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Suggested Answer (By Mr Malik Mumtaz Ahmad)

(CAF2) Introduction to Economics & Finance – Assessment-1


C-2,3&4

Q.1
Short run is a period of time in which at least one input is fixed. Therefore, if a producer wants to
increase his output he can only change the variable input of production.
The following table shows short run cost curves. Column (1) shows unit of output (Q) while column 2
shows fixed cost of production in rupees. Fixed or supplementary cost (FC) is the cost which does not
change with the change in output e.g. rent of land, interest on capital etc. Hence, it remains Rs. 10
whether the output is 0 or maximum i.e. 6 units. Column (3) shows variable or prime cost (VC) which
changes with the change in output e.g. cost of raw material, wages of labour etc. Column (4) shows total
cost which is the summation of fixed cost and variable cost. Column (5) shows average fixed cost
(AFC) or per unit fixed cost. Average fixed cost decreases from Rs 10 to Rs 5 and so on. This shows
that fixed cost is thinly distributed over number of units. Average variable Cost (AVC) means per unit
variable cost.
Column (7) shows average cost (AC) or average total cost which is per unit cost.

TC
AC = or AC = ACF + AVC
Q
Column (8) shows marginal cost (MC) of the production. Marginal cost is the additional cost incurred on
an additional unit of output.
TC
MC =
Q
Units of F.C (Rs.) V.C (Rs.) T.C (Rs.) A.F.C (Rs.) A.V.C (Rs.) A.C (Rs.) M.C (Rs.)
output (Q)
(1) (2) (3) (4) (5) (6) (7) (8)
0 10 0 10 - - - -
1 10 8 18 10 8 18 8
2 10 14 24 5 7 12 6
3 10 17 27 3.3 5.7 9 3
4 10 22 32 2.5 5.5 8 5
5 10 30 40 2 6 8 8
6 10 44 54 1.6 7.3 9 14
Relationship between AC, AVC and MC:
(i) When the average cost and average variable cost are falling, marginal cost lies below them. Since,
the additional cost incurred on every additional unit of output decreases, it pulls down the average
cost and average variable cost.
(ii) When the average cost and average variable cost are minimum, marginal cost is equal to them.
(iii) When the average cost and average variable cost are rising, the marginal cost is above them.
When the diminishing return sets in, the marginal cost will increase. Since, the additional cost
incurred on every additional unit of output increases, the average cost and average variable cost
will increase.
Q.2 (a)

Quantity Price Total revenue Marginal revenue Total cost Marginal cost Profit
sold (Rs) (Rs) (Rs) (Rs) (Rs)
1 34 34 34 12 12 22
2 30 60 26 20 8 40
3 27 81 21 34 14 47
4 25 100 19 53 19 47
5 23 115 15 75 22 40
6 21 126 11 102 27 24
7 19 133 7 131 29 2

Q.2 (b)
The profit maximizing level of output is 4th unit where MC is equal to MR and profit is maximum, i.e Rs
47.

Q.3 (a)
A monopoly firm has following advantages:
(i) Economies of scale: All the advantages of large scale firm are the advantages of monopoly which
are also called as economies of scale.
(ii) International competitiveness: Economies of scale at home enables monopoly to be able to
compete internationally.
(iii) Economic profit: Being a large scale firm without competitors, a monopoly always earn super
normal profit.
The following are the disadvantages of monopoly:
(i) High price: A monopoly producer charges higher price because he has no competitor in the
market. This policy of a monopolist is against a consumer.
(ii) Excess capacity: A monopoly firm always has an excess capacity. It does not produce at its
optimum level as a perfectly competitor firm does.
(iii) Productive inefficiency: A monopoly firm will be productively inefficient when it does not produce
at minimum average cost. Hence monopoly always charges higher price, produces less than the
competitive firm and is productively inefficient.
(iv) Stifle competition: By erecting various barriers against new entrant, a monopoly stifles
competition which is harmful for consumer.
(v) Supernormal profit: A monopoly firm always earns supernormal profit in long-run.
(vi) Price discrimination: A monopoly firm charges differentiated prices of the same product which is
against the interest of the consumers.
Q.3 (b)
Price discrimination means charging different prices of the same product or same price of the different
products, e.g. telephone calls, electricity rates, railway fare etc.

Conditions under which price discrimination is possible:


(i) Control over supply:
Price discrimination will be possible when a firm controls the whole supply of the product and no
other producer is producing its close substitute.
(ii) Prevention of resale:
A monopoly firm will charge differentiated prices of the product when it prevents resale of the
product from cheaper market to dearer market.
(iii) Laziness of the consumer:
A lethargic consumer purchases a product from the nearby shop and pays higher price of the
product which is being sold at lower price in other localities.
(iv) Ignorance of consumer:
Due to lack of knowledge, a consumer does not know that the product which he is purchasing at
higher price is being sold at the lower price in another market. This enables the monopolist to
charge differentiated prices.
(v) Prejudice or preference:
A monopoly producer will be able to charge different price of the product when a consumer
attaches special preference or shows certain prejudice for a product.
(vi) Special order:
Purchasing the product on special order also enables a monopoly producer to charge the higher
price.
Q.4 (a)
Perfect competition is a market form in which a large number of producers/sellers are selling
homogeneous product. Perfect competition has following characteristics:
(i) In perfectly competitive market hundreds and thousands of sellers of the commodity exist. For
example grain market, egg market, fruit market, vegetable market etc. There is also large number
of buyers in a market.
(ii) All the buyers and the sellers have information about the current price of the product.
(iii) The product which all the sellers/producers are selling is identical. For example, eggs, rice, potato,
carrots etc are homogeneous products being sold in the market.
(iv) A product can be transported from one place to another place without any cost. Similarly there is no
cost of collection of information in the market.
(v) The factors of production are perfectly mobile.
(vi) A firm can enter the industry at any time and it can exit out of the industry as well. There are no
entry barriers in perfect competition.

Q.4 (b)
The following schedule shows the possible data of a monopoly firm. A monopolist will be in equilibrium
at a point where:

(i) Marginal cost is equal to marginal revenue, and


(ii) Marginal cost cuts marginal revenue from below.
A firm will go on producing until every additional unit of output contribute more to the revenue than to
the cost and ceases to produce further where its additional revenue equals additional cost. Because,
after this point, the marginal revenue is less than the marginal cost, and a producer will be loser.
Before 3rd unit of output, the additional revenue of an additional unit of output exceeds additional cost.
At 3rd unit, the marginal revenue equalizes marginal cost. This is the point of monopolist’s equilibrium.

Output Price Total Marginal Total cost Marginal


(Units) revenue revenue cost
1 10 10 10 7 7
2 9 18 8 10 3
3 8 24 6 16 6
4 7 28 4 28 12
5 6 30 2 48 20
Q.5 (a)
Average cost means per unit cost. It is calculated by dividing total cost over units of output.
TC
AC = or AC = ACF + AVC
Q
Deriving Long Run Average Cost:
The Long run average cost (LAC) curve can be derived from the short run average cost (SAC) curves as
shown in following Figure. Assuming a producer who starts a business with a plant showing short run
average cost SAC1. The SAC1 will be most efficient to produce Q1 quantity of output. If he plans to
produce Q2 output, bQ2 per unit cost will incurr
with SAC1 plant which is least cost efficient. So, Cost
he will install a second plant showing cost curve
SAC2. SAC2 is most cost efficient to produce Q2
output because now Q2 output can be produced SAC1 SAC2 SAC3
with b1Q2 average cost rather than bQ2. Similarly c LRAC
SAC2 will be least cost efficient to produce Q3 b
output. The average cost to produce Q3 output
a
with SAC2 is CQ3 while it is C1Q3 with SAC3. So, c1
he will install a third plant whose short run b1
average cost is SAC3. Drawing the tangent of all
the short run cost curves, we get a long run
average cost curve, LAC. O Q1 Q2 Q3 Output
Q.5 (b)
Inferior good is a good whose demand decreases with the increase in consumer income. In following
figure, a consumer is in equilibrium at point E1 where budget line BL1 is tangent to an indifference curve
IC1. When the price of good X (an inferior good) decreases the budget line becomes BL 2. Now, the
consumer equilibrium shifts to a higher indifference curve IC2 at point E3. The movement from E1 to E3 is
the price effect which is the resultant of income and substitution effect. Thus, the consumer increases
the quantity demanded of an inferior good from X1 to X3 because law of demand applies on inferior
goods.
Substitution Effect
To separate the substitution effect, the budget line GH is drawn
on IC1 which is parallel to BL2. The movement from E1 to E2 on
the same indifference curve shows the substitution effect. Thus,
the consumer increases the quantity demanded of good X (an
inferior good) from X1 to X2 because it is now cheaper than
good Y.
Income Effect:
When consumer real income increases due to fall in price of
good X, he decreases its quantity from X2 to X3. Since the
positive substitution effect is greater than the positive price
effect, the income effect must be negative which is equal to X2
to X3.

Q.6

(i) (c) (ii) (d) (iii) (c) (iv) (b)


(v) (a) (vi) (b) (vii) (b) (viii) (d)

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