IGNOU : BCOM : BCOG 171 - Principles of Micro Economics ( NOTES FOR FREE )

Commerce ePathshala NOTES (IGNOU)

Important Questions & Answers

 

IGNOU : BCOM

BCOG 171 – PRINCIPLES OF MICRO ECONOMICS

 

 

Q – What are the Factors of Production ? Explain.

Ans. FACTORS OF PRODUCTION

We have already learnt that the nature provides us, free of cost, with only a limited resources which are insufficient for satisfying all our wants. Accordingly, their availability has to be increased for satisfying additional wants. You can also say that these resources have to be produced.

In economics, the term ‘Production' implies the transformation of various inputs into outputs thereby increasing the want-satisfying capacity of the inputs. Items which are so transformed are called inputs while output is nothing but the transformed form of inputs. A particular transformation is production if the want-satisfying capacity of the output (also called 'product') is more than that of its inputs. To put it differently production is nothing but the creation of utility. Now you may ask what utility is. In economics, utility means the expected satisfaction which the consumers hope to derive from the use of various goods and services.

1.     Land

The term ‘Land’ does not represent just the area available for cultivation, factories, houses, roads, etc. It is used in a much broader sense. It includes the materials and the forces which nature gives us free for the satisfaction of our wants or for the production of goods and services. Thus, the term land not only includes land in ordinary sense of the term, but also the resources like water, climate, sunshine, minerals and the like.

In other words, land includes not only the land used for agricultural or industrial purposes, but also all the natural resources taken from above or below the soil. Thus, land represents the sum total of natural resources available to the economy.

Defined in this way, supply of land is fixed. It is predetermined by nature, and man cannot add to it through his own efforts. While an individual can get more of land by paying for it, the society as a whole cannot increase its availability. Land has no mobility. Land cannot be transferred from one place to another. But its use can be transferred; a plot of land can be used either for paddy or for jute. However, a transfer price is necessary.

What about the market prices of different forms of land or natural resources? Although we say that land is a free gift of nature, an individual may not get the land free of cost. He has to pay some money and buy it. Market price to land comes into existence as a result of economic arrangements like private ownership and inheritance. Being scarce in supply, its ownership and possible use generate a price, which is normally called ‘rent’.

2.     Labour

In economics, the term labour is used to denote any manual or mental activity that is undertaken in exchange for a payment. This concept of labour, however, is confined to only human effort and the work performed by animals and machines is not considered as labour. It is noteworthy that labour cannot be separated from the person of the labourer and used as an input. That is to say, the labourer has to sell it in person. Another feature of labour is that its performance cannot be postponed. If a labourer does not work during one month, then the labour of that period cannot be performed in future. Labour not performed is labour lost forever. For this reason, the bargaining strength of workers tends to be low and they frequently have to accept low wages or go without any income. Moreover, those workers who do not have any other source of income find themselves in a still weaker bargaining position.

3.     Capital

The term ‘capital’ refers to that group of productive resources which are the result of human labour. Capital represents man-made productive resources. They are produced means of production. While land is a free gift of nature in the sense that its availability is there without spending any labour on it, capital is not a free gift in that sense. Capital is, in a way, a form of concealed or crystallized labour. It appears in various forms such as plant and machinery, buildings, roads, bridges, means of transportation and communication, and so on.

4.     Entrepreneurship

Economists believe in the existence of a fourth factor of production, namely, organization or entrepreneurship which is supplied by the entrepreneur. Land, labour and capital by themselves cannot come together and organize themselves into productive processes to yield output. They have to be procured and put to work in a systematic and coordinated manner. Most production processes are time consuming. The entrepreneur procures the inputs and pays for them in anticipation of receiving larger sales proceeds when the output is sold. It is the entrepreneur who assumes the risk of loss and it is he who is entitled to a profit, if there is any. The job of the entrepreneur is particularly risky in an atmosphere of uncertainty.

 

 

Q – What are the Central Problems of an economy ? Explain.

Ans. FUNDAMENTAL/ CENTRAL PROBLEMS OF AN ECONOMY

Basic characteristic of every economic system is the scarcity of resources in relation to human needs, and the use of such resources in alternative ways to meet the ends. Accordingly, every economy is faced with certain basic or fundamental problems which it must try to solve within its socio-economic framework. These fundamental problems are:

i)                What to produce?

ii)              How to produce?

iii)            For whom to produce?

What to Produce?

You have already learnt that an economy does not have enough resources to produce everything required by it. So, it must be selective and decide what to produce and what not to produce. When some goods are not produced, some wants of the society remain unsatisfied. The decisions regarding the wants to be satisfied and the goods and services to be produced are interrelated and one does not stand independent of the other. This is called ‘Allocation of productive resources’. If some factors of production are employed in the production of product X, they are not, to the extent being employed in the production of product Y. The problems can be illustrated by the famous Production Possibility Curve which you shall study later in this unit.

You should note that this problem cannot be removed completely from the scene. Developed economies, for example, have more productive resources. Even in these cases, the resources are not sufficient for meeting all their needs. Moreover, the nature of this problem does not change by changing the structure of the economy. Irrespective of the type of economic system-a capitalist or a socialist or a mixed economy—the allocation of resources between production of different goods has to be decided. Later in this unit, you will study how different economic systems solve their problems in different ways.

How to Produce?

This is a problem which covers the details of the allocation of productive resources in the production of various goods and services. More precisely, you can say that when an economy decides to produce product X it has also to work out exactly how much of labour, capital, land etc., would go into its participation. The exact proportion of factors of production used in the production of an item is called the technique of production of that item. For example, we may think of goods which are produced by using more of labour than capital. In such cases, labour intensive techniques of production are said to be in use. On the other hand, if more of capital goes into the production of an item, then, we say, that it is being produced by a capital-intensive technique. For any country, ideally speaking, the choice of technique of production depend upon the relative availability of factors of production. A country like ours which has more of labour and less of capital should go in for labor-intensive techniques of production. Similarly, there are many countries which have abundance of capital but a shortage of labour. They should prefer capital-intensive methods of production.

For Whom to Produce?

A society comprises a large number of individuals and households. All the output of consumption goods and services is ultimately meant for their use. Therefore, all the goods and services produced are to be distributed amongst the individuals and households. The share of each individual and household has to be determined and also the quantities of specific goods and services which comprise that share.

You can easily see that it is possible to propose different principles whereby this distribution may be carried out. In an economic system organized on market principles, the income shares of individual members of the society are determined in the following manner. In a market economy, productive resources are privately owned. They are sold, bought and hired like any other goods or services. The price of a productive resource is determined by the market forces of demand and supply. Whenever it is to be employed by a producer, he has to pay its market price to its owner. It is for the owner to supply it to the market or withhold it. The income of each individual, under these conditions, is determined by the amounts of different productive resources owned and supplied by him to the market and their respective prices.

 

 

Q – Define Opportunity Cost.

Ans. OPPORTUNITY COST

The term opportunity cost refers to the cost of getting something in the form of losing something else in exchange. Every gain to the economy as a whole or to an individual economic unit has an opportunity cost. This fact has its origin in the shortage or scarcity of resources in comparison with their needs. The concepts of opportunity cost can be illustrated in many ways. For a consumer, the opportunity cost of buying an item shows itself in the form of the price which he pays for it in money terms. But in the final analysis, it is the goods and services which he cannot get because he chose to buy that item. In the same way, when somebody saves a portion of his income, then the opportunity cost of that saving is the sacrifice of current consumption. In contrast, the opportunity cost of current consumption is the loss of similar consumption in future which would have been possible through saving now and spending later. For a lender, the opportunity cost of yield from investing in one form of financial assets is the loss of yield from the next best alternative investment. For a factor of production, the opportunity cost of earnings from the existing employment is the loss of earnings from the next best available employment. This is also known as the transfer earnings of that factor of production. For a producer, the opportunity cost of producing an item A is the corresponding loss of what could have been produced otherwise.

 

 

Q – Comment on the Following

·       Concept of Equilibrium

·       Ceteris Paribus

 

Ans. Concept of Equilibrium

Equilibrium The concept of equilibrium is an important tool of analysis in economics. It is very frequently used and you should become familiar with it. Usually, an economic variable (such as the price of a commodity) is subject to various forces trying to pull it in different directions. When these forces are in balance, the value of variable stops changing and it is said to be in equilibrium.

Ceteris Paribus

It is for these reasons that every economic law has to be stated with some conditions or qualifications. It is accompanied by the words, ceteris paribus which means ‘other things, being equal’. Even when these words are not stated explicitly, they are supposed to be there. The statement of this condition means that once the said causes start working, they are not disturbed by any outside force till the final outcome. You should note that even in other sciences also, this condition is always there in an explicit form. In other sciences, the ceteris paribus frequently holds or can be made operative under laboratory conditions. But in economics, this condition is not satisfied. You cannot conduct economic experiments under controlled conditions. Since economic laws are the statements of economic activities in response to various forces, the economists use certain guiding principles under which the response is supposed to come into existence. One such guiding principle is that every economic unit decides about its response to various causes on the criterion of rationality. It means that the response is determined in such a way that it is expected to serve the interest of the responding units in the best possible manner. For example, for a given amount of expenditure, a consumer is supposed to aim at getting maximum possible utility from his purchases. A monopolist is expected to choose that quantity of output and fix that price for his product which brings him maximum profit.

 

 

Q – What is Law of Demand ? Distinguish between substitution and income effects of a price rise.

Ans. Generally speaking, in almost all commodities, the demand of a commodity increases as the price of the commodity falls and vice versa; price of other commodities, income of the consumer and tastes of the consumer remaining unchanged. The reason of this tendency will be explained in 3.5.3. This particular relation between the price of a commodity and amount demanded is called the 'Law of Demand'. In short, the law of demand can thus be stated as follows: Other things remaining equal, there is an inverse relationship between the price of a commodity and its quantity demanded.

The Explanation of the Law of Demand

1.Substitution Effect

Substitution effect results from a change in the relative price of a commodity. Suppose a Pepsi Can and a Coke Can both are priced at 20 each. If the price of Coke is raised to 25, and the price of Pepsi is not changed, Pepsi will become relatively cheaper to Coke, i.e. although the absolute price of Pepsi has not changed, the relative price of Pepsi has gone down. The change, in the relative price of commodity causes substitution effect. When the price of a commodity say mango falls, prices of other fruits remaining constant, the consumer buys more mangoes by buying less of other fruits. This happens because mango starts looking relatively cheaper to him. This can also be stated by saying that the consumer substitutes mango for other fruits when the price of mango drops. This effect is called ‘substitution effect’. This is the main reason for the consumer to buy more of mango, when the price of mango falls, provided prices of other fruits remain unchanged.

2. Income Effect

Given the money income of the consumer, as price of mango falls the purchasing power of that given money income rises, or to put it differently by stating that as price of mango falls, given money income of the consumer, his real income rises. Thus, he can buy more of the mangoes with the same money income and consequently, there is tendency for the demand for mangoes to rise. This rise in real income with the fall in price of the commodity is called the ‘income effect’. The rise in money income has the same impact on the quantity demanded of a commodity as the rise in real income. Such a commodity whose quantity demanded rises with the rise in money or real income is called a ‘normal commodity’. The income effect in such a case is called positive income effect. It is positive because there is a direct relationship between the income and the quantity demanded. In a case when rise in money or real income leads to a fall in the quantity demanded of a commodity, we have a case of negative income effect. The negative income effect operates in the case of a commodity which is called an ‘inferior commodity’. An unbranded cardigan is an inferior commodity in comparison to a branded cardigan.

 

 

Q - Explain Giffen Goods.

Ans. GIFFEN GOOD

A case where negative income effect outweighs substitution effect is possible when we have ‘Giffen good’ named after the Robert Giffen who first talked of such paradox. In case of a Giffen Good the fall in price of a commodity need not lead to an increase in the quantity demanded of the commodity. On the contrary, a fall in the price of a Giffen good may result in a fall in demand for this good.

 

 

Q – State the Determinants of demand of a consumer.

Ans. The demand of a commodity or the quantity demanded of a commodity on the part of a consumer is dependent on a number of factors. Some of the important factors influencing the demand of a commodity are given below:

1)     Price of the commodity: The price of the commodity has an important influence on the quantity demanded by a consumer. Normally, the higher the price of the commodity, the lower the demand of the commodity. This, as will be explained later, is referred to as the operation of the law of demand. The law of demand is always stated on the assumption that the other factors influencing demand remain constant.

2)     Size of the consumer's income: The demand for a commodity is also influenced by the size of the income of the consumer. In cases where the increase in income of the consumer leads to an increase in the quantity demanded of the commodity is referred to a case of a 'normal commodity'. Sometimes an increase in the size of the income leads to a fall in the quantity demanded of the commodity. Such a situation is possible when the commodity in question is what is referred to as an “inferior commodity'.

3)     Prices of other commodity: A consumer’s demand for a commodity is equally influenced by the prices of commodities other than the commodity in question.

In some cases, the demand for the commodity in question will increase as the price of the other commodities increases while in other cases the demand for the commodity will decrease as the price of the other commodity increases. The first case is a situation of what is called a 'substitute' and the latter case is a situation of what is called a complement'. Tea and coffee are examples of substitutes while car and petrol or ink pen and ink are examples of complements.

4)     Tastes of consumer: The demand for a commodity is also influenced by the tastes of the consumer. If a consumer has developed a taste for a particular commodity, he/she will demand more of that commodity. Similarly, if a consumer has changed his taste against a particular commodity, less of it will be demanded at a particular price. The change of tastes can be illustrated with the help of an example. The consumers have developed taste for colored T.V so that even if price of it rises consumers will still buy more of it. Taste for colored T.V has developed at the cost of black and white T.V. Thus, even if the price of black and white T.V. falls, the consumers will still buy less of it.

 

 

Q – State the importance of Price Elasticity of Demand.

Ans. IMPORTANCE OF PRICE ELASTICITYOF DEMAND

The price elasticity of demand is very important in a number of policy decisions. It is especially useful for government policies relating to individual commodity markets. Some of the important fields in which the importance of price elasticity of demand can be realized are discussed below:

1. Price fixation by a monopolist: The monopolist is always interested in charging a higher price from the consumer. If he comes to know that the price elasticity of demand of a commodity is low, he would fix up a higher price for the commodity. He would not be able to charge a very high price for a commodity whose price elasticity of demand is relatively higher.

2. Price support programme of the government: Normally, the price elasticity of demand of agricultural commodities like wheat, rice etc., is relatively less. This implies that a given increase in supply say because of better monsoon will lead to a relatively more fall in price. This would reduce the income of the farmer. The government in order to protect the interest of the farmers can announce what is called price support programme such that the price of the commodity will not be allowed to fall below a particular level. Obviously, this would lead to a situation where the quantity supplied will be more than the quantity demanded of a commodity at the price announced by the government.

3. Incidence of indirect taxes: A government imposes indirect taxes on the commodities. Whenever an indirect tax is imposed, the burden of this tax is borne partly by the consumer and partly by the producer himself. The share of burden of an indirect tax borne by the consumer and the produver depends

Upon = Price Elasticity of Supply/ Price Elasticity of demand

For example, a situation where Price elasticity of demand the demand curve is perfectly inelastic, irrespective of the shape of the supply curve, the whole burden of the indirect tax will be borne by the consumer, on the other hand if the demand curve is perfectly elastic the whole burden of the indirect tax will be borne by the producer or the supplier. The situations between two will be decided by the ratio of price elasticity of supply to price elasticity of demand.

 

 

Q – What are the determinants of Supply ? Explain.

Ans. There are a number of factors which influence the supply of a commodity. It is difficult for us to analyse the effect of a simultaneous change in all the factors which influence the supply of a commodity. Therefore, normally, we think of a situation where one of the factors influencing supply changes, assuming other factors as unchanged, and then work out the effect of a change in that factor on the quantity of the commodity supplied by a producer or a group of producers. It is the same approach which was adopted in unit 6 when the law of demand was discussed where the quantity demanded of a commodity was taken to be dependent on the price of that commodity, other factors influencing demand were assumed as unchanged. Some of the important factors influencing supply or quantity supplied of a commodity can be identified as follows:

1)     Price of the commodity supplied: The price of a commodity is determined by the forces of demand and supply. Any change in the price of a commodity exerts an influence on the supply of that commodity. Generally speaking, the higher the price of the commodity, the more profitable will it be to produce or supply that commodity, other things remaining unchanged. The direct relationship between price and supply of a commodity is also referred to as the ‘Law of Supply'.

2)     A change in the price of one factor of production will cause changes in the relative profitability of producing different commodities. This will cause producers to shift from the production of one commodity to another, and thus cause changes in the supplies of different commodities. For example, a fall in the price of land will have a larger effect on cost of production of an agricultural product and only a very small effect on the costs of producing, say televisions. In other words, cost of production and supply of that commodity will be influenced more with a change in the price of a factor of production which uses relatively more of that factor whose price has changed in relation to other factors of production.

3)     Price of other goods: Other things remaining unchanged, the supply and production of a commodity will fall as the prices of other commodities rise and vice versa. This happens because normally a producer chooses that commodity for production which earns him the highest profit. For example, a producer chooses to produce, say television sets, because he can earn more profits in this line of production than in the production of any other goods. Now suppose the price of air conditioners goes up in the market. It may now be more profitable to produce air conditioners as compared to the television sets. It encourages the producer to gradually reduce the production of television sets and increase the production of air conditioners. So, a rise in the price of air conditioners tends to reduce the production and supply of television sets.

4)     The state of technology: The state of knowledge changes over time and along with that the methods employed to produce a commodity also undergo a change. The increase in the knowledge about the means of production and the methods of production lead to lower costs of production of products already being produced and to a large variety of new products. For example, the electronics industry rests upon transistors which have revolutionized - production and supply of televisions along with other electronic equipments like computers. Thus, as knowledge improved supply of different commodities, in which the newer knowledge gets embodied through newer technologies, also increases.

5)     Goal of the producer: The objective with which the producer undertakes production also influences the supply of the commodity. The goal of the producer may be to maximize total profits or to maximize sales or to capture the market in the long run. If a producer wants to earn maximum profits, he will plan to produce that quantity of output which gives him the maximum profit. It does not imply that he cannot produce more but he will not do so because producing more may reduce his profit. Now suppose that the goal of the producer is to maximize sales rather than profits. In that situation he may set a target of less than maximum profits in the short run. He will go on increasing his supply as long as his target is not adversely affected. The goal of maximization of sales is promoted by the desire of the firm to maximize profits in the long run. Similarly, if producers are reluctant to take risks, we would expect smaller production and supply of any commodity which carries more risk.

6)     Other factors: There can be many other factors influencing supply. Some of other factors are expected changes in government policy, fear of war, unexpected climatic conditions, expected change in prices, growing inequalities of income influencing the demand of particular types of goods and hence making them more profitable to produce.

 

 

Q – State the determinants of Elasticity Supply.

Ans. Determinants of Elasticity of Supply

Elasticity of supply depends on a number of factors and all these factors are to be taken together before one can comment on the elasticity of supply of a commodity. Some of the important determinants of elasticity of supply are given as follows:

1) Behaviour of costs as output varies: As output of a commodity rises total cost does show a tendency to rise but it does not rise at a uniform rate. Normally, total cost rises at a falling rate in the beginning, then at a constant rate and finally at a rising rate. If cost of production rises rapidly as output rises, then there is less stimulus to expand production in response to rise in price and accordingly supply will tend to less elastic. If, on the other hand, total costs rise but rather slowly as production increases, a rise in price which raises profits will bring about a large increase in quantity supplied and so, the supply will be more elastic.

2) Nature of the commodity: Commodities may be classified, based on their nature, into (i) perishable and (ii) durable. Perishable products cannot be stored and thus, their supply does not respond very much to the change in their prices. So, supply of perishable products is inelastic. Durable products, on the other hand, can be stored and their supply responds to the change in their prices. The supply elasticity of durable products is relatively elastic.

3) Time: Supply of a commodity comes from its production which involves a time-lag. If the size of the plant is given and other adjustments in terms of technology etc., are not allowed, a producer cannot effectively respond to the change in price. Under such a situation i.e., in the shortrun; supply of a commodity is less elastic. In the long run, when the size of the plant can be changed and technological changes are also allowed supply responds to the change in price and hence, elasticity of supply is more elastic or the supply curve becomes flatter.

4) Price expectations: Expectation of future prices also influences elasticity of supply. If the producers expect that prices in the future will not be allowed to fall below a particular level, they would not mind producing more. Further if, producers expect prices to rise in the future they may hold more stocks and may supply less quantity in the market. Supply in such a case will be inelastic. If the prices are expected to fall in the future, supply will be more elastic.

5) Nature of techniques of production: If techniques of production required to produce a commodity are simple, the producer responds to a rise in price and supplies more which makes supply more elastic. More complex and cumbersome the techniques of production required to produce a commodity, more difficult it will be for the supply to respond to rising price and, therefore, less elastic will be the supply.

 

 

Q – Explain Marginal Utility, Total Utility & Average utility.

Ans. The utility of the last unit of a commodity acquired by a consumer is called its Marginal Utility (MU). It means that while finding out MU of a commodity, it is necessary to look at the quantity of the commodity acquired by the consumer. Thus look at Table 7.1 Column 2. If the consumer buys only one banana, then MU is the utility of that banana itself, that is, 25 units. In case the consumer buys two bananas, the MU is the utility of the second banana – in this case 18 units. Similarly, with five bananas, MU of the fifth banana is 3 units, with six bananas -- MU of the sixth banana is zero, and with seven bananas, it is minus two units.(The explanation for MU falling with successive additions of bananas will be found later in this Unit).

Total Utility (TU) represents the sum of utilities of all the units of a commodity acquired by the consumer. In the example provided in Table 7.1, if the consumer gets three bananas, then TU is 25+ 18+12= 55 units. The figures of TU for respective number of bananas can be read from column 4 of Table 7.1. You would note that TU is nothing but sum of successive marginal utilities and MU is nothing but the addition to TU on account of the last unit of the commodity acquired. Therefore, when MU is zero, TU remains unchanged. In our example, TU remains 65 units when sixth banana is added. Also, TU will fall if MU is negative as happens when seventh banana is added.

	Marginal Utility	Total Utility	Average utlity
1	2	3	4
1st Banana	25	25	25
2nd Banana	18	21.5	43
3rd Banana	12	18.3	55
4th Banana	7	15.5	62
5th Banana	3	13	65
6th Banana	0	10.8	65
7th Banana	-2	9	63

 

Average Utility (AU) is obtained by dividing total utility by the number of units of the commodity. In table 7.1, figures of average utility are shown in column 3. Remember that, generally, change in average utility is sale for at the most equal to) the change in MU. This happens because the addition to TU caused by MU gets spread over all the units of the commodity when we consider AU. For example, when third banana is acquired by the consumer, 12 falls from 18 to 12 units or a fall of 6 units. However, the AU falls from 21.5 to 18.3 units, or by 3.2 units. Similarly, the reduction in MU is of two units when seventh banana is acquired, but the fall in AU is by 1.8 units only.

 

 

Q – State the Limitations for Law of diminishing Marginal Utility.

Ans. Limitations There are innumerable situations in which the law of dim cannot be applied. The limitations of the law are contained in the violation of the qualifying phrase, "other things being equal” which means that nothing should happen to increase the intensity of wants for the satisfaction of which the commodity under consideration is being used. However, other things need not remain the same, the intensity of the wants in the process of satisfaction may increase and if that happens, the law of diminishing marginal utility will get violated. Thus, the limitations of the law are nothing but the most common causes leading to an increase in the intensity of wants during the process of their satisfaction and thus causing an upward shift in the MU of the commodity. Following are the limitations of this law:

1.     Suitable units: For the application of the law of diminishing marginal utility, it is necessary that the commodity should be supplied to the consumer in suitable units. Shoes, for example, should be in pairs and not in individual pieces. Wall paper for the house should be enough for at least a particular area to be covered.

2.     Time-factor: A want can recur and increase in intensity if passage of time is allowed between consumption of two units of a commodity. A person may get greater utility from the second chapati if it is consumed the next day. Similarly, a second cup of water may yield greater utility if the consumer is forced to become thirstier by delaying its availability.

3.     Tastes, fashion, and income: Given enough time, these things can undergo a change and, therefore, alter the intensity of the want. However, it is not necessary that these factors would necessarily intensify it; they may even weaken it. It is well known that a change in fashion alters the acceptability of a commodity and thereby it’s utility. Some commodities gain in utility because more people want them and in larger quantities. As against this, some commodities go out of fashion and, therefore, lose in utility. In the same way, an individual's tastes (or preferences) can also undergo a change.

4.     Anticipated availability of the commodity: If the consumer comes to believe, rightly or wrongly, that the availability of the commodity would fall in the forthcoming time interval, its MU would go up.

5.     Capacity to enjoy a commodity: It frequently happens that the capacity of a person to enjoy a particular commodity undergoes a change during its consumption. In that case, the law of diminishing MU may not hold.

6.     Rare collections: Some commodities like rare coins, paintings etc., constitute a special category of their own. Their supply is usually of non-identical items and they add to the total enjoyment of the collector more than proportionately. Their increasing stock adds to the sense of enjoyment, social price, knowledge and similar other aspects of the collector's life and thus the principle of diminishing MU lose its relevance in their case.

7.     Change in the availability of related commodities: Some commodities are related to each other. Two specified commodities for example, may be jointly needed for the satisfaction of a want. They are known as complementary commodities. In that case, availability of one of them is useless to the consumer; but its availability raises the utility of the complementary commodity. You can think of a large number of cases in which the availability of one commodity increases the utility of the other. Some examples are of an electric fan and electricity, Box pen and refill, cooking fuel and uncooked food and so on.

8.     Position in relation to other persons: Man is a social animal. Accordingly, his desire to have possessions and to consume various commodities and services is greatly influenced by his position in the society. Therefore, the utility of a commodity to the person under study changes when its availability to other members of society undergoes a change.

 

 

Q – State the Limitations of Utility Analysis.

Ans. Before taking up indifference curves analysis, you should be able to state the limitations of the utility approach in a systematic manner. Therefore, let us have a brief look at them before going to indifference curves.

i) You are already familiar with the fact that utility is subjective. It cannot be measured in cardinal or absolute terms. It can only be expressed in ordinal terms. However, it is still assumed that utility can be measured cardinally.

ii) Another limitations of utility analysis relates to the assumption that marginal utility of money remains constant. You have noted in unit 7 that from all observations, money obeys the law of diminishing marginal utility. Even Marshall says so. However, when it comes to demand behaviour of a consumer, it has to be assumed that marginal utility of money remains constant.

iii) On account of the assumption of cardinal measurement of utility, the analysis can be extended to state that interpersonal comparisons of utility are also possible. In that case, you are able to say which of the two individuals, for example, A and B, gets more of utility from a given commodity and how much. On scientific grounds, however, interpersonal comparisons of utility are not possible because utility is not measurable in absolute quantities.

iv) Utility analysis of demand cannot explain what is known as Giffin’s Paradox. Giffin found that the demand for bread increased with an increase in its price. The explanation of this phenomenon lay in the fact that during Giffin's days in England, workers were very poor, Bread was their basic necessity of life and they had to spend a high proportion of their income on it. With a rise in the price of bread, a poor worker was not left with enough money to buy other articles of food which were considered 'better’and were more expensive. As a result, the poor worker had to reduce his demand for other food articles and instead consume more of bread which was still cheaper compared with them. In the same manner, economists have found that demand for a commodity is affected not only by its current price and marginal utility, but also by expected changes in its price.

v) Marshallian utility analysis is not able to isolate the effect of changes in income of the consumer on the demand for a commodity. The fact is that demand is affected by a number of variables. And change in income is one of them. When the price of a commodity falls (rises) it means that the consumer is able to buy more (less) of other commodities put together.

vi) Another shortcoming of Marshallian utility analysis is that it is not able to cover the case of related commodities that is commodities which are complementary or substitutes.

 

 

Q – Describe Economies of scale & Diseconomies of Scale.

Ans. Economies of Scale

Economies of scale are the advantages which a producing unit enjoys by expanding the size of plant and the scale of operation. These advantages or economies enable a firm to get proportionately larger output than increments in factor inputs or after adjusting all inputs. Optimally, the average cost of production can be reduced by increasing the size of the plant. These economies of scale are also referred to as internal economies because they are peculiar to a particular producing unit and are enjoyed by it by expansion of its own scale of production. Some of the economies of scale are given as follows:

1)     Higher degree of specialisation and division of labour: As scale of production expands, higher degree of specialisation of both machinery and labour becomes possible. The use of specialised machinery and labour increases productivity per unit of inputs. Their cumulative effects contribute to increasing returns to scale. As scale of production increases more labour is employed and the opportunities for specialisation and division of labour are captured by the producing unit. A larger plant with a larger workforce may enable each worker to specialise in one job, gaining proficiency and waste less time in moving about from one job to another and also in changing tools. Thus, important savings may be realised by increasing the scale of production. The specialisation may also take the form of machinery which a particular machine may be earmarked for a particular task in which it can be best used.

2)     Technical indivisibilities: Some factors, particularly mechanical equipment, used in the process of production are available in a minimum size. Full use of them can be made only when production is carried on a large scale but because of indivisibility or lumpiness, they have to be employed even at a small level of output. Such inputs cannot be divided into small sizes to suit the small scale of production. Thus because of indivisibility of such factors, they have to be employed in a minimum quantity even if scale of production is relatively small. Therefore, when scale of production is increased by increasing all inputs, productivity of indivisible factor increases considerably and thus, in turn, results in increasing returns to scale.

3)     Managerial economies: Like specialised machines, managerial skills are also indivisible. Suppose a manager can optimally supervise 10,000 units of production in a week but only 5,000 units are produced in a week then the managerial cost gets distributed over less units of output. It will be possible to reduce cost per unit until 10,000 units are produced or total output will rise, proportionately more with increments of labour and capital inputs. The extent to which managerial economies can be enjoyed by a producing unit depends on the efficiency of the manager.

4)     Superior machinery : The increase in the scale of production enables the efficiency of factors to be increased by the introduction of superior and more specialised machinery. So, even if there is no lumpiness of a factor and all factors are proportionately increased, increasing returns may operate because of the possibility of introducing more superior and specialised machinery. The possibility of installing technologically more efficient machinery is an equally important factor responsible for increasing returns to operate initially.

5)     Dimensional relations: Increasing returns to scale is also a matter of dimensional relations. For example when the size of a room (10' 5' = 50 sq ft) is doubled (20' 10') the area of the room is more than doubled (i.e.= (equal to) 200 sq.ft.) Similarly, if we double the number of bricks and other inputs that go with them, the storage capacity of the warehouse is more than doubled. This is thus a case of increasing returns to scale. Similarly, if the diameter of a pipe is doubled, the flow of water is more than doubled. Following the same logic when labour and capital are doubled, the output is more than doubled.

 

Diseconomies of Scale

Diseconomies of Scale are the disadvantages which a producing unit gets by: expanding the size of the plant or scale of production beyond a particular level. Diseconomies of scale are also referred to as internal diseconomies because they are peculiar to a particular producing unit. Some of the diseconomies of scale can be enumerated as follows:

1) Limitations to efficient management: Managing a unit entails controlling and coordinating a wide variety of activities such as production, sales, advertisement, transportation etc. As the scale of plant expands beyond a particular point, top management is forced to delegate responsibility and authority to lower management. This leads to loosening of control and thus the efficiency of operation begins to decline. Even if all the variable factors are increased in a given proportion, total output does not increase by the same proportion.

2) Limited uses of the natural resources: If production is defined as mining of natural resources, then this factor is very important. For example, doubling of coal mining plants may not double the coal output because of limitedness of coal deposits or difficult accessibility to coal deposits. Similarly, doubling the fishing fleet may not double the fish output because the availability of fish may decrease when fishing is carried out on an increasing scale.

It is quite difficult to determine when diseconomies of scale set in and when they become strong enough to outweigh the economies of scale. One thing can be safely stated that diseconomies become important when economies of scale are negligible. Even after the efficiency of management begins to fall, technological economies of scale may offset the diseconomies over a wide range of outputs. Diseconomies of scale primarily arise because of management factor while economies of scale arise because of technological, management or technical indivisibility. It is only when management diseconomies of scale outweigh economies of scale arising because of management and factors the net diseconomies of scale will exist to explain the emergence of diminishing returns to scale.

 

 

Q – State the relation between Total Cost, Average Cost & Marginal Cost.

Ans. TOTAL COST, AVERAGE COST & MARGINAL COST

Total cost (TC) of a firm is the sum-total of all the explicit and implicit expenditures incurred for producing a given level of output. It represents the money value of the total resources required for production of goods and services. For example, a shoe-maker’s total cost will 7 include the amount s/he spends on leather, thread, rent for his/her workshop, interest on borrowed capital, wages and salaries of employees, etc., and the amount s/he charges for his/her services and funds invested in the business. The total cost concept is useful in break-even analysis and finding out whether a firm is making profit or not.

Average cost (AC) is the cost per unit of output. That is, average cost equals the total cost divided by the number of units produced (N).If TC =₹500 and N = 50 then AC = ₹10.The average cost concept is significant for calculating the per unit profit.

Marginal cost (MC) refers to the change in total cost associated with a one-unit change in output. Marginal cost (MC) is the extra cost of producing one additional unit. At a given level of output, one examines the additional costs being incurred in producing one extra unit and this yields the marginal cost. For example, if TC of producing 100 units is ₹10,000 and the TC of producing 101 units is ₹10,050, then MC at N = 101 equals ₹50.This cost concept is significant to short-term decisions about profit maximizing rates of output. For example, in an automobile manufacturing plant, the marginal cost of making one additional car per production period would be the labour, material, and energy costs directly associated with that extra car. Marginal cost is that sub category of incremental cost in the sense that incremental cost may include both fixed costs and marginal costs.

However, when production is not conceived in small units, management will be interested in incremental cost instead of marginal cost. For example, if a firm produces 5000 units of TV sets, it may not be possible to determine the change in cost involved in producing 5001 units of TV sets. This difficulty can be resolved by taking units to significant size. For example, if the TV sets produced is measured to hundreds of units and total cost (TC) of producing the current level of three hundred TV sets is ₹15, 00,000 and the firm decides to increase the production to four hundred TV sets and estimates the TC as ₹18, 00,000, then the incremental cost of producing one hundred TV sets (above the present production level of three hundred units) is ₹3, 00,000. The marginal and incremental cost concepts are needed in deciding whether a firm needs to expand its production or not. In fact, the relevant costs to be considered will depend upon the situation or production problem faced by the manager.

 

 

Q – State the Problems in Estimation of Cost Function.

Ans. Problems in Estimation of Cost Function

We confront certain problems while attempting to derive empirical cost functions from economic data. Some of these problems are briefly discussed below.

1. In collecting cost and output data we must be certain that they are properly paired. That is, the cost data applicable to the corresponding data on output.

2. We must also try to obtain data on cost and output during a time period when the output has been produced at relatively even rate. If for example, a month is chosen as the relevant time period over which the variables are measured, it would not be desirable to have wide weekly fluctuations in the rate of output. The monthly data in such a case would represent an average output rate that could disguise the true costoutput relationship. Not only should the output rate be uniform, but it also should be a rate to which the firm is fully adjusted. Furthermore, there should be no disruptions in the output due to external factors such as power failures, delays in receiving necessary supplies, etc. To generate the data necessary for a meaningful statistical analysis, the observations must include a wide range of rates of output. Observing cost-output data for the last 24 months, when the rate of output was the same each month, would provide little information concerning the appropriate cost function.

3. The cost data is normally collected and recorded by accountants for their own purposes and in a manner that it makes the information less than perfect from the perspective of economic analysis. While collecting historical data on cost, care must be taken to ensure that all explicit as well as implicit costs have been properly taken into account, and that all the costs are properly identified by time period in which they were incurred.

4. For situations in which more than one product is being produced with given productive factors, it may not be possible to separate costs according to output in a meaningful way. One simple approach of allocating costs among various products is based on the relative proportion of each product in the total output. However, this may not always accurately reflect the cost appropriate to each output.

5. Since prices change over time, any money value cost would therefore relate partly to output changes and partly to price changes. In order to estimate the cost-output relationship, the impact of price change on cost needs to be eliminated by deflating the cost data by price indices. Wages and equipment price indices are readily available and frequently used to ‘deflate’ the money cost.

6. Finally, there is a problem of choosing the functional form of equation or curve that would fit the data best. The usefulness of any cost function for practical application depends, to a large extent, on appropriateness of the functional form chosen. There are three functional forms of cost functions, which are popular, viz., linear, quadratic and cubic. The choice of a particular function depends upon the correspondence of the economic properties of the data to the mathematical properties of the alternative hypotheses of total cost function.

The accounting and engineering methods are more appropriate than the econometric method for estimating the cost function at the firm level, while the econometric method is more suitable for estimating the cost function at the industry or national level. There has been a growing application of the econometric method at the macro level and there are good prospects for its use even at the micro level. However, it must be understood that the three approaches discussed above are not competitive, but are rather complementary to each other. They supplement each other. The choice of a method therefore depends upon the purpose of study, time and expense considerations.

 

Q – Explain estimation of Cost Function.

Ans. ESTIMATION OF COST FUNCTION

Several methods exist for the measurement of the actual cost-output relation for a particular firm or a group of firms, but the three broad approaches - accounting, engineering and econometric – are the most important and commonly used.

Accounting Method

This method is used by the cost accountants. In this method, the cost-output relationship is estimated by classifying the total cost into fixed, variable and semi-variable costs. These components are then estimated separately. The average variable cost, the semi-variable cost which is fixed over a certain range of output, and fixed costs are determined on the basis of inspection and experience. The total cost, the average cost and the marginal cost for each level of output can then be obtained through a simple arithmetic procedure. Although, the accounting method appears to be quite simple, it is a bit cumbersome as one has to maintain a detailed breakdown of costs over a period to arrive at good estimates of actual costoutput relationship. One must have experience with a wide range of fluctuations in output rate to come up with accurate estimates.

Engineering Method

The engineering method of cost estimation is based directly on the physical relationship of inputs to output, and uses the price of inputs to determine costs. This method of estimating real world cost function rests clearly on the knowledge that the shape of any cost function is dependent on: (a) the production function and (b) the price of inputs. We have seen earlier in Unit – 7 while discussing the estimation of production function that for a given the production function and input prices, the optimum input combination for a given output level can be determined. The resultant cost curve can then be formulated by multiplying each input in the least cost combination by its price, to develop the cost function. This method is called engineering method as the estimates of least cost combinations are provided by engineers. The assumption made while using this method is that both the technology and factor prices are constant. This method may not always give the correct estimate of costs as the technology and factor prices do change substantially over a period of time. Therefore, this method is more relevant for the short run. Also, this method may be useful if good historical data is difficult to obtain. But this method requires a sound understanding of engineering and a detailed sampling of the different processes under controlled conditions, which may not always be possible.

Econometric Method

This method is also sometimes called statistical method and is widely used for estimating cost functions. Under this method, the historical data on cost and output are used to estimate the costoutput relationship. The basic technique of regression is used for this purpose. The data could be a time series data of a firm in the industry or of all firms in the industry or a cross-section data for a particular year from various firms in the industry. Depending on the kind of data used, we can estimate short run or long run cost functions. For instance, if time series data of a firm whose output capacity has not changed much during the sample period is used, the cost function will be short run. On the other hand, if cross-section data of many firms with varying sizes, or the time series data of the industry as a whole is used, the estimated cost function will be the long run one.

 

 

Q – Explain Cost Function & It’s Determinants.

Ans. COST FUNCTION AND ITS DETERMINANTS

Cost function expresses the relationship between cost and its determinants such as the size of plant, level of output, input prices, technology, managerial efficiency, etc. In a mathematical form, it can be expressed as,

C = f (S, O, P, T, E….)

Where, C = cost (it can be unit cost or total cost)

S = plant size O = output level

P = prices of inputs used in production

T = nature of technology

E = managerial efficiency

Determinants of Cost Function The cost of production depends on many factors and these factors vary from one firm to another firm in the same industry or from one industry to another industry. The main determinants of a cost function are:

a) plant size

b) output level

c) prices of inputs used in production,

d) nature of technology

e) managerial efficiency

We will discuss briefly the influence of each of these factors on cost.

a) Plant size: Plant size is an important variable in determining cost. The scale of operations or plant size and the unit cost are inversely related in the sense that as the former increases, unit cost decreases, and vice versa. Such a relationship gives downward slope of cost function depending upon the different sizes of plants taken into account. Such a cost function gives primarily engineering estimates of cost.

b) Output level: Output level and total cost are positively related, as the total cost increases with increase in output and total cost decreases with decrease in output. This is because increased production requires increased use of raw materials, labour, etc., and if the increase is substantial, even fixed inputs like plant and equipment, and managerial staff may have to be increased.

c) Price of inputs: Changes in input prices also influence cost, depending on the relative usage of the inputs and relative changes in their prices. This is because more money will have to be paid to those inputs whose prices have increased and there will be no simultaneous reduction in the costs from any other source. Therefore, the cost of production varies directly with the prices of production.

d) Technology: Technology is a significant factor in determining cost. By definition, improvement in technology increases production leading to increase in productivity and decrease in production cost. Therefore, cost varies inversely with technological progress. Technology is often quantified as capital-output ratio. Improved technology is generally found to have higher capital-output ratio.

e) Managerial efficiency: This is another factor influencing the cost of production. More the managerial efficiency less the cost of production. It is difficult to measure managerial efficiency quantitatively. However, a change in cost at two points of time may explain how organizational or managerial changes within the firm have brought about cost efficiency, provided it is possible to exclude the effect of other factors.

 

 

Q – State the types of Statistical Analysis.

Ans. Types of Statistical Analyses

Once a functional form of a production function is chosen the next step is to select the type of statistical analysis to be used in its estimation. Generally, there are three types of statistical analyses used for estimation of a production function. These are:

(a) time series analysis,(b)cross-section analysis and(c) engineering analysis.

a) Time series analysis: The amount of various inputs used in various periods in the past and the amount of output produced in each period is called time series data. For example, we may obtain data concerning the amount of labour, the amount of capital, and the amount of various raw materials used in the steel industry during each year from 1970 to 2000. On the basis of such data and information concerning the annual output of steel during 1970 to 2000, we may estimate the relationship between the amount soft he inputs and the resulting output, using regression techniques.

Analysis of time series data is appropriate for a single firm that has not undergone significant changes in technology during the time span analyzed. That is, we cannot use time series data for estimating the production function of a firm that has gone through significant technological changes. There are even more problems associated with the estimation a production function for an industry using time series data. For example, even if all firms have operated over the same time span, changes in capacity, inputs and outputs may have proceeded at a different pace for each firm. Thus, cross section data may be more appropriate.

b) Cross-section analysis: The amount of inputs used and output produced in various firms or sectors of the industry at a given time is called cross- section data. For example, we may obtain data concerning the amount of labour, the amount of capital, and the amount of various raw materials used in various firms in the steel industry in the year 2000. On the basis of such data and information concerning the year 2000, output of each firm, we may use regression techniques to estimate the relationship between the amounts of the inputs and the resulting output.

c) Engineering analysis: In this analysis we use technical information supplied by the engineer or the agricultural scientist. This analysis is undertaken when the above two types do not suffice. The data in this analysis is collected by experiment or from experience with day-to-day working of the technical process. There are advantages to be gained from approaching the measurement of the production function from this angle. Because the range of applicability of the data is known, and, unlike time- series and cross-section studies, we are not restricted to the narrow range of actual observations.

 

 

Q – State the Factors Determining the Nature of Competition.

Ans. We have already seen that the number of firms and product differentiation are extremely crucial in determining the nature of competition in a market. It has been tacitly assumed that there are a large number of buyers. What would happen if there are several firms producing standardized product but only one buyer? Obviously, the buyer would control the price, he will dictate how much to buy from whom. The entire price-volume decision takes on a different qualitative dimension. Similarly, product features and characteristics, the natures of production systems, the possibility of new entrants in a market have profound impact on the competitive behaviour of firms in a market. The ‘entry’ of new firms has special relevance in business behaviour which we discuss in the next section and deal with other issues in the present one.

Effect of Buyers

We have already referred to the case where there is only one buyer. Such a situation has been referred to as monopsony. For example, there are just six firms in India manufacturing railway wagons all of which supply to just one buyer, the Railways. Such a situation can also exist in a local labour market where a single large firm is the only provider of jobs for the people in the vicinity. More frequently encountered in the Indian markets is a case of a few large buyers, defined as oligopsony. The explosive industry which makes detonators and commercial explosives has three major customers: Coal India Ltd. (CIL), Department of Irrigation and various governmental agencies working on road building activities. Of these, just one customer, CIL takes nearly 60% of theindustry’s output. There are about 10 firms in the industry, which negotiate prices and quantities with CIL to finalize their short-term plans. Most industries manufacturing heavy equipment in India are typically dominated by a few manufacturers and few buyers with the Government being the major buyer. Price and volume determination in such products often takes the form of ‘negotiation across the table’ rather than the operation of any market forces. Since the members in the whole market inclusive of buyers and sellers are not many, very often they know each other. In other situations, like the consumer goods, firms have no direct contact with their customers.

Production Characteristics

Minimum efficient scale (MES) of production in relation to the overall industry output and market requirement sometimes plays a major role in shaping the market structure. MES is the minimum scale of output that is necessary for a firm to produce in order to take advantages of economies of scale. For example, the minimum efficient scale for an automobile firm is very high. This is intuitively appealing because if only 100 cars are produced in a capital intensive automobile plant, the average costs will be high, while a larger volume of cars will allow the fixed costs to be spread over a number of cars, thus reducing average costs and increasing the minimum efficient scale. MES for a service firm such as a travel agent will accordingly be relatively small. The reason why there are no more than say, around 10 integrated steel plants even in an advanced country like the U. S. A. can be partly explained by economies of scale and thus MES. Since the minimum economic size of such a steel plant is a few million tonnes, the entire world steel industry can have no more than 100 efficient and profitable firms. Thus every country has only a handful of steel plants. On the other hand, when one comes to rolling mills which take the steel billets or bars as input, the minimum efficient size comes down considerably, and given the existing demand, several firms can be seen to operate.

Product Characteristics

We have already stated that product differentiation is an important market characteristic because it indicates a firm’s ability to affect price. If a firms product is perceived as having unique features, it can command a premium price and the firm is said to possess market power. For example, the Rolls Royce has come to be regarded as the ultimate in automobile luxury and therefore commands a high price. Consumers are willing to pay that premium for the product. The degree of competition faced by Rolls Royce or Mercedes Benz is thus very low. One could also consider the example of railway services 10 in India. Indian Railway Catering and Tourism Corporation (IRCTC) have monopoly in railways so people are just dependent on IRCTC for railway ticket bookings. Thus, the market for railway services is not competitive in the sense that only one corporation provides the service. Although this monopoly is due to government restrictions in India which is going to change in the coming years. On the other hand, for a product like soap or detergents, there are many firms producing a large variety of substitutable products. Therefore, one notices more competition, in the detergent market. The physical characteristics of a product can also influence the competitive structure of its market. If the distribution cost is a major element in the cost of a product, competition would tend to get localized. Similarly, for perishable products, the competition is invariably local.

Conflict between physical characteristics and minimum economic size

An interesting question arises in the case of a product like cement. For reasons of minimizing the transport costs on raw materials, most cement plants in the country are located near mine sites. A large efficient plant near a mine site can manufacture cement at the optimum cost, but the local demand is never large enough. If such a plant has to sell in far away markets (from Gujarat to Kerala, for example) the transport costs can be quite high. Customers located in such areas will always buy cement at a much higher price. The government partly offsets this by using the mechanism of levy price which is the same throughout the country.

 

 

Q – Explain Barriers to Entry.

Ans. BARRIERS TO ENTRY

Market selection: Entry and Exit Market selection process includes firm’s entry, then its survival and finally the exit process. The selection and expansion depends how efficient the firm is. The efficient firms enter and the inefficient ones exit.

Conditions of Entry: The entry of a new firm in an industry or a market depends on the ease with which it can enter. If we see the long-term perspective, the number of firms and the degree of seller concentration depends on the conditions of entry. In case of free entry, the number of sellers is large in number and in case of restricted entry, the number of sellers tend to reduce. In the long run the degree of competition depends on the condition of entry. A new entrant could bring with it the following advantages.

·       Provides new goods and services,

·       Changes the balance between different sectors,

·       Comes with new technological and managerial techniques,

·       Increases opportunities.

 

Factors determining conditions of entry

The following are some of the factors that determine the structure of any market. This list is not meant to be exhaustive, but is likely to cover a large part of real world situations.

·       Legal barriers

·       Initial capital cost

·       Vertical integration

·       Optimum scale of production

·       Product differentiation

 

Legal barriers: Almost all countries have their set of rules and regulations. Patent law is one such regulation, which promotes and protects the interests of inventors and innovators. Under this law, no firm other than the patent holder or the licensed firm is allowed to make use of the process. India has its own legal barriers and it has certain laws like Industrial Licensing Regulation and Reservation of products, which restrict entry and thus protect the incumbent firm from competition.

Initial capital cost: For industries producing basic inputs like coal, steel, power etc., the initial capital cost is quite high. Therefore, it becomes difficult for new entrepreneurs to enter. In industries where the capital requirement is high, the market is dominated by a few firms, whereas for industries such as non-durable consumer goods, the initial capital cost is less and therefore the number of firms in the market can be quite large.

Vertical integration: A vertically integrated firm is one that produces raw material i.e. an intermediate product as well as the final product. Examples of vertically integrated firms in India are integrated steel plants such as SAIL and TISCO and DMart a supermarket chain. Entry in this case is restricted to limited producers as here the existing producer produces raw material or an intermediate product along with the final product. New entrants will find that their capital requirements are high and hence it will not be easy for them to enter the market.

Optimization: Optimum scale of production means the scale of output at which the long run average cost of production is minimum. As defined earlier this is the minimum efficient scale of production for the firm. If the optimum scale of output for any product is quite large and if the total market is can be efficiently served by a few firms, the new entrants will find it difficult to enter such markets. Examples of such markets are electricity generation and aircraft production.

Product differentiation: New entrant faces difficulty to enter the market where the products are highly differentiated. Consider the ready to eat breakfast cereal industry in the US. Kellogs is the market leader and produces more than 40 different kinds of cereal ranging from the ordinary corn flakes to granola flakes and muesli. With such a wide variety, new entrants find it difficult to compete with Kellogs for shelf space in retail outlets which is crowded with Kellogs products. By implementing such widespread product differentiation, Kellogs has managed to increase the cost of entry for potential entrants in the market.

Natural barriers: Economies of scale create a natural barrier to the entry of new firms and it occurs when the long run average cost curve of a firm decreases over a large range of output, in relation to the demand for the product. Due to the existence of substantial economies of scale, the average cost at smaller rates is so high that the entry is not profitable for small-scale firms. This results in existence of natural monopoly. Power generation, Aircraft manufacturers, Railways, etc. are examples of natural monopolies. You should keep in mind that technological progress often undermines the natural monopoly character of certain industries. This has happened in telecommunications, which not very long ago used to be considered a natural monopoly.

Legal barriers: Patents, as discussed above, are an example of a legal entry barrier. Industrial licensing that used to be common in India in the 1970s and 80s is another example of such a barrier. By giving a license to a firm the government provided exclusive rights to that firm or a few firms to produce. This restricted the number of players in the market through industrial licensing, thus creating a legal entry barrier.

Strategic barriers: Such barriers exist exclusively due to the strategic behaviour of existing firms. Managers undertake investments to deter entry by raising the rival’s entry costs. To bar or restrict the entry of a new entrant, an established firm may change price lower than the short-run profit-maximizing price. This strategy is known as entry limit pricing. The entry limit pricing depends on established firm taking a cost advantage over potential entrants. The established firm must have a long run average cost curve below that of the other firm in order to lower its price and continue to make an economic profit.

Building Excess Capacity: Another way to restrict the entry is to build and maintain excess capacity over and above the required amount. This poses a threat to the new entrant deliberating the fact that the established firm is prepared to increase the output and lower the price if and when entry occurs. The excess capacity can be built up easily as it takes a longer time for the new entrant to build a factory of such capacity. This type of barrier is also known as capacity barrier to entry.

Producing Multiple Products: Economies of scope arise when cost of producing two or more goods together is less costly than producing the two goods separately. The process goes on and becomes cost effective as more goods are produced. This acts as entry deterrent for new firms.

New Product Development: Producing substitutes for its own product in the market can discourage the entry for the new firms. For example HUL producing different types of soaps targeted to different customer base. The more the number of substitutes, the lower and more elastic is the demand for any given product in the market. This makes the entry of new firm more difficult.

Take the case of Microsoft. Why does every other personal computer (PC)/laptop that one comes across is Microsoft windows compatible. The PC cannot work without windows. By developing industry level standards, Microsoft has created ‘high switching costs’ in an attempt to create entry barriers.

 

 

Q – State the Characteristics of Perfect Competition.

Ans. CHARACTERISTICS OF PERFECT COMPETITION

Perfect competition is a form of market in which there are a large number of buyers and sellers competing with each other in the purchase and sale of goods, respectively and no individual buyer or seller has any influence over the price. Thus perfect competition is an ideal form of market structure in which there is the greatest degree of competition. A perfectly competitive market has the following characteristics:

1. There are a large number of independent, relatively small sellers and buyers as compared to the market as a whole. That is why none of them is capable of influencing the market price. Further, buyers/sellers should not have any kind of association or union to arrive at an understanding with regard to market demand/price or sales.

2. The products sold by different sellers are homogenous and identical. There should not be any differentiation of products by sellers by way of quality, variety, colour, design, packaging or other selling conditions of the product. That is, from the point of view of buyers, the products of competing sellers are completely substitutable

3. There is absolutely no restriction on entry of new firms into the industry and the existing firms are free to leave the industry. This ensures that even in the long run the number of firms would continue to remain large and the relative share of each firm would continue to remain insignificant.

4. Both buyers and sellers in the market have perfect knowledge about the conditions in which they are operating. Buyers know the prices being charged by different competing sellers and sellers know the prices that different buyers are offering.

5. The distance between the locations of competing sellers is not significant and therefore the price of the product is not affected by the cost of transportation of goods. Buyers do not have to incur noticeable transport costs if they want to switch over from one seller to another.

 

 

Q –  Comment on the Following –

1.     Price Discrimination

2.     Peak Load Pricing

3.     Transfer Pricing

 

Ans.

1. PRICE DISCRIMINATION

In economic jargon, price discrimination is usually termed monopoly price discrimination. This label is appropriate because price discrimination cannot happen in a perfectly competitive industry in equilibrium. Monopoly power must be present in a market for price discrimination to exist. This seems a trivial point, when you understand, the definition of price discrimination; the practice of charging different prices to various consumers for a given product. In a competitive market, consumers would simply buy from the cheapest seller, and producers would sell to the highest bidders, and that would be that.

With monopoly power, however, the opportunity may exist for the firm to offer different terms (of which price is only one component) to different purchasers, thus dividing the market–a practice known as market segmentation. Price discrimination refers to the situation where a monopoly firm charges different prices for exactly the same product. The monopoly firm (a single seller in the market) can discriminate between different buyers by charging them different prices because it has the power to control price by changing its output. The buyers of its product have no choice but to buy from it as the product has no close substitutes.

There are three types of price discrimination – First Degree price discrimination, Second Degree price discrimination, and Third Degree price discrimination. First degree price discrimination refers to a situation where the monopolist charges a different price for different units of output according to the willingness to pay of the consumer. For example, a doctor who is the only super specialist in the town may charge different fee for conducting surgery from different patients based on their ability to pay. Second degree price discrimination refers to a situation where the monopolist charges different prices for different set of units of the same product. For example, the electricity charges per unit of the first 100 Kwh of power consumption may be different from the rate charged for the additional 100 Kwhs. Another example is railway passenger fares; the per kilometer fare is higher for the first few kilometers, which declines as the distance increases. Thus the discrimination is based on volume of purchases. When the monopolist firm divides the market (for its product) into two or more markets (groups of buyers or segments) and charges different price in each market, it is known as third degree price discrimination. Airline tickets are a common example of this form of price discrimination. For example, lower rates are applicable to senior citizens than business travelers, electricity rates applicable to residential users are lower than those applied to commercial establishments and soon.

a)     First Degree Price Discrimination

 Monopolists engage in priced is crimination when they can increase their profits by doing so. Even if sellers know the maximum amount that different customers are willing to pay, developing a pricing scheme that makes each customer pay that amount, a practice known as first degree price discrimination, can be difficult. Under first degree price discrimination, the full benefit from the trade between buyer and seller accrues to the seller. One strategy to achieve first degree price discrimination is to sell to the highest bidders through sealed bid auctions. The auction approach is best suited for situations where the volume of sales are low (usually due to scarcity of the product), where there are many potential buyers who are unable to co-operate among themselves and where buyers all have access to the same information about the product’s characteristics. The auction approach would enable to seller to identify those buyers with the highest willingness to pay and would yield the highest possible revenues for the same production costs. This is a common strategy for the sale of very special types of products such as art objects, antique furniture or the rights to the mining and exploration of plots of land. It is not suitable for most bulk-produced products such as cans of color computers. Perfect or first-degree price discrimination can occur when a firm knows the maximum price the individual is willing to pay for each successive unit. The firm could then charge that highest price for each successive unit and capture the entire consumer surplus. Remember that all forms of price discrimination involve some monopoly power, but perfect price discrimination involves a degree of monopoly power rarely found in the real world.

b)    Second Degree Price Discrimination

Where the auction approach is not feasible, the company must do its best to approximate the first degree outcome using its pricing structure. This is based on the notion that an individual consumer derives diminishing satisfaction from each successive unit of any product consumed. 5 This form of price discrimination, which is based on the volume of consumer purchases, is very common and is known as second degree price discrimination. Other forms of second degree price discrimination include two-tier tariffs, i.e. prices where the consumer must pay a flat fee for access and then a separate fee (which may be zero) for usage. This is typical of many clubs, amusement parks and transport facilities offering monthly or annual passes.

c)     Third Degree Price Discrimination

Pricing based on what type of consumer is doing the purchasing rather than the volume of purchase is an approach known as third degree price discrimination. This is very common in the sales of air and rail travel, movie tickets and other products where consumers can be segmented into different groups, who are likely to differ greatly in their willingness to pay based on certain easily identifiable attributes.

 

 

2. PEAK LOAD PRICING

Peak load pricing is a type of third-degree price discrimination in which the discrimination base is temporal. We single out this particular form of price discrimination in part because of its widespread use. But remember that all forms of third-degree price discrimination, including peak load pricing, involve a seller attempting to capitalize on the fact that buyers’ demand elasticities vary. In the case of peak load pricing, customer demand elasticities vary with time.

Very few, if any, business economic activities are characterized by an absolutely constant demand during all seasons of the year and at all times of day. For many, the variations, or fluctuations, are not large enough to be of concern; but for some activities, fluctuations in demand are significant. These variations are sometimes relatively stable and predictable. Hotel 9 booking prices for vacation spots (say hill stations in India) are good example of peak load pricing. During peak season (summers), hotels booking charges are highest and reduced during off season. Travellers are encouraged to visit hill station during slack period (off season) and those who visit during peak season pay relatively higher prices. Whenever price discrimination is based on time differentials, the object of the selling firm is to charge a higher price for the product during the more inelastic period and a lower price during the more elastic interval.

 

3.      Transfer Pricing

In today’s world, a lot of companies have divided their operations into several divisions. Transfer pricing is setting the price for goods that are sold between these related legal entities (branches, subsidiary etc.). It means the price of goods, which is paid by one unit of an organization to another unit. E.g., Branch A of a company sells goods to Branch B, the price paid by B is the transfer price. Transactions covered under transfer pricing are Sale of finished goods, Purchase of raw material, IT Enabled services, Purchase of fixed assets, Sale or purchase of machinery, Sale or purchase of Intangibles, Reimbursement of expenses paid/received, Support services, Software Development services, Technical Service fees, Management fees, Royalty fees, Corporate Guarantee fees, Loan received or paid etc.

Purpose of transfer pricing

·       Profits of different units can be ascertained separately and this helps in separate performance evaluation of each unit of an organization.

·       Transfer pricing also impact resource allocation among different units of an organization.

Organization for Economic Cooperation and Development (OECD) is responsible for governing transfer pricing for multinational companies. Through transfer pricing, multinationals try to take tax advantage and that is the reason OECD has set some guidelines. It has specified a particular principle named Arm’s Length Principle (ALP) for these type of dealings between related parties. ALP states that prices should be set by assuming each party as independent, not dependent or related parties. In simple words, it means transactions should be executed at fair market price. In addition to this principle, guidelines also specify different methods of transfer pricing. These methods are divided into two main heads: Traditional Transaction Methods and Transactional Profit Methods.

Traditional Transaction Methods

·       Comparable Uncontrolled Price (CUP) method - Under these methods, comparison is done between the terms and conditions of uncontrolled transactions (with unrelated parties) and controlled transactions (related parties). This requires high standard comparable data to ensure that transaction has been done on the basis of ALP.

·       Resale price method - In this method, selling price of a product is used which is known as resale price. Margin amount and different costs (determined by comparing to unrelated transactions) are deducted to determine resale price.

·       Cost Plus method - Under this, a markup (profit) amount is added in the total costs incurred by the supplier unit of the organization.

Transactional Profit Methods

·       The Comparable Profits Method Under this method, basis of the transfer price is net profit of controlled transaction.

The Profit Split Method This pricing method