Economic Theory

Assignment

SET - 1

Answer – 1

In economics, demand refers to the quantity of a good or service that consumers are willing and able to buy
at a given price, within a specific time frame. It is influenced by factors such as price, consumer preferences,
income levels, and the prices of related goods. Demand is typically represented graphically as a downward-
sloping curve, showing the inverse relationship between price and quantity demanded, known as the law of
demand. It's a fundamental concept in understanding market behaviour and plays a crucial role in
determining prices and production levels.

Elasticity of demand - Elasticity of demand is a measure of how responsive the quantity demanded of a good
or service is to changes in its price. It helps us understand how sensitive consumers are to price changes and
how these changes affect total revenue for producers.

1) Price Elasticity of Demand –

i) Price elasticity of demand measures the percentage change in quantity demanded relative to a percentage
change in price.

ii) If Price Elasticity of demand is –

• More than 1 - demand is elastic, indicating that consumers are very responsive to price changes.
• Equal to 1 - demand is unit elastic, meaning that percentage change in quantity demanded equals
percentage change in price.
• Less than 1 - demand is inelastic, suggesting that consumers are not very responsive to price
changes.

2) Factors affecting Price Elasticity of Demand –

i) Availability of Substitutes - The more substitutes available, the more elastic the demand tends to be.

ii) Necessity v/s Luxury - Necessities tend to have inelastic demand, while luxuries often have elastic
demand.

iii) Time Horizon - Demand tends to be more elastic over longer periods as consumers have more time to
adjust their behaviour.

3) Income Elasticity of Demand –

i) Income Elasticity of demand measures the responsiveness of quantity demanded to changes in income.

ii) Income elasticity of demand

• More than zero – Indicates a normal good

• Less than zero – Indicates an inferior good
4) Cross price elasticity of demand –

i) Cross price elasticity of demand measures the responsiveness of quantity demanded of one good to a
change in the price of another good.

ii) Cross price elasticity of demand

• More than zero – Indicates substitute goods

• Less than zero - Indicates complimentary goods

Answer – 2
Factors affecting supply are :-

1) Technological Advancements - Innovations and technological advancements can impact supply by

lowering production costs, improving efficiency, or creating entirely new products. For example, the
development of automated machinery has significantly reduced labour costs in manufacturing, allowing
companies to increase supply without a proportional increase in costs. Similarly, advancements in
agricultural technology, such as genetically modified seeds, have increased crop yields, leading to higher
agricultural outputs.

2) Cost of Production - The cost of inputs such as labour, raw materials, and machinery significantly
influences supply. If input costs rise, producers might produce less to maintain profitability unless they can
pass those costs onto consumers through higher prices. Conversely, if input costs decrease, producers
might increase supply to take advantage of increased profitability. For instance, if the price of wheat, a
crucial input for bakeries, increases, bakeries might reduce bread production to offset rising costs.
Conversely, if technological advancements reduce the cost of solar panels, solar energy companies might
ramp up production to meet increasing demand.

3) Price of Product - The most fundamental factor affecting supply is the price of the product itself. As
the price rises, suppliers are incentivized to produce more because higher prices mean higher profits.
Conversely, if prices fall, suppliers may reduce production to avoid losses. For example, when the price of
crude oil rises, oil companies increase drilling activities to capitalize on higher profits. Conversely, if the
price of smartphones drops due to intense competition, manufacturers might scale back production to
prevent losses.

4) Government Policies and Regulations - Government policies, such as taxes, subsidies, and
regulations, can profoundly affect supply. Taxes and regulations that increase the cost of production
typically reduce supply, while subsidies or deregulation can increase supply. For instance, strict
environmental regulations might compel factories to invest in costly pollution control measures, reducing
their output to maintain profitability. Conversely, government subsidies for renewable energy production
might incentivize companies to increase supply in the renewable energy sector.

These factors interact dynamically to determine the quantity of goods and services supplied in the market.
Understanding these factors is essential for businesses, policymakers, and consumers to make informed
decisions about production, investment, and consumption.

Answer – 3
The concept of indifference curves is a fundamental tool in microeconomic analysis, particularly in
consumer theory. Indifference curves represent various combinations of two goods that provide a
consumer with equal satisfaction or utility.
The concept of indifference curves is a fundamental tool in microeconomic analysis, particularly in
consumer theory. Indifference curves represent various combinations of two goods that provide a
consumer with equal satisfaction or utility. Let's delve into the concept and characteristics of indifference
curves. Each point on an indifference curve indicates a specific combination of the two goods, and the
consumer is indifferent between these combinations. However, as we move from one indifference curve
to another, the level of satisfaction increases because higher indifference curves represent higher levels of
utility.

Characteristics of Indifference Curves :-

1) Downward Sloping - Indifference curves slope downwards from left to right, indicating the negative
relationship between the two goods. This slope reflects the principle of diminishing marginal rate of
substitution, which states that as the consumer consumes more of one good, they are willing to sacrifice
less of the other to maintain the same level of satisfaction.

2) Non – Intersecting - Indifference curves do not intersect each other. If two curves intersected, it would
imply that at the point of intersection, the consumer would be indifferent between two different levels of
satisfaction, which violates the assumption of transitivity in consumer preferences.

3) Higher indifference curve represents higher level of satisfaction - Indifference curves further from
the origin represent higher levels of satisfaction or utility for the consumer. This is because each curve
represents a different level of total utility, with higher curves indicating greater total utility.

4) Convex to the Origin - Indifference curves are convex to the origin, which means they bend inward as
they move away from the origin. This convexity reflects the diminishing marginal rate of substitution. As
the consumer has more of one good, they are less willing to give up units of that good to obtain additional
units of the other good.

5) Indifference Map - A set of indifference curves, representing different levels of satisfaction, is called an
indifference map. The map provides a comprehensive picture of the consumer's preferences for the two
goods.

6) No indifference curve touch either axis - An indifference curve never touches either axis because
such a point would imply that the consumer is consuming only one good, which contradicts the
assumption that the consumer consumes a combination of goods.

Understanding indifference curves helps economists analyze consumer behaviour, make predictions about
consumer choices, and study the effects of changes in prices or incomes on consumer preferences. It also
provides insights into the concept of consumer equilibrium, where the consumer maximizes utility subject
to their budget constraint.

Set – 2
Answer – 4
Perfect competition is a market structure characterized by a large number of small firms producing
identical products, ease of entry and exit, perfect information, and no barriers to entry. In a perfectly
competitive market, each firm is a price taker, meaning they cannot influence the market price and must
accept the prevailing market price as given.

1) Identical Products - In perfect competition, all firms produce identical or homogeneous products that
are perfect substitutes for each other. Consumers perceive no difference between the products offered by
different firms, leading to a horizontal demand curve for each individual firm.
2) Large number of buyers and sellers - Perfectly competitive markets consist of a large number of
buyers and sellers, none of whom have the market power to influence the market price individually. Each
firm's output is negligible compared to the total market output, leading to perfect competition.

3) Ease of entry and exit - Firms can freely enter or exit the market without incurring significant barriers
or costs. This condition ensures that no single firm can control the market and that new firms can enter to
compete with existing ones.

4) Perfect information - Both buyers and sellers have perfect information about market conditions,
including prices, costs, and product quality. This ensures that there are no information asymmetries in the
market, and all participants can make informed decisions.

5) Short term and long term equilibrium - In the short run, firms can make supernormal profits if
the market price exceeds average total cost (ATC). Conversely, firms may incur losses if the market price is
below ATC. However, in the long run, firms can enter or exit the market depending on profitability. If firms
are making supernormal profits, new firms will enter, increasing market supply and driving prices down
until only normal profits are earned. Conversely, if firms are incurring losses, some firms will exit, reducing
market supply and causing prices to rise until normal profits are restored.

In summary, perfect competition is a market structure characterized by numerous small firms producing
identical products, with prices determined by the intersection of market demand and supply. Each firm is
a price taker, and profits are driven to zero in the long run due to free entry and exit.

In perfect competition, price determination is driven by the interaction of market demand and supply.
Each firm in a perfectly competitive market is a price taker, meaning it has no influence over the market
price and must accept the prevailing price as given. The market demand curve represents the collective
demand from consumers, while the market supply curve represents the total output supplied by all firms.

The equilibrium price is established where market demand equals market supply. At this price, the quantity
demanded by consumers equals the quantity supplied by firms. Since each firm faces a perfectly elastic
(horizontal) demand curve at the market price, they sell their output at this price.

In the short run, firms may earn supernormal profits if the market price exceeds average total cost (ATC)
or incur losses if the market price falls below ATC. However, in the long run, firms can freely enter or exit
the market, driving profits to zero as new firms enter in response to supernormal profits, and existing firms
exit in response to losses, eventually leading to a situation where firms earn only normal profits.

Answer – 5
The paradox of thrift, often attributed to the economist John Maynard Keynes, refers to a situation where
individual attempts to save more during an economic downturn can collectively lead to a decline in
aggregate demand, worsening the economic downturn. In essence, while thriftiness at an individual level
is typically considered prudent, if everyone attempts to save more simultaneously, it can have adverse
macroeconomic effects.

1) Individual saving behaviour - Individually, saving money is seen as a rational behaviour. People
save for various reasons such as retirement, emergencies, or large purchases. During economic uncertainty
or downturns, individuals may become more cautious and increase their saving rate as a hedge against
future uncertainties. This behaviour is understandable as it provides individuals with financial security and
stability.

2) Aggregate Demand - However, when everyone in an economy tries to save more simultaneously, it
leads to a decrease in consumer spending. Consumer spending is a significant component of aggregate
demand, which drives economic growth. When people spend less, businesses experience a reduction in
revenue, leading to lower profits, layoffs, and reduced investment in new projects. This decline in consumer
spending exacerbates the economic downturn, leading to a cycle of decreased demand, further layoffs,
and reduced incomes.

3) Multiplier Effect - The paradox of thrift is magnified by the multiplier effect. When individuals reduce
their spending, it affects not only the immediate recipients of that spending but also subsequent rounds
of spending. For example, if a consumer cuts back on buying a new car, it not only impacts the car
manufacturer but also the suppliers, retailers, and other businesses that rely on the automotive industry.
This ripple effect can lead to a significant contraction in economic activity.

4) Aggregate Supply - Additionally, a decrease in aggregate demand can lead to a reduction in

aggregate supply as businesses produce fewer goods and services in response to lower demand. This can
further exacerbate unemployment and decrease overall economic output.

In conclusion, while saving is prudent at an individual level, the paradox of thrift highlights how excessive
saving can have detrimental effects on the overall economy by reducing aggregate demand, exacerbating
economic downturns, and leading to a vicious cycle of decreased consumption, investment, and
employment. Effective policy responses are crucial to counteract this paradox and support economic
recovery.

Answer – 6
The Marginal Productivity Theory of Wage Determination is a fundamental concept in labour economics
that posits that the wage rate for a particular type of labour is determined by the marginal productivity of
that labour. Developed primarily by economists such as John Bates Clark and Philip Wicksteed, this theory
suggests that employers pay workers according to the additional output or marginal product they
contribute to the production process.

Here's an analysis of the Marginal Productivity Theory

1) Marginal Productivity - According to the theory, in a competitive labour market, the marginal
productivity of labour declines as more workers are hired. Initially, as more workers are added, total output
increases at an increasing rate due to specialization and division of labour. However, at some point, the
addition of more workers leads to diminishing returns, causing the marginal productivity of labour to
decline.

2) Wage determination - In a competitive labour market, employers will hire workers until the marginal
revenue product of labour equals the wage rate. The marginal revenue product of labour represents the
additional revenue generated by employing one more unit of labour. Employers will continue to hire
workers as long as the marginal revenue product exceeds the wage rate, as doing so increases profits.
Conversely, if the wage rate exceeds the marginal revenue product, employers will reduce hiring or lay off
workers to minimize costs.

3) Labour Demand Curve - The Marginal Productivity Theory implies that the demand for labour is
derived from the demand for the final product. As the demand for the final product increases, firms are
willing to pay higher wages to attract more workers to produce additional output. Conversely, a decrease
in the demand for the final product leads to a decrease in labour demand and lower wages.

4) Human capital - Another critique is that the theory does not fully account for factors such as human
capital, skills, education, and experience, which can significantly influence an individual's productivity and
earning potential. Human capital theory suggests that investments in education and training can enhance
productivity and lead to higher wages, irrespective of marginal productivity alone.