PART: A Introductory Micro Economics Capsules UNIT: I TOPIC: INTRODUCTION

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1 CLASS- XII ECONOMICS PART: A Introductory Micro Economics Capsules UNIT: I TOPIC: INTRODUCTION A: Basic concepts 1. Definition of Economics 2. Central problems of an economy 3. Production possibility curve 4. Opportunity Cost 5. Micro Economics and Macro Economics Definition of Economics: Economics is a Social Science. It seeks to answer questions relating to the economic behavior of the people of the society and the economy. Central Problems of an economy: I) Problem of allocation of recourses a) What to produce & How much to produce? b) How to produce? c) For whom to produce? II) Fuller utilization of resources III) Growth of resources of economic development. 1. The what problem refers to which goods and services will be produced in an economy and in what quantities. 2. The how problem refers to the choice of methods of production of goods and services. 3. The for whom problem concerns with the distribution of income and wealth. Marks : 4 Production possibility curve. A production possibility curve depicts those different combinations of two commodities that an economy can produce with the help of available resources. 4. Normally, the production possibility curve is concave to the origin. It is because of increasing marginal opportunity cost. 5. A production possibility curve shifts out due to technological progress or increases in the supply of resources available to an economy or both. Opportunity Cost. It refers to the cost of a factor in the next best use/ activity. Micro and Macro Economics: ECONOMICS Q1-XII-3

2 Micro economics studies the economic activities of individual units in the economy like a consumer, a producer, a market. Macro economics studies aggregates at the level of the economy like aggregate demand, aggregate supply, total saving, total investment, population etc..positive Economics and Normative Economics Positive Economics deals with what is and Normative Economics deals with what ought to be. B: Question Answer: Very short answer type questions with answers ( 1 mark each) 1) What is meant by economic problem? Ans. By economic problem we mean the problem of choice. 2) Why does economic problem arise? Ans. The economic problem arises due to scarcity of resources. 3) What is the shape of production possibility curve? Ans. PPC is concave to the origin and slopes downwards. 4) Who is known as the Father of economics? Ans. Adam Smith. 5) What is meant by scarcity definition? Ans. Economics is a science that studies human behavior as a relationship between ends and scarce means which have alternative uses. 6) What are the main features of human wants? Ans. i.wants are unlimited. ii. They arise again and again (wants are recurrent). 7) Who gave the welfare definition of economics? Ans. Dr. Marshall 8) What do you mean by allocation of resources? Ans. It means the distribution of resources for the production of consumer goods and services. 9) What is meant by economising resources? Ans. Making the best utilization of scarce resources. 10) Why do all economies have similar economic problems? Ans. Scarcity of resources gives birth to economic problems in all economies. 11) Use production possibility curve technique to show growth of resources in an economy. Ans: ECONOMICS Q1-XII-4

3 12) Define marginal opportunity cost along the PPC? Ans: Marginal Opportunity cost refers to the loss of output of good-y when resources are shifted from Y to produce an additional unit of good-x. Short answer type questions with answers (3 or 4 marks each) 1. Draw a production possibility curves and show the following situations in the diagram. a) Full employment of resources b) Under utilization of resources c) Growth of resources Ans. 2. What are the central problems of the economy? Ans. They are as follows: a) The problem of allocation of resources i. What to produce and how much to produce ii. How to produce? iii. For whom to produce? b) How to achieve fuller utilization of resources c) How to achieve growth of resources. 3. What are the economic activities of economy? Explain them. Ans. 1) Production: The production is the process of creation of utility like wood into furniture as Table, chair etc. 2) Consumption: The process of using up the commodity for the satisfaction of wants. 3) Investment: Addition made to the stock of capital. 4.What are the characteristics of PPC? Ans. i) The production possibility curve slopes downwards to the right indicating that the economy has to sacrifice,more and more amount of the other good per unit increase in the production of the good in question. ECONOMICS Q1-XII-5

4 ii) It is concave to the point of origin: it shows the operation of the law of increasing marginal opportunity cost. 5. An economy always produces on, but not inside, a PPC. Define or refute? Ans. In the economy with the given resources being fully employed and technology given, the combination of two goods will be any where on PPC. The society decides any combination like A,B on PPC. If there is inefficient use of resources or unemployment in any form in the economy, the economy will operate strictly within the PPC, for example, at point G. 6. Distinguish between Micro and Macro economics. Micro 1.It deals with the behaviour of individual economic units. 2. Demand and supply are the main tools of analysis. 3.It explains how resources are allocated among various goods and services and how N.I. is distributed in the economy 4.It is concerned with the determination of equilibrium level of prices of goods and services of a firm. Macro 1.It deals with the study of the economy as whole 2.Aggregate demand and aggregate supply are the main tools of analysis. 3.It explains how productive capacity and N.I. of the country increase over time. 4.It is concerned with the determination of equilibrium level of output, employment and income etc. of the economy. 7. Explain the central problems facing an economy. Scarcity of resources is a common feature of all types of economics.every economy has to face problems relating to choice which are known as central problems. 1. Problem of allocation of resources. Every economy has to allocate its available resources in the production of goods and services. While allocating resources the economy has to decide what, how and for whom to produce. 2. Problem of Efficient utilization of resources. The problem refers how to use available resources in the best possible manner and to get maximum production. 3. Problem of Growth of Recourses. It has become most essential for under developed countries not only to make the full use of their resources but to increase their production capacities also through the growth of resources. ECONOMICS Q1-XII-6

5 UNIT-II Consumer s Equilibrium and demand CHAPTER II Consumer Choice and demand curve A. Basic Concepts: 1. Consumers are the persons who make demand for final goods and services. 2. Producers are those who supply final goods and services. 3. Final goods are the things consumed by household. 4. Intermediate goods are consumed by producers. 5. Utility refers to the want satisfying power of a commodity. 6. Total utility refers to the total psychological satisfaction obtained by a consumer from consuming a given amount of particular good. 7. Marginal utility is the extra or additional utility obtained from the last unit consumed. 8. Law of diminishing marginal utility states that as a consumer consumes more and more of a commodity, the M.U. derived from each additional unit goes on diminishing. 9. The consumer is in equilibrium when he maximizes his satisfaction at a given income and price of commodity and it is attained when = Its price M.U. of a Product M.U. of a Rupee Marks : 13 Or, M.U. of a Product = M.U. of a rupee Consumers equilibrium through IC approach; Consumer equilibrium refers to a situation, in which a consumer derives maximum satisfaction, with no intention to change it and subject to given prices and his given income. The point of maximum satisfaction is achieved by studying indifference map and budget line together. On an indifference map, higher indifference curve represents a higher level of satisfaction than any lower indifference curve. So, a consumer always tries to remain at the highest possible indifference curve, subject to his budget constraint. The consumer s equilibrium under the indifference curve theory must meet the following two conditions: (i) MRSXY = Ratio of prices or PX/PY Let the two goods be X and Y. (iii) The first condition for consumer s equilibrium is that MRSXY = PX/PY a. If MRSXY > PX/PY, it means that the consumer is willing to pay more for X than the price prevailing in the market. As a result, the consumer buys more of X. As a result, MRS falls till it becomes equal to the ratio of prices and the equilibrium is established. b. If MRSXY < PX/PY, it means that the consumer is willing to pay less for X than the price prevailing in the market. It induces the consumer to buys less of X and more of Y. As a result, MRS rises till it becomes equal to the ratio of prices and the equilibrium is established. (ii) MRS continuously falls: The second condition for consumer s equilibrium is that MRS must be diminishing at the point of equilibrium, i.e. the indifference curve must be convex to the origin at the point of equilibrium. Unless MRS continuously falls, the equilibrium cannot be established. Thus, both the conditions ECONOMICS Q1-XII-7

6 need to be fulfilled for a consumer to be in equilibrium. Let us now understand this with the help of a diagram:, IC1, IC2 and IC3 are the three indifference curves and AB is the budget line. With the constraint of budget line, the highest indifference curve, which a consumer can reach, is IC2. The budget line is tangent to indifference curve IC2 at point E. This is the point of consumer equilibrium, where the consumer purchases OM quantity of commodity X and ON quantity of commodity Y. All other points on the budget line to the left or right of point E will lie on lower indifference curves and thus indicate a lower level of satisfaction. As budget line can be tangent to one and only one indifference curve, consumer maximizes his satisfaction at point E, when both the conditions of consumer s equilibrium are satisfied: (i) MRS = Ratio of prices or PX/PY: At tangency point E, the absolute value of the slope of the indifference curve (MRS between X and Y) and that of the budget line (price ratio) are same. Equilibrium cannot be established at any other point as MRSXY > PX/PY at all points to the left of point E and MRSXY < PX/PY at all points to the right of point E. So, equilibrium is established at point E, when MRSXY = PX/PY. (ii) MRS continuously falls: The second condition is also satisfied at point E as MRS is diminishing at point E, i.e. IC2 is convex to the origin. Demand and its determinants 1.Demand is the quantity of a good that that the consumer is willing to buy at a price at a time. 2.Price of related goods, income and tastes of the consumer are the determinants of demand. 3.Law of demand states that other things remaining same, as the price of commodity increases, the quantity demanded by a consumer falls and vice-versa. 4.Demand curve slopes downwards because of operation of diminishing marginal utility, income effect and substitution effect. 5.Exceptions to the law of demand conspicuous consumption, Giffen goods, Necessary goods, Expectations of future change in price. 6.Change in quantity demanded or Movement along the demand curve- whenever there is a change in the price of commodity, the quantity demanded of the commodity changes, other things remaining constant.. 7. Increase and decrease of demand: when demand changes not due to price but due to other factors like income, tastes & preferences then it is termed as change in demand. Elasticity of demand 1. The degree of responsiveness of demand to a change in the price of a commodity. 2. Price elasticity - the percentage change in quantity demanded divided. by the percentage change in the price of the commodity. Ep = %Change in Quantity Demanded % Change in price Measurement of Elasticity of demand.1. Proportionate or percentage method. ECONOMICS Q1-XII-8

7 (i) e p = (Q 1 -Q 0 )/Q 0 (P 1 -P 0 )/P 0 OR (ii) e p = Q/ P x P 0 / Q 0 Types of Elasticity of demand 1. Perfectly inelastic demand. 2. Inelastic demand. 3. Unitary elastic demand. 4. Elastic demand. 5. Perfectly Elastic demand. Determinants of Elasticity of demand or Factors affecting elasticity of demand. 1. Availability of close substitutes 2. Habits. 3. Change in income 4. Proportion of income spent on a particular good. 5. Postponement of demand. B. Question-Answer [1 mark each] 1. What is equilibrium?, Ans. The position or state of rest. 2. What are final goods? Ans. All those goods which are used for consumption or for capital formation. Example - Bread, vegetables, machines.etc. 3. What are intermediate goods? Ans. They are the raw materials consumed in producing other goods. 4. What is total utility? Ans. The total psychological satisfaction obtained by a consumer from consuming a particular commodity., 5. What is marginal utility? Ans. The utility derived from the last unit consumed. 6. State the law of diminishing marginal utility. Ans. The law states that after consuming a certain amount of a good or service the Marginal utility from it diminishes as more and more is consumed. 7. State the condition of consumer's equilibrium. Ans.The condition is - Marginal utility of a product =its price. Marginal utility of a Rupee 8.What are inferior goods? Ans.Inferior goods are those for which demand falls as income increase. ECONOMICS Q1-XII-9

8 Short type questions - answers [3/4 marks each] 1. What is meant by income effect? Ans. Income effect is the part of the price effect. When the price of a commodity falls, real income of the individual increases. As a result, more of the goods will be bought and his demand increases. This part of the increase in demand due to increase in real income is income effect of a fall in the price of a good on its demand. 2. What is substitution effect? Ans. When the price of a commodity falls, the commodity becomes relatively cheaper than its substitutes. So the people consuming.the substitute also start demanding this commodity and its demand increases. This is substitution effect. 3. Can the demand curve slope upwards? Ans. In some cases the demand curve slopes upwards. i) Giffen goods. Inferior goods have large negative income effect. ii) Demand increases when prestige is attached to the possession of a good, 4. What is meant by Elasticity of demand? Ans. Elasticity of demand shows the degree of responsiveness of demand to change in the price of a commodity. 5. Price of a commodity rises from Rs. 5 to Rs. 6. As a result its demand falls from 100 units to 80 units. Find out price elasticity of demand by percentage method. Ans: E P = Q/ P X P/Q = 20/1 X 5/100 =1 6. On the basis of information given below compare the price elasticities of good A and B. a) Good A (b) Good B Price Total expenditure (Rs) Price Total expenditure(rs) Ans: (a) Price T.E QD (b) price T.E QD E P = Q/ P X P/ Q E P = Q/ P X P/Q = 1/1 x 4/5=0.8 = 1/ 1 x 3/5 = 0.6 Demand for good A is more elastic than that of good B.. 7. Differentiate between change in demand and change in quantity demanded. Ans. Change in demand or Shift of the demand curve: i) This happens when at the same price more or less is demanded. ii) Other factors affecting demand change causing a right or leftward shift of the demand curve. iii) It is of two types - increase in demand (rightward shift) and decrease in demand (leftward shift). Change in Quantity demanded ECONOMICS Q1-XII-10

9 Change in quantity demanded or movement along the demand curve: i) This happens, when at a lower(higher) price, more(less) is demanded. ii) Other factors affecting demand remain constant. iii) It is of two types expansion(downward movement along a demand curve and contraction of demand (upward movement along a demand curve). Long questions [ 6 Marks each] 1. What are the determinants of demand? Explain. Ans. Following are the determinant of demand. / (i)income of the consumer - The effect of change in Income on the demand depends on the Nature of commodity.... Normal Goods: - If Income Increases the demand for normal goods Increases. Inferior goods :- Their demand falls with an increase in the income. ii) Prices of related goods: Substitute goods:- There is a direct (positive) relationship between the price of a good and demand of its substitute goods. If the price of coffee increases, its demand will fall and people will start consuming its substitute-tea. Complementary goods :- There is a negative or inverse relationship between the price and demand of complementary goods. If the price of sugar increases, demand for tea will decrease. iii) Tastes - If there is a favorable change in taste, demand will increase and the demand curve shifts rightwards and vice-versa. iv) Expectations: If the expectation is for the prices to rise in future, then there is increase in demand and ECONOMICS Q1-XII-11

10 if the expectation is for the prices to fall in future then there is fall in demand.. 2. Explain the factors affecting price elasticity of demand. Ans. Elasticity of demand is the responsiveness of demand to changes in the price of a commodity. i) Availability of close substitutes - If close substitutes of a product are available, elasticity is high because a small increase in price will make the consumers switch over to other products in a big way. As a result, there is a proportionately large fall in demand for the product. In the absence of close substitutes the elasticity is likely to be small. ii) Nature of the commodity. Demands for essential products are likely to be in elastic whereas demand for luxury items is relatively elastic. iii) Proportion of total expenditure spent on the product. If the amount spent on a product forms a small proportion of the, total expenditure on all goods and services we consume, then the price elasticity is likely to be small.. iv) Habits - If a person gets into the habit of consuming a commodity, it becomes difficult for him to reduce the consumption of that commodity even at a higher price and hence for such commodities demand is relatively inelastic. Production and Costs A: Basic Concepts UNIT- III Producer Behaviour and Supply Chapter - 3 Production - is the transformation of inputs into output. Production function It is a relationship between inputs used and output produced by the firm. Various combinations of inputs. Factors inputs are classified as (i) Fixed factors and (ii) variable factors. [Marks 13] i) Fixed Factors are those factors which do not vary to change the level output. Their costs remain fixed even with the change in output e.g. land, machinery, top management etc. ii) Variable Factors are those factors which vary to change the level of output. The costs of such factors vary with level of output. E.g. labour, raw material etc. ECONOMICS Q1-XII-12

11 The Short run and The Long run: Short run refers to that period when all the factors can not be changed by a firm to change the level of output. Some factors of production are fixed and some are variable. Long run refers to the period when all the factors can be changed by a firm to change the level of output. All factors are variable and no factor is fixed. Law of variable proportions and Law of Diminishing Returns : Law of variable proportions : It says that the marginal product of a factor input initially rises with its employment level. But after reaching a certain level of employment, it starts falling. Law of Diminishing marginal product or law of diminishing returns : It says that if we keep increasing the employment of an input, with other inputs fixed, eventually a point will be reached after which the marginal product of that input will start falling. The reasons behind the law of diminishing returns or the law of variable proportions. (i) Initially, the factor proportions become more and more suitable for the production, as a result marginal product increases. (ii) After a certain level, the production process becomes too crowded with the variable input and the factor proportions become less and less suitable for production. As a result marginal product of the variable input starts falling. Returns To A Variable Factor Units of Labour Total product AP MP (Quintals) (Quintals) (Quintals) Stage I Stage of increasing returns to a factor Stage II Stage of Diminishing returns to a factor Stage III Stage of negative returns to a factor ECONOMICS Q1-XII-13

12 According to this law as more and more units of a variable factor are applied with fixed factors, in the short run, initially the TP increases at an increasing rate ; after a certain level of employment the TP increases at diminishing rate and finally, total product starts declining with every increase in the variable input. First Stage : i) TPP increases at an increasing rate ii) MPP increases and reaches its maximum point. Second Stage : i) TPP increases at a diminishing rate ii) MPP decreases but remains positive & finally becomes zero. Third Stage : i) TPP begins to fall. ii) MPP becomes negative.. COSTS A: Basic Concept: COSTS : The expenses incurred by the producer on hiring & Purchasing the factors of production are known as the cost of production. Total cost is the amount of money incurred on the production of a given level of output. Short Run: There are two types of costs 1. Fixed Costs are those costs which do not vary with the level of output. These costs include depreciation allowance, interest on fixed capital, rent of building, wages and salaries of permanent employees, insurance premium etc. These are called overhead costs. ECONOMICS Q1-XII-14

13 2. Variable costs are those costs that change with the level of output. For e.g. labour costs and costs of raw materials. TC = Total Fixed Cost (TFC) + Total variable cost (TVC) (a) Total fixed cost curve is horizontal because fixed costs do not change with the change in output. (b) TVC and TC increase with the output. These curves are upward sloping. (c) Total cost curve is the vertical summation of the total fixed cost and total variable cost curves. (a) At the zero level of output, TC = TFC because TVC is zero, when output is zero. COST T C T V C T F C OUT PUT Output TFC TVC TC Average cost is the cost per unit of output : AC = TC/Q TC = Total cost, Q = Quantity of output. Average cost is the sum of average fixed cost and average variable cost. AC = AFC + AVC Reasons for U - shape of the SAC Curve. (i)operation of the law of variable proportions. ECONOMICS Q1-XII-15

14 (ii)the shapes of AFC and AVC curves. Average fixed cost is the per unit fixed cost of producing a commodity. AFC = TFC/Q TFC = Total Fixed Cost, Q = Quantity of output. AFC can be calculated by dividing total fixed cost by quantity of output produced. The shape of AFC curve is rectangular hyperbola. Average variable cost is the per unit variable cost of producing a commodity. AVC =TVC/Q TVC = Total variable cost, Q = Quantity of output. AVC is obtained by dividing total variable cost by the quantity of output. Note : i) The AFC curve continuously decreases as output increases because the numerator of the ratio TFC / Q is constant while the denominator increases. ii) The AVC and ATC curves slope downwards initially and then rise upwards i.e. they are U-shaped. Marginal cost is defined as the change in total cost when one extra unit of output is produced. Inotherwords, it is the additional cost of producing an extra unit of output. Total costs and total variable costs differ only by a constant amount i.e. TFC. MC is the increase in TVC when one extra unit is produced. TVC = the sum of MCs. = The area under the marginal cost curve. Output : MC(Rs) : Here, the TVC of producing 5 units of output is Rs ( ) = Rs. 27. Similarly, the TVC of producing 9 units will be Rs( ) = Rs. 100 The MC is initially decreasing in output and then it is increasing i.e. it is U ` shaped. The reason behind the U shape of the MC curve is the law of diminishing returns. i.e. other inputs remaining the same, when a firm raises a variable input in the short run, initially the MP rises which leads to a fall in MC ; after a certain point the employment of Input leads to a decrease in its marginal product and then MC rises. As more and more output is produced, initially the rate of increase in the requirement of the variable input will be less and less ; and after a certain point, it will be more and more. Initially, the rate of increase in the variable cost which is same as the MC will be less as output increase and then, it will be more and more when output increases further. so the MC curve is U- shaped. ECONOMICS Q1-XII-16

15 Relationship between AVC, ATC and MC. 1. AVC, ATC and MC curves are U shaped. 2. MC curve cuts the AVC and ATC curves at their minimum points. 3. MC is the addition to both the TVC and the TC. (a) The AVC curve is decreasing in the range of output from O to q 0. At any output level in this range MC<AVC (b) At any output greater than q 0, AVC is increasing in output, hence MC>AVC. (c) (a) and (b) together imply that the MC curve must cut the AVC curve at the AVC s minimum point. Relationship between TC and MC. 1. When the TC rises at a diminishing rate, the MC declines. 2. When the rate of increase in TC stops, the MC is at its minimum. 3. When the rate of increase in TC starts rising, the MC is increasing. Chapter - 4 The Theory of the Firm under Perfect Competition A: Basic Concepts: Revenue : The money receipts from the sale of the product. Total Revenue : refers to the total amount of money received by the firm from the sale of its products. TR = Price x output. Average Revenue is the revenue per unit of the output AR = TR / Q = P X Q / Q = P AR is always equal to price. Marginal Revenue is defined as the change in total revenue when one extra unit is sold. i.e. it is the revenue obtained from one extra or last unit sold.suppose the firm s output has increased from q0 to (q0+1). Given market price is P, notice that MR= ( TR from output(q0+1) ) (TR from output q0) = (P * (q0+1) ) (pq0) = P In other words, for a price taking firm, marginal revenue equals the market price. ECONOMICS Q1-XII-17

16 A Competitive firm is a price taker. If it sells one extra unit, the extra revenue generated will be equal to whatever the price is MR = P for a competitive firm. Profit : the difference between TR and TC. Producer s equilibrium : an equilibrium notion in the sense that if the firm selects the level of output at which profit is maximized, it would like to stay or rest at that level of output ; there is no incentive for it to increase or decrease output from that level. Producer s equilibrium : The Basis of the supply curve 1. TVC = the areas under the marginal cost curve. 2. TR is equal to the area under the price line The Profit maximizing condition : A competitive firm faces the market price Po i.e. PoA is the price line and its marginal cost curve is denoted by MC. A competitive firm s profit is maximized at the point where the price line intersects the MC curve i.e. P = MC (i.e. at point q 0 ) with P denoting the market price. This is the profit maximizing condition or the condition for producer s equilibrium. Why is profit maximized where the price line intersects the MC curve? Gross profit = TR TVC = profit + TFC. Since TFC is constant, profit is maximized where gross profit is maximized and vice-versa. At the market price Po, the gross profit is maximized at the output q 0, where the price line Po inter sects the MC curve. TR = the area under the price line = OPoAq 0. TVC = the area under the MC curve = ODAq 0 Gross profit = OPoAq 0 ODAq 0 = DPoA At any output less than q 0 say q, the gross profit = DPoA B. This is less than DPoA. ECONOMICS Q1-XII-18

17 At the level of output greater than q 0 i.e. q, the total revenue = OPoA q and the total variable cost = ODCq. Gross profit = OPoAOq ODPCq = DPoA ACA This is also less than DPoA. Hence, at any level of output either less or greater than q 0, the gross profit is less. Hence, profits are maximum at q 0 where P=MC. Rational behind the condition P = MC. Producer s equilibrium condition P = MC be increasing with output. Starting from the level of output at which P = MC, the firm decides to produce one unit more. Given that MC is increasing in output, P will be less than MC. But P and MC are respectively equal to extra revenues earned & extra costs incurred. Hence, extra revenues will be less than the extra costs, implying that the profits will be less. Suppose the firm decides to produce one unit less than where P = MC. In this case the revenues sacrificed (equal to P) are greater than savings in costs. (equal to MC) Hence profits will also be less. Increasing or decreasing output from where P = MC results in less profits. Profit is maximized where P = MC as long as MC is increasing in output. A competitive firm chooses an output only on the rising portion of the MC curve. General profit maximizing condition : For a competitive firm, P = MR, MR = MC Law of supply and the supply curve : Supply : Quantity of a commodity which a firm or an industry is willing to produce at a particular price, during a given time period. Law of supply : Other things remaining unchanged, an increase in the price of a product leads to an increase in the quantity supplied of it and vice-versa. Supply schedule : The table which shows the quantities of a commodity supplied at various prices during a given time period. Supply curve : The graphical representation of a supply schedule. The rising part of the MC curve is the supply curve itself. All price output combinations are simply the points of the rising part of the MC curve. Change in quantity supplied : a movement along a given supply curve because of a price change. Change in supply : a shift of the supply curve due to a change in other factors. Determinants of supply or the supply curve : the factors that change the supply are the determinants of supply ECONOMICS Q1-XII-19

18 1. Technological Change : Science and research laboratories and business firms look for new technology or methods that reduce costs of production. Such a technological advance lowers marginal costs at any given level of output. Since the MC curve is essentially the supply curve, a technological progress shifts the supply curve to the right. 2. Input Prices : changes in raw material prices, wages to workers etc. can also affect the MC curve and the supply curve. An increase (a decrease) in an input price shifts the supply curve to the left (right). 3. Unit Tax : A tax that the government imposes per unit sale of output. Hence they add to the TVC, and a change in the rate of this tax affects the overall MC. An increase (a decrease) in the unit tax shifts the supply curve to the left (right) 4. The prices of related products An increase (a decrease) in the price of a substitute good in production shifts the supply curve of a good to the left (right). Market supply curve is derived by the horizontal summation of the individual supply curves. Factors affecting the market supply curve: i) Technological change ii) Change in input prices iii) No, of firms: An increase (a decrease) in the number of firms shifts the market supply curve to the right (left). iv) More (less) competition shifts the market supply curve to the right (left). v) Time Horizon: In a short period within which firms cannot adjust their output to any change in price, the supply curve of a firm or the whole industry is vertical. In a longer run the supply curve will be upward sloping because inputs can be changed. Movement along a supply curve : When other factors influencing supply do not change, and the own price of the commodity changes, the change in supply takes place along the curve only. This is called movement along a supply curve. A movement from one point to another on the same supply curve is also referred to as a change in quantity supplied. Shifts of the supply curve : When supply changes due to changes in factors other than the own price of the commodity, it results in a shift of the supply curve. This is also referred to as a change in supply. ECONOMICS Q1-XII-20

19 Extension and Contraction of Supply: Other things remaining the same, the rise in supply of a commodity due to rise in its price is called extension of supply. Extension of supply leads to an upward movement along the supply curve. price P1 S P S O Q Q1 Q.S. Other things remaining the same, the fall in supply of a commodity due to fall in its price is called contraction of supply.contraction of supply leads to a downward movement along the supply curve. price P E S P1 E1 O Q1 Q Q.S. Increase and Decrease in Supply: The price of the commodity remaining the same, rise in supply of the commodity due to other factors like improvement in technology, low input price etc. is known as increase in supply. Increase in supply leads to a rightward shift of the supply curve. Price S S1 P E E1 O Q Q1 Q.S. ECONOMICS Q1-XII-21

20 The price of the commodity remaining the same, fall in the supply of a commodity due to other factors like rise in input prices, rise in unit tax etc.is known as decrease in supply.decrease in supply leads to a leftward shift of the supply curve. S1 Price S P O Q1 Q Q.S. PRICE ELASTICITY OF SUPPLY: Quantifies the responsiveness of quantity supplied to a change in price of a commodity. e s = P / S x s / p denotes the change If the supply curve is vertical, then the price elasticity of supply is obviously zero. Supply curve is positively sloped. The price elasticity is positive. B: Question-Answer Very short answer questions : (1 mark each) 1) What is production function? Production function is the technological relationship between factors of production and physical quantities of output. 2) What is meant by total physical product (TPP)? TPP refers to the total volume of goods and services produced during a specified period at a particular level of employment of an input when the employment of other inputs is unchanged. TPP = Σ MPP or TPP = APP x L (L = variable factor) 3) What is meant by average physical product? APP is production per unit of the variable factor. APP = TPP/L 4) What is marginal physical product? MPP = TPP n TPP n 1 5) How is the TPP derived from MPP schedule? By adding up marginal physical product of various units of a variable factor. TPP = Σ MPP. 6) What is meant by returns to a factor? ECONOMICS Q1-XII-22

21 Returns to a factor explain the behaviour of the output while the employment of one input varies, keeping other inputs constant. 7) State the law of variable proportions. If one factor is increased keeping other factors constant, MPP initially increases with an increase in the employment of the input, then it diminishes and finally becomes negative. 8) State the law of diminishing returns. The employment of other inputs remaining the same as more of a particular input is used in production, after a certain level, the MPP decreases with further employment of it. 9) What is meant by fixed factors? Those factors of production whose supply cannot be increased in the short run. 10) What are variable factors? Those factors whose supply can be changed at any time according to requirement for more production. 11) What is meant by fixed cost? Those short run costs which do not vary with the level of output are known as fixed costs. For e.g. depreciation of machines, interest on fixed capital. 12) What is meant by variable cost? Those costs which vary with the level of output ; e.g. Cost of raw material. 13) What is total cost? It is the total of all costs equal to the sum of total fixed costs and total variable costs. 14) What is total variable costs? It is the total of all costs that vary with the level of output. 15) What is average cost? It is the total cost divided by the output AC = TC/ Q 16) What is average fixed cost? It is the total fixed costs divided by the output. AFC = TFC / Q 17) What is average variable cost? It is the total variable cost divided by the output. AVC = TVC / Q 18) What is meant by marginal cost? MC is the increase in total cost or total variable cost incurred when an extra unit of output is produced. 19) What is the general shape of AFC? AFC is a rectangular hyperbola. 21) What do you mean by volume discount? It is the discount on price when a large quantity of input is purchased by a firm. ECONOMICS Q1-XII-23

22 22) What does producer s equilibrium mean? It is a situation when a producer maximizes his profits, minimizes losses (if any) in the production of goods and services. 23) What is the condition of producer s equilibrium? P = MC in perfect market. MR = MC in imperfect market. 24) What is price-line? It is the horizontal line that represents the market price facing a competitive firm. 25) What is profit? Profit is the difference between total revenue and total cost. 26) What is market structure? It refers to the no. of firms, the nature of competition between them and the nature of the product. 27) What is market period? It is that short a period within which firms cannot adjust their output to any change in price and thus a firm s output is given. 28) What is overhead cost? It is the total of all costs that are independent of the level of output. 29) What does supply mean? Supply refers to the quantity of a commodity that a seller offers for sale at a given price, at a point of time in specific market. 30) What does stock imply? Stock of a commodity refers to the total quantity of a commodity which at any point of time a seller can make available for sale in the market. 31) State the law of supply. Other things remaining the same, higher the price, greater the quantity supplied and lower the price, smaller the quantity supplied. 32) What is supply schedule? A supply schedule is a tabular statement that gives a full account of supply of a particular commodity at different prices at a point of time in a specific market. 33) What is supply curve? It is the graphic presentation of quantity supplied of a product showing that higher the price, the greater is the quantity supplied and vice-versa. 34) What is market supply curve? Market supply curve is the graphic presentation of market supply schedule which shows total quantities offered for sale at various prices by different firms producing a particular commodity. 35) What is meant by change in supply? If the price of the commodity remains constant and the supply is changed by the changes in other factors, it is known as change in supply. 36) What is extension in supply? ECONOMICS Q1-XII-24

23 Other things being equal, when quantity supplied of a commodity increases due to rise in price alone, it is known as extension in supply. 37) What is contraction in supply? When there is a fall in supply due to a fall in price, it is known as contraction in supply. 38) What is increase in supply? When supply of a product increases due to other factors like improvement in technique of production, changes in goals of firms etc. it is known as increase in supply. 39) What does decrease in supply mean? When supply of a product falls due to other factors like expected fall in prices in future, rise in factor prices etc. it is known as decrease in supply. 40) What is price elasticity of supply? Elasticity of supply is the responsiveness of supply of a commodity to a change in its price. 41) Write the formula for elasticity of supply. e s = P / S x s / p 42) What does supply function mean? It is a functional relation between supply of a commodity and its various determinants. 43) What effect does a cost saving technical progress have on the supply curve? Supply curve shifts rightward. 44) What effect does an increase in input price have on supply curve? Supply curve shifts leftward. 45) What effect does an increase in excise tax rate have on the supply curve of the product? Leftward shift of the supply curve. Short Answer Question [ 3 or 4 marks each ] 1. Explain the determinants of supply i) Price of the commodity Higher the price, greater would be the supply. ii) Prices of factors of production with he rise in prices of factors of production, cost of product will rise. So the supply will fall. iii) Goals of the firms If the firm has the goal of profit maximisation, supply will rise. 2. Distinguish between short run and long run Short Run Long Run i) The period when all the factors cannot i) All the factors of production be changed become variable ii) Some factors are fixed and some are ii) All are variable variable 3. Returns to a factor Returns to scale i) Short run concept i) Long run concept ii) Only one or some inputs can be changed ii) All factors are variable keeping other inputs fixed. iii) Factor ratio changes iii) No change in factor ratio iv) There is no change in scale of production iv) change in scale of production v) Refers to change in output when one input v) Refers to change in output when all ECONOMICS Q1-XII-25

24 input is variable. 4. What is the relationship between AP and MP? i) When MP increases, AP also increases ii) iii) iv) MP increases at a greater rate as compared to AP. At one stage AP becomes equal to marginal product. AP falls when MP falls at a greater rate. v) AP falls even when MP is zero. 5. What is the relationship between TP & MP? i) When MP increases TP increases at an increasing rate. ii) iii) iv) When MP falls, TP increases at a diminishing rate. When TP is maximum, MP is zero and AP falls. When MP is negative, TP diminishes. 6. Differentiate between fixed cost and variable cost Fixed cost inputs are variable. Variable cost i) amount spent on fixed factor i) amount spent on variable factors ii) does not vary with the change in output ii) varies with the change in output iii) remains the same even when output is zero iii) It s zero when output is nil iv) Example - rent, insurance premium iv)example cost of raw materials, salaries of permanent workers. 7. Explain the relationship between MC and AC i) When MC<AC, AC falls. ii) iii) iv) When MC = AC, AC is at its minimum. When MC>AC, AC increases. When MC starts rising, AC continue of fall. v) Minimum point of MC comes before the minimum points of AC. 8. What is the relationship between MC and TC. i) When TC rises at a decreasing rate MC falls ii) When the rate of increase in TC starts diminishing, MC becomes minimum iii) When TC increases at an increasing rate MC increases 9. Why are the MR and AR of a perfectly competitive firm equal? Because price of the good remains same at all levels of output due to the existence of a large number of firms and the firms produce and sell homogeneous product. Output Price TR AR ECONOMICS Q1-XII-26

25 Why is the AC curve U shaped? i) Because of law of variable proportion :- In the beginning, with increase in output, AC falls because of the operation of the law of increasing returns. After reaching the minimum point, when we increase the output, AC starts increasing due to the operation of diminishing returns. ii) Indivisibilities of the factor In the short run when a firm increases the output, due to indivisibilities of some fixed factors of production, AC curve falls in the beginning. After the optimum point, AC increases. Thus AC curve gets U-shape. 11. What is producer s equilibrium? Write the condition of producer s equilibrium? A producer is in equilibrium when it maximizes profits and has no tendency to move away from this situation till circumstances remain unchanged. Conditions: i) ii) MR = MC MC curve cuts MR from below. 12. Calculate TFC, TVC, AFC, AVC, MC when Output : TC : Ans: Output TC TFC TVC AFC AVC MC Differentiate between increase in supply and decrease in supply Increase in supply More quantity at the same price Same quantity at a lower price Decrease in supply Less quantity at the same price Same quantity at a higher price ECONOMICS Q1-XII-27

26 ii) Causes Causes Improvement in technique of production Obsolete technology Change in goals of firm Changes in goals of firm Fall in factor prices Rise in factor prices Increase in number of firms Decrease in number of firms Tax concessions and subsidies Increase in tax rates Increase in prices of related goods Fall in prices of related goods. 14. Distinguish between extension in supply and contraction in supply Extension in supply Contraction in supply i) A rise in supply of a commodity due to i) There is a fall in supply due to fall in rise in its price, other things remaining price, other factors remaining unchanged. Constant. Note : Draw the diagram below the explanation. 15. Mention the factors affecting market supply curve. i) No. of firms. ii) Possibility of expected change in price iii) Taxes and subsidies. iv) Change in technology v) Input price changes vi) Agreement among producers. 16. Mention the factors determining elasticity of supply. i) Nature of commodity ECONOMICS Q1-XII-28

27 Perishable and agricultural goods-inelastic Durable goods elastic ii) Cost of production If the production is subject to diminishing costs supply will be more elastic. In case of increasing costs, supply will be less elastic. iii) Time period During short period, supply will be less elastic In long period, supply is more elastic iv) Technique of production Goods using simple technique of production elastic supply In case of complex goods, less elastic v) Risk bearing capacity The goods will have elastic supply if risk bearing capacity of the firms is large. If producers are unable to bear risk, they will produce less elastic goods. 17. When the price of wheat was Rs. 500 per quintal, a producer supplies 10 quintals but when price rises to Rs. 550 per quintal, he supplies 12 quintals of wheat. Determine price elasticity of supply. e s = P / S x s / p = 500 / 10 x 2 / 50 Thus, e s = A seller sells 80 Kgs of potatoes a day when the price of potatoes is Rs. 4 per kilogram. The price elasticity of supply of potatoes is known to be 2, how much quantity of potatoes will the seller supply when the price rises to Rs. 5 per Kgs. e s = P / S x s / p 2 = 4 / 80 x s /1 2 = 4 s / 80 4 s = 80 x 2 4 s = 160 s = 160 / 4 = 40 Total supply by the seller at price of Rs. 5 = S + S = = 120 Kgs 19. The co-efficient of elasticity of supply is 1 5. What percentage change in supply will happen if its price rises by 40%. e s = % change in quantity supply / % change in price 1 5 = x% / 40% x% =1.5 x 40 = 60 Long Answer Questions (6 marks each) 1. Explain the law of variable proportion with the help of a suitable diagram. ECONOMICS Q1-XII-29

28 The law of variable proportions states that if the input of one resource is increased by equal amount per unit of time while the inputs of other resources are held constant, total output will increase, but beyond some point the resulting output increases will become smaller and smaller. Assumptions of the law : i) There is one variable input and the other inputs are fixed. ii) Units of variable input are increased by an equal amount each time. iii) All the units of variable input are homogeneous. iv) The state of technology is given. v) Different factors can be employed in varying proportions. Units of labour Total product Marginal Product Average Product Stage I : Stage II : Stage III : Stages Total Product Marginal Product Average Product 1st TP increases at an increasing At initial stage MP increases AP also increases Stage rate and reaches maximum level 2nd TP increases at a diminishing Decreases and becomes Zero AP falls, becomes equal Stage rate and becomes the highest. to MP. Starts decreasing further but never becomes zero. 3rd Starts declining Becomes negative Further decreases but ECONOMICS Q1-XII-30

29 Stage never becomes zero or negative. UNIT IV Forms of Market and Price determination CHAPTER 5 Price determination under perfect competition with simple applications A. Basic concepts 1) Excess demand pushes up the market price by causing competition among buyers. Excess supply pushes down the market price by causing competition among the sellers. 2) At the market equilibrium, there is no excess demand or excess supply and demand and supply curves intersect. 3) Equilibrium price is the price at which the quantity demanded is equal to quantity supplied. 4) A non-viable industry is one in which demand and supply curves do not intersect. The supply curve lies above the demand curve and thus nothing is produced. 5) A rightward (left ward) shift of the demand curve leads to an increase (a decrease in) price and quantity transacted. If the demand curve shifts to the right and the supply curve to the left, the price rises. 6) A rightward (leftward) shift of the supply curve leads to a decrease (an increase) in price and an increase (a decrease) in quantity transacted. 7) An increase in the price of a substitute (complementary) good in consumption leads to an increase (a decrease) in price and quantity transacted of a good in question. 8) An increase in income results in higher (a lower) price and quantity transacted if the good is normal (inferior). 9) A favourable (unfavourable) taste shift leads to a higher (lower) price and quantity transacted. 10)A cost reducing technological progress leads to a lower price and more quantity being sold. 11)An increase in an input price leads to a higher price, and less quantity being sold. 12)An increase in rate of exise duty leads to a higher price and less quantity being exchanged. 13)A price control system includes a rationing scheme. Marks : 10 14)A price support system leads to a surplus of output, which is purchased by the government. B: Question Answer ECONOMICS Q1-XII-31

30 Very short type questions : (1 mark each) 1. Give the meaning of excess demand for a product? Ans: When quantity supplied is less than quantity demanded of a product. 2. What do you mean by excess supply of a product? Ans: When quantity demanded is less than quantity supplied of a product. 3. Define market equilibrium. Ans: It refers to a market situation in which demand equals supply. 4. What is meant by equilibrium price. Ans: The price at which quantity demanded is equal to quantity supplied. 5. What is the relationship between the control price and the equilibrium price? Ans: The control price is less than equilibrium price. 6. What is the relationship between the support price and the equilibrium price? Ans: The support price is higher than the equilibrium price. 7. What is equilibrium quantity? Ans: The quantity sold at the equilibrium price. 8. What is control price? Ans: The price fixed by the government in case of essential commodities. 9. When will an increase in demand imply an increase in price but no change in quantity supplied? Ans: When the supply is perfectly inelastic during very short period. 10. What is black marketing? Ans: It refers to a situation in which a particular commodity is sold at a price higher than the price fixed by the government (control price). Short type questions [3 or 4 marks] 1. How does an increase in input price affect the equilibrium quantity exchanged in the product market? Ans: An increase in an input price leads to a higher price and less quantity being exchanged. Use diagram showing supply curve shifting to the left. 2. How does an increase in the income affect the equilibrium price of a product? Ans: An increase in income results in a higher (a lower) price and quantity exchanged according as the good is normal (inferior). [Hints: Use diagram showing demand curve shifting to the right in case of normal goods, as income increases. 3. What will be impact on market price and quantity exchanged when there is a rightward shift in the demand curve? Ans: Supply remaining the same, a rightward shift in the demand curve means higher price and higher quantity sold. Use diagram. 4. What will be impact on market price and quantity exchanged when the demand curve is perfectly elastic and the supply curve shifts out? Ans: No change in the market price, equilibrium quantity will increase. 5. What will be impact on market price and quantity exchanged when both the demand and supply curve decrease in same proportion? Ans: Price remains the same, equilibrium quantity decreases. Use diagram. Long answer type questions [ 6 Marks] ECONOMICS Q1-XII-32

31 1. Equilibrium price may or may not change with shifts in both demand and supply curves Comment. Ans: i) If both demand and supply curves increase in same proportion, there will be no change in equilibrium price but equilibrium quantity will increase. ii) When both the demand and supply curve decrease in same proportion, price remains the same but the equilibrium quantity will decrease. iii) If the supply curve increases in a greater proportion than the demand curve, price of the product will decrease. Note: Use diagram in each case. A: BASIC CONCEPTS: CHAPTER - 6 FORM OF MARKET STRUCTURE Imperfectly competitive markets are of three types: monopoly, monopolistic competition and oligopoly. In perfect competition there are a large number of sellers selling a homogeneous product. In monopoly there is a single seller selling a product which has no close substitute. Monopolistic competition is a market having a large number of sellers selling differentiated products. It consists of competitive and monopolistic elements. In other words, the monopolistic compete with each other in this market structure. A monopoly market structure emerges from licensing, granting of a patent or forming a cartel. A monopoly is a price maker. A perfectly competitive firm is a price taker. In perfect competition price remains low and hence consumers are gainers. In monopoly a higher price is charged and less is sold. Patents encourage discovery and invention. Oligopoly market has few sellers.a perfect oligopoly market produces only homogeneous products whereas an imperfect oligopoly market produces differentiated products. In collusive oligopoly market,firms cooperate with each other in taking price and output decisions whereas in non-collusive oligopoly, firms compete with each other in taking price and output decisions, B: QUESTION-ANSWER: Very short type questions: [1 Mark each] 1. What is perfect competion? Ans. It is a market situation in which there are large number of buyers and sellers selling a homogeneous product at a uniform price. ECONOMICS Q1-XII-33

32 2. What is abnormal profit? Ans. It is equal to the producer s excess earning over the opportunity cost. 3. What is normal profit? Ans. It is the profit which a firm must earn in the long run to remain in business. 4. What is monopoly? Ans. It is a market situation in which there is a single seller selling a commodity which has no close substitute. 5. What is monopolistic competition? Ans. It is a market situation where there are large number of sellers selling differentiated products. 6. What is the shape of the demand curve under Monopoly? Ans. It is downward sloping and price-inelastic. 7. What is the shape of demand curve under Monopolistic competition? Ans. It is down ward sloping & price - elastic. 8. Why is the demand curve under monopoly downward sloping? Ans. It is so because a monopolist can sell more only by reducing price. 9. Why is the demand curve under monopolistic competition flatter? Ans. The demand curve is flatter because a large number of substitutes(differentiated product) are sold in this market. 10. What is the shape of demand curve under perfect competition? Ans. A perfectly competitive firm faces a perfectly elastic demand curve. Short answer questions (3 or 4 marks) 11. What are the main features of prefect competition? Ans. Perfect competition has the following features: (a) There are a large number of buyers and sellers in the market. (b) Product is homogeneous (c) There is free entry and exit of firms. 12. What are the conditions for monopoly market? Ans. (a) There must be a single seller of the commodity. (b) No close substitute of the product of the firm is available. (c) There are barriers to entry. The barriers can be economic, institutional or artificial in nature. These barriers are so strong that they prevent entry of any firm except the one firm which is already in the field. 13. What are the main features of monopolistic competition? Ans. It is a market situation which has both the competitive elements and monopolistic elements. It has the following features : (a) There are a large number of sellers and buyers. (b) There is free entry and exit in the long run. ECONOMICS Q1-XII-34

33 (c) There is product differentiation i.e. each firm produces a brand that is unique and different from what other firm produces. 14. How is a firm under perfect competition a price-taker but the industry is a price-maker? On the other hand, the number of firms in the industry is so large that any individual firm, through its action, can not influence the market price. They have to take the price determined at the industry level as given. So, the firms are considered to be price takers. Under perfect competition, the price is determined by intersection of demand and supply curve of the industry as a whole. So, the industry is called the price maker. 15. Why is the shape of the demand curve under monopoly less elastic? Explain : Ans. (a) The demand curve facing a monopolist is downward sloping as he can expect to sell more by reducing the price. This is shown in the diagram. The monopolist sells OM quantity at OP price. If he wants to increase his sales by MM 1 he can do this by reducing price by PP 1, as a fall in price will cause an increase in quantity demanded. (b) The demand curve under monopoly is also very steep, that is, the demand curve DD in the diagram is in-elastic due to the absence of close substitutes. 16. Why is the shape of the demand curve under monopolistic competition more elastic? Explain : Ans. (a) The demand curve facing a producer under monopolistic competition is downward sloping as shown by the demand curve DD in the diagram. A producer in such a market can increase his sales by reducing his price. Quantity demanded i.e. sale can be increased by MM 1 if price is reduced by PP 1. (b) (c) The demand curve is more elastic as the differentiated products are close substitutes of each other. Number of firms is large. 17. Long answer questions (6 marks each) Ans. Differentiate between Perfect competition and monopolistic competition. ECONOMICS Q1-XII-35

34 Perfect Competition Monopolistic competition a) Infinitely large number of firms a) A large numbers of firms b) Homogeneous products b) Differentiated products c) Firms have no control over price. c) Firms have some control over price. d) Demand is infinitely elastic d) Demand is more elastic e) Demand curve (AR) is a straight line e) Demand curve is a flatter downward parallel to horizontal axis shown below showing greater elasticity f) P = MC at equilibrium point. f) P>MC at equilibrium point. g) No selling costs incurred g) Selling costs are important features in this competition. h) Price is lower than the price in h) Price is higher than competitive price due monopolistic competition. to the monopoly element. i) AR = MR i) AR>MR or MR<AR 18. Differentiate between monopoly and monopolistic competition. Monopolistic competition Monopoly a) There are a large number of sellers. a) There is a single seller. b) There is product differentiation, products b) Unique products with no close are close substitutes for each other. substitutes. c) Price elasticity of demand is more c) Price elasticity of demand is less. d) Firms have some control over price. d) Monopolist has considerable control over price. e) Presence of selling cost is an important e) No selling cost as there is no feature. competition. f) Free entry and exit of the firm f) Barriers to entry of a new firm g) Price discrimination can not be followed. g) Price discrimination may be followed under certain conditions. 19. Explain the relationship between TR and MR under monopoly with the help of a schedule and diagram : Ans. TR increases as long as MR is positive. TR is maximum when MR = O TR decreases as MR is negative. Table Output Price TR MR (in units) (in Rs.) (in Rs.) (in Rs.) ECONOMICS Q1-XII-36

35 If we plot the above schedule on the graph paper we obtain the TR and MR curves. The TR curve is inverse U-shaped because the monopolist can sell more by reducing the price. So, the TR first increases with output and then it decreases. Thus, the shape of the TR curve is different under monopoly, than the one under a competitive firm SIMPLE APPLICATION TOOLS Price Ceiling:- means maximum price of a commodity fixed by the government that the sellers can charge from the buyers. It is imposed on necessary commodities like wheat, rice, kerosene, oil, sugar etc. Price ceiling results in excess demand and less supply in the market. It is below the equilibrium price.the shortage of commodity in the market results in following implications a) Emergence of black market b) Rationing Price Floor (minimum support Price) :- it is fixed by the government necessarily above the equilibrium price. Sometimes when government feels that the price for a particular good or service should not fall below certain level and sets a floor or a minimum price for these goods and services Example: - Imposition of support price on agricultural commodities in case of requirement the government fixes the support price above the equilibrium price. Price floor results in excess supply and less demand Part - B I ntroductory M acro Economics Capsules UNIT V National I ncome and Related aggregates A: Basic concepts: 1. National Income(NNP FC ) : N.I. is the sum of domestic factor income (NDP FC ) and net factor income from abroad (NFIA). MARKS 10 ECONOMICS Q1-XII-37

36 2. Closed Economy : An Economy which does not have economic relations with other countries. 3. Open Economy : An Economy which has economic relations with other countries. 4. Final Goods : All goods which are meant either for consumption or for investment. 5. Net Domestic product : It is the gross domestic product less consumption of fixed capital. 6. Accounting period : An accounting year or a financial year often does not coincide with a calendar year. It covers the period from 1 st April of the present year up to 31 st March of the next year 7. Nominal GNP : GNP measured in terms of current market prices. 8. Real GNP : GNP computed as per constant prices. 9. Real Flow : The flow of income in terms of goods and services. 10. Money Flow : The flow of income in terms of money. B: Question- Answers Very short answer-questions (1 mark) 1. Define National income at current prices? Ans. N.I. at current prices is the money value of final goods and services estimated at current prices produced by normal residents during an accounting year. 2. Define factor income? Ans. Income earned by a factor of production i.e. in form of Rent, wages, interest and profit, in the process of production. 3. What is the name of income earned from property and entrepreneurship? Ans. Operating surplus. 4. What are the components of profit. Ans. (i) Undistributed profit, (ii) corporation tax, (iii) dividends. 5. Define personal Income? Ans. It is defined as current income of persons or household from all sources. 6. Define personal disposable income. Ans. It is that part of the personal income which is available to the households for expenditure 7. What is meant by double counting? Ans. Double counting means counting the value of the commodity more than once. 8. What is meant by Net indirect taxes? Ans. Net indirect taxes is the difference between indirect taxes and economic subsidies. 9. What are the main components of operating surplus? Ans. (i) Rent (ii) Interest (iii) Profit 10. Who prepares the National Income estimates of the country? Ans. Central Statistical Organization (C. S. O.) 11. What is added to domestic factor income to obtain national income? Ans. Net factor income from abroad is added to domestic factor income to obtain national income. 12. What is final consumption expenditure? Ans. Expenditure incurred on final goods and services is called final expenditure. ECONOMICS Q1-XII-38

37 13. What is primary sector? Ans. It is the sector which produces goods by exploiting natural resources like land, water, mines, forests etc. 14. What are intermediate goods/ inputs? Ans. The goods or inputs which get used up in producing other goods or are meant for resale are called intermediate goods/ inputs. 15. Why is imputed rent included in national income? Ans. Housing services are productive. Therefore imputed rent of owner-occupied houses forms a part of national income. 16. Define the concept of value added? Ans. It is defined as the difference between total value of output of a firm and value of inputs bought from others. 17. What is called Green GNP? Ans. Green GNP would help to attain sustainable use of the natural resources and equitable distribution of the benefits of development. 18. When is national income equal to domestic income? Ans. When net factor income from abroad is zero. 19. What are transfer payments? Ans. Transfer payments are payments for which no goods or services are provided in exchange. 20. Explain the meaning of non-market activities. Ans. Non market activities are those activities which have no market price. Ex. An electrical fault can be repaired by himself. Short answer type questions (3 & 4 marks) 1. Explain briefly the components of domestic factor income. Ans. Domestic factor income has been classified into three parts : (1) Compensation of employees : All payments by residents producers of wages and salaries to their employees in kind and in cash, social security contributions paid by employers etc. (2) Operating Surplus : The income earned from property and entrepreneurship is called operating surplus. They are rent, interest and profit. (3) Mixed income of self employed : Income of own account workers, profits and dividends of unincorporated enterprises. 2. What are the main components of Gross Domestic product at market price by Expenditure Method? Ans. There are four components : (1) Private final consumption expenditure. ECONOMICS Q1-XII-39

38 (2) Govt. final consumption expenditure. (3) Gross Domestic capital formation. (4) Net exports (Exports Imports). 3. Differentiate between intermediate goods and final goods with example. Ans. Intermediate goods Final Goods (1) These goods get used up in (1) These are used for final producing other goods and services. consumption or for capital formation. (2) These are for resale (2) These are not for resale. (3) Value of these commodities are not (3) Value of these commodities are included in N.I. included in the N.I. (4) Ex : Coal used in factory. (4) Ex : Coal used at home for cooking. 4. State the components of net factor income from abroad. Ans. The normal resident of a country earn income from abroad and income is paid to non-residents for their factor services within the domestic territory. The difference between these two is net factor income from abroad. Components : 1) Net compensation of employees. 2) Net income from property and entrepreneurship. 3) Net retained earning of resident companies from abroad. 5. Differentiate between current transfer and capital transfers. Ans. Current Transfers Capital Transfers (1) Current transfers are made from current (1) Capital transfer are made out of the income. past savings and wealth of the donor. (2) They contribute to the current income of (2) They contribute to capital formation of the recipient. of the recipient. (3) They are used for current consumption (3) They are used for long term expenditure. expenditure.. 7. Calculate Net value added at factor cost from the following data : Items Rs. in Crores 1) Intermediate consumption 30 2) Consumption fixed capital 12 3) Indirect taxes 10 4) Sales 120 5) Closing Stock 40 6) Subsidies 6 7) Opening Stock 12 Ans. Solution : Net value added at factor cost = Sales + Closing stock opening stock Intermediate consumption consumption of fixed capital Indirect taxes + subsidies = = ( ) ( ) ECONOMICS Q1-XII-40

39 = = 102 Rs. Crores 8. From the following data calculate the Gross National product at market price. Rs. in Crores 1) Value of output in primary sector ) Intermediate consumption of secondary sector 700 3) Net factor income from abroad ( ) 40 4) Net indirect taxes 200 5) Value of output in secondary sector ) Value of output in tertiary sector ) Intermediate consumption of primary sector 800 8) Intermediate consumption of teritiary sector 1500 Ans. Solution : GNP MP = [Value of output in primary sector value of intermediate consumption in primary sector] + [Value of output in secondary sector value of intermediate consumption in secondary sector] + [Value of output in Teritiary value of intermediate consumption in Teritiary sector] + Net factor income from abroad. = [ ] + [ ] + [ ] + ( ) 40 = = = 3060 Rs. Crores. 9. Show the circular flow of income with two-sector Economy with the help of a diagram. Ans. ECONOMICS Q1-XII-41

40 Long answer questions (6 Marks each) 1. What precautions will be taken for calculating national income by expenditure method? Ans. (1) Expenditure on second hand goods is to be excluded since the same is not incurred on currently produced goods. (2) All govt. expenditure on transfer payments should be excluded. (3) To avoid double counting expenditure on intermediate goods and services should be excluded. (4) Expenditure on purchases of shares, bonds etc. should not be included since they are just transfer of ownership of physical assets. 2. Explain briefly the income method of measuring national income. Also state any two precautions to be taken in using this method. Ans. N.I. is measured in terms of payments made to the primary factors of production. Income method is also called as Factor payment method. It involves different steps : Step I : Identification and classifications of producing enterprises : (a) Primary (b) secondary (c) tertiary sectors Step II : Classification of factor income into different types : (i) Compensation of employees (ii) Rent (iii) Interest (iv) profit (v) mixed income Step III : Estimate factor income in every sector Step IV : Adding up factor income of all sectors to get NDP FC Step V : Add NIFA to NDP FC to arrive at National Income (NNP FC ). Precautions: (1) Imputed rent of owner occupied houses and value of production for self-consumption should be included. (2) Illegal income from smuggling, gambling are not included in estimating N.I. ECONOMICS Q1-XII-42

41 3. Distinguish between GDP and GNP. How are they related to each one another? Ans. GDP: It is the total value of all goods and services produced within the domestic territory of a country in an accounting year. When GDP is computed at current prices it is called GDP MP. But on the other hand, when it is estimated on some base-year s price, it is known as GDP at constant price. GNP: It is a wider concept than the concept of GDP. It is the gross money value of all the final goods and services produced by normal residents of a country within and outside the country. If net factor income from abroad is positive then GNP is greater than GDP. GDP is greater than GNP, when net factor income from abroad is negative. GDP = GNP Net factor income from abroad. GNP = GDP + Net factor income from abroad. 5. From the following data Calculate the GDP at Factor cost by (a) Expenditure method and (b) Income method. Items : Rs.in Crores 1) Personal consumption expenditure 700 2) Wages and salaries 700 3) Employer s contribution to social security schemes 100 4) Gross domestic capital formation 70 5) Rent 100 6) Mixed income 600 7) Net factor income from abroad 25 8) Consumption of fixed capital 25 9) Indirect taxes 10 10) Net exports 35 11) Government final consumption expenditure ) Profit 63 13) Interest 12 14) Subsidies 5 Ans. Solutions: 1) GDP FC by Expenditure Method: GDP MP = Personal consumption expenditure + Govt. final consumption expenditure + Gross domestic capital formation + net exports. = = 1605 Rs. in Crores. GDP FC = GDP MP Indirect taxes + Subsides = ECONOMICS Q1-XII-43

42 = = 1600 Rs. in Crores. 2) GDP FC by Income Method: (i) GDP FC = Rent + Interest + wages & salaries + employer s contribution to social security schemes + profit + mixed income + consumption of fixed capital = = 1600 Rs. Crores. GDP FC by Exp. method = 1600 Rs. Crores GDP FC by Income Method = 1600 Rs. Crores 6. Calculate NNP FC by Income method and expenditure methods. Items Rs.in Crores (a) Compensation of employees 250 (b) Govt. final consumption expenditure 250 (c) Indirect taxes 20 (d) Gross fixed capital formation 75 (e) Operating surplus 360 (f) Changes in stock 60 (g) Imports 64 (h) Exports 130 (i) Net factor income from abroad 25 (j) Subsidies 5 (k) Mixed income of self employed 16 (l) Consumption of fixed capital 10 (m) Private final consumption expenditure 200 (n) Interest on national debt 20 Ans. Solutions: i) NNP FC by income Method: = Compensation of employees + Operating surplus + Mixed income of self- employed + Net factor income from abroad = = 651 Rs. Crores. ii) NNP FC by Expenditure Method: Step I: GDP MP = Private final consumption exp. + Govt. final Consumption exp. + Gross fixed capital formation + changes in stock + Exports Imports = = = 651 Rs. in Crores. Step II: NNP FC = GDP MP - Depreciation + Net factor income from abroad Indirect taxes + subsidies = ECONOMICS Q1-XII-44

43 A: BASIC CONCEPT: = = 651 Rs. in Crores. UNIT VI MONEY AND BANKING The main function of money in an economy is to facilitate the exchange of goods and services. The exchange of goods against goods is called barter system. Money performs four specific functions a unit of value, a medium of exchange, a standard of deferred payments and a store of value (functional definition). India follows a managed paper currency standard with a minimum reserve system of note issue. Money supply is the total stock of money of various kinds at a particular point of time. Banking is the process of accepting deposits and advancing loans. [M ARKS=6] The central bank is the apex institution of a country s monetary system. Its main responsibility is to design and control the monetary policy of the country. MONEY CREATION/DEPOSIT CREATION/CREDIT CREATION BY COMMERCIAL BANK Let us understand the process of credit creation with the following example. Suppose there is an initial deposit of Rs and L.R.R. is 20% i.e., the banks have to keep Rs. 200 and lend Rs. 800/-. All the transactions are routed through banks. The borrower withdraws his Rs. 800/- for making payments which are routed through banks in the form of deposits account. The Bank receives Rs. 800/- as deposit and keeps 20% of Rs.800/- i.e., Rs.160/- and lends Rs.640/-. Again the borrower uses this for payment which flows back into the banks thereby increasing the flow of deposits. 95 Deposits (in Rs.) Loans (in Rs.) Cash Reserve Ratio (20%) Initial deposit First round Second round Total MONEY MULTIPLIER: Money Multiplier = 1/LRR. In the above example LRR is 20% i.e., 0.2, so money multiplier is equal to 1/0.2=5. Why only a fraction of deposits is kept as Cash Reserve? a) All depositors do not withdraw the money at the same time. b) There is constant flow of new deposits into the banks. CENTRAL BANK MEANING: An apex body that controls, operates, regulates and directs the entire banking and monetary structure of the country. FUNCTIONS OF CENTRAL BANK: i) Currency authority or bank of issue: Central bank is a sole authority to issue currency in the country. Central Bank is obliged to back the currency with assets of equal value (usually gold coins, gold bullions, foreign securities etc.,) Advantages of sole authority of note issue: a) Uniformity in note circulation b) Better supervision and control c) It is easy to control credit d) Ensures public faith e) Stabilization of internal and external value of currency ii) Banker to the Government: As a banker it carries out all banking business of the ECONOMICS Q1-XII-45

44 Government and maintains current account for keeping cash balances of the government. Accepts receipts and makes payments for the government. It also gives loans and Advances to the government. 96 iii) Banker s bank and supervisor: Acts as a banker to other banks in the country a) Custodian of cash reserves:- Commercial banks must keep a certain proportion of cash reserves with the central bank (CRR) b) Lender of last resort: - When commercial banks fail to need their financial requirements from other sources, they approach Central Bank which gives loans and advances. c) Clearing house: - Since the Central Bank holds the cash reserves of commercial banks it is easier and more convenient to act as clearing house of commercial banks. iv) Controller of money supply and credit: - Central Bank or RBI plays an important role during the times of economic fluctuations. It influences the money supply through quantitative and qualitative instruments. Former refers to the volume of credit and the latter refers to regulate the direction of credit. v) Custodian of foreign exchange reserves. Another important function of Central Bank is the custodian of foreign exchange reserves. Central Bank acts as custodian of country s stock of gold and foreign exchange reserves. It helps in stabilizing the external value of money and maintaining favourable balance of payments in the economy. QUANTITATIVE INSTRUMENTS: i) Bank Rate policy: - It refers to the rate at which the central bank lends money to commercial banks as a lender of the last resort. Central Bank increases the bank rate during inflation (excess demand) and reduces the same in times of deflation (deficient demand) ii) Open Market Operations: It refers to the buying and selling of securities by the Central Bank from/ to the public and commercial banks. It sells government securities during inflation/excess demand and buys the securities during deflation/deficient demand. iii) Legal Reserve Ratio: R.B.I. can influence the credit creation power of commercial banks by making changes in CRR and SLR Cash Reserve Ratio (CRR): It refers to the minimum percentage of net demand and time liabilities to be kept by commercial banks with central bank. Reserve Bank increases CRR during inflation and decreases the same during deflation 97 Statutory Liquidity Ratio (SLR): It refers to minimum percentage of net demand and time liabilities which commercial banks required to maintain with themselves. SLR is increased during inflation or excess demand and decreased during deflation or deficient demand. Reverse Repo Rate: Securities are acquired by the RBI from the commercial banks with a simultaneous commitment to re-sell them to the commercial banks at predetermined rate and date QUALITATIVE INSTRUMENTS: 1. Margin Requirements: It is the difference between the amount of loan and market value of the security offered by the borrower against the loan. Margin requirements are increased during inflation and decreased during deflation. 2. Moral suasion: It is a combination of persuasion and pressure that Central Bank applies on other banks in order to get them act in a manner in line with its policy. 3. Selective credit controls: Central Bank gives direction to other banks to give or not to give credit for certain purposes to particular sectors. B: QUESTION ANSWER Very short Answer type (1 mark) : ECONOMICS Q1-XII-46

45 1. What is the main function of money in an economic system? 2. What is barter system? 3. What is money? 4. What is currency? 5. What monetary system does India follow? 6. What is money supply? 7. Which is the most liquid form of money supply? 8. What is bank rate? 9. What is an overdraft? 10. What is open market operation? 11. What is cash reserve ratio? Answer : 1. The main function of money in an economic system is to facilitate the exchange of goods and services. 2. The exchange of goods against goods is called barter system. 3. Money is a thing which performs four function (a) a units of value (b) a medium of exchange (c) a standard of deferred payments and (d) a store of value 4. Currency is the money issued by the central bank including paper currencies and coins. 5. India is following a convertible paper standard with minimum reserve system. 6. Money supply is the total stock of money of various kinds in existence at any particular point of time. 7. M 1 is the most liquid form of money supply M 1 = C + DD + OD 8. Bank rate is the rate at which the RBI lends funds to commercial banks against approved securities or eligible bills of exchange. 9. Overdraft is a facility provided by commercial banks under which a customer is given an advance allowing him to over-draw his current account up to an agreed limit. 10. Open market operation is the buying and selling of Govt. securities by the central bank from and to the public and banks on its own account respectively. 11. This is the portion of net demand and time liabilities every bank is required to deposit with the RBI. Short Answer Type (3/4 marks) : 1. What are the drawbacks of Barter system? 2. Explain the important functions of money. 3. What are the various measurements of money supply? 4. What are the differences between central bank and commercial bank. 5. How can money be classified? Answer : 1. The drawback of barter system are : ECONOMICS Q1-XII-47

46 1) Absence of a common unit of measurement There was no single unit of measuring the value of different goods as different countries were using different things as money. 2. Lack of double coincidence of wants There is no guarantee that both the parties (buyers and sellers) will be agreed to exchange their goods at a time. 3. Problem of future payments There was no single unit to engage in contracts involving future payments. 4. Storage and transfer problem There was no general method of saving purchasing power. Storage may need more cost or high depreciation. Transferring immovable goods was also impossible. 2. Important functions of money are : a) A unit of value Money is the generally accepted as a unit of value of all goods and services. b) Medium of exchange Money facilitates the buying and selling of goods and services. c) A standard of deferred payment Money helps in settling the loan taken and repayment is made in future date. d) Storage of value Store of value means shifting of purchasing power from the present to the future. As such, the holders of money are holders of generalised purchasing power from present to the future. 3. There are four alternative measurement of money supply : a) M 1 = C + DD + OD Whose, C = currency held by the public. DD = demand deposits in the bank (net). OD = Other deposits with the RBI. b) M 2 = M 1 + Savings deposits with post office savings banks. M 3 = M 1 + (net) time deposits with the banks M 4 = M 3 + total deposits with post office savings Organisation (excluding National Savings Certificate) 4. Central Bank Commercial Bank a) It s a govt. bank It s a public bank. b) Bank of note issue It can t issue currencies c) It s the apex bank in the banking system. There are large number of commercial banks. d) It controls credit in the economy. It creates credit in the economy e) It s main aim is the monetary management of It s main aim is profit earning. the economy. 5. Money can be classified as : a) Full bodied money This is a money whose value as a commodity for non monetary purpose is as great as its value as money. (Intrinsic value = Extrinsic value) b) Representative full bodied money Its a paper money which represents in circulation an amount of money with a commodity value equal to the value of the money. (Extrinsic value is greater than intrinsic value) ECONOMICS Q1-XII-48

47 c) Credit money It s the money whose value as money is greater than the commodity value of the material from which money is made. Credit money may be of token coins, representative token money, circulating promissory notes issued by the central bank and deposits at banks. Long Answer Type (6 marks) : 1. Functions of a commercial bank? (Explain in brief any four main functions of Commercial bank) 2. Explain in brief any four functions of a central bank? Answer : 1. The main functions of a commercial bank are : a) Acceptance of deposits The bank accepts three types of deposits i) Current account deposits they are payable on demand and can be withdrawn by cheque without any restriction. No interest is paid ii) Termed / fixed deposits they are fixed for a certain time period ; are not payable on demand and bear high rate of interest. iii) Savings accounts deposits these are payable on demand and withdrawable by cheque but with restriction and bears lower rate of interest. b) Giving loans Banks advance loans to the borrowers in different forms : Cash credit Demand loans Short term loans. c) Overdraft Under this system, the customer can get more than what they have deposited, but with extra interest and a short period of time. This facility is generally given to the businessmen. d) Discounting bills of exchange The bank discounts the bills of exchange a document acknowledging an amount of money in consideration for goods received after deducting the commission and pays the present value of the bill to the party. e) Investment The bank invests extra funds in terms of purchasing securities. f) Agency function The bank performs certain agency functions for its worthy customers in return for a commission. g) Miscellaneous function It includes purchase and sale of foreign exchange, issue of traveller s cheque, provision of locker and underwriting activities. 2. As the apex institution in the monetary system of a country the central bank s functions are : a) Currency Authority The central bank is the sole authority for the issue of currency in the country - its monetary liability. The central govt. also borrows from it. b) Banker to Govt. The central bank carries out all the banking business of the govt. and manages public debt. c) Bankers Bank and supervisor All the commercial banks keep a part of their cash reserves with the central bank, which is used as an instrument of monetary and credit control. It also provides clearing and remittance facilities. This bank also supervises, regulates and controls the commercial banks. d) Controller of money supply & credit Credit is an important element of the money supply. The central bank controls the supply of credit through quantitative measures and qualitative measures. ECONOMICS Q1-XII-49

48 UNIT VII DETERMINATION OF INCOME & EMPLOYMENT Aggregate demand & Aggregate Supply in M acro Economics [Marks=12] A: BASIC CONCEPTS 1. Aggregate Demand (AD) is the total demand for goods and services in the economy in a year. 2. Aggregate Supply (AS) is the total supply of goods and services in the economy in a year. 3. In classical economics, AS perfectly inelastic with respect to prices at full-employment level of output. 4. Equilibrium may be of two types full-employment equilibrium and under employment equilibrium. 5. Full employment equilibrium is that equilibrium where all resources available in the economy are employed efficiently. 6. Under employment equilibrium is that equilibrium where all resources available are not employed, that is, some are lying unused. 7. In Keynesian economics, AS is perfectly elastic due to (a) wage-price rigidity and (b) constant marginal product of labour. Very short Answer type Question : 1. What is aggregate demand? 2. Define aggregate supply? 3. What is meant by full employment level of output? 4. What is involuntary unemployment? 5. State the Say s law of market. Answer : 1. Aggregate Demand is the total demand for goods and services in the economy. 2. Aggregate supply is the total supply of goods and services in the economy. 3. The full employment level of output (goods and services) is the maximum output that the economy is capable of producing by using all the available resources efficiently. 4. It is a situation when those who seek work at the prevailing wage rate do not get it. 5. Supply creates its own demand. Short answer type (3/4 marks) : 1. How is the classical concept of aggregate supply different from the Keynesian concept of aggregate supply? 2. Explain the concept of full employment equilibrium Answer : 1. In classical concept : aggregate supply is perfectly inelastic to prices As curve is a vertical straight line at equilibrium level of output. ECONOMICS Q1-XII-50

49 Any change in the prices has no impact on the AS curve. AS is constant at the full employment level regardless of price level. In Keynesian concept : AS is perfectly elastic with respect to price level. AS curve in a horizontal straight line up to equilibrium level of output. After the equilibrium point the AS curve becomes perfectly in-elastic 2. Full employment equilibrium is an equilibrium state where all the available resources are fully (efficiently) utilized ; It s a classical concept. To the Classical, there is always full employment in the economy consequent upon wage price flexibility and the Say s law of market. If any disequilibrium takes place, it is a short run phenomenon and will be corrected automatically by the price mechanism. Diagrammatically E = Equilibrium point OP = Equilibrium price OQ = Equilibrium output at full employment. Aggregate demand and its components Basic Concepts : The components of aggregate demand (AD) are consumption, investment, govt. expenditure and net export. The relationship between consumption and income is called consumption function. Saving is the surplus of income over consumption. The relationship between saving and income in known as saving function. Investment means addition to the stock of capital goods in the form of structures, equipments or inventories. Investment demand and the rate of interest are inversely related. Net export is the difference between exports and imports. The equilibrium level of income is that level of income where AD = AS and planned savings = planned investment. Deficient demand is the shortage of AD at a level with respect to the AD at full employment level (AD < AS) Excess demand is the surplus of AD at a level with respect to AD at full employment level. (AD > AS) Excess and deficient demand may be corrected through fiscal policy and monetary policy measures. B: QUESTION ANSWER: ECONOMICS Q1-XII-51

50 Very Short Answer type (1 mark) : 1. What are the components of aggregate demand? 2. What is consumption function? 3. What is marginal propensity to consume (MPC)? 4. What is saving function? 5. What is marginal propensity to save (MPS)? 6. What is average propensity to save (APS)? 7. What is average propensity to consume (APC)? 8. What is investment? 9. Define interest. 10. If the consumption function is C = Y, what is the value of MPC? 11. If consumption in Rs. 800 when income is Rs. 1000, What would be APS? Answer : 1. The components of AD are consumption, investment, govt. expenditure and net export. 2. The relationship between consumption and income is called consumption function. C = f(y) 3. MPC is the ratio of change in consumption to change in income. MPC = C/ Y denoted by b. 4. The relationship between savings and income is called savings function. S = f(y) 5. MPS is the ratio of change in savings to change in income. MPS = S/ Y 6. APS is the ratio of savings to income. APS = S/Y 7. APC is the ratio of consumption to income. APC = C/Y 8. Investment is the addition to stock of capital in the form of equipment, structures and inventories. 9. Interest is the price paid for the borrowing of capital. 10. MPC = APS = S/Y = ( )/1000 = 200/1000 = 0.2 Short Answer Type : (3/4 marks) 1. Explain the concept of consumption function. 2. Draw a hypothetical propensity to save curve from the propensity to consume curve. 3. Explain the relationship between MPC and MPS. 4. Explain the concept of multiplier. 5. Explain the concept of deficient demand / excess demand with diagram. 6. What fiscal and monetary policies can be adopted to control inflationary gap? 7. What fiscal and monetary policies can be adopted to correct deflationary gap? Answer : 1. The relationship between consumption and income is called the consumption function Symbolically, C = f (Y) In equation, C = C + by C > 0 ; 0 < b < 1 Where, C = consumption ECONOMICS Q1-XII-52

51 C b Y = autonomous consumption at zero level of income. = MPC = level of income. As the consumption function shows, there is a positive relationship between income and consumption. The slope of the curve is MPC, which is equal to C/ Y. 2. We know that Y = C + S. If Y = C, then the savings is zero. Therefore, the savings curve must intersect the axis at the same income level where consumption function and 45º line, intersects. As such, at zero level of income, the total consumption (autonomous) is to be equal to dissavings. 3. MPC MPS a) MPC = C / Y MPS = S / Y b) Y = C+S Y = C+S Y = C + S Y = C + S Y/ Y = C / Y+ S/ Y Y/ Y = C / Y+ S/ Y C/ Y = Y / Y- S/ Y (i) S/ Y = Y / Y- C/ Y (i) Thus MPC = 1 MPS (ii) Thus MPS = 1 MPC (ii) c) If MPS = 0.2, If MPC = 0.8, MPC = MPS = = 0.8 = The concept of multiplier was developed by J.M. Keynes, which is better known as investment multiplier. This principle studies the relationship between investment and resulting change in income, because change in investment causes change in income at a multiple rate. This multiple is called multiplier. For example, if an increase in investment by Rs. 8 crores result in an increase in income of Rs. 32 crores, then the multiplier is 32/8 = 4, that is, Y/ I NOTE : (Use capital letters for MPC, MPS) ECONOMICS Q1-XII-53

52 As such,. if an economy wants to earn more, then the investment must increase. The multiplier has a positive relationship with MPC but negative with MPS. 5. If the AD at a level of output is less than the full employment level, it is known as deficient demand. Deficient demand gives rise to a deflationary gap. (Fig. I) If the AD at a level of output is more than the full employment level, it is known as excess demand. Excess demand gives rise to an inflationary gap. (Fig = II) Diagrammatically, Deflationary gap appears at full employment equilibrium to the magnitude of FG- fig(i) Inflationary gap appears after full employment level of income and employment is reached which is equal to FG as shown in figure(ii) 6. Measures to control inflationary gap are Excess demand results is in inflationary gap which causes a rise in the price level or inflation ; the value of money will fall. To control this situation ; we can take the following steps Fiscal measures a) reducing the govt. expenditure. b) increasing the rate and base of taxes. Monetary Measures a) increase the rate of interest. b) increase the reserve ratio. c) increase the bank rate. d) increase the selling of securities in the open market. e) strict directions are to be given to the banks by the RBI not to advance loans. 7. In a deflationary situation, the following measures may be taken to control the deficient demand. Fiscal measures a) increasing govt. expenditure. b) reducing the tax rate and tax base. Monetary Measures a) decrease the rate of interest. b) decrease the reserve ratio. c) decrease the bank rate. d) purchasing of the securities by the commercial banks. ECONOMICS Q1-XII-54

53 Long answer Type : (6 mark) : e) liberal in lending loans 1. Explain the determination of equilibrium level of output in consumption - investment approach. Answer : 1. The economy, as shown in the diagram, is in equilibrium at point E on the 45º line. The equilibrium level of output is OM, whose aggregate demand (desired level of spending) is equal to the level of output. C + I or aggregate demand curve is upward sloping with a positive intercept. If the economy is beyond OM output (OM 1 ) the aggregate demand line (C + I curve) will be below the 45º line which implies that the planned spending in less than the planned output. As a result, the rise in inventory will lead to reduction in employment and output which will continue up to equilibrium level of output. On the other hand if the economy is at a lower level (OM 2 ) the C+I line will lie above 45º line. As a result, the inventory will decrease leading to expansion in employment and output till the equilibrium level in attained. This is how the equilibrium will be maintained permanently Marks 6 UNIT VIII Government Budget and the Economy A. Basic concepts The budget is an annual statement of the estimated receipts and expenditures of the government over the fiscal year, which runs form April 1 to March 31. The government implements its policies through the budget. The budget impacts the economy through aggregate fiscal discipline, resource allocation and provision of programmes and delivery of services. The budget is divided into revenue budget and capital budget. Revenue may be divided into revenue receipts and capital receipts. Expenditure may be classified as revenue vs. capital, plan vs non-plan and developmental vs non-developmental. Budgets are of three types surplus, balanced and deficit. Three components of deficit are fiscal deficit, revenue deficit and primary deficit. ECONOMICS Q1-XII-55