Economics Questions And Answers

The law of diminishing marginal

The law of diminishing marginal returns stats that when a firm introduces
more variable inputs successively with one fixed factor of production, total
returns would continuously increase, but marginal returns would diminish
(Anderton, 1993). This can be explained with the help of graph given below.

It can be seen from the graph that when the firm was initially increasing the
number of workers, total output was increasing at a greater rate every time;
this is not because every new worker is more productive but merely because
of the combined effect (Colander, 2007).

It can also be seen that total output is ultimately increasing at a decreasing

rate. This basically is occurring because the proportion of inputs is
continuously varying. The firm is facing scarcity of resources of capital
(Lipsey, 2002). The ratio between capital and labour is continuously
widening, which means that after a certain time, the capital is not enough for
the increased workers, hence the returns started to diminish.

Since this situation would always be faced by every firm in the short run.
That is why this fact is known as the law of variable proportions or
diminishing returns.

E.g. if the firm is facing shortage of capital, then increasing the number of
labourers would benefit it to the extent where by it can make 6 workers work
at a machine at a time, rather than two. However when all the machines
would be fully employed along with their operators, than the hiring up of new
workers would only lead to increased costs, but no increased output or
productivity.

In short, a firm faces diminishing returns when it increases its factor inputs
with one factor fixed (i.e. the short run) and hence suffers diminishing
productivities (Lipsey, 2002).

On the other hand, economies of scales are those cost saving advantages
which occur when a firm increases its scale of production. This might be
informed of purchasing/bulk buying economies, technical economies,
marketing, managerial, financial and risk bearing economies.

The decreasing economies of scale is the phenomenon which applies to the

long run production of a firm. In fact, this phenomenon even includes the
theory of Diminishing Marginal Returns. It so happens that when the firm
adopts an ever-increasing production status (in the long run) its cost saving
advantages tend to be more and more less (Lipsey, 2002). E.g. Bulk buying
discounts may reach at a certain limit and then no longer discounts be
offered. Similarly, fixed costs might be at first spread at a higher proportion
that this proportion might decline with time, since the addition of more units
would tend to contribute lesser in bearing up fixed costs. The economies of
scale which would have been showing increasing returns to scale would then
start to show diminishing returns to scale. This is also known as
Diseconomies of Scale (Anderton, 1993).

When the size of the organization becomes too big, the actual owner cannot
control everything directly due to which de centralization occurs.
Organization structure widens horizontally and vertically. Chain of command
becomes too long due to which communication gaps develop. The mangers
are unable to coordinate across different departments. Due to these factors,
decision making is delayed. Apart from that, being away from centre, lower
level managers do not remain efficient. In short due to large size of
organization, it becomes difficult to manage, due to which per unit cost
ultimately increases (Young, 1987).

Too many workers are appointed to handle large scale production, due to
which supervision cost increases by more than proportionately. Workers are
not handled properly be the management. Monetary and non-monetary
benefits are not in line with worker’s productivity; therefore de motivation
among many workers develops. These all factors contribute to an increase in
total cost greater in proportion to output.

Explain and illustrate using diagrams the difference

between price and non price influences that affect the
behaviour of a demand curve.

Answer:

A demand curve shows the respective quantities of goods that consumers

are willing and able to buy at different prices. The behaviour of a demand
curve can be elastic, or inelastic.

Elasticity of demand is referred to as the responsiveness of demand towards

a change in price. An inelastic behaviour of the demand curve would tell that
consumers are irresponsive towards changes in price. Similarly, an elastic
behaviour of the demand curve would show that more consumers are
responsive towards price changes. It normally happens that consumers start
buying more, or new consumers start buying the product, when its price falls
and vice versa.
The price factor which determines the demand curve behaviour is its
expensiveness or cheapness. When prices are set at higher levels, demand is
said to be more elastic. The graph given below shows that at higher levels of
demand curve, elasticity is said to be higher than 1. This means that an
upward or downward change in price would cause the demand to decrease
or increase by more than 10%. When people buy goods at high prices, and
are aware of buying it expensive, then they tend to stop using the, or
decrease its use considerably when the prices go further up. However,
people would be highly attracted towards the product if it is high priced, and
its price suddenly falls, other things constant.

Demand curve would be inelastic at lower levels of price. This happens

because since the price of the product would be set too low, consumers
would not pay heed to any changes in price. Be it high or low. Similarly since
nearly all the potential consumers would be consuming the product, there
would be no intensity for increased demand. Higher prices (at low price level)
would not affect the consumption too much (Lipsey, 2002).

Non price factors affecting the demand curve behaviour include the causes
given below:

Direct Taxes High direct taxes mean lesser disposable incomes for
consumers, and hence less willingness and ability to buy. Lower direct taxes
would make consumers more responsive.

Availability of Substitutes: Availability of substitutes would mean that

demand would be more elastic. Consumers might switch towards other
substitutes if price is increased.

Degree of Necessity: FMCG’s and daily purpose goods would face an

inelastic demand curve since they are necessities and are demanded at any
price level.

Degree of Addictiveness: If goods are habit forming or addictive, then

their demand would turn to be inelastic.

Proportion of Income Spent: The higher the proportion spent, the more
elastic the demand.

The Situation or location where the product is bought. E.g. a consumer won’t
pay 5 rupees extra for a bottle of Pepsi from a local shop. However,
consumers would surely pay, and Do pay 100 rupees for the pitcher
containing the same amount of Pepsi.
Elastic Demand (Non price Factor) Inelastic
Demand (Non price Factor)

Explain and illustrate using diagrams the difference

between price and non price influences that affect the
behaviour of a supply curve.

Answer:

A supply curve shows the respective quantities of goods that producers are
willing and able to buy at different prices (Parkin, 2000). The behaviour of a
supply curve can be elastic, or inelastic.

Elasticity of supply is referred to as the responsiveness of supply towards a

change in price. An inelastic behaviour of the supply curve would tell that
producer is irresponsive towards changes in price. Similarly, an elastic
behaviour of the supply curve would show that the producer(s) is responsive
towards price changes (Anderton, 1993). It normally happens that producer
starts supplying more goods in the market, or new producers enter the
market, so its price falls and vice versa.

The price factor which determines the supply curve behaviour is its
expensiveness or cheapness. When prices are set at higher levels, supply is
said to be more elastic. The graph given below shows that at higher levels of
supply curve, elasticity is said to be higher than 1 (Parkin, 2000). This means
that an upward or downward change in price would cause the supply to
decrease or increase by more than 10%. When producer sells the goods at
high prices, then they tend to stop selling the product, or decrease its supply
if offered a slightly lower price. However, producers would be highly
attracted towards the product if it is high priced, and its price suddenly falls,
other things constant.

Supply curve would be inelastic at lower levels of price. This happens

because since the price of the product would be set too low, producers would
not pay heed to any changes in price be it high or low. Similarly, since nearly
all the potential producers would be producing the product, there would be
no intensity for increased supply. Higher prices (at low price level) would not
affect the production too much. Producers would only keep on producing.

Time: Supply tends to be more elastic in the long run. Production decisions
can be changed and firms or producers can react to price changes.
Factors of Production: Supply can be elastic if FOP’s are available such as
trained labour, raw materials, etc.

Stock Levels: If there are high amounts of stock piled up in the warehouses,
then the supply would tend to be more elastic as producers would try to get
rid of old stock and accommodate newer stock.

Number of Firms in the Industry: Supply will be more elastic if there are
a lot of firms in the industry, because there will be greater chance of
someone having available factors and stock. Low number of firms
guarantees low inelasticity.

Elastic Supply (Non price Factor) Inelastic Supply

(Non price Factor)

Explain and illustrate with diagrams how and why a

marginal cost curve maps out a supply curve.

Answer:

To maximize profit a firm would sell its output at a price where it equals to its
marginal cost. I.e. the firm would keep on selling its output, until the price it
starts to receive for its output equals to the cost of producing one extra unit.
Hence a marginal cost curve maps out the supply curve of a firm. As long as
the firm produces something, it will maximize its profits by producing “on the
marginal cost curve.”

Observing the graph above, we can say that if the firm sells its output at a
price of P0, the producer would deem it profitable as long as the MC
(Marginal Cost) is being covered by P (Price). In fact, MC determines how
many units a firm will supply, because it is assumed when studying economic
that all firms have a profit maximizing objective in general. Supply curves
that are drawn by a common economics student are nothing more than
Marginal Cost curves in cover.

If a government wishes to raise more sales tax revenue

should they impose the tax on goods that show a higher or
lower price elasticity of supply? Illustrate with diagrams
and define the producer and producer incidence of this
tax.
Answer:

When an indirect tax is imposed on a good, the burden of tax is either borne
by the producer or consumer. Who will bear the burden of tax actually
depends on price elasticity of demand and supply.

In all the three cases, i.e. elastic, inelastic or unitary elastic, a tax of $2 has
been imposed. In the first case the supply curve is perfectly inelastic, in
second case the supply is only elastic, and in the third case it is perfectly
elastic.

It can be seen in the first case that when a tax of $2 has been imposed, the
price of the good has also increased by 2. It shows that all the burden of tax
has been borne by the consumer only. The reason of this is that supply is
perfectly elastic, and cannot be avoided. Producers are not willing to supply
the product at any other price than the prevalent price.

In the 2nd case supply is inelastic, which means producer is irresponsive a

change in the price, therefore any imposition of tax would cause a
contraction in supply; hence, the tax burden is shared between the
consumer and producers. It can be seen in the diagrams that imposition of a
2$ tax is reflected in price only by $1.

In the 3rd and last case, supply of the producer is perfectly inelastic which
means firms would supply this product at any price. Therefore, any tax
imposed on the producer cannot be shifted on the consumer. Hence, after
tax price is same.

It is obvious now that who will bear the tax depends on the price elasticity of
supply. The more a supply curve is elastic, the more the burden on consumer
and vice versa.

Pick an industry that you believe satisfies the

criteria of perfect competition and explain and
illustrate with diagrams your case for picking this
industry
Answer:

Perfect competition is a market structure where there are a large number of

small firms producing a homogenous good. One such type of industry could
be the farming industry. All the firms in the market (farms in this case) are so
small that their output as compared to the output of the industry is so small
that they are unable to cause any influences on the market supply and price,
therefore all the farms are to be known as price takers. Price taker means
that the price of the good is determined in the market place by the forces of
demand & supply. Whatever the price is prevalent in the market, the firm
would have to accept it. There is no union of any kind representing the
sellers, neither is there any government intervention. In a perfect
competition firms can easily enter and exit the market. Same applies for
farming, where an entrepreneur can easily set up a firm, and if deemed
unprofitable, can easily leave it. This means that there are no barriers to
entry and exit. This also means that settings up costs are very small and
there are almost no legal formalities required. This also indicates that
resources are fully transformable, as is the case with farming. Land can be
used for any other purpose, tractors be easily sold, and seeds cost very
cheap. Knowledge about price and other market conditions on the part of
consumers and firms is perfect. So is the case with farming where the
consumer nearly knows everything about the agricultural product. E.g.
consumers can commonly identify which types of signs are found in good
fruits or vegetables. Similarly, farmers do know about prevalent market rates
and other conditions. Due to this, neither producer nor the consumer is able
to exploit each other. All the firms in the industry are profit maximising firms,
and so is the case with farmers, who tend to earn more and more from
farming.

As we know that all the firms are price takers, an individual firm would sell its
whole output at the price which is predetermined in the market. Farmers
have no other choice than to sell their output at the price that is currently
being quoted for their product. Demand curve faced by a firm perfect
competition would be perfectly elastic.

Explain and illustrate with diagrams how the profit

maximising price and output is determined for (1)
the individual firm within this industry and (2) this
industry as a whole.
Answer:

The demand curve faced by the firm in this industry is perfectly elastic. Due
to this, the demand curve is also the marginal revenue curve of the firm,
because every unit is being sold at the same price. Plotting the cost structure
of the firm we can find out the profit maximising level of output of the farm.

At quantity Q in the diagram, profits of the farm are maximised. At this

quantity, the farm would be enjoying abnormal profits in the short run. As
there are no barriers to entry or exit, these abnormal profits would attract
new firms to enter into the industry, due to which prices would fall, and soon
the farm would only be making normal profit.

As the farm would only be earning normal profits, it would expect that price
would increase in the long run, and the form would be making abnormal
profits. It the price further falls and there is no positive contribution towards
fixed costs, the firm would shut down.

Explain and illustrate with diagrams the

characteristics of oligopoly.
Answer:

Oligopoly is a market structure about which no simple and straightforward

explanation can be given because it is very diverse in nature. Some
oligopolies would have only few large firms and the others would have large
number of firms but few dominant firms. On the other hand, some oligopolies
would be producing a standardised good and some a highly differentiated
good. In some oligopolies the firms would be highly competing against each
other and some might be quite cooperative. There would be strong barriers
to entry and the firms would be price makers. Knowledge about price and
other market conditions is imperfect; firms would also be involved in creating
barriers towards entry of new firms. In an oligopolistic market firms attempt
to merge or takeover other firms in order to further reduce the competition.
The behaviour of firms in an oligopoly would be quite rivalrous. All firms
would closely watch each other’s activities and would thus determine their
own strategy. The firms create the following artificial barriers:

The Oligopoly is characterised by price wars, furious non price competitions,

predatory pricing or limit pricing.

Above the kink, demand is relatively elastic because all other firm’s prices
remain unchanged. Below the link, demand is relatively inelastic because all
other firms will introduce a similar price cut, eventually leading to a price
war. Therefore, the best option for the oligopolistic firm is to produce at point
E which is the equilibrium point and the kink point. A profit maximizing
producer with some market power will set marginal costs equal to marginal
revenue.
Illustrate and explain how the oligopolistic firms
determines their collective profit maximising price
and output levels when they collude and act like a
cartel (monopoly).
Answer:

A cartel might be joined by oligopolistic firms to increase their individual

market power, and the member firms work together to determine the
combined level of output to be produced by each member and the relative
price to be charged. By being one, the cartel members try to act like a
monopoly and succeed. For e.g. if each member firm is the producer of an
undifferentiated good, such as oil, the demand curve to be faced by it would
be horizontal, that is perfectly elastic. However, if these firms join a cartel,
they will then face a joint demand curve, which would be downward sloping,
just like a monopolist. Actually, the profit maximizing decisions of an
oligopoly (in a joint cartel) are as the same of a monopoly as shown in the
figure below. The cartel member firms would decide their joint output level,
where their combined marginal cost would equal combined marginal
revenue. The cartel’s decided price would be determined by the market
demand curve at the level of output chosen by the cartel. The cartel’s profit
would, then be equal to the area of rectangular box, labeled “abcd” in our
Figure. A cartel would, just like a monopoly, try to produce or supply less
output and charge a higher price than to find it self in a competitive market.
Previously due to the elastic demand curve, the firms could not have
individually charged a high price by altering their respective outputs
individually.

Illustrate and explain with diagrams how a

cheating oligopolist would choose its profit
maximising output level if attempting to increase
its market share at the agreed original price.
Answer:

Cartel members will try to cheat on their agreement to limit production. By

producing more output than it has been agreed to a cartel member can
increase its share of the cartel’s profits. Before the cartel is formed produces
output earns no profit. After joining the cartel it reduces its output and
changes the price to the cartel price. The firm then earns profits of abcd. If a
firm were to cheat on this agreement and produce an higher output instead
of the existent one, providing the other members don’t cheat then it can
view its supply curve as horizontal at the cartel price. It cannot affect price
by changing output, therefore it can produce and sell additional outputs
without changing the price. So if a firm cheats on a cartel it gains the greater
profit instead of abcd.

Illustrate and explain with diagrams how a

cheating oligopolist would choose its profit
maximising price and output levels if it attempted
to undercut the price charged by the other
oligopolistic firms.
Answer:

One more way for members to cheat on the cartel is to lower prices. An
undetected price cut will boost company’s sales to grab the consumers from
other sellers, as well as customers who are not buying the product at all.
Some of these adjustments may be non financial, including better credit
terms, faster delivery, or related free services. The firm has an incentive to
cheat by lowering price because the demand curve facing each firm is more
elastic than the market demand curve as shown below.

Since the earlier demand curve faced by the firm in the industry as whole
would have been more inelastic, the form would not have been able to
attract buyers. However once the cartel has decided on a price, and then the
cheater tries to sells the output with a price cut, demand for the output of
that particular producer would increase considerably. The firm would
maximize its profit where MR = MC by expanding output and lowering its
price. An industry demand curve is drawn below.

It can be seen that lowering the price by the industry as a whole would not
have benefited anyone. However, if a firm cheat, then it may take the
advantage of the elastic demand curve it would face and grab market share.

Outline a micro economic reform issue that is

relevant to an economy of your choice (i.e home
country or Australia) and explain why this market
or industry reform has been implemented?

Answer:

Infrastructure and related industries form an essential part of the economy

and have been characterised by a long tradition of government ownership
and monopoly (Colander, 2007).. The operation, access and cost of
infrastructure services affect all industries and play a significant role in their
competitiveness and in the productivity of the economy

Given the importance of these industries, they have been the subject of
considerable reform effort in recent years.

Jurisdictions have pursued a wide variety of approaches in reforming their

infrastructure industries. However, the reforms can be grouped into five
broad categories: resolving specific problems (eg: 1983 rationalisation of the
Queensland Electricity Commission);

• administrative (eg: Commonwealth 1988 GBE reforms);

• pricing (eg: implementing more appropriate cost reflective pricing

systems);

• increased competition (eg: improving third party access); and

• Privatisation (eg: airlines, banks and electricity assets).

How successful do you think these reform

measures were and say why referring to some data
or research that has been performed.
Answer:

While reforms gathered some momentum over time, there was not a
seamless program of implementation. The enthusiasm for reform varied
among governments, over time and across jurisdictions. Reform in some
areas could only be taken so far and had to be revisited when further
problems were identified, lessons were learnt, or further pressures emerged.
Moreover, not all policy changes introduced could be regarded as true reform
in terms of bringing improvement in living standards. For example, some
policy changes had more to do with governments managing short term fiscal
constraints.