Difference between Diminishing Marginal Returns and Decreasing Returns to Scale - Assignment Example

Answers to Microeconomics Questions 2009 Question 1: Difference between Diminishing Marginal Returns and Decreasing Returns to Scale According to the law of diminishing returns, as the amount of one variable input increases, other inputs remaining fixed, marginal product, that is, the output increase per unit of input increase, diminishes. This happens only in the short run. On the other hand, the decreasing returns to scale is the situation in the long run when, with additional increase in inputs, output increases by less than the increase in the inputs. The following chart shows the change in output, Q, as input (L) is increased gradually by one unit. From the above chart, the marginal product curve may be drawn as follows. As seen from the above diagram, as labor increases upto the 3rd unit, the marginal product increases and thereafter, marginal product diminishes with increase in labor, other inputs remaining constant. The following diagram shows decreasing returns to scale through isoquants, that is combinations of the two variables of production, labor and capital, that produce the same output. As both labor and capital increases by one unit, output increases by less than one unit. Conversely, an output increase by one unit would require more than one unit increase of either or both labor and capital as both labor and capital increases. This is shown in the following diagram. Question 2: a) Effect of price and non-price effect on demand curve The demand function may be written as Qd = f (p) when income and tastes are constant. As price falls from 10 to 5, the consumer moves along the demand D1 so that quantity demanded increases from 10 to 20. When income increases, the demand curve shifts to D2 so that even with the price remaining the same, output demanded increases to 30. b) Price and non-price effect on supply curve The supply function is given by Qs = f (p). With the same technology that keeps the costs of production constant, the firm supplies higher amounts of output as price increases. If price rises from 1 to 2, quantity supplied increases from 5 to 10 as the firm moves along the supply curve S1. But, if costs of production falls, even at the same price level of 1, the firm may supply 15 units as the supply curve shifts to S2. c) Derivation of the supply curve from the Marginal Cost curve For a firm, the profit maximizing output in the short run is that at which marginal revenue is equal to marginal cost. The MC curve is u-shaped becase of the law of diminishing returns as the variable input rises. In terms of the MC curve, profit maximization is achieved when the MR touches the MC curve in the rising phase of the latter. If none of the investments of the firm are in sunk costs, the firm may decide to temporarily shut down at the minimum point of the average variable cost curve. As price rises, the demand curve, or the MR curve, facing the firm in the perfectly competitive market shifts up. The subsequent points of intersection of the MC and MR will be achieved at higher quantities of output supplied. So the MC curve above the minimum point of the AVC cost is the supply curve. Question 3: Incidence of sales tax on consumers and producers When the government imposes sales tax on a product, the incidence is shared between buyers and sellers. Ps is the price that buyers pay, inclusive of tax, and Ps is the price that sellers get, after paying the tax. Buyers lose consumer surplus to the extent of the area A because of the rise in price from the equilibrium price, P0, as well as the area B, because of lower production from Q0 to Q1 since some demand has fallen as a result of some customers not being able to afford the product at the higher price. Producer surplus, on the other hand falls by the areas D and C since price received by the buyers and quantities that they can produce on the basis of demand have fallen. The amount of tax revenue is given by the area A+D as this is the amount that is paid for the output that is bought by the consumers and sold by the producers who are still in the market after the tax is imposed. If the demand curve is less elastic than that shown in the diagram, that is the demand curve is steeper, and the supply curve remains the same, the area of A+D will be larger. That is, tax revenue is higher for products that have lower price elasticity to demand. This means that for products which are less sensitive to price change would give the government higher tax revenue if sales tax is imposed on them. Question 4: a) Example of a perfectly competitive industry Wheat production satisfies the conditions of perfect competition most closely. There are a large number of buyers and sellers; the product is homogenous as long as it is not branded; there are no entry and exit barriers since wheat production does not require very sophisticated technology; there is a free flow of information among all buyers and sellers. As a result, producers of wheat are price takers. b) 1) Profit maximizing output and price for a firm in the industry In the above figure, the producer of wheat maximizes profit at the level when MR=MC = P. If the average variable cost, AVC tangent at this point of intersection of MR and MC, the producer breaks even. If the AVC is below the point of intersection of MR and MC, the producer makes profit. Seeing this firm making profit, others enter the market. The industry supply increases leading to price fall so that the profit-making producer’s marginal revenue falls leading back to the breakeven level. On the other hand, if the AVC is above the point of intersection of MR and MC, the producer is making a loss, resulting in its exit from the market. Supply in the industry would fall, leading to excess demand and hence price rise. As a result, the MR rises and leads back to the break even profit. Thus, the industry is at equilibrium when all firms are at breakeven as shown in the following diagram where demand and supply are equal. 2) Profit maximizing output and price for the industry If price of wheat falls below P0, the information would reach all consumers and demand would rise to Q1 according to the demand curve. If supply remains constant, given by the supply curve based on the technology of production and hence costs, there would be excess demand for wheat. This would drive price up till it goes back to P0 when demand is equal to price. Question 5 a) Output TC AC MC 0 10 1 18 18 8 2 24 12 6 3 30 10 6 4 38 9.5 8 5 50 10 12 6 66 11 16 7 91 13 25 8 120 15 29 b) c) The long run cost for the firm would be at the price level when the firm reaches the break even level. For this, average variable cost would be tangent to the point of intersection of MR and MC. For this, we need to know the shape and level of the average variable cost. Read More