. the form of the good or service created,
3. the temporal and spatial distribution of the good or service produced.

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A production process can be defined as any activity that increases the similarity between the
pattern of demand for goods and services, and the quantity, form, and distribution of these
goods and services available to the market place.

high unemployment rates and long spells of unemployment are the result of profuse
legislation of the labor market or of market imperfections that would have prevailed even
without government intervention.
It is worth remembering that Sri Lanka is a partially closed economy, in which many import-
competing activities are greater than they should be, because of protection.

In the “long run”, all of these factors of production can be adjusted by management The
“short run”, however, is defined as a period in which at least one of the factors of production
is fixed.

A fixed factor of production is one whose quantity cannot readily be changed.

Examples include major pieces of equipment, suitable factory space, and key managerial
personnel.

A variable factor of production is one whose usage rate can be changed easily.

Examples include electrical power consumption, transportation services, and most raw
material inputs. In the short run, a firm’s “scale of operations” determines the maximum
number of outputs that can be produced. In the long run, there are no scale limitations.

But when we consider the practical situation lot of our industries not labour intensive industries, lot of
them are capital intensive. The reason is, Sri Lanka labour market is distorted due to low productivity,
labour regulations, union influences. Although money wage rate is less non wage cost is high. So due
to those reasons labour market become expensive. To maximise the productivity, efficiency and the
revenue organisations always prefer to have capital intensive environment.

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 C) The Cobb- Douglas is the most widely used production function in empirical work.
The function is expressed by
Q = AKαLβ

Where Q is the output and L and K are inputs of labour and capital, respectively. A, ( alpha)
and ( beta) are positive parameters determined in each case by the data. The greater the value
of A, the more advanced in the technology. The parameter measures the percentage increase
in Q resulting from a 1% increase in L while holding K constant. Similarly, measures the
percentage increase in Q resulting from a one-percent increase in K while holding L constant.
Thus, and are the output elasticity of L and K, respectively. If + =1 , there are constant
returns to scale; if a + b > 1, there are increasing returns to scale; and if a+b<1, there are
decreasing returns to scale. For the cobb-Douglas function, e =1

Q = AKαLβ

Q = 20KαLβ

c) I) Q = AKαLβ

Q = 20K0.5L0.5

A=20
β=0.5
α=0.5

So; Q= 20(KL)1/2

Capital stock = Rs.100 per unit

Price of output = Rs. 2 per unit
Current wages = Rs. 10 per unit

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 Q=20*10*(L)1/2
Q=200*(L)1/2
L = (Q/200)2

Therefore the L = (Q/200)2

Therefore following chart can be formed.

Here TPL = QL
TR = QL* Unit Price
TC = Fixed Cost + L*QL

L QL TPL TR TC APL MPL

0 - - - 100.0 - -
1 200.0 200.0 400.0 2,100.0 200.0 200.0
2 282.8 282.8 565.7 2,928.4 141.4 82.8
3 346.4 346.4 692.8 3,564.1 115.5 63.6
4 400.0 400.0 800.0 4,100.0 100.0 53.6
5 447.2 447.2 894.4 4,572.1 89.4 47.2
6 489.9 489.9 979.8 4,999.0 81.6 42.7
7 529.2 529.2 1,058.3 5,391.5 75.6 39.3
8 565.7 565.7 1,131.4 5,756.9 70.7 36.5
9 600.0 600.0 1,200.0 6,100.0 66.7 34.3

29
11)

30
III) Generally profit means positive difference between total cost and total
revenue. Total cost can be broken in to the following categories which are
as follows,

Total fixed cost: total fixed cost is the cost is the opportunity incurred in the
short run that does not depend on the quantity of output. A firm can produce a
little output or a lot, increase or decrease production, or even stop producing
altogether, but fixed cost remains unchanged.

Total variable cost: This is a kind of cost varies based on the quantity of
output.

In the long run production we need to consider both fixed cost and the variable
cost. In the short run production process we only consider the variable cost.

In some circumstances price of a product may be less than the average cost but
greater than the average variable cost. When the production continuing we can
decrease the average fixed cost. So at the certain point the average cost will go
below the marginal revenue. At that point the business earns profit.

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Question – 05

a) Distinguish between the total approach and the marginal approach

for explaining a firm’s equilibrium with regard to producing and selling
a product.

Total approach Marginal approach

In marginal approach, we can identify
In TR\TC approach, producer finds whether firms earns super profit or normal
the largest positive
difference profit or in a policy of lost minimizing or
between TR & TC. Corresponding to whether it has reach shut down position
that largest difference producer
decides what output to be produce.

In TP approach, when he reach the maximum

total profit he decides the output to be
produce

In the total approach we take;

Total profit = Total revenue (TR) – Total cost (TC)

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The above graph gives the total revenue (TR), total cost (TC), total fixed cost (TFC)
and the profit curve of a company.

Firstly, we see that the profit curve is at its maximum at this point (A). Secondly, we
see that at the point (B) that the tangent on the total cost curve (TC) is parallel to the
total revenue curve (TR). At this point the surplus of revenue (BC) is the greatest.
Because of total revenue minus total costs is equal to profit, the line segment CB is
equal in length to the line segment AQ. So at the point C firm get maximum profit.

When we consider the marginal approach;

We need to understand the behaviour of marginal cost (MC), average total cost (ATC),
marginal revenue (MR), Demand (D) and the price (P) in the perfectly competitive
market.

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In this situation;

Marginal profit (MR) = Marginal Revenue (MR) - Marginal cost (MC)

Then, if marginal revenue is greater than marginal cost, marginal profit is positive.
And if marginal revenue is less than marginal cost, marginal profit is negative. When
marginal revenue equals marginal cost, marginal profit is zero. Since total profit
increases when marginal profit is positive and total profit decreases when marginal
profit is negative, it must reach a maximum where marginal profit is zero or where
marginal cost equals marginal revenue. This is because the producer has collected
positive profit up until the intersection of MR and MC. The intersection of marginal
revenue (MR) with marginal cost (MC) is shown in the above diagram as point A. If
the firm operate and produce more than the point A, the marginal cost (MC) higher
than the marginal revenue (MR), which is price of the commodity. So the optimum
level of production (equilibrium point) is the point where the marginal cost is equal to
the price of the product.

Regardless of the approach we used, we get the same equilibrium point, which
maximise the organizational profit.

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 C) 1) Suppose that the following table gives a schedule of short run
total cost (STC) of production of a perfectly competitive firm.

Quantity produced (Q) units Total cost (STC) Rs.

0 5
1 10
2 14
3 17
4 19
5 22
6 26
7 31
8 37
9 44

The market price of the homogeneous product produced by this firm is

Rs.4.

i) Find average cost (AC), average variable cost (AVC), marginal cost
(MC) and marginal revenue (MR) schedules and plot them on one set
of axes and mark the output levels the firm faces the highest loss,
break even, and profit maximizing.

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 Q TC TFC TVC AC AVC MC P TR AR MR
0 5 5 0 0 0 4 0 0 0
1 10 5 5 10 5 5 4 4 4 4
2 14 5 9 7 4.5 -0.5 4 8 4 4
3 17 5 12 5.67 4 -0.5 4 12 4 4
4 19 5 14 4.75 3.5 -0.5 4 16 4 4
5 22 5 17 4.4 3.4 -0.1 4 20 4 4
6 26 5 21 4.33 3.5 0.1 4 24 4 4
7 31 5 26 4.42 3.71 0.21 4 28 4 4
8 37 5 32 4.63 4 0.29 4 32 4 4
9 44 5 39 4.88 4.33 0.33 4 36 4 4

(2) (3)

Highest Loss - According to the graph total highest loss -6.0 per unit

Break Even -There is no any intersection point Marginal Revenue and Average Cost
Curves
Profit Maximizing - Intersecting Points of Marginal Revenue (MR) Curve and Marginal Cost
(MC) Curves are 2,4 And 6, 4, So Profit maximizing From Quantity 2 to Quantity 6

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c)
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 II) Find the shutdown price for the firm and the price limit over which
the firm can earn an economic profit.

Shut Down price for the firm - Rs. 3.40 (at Intersecting Points of Marginal Cost (MC)
Curve and Average Variable Cost (AVC) Curve)

Price Limit for Profit - Rs. 4.30 (AT Intersecting Points of Marginal Cost (MC)
Curve and Average Cost (AC) Curve)

III) Explain why some businessmen continue with their businesses

complaining that their businesses are not profitable.

Generally profit means positive difference between total cost and total revenue. Total
cost can be broken in to the following categories which are as follows,

Total fixed cost: total fixed cost is the cost is the opportunity incurred in the
short run that does not depend on the quantity of output. A firm can produce a
little output or a lot, increase or decrease production, or even stop producing
altogether, but fixed cost remains unchanged.

Total variable cost: This is a kind of cost varies based on the quantity of
output.

In the long run production we need to consider both fixed cost and the variable
cost. In the short run production process we only consider the variable cost.

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 In some circumstances price of a product may be less than the average cost but
greater than the average variable cost. When the production continuing we can
decrease the average fixed cost. So at the certain point the average cost will go
below the marginal revenue. At that point the business earns profit.

Question – 06

a) For ensuring consumer welfare “perfectly competitive markets are

always better than any other forms of markets”. Elaborate this
statement based on your theoretical knowledge on the major forms of
market.

Basically perfect competitive market is an imaginary market structure. We cannot see pure
perfect competitive market in the real world. Anyhow in compared with other market
structures, it keeps consumers’ welfare very much. Actually features or characteristics of this
market always ensure consumer sovereignty.

In perfect competitive market its market price is equal to its marginal cost. MR = P that
means the price they get from consumer is equal only to the variable cost. They earn
economical profit. In this Competitive market Knowledge of the product is high
and the buyers and sellers are unlimited. Products are homogeneous. Sellers do not
have high power comparing with buyers. So Buyers are key players who handle
the market.

In compared with monopoly

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Firms come under the monopoly market structure can earn abnormal profit in the long
run by controlling the amount supply of goods and services. It is not good for
consumers. Consumers have to pay higher price for goods and services unnecessarily.

But in the perfect market structure, there is no chance for abnormal profit in the long
run. In the short run firms can earn abnormal profit, but in the long run that has
converted into normal profit due to higher supply. Because there is no restriction
regarding entry in to the market. That is why so much of firms are coming in to the
market by looking the perfect competitive firms’ abnormal profit.

In the case of monopoly it is not possible because entry is strictly restricted. No firms
can enter in to the market.

In compared with other market structures,

In the long run equilibrium sense, other markets are not in good cost effective
practices. Firms come under the other market structures (monopoly, monopolistic,
oligopoly) does not operate their production function at the possible lowest cost. This
practice seriously affects consumers’ welfare negatively.

In the perfect competitive market, firms decide their optimum production level at the
possible lowest cost in the long run. See the diagram

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 b) “A non-price competition can be witnessed in some of the
oligopoly markets than the other means of competition”. Explain
why such a competition can arise stating the major strategies
used in non-price competition.

Non-price competition refers to competition among firms that choose to distinguish their
product via non-price means. EX: style, delivery, location, atmosphere, promotions, etc. Non-
price competition is often used by firms that wish to differentiate between virtually identical
products (dry-cleaners, food products, cigarettes, etc). Although any firm can use non-price
competition, it is most common among monopolistically competitive firms. The reason for this
is that firms which operate in the monopolistically competitive market are price takers, that is,
they simply do not have enough market power to influence or change the price of their good.
Consequently, in order to distinguish themselves, they must use non-price means.

Quick Reference to Basic Market Structures

Seller Entry Seller Buyer Entry Buyer

Market Structure
Barriers Number Barriers Number

Perfect Competition No Many No Many

Monopolistic
No Many No Many
competition

c)Oligopoly Yes Few No Many

Oligopsony No Many Yes Few

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Monopoly Yes One No Many

Monopsony No Many Yes One

The correct sequence of the market structure from most to least

competitive is perfect competition, imperfect competition,oligopoly, and
pure monopoly.

c) Suppose your firm has agreed with other firms in the industry
under a market sharing cartel agreement to produce two
products, X and Y subject to the production quota given by
X+Y=56. The firm’s cost function (C) has been estimated as
C=4X2+3XY+6Y2.

i) Find the amounts of X and Y to be produced to minimize firm’s

cost subject to the given quota forming a Lagrangian function,
and the minimum cost when producing this optimal product
mix.

C = 4X2+3XY+6Y2
X+Y = 56
56-X-Y = 0
λ (56-X-Y) = 0
C = 4X2+3XY+6Y2+λ(56-X-Y)

λ=0

λ=0

=0 => X+Y = 56

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 So;

8X+3Y-λ = 0
3X+12Y- =0
-X-Y = -56

AX=B

X = |A1| / |A| , y = |A2| / |A| , λ = |A3| / |A|

A=

|A| = 8[12*0-(-1)*(-1)]+3*(-1)[3*0-(-1)*(-1)]+(-1)[3*(-1)-12*(-1)]
= -8+3-9 = -14

A1 =

|A1| = 0+3*(-1)[0-(-1*(-56))]+(-1)[0-(12*(-56))]
= 3*56-12*56 = -504

A2 =

|A2| = 8(0-56)+0+(-1)(3*(-56)-0)

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= -5*56 = -280

A3 =

|A3| = 8(-12*56-0)+3(-1)(-3*56-0)+0
= -96*56+9*56 = -4872

x = |A1|/|A| = 504/14 = 36

y = |A2|/|A| = 280/14 = 20

λ = |A3|/|A| = 4872/14 = 348

Minimize cost at; X = 36, Y = 20, λ = 348

Cost; C = 4X2+3XY+6Y2
At this optimal point ; COptimal = 4*36*36+3*36*20+6*20*20
= 9744

ii) Estimate the shadow price if the production quota increased

to 57, and discuss its importance as a managerial decision tool.

C = 4X2+3XY+6Y2
When the production quota is increase to 57
X+Y = 57
57-X-Y = 0
λ (57-X-Y) = 0
C = 4X2+3XY+6Y2+λ(57-X-Y)

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 ∂C/∂X = 8X+3Y-λ = 0
∂C/∂Y = 3X+12Y-λ =0

∂C/∂λ = 57-X-Y = 0

So;

8X+3Y-λ = 0
3X+12Y- =0
-X-Y = -57

AX=B

8 3 -1 X 0
3 12 -1 Y = 0
-1 -1 0 Z -57

X = |A1| / |A| , y = |A2| / |A| , λ = |A3| / |A|

A=

|A| = 8[12*0-(-1)*(-1)]+3*(-1)[3*0-(-1)*(-1)]+(-1)[3*(-1)-12*(-1)]
= -8+3-9 = -14

A1 = 0 3 -1
0 12 -1
-57 -1 0

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|A1| = 0+3*(-1)[0-(-1*(-57))]+(-1)[0-(12*(-57))]
= 3*57-12*57 = -513

A2 = 8 0 -1
3 0 -1
-1 -57 0

|A2| = 8(0-57)+0+(-1)(3*(-57)-0)
= -5*57 = -285

A3 = 8 3 0
3 12 0
-1 -1 -57

|A3| = 8(-12*56-0)+3(-1)(-3*56-0)+0
= -96*57+9*57 = -4559

X = |A1|/|A| = 513/14 = 36.65

Y = |A2|/|A| = 285/14 = 20.35

λ = |A3|/|A| = 4559/14 = 348

Minimize cost at; X = 36, Y = 20, λ = 325.64

In this situation the shadow price; λ is equal to 325.64

Shadow price gives the indication of the increasing or decreasing of marginal

cost when we increase or decrease the output by one unit.

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So at the same shadow price can be taken as the opportunity cost of the
marginal output.

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