TABLE OF CONTENTS

Unit 1 Micro Economics

Unit 2 Macro Economics

Unit 3 Statistics & Econometrics UNIT

Unit 4 Mathematical Economics

Unit 5 International Economics

Unit 6 Public Economics

Unit 7 Money and Banking

Unit 8 Growth and Development Economics

Unit 9 Environmental Economics and Demography

Unit 10 Indian Economy

Microeconomics
What is Microeconomics?
Microeconomics is the social science that studies the implications of human action, specifically
about how those decisions affect the utilization and distribution of scarce resources. Microeco-
nomics shows how and why different goods have different values, how individuals make more ef-
ficient or more productive decisions, and how individuals best coordinate and cooperate with one
another. Generally speaking, microeconomics is considered a more complete, advanced, and set-
tledscience than macroeconomics.

KEY TAKEAWAYS
• Microeconomics studies the decisions of individuals and firms to allocate resources of pro-
duction, exchange, and consumption.
• Microeconomics deals with prices and production in single markets and the interaction be-
tween different markets, but leaves the study of economy-wide aggregates to macroeco-
nomics.
• Microeconomists use mathematics as a language to formulate theories and observational
studies to test their theories against thereal world performance of markets.

What is Microeconomics?
Understanding Microeconomics
Microeconomics is the study of economic tendencies, or what is likely to happen when individuals
make certain choices or when the factors of production change. Individual actors are often
grouped into microeconomic subgroups, such as buyers, sellers, and business owners. These
groups create the supply and demand for resources, using money and interest rates as a pricing
mechanism for coordination.

The Uses of Microeconomics

As a purely normative science, microeconomics does not try to explain what should happen in a
market. Instead, microeconomics only explains what to expect if certain conditions change. If a
manufacturer raises the prices of cars, microeconomics says consumers will tend to buy fewer
than before. If a major copper mine collapses in South America, the price of copper will tend to in-
crease, because supply is restricted.

Microeconomics could help an investor see why Apple Inc. stock prices might fall if consumers
buy fewer iPhones. Microeconomics could also explain why a higher minimum wage might force
The Wendy's Company to hire fewer workers. Microeconomics can address questions like these
that might have very broad implications for the economy; however, questions about aggregate
economic numbers remain the purview of macroeconomics, such as what might happen to the
gross domesticproduct (GDP) of China in 2020.

Method of Microeconomics
Most modern microeconomic study is performed according to general equilibrium theory, devel-
oped by Léon Walras in Elements of Pure Economics (1874) and partial equilibrium theory, intro-
duced by Alfred Marshall in Principles of Economics (1890). The Marshallian and Walrasian meth-
ods fall under the larger umbrella
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of neoclassical microeconomics. Neoclassical economics focuses on how consumers and pro-
ducers make rational choices to maximize their economic well being, subject to the constraints of
how much income and resources they have available. Neoclassical economists make simplifying
assumptions about markets – such as perfect knowledge, infinite numbers of buyers and sellers,
homogeneous goods, or static variable relationships – in order to construct mathematical models
of economic behavior.

These methods attempt to represent human behavior in functional mathematical language, which
allows economists to develop mathematically testable models of individual markets. As logical
positivists, neoclassicals believe in constructing measurable hypotheses about economic events,
then using empirical evidence to see which hypotheses work best. Unlike physicists or biologists,
economists cannot run repeatable tests, so their empirical research depends on the collection and
observation of economic data from real world markets.
The economic efficiency of markets is then determined by how well realmarkets adhere to the rules
of the model.

Basic Concepts of Microeconomics

The study of microeconomics involves several key concepts, including(but not limited to):
• Production theory: This is the study of production — or the process of converting inputs into
outputs. Producers seek to choose the combination of inputs and method of combining
them that will minimize cost in order to maximize their profits.
• Utility theory: Analogous to production theory, consumers will choose to purchase and con-
sume a combination of goods that will maximize their happiness or “utility”, subject to the
constraint of how much income they have available to spend.
• Price theory: Production theory and utility theory interact to produce the theory of supply
and demand, which determine prices in a competitive market. In a perfectly competitive
market, it concludes that the price demanded by consumers is the same supplied by pro-
ducers. That results in economic equilibrium.
• Industrial organization and market structure: Microeconomists study the many ways that
markets can be structured, from perfect competition to monopolies, and the ways that pro-
duction and prices will develop in these different types of markets.

In short, the subject matter of microeconomics dealswith:

(a) Determination of prices of individual products and factors;and
(b) Allocation of resources to their most valuable uses so as to maximise total output of the econ-
omy (i.e., deals with centralproblems of ‘what, how and for whom to produce’).

Now Lets Discuss in Brief

What Is Consumer Theory?
Consumer theory is the study of how people decide to spend their money, given their preferences
and budget constraints. A branch of microeconomics, consumer theory shows how individuals
make choices, given restrains, such as their income and the prices of goods and services. Through
consumer theory, we are better able to understand how individuals’ tastes and incomes influence
the demandcurve. These choices are among the most critical factors, shaping theoverall economy.

Understanding Consumer Theory

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Consumers are able to choose different bundles of goods and services; logically, they choose
those that bring the greatest benefit (or maximizes utility, in economic terms). Working through ex-
amples and/or cases, consumer theory usually requires the following inputs:

• A full set of consumption options

• How much utility a consumer derives from each bundle in the set ofoptions
• A set of prices assigned to each bundle
• Any initial bundle the consumer currently holds

Example of Consumer Theory

For example, consider a consumer, Kyle, who has $200 (his budget constraint), who must choose
how to allocate his funds between pizza and video games (the bundle of goods). If pizzas cost $10
and video games cost $50, Kyle can purchase any combination of pizzas and video games that
costs no more than $200. He could buy 20 pizzas, or
four video games, or five pizzas and three video games, or he could keep all $200 in his pocket. But
how can an outsider predict how Kyle ismost likely to spend his money? Consumer theory can help
give an answer to this question.

Limitations of Consumer Theory

Challenges to developing a practical formula for this situation are numerous. People are not al-
ways rational, for example, and occasionally they are indifferent to the choices available. Some de-
cisions are particularly difficult to make, because consumers are not familiar with the products, or
the decision has an emotional component that isn't able to be captured in an economic function.

Consumer theory therefore makes several assumptions to simplify the process. For example, in
Kyle’s case (above), economics can assume he understands his preferences for pizza and video
games and can decide how much of each he wants to purchase. It also assumes there are enough
video games and pizzas available for Kyle to choosethe quantity of each he desires.

Theory of Production and Costs-

In the Cost Theory, there are two types of costs associated with production – Fixed Costs andVari-
able Costs.

In the short-run, at least one factor of production is fixed, so firms face both fixed and variable
costs. The shape of the cost curves in the short run reflect the law of diminishingreturns.

Cost Theory – Types of Costs

A. Fixed Cost
Fixed costs are costs that do not vary with different levels of production and fixed costsexists even
if output is zero. Example: rent or salaries.

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In the above diagram, the fixed cost remains constant regardless of the quantity produced.
B. Average Fixed Cost
Average Fixed Cost = Fixed Costs/Quantity.

In the above diagram, we see that when the quantity produced is low, the average fixed cost is
very high and this cost lowers as the quantity produced increases.

For example, if the Fixed Cost is $100 and initially you produce two units, then the average fixed
cost is $50. If you start creating 20 units, then the average fixed cost falls to $5.

C. Variable Costs
Variable Costs are costs that vary with the level of output. Ex: electricity

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 In the above diagram, the variable cost curve starts from zero. It means when output is zero, the
variable cost is zero, but as production increases the variable cost increases. It keeps rising to
the point that economies of scale cannot lower the per unit cost anymore hence the steep in-
cline.

D. Marginal Cost
Marginal Cost is the increase in cost caused by producing one more unit of the good.

The Marginal Cost curve is U shaped because initially when a firm increases its output, total
costs, as well as variable costs, start to increase at a diminishing rate. At this stage, due to
economies of scale and the Law of Diminishing Returns, Marginal Cost falls till it becomes min-
imum. Then as output rises, the marginal cost increases.

E. Total Cost
Total Cost = Fixed Cost + Variable Cost

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 When the output is zero, variable costs are also zero. But we have fixed costs which is where the
Total Costs start. The Total Cost remains parallel to the Variable Cost, and the distance between
the two curves is the Fixed Cost.

F. Average Total Cost

Average Total Cost = Total Cost/Quantity. (Total Cost = Fixed Cost + Variable Cost)

Average Variable
Cost = Variable Costs/Quantity.

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Marginal Cost, Average Cost, Average Variable Cost
Note: If average costs are falling then marginal costs must be less than average while if average
costs are rising then marginal must be more than average. Marginal cost on its wayup must cut the
cost curve at its minimum point.

If Marginal Cost is less than Average Variable Cost, then Average Cost goes down.If Marginal Cost
is higher than Average Variable Cost, then Average Cost goes up.
If Marginal Cost is equal to Average Variable Cost, then Average Cost will be at minimum.

Importance of Distinction between Fixed andVariable Costs

This distinction is important in cost theory. Every firm has the object to maximize profits or
minimize losses if losses are unavoidable. At times the price of the product may not cover the av-
erage total cost. Then the firm will have to decide whether to shut down or producesome output.

1. The decision to Shut Down the Firm

The producer may not cover the total costs if the price of the product is less than the short- run av-
erage cost. Then the distinction between fixed cost and variable cost is important.
If the price does not cover average variable costs, the firm prefers to shut down. In other words, if
the total revenue (total sale proceeds) does not include total variable costs, the business must
shut down. Otherwise, its total loss will be higher than the fixed costs. It willproduce something on-
ly when the price covers the average variable cost and part of the average fixed costs. The output
at which marginal cost is equal to marginal revenue keeps losses minimum.

2. Break-Even Point
At times the firm may not make any profit. It just pays to produce a given output. Total revenue is
only equal to the total cost. The company has crossed the losses zone and is aboutto enter the ze-
ro profit zone. The output at which total revenue becomes equal to total cost represents the break-
even point.

Theory of production
Theory of production, in economics, an effort to explain the principles by which a business firm
decides how much of each commodity that it sells (its “outputs” or “products”) it will produce, and
how much of each kind of labour, raw material, fixed capital good, etc., that it employs (its “inputs”
or “factors of production”) it will use. The theory involves some of the most fundamental principles
of economics. These include the relationship between the prices of commodities and the prices
(or wages or rents) of the productive factors used to produce them and also the relationships be-
tween the prices of commodities and productive factors, on the one hand, and the quantities of
these commodities and productive factors that are produced or used, on the other.
The various decisions a business enterprise makes about its productive activities can be classified
into three layers of increasing complexity. The first layer includes decisions about methods of pro-
ducing a given quantity of the output in a plant of given size and equipment. It involves the prob-
lem of what is called short-run cost minimization. The second layer, including the determination of
the most profitable quantities of products to produce in any given plant, deals with what is called
short-run profit maximization. The third layer, concerning the determination of the most profitable
size and equipment of plant, relates to what is called long-run profit maximization.

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Minimization Of Short-Run Costs
The production function
However much of a commodity a business firm produces, it endeavours to produce it as cheaply
as possible. Taking the quality of the product and the prices of the productive factors as given,
which is the usual situation, the firm’s task is to determine the cheapest combination of factors of
production that can produce the desired output. This task is best understood in terms of what is
called the production function, i.e., an equation that expresses the relationship between the quanti-
ties of factors employed and the amount of product obtained. It states the amount of product that
can be obtained from each and every combination of factors. This relationship can be written
mathematically as y = f (x1, x2, . . ., xn; k1, k2, . . ., km). Here, y denotes the quantity of output. The
firm is presumed to use n variable factors of production; that is, factors like hourly paid production
workers and raw materials, the quantities of which can be increased or decreased. In the formula
the quantity of the first variablefactor is denoted by x1 and so on. The firm is also presumed to use
m fixed factors, or factors like fixed machinery, salaried staff, etc., the quantities of which cannot
be varied readily or habitually. The available quantity of the first fixed factor is indicated in the for-
mal by k1 and so on. The entire formula expresses the amount of output that results when speci-
fied quantities of factors are employed. It must be noted that though the quantities of the factors
determine the quantity of output, the reverse is not true, and as a general rule there will be many
combinations of productive factors that could be used to produce the same output. Finding the
cheapest of these is the problem of cost minimization.

The cost of production is simply the sum of the costs of all of thevarious factors. It can be written:

in which p1 denotes the price of a unit of the first variable factor, r1 denotes the annual cost of
owning and maintaining the first fixed factor, and so on. Here again one group of terms, the first,
covers variable cost (roughly“direct costs” in accounting terminology), which can be changed readi-
ly; another group, the second,
covers fixed cost (accountants’ “overhead costs”), which includes items not easily varied. The dis-
cussion will deal first with variable cost.

The principles involved in selecting the cheapest combination of variable factors can be seen in
terms of a simple example. If a firm manufactures gold necklace chains in such a way that there
are only two variable factors, labour (specifically, goldsmith-hours) and gold wire, the production
function for such a firm will be y = f (x1, x2; k), in which the symbol k is included simply as a re-
minder that the number of chains producible by x1 feet of gold wire and x2 goldsmith-hours de-
pends on the amount of machinery and other fixed capital available. Since there are only two varia-
ble factors, this production function can be portrayed graphically in a figure known as an isoquant
diagram (Figure 1). In the graph, goldsmith-hours per month are plotted horizontally and the num-
ber of feet of gold wire used per month vertically. Each of the curved lines, called an isoquant, will
then represent a certain number of necklace chains produced. The data displayed show that 100
goldsmith-hours plus 900 feet of gold wire can produce 200 necklace chains. But there are other
combinations of variable inputs that could also produce 200 necklace chains per month. If the
goldsmiths work more carefully and slowly, they can produce 200 chains from 850 feet of wire; but
to produce so many chains more goldsmith-hours will be required, perhaps 130. The isoquant la-

8
belled “200” shows all the combinations of the variable inputs that will just suffice to produce 200
chains. The other two isoquants shown are interpreted similarly. It is obvious that many more
isoquants, in principle an infinite number, could also be drawn. This diagram is a graphic display of
the relationships expressed in the production function.

Theory of production
QUICK FACTS

Substitution of factors
The isoquants also illustrate an important economic phenomenon: that of factor substitution. This
means that one variable factor can be substituted for others; as a general rule a more lavish use of
one variable factor will permit an unchanged amount of output to be produced with fewer units of
some or all of the others. In the example above, labour was literally as good as gold and could be
substituted for it. If it were not for factor substitution there would be no room for further decision
after y, the number of chains to be produced, had been established.

The shape of the isoquants shown, for which there is a good deal of empirical support, is very im-
portant. In moving along any one isoquant, the more of one factor that is employed, the less of the
other will be needed to maintain the stated output; this is the graphic representation of factor sub-
stitutability. But there is a corollary: the more of one factor that is employed, the less it will be pos-
sible to reduce the use of the other by using more of the first. This is the property known as “dimin-
ishing marginal rates of substitution.” The marginal rate of substitution of factor 1 for factor 2 is
the number of units by which x1 can be reduced per unit increase in x, output remaining un-
changed. In the diagram, if feet of gold wire are indicated by x1 and goldsmith-hours by x2, then the
marginal rate of substitution is shown by the steepness (the negative of the slope) of the isoquant;
and it will be seen that it diminishes steadily as x2 increases because it becomes harder and hard-
er to economize on the use of gold simply by taking more care. The remainder of the analysis
rests heavily on the assumption that diminishing marginal rates of substitution are characteristic
of the production process generally.

The cost data and the technological data can now be brought together. The variable cost of using
x1, x2 units of the factors of production is written p1x1 + p2x2, and this information can be added
to the isoquant diagram (Figure 2). The straight line labelled v2, called the v2-isocost line, shows
all the combinations of input that can be purchased for a specified variable cost, v2. The other two
isocost lines shown are interpreted similarly. The general formula for an isocost line is p1x1 + p2x2

9
= v, in which v is some particular variable cost. The slope of an isocost line is found by dividing p2
by p1 and depends only on theratio of the prices of the two factors.

Figure 2: Isoquant diagram for two factors of production, x1 and x2

Three isocost lines are shown, corresponding to variable costs amounting to v1, v2, and v3. If 200
units are to be produced, expenditure of v1 on variable factors will not suffice since the v1-isocost
line never reaches the isoquant for 200 units. An expenditure of v3 is more than sufficient; and v2
is the lowest variable cost for which 200 units can be produced. Thus v2 is found to be the mini-
mum variable cost of producing 200 units (as v3 is of 300 units) and the coordinates of the point
where the v2 isocost line touches the 200-unit isoquant are the quantities of the two factors that
will be used when 200 units are to be produced and the prices of the two factors are in the ratio
p2/p1. It may be noted that the cheapest combination for the production of any quantity will be
found at the point at which the relevant isoquant is tangent to an isocost line. Thus, since the
slope of an isoquant is given by the marginal rate of substitution, any firm trying to produce as
cheaply as possible will always purchase or hire factors in quantities such that the marginal rate of
substitution will equal the ratio of their prices.

The isoquant–isocost diagram (or the corresponding solution by the alternative means of the cal-
culus) solves the short-run cost minimization problem by determining the least-cost combination
of variable factors that can produce a given output in a given plant. The variable cost incurred
when the least-cost combination of inputs is used in conjunction with a given outfit of fixed
equipment is called the variable cost of that quantity of output and denoted VC(y). The total cost
incurred, variable plus fixed, is the short-run cost of that output, denoted SRC(y). Clearly SRC(y) =
VC(y) + R(K), in which the second term symbolizes the sum of the annual costs of the fixed factors
available.

Marginal cost
Two other concepts now become important. The average variable cost, written AVC(y), is the varia-
ble cost per unit of output.
Algebraically, AVC(y) = VC(y)/y. The marginal variable cost, or simply marginal cost [MC(y)] is,
roughly, the increase in variable cost incurred when output is increased by one unit; i.e., MC(y) =
VC(y + 1) - VC(y). Though for theoretical purposes a more precise definition can be obtained by re-
garding VC(y) as a continuous function of output, this is not necessary in the present case.
The usual behaviour of average and marginal variable costs in response to changes in the level of
output from a given fixed plant is shown in Figure 3. In this figure costs (in dollars per unit) are
measured vertically and output (in units per year) is shown horizontally. The figure is drawn for
some particular fixed plant, and it can be seen that average costs are fairly high for very low levels
10
of output relative to the size of the plant, largely because there is not enough work to keep a well-
balanced work force fully occupied.

People are either idle much of the time or shifting, expensively, from job to job. As output increas-
es from a low level, average costs decline to a low plateau. But as the capacity of the plant is ap-
proached, the inefficiencies incident on plant congestion force average costs up quite rapidly.
Overtime may be incurred, outmoded equipment and inexperienced hands may be called into use,
there may not be time to take machinery off the line for routine maintenance; or minor breakdowns
and delays may disrupt schedules seriously because of inadequate slack and reserves. Thus the
AVC curve has the flat- bottomed U-shape shown. The MC curve, as might be expected, falls faster
and rises more rapidly than the AVC curve.

Figure 3: Average variable costs (AVC) and marginal variable costs (MC) in re-
lation to
Maximization Of Short-Run Profits
The average and marginal cost curves just deduced are the keys to the solution of the second-level
problem, the determination of the most profitable level of output to produce in a given plant. The
onlyadditional datum needed is the price of the product, say p0.
The most profitable amount of output may be found by using these data. If the marginal cost of
any given output (y) is less than the price, sales revenues will increase more than costs if output is
increased byone unit (or even a few more); and profits will rise. Contrariwise, if the marginal cost is
greater than the price, profits will be increased by cutting back output by at least one unit. It then
follows that the output that maximizes profits is the one for which MC(y) = p0. This is the second
basic finding: in response to any price the profit-maximizing firm will produce and offer the quanti-
ty for which the marginal cost equals that price.

Such a conclusion is shown in Figure 3. In response to the price, p0, shown, the firm will offer the
quantity y* given by the value of y for which the ordinate of the MC curve equals the price. If a de-
notes the corresponding average variable cost, net revenue per unit will be equal to p0 - a, and the
total excess of revenues over variable costs will be y*(p0 - a), which is represented graphically by
the shaded rectangle in the figure.

Marginal cost and price

The conclusion that marginal cost tends to equal price is important in that it shows how the quan-
tity of output produced by a firm is influenced by the market price. If the market price is lower than
11
the lowest point on the average variable cost curve, the firm will “cut its losses” by not producing
anything. At any higher market price, the firm will produce the quantity for which marginal cost
equals that price.
Thus the quantity that the firm will produce in response to any price, and for this reason the mar-
ginal cost curve is said to be the short- run supply curve for the firm.
The short-run supply curve for a product—that is, the total amount thatall the firms producing it will
produce in response to any market price—follows immediately, and is seen to be the sum of the
short-run supply curves (or marginal cost curves, except when the price is below the bottoms of
the average variable cost curves for some firms) of all the firms in the industry. This curve is of
fundamental importance for economic analysis, for together with the demand curve for the product
it determines the market price of the commodity and the amount that will be produced and pur-
chased.

One pitfall must, however, be noted. In the demonstration of the supply curves for the firms, and
hence of the industry, it was assumedthat factor prices were fixed. Though this is fair enough for a
single firm, the fact is that if all firms together attempt to increase their outputs in response to an
increase in the price of the product, they are likely to bid up the prices of some or all of the factors
of production that they use. In that event the product supply curve as calculated will overstate the
increase in output that will be elicited by an increase in price. A more sophisticated type of supply
curve, incorporating induced changes in factor prices, is therefore necessary. Such curves are dis-
cussed in the standard literature of this subject.

Marginal product
It is now possible to derive the relationship between product prices and factor prices, which is the
basis of the theory of income distribution. To this end, the marginal product of a factor is defined
asthe amount that output would be increased if one more unit of the factor were employed, all oth-
er circumstances remaining the same.
Algebraically, it may be expressed as the difference between the product of a given amount of the
factor and the product when that factor is increased by an additional unit. Thus if MP1(x1) denotes
the marginal product of factor 1 when x1 units are employed, then MP1(x1) = f(x1 + 1, x2, . . . ,xn; k)
- f(x1, x2 . . . ,xn; k). The marginal products are closely related to the marginal rates of substitution
previously defined.If an additional unit of factor 1 will increase output by f1 units, for example, then
one more unit of output can be obtained by employing 1/f1 more units of factor 1. Similarly, if the
marginal product of factor 2is f2, then output will fall by one unit if the use of factor 2 is reduced by
1/f2 units. Thus output will remain unchanged, to a good approximation, if 1/f1 units of factor 1
are used to replace 1/f2 units of factor 2. The marginal rate of substitution is therefore f2/f1, or the
ratio of the marginal products of the two factors. It has already been shown that the marginal rate
of substitution also equals the ratio of the prices of the factors, and it therefore follows that the
prices (or wages) of thefactors are proportional to their marginal products.

This is one of the most significant theoretical findings in economics. To restate it briefly: factors of
production are paid in proportion to their marginal products. This is not a question of social equity
but merely a consequence of the efforts of businessmen to produce as cheaply as possible.
Further, the marginal products of the factors are closely related to marginal costs and, therefore, to
product prices. For if one more unit of factor 1 is employed, output will be increased by MP1(x1)
units and variable cost by p1; so the marginal cost of additional units produced will be p1/MP1(x1).
Similarly, if additional output is obtained by employing an additional unit of factor 2, the marginal
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cost will be p2/MP2(x2). But, as shown above, these two numbers are the same; whichever factor i
is used to increase output, the marginal cost will be pi/MPi(xi) and, furthermore, the firm will
choose its output level sothat the marginal cost will be equal to the price, p0.

Therefore it has been established that p1 = p0MP1(x1), p2 = p0MP2(x2), or the price of each factor
is the price of the product multiplied by its marginal product, which is the value of its marginal
product. This, also, is a fundamental theorem of income distribution and one of the most signifi-
cant theorems in economics. Its logic can be perceived directly. If the equality is violated for any
factor, the businessman can increase his profits either by hiring units of the factor or by laying
themoff until the equality is satisfied, and presumably the businessman will do so.

The theory of production decisions in the short run, as just outlined, leads to two conclusions (of
fundamental importance throughout the field of economics) about the responses of business
firms to the market prices of the commodities they produce and the factors of production they buy
or hire: (1) the firm will produce the quantity of its product for which the marginal cost is equal to
the market price and (2) it will purchase or hire factors of production in such quantities that the
price of the commodity produced multiplied by the marginal product of the factor will be equal to
the cost of a unit of the factor. The first explains the supply curves of the commodities produced
in an economy. Though the conclusions were deduced within the context of a firm that uses two
factors of production, they are clearly applicable ingeneral.

Maximization Of Long-Run Profits

Relationship between the short run and thelong run
The theory of long-run profit-maximizing behaviour rests on the short- run theory that has just been
presented but is considerably more complex because of two features: (1) long-run cost curves, to
be defined below, are more varied in shape than the corresponding short- run cost curves, and (2)
the long-run behaviour of an industry cannot be deduced simply from the long-run behaviour of the
firms in it because the roster of firms is subject to change. It is of the essence of long-run adjust-
ments that they take place by the addition or dismantling of fixed productive capacity by both es-
tablished firms and new or recently created firms.

At any one time an established firm with an existing plant will make its short-run decisions by
comparing the ruling price of its commodity with cost curves corresponding to that plant. If the
price is so high that the firm is operating on the rising leg of its short-run cost curve, its marginal
costs will be high—higher than its average costs—and it will be enjoying operating profits, as
shown in Figure 3. The firm will then consider whether it could increase its profits by enlarging its
plant. Theeffect of plant enlargement is to reduce the variable cost of producing high levels of out-
put by reducing the strain on limited production facilities, at the expense of increasing the level of
fixed costs.

In response to any level of output that it expects to continue for some time, the firm will desire and
eventually acquire the fixed plant for which the short-run costs of that level of output are as low as
possible. This leads to the concept of the long-run cost curve: the long-run costs of any level of
output are the short-run costs of producing that output in the plant that makes those short-run
costs as low as possible.
These result from balancing the fixed costs entailed by any plant against the short-run costs of
producing in that plant. The long-run costs of producing y are denoted by LRC(y). The average

13
long-run cost of y is the long-run cost per unit of y [algebraically LAC(y) = LRC(y)/y]. The marginal
long-run cost is the increase in long-run cost resulting from an increase of one unit in the level of
output. It represents a combination of short-run and long-run adjustments to a slight increase in
the rate of output. It can be shown that the long-run marginal cost equals the marginal cost as pre-
viously defined when thecost-minimizing fixed plant is used.

Long-run cost curves

Cost curves appropriate for long-run analysis are more varied in shape than short-run cost curves
and fall into three broad classes. In constant-cost industries, average cost is about the same at all
levels of output except the very lowest. Constant costs prevail in manufacturing industries in which
capacity is expanded by replicating facilities without changing the technique of production, as a
cotton mill expands by increasing the number of spindles. In decreasing-cost industries, average
cost declines as the rate of output grows, at least until the plant is large enough to supply an ap-
preciable fraction of its market. Decreasing costs are characteristic of manufacturing in which
heavy, automated machinery is economical for large volumes of output. Automobile and steel
manufacturing are leading examples.

Decreasing costs are inconsistent with competitive conditions, since they permit a few large firms
to drive all smaller competitors out of business. Finally, in increasing-cost industries average costs
rise with the volume of output generally because the firm cannot obtain additional fixed capacity
that is as efficient as the plant it already has. The most important examples are agriculture and ex-
tractive industries.

Criticisms Of The Theory

The theory of production has been subject to much criticism. One objection is that the concept of
the production function is not derived from observation or practice. Even the most sophisticated
firms do not know the direct functional relationship between their basic raw inputs and their ulti-
mate outputs. This objection can be got around by applying the recently developed techniques of
linear programming, which employ observable data without recourse to the production function
and lead to practically the same conclusions.
On another level the theory has been charged with excessive simplification. It assumes that there
are no changes in the rest of the economy while individual firms and industries are making the ad-
justments described in the theory; it neglects changes in the technique of production; and it pays
no attention to the risks and uncertainties that becloud all business decisions. These criticisms are
especially damaging to the theory of long-run profit maximization. On still another level, critics of
the theory maintain that businessmen are not always concerned with maximizing profits or mini-
mizing costs.
Though all of the criticisms have merit, the simplified theory of production does nevertheless indi-
cate some basic forces and tendencies operating in the economy. The theorems should be under-
stood as conditions that the economy tends toward, rather than conditions that are always and in-
stantaneously achieved. It is rare forthem to be attained exactly, but it is just as rare for substantial
violations of the theorems to endure.

Only the simplest aspects of the theory were described above. Without much difficulty it could be
extended to cover firms that produce more than one product, as almost all firms do. With more dif-
ficulty it could be applied to firms whose decisions affect the prices at which they sell and buy
(monopoly, monopolistic competition, monopsony). The behaviour of other firms that recognize
14
the possibility that their competitors may retaliate (oligopoly) is still a theory of production subject
to controversy and research.

Managerial Decision-MakingUnder Risk and Uncertainty

we will discuss about Managerial Decision-Making Environment:-
1. Concept of Decision-Making Environment
2. Decision-Making Environment underUncertainty
3. Risk Analysis
4. Certainty Equivalents.

Concept of Decision-Making Environment:

The starting point of decision theory is the distinction among three different states of nature or de-
cision environments: certainty, risk and uncertainty.
The distinction is drawn on the basis of the degree of knowledge or information possessed by the
decision-maker. Certainty can be characterized as a state in which the decision-maker possesses
complete and perfect knowledge regarding the impact of all of the available alternatives.

In our day-today conversation, we use the two terms ‘risk’ and ‘uncertainty’ synonymously. Both im-
ply ‘a lack of certainty’.

But there is a difference between the two concepts. Risk can be characterized as a state in which
the decision-maker has only imperfect knowledge and incomplete information but is still able to
assign probability estimates to the possible outcomes of a decision.

These estimates may be subjective judgments, or they may be derived mathematically from a
probability distribution.

Uncertainty is a state in which the decision-maker does nothave even the information to make sub-
jective probability assessments.

It was Frank Knight who first drew a distinction between risk and uncertainty. Risk is objective but
uncertainty is subjective; risk can be measured or quantified but uncertainty cannot be. Modern de-
cision theory is based on this distinction.

In general, two approaches are used to estimate the probabilities of decision outcomes. The first
one is deductive and it goes by the name a priori measurement; the second one is based on statis-
tical analysis of data and is called a posteriori.

With the priori method, the decision-maker is able to derive probability estimates without carrying
out any real world experiment or analysis. For example, we know that if we toss an unbiased coin,
one of two equally likely outcomes (i.e., either head or tail) occur, and the probability of each out-
comeis predetermined.

The a posteriori measurement of probability is based on the assumption that past is a true repre-
sentative (guide to) of the future. For example, insurance companies often examine historical data
in order to determine the probability that a typical twenty-five year-old male will die, have an auto-
mobileaccident, or incur a fire loss.

Thus the implication is that even though they cannot predict the probability that a particular indi-
15
vidual will have an accident, they can predict how many individuals in a particular age group are
likely to have an accident and then fixtheir premium levels accordingly.

By contrast, uncertainty implies that the probabilities of various outcomes are unknown and cannot
be estimated. It is

largely because of these two characteristics that the decision- making in an uncertain environment
involves more subjectivejudgment.

Uncertainty does not seem to suggest that the decision-maker does not have any knowledge. In-
stead it implies that there is no logical or consistent approach to assignment of probabilities to the
possible outcomes.

Some Characteristics of a Decision Problem: All business decision problems have certain com-
moncharacteristics.

These not only constitute a formal description of the problem but also provide the structure nec-
essary fora solution:

1. A decision-maker
2. Alternative courses of action (strategies)
3. Events or outcomes
4. Consequences or payoffs.

In order to illustrate these common characteristics of a decision problem, we may start with a
simple real life example. Suppose you are the inventory manager of Calcutta’s New York, which is
selling men’s dresses. Your company is not a dress manufacturer. It is just a retail store selling
readymade garments. You have to decide how many men’s T-shirts to order for the summer sea-
son.

The manufacturer of these has imposed a condition on you: You have to order in batches of 100. If
only 100 T-shirts are ordered, the cost is Rs. 10 per shirt, if 200 or more are ordered, the cost is Rs.
9 per shirt; and if 300 or more shirtsare ordered the cost is Rs. 8.50.

The results of market survey provide you with information that the selling price will be Rs. 12 and
that the possible sales levels are 100, 150, or 200 units. But you cannot assign any probability es-
timate to the alternative levels of demand or sales.

If any T- shirt remains unsold during summer, it can be dis-posed off at half the price in winter. The
marketing manager also feels that there is a goodwill loss of 50 paise for each T- shirt that con-
sumers want to purchase from your shop but cannot because of inadequate supplies.

It is not possible for you to wait for some time to study the nature (or determine the level) of de-
mand, nor can you placemore than one order. Thus, a situation of complete uncertainty prevails.

In our example, the decision-maker is the inventory manager, who must decide how many T- shirts
to order in the face of uncertain demand. The three alternative strategies are to order 100 shirts
(A1), 200 (A2) or 300 (A3).

The states of nature (which are external to and beyond the control of the inventory manager) are
16
the events and in this case are three levels of demand: 100 (D1), 150 (D2), or 200 (D3). Since the
inventory manager does not know which of the events will occur, he is forced to make his decision
in the face of uncertain outcomes.

The consequences are measures of the net benefit or payoff (reward) association with each of the
levels of demand. The specific consequence or outcome depends not only on the decision (A1, A2,
or A3) that is made but also on the event (D1, D2, or D3) that occurs.

That is, there is a consequence or outcome associated with each combination of decision or ac-
tion and event. These consequences are generally summarized in a payoff matrix.

The Payoff Matrix:

A payoff matrix is an essential tool of decision-making. It is a nice way of summarizing the interac-
tions of various alternative action and events. Thus we can say that a payoff matrix provides the
decision-maker with quantitative measures of the payoff for each possible consequence and for
each alternative under consideration.

Positive payoff implies profit and negative pay-off impliesloss. For the T-shirts inventory and order-
ing problem, thepayoff matrix is presented in Table 8.1

If the future event that will occur could be predicted with certainty, the decision-maker would mere-
ly look down the column and select the optimal decision. If, for instance, it were known for certain
that demand would be 150 T-shirts, the decision-maker would order 200, in order to maximize his
pay-off.

However, since the decision-maker does not have any knowledge about which event (state of na-
ture) will occur or what is the chance of a particular event occurring, he is faced with a situation of
total uncertainty.

Decision-Making Environment underUncertainty:

We may now utilize that pay-off matrix to investigate the nature and effectiveness of various crite-
ria of decision makingunder uncertainty.

Four major criteria that are based entirely on thepayoff matrix approach are:
(1) Maximin (Wald),
(2) Maximax,
(3) Hurwicz alpha index, and
(4) Minimax regret (Savage).

17
In those situations where the decision-maker is willing to assign subjective probabilities to the
possible outcomes, thetwo other criteria are

a. The Laplace (Bayes’) and

b. The maximization of expected value.

It may be noted that once subjective probabilities are introduced, the distinction between risk and
uncertainty getsblurred.

1. Maximin:
The maximin (or Wald) criterion is often called the criterion of pessimism. It is based on the be-
lief that nature is unkind and that the decision-maker therefore should determine the worst pos-
sible outcome for each of the actions and select the one yielding the best of the worst (maximin)
results. That is,the decision-maker should choose the best of the worst.

In our T-shirt example the minimum payoffs associated with each of the ac-
tions are presentedbelow:

If the decision-maker is a pessimist and assumes that nature will always be niggardly and unchari-
table the optimal decision would be to order 100 T- shirts because this action maximizes the mini-
mum payoff. Thus, the criterion is conservative in nature and is well-suited to firms whose very
survival is at stake because of losses.

2. Maximax:
An exactly opposite criterion is the maximax criterion. It is known as the criterion of optimism
because it is based on the assumption that nature is benevolent (kind). Thus, this criterion is
suitable to those who are particularly venturesome(extreme risk takers).

In direct contrast to the maximin criterion the maximax implies selection of the alternative that
is the “best of the best”. This is equivalent to assuming with extreme optimism that the best
possible outcome will always occur.

In our example, the best possible outcome, giveneach of the levels of demand,
are the following:

18
The decision-maker would thus choose to order 200 units because this offers the maximum possi-
ble payoff.

3. Hurwicz Alpha Index:

The Hurwicz alpha criterion seeks to achieve a pragmatic compromise between the two extreme
criteria presented above. The focus is on an index which is based on the derivation of a coefficient
known as the coefficient of optimism.

Here the decision-maker considers both the maximum and the minimum payoffs from each action
and weighs these extreme outcomes in accordance with subjective evaluations of either optimism
or pessimism.

If, for instance, we assume that the decision-maker has a coefficient of 0.25 for a particular set of
actions, the implication is clear. He has implicitly assigned a probability ofoccurrence of 0.25 to the
maximum payoff and of 0.75 to the minimum payoff.

As a general rule the value of following a particular action can be determined

according to the followingindex:
Hi =αCmax + (1 – α)Cmin (8.1)

The decision-maker would then pick that option which yielded the maximum Hi value. Equation
(8.1) indicates that the more optimistic the decision maker, the larger will be the Hi value, and vice
versa. A value of alpha (a) equal to 0.5 implies that the decision-maker is neither an optimist nor a
pessimist.

The results of applying the Hurwicz criterion in Eq. (8.1) assuming an alpha
value of 0.25 are presentedbelow:

19
Thus, the decision-maker would choose A1, i.e., order 100 T-shirts. The major drawback of this de-
cision criterion, however, is the assignment of probabilities for the states of optimism and pessi-
mism.

4. Minimax Regret:
The minimax regret has been proposed by Savage. This criterion suggests that after a decision
has been made and the outcome has been noted, the decision-maker may experience regret be-
cause by now he knows what event occurred and possibly wishes that he had selected a better
alternative. Thus, this criterion suggests that the decision-maker should attempt to minimize his
maximum regret.

The implication is that the decision-maker would develop a regret (opportunity loss) matrix and
then apply the minimax rule to select an action. Regret is defined as the difference between the
actual payoff and the expected pay-off, i.e., the payoff that would have been received if the deci-
sion maker had known what event was going to occur.

The conversion of a payoff matrix to a regret matrix is very easy. All we have to do is to subtract
each entry in the payoffmatrix from the largest entry in its column.

It is quite obvious that the largest entry in every column will have zero regret. The implication is
that if the decision-maker had indeed selected that action, he would have experienced no regret
(that is, no opportunity loss). Table 8.2 depicts the regret matrix for the T-shirt inventory prob-
lem.

20
The regret value in Table 8.2 represent the difference in value between what one obtains for a given
action and a given event and what one could obtain if one knew beforehand that the given event
was, in fact, the actual event. For example, if 100 T-shirts are ordered and demand is 150 units,
then regret is Rs. 125, as Rs. 300 (Rs. 125 more) could be received by ordering 200 units.

Thus, if the decision-maker had known that demand was going to be 150 T-shirts, his optimal deci-
sion would have been to order 200 T-shirts; if he had ordered only 100 T- shirts his opportunity loss
would be Rs. 125. The remaining entries in the regret matrix are computed by following the same
procedure, i.e., by comparing the optimal decision with the other possibilities.

The maximum regret values for each of the action or actions are presented be-
low:

The smallest possible regret (or minimum opportunity loss) would be incurred by ordering 200
units. If the original payoff table is stated in terms of losses or costs, the decision-maker will then
select the smallest loss for each event and subtract this value from each row entry.

a. Laplace (Bayes’) Criterion:

The Laplace criterion of insufficient reason differs from the minimax regret criterion in that it in-
volves the use of probabilities, that is, if we are uncertain as to which event will occur, we can
assume (correctly or incorrectly) that all states (levels of demand) are equally likely and then

21
 assign the same probability to each of the events, i.e., we assume that each event is equi-
probable.

These probability assignments can then be utilized to calculate the expected payoff for each ac-
tion and to choose that action with the maximum (smallest) expected payoff (loss). For the T-
shirt example, the probability assigned to each of the three events would be 0.33, and the ex-
pected monetary value (EMV) would be

Therefore, following the Laplace criterion, the decision-maker would order 200 units because it has
the highest expected value. This criterion is, however, criticized on the ground that the assumption
of equally likely events may be incorrect and the user of this criterion must consider the basic va-
lidity of theassumption.

b. Maximizing Expected Value:

This criterion is also based on the assignment of probabilities. However, the assumption that
each event is equi-probable is not made. Instead, the analyst makes a more critical appraisal be-
fore assigning subjective probabilities to each event. By assigning subjective probabilities, the
decision maker is, in essence, converting an uncertain situation into a situation of risk.

Suppose, for example, the inventory manager and the marketing manager reach a consensus of
opinion that the applicable probabilities for these different states of nature are: sell 100 units,
0.5; sell 150 units, 0.3; and sell 200 units, 0.2.

Since the events are mutually exclusive, the sum of theirprobabilities is equal to 1.

Based on this estimation of probabilities, the ex-pected payoff can be comput-

ed as follows:
A1 (100) = 0.5 (Rs. 200) + 0.3 (Rs. 175) + 0.2 (Rs. 150) (8.5)

= Rs. 182.50

A2 (200) = 0.5 (0) + 0.3 (Rs. 300) + 0.2 (Rs. 600) (8.6)

= Rs. 210.00

A3 (100) = 0.5 (Rs. 150) + 0.3 (Rs. 150) + 0.2 (Rs. 450) (8.7)

= Rs. 60.00

Therefore, by using the maximization of expected value criterion, the inventory manager would

22
choose A2, i.e., order 200 units.

A useful extension of the expected value criterion is the expected opportunity loss (EOL) criterion.
It differs from theEMV in the sense that it involves the use of the regret matrix.

In our example, the expected opportunity losses canbe computed as:

EOL (A1) = 0.5(0) + 0.3 (Rs. 125) + 0.2 (Rs. 450) (8.8)

= Rs. 127.50

EOL (A2) = 0.5 (Rs. 200) + 0.3 (0) + 0.2 (0) (8.9)

= Rs. 100.00

EOL (A3) = 0.5 (Rs. 350) + 0.3(Rs. 150) + 0.2(Rs. 150) (8.10)

= Rs. 250.00

The EOL criterion leads us to take the minimum EOL, which, in the T-shirt example, would be to or-
der 200 units.

Summary:
The results of employing the six criteria to our T-shirt example are given in Table 8.3. It is clear that
there is no perfect convergence of decisions, although A2 is dominant. In the final analysis, the in-
ventory manager can easily toss out the A3 option, but he must still bear the burden of choosing
A1 or A2 in the face of uncertain demand.

Expected Value of Perfect Information (EVPI):

So long our stress was on selection of an alternative on the basis of information currently pos-
sessed by the decision- maker. In most real-life situations, the decision-maker has the option of
gathering additional information before arriving at adecision.

To a rational decision-maker, the value of information can be treated as the difference between
what the payoff would be with the information currently available and the payoff that would be
earned if he were to know with certainty the out- come prior to arriving at a decision.

Simply put, the value of perfect information is the difference between the maximum profit in a cer-
tain environment and themaximum profit in an uncertain environment.

In our T-shirt example, the EMV under conditions of uncertainty for the optimal decision of ordering
23
200 units wasfound to be Rs. 210. To compute the EMV under conditions of certainty, we start with
the assumption that the decision- maker selected the option with the highest payoff for each of the
alternatives.

For example, if the inventory manager knew, before arriving at the decision, that actual demand
were going to be 100 units, the optimal decision would be to order 100 units with a payoff of Rs.
200; if demand were going to be 150 units, he would place order for 200 units with a payoff of Rs.
300 and ifdemand were 200 units, he would order 200 and the payoff would be Rs. 600.

To compute the expected value of perfect information, we simply apply the

same probabilities that were used in the EMV computations to these certain
payoffs:
Expected profit under certainty
= 0.5 (Rs. 200) + 0.3 (Rs. 300) + 0.2 (Rs. 600)

= Rs. 310 (8.11)

Therefore, in our example, the expected value of perfect information is to be computed as fol-
lows:EMV under conditions of certainty = Rs. 310

EMV under conditions of uncertainty = Rs. 210 Expected value of perfect information = Rs. 100

Thus, the inventory manager knows that the maximum amount that he would pay for a perfect pre-
diction of demand would be Rs. 100. To pay more for perfect information than the loss that would
result because of a lack of this information(uncertainty) would be irrational.

However, it is virtually impossible, in practice, to gather perfect information. Yet the computation of
its value is extremely useful to a manager. For example, if he believes that the probability that addi-
tional information will be correct is 0.3, the value of this information would be Rs. 30 (Rs. 100 x
0.3).

The basic point to note here is that they provide the decision-maker with a procedure for evaluating
the benefits of obtaining additional information and comparing them with the costs of this infor-
mation.

Sensitivity Analysis:
One major drawback in the use of the EMV, EOL or EVPI is the method used to assign probabilities
to the events. In particular, managers are likely to say “I feel the probability of this event occurring
is between 0.3 and 0.5”. Under these circumstances sensitivity analysis often bears fruit because it
provides a measure of how probability assignment affects thedecision.

Suppose, our inventory manager had obtained a different set of probability estimates for the three
levels of T-shirt demand — that is, the probabilities are 0.2 for 100, 0.3 for 150 and 0.5 for 200 T-
shirts. Based on these probabilities the expected value of the three actions (order 100, 200 or 300)
would be Rs. 167.50, Rs. 390 and Rs. 240, respectively.

The optimal decision would still be the same, viz., ordering200 units; thus the manager’s decision is
not very much sensitive to changes in the probability assignments. This assumes strategic signifi-
cance both in reducing the anxiety surrounding the decision and in measuring the need for addi-

24
tional information.

Additional Examples:
Example 1
Suppose that you have the following payoff matrix:

Select the optimal action by applying maximin, maximax,Hurwicz (= 0.3 ), minimax regret and the

Laplace criteria. Compare your choice under each criteria.

25
Example 2:
A marketing manager has to determine in which of two regions a new product should be intro-
duced. The level of salescan be characterized as either high, average or low. He estimates that the
probabilities associated with each of these outcomes are 0.25, 0.50 and 0.25, respectively.

The payoff matrix has been constructed as follows:

Using EMV as a criterion, in which of the two regions should

26
the product be introduced?

Solution:
EMV(A1) = 0.25 (40,000) + 0.50 (30,000)+ 0.25 (20,000)

= Rs. 30,000

EMV (A2) = 0.25 (70,000) + 0.50 (20,000) + 0.25 (0)

= Rs. 27,500

Select A1

Example 3:
In the following payoff matrix of a decision problem show that strategy A will be chosen by the
Bayes’ criterion, strategy B by the maximin criterion, C by the Hurwicz α (for α < 1/2) and D by the
minimax regret criterion:

27
28
Example 5
Consider a hypothetical 4 x 6 payoff matrix representing a maximizing problem of decision-maker,
faced with total uncertainty. Find out his optimal strategy considering that (a) he is a partial opti-
mist (Hurwicz criterion, with the coefficient of optimism 60%), (b) he is an extreme pessimist (Sav-
age criterion) and (c) he is a subjectivist (Laplace criterion).

29
Since it has the highest payoff the decision-maker wouldchoose A4.

If the minimax criterion is followed, the decision maker wouldagain choose A4.

Since the first decision (A1) has the highest expected value it will be taken.

Decision-Making Environment under RiskAnalysis:

Here we drew a distinction between risk and uncertainty. Recall that risk is characterized as a state
in which the

decision-maker has only imperfect information about the decision environment, i.e., the impact of
all of the available alternatives. But the decision-maker is still able to assign probability estimates
to the possible outcomes of a decision.These estimates are either subjective judgments or may be
derived from a theoretical probability distribution.
30
Uncertainty refers to a state in which the decision-maker lacks even the information to assign sub-
jective probabilities.

This distinction was first drawn by F. H. Knight who noted that risk is objective but uncertainty is
subjective. Yet, the twoterms are often used interchangeably to mean simply ‘a lack ofcertainty’.

However, the important point to note is that the use of subjective probabilities has diminished the
significance of thedistinction between risk and uncertainty. In other words, by assigning subjective
probabilities to decision problems, deci- sion-making under uncertainty can easily be converted in-
to risk analysis.

i. Treatment of Risk in Economic Analysis:

Risk analysis involves a situation in which the probabilities associated with each of the payoffs are
known.

There are two alternative ways of deriving theseprobabilities:

(a) By an analysis of historical patterns, or

(b) By reference to a theoretical probability distribution (such as the binomial distribution, Poisson
distribution or normal distribution).
Risk analysis is based on the concept of random variable. A random variable is any variable
whose value is uncertain, thatis, whose value is subject to probabilistic variation.
For example, when one rolls a die the number that comes up is a random variable. The price of
tea next week may also be random owing to unforeseen shifts in supply and demand.
Now the values that a random variable can assume may not be equally likely (i.e., equi-probable
events).
For this reason it is necessary to look at the probability dis- tribution of the random variable,
which is a listing- of the possible outcomes with the associated probabilities of those out-
comes.

For the roll of a die, the probability distribution is asfollows:

Here we let X denote the number on the face of the die and P(X) represents the probability of that
outcome. In this case, the six possible outcomes are equally likely (i.e., each one is an equi-
probable event.)

Expected Value:
An important characteristic of a random variable is its expected value or mean. Recall that the ex-
pected value is a weighted average of the possible outcomes, where the weights are the objective
probabilities of possible outcomes.

The expected value (denoted by E) of the outcomewhen a fair die is rolled is:

31
The primary decision criterion in an environment characterized by risk is the expected value (E) cri-
terion.

The criterion can simply be stated as:

where the Xs refer to the payoffs from each event and to the probabilities associated with each of
the payoffs. The concept may now be illustrated. Suppose we have the following pay-off matrix

(Table 8.4). Table 8.5 lists the respective probabilities for each of the events and the associated
expected values.

If the decision-maker analyses the expected values of each ofthe actions, he arrives at the decision
to select the option which is having the highest expected value, i.e., option 2 in this example.

32
However, the difficulty with the expected value criterion is that on the basis of it, one cannot always
make an unambiguous decision. If, for instance, the probabilities or the pay-offs were changed
such that A2 and A3 had the same expected value of Rs. 504.50, it would be difficult for the deci-
sion-maker to measure the degree of risk associated with each action and thus arrive at a clear-
cut decision. In such a situation some criterion has to be tried to arrive at a relative measure of
risk.

ii. Measurement of Risk:

The expected monetary value (EMV) criterion no doubt furnishes necessary and useful infor-
mation to the decision- maker. But its major defect is that it can obscure the presence of abnor-
mally high potential losses or exceptionally attractive potential gains. True, expected value is a
mathematical av- erage the mean of a probability distribution that neatly summarizes an entire
distribution of outcomes.

This simply explains why a decision maker who passes decisions solely on expected value is
likely to make choices that are inconsistent with his psychological preferences for risk taking.
When decisions are based on the EMV criterion, it is implicitly based on the assumption that a
decision-maker is

able to withstand the short-run fluctuations and is a continuous participant in comparable EMV
decisionproblems.

For their own survival, however, decision-makers commonly choose a course of action that is
supposed to provide a satisfactory return subject to the acceptance of a certain degree (level) of
risk.

With our present state of knowledge, the most useful way of measuring the degree of risk from
the perspective of a decision-maker, is the nature of the probability distribution — more specifi-
cally, its spread or dispersion about a mean.

In truth, the less dispersed the probability distribution of possible outcomes, the smaller the de-
gree of risk of any given decision. In other words, the closer the values of all possible outcomes
are to the expected value, the less risky the choice is likely to be. Fig. 8.1 illustrates this observa-
tion.

33
Here, for the sake of simplicity, we consider only two probability distributions. Each alternative
gives the samepayoff or EMV of Rs. 1200.

However, the distribution of possible outcomes is more closely concentrated around this expected
payoff for alternative A than it is for alternative B, i.e., for B it is more spread out around E(V). So
according to our criterion, alternative A would be treated as less risky than alternative B.

Thus even if the two alternative have the same EMV, the de- cision maker would choose the option
having the least dispersion (or maximum concentration). Students with somebackground of statis-
tics know that the simplest measure of dispersion of the possible outcomes around the mean (i.e.,
expected value) is the standard deviation of the probability distribution.

It is expressed as:

We illustrate the concept in table 8.6 below:

If we adopt the simple EMV criterion, a cursory glance would make project B apparently seem to be
the best possible choice. However, a closer scrutiny of the cash flows also reveals that project A
has a small expected value, but, at the same time, it shows less variation and according to our
yardstick, appears to be less risky.

By putting the values of cash flow (X), expected value (EMV), and assigned probability from Table
8.6 into equation (8.13) we are in a position to quantify this risk. The results of our calculations are
shown in Table 8.7.

34
 2 2

We simply calculate the standard deviation for project A and B as the square root of the variances
σA and σB . Thus we get σA = Rs. 547.7 for project A and σ B = Rs. 3197.3 for project B. Thus,
the project B has a higher EMV but it is risker since it has a higher standard deviation. In other
words, even if the returns from project B are higher on average than that of A, the former exhibits
greater variability. Hence, it involves morerisk.

If, however, two projects or alternatives have significantly different expected monetary values, we
can use standard deviation to measure relative risk of the two projects.

Suppose, that project A has an EMV of Rs. 500,000 and a standard deviation of Rs. 500, whereas
project B has an EMVof Rs. 100,000 and a S.D. of only Rs. 200.

In such a situation, we cannot compare the two projects so easily by using the standard deviation
measure. Here a new measure of relative risk, known as the coefficient of variation or the index of
relative risk, is often used.

This is expressed as:

In case of two or more projects (alternatives) having unequal costs or benefits (payoffs) the CV is
undoubtedly a preferable measure of relative risk. In our example, the coefficients of variation for
35
projects A and B are, respectively, 0.001 and 0.002.

Thus, according to our criterion, project A is less risky than project b. From Table 8.7 we can com-
pute CV for project A and B. For project A it is 0.183 and for project B, 0.297. This simply indicates
that project b is characterized by greater degree of risk than project A.

Subjective Probability:
So long we restricted ourselves to considerations of risk involving objective probabilities. Such ob-
jective probability is couched in terms of relative frequency. In fact, the probability of an event’s
happening is the relative frequency of its occurrence. This concept of probability is said to be ob-
jective in the sense that the values can be determined experimentally as in tossing a coin 10 times,
or rolling a fair die 100 times.

In some cases, however, a relative frequency (also known as the classical) interpretation of proba-
bility does not work because repeated trials are not possible. One may, for instance, ask what is
the probability of successfully introducing a new breakfast food (like Maggie).

Since there are constant changes in market conditions and in the number (range) of competitive
(rival) products, it is not possible to repeat the experiment under the same conditions hundreds of
times. In such situations the decision-maker has to assign probabilities on the basis of his own be-
lief in the likelihood of a future event. These probabilities are called subjective probabilities.

The decision-maker thus attaches his best estimate of the ‘true’ probability to each possible out-
come. In reaching decisions he makes use of these subjective probabilities in precisely the same
way the objective (or relative frequency)probabilities would be used if they were available.

iii. Profit Planning under Risk and Uncertainty: In traditional economic theory it is assumed that the
firm’s objective is to maximise its profits under conditions of certainty. However, the real com-
mercial world is characterized by uncertainty.

The presence of uncertainty upsets the profit- maximization objective. Let us consider a simple
competitive market where the demand (average revenue curve) faced by a seller is a horizontal
straight line. The implication is that the firm is a price-maker. It can sell as much as it likes at the
prevailing market price. Now let us relax the assumption.

Suppose the horizontal demand curve facing a competitive firm moves up and down in a ran-
dom (unsystematic) fashion. The implication is that the price that the firm faces is not stable.
Rather it is a random variable. In Fig. 8.2 we show the likelihood of a particular price on a given
day by the height of the bell-shaped curve.

The fact that the curve is highest for prices very close to the average or expected price P indi-
cates that these prices are most likely. Contrarily, abnormally high or exceptionally lowprices are
possible but unlikely.

36
Fig. 8.2 makes one thing clear at least: when demand is random, the actual price is subject to a
probability distribution. On average, the price will be equal to the mean price of P. Since price is
random, profit will be random, too.

As another example, let us consider the following discreteprobability distribution of prices.

It is not possible to know in advance the actual price for tomorrow. But we can calculate the ex-
pected price which is

P = 5(0.08)-t 6(0.14) + 7(0.18) + 8(0.20) + 9(0.18) + 10(0.12)

+ 11(0.08) + 12(0.02)

= Rs. 8.04

This is the average price which is arrived at by multiplying each possible price by the probability of
its occurrence andadding up the results.

Random Profit:
Now we have a random price for the firm’s output. It is further assumed that the manager must
specify the quantity of output before he observes the actual price that consumers will pay for the
commodity. Such things often happen in reality and managers have to face such uncertain situa-
tions. For example, farmers face considerable uncertainty about the price they will receive in Octo-
ber for a crop planted in July.

Similarly, producers of new fashion garments and new model wrist watches must often produce a
considerable quantity before they are able to know consumers’ reaction to their products. For sim-
plicity, we assume that the product is perishable. So the manager has to sell all the output rather
than store some of it for future sales.
37
Since profit is total revenue (= price x quantity) less total cost of producing the required quantity,
profit is also a function ofthe random price. Consequently, profit is also random.

Since profit is a random variable, the concept of maximum profit becomes meaningless. It is be-
cause one cannot maximize something which one cannot control. If profit maximization does not
appear to be a sensible goal, one has to search out or identify another objective function for the
firm.

Such a new objective function has to take account oftwo factors:

(1) The firm’s attitude toward risk and
(2) The manager’s perceptions of the likelihood of various out-comes.

It is gratifying to note that the expected utility approach to decision problems under risk accom-
modates both factors andprovides a logical way to arrive at decisions.

iv. Expected Utility Theory and Risk Aversion:

In the context of decision problems whose uncertain possible outcomes constitute rupee pay-
ments with known probabilities of occurrence, it has been observed by many that a simple pref-
erence for higher rupee amounts is not sufficient to explain the choices (that is, decisions)
made by various in- dividuals.

The classic example, known as the St. Petersburg Paradox, and formulated by the famous
mathematician, Daniel Bernoulli, about 250 years ago, illustrates a dilemma.

Bernoulli observed that gamblers did not respond to the expected rupee prices in games of
chances. Instead, he suggested that they responded to the utility that the prizesmight produce.

The paradox consists of an unbiased coin (i.e., a coin in which the probability of head or tail is
1/2) which is tossed

repeatedly until the first head appears. The player is supposed to receive or win 2n rupees as
soon as the first head appears on the n-th toss.

Now the relevant question here is: how much should the player be ready to pay to take part in
this gamble (i.e., how much should he be willing to wager)? To answer this question we have to
find out the EMV of such a gamble which is:

Here EMV is the sum of an infinite arithmetic series of 1’s.

Thus if we go by the EMV criterion we can assert that the gambler (player in our example) will be
ready to wager everything he owns in return for the chance to receive 2n rupees.
38
However, in real life most people prefer to play safe and avoidrisk. Therefore they would decide not
to participate in this type of gamble characterized by highly uncertain outcome against an unlim-
ited payment (that has to be made if the gamble is accepted).

Thus, the prediction is that actual monetary values of the possible outcomes of the gamble fail to
reflect the true preference of a representative individual for these outcomes. So the maximization
of EMV criterion is not a reliable guide in predicting the strategic action or strategic choice of an
individual in a given decision environment.

The same conclusion is also reached from other examples of behaviour, such as diversification of
investment portfolio as

also the simultaneous purchases of lottery tickets (that isgambling) and insurance.

By rejecting maximization of EMV criterion as a valid guide for decision-making in situations in-
volving risk, Von Neuman and Oskar Morgenstern developed an alternative framework (based on
expected utilities of the outcomes) which can be uti-lized for decision-making in a situation of risk.

They have proved conclusively that the Maximization of expected utility criterion, which is a prefer-
able alternative to EMV criterion, yields decisions that are in accord with the true preference of the
individual (the player) provided one condition is satisfied: he is able to assess a consistent set of
utilities over the possible outcomes in the problem.

They calculate expected utility in the same way expected valueis calculated by multiplying the utili-
ty of each outcome by its probability of occurrence, and then summing up the whole thing, thus:

This criterion apparently appears to be very effective. But a number of difficulties crop up when we
try to implement it. Firstly, in a large organization, whose utility function has to be used remains an
open question. Secondly, in case of large private firms characterized by separation of ownership
from management whose utility function — the managers’ or shareholders’ — has to be used is an-
other question.

Suppose we decide to use the utility functions of shareholders. Since different shareholders are in-
volved and they have

different utility functions, which are not directly comparable, it is virtually impossible to arrive at a
group utility function.

Secondly, complex problems arise in measuring the utility function of an individual. Yet with the
present state of knowledge, the utility function is the only tool available for incorporating the deci-
sion maker’s true preferences for the outcomes of the problem into the decision-making frame-
work.

Illustration:
39
We may now see how to utilize the new criterion, i.e., the maximization of expected utility criterion
in arriving at decisions under risk. Suppose an entrepreneur has developed a new product which is
yet to be put into the market. He is considering whether or not to make long-term investment for
introducing the product in the market.

Suppose on the basis of intensive market survey and research it is discovered that 20% of such
product met with success in the past and the remainder (80%) were failures. It is estimated that
the cost of producing and marketing a batch ofthe product will be Rs. 4,000.

If we assume that a sub-contractor can be engaged to manufacture the product, there is no need
for any investment in production facilities. It is also estimated that if the marketing effort is suc-
cessful, a profit of Rs. 16,000 will result.

We additionally assume that it is very easy to copy the product. Therefore, sooner or later, inten-
sive competition will restrict the profitable sales of the product. Thus the initial amount which is
produced can be profitably sold.

On the contrary, if the product is not initially successful and there is total failure of the marketing
effort, the maximum amount of loss the entrepreneur has to incur will be Rs.

4,000, i.e., the cost of production and marketing.

We may now summarize the basic characteristics of the decision problem in the following payoff
matrix.

It is quite obvious that the action or decision — ‘Do not invest in the product’ — results in a zero re-
turn or pay-off regardless of the decision- environment, i.e., the state of nature. In the row below
the matrix we show the probability of occurrence ofeach state of nature.

The EMV of the decision to ‘invest in the product’ is:

EMV1 = Rs. 16,000 x .20 + (Rs. -4000) x .80 = Re. 0.

On the contrary, for the alternative decision ‘do notinvest’ it is:

EMV2 = 0 x .20 + 0 x .80 = Re. 0.

Thus, in this simple example, it is very difficult for the entrepreneur to arrive at a decision on the

40
basis of EMV criterion. Since EMV is the same under two alternative actions the decision-maker
would remain indifferent between them.

Now we may incorporate the utility function of the entrepreneur into the decision-making frame-
work and see if it

enables the entrepreneur to express his risk preference. His risk reference can be measured by the
nature of his utility function.

Suppose, in the first case, that the entrepreneur has the utilityfunction, shown in Fig. 8.3.

The utility function is characterized by diminishing marginal utility of money. Recall that the word
‘margin’ always refers to anything extra. Therefore, marginal utility measures the satisfaction the
individual receives from a small increase in his stock of wealth.

Here we use the three terms ‘wealth’, ‘money’ and ‘return’ synonymously. The slope of the utility
function at any pointmeasures marginal utility.

In reality we observe that as an individual’s stock of wealth (money) increases, every additional
unit of wealth gives him gradually less and less extra satisfaction (utility). From this emerges the
diminishing marginal utility hypothesis. Here, in Fig. 8.3 the slope of the utility function falls as the
41
decision- maker’s stock of wealth increases. This corroborates the diminishing marginal utility hy-
pothesis.

The implication is simple: as his wealth increases, the individual receives less and less extra utility
(satisfaction) from each extra rupee that he receives. Now by using equation (15) we can calculate
expected utility, based on the utilityfunction of Fig. 8.3.

For the decision to ‘invest in the product’ it is:

E(U1) = U(Rs. 16,000) x .20 + U(Rs. -4000) x .80

= .375 x .20 + (-.50) x .80

= – .325

For the alternative action, i.e., for the decision ‘Donot invest’ it is:
E(U2) = U(0) x .20 (0) x .80

= 0 x .20 + 0 x .80 = 0

Thus the decision ‘Do not invest’ has a higher expected utility.Therefore, by using the maximization
of expected utility criterion, the rational entrepreneur would decide against the project. He would
decide not to invest in the new product.

Thus diminishing marginal utility of money leads directly to risk aversion. In term of EMV this in-
vestment is an exampleof fair gamble since its EMV is zero.

On the basis of differences in attitude toward risk, decision- makers are classified into three cate-
gories: risk-averter, risk-indifferent and risk- lover. In our example the investor is a risk-averter.

A risk-averter is one who, because of diminishing marginal utility of money, expresses a definite
preference for not undertaking a fair investment or fair gamble, such as the oneillustrated above. It
is also possible for the risk-averter to be reluctant to undertake investments having positive EMVs.

Now let us consider a second situation — an exactly opposite one where the entrepreneur has the
utility function, characterized by increasing marginal utility of money. Here the slope of the utility
function is increasing as the individual’swealth increases.

This reveals the increasing marginal utility hypothesis The implication of this hypothesis is simple
enough: as the individual’s wealth increases, he receives more extra utility from each extra rupee
that he receives.

42
On the basis of the data which accompany the utility function of Fig. 8.4, the expected utility of the
decision to ‘Invest in theProduct’ is:

E(U1) = U(Rs. 16,000) x .20 + U(Rs. – 4,000) x .80

= .65 x .20 + (- .10) x .80 = 0.5

It is zero for the alternative action. ‘Do not Invest’, i.e., E(U2) =

0. (Try to guess why.) Thus the optimal decision would be to accept the project, i.e., invest in the
product.

A decision-maker who, because of an increasing marginal utility of money, exhibits a definite pref-
erence for undertaking actuarially fair investments such as this one is called a risk- lover. It is be-
cause he loves to take risk. It is also possible for a risk- lover to be eager and willing to undertake
investments having negative EMVs.

Finally, let us consider a situation in which the entrepreneurhas a linear utility function, as shown in
Fig. 8.5.

43
Here the utility function shows constant marginal utility of money. The implication is that as the
individual’s wealth increases he receives the same extra utility from each additional rupee that he
receives. It is left as an exercise to thereader to demonstrate that the expected utilities of both the
decisions: ‘investment in the product’ and ‘do not invest’ are zero.

Therefore, the entrepreneur with a linear utility function would show indifference to the two alterna-
tive actions when attempting to maximise expected utility. He would, therefore, be called a risk-
indifferent (neutral) decision-maker. It is in- teresting to note that this is the same decision (that is,
indifference) as was obtained in the first part with the EMV criterion.

It is also possible to show that for a risk- neutral individual, the maximization of EMV criterion will
generally yield the same decisions as the maximization of expected utility criterion.

The implication of this statement for decision-making purposes is that if the decision-maker feels
that he is having a linear utility function over the range of outcomes in a decision problem, there is
hardly any need to go through the whole complex process of seeking to derive his utility function
of money.

In such a situation, taking the action with the highest EMV will surely lead to decisions that are
quite in accord with thetrue preferences of the decision-maker.

In short, the decision-maker’s attitude toward risk determines the shape of his utility function and
assists the choice of alternative in a decision problem involving risk.

v. Sequential Decision Making: Decision TreeAnalysis:

A new technique of decision making under risk consists of using tree diagrams or decision trees. A
decision tree is usedfor sequential decision-making. Suppose Mr. X is a decision-maker with a utili-
ty function shown in Fig. 8.6 who has an income of Rs. 15,000, and he is given the following offer.

44
Mr. X’s friend Mr. Y will flip a coin. If a head appears in the first toss Mr. X owes Mr. Y Rs. 5,000; if a
tail appears, Mr. Ywill pay Mr. X Rs. 6,000. Mr. X’s EMV from playing this gamble is Rs. 500 (a 50%
chance of losing Rs. 5,000 supported by a 50% chance of winning Rs. 6,000).

It is worthwhile for Mr. X to decline the bet if the reduction in utility from losing Rs. 5,000 is greater
than the increase in utility from winning Rs. 6,000. Table 8.9 and Fig. 8.6 summaries mathematical-
ly Mr. X’s decision, i.e., not to take the coin flipping bet, in two different ways.

In Table 8.6, a comparison of the EMV of ‘Take Bet’ with

‘Decline Bet’, shows that the Rs. 500 expected gain from taking the bet is surely better than the ze-
ro rupee gain from declining the bet. If we bring into focus the concept of utility,the expected utility

45
loss of 25 from betting is obviously inferior to the no-change outcome.

Fig. 8.7 presents the same information using decision trees.

The tree in panel (a) considers monetary gain and loss; the tree in panel (b) shows utility gain and
loss. The initial branch of both the trees — upper and lower, represents bet or decline bet decision,
with each subsequent branch representing the possible outcomes and the associated probabili-
ties.

After setting forth the probabilities, we calculate the expected monetary values — which are shown
in the brackets. We can now compare the figures in brackets — (Rs. 500) and (Re. 0)

— in the upper tree with the expected utility figures — (-0.25)and (0) — in the lower tree.

The major advantage of the decision tree approach is its brevity. In fact, it is easier to comprehend
‘trees’ easily than tables when we move to more realistic business situations involving various de-
cisions (branches). Moreover, decision trees highlight the sequential nature of decision-making.

Example:
Choosing a Technique of Production:
Suppose Mr. Ram is a project manager and has been entrusted with the responsibility of develop-
ing a new circuitboard which is an important component of a colour TV.

The budgetary limit of the project has been set at Rs. 400,000 and Mr. Ram has been given six
months time to complete the project. The R&D engineers have succeeded in identifying two ap-
46
proaches, one utilizing conventional materials and another using a newly developed chip.

It has been estimated by the marketing department that if the circuit board is produced with con-
ventional materials, the company will make a profit of Rs. 478,300. The newer computer chip of-
fers the twin advantages of simplicity and reliability when compared with the use of conventional
mate-rials.

There will also be a cost saving of Rs. 150,000. Additionally, the new computer chip would gener-
ate additional profits of Rs. 121,700 over and above the cost savings. Thus the total payoff from
using the new technology chip would be equal to Rs. 750,000 (=Rs. 478,300 + Rs. 150,000+ Rs.
121,700).

Given sufficient time and money, either of the two methods could be developed to specifications.
However, with fixed budget and limited time, Mr. Ram arrives at the estimate that there is a 30%
chance that the circuit board made from the conventional materials will not be up to the mark and
a 50% chance that the newer technology using the chip will fail to meet specifications.

The end result of the project involves the construction of a functional prototype. The prototype
would cost Rs. 60,000 if all conventional materials are used and Rs. 100,000 if the newly designed
chip is used. So the crucial decision problem facing Mr. Ram is one of choosing which of the two
designs should be used in constructing the prototype model.

Since the financial limit has been set at Rs. 400,000, Mr. Ram has the option of simultaneously
pursing the development of both prototypes.

It is because the total cost is Rs. 160,000 which is much less than the budgetary limit of Rs.
400,000. However, if both the

prototypes are developed, an additional labour cost of Rs.107,000 has to be incurred. Fig. 8.8 pre-
sents the decisiontree associated both the problem faced by Mr. Ram.

47
If the maximization of EMV criterion is followed, the decision would be to build both prototypes be-
cause the expected profits of Rs. 325,410 would far exceed the profit of any one ofthe two.

However, in order to measure the riskiness of the three alternatives, Mr. Ram computes the stand-
ard deviation of each of the alternatives. Moreover, he computes coefficient of variation to make a
comparison of the degree of riskiness of the three actions.

The results of such computations are presented inTable 8.10 below:

It is clear that construction of the prototype using conventional materials (A1) is the least risky al-
ternative. But its payoff is also the lowest of the three. Hence Mr. Ram is faced with a perplexing
dilemma — a trade-off between riskand profitability. Larger return implies higher risk.

vi. Adjusting the Valuation Model for Risk: Diminishing marginal utility of money leads directly to
risk aversion. Such risk aversion is reflected in the valuation model used by investors to deter-
mine the worth of a firm. Thus, if a firm succeeds in taking an action that increases itsrisk level,
this action affects its value.

The model was introduced as a way of discounting future income stream to the
present:

Where Rt = sales revenue from Qt units; Ct = cost of producing Qt units;

Πt = profit;

r = interest rate; and

t = time period under consideration; t equal to zero in base (current) year and n at the end of n time
periods.

The model, it may be recalled, states that the value of a firm to its investors is the discounted pre-
sent worth of future profits or income. Under uncertain conditions the profits in the numerator, Rt
– Ct = Pt, are really the expected value of the profits each year.

If the firm has to choose between alternative methods of operation, one with high expected profits
and high risk and another with smaller expected profits and lower risk, will the higher expected
profits be sufficient to neutralize the high degree of risk involved in it? If so, the riskier alternative
will surely be preferred; otherwise the low-risk project or methodof operation should be accepted.
48
We devoted ourselves to developing a broad understanding of the economic aspects of the NPV
equation. We noted that an economic organization seeks to maximize its prospects for economic
survival by maximizing NPV.

Now we shall interpret our valuation model of the firm in terms of the expected utility approach.
The switch-over from utility theory to the NPV model is a simple exercise. Because of the diminish-
ing marginal utility of money most decision- makers (e.g., investors) are risk averters.

Now, in the context of our NPV model we may assert that risk aversion is reflected in the fact that
any decision that a firm makes will surely change its risk level — the degree of risk to which it is
exposed. The change in the risk level because of the decision taken by the firm will have a direct
bearing on its NPV level. Now an important question is: how to adjust our basic valuation model for
risk?

There are two ways of adjusting the model in the lightof reality, i.e.,:
(1) Using the concept of certainty equivalent and
(2) Using risk- adjusted discount rate.

Decision-Making Environment under CertaintyEquivalents:

The first method of dealing with risk it to replace the expected net income figures (Rt — Ct) in the
NPV equation with their certainty equivalents.

We may now illustrate the concept. Suppose Mr. Hari has purchased a lottery ticket that has a 50-
50 chance of paying Rs. 1,000 or Re. 0. Thus the lottery is equivalent to tossing an unbiased coin. If
head appears, Mr. Hari will get Rs. 1,000 and if tail appears he gets nothing. If we adopt the classi-
cal definition of probability as the limit of relative frequency, we know one thing at least.

If Mr. Hari tosses the coin again and again, on an average, he would win (get a head) half the time
and lose (get a tail) half the time. Thus Mr. Hari’s average or expected payoff in this game is Rs.
500 per ticket. This much is known to us.

But what we do not know as yet is; how much would Mr. Haribe willing to sell his ticket for? To put
the question in a different language, what is the lowest offer that Mr. Hari is willing to accept — Rs.
300, Rs. 500 or Rs. 600? The cash offer he would accept in order to be induced to part with his
ticket is the certainty equivalent (CE) of the lottery.

If, for instance, he would accept Rs. 300 (CE = Rs. 300), then his risk premium (RP) can be de-
fined as:RP = EMV- CE

Rs. 200 = Rs. 500 – Rs. 300 (8.18)

In such a situation Mr. Hari is willing to pay Rs. 200 risk premium to quit (sell the lottery ticket).
Since his CE is less than his EMV, the risk premium is positive and he would be classified as a risk-
averter. Had his CE exactly equalled the EMV of Rs. 500, he would be described as risk- neutral (in-
different).

Alternatively, he may be a risk-lover, in which case he would not exit the game (part with the lottery
ticket) unless he re- ceived more than Rs. 500. On the basis of this simple example, we may define
CE of a decision as “the sum of money, available with certainty, that would cause the decision-

49
maker to be indifferent between accepting the certain sum of money and making a decision (or
taking the gamble)”.

It is obvious that CE sum equal to the EMV implies risk indifference. Likewise, a CE sum greater
than the EMV indicates risk. Therefore, an individual’s attitude toward risk is directly reflected in the
CE adjustment factor.

It is calculated as the ratio of the equivalent certain rupees sum (i.e., the certain sum whose utility
is equal to the expected utility of the risky alternative) divided by the ex- pected rupee outcome
from the risky alternative as equation(8.18) shows.

α = Equivalent Certain Sum/Expected Risky Sum

Let us suppose that Zt represents the CE for net income (Rt – Ct) in period t.

Now the NPV equation may be rewritten as:

The calculation of the certainty equivalent (Z t) could be done on a purely subjective basis by the
individual carrying out the financial analysis, or the analyst could make use of a formal estimate
(based on actual information and an appropriate

model). If we substitute the value of Z t in equation (8.19), the NPV calculation would reflect a crude
adjustment for risk.

It may be emphasized at this stage that the process of adjusting for time and risk in the NP V
model is a complex and controversial task. In fact, even the order (risk first or time first) in which
one adjusts the cash flow (numerator in the NPV model) can have a major impact on the final re-
sults.

The most obvious defect of the CE approach, outlined above, is that it requires the specification of
a utility function so thatrisk premium can be numerically measured or quantified.

However, one way possible of overcoming this problem is to go through an alternative and better
known risk adjustmentprocess — the risk adjusted discount rate method.

The Risk Adjusted Discounted Rate (RADR):

The RADR approach is very easy to use and therefore very popular. In order to understand the con-
cept let us go back to equation (8.16). Recall that the CE approach to adjusting our basic valuation
model to risk operated on the numerator (R t — Ct). By contrast, the RADR method focuses on the
de- nominator.

To be more specific, the RADR procedure replaces the discount rate with a new term p, which is the
sum of the initialdiscount rate and risk factor k. That is p = r + k. If, for instance, r equals 10% and k
equals 3%, the new risk-adjusted discount rate becomes 13%.

Increasing the discount rate implies deflating NPV. Since NPV analysis uses a compounding factor
in the denominator
50
(1+r)t the incorporation of a risk adjustment factor in the denominator to deflate future values,
heightens this compounding.

To illustrate, a discount rate of 10% becomes a discount factorof 1.46 [= (1.10)4] by the end of four
years, and the 13% rate becomes 1.63 [=(1.13)4].

However, there is hardly any justification for the assumption of a compounding risk factor, rather
than a risk difference of just three percentage points (1.13 – 1.10) or a ratio of (1.63 – 1.46=)
1.116 by the end of four years. Thus, the risk differential increases with the number of years in the
project.

This particular observation has important implications for project planning and long-term invest-
ment decision. If, for example, there are two investment projects with the same degree of risk but
differing time horizons, then the use of a common discount rate (such as 13%, in our example) is
sure tohave a distorting influence for the longer project.

The reason is simple enough: the risk factor will continue to compound in later years. However, the
RADR is not withoutits defects. Its major defect is that, as one number, the discount rate is used to
combine the effects of both risk and the time value of money.

The RADR is often made us of in capital budgeting (i.e., long- term investment) decisions. If this
factor is brought into consideration, future cash flows for each project are discounted at a rate, K*,
which is based on the risk associated with the project. Fig. 8.9 illustrates the relationship between
K* and project risk.

Here the rƒ value denotes the risk-free rate, i.e., the minimum acceptable rate of return from an in-
vestment project having certain cash flow streams. Fig. 8.9 makes one point clear at least: the
greater the project risk the higher the rate used in discounting the project’s cash flows.

Decision under Conflict and Game Theory:

So far we have considered only a single decision maker. The states of nature occur passively and

51
independently of the strategies chosen. When opponents are involved, the opponents’ strategies
can be represented by the columns.

These will replace the states of nature and there will be as many columns as strategies. The two
decision-makers will not choose their strategies independently. There will be interaction, the basis
of which is conflict of interest.

Decision theory involving 2 or more decision makers is known as game theory. Games are classi-
fied according to number of players and degree of conflict of interest.

With complete conflict of interest the game is a zero-sum game. Most parlour games are of this
type. A duopoly battle tocapture a higher share of the market is another. If the conflict of interest is
not complete, the game is called a non-zero sum game. With external economies, such games
could arise.

Let us consider a decision problem facing two players. Both players wish to maximise their pay-
offs. Player A has 3 and player B has 4 strategies. For example, 3 multinationals want contracts in a
Banana Republic. The first company could either bribe the present government, arranging a coup
in- vasion. The second company has an extra option of getting a neighbouring country to attack.
The payoffs are measured in terms of profit.

With a zero sum game, player A’s gain is B’s loss. Therefore a single matrix can represent both
players payoffs. Payoff to B = – (Payoff to A).

If A chooses strategy A1, B will try to maximise his own payoff (that is, minimise A’s payoff). So B
will choose B 2 . Similarly if A chooses A2, B will choose B3. If A chooses A3, B will chose B1. So
the relevant payoffs for each strategy is the minimum for each now. A will maximise this and
choose A2. This is nothing but the maximin criterion.

Whatever strategy B chooses, A will try to maximise his ownpay-offs. So if B chooses B1, A choos-
es A1 and so on.

52
B will choose strategy B3. This minimises A’s payoff and therefore maximises his own. So B
chooses the minimax criterion. In this case the payoffs under minimax and maximin principles are
the same and equal to 1.5. If thishappens, such a value is called a saddle point. It is the solution to
the game.

But even if no saddle point exists, a solution to any zero-sum-two person game will exist. The solu-
tion will be in terms of mixed strategies (where the specific strategy to be used is selected ran-
domly with a pre-determined probability). The proof of this is known as the fundamental theorem
of game theory.

It is sometimes difficult to get the exact utilities required to construct a payoff matrix. Ranked data
are then often used. The two competitors may not have the same approximate utilities (with a
negative sign). The two payoff matrices will be required. It will also be necessary to assume that
each competitor can estimate the other’s utility. It is the existence of such dissimilar utilities that
cause non-zero-sum type of games.

It may also be that the opponent’s utilities are not known at all: The decision problem would then
have to be treated underuncertainty. Not knowing the opponent’s utilities implies thatthe player has
no idea at all about the possible choice of strategies that is equivalent to decision-making under
uncertainty for a single decision-maker.

In terms of actual conditions a large number of problems is involved with states of nature. Even
with situations involving antagonistic decision makers, this analysis is often not applicable under
perfect competition.

The activities of a single entrepreneur will not then affect market conditions. But whenever a single
firm controls a large share of the market, either with duopoly or oligopoly, game theory becomes
important. Even monopoly can be represented as a game between a producer and seller.

5 Types of Games in GameTheory (With Diagram)

In the game theory, different types of games help in theanalysis of different types of problems.

The different types of games are formed on the basis of number of players involved in a game,
symmetry of the game,and cooperation among players.

53
The different types of games (as shown in Figure-1)are explained below:
1. Cooperative and Non-Cooperative Games: Cooperative games are the one in which players are
convinced to adopt a particular strategy through negotiations and agreements between players.
Let us take the example cited in prisoner’s dilemma to understand the concept of cooperative
games. In case, John and Mac had been able to contact each other, then they must have decid-
ed to remain silent. Therefore, their negotiation would have helped in solving out the problem.

Another example can be cited for pan masala organizations. Suppose pan masala organizations
have high ad-expenditure that they want to reduce. However, they are not sure whether other or-
ganizations would follow them or not.

This creates a situation of dilemma among pan masala organizations. However, the government
restricts the advertisement of pan masala on televisions. This would help in reducing the ad-
expenditure of pan masala organizations.This is an example of cooperative game.

However, non-cooperative games refer to the games in which the players decide on their own
strategy to maximize their profit. The best example of a non-cooperative game is prisoner’s di-
lemma. Non-cooperative games provide accurate results. This is because in non-cooperative
games, a very deepanalysis of a problem takes place.

2. Normal Form and Extensive Form Games:

Normal form games refer to the description of game in the form of matrix. In other words, when
the payoff and strategies of a game are represented in a tabular form, it is termed as normal
form games. Normal form games help in identifying the dominated strategies and Nash equilib-
rium. In normal form games, the matrix demonstrates the strategies adopted by the different
players of the game and their possible outcomes.

On the other hand, extensive form games are the one in whichthe description of game is done in
the form of a decision tree. Extensive form games help in the representation of events that can
occur by chance. These games consist of a tree-like structure in which the names of players are
represented on different nodes.

54
 In addition, in this structure, the feasible actions and pay offs of each players are also given. Let
us understand the concept of extensive form games with the help of an example. Suppose or-
ganization A wants to enter a new market, while organization B is the existing organization in
that market.

Organization A has two strategies; one IS to enter the market and challenge to survive or do not
enter the market and remain deprived of the profit that it can earn. Similarly, organization B also
has two strategies either to fight for its existence or to cooperate with organization A.

Figure-2 shows the decision tree for the presentsituation:

In Figure-2, organization A takes the first step that would be followed by organization B later on. In
case, organization A does not enter the market, then its payoffs would be zero.

However, if it enters the market, the market situation wouldbe totally dependent on organization B.

If they both get into the price war, then both of them would suffer the loss of 3. On the other hand,
if organization B cooperates, then both of them would earn equal profits. In this case, the best op-
tion would be that organization A entersthe market and organization B cooperates.

3. Simultaneous Move Games and Sequential MoveGames:

Simultaneous games are the one in which the move of two players (the strategy adopted by two
players) is simultaneous. In simultaneous move, players do not have knowledge about the move
of other players. On the contrary, sequential games are the one in which players are aware about
the moves ofplayers who have already adopted a strategy.

However, in sequential games, the players do not have a deep knowledge about the strategies of
other players. For example, a player has knowledge that the other player would not use a single

55
 strategy, but he/she is not sure about the number of strategies the other player may use. Simul-
taneous games are represented in normal form while sequential games are represented in ex-
tensive form.

Let us understand the application of simultaneous move games with the help of an example.
Suppose organizations X and Y want to minimize their cost by outsourcing their marketing activ-
ities. However, they have a fear that outsourcing of marketing activities would result in increase
of sale of the other competitor. The strategies that they can adopt are either to outsource or not
to outsource the marketing activities.

The payoff matrix for the two organizations is shownin Table-10:

In Table-10, it can be seen that both the organizations X and Y are unaware about the strategy of
each other. Both of them

work on the perception that the other one would adopt the best strategy for itself. Therefore, both
the organizations would adopt the strategy, which is best for them.

The same example can also be used for the explanation of sequential move games. Suppose or-
ganization X is the firstone to decide whether it should outsource the marketing activities or not.

The game tree that represents the decision of organization X and Y is shown in
Figure-3:

56
In Figure-3, the first move is taken by organization X while organization Y would take decision on
the basis of the decisiontaken by X. However, the final outcome depends on the decision of organ-
ization Y. In the present case, the second player is aware of the decision of the first player.

4. Constant Sum, Zero Sum, and Non-Zero SumGames:

Constant sum game is the one in which the sum of outcome of all the players remains constant
even if the outcomes are different. Zero sum game is a type of constant sum game in which the
sum of outcomes of all players is zero. In zero sum game, the strategies of different players
cannot affect theavailable resources.

Moreover, in zero sum game, the gain of one player is always equal to the loss of the other play-
er. On the other hand, non- zero sum game are the games in which sum of the outcomes of all
the players is not zero.

A non-zero sum game can be transformed to zero sum game by adding one dummy player. The
losses of dummy player are overridden by the net earnings of players. Examples of zero sum
games are chess and gambling. In these games, the gain of one player results in the loss of the
other player. However, cooperative games are the example of non-zero games. This is because
in cooperative games, either every player wins or loses.

5. Symmetric and Asymmetric Games:

In symmetric games, strategies adopted by all players are same. Symmetry can exist in short-
term games only because in long-term games the number of options with a player increases.
The decisions in a symmetric game depend on the strategies used, not on the players of the
game. Even in case of interchanging players, the decisions remain the same in symmetric
games. Example of symmetric games is prisoner’s dilemma.

On the other hand, asymmetric games are the one in which strategies adopted by players are
different. In asymmetric games, the strategy that provides benefit to one player may not be
equally beneficial for the other player. However, decision making in asymmetric games depends
on the different types of strategies and decision of players. Example of asymmetric game is en-
try of new organization in a market
57
 because different organizations adopt different strategies toenter in the same market.

Types of Market Structures

As we have seen, in economics the definition of a market has avery wide scope. So understandably
not all markets are the same or similar. We can characterize market structures based onthe compe-
tition levels and the nature of these markets. Let us study the four basic types of market structures.

Types of Market Structures

A variety of market structures will characterize an economy.Such market structures essentially refer
to the degree of competition in a market.

There are other determinants of market structures such as the nature of the goods and products,
the number of sellers,number of consumers, the nature of the product or service,

economies of scale etc. We will discuss the four basic types ofmarket structures in any economy.

One thing to remember is that not all these types of market structures actually exist. Some of them
are just theoretical concepts. But they help us understand the principles behind the classification of
market structures.

1] Perfect Competiton
In a perfect competition market structure, there are a large number of buyers and sellers. All the
sellers of the market are small sellers in competition with each other. There is no one big seller with
any significant influence on the market. So all the firms in such a market are price takers.
There are certain assumptions when discussing the perfect competition. This is the reason a per-
fect competition market ispretty much a theoretical concept. These assumptions are as follows,

• The products on the market are homogeneous, i.e. they arecompletely identical
• All firms only have the motive of profit maximization
• There is free entry and exit from the market, i.e. there are nobarriers
• And there is no concept of consumer preference

2] Monopolistic Competition

This is a more realistic scenario that actually occurs in the real world. In monopolistic competi-
58
 tion, there are still a large number of buyers as well as sellers. But they all do not sell homoge-
neous products. The products are similar but all sellerssell slightly differentiated products.
Now the consumers have the preference of choosing one product over another. The sellers can
also charge a marginally higher price since they may enjoy some market power. So the sellers be-
come the price setters to a certain extent.
For example, the market for cereals is a monopolistic competition. The products are all similar
but slightly differentiated in terms of taste and flavours. Another suchexample is toothpaste.

3] Oligopoly
In an oligopoly, there are only a few firms in the market. Whilethere is no clarity about the number
of firms, 3-5 dominant firms are considered the norm. So in the case of an oligopoly, the buyers
are far greater than the sellers.
The firms in this case either compete with another to collaborate together, They use their market
influence to set the prices and inturn maximize their profits. So the consumers become the price
takers. In an oligopoly, there are various barriers to entry in the market, and new firms find it diffi-
cult to establish themselves.
4] Monopoly
In a monopoly type of market structure, there is only one seller,so a single firm will control the en-
tire market. It can set any price it wishes since it has all the market power. Consumers do not
have any alternative and must pay the price set by the seller.
Monopolies are extremely undesirable. Here the consumer loose all their power and market forces
become irrelevant. However, apure monopoly is very rare in reality.

Solved Question on Market Structures

Q: The cellular industry is an example of which of thefollowing?

a. Monopolistic Competition
b. Monopoly
c. Perfect Competition
d. Oligopoly

Ans: The correct option is D. In the cellular industry there are 3-5 dominant firms (Airtel, Vodafone, Jio
etc). These are the pricesetters. And consumers have a limited choice between these fewchoices.

Competitive Equilibrium
What Is Competitive Equilibrium?
Competitive equilibrium is a condition in which profit-maximizing producers and utility-maximizing
consumers in competitive markets with freely determined prices arrive at an equilibrium price. At
this equilibrium price, the quantity supplied is equal to the quantity demanded. In other words, all
parties—buyers and sellers—are satisfied that they're getting a fair deal.

Competitive equilibrium is also called Walrasian equilibrium.

KEY TAKEAWAYS
• Competitive equilibrium is achieved when profit-maximizing producers and utility-
maximizing consumers settle on a price thatsuits all parties.
• At this equilibrium price, the quantity supplied by producers is equal to the quantity demand-
ed by consumers.
• The theory serves many purposes, operating as a benchmark for efficiency in economic
59
 analysis.

Understanding Competitive Equilibrium

As discussed in the law of supply and demand, consumers and producers generally want two dif-
ferent things. The former wants to pay as little as possible, while the latter seeks to sell its goods
at the highestpossible price.

That means when prices are hiked, demand tends to fall and supply rises—and when prices are
slashed, demand increases and supply declines.

Eventually, these two forces end up balancing out.

The supply and demand curve intersects and a price that suits all partiesis reached. Suddenly, what
buyers are willing to pay equals what suppliers are willing to sell the goods they produce for.

At equilibrium prices, each agent maximizes his or her objective function subject to his or her tech-
nological limitations and resource constraints, and the market clears the aggregated supply and
demand for theproducts in question.

Benefits of Competitive Equilibrium

The competitive equilibrium can be considered a specialized branch of game theory that deals with
making decisions in large markets. It serves many purposes, operating as a benchmark for effi-
ciency in economic analysis.

In a capitalist market, vital regulatory functions, such as ensuring stability, competency and fair-
ness are left to the mechanisms of pricing.Thus, competitive equilibrium theory of equilibrium pric-
es acquired a prominent place in mathematical economics. With the advent of the internet, exten-
sive research has been done at the intersection of computer science and economic theory.

Competitive equilibrium can be used to predict the equilibrium price and total quantity in the mar-
ket, as well as the quantity consumed by each individual and output per firm. Moreover, it is often
used extensively to analyze economic activities dealing with fiscal or tax policy, in finance for anal-
ysis of stock markets and commodity markets, as well as to study interest, exchange rates, and
other prices.

Special Considerations
The theory relies on the assumption of competitive markets, where each trader decides upon a
quantity that is so small compared to the total quantity traded, such that their individual transac-
tions have no influence on the prices. Competitive markets are an ideal, and a standard by which
other market structures are evaluated.

Competitive Equilibrium vs. General Equilibrium

The defining characteristic of competitive equilibrium is that it is competitive. By contrast, a gen-
eral equilibrium's defining characteristic is that it is an equilibrium on more than one market; as op-
posed to the partial equilibrium in which we hold at least one price fixed and analyze the response
of other markets/prices only.

The difference between the two types of equilibriums is all about the emphasis. Any general equi-
librium is a competitive equilibrium, but not any competitive equilibrium is necessarily general equi-

60
librium.

3 Static Properties of a General Equilibrium State

Three static properties are observed in a general equilibrium solution, reached

with a free competitivemarket mechanism:
(a) Efficient allocation of resources among firms (equilibriumof production).
(b) Efficient distribution of the commodities produced between the two consumers (equilibrium of
consumption).
(c) Efficient combination of products (simultaneousequilibrium of production and consumption).
These properties are called marginal conditions of Pareto optimality or Pareto efficiency. A sit-
uation is defined as Pareto optimal (or efficient) if it is impossible to make anyone better- off
without making someone worse-off. In the following paragraphs we discuss briefly the three
optimality properties that are observed in a general equilibrium state.

(a) Equilibrium of production (efficiency in factorsubstitution):

Equilibrium of production requires the determination of the efficient distribution of the available
productive factors among the existing firms (efficiency in factor substitution). We know that the
firm is in equilibrium if it chooses the factor combination (for producing the most lucrative level of
output)which minimizes its cost. Thus the equilibrium of the firm requires that

where w and r are the factor prices prevailing in the market

and MRTS is the marginal rate of technical substitution between the factors. The joint equilibrium
of production of thetwo firms in our simple model can be derived by the use of the Edge-worth box
of production. On the axes of this construct we measure the given quantities of the factors of pro-
duction, K and L (figure 22.23). The isoquants of commodity X are plotted with origin the south-
west corner and the isoquants of y are plotted with origin the north-east corner.

The locus of points of tangency of the X and Y isoquants iscalled the Edge-worth contract curve of
production. This curve is of particular importance because it includes the efficient allocations of K
and L between the firms.

61
Each point of the Edge-worth box shows a specific allocation of K and L in the production of com-
modities X and y. Such anallocation defines six variables the amounts of Y and X produced and the
amounts of capital and labour allocated to the production of Y and X.

For example point Z shows that:

X3 is the quantity produced of commodity X Y2 is the quantity produced of commodity Y
Kx is the amount of capital allocated to the production of X3 Ky is the amount of capital allocated
to the production of Y 2 Lx is the amount of labour allocated to the production of X3 Ly is the
amount of labour allocated to the production of Y2 However, not all points of the Edge-worth box
represent efficient allocations of the available resources. Given that K and L are limited in supply,
their use should produce the greatest possible output. An allocation of inputs is efficient if the pro-
duced combination of X and Y is such that it is impossible to increase the production of one com-
modity without decreasing the quantity of the other.

From figure 22.23 we see that efficient production takes place on the Edge-worth contract curve. It
is impossible to move to a point off this curve without reducing the quantity of at least one com-
modity. Point Z is a point of inefficient production, since a reallocation of K and L between the two
commodities (or firms) such as to reach any point from a to b leads to a greater production of one
or both commodities.

Since the Edge-worth contract curve of production is the locus of tangencies

of the X and Y isoquants, at each one of its points the slopes of the isoquants
are equal:

In our simple general equilibrium model the firms, being profit maximisers in competitive markets,
will be in equilibrium only if they produce somewhere on the Edgeworth contract curve. This fol-
lows from the fact that the factor prices facing the producers are the same, and their profit maxi-
misation requires that each firm equates its MRTS L k with the ratio of factor prices w/r MRTSxL,k
= MRTSyL,k = w/r (1)

In summary. The general equilibrium of production occurs at a point where the MRTSL,k is the

62
same for all the firms, that is, at a point which satisfies the Pareto- optimality criterion of efficiency
in factor substitution the general equilibrium of production is a Pareto-efficient allocation of re-
sources. The production equilibrium is not unique, since it may occur at any point along the Edge-
worth contract curve there is an infinite number of possible Pareto-optimal production equilibria.

However, with perfect competition, one of these equilibria will be realized, the one at which the
(‘equalised’ between the firms) MRTSL,K is equal to the ratio of the market factor prices w/r. That
is, with perfect competition general equilibrium of production occurs where condition (1) is satis-
fied.

If the factor prices are given, from the Edgeworth box of production we can determine the amounts
of X and Y which maximise the profits of firms. However, in a general equilibrium, these quantities
must be equal to those which consumers want to buy in order to maximise their utility.

Consumers decide their purchases on the basis of the prices ofcommodities, Px and Py.
Thus, in order to bring together the production side of the system with the demand side, we must
define the equilibrium of the firms in the product space, using as a tool the production possibility
curve of the economy. This is derived from the Edgeworth contract curve of production, by map-
pingits points on a graph on whose axes we measure the quantities

From each point of the Edgeworth contract curve of produc- tion we can read off the maximum ob-
tainable quantity of one commodity, given the quantity of the other. For example, point a in figure
22.23 shows that, given the quantity of X is X3, the maximum quantity of Y that can be produced
(with the given factors K and L) is Y3.

The X3, Y3 combination is presented by point a’ in figure 22.24. Similarly, point b of the Edge-worth
contract curve of production shows that, given X4, the maximum amount of Y that the economy
can produce is Y2. Point b’ in figure 22.24 is the mapping of b from the factor space to the produc-
tion space.

In summary, the production possibility curve of an economy is the locus of all Pareto-efficient out-
puts, given the resource endownment (K and L) and the state of technology. This curve shows the
maximum quantity of a good obtainable, given the quantity of the other good. At any point on the
curve all factors are optimally (efficiently) employed. Any point inside the curve is technically inef-
ficient, implying unemployed resources. Any point above the curve is unattainable, unless addi-
tional resources or a new technology or both are found.

63
The production possibility curve is also called the product transformation curve because it shows
how a commodity is ‘transformed’ into another, by transferring some factors fromthe production of
one commodity to the other.

The negative of the slope of the production possibility curve is called the marginal rate of (product)
transformation, MRPTxy and it shows the amount of Y that must be sacrificed in order to obtain an
additional unit of X. The economic meaning of the transformation curve is the rate at which a
commodity can be transformed into another. By definition MRPTx,y = dY/dX

Since dY/dX is negative, the MRPT is a positive number. It can be shown that the MRPTxy is equal
to the ratio of the marginal costs of the two products

In perfect competition the profit-maximising producer equates the price of the commodity pro-
duced to the long-runmarginal cost of production
64
MCX = Px and MCy = Py

Therefore the slope of the production possibility curve is also equal to the ratio of the prices at
which X and Y will be supplied by perfectly competitive industries

MRPTx,y = MCx / MCy = Px / Py …(2)

Given the commodity prices, general equilibrium of production is reached at the point on the pro-
duction transformation curve that has a slope equal to the ratio of these prices. Such a general
equilibrium of production is shown in figure 22.25. Assume that the market prices of commodities
define the slope of the line AB. The ratio 0A/0B measures the ratio of the marginal cost of and
hence the supply price of X to that of y.

The general equilibrium product-mix from the point of view of firms is given by point T. The two
firms are in equilibrium producing the levels of output Ye and Xe.

(b) Equilibrium of consumption (efficiency indistribution of commodities):

We must now show how each consumer, faced with the market prices Px and Py, reaches
equilibrium, that is, maximises his satisfaction. From the theory of consumer behaviour we
know that the consumer maximises his utility by equating the marginal rate of substitution of
the two commodities (slope of his indifference curves) to the price ratio of the commodities.
Thus the condition for consumer equilibrium is
MRSx,y = Px /Py
Since both consumers in perfectly competitive markets are faced with the same prices the
condition for joint or generalequilibrium of both consumers is
MRSAx,y = MRSBx,y = Px /Py (3)
This general equilibrium of consumption for the product mix Ye, Xe is shown in figure 22.26.
We construct an Edgeworth box for consumption with the precise dimensions Ye and Xe by
dropping from point T (on the product transformation curve) lines parallel to the commodity
axes. We next plot the

65
 indifference curves of consumer A with origin the south-west corner, and the indifference
curves of B with origin the north-east corner.

Any point in the Edgeworth consumption box shows six variables: the total quantities Ye and
Xe, and a particular distribution of these quantities between the two consumers. However, not
all distributions are efficient in the Pareto sense. A Pareto- efficient distribution of commodities
is one such that it is impossible to increase the utility of one consumer without reducing the
utility of the other. From figure 22.26 it is seen that only points of tangency of the indifference
curves of the two consumers represent Pareto-efficient distributions. The locus of these points
is called the Edge- worth contract curve of consumption. It should be clear that at each point of
this curve the following equilibrium condition is satisfied MRSAx,y = MRSBx,y

Thus for a given product-mix (such as T, which we are considering) there is an infinite number
of possible Pareto- optimal equilibria of distribution: the equilibrium of consumption is not
unique, since it can occur at any point of the contract curve of consumption. However, with per-
fect competition, only one of these points is consistent with the

general equilibrium of the system. This is the point of the contract curve where the (‘equalised’)
MRSx,y of the consumers is equal to the price ratio of the commodities, that is, where condi-
tion (3) is fulfilled.

In figure 22.26 the equilibrium of the consumers is defined by point T. Consumer A reaches the
utility level implied by the indifference curve A2, buying 0M of X and ON of Y. Consumer B
reaches the utility level implied by the indifference curve B4, buying the remaining quantities
MXe of X and NYe of Y.

(c) Simultaneous equilibrium of production andconsumption (efficiency in product-mix):

From the discussion of the preceding two sections it follows that the general equilibrium of the
system as a whole requires the fulfillment of a third condition, namely that the marginal rate of
product transformation (slope of the PPC) be equal to the marginal rate of substitution of the
two commodities between the consumers

MRPTx,y = MRSAx,y = MRSBx,y

66
 In perfect competition this condition is satisfied, since, fromexpression (2)

MRPTx,y = Px/Py

and from expression (3)

MRSAx,y = MRSBx,y = Px/Py so that

MRPTX, y = MRSAx,y = MRSBx,y (4)

This is the third condition of Pareto efficiency. It refers to the efficiency of product substitution
(or optimal composition of output). Since the MRPT shows the rate at which a good can be
transformed into another in production, and the MRS shows the rate at which the consumers
are willing to exchange one good for another, the system is not in equilibrium unless the two ra-
tios are equal. Only then the production sectors’ plans are consistent with the household sec-
tors’ plans, and thetwo are in equilibrium.

A simple numerical example may illustrate the argument. Suppose that the MRPTX,y is 2 Y/X,
while the MRSX,y — Y/X. The economy can produce two units of Y by sacrificing one unit of X,
while the consumers are willing to exchange one unit of X for one unit of Y. In figure 22.27 the
inequality of thetwo ratios is shown by points c and d.

Apparently firms produce a smaller quantity of Y and a largerquantity of X relative to the prefer-
ences of the consumers.

Given the assumption of consumer sovereignty, firms must reduce X and increase the produc-
tion of Y for the attainment of general equilibrium. The economic meaning of the third efficien-
cy criterion is that the combination of outputs must be optimal from both the consumers’ and
the producers’ point ofview.

In summary, with perfect competition (and no discontinuities and with con-

stant returns to scale) the simple two-factor, two-commodity, two- consumer
system has a general equilibrium solution, in which three Pareto-efficiency
conditions aresatisfied:
1. The MRS between the two goods is equal for both consumers. This efficiency in distribution im-

67
 plies optimalallocation of the goods among consumers.

2. The MRTS between the two factors is equal for all firms. This efficiency in factor substitution
implies optimal allocation of the factors among the two firms.

3. The MRS and the MRPT are equal for the two goods. This efficiency in product- mix implies op-
timal composition of output in the economy and thus optimal allocation of resources.

Whether such a general equilibrium solution (on the PPC) is desirable for the society as a whole
is another question, whichis the core of Welfare Economics.

Short run competitive equilibrium in an economy with production

Definition
A short run competitive equilibrium is a situation in which, given the firms in the market, the price is
such that that total amount the firms wish to supply is equal to the total amount the consumers
wish to demand.

More precisely, a short run competitive equilibrium consists of a price p and an output yi for each
firm i such that, given the price p, the amount each firm i wishes to supply is yi and the sum iyi
of all the firms outputs is equal to the total amount Qd(p) demanded.

If the firms in the industry have different cost functions, then the aggregate supplyfunction will look
something like this:

Now suppose that there are n firms, all with the same cost function, and hence the same short run
supply function, say ys. Then a short run competitive equilibrium is a price p and an output y for
each firm such that

y = ys(p) and ny = Qd(p).

Efficiency of short run equilibrium

In an exchange economy, a competitive equilibrium is Pareto efficient. Now consider an economy
in which goods are produced by firms.

In a competitive equilibrium price is equal to short run marginal cost, so no firm can sell an extra
68
unit at a price that covers its short run marginal cost. Short run marginal cost is the market value of
the variable inputs needed to produce the extra unit of output, so in an equilibrium it is not possible
to sell another unit at a price that coversthe market value of the inputs needed to produce that unit.
If the market value of the variable inputs needed to produce an extra unit of output measures their
social cost and the price at which a unit can be sold measures the social value of the unit, then in
an equilibrium the socially optimal amount of the good is produced.

A rough measure of the consumers' gains from trade is the area under the demand curve and
above the price, indicated by the light purple area in the figure below. This area is called the con-
sumers' surplus. A measure of the gain to the producers is the difference between their revenue
and their variable cost (since fixed cost is fixed!); this measure is called the producers' surplus.
The total variable cost is the area underthe supply function (which is the marginal cost function) up
to the equilibrium output;so the producers' surplus is equal to the area between the supply function
and the price, indicated by the pink area in the following figure.

The sum of consumers' surplus and producers' surplus is a measure of the total gainsfrom trade in
equilibrium. As you can see, it is maximized in a competitive equilibrium.

Long run competitive equilibrium in an economy with production

Basic theory
In the long run firms can enter and exit the industry.

Theory: A situation is a long run equilibrium if

• no firm in the industry wants to leave

• no potential firm wants to enter.

Implications: Given the definition of economic profit, the theory implies that in a long run equilibri-
um

• no existing firm makes a loss

• any potential firm that entered would make a loss

Assuming that the technology (and hence cost functions) of every firm are the same, and ignoring
69
the discrete change that may occur in the firms' maximal profits when afirm enters, the theory thus
implies that in a long run equilibrium every firm's maximal profit is zero or, equivalently, price is equal
to minimum average cost.

Terminology: the output at which LAC is minimal is the efficient scale of production. LAC at the ef-
ficient scale of production is thus the minimum average cost. In the following figure, y* is the effi-
cient scale of production and p* is the minimum average cost.

Given this terminology, another implicaton of the theory is: every firm produces at the efficient scale
of production.

What determines the equilibrium number of firms? Given the equilibrium price (minimum average
cost), the aggregate demand function Qd gives us the total amount Y* = Qd(p*) that must be pro-
duced in equilibrium. We know how much each firm produces in equilibrium (y*, the output equal to
its efficient scale of production), so if we divide Y* by this amount we obtain the equilibrium num-
ber of firms.

Changes in industry output may affect the cost function

In order to define a long run competitive equilibrium more precisely, we need to take account of the
fact that changes in industry output may affect the firms' cost functions. In the long run, as all
firms expand or contract, the change in the industry's demand for inputs may lead to input prices to
change. (This is likely to be the case for any input for which the industry uses a significant fraction
of the total amount of that input that is available in the economy.) Thus we should index the firms'
cost function by industry output: TCY(y) denote the total cost of producing y units of output when
the output of the industry is Y. If an increase in industry output leads to an increase in the prices of
the inputs used then TC increases in Y: TCY'(y) > TCY(y) for all y whenever Y' > Y. A logical possibil-
ity is that TC is decreasing in Y, though this possibility seems unlikely to occur.

Some terminology:
• if TCY(y) is independent of Y the industry is a constant cost industry.
• if TCY(y) is increasing in Y for all value of y the industry is an increasing cost industry.
• if TCY(y) is decreasing in Y for all value of y the industry is an decreasing cost industry.

70
Definition of a long run competitive equilibrium
Denote by LACY(y) the long run average cost corresponding to TCY(y) (i.e. LACY(y) = TCY(y)/y) and
by Qd the aggregate demand function. Then we can define a long run competitive equilibrium pre-
cisely as follows.

The long run competitive equilibrium when every firm's long run average cost curve is the same,
given by LACY, is characterized by a price p*, an output y* for each firm, and a number n* of firms
such that

p* is the minimum of LACn*y* y* is the minimizer of LACn*y* Qd(p*) = n*y*.

These conditions are interrelated: the variables p*, y*, and n* appear in each of them. Thus to solve
for a long run equilibrium in general we need to solve threesimultaneous equations in the three var-
iables p*, y*, and n*.

In the case of a constant cost industry, in which LAC is independent of industry output, the three
conditions reduce to p* is the minimum of LACy* is the minimizer of LACQd(p*) = n*y*.

These conditions have a very simple structure: the first one determines p*, the second determines
y*, and the last determines n*, given p* and y*. Thus it is straightforward to find the long run equi-
librium in a constant cost industry.

Given how the short run and long run cost curves are related, note that in a long run equilibrium we
have:

p* = LACY(y*) = SACY,y*(y*) = LMCY(y*) = SMCY,y*(y*), where SACY,y* and SMCY,y* are the short
run cost curves when the aggregate demand is Y = n*y* and the firm's plant is optimal for produc-
ing y* units of output.

The long run industry supply function

If the aggregate demand curve shifts (consumers' tastes change, the prices of other goods change,
the population increases or decreases, ...) then the long run equilibrium changes. The path of the

71
pairs (Y,p) (where Y is aggregate demand and p is price) traced out as demand changes is called
the long run supply function.

Constant cost industry

In a constant cost industry, LAC is independent of industry output, so the long run supply function
is horizontal, as in the following figure, which shows the effect of a shift in the aggregate demand
curve from D1 to D2. In each case the long run

equilibrium price is p* and the output of each firm is y*. When the demand is D1 the number of
firms is n1*, and when demand is D2 the number of firms is n2*.

We can tell a dynamic story when the demand shifts. If it shifts to the right, forexample,

• in the short run each firm produces more, and makes profit
• then more firms enter
• the short run supply (given the number of firms) therefore moves out
• the price falls, and each firm reduces its output again.

Increasing cost industry

In an increasing cost industry the cost curve shifts up as industry output increases, so the industry
supply curve is upward-sloping. The following figure is drawn under the assumption that as the
cost curve shifts up, the efficient scale for each firm remains the same, equal to y*. When the ag-
gregate demand curve is D1 the equilibrium price is p1* and the number of firms is n1*; when the
aggregate demand curve is D2 the equilibrium price is p2* and the number of firms is n2*.

72
Again we can tell a dynamic story: Initially each of n1* firms produces y* and the price is p1*. Sup-
pose demand increases from D1 to D2.

• in the short run price rises, as each firm expands and moves up its short runsupply function
• the profit induces more firms to enter
• input prices rise as the demand for inputs increases, so LAC rises
• in the new long run equilibrium there are n2* firms, each producing y* as before.

Factor Pricing: Concept andTheories

Factors of production can be defined as inputs used for producing goods or services with the aim
to make economicprofit.

In economics, there are four main factors of production, namely land, labor, capital, and enterprise.
The price that anentrepreneur pays for availing the services of these factors iscalled factor pricing.

SAn entrepreneur pays rent, wages, interest, and profit for availing the services of land, labor, capi-
tal, and enterprise respectively. The theory of factor pricing deals with the price determination of
different factors of production.

The determination of factor prices is always assumed to be similar to the determination of product
prices. This is because in both the cases, the prices are determined with the help of demand and
supply forces. Moreover, the demand for factors of production is similar to the demand for prod-
ucts.

However, there are two main differences on the supply side of factors of production and products.
Firstly, in product market, the supply of a product is determined by its marginal cost of production.
On the other hand, in factor market, it is not possible to determine the supply of factors on the ba-
sis of marginal cost.

For example, it is difficult to ascertain the exact cost of production for factors, such as land and
capital. Secondly, the supply of factors of production cannot be readily adjusted as in the case of
products. For instance, if the demand for a land increases, then it is not possible to increase its
supply immediately.

73
Concept of Factor Pricing:
Factor pricing is associated with the prices that an entrepreneur pays to avail the services ren-
dered by the factorsof production. For example, an entrepreneur needs to pay wages to labor, rents
for availing land, and interests for capitalso that he/she can earn maximum profit. These factors of
production directly affect the production process of an organization.

In context of an economy, these four factors of production when combined together produce a net
aggregate of products, which is termed as national income. Therefore, it is important to determine
the prices of these four factors of production.

The theory of factor pricing deals with the determination of the share prices of four factors of pro-
duction, namely land, labor, capital and enterprise.

In other words, the theory of factor pricing is concerned with the principles according to which the
price of each factor of production is determined and distributed. Therefore, the theory of factor
pricing is also known as theory of distribution. According to Chapman, the theory of distribution,
“accounts for the sharing of the wealth produced by a community among the agents, or the owners
of the agents, which have been active in its production.”

There are two aspects of each factor of production,which are as follows:

i. Price Aspect:
Refers to the aspect in which an organization pays a certain amount to avail the services of fac-
tors of production. For example, wages, rents, and interests constitute the price of factors of
production.
ii. Income Aspect:
Refers to another aspect in which a certain amount is received by a factor of production. For in-
stance, rents received by a landlord and wages received by labor constitute the income generat-
ed from the factors of production.

Generally, it is assumed that factor pricing theory is similar to product pricing theory. However,
there are certain differences between the two theories. Both the theories assume the determina-
tion of prices by the interaction of two marketforces, namely demand and supply.

However, there are differences in the nature of demand and supply of factors of production with
respect to that of products. The demand for factors of production is derived demand, while de-
mand for products is direct demand.

Moreover, the demand for the factors of production is jointdemand.

This is because a product cannot be produced using a single factor of production. On the other
hand, the supply of products is closely related with the cost of production, whereas there is no
cost of production for factors. For example, there is no cost of production for land, labor, and
capital. Therefore, the factor pricing is separated from productpricing.

Theories of Factor Pricing:

The theory of factor pricing is concerned with the principles according to which the price of each
factor of production is determined and distributed. The distribution of factors of production can be
of two types, namely personal and functional. Personal distribution is concerned with the distribu-
tion of income among different individuals.
74
It is associated with the amount of income generated not with the source of income. For example,
an individual earns Rs.

20,000 per month; this income can be earned by him/her bywages, rents, or dividends. On the other
hand, functional distribution is associated with the distribution of income among different factors
of production as per their functions.

It is concerned with the source of income, such as wages, rents, interests, and profits. In regard of
distribution of factors of production, there are two theories, namely marginal productivity theory
and modern theory of factor pricing.

What is general equilibrium theory inmacroeconomics?

General equilibrium theory is a macroeconomic theory that explains how supply and demand in an
economy with many markets interact dynamically and eventually culminate in an equilibrium of
prices. The theory assumes that there is a gap between actual prices and equilibrium prices. The
goal of general equilibrium theory is to identify the precise set of circumstances under which the
equilibrium price is likely to achieve stability. The theory is most closely associated with Léon
Walras, who wrote "Elements of Pure Economics" in 1874. While the idea had been vaguely hinted
at by earlier economists, he was the first one to articulate the idea thoroughly.

Walras started his explanation of general equilibrium theory by describing the simplest economy
imaginable. In this economy, there were only two goods that could be exchanged, referred to as x
and y. Everyone in the economy was presumed to be a buyer of one of these products and a seller
of the other. Under this model, supply and demandwould be interdependent, because the consump-
tion of each of the goodswould be dependent on the wages derived from selling each of the goods.

The price of each of the goods would be decided by a bidding process, which Walras referred to as
"tâtonnement" (or "groping" in English). He described this in terms of an individual seller calling out
the price of a good in the market and consumers responding by either buying or declining to pay.
Through a trial and error process, the seller would adjust the price to suit demand – the equilibrium
price. Walras believed that there would be no exchange of goods until the equilibrium price was
reached, an assumption which has been criticized by others.

When describing equilibrium on a grander scale, Walras applied this principle to multi-market set-
tings, which are much more intricate. He introduced a third good to his model – referred to as z.
From this, three price ratios could be determined, one of which would be redundant as it would not
give any information that could not be identified from the others. This redundant good could be
identified as the standard by which all other price ratios could be expressed – the standard would
provide a guide to currency rates.

Theoretically, Walras's theory had transformational effects. Economics, formerly a literary and
philosophical discipline, was now viewed as a determinist science. His insistence that economics
could be reduced to disciplined mathematical analysis persists today. In more recent terms, it can
also be said that Walras' general equilibrium theory has long-lasting effects. It blurs the lines be-
tween microeconomics and macroeconomics, as the economics that relate to individual house-
holds and companies cannot be viewed as existing separately from the macroeconomy.

What is Economic Efficiency?

Economic efficiency is when all goods and factors of production in an economy are distributed or
75
allocated to their most valuable uses andwaste is eliminated or minimized.

KEY TAKEAWAYS
• Economic efficiency is when every scarce resource in an economy is used and distributed
among producers and consumers in a way that produces the most economic output and
benefit to consumers.
• Economic efficiency can involve efficient production decisions within firms and industries,
efficient consumption decisions by individual consumers, and efficient distribution of con-
sumer andproducer goods across individual consumers and firms.
• Pareto efficiency is when every economic good is optimally allocated across production and
consumption so that no change to the arrangement can be made to make anyone better off
without making someone else worse off.

Economic Efficiency
Understanding Economic Efficiency
Economic efficiency implies an economic state in which every resource is optimally allocated to
serve each individual or entity in the best way while minimizing waste and inefficiency. When an
economy is economically efficient, any changes made to assist one entity would harm another. In
terms of production, goods are produced at their lowest possible cost, as are the variable inputs of
production.

Some terms that encompass phases of economic efficiency

include allocative efficiency, productive efficiency, distributive efficiency, and Pareto efficiency. A
state of economic efficiency is essentially theoretical; a limit that can be approached but never
reached. Instead, economists look at the amount of loss, referred to as waste, between pure effi-
ciency and reality to see how efficiently an economy functions.

Economic Efficiency and Scarcity

The principles of economic efficiency are based on the concept that resources are scarce. There-
fore, there are not sufficient resources to ensure that all aspects of an economy function at their
highest capacity at all times. Instead, scarce resources must be distributed to meet the needs of
the economy in an ideal way while also limiting the amount of waste produced. The ideal state is
related to the welfare of the population with peak efficiency also resulting in the highest level of
welfare possible based on the resources available.

Efficiency in Production, Allocation, and Distribution

Productive firms seek to maximize their profits by bringing in the most revenue while minimizing
costs. To do this, they choose the combination of inputs that minimize their costs while producing
as much output as possible. By doing so, they operate efficiently; when all firms in the economy do
so, it is known as productive efficiency.

Consumers, likewise, seek to maximize their well-being by consuming combinations of final con-
sumer goods that produce the highest total satisfaction of their wants and needs at the lowest
cost to them. The resulting consumer demand guides productive (through the laws of supply and
demand) firms to produce the right quantities of consumer goods in the economy that will provide
the highest consumer satisfaction relative to the costs of inputs. When economic resources are
allocated across different firms and industries (each following the principle of productive efficien-
cy) in a way that produces the right quantities of finalconsumer goods, this is called allocative effi-
76
ciency.

Finally, because each individual values goods differently and according to the law of diminishing
marginal utility, the distribution of final consumer goods in an economy are efficient or inefficient.
Distributive efficiency is when the consumer goods in an economy are distributed so that each unit
is consumed by the individual who values that unit most highly compared to all other individuals.
Note that this type of efficiency assumes that the amount of value that individuals place on eco-
nomic goods can be quantified and compared across individuals.

Economic Efficiency and Welfare

Measuring economic efficiency is often subjective, relying on assumptions about the social good,
or welfare, created and how well thatserves consumers. In this regard, welfare relates to the stand-
ard of living and relative comfort experienced by people within the economy. At peak economic ef-
ficiency (when the economy is at productive and allocative efficiency), the welfare of one cannot
be improved without subsequently lowering the welfare of another. This point is called Pareto effi-
ciency.

Even if Pareto efficiency is reached, the standard of living of all individuals within the economy may
not be equal. Pareto efficiency does not include issues of fairness or equality among those within a
particular economy. Instead, the focus is purely on reaching a point of optimal operation regarding
the use of limited or scarce resources. It states that efficiency is obtained when a distribution ex-
ists where one party's situation cannot be improved without making another party's situation
worse.

Pareto Efficiency
What Is Pareto Efficiency?
Pareto efficiency, or Pareto optimality, is an economic state where resources cannot be reallocat-
ed to make one individual better off without making at least one individual worse off. Pareto effi-
ciency implies that resources are allocated in the most economically efficient manner, but does not
imply equality or fairness.

KEY TAKEAWAYS
• Pareto efficiency is when an economy has its resources and goods allocated to the maxi-
mum level of efficiency, and no change can bemade without making someone worse off.
• Pure Pareto efficiency exists only in theory though the economy can move toward Pareto ef-
ficiency.
• Alternative criteria for economic efficiency based on Pareto efficiency are often used to
make economic policy, as it is very difficult to make any change that will not make any one
individualworse off.

Pareto Efficiency
Understanding Pareto Efficiency
Pareto efficiency, named after the Italian economist and political scientist Vilfredo Pareto (1848-
1923), is a major pillar of welfare economics.

In neoclassical economics, alongside the theoretical construct of perfect competition, is used as a

benchmark to judge the efficiency of real markets—though neither perfectly efficient nor perfectly
competitive markets occur outside of economic theory.

77
Hypothetically, if there were perfect competition and resources were used to their maximum effi-
cient capacity, then everyone would be at their highest standard of living, or Pareto efficiency.
Economists Kenneth Arrow, and Gerard Debreu demonstrated theoretically that under the assump-
tion of perfect competition and where all goods and services are tradeable in competitive markets
with zero transaction costs, an economy will tend toward Pareto efficiency.

In any situation other than Pareto efficiency, some changes to the allocation of resources in an
economy can be made such that at least one individual gains and no individuals lose from the
change. Only changes in allocation of resources that meet this condition are considered moves
toward Pareto efficiency. Such a change is called a Pareto improvement.

A Pareto improvement occurs when a change in allocation harms no one and helps at least one
person, given an initial allocation of goods for a set of persons. The theory suggests that Pareto
improvements will keep enhancing value to an economy until it achieves a Pareto equilibrium,
where no more Pareto improvements can be made. Conversely, when an economy is at Pareto ef-
ficiency, any change to the allocation of resources will make at least one individual worse off.

Pareto in Practice
In practice, it is almost impossible to take any social action, such as a change in economic policy,
without making at least one person worse off, which is why other criteria of economic efficiency
have found a wideruse in economics.

These include the following:

• Buchanan unanimity criterion: under which a change is efficient of all members of society
unanimously consent to it.
• Kaldor-Hicks efficiency: under which a change is efficient if the gains to the winners of any
change in allocation outweigh the damage to the losers.
• Coase Theorem: which states that individuals can bargain overthe gains and losses to reach
an economically efficient outcomeunder competitive markets with no transaction cost.

These alternative criteria for economic efficiency all to some extent relax the strict requirements of
pure Pareto efficiency in the pragmatic interestof real world policy and decision making.

Aside from applications in economics, the concept of Pareto improvements can be found in many
scientific fields where trade-offs are simulated and studied to determine the number and type of
reallocation of resource variables necessary to achieve Pareto efficiency.

In the business world, factory managers may run Pareto improvement trials, in which they reallo-
cate labor resources to try to boost the productivity of assembly workers without say, decreasing
the productivityof the packing and shipping workers.

The Kaldor – Hicks Criterion Postulations

The compensation criterion of Kaldor – Hicks is based on the following:

1. Each individual’s satisfactions are independent from the others so that he is the best judge of
his welfare.
2. There is the absence of external effects in production and consumption.
3. The tastes of each individual are constant.
4. It is possible to separate the problems of production and exchange from the problem of
78
 distribution.
5. It is assumed that utility is measured ordinarily and interpersonal comparisons are impossi-
ble.

Explanation
According to Kaldor, the test of increase in social welfare is that if some people are made better off
and others worse off, the gainers from the change could more than compensate the losers and yet
be better off themselves. The actual payment of compensation is regarded as a political or ethical
decision.

Kaldor does not require that the losers should actually be compensated. Rather he requires that the
gainers should be able potentially to compensate the losers out of their gains. Hicks presents the
same criterion in a little different way thus: “If A is made so much better off by the change that he
could compensate B for his loss, and still have something left over, then the reorganisation is une-
quivocal improvement. “

Thus the Kaldor Hicks criterion implies that if an economic change leads to the production of more
goods and services they can be so distributed as to make some people better off and none worse
off. Actual redistribution being a political or ethical issue, need not take place. It is enough that re-
organisations create such conditions thatredistribution can be effected.

This criterion is illustrated with the help of utility possibility curves for two individuals. If A and B
are two individuals, each utility possibility curve represents the locus of all combinations of their
utility levels. Each curve is related to a given fixed bundle of goods and the various points on each
curve are obtained by costless lump sum redistribution of a fixed commodity bundle.

Let X and Y be the two bundles of goods represented by the utility possibility curves B1A1 and
B2A2 respectively as utility possibility shown in the below diagram. Starting from a given bundle of
goods represented by Q2 in terms of the Paretian criterion any change which leads to a movement
to any one of the points C,D and E is a Pareto improvement on the B1A1 curve because it makes
both individuals better off or atleast one better off without making the other worse off. But any
movement outside C and E to Q1 cannot be evaluated by the Paretian criterion for the reason that
it improves A’s welfare at the expense of B. Nevertheless, a move from Q2 to Q1 can be evaluated
in terms of the Kaldor-Hicks criterion.

This can be done by (i) asking B how much he would be willing to pay A to prevent this move and
(ii) asking A how much he would be willing to pay to B to forgo it. If (ii) > (i), the change increases
welfare for the reason that A would potentially compensate B for his loss and still be better off at
Q1 than at Q2.

79
A simple test for an improvement of welfare according to the Kaldor-Hicks criterion is that the ini-
tial bundle should lie below the utility possibility curve representing the new bundle. Thus a move
from Q2 to Q1 satisfies the Kaldor – Hicks criterion for the reason that Q2 lies below the utility
possibility curve B1 A1 of the final bundle Q1.
To present it differently, a move to Q1 can be contemplated to generate the point D on the same
utility possibility curve B1A1 which is unambiguously better than Q2. After compensation one can
move from D to Q1.

Criticisms
1. Ignores Income Distribution – The Kaldor Hicks compensation principle, according to Dr. Little,
is merely a definition and not a “test” of increase in welfare for the reason that it ignores in-
come distribution. In fact, the problem of distribution cannot be ignored where the problem of
productive efficiency is involved. To say that one ‘bundle of goods’ is greater than the order is
meaningless without reference to income distribution. For any comparison between two
bundles of goods involves their money values at their marketprices.

2. No universal Validity – Scitovsky has criticised Kaldor for the view that the state is fully re-
sponsible for maintaining an equitable distribution of income. If there is unequal income distri-
bution in a community, it is corrected as a matter of course by the state through a system of
compensations.

3. According to Scitovsky, “This is likely to be the case in a socialist economy.” But in a free en-
terprise economy, the effects of a certain economic reorganisations on efficiency and equity
cannot be separated for the reason that compensation payments are not feasible politically.
Thus the Kaldor Hicks criterion has no universal validity, according to Scitovsky.

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80
Welfare Economics
What is Welfare Economics
Welfare economics focuses on the optimal allocation of resources and goods and how the alloca-
tion of these resources affects social welfare. This relates directly to the study of income distribu-
tion and how it affectsthe common good. Welfare economics is a subjective study that may assign
units of welfare or utility to create models that measure the improvements to individuals based on
their personal scales.

BREAKING DOWN Welfare Economics

Welfare economics looks at the distribution of resources and how it affects an economy's overall
sense of well-being. With different optimal states existing in an economy in terms of the allocation
of resources, welfare economics seeks the economic state that will create the highest overall level
of social satisfaction among its members.

Welfare economics uses the perspective and techniques of microeconomics, but it can be aggre-
gated to make macroeconomic conclusions. Some economists suggest that greater states of
overall social good might be achieved by redistributing income in the economy. This models the
theory behind economic or allocative efficiency, suggesting that there exists a point where the so-
cial well-being experienced from the allocated resources can hit a maximum, a point considered to
be the most efficient. If that point is reached, the economy is functioning in a way that any subse-
quent changes to raise the feelings of well-being in one area would require the lowering of well- be-
ing in another.

Welfare Economics and Public Policy

Issues regarding welfare economics may serve as guides during the creation of public policy. Wel-
fare economics includes efforts to establish a minimum quality of living expectation within an area
including access to commonly required services and the availability of living-wage jobs or afforda-
ble housing.

Welfare economics works in contrast to capitalist ideals. Government intervention regarding eco-
nomic matters is fully rejected in pure capitalism. Focus is instead put on individual choice, ac-
complishment, and development, as well as the pursuit of personal wealth. The theory behind capi-
talism supports that society will experience an associated benefit through the pursuit of personal
wealth.

Welfare Economics and Utility

Utility refers to the perceived value associated with a particular good or service. The perceived val-
ue is intrinsic and relates to whether a buyer feels the amount of value received for a certain good
or service is at least equal to or greater than the amount of funds required to purchase it. Addition-
ally, it suggests that a certain unit of currency, such as a dollar, has the same perceived value to an
individual as it does to a corporation, regardless of how the income amounts of each entity differ.

Fundamental theorems
The fundamental theorem of arithmetic
The fundamental theorem of arithmetic connects the natural numbers with primes. The theorem
states that every integer greater than one can be representeduniquely as a product of primes.

This theorem connects something ordinary and common (the natural numbers) with something

81
rare and unusual (primes). It is trivial to enumerate the natural numbers, but each natural number
is "built" from prime numbers, which defy enumeration. The natural numbers are regularly spaced,
but the gap between consecutive prime numbers is extremely variable. If p is a prime number,
sometimes p+2 is also prime (the so-called twin primes), but sometimes there is a huge gap before
the next prime.

The fundamental theorem of algebra

The fundamental theorem of algebra connects polynomials with their roots (or zeros). Along the
way it informs us that the real numbers are not sufficient for solving algebraic equation, a fact
known to every child who has pondered the solution to the equation x2 = –1. The fundamental
theorem of algebra tells us that we need complex numbers to be able to find all roots. The theorem
states that every nonconstant polynomial of degree n has exactly n roots in the complex number sys-
tem. Like the fundamental theorem of arithmetic, this is an "existence" theorem: it tells you the
roots are there, but doesn't help you to find them.

The fundamental theorem of calculus

The fundamental theorem of calculus (FTC) connects derivatives and integrals. Derivatives tell us
about the rate at which something changes; integrals tell us how to accumulate some quantity.
That these should be related is not obvious, but the FTC says that the rate of change for a certain
integral is given by the function whose values are being accumulated. Specifically, if f is any con-
tinuous function on the interval [a, b], then for every value of x in [a,b] you can compute the follow-
ing function:

The FTC states that F'(x) = f(x). That is, derivatives and integrals are inverseoperations.

Unlike the previous theorems, the fundamental theorem of calculus provides a computational tool.
It shows that you can solve integrals by constructing "antiderivatives."

The fundamental theorem of linear algebra

Not everyone knows about the fundamental theorem of linear algebra, but there is an excellent
1993 article by Gil Strang that describes its importance. For an m x n matrix A, the theorem relates
the dimensions of the row space of A (R(A)) and the nullspace of A (N(A)). The result is that
dim(R(A)) + dim(N(A)) = n.

The theorem also describes four important subspaces and describes the geometry of A and At
when thought of as linear transformations. The theorem shows that some subspaces are orthogo-
nal to others. (Strang actually combines four theorems into his statement of the Fundamental
Theorem, including a theorem that motivates the statistical practice of ordinary least squares.)

The fundamental theorem of statistics

Although most statistical textbooks do not single out a result as THE fundamental theorem of sta-
tistics, I can think of two results that could make a claim to the title. These results are based in
probability theory, so perhaps they are more aptly named fundamental theorems of probability.

• The Law of Large Numbers (LLN) provides the mathematical basis for understanding ran-
82
 dom events. The LLN says that if you repeat a trial many times, then the average of the ob-
served values tend to be close tothe expected value. (In general, the more trials you run, the
better the estimates.) For example, you toss a fair die many times and compute the average
of the numbers that appear. The average should converge to 3.5, which is the expected val-
ue of the roll because (1+2+3+4+5+6)/6 = 3.5. The same theorem ensures that about one-
sixth of the faces are1s, one-sixth are 2s, and so forth.

• The Central Limit theorem (CLT) states that the mean of a sample of size n is approximately
normally distributed when n is large. Perhaps more importantly, the CLT provides the mean
and the standard deviation of the sampling distribution in terms of the sample size, the
population mean μ, and the population variance σ 2. Specifically, the sampling distribution of
the mean is approximately normally distributed with mean μ and standard deviation
σ/sqrt(n).

Of these, the Central Limit theorem gets my vote for being the Fundamental Theorem of
Statistics. The LLN is important, but hardly surprising. It is the basis for frequentist statistics
and assures us that large random samples tend to reflect the population. In contrast, the
CLT is surprising because the sampling distribution of the mean is approximately normal
regardless of the distribution of the original data! As a bonus, the CLT can be used computa-
tionally. It forms the basis for many statistical tests by estimating the accuracy of a statisti-
cal estimate. Lastly, the CLT connects important concepts in statistics: means, variances,
sample size, and accuracy of pointestimates.

Social Welfare Function of Economics (With Diagram)

In this article we will discuss about the social welfare function of economics, explained with the
help of a suitable diagram.

The compensation principle only wants to know whether the losers could be compensated; it does
not tell us that the losers should actually be compensated. It is argued that whether compensation
should be provided and in what manner—all these are moral issues.

Another problem with the compensation criteria is that they only compare between a few alterna-
tives to tell us what is themost desirable of these alternatives, but they do- not tell us the state that
achieves the maximum possible welfare. Some economists thought, it was first suggested by
Abram Bergson in 1938, that the problems with the compensation criteria could be solved by con-
sidering a social welfare function.

The social welfare function (SWF) is a sort of social indifference map consisting of the social indif-
ference curves (SICs). An SIC gives the various combinations of utilities of the two individuals that
comprise the society, that result in the same level of social welfare (W). To show this diagrammati-
cally, let us denote the utilities of the two consumers by UI and UII.

The SWF then is:

W = f(UI, UII).

The SICs have been shown in Fig. 21.7. Each of them shows the different combinations of UI and
UII that give a particular level of social welfare (W). SICs are negatively sloped because as I is
made better off, II must be made worse off, to give us the same W.

83
If, at the initial (UI, UII) combination, both the individuals, or any one of them, are made better off,
the utility level of the other remaining the same, then that would result in a higher level of W and
the society would move to a higher SIC. In Fig. 21.7, W2 represents a higher level of social welfare
than W1.

et us note that the SICs need not be convex or concave to theorigin. For there is no rule here that as
UI increases UII would fall at a diminishing or at an increasing rate. Once we formulate the SWF
and the SICs, we are well equipped to compare different policies and find out the policies that max-

imise social welfare subject to the available economicresources.

But how are we to obtain, or who is to determine, the combinations of UI and UII that would give
the society the same level of welfare, or, who is to determine the combinations that would not give
the same—but a lower or higher—level of social welfare? In a dictatorship, the dictator performs
this function. Here the SWF and SICs reflect the value judgements of the dictator.

ADVERTISEMENTS:
In a democracy, the value judgements must be determined collectively by the members of the so-
ciety. The individuals canexpress their value judgements by means of voting. But Arrow pointed out
that social welfare could not be evaluated by a democratic vote. This is known as Arrow’s Impos-
sibility Theorem.

According to Arrow, the social welfare choices should be transitive, i.e., if situation A is preferred to
situation B and B is preferred to C, then A is preferred to C. Given the transitivity assumption, let us
now consider the following rankings of three policies A, B and C by three individuals I, II and III (the
lower number indicating a higher rank).

From the above rankings we obtain: Individuals I and II prefer the policy A to policy B. Thus, a ma-
jority vote between the policies A and B will lead to the choice of A. Again I and IIIprefer B to C. So a
majority vote between B and C will lead to the choice of B. Thus, we obtain A is preferred to B and
B is preferred C. This would imply, because of transitivity, that A is preferred to C.

Therefore, if transitivity holds, we obtain A is preferred to B and A is preferred to C. Therefore,

democratic vote gives us that A is the policy that should be selected. However, when weconsider A
and C, we find that both II and III prefer C to A.

So, the majority vote between A and C will lead to a choice of C, and transitivity will not hold. Thus,
democratic votes lead to the choice of all the three policies, i.e., here we arrive at what is known as

84
the voting paradox.

The above method of voting by ranks is paradoxical and confusing, and we may come out of it, if
account is taken of the intensity of the preferences of different individuals, and a scheme of com-
pensation is made use of. This is actually the idea behind the compensation principle.

For example, if the consumer I and II’s preference for A is very intense and it is worth, say, Rs 1000
to each, and consumer I and Ill’s preference for B, and II and Ill’s preference for C, are not so in-
tense, it is worth Rs 100, say, for each of them, then certainly a compensation scheme might be
worked out and policy A might be implemented.

However, the criterion of SWF and also the Kaldor-Hicks compensation criterion based on potential
and not actual compensation, requires an assumption of omniscience on the part of the individuals
evaluating the different policies.

But such an assumption is totally unrealistic, because individual’s utilities are highly subjective,
and it is very difficult for others to evaluate them. Only actual compensation will help an evalua-
tion. In many instances, however, it is not clear to whom compensation is to be made.

Asymmetric Information
What Is Asymmetric Information?
Asymmetric information, also known as "information failure," occurs when one party to an eco-
nomic transaction possesses greater material knowledge than the other party. This typically mani-
fests when the seller of a good or service possesses greater knowledge than the buyer; however,
the reverse dynamic is also possible. Almost all economic transactions involve information asym-
metries.

Asymmetric Information
Understanding Asymmetric Information
Asymmetric information is the specialization and division of knowledge, as applied to any econom-
ic trade. For example, doctors typically know more about medical practices than their patients. Af-
ter all, physicians have extensive medical school educational backgrounds that their patients gen-
erally don't have. This principle equally applies to architects, teachers, police officers, attorneys, en-
gineers, fitness instructors, and other trained professionals.

The Economic Advantages of Asymmetric Information

Asymmetric information isn't necessarily a bad thing. In fact, growing asymmetrical information is
the desired outcome of a healthy market economy. As workers strive to become increasingly spe-
cialized in their chosen fields, they become more productive, and can consequently provide greater
value to workers in other fields.
85
For example, a stockbroker's knowledge is more valuable to a non- investment professional, such
as a farmer, who may be interested inconfidently trading stocks, to prepare for retirement.

One alternative to ever-expanding asymmetric information is for workers to study all fields, rather
than specialize in fields where they can provide the most value. However, this is an impractical so-
lution, with high opportunity costs and potentially lower aggregate outputs, which would lower
standards of living.

Another alternative to asymmetric information is to make information abundantly and inexpensive-

ly available through the internet and otherdata sources.

The Disadvantages of Asymmetric Information

In some circumstances, asymmetric information may have near fraudulent consequences, such as
adverse selection, which describes a phenomenon where an insurance company encounters the
probability ofextreme loss due to a risk that was not divulged at the time of a policy's sale.

For example, if the insured hides the fact that he's a heavy smoker and frequently engages in dan-
gerous recreational activities, this asymmetrical flow of information constitutes adverse selection
and could raise insurance premiums for all customers, forcing the healthy to withdraw. The solu-
tion is for life insurance providers is to perform thorough actuarial work and conduct detailed
health screenings, and then charge different premiums to customers based on their honestly- dis-
closed risk profiles.

KEY TAKEAWAYS
• Asymmetric information, also known as "information failure," occurs when one party to an
economic transaction possesses greater material knowledge than the other party.
• Asymmetric information typically manifests when the seller of a good or service possesses
greater knowledge than the buyer; however, the reverse dynamic is also possible. Almost all
economic transactions involve information asymmetries.

Special Considerations: Information Asymmetry in Finance

To prevent abuse of customers or clients by finance specialists, financialmarkets often rely on rep-
utation mechanisms. Financial advisors and fund companies that prove to be the most honest and
effective stewards of their clients' assets tend to gain clients, while dishonest or ineffective agents
tend to lose clients, face legal damages, or both.

[Important: In certain asymmetric information models, one party can retaliate for contract
breaches, while the other party cannot.]

Moral Hazard vs. Adverse Selection: What'sthe Difference?

Moral Hazard vs. Adverse Selection: An Overview
Moral hazard and adverse selection are two terms used in economics, risk management, and in-
surance to describe situations where one partyis at a disadvantage.

Moral hazard occurs when there is asymmetric information between two parties and a change in
the behavior of one party after a deal is struck. Adverse selection occurs when there's a lack of
symmetric information prior to a deal between a buyer and a seller.

Asymmetric information, also called information failure, happens when one party to a transaction
86
has greater material knowledge than the otherparty. Typically, the more knowledgeable party is the
seller. Symmetric information is when both parties have equal knowledge.

Adverse Selection
Moral Hazard
Moral hazard occurs when a party that has agreed to a transaction provides misleading infor-
mation or changes their behavior because they believe that they won't have to face any conse-
quences for their actions.

Moral hazard is the risk that one party has not entered into the contract in good faith or has provid-
ed false details about its assets, liabilities, orcredit capacity.

In addition, moral hazard may also mean a party has an incentive to take unusual risks in a desper-
ate attempt to earn a profit before the contract settles.

Adverse Selection
Adverse selection describes a situation in which one party in a deal has more accurate and differ-
ent information than the other party. The party with less information is at a disadvantage to the
party with more information. This asymmetry causes a lack of efficiency in the price and quantity
of goods and services. Most information in a market economy is transferred through prices, which
means that adverse selection tends to result from ineffective price signals.

Example of Moral Hazard

For an example of moral hazard, consider the implications of buying insurance. Let's assume a
homeowner does not have homeowners insurance or flood insurance and lives in a flood zone. The
homeowneris very careful and subscribes to a home security system that helps prevent burglaries.
When there are storms, he prepares for floods by clearing the drains and moving furniture to pre-
vent damage.

However, the homeowner is tired of always having to worry about potential burglaries and prepar-
ing for floods, so he buys the home and flood insurance. After his house is insured, his behavior
changes and he is less attentive, he leaves his doors unlocked, cancels the home security system
subscription and does not prepare for floods. In this case, the insurance company is faced with the
risks of floods and burglaries and their consequences, and the problem of moral hazard arises.

Example of Adverse Selection

Life insurance premiums can be a way of looking at an example
of adverse selection. Let's assume there are two sets of people in the population, those who
smoke and do not exercise, and those who do notsmoke and do exercise. It is common knowledge
that those who smoke and don't exercise have shorter life expectancies than those who don't

smoke and do exercise. Suppose there are two individuals who are looking to buy life insurance,
one who smokes and does not exercise, and one who doesn't smoke and exercises daily. However,
the insurance company, without further information, cannot differentiate between the individual
who smokes and doesn't exercise and the other person.

The insurance company asks the individuals to fill out questionnaires todistinguish them. However,
the individual that smokes and doesn't exercise knows that answering truthfully means higher in-
surance premiums, so he lies and says he doesn't smoke and exercises daily.
87
This leads to adverse selection, where the life insurance company is at a disadvantage and then
charges the same premium to both individuals.

However, insurance is more valuable to the non-exercising smoker than the exercising non-smoker
because one party has more to gain. The non-exercising smoker needs health insurance more and
benefits from the lower premium.

KEY TAKEAWAYS
• Both moral hazard and adverse selection are terms used in economics, risk management,
and insurance to describe situationswhere one party is at a disadvantage to another.
• Moral hazard is the risk that one party has not entered into the contract in good faith or has
changed their behavior after a deal is struck because they believe that they won't have to
face any consequences.
• Adverse selection is when sellers have information that buyers do not have, or vice versa,
about some aspect of product quality. It is also the tendency of those in dangerous jobs or
high-risk lifestylesto purchase life insurance.

ECONOMICS UNIT-1 MCQ

PART-1
1. Suppose the supply for product A is perfectly elastic. If the demand forthis product increases:
A. the equilibrium price and quantity will increase;
B. the equilibrium price and quantity will decrease;
C. the equilibrium quantity will increase but the price will not change;
D. the equilibrium price will increase but the quantity will not change.

2. If the coefficient of income elasticity of demand is higher than 1 andthe revenue increases, the
share of expenditures for commodity X in total expenditure:
A. will increase;
B. will decrease;
C. will remain constant;
D. can not be determined.

3. If the demand for agricultural products is inelastic:

A. as the prices decrease, the revenues earned by producers increase;
B. as the prices decrease, the revenues earned by producers decrease;
C. rising prices do not lead to differentiation in producers' incomes;
D. the percentage decrease in prices is lower than the percentageincrease in demand.

4. For a rational consumer who has to choose between two goods in the context of budget con-
straints, the price change of one of the goods, caeteris paribus, will determine:
A. a parallel shift of the budget line to the left;
B. a change in the slope of the budget line;
C. no change in the budget line;
D. a parallel shift of budget line to the right.

5. The price of the product A was reduced from 100 to 90 lei and, as a result, the quantity de-
88
manded
has increased from 70 to 75 units. The demand is:
A. inelastic;
B. elastic;
C. unit elastic;
D. can not be determined from the given information.

6. Choose the false statement:

A. in general, the demand for necessity goods is less elastic than demandfor luxury goods;
B. if the price and the producers` income are directly proportional, thedemand is elastic;
C. after a long period of time since the change in the price of the good A,supply
becomes more elastic; B. for a company whose production process involves making two goods,
one main and the other secondary, if the price of the main good increases, - caeteris paribus - the
supply on the secondary good`s market will increase (and vice versa).2

7. If the demand curve for product A moves to the right, and the price of product B decreases, it
can be concluded that:
A. A and B are substitute goods;
B. A and B are complementary goods;
C. A is an inferior good, and B is a superior good;
D. Both goods A and B are inferior.

8. Suppose the price of a good decreases by 10% and the quantity demanded for a certain period
of time
increases by 15%. In these conditions:
A. the revenues earned by producers decrease;
B. the revenues earned by producers increase;
C. the revenues are not influenced in any way;
D. the company's expenses rise.

9. If a price increase of 50% results in an increase in the quantity supplyed of an economic good
from 10 to 20 pieces, calculate the coefficient of price elasticity of supply.
A. ¼.
B. ½
C. 1
D. 2.

10. The total utility coincides with the marginal utility:

A. for the first unit consumed;
B. only for the irrational consumer;
C. at the level of the last unit consumed;
D. at the saturation point.

11. The indifference curve means:

A. equal consumption of two goods;
B. equal utility from the consumption of two combinations of goods;
C. equal consumer income;
D. equal prices of the goods consumed.
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12. The points located at the intersection of the budget line with thecoordinate axes mean:
A. the consumer does not spend all his income;
B. the consumer spends all his income for only one good;
C. the consumer spends absolutely nothing;
D. these are points impossible to reach by the consumer.

13. An economic agent contracts a loan of 15.000 lei, which he will repayin three equal annual
installments. What will be the total interest paid, knowing that theannual interest rate is 12%
per year?
A. 3.600 lei;
B. 1.800 lei;
C. 5.400 lei;
D. 1.500 lei.

14. An economic agent makes a bank deposit of 10.000 lei with aninterest rate of 5%. What will be
the amount in the bank after 2 years, if the economic agent does not make withdrawals from the
account created during this period?
A. 11.000 lei;
B. 1.000 lei;
C. 11.025 lei;
D. 500 lei.

15. Which of the following statements are false?

A. information, the entrepreneur's ability, technical progress are neo-factors of production;
B. according to the stages of the circular flow of the company's capital, ittakes three forms: mon-
ey, capital goods and commodity;
C. fixed capital depreciation is only due to physical deterioration;
D. the factors of production are resources attracted and used in economicactivity.

16. Which of the following aspects distinguish fixed capital from workingcapital:
A. the number of cycles of production they participate in;
B. the location of the production activity;
C. the period of time after which they are replaced;
D. the way they transmit their value to the new product.A (a,d) B (c,d) C (a,c,d) D (b,c,d)

17. The following data is given for a company: material costs 89 mil;working capital 45 mil; indirect
salaries 10 mil; fixed costs 90 mil.; variable costs 52 mil. Calculate fixed material costs and depre-
ciation:
A. 60 and 64; B.
B. 70 and 56
C. 80 and 44
D. 89 and 45.

18. Fixed cost includes:

A. expenditures for the salaries of the administrative staff;
B. expenditure for depreciation of fixed capital;
C. energy costs for manufacturing;
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D. expenditure for general lighting. A. (a,b,c) B. (a,b,d) C. (a,c,d) D. (b,c,d)

19. When production volume is zero:

A. the fixed cost is 0;
B. the variable cost is 0;
C. the fixed cost is higher than the variable cost;
D. the variable cost is higher than the fixed cost.A (a,b,c) B (b,c,d) C (b,c) D (a,d)

20. Calculate the average fixed cost (AFC), for a level of production Q = 20, knowing that the total
cost function is: TC = 200 + 3Q + 2Q2
A. 1060;
B. 200;
C. 20;
D. 10.

21. Which of the following statements is false:

A. perfect competition involves many sellers of standardized products;
B. monopolistic competition involves many sellers of homogeneousproducts;
C. the oligopoly involves several producers of standardized ordifferentiated products;
D. monopoly involves a single product for which there are no closesubstitutes.

22. On the market with perfect competition:

A. the firm is a "price-taker," meaning, it takes over the market price;
B. the firm is a "price-maker", meaning, it determines the market price;
C. the companies’ products are differentiated;
D. input barriers are minimal, and exit barriers are maximal.
23. Which of the following conditions indicate that a good is producedunder perfect competition:
A. producers` profits are high;
B. producers` profits are small;
C. total supply is inelastic;
D. individual demand is perfectly elastic.
24. The profit maximization condition for a firm in a market withmonopolistic competition is the
following (MR is marginal revenue, MC is marginal cost, P is price, ATC isaverage total cost, TR
is total revenue):
A. MR = MC;
B. MC = P;
C. MR = ATC;
D. TR to be maximum.

25. Which of the following statements about monopoly is true:

A. there are several companies producing a specific product;
B. there is only one producing company, but the product has closesubstitutes;
C. there are no competitors on the relevant market;
D. input barriers are low.

26. There are differences between monopolistic and perfect competitionregarding:

A. market entry;
B. the number of sellers and buyers;
91
C. the market power of competitors;
D. homogeneity of products.

27. Which of the following can be considered as the basic features of public goods: are state-
owned;
A. are characterized by non-excludability and non-rivalry;
B. are characterized by excludability and rivalry;
C. may be positive or negative.

28. Which of the following solutions are not part of the ways ofinternalizing externalities:
A. the imposition of fines on the producer of negative externalities;
B. the introduction of taxes and duties that bring private costs to thelevel of social costs;
C. closure of companies producing positive or negative externalities;
D. the association of the negative externality manufacturer with thereceptor of such an effect.

29. Normally, the natural economy is characterized by:

A. price formation through complex mechanisms;
B. perfect competition;
C. the preponderance of product exchange;
D. the satisfaction of the individual and community needs of its ownproduction.

30. Which of the following features define human needs:

A. are not concurrent;
B. do not disappear momentarily if they are satisfied;
C. are unlimited in capacity;
D. are unlimited in number.

ANSWERS:
1.C 11.B 21.B

2.A 12.B 22.A

3.B 13.A 23.D

4.B 14.C 24.A

5.A 15.C 25.C

6.B 16.C 26.D

7.B 17.C 27.B

8.B 18.B 28.C

9.D 19.C 29.D

10.A 20.D 30.D

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PART-2
1. The higher the interest rate:
a. The greater the present value of a future amount
b. The smaller the present value of a future amount
c. The greater the level of inflation
d. None of the statements associated with this question are correctAns- b
2. If the interest rate is 10% and cash flows are $1,000 at the end of year one and $2,000 at the end
of year two, then the present value of these cash flows is
a. $2,562
b. $3,200
c. $439
d. $3,000 ans- a

3. Accounting profits are:

a. Total revenue minus total cost
b. Total cost minus total revenue
c. Marginal revenue minus total cost
d. Total revenue minus marginal cost Ans- a

4. Economic profits are:

a. Total revenue minus total cost
b. Marginal revenue minus marginal cost
c. Total revenue minus total opportunity cost
d. Total profits of the economy as a whole ans- c

5. Which of the following is an implicit cost to a firm that produces a good or service?
a. Labor costs
b. Costs of operating production machinery
c. C.Foregone profits of producing a different good or service
d. Costs of renting or buying land for a production site ans- c

6. Which of the following is an implicit cost of going to college?

a. Tuition
b. Cost of books and supplies
c. Room and board
d. Foregone wages Ans- d

7. Which of the following signals to the owners of scarce resources are the best uses of those re-
sources?
a. Profits of businesses
b. Government regulations
c. Economic indicators
d. The accounting cost of those resources ANS- a

8. The primary inducement for new firms to enter an industry is:

a. Increased technology
93
b. Availability of labor
c. Low capital costs
d. Presence of economic profits Ans-D

9. As more firms enter an industry

a. Accounting profits increase
b. B. Economic profits decrease
c. Prices rise
d. None of the statements associated with this question are correct ans- b

10. Scarce resources are ultimately allocated toward the production of goods most wanted by so-
ciety because:
a. Firms attempt to maximize profits
b. They are most efficiently utilized in these areas
c. Consumers demand inexpensive goods and services
d. Managers are benevolent Ans- a

11. The opportunity cost of receiving ten dollars in the future as opposed to getting that ten dol-
lars today is:
a. The foregone interest that could be earned if you had the money today
b. The taxes paid on any earnings
c. The value of $10 relative to the total income of that person
d. The value of $10 relative to the total income of all persons Ans- a

12. If the interest rate is 5%, what is the present value of ten dollarsreceived one year from now?
a. $9.50
b. $10.05
c. $9.52
d. $9.77 ans- c

13. If you put $1,000 in a savings account at an interest rate of 10%,how much money will you have
in one year?
a. $1,200
b. $909
c. $950
d. $1,100 Ans- d

14. If the interest rate is five percent, the present value of $200received at the end of five years is:
a. $121.34
b. $156.71
c. $176.41
d. $132.62 ans- b

15. When dealing with present value, a higher interest rate:

a. Does not effect the present value of the future amount
b. Increases the present value of a future amount
c. Decreases the present value of a future amount
d. None of the statements associated with this question are correct ans- c
94
16. A farm must decide whether or not to purchase a new tractor. The tractor will reduce costs by
$2,000 in the first year, $2,500 in the second and $3,000 in the third and final year of usefulness.
The tractor costs $9,000 today, while the above cost savings will be realized at the end of each
year. If the interest rate is seven percent, what is the net present value of purchasing the tractor?
a. $6,764
b. $9,362
c. $18,362
d. None of the statements associated with this question are correct Ans- d

17. A firm will have constant profits of $100,000 per year for the next four years and the interest
rate is six percent. Assuming these profits are realized at the end of each year, what is the present
value these future profits?
a. $325,816
b. $376,741
c. $400,000
d. $346,511 Ans- d

18. A firm will maximize the present value of future profits by maximizing current profits when the:
a. a.Growth rate in profits is constant
b. b.Growth rate in profits is larger than the interest rate
c. C.Interest rate is larger than the growth rate iprofits and both are constant
d. d.Growth rate and interest rate are constant and equal Ans- c

19. Suppose the interest rate is five percent, the expected growth rate of the firm is two percent,
and the firm is expected to continue forever. If current profits are $1,000, what is the value of the
firm?
a. $31,000
b. $30,000
c. $26,500
d. $35,000 Ans- d

20. To maximize profits, a firm should continue to increase production of agood until:
a. Total revenue equal total cost
b. Profits are zero
c. Marginal revenue equals marginal cost
d. Average cost equals average revenue ans- c

Use the following table to answer questions 21-25:

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21. What is the marginal revenue of producingthe third unit?
a. 250
b. b.70
c. 0
d. 90 Ans- b

22. What is the marginal cost of producingthe fifth unit?

a. 270
b. 110
c. 50
d. 0 Ans- b

23. At what level of output does marginal cost equal marginal revenue?
a. 1
b. 2
c. 3
d. 4 ans- c

24. What is the level of net benefits when four units are produced?
a. 0
b. 70
c. 70
d. 20 Ans- d

25. What is the marginal net benefit of producing the fourth unit?
a. 50
b. 0
c. 60
d. 40 Ans- a

26. The additional benefits that arise by using an additional unit of the managerial control variable
is defined as the:
a. Total benefit
b. Opportunity cost
c. C.Marginal benefit
d. Present value of benefits ans- c

27. The additional cost incurred by using an additional unit of the managerial control variable is
defined as the:
a. Total cost
b. Net cost
c. Net benefit
d. Marginal cost Ans- d

28. The change in net benefits that arise from a one unit change in quantity is the:
a. Marginal net benefits
b. Total net benefits
c. Variable benefits
96
d. Present value benefits Ans- a

29. The difference between marginal benefits and marginal costs are the:
a. Profits
b. Marginal net benefits
c. Opportunity cost
d. Accounting cost Ans- b

30. In order to maximize net benefits, firms should produce where:

a. Total benefits equal total costs
b. Profits are zero
c. Marginal cost is minimized
d. Marginal benefits equal marginal costs Ans- d

31. Given the cost function C(Y) = 6Y2, what is the marginal cost?
a. 6Y
b. Y2
c. 3Y
d. 12Y Ans- d

32. Given the benefit function B(Y) = 400Y - 2Y2, the marginal benefit is:
a. 200Y
b. 400 -2Y2
c. 400 - 4Y
d. 800 -2Y ans-c c

33. Suppose total benefits and total costs are given by B(Y) = 100Y - 8Y2 and C(Y) = 10Y2. Then
marginal benefits are:
a. 100 -16Y
b. 100Y - 8Y2
c. 50 - 4Y
d. 200Y - 10Y ans- a

34. Suppose total benefits and total costs are given by B(Y) = 100Y - 8Y2 and C(Y) = 10Y2. Then
marginal costs are:
a. 20Y2
b. 40
c. 5Y
d. 20Y Ans- d

35. Suppose total benefits and total costs are given by B(Y) = 100Y - 8Y2 and C(Y) = 10Y2. What
level of Y will yield the maximum net benefits?
a. 75/36
b. 75/18
c. 50/18
d. 100/36 Ans- d

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36. Suppose total benefits and total costs are given by B(Y) = 100Y - 8Y2 and C(Y) = 10Y2. What is
the maximum level of net benefits?
a. 92
b. B. 139
c. 78
d. None of the statements associated with this question are correct Ans- b

37. If a producer offers a price that is in excess of a consumer's valuation of the good, the con-
sumer:
a. Must buy the good at that price
b. B. Will refuse to purchase the good
c. Must revalue the good
d. None of the statements associated with this question are correct Ans- b

38. Negotiations between the buyer and seller of a new house is an example of:
a. Consumer-consumer rivalry
b. B. Consumer-producer rivalry
c. Producer-producer rivalry
d. Monopoly Ans- b

39. The behavior of bidders in an auction is an example of:

a. Consumer-consumer rivalry
b. Consumer-producer rivalry
c. Producer-producer rivalry
d. None of the statements associated with this question are correct Ans- a

40. Under producer-producer rivalry, individual firms want to sell the product at the maximum price
consumers will pay, but are unable to do this because of:
a. Cost considerations
b. The scarcity of resources
c. Competition among sellers
d. Competition among buyers ans- c

41. In the Wealth of Nations, Adam Smith argues that:

a. Self-interest leads to the efficient allocation of resources
b. Benevolence leads to the efficient allocation of resources
c. Profits are maximized where marginal revenue equals net marginalbenefits
d. None of the statements associated with this question are correct Ans- a

42. Other things equal, the greater the interest rate:

a. The lower the NPV
b. The higher the NPV
c. The higher the PV
d. None of the statements associated with this question are correct Ans- a

43. Economics
a. Exists because of the scarcity
b. Is not related to decision-making
98
c. Is the science for the rich
d. Has nothing to do with the allocation of resources Ans- a

44. Managerial economics

a. Has little to say about day-to-day decisions
b. Is valuable to the coordinator of a shelter for the homeless
c. Is not relevant for managers of "not-for-profit" groups
d. Is the study of how to get rich in the stock market Ans- b

1-12

45. Basic principles that comprise good management include

a. Identifying goals and constraints
b. Recognizing the nature and importance of profits
c. Understanding incentives
d. All of the statements associated with this question are correct Ans- d

46. Which of the following is the main goal of a continuing company?

a. To maximize the value of the firm
b. To minimize costs
c. To improve product quality
d. To enhance the service to its customers Ans- a

47. Which of the following is (are) true?

a. Accounting costs generally understate economic costs
b. Accounting profits generally overstate economic profits
c. In the absence of any opportunity costs, accounting profits equaleconomic profits
d. All of the statements associated with this question are correct Ans- d

48. Which of the following is incorrect?

a. Accounting profits generally overstate economic profits
b. Accounting profits do not take opportunity cost into account
c. Economic costs include not only the accounting costs but also the opportunity costs of the re-
sources used in production
d. Managers should only be interested in accounting profits Ans- d

49. What is the main role of economic profits?

a. To signal where resources are most highly valued
b. To help firms cover their production costs
c. To help consumers cover their opportunity cost
d. None of the statements associated with this question are correct Ans- a

50. If the annual interest rate is 0%, the present value of receiving $1.10 in the next year is:
a. $1.00
b. $1.01
c. $1.11
d. $1.10 Ans- d

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51. If the interest rate is 5%, $10 received at the end of 7 years is worth how much today?
a. 100/(0.05)7
b. 100/(1 +0.05)7 c.
c. 100/(1 + 5)7
d. 100 ans- b

52. As the interest rate increases, the opportunity cost of waiting to receive a future amount:
a. Increases
b. Decreases
c. May rise or fall
d. Remains the same Ans- a

53. The higher the interest rate, the greater the

a. Present value
b. Net present value
c. All of the statements associated with this question are correct
d. None of the statements associated with this question are correct Ans- d

54. To an economist, maximizing profit is:

a. Maximizing the value of the firm
b. Maximizing the current year's profits
c. Minimizing the permanent total costs
d. Minimizing the future risks Ans- a

55. The value of the firm is the:

a. Current value of profits
b. Present discounted value of all future profits
c. Average value of all future profits
d. Total value of all future profits Ans- b

56. Marginal benefits are the:

a. Incremental benefits of a decision
b. Average benefits of a decision
c. Total benefits of a decision
d. Present discounted benefit of a decision Ans- a

57. The optimal amount of studying is determined by comparing:

a. Marginal benefit and the total cost of studying
b. Marginal benefit and the total benefit of studying
c. Marginal benefit and the marginal cost of studying
d. Total benefit and the total cost of studyingans-c

58. If marginal benefits exceed marginal costs, it is profitable to:

a. Increase Q
b. Decrease Q
c. Stay at that level of Q
d. All of the statements associated with this question are correct Ans- a
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59. If marginal costs exceed marginal benefits, then:
a. The firm ends up with a net loss
b. The firm's average costs exceed average benefits
c. The firm should decrease its production level
d. None of the statements associated with this question are correct ans- c

60. In order to maximize net benefits, the managerial control variable should be used up to the
point where:
a. Total costs equal total benefits
b. Average costs equal marginal benefits
c. Average benefits equal marginal costs
d. Net marginal benefits equal zero Ans- d

61. Maximizing total benefits is equivalent to maximizing net benefits if and only if there are:
a. Constant costs associated with achieving more benefits
b. No costs associated with achieving more benefits
c. Increasing costs associated with achieving more benefits
d. Decreasing costs associated with achieving more benefits Ans- b

62. Which of the following is the incorrect statement?

a. The marginal benefits curve is the slope of the total benefits curve
b. Db(Q)/dQ = MB
c. The slope of the net benefit curve is horizontal where MB = MC
d. The difference in the slope of the total benefit curve and the totalcost curve is maximized at the
optimal level of Q Ans- d

63. When MB = 300 - 12Y and TC = 12Y + 108, the optimal level of Y is:
a. 25
b. 4.5
c. 8
d. 24 Ans- d

64. Incentive plans imply:

a. If managers get highly paid, then they work hard
b. If managers put forth little effort, they receive little pay; if they put forth much effort and hence
generate many sales, they receive alot of pay
c. Managers are not selfish
d. Managers should be watched all the time Ans- b

65. Which of the following is not the source of rivalry that exists in economic transactions?
a. Consumer-producer rivalry
b. Producer-producer rivalry
c. Government-producer rivalry
d. All of the statements associated with this question are correct ans-c

66. Consumer-producer rivalry occurs because of:

a. Consumers' high valuation and producers' low production cost of a good
101
b. Producers' high production cost and consumers' low valuation of a good
c. The competing interests of consumers and producers
d. None of the statements associated with this question are correct ans- c

67. Trade will take place:

a. If the maximum that a consumer is willing and able to pay is less than the minimum price the
producer is willing and able to accept fora good
b. If the maximum that a consumer is willing and able to pay is greater than the minimum price
the producer is willing and able toaccept for a good
c. Only if the maximum that a consumer is willing and able to pay is equal to the minimum price
the producer is willing and able to accept for a good
d. None of the statements associated with this question are correct Ans- b

68. Consumer-consumer rivalry:

a. Increases the negotiating power of consumers in the market place
b. Reduces the negotiating power of producers in the market place
c. Reduces the negotiating power of consumers in the market place
d. Increases the likelihood of government intervention in the market place ans- c

PART- 3
Demand for a commodity refers to:
Need for the commodity Desire for the commodity
Amount of the commodity demanded at a particular price and at aparticular time
Quantity demanded of that commodity(Ans: c)

Which among the following statement is INCORRECT?

On a linear demand curve, all the five forms of elasticity can be depicted’
If two demand curves are linear and intersecting each other then coefficient of elasticity would be
same on different demand curves at the point of intersection.
If two demand curves are linear, and parallel to each other then at a particular price the coefficient
of elasticity would be different on differentdemand curves.
The price elasticity of demand is expressed in terms of relative not absolute, changes in Price and
quantity demanded’
(Ans: b)

If the demand for a good is inelastic, an increase in its price will cause the total expenditure of the
consumers of the good to:

Increase Decrease Remain the sameBecome zero (Ans: a)

The horizontal demand curve parallel to x-axis implies that the elasticityof demand is:

Zero Infinite
Equal to one
Greater than zero but less than infinity(Ans: b)
An individual demand curve slopes downward to the right because of the:
Working of the law of diminishing marginal utilitysubstitution effect of decrease in price
income effect of fall in PriceAll of the above
(Ans: d)
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Income elasticity of demand is defined as the responsiveness of:Quantity demanded to a change in
income
Quantity demanded to a change in price
Price to a change in income
Income to a change in quantity demanded(Ans:a)

The supply of a good refers to:

Stock available for sale Total stock in the warehouse
Actual Production of the good
Quantity of the good offered for sale at a particular price per unit of time(Ans: d)
In the short run, when the output of a firm increases, its average fixedcost:

Remains constant
DecreasesIncreases
First decreases and then rises(Ans: b)
The cost of one thing in terms of the alternative given up is called:Real cost
Production costPhysical cost opportunity cost(Ans: d)

Assume that consumer’s income and the number of sellers in the market for good X both falls.
Based on this information, we can conclude with certainty that the equilibrium:
Price will decrease Price will increase Quantity will increaseQuantity will decrease(Ans: d)
The economist’s objections to monopoly rest on which of the followinggrounds?

There is a transfer of income from consumers to the monopolist

There is welfare loss as resources tend to be misallocated under monopolyOnly A is correct
Both A and B are correct(Ans: d)

In which of the following market structure is the degree of control over the price of its product by a
firm very large?

Imperfect competitionPerfect competition Monopoly

In A and B both(Ans: c)

69. Consumer-consumer rivalry arises because of:

a. Human nature
b. The limited number of suppliers
c. The scarcity of goods available
d. None of the statements associated with this question are correct ans- c

70. Producer-producer rivalry functions:

a. Only when multiple sellers for a product compete in the market
b. Only when single sellers for a product compete in the market
c. Regardless of the number of sellers
d. Even when customers are not scarce Ans- a

71. Because of producer-producer rivalry, the price will tend to:

a. Be driven to a lower price
b. Rise up to the maximum price the consumers are willing and able to pay
103
c. Be the same as the competitive price
d. Be the same as the monopoly price Ans- a

72. Which is the correct statement about the relationshipbetween government and the market?
a. Government should intervene on the consumers' behalf
b. Government should intervene on the producers' behalf
c. Government should not intervene on any party's behalf
d. Government often plays a role in disciplining the market process Ans- d

73. Suppose the growth rate of the firm's profit is 5%, the interest rate is 6%, and the current profits
of the firm are 80 million dollars: Whatis the value of the firm?
a. $89.2 million
b. $1,413.3 million
c. $8,480 million
d. None of the statements associated with this question are correct ans- c

74. Suppose the growth rate of the firm's profit is 5%, the interest rate is 6%, and the current profits
of the firm are 100 million dollars. What is the value of the firm?
a. $111.5 million
b. $1,766.6 million
c. $10,600 million
d. None of the statements associated with this question are correct ans- c

75. Maximizing the present value of all future profits is the same as maximizing current profits if
the growth rate in profits is:
a. Greater than the interest rate
b. Less than the interest rate
c. Equal to the interest rate
d. Not constant over time Ans- b

76. Marginal benefit refers to:

a. The average benefits that arise by using an additional unit of themanagerial control variables
b. The additional benefits that arise by using an additional unit ofthe managerial control variables
c. The change in average benefits arising from a change in the control variable
d. None of the statements associated with this question are correct Ans- b

77. Generally when calculating profits as total revenue minus total costs, accounting profits are
larger than economic profits becauseeconomists take into account
a. Only explicit costs
b. Only implicit costs
c. Both explicit and implicit costs
d. Both types of profits are always equal because they account for the samecosts ans- c

78. "Our marginal revenue is greater than our marginal cost at the current production level." This
statement indicates that the firm
a. Is maximizing profits
b. Should increase the quantity produced to increase profits
104
c. Should decrease the quantity produced to increase profits
d. None of the statements associated with this question are correct Ans- b

79. If the interest rate is 5% and cash flows are $3,000 at the end of year one and $5,000 at the end
of year two, then the present value ofthese cash flows is
a. $7,392.29
b. $8,400.34
c. $4,222.50
d. $400.74 ans- a

80. New firms have incentive to enter an industry when there is

a. New production technologies
b. Positive economic profits
c. An abundance of labor
d. High capital costs Ans- b

Chapter 01 - The Fundamentals of Managerial Economics

81. Property owners move scarce resources towards the production ofgoods most valued by socie-
ty because
a. Government controls the allocation of resources
b. Consumers demand inexpensive goods and services
c. Managers are solely pursuing the interests of society
d. Firms attempt to maximize profits Ans- b

82. If the interest rate is 12.5%, what is the present value of $200received in one year?
a. $25
b. $177.77
c. $197
d. $225 ans- b

83. If you put $700 in a savings account at an interest rate of 3%, how much money will you have in
one year?
a. $370
b. $679.61
c. $703.00
d. $721 Ans- d

84. If the interest rate is 3%, the present value of $900 received atthe end of 4 years is:
a. $792.00
b. $799.64
c. $873.79
d. $927.40 ans- b
1-22

85. Maximizing the lifetime value of the firm is equivalent to maximizing the firm's current profits if
the
105
a. Interest rate is larger than the growth rate in profits and both are constant
b. Growth rate in profits is constant and is larger than the interest rate
c. Interest rate is smaller than the growth rate of profits
d. Growth rate of profits and the interest rate are equal Ans- a

86. Given the benefit function B(Y) = 200Y - 3Y2, the marginal benefit is:
a. 600Y
b. 200 - 3Y
c. 200 - 6Y2
d. 200 - 6Y Ans- d

87. Negotiation between the buyer and seller of a new ski-boat is anexample of:
a. Consumer-producer rivalry
b. Consumer-consumer rivalry
c. Producer-producer rivalry
d. None of the statements associated with this question are correct Ans- a

88. If the annual interest rate is 0%, the present value of receiving $210 in the next year is:
a. $221
b. $200
c. $201
d. $210 Ans- d

89. If the interest rate is 7%, $500 received at the end of 9 years isworth how much today?
a. 500/(0.07)9
b. 500/(1+.07)9
c. 500/(1 + 7)9
d. 500 ans- b

90. Suppose the growth rate of the firm's profit is 7%, the interest rate is 10%, and the current prof-
its of the firm are 120 million dollars: What is the value of the firm?
a. $44 million
b. $4,280 million
c. $4,400 million
d. $6,800 million ans- c

91. The opportunity cost of an action is the

a. Monetary payment the action required
b. Value of the most highly valued alternative action given up
c. Cost of all alternative actions that could have been taken
d. None of the statements associated with this question are correct Ans- b

106
Use the following table to answer questions 92-101:

92. What is the total benefit associated with producing four units of thecontrol variable, Q (identify
point A in theabove table)?
a. 600
b. 2,600
c. 3,000
d. 3,400 ans- c

93. What is the total cost associated with producing eight units of the control variable, Q (identify
point B in theabove table)?
a. 3,000
b. 3,600
c. 3,800
d. 4,200 ans- b

94. What is the net benefit associated with producing two units of the control variable, Q (identify
point C in theabove table)?
a. 600
b. 800
c. 1,200
d. 1,400 Ans- d

95. What is the marginal benefit associated with producing six units of thecontrol variable, Q (iden-
tify point D in theabove table)?
a. 600
b. 400
c. 200
d. 100 ans- b

96. What is the marginal cost associated with producing three units of thecontrol variable, Q (iden-
tify point E in the above table)?
a. 50
107
b. 100
c. 200
d. 300 Ans- d

97. What is the marginal net benefit associated with producing five units of the control variable, Q
(identify point F in the abovetable)?
a. -100
b. -75
c. 0
d. 100 Ans- c

PART-3 –

1- Demand for a commodity refers to:

a. Need for the commodity
b. Desire for the commodity
c. Amount of the commodity demanded at a particular price and at aparticular time
d. Quantity demanded of that commodity(Ans: c)

2- Which among the following statement is INCORRECT?

a. On a linear demand curve, all the five forms of elasticity can bedepicted’
b. If two demand curves are linear and intersecting each other then coefficient of elasticity would
be same on different demand curves atthe point of intersection.
c. If two demand curves are linear, and parallel to each other then at a particular price the coeffi-
cient of elasticity would be different on different demand curves.
d. The price elasticity of demand is expressed in terms of relative not absolute, changes in Price
and quantity demanded’ (Ans: b)

3- If the demand for a good is inelastic, an increase in its price will cause the total expenditure of
the consumers of the good to:
a. Increase
b. Decrease
c. Remain the same
d. Become zero (Ans: a)

4- The horizontal demand curve parallel to x-axis implies that theelasticity of demand is:
a. Zero
b. Infinite
c. Equal to one
d. Greater than zero but less than infinity(Ans: b)

5- An individual demand curve slopes downward to the right because ofthe:

a. Working of the law of diminishing marginal utility
b. substitution effect of decrease in price
c. income effect of fall in Price
d. All of the above(Ans: d)

6- Income elasticity of demand is defined as the responsiveness of:

108
a. Quantity demanded to a change in income
b. Quantity demanded to a change in price
c. Price to a change in income
d. Income to a change in quantity demanded(Ans:a)

7- The supply of a good refers to:

a. Stock available for sale
b. Total stock in the warehouse
c. Actual Production of the good
d. Quantity of the good offered for sale at a particular price per unit oftime (Ans: d)

8- In the short run, when the output of a firm increases, its average fixedcost:
a. Remains constant
b. Decreases
c. Increases
d. First decreases and then rises(Ans: b)

9- The cost of one thing in terms of the alternative given up is called:

a. Real cost
b. Production cost
c. Physical cost
d. opportunity cost(Ans: d)

10- Assume that consumer’s income and the number of sellers in the market for good X both
falls. Based on this information, we can concludewith certainty that the equilibrium:
a. Price will decrease
b. Price will increase
c. Quantity will increase
d. Quantity will decrease(Ans: d)

11- The economist’s objections to monopoly rest on which of the followinggrounds?

a. There is a transfer of income from consumers to the monopolist
b. There is welfare loss as resources tend to be misallocated undermonopoly
c. Only A is correct
d. Both A and B are correct(Ans: d)

12- In which of the following market structure is the degree of controlover the price of its product
by a firm very large?
a. Imperfect competition
b. Perfect competition
c. Monopoly
d. In A and B both(Ans: c)

98. The marginal cost in the above table is

a. Increasing at an increasing rate
b. Decreasing at an increasing rate
c. Increasing at a constant rate
109
d. Decreasing at a decreasing rate ans- c

99. The marginal benefit in the above table is

a. Increasing at a constant rate
b. B. Decreasing at a constant rate
c. Increasing at a decreasing rate
d. Decreasing at an increasing rate Ans- b

100. To maximize net benefits in the above table it is most appropriate touse
a. Four units of the control variable, since the marginal benefit exceedsmarginal cost
b. Six units of the control variable, since the marginal cost exceedsmarginal benefit
c. C.Five units of the control variable, since net marginal benefits are zero
d. None of the statements associated with this question are correct ans- c

101. Total benefits in the above table are

a. Increasing at a decreasing rate
b. Increasing at a constant rate
c. Decreasing at a constant rate
d. Decreasing at an increasing rate Ans- a

102. Total costs in the above table are

a. Decreasing at a constant rate
b. Decreasing at an decreasing rate
c. Increasing at a constant rate
d. Increasing at an increasing rate Ans-b

103. Net benefits in the above table

a. Initially increase, reach a maximumand then decrease
b. Initially decrease, reach aminimum and then increase
c. Remain the relatively stable overdifferent values for the control variable
d. Initially remain relatively stableand then decrease Ans- b

104. Marginal net benefits in theabove table

a. Initially increase, reach amaximum and then decrease
b. Initially decrease, reach aminimum and then increase
c. Remain the relatively stable overdifferent values for the control variable
d. Initially remain relatively stableand then decrease Ans- b

105- The offer curves introduced byAlfred Marshall, helps us to understand how the is estab-
lished in international trade.
a. Terms of trade
b. Equilibrium price ratio
c. Exchange rate
d. Satisfaction level(Ans: a)

106- Demand for factors of productionis:

a. Derived demand
b. Joint demand
110
c. Composite demand
d. None of the above(Ans: a)

107- The producer’s demand for a factorof production is governed by the of that factor.
a. Price

b. Marginal Productivity
c. Availability
d. Profitability(Ans: b)

108- Under conditions of perfect competition in the product market:

a. MRP=VMP
b. MRP > VMP
c. VMP > MRP
d. None of the above(Ans: a)

109- Which among the followingstatements is INCORRECT?

a. Coefficient of correlation can be computed directly from thedata without measuring deviation.
b. Measures of Dispersion arealso called averages of the second order.
c. Standard deviation can benegative.
d. Mean deviation can never benegative. (Ans: c)

110- One of the methods to find outMode is:

a. Mode = 3 Median + 2 Mean
b. Mode=3 Median – 3 Mean
c. Mode = 2 Median – 3 Mean
d. Mode=3 Median – 2 Mean(Ans: d)

111- Which among the followingstatements is INCORRECT?

a. Index number is a relativemeasurement.
b. In fact all index numbers areweighted.
c. Theoretically the best average inconstruction of index numbers isGeometric mean.
d. It is not possible to shift thebase if it is the case of fixedbase index
(Ans: d)

112- Mean Deviation can be calculatedfrom:

a. Mean
b. Median
c. Mode
d. Any of the above(Ans: d)

113- Scatter diagram is used to study in economic statistics.

a. Variability in the series
b. Nature of Correlation in thetwo series
c. Regression
d. Secular trend (Ans: b)

114- Coefficient of Correlation (r) issignificant, if:

111
a. r > 5 times Probable Error
b. r < 6 times Probable Error
c. r > 6 times Probable Error
d. r = 6 times Probable Error(Ans: c)

115- Which statistical measure helps inmeasuring the purchasing power of money?
a. Arithmetic average
b. Index numbers
c. Harmonic mean
d. Time series(Ans: b)

116- Fisher’s ideal index number is:

a. Arithmetic mean of Laspeyre’sand Paasche’s index
b. Harmonic mean of Laspeyre’sand Paasche’s index
c. Geometric mean of Laspeyre’sand Paasche’s index
d. None of the above (Ans: c)

117- Which among the following isNOT a correct statement?

a. Welfare economics is based onvalue judgements.
b. Welfare economics is also called ‘economics with a heart’.
c. Welfare economics focuses onquestions about equity as wellas efficiency.
d. The founder of Welfareeconomics was Alfred Marshall. (Ans: d)

118- Who is the ‘lender of the last resort’ in the banking structure ofIndia?
a. State Bank of India
b. Reserve Bank of India
c. EXIM Bank of India
d. Union Bank of India(Ans: b)

119- is the official minimum rate at which the Central Bank of a countryis prepared to redis-
count approved bills held by the commercial banks.
a. Repo rate
b. Bank rate
c. Prime lending rate
d. Reverse repo rate(Ans: b)

120- In order to control credit, ReserveBank of India should:

a. Increase CRR and decrease Bankrate
b. Decrease CRR and reduce Bankrate
c. Increase CRR and increase Bankrate
d. Reduce CRR and increase Bankrate (Ans: c)

121- Which among the following is afunction of the Reserve Bank of India?
a. Bank issues the letters of creditto their customers certifying their creditability
b. Collecting and compilation of statistical information relating to banking & other financial sec-
tors
c. Banks under write the securities issued by public orprivate organizations
d. Accepting deposits from thepublic (Ans: b)
112
122- Credit creation power of the commercial banks gets limited bywhich of the following?
a. Banking habits of the people
b. Cash reserve ratio
c. Credit policy of the central bank
d. All of the above(Ans: d)

123- Number of times a unit of money changes hands in the course of a yearis called
a. Supply of money
b. Purchasing power of money
c. Velocity of money
d. Value of money(Ans: c)

124- is the difference between total receipts and total expenditure.

a. Capital deficit
b. Budget deficit
c. Fiscal deficit
d. Revenue deficit (Ans: b)

125- What is meant by Autarky ininternational trade?

a. Monopoly in internationaltrade
b. Imposition of restrictions ininternational trade
c. Removal of all restrictions frominternational trade
d. The idea of self sufficiency andno international trade by a country (Ans: d)

126- The following is the direct taxamong:

a. House tax
b. Entertainment tax
c. Service tax
d. Value Added tax(Ans: a)

127- Which among the following is acause of inflation?

a. Deficit financing
b. Rise in external loans
c. Unfavourable balance ofpayment
d. A hike in the CRR by the centralbank of the country (Ans: a)

128- Cost push inflation occurs becauseof:

a. Wage push
b. Profit push
c. Both A and B
d. Ineffective policies of thegovernment (Ans: c)

129- Which among the following is NOTcorrect?

a. During inflation lenders sufferand borrowers benefit out’
b. Rising inflation indicates rising aggregate demand and indicates comparatively lower supply
and higher purchasing capacity among the consumers’
c. With rising inflation the currency of the economy depreciates provided it followsthe flexible cur-
113
 rency regime.
d. Inflation decreases the nominal(face) value of the wages while the real value increases. (Ans:d)

130- The capital that is consumed byan economy or a firm in the production process is known as:
a. Capital loss
b. Production cost
c. Dead-weight loss
d. Depreciation(Ans: d)

131- Who propounded the opportunitycost Theory of international trade?

a. Ricardo
b. Marshall
c. Heckscher & Ohlin
d. Haberler(Ans: d)

132- Which among the following is NOTcorrect?

a. Floating exchange rate system works on the market mechanism
b. Floating exchange rate breedsuncertainties and speculation
c. Economic and political factors and value judgments influence the choice of the exchange rate
system
d. The system of floating exchangerate requires comprehensive government intervention (Ans: d)

133- Which among below is NOT acorrect statement?

a. Bretton Woods conference gave birth to two internationalorganizations-
b. Theory of Absolute Advantagein international trade is given by Adam Smith’
c. Pure and perfect competition isthe same market structures.
d. Mint par theory of exchange rate determination is applicable in countries under gold standard.
(Ans: c)

134- Terms of trade that relate to the Real Ratio of international exchange between commodities is
called:
a. Real cost terms of trade
b. Commodity terms of trade
c. Income terms of trade
d. Utility terms of trade(Ans: c)

135- Who among the following enunciated the concept of singlefactoral terms of trade?
a. Jacob Viner
b. G.S.Donens
c. Taussig
d. J.S.Mill(Ans: a)

136- ‘Infant industry argument’ in international trade is given in supportof:

a. Granting Protection
b. Free trade
c. Encouragement to export oriented small and tiny industries
d. None of the above(Ans: a)

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137- Which of the following is also known as International Bank for Reconstruction and Develop-
ment?
a. Asian Development Bank
b. World Bank
c. Reserve Bank of India
d. International Monetary Fund(Ans: b)

138- Which among the following is nota function of International MonetaryFund?

a. It serves a medium term andlong term credit institution’
b. It provides a mechanism for improving short term balanceof payments position’
c. It provides machinery for international consultations’
d. It provides reservoir of thecurrencies of the member countries and enables members to borrow
one another’s currency’
(Ans: a)

139- The new world Trade organization (WTO), which replaced the GATT cameinto effect from
a. 1ST January 1991
b. 1st January 1995
c. 1st April 1994
d. 1st May 1995(Ans: b)

Change in fiscal policy affects thebalance of payments through:

a. The current account only
b. The capital account only
c. Both, the current account andcapital account
d. Neither current account norcapital account (Ans: c)

PART – 4

1. A country’s government runs a budget deficit when which of the following occurs in
a given year?
(A) The amount of new loans to developing nations exceeds the amount of loans paid off by de-
veloping nations.
(B) Government spending exceeds tax revenues.
(C) The debt owed to foreigners exceeds the debt owed to the country’s citizens.
(D) The amount borrowed exceeds the interest payment on the national debt.
(E) Interest payments on the national debt exceedspending on goods and services.

2. A high marginal propensity to consume implies which of the following?

(A) A small change in consumption when income changes
(B) A high savings rate
(C) A high marginal tax rate
(D) An equilibrium level of income near fullemployment
(E) A low marginal propensity to save

3. The transaction demand for money is very closely associated with money’s use as a

115
(A) store of value
(B) standard unit of account
(C) measure of value
(D) medium of exchange
(E) standard of deferred payment

4. Unlike a market economy, a command economy uses

(A) more centralized planning in economic decision making
(B) consumer sovereignty to make production decisions
(C) its resources more efficiently
(D) price signals in economic decision making
(E) the popular vote in making resource alloca- tion decisions

5. The value of a country’s currency will tend to appreciate if

(A) demand for the country’s exports increases
(B) the country’s money supply increases
(C) the country’s citizens increase their travel abroad
(D) domestic interest rates decrease
(E) tariffs on the country’s imports decrease

6. Which of the following best illustrates an improvement in a country’s standard of living?

(A) An increase in real per capita gross domestic product
(B) An increase in nominal per capita gross domestic product
(C) Price stability
(D) A balanced budget
(E) An increase in the consumer price index
7. Hyperinflation is typically caused by
(A) high tax rates that discourage work effort
(B) continuous expansion of the money supply to finance government budget deficits
(C) trade surpluses that are caused by strongprotectionist policies
(D) bad harvests that lead to widespreadshortages
(E) a large decline in corporate profits that leads to a decrease in production

8. All of the following changes will shift the investment demand curve to the right EXCEPT
(A) a decrease in the corporate income tax rate
(B) an increase in the productivity of new capital goods
(C) an increase in the real interest rate
(D) an increase in corporate profits
(E) an increase in real gross domestic product

9. The official unemployment rate understates the unemployment level in the economy because
the official unemployment rate
(A) ignores the duration of unemployment
(B) ignores underemployed and discouragedworkers
(C) includes jobs created by the undergroundeconomy
(D) excludes all unemployed teenagers
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(E) excludes frictionally unemployed workers

10. If a reduction in aggregate supply is followed by an increase in aggregate demand, which of the
following will definitely occur?
(A) Output will increase.
(B) Output will decrease.
(C) Output will not change.
(D) The price level will increase.
(E) The price level will decrease.
11. Which of the following combinations of changes in government spending and taxes is neces-
sarily expansionary?
Government
Spending Taxes
(A) Increase Increase
(B) Increase Decrease
(C) Decrease Not change
(D) Decrease Increase
(E) Decrease Decrease

12. The amount of money that the public wants to hold in the form of cash will
(A) be unaffected by any change in interest rates or the price level
(B) increase if interest rates increase
(C) decrease if interest rates increase
(D) increase if the price level decreases
(E) decrease if the price level remains constant

13. For an economy consisting of households and businesses only, which of the following is con-
sistent with the circular flow of income and production?
(A) Households are producers of goods and services and consumers of resources.
(B) Households are users of resources, and businesses are sources of saving.
(C) Households are suppliers of resources and consumers of goods and services.
(D) Businesses are users of taxes, and households are sources of taxes.
(E) Businesses are suppliers of resources and consumers of goods and services.

14. With an increase in the real interest rate, consumption and real gross domestic product will
most likely change in which of the following ways?
Real GrossConsumption Domestic Product
(A) Increase Increase
(B) Increase Decrease
(C) Decrease Increase
(D) Decrease Decrease
(E) No change Increase
15. According to the short-run Phillips curve, lower inflation rates are associated with
(A) higher unemployment rates

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(B) higher government spending
(C) larger budget deficits
(D) greater labor-force participation rates
(E) smaller labor-force participation rates

16. Which of the following will lead to a decrease in a nation’s money supply?
(A) A decrease in income tax rates
(B) A decrease in the discount rate
(C) An open market purchase of government securities by the central bank
(D) An increase in reserve requirements
(E) An increase in government expenditures on goods and services
17. An increase in which of the following would cause the aggregate demand curve to shift to the
left?
(A) Consumer optimism
(B) Population
(C) Cost of resources
(D) Income taxes
(E) Net exports

18. Which of the following changes in the supply of and the demand for a good will definitely re-
sult ina decrease in both the equilibrium price and quantity of the good?
Supply Demand
(A) Increase Increase
(B) Increase No change
(C) No change Decrease
(D) Decrease Increase
(E) Decrease Decrease

BANK A

Assets Actual reserves $1,000 Liabilities Demand deposits $5,000

Loans $4,000
BANK B
Assets Liabilities
Actual reserves $ 100 Demand deposits $ 600
Loans $ 500
BANK C
Assets Liabilities
Actual reserves $ 10 Demand deposits $ 100
Loans $ 90

19. Based on the balance sheets above for three different banks, which of the following is true, if
the reserve requirement is 10 percent?

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(A) Bank A has no excess reserves.
(B) Bank B has no excess reserves.
(C) Bank B can increase its loans by $500.
(D) Bank B can increase its loans by $40.
(E) Bank C has excess reserves.

20. Which of the following will most likely lead to adecrease in inflationary expectations?
(A) A decrease in the marginal propensity to save
(B) A decrease in imports
(C) A decrease in the money supply
(D) An increase in the government budget deficit
(E) An increase in the prices of raw materials

21. With an upward-sloping short-run aggregate supply curve, an increase in government expendi-
ture will most likely
(A) reduce the price level
(B) reduce the level of nominal gross domestic product
(C) increase real gross domestic product
(D) shift the short-run aggregate supply curve to the right
(E) shift both the aggregate demand curve and the long-run aggregate supply curve to the left

22. Which of the following are the most likely short-run effects of an increase in government ex-
penditures?

Unemployment Rate Inflation Rate Real Gross Domestic Product

(A) Increase Increase Increase
(B) Increase Increase Decrease
(C) Decrease Increase Increase
(D) Decrease Decrease Increase
(E) No change Decrease Increase
23. In the short run, an expansionary monetary policy would most likely result in which of the fol-
lowing changes in the price level and real gross domestic product (GDP) ?
Price Level Real GDP
(A) Decrease Increase
(B) No change Decrease
(C) Increase No change
(D) Increase Decrease
(E) Increase Increase

24. A reduction in inflation can best be achieved by which of the following combinations of fiscal
andmonetary policy?
Fiscal Policy Monetary Policy
(A) Increase taxes Sell government bonds
(B) Decrease taxes Buy governmentbonds

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(C) Decrease taxes Lower marginrequirements
(D) Decrease government Lower discount rate spending
(E) Increase government Raise discount rate spending

25. Which of the following is likely to occur following the depreciation of the United States dollar?
(A) United States imports will increase.
(B) United States exports will increase.
(C) Demand for the United States dollar will decrease.
(D) United States demand for foreign currencies will increase.
(E) United States goods will become more expensive in foreign markets.

26. The table below shows the production alternatives of Country A and Country B for producing
com- puters and cars with equal amounts of resources that are fully and efficiently employed.
Country ComputersCars
A 24 0
0 12

B 45 0
0 15
27. Which of the following is true accordingto the data in the table?
(A) Country A has an absolute and comparative advantage in the production of computers.
(B) Country B has an absolute and comparative advantage in the production of computers.
(C) Country B should import computers and export cars.
(D) Since Country B has an absolute advantage in the production of both goods, it will not trade
with Country A.
(E) Neither country can benefit from trade.
28. Which of the following individuals is consideredofficially unemployed?
(A) Chris, who has not worked for more than three years and has given up looking for work
(B) Kim, who is going to school full-time and is waiting until graduation before lookingfor a job
(C) Pat, who recently left a job to look for a different job in another town
(D) Leslie, who retired after turning 65 onlyfive months ago
(E) Lee, who is working 20 hours per week andis seeking full-time employment

29. An increase in net investment leads to faster economic growth because capital per worker and
output per worker will change in which of the following ways?
Capital Output
per Worker per Worker
(A) Increase Increase
(B) Increase Decrease
(C) No change Increase
(D) Decrease Increase
(E) Decrease Decrease

30. If a country’s economy is operating below the full-employment level of output at a very low in-

120
 flation rate, the central bank of the country is most likely to
(A) pursue an expansionary monetary policy because it is required to do so by law whenever out-
put is below the full- employment level
(B) pursue an expansionary fiscal policy because it is required to do so by law whenever output is
below the full-employment level
(C) lower the discount rate and buy bonds on the open market to generate an increase in output
(D) lower the required reserve ratio and sell bonds on the open market to generate an increase in
output
(E) raise the discount rate and lower the required reserve ratio to generate an increase in output
31. Assume that an economy is currently in long-run equilibrium and the short-run aggregate sup-
ply curve is upward sloping. An adverse supply shock, such as a drought, will most likely cause
which of the following to the economy in the short run?
(A) A decrease in the price level and a decrease in the nominal wage
(B) A decrease in the price level and an increase in the nominal wage
(C) An increase in the price level and an increase in the nominal wage
(D) An increase in the price level and an increase in the real wage
(E) An increase in the price level and a decrease in the real wage

32. If Country Alpha has been experiencing a higher inflation rate than Country Beta over the past
decade, which of the following is true?
(A) Alpha’s currency will have appreciated relative to Beta’s currency.
(B) Alpha’s currency will have depreciated relative to Beta’s currency.
(C) Alpha will have had lower nominal interest rates than Beta.
(D) Alpha will have had slower growth in the money supply than Beta.
(E) Alpha’s economy will have grown at a faster rate than Beta’s.

33. Based on the economic figures in the table above, what is the value of gross domestic product,
in billions of dollars?
(A) $4,500
(B) $4,700
(C) $4,900
(D) $5,150
(E) $5,950

34. Which of the following best explains the increase in national income that results from equal in-
creasesin government spending and taxes?
(A) Consumers do not reduce their spending by the full amount of the tax increase.
(B) The government purchases some goods that consumers would have purchased on their own
anyway.
(C) Consumers believe all tax cuts are transitory.
(D) The increase in government spending causes a decrease in investment.
(E) Consumers are aware of tax increases but not of increases in government spending.

35. Which of the following statements is true of unanticipated inflation?

(A) It decreases the economic well-being of allmembers of society proportionately.
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(B) It decreases the economic well-being of allmembers of society equally.
(C) It increases the economic well-being of net creditors.
(D) It increases the economic well-being of net debtors.
(E) It increases the economic well-being of workers with long-term labor contracts.

36. A simultaneous increase in inflation and unem- ployment could be explained by an increase in
which of the following?
(A) Consumer spending
(B) The money supply
(C) Labor productivity
(D) Investment spending
(E) Inflationary expectations
37. A country can have an increased surplus in its balance of trade as a result of
(A) an increase in domestic inflation
(B) declining imports and rising exports
(C) higher tariffs imposed by its trading partners
(D) an increase in capital inflow
(E) an appreciating currency

38. Policies intended to reduce demand-pull inflation are most likely to increase which of the fol-
lowing in the short run?
(A) Gross domestic product
(B) The labor force participation rate
(C) The price level
(D) Unemployment
(E) Wage levels

39. An increase in the government budget deficit is most likely to result in an increase in which of
thefollowing?
(A) The marginal propensity to consume
(B) Exports
(C) The real interest rate
(D) The money supply
(E) The simple multiplier

40. An increase in which of the following would bemost likely to increase long-run growth?
(A) Pension payments
(B) Unemployment compensations
(C) Subsidies to businesses for purchases of capital goods
(D) Tariffs on imported capital goods
(E) Tariffs on imported oil

41. A commercial bank’s ability to create moneydepends on which of the following?

(A) The existence of a central bank
(B) A fractional reserve banking system
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(C) Gold or silver reserves backing up thecurrency
(D) A large national debt
(E) The existence of both checking accounts and savings accounts
42. The consumer price index (CPI) is designed to measure changes in the
(A) spending patterns of urban consumers only
(B) spending patterns of all consumers
(C) wholesale price of manufactured goods
(D) prices of all goods and services produced in an economy
(E) cost of a select market basket of goods and services

43. A barter economy is different from a money economy in that a barter economy
(A) encourages specialization and division of labor
(B) involves higher costs for each transaction
(C) eliminates the need for a double coincidence of wants
(D) has only a few assets that serve as a medium of exchange
(E) promotes market exchanges

44. In the short run, which of the following would occur to bond prices and interest rates if a cen-
tralbank bought bonds through open-market operations?
Bond Prices Interest Rates
(A) No change Increase
(B) Increase Increase
(C) Increase Decrease
(D) Decrease Increase
(E) Decrease Decrease

45. Suppose that in an economy with lump-sum taxes and no international trade, autonomous in-
vest- ment spending increases by $2 million. If the marginal propensity to consume is 0.75,
equi- librium gross domestic product will change by a maximum of
(A) $0.5 million
(B) $1.5 million
(C) $2.0 million
(D) $8.0 million
(E) $15.0 million
46. Assume that the required reserve ratio is 10 percent, banks keep no excess reserves,
and borrowers deposit all loans made by banks. Suppose you have saved $100 in cash at home
and decide to deposit it in your checking account. As a result of your deposit, the money sup-
ply can increase by a maximum of
(A) $800
(B) $900

47. The diagram above shows the production possi- bilities curve for an economy that produces
only consumption and capital goods. All of the following statements about this economy are
true EXCEPT:
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(A) Producing at point Z results in theunderutilization of resources.
(B) The combination represented by point Y is unattainable, given the scarcity of resources.
(C) Resources are fully utilized at points W and X.
(D) Producing at point X will result in greater economic growth than will producing at point W.
(E) Point X represents the most efficient combination of the two goods that can be produced by
this economy.
$1,000
(D) $1,100
(E) $1,200

48. Which of the following would be the initial impact on an economy if wages were to increase
more than worker productivity?
(A) There would be no initial impact, since neither the aggregate supply curve nor the aggregate
demand curve would shift.
(B) Employment would increase, causing a rightward shift in the aggregate demand curve.
(C) The price level would increase, resulting in excess aggregate supply.
(D) The short-run aggregate supply curve would shift to the left, increasing the price level.
(E) The aggregate demand curve would shift to the left, increasing the price level.

49. Under a flexible exchange-rate system, the Indian rupee will appreciate against the Japanese
yen when
(A) India’s inflation rate exceeds Japan’s
(B) India has a trade deficit with Japan
(C) Japan’s economy enters a recession, but India’s does not
(D) Japan’s money supply decreases while India’s money supply increases
(E) real interest rates in India increase relative to those in Japan

50. Which of the following occurs as investment becomes more responsive to changes in the in-
terest rate?
(A) Monetary policy becomes more effective at changing real gross domestic product.
(B) Fiscal policy becomes more effective at changing real gross domestic product.
(C) Monetary policy becomes more effective at changing interest rates.
(D) Fiscal policy becomes more effective at changing interest rates.

124
(E) There is no change in the effectiveness of either monetary or fiscal policy.

51. If two nations specialize according to the law of comparative advantage and then trade with
eachother, which of the following would be true?
(A) A smaller number of goods would be avail- able in each trading nation.
(B) Total world production of goods woulddecrease.
(C) Everyone within each nation would bebetter off.
(D) Each nation would increase its consumption possibilities.
(E) One nation would gain at the expense of theother nation.

52. The shifting of a country’s production possibil- ities curve to the right will most likely cause
(A) net exports to decline
(B) inflation to increase
(C) the aggregate demand curve to shift to the left
(D) the long-run aggregate supply curve to shift to the left
(E) the long-run aggregate supply curve to shiftto the right
53. One explanation for the downward slope of the aggregate demand curve is that when the price
level increases, which of the following will decrease?
(A) Real value of assets
(B) Prices of foreign goods
(C) Prices of substitute goods
(D) Expectations of future prices
(E) Government deficit

54. Which of the following is true about changes in tax rates, changes in the level of government
expenditures, and changes in the money supply?
(A) They are automatic stabilizers.
(B) They are tools of discretionary fiscal policy.
(C) They have different lag times between implementation of a policy and its effects on aggregate
demand.
(D) They are favored equally by both classical and Keynesian economists to fine-tune the econo-
my.
(E) All are controlled by the Federal Reserve system.

55. An increase in which of the following would LEAST likely increase labor productivity?
(A) Physical capital
(B) Human capital
(C) Technological improvements
(D) Educational achievement
(E) The labor force

56. Tariffs are different from assigned import quotas in that tariffs will
(A) restrict imports
(B) increase the price of imported goods
(C) benefit domestic consumers of imported goods
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(D) hurt domestic producers of goods facing import competition
(E) generate additional revenue for the domestic government

57. In the narrowest definition of money, M1, savings accounts are excluded because they are
(A) not a medium of exchange
(B) not insured by federal deposit insurance
(C) available from financial institutions other than banks
(D) a store of purchasing power
(E) interest-paying accounts

For which of the following sets of unemployment and inflation rates will a central bank be most re-
luctant to increase the rate of growth in the money supply?

Unemployment Rate Inflation Rate

(A) 10% 2%
(B) 10% 5%
(C) 10% 10%
(D) 5% 5%
(E) 5% 10%

58. Assume that Jane’s marginal propensity to consume equals 0.8, and that in 2004 Jane spent
$36,000 from her disposable income of $40,000. If her disposable income in 2005increased to
$50,000, her consumption spending increased by
(A) $4,000
(B) $8,000
(C) $9,000
(D) $10,000
(E) $14,000

59. Advocates of a monetary rule recommend increasing the money supply at a rate that is equal
to the rate of increase in which of the following?
(A) Price level
(B) Unemployment rate
(C) Level of exports
(D) Level of imports
(E) Long-run real gross domestic product

60. If economic agents perfectly anticipate policy changes and if all prices, including wages, are
completely flexible, which of the following will be true in the long run?
(A) The price level will be constant.
(B) There will be no trade-off between inflation and unemployment.
(C) The unemployment rate will be less than the natural rate of unemployment.
(D) The unemployment rate will be greater than the natural rate of unemployment.
(E) Changes in the money supply will not lead to changes in the price level.

ANSWER –
126
Multiple-Choice Questions
Question # Key
1 B
2 E
3 D
4 A
5 A
6 A
7 B
8 C
9 B
10 D
11 B
12 C
13 C
14 D
15 A
16 D
17 D
18 C
19 D
20 C
21 C
22 C
23 E
24 A
25 B
26 B
27 C
28 A
29 C
30 E
31 B
32 A
33 A
34 D
35 E
36 B
37 D
38 C
39 C
40 B
41 E
42 B
43 C

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44 D
45 E
46 B
47 D
48 E
49 A
50 D
51 E
52 A
53 C
54 E
55 E
56 A
57 E
58 B
59 E
60 B

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