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GNDU Question Paper-2024
BBA 1
st
Semester
Managerial Economics
Time Allowed: Three Hours Max. Marks: 100
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. What do you mean by demand? Explain the law of demand with its limitations in detail.
2. Critically explain the Law of Diminishing Marginal Utility.
SECTION-B
3. Discuss the properties of indifference curves and consumer's equilibrium with the help of
indifference curves.
4. Describe the concept of supply and discuss the factors affecting the supply.
SECTION-C
5. Explain the Law of Returns to Scale and its implications.
6. Explain the theory of cost in the short and long run in detail.
SECTION-D
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7. What is monopolistic competition? Explain the price and output determination under
monopolistic competition in the short and long run.
8. What is perfect competition? Discuss the equilibrium of firm under perfect
competition in detail.
GNDU Answer Paper-2024
BBA 1
st
Semester
Managerial Economics
Time Allowed: Three Hours Max. Marks: 100
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. What do you mean by demand? Explain the law of demand with its limitations in detail.
Ans: A Story of Want, Willingness, and Wallets — Understanding Demand
Imagine a small town named Marketville, where people come every morning to buy fruits,
clothes, and other goods. There’s a cheerful fruit seller named Ravi, who sells fresh
mangoes every summer. Now, the story of “demand” begins with Ravi and his customers.
When Ravi sells mangoes at ₹100 per dozen, people buy fewer mangoes — maybe just one
or two dozens. But when he lowers the price to ₹60, suddenly his stall is surrounded by
customers! Everyone wants to buy mangoes — some for juice, some for jam, and some just
to enjoy the sweetness.
What changed? The price went down, and the demand went up.
This simple situation captures the heart of one of the most important concepts in economics
— the Law of Demand. But before we dive into that, let’s understand what exactly demand
means.
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Meaning of Demand
In everyday language, “demand” simply means a desire to have something. But in
economics, the word has a deeper meaning.
Economists say demand is not just a desire, it is a desire backed by willingness and ability
to pay.
For example:
If you wish to buy an iPhone but don’t have enough money, that’s just a desire. But if you
not only want it but also have the money and are ready to pay the price — that’s demand.
So, in simple words:
Demand refers to the quantity of a commodity that a consumer is willing and able to buy
at a given price during a given period of time.
Three important parts must exist together for demand to be real:
1. Desire for the commodity.
2. Ability to pay for it.
3. Willingness to pay the price.
If any one of these is missing, there is no real demand in the economic sense.
The Law of Demand — A Golden Rule of Market Behavior
Now, let’s return to Ravi’s mango shop. When he raised his prices, fewer people bought
mangoes. When he reduced the price, sales shot up.
This is exactly what economists have observed for centuries — when price falls, people buy
more; when price rises, people buy less.
This natural behavior of consumers is known as the Law of Demand.
Definition of the Law of Demand
The Law of Demand states that:
Other things being equal (ceteris paribus), the quantity demanded of a commodity increases
when its price falls and decreases when its price rises.
In simpler words:
Price and demand move in opposite directions.
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• When price goes up, demand goes down.
• When price goes down, demand goes up.
That’s why we say the law of demand shows an inverse relationship between price and
quantity demanded.
Example to Understand Better
Let’s take a simple table to make this more visual:
Price of Mangoes (₹ per dozen)
Quantity Demanded (dozens)
100
2
80
3
60
5
40
7
20
10
From the table, you can see that as the price falls from ₹100 to ₹20, the number of mangoes
demanded increases from 2 to 10 dozens.
If we draw this data on a graph, we get a downward-sloping demand curve, showing the
inverse relationship between price and demand.
Reasons Behind the Law of Demand
Why do people buy more when prices fall? There are several simple and logical reasons:
1. Substitution Effect
When the price of a commodity falls, people substitute it for other, more expensive
goods. For example, if mangoes become cheaper than apples, people buy more
mangoes instead of apples.
2. Income Effect
When price falls, people’s real income (purchasing power) increases. They feel richer
and can afford to buy more of the same good.
3. Law of Diminishing Marginal Utility
As we consume more units of a good, the satisfaction (utility) from each additional
unit decreases. Therefore, we are willing to buy additional units only at a lower
price.
4. New Consumers Enter the Market
When prices fall, even people who previously couldn’t afford the good now start
buying it, thus increasing total demand.
5. Multiple Uses of a Commodity
Some goods have many uses. For example, electricity is used for lighting, heating,
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and machinery. When its price falls, people use it for more purposes, increasing
demand.
Assumptions of the Law of Demand
Economists always say “other things being equal”. This means the law will work only when
certain factors remain unchanged, such as:
• Consumer’s income
• Price of related goods
• Tastes and preferences
• Expectations about future prices
If any of these change, the law may not hold true.
Limitations of the Law of Demand
Though the law of demand is one of the most trusted laws in economics, there are
situations where it does not apply. Let’s understand these exceptions in a lively way:
1. Giffen Goods — The Poor Man’s Paradox
There are some inferior goods (named after economist Sir Robert Giffen) where demand
actually increases when prices rise.
Example: In poor households, if the price of a staple food like bajra or rice rises, they may
still buy more of it because they cannot afford costly alternatives. So, they cut down on
other items and consume more of the staple.
2. Prestige or Luxury Goods
For some goods, higher prices increase their charm. Think of diamond rings, luxury cars, or
designer clothes. People buy them not just for use, but to show status. If the price falls too
much, they may lose their prestige value.
3. Expectation of Future Price Changes
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If people expect prices to rise in the future, they might buy more even at higher current
prices. For example, if people expect petrol prices to increase next week, they may fill their
tanks today, even if prices are high.
4. Ignorance of the Consumer
Sometimes, consumers mistakenly believe that a higher-priced product must be of better
quality. Due to this misunderstanding, they may buy more at higher prices.
5. Necessities of Life
Certain goods, such as salt, medicines, or milk, are essential. Their demand remains constant
regardless of price changes. Even if the price of salt doubles, people cannot reduce its
consumption significantly.
6. Emergency or Panic Situations
During wars, pandemics, or natural disasters, people buy goods in panic, even at very high
prices. For instance, during the COVID-19 pandemic, people purchased sanitizers and masks
regardless of their cost.
Conclusion
The story of demand is essentially the story of human behavior — how people react to
prices, income, and desires. The Law of Demand captures this beautifully by showing that
price and demand move in opposite directions under normal conditions.
Yet, economics is about real life, and real life always has exceptions. That’s why the law of
demand, though powerful, is not absolute. Giffen goods, prestige items, and human
emotions sometimes bend the rule.
Still, this law remains one of the cornerstones of economics — guiding producers in setting
prices, helping governments frame policies, and allowing consumers to make wiser choices.
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2. Critically explain the Law of Diminishing Marginal Utility.
Ans: Imagine you’ve just come home after a long, tiring day. You’re extremely thirsty.
Someone offers you a glass of cold water. You drink it eagerly, and it feels heavenly. A
second glass is offered—you drink again, and it still feels good, but not as satisfying as the
first. By the third glass, you’re starting to feel full. By the fourth, you’re uncomfortable. If
someone forces you to drink a fifth, you might even feel sick.
This simple everyday experience captures the essence of one of the most fundamental
principles of economics: the Law of Diminishing Marginal Utility. It explains why our
satisfaction (utility) decreases as we consume more and more of the same good.
Let’s now explore this law in detail, its assumptions, its criticisms, and its real-world
applications—step by step, like a story unfolding.
Meaning of the Law
The Law of Diminishing Marginal Utility (DMU) states:
As a consumer consumes more and more units of a commodity, the additional satisfaction
(marginal utility) derived from each successive unit decreases, eventually reaching zero or
even becoming negative.
• Utility means satisfaction or pleasure derived from consuming a good or service.
• Marginal Utility (MU) is the extra satisfaction gained from consuming one more unit.
In simple words: The first bite of pizza tastes amazing, the second is good, the third is
okay, and by the fourth or fifth, you don’t enjoy it as much.
Historical Background
The law was first introduced by H.H. Gossen, a German economist, in the 19th century. It is
sometimes called Gossen’s First Law of Consumption. Later, economists like Alfred Marshall
popularized it and made it a cornerstone of microeconomics.
Assumptions of the Law
For the law to hold true, certain conditions must exist:
1. Rational Consumer: The consumer aims to maximize satisfaction.
2. Homogeneous Units: All units of the commodity are identical in size, quality, and
taste.
3. Continuous Consumption: Units are consumed one after another without long gaps.
4. Constant Tastes: Consumer preferences remain unchanged during consumption.
5. Reasonable Quantity: The commodity is consumed in practical amounts, not in tiny
or huge extremes.
6. No Change in Related Goods: Prices and availability of substitutes remain constant.
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Illustration with Example
Suppose a person eats mangoes. The table below shows how utility behaves:
Mango (Unit)
Total Utility (TU)
Marginal Utility (MU)
1st
20
20
2nd
38
18
3rd
54
16
4th
66
12
5th
74
8
6th
78
4
7th
78
0
8th
76
-2
• At first, MU is high (20).
• With each mango, MU falls.
• At the 7th mango, MU = 0 (no extra satisfaction).
• At the 8th mango, MU becomes negative (disutility).
Graphical Representation
This shows the direct relationship between total utility and marginal utility.
Importance of the Law
1. Basis of Demand Curve:
o As MU decreases, consumers are willing to pay less for additional units.
o This explains why the demand curve slopes downward.
2. Consumer’s Equilibrium:
o A consumer allocates income across goods so that MU per rupee spent is
equal for all goods.
3. Pricing of Goods:
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o Sellers know that consumers won’t pay the same price for every unit.
Discounts and bulk offers are based on this principle.
4. Public Finance:
o Justifies progressive taxation: the utility of money decreases as income rises,
so the rich can pay higher taxes without much loss of satisfaction.
5. Policy Making:
o Helps governments design welfare schemes, subsidies, and rationing systems.
Critical Evaluation of the Law
While the law is powerful, it is not without limitations. Let’s critically examine it.
Strengths
• Matches real-life experiences (food, drinks, entertainment).
• Explains consumer behavior and demand.
• Provides foundation for many economic theories.
Criticisms
1. Utility Cannot Be Measured Exactly:
o The law assumes utility can be measured numerically (20 utils, 18 utils, etc.),
but in reality, satisfaction is subjective.
2. Not Always Continuous Consumption:
o If you eat one ice cream today and another tomorrow, the second may give
equal or more satisfaction.
3. Changing Tastes and Preferences:
o Human desires are not constant. Sometimes, repeated consumption
increases satisfaction (e.g., music, hobbies).
4. Quality Variation:
o If the second unit is of better quality (e.g., a bigger slice of cake), it may give
more utility than the first.
5. Applies Only to Homogeneous Goods:
o In real life, goods are rarely identical.
6. Exceptions:
o Collectibles (stamps, coins) may give increasing satisfaction.
o Addictive goods (alcohol, drugs) may not follow the law.
Real-Life Applications
1. Marketing and Sales:
o “Buy one, get one free” offers recognize that customers value the first unit
more than the second.
2. Entertainment Industry:
o Subscription models (Netflix, Spotify) spread consumption over time to avoid
diminishing utility.
3. Food Industry:
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o Restaurants serve smaller portions, knowing that satisfaction decreases with
each bite.
4. Public Policy:
o Welfare schemes provide minimum essential goods to maximize social
satisfaction.
Conclusion
The Law of Diminishing Marginal Utility is one of the simplest yet most powerful ideas in
economics. It explains why we don’t keep consuming endlessly, why demand curves slope
downward, and why pricing strategies, taxation, and welfare policies work the way they do.
But it is not perfect. It assumes measurable utility, constant tastes, and identical goods—
conditions that rarely exist in real life. Still, as a guiding principle, it captures a universal
truth: the more we have of something, the less we value each additional unit.
So, whether it’s mangoes, money, or movies, the law reminds us of a basic human tendency:
our satisfaction diminishes with repetition. And that simple truth shapes not just our daily
choices, but entire economic systems.
SECTION-B
3. Discuss the properties of indifference curves and consumer's equilibrium with the help of
indifference curves.
Ans: Understanding the Concept through a Story: The Journey of a Smart Consumer
Let’s begin this topic not with graphs or formulas, but with a story — the story of Riya, a
young woman who loves chocolates and coffee. She has a fixed pocket money each week,
and she wants to enjoy both as much as possible. But here’s the twist — if she buys more
chocolates, she has to buy less coffee, and if she spends more on coffee, she has to cut
down on chocolates.
Now the question is: How does Riya decide the perfect combination of chocolates and coffee
that gives her the maximum satisfaction?
To understand this, economists developed a very useful tool — the Indifference Curve.
1. What is an Indifference Curve?
An Indifference Curve (IC) is a graphical representation of all the different combinations of
two goods that give equal satisfaction to a consumer.
In Riya’s case, one point may represent 2 coffees and 3 chocolates, and another point may
represent 3 coffees and 2 chocolates. Though the quantities differ, she feels equally happy
with either combination.
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So, each point on the indifference curve shows equal utility (or satisfaction). The curve
itself is like Riya’s “happiness map” — she doesn’t prefer one point over another on the
same curve, because both make her equally satisfied.
2. The Meaning Behind Indifference Curves
An indifference curve helps us understand a simple but powerful truth of human behavior:
People always face choices. Resources (like money) are limited, but wants are unlimited.
Therefore, every time we buy more of one thing, we have to give up some of another.
This sacrifice is known as the Marginal Rate of Substitution (MRS) — that is, how many
units of one good a person is willing to give up to get one more unit of another, without
changing their overall satisfaction.
For example, Riya might be willing to give up 1 chocolate for 1 extra cup of coffee at first.
But as she keeps giving up more chocolates, she may hesitate — now she might give up only
half a chocolate for one more coffee. This shows that the willingness to substitute decreases
as one moves along the curve.
3. Properties of Indifference Curves
Now that we know what an indifference curve means, let’s explore its properties or
characteristics in a simple and visual way.
(i) Indifference Curves Slope Downward from Left to Right
The first property is that indifference curves slope downward. This happens because if Riya
wants to consume more of one good (say coffee), she must give up some of the other (say
chocolates) to stay equally satisfied.
If the curve sloped upward, it would mean Riya is getting more of both goods and still being
equally happy — which is impossible because “more of both” means higher satisfaction, not
equal satisfaction.
(ii) Indifference Curves are Convex to the Origin
This is because of the diminishing marginal rate of substitution (MRS).
In simple words, as Riya substitutes chocolates for coffee, she values each additional cup of
coffee less and less compared to chocolates. She doesn’t want to give up too many
chocolates for another coffee because variety matters to her happiness.
Therefore, the curve bends towards the origin — it’s convex (bowed inward).
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(iii) Higher Indifference Curves Represent Higher Satisfaction
Imagine three curves — IC₁, IC₂, and IC₃ — where each higher curve lies above the previous
one.
• IC₁ might represent low satisfaction (few coffees and chocolates).
• IC₂ gives more satisfaction (a better mix).
• IC₃ gives the highest satisfaction (more of both goods).
So, the further away the curve from the origin, the happier the consumer. But of course, she
can’t always reach the highest curve because her income limits her spending.
(iv) Indifference Curves Never Intersect
If two indifference curves cross each other, it would mean one point gives two different
levels of satisfaction at the same time — which is logically impossible.
So, just like two roads that never meet, indifference curves do not intersect.
(v) Indifference Curves Do Not Touch Either Axis
If a curve touched one of the axes, it would mean the consumer is consuming only one good
and none of the other. In reality, that wouldn’t give equal satisfaction because consumers
usually enjoy a mix of goods. Hence, ICs never touch the axes.
4. The Budget Line — The Consumer’s Limitation
Now, let’s bring reality into the picture. While Riya might want to reach the highest possible
indifference curve, her income is limited.
The budget line (or price line) shows all combinations of the two goods that she can afford
with her income at current prices.
For example, if coffee costs ₹50 and chocolate costs ₹25, and her total income is ₹250, she
could buy:
• 5 coffees (5 × ₹50 = ₹250), or
• 10 chocolates (10 × ₹25 = ₹250),
or a mix like 3 coffees and 4 chocolates.
This line is straight and slopes downward, because if she buys more coffee, she has less
money left for chocolates, and vice versa.
5. Consumer’s Equilibrium — The Point of Maximum Satisfaction
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Now comes the most interesting part — how does a consumer reach equilibrium?
Equilibrium means the consumer is in the best possible situation — she is spending her
limited income in such a way that she gets the highest satisfaction possible.
On a graph, this happens where the budget line is tangent to the indifference curve.
Let’s visualize this:
• The budget line represents what Riya can afford.
• The indifference curve represents what Riya likes.
• The point where both meet perfectly — that’s her consumer equilibrium.
At this point, two important things happen:
1. She is on the highest indifference curve possible within her budget.
2. Her marginal rate of substitution (MRS) between the two goods equals the price
ratio of the goods.
In equation form:
MRS (Coffee for Chocolate) = Price of Coffee / Price of Chocolate
This balance shows that the rate at which Riya is willing to trade one good for another is
exactly equal to what the market requires her to trade because of prices. If this equality
didn’t hold, she could rearrange her spending to get more satisfaction — but at equilibrium,
she can’t do any better.
6. What Happens If the Situation Changes?
Suppose Riya’s income increases — her budget line shifts upward, allowing her to reach a
higher indifference curve (more happiness!).
If prices change, the slope of her budget line also changes. For example:
• If coffee becomes cheaper, the line becomes flatter — she can afford more coffee.
• If chocolate becomes expensive, the line becomes steeper — she can afford less.
In each case, Riya’s equilibrium point will move to a new combination of goods that again
gives her maximum satisfaction under the new conditions.
7. The Human Essence Behind the Curves
Behind all these curves, graphs, and lines, there’s a beautiful logic — the study of human
choice.
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Every consumer, like Riya, faces trade-offs every single day: “Should I buy this or that?
Should I save or spend?”
Indifference curves don’t just show mathematics — they reflect human nature. They tell us
how we make decisions, balance our wants, and strive for happiness within limits.
Conclusion
To sum up, indifference curves represent the consumer’s preferences, while the budget line
represents their financial limitation. The point where both meet gives the consumer’s
equilibrium — the position of maximum satisfaction.
This concept beautifully blends psychology with economics. It shows that economics is not
just about money or numbers, but about human choices, desires, and the art of making the
best out of limited means.
Just like Riya’s story, every consumer seeks balance — between what they want and what
they can afford. And the indifference curve theory helps us understand exactly how that
balance is achieved.
4. Describe the concept of supply and discuss the factors affecting the supply.
Ans: Imagine a farmer named Raghav who owns a small piece of land in Punjab. Every
season, he decides how much wheat to bring to the market. If the price of wheat is high, he
feels encouraged to sell more. If the price is low, he might hold back some stock or switch to
another crop next season. His decision is not random—it is guided by the economic principle
of supply.
Supply is not just about how much is produced; it is about how much producers are willing
and able to bring to the market at a particular price and time. Just like Raghav, every
producer—whether a farmer, a factory owner, or a service provider—faces this decision.
And their choices collectively shape the supply in the economy.
Let’s now explore the concept of supply in detail and then discuss the various factors that
influence it.
Concept of Supply
In economics, 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 given period of time.
• It is always expressed in relation to price and time.
• For example: Saying “a farmer has 500 kg of wheat” is not supply. But saying “a
farmer is willing to sell 500 kg of wheat at ₹25 per kg this week” is supply.
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Thus, supply is not just about availability; it is about willingness to sell at a certain price
and within a certain time frame.
Law of Supply
The law of supply states that, other things being equal, the quantity supplied of a good rises
when the price rises, and falls when the price falls.
• This is because higher prices mean higher profits, encouraging producers to supply
more.
• Graphically, the supply curve slopes upward from left to right.
Factors Affecting Supply
Supply is not determined by price alone. Many other factors influence how much producers
are willing to supply. Let’s discuss them one by one, with examples.
1. Price of the Commodity
• The most direct factor.
• Higher price → higher supply (producers want more profit).
• Lower price → lower supply.
Example: If the price of sugar rises, sugar mills will increase production to earn more.
2. Cost of Production
• If costs (raw materials, wages, electricity) rise, profit margins shrink, and supply falls.
• If costs fall, supply increases.
Example: If the cost of fertilizers decreases, farmers can produce more crops at the same
cost, increasing supply.
3. Technology
• Better technology reduces production costs and increases efficiency.
• This shifts the supply curve to the right (more supply at the same price).
Example: Introduction of high-yield seeds during the Green Revolution increased
agricultural supply in India.
4. Prices of Related Goods
• Producers often have choices about what to produce.
• If the price of one product rises, producers may shift resources to that product,
reducing supply of others.
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Example: If the price of cotton rises, farmers may grow more cotton instead of wheat,
reducing wheat supply.
5. Number of Sellers in the Market
• More sellers → greater supply.
• Fewer sellers → lower supply.
Example: Entry of new smartphone companies like Xiaomi and Realme increased the supply
of affordable phones in India.
6. Government Policies (Taxes and Subsidies)
• Taxes increase costs, reducing supply.
• Subsidies reduce costs, increasing supply.
Example: Subsidies on solar panels encourage producers to supply more renewable energy
products.
7. Expectations of Future Prices
• If producers expect prices to rise in the future, they may withhold supply now.
• If they expect prices to fall, they may increase supply immediately.
Example: If gold prices are expected to rise, sellers may hold back gold today to sell later at
higher prices.
8. Natural Factors (Weather, Climate, Disasters)
• Especially important for agriculture.
• Good weather → higher supply.
• Droughts, floods, or pests → lower supply.
Example: A good monsoon increases the supply of rice in India, while drought reduces it.
9. Availability of Inputs
• If raw materials, labor, or capital are easily available, supply increases.
• Shortages reduce supply.
Example: Shortage of semiconductor chips in 2021 reduced the supply of cars and
electronics worldwide.
10. Objectives of the Firm
• If a firm aims to maximize profit, it may restrict supply to keep prices high.
• If it aims to maximize sales or market share, it may increase supply even at lower
prices.
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Example: Startups often supply products at low prices to capture market share, even if
profits are low initially.
Diagrammatic Explanation
Supply Curve: Upward sloping from left to right
Factors like technology, costs, and subsidies shift the curve right or left
Critical Insights
• Supply is not static; it changes with market conditions.
• While the law of supply shows a direct relationship between price and supply, real-
world factors like government policies, technology, and natural conditions often shift
the supply curve.
• Understanding supply is crucial for businesses (to plan production), for governments
(to design policies), and for consumers (to understand price changes).
Conclusion
The concept of supply is at the heart of economics. It tells us how much producers are
willing to bring to the market at different prices and times. But supply is not influenced by
price alone—it is shaped by costs, technology, government policies, expectations, natural
conditions, and many other factors.
Think back to Raghav, our farmer. His decision to supply wheat depends not only on today’s
price but also on fertilizer costs, weather, government subsidies, and his expectations for
the future. Multiply his decision by millions of producers across the country, and you get the
supply side of the economy.
Thus, supply is not just a number—it is a living, dynamic reflection of how producers
respond to opportunities, challenges, and incentives. And that’s what makes it one of the
most fascinating and essential concepts in economics.
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SECTION-C
5. Explain the Law of Returns to Scale and its implications.
Ans: Law of Returns to Scale and Its Implications
Imagine a small bakery in your town. At first, it has only one oven and one baker. The bakery
makes a modest number of cakes every day. Business is good, but the owner dreams bigger.
He thinks, “What if I hire more bakers and buy more ovens? I could make more cakes, satisfy
more customers, and earn more profit!”
This thought leads us directly into the fascinating world of economics and introduces one of
its most important concepts: the Law of Returns to Scale. This law is like a guiding principle
for businesses and industries, helping them understand what happens when they change
the scale of production. It explains the relationship between the amount of inputs used (like
labor, capital, machines) and the output produced when all inputs are increased
proportionally.
Understanding Returns to Scale
Let’s return to our bakery. Initially, it has:
• 1 oven
• 1 baker
Together, they make 50 cakes a day. Now, the owner decides to double everything—2
ovens and 2 bakers. What happens to cake production? Does it double to 100 cakes? Or
does it increase by more or less than double?
This is where returns to scale come in. Economists categorize the results into three types:
1. Increasing Returns to Scale (IRS)
2. Constant Returns to Scale (CRS)
3. Decreasing Returns to Scale (DRS)
1. Increasing Returns to Scale (IRS)
Suppose our bakery, after doubling the inputs, produces 120 cakes instead of 100. This
means output has increased more than proportionally compared to inputs.
Why does this happen? There are several reasons:
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• Specialization: With more bakers, each can focus on what they do best. One makes
cakes, another decorates, another manages ovens. This specialization boosts
efficiency.
• Better utilization of machines: Two ovens can now work simultaneously without
waiting, reducing idle time.
• Teamwork and coordination: With more hands on deck, tasks are completed faster.
Implication: When a business experiences increasing returns to scale, it benefits from
growth. Large-scale production reduces costs per unit and increases profits. Big industries
like automobile or electronics often enjoy IRS in their early stages.
2. Constant Returns to Scale (CRS)
Now, imagine our bakery grows further. The owner quadruples everything—4 ovens and 4
bakers. The output rises exactly fourfold to 200 cakes. Here, the increase in output is
exactly proportional to the increase in inputs.
This is called constant returns to scale. It typically occurs when a firm has reached a stable
size where all factors are perfectly balanced:
• Labor is efficiently matched with machines.
• Resources are fully utilized.
• Production processes are standardized.
Implication: CRS indicates a business is operating efficiently. The cost per unit remains
stable even as production expands. For planners and managers, it’s a sign of optimal
growth.
3. Decreasing Returns to Scale (DRS)
But let’s say the bakery expands too much—10 ovens, 10 bakers, and even assistants—but
production rises to only 450 cakes instead of the expected 500. This is decreasing returns
to scale, where output increases less than proportionally to inputs.
Why does this happen?
• Management difficulties: Too many workers can cause confusion or conflicts.
Coordinating tasks becomes harder.
• Inefficient use of machines: Some ovens may remain idle because there aren’t
enough tasks for everyone.
• Crowding: Too many bakers in a small space can slow down work instead of
speeding it up.
Implication: DRS warns businesses about over-expansion. Growing beyond a certain point
can increase costs per unit, reduce efficiency, and hurt profits. Firms need to carefully plan
when scaling up.
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Real-Life Applications and Examples
The Law of Returns to Scale is not just a theory—it guides real businesses and industries.
1. Manufacturing: Car manufacturers like Toyota or Tesla experience IRS when adding
more assembly lines and workers, reducing the average cost per car. But if they over-
expand without proper planning, they may face DRS.
2. Agriculture: A farm doubling its land, tractors, and workers may get more than
double the crop initially due to better soil use and mechanization (IRS). But too much
land without proper management may lead to DRS.
3. Software Industry: Adding more programmers and servers can speed up app
development (IRS). However, after a point, communication overhead slows progress
(DRS).
Implications for Firms and Policy Makers
1. Optimal Scale of Production: Understanding returns to scale helps firms decide the
ideal size for production to maximize profit and efficiency.
2. Cost Management: IRS reduces average costs, which allows firms to offer
competitive prices and expand market share. DRS increases costs, signaling firms to
pause expansion.
3. Strategic Planning: By analyzing returns to scale, managers can predict challenges in
coordination, space, labor, and machinery.
4. Economic Growth: At a macro level, industries experiencing IRS contribute to
national economic growth by producing more at lower costs.
Conclusion: The Story of Growth
The Law of Returns to Scale is like the story of our bakery—it teaches us that growth is not
just about adding more resources. It’s about how efficiently we use them. Early growth can
bring rewards through increasing returns, steady growth brings stability through constant
returns, but uncontrolled expansion may bring inefficiency and loss through decreasing
returns.
In essence, it is a roadmap for businesses: start small, scale smartly, optimize resources, and
avoid pitfalls of over-expansion. It reminds us that in economics, as in life, more is not
always better—balance and planning are key.
The bakery that understands these principles will not just bake more cakes; it will bake them
smarter, earn more, and thrive sustainably—a lesson every student, entrepreneur, and
economist can relate to.
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6. Explain the theory of cost in the short and long run in detail.
Ans: Picture a small bakery run by Ananya. She has rented a shop, bought an oven, and
hired two helpers. Every day she bakes cakes and sells them in her neighborhood. Now, as
her business grows, she faces a question: How much does it really cost me to produce each
cake?
At first, her costs are simple—rent, wages, and ingredients. But as she produces more, she
notices something interesting: the cost per cake changes depending on how many cakes she
bakes. If she bakes too few, the rent feels expensive per unit. If she bakes too many, the
oven gets overloaded, and efficiency drops. Later, when her bakery expands into a bigger
factory, she realizes that costs behave differently in the long run compared to the short run.
This everyday story of Ananya’s bakery is the essence of the theory of cost in economics.
Let’s now explore it step by step.
The Theory of Cost
In economics, cost refers to the expenditure incurred by a firm in producing goods and
services. But costs are not static—they change with output and with time. Economists study
cost behavior in two time frames:
1. Short Run: A period where at least one factor of production (like land, building, or
machinery) is fixed.
2. Long Run: A period where all factors of production are variable, and firms can adjust
plant size, machinery, and workforce.
Part (a): Cost in the Short Run
In the short run, some inputs are fixed (like Ananya’s oven and shop rent), while others are
variable (like flour, sugar, and wages of temporary workers). This creates two types of costs:
1. Fixed Costs (TFC)
• Costs that do not change with output.
• Even if Ananya bakes zero cakes, she still pays rent for the shop and interest on
loans.
• Graphically: a horizontal line.
2. Variable Costs (TVC)
• Costs that change with output.
• More cakes → more flour, sugar, electricity, and wages.
• Graphically: starts from zero and rises with output.
3. Total Cost (TC)
• Sum of fixed and variable costs.
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• Formula: TC = TFC + TVC
Average and Marginal Costs in the Short Run
1. Average Fixed Cost (AFC):
o TFC divided by output.
o Falls continuously as output increases (spreading rent over more cakes).
2. Average Variable Cost (AVC):
o TVC divided by output.
o U-shaped: falls initially due to efficiency, then rises due to diminishing
returns.
3. Average Total Cost (ATC):
o TC divided by output.
o Also U-shaped, since it combines AFC and AVC.
4. Marginal Cost (MC):
o Extra cost of producing one more unit.
o Formula: ΔTC / ΔQ
o Also U-shaped, and it cuts AVC and ATC at their minimum points.
Why U-Shaped Curves?
The U-shape of AVC, ATC, and MC is explained by the Law of Variable Proportions:
• At first, adding more workers to a fixed oven increases efficiency (falling costs).
• After a point, overcrowding reduces efficiency (rising costs).
In Ananya’s bakery, two helpers may improve output, but if she hires ten helpers in the
same small kitchen, chaos reduces productivity.
Part (b): Cost in the Long Run
In the long run, there are no fixed costs. All inputs are variable. Firms can expand plant size,
buy new machinery, or shift to a bigger location.
1. Long Run Average Cost (LAC)
• Shows the minimum average cost of producing different levels of output when all
inputs are variable.
• Derived from a series of short-run average cost curves (SACs).
• Envelope curve: LAC is tangent to all SACs.
2. Shape of LAC Curve
• Typically U-shaped but flatter than SAC.
• Falls initially due to economies of scale (cost advantages from expansion).
• Rises later due to diseconomies of scale (management inefficiencies, coordination
problems).
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Economies of Scale (Why Costs Fall in Long Run)
1. Internal Economies:
o Technical: Better machinery reduces cost.
o Managerial: Specialized managers improve efficiency.
o Financial: Large firms get cheaper loans.
o Marketing: Bulk buying reduces input costs.
2. External Economies:
o Growth of industry benefits all firms (skilled labor pool, better infrastructure).
Diseconomies of Scale (Why Costs Rise in Long Run)
• Over-expansion leads to higher costs.
• Problems of coordination, communication, and bureaucracy.
• Example: A bakery chain with too many outlets may face inefficiency in supply chain
management.
Long Run Marginal Cost (LMC)
• Additional cost of producing one more unit when all inputs are variable.
• LMC intersects LAC at its minimum point, just like MC intersects ATC in the short run.
Key Differences Between Short Run and Long Run Costs
Aspect
Short Run
Long Run
Inputs
Some fixed, some variable
All inputs variable
Fixed
Costs
Exist (rent, machinery)
None
Curves
AFC, AVC, ATC, MC
LAC, LMC
Shape
U-shaped due to diminishing
returns
U-shaped due to economies/diseconomies
of scale
Flexibility
Limited (cannot change plant
size)
Full flexibility (can change plant size,
technology)
Real-Life Application
• Startups: In the short run, they operate with limited resources (small office, few
employees). Costs per unit may be high.
• Established Firms: In the long run, they expand, adopt better technology, and
reduce costs.
• Policy Making: Governments study cost curves to decide subsidies, taxation, and
support for industries.
Conclusion
The theory of cost explains how production costs behave in the short run and long run. In
the short run, firms face fixed and variable costs, leading to U-shaped average and marginal
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cost curves due to the law of variable proportions. In the long run, all costs are variable, and
firms can adjust plant size, leading to economies and diseconomies of scale.
Think back to Ananya’s bakery:
• In the short run, she is limited by her small oven and shop rent.
• In the long run, she can open a bigger factory, hire specialized managers, and reduce
costs per cake—until expansion becomes too large and inefficiencies creep in.
Thus, the theory of cost is not just abstract economics—it is the story of every business,
from a small bakery to a multinational corporation, as they balance resources, scale, and
efficiency over time.
SECTION-D
7. What is monopolistic competition? Explain the price and output determination under
monopolistic competition in the short and long run.
Ans: Understanding Monopolistic Competition: A Tale of Many Shops
Imagine walking down a bustling street in your city. On this street, there are dozens of small
shops, each selling a similar product—let’s say ice cream. Some shops sell chocolate flavor,
some vanilla, some offer unique toppings or organic ingredients. While all of them sell ice
cream, each shop has its own style, flavor, and charm. You, as a customer, have plenty of
options, and your choice depends not just on price but also on quality, taste, or even the
shop’s reputation.
This street perfectly illustrates monopolistic competition—a type of market structure that
lies somewhere between perfect competition and monopoly. Let’s understand this concept
more closely through this story.
What is Monopolistic Competition?
Monopolistic competition is a market structure in which:
1. Many sellers exist, each with a relatively small share of the market. No single seller
can control the market entirely.
2. Products are differentiated, meaning each seller tries to make their product slightly
different through branding, quality, features, or advertising.
3. Free entry and exit exist in the long run. New firms can enter the market if they see
profits, and existing firms can leave if they face losses.
4. Each firm has some control over price, but it cannot set the price too high because
close substitutes exist.
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So, in our ice cream example, each shop is a mini-monopoly over its unique flavor or style,
yet faces competition from all other shops on the street.
Price and Output Determination: The Short Run
Let’s imagine Chocolate Delight, one of the ice cream shops. In the short run, Chocolate
Delight faces a downward-sloping demand curve. This means that if it wants to sell more ice
cream, it has to lower the price.
Now, the shop has costs of production—buying ingredients, paying workers, and renting the
shop. These costs are represented by Average Total Cost (ATC) and Marginal Cost (MC)
curves.
How does Chocolate Delight decide how much ice cream to sell and at what price?
1. Profit Maximization Rule: The shop maximizes profit where Marginal Revenue (MR)
= Marginal Cost (MC). Marginal revenue is the extra income from selling one more
unit, and marginal cost is the extra cost of producing that unit.
2. Price Determination: Once the shop knows the profit-maximizing quantity, it looks
up to the demand curve to find the price it can charge.
• If the price (from the demand curve) is above ATC, the shop earns a profit.
• If the price is below ATC, it suffers a loss.
• If price equals ATC, it breaks even.
In the short run, firms can earn supernormal profits, normal profits, or even losses. Our
Chocolate Delight may sell premium chocolate scoops at a higher price than its average cost,
earning profits, or it may have misjudged demand and make a loss.
Graphical Story: Imagine the MR curve below the demand curve, and the MC curve cutting
MR from below. The intersection determines the output, and the price is found from the
demand curve at that output. Profits are the vertical distance between price and ATC at the
chosen quantity.
Price and Output Determination: The Long Run
In the long run, the story changes because monopolistic competition allows free entry and
exit.
Suppose Chocolate Delight is earning profits. Other entrepreneurs notice this and open their
own ice cream shops nearby. Maybe a new shop sells strawberry-chocolate mix, another
offers sugar-free options. As more shops enter:
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1. The demand for Chocolate Delight’s ice cream falls because customers now have
alternatives. Its demand curve shifts leftward, and it becomes more elastic (flatter),
meaning people can easily switch to competitors.
2. If Chocolate Delight was facing supernormal profits before, these profits shrink as
competition rises.
On the other hand, if Chocolate Delight was making losses, some shops would exit the
market. Less competition would increase the demand for remaining shops’ products,
helping them return to normal profit.
Equilibrium in the Long Run:
• In the long run, each firm earns normal profit, meaning price = average total cost (P
= ATC).
• Output is determined where MR = MC, just like in the short run.
• But the key difference is that in the long run, there are no supernormal profits or
losses, because the entry and exit of firms balance the market.
Think of it as a street that keeps adjusting: new ice cream shops come in when business
looks lucrative, and failing shops leave when business declines. Eventually, each shop sells
enough ice cream to cover costs but not make extraordinary profits.
Key Features Highlighted in Price & Output Determination
1. Downward-Sloping Demand: Unlike perfect competition, each firm faces a slightly
downward-sloping demand because of product differentiation. It has some control
over its price.
2. MR < Price: Because the firm lowers the price to sell more units, marginal revenue is
always less than price. This is a feature common with monopolies.
3. Short-Run Profits/Losses: In the short run, firms can make profits, losses, or break
even. This is because the number of firms is fixed temporarily, and product
differentiation allows pricing power.
4. Long-Run Normal Profit: In the long run, due to free entry and exit, firms only make
normal profits. The demand curve becomes tangent to the ATC curve at the
equilibrium output.
5. Excess Capacity: An interesting feature is that firms in monopolistic competition do
not produce at minimum ATC in the long run. They operate with excess capacity,
meaning they could produce more efficiently but choose to produce less to maintain
a higher price.
A Simple Analogy
Imagine our ice cream street again. In the short run, some shops sell out fast because
customers love their flavors, and they make extra money. But soon, new shops open with
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enticing varieties, and customers are spread thin. Profits even out, and shops settle into a
rhythm where they make enough to stay in business but not too much to attract a flood of
competitors.
In other words, short run = excitement and unpredictability, long run = stability and
balance.
Conclusion
Monopolistic competition is a fascinating market structure because it blends monopoly
power with competition. Firms sell differentiated products, giving them some pricing power,
yet the presence of many competitors ensures no firm can dominate.
• Short-run: Firms can earn profits or suffer losses; price and output are determined
where MR = MC, and price comes from the demand curve.
• Long-run: Free entry and exit drive firms to normal profit, with price equal to
average total cost. Firms operate with excess capacity, not fully exploiting resources,
but providing variety and choice to consumers.
In real life, this explains why your city street is filled with coffee shops, ice cream parlors,
and boutique stores—each trying to be unique, each facing competitors, each finding its
balance between price, output, and profit. Monopolistic competition is not just a theory—
it’s the vibrant marketplace we walk through every day.
8. What is perfect competition? Discuss the equilibrium of firm under perfect
competition in detail.
Ans: Imagine walking into a bustling farmer’s market on a Sunday morning. There are
dozens of stalls selling the same fresh tomatoes. Each seller has baskets that look almost
identical—same size, same quality, same freshness. Buyers move freely from one stall to
another. If one seller tries to charge even a rupee more, customers immediately walk away
to the next stall. No seller can dictate the price; they all simply accept the going market rate.
This simple scene is the closest real-world example of perfect competition—a market
structure where no single buyer or seller has the power to influence price. Everyone is a
“price taker,” and the market price is determined purely by the forces of demand and
supply.
Now, let’s explore what perfect competition really means, its features, and then dive into
the heart of the question: how a firm achieves equilibrium under perfect competition in
the short run and long run.
What is Perfect Competition?
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Perfect competition is a type of market structure characterized by:
1. Large number of buyers and sellers – so no single participant can influence price.
2. Homogeneous products – goods are identical in quality and features.
3. Free entry and exit – firms can join or leave the market without restrictions.
4. Perfect knowledge – buyers and sellers know all prices and market conditions.
5. No transportation costs or barriers – goods can move freely.
6. Price takers – firms accept the market price; they cannot set their own.
In short: Perfect competition is an idealized market where competition is so intense that
only efficiency and cost control matter.
Equilibrium of a Firm under Perfect Competition
Equilibrium means a state of balance where the firm has no incentive to change its level of
output. In economics, a firm is in equilibrium when it maximizes profit, which occurs when:
• Marginal Cost (MC) = Marginal Revenue (MR)
• And MC cuts MR from below.
Since in perfect competition, Price = Average Revenue (AR) = Marginal Revenue (MR), the
condition becomes: MC = MR = Price
Let’s now see how this works in the short run and the long run.
Part (a): Short-Run Equilibrium of a Firm
In the short run, some factors (like plant size, machinery) are fixed, while others (like labor,
raw materials) are variable. A firm may earn supernormal profits, normal profits, or losses
depending on cost conditions.
1. Supernormal Profits
• If the market price is higher than the firm’s average cost (AC), the firm earns extra
profits.
• Graphically: Price line (AR=MR) lies above AC curve at equilibrium output.
Example: If Ananya’s bakery sells cakes at ₹200 each while her average cost is ₹150, she
earns ₹50 profit per cake.
2. Normal Profits
• If the market price equals average cost, the firm just covers all costs (including
opportunity cost).
• No incentive to expand or shut down.
3. Losses
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• If the market price is below average cost, the firm incurs losses.
• However, as long as price covers average variable cost (AVC), the firm continues in
the short run (to cover part of fixed costs).
• If price falls below AVC, the firm shuts down.
Part (b): Long-Run Equilibrium of a Firm
In the long run, all factors are variable. Firms can expand plant size, adopt new technology,
or exit the market.
Key Features of Long-Run Equilibrium:
1. Free Entry and Exit:
o If firms earn supernormal profits in the short run, new firms enter.
o This increases supply, lowering the market price until only normal profits
remain.
2. Losses and Exit:
o If firms incur losses, some exit the market.
o Supply decreases, price rises, and remaining firms return to normal profits.
3. Normal Profits in Long Run:
o In the long run, firms earn only normal profits.
o Price = Minimum Average Cost (AC).
o Condition: MC = MR = AR = AC
Thus, in the long run, perfect competition ensures efficiency—firms produce at the
lowest possible cost, and resources are optimally allocated.
Efficiency under Perfect Competition
1. Allocative Efficiency:
o Price = Marginal Cost → resources are allocated to goods most valued by
society.
2. Productive Efficiency:
o Firms produce at the lowest point of AC curve.
3. Dynamic Efficiency:
o In the long run, firms innovate to reduce costs and survive.
Real-Life Examples
• Agricultural markets (wheat, rice, vegetables) often resemble perfect competition.
• Foreign exchange markets also come close, as currencies are homogeneous and
traded globally.
Critical Evaluation
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While perfect competition is a useful model, it rarely exists in reality because:
• Products are rarely identical.
• Perfect knowledge is unrealistic.
• Barriers to entry often exist.
• Advertising and branding create differentiation.
However, it remains important as a benchmark to compare other market structures
(monopoly, oligopoly, monopolistic competition).
Conclusion
Perfect competition is like the farmer’s market where no seller can cheat or dominate, and
prices are set purely by demand and supply. In the short run, firms may earn profits or
losses, but in the long run, free entry and exit ensure that only normal profits remain.
This equilibrium ensures that society’s resources are used efficiently, consumers pay fair
prices, and firms operate at the lowest possible cost.
So, whether it’s Raghav selling wheat in Punjab or Ananya baking cakes in her bakery, the
principle of perfect competition reminds us of a simple truth: in a world of many sellers and
buyers, no one controls the market—the market controls everyone.
“This paper has been carefully prepared for educational purposes. If you notice any mistakes or
have suggestions, feel free to share your feedback.”
