Eco I Uni 1 Model Paper PDF

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Unit 1Model Paper based on previous years’ question papers16 markers What is demand? Explain the determinants of demand. Synopsis:Introduction – Determinants of demand – ConclusionIntroductionDemand may be defined as the amount of the commodity an individual is willing to buy at a particular price a...

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Unit 1 Model Paper based on previous years’ question papers 16 markers 1. What is demand? Explain the determinants of demand.

Synopsis: Introduction – Determinants of demand – Conclusion Introduction Demand may be defined as the amount of the commodity an individual is willing to buy at a particular price and at a particular time. q = f(p) It means quantity demanded is a function of Price Here q= quantity demanded and P = price of the commodity. The relationship between demand and Price can be understood by the following table:

The above table represented in the form of graph is called Demand curve.

Thus we can see that other factors remaining constant price of a product and its quantity demanded is inversely related. This relation is called the law of demand. Determinants of Demand Demand is a multivariate function. It is determined by many variables. Traditionally the most important determinants of the market demand are considered to be the price of the commodity in question, the prices of other commodities, consumers’ income and tastes. Apart from these factors, demand is affected by numerous other factors such as distribution of income, total population and its composition, wealth, credit availability and habits. 1. Income of the consumer: A consumer’s demand is influenced by the size of his income. With increase in the level of income, there is increase in the demand for goods and services. A rise in income causes a rise in consumption. As a result, a consumer buys more. For most of the goods, the income effect is positive. But for the inferior goods, the income effect is negative. That means with a rise in income, demand for inferior goods may fall. 2. Price of the commodity: Price is a very important factor, which influences demand for the commodity. Generally, demand for the commodity expands when its price falls, in the same way if the price increases, demand for the commodity contracts. It should be noted that it might not happen, if other things do not remain constant. 3. Changes in the prices of related goods: Sometimes, the demand for a good might be influenced by prices changes of other goods. There are two types of related goods. They are substitutes and complements. Tea and Coffee are good substitutes. A rise in the price of coffee will increase the demand for tea and vice versa. Bread and butter are complements. A fall in the price of bread will increase the demand for butter and vice versa. 4. Tastes and preferences of the consumers: Demand depends on people’s tastes, preferences, habits and social customs. A change in any of these must bring about a change in demand. For example, if people develop a taste for tea in place of coffee, the demand for tea will increase and that for coffee will decrease. 5. Change in the distribution of income: If the distribution of income is unequal, there will be many poor people and few rich people in society. The level of demand in such a society will be low. On the other hand, if there is equitable distribution of income, the demand for necessaries commonly consumed by the poor will increase and the demand for luxuries consumed by the rich will decrease. However, the net effect of an equitable distribution of income is an increase in the level of demand. 6. Price expectations: Expectations of people regarding the future prices of goods also influence their demand. If people anticipate a rise in the prices of goods in future due to some reasons, the demand for goods will rise to avoid more prices in future. Contrarily, if the people expect a fall in price, the demand for the commodity will fall.

7. State of economic activity: The state of economic activity is major determinant influencing the demand for a commodity. During the period of boom, prosperity prevails in the economy. Investment, employment and income increase. The demand for both capital goods and consumer goods increase. But in period of depression demand declines due to low investment and low income. The level of demand for a commodity is also influenced by other factors like population, composition of population, taxation policy of the government, advertisement, natural calamities, pattern of saving, inventions and discoveries and outbreak of war, emergencies, weather, technical progress etc. Conclusion These are some of the determinants of demand. But of these determinants of demand, price of the product is regarded as the most important determinant.

2. State the law of supply with an illustration and diagram. Synopsis: Introduction – Law of Supply – Conclusion. Introduction Supply is the quantity of a product that a producer is willing and able to supply onto the market at a given price in a given time period. Law of Supply The law of supply expresses the relationship between the supply and price of a product. It states the direct relationship between the price of a product and its supply while other factors are kept constant. The law of supply can be stated as “other things remaining the same, the supply of a commodity expands with the rise in price and contracts with the fall in price.” The concept of law of supply can be explained with the help of a supply schedule and a supply curve. Supply Schedule Supply schedule represents the relationship between prices and the quantities that the firms are willing to produce and supply. In other words, at what price, how much quantity a firm wants to produce and supply. Suppose the following is an individual’s supply schedule of oranges. Table 1 Price Per Dozen ($)

Quantity Supplied (in dozens)

4

3

6

6

8

9

10

12

Price Per Dozen ($)

Quantity Supplied (in dozens)

12

13

The supply curve is a graphical representation of the law of supply. The supply curve has a positive slope, and it moves upwards to the right. This curve shows that at the price of $6, six dozens will be supplied and at the higher price $12, a larger quantity of 13 dozens will be supplied. Conclusion The law of supply states that other things being equal, the supply of a commodity extends with a rise in price and contracts with a fall in price. There are however a few exceptions to the law of supply, viz., Exceptions of a fall in price, Sellers who are in need of cash, When leaving the industry, Agricultural output and Backward sloping supply curve of labour.

3. What is cost? Explain cost of production in short period and long period through cost curves. Synopsis: Introduction – Short run Cost and Long run costs in traditional theory – Short run and long run concepts in modern theory – Conclusion. Introduction Cost of production refers to the total sum of money needed for the production of a particular quantity of output. When commodities and services are produced, various expenses have to be incurred, e.g., purchase of raw materials, payment to labour, landlord, capitalist, etc. The sum total of the expenses incurred plus the normal profit expected by the producer is called the cost of production. Short run is the time period when there is only one variable factor and all the factors are kept constant, whereas, long run is the time period when all the factors of production are variable. Traditional theory of Cost Short-run Cost Total Fixed Cost: It refers to the total obligations incurred by the firm per unit of time for all fixed inputs.

Total Variable Cost:the total obligations incurred by the firm per unit of time for all the variable input it uses. Total cost = TFC + TVC TFC is a straight line parallel to the output axis. The TVC has an inverse S- shape which reflects the law of variable proportions. TC is also inverse S-shaped.

Short-Run Average Costs: In the short run analysis of the firm, average costs are more important than total costs. The short-run average costs of a firm are the average fixed costs, the average variable costs, and the average total costs. 1. Average Fixed Costs or AFC AFC equal total fixed costs at each level of output divided by the number of units produced: AFC = TFC /Q The average fixed costs diminish continuously as output increases. This is natural because when constant total fixed costs are divided by a continuously increasing unit of output, the result is continuously diminishing average fixed costs. Thus the AFC curve is a downward sloping curve which approaches the quantity axis without touching it, as shown in Figure 3. It is a rectangular hyperbola. 2. Short-Run Average Variable Costs (or SAVC) SAVC equals total variable costs at each level of output divided by the number of units produced: SAVC = TVC/Q The average variable costs first decline with the rise in output as larger quantities of variable factors is applied to fixed plant and equipment. But eventually they begin to rise due to the law of diminishing returns. Thus the SAVC curve is U-shaped, as shown in Figure 3.

3. Short-Run Average Total Costs (or SATC or SAC) They are arrived at by dividing the total costs at each level of output by the number of units produced: SAC or SATC = TC/Q TFC/Q + TVC/Q = AFC+ AVC Average total costs reflect the influence of both the average fixed costs and average variable costs. At first average total costs are high at low levels of output because both average fixed costs and average variable costs are large. But as output increases, the average total costs fall sharply because of the steady decline of both average fixed costs and average variable costs till they reach the minimum point. This results from the internal economies, from better utilization of existing plant, labour, etc. The minimum point В in the figure represents optimal capacity. The rising portion of the SAC curve results from producing above capacity and the appearance of internal diseconomies of management, labour, etc. Thus the SAC curve is U- shaped due to the operation of the law of variable proportions, as shown in Figure 3. 4. Short Run Marginal Cost: A fundamental concept for the determination of the exact level of output of a firm is the marginal cost. Marginal cost is the addition to total cost by producing an additional unit of output: SMC = ∆ТС/∆Q Algebraically, MCn= TCn- TCn-1. Since total fixed costs do not change with output, therefore, marginal fixed cost is zero. So marginal cost can be calculated either from total variable costs or total costs. The result would be the same in both the cases. As total variable costs or total costs first fall and then rise, marginal cost also behaves in the same way. The SMC curve is also U-shaped, as shown in Figure 3. Relationship between the cost curves 1. The minimum point of ATC curve lies to the right of the minimum point of AVC curve. 2. The MC curve cuts AVC and ATC curves at their lowest points. Long-run Cost Curves of the traditional theory Long –run AC curve:

Long-run cost curve is a planning curve. It is a guide to the entrepreneur in his decision to plan the future expansion of his output. The long-run AC curve is derived from the short-run cost curves. Each point on the LAC corresponds to a point on a short-run cost curve, which is tangent to the LAC at that point. The point of tangency occurs to the falling part of the SAC curves for the points lying to the left of M the point of tangency occurs to the rising portion of SAC curves for points lying to the right of M. Only at the minimum point M of the LAC is the corresponding SAC also at a minimum. Each point of LAC shows the minimum cost for producing the corresponding level of output. In the traditional theory of the firm, the LAC curve is U-shaped and it is often called the ‘envelope curve’ because it envelopes the SRC curves. The U- shape of the LAC curve reflects the laws of returns to scale. The U-shaped LAC curve implies that each plant size is designed to produce optimally a single level of output. The plant is completely inflexible. Any departure leads to increasing costs. There is no reserve capacity. Long-run MC curve:

The long-run MC is derived from the SRMC curves. The LRMC is formed from the points of intersection of the SRMC curves with vertical lines drawn from the points of tangency of the corresponding SAC curve and the LAC curve. The LMC must be equal to SMC for the output at which the corresponding SAC is tangent to LAC.

Modern Cost Theory As early as 1939, George Stigler, suggested that the short-run AVC has a flat stretch over a range of output which reflects the fact that firms build plants with some flexibility in their productive capacity. Short-run Cost curves Here also, AFC is a rectangular hyperbola but it has some reserve capacity. The SAVC curve in modern theory has a saucer-type shape, i.e., it is broadly U-shaped but has a flat stretch over a range of output, corresponding to the built-in-the-plant reserve capacity. Over this stretch, the SAVC is equal to the MC, both being constant per unit of output. To the left of the flat stretch, MC lies below the SAVC while to the right of the flat stretch the MC rises above the SAVC.

The reserve capacity makes it possible to have constant SAVC within a certain range of output. It should be clear that this reserve capacity is planned in order to give the maximum flexibility in the operation of the firm.X1X2 reflects the planned reserve capacity which does not lead to increase in costs. On an average the entrepreneur expects to operate his plant within X 1X2 range. ATC is obtained by adding the AFC and AVC at each level of output. The ATC curve falls continuously up to the level of output X 2 at which the reserve capacity is exhausted. Beyond that level ATC will start rising. The MC will intersect the ATC at its minimum point.

Long-run cost Curves

The long-run costs in the modern cost theory may be classified into production costs and managerial costs. All costs are variable in the long run and they give rise to a long-run cost curve which is roughly Lshaped. The production costs fall continuously with increases in output. At very large scales of output managerial costs may rise. But the fall in production costs more than offsets the increase in the managerial costs so that the LAC curve falls smoothly or becomes flat at very large scales of output, thereby giving rise to the L-shape of the LAC curve.

This curve does not turn up at very large scales of output It does not envelope the SAC curves but intersects them at the optimal level of output of each plant. In the modern theory of costs, if the LAC curve falls smoothly and continuously even at very large scales of output, the LMC curve will lie below the LAC curve throughout its length, as shown in the Figure.

If the LAC curve is downward sloping up to the point of a minimum optimal scale of plant or a mini mum efficient scale (MES) of plant beyond which no further scale economies exist, the LAC curve becomes horizontal. In this case, the LMC curve lies below the LAC curve until the point M is reached, and beyond this point the LMC curve coincides with the LA С curve, as shown in the Figure below.

4. What is demand? State the law of demand with an illustration and diagram. OR Explain the law of demand with the help of a schedule and curves.

Synopsis: Introduction: Meaning and definition of demand – Law of Demand – Exceptions to the law of demand – Conclusion. Introduction The demand for a commodity is essentially consumer’s attitude and reaction towards that commodity. Precisely stated, the demand for a commodity is the amount of that commodity an individual will purchase or willing to take off from the market at various given prices in a given period of time. Thus, demand in economics implies both the desire to purchase and the ability to pay for a good. A mere desire for a commodity does not constitute demand for it, if it is not backed by the ability to pay. Demand for a good is determined by several factors such as price of the commodity, tastes and desires of the consumer for a commodity, income of the consumer, and the prices of related goods – substitutes or complements, price expectations, state of economic activity etc. Demand might be represented by a linear demand function such as Q(d) = a - bP Q(d) represents the demand for a good P represents the price of that good. The Law of Demand The law of demand expresses the functional relationship between price and quantity of the commodity demanded. According to the law of demand, other things being equal, if the price of a commodity

falls, the quantity demanded of it will rise and if the price of the commodity rises, its quantity demanded will increase. Thus, according to the law of demand, there is an inverse relationship between price and quantity demanded, other things remaining the same ( ceteris paribus). The law of demand can be explained with a demand schedule and a demand curve. A demand schedule is represented in the table given below. It can be seen from this demand schedule that when the price of the commodity X is Rs.12, the quantity demanded of X is 10, when price falls to Rs.10, the quantity demanded increases to 20 and so on. We can convert this demand schedule into a demand curve graphically by plotting the various price-quantity combinations. This has been done in the figure below where we plot price along the Y- axis and quantity demanded along the X- axis. Price

Quantity Demanded

12

10

10

20

8

30

6

40

4

50

2

60

14 12 10

price

8 6 4 2 0 0

10

20

30

40

50

60

70

Quantity

The demand curve is a graphic representation of quantities of a good which will be demanded by the consumer at various possible prices at a given moment of time. The downward sloping demand curve is in accordance with the law of demand, which describes an inverse relationship between price and demand.

By summing up the various quantities demanded by all the consumers in the market at various prices we get the market demand and its graphical representation is the market demand curve which also slopes downward to the right as it is the lateral summation of individual demand curves. Exceptions to the Law of Demand: As a general rule, demand curve slopes downwards, showing the inverse relationship between price and quantity demanded. However, in certain special circumstances, the reverse may occur, i.e. a rise in price may increase the demand. These circumstances are known as ‘Exceptions to the Law of Demand’. Some of the Important Exceptions are: 1. Giffen Goods: A Giffen good is a good for which demand increases as the price increases, and falls when the price decreases. A Giffen good has an upward-sloping demand curve, which is contrary to the fundamental law of demand which states that quantity demanded for a product falls as the price increases, resulting in a downward slope for the demand curve. A Giffen good is typically an inferior product that does not have easily available substitutes, as a result of which the income effect dominates the substitution effect. Giffen goods are quite rare, to the extent that there is some debate about their actual existence. The term is named after the economist Robert Giffen. th The most commonly cited example of a Giffen good is that of the Irish potato famine in the 19 century. During the famine, as the price of potatoes rose, impoverished consumers had little money left for more nutritious but expensive food items like meat (the income effect). So even though they would have preferred to buy more meat and fewer potatoes (the substitution effect), the lack of money led them to buy more potatoes and less meat. In this case, the income effect dominated the substitution effect, a characteristic of a Giffen good. 2. Goods having Prestige Value: Veblen Effect: One exception to the law of demand is associated with the name of the economist, Thorstein Veblen who propounded the doctrine...