MICRO ECONOMICS QUESTION BANK

Q1) Explain the meaning and theory of production function?

Ans) The production function shows the relationship between the amount of goods a firm produces
(output) and the resources it uses to make them, like labour, capital, and land.

It tells us how much output can be made if we use a certain amount of inputs. This relationship is
physical, meaning it doesn’t deal with money or prices—just the actual quantities of input and
output.

The production function is always for a specific period of time. It shows how a flow of inputs, like
hours of work or number of machines, leads to a flow of output, like the number of products made,
during that time.

Another important point is that the production function depends on technology. When technology
improves, a firm can often produce more output with the same amount of inputs, or use fewer
inputs to produce the same output.

However, not all changes are helpful—sometimes new technology may require more inputs for the
same result.

We can also express the production function mathematically.

A general form is:

Q = f(L, C, N)

Where:

• Q is the quantity of output,

• L is labour,

• C is capital, and

• N is land.

In a simpler case, with just labour and capital, it becomes:

Q = f(L, C)

So, in simple terms, the production function helps us understand how much we can produce if we
know how many workers, machines, and land we have—and how that changes with technology.

DEFININATION :-“Production function is the relationship between inputs of productive

services per unit of time and outputs of product per unit of time.” Prof.

George J. Stigler

THE THEORY OF PRODUCTION:-

• Inputs and Outputs:
Inputs are the resources used in the production process—such as labour (workers), capital
(machines and tools), and raw materials (like wood, metal, etc.). These are combined in
different ways to create final products or services, which are the outputs.

• Production Function:
This is a mathematical formula that shows how much output can be produced with different
combinations of inputs. It helps businesses and economists understand the relationship between
the amount of resources used and the goods produced.

• Marginal Product:
This concept explains how much extra output is produced when one more unit of an input is
added, while keeping other inputs the same. For example, if a company hires one more worker,
the marginal product is the number of extra items that worker helps to produce.

• Law of Diminishing Marginal Returns:

This law states that if you keep increasing one input (like more workers) while keeping others
fixed (like the number of machines), the additional output from each new input will eventually
get smaller. This happens because resources become too crowded or less efficient when
overused.

• Optimal Resource Allocation:

The theory helps firms figure out the best combination of inputs to get the highest output or to
produce goods at the lowest cost. This helps in using resources efficiently and avoiding waste.

• Production Levels:
It explains how changing the amount of inputs affects how much a firm can produce. This helps
businesses make better decisions about how much to produce based on available resources and
customer demand.

• Technology and Innovation:

Improvements in technology can lead to more efficient production. For example, a new machine
might allow a company to produce more goods in less time or with fewer workers. Innovation
can change the production process, increasing output with the same or even fewer inputs.

• Importance:
The Theory of Production is essential in economics because it guides decision-making for
businesses and governments. It helps them understand how to use resources wisely, how to
increase productivity, and how to meet consumer needs in the most efficient way.
Q2) THE LAW OF VARIABLE PROPORTION?

ANS) The Law of Variable Proportions, also known as the Law of Diminishing
Returns, is a vital concept in microeconomics that explains how production
output changes when only one input is increased while others are held
constant. This law mainly applies to the short-run production period, where
one input is fixed (like capital or land), and the other input (usually labour) is
varied.
This law states that as the quantity of a variable input increases, the total
output initially rises at an increasing rate, then at a decreasing rate, and finally
begins to decline. This happens because fixed inputs become overused and
cannot contribute effectively to the increasing amount of variable inputs.

Key Concepts and Definitions:

• Short-Run: A period in which at least one factor of production (e.g.,
capital) remains fixed.
• Variable Input: The input that can be increased (usually labour).
• Fixed Input: The input that stays constant (such as land or machinery).
• Total Product (TP): The total quantity of output produced.
• Marginal Product (MP): The additional output resulting from using one
more unit of the variable input.
• Average Product (AP): The output per unit of the variable input.

Three Stages of the Law of Variable Proportions:

1. Stage I – Increasing Returns to the Variable Input:
• In this stage, Total Product (TP) increases at an increasing rate.
• Both Marginal Product (MP) and Average Product (AP) also rise.
• This stage shows growing efficiency, and each extra unit of input adds
more to the output than the previous one.
2. Stage II – Diminishing Returns to the Variable Input:
• Here, TP continues to rise but at a decreasing rate.
• MP and AP both begin to decline, though they remain positive.
• The output increases, but the efficiency of added labour drops due to
overcrowding or limited use of capital.
3. Stage III – Negative Returns to the Variable Input:
• In this final stage, TP actually declines, even though more units of the
variable input are being added.
• MP becomes negative, and AP continues to fall, though it stays above
zero.
• This stage shows inefficiency, poor coordination, and overuse of
resources.

Graphical Representation:
• A typical graph shows the TP curve rising rapidly in Stage I, slowing down
in Stage II, and falling in Stage III.
• The MP curve rises, reaches a peak, falls to zero, and then turns
negative.
• The AP curve rises, peaks, and then gradually falls but does not become
negative.

Conclusion:
The Law of Variable Proportions is a fundamental principle in economics that
illustrates how output changes as one input is increased while others remain
fixed. It is crucial for understanding production efficiency in the short run and
helps businesses plan their input usage smartly. By recognizing the three
stages—increasing returns, diminishing returns, and negative returns—firms
can produce effectively without wasting resources.

Q3) ECONOMIES OF SCALE AND DISECONOMIES OF SCALE?

ANS)When a business grows bigger, the way it makes products changes. Sometimes, the
business becomes more efficient, and it can make goods at a lower cost. This is called
economies of scale.
But if a business gets too big, it can become harder to manage. Then, the cost of making
products can go up. This is called diseconomies of scale.
Both are important in business, and companies need to know when to grow and when to
stop.

1. Economies of Scale
These are the benefits a business gets when it grows and produces more goods. It becomes
cheaper to make each product because fixed costs (like rent, machines, salaries) are shared
over more items.
Types of Economies of Scale:

A. Internal Economies of Scale (happen inside the business)

These happen when a business grows and improves how it works.
1. Technical Economies
• Big businesses can buy better machines or use technology to make goods faster and
more cheaply.
• For example, a large bakery can use automatic mixers and ovens to bake thousands
of loaves per day, while a small bakery does everything by hand.
2. Managerial Economies
• Bigger companies can hire skilled managers for different departments like sales, HR,
or finance.
• These managers help the company run better and reduce mistakes.
3. Financial Economies
• Large businesses are seen as safer by banks.
 • So, they get loans with lower interest rates than small businesses.
4. Purchasing Economies (also called Buying Economies)
• Big firms buy raw materials in bulk, like buying 1000 tons of flour instead of 10.
• They get discounts, so each unit costs less.
5. Marketing Economies
• Big companies can spend a lot on advertising and reach millions of people.
• The cost of one ad is shared across all products.
• Example: Coca-Cola’s ads are seen worldwide, but they only make the ad once.

B. External Economies of Scale (happen outside the business)

These happen when the whole industry grows.
1. Skilled Workers in One Area
• If many similar businesses are in one place, it’s easier to find trained workers.
2. Better Services and Infrastructure
• The government or private companies may build better roads, internet, and
transport for the area.
3. Suppliers Move Closer
• As more businesses open, suppliers of raw materials and services move nearby,
reducing costs.
Example:
In Silicon Valley, many tech companies are located close together. They all benefit from fast
internet, smart workers, and nearby software companies.

2. Diseconomies of Scale
These are the disadvantages or problems that happen when a business becomes too big.
Instead of saving money, it starts spending more to make each product.
Types of Diseconomies of Scale:

A. Internal Diseconomies of Scale (inside the business)

1. Communication Problems
• As a company grows, it has more departments and more people.
 • It becomes harder to pass information clearly and quickly.
• This can lead to mistakes or delays.
2. Slow Decision-Making
• In big businesses, decisions have to go through many levels of managers.
• This slows things down and reduces flexibility.
3. Poor Worker Motivation
• In large companies, workers might feel unimportant or unnoticed.
• This can lead to low motivation and poor performance.
Example:
In a small shop, the owner knows every worker. But in a giant company, a worker might feel
like “just a number.”

B. External Diseconomies of Scale (outside the business)

1. Too Much Competition for Resources
• When many big companies are in one area, they all need land, workers, and raw
materials.
• Prices go up because everyone wants the same things.
2. Traffic and Pollution
• Too many businesses in one place can cause traffic jams and pollution.
• This leads to complaints, fines, or new government rules that increase costs.

Conclusion
Economies of scale help businesses become stronger, make more profit, and sell at lower
prices. But if they grow too big, they can face problems like confusion, waste, or high costs –
these are diseconomies of scale. So, businesses must grow wisely. They should aim to reach
the right size – big enough to benefit, but not too big to suffer.

Q4 Explain the Law of Returns To Scale ?( Increasing and , Decreasing )

ANS) The Law of Returns to Scale explains how a firm’s output changes when it increases all
inputs (like labour and capital) in the same proportion in the long run. Unlike the short
run—where some inputs are fixed—in the long run, a firm can change all factors of
production. This law helps us understand the efficiency and productivity of firms as they
grow larger and expand production.

When a firm increases its inputs (e.g. both labour and capital) in the same ratio, the
resulting change in output can be of three types:
1. Increasing Returns to Scale
2. Constant Returns to Scale
3. Decreasing (or Diminishing) Returns to Scale
In the long run, output can be increased by increasing all factors in the same proportion.
Generally, laws of returns to scale refer to an increase in output due to increase in all factors
in the same proportion. Such an increase is called returns to scale. Suppose, initially
production function is as follows: P = f (L, K) Now, if both the factors of production i.e.,
labour and capital are increased in same proportion i.e., x, product function will be
rewritten as.

The above stated table explains the following three stages of returns to scale:

Increasing Returns to Scale: Increasing returns to scale or diminishing cost refers to a

situation when all factors of production are increased, output increases at a higher rate. It
means if all inputs are doubled, output will also increase at the faster rate than double.
Hence, it is said to be increasing returns to scale. This increase is due to many reasons like
division external economies of scale. Increasing returns to scale can be illustrated with
thehelp of a diagram 8.

In figure 8, the OX axis represents an increase in labour and capital while the OY axis shows
an increase in output. When labour and capital increases from Q to Q1, output also
increases from P to P1 which is higher than the factors of production i.e. labour and capital.
Diminishing Returns to Scale: Diminishing returns or increasing costs refer to that
production situation, where if all the factors of production are increased in a given
proportion, output increases in a smaller proportion. It means, if inputs are doubled, output
will be less than doubled. If 20 percent increase in labour and capital is followed by 10
percent increase in output, then it is an instance of diminishing returns to scale. The main
cause of the operation of diminishing returns to scale is that internal and external
economies are less than internal and external diseconomies. It is clear from diagram 9.

In this diagram 9, diminishing returns to scale has been shown. On

the OX axis, labour and capital are given while on the OY axis, output. When factors of
production increase from Q to Q1 (more quantity) but as a result increase in output, i.e. P to
P1 is less. We see that the increase in factors of production is more and increase in
production is comparatively less, thus diminishing returns to scale apply.

Constant Returns to Scale: Constant returns to scale or constant cost refers to the
production situation in which output increases exactly in the same proportion in which
factors of production are increased. In simple terms, if factors of production are doubled
output will also be doubled. In this case internal and external economies are exactly equal
to internal and external diseconomies. This situation arises when after reaching a certain
level of production, economies of scale are balanced by diseconomies of scale. This is known
as homogeneous production function. Cobb-Douglas linear homogenous production
function is a good example of this kind. This is shown in diagram 10. In figure 10, we see that
increase in factors of production i.e. labour and capital are equal to the proportion of output
increase. Therefore, the result is constant returns to scale.
1) Short Notes - 5 Marks (Compulsory )

A)Write a note on Total Cost ?

Ans) Total Cost (TC) refers to the total amount of money a business spends to
produce goods or services. Every business, no matter what it produces, has
costs involved in making those products, whether it's a small bakery or a big
factory. These costs are essential to calculate because they help the business
understand how much it spends in total and whether it can make a profit.

Total cost is the combination of two types of costs:

1. Fixed Costs (FC):

Fixed costs are costs that do not change, regardless of how many
products a company produces. These costs remain the same even if the
company produces zero products. They are predictable and constant.

Examples of Fixed Costs:

Rent: The cost of leasing or renting the building where the business operates.

Salaries of permanent employees: The wages of managers, security staff, or

office workers who are paid the same amount regardless of how much is
produced.

Insurance: The premium paid for business insurance remains the same.

Depreciation: The reduction in value of machinery or equipment over time.

Since fixed costs don't depend on production, they have to be paid even if the
business isn't producing anything. This makes them easy to calculate and
manage, but they can put pressure on a business if sales are low.

2. Variable Costs (VC):

Variable costs change directly in line with the amount of goods or
services a company produces. The more products a company makes, the
 higher the variable costs. If the company stops producing, variable costs
also stop.

Examples of Variable Costs:

Raw Materials: If you're making toys, you need more plastic, paint, and
packaging material the more toys you produce.

Labor (Wages for temporary workers): If workers are paid per item they make
(like piece-rate workers), then the cost increases with the number of products
made.

Utilities (Electricity, Water): The more machines running, the more electricity
is needed. More production means higher energy bills.

Shipping Costs: If the company ships products, the shipping costs will increase
with the number of products sold.

Variable costs are closely linked to production levels, so they are more flexible
than fixed costs. When production goes up, variable costs go up, and when
production slows down, variable costs go down.

Formula for Total Cost:

The total cost is simply the sum of the fixed costs and variable costs. The
formula looks like this:

Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC)

For example, let’s say:

• A factory has fixed costs of $2,000 (for rent and salaries).

• The variable costs for producing 500 units of a product are $1,500 (for
materials, temporary workers, and utilities).

So, the total cost for producing 500 units would be:

TC = $2,000 (Fixed Costs) + $1,500 (Variable Costs) = $3,500

This means the factory spends $3,500 to produce 500 units.

B) What Is Social Cost and Private Cost ?

Ans) Private Costs

Definition: Private costs are the costs that a person or business pays directly
when they are involved in an activity. These are the expenses related to
producing or consuming a product that are paid by the producer or the
consumer only.

Examples:

A business pays for raw materials, labor, and machinery to make products.
These are the business's private costs.

A consumer pays for the price of a product or service, like buying a phone or
paying for a movie ticket. This is their private cost.

Relevance:
Private costs are what businesses or consumers think about when deciding if
it's worth making or buying something. If the private costs are too high, they
might not do it.

Social Costs

Definition:
Social costs are the total costs of an activity, including both private costs (the
costs that the business or consumer pays) and external costs (costs that affect
other people who aren't directly involved in the activity). Social costs look at
the bigger impact on society as a whole.

Examples:

If a factory makes products but also pollutes the environment, the factory’s
private cost is for wages and materials. But the social cost includes the harm
caused by the pollution, like the cost of cleaning it up and the health problems
for people nearby.

When people drive cars, they pay for fuel and maintenance (private cost). But
the social cost also includes traffic jams, road damage, and pollution, which
affect other people.

Relevance:
Social costs are important because they show the true impact of an activity on
society. If we only think about private costs, businesses might make too many
harmful products or services (like polluting), or too few helpful ones (like green
energy). This can lead to problems in the economy, called market failure.

In short:

• Private Costs are what individuals or firms pay directly for their activities.

• Social Costs include both private costs and any extra costs that affect
others, like pollution or traffic.

C) Define Total Revenue

Ans) Total Revenue (TR) is the total amount of money a business makes from
selling its products or services. It’s calculated by multiplying the price of each
product by the number of products sold. For example, if a business sells a
product for $10 and sells 100 items, the total revenue would be $1,000. This is
the money the business earns from sales before subtracting any costs or
expenses.

Understanding total revenue is important because it shows how well a

business is performing in terms of sales. However, it doesn't tell the full picture
of profitability. A business can have high total revenue but still be losing money
if its costs are too high. For example, if the business spends a lot of money on
making the product or running the company, its profit could be small or even
negative.
The total revenue also helps businesses decide on their pricing strategies. If a
company raises the price of a product, it may make more money per item sold,
but the number of items sold may decrease. On the other hand, lowering the
price could lead to selling more products, but it depends on how much the
sales increase. Knowing how to balance price and sales is crucial for a
business’s success.

In short, total revenue is the income a business gets from selling its products,
and it helps business owners understand how much money they are making
from their sales activities.

D) Marginal Revenue ?

Ans) Marginal Revenue (MR) is the additional revenue a business earns from
selling one more unit of a product. It helps businesses understand how much
extra income they generate when they sell one additional unit.

For example, consider a company that sells a product for ₹500 each. If they sell
100 units, their total revenue is ₹50,000 (100 × ₹500). If they sell one more
unit, making it 101 units, their total revenue increases to ₹50,500 (101 × ₹500).
The marginal revenue is the difference in total revenue, which in this case is
₹500 (₹50,500 - ₹50,000). This means the company earns ₹500 in extra
revenue by selling one additional unit.

Marginal revenue is important because it helps businesses decide whether

increasing production will be profitable. If the marginal revenue is greater than
the cost of producing one additional unit (known as marginal cost), then it is
profitable to produce more units. However, if the marginal revenue is less than
the marginal cost, producing more units could lead to a loss.

Businesses often experience a decrease in marginal revenue as they continue

to produce and sell more units, especially in competitive markets. This is due
to the law of diminishing returns, which suggests that the additional revenue
from each new unit sold tends to decrease as the number of units increases.
Understanding marginal revenue also helps businesses determine the optimal
price for their products. By balancing price and production, they can maximize
their total revenue and avoid producing beyond a profitable point.

In summary, understanding marginal revenue is essential for businesses to

optimize their production levels and pricing strategies in order to maximize
their profits. It provides valuable insights into how changes in production affect
overall revenue and helps guide important business decisions.

D) Explicit and Implicit Cost

Ans) Explicit and Implicit Costs

Explicit Costs and Implicit Costs are two types of costs that businesses face
when producing goods or services. These costs help to determine the total cost
of running a business and are essential for calculating profits. Here's a
breakdown of each:

Explicit Costs

Definition:
Explicit costs are direct, out-of-pocket expenses that a business incurs while
running its operations. These costs are clearly stated in the company's financial
records, and they involve actual cash payments.

Examples:

• Wages paid to employees.

• Rent for office space or factory premises.

• Raw materials used in production.

• Utilities like electricity and water.

• Insurance premiums.
These are the costs that are easy to identify and quantify because money is
actually paid out for them.

Relevance:
Explicit costs are important because they are accounted for in the financial
statements of a business, such as the income statement. They are also used to
calculate a business’s accounting profit, which is Total Revenue - Explicit
Costs.

Implicit Costs

Definition:
Implicit costs represent the opportunity costs of using resources owned by the
business, which could have been used elsewhere. These costs do not involve
actual monetary payments, but they still reflect the potential income or
benefit that is foregone by choosing one option over another.

Examples:

• The owner’s time spent running the business instead of working

elsewhere.

• The use of the business owner’s capital, like using personal savings to
finance the business instead of earning interest or investment returns
elsewhere.

• The use of personal equipment for business activities, which could have
been rented or used for other purposes.

Relevance:
Implicit costs are important for understanding the true economic profit of a
business. Economic profit is calculated as Total Revenue - (Explicit Costs +
Implicit Costs). Implicit costs are not recorded in financial statements but are
critical for assessing the opportunity cost of business decisions.
F)Opportunity Cost

Ans) Opportunity Cost is a key concept in economics that refers to the value
of the next best alternative that must be sacrificed when making a decision.
Essentially, it is the cost of forgoing the next best option when a choice is
made. Every decision we make involves trade-offs, and opportunity cost helps
to quantify what we lose by choosing one option over another.

For example, consider a business that decides to invest ₹10,000 in new

machinery to increase production. The opportunity cost here would be the
alternative uses of that ₹10,000, such as spending it on marketing to attract
more customers or hiring additional staff to improve efficiency. By choosing to
buy the machinery, the company gives up the potential benefits it could have
gained from these other investments.

Similarly, on a personal level, if you decide to spend your evening studying for
an exam rather than attending a movie, the opportunity cost is the
entertainment and relaxation you miss out on. This helps to show that the cost
of a decision is not always just financial; it can also include time, enjoyment, or
other resources.

In business and economics, understanding opportunity cost is crucial because

it allows individuals and organizations to make more informed choices. It
highlights that every decision has consequences, and by considering what you
are giving up, you can weigh the trade-offs more effectively. For governments,
opportunity cost plays a role in policy-making, where allocating funds to one
project, like building infrastructure, may mean sacrificing the benefits of
funding other areas, such as healthcare or education.

Ultimately, opportunity cost encourages better decision-making by reminding

us that resources (like money, time, and effort) are limited. Whether for
individuals or businesses, evaluating opportunity costs ensures that resources
are used in the most productive way possible.