2 marks questions

1. Lionel Robbins definition of economics

Ans- Lionel Robbins defined economics as. “the science which
studies human behaviour as a relationship between ends and
scarce means which have alternative uses”
2. Dx= f(………………….)
Ans- Dx= f(Px , Pr, Y, T, E, S&C, S&W, DY)
Where, Px= Price of own Commodity
Pr= Price of related goods
Y= Income of the consumer
T= Tastes and preferences
E= Expectations of future fall and rise in prices
S&C= Size and composition of population
S&W= Season and Weather
DY= Distribution of Income
3. Define the term Opportunity Cost

Ans- It is the cost of next best alternative foregone. let us suppose that a
person is having Rs. 50000 in his hand and He has the option to keep it with himself at
home or deposit in the bank which will generate interest of 4% annually so now the
opportunity cost of keeping money at home is Rs. 2000 per year as opposed to Bank.

4. (i)Cosumer’s Surplus= ………………………?

Ans= Consumer’s Surplus= Amount consumer is willing to pay- Amount
consumer is actually paying
(ii) TC= …………..+……………
Ans- TC=TFC+TVC

5. Define Fixed Cost and Variable Cost

Ans- Fixed Costs are those cost which donot vary directly with the level of
output and variable cost are those cost which vary directly with the level of
output.

6. Relationship Between MC and AC.

 Ans- (i) When MC is less than AC, AC falls with increase In output.
(ii) When MC is equal to AC, i.e when MC and AC curves intersect each
other at point A, AC is constant and at its minimum point.
(iii) When MC is more than AC, AC rises with increase in output.
(iv) Thereafter, both AC and MC rise but MC increases at a faster rate
as compared to AC. AS a result, MC curve is steeper as compared to AC
curve.
7. Meaning of Indifference Map.
Ans- Indifference Map refers to the family of Indifference curves
that represent consumer preferences over all bundles of the
two goods.

8. Define Transitivity assumption of Indifference curve.

Ans- The assumption of transitivity implies that if a consumer
prefers a bundle of goods A to another bundle of goods B, and
 the consumer is indifferent between bundle B and a third bundle
C, then consumer should prefer bundle A to bundle C.

9. Derivation of Average productivity and Marginal Productivity of labour from

total productivity curves.

4 Marks

1. Differentiate between normal goods and inferior goods.

Ans-

Normal goods Inferior goods

1. Goods whose demand 1. Goods whose demand
increases with increase in decreases with increases in
income and vice versa income and vice versa.

2. Income effect is positive 2.Income effect is negative

3. When income of the
consumer increases demand
for these products shifts
towards right and vice versa
4. Eg- Branded shoes, good
3 . When income of the
consumer increases demand
curve shifts towards left and vice
versa.
5. Bajra, Dalda, Black and White
 clothes, desi Ghee etc T.V

2. “Costing is an aid to management”. Comment.

Ans- Costing – An Aid to Management basically means that cost

accounting helps the management in carrying out most of its functions.
It provides basic cost data and performs cost functions that provide the
management will all the information they require.

It standardizes, records, analyzes, compares, reports and makes

recommendations. Only financial accounting data will not suffice, as it
will not provide the management will all the data it requires. A good
cost account system helps the management in the following ways,

 Classification of Costs: Costs are collected and then classified in

various categories and under various heads. This provides more
information about the type of costs and allows for cost ascertainment
and finding the profitability of each area of activity or each product.
 Control of Costs: Costing allows the management to keep control of
materials, labour, and overheads. A check is kept on the stores and
materials ledger. This points out any theft, loss etc. Costing also
provides relevant information about labour costs via machine hours
and labour capacity etc. It also classifies overheads as variable and
fixed to help us control these costs.
 Budgeting: These include the analysis of budgets and performance
reports. First costing helps with forming the budget, i.e. the
quantification of the plans of the management. Then it measures
deviances of the budget from the actual performance numbers
according to the performance report. It also helps find the reason for
deviances and helps solve any problems.
 Price Determination: One of the first things cost accounting is to do
is make the distinction between variable and fixed costs. This allows
 the management to fix remunerative prices for their products
according to the economic situation prevailing at the time.
 Expansion Plans: If the management of a firm wishes to expand then
this decision will be based on the information that costing provides.
The entire expansion policy will depend on the cost of production at
various production levels.

3. Differentiate between management and Scientific management.

Ans- Management and scientific management are two concepts related to
the organization and execution of work, but they differ in their approaches
and perspectives. Here's a differentiation between the two:

1. Definition:
-Management: Management is a broader concept that involves planning,
organizing, directing, and controlling resources (human, financial, and
physical) to achieve organizational goals efficiently and effectively.
- Scientific Management: Scientific management, on the other hand, is a
specific approach to management developed by Frederick Taylor in the
early 20th century. It focuses on using scientific methods to analyze and
optimize work processes for increased efficiency.

2. Scope:
- Management: Management encompasses a wide range of activities,
including strategic planning, organizational design, decision-making,
leadership, and coordination of various functions within an organization.
- Scientific Management: Scientific management is a more specialized and
narrow approach that primarily deals with improving the efficiency of
individual tasks and jobs through the application of scientific principles.

3. Approach to Work:
 - Management: Traditional management looks at the overall coordination
and integration of various organizational functions. It emphasizes human
relations, leadership, and adaptability to change.
- Scientific Management: Scientific management focuses on the detailed
analysis and optimization of individual tasks. It aims to find the "one best
way" to perform each task by applying scientific methods.

4. Focus on Workers:
- Management: Management recognizes the importance of human
resources and aims to motivate and engage employees to achieve
organizational objectives.
- Scientific Management: Scientific management, while concerned with
efficiency, is often criticized for its mechanistic view of workers, treating
them as replaceable parts of a machine rather than as individuals with
unique skills and motivations.

5. Time Period:
- Management: The concept of management has evolved over time and
has been influenced by various theories and approaches. It is a broader and
ongoing field of study.
- Scientific Management: Scientific management was developed during
the late 19th and early 20th centuries and was more prevalent during the
early stages of industrialization.

6. Key Figure:
- Management: No specific individual is associated with the term
"management" as it represents a general field of study and practice.
- Scientific Management: Frederick Taylor is considered the key figure in
the development of scientific management.

While scientific management made significant contributions to the

understanding of work processes and efficiency, modern management
 practices often incorporate a more humanistic and holistic approach, taking
into account the broader aspects of organizational dynamics and employee
well-being.
4. Calculate ARR on the investment from the following data-
Initial Investment= Rs 600,000
Expected profits for 5 years= Rs 55000, Rs 75000, Rs 95000, Rs 69000, Rs
45000 respectively.
Ans- ARR= Average annual net earnings after taxes/Initial Investment*100
= Average annual net earnings after taxes=
55,000+75,000+95,000+69,000+45,000/5= Rs67,800
ARR= 67,800/600,000*100= 11.3%
5. Differentiate between extension in demand and increase in demand

Extension in demand Increase in demand

1. It is due to fall in the 1. It is due other factors keeping
price of commodity price constant.
keeping other factors
constant.
2. Tabular Presentation 2. Tabular Presentation
Price QDD Price Demand
20 100 20 100
15 150 20 150
3. Diagrammatic 3 Diagrammatic
Presentation Presentation

4. It shows the downward 4 It shows the rightward

 movement along the shift in the demand
same demand curve. curve.

6 Differentiate between contraction in demand and decrease in

demand.

Contraction in demand Decrease in demand

1. It is due to rise in 1. It is due to other factors keeping
price keeping price of the commodity constant.
other factors
constant.
2. Tabular 2. Tabular Presentation
Presentation Price Demand
Price QDD 2 20
2 20 2 10
4 10

3. Graphical Graphical Presentation

Presentation

4. There is upward There is leftward shift in the

movement along demand curve.
the same demand
curve.

7 . Differentiate between Unity of command and Unity of Direction

Unity of command and unity of direction are two principles of management
that originated from Henri Fayol's classical management theory. These
principles are often applied in organizational structures to enhance
efficiency and effectiveness. Here's the differentiation between the two:

1. Unity of Command:
- Definition: Unity of command emphasizes that each employee should
receive orders and instructions from only one superior or authority.
- Purpose: The primary goal is to avoid confusion and conflict by ensuring
that individuals have a single supervisor to report to and receive
instructions from.
- Advantages: Clear lines of authority help in maintaining discipline,
reducing conflicts, and ensuring a more streamlined flow of communication
within the organization.
- Example: In a military setting, soldiers report to a specific commanding
officer, and they receive orders only from that officer.

2. Unity of Direction:
- Definition: Unity of direction focuses on ensuring that activities within an
organization are directed towards common objectives and goals.
- Purpose: The aim is to ensure that everyone within the organization is
moving in the same direction, working towards common objectives, and
avoiding conflicting or contradictory efforts.
- Advantages: Helps in achieving organizational goals more efficiently by
aligning efforts, resources, and activities towards a shared vision.
- Example: In a business, all departments such as marketing, sales,
production, and finance should work cohesively to achieve the overall
company objectives.

In summary, while unity of command deals with the hierarchy and the flow
of authority within an organization, unity of direction deals with aligning
efforts and activities towards common goals. Both principles contribute to
the overall effectiveness and efficiency of an organization by providing
clarity and coordination in decision-making and actions.

8. Two Indifference curves can never intersect each other. Comment.

Ans-

All the points on a single indifference curve represents same level of satisfaction. Point A and
Point B on IC1 represents same level of satisfaction. Point A and Point C on Ic2 represents sAme
level of satisfaction. So accordingly, C should be equal to B. But C is not equal to B. Both the
points represents different level of satisfaction. So, Two indifference curves can never intersect
each other.

9. Calculate Pay back period if: Initial Investment= Rs 900,000

Cash inflows during 4 years are- Rs 450,000, Rs 300,000, Rs
200,000, Rs 50,000
Ans-

Years Cash Inflows Cumulative Cash

Inflows
0 (900,000) (900,000)
1 450,000 (450,000)
2 300,000 (150,000)
3 200,000 50,000
4 50,000 100,000
Pay back period= years before full recovery+ (Unrecovered cost at
the start of the year/ Cash inflows during the year)
= 2+ 150,000/200,000= 2.75 years
10. Discuss Giffen’s Paradox

Giffen's paradox is an economic concept named after the 19th-

century Scottish economist Sir Robert Giffen. The paradox
challenges the traditional law of demand, which states that as the
price of a good rises, the quantity demanded should fall, and vice
versa. Giffen's paradox suggests a scenario where an increase in
the price of a good leads to an increase in its quantity demanded,
and a decrease in price results in a decrease in quantity
demanded.

The key conditions for Giffen's paradox to occur are:

1. Inferior goods: The good in question must be an inferior good,

meaning that it is perceived as lower quality or less desirable than
alternative goods.

2. Substitution effect vs. income effect: The substitution effect and

income effect, which usually work in opposite directions, must be
overpowered by the income effect. The substitution effect
suggests that as the price of a good increases, consumers will
switch to alternative, cheaper goods. The income effect states
that as the price of a good rises, the real income of consumers
decreases, leading them to reduce their overall consumption.

3. Dominance of the income effect: In the case of Giffen goods,

the income effect dominates the substitution effect. When the
price of the inferior good rises, consumers may actually increase
their quantity demanded due to the reduced real income, even
though they would typically substitute it with a better alternative.

A classic example often used to explain Giffen's paradox is the

hypothetical case of a staple food item like bread in a subsistence
economy. If the price of bread rises significantly, the real income
of consumers may decrease to the extent that they cannot afford
more expensive substitutes, such as meat. In this situation,
consumers might paradoxically buy more bread because it
remains one of the few affordable food options despite the price
increase.

It's important to note that Giffen's paradox is considered a rare

and somewhat controversial phenomenon. Empirical evidence
supporting its existence is limited, and the conditions required for
it to occur are not frequently met in modern, developed
economies. Additionally, changes in consumer behavior and
market dynamics over time may further diminish the relevance of
Giffen's paradox in contemporary economic analysis.
11. Role of factors of production in production.
Ans-
The factors of production are the resources or inputs used in the
process of producing goods and services. There are generally four
primary factors of production, and their roles are crucial in the
production process. These factors are:

1. Land:
- Role: Land represents all natural resources used in production.
This includes physical land itself, as well as the resources that
come from the land, such as minerals, water, forests, and
agricultural products.
- Significance: Land is the foundation for production. It provides
the raw materials and space necessary for various economic
activities. The quality and availability of land can significantly
impact the efficiency and output of production processes.

2. Labor:
- Role: Labor refers to the human effort, both physical and
mental, applied to the production process. It includes the skills,
knowledge, and abilities of the workforce.
- Significance: Labor is a dynamic factor that directly influences
the efficiency and productivity of production. The quality of labor,
its level of education and training, and the overall work
environment contribute to the success of production processes.

3. Capital:
 - Role: Capital represents the tools, equipment, machinery, and
infrastructure used in production. It includes both physical capital
(such as machines and buildings) and financial capital (money
used to purchase these assets).
- Significance: Capital plays a critical role in enhancing the
efficiency and scale of production. Modern industrial processes
heavily rely on advanced capital equipment, which enables
increased output and cost-effectiveness.

4. Entrepreneurship:
- Role: Entrepreneurship involves the process of combining the
other factors of production (land, labor, and capital) to create and
organize a business venture. Entrepreneurs make decisions
regarding what to produce, how to produce, and for whom to
produce.
- Significance: Entrepreneurs are essential for innovation, risk-
taking, and the overall coordination of production activities. Their
ability to identify opportunities, organize resources, and manage
risks is crucial for the success and growth of businesses.

The interaction and combination of these factors are necessary

for the production of goods and services. An effective and
efficient production process requires the optimal utilization of
land, labor, and capital, guided by entrepreneurial vision and
management. The role of each factor can vary depending on the
nature of the industry, technology, and economic conditions.
Successful production often involves a careful balance and
coordination of these factors to achieve desired outcomes.
12. Discuss Internal and external economies with examples.
Ans-

Internal Economies of Scale:

1. Technical Economies:
- Definition: Technical economies of scale occur when the size of
production enables a firm to use more advanced and specialized
technologies, leading to cost savings.
- Example: An automobile manufacturing company investing in
automated assembly lines that reduce labor costs and increase
production efficiency. The cost of these technologies can be
spread over a larger output, lowering the average cost per unit.

2. Managerial Economies:
- Definition: Managerial economies of scale refer to cost
advantages resulting from the efficient organization and
specialization of management functions within a growing firm.
- Example: A large corporation may have separate departments
for finance, marketing, and operations, allowing each department
to specialize in its area. This specialization enhances decision-
making efficiency and reduces overall managerial costs.

3. Financial Economies:
- Definition: Financial economies of scale occur when larger
firms have better access to financial markets and can obtain
capital at lower costs.
 - Example: A large multinational corporation can secure loans at
lower interest rates due to its established creditworthiness. This
lower cost of capital translates into reduced financing expenses
and contributes to overall cost savings.

4. Marketing Economies:
- Definition: Marketing economies of scale result from the ability
of larger firms to spread marketing and advertising expenses over
a larger output.
- Example: A well-known brand can benefit from economies of
scale in marketing by negotiating better rates with advertising
agencies and reaching a broader audience, reducing the cost of
marketing per unit sold.

5. Risk-Bearing Economies:
- Definition: Risk-bearing economies of scale occur when larger
firms can diversify their products or markets, spreading risk and
minimizing the impact of fluctuations in one area.
- Example: A conglomerate with diverse business units in
different industries is less vulnerable to the downturn of any
single sector. The risk is spread across various activities, providing
stability and reducing the impact of economic uncertainties.

External Economies of Scale:

1. Transportation Economies:
 - Definition: Transportation economies of scale arise when
multiple firms in an industry or region share transportation
infrastructure, reducing costs for all participants.
- Example: Companies located in an industrial park benefit from
shared transportation networks, reducing individual shipping
costs and improving overall logistical efficiency.

2. Specialization Economies:
- Definition: Specialization economies of scale occur when a
concentration of related industries in a specific area leads to the
development of specialized labor, suppliers, and services.
- Example: Silicon Valley is a hub for technology companies,
providing access to a skilled workforce, specialized suppliers, and
research institutions. This concentration fosters innovation and
lowers costs for all participants.

3. Knowledge or Information Economies:

- Definition: Knowledge or information economies of scale result
from the sharing of information, research, and development
activities among firms in a specific region or industry.
- Example: Research clusters or technology parks where multiple
companies share research facilities and collaborate on innovation.
This shared knowledge base reduces individual research costs and
accelerates technological advancements.

4. Infrastructure Economies:
 - Definition: Infrastructure economies of scale occur when
multiple firms benefit from shared infrastructure, such as utilities,
communication networks, or industrial parks.
- Example: Several manufacturing plants located in an industrial
park share common utilities, such as power and water supply,
reducing the infrastructure costs for each individual firm.

5. Training and Education Economies:

- Definition: Training and education economies of scale arise
when a concentration of firms in a particular sector leads to the
development of specialized training programs or educational
institutions.
- Example: A cluster of pharmaceutical companies supporting
the establishment of a specialized pharmacy school that caters to
the industry's needs. This results in a skilled workforce tailored to
the sector's requirements, reducing training costs for individual
firms.

Understanding and leveraging both internal and external

economies of scale are essential for businesses seeking to
optimize their production processes, reduce costs, and enhance
competitiveness in the marketplace.

13. Calculate contribution from the following data:

Particulars Project A Project B

Sales Rs 50,000 Rs 90,000
Fixed cost= Rs 10,000

Variable Cost Project A= Rs 10,000

Variable Cost of Project B= Rs 45,000

Solution –

Contribution of Project A= Sales of project A- Variable Cost of project

A= Rs 50,000- Rs 10,000- 40,000

Contribution of Project B= Sales of project B- Variable Cost of project B=

90,000-45,000= 45,000

14. Explain the relationship between MP and AP with the help of

suitable graph.

Ans-

1. As long as MP is greater than AP, AP is rising.

2. When MP is equal to AP, AP is at its maximum point.
3. When MP is below AP, AP is falling.

15. Explain the relationship between TC, TFC and TVC with the help of
suitable graph.
 1. TFC is a horizontal straight line parallel to X-axis as it does not vary
with the level of output.
2. TC and TVC are inverse S- shaped curves due to law of variable
proportions.
3. At zero level of output, TC=TFC because TVC is zero.
4. The vertical distance between TC and TVC is equal to TFC and it is
constant due to constant TFC.
5. The vertical distance between TC and TFC is equal to TVC and it is
continuously rising due to rising TVC.

16. Explain the total expenditure method of elasticity of demand.

Ans-
There are three possibilities:

(i) If with a fall in price (demand increases) the total expenditure

increases or with a rise in price (demand falls), the total
expenditure falls, in that case the elasticity of demand is greater
than one i.e. ED > 1.

(ii) If with a rise or fall in the price (demand falls or rises

respectively), the total expenditure remains the same, the demand
will be unitary elastic or ED = 1.
(iii) If with a fall in price (Demand rises), the total expenditure also
falls, and with a rise in price (Demand falls) the total expenditure
also rises, the demand is said to be less classic or elasticity of
demand is less than one (ED < 1).
This can be expressed with the help of a Chart.

In the Table we find three possibilities:

A. More Elastic Demand:

When price is Rs. 10 the quantity demanded is 1 unit and total
expenditure is 10. Now price falls from Rs. 10 to Rs. 6, the quantity
demanded increases from 1 to 5 units and correspondingly the total
expenditure increases from Rs. 10 to Rs. 30. Thus it is clear that
with the fall in price, the total expenditure increases and vice-versa.
So elasticity of demand is greater than one or ED >1.
B. Unitary Elastic Demand:
If price is Rs. 6, demand is 5 units so the total outlay is Rs. 30. Now
price falls to Rs. 5, the demand increases to 6 units but the total
expenditure remains the same i.e., Rs. 30. Thus it is clear that with
the rise or fall in price, the total expenditure remains the same. The
elasticity of demand in this case is equal to one or

ED = 1.

B. Unitary Elastic Demand:

If price is Rs. 6, demand is 5 units so the total outlay is Rs. 30. Now
price falls to Rs. 5, the demand increases to 6 units but the total
expenditure remains the same i.e., Rs. 30. Thus it is clear that with
the rise or fall in price, the total expenditure remains the same. The
elasticity of demand in this case is equal to one or

ED = 1.

The total expenditure can be explained with the help of Fig. 7.

In the fig., there are three phases of the total expenditure curve.

Downward sloping (from A to D), (ii) Vertical (from D to G), (iii)

Upward sloping (G to J).
(i) Downward Sloping Curve:

If the price- total expenditure curve slopes downward from left to

right, it means the elasticity of demand is greater than one. As we
see in the diagram that when price falls from Rs. 10 to Rs. 5 the
total expenditure increases from Rs. 10 to Rs. 30. It means, there is
opposite relationship between price and total expenditure. The
elasticity of demand in this case is greater than one. Thus the curve
from A to D represents the elasticity greater than one or ED >1.
(ii) Vertical Curve.

If price-total expenditure curve is vertical or parallel to 7-axis, it

means that with fall in price from Rs. 6 to Rs. 5 the total
expenditure remains the same. Thus if total expenditure does not
change with the rise or fall in price, the elasticity of demand will be
equal to one. Thus by joining points D and G we get vertical curve
showing elasticity of demand equal to one or Ed =1.

(iii) Upward Sloping Curve:

If price-total expenditure curve rises upward from left to right, it
means the elasticity of demand is less than one. In the diagram, we
find that when price falls from Rs. 5 to Re. 1the total expenditure
also falls from Rs. 30 to Rs. 10. It means by joining G, H, I, J we get
an upward sloping curve showing elasticity of demand less than one
or ED < 1. Thus it is clear that the changes in total expenditure due
to changes in price also affect the elasticity of demand.

17. Annual usage of materials in a firm is 1000 unitrs and ordering cost
per order is Rs 25. Cost per unit of material is Rs 50 and annual carrying
cost as a percent of inventory is 10%. Calculate EOQ and No of orders.
Carrying cost= 50*10/100= Rs 5 per unit.

EOQ= 100 units

No. of orders per annum= Annual consumption/EOQ= 1000 units/100

units= 10

12 Marks Questions.
1. Critically examine the Theory of Marginal Productivity.

Ans-
The oldest and most significant theory of factor pricing is the
marginal productivity theory. It is also known as Micro Theory of
Factor Pricing.

It was propounded by the German economist T.H. Von Thunen. But

later on many economists like Karl Mcnger, Walras, Wickstcad,
Edgeworth and Clark etc. contributed for the development of this
theory.

According to this theory, remuneration of cache factor of

production tends to be equal to its marginal productivity.
Marginal productivity is the addition that the use of one extra unit
of the factor makes to the total production. So long as the marginal
cost of a factor is less than the marginal productivity, the
entrepreneur will go on employing more and more units of the
factors. He will stop giving further employment as soon as the
marginal productivity of the factor is equal to the marginal cost of
the factors.

Definitions:

“The distribution of income of society is controlled by a natural law,

if it worked without friction, would give to every agent of production
the amount of wealth which that agent creates.” -J.B. Clark

“The marginal productivity theory contends that in equilibrium

each productive agent will be rewarded in accordance with its
marginal productivity.” -Mark Blaug

“The marginal productivity theory of income distribution states that

in the long run under perfect competition, factors of production
would tend to receive a real rate of return which was exactly equal
to their marginal productivity.” –Liebhafasky

Assumptions of the Theory:

The main assumptions of the theory are as under:

1. Perfect Competition:
The marginal productivity theory rests upon the fundamental
assumption of perfect competition. This is because it cannot take
into account unequal bargaining power between the buyers and the
sellers.

2. Homogeneous Factors:
This theory assumes that units of a factor of production are
homogeneous. This implies that different units of factor of
production have the same efficiency. Thus, the productivity of all
workers offering the particular type of labour is the same.
3. Rational Behaviour:
The theory assumes that every producer desires to reap maximum
profits. This is because the organizer is a rational person and he so
combines the different factors of production in such a way that
marginal productivity from a unit of money is the same in the case
of every factor of production.

4. Perfect Substitutability:
The theory is also based upon the assumption of perfect
substitution not only between the different units of the same factor
but also between the different units of various factors of production.

5. Perfect Mobility:
The theory assumes that both labour and capital are perfectly
mobile between industries and localities. In the absence of this
assumption the factor rewards could never tend to be equal as
between different regions or employments.

6. Interchangeability:
It implies that all units of a factor are equally efficient and
interchangeable. This is because different units of a factor of
production are homogeneous, since they are of the same efficiency,
they can be employed inter-changeable, and e.g., whether we
employ the fourth man or the fifth man, his productivity shall be the
same.

7. Perfect Adaptability:
The theory takes for granted that various factors of production are
perfectly adaptable as between different occupations.

8. Knowledge about Marginal Productivity:

Both producers and owners of factors of production have means of
knowing the value of factor’s marginal product.
9. Full Employment:
It is assumed that various factors of production are fully employed
with the exception of those who seek a wage above the value of their
marginal product.

10. Law of Variable Proportions:

The law of variable proportions is applicable in the economy.

11. The Amount of Factors of Production should be Capable

of being Varied:
It is assumed that the quantity of factors of production can be
varied i.e. their units can either be increased or decreased. Then the
remuneration of a factor becomes equal to its marginal productivity.

12. The Law of Diminishing Marginal Returns:

It means that as units of a factor of production are increased the
marginal productivity goes on diminishing.

13. Long-Run Analysis:

Marginal productivity theory of distribution seeks to explain
determination of a factor’s remuneration only in the long period.

Explanation of the Theory:

The marginal productivity theory states that under perfect

competition, price of each factor of production will be equal to its
marginal productivity. The price of the factor is determined by the
industry. The firm will employ that number of a given factor at
which price is equal to its marginal productivity. Thus, for industry,
it is a theory of factor pricing while for a firm it is a factor demand
theory.

Analysis of Marginal Productivity Theory from the Point of View of

an Industry:

Under the conditions of perfect competition, price of each factor of

production is determined by the equality of demand and supply. As
the theory assumes that there exists full employment in the
economy, therefore, supply of the factor is assumed to be constant.
So, factor price is determined by its demand which itself is
determined by the marginal productivity. Thus, under such
conditions, it becomes essential to throw light on the demand curve
or marginal productivity curve of an industry.

As the industry consists of a group of many firms, accordingly, its

demand curve can be drawn with the demand curves of all the firms
in the industry. Moreover, marginal revenue productivity of a factor
constitutes its demand curve. It is only due to this reason that a
firm’s demand or labour depends on its marginal revenue
productivity. A firm will employ that number of labourers at which
their marginal revenue productivity is equal to the prevailing wage
rate.

Fig. 2 shows that at wage rate OP 1, the demand for labour is

ON1 and marginal revenue productivity curve is MRP 1. If wage rate
falls to OP, firms will increase production by demanding more
labour. In such a situation the price of the commodity will fall and
marginal revenue productivity curve will also shift to MRP 2.

At OP wages, the demand for labour will increase to ON. DD 1 is the

firm’s demand curve for labour. The summation of demand of all
the firms shows demand curve of an industry. Since the number of
firms is not constant under perfectly competitive market, it is not
possible to estimate the summation of demand curves of all firms.
However, one thing is certain that is the demand curve of industry
also slopes downward from left to right. The point where demand
for and supply of a factor are equal will determine the factor price
for the industry. This theory assumes the supply of a factor to be
fixed.

Thus factor price is determined by the demand for factor i.e. factor
price will be equal to the marginal revenue productivity. It has been
shown by Fig. 3. In the Fig. 3, number of labour has been taken on
OX axis whereas wages and MRP have been taken on OY axis. DD 1 is
the industry’s demand curve for labour. This is also the Marginal
Revenue Productivity curve.

Factor Price (OW) = Marginal Revenue Productivity MRP.

Thus under perfect competition, factor price is determined by the
industry and firm demands units of a factor at this price.

Analysis of Marginal Productivity Theory from the Point of View of

Firm:

Under perfect competition, number of firms is very large. No single

firm can influence the market price of a factor of production. Every
firm acts as a price taker and not a price maker. Therefore, it has to
accept the prevailing price. No employer would like to pay more
than what others are paying. In other words, a firm will employ that
number of a factor at which its price is equal to the value of
marginal productivity. Therefore, from the point of view of a firm,
the theory indicates how many units of a factor it should demand.

It is due to this reason that it is also called Theory of Factor

Demand. Other things remaining the same, as more and more
labourers are employed by a firm, its marginal physical productivity
goes or- diminishing. As price under perfect competition remains
constant, so when marginal physical productivity of labour goes on
diminishing, marginal revenue productivity will also go on
diminishing. Therefore, in order to get the equilibrium position, a
firm will employ labourers up to a point where their respective
marginal revenue productivity is equal to their wage rate.

Table 2 indicates that wage rate of labour is Rs. 55 per labourers.

Price of the product produced by the labourer is Rs. 5 per unit. Now,
when a firm employs one labourer, his marginal physical
productivity is 20 units. By multiplying the MPP with price of the
product we get marginal revenue productivity. Here, it is Rs. 100 for
the first labour. The marginal revenue productivity of second
labourer is Rs. 85 and of third labourer it is Rs. 70.

The marginal revenue productivity of fourth labourer is Rs. 55

which is equal to wage rate. The firm will earn maximum profits if it
employs up to the fourth labourer. If the firm employs fifth
labourer, it will have to suffer losses of Rs. 15. Therefore, to get
maximum profits, a firm will employ a factor upto a point where
MRP is equal to price.

In Fig. 4 number of labourers has been measured on OX-axis and

wage rate on Y-axis. MRP is marginal revenue productivity curve
and WW is the wage rate prevailing in the market. Since, under
perfect competition wage rate will remain constant that is why WW
wage line is parallel to OX-axis.

MRP curve is sloping down-ward. It cuts WW at point E which is

the equilibrium wage rate of Rs. 55. At point E, firm will demand
only four labourers. Thus, from the above, we can conclude that a
factor is demanded up to the limit where its marginal productivity is
equal to prevailing price.
Under perfect competition, in long period in the equilibrium
position, not only the marginal wages of a firm are equal to
marginal revenue productivity, even the average wages of the firm
are equal to average net revenue productivity as has been shown in
Fig. 5. The fig. 5 shows that at point ‘E’ marginal wages of labour are
equal to marginal revenue productivity and the firm employs OM
number of workers. At this point, even the average net revenue
productivity is equal to average wages. Thus firm earns only normal
profit. If wage line shifts from NN to N[N] then the demand for
labour increases from OM to OM 1.

Determination of Factor Pricing under Imperfect Competition:

Marginal productivity theory applies to the condition of perfect

competition. But in real life we face imperfect competition.
Therefore, economists like Robinson, Chamberlin have analyzed
factor pricing under imperfect competition. There are various firms
under imperfect competition. But here we shall analyze only
Monopsony. Under monopsony, there is perfect competition in
product market. Consequently MRP is equal to VMP. There is
imperfect competition in factor market.

It indicates that there is only one buyer of the factors. Therefore,

monopsony refers to a situation of market where only a single firm
provides employment to the factors. If the firm demands more
factors, factor price will go up and vice-versa. However, the
determination of factor price under monopsony can be explained
with the help of Fig. 6.

In Fig. 6 number of labourers has been shown on X-axis and wages

on Y-axis. MW is marginal wage curve and ARP is the average wage
curve. MRP is the marginal revenue productivity curve and AW is
the average revenue productivity curve.

In the fig. 6 a monopsony will employ that number of labourers at

which their marginal wage is equal to MRP. In the fig. 6 firm is in
equilibrium at point E. Here, firm will employ ON labourers and
they will be paid wages equal to NF. In this way, ON labourers will
get less wages than their MRP i.e. EN. Monopsony firm will have EF
profit per labourer which arises due to exploitation of labourers.
Total profit SFWW’ is due to exploitation of labour.

Criticisms

1. In determination of marginal product:

Firstly, main product is a joint product— produced by all the factors

jointly. Hence the marginal product of any particular factor (say,
land or labour) cannot be separately determined. As William Petty
pointed out as early in 1662: Labour is the father and active
principle of wealth, as lands are the mother.

2. Unrealistic:
It is also shown that the employment of one additional unit of a
factor may cause an improvement in the whole of organisation in
which case the MPP of the variable factors may increase. In such
circumstances, if the factor is paid in accordance with the VMP, the
total product will get exhausted before the distribution is
completed. This is absurd. We cannot think of such a situation in
reality.

3. Market imperfection:

The theory assumes the existence of perfect competition, which is

rarely found in the real world. But E. Chamberlin has shown that
the theory can also be applied in the case of monopoly and
imperfect competition, where the marginal price of a factor would
be equal to its MRP (not to its VMP).

4. Full employment:

Again, the assumption of full employment is also unrealistic. Full

employment is also a myth, not a reflection of reality.

5. Difficulties of factor substitution:

W. W. Leontief, the Nobel economist, denies the possibility of free

substitution of the factors always owing to the technical conditions
of production. In some products process, one factor cannot be
substituted by another. Moreover organisation or entrepreneurship
is a specific factor which cannot be substituted by any other factor.

6. Emphasis on the demand side only:

The theory is one-sided as it ignores the supply side of a factor; it

has emphasised only the demand side i.e., the employer’s side, hi
the opinion of Samuelson, the marginal productivity theory is
simply a theory of one aspect of the demand for productive services
by the firm.
7. Inhuman theory:

Finally, the theory is often described as ‘inhuman’ as it treats

human and non-human factors in the same way for the
determination of factor price.

2. What do you mean by consumer Surplus. Discuss both

Marshallian and Hicksian approaches of consumer surplus.

Ans-

Meaning:
The concept of consumer surplus was first formulated by Dupuit in
1844 to measure social benefits of public goods such as canals,
bridges, national highways. Marshall further refined and popularised
this in his ‘Principles of Economics” published in 1890.

The concept of consumer surplus became the basis of old welfare

economics. Marshall’s concept of consumer’s surplus was based on the
cardinal measurability and interpersonal comparisons of utility.
According to him, every increase in consumer’s surplus is an indicator
of the increase in social welfare. As we shall see below, consumer’s
surplus is simply the difference between the price that ‘one is willing
to pay’ and ‘the price one actually pays’ for a particular product.

Concept of consumer’s surplus is a very important concept in

economic theory, especially in theory of demand and welfare
economics. This concept is important not only in economic theory but
also in formulation of economic policies such as taxation by the
Government and price policy pursued by the monopolistic seller of a
product.
The essence of the concept of consumer’s surplus is that a consumer
derives extra satisfaction from the purchases he daily makes over the
price he actually pays for them. In other words, people generally get
more utility from the consumption of goods than the price they
actually pay for them.

It has been found that people are prepared to pay more price for the
goods than they actually pay for them. This extra satisfaction which
the consumers obtain from buying a good has been called consumer
surplus.

Thus, Marshall defines the consumer’s surplus in the following words:

“excess of the price which a consumer would be willing to pay rather
than go without a thing over that which he actually does pay is the
economic measure of this surplus satisfaction…. it may be called
consumer’s surplus.”

The amount of money which a person is willing to pay for a good

indicates the amount of utility he derives from that good; the greater
the amount of money he is willing to pay, the greater the utility he
obtains from it.

Therefore, the marginal utility of a unit of a good determines the price

a consumer will be prepared to pay for that unit. The total utility
which a person gets from a good is given by the sum of marginal
utilities (IMU) of the units of a good purchased and the total price
which he actually pays is equal to the price per unit of the good
multiplied by the number of units of it purchased.
Thus:
Consumer’s surplus = What a consumer is willing to pay minus what
he actually pays.

= ∑ Marginal utility – (Price x Number of units of a commodity

purchased)

The concept of consumer surplus is derived from the law of

diminishing marginal utility. As we purchase more units of a good, its
marginal utility goes on diminishing. It is because of the diminishing
marginal utility that consumer’s willingness to pay for additional units
of a commodity declines as he has more units of the commodity.

The consumer is in equilibrium when marginal utility from a

commodity becomes equal to its given price. In other words, consumer
purchases the number of units of a commodity at which marginal
utility is equal to price. This means that at the margin what a
consumer will be willing to pay (i.e., marginal utility) is equal to the
price he actually pays.

But for the previous units which he purchases, his willingness to pay
(or the marginal utility he derives from the commodity) is greater than
the price he actually pays for them. This is because the price of the
commodity is given and constant for him and therefore price of all the
units is the same.

Marshall’s Measure of Consumer Surplus:

Consumer surplus measures extra utility or satisfaction which a
consumer obtains from the consumption of a certain amount of a
commodity over and above the utility of its market value. Thus the
total utility obtained from consuming water is immense while its
market value is negligible.

It is due to the occurrence of diminishing marginal utility that a

consumer gets total utility from the consumption of a commodity
greater than its market value. Marshall tried to obtain the monetary
measure of this surplus, that is, how many rupees this surplus of
utility is worth to the consumer.

It is the monetary value of this surplus that Marshall called consumer

surplus. To determine this monetary measure of consumer surplus we
are required to measure two things. First, the total utility in terms of
money that a consumer expects to get from the consumption of a
certain amount of a commodity. Second, the total market value of the
amount of commodity consumed by him.

It is quite easy to measure the total market value as it is equal to

market price of a commodity multiplied by its quantity purchased (i.e.,
P.Q.). An important contribution of Marshall has been the way he
devised to determine the monetary measure of the total utility a
consumer obtained from the commodity. Consider Table 14.1 which
has been graphically shown in Fig. 14.1.
Table 14.1: Marginal Utility and Consumer Surplus:

Suppose for the first unit of the commodity the consumer is prepared
to pay Rs. 20. This means that the first unit of the commodity is at
least worth Rs. 20 to him. In other words, he derives marginal utility
equal to Rs. 20 from the first unit.
For the second unit of the commodity, he is willing to pay Rs. 18, that
is, the second unit is at least worth Rs. 18 to him. This is in accordance
with the law of diminishing marginal utility. Similarly, the marginal
utility of the third, fourth, fifth and sixth units of the commodity fall to
Rs. 16, 14, 12 and 10 respectively.
However, actually the consumer has not to pay the sum of money
equal to the marginal utility or marginal valuation he places on them.
For all the units of the commodity he has to pay the current market
price of the commodity.

Suppose the current market price of the commodity is Rs. 12. It will be
seen from the Table 14.1 and Fig. 14.1 that the consumer will buy 5
units of the commodity at this price because his marginal utility of the
fifth unit just equals the market price of Rs. 12.

This shows that his marginal utility of the first four units is greater
than the market price which he actually pays for them. He will
therefore obtain surplus or net marginal benefit of Rs. 8 (Rs. 20 – 12)
from the first unit, Rs. 6 (= Rs. 18-12) from the second unit, Rs. 4 from
the third unit and Rs. 2 from the fourth unit and zero from the fifth
unit. He thus obtains total consumer surplus or total net benefit equal
to Rs. 20.

Measurement of Consumer Surplus as an Area under the

Demand Curve:

The analysis of consumer surplus made above is based on discrete

units of the commodity. If we assume that the commodity is perfectly
divisible, which is usually made in economic theory, the consumer
surplus can be represented by an area under the demand curve.

The measurement of consumer surplus from a commodity from the

demand or marginal utility curve is illustrated in Fig. 14.2 in which
along the X-axis the amount of the commodity has been measured and
on the Y-axis the marginal utility (or willingness to pay for the
commodity) and the price of the commodity are measured.

DD’ is the demand or marginal utility curve which is sloping

downward, indicating that as the consumer buys more units of the
commodity falls, marginal utility of the additional units of the
commodity. As said above, marginal utility shows the price which a
person is willing to pay for the different units rather than go without
them.

If OP is the price that prevails in the market, then the consumer will be
in equilibrium when he buys OM units of the commodity, since at OM
units, marginal utility from a unit of the commodity is equal to the
given price OP.

The Mth unit of the commodity does not yield any consumer’s surplus
to the consumer since this is the last unit purchased and for this price
paid is equal to the marginal utility which indicates the price that he is
prepared to pay rather than go without it.

But for the intra-marginal units i.e., units before Mth unit, marginal
utility is greater than the price and. therefore, these units yield
consumer’s surplus to the consumer. The total utility of a certain
quantity of a commodity to a consumer can be known by summing up
the marginal utilities of the various units purchased.
In Fig. 14.2, the total utility derived by the consumer from OM units of
the commodity will be equal to the area under the demand or marginal
utility curve up to point M. That is, the total utility of OM units in Fig.
14.2 is equal to ODSM.
In other words, for OM units of the good the consumer will be
prepared to pay the sum equal to Rs. ODSM. But given the price equal
to OP, the consumer will actually pay the sum equal to Rs. OPSM for
OM units of the good. It is thus clear that the consumer derives extra
utility equal to ODSM minus OPSM = DPS, which has been shaded in
Fig. 14.2. To conclude when we draw a demand curve, the monetary
measure of consumer surplus can be obtained by the area under the
demand curve over and above the rectangular area representing the
total market value (i.e., PQ. or the area OPSM) of the amount of the
commodity purchased.

If market price of the commodity rises above OP, the consumer will
buy fewer units of the commodity than OM. As a result, consumer’s
surplus obtained by him from his purchase will decline. On the other
hand, if price falls below OP, the consumer will be in equilibrium
when he is purchasing more units of the commodity than OM.

As a result of this, the consumer’s surplus will increase. Thus, given

the marginal utility curve of the consumer, the higher the price, the
smaller the consumer’s surplus and the lower the price, the greater the
consumer’s surplus.

It worth noting here that in our analysis of consumer’s surplus, we

have assumed that perfect competition prevails in the market so that
the consumer faces a given price, whatever the amount of the
commodity he purchases.

But if seller of a commodity discriminates the prices and charges

different prices for the different units of the good, some units at a
higher price and some at a lower price, then in this case consumer’s
surplus will be smaller.

Thus, when the seller makes price discrimination and sells different
units of a good at different prices, the consumer will obtain smaller
amount of consumer’s surplus than under perfect competition. If the
seller indulges in perfect price discrimination, that is, if he charges
price for each unit of the commodity equal to what any consumer will
be prepared to pay for it, then in that case no consumer’s surplus will
acquire to the consumer.

Consumer Surplus and Gain from a Change in Price:

In our above analysis consumer’s surplus has been explained by
considering the surplus of utility or its money value which a consumer
obtains from a given quantity of the commodity rather than nothing at
all.

However, viewing consumer surplus derived by the consumer from his

consumption of a commodity by considering it in all or none situation
has rather limited uses. In a more useful way, consumer’s surplus can
be considered as net benefit or extra utility which a consumer obtains
from the changes in price of a good or in the levels of its consumption.

Consider Fig. 14.3 where DD shows the demand curve for food. At a
market price OP of the food, the consumer buys OQ quantity of the
food. The total market value which he pays for OQ food is equal to the
area OPEQ, that is, price OP multiplied by quantity OQ.

The total benefit, utility or use-value of OQ quantity of food is the area

ODEQ. Thus, consumer’s surplus obtained by the consumer would be
equal to the area PED. Now, if price of food falls to OP’, the consumer
will buy OQ’ quantity of food and the consumer surplus will increase
to P ‘TD.

The net increase in the consumer’s surplus as a result of fall in price is

the shaded area PETP’, (P’TD – PED = PETP’). This measures the net
benefit or extra utility obtained by the consumer from the fall in price
of food. This net benefit can be decomposed into two parts. First, the
increase in consumer surplus arising on consuming previous OQ
quantity of food due to fall in price.

Second, the increase in consumer surplus equal to the small triangle

EST arising due to the increase in consumption of the food following
the lowering of its price (PETP’- PESP’ + EST).

Measurement of Consumer’s Surplus through Indifference

Curve Analysis:
We have explained above the Marshallian method of measuring
consumer’s surplus. Marshallian method has been criticised by the
advocates of ordinal utility analysis.

Two basic assumptions made by Marshall in his

measurement of consumer’s surplus are:

(1) Utility can be quantitatively or cardinally measured, and

(2) When a person spends more money on a commodity, the marginal
utility of money does not change or when the price of a commodity
falls and as a result consumer becomes better off and his real income
increases, the marginal utility of money remains constant.

Economists like Hicks and Allen have expressed the view that utility is
a subjective and psychic entity and, therefore, it cannot be cardinally
measured. They further point out that marginal utility of money does
not remain constant with the rise and fall in real income of the
consumer following the changes in price of a commodity.

The implication of Marshallian assumption of constant marginal

utility of money is that he neglects the income effect of the price
change. But in some cases income effect of the price change is very
significant and cannot be ignored.

Marshall defended his assumption of constancy of marginal utility of

money on the ground that an individual spends a negligible part of his
income on an individual commodity and, therefore, a change in its
price does not make any significant change in the marginal utility of
money. But this need not be so in case of all commodities.

Prof. J.R. Hicks rehabilitated the concept of consumer’s surplus by

measuring it with indifference curve technique of his ordinal utility
analysis. Indifference curve technique does not make the assumption
of cardinal measurability of utility, nor does it assume that marginal
utility of money remains constant. However, without these invalid
assumptions, Hicks was able to measure the consumer’s surplus with
his indifference curve technique.

The concept of consumer’s surplus was criticised mainly on the ground

that it was difficult to measure it in cardinal utility terms. Therefore,
Hicksian measurement of consumer’s surplus in terms of ordinal
utility went a long way in establishing the validity of the concept of
consumer’s surplus.

How consumer’s surplus is measured with the aid of Hicksian

indifference curve technique is illustrated in Fig. 14.4. In Fig. 14.4, we
have measured the quantity of commodity X along the X-axis, and
money along the Y-axis. It is worth noting that money represents other
goods except the commodity X.
We have also shown some indifference curves between the given
commodity X and money for the consumer, the scale of his preference
being given. We know that consumer’s scale of preferences depends on
his tastes and is quite independent of his income and market prices of
the good. This will help us in understanding the concept of consumer’s
surplus with the aid of indifference curves.
Suppose, a consumer has OM amount of money which he can spend
on the commodity X and the remaining amount on other goods. The
indifference curve IC1 touches the point M indicating thereby that all
combinations of money and commodity represented on the
indifference curve IC1 give the same satisfaction to the consumer as
OM amount of money.
For example, take combination R on an indifference curve IC1. It
follows that OA amount of commodity X and OS amount of money will
give the same satisfaction to the consumer as OM amount of money
because both M and R combinations lie on the same indifference curve
IC1.
In other words, it means that the consumer is willing to pay MS
amount of money for OA amount of the commodity X. It is thus clear
that, given the scale of preferences of the consumer, he derives the
same satisfaction from OA amount of the commodity X as from MS
amount of money. In other words, he is prepared to give up MS (or
FR) for OA amount of commodity X.

Now, suppose that the price of commodity X in the market is such that
we get the budget line ML (price of X is equal to OM/OL). We know
from out analysis of consumer’s equilibrium that consumer is in
equilibrium where the given budget line is tangent to an indifference
curve. It will be seen from Fig. 14.4 that the budget line ML is tangent
to the indifference curve IC2 at point H, where the consumer is having
OA amount of commodity X and OT amount of money.
Thus, given the market price of the commodity X, the consumer has
actually spent MT amount of money for acquiring OA amount of
commodity X. But, as mentioned above, he was prepared to forego MS
(or FR) amount of money for having OA amount of X.

Therefore, the consumer actually pays TS or HR less amount of money

than he is prepared to pay for OA amount of the commodity X rather
than go without it. Thus, TS or HR is the amount of consumer’s
surplus which the consumer derives from purchasing OA amount of
the commodity.

In this way Hicks explained consumer’s surplus with his indifference

curves technique without assuming cardinal measurability of utility
and without assuming constancy of the marginal utility of money.
Since Marshall made these dubious assumptions for measuring
consumer surplus, his method of measurement is regarded as invalid
and Hicksian method of measurement with the technique of
indifference curves is regarded as superior to the Marshallian method.

Critical Evaluation of the Concept of Consumer’s Surplus:

The concept of consumer’s surplus has been severely criticised ever
since Marshall propounded and developed it in his Principles of
Economics. Critics have described it as quite imaginary, unreal and
useless. Most of the criticisms of the concept have been levelled
against the Marshallian method of measuring it as an area under the
demand curve. However, some critics have challenged the validity of
the concept itself.

Marshallian concept of consumer’s surplus has also been criticised on

the ground of its being based upon unrealistic and questionable
assumptions.

We explain below the various criticisms levelled against this

concept and will critically appraise them:
1. It has been pointed out by several economists that the concept of
consumer’s surplus is quite hypothetical, imaginary and illusory. They
say that a consumer cannot afford to pay for a commodity more than
his income. The maximum amount which a person can pay for a
commodity or for a number of commodities is limited by the amount
of his money income.

And, as is well-known, a consumer wants a number of goods on which

he has to spend his money. Total sum of money actually spent by him
on the goods cannot be greater than his total money income. Thus
what a person can be prepared to pay for a number of goods he
purchases cannot be greater than the amount of his money income.
Viewed in this light, there can be no question of consumer getting any
consumer’s surplus for his total purchases of the goods.

But, in our view, the above criticism misses the real point involved in
the concept of consumer’s surplus. The essence of the concept of
consumer’s surplus is that consumer gets excess psychic satisfaction
from his purchases of the goods.

It is true that with his limited money income, consumer cannot pay
more than his total money income for his total purchases than that he
actually pays. But nothing prevents him from feeling and thinking that
he derives more satisfaction from the goods than the price he actually
pays for them and if he had the means he would have paid much more
for the goods than he actually pays for them.

2. Another criticism against consumer’s surplus is that it is based upon

the invalid assumption that different units of the goods give different
amount of satisfaction to the consumer. We have explained above how
Marshall calculated consumer’s surplus derived by the consumer from
a good.

Consumer purchases the amount of a good at which marginal utility is

equal to its price. It is assumed that marginal utility of a good
diminishes as the consumer has more units of it. This means that
while at the margin of the purchase, marginal utility of the good is
equal to its price, for the previous intra-marginal units, marginal
utility is higher than the price and, on these intra-marginal units, a
consumer obtains consumer’s surplus.

Now, the critics point out that when a consumer takes more units of a
commodity it is not only the utility of the marginal unit that declines
but also all previous units of the commodity he has taken. Thus, as all
units of a commodity are assumed alike, all would have the same
utility. And when, at the margin, price is equal to the marginal utility
of the last unit purchased, the price will also be equal to the utility of
the previous units and consumer would, therefore, not get any
consumer’s surplus.

But this criticism is also not acceptable because even though all units
of a commodity may be alike, they do not give same satisfaction to the
consumer; as the consumer takes the first unit, he derives more
satisfaction from it and when he takes up the second unit, it does not
give him as much satisfaction as the first one, because while taking the
second unit, a part of his want has already been satisfied.

Similarly, when he takes the third unit, it will not give him as much
satisfaction as the previous two units, because now a part of his want
has been satisfied. Similarly, when he takes the third unit, it will not
give him as much satisfaction as the previous two units.

If we accept the above criticism, we then deny the law of diminishing

marginal utility. But diminishing marginal utility from a good
describes the fundamental human tendency and has also been
confirmed by observation of actual consumer’s behaviour.

The concept of consumer’s surplus is derived from the law of

diminishing marginal utility. If law of diminishing marginal utility is
valid, the validity of the Marshallian concept of consumer’s surplus
cannot be challenged.

3. The concept of consumer’s surplus has also been criticised on the

ground that it ignores the interdependence between the goods, that is,
the relations of substitute and complementary goods. Thus, it is
pointed out that if only tea were available and no other substitute
drinks such as milk, coffee, etc., were there, and then the consumer
would have been prepared to pay much more price for tea than that in
the presence of substitute drinks.

Thus, the magnitude of consumer’s surplus derived from a commodity

depends upon the availability of substitutes. This is because if only tea
were available, consumer will have no choice and would be afraid that
if he does not get tea, he cannot satisfy his given want by consuming
any other commodity.

Therefore, he will be willing to pay more for a cup of tea rather than go
without it. But if substitutes of tea are available, he would not be
prepared to pay as much price since he will think that if he is deprived
of tea, he will take other substitute drinks like milk and coffee.

Thus, it is said that consumer’s surplus is not a definite, precise and

unambiguous concept; it depends upon the availability of substitutes.
The degree of substitutability between different goods is different for
different consumers, and this makes the concept of consumer’s
surplus a little vague and ambiguous.

Marshall was aware of this difficulty and, to overcome this, he

suggested that for the purpose of measuring consumer’s surplus,
substitute products like tea and coffee be clubbed together and
considered as one single commodity.
4. Prof. Nicholson described the concept of consumer’s surplus as
hypothetical and imaginary. He writes, “Of what avail is it to say that
the utility of an income of (say) £100 a year is worth (say) £1000 a
year”. According to Prof. Nicholson and other critics, it is difficult to
say how much price a consumer would be willing to pay for a good
rather than go without it.

This is because consumer does not face this question in the market
when he buys goods; he has to pay and accept the price that prevails in
the market. It is very difficult for him to say how much he would be
prepared to pay rather than go without it. However, in our view, this
criticism only indicates that it is difficult to measure consumer’s
surplus precisely. That a consumer gets extra satisfaction from a good
than the price he pays for it is undeniable.

Moreover, as J.R. Hicks has pointed out “the best way of looking at
consumer’s surplus is to regard it as a means of expressing it in terms
of money income gain which accrues to the consumer as a result of a
fall in price.”

When the price of a commodity falls, the money income of the

consumer being given, the budget line will switch to the right and the
consumer will be in equilibrium at a higher indifference curve and as a
result his satisfaction will increase. Thus, consumer derives more
satisfaction at a lower price than that at the higher original price of the
good.
This implies that fall in the price of a commodity, and, therefore, the
availability of the commodity at a cheaper price adds to the
satisfaction of the consumer and this is in fact the change in
consumer’s surplus brought about by change in the price of the good.
Prof. J.R. Hicks has further extended the concept of consumer’s
surplus considering it from the viewpoint of gain which a consumer
gets from a fall in price of a good.

Moreover, the concept of consumer’s surplus is useful and meaningful

and not unreal because it indicates that he gets certain extra
satisfaction and advantages from the use of amenities available in
modern towns and cities.

5. The concept of consumer’s surplus has also been criticised on the

ground that it is based upon questionable assumptions of cardinal
measurability of utility and constancy of the marginal utility of money.
Critics point out that utility is a psychic entity and cannot be measured
in quantitative cardinal terms.

In view of this, they point out that consumer’s surplus cannot be

measured by the area under the demand curve, as Marshall did it. This
is because Marshallian demand curve is based on the marginal utility
curve in drawing which it is assumed that utility is cardinally
measurable.

By assuming constant marginal utility of money, Marshall ignored

income effect of the price change. Of course, income effect of the price
change in case of most of the commodities is negligible and can be
validly ignored.

But in case of some important commodities such as food-grains,

income effect of the price change is quite significant and cannot be
validly ignored. Therefore, the Marshallian method of measurement of
consumer surplus as area under the demand curve, ignoring the
income effect, is not perfectly correct.

However, this does not invalidate the concept of consumer’s surplus.

As has been explained above, J.R. Hicks has been able to provide a
money measure of consumer’s surplus with his indifference curve
technique of ordinal utility analysis which does not assume cardinal
measurement of utility and constant marginal utility of money. Hicks
have not only rehabilitated the concept of consumer’s surplus but have
also extended and developed it further.

Despite some of the shortcomings of the concept of consumer surplus,

some of which are based on wrong interpretation of the concept of
consumer surplus, it is of great significance not only in economic
theory but also in the formulation of economic policies by the
Government. The concept of consumer’s surplus has a great practical
importance in the formulation of economic policies by the
Government. We explain below some important uses and applications
of consumer surplus.

3. Discuss in detail Law of Variable Proportions.

 Ans- 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 labour.

Land is a fixed factor whereas labour 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., labour.
Accordingly, the proportion between land and labour will be
1: 5. If the number of laborers is increased to 2, the new
proportion between labour 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 labour are the only two
factors of production.
By keeping land as a fixed factor, the production of
variable factor i.e., labour can be shown with the help of
the following table:

From the table 1 it is clear that there are three stages of the law of
variable proportion. In the first stage average production increases
as there are more and more doses of labour and capital employed
with fixed factors (land). We see that total product, average product,
and marginal product increases but average product and marginal
product increases up to 40 units. Later on, both start decreasing
because proportion of workers to land was sufficient and land is not
properly used. This is the end of the first stage.

The second stage starts from where the first stage ends or where
AP=MP. In this stage, average product and marginal product start
falling. We should note that marginal product falls at a faster rate
than the average product. Here, total product increases at a
diminishing rate. It is also maximum at 70 units of labour where
marginal product becomes zero while average product is never zero
or negative.
The third stage begins where second stage ends. This starts from
8th unit. Here, marginal product is negative and total product falls
but average product is still positive. At this stage, any additional
dose leads to positive nuisance because additional dose leads to
negative marginal product.

Graphic Presentation:

In fig. 1, on OX axis, we have measured number of labourers while

quantity of product is shown on OY axis. TP is total product curve.
Up to point ‘E’, total product is increasing at increasing rate.
Between points E and G it is increasing at the decreasing rate. Here
marginal product has started falling. At point ‘G’ i.e., when 7 units
of labourers are employed, total product is maximum while,
marginal product is zero. Thereafter, it begins to diminish
corresponding to negative marginal product. In the lower part of the
figure MP is marginal product curve.
Up to point ‘H’ marginal product increases. At point ‘H’, i.e., when 3
units of labourers are employed, it is maximum. After that,
marginal product begins to decrease. Before point ‘I’ marginal
product becomes zero at point C and it turns negative. AP curve
represents average product. Before point ‘I’, average product is less
than marginal product. At point ‘I’ average product is maximum. Up
to point T, average product increases but after that it starts to
diminish.

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 labour becomes negative. The employer will
suffer losses by employing more units of labourers. However, of the
three stages, a firm will like to produce up to any given point in the
second stage only

In Which Stage Rational Decision is Possible:

To make the things simple, let us suppose that, a is variable factor

and b is the fixed factor. And a 1, a2 , a3….are units of a and b 1 b2b3……
are unit of b.

Stage I is characterized by increasing AP, so that the total product

must also be increasing. This means that the efficiency of the
variable factor of production is increasing i.e., output per unit of a is
increasing. The efficiency of b, the fixed factor, is also increasing,
since the total product with b 1 is increasing.

The stage II is characterized by decreasing AP and a decreasing MP,

but with MP not negative. Thus, the efficiency of the variable factor
is falling, while the efficiency of b, the fixed factor, is increasing,
since the TP with b 1 continues to increase.

Finally, stage III is characterized by falling AP and MP, and further

by negative MP. Thus, the efficiency of both the fixed and variable
factor is decreasing.
Rational Decision:
Stage II becomes the relevant and important stage of production.
Production will not take place in either of the other two stages. It
means production will not take place in stage III and stage I. Thus,
a rational producer will operate in stage II.

Suppose b were a free resource; i.e., it commanded no price. An

entrepreneur would want to achieve the greatest efficiency possible
from the factor for which he is paying, i.e., from factor a. Thus, he
would want to produce where AP is maximum or at the boundary
between stage I and II.

If on the other hand, a were the free resource, then he would want
to employ b to its most efficient point; this is the boundary between
stage II and III.

Obviously, if both resources commanded a price, he would produce

somewhere in stage II. At what place in this stage production takes
place would depend upon the relative prices of a and b.

Condition or Causes of Applicability:

There are many causes which are responsible for the application of
the law of variable proportions.

They are as follows:

1. Under Utilization of Fixed Factor:

In initial stage of production, fixed factors of production like land or
machine, is under-utilized. More units of variable factor, like
labour, are needed for its proper utilization. As a result of
employment of additional units of variable factors there is proper
utilization of fixed factor. In short, increasing returns to a factor
begins to manifest itself in the first stage.

2. Fixed Factors of Production.

The foremost cause of the operation of this law is that some of the
factors of production are fixed during the short period. When the
fixed factor is used with variable factor, then its ratio compared to
variable factor falls. Production is the result of the co-operation of
all factors. When an additional unit of a variable factor has to
produce with the help of relatively fixed factor, then the marginal
return of variable factor begins to decline.

3. Optimum Production:
After making the optimum use of a fixed factor, then the marginal
return of such variable factor begins to diminish. The simple reason
is that after the optimum use, the ratio of fixed and variable factors
become defective. Let us suppose a machine is a fixed factor of
production. It is put to optimum use when 4 labourers are employed
on it. If 5 labourers are put on it, then total production increases
very little and the marginal product diminishes.

4. Imperfect Substitutes:
Mrs. Joan Robinson has put the argument that imperfect
substitution of factors is mainly responsible for the operation of the
law of diminishing returns. One factor cannot be used in place of
the other factor. After optimum use of fixed factors, variable factors
are increased and the amount of fixed factor could be increased by
its substitutes.

Such a substitution would increase the production in the same

proportion as earlier. But in real practice factors are imperfect
substitutes. However, after the optimum use of a fixed factor, it
cannot be substituted by another factor.

Applicability of the Law of Variable Proportions:

The law of variable proportions is universal as it applies to all fields

of production. This law applies to any field of production where
some factors are fixed and others are variable. That is why it is
called the law of universal application.

The main cause of application of this law is the fixity of any one
factor. Land, mines, fisheries, and house building etc. are not the
only examples of fixed factors. Machines, raw materials may also
become fixed in the short period. Therefore, this law holds good in
all activities of production etc. agriculture, mining, manufacturing
industries.

1. Application to Agriculture:
With a view of raising agricultural production, labour and capital
can be increased to any extent but not the land, being fixed factor.
Thus when more and more units of variable factors like labour and
capital are applied to a fixed factor then their marginal product
starts to diminish and this law becomes operative.

2. Application to Industries:
In order to increase production of manufactured goods, factors of
production has to be increased. It can be increased as desired for a
long period, being variable factors. Thus, law of increasing returns
operates in industries for a long period. But, this situation arises
when additional units of labour, capital and enterprise are of
inferior quality or are available at higher cost.

As a result, after a point, marginal product increases less

proportionately than increase in the units of labour and capital. In
this way, the law is equally valid in industries.

Postponement of the Law:

The postponement of the law of variable proportions is

possible under following conditions:

(i) Improvement in Technique of Production:

The operation of the law can be postponed in case variable factors
techniques of production are improved.

(ii) Perfect Substitute:

The law of variable proportion can also be postponed in case factors
of production are made perfect substitutes i.e., when one factor can
be substituted for the other.
4. Q1. From the books of accounts of M/s. Tejas Enterprises, following
details have been extracted for the year ending 31st Dec, 2018:

Particulars Amount (rs)

Opening stock of raw material 2,88,000
Closing stock of raw material 3,00,000
Material Purchased during the 9,42,000
year
Direct labour cost 4,43,000
Indirect Wages 54,000
Salaries to office staff 2,12,000
Freight outward 43,000
Repairs for plant and machinery 21,000
Factory rent and taxes 55,000
Office rent and taxes 32,000
Distribution expenses 76,000
Salesman Salaries and commission 54,000
Manager’s salary (40% of his time 60,000
used in factory and rest in office)
Factory electricity charges 25,000
Office telephone expenses 5,000
Opening stock of finished goods 2,03,000
Closing stock of finished goods 1,12,000
Depreciation of office furniture 13,000
5. You are required to prepare cost sheet for the firm from the above
given details.
Solution
M/s. Tejas Enterprises
Cost sheet
For the year ending 31st December 2018

Particulars Amount (Rs.) Amount(Rs)

Direct Materials:
Purchases during the 9,42,000
year
Add: Opening stock of 2,88,000
raw material
Less: Closing Stock of (300,000)
Raw material
Direct Material 9,30,000 9,30,000
Consumed
Direct Labour cost 4,43,000
Prime Cost 13,73,000
Add: Factory
overheads
Indirect Wages 54,000
Repairs for plant and 21,000
machinery
Factory rent and taxes 55,000
Manager’s salary- 24,000
Factory
Factory electricity 25,000
charge
Total Factory 1,79,000 1,79,000
overheads
Factory/Work Cost 15,52,000
Add: Office and
administrative
expenses
Salaries to office staff 2,12,000
Office rent and taxes 32,000
Manager’s salaries-
Office 36,000
Office telephone 5,000
expenses
Depreciation of office 13,000
furniture
Total office and 2,98,000 2,98,000
administrative
overheads
Cost of Production 18,50,000
Add: Opening stock of 2,03,000
finished goods
Less:Closing stock of 1,12,000
finished goods
Cost of goods sold 19,41,000
Add: Selling and
distribution overheads
Freight outward 43,000
Distribution expenses 76,000
Salesman salaries and 54,000
commission
Total selling and 1,73,000 1,73,000
distribution overheads
Total cost/Cost of 21,14,000
sales

5 . Select the best project by Net Present Value method and give reason
for the same (estimated life is 5 years)

Project A: Initial Investment= Rs 3,50,000, Scrap Value= Rs 40,000

Project B: Initial Investment= Rs 4,50,000, Scrap Value= Rs 55,000

Cash inflows of Project Cash inflows of Project Net Present Value of

A B Re.1@ 10% discount
factor
1,00,000 1,45,000 0.909
1,10,000 1,75,000 0.826
1,20,000 1,45,000 0.751
90,000 1,25,000 0.683
65,000 95,000 0.621

Solution:

Present Value of A Present value of B

90,900 131,805
90,860 1,44,550
90,120 108,895
61,470 85,375
40,365 58,995
24,840 34,155
Total present value of A=398,555 Total present Value of B= 563,775
Net present value= Total present value- Initial investment

NPV of A= 398,555- 350,000 =48,555

NPV of B=563,775-450,000= 113,775

Project B will be profitable as its NPV is higher than project B.

6. XYZ ltd. Is engaged in manufacturing of toys-

Sales= 10,000 pieces
Selling price per unit- Rs 50
Variable cost per unit- Rs 30
Fixed cost- Rs 100,000
Calculate break even point
(i) In units
(ii) In (Rupees)
(iii) P/V ratio
 (iv) If fixed cost increases by Rs 20,000 then, recalculate break
even point in units and in rupees

Ans-

Break even point in units-

Fixed cost/ Selling price per unit-Variable cost per unit

Rs 100,000/Rs 50-Rs 30

=Rs 5000 units

Break even point in rupees=

Rs 5000 units* Rs 50= Rs 250,000

P/V ratio= Contribution per unit/Selling price per unit*100

Contribution per unit= Selling price per unit- Variable cost per unit

Rs 50- Rs 30= Rs 20

P/V ratio= 20/50*100 = 40%

When fixed cost increases by Rs 20,000

Break even point in units=

Fixed cost/ Selling price per unit-Variable cost per unit

= Rs 1,20,000/Rs 20= Rs 6,000

Break even point in rupees= Rs 6,000*Rs 50= 300,000