Wednesday, July 31, 2013

Microeconomics (2067Q3): What is meant by "Consumer's Equilibrium"? How would the equilibrium of a consumer in respect of a particular commodity be affected if (a) the price of that commodity rise, (b) the income of the consumer falls, and (c) the price of a substitute commodity falls? Use indifference curve technique for the answer.

Consumer's Equilibrium

Consumer's equilibrium is a state of the consumer at which he will get maximum satisfaction from the purchase of different available goods and services with his limited amount of money. Hicks and Allen developed IC to demonstrate the situation of consumer's equilibrium graphically with the help of budget line. 

Effects on Consumer's Equilibrium – using indifference curve technique
a. Price of commodity rise
It changes in the price of that commodity and the budget line of consumer. If income is held constant, and the price of that commodity changes then the slope of curve will change. If the price increases, the budget line will move inwards.

Here in figure, if price of Apples increases from Rs. 6 per unit to Rs. 12 per unit, then for a budget of Rs. 24, price line will shift inward to L3­­. If price of Apples decreases from Rs. 6 to Rs. 4 per unit, then for a budget of Rs. 24, price line will shift outward to L2.

b. Income of consumer falls
If consumer's income increases then he will be able to purchase higher combinations of goods. Hence an increase in consumer's income will result in a shift in the budget line. If the prices of two goods have remained same, then the increase in income will result in a parallel shift in the budget line.
As in figure below, if budget (income) of consumer increases to Rs. 36, then budget line will shift outward to L2. Similarly, if income reduces to Rs. 12, then budget line will shift inward to L3

 c. Price of a substitute commodity falls

Substitution effect means if utility held constant, as the price of the good increases, consumers substitute other, relatively cheaper goods for that one. So, if the price of substitute commodity falls then consumer switches to new commodity rather than recently using one.

There are two methods to measure substitution effect:
i. Slutsky's Measure
 As in figure above, if the price of a substitute commodity falls, then movement from D to F will be the substitution effect. That means, the consumers substitute the consuming commodity at point D by point F and MN is the effect shown by substitution.

ii. Hicks Measure
Same as in Slutsky's approach but here one curve is removed for analyzing substitution effect as well as price effect.

Microeconomics (2067Q2): What are the characteristics of Indifference Curve? How it is superior to the traditional Demand Curve?

Characteristics of Indifference Curve (IC)

  1. The slope of IC is negative i.e. it slope downwards from left to right. For example, if the quantity of one commodity is increased, the quantity of other commodity must be decreased in order to stay at the same level of satisfaction.
  2. ICs are convex to origin.
  3. ICs don't intersect each other. If they did, the point of intersection would imply different level of satisfaction which is not possible from the definition itself and from the assumption of "transitivity".
  4. Higher IC represents higher level of satisfaction. It means – the further away an IC from the origin, higher the level of utility it demonstrates.

Indifference Curve (IC) is superior to the traditional Demand Curve due to following reasons:

  1. IC analysis is more realistic in measuring utility.
  2. Free from the defect of independent utility.
  3. Free from unrealistic assumption of constant marginal utility of money.
  4. Based on less assumption.
  5. Explanation of income and substitution effects.
  6. Explanation of Giffen's Paradox.

Sunday, July 28, 2013

Microeconomics (2066Q4): Explain the nature of the cost curves. How is the long run average cost curve derived?


·        AFC is a continuously decreasing function
·        AVC & ATC curves are U-shaped
·        The vertical distance between ATC & AVC at each output level is equal to AFC
·        MC crosses both AVC & ATC from below at their respective minimums
·        MC is not affected by fixed costs

Relationship between AC and MC
·        When MC<AC, AC is falling
·        When MC=AC, AC is minimum
·        When MC>AC, AC is rising
·        The minimum point of MC always comes before the minimum point of AC
·        When MC is falling AC cannot rise, it must also fall.

Derivation of long run average cost curve
In the long run, all inputs (factors of production) are variable and firms can enter or exit any industry or market. Consequently, a firm's output and costs are unconstrained in the sense that the firm can produce any output level it chooses by employing the needed quantities of inputs (such as labor and capital) and incurring the total costs of producing that output level.
The Long Run Average Cost, LRAC, curve of a firm shows the minimum or lowest average total cost at which a firm can produce any given level of output in the long run (when all inputs are variable).

In the long run, all inputs (factors of production) are variable and firms can enter or exit any industry or market.
Assumption - A firm is uncertain about the demand in the long run and is considering four alternate plants. The short run curves are given by SAC1, SAC2, SAC3 and SAC4.
Look at the following figure. In this figure, we have 4 short run curves SAC1, SAC2, SAC3 and SAC4.
·        To produce Q0, The firm will use SAC1 curve. At this output cost is P0
·        To produce Q1, The firm will again use SAC1 curve. At this output cost is P0
·        To produce Q2, The firm will use SAC2 curve. If it will continue to use SAC1 curve, then the cost will increase to P2. So, it would be better for the firm to bring second plant into the production.
·        At SAC2 curve, the cost of producing Q2 would be P1, much less than P2
·        Lets see Q3: to Produce Q3, firm can either use SAC3 or SAC4 curve.
·        For Q3, the firm will use SAC4 curve, as it has low cost.
·        For Q3, the cost of producing at SAC3 is much higher than SAC4.
In the long run, a firm will use the level of inputs that can produce a given level of output at the lowest possible average cost. Consequently, the LRAC curve is the envelope of the short run average cost (SAC) curves, where each SRAC curve is defined by a specific quantity of inputs
The Long Run Cost Function describes the least-cost method of producing a given amount of output. The "Long Run" part of the cost function means that all inputs are variable. In the simple case, you'd consider capital and labor. In the long run, both capital and labor may be adjusted. In the short-run, however, capital may not be adjusted. (You can't buy and install new machinery by next week, or sell a factory and be moved out.) You can, however, hire new employees to start work tomorrow..
·        In the long run all inputs are flexible, while in the short run some inputs are not flexible, long-run cost will always be less than or equal to short-run cost.
·        In the short run the firm faces an additional constraint: all expansion must proceed using only the variable input. And additional constraints increase cost.

·        The envelope relationship is the relationship explaining that, at the planned output level, short-run average total cost equals long-run average total cost, but at all other levels of output; short-run average total cost is higher than long-run average total cost.

Microeconomics (2066Q3): How is consumer's equilibrium achieved under indifference curve condition? Illustrate the price effect on the consumer's equilibrium, separating it into the income effect and substitution effect.

Consumer's equilibrium achieved under indifference curve condition

Consumers choose a combination of goods which maximize their satisfaction under the limited available budget. A consumer is said to be achieved equilibrium at a point where the price line (budget line) is touching the highest attainable indifference curve from below.

The are two conditions to achieve consumer's equilibrium:
1. Budget line should be tangent to the indifference curve
2. Indifference curve must be convex to the origin

Assumptions to determine consumer's equilibrium condition are as follows:-
  1. Rationality: Consumer is rational so he wants to obtain maximum satisfaction by choosing available goods under his budget.
  2. Utility is ordinal: Consumer can rank his preference according to his satisfaction on each combination of goods.
  3. Consistency of choice: Consumer assumed to consistent on his decision of choosing goods.
  4. Perfect competition: There should be perfect competition in market for that purchased goods.
  5. Total utility: It depends on quantities of goods consumed by consumer.

Here, IC2 is tangent on budget line T and is also attainable (ie. affordable by consumer) but IC1 is attainable but consumer has more capacity to buy other more goods. So, IC1 can't match the highest attainable capacity of consumer. Similarly,  IC3 can't afford by consumer due to his budget constraint.

For the second condition, ICs should be convex to origin that means MRS (Marginal Rate of Satisfaction) should be diminishing at the equililibrium point.

Price effect on the consumer's equilibrium

Consumer's choice of consuming any goods depend on the prices of those goods as well as the income of that consumer. So, if price changes, the consumer's equilibrium choice will also change. The price effect can be defined as the change in the consumption of goods when the price of either of two goods changes while the price of other good and income of the consumer remain constant. The effect of a price change on consumer's equilibrium choice can be divided into two effects: income effect and substitution effect.

1. Income effect: It is an effect on the consumer equilibrium caused by change in his income if relative prices remain constant. This effect is due to the change in real income. For eg. when the price goes up the consumer is not able to buy as much as that he could purchase before. This effect is measured as the difference between the "intermediate consumption" at G and the final consumption of q1 and q2 at E. Unlike substitution effect, the income effect can be both positive and negative depending on whether the product is a normal or inferior good. 
2. Substitution effect: It refers to change in the amount of goods purchased due to change in their relative prices alone, while real income of the consumer remains constant. The effect due to replacement of relatively expensive goods by relatively cheaper goods is called substitution effect. There are two methods to measure substitution effect:
  • Slutsky's measure: According to Slutskian approach, consumer's real income is so reduced that he is able to purchase the original combination of two goods at new price ratio.
  • Hicks measure: According to Hicks approach, constant real income means that consumer will remain on same indifference curve as before the change in price.

Friday, July 26, 2013

Microeconomics (2066Q2): What is monopolistic competition? How price and output is determined under it in the long run? In what respect it is different under perfect competition?

Monopolistic Competition

It refers to a market structure in which a large number of sellers are offering similar but not identical products. Eg. biscuits, shampoo, washing soaps, tooth paste, tea etc.

Characteristics of Monopolistic Competition

  1. Many sellers
  2. Freedom of entry and exit
  3. Perfect information
  4. Heterogeneous product
  5. Every firm has negatively sloped demand curve

Determination of price and output in long run equilibrium under monopolistic competition

A monopolistic competitive firm achieves long-run equilibrium via the adjustment of market price, number of firms in the industry and scale of production of each firm. Due to this adjustment, each firm produces at a tangent point between its negatively sloped Average Revenue (AR) curve and its Long-run Average Cost (LRAC) curve to maintain economies of scale.

So, new two equilibrium conditions are achieved:

Here, first condition means each firm maximizes profit and has no reason to adjust its quantity of output.
The second condition means each firm in the industry is earning only a normal profit. Economic profit is zero and there is no economic loss.

Now,  these two equilibrium conditions can be divided into six specific conditions:
  1. Economic Inefficiency (P>MC)
  2. Profit Maximization (MR=MC)
  3. Market Control (P=AR>MR)
  4. Breakeven Output (P=AR=ATC)
  5. Excess Capacity (ATC>MC)
  6. Economies of Scale (LRAC>LRMC)
Hence, price and output is determined by the market structure and competitors price because there is high competition, difference between cost and price be very little. So, according to graph given above, price should increase slightly to maintain the few quantity of production.

Microeconomics (2066Q1): Distinguish between inductive and deductive methods in economics. Which method, in your opinion, is more appropriate in microeconomics? Why?

The inductive and deductive methods in economics are two methods for deriving economic generalizations and economic analysis.

Inductive Method
Deductive Method
It is also called empirical method.
It is also called analytical, abstract or prior method.
It is adopted by Historical school of economists.
It is adopted by classical and neo-classical school of economists.
Data collected from a certain economic phenomenon. Then arranged systematically and general conclusions are drawn from them.
Conclusions are derived from general truths and few general principles.
This method includes steps:
a.       Observation
b.      Formation of hypothesis
c.       Generalization
d.      Verification
This method includes steps:
a.       Perception on problem
b.      Defining terms
c.       Deducing hypothesis from assumptions
d.      Hypothesis testing
Eg: In a survey, out of 100 persons, 90 persons use shampoo for washing hair while 10 persons use soaps. Then it concludes people like to use shampoo for washing hair.
Eg: If we assume that people are entirely motivated by self interest. Then we proceed from general to particular in order to have conclusion.

In my opinion, deductive method is better in microeconomics because it consists strong theoretical background to support the method which can assure it's reliability and correctness.

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