MICRO ECONOMICS

Q.1 What do you understand by price affect how can be separated from income and
substitution effect?
Ans. Price effect : Price effect can be defined as the change in the quantity demanded of a
commudity as a result of decrease in its price. This change in demand take place through the
substitution effect and income effect. The price effect is the combination of both income and
substitution effect. The effect of the price depends on the nature of the goods. For example,
standard and Giffen (inferior) goods have positive and negative effects. However, normal goods
have zero impact. The substitution of effect it’s always negative however the income effect can
be positive or negative therefore the price effect can be positive or negative depending on the
direction and magnitude of both substitute and income effects.

it is necessary to consider the nature of goods to understand this effect. It includes

normal, inferior, and giffin goods. Therefore, in the case of normal goods, the impact of price on
demand is positive. So, if the cost of these goods falls, the consumer’s income increases, and the
product’s demand increases. In contrast, if the price increases, its demand will fall. As a result, it
causes an indirect relationship between price and quantity purchased.

Ex = Suppose ABC firm has been dealing in the chocolate business for the past 15 years. They
import premium quality cacao beans from Ecuador in South America. However, in 2022, when
the government removed certain trade restrictions on cacao beans, it reduced the price of
chocolates. In addition, this incident occurred right before Christmas. As a result, the demand for
chocolates leaped. However, if the Ecuadorian government had imposed restrictions, the price
effect would have caused a fall in demand, causing a positive impact.

Income effect : with a fall in the price of a commodity, purchasing power of the consumer
increases. he can buy the same quantity of commodity with less income spent. In the case of
normal goods, the income effect is positive as the quantity demanded of the commodity
increases with an increase in income. However, the income effect is negative for inferior goods
because consumer preferred to buy other goods as there real income rises.

Substitution effect : that is the price of a community falls, it becomes cheaper in comparison to
the other community. Therefore, consumers will buy more of the community as it is relatively
cheaper compared to the other goods that are expensive. The increase in quantity demanded
due to a change in relative price is called the substitution effect.

Price effect = income effect + substitution effect

 Price Effect For Different Goods:-

it is necessary to consider the nature of goods to understand this effect. It includes
normal, inferior, and giffin goods. Therefore, in the case of normal goods, the impact of price
on demand is positive. So, if the cost of these goods falls, the consumer’s income increases,
and the product’s demand increases. In contrast, if the price increases, its demand will fall.
As a result, it causes an indirect relationship between price and quantity purchased.
 here are three possible combinations of income and substitution effects that lead to
different price effects:
 Normal goods

The overall price effect is positive for normal goods because both the income and substitution effects
are positive.

Price effect = substitution effect + income effect

where the price effect is positive as income and
substitution effects are positive
 Inferior goods

The substitution effect is negative, but the income effect is positive for inferior goods. However, the
overall price effect is still negative for inferior goods. This is because the magnitude of the negative
substitution effect is greater than the magnitude of the positive income effect.

Price effect(-) = substitution effect(-) + income effect(+)

where the price effect is negative because
|substitution effect| > |income effect|
 Giffen goods

Similar to inferior goods, the substitution effect is negative but the income effect is positive for Giffen
goods. However, the overall price effect becomes positive for Giffen goods. This happens because the
magnitude of the negative substitution effect is less than the magnitude of the positive income effect.

Price effect (+) = substitution effect(-) + income effect(+)

where the price effect is positive because
|income effect| > |substitution effect|

 Separation of price effect from income and substitution effect:-

Price effect is a combination of income and substitution effects taking place simultaneously. But, only
the price effect is observed as a change in quantity demanded with a change in price. Price effect
needs to be decomposed into income and substitution effects to study their magnitude and direction.

as the price of a commodity falls, it becomes cheaper in comparison to other commodities leading to a
substitution effect. The real income of consumers also increases leading to the income effect. Both of
these effects make up the price effect.

the decomposition of the price effect into substitution and income effects is done
using the indifference curve with the budget line of the consumer. There are two
approaches to separating the total effect into income and substitution effect namely
the Hicksian approach and the Slutsky approach.

 The Hicksian Method:

In the diagram, the x-axis represents units of good X and the y-axis represents units of good Y.
AB is the initial line tangent with indifference curve IC 1 at point E1 with X1 units of good X
and Y1 units of good Y. Suppose that there is a decrease in the price of good X and as a
result, the budget line rotates from ‘AB to ‘AB 1’. There is an increase in the real income of the
consumer. The new equilibrium point is at E2, where the new budget line ‘AB1’ is tangent to the indifference
curve IC2 . At the equilibrium point E 2, the consumer can purchase X 2 units of X good and
Y2 units of Y good. Here the movement from equilibrium point E 1 to E2 or X1 to X2 is known as
the price effect.

As we know, this price effect consists of income and substitution effects. Now To make the
compensating variation in income in order to isolate the substitution effect, the consumer’s
money income is reduced by drawing the budget line JT parallel to AB 1, so that it is tangent
to the original indifference curve IC 1 at point E 3. The reason for the compensating variation
in income is to allow the consumer to remain on the same level of satisfaction as before
the price change. Thus, line JT is known as the compensated budget line.

Now the movement from point E1 to E3 on the same indifference curve (IC1) shows the
substitution effect. Here, the consumer buys more units of good X because it has become
relatively cheaper than before, and thus he substitutes expensive (Y good) for good X. the
substitution effect of a price change is always negative, real income being held
constant.

The income effect can be obtained by subtracting the substitution effect from the price effect, which will be
equal to the difference between E3 and E2 or X3 and X2. To isolate the income effect from the price
effect, return the income which was taken away from the consumer so that he goes
back to the budget line AB 1, and is again in equilibrium at point T on the curve. The
movement from point E on the lower indifference curve IC 1, to point E on the high
3 2

indifference curve IC 2 is the income effect .By the method of compensating variation
in income, the real income of the consumer has increased as a result of the fall in the
price of X. The income effect with respect to the price change for a normal good is
negative.

The entire effect can be written as;

Movement from E1 to E2 or X1 to X2 = Price Effect (PE)
Movement from E1 to E3 or X1 to X3= Substitution Effect (SE)
Movement from E3 to E2 or X3 to X2= Income Effect (IE)

 Conclusion
 he price effect is the totality of income and substitution effect. It means that
the total price effect can be split into two components as income effect and
substitution effect. According to the Hisksian substitution effect, when the
price of any good falls (say good X) money income of the consumer is
reduced by the amount of real income increased so that real income
becomes constant implying that the consumer is neither better off nor
worse off than before.
 In the case of a normal good, the substitution effect is negative as to
maintain the same level of satisfaction on the same indifference curve, a
consumer increases the quantity demand of goods X whose price has fallen,
and decreased the quantity demand for good Y as the price of X becomes
relatively cheaper than the price of Y. The income effect is positive. Thus,
the decomposition of the price effect into substitution and income effect
can be done with the help of the indifference curve and budget line.

Q.2 What is the elasticity of demand? How it can be measured also

explain the different methods of calculating elasticity of demand.
Ans. Elasticity of demand refers to the shift in demand for an item or service
when a change occurs in one of the variables that buyers consider as part
of their purchase decisions. It’s a relationship between demand and
another variable, such as price, income of the customer, price of related
goods, other variables. to measure how much consumer respond due to
change in price, income etc. economists use the concept of elasticity.
When a change in any one of those variables causes a significant
alteration in demand for a product or service, its elasticity of demand is
considered high. In other words, elasticity shows that a customer’s buying
behavior is highly flexible, or stretchy — like an elastic waistband. For
example, If a customer is willing to buy a different brand of coffee simply
because it’s on sale that week or completely forgo buying coffee because
its price has gone up, coffee can be said to have elastic demand.

Understanding elasticity of demand can help guide a business’s marketing

and selling strategies to maximize profitability.By contrast, products that
 are inelastic do not experience large shifts in demand due to changes in
their purchase - consideration variables. Customers remain rigid or firm in
their buying choices for certain products and are unwilling or unable to be
flexible.
 Types of Elasticity
Elasticity of demand is classified into three types based on the many
elements that influence the quantity desired for a product: price elasticity
of demand (PED), cross elasticity of demand (XED), and income elasticity
of demand (IED) (YED).
 Price Elasticity of Demand (PED)
The quantity requested for a product is affected by any change in the price of a
commodity, whether it be a drop or an increase. For example, as the price of
ceiling fans rises, the quantity requested decreases. The price elasticity of
demand measures how much the quantity demanded response due to change
in price it is computed as the percentage change in quantity demand divided
by the percentage change in price. (-) MINUS SIGN in the formula shows the
negative relation between the price and demand.
PED = % change in quantity / % change in price
OR
PED = [(Q2–Q1)/Q1] / [(P2–P1)/P1]
Q1 = initial quantity of demand
Q2 = new quantity of demand
P1 = initial price
P2 = new price
 Income Elasticity of Demand (YED):
Income elasticity of demand is the relationship between demand and a
customer’s income. As income decreases, quantity of demand tends to
decline, even if all other factors remain the same, including price. YED
tends to differ according to the priority of a product, meaning that what
economists refer to as “normal goods,” like food, clothes and other
necessities, are likely to be prioritized over luxury goods when customers’
income declines. Further, spending on normal goods is more likely to
increase first when income increases, and increase of luxury goods
happens on a lag. The formula for YED is:

YED = % change in quantity / % change in income

Or
YED = [(Q2–Q1)/Q1] / [(Y2–Y1)/Y1]
Q1 = initial quantity of demand
Q2 = new quantity of demand
Y1 = initial income
Y2 = new income

 Cross Elasticity of Demand (XED):

Cross elasticity happens when changes in the price of one product effect
changes in demand for another. The two products must be related, either
as complements or substitutes for each other. When products are
substitutes for each other, a rise in the price of one will usually cause a
rise in demand for the other. For example, if coffee prices rise, then
demand for breakfast tea is likely to increase as customers substitute tea
for coffee. When two products are complementary, a rise in the price of
one will usually cause a decrease in the demand for the other. For
example, if coffee prices rise, demand for coffee creamer will likely decline
as people drink less coffee. XED does not apply to unrelated products,
such as airline tickets and oranges. The formula for XED is:

XED = % change in quantity for product A / % change in price for

product B
Or
XED = [(Q2a – Q1a) / (Q2a + Q1a)] / [(P2b – P1b) / (P2b + P1b)]
Q1 =
a initial quantity of demand of product A
Q2 =
a new quantity of demand of product A
P1 =
b initial price of product B
P2 = new price of product B
b

 Methods of Measuring Price Elasticity of Demand

 Basically, there are four ways by which we can calculate the price elasticity
of demand, and these are:
1. Percentage method
2. Total outlay method
3. Point method
4. Arc method

1. Percentage method : According to this method, elasticity is measured as

the ratio of percentage change in the quantity demanded to percentage
change in the price other factors remaining constant. It is the most common
method hello for messaging for measuring the price elasticity of demand.
This method was introduced by professor Alfred Marshall. This method is
also called proportionate method add mathematical method I’m flux
method and flux method.
the price elasticity of demand can, according to this approach, be
mathematically expressed as -
PED = % change in quantity demanded / % change in price, where

For example, when the price of a commodity was Rs 10 per unit, the market
demand for that commodity was 50 units a day. When the price of the product
dropped to Rs 8, demand increased to 60 units. The price elasticity of demand
can here be evaluated as -
PED = %change in quantity demanded / % change in price, where
 demand price elasticity is often a negative number since the quantity
requested and the product share price are inversely related. This
implies that the higher the price, the lower the demand, and the lower
the price, the greater the product demand.

 Total Outlay Method

Professor Alfred Marshall developed the total outlay method, also known as
the overall cost method of calculating price demand elasticity. according to
this approach, The price elasticity of demand can be calculated by comparing
the total expenditure on the commodity before and after the price
adjustment.

We can get one of three results when comparing the expenditure. They are
the :

 Request elasticity would be greater than the unity of (Ep > 1). If total
expenditure rises with a decrease in price and decreases with a rise in
price, the value of the PED is greater than 1. Here, price rises, and
overall spending or outlays shift in the opposite direction.
 on the X-axis, gross outlay or cost is calculated in the graph while the
price on the Y-axis is measured. The transfer from point A to point B
demonstrates elastic demand in the figure, as we can see that overall
spending has risen with price decreases.

 The elasticity of demand will be equal to unity (Ep = 1). If, in response
to a rise in the price of the commodity, the overall expenditure on the
commodity remains unchanged, the value of the PED would be equal
to 1, it is called unitary elastic.

As total expenditure has remained unchanged with the change in price,

the shift from point B to point C demonstrates unitary elastic demand.

 The elasticity of demand will be less than unity (Ep < 1) . The value of
PED would be less than 1 if total spending decreases with a decline in
price and rises with a rise in price. Here, commodity prices and overall
spending are going in the same direction.

as overall expenditure, as well as price, has decreased, the shift from

point C to point D indicates inelastic demand.

 Point / geometric method

Prof. Marshall devised a geometrical method for measuring
elasticity at a point on the demand curve.
In point elasticity, we measure elasticity at a given point on a
demand curve. According to this method, price elasticity is
measured on different points of a simple straight line demand
curve.

In a linear demand curve, the value of point price elasticity of

demand is different at different points on the demand curve. It
can take value from zero to infinity. The following graphical
presentation shows different elasticities along a linear demand
curve;

Different Elasticities along a linear demand curve

In the above figure five points L, M, N, P, and Q are taken on the given linear
demand curve. The elasticity of demand at each point can be identified with
the help of the above method. Suppose the N point is in the exact center of
the given demand curve. So, the elasticity of demand at point N is unitary. It
is because at the mid-point of the demand curve the lower segment and
upper segment of the demand curve are equal.
Thus,
 ep at point N= (Lower segment of the demand curve)/ (Upper segment
of the demand curve) = DN/NC=1.
 At any point to the right of the mid-point (for example point P) the
point elasticity of demand is less than unitary which means demand is
inelastic or less elastic. This is because to the right of the mid-point of
 the demand curve, the lower segment is shorter than the upper
segment.
 Any point left to the mid-point of the demand curve (for example at
point M) the point elasticity of demand is greater than unitary means
demand is more elastic.
 At the point where the demand curve meets Y-axis (for example point
L), the point elasticity is infinity. This is because the whole length of the
demand curve will be the lower segment and the value of the upper
segment is zero.
 At any point where the demand curve meets the X-axis (for example
point Q), the point elasticity is zero. This is because the whole length of
the demand curve is covered by the upper segment and the lower
segment is zero.

 Point Elasticity of demand and a non-linear demand curve

The nonlinear demand curve infers different slopes at different points
throughout the demand curve. If the demand curve is non-linear then the
price elasticity of demand at a point on it can be measured by drawing a
tangent line to that point and then apply the price elasticity formula;
ep at any point= (Lower segment of the demand curve)/ (Upper segment
of the demand curve)
The following figure shows the non-linear demand curve and method of
measurement of point price elasticity of demand at different points of the
demand curve.

In the figure, DDPoint Method

is the and Case of
non-linear Non-Linear
demand Demand
curve. Curveelasticity at point A on
Price
it can be computed by drawing a tangent line MN to point A. Then price
elasticity of demand at point A is;
 ep at point A= TN/AT*AT/OT= TN/OT, the elasticity is greater than one or the
demand is more elastic.
Similarly, point elasticity at point B can be computed by drawing a straight-
line JK tangent to point B on the demand curve DD. The elasticity can be
computed with the following formula;
ep at point B= SK/BS*BS/OS= SK/OS, the elasticity is less than one or the
demand is less elastic.

 Arc/Mid-Point Method of Measurement of Price Elasticity of

Demand
The point method of measurement of price elasticity of demand is not
accurate as we cannot get the information on very small changes in price and
quantity demanded in the market. Thus, in the case of a large change in
price, the point method is not suitable to measure the price elasticity. Here
the term ARC refers to the section or portion of a demand curve between
two points.

Thus the formula required under this method is:

Where P1 and Q1 are the original price and quantity, and P2, Q2 are the new one.

The following figure and subsequent explanation show the detail regarding
the measurement of price elasticity of demand under the arc method.

In figure DD is the demand curve and based on the change in price and quantity,
ep is calculated and which has the same value from A to B or from B to A because
we take the average values while calculating the coefficient of elasticity. Thus, under
such a method, the movement from A to B or movement from B to A gives the
same value of ep.
Thus, the point method of measurement of price elasticity of demand is used in the
case when the changes in price and quantity are small but we use the arc method
to measure the elasticity of demand when the change in price and quantity is
relatively large. When the elasticity has to measure over some range or arc along a
demand curve rather than at a particular point, the point elasticity does not provide
the true and correct magnitude of price elasticity of demand.
So, we have to use the arc method to measure the price elasticity of demand when
the change in price and quantity is larger. Arc method is more suitable to use
because of its technique. In the case of the non-linear demand curve, the use of the
arc method is more suitable. We have to keep in our mind that the arc elasticity
measure takes into account the midpoint of the chord that connects the two points
on the demand curve.

Q.3 Explain the law of variable proportions with the help of diagram.

Ans. This law exhibits the short-run production functions in which one
factor varies while the others are fixed. Also, when you obtain
extra output on applying an extra unit of the input, then this
output is either equal to or less than the output that you obtain
from the previous unit. The Law of Variable Proportions concerns
itself with the way the output changes when you increase the
number of units of a variable factor. Hence, it refers to the effect
of the changing factor-ratio on the output.
In other words, the law exhibits the relationship between the units
of a variable factor and the amount of output in the short-term.
This is assuming that all other factors are constant. This
relationship is also called returns to a variable factor.

The law states that keeping other factors constant, when you
increase the variable factor, then the total product initially
 increases at an increases rate, then increases at a diminishing rate,
and eventually starts declining.

Let’s look at an example to understand this better:

Let’s say that you have 10 acres of land and 1 unit of labour for
production. Therefore, the land-labour ratio is 10:1. Now, if you
keep the land constant but increase the units of labour to 2, the
land-labour ratio becomes 5:1.Therefore, as you can see, the law
analyses the effects of a change in the factor ratio on the amount
of out and hence called the Law of Variable Proportions.

 Law of Variable Proportions Explained

Let’s understand this law with the help of another example:

In this example, the land is the fixed factor and labour is the
variable factor. The table shows the different amounts of output
when you apply different units of labour to one acre of land which
needs fixing.
The following diagram explains the law of variable proportions. In
order to make a simple presentation, we draw a Total Physical Product
(TPP) curve and a Marginal Physical Product (MPP) curve as smooth
curves against the variable input (labour).

 Three Stages of the Law

The law has three stages as explained below:

1. Stage III – Now, the TPP starts declining, MPP decreases and
becomes negative. Therefore, it is called the stage of negative returns.
In this example, Stage III runs between seven to eight units of labour
(from the point M onwards).

 Reasons for increasing returns to a factor:- (Phase I)

 Reason for diminishing return to a factor:- (Phase II)

 Reasons for negative return to a factor:- (Phase III)

Q.3 What do you understand by law of return to scale,
explain its various stages with help of diagram.
Ans. Production is a very important activity because it transforms the
goods into such a form that it fulfills the needs of the consumer. All
the factors of production, in the long run, are variable. so, the scale of
production can be changed according to the changes in the quantity
of all factors of production.
When the output changes in the same proportion due to the changes
in the inputs of the production process, it is referred to as the law of
returns to scale. The law of returns to scale is only applied in the case
of the long run. Because in the long run production process, no factor
is fixed. here are increasing, decreasing, and constant returns to scale .
According to Watson, “Returns to Scale is related to the behaviour of total
output as all inputs are varied in same proportion and it is a long run concept.”

 The Types Of Returns To Scale

There are generally thee types of returns to scale . when all the factor inputs are
varied in the same proportions, then the scale of production may take three
 forms; viz., Increasing Returns to Scale, Constant Return to Scale, and
Diminishing Returns to Scale.
1. Increasing Returns to Scale:
In the first stage of Returns to Scale, the proportionate increase in total output is more
than the proportionate increase in inputs. In simple terms, if all the inputs increase by
100%, then the increase in output will be more than 100%.
Example:
Inputs (units) where K= Output (units) % increase in % increase in
capital and L= labour inputs outputs

1K+2L 100 - -

2K+4L 250 100% 150%

4K+8L 600 100% 140%

The main reason behind Increasing Returns to Scale is Economies of Large

Scale. Economies mean the benefits because of the large scale of production.
Economies of scale are of two types; viz., Internal Economies and External Economies.
 Internal Economies: Internal Economies means the benefits of large-scale
production available to an organisation within its own operation. For
example, Managerial Economies are achieved by dividing labour and
specialisation.
 External Economies: External Economies mean the benefits of large-scale
production shared by all the firms of an industry when the industry as a whole
expands. For example, better infrastructural facilities, better transportation,
etc.
2. Constant Return to Scale:
In the second stage of Returns to Scale, the proportionate increase in the total output is
equal to the proportionate increase in inputs. In simple terms, if all the inputs increase
by 100%, then the increase in output will also be 100%.

Inputs (units) where K= capital Output % increase in % increase in

and L= labour (units) inputs outputs

6K+12L 600 - -

8K+16L 1200 100% 100%

16K+32L 2400 100% 100%

Example:

o Once the firm has achieved the point of optimum capacity, it operates on
Constant Returns to Scale. Here the production of a Firm reaches a point, where
the resources of the economy are utilised optimally .After the point of optimum
capacity, the economies of production are counterbalanced by the diseconomies
of production.

3. Diminishing Returns to Scale:

In the third stage of Returns to Scale, the proportionate increase in the total output is
less than the proportionate increase in inputs. In simple terms, if all the inputs increase
by 100%, then the increase in output will be less than 100%.
Example:
Inputs (units) where K= capital and Output % increase in % increase in
L= labour (units) inputs outputs

16K+32L 2400 - -

32K+64L 4200 100% 75%

64K+128L 7350 100% 75%

The main
reason behind Diminishing Returns to Scale is Diseconomies of Large
Scale. Diseconomies of Scale mean that the firm has now become so large that it has
become difficult to manage its operations. Diseconomies of Scale are of two types; viz.,
Internal Diseconomies and External Diseconomies.
 Internal Diseconomies: Internal Diseconomies means the disadvantages of
the large-scale production that a firm has to suffer because of its own
operations. For example, Technological Diseconomies because of the heavy
cost of wear and tear.
 External Diseconomies: External Diseconomies mean the disadvantages of
large-scale production that all the firms of the industry have to suffer when
the industry as a whole expands. For example, stiff competition, etc.
  Assumptions Of The Law Of Returns To Scale

There are a few assumptions in the law of returns to scale which are stated below.

o There are only two variables used by the firm: labour and capital.
o Labour and capital are integrated with a fixed proportion.
o Prices do not fluctuate.
o The technology remains the same and does not change .

Q.4 Write a short note on expansion path.

Ans. Expansion Path in the Long Run:-

In the long run, the firm can change its old machines, equipment and plants, scale of
production, organization and management in order to expand its output. The firm’s
objective is the choice of optimal expansion path in order to minimize its costs or
maximize its profits. The expansion path is the locus of different points of firm’s
equilibrium when it changes its total outlay to expand output while relative factor prices
remain constant.

 Assumptions

(i) There are two factors of production, labour and capital, which are variable.

(ii) All units of labour and capital are homogeneous.

(iii) The price of labour (w) is constant.

(iv) The price of capital (r) is constant.

(v) The firm increases its total outlay in order to expand its output.

 Explanation

Given these assumptions, in order to maximize its profits or to have the

least cost combination, the firm combines labour and capital in such a way
that the ratio of their MP is equal to the ratio of their prices, i.e., MP L/MPK =
w/ r. This equality occurs at the point of tangency between an isocost line
and an isoquant curve.
This is explained in Figure 1, where С1L1 C2L2 and C3L3are the different
isocost lines. The line C2L2shows higher total outlay than the line C1L1 and
С3L3 still higher total outlay than the line C2L2. They are shown parallel to
each other thereby reflecting constant factor prices. There are three
isoquants 100, 200 and 300 representing successively higher levels of
output.

The firm is in equilibrium at point P where the isoquant 100 is tangent to its
corresponding isocost line С1L1 and similarly the other two isoquants 200
and 300 are tangent to isocost lines С2L2and C3L3 respectively at points Q
and R. Each point of tangency shows optimal combination of labour and
capital that produces an optimal output level. The line OS joining these
equilibrium points P, Q and R through the origin is the expansion path of
the firm. The firm expands its output along this line keeping factor prices as
constant.

The straight line expansion path through the origin, OS, implies a
homogeneous production function (or constant returns to scale). Such an
ex- pension path is called an isocline which is the locus of points о along
which MRTSLK = MPL/MPK = w/r. Thus OS is the optimal expansion path for
the firm in the long run.

But the choice of the expansion path depends on the ratio of factor prices.
If the ratio of factor prices increases, the isocost lines become flatter, as
shown in figure 2, and the optimal expansion path will be ОТ. If initially the
slope of the isocost lines is steep and the expansion path is OS, with the
increase in the ratio of factor prices the optimal expansion path of the firm
changes to ОТ. Both the expansion paths show homogeneous production
function.
In case the production function is non- homogeneous the optimal
expansion path will not be a straight line from the origin. Rather, it will be a
zigzag line OS, as shown in Figure 3. It is a curved isocline which is the
optimal expansion path of the firm because at the points of tangency L, M
and N, the slopes of the isocost lines (w/r) and isoquants (MRTSLK ) are
equal.

 Expansion Path in the Short Run:-

In the short run, the firm can increase only the variable factors and
not the fixed factors in order to increase its output, while relative
factor prices remain constant. Suppose capital is the fixed factor and
 labour is the variable factor, other assumptions remaining the same.
The firm cannot choose the optimal expansion path OS. It can ex-
pand its output only along the line С С’, as shown in Figure 4. But this
is not the optimal expansion path because points P, S and T are not
on the isocline.

Q.5 What is production function? Explain the various type of

production function.
Ans. Production:-
A producer or firm combines a variety of inputs, such as land, labour, capital,
entrepreneurship, and other inputs, such as raw materials and fuel, to generate the
products and services that customers want. Production is a process that business uses to
convert inputs into outputs. Production involves a series of activities that convert the
inputs into outputs that people can use for the fulfilment of their needs. Production is
basically the transformation of inputs into output. Input is anything that is utilised in the
creation of a commodity and Output is something that gets produced at the end of the
production process. The relationship between inputs and outputs is defined using
the Production Function.

 Fixed and Variable Factors

Fixed factors are those production inputs whose quantity can not be changed with the
change in output. For instance, it is not possible to change a large amount of land,
equipment, etc., to produce more output.

Contrarily, variable production factors are those whose amount is easily influenced by
changes in output level. For instance, we may quickly alter the labour force to boost or
lower productivity.
  Production Function:-
Production Function is the relationship between physical inputs (land, labour, capital,
etc.) and physical outputs (quantity produced). In another way, a production function is
a mathematical relationship involving inputs and output that enables the maximum
output to be created with a specific set of input factors and technological capabilities.
In the words of Watson, “Production Function is the relationship between a firm’s
production (output) and the material factors of production (input).”
Qx = f (L, K)

Suppose there are two-factor inputs: labour (L) and capital (K). Qx is the quantity of
output of commodity x, f is the function, L is the unit of labour and k is the unit capital.
According to this, the amount of output depends on the labour and capital inputs
utilised in manufacturing.

Here, there are two things to think about. First, the production function must be taken
into account in relation to a specific time frame, such as a short term and a long period.
Second, the state of technology affects how well manufacturing functions. It's vital to
remember that a production function merely depicts the physical relationship and has no
financial value.

 Assumptions of Production Function

 Both inputs and outputs are divisible.
 There are only two factors of production, i.e., land (Variable element) and
capital (Fixed element).
 Factors of production are imperfect substitutes.
 Technology is constant.
 Features of Production Function

1. Complementary: A producer will have to combine the inputs to produce

outputs. Outputs can not get generated without the use of inputs.
2. Specificity: For any given output, the combination of inputs that may be
used is clearly defined. What type of factors are needed for the production of
a particular product is clearly mentioned before the actual production gets
started.
3. Production Period: The period of the production process is clearly
explained to the production unit. Each stage of production is given some
specific time. Production generally gets completed over a long period of
time.
 Short and long run production function
Production function on the basis of the time period can be divided into two
categories: Short Run Production Function and Long Run Production
Function. In these production functions, the combination and behaviour of
variable factors and fixed factors are different.
 Short Run Production Function : Short Run is a period of time where output
can only be changed by changing the level of variable inputs. In the short run,
some factors are variable and some are fixed. Fixed factors remain constant in
the short run like land, capital, plant, machinery, etc. Production can be raised by
only increasing the level of variable inputs like labour. Therefore, the situation
where the output is increased by only increasing the variable factors of input and
keeping the fixed factors constant is termed as Short Run Production Function.
This relationship is explained by the ‘Law of Variable Proportions.’
 Long Run Production Function: Long Run is a span of time where the output
can be increased by increasing all the factors of production whether it is fixed
(land, capital, plant, machinery, etc.) or variable (labour). Long run is enough
time to alter all the factors of production. All factors are said to be variable in the
long run. Therefore, the situation where the output is increased by increasing all
the inputs simultaneously and in the same proportion is termed Long Run
Production Function. This relationship is explained by the ‘Law of Returns to
Scale.’

 Types of production function:-

Depending on how much one input can be substituted for another, there are
many types of production functions.
 Cobb Douglas Production Function
 Charles W. Cobb and Paul H. Douglas, two American economists, developed the
Cobb Douglas production function to examine the relationship between input and
output. The Cobb-Douglas production function is the kind of production function
that allows for some substitution of one input by other sources. For instance, capital
and labour can be substituted for one another, but only to a certain extent. This is
how the Cobb Douglas production function can be represented mathematically:

Q = AK^a L^b ( here, A is a positive constant, and a and b are positive fractions )

 Leontief Production Function

The W. Wassily Leontif-developed Leontief production function uses a set ratio of

inputs with no sustainability between them. It means that the Leontief production
function exists if the input-output ratio is free of the production scale. It presumes that
the production factors are strictly complementary. The fixed proportion production
function is another name for the Leontief production function. The following is an
expression for this production function:

q = min (z1/a, z2/b)

 CES Production Function

Constant Elasticity Substitution is referred to as CES. The output is constantly changing

as a result of changes in the production's input, as seen by the CES production function.
It is expressed as :

Q = A [aK^–β (1–a) L^–β] ^–1/β

 Concept of Product:- (optional)

Product or output refers to the volume of the goods that the company produces using
inputs during a specified period of time. The concept of product can be looked at from
three different angles: Total Product, Marginal Product, and Average Product.
1. Total Product: Total Product (TP) refers to the total quantity of goods that the firm
produced during a given course of time with the given number of inputs. Total Product
is also known as Total Physical Product (TPP) or Total Output or Total Return. For
example, if 6 labours produce 10 kg of wheat, then the total product is 60 kg. A
company can increase TP in the short term by focusing primarily on the variable
components. But over time, both fixed and variable elements can be increased to raise
TP.
2. Average Product: Average Product refers to output per unit of a variable input. AP
is calculated by dividing TP by units of the variable factor. For example, if the total
product is 60 kg of wheat produced by 6 labours (variable inputs), then the average
product will be 60/6, i.e., 10 kg.

Average Product =

3. Marginal Product: Marginal Product refers to the addition to the total product when
one more unit of a variable factor is employed. It calculates the extra output per
additional unit of input while keeping all other inputs constant. Other names of
Marginal Product are Marginal Physical Product (MPP) or Marginal Return.
MPn = TPn – TPn-1
Here,
MPn = Marginal product of nth unit of the variable factor,
TPn = Total product of n units of the variable factor, and
TPn-1 = Total product of (n-1) units of the variable factor

 Conclusion:
In this blog post, we learned that the Production Function is the actual connection
between inputs and outputs and that production is the process that a firm utilises to
transform inputs into outputs. Additionally, we studied the significance of the short run
and long run production functions. How much one input can be replaced by another
affects the three different types of production functions (Cobb Douglas production
function, Leontief production function, and CES production function). Additionally, we
examined the sustainability, complementarity, distinctiveness, and production period,
which are the four fundamental characteristics of the production function.

Q.5 What are the main features of perfect competition? Also

explain the price determination under perfect
competition.
Ans. What Is Perfect Competition?

 perfect competition is an ideal type of market structure where all producers and
consumers have full and symmetric information and no transaction costs. Under
perfect competition, there are many buyers and sellers, and prices reflect supply
and demand. Companies earn just enough profit to stay in business and no more.
 If they were to earn excess profits, other companies would enter the market and
drive profits down. Perfect competition is theoretically the opposite of a
monopolistic market. The opposite of perfect competition is imperfect
competition, which exists when a market violates the abstract tenets of
neoclassical pure or perfect competition.
 Features / Characteristics of Perfect Competition:-
The main features of perfect competition are as follows:
1. Many Buyers and Sellers – There will always be a huge number of buyers and
sellers in this form of marketplace. The advantage of having a large number of
small-sized producers is that they cannot combine to influence the market price.
If the quantity offered by an individual seller is very small compared to the total
market produce, they cannot influence the market price independently.
Similarly, if there are many buyers, then an individual will not have the power to
influence the price by altering demand for a product. The individual demand will
not be large enough to change the price.
2. Homogeneous Market – The product or service produced by the buyers in a
perfectly competitive market should be homogenous in all respects. There should
be no differentiation between them in terms of quantity, size, taste, etc., so that
the products are perfect substitutes for each other. If a seller tries to charge a
higher price for products that are so similar, they will lose their customers
immediately.
3. Free Entry and Exit – Another condition of a perfectly competitive market is
that no artificial restrictions prevent a firm’s entry, or compel an existing firm to
stay put when they want to leave. Their decision to enter, stay or leave the
market depends purely on economic factors.
4. Perfect Knowledge – The buyers and sellers have perfect knowledge about the
market conditions. The buyers are aware of the details of the product sold as well
as its price. At the same time, the sellers know about the potential sales of their
products at different price points. Since the buyers are already informed about
the product, there is no need for advertising or sales promotion. So firms don’t
have to invest a single penny in these activities. It also helps sellers save on
advertising or other marketing activities, which keeps the price of their products
low.
5. Transport Cost – In the perfectly competitive market, the costs for transporting
goods, services or factors of production from one place to another is either zero
or constant for all sellers. the transport cost is uniform for all of them.
6. Absence of Artificial Restrictions – There is no interference from the
government or any other regulatory body to hinder the smooth functioning of the
perfect competition. There are no controls or restrictions over the supply or
 pricing and the price can change solely based on the demand and supply
conditions.
7. Uniform Price – There is a single uniform price for all products and services in
a perfectly competitive market. The forces of demand and supply determine it.

 Price Deteremination Under Perfect Competition

(PENDING…)

Q. What do you understand by Monopoly?

Ans. Monopoly is the market situation in which there are large number of buyers and
only one seller of the product. If you break up the word “Monopoly”, you get
“Mono” which means single or solo, and “Poly” which means “seller”. Thus a
monopoly market is the one where a firm is the sole seller of a product
without any close substitutes. In a monopoly market structure, a single firm
or a group of firms can combine to gain control over the supply of any
product.

 What is a Monopoly Market?

A monopoly market is a form of market where the whole supply of a product
is controlled by a single seller. There are three essential conditions to be met
to categorize a market as a monopoly market.

1. There is a Single Producer - The product must have a single producer

or seller. That seller could be either an individual, a joint-stock
company, or a firm of partners. This condition has to be met to
eliminate any competition.
2. There are No Close Substitutes - There will be a competition if other
firms are selling similar kinds of products. Hence in a monopoly
market, there must be no close substitute for the product.
 3. Restrictions on the Entry of any New Firm - There needs to be a
strict barrier for new firms to enter the market or produce similar
products.

The above 3 conditions give a monopoly market the power to influence the
price of certain products. This is the true essence of a monopoly market.

 Features of a Monopoly:-
Following are the main features of monopoly:-
1. Single seller and several buyers
The primary feature of a monopoly is a single seller and several buyers. Also, in
a monopoly, there is no difference between the firm and the industry. This is
because there is only one producer and/or seller. Therefore, the firm’s demand
curve is the industry’s demand curve. Since there are several buyers, an
individual buyer cannot affect the price in a monopoly market.
2. No close substitute
In a monopoly, the product that the monopolist produces has no close substitute.
If a close substitute exists, then the monopoly cannot exist.
Remember, a monopoly can only exist when the cross-elasticity of the product
that the monopolist produces is zero. Therefore, the monopolist can determine
the price of his own choice and refuse to sell below the determined price.
3. Restriction on the entry of new firms:
Even if the monopolist firm is earning super-normal profits, new firms face many
hurdles in trying to enter the industry. There are many reasons for this like legal
barriers, technology, or a naturally occurring substance which others cannot find.
Sometimes, the monopolist works in a small market making it economically
challenging for new firms to enter.
4. Price maker:
A monopolist is the price maker. A price maker is one who has got control over
the supply of the product., in case, the monopolist increase the supply of
commodity, the price of it may fall. If he reduses the supply, the price of it may
rise.
5. Price discrimination:
A monopolist maybe able to charge different prices for the same product from
different customers.

 Causes and sources of Monopoly:-

 1. Control over raw material: a firm maybe a sole owner of a natural resource. By
controlling the key raw material or natural resoures a firm can monopolies the
industry and keep new competitors out.
2. Patent : patent is an exclusive right granted by the govt. to use some productive
techniques or to produce certain products.
3. Government policy: government may grant a license to a firm to have the
exclusive privilege to produce a given good or service in a particular area . no
firm can enter into that area without a license provided by the government.
4. Historical or entry lag: a former enjoy monopoly because of early start in the
field and no one else has the necessary know how the first farm to market some
product will usually enjoy a monopoly position.
5. Limit pricing policy: it is the policy which aim at the prevention of new entry
this can be achieved by setting a price just below the minimum long run average
cost of the possible potential entrant.
6. Capital size: monopoly may also be cause due to the huge amount of capital
required to establish a particular productive unit

PRICE AND OUTPUT DETERMINATION UNDER

MONOPOLY (PENDING) (optional)

Q. Explain price discrimination under Monopoly.

Ans. In monopoly there is a single seller of a product called monopolist. The
monopolist has control over pricing, demand, supply decisions. thus, sets space in
a way so that maximum profit can be earned.
 The monopolist often charges different prices from different consumers for
the same product this practice of changing different prices for identical
product is called price discrimination.
 According to Robinson “price discrimination is charging different prices
for the same product or same prices for the differentiated product.”
 Types of price discrimination:-
1. Personal Price Discrimination: When a monopolist charges different
prices from different Customers for the same product, then it is
called personal price discrimination. Personal price discrimination
becomes possible because of the ignorance of the consumers.
 2. Geographical Price Discrimination: When a monopolist charges
different prices in different areas for the same product, In a market
where demand is elastic, he charges low prices and where demand is
inelastic he charges high price.
3. Price Discrimination According to use: When a monopolist
charges different prices for the different uses of a product, then it is
called price discrimination according to use, i.e., electricity charge
per unit for domestic use different from commercial use.
4. Price Discrimination According to time: When a monopolist sell
the same product at different price at different time, i.e., call charges
were low of night calls and early morning calls and high rate for day
time calls.
 Degrees of price discrimination:-
1. First degree price discrimination: It refers to a price discrimination in
which a monopolist charges the maximum price that each buyer is
willing to pay. This is also know as perfect price discrimination as it
involves maximum exploitation of consumers, in this, consumers fail to
enjoy any consumer surplus, first degree is practiced by lawyers and
doctors.
2. Second degree of price discrimination: it refers to a price discrimination
in which buyers are divided into different groups and different prices
are charged from these groups depending upon what they are willing to
pay railways and airlines practice this type of price discrimination for
example dividing bias into different groups.
3. Third-degree price discrimination : is a pricing strategy that involves
charging different prices for the same product to different consumer
groups such as students, military personnel, or older adults. It's also
known as group price discrimination. You'll commonly see this type of
pricing strategy in movie theater ticket sales, admission prices to
amusement parks, and restaurant offers. The travel and tourism industry
also uses third-degree price discrimination for those who book on a last-
minute basis. Consumer groups that may otherwise not be able or
willing to purchase a product due to their lower income can be captured
by this pricing strategy, thus increasing company profits.
 Conditions of price discrimination:-
 Certain conditions affect price discrimination. These factors have a
significant impact on price discrimination. A few of the critical conditions
are discussed below -

1. Existence of Monopoly: Price discrimination is possible only under the

condition of monopoly that is why it is also called discriminating
monopoly.
2. Market power: A firm can only impact price discrimination when it has
some market power. This market power helps to set a higher price than the
cost of production. This business gets market power via a strong brand
image and patent protection.
3. Difference in the Elasticity of Demand : Monopolist will fix higher price
per unit in the market where demand is inelastic and lower piece per unit in
the market where demand is elastic.
4. Production Of Commodity To Oder: get a commodity made to order,
possible for the producer or the seller no practice price discrimination.
5. Legal Sanction: Price discrimination can be legally sanctioned in some
cases. For example, Electricity Board changes different rates of electricity
for domestic use and industrial use.
6. Product Differentiation: A monopolist by changing the packing, name,
label, etc of the charge different prices, although the good is of the same
quality.

 Positive effects of price discrimination:-

There are a lot of advantages of price discrimination to the seller. Price
discrimination gives them a higher profit and proper utilization of
resources. The fee of Other advantages of price discrimination are
discussed below -
1. Increased profits: The profit margin automatically increases when
businesses set higher prices on goods and services. This helps the firm to
maximize its revenue.
2. Increased client surplus : Price discrimination allows clients to pay as per
their readiness. The client is willing to pay lower prices for purchasing
goods and services at a lower rate. This results in more clients being able to
afford a good and service by growing overall sales.
3. Efficient allocation of resources : Price discrimination makes the proper
utilization of resources. This allows the clients who value the good the
 most to purchase it. This leads to the proper utilization of aid and a more
efficient economy.
4. Increased innovation : Price discrimination allows firms to recharge higher
prices for new and enhanced goods. This results in research and
development investment and more innovative goods and services.
 Disadvantage Price Discrimination
Though, in certain cases, price discrimination proves to be advantageous for the
sellers, it still suffers from various drawbacks. Some of the key drawbacks of
price discrimination are examined below -

1. Reduced client welfare: Due to price discrimination, some clients pay high
prices while others pay a lower price. This can lead to some clients being
priced out of the market, which reduces client choice.
2. Increased administrative costs: Price discrimination increases the
administrative cost for the business. Activities like compiling client data
and developing price strategies might cost extra to the business. Covering
these costs is generally high in the case of small firms.
3. Reduced competition: Price discrimination reduces the competition in the
market. This allows the larger business with more resources to charge a
higher price. Large businesses keep the small competitors away by
charging a high price. This leads to less creation and less variety of choices
for the clients.
4. Potential for discrimination: Price discrimination can also lead to
discrimination based on race, gender, social, or economic status.

Q. MONOPOLY POWER (pending..)

Q. Explain The Marginal Productivity Theory of Distribution

(With Diagram)
Ans. The marginal productivity theory of distribution, as developed by J. B.
Clark, at the end of the 19th century, provides a general explanation of how
the price (of the earnings) of a factor of production is determined. In other
 words, it aims to define how much should a worker be paid according to
their capacity to produce. In other words, it suggests some broad principles
regarding the distribution of the national income among the four factors of
production.
According to Mark Blang, "The marginal productivity theory contends that
in equilibrium each productive agent will be rewarded in accordance with
its marginal productivity.
according to this theory, the price (or the earnings) of a factor tends to
equal the value of its marginal product. Thus, rent is equal to the value of
the marginal product (VMP) of land; wages are equal to the VMP of labour
and so on. The neo-classical economists have applied the same principle of
profit maximisation (MC = MR) to determine the factor price.
 Assumptions of the Theory:
The marginal productivity theory of distribution is based on the following
seven assumptions:
1. Perfect competition in both product and factor markets: Firstly, the theory
assumes the perfect competition in both product and factor markets. It
means that both the price of the product and the price of the factor (say,
labour) remains unchanged.
2. Operation of the law of diminishing returns : Secondly, the theory assumes
that the marginal product of a factor would diminish as additional units of
the factor are employed while keeping other factors constant.
3. Homogeneity and divisibility of the factor : Thirdly, all the units of a factor
are assumed to be divisible and homogeneous. It means that a factor can be
divided into small units and each unit of it will be of the same kind and of
the same quality.
4. Operation of the law of substitution : the theory assumes the possibility of
the substitution of different factors. It means that the factors like labour,
capital and others can be freely and easily substituted for one another. For
example, land can be substituted by labour and labour by capital.
5. Profit maximisation: the employer is assumed to employ the different
factors in such a way and in such a proportion that he gets the maximum
profits. This can be achieved by employing each factor up to that level at
which the price of each is equal to the value of its marginal product.
6. Full employment of factors : he theory assumes full employment for factors.
Otherwise each factor cannot be paid in accordance with its marginal
 product. If some units of a particular factor remain unemployed, they
would be then willing to accept the employment at a price less than the
value of their marginal product.
7. Exhaustion of the total product : Finally, the theory assumes that the
payment to each factor according to its marginal productivity completely
exhausts the total product, leaving neither a surplus nor a deficit at the end.
 Some Key Concepts:
The theory is also based on key certain concepts.
These are the following:
1. MPP: The first is marginal physical product of a factor. The marginal
physical product (MPP) of a factor, say, of labour, is the increase in the
total product of the firm as additional workers are employed by it.
2. VMP: The second concept is value of marginal product. If we multiply the
MPP of a factor by the price of the product, we would get the value of the
marginal product (VMP) of that factor.
3. MRP: The third concept is marginal revenue product (MRP). Under perfect
competition, the VMP of the factor is equal to its marginal revenue product
(MRP), which is the addition to the total revenue when more and more
units of a factor are added to the fixed amount of other factors, or MRP =
MPP x MR under perfect competition.

 Explanation of the Theory:

o From the viewpoint of the industry (optional)

From the viewpoint of an industry, the marginal productivity theory studies
how the price of a factor is determined. Under perfect competition price of
a factor is determined at that level where the market demand for the factor
is equal to it supply, this theory assumes the state of full employment in the
system and supply of factors remain same. Therefore factor price is
determined by its demand alone.
1. Factor Price Determination : -
 Price of a factor will be determined at a point where industry's
demand curve for the factor intersects its supply curve. Supply
of the factor is assumed to be fixed from industry's point of
view.

Supply curve is parallel to y-axis which indicates that under

full employment condition, OQ L supply of factor is fixed.

2. From the viewpoint of the industry:- (main)

The theory states that the firm employs each factor up to that number
where its price or factor cost is equal to marginal revenue product or
VMP, i.e., MFC = MRP or VMP
Thus, wages tend to be equal to the VMP of labour; interest is equal
to VMP of capital and so on. By equating VMP of each factor with
its cost a profit- seeking firm maximises its total profits.
1. Let us illustrate the theory with reference to the determination
of the price of labour, i.e., wages:
MRP or VMP of Factor price or
Units of factor Price of product
MPP labour (MPP x marginal cost
(Labour) (AR = MR)
MR) (wages)
1 10 2 10x2= 20 8
2 8 2 16 8
3 6 2 12 8
4 4 2 8 8
5 2 2 4 8
Let us suppose that the price of the product is Rs. 2 (constant) and
the wages per unit of labour are Rs. 8 (constant). As the number of
factors other than labour remain unchanged, wages represent the
marginal cost (MC).
 Table shows that at 2 or 3 labourers, the VMP or MRP of labour is
greater than wages; so the firm can earn more profits by employing
an additional labour. But at 5 labourers, the VMP or MRP of labour
is less than wages, so it would reduce the number of labourers. But
when it employs 4 labourers, the wage rate (Rs. 8) becomes equal to
the VMP or MRP of labour (also Rs. 8). Here the firm gets the
maximum profits because its marginal cost of labour is equal to its
marginal revenue (VMP or MRP, Rs. 8).
Thus, under the assumption of perfect competition a firm employs a
factor up to that number at which the price of the factor is just equal
to the value of the marginal product (=MRP of the factor).
The theory may now be illustrated diagrammatically. The theory may now be
illustrated diagrammatically. Here WW is the wage line indicating the constant
rate of wages at each level of employment (AW = MW. Here AW is average
wage and MW is marginal wage). The VMP line shows the value of marginal
product curve of labour, and it goes downwards from left to right indicating
diminishing MPP of labour. the firm employs OL number of labourers, because
by doing so it equates the MRP of labour with the wage ratio, and makes
optimum purchase of labour.

2. Employment of factor by a firm:-

 Critisim:-
1. Unrealistic Assumptions:-_
This theory has a very little practical significance due to unrealistic
assumptions like perfect competition, perfect mobility, full employment.
2. Heterogeneous Factors :
The theory assumes that all the unis of a given factor are homogeneous,
which is wrong. In reality, different unit of a given factor are
heterogeneous.
3. Indivisible Factors: -
assumption of the theory that factors can be divided into small parts is
also far from truth.
4. Difficulties in Measurement of Marginal Productivity: -
It is not always possible to measure marginal productivity due to several
reasons.
5. Lop-Sided : -
This theory takes into consideration only the demand side and assumes
supply to be constant.
6. Long-term Stationary Economy: -
This theory presumes long-term stationary economy and the condition of
perfectly competition equilibrium in the economy in the long run. Under
this, price of factors will be equal to their average productivity and
marginal productivity which Is impossible in real would (dynamic)
conditions.
7. Cause & Effect: -
According to this theory, price of each factor is influenced by its marginal
productivity. Hence MP is the cause and factor pricing is the effect. But
 according to prof. Webls, factor price also affects MP. By paying higher
price to a factor, its efficiency can be enhanced.

Q. Explain The liquidity preference theory/ keyens theory of

interest with the help
Ans. Liquidity preference theory argues that people prefer to keep assets in a
liquid form, such as cash, over less liquid assets like bonds, stocks, or real estate.
Liquidity preference theory describes the supply and demand for money as
measured through liquidity.
John Maynard Keynes mentioned the concept in his book The General Theory of
Employment, Interest, and Money (1936) concerning the connection between
interest rates and the supply and demand for money.
However, there is a tradeoff between holding cash, which offers liquidity but no
returns, versus bonds, which provide interest or returns but are less liquid. The
interest rate is, effectively, the reward investors demand to part with liquidity and
hold less liquid assets like bonds.
Liquidity preference theory says that interest rates adjust to balance the desire to
hold cash against less liquid assets. The more people prefer liquidity, the higher
interest rates must rise to make them willing to hold bonds. Thus, the theory
views interest rates as a payment for parting with liquidity.
 How Does Liquidity Preference Theory Work?
Liquidity preference theory, developed by John Maynard Keynes, aims to
explain how interest rates are determined. The key premise is that people
naturally prefer holding assets in liquid form—that is, in a manner that it
can be quickly converted into cash at little cost. The most liquid asset is
money.
According to the theory, interest rates provide an incentive (something that
encourages a person to do something) for people to overcome their
liquidity preference and hold less liquid assets like bonds. Bonds provide
interest income but are less liquid than cash since they cannot be
immediately converted to money.
 For this reason, the theory holds that interest rates are determined by the
supply and demand for money, which depends in part on this preference.
When liquidity preference is high, people want to hold more cash,
decreasing the money supply and reducing bond prices. To match this
preference, interest rates have to rise as an incentive for giving up this
liquidity. Conversely, a lower liquidity preference means people are willing
to hold more bonds, increasing the money supply and lowering interest
rates.

 Three Motives of Liquidity Preference

According to J.M. Keynes, there are three motives of demand for
money or liquidity preference which are discussed as under: -
o Transactions motive:
People need money to handle their daily transaction. It is because
there is time lag between the expenditure and income. Income is
received after a month or a fortnight whereas expenditure is
incurred by the individual, households or firms almost every day. As
such each individual and firm would like to hold a part of their
income in cash for meeting their routine transaction of the day. Transaction
demand for money depends upon: -
(a) Size of income
(b) Periodicity of income received
(c) Mode of expenditure
However by and large demand for transaction motive is taken as the
function of income, i.e.,
LT = f(Y)

o Precautionary motive: The desire of an individual or firm to hold

money to encounter certain emergent situations in future like
sickness, unemployment, accident losses, etc., is known as
 precautionary demand for money. The amount of cash held for
precautionary motive is also a direct function of the level of income
and independent of the rate of interest.
LP = f(Y)

o Speculative Motive (Ls): - It refers to demand for cash balances

for the purpose of investment money market, implying the purchase
of bonds or related financial assets. Keynes advocated that if people
have extra cash balance meeting the transactions and precaution they
tend to use it for purchasing bond which offer an assured returns.
Speculative demand for money is a function of rate of interest.
When people expect rate of interest to increase in future, they will be
reluctant to part with their liquidity at present. On the other hand, if
rate interest is expected to come down is the -future, people would
be willing to convert their liquidity into bonds. Thus, Is varies
inversely of 2 with the rate of interest.

Ls = f(ROI)

Analysing the inverse relationship between the rate of interest and

speculative demand for money J. M. Keynes offers a new concept of
the "Liquidity Trap?
There is an inverse relationship
between rate of interest and
speculative demand for money.

Liquidity trap shows a situation of absolute liquidity preference

"when all speculative (ROI) balances are held as cash and not a
 rupee or a dollar is converted into interest bearing Instruments like
bonds.

 Total demand for money:-

Sum Total demand for money is the of money demanded for
transactions, precautionary and speculative purpose.
Md = LT + Lp + Ls = f (Y, ROI)

 Equilibrium rate of interest:-

Money market is said to be in equilibrium when demand for money is
equal to supply of money. Total demand for money is an inverse
function of the rate of interest. Supply of money is exogenously
determined by the monetary authority, hence, taken as constant at any
point of time. Interest rate determination through Md and Ms. functions
is known as Liquidity Preference theory.

 Change in Equilibrium:-
o Change in demand-
 o Change in Supply-

 Criticism:-

1. Indeterminate : - Classical theory of interest was criticised by Keynes as

indeterminate, the same can be said about his theory as well- According to
this theory, rate of interest is determined by Demand for money and Supply
of money. But DM = f (ROI, Y. DM cannot be known unless rate of
interest is known.
2. More Emphasis On Monetary Factors : - nation of Keynes has ignored the
effects of real factors on the determination of rate of interest. He has laid
exclusive emphasis on monetary factors and set aside real factors as
productivity, time preference, etc. According to many economists,
coordination of real and -monetary phenomenon is a must.
3. Savings Eschewed : - Keynesian analysis eschews the significance of
savings in interest rate determination. Without saving, the question of
parting with liquidity does not arise.
4. Only A Short Period Analysis : - This theory explains the rate of interest in
short period alone and ignores rate of interest in long run.
5. Inconsistent : - According to keynes, when SM is less, rate of interest rises
and vice-versa. But during depression although Ms is low, yet the rate of
interest is low. On the other hand, during boom, Ms is more, Still rate of
interest is high. Hence, Keynes theory becomes inconsistent.
6. Self contradictory:- according to Keynes interest is the reward for parting
with liquidity. But if a person keeps his surplus wealth in the form of bank
deposits or short period treasury bills then he gets interest and also enjoy
liquidity.
7. Inadequate to explain the variation in the rate of interest:- the theory fails
to explain variation in the rate of interest at a given time because at a given
time liquidity preference is uniform. A person will lend his funds at
different rates of interest for duration of time although is liquidity
preference under all condition remains uniform. This theory therefore does
not give any importance who the effect of time element on rate of interest.
8. Liquidity is not related to three motives only:- keynes’ view that liquidity
is related to only three motives that is LT, LP and LS is also not correct.
Liquidity can arise for other motives also that is convenience motive,
business expansion motive, etc.
9. Unrealistic assumptions :- Keynes theory is based on unrealistic
assumption that people can hold real wealth either in cash form or in
bonds. But according to Tobin, these days short term debentures enable
people to enjoy the advantage of liquidity as well as interest.
10.Criticism of liquidity trap:- according to Tobin in real life, the rate of
interest cannot fall so low that people become keen to hold all their wealth
in cash.

Q. Critically examine the Ricardian theory of rent.

Ans. David Ricardo, an English classical economist, first developed a
theory in 1817 to explain the origin and nature of economic rent. Ricardo
defined rent as, “that portion of the produce of the earth which is paid to
 the landlord for the use of the original and indestructible powers of the
soil.”
 Assumptions:-
The Ricardian theory of rent is based on the following assumptions:
1. Rent of land arises due to the differences in the fertility or situation of the
different plots of land. It arises owing to the original and indestructible
powers of the soil.
2. Ricardo assumes the operation of the law of diminishing marginal returns
in the case of cultivation of land. As the different plots of land differ in
fertility, the produce from the inferior plots of land diminishes though the
total cost of production in each plot of land is the same.
3. In the Ricardian theory it is assumed that land, being a gift of nature, has
no supply price and no cost of production. So rent is not a part of cost, and
being so it does not and cannot enter into cost and price. This means that
from society’s point of view the entire return from land is a surplus
earning.
4. Supply of land is fixed.
5. Land has only one use that is cultivation.
6. Perfect competition in product market.
7. Law of diminishing returns operates in the agriculture.
8. Demand for agriculture product increase with the increase in population.
9. Cost of agriculture produce depends on the amount of labour spent on it.
 Determination of rent:-
According to Ricardo, rent can be determined in three forms as:
1. Extensive cultivation
2. Intensive cultivation

1. Rent In Extensive Cultivation : - Extensive cultivation refers to the

cultivation in which more land is used to increase production.
 Rent = AR – AC
or
Rent = price – AC
2. Rent In intensive Cultivation:- It refers to that cultivation wherein to
increase production more and more unite of labour and capital are employed
on a given piece of land. Under intensive cultivation, additional units of
labour and capital lead to increase in production at diminishing rate due to the
application of law of diminishing returns.
 If due to any reason MRP Curve shifts upward to MRP 1, new equilibrium
point will be E₁.
Total Output = AOQeE₁
Total Cast Rent = WOQeE₁
Rent = AWE₁

 Criticism :
(i) Fertility of soil is neither original nor destructible.
(ii) Fertile land might not be used for the cultivation first of all.
(iii) Marginal or no-rent land may exist not
(iv) Rent is not due to fertility but due to Scarcity.
(v) Rent is not included in the price of a product is also wrong.
(vi) Rent is not paid only for land.
(vii) Difficulty in measuring productivity of land before fixing rent.
(viii) Every land has some fertility.
(ix) Unrealistic assumption of perfect competition.
(x) land have many alternative uses.

Q. Explain the collective bargaining theory of wages.

Ans. Collective bargaining is the process in which working people, through their
unions, negotiate contracts with their employers to determine their terms of
employment, including pay, benefits, hours, leave, job health and safety policies,
ways to balance work and family, and more. Collective bargaining is a way to
solve workplace problems. It is also the best means for raising wages. Indeed,
through collective bargaining, working people in unions have higher wages,
better benefits and safer workplaces.
The goal is to come up with a collective bargaining agreement through a written
contract. According to the International Labour Organization, collective
bargaining is a fundamental right for all employees.
According to Dale Yoder, "Collective bargaining is the term used to describe a
situation in which the essential conditions of employment are determined by
bargaining process undertaken by representatives of a group of workers on the
one hand and of one or more employers on the other."
 Stages of collective bargaining:-
The goal of group bargaining is to reach an agreement that satisfies both
the employer and the union. When a group of employees wants to negotiate
with an employer, they usually go through a multistep process that includes
the following phases:
1. Preparation:-
during the first stage, a group of employees meets several times to decide
what they want to negotiate. In many instances, this can refer to long-term
issues that the union has been fighting for, like improvement in workplace
diversity and inclusion. During this stage, it's also common for the
employer to designate specialists to help them review documentation in
preparation for negotiating
with the union.
2. Establishing representatives:-
As employees are preparing for negotiations, they engage in research and
select one person to represent them in meetings with the employer.
Depending on what they want to accomplish, they may do this by joining
an already existing union or creating a new one. Both options have their
benefits.
3. propose:-
The opening stage begins when the union presents their proposal to the
employer. If the changes they demand are contractual, the employer is
likely to request some time to process the proposal and consult with the
legal, human resources and even accounting departments. During this
phase, it's critical to determine the importance of the issues and clarify each
party's position.
4. Bargain:-
During trading, the employer openly reacts to the proposal. Depending on
the situation and what's in the proposal, the employer can accept it
 immediately, reject it or propose additional changes that work better for the
organisation based on its current business model and valid contracts. This
stage is often the longest, as negotiations can go back and forth until both
sides reach a consensus.
5. Agreement:-
Once both parties agree on what they've decided, a labour relations
specialist begins preparing a draft of the agreement. When the final
proposal is complete, both sides once again review it to confirm their
demands. It's necessary to document this step formally, for example, by
collecting handwritten signatures from representatives of both the
organization and the union.
 Types of collective bargaining:-
There are different approaches to bargaining. Some of them include:
1. Conjunctive bargaining: This type of bargaining happens when both the
employer and the union want to gain from the other party's loss. It usually
refers to negotiating salaries and other employee benefits.
2. Co-operative bargaining: In this type of bargaining, both parties want to
reach a solution that can benefit both parties simultaneously. both parties
realize the importance of surviving in difficult times (like recession) Co-
operative bargaining is common in disputes over technology, equipment or
work terms.
3. Productivity bargaining: Productivity bargaining is when an employer
agrees to offer employees additional bonuses or improve their work
conditions in hopes that this can increase employee productivity.
Essentially, the employer's main concern is the organisation's success.
4. Composite bargaining: Composite bargaining refers to a situation in which
employees decide to bargain because they're concerned about their working
conditions or policies. Their main goal is to create a safer and healthier
workplace for themselves and others.
5. Concessionary Bargaining:- As its name implies, concessionary bargaining
focuses on union leaders making concessions in exchange for job security.
This is common during an economic downturn or a recession. Union
leaders may agree to give up certain benefits to guarantee the survival of
the employee pool and, ultimately, of the business.
 Importance of collective bargaining:-
Group bargaining is a tool that employees can use to address workplace
issues and request better wages, benefits or workplace conditions. Here's
what bargaining can help them with:
1. More employee training and support
Many employees choose group bargaining as a way to demonstrate
their discontent in terms of how much training and support they
receive from the employer. Coming together and presenting their
demands as a group is more likely to get the employer's attention, as
it often means there's a real issue that many members of the
organisation experience.
2. Better compensation and benefits
Some unions choose group bargaining to draw attention to a
compensation problem within the organisation or the industry. In this
sense, negotiating higher wages can be the first step to
revolutionizing compensation standards across the entire industry.
Rejecting employees' demands can lead to strikes, which is why it's
often beneficial for employers or the government to enter
negotiations and try to reach a consensus with a trade union.
3. improvement in workplace conditions
It's also possible to use the power of bargaining to influence a
positive change in workplace conditions. By researching national or
industry standards and preparing a proposal, employees can identify
workplace hazards and demand that the employer eliminates them. If
that's the main purpose behind bargaining, then it's helpful to work
with a compliance officer who'd use their expertise to support the
union.
4. A solution to day-to-day workplace issues
Lastly, group bargaining can help employees address and ask for
solutions to other day-to-day issues they encounter at work.
Depending on the industry or organization, this can refer to
improvement in work schedules or providing employees with more
resources. Through negotiation with employers collaboratively,
employees can feel a sense of belonging and unity, which may
increase their productivity and satisfaction if the employer agrees to
implement the changes they request.
Q. Explain the risk and uncertainty theory of profit.
Ans. Risk theory of profit:-
Risk theory of profit was propounded by F.B. Hawley. This theory regards
risk-taking as the main function of the entrepreneur. An entrepreneur
coordinates with other factors of production like capital, labour, land etc.
and initiates production. According to Hawley, there is proportional
relationship between risk and profit. Higher the risk of the entrepreneur,
greater will be his profit and vice-versa.
 The risk in business may arise due to several factors, Viz.
Obsolescence of a product, non-availability of crucial materials,
sudden fall in the prices, introduction of a better substitute by the
competitor, risk due to war, fire or any other natural calamity.
According to Hawley, an entrepreneur may have to bear four kinds of
risks:-
(i) replacement
(ii) obsolescence
(iii) risk proper
(iv) uncertainty
 replacement and obsolescence are calculated and therefore they are
insured. But the other two are unknown and unforeseen risks. It is for
bearing such risk profit is paid to entrepreneur. No entrepreneur will
be willing to undertake risks if he gets only the normal return.
 Therefore the reward for risk-taking must be higher than the actual
value of the risk. If the entrepreneur does not receive the reward, he
will not be prepared to undertake the risk. Thus higher the risk
greater is the possibility of profit.
 According to Hawley the entrepreneur can avoid certain risks for a
fixed payment to the insurance company. But he cannot get rid of all
risks by means of insurance. If he does so he is not an entrepreneur
and would earn only wages of management and not profit.
 Criticism:
1. Risk-taking is not the only entrepreneurial function which leads to
emergence of profits. Profits are also due to the organizational and
coordinating ability of the entrepreneur. It is also reward for innovation.
 2. According to Carver profit is paid to an entrepreneur not for beaming
the risk but for minimizing and avoiding risk.
3. This theory assumes that profit is proportional to risk undertaken by
entrepreneurs. But this is not true in practical life because even
entrepreneurs who do not take any risk are paid profit.
4. Knight says that it is not every risk that gives profit. It is unforeseen
and noninsured risks that account for profit. According to Knight risks
are of two types viz., foreseeable risk and unforeseeable risk. The risk
of fire in a factory is a foreseeable risk and can be covered through
insurance.
The premium paid for the fire insurance can be included in the cost of
production. The entrepreneur can foresee such a risk and insures it. An
insurable risk in reality is no risk and profit cannot arise due to insurable
risk.
5. There is little empirical evidence to prove that entrepreneurs earn
more in risky enterprises. In a way all enterprises are risky, for an
element of uncertainty is present in them and every entrepreneur aims at
making large profits.
 Uncertainty bearing theory of profit:-
According to Frank H. Knight, main function of the entrepreneur is to bear
all uncertainties relating to production. Profit is a reward for bearing
uninsurable future uncertainty. Profit is concerned exclusively with
uncertainty bearing. This theory, starts on the foundation of Hawley’s risk
bearing theory. Knight agrees with Hawley that profit is a reward for risk-
taking. Business risks can be of two types : -
1. Certain Risks : These are the risks which can be insured. These refer
to theft, accident, fire, etc. Every entrepreneur can foresee them and
can get of rid of them by means of insurance. If there is any loss that
insurance company pays the total value of the lost property Payment
of insurance premium with regard to these risks forms part of cost of
production. Certain risks are measurable, the probability of their
occurrence can be statistically calculated. The entrepreneur gets no
profits on account of these risks.
2. Uncertain Risks: According to knight, an entrepreneur has to bear
several types of uncertain risks which cannot be foreseen nor insured
 against. These risks alone give rise to profit. Uncertain risks
includes:-
1) Changes in prices due to technological changes,
2) Decrease in the demand due to changes in tastes and fashions,
population,
incomes etc.
3) Competition from new firms or new products,
4) Government may interfere into the affairs of the industry and fix
lower prices,
5) Cyclical economic depressions resulting in lack of demand, falling
prices etc.
Since these risks cannot be foreseen and estimated accurately no insurance
company will be prepared to cover against them. Hence, these are called
uncertainties. According to Prof. Knight there is a direct relationship
between profit and uncertainty bearing. Greater the uncertainty bearing, the
higher will be the level of profits and vice versa.
 Criticism:
1. According to this theory, profit is the reward for uncertainty bearing. But
critics point out that sometimes an entrepreneur earns no profit in spite of
uncertainty bearing.
2. Uncertainty bearing is one of the determinants of profit and it is not the only
determinant. Profit is also a reward for many other activities performed by
entrepreneur like initiating, coordinating and bargaining, etc.
4. In modern business corporations ownership is separate from control.
Decision-making is done by the salaried managers who control and organise
the corporation. Ownership rests with the shareholders who ultimately bear
uncertainties of business. Knight does not separate ownership and control and
this theory becomes unrealistic.
5. Uncertainty bearing cannot be looked upon as a separate factor of
production like land, labour or capital. It is a psychological concept which
forms part of the real cost of production.
6. Monopoly firms earn much larger profits than competitive firms and they
are not due to the presence of uncertainty. This theory throws no light on
monopoly profit.
Q.Explain the Concept of Social Welfare function. (important)
Ans. . The concept of social welfare function was first introduced by Prof.
Bergson and later on developed by Samuelson, Tintner and Arrow.
They are of the view that no meaningful propositions can be made in welfare
economics without introducing value judgments.
The concept of social welfare is an attempt at providing a scientifically
normative study of welfare economics.
social welfare function shows the factors which the welfare of a society is
supposed to depend.
Bergson defines it "as a function either of the welfare of each member of the
community or of the quantities of products consumed and services rendered by
each member of the community."
In its original form the Bergson social welfare function is formulated in a
completely general manner.
It is a function which establishes a relation between social welfare and all
possible variables which affect each individual's welfare, such as a services
and consumption of each individual. It is an ordinal index of society's welfare
and is a function of individual utilities.
It is expressed as W = F (U,,U ₂, U ₁) where W is the social economic welfare,
F is for function, and U, U............. 2,...individuals. W is an increasing
function of these utilities. UN is the levels of utilities of 1, The general
properties of the social welfare function are similar to those of an individual
utility function. In particular, the value of the welfare index increases
whenever the utility level of one individual is increased without lowering that
of the other individual. Thus the social welfare function is consistent with the
Pareto optimality criterion, but it goes much further, since it assigns a value to
every economic state, including those which according to the Pareto criterion
are regarded as non-comparable. The existence of a social welfare function,
therefore, implies a comparison of the welfare position of the individual
members of society.
 Assumptions : (a) It assumes that social welfare depends on each individual's
wealth and income and each individual's welfare depends, in turn, on his
wealth and income and on the distribution of welfare among the members of
the society. (h) It assumes the presence of external economies and
diseconomies with their consequent effects. (c) It is based on ordinal ranking
of combinations of those variables which influence individual welfare. (d)
Interpersonal comparisons of utility involving value judgments are freely
permissible

(pending..)
Q. Explain the Pareto’s criteria of welfare.
Ans. This criterion refers to economic efficiency which can be objectively
measured. It is called Pareto criterion after the famous Italian economist
Vilfredo Pareto (1848-1923). According to this criterion any change that
makes at least one individual better-off and no one worse-off is an
improvement in social welfare. Conversely, a change that makes no one
better-off and at least one worse-off is a decrease in social welfare.
The criterion can be stated in a somewhat different way: a situation in which it
is impossible to make anyone better-off without making someone worse-off is
said to be Pareto-optimal or Pareto efficient.
Alternative criteria for economic efficiency based on Pareto efficiency are often
used to make economic policy, as it is very difficult to make any change that
will not make any one individual worse off.
In any situation other than Pareto efficiency, some changes to the allocation of
resources in an economy can be made, such that at least one individual gains
and no individuals lose from the change. Only changes in the allocation of
resources that meet this condition are considered moves toward Pareto
efficiency. Such a change is called a Pareto improvement.
A Pareto improvement occurs when a change in allocation harms no one and
helps at least one person, given an initial allocation of goods for a set of
persons. The theory suggests that Pareto improvements will keep enhancing
the value of an economy until it achieves a Pareto equilibrium, where no more
Pareto improvements can be made. Conversely, when an economy is at Pareto
 efficiency, any change to the allocation of resources will make at least one
individual worse off.
For the attainment of a Pareto-efficient situation in an economy three marginal
conditions must be satisfied:
(a) Efficiency of distribution of commodities among consumers (efficiency in
exchange)
(b) Efficiency of the allocation of factors among firms (efficiency of
production)
(c) Efficiency in the allocation of factors among commodities (efficiency in
the product-mix, or composition of output).
(a) Efficiency of distribution of commodities among consumers :
The first condition for Pareto optimality relates to efficiency in exchange. The
required condition is that “the marginal rate of substitution between any two
products must be the same for every individual who consumes both.” It means
that the marginal rate of substitution (MRS) between two consumer goods
must be equal to the ratio of their prices. Since under perfect competition
every consumer aims at maximising his utility, he will equate his MRS for two
goods, X and Y to their price ratio (Px/Py).

The box diagram Figure 1 explains the optimum condition of exchange. Take two
individuals A and В who possess two goods X and Y in fixed quantities
respectively. Oa is the origin for consumer A and Ob the origin for В.
At point E the marginal rate of substitution between the two goods is not equal to
the ratio of their prices because the two curves do not have the same slope. So E is
not the point of у optimum exchange of the two goods X and Y between the two
individuals A and B. Let us try to find out such a point where one individual
becomes better off without making the other worse off.
Suppose A would like to have more of X and В more of Y. Each will be better off
without making the other worse off if he moves to a higher indifference curve. Let
them move from point E to R. At R, A gets more of Х by sacrificing some Y, while
В gets more of Y by sacrificing some amount of X.
There is no improvement in B’s position because he is on the same indifference
curve B1 but A is much better off at R having moved to a higher indifference curve
from A1 to A3 If, however, A and В move from E to P, A is as well off as before for
he remains on the same indifference curve A1 В becomes much better off having
moved from B1 to B3.
It is only when they move from E to Q that both are on higher indifference curves.
P, Q and R are, thus, the three conceivable points of exchange, The contract curve
CC is the locus of these points of tangency which shows the various positions of
exchange that equalize the marginal rates of substitution of X and Y.
Any point on the CC curve, therefore, satisfies this optimum condition of
exchange. But a movement along the contract curve in either direction always
tends to make one individual better off at the expense of the other. Thus each point
on the contract curve represents optimum social welfare in the Paretian sense.
(b) Efficiency in Production:
To derive the marginal condition for a Pareto-optimal allocation of factors
among producers we use an argument closely analogous to the one used for
the derivation of the marginal condition for optimal distribution of
commodities among consumers. In the case of allocation of given resources K
and L we use the Edgeworth box of production shown in figure 2. Only points
on the contract curve of production are Pareto-efficient. Point H is inefficient,
since a reallocation of the given K and L between the producers of X and Y
such as to reach any point from c to d inclusive results in the increase of at
least one commodity without a reduction in the other. Them contract curve is
the locus of points of tangency of the isoquants of the two firms which
produce X and Y, that is, points where the slopes of the isoquants are equal.
Thus at each point of the contract curve the following condition holds
MRTSXLK = MRTSYLK
 Therefore we may state the marginal condition for a Pareto-optimal allocation
of factors among firms as follows:
The marginal condition for a Pareto-optimal allocation of-factors (inputs)
requires that the MRTS between labour and capital be equal for all
commodities produced by different firms.

(c) Efficiency in Exchange and Production (Product Mix):

Pareto optimality under perfect competition also requires that the marginal rate of
substitution (MRS) between two products must equal the marginal rate of
transformation (MRT) between them. It means simultaneous efficiency in
consumption and production.
Since the price ratios of the two products to consumers and firms are the same
under perfect competition, the MRS of all individuals will be identical with MRT
of all firms consequently, the two products will be produced and exchanged
efficiently. Symbolically, MRSXY = PX/PY, and MRTxy = Px/Py. Therefore,
MRSXY = MRTxy.
Figure 3 illustrates overall Pareto optimality in consumption and production. PP; is
the transformation curve or the production possibility frontier for two goods X and
Y. Any point on the PP curve shows the marginal rate of transformation (MRT)
between X and Y which reflects the relative opportunity costs of producing X and
Y, that is MCx/MCy . Curves I1 and I2 are the indifference curves which represent
consumer tastes for these two goods.
The slope of an indifference curve at any point shows the marginal rate of
substitution (MRS) between X and Y. Pareto optimality is achieved at point E
where the slopes of the transformation curve PPt and the indifference curve 12 are
equal. This equality in slopes is shown by the price line cc which indicates that at
point £ the MRSxy = MRTxy = Px/Py or MUx/MUy_=MCx/MCr = Px/Py.
Given the production possibility frontier PP1, there is no other indifference curve
which satisfies Parteo efficiency. Point A is of inefficient production because it is
below the PPI curve. Point B is on the production possibility frontier but it is on a
lower indifference curve I1, where the consumer satisfaction is not maximised.
Therefore, Pareto optimality exists only at point E, where there is efficiency in
both consumption and production when the society consumes and produces OX1
of good X and OY1 of good Y.
Thus the conditions necessary for the attainment of Pareto optimality relate to
efficiency in consumption, efficiency in production, and efficiency in both
consumption and production.

 Drawbacks:-
The Pareto criterion cannot evaluate a change that makes some individuals
better- off and others worse-off. Since most government policies involve
changes that benefit some and harm others it is
obvious that the strict Pareto criterion is of limited applicability in real-
world situations. Furthermore, a Pareto-optimal situation does not guarantee
the maximization of the social welfare. For example, we know that any point
on the production possibility curve represents a Pareto efficient situation. To
decide which of these points yields maximum social welfare we need an
interpersonal comparison of the individual consumer's utility. In a
subsequent section we will show that the Pareto- optimal state is a necessary
but not sufficient condition for maximum social welfare.
 The Kaldor-Hicks Compensation Principle
(IMPORTANT)
Nicholas Kaldor and J.R.Hicks put forwarded the welfare criterion based
upon the compensating payments in 1939. If a certain change in economic
organization or policy, according to Kaldor, makes some people better off
and the others worse off, there will be a net increase in social welfare, when
the gainers in welfare compensate the losers and are still better off than
before.
 Assumptions:
1. An individual himself is the best judge of his satisfaction which is
independent of the satisfaction of others.
2. There is constancy of the tastes of the individuals.
3. There can be ordinal measurement of utility.
4. The inter-personal comparisons of utilities are not possible.
5. There is an absence of externalities in production and consumption
 Compensation Principle:
J.R.hicks put forwarded his compensation criterion which is the
reverse of Kaldor’s criterion. According to him, if an economic change
makes some people better off and the others worse off and the losers cannot
bribe the gainers not to make the given change, then there is an increase in
the net welfare of the society from that economic change. Suppose the
government proposes to impose a tax which will benefit some and harm
others. If the latter fail to bribe
the government officials not to introduce the proposed tax, then the given
change in tax policy will result in a net increase in the welfare of the society.
Prof. hick has given his criterion from the loser's point of view, whereas
Kaldor had formulated this criterion from the gainer's point of view. Though
the two criteria are exposed differently, but they are really the same. Thus,
that is why the two criteria are generally called by a single name, ‘Kaldor-
Hicks Criterion'. (Nicholas Kaldor, 1939).

 Utility Possibility Curve :

 In the given figure, A’s utility is measured along the horizontal scale and B’s
utility along the vertical scale. RS is the utility possibility curve. It indicates
the different combinations of the utilities obtained by A and B. The
movement downwards along the curve RS shows an increase in the utility of
A and a fall in the utility of B. On the opposite, an upward movement along
RS curve shows a fall in the utility of A and a rise in utility of B. these
movements along the utility possibility curve may be on account of
redistribution of income.
Suppose the two individuals A and B are initially at the point C inside the
utility possibility curve. If some change takes place in the economic policy
and A and B moves to position D from C, there is a fall in the utility of A
whereas there is an increase in the utility of B. It is not possible to evaluate
the movement from C to D from Paretian criterion. The points E, F and G
lying upon EF segment of the utility possibility curve RS are socially
preferable to the point C on the basis of Paretian criterion as at least one
individual becomes better off while none is worse off at the points E,F and
G. As there is movement from C to D, it has to be seen if the individual B
(the gainer) can compensate the individual A (the loser) and still be better off
than C.
According to Kaldor-Hicks criterion, as B compensates A, the income
redistribution causes the movement from D to E where A’s utility remains as
before but B is still better off. It signifies that there is a net increase in the
welfare of the society just by the redistribution of income. Even the
movement from D to G will result in a net increase in social welfare because
at G both A and B are better off than at the original position C. According to
Kaldor-Hicks criterion, it is not necessary to pay compensation actually to
judge whether the social welfare has increased or not. Only requirement is
that the gainer should be potentially able to compensate the loser for the loss
in his welfare and still be better off.
 Criticism:- (5, 6, 7.. Optional)
1. This criterion implicitly assumes that marginal utility of money is the
same for all the individuals in the society.
 2. It suggested potential compensation rather than actual compensation. In
case the potential compensation is not paid, the welfare would be
measured only in terms of utility and that would require the inter personal
comparisons of utility and value judgements.
3. It evaluates the gains and losses due to an economic change in money
terms, overlooking the real value of gains and losses.
4. It ignores the existing distribution of income of the community. If the
income distribution is unequal, the compensation by the gainers (the rich)
paid out to losers (the poor) will fail to offset the loss on account of the
differences in the marginal utility of money in case of the rich and the
poor.
5. This theory involves interpersonal comparison the welfare economists
wanted to avoid.
6. This theory isolated the production and exchange from distribution and
this ignores distribution.
7. Economic welfare could not be increased by a resource reallocation
unless the compensation is actually paid.

Q. Value judgement (optional but impo.)