Assignment Code: BECC-132 /TMA /2023-24

Course Code: BECC-132

Assignment Name: Principles of Microeconomics-II

Year: 2023-24

Verification Status: Verified by Professor

Assignment One

Answer the following Descriptive Category questions in about 500 words each. Each question carries 20 marks

Q1a) Discuss the features of an Oligopolistic market structure. What are the various reasons that lead to emergence of this market structure?

Ans) One of the defining characteristics of an oligopolistic market structure is the dominance of a relatively small number of large enterprises in the market.

Few Dominant Firms: A relatively small number of big companies, each of which holds a sizeable portion of the market, are the ones who control the industry. As a result of their scale and significance, these companies have the power to exert influence over the characteristics of the market, including prices and competition.

Interdependence: In the market, the actions performed by one company have a big impact on the other companies. One company's decisions on price adjustments, product differentiation, or marketing techniques will elicit responses from other companies in the industry, which will result in strategic dependency within the industry.

Barriers to Entry: There are a number of factors that discourage new businesses from entering the market. These factors include economies of scale, patents, brand loyalty, and considerable financial requirements with high hurdles. It is because of this that the market positions of the current companies are able to remain stable.

Product Differentiation: Product differentiation tactics are frequently the focus of businesses in order to differentiate their offerings from those of their rivals. This can be accomplished through branding, specific features, quality, or customer service, which ultimately results in competition that is not based on price.

Non-Price Competition: Competition encompasses more than just alterations to prices. For the purpose of gaining a competitive advantage, businesses compete with one another based on product quality, advertising, innovation, and customer service.

Mutual Interdependence: There is a possibility of cooperation or tacit understanding among the few dominant players because of the fact that there are only a few of them. On the other hand, antitrust laws in many countries restrict behaviour that is characterised as cartel-like or explicit cooperation.

Several factors contribute to the emergence of an oligopolistic market structure:

a)     Economies of Scale: Industries that benefit from economies of scale often witness the emergence of a few dominant players. High initial investment requirements and decreasing average costs with increased production lead to market concentration.

b)     High Entry Barriers: Industries with high capital requirements, technology dependence, and strong brand loyalty present significant entry barriers, reinforcing the dominance of existing players.

c)     Technological Advancements: Industries that require heavy research and development (R&D) investment, leading to patented products or unique technology, tend to have limited players due to intellectual property rights and innovation advantages.

d)     Government Regulation: Sometimes, regulations or policies can inadvertently create barriers to entry or protect existing firms, fostering oligopolistic market conditions.

e)     Mergers and Acquisitions: Consolidation through mergers or acquisitions among large firms can reduce competition and lead to an oligopolistic market.

For the purpose of ensuring fair competition, preventing monopolistic behaviour, and protecting consumer interests, it is vital for policymakers to have a thorough understanding of the factors and traits that comprise an oligopolistic market structure. It is common practise for regulatory organisations to keep an eye on these markets in order to preserve competitive conditions and prevent collusion that could be detrimental to consumers.

Q1b) With regards the Kinked demand curve theory given by Paul Sweezy, answer the following:

(i) What does the kinked demand curve model of oligopoly assumes about the price elasticity of demand?

Ans) The kinked demand curve model in oligopoly is based on the assumption that a specific pattern of price elasticity of demand (PED) exists for a company's individual product. This model, which was proposed by economist Paul Sweezy in the middle of the 20th century, makes an attempt to be an explanation for the pricing behaviour and stability that is found in oligopolistic marketplaces.

The main assumption of the kinked demand curve model is that the demand curve facing an oligopolistic firm has a distinct kink or bend at the current price level. It suggests that at a specific price point, the PED changes abruptly, leading to a kink in the demand curve.

The model posits two different PED scenarios above and below the prevailing market price:

a)     Above the Price Level: Above the current price, the model assumes that demand becomes highly elastic. A small increase in price by one firm could lead to a significant loss in market share as consumers switch to competitors due to the perception of a higher price.

b)     Below the Price Level: Below the current price, the model assumes that demand becomes inelastic. Any decrease in price by one firm would not result in a proportionate gain in market share since competitors are unlikely to match the price decrease. Consumers may not significantly increase their purchases in response to a lower price.

A kink or discontinuity is created in the demand curve as a result of the asymmetric perception of price changes that consumers have developed. Above the current price, the curve maintains a reasonably flat shape, whereas below it, it becomes steep.

The key assumptions underlying this model regarding the PED are:

a)     Asymmetric Reaction: Competitors in an oligopolistic market are assumed to match price cuts but not price increases. Therefore, firms expect retaliation from competitors if they raise prices, leading to a highly elastic demand above the price level.

b)     Price Rigidity: At the current price on the market, there is a presumption that prices maintain their rigidity. Since of the extremely elastic response from customers, businesses typically maintain prices at a consistent level because they anticipate that any divergence from the norm could result in a major loss of market share.

c)     Firm Interdependence: The kinked demand curve model implies that firms in oligopoly are interdependent and base their pricing decisions on the expected reactions of rivals. The assumption is that competitors will not match price decreases, leading to an inelastic response below the price level.

This model offers insights into the behaviour of firms in oligopolistic markets, it has limitations. Critics argue that in the real world, the assumptions of firm behaviour, consumer reaction, and price rigidity might not hold uniformly across all industries or situations. Additionally, empirical validation of the kinked demand curve model has been challenging due to the complexities of real-world markets and the multitude of factors influencing pricing decisions in oligopolies.

(ii) Comment upon the discontinuous shape of the Marginal revenue curve under this model.

Ans) In the kinked demand curve model of oligopoly, the marginal revenue (MR) curve has a discontinuous shape, mirroring the distinctive kink found in the demand curve. The shape of the MR curve is a critical element in understanding the pricing behaviour of firms in this model.

The MR curve represents the change in total revenue resulting from the sale of one additional unit of a product. It is directly related to the demand curve and plays a crucial role in profit maximization decisions for firms in competitive markets. In oligopoly, the MR curve reflects the reaction of rivals to price changes and the resulting impact on the firm's revenue.

The key characteristics of the MR curve in the kinked demand curve model are:

a)     Discontinuity: Similar to the demand curve, the MR curve exhibits a discontinuity or abrupt change at the prevailing market price. It reflects the sudden change in price elasticity of demand above and below the current price level.

b)     Two Segments: The MR curve is divided into two distinct segments, reflecting different elasticities of demand. Above the kink, the MR curve is relatively flatter, indicating higher price elasticity and implying that any increase in price will result in a significant loss of market share for the firm. Below the kink, the MR curve becomes steeper, signifying lower price elasticity and suggesting that price reductions may not significantly boost market share.

c)     Profit Maximization: The discontinuous nature of the MR curve influences the profit-maximizing output level and price-setting decisions of firms. At the quantity where MR equals marginal cost (MC), firms maximize profits. In the kinked demand curve model, this occurs at the level of output corresponding to the kink or point of discontinuity in the MR curve. As such, firms tend to operate at the prevailing output level and price due to the perception of market instability beyond that level.

d)     Stability at Current Price: The discontinuous MR curve implies that firms are incentivized to maintain the status quo regarding price. Any deviation from the current price may result in adverse reactions from competitors. The discontinuity in the MR curve acts as a barrier, discouraging firms from altering prices, thereby maintaining stability in the market.

e)     Assumption of Behaviour: The discontinuous MR curve assumes asymmetric behaviour among competitors. It suggests that rivals are more likely to match price reductions than price increases. This asymmetry in response reinforces the stability of the market around the prevailing price level.

The discontinuous shape of the MR curve in the kinked demand curve model reflects the strategic interdependence and cautious pricing behaviour of firms in oligopoly. However, this model simplifies the complexities of real-world markets and has been subject to criticism due to its stringent assumptions and limited empirical support. Despite its insights, the applicability of the kinked demand curve model to various industries and situations remains a topic of debate among economists.

Q2a) A country can have a comparative advantage in producing a good even if it is absolutely less efficient at producing that good. Do you agree? Explain using an example.

Ans) A nation may have a comparative advantage in the production of a particular good, even if it is less efficient in manufacturing that good in contrast to another nation. This is because it is feasible for a nation to have a comparative advantage in making that good. Rather than being focused on absolute efficiency, David Ricardo initially presented the concept of comparative advantage. This concept is based on the relative opportunity costs of production rather than on absolute efficiency.

For example, take into consideration two hypothetical nations, A and B, as well as two products, automobiles, and computers. Let us imagine that Country A is capable of producing one automobile in one hundred hours or one computer in fifty hours, but Country B is capable of producing one automobile in eighty hours or one computer in forty hours. In terms of absolute efficiency, Country B is superior to Country A when it comes to the production of automobiles and computers. The reason for this is because the production of each individual unit of both products requires fewer hours than the creation of the other item.

However, when evaluating the opportunity costs or trade-offs, the concept of comparative advantage becomes apparent. In Country A, to produce one car, it foregoes the production of 2 computers (100 hours divided by 50 hours per computer), whereas in Country B, producing one car means sacrificing 2.67 computers (80 hours divided by 30 hours per computer).

Furthermore, despite the fact that Country B is more effective in the production of both automobiles and computers, it has a lower opportunity cost in the production of automobiles in comparison to the production of computers in Country A. On the other hand, Country A has a comparative advantage in the computer industry since, in comparison to Country B, it produces fewer automobiles for every electronic device that it manufactures.

Now that these opportunity costs have been taken into consideration, it would be beneficial for both countries to specialise on the products in which they have a comparative advantage over their rivals. Country A is an expert in the production of computers, while Country B is a specialist in the auto industry. After that, they engage in trade depending on the relative efficiencies of their respective businesses.

This scenario is an illustration of the principle of comparative advantage, which demonstrates that even if one nation is completely less efficient in manufacturing a particular good, that nation may still enjoy a comparative advantage and benefit from specialising in that particular good. One example that illustrates this principle is the scenario that came before it.

This concept forms the basis of international trade, showing that trade can create value by allowing countries to focus on goods they can produce most efficiently relative to their trading partners. By leveraging on the fact that different nations have different opportunity costs, it encourages specialisation, which in turn leads to improved productivity and, ultimately, improves the welfare of the entire world.

Q2b) Consider the following Table 1 which represents labour time (in minutes) requirements for the production of a unit of commodity X and Y by country A and B, and answer the questions that follow:

Table 1: Labour time (in minutes) requirement for production of a unit of Good X and Y by Country A and B

(i) Which country among A and B has absolute advantage in producing commodity X and which has in producing commodity Y? Give reason.

Ans) Based on Table 1:

Country A has an absolute advantage in producing commodity Y. This is because it takes them only 20 minutes to produce one unit of Y, while Country B takes 60 minutes - twice as long.

Country B has an absolute advantage in producing commodity X. Conversely, Country B can produce one unit of X in 30 minutes, compared to Country A's 20 minutes. Although Country A is faster for Y, Country B is still faster for X in absolute terms.

Reasoning:

Absolute advantage refers to the ability to produce a good or service using fewer resources (like labour time) than any other producer. In this case, each country has an absolute advantage in one commodity because they require less time to produce it compared to the other country for that specific good.

(ii) Which country among A and B has comparative advantage in producing commodity X and which has in producing commodity Y? Give reason.

Ans) Country A has a comparative advantage in producing both commodity X and Y.

Relative Labour Time: In both cases, A takes less time per unit compared to B. For X, A takes 20 minutes while B takes 30, and for Y, A takes 20 minutes while B takes 60.

Opportunity Cost: The concept of comparative advantage focuses on opportunity cost, which is the potential benefit not realized by choosing one option over another. In this case, for B, the opportunity cost of producing X is higher than producing Y because it takes them twice as long (60 minutes) to produce Y compared to X (30 minutes). For A, the opportunity cost of both goods is equal (20 minutes each), making them equally efficient in both.

Therefore, even though A's absolute labour time is lower in only one good (X), its relative efficiency is higher in both goods compared to B. This indicates that A can specialize in producing both X and Y and trade with B, who can specialize in goods where it has a comparative advantage (potentially outside the scope of the table).

This demonstrates the principle of comparative advantage, where it is not just about absolute efficiency but rather relative efficiency that matters in determining which country should produce what for optimal trade benefits.

(iii) Suppose after trade each country specialises in production of commodity in which it has a comparative advantage, which country will specialise in producing commodity X?

Ans) Country A will specialize in producing commodity X.

Comparative advantage: We need to compare the relative labour times, not just the absolute times.

a)     Country A: Takes 20 minutes for both X and Y, so the relative cost of producing X compared to Y is 1 (20/20).

b)     Country B: Takes 30 minutes for X and 60 minutes for Y, so the relative cost of X compared to Y is 0.5 (30/60).

Lower relative cost: Since Country B's relative cost for X is lower than Country A's, it means they can produce X at a comparatively lower opportunity cost (sacrificing less Y for each X).

Specialization: Therefore, in a free trade scenario, Country B will specialize in producing X where they have a comparative advantage, while Country A will specialize in producing Y (where their relative cost is also lower than B).

This analysis demonstrates that even though Country A has the same absolute labour time for both goods, their comparative advantage lies in producing Y, leading to specialization in that good under free trade.

Assignment Two

Answer the following Middle Category questions in about 250 words each. Each question carries 10 marks.

Q3) What is meant by Pareto efficient allocation of resources? Is Perfect competition market equilibrium Pareto efficient? Discuss using appropriate diagrams.

Ans) When it is difficult to improve the situation of one person without also making the situation of another person worse, this is an example of a Pareto effective allocation of resources. In essence, it is the state in which resources are utilised in the manner that is the most economically efficient for all parties involved within the system. While this does not necessarily indicate that there is complete equality, it does suggest that there is a circumstance in which any change would have a detrimental impact on at least one person.

The argument for perfect competition being Pareto efficient rests on its key features:

a)     Price Takers: Firms are unable to exert any influence over market prices, which guarantees effective resource allocation.

b)     Free Entry & Exit: Entry and exit obstacles are kept to a minimum, which helps to prevent the formation of inefficient monopolies.

c)     Perfect Information: Price and cost information is completely understood by each and every participant.

In this scenario, the equilibrium price and quantity result in:

a)     Productive Efficiency: Firms produce at the minimum average cost, minimizing resource waste.

b)     Allocative Efficiency: Price equals marginal cost, ensuring consumers pay the true cost of production.

 Therefore, perfect competition satisfies the conditions for Pareto efficiency:

The equilibrium point (P*, Q*) represents Pareto efficiency, where consumers receive goods at the true cost of production, and firms operate at minimum cost. Any deviation from this point would make someone worse off (e.g., higher prices for consumers, inefficient production for firms).

Q4) Using appropriate diagram, show how interaction of demand and supply curve in land market leads to determination of equilibrium rent.

Ans) It is necessary to do an analysis of the relationship between demand and supply curves in order to have an understanding of how rent is determined in the land market.

Land Demand Curve:

Downward sloping:

a)     Factors affecting demand: Population growth, urbanization, agricultural productivity, expected future rents.

b)     Higher land rent (price) decreases demand (quantity) because it increases production costs.

Equilibrium Rent:

The intersection of the demand and supply curves determines the equilibrium rent (R*) and quantity (Q*).At this point, the quantity of land demanded by users (farmers, developers) equals the available land. Any rent above R* would exceed user willingness to pay, leaving land unused.

Landowners would be encouraged to remove their land from the market if they received a rent that was lower than R* since it would not cover their opportunity cost.

Shifts in Curves:

Alterations in the factors that influence supply or demand will cause the respective curves to move, which will ultimately result in a new equilibrium. By way of illustration, if there is a rise in population growth (↑ demand), the demand curve will move to the right, resulting in an increase in equilibrium rent. There is a possibility that technological developments in agriculture (↓ supply) could cause a modest inward shift of the supply curve, which would also result in an increase in equilibrium rent.

Q5) Discuss various forms of government interventions intended to internalize externalities.

Ans) When it comes to addressing externalities, which are costs or advantages that affect parties that are not directly involved in a transaction, governments frequently step in to intervene. The objective of internalising externalities is to adjust private costs or advantages such that they are in line with society costs or benefits.

a)     Taxes and Subsidies: Taxes on negative externalities (like pollution) increase the private cost, internalizing the externality. Subsidies for positive externalities (like education) lower the private cost, encouraging their provision.

b)     Cap-and-Trade Systems: Governments set a cap on total emissions and issue permits allowing a certain level of emissions. Companies can buy or sell these permits. It incentivizes companies to reduce emissions efficiently.

c)     Regulation: Governments can impose regulations to internalize externalities. For instance, setting emission standards for vehicles or requiring firms to install pollution control equipment.

d)     Public Provision: In cases where positive externalities are significant (like healthcare or education), the government may provide these goods or services publicly to ensure broader access.

e)     Legal Enforcement: Establishing property rights and legal frameworks allows affected parties to seek compensation or resolution for externalities caused by others' actions.

f)      Public Awareness and Education: It is possible that informing the public about the impacts of the externalities would result in voluntary adjustments in behaviour, which will lead to a reduction in the negative externalities.

g)     Public-Private Partnerships: Collaborations between private entities and public administrations to handle externalities, such as collaborative projects for the development of infrastructure or the preservation of the environment.

Assignment Three

Answer the following Short Category questions in about 100 words each. Each question carries 6 marks.

Q6) Discuss Joseph Schumpeter’s theory of profit.

Ans) Joseph Schumpeter's theory of profit revolves around the idea of entrepreneurial innovation driving economic progress. He viewed entrepreneurs as central figures in capitalism, introducing new products, methods, or markets, which disrupt the status quo. According to Schumpeter, these innovations lead to temporary monopoly profits, termed "entrepreneurial profits." However, these profits attract competition, eroding the monopoly and reducing profits over time. Schumpeter was of the opinion that this process, which is often referred to as creative destruction, is essential for the development of the economy since it continuously revitalises the economy by replacing ways that are no longer effective with new and innovative ones.

Q7) The concept of quasi-rent is an extension of the Ricardian concept of rent to other factors of production. Elucidate.

Ans) The concept of quasi-rent, an extension of Ricardian rent, applies the principle of surplus above opportunity cost beyond land to other factors of production. Ricardian rent reflects the surplus earned from land due to its fixed supply and differential fertility. Quasi-rent broadens this idea, applying it to temporary surplus earnings of capital equipment or specialized labour when their supply is fixed or inelastic in the short term. Unlike land, the supply of these factors can change in the long run, making quasi-rents temporary. It signifies the surplus earned over and above the minimum required to keep these factors in their current use, akin to Ricardian rent but applied more broadly.

Q8) Discuss the concept of excess capacity associated with the long run equilibrium under Monopolistic competition.

Ans) In monopolistic competition, firms have excess capacity in the long run equilibrium due to product differentiation. Each firm produces a slightly different product, creating a degree of market power. While firms have some control over price, they do not reach the perfect efficiency of perfectly competitive markets. As demand is not enough to fully utilize their production capacities, firms operate below the optimal output level. This leads to excess capacity, meaning they have the potential to produce more but do not due to limited demand for their slightly differentiated products. This condition persists in the long run, causing inefficiency compared to perfect competition.

Q9) What has been the impact of the WTO on Indian economy?

Ans) There has been a considerable impact that the World Trade Organization (WTO) has had on the economy of India.

Its impact includes:

a)     Trade Liberalization: WTO agreements led India to open its markets, boosting trade and investment.

b)     Export Growth: Indian exports expanded due to increased market access globally.

c)     Domestic Regulations: WTO rules influenced India's policies on agriculture, intellectual property, and services.

d)     Challenges: Indian agriculture faced competition, and sectors like pharmaceuticals saw stricter patent laws.

e)     Disputes: India engaged in WTO disputes, safeguarding its interests on issues like agriculture subsidies.

Q10) What is meant by derived demand of a factor?

Ans) Derived demand refers to the demand for a factor of production (like labour or capital) that arises from the demand for the goods or services it helps produce. It is not demanded for its own sake but because it contributes to the production of another good or service. For instance, the demand for labour in the construction industry is derived from the demand for houses. If the demand for houses increases, the demand for construction workers also rises. The amount of demand that is derived for a factor is dependent on the amount of demand that is for the ultimate product that the factor helps to make or furnish.