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GNDU Question Paper-2021
B.A 1
st
Semester
ECONOMICS
(Micro Economics)
Time Allowed: Three Hours Max. Marks: 100
Note: Attempt Five questions in all, selecting at least One question from each section. The
Fifth question may be attempted from any section. All questions carry equal marks.
SECTION-A
1. (1) Critically examine scarcity definition of Economics.
(ii) What are the basic economic problems faced by an economy?
2. What is an Indifference curve? Discuss consumer equilibrium with the help of
Indifference curves.
SECTION-B
3. Discuss the three stages of law of variable proportions. What are the causes of the
operation of law of variable proportions ?-
4. What are the different concepts related to costs? Why is short run AC curve U shaped ?
SECTION-C
5. What are the characteristics of Perfect Competition? How is the price of a commodity
determined under Perfect Competition?
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6. What is monopolistic competition? How is the equilibrium of firm and group
determined under monopolistic competition?
SECTION-D
7. (1) Explain clearly the modern theory of distribution.
(ii) How is rent determined through the Ricardian theory?
8. (1) Explain Knight's uncertainty theory of profit. What objections are raised against it?
(ii) Critically examine the loanable funds theory of interest.
GNDU Answer Paper-2021
B.A 1
st
Semester
ECONOMICS
(Micro Economics)
Time Allowed: Three Hours Max. Marks: 100
Note: Attempt Five questions in all, selecting at least One question from each section. The
Fifth question may be attempted from any section. All questions carry equal marks.
SECTION-A
1. (1) Critically examine scarcity definition of Economics.
(ii) What are the basic economic problems faced by an economy?
Ans: Part (i): Critically Examine the Scarcity Definition of Economics
The Arrival of Lord Robbins
Guru Artha told Chintu about a great economist named Lionel Robbins, who in 1932 gave a
new and powerful definition of economics that became very famous.
Robbins said:
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“Economics is the science which studies human behaviour as a relationship between ends
and scarce means which have alternative uses.”
Let’s break this down and understand it like a story from the village:
Meaning of Robbins' Scarcity Definition (with Examples)
In village Arthashastra:
• People wanted many things — food, clothes, a better house, education for children,
even entertainment (these are called “ends”).
• But they had limited resources like land, time, money, and tools (scarce means).
• The land could be used to grow wheat or vegetables (alternative uses).
So Robbins said that economics is about how people make choices when they can’t have
everything they want — because resources are scarce.
Features of Scarcity Definition
Let’s explore the major features of this definition like Guru Artha explained:
1. Unlimited Wants
Humans always want more — more income, more comfort, more leisure.
• Example: Chintu wants to buy both a bicycle and a smartphone, but he can only
afford one.
2. Limited Resources
There is only so much land, labor, time, and money.
• Example: The village has only one tractor, and two farmers want to use it at the
same time.
3. Alternative Uses of Resources
Each resource can be used in multiple ways.
• Example: A piece of land can grow rice or build a house — the villager must choose
wisely.
4. Problem of Choice
Economics becomes the study of choice-making — what to do with limited resources.
Merits of the Scarcity Definition
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Guru Artha clapped and said, “Robbins’ definition was like fresh rain — it changed the field
of economics.”
1. Universal Application:
It applies to all economies — poor or rich, capitalist or socialist.
2. Scientific & Neutral:
It makes economics more scientific and value-free (no judgment on good or bad
choices).
3. Focus on Decision Making:
It explains everyday economic choices of individuals, families, businesses, and
governments.
Criticism of Scarcity Definition
But, as every coin has two sides, Guru Artha warned about the limitations of Robbins’ view.
1. Ignores Human Welfare
Robbins focused only on scarcity and choice, not on welfare or well-being.
For example, choosing between two harmful products still fits the definition — but does
that help society?
2. No Moral Guidance
Economics becomes value-neutral. It doesn’t tell us what is good or bad for people.
3. Too Abstract and Theoretical
This definition is very theoretical and may not explain real-life problems like poverty,
inequality, or unemployment in practical terms.
4. Ignores Growth and Development
It doesn’t focus on how resources increase over time through innovation, technology, and
education.
Summary of Part (i): Scarcity Definition – A Balance Sheet
Point
Explanation
Given by
Lionel Robbins in 1932
Core Idea
Unlimited wants, limited resources, choice-making
Strengths
Scientific, universal, decision-oriented
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Weaknesses
Ignores welfare, no moral values, too narrow
Part (ii): What are the Basic Economic Problems Faced by an Economy?
Guru Artha now took Chintu on a walk through the village farms and asked:
“Look around you — what do you see?”
Chintu replied,
“I see fields, people working, some unemployed youth, shops, and also some families who
are struggling.”
Guru smiled and said,
“Every economy, whether a small village or a big country, faces 3 main problems due to
scarcity. Let me explain them to you through the Basic Economic Problems."
1. What to Produce?
This means deciding what goods and services should be produced, and in what quantity.
Story Example: In Arthashastra, the farmers had to decide whether to grow rice or
cotton. The land was limited, so they had to choose based on:
• Market demand
• Profitability
• Community needs
In real-world terms:
• Should India invest more in defense or education?
• Should a bakery make more cakes or more bread?
2. How to Produce?
This problem relates to choosing the technique of production — whether to use more labor
(human workers) or more capital (machines).
Story Example: In Arthashastra, one family used bullock carts, while another used
tractors. Both produced wheat, but the cost and employment effects were different.
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For India (a labor-rich country), using labor-intensive techniques may be better to provide
jobs.
For a country like the USA, capital-intensive techniques may be more efficient.
3. For Whom to Produce?
This problem deals with the distribution of goods: Who will get how much? Should rich
people get more, or should it be equal?
Story Example: The village potter made 20 pots. Should he sell them all to the richest
man or give some to the poor family?
In the economy:
• Should luxury cars be the focus (for the rich)?
• Or should affordable housing be prioritized (for the middle class and poor)?
This is a moral and economic choice every society must make.
Additional Problems Faced by Economies Today
Guru Artha explained that as societies evolve, they face more challenges:
4. Problem of Full Employment of Resources
Sometimes, resources like labor or land are not used fully.
Example: If a village has 100 workers, but only 70 are working, that means
underemployment.
5. Problem of Economic Growth
Every society wants to increase its wealth and improve living standards over time.
This means:
• Investing in education
• Using technology
• Encouraging savings and business
In the village, when Chintu’s father introduced solar pumps, productivity increased — this is
growth!
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6. Problem of Efficient Use of Resources
Efficiency means using resources in such a way that there is no wastage.
• Example: If water is wasted while irrigating fields, it’s bad for the village.
Economies must produce maximum output with minimum cost.
7. Problem of Equity
This is about fair distribution of income and wealth.
If a few people in the village become super-rich and others remain poor, it creates
inequality, leading to conflict and unhappiness.
Modern economies try to reduce inequality through:
• Taxation
• Free education
• Welfare programs
Conclusion: Economics — More Than Just Scarcity
As the sun began to set, Guru Artha said:
“Chintu, remember — economics is not just about money or scarcity. It’s about people,
decisions, fairness, and progress. The Scarcity Definition by Robbins helps us understand
choices, but it is only a part of the bigger picture. And the basic problems of an economy
show us the challenges that every society must solve to grow, develop, and stay fair.”
Chintu smiled and said,
“Guruji, I think now I truly understand economics — not just as a subject, but as a way of
life.”
2. What is an Indifference curve? Discuss consumer equilibrium with the help of
Indifference curves.
Ans: A New Beginning – Let’s Think of Choices Like Food
Imagine you are sitting in a restaurant. The waiter gives you a combo menu.
• Combo A: 2 pizzas + 3 burgers
• Combo B: 3 pizzas + 2 burgers
• Combo C: 1 pizza + 4 burgers
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You think about it. You love pizza, but burgers are tasty too. Surprisingly, you like all three
combos equally. You would be equally happy if you got any one of them. You don’t prefer
one over the other.
This simple idea — you’re equally satisfied with different combinations — is the heart of a
concept in Economics called the Indifference Curve.
What is an Indifference Curve?
In simple words:
An Indifference Curve is a graph that shows different combinations of two goods which give
the same level of satisfaction (or utility) to a consumer.
So, if you are indifferent (don’t mind) between Combo A and Combo B, it means both give
you equal satisfaction — even though the quantities of pizza and burger are different.
Formal Definition (easy language)
An Indifference Curve is a line on a graph that represents all the combinations of two goods
which give a consumer the same level of satisfaction. So, the consumer is "indifferent"
among these combinations.
Example: Ravi’s Food Choices (Story)
Let’s meet Ravi, a college student. He loves two things: Maggi and Cold Drinks.
One day, his friend asks: “If I give you 3 Maggi and 1 Cold Drink, will you be happy?”
Ravi smiles and says, “Yes.”
Then the friend says: “What about 2 Maggi and 2 Cold Drinks?”
Ravi replies, “Yes, that’s also good!”
Then: “How about 1 Maggi and 3 Cold Drinks?”
Again, Ravi says, “Yes, I’d be equally happy.”
So Ravi doesn’t mind which combo he gets — all give him the same joy.
If we put these combinations (3,1), (2,2), (1,3) on a graph (Maggi on X-axis and Cold Drinks
on Y-axis), we can join these points to make a curve.
That’s an Indifference Curve — it shows the combinations that make Ravi equally satisfied.
Assumptions of Indifference Curve Analysis
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To properly understand and draw indifference curves, economists make a few basic
assumptions:
1. Rational Consumer
The consumer wants to maximize satisfaction and makes logical decisions.
2. Two Goods Only
We take only 2 goods (like Maggi and Cold Drink) to keep things simple.
3. More is Better
The consumer always prefers more quantity of a good.
4. Ordinal Utility
The satisfaction can’t be measured in numbers, but can be ranked. (We say "I like A
more than B", not "A gives me 40 utils and B gives 30 utils").
5. Diminishing Marginal Rate of Substitution
If you give up one good to get more of another, your willingness to substitute
reduces over time.
Properties of Indifference Curves
Let’s understand the features of Indifference Curves using simple language and examples:
Indifference Curves Slope Downward from Left to Right
Why?
Because if you reduce the quantity of one good, you must increase the other to keep
satisfaction the same.
Example: If Ravi eats less Maggi, he’ll need more Cold Drinks to stay equally happy.
Higher Indifference Curve = Higher Satisfaction
A curve that lies above another represents higher satisfaction, because it has more of at
least one good.
Example: (3 Maggi, 3 Cold Drinks) is better than (2 Maggi, 2 Cold Drinks).
Indifference Curves Never Intersect
If they crossed, it would mean the same combo gives two different satisfaction levels, which
is illogical.
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Indifference Curves are Convex to the Origin
Why?
Because of the Law of Diminishing Marginal Rate of Substitution.
What is Marginal Rate of Substitution (MRS)?
MRS tells us how much of one good a person is willing to give up to get one more unit of the
other good while staying equally happy.
Ravi’s Example:
• He might give up 2 Cold Drinks for 1 extra Maggi at first.
• Later, he might give up only 1 Cold Drink for another Maggi.
So his willingness to substitute reduces — that’s why the Indifference Curve is convex.
Now Let’s Bring in the Budget Line
So far, we only looked at satisfaction.
But in real life, people have limited money. You can't buy unlimited Maggi and Cold Drinks.
So now we introduce the Budget Line.
What is a Budget Line?
The Budget Line shows all the combinations of two goods that a consumer can afford with
their given income and prices of goods.
Budget Equation:
Let’s say:
• Price of Maggi = ₹10
• Price of Cold Drink = ₹20
• Ravi's Budget = ₹100
Then the equation becomes:
10 × Maggi + 20 × Cold Drink = 100
This line, when drawn, shows all affordable combos.
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What is Consumer Equilibrium?
Here comes the most important part of your question.
Consumer Equilibrium is the point where the consumer gets the maximum satisfaction,
given his income and the prices of goods.
This happens where the Indifference Curve is tangent to the Budget Line.
Why is this the best point?
Let’s understand with a short example:
Ravi wants to spend his ₹100 in a way that gives him the highest satisfaction.
He can afford different combos of Maggi and Cold Drink (shown by the budget line). But
among those, the combo that lies on the highest possible Indifference Curve (within his
budget) gives him maximum utility.
So at equilibrium:
Slope of Indifference Curve = Slope of Budget Line
Or,
MRS = Price of Maggi / Price of Cold Drink
This means, Ravi’s willingness to substitute is equal to the market trade-off between the
two goods.
Diagram of Consumer Equilibrium (Describe It)
In your exam, draw this properly:
• X-axis: Quantity of Good X (e.g. Maggi)
• Y-axis: Quantity of Good Y (e.g. Cold Drink)
• Draw 3 Indifference Curves (IC1, IC2, IC3)
• Draw Budget Line (touching only one of them — highest possible)
• Show Equilibrium at point E (where Budget Line is tangent to IC2)
Label clearly:
• IC1 = low satisfaction
• IC2 = max satisfaction within budget (equilibrium point)
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• IC3 = not affordable
Let’s Wrap Up with a Final Example – Reena’s Shopping Day
Reena has ₹500 to spend. She wants to buy books and chocolates.
Prices:
• 1 Book = ₹100
• 1 Chocolate box = ₹50
She can buy:
• 5 books, 0 chocolates
• 4 books, 2 chocolates
• 3 books, 4 chocolates
• 2 books, 6 chocolates
• 0 books, 10 chocolates
She draws this Budget Line.
Now, among these, she also thinks about her happiness:
• Too many books, no chocolates = boring
• Too many chocolates, no books = unhealthy!
She chooses 2 books and 6 chocolates — the combo where the budget line touches her
highest possible indifference curve.
That is her consumer equilibrium — she’s spent all her money and is perfectly happy with
her combo.
SECTION-B
3. Discuss the three stages of law of variable proportions. What are the causes of the
operation of law of variable proportions ?-
Ans: A Journey Through the Law of Variable Proportions
Once upon a time, in a sun-kissed village at the edge of a winding river, lived Rohan, a
spirited farmer. Every planting season, Rohan faced the same puzzle: how many bags of
fertilizer should he sprinkle on his paddy field? Too little, and his rice stalks were sparse. Too
much, and the extra nutrients ended up wasted, or worse, hurt the yield. Year after year, he
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noticed a curious pattern in his harvests—a pattern that mirrored a fundamental economic
truth known as the Law of Variable Proportions.
Let’s embark on Rohan’s journey together and uncover the three stages of this law, and
then peel back its underlying causes. Imagine you’re walking alongside him, shovel in hand,
feeling the soil’s promise under your boots.
1. Setting the Stage: Fixed Fields and Variable Seeds
In economics, the Law of Variable Proportions describes how output changes when one
input (the “variable factor,” like seeds or fertilizer) is increased, while all other inputs (the
“fixed factors,” like land and irrigation canals) stay the same. It unfolds in the short run,
when some resources are fixed.
• Fixed Factors: Land size, irrigation channels, earthworms in the soil.
• Variable Factor: Bags of fertilizer, sacks of seeds, hours of labor.
Picture Rohan’s field as a stage, the land’s area and water supply as the sturdy backdrop.
Every extra bag of fertilizer he adds is like sending another actor onto that stage. Initially,
the performance (the harvest) dazzles. But beyond a point, the play becomes chaotic—too
many actors jostling for space.
With this setup in mind, let’s walk through the three memorable acts of this agricultural
drama.
2. Stage I: The Rise of Increasing Returns
The Scene
Rohan begins his planting season with just a handful of fertilizer bags. His rice plants emerge
pale and protein-starved. Then, on a sunlit morning, he adds the first bag of fertilizer and
watches his plants perk up.
The Magic of Synergy
In Stage I, each additional unit of fertilizer delivers a larger boost in yield than the one
before it. This happens because:
• Underutilization of Land At the start, the fixed factors (land, sunlight, water
channels) aren’t fully exploited. A little extra fertilizer helps plants spread roots
deeper, leaf more luxuriously, and capture sunlight more effectively.
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• Improved Efficiency Workers can apply fertilizer precisely where it’s needed—
around each seedling—so nutrients don’t go wasted.
A Tale Within the Tale
Imagine Rohan’s neighbor, Meena, giving him a small bag of premium compost. The first
handful sprinkled around the seedlings transforms them almost overnight. His marginal
yield leaps from 20 to 30 kilograms per extra bag of fertilizer. The soil, once starved,
suddenly sings a richer tune.
The Numbers
• First bag raises yield by 20 kg.
• Second bag raises yield by 25 kg (even more!).
• Third bag raises yield by 30 kg (peak excitement!).
This steep upward climb is Stage I, the golden era of increasing marginal returns, where
each extra dose seems better than the last.
3. Stage II: The Dance of Diminishing Returns
The Turning Point
Soon enough, Rohan senses the first whisper of change. His fourth and fifth bags still boost
the harvest, but not by as much. Instead of 30 kg, the fourth bag adds 20 kg; the fifth, just
15 kg. Yields rise, but the pace has slowed.
Why the Slowdown?
In Stage II, the variable factor (fertilizer) continues to improve productivity, but at a
decreasing rate. Here’s why:
• Crowding on the Stage As roots expand, they compete for water and minerals in the
same patch of soil. There’s still room for improvement, but diminishing space means
less bang per fertilizer bag.
• Fixed Factor Constraints Irrigation canals, once more than adequate, now strain to
deliver enough water to the denser root system. The fixed factors can’t keep up with
the faster pace of fertilization.
The Sweet Spot
This phase is the most balanced and realistic for farmers. Yields climb, but each additional
unit of fertilizer yields less of an increase than before. Often, it’s here Rohan finds his profit-
maximizing point—beyond which extra fertilizer costs more than the extra rice it produces.
Rohan’s Reflection
Sitting under a banyan tree, Rohan calculates his costs. The fifth bag of fertilizer is ₹600 but
yields only 15 kg of rice. Selling rice at ₹40 per kg nets him ₹600—but barely covers the cost.
He decides that five bags hit the sweet spot between cost and return.
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4. Stage III: The Fall into Negative Returns
When Too Much Becomes Too Little
Emboldened by his initial success, Rohan experiments with the sixth and seventh bags. To
his dismay, the sixth bag raises his yield by a mere 2 kg; the seventh actually reduces total
output by 5 kg. His lush field now shows signs of salt buildup, weakened stalks, and stunted
growth.
The Downward Spiral
This is Stage III, the realm of negative marginal returns. Additional fertilizer:
• Disrupts Soil Chemistry Excess nitrates can leach calcium, weaken cell walls, and
burn plant roots.
• Wastes Resources Water cannot flush the surplus salts away fast enough, leading to
root suffocation.
• Invites Pests and Disease Over-fertilized, tender shoots become feast for insects and
fungi.
Rohan watches in dismay as his harvest shrinks. Once a symbol of prosperity, his field now
whispers a cautionary tale: sometimes, more is less.
The Underlying Causes of the Law’s Operation
Why does the performance change so dramatically across these stages? Below are the core
causes that guide the Law of Variable Proportions.
1. The Fixity of Certain Factors
• In the short run, some inputs remain fixed—land area, major machinery, irrigation
infrastructure.
• The variable factor can only leverage those fixed factors to a point; beyond that, it
begins to crowd them.
• Without expanding land or upgrading equipment, you eventually hit physical and
biological limits.
2. Diminishing Marginal Utility in Production
• Each additional unit of fertilizer offers less satisfaction—or in economic terms, less
marginal product—after the initial boost.
• Just as biting into the first slice of pizza is delicious, but the fifth slice is less thrilling,
the first bags of fertilizer yield great returns, the later ones don’t.
3. Technical and Biological Constraints
• Soil Structure Soil has a finite capacity to absorb nutrients. Overload leads to
nutrient imbalances that harm plant physiology.
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• Enzymatic and Cellular Limits Plants can process only so many nutrients in a given
timeframe. Once the cellular pathways are saturated, extra input can cause
toxicity.
4. Overcrowding of Variable Inputs
• Too many workers in a small factory floor bump elbows; too much fertilizer in
limited soil space crowds out optimal root growth.
• Each new unit of the variable factor must share the fixed resources with all
predecessors, diluting its effectiveness.
5. Optimal Allocation and Resource Efficiency
• The law nudges decision-makers toward an economic optimum, where the last unit
of input added yields revenue equal to its cost.
• Beyond that point, the efficiency of resource allocation declines, making additional
inputs economically unjustifiable.
A Second Story: The Cotton Mill Conundrum
In a nearby town, Maya ran a small cotton textile mill. Her fixed factors were the building,
the spinning machines, and the power supply. Labor—an hourly variable factor—held the
key to her daily output.
• Day 1: 10 workers produced 100 meters of cloth.
• Day 5: 14 workers produced 160 meters—each new worker adding more output
than the previous one (Stage I).
• Day 10: 20 workers produced 250 meters—still rising but more slowly (Stage II).
• Day 25: 30 workers produced just 220 meters—laborers tripping over each other,
machines jamming, output falling (Stage III).
Maya’s experience mirrored Rohan’s field: fixed machines, variable labor, and three distinct
stages of returns. When she redrew her production schedule to stay in Stage II, her mill
hummed with efficiency and profit.
Bringing It All Together
The Law of Variable Proportions reveals a universal truth: adding more of one input to fixed
others will initially boost output at an increasing rate, then a decreasing rate, and finally
push output downward. These three stages—increasing returns, diminishing returns, and
negative returns—are shaped by biological limits, technical constraints, and the
fundamental economics of scarcity.
For students, the lesson is clear: always seek the optimum point where the cost of the last
unit of input matches its additional output. For farmers like Rohan and mill owners like
Maya, it’s the difference between profit and loss, abundance and waste.
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Economics, at its heart, is the art of balancing inputs to craft the richest, most sustainable
harvest—whether that harvest is rice soaked in monsoon rains or bolts of cotton cloth spun
by whirring machines.
4. What are the different concepts related to costs? Why is short run AC curve U shaped ?
Ans: A Secret Ingredient for Success: Costs Unveiled
High above the cobblestone lane of Garamond Street, within the walls of Franny’s Flour &
Fire Bakery, the counters always smelled of vanilla and fresh dough. Franny, an artisan
baker, prided herself on perfect pastries—and on mastering her finances. Every morning, as
she weighed flour and sugar, she silently calculated the true cost of each croissant. Little did
she know that the world of economics had a whole menu of cost concepts waiting to be
tasted.
This tale will whisk you through those cost ideas—like Fixed Cost and Marginal Cost—before
explaining why the short-run Average Cost (AC) curve gracefully dips and then rises, tracing
a U shape that every student must understand. By the end, you’ll see costs not as dry
numbers but as the secret ingredients guiding every firm toward the perfect recipe for
profit.
1. The Family of Cost Concepts
Before plotting curves, we must meet the cast of characters—the different cost concepts
that firms juggle in the short run and beyond. Imagine Franny’s ledger opened each morning
to reveal these entries:
• Fixed Cost (FC) These are costs that never budge, no matter how many pastries
Franny bakes. Her rent, oven lease, and insurance payments total ₹20,000 every
month. Even if she rests the rolling pin for a week, those costs remain—hence
“fixed.”
• Variable Cost (VC) Flour, sugar, butter, and labor hours tick up and down with
production. If Franny makes 100 croissants, butter costs ₹500; if she makes 200, it’s
₹1,000. These costs vary directly with output.
• Total Cost (TC) Simply FC + VC. In any month, Franny’s baker’s delight ledger shows
Total Cost = ₹20,000 (fixed) + ₹X (variable). If her VC reaches ₹10,000, then TC lands
at ₹30,000.
• Average Cost (AC) The cost per unit of output:
• AC = TC / Q
If Franny bakes 1,000 croissants, her AC is ₹30 per croissant. This tells her whether her
selling price of ₹40 covers her all-in cost.
• Average Fixed Cost (AFC) As output rises, fixed costs spread thinner:
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• AFC = FC / Q
At 500 pastries, AFC is ₹40; at 1,000, it halves to ₹20.
• Average Variable Cost (AVC) Simply VC per unit:
• AVC = VC / Q
If her total ingredients and labor cost ₹12,000 for 1,000 pastries, AVC is ₹12.
• Marginal Cost (MC) The change in total cost when output increases by one more
unit:
• MC = ΔTC / ΔQ
If adding the 101st pastry pushes her VC from ₹12,000 to ₹12,012, MC = ₹12.
These core concepts—FC, VC, TC, AC, AFC, AVC, and MC—form the foundation of any firm’s
short-run decisions. They reveal when to bake more, bake less, or temporarily close the
oven door.
2. Short-Run vs. Long-Run: A Tale of Two Horizons
Before we sketch the U-shaped AC curve, let’s clarify the short run in economic lingo:
• Short Run At least one input is fixed—Franny’s bakery floor space and ovens can’t be
doubled overnight. She can hire extra bakers or buy more ingredients, but she
cannot instantly enlarge her kitchen.
• Long Run All inputs become variable. Franny could sign a lease on a second shop,
install more ovens, and hire a full brigade of bakers. In the long run, she can adjust
every resource.
Our focus here is the short run—where the interplay of fixed and variable factors births the
U-shaped AC curve.
3. The U-Shaped Short-Run AC Curve: A Two-Act Drama
Imagine plotting Franny’s AC against the number of croissants baked per month. At first, AC
falls, reaches a trough, then rises. Why does it behave like a gentle cup or a smiling “U”?
Let’s explore the two main forces at work:
Act I: The Spreading Out Effect (Falling Portion)
1. Spreading Fixed Costs As Franny bakes more croissants, her unchanging rent and
oven lease get divided across a larger output. Baking 500 pastries makes AFC =
₹20,000/500 = ₹40. Baking 1,000 pastries halves AFC to ₹20. This relentless decline
in AFC drags the overall AC downward.
2. Increasing Marginal Returns (Initial Gains) When Franny hires her first extra
assistant, her ovens hum at full tilt: dough is kneaded faster, shelves restocked
promptly, and fewer pastries get burned. The extra labor complements the fixed
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ovens and workspace perfectly, boosting output significantly. This initial surge in
productivity pushes MC below AC, pulling AC further down.
Together, these two forces—shrinking AFC and rising early productivity—sculpt the
downward-sloping left side of the AC curve.
Act II: The Diminishing Returns Effect (Rising Portion)
1. Law of Diminishing Marginal Returns Beyond a certain point, each extra assistant in
the same kitchen starts bumping elbows. The third baker jostles the fourth when
rolling dough; ingredients pile up; ovens queue behind one another. The extra
output per new baker shrinks. Marginal Cost (MC) then begins to rise.
2. Marginal Cost Surpasses Average Cost Once MC climbs above AC, every additional
croissant costs more than the current per-unit average. This pushes AC upward.
Baking beyond 1,500 pastries might overload the ovens, force overtime wages, or
require frequent equipment repairs—driving costs per pastry skyward.
This dance of rising MC and the ever-spreading fixed costs yields the U shape: a descent to
an optimal minimum, then a climb as inefficiencies set in.
4. A Second Oven Story: The Ceramics Studio
Not far from Garamond Street, Petra ran a ceramics studio. Her fixed costs were kiln rent
and studio lighting; her variable inputs were clay and painter’s time. She noticed:
• At 50 mugs per week, AC fell sharply as kiln costs spread.
• By 120 mugs, AC hit its minimum—the perfect balance between kiln use and painter
availability.
• Beyond 120, painters queued for the single kiln, clay piled up unshaped, and
overtime premiums nudged AC upward.
Petra’s cost curve traced the same U shape. Both Franny and Petra discovered that
spreading effect and diminishing returns are universal forces in the short run.
5. Why the U Shape Matters to Every Firm
Understanding this U shape isn’t a mere academic exercise; it’s the compass guiding real
business choices:
• Choosing Output Level Firms aim to operate where AC is lowest—the bottom of the
U—because that’s where profit per unit is maximized, given a market price above
AC.
• Pricing Decisions If market price dips below AC but stays above AVC, firms might
temporarily produce to cover variable costs, hoping fixed costs are just “sunk” this
period. Once price falls below AVC, it’s time to halt production in the short run.
• Capacity Planning Recognizing when MC starts to rise signals firms to consider
expanding capacity (moving toward the long run) if they expect sustained demand.
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6. Beyond the Basics: Hidden Cost Concepts
While FC, VC, TC, AC, and MC anchor the short-run picture, several advanced cost ideas
enrich the narrative:
• Opportunity Cost The value of the next-best alternative forgone. If Franny uses her
extra hour to bake cookies instead of teaching baking classes, the foregone teaching
fee is her opportunity cost.
• Sunk Cost Costs already spent and irrecoverable—like the non-refundable deposit on
that fancy convection oven. Rational decisions ignore sunk costs; they focus on
future costs and revenues.
• Explicit vs. Implicit Costs Explicit costs involve direct payments—ingredients, wages.
Implicit costs represent foregone income—Franny’s own unpaid labor or the rent
she could earn by leasing out her kitchen space.
• Long-Run Average Cost (LRAC) When all inputs are variable, firms can choose the
optimal scale. LRAC may form a different U shape, reflecting economies and
diseconomies of scale as the firm grows. This curve envelops the various short-run
AC curves for each fixed-plant size.
These refined concepts help businesses evaluate real profitability, plan expansions, and
decide whether to enter or exit a market.
7. Tracing the Mathematics: How MC and AC Interact
Behind the curves lies a simple mathematical truth:
• When MC < AC, AC falls.
• When MC > AC, AC rises.
• The MC curve cuts the AC curve exactly at AC’s minimum point.
Why? Because adding a unit whose cost is below the current average will pull the average
down, and vice versa. It’s the same principle as grade-point averages in school—scoring
above your GPA pushes it up; scoring below drags it down.
Graphically, the MC curve is typically J-shaped (first descending then ascending),
intersecting the bottom of the U-shaped AC curve. This intersection marks the most cost-
efficient output level in the short run.
8. Stitching the Lessons into Franny’s Dream
One evening, Franny tallied her monthly bakery results:
• At 800 croissants, AC was ₹35.
• At 1,200 croissants, AC bottomed at ₹28.
• At 1,800 croissants, AC climbed to ₹32.
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Plotting these points revealed the U. She realized the 1,200 mark was her sweet spot—
where her priced-at-₹40 croissants netted her the greatest profit margin. Any attempt to
produce 1,800 meant overtime wages and ingredient spoilage, eroding her gains.
This single insight changed Franny’s strategy: she capped production at 1,200, hired flexible
part-time help during peak seasons, and planned for a second storefront when demand kept
growing.
Key Takeaways
1. Cost Concepts
o Fixed, Variable, Total, Average, Marginal
o Opportunity, Sunk, Explicit vs. Implicit
2. Short-Run vs. Long-Run
o Short run: at least one fixed factor; U-shaped AC.
o Long run: all factors variable; different cost dynamics.
3. Why AC is U-Shaped
o Spreading Effect lowers AFC and AC initially.
o Increasing Marginal Returns lower MC and AC at first.
o Diminishing Returns raise MC, then AC thereafter.
4. MC-AC Relationship
o MC curve intersects AC at its minimum—guiding optimal output.
5. Managerial Implications
o Identifying cost-minimizing output ensures profit maximization.
o Recognizing rising MC signals capacity expansion decisions.
Understanding costs is like mastering a secret recipe: with the right balance of ingredients—
fixed ovens, variable flour, and skilled labor—you achieve the perfect bake. And by plotting
your U-shaped AC curve, you discover the precise output that fills your ovens without
burning your profits.
SECTION-C
5. What are the characteristics of Perfect Competition? How is the price of a commodity
determined under Perfect Competition?
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Ans: The Market of Mirrors: Understanding Perfect Competition and Price
Determination
In a land not too far from here, there was a curious market known as The Market of Mirrors.
This market was unlike any other — every shop looked the same, every seller shouted the
same price, and every buyer had full knowledge of where the best deal could be found. No
one could trick anyone, and no one could make excess profit. It was a place of perfect
balance, fairness, and transparency — a true representation of Perfect Competition.
Let us step into this magical market to explore what Perfect Competition means, what its
key characteristics are, and most importantly, how prices are determined in such a
marketplace.
What is Perfect Competition?
Perfect competition is an ideal market structure in economics where a large number of
buyers and sellers operate, and no single buyer or seller has the power to influence the
price of a commodity. It is a theoretical model — a kind of “perfect world” market — where
prices are determined purely by the forces of demand and supply.
Characteristics of Perfect Competition
Let’s begin with the six key features that define a perfectly competitive market:
1. Large Number of Buyers and Sellers
Imagine a vast grain market in a rural town — there are hundreds of farmers selling wheat,
and just as many buyers. No single buyer or seller is powerful enough to influence the
market price. This ensures that everyone is a price taker, not a price maker.
Even if a farmer tries to sell wheat at a higher price, no one buys from him — because
everyone else is selling it cheaper. Similarly, buyers can’t force sellers to lower the price.
2. Homogeneous Products
In perfect competition, all products are identical. There is no brand name, no quality
variation, no special packaging — everything is the same. A kilo of wheat from one seller is
the same as from another.
This ensures that buyers have no reason to prefer one seller over another, keeping the
competition fair and focused on price.
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3. Free Entry and Exit
Firms can freely enter or leave the market depending on their profits. There are no legal,
technical, or financial barriers.
If profits are high, new firms will enter. If losses mount, firms will leave. This leads to
long-run equilibrium where firms only earn normal profits (just enough to stay in business).
4. Perfect Knowledge of the Market
Buyers and sellers have complete information about the market — prices, quality, and
availability.
A buyer knows exactly where to get the cheapest goods, and sellers know what price
others are charging.
5. No Transportation Cost
It is assumed that there are no transport costs, or they are equal for all sellers. This ensures
that price differences don't arise due to geographical reasons.
If transporting wheat from one place to another cost more for some sellers, they’d have
to raise prices — but that would break the "perfect" balance.
6. No Government Intervention
There are no taxes, subsidies, or regulations. The government does not control prices,
production, or trade.
Prices are purely determined by market forces — demand and supply.
How is Price Determined Under Perfect Competition?
Now comes the heart of the story — how is the price of a product like wheat, rice, or sugar
decided when so many buyers and sellers are involved?
The answer lies in Demand and Supply.
Price Determination in the Market
Let’s understand this using a simple diagram and story.
Story: The Tale of Aarav and the Village Market
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Aarav, a young economist, visited the village of Sonpur where he observed the wheat
market. Each morning, hundreds of farmers brought sacks of wheat, while buyers —
housewives, shopkeepers, and flour mill owners — gathered with money in hand.
One day, the farmers wanted ₹30 per kg. But buyers were only willing to pay ₹20. No one
was buying. The price was too high.
The next day, some farmers reduced the price to ₹25 — a few buyers came forward.
Finally, at ₹22 per kg, something magical happened: the quantity of wheat that sellers were
willing to sell exactly matched the quantity buyers wanted to buy. That price — ₹22 —
became the equilibrium price, and it stayed there as long as market conditions didn’t
change.
Aarav smiled. He had just witnessed the Law of Demand and Supply in action.
The Price Determination Graph (Total Market)
Price (₹/kg)
Quantity Demanded (kg)
Quantity Supplied (kg)
20
100
60
22
80
80 (Equilibrium)
25
60
100
Explanation:
• At ₹20, demand > supply → shortage → price rises
• At ₹25, supply > demand → surplus → price falls
• At ₹22, demand = supply → equilibrium → price remains stable
Price Takers: The Role of Individual Firms
In perfect competition, an individual seller has no power to change the price.
If the market price is ₹22 per kg, every seller can sell as much as they want at that price. But
if they try to sell at ₹23, no one buys. If they sell at ₹21, they’ll earn less profit than
necessary.
Thus, every seller accepts the market price — they are price takers.
Individual Firm’s Graph
• AR (Average Revenue) = MR (Marginal Revenue) = Market Price
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• The firm’s cost curves (MC and AC) determine how much they will produce to
maximize profit.
• The firm will produce where MC = MR
Long-Run Equilibrium: Normal Profits
In the short run, firms may earn supernormal profits (extra profit above normal) or losses.
But in the long run, the freedom of entry and exit ensures that all firms earn only normal
profits.
• If firms earn high profits, new firms enter → supply increases → price falls
• If firms suffer losses, some exit → supply falls → price rises
Eventually, the market settles where Price = Minimum Average Cost (AC) → normal profit
6. What is monopolistic competition? How is the equilibrium of firm and group
determined under monopolistic competition?
Ans: A Fresh Beginning: The Town of Bazaarville
In the heart of a bustling valley, nestled between green hills, was a vibrant little town called
Bazaarville. This town was famous for one thing—its street lined with dozens of tea stalls.
Not ordinary ones, though. Each tea shop had its own flavor, charm, and loyal customers.
There was Auntie Meera’s Masala Chai, with her special spice blend passed down through
generations. A few stalls down, Sunny’s Lemon Zing catered to the youth with funky flavors.
And then there was Chotu’s Cutting Chai, quick, strong, and always piping hot for the
working crowd.
Everyone in Bazaarville sold tea, but no two teas were exactly the same.
And right there, in this tea-scented street, lies the perfect stage to understand the
fascinating concept of monopolistic competition—a market where many sellers sell similar
but not identical products.
Part 1: What is Monopolistic Competition?
Let’s begin with the basic idea.
Monopolistic Competition is a type of market structure characterized by the following:
Key Features:
1. Large Number of Sellers: Many firms operate, but each has a relatively small share
of the market.
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2. Product Differentiation: Products are not identical—they are slightly different in
terms of brand, quality, taste, packaging, etc.
3. Freedom of Entry and Exit: New firms can enter or leave the market easily in the
long run.
4. Selling Costs: Firms often spend on advertising and packaging to attract customers.
5. Some Control Over Price: Due to product differences, each firm has a bit of
monopoly power and can set its own price within a range.
In our story, Auntie Meera and Sunny both sell tea, but they differentiate their products
through unique recipes, cups, and even the ambience of their stalls.
Now, let’s explore how equilibrium is reached in such a market—first for an individual firm,
then for the group of all firms.
Part 2: Equilibrium of a Firm under Monopolistic Competition
Let’s imagine Auntie Meera’s stall again.
She knows that people love her spicy cardamom flavor. This uniqueness gives her a
downward-sloping demand curve—meaning she can sell more tea only by lowering the
price.
Short-Run Equilibrium of a Firm
In the short run, firms can earn abnormal profits or face losses, depending on demand and
cost conditions.
How is Equilibrium Determined?
• Equilibrium occurs where Marginal Cost (MC) = Marginal Revenue (MR).
• At this point, the firm maximizes its profit.
• Depending on the Average Cost (AC):
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o If Price > AC, the firm earns supernormal profits.
o If Price = AC, it earns normal profits.
o If Price < AC, it suffers losses, but may continue if losses are less than fixed
costs.
Visual Example:
Let’s say Meera sells tea at ₹20 and her average cost is ₹15. She earns a profit of ₹5 per cup.
This is her short-run equilibrium with supernormal profits.
But this won't last forever…
Part 3: Long-Run Equilibrium of the Firm
Now, let’s say Sunny notices Meera’s success and starts copying her flavor. Then more
sellers join in, offering similar teas. What happens?
New firms enter the market, increasing competition and reducing the number of customers
per stall.
As a result:
• Demand curve shifts leftward.
• The firm now faces more elastic demand (customers can easily switch).
• Supernormal profits vanish, and the firm only earns normal profits in the long run.
Long-Run Equilibrium:
• Still occurs at MC = MR, but now Price = AC.
• There are no supernormal profits.
• Each firm still has its unique product, but cannot dominate due to competition.
In Bazaarville, Auntie Meera adapts—she improves packaging and adds cookies. She
survives, but now earns just enough to stay in business, like others.
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Part 4: Equilibrium of the Group under Monopolistic Competition
So far, we’ve focused on one seller. Now let’s understand how the entire group of firms
behaves.
In monopolistic competition, firms are interdependent but do not react strongly to each
other like in oligopoly. Why?
Because their products are not perfect substitutes.
Each firm’s demand curve is independent, but the overall market faces a common rule:
entry and exit lead to zero economic profits in the long run.
Thus, in group equilibrium:
• All firms earn normal profits.
• Each has excess capacity—they do not produce at minimum average cost, unlike
perfect competition.
• There's product variety, which is good for consumers.
Part 5: A Second Tale – The Perfume Puzzle
In another town, Neha opens a perfume boutique. She designs unique, handcrafted
fragrances. At first, she becomes popular, earning high profits.
But over time, others enter the perfume business, creating similar scents. Competition rises,
and Neha must cut prices or spend more on branding.
Eventually, like Auntie Meera, she earns just enough to stay afloat. The market adjusts, and
a new long-run equilibrium is achieved.
Her story also reflects monopolistic competition: variety, creativity, entry of rivals, and
eventual normalization of profits.
SECTION-D
7. (1) Explain clearly the modern theory of distribution.
(ii) How is rent determined through the Ricardian theory?
Ans: From the Market to the Mill: Understanding the Modern Theory of Distribution &
Ricardian Rent Theory
A New Beginning: Not in a Village, But in a Marketplace
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Let’s not begin in a farm this time. Instead, imagine a busy marketplace. The air buzzes with
the chatter of buyers and sellers. On one end, a wooden cart vendor sharpens his tools. On
another, a young techie named Nisha sets up a digital payment kiosk. Every person here is
earning something—be it wages, interest, rent, or profit.
But have you ever wondered: How is their income determined?
Why does the cart vendor earn ₹500 a day while the stall owner earns ₹2000? Why does the
bank get interest on loans, and the landowner get rent?
This brings us to the Modern Theory of Distribution and then, zooming into one part of it—
Ricardo’s Theory of Rent.
Let’s break them down like a fascinating journey through the marketplace and then take a
stroll into the past with Ricardo’s story of land.
Part 1: Modern Theory of Distribution – The Market Mechanism Behind All Incomes
What is Distribution?
In economics, distribution refers to how the total income or output in an economy is divided
among the factors of production—namely:
1. Land → earns Rent
2. Labour → earns Wages
3. Capital → earns Interest
4. Entrepreneurship → earns Profit
The Modern Theory of Distribution studies how each factor’s income is determined based
on demand and supply, just like goods in a market.
The Core Idea: Each Factor Has Its Own Market
Let’s simplify this using a familiar idea:
Just like potatoes or mobile phones have a market price determined by buyers and sellers,
factors of production also have prices:
• Wages for labour
• Rent for land
• Interest for capital
• Profit for entrepreneurship
Each of these prices is determined in factor markets, based on:
• Demand for the factor
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• Supply of the factor
The Theory in Depth: Factor Demand and Supply
Demand for Factors
The demand for a factor of production is derived demand.
• Why “derived”? Because no one wants labour or land for its own sake—they want it
because it helps produce something else that can be sold for profit.
Example: A factory doesn’t hire a worker just because they love workers. They hire them to
produce goods, which can then be sold in the market.
Marginal Productivity Theory
The modern theory of distribution heavily depends on the concept of marginal productivity.
It says: Each factor is paid according to its Marginal Revenue Product (MRP).
MRP in Simple Words:
Let’s say you’re running a samosa stall.
• You hire one helper → total sale increases by ₹200/day.
• You hire a second → total sale increases by ₹150/day.
• The MRP of the second helper is ₹150.
So, how much wage will you pay?
You’ll pay equal to or less than ₹150.
No one pays a worker more than what they add to the total revenue.
This is the heart of factor demand in modern theory.
Supply of Factors
Each factor has its own nature of supply:
• Land: Perfectly inelastic (we can’t create more land).
• Labour: Upward-sloping supply curve (more wages attract more people).
• Capital: More interest → more saving/investment.
So, the equilibrium price (income) of each factor is determined where demand = supply in
its factor market.
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Summary of Modern Theory (Key Points):
Component
Explanation
Scope
Explains all factor incomes: rent, wages, interest, and profit
Foundation
Based on demand (MRP) and supply in factor markets
Assumption
Perfect competition, full employment, rational behaviour
Outcome
Equilibrium income for each factor where MRP = Price of factor
Payment Rule
Each factor gets paid according to its marginal productivity
Story Interlude: Nisha’s Digital Market Kiosk
Meet Nisha, a smart young girl who starts a digital payment kiosk in a crowded market.
She hires 1 assistant who brings in 30 new customers per day. She earns ₹300 extra from
those customers.
Encouraged, she hires a second assistant, but now only 20 extra customers come.
The marginal productivity is falling.
She realises: “I should pay my second assistant ₹200 maximum, else I make no profit.”
This is marginal productivity in real life—and the basis of the modern theory of distribution.
Whether it’s a helper, a machine, or a patch of land—each input is paid based on what it
adds to total output.
Part 2: Ricardian Theory of Rent – A Tale of Two Fields
David Ricardo’s Insight
Now let’s zoom into one type of income: Rent.
And here’s where we meet David Ricardo, an early 19th-century economist.
He wanted to explain why rent arises on land and how it's determined.
He gave the answer in his famous theory of differential rent, also called the Ricardian
Theory of Rent.
Basic Assumptions of Ricardian Rent Theory:
1. Land is a gift of nature – fixed in supply and heterogeneous in quality.
2. Land has no supply price – it exists regardless of demand.
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3. Different lands give different outputs – even with the same input.
4. Perfect competition exists.
5. Law of diminishing returns applies.
Ricardo's Core Idea: Rent is a Reward for Fertility
Let’s understand Ricardo’s theory through a simple story.
Story: Ravi and the Three Patches
Ravi is a farmer in an ancient kingdom.
He receives three patches of land:
• Plot A (most fertile)
• Plot B (average)
• Plot C (least fertile)
He uses the same amount of seeds and labor on all three plots.
• Plot A yields 100 kg of wheat.
• Plot B yields 80 kg.
• Plot C yields 60 kg.
So, Where Does Rent Come From?
Ricardo says: Rent arises on more fertile lands due to their higher productivity.
• Plot C is the worst and gives the minimum output. It earns zero rent.
• Plot B yields 20 kg more, so it earns rent = value of 20 kg.
• Plot A yields 40 kg more, so it earns rent = value of 40 kg.
This is called Differential Rent.
Rent is not paid for land itself but for the advantages that superior land gives.
Graphical Representation:
X-axis: Plots of land (ranked by fertility)
Y-axis: Output
• The lowest productivity (from Plot C) sets the no-rent land.
• Any land yielding above this baseline earns differential rent.
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Important Highlights of Ricardian Theory:
Concept
Explanation
No-Rent Land
Marginal land (like Plot C) earns nothing—just enough to cover
cost.
Rent is Price
Determined
Rent is determined by the price of the produce, not the other
way around.
Not Part of Cost
Since land is a free gift, rent does not enter into the cost of
production.
Caused by Scarcity
Rent arises due to scarcity of fertile land.
Final Thoughts: Bridging the Two Theories
• The Modern Theory shows how every factor earns its income in a market through
supply and demand and marginal productivity.
• The Ricardian Theory zooms in on land and shows why only some lands earn rent,
based on their productivity compared to marginal land.
Comparison Table: Modern vs Ricardian Distribution (for understanding)
Aspect
Modern Theory
Ricardian Rent Theory
Focus
All factor incomes
Only rent (land income)
Basis
Demand-Supply & MRP
Differential productivity of land
Key Principle
MRP = Price of factor
Rent = Difference in productivity
Applicability
Labour, capital, land, entrepreneur
Only land
Nature of Factor
Variable
Fixed and heterogeneous
Rent Considered
Part of income like others
Surplus; not part of cost
Wrap-Up: What Should You Remember for Exams?
• Always define what is being explained.
• Use real-world examples or simple stories to bring clarity.
• If possible, use a diagram (especially for Ricardian rent or MRP).
• End with a summary table or comparison.
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• Link theory to practical insights (like farmers, workers, or entrepreneurs).
8. (1) Explain Knight's uncertainty theory of profit. What objections are raised against it?
(ii) Critically examine the loanable funds theory of interest.
Ans: The Rainmaker and the Risk: Knight's Uncertainty Theory of Profit
A Different Kind of Beginning...
In a bustling market town nestled between green hills and blue rivers, lived a man named
Kavi. He wasn’t a merchant, nor a banker, nor even a farmer. He was a planner. He had
ideas, vision, and—most importantly—a deep understanding of how uncertain life could be.
One day, he decided to buy a small patch of dry land on the outskirts of the town. Everyone
laughed. “There’s no irrigation!” they said. “It hasn’t rained in months!”
But Kavi had a plan.
He studied wind patterns, dug deep for groundwater, and invested in drought-resistant
seeds. While others feared failure, he embraced the risk. The heavens smiled. Rains came—
late, but enough. That year, while others barely broke even, Kavi earned double profits.
This is what Frank H. Knight—a great American economist—talked about in his Uncertainty
Theory of Profit.
Let’s step into this theory with the same curiosity Kavi had and explore what Knight really
meant.
Part I: Understanding Knight’s Uncertainty Theory of Profit
Who Was Frank H. Knight?
Frank H. Knight (1885–1972) was a pioneer in economic thought. In his famous book “Risk,
Uncertainty, and Profit” (1921), he introduced a revolutionary idea:
"Profit arises due to uncertainty in business."
This theory changed how economists understood the role of the entrepreneur.
What Is Knight’s Uncertainty Theory?
According to Knight, profits are not just a return for capital or management—they are a
reward for bearing uncertainty.
He made a very important distinction:
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• Risk: Measurable and predictable. Like the chance of a building catching fire
(insurance companies handle this).
• Uncertainty: Unmeasurable and unpredictable. Like future tastes, technologies,
market changes, or pandemics!
Knight argued that normal risks can be insured, and they do not generate profits. But true
profit arises from decisions taken under uncertainty—those events no one can predict or
insure against.
Types of Risks According to Knight
Knight said not all uncertainties lead to profit. Only non-insurable, non-predictable
uncertainties are relevant. He categorized risks as:
1. Foreseeable Risks
o Fire, theft, accidents
o These are insurable; thus, not profit-generating
2. Unforeseeable Uncertainties
o Consumer preferences, future inventions, market crashes
o These are uninsurable, and entrepreneurs bear them
Role of the Entrepreneur
The entrepreneur is the decision-maker under uncertainty.
According to Knight:
• Entrepreneurs must predict the future market conditions.
• They make decisions on investments, pricing, production, and marketing.
• If their predictions are right, they earn profit.
• If not, they bear losses.
So, profit = reward for successful decision-making under uncertainty.
Story Within the Theory: The Circus Organizer
Imagine a man named Rishi planning a traveling circus.
• He rents a tent, hires performers, and prints tickets.
• He doesn’t know if it will rain or shine on the show day.
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• He doesn’t know if a new movie will release and take away his crowd.
• He can’t insure “audience mood.”
If he manages to fill the tent, he profits. If not, he incurs a loss.
This shows uncertainty in action. Rishi can’t predict human behavior. That’s what Knight
emphasizes.
Knight’s Theory in Real Life
Knight’s theory is visible in every real-world startup:
• A tech entrepreneur launching a new app can’t predict user interest.
• A fashion designer can’t guarantee trends will favor their colors.
• A farmer can’t be sure of the weather next season.
All these people are uncertainty-bearers, and their profit is not fixed—it depends on how
right (or wrong) they are.
Objections to Knight’s Theory
Although brilliant, Knight’s theory isn’t without criticisms. Here are the main objections:
1. Ignores Other Factors of Profit
Critics say:
• Profit may arise from innovation (Schumpeter's view)
• Or monopoly power, capital investment, bargaining, etc.
Knight’s theory focuses only on uncertainty.
2. Overemphasis on Uncertainty
• Some argue that not all uncertain decisions lead to profit.
• Many risky ventures fail completely.
• So, uncertainty alone cannot justify profit—you also need strategy, innovation, and
execution.
3. Neglects Market Structures
• In real markets, profits may be influenced by:
o Government policies
o Market monopoly or oligopoly
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o Brand power
Knight didn’t include these practical aspects.
4. Doesn’t Quantify Uncertainty
• Knight talks philosophically but doesn’t offer a way to measure uncertainty.
• Without measurement, it’s hard to apply the theory in economics or business
modeling.
Still, Why Knight’s Theory Is Valuable
Despite criticisms, Knight’s theory is respected because:
• It highlights the non-routine nature of entrepreneurship.
• It distinguishes entrepreneurial profits from wages, interest, and rent.
• It explains why profits are not guaranteed.
• It lays the foundation for modern entrepreneurship theory.
Summary of Part I: Knight’s Uncertainty Theory
Aspect
Explanation
Introduced by
Frank H. Knight
Year
1921
Main Idea
Profit is a reward for bearing uncertainty
Difference
Risk = measurable (insurable), Uncertainty = unmeasurable (not
insurable)
Role of
Entrepreneur
Decision-making under uncertainty
Objections
Ignores other sources of profit, doesn’t quantify uncertainty
Part II: Loanable Funds Theory of Interest
Let’s Begin with a Thoughtful Scenario
In the same town as Rohan and Kavi, a young woman named Tara ran a startup that made
biodegradable bags. She needed ₹1,00,000 to upgrade her machines. Meanwhile, Ravi, a
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retired teacher, had some savings lying idle. Through a local bank, Tara borrowed Ravi’s
savings and paid him interest.
This is the core of the Loanable Funds Theory of Interest—the idea that interest is the price
paid for borrowing someone’s savings.
What Is the Loanable Funds Theory?
Developed by economists like Knut Wicksell, Dennis Robertson, and others, this theory says:
Rate of interest is determined by the demand and supply of loanable funds.
Components of Loanable Funds
A. Supply of Loanable Funds
Comes from:
• Savings (individuals, firms)
• Dishoarding (money kept idle now brought into use)
• Bank Credit Creation
• Disinvestment (selling old assets to get funds)
B. Demand for Loanable Funds
Comes from:
• Investments (businesses borrowing to invest)
• Government borrowings
• Consumer borrowings (for homes, cars, education)
How Interest Is Determined?
• Just like price is determined by demand and supply, so is interest.
• If demand > supply, interest rate rises.
• If supply > demand, interest rate falls.
The equilibrium interest rate is where:
Supply of loanable funds = Demand for loanable funds
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Diagram Description (Optional for exam)
A simple graph where:
• X-axis = Quantity of Loanable Funds
• Y-axis = Interest Rate
• Supply curve slopes upward (as higher interest encourages saving)
• Demand curve slopes downward (as lower interest encourages borrowing)
• Their intersection gives the equilibrium interest rate.
Criticism of Loanable Funds Theory
1. Overemphasis on Savings
• It assumes more savings = more loanable funds.
• But in poor countries, people don’t save much, yet interest still functions.
• Liquidity preference (Keynes) matters more.
2. Interest Rate Affects Saving—Not the Other Way
• Some critics say interest doesn’t decide saving. People save for future, not just for
higher interest.
3. Neglects Role of Money Supply
• This theory doesn’t fully account for how central banks influence interest through
monetary policy.
4. No Role of Speculation or Psychology
• Ignores human emotions, speculation, expectations, which are covered in Keynesian
theory.
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Final Thoughts and Comparison
Comparing Both Theories
Feature
Knight's Theory
Loanable Funds Theory
Topic
Profit
Interest
Focus
Uncertainty in decision-making
Market of borrowed funds
Main Actor
Entrepreneur
Saver and Investor
Basis
Non-insurable uncertainty
Demand-Supply of funds
Time Frame
Short run
Both short and long run
Criticism
Too abstract
Ignores psychological & monetary aspects
Conclusion: What Do We Learn?
Both Knight’s and the Loanable Funds theories remind us that economics is a study of real
people making real choices under real constraints.
Knight taught us that true entrepreneurship is about boldly facing uncertainty, much like a
farmer betting on the monsoon or a startup investing in a risky product.
The Loanable Funds Theory explained how savings fuel investment, connecting
grandmothers’ piggy banks to national infrastructure projects.
In the end, these theories aren’t just diagrams and definitions—they are stories of decision-
making, risk, trust, and the eternal balance between the present and the future.
“This paper has been carefully prepared for educational purposes. If you notice any mistakes or
have suggestions, feel free to share your feedback.”
