Question

18) Explain whether you agree or disagree with the following statement. “The concept of diminishing returns refers to a firm's long-run average cost increasing as output increases.”

19) What three main assumptions need to be satisfied if a market is to be described as perfectly competitive? Explain why each of these assumptions is important.

20) What is moral hazard? Explain using an example.

Answer 1

18) I disagree with the given statement as the concept of diminishing returns refers to a firms short run average total cost of production and not the long run cost.

In the short run,the amount of fixed capital is constant and the firm can only make changes in the amount of one input such as labour.The fixed cost of capital is high but the variable cost of labour is low so costs increases more slowly as output increases.As long as the marginal cost of production is lower than the average total cost of production,the average cost is decreasing but, as MC increases due to the law of diminishing returns,the marginal cost of production will eventually be higher than the average total cost and the average cost will begin to increase.The short run average total cost will be U-shaped.

19) The three main assumptions of perfectly competitive market are-

Firms are Price taker- in a perfectly competitive market,all the firms are price takers that is no individual firm can set prices for their products and they have to accept the prevailing price in the market.This is due to the presence of large number of buyers and sellers.Large number of sellers means that the market is so big that all the producers produce only a small share of the production and thus their output will have no noticeable effect on the market supply and therefore the price of the good.Also,the large number of buyers means that no single buyer can influence the price by changing his demand for the good.

Homogeneous Product- all the firm in the market produce homogeneous or perfectly standardised good.The products are similar not only in their physical characteristics such as colour,size,components but also, their environmental factors such as location of the seller.The products are indistinguishable from one another and re perfect subsititutes for one another.This will mean a unniform price for all the goods in the market.

Freedom of Entry and Exit-in perfect competition,the new firms are free to enter the industry and the existing firms are free to exit the industry at any time if they want.There are no restrictions,be it legal,natural or man made on the entry and exit of firms.This ensures that market remains perfectly competitive and no firm is able to dominate or change the price when the firms exit as new firms will enter the industry.