ECONOMICS ASSIGNMENT

By-Sachin Raj Reddy

LONG QUESTIONS
Q) What are productive and allocative efficiencies? Assume a govt. must spend only on two services

i.e., health and education. With the help of the Production Possibility Frontier, please explain how a

govt. should distribute its limited public funds between these two crucial services to achieve

productive efficiency and allocative efficiency.

A) Efficiency as the term is often used in economics as a concept to reduce wastage and allocate the

resources optimally. This concept is essential as it allows enterprises to reduce costs and increase the

overall output. Efficiency is achieved when there is an overall reduction in market failure and this can be

done by reducing externalities, the emergence of public goods, free riders, and monopolies. There are

generally two types of efficiencies, productive and allocative.

1) Productive Efficiency – This form of efficiency is where a given entity produces maximum amounts of

goods within its allocated resources and tries its maximum to minimize its costs. Here, the two important

components, Labour, and Capital (L, K), play a crucial role in achieving maximum efficiency. Other

factors such as equipment, material, and technology do play an important role. In long-run equilibrium for

perfectly competitive markets, the point at which the base of the average cost curve is known as a

productive efficient point. Here the Marginal cost is equal to the average total cost.

2)Allocative Efficiency – Allocative Efficiency is a utilitarian concept where the goods that are being

produced by the entity maximize the welfare and the needs of the society. Here, the resources are used in

such a way that the marginal benefit of the society is equal to their marginal cost. There is no presence of

consumer surplus in a perfectly competitive market as the entity is fully informed about the choices of the

consumer. Here, the bundles chosen by the customers play a crucial role than the productive efficiency of
the given entity.

In the diagram, there exists a given budget constraint that is clearly to be allocated between two important

aspects: health and education. The allocation of funds for these two entities heavily depends on the

necessity of the state, if we think from a production point of view, the resources must be split in equal

halves. This metric is much more viable in terms of productive efficiency. But, if we try to understand the

perspective of allocative efficiency, it is very clear that we must understand the demands of the customer

and then allocate the sources accordingly. There are variating demands that require different bundles with

different sets of customers.

Q) Please explain why workers behave differently in response to their rise in hourly pay. Some

workers may choose to work more hours, whereas others may not (they choose to work the same or

even fewer hours). Use Income and substitution effects to explain why this is the case.
A) It must be clearly understood that depending on the choice of the consumer the choice is made. And

now when we talk in the case of a rise in hourly pay it is fundamental to understand the trade-off and the

opportunity cost.

Trade-Off – This concept is very similar to that of a barter system, here in the case of hourly raise pay, the

worker would like to forego a higher pay with a few hours of leisure and time for himself.

Opportunity Cost – It is the potential foregone value from choosing the other product. In the case of the

hourly wage rise, a few are willing to let go of the financial incentive for a much leisure time and some

are willing to work even harder as the financial incentive to do so is much higher. Now in this scenario,

we have to analyse two important concepts as a whole. They are the income Effect and Substitution

Effect.

Income Effect - The income effect refers to how changes in a person's income impact their consumption

habits. When income increases, people tend to spend more, and when income decreases, they tend to

spend less. This effect does not determine what specific goods individuals will buy. It simply means that

they may choose to purchase more expensive items in smaller quantities or cheaper items in larger

quantities based on their circumstances and personal preferences. The income effect can have both direct

and indirect impacts. For example, if a consumer's income decreases, they may choose to purchase less

clothing, which is a direct effect of their income change. Indirectly, the income effect is when consumers

must adjust their spending on various goods due to factors unrelated to their income. For instance, if food

prices increase, consumers will have less disposable income available for other expenses like dining out.

Substitution Effect - The substitution effect happens when a consumer decides to replace

one product with another because of changes in prices and finances. This could involve

replacing cheaper items with more expensive ones or vice-versa. For example, if a consumer

receives a good return on an investment or unexpectedly comes into money, they may choose

to replace an old model item like a car with a new one.

 The substitution effect typically leads consumers to favor the more affordable alternative,

shifting their consumption patterns. For example, if private college tuition is higher than

public college tuition, students may opt for the less expensive option. However, even a slight

decrease in private tuition costs can make it more attractive and encourage more students to

enroll.

The diagram, clearly shows that the price effect is equal to an addition between the Income

Effect and the Substitution Effect. Here the effect is

dependent on the choice of the consumer whether he wants to earn more with the Income

Effect or wants to prioritize his leisure by reducing his work hours and keep the real income

unaffected. For the workers, a rise in the hourly wage rate might as a normal good for a few it

might act as a Giffen good.

SHORT QUESTIONS
Q) Derive the supply curve of a firm in a perfectly competitive market.

A) A perfectly competitive market is type of a market that consists of many buyers and sellers and none of

these buyers have any sort of control over the price. In a perfectly competitive market, Firms and

consumers are price takers, the price here is decided with the forces of market demand and supply.

The supply curve of the firm shows what various quantities of commodity a firm is willing to supply at

different prices. The quantity that a firm is willing to supply at a particular price that is (equilibrium

output) is determined by the equality of SMC or MR (MR=AR=P in the short run, perfect competition).

By finding out the equilibrium output at different prices and by joining these equilibrium points we can

derive a short-run supply curve of the firm. The derivation is shown below.

The above

diagram shows the price on the y-axis and the output and the x-axis. SAC is the short-run average cost,

SAVC is the short-run average variable cost, and the SMC is the short-run marginal cost curve. At the

equilibrium price P, the equilibrium point is E, and the equilibrium output is Q, here the firm is only able

to cover the variable cost since P=AVC. Below point P, the firm will not produce since P<AVC. Hence E

is the shutdown point since the firm will not be able to produce below is.

At price P1 the equilibrium point is E2 and the equilibrium quantity is Q2. Here the SMC=SAC, the firm

can recover its cost in the situation of no profit and loss. Hence point E1 is referred to as a break-even
point. Similarly, at price P3, the equilibrium quantity is Q3 and the Equilibrium Quantity is E3. At this

point, the firm is earning super-normal profits as AR>SAC. By joining E, E1, and E2, we get the firm’s

short-run supply curve.

So that part of the short-run MC curve that lies above the minimum point of the AVC curve is the firm's

supply curve in the short-run.

Q) Explain the shutdown point of a firm with the help of a diagram.

A) The intersection of the average variable cost curve and the marginal cost curve, which shows the price

below which the firm would lack enough revenue to cover its variable costs, is called the shutdown

point. Simply put, a shutdown point is a level of operations at which a firm experiences no benefit in

continuing its operation or production. It can also be defined as a point where the firm earns enough
 revenue to cover its total variable cost.

Q) How government’s interventions with price fixation (ceiling and floor prices) lead to a

deadweight loss?

In a perfectly competitive market, the market price is determined by the forces of demand and supply.

Due to various reasons like hoarding, black-marketing, etc. the government at times needs to intervene in

the market. This intervention by the Government in the market is in the form of floor and ceiling price

that further leads to deadweight loss which is explained below with the help of the diagram
The above diagram shows the price on the y-axis and the quantity on the x-axis. SS is the upward-sloping

supply curve and DD is the downward-sloping demand curve. The SS and DD intersect at point E which

is the Equilibrium price (P) and equilibrium quantity (Q). Here the triangle KEP shows the consumer

surplus and triangle REP shows the producer surplus, and there is no deadweight loss.

The above diagram shows the price on the y-axis and the quantity on the x-axis. Now point E is the

equilibrium point. But in this diagram, there is a government intervention in the form of ceiling price

which reduces the consumer and producer surplus and leads to a deadweight loss in the form of the

triangle shaded that is B+C. Due to government intervention, there is a redistribution of surplus from

Producer to consumer

The above diagram shows the price on the y-axis and the quantity on the x-axis. Now point E is the

equilibrium point. But in this diagram, there is a government intervention in the form of floor price which

reduces the consumer and producer surplus and leads to a deadweight loss which is the shaded triangle

K+F Due to the government intervention there is redistribution of surplus from consumer to producer.
Hence the above diagrams show how government intervention leads to deadweight loss. The neo-classical

economists hence believe that the market should be left free (laissez-faire) without any government

intervention.