2017:

12. (b) “A proportionate increase in all input affect total production”- demonstrate the statement
using the concept of Returns to Scale. 2015
Or, Explain the law of returns to scale in the long- run production function. Why do we get decreasing
returns to scale?
Answer:
Returns to scale refer to the behaviour of output to change in the scale of operation of a firm when all factor
inputs, are changed in some constant proportion, given the state of technology.
There are three aspects of returns to scale
(i) Increasing Returns to Scale
(ii) Diminishing Returns to Scale and
(iii) Constant Returns to Scale.
(i) Increasing Returns to Scale:
Increasing returns to scale refers to situation in which output increases by a greater proportion than increase
in factor inputs or when increase in scale of operation is proportionately less than the increase in output. In
other words, if a given change in factor inputs results into a proportionately greater change in output, it is
called increasing returns to scale. Under increasing returns to scale, doubling of resources more than doubles
the level of output. As shown in fig. units of labour and capital are doubled from 2 unit to 4 units and output
more than doubles from 50 units to 120 units. Increasing return to scale are also called economies of sc

(ii) Diminishing Returns to Scale:

Diminishing Returns to scale refers to a situation in which output increases in lesser proportion than
increase in factor inputs or when increase in the scale of operations is proportionately greater than the
increase in output. In other words if a given change in factor inputs results into a proportionately smaller
changes in output, it is a case of diminishing returns to scale, Fig. shows that by doubling the quantity of
factors used in production, the producer is unable to double the output. There are diminishing returns to
scale. The diminishing returns to scale are due to diseconomies of scale.

(iii) Constant Returns to Scale:

Constant Returns to scale refers to situations in which expansion in output happens to be just proportionate
to the expansion in factor inputs. In other words constant returns to scale means that the size of inputs and the
size of the output increases in the same proportion. Doubling the input doubles the output. This is seen in Fig.
Here the inputs and output are increasing in the same proportion.

13. (b) Determine and describe the profit maximizing level of quantity of a perfectly competitive firm in the
short-run.
Or, Explain the equilibrium of the firm in the short run under perfect competition. / Determination of short-
run Equilibrium of the firm
Answer:
The profit maximization rule for a perfectly competitive firm states that the perfectly competitive firm will
maximize its profits when it produces that quantity where marginal revenue equals marginal cost (MC=MR)
and marginal cost curve cuts marginal revenue curve from below.
A firm in short- run equilibrium may face any of the three situations:-
1. It may earn super-normal profits, because is the short-run new firms cannot enter the industry.
2. It may earn normal profits.
3. It may even suffer minimum losses.
All the three situations faced by the firms in equilibrium in short-run are explained diagrammatically as
follows:
(1) Super-normal Profits:
A firm is in equilibrium when its marginal cost is equal to marginal revenue (MC=MR) and marginal cost
curve cuts marginal revenue curve from below. A firm in equilibrium earns super normal profit, when average
revenue (price per unit) determined by the industry is more than its average cost. This situation is shown in
Fig. In this figure, output of the firm is shown of OX-axis and Cost/Revenue of OY-axis, MC is marginal
cost and AC is average cost curve. PP is average revenue and marginal revenue curve (AR=MR),
because under perfect competition AR=MR. Supposing, OP is the price determined by the industry, At this
price, firm’ equilibrium will be at point E, where marginal cost is equal to marginal revenue and marginal
cost curve cuts marginal revenue curve from below. Equilibrium output is OM. At this output AR (Price)
= EM and AC = AM. Since AR (EM) >AC (AM) firm is earning EA super-normal profit per unit of output.
Total super normal profit of the firm on OM output is BA ×EA=EABP, the shaded area.

Thus firm will be in equilibrium at point E and produce OM output at OP price. At this output it will be earning
EABP super normal profit.
(2) Normal Profit:
A firm in equilibrium earns normal profits when its average cost (AC) is equal to the price (AR) determined
by the industries, AC=AR. It is shown in Fig. At OP price determined by industry, firm’s equilibrium is at
point E; marginal cost and marginal revenue are equal and marginal cost curve cuts marginal revenue curve
from below. The firm earns normal profits at OM output because at this output it’s MC=MR=AR=AC. In
other words, average cost and price per unit (average revenue) are equal.

(3) Minimum Loss:

A firm in equilibrium may incur minimum loss when the average cost of equilibrium output is more than price
(AR) determined by industry, i.e. when price (AR) is equal to average variable cost(AR=AVC) and not
average cost (AC). Even if, the firm discontinues its production, in the short-period, it will have to bear the
loss of fixed cost. Loss of fixed costs is the minimum loss of the firm. As long as price (AR) is more than or
equal to average variable cost (AVC). The firm will continue its production. In case, price (AR) is less than
the average variable cost (AVC) the firm will prefer to shut down the unit. Minimum loss is shown in fig.

(c) At what level of output perfectly competitive firm stops its production? Explain with diagram.
Q. Define shut down point. Show shut down point of a firm that operates in a perfectly competitive market.
Answer:
Shut down situation: Shut down point is that at which the price is equal to average variable costs or with
the prevailing price the firm covers its variable costs only.

The shutdown point is reached when the market price falls to a level equal to the minimum of average variable
cost. In other words at shut down point,
AR=AVC (at the firm’s equilibrium output where MC=MR=AVC)
Or TR=VC
It is called shut-down point since its loss from production where MR= MC is the same as its loss from
shutting down. Thus in short-period a firm might produce at a loss rather than close down since it will have
to bear the loss of fixed costs even when it closes down the production. The situation of shut down point of
the firm is illustrated in Fig.
In this figure, AC is average cost curve and AVC is Average variable cost curve. Supposing, price (AR)
Determined by industry is OP. At this price, firm is in equilibrium at point E, where marginal cost is equal to
marginal revenue and marginal cost curve cuts marginal revenue curve from below. At Equilibrium point E
firm produces ON equilibrium output, its average cost is AN while its average Revenue (price) is EN(OP). In
other words, average Cost is more than average revenue by AE which represents per unit loss. As such firm’s
total loss is AE × PE (ON) =AEPB, the shaded area. Although At OP price the firm is not covering its average
cost, yet it is getting more than its average variable cost, as shown by EK.
If price falls to OP1, then the equilibrium output will be OM. At this price, firm will be getting its average
variable cost only and so will be incurring the loss of total fixed cost. It will constitute the minimum loss to
the firm and it will continue its production even at OP1 price. In case price falls below OP1 then firm will not
be able to meet its average variable cost even. It will constitute more than minimum loss and to avoid it the
firm will prefer to shut down its production. Thus , a firm in equilibrium in the short- period will continue its
production so long as its losses are minimum and are confined to fixed costs only i.e, so long as the price it
equal to average variable cost. The firm will shut down its production if and where the price falls below it.

2016:
1.(b) Briefly describe the role of profit in the economy.
Answer: Role and Functions of Profits:
Profits play an important role in a free market economy. Profits perform two important primary roles in such
an economy.
First, profits serve as a signal to change the rate of output or for the firms to enter or leave the industry.
Second, profits play a critical role in providing incentive to introduce innovations and increase productive
efficiency and take risks.
Thus, high economic profits being earned in an industry serve as a signal that consumers want more of the
commodity being produced by that industry. These profits indicate to the firm to expend output of the
commodity and for the new firms to enter the industry to gain a share of economic profits that exist in the
industry. As a result, more resources will be allocated to the output of that industry.
On the other hand, below normal profits in an industry serve as a signal that either less output of the industry
is demanded by the consumers or inefficient production methods are being used by the firms. In response to
the lower demand for the product the firms will reduce their output and also some firms will leave the industry.
7. Why is the long - run average cost curve ‘U’ shaped?
Answer:
Long-run average total cost curves are U-shaped mainly because of economies of scale, constant returns to
scale, and diseconomies of scale. Economies of scale explain the falling segment, while diseconomies of scale
explain the rising segment. The minimum segment is explained by the constant returns to scale.
Economies of scale are cost advantages that firms enjoy because of their volume of production or scale of
operation. Thus, economies of scale can be as a result of efficient machinery, greater division of labor, or
specialization such that employees become better at specific tasks. These economies of scale lead to increasing
returns to scale, whereby output increases by more than proportional increase in inputs. With this, the long-
run average costs curve is declining.
As a firm increases in size, having utilized all efficient machinery and division and specialization of labor, it
will reach a point of constant returns to scale where both average costs and output increase by the same
proportion. This will be the minimum point of the long-run average cost curve.
Beyond the minimum point, there will be a scenario of diseconomies of scale because any increase in output
or any efforts by firm to expand in size means the firm experience in higher costs. Diseconomies of scale
might originate from coordination problems once firms become too large. Also, as firms face diseconomies
of scale, they also face decreasing returns to scale, where output increases by less than proportionate change
in inputs. This is the rising segment of the long-run average cost curve.

13. (b) In a perfectly competitive market, the goal of a firm is to maximize the difference between total
revenue and total cost; explain the statement using hypothetical example.
Answer:
Total Revenue and Total Cost Approach:
A firm is in equilibrium when it is earring maximum profits. A firm’s total profit can be estimated by the
difference between total revenue and total cost e.g.

π = TR-TC

(Here π = Total profit; TR=Total revenue; TC=Total cost

A firm is equilibrium when it produces that amount of output at which the difference between total revenue
and total cost. This situation is shown in Fig. In this figure, output is shown on OX-axis and cost, revenue and
profit on OY-axis. TR is total revenue curve. It is a straight line curve forming an angle of 450 at the point of
organ O. It signifies that price of each unit of the commodity is fixed. TC is total Cost curve. TPC represents
total profit curve.

i. When the firm produces less than OM1 amount of output, it incurs loss because from O to M1 amount
of output total cost is more than total revenue, i.e. TC curve is above TR curve.
 ii. When firm produces OM1 units then it incurs neither any loss nor does it make any profit; because at
this output its total cost is equal to its total revenue. (TR=TC). In Economic, point ‘A’ is called ‘Break
Even Point’, because at this point both profit and loss are zero.
iii. Between any level of output M1 and M2, firm earns profit. In this situation, total revenue is more than
total cost (TR>TC). At M2 amount of output, firm's profit is again reduced to zero. As such point B is
also called 'Break -even point'. After point 'B', TC curve is above TR curve. It is evident from this
figure that when firm produce OM amount of Output, then the difference between TR and TC i.e. RS
is maximum. At OM output, it is clear from TPC that firm is getting maximum profit because beyond
OM amount of output TPC begins to decline. Thus firm will be in equilibrium at OM amount of output
where it is earning maximum profit.
2015:
2. What is the shape of the marginal revenue curve if the total revenue curve is a-positively sloped
straight line? Graphically arrange your answer.
Answer:
When TR curve is positively sloped straight line, MR is a horizontal line parallel to X-axis. MR coincides
with the demand curve. Price or AR is constant at each level of output. When AR is constant, MR is also
constant.

10. (a) What are the relationship between marginal and incremental cost?
Answer:
Incremental cost is the change in cost caused by a given managerial decision.
Incremental costs are closely related to the concept of marginal cost but with a relatively wider connotation.
While marginal cost refers to the change in total cost resulting from producing an additional unit of output,
incremental cost refers to total additional cost associated with the decision to expand output or to add a new
variety of product etc. It represents the difference between two alternatives. So both are concerned with the
change in the total cost where marginal costs refers to the increase or decrease in that results from producing
or distributing an additional unit of output and, incremental cost refers to the change in the total output as a
result of change in the methods of production or distribution such as addition of a product or territory, use of
improved technology or selection of an additional sales channel.