Business Economics Questions and Answers

Answer: A

The demand curve slopes downward because of diminishing marginal utility.

As a consumer buys more units of a good, each additional unit gives less satisfaction than the one before. A consumer will therefore buy more only if the price falls, so that price matches the lower marginal utility. This produces the inverse relation between price and quantity demanded, together with the income and substitution effects of a price change.

Increasing marginal or average utility would make the curve slope the other way, and total utility on its own does not explain the slope.

Answer: A

The correct formula is Total Cost = Total Fixed Cost + Total Variable Cost.

Fixed costs, such as rent and salaries, do not change with output in the short run, while variable costs, such as raw materials and power, rise with output. Total cost at any level of output is the sum of the two:

\[ TC = TFC + TVC \]

Dividing, multiplying or subtracting the two components does not give total cost. Subtraction would give TFC - TVC, which can even be negative.

Answer: A

Marginal cost can be written as \(\Delta\) Total Cost / \(\Delta\) Quantity.

Marginal cost is the addition to total cost from producing one more unit of output, so it is the change in total cost divided by the change in quantity:

\[ MC = \frac{\Delta TC}{\Delta Q} \]

Since fixed cost does not change with output, MC also equals the change in total variable cost per unit. Multiplying the changes, or dividing quantity by a change in fixed or average cost, does not give the cost of an extra unit.

Answer: A

The correct matching is a-(ii), b-(i), c-(iv), d-(iii).

• Monopoly: a single seller facing many buyers (ii).
• Oligopoly: a few sellers serving many buyers (i).
• Perfect competition: many sellers of an identical product (iv).
• Monopolistic competition: many sellers of differentiated products (iii).

The other codes give the identical product to monopolistic competition or the single seller to oligopoly.

Answer: C

The outcomes are similar because in both firms will only earn a normal profit.

In both market structures entry and exit are free. If firms earn supernormal profits, new firms enter until the profits are competed away; if they make losses, firms leave. So in the long run price equals average cost and every firm earns only normal profit.

The structures differ in the other respects. Under monopolistic competition the demand curve slopes downward, so the firm produces below the output of minimum average cost, with excess capacity; output is not the efficient level, and economies of scale are not fully realised.

Answer: B

Marginal cost pricing is recommended to achieve economic efficiency.

When price equals marginal cost, consumers pay exactly the cost to society of producing one more unit, so output is expanded to the point where the value of the last unit to buyers equals its cost. This gives allocative efficiency, which is why it is suggested for public and non-profit enterprises.

It is not aimed at maximum profit or normal profit; where average cost is falling, marginal cost pricing can even cause losses that need a subsidy. Minimising losses is not its purpose.

Answer: C

When average cost is declining, marginal cost must be below average cost. Average cost falls only when the extra unit costs less than the average of the units already produced, because adding a cheaper unit pulls the average down.

If marginal cost were above average cost, the average would be pulled up. Marginal cost may well be rising while average cost is still falling, as long as it remains below the average, so it need not be declining either. Marginal cost cuts average cost at the minimum point of the average cost curve, where the two are equal.

Answer: C

The kinked demand curve is related to oligopoly. Paul Sweezy explained that when a firm in an oligopoly raises its price, rivals do not follow, so demand is elastic above the kink. When it cuts the price, rivals match it, so demand below the kink is inelastic, which keeps prices rigid.

Monopoly and discriminating monopoly have a single seller with a downward sloping curve and no kink. Under perfect competition the firm's demand curve is horizontal. The kinked shape arises only from interdependent behaviour in oligopoly.

Answer: D

Elasticity of demand is highly elastic. Price elasticity is the percentage change in quantity demanded divided by the percentage change in price.

A value greater than 1 means demand is elastic, and a value as large as 2 is described as highly elastic here. It is not perfectly elastic, which means infinite elasticity, nor perfectly inelastic, which is zero, nor unit elastic, which would need a 20 per cent rise in quantity for a 20 per cent fall in price.

Answer: A

The key is that for inferior goods the income effect is negative while the substitution effect is positive, in the sign convention where an effect is measured by the change in quantity demanded when the price falls. A fall in price raises real income, and for an inferior good that extra income reduces the quantity bought, so the income effect is negative. The substitution effect pushes the quantity up, since the good is now relatively cheaper.

The other options either give both effects the same sign, which would be the case of a normal good, or reverse the signs, which is a different convention. The net result is positive unless the good is a Giffen good, where the negative income effect outweighs the substitution effect.