ASSIGNMENT

ON
ECONOMIC THEORY
SESSION AUGUST 2023

Program: - BACHELOR OF COMMERCE (B.COM)

Submitted by: Vidya Thakur

Roll no:
Semester: First
 Table of Context

 Acknowledgment.
 Assignment Set-I
 Definition of Utility and Law of Diminishing marginal
utility.
 Factor affecting supply along with suitable examples.
 Elucidate the concept of isoquants and their types.
 Assignment Set-II
 Monopolistic competition and price determination under
it.
 Theory of wage determination.
 Concept of “Paradox of thrift”.
 ACKNOWLEDGMENT

I am really grateful for the opportunity of this

assignment. I would like to sincerely thank my university for
providing all the necessary resources and facilities online,
without those resources this assignment would not have been
completed.

Secondly, I would like to thank my parents,

family members, and friends, who have always been there
whenever needed.

Lastly, I thank them all from my heart and wish

that they will continue to support me like this.

The journey of making this assignment has been

beautiful, as well as knowledgeable for me and I have learned
a lot from it.
 Assignment Set-1

Q1. What is utility? Examine the importance of the law of

diminishing marginal utility in it.
Ans.

Utility: - In simple terms, the want satisfying power of a good

is called utility. In the twentieth century, Marshall and Pigou further elaborated on
cardinal utility analysis. According to this analysis, the utility can be measured in
cardinal numbers, like 1,2,3,4, etc. A cardinal number is a number that can be
added or subtracted. Ordinal utility we cannot measure utility in numbers in this
consumers can rank in order of satisfaction they received from the consumption of
goods. Fisher has used the term “Util” as a measure of utility.

Importance of the law of diminishing marginal utility in demand analysis: -

The law of diminishing marginal utility states that all else equal,
as consumption increases, the marginal utility derived from each additional unit
declines. In simple terms, the law of diminishing marginal utility means that the
more of an item that you use or consume, the less satisfaction you get from each
additional unit consumed or used.

i) Helps to utilize resources economically: When the consumer purchases more

units of a commodity, his marginal utility decreases. Due to this behavior, the
consumer cuts his expenditure on that commodity.

(ii) It has practical application: This law has a practical application in the field of
public finance, as the principle of taxation is based on this law.
(iii) Base to other economic laws: The law of diminishing marginal utility is the
base for other economic laws like the law of demand, the elasticity of demand,
consumer surplus, the law of substitution, etc.

(iv) Theory of value is based on this law: The theory of value is based on the law
of diminishing utility. The value of a commodity falls with an increase in the
supply of that commodity. This forms the basis for determining prices.

(v) Basis for ‘diamond-water paradox’: Adam Smith explained the famous
‘diamond-water paradox’ with the help of the law of diminishing marginal utility.
Diamond is relatively less in supply. So, diamond has high marginal utility and
high price. As water is relatively plenty in supply, it possesses low marginal utility
and has a low price though its total utility is very high. That is why, water has low
price when compared to diamonds though water is more useful than diamond.

(vi) It is the basis for the socialist plea: The law of diminishing utility is the basis
for the socialist plea for an equitable distribution of wealth. The marginal utility of
money to the rich is low. So* it is good that the Government should acquire
surplus wealth and distribute the same to the poor, who have high marginal utility
for money, by imposing direct taxes. Above are the practical benefits of studying
the law of diminishing marginal utility.
 Q2. Factors affecting supply along with suitable examples.
Ans.

Supply is the amount of an item that is available for use or

purchase. The definition of supply in economics is the amount of something that a
producer or seller is willing and capable of providing to buyers. Supply simply
constitutes of the amount of a product or item. The concept of supply forms part of
the foundation of all economic and business activity.

The law of supply in economics states that supply will increase as price increases,
due to the fact that producers want to maximize profits. In this instance, the law
assumes that all other factors are equal and price is the only independent element,
meaning supply is completely dependent on the price. The concept of "quantity
supplied" refers to the amount of the item that is available. Quantity has a close
relationship with the price of the item. According to supply law, the quantity
supplied will decrease when the price decreases, as there's less opportunity for
sellers to profit.

Factors Affecting Supply in Economics

Production alternatives play a big role with suppliers; affecting their product
choices. Production alternatives point to other products that a supplier can produce
instead. Alternatives are usually more profitable, hence their heavy influence on
suppliers' decisions. If a big apple farmer can increase their profit by selling
oranges instead, the market supply of apples will drop when the farmer shifts over
to oranges.

1. Price of The Good: As stated in accordance with the law of supply, the
supply of a certain good will increase proportionately to an increase in price.
 When the price of good rises, supplying that good becomes more lucrative,
which lures more suppliers aiming to capitalize on the high profit margins.
The price of goods are further affected by other market factors.
2. Price of Related Goods: The supply of a certain good can also be affected
by the price of related goods. This is found in the connection between a good
and its related goods. Leather is the ideal example of this. A related good of
leather is cow meat, as both goods come from cows. The price of leather
related goods, which is animal meat, can affect the price of leather itself. If
the price of meat drops, fewer animals will be butchered to supply meat
according to the law of supply. This, in turn, means there'll be a smaller
supply of leather as the price drops.
3. Production Conditions: Production conditions naturally play a significant
role in supply. Poor conditions will result in less output and thus, less
supply, whereas productive conditions will result in better output. These
conditions are typically determined by resources and labor. If there's a
scarcity of labor and resources, production costs will go up and output will
decrease, resulting in a supply drop.
4. Future Expectations: Future expectations of price have a more complex
role in aggregate supply. If sellers expect input prices to increase, they will
produce less, due to profit margins that'll be narrowing in the future.
Contrary, if sellers expect input costs to drop, they will produce more as
profit margins stand to grow in the future. This concept is highly relevant to
market investors and speculators.
5. Input Price: Input price influences supply in a more indirect manner. Input
costs are the costs involved with producing a certain good. If these costs are
high, sellers can produce less, bringing down the supply, and vice versa. As
 input costs rise, producers also have to produce and sell more goods in order
to remain profitable, due to fallen profit margins.
6. Number of Suppliers: The number of suppliers in a market brings forth the
element of competition. More suppliers inherently point to prices that are
high. This is counteracted by competition as these suppliers have to contend
for market share - a factor that brings prices as well as aggregate supply
back down. This decrease in price sees suppliers move out of the market in
light of lower profitability.
7. Government Policy: Government policies have a very broad effect on
markets and the supply within these markets. An example is how a
government can ban the import of precious metals. This will drive up the
production costs relating to cars, and as a consequence, the supply of cars
will drop. Subsequently, car prices will rise considering the scarcity and
more suppliers will enter the market; supporting the quantity of supply.
 Q3. Elucidate the concept of isoquants. Also discuss their types.
Ans.

An isoquant curve is a concave-shaped line on a graph, used in

the study of microeconomics, that charts all the factors, or inputs, that produce a
specified level of output. This graph is used as a metric for the influence that the
inputs—most commonly, capital and labor—have on the obtainable level of output
or production. The term "isoquant," broken down in Latin, means “equal quantity,”
with “iso” meaning equal and “quant” meaning quantity. Essentially, the curve
represents a consistent amount of output. The isoquant is known, alternatively, as
an equal product curve or a production indifference curve. It may also be called an
iso-product curve. An isoquant shows combinations of capital and labor and the
technological tradeoff between the two—how much capital would be required to
replace a unit of labor at a certain production point to generate the same output.
Labor is often placed along the X-axis of the isoquant graph, and capital along the
Y-axis.

Important Properties of the Isoquant curve:

 An isoquant curve slopes downward or is negatively sloped.

 An isoquant curve, because of the MRTS effect, is convex to its origin.

 An isoquant curves cannot be tangent or intersect one another.

 Isoquant curves in the upper portions of the chart yield higher outputs.
  An isoquant curve should not touch the X or Y axis on the graph.

Types of Isoquant curve:

1. Linear Isoquant: It is quite an unrealistic approach where one factor completely

substitutes the other in the production process. When the isoquant curve intersects
x-axis, capital is entirely replaced by the labour. Also, when the curve crosses the
y-axis, the production is done through capital itself, without employing any labour.

2. Smooth Convex Isoquant: In a two-product framework, when one of the

factors of production can be continuously substituted by the other, we get a smooth
and convex isoquant This isoquant is ‘smooth’ because the points on the isoquant
are very close to each other. Close proximity of points on the isoquant signifies the
fact that the effect of a slight reduction in one factor of production can be
compensated by a marginal increase of the other.

3. Input-Output Isoquant: Input-output isoquants are L-shaped curve in the

figure below and also known as Leontief isoquants. They assume a perfect
complementary nature between factors implying zero substitutability. Factors are
jointly used in a fixed proportion. It means that there is only one method of
production to produce a commodity. Hence, to increase output, both factors are to
be increased holding the proportion constant.

4. Kinked Isoquant: In such an isoquant curve, the factors of production can

substitute each other to a limited extent. Also, there are a limited number of
production processes to support this substitution. The substitution is possible only
at the kinks and no substitution is possible.
 Assignment Set-2

Q4. Define Monopolistic Competition and explain the price

determination under it.
Ans.

Monopolistic competition is a type of market structure where

many companies are present in an industry, and they produce similar but
differentiated products. With monopolistic competition, no singular company
maintains a total monopoly over any other within its market, and companies have
slight control over the prices they charge for their services. As a result, companies
can enter their market quickly when they determine that there's potential to earn
revenue and leave when there's a lower likelihood of generating profit. Companies
within these types of markets often experience profit in the short term but may
require greater levels of innovation to generate it long term.

Characteristics of Monopolistic Competition

1. Low Barriers to Entry: In monopolistic competition, one firm does not

monopolize the market and multiple companies can enter the market and all
can compete for a market share. Companies do not need to consider how
their decisions influence competitors so each firm can operate without fear
of raising competition.
 2. Product Differentiation; Competing companies differentiate their similar
products with distinct marketing strategies, brand names, and different
quality levels.
3. Pricing; Companies in monopolistic competition act as price makers and set
prices for goods and services. Firms in monopolistic competition can raise or
lower prices without inciting a price war, often found in oligopolies.
4. Demand Elasticity: Demand is highly elastic in monopolistic competition
and very responsive to price changes. Consumers will change from one
brand name to another for items like laundry detergent based solely on price
increases.

Price determination under monopolistic competition: -

A firm under monopolistic competition has to face various problems which are
absent under perfect competition. Since the market of an individual firm under
perfect competition is completely merged with the general one, it can sell any
amount of the good at the ruling market price. But, under monopolistic
competition, individual firm’s market is isolated to a certain degree from those of
its rivals with the result that its sales are limited and depend upon: 1) Its price, 2)
The nature of its product, and 3) The advertising outlay it makes. Thus, the firm
under monopolistic competition has to confront a more complicated problem than
the perfectly competitive firm. The equilibrium of an individual firm under
monopolistic competition involves equilibrium in three respects, that is, in regard
to the price, the nature of the product, and the amount of advertising outlay it
should make.

The equilibrium of the firm in respect of three variables simultaneously – price,

nature of product, selling outlay – is difficult to discuss. Therefore, the method of
explaining equilibrium in respect of each of them separately is adopted, keeping
the other two variables given and constant. Moreover, as noted above, the
equilibrium under monopolistic competition involves “individual equilibrium” of
the firms as well as “group equilibrium”. We shall discuss these two types of
equilibrium first in respect of price and output and then in respects of product and
advertising expenditure adjustments

Individual Firm’s Equilibrium in Short-Run Period:

The demand curve for the product of an individual firm, as noted

above, is downward sloping. Since the various firms under monopolistic
competition produce products which are close substitutes to each other, the
position and elasticity of the demand curve for the product of any of them depend
upon the availability of the competitive substitutes and their prices. Therefore, the
equilibrium adjustment of an individual firm cannot be defined in isolation from
the general field of which it is a part. However, for the sake of simplicity in
analysis, conditions regarding the availability of substitute products produced by
the rival firms and prices charged for them are held constant while the equilibrium
adjustment of an individual firm is considered in isolation. Since close substitutes
for its product are available in the market, the demand curve for the product of an
individual firm working under conditions of monopolistic competition is fairly
elastic. Thus, although a firm under monopolistic competition has monopolistic
control over its variety of product but its control is tempered by the fact that there
are close substitutes available in the market and that if it sets too high a price for its
product, many of its customers will shift to the rival products.

in the short run, firms can earn supernormal profits. However, in the long run,
there is a gradual decrease in the profits of the firms. This is because in the long
run, several new firms enter the market due to freedom of entry. When these new
firms start production the market supply would increase and the price would fall.
This would automatically increase the level of competition in the market.
Consequently, AR curve shifts from right to left and supernormal profits are
eliminated. The firms will be able to earn normal profits only. In the long run, the
AR curve is more elastic than that of in the short run. This is because of an
increase in the number of substitute products in the long-run. The long-run
equilibrium of monopolistically competitive firms is achieved when average
revenue is equal to average cost. In such a case, the firms receive normal profits.

Individual Firm’s Equilibrium in Long Run:

In the short run, firms can earn supernormal profits. However,

in the long run, there is a gradual decrease in the profits of the firms. This is
because in the long run, several new firms enter the market due to freedom of
entry. When these new firms start production the market supply would increase
and the price would fall. This would automatically increase the level of
competition in the market. Consequently, the AR curve shifts from right to left and
supernormal profits are eliminated. The firms will be able to earn normal profits
only. In the long run, the AR curve is more elastic than that of in the short run.
This is because of an increase in the number of substitute products in the long run.
The long-run equilibrium of monopolistically competitive firms is achieved when
average revenue is equal to average cost. In such a case, the firms receive normal
profits.
 Q5. Critically analyze the subsistence theory of waste
determination.
Ans.

The subsistence theory of wages was first formulated by the

Physiocrats school of France, which nourished during the 18th century. The father
of economics, Adam Smith also subscribed to this theory. The German economist
Lassele styled it as the Iron Law of Wages and It is also known as the Brazen Law
of Wages. Ricardo and Malthus also contributed to this theory.

According to the Subsistence theory of wages in the long run

wages of labourers are determined at that level of wages which is just sufficient to
meet the basic necessities of life. This level of wages is called a subsistence wage
level. In simple words according to this theory, in the long run, wages
would tend to just equal enough food, clothing, and shelter to maintain existence.
The subsistence wage theory was based on Malthus's theory of population. The
main assumptions of Malthus's theory of population are the following:

1. Low diminishing returns in production. Which states that there were definite
limits to a continued high rate of expansion of food production.

2. Population increases faster than food production. According to the

subsistence theory of wages in the long run wages of labour will be equal to
 the subsistence level. If wages fall below this will lead to starvation among
labourers. That will further lead to a decrease in labour supply. With the
decrease in labour supply, the demand and supply forces will increase the
wage rate to the subsistence level. However, if the wage rate increases above
subsistence level that will encourage laborers to bear more children which
will increase labour supply further, and again that will lead to a fall in wages
to the subsistence level.

Criticism the Subsistence theory of wages: -

1. The subsistence theory of wages assumes that an increase in wages will

always lead to an increase in population. This is contrary to facts.

2. This theory explains wage determination only from supply-side conditions

of labour and pays no attention to the reason why labour is demanded. III.
The theory is only applicable in the long run.

3. This theory ignores the influence of trade unions on wages. Trade unions
play an important part in the determination of wages.

4. This theory fails to explain why wages are unequal in various occupations,
regions, and between different persons.
 Q5. Examine the concept of “Paradox of thrift”.
Ans.

The paradox of thrift refers to a situation in which people tend

to save more money, thereby leading to a fall in aggregate savings of the economy
as a whole. In other words, when everyone increases their saving-income
proportion, MPS, then aggregate demand falls as consumption reduces. This leads
to a decrease in the level of employment and income and reduces total savings in
the economy. The concept was suggested by Keynes to depict how increased
savings at an individual level will gradually lead to a slowdown in the economy.

According to Keynesian theory, the proper response to an

economic recession is more spending, more risk-taking, and fewer savings.
Keynesians believe a recessed economy does not produce at full capacity because
some of its factors of production (land, labor, and capital) are unemployed.
Keynesians also argue that consumption, or spending, drives economic growth.
Thus, even though it makes sense for individuals and households to reduce
consumption during tough times, this is the wrong prescription for the larger
economy.

A pullback in aggregate consumer spending might force businesses to produce

even less, deepening the recession. This disconnect between individual and group
rationality is the basis of the savings paradox. An example of this was witnessed
during the Great Recession that followed the financial crisis of 2008. During that
time, the savings rate for the average American household increased from 2.9 % to
5%. The Federal Reserve slashed interest rates in order to boost spending in the
American economy.

The first conceptual description of the paradox of thrift may have been written in
Bernard Mandeville’s “The Fable of the Bees” (1714). Mandeville argued for
increased expenditure as the key to prosperity, rather than savings. Keynes credited
Mandeville for the concept in his book “The General Theory of Employment,
Interest, and Money” (1936).

Circular Flow Economic Model: -

Keynes helped revive the circular flow model of the economy. This theory states
that an increase in current spending drives future spending. Current spending, after
all, results in more income for current producers. Those producers rationally
deploy their new income, sometimes expanding business and hiring new workers;
these new workers earn new income, which then may be spent.

To boost current spending, Keynes argued for lower interest rates to lower
current savings rates. If low interest rates do not create more borrowing and
spending, Keynes said, the government could engage in deficit spending to fill the
gap.

Limitations of the Paradox of Thrift:- The circular flow model ignores the
lesson of Say’s law, which states goods must be produced before they can be
exchanged. Capital machines, which drive higher levels of production, require
additional savings and investment. The circular flow model only works in a
framework without capital goods. Also, the theory ignores the potential
for inflation or deflation. If higher current spending causes future prices to rise
concordantly, future production and employment will remain unchanged.
Similarly, if current thrift during a recession forces future prices to fall, future
production and employment need not decline as Keynes predicted.

Finally, the paradox of thrift ignores the potential for saved

income to be lent out by banks. When some individuals increase their savings,
interest rates tend to fall, and banks make additional loans.