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GNDU Question Paper-2024
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. State and explain all the basic economic problems as caused by scarcity of resources
and unlimited wants. How can they be solved?
2.(a) Define Demand and Supply. How do they help in market price determination?
(b) Explain how the equilibrium of any consumer can be determine with the help of
Indifference Curves approach.
SECTION-B
3. Define production function. Also explain the Laws of returns to scale i detail.
4. Explain in detail all the short run and long run cost curves as per traditional theory of
costs and their mutual relationship.
SECTION-C
5. What are the basic assumptions of perfect competition? How price an output of any
firm and industry can be determined under this market
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6. What are main features of monopoly? What are the reasons for emergence? How any
monopolist is in equilibrium in short period?
SECTION – D
7. Define Rent . Write In detail about Ricardian Theory of rent .
8. Compare and contrast between Classical theory and Loanable Funds theory of interest
GNDU Answer Paper-2024
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. State and explain all the basic economic problems as caused by scarcity of resources
and unlimited wants. How can they be solved?
Ans: Imagine a small village called Econoville. In this village, every person has dreams,
desires, and unlimited wants. Some want more food, some want bigger houses, others want
clothes, toys, or even a small car. But there’s a problem. The resources available in
Econoville — like land, labor, capital, and raw materials — are limited. The villagers cannot
satisfy all their wants at the same time because the resources are scarce. This simple story
of Econoville is a reflection of what every economy faces in the real world.
This situation leads us to the basic economic problems, which arise due to the combination
of unlimited wants and scarcity of resources. Economists call them the fundamental
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economic problems. Let’s explore each of them in detail in a story-like way so you can easily
understand and explain them.
1. What to produce?
In Econoville, the villagers had a meeting. The farmers wanted to grow more wheat, the
carpenters wanted to make more furniture, and the textile workers wanted to produce
more clothes. But there was a problem: there were not enough resources to produce
everything. They had to make a choice.
This is the first economic problem: What to produce?
• Explanation: Since resources like land, labor, and capital are limited, society cannot
produce all goods and services. It has to decide which goods and services should be
produced and in what quantity. Should they produce more food or more luxury
items? Should they invest in healthcare or education? These choices are necessary
because of scarcity.
• Example: If the villagers decide to produce more wheat, they might have less wood
for furniture. If they choose luxury items, basic needs might remain unmet.
• Solution: Economies solve this problem through prioritization. Governments or
markets decide based on the needs of people or profit motives. In some economies,
the government decides what should be produced (like in a planned economy). In
others, the market decides based on demand and supply (like in a capitalist
economy).
2. How to produce?
After deciding what to produce, the villagers faced another dilemma. Should they use
traditional farming methods with more labor and less machinery? Or should they invest in
machines that save labor but require capital?
This is the second economic problem: How to produce?
• Explanation: Scarce resources mean that production methods must be efficient.
Economies need to decide the combination of resources — land, labor, and capital
— to produce goods. Should they use labor-intensive methods (more human effort)
or capital-intensive methods (more machines and technology)?
• Example: Suppose a textile workshop has 10 workers and 2 sewing machines. They
could produce more by using machines efficiently (capital-intensive) or by making
workers work harder (labor-intensive).
• Solution: Economists suggest using the most efficient combination of resources,
which ensures maximum output at minimum cost. In simple terms, do not waste
resources; use them smartly.
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3. For whom to produce?
Once goods are produced, the villagers faced another problem: who will get the goods?
Should the wheat be given to everyone equally, or only to those who can pay? Should
furniture go to the rich villagers or to the ones who need it most?
This is the third economic problem: For whom to produce?
• Explanation: Scarcity forces societies to make choices about distribution. Not
everyone can have everything, so the economy has to decide who gets what. This
involves questions of fairness, income, and purchasing power.
• Example: If the village produces 100 kg of wheat, should it be shared equally among
50 villagers, or should it go more to those who work more or contribute more?
• Solution: The problem is solved in different ways in different economies:
o Market economy: Goods are distributed based on purchasing power; those
who can pay get goods.
o Socialist/planned economy: Goods are distributed based on need, ensuring
everyone gets at least the basic necessities.
o Mixed economy: Combines both market forces and government
interventions.
4. The Problem of Scarcity
All these problems—what, how, and for whom to produce—arise because of scarcity.
Scarcity means that resources are limited, but human wants are unlimited.
• Explanation: Scarcity forces economies to make choices. Every choice involves a
trade-off. If you choose to produce more wheat, you might produce less furniture. If
you spend more money on defense, you might have less for healthcare.
• Example in Econoville: The villagers can only produce 200 units of goods in total. If
they want more food, they must sacrifice other items like clothes or toys. This is
called opportunity cost, which is the value of the next best alternative forgone.
• Diagram: You can draw a Production Possibility Curve (PPC) to show scarcity and
trade-offs.
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• Any point on the curve shows efficient use of resources.
• Points inside the curve indicate underutilization.
• Points outside the curve are unattainable due to scarcity.
5. How to solve these basic economic problems?
Now, let’s see how the villagers of Econoville, and by extension any economy, can solve
these problems:
1. Efficient use of resources: Avoid wastage and use resources where they give the
maximum output. Efficiency is key.
2. Prioritization: Decide what is most important to produce first—basic needs like food,
clothing, and shelter should be prioritized.
3. Use of technology: Modern machines, automation, and innovative methods can
increase productivity and reduce scarcity.
4. Distribution strategies: Create fair ways to share goods, either based on need,
contribution, or market forces, depending on the type of economy.
5. Government intervention: Governments can step in to regulate production and
distribution, especially for essential goods like food, medicine, and education.
6. Market mechanisms: Prices act as signals. High demand increases prices,
encouraging producers to make more. Low demand reduces production.
7. International trade: Scarcity at home can be balanced by trading with other regions
or countries where resources are more abundant.
Conclusion
The story of Econoville teaches us a fundamental lesson: economics is about choices.
Because human wants are endless and resources are limited, every economy—be it a small
village or a large country—faces the same basic problems:
1. What to produce?
2. How to produce?
3. For whom to produce?
These problems are inevitable, but smart decisions, efficient use of resources, fair
distribution, and technology can help solve them. Scarcity may never completely disappear,
but the choices we make can maximize satisfaction and minimize waste.
Think of it like this: life in Econoville is a constant balancing act, where each decision affects
the happiness and wellbeing of the villagers. Economics is simply the science that studies
how to make these choices wisely.
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Diagram suggestion for your answer sheet:
Title: Basic Economic Problems due to Scarcity
Unlimited Wants
|
v
Scarcity of Resources
|
---------------------------------
| | |
What to produce How to produce For whom to produce
This diagram clearly shows that all economic problems stem from scarcity caused by
unlimited human wants.
2.(a) Define Demand and Supply. How do they help in market price determination?
(b) Explain how the equilibrium of any consumer can be determine with the help of
Indifference Curves approach.
Ans: (a) Demand and Supply: Their Role in Market Price Determination
A Fresh Beginning
Picture yourself walking into a bustling vegetable market. Vendors shout prices, buyers
bargain, and goods exchange hands. One stall sells tomatoes at ₹40 per kg, another at ₹50.
Some buyers walk away, others buy happily. After a while, the price seems to settle around
₹45.
What just happened? That “settling” of price is not magic—it is the result of demand and
supply interacting. These two forces are the heartbeat of any market.
Demand: The Buyer’s Side of the Story
Definition: Demand is the quantity of a good or service that consumers are willing and able
to purchase at different prices during a given period of time.
• Law of Demand: Other things being equal, when the price of a good falls, its demand
rises; when the price rises, demand falls.
• Reason: This happens because of substitution effect (cheaper goods replace costlier
ones) and income effect (a fall in price increases real income).
Graphically:
• The demand curve slopes downward from left to right.
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Supply: The Seller’s Side of the Story
Definition: Supply is the quantity of a good or service that producers are willing and able to
offer for sale at different prices during a given period of time.
• Law of Supply: Other things being equal, when the price of a good rises, its supply
increases; when the price falls, supply decreases.
• Reason: Higher prices mean higher profits, so producers are motivated to produce
more.
Graphically:
• The supply curve slopes upward from left to right.
Market Price Determination: Where Demand Meets Supply
Now, let’s put the two together.
• At high prices, demand is low but supply is high → surplus.
• At low prices, demand is high but supply is low → shortage.
• At one particular price, demand equals supply → equilibrium price.
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• E is the equilibrium point where demand (D) and supply (S) intersect.
• The corresponding price is the equilibrium price, and the quantity is the equilibrium
quantity.
Story Example: In our tomato market, when sellers tried to charge ₹50, buyers resisted,
creating unsold stock. When sellers dropped to ₹40, buyers rushed, creating shortages.
Finally, at ₹45, the number of tomatoes buyers wanted equaled the number sellers offered.
That’s equilibrium.
Importance of Demand and Supply in Price Determination
1. Balances the Market: Prevents long-term shortages or surpluses.
2. Signals to Producers: High demand and high prices encourage more production.
3. Signals to Consumers: High prices discourage overconsumption.
4. Dynamic Adjustment: Prices change with shifts in demand (festivals, seasons) or
supply (good harvest, drought).
Thus, demand and supply are like two dancers—sometimes one leads, sometimes the other,
but together they set the rhythm of market prices.
(b) Consumer Equilibrium through Indifference Curve Approach
A Fresh Beginning
Now, let’s leave the noisy market and step into the quiet mind of a consumer. Imagine you
have ₹100 in your pocket. You love chocolates and coffee. How do you decide how much of
each to buy? Too much chocolate leaves you craving coffee; too much coffee leaves you
missing chocolate. Somewhere in between lies your equilibrium—the point where you are
most satisfied.
Economists explain this beautifully through the Indifference Curve Approach, developed by
Hicks and Allen.
Key Concepts Before the Equilibrium
1. Indifference Curve (IC)
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• An indifference curve shows different combinations of two goods that give the
consumer the same level of satisfaction.
• Example: 2 chocolates + 1 coffee = 1 chocolate + 2 coffees (both equally satisfying).
• Properties:
o Slopes downward (if you take less of one good, you need more of the other).
o Convex to the origin (diminishing marginal rate of substitution).
o Higher IC = higher satisfaction.
Diagram:
2. Budget Line (BL)
• The budget line shows all combinations of two goods a consumer can buy with a
given income and prices.
• Equation: PxX + PyY = M
o Px = price of good X
o Py = price of good Y
o M = income
Diagram:
Consumer Equilibrium: Where IC Meets BL
A consumer is in equilibrium when:
1. The budget line is tangent to the highest possible indifference curve.
2. At this point, the slope of IC (MRSxy) = slope of BL (Px/Py).
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Diagram:
At point E, the consumer maximizes satisfaction given income and prices.
• Any point below (on IC1 or IC2) gives less satisfaction.
• Any point above IC3 is unattainable with current income.
Conditions for Consumer Equilibrium
1. MRSxy = Px/Py
o Marginal Rate of Substitution (how much of Y the consumer is willing to give
up for one more unit of X) equals the price ratio.
2. Convexity Condition
o The IC must be convex to the origin, ensuring diminishing MRS.
Story Example
Suppose chocolates cost ₹10 each, coffee costs ₹20 each, and you have ₹100.
• Budget line: 10X + 20Y = 100.
• Possible bundles: (10 chocolates, 0 coffee), (5 chocolates, 2 coffees), etc.
• You try different bundles, but only at the tangency point do you feel perfectly
balanced—not too much chocolate, not too much coffee. That’s your equilibrium.
Why Indifference Curve Approach is Superior
• Unlike older “utility” approaches, it doesn’t require measuring satisfaction in
numbers.
• It focuses on preferences and choices, which are more realistic.
• It explains substitution between goods and the impact of income and price changes.
Bringing It All Together
• Demand and Supply explain how the market as a whole decides prices. They are like
the orchestra of buyers and sellers creating harmony in the marketplace.
• Indifference Curves and Budget Lines explain how an individual consumer decides
what to buy. They are like the inner melody of personal choice and satisfaction.
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Together, they show us that economics is not just about numbers—it’s about human
behavior, balancing desires with resources, and finding equilibrium both in markets and in
minds.
Conclusion
In part (a), we saw how demand and supply interact to determine market price. Demand
pulls downward, supply pushes upward, and equilibrium is the handshake between the two.
In part (b), we stepped into the shoes of a consumer and saw how indifference curves and
budget lines help determine equilibrium—where satisfaction is maximized within income
limits.
So, whether it’s the price of tomatoes in a market or the choice between chocolates and
coffee, economics teaches us that balance—between forces, between desires, between
resources—is the key.
SECTION-B
3. Define production function. Also explain the Laws of returns to scale detail.
Ans: Production Function and Laws of Returns to Scale
Imagine you are an entrepreneur who just opened a small bakery. Every day, you mix flour,
sugar, yeast, and eggs to bake delicious cakes. You hire a few workers to help you, buy
ovens, and invest in better kitchen tools. But soon, you start wondering: “If I hire more
workers or buy more ovens, how much more cake can I produce?”
This is exactly where the concept of production function comes in. Think of a production
function as the recipe of your business. It tells you how inputs – like labor, machinery, land,
or raw materials – are transformed into outputs, which, in your case, are cakes. The
production function is a fundamental concept in economics because it helps business
owners, managers, and economists understand the relationship between what we put into
production and what we get out of it.
Definition of Production Function
In simple terms, a production function is a mathematical or graphical representation that
shows the maximum output that can be produced with a given set of inputs, under the
current state of technology. Formally, economists define it as:
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Here:
• Q = Output (total products produced)
• L = Labor (workers, hours of work)
• K = Capital (machines, tools, ovens in your bakery)
• R = Raw materials (flour, sugar, etc.)
• f = Function showing the relationship between inputs and output
Think of it as a magical machine: you feed in different amounts of labor and capital, and the
machine tells you how much output you can generate. But it’s not always as simple as
doubling inputs to double outputs – this is where the laws of returns to scale come into
play.
Laws of Returns to Scale
Now, imagine that your bakery becomes famous. You decide to expand. You double the
number of bakers, double the ovens, and double the raw materials. Will your output double
too? Or maybe it will more than double, or less than double? The pattern of how output
changes when you scale up all inputs is explained by the laws of returns to scale.
Returns to scale are concerned with the long-run production, where all inputs can be
varied. There are three types:
1. Increasing Returns to Scale (IRS)
2. Constant Returns to Scale (CRS)
3. Decreasing Returns to Scale (DRS)
Let’s explore them one by one.
1. Increasing Returns to Scale (IRS)
Imagine you initially had only two bakers and one oven. You were producing 100 cakes per
day. Now you hire four bakers and buy two more ovens (doubling all inputs). Surprisingly,
your output jumps to 250 cakes instead of just 200. Why?
This is called increasing returns to scale. In simple words, it means that when all inputs are
increased by a certain proportion, output increases by a greater proportion.
Why does this happen?
• Specialization of labor: More bakers can focus on specific tasks – one mixes, one
bakes, one decorates – which improves efficiency.
• Better utilization of machinery: More workers mean ovens and mixers are used
more efficiently.
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• Economies of scale: Bulk purchasing of ingredients and sharing resources lowers
costs per unit.
Mathematical Expression:
If we double all inputs:
f(2L,2K)>2f(L,K)
Diagram for IRS:
The curve shows that output rises faster than the increase in inputs.
2. Constant Returns to Scale (CRS)
As your bakery grows even bigger, you double your bakers and ovens again. This time, your
output doubles exactly – 500 cakes become 1000 cakes. This is constant returns to scale.
Here, output increases in the same proportion as inputs. If you scale inputs by a factor,
output scales by the same factor.
Why does this happen?
• Resources are perfectly balanced.
• Efficiency gains from specialization have been fully realized.
• There are no new economies of scale, and the production system works optimally.
Mathematical Expression:
Diagram for CRS:
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The straight line shows a proportional increase between inputs and output.
3. Decreasing Returns to Scale (DRS)
Finally, imagine your bakery becomes a huge factory with 100 bakers and 50 ovens. You
decide to double all inputs again. But now your output increases by a smaller proportion –
from 10,000 cakes to only 18,000 instead of 20,000. This is decreasing returns to scale.
Here, output increases by a smaller proportion than inputs.
Why does this happen?
• Overcrowding: Too many bakers for the available ovens, leading to inefficiency.
• Management challenges: Coordination and supervision become harder in large
teams.
• Diminishing flexibility: Machinery and space cannot accommodate more inputs
efficiently.
Mathematical Expression:
Diagram for DRS:
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The curve flattens, showing that output grows slower than input increase.
Key Points About Returns to Scale
1. Returns to scale deal with long-run production, where all inputs are variable.
2. They are different from returns to a factor, which examines changes in output when
only one input changes while others remain fixed.
3. Firms usually experience increasing returns initially, constant returns at medium
scale, and decreasing returns at very large scale.
4. Understanding returns to scale helps managers decide optimal size of production,
expansion strategies, and resource allocation.
Connecting Production Function and Returns to Scale: A Story Perspective
Think of your bakery again. In the beginning, you were a small team of two. By trial and
error, you learned the recipe, optimized tasks, and experimented with combining workers
and machines. When you increased your inputs a little, production skyrocketed – this was
your increasing returns phase.
As your bakery reached medium size, every new worker and oven contributed
proportionally – constant returns phase. You were operating efficiently, and the bakery ran
like a well-oiled machine.
Eventually, when your bakery became enormous, adding more workers and ovens didn’t
help as much. Bakers had to wait for ovens, ingredients piled up, and chaos in coordination
began – decreasing returns phase.
In real life, most businesses experience all three stages at different production levels.
Knowing these helps a manager plan growth, invest wisely, and maintain efficiency.
Conclusion
The production function is the heart of any business’s production process. It tells us how
inputs like labor, capital, and raw materials combine to produce output. The laws of returns
to scale explain what happens when all inputs are increased:
• Increasing returns to scale: output grows faster than inputs.
• Constant returns to scale: output grows proportionally to inputs.
• Decreasing returns to scale: output grows slower than inputs.
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These concepts are essential for understanding business growth, efficiency, and resource
optimization. Just like in a bakery, knowing how scaling up affects output can help
businesses expand intelligently and avoid unnecessary waste or inefficiency.
4. Explain in detail all the short run and long run cost curves as per traditional theory of
costs and their mutual relationship.
Ans: Short-Run and Long-Run Cost Curves in Traditional Theory of Costs
A Fresh Beginning
Suppose you start a bakery. On day one, you’ve already rented a shop, bought ovens, and
hired a few permanent staff. These are your fixed commitments—you can’t change them
immediately. But you can still vary how much flour you buy, how many temporary helpers
you hire, or how many cakes you bake. This situation—where some inputs are fixed and
others are variable—is what economists call the short run.
Now imagine five years later. You can move to a bigger shop, buy more ovens, or even shift
to a new city. Here, nothing is fixed—you can change all inputs. This is the long run.
The traditional theory of costs studies how your expenses behave in these two time frames.
Let’s explore the curves one by one.
Short-Run Cost Curves
In the short run, at least one factor (like plant size or machinery) is fixed. Costs are divided
into fixed costs and variable costs.
1. Total Fixed Cost (TFC)
• These are costs that do not change with output.
• Examples: rent of the bakery, salaries of permanent staff, depreciation of ovens.
• Graph: A horizontal line parallel to the X-axis (output axis).
2. Total Variable Cost (TVC)
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• These change with output.
• Examples: flour, sugar, electricity, wages of temporary helpers.
• Initially rises slowly (due to increasing returns), then steeply (due to diminishing
returns).
• Graph: An S-shaped curve starting from the origin.
3. Total Cost (TC)
• TC = TFC + TVC.
• Graphically, it is the TVC curve shifted upward by the amount of TFC.
4. Average Fixed Cost (AFC)
• AFC = TFC / Q.
• As output increases, AFC falls continuously (spreading overhead effect).
• Graph: A rectangular hyperbola.
5. Average Variable Cost (AVC)
• AVC = TVC / Q.
• Initially falls due to better utilization of variable inputs, then rises due to diminishing
returns.
• Graph: U-shaped.
6. Average Total Cost (ATC or AC)
• AC = TC / Q = AFC + AVC.
• Also U-shaped, but lies above AVC.
• The gap between AC and AVC narrows as output increases (because AFC keeps
falling).
7. Marginal Cost (MC)
• MC = ΔTC / ΔQ.
• It is the cost of producing one more unit.
• Graph: U-shaped, cutting AVC and AC at their minimum points.
Relationship Among Short-Run Curves
• MC pulls AVC and AC down when it is below them, and pushes them up when it is
above them.
• AFC always declines, so the distance between AC and AVC shrinks with output.
• All short-run curves reflect the law of variable proportions: initially increasing
returns, then diminishing returns.
Long-Run Cost Curves
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In the long run, all factors are variable. There are no fixed costs. Firms can choose the most
efficient plant size for any level of output.
1. Long-Run Total Cost (LRTC)
• Shows the least cost of producing different levels of output when all inputs are
variable.
• Derived from the envelope of short-run total cost curves.
2. Long-Run Average Cost (LRAC)
• LRAC = LRTC / Q.
• It is also called the envelope curve because it is drawn as a smooth curve tangent to
various short-run average cost (SRAC) curves.
• Shape: U-shaped, but flatter than SRAC.
Why U-shaped?
• Economies of Scale: As output increases, specialization, bulk buying, and better
technology reduce costs.
• Constant Returns to Scale: Costs remain stable at some range.
• Diseconomies of Scale: Beyond a point, management inefficiencies and coordination
problems raise costs.
3. Long-Run Marginal Cost (LRMC)
• LRMC = ΔLRTC / ΔQ.
• It cuts LRAC at its minimum point, just like in the short run.
Diagram of LRAC and SRAC
Each SRAC represents a plant size.
• LRAC is tangent to all SRACs, showing the least cost for each output.
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Mutual Relationship Between Short-Run and Long-Run Cost Curves
1. Envelope Relationship
o LRAC is the envelope of all SRACs.
o At low output, a small plant (SRAC1) is cheapest.
o At medium output, a medium plant (SRAC2) is cheapest.
o At high output, a large plant (SRAC3) is cheapest.
2. Flexibility
o In the short run, the firm is “stuck” with a given plant size, so costs may be
higher.
o In the long run, the firm can adjust plant size, so costs are minimized.
3. Shape Difference
o SRAC curves are more sharply U-shaped due to the law of variable
proportions.
o LRAC is flatter because it reflects economies and diseconomies of scale.
4. Marginal Cost Relationship
o In both short and long run, MC curves intersect AC curves at their minimum
points.
o This shows the universal principle: when marginal is below average, it pulls
average down; when above, it pushes average up.
Story-Like Example
Think again of your bakery:
• In the short run, you have one oven. If demand rises, you can hire more helpers and
buy more flour, but after a point, the oven becomes overcrowded, and costs rise
steeply. That’s your SRAC.
• In the long run, you can buy a second oven or move to a bigger shop. Now you can
produce more at lower average cost. That’s your LRAC.
• If demand keeps rising, you may open a factory with ten ovens. But managing so
many workers may create inefficiencies, raising costs again. That’s the upward slope
of LRAC.
Conclusion
The traditional theory of costs gives us a clear picture of how firms behave in the short run
and long run.
• In the short run, costs are shaped by fixed commitments and the law of variable
proportions, giving us TFC, TVC, TC, AFC, AVC, AC, and MC curves.
• In the long run, all inputs are variable, and costs are shaped by economies and
diseconomies of scale, giving us LRAC and LRMC.
• The mutual relationship is that LRAC is the envelope of SRACs, showing the least
cost for each level of output.
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In simple words: the short run is about making the best of what you have, while the long run
is about choosing the best possible setup. Together, these curves tell the story of how firms
balance resources, technology, and scale to minimize costs and maximize efficiency.
SECTION-C
5. What are the basic assumptions of perfect competition? How price an output of any
firm and industry can be determined under this market
Ans: Perfect Competition: Assumptions and Price-Output Determination
A Fresh Beginning
Imagine you are walking into a huge farmer’s market on a Sunday morning. Everywhere you
look, there are dozens of stalls selling the same fresh tomatoes. The tomatoes look
identical—red, juicy, and fresh. Buyers move from one stall to another, but no seller dares
to charge even ₹1 more than the others, because buyers will simply walk away to the next
stall. Sellers, too, cannot lower prices much, because they know the market price is already
fixed by the overall demand and supply of tomatoes.
This is the essence of perfect competition—a market where no single buyer or seller has the
power to influence price. Everyone is a “price taker,” and the market itself decides the price.
Basic Assumptions of Perfect Competition
Economists describe perfect competition as an “ideal” market structure. It rarely exists in
reality, but it helps us understand how markets work in theory. The key assumptions are:
1. Large Number of Buyers and Sellers
• There are so many buyers and sellers that no single participant can influence the
market price.
• Each seller contributes only a tiny fraction of total supply, and each buyer demands
only a small fraction of total demand.
2. Homogeneous Product
• All firms sell identical products—same quality, same features.
• For example, wheat, rice, or tomatoes in a farmer’s market.
• Because products are identical, buyers don’t prefer one seller over another.
3. Free Entry and Exit of Firms
• Firms can freely enter the market if they see profits.
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• They can also exit if they face losses.
• This ensures that in the long run, firms earn only normal profits (no abnormal profits
or losses).
4. Perfect Knowledge
• Buyers and sellers have complete knowledge of prices and market conditions.
• No seller can charge more, and no buyer can be cheated.
5. Perfect Mobility of Factors
• Factors of production (land, labor, capital) can move freely from one use to another.
• This ensures resources are allocated efficiently.
6. Absence of Transportation Costs
• It is assumed that transportation costs are zero, so price differences due to location
do not exist.
7. Firms are Price Takers
• Since no firm can influence the market price, each firm accepts the price determined
by the industry.
8. Perfect Competition in the Long Run
• In the long run, abnormal profits attract new firms, and losses drive firms out.
• This process ensures that only normal profits remain.
Price and Output Determination under Perfect Competition
Now that we know the assumptions, let’s see how price and output are determined.
1. Industry Equilibrium (Market Level)
The industry means all firms together. Price is determined by the interaction of market
demand and market supply.
• Market Demand: The total quantity buyers are willing to purchase at different
prices.
• Market Supply: The total quantity sellers are willing to sell at different prices.
The equilibrium price is where demand equals supply.
Diagram (Industry Equilibrium):
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• D = Demand curve (downward sloping).
• S = Supply curve (upward sloping).
• E = Equilibrium point where demand = supply.
• Price at E = Equilibrium Price.
• Quantity at E = Equilibrium Quantity.
2. Firm Equilibrium (Individual Seller)
Now let’s zoom into one seller’s stall in the market. Since the firm is a price taker, it cannot
set its own price. It must sell at the market price determined by the industry.
• The firm’s demand curve is perfectly elastic (horizontal line) at the market price.
• This means the firm can sell any quantity at that price, but nothing at a higher price.
Diagram (Firm Equilibrium):
AR (Average Revenue) = MR (Marginal Revenue) = Price (horizontal line).
• The firm’s MC (Marginal Cost) curve is U-shaped.
• The firm is in equilibrium where MC = MR.
• This is the profit-maximizing output.
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Short-Run Equilibrium of a Firm
In the short run, a firm may earn:
1. Supernormal Profits: If price > AC.
2. Normal Profits: If price = AC.
3. Losses: If price < AC (but firm may continue if price ≥ AVC).
Diagram (Supernormal Profits):
The shaded rectangle between Price and AC shows supernormal profits.
Long-Run Equilibrium of a Firm
In the long run, free entry and exit of firms ensure that only normal profits remain.
• If firms earn supernormal profits, new firms enter → supply increases → price falls.
• If firms incur losses, some exit → supply decreases → price rises.
• Finally, price settles where P = MC = AC, and firms earn only normal profits.
Diagram (Long-Run Equilibrium):
Here, the firm produces at the minimum point of AC, earning normal profits.
Industry vs Firm: A Quick Comparison
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• Industry: Determines price by demand and supply.
• Firm: Accepts that price and adjusts output where MC = MR.
Story-Like Example
Think again of the tomato market:
• The industry (all sellers together) sets the price at ₹45 per kg, where total demand
equals total supply.
• Your stall (the firm) cannot change this price. If you try to charge ₹50, buyers will
leave. If you charge ₹40, you’ll lose money unnecessarily.
• So you sell at ₹45, and you decide how many kilos to sell by comparing your costs. If
your cost of producing the last kilo is less than ₹45, you produce more. If it is more,
you stop. That’s equilibrium.
Conclusion
Perfect competition may be rare in the real world, but it gives us a clear framework to
understand how markets work.
• Its assumptions—large number of buyers and sellers, homogeneous products, free
entry and exit, perfect knowledge, and price-taking behavior—create a world of
fairness and efficiency.
• Price and output determination happens in two steps: the industry sets the price
through demand and supply, and the firm accepts that price and chooses output
where MC = MR.
• In the short run, firms may earn profits or losses, but in the long run, only normal
profits remain.
So, the next time you walk into a farmer’s market and see identical stalls selling at the same
price, remember—you are witnessing a glimpse of perfect competition in action.
6. What are main features of monopoly? What are the reasons for emergence? How any
monopolist is in equilibrium in short period?
Ans: Imagine you are walking in a town, and suddenly you notice that there is only one
bakery in the entire town. This bakery is the only place where you can buy bread. No other
bakeries exist, and no one else is allowed to open one because of strict town rules. The
baker controls the price, quantity, and even decides which type of bread to sell. This
situation is a perfect example of monopoly in economics.
What is Monopoly?
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In economics, a monopoly is a market structure in which there is only one seller of a
product or service, and there are no close substitutes. This single seller has significant
control over the market, including prices, supply, and sometimes the quality of the product.
The term “monopoly” comes from the Greek words “mono” meaning single and “polein”
meaning to sell — so it literally means “single seller.”
Main Features of Monopoly
To understand monopoly more clearly, let’s list its main characteristics:
1. Single Seller:
Just like the only bakery in town, a monopoly market has only one seller who
controls the entire supply of a product. There are no competitors in this market.
2. Unique Product:
The product sold by a monopolist has no close substitutes. If it’s bread from our
bakery, the town residents cannot get a similar type of bread elsewhere.
3. Price Maker:
Unlike in a competitive market where prices are determined by supply and demand,
a monopolist decides the price. They can charge higher or lower prices depending on
the demand. Essentially, they have market power.
4. Barriers to Entry:
Monopoly exists because new firms cannot enter the market. There may be legal
restrictions, high costs, or control over essential resources. For instance, in our
bakery example, the town authorities might have restricted others from opening
bakeries.
5. Control over Supply:
The monopolist can adjust the quantity of goods produced to maximize profit. If they
produce less, prices rise. If they produce more, prices fall.
6. Profit Maximization:
A monopolist is always focused on maximizing profit, whether in the short run or
long run. They calculate costs, revenue, and demand to find the best point for profit.
7. Absence of Competition:
Since there is no competition, the monopolist may have less incentive to innovate or
improve the product. The consumer has no choice but to buy from them.
Reasons for the Emergence of Monopoly
Now you might wonder: Why do monopolies exist? Why is there only one seller in some
markets? Let’s explore the main reasons:
1. Legal Barriers:
The government sometimes grants exclusive rights to a single firm. For example, the
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postal service in many countries is a monopoly because the government wants to
control it.
2. Control over Resources:
If a firm controls a critical resource, no one else can produce the product. For
instance, if a company owns all diamond mines in a country, it automatically
becomes a monopoly.
3. High Capital Requirements:
Some industries, like steel production or aircraft manufacturing, require huge
investments. This discourages new firms from entering, creating a monopoly.
4. Economies of Scale:
When producing at a large scale, the cost per unit decreases. A big firm can
dominate the market because small firms cannot compete with the low cost and
high efficiency.
5. Technological Superiority:
A firm may have unique technology or patents that prevent others from entering
the market. Think of pharmaceutical companies that hold patents for life-saving
drugs.
6. Natural Monopoly:
Sometimes, it’s more efficient for a single firm to serve the entire market, especially
in utilities like electricity or water supply. Here, the monopoly arises naturally.
7. Strategic Actions:
Firms may deliberately eliminate competition through aggressive pricing or
exclusive deals with suppliers. Over time, this creates monopoly power.
Short-Run Equilibrium of a Monopolist
Now that we understand what monopoly is and why it exists, let’s see how a monopolist
decides the quantity to produce and the price to charge in the short run. To make it simple,
let’s imagine our bakery again.
• The baker wants to maximize profit.
• Profit is the difference between total revenue (TR) and total cost (TC).
Step 1: Understanding Revenue
1. Total Revenue (TR):
TR = Price × Quantity sold
If the baker sells 10 loaves at ₹50 each, TR = 10 × 50 = ₹500.
2. Marginal Revenue (MR):
MR is the extra revenue gained by selling one more unit. In monopoly, MR is always
less than price because to sell more, the monopolist must lower the price for all
units.
Step 2: Understanding Costs
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1. Total Cost (TC):
Includes costs like flour, labor, electricity, rent, etc.
2. Marginal Cost (MC):
MC is the extra cost of producing one additional loaf of bread.
Step 3: Profit Maximization Rule
The monopolist maximizes profit where:
MR=MCMR = MCMR=MC
• If MR > MC → produce more (profit increases)
• If MR < MC → produce less (profit decreases)
Once MR = MC, the monopolist finds the optimal quantity to produce. Then, using the
demand curve, they determine the highest price consumers are willing to pay for that
quantity.
Step 4: Short-Run Equilibrium Diagram
Here’s a simple diagram to visualize it:
Explanation of the diagram:
• The downward sloping demand curve (D) shows that higher prices reduce quantity
demanded.
• The MR curve lies below the demand curve.
• The intersection of MR and MC gives the profit-maximizing quantity (Q*).
• Price (P*) is found on the demand curve corresponding to Q*.
At this point, the monopolist earns maximum possible profit in the short run.
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Short-Run Possibilities for a Monopolist
1. Supernormal Profit:
If TR > TC, the monopolist earns extra profit. This often happens in markets with high
demand or low competition.
2. Normal Profit:
If TR = TC, the firm earns just enough to cover costs. The monopolist is surviving but
not earning extra.
3. Loss:
If TR < TC, the monopolist incurs a loss. In short run, they may continue producing if
they can cover variable costs, hoping conditions improve later.
Human Story to Remember Monopoly
Think of monopoly like a king ruling a small kingdom:
• The king (monopolist) is the only source of bread (product).
• He can decide the price, control supply, and maximize wealth.
• Villagers (consumers) have no choice but to buy from him.
• New bakers can’t enter because the king guards resources, money, and laws.
The story helps you remember: Monopoly = Single seller + Price maker + Barriers to entry +
Profit focus.
Conclusion
Monopoly is a fascinating market structure where one seller dominates the market. Its
main features include a single seller, unique product, price-making ability, high barriers to
entry, and profit-maximizing behavior. Monopolies emerge due to legal barriers, control of
resources, high costs, economies of scale, patents, natural monopoly, or strategic actions.
In the short run, a monopolist reaches equilibrium where MR = MC, deciding both price and
quantity to maximize profit.
By imagining the bakery or king analogy, this concept becomes easy to visualize and
remember, making it simple for any student to understand and enjoyable for an examiner
to read.
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SECTION – D
7. Define Rent . Write In detail about Ricardian Theory of rent .
Ans: Imagine yourself walking through a village, where farmers are working on different
pieces of land. Some lands are naturally fertile, others less so, and some barely grow
anything. As you watch, a question pops up in your mind: Why does the owner of a fertile
plot of land get more income than someone who owns less fertile land, even though all are
working equally hard?
This is where the concept of rent comes into play. Let’s understand it step by step.
Definition of Rent
In economics, rent is the income earned by the owner of a piece of land simply because
they own it. It’s important to note that rent arises not because the owner does something
extra, but because the land itself has special qualities—like fertility, location, or scarcity.
In simpler words:
Rent is the payment made for the use of land or other natural resources.
Here, “land” doesn’t just mean soil; it includes all natural resources that are fixed in supply.
Rent is different from wages or profits because it doesn’t depend on effort or investment—
just on owning the land.
Historical Context: David Ricardo and Rent
Now, let’s travel back in time to the early 19th century. Imagine a smart economist named
David Ricardo, who loved observing farms, lands, and agriculture. He was curious: Why does
one farmer pay more for land than another, even when both are producing crops?
After careful observation, Ricardo developed his famous Ricardian Theory of Rent, which
explains how rent arises naturally due to differences in land fertility. His theory became one
of the cornerstone ideas in classical economics.
Ricardian Theory of Rent Explained
Ricardo’s theory is based on a simple, relatable story. Let’s break it into digestible points:
1. All Land is Not Equal
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Think of three pieces of land:
• Land A: Highly fertile, produces 100 quintals of wheat per year.
• Land B: Medium fertile, produces 80 quintals.
• Land C: Less fertile, produces 60 quintals.
All farmers have the same tools, labor, and seeds. The difference in output comes solely
from the fertility of the land.
Ricardo observed that farmers using less fertile land will still produce less, but they must pay
rent if more fertile land is available.
2. Rent Depends on Productivity Differences
Rent arises not because of effort, but because of differences in productivity.
• Land C, the least fertile, may yield just enough for the farmer to cover costs of labor
and seed. In Ricardo’s terms, it is the marginal land—land that just covers the cost of
production without generating any rent.
• Land B produces more than Land C. The extra production (20 quintals) is the rent of
Land B.
• Land A produces even more. The extra production (40 quintals above Land C) is the
rent of Land A.
In short, rent is the surplus of produce earned by the more fertile land over the marginal
land.
3. Key Assumptions of Ricardo’s Theory
Ricardo built his theory on some clear assumptions:
1. Fixed supply of land: The total land available cannot be increased.
2. Different fertility of land: Lands are not equally productive.
3. Cultivation of marginal land: Rent is measured relative to the least fertile land in
use.
4. Uniformity of capital and labor: The same effort and investment produce different
outputs due to land quality alone.
5. Rent does not determine price: Price of agricultural produce is determined by the
cost of production on marginal land (the least fertile land).
4. How Rent is Determined
Let’s continue with our story:
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Suppose the market price of wheat is fixed. Farmer on Land C barely covers costs—so no
rent is paid. Farmers on Land A and B produce more than this minimum requirement. This
extra produce represents rent.
Mathematically:
Rent = Produce of Fertile Land – Produce of Marginal Land
Example:
Land
Output (quintals)
Output of Marginal Land
Rent (quintals)
A
100
60
40
B
80
60
20
C
60
60
0
This simple table shows how differences in productivity create rent naturally.
5. Price of Agricultural Produce and Rent
Ricardo emphasized that rent is a result of price, not a cause.
• Price of wheat is determined by production on marginal land (Land C).
• Fertile lands earn rent as a surplus over the cost of production of marginal land.
This is a subtle but important point: owners of fertile land earn more because society values
the produce, not because the landowner is working harder.
Graphical Representation of Ricardian Rent
A diagram helps make Ricardo’s theory crystal clear:
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• X-axis: Different lands (from marginal to fertile)
• Y-axis: Output produced
• The vertical difference between marginal land and other lands = Rent
This simple diagram shows how rent increases with fertility. Land C has no rent, Land B
earns a moderate rent, and Land A earns the highest rent.
6. Importance of Ricardian Theory of Rent
Ricardo’s theory is more than just a farm story—it has far-reaching implications:
1. Explains distribution of income: Rent is a key factor in understanding why landlords
earn more than laborers, even if effort is equal.
2. Policy implications: Governments can design land taxes based on surplus rent.
3. Foundation for modern economics: Concepts like economic rent, differential rent,
and land taxation are built on Ricardo’s ideas.
4. Helps in understanding agricultural prices: Shows why price depends on production
costs of marginal land.
7. Criticisms of Ricardian Theory
No theory is perfect. Ricardo’s theory faced some criticisms:
1. Ignores intensive cultivation: Modern agriculture can increase output per acre
through better technology.
2. Assumes fixed supply of land: In reality, new lands may be reclaimed for cultivation.
3. Focuses only on agriculture: Doesn’t explain rent in urban land or commercial real
estate.
4. Neglects role of capital and labor differences: Ricardo assumed they are uniform,
which is rarely true.
Despite these limitations, Ricardian theory remains a classic, especially for understanding
differential rent due to natural fertility.
8. Real-Life Example
Think about city real estate today:
• A shop in a busy market (prime location) earns higher rent than a shop in a remote
area.
• The difference in rent is location advantage, just like Ricardo’s fertile vs. less fertile
land.
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This shows how the basic idea of differential rent still applies, even outside agriculture.
Conclusion
To sum up the story:
• Rent arises because land is not equally productive.
• Marginal land sets the baseline cost of production.
• Fertile or prime lands earn surplus output as rent.
• Ricardo’s theory explains rent as a natural outcome of differences in land fertility,
not effort or investment.
By looking at it as a story of farmers, lands, and surplus produce, we can see how economic
principles emerge from simple real-life observations. Ricardo showed the world that
something as simple as land fertility can shape income distribution, prices, and even policy
decisions.
8. Compare and contrast between Classical theory and Loanable Funds theory of interest
Ans: Classical Theory vs Loanable Funds Theory of Interest
A Fresh Beginning
Imagine a village where people save grain after harvest. Some farmers have surplus grain,
while others need extra to sow seeds for the next season. The ones with surplus lend it to
those in need, and in return, they get a reward—say, a little extra grain after the harvest.
That extra reward is what we call interest.
Now, the big question is: how is the rate of interest (how much extra) decided? Economists
have debated this for centuries. Two major explanations emerged: the Classical Theory and
the Loanable Funds Theory. Let’s explore them step by step.
The Classical Theory of Interest
The Classical Theory, developed by economists like Ricardo, Marshall, and Pigou, is often
called the real theory of interest.
Core Idea
• Interest is the reward for saving and the cost of using capital.
• The rate of interest is determined by the demand for capital (investment) and the
supply of capital (savings).
Demand for Capital
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• Entrepreneurs demand capital to invest in machines, tools, and production.
• The demand depends on the marginal productivity of capital—the extra output
produced by one more unit of capital.
• As interest rates fall, more investments become profitable, so demand for capital
rises.
• Thus, demand for capital is a downward-sloping curve.
Supply of Capital
• Supply comes from people’s savings.
• The higher the interest rate, the more people are willing to save (since they get a
better reward).
• Thus, supply of capital is an upward-sloping curve.
Equilibrium
• The intersection of demand and supply determines the equilibrium rate of interest.
Diagram (Classical Theory):
At point E, demand for capital = supply of savings → equilibrium interest rate.
Assumptions of Classical Theory
1. Full employment of resources.
2. Money is only a medium of exchange (neutral).
3. Savings depend only on interest rate.
4. Investment depends only on interest rate.
Limitations of Classical Theory
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• It ignores the role of money and banks.
• It assumes full employment, which is unrealistic.
• It treats saving as only a function of interest, ignoring income levels.
• It cannot explain short-term fluctuations in interest rates.
The Loanable Funds Theory of Interest
The Loanable Funds Theory, developed by economists like Knut Wicksell, Ohlin, and
Robertson, is a broader and more realistic theory.
Core Idea
• Interest is the price of loanable funds.
• The rate of interest is determined by the demand for loanable funds and the supply
of loanable funds.
Demand for Loanable Funds
Demand comes from three sources:
1. Investment (I): Entrepreneurs borrow to invest in capital goods.
2. Hoarding (H): Some people demand money to hold as idle cash.
3. Dissaving (DS): People who spend more than their income borrow funds.
Thus, demand for loanable funds = I + H + DS.
Supply of Loanable Funds
Supply comes from four sources:
1. Savings (S): Households save part of their income.
2. Dishoarding (DH): People release previously hoarded money.
3. Disinvestment (DI): Selling old assets provides funds.
4. Bank Credit (BC): Banks create credit and supply funds.
Thus, supply of loanable funds = S + DH + DI + BC.
Equilibrium
• The rate of interest is determined where demand for loanable funds = supply of
loanable funds.
Diagram (Loanable Funds Theory):
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At point E, demand = supply → equilibrium interest rate.
Why Loanable Funds Theory is Superior
• It includes both real factors (savings, investment) and monetary factors (bank credit,
hoarding).
• It explains how monetary policy, government borrowing, and banking affect interest
rates.
• It is more realistic because it recognizes that savings depend not only on interest but
also on income.
Comparison Between Classical Theory and Loanable Funds Theory
Aspect
Classical Theory
Loanable Funds Theory
Nature
Real theory (focus on savings &
investment)
Real + monetary theory (includes
banks, hoarding, credit)
Interest
Defined As
Reward for saving, cost of capital
Price of loanable funds
Demand Side
Investment demand (based on
marginal productivity of capital)
Investment + hoarding + dissaving
Supply Side
Savings only
Savings + dishoarding +
disinvestment + bank credit
Role of Money
Ignored (money is neutral)
Important (credit creation,
hoarding, dishoarding)
Assumptions
Full employment, savings
depend only on interest
No full employment assumption,
savings depend on income &
interest
Scope
Narrow, less realistic
Broader, more realistic
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Equilibrium
Where savings = investment
Where demand for loanable funds =
supply of loanable funds
Story-Like Illustration
Think again of our village:
• In the Classical view, interest is decided only by how much grain people save and
how much others want to borrow for sowing. Money is just a veil.
• In the Loanable Funds view, the picture is richer. Not only do savers and borrowers
matter, but also:
o Some villagers hoard grain in secret pits (hoarding).
o Some release old stock (dishoarding).
o Some sell old tools to get grain (disinvestment).
o And the village bank lends extra grain by issuing credit notes (bank credit).
Clearly, the second story feels closer to reality.
Conclusion
The Classical Theory of interest was a pioneering attempt to explain interest as the
balancing point between savings and investment. But it was too narrow, ignoring money,
banks, and hoarding. The Loanable Funds Theory improved upon it by including both real
and monetary factors, making it more comprehensive and realistic.
In simple words:
• Classical Theory = a world of savers and investors only.
• Loanable Funds Theory = a world of savers, investors, hoarders, dishoarders, banks,
and governments—all influencing interest rates.
That’s why modern economists regard the Loanable Funds Theory as a more accurate
explanation of how interest rates are determined in real economies.
“This paper has been carefully prepared for educational purposes. If you notice any mistakes or
have suggestions, feel free to share your feedback.”
