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BCOG-171: Principles of Micro Economics

BCOG-171: Principles of Micro Economics

IGNOU Solved Assignment Solution for 2021-22

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Assignment Code: BCOG-171/TMA/2021-22

Course Code: BCOG-171

Assignment Name: Principles of Micro Economics

Year: 2021-2022

Verification Status: Verified by Professor

Marks = 100


(This section contains five questions of 10 marks each)


Q1) What do you understand by economic system? Discuss the various economic systems in their sequential order. (4, 6)

Ans) The concept of economic system is represented by the following sequence:


Concept of Scarcity

All economic activity is based on the concept of "scarcity." The concept of scarcity is expressed in two fundamental facts of economic life:


Unlimited Wants or Ends:

Everyone has some desires. If they are not satisfied, they experience 'pain,' which can be physical, psychological, or a combination of both. When a want is met, however, the sensation of 'pain' is replaced by that of ‘satisfaction' or 'fulfilment.' This fact compels every human being to fulfil his desires. Some people strive to curb their desires, yet even they make an effort to fulfil their desires, no matter how limited they may be. You should be aware that various people have typically diverse wants, and that the wants of even the same individual change across time, place, and status. This is due to the fact that a person's desires are influenced by a variety of variables. These variables vary from person to person and over time. They include his physical well-being, his views and attitudes, the society to which he belongs, the location where he resides during the year, and so on. A person's desires alter as his or her money fluctuates.


Human desires have distinct qualities that should be noted in order to comprehend the nature of an economic system. One of these characteristics is that many human desires cannot be satisfied indefinitely. These desires are said to as 'recurring'. When such a desire is gratified, it resurfaces and must be satisfied again and again. For example, a person can eat to satisfy his hunger, but he will grow hungry again after a while and will require food to do so. Another feature of human desires is that they evolve through time. That is to say, while certain desires are met, new ones emerge to take their place.


These two qualities of desires, namely:

  1. Recurrence of previously gratified desires.

  2. The emergence of new desires indicates that human desires are limitless and continue to grow.

Humans have an insatiable need to enhance their standard of living and to discover new things. They have a strong desire to try new things. In addition, the ever-changing situation of affairs creates new desires.


It's worth noting that satisfying a need necessitates the usage of some commodities or services, referred to as 'means of satisfaction.' Any specific desire can be met in a variety of ways. Similarly, a single mean can be used to satisfy a variety of desires. However, for our purposes, a more important fundamental fact is that the available commodities and services are never enough to fulfil all of our recurring and ever-increasing desires.


Scarce Resources or Means:

The fulfilment of desires necessitates the allocation of resources (or the means to satisfy wants). The availability of resources is constrained by the demands. This fundamental principle applies to all individuals, groups, and communities; no matter how wealthy a person or economy is, it cannot escape the grip of scarcity.


Scarcity refers to a scenario in which available resources are insufficient to meet demand. However, finite resources can be put to other purposes. A single person can work on both building a software solution and preparing executive guidelines. Due to a lack of time, he can only accomplish one task at a time.


You've set aside three hours each day for rest and pleasure. You have a variety of alternatives at your disposal, including:

  1. Spend the time with a friend.

  2. Watch a film.

  3. Playing a video game is a fun way to pass the time.

  4. Spend time on social media sites such as Facebook, Twitter, and others.


As a result, resources must be distributed among various purposes in a methodical and coordinated manner. Every person and economy must devise a way to accomplish this.


Some scholars argue that in order to address this imbalance, humans should reduce their desires. However, just a few people agree with this idea, and their thoughts and actions have little impact on society's overall thinking and behaviour. To put it another way, society does not wish to rein in the expansion of desires. It merely seeks to please a growing number of them. And this is the fundamental pattern of behaviour that we must accept as fact.


Satisfaction of growing desires necessitates a two-pronged approach:


The resources offered by nature are insufficient to meet all of the needs of society's members. As a result, their availability must be enhanced in any way possible, such as through organising production centres, educating labour, developing production methods, and establishing institutions such as money and banking, among other things.


You've discovered that no one's every want can be met. As a result, a method must be established in which the most critical and urgent wants are identified and given precedence out of the total. In other words, finite resources must be rationed among society's members, and their usage for various purposes must be governed. It indicates that resource utilisation must be 'Economised,' which means that resources cannot be wasted or diverted to less important purposes.


An Economic System or Economy

Different communities attempt to address these difficulties in various ways, and in the process, each culture produces a 'economy.' The phrase "economy" or "economic system" covers a wide range of topics. It encompasses the complete set-up put in place to address the fundamental and long-term problem of a misalignment of means and desires. As a result, it encompasses not only a country's natural resources, but also those developed by humans. It refers to the complete process of producing, trading, exchanging, transporting, and distributing products and services. Similarly, an economic system includes many institutions such as money, banking, financial assets, and markets that were formed and maintained to achieve the above-mentioned twin aims.


You'd learn that the composition of an economy is influenced by a variety of things. The specific nature of a country's economy is determined by its natural resources, geographical and climatic variables, social, political, and religious structure, previous history, and many other elements. As a result, one country's economy may differ significantly from another's. For this reason, we refer to the Indian economy as opposed to the British or Japanese economies. As a result, the phrase "Indian Economy" refers to the entire set-up, institutions, and arrangements that Indian society has put in place to achieve the twin goals of:

  1. Increasing the number of options for satisfying desires.

  2. Using them in the most cost-effective way possible. The Indian economy includes all natural and man-made producing resources.


Knowledge of an economy's most important and distinguishing characteristics aids in the analysis of its issues and potential remedies. As a result, we classify economies based on their defining characteristics. Take the instance of a capitalist economy, for example. Individuals own and inherit the means of production in this instance, and prices of commodities and services in the market govern various economic decisions. An individual's income is determined by the means of production he provides to the market and the prices at which he is compensated for his services.


Another way to distinguish between different economies is to look at the type of productive resources, income, and employment, for example. An economy might be agricultural or industrial based on this foundation. Similarly, an economy can be classified as developed or underdeveloped depending on its level of development (that is, its ability to provide means of fulfilment). It's also worth noting that, throughout time, the key characteristics of an economy change, whether as a result of historical evolution or purposeful policy initiatives. As a result, every economy must address the fundamental issue of a scarcity of means of fulfilment in the face of ever-increasing desires. Alternative combinations of means and desires are possible. Whether a country's economy is developed or underdeveloped, scarcity is a concern.


As a result, it must handle two issues:

  1. Increasing the number of options for gratification.

  2. Defining the needs that must be met in order of priority.


Economic Entities

An economic system's decision-making elements are known as economic entities. Individuals, households, business entities and companies, institutions, and other State organs are commonly thought of as economic units. They make a range of decisions in their various roles as consumers, savers, investors, buyers of inputs, suppliers of goods and services, borrowers, lenders, and so on. Economic entities' decisions and activities make up the workings of an economy and define its health and efficiency.


Q2) Diagrammatically explain the concepts if income effect, substitution effect and price effect. Also show the manner in which price effect can be split up into income and substitution effects. (6, 4)

Ans) The law of demand holds that the price of a commodity is inversely proportional to the quantity required. Why is this the case? The following three concepts can be used to provide the answer:


Price Effect is the sum total of the substitution effect and income effect, i.e.

PE = SE + IE

Where PE = Price Effect.

SE = Substitution Effect

IE = Income Effect


Substitution Effect

A change in the relative price of a commodity causes the substitution effect. Assume that a Pepsi can and a Coke can both cost $20. If the price of Coke is raised to $25 and the price of Pepsi remains unchanged, Pepsi will become relatively less expensive than Coke, i.e., while the absolute price of Pepsi remains unchanged, the relative price of Pepsi has decreased. The substitution effect is caused by a change in the relative price of a commodity.


When the price of a commodity, such as mangoes, lowers while the price of other fruits remains stable, the customer purchases more mangoes while purchasing fewer other fruits. This occurs because mango begins to appear less expensive to him. This can also be phrased as the consumer substituting other fruits for mango when the price of mango falls. The ‘substitution effect' is the name given to this phenomenon. When the price of mango falls, consumers are more likely to buy more of it, as long as the price of other fruits remains unchanged.


Income Effect

As the price of mango falls, the purchasing power of that given money income rises, or to put it another way, as the price of mango falls, the purchasing power of that given money income rises, or to put it another way, as the price of mango falls, the purchasing power of that given money income rises, or to put it another way, as the price of mango falls, the purchasing power of that given money income rises. As a result, he may buy more mangoes with the same amount of money, and hence the demand for mangoes is likely to rise.


The 'income effect' refers to the increase in real income that occurs when the price of an item falls. A rise in monetary income has the same effect on the quantity of an item demanded as a rise in real income. A 'normal commodity' is one whose quantity desired rises in tandem with the increase in money or real income. In this scenario, the income effect is referred to as a positive income effect. It is positive since the quantity sought and the income have a direct relationship. A negative income effect occurs when an increase in money or real income causes a decrease in the quantity required of a commodity. When a commodity is classified as a 'inferior commodity,' the negative income effect kicks in. In comparison to a branded cardigan, an unbranded cardigan is a lower-quality product.


Price Effect

The 'price effect' ties the amount required of a commodity to the price of the commodity by combining the substitution effect and the income effect. When the price of a commodity changes, it's vital to remember that the substitution effect and the income effect don't happen in that order. In reality, when the price of a commodity changes, both substitution and income impacts occur at the same time. When the 'substitution effect' and the 'income effect' are combined, the result is the 'price effect.' There are three examples that we can think of.


  1. The substitution effect always works in such a way that when the price of a commodity declines, the quantity required of it rises. If, in addition to the replacement impact, we include the income effect, and if it is positive (as in the case of a normal item), the rule of demand will inevitably apply.

  2. Given substitution effect, if income effect is negative (a case of an inferior commodity) the law of demand can still apply provided the substitution effect outweighs or is more powerful than the negative income effect.

  3. If the income effect is negative (as in the case of an inferior commodity), the law of demand will not apply as long as the negative income effect outweighs or outweighs or outweighs the substitution effect.


The substitution effect and the income effect were named after the effects of a change in the price of bread on the quantity demanded by J.R. Hicks. When the price of x, and hence the relative prices of x and y, vary, the substitution effect indicates how consumption of x changes.


Q3) Distinguish between fixed and variable inputs. What is the importance of this distinction in the theory of production? (6, 4)

Ans) Fixed inputs can't be quickly increased or lowered in a short period of time. The building is a fixed input in the pizza example. When an entrepreneur signs a lease, he or she is obligated to stay in the building until it expires. The maximum output capacity of a company is defined by fixed inputs. This is similar to the maximum quantities of products a society can generate at a given time with its available resources, as illustrated by society's production possibilities curve. Fixed inputs do not alter in response to changes in output.


Inputs that can be quickly raised or lowered in a short period of time are known as variable inputs. Ingredients would be changeable inputs because the pizzaiolo might order more with a phone call. The owner might also swiftly recruit a new individual to work the counter. As output varies, variable inputs rise or decrease.


It's crucial to classify inputs into fixed and variable inputs while analysing the manufacturing process. A fixed input is one whose amount cannot easily change in response to changes in output. This position is presented to us due to the analytical simplicity of the issue, not because any input is ever completely fixed. Buildings, machinery, and management are examples of inputs that are difficult to increase or decrease.


A variable input, on the other hand, is one whose quantity can be adjusted at the same time as desired output changes. Variable inputs include the employment of unskilled and semi-skilled labour as well as raw material inputs.


Q4) What is meant by income inequality? How is distribution of income different in the less developed countries from that in the developed countries? (4, 6)

Ans) In economics, income inequality refers to a considerable gap in income distribution among people, groups, communities, social classes, or countries. Inequality in income is a significant aspect of social stratification and social class. Many other forms of inequality, such as income, political power, and social position, impact and are affected by it. Income is a fundamental driver of quality of life, affecting the health and well-being of individuals and families, and it varies according to social characteristics including gender, age, and race or ethnicity.


A society is made up of many individuals and homes. All of the output of consumer products and services is destined for their consumption. As a result, all created products and services must be dispersed to individuals and households. Each individual's and household's portion, as well as the quantities of certain commodities and services that make up that share, must be decided.


Individual members of society's income shares are determined in the following way under a market-based economic system. Producing resources are privately owned in a market economy. They are sold, bought, and rented in the same way that other commodities and services are. The market forces of demand and supply determine the price of a productive resource. Whenever a producer wants to use it, he must pay the market price to the owner. It is up to the owner to either supply it to the market or not. Under these circumstances, each individual's income is determined by the amounts of various productive resources he owns and supplies to the market, as well as their respective values.


Clearly, there are numerous flaws in this income distribution system. It has nothing to do with the effort put forth by society's members. The ownership of means of production is unequally distributed among society's members. This leads to large-scale income distribution discrepancies. Governments in modern economies attempt to eliminate inequality by various methods such as taxation, among others. In a socialist economy, on the other hand, efforts are made to eliminate inequalities by transferring ownership of means of production (other than labour) to the state or cooperatives and tying individual members of society's earnings to their work performance. The state ensures that everyone has access to basic essentials and that the elderly, sick, and children are cared for. Individuals might supplement their income by completing supplementary work.


It is conceivable to have total physical rationing of commodities and services in an immature economic system with a small number of houses and persons. However, as a country develops, its organisational structure grows more complicated. It begins to produce significantly more goods and services. As the number of jobs grows, so does the variety of inputs and outputs, resulting in a growth in goods and services. Quite frequently, the size of the society grows as well.


It is no longer conceivable to have a system of comprehensive physical rationing of goods and services in such conditions. It is more feasible to secure individual members of society's purchasing capacity while also setting pricing for goods and services. When members have purchasing power, they can choose what they want to buy and how much they want to pay for it, as long as they pay for it. However, in this case, the issue of who to produce boils down to the allocation of revenue among society's members. It's possible that the real structure of income distribution contains inequities that society finds unacceptable. In that instance, the government uses a variety of policy tools, including taxation, to try to change the income distribution.


There is no simple answer to the distribution problem. It is not always possible for everyone to agree on a specific rule of income distribution or the level of income inequality that should be tolerated. It's also difficult to evaluate the relative needs of society's members. Furthermore, every system of income distribution is going to have an impact on the members of society's incentives for production and, as a result, on the amount of national revenue.


Q5) Explain the marginal productivity theory of distribution. Also state its assumptions. (4, 6)

Ans) J. B. Clark created the marginal productivity theory of distribution around the end of the nineteenth century, and it explains how the price (of the earnings) of a factor of production is decided. In other words, it proposes some basic rules for distributing national wealth across the four production elements.


The price (or earnings) of a factor tends to equal the value of its marginal product, according to this idea. Rent is equal to the value of the marginal product (VMP) of land; wages are equal to the value of the marginal product (VMP) of labour, and so on. To compute the factor price, neo-classical economists used the same profit maximisation approach (MC = MR). Just as an entrepreneur maximises total profits by equating MC and MR, he also maximises profits by equating each factor's marginal output with its marginal cost.


Assumptions of the Theory


The marginal productivity theory of distribution is based on the following seven assumptions:


Perfect Competition in both Product and Factor Markets:

Firstly, the theory assumes the perfect competition in both product and factor markets. It means that both the price of the product and the price of the factor (say, labour) remains unchanged.


Operation of the Law of Diminishing Returns:

Secondly, the theory assumes that the marginal product of a factor would diminish as additional units of the factor are employed while keeping other factors constant.


Homogeneity and Divisibility of the Factor:

Thirdly, all the units of a factor are assumed to be divisible and homogeneous. It means that a factor can be divided into small units and each unit of it will be of the same kind and of the same quality.


Operation of the Law of Substitution:

Fourthly, the theory assumes the possibility of the substitution of different factors. It means that the factors like labour, capital and others can be freely and easily substituted for one another. For example, land can be substituted by labour and labour by capital.


Profit Maximisation:

Fifthly, the employer is assumed to employ the different factors in such a way and in such a proportion that he gets the maximum profits. This can be achieved by employing each factor up to that level at which the price of each is equal to the value of its marginal product.


Full Employment of Factors:

Sixthly, the theory assumes full employment for factors. Otherwise each factor cannot be paid in accordance with its marginal product. If some units of a particular factor remain unemployed, they would be then willing to accept the employment at a price less than the value of their marginal product.


Exhaustion of the Total Product:

Finally, the theory assumes that the payment to each factor according to its marginal productivity completely exhausts the total product, leaving neither a surplus nor a deficit at the end.


Section B

(This section contains five short questions of 6 marks each)


Q6) State the reasons on account of which almost every modern economy is a dynamic one. (6)

Ans) Both the parameters of the economy and other items are permitted to alter in an unpredictable manner in dynamic economics or dynamic analysis. As a result, calculating the new equilibrium position using initial equilibrium conditions is no longer possible. As a result, in dynamic analysis, economic changes occur at rates that are constantly altering in an unpredictable manner. The only way to determine a variable's current position in the economy in comparison to its starting position is to trace the path of change, that is, to follow each state of change and account for any difference in all the deciding causes. It's worth noting that, in actuality, practically every economic system is dynamic, meaning it changes in unpredictable ways. It is especially true in modern economy, where there is a constant endeavour to speed up the process of growth while still being subject to external influences. Static analysis, on the other hand, has its advantages. It instructs an analyst on how to account for each variable.


Q7) Explain the exceptions to the law of demand using the distinction between substitution and income effects. (6)

Ans) It's worth noting that the law of supply and demand holds true in the vast majority of circumstances. The price will continue to fluctuate until it reaches a point of equilibrium. The law of demand, however, has notable exceptions. Giffen commodities, Veblen goods, probable price shifts, and vital goods are among them.


The following are exceptions to the law of demand:


Giffen Goods

Giffen Goods is a concept that was introduced by Sir Robert Giffen. These goods are goods that are inferior in comparison to luxury goods. However, the unique characteristic of Giffen goods is that as its price increases, the demand also increases. And this feature is what makes it an exception to the law of demand.


The Irish Potato Famine is a classic example of the Giffen goods concept. Potato is a staple in the Irish diet. During the potato famine, when the price of potatoes increased, people spent less on luxury foods such as meat and bought more potatoes to stick to their diet. So as the price of potatoes increased, so did the demand, which is a complete reversal of the law of demand.


Veblen Goods

The second exception to the law of demand is the concept of Veblen goods. Veblen Goods is a concept that is named after the economist Thorstein Veblen, who introduced the theory of “conspicuous consumption“. According to Veblen, there are certain goods that become more valuable as their price increases. If a product is expensive, then its value and utility are perceived to be more, and hence the demand for that product increases.


And this happens mostly with precious metals and stones such as gold and diamonds and luxury cars such as Rolls-Royce. As the price of these goods increases, their demand also increases because these products then become a status symbol.


The Expectation of Price Change:

In addition to Giffen and Veblen goods, another exception to the law of demand is the expectation of price change. There are times when the price of a product increases and market conditions are such that the product may get more expensive. In such cases, consumers may buy more of these products before the price increases any further. Consequently, when the price drops or may be expected to drop further, consumers might postpone the purchase to avail the benefits of a lower price.


For instance, in recent times, the price of onions had increased to quite an extent. Consumers started buying and storing more onions fearing further price rise, which resulted in increased demand.


There are also times when consumers may buy and store commodities due to a fear of shortage. Therefore, even if the price of a product increases, its associated demand may also increase as the product may be taken off the shelf or it might cease to exist in the market.


Necessary Goods and Services:

Another exception to the law of demand is necessary or basic goods. People will continue to buy necessities such as medicines or basic staples such as sugar or salt even if the price increases. The prices of these products do not affect their associated demand.


Change in Income:

Sometimes the demand for a product may change according to the change in income. If a household’s income increases, they may purchase more products irrespective of the increase in their price, thereby increasing the demand for the product. Similarly, they might postpone buying a product even if its price reduces if their income has reduced. Hence, change in a consumer’s income pattern may also be an exception to the law of demand.


Solved Example:

Q: Which of the following is a Veblen Good?

(i) Potatoes

(ii) Salt

(iii) Luxury Car

(iv) None of the above


Ans: The correct answer is C. A luxury car is a Veblen good. They are expensive products whose value increases if the price is higher. More expensive the product, the higher its value.


Q8) Explain the various determinants of supply of a commodity. (6)

Ans) The various determinants of supply of a commodity are as follows:


Price of the Commodity Supplied: The forces of demand and supply determine the price of a commodity. Any change in a commodity's price has an impact on the supply of that commodity. In general, the higher the price of an item, the more lucrative it is to produce or provide that commodity, assuming all other factors remain constant. The 'Law of Supply' refers to the direct relationship between a commodity's price and supply.


The Prices of Factors of Production or Cost of Production: If the prices of the factors of production rise, the cost of production rises, lowering profits assuming sales receipts remain unchanged. An increase in the cost of producing a commodity discourages its production or supply. A decrease in the cost of producing a commodity, on the other hand, increases its production or supply.


Changes in the relative profitability of producing different commodities are influenced by changes in the price of one factor of production. As a result, producers will switch from one commodity to another, resulting in fluctuations in the supply of different commodities. A decrease in the price of land, for example, will have a greater impact on the cost of producing agricultural products and a much smaller impact on the cost of producing, say, televisions. In other words, a change in the price of a factor of production that consumes proportionally more of that factor whose price has changed in contrast to other factors of production will have a greater impact on the cost of production and supply of that commodity.


Price of Other Goods: If all other factors remain constant, a commodity's supply and production will decrease if the prices of other commodities rise, and vice versa. This occurs because, in most cases, a producer selects the commodity with the biggest profit margin for production. For example, a producer may choose to build television sets rather than other things because he can make more money in this line of business. Assume that the cost of air conditioners rises in the market. Producing air conditioners may now be more profitable than producing television sets. It encourages the manufacturer to gradually cut television set output while increasing air conditioner production. As a result, an increase in the price of air conditioners tends to diminish television set manufacture and supply.


The State of Technology: The state of knowledge evolves over time, and with it, the methods used to generate a commodity change as well. Increased knowledge of production methods and means leads to cheaper production costs for existing items and a wider range of new ones. The electronics industry, for example, is based on transistors, which have revolutionised the manufacture and supply of televisions and other electronic devices such as computers. As knowledge improves, so does the supply of various commodities, in which newer knowledge is reflected through better technologies.


Goal of the Producer: The producer's motivation for producing a product has an impact on the commodity's supply. The producer's goal could be to maximise total earnings, increase sales, or capture the market in the long run.


If a producer wants to make the most money, he will plan to generate the amount of output that will provide him the most profit. It doesn't mean he won't produce more; it just means he won't because doing so would diminish his profit. Assume that the producer's purpose is to maximise sales rather than profits. In that case, he can set a short-term profit target that is smaller than maximum profits. He will continue to increase his supply as long as his aim is not jeopardised. The ambition of the company to maximise earnings in the long run promotes the objective of sales maximisation. In the same way, if producers are hesitant to take risks, we should expect lower output and supply of any commodity with a higher risk.


Other Factors: There are a variety of different factors that can influence supply. Predicted changes in government policy, fear of war, unanticipated meteorological conditions, expected price changes, and expanding economic inequalities all influence demand for specific sorts of commodities, making them more profitable to produce.


Q9) What is monopoly? How is it different from perfect competition? (6)

Ans) Monopoly is a market arrangement in which there is only one seller. A pure or absolute monopoly, on the other hand, is as uncommon as pure or perfect competition. It's possible that one seller controls a disproportionately large share of the market. However, it is quite doubtful that he has complete control of the market. This is more likely in economies where the government owns all of the means of production, and the government is a monopoly. This does not occur in a mixed economy like the one that exists in India. The factor of monopoly can be overwhelming when it comes to natural monopolies, such as suppliers of drinking water or electricity, or specific modes of communication and transportation, or health.


The most common monopolies are ones in which one of the sellers has a significant amount of influence or command over the market and, as a result, over the price at which he prefers to sell his output. This must be compared with perfect competition, in which a seller has no say over the price at which he wants to sell his product.


Q10) How did classical economists explain distribution of income among various factors of production? (6)

Ans) The classical school's most famous economists were Adam Smith and David Ricardo. These economists attempted to explain product pricing using "Natural rates" of compensation for labour, land, and capital. Special ideas were used to explain these natural reward rates. Even the most eminent classical economists did not always agree on how to explain rent, wages, interest, and profit, and in some situations their disagreements were significant.


Ricardo's theory is the most reliable for explaining rent. Wages are explained by two theories. The Subsistence Wage Theory was created by Adam Smith and David Ricardo. Other classical economists, such as J.S. Mill, supported the Wages-Fund Theory as a way to explain wage rates. Interest has been explained in terms of savings demand and supply. Despite using the concept of profit in their publications, classical economists were unable to construct a consistent theory of profit.



According to Ricardo, rent is the percentage of the earth's produce that is paid to the landlord in exchange for the soil's original and indestructible powers. According to him, the landlord does not earn rent by performing specific land modifications. After the costs of agriculture, as represented by payments to labour and capital, have been satisfied, there is a surplus. Ricardo used logical reasoning to create his notion of rent. In his opinion, man must have first farmed the highest quality land, and rent could not exist until such a land became available.


People are driven to cultivate the second-best quality land as the population swells and the need for food grains rises. Obviously, output on this area, which is now considered marginal, will be lower than on better-quality land. According to Ricardo, there can't be any rent on marginal land. The issue of paying rent on this land does not arise because the supply of this land is still plentiful. However, rent arises as a result of extra output on the best land, as opposed to marginal land.



The main proponents of the Subsistence Wage Theory are Adam Smith and David Ricardo. The Wages Fund Theory was proposed by T.R. Malthus and J.S. Mill. The Subsistence Wage Theory argues that labour is bought and sold in the market like any other commodity, and that its value is decided in the same way that other commodities' values are established. According to the Subsistence Wage Theory, workers earn just the subsistence wage in the long run, regardless of their production levels. However, in the short run, the real wage rate may differ from the subsistence wage, but in the long run, due to changes in labour supply, the actual wage rate will tend to equal the subsistence wage.


Ricardo believed that the subsistence wage level will be rigorously set at all times. J.S. Mill had articulated the Wages Fund idea in the most convincing manner. Wage rate, he claims, is determined by the workforce-to-working-capital ratio, which is intended to be spent directly on the procurement of labour. In practise, the Salaries fund, which is the amount of working capital put aside for purchasing labour services, is not a fund set aside for paying wages. The makers can only make an educated guess at it. The national estimate of wages fund is made up of the sum of these individual producers' estimates, which is usually set over time.



The classical theory of interest is most famously advocated by J.S. Mill. According to him, the rate of interest is determined by the relationship between capital demand and supply. "The rate of interest depends essentially and permanently on the comparative amount of real capital supplied and required in the form of a loan," he explained, adding that "fluctuations in the rate of interest originate from variations in either the demand for loans or the supply." Saving is functionally tied to interest in the classical theory, and it varies directly with it. The demand for capital is inversely proportional to the interest rate. At a rate of interest determined by the intersection of the demand and supply schedules, the demand for and supply of capital are equal.



The classical economists did not offer a consistent profit theory. It was challenging for them since they had previously depended on the labour theory of value to explain commodity values. The worth of a commodity, according to this notion, is determined by the amount of labour it contains. This may have been true in previous societies where labour was the sole source of goods. Even in Adam Smith's time, employers employed their own capital in conjunction with hired labour to produce goods. Profits, in his perspective, are only related to the size of an employer's capital stock. Ricardo, who depended on the labour theory of value as well, was unable to effectively explain the origins of capitalist profit.


To summarise, traditional theories that explain rent, wages, interest, and profit provide some insight into the distribution process, but they are not totally true and have been abandoned as a result. Land alone does not earn rent, according to modern economists. It can affect any manufacturing aspect. This method will be taught to you in a later Unit. Wages are not decided by the workers' subsistence level or the wages fund. The wage rate is mostly determined by the marginal productivity of workers. The main premise of the classical theory of interest is wrong since neither saving, nor investment are interest elastic. Finally, the traditional view is unable to explain why profits occur.



Section C

(This section contains four short questions of 5 marks each)


Q11) ‘Scarcity is the mother of every economic system.’ Explain. (5)

Ans) The concept of scarcity refers to the fact that resources are in short supply. All resources are limited, yet their scarcity varies depending on the context in which they are viewed, since some are scarce while others are not.


We could make an endless number of anything we knew how to manufacture (and many things we don't even try to build because of a lack of resources) if resources weren't scarce. But that is not the world in which we live.


At its foundation, economics is the study of how to optimally allocate finite resources. Given the restricted inputs required to construct these conceptions, economists frequently try to optimise rather opaque notions of 'utility' or 'wellbeing.' In its most basic form, economics is an academic endeavour to make the best use of the world's limited resources. To put it another way, economics is the study of how to make the most of the limited resources available to us.


To return to your point, all economic issues come from the amount of a specific resource that exists and how it is distributed throughout the world/universe. (In the not-too-distant future, humans will most certainly mine resources from asteroids and other extra-terrestrial bodies, forcing us to reconsider what is and isn't rare.)


The fact that there is plenty of water in the universe, yet we can only really access it on the planet Earth, is an example of this context. Time is precious in the sense that human life expectancies are currently limited, but it is not scarce in the sense that large-scale projects such as the construction of the Great Wall could be addressed by a large number of labourers.


Q12) Discuss the outlay method to find out price elasticity of demand. (5)

Ans) When the changes in price and demand are not minor, the outlay technique is used to calculate price elasticity of demand. Another thing to keep in mind regarding the outlay technique is that it cannot assist us in determining the price elasticity of demand co-efficient. It only aids us in identifying three scenarios:


  1. Whether the demand price elasticity is one or one hundred percent.

  2. Whether the demand price elasticity is greater than one or greater than unity.

  3. If the price elasticity of demand is less than one or equal to one.

This method can be explained with the help of numerical example. Study Illustration 5, 6 and 7 for this purpose.


When shown in the diagrams above, as the price of an item declines, so does the amount desired for that commodity.


Table 1 shows that even though the price of the commodity has fallen from Rs. 5 to Rs. 4, the total amount spent on the commodity or outflow has remained constant at Rs. 100. It's a case of what's known as demand price elasticity of one.


In table 2, the total money spent on the commodity or outlay goes from Rs. 100 to Rs. 88 as the price of the commodity lowers from Rs. 5 to Rs. 4. It's when the price elasticity of demand is less than one.


Finally, in table 3, the total money spent on the commodity or outflow increases from Rs. 100 to Rs. 120 as the price of the commodity falls from Rs. 5 to Rs. 4. It's a situation when the price elasticity of demand is greater than one.


The outlay is measured on the X-axis, while the price of the commodity is measured on the Y-axis. Because there is a direct relationship between the price of the commodity and outlay, we get a situation of less than unity from 0 to a. Because the outlay is constant regardless of the change in the price of the commodity, the price elasticity of demand between a and b is unity. Finally, because there is an inverse relationship between the price of the commodity and the outlay, the price elasticity of demand between b and c is greater than unity.

As a result, when the price of a commodity grows but spending likewise rises, the elasticity of demand is less than unity. Similarly, when the price rises while the outlay remains constant, the price elasticity of demand is equal to one. Finally, when the price of the commodity grows while the outlay decreases, the price elasticity of demand exceeds unity.


Q13) Explain the characteristics of monopolistic competition. (5)

Ans) The characteristics of monopolistic competition are as follows:


Many Buyers and Sellers

There are a lot of buyers and sellers in the market, which is similar to ideal competition. Monopolistic Competition, on the other hand, has less. Other market configurations, such as a monopoly or an oligopoly, do not provide consumers with as many options.


Slightly Differentiated Products

In a monopolistic market, firms produce relatively similar items that are marginally differentiated to add value over the competition. A good example is clothing markets. There are many various sorts of clothing, each with its own distinct style. Physical, marketing, human capital, and differentiation through distribution are all examples of differentiation.


Maximise Profits

Firms that operate in a monopolistic market have very similar products but are slightly differentiated to add value over the competition. Clothing markets are a prime example. There are many types of clothes, each with a slightly different style. This differentiation can be seen in four ways: Physical, Marketing, Human capital, and differentiation through distribution.


Low Barriers to Entry and Exit

New entrants are easily able to enter as there are none or very insignificant barriers to entry. The cost to start a new business is low and the risk involved in failing is also comparatively low. So the incentive to enter the market is high, whilst few tools are needed. In other words, there are many more people who are able and willing to compete.


Potential Supernormal Profits in the Short Term

Monopolistic firms can make supernormal profits if they can benefit from a gap in the market. Looking at clothing, for example, one company may create a new design that has never been done before. If it goes down a hit with the customers, the firm benefits from high levels of demand. These lead to supernormal profits in the short-term until other firms become aware. They then try to make similar products, thereby reducing the level of profits of the original firm.


Normal Profits in the Long Run

Over the long-term, profits shrink as new entrants enter the market to compete. Due to low barriers to entry, new firms can see any supernormal profits that are made and come in to take their share. So whilst some firms may benefit from new products in the short-term, these supernormal profits are brought back down again with the introduction of competition.


Imperfect Information

In perfect competition, the customer is able to gather information relatively easily as all products are the same. At the same time, the cost to gather information in a monopoly structure is relatively low as there is only one firm. By contrast, in monopolistic competition, many firms offer slightly different products – which makes information gathering more time consuming and costly. Insurance is a prime example – which is why a number of comparison sites have come into existence.


Non-Price Competition

The market offers slightly different products, so businesses compete on product/service quality. This can come through shorter wait times or more attentive employees. At the same time, firms will also compete on other non-price factors such as location, branding/advertising, and quality.


Q14) Critically examine the law of equimarginal utility (5)

Ans) To satisfy unlimited wants a consumer needs more than one commodity. So, the law of diminishing marginal utility is extended and is called the “Law of Equimarginal utility’. It is also called the “Law of substitution" “The law of consumer's equilibrium", “Gossen second law" and "The law of maximum satisfaction”.



"If a guy possesses a thing that he may put to numerous uses, he will distribute it among these uses in such a way that it has the same marginal utility in all of them," Marshall says. He would win by removing some of it from the second use and applying it to the first if it had a higher marginal utility in one use than another."



  1. The reasonable shopper seeks to get the most out of his purchase.

  2. The utility is cardinally measured.

  3. Money's marginal utility remains constant.

  4. The consumer's earnings are disclosed.

  5. In the market, there is perfect competition.

  6. The prices of the goods are provided.

  7. The principle of declining marginal utility is in effect.



The law can be explained with the help of an example. Suppose a consumer wants to spend his limited income on Apple and Orange. He is said to be in equilibrium, only when he gets maximum satisfaction with his limited income. Therefore, he will be in equilibrium, when

Marginal utility of Apple / Price of Apple = Marginal utility of Orange / Price of Orange = K

MU / P = MU / P = K


K – Constant Marginal Utility of Money

Let us assume that the customer wants to spend his entire income (Rs. 11) on Apple and Orange. The price of an Apple and Orange is Rs. 1 each.


If the consumer wants to attain maximum utility, he should buy 6 units of Apples and 5 units of Oranges so that he can get 150 units.


Here MUA / P = MU / P

i.e. 4 / 1 = 4 / 1



In the diagram, X-axis represents the amount of money spent and the Y-axis marginal utilities of Apple and Orange. If the consumer spends Rs. 6 on Apple and Rs. 5 on Orange, the marginal utilities of both are equal i.e. AA = BB. Hence, he gets maximum utility.

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