Microeconomics

Determination of Equilibrium Price under Perfect Competition

Meaning: Equilibrium price is the price at which the quantity demanded of a commodity is exactly equal to the quantity supplied. At this price the market is cleared — there is neither a shortage nor a surplus — so the price has no tendency to move up or down.

How it is determined: Under perfect competition there are a large number of buyers and sellers, and no single buyer or seller can influence the price. Therefore price is determined automatically by the interaction of two market forces — market demand and market supply. The point where the demand curve and the supply curve intersect is the equilibrium point, and the price corresponding to it is the equilibrium price. Hence the condition is:

$\text{Market Demand} = \text{Market Supply}$

Illustration (Demand and Supply Schedule)

Diagram

   Y
Price
   |      D          S
   |       \        /
   |        \      /
   |         \    /
 P | - - - - - \  / - - - - - E   (Equilibrium point)
   |            \/
   |            /\
   |           /  \
   |          /    \
   |_________/______\________ X
   O         Q   Quantity

In the diagram:

• OX axis = quantity demanded and supplied; OY axis = price.
• DD is the downward-sloping demand curve (more is demanded at a lower price).
• SS is the upward-sloping supply curve (more is supplied at a higher price).
• The two curves intersect at E, the equilibrium point.
• OP is the equilibrium price and OQ is the equilibrium quantity.

Why the price settles at OP

1. When price is above OP (say Rs 40): Sellers are willing to sell more than buyers are willing to buy, so supply exceeds demand. A surplus arises. Sellers compete with one another to sell their stock, which pushes the price down until it returns to OP.

2. When price is below OP (say Rs 20): Buyers want more than sellers are willing to offer, so demand exceeds supply. A shortage arises. Buyers compete with one another to buy the limited stock, which pushes the price up until it returns to OP.

3. At OP: Demand equals supply, the surplus and shortage both disappear, and the market is in equilibrium. Neither buyers nor sellers have any reason to change the price.

Conclusion: Thus, under perfect competition the equilibrium price is not fixed by any individual or government but is automatically determined by the free play of demand and supply forces at the point where the demand curve cuts the supply curve.

By the interaction of market demand and market supply.

Under perfect competition, price is determined at the point where market demand and market supply are equal (equilibrium point). If demand exceeds supply, price rises; if supply exceeds demand, price falls.

Completed table

Formulae: $AR = \dfrac{TR}{Q}$ and $MR = TR_n - TR_{n-1}$ (for the first unit, MR = TR).

Diagram

Take quantity on the X-axis and revenue (Rs) on the Y-axis.

• AR points: (1, 20), (2, 17.5), (3, 15), (4, 12.5), (5, 10), (6, 7.5). Join them to get a downward-sloping straight line.
• MR points: (1, 20), (2, 15), (3, 10), (4, 5), (5, 0), (6, −5). Join them to get a steeper straight line below AR.

Points to note

• Both curves slope downward, showing the firm can sell more only by lowering the price (imperfect competition).
• MR lies below AR after the first unit and falls twice as fast.
• MR is zero at Q = 5, where TR is maximum (Rs 50), and negative at Q = 6.

The classical theory of interest, also called the real theory of interest, explains the rate of interest as being determined by the real forces of saving and investment in the economy, independent of money. It was developed by classical economists like Adam Smith, Ricardo, and later refined by Knut Wicksell. According to this theory, interest is the reward for saving (waiting) and the price paid for the use of capital.

Main points of the classical theory:

1. Interest is determined by demand for and supply of capital:

   • Demand for capital (Investment): Investors borrow funds to invest in capital goods. The demand for capital depends on the rate of interest and the marginal productivity of capital. At a lower interest rate, investment demand is high; at a higher rate, it is low. Hence, the investment demand curve slopes downward.
   • Supply of capital (Saving): Saving comes from people who abstain from present consumption. The supply of saving depends on the rate of interest — higher interest encourages more saving. Hence, the saving supply curve slopes upward.

2. Equilibrium rate of interest: The rate of interest is determined at the point where the demand for capital (investment) equals the supply of capital (saving). This is the equilibrium or natural rate of interest.

   $I(r) = S(r)$

   where $I$ = investment demand and $S$ = saving supply. At this rate, the capital market clears — there is neither excess demand nor excess supply of loanable funds.

3. Interest as a real phenomenon: Since saving and investment are real variables (measured in goods, not money), the classical theory holds that the interest rate is a real variable determined by real factors. Money is only a veil and does not affect the interest rate.

4. Flexibility of interest rate: Classical economists assumed that the interest rate is flexible and adjusts automatically to equate saving and investment. If saving exceeds investment, the interest rate falls; if investment exceeds saving, it rises. This automatic adjustment ensures full employment equilibrium.

Criticism (brief):

• Keynes criticized the theory, arguing that interest is a monetary phenomenon determined by liquidity preference and the money supply, not by saving and investment.
• Saving and investment are not always interest-elastic; they may be influenced by income rather than the interest rate.
• The theory assumes full employment, which may not hold in reality.

Conclusion: In short, the classical theory explains interest as the price that equilibrates the demand for capital (investment) with the supply of capital (saving), making it a real, automatic, and self-adjusting mechanism in the economy.

The uncertainty bearing theory of profit was propounded by the American economist Frank H. Knight in his book Risk, Uncertainty and Profit (1921). According to this theory, profit is the reward for bearing non-insurable risks or uncertainties in business. It explains profit as the reward for the entrepreneur's willingness to face uncertain future conditions.

Main points of the theory:

1. Risk and uncertainty are different: Knight made a clear distinction between risk and uncertainty. Risk refers to those future events whose probability can be calculated or insured against (e.g. fire, theft, accident). Uncertainty refers to those events whose probability cannot be calculated and which cannot be insured (e.g. changes in demand, price fluctuations, government policy, technological change).

2. Insurable risks do not earn profit: Risks like fire, theft and accidents can be covered by insurance. The premium paid for insurance is a cost of production. Therefore, such risks do not give rise to profit. Only non-insurable risks, i.e. uncertainties, are the source of profit.

3. Profit is the reward for uncertainty bearing: The entrepreneur bears the burden of uncertainties. In return for bearing this burden, he receives profit. Hence, profit is a residual income — what remains after paying all costs, including the wages of management and the insurance premium.

4. Types of uncertainty: Knight classified uncertainty into two types:

   • Primary uncertainty: Uncertainties arising from changes in consumer tastes, natural calamities, and changes in government policy.
   • Secondary uncertainty: Uncertainties arising from the actions of other businessmen, such as changes in the price policy of competitors.

5. Profit varies with uncertainty: The greater the uncertainty borne by the entrepreneur, the higher the expected profit. In industries where future conditions are highly uncertain (e.g. new products, speculative business), profits are high; in stable industries, profits are low.

Conclusion: In short, this theory holds that profit is not a reward for routine management but for the willingness to bear risks that cannot be insured. It is the entrepreneur's courage and foresight in facing an unknown future that earns him profit. The theory is important because it explains why profits differ among firms and industries according to the degree of uncertainty they face.

Completed table

Formulae: $AC = \dfrac{TC}{Q}$ and $MC_n = TC_n - TC_{n-1}$ (for the first unit, MC = TC).

Curves

The table contains cost data only, so the curves that can be drawn from it are the AC and MC curves (the question's mention of AR and MR appears to be a misprint, as no price or revenue is given).

Take Q on the X-axis and cost (Rs) on the Y-axis.

• Plot AC: (1, 15), (2, 14), (3, 13), (4, 13), (5, 14), (6, 16). The curve is U-shaped.
• Plot MC: (1, 15), (2, 13), (3, 11), (4, 13), (5, 18), (6, 26). It falls to a minimum at Q = 3, then rises steeply.
• MC cuts AC from below at the minimum point of AC (Rs 13, at Q = 3 to 4).

Completed table

Formulae: $AR = \dfrac{TR}{Q}$ and $MR = TR_n - TR_{n-1}$ (for the first unit, MR = TR).

Diagram

Take quantity on the X-axis and revenue (Rs) on the Y-axis.

• AR points: (1, 20), (2, 18), (3, 16), (4, 14), (5, 12), (6, 10), (7, 8). Join them to get a downward-sloping straight line.
• MR points: (1, 20), (2, 16), (3, 12), (4, 8), (5, 4), (6, 0), (7, −4). Join them to get a steeper straight line lying below AR.

MR becomes zero at Q = 6, where TR is maximum (Rs 60), and is negative afterwards. Both curves slope downward because the firm must lower its price to sell more (imperfect competition).

The sum of total fixed cost and total variable cost of producing a given level of output.

Total cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC). It is the total money expense incurred by a firm on fixed and variable factors for producing a given quantity of output.

$AR = \frac{TR}{Q} = \frac{12{,}000}{40} = \text{Rs } 300$

The average revenue is Rs 300 per unit.

A perfect competition market is a market structure characterized by a very large number of buyers and sellers, homogeneous (identical) products, free entry and exit of firms, perfect knowledge of the market, perfect mobility of factors of production, and a single uniform price determined by the forces of demand and supply.

Completed table

Working

• TR = P × Q. For example, at Q = 2: TR = 9 × 2 = Rs 18.
• AR = TR ÷ Q. Since AR = (P × Q) ÷ Q = P, the AR column is the same as the price column.
• MR = addition to TR from selling one more unit. For example, MR at Q = 2 is 18 − 10 = Rs 8; at Q = 7 it is 28 − 30 = Rs −2.

Drawing the AR and MR curves

1. On graph paper take quantity on the X-axis (1 to 7 units) and revenue on the Y-axis (Rs −2 to Rs 10).
2. Plot the AR points (1,10), (2,9), (3,8), (4,7), (5,6), (6,5), (7,4) and join them. The AR curve is a straight downward-sloping line — it is the same as the demand curve facing the firm.
3. Plot the MR points (1,10), (2,8), (3,6), (4,4), (5,2), (6,0), (7,−2) and join them. The MR curve is also a straight line sloping downward, but it falls twice as fast as AR.
4. Label the axes and both curves clearly.

Conclusion

Under imperfect competition (monopoly), price falls as more is sold, so both AR and MR slope downward. The MR curve lies below the AR curve at every quantity after the first unit, because to sell an extra unit the firm must lower the price on all units. MR becomes zero at Q = 6 (where TR is maximum) and negative beyond it.

Price determination under monopoly

A monopoly has a single seller of a product with no close substitutes, so the firm is the whole industry and can fix the price. The demand curve it faces (AR) slopes downward, so to sell more it must lower the price, and therefore MR lies below AR.

Equilibrium conditions (profit maximisation):

1. $MC = MR$
2. The MC curve cuts the MR curve from below.

Explanation with the diagram

Take quantity on the X-axis and price/revenue/cost on the Y-axis. Draw a downward-sloping AR (demand) curve, an MR curve below it, and an upward-sloping MC curve.

• MC cuts MR at point E. The output corresponding to E is OQ, the equilibrium output.
• Extend a vertical line from Q upward until it meets the AR curve at point P. The price corresponding to this point is OP, the monopoly price.
• The average cost at OQ is read from the AC curve. Supernormal profit per unit = price − average cost, so total profit = (OP − AC) × OQ.

Why OQ and not another output:

• Before OQ, MR > MC, so producing one more unit adds more to revenue than to cost, and profit rises.
• Beyond OQ, MC > MR, so each extra unit adds more to cost than to revenue, and profit falls.

Thus the monopolist produces OQ and charges OP, the price read from the demand curve at the output where MC = MR.

Ricardian Theory of Rent

The Ricardian theory of rent was propounded by the classical economist David Ricardo. It explains rent as the reward paid for the use of land, based on the differences in the fertility of land. According to this theory, rent arises due to two main reasons: the scarcity of fertile land and the differences in the fertility of different plots of land.

Main points of the theory:

1. Rent arises from the original and indestructible powers of the soil: Ricardo believed that land possesses certain original qualities (fertility) that cannot be destroyed. Rent is paid for the use of these natural powers of the soil.

2. Rent arises due to differences in fertility: All lands are not equally fertile. Some lands are more fertile, some less, and some are barren. Rent arises because of these differences in fertility. The more fertile land earns rent, while the least fertile land (marginal land) earns no rent.

3. Marginal land earns no rent: The marginal land is the least fertile land that is cultivated to meet the demand for food. Since the produce from this land just covers the cost of cultivation (wages, profit, etc.), it yields no rent. Rent is measured as the surplus produce of superior land over the marginal land.

4. Law of diminishing returns operates: As more and more labour and capital are applied to the same land, the additional output goes on diminishing. This makes it necessary to cultivate inferior lands to meet the growing demand for food. The cultivation of inferior land raises the price of food grains, which in turn creates rent on superior lands.

5. Rent is a surplus, not a cost: According to Ricardo, rent is not a part of the cost of production. It is a surplus that arises due to the difference in fertility. It does not enter into the price of the produce; rather, the price of the produce determines rent.

Example: Suppose there are three plots of land — A, B, and C. Plot A is the most fertile and produces 40 quintals of wheat, plot B produces 30 quintals, and plot C (marginal land) produces 20 quintals with the same cost of cultivation. If the cost of cultivation is equal to the value of 20 quintals (the produce of marginal land), then plot C earns no rent. Plot B earns rent equal to the value of 10 quintals (30 − 20), and plot A earns rent equal to the value of 20 quintals (40 − 20).

Conclusion: In short, the Ricardian theory of rent states that rent is the reward paid for the original and indestructible powers of the soil, and it arises due to the scarcity of fertile land and the differences in the fertility of different plots of land. The marginal land yields no rent, and rent is a surplus over the marginal land's produce.

Cost which varies directly with the level of output.

Marginal revenue is the addition to total revenue from selling one more unit. The 4th unit itself generates Rs 25, so

$MR_4 = \text{Rs } 25$

Perfect competition

In a perfectly competitive market, all buyers and sellers have complete (perfect) knowledge of market conditions — prices, quality of goods, and available alternatives — so no single buyer or seller can influence the price.

Ricardian Theory of Rent

Statement: According to David Ricardo, rent is "that portion of the produce of the earth which is paid to the landlord for the use of the original and indestructible powers of the soil." Rent arises because of the differences in the fertility of land, not because of the absolute fertility of land. Hence it is also called the theory of differential rent.

Assumptions

1. Land is owned by landlords and rented to tenants.
2. Lands differ in fertility — some are more fertile, some less.
3. The most fertile land is cultivated first; as population grows, less fertile land is brought under cultivation.
4. There is no rent on the marginal (least fertile) land.
5. Price of produce is determined by the cost of production on the marginal land.
6. Law of diminishing returns operates.

Explanation with a Table

Suppose there are four grades of land — A, B, C and D — and each requires the same cost of production, Rs 100 per hectare. The output differs due to differences in fertility. Price per quintal is fixed at Rs 10 (determined by the marginal land D).

Land D is the marginal land, where total revenue just equals total cost, so it earns no rent. Lands A, B and C earn rent of Rs 150, Rs 100 and Rs 50 respectively because of their superior fertility. This surplus over cost is differential rent.

Diagram

   Rent (Rs)
      |
 150  |████████████████  A
      |
 100  |██████████        B
      |
  50  |█████             C
      |
   0  |_________________ D  (marginal land)
      +----------------------------> Grade of land
        A     B     C     D

The shaded bars show rent falling as fertility declines, and becoming zero on the marginal land D.

Conclusion

• Rent arises due to differences in the fertility of land.
• The marginal land yields no rent; rent is a surplus earned by intra-marginal lands.
• As population increases, still poorer lands are brought under cultivation, the marginal land shifts outward, and rent on superior lands rises.

Criticism: The theory assumes that the most fertile land is cultivated first and that the "original and indestructible powers" of the soil exist — both of which are unrealistic. It also ignores the role of scarcity and situation (location) of land in determining rent.

Nominal wage vs Real wage

Nominal wage is the wage expressed in terms of money — the actual amount of money a worker receives for his labour. It is also called money wage. For example, if a worker is paid Rs 1,000 per day, that Rs 1,000 is his nominal wage. Nominal wage does not tell us how much goods and services the worker can actually buy with that money.

Real wage is the wage expressed in terms of the goods and services that the money wage can actually purchase. It is the purchasing power of the nominal wage. It shows the real standard of living of the worker. For example, if the price level rises and the same Rs 1,000 can buy only half the goods it bought before, the real wage of the worker has fallen even though his nominal wage is unchanged.

Differences:

Conclusion: Nominal wage is only the money value of labour, while real wage is its real purchasing power. A rise in nominal wage does not necessarily mean a rise in real wage, because if prices rise faster than money wages, the worker is actually worse off. Hence real wage is the true measure of a worker's economic welfare.

Cost of production

The cost incurred by a producer in producing goods and services is called the cost of production. It includes expenses on raw materials, wages, rent, interest, and other inputs used in production.

Marginal Cost = Rs 10

MC = Change in Total Cost ÷ Change in Output = TC₅ − TC₄ = 60 − 50 = Rs 10

Profit

Profit is the reward the producer (entrepreneur) receives for organising the factors of production and bearing the risk and uncertainty involved in the production process.

Completed table

Total Fixed Cost stays the same at every level of output, because fixed cost does not change with the quantity produced. So TFC = Rs. 40 at every Q. Total Cost is the sum of TFC and TVC: TC = TFC + TVC.

Working (TC = TFC + TVC)

• Q = 0: TC = 40 + 0 = 40
• Q = 1: TC = 40 + 20 = 60
• Q = 2: TC = 40 + 30 = 70
• Q = 3: TC = 40 + 35 = 75
• Q = 4: TC = 40 + 45 = 85
• Q = 5: TC = 40 + 65 = 105

Drawing the curves

Take quantity (Q) on the X-axis and cost in Rs. on the Y-axis. Plot the points from the table and join them.

• TFC curve: Plot (0, 40), (1, 40), (2, 40), (3, 40), (4, 40), (5, 40). Join these points — you get a straight horizontal line parallel to the X-axis. This shows that fixed cost remains constant at Rs. 40 at all levels of output.
• TVC curve: Plot (0, 0), (1, 20), (2, 30), (3, 35), (4, 45), (5, 65). Join these points — you get an upward-sloping curve that starts from the origin. It rises slowly at first and then more steeply, showing that variable cost increases with output.
• TC curve: Plot (0, 40), (1, 60), (2, 70), (3, 75), (4, 85), (5, 105). Join these points — you get an upward-sloping curve that starts at Rs. 40 on the Y-axis (not from the origin).

Key relation to show in the graph: The TC curve lies above the TVC curve, and the vertical distance between them is always equal to TFC (Rs. 40) at every level of output. At Q = 0, TC = TFC = Rs. 40 while TVC = 0.

The subsistence theory of wage, developed by classical economists like Adam Smith, David Ricardo and Malthus, states that wages tend to settle at the minimum level needed for a worker to survive and reproduce — just enough to keep the labour force constant. In the long run, wages cannot rise above or fall below this subsistence level. However, the theory has been criticised on the following grounds:

1. Wages are not always at subsistence level. In practice, workers in many countries earn much more than the bare minimum needed for survival. The rising standard of living of workers in developed countries shows that wages can rise well above subsistence level, which the theory fails to explain.

2. It ignores the role of trade unions. The theory assumes wages are determined only by population and food supply. It ignores that trade unions bargain collectively and can push wages above the subsistence level, as seen in many industries today.

3. It ignores other factors affecting wages. Wages depend on many things — the productivity of labour, the demand for labour, the bargaining power of workers, government wage laws and the cost of living. The theory considers only population growth and food supply, so it is one-sided.

4. It is based on a wrong assumption about population. The theory assumes that any rise in wages leads to more children and thus more workers, which pulls wages back down. But this is not always true — with education and family planning, higher income does not necessarily mean a larger population.

5. It fails to explain wage differences. The theory cannot explain why wages differ between occupations, industries and regions. If wages were only at subsistence level, all workers would earn the same amount, which is not the case in reality.

6. It is pessimistic and outdated. The theory gives a gloomy picture that workers can never improve their condition. In modern times, with economic growth, education and welfare policies, workers' living standards have improved, so the theory does not hold good.

Conclusion: Although the subsistence theory explains wage determination in very backward economies, it is not applicable in the modern world because it ignores productivity, trade unions, government policy and the rising standard of living of workers.

Assumptions of Ricardian Theory of Rent

1. Fixed supply of land: The total supply of land is fixed and perfectly inelastic. It cannot be increased or decreased, so land has no supply price (no cost of production).
2. Original and indestructible powers of soil: Land is assumed to possess original fertility that cannot be destroyed. The fertility differences between plots are natural and permanent.

(Other valid assumptions: land is used for cultivation of corn; different plots differ in fertility; the law of diminishing returns operates; perfect competition prevails; rent is paid only for the use of land.)

Types of Rent

1. Economic Rent (Pure Rent) It is the payment made for the use of land only, i.e. the surplus earned by a factor of production over and above its transfer earnings. According to Ricardo, rent arises due to the original and indestructible powers of the soil. It is also called scarcity rent or differential rent.

2. Contract Rent It is the actual payment made by a tenant to the landlord under an agreement or contract. It includes not only the pure rent of land but also charges for buildings, fences, wells, and other improvements made on the land. Hence, contract rent is usually greater than economic rent.

3. Differential Rent It is the rent that arises due to differences in the fertility of land. More fertile land yields a larger surplus over cost, so it earns higher rent, while less fertile land earns lower or no rent. Ricardo explained this with the example of graded plots of land.

4. Scarcity Rent It is the rent that arises because the supply of land is limited in relation to its demand. Even if all land were of equal fertility, rent would still arise once the demand for land exceeds its fixed supply. Thus scarcity of land is the fundamental cause of rent.

Perfect competition.

In perfect competition, the price is the same for every unit sold, so average revenue (AR) and marginal revenue (MR) are both equal to that price. Hence AR = MR (a horizontal line).

Average cost = Total cost ÷ Quantity = 450 ÷ 15 = Rs. 30 per kg.

A market confined to a small area such as a village, town or district, where goods and services are bought and sold among the local people.

The least fertile land that is only just worth cultivating, whose produce just covers the cost of cultivation, so it yields no rent (no surplus).

(i) Equilibrium price and equilibrium quantity

The demand curve DD and the supply curve SS intersect each other at point E. At this point, the quantity demanded equals the quantity supplied.

• Equilibrium price = Rs 15
• Equilibrium quantity = 30 units

(ii) Condition of demand and supply at price Rs 20

At price Rs 20 (which is above the equilibrium price):

• Quantity demanded = 20 units (from the demand curve DD)
• Quantity supplied = 40 units (from the supply curve SS)

Here, supply (40 units) is greater than demand (20 units). The difference is 40 − 20 = 20 units of excess supply (surplus). Since the price is higher than the equilibrium price, sellers cannot sell all their goods, so competition among sellers will push the price down towards Rs 15, where demand and supply become equal again.

(iii) Reasons for the slopes of the two curves

Negative slope of the market demand curve: The demand curve slopes downward from left to right because of the inverse relationship between price and quantity demanded (the law of demand). When price falls, demand rises, and when price rises, demand falls. This happens because:

• Income effect: A fall in price leaves the consumer with more real income, so he buys more.
• Substitution effect: A fall in the price of a commodity makes it cheaper than its substitutes, so consumers shift to it.
• Law of diminishing marginal utility: As a consumer buys more units, the additional satisfaction from each extra unit falls, so he will buy more only at a lower price.
• New buyers and multiple uses: At a lower price, new buyers enter the market and the same commodity can be put to many uses.

Positive slope of the market supply curve: The supply curve slopes upward from left to right because of the direct relationship between price and quantity supplied (the law of supply). When price rises, supply rises, and when price falls, supply falls. This happens because:

• Profit motive: A higher price means higher profit per unit, so producers are willing to supply more.
• Higher cost of extra output: To produce more, firms must use less efficient resources and pay more for inputs, so they supply extra units only at a higher price.
• Entry of new firms: A higher price attracts new firms into the industry, increasing total market supply.

The subsistence theory of wages is one of the oldest wage theories. It is associated with classical economists such as Ricardo and Malthus (through the Malthusian theory of population), and the name Iron Law of Wages was given by Ferdinand Lassalle.

Main points

1. Wages equal the subsistence level: Wages are determined by the minimum food, clothing and shelter a labourer needs to keep himself and his family alive.
2. Wages above subsistence: Labourers live better and have more children. The supply of labour rises and pushes wages back down to the subsistence level.
3. Wages below subsistence: Labourers become weak, many die, and fewer children are born. The supply of labour falls and wages rise back to the subsistence level.
4. Link with population: Any rise in wages is absorbed by population growth, so wages hover around the subsistence level in the long run.
5. No scope for improvement: A labourer earns just enough to survive and reproduce the next generation of workers.

Criticism

• It is pessimistic and treats labourers as mere machines for producing children.
• It ignores trade unions, productivity and demand for labour.
• Modern wages are far above subsistence level because of education, skill and technology.

Conclusion: Wages are fixed at the minimum needed for survival. The theory is not fully applicable today but was an important early explanation of wages.

Definition of Interest

Interest is the price paid by a borrower to a lender for the use of money over a certain period of time. In other words, it is the reward or compensation paid by the user of capital to the owner of capital for the use of capital. It is usually expressed as a percentage of the principal amount per annum (per year).

Elements of Gross Interest

Gross interest is the total amount of interest paid by a borrower to a lender. It is not only the reward for the use of capital but also includes several other elements. The main elements of gross interest are:

1. Pure interest (net interest): This is the actual payment made for the use of capital only. It is the reward given to the lender for parting with his or her money and forgoing present consumption. It is also called net interest or true interest.

2. Risk premium (insurance against risk): The lender faces the risk of non-repayment of the loan. To cover this risk, the borrower pays an extra amount over and above pure interest. This extra amount is called the risk premium. The greater the risk, the higher the risk premium.

3. Reward for management or inconvenience: The lender may have to face inconvenience and spend time and effort in managing the loan, keeping records, and recovering the amount. The payment made to cover this inconvenience and management cost is another element of gross interest.

4. Reward for liquidity preference: By lending money, the lender loses liquidity (the ability to use cash immediately). The lender is compensated for this sacrifice of liquidity, and this compensation forms a part of gross interest.

Conclusion

Thus, gross interest = pure interest + risk premium + reward for management/inconvenience + reward for liquidity preference. Gross interest is always greater than pure interest because it includes all these elements, while pure interest is only the payment for the use of capital.

Because of the law of variable proportions.

Average cost (AC) = $\dfrac{\text{Total Cost}}{\text{Quantity}}$

$AC = \frac{300}{15} = \text{Rs. } 20$

So, the average cost is Rs. 20.

The two conditions are:

1. MC = MR (marginal cost equals marginal revenue), and
2. MC must cut MR from below (MC slopes upward more steeply than MR at the equilibrium point).

According to the classical theory of interest, the equilibrium rate of interest is determined by the interaction of the demand for capital (investment demand, which is inversely related to the rate of interest) and the supply of capital (savings, which is directly related to the rate of interest). The rate at which the demand for capital equals the supply of capital — that is, where saving = investment — is the equilibrium rate of interest.

(i) Market demand and supply curve

Take:

• X-axis = Quantity (kg)
• Y-axis = Price (Rs per kg)

Plot the demand points:
(10, 5), (8, 10), (6, 15), (4, 20), (2, 25)
Join them to get the downward-sloping demand curve DD.

Plot the supply points:
(2, 5), (4, 10), (6, 15), (8, 20), (10, 25)
Join them to get the upward-sloping supply curve SS.

The two curves intersect at point E.

Price (Rs/kg)
25 | D           S
20 |   D       S
15 |     D   S  E
10 |     S   D
 5 | S           D
   +----------------
     2   4   6   8   10   Quantity (kg)

(ii) Equilibrium price and quantity

Equilibrium occurs where market demand = market supply.

From the table, at price Rs 15 per kg:

• Market demand = 6 kg
• Market supply = 6 kg

So,

• Equilibrium price = Rs 15 per kg
• Equilibrium quantity = 6 kg

(iii) Relationship of price with demand and supply

• Price and demand: There is an inverse (negative) relationship. When price rises from Rs 5 to Rs 25, demand falls from 10 kg to 2 kg. This is the law of demand.
• Price and supply: There is a direct (positive) relationship. When price rises from Rs 5 to Rs 25, supply rises from 2 kg to 10 kg. This is the law of supply.

Formulae: $AC = \dfrac{TC}{Q}$, $TC = AC \times Q$, $MC_n = TC_n - TC_{n-1}$ (for the first unit, MC = TC).

• Q = 1: $TC = 30 \times 1 = 30$; MC = 30
• Q = 2: $AC = 50/2 = 25$; $MC = 50 - 30 = 20$
• Q = 3: $TC = 50 + 4 = 54$; $AC = 54/3 = 18$
• Q = 4: $TC = 22 \times 4 = 88$; $MC = 88 - 54 = 34$
• Q = 5: $AC = 125/5 = 25$; $MC = 125 - 88 = 37$

Completed table

Drawing the curves

Take output (Q) on the X-axis and cost (Rs) on the Y-axis.

• AC points: (1, 30), (2, 25), (3, 18), (4, 22), (5, 25). Joined smoothly they give a U-shaped curve with its minimum near Q = 3.
• MC points: (1, 30), (2, 20), (3, 4), (4, 34), (5, 37). MC falls to a minimum at Q = 3, then rises steeply.
• MC cuts AC from below at the minimum point of AC.

Marginal revenue (MR) is the addition to total revenue when one more unit of output is sold. It is calculated as $MR = TR_n - TR_{n-1}$, or $MR = \dfrac{\Delta TR}{\Delta Q}$.

$TVC = TC - TFC = 250 - 100 =$ Rs 150

$AVC = \dfrac{TVC}{Q} = \dfrac{150}{10} =$ Rs 15 per unit

The factor market is the market in which the factors of production (land, labour, capital and organisation) are bought and sold or hired. Their prices are rent, wage, interest and profit.

The essence of the subsistence theory is that in the long run wages tend to equal the bare minimum a worker needs to survive and keep up the supply of labour. If wages rise above this level, population and labour supply grow and wages fall back; if they fall below it, labour supply shrinks and wages rise again.

Formulae: $TC = TFC + TVC$, $AFC = \dfrac{TFC}{Q}$, $AVC = \dfrac{TVC}{Q}$, $AC = \dfrac{TC}{Q}$ (or $AFC + AVC$), $MC = TC_n - TC_{n-1}$. Here the serial number SN is the quantity (Q) produced.

Completed table

Sample working

• At SN = 3: $TC = 200 + 90 = 290$; $AFC = \dfrac{200}{3} = 66.67$; $AVC = \dfrac{90}{3} = 30$; $AC = \dfrac{290}{3} = 96.67$; $MC = 290 - 280 = 10$.
• At SN = 6: $TC = 200 + 210 = 410$; $AFC = \dfrac{200}{6} = 33.33$; $AVC = \dfrac{210}{6} = 35$; $AC = \dfrac{410}{6} = 68.33$; $MC = 410 - 340 = 70$.

Check: $AC = AFC + AVC$ in every row (for example, $50 + 26.25 = 76.25$). TFC stays constant at Rs 200, and MC falls up to 3 units and then rises.

(i) Demand and supply curves on one diagram

Take quantity (kg) on the X-axis and price (Rs/kg) on the Y-axis.

• Plot the demand points (100, 10), (80, 20), (60, 30), (40, 40), (20, 50) and join them. This gives the downward-sloping demand curve DD.
• Plot the supply points (20, 10), (40, 20), (60, 30), (80, 40), (100, 50) and join them. This gives the upward-sloping supply curve SS.
• The two curves cross at point E (60 kg, Rs 30).

(ii) Relationships

• Price and quantity demanded: inverse. As the price rises from Rs 10 to Rs 50, the quantity demanded falls from 100 kg to 20 kg. This is the law of demand, so DD slopes downward.
• Price and quantity supplied: direct. As the price rises from Rs 10 to Rs 50, the quantity supplied rises from 20 kg to 100 kg. This is the law of supply, so SS slopes upward.

(iii) Interaction and equilibrium

In a perfectly competitive market, many buyers and sellers act independently and the price is set by the interaction of market demand and market supply.

• Below Rs 30 (for example Rs 20): demand is 80 kg but supply is only 40 kg. There is a shortage of 40 kg, buyers compete, and the price rises.
• Above Rs 30 (for example Rs 40): supply is 80 kg but demand is only 40 kg. There is a surplus of 40 kg, sellers compete, and the price falls.
• At Rs 30: quantity demanded = quantity supplied = 60 kg. There is neither shortage nor surplus, so the price has no tendency to change.

Hence the demand and supply curves intersect at E, and the equilibrium price is Rs 30 per kg and the equilibrium quantity is 60 kg.

Economic rent and contract rent

Conclusion: Economic rent is the surplus over transfer earning, while contract rent is the amount actually agreed upon by the parties to a contract.

a. Market demand and supply curves

Take:

• X-axis = Quantity of commodity (kg)
• Y-axis = Market price of commodity (Rs/kg)

Plot the following points from the table:

Join the demand points to get the downward-sloping market demand curve DD.
Join the supply points to get the upward-sloping market supply curve SS.

Schematic diagram:

Price (Rs/kg)
5 |        D                S
4 |      D                S
3 |          D = S  (E)
2 |    D                S
1 |  D                S
  +--------------------------------
    0 2 4 6 8 10 Quantity (kg)

Here, E is the equilibrium point where the demand curve and supply curve intersect.

b. Relationships between price and quantity demanded/supplied

• Market price and quantity demanded: They are inversely related. The demand curve DD slopes downward from left to right. As price rises from Rs 1 to Rs 5 per kg, quantity demanded falls from 10 kg to 2 kg.
• Market price and quantity supplied: They are directly related. The supply curve SS slopes upward from left to right. As price rises from Rs 1 to Rs 5 per kg, quantity supplied rises from 2 kg to 10 kg.

c. Interaction of demand and supply and equilibrium

In a perfectly competitive market, equilibrium occurs where market demand equals market supply.

From the table and diagram:

• At price Rs 3/kg, quantity demanded = 6 kg and quantity supplied = 6 kg.
• Therefore, equilibrium price = Rs 3 per kg
• Equilibrium quantity = 6 kg

Interaction:

• If price is below Rs 3/kg, e.g. Rs 2/kg, demand is 8 kg but supply is only 4 kg. There is a shortage of 4 kg. Buyers compete to buy the commodity, so price rises toward Rs 3/kg.
• If price is above Rs 3/kg, e.g. Rs 4/kg, supply is 8 kg but demand is only 4 kg. There is a surplus of 4 kg. Sellers compete to sell the commodity, so price falls toward Rs 3/kg.
• Thus, the market automatically reaches equilibrium at Rs 3/kg, where demand and supply are equal at 6 kg.

A price taker.

A firm under perfect competition must accept the market-determined price and cannot influence it, because its output is a tiny fraction of total market supply and the product is homogeneous.

The subsistence theory of wages is one of the earliest wage theories. It is associated with classical economists such as Ricardo (and Malthus's population ideas), and the name iron law of wages was given by Ferdinand Lassalle.

Main idea: In the long run, wages tend to equal the subsistence level, the minimum amount of food, clothing and shelter a worker needs to keep himself and his family alive and to maintain the supply of labour.

Explanation

1. Wages above subsistence: Workers live better and raise larger families. The supply of labour increases, competition for jobs rises and wages fall back to the subsistence level.
2. Wages below subsistence: Hunger and disease raise the death rate and fewer children are born. The supply of labour falls and wages rise back to the subsistence level.
3. Self-adjusting: Wages therefore keep returning to the subsistence level, like an "iron law" that workers cannot escape.

Criticism

• It is pessimistic and treats workers as if they only seek survival.
• It ignores demand for labour, productivity, trade unions and government wage laws.
• In most countries actual wages are well above subsistence, and it cannot explain wage differences between occupations.

Conclusion: The theory says wages are fixed at the bare minimum needed for survival. It is historically important but unrealistic today.

(i) Completed table

Formulae: $TR = P \times Q$, $AR = \dfrac{TR}{Q}$, $MR = TR_n - TR_{n-1}$.

(ii) AR and MR curves in a single diagram

Take quantity (Q) on the X-axis and revenue (Rs) on the Y-axis.

• Plot AR: (1, 10), (2, 9), (3, 8), (4, 7), (5, 6), (6, 5), (7, 4) and join them. AR is a downward-sloping straight line (it is the firm's demand curve).
• Plot MR: (1, 10), (2, 8), (3, 6), (4, 4), (5, 2), (6, 0), (7, −2) and join them. MR is also a straight line but falls twice as steeply as AR and lies below it.
• MR cuts the X-axis at Q = 6, where TR is maximum (Rs 30); beyond this MR is negative.

Given:

• Total fixed cost (TFC) = Rs 60 per day
• Total variable cost (TVC) for 30 pieces = Rs 300
• Quantity produced (Q) = 30 pieces

Formulas: $AVC = \frac{TVC}{Q}$ $TC = TFC + TVC$

i. Average Variable Cost (AVC): $AVC = \frac{300}{30} = Rs\ 10$

So, the average variable cost is Rs 10 per piece of Selroti.

ii. Total Cost (TC) for 30 pieces: $TC = TFC + TVC$ $TC = 60 + 300 = Rs\ 360$

So, the total cost is Rs 360.

iii. Total cost when no Selroti is made: If Anjali makes 0 Selroti, then TVC = Rs 0.
$TC = TFC + TVC = 60 + 0 = Rs\ 60$

So, the total cost for that day will be Rs 60.

Given: $P = 130 - 2Q$ and $MC = 10 + 4Q$.

MR starts from the same Y-intercept as demand (130) and has twice the slope of demand:

$MR = 130 - 4Q$

Equilibrium condition of a monopoly firm: $MR = MC$

$130 - 4Q = 10 + 4Q$

$120 = 8Q \;\Rightarrow\; Q = 15$

Price from the demand function:

$P = 130 - 2(15) = 130 - 30 = 100$

Verification: $MR = 130 - 4(15) = 70$ and $MC = 10 + 4(15) = 70$, so $MR = MC$.

Equilibrium quantity = 15 units; equilibrium price = Rs 100.

Fixed cost

Fixed cost is the expenditure incurred on fixed factors (machinery, buildings, permanent staff) that do not change with the level of output in the short run.

Marginal Revenue (MR) = Change in Total Revenue / Change in Quantity
$MR = \frac{24 - 18}{4 - 3} = \frac{6}{1} = \text{Rs. }6$

So, the marginal revenue from the sale of the 4th unit is Rs. 6.

Single seller and no close substitutes.

A monopoly market has only one seller (or producer) of a good that has no close substitute, so the seller has full control over price.

Working: $AR = \dfrac{TR}{Q}$ and $MR = TR_n - TR_{n-1}$.

The printed AR = 6 at Q = 2 is inconsistent with TR = 10 ($10/2 = 5$); the AR column must fall by 1 each unit (6, 5, 4, 3, 2), consistent with the other given values, so AR at Q = 2 is 5.

• Q = 2: TR = 10, AR = 5.
• Q = 3: MR = 2, so $TR = 10 + 2 = 12$; $AR = 12/3 = 4$.
• Q = 4: AR = 3, so $TR = 3 \times 4 = 12$; $MR = 12 - 12 = 0$.
• Q = 5: MR = −2, so $TR = 12 - 2 = 10$; $AR = 10/5 = 2$.
• Q = 1: $TR = AR = 6$ and $MR = 6$; then Q = 2: $MR = 10 - 6 = 4$.

Completed table

Diagram

Take quantity on the X-axis and revenue (Rs) on the Y-axis.

• AR points: (1, 6), (2, 5), (3, 4), (4, 3), (5, 2). Join them to get a downward-sloping straight line.
• MR points: (1, 6), (2, 4), (3, 2), (4, 0), (5, −2). Join them to get a steeper straight line below AR, cutting the X-axis at Q = 4 where TR is maximum.

Subsistence Theory of Wages

The Subsistence Theory of Wages is one of the oldest theories of wages. It was developed by classical economists like Adam Smith and later explained in detail by David Ricardo. It is also known as the Iron Law of Wages because it states that wages always tend to fall to the minimum level needed for a worker's survival.

Main Ideas of the Theory

1. Wages tend to equal subsistence level: According to this theory, in the long run, the wage of a worker is just enough to meet his basic needs — food, clothing, shelter — and to keep him and his family alive. This minimum amount is called the subsistence wage.

2. Wages depend on population growth: The theory links wages with population. If wages rise above the subsistence level, workers become better off, and this leads to an increase in population. More workers mean more competition for jobs, which pushes wages down again to the subsistence level.

3. If wages fall below subsistence level: When wages fall below the minimum needed for survival, workers suffer from poverty, hunger and disease. This increases the death rate and reduces the number of workers. As labour becomes scarce, wages rise back to the subsistence level.

4. Wages remain at subsistence level in the long run: According to this theory, there is a natural tendency for wages to settle at the subsistence level. Any rise or fall is only temporary and wages return to this minimum level.

5. Based on the Malthusian Theory of Population: The theory is closely related to Malthus's idea that population grows faster than food supply. It assumes that any rise in income will only increase population, not the standard of living of workers.

Conclusion

In short, the Subsistence Theory of Wages states that wages are determined by the minimum amount required for a worker's survival. Wages above this level increase population and bring wages down, while wages below this level reduce population and push wages up. Thus, in the long run, wages remain at the subsistence level.

Uncertainty-Bearing Theory of Profit (developed by Frank H. Knight) says that profit is the reward for bearing the non-insurable uncertainties of business. Uncertainty is therefore the source of profit.

Role of uncertainty in profit generation

1. Source of profit: The entrepreneur produces for an unknown future, since demand, prices, costs and government policy cannot be known in advance. Bearing this uncertainty is rewarded with profit. If everything were certain, only wages, rent and interest would exist.
2. Risk versus uncertainty: Insurable risks such as fire, theft and accidents can be covered by an insurance premium, which is a cost of production and gives no profit. Non-insurable uncertainties, such as changes in demand, competition, technology and prices, cannot be insured, so profit arises only from bearing these.
3. Reward and size of profit: Profit is the residual left after paying all contractual costs. The greater the uncertainty borne, the greater the expected profit. If the entrepreneur judges wrongly, the result is loss.
4. Dynamic role: Uncertainty forces the entrepreneur to forecast, innovate and adjust production; those who judge it better earn more.

Conclusion: Profit is not a fixed payment like wages but a residual reward for undertaking non-insurable uncertainty.