PRINCIPLES OF ECONOMICS PAPER 3 RD Question 1 Objectives. Select appropriate alternative. (A) The meaning of the world Economic is most closely associated with the word. (a) Free (b) Scarce (c) Unlimited (d) Unrestricted Answer (b) Scarce (B) In a Free Enterprise Economy, the problems of what, how & for whom are solved by (a) Planning Committee (b) Elected Representatives of People (c) Price Mechanism (d) None of the above Answer (c) Price Mechanism (C) Microeconomic theory studies, how a Free-enterprise economy determines (a) The price of goods (b) The price of services (c) The price of economic resources (d) All of the above Answer All of the above (D) The individuals demand curve for commodity represents (a) a maximum boundary of the individuals intentions (b) a minimum boundary of the individuals intentions (c) Both maximum and minimum boundary of the individuals intentions. (d) Neither a maximum not a minimum boundary of the individuals intentions. Answer (c) both maximum and minimum boundary of the individuals intentions. (E) If the supply curve for a commodity is positively sloped, a rise in the price of commodity (ceteris paribus) results in and is referred to as (a) An increase in supply (b) An increase in quantity supplied (c) A decrease in the supply or (d) A decrease in the quantity supplied Answer An increase in supply (F) Arc Elasticity gives a better estimate of point elasticity of a curvilinear demand curve as (a) the size of the arc become smaller (b) the curvature of the demand curve over the arc becomes less (c) both the above (d) neither of the above Answer (c) both of the above (G)An increase in the price of a commodity when demand is inelastic causes the total expenditures of consumers of commodity to (a) Increase (b) decrease (c) remain unchanged (d) any of the above
Answer (c) Remain unchanged (H)If the amount of a commodity purchased remains unchanged when the price of another commodity changes, the cross elasticity of demand between them is (a) Negative (b) positive (c) zero (d) one Answer (c) zero (I) which of the following industries most closely approximates the perfectly competitive model (a) Automobile (b) cigarette (c) Newspapers (d) wheatfarming Answer (d) wheat-farming (J) When M.C > A.C. then A.C. (a) rises (b) falls M.C. < A.C. then A.C. (a) rises (b) falls Answer (b) Falls (a) Rises Question 2 From the demand function Qdx = 12-2 px Derive (a) Individuals demand schedule (b) Individuals demand curve What is the maximum quantity this individual will ever demand of commodity X per time period? Answer Qdx = 12-2 px Demand function INDIVIDUAL DEMAND SCHEDULE PRICE (PX) QUANTIT DEMANDED (QDX) 6 0 5 2 4 4 3 6 2 8 1 1 0 12 INDIVIDUAL DEMAND CURVE 7 6 5
4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 11 12 The maximum Quantity that the individual may demand will be 12 units at 0 price. Question 3 clearly explain the concept of Income Effect and substitution effects & shape of the demand Curve. Answer INCOME EFFECTS; A change in the quality demanded in response is the change in the real Income of the consumer is called Income Effect. With an increase in the Income an individual will be able to purchase or demand more of a commodity. Hence the extent to which a consumers demand for a commodity changes consequent upon a change in his income is called income effect. REAL INCOME: is measured in terms of goods and services for e.g.: If the price of commodity X falls then the consumer can buy more of X with the present income. So essentially the purchasing power increases or the real income increases. D 2 1 O Q Q1 Q2 X THE SHAPE OF THE DEMAND CUVE: is positively sloped for normal goods. As with an increase the income the quantity demand of normal goods increases. SUBSTITUTION EFFECT: The change in the quantity demanded of one commodity in response to the change in the price of another commodity. When the price of a commodity falls, it becomes cheaper in respect to other substitute commodities and the consumer. It is induced to substitute a cheaper commodity with a costlier commodity. For example If the price of coffee increases then the people are induced to substitute it with the consumption of tea, which is a cheaper substitute.
D R1 R O Q Q Q1 X If commodity R and S are good substitutes of each other. Then if the price of r increases then the consumer will be induced to substitute costlier commodity R with cheaper substitute S. Hence with an increase in price of R the quantity demanded of commodity S increases. Question 4 Distinguish between Total Utility & Marginal Utility and Explain relationship with hypothetical schedule. Answer UTILIT: means the power to satisfy a human want. Any commodity or service, which can satisfy human want, is said to have utility. The amount of satisfaction actually obtained from its consumption is a psychological entity, which is incapable of measurement and differs from place to place and different people. MARGINAL UTILIT: Marginal utility denotes the additional utility arising firm consumption of an additional unit of a commodity. (MUn =TUn.TUn-1.) TOTAL UTILIT: Total utility is the sum of utility derived from different units of a commodity consumed by an individual. TUn=MU1+MU2+MU3+----------------MUn UTILIT SCHEDULE CUPS OF TEA TOTAL UTILIT MARGINAL UTILIT CONSUMED 0 0-1 10 10 2 18 8 3 24 6 4 26 2 5 26 0 6 24-2
7 21-3 DIMNISHING MARGINAL UTILIT: The marginal utility of a commodity goes on decreasing or diminishing with the consumption of every successive unit of a commodity i.e., the utility or satisfaction derived with the consumption of 1 st unit is much more than the utility derived from the 4 th unit of the same commodity. THE TOTAL UTILIT: derives however increases initially with every successive unit of commodity consumed and then remains the same after which it begins to fall. The total utility is maximum when marginal utility is 0 and diminishes when MV becomes negative. LAW OF EQUI MARGINAL UTILIT- The consumer is assumed to be rational and will spend his income to maximum the utility or satisfaction. Law of Equi - Marginal utility states that a consumer will spend his income in such a way that the marginal utility derived from each commodity is proportional to its price. MUx = MUx = MU per unit ------ ------ --------------- Px Py Price paid Question 5 Why is water, which is essential to life, so cheap while diamonds, which are not essential to life, so expensive? Answer - Economics is the science which studies human behavior as a relationship between ends and scarce means, which have alternative uses. It is the study to allocate the scarce resources effectively and efficiently to maximum utilization. However water is a resource, which is available in abundance. Three fourth of the earth is covered with water which is a resource available in plenty and there is a limited demand for the resource which can be easily met because of which it is cheaply available. Whatever be the demand water may be available at the same cost or zero cost. D P1 P D
O Q X Quantity demanded As these are the necessities any in not show a tendency of full in demand. On the other hand Diamond is a precious stone, which is rarely available, because of which the price is very high or it is costly. Diamond jewelry is also possessed as a matter of status symbol or prestige as the same is a rare commodity, which makes it very costly and expensive. Hence more of such prestige commodities are purchased or demanded with an increase in the prices because of the status symbol. Price of Diamond D P2 P1 O Q1 Q2 X Question 6 Differentiate between Cardinal & Ordinal Measurement of utility. Answer Cardinal measurement of utility The exponents of Marginal utility analysis regard utility to be a cardinal concept wherein utility is measurable and quantifiable concept. Utility can be measured in units called utils and further measured in terms of total and marginal utility. According to them, a person can express the utility or satisfaction from the consumption of a commodity in quantitative terms and can further compare in respect of size, how much more on level of utility is greater than another. On the basis of above concept two other principles have been derived: - 1. Law of diminishing marginal utility: - This law states that with the consumption of successive units of the same commodity the utility derived goes on decreasing i.e. the satisfaction derived out of 1 st unit will be much more than that of 4 th or 5 th unit of the same commodity.
2. Law of Equi-Marginal utility: -This law presumes that consumer is rational and that he calculates and substitutes good to maximize his utility or satisfaction. The consumer will spend his money income on different goods in such a way that marginal utility of each good is proportional to its price. Indifference curves or ordinal utility: - According to the indifference curve approach the utility cannot be measured in quantitative term though the utility of different units of the same commodity or different commodities can definitely be compared. The consumer can rank different combination of goods in order of preferences, as utility is a very subjective approach and later compared. An indifferent curve of a consumer can be defined as a curve, which represents different alternative combinations of two goods, which give the same satisfaction. A A E D A J1 J1 I1 I C I O B X O B X O B X 1. IC (Indifference curves) always slope down ward from left to right as a consumer has to sacrifice some amount of a commodity to have more of B. 2. Indifference curves can never intersects each other as shown in diagram (b) E=C as they lie on same indifference curve I. Similarly E=D as they lie on I1. But C=/=D as they lie on 2 different indifference curves. 3. The higher IC represents higher satisfaction as it involves greater quantity of both the commodities A&B. Question 7 - Define & explain with the help of diagram three stages of production for labour (Take labour on one acre of land on x axis and Product on axis.) Answer - III Product I II TP
O X Labour on one acre of land Production Function: - Production function is relation between the Input and the output i.e., relation between the rate of Input factor i.e. raw material or labour in this case and the rate of output i.e. the product manufacture. The Inputs or the factors of production can be fixed or variables. Fixed Inputs are those whose quantity cannot be changed in the short been irrespective of the output like plant & Machinery, land etc. On the other hand variable inputs are the ones whose quantity can be changed during the short run to increase the output of the product. These may be three stages of Production function: Stage 1 This is the stage when the output product increases at an increasing rate in response to the increase in the variable input i.e. labour. Stage 2 In this stage after a point of time with every successive increase in the input i.e. labour the product increases at a diminishing or decreasing rate. This is called law of Diminishing returns wherein the TP curve rises at a diminishing rate. Stage 3 In this stage the returns to the form of the output to every successive input become stagnant or constant i.e., no further increase in made to the output by employing one more unit of labour. After which the return start to decrease and the total product curve declines. Question 8 Write a note on Keynes Theory of Employment & Income. Answer - According to this theory Keynes held that involuntary unemployment is a normal phenomenon and thus the actual national Income remains invariably less than that could be realized had the economy operated at the full employment level. He emphasized the existence of frictional and voluntary unemployment. The major merit of the theory is that it explains the working of the Economy irrespective of the level of employment. The logical starting point of Keynes theory of employment is the principle of effective demand. Total employment depends on total demand, and unemployment results from a deficiency to total demand. Effective demand manifests itself in the spending of income. As employment increases, income increases Theory of employment and income in 2-sector model spending in a country is possible either as investment or consumption, the total of, which is aggregate demand, which in turn determines the level of employment and income. As income rises, consumption will increase but the rate of increase in consumption is less than rise in Income. Rest income will lead to increase in saving and consequently investment. Andy shortfall in investment will bring involuntary unemployment and excess of investment will lead to employment and Income Increase, which determines Effective Demand. Effective Demand: - is determined by the equilibrium of aggregate demand and aggregate supply.
Aggregate Demand: - it is the total sum of money expected from the sale of the output produced when N amount of Labour is employed. D=f(N) Hence D will increase if employment increase & vice versa. When the output increases as a result of expansion of employment. AD curve rises at a diminishing rate. AD Price or Proceeds O Aggregate Supply: - This is the minimum price or proceeds to be offered to the producers to induce them to provide any given amount of employment. If Z is the aggregate supply price of output from N workers then Z = g (N) Lower the employment level lower is the output. Hence the AS curve is also upward rising. AS Cost of Proceeds Employment Equilibrium employment O X AS R K AD
Proceeds O E X The equilibrium level of employment is determined by the intersection of the AD and AS curve, which is the point where producers can maximize their profits. At the point K the volume of employment is OE and the aggregate demand is OR. Question 9 In P.C. equilibrium price is lower & Output is higher than what it is under Monopoly. Answer Under Perfect Competition: - Following are the characteristics of P.C.: 1. Large number of buyers and seller: - Under P.C. there are large number of buyers & sellers and hence no one person is able to influence the market price by varying supply or demand. 2. Homogenous Product: - The articles produced by the entire firm are identical and standardize. Hence seller charges same price as in market. 3. Free Entry & Exit: -There is no restriction on the entry or exit from the industry. If the profit is more new firms will enter and profits get shared. If losses then firms close down and losses take place. 4. Perfect Knowledge: - Buyers and sellers have the perfect knowledge of the market and the goods that are offered and accepted, which guarantees the uniformity in prices. 5. Perfect Mobility: - The factors of production are perfectly mobile and can be transported easily to meet the demand. Because of the above factors in a perfectly competitive market the price is set by the equilibrium of Demand and supply. The firms are price takers and market is the price maker. Pure or perfect monopoly is a market structure in which there is a single seller / producer controls the whole supply of a single commodity. However in case of Monopoly the following are the features: 1. Single Producer: - There is only one firm producing the commodity. 2. Absence of close substitutes: - there is complete absence of any close substitute available and is a heterogeneous product Because of the above two advantages a monopolist can determine its own selling policy as to how much commodity is to be sold at what price as he is the whole sale seller Price
MC y MC Price AC P AC P C MR AP O Q X O Q X Quantity (a) Perfect Completion (Normal Profit/Break even) Quantity (b) Monopoly (Profits) Question 10 Critically explain Loanable fund theory. Answer Loanable fund Theory According to this theory interest is the price paid for the loan and is determined by the Demand and supply of loanable funds. The equilibrium rate of interest is determined at the point where supply of loanable funds is equal to demand for loanable fund. The various factors effecting the supply of loanable funds are: 1. Savings: - Saving is a substantial source of loanable funds done by individuals and households. If people save more then there are more funds available to give loans. Individuals save in the hope of anticipated income, business save for further expansion or to meet dividend obligations. 2. Bank Money: - The commercial banks also advances loans to businesses and industries for investment purposes which determines the apply of loanable funds. 3. Dishoarding of cash: - When people release the hoarded cash the supply of loanable fund increases. People hoard cash to maintain liquidity or take advantage of higher interest rate by lending money themselves. 4. Disinvestment: - God amount of depreciation reserves are kept so as to replace fixed asset. Entrepreneurs may allow machinery & equipment to worn out without replacement or capital may be withdrawn from business to increase loanable money. On the other hand Demand for loanable funds is determined by following factors: 1. Investment Demand: - The businessmen or firms want to take loans for investment expenditure. It means, they create demand for loanable funds to purchase capital goods like machinery or inventories. A businessman does not increase the stock of goods if he finds that the rate of interest exceeds the net return on investment. We
thus see that at a low rate of interest there will be greater investment demand and vice versa. 2. Consumption Demand: - People may take loan and use it to keep cash balances. It means they hoard money at present out of borrowed funds and purpose to use that money sometimes in future. These loans are demanded for household goods like automobiles etc. where lower interest rate will induce people to borrow more for consumption. 3. Demand for hoarding: - - Hoarded money means idle cash balance. People save money when they do not spend all their disposable income on consumption. Some people lend money or purchase securities & some hoards it. People hoard money to take benefits of the changes in the rate of interest or changes in the prices of securities in the future. People will hoard less money if higher rate of interest is in the market. On the other hand they like to hoard money when there is lower rate of interest in the market.