Suggested Solution Revision Test-02

Answer No 1.
(02 marks for diagram)
Definition: (01 mark)
Substitution effect means the effect on the indifference
curve due to change in quantity of goods purchased
due to change in relative prices with no change in income.

Substitution Effect: (01 mark)

If the price of good B falls, the consumer will decrease
the consumption of good A and increase the consumption
of good B

(b)
Definition: (02 marks)
Indifference Curve represents various combinations of two goods, where each combination provides
same level of utility/satisfaction i.e. consumer is indifferent among each combination.

(c)
Indifference curves are usually convex to the origin: (02 marks)
Because Marginal Rate of Substitution diminishes as we move down the curve, because every next unit
of Commodity ‘X’ is giving less and less satisfaction, therefore less and less units of commodity ‘Y’ will
be sacrificed.

Answer No 2.
(a) Law of Diminishing Marginal Utility: (02 marks)
Marginal Utility (i.e. additional utility from consumption of an additional unit) of a good
decreases with every successive unit consumed, other things remaining the same.

(b) The consumer is said to be in equilibrium when the maximum possible (01 mark)
satisfaction is obtained from the individual’s purchases, at the prices
prevailing in the market and the amount of money the individual possess for making purchases

(c) Assumptions of Indifference Curve: (03 marks)

1. Satisfaction is measured using Ordinal measurement.
2. Whole income of consumer is to be spent on two goods only.
3. Consumer is rational and wants to maximize its satisfaction.
4. Goods are substitutable and divisible.
5. Preferences are not self-contradictory.
6. Income of the consumer, and price of the good is fixed.

1 | Revision Test-02 (4, 5, 6, 7 ) by: H M Hasnan MA(Economics)

 Suggested Solution Revision Test-02
(d)
Diagram and Explanation: (1.5 mark)

Explanation: (2.5 mark)

1. Units of Good X and Good Y are shown on X-axis and Y-axis respectively.
2. Line BL represents Budget Line of the consumer.
3. IC0, IC1 and IC2 are three indifference curves representing different levels of satisfaction.
4. IC1 represents highest level of satisfaction but it is beyond budget line, hence it is impossible
to attain.
5. IC2 is within budget but is represents lowest level of satisfaction, hence it is inefficient.
6. IC0 represents highest possible indifference curve on which budget line is tangent hence
tangent point “E” on this curve is the Equilibrium Point.

Answer No 3.
(a) (i) (02 marks)

(ii) (02 marks)

AR = £25, AC = £15, therefore profit per unit = £10
profit = no. of units x profit per unit
£20,000 = 2,000 units x £10
profit maximising output is 2,000 units

2 | Revision Test-02 (4, 5, 6, 7 ) by: H M Hasnan MA(Economics)

 Suggested Solution Revision Test-02
(c) Revenue / cost

(d) the average cost of production is at a minimum.

Answer No 4.
(a) (02 marks)
Short-run average cost curve is U shaped:
• The shape of the short-run ATC is the result of the interaction between the average fixed cost
and the average variable cost: ATC = AFC + AVC.
• As the firm’s output rises, the average fixed cost will fall because the total fixed cost is being
spread over an increasing number of units. However, at the same time, average variable cost
will be rising because of diminishing returns to the variable factor.
• Hence the curve falls on account of spread of fixed costs and rises when the variable costs start
rising after a certain level, thus giving the curve a U shape

(b)
Duopoly: (1.5 mark)
Duopoly is a special case of market when there are only two sellers and
both the sellers are independent in price and output determination yet a change in
price and output of one affects the other.
e.g Pepsi and coke, Air Bus and Boeing

Oligopoly: (1.5 mark)

Oligopoly is a market situation in which an industry is dominated by a few large sellers (usually more
than 2 but less than 20), which sell substitute goods and are interdependent on each other.
e.g Airline market, Car makers and Mobile companies.

(c) Firm’s Equilibrium means level of Price and Output at which firm earns maximum profit. It is the
point where MC = MR and MC cuts MR from below. (02 marks)

Answer-05

(i) (b) The change in total utility as a result of consuming an additional unit of a product.
(ii) (d) lower marginal utility, but may increase total utility
(iii) (d) b and c above
(iv) (a) MC curve

3 | Revision Test-02 (4, 5, 6, 7 ) by: H M Hasnan MA(Economics)

 Suggested Solution Revision Test-02
(v) (d) All of the above
(vi) (d) diminishing returns
(vii) (b) average variable cost
(viii) (b) Downward
(ix) (c) Rent
(x) (c) Increased taxation
(xi) (b) aggregate demand is greater than the full employment level of income
(xii) (c) A decrease in government expenditure
(xiii) (a) When interest rate rises
(xiv) (a) The economy will naturally settle at a level of output that ensures full
(xv) (b) It will shift to the right

Answer-06
(a) (each carry 1 mark, subject to max 05)
Following are the conditions which are necessary for the existence of perfect competition:

• Large number of sellers:

There are large number of small firms. Each firm is too small to influence the market price.
• Homogenous Product:
All firms produce homogeneous products i.e. product of one firm is identical to the product of
other firms, and are perfect substitutes.
• Free entry and exit:
There are no barriers to entry. Firms can easily enter and exit the market with fluctuations in
profit.
• Perfect knowledge of price:
Buyers and sellers are fully aware of prices. Therefore, no producer can charge price different
than market price.
• Transportation costs are negligible:
Because of zero transportation cost, price-discrimination at different location is not possible.
• Perfect mobility of factors of production:
Therefore, factors of production can easily move ‘in’ or ‘out’ of the market to increase or
decrease supply in accordance with demand.
• Firms are Efficient:
The firm under perfect competition produces efficiently in long-run where Average Cost is at
minimum.
• Firms are Price Takers:
Firm has no control over price; and price is determined by market demand and supply).
Demand curve of firms is perfectly elastic.

(b) (05 marks)

Less likely by its nature, it is assumed that the LRAS curve doesn’t fluctuate too greatly.
Instead, if there are significant, permanent changes to the productive potential of the
economy, then this will lead to a shift.
An increase in the quantity and productivity of the factors of production, or an advance in
technological capabilities in the economy would cause an increase in the productive
potential, and therefore the LRAS.
A lot of changes in the SRAS come about from resources becoming more or

4 | Revision Test-02 (4, 5, 6, 7 ) by: H M Hasnan MA(Economics)

 Suggested Solution Revision Test-02
less efficient. However because the LRAS assumes full efficiency, it isn’t affected by these
changes.

Answer-07
(a)
There are three methods to calculate GDP i.e. Expenditure method, Income method and
Product/Output method.

Expenditure Method: (02 marks)

Under Expenditure method, an economy is divided into four sectors; and then spending by all sectors
during the year is added i.e.
GDP = C + I + G + (X – M)

Income Method: (02 marks)

Under this method, an economy is divided into four factors of production; and then income of all factors
is added i.e.
National Income = Rent + Wages + Interest + Profit

Product/Output approach: (or Value-added approach) (02 marks)

Under this method, an economy is divided into different sectors of production; and then net value of all
final goods and services produced during the year are added i.e.
National Income = Value of Final goods/services – Value of Intermediate goods/services (all sectors)

(b) (01 mark for each, maximum 04 marks)

Difficulties in measuring/calculating National Income:

1. Decisions to make before measurement of national income:

Country has to decide which method of measurement to use.

2. Lack of trained staff:

Collection, compilation and analysis of statistical data is highly technical exercise and it is difficult to
arrange sufficiently trained staff for it.

3. Illiteracy/unreliable record keeping:

No systematic accounts are maintained by producers.

4. Some income cannot be captured:

e.g. a. Underground (or Black/Shadow) Economy Transactions. Non-market transactions

5. Some items may be wrongly included in national income:

e.g. a. Risk of double counting. Transfer Payments.

Complexities in calculation of national income:

. Complications in treatment of income of multinational firms.
Calculation of depreciation, valuation of inventories is a difficult and subjective procedure.

5 | Revision Test-02 (4, 5, 6, 7 ) by: H M Hasnan MA(Economics)

 Suggested Solution Revision Test-02
Answer-08
(a)
Autonomous Consumption (2.5 marks)
part of consumption which does not change with income. It is incurred even if income is Zero).

Induced Consumption (consumption which changes with the change in income). (2.5 marks)

(b)
Following are three related proposition of Keynes’ law of consumption: (0.5 marks)

1. Increase in income will lead to increase in consumption and saving.

2. When income of consumers increases, consumption increases; but increase in consumption is less
than increase in income. (i.e. MPC < 1)
3. What is not consumed, is saved. (i.e. MPC + MPS = 1)

Answer-09 (05 marks)

(a) Keynesian

The key point to note is that the level of output increases proportionately more
than the price level. In a deep recession/ depression the price level won’t
increase at all.
OR
Classical

Both the price level and level of output increases with the increase in aggregate demand.

6 | Revision Test-02 (4, 5, 6, 7 ) by: H M Hasnan MA(Economics)

 Suggested Solution Revision Test-02
(b)

A fall in interest rates should decrease the cost of investment relative to the potential yield that the
investment might bring, thereby increasing the likelihood that investment will occur.
Firms will invest if the discounted yield (i.e. the benefit) exceeds the cost of the project (03 marks)
(02 marks for diagram)

The MEC schedule shows the total level of investment which will take place in
the economy at each level of the interest rate.

7 | Revision Test-02 (4, 5, 6, 7 ) by: H M Hasnan MA(Economics)