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GNDU Question Paper-2022
Bachelor of Business Administration
B.B.A 1
st
Semester
Managerial Economics-I
Time Allowed: Three Hours Maximum Marks: 50
Note: Attempt Five questions in all, selecting at least One question from each section. The
Fifth question may be attempted from any section. All questions carry equal marks.
SECTION-A
1. Explain the law of Equi-Marginal Utility. Point out its limitations and importance.
2. Describe the concept of price elasticity of demand. How it is measured?
SECTION-B
3. Describe, the concept of supply and explain the factors affecting the supply.
4. What are the properties of indifference curves ? Explain consumer's equilibrium with
the help of indifference curves.
SECTION-C
5. Discuss the law of returns to scale in detail.
6. Explain the theory of cost in short run and long run.
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SECTION-D
7. Discuss the equilibrium of industry under perfect competition in the short run and long
run.
8. Explain the concept of monopoly and discuss the price determination under monopoly.
GNDU Answer Paper-2022
Bachelor of Business Administration
B.B.A 1
st
Semester
Managerial Economics-I
Time Allowed: Three Hours Maximum Marks: 50
Note: Attempt Five questions in all, selecting at least One question from each section. The
Fifth question may be attempted from any section. All questions carry equal marks.
SECTION-A
1. Explain the law of Equi-Marginal Utility. Point out its limitations and importance.
Ans: Choosing wisely with a small wallet: The law of equi-marginal utility
Ananya walks into a bustling campus canteen with ₹100 in her pocket and many cravings in
her head: samosas, cold coffee, and a bowl of fruit. She can’t buy everything; she has to
choose. After the first samosa, her joy is big. After the second, a bit less. Meanwhile, a
chilled sip of coffee promises a fresh kick. How should she split her ₹100 so that, when she’s
done eating and drinking, the happiness she squeezed out of every last rupee feels “just
right”? This everyday dilemma is the story of the law of equi-marginal utility.
The core idea in plain words
The law of equi-marginal utility (also called the law of substitution or the law of maximum
satisfaction) says that a rational consumer with a limited budget allocates spending across
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goods so that the last rupee spent on each good gives the same extra satisfaction (marginal
utility). When this happens, total satisfaction (utility) from the whole budget is maximized.
Put like a rule:
• A consumer will keep shifting expenditure from a good that gives lower marginal
utility per rupee to another that gives higher marginal utility per rupee, until the
“marginal utility per rupee” is equal for all goods bought.
In symbolic form for goods x,y,z with prices Px,Py,Pz and marginal utilities MUx,MUy,MUz,:
Subject to the budget constraint:
This “equal marginal utility per rupee” condition is the sweet spot.
Why the law works: Diminishing extra satisfaction
• Diminishing marginal utility: As you consume more of one item in quick succession,
each additional unit gives less extra satisfaction than the previous one.
• Substitution toward higher payoff: If the last rupee spent on coffee gives more extra
satisfaction than the last rupee spent on samosas, you’ll substitute a rupee from
samosas to coffee. Each switch narrows the gap until both last rupees deliver the
same kick.
When every last rupee gives the same extra push in happiness, there’s no reason to
reallocate; total utility can’t be improved by reshuffling the budget.
A crisp numerical illustration
Suppose Ananya considers two items:
• Samosa price Ps=₹20P_s = ₹20
• Coffee price Pc=₹40P_c = ₹40
• Budget =₹100= ₹100
Assume her marginal utility (MU) from samosas and coffees diminishes as she consumes
more.
• Samosa MUs: 70, 50, 35, 25, 18 (for the 1st, 2nd, … 5th)
• Coffee MUs: 120, 80, 55 (for the 1st, 2nd, 3rd)
Compute “marginal utility per rupee” (MU/₹) to guide each purchase:
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• Samosa MU/₹: 70/20 = 3.5; 50/20 = 2.5; 35/20 = 1.75; 25/20 = 1.25; 18/20 = 0.9
• Coffee MU/₹: 120/40 = 3.0; 80/40 = 2.0; 55/40 = 1.375
Allocate rupees step by step to the highest MU/₹ each time, respecting the ₹100 budget:
• 1st pick: samosa (3.5) → spend ₹20 (left ₹80)
• 2nd pick: coffee (3.0) → spend ₹40 (left ₹40)
• 3rd pick: samosa (next is 2.5) → spend ₹20 (left ₹20)
• 4th pick: coffee (next is 2.0) → would need ₹40, but only ₹20 remains
With ₹20 left, only a samosa is affordable. Compare MU/₹ for the next units: samosa 1.75 vs
coffee 2.0 (but coffee needs ₹40). She buys the 3rd samosa (1.75 per rupee) because that’s
the feasible best use of the final ₹20.
Final bundle: 3 samosas (₹60) + 1 coffee (₹40) = ₹100.
Check the equalization idea:
• Last samosa’s MU/₹ = 35/20 = 1.75
• Last coffee’s MU/₹ = 120/40 = 3.0 (but she actually bought only 1 coffee; if she had
₹40 more, she would consider the second coffee with MU/₹ = 2.0 and keep
balancing)
In practice, with lumpy prices and limited money, we get as close as feasible to equalizing
MU per rupee across goods.
Assumptions that keep the law tidy
• Diminishing marginal utility: Each extra unit gives less added satisfaction than the
previous one.
• Cardinal measurability (or at least comparability): Utilities can be ordered and
compared well enough to guide choices.
• Rational behaviour: The consumer aims to maximize satisfaction given constraints.
• Given prices and income: Prices don’t change during the decision and the budget is
fixed.
• Divisibility/availability: Goods can be bought in small units to fine-tune allocation.
• Independent utilities: The satisfaction from one good doesn’t depend on how much
of another you consume (no strong complementarities).
These simplify the logic so the “equal marginal utility per rupee” criterion cleanly identifies
the best bundle.
Limitations you should remember
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• Measuring utility is tricky: Real people can’t assign precise numbers to satisfaction;
much of the world runs on preferences rather than cardinal scores.
• Interdependent goods: Complements (like tea and sugar) and strong substitutes tie
utilities together, bending the neat independence assumption.
• Indivisible and lumpy purchases: You can’t buy half a coffee or one-third of a shirt;
equalization becomes approximate, not exact.
• Changing prices and income: Discounts, surge pricing, or sudden budget changes
shift the ground mid-decision.
• Bounded rationality and habits: People follow routines, rely on rules of thumb, and
make emotional choices—often stopping short of the “optimal” mix.
• Ignorance or limited information: Not knowing future needs or alternative options
can lock consumers into sub-par bundles.
• Satiation and context: After a point, more brings no extra joy; context (time of day,
mood) alters perceived marginal utilities.
• Time costs and effort: Searching and switching entail effort; the “best” allocation
might not be worth the hassle of constant recalculation.
Even with these limitations, the law remains a powerful compass for understanding
everyday choices.
Why the law matters (far beyond snacks)
• Consumer decision-making:
o Practical budgeting: Helps households spread limited income across food,
transport, data plans, and leisure to feel “best off.”
o Explains substitution: When the price of one good rises, consumers switch to
alternatives until marginal utility per rupee re-aligns, echoing the law of
demand.
• Business pricing and product mix:
o Bundling and sizes: Firms design bundles so the buyer’s perceived MU/₹
looks attractive at targeted price points.
o Versioning: Different product versions (basic, standard, premium) are priced
so that the “marginal upgrade” feels worth it.
• Public finance and policy:
o Equi-marginal principle in allocation: Governments try to allocate limited
funds across health, education, and infrastructure so that the last rupee
spent in each sector yields roughly equal social benefit.
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o Environmental policy: Spending across pollution abatement options is guided
by equalizing “marginal abatement cost” across sources.
• Production and operations (same principle, different dress):
o Cost minimization: Firms distribute a fixed budget across inputs so that the
ratio of marginal product to input price is equalized:
• Project selection: Managers fund projects until the marginal return per rupee is
equal across projects in the portfolio.
• Personal time management:
o Hours allocation: Students and professionals split time among tasks until the
last hour on each delivers similar incremental benefit—an intuitive echo of
equi-marginal thinking.
A short story of smart spending
Later that week, Ananya plans a weekend: a movie ticket, a café meet-up, and a new
e-book. The movie’s first viewing thrills her, but a second show the same day wouldn’t. The
café meet-up starts high on joy, then tapers. The e-book’s first chapters give solid
satisfaction per rupee, then level off. She divides her ₹500 across all three so that the last
rupee on each brings roughly the same extra smile. She goes home satisfied—not because
she bought everything, but because she bought enough of the right things.
Common mistakes to avoid in exams
• Confusing equal MU with equal MU per rupee: It’s the ratio MU/PMU/P that must be
equal across goods, not the raw marginal utilities.
• Forgetting the budget constraint: Equalization without staying within income is
meaningless.
• Ignoring prices: If prices differ, equal raw marginal utilities will not maximize
satisfaction; only equal MU/PMU/P will.
• Overlooking feasibility: With indivisible goods, you aim for the closest feasible
equalization.
The bottom line
The law of equi-marginal utility is a simple, powerful way to think about making the most of
limited means: keep shifting your next rupee to where it does the most good, until the last
rupee you spend on each option pulls its weight equally. Yes, real life is messy—habits,
lumpy prices, and imperfect information blur the edges. But as a guiding principle for
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consumers, managers, and policymakers, it’s hard to beat: when the marginal gain per
rupee is equalized, total satisfaction stands tallest.
2. Describe the concept of price elasticity of demand. How it is measured?
Ans: Price elasticity of demand
On a drizzly Saturday, Ayaan opens his tiny mobile shop near the bus stand. He sells 1 GB
top-ups for ₹20. Morning crowds keep him busy. Just before lunch, supply costs nudge up,
so he experiments: “Let’s try ₹25.” The queue thins; regulars hesitate; a few switch to the
kiosk across the street. By evening, he drops the price to ₹18 and the crowd returns. Ayaan
hasn’t read a textbook today, but he’s living one: when price moves, quantity demanded
moves too—sometimes a lot, sometimes a little. Price elasticity of demand is simply a
careful way to measure how sensitive that movement is.
The concept and intuition
Price elasticity of demand (PED) tells us how responsive buyers are when the price of a good
changes. Formally,
Because demand slopes downward, E
d
is usually negative. In practice, we discuss the
magnitude ∣Ed∣:
• Elastic demand: ∣Ed∣>1. A small price change triggers a bigger percentage change in
quantity.
• Unit elastic: ∣Ed∣=1. Price and quantity move by the same percentage.
• Inelastic demand: ∣Ed∣<1. Quantity barely reacts to price.
Why are some goods more sensitive than others?
• Substitutes:
o Core idea: The more alternatives, the easier it is to switch.
o Result: More substitutes make demand more elastic.
• Nature of the good:
o Necessities: You can’t easily cut back on salt or basic medicines—inelastic.
o Luxuries: You can delay or skip—elastic.
• Budget share:
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o Larger share: A 10% rent hike hurts more than a 10% toothpick hike—more
elastic.
• Time horizon:
o Short run vs long run: Over time, people find workarounds, so demand
becomes more elastic.
• Definition of the market:
o Narrow vs broad: “Vanilla ice cream” has more substitutes than “dessert”—
narrower definitions tend to be more elastic.
Ayaan’s data packs have close substitutes across the street; bread at the only village bakery
does not. That difference is elasticity at work.
How it is measured
Percentage (proportionate) method
For discrete changes, use percentage changes or their proportional form:
• Use: Quick estimates around a given point.
• Caution: Results depend on whether you compute percentages from the old or new
base.
Point elasticity (calculus method)
At a specific point on a smooth demand curve:
• Use: Tiny price changes; theoretical work and continuous data.
Arc elasticity (midpoint method)
To avoid base-dependence for sizable changes, average the starting and ending values:
or equivalently,
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• Use: Before-after comparisons when changes aren’t tiny.
Total outlay (total revenue) method
Track what happens to total spending TR=P×QTR = P \times Q when price changes:
• If price ↑ and TR ↑: Demand is inelastic (∣Ed∣<1).
• If price ↑ and TR ↓: Demand is elastic (∣Ed∣>1).
• If price ↑ and TR unchanged: Unit elastic (∣Ed∣=1).
• Use: Fast classification when you have sales revenue but limited detail.
Revenue–marginal revenue link (managerial method)
There’s a tight relationship between price (average revenue ARAR) and marginal revenue
MRMR:
so, in magnitudes,
• Use: Firms with demand and MR estimates can infer elasticity at the operating point.
Geometric method (straight-line demand)
On a linear demand curve, elasticity varies by location:
• At the midpoint: ∣Ed∣=1|.
• Above midpoint (high price, low quantity): ∣Ed∣>1.
• Below midpoint (low price, high quantity): ∣Ed∣<1.
A handy geometric rule at a point on a straight-line demand:
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where segments are measured along the price axis from the point to the intercepts.
A clean numerical illustration
Suppose a local cinema reduces the ticket price from ₹200 to ₹180. Attendance per show
rises from 300 to 360. Is demand elastic over this range?
• Compute changes:
o ΔP: −₹20-₹20
o ΔQ: +60+60
o P₁ + P₂: ₹200+₹180=₹380₹200 + ₹180 = ₹380
o Q₁ + Q₂: 300+360=660300 + 360 = 660
• Arc elasticity:
• Interpretation: ∣Ed∣≈1.73|E_d| (elastic). A 10% price cut leads to roughly a 17.3%
rise in quantity. Check the revenue hint:
o Before: ₹200×300=₹60,000₹200 \times 300 = ₹60{,}000
o After: ₹180×360=₹64,800₹180 \times 360 = ₹64{,}800
o TR rises: Consistent with elastic demand when price falls.
Now imagine the price drops further, from ₹180 to ₹170, and attendance barely moves from
360 to 365. Compute arc elasticity again and you’ll likely find ∣Ed∣<1|E_d| < 1, illustrating
that elasticity can change along the same demand curve.
Why elasticity matters
• Pricing strategy:
o Elastic demand:
▪ Implication: Price cuts can raise revenue; hikes can hurt more than
expected.
▪ Action: Differentiate your product or bundle features to reduce
substitutability if you must raise price.
o Inelastic demand:
▪ Implication: Moderate price increases can raise revenue with smaller
quantity losses.
▪ Action: Ensure fairness and communication, especially for essentials.
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• Tax policy and welfare:
o Goal: Raise revenue without large distortions.
o Practice: Inelastic goods (e.g., petrol, cigarettes) are often taxed more, but
policymakers balance revenue with equity and health objectives.
• Capacity and planning:
o Peak vs off-peak: Transit, electricity, and telecoms set differential prices
because short-run demand is less elastic at peak times.
• Risk management for producers:
o Commodity traps: A bumper crop plus inelastic demand can reduce farmers’
total revenue as prices fall more than quantities rise.
• Smart consumer choices:
o Personal budgeting: Knowing where your own demand is elastic helps you
switch and save; where it’s inelastic, you plan buffers.
A brief second story: During a festive week, a ride-hailing app raises surge prices. For airport
rides late at night, demand hardly budges—few substitutes, urgent need, short time
window: inelastic. For short city hops on a lazy Sunday, riders switch to metros and autos—
more substitutes, flexible plans: elastic. Same service, different elasticity because context
changes the ease of switching.
Common exam pitfalls and quick fixes
• Mixing slope with elasticity:
o Fix: Remember, slope is ΔP/ΔQ , while elasticity scales slope by P/Q:
• Forgetting the sign:
o Fix: Acknowledge that Ed is negative for normal downward demand; use ∣Ed∣
to classify.
• Base-bias in percentages:
o Fix: Use the midpoint (arc) method for finite changes to avoid upward vs
downward bias.
• Overgeneralizing:
o Fix: Elasticity varies by time, market definition, and buyer type; always
specify the context.
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• Ignoring total revenue clues:
o Fix: If detailed data is scarce, observe how total revenue moves with price to
infer elasticity.
The takeaway
Price elasticity of demand turns Ayaan’s hunches into a number: how strongly buyers react
when price nudges up or down. Define it as the percentage change in quantity over the
percentage change in price; measure it with point, arc, percentage, revenue, or geometric
methods; and read it with care—context, substitutes, time, and budget share all shape the
outcome. Get this right, and pricing, policy, and everyday decisions stop being guesswork
and start being grounded, precise, and fair.
SECTION-B
3. Describe, the concept of supply and explain the factors affecting the supply.
Ans: The Story Behind Supply: What Sellers Bring to the Market
Early one morning, Kabir, a vegetable vendor, sets up his stall at the local market. He has 50
kilos of tomatoes, freshly picked from nearby farms. As the sun rises and customers arrive,
he hears that prices are expected to rise due to a festival. By noon, he’s already planning to
bring more tomatoes tomorrow. Why? Because higher prices motivate him to supply more.
This simple decision—how much to bring and when—is the essence of supply.
Supply isn’t just about having goods; it’s about the willingness and ability to offer them for
sale at different prices. Let’s explore this concept, understand what affects it, and learn how
it’s measured—all through stories and examples that make it easy to grasp.
What Is Supply?
Supply refers to the quantity of a good or service that producers are willing and able to offer
for sale at different prices during a specific time period.
It’s not just about having stock—it’s about choosing to sell it. Sellers respond to market
signals, especially price, to decide how much to supply.
Key Elements:
• Quantity: How much is offered.
• Price: The main factor influencing supply.
• Time: Supply is always tied to a time frame (per day, per month, etc.).
• Willingness and Ability: Sellers must want to sell and be capable of doing so.
The Law of Supply
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The Law of Supply states that, all other things being equal, the quantity supplied of a good
increases as its price increases, and decreases as its price decreases.
In simple terms:
• Price ↑ → Supply ↑
• Price ↓ → Supply ↓
Why? Because higher prices mean higher potential profits, encouraging producers to
produce and sell more.
Graphically:
The supply curve slopes upward from left to right.
While price is the most direct influence, many other factors affect supply. Let’s explore
them:
Price of the Good
• As price increases, producers are more motivated to supply more.
• Example: Kabir brings more tomatoes when prices rise during festivals.
Cost of Production
• Includes wages, raw materials, rent, etc.
• If costs rise, supply may decrease because profit margins shrink.
• Example: If fertilizer prices go up, farmers may reduce crop output.
Technology
• Better technology increases efficiency and output.
• Example: A bakery installs a new oven that bakes twice as fast, increasing supply.
Prices of Related Goods
• If a producer can switch between products, the price of alternatives affects supply.
• Example: A farmer may grow more onions instead of potatoes if onion prices rise.
Government Policies
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• Taxes, subsidies, and regulations impact supply.
• Example: A subsidy on solar panels encourages producers to supply more.
Expectations of Future Prices
• If sellers expect prices to rise, they may hold back supply now.
• Example: A gold trader may wait to sell if prices are expected to increase next week.
Number of Sellers
• More sellers in the market increase total supply.
• Example: If more dairy farms open, milk supply increases.
Natural Conditions
• Weather, disasters, and seasonal changes affect supply.
• Example: A drought reduces crop supply; good weather boosts it.
Availability of Inputs
• If raw materials or labor are scarce, supply may fall.
• Example: A shortage of skilled workers can reduce software development output.
How Is Supply Measured?
Supply is measured in terms of quantity supplied at different prices. But to understand how
responsive supply is to price changes, we use:
Price Elasticity of Supply (PES)
Price Elasticity of Supply measures how much the quantity supplied changes in response to a
change in price.
Formula:
Interpretation:
• PES > 1 → Supply is elastic (responsive).
• PES = 1 → Unit elastic.
• PES < 1 → Supply is inelastic (not very responsive).
• PES = 0 → Perfectly inelastic (no change in quantity).
• PES = ∞ → Perfectly elastic (any quantity supplied at a fixed price).
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Example:
If the price of oranges increases by 10% and the quantity supplied increases by 20%, then:
This means supply is elastic.
A Real-Life Story: The Rainy Day Dilemma
Ravi owns a roadside tea stall. On rainy days, demand spikes. He knows this and prepares
extra tea in advance. But one day, heavy rain floods the supply route, and milk doesn’t
arrive. Despite high prices and demand, Ravi can’t increase supply. This shows how
availability of inputs and natural conditions can limit supply—even when prices are
favorable.
Supply Schedule and Supply Curve
A Supply Schedule is a table showing quantities supplied at different prices.
Price (₹)
Quantity Supplied
10
100
20
200
30
300
Plotting this gives the Supply Curve, which slopes upward.
Movement vs. Shift in Supply
Movement Along the Supply Curve:
• Caused by a change in the price of the good.
• Example: Price rises from ₹10 to ₹20 → movement upward along the curve.
Shift in the Supply Curve:
• Caused by other factors (technology, input costs, etc.).
• Example: A new machine increases output → supply curve shifts right.
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Importance of Understanding Supply
• For Producers: Helps in planning production and pricing strategies.
• For Governments: Guides policy decisions like subsidies and taxes.
• For Consumers: Affects availability and pricing of goods.
• For Economists: Helps analyze market behavior and predict trends.
Common Mistakes to Avoid
• Confusing supply with stock: Supply is what’s offered for sale, not just what’s
available.
• Ignoring time frame: Supply must be tied to a specific period.
• Assuming supply is only affected by price: Many non-price factors play a role.
• Mixing up movement and shift: Movement is due to price; shift is due to other
factors.
Conclusion
Supply is the lifeblood of markets—it’s what sellers bring to the table. It responds to price,
but also to costs, technology, policies, and nature. Measuring supply and understanding its
elasticity helps everyone—from street vendors to policymakers—make smarter decisions.
Just like Kabir and Ravi, every seller reads the signals, adapts to conditions, and decides how
much to offer. That’s supply in action: dynamic, responsive, and essential.
4. What are the properties of indifference curves ? Explain consumer's equilibrium with
the help of indifference curves.
Ans: The Tale of Choices: Understanding Indifference Curves and Consumer’s
Equilibrium
Imagine Riya, a college student with a tight budget and a love for snacks. Every weekend,
she visits the local store to buy her two favorite treats: chocolates and chips. She has ₹100
to spend, and she wants to enjoy both—but how much of each should she buy to feel
happiest without overspending?
This simple dilemma—how to choose between two goods—is at the heart of consumer
behavior. Economists use a powerful tool called the indifference curve to explain how
consumers like Riya make choices. Let’s dive into this concept and explore how it leads to
consumer’s equilibrium, all through relatable examples and a story that brings the theory to
life.
What Is an Indifference Curve?
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An indifference curve is a graph that shows different combinations of two goods that give a
consumer the same level of satisfaction or utility.
In other words, every point on the curve represents a bundle of goods that the consumer
likes equally. She’s indifferent between them—hence the name.
Example:
Riya might be equally happy with:
• 4 chocolates and 2 chips
• 3 chocolates and 3 chips
• 2 chocolates and 4 chips
All these combinations lie on the same indifference curve.
Properties of Indifference Curves
Let’s explore the key properties that make indifference curves such a useful tool in
economics.
Indifference Curves Slope Downward
Why? Because if a consumer gives up some of one good, she must get more of the other to
maintain the same satisfaction.
• If Riya gives up 1 chocolate, she’ll want more chips to stay equally happy.
This reflects the trade-off between goods.
Higher Indifference Curves Represent Higher Satisfaction
The farther an indifference curve is from the origin, the more goods it represents—and the
happier the consumer is.
• Curve I₁: 2 chocolates + 2 chips
• Curve I₂: 4 chocolates + 4 chips
Riya prefers I₂ over I₁ because it gives her more of both.
Indifference Curves Never Intersect
If two curves intersected, it would mean the same combination gives two different levels of
satisfaction—which is impossible.
• Riya can’t be equally happy with one bundle and also find it better than another at
the same time.
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Indifference Curves Are Convex to the Origin
This means they bend inward. Why? Because of the diminishing marginal rate of
substitution (MRS).
• As Riya consumes more chocolates, she’s willing to give up fewer chips for each extra
chocolate.
• Her willingness to substitute decreases as she gets more of one good.
This reflects realistic consumer behavior.
Marginal Rate of Substitution (MRS)
MRS is the rate at which a consumer is willing to substitute one good for another while
maintaining the same level of satisfaction.
Example:
• Riya may give up 2 chips for 1 chocolate at first.
• Later, she may only give up 1 chip for 1 chocolate.
This shows diminishing MRS, which is why indifference curves are convex.
Budget Line: The Constraint
Now let’s introduce the budget line—the boundary of what a consumer can afford.
It shows all combinations of two goods that a consumer can buy with a fixed income and
given prices.
Example:
Riya has ₹100. Chocolates cost ₹10 each, chips ₹5 each.
• If she buys only chocolates: ₹100 ÷ ₹10 = 10 chocolates
• If she buys only chips: ₹100 ÷ ₹5 = 20 chips
The budget line connects these two points.
Consumer’s Equilibrium: The Sweet Spot
Consumer’s equilibrium is the point where the consumer maximizes satisfaction given her
budget.
It occurs where the budget line is tangent to the highest possible indifference curve.
Why Tangency?
At this point:
• The slope of the indifference curve (MRS) = slope of the budget line (price ratio)
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• The consumer is getting the best possible combination of goods within her budget.
Mathematically:
Where:
• MRS
xy
= Marginal rate of substitution between good X and Y
• P
x
P
y
= Prices of good X and Y
A Real-Life Story: The Café Choice
Aman visits a café every Sunday with ₹200. He loves coffee and pastries. Coffee costs ₹50,
pastries ₹25. He wants to enjoy both but not overspend.
He tries different combinations:
• 2 coffees + 2 pastries
• 1 coffee + 4 pastries
• 3 coffees + 1 pastry
He realizes that 2 coffees and 2 pastries give him the most joy without breaking his budget.
This is his consumer’s equilibrium—the point where his budget line touches his highest
indifference curve.
Why Is This Important?
Understanding indifference curves and consumer’s equilibrium helps in:
• Predicting consumer behavior: How people make choices.
• Designing pricing strategies: Businesses can adjust prices to influence demand.
• Policy-making: Governments can assess how taxes or subsidies affect consumption.
Common Misunderstandings
• Thinking more is always better: Only if it fits within the budget.
• Assuming straight indifference curves: They’re usually curved due to diminishing
MRS.
• Confusing budget line with indifference curve: One shows affordability, the other
shows preference.
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Conclusion
Indifference curves are like maps of satisfaction. They show how consumers balance choices
between goods. When combined with the budget line, they reveal the point of consumer’s
equilibrium—where happiness meets affordability.
Just like Riya and Aman, every consumer navigates this invisible landscape of choices. And
with the help of indifference curves, economists can decode these decisions, making sense
of the everyday magic behind what we buy and why.
SECTION-C
5. Discuss the law of returns to scale in detail.
Ans: The bakery that grew: Law of returns to scale made simple
Before sunrise, the smell of warm bread floats out of Kiran’s tiny bakery. At first, it’s just
her, one oven, and a handful of trays. As the town falls in love with her soft loaves, she
wonders: “If I double everything—more ovens, more helpers, more flour—will I get exactly
double the bread? More than double? Or, somehow, less?” That question is the heart of the
law of returns to scale.
This is a story about what happens when all inputs grow together—capital and labor, ovens
and bakers, trays and time—and how output responds. Let’s unpack it in a way that’s crisp,
visual, and exam-friendly.
What “returns to scale” really means
Returns to scale study how output changes when we increase all inputs by the same
proportion in the long run (when every input is variable). If Kiran doubles both labor and
ovens, does bread output exactly double, more than double, or less than double?
• Definition: Returns to scale describe the proportional change in output resulting
from an equal proportional change in all inputs over the long run.
• Production function lens: Write output as Q=f(K,L) . Ask what happens to f(tK,tL)
when t>1t .
• Three possibilities:
o If f(tK,tL)>t⋅f(K,L): increasing returns to scale.
o If f(tK,tL)=t⋅f(K,L): constant returns to scale.
o If f(tK,tL)<t⋅f(K,L) : decreasing returns to scale.
• Assumptions:
o Long run: all inputs are variable.
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o Technology fixed: no sudden innovations mid-comparison.
o Proportionate scaling: inputs move together (e.g., both double).
The three types of returns to scale
• Increasing returns to scale (IRS): Output rises by a greater percentage than inputs.
o Example intuition: Double bakers and ovens, and—thanks to specialization
and better coordination—output rises 2.5×.
o Label: More-than-proportional output.
• Constant returns to scale (CRS): Output rises by exactly the same percentage as
inputs.
o Example intuition: Double everything and get exactly twice the bread.
o Label: Proportional output.
• Decreasing returns to scale (DRS): Output rises by a smaller percentage than
inputs.
o Example intuition: Double everything but, due to crowding and complexity,
output rises only 1.6×.
o Label: Less-than-proportional output.
Why these returns happen: economies and diseconomies of scale
Think of scaling as unlocking benefits at first—then hitting growing pains.
• Technical economies:
o Bigger, better machines: Large ovens reduce heat loss per loaf.
o Division of labour: Bakers specialize—mixing, shaping, baking—to raise
productivity.
• Managerial economies:
o Specialized roles: Procurement, quality control, scheduling—each done by
experts.
o Learning effects: Routines improve; mistakes fall.
• Purchasing and financial economies:
o Bulk buying: Flour and sugar at lower per-unit cost.
o Cheaper finance: Larger, stable firms borrow at better rates.
• Marketing and network economies:
o Spreading fixed costs: Advertising and logistics become cheaper per unit.
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o Reputation effects: Stable demand boosts utilization.
These lead to IRS. But beyond some scale, frictions accumulate:
• Coordination and communication costs:
o Too many layers: Messages slow, errors rise.
o Scheduling complexity: Keeping ovens, deliveries, and staff aligned gets
harder.
• Bureaucratic drag:
o Rules over flexibility: Approvals delay action.
o Overhead grows: Managers of managers add cost.
• Resource congestion:
o Space limits: Workers crowd ovens; queues form.
o Local input constraints: Skilled labor or quality suppliers become scarce.
These create DRS. In between, many firms pass through CRS—a “just right” zone where
scale neither helps nor hurts proportionally.
Measuring returns to scale (with simple math and a story check)
There are several clean ways to measure returns to scale. Each tells the same story from a
slightly different angle.
• Proportional change method:
o Idea: Increase all inputs by tt and observe the output multiple.
o Label: Compare
% 𝛥𝑄
% ∆ 𝑎𝑙𝑙 𝑖𝑛𝑝𝑢𝑡𝑠
o If a 100% input increase leads to a 150% output increase, IRS. If 100% →
100%, CRS. If 100% → 60%, DRS.
• Homogeneous (degree) test:
o Concept: If the production function is homogeneous of degree n, then
f(tK,tL)=t
n
f(K,L)
o Label:
▪ n>1n > 1: IRS
▪ n=1n = 1: CRS
▪ n<1n < 1: DRS
• Cobb–Douglas shortcut:
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o Form: Q=AK
a
L
b
.
o Label:
▪ α+β>1 > 1: IRS
▪ α+β=1 = 1: CRS
▪ α+β<1 < 1: DRS
• Elasticity of scale (scale elasticity):
o Definition: The percentage change in output resulting from a 1%
equiproportionate change in all inputs.
o Label:
▪ Es>1: IRS
▪ Es=1: CRS
▪ Es<1: DRS
o For Cobb–Douglas, Es=α+β.
• Tiny numeric example:
o Setup: Start with K=10, L=10, output Q=100 Double inputs to K=20K = 20,
L=20L = 20.
o Case 1 (IRS): New Q=260Q = 260 → more than double.
o Case 2 (CRS): New Q=200Q = 200 → exactly double.
o Case 3 (DRS): New Q=160Q = 160 → less than double.
• Graphical representation (isoquants):
o Indifference-like curves for production: An isoquant shows all KK-LL
combinations yielding the same QQ.
o Expansion path: The locus of cost-minimizing input mixes as the firm scales
up.
o Label:
▪ Isoquants get “closer” as you move away from the origin → IRS (each
new output level needs relatively fewer extra inputs).
▪ Isoquants evenly spaced → CRS.
▪ Isoquants get “farther apart” → DRS.
Story check: Kiran doubles bakers and ovens. In her first big kitchen, specialized roles, bulk
buying, and better ovens click—her output rises more than double (IRS). As she turns into a
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large plant with multiple departments, coordination drags, space tightens, and supervision
costs swell—output rises less than double (DRS). In between, there’s a comfortable plateau
(CRS).
Don’t confuse it with the law of variable proportions
It’s easy to mix up short-run and long-run ideas, so here’s a quick distinction to keep you
sharp.
• Time horizon:
o Law of variable proportions: Short run—only one input varies (e.g., more
labor with fixed capital).
o Returns to scale: Long run—all inputs vary together.
• Cause of diminishing returns:
o Variable proportions: Crowding around a fixed input (add more workers to
the same oven).
o Returns to scale: Coordination complexity at very large size, not a fixed input
constraint.
• Measurement focus:
o Variable proportions: Marginal product of the variable input.
o Returns to scale: Proportional change in output when all inputs change
proportionally.
Practical implications and a gentle wrap-up
• For managers planning growth:
o Scale deliberately:
▪ Start small to exploit IRS via specialization and better tech utilization.
▪ Monitor when added layers create delays and miscommunication—an
early sign of DRS.
• For cost planning:
o Unit cost trajectory:
▪ IRS zone: Average cost tends to fall as you scale.
▪ CRS zone: Average cost stabilizes.
▪ DRS zone: Average cost begins to rise; consider decentralizing or
modularizing operations.
• For strategy:
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o Sweet spot of scale:
▪ Industries with high fixed costs (steel, airlines, software platforms)
often enjoy long stretches of IRS/CRS—go big to be efficient.
▪ Craft or customized services may hit DRS sooner—stay agile, focus on
quality niches.
• For exam answers:
o Clear structure: Define returns to scale; list IRS/CRS/DRS; explain economies
and diseconomies; show how to measure (homogeneous degree, Cobb–
Douglas, isoquants); end with the short-run vs long-run distinction.
One last image: Kiran’s journey is a curve, not a straight line. In her tiny shop, every extra
tray and task finds its place—output grows faster than inputs. In her mid-sized kitchen,
growth is steady and predictable. In the sprawling factory, whispers get lost, schedules
collide, and each extra input adds less to output. That arc—from faster-than-proportional to
proportional to less-than-proportional growth—is the law of returns to scale, told through
the life of a bakery.
When you see a firm grow, ask two questions: Are all inputs rising together? And does
output rise more, the same, or less than that? Your answer will tell you exactly which return
to scale is at work—and how to scale wisely.
6. Explain the theory of cost in short run and long run.
Ans: Costs, clocks, and choices: The short run and the long run made simple
It’s 6 a.m. in Meera’s printing shop. The presses hum, orders pile in, and a big college
festival just doubled demand for flyers. Meera can add extra workers today and pay
overtime, but she can’t magically add a new press by evening. Weeks later, when festival
season becomes a regular boom, she considers buying another press. That difference—what
you can adjust today versus what you can redesign over time—is the heart of cost theory in
the short run and the long run.
Let’s turn this into a clear map you can use in exams and in real decisions.
Short run vs long run: The time lenses of cost
• Short run: At least one input is fixed. Typically, capital (plant size, machinery) is fixed;
labor and materials are variable. Decisions are about how much to produce with the
existing setup.
• Long run: All inputs are variable. Firms can change plant size, adopt new technology,
or relocate. Decisions are about which setup to choose for a given output.
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Think: “How do I work with what I have today?” versus “What should I build for tomorrow?”
Short-run cost theory
In the short run, costs split into fixed and variable parts.
• Total Fixed Cost (TFC): Costs that don’t change with output in the short run—rent,
insurance, salaried supervisors, depreciation. Even if output is zero, TFC persists.
• Total Variable Cost (TVC): Costs that change with output—materials, hourly wages,
power, packaging.
• Total Cost (TC): TC = TFC + TVC.
From these, we derive per-unit (average) and incremental (marginal) costs:
• Average Fixed Cost (AFC) = TFC / Q. Falls continuously as output rises (spreads
overhead).
• Average Variable Cost (AVC) = TVC / Q. Typically U-shaped due to increasing then
diminishing returns.
• Average Cost (AC) or ATC = TC / Q = AFC + AVC. U-shaped because falling AFC meets
rising AVC.
• Marginal Cost (MC) = ΔTC / ΔQ (or ΔTVC / ΔQ). MC first falls (specialization) then
rises (diminishing marginal returns).
Why the U-shapes?
• At low output, workers and machines aren’t fully utilized—specialization raises
efficiency, driving AVC and MC down.
• Beyond a point, with fixed plant, extra units crowd the process—diminishing
marginal product makes MC and then AVC rise.
Key relationships (great for diagrams and explanations):
• MC cuts AVC and AC at their minimum points.
• When MC < AC, AC falls; when MC > AC, AC rises.
• AFC always declines but never hits zero.
A day in Meera’s shop:
• Early morning: idle time is reduced, teams coordinate better—MC falls.
• Midday rush: presses are fully loaded; adding another worker yields little extra
output—MC climbs.
• Her AC is lowest at the output where MC intersects AC.
Shutdown and breakeven (decision rules):
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• Price (P) ≥ minimum AVC: Continue producing in the short run to cover variable
costs and some fixed costs.
• P < minimum AVC: Shut down immediately—each unit adds loss beyond fixed costs.
• P = AC at its minimum: Long-run normal profit benchmark (but that’s a long-run idea,
used as a reference).
Long-run cost theory
In the long run, the firm can choose the most efficient plant for each output level. No fixed
inputs: all costs are variable, and every short-run AC curve (SRAC) corresponds to a
particular plant size.
• The Long-Run Average Cost (LRAC) curve is the “envelope” of many SRACs—the
lower bound through their minimum regions.
• The Long-Run Marginal Cost (LRMC) curve intersects LRAC at its minimum.
Typical LRAC shape:
• Downward-sloping segment: Economies of scale—average cost falls as output rises.
• Flat segment: Constant returns to scale—AC stable across a range.
• Upward-sloping segment: Diseconomies of scale—coordination complexity makes AC
rise.
Sources of economies of scale (why LRAC falls initially):
• Technical: Larger, more efficient machines; better process integration.
• Managerial: Specialization of roles; improved control systems.
• Purchasing/Financial: Bulk buying discounts; cheaper credit.
• Marketing/Distribution: Spreading fixed promotional and logistics costs.
• Learning curve: Cumulative experience reduces waste and time.
Sources of diseconomies (why LRAC rises later):
• Coordination overhead: More layers, slower decisions.
• Communication gaps: Errors and delays multiply.
• Congestion: Space and local resource constraints.
Minimum Efficient Scale (MES):
• The smallest output at which the firm hits the bottom of the LRAC (or the flat
minimum range).
• An industry with small MES relative to market demand supports many firms
(competitive).
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• Large MES relative to demand tends toward concentrated markets.
Plant switching intuition:
• If Meera plans to produce more every season, she chooses a bigger plant (shifts to a
lower SRAC suited for that output). If demand falls, a smaller plant becomes optimal.
Connecting short run and long run
• In the long run, the firm picks the SRAC curve that minimizes cost at the planned
output—this point lies where SRAC is tangent to LRAC.
• Producing far left or right on a given SRAC is costly in the long run; better to adjust
plant size and return to a tangency point.
Graph picture (describe for exams):
• Draw a family of U-shaped SRAC curves (SRAC₁, SRAC₂, SRAC₃…) stacked from left to
right.
• Sketch a smooth LRAC touching the bottoms/left slopes of these SRACs—like a
scalloped envelope.
• Mark LRMC cutting LRAC at its lowest point.
Short-run vs long-run marginal cost
• SRMC reflects the extra cost of one more unit with fixed plant—steep rise after
capacity.
• LRMC reflects the extra cost when the firm can adjust all inputs—smoother, and it
intersects LRAC at its minimum.
Relationship tips:
• Where LRAC falls, LRMC < LRAC.
• Where LRAC rises, LRMC > LRAC.
• They are equal at LRAC’s minimum.
A quick numerical feel (without heavy math)
Imagine SRAC at 1,000 flyers/day has AC = ₹2.80. If Meera pushes to 1,300 on the same
plant, AC jumps to ₹3.30 (overtime, errors). A larger plant designed for 1,300 has AC =
₹2.70. Short run, she can squeeze output but pays more per unit; long run, she retools to
the plant whose SRAC is tangent to LRAC at 1,300 and saves cost.
Common exam pitfalls (and how to avoid them)
• Mixing short-run diminishing returns with long-run diseconomies:
o Short run: diminishing marginal product because capital is fixed.
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o Long run: rising AC due to scale/coordination issues, not a fixed factor.
• Drawing LRAC below all SRACs:
o LRAC is an envelope; it’s never above the tangency points but can be equal at
those points.
• Forgetting the shutdown rule and the MC–AC relationships:
o Always state MC cuts AVC and AC at minima; tie shutdown to min AVC.
• Ignoring MES and industry structure implications:
o Mention how MES shapes the number of firms and competition.
The takeaway story
When demand spikes today, Meera hires extra hands and pays overtime—short-run choices
on a fixed press, where MC rises fast after capacity. When high demand becomes the new
normal, she invests in another press—long-run redesign of her cost structure. Short-run
costs tell her how to stretch what she has; long-run costs tell her what to build next. Master
both, and you can run a shop—or an exam answer—with clarity and confidence.
SECTION-D
7. Discuss the equilibrium of industry under perfect competition in the short run and long
run.
Ans: Dawn at the grain bazaar
Before sunrise, a quiet grain bazaar begins to hum. Dozens of tiny stalls open: each farmer
unloads sacks of wheat, checks the day’s going price on a chalkboard, and decides how
much to sell. None of them can sway the price alone; each is too small. Buyers—millers,
shopkeepers, households—start bidding with full knowledge that if one stall runs out, the
next will sell at the same price. That calm, almost automatic dance of many small sellers and
many small buyers meeting at a single market price is the heartbeat of perfect competition.
Our job is to understand how this market—an “industry”—finds its balance in the short run
and how it settles into a deeper, long-run calm.
The setting: What “perfect competition” really means
• Atomic participants: Many buyers and sellers; each firm is a price taker, not a price
maker.
• Homogeneous product: No brand differences; one unit is indistinguishable from
another.
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• Free entry and exit (long run): Firms can join or leave the industry without special
barriers.
• Perfect information: Buyers and sellers know prices and technology.
• No externalities or transaction frictions: Private decisions reflect true social costs
and benefits.
With these in place, the market decides the price; each firm simply chooses how much to
produce at that price.
Short run equilibrium of the industry
In the short run, some inputs are fixed (like plant size), so firms cannot freely scale up or
down the capacity itself—they only adjust how intensively they use it.
How the industry price is determined
• Market demand: Downward-sloping curve aggregating all buyers.
• Industry supply (short run): The horizontal sum of each firm’s marginal cost curve
above its average variable cost. At any given price, each firm supplies where its
short-run marginal cost (SMC) equals price, as long as it covers variable costs.
• Equilibrium price and quantity: The intersection of the market demand curve and
the short-run industry supply curve pins down the market price PSRP^{SR} and total
quantity QSRQ^{SR}. No single firm sets this; the market does.
How a price-taking firm behaves at that price
• Decision rule: A competitive firm chooses output where
provided marginal cost is rising at that point.
• Shutdown condition: In the short run, the firm produces only if it covers variable
costs:
• Profit or loss in the short run: Profit is
If P>ACP > AC at the chosen output, the firm earns supernormal profit; if AVC≤P<ACAVC \le
P < AC, it covers variable costs but incurs a loss smaller than fixed costs; if P<AVCP < AVC, it
shuts down to avoid larger losses.
What “industry equilibrium” means in the short run
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• Fixed number of firms: Because entry and exit take time, the number of firms is
fixed.
• Market clears: At the equilibrium price, the quantity that existing firms collectively
want to supply equals the quantity buyers want to purchase.
• Diverse firm fortunes: Some firms may be making profits, others breaking even,
others taking losses—yet the market as a whole is in balance at that price-quantity
pair.
Think of the bazaar at 10 a.m.: today’s price is set where total sacks demanded match total
sacks supplied from the existing stalls. A highly efficient farmer may earn a tidy profit; a less
efficient one may barely cover costs—but the bazaar itself is in short-run equilibrium.
Short run shocks and adjustment
• Demand surge: If buyers suddenly want more, the demand curve shifts right, raising
price. Each firm slides up its SMC and produces more; total industry output rises.
Some firms now earn supernormal profits.
• Demand slump: If demand falls, price falls. Firms reduce output; some produce at a
loss but keep operating if P≥AVCP \ge AVC. If PP dips below AVC\min AVC, the least
efficient firms shut down temporarily.
• Cost shocks: A rise in variable input prices shifts each firm’s SMC and AVC upward,
reducing supply and raising market price; the reverse holds for cost reductions.
These responses are “short run” because the number of firms and plant sizes are
unchanged. The real transformation begins when firms can enter or leave.
Long run equilibrium of the industry
In the long run, all inputs are variable, and firms can enter or exit freely. Plant size can be
optimized. This unlocks the deeper equilibrium.
Core long-run conditions
• Zero economic profit (normal profit): Entry erodes positive profits; exit eliminates
sustained losses. Equilibrium requires
where LACLAC is the long-run average cost. At this point, firms earn just enough to cover all
explicit and implicit costs (including a normal return to entrepreneurship).
• Firm’s output choice: Each firm produces where
with MCMC the long-run marginal cost at the cost-minimizing scale.
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• Efficiencies achieved:
o Productive efficiency: Producing at LAC\min LAC means no waste; the firm
operates at the lowest feasible unit cost.
o Allocative efficiency: Because P=MCP = MC, the value buyers place on the
last unit equals the cost of resources used to make it.
How the long run industry supply is shaped
The long-run industry supply curve (LRIS) connects equilibrium prices and quantities across
different industry scales once entry/exit and plant-size choices have fully adjusted. Its slope
depends on how input markets respond as the industry expands:
• Constant-cost industry: Input prices don’t change when the industry grows. New
entrants can adopt the same technology and face the same input costs. LRIS is
horizontal at P=LACP = \min LAC. A permanent demand increase raises quantity but
price returns to LAC\min LAC after entry expands supply.
• Increasing-cost industry: Expansion bids up input prices or forces firms onto less
favorable sites. LRIS slopes upward. A permanent demand increase leads to a higher
long-run price to cover higher costs.
• Decreasing-cost industry: Expansion brings external economies (e.g., better supplier
networks), pushing costs down. LRIS slopes downward; long-run price falls as the
industry scales.
Across all three, the destination is the same logic: entry/exit continue until firms earn zero
economic profit and produce at their cost-minimizing scale.
A brief tale of lemonade and the power of entry
One hot summer, a neighborhood sees a single lemonade stand charging ₹30 a cup and
making fat profits. Kids walking by notice the steady line and set up their own stands the
next day. With three, then five stands, the price drifts down as customers have more
options. Each new stand splits demand, and competition forces every seller to trim costs
and match the going price. By week’s end, the price settles around the cost of lemons,
sugar, cups, and a fair allowance for the kids’ time—no more, no less. Some kids leave (it
wasn’t as lucrative as it looked), and those who stay sell exactly the amount that makes
their last cup’s cost equal the price. That calm end-state—no one eager to enter, no one
forced to exit—is the long-run competitive equilibrium.
Translate that back to the industry:
• When profits exist, entry shifts industry supply right, lowering price.
• When losses exist, exit shifts industry supply left, raising price.
• The process stops only when P=minLACP = \min LAC, so no firm has an incentive to
come or go.
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Short run versus long run: Clear contrasts and takeaways
• Nature of adjustment: In the short run, firms vary output with existing plants; in the
long run, they also adjust plant size and firms can enter or exit.
• Price and profits: Short-run price can sit above or below average cost, allowing
supernormal profits or losses. Long-run price settles so that firms earn normal profit:
P=LACP = \ LAC.
• Firm condition: Short run: produce where P=MCP = MC if P≥AVCP \AVC; shut down if
P<AVCP < \ AVC. Long run: produce where P=MCP = MC and P=ACP =LAC.
• Industry supply: Short-run supply is the horizontal sum of firms’ SMC above
AVCAVC. Long-run supply reflects entry/exit and can be horizontal, upward, or
downward sloping depending on cost conditions.
• Efficiency: Only in the long run under perfect competition do we jointly achieve
productive efficiency (P=LACP = \ LAC) and allocative efficiency (P=MCP = MC).
Putting it all together
Return to the grain bazaar. In the short run, today’s price emerges where the total wheat
buyers want equals what the existing farmers, given their current fields and equipment, are
willing to supply. Some farmers do well; some scrape by; a few shut their stalls for the day if
the price drops too low. Over months and seasons, however, the deeper forces play out:
new farmers enter if the market has been rewarding; marginal ones switch crops or exit if it
hasn’t. Input markets adjust; technologies diffuse. Eventually, the bazaar settles into a
rhythm where the going price matches the lowest sustainable unit cost, each farmer
operates at an efficient scale, and no one has a compelling reason to join or to leave. That is
the industry’s equilibrium in perfect competition: stable, self-correcting, and quietly
efficient in the long run—yet always responsive in the short run to the winds of demand and
cost.
8. Explain the concept of monopoly and discuss the price determination under monopoly.
Ans: The lone bridge over the river
Imagine a bustling town split by a wide river. For years, people rowed across or waited for
ferries—until one company built the only bridge. Now, every school bus, trader, and traveler
depends on that single crossing. The bridge owner doesn’t face rival tolls a mile upstream;
they face all the town’s demand for crossing. They can set the toll high or low, knowing that
fewer people cross when the toll rises and more come when it falls. That is the essence of
monopoly: one seller, facing the entire market, choosing the price by choosing how much to
serve.
What a monopoly is
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• Single seller with market power: One firm supplies the entire market for a product
with no close substitutes. Buyers cannot easily switch.
• Barriers to entry: Other firms are kept out by strong obstacles that protect the
monopolist’s position.
• Price maker, not price taker: The monopolist faces the market demand curve and
understands that its own output choice affects the market price.
• Unique demand frontier: Because the firm is the market, its demand curve is the
market’s own downward-sloping demand, not a flat line.
Why monopolies arise
• Legal protection: Patents, copyrights, trademarks, licenses, or exclusive franchises
can grant a legal monopoly.
• Control of key resources: Ownership of a rare input (a unique mineral deposit, a
landing slot, or a platform standard).
• Natural monopoly and economies of scale: When average cost falls over a very large
range of output, one big firm can serve the market cheaper than many small ones.
Think of utilities where duplicating networks is wasteful.
• Network effects: The product becomes more valuable as more people use it, tipping
markets toward a single dominant provider.
• Strategic barriers: Aggressive tactics like limit pricing, exclusive contracts, or high
fixed costs that deter entrants.
The monopolist’s demand and revenue
Unlike a competitive firm that takes price as given, a monopolist knows price depends on
quantity sold.
• Downward-sloping demand and marginal revenue: To sell one more unit, the
monopolist must lower price, not just for the last unit but for all units. This makes
marginal revenue (MR) fall faster than price. At any positive price elasticity, MR<PMR
< P.
• Revenue mechanics: Total revenue first rises as quantity increases, then—if the firm
pushes price too low—can fall when the price cut erodes earnings more than the
extra units help.
• Elasticity matters: When demand is elastic, lowering price raises revenue; when
inelastic, lowering price cuts revenue. Monopoly pricing lives in the elastic region for
profit maximization.
How price is determined under monopoly
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The bridge owner doesn’t consult a “market price”; they compute it from demand and their
costs. The rule is simple but powerful.
• Step 1 — Choose the profit maximizing output: Set output where marginal revenue
equals marginal cost.
MR=MC
At this quantity, producing an extra unit would add as much to cost as to revenue, so
expanding or contracting would reduce profit.
• Step 2 — Read the price off the demand curve: After picking the optimal quantity Q
∗
,
charge the highest price consumers are willing to pay for that quantity.
P
∗
=D(Q
∗
)
The monopolist does not set P=MCP = MC. It sets quantity by MR=MCMR = MC and finds
price from demand.
• Step 3 — Compute profit: Profit equals price minus average cost times quantity.
π=(P
∗
−AC
∗
)⋅Q
∗
If P∗>AC∗P
*
> AC
*
, the monopolist earns positive economic profit. If the best feasible PP is
below average variable cost at all quantities, it shuts down in the short run.
• No supply curve: There is no well-defined monopoly supply curve. Because the
chosen quantity depends on both demand and the MR=MCMR = MC intersection,
the same cost curve can yield different quantities at different points of the demand
curve. A single curve mapping price to quantity independent of demand does not
exist.
• Graph intuition without the graph: Picture a downward-sloping demand curve.
Below it lies the marginal revenue curve, steeper and crossing the quantity axis
sooner. The marginal cost curve rises with output. Where MR meets MC, drop a
vertical line to the quantity axis to get Q
∗
, then go up to the demand curve to read
off P
∗
.
Markups and elasticity
Why does the monopolist price above marginal cost? The answer is in elasticity. The less
sensitive buyers are to price, the bigger the gap the monopolist can sustain between price
and marginal cost.
• Lerner index of market power:
where Ed is the price elasticity of demand (a negative number). With more elastic demand
in magnitude (say −5-5), the markup is small; with less elastic demand (say −1.25-1.25), the
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markup is larger. This formula shows the monopolist never optimally prices in the inelastic
region; if demand were inelastic, raising price would both increase revenue and reduce
output cost, boosting profit further.
• Implication for policy and strategy: Anything that makes demand more elastic—
better substitutes, informed consumers—presses price closer to marginal cost.
Short run and long run for a monopoly
• Short run flexibility: The monopolist chooses Q by MR=MC given its existing plant. It
may earn positive profits, break even, or incur losses. If at every feasible quantity the
price falls below average variable cost, it shuts down temporarily.
• Long run persistence: With barriers to entry intact, the monopolist can maintain
economic profits over time. It adjusts plant size to minimize long run average cost at
its chosen Q. Unlike perfect competition, entry does not erode profit unless the
barrier weakens.
• Natural monopoly nuance: When long run average cost declines over the whole
demand range (e.g., water or electricity networks), the efficient scale is so large that
one firm is cheapest. Left unregulated, such a monopolist sets MR=MC and prices
above MC, creating a wedge between price and cost.
Welfare effects and the missing triangles
Monopoly reshapes value creation and distribution.
• Consumer versus producer surplus: Compared to competitive pricing, a monopolist
restricts output and raises price. Consumers lose surplus, the monopolist gains some
of it as profit.
• Deadweight loss: Some trades that would have happened at a competitive price
P=MC no longer occur. The value buyers place on those forgone units exceeds their
marginal cost, but monopoly pricing blocks them. That lost net benefit is the
deadweight loss.
• Dynamic considerations: Some monopolies arise from innovation and can accelerate
research by promising temporary profits; others are entrenched by regulation or
network effects. The welfare verdict can hinge on how the monopoly came to be and
how long it lasts.
Price discrimination and multiple prices
If the bridge owner can charge different tolls to different travellers, the story complicates—
and often intensifies—output and revenue.
• First degree price discrimination: Charge each buyer exactly their maximum
willingness to pay for each unit. In theory, quantity expands to where P=MC,
eliminating deadweight loss but transferring all surplus to the monopolist.
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• Second degree price discrimination: Use menus or nonlinear prices (block tariffs,
quantity discounts) so that heavy users face lower per unit prices than light users.
Firms design bundles to make each buyer self-select.
• Third degree price discrimination: Segment groups with different elasticities
(students versus business travellers) and set a higher price where demand is less
elastic and a lower price where it is more elastic.
• Effect on welfare: Discrimination typically raises output compared to a single price
monopoly. Whether society benefits overall depends on how the extra output
compares to the redistribution of surplus.
A short tale of two ferries
Before the bridge, two small ferries competed, keeping fares close to the cost of fuel and
crew. After the bridge opened, ferries shut down because the bridge was faster and more
reliable. The bridge owner became the only option. At first, tolls were modest, but as
commuters grew dependent, the owner raised prices. Some travelers carpooled or shifted
routes, softening demand; others had no good alternative. Sensing that students and
pensioners were more price sensitive, the owner introduced discounted passes while
keeping peak-hour tolls high. Output rose with the discounts, profits increased, and yet
certain would-be travelers were still priced out. Regulators eventually stepped in, nudging
tolls closer to cost during off-peak hours and capping peaks to curb deadweight loss. The
bridge remained one, but its pricing reflected the push and pull of demand elasticity, cost,
and public oversight.
Regulation and remedies
Because monopoly can create deadweight loss and redistribute surplus, societies often
respond.
• Marginal cost pricing: Set P=MC to achieve allocative efficiency. If average cost
exceeds marginal cost (as in natural monopoly), this can require subsidies because
the firm would otherwise incur losses.
• Average cost pricing: Set P=AC so the firm breaks even. This ensures viability but
leaves price above marginal cost, with some residual inefficiency.
• Antitrust and market design: Breakups, bans on exclusionary contracts, or
facilitating entry by lowering switching costs and enabling interoperability can
reduce market power without price regulation.
The core insight
A monopoly is a single seller facing the market’s demand. It chooses quantity so that
MR=MC and then sets the highest price consistent with that quantity, yielding a price above
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marginal cost whenever demand is not perfectly elastic. The size of the markup depends on
elasticity; the persistence of profit depends on barriers to entry; and the social cost appears
as deadweight loss from restricted output. Bring in discrimination or regulation, and the
pricing landscape changes, but the central logic—the firm writes the price by writing the
quantity—remains the quiet engine under the lone bridge.
“This paper has been carefully prepared for educational purposes. If you notice any mistakes or
have suggestions, feel free to share your feedback.”
