MICROECONOMICS UNIT -1 INTRODUCTION (6 MARKS)

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1 MICROECONOMICS UNIT -1 INTRODUCTION (6 MARKS) Q.1 Distinguish between microeconomics and macroeconomics. 3 Basis Microeconomics Macroeconomics Definition Microeconomics deals with the decision making behaviour of individual economic units. Macroeconomics deals with the decision making behaviour of economy as a whole. Examples The decision making behaviour of a consumer, a producer, a firm, an industry, a factor of production National income accounting, money and banking, determination of income, output and employment, government budget and the balance of payment Tools Demand and supply are the main tools of microeconomics. Aggregate demand and aggregate supply are the main tools of macroeconomics. Other name Microeconomics is also known as price theory. Macroeconomics is also known as national income theory. Q.2 Discuss the central problems of an economy. Why do they arise? 3 There are three central problems: a. What to produce: it means which goods and services are to be produced in the economy. b. How to produce: it means which technology is to be used in production. (Capital intensive/labour intensive). c. For whom to produce: it means how the total production or total income generated is to be distributed. These problems arises because of two reasons: a. Wants are unlimited with respect to scares resources. b. These resources have alternative uses. Q.3 Why the slope of PPC is concave to the origin? Explain with the help of example. Explain with an example how a PPC can be sloped as convex to the origin. Explain with an example how a PPC can be sloped a negative sloped straight line. The slope of PPC is concave to the origin because of the increasing marginal opportunity cost (MOC). When the economy shifts some resources from the production of one good to another, in which they are less specialized then it will result in more loss of output than gain. Combination: A B C D E F GUN : BUTTER : MOC : (increasing MOC) 3

2 The slope of PPC can be convex to the origin if the marginal opportunity cost decreases. When the economy shifts some resources from the production of one good to another, in which they are more specialized then it will result in less loss of output than gain. Combination: A B C D E GUN : BUTTER : MOC : (decreasing MOC) The slope of PPC can be a negative sloped straight line if the marginal opportunity cost remains constant. When the economy shifts some resources from the production of one good to another, in which they are equally specialized then it will result in equal loss of output and gain. Combination: A B C D E GUN : BUTTER : MOC : (constant MOC) Q.4 Explain the concept of opportunity cost with the help of example. 3 The next best alternative use of a factor is called its opportunity cost. For example a person can earn Rs , 9000 and 8000 at different places then he will be in that job which will give him Rs and its opportunity cost is Rs

3 UNIT -2 CONSUMER S EQUILIBBRIUM AND DEMAND (16 MARKS) Q 5 Identify the effect on demand of the following 6 (a)govt enhanced the pay of the government employees. How will this affect the demand curve of government employees? (b)a new car factory comes up in Gujarat; many people who previously unemployed, in the area are now employed.how will this affect demand curve of television. (c) There are train and bus service between Ahmedabad and New Delhi. Suppose the train fare between two cities comes down, how will this affect the demand curve for bus travel between two cities? a. When government increases the salaries of Government employees then there demand for different goods will increase and the demand curve shift towards right. b. New car factory in Gujarat will provide employment to the public so the income will increase and ultimately will increase the demand for televisions. This will shift the demand curve towards right. Q 6 c. Due to the decrease in rail fare between Ahmedabad and New Delhi the demand for Railways will increase among passengers. This will adversely affect the demand for bus services. That is why the demand for buses will decrease and the demand curve will shift towards left. If the price of a good increases, a family s spending on the product has to increase. Defend or refute. When the price of a good increases it is not necessary that the family spending on that product has to increase whether the expenditure increase or decrease depends on the nature of that good commodity is necessity then the increase in price will certainly increasing spending of that family on the other hand if the commodity is normal luxury then the increase in price will force the family to shift its consumption on another commodities so the expenditure will decrease it can be explained with the help of following diagrams: Q 7 In first diagram the demand curve is inelastic. The increase in price from rupees 2 to rupees 10 results in the increase in expenditure from 6 to 20. Second diagram shows that the demand is elastic and if the price increases from rupees 25 to 30 then the total expenditure decreases from rupees 75 to 30. So we can conclude that in case of Elastic demand the increasing price results in the decrease in expenditure and in case of inelastic demand increase in price will result in the increase in expenditure also. Consumer consumes only two goods X and Y and is in equilibrium. Show that when price of good Y falls demand for Y Rises. Answer this question with the help of utility analysis. Or A consumer consumes only two goods. Explain consumer s equilibrium with the help of utility analysis. Or What changes will take place if the condition of consumer equilibrium is not fulfilled. Use utility analysis. A consumer is said to be rational and he will be in equilibrium when he maximizes his satisfaction his utility. In case of two commodities a consumer have to fulfill the following condition: MU x /P x = MU y /P y But when the price of good Y falls it means that consumer will get more satisfaction from good Y. it also

4 Q 8 means that the condition of equilibrium is not satisfied because now the situation is as following: MU x /P x < MU y /P y So he will buy more units of good Y. As per the law of diminishing marginal utility consumption of additional units of good Y will diminish its marginal utility. The consumer will continue to buy the good Y till its MU diminishes and becomes equal to MU of good X. It is hereby proved that when price of good be false its demand increases. What changes will take place if the condition of consumer equilibrium is not fulfilled. Use indifference curve analysis. A consumer consumes only two goods. Explain consumer s equilibrium with the help of indifference curve analysis. State the conditions of consumer s equilibrium and their rationale Consumer s Equilibrium: It refers to a situation in which a consumer with given income and given prices purchases such a combination of goods which gives him maximum satisfaction and he is not willing to make any change in it. For a consumer to be in equilibrium, two conditions must be fulfilled. These are: a. Price line/ Budget line should be tangent to the Indifference curve i.e. MRS xy = P x / P y b.ic should be convex to the origin. As per the above conditions the consumer s equilibrium can be shown with the help of following diagram: Q 9 In this diagram the LM is budget line. IC 1, IC 2 and IC 3 are different levels of satisfactions for a consumer (IC Map). Consumer s equilibrium is on point Q where both of the conditions are fulfilled. What if conditions are not fulfilled: If MRS xy > P x / P y (point P in above diagram) It means that consumer is willing to sacrifice more units of good Y to get additional X. Also the point P is on IC 1 the lower IC where the consumer is spending the same amount of money. So he will not be in equilibrium on point P as he can reach on IC 2 by spending the same amount at point Q. If MRS xy < P x / P y (point R in above diagram) It means that consumer is willing to sacrifice more units of good X to get additional Y. Also the point R is on IC 1 the lower IC where the consumer is spending the same amount of money. So he will not be in equilibrium on point R as he can reach on IC 2 by spending the same amount at point Q. If IC is not negative sloped and convex to the origin: Negative slope of IC is due to the limited income a consumer has. Similarly the convexity is due to the diminishing marginal rate of substitution implying that the intensity of the desire for good decreases with its increased consumption (similarly as diminishing marginal utility). If this condition is not fulfilled it means the law of diminishing marginal utility is not applicable and for every additional unit he get he will get more satisfaction and equilibrium will never be achieved. Price of good X = 8, MU x = 40, Price of good Y = 5, MU y = 50. Find whether the consumer is in equilibrium or not. Give reason in support of your answer. What should a rational consumer do in such situation? For a consumer to be in equilibrium: MUx/Px = MUy/Py As per given values:

5 Q 10 40/8 = 50/ It means consumer is not in equilibrium. He is getting more satisfaction from good Y. A rational consumer will buy more units of good Y till its utility diminishes and becomes equal to that of good X. Price of good X = 10 per unit, price of good Y = 4 per unit. The ratio of substitution between good X and good Y (MRS xy ) = 5. Find whether the consumer is in equilibrium or not. Give reason in support of your answer. What should a rational consumer do in such situation? For a consumer to be in equilibrium MRS xy = P x / P y As per given values: 5 = 10/ it means that consumer is not in equilibrium because MRS xy > P x / P y It also means that consumer is ready to sacrifice more units of good Y for additional X. So a rational consumer will increase the consumption of good X till the MRS xy diminishes and becomes equal to the price ratio of two goods. Q 11 Q 12 UNIT -3 PRODUCER S BEHAVIOUR AND SUPPLY (16 MARKS) Identify the different phases of the law of variable proportions from the following schedule. Give reasons for your answer. Variable input (units) TP (Units) Variable TP MP Phases Input Increasing return to a factor Diminishing return to a factor Negative return to a factor (i) From unit 1 to unit 2, MP is increasing and TP increasing at an increasing rate so it shows 1 st phase. (ii) Unit 2 to unit 3, MP is diminishing and TP increasing at a diminishing rate so it shows 2 nd phase. (iii) Unit 4 onwards, MP is negative and TP falling so it shows 3 rd phase. Draw ATC, AVC and AFC curve on the same graph. Explain the relationship between ATC and AVC. Do they intersect each other? Give reason in support of your answer. COST

6 ATC AVC AFC Q 13 Q 14 OUTPUT Since ATC is the sum total of AFC and AVC. As output increases the AFC tends to decrease. That is why ATC & AVC comes closer to each other with the increase in output because of decrease in AFC. At a price of Rs. 8 per unit, the quantity supplied of a commodity is 200 units. Its price elasticity of supply is 1.5. If its price rises to Rs. 10 per unit, calculate its quantity supplied at new price. E S = ΔQ/ΔP P/Q ΔQ = Q 1 Q = X ΔP = P 1 P = 10 8 = 2 P = 8 Q = 200 E S = 1.5 Then: E S = ΔQ/ΔP P/Q 1.5 = X 200 /2 8/200 X = 275 UNITS. What are the total fixed cost, total variable cost and total cost of a firm? How are they related? Total Cost (TC) -Total Cost is the total expenditure incurred on the production of a commodity. It is the sum total of Total Fixed Cost and Total Variable Cost. TC=TVC+TFC Total Variable cost (TVC) - Expenditure incurred on the variable factors of production is known as Total Variable Cost. Variable costs vary with change in output. TVC=TC-TFC Total Fixed Cost (TFC) -Expenditure incurred on the fixed factors of production are known as Total fixed costs. Fixed costs do not vary with change in output. TFC=TC-TVC Since TC = TFC + TVC and TFC remain same at each level of output that is why the TC and TVC curve remain parallel in short run.

7 Q 15 Differentiate between short run and long run production function. Short run production function Long run production function At least one factor of production is kept All factors of production are variable. constant and others are variable. Factor ratio changes. Factor ratio remains constant. Generates law of variable proportion. Generates returns to scale. Q 16 What is the likely behaviour of the AR and MR curve when a firm is able to sell additional units on: a. Given price b. By lowering the price a. Given price: In this situation price or AR remain constant. So MR is equal to AR. Both are represented by the same horizontal line parallel to X-axis. b. By lowering the price: The average revenue curve and marginal revenue curve both slopes downward from left to right. Since AR falls MR curve lies below the AR curve. Slope of MR curve is just double than the slope of AR in case of linear AR curve. MR can be positive, negative or zero but AR is always positive. Q 17 Draw supply curves showing : a. Elastic supply b. Unitary elastic supply c. Inelastic supply a. Elastic supply Es > 1 (Supply curve intersects Y axis)

8 b. Unitary elastic supply Es = 1 (Supply curve passes through origin). c. Inelastic supply Es < 1 (supply curve intersects X axis) Q 18 How does a change in per unit tax influence the supply of a good? Explain. How does a change in technology influence the supply of a good? Explain. Increase in per unit tax increases the cost of production which reduces the profits of the producer. So the producer will decrease the supply and supply curve will shift towards left. Decrease in tax rate will shift supply curve towards right. Upgraded technology will increase the supply while degraded technology will shift the curve to left. Q 19 LONG ANSWER TYPE QUESTIONS Why is equality between MC and MR necessary for a firm to be in equilibrium? Is it sufficient to ensure the equilibrium? Explain why will a producer not be in equilibrium if the conditions of equilibrium are not met?

9 Explain the rationale behind the conditions of equilibrium of a producer. Producer s equilibrium refers to a position at which the producer gets maximum profit with minimum cost. For a producer/firm to be in equilibrium two conditions must be fulfilled: a. MC = MR and b. MC should be rising at the point of equilibrium. Producer s equilibrium can be explained with the help of following diagram: Q 19 Two things to be noted: 1. Area under MC curve is TVC 2. Area under MR curve (=AR curve) is TR. Equilibrium is at point E where the level of output is OQ e. Here both the conditions are fulfilled. That is: a. MC = MR and b. MC is rising at the point of equilibrium. What if MC = MR but MC is falling: At OQ 1 output: Where the MR = MC but the MC is falling: Total revenue = OPBQ 1 (area under MR = AR curve) Total Variable Cost = OABQ 1 (area under MC curve) Since OABQ 1 > OPBQ 1 by ABC which is loss for the firm. What if MC < MR At OQ 2 output: Where the MR > MC Firm could get additional profits of CDE area by producing OQe output but it will have to sacrifice the profit if it continues to produce OQ 2 output. What if MC > MR At OQ 3 output: Where the MC > MR the loss for the firm will be the area of EFG. Price of the commodity is given at Rs. 8 per unit. From the following table; find out the level of Output (in units) Marginal Revenue (Rs.) Total cost (Rs.) output at which the producer will be in equilibrium. Give reasons for your answer

10 Output (in units) Marginal Revenue Total cost Marginal Cost Equilibrium Producer s equilibrium is at 4 th unit of output. Here both the conditions are fulfilled. That is: a. MC = MR and b. MC is rising at the point of equilibrium. Q 20 What are the different phases in the law of variable proportion in terms of marginal product? Give reason behind each phase. What are the different phases in the law of variable proportion in terms of total product? Give reason behind each phase. State the different phases of changes in total and marginal product in the law of variable proportions. Use diagram. The law of variable proportion states that other factors of production remain constant, as more and more units of variable factor is employed in the beginning total product (TP) increases at increasing rate, then increases at a decreasing rate and ultimately decline. In short, the effect on total production/ marginal production in short run when variable factor is increased is called the law of variable proportion. I phase: MP increases, due to which TP increases at increasing rate. AP also increases. The stage lasts where the MP is maximum. Reasons: a. better utilization of the fixed input with increase in variable input, b. Benefits of division and specialization of the variable input used, say, labour, c. Indivisibility of fixed input. II phase: MP decreases, due to which TP increases but at decreasing rate. AP also reaches at maximum and start decreasing. The stage lasts where the TP is maximum and MP is zero. Reasons: a. Optimum combination between fixed and variable inputs is disturbed with increasing use of the

11 Q 22 variable input, b. After a certain level of employment of the variable input, the benefits from the division of labour will diminish leading to diminishing return. c. Imperfect substitutes between fixed input and variable input AFC at 4 th unit of output is 25. Find TFC, TC, AFC, AVC ATC and MC from the following table: Units: TVC : OUTPUT( Q) TFC A TVC B TC A+B AFC=TFC /Q AVC=TVC/ Q AC= TC/Q MC= TCn-TCn x4=

12 UNIT -4 FMS OF MARKET AND PRICE DETERMINATION UNDER PERFECT COMPETITION WITH SIMPLE APPLICATION (12 MARKS) SHT ANSWER TYPE QUESTIONS Q 23 What is the significance of: a. Single seller in the monopoly b. Differentiated product in monopolistic competition a. Single seller: It means the monopolist has full control over the supply and price of commodity. So the monopolist firm becomes price maker. b. Differentiated product: These differentiated products enable the firms to have control on their own output, & thus the firms are partially price makers and their products have highly elastic demand. Q 24 Comment on the shape of MR curve when TR curve is a. Positively sloped straight line passing through the point of origin. b. Horizontal line When TR is Positively sloped straight line: the MR curve will be the horizontal to X-axis. When TR is horizontal line: the MR will be zero and the MR curve will coincides the X-axis. Q 25 Explain the significance of the feature free entry and exit under perfect competitive market. Under perfect competition there are no barrier to entry and exit of firms in industry. So new firms will enter in the market if the existing firms are earning supernormal profits. On the other hand loss making firm will quit the market. This freedom ensures that firms earn just the normal profits in the long run. Q 26 Explain the implication of non-price competition in an oligopoly market. Under oligopoly firms generally avoid the competition based on the price as it may result them loss. So they indulge themselves in non-price competition and spends heavily on providing after sale services, warranty on the product, advertising etc. Overall it increases the cost of production and put adverse effects on public welfare. Q 26 What are the effects of floor price/ceiling price on the market of a good? Use diagram. The minimum price, over and above the equilibrium price, fixed by the government for a good is called floor price. This price helps producers (mainly farmers) to continue to produce as they will get assured price of their product. It also ensures the stability in the market by regular supply. Q 27 LONG ANSWER TYPE QUESTIONS What will be the effect on the equilibrium price of a good when: a. price of related goods decreases b. govt. decreases per unit tax on the good c. factor prices decreases In all above cases the supply of the concerned good will increase due to which the supply curve will shift towards right and the equilibrium price will decrease. Explain the chain of effects of this change.

13 Q 28 Chain of effects: 1. Due to above reasons the supply will increase. 2. This generates excess supply by ef on existing price op. 3. Due to excess supply the price tends to decrease in the market. 4. Due to decrease in price the demand will expand from point e to e1. 5. Decrease in price also contracts the supply from point f to e1. 6. Finally the equilibrium attains at point e1. What will be the effect on the equilibrium price of a good when: a. price of substitute goods increases b. income of the consumer increases c. price of complementary goods decreases In all above cases the demand for the concerned good will increase due to which the demand curve will shift towards right and the equilibrium price will increase. Q 29 Chain of effects: 1. Due to above reasons the demand will increase. 2. This generates excess demand by Ef on existing price OP. 3. Due to excess demand the price tends to increase in the market. 4. Due to increase in price the supply will expand from point E to E1. 5. Increase in price also contracts the demand from point F to E1. 6. Finally the equilibrium attains at point E1. Define collusive and non-collusive oligopoly. Explain the features of oligopoly. Collusive oligopoly is one in which the firms cooperate with each other in deciding price and output. Non collusive oligopoly is one in which firms compete with each other. Features of oligopoly 1. Few firms - Few firms mean either only a few firms in number or a few big firms producing most of the output of the industry. The exact number of firms is not defined. The word few signifies that the number of firms is manageable enough to make a guess of the likely reactions of rival by a firm. 2. Firms are interdependent in taking price and output decisions -When there are only a limited number of firms, it is likely that rivals have some knowledge as to how these firms operate. It one firm does

14 something about the price and quantity of the product it produces, the rivals are likely to take quick note of it and react by changing their own price and output plans- It makes each firm dependent on other firms in the industry. 3. Barriers to the entry of firms- The main reason why the number of firms is small is that there are barriers which prevent entry of firms into industry. Patents, large capital, control over the crucial raw materials etc. prevent new firms from entering into industry. Only those who are able to cross these barriers are able to enter. 4. Non-price competition- Firms try to avoid price competition for the fear of price war. They use other methods like advertising, better services to customers, etc. to compete with each other. Q 30 Q 31 Q 32 Define perfect competition? Explain the features of perfectly competitive market. Perfect competition is a form of the Market in which large number of buyers and sellers, selling homogeneous products at a uniform price. Features: 1. Large number of buyers and sellers There are large number of buyers and sellers in perfect competitive market it means no single buyer or seller can influence the market It is because each seller sells a very small portion of the market supply, similarly the demand of each buyer is also very small in the market. 2. Homogeneous product - The product sold in the market is homogeneous or identical in all respect i.e. shape, size, colour, composition, etc. 3. Free entry and exit of firms -Under perfect competition there are no barrier to entry and exit of firms in industry. But entry and exit may take time so it happens only in long runs. This freedom ensures that firms earn just the normal profits in the long run. 4. Perfect knowledge of market-in these markets all the sellers as well as buyers have the complete information about the market situation. It means they are well aware about the product and its price. Thus the price remains same. 5. Perfect mobility The factors of production i.e. land, labour, capital and entrepreneur are perfectly mobile. There is no geographical and occupational restriction on their movement. It means factors of production are free to move from one place to another place and one job to another job in which they get better price. 6. No selling and transportation cost- It assumes that there is no selling and transportation cost. Thus the price remains same everywhere. Explain the features of Monopoly market. Monopoly It s a market situation where there is a single seller of a commodity which has no close substitutes. Main features of a monopoly market are- 1. Single seller- Under monopoly there is an only seller of commodity in the industry, so the difference between firm and industry get vanished. It means the monopolist has full control over the supply and price of commodity. 2. No close substitute- The monopolist produces a distinct product which has no close substitute in the market. Therefore the monopoly firm has no fear of competition from any other commodity. 3. Barriers on entry- There are strong or significant barrier to the entry of new firms. These barriers may be legal barriers like patent right or licensing etc.; as a result monopolist firm can earn abnormal profit in the long run. 4. Price discrimination-when a monopolist charge different prices from different buyers for the same product is called price discrimination. It s a distinct feature of monopoly market. E.g. railways charge different fare for senior citizens, children and others for same journey. 5. Independent price policy - In monopoly, firm and industry are same so the firm has complete control over the output and it fixes its price by itself. Thus firm is price marker in monopoly. Explain the features of Monopolistic competition. Monopolistic Competition- It refers to such a market structure where there are large number of buyers and sellers and the firms produce & sell differentiated product which has many close substitute available.

15 1. In this kind of market situation, there exist a fairly large number of firms which have a greater competition among themselves. Due to this, the firms do not have total control over the market supply of the product. 2. The firms produce & sell heterogeneous (differentiated) products, in this kind of markets, which enable the firms to have control on their own output, & thus the firms are price makers. 3. There is a freedom of entry & exit of firms in the market, to a considerable extent, due to which the number of firms always remain fairly large. As a result, the firms can earn only the normal profits in the long run. 4. The unique feature of this type of market situation is prevalence of selling cost, i.e. the expenditure made by the firms to promote the sales of their products viz. sale exhibition, discount offer, showroom demonstration, advertisement & wide campaigning cost etc. 5. The firms, in this type of markets, are price makers, as all these firms have distinct consumers of their product. As the firms produce & sell differentiated product, the price of products of each firm is different, irrespective of their similarity. Because of this, the AR (demand) curve slopes negatively at gradual rate. Q 33 Q 36 MACROECONOMICS UNIT -5 NATIONAL INCOME AND RELATED AGGREGATES (15 MARKS) SHT ANSWER TYPE QUESTIONS Distinguish between personal income and private income? Private income consists of factor income and transfer income received from all sources by private sectors within and outside the country. Private income = NNP FC - income from property and entrepreneurship accrued to government administrative department - savings of non-departmental enterprises + national debt interest + current transfers from rest of the world + net current transfers from rest of the world Distinguish between nominal GNP and real GNP. Personal income: -It is income actually received by the residents of a country from all sources within and outside the country. Personal income = private income corporate tax corporate savings (undistributed profit)

16 Nominal GNP is measured at current prices. Since this aggregate measures the value of goods and services at current year prices, GNP will change when volume of product changes or price changes or when both changes. Real GNP is computed at the constant prices. Under real GNP, value is expressed in terms of prices prevailing in the base year. This measure takes only quantity changes. Real GNP is the indicator of real income level in the economy. Q 37 Q 38 Q 39 Q 40 Explain the main steps involved in measuring national income through product method. a. Identification and classification of producing units into different sectors like primary, secondary and tertiary sectors. b. Estimate value of output by adding sales + change in stock (sales = quantity sold x price) Value of output = sales + change in stock c. Estimate gross value added by value of output intermediate consumption Gross Value Added = Value of output - intermediate consumption Gross Value Added is also termed as GDP MP d. Add net factor income from abroad and deduct depreciation and net indirect tax to GDP MP to obtain NNP FC which is national income. NNP FC = GDP MP Depreciation NFIFA - NIT Explain the steps involved in calculation of national income through income method. a. Classify the producing enterprises into different sectors like primary, secondary and tertiary. b. Estimate the factor income paid by the producing units in each sector i.e. *Compensation of employees *Operating surplus *Mixed income of self employed c. Add the factor income by all the sectors to arrive at the NDP Fc (Which is called domestic income) NDP FC = Compensation of employees + Operating surplus + Mixed income of self employed d. Add net factor income from abroad to the net domestic product at factor cost to arrive at the net national product at factor cost (National Income). NNP FC = NDP FC + NFIFA Explain the main steps involved in measuring national income through expenditure method. a. Classify the economic units incurring final expenditure into distant groups like households, government, firms, rest of the world. b. Estimate the following final expenditure by all economic units: 1. Private final consumption expenditure (C) 2. Government final consumption expenditure (G) 3. Gross domestic capital formation (I) 4. Net export (X-M) c. Sum total of above gives GDP MP GDP MP = C + I + G + (X - M) d. Deduct depreciation, net indirect taxes to get NDP FC e. Add net factor income from abroad and deduct depreciation and net indirect tax to GDP MP to obtain NNP FC which is national income. NNP FC = GDP MP Depreciation + NFIFA - NIT Write down the limitations of using GDP as an index of welfare of a country. a. The GDP figures give no indications of the population, skill and resources of the country. A country may be having high GDP but it may be consumed by the increasing population, so that the level of people s wellbeing or welfare standard of living remains low. b. High GDP may be due to greater area of the country or due to the concentration of some resources in out particular country. c. GDP does not consider the level of prices of the country. People may be having income but

17 Q 41 may not be able to enjoy high standard of living due to high prices. d. High GDP may be due to the large contribution made by a few industrialists e. Level of unemployment is not taken into account. f. GDP does not care to reduce ecological degradation. Due to excess of economic activity which leads to ecological degradation reduces the welfare of the people. g. Hence GDP and economic welfare are not positively related. Income in GDP does not bring about increase in economic welfare. What is double counting? How can it be avoided? Counting the value of commodities at every stage of production by more than one time is called double counting. It can be avoided by a. Taking value added method in the calculation of the national income. b. By taking the value of final commodity only while calculating national income. Example: Sr. no. Production Process Market Value (Rs) Value Added (Rs) 1. Sheep Ranching Wool Processing = Suit Manufacturing = Whole Seller = Retailor 1500 (final good) = 500 Total = Q 42 Example shows that the addition of market value at each production process results in double counting (Rs. 3800). To avoid this double counting only the market value of final good (Rs 1500) is to be considered or value added at each production process should be taken to compute national income. Will the following be included in National Income of India? Give reasons for your answer. a. Financial help given to flood victims b. Profits earned by an Indian bank from its branches abroad. c. Salaries paid to non-resident Indians working in Indian Embassy in America. d. Interest received by an individual from banks a. Financial help is a transfer payment because no factor service is provided in return. It is, therefore, not included in national income. b. Profit earned by an Indian bank from its branched abroad is factor income from abroad, and so included in national income. c. Salaries paid to NRI working in Indian embassy in America are factor income paid to abroad. It is not include in India s national income. d. Interest received by an individual from banks is a factor payment by a productive enterprise. It is included in national income.

18 Q 43 Q 44 Q 45 Q 46 Q 47 Q 48 Q 49 UNIT - 6 MONEY AND BANKING (8 MARKS) SHT ANSWER TYPE QUESTIONS Define money. How money can solve the problem of double coincidence of wants? Anything which has general acceptability in exchange of goods and services and can be stored as a value is called money. Money can solve the problem of double coincidence of wants. With the help of money we can easily buy any good which we want. There is no need to find the person which has the same good which we want and he is willing to buy the good which we have as in case of barter system. Explain the function of money as the standard of deferred payments. Money acts as the standard of deferred payments. It means we can pay the amount at any time in near future for those goods and services which we want to buy now. Since money has general acceptability and its value doesn t depreciate in comparison to other goods so there will be no question of disagreement regarding the quality and quantity of payments to be made in near future. What do you mean by: a. the medium of exchange function of money b. the unit of account (measure of value) function of money (a): Money acts as the medium of exchange. It means we can buy any good in exchange of money. (b): It means the value of any good or service can be measured in terms of money. In other words the price we pay for a particular good is equal to the units of money we spend. Define money supply. What are the components of money supply? The stock of money in form of coins, currency notes and demand deposits with commercial banks at a particular point of time is called money supply. Main components of money supply are: a. Currency held by the public which includes notes and coins, b. Demand deposits with commercial banks which include current account deposits and saving account deposits. You are made the governor of Reserve Bank of India. How will you control the inflationary conditions without affecting the overall money supply in the economy? Being the governor of RBI qualitative measures can be adopted to control inflationary trends without affecting overall money supply in the economy. These are: a. Change in required margins: It means the difference between the current value of the security offered for loan and the value of loan granted. If a particular sector is facing inflationary trends then the required margins will be increased which in turn will harass the demand for loans in that sector. b. Rationing of credit: It means the fixation of credit quotas for different business activities. To reduce the inflationary pressure, the credit quota is reduced in that particular activity so there will be less availability of credit. What do you mean by open market operations? How does this reduce the excess money supply in the economy? It refers to the sale and purchase of securities in the open market by the central bank. To reduce the money supply central bank sells the securities to the commercial banks. This results in the decrease in loaning capacity of commercial banks which means less availability of credit to the public. Explain how does a central bank control money supply by changing: a. Repo rate b. Reverse repo rate

19 Q 50 Q 51 Q 52 (a): The rate of interest at which central bank advances short term loans to commercial banks is called repo rate. Repo rate is increased if central bank wants to reduce the money supply. The borrowings for commercial banks become costlier so they will increases the interest rate on loans demanded by the public. This will result in the decrease in the demand for loans and hence the decrease in money supply. (b): The rate of interest at which central bank borrows from commercial banks is called reverse repo rate. Increase in reverse repo rate will attract commercial banks to deposit their excess funds with central bank which means less availability of money to be granted as loans. Explain the roll of following to reduce money supply in the economy: a. statutory liquid ratio b. cash reserve ratio a. Statutory liquid ratio is the percentage of total cash deposit of the commercial banks which they have to invest in government securities. To reduce the money supply central bank will increase the SLR. This results in the decrease in loaning capacity of commercial banks which means less availability of credit to the public. b. Cash reserve ratio is the percentage of total cash deposit of the commercial banks which they have to keep with the central bank in form of cash. To reduce the money supply central bank will increase the CRR. This results in the decrease in loaning capacity of commercial banks which means less availability of credit to the public. The central bank acts as lender of last resort. How? The central bank acts as lender of last resort for the other banks of the country. It means that if a commercial bank fails to get financial accommodation from anywhere, it approaches the central bank as a last resort. Central bank advances loan to such a bank against approved securities. As a lender of the last resort, central bank exercises control over the entire banking system of the country. LONG ANSWER TYPE QUESTIONS Can commercial banks create money? Explain with an example. The deposits held by banks are used for giving loans. However banks cannot use the whole of deposits for lending. It is legally compulsory for the banks to keep a certain minimum fraction of their deposits as resources. The friction is called legal reserve ratio (LRR) is fixed by the central bank. Example: suppose initial deposits in is bank are rupees 1000 and LRR is 20% It means, banks are required to keeps only Rs. 200 as cash reserves and free to lend Rs This 800 will again come in the bank as deposit. With new deposit of Rs.800, banks keep 20% as reserves and lend the balance Rs. 640 to other person, and so on. Deposits (in Rs.) Loans (in Rs.) Cash Reserves (20%) Initial deposit Round I Round II Money Multiplier = 1/LRR= 1/0.2=5 Total Deposit = Initial Deposit X Money Multiplier = 1000X5 = 5000Rs.

20 Q 53 Q 54 UNIT - 7 DETERMINATIION OF INCOME AND EMPLOYMENT ( 12 MARKS) Define Aggregate demand. State its components. Aggregate demand is the total demand for goods and services in the economy. Aggregate demand in fact represents the total expenditure of goods and services in an economy. There are four components of aggregate demand (AD): (i)consumption (ii) investment (ii) government expenditure (iv)net export (X-M) AD=C+I+G+(X-M) What is meant by investment multiplier? Explain the relation between MPC and investment multiplier? Investment multiplier is defined as the ratio of change in income due to change in investment Multiplier (k) = Y/ I and Q 55 Relationship between multiplier and MPC: the value of the multiplier varies directly with MPC Higher the MPC, the higher will be the multiplier and vice versa. F example, if MPC =. 5, K= 2. If MPC=.8, K=5 Draw consumption function and saving function on same diagram. Where, C = Consumption; = Autonomous consumption / minimum level of consumption; c = Marginal propensity to consume; Y= Level of income. cy = induced consumption Where, S = Savings

21 = Autonomous Savings (1 c) = Marginal propensity to save; Y= Level of income. (1- c )Y = Induced Savings Q 56 Draw a linear consumption curve and show the points where the: APC = 1 APC > 1 APC < 1 Q 57 a. At OY level of income the consumption is more than income. Since APC = C / Y and here C > Y, that is why APC > 1 b. At OY 1 level of income the consumption is equal to income. Since APC = C / Y and here C = Y, that is why APC = 1 c. At OY 2 level of income the consumption is less than income. Since APC = C / Y and here C < Y that is why APC < 1 Draw a linear consumption curve and derive a saving function from it. Explain the process. Explain the steps in deriving saving curve from a consumption curve. Use diagram.

22 Q 58 Q 59 Process: Draw a consumption curve as per in above diagram and take the same distance of autonomous consumption for negative autonomous saving in diagram below the consumption curve. At OY 1 level of income Y = C at point E. so the saving at this income = 0. That is why saving curve intersect X- axis at OY 1 level of income. By stretching the same line towards right we get saving curve. Draw a linear consumption curve and derive a saving function from it. Explain the process. Explain the steps in deriving saving curve from a consumption curve. Use diagram. Same as in answer 5. The diagrams will interchange. Saving curve will be on upper side and the consumption curve, down side. If in an economy C = Y and I = Calculate: a. Equilibrium level of national income and b. Saving at equilibrium level of national income. At equilibrium level, AS = AD a. Y = C + I Y = Y Y 0.9 Y= 3200 Y (1 0.9) =320 Y = 3200/0.1= b. C = Y By putting value of Y, C= S = Y- C S= = 3000 Q 60 State whether the following statements are true or false a. The Value of MPS can never be negative. b. The value of APS can never be greater than 1. a. Yes, it is true. MPS = S / Y, additional S and Y always in positive because of positive relationship between S and Y.MPS can never be negative. b. True, because even if all the income is saved and nothing is spent, S = Y then APS = 1 maximum

23 value can possible up to 1 not greater than 1. Q 61 Q 62 As a result of increase in investment by Rs 75 crores, national income rises by Rs. 300 crores. Calculate a marginal propensity to save (MPS)? Multiplier (k) = Y/ I = 300 / 75 = 4 K = 1 / MPS, 4 = 1/ MPS MPS = ¼ or 0.25 LONG ANSWER TYPE QUESTIONS Why should planned savings and planned investment be equal at equilibrium level of income? Explain with the help of diagram. Equilibrium level of income is determined at a point where ex-ante or planned saving is equal to planned investment. AS = AD C + S = C + I S = I Q 64 Equilibrium of the economy is at point E. the level of income is OY*. Here the planned saving and planned invest are equal. What if planned saving is more than planned investment? (FG at OY 2 level of income) Excess of planned savings over planned investment means that the expenditure in the economy is less than what the producers had expected. This would result in undesired or unplanned buildup of unsold stock. To correct this situation producer will produce less. This will reduce level of output and income. Fall in income will result in fall in savings. These changes will continue till income falls to a level at which savings equal investment. # Just opposite will happen when planned investment is more than planned savings. Explain the concept of inflationary gap (excess demand). What is its impact on output, employment and price level in the economy? How reverse repo rate can help in controlling the inflationary gap? Inflationary gap may be defined as an excess of aggregate demand over aggregate supply at the full employment level. The inflationary gap results in the rise in general price level which is called inflation. The amount by which aggregate demand exceeds the level of aggregate production corresponding to full employment level of national income is known as inflationary gap.

24 Q 66 Inflationary gap occurs when people spend more money than the income generated. This results in unwanted and unplanned decrease in inventories of producers. They want to raise their production but cannot as the economy is already operating at full employment level of output (OY F ). This results in inflationary gap (EF). Central bank will increase the reverse repo rate which will attract commercial banks to deposit their reserve funds in safe hands of central bank. This will result in the flow of money from the economy towards the central bank. This will reduce the loaning capacity of banks hence the money supply and aggregate demand. Explain the concept of deflationary gap (deficient demand). What is its impact on output, employment and price level in the economy? How it can be controlled by government spending and taxation policy? Is it possible that the economy operates at under employment equilibrium? Explain with the help of diagram. What roll can the government play to achieve full employment? Deflationary gap may be defined as an excess of aggregate supply over aggregate demand at the full employment level. The deflationary gap results in the decrease in general price level. The amount by which aggregate demand is less than the level of aggregate production corresponding to full employment level of national income is known as deflationary gap. Deflationary gap occurs when people spend less money than the income generated. This results in unwanted and unplanned increase in inventories of producers. They will decrease their production hence output. The economy will be on new equilibrium point G showing under employment. Earlier the economy was operating at full employment level of output (OY F ). The deflationary gap is shown by EF. a. The Government should increase its expenditure on public programme.. b. The Government should decrease the taxes. Both these measures will retain more money with the public which in turn will increase the

25 aggregate demand in the economy. Q 67 Q 68 Q 69 Q 70 UNIT - 8 GOVERNMENT BUDGET AND THE ECONOMY ( 8 MARKS) SHT ANSWER TYPE QUESTIONS Write any three functions of Government budget. a. Redistribution of Income and wealth with the help of taxes and subsidies to reduce inequalities in the economy. b. Reallocation of resources for the balanced development of the country. c. Economic stability in the country by using fiscal and monetary policies to prevent business fluctuations. Explain the "Reallocation of resources" as the objective of government Budget. It means managed and proper distribution of resources. As private sector cannot provide all the goods and services the government has to provide these goods. so government uses its taxation and public expenditure policy to allocate the resources. It charges taxes on those areas which are already developed and spends money on backward areas to promote balanced economic development. Government raises its expenditure on producing public goods. Which economic value does it reflect? Explain. Increased expenditure by government on public goods like defense, maintaining law and order etc. increases their availability to the people of the country. For example more expenditure on maintaining law and order raises the sense of security among the people. Any such expenditure raises welfare of the people. What is meant by capital receipt? What are the components of capital receipts of the government?

26 Q 71 Q 73 Q74 Q 75 Q 76 Capital receipts are those which either create a liability or lead to reduction in assets. The main components are: Recoveries of loans from state govt., union territory govt. & other parties. Borrowings from the market, Reserve bank & other sources. Other receipts like disinvestment. Explain the basis of classifying taxes into direct & Indirect taxes? A direct tax is a tax the final burden of which falls on those on whom it is legally imposed & the impact of which cannot be shifted. For ex. Income tax. On the other hand indirect taxes are those taxes which are paid to the govt. by one person but their burden is borne by another person. For ex. VAT paid by shopkeepers to the govt. usually recovers it from the customers. Explain the role of government budget in fighting inflationary & deflationary tendencies. Govt. budget Or budgetary policy of the govt. plays a significant role in fighting inflationary & deflationary tendencies in the country. To combat inflationary tendencies, fiscal deficit is reduced by lowering govt. expenditure & raising govt. receipts. Exp. Lowered by cutting subsidies & receipts raised by increasing taxation. Likewise, deflationary tendencies are combated by increasing govt. expenditure by lowering receipts particularly by way of moderate tax structure. Give the relationship between the revenue deficit & fiscal deficit. When current expenditure is up revenue deficits tend to rise. The rising revenue deficit is reflected as a fiscal deficit & when fiscal deficit is high owing to high revenue deficit GDP growth receives a setback which raises unemployment. This leads to cut in govt. revenue receipts & raise in govt. welfare expenditure which economy driven to a state of stagnation. LONG ANSWER TYPE QUESTIONS Explain the concept of primary deficit in a government budget. What does it indicate? Primary deficit is the difference between fiscal deficit & interest payments. It indicates estimated borrowing by the govt. on account of excess of current year expenditures over current year receipts, exclusive of the burden of interest payments related to past debts. Primary deficit thus indicates the extent to which the govt. needs to borrow to implement its budgetary programmes & policies for the year ahead. In other words primary deficit shows that the country is in debt trap. Explain the concept of fiscal deficit in a government budget. What does it indicate? Fiscal deficit is the excess of budgetary exp. Over the receipts of the govt. excluding borrowing. Fiscal deficit = Total Expenditure [Revenue Receipts + Recoveries of Loans + Other Capital Receipts Mainly From Disinvestment] Fiscal Deficit = Total Expenditure [Revenue Receipts + Non Debt Creating Capital Receipts] Fiscal Deficit = Overall Borrowing Requirements of the Government It indicates borrowing requirement of the govt. to cope with the expenditures. Higher borrowing implies higher burden of repayment of loans and of interest on the future generations. Higher fiscal deficits points to the lack of financial discipline in the economy. It triggers inflationary pressures & lower credit rating of the domestic economy. Q 77 What are the implications of revenue deficit? State two measures to reduce this deficit. Revenue deficit is related to revenue expenditure & revenue receipts of the govt. Revenue deficit = Revenue expenditure - Revenue receipts Higher revenue deficit gives a warning to the govt. either to cut its expenditure or increase its tax/non tax receipts. Govt. cope this situation through borrowings or disinvestment. While borrowings increase liability of the govt., disinvestment reduces her assets. A well planned strategy is needed to strike a balance between assets & liabilities. Q 78 Giving reasons, categorize the following into direct & indirect tax :