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Q1. What is the Economic Problem?
The economic problem, sometimes called the basic, central or fundamental
economic problem, is one of the fundamental economic theories in the operation
of any economy. It asserts that there is scarcity, or that the finite resources
available are insufficient to satisfy all human wants and needs. The problem then
becomes how to determine what is to be produced and how the factors of
production (such as capital and labor) are to be allocated. Economics revolves
around methods and possibilities of solving the economic problem.
Economic problem arises mainly due to two reasons- (i) human wants are
unlimited (ii) means to satisfy human wants are scarce.
Q2. What are the factors of production?
An economic term to describe the inputs that are used in the production of goods
or services in the attempt to make an economic profit. The factors of production
include land, labor, capital and entrepreneurship. In essence, land, labor, capital
and entrepreneurship encompass all of the inputs needed to produce a good or
service. Land represents all natural resources, such as timber and gold, used in
the production of a good. Labor is all of the work that laborers and workers
perform at all levels of an organization, except for the entrepreneur. The
entrepreneur is the individual who takes an idea and attempts to make an
economic profit from it by combining all other factors of production. The
entrepreneur also takes on all of the risks and rewards of the business. The capital
is all of the tools and machinery used to produce a good or service.
In a command economic system or planned economy, the government controls
the economy. The state decides how to use and distribute resources. The
government regulates prices and wages; it may even determine what sorts of
work individuals do. Socialism is a type of command economic system.
Historically, the government has assumed varying degrees of control over the
economy in socialist countries. In some, only major industries have been
subjected to government management; in others, the government has exercised
far more extensive control over the economy.
The classic (failed) example of a command economy was the communist Soviet
Union. The collapse of the communist bloc in the late 1980s led to the demise of
many command economies around the world; Cuba continues to hold on to its
planned economy even today.
In market economies, economic decisions are made by individuals. The
unfettered interaction of individuals and companies in the marketplace
determines how resources are allocated and goods are distributed. Individuals
choose how to invest their personal resources—what training to pursue, what
jobs to take, what goods or services to produce. And individuals decide what to
consume. Within a pure market economy the government is entirely absent from
The United States in the late nineteenth century, at the height of the lassez-faire
era, was about as close as we've seen to a pure market economy in modern
A mixed economic system combines elements of the market and command
economy. Many economic decisions are made in the market by individuals. But
the government also plays a role in the allocation and distribution of resources.
The United States today, like most advanced nations, is a mixed economy. The
eternal question for mixed economies is just what the right mix between the
public and private sectors of the economy should be.
Q4. Types of Business Activities?
1.A sole proprietorship, also known as the sole trader or simply a proprietorship,
is a type of business entity that is owned and run by one individual and in which
there is no legal distinction between the owner and the business.
The owner receives all profits (subject to taxation specific to the business) and has
unlimited responsibility for all losses and debts. Every asset of the business is
owned by the proprietor and all debts of the business are the proprietor's. It is a
"sole" proprietorship in contrast with partnerships. A sole proprietor may use a
trade name or business name other than his or her legal name.
2. A business organization in which two or more individuals manage and operate
the business. Both owners are equally and personally liable for the debts from the
business. Partnership doesn't always mean two people. There are many large
partnerships who have thousands of partners.
3. A public limited company (legally abbreviated to PLC) is a type of public
company (publicly held company). It is a limited (liability) company whose shares
are freely sold and traded to the public, with a minimum share capital of £50,000
and the letters PLC after its name.
Similar companies in the United States are
called publicly traded companies. A PLC can be either an unlisted or listed
company on the stock exchanges.
4. A limited company is a company in which the liability of members or
subscribers of the company is limited to what they have invested or guaranteed
to the company. Limited companies may be limited by shares or by guarantee.
And the former of these, a limited company limited by shares, may be further
divided into public companies and private companies. Who may become a
member of a private limited company is restricted by law and by the company's
rules. In contrast anyone may buy shares in a public limited company.
Limited companies can be found in most countries, although the detailed rules
governing them vary widely. It is also common for a distinction to be made
between the publicly tradable companies of plc type (for example, the German
Aktiengesellschaft (AG), Czech a.s. and the Mexican, French, Polish and Romanian
S.A.), and the "private" types of company (such as the German GmbH, Polish Sp. z
o.o., the Czech s.r.o. and Slovak s.r.o.).
Q5. Division Of labour?
The division of labour is the specialisation of cooperating individuals who perform
specific tasks and roles. Historically, an increasingly complex division of labour is
associated with the growth of total output and trade, the rise of capitalism, and of
the complexity of industrialised processes. The concept and implementation of
division of labour has been observed in ancient Sumerian (Mesopotamian)
culture, where assignment of jobs in some cities coincided with an increase in
trade and economic interdependence. In addition to trade and economic
interdependence, division of labour generally increases both producer and
individual worker productivity.
In contrast to division of labour, division of work refers to the division of a large
task, contract, or project into smaller tasks — each with a separate schedule
within the overall project schedule. Division of labour, instead, refers to the
allocation of tasks to individuals or organisations according to the skills and/or
equipment those people or organisations possess. Often division of labour and
division of work are both part of the economic activity within an industrial nation
Q6. Demand And Supply?
In microeconomics, supply and demand is an economic model of price
determination in a market. It concludes that in a competitive market, the unit
price for a particular good will vary until it settles at a point where the quantity
demanded by consumers (at current price) will equal the quantity supplied by
producers (at current price), resulting in an economic equilibrium for price and
The four basic laws of supply and demand are:
1. If demand increases and supply remains unchanged, a shortage occurs,
leading to a higher equilibrium price.
2. If demand decreases and supply remains unchanged, a surplus occurs,
leading to a lower equilibrium price.
3. If demand remains unchanged and supply increases, a surplus occurs,
leading to a lower equilibrium price.
4. If demand remains unchanged and supply decreases, a shortage occurs,
leading to a higher equilibrium price.
Equilibrium is defined to be the price-quantity pair where the quantity demanded
is equal to the quantity supplied, represented by the intersection of the demand
and supply curves.
Market Equilibrium: A situation in a market when the price is such that the
quantity that consumers demand is correctly balanced by the quantity that firms
wish to supply.
Comparative static analysis: Examines the likely effect on the equilibrium of a
change in the external conditions affecting the market.
Changes in market equilibrium: Practical uses of supply and demand analysis
often center on the different variables that change equilibrium price and quantity,
represented as shifts in the respective curves. Comparative statics of such a shift
traces the effects from the initial equilibrium to the new equilibrium.
Demand curve shifts:
When consumers increase the quantity demanded at a given price, it is referred
to as an increase in demand. Increased demand can be represented on the graph
as the curve being shifted to the right. At each price point, a greater quantity is
demanded, as from the initial curve D1 to the new curve D2. In the diagram, this
raises the equilibrium price from P1 to the higher P2. This raises the equilibrium
quantity from Q1 to the higher Q2. A movement along the curve is described as a
"change in the quantity demanded" to distinguish it from a "change in demand,"
that is, a shift of the curve. there has been an increase in demand which has
caused an increase in (equilibrium) quantity. The increase in demand could also
come from changing tastes and fashions, incomes, price changes in
complementary and substitute goods, market expectations, and number of
buyers. This would cause the entire demand curve to shift changing the
equilibrium price and quantity. Note in the diagram that the shift of the demand
curve, by causing a new equilibrium price to emerge, resulted in movement along
the supply curve from the point (Q1, P1) to the point Q2, P2).
If the demand decreases, then the opposite happens: a shift of the curve to the
left. If the demand starts at D2, and decreases to D1, the equilibrium price will
decrease, and the equilibrium quantity will also decrease. The quantity supplied
at each price is the same as before the demand shift, reflecting the fact that the
supply curve has not shifted; but the equilibrium quantity and price are different
as a result of the change the movement of the demand curve in response to a
change in a non-price determinant of demand is caused by a change in the x-
intercept, the constant term of the demand equation. LAW OF DIMINISHING
MARGINAL UTILITY-states that marginal utility tends to diminish more and more
(standard) units of a commodity are (continuously) consumed by a consumer.
Supply curve shifts:
When technological progress occurs, the supply curve shifts. For example, assume
that someone invents a better way of growing wheat so that the cost of growing a
given quantity of wheat decreases. Otherwise stated, producers will be willing to
supply more wheat at every price and this shifts the supply curve S1 outward, to
S2—an increase in supply. This increase in supply causes the equilibrium price to
decrease from P1 to P2. The equilibrium quantity increases from Q1 to Q2 as
consumers move along the demand curve to the new lower price. As a result of a
supply curve shift, the price and the quantity move in opposite directions. If the
quantity supplied decreases, the opposite happens. If the supply curve starts at
S2, and shifts leftward to S1, the equilibrium price will increase and the
equilibrium quantity will decrease as consumers move along the demand curve to
the new higher price and associated lower quantity demanded. The quantity
demanded at each price is the same as before the supply shift, reflecting the fact
that the demand curve has not shifted. But due to the change (shift) in supply, the
equilibrium quantity and price have changed.
The movement of the supply curve in response to a change in a non-price
determinant of supply is caused by a change in the y-intercept, the constant term
of the supply equation. The supply curve shifts up and down the y axis as non-
price determinants of demand change.
ELASTICITY OF DEMAND AND SUPPLY:
In economics, elasticity is the measurement of how changing one economic
variable affects others. An elastic variable is one which responds
disproportionately to changes in other variables. Similarly, an inelastic variable is
one which changes less than proportionately in response to changes in other
In more technical terms, it is the ratio of the percentage change in one variable to
the percentage change in another variable, when the latter variable has a causal
influence on the former. It is a tool for measuring the responsiveness of a
variable, or of the function that determines it, to changes in causative variables in
a unitless way. Frequently used elasticities include price elasticity of demand,
price elasticity of supply, income elasticity of demand, elasticity of substitution
between factors of production and elasticity of intertemporal substitution.
Elasticities of demand
Price elasticity of demand
Price elasticity of demand measures the percentage change in quantity demanded
caused by a percent change in price. As such, it measures the extent of movement
along the demand curve. This elasticity is almost always negative and is usually
expressed in terms of absolute value (i.e. as positive numbers) since the negative
can be assumed. In these terms, then, if the elasticity is greater than 1 demand is
said to be elastic; between zero and one demand is inelastic and if it equals one,
demand is unit-elastic. A perfectly elastic demand curve is horizontal (with an
elasticity of infinity) whereas a perfectly inelastic demand curve is vertical (with
an elasticity of 0).
Income elasticity of demand
Income elasticity of demand measures the percentage change in demand caused
by a percent change in income. A change in income causes the demand curve to
shift reflecting the change in demand. IED is a measurement of how far the curve
shifts horizontally along the X-axis. Income elasticity can be used to classify goods
as normal or inferior. With a normal good demand varies in the same direction as
income. With an inferior good demand and income move in opposite directions.
Cross price elasticity of demand
Cross price elasticity of demand measures the percentage change in demand for a
particular good caused by a percent change in the price of another good. Goods
can be complements, substitutes or unrelated. A change in the price of a related
good causes the demand curve to shift reflecting a change in demand for the
original good. Cross price elasticity is a measurement of how far, and in which
direction, the curve shifts horizontally along the x-axis. A positive cross-price
elasticity means that the goods are substitute goods.
Cross elasticity of demand between firms
Cross elasticity of demand for firms, sometimes referred to as conjectural
variation, is a measure of the interdependence between firms. It captures the
extent to which one firm reacts to changes in strategic variables (price, quantity,
location, advertising, etc.) made by other firms.
Elasticity of intertemporal substitution
It is possible to consider the combined effects of two or more determinant of
demand. The steps are as follows: PED = (∆Q/∆P) x P/Q. Convert this to the
predictive equation: ∆Q/Q = PED(∆P/P) if you wish to find the combined effect of
changes in two or more determinants of demand you simply add the separate
effects: ∆Q/Q = PED(∆P/P) + YED(∆Y/Y)*12+
Remember you are still only considering the effect in demand of a change in two
of the variables. All other variables must be held constant. Note also that
graphically this problem would involve a shift of the curve and a movement along
the shifted curve.
Elasticities of supply
Price elasticity of supply
The price elasticity of supply measures how the amount of a good firms wish to
supply changes in response to a change in price. In a manner analogous to the
price elasticity of demand, it captures the extent of movement along the supply
curve. If the price elasticity of supply is zero the supply of a good supplied is
"inelastic" and the quantity supplied is fixed.
Elasticities of scale
Elasticity of scale or output elasticities measure the percentage change in output
induced by a percent change in inputs. A production function or process is said to
exhibit constant returns to scale if a percentage change in inputs results in an
equal percentage in outputs (an elasticity equal to 1). It exhibits increasing returns
to scale if a percentage change in inputs results in greater percentage change in
output (an elasticity greater than 1). The definition of decreasing returns to scale
Q8. Factors effecting
There are various factors that affect it:
- Prices. If prices are high then consumption will be low because consuming will
use up a higher percentage of a person's income.
- Inflation. If inflation is low but is rising, then people will want to buy more
earlier, so that they get it for a cheaper price as opposed to having to pay for it
when inflation is higher. The same applies but reversed when inflation is high but
- Taxes. If taxes are very high on goods then people may object to this and not
buy goods out of protest or they may not be able to afford goods.
Interest rates: Higher interest rates will encourage people to save more.
Availability of appropriate savings schemes: With more options to save
money people will be attracted to save more
Advertising of/knowledge about what is available at financial
Confidence/trust in financial institutions
Size of real disposable income: Disposable income is the income left
after paying taxes. Thus more money left in pockets will encourage
people to save more.
Rate of inflation: when inflation is high people have less money left with
them to save because a major part of their disposable income will be
spent to satisfy their needs and wants.
Save for a future purchase: People might save with the motive to carry
out a future purchase e.g. a house
Precautionary factors: People might be ‘saving for a rainy day’
Tastes and preferences of consumers: It also depends on a individuals
preference. Some people save more than others.
Consumer confidence/expectations about future changes in the
economy, e.g. risk of unemployment may lead to people saving more
The interest rate and a rebate. The interest rate is self explanatory. As for the
rebate, some loans have money taken out of them and if you're on time to pay
the first 12 repayments, you get that rebate money back and don't have to pay it.
However, if you mess up, you lose that rebate and end up paying more.
Q9. What is meant by Financial Institution?
In financial economics, a financial institution is an institution that provides
financial services for its clients or members. Probably the most important
financial service provided by financial institutions is acting as financial
intermediaries. Most financial institutions are regulated by the government.
Broadly speaking, there are three major types of financial institutions:
1. Depositary Institutions : Deposit-taking institutions that accept and manage
deposits and make loans, including banks, building societies, credit unions,
trust companies, and mortgage loan companies
2. Contractual Institutions : Insurance companies and pension funds; and
3. Investment Institutes : Investment Banks, underwriters, brokerage firms.
Q10. What is the role of a
1. Bank of Note Issue:
The central bank has the sole monopoly of note issue in almost every country. The
currency notes printed and issued by the central bank become unlimited legal
tender throughout the country.
In the words of De Kock, "The privilege of note-issue was almost everywhere
associated with the origin and development of central banks."
However, the monopoly of central bank to issue the currency notes may be
partial in certain countries. For example, in India, one rupee notes are issued by
the Ministry of Finance and all other notes are issued by the Reserve Bank of
The main advantages of giving the monopoly right of note issue to the central
bank are given below:
(i) It brings uniformity in the monetary system of note issue and note circulation.
(ii) The central bank can exercise better control over the money supply in the
country. It increases public confidence in the monetary system of the country.
(iii) Monetary management of the paper currency becomes easier. Being the
supreme bank of the country, the central bank has full information about the
monetary requirements of the economy and, therefore, can change the quantity
of currency accordingly.
(iv) It enables the central bank to exercise control over the creation of credit by
the commercial banks.
(v) The central bank also earns profit from the issue of paper currency.
(vi) Granting of monopoly right of note issue to the central bank avoids the
political interference in the matter of note issue.
2. Banker, Agent and Adviser to the Government:
The central bank functions as a banker, agent and financial adviser to the
(a) As a banker to government, the central bank performs the same functions for
the government as a commercial bank performs for its customers. It maintains
the accounts of the central as well as state government; it receives deposits from
government; it makes short-term advances to the government; it collects cheques
and drafts deposited in the government account; it provides foreign exchange
resources to the government for repaying external debt or purchasing foreign
goods or making other payments,
(b) As an Agent to the government, the central bank collects taxes and other
payments on behalf of the government. It raises loans from the public and thus
manages public debt. It also represents the government in the international
financial institutions and conferences,
(c) As a financial adviser to the lent, the central bank gives advise to the
government on economic, monetary, financial and fiscal ^natters such as deficit
financing, devaluation, trade policy, foreign exchange policy, etc.
3. Bankers' Bank:
The central bank acts as the bankers' bank in three capacities:
(a) custodian of the cash preserves of the commercial banks;
(b) as the lender of the last resort; and (c) as clearing agent. In this way, the
central bank acts as a friend, philosopher and guide to the commercial banks
As a custodian of the cash reserves of the commercial banks the central bank
maintains the cash reserves of the commercial banks. Every commercial bank has
to keep a certain percentage of its cash balances as deposits with the central
banks. These cash reserves can be utilised by the commercial banks in times of
The centralization of cash reserves in the central bank has the following
(i) Centralised cash reserves inspire confidence of the public in the banking
system of the country.
(ii) Centralised cash reserves provide the basis of a larger and more elastic credit
structure than if these amounts were scattered among the individual banks.
(iii) Centralised reserves can be used to the fullest possible extent and in the most
effective manner during the periods of seasonal strains and financial
(iv) Centralised reserves enable the central bank to provide financial
accommodation to the commercial banks which are in temporary difficulties. In
fact the central bank functions as the lender of the last resort on the basis of the
centralised cash reserves.
(v) The system of contralised cash reserves enables the central bank to influence
the creation of credit by the commercial banks by increasing or decreasing the
cash reserves through the technique of variable cash-reserve ratio.
(vi) The cash reserves with the central bank can be used to promote national
4. Lender of Last Resort:
As the supreme bank of the country and the bankers' bank, the central bank acts
as the lender of the last resort. In other words, in case the commercial banks are
not able to meet their financial requirements from other sources, they can, as a
last resort, approach the central bank for financial accommodation. The central
bank provides financial accommodation to the commercial banks by rediscounting
their eligible securities and exchange bills.
The main advantages of the central bank's functioning as the lender of the last
resort are :
(i) It increases the elasticity and liquidity of the whole credit structure of the
(ii) It enables the commercial banks to carry on their activities even with their
limited cash reserves.
(iii) It provides financial help to the commercial banks in times of emergency.
(iv) It enables the central bank to exercise its control over banking system of the
5. Clearing Agent:
As the custodian of the cash reserves of the commercial banks, the central bank
acts as the clearing house for these banks. Since all banks have their accounts
with the central bank, the central bank can easily settle the claims of various
banks against each other with least use of cash. The clearing house function of
the central bank has the following advantages:
(i) It economies the use of cash by banks while settling their claims and counter-
(i) It reduces the withdrawals of cash and these enable the commercial banks to
create credit on a large scale.
(ii) It keeps the central bank fully informed about the liquidity position of the
Commercial banks perform many functions. They satisfy the financial needs of the
sectors such as agriculture, industry, trade, communication, so they play very
significant role in a process of economic social needs. The functions performed by
banks, since recently, are becoming customer-centred and are widening their
functions. Generally, the functions of commercial banks are divided into two
categories: primary functions and the secondary functions. The following chart
simplifies the functions of commercial banks.
Commercial banks perform various primary functions, some of them are given
Commercial banks accept various types of deposits from public especially
from its clients, including saving account deposits, recurring account
deposits, and fixed deposits. These deposits are payable after a certain time
Commercial banks provide loans and advances of various forms, including
an overdraft facility, cash credit, bill discounting, money at call etc. They
also give demand and demand and term loans to all types of clients against
Credit creation is most significant function of commercial banks. While
sanctioning a loan to a customer, they do not provide cash to the borrower.
Instead, they open a deposit account from which the borrower can
withdraw. In other words, while sanctioning a loan, they automatically
create deposits, known as a credit creation from commercial banks.
Along with primary functions, commercial banks perform several secondary
functions, including many agency functions or general utility functions. The
secondary functions of commercial banks can be divided into agency functions
and utility functions.
The agency functions are the following:
To collect and clear cheque, dividends and interest warrant.
To make payments of rent, insurance premium, etc.
To deal in foreign exchange transactions.
To purchase and sell securities.
To act as trusty, attorney, correspondent and executor.
To accept tax proceeds and tax returns.
The utility functions are the following:
To provide safety locker facility to customers.
To provide money transfer facility.
To issue traveller's cheque.
To act as referees.
To accept various bills for payment: phone bills, gas bills, water bills, etc.
To provide merchant banking facility.
To provide various cards: credit cards, debit cards, smart cards, etc.
Q11. Features of a perfect competition?
1. Large number:
In perfect competition, there must be large number of buyers and sellers. Each
buyer buys a small quantity of the total amount. Each seller is so large that no
single buyer or seller can influence the price and affect the market. According to
Scitovsky buyers and sellers are price takers in the purely competitive market.
Each seller (or firm) sells its products at the price determined by the market.
Similarly, each buyer buys the commodity at the price determined by the market.
2. Homogeneous product:
Under perfect competition, the product offered for sale by all the seller must be
identical in every respect. The goods offered for sale are perfect substitutes of
one another. Buyers have no special preference for the product of a particular
seller. No seller can raise the price above the prevailing price or lower the price
below the prevailing price.
3. Free entry and exit:
Under perfect competition, there will be no restriction on the entry and exit of
both buyers and sellers. If the existing sellers start making abnormal profits, new
sellers should be able to enter the market freely. This will bring down the
abnormal profits to the normal level. Similarly, when losses will occur existing
sellers may leave the market. However, such free entry or free exit is possible
only in the long run, but not in the short-run.
4. Perfect knowledge:
Perfect competition implies perfect knowledge on the part of buyers and sellers
regarding the market conditions. As a results, no buyer will be prepared to pay a
price higher than the prevailing price. Sellers will not charge a price higher or
lower than the prevailing price. In this market, advertisement has no scope.
5. Perfect mobility of factors of production:
The second perfection mobility of factors of production from one use to another
use. This feature ensures that all sellers or firms get equal advantages so far as
services of factors of production are concerned. This is essential to enable the
firms and industry to achieve equilibrium.
6. Absence of transport cost:
Under perfect competition transport, cost does not exist. Since commodities
have, the same price it logically follows that there will be no transport cost. In the
event of the presence of cost of transport, there will be no single price in the
market. Transport cost occurs when there is no perfect knowledge of the market
conditions on the part of buyers and sellers.
7. No attachment:
There is no attachment between the buyers and sellers under perfect
competition. Since products of all sellers are identical and their prices are the
same a buyer is free to buy the commodity from any seller he likes. He has no
special inclination for the product of any seller as in case of monopolistic
competition or oligopoly. Theoretically, perfect competition is irrelevant. In
reality, it does not exist. So it is a myth.
Q12. What is a monopoly?
A monopoly (to sell) exists when a specific person or enterprise is the only
supplier of a particular commodity (this contrasts with a monopsony which
relates to a single entity's control of a market to purchase a good or service, and
with oligopoly which consists of a few entities dominating an industry).
Monopolies are thus characterized by a lack of economic competition to produce
the good or service and a lack of viable substitute goods. The verb "monopolize"
refers to the process by which a company gains the ability to raise prices or
exclude competitors. In economics, a monopoly is a single seller. In law, a
monopoly is a business entity that has significant market power, that is, the
power to charge high prices. Although monopolies may be big businesses, size is
not a characteristic of a monopoly. A small business may still have the power to
raise prices in a small industry (or market).
A monopoly is distinguished from a monopsony, in which there is only one buyer
of a product or service; a monopoly may also have monopsony control of a sector
of a market. Likewise, a monopoly should be distinguished from a cartel (a form
of oligopoly), in which several providers act together to coordinate services,
prices or sale of goods. Monopolies, monopsonies and oligopolies are all
situations such that one or a few of the entities have market power and therefore
interact with their customers (monopoly), suppliers (monopsony) and the other
companies (oligopoly) in ways that leave market interactions distorted.
Q13.Formation of monopolies
Monopolies can form for a variety of reasons, including the following:
1. If a firm has exclusive ownership of a scarce resource, such as Microsoft
owning the Windows operating system brand, it has monopoly power over
this resource and is the only firm that can exploit it.
2. Governments may grant a firm monopoly status, such as with the Post
Office, which was given monopoly status by Oliver Cromwell in 1654. The
Royal Mail Group finally lost its monopoly status in 2006, when the market
was opened up to competition.
3. Producers may have patents over designs, or copyright over ideas,
characters, images, sounds or names, giving them exclusive rights to sell a
good or service, such as a song writer having a monopoly over their own
4. A monopoly could be created following the merger of two or more firms.
Given that this will reduce competition, such mergers are subject to close
regulation and may be prevented if the two firms gain a combined market
share of 25% or more.
Q14. Advantages and disadvantages of monopoly?
The advantages of monopolies
Monopolies can be defended on the following grounds:
1. They can benefit from economies of scale, and may be ‘natural’
monopolies, so it may be argued that it is best for them to remain
monopolies to avoid the wasteful duplication of infrastructure that would
happen if new firms were encouraged to build their own infrastructure.
2. Domestic monopolies can become dominant in their own territory and then
penetrate overseas markets, earning a country valuable export revenues.
This is certainly the case with Microsoft.
3. According to Austrian economist Joseph Schumpeter, inefficient firms,
including monopolies, would eventually be replaced by more efficient and
effective firms through a process called creative destruction.
4. It has been consistently argued by some economists that monopoly power
is required to generate dynamic efficiency, that is, technological
progressiveness. This is because:
1. High profit levels boost investment in R&D.
2. Innovation is more likely with large enterprises and this innovation
can lead to lower costs than in competitive markets.
3. A firm needs a dominant position to bear the risks associated with
4. Firms need to be able to protect their intellectual property by
establishing barriers to entry; otherwise, there will be a free rider
5. Why spend large sums on R&D if ideas or designs are instantly copied
by rivals who have not allocated funds to R&D?
6. However, monopolies are protected from competition by barriers to
entry and this will generate high levels of supernormal profits.
7. If some of these profits are invested in new technology, costs are
reduced via process innovation. This makes the monopolist’s supply
curve to the right of the industry supply curve. The result is lower
price and higher output in the long run.
The disadvantages of monopoly to the consumer
Monopolies can be criticised because of their potential negative effects on the
1. Restricting output onto the market.
2. Charging a higher price than in a more competitive market.
3. Reducing consumer surplus and economic welfare.
4. Restricting choice for consumers.
5. Reducing consumer sovereignty.
The traditional view of monopoly stresses the costs to society associated with
higher prices. Because of the lack of competition, the monopolist can charge a
higher price (P1) than in a more competitive market (at P).
The area of economic welfare under perfect competition is E, F, B. The loss of
consumer surplus if the market is taken over by a monopoly is P P1 A B. The new
area of producer surplus, at the higher price P1, is E, P1, A, C. Thus, the overall
(net) loss of economic welfare is area A B C.
The area of deadweight loss for a monopolist can also be shown in a more simple
form, comparing perfect competition with monopoly.
Q15. Pricing Strategies?
Premium pricing strategy establishes a price higher than the competitors. It's a
strategy that can be effectively used when there is something unique about the
product or when the product is first to market and the business has a distinct
competitive advantage. Premium pricing can be a good strategy for companies
entering the market with a new market and hoping to maximize revenue during
the early stages of the product life cycle.
A penetration pricing strategy is designed to capture market share by entering the
market with a low price relative to the competition to attract buyers. The idea is
that the business will be able to raise awareness and get people to try the
product. Even though penetration pricing may initially create a loss for the
company, the hope is that it will help to generate word-of-mouth and create
awareness amid a crowded market category.
Economy pricing is a familiar pricing strategy for organizations that include Wal-
Mart, whose brand is based on this strategy. Aldi, a food store, is another
example of economy pricing strategy. Companies take a very basic, low-cost
approach to marketing--nothing fancy, just the bare minimum to keep prices low
and attract a specific segment of the market that is very price sensitive.
Businesses that have a significant competitive advantage can enter the market
with a price skimming strategy designed to gain maximum revenue advantage
before other competitors begin offering similar products or product alternatives.
Psychological pricing strategy is commonly used by marketers in the prices they
establish for their products. For instance, $99 is psychologically "less" in the minds
of consumers than $100. It's a minor distinction that can make a big difference.