BACHELOR'S DEGREE PROGRAMME
Term-End Examination June, 2011
EEC-11: FUNDAMENTALS OF ECONOMICS
Time: 3 hours Maximum Marks: 100 (Weightage: 70%)
Note: Answer questions from all sections as per instructions.
SECTION - A
Attempt any two questions from this section in about 500 words each: 2x20=40
1. What is meant by elasticity of demand? Explain the factors that influence elasticity of demand.
Ans: Demand is desire backed by willingness to pay and ability to pay i.e. a wish to have a commodity does not become demand. A person wishing to have a commodity should be willing to pay for it and should have ability to pay for it. Thus a desire becomes demand if it is backed by willingness to pay and ability to pay. Demand is meaningless unless it is stated with reference to a price.
Decisions regarding what to produce, how to produce and for who to produce are taken on the basis of price signals coming from the market. The law of demand explains inverse relationship between price and quantity demanded. When price falls quantity demanded of that commodity will increase. The deficiency of law of demand is removed by the concept of elasticity of demand.
MEANING AND DEFINITION OF ELASTICITY OF DEMAND
The term elasticity was developed by Alfred Marshall, and is used to measure the relationship between price and quantity demanded. The law states that the price of a commodity falls, the quantity demanded of that commodity will increase, i.e. it explains only the direction of change in demand and not the extent of change. This deficiency is removed by the concept of elasticity of demand.
Elasticity means responsiveness. Elasticity of demand refers to the responsiveness of quantity demanded of a commodity to change in its price.
According to E.K. Estham, “elasticity of demand is a measure of the responsiveness of quantity demanded to a change in price”.
FACTORS INFLUENCING PRICE ELASTICITY OF DEMAND
1. Nature of commodity: Elasticity depends on whether the commodity is a necessity, comfort or luxury. Necessities of life have inelastic demand and comforts and luxuries have elastic demand.
2. Availability of substitutes: Goods with substitutes have elastic demand and goods without substitutes have inelastic demand. For example: coffee and tea are substitutes. If price of tea increases, people may switch over to coffee. If price of coffee raises people may shift to tea. The demand of salt is inelastic.
3. Uses of the commodity: Certain goods can be put to many uses. Example – electricity. Such goods have elastic demand because as the price decreases, they will be put to more uses.
4. Proportion of income spent on commodity: For some goods, consumers spend only a small part of their income. The demand will be inelastic. For e.g.: - salt and matches
5. Price of goods: Generally cheap goods have inelastic demand and expensive goods have elastic demand.
6. Income of consumers: Very rich people have inelastic demand for goods and poor people have elastic demand. Because rich people will buy the commodity at all levels of prices where poor people there is a change in quantity of consumption according to change in price.
7. Time period: Elasticity would be more in the long run than in the short run. Because in the long run consumers can adjust their demand by switching over to cheaper substitutes. Production of cheaper substitutes is possible only in the long run.
8. Distribution of income and wealth in the society: If there is unequal distribution of income, the demand of commodities will be relatively inelastic. If the distribution of income and wealth in the society is equal there will be elastic demand for commodities.
2. Explain the meaning of IS and LM curves. How does an economy realise equilibrium in both goods and money market?
Ans: Meaning of IS and LM Curve: The IS-LM (Investment Saving – Liquidity Preference Money Supply) model is a macroeconomic model that graphically represents two intersecting curves. The investment/saving (IS) curve is a variation of the income-expenditure model incorporating market interest rates (demand), while the liquidity preference/money supply equilibrium (LM) curve represents the amount of money available for investing (supply). The model explains the decisions made by investors when it comes to investments with the amount of money available and the interest they will receive. Equilibrium is achieved when the amount invested equals the amount available to invest.
General Equilibrium in the IS-LM framework
The intention of the IS-LM framework is to bring the product market and money market outcomes into a single diagram so that we can simultaneously determine the equilibrium value of national income and the interest rate. In doing so, it recognises the interdependency between these markets, a point that Keynes demonstrated clearly.
The IS-LM framework thus conceives of a general equilibrium defined as the interest rate and income level that generates simultaneous equilibrium in the both the product and money markets. In a graphical form, this equilibrium position corresponds to the intersection of the IS and LM curves. In the Advanced Material Box we derive the algebra corresponding to this general equilibrium.
Figure given below shows the IS-LM solution for equilibrium income and interest rates, Y*, i*. Two things are worth noting. The vertical green line at YFE, denotes a full employment national output level. In other words, at this output level all available labour and capital are being productively deployed.
The IS-LM joint equilibrium thus can occur at levels of income which are below full employment in the labour market. This is consistent with Keynes’ insight that the capitalist monetary system has a tendency to reach under-full employment steady states which need to be shocked by policy interventions.
At Y* and i*, business firms are selling as much as they expected to sell and have no incentive to expand production and employment. The desire for liquidity by firms and households are also being full met by the available supply of money. This under-full employment equilibrium can be reached at interest rates above the minimum rate, where the economy enters a liquidity trap.
3. Explain the concept of balance of payments. What are its components ? Explain why balance of payments always balanced ?
Ans: Balance of Payment: The Balance of Payments (BOP) of a country is a systematic record of all economic transactions between the residents of a country and the rest of the world. It is composed of all receipts on account of goods exported, services rendered and capital received by residents and payments made by them on account of goods imported, services received and capital transferred to non-residents or foreigners.
The Balance of Payment or BOP is shown in the form of an Account or Balance sheet which enumerates how much has been received from foreigners and how much has been paid to them during a particular accounting period. Usually the accounts are prepared on an annual basis. The Balance of Payments Account of a country shows, on its credit side, the different items for which it has received payment and the amount of such payments. These are called the credit items. On the debit side the Account shows the items for which the country had paid to foreigners and the amount of such payments.
The Balance of Payment (BOP) statement is divided into two major accounts.
(i) Current Account and
(ii) Capital Account.
Transaction relating to goods, services and income constitute the current account, while those relating to claims and liabilities of a financial nature, which go to finance the deficit on current account or to absorb its surplus, form the capital account. The sum of these current and capital account transactions together constitute the basic Balance of Payments.
Balance of Current Account = [Export of goods + export of services + unrequited receipts] – [Imports of goods + Imports of services + unrequited payments] – unrequited receipts include gifts and indemnities etc. from foreigners while unrequited payments are gifts and indemnities to foreigners. Only in the year 1976-77 to 1979-80, India had a small current account surplus of 0.6% of GDP otherwise there is generally a deficit.
Balance of Capital Account = Capital Receipts – Capital Payments. Capital receipts include borrowings from, capital repayments by or sale of assets to foreigners. Capital payment includes lending to, capital repayments to or purchase of assets from foreigners.
Balance of Payment (BOP) = Balance of Current Account + Balance of Capital Account.
The Balance of Payment is sometimes also presented in three divisions as follows:
I. Current Account:
(a) Visible trade relating to imports and exports.
(b) Invisible items, viz, receipts and payments for such services as shipping.
(c) Unilateral transfers such as donations.
II. Capital Account:
(a) Short term movement of capital made by instruments of less than one year’s maturity, both private and government.
(b) Long term movement of capital, both private and governmental.
III. Official Reserve Assets Accounts:
(a) Gold stock.
(b) Holding of its convertible foreign currencies.
(c) Special Drawing Rights.
The official Reserve Assets Accounts consists of gold stock, holdings of its convertible foreign currencies, and Special Drawing Rights (SDRs). This account is the balancing item with respect to current and capital account transactions.
Why Balance of Payments always balanced?
They are the Debit Items. If the total of the debit items and the total of the credit items are equal in value, the country’s international payments are balanced. In other words, if the entries are done in a proper way debits and credits will always be in balance, so that in an accounting sense the BOP will always be in balance. Each debit has a corresponding credit entry. If the credit items are larger, so that there is a net balance due to it, the country is said to have a Favourable Balance. If the debit items are larger, so that there is a net balance due to foreigners, the country is said to have an Unfavourable Balance. The terms ‘favourable’ and ‘unfavourable’ are misleading but have the sanction of long usage.
4. Explain , with the help of indifference curves the impact on a consumer's demand of a rise in price of a commodity.
Ans: Effect of change in Price on Consumer’s Demand: The price effect shows the effect of a change in the price of a commodity on its quantity purchased by the consumer, when the price of other commodity and consumer’s income remain constant. We study the effect of rise in the price of good X on consumer’s equilibrium.
Assumptions: This analysis is based on the following assumptions:
1. Consumer wants to buy two goods X and Y.
2. Of these goods, the price of good X rises.
3. The price of good Y is given and constant.
4. Consumer’s income remains constant.
5. There is no change in tastes and preferences of the consumer.
Given these assumptions, the price effect is shown in Fig 28. When the price of good X rises, the consumer’s budget line PQ will extend further out to the right as PQ1 showing that the consumer will buy less X than before as X has become cheaper. The budget line PQ1 shows a further fall in the price of X.
Each of the budget lines fanning out from P is a tangent to an indifference curve I1, I2and I3 at R, S and T respectively. The curve PCC connecting the locus of these equilibrium points is called the price-consumption curve or PCC. PCC curve is defined as the locus of optimum combination of X and Y that result from a change in relative prices, holding money income constant.
In Fig. 28, the PCC curve slopes downward. As the price of X rises, the consumer buys less of X and more of Y. Thus at point S on the PCC curve, he purchases OB of X and OM of Y instead of OA of X and OL of Y at point R. A downward sloping price-consumption curve thus shows that the two goods X and Y substitutes for one another. If the PCC slopes upward as shown in Fig. 29, X and Y are complementary goods. The consumer purchases larger quantities AB and MN of both the goods at points R and T respectively.
SECTION - B
Answer any four questions from this section in about 250 words each. 4x12=48
5. What are the basic assumptions of perfect competition ? How does a perfectly competitive firm achieve equilibrium in the long run ?
Ans: Assumptions of Perfect Competition
- Large Number of Buyers and Sellers: There is large number of buyers and sellers, each buying or selling only a trivial fraction of the total market transactions.
- Homogeneous Product: Under perfect competition, rival firms sell a standardized good or service. There are no brand names, trademarks, patents in perfectly competitive market.
- Absence of Collusion or Artificial Restraint: Another condition is that there is no collusion among the buyers or sellers or sellers and buyers.
- Perfect Mobility of Factors of Production: Another important characteristic of perfect competition is that the factors of production are free to move from one firm to another throughout the economy.
- Profit Maximization: The goal of all firms in the industry is profit maximization.
- Perfect Knowledge: All buyers and sellers in the market possess perfect knowledge regarding the current and potential price and the availability of the commodity.
- No Transport Costs: This assumption is essential, as the same price will prevail only then in the market. Information regarding market trends is free and costless.
Equilibrium of a Firm under Perfect Competition
A firm is in equilibrium when it has no tendency to change its level of output. It needs neither expansion nor contraction. It wants to earn maximum profits. In the words of A.W. Stonier and D.C. Hague, “A firm will be in equilibrium when it is earning maximum money profits.”
Equilibrium of the firm can be analysed in both short-run and long-run periods. A firm can earn the maximum profits in the short run or may incur the minimum loss. But in the long run, it can earn only normal profit.
Long-run Equilibrium of the Firm:
In the long-run, it is possible to make more adjustments than in the short-run. The firm can adjust its plant capacity and scale of operations to the changed circumstances. Therefore, all costs are variable. Firms must earn only normal profits. In case the price is above the long-run AC curve firms will be earning supernormal profits.
Attracted by them, new firms will enter the industry and supernormal profits will be competed away. If the price is below the LAC curve firms will be incurring losses. As a result, some of the firms will leave the industry so that no firm earns more than normal profits. Thus “in the long-run firms are in equilibrium when they have adjusted their plant so as to produce at the minimum point of their long-run AC curve, which is tangent (at this point) to the demand (AR) curve defined by the market price” so that they earn normal profits.
6. Explain the law of variable proportions through appropriate diagram.
Ans: Law of Variable Proportions: The law of variable proportion is one of the fundamental laws of economics. It is also known as the 'Law of Diminishing Marginal Returns' or the 'Law of Diminishing Marginal Productivity.' This Law of variable proportion shows the input-output relationship or production function with one variable factor, i.e., a factor, which can be changed, while other factors of production are kept constant. This is explained with the help of the following example:
Suppose a farmer has 20 acres of land to cultivate. The land has some fixed investment, Le., capital in the form of tube well, farmhouse and farm machinery. The amount of land and capital is supposed to be fixed factors of production. However, the farmer can vary the number of workers employed on its land. Labour is thus the variable factor of production. The change in the number of workers will change the output.
Assumptions for Law of Variable Proportions
The law of variable proportions functions is based on following assumptions:
- Constant technology: The technology is assumed to be constant because technological changes will result into rise of marginal and average product.
- Snort-run: The law operates in the short-run because it is here that some factors are fixed and others are variable. In the long-run, all factors are variable.
- Homogeneous input: The variable input employed is homogeneous or identical in amount and quality.
- Use of varying amount of variable factor: It is possible to use various amounts of a variable factor on the fixed factors of production.
Three Stages of Production
A graphic description of the production function is shown in following figure 4.1. The total, marginal and average product curves in Figure 4.1, demonstrates the law of variable proportions. The figure also shows three stages of production associated with law of variable proportions. The total product curve is divided into three segments popularly known as three stages of production.
7. What according to Keynes are the different types of demand for money ? What are its implications ?
Ans: Refer below
8. Explain the product exhaustion theorem. What are the underlying assumptions in this theorem ? Or Euler’s theorem holds goods under perfectly competitive market?
Ans: The product exhaustion theorem states that since factors of production are rewarded equal to their marginal product, they will exhaust the total product. The way this proposition is solved has been called the adding up problem. Wick steed in The Coordination of the Laws of Distribution demonstrated with the help of Euler’s Theorem, that payment in accordance with marginal productivity to each factor exactly exhausts the total product.
The adding up problem states that in a competitive factor market when every factor employed in the production process is paid equal to the value of its marginal product, then pay in the production process is paid a price equal to the value of its marginal product, then payments to the factors exhaust the total value of the product. It can be represented numerically as under: Q = (MPL) L + (MPc) C
Where, Q is total output, MP is marginal product, L is labour and K is capital. To find out the value of output, multiply through P (Price). Thus
P x Q = (MPL X P) L + (MPc x P) C
(MPL X P) = VMPL and (MPc x P) = VMPc
PQ = VMPL x VMPc
Where, VMPL is the value of marginal product of labour and VMPc is the value of marginal product of capital.
Assumptions of this theorem
- It assumes a linear standardised production of first degree which implies invariable returns to scale.
- It assumes that the factors are complementary, i.e. if a variable factor increases; it increases the marginal productivity of the fixed factor.
- It assumes that factors of production are perfectly divisible.
- The relative shares of the factors are invariable and independent of the level of the product.
- There is a stationary, reckless economy where there are no profits.
- There is perfect competition.
- It is applicable only in the long run.
Based on these postulations of Euler, Wicksteed proved his theorem that when each factor was paid according to its marginal product, the total product would be exactly exhausted. This is based on the postulation of a linear standardised function. Few economists criticised his work and pointed out that the production function does not yield a horizontal long run average cost curve LRAC but a U Shaped LRAC curve. The U shaped LRAC curve first shows decreasing returns to scale, then constant and in the end increasing returns to scale.
9. Describe the determination of equilibrium price and quantity under simple monopoly.
Ans: MONOPOLY :- In a monopolistic market there is no perfect substitute for the product of a single seller and there is a separate demand curve for the product of each seller.
PRICE AND OUTPUT DETERMINATION UNDER MONOPOLY
The object of the monopolist is to earn maximum profit. The monopolist will charge such a price which will give him the maximum profit. He always compares marginal revenue with cost at its output rate. The profit of firm is maximum when it’s MR = MC and Marginal cost curve cuts the marginal revenue curve from below. The MR curve in negatively sloped and it also lies below the AR curve at all levels of output, except the first unit. The monopolist controls the whole market and no new firm can enter into the market so the distinction between a long run and short run is not necessary. The price and output determination can be explained by the following diagram :
EXPLANATION :- In this diagram AR curve is higher than the MR curve. The MC curve cuts the MR curve at a point E. Equilibrium occurs at a point E, where MR = MC. So the best level of output for the monopolist firm is OF. As regards the determination of price monopolist fixes the price OP because the total revenue of the firm will be maximum at the equilibrium output OF.
The cost of the firm will be = OSEF
The revenue of the firm will be = OPKF
10. What is a production function ? Show that Cobb - Douglas production function is linear homogeneous.
Ans: Meaning of production function: The production function relates the output of a firm to the amount of inputs, typically capital and labour. A firm may maximize its profits given its production function, but generally takes the production function as a given element of that problem.
Cobb-Douglas Production Function:
Charles W. Cobb and Paul H. Douglas studied the relationship of inputs and outputs and formed an empirical production function, popularly known as Cobb-Douglas production function. Originally, C-D production function applied not to the production process of an individual firm but to the whole of the manufacturing production. The Cobb-Douglas production function is expressed by : Q = ALαKβ
Where Q is output and L and A’ are inputs of labour and capital respectively. A, α and β are positive parameters where α > 0, β > 0. The equation tells that output depends directly on L and K and that part of output which cannot be explained by L and К is explained by A which is the ‘residual’, often called technical change.
The marginal products of labour and capital are the functions of the parameters A, α and β and the ratios of labour and capital inputs. That is,
MPL =∂Q/∂L = αAL α-1K β
MPK = ∂Q/∂K = βAL αK β-1
The two parameters a and P taken together measure the degree of the homogeneity of the function. Although the С-D production function is a multiplicative type and is non-linear in its general form, it can be transferred into linear function by taking it in its logarithmic form. That is why, this function is also known as log linear function, which is
Log Q = log A + a log L + p log K
SECTION - C
Answer all Questions from this section in about 100 words each. 2x6=12
11. Write short notes on any two of the following :
(a) Backward - bending supply curve of labour
Ans: A labour supply curve that is positively-sloped for relatively small quantities of labour and negatively-sloped for relatively large quantities of labour. In other words, workers supply larger quantities of labour in response to a higher wage when the wage is relatively low. However, when the wage reaches a relatively high level, further increases in the wage entice workers to reduce the quantity supplied. The supply curve thus bends back on itself.
(b) Phillips curve
Ans: Refer below
(c) Terms of trade
Ans: The Terms of Trade is the average price of exports / by the average price of imports. It is a measure of a countries relative competitiveness. If export prices rise relative to import prices we say there has been an improvement in the terms of trade. If import prices rise relative to export prices we say there has been a deterioration in the terms of trade.
(d) Oligopoly
Ans: Refer below
12. Distinguish between any two of the following :
(a) Partial and general equilibrium
Ans: The main difference between partial and general equilibrium models is, that partial equilibrium models assume that what happens on the market one wants to analyze has no effect on other markets. Therefore in partial equilibrium models one only considers a market for one good and assumes that the price of every other good or the wealth one has does not change.
In general equilibrium models every market has an effect on every other market and therefore a change in one market may have changes in another market and therefore one has to model every market simultaneously.
(b) Fixed cost and variable cost
Ans: In economics, fixed costs and variable costs are the two main kinds of costs associated with production of a good or service.
Fixed costs are costs that do not vary with the level of production. They are the same if a firm produces one unit of their product or one million units. Fixed costs typically include such things as the rent on the building in which the firm produces its product.
Variable costs are the costs that do vary with the level of production. For example, a restaurant's fixed costs will include the cost of the food they prepare and serve to customers as well as the cost of the labor of wait staff and cooks.
(c) Stocks and flows
Ans: Difference between stock and flows:
Stocks
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Flows
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(d) Taxes and transfer payments
Ans: Taxes payments refer to collection of tax from public. These payments are made to the government. In economics, a transfer payment is a redistribution of income in the market system. These payments are considered to be non-exhaustive because they do not directly absorb resources or create output.