Assignment No-2

Programme Name :MBA Semester: I

UID :- D21MBA16776 Credit: 4
Course Title : Managerial Economics Course Code: 21MBA615
Submitted Date: Last date of Submission: 21/07/2021
Max. Marks: 30 Weightage: 15 Marks

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SECTION A

Q1. How does Managerial Economics Different from Economics?

Ans: - Economics deals mainly with the theoretical aspect only whereas
Managerial Economics deals with the practical aspect.
... Managerial Economics studies the activities of an individual firm or unit.
Its analysis of problems is micro in nature, whereas Economics analyzes
problems both from micro and macro point of views.

Difference between Managerial Economics and Economics

The difference between managerial economics and economics can be

understood with the help of the following points:

 Managerial economics involves application of economic principles to the

problems of a business firm whereas; economics deals with the study of
these principles only. Economics ignores the application of economic
principles to the problems of a business firm.
 Managerial economics is micro-economic in character; however,
Economics is both macro-economic and micro-economic.
 Managerial economics, though micro in character, deals only with a
firm and has nothing to do with an individual’s economic problems.
But microeconomics as a branch of economics deals with both
economics of the individual as well as economics of a firm.
 Under micro economics, the distribution theories, viz .wages, interest and
profit, are also dealt with .Managerial economics on the contrary is
mainly concerned with profit theory and does not consider other
distribution theories. Thus, the scope of economics is wider than that of
managerial economics.
 Economic theory assumes economic relationships and builds economic
models. Managerial economics adopts, modifies and reformulates the
economic models to suit the specific conditions and serves the specific
problem solving process. Thus, economics gives the simplified model,
whereas managerial economics modifies and enlarges it.

Q2. Develop the relationship between total utility and marginal utility
with the help of schedule.
Ans: - The relation between total and marginal utility is explained with the
help of Table 1. So long as total utility is increasing, marginal utility is
decreasing up to the 4th unit. When total utility is maximum at the 5th unit,
marginal utility is zero. It is the point of satiety for the consumer.
While total utility measures the aggregate satisfaction an individual receives
from the consumption of a specific quantity of a good or service, marginal
utility is the satisfaction an individual receives from consuming one
additional unit of a good or service
Total Utility refers TU and Marginal Utility refers MU
TU increases with an increase in consumption of a commodity as long as
MU is positive. In this phase, TU increases but a diminishing rate
as MU from each successive unit tends to diminish. 2. When TU reaches its
maximum, MU becomes zero.

Q3. Explain Giffen Paradox through indifference curve analysis.

Ans: - Giffen's paradox refers to the possibility that standard competitive
demand, with nominal wealth held constant, can be upward sloping, violating the
law of demand. Thus the indifference curve analysis
is superior to Marshallian analysis in that it yields a more general law of
demand which covers the Giffen-good case. The explanation for the
occurrence of a Giffen good is that in its case the negative income effect
outweighs the substitution effect.
For instance, as Mr. Giffen has pointed out, a rise in the price of bread makes
so large a drain on the resources of the poorer laboring families and raises so
much the marginal utility of money to them, that they are forced to curtail
their consumption of meat and the more expensive farinaceous foods: and,
bread being

Q4. In what way production function is different from

cost function?
Ans: - Production function: Relates physical output of a production process
to physical inputs or factors of production. Marginal cost: The increase
in cost that accompanies a unit increase in output; the partial derivative of
the cost function with respect to output.
We'veexplainedthatafirm'stotalcostsdependonthequantitiesofinputs the firm
uses to produce its output and the cost of those inputs to the firm. The firm's
production function tells us how much output the firm.
will produce with given amounts of inputs From the firm's perspective,
factor payments are costs.
Total cost is what the firm pays for producing and selling its products. Recall
that production involves the firm converting inputs to outputs. Each of those
inputs has a cost to the firm. The sum of all those costs is total cost. We will
learn in this chapter that short run costs are different from long run costs.

Q5.Explain the geometrical relationship between the linear

AR and MR curves.
Ans: - Relationship between Average Revenue and Marginal Revenue are as
follows: -
Learn about the relationship between AR and MRCurves.
The relation between average revenue and marginal revenue can be
discussed under pure competition, monopoly or monopolistic competition
or imperfect competition.

(1) Under Pure Competition:

The average revenue curve is a horizontal straight line parallel to the X-
axis and the marginal revenue curve coincides with it. This is because
under pure (or perfect) competition the number of firms selling an
identical product is very large.

The price is determined by the market forces of supply and

demand so that only one price tends to prevail for the whole
industry, as shown in Table 1. It is OP, as shown in Panel (A) of
Figure 1. Each firm can sell as much as it wishes at the market
price OP.

Thus the demand for the firm’s product becomes infinitely elastic.
Since the demand curve is the firm’s average revenue curve, the shape
of the AR curve is horizontal to the X-axis at price OP, as shown in
Panel (B) and the MR curve coincides with it. This is also shown in
Table 1 where AR and MR remain constant at Rs.20 at every level of
output. Any change in the demand and supply conditions will change
the market price of the product, and
 consequently the horizontal AR curve of the firm.

(2) Monopolistic Competition:

Under monopolistic competition, the relationship between AR and MR is
the same as under monopoly. But there is an exception that the AR curve
is more elastic, as shown in Figure 6. This is because products are close
substitutes under monopolistic competition. The firm can increase its
sales by a reduction in its price.

Q6. State the difference between firm and industry at your point
of view?
Ans: - Industry refers to a kind of business inside an economy while a firm
is a business establishment inside an industry. A firm is a type of
business whereas an industry is a sub sector of an economy. • Rules and
regulations are made for an industry, and that typically apply to
all firms inside the industry

Firm
A business (also known as an enterprise, a company, or a firm) is an organizational
entity and legal entity made up of an association of people, be they natural, legal, or a
mixture of both who share a common purpose and unite in order to focus their
various talents and organize their collectively available skills or resources to achieve
specific declared goals and are involved in the provision of goods and services to
consumers. A business can also be described as an organization that provides goods
and services for human needs.
A company or association of persons can be created at law as legal person so
thatthecompanyinitselfcanacceptlimitedliabilityforcivilresponsibilityand taxation
incurred as members perform (or fail) to discharge their duty within the publicly
declared "birth certificate" or published policy.
Because companies are legal persons, they also may associate and register
themselves as companies – often known as a corporate group. When the company
closes it may need a "death certificate" to avoid further legal obligations.
Industry
An industry is the production of goods or related services within an economy. The
major source of revenue of a group or company is the indicator of its relevant
industry. When a large group has multiple sources of revenue generation, it is
considered to be working in different industries.
Manufacturing industry became a key sector of production and labour in
European and North American countries during the Industrial Revolution,
upsetting previous mercantile and feudal economies. This came through many
successive rapid advances in technology, such as the production of steel and
coal.
Following the Industrial Revolution, possibly a third of the economic output comes
from manufacturing industries. Many developed countries and many
developing/semi-developed countries (China, India etc.) depend significantly on
manufacturing industry.

Q7. What is circular flow in a Simple economic model? Discuss

Ans: - The circular flow model demonstrates how money moves through
society. Money flows from producers to workers as wages and flows back to
producers as payment for products. In short, an economy is an
endless circular flow of money. That is the basic form of the model, but
actual money flows are more complicated.
The economy can be thought of as two cycles moving in opposite
directions. In one direction, we see goods and services flowing from
individuals to businesses and back again. This represents the idea that, as
laborers, we go to work to make things or provide services that people
want.

In the opposite direction, we see money flowing from businesses to

households and back again. This represents the income we generate from
the work we do, which we use to pay for the things we want.

Both of these cycles are necessary to make the economy work. When we
buy things, we pay money for them. When we go to work, we make
things in exchange for money.
The circular flow model of the economy distills the idea outlined above
and shows the flow of money and goods and services in a capitalist
economy.

Q8. Can the Keynesian theory of income and employment is

determined through aggregate

Ans: - Keynesian Theory of Income determination. According to Keynes’ own theory of

income and employment: "In the short period, level of national income and so of
employment is determined by
aggregate demand and aggregate supply in the country.

The Keynesian Theory of Income, Output and Employment!

In the Keynesian theory, employment depends upon effective demand.
Effective demand results in output. Output creates income. Income provides
employment. Since Keynes assumes all these four quantities, viz., effective
demand (ED), output (Q), income (Y) and employment (N) equal to each
other, he regards employment as a function of income.

Effective demand is determined by two factors, the aggregate supply

function and the aggregate demand function. The aggregate supply function
depends on physical or technical conditions of production which do not
change in the short-run.

Since Keynes assumes the aggregate supply function to be stable, he

concentrates his entire attention up on the aggregate demand function to
fight depression and unemployment. Thus employment depends on
aggregate demand which in turn is determined by consumption demand
and investment demand.

According to Keynes, employment can be increased by increasing

consumption and/or investment. Consumption depends on income C(Y)
and when income rises, consumption also rises but not as much as
income. In other words, as income rises, saving rises.

Consumption can be increased by raising the propensity to consume in

order to increase income and employment. But the propensity to consume
depends upon the psychology of the people, their tastes, habits, wants and
the social structure which determine the distribution of income.

All these elements remain constant during the short-run. Therefore, the
propensity to consume is stable. Employment thus depends on
investment and it varies in the same direction as the volume of
investment.

Investment, in turn, depends on the rate of interest and the marginal

efficiency of capital (MEC). Investment can be increased by a fall in the
rate of interest and/or arise in the MEC. The MEC depends on the supply
price of capital assets and their prospective yield.

It can be raised when the supply price of capital assets falls or their
prospective yield increases. Since the supply price of capital assets is
stable in the short- run, it is difficult to lower it. The second
determinant of MEC is the prospective yield of capital assets which
depends on the expectations of yields on the part of businessmen. It is
again a psychological factor which cannot be depended upon to increase
the MEC to raise investment. Thus there is little scope for increasing
investment by raising the MEC.

Q9. What is propensity to consume? Discuss any two factors on

which the consumption curve depends.

Ans: - Propensity to consume, in economics, the proportion of total income or

of an increase in income that consumers tend to spend on goods and services
rather than to save.

The main factors that drive the marginal propensity to consume (MPC)
are the availability of credit, taxation levels, and consumer confidence.
According to Keynesian economic theory, the propensity to
consume can be influenced by government economic policy. According to
Keynes, two types of factors influence the consumption function:
subjective and objective. The subjective factors are endogenous or internal
to the economic system itself. Consumption function, in economics, the
relationship between consumer spending and the various factors determining
it. At the household or family level, these factors may include income,
wealth, expectations about the level and riskiness of future income or
wealth, interest rates, age, education, and family size.

Q10. Distinguish between demand-pull and cost-cash inflation.

Ans: -

Cost-Push Inflation vs. Demand-Pull Inflation: An Overview

There are four main drivers behind inflation. Among them is cost-push inflation
or the decrease in the aggregate supply of goods and services stemming from an
increase in the cost of production, and demand-pull inflation, or the increase in
aggregate demand, categorized by the four
Sections of the macro economy: households, business, governments, and foreign
buyers. The two other contributing factors to inflation include an increase in the
money supply of an economy and a decrease in the demand for money.

Inflation is the rate at which the general price level of goods and
Services rises. This, in turn, causes a drop in purchasing power. This is not to
be confused with the change in the prices of individual goods and services,
which rise and fall all the time. Inflation happens when prices rise across the
economy to a certain degree.

SECTION B

Q1. What are the types of demand determinants?

Ans: - The Five Determinants of Demand

The five determinants of demand are:

1. The price of the good or service.

2. The income of buyers.
3. The prices of related goods or services—either complementary and
purchased along with a particular item, or substitutes and bought instead
of a product.
4. The tastes or preferences of consumers will drive demand.
5. Consumer expectations. Most often, this refers to whether a consumer
believes prices for the product will rise or fall in the future.

For aggregate demand, the number of buyers in the market is the sixth
determinant.

Demand Equation or Function

This equation expresses the relationship between demand and its five
determinants
qD = f (price, income, prices of related goods, tastes, expectations)

As you can see, this isn't a straightforward equation like 2 + 2 = 4. It isn't that
simple to create an equation that accurately predicts the exact quantity that
consumers will demand.

Instead, this equation highlights the relationship between demand and its key
factors. The quantity demanded (qD) is a function of five factors—price, buyer
income, the price of related goods, consumer tastes, and any consumer
expectations of future supply and prices. As these factors change, so too does the
quantity demanded.

How Each Determinant Affects Demand

Each factor's impact on demand is unique. When the income of the buyer
increases, for example, that could also increase demand. The buyer has more
money and is more likely to spend it. But when other factors increase—like
the price of related goods, for example demand could decrease.

Before breaking down the effect of each determinant, it's important to note that
these factors don’t change in a vacuum. All the factors are in flux all the time. To
understand how one determinant affects demand, you must first hypothetically
assume that all the other determinants don’t change.

The law of demand states that when prices rise, the quantity of demand falls.
That also means that when prices drop, demand will grow. People base their
purchasing decisions on price if all other things are equal. The exact quantity
bought for each price level is described in the demand schedule. It's then
plotted on a graph to show the demand curve.

Income

When income rises, so will the quantity demanded. When income falls, so
will demand. But if your income doubles, you won't always buy twice as
much of a particular good or service. There's only so many pints of ice cream
you'd want to eat, no matter how wealthy you are, and this is an example of
"marginal utility."
Prices of related goods or services

The price of complementary goods or services raises the cost of using the
product you demand, so you'll want less. For example, when gas prices rose to
$4 a gallon in 2008, the demand for gas-guzzling trucks and SUVs fell.2

Gas is a complementary good to these vehicles. The cost of driving a truck

rose along with gas prices.

The opposite reaction occurs when the price of a substitute rises. When that
happens, people will want more of the good or service and less of its substitute.
That's why Apple continually innovates with its iPhones and iPods. As soon as
a substitute, such as a new Android phone, appears at a lower price, Apple
comes out with a better product. Then the Android is no longer a substitute.

Tastes

When the public’s desires, emotions, or preferences change in favor of a product,

so does the quantity demanded. Likewise, when tastes go against it that depresses
the amount demanded. Brand advertising tries to increase the desire for
consumer goods.

Expectations

When people expect that the value of something will rise, they demand more of
it. That helps explains the housing asset bubble of 2005. Housing prices rose,
but people kept buying houses because they expected the price to continue to
increase. Prices continued increasing until the bubble burst in 2007. New home
prices fell 22% from their peak of $262,200 in March 2007 to $204,200 in
October 2010.However, the quantity demanded didn't increase even as the
price decreased and sales fell from a peak of 1.2 million in 2005 to a low of
306,000 in 2011.

So why the quantity didn’t demanded increase as the price fell? It's in part
because the broader economy was experiencing a recession. People expected
prices to continue falling, so they didn't feel an urgency to buy a home. Record
levels of foreclosures entered the market due to the subprime mortgage crisis.
Demand for homes didn't increase until people
expected future home prices would, too. Number

of buyers in the market

The number of consumers affects overall, or “aggregate,” demand. As more

buyers enter the market, demand rises. That's true even if prices don't change,
and the U.S. saw this during the housing bubble of 2005. Low-cost and sub-
prime mortgages increased the number of people who could afford a house. The
total number of buyers in the market expanded. This increased demand for
housing. When housing prices started to fall, many realized they couldn't afford
the remortgages. At that point, they
Foreclosed. That reduced the number of buyers and drove down demand.

Q2. What is the relation among Average Cost, Marginal Cost, and
Total Cost?
Ans: - Average cost is obtained by dividing total cost by the number of units
produced. Marginal cost is the cost of producing one additional unit of output.
The total cost, in this reference, is the sum total of the total fixed cost plus total
variable cost at a given level of output.

EXPLAIN: -
Relationship between Total Cost and Marginal Cost

There is a close relationship between Total Cost and Marginal Cost. We know the
marginal cost is the addition to total cost when one more unit of output is
produced. When TC rises at a diminishing rate, MC declines. As the rate of
increase of TC stops diminishing, MC is at its minimum point. When the rate of
increase in total cost starts rising, the marginal cost increases. This concept can be
better understood from the figure given below.

As we can see from the graph given above, when TC rises at a diminishing rate
till point D, MC declines. MC reaches its minimum point at point E.
When the rate of increase of TC starts rising after point d, MC also starts
increasing after point E.

(i) Total Cost Total cost can be known by aggregating fixed cost and
variable cost. With increase in output, total cost is also increasing. It
includes both total fixed cost and total variable cost. It may also be
called as total cost of production and expressed like this – TC = TFC +
TVC TC curve can be obtained by adding vertically the TFC curve
and TVC curve.
(ii) Average Cost the Average Cost is the per unit cost of production
obtained by dividing the total cost (TC) by the total output (Q). By per
unit cost of production, we mean that all the fixed and variable costs
are taken into the consideration for calculating the average cost. Thus,
it is also called as Per Unit Total Cost. Short run average cost (SAC) is
the per unit cost of production of a commodity in the short run. It can
be expressed like this – SAC = TC/Q = Total Cost/Total Output
(iii) Marginal Cost Marginal cost is the addition to the Total Cost caused
by producing one more unit of output. In other words, marginal cost
is the addition to the total cost of producing n units instead of n-1 units
(i.e. one less) where n is any given number. It can be expressed as –
MC = TCn – TCn-1 Since marginal cost is a change in total cost as a
result of a unit change in output, it can also be written as : Where ∆TC
represents a change in total cost and ∆Q represents a unit change in
output or total product. Relation between Average Cost and Marginal
Cost:
(i) Both AC and MC are calculated from TC : Average cost can be
worked out by dividing the total cost by total output. AC =
TC/Q Likewise, marginal cost can also be calculated from total
cost. The addition made to the total cost by producing one more
unit of the commodity is called marginal cost. MC = TCn –
TCn-1
(ii) When AC falls, MC also falls: When average cost falls,
marginal cost also falls. In this case, marginal cost falls more
rapidly than the average cost. That is why when marginal cost
curve is falling; it is below the average cost curve.
(iii) When AC rises, MC is also rising: When average cost rises,
marginal cost also rises but marginal cost rises more rapidly than
the average cost.
(iv) MC cuts AC at its lowest point: When average cost is minimum
then marginal cost will be equal to it.
(v) For a brief stretch, AC may continue to decline even when MC
is rising: Shows that between points F and E, marginal cost is
rising
 while AC continues to fall.
(vi) Mutual Interaction between MC and AC: When marginal cost is
more than average cost, average cost has a tendency to rise. It
seems as if marginal cost curve is pulling the AC curve upward.
On the other hand, when MC is less than AC, it pulls the AC
curve downward. When MC is equal to AC then the latter is
constant.

1. Average Cost (AC) and Marginal Cost (MC)

2. Average Variable Cost (AVC) and Marginal Cost (MC)

3. Average Cost (AC) and Average Variable Cost (AVC) and

Marginal Cost (MC)

4. Average Cost (AC) and Average Variable Cost (AVC)

5. Total Cost (TC) and Marginal Cost (MC)

6. Total Variable Cost (TVC) and Marginal Cost (MC)

Relationship between AC and MC:

i. There exists a close relationship between AC and MC.

ii. Both AC and MC are derived from total cost (TC). AC refers to TC per unit of
output and MC refers to addition to TC when one more unit of output is
produced.
iii. Both AC and MC curves are U-shaped due to the Law of Variable Proportions. The
relationship between the two can be
 better illustrated through following schedule and diagram.

(xiii) Table 6.8: Relationship between AC and MC:

Output TC (Rs.) AC (Rs.) MC (Rs.) Phase
(units)

01 1218 -18 -6 I (MC <AC

2 22 11 4

3 27 9 5

4 36 9 9 II (MC =
A

5 47 9.40 11 III (MC

>A

Q-3. State and explain the law of equi-marginal utility with the
help of an illustration.
Ans: - Law of Equi-Marginal Utility.. .the law states that a consumer
should spend his limited income on different commodities in such a way that
the last rupee spent on each commodity yield him equal marginal utility in
order to get maximum satisfaction.

Law Of Equi-Marginal Utility

The idea of equi-marginal principle was first mentioned by H.H.Gossen
(1810-1858) of Germany. Hence it is called Gossen's second Law. Alfred
Marshall made significant refinements of this law in his ' Principles of
Economics'.

The law of equi-marginal utility explains the behavior of a consumer when he

consumers more than one commodity. Wants are unlimited but the income which
is available to the consumers to satisfy all his wants is limited. This law explains
how the consumer spends his limited income on various commodities to get
maximum satisfaction. The law of equi- marginal utility is also known as the law
of substitution or the law of maximum satisfaction or the principle of
proportionality between prices and marginal utility.

Definition

In the words of Prof. Marshall, 'If a person has a thing which can be put to
several uses, he will distribute it among these uses in such a way that it has the
same marginal utility in all'.
Assumptions

1. The consumer is rational so he wants to get maximum satisfaction.

2. The utility of each commodity is measurable.

3. The marginal utility of money remains constant.

4. The income of the consumer is given.

5. The prices of the commodities are given.

6. The law is based on the law of diminishing marginal utility.

Explanation of the law

Suppose there are two goods X and Y on which a consumer has to spend a
given income. The consumer being rational, he will try to spend his limited income
on goods X and Y to maximize his total utility or satisfaction. Only at that point
the consumer will be in equilibrium.

According to the law of equi-marginal utility, the consumer will be in

equilibrium at the point where the utility derived from the last rupee spent on each
is equal.

Limitations of the Law

The law of equi-marginal utility bristles with the following difficulties.

1. Indivisibility of Goods

The theory is weakened by the fact that many commodities like a car, a house
etc. is indivisible. In the case of indivisible goods, the law is not applicable.
2. The Marginal Utility of Money is Not Constant

The theory is based on the assumption that the marginal utility of money is
constant. But that is not really so.

3. The Measurement of Utility is not Possible

Marshall States that the price a consumer is willing to pay for a commodity is
equal to its marginal utility. But modern economists argue that, if two persons are
paying an equal price for given commodity, it does not mean that both are getting
the same level of utility. Thus utility is a subjective concept, which cannot be
measured, in quantitative terms.

4. Utilities are Interdependent

This law assumes that commodities are independent and therefore their
marginal utilities are also independent. But in real life commodities are either
substitutes or complements. Their utilities are therefore
interdependent.

5. Indefinite Budget Period

According to Prof. K.E. Boulding, indefinite budget period is another difficulty

in the law. Normally the budget period is assumed to be a year. But there are
certain commodities which are available in several succeeding accounting periods.
It is difficult to calculate marginal utility for such commodities.
 In conclusion, we may say all prudent and rational persons are expected to act
up on the law consciously or unconsciously. As Chapman puts it,

'We are not, of course compelled to distribute our incomes according to the law
of substitution or equi-marginal expenditure, as a stone thrown into the air is
compelled, in a sense to fall back to the earth, but as a matter of fact, we do in a
certain rough fashion, because we are reasonable.'

Importance

According to Marshall, 'the applications of this principle extend over almost

every field of economic activity.'

1. It applies to consumption

Every rational human being wants to get maximum satisfaction with his
limited means. The consumer arranges his expenditure in such a way that,
MUx/Px = MUy/Py = M Uz/Pz so that he will get maximum
satisfaction.

2. It applies to production

The aim of the producer is to get maximum output with least-cost, so that his
profit will be maximum. Towards this end, he will substitute one factor for another
till
 MPl / Pl = MPc / Pc = MPn / Pn

3. Distribution of Earnings Between Savings and Consumption

According to Marshall, a prudent person will endeavor to distribute his

resources between his present needs and future needs in such a way that the
marginal utility of the last rupee put in savings is equal to the marginal utility of
the last rupee spent on consumption.

4. It applies to distribution

The general theory of distribution involves the principle of substitution. In

distribution, the rewards to the various factors of production, that is their relative
shares, are determined by the principle of equi-marginal utility.

5. It Applies to Public Finance

The principle of 'Maximum Social Advantage' as enunciated by Professors

Hicks and Dalton states that, the revenue should be distributed in such a way
that the last unit of expenditure on various programs brings equal welfare, so
that social welfare is maximized.

6. Expenditure of Time

Prof. Boulding relates Marshall's law of equi-marginal utility to the

expenditures of limited time, i.e. twenty-four hours. He states that a person should
spend his limited time among alternative uses such as reading; studying and
gardening, in such a way that the marginal utility from all these uses are equal.

Q-4. Explain consumer’s equilibrium with utility approach

when consumer is consuming one good.

Ans: - The state at which a consumer derives maximum utility from the
consumption of one or more goods and services given his/her level of income
is called consumer's equilibrium. At that level of balance between total
utility and income, the marginal utility of a product is equal to
It’s one unit price.

Consumer Equilibrium
The state of balance obtained by an end-user of products refers to the number of
goods and services they can buy, given their existing level of income and the
prevailing level of cost prices. Consumer equilibrium permits a customer to get the
most satisfaction possible from their income.

(A) Meaning Consumer’s Equilibrium means a state of maximum

of consumer’s satisfaction.
equilibrium

A situation where a consumer spends his given income

purchasing one or more commodities so that he gets
maximum satisfaction and has no urge to change this level of
consumption, given the prices of commodities, is known as
the consumer’s equilibrium.

The consumer will be in the state of equilibrium when the

(B) Condition of following condition is fulfilled:
consumer equilibrium
in case of a single The marginal utility of commodity X in terms of rupees
commodity is equal to the price of commodity X in rupees. [MUx (in
₹) = Px (in ₹)]
Or
Mux (in utils) = Px (in ₹) or MU of Commodity X (in
utils) = Px (in
₹)
MUm (in utils) MU of Money (₹)(inutils)

(C) Explanation In the given example, the level of consumer’s equilibrium is 3 units.
and conclusion
Where,
MU of ice cream in rupees = Price of ice cream in rupees, i.e.,
₹30

 Before this level, e., at the first and the second level, MU>
Price, i.e., benefit is more than cost. So, the consumer
increases the consumption to attain equilibrium.

 After this level, i.e., at the fourth and the fifth level, MU<
Price, e., benefit is less than cost. So, the consumer cuts or
decreases the consumption to be in the state of equilibrium.
Only at the level of 3 units, the condition of consumer’s
equilibrium is fulfilled.
A consumer consumes the quantity at which MUx = Px to be in the
state of equilibrium.
One-Commodity Equilibrium:
When a consumer is purchasing one commodity, he stops buying when its price
and utility have been equated.

At this point, his total utility is the maximum. He is said to be in equilibrium at

this point, because he is getting maximum satisfaction and he will buy neither
more nor less.

Equilibrium with More Than One Commodity:

According to Mashallian utility analysis, when expenditure of a consumer has
been completely adjusted, that is, when marginal utility in each direction of
his purchases is the same, it is called consumer’s equilibrium. Then he has no
desire to buy any more of one commodity and less of another.

Given a set of market prices, his wants and his income, the consumer may
besaidtobeinequilibriumwhenmarginalutilitieshavebeenequalizedand maximum
satisfaction obtained. There will then be no inducement to revise his scheme of
expenditure.

He will continue to buy the same commodities and in the same quantities until
either his income or his wants or prices change. Adjustment of wants to one
another and to his environments is a sign of consumer’s equilibrium. For a
consumer “to be in equilibrium with respect to all goods, the marginal significance
of all goods in terms of money must equal their money prices.”

In order to derive maximum satisfaction from the amount of money that a

consumer has, he will so apportion his expenditure that the marginal utilities of
the goods purchased will be in proportion to their prices.

Thus, a consumer will be in equilibrium when

M.U. of X /price of X = M.U. of Y / price of Y/ M.U. of Z / price of Z = k This

is also called the principle of proportionality.

In case the price of one commodity rises, less of this commodity and more of
the other commodities will be purchased so that the proportion will be
restored. In the case of durable goods it may not be possible to maintain
proportionality. The above equation will hold good only if the consumers’ tastes
and other circumstances remain unchanged and the commodities are perfectly
divisible.

Now if price of commodity X falls, if the fraction is still to be equal to k which is

constant, the numerator, i.e., the marginal utility of X must also fall.
This will happen only when the consumer consumes more of X. Hence a fall in
the price of X leads to more of X being demanded. The position may, however,
seem unrealistic. In real life, no sensible consumer bothers about making minute
marginal adjustments. Human beings are not calculating machines.

The above explanation of a consumer’s equilibrium has been given with the help
of the concept of utility; it is, therefore, called the analysis of demand or
consumer’s behavior. Modern economists explain consumer’s equilibrium with
the help of indifference curves referred to below in Appendix.

Shortcomings of the Utility Analysis:

We have given so far utility analysis of Consumers’ behavior.

Utility analysis, also called the Marshallian analysis, as an approach to the

study of consumer’s behavior, rests on the following two fundamental
assumptions:
(i) Utility is measurable and can be added or subtracted. In other words, utility
is a quantifiable concept; and

(ii) Marginal utility of money remains constant as a consumer spends more and
more of his money.

Q-5. Discuss the law of variable proportions with the help of

a suitable illustration.
Ans: - Law of Variable proportion:
Law of Variable Proportions (LVP) states that as we increase the quantity of
only one input keeping other inputs fixed, total product (TP) initially increases
at an increasing rate, then at a decreasing rate and finally at a negative rate.

The law of variable proportions states that as the. Quantity of one factor is
increased, keeping the other. Factors fixed, the marginal product of that factor
will. Eventually decline.

increment per unit of time while the inputs of other resources are held constant,
total output will increase, but beyond some point the resulting output increases
will become smaller and smaller.” Left” The law of variable proportion states
that if the inputs of one resource are increased by equal witch.

Law of Variable Proportions: Assumptions, Explanation, Stages, Causes of

Applicability and Applicability of the Law of Variable Proportions!
Law of Variable Proportions occupies an important place in economic theory.
This law is also known as Law of Proportionality.

Keeping other factors fixed, the law explains the production function with one
factor variable. In the short run when output of a commodity is sought to be
increased, the law of variable proportions comes into operation.

Therefore, when the number of one factor is increased or decreased, while

other factors are constant, the proportion between the factors is altered.
For instance, there are two factors of production viz., land and labor.

Land is a fixed factor whereas labor is a variable factor. Now, suppose we have a
land measuring 5 hectares. We grow wheat on it with the help of variable factor
i.e., labor. Accordingly, the proportion between land and labor will be 1: 5. If the
number of laborers is increased to 2, the new proportion between labor and land
will be 2: 5. Due to change in the proportion of factors there will also emerge a
change in total output at different rates. This tendency in the theory of production
called the Law of Variable Proportion.
Definitions:
“As the proportion of the factor in a combination of factors is increased after a
point, first the marginal and then the average product of that factor will
diminish.”Benham

“An increase in some inputs relative to other fixed inputs will in a given state
of technology cause output to increase, but after a point the extra output
resulting from the same additions of extra inputs will become less and
less.”Samuelson.

“The law of variable proportion states that if the inputs of one resource is
increased by equal increment per unit of time while the inputs of other resources
are held constant, total output will increase, but beyond some point the resulting
output increases will become smaller and smaller.” Leftwitch

Assumptions:
Law of variable proportions is based on following assumptions:
(i) Constant Technology:
The state of technology is assumed to be given and constant. If there is an
improvement in technology the production function will move upward.

(ii) Factor Proportions are Variable:

The law assumes that factor proportions are variable. If factors of production are
to be combined in a fixed proportion, the law has no validity.

(iii) Homogeneous Factor Units: The units of variable factor are homogeneous.
Each unit is identical in quality and amount with every other unit.

(iv) Short-Run:
The law operates in the short-run when it is not possible to vary all factor inputs.
Explanation of the Law:
In order to understand the law of variable proportions we take the example of
agriculture. Suppose land and labors are the only two factors of production.

Three Stages of the Law:

1. First Stage:
First stage starts from point ‘O’ and ends up to point F. At point F average
product is maximum and is equal to marginal product. In this stage, total
product increases initially at increasing rate up to point E. between ‘E’ and
‘F’ it increases at diminishing rate. Similarly marginal product also increases
initially and reaches its maximum at point ‘H’. Later on, it begins to diminish
and becomes equal to average product at point T. In this stage, marginal
product exceeds average product (MP>AP).

2. Second Stage:
It begins from the point F. In this stage, total product increases at diminishing
rate and is at its maximum at point ‘G’ correspondingly marginal product
diminishes rapidly and becomes ‘zero’ at point ‘C’. Average product is
maximum at point ‘I’ and thereafter it begins to decrease. In this stage,
marginal product is less than average product (MP
< AP).

3. Third Stage:
This stage begins beyond point ‘G’. Here total product starts diminishing.
Average product also declines. Marginal product turns negative. Law of
diminishing returns firmly manifests itself. In this stage, no firm will produce
anything. This happens because marginal product of the labor becomes
negative. The employer will suffer losses by employing more units of laborers.
However, of the three stages, a firm will like to produce up to any given point
in the second stage only.