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Question Paper

Economics (MB141) : January 2004


Section A : Basic Concepts (30 Marks)
• This section consists of questions with serial number 1 - 30.
• Answer all questions.
• Each question carries one mark.

1. When people have very little time to respond to price changes, demand becomes < Answer >
a. More elastic
b. Less elastic
c. Unitary elastic
d. Perfectly elastic
e. Perfectly inelastic.
2. Which of the following statements is not correct? < Answer >
a. The fixed cost of a firm in the long run will be less than the fixed cost of the firm in the short run
b. Fixed costs are not dependent on the firm’s level of output
c. The difference between average total cost and average variable cost indicates the amount of
average fixed cost of a firm
d. With the increase in output, the average fixed cost of the firm initially decreases at a decreasing
rate and later at an increasing rate
e. When the output is zero, the total cost of the firm will be just equal to its fixed costs.
3. Which of the following is not true with respect to a perfectly competitive market? < Answer >
a. There are many sellers in the market
b. Individual firms are price makers
c. Products sold by the firms are identical
d. Anyone can enter or exit the industry without difficulty
e. Buyers and sellers have perfect information about the market.
4. If sales of CD players increase from 10,000 to 14,000 per month as per capita income increases from< Answer >
Rs. 15,000 to Rs.20,000, which of the following is true?
a. Demand for CD players is income inelastic
b. CD player is a Giffen good
c. CD player is an inferior good, but not a Giffen good
d. CD player is a luxury
e. CD player is a necessity.
5. A profit maximizing firm seeks to maximize the difference between < Answer >
a. Marginal revenue and marginal cost
b. Marginal revenue and average cost
c. Total revenue and marginal revenue
d. Total revenue and average cost
e. Average revenue and average cost.
6. The daily income of Kamesh is Rs.100. He spends all his income on goods X and Y. Currently, the< Answer >
prices of goods X and Y are Rs.6 and Rs.4, respectively. Mr. Kamesh daily buys 10 units of good X and
10 units of good Y. If the utility of the last unit of good X and good Y consumed added same amount of
utility to the total utility, then we can say that
a. The current consumption pattern of Mr. Kamesh gives him the maximum possible utility
b. He obtains higher additional utility per rupee from good X than from good Y
c. He should buy more of good X and fewer of good Y
d. He should buy more of good Y and fewer of good X
e. Both (b) and (c) above.
7. When marginal utility is negative, total utility is < Answer >
a. Increasing
b. At a minimum
c. Equal to zero
d. Decreasing
e. At a maximum.
8. Which of the following represents the marginal rate of technical substitution (MRTS)? < Answer >
a. Slope of the isocost curve
b. Slope of the indifference curve
c. Slope of the isoquant curve
d. Slope of the budget line
e. Slope of the average cost curve.
9. Which of the following is true if marginal cost of a firm is increasing, but is less than the average cost? < Answer >
a. Average fixed cost is increasing
b. Average cost is decreasing
c. Average cost is increasing
d. Average variable cost is increasing
e. Average variable cost is decreasing.
10. Sugar is an important ingredient in the preparation of ice cream. Which of the following is/are true,< Answer >
ceteris peribus, if price of sugar falls?
I. Demand for ice cream will decrease.
II. Supply of ice cream will increase.
III. Price of ice cream will increase.
IV. Price of ice cream will decrease.

a. Only (I) above


b. Only (II) above
c. Only (III) above
d. Both (I) and (IV) above
e. Both (II) and (IV) above.
11. Which of the following better resembles the demand curve of a consumer? < Answer >
a. Indifference curve
b. Marginal utility curve
c. Budget line
d. Total utility curve
e. Average utility curve.
12. Law of diminishing returns is not relevant when < Answer >
a. All labors are equally efficient
b. The time period is short
c. All factor inputs are increased by the same proportion
d. Technology remains constant
e. Capital is held constant.
13. Which of the following statements is true? < Answer >
a. Capital enhances the productivity of labor
b. Labor enhances the productivity of capital
c. An increase in the market wage rate for labor would induce firms to adopt more capital-intensive
technologies
d. Most goods and services can be produced in a number of ways using alternative technologies
e. All of the above.
14. The management of a company has finally agreed to increase the wages of the laborers by 10% after< Answer >
hard negotiations with labor union. Which of the following would not be affected by this decision?
a. Economic costs
b. Accounting profits
c. Direct costs
d. Implicit costs
e. Fixed costs.
15. Which of the following statements is true with regard to price elasticity of demand? < Answer >
a. Elasticity remains constant throughout the demand curve
b. Elasticity increases with increase in quantity demanded
c. Elasticity increases as the price decreases
d. Elasticity is equal to the slope of the demand curve
e. Higher the elasticity, more responsive the demand is for a given change in price.
16. Which of the following is not a transfer payment? < Answer >
a. Invalidity benefit
b. Flood relief
c. Government pensions
d. Salaries paid to Members of Parliament
e. Scholarships.
17. GDP at factor cost exceeds GDP at market price < Answer >
a. When the net factor income from abroad is negative
b. When the net factor income from abroad is positive
c. When depreciation of fixed capital exceeds gross investment
d. When direct taxes exceed indirect taxes
e. When subsidies exceed indirect taxes.
18. Which of the following is not an instrument of monetary policy? < Answer >
a. Bank rate
b. Reserve requirement
c. Open market operations
d. Tax rate
e. Selective credit controls.
19. Usually marginal propensity to consume (MPC) is < Answer >
a. > Zero
b. < Zero
c. >1
d. <1
e. Both (a) and (d) above.
20. Banks can create money < Answer >
a. By printing currency notes
b. By paying interest to their depositors
c. By making loans that result in additional deposits
d. By offering financial services, such as money market accounts
e. By accepting deposits from the public.
21. Which of the following variables is a flow variable? < Answer >
a. Capital stock
b. A firm’s assets
c. Gross fixed investment
d. Price index
e. Public debt.
22. If the Average Propensity to Consume (APC) in an economy is 1.05, Average Propensity to Save (APS)< Answer >
in the economy would be
a. – 0.05
b. – 0.95
c. 1.00
d. 1.05
e. Insufficient data.
23. Monetary policy will be more effective when < Answer >
a. The economy is facing recession
b. The private investment is more sensitive to interest rate
c. The private investment is less sensitive to interest rate
d. The economy is suffering from liquidity trap
e. The economy is in boom.
24. In an economy, if marginal propensity to save (MPS) is 0.20, multiplier for the economy is < Answer >
a. 0.20
b. 0.80
c. 1.00
d. 1.25
e. 5.00.
25. An increase in the supply of money in the economy will result in < Answer >
a. An increase in unemployment
b. An increase in interest rate
c. An increase in the price level
d. A decrease in output
e. Both (b) and (c) above.
< Answer >
26. According to the classical economists, the Aggregate Supply curve is
a. Vertical
b. Horizontal
c. First horizontal and then vertical
d. First vertical and then horizontal
e. Positively sloped.
< Answer >
27. Which of the following variables will be at low levels during boom phase of a business cycle?
a. Bank reserves
b. Wage rates
c. Bank credit
d. Inventory
e. Cost of production.
The slope of the savings function represents < Answer >
28.
a. Average Propensity to Save
b. Marginal Propensity to Consume
c. Marginal Propensity to Save
d. Average Propensity to Consume
e. None of the above.
< Answer >
29. Imperfect information about the labor market leads to
a. Structural unemployment
b. Cyclical unemployment
c. Frictional unemployment
d. Disguised unemployment
e. Natural unemployment.
< Answer >
30. Which of the following is true, if Mr. Somesh transfers Rs.1000 from his current account in a bank to a
fixed deposit scheme in the same bank?
a. M1 falls, but M2 rises
b. Both M1 and M2 rises
c. M1 falls, but M3 rises
d. M2 falls, but M3 remains constant
e. Both M2 and M3 remain constant.
END OF SECTION A
Section B : Problems/Caselets (50 Marks)
• This section consists of questions with serial number 1 – 8.
• Answer all questions.
• Marks are indicated against each question.
• Detailed workings should form part of your answer.
• Do not spend more than 110 - 120 minutes on Section B.
1. The demand function of a monopolist is estimated as
P = 3,000 – 3Q
The cost function of the monopolist is given by
TC = 3Q3 – 3Q2 – 600Q
You are required to determine:
a. The profit maximizing output and the profit at that level of output for the monopolist.
b. The break-even level of output of the monopolist.
(5 + 3 = 8 marks) < Answer >
2. Flying Horse, a travel agency, operates its luxury bus services from Hyderabad to Tirupati. It incurs a fixed cost of
Rs.20,000 for hiring the bus; while its variable cost is given by
500Q – 9Q2 + 0.25Q3.
You are required to determine:
a. The Total Cost function of Flying Horse.
b. The Average Cost function of Flying Horse.
c. The Marginal Cost function of Flying Horse.
(1 + 2 + 2 = 5 marks) < Answer >
3. The following information is taken from the national income accounts of a hypothetical economy:
Particulars Million units of
currency (MUC)
GNP at factor prices 1,42,500
Indirect taxes 21,000
NDP at market prices 1,50,633
NNP at market prices 1,50,000
GNP at market prices 1,60,500
Personal income taxes 15,000
Corporate profit taxes 9,750
Retained earnings 45,000
Subsidies 3,000
You are required to compute:
a. National income.
b. Personal income.
c. Personal disposable income.
(3 + 2 + 1 = 6 marks) < Answer >
4. The following balances are taken from the balance sheet of the Central Bank of a country.
Particulars MUC
Financial Assets 24,000
Other Assets 100
Net worth 1,000
Other non-monetary liabilities 525
The currency/deposit ratio has been ascertained as 0.24. Reserve ratio imposed by the Central Bank is 7%. The
amount of Government money is 25 MUC.
You are required to compute:
a. High-powered money in the economy.
b. Money supply in the economy.
(3 + 3 = 6 marks) < Answer >

Caselet 1
Read the caselet carefully and answer the following questions:
5. What type of market structure do you see in the European car industry? Briefly discuss the characteristics of such
a market?
(7 marks) < Answer >
6. How can the European car manufacturers differentiate their products? Explain.
(6 marks) < Answer >
One after another European carmakers are queuing up to report falling profits or yet more horrible losses. Last
week Renault, PSA Peugeot Citroën and Daimler Chrysler reported bad news, while Volkswagen said its profits
were down by half in the second quarter; on July 31st, it was Fiat's turn to report on its worst-ever crisis. Although
each unhappy company has its own problems, there are three common ones.
The gloom is mainly caused by falling sales in western Europe, persistent over-capacity of up to 30% and a rush to
slash prices and offer special deals such as free insurance or finance just to “move the metal”—much as the “Big
Three” carmakers in Detroit have done for almost two years. The trouble with discounting is that it can be almost
impossible to stop. Steve Evans, head of Car Price Check in Britain, says average British prices are down 7% from
a year ago, with some dealers offering discounts of 30%. “There's too much metal chasing too little demand,” he
says.
On top of these domestic woes, DaimlerChrysler, BMW and Volkswagen are all heavily exposed to America.
Daimler's Chrysler division wrote off more than $1 billion in the latest quarter because a price war forced a
reduction in the value of growing stocks of unsold vehicles in America. VW's boss, Bernd Pischetsrieder, says he
is concentrating on selling vehicles profitably in North America rather than aiming for gains in market share.
Meanwhile, BMW, which saw sales fall by over 5% in the first half, is discounting heavily in America in order to
win sales from Mercedes and Toyota's Lexus. Its second-quarter profits are expected to be down by as much as
15%.
VW's 49% fall in second-quarter profit is caused partly by its American problems and partly by weakness in
Germany, where uncertainty over tax changes has helped to depress car sales even further. Mr Pischetsrieder is
refreshing VW's ageing product range and plugging gaps with new niche vehicles. He wants to get away from his
predecessor's preference for making dozens of models with four basic platforms (or chassis). This has led to VW
having too many similar models (under its Audi, Seat and Skoda brands) competing with one another. Sharing
platforms also means that models age at the same time.
Peugeot has long had the reputation of best managing the product cycle, keeping up a steady flow of attractive
new cars under its Peugeot or Citroën brands. Not even this could stop first-half net profit falling by 12%.
Operating margins are down from 5.2% to 3.7%. Peugeot has been Europe's most successful volume carmaker,
running its factories flat-out, compared with the industry's poor average plant-utilisation of around 75%. That it
now thinks it will fall short of its 2003 profit target is indicative of a tough time ahead for everyone in Europe's
volume car market.
Two of the biggest victims are General Motors Europe and Ford Europe. Both were caught flat-footed in the late
1990s, when Renault, Peugeot and Volkswagen improved dramatically. Since then both American groups have
made efforts to trim capacity and raise productivity to get back into profit. GM closed one car-assembly factory in
Britain and launched a plan to turn round its Adam Opel brand in Germany by slashing costs and boosting sales.
But the target of break-even this year has been quietly dropped by GM Europe, and the group is again staring at
losses in Europe, of around $500m.
Europe's weakest manufacturer remains Fiat, whose market share trails its rivals. The Italian group has raised
almost €10 billion ($11.5 billion) from disposals and a share issue, and aims to pour it into developing 26 new
models in three years. After a period of revolving doors at the top, Fiat is now in the hands of a chief executive,
Giuseppe Morchio, who made his reputation by turning round Pirelli, when the Italian tyre company was
struggling. He is counting on a renewal of Fiat's tired model range reviving the company's fortunes by enough to
persuade GM to put in another €1 billion towards financing his rescue plan. Fiat just might surprise the sceptics
and bounce back—one or two hit products can quickly boost productivity and turn loss into profit. But price wars
make such things much harder.
Caselet 2
Read the caselet carefully and answer the following questions:

7. What do you understand by inflation? Do you think that fixed income earners like pensioners are worst sufferers
of inflation? Why or why not? Explain
(6 marks) < Answer >
8. Briefly explain how the unemployment is associated with inflation? Does this relationship exist in the long run?
Discuss.
(6 marks) < Answer >
With corporate bottom lines under severe pressure, inflation picking up and jobs under threat, it's suddenly cool to
be a tightwad. When asked about the major reasons for disquiet, most consumers talked about two things: the
pickup in inflation that eats into today's rupees and the drop in interest rates, which erodes safe returns on savings.
Frighteningly, the most-discussed index of inflation in India, the wholesale price index, mis-represents changes in
price levels. Today, the WPI is totally out of sync with economic reality: it has a 64% weight for manufactures,
22% for primary goods, 14% for fuel and power and no weight at all for services.
Of course, to the extent that the manufacturing sector is one of the biggest consumers of services, prices of
manufactured will reflect the higher price of services. Nonetheless, it is undoubtedly true that the WPI as it stands
today does under-report service sector inflation.
The result is people now treat the WPI numbers with growing scepticism. Unfortunately, the government has used
artificially low WPI numbers to push for lower interest rates. As interest rates decline and returns from savings
fall, people begin to cut back on consumption, strengthening the downward spiral. Not surprisingly, the most
pessimistic consumers in India today are 45-55-year-olds, nearing the end of their working lives and looking ahead
to an uncertain future. Younger people, between 25 to 34 years, are more confident, but even their brio has been
shaken up: confidence levels here as in all other age groups have fallen. This is the time for the government to
intervene with reforms: slash red tape, stop interfering in business, free up sectoral bottlenecks to overseas
investment, lower tariffs and boost public investment.
END OF SECTION B

Section C : Applied Theory (20 Marks)

• This section consists of questions with serial number 9 - 10.


• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 25 -30 minutes on Section C.
9. For the last few years, Hyderabad, quickly restyling itself as Cyberabad, is emerging as a mega business center for
information technology companies. Due to this IT revolution, there is a sharp increase in housing rentals in
Hyderabad. Suppose the Municipal Corporation of Hyderabad decides to impose rent control in Hyderabad for the
welfare of the poorer sections. Using supply and demand analysis, illustrate how rent control influences the
housing market in Hyderabad if rents are set below the market equilibrium rents.
(10 marks) < Answer >
10. The government’s failure to rein in fiscal deficit has emerged as a major impediment threatening the economy,
nullifying benefits arising out of low inflation, soft interest regime, huge foreign exchange reserves and upturn in
the performance of the manufacturing sector. The World Bank has expressed serious concern over the high level of
fiscal deficit in India. According to the Bank, the persistence of large budget deficits is a major hindrance of
growth in India. Discuss the problems associated with the high fiscal deficit for a developing country like India.
(10 marks) < Answer >

END OF SECTION C
END OF QUESTION PAPER

Suggested Answers
Economics (MB141) : January 2004
1. Answer : (b) < TOP >
Reason : The time frame allowed for the consumers to respond to price changes is one of the factors determining
the price elasticity of a good. In the long run demand becomes more elastic, because customers have
more time to find substitutes and adjust their consumption patterns. When people have very little time
to respond to price changes, demand becomes less elastic.
2. Answer : (d) < TOP >
Reason : In long run, all costs are variable, which means there will be no fixed costs.
(a) In the long run, the fixed cost will be zero. Hence, the fixed cost of a firm in the long run will be
lesser than the fixed cost of the firm in the short run.
(b) Fixed costs remain constant, i.e. are independent to the firm’s level of output.
(c) The difference between average total cost and average variable costs signifies the amount of
average fixed cost of a firm.
(d) With the increase of output, the average fixed cost falls at a decreasing rate. Hence the statement
(d) is not correct.
(e) When the firm is not producing anything, its variable cost will be zero. Hence, the total cost
of the firm will be just equal to its fixed costs.
3. Answer : (b) < TOP >
Reason : (a) True. In perfect competition there are many sellers and buyers
(b) Not true. In perfect competition firms do not have any price making power as there are many
sellers and the product is homogeneous.
(c) True. In perfect competition product sold by all the firms is assumed to be homogeneous.
(d) True. In perfect competition entry and exit of firms is free.
(e) True. In perfect competition buyers and sellers have access unlimited information
about the market.
4. Answer : (d) < TOP >
Reason : When income increases by 33.33%, demand for CD players increase by 40%. Therefore, income
elasticity of demand for CD players is 1.20.
(a) Is not the answer since the demand is elastic as the income elasticity is 1.20.
(b) Is not the answer since the CD player is a normal good as income elasticity is positive.
(c) Is not the answer since the CD player is a normal good as income elasticity is positive.
(d) Is the answer since income elasticity is positive and greater than one.
(e) Is not the answer since income elasticity is greater than one. For necessities income elasticity of
demand is positive but less than one.
5. Answer : (e) < TOP >
Reason : The profit of a firm refers to the difference between total revenue and total cost. Hence, to maximize
the profits, the firm should maximize the difference between total revenue and total cost. The difference
between average revenue (AR) and average cost (AC) represents the average profit of the firm. Hence
maximization of difference between average revenue and average cost also indicates profit
maximization. A firm maximizes its profit when it produces and sells an output at which marginal
revenue (MR) is equal to marginal cost (MC).
6. Answer : (d) < TOP >
Reason : To maximize his total utility, a consumer should spend his income such that the last rupee spent on all
goods gives same amount of additional utility i.e. MUx/Px = MUy/Py. The marginal utilities of last
good X and good Y are same, hence it can be written as MUx/Px = MUx/Py. As the price of good X is
more than good Y, MUx/Px < MUx/Py, which means that the consumer has not achieved maximum possible
satisfaction. In order to reach maximum satisfaction, he should, thus, consume more of good Y and less
of good X because marginal utility per rupee from good Y is more than good X.
7. Answer : (d) < TOP >
Reason : Marginal Utility is change in Total Utility when additional unit of the good is consumed. If MU is
negative, Total Utility will be decreasing.
8. Answer : (c) < TOP >
Reason : The slope of the isoquant represents the Marginal Rate of Technical Substitution (MRTS) between
labor (L) and capital (K). MRTS is equal to the ratio of the marginal productivities of two factors.
(a) The slope of the isocost curve represents ratio of wages (w) and interest (r).
(b) The slope of the indifference curve signifies marginal rate of substitution of goods (MRS).
(c) The slope of the isoquant curve signifies the marginal rate of technical substitution (MRTS)
between labor and capital.
(d) The slope of the budget line represents ratio of price of good X and good Y.
(e) The slope of the average cost curve only shows the rate of change in average cost curve with
respect change in output.
9. Answer : (b) < TOP >
Reason : (a) Average fixed cost (AFC) falls with the increase of output whether or not marginal cost is
increasing or decreasing. Hence (a) is not correct.
(b) When marginal cost is increasing, but less than average total cost, the average cost will fall.
(c) Since (b) is correct, (c) cannot be the answer.
(d) & (e) The average variable cost will be equal or less than average cost since average cost
comprises of both AVC and AFC (i.e. average variable costs and average fixed costs). When
marginal cost of a firm is increasing, but less than average total cost, average variable cost may be
increasing or decreasing.
10. Answer : (e) < TOP >
Reason : When price of sugar falls, it reduces the cost of production of ice cream. This encourages suppliers to
supply more to increase their profits. When supply of ice cream increases (supply curve shifts right),
the price of ice cream falls.
With the fall in price, because of increased supply, the demand for the good increases.
Supply increases with the fall in the cost of production.
Price of ice cream will fall because of increased supply.
Hence, the correct answer is (e).
11. Answer : (b) < TOP >
Reason : The law of demand is directly derived from the law of diminishing marginal utility. When the price of
the good falls, the consumer buys more of the good so as to equate the marginal utility to the lower
price. The downward sloping marginal utility curve can be converted into the downward sloping
demand curve.
(a) Is not the answer because indifference curve doesn’t resemble the demand curve of a consumer.
An indifference curve depicts the various alternative combinations of the goods, which provide
same level of satisfaction to the consumer.
(b) Is the answer because marginal utility curve resembles the demand curve of a consumer.
(c) Is not the answer because budget line is not same as the demand curve of a consumer. Budget line
represents all the combinations of the two commodities, which the consumer can buy by spending
his entire income for the given prices of the two commodities.
(d) Is not the answer because total utility curve is not same as the demand curve of a consumer. Total
utility curve is a curve representing the sum of all the utilities derived from the total number of
units consumed.
(e) Is not the answer because average utility curve is not same as the demand curve of a consumer.
12. Answer : (c) < TOP >
Reason : The law of diminishing returns states that by employing more units of some factors of production to
work with one or more fixed factors, the total product will increase at an increasing rate, then at a
constant rate and finally at a diminishing rate.
(a) Is not the answer because the law of diminishing returns holds good when all labors are equally
efficient i.e. labor are homogeneous.
(b) Is not the answer because the law of diminishing returns is relevant only when the time period is
short because in long run all factors are variable.
(c) Is the answer because the law of diminishing returns is not applicable when the two inputs are
used in same proportion. When all factor inputs are increased by the same proportion, this law is
not relevant.
(d) Is not the answer because the law of diminishing returns assumes that the state of technology is
given and remains constant.
(e) Is not the answer because according to the law of diminishing returns, one factor of production
must always be kept constant at a given level. So if capital is held constant, with varying labor,
this law of diminishing returns holds good.
13. Answer : (e) < TOP >
Reason : All the statements are true. As one input is increase by keeping the other input constant, productivity of
the fixed inputs increases.
If price of one factor input increase, producers tend to substitute relatively less expensive inputs for this
input.
14. Answer : (d) < TOP >
Reason : When the management of a company has increased the salary of the staff by 10%, it will not affect the
implicit cost. Implicit cost incurred by a firm is actually the opportunity cost of the factor owned by
him. Opportunity cost of any input is the next best alternative use that is sacrificed by its present use. It
indicates what a factor can earn in the next best use.
(a) Is not answer because when there is an increase in salary of the staff by 10%, economic cost
increases.
(b) Is not answer because when there is an increase in salary of the staff by 10%, accounting profit
decreases. Because accounting profits is the firm’s total revenue less its economic cost. So when
the economic cost increases, accounting profits decreases.
(c) Is not answer because when there is an increase in salary of the staff by 10%, direct cost
increases. Because direct costs are costs which can be directly contributed to production of a given
product.
(d) Is the answer because when there is an increase in salary of the staff by 10%, implicit cost will not
be affected.
(e) Is not answer because when there is an increase in salary of the staff by 10%, fixed cost is
affected, since salary paid to administrative staff is fixed in nature.
15. Answer : (e) < TOP >
Reason : (a) Is not the answer because it is a false statement that elasticity remains constant throughout the
demand curve. Elasticity takes different values at different point on the demand curve.
(b) Is not the answer because it is a false statement that elasticity increases with increase in quantity
demanded.
(c) Is not the answer because it is a false statement that elasticity increases as the price decreases.
(d) Is not the answer because it is a false statement that elasticity is equal to the slope of the demand
curve. If the demand function is represented by P = f (Q), then the slope of the demand curve is
given by ∂P/ ∂Q and its elasticity is given by ep = P/Q. ∂Q/ ∂P.
(e) Is the answer because higher the elasticity, more responsive the demand is for a given change in
price. Higher the elasticity, higher is the percentage change in quantity demanded than the
percentage change in price.
16. Answer : (d) < TOP >
Reason : Transfer payments are payments which cannot be regarded as payment for current services or
production and therefore do not enter national income. Of the above, invalidity benefit, flood relief,
government pensions and Scholarships do not involve any production activity and are transfer
payments. Where as, salaries paid to Members of Parliament are compensation to the services rendered
by the members, hence it is not a transfer payment.
17. Answer : (e) < TOP >
Reason : GDPFC = GDPMP – Indirect taxes + Subsidies
∴ If GDPFC > GDPMP, Subsidies > Indirect taxes
18. Answer : (d) < TOP >
Reason : Taxation is not an instrument of monetary policy, rather it is a fiscal policy instruments. So the answer is
(d).
19. Answer : (e) < TOP >
Reason : When income of a consumer increases, some of the income is saved and some of the income is spent
on consumption. Therefore, MPC > 0 but < 1.
20. Answer : (c) < TOP >
Reason : Loans are a form of credit, and as they can be used to purchase goods and services they are the
equivalent of money. Banks through the ‘process of credit creation’ creates the money. The process of
credit creation is done by accepting deposits and lending loans.
21. Answer : (c) < TOP >
Reason : A variable is a stock if it is measured at a particular point of time. It is a flow variable if it is measured
over a period of time.
(a) Capital stock is measured at a particular point of time, hence is a stock variable
(b) A firm’s assets are measured at a particular point of time, hence is a stock variable
(c) Investment is measured over a period of time hence is a flow variable.
(d) Price index is measured at a particular point of time, hence is a stock variable
(e) Public debt is measured at a particular point of time, hence is a stock variable
22. Answer : (a) < TOP >
Reason : APC + APS = 1
Thus, APS = 1 – APC = 1 – 1.05 = – 0.05.
23. Answer : (b) < TOP >
Reason : Monetary policy mainly controls the economy by regulating the interest rates through changes in
money supply. If the private investment is more sensitive to interest rate, then monetary policy can
more effectively regulate the economy.
a. A recessionary condition cannot make a monetary policy more effective.
b. When private investment is more sensitive to interest rate monetary policy will be more
effective as a small change in the interest rate would lead to a greater change in the output.
d. During liquidity trap, the effectiveness of monetary policy decreases because during such
policy, changes in interest rate cannot have any effect on investments.
e. Effectiveness of the monetary policy is not determined by the phases of business
cycle.
24. Answer : (e) < TOP >
1 1
=
Reason : Multiplier = MPS 0.20 = 5.
25. Answer : (c) < TOP >
Reason : An increase in the supply of money in the economy will result in an increase the price level .
So the answer is (c).
26. Answer : (a) < TOP >
Reason : (a) Classical economists assume flexible wages in the economy. Flexibility of wages results in full
employment of labor in the economy. Hence the aggregate supply curve becomes vertical at the
full employment level. Therefore, the answer is (a).
(b) Is not the answer. If Aggregate Supply curve is horizontal, increase in the Aggregate Demand
does not exert pressure on the price level and more goods and services are supplied at the same
price level. This can happen only if there is very high level of unemployed resources in the
economy. But, classical economists assume full employment of resources.
(c) If Aggregate Supply curve is first horizontal and then vertical, it implies Aggregate Supply is
perfectly elastic until the full employment level is reached and perfectly inelastic at the full
employment level of output. Hence, (c) is not the answer.
(d) Is not the answer. Aggregate Supply curve with such a shape does not exist.
(e) Is not the answer. A positively sloped Aggregate Supply curve is not possible under the classical
assumption of perfectly flexible wages.
27. Answer : (d) < TOP >
Reason : (a) During a boom bank reserves will be high as the bank credit is high to support the increased
economic activity
(b) Wage rate will be high as demand for labor increase during the boom phase
(c) As the economic activity increase during the boom bank credit also increases
(d) During a boom demand increased at a faster rate and inventories tend to be low. All other
variables tend to increase during a boom.
(e) Cost of production will be high as demand for factors of production will be relatively high
during the boom phase.
28. Answer : (c) < TOP >
Reason : Savings function captures the relation between the savings and the disposable income. Slope of savings
function indicates how responsive savings are as income changes. That is, slope of the savings function
is equal to ∆S/∆Y, which is nothing but Marginal Propensity to Save.
(a) Is not the answer. Average Propensity to Save is equal to S/Yd.
(b) Is not the answer. Marginal Propensity to Consume is equal to ∆C/∆Yd.
(c) Is the answer. Marginal Propensity to Save is equal to ∆S/∆Yd.
(d) Is not the answer. Average Propensity to Consume is equal to C/Yd.
29. Answer : (c) < TOP >
Reason : Unemployment caused by imperfect information about the available jobs and skills in the market is
called fictional unemployment.
30. Answer : (d) < TOP >
Reason : Savings account deposits as well as fixed deposits form part of M3 definition of money supply. M1 =
Currency with the public + Demand deposits with the banking system, while M2 = M1 + Post office
savings bank deposits. Thus, transfer of funds from savings account, reduces both M1 and M2.
However, M3 remains constant as decrease in savings account deposits is equally compensated by the
increase in time deposits with the banking system.
Section B: Problems
1.
a. The monopolist can maximize his profit by equating MC and MR
P = 3,000 – 3Q
TR = 3,000Q – 3Q2
MR = 3000 – 6Q
TC = 3Q3 – 3Q2 – 600Q
MC = 9Q2 – 6Q – 600
To maximize profits,
MC = MR
9Q2 – 6Q – 600 = 3,000 – 6Q
9Q2 = 3,600
Q2 = 400
Q = 20 units.
Price = 3,000 – 3Q = 3,000 – 3(20) = Rs.2940.
Profit = TR – TC = 3,000Q – 3Q2 – ( 3Q3 – 3Q2 – 600Q)
= 3,000(20) – 3(20)2 – 3(20)3 + 3(20)2 + 600(20)
= 60,000 – 1,200 –24,000 +1,200 +12,000
= Rs.48,000

b The break-even level of output of the firm is determined when TR = TC.


3,000Q – 3Q2 = 3Q3 – 3Q2 – 600Q
3Q3 – 3600Q = 0
3Q (Q2 – 1200) = 0
Q = 34.64= 35 units.
< TOP >
2. a. Total Cost (TC)= Fixed Cost +Variable Cost
Fixed Cost = Rs.20, 000
Variable Cost = 500Q – 9Q2 + 0.25Q3
∴Total Cost = 20, 000 + 500Q – 9Q2 + 0.25Q3
b. Average Cost = Total Cost / Q
= 20, 000 / Q + 500 – 9Q + 0.25Q2
c. Marginal Cost = ∂TC/∂ Q
= 500 – 18Q + 0.75Q2
< TOP >
3. a. National income = NNP at factor cost
= NNP at market prices – Indirect taxes + Subsidies
= 1,50,000 – 21,000 + 3,000
= 1,32,000 MUC
b. Personal income = National income – Corporate profit taxes – Retained profits
= 1,32,000 – 9,750 – 45,000
= 77,250 MUC
c. Personal disposable income = Personal income – Personal income taxes
= 77,250 – 15,000
= 62,250 MUC.
< TOP >

4. a. High powered money = Monetary Liabilities of RBI + Government Money


Monetary liabilities of RBI = Financial Assets + Other Assets – Non-monetary liabilities
Non-monetary liabilities = Other non-monetary liabilities + Net worth
= 525 + 1,000 = 1,525 MUC
∴ Monetary liabilities = 24,000 + 100 – 1525 = 22,575 MUC
Government money = 25 MUC
∴ High powered money (H) = 22,575 + 25 = 22,600 MUC

b. Money Supply = H×m


1+ Cu 1 + 0.24 1.24
Money multiplier (m) = Cu + r = 0.24 + 0.07 = 0.31 = 4
∴ Money Supply in the economy = 22,600 × 4
= 90,400 MUC.
< TOP >

5. The European car industry is an oligopoly. In car industry a few sellers dominate the sales of a product and the
entry of new sellers is difficult or impossible. The product can be either differentiated or standardized.
Characteristics of oligopoly market:
i. Only a few firms supply the entire market with a product that may be standardized or differentiated.
ii. At least some firms have large market shares and thus can influence the price of a product.
iii. The firms in the oligopolistic industry are aware of their interdependence and always consider their rivals’
reactions when selecting prices, output goals, advertising budgets, and other business policies.
iv. There is a great importance of advertising and selling costs under conditions of market situation
characterized by oligopoly. A direct effect of interdependence of oligopolists is that the various firms have
to incur a good deal of costs on advertising and on other measures of sales promotion.
v. An oligopolistic firm faces an indeterminate demand curve. The demand curve faced by an oligopolistic
firm represents different quantities of output that the firm can sell at different prices. These quantities cannot
be definitely determined because the quantities will be different depending on the different reaction patterns
of the rivals. When any firm changes its own price, rivals will also change their prices and as a result the
demand curve faced by an oligopolist firm loses its definiteness.
vi. The oligopoly market is concerned with group behavior. There is no generally accepted theory on group
behavior. It basically depends on the behavior on the behavior of the members of the group. For example, it
may happen that members of the group may compete with one another (Non-collusive Oligopoly), or it may
happen that the members come to an understanding (Collusive oligopoly) among themselves and form a
general body to promote their common interests. It may also happen that there is a leader in the group and
other members of the group follow the leader.,(Price leadership), etc.
< TOP >
6. An oligopoly market structure sellers try to differentiate their products mainly on the basis of four aspects:
i. Physical Features – size, weight, color, design, particular attributes, etc.
ii. Location –The number and variety of locations where a product is available. Some are available
everywhere; while others available only at select outlets.
iii. Services – Products can be differentiated on the basis of the services that accompany them.
iv. Product images – The image that the producer tries to build up in the consumer’s mind through packaging
etc.
< TOP >
7. Inflation is defined as an increase in the general level of prices in the economy that is sustained over a period of
time. The increase in the price of a particular good is not called inflation. Inflation is measured for a basket of
goods and services. With in the basket, prices of some of the goods and services may rise and prices of some of
the goods and services may fall. When the overall price of the defined basket increases, it is called inflation.
Inflation impacts different social groups differently. Some people gain from inflation while others get hurt. The
impact of inflation depends upon the amount of income and wealth that inflation takes away from a particular
group. Usually, inflation has a negative effect more on fixed income groups than on high and flexible group. It is
generally believed that ‘ the rich get richer and the poor get poorer’ because of inflation. This is generally the case
with prisoners, wage earners and those receiving a fixed monetary income. Though their monetary income is
constant, real income is reduced because of inflation.
< TOP >
8. The two variables that receive the most attention in macroeconomics are unemployment and inflation. The
British economist A W Phillips pioneered in the investigation of the relation between rate of unemployment and
rate of wage increase. When tracing the link between rate of change in wages and unemployment over nearly a
century for the United Kingdom, Phillips discovered an inverse relationship. When wage rates were rising
rapidly, unemployment rates were low. Correspondingly, wage rates rose more slowly when the unemployment
rates were high.
Though the original Phillips curve identified the relation between the change in wage rates and unemployment
rates, a modified Phillips curve indicates the relation between rate of inflation and unemployment rate. As we
discussed above wage increases not matched by increases in labor productivity are converted into increases in the
price level. In terms of rates, an increase in the growth rate of wage rates not matched by an equal increase in the
growth rate of labor productivity is converted into an increase in the inflation rate. For example, all other things
being equal, if initially money-wage rates are increasing by 5 percent per year and labor productivity is increasing
by 2 percent per year, the rate of inflation will be 3 percent per year. If the increase in the money-wage rates
increases to 8 percent per year and the increase in the labor productivity to 4 percent per year, the inflation will
increase to 4 percent per year.
The inverse relation found by Phillips is best explained by the behavior of organized labor. Organized labor can
cause autonomous increase in wage rates in excess of increase in productivity, which leads to inflation. The
degree to which labor can do this will vary inversely with the unemployment rate and the ease of labor markets.
With lower unemployment and tighter labor markets, organized labor will become more aggressive and press for
larger wage increases. Under the opposite conditions, organized labor will be less demanding. Furthermore, low
unemployment and tight labor markets are indicative of buoyant demand for goods and abundant profits. During
such times, business will usually grant the “excessive” wage increase demands.
Phillips curve indicates a trade-off between inflation and unemployment. That is, policy makers can choose a
particular combination of inflation and unemployment from the menu indicated by Phillips curve.

In this figure, the policy makers can choose 2 percent unemployment with 5 percent inflation or 3 percent
inflation with 6 percent rate of unemployment or any other combination on the Phillips curve.
Though such a trade-off seem to exist in the western countries in 1960s, the ‘70s portrayed a different picture of
`Stagflation’, where high level of unemployment was accompanied by high rates of inflation. This led to the view
that the downward sloping Phillips curve is relevant only in the short run and in the long run there is no trade-off
in which case the Phillips curve is vertical.
In the long run, the vertical long run Phillips curve is positioned at the natural rate of unemployment.
< TOP >

Section C: Applied Theory


9. Rent control is a type of price ceiling that the government authorities sometimes use for rented housing. Rent
control can prevent housing markets from reaching equilibrium in case when the rents are set below the market
equilibrium rents. Typically, rent control limits increase in monthly rental rates or establish rules that are than
used to determine the ‘fair’ monthly rents for housing. They seek to keep rents lower than those that would
prevail in equilibrium in a competitive market. Rent controls benefit lower-income people who would otherwise
have to pay higher percentages of their income for rent.
Using supply and demand analysis we can illustrate how rent control causes housing shortages when the rents set
by law are below the market equilibrium rents.
Suppose the market equilibrium rent per room is Rs. 2,500 and at this rent 20,000 rooms per year would be
rented. Now suppose a local rent control ordinance establishes a ceiling of Rs. 1,250 per room. Because the
controlled rent is below the market equilibrium rent, the result is a shortage of housing. At Rs. 1,250 per room the
number of rooms demanded per year is 25,000, while the number supplied is only 15,000, resulting in a shortage
of 10,000 rooms.

The shortage arises from an increase in the number of houses demanded from the quantity that would exist at the
equilibrium rent and from a decrease in the quantity of houses supplied to a level below the quantity that would
prevail at the equilibrium level.
Rent controls do make houses less expensive for tenants. Landlords respond to the reduction in rent by decreasing
the quantity and often the quality of houses. This results in a shortage of rental houses.
< TOP >
10. The fiscal deficit is equal to “Borrowings and Other Liabilities” of the government. It measures the overall
borrowing required to finance Government expenditure. Therefore, fiscal deficit is a net addition to public debt.
Large fiscal deficits have implications on money supply, growth, inflation and for the access to resources for
private investment.
• Money Supply Growth
We expect the government to be able to finance this fiscal deficit with a remarkably small money creation
component. When debt is monetized, net RBI credit to government increases which increases the high-powered
money in the economy. With the introduction of WMA on April 1, 1997 the component of debt monetized is
limited, providing greater autonomy to the RBI in its conduct of monetary policy.
• Inflation
Since the fiscal deficit is not monetized to a large extent, high fiscal deficit does not imply a high growth in
money supply. Further, the comfortable position on food grain stocks and foreign exchange reserves give
the government levers through which inflation can be kept under control.
But, a large part of the fiscal deficit is used to finance current government expenditure, which is
unproductive by its nature. This expenditure instantaneously increases the aggregate demand in the economy
without any increase in the production/supply. This would finally lead to an inflationary situation in the long
run.
• Crowding-out of Private Investment
Continued reliance of government on market borrowings may lead to crowding-out of private investment.
When government borrows from the market, liquidity position in the market becomes tight leading to a
higher rate of interest. This higher rate of interest is a higher cost of capital, which discourages private
investment. If the government can monetize a significant portion of its deficit, this may not lead to
crowding-out of private investment. This concern is more serious when the private savings are not able to
sustain increased government borrowings.
• Crowding-out of Essential Public Expenditure
Fiscal deficit is a net addition to public debt. Increased public debt necessitates more debt service in the
form of interest and repayment of borrowings. With increased reliance on market borrowings, cost of debt
also increases for the government, which results in increased burden of interest. This increased interest
burden crowds-out essential public expenditure on health, education and other social and economic welfare.
< TOP >

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