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ASSIGNMENT SOLUTIONS GUIDE (2014-2015)

E.C.O.-6
Economic Theory
Disclaimer/Special Note: These are just the sample of the Answers/Solutions to some of the Questions given in the
Assignments. These Sample Answers/Solutions are prepared by Private Teacher/Tutors/Auhtors for the help and Guidance
of the student to get an idea of how he/she can answer the Questions of the Assignments. We do not claim 100% Accuracy
of these sample Answers as these are based on the knowledge and cabability of Private Teacher/Tutor. Sample answers
may be seen as the Guide/Help Book for the reference to prepare the answers of the Question given in the assignment. As
these solutions and answers are prepared by the private teacher/tutor so the chances of error or mistake cannot be denied.
Any Omission or Error is highly regretted though every care has been taken while preparing these Sample Answers/
Solutions. Please consult your own Teacher/Tutor before you prepare a Particular Answer & for uptodate and exact
information, data and solution. Student should must read and refer the official study material provided by the university.

1. Critically examine the law of Equimarginal Utility.

Ans.The Law of Equimarginal Utility: This law gives to a very difficult question that is In what way should
a person allocate his limited resources among different uses so as to maximize the total utility derived from consumption.
Consumer equilibrium is said to be established when the consumer has allocated his resources among the various
users so that his total utility will be maximum and he has no motivation for change.
The Law of Equiy: Marginal utility states that a consumer will reach the stage of equilibrium when the
marginal utilities of the various commodities that he consumes are equal.
According to Marshall, if a person has a thing which he can put to several uses, he will distribute it among these
uses in such a way that it has the same marginal utility in all.
Explanation: As a consumer buys an variety of goods like food, clothing, jewellery, etc., the more he gets of one
good the less he will buy the another good because of his limited money at disposal. Now the marginal utility of the
good declines with increased purchases; marginal utility of other goods would be high; so the consumer would gain
by substituting among goods with higher marginal utility for goods with lower marginal utility. The process of
substitution shall continue until he arrives at the optimum combination which gives him maximum total utility.

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Units
1
2
3
4
5
6

M.U. of x

MU of y

MU of z

10
8
7
4
2
0

14
12
10
8
6
4

18
15
12
8
5
3

We assume that each of the commodity costs Re. 1 each. In order to reach the equilibrium the consumer should
that combination where MUx = MUy = MUz. This situation can be attained when consumer buys the following
combination [2x + 4y + 4z] for Rs. 10. At this stage the derived total utility equals to (10 +8) + ( 12 + 12 + 10 + 8)
+ ( 18 + 15 + 12 + 8 ) = 115 utils. This is the maximum utility he can derive from the given money.
Modern View of Law of the Equimarginal Utility
The major disadvantage of classical view is their assumption that prices of all the commodities are same, which
is not possible. So a new concept was given by modern economist called as law of proportional marginal utility.
According to this the two factors that influence the consumer behaviour are:
(a) The marginal utility of the various goods to be consumed.
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(b) The prices of various goods.

This law states that consumer will be in equilibrium where marginal utility of money expenditure on all goods
consumed is the same. The marginal utility of expenditure on a good equals the marginal utility of a good divided by
the price of the good.
In order to be in equilibrium, the ratio of marginal utility of good X to its price is equal to the ratio of marginal
utility of good Y to its price and so on.
Symbolically,

MU y
MU x
MU z
=
=
= Marginal Utility of Money
Py
Px
Pz

Quantity

MUx

Px

Ratio

MUy

Py

Ratio

MUz

Pz

Ratio

1
2
3
4
5

8
6
4
2
1

2
2
2
2
2

4
3
2
1
.5

14
10
6
4
2

5
5
5
5
5

2.8
2
1.2
.8
.4

9
6
4
3
2

3
3
3
3
3

3
2
1.33
1
.66

Y
MUx3
Px3

MUx /Px

N
MUx3
Px3

MUx1
Px1

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Z

Price

Px1

Px2

Px3

0 q1

q2

q3
Quantity

Limitations of Law
(a) Assumption of rationality is not practical because individuals do not prefer to make such arithmetical
calculations and experiments.
(b) Ignorance on the part of the consumer always results in other equilibrium position. They are not aware of
substitute goods and accept whatever is made available.
(c) Because of habits and fashion trends consumer goes for non-economic considerations rather than by economic
considerations.
(d) Goods are indivisible.
(e) Assumption is that there is a particular time period during which consumer makes his purchases, while there
are many commodities of durable nature having long duration time period.
(f) Utility can not be measured cordinally.
(g) Utility is not additive.
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Q. 2. Explain an industrys short period equilibrium in conditions of perfect competition.

Ans. Equilibrium of a firm in short run: Short run is that time period in which there are both variable and
fixed factors of production. Only quantity of variable factors can be changed, but not of the fixed factors.
Short run equilibrium of a firm is attained at a level of output which satisfies the following two conditions:
1. MC = MR 2. MC cuts MR from below.
When a firm is in short run equilibrium, a perfectly competitive firm may find itself in any of the following
conditions:
(a) It suffers loss.
(b) It earns profit.
(c) It breaks even.
1. It Earns Profit: A firm earns profit if at the equilibrium level of output; its average revenue (AR) is more than
its (AC).
From the figure we conclude that
Equilibrium Point
= E (MR = MC)
Equilibrium Output
= OQ
Average Revenue
= QE
Average Cost
= QK
Therefore profit per unit
= QK QE = EK
Total Profit
= EK OQ = Area PEKT
Y

N
AR > AC

AC

MC

Revenue/Cost

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E

AR = MR

Super
Normal Profit

Output

2. It Breaks Even: A firm breaks even when at the equilibrium level of output; its average revenue (AR) is equal
to (AC).
Average Revenue
= QE
Average Cost
= QE
Therefore the firms break even (no profit and no loss).
Y

MC

Revenue Cost

AC

AR = MR
P

Normal Profit

X
O

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M
Output

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3. It Suffers Loss: A firm incurs loss if at the equilibrium level of output; its average cost (AC) is more than the
average revenue (AR) or the market price.
From the figure we can see that
Equilibrium point
= E (MR = MC)
Equilibrium output
= OQ
Average revenue
= QE
Average cost
= QK
Therefore loss per unit
= QK QE = EK
Total loss
= EK OQ = Area PEKT
Shut down point for a perfect competitive firm:
We know that at the point where AC > AR, then firm incurs losses. But the question is that at this point whether
the firm should continue to produce or should it shut down?
We know that total cost of any firm consist of fixed cost and variable cost. Fixed cost once incurred, cannot be
recovered even if firms shuts down. Therefore the decision depends upon the behaviour of variable cost.
A firm will continue to produce if at the equilibrium level of output the Average Revenue of the firm is more than
the Average Variable Cost. It means AR > AVC. Otherwise the firm will shut down.
The firm will not produce at the equilibrium output where Average Variable Cost is more than the Average
Revenue. If it produces and sells at the market price QE, it suffers additional loss of EF in addition to loss of fixed
cost.
But if the equilibrium level of output where AVC = OQ, whereas AR = QE. By continuing the production, the
firm not only recovers not only whole of its variable cost, but in addition also recovers a part of their fixed cost. Its
total losses would be less if it continues production than if it were to close down its operations.

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Y

Loss

Revenue / Cost

MC

AC
AVC

AR = MR

P
P1

AR = MR

Shut down
Point

N Output

3. Explain the concept of price leadership. Does acceptance of price leadership solve all problems of
oligopoly equilibrium?
Ans. When a firm that is the leader in its sector determines the price of goods or services. Price leadership can
leave the leader's rivals with little choice but to follow its lead and match these prices if they are to hold onto their
market share. Alternatively, competitors may also choose to lower their prices in the hope of gaining market share as
discounters. Price leadership can be positive when the leader sets prices higher, since its competitors would be
justified in ratcheting their prices higher as well, without the threat of losing market share. In fact, higher prices may
improve profitability for all firms.
More commonly, undisputed market leaders such as the big-box retailers use their operating efficiencies to
relentlessly mark down prices. This forces smaller rivals to lower prices as well in order to retain market share. Since
these smaller firms often do not have the same economies of scale as the price leaders, this attempt to match the
leader's prices may lead to mounting losses over a prolonged period, to the point where they may be forced to
eventually close their doors.
Price and Output Determination Under Oligopoly: Pure monopoly, monopolistic competition and perfect
competition, all refers to rather clear cut market agreements, oligopoly does not. It includes the 'tight' oligopoly
situation in which two or three firms dominate an entire market as well as the 'loose' oligopoly situation in which six
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or seven firms share a very large percentage of a market. While other firms share the remainder.
It includes both differentiation and standardization. It encompasses the cases in which firms are acting in collusion
and in which they are acting independently. In short, the existence of many types of oligopoly prevents the development of a general theory of price and output. Moreover the element of mutual interdependence found in Oligopolistic
market further complicates the determination of price and output.
Despite these analytical difficulties, two interrelated Characteristics of Oligopolistic pricing stand out
Firstly oligopolistic prices tend to be inflexible or sticky price change less frequently in oligopoly than they
do under pure competition, monopoly and monopolistic competition.
When oligopolistic prices do change, firms are likely to change there prices together, they act in collusion in
setting and changing prices.
We shall study the price and output determination under oligopoly in the following situation.
Independent Pricing or Price Determination in Non-Collusion Oligopoly
Each firm can follow an independent price and output policy on the basis of his judgements about the reaction of
his rivals. If the firms are producing homogenous products it may lead to price war. Each firm has to fix the price at
the competitive level. On the other hand, in case of differentiated oligopoly, due to product differentiation each firm
has some monopoly control over the market and there for fixes near monopoly price thus the actual price may fall
between the two limits.
The Upper Limit of Monopoly Price and,
The Lower Limit of Competitive Price.
It is not theoretically possible to determine the exact price within these limits. However they may be the following
possibilities.
(i) There may be complete price instability in the market as a result of price war.
(ii) The price may settle down at intermediate level as a result of the working of the market forces.
(iii) The firm may accept the prevailing price and adjust to that prevailing price.
So long as the firm earns adequate profits at the prevailing price, it may not try changing it. Any effect to change
it may create uncertain ties in the market. He will stick to that price to avoid uncertainties .thus the price tends to be
rigid where oligopolist takes independent action.
Q. 4. Discuss the concepts of money wage and real wage. How are competitive wages determined?
Ans. Meaning of Wages: A wage may be defined as a sum of money paid under contract by an employer to a
worker for services rendered. Wages or wage rate are the price paid for the use of the labour.
Types of Wages
(a) Nominal Wages or Money Wages: These are those wages which are paid to the workers in terms of money.
A labourer gets Rs.100 per day as wages in terms of money and another. A labourer gets Rs. 60 per day as wages in
terms of money. According to Whitehead, "Money wages refer to actual money earned by the worker." Thus, nominal
wages refer to the amount of money which a labourer gets per day or per week as per the agreement of work.
(b) Real Wages: Real wages refer to the quantities of goods and services which a labourer gets in return for his
money wages. Real wages are the purchasing power of money wages.
Factors Determining the Real Wages
1. Money Wages: Other things remaining the same, if money wages are more, real wages will also be more.
There is thus a direct relation between money wages and real wages.
2. Price Level: Real wages are much influenced by the purchasing power of money or the price level. If prices
are rising, the real wages will fall. On the contrary, if prices are falling, the real wages will increase. In other words,
if money wages remain constant, here will be an inverse relation between the price level and real wages.
3. Supplementary Income: Real wages of an employee will be more if in addition to his fixed money income
he gets supplementary income like bonus, free accommodation, free mid-day meals, uniform, medical facilities, free
education to his children, transport facilities etc.
4. Nature of Employment: Real wages of a labourer also depend on the nature of employment. It means,
whether the labourer has a regular employment or casual employment. Real wages will be more if he has a regular
employment and less if the employment is casual.
5. Hours of Work: If a labourer gets the same amount of money wages as the other labourer by working for less
number of hours than the latter, then his real wages will be more. It is because in the saved hours of work he can do
some other work and this add to his total money wages.

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6. Trade Expenses: If a worker is bound to spend a part of his money wages on trade expenses, his real wages
will fall.
7. Social Status: Money wages of a Head Clerk in a government office and a Sub-inspector of Police may be
equal, but the social status of a Sub-inspector is higher than that of a Head Clerk. Hence, real wages of the Subinspector will be high.
Wage Determination under Perfect Competition: According to the Modern Theory of Wages, wages are the
prices of the services of the labour. Just as the price of a commodity is determined by its demand and supply, likewise
price of the services of labourers is also determined by their demand and supply. In other words, General Theory of
Value is as much applicable to determination of wages as to price. Thus to determine the wage, it is necessary to
examine demand for labour, supply of labour and their interaction.
Demand of Labour: In factor market demand of labour is made by producers and entrepreneurs. Demand of
labourers is a derived demand and thus it depends on the demand of goods and services which they help to produce.
Demand of labour refers to that number of labourers which the producers are willing to employ at a given rate of
wage. Demand of labour is influenced by the following factors:
Demand for the Commodities: If demand for goods produced by the labour is less, there will be less demand
for labour and if demand for goods is more, then there will be more demand for labour also.
Price of Other Factors of Production: Demand for labour is influenced by the price of other factors of production
and the possibility of substitution of labour. If other factors are more expensive than labourers, then there will be
more demand for labourers in place of such expenses and other factors and vice versa. Cheaper technology may
substitute labour. Demand for labour depends on its marginal productivity. Because of this fact, demand curve of
labour is downward sloping as shown in figure.
In fig. DD is the demand curve of labourers. It slopes downward signifying that more labourers are demanded at
low wages and less on high wages.

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Y

Wages / MRP

Industry's
Demand Curve

No. of Labourers

Supply of Labour: Supply of labour means the number of labourers doing a particular job who willingly offer
their services at different wage rates and the number of hours or days that each labourer is prepared to work at
different wage rates.
Normally there is a direct relation between the supply of labour and rate of wage. Supply of labour depends
upon:
(a) Economic Factors: These are existing employment, desire to increase monetary income, bargaining power
of the labourers, size of population and income distribution etc.
(b) Non-Economic Factors: These are domestic environment, family affection, social conditions, religious
views, education etc.
(c) Psychological Factors: Because of psychological factors a labourer decides as to how much of his time he
should devote to work and how much time to leisure.
Normally supply curve of labour is an upward sloping curve from left to right, but on account of psychological
factors the supply curve can be backward sloping. It is so because as the wage exceed a particular limit, the labourer
begins to prefer leisure to work. Change of wage affects the supply of labour in two ways:
(i) Substitution Effect: Increase in wage rate will stimulate the labourers to work more, as such he will substitute
work hours for leisure hours. Thus, rise in wage rate leads to increased supply of labour. Substitution effect
is positive.
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(ii) Income Effect: Income effect discourages work and encourages leisure. Income effect is therefore negative.
Y

Wages

P1

W1

W
O

S
N1
Units of Labour

Thus increase in wage has two contradictory effects. To begin with, substitution effect is more powerful, as such
increase in wage rate leads to increase in supply of labour but after a point, income effect becomes more powerful
and causes decrease in supply of labour.
Supply curve of labour begins to slope backwards as shown in figure. It indicates that when wage rate is OW, the
supply of labour is ON. If wage rate is OW1, supply of labour decreases to ON1.
Ordinarily it is assumed that despite there being one exception, supply curve of labour, like the supply curve of
any other factor, moves upward from left to right.
Q. 5. What is meant by income inequality analyses? The need for income redistribution also discusses the
measures which are being generally adopted in capital countries for reducing inequality of income.
Ans. Income inequality describes the extent to which income is distributed unevenly among residents of an
area. High level of inequality indicate that a small number of people receive most of the total income, and that
most people receive only a small share of the total. Inequality can be a barrier to social cohesion and democratic
participation when income determines access to social settings and political institutions.
Types of Inequality
Size distribution of income
Functional distribution of income
Distribution of income by recipient
Distribution of wealth
Poverty: absolute and relative
Income Distribution: Everywhere in the world, where means of production are privately owned, distribution of income

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is far from equitable. Without exception in all the capitalist countries - developed and undeveloped - a small minority appropriates
a large part of national income whereas a vast majority subsists on meager incomes. It has been observed that inequality of
income is generally greater in less developed countries. It often increases during the early stages of development, reaches a peak,
and then declines.
Some Facts Pertaining to Income Distribution: Simon Kuznets, a leading American economist has done some
pioneer work in this area. This table shows size distribution of' income before taxes among families of consuming units:

Size Distribution of Income before Taxes among Families or Consuming Units

Developed Countries
Underdeveloped Countries
S.No.
Household
Per cent Share
Multiple of
Per cent share
Multiple
Income (per cent) in Total Income Average Income in Total Incomeof Average Income
1
2
3
4
5
6
7

020
2140
4160
6180
8190
9195
96100

4
11
16
22
16
11
20

.2
.55
.8
1.1
1.6
2.2
4.0

8
11
13
16
12
10
30

0.4
0.55
0.65
0.8
1.2
2.0
6.0

However, now it is a well known fact that income distribution is much less unequal in the communist countries
than in the capitalist countries. We can see that capitalist countries - both developed and underdeveloped - reflect
widespread income inequalities. In developed countries, the top 5 per cent group accounted for 20 per cent of the
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national income. The share of this group was still larger in the underdeveloped countries. It was 30 per cent of the
national income on excluding this group of families; you would observe that there was greater inequality of income
in developed countries than in the underdeveloped countries, even the relative position of the bottom 40 per cent in
developed countries was worse than that of their counterparts in the underdeveloped countries.
Another important study on inequality of income has been conducted by Irma Adelman and Cynthia Taft Moms.
In their study of 43 underdeveloped countries, they have found substantial inequality in income distribution.
Inequality in Income Distribution
(Percentage Shares by Population Groups)
Country
Argentina
Brazil
Burma
Sri Lanka
India
Nigeria
Pakistan
Philppines
Tanjania
Zambia

0-40

40-60

60-80

80-100

95-100

17.30
12.50
23.00
13.66
20.00
14.00
17.50
12.70
19.50
15.85

13.10
10.20
13.00
13.81
16.00
9.00
15.50
12.00
9.75
11.10

17.60
15.80
15.50
20.22
22.00
16.10
22.00
19.50
9.75
15.95

52.00
61.50
48.50
52.31
42.00
60.90
45.00
55.80
61.00
57.10

29.40
38.40
28.21
18.38
20.00
38.38
20.00
27.50
42.90
37.50

This study is based on data for the late 1950s and l960s. The results of this study are quite revealing. We can see
that the share of the top 5 per cent of population is more than that of the bottom 40 per cent. In fact, this was true for
41 countries out of a total of 43 countries. Moreover the share of the top 5 per cent of the population was greater than
the share of the bottom 60 per cent of the population in as many as 2 countries out of the 43 countries. This study
further revealed that in 32 countries out of the 43 countries covered in the study, top 20 per cent of the population
accounted for 50 per cent or more of the national income.
Trends of Inequality of Income
In this field the path breaking work was done by Simon Kuznets. His two studies indicated that income distribution
shows a tendency to get worse over time before it gets better. Later on Adelman and Moms conducted a study. Their
study confirmed the findings of Kuznets. Adelman and Moms observed that when economic growth starts in a
backward agrarian economy through the expansion of a small modem sector, inequality in the distribution of income
generally increases. According to them, "The income share of the poorest 60 per cent declines significantly, as does
that of the middle 20 per cent, and the income share of the top 3 per cent increases strikingly. The gains of the top 5
per cent are particularly great in very low income countries due to their dualistic structure. In these countries, the
economic growth is largely concentrated in the modern sector and its benefits go mainly to the wealthiest 5 per cent
of the population.
The condition of the porest 60 per cent typically worsens, both relatively and absolutely. The study has clearly
shown that in an average country passing through the earliest phases of economic development, it takes at least a
generation for the poorest 60 per cent to recover the loss in absolute income associated with the typical spurt-in
growth.
Once low income countries move beyond the stage of economic growth largely restricted to a narrow modern
sector, further development does not cause any more distortions in the distribution of income. The income distribution
starts improving in favor of the poorest 60 per cent after these countries reach a reasonably high level of development,
because in this phase growth activity is broad-based and its beneficiaries are to be found in all of sections of the
society.

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Measuring Income Inequality

Inequality Table for India : 1975-76 Income
Household
Income by

Per cent Share

of Income

Cumulative per
centage of Population

Absolute
Equality

Absolute
Inquality

Actual Income
Distribution

Lowest fifth
7.0
20
20
0
7.0
Second fifth
9.2
40
40
0
16.2
Third fifth1
3.6
60
60
0
30.1
Fourth fifth
20.5
80
80
0
50.6
Highest fifth
49.4
100
100
100*
100
* In the highest group top few individuals receive the total income.
We will observe in the Inequality Table that in the assumed case of absolute equality, every income group of
households gets a proportionate share in the national income. This certainly is an extreme situation and cannot be
expected to be found in any country. The other extreme situation will be of absolute inequality. Even this does not
exist in any country. In this assumed situation only a few persons get all the income and rest of the people go without
any income. These two extreme cases are purely hypothetical. The real distribution of income in any country will
figure somewhere between these two extreme cases of absolute equality and inequality. We will observe in the
column showing real income distribution in Table that in India in 1975-76 the lowest 20% got a mere 7.0% of the
national income in that year which was around 1/3 of the proportionate share in the national income. The percentage
shares of the II and III quintiles were also substantially lower than their proportionate shares. However, the IV group
of households was not as unlucky as the poorest 60% households. The percentage share of the IV quintile the
national income was 20.5% which was marginally higher than its proportionate share. The highest 20% households
appropriated 49.4% of the national income.
In this regard the technique of Lorenz curve is superior to the technique of Inequality Table. The Lorenz curve is
a graphic method of studying dispersion. It is now widely used for measuring inequality of income. The Lorenz
curve is a cumulative percentage curve in which percentages of the population are combined with the percentages of
the income.
At the time of drawing the Lorenz curve the following method is to be adopted:
(i) The cumulative percentages of the population or households arranged from the poorest to the richest are
shown on the X-axis, and the cumulative percentages of the income accruing to the cumulative percentages
of the population are represented on the Y-axis.
(ii) A diagonal line is drawn from 0% of population and 0% of income to 100 per cent of population and 100 per
cent of income. Since every point on this diagonal shows that a certain % age of population enjoys exactly
the proportionate share of income it is known as the line of absolute equality.
(iii) In the end, the different points corresponding to cumulative %ages of population and income are plotted and
a line joining them is drawn. It is obvious, that any Lorenz curve representing real distribution of income in
a country must lie below the diagonal, and its slope should increasingly rise upwards.

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100

Eq
ua
tit
y

of
Ab
so
lu
te

60

40

Li
ne

% of Income

80

n
re
Lo

ur
zC

ve

20

20

40
60
80
% of age Population

100

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