Category: KSEEB Important Questions

Karnataka 2nd PUC Economics Important Questions Chapter 6 Open Economy Macroeconomics

Very Short Answer Type Questions

Question 1.
What do you mean by open economy?
Answer:
An economy which has economic rela¬tions with other countries of the world with regard to good and services, financial assests. etc.

Question 2.
Give the meaning of foreign trade?
Answer:
Foreign trade refers to trade betwee different countries.

Question 3.
What is meant by balance of trade?
Answer:
Balance of trade refers to Difference between the value of visible items of exports and imports during a year.

Question 4.
State the meaning of exchange rate?
Answer:
An exchange rate is the rate at which one curency is converted into another.

Question 5.
What do you mean by closed economy?
Answer:
An economy that does not interact with the economy of any other country is called as closed economy.

Question 6.
Expand BOP?
Answer:
BOP – Balance of Payments.

Question 7.
What is trade?
Answer:
The term trade refers to exchange of goods and services between two individuals or nations.

Question 8.
What do you understand by flexible exchange rate?
Answer:
Flexible exchange rate is a system in which exchange rate keeps on changing or floating.

Short Answer Type Questions

Question 1.
Distinguish between closed economy and open economy?
Answer:
Closed economy

1. A closed economy is an economy that does’nt interact with other countries economies.
2. Closed economy prohibits import and export.
3. Closed economy follows restricted trade policies.

Open economy

1. An open economy is an economy which has economic relations with other countries economies.
2. Open economy engages in import and export.
3. Open economy follows free trade policies.

Question 2.
What do you mean by unilateral trade?
Answer:
Unilateral trade can be defined as trade that is imposed on one nation by the other nation, benefiting the later which is usally, is a developed country.
ex: India has unilateral trade agreement with England prior to Independence.

Question 3.
What do you mean by bilateral trade?
Answer:
Bilateral trade means the system of trading exclusively between two countries or two groups of countries, for their mutual advantage.
ex: Indo-Srilankan free trade agreement.

Question 4.
Name the three important accounts of Balance of payments?
Answer:
The three important accounts of BOP are:

1. current account
2. capital account
3. official account

Question 5.
State the meaning of official Reserve Account?
Answer:
The official reserve account of a country indicates change in a country’s reserve assets during a year. It is in the form of foreign currencies, gold and special drawing rights.

Question 6.
What do you mean by multilateral trade?
Answer:
It refers to involvement of three or more groups of countries in trade. Trade is regulated between the nations without discrimination.

Question 7.
What are the differences between balance of trade and balance of payments?
Answer:
Balance of trade:

1. Balance of trade refers to the difference between the value of visible items of exports and imports during a year.
2. Balance of trade is narrow concept.
3. The Balance of trade is only a partial study of the BOP.

Balance of Payments:

1. Balance of payments is the difference between the value of visible and invisible items of exports and imports.
2. Balance of Payments is Broader concept.
3. Balance payments give a complete picture of a country’s international economic transactions.

Question 8.
Distinguish between nominal and real exchange Rates?
Answer:
Nominal exchange rate:

• When the exchange rate is quoted in terms of money it is called as nominal exchange rate.
• The nominal exchange rate, means, the amount of domestic currency paid to purchase one unit of foreign currency.

Real exchange rate

• Real exchange is the ratio of foreign prices to domestic prices measured in the same currency.
• The real exchange rate means, the relative price of foreign goods in terms of domestic goods.

Question 9.
What is fixed exchange rate?
Answer:
An exchange rate between the currencies of two or more countries is fixed more by the monetary authority at a particular level.

Long Answer Type Questions

Question 1.
Explain the structure of balance of payments?
Answer:
The structure of balance of payments includes three main accounts:

• Current Account
• Capital Account
• Official Reserve Account
• Current Account

Current Account of Balance of payments deals with exports and imports of goods and services and transfer payments.

Current account consists of three sub groups:

1. Trade account or export and import of commodities.
2. Invisible account or services rendered and received.
3. transfer of payments.

Capital Account:
Capital Account deals with payments of debts and claims. It includes capital transactions such as

• Borrowing and lending loans,
• Repayments of loans,
• And sale and purchase of assets from foreign countries.

Official Account:
If a country receives an excess of foreign exchange than the foreign exchange expenditure it results in surplus.

Question 2.
Explain the theories of determination of exchange rate?
Answer:
There are two important theories which of any commodity is determined by the free play of the forces of demand and supply.

Question 3.
What are the exchange rate systems?
Answer:
There are three important exchange rate systems, namely

1. Flexible Exchange Rate.
2. Fixed Exchange Rate.
3. Managed Exchange Rate.

Flexible exchange Rate:
A flexible exchange rate is a system in which exchange rate keeps on changing or floating. In this system exchange rate is determined by the market forces of demand and supply.

Fixed exchange Rate:
Under the fixed exchange rate the exchange rate is fixed by the monetary authority. In this case, the exchange rate is fixed at a particular level.

Managed floating Rate:
Managed floating system is a mixture of flexible and fixed exchange rate systems. Under this system exchange rate is fixed by the market forces.

Question 4.
Give the meaning of the balance of payments and explain its structure?
Answer:
Balance of payments is the difference between the value of visible and invisible items of exports and imports. In other words Balance of payments is a statement of systematic record of all economic transactions between one country and the rest of the world during a year.

It shows what is sent to foreign countries by nations and what is received by them in return. Balance of payment shows the International economic position of the country in making decisions of monetary and fiscal policies, foreign trade, foreign exchange and international payments to the government authorities for structure ofBalance ofpayments

The structure of balance of payments includes three main accounts:

1. Current Account
2. Capital Account
3. Official Reserve Account

Current Account:
Current Account ofBalance ofpayments deals with exports and imports of goods and se rvices and transfer payments.

The current account consists of three sub groups:

1. Trade account or export and import of commodities.
2. Invisible account or services rendered and received.
3. Transfer of payments.

Capital Account: Capital Account deals with payments of debts and claims. It includes capital transactions such as

1. Borrowing and lending loans,
2. Repayments of loans,
3. And sale and purchase of assets from foreign countries.

Official Account:
If a country receives excess of foreign exchange than the foreign exchange expenditure it results in surplus.

Exercises

Question 1.
Differentiate between balance of trade and current account balance
Answer:
The balance of exports and imports of goods is referred as the balance of trade. Adding trade in services and net transfers to the trade balance, we get the current account balance = Trade balance (Balance of Trade) + Trade in services and net transfers.

Question 2.
What are official reserve transa ctions? Explain their importance in the balance of payments.
Answer:
The transactions carried by monetary authority of a country, which cause changes in official reserves, are termed as official reserve transactions (ORT). These transactions are carried through purchase or sale of currency in the exchange market for foreign currencies or other assets. The reserves are drawn by selling foreign currencies in exchange market during deficits and foreign currencies are purchased during surplus. When the official reserves increases or decreases, it is called overall balance of payments surplus or deficit respectively.

Importance of ORT in balance of payments:

1. Purchase of a country’s own currency is a credit item in the balance of payments; whereas, sale of the-currency is a debit item
2. It helps to adjust the deficit and surplus in ‘ balance of payments. ,

Question 3.
Distinguish between the nominal exchange rate and the real exchange rate.
Answer:
If you were to decide whether to buy domestic goods or foreign goods, which rate would be more relevant? Explain.

Nominal exchange rate is the price of one currency in terms of another. It is the amount of domestic currency required to buy one unit of foreign currency. For example, a rupee- do liar exchange rate of Rs 45 means that it costs 45 rupees to buy 1 dollar.

Real exchange rate is the ratio of foreign prices to domestic prices. In other words, it measures foreign prices relative to domestic prices.

Real exchange rate = e\(\frac{\mathrm{P}_{\mathrm{f}}}{\mathrm{P}}\)

Where Pf- price level of foreign currency P – Price level of domestic currency For example, if a watch costs $ 40 in the US and the nominal exchange rate is 50 per US dollar, then, with real exchange rate of 1 Dollar it should cost Rs. 2,000 (ePf = 50 × 40 = Rs 2000) in India.

If I was to decide whether to buy domestic goods or foreign goods, then real exchange rate will be more relevant, because real exchange rate takes the inflation differential among the countries into account and is also used as an indicator of a country’s competitiveness in the foreign trade.

Question 4.
Suppose it takes 1.25 yen to buy a rupee, and the price level in Japan is 3 and the price level in India is 1.2. Calculate the real exchange rate between India and Japan (the price of Japanese goods in terms of Indian goods). (Hint: First find out the nominal exchange rate as a price of yen in rupees).
Answer:
Price level in foreign country: (Japan) Pf= 3
Price level in home country: (India)
P = 1.2
Now, real exchange rate = e\(\frac{\mathrm{P}_{\mathrm{f}}}{\mathrm{P}}\)
Price of 1.25 yen = 1 rupee

Price of 1 yen = \(\frac{1}{1.25}=\frac{100}{125}=\frac{4}{5}\) rupee
Therefore, e = \(\frac{1}{1.25}=\frac{100}{125}=\frac{4}{5}\)

So, real exchange rate = e\(\frac{\mathrm{P}_{\mathrm{f}}}{\mathrm{P}}\)
= \(\frac{4}{5} \times \frac{30}{1.2}\) = 2

Therefore, the real exchange rate is 2.

Question 5.
Explain the automatic mechanism by which BoP equilibrium was achieved under the gold standard.
Answer:
Under the gold standard, adjustment to BOP surpluses or deficits cannot be brought about through changes in the exchange rates.

The adjustment must either come about automatically through the working of the economic system or be brought about by the government. Under the gold standard system, all the currencies were defined in terms of gold. Each participant country committed to guaranteeing the free convertibility of its currency into gold. Each participant country committed to guaranteeing the free convertibility of its currency into gold at a fixed price into another asset (gold) acceptable in international payments. This also made it possible for each currency to be convertible into all others at a fixed price. Exchange rates were open economy. Macroeconomics is determined by its worth in terms of gold ( where currency was trade) of gold its actual gold content).

For example, if one unit of saying currency A was worth one gram of gold, or one unit of currency B was worth two grams of gold, currency B would be worth twice as much as currency A without having to first buy gold and then sell it. The rates would fluctuate between an upper and a lower limit. These limits being set by the costs of melting, shipping, and recovering between the two countries. To maintain the official parity, each country needed an adequate stock of gold reserves. All countries on the gold standard have stable exchange rates. Thus fixed rates were maintained by an automatic equilibrium mechanism

Question 6.
How is the exchange rate determined under a flexible exchange rate regime?
Answer:
Under a flexible exchange rate regime, the rate of exchange is determined by the forces of demand and supply. In other words, the equilibrium rate of exchange occurs where demand and supply are equal to each other. This can be illustrated with the help of the given figure:

In the figure, the x-axis represents demand for and supply of foreign currency andy-axis represents the exchange rate. DD is the demand curve that is downward sloping, showing an inverse relationship between the rate of exchange and demand for foreign currency. Whereas, the supply curve is upward sloping, showing a positive relationship between the rate of exchange and the supply of foreign currency. E is the equilibrium rate of exchange, where the demand equates to the supply of foreign exchange (OR). Now, if the exchange rate rises to OR₁, then the supply exceeds the demand, forcing the exchange rate to fall back to OR. On the contrary, if the exchange rate falls to OR₂, there is excess demand oversupply.

Hence, the rate of exchange rises from R₂ to R. Hence, the equilibrium exchange rate (OR) is determined by demand and supply of foreign currency.

Question 7.
Differentiate between devaluation and depreciation.
Answer:

Devaluation	Depreciation
1. It occurs when the currency exchange rate is officially lowered under fixed exchange rate system.	1. When the value of currency falls as compared to other currencies, it is known as depreciation.
2. It exists under a fixed exchange rate.	2. It exists under a flexible exchange rate.
3. It is due to the government’s decision	3. It is due to the demand and supply forces.

Question 8.
Would the central bank need to intervene in a managed floating system? Explain
Answer:
Managed floating system is a combination of two systems fixed and floating exchange rate systems. It calls for the government or central bank to intervene when the need for the same is needed. The government or the central bank helps in moderating the exchange rate movements by purchasing and selling of foreign currency. Thus, to avoid dirty floating, the government exercises its power to intervene, whenever the need arises.

Question 9.
Are the concepts of demand for domestic goods and domestic demand for goods the same?
Answer:
In a closed economy, the demand for domestic goods and domestic demand for goods are similar terms. However, in an open economy, these two terms have different meanings. Demand for domestic goods includes both domestic and foreign demand for domestic goods. Whereas domestic demand for goods refers to the domestic market demand of a country, that is either produced domestically or abroad (foreign countries).

Question 10.
What is the marginal propensity to import when M = 60 + 0.06Y? What is the relationship between the marginal propensity to import and the aggregate demand function?
Answer:
Marginal propensity to import is the fraction of additional income spent on imports. It is given that M = 60 + 0.06Y Therefore, marginal propensity to import (m) = 0.06. It reflects induced imports; that is the part of the total imports, which is a function of income.

Since the marginal propensity to import negatively affects the aggregate demand function, when income increases the aggregate demand decreases. This is because the additional income is spent on foreign goods and not on domestic products.

Question 11.
Why is the open economy autonomous expenditure multiplier smaller than the closed economy one?
Answer:
In case of a closed economy, equilibrium level ofineome is given by
Y = C + cY + I + G
Or, Y – c Y = C +1 + G
Or, Y (1 – c) = C + I + G
Or,Let, (C + I + G) = A1
Or, Y = \(\frac{\mathrm{A}_{1}}{1-\mathrm{c}}\) ………………(1)
Or, \(\frac{\Delta \mathrm{Y}}{\Delta \mathrm{A}_{1}}=\frac{1}{1-\mathrm{c}}\)

In the case of an open economy, equilibrium level ofineome is given by
Y = C + cY + I + G + X- M- mY
Or, Y – c Y – mY = C + I + G + X
Or, Y (1 – c – m) = C + I + G + X
Or, Y = \(\frac{\mathrm{C}+\mathrm{I}+\mathrm{G}+\mathrm{X}}{1-\mathrm{c}-\mathrm{m}}\)

Let autonomous expenditure (A₂) = C + I + G + X
Or, Y = \frac{\mathrm{A}_{2}}{1-\mathrm{c}-\mathrm{m}}
\(\frac{\Delta Y}{\Delta A_{2}}=\frac{1}{1-c-m}\) ………………………(2)

Comparing equations (1) and (2) and the denominators of the two multipliers, we can conclude that the multiplier in an open economy is smaller than that in a closed economy, as the denominator in an open economy is greater than the denominator in a closed economy.

Question 12.
Calculate the open economy multiplier with proportional taxes, T = tY, instead of lump-sum taxes as assumed in the text.
Answer:
In the case of proportional tax, the equilibrium income would be
Y = C+c (1 -1) Y+1 + G + X – M – mY
Y – c(1 – t)Y + mY = C + 1 + G + X – M
Y[1 – c(1 – t) + m] = C + I + G + X – M
Y = \(\frac{C+I+G+X-M}{1-c(1-Y)+m}\)
Autonomous expenditure (A) = C + I + G + X – M
Therefore, open economy multiplier with proportional taxes
\(\frac{\Delta Y}{\Delta A}=\frac{1}{1-c(1-t)+m}\)

Question 13.
Suppose C = 40 + 0.8Y D. T = 50,1 = 60, G = 40, X = 90, M = 50 + 0.05Y
(a) Find equilibrium income
(b) Find the net export balance at equilibrium income
(c) What happens to equilibrium income and the net export balance when the government purchases increase from 40 to 50?
Answer:
C = 40 + 0.8YD 4
T = 50
I = 60
G = 40
X = 90
M = 50 + 0.05Y

(a) Equilibrium level of income
Y = C + c(Y – T) + I + G + X – M – mY
Y = \(\frac{\mathrm{A}}{1-\mathrm{c}+\mathrm{m}}\)
Where, A= C – CT + I + G + X – M

(b) Net exports at equilibrium income
NX = X – M – mY
= 90 – 50 – 0.05 × 560 = 40 – 28 = 12

(c) When G increase from 40 to 50, Equilibrium income

Net export balance at equilibrium income
NX = X – (M – mY)
= 90 – 50 + 0.05 × 600 = 40 – 30 = 10

Question 14.
In the above example, if exports change to X = 100, find the change in equilibrium income and the net export balance.
Answer:
C = 40 + 0.8 YD
T = 50
I = 60
G = 40
X= 100
M = 50 + 0.05Y

Net export balance NX = X – M – 0.05Y
= 100 – 50 – 0.05 × 600
= 50 – 0.05 × 60
= 50 – 30 = 20

Question 15.
Explain why G -T = (S^g – I) – (X – M).
Answer:
In a closed economy, savings and investments are equal at the equilibrium level of income. However, in open economy savings and investments differ.
Y = C + I + G + X – M
Or, Y = C + I + G + NX [As NX = X – M]
Or, Y – C – G = I + NX
Or, S = I + NX
Savings in an economy include private savings (S^p) and government savings (S^g).
So, S^p + S^g = I + NX
Or, NX = S^p + S^g – I
Or, NX = (Y- C – T) + (T – G) – I
Or, NX = Y – C – T + T – G – I [ S^p = Y – C – T][S^g = T – G]
Or, NX = Y – C – G – I
Or, G = Y- C – I – NX
Or, G – T = Y – C – I – NX – T

[Subtracting T from both sides]
Or, G – T = Y – C – T – I – NX
Or, G – T = (S^p – I) – NX
Or, G – T = (S^g – I) – (X – M) [NX = X – M]

Question 16.
If inflation is higher in country A than in country B, and the exchange rate between the two countries is fixed, what is likely to happen to the trade balance between the two countries?
Answer:
Country A has higher inflation than country B. Since, the exchange rate is fixed, it is advantageous for country B to export goods to country A. Similarly, it is advantageous for country A to import goods from country B. On the other hand, it would be expensive for country Ato export goods to country B. Thus, country A will have trade deficit as it will import more goods as compared to exports, from country B. Country B will import less goods as compared to exports, from country A. Hence, there is a trade surplus in country B.

Question 17.
Should a current account deficit be a cause for alarm? Explain.
Answer:
Current account deficit is the excess of total imports of goods, services and transfers over total exports of goods, services and transfers. This situation makes a country debtor to the rest of the world. But, this cannot be always treated as a cause for alarm because countries might be running in deficits (current account) to increase productivity and exports in future. Also, more investment wifi help in building capital stock, which in future will lead to rise in output.

Question 18.
Suppose C = 100 + 0.75YD, I = 500, G = 750, taxes are 20 per cent of income, X = 150, M = 100 + 0.2F. Calculate equilibrium income, the budget deficit or surplus and the trade deficit or surplus.
Answer:
C = 100 + 0.75YD
I = 500 G = 750
X = 150
M = 100 + 0.2Y
Equilibrium income (Y) = C + c (Y – T) + I + G + X – M – mY
Or, Y = 100 + 75 + 750 + 150 – 100 – 0.2 Y

Government expenditure = 750 Government receipts (taxes) = 466.6
Since, government expenditure > government receipts
It shows the government is running budget deficit
NX = X – M – MY
= 150 – 100 – 466.66
= 150 – 566.66
= 416.66
Since NX is negative, it implies trade deficit.

Question 19.
Discuss some of the exchange rate arrangements that countries have entered into to bring about stability in their external accounts.
Answer:
To combine the two extreme positions, ‘fixed’ and ‘flexible’, the following exchange rate arrangements are used by governments to bring stability in external accounts:
1. Wider Bands: A system that allows adjustment in fixed exchange rate is referred to as wider bands. It permits only 10% variation between the currencies of any two countries. For example, a country can improve its balance of payments (BoP) deficit by depreciating its currency, which leads to increase in demand for domestic goods due to an increase in purchasing power of other currencies. This further leads to the increase in exports, hence inproving the BoP.

2. Crawling Peg: Crawling peg system allows continuous and regular adjustments in the exchange rate. Only 1% of variation is allowed at a time.

3. Managed to float: Managed floating is a scheme under which government can intervene to vary the exchange rate when the situation demands so. There is no specific limit of variation as in crawling peg and wider bands.

2nd PUC Economics Important Questions with Answers

Karnataka 2nd PUC Economics Important Questions Chapter 5 Government Budget and the Economy

Very Short Answer Type Questions

Question 1.
What is budget?
Answer:
Budget is a financial statement of anticipated revenue and expenditure of the government for the coming financial year.

Question 2.
Give the meaning of deficit budget?
Answer:
If the anticipated expenditure of the government exceeds its anticipated revenue in a year, then it is known as deficit budget.

Question 3.
Name the two accounts of a government budget?
Answer:
The two accounts of a government budget are:

1. Revenue account
2. Capital account

Question 4.
Give any two examples for direct tax.
Answer:
The two examples for direct tax are:

1. Individual Income tax
2. Professional tax etc

Question 5.
Define fiscal policy.
Answer:
According to Arthur Smithies “Fiscal policy is a policy under which the government uses its expenditure and revenues programmes to produce desirable effects and to avoid undesirable effects on the national income, output and employment.

Question 6.
Brief the meaning of progressive tax?
Answer:
A progressive tax is a tax system in which the rate of tax increases as income increases.

Question 7.
State any two sources of non – tax revenue?
Answer:
The two sources of non – tax revenue is:

1. Interest receipts
2. Profits of Public sector undertakings.

Question 8.
Give the meaning of deficit financing.
Answer:
“Deficit financing is an instrument for fiscal policy to raise the level of output and employment”.

Question 9.
How is primary deficit calculated?
Answer:
Primary deficit can be calculated as: Primary deficit = Fiscal deficit – Interest payments

Question 10.
What is fiscal deficit?
Answer:
Fiscal deficit refers to the difference between the government’s total expenditure and its total receipts excluding borrowings

Question 11.
What is balanced budget?
Answer:
If the anticipated revenue of the govt equals its anticipated expenditure in a year is called balanced budget.

Question 12.
What is VAT?
Answer:
VAT – Value Added Tax: tax levied on the value added to the product at all stages.

Question 13.
Give the meaning of public expenditure?
Answer:
It refers to the expenditure incurred by the govt for the promotion of economic and social welfare of the people.

Question 14.
What is public revenue?
Answer:
It means the income earned by the govt from both tax and non-tax revenues.

Question 15.
What is disinvestment?
Answer:
Attempting to raise revenues through the sale of shares of public sector undertakings in the open market. This is called disinvestment.

Short Answer Type Questions

Question 1.
Mention any four objectives of the government budget.
Answer:
The four objectives of the government budget are:

• Re-allocation of resources to achieve the desired socio-economic goals.
• Re-distribution of income and wealth
• To prevent income fluctuations
• To control monopolies

Question 2.
What is tax revenue? Mention its types?
Answer:
A tax is a compulsory payment made by the people to the govemment without expecting any direct returns.
There are 2 types of tax revenue

1. Direct tax
2. Indirect tax

Question 3.
What do you mean by non-plan revenue expenditure? Give an example.
Answer:
It relates to the expenditure incurred on defence services, law and order, interest payments etc.,

Question 4.
Distinguish between surplus budget and deficit budget.
Answer:
Surplus Budget:
If the anticipated revenue of the government exceeds its anticipated expenditure in a year, then it is known as Surplus Budget.

Deficit Budget:
If the anticipated expenditure of the government exceeds its anticipated revenue in a year then it is known as deficit budget.

Question 5.
Differentiate between direct and indirect tax
Answer:
Direct tax:
The taxes levied on the income and wealth of the people are called direct taxes. They include:
(a) Personal Income tax
(b) Corporation tax

Indirect Tax:
The tax levied on the goods and services are called indirect taxes. They include
(a) Central excise duties
(b) Customs duties

Question 6.
What are the major components of non-plan revenue, expenditure of the government in developing countries?
Answer:
The major components of non-plan revenue expenditure of the government in developing countries are:
(a) Expenditure on defence service
(b) Interest payments on borrowings
(c) Subsidies constitute

Question 7.
What are the uses of tax systems as an instrument of fiscal policy in India?
Answer:
The uses of tax system as an instrument of fiscal policy in India

• To mobilize revenue and check unwanted expenditure,
• To affect changes in the pattern of distribution of income and wealth.
• To use as a weapon to control inflation and deflation.

Question 8.
Name any four objectives of fiscal policy?
Answer:
The four objectives of fiscal policy are:

• Mobilisation of resources to finance development projects
• To accelerate the growth of public sector
• To reduce regional disparities, poverty and unemployment.
• For optimum utilisation of resources.

Question 9.
Give any four suggestions to reduce market loans in India?
Answer:
The four suggestions to reduce market loans in India, they are:

• The government of RBI should be integrated with those of the government
• Utilization of the resources generated through the sale of a part of the vast real estate
• Utilization of the resources generated through disinvestment
• A substantial part of gold reserves created by gold seized from smuggling and other illegal activities should be auctioned

Question 10.
How can a deficit be reduced?
Answer:
The govt of India can reduce deficit through following ways:

• Increasing direct tax collection more effectively
• Curtailing government expenditure through efficient and better administration
• Attempting to raise revenues through the sale of shares of public sector undertakings in the open market.

Long Answer Type Questions

Question 1.
Write a note on the revenue account of the government budget?
Answer:
Revenue Account comprises

1. Revenue Receipts
2. Revenue Expenditure.

1. Revenue Receipts:
Refers to revenue earned by the government from tax and non – tax sources.
(a) Tax revenue consists of the proceeds of taxes and other duties levied by the government. “A tax is a compulsory payment made by the people to the government without expecting any direct returns.

(b) Non-tax revenue: Revenue collected from sources other than tax sources is non – tax revenue. Its consists of fees, fines and grant-in-aid from foreign countries.

2. Revenue expenditure:
The revenue expenditure relates to the expenditure incurred on implementation of economic plans, government provisions etc.
(a) Plan revenue expenditure:
Plan revenue expenditure relates to the expenditure incurred on implementation of economic plans, the government provisions etc.

(b) Non – plan revenue expenditure:
Non-plan revenue expenditure relates to the expenditure incurred on defence services, law and order, Interest payments etc.

Question 2.
Explain the role of public expenditure as an instrument of fiscal policy?
Answer:
The role of public expenditure as an instrument of fiscal policy:
Public expenditure refers to the expenditure incurred by the government for the promotion of the economic and social welfare of the people.

1. Public expenditure has several effects in income, output and employment. Therefore, it is regarded as a significant instrument in the determination of economic development of a country.
2. The public expenditure is important in those sectors where private spending is either less or nil.
3. Public expenditure plays important role in development of infrastructural facilities like industries, irrigation and power projects etc.
4. Besides government has to incur expenditure on defence, administration, tax collection, external affairs etc.
5. The pulbic expenditure is also important for
   (a) Participation in material production
   (b) Provision of social services
   (c) Maintenance and enforcement of law and order.

Question 3.
Does public debt impose a burden? Explain.
Answer:
Public debt refers to borrowings of the government to meet budget deficits. It is used as an effective instrument of fiscal policy to control inflation or deflation.

1. When the government goes on borrowing, debts accumulates and burden of interest increases.
2. Then the government has to impose higher taxes on the people.
3. Public debt will reduce disposable income, consumption, savings and national Income.
4. The public debt increases “burden” on the future generation.
5. Internal debt is manageable but where as external debt it seriously affects the country development.
6. And public debt should be reduced substantially to avoid collapse of the fiscal system.

Question 4.
Explain the types of Budget deficits?
Answer:
The Budget deficits are of three types:

1. Revenue deficit
2. Fiscal deficit
3. Primary deficit

1. Revenue deficit:
Revenue deficit refers to the excess of the government’s Revenue expenditure over its revenue receipts.
It can be expressed as Revenue deficit=Revenue expenditure – Revenue Receipts.

2. Fiscal deficit:
Fiscal deficit refers to the excess of government’s total expenditure over its total revenue.
It can be expressed as Fiscal deficit = Total expenditure – Revenue Receipts + Non – Debt receipts.

3. Primary deficit:
Primary deficit refers to the excess of fiscal deficit over Interest payments.
It can be expressed as Primary deficit = Fiscal deficit – Interest payments.

Question 5.
Explain the components of government budget?
Answer:
The components of government budget are:
(A) Revenue account
(B) Capital account

(A) Revenue Account:

1. Revenue Receipts
2. Revenue Expenditure

1. Revenue Receipts:
Refers to revenue earned by the government from tax and non – tax sources.
(a) Tax revenue consists of the proceeds of taxes and other duties levied by the government. “A tax is a compulsory payment made by the people to the government without expecting any direct returns”.

(b) Non-tax revenue: Revenue collected from sources other than tax sources is non – tax revenue. Its consists of fees, fines and grant-in-aid from foreign countries.

2. Revenue expenditure:
The revenue expenditure relates to the expenditure incurred on implementation of economic plans, government provisions etc.
(a) Plan revenue expenditure:
Plan revenue expenditure relates to the expenditure incurred on implementation of economic plans, the government provisions etc.

(b) Non – plan revenue expenditure: Non-plan revenue expenditure relates to the expenditure incurred on defence services, law and order, Interest payments etc.

(B) CapitalAccount:

1. Capital Receipts
2. Capital Expenditure

1. Capital Receipts:
Capital receipts are those receipts of the government that create liability [ex: borrowings] or reduce financial assets [ex. disinvestment].

2. Capital expenditure:
Capital expenditure refers to the expenditure incurred on the acquisition of assets such as land, building, machinery, loans and advances, etc.

The capital expenditure is also categoriged as:
(a) Plan capital expenditure: The plan capital expenditure relates to expenditure incrurred for creating permanent revenue yielding assets, ex: Agriculture, transport, industries etc.

(b) Non – plan capital expenditure: Non plan capital expenditure relates to expenditure incurred on compensation, rehabilitation facilities during natural calamities, and it also includes repayment of loans.

Question 6.
Describe the instruments of fiscal policy.
Answer:
The instruments of fiscal policy are:

1. Public expenditure
2. Public revenue
3. Public debt
4. Deficit financing

1. Public expenditure:
Public expenditure refers to the expenditure incurred by the government for the promotion of the economic and social welfare of the people.

Public expenditure has several effects on income, output and employment. Therefore, it is regarded as a significant instrument in the determination of the economic development of a country.

The public expenditure becomes important for the development of infrastructural facilities, by govt like industries, irrigation and power projects, public health, education, transportation, housing etc.

2. Public revenue:
Public revenue refers to the income earned by the government from both tax and non – tax revenues. A suitable tax policy is always regarded as an important technique in bringing about economic stability. Because changes in the rates of taxes will course change in the level of disposable income and consumption expenditure of the people. Generally, Government generates revenues through tax and non-tax sources

3. Public debt:
Public debt refers to the borrowings of the goverment to meet budget deficits. It is used as an effective instrument of fiscal policy to control inflation or deflation. Public debt and public deficit are inter related. When the government goes on borrowing , debts accumulates and burden of interest increases. This may result in imposing higher rate of taxes on the people by government. Consequently, the growth of the economy will be retarded.

4. Deficit financing:
Deficit financing is the policy of estimation of exessive expenditures by the government over its revenue deliberately to set the economy on the path of economic growth.
In brief, it refers to higher expenditure over receipts Deficit financing is also known as budgetary deficit.
Deficit financing leads to an increase in demand, investment, production, employ and income and even it helps in accelarating the pace of economic growth in the economy.

Exercises

Question 1.
Explain why public goods must be provided by the government.
Answer:
A good that is non-rival and non-excludable is referred to as public good. Non-rival means that consumption by one individual does not affect the consumption of another individual. Whereas, non-excludable implies that no individual can be excluded from using the good. For example, parks, roads, national defence, etc.

These goods must be provided by the government because of the following reasons:

• The benefits of public goods can be easily enjoyed by anyone without affecting the consumption of other individuals. There arises market failure.
• No individual can be excluded from using public goods as it is available to all. The link between the producer and the consumer becomes non-functional, necessitating government interference through public provisions.

Question 2.
Distinguish between revenue expenditure and capital expenditure.
Answer:

Question 3.
‘The fiscal deficit gives the borrowing requirement of the government’. Elucidate.
Answer:
Fiscal deficit is the excess of total expenditure over total receipts. That is, when total government expenditure is greater than total government receipts, the government faces fiscal deficit.

The fiscal deficit is estimated as:
Total Expenditure (revenue + capital) – Total Receipts (excluding borrowings). The fiscal deficit gives an indication to the government about the total borrowing requirements from all sources. The fiscal deficit can be financed through domestic borrowings and/or borrowings from abroad. A greater fiscal deficit implies greater borrowings by the government.

Question 4.
Give the relationship between the revenue deficit and the fiscal deficit.
Answer:
The relationship between the revenue deficit and the fiscal deficit can be explained through the following points:
1. Revenue deficit is the difference between the government’s revenue expenditures and the government’s receipts.
Revenue deficit = Revenue expenditures – Revenue receipts

On the other hand, the fiscal deficit is the difference between the total expenditure and the total receipt of the government. Fiscal deficit =Total Expenditure – Total Receipts (excluding borrowings)

2. The term ‘ fiscal deficit ’ is used in a broader sense than the term ‘revenue deficit’.

3. As the revenue deficit increases, the proportion of fiscal deficit also increases.

Question 5.
Suppose that for a particular economy, investment is equal to 200, government purchases are 150, net taxes (that is lump-sum taxes minus transfers) is 100 and consumption is given by ‘C= 100 + 0.75F
(a) What is the level of equilibrium income?
(b) Calculate the value of the government expenditure multiplier and the tax multiplier.
(c) If government expenditure increases by 200, find the change in equilibrium income.
Answer:
I = 200
G = 150
T =100
C = 100 +0.75 Y
So, C (Autonomous consumption) = 100 And, MPC (c) = 0.75
(a) Equilibrium level of income
= \(\frac{1}{1-0.75}\) (100-0.75 × 100 + 200 + 150) 1-0.75v
= \(\frac{1}{0.25}\) × 375
= Rs. 1500

(b) Government expenditure multiplier

(c) Δ G = 200
New equilibrium income
= \(\frac{1}{1-c}\) [C – cT + 1 + G + ΔG]
= \(\frac{1}{1-0.75}\) [100-0.75 × 100 + 200 + 150 + 201
= \(\frac{1}{0.25}\) × 575
= \(\frac{100 \times 575}{25}\)
= Rs 2300
‘ Therefore, change in equilibrium income = 2300- 1500 = Rs. 800

Question 6.
Consider an economy described by the following functions: C=20+0.80Y, I = 30, G = 50, TR = 100
(a) Find the equilibrium level of income and the autonomous expenditure multiplier in the model,
(b) If government expenditure increases by 30, what is the impact on equilibrium income?
(c) If a lump-sum tax of 30 is added to pay for the increase in government purchases, how will equilibrium income change?
Answer:
I = 30 c = 0.80
G =50
T = 100
Equilibrium level of income

= 900
Expenditure multiplier = \(\frac{1}{1-c}\)

Equilibrium level of income inceases by 150 (1050 – 900)

(c) Tax multiplier = \(\frac{-c}{1-c}\)

Question 7.
In the above question, calculate the effect on output of a 10 per cent increase in transfers, and a 10 per cent increase in lump-sum taxes. Compare the effects of the two.
Answer;
MPC = 0.80
C=20
I = 30
G = 50
TR = 100
ATR = 10
Equilibrium level of income

= Rs. 940
change in income = 940 – 900 = Rs 40
increase in lump-sum tax ΔT= 10
change in income = Δ T = \(\frac{-c}{1-c}\)
= -10 × \(\frac{0.80}{0.20}\)
= -10 × 4
= -40
From the above results, we can conclude that increase of 10 percent in transfers will raise the income by 40%.

Question 8.
We suppose that C = 70 + 0.70Y D, I = 90, G = 100, T = 0.10Y
(a) Find the equilibrium income.
(b) What are tax revenues at equilibrium
Income? Does the government have a balanced budget?
Answer:
(a) C = 70 + 0.70 YD
I = 90
G= 100
T=0.10y
Y = C + I + G
Y = 70 + 0.70Y + 90 + 100
Y = 70 + 0.70YD + 190
Y = 70 + 0.70 (Y-T) + 190
Y= 70 + 0.70Y- 0.70 × 0.10 Y+190
Y = 70 + 0.70Y – 0.07Y + 190
Y = 70 + 0.63Y + 190
Y = 260 + 0.63Y Y – 0.634 = 260
0.37Y = 260
Y = \(\frac{260}{0.37}\)
Y = 702.7

(b) T = 0.10Y
= 0.10 × 702.7
= 70.27
Government expenditure = 100
Tax revenue = 70.27
As, G > T, Government has a deficit budget, not a balanced budget.

Question 9.
Suppose marginal propensity to consume is 0.75 and there is a 20 per cent proportional income tax. Find the change in equilibrium income for the following
(a) Government purchases increase by 20
(b) Transfers decrease by 20.
In case of proportional taxes
Answer:

(b) Transfer decreases by 20

Question 10.
Explain why the tax multiplier is smaller in absolute value than the government expenditure multiplier.
Answer:
The tax multiplier is smaller in absolute value than the government expenditure multiplier, as the government expenditure affects the total expenditure and taxes through the multiplier. Tax multiplier also influences disposable income that affects the overall consumption level.

The reason is explained through the following example.
Let’s assume MPC be to 0.80.
= \(\frac{1}{1-0.80}\)
Then, the government expenditure multiplier = \(\frac{1}{1-c}\)
\(\frac{100}{0.20}\) = 5
Tax multiplier = \(\frac{-c}{1-c}=\frac{-80}{1-0.80}\)
= \(\frac{-0.80}{0.20}\)
= – 4
This shows that the government expenditure multiplier is more than the tax multiplier.

Question 11.
Explain the relation between government deficit and government debt.
Answer:
The relation between government deficit and government debt can be explained through the following points.

1. The government deficit is the excess of total expenditure over total receipt of the government; whereas, government debt is the amount- of liability, owed by the government to the public, foreign and other institutions.
2. The term government deficit implies an increase in the debt of the government. In other words, if the government continues to borrow to finance deficit, it leads to additional debt.

Question 12.
Does public debt impose a burden? Explain.
Answer:
Government debt or public debt refers to the amount or money that a central government owes. This amount may be borrowings of the government from banks, public financial institutions and from other external and internal sources. Public debt definitely imposes a burden on the economy as a whole, which is described through the following points.
1. Adverse effect on productivity and investment: A government may impose taxes or get money printed to repay the debt. This however reduces the peoples’ ability to work, save and invest, thus hampering the development of a country,

2. Burden on younger generations: The government transfers the burden of reduced consumption on future generations. Higher government borrowings in the present leads to higher taxes levied in future in order to repay the past obligations. The government imposes taxes on the younger generations, lowering their consumption, savings and investments.

Hence, higher public debt has negative effect on the welfare of the younger generations.

3. Lowers the private investment: The government attracts more investment by raising rates of interests on bonds and securities. As a result/a major part of savings of citizens goes in the hands of the government, thus crowding out private investments.

4. Leads to the drain of National wealth: The wealth of the country is drained out at the time of repaying loans taken from foreign countries and institutions.

Question 13.
Are fiscal deficits inflationary?
Answer:
Fiscal deficits are not necessarily inflationary, though, they are generally regarded as inflationary. When the government expenditure increases and tax reduces, there is a government deficit and there will be a corresponding increase in the aggregate demand. However, the firms might not be able to meet the growing demands, forcing the price to rise. Hence fiscal deficits are inflationary in this sense.

But on the other hand, initially, if the resources are underutilized (due to insufficient demand) and output is below frill employment level, then with the increase in government expenditure, more factor resources will be employed to cater to the increasing demand without exerting much pressure on the price to rise. In this situation, a high fiscal deficit is accompanied by high demand, greater output level and a lesser inflationary situation. Hence, whether the fiscal deficits are inflationary or not depends on how close is the original output level to the full employment level.

Question 14.
Discuss the issue of deficit reduction.
Answer:
The ways of government budget deficit reduction are the following:
1. Decreasing expenditure
(a) The expenditure of government should be decreased by making government activities more planned and effective.
(b) The government can encourage the private sector to undertake capital projects.

2. Increasing revenue
(a) Higher taxes imply higher income earned by the government. Also, new taxes may add to the revenues of the government.
(b) The government can sell shares of Public Sector Undertakings (PSU disinvestment) to increase its revenue.

2nd PUC Economics Important Questions with Answers

Karnataka 2nd PUC Economics Important Questions Chapter 4 Consumption and Investment Function

Very Short Answer Type Questions

Question 1.
What is consumption?
Answer:
Total quantity of goods bought and used by consumers during a period
Or
The process of using a good or a service by consumers to satisfy a want.

Question 2.
What is Saving?
Answer;
Saving is that part of the income which is not spent on consumption.

Question 3.
What is investment?
Answer:
Investment means the purchase of stocks and shares, debentures etc.,

Question 4.
State the meanings of marginal propensity to consume.
Answer:
Marginal propensity to cosume is the ratio of change in consumption to the change in income.

Question 5.
What is average propensity to consume.
Answer:
The ratio of consumption expenditure to income in a given period of time APC = c/y

Question 6.
What is consumption function?
Answer:
The functional relationship between income and consumption expenditure.

Question 7.
What is multiplier?
Answer:
The ratio of the total change in income to the initial change in investment is known as multiplier. ‘

Short Answer Type Questions

Question 1.
What is income, according to Keynes?
Answer;
Income is equal to consumption plus investment and saving is excess ofincome over consumption.

Question 2.
What is liquidity trap?
Answer:
If additional money’s injected within the economy it will be used up to satiate peoples craving for money balances without increasing the demand for bonds and without lowering the rate of interest. Such situation is called a liquidity trap.

Question 3.
What is Keynes psychological law of consumption function?
Answer:
According to Keynes “ when income increases, consumption also increases but by the smaller amount, part of income will be saved.

Question 4.
What is Marginal efficiency of Capital (MEC)?
Answer:
If defined as the expected rate of returns over the cost expected from marginal capital asset. If depends on prospective yield and supply price.

Question 5.
Name the types of investment.
Answer:

1. Private investment and public investment
2. Induced investment and Autonomous investment.
3. Ex-ante investment and Ex-post investment
4. Gross investment and Net investment.

Question 6.
How is saving equal to investment?
Answer:
The equality between the savings and investment is brought through the mechanism of interest rate. When saving is less than investment, a rise in the rate of interest brings down investment and increases saving till saving equals investment.

Question 7.
Mention the factors affecting marginal propensity to consume.
Answer:
The factors affecting marginal propensity to coiisume are:
(a) Disposable income
(b) Transfer of payments
(c) Fewer taxes

Question 8.
Explain the relationship between multiplier and marginal propensity to consume.
Answer:
The value of multiplier is determined by MPC. IfMPC is higher, multiplier will also be higher. The converse is also true. But the value of multipher is always more than one the multiplies can be calculated by the following Formula K = 1/1-MPC

Question 9.
Distinguish between autonomous and induced investment.
Answer:
Autonomous investment

1. It may be termed as public investment.
2. It made in the creation of economic and social infrastructure
3. It is income effect

Induced investment

1. It may be made by the people
2. It as a result of change in the income level
3. Investment is income inelastic

Long Answer Type Questions

Question 1.
What is investment? Explain the types of investment.
Answer:
According to Keynes, investment refers to an addition to the nation’s physical stock of capital assets like the building of new factories, new machines, new plants and equipments as well as any addition to the stock of the goods in the process of production.

In ordinary term investment means the purchase of stocks and shares, debentures, government bonds and equities.

Types of Investment:
Private Investment and Public Investment: Private investment is the investment which is undertaken by private investors,’firm holders and industrialists.
Public investments is the investment made by the government bodies. Such investment yield social benefits.

Induced investment and Autonomous investment:
Induced investment made by the people as a result of change in the income level so it is income elastic.
Autonomous investment may be termed as public investment may be termed as public investment made in the creation of economic and social infrastructure.

Ex-ante (planned) and expost (unplanned) investment:
Ex-ante investment is a planned investment that is intended to be invested
Ex-post investment is the one that has been actually made.

Gross investment and net investment: Gross investment is the total value of the asset made or required.
Net investment is gross investment minus depreciation

Question 2.
Explain Keynes consumption function.
Answer:
Keynes consumption function is an important concept of general theory. It shows the relationship between income and consumption. Symbolically represented as C=f(y) where C is consumption and y is income. Consumptin function is a schedule showing various amount of consumption expenditure at different level of income. The consumption schedule given in table

Consumption Schedule

Income(y) (in crores)	Consumption C (in crores)
0	20
50	60
100	100
150	140
200	180

As shown in table consumption expenditure increases with increase in income. When income is zero during the depression, people spend out of their past saving on consumption. A rise in income to Rs.50 crores is not enough to meet consumption expenditure of Rs.60 crores. At this stage, Rs 10 crores is dis-saved when income is RS. 100 crores, consumption expenditure is also RslOO crores. After this stage, income is shown to increase by Rs.50 crores and consumption by Rs.40 cr. This implies that increase in consumption is less than increase in income.

Income is measured along OX axis and consumption is measured along OY axis OS=A curve is in 45° It points out that at all levels, income and consumption are equal.

C is the consumption curue. it is upward sloping curue indicating that is an increasing function in income. At B, C = y or oy₁ = OC₁ When income increases to oy₂ consumption is not equal to increase in income. In the diagram C C₂ < y₁y₂ The income saved is SS₁

Question 3.
Explain the investment function of Keynes.
Answer:
Investment function is given much importance in the Keynesian. Theory of employment. Employment depends upon effective demand Effective demand decides income, output and employment. The two major constituents of effective demand are investment is more strategic variable, consumption being constant in the short period.

According Keynes investment refers to an addition to the nation’s physical stock and capital assets and stock of finished goods in the process of production.

As said above, investment is more important strategic variable. As the income of the community increases. Consumption will also increase. But, it does not increase in the same rate as income increases. There will be a gap between income and consumption. The gap must be bridged to increase employment and production. This gap is saving and it becomes investment. In other words, employment cannot increase, unless investment increases.

Question 4.
Discuss the concept of multiplier of Keynes?
Answer:
The concept of multiplier is an important contribution of Keynes to economic analysis. It occupies an important place in the Keynesian model of employment. The concept of multiplier was first originated by lord R.F.Kaha Keynes has successfully implemented it in his employment theory.

According to Keynes, an initial increase in investment increases the final income by many times. Change in investment leads to changes in consumption which in turn will lead to changes in income. The ratio of the total change in income to the initial change in investment is known as multiplier.

Therefore K = y/I is increase in income, y is increase in investment and K is multiplier.
The value of multiplier is determined by MPC. If MPC is higher, multiplier will also be higher. The converse is also true. But the value of multiplier is always more than one the multiplies can be calculated by the following formula
K = 1/1-MPC

If MPC is deducted from 1, we get marginal propensity to save (MPS)
The formula is K = 1/MPS

The formula states that the multiplier is the reciprocal of MPS

Question 5.
Explain the concepts of saving and investment. Discuss the equality between saving and investment.
Answer:
Investment means the purchase of stocks and shares, debentures etc. According to keynes investment refers to an addition to the nations physical stock of capital goods like buildings, machine etc. It also includes addition to the stock of goods in the process of production, inventories and fixed capital keynes states that, a country should produce equivalent to what it spends. Hence, income (y) is equal to expenditure (E). y=E. The total income, therefore includes the money earned by producing consumption goods (c) and investment goods (I).

Symbolically, y = C + 1
Therefore, I = y – C
Investment is generally influenced by marginal efficiency of capital and rate of interest. It also depends on consumption.

Saving is that part of the income which is not spent on consumption. This is the excess of income over expenditure. In short, income not consumed is income saved. This is the demand side of income.

The country as a whole spends its income on consumption and the remainder is saved.

Therefore, y = c + s where, y = income or c = consumption s = y – c s = saving

Equality between saving and Investment

According to classical economists, saving and investment are always equal in full employment economy. They opined that saving and investment are a function of rate of interest.

Symbolically S = f(r) and I = f(r) where, r = rate of interest.
Therefore S = I
When saving is less than investment, a rise in the rate of interest brings down investment and increases saving till saving equals investment.

However, keynes does not agree with the classical view of saving – investment equality. He gives two views (1) The first view is the accounting equality between saving and investment. This is used in national income accounting. It tells that actual saving and investment are always equal at all times and at any level of income keynes defines saving as excess of income over consumption. Hence, saving and investment are always equal.

Symbolically (1) S = y- c
(2) I = y – c

Since, y – c is common in equations (1) and.(2) it follows that (3) S = I

Keynes also used another method to establish this equality. According to him, income is equal to consumption plus investment and saving is excess of income over consumption.
Thus, y = c + s
y = c +1
Therefore, c + s = c +1
∴ s = I
Thus both saving and investment are the difference between income and consumption. Hence they are equal.

2. The second view of keynes is functional equality. In this sense, saving and investment are not only equal but they are also in equilibrium. Income is a function of saving and investment. When saving exceeds saving income rises. This process of changes in income, saving and investment will continue till saving and investment are not only equal but are also in equilibrium.

Question 6.
Explain keynes consumption function. Discuss the properties of consumption function.
Answer:
The value of multiplier is determined by MPC. IfMPC is higher, multiplier will also be higher. The converse is also time. But the value of multiplier is always more than one the multiplies can be calculated by the following formula, K = \(\frac{1}{1-M P C}\)

Properties or Technical Attributes of consumption function:
The relationship between income and consumption is measured by two technical properties. They are, –

1. Average propensity to consume
2. Marginal propensity to consume

The diagram, income is measured along ox axis and consumption is measured along oy axis. PC is propensity to consume. As income increases from to y2, consumption also increases from to C2. But consumption does not increase proportionately to the increase in income. RQ is change in income and NQ is change in consumption. RQ is greater than NQ.

Question 3.
What is investment function? Explain the types and determinants of investment
Answer:
Keynes consumption function is an important concept of general theory. It shows the relationship between income and consumptioa Symbolically represented as C = f(y), where C is consumption and y is income. Consumption function is a schedule showing various amounts of consumption expenditure at different levels of income. The consumption schedule is given in table.

Consumption Schedule

Income(y) (in crores)	Consumption C (in crores)
0	20
50	60
100	100
150	140
200	180

As shown in table consumption expenditure increases with increase in income. When income is zero during the depression, people spend out of their past saving on consumption. A rise in income to Rs.50 crores is not enough to meet consumption expenditure of Rs.60 crores. At this stage, Rs. 10 crores is dis-saved. When income is Rs. 100 crores, consumption expenditure is also Rs. 100 crores. After this stage, income is shown to increase by Rs.50 crores and consumption by Rs.40 cr. This implies that increase in consumption is less than increase in income.

Income is measured along OX axis and consumption is measured along OY axis. OA curue is in 45°. It points out that at all levels, income and consumption are equal.

C is the consumption curue. It is upward sloping curue indicating that is an increasing function in income. At B, C = y or oy, = OCr When income increases to oy₂, consumption increases to OC₂. But, increase in consumption is not equal to increase in income. In the diagram C₁C₂<y₁y₂ The income saved is SS₁. According to keynes, investment refers to an addition to the nation’s physical stock of capital assets like the building of new factories, new machines, new plants and equipments as well as any addition to the stock of the goods in the process of production.

In ordinary term investment means the purchase of stocks and shares, debentures, government bonds and equities.

Types of Investment:
Private Investment and Public Investment:
Private investment is the investment which is undertaken by private investors, firm holders and industrialists.
Public investments is the investment made by the government bodies. Such investment yield social benefits.

Induced Investment and Autonomous investment:
Induced investment made by the people as a result of change in the income level so it is income elastic.
Autonomous investment may be termed as public investment made in the creation of economic and social infrastructure.

Ex-ante (planned) and Expost (unplanned) investment:
Ex-ante investment is a planned investment that is intended to be invested.
Ex-post investment is the one that has been actually made.

Gross Investment and Net Investment:
Gross Investment is the total value of the asset made or required.
Net Investment is gross investment minus depreciation.

Determinants of investment:
Investment depends on two factors.

They are:

1. Marginal efficiency of capital (MEC)
2. Rate of interest

1. Average Propensity to consume (APC)
It is the ratio of consumption expenditure to income in a given period of time.

Symbolically, APC = \(\frac{\mathrm{C}}{\mathrm{y}}\)
Where C is consumption and y is income.

Thus APC gives the proportion of income consumed. As income increases, the proportion of income spent on consumption decreases. APC declines. On the other hand, average propensity to save (APS) increases with an increase in income.

2. Marginal propensity to consume (MPC)
It is the ratio of change in consumption to the change in income. In other words, it is an increase in income (Δy)
MPC = \(\frac{\Delta \mathrm{C}}{\Delta \mathrm{y}}\)
Generally, the relationship between income and consumption is such that when income rises, consumption also rises, but by less than the rise in income. It is always positive but less than once.

Now it is easy to find out Marginal propensity to save (MPS). The earned income should be spent or saved, y = c + s. Therefore, increase in y = MPC + MPS. So MPS = 1 – MPC.

According to Keynes MEC plays a major role in determining the level of investment than the rate of interest. MEC refers to the expected yield from new capital assets. It depends on prospetive yield & supply price.

Prospective yield is the total net return expected from the asset over its lifetime.
Supply price is the cost of producing a new asset. It also called replacement cost.

If the prospective yield is more than the supply price, MEC will become greater and investment will also be greater. MEC will be greater when supply price is smaller.

On the other hand, the investment is also determined by the rate of interest. Investment is low when the rate of interest is high as people compare rate of interest with MEC and vice versa. Thus, investment will depend on the prevailing rate of interest.

Exercises

Question 1.
What is marginal propensity to consume? How is it related to marginal propensity to save?
Answer:
Marginal propensity to consume refers to the ratio of change in the consumer’s expenditure due to the change in disposable income (income after deducting taxes). In other words, MPC measures how consumption will vary with the change in income.
So,
MPC = \(\frac{\Delta \mathrm{C}}{\Delta \mathrm{Y}}\)
Where,
y = Change in income
ΔC = Change in consumption

For example, if income increases from Rs 200 crores to Rs 250crores and consumption increases fromRs 20 crores to Rs 40 crores, it implies that 0.4 is the MPC or 40% increase in the income is being consumed.

This can further be explained with the help of a table and a diagram.
If income and consumption are:

Income in Rs (Y)	Consumption Expenditure in Rs (C)
200	20
250	40

Then MPC = \(\frac{\Delta \mathrm{C}}{\Delta \mathrm{Y}}=\frac{20}{50}\) = 0.4

Also, MPC can be explained with the given diagram.

In the diagram, x-axis represents national income and y-axis represents consumption level.
So, MPC = \(\frac{\mathrm{BC}}{\mathrm{AC}}\)

The relationship between MPC and MPS can be explained as
Y = C + S (Assuming that the income earned is either consumed or saved)
Or, ΔY = ΔC + ΔS
Dividing both sides by ΔY
Or, MPC = 1 – MPS
Or, MPS = 1 – MPC
So, the sum of MPC and MPS is always equal to unity.

Question 2.
What is the difference between ex ante investment and ex post investment?
Answer:

Ex-ante Investment	Ex-post Investment
1. It refers to the planned or intended investment during a particular period of time.	1. It refers to the actual level of investment during a particular period of time.
2. It is imaginary (intended), in which a firm assumes the level of investment on its own.	2. It is factual or original that signifies the existing investment of a particular time.
3. It is planned on the basis of future expectations.	3. It is the actual result of variables.

Question 3.
What do you understand by ‘parametric shift of a line’? How does a line shift when its:
(i) slope decreases, and
(ii) its intercept increases?
Answer:
Considering the equation of a straight line as b = ma + ε
Where m = slope of straight line, m> 0
ε = intercept on vertical axis, ε >0

Also, when a increases by 1 unit, the value of b increases by m units.
As the value of m increases, the straight line rotates upward around the same vertical intercept. This movement is an example of parametric shift of the graph.

1. A straight line rotates downward around the same vertical intercept as its slope decreases.
2. A straight line shifts parallelly upward when its intercept increases.

Question 4.
What is ‘effective demand’? How will you derive the autonomous expenditure multiplier when price of final goods and the rate of interest are given?
Answer:
Effective demand refers to a situation in which equilibrium output is determined solely by the level of aggregate demand. This is because of the assumption that the supply is infinitely elastic and if there exists any inequality between the Aggregate Demand (AD) and the Aggregate Supply (AS), then the equilibrium output will only be influenced by AD. The concept of effective demand can be explained with the help of the given diagram.

The x-axis represents income/output level and y-axis represents the level of aggregate demand. E is the equilibrium point where the two curves AS and AD meet. EG is the effective demand and output level is determined by AD (assuming the elasticity of supply to be perfectly elastic).
Autonomous expenditure multiplier is derived as
Y=AD (at equilibrium)
Y = A + c Y [Where AD = A + c Y]
Y – cY = A
Y(1 – c) = A
Y = \(\frac{A}{1-c}\)
A = Autonomous expenditure c = MPC
Y = level of income
\(\frac{1}{1-c}\) = autonomous expenditure multiplier

So, the autonomous expenditure multiplier is dependent on the income and MPC.

Question 5.
Measure the level of ex-ante aggregate demand when autonomous investment and consumption expenditure (A) is Rs 50 crores, and MPS is 0.2 and level of income (Y) is Rs 4000 crores. State whether the economy is in equilibrium or not (cite reasons).
Answer:
Consumption expenditure (A) = Rs 50 Crores
MPS = 0.2
So, MPC = 1 – MPS = 1-0.2 = 0.8
Y = 4000 Crores
We know that AD = A + cY………….(1)
Putting the values in equation………..(1)
AD = 50+ 0.8 x 4000
= 50 + 3200
= Rs 3250 Crores
But, Rs 3250 < Rs 4000
Implies that AD < Y
Hence, the economy is not in equilibrium.

Question 6.
Explain‘Paradox of Thrift’.
Answer:
Paradox of thrift refers to a situation in which people tend to save more money, thereby leading to a fall in the savings of the economy as a whole. In other words, when everyone increases his/her saving-income proportion i.e. MPS (s), then, the aggregate demand will fall as consumption decreases. This will further lead to a decrease in employment and income level and finally this will reduce the total savings for the economy. This concept was suggested by Keynes wherein increased saving at individual levels will gradually lead to the slowdown of economy in terms of circular flow of income.

2nd PUC Economics Important Questions with Answers

Karnataka 2nd PUC Economics Important Questions Chapter 3 Money and Banking

Very Short Answer Type Questions

Question 1.
What is Barter system?
Answer:
Exchange of goods for goods is called barter system.

Question 2.
What is money?
Money is anything that is commonly accepted as a medium of exchange for goods and services and also acts as a measure of value.

Question 3.
Define money, according to walker.
Answer:
According to F.A.Walker: “Money is what money does”.

Question 4.
Mention two primary functions of money.
Answer:

1. Medium of exchange.
2. Measure of value.

Question 5.
What is high powered money?
Answer:
The money supplied by RBI and govt of India together provide monetary base. They together are known as high-powered money.

Question 6.
What is demand for money?
Answer:
Demand for money refers to the total money demanded by the people in the form of cash for various purposes.

Question 7.
Give the meaning of supply of money?
Answer:
Supply of money refers to aggregate stock of money held by the people in the country at a particular point of time.

Question 8.
Expand ATM.
Answer:
ATM-Automated Teller Machine.

Question 9.
What is Narrow money?
Answer:
The money which is fully liquid and available whenever people need is called narrow money.

Question 10.
What is Broad Money?
Answer:
It refers to the money that is held in the form of savings and Net time deposits besides the currency and demand deposits.

Question 11.
What is primary deposit?
Answer:
When a bank accepts cash from the customer and opens a deposit account in his name, it is called primary deposit.

Question 12.
What is bank rate?
Answer:
Bank rate is the rate of interest charged by the RBI for providing funds of loans to the banking system.

Question 13.
Give the meaning of over draft.
Answer:
Overdraft is a facility provided by a bank to its current account holders.

Question 14.
What is cash Reserve Ratio?
Answer:
It is a certain percentage of bank deposits which commercial banks are required to keep with the RBI in the form of reserves.

Question 15.
What is statutory Liquidity Ratio?
Answer:
It is a certain percentage of bank deposits which commercial banks are required to keep with itself in the form of cash reserves.

Question 16.
Name the difficulties in the Barter system.
Answer:

• Lack of double coincidence of wants
• Lack of common measure ofvalue
• Lack of Divisibility
• Difficulty in storing wealth

Question 17.
Name the motives of Demand for money according to J.M.Keynes.
Answer:
According to Keynes, the demand for money arises because of the following 3 motives.

• Transaction motive.
• Precautionary motive
• Speculative motive

Question 18.
What are the various types of Deposits?
Answer:

• Current account deposits
• Savings account deposits
• Fixed deposits
• Recurring deposits

Question 19.
Give four objectives of monetary policy.
Answer:
The important objectives of monetary policy are as follows:

1. Neutral monetary policy
2. Exchange rate stability
3. Price stability
4. Control of business cycles
5. Full employment

Question 20.
What do you mean by open market operations?
Answer:
It is an instrument of monetary policy which involves buying and selling of govt securities in the open market.

Question 21.
What role of RBI is known as ‘lender of last resort’?
Answer:
The RBI helps the commercial banks in tmes of their financial crisis. When commercial banks are not able to get financial assistance from any source RBI comes to their rescue. The RBI lends money to the commercial banks against the rediscounting of the bills of exchange. This role of the RBI saves the commercial banks from being bankrupt.

Question 22.
What are the instruments of monetary policy of RBI?
Answer:
There are 2 instruments of monetary policy of rbi
1. Quantitative methods
(a) Bank rate
(b) Open market operation
(c) Cash reserve ratio
(d) Statutory liquidity ratio

2. Qualitative methods
(a) Margin requirements
(b) Credit rationing
(c) Moral suasion
(d) Publicity

Question 23.
Why is speculative demand for money inversely to the rate of interest?
Answer:
If the interest rate on the bond is low and people expect the interest rate to rise in the future. The negatives relationship between the bond prices and rate of interest. The fall in the bond prices causes capital loss to the bondholders. To counter this situation, the preference for holding bonds falls and desite to hold idle cash balance rises and vice versa. That is M_s^d = f(i_e)

Long Answer Type Questions

Question 1.
Distinguish between Narrow money and Broad money.
Answer:
Narrow Money:
(a) It refers to coins and currency notes with the public, demand deposits with banks and other deposits with RBI
(b) It is represented in M₁
(c) It is fully rigid

Broad Money:
(a) The money that is held in the form of savings and net time deposits besides the currency and demand deposits.
(b) It is represented in M₃
(c) It includes both full liquid and less liquid money

Question 2.
Distinguish between primary and Derivative deposits
Answer:
Primary deposits:
(a) When a bank accepts cash from the customer and opens a deposit account in his name
(b) It converts currency money into deposit money.
(c) It does not creates credit.

Derivative deposits:
(a) When customers are granted loans and advances by a banks.
(b) It pay loan into customers account directly
(c) It creates credit.

Question 3.
Distinguish between scheduled banks and non-scheduled banks?
Answer:
Scheduled banks
(a) Scheduled banks are those banks which include in the second schedule of RBI Act 1934.
(b) Their paid up capital and reserve fund of Rs.5 lakhs and above
(c) They require required to fulfil certain conditions of RBI

Non Scheduled banks:
(a) Those banks which are not included in second schedule of RBI Act 1934
(b) Their paid up capital and reserve fund is less than Rs.5 lakhs
(c) Less conditions has to be fulfilled of RBI’s wages interest and profit.

Question 4.
Explain the primary functions of money.
Answer:
Primary functions of money: Money performs two main primary functions.

A medium of Exchange: The most important function ofmoney is that, it serves as a medium of exchange. It facilitates exchange through a common medium i.e. currency. This function of money has eliminated the problem of the lack of double coincidence of wants in barter system. With money purchase and sale can be easily separated.

Measure of value: The values of all goods and services can be expressed interms of money. Money has provided a common yardstick to measure the value of all commodities and services in a common unit known as price this has made different goods and services comparable to each other interms of respective prices.

Question 5.
Write a note on the supply of money.
Answer:
Supply of money refers to aggregate stock of money held by the people in the country at a particular point of time. Currency notes are issued by RBI and coins are issued by Govt of India. Thus, the supply of money at a particular point of time denotes the total amount of money in circulation.

The stock of money has the following 2 major components.

1. The currency component.
2. The deposit component.

Measures of money supply:
Since, April 1977, RBI has adopted 4 concepts of money supply i.e., M1 M2, M3, and M4
M₁: It includes currency with public, demand deposits and other deposits with RBI. It is measured as follows:
M₁ = C + DD + OD
Where, C – Currency with public
DD – Demand deposits with commercial bank
OD – Other Deposits with RBI.

M₂ = It includes
M = M₁ + POSBD
Where, POSBD – Post office savings Deposits.

M₃ = It includes
M₃ = M₁ + TD
Where TD – Time deposits with al banks.

M₄ = It includes
M₄ = M + TOPD
Where, TOPD – Total Post Office Deposits.

Question 6.
Explain the quantitative methods of credit control.
Answer:
Quantitative methods are non-discriminatory in character as they do expand or contract the flow of money in all the channels.

Bank rate:
The bank rate is the rate of interest charged by the RBI for providing funds or loans to the banking system This is also known as discount rate. It includes commercial and co-operative banks, Industrial Development Bank of India, Industrial Finance corporation, other approved financial institutions. Increase in bank rate, increase the cost of borrowing by commercial banks, Which results in a reduction in the volume of credit. As on 29 October 2013 the bank rate was 8.75 percent.

Open market operations:
It is an instrument of monetary policy which involves buying and selling of govt securities in the open market. The RBI purchases securities to expand the credit and sales to contract it.

Cash Reserve Ratio: (CRR)
It is a certain percentage of bank deposits which commercial banks are required to keep with the RBI in the form of reserves. An increase in CRR with RBI leads to a contraction of credit and vice versa. As of October 2013, the CRR was 4%.

Statutory Liquidity Ratio (SLR):
It is a certain percentage of bank deposits which commercial banks are required to keep with itself in the form of cash reserves The current SLR is 23 %.

Question 7.
Explain the qualitative or selective methods of credit control.
Answer:
Qualitative or selective methods affect money supply indirectly and discriminately. They are:

Margin Requirements:
The difference between the market value of securities and the amount lent against these securities is called margin. A central bank varies the margin requirements from time to time to regulate the volume of the credit.

Regulation of consumer credit Credit given to consumer to buy certain durable goods like cars, TV, washing etc is called consumer credit. This method used to check the consumer credit, by increases margin requirements, reducing repayment period etc.

Control through Directives:
The central bank may enforce the written or oral directives in desired direction to the commercial banks.

Credit Rationing:
The central bank fixes a maximum amount of loans and advances for each commercial bank.

Direct Action:
It refers to the forced measures taken by the central bank against commercial banks. It may refuse to rediscount bills and may charge the panel rate of interest for money borrowed beyond the prescribed limit.

Moral suasion:
This method of control involves the techniques of advice and request made by the central bank to the commercial banks to co-operate with the implementation of its credit policies.

Publicity:
The Central bank by giving regular publicity to money market trends, educates the commercial banks to regulate credit.

Question 8.
Explain the objectives of monetary policy.
Answer:
It is a responsibility of the RBI to frame a suitable monetary policy and ensure that, banks create credit according to the needs of the economy and divert the funds towards desirable sectors.

The important objectives of monetary policy are as follows:

Neutral monetary policy:
It can reduce the fluctuations in the interest rates to the minimum.

Exchange rate stability: – Instability of the exchange rates is harmful for the foreign trade of a country. Thus the central bank can stabilize the rate of foreign exchange by controlling bank credit.

Price stability:
The price fluctuations cause disturbances in the economic system. So RBI, by regulating the supply of credit in accordance with the needs of the people, can bring about price stability in the country.

Control of business cycles:
The objective of economic policy of the RBI should be remove cyclical fluctuations and ensure economic stability in the country.

Full employment:
Economic stability with full employment and high per capita income has been considered as an important objective of monetary policy.

In addition to the above objectives, achieving economic growth and providing social justice are also important objectives of monetary policy.

Question 9.
Explain the primary functions of the commercial banks.
Answer:
Commercial banks perform primary functions,
(a) Accepting deposits: Accepting deposits is the most important function of commercial banks. They are:

Current account deposits:
Money from these accounts can be withdrawn any number of times as desired by the depositors.

Savings account deposits:
People with low income, salary earners etc, open these accounts. Money is withdrawn only once or twice in a week.

Fixed deposits:
Money in these accounts is deposited for a fixed period of time and cannot be withdrawn before the maturity of the period.

Recurring deposits:
Money in these accounts is deposited in monthly installments for a period of one year or more. After the completion of the last installment, the total amount is paid to the depositor along with the interest.

(b) Advancing loans:
Another important function of commer¬cial banks is to advance loans to the public.
The various types of loans and advances are as follows.

Overdraft:
It is a facility provided by a bank to its current account holders. The banks allows such customers to over draw thier accounts upto certain limit. It available to business firms and companies.

Cash credit:
It is a type of loan which is given to the borrower against the current assets such as shares, stocks, bonds etc.

Loans:
The loan is a financial arrangement in which credit is provided by a commercial bank through opening a separate account loan account. Interest is charged on the entire amount sanctioned by the bank.

Discounting of bills of exchange:
It means encashing the bills of exchange from the banks before the date of maturity. The bank deducts a certain amount of discount from the face value of the bill and pays the balance to the person discounting the Biji.

Question 10.
What is money? Explain the functions of money?
Answer:
According to F. A. walker “ Money is what money does”.
The Functions of money are classified under four categories Namely

1. Primary Functions
2. Secondary Functions
3. Contingent Functions
4. Other Functions

1. Primary Functions:
Money performs are two main primary Functions:

A medium of Exchange:
The most important function of money is that, it serves as a medium of exchange. It facilitates exchange through a common medium i.e, currency. This function of money has eliminated the problem of the lack of co-incidence of wants which was the main difficulty under barter system. Money has widened the scope of market.

Measure of value:
Money serves as a common unit of value. The values of all goods and services can be expressed in terms of money. Money has provided a common yard stick to measure the value of all commodities and services in a comon unit known as price. This has made different goods and services comparable to each other in terms of respective prices.

2. Secondary Functions of Money:
The secondary functions of money can be divided into following three parts.

Standard of deferred Payments:
Money can be used for fixture payments. deffered payments refer to the future payments and contractual payments such as loans and interest payments, salaries etc. This function has attained more significance in modem times with the expansion of trade based on credit.

Store of value:
Money is used as a store of value. As money is not perishable and as the value is comparatively stable, it can be stored for any number of days. People can store a part of their present earnings for fixture use. Thus money is a bridge from present to future. This function ofmoneypromoted savings, investment and capital formation.

Transfer value:
Money has been a measure of transferring wealth from one place to another. As money has general acceptability, purchasing power can be transferred from one person to another or from one time to another. Thus money serves both for the time transfer and place transfer of purchasing power.

3. Contingent Functions of Money:
The following are the various contingent functions ofmoney.

Distribution of National Income:
Money facilitates the distribution of national income among the four factors of production as a reward in the form of rent, wages, interest and profit.

Basis of credit:
The modem economy is based on credit. Money serves as a basis of the vast structure of modem credit system.

Maximizes consumers and producers satisfaction:
The money plays an important role in equalizing the marginal utilities of the consumer because the prices of all commodities are expressed in money. Like wise, money also helps the producer in equalizing marginal productivities because ultimately these productivities are measured in terms of money.

Liquidity and uniformity
Money gives liquidity to various forms of wealth. That is money is most liquid form of all the assets and wealth. Money can be connected into any type of asset and type of asset can be converted into money. ‘ ’

4. Other Functions of money are:

• Helpful in making or taking decisions for daily requirements
• Represents generalized purchasing power
• Safeguards repayment capacity.

Question 11.
Explain the three motives of Demand for money?
Answer:
Money is the most liquid form of asset. The demand for money refers to the total money demanded by the people in the form of cash for various purposes.

According to Keynes, the demand for money arises because of the following three motives:

• Transaction motive
• Precautionary motive
• Speculative motive

Transaction motive:
We incur some or the other expenditure to fulfill our day-to-day needs such as food, shelter, clothing, etc. In other words, we require to hold some portion of money in the form of cash to meet our daily expenses. Thus, transaction motive relates to the demand for money for the day-to-day expenditure of individuals and business firms. Holding cash to meet daily transactions is called transaction demand for money. The need for holding cash arises because there is a time gap between receipt and income and the consumption expenditure.

Usually, people receive income at certain intervals of time such as a week, a month, etc., which is to be consumed throughout the period till the next receipt. Thus people have a tendency to hold money in cash for various transaction purposes. This demand for money is a positive function of income. As income rises, people tend to spend more, consequently, they demand more money to carry out the increased transaction needs. Algebraically.
M_p^d = f(y)
Where, M_p^d = Represents the transaction demand for money.
Y = Represents the income of an individual
f = Represents functional relationship between transaction demand for money and individual income.
As y tends to rise M_p^d will also rise.

Precautionary Motive:
The future is full of uncertainties. Sometimes people hold some amount of money for unforeseen expenses such as medical expenses, accidents, emergencies, etc. The demand for money to meet these unforeseen and unexpected expenses is known as precautionary demand for money. Like the transaction demand for money, precautionary demand for money is also a positive function of income. As income rises precautionary demand for money also rises and vice versa. Algebraically,

MM_p^d = f(y)
Where, Mtd = Represents the Precautionary demand for money.
Y = Represents the income of an individual
f = Represents functional relationship between Precautionary demand for money and individual income.
As y tends to rise Mp will also rise.

Speculative Motive:
Besides cash, people also tend to hold wealth in the form of property, gold, bonds, shares, etc. The speculative demand for money refers to the demand for money that people hold as idle cash balance to speculative with the aim of earning capital gains and profits. Keynes assumed that people store wealth in the form of money or bonds. Bonds refer to the financial papers that bear the promise of a future stream of monetary income over a period of time.

The bonds are issued by the firms to borrow from the general public. Keynes demonstrated that there exists an inverse relationship between the rate of interest and speculative demand for money.

If the interest rate on the bond is low, and people expect the interest rate to rise in the future. This implies that people expect the bond price to fall because of the negative relationship between the bond prices and the rate of interest. This fall in the bond prices causes capital loss to the bondholders. To counter this situation, the preference for holding bonds falls and desire to hold idle cash balance rises. Thus speculative demand for money rises.

On the other hand, if the current interest rate on securities and bonds is high, then people expect the interest rate to fall in the future. This implies that people expect bond prices to rise in the future this is because the negative relationship between bond prices and the rate of interest. This rise in the bond prices implies a capital gain’ to the bond holders. Consequently, the preference to hold bonds increase and the people desire to hold lesser idle cash balances. There by the speculative demand for money falls.

Hence, the speculative demand for money is inversly related to the expected rate of interest.
That is M_b^d – f(y)
Where, M_b^d = Represents the speculative demand for money.
Y = Represents the expected rate of interest
f = functional relationship between speculative demand for money and expected rate of interest.

Question 12.
Explain the functions of commercial banks?
Answer:
Commercial banks play an important role in the economic life of a country. These banks perform a variety of functions and help the businessmen and the traders. Modern commercial banks perform mainly two types of functions.

1. Primary functions:
2. Secondary functions.

1. Primary functions:
Accepting deposits is the most important function of commercial banks. They accept several types of deposits form the public. They are discussed below

Current account deposits:
These deposits are payable on demand. Money from these accounts can be withdrawn any number of times as desired by the depositors. Normally, no interest is paid on these deposits. These accounts are generally maintained by the traders and businessmen. Current deposits are also called demand deposits.

Saving account deposits:
People with low income, salary earners, etc., generally open these accounts, certain restrictions are imposed on these accounts regarding the number of withdrawals. Money deposited in the account can be withdrawn either once or twice a week. Rate of interest paid on these deposits is low as compared to that on fixed deposits. This type of account encourages and mobilizes small savings in the country.

Fixed deposits:
Money in these accounts is deposited for a fixed period of time and cannot be withdrawn before the maturity of that period. The rate of interest paid on these deposits is higher than that on other deposits. The rates of interest depend upon the period for which money is deposited. The longer the period, the higher is the rate of interest. Fixed deposits are also called time deposits.

Recurring deposits:
Money in these accounts is deposited in monthly installments for a period of one year or more. After the completion of the last installment, the total amount accumulated is paid to the depositer along with the interest. The rate of interest on these deposits is nearly the same as on fixed deposits.

Advancing of loans:
Another important function of commercial banks is to advance loans to the public. After keeping certain portions of cash reserves the banks lent remaining portion of deposits to the needy borrowers.

The various types of loans and advances are as follows:
1. Overdraft:
It is a facility provided by a bank to its current accounts holders. The bank allows such customers to over draw their accounts upto certain limit, interest is charged on the amount actually overdrawn by the customer. This facility is generally available to business firms and companies.

2. Cash credit:
It is a type of loan which is given to the borrower against the current assets, such as shares, stocks, bonds etc. The bank opens the account in the name of the borrowers and allows him to withdraw the money from time to.time up to a certain limit as determined by the value of his current assets. Interest is charged only on the amount actually withdrawn from the amount.

3. Loans:
Loan is financial arrangement in which credit is provided by a commercial bank through opening a separate account is called loan account. In this method the bank gives a specified sum of money to a person or a firm against some collateral security. The loan amount is credited to the account of the borrower and the borrower can withdrawn money from the account according to his requirements. But the interest is charged on the entire amount sanctioned by the bank.

4. Discounting of bills of exchange:
This is another type of lending by the modem banks. Discounting the bill of exchange means encashing the bills of exchange from the banks before the date of maturity. The bank deducts a cartain amount of discount from the face value of the bill and pays the balance to the person discounting the bill. The discount deducted by the bank is actually the amount of interest (discount charge) charged by the bank for lending the money.

2. Secondary functions:
Commercial banks also perform certain other functions. These are called secondary functions. They are mainly of two types.

• Agency services
• General Utility services.

Besides, the commercial banks have started performing a number of other functions- in recent years, such are banking, merchant banking, mutual funds, advances to priority sector like agriculture, small scale industries, retail trade, small business, self employment, consumption loans, educational loans, housing loans etc.

Question 13.
What is Credit creation? How do the banks create credit?
Answer:
Creation of credit is one of the most important functions of commericial banks. According to R.S.Sayers “Banks are not merely purveyors of money, but also manufactures of money”. Bank credit means bank loans and advances. A bank keeps a certain proportion of its deposits as minimum reserve for meeting the demand of the depositors and lends out the remaining reserve to earn income. The bank loan is not paid directly to the borrower but is only creadited to his account and allows him to withdraw the required amount. Every bank loan creates an equivalent deposit in the bank. In this way the bank creates credit. Thus credit creation means expansion of deposits.

Bank deposits arise in two ways.

• Primary deposits
• Secondary m derivative deposits

Primary deposits:
When a bank accepts cash from the customer and opens a deposit account in his name, it is called primary deposit. The creation of primary deposit does not mean credit creation. These deposit simply convert currency money into deposit money.

Derivative deposits:
Deposits also arise when customers are granted loans and advances by a bank, such deposits are called derivative deposits. When a bank grants a loan to its customer it does not actually pay cash to him but simply credit to the customer’s account. Thus, whenever a loan is granted, derivative deposit is created by the bank.

Therefore, credit creation is nothing but expansion of bank deposits through the process of loans and advances as well as investments.

Central bank is the first source of money supply in the form of currency in circulation. The RBI is the note-issuing authority of the country. The RBI ensures availability of currency to meet the transaction needs of the economy.

The commercial banks are the second sources of money supply. The money that commercial banks supply is called credit money.

Question 14.
Explain the functions of the RBI.
Answer:
RBI is the apex banking institution in the country. It was established on April 1,1935 as per the RBI Act, 1934 as a private shareholders bank.

After the independence RBI was nationalised by the government on 1st January 1949 and converted it as the central Bank of country. It has the pivotal place in the banking sector and directly controls all the banks and financial Institutions in the country.

Resources: RBI as paid up capital of Rs. 5 crore. The capital is composed of 5 lakh shares of Rs. 100 each. All the shares are held by the central Government.

Management: The management and supervisior of RBI is entrusted to a central Board of Director with 20 members of these 20 directors one is a governor, 4 pity governors, one director of finance department, 10 directors selected from fields and nominated by the Government and 4 representation of the regional boards in kolkta, chennai, Mumbai and Delhi.

Functions are explained in brief as given below.
1. Traditional functions
The traditional functions of the RBI are as follows:

Issuing currency notes:
RBI has authority of pringing and issuing currency notes in the country. Expect the Due rupee note the RBI issues denomination of Rs. 2, 5, 10, 20; 50, 100, 500 and Rs. 1000 currency notes in the country. The one rupee is issued by finance ministry of central government. From 1956 onwards the RBI is following minimum reserve system of Note Issue. Where it has kept Rs. 200 crore worth of reserve (Rs. 85 crore worth of Gold and Rs. 115 crore worth of foreign exchange) against the currency issued.

Banker to Government:
RBI act as banker, agent and adviser to the Government. As a government banker and agent it opens accounts of the government, exeires money and makes payments on behalf the government, transfer government funds, given credit to the government, manages public debt, and maintains amounts of expenditure. As an adviser, it advises the government on all financial matters.

Bankers Bank:
RBI acts as bankers bank. All the banks in the country are within the control of RBI. According to Banking Regulations Act. 1949 all commercial banks in country have to keep certain portion of their deposits as cash reserve with the RBI. RBI also gives the credit to banks by discounting the bills and advancing money on various securities. RBI also provides cleainig house facilities to banks for the settlement of inter bank claims.

Credit control:
RBI has the important function of control of credit generated by commercial banks in the country. It is an important function of the RBI. RBI exercises both quantitative techniques to control credit.

The quantitative methods of credit control includes.
(a) Bank rate policy
(b) Open market operations
(c) Cash reserve ratio.
(d) statutory liquidity ratio etc.,

The quantitative techniques are:
(a) Giving directions to banks
(b) Margin requirements.
(c) Moral seasion
(d) Direct action etc.,

Leader of money market:
RBI is the leader of money market in the country. It controls the activities of different components of the money market such as commercial banks, financial institutions, etc.

Custodian of foreign exchange reserves:
RBI preserves and protects the precious foreign exchange of the country. It has continuous contacts with international monetary institutions.

Lender of Last resort:
BBI is the lender of last resort to all the commercial banks in the country. The RBI lends money to banks by en-discounting bills and advancing money on other securities.

Clearing house:
RBI acts as clearinghouse. The mutual claims of banks are settled through books adjustments by way of accounts of various banks maintained by the RBI.

2. Development functions
In addition to the traditional functions, RBI performs the following developmental functions.

Agricultural finance:
RBI has the sperate agricultural is apex institution. Which was extablished in year 1935. Which consist of paid up capital of Rs. 5 crores and its consists of management which includes 20 members under that one is governor. 4 deputy governor one director fo finance and 10 director selected from other fields.

So the main instruments of monetary policy of RBI includes:
1. Quantitative or General controls:
This are the main controls under RBI where it includes control like
(a) Bank rate
(b) Cash Reserve Ratio
(c) Open market operation
(d) statutory liquidity ratio

(a) Bank Rate policy (BRP)
The bank rate has been defined in the Reserve Bank of India Act as the standard rate at which it (the RBI) is prepared to buy or rediscount bills of exchange or other commercial papers eligible for purchase under this Act.

(b) Open Market Operations (OMO):
It this defined by RBI refers to “Broadly to the purchase and sale by central bank of a variety of Assets such as foreign exchange, gold, government securities and even company shares”.

(c) Variable Reserve Ratio (VRR):
RBI also uses the method of VRR to control in credit in INdia. Under this every bank is enquired by law to keep a certain percentage of its total deposits in the form of a reserve fund and also a certain percentage with the RBI.

This ratio includes two types of requirements

1. Cash Reserve Ratio (CRR)
2. Statutory Liquidity Ratio (SLR)

1. Cash Reserve Ratio (CRR):
CRR refers to that portion of total deposits of a commercial bank which it as to keep with the RBI in the form of cash reserve under the RBI (Amendment Act of 1962) RBI is empowered to determine CRR for the commercial banks in the range of 3%-15% for the agreement demand and time availabilities.

2. Staturtory liquidity Ratio (SLR):
SLR refers to that portion of total deposits of a commercial banks which it as to keep with itself in the form of cash reserves.

According to banking regulation (Amendment Act of 1962) maintains a minimum statutory liquidity ratio of 25% by the banks against their net demand and time liabilities. But RBI to raises SLR up to 40%.

Selective credit controls or Qualitative:
Selective credit controls are considered as useful supplement to general credit regulation. This control were introduced by the RBI for the first time in 1956.

This controls are meant to regulate credit for specific purposes. This control consist of three techiniques viz, the determination of margin requirements for loans, determination of maximum amount of advances and charging of discriminatoiy interest rates.

Exercises

Question 1.
What is a barter system? What are its drawbacks?
Answer:
Barter system is a system that was used in ancient times to exchange goods. In other words, this system was used to exchange one commodity for another before the monetary system came into existence. For example, if a person having rice wants tea, then he can exchange rice with a person who has tea and needs rice. The economy having the barter system was called ‘C-C economy’, i.e. commodity is exchanged for commodity.

The various drawbacks of the barter system are as follows:
1. Lack of double coincidence: the lack of double coincidence ofwants is the maj or drawback, it is very rare when the owner of same good or service could find some who wanted his good or service and possessed that good or service that the first person wanted, no exchange is possible if the double coincidence is not there.

2. Lack of common unit of value: Under barter system, there was no common unit for measuring the value of one good in terms of the other good for the purpose of exchange. For example, a horse cannot be measured in terms office in the case of exchange between rice and horse.

3. Difficulty in wealth storage: It was very difficult to store commodities for future exchange purposes. Perishable goods like grains, milk, and meat could not be stored to exchange goods in the future. Therefore, wealth storage was a major difficulty of batter system,

4. Lack of standard of deferred payments: The future payments could not be met in a C-C economy (barter system) as wealth could not be stored. It was very difficult to pay back loans.

Question 2.
What are the main functions of money? How does money overcome the shortcomings of a barter system?
Answer:
The main functions of money are as follows:
1. Medium of exchange: Money acts as a medium of exchange as it facilitates exchange through a common medium, i.e. currency. In other words, money helps in the buying and selling of goods. For example, a person can self his goods to another for money and that person can use money to purchase goods of his choice. Money solves the problem of double coincidence of wants.

2. Unit of value: The values of goods can be measured in terms of money. It is a common medium through which we can calculate the value of each and every good. The value of a good in tenns of money is called the price. In barter system the lack of a common denominator for measuring values of goods was a major drawback.

3. Store of value: This function explains the importance of money as value storage. This implies that wealth in the form of money can be stored easily as a medium of exchange for future use. For example, money can be stored in banks for meeting emergency and future needs.

4. Standard of deferred payments: Payments can easily be made through the medium of money. In other words, it is very difficult to pay back a loan in terms of goods and services. However, with the advent of money the payments of loans or interests can easily be made.

Money overcomes the shortcomings of barter system in the following manner:

1. Money solves the problem of double coincidence of wants. For example, if a person needs wheat in exchange of tea, then he/she must search for a person who is ready to trade wheat for tea.
2. In barter system, it was very difficult to measure the value of one good in terms of another. For example, it is difficult to calculate the value of a cow in terms of wheat.
3. It was very difficult to store goods, especially perishable goods (Suits, meat, etc.) for the purpose of value storage. Money serves this purpose.
4. The contractual or future payments are much difficult to be made in barter system. For example, a worker working on contract basis could not be paid in terms of rice or chairs.

Question 3.
What is transaction demand for money? How is it related to the value of transactions over a specified period of time?
Answer:
Transaction demand for money refers to the demand for money for meeting day-to-day transactional needs. As money is a liquid asset (easily acceptable or exchangeable), everyone has the tendency to hold money. People earn incomes at distinct points of time but consume throughout the entire period. So, people tend to hold money for transaction purposes.

The relationship between the value of transactions and transaction demand for money can be explained as:

The transaction demand for money in an economy MTD can be written as MTD = KT
Or, \(\frac{1}{k}\)M° = T = T
Or, MTD = T Where,
v\(\frac{1}{k}\), represents velocity of circulation of money

T = Total value of transactions in the economy over a period of time K is a positive fraction M” = Stock of money people are willing to hold at a particular point of time.

The transaction demand for money is positively related to the total value of transactions and negatively related to the velocity with which money is circulated.

Question 4.
Suppose a bond promises Rs.500 at the end of two years with no intermediate return. If the rate of interest is 5 percent per annum what is the price of the bond?
Answer:
Let the price of the bond be Rs. P We know that,
A = P\(\left(1+\frac{r}{100}\right)^{n}\)
It is given that
A = Rs.500
r = 5%
n = 2 years

Substituting the values in.the formula

Or, P = \(\frac{200000}{4}\) = 453.51
So, P = Rs. 453.51
Therefore, Price of the bond is Rs. 453.51.

Question 5.
Why is speculative demand for money inversely related to the rate of interest?
Answer:
Speculative demand for money is made for return in the form of interest, hence rate of interest determiners the speculative demand for money of the rate of interest higher the speculative demand for money will be low and vice versa, the reason is that people willconvert their money into bonds when the interest on bond is higher, in that case demand for speculative purpose will be low. On the other hands of the rate of interest is lower than the expected interest, people will not convert their money in bonds and keep money in hand for speculative purpose. In this way a specular demand money in inversely related to the rate of interest.

Question 6.
What is ‘liquidity trap?
Answer:
Liquidity trap is a situation in which speculative demand function is infinitely elastic; it is explained as follows:

The price of a bond has an inverse relationship with the market interest rate. If the interest rate is very high and people expect it to fall in the future, then the bond prices will rise being inversely related to the interest rate. In order to earn capital gains in future, people will purchase bonds (as bonds are cheaper) and hence the speculative demand for money will become low. On the contrary, if the interest rate is low and people expect it to rise in future, then the bond prices will fall and in order to avoid capital loss, people will sell their bonds and convert their bonds into idle cash balances.

Liquidity trap is an extreme case of the latter situation. When the interest rates are very low, then everyone expect interest rates to go up in future. Thus, to avoid capital loss, everybody prefers to maintain cash balance and not bond. Consequently, the speculative demand for money is infinitely elastic. In this situation, if the additional money is pumped into the economy, then, this will only satisfy the thirst for money, without increasing the demand for bonds. Pumping additional money in this situation will further exaggerate the condition as this will further reduce the interest rate below γmin.

The relationship between speculative demand for money and the rate of interest is given as:
Mds = \(\frac{r_{\min }-r}{r-r_{\min }}\)

In the above diagram, interest rate is represented on the vertical axis and speculative demand on the horizontal axis. When r= r min, the economy is in liquidity trap, where the speculative demand for money is infinite elastic.

Question 7.
What are the alternative definitions of money supply in India?
Answer:
The various definitions of money supply in Inida as prescribed by RBI are M₁ M₂ M₃ and M₄.
M₁, M₂, M_3, and M₄ have arranged the descending order of liquidity. In other words, M₁, has the highest liquidity and M4 has the least liquidity.
So M₁ =C+DD+OD Where,
C – Currency held by public
DD = Net demand deposits of the bank
OD = other deposits held by RBI
M₂ = M₁ + Savings of the people with Post offices (M₁ includes the components of M as well as the savings of people with Post office.)
M₃ = M₁ + Net time deposits with commercial banks (M₁ is the most commonly used measure of the money supply. It indues the components of M₁ and net time deposits of commercial banks.)
M₄ = M₃ + Total deposits with post offices (excluding National Saving certificate)

All these definitions of money supply in India are represented in the flow chart given below.

Question 8.
What is a ‘legal tender? What is ‘fiat money’?
Answer:
Legal tender: Legal tender means the acceptance of the money the citizens of a country for settlement of any kind of transaction.

Fiat money: Fiat money is that money which does not have intrinsic value like gold, silver coins.

Question 9.
What is High Powered Money?
Answer:
High powered money is the total liability ofthe monetary authority of the country. This is also called the monetary base and is created by the RBI. High powered money includes currency (notes and coins), deposits with the government and reserves of commercial banks with RBI.
So, to sum up, high powered money is
H = C + R Where
H – High powered money
C – Currency
R – Cash Reserves of commercial banks

Question 10.
Explain the functions of a commercial bank.
Answer:
Commercial banks perform various functions that are as follows:
(a) Accepting deposits: The basic function of commercial banks is to accept deposits of the customers. These deposits are of the following types:
1. SavingAccounts: Saving accounts cater to the needs of those individuals who wish to save a part of their income and earn interest on the amount saved. Account holders of saving accounts can deposit
cheques, drafts, etc. However, there is a limit on withdrawal.

2. Fixed deposit accounts: As the name suggests, fixed deposit accounts imply deposits are kept for fixed periods oftime; for example, Rs.500 per month for 5 years. The period has to be decided in advance, while opening the account. Holders of these accounts do not enjoy the cheque facility. Higher the time period, higher will be the interest rate, which is decided by RBI.

3. Current deposits accounts: Current deposit accounts are also called ‘demand deposits’ as the depositor can withdraw money at any time through cheques. Businessmen use this accouht to make many transactions in a single day; however, they do not earn interest on the deposits. Banks provide account statements to the current account holders at regular intervals.

(b) Granting loans and advances: The second most important function of the commercial banks is to give loans and advances. The rate of interest charged by the banks on loans is higher than the rate of interest paid by the banks on demand deposits and saving deposits. Loans granted by commercial banks are generally for long term and are given against securities. Advances are given by abank only for a short span oftime

(c) Agency functions : The commercial banks perform various agency functions with the prime purpose of acceptance of deposits and granting of loans.

Their functions include:

1. Transfer of funds-The banks provide easy flow of funds from place to place via mail transfers, demand drafts, etc.
2. Collection of funds- The banks also collect funds on behalf of its customers through bills, cheques, etc.
3. Banks collect insurance premiums, dividends, interest on debentures, etc.
4. Banks assist in the process oftax payment by the accountholders.
5. Banks also play the role of trustees or executors.

(c) Discounting bills of exchange:
Commercial Banks provide financial assistance to the business community by discounting bills of exchange. The banks purchase these bills, produced by customers, by deducting interest from the face value of the bill, thus providing easy finances to the business community when required.

(d) Credit creation: Commercial banks create credit in the economy through demand deposits. Credit creation paves the path for the growth of the economy.

(e) Other functions:

• Providing locker facility
• Purchase and sale of foreign exchange
• Issue of gift cheques
• Underwriting of shares and debentures
• Providing information and statistical data useful to customers

Question 11.
What is money multiplier? How will you determine its value? What ratios play an important role in the determination of the value of the money multiplier?
Answer:
Money multiplier is the ratio of the stock of money to the stock of high powered money in an economy
i.e. MM = \(\frac{\mathrm{M}}{\mathrm{H}}\)
Where, is the money multiplier M represents stock of money H represents high powered money The value of money multiplier is always greater than 1.

The value of money multiplier can be derived as follows:
We know that M = C + DD = (1 + cdr) DD
Where M=Money supply
C = Currency held by people
cdr=Currency deposit ratio
DD=Demand deposits

Let treasury deposits of government be D
We know, High powered money = Currency + Reserve money
Or, H = C + R
= cdrD + rdrD
= D (cdr+rdr) (Taking D common)

Money multiplier = \(\frac{\mathrm{M}}{\mathrm{H}}\)
So, the ratio ofmoney supply to high powered money \(\frac{\mathrm{M}}{\mathrm{H}}\) becomes
But rdr < 1
So, \(\frac{\mathrm{M}}{\mathrm{H}}=\frac{1+\mathrm{cdr}}{\mathrm{cdr}+\mathrm{rdr}}\) >1
The currency deposit ratio (cdr) and the reserve deposit ratio (rdr) play an important role in determining the money multiplier.

The currency deposit ratio (cdr) is the ratio of the money (currency) held by public to that they hold in bank deposits.

That is, cdr = \(\frac{\mathrm{C}}{\mathrm{DD}}\)
The reserve deposit ratio (rdr) is the proportion of the total deposits kept by the commercial banks as reserve.

Question 12.
What are the instruments of monetary policy of RBI? How does RBI stabilize money supply against exogenous
shocks?
Answer:
The monetary policy(credit policy) of RBI involves the two instruments given in the below

Quantitative Measures: Quantitative measures refer to those measures that affect the variables, which in turn affect the overall money supply in the economy.

Instruments of quantitative measures:
(a) Bank rate: The rate at which central bank provides loan to commercial banks is called bank rate. This instrument is a key at the hands of RBI to control the money supply. Increase in the bank rate will make the loans more expensive for the commercial banks; thereby, pressurizing the banks to increase the rate of lending. The public capacity to take credit wall gradually fall leading to die fall in the volume of credit demanded. The reverse happens in case of a decrease in the bank rate. The increased lending capacity of banks, as well as increased public demand for credit, will automatically lead to a rise in the volume of credit.

(b) Varying reserve ratios: The reserve ratio determines the reserve requirements, wherein banks are liable to maintain reserves with the central bank.

The three main ratios are:
1. Cash Reserve Ratio (CRR): It refers to the minimum amount of funds that a commercial bank has to maintain with the Reserve Bank of India, in the form of deposits. For example, suppose the total assets of a bank are worth Rs.200 crores and the minimum cash reserve ratio i s 10%. Then the amount that the commercial bank has to maintain with RBI is Rs.20 crores. If this ratio rises to 20%, then the reserve with RBI increases to Rs.40 crores. Thus, less money will be left with the commerci al bank for lending. This will eventually lead to considerable decrease inthe money supply. On die contrary, a fall in CRR will lead to an increase in the money supply.

2. Statuary Liquidity Ratio (SLR): SLR is concerned with maintaining the minimum reserve of assets with RBI, whereas the cash reserve ratio is concerned with maintainingcash balance (reserve) with RBI. So, SLR is defined as the minimum percentage of assets to be maintained in the form of either fixed or liquid assets with RBI. The flow of credit isreduced by increasing tliis liquidity ratio and vice-versa In the previous example, this can be understood as rise in SLR will restrict the banks to pump money in-the economy, thereby contributing towards decrease in money supply. The reverse case happens if there is a fall in SLR, as it increases the money supply in the economy.

(c) Open Market Operations (OMO):
Open Market operations refer to the buying and sell ing of securities in an open market , in order to affect the money supply in the economy. The selling of securities by RBI will wipe out the extra cash balance from the economy, thereby limiting the money supply, whereas in the case ofbuying securities by RBI, additional money is pumped into the economy stimulating the money supply.

Qualitative Measures:
The measures that affect the credit qualitatively are:
1. Marginal Requirements: The commercial banks’ function to grant loan rests upon the value of security being mortgaged. So, the banks keep a margin, which is the difference between the market value of security and the loan value. For example, a commercial bank grants loan ofRs. 80,000against security of Rs. 1,00,000. So, the margin is calculated as 1,00,000 – 80,000 = 20,000. When the central bank decides to restrict the flow of money, then the margin requirement of loan is raised and vice-versa in the case of expansionary credit policy.

2. Selective Credit Control (SCC’s): An instrument of the monetary policy that affects the flow of credit to particular sectors positively and negatively is known as selective credit control. The positive aspect is concerned with the increased flow of credit to the priority sectors. However, the negative aspect is concerned with the measures to restrict credit to a particular sector.

3. Moral suasion: this method of credit control involves the techniques of advance and requests made by the central bank to the commercial banks to co-operate with the implementation of its credit policies, central bank may request commercial banks not to give loans for un-productive purposes, which does not add to economic growth but increases inflation.

Question 13.
Do you consider a commercial bank ‘creator of money’ in the economy’?
Answer:
Commercial banks play the important role of money creator in the economy. They have the capacity to generate credit through demand deposits. These demand deposits make credit more than the initial deposits.

The process of money creation can be explained by taking an example of a bank XYZ. A depositor deposits Rs. 10,000 in his savings account, which will become the demand deposit of the bank. Based on the assumption that not all customers will turn up at the same day to withdraw their deposits, bank maintains a minimum cash reserve of 10 % of the demand deposits, i.e. Rs. 1000. It lends the remaining amount ofRs.9000 in the form of credit to other customers. This further creates deposits for the bank XYZ. With the cash reserve ofRs. 1000, the credit creation is worth Rs. 10,000.

So, the credit multiplier is given by:
Credit multiplier = 1/CRR = 1/10%= 10

The money supply in the economy will increase by the amount (times) of credit multiplier.

Question 14.
What role of RBI is known as ‘lender of last resort’?
Answer:
When a commercial bank faces financial crisis and fails to obtain funds from ether sources, then the central bank plays the vital role of ‘ lender of last resort ’ and provides them with the financial assistance in the form of credit: This role of the central bank saves the commercial bank from bankruptcy. Thus, the central bank plays the role of guarantor for the commercial banks and maintains a sound and healthy banking system in the economy.

2nd PUC Economics Important Questions with Answers

Karnataka 2nd PUC Economics Important Questions Chapter 2 National Income Accounting

Very Short Answer Type Questions

Question 1.
Give the meaning of National income?
Answer:
The money value of all final goods and services produced in a country in a year.

Question 2.
What are final goods?
Answer:
Goods which are purchased for final use are final goods.
Ex: T.V, wrist watch etc.,

Question 3.
What are intermediate goods?
Answer:
Goods which are produced by some producer and used by some other producer as material input are called intermediate goods. Ex: Wood used to produce fiirniture etc

Question 4.
What is deducted from GDP to arrive at NDP?
Answer:
Depreciation cost is deducted from GDP to arrive at NDP

Question 5.
Give the meaning of per capita in come?
Answer:
It refers to the average income of the people of a country.

Question 6.
What is economic welfare?
Answer:
Economic welfare means the satisfaction derived by the people from consumption of goods and services.

Question 7.
What are externalities?
Answer:
Externalities are unintentional consequences of an economic action of a person or firm that accrues to another person or firm.

Question 8.
What is inventory?
Answer:
Output which could not be sold in the same year is known as inventory.

Question 9.
What are Transfer Payments?
Answer:
Payments made by govt such as old age pension, widow pension, scholarship etc are called transfer payment.

Question 10.
What do you mean by Depreciation cost?
Answer:
The value of capital goods should be deducted from gross investment to arrive at net investment. Such deduction is called depreciation cost.

Question 11.
Between net investment and capital which is a storck and which is a flow.
Answer:
Stock is net investment Flow is capital

Question 12.
Name the factors of production.
Answer:
Land, Labour, capital and organisation

Short Answer Type Questions

Question 1.
Distinguish between consumer goods and capital goods. Give examples.
Answer:
Consumer goods

• Goods which are purchased for consumption
• Ex:-Food, drinks, etc.,

Capital goods

• Goods which are used in the production of some other goods.
• Ex: factories, machinery, etc.,

Question 2.
Give the meaning of circular flow of income.
Answer:
The process whereby the national income and expenditure of an economy flows in a circular manner continuously between different sectors.

Question 3.
Classify the following into stocks and flows.
Answer:
Bank deposits, salary, wealth, food grain stock, exports, imports, foreign exchange reserves, national income Stocks are-Bank deposits, food grain stock, foreign exchange reserves.
Flow-Salary, wealth, exports, imports, and national income.

Question 4.
Name the factor payments.
Answer:

1. Land-Rent
2. Labour-wages
3. Capital-Interest
4. Organisation-Profit

Question 5.
How does GNP differ from GDP?
Answer:
GNP:

• If is the aggregate money value of all final goods and services produced by country in a year including net income from abroad.
• It is wider concept

GDP:

• It is the aggregate value of final goods and services produces within a country in a year
• It is a narrow concept

Question 6.
Distinguish between nominal national income and real national income
Answer:
Nominal national income:

• The national income figures are expressed in the current year prices
• It does not give a clear picture of the economy

Real Nation Income:

• The national income is expressed in terms of base year prices.
• It gives clear picture of the economic conditions.

Question 7.
Name the methods of measuring national income.
Answer:
There are 3 methods of measuring national income:-

1. Income method
2. Expenditure method and
3. Product method

Question 8.
What is the opinion of the IMF with regard to income from foreign firms?
Answer:
The IMF of the opinion that the income of a foreign firm should be included in the income of the country where it is located. However, profits earned by foreign firms should be credited to the parent country.

Question 9.
Nishanth is a lecturer in a college. He teaches his children at home. Are both teachings included in national income measurement? If not, why?
Answer:
The Nishanth that he teaches his children at home will not be included in National income. Because it comes under unaccountable and unofficial service clearly.

Question 10.
What are externalities? Explain with an example.
Answer:
Externalities are unintentional consequences of the economic activity of a person or firm that accrues to another person or firm.

For example, The construction of a road is a positive externality because it increases the value of long along the road

Heavy traffic on the road creates the problem of pollution. This is a negative externality

Question 11.
Name any 4 reasons why GDP is not a true indicator of welfare?
Answer:

1. Inequality in the distribution of income
2. Non-monetary exchanges
3. Harmful goods
4. Externalities
5. Manner of Production

Question 12.
Distinguish between stock and flow Stock:
Answer:
Stock refers to a quantity existing at a particular point of time

It is a static concept Flow:
Flows are additions made to the stock It is a dynamic concept.

Question 13.
Mention any 4 precautions that should be taken while estimating national income by-product method.
Answer:

• Avoid double counting
• The value of goods used for self-consumption should be added by guesswork.
• Depreciation cost should be deducted
• The value of second hand goods should be ignored.

Long Answer Type Questions

Question 1.
Describe the Circular Flow of income in a simple economy.
Answer:
There are innumerable producers and households in an economy. A simple economy is a closed economy. A simple economy is a closed economy in which there is no government or external trade or savings.

A simple two-sector model economy based on the following assumptions.

• There are only two sectors in the economy. They are the household sector and firms.
• Households are the owners of factors of production and firms buy these factors.
• Households receive income by selling factor services and spend their entire income on consumption.
• Finns sell their entire production to the households. There are no inventories.
• The economy is a closed economy, without govt.
• This circular flow of income can be explained with the help of a chart.

In the chart showing 2 types of the circular flow of income. They are:

1. Real Flow of incocme
2. Money Flow of income

Real Flow of income:
It refers to the rendering of factor services by households to firms, and the firms produce goods and services by employing factor services.

Money flow of income:
All payments by the firms to the households for factor services.
Thus production is a continuous activity because human wants are unlimited. This makes the flow of income circular.

Question 2.
Explain macro economic identities GDP,NDP,GNP and NNP.
Answer:
(a) GDP (Gross Domestic Product): GDP is the aggregate value of final goods and services produced within the country during a year.
GDP = C + I + G + net X
Where,
C = Gross final consumption expenditure
I = Gross private sector investment
G = Governments consumption and investment expenditure
Net X = net exports

(b) NDP (Net Domestic Product):
It is the aggregate money value of all final goods and services produced within the country less depreciation cost. When depreciation allowances is substracted from GDP we get NDP.
Hence, NDP = C + I + G + net X-DC or
NDP = GDP – Depreciation cost.

(c) GNP (Gross National Product):
It is the aggregate money value of all final goods and services produced by a country in a year including net income from abroad. GNP = C + I + G + (X – M) + (R – P)
(R – P) = Income received from abroad (R) and income paid to foreigners (P)

(d) NNP (Net National Product):
It is the aggregate market value of the final goods and services produced in a country in a year after deducting depreciation charges provided for the replacement of worn-out capital assets.
NNP = GNP – Depreciation

Question 3.
Write a note on Nominal national income, Real national income.
Answer:
Nominal National Income:
When the national income figures are expressed in the prices in current year in which it is calculated it is called nominal national income.

Nominal national income does not give a clear picture of the condition of the economy. PThe actual production of goods and services might have been less in the current year.

Real National Income:
When national income is expressed interms of base year prices or constant prices, is called real national income. The price level for that year is assued to be 100.

The following formula is used for calculating real national income.
Real national income = National income for the current year × base
\(\frac{\text { year price index }}{\text { Current year price index }}\) × 100

Question 4.
Describe any five problems in the measurement of national income.
Answer:
National income accounting is not an easy task. A number of difficulties arise in the measurement of national income accurately.
Some of these difficulties are:
Transfer Payments: Payments made by government such as old age pension, widow pension. Unemployment benefit etc, are called transfer payments. These are a part of individual income as well as apart of govt expenditure. Therefore, these payments are ignored from national income.

Treatment of government services: Govt provides various public services like defence, administration, justice etc. It is difficult to measure the value of such services.

Unpaid services:
Unpaid services performend by house wives, charitable institutions, NSS students etc are not included in national income this leads to under estimation of nationall income.

Income from illegal activities:
Income from illegal activities such as
smuggling, gambling, illicit brewing of liquor, black marketing etc. Is not included in national income. This reduces the actual value of .national income.

Changing general price level:
Change in price level also makes accurate estimation of national income difficult. This is because when general prices rise, the national income in money terms increases even though the national output remains constant.

Question 5.
Describe the relationship between national income and welfare.
Answer:
The ultimate objective of economic policy is to promote the welfare of the people welfare is satisfaction or state of wellbeing.

Prof.A.C.Pigou defines economic welfare as “that part of general welfare that can be brought directly or indirectly into relation with measuring rod of money.” Economic welfare is the satisfaction of utility derived by an individual from the use of economic goods and services.

According to AC. Pigou, Alfred Marshall and J.R.Hicks, national income and national welfare are positively correlated. An increase in national income causes an improvement in economic welfare if it is equally distributed among the people. If GDP increases, people get more income. This enables them to buy more goods and services and increase their welfare therefore, national income is treated as the indicator of the welfare of the people. But this may not be true always.

National income is not a relaiable index of economic welfare for certain reasons.

• Inequality in the distribution of income
• Non-monetary exchanges
• Harmful goods
• Manner of production
• Extemaltites

Considering all these points we may conclude that GDP is not barometer economic welfare it is not only a rough indicator inspite ofthese limitations national income occupies a significant place in the formulation of economic policy and comparing the level of economic growth in different countries.

Question 6.
Analyze why GDP is not a barometer of economic welfare but only a rough indicator.
Answer:
National income is not a reliable index of economic welfare for certain reasons.
Inequality in the distribution of income:
An increase in national income inequalities in the distribution of income may occur. That is increased GDP may have increased the income of the small minority but the majority may have remained poor. In this case, welfare of the majority decreases even though the GDP increases.

Non-monetary exchanges:
There are many activities in an economy which are not evaluated in monetary terms. For instance the services of house wives, NGO’s NSS -students etc are not accounted for the national income. .

Harmful goods:
National income does not consider whether the goods and services produced are useful to the people. For example:- Production of cigarettes, liquor, drugs etc is injurious to health but decreases the welfare of the people.

Manner of production:
If more goods are produced by polluting the environment, or by child labour then economic welfare cannot increase.

Externalities:
Externalities are unintentional consequences of an economic action of a person that accrues to another person or firm. These consequences may good or bad positive externalities increase welfare and negative externalities decrease welfare.

Considering all these points we may conclude that GDP is not barometer of economic welfare. It is only a rough indicator.

Question 7.
Discuss the difficulties in the measurement of national income.
Answer:
National income accounting is not an easy task. A number of difficulties arise in the measurement of national income accurately.
Some of these difficulties are:
Transfer payments:
Payments made by government such as old age pension, widow pension. Unemployment benefit etc are calledtransfer payments. These are a part of individual income as well as a part of govt expenditure. Therefore, these payments are ignored from national income.

Treatment of government services: Govt provides various public services like defence, administration, justice etc. It is difficult to measure the value of such services.

Unpaid services:
Unpaid services performed by house wives, charitable institutions, NSS students etc are not included in national income this leads to under estimation of national income.

Income from illegal activities:
Income from illegal activities such as smuggling, gambling, illicit brewing of liquor, black marketing etc. It is not included in national income. This reduces the actual value ofnational income.

Changing general price level:
Change in price level also makes accurate estimation ofnational income difficult. This is because when general prices rise, the national income in money terms increases even though
the national output remains the same. Similarly, if prices fall in national income in money terms decreases even though the national output remains constant.

Income of foreign firms:
Another problem is with regard to. the income generated by foreign firms. The IMF is of the opinion that the income of a foreign firm should be included in the income of the country where it is located.

Production for self-consumption
Agricultural produce like vegetables, fruits etc., such goods do not enter the market. Farmers do not maintain any accounts regarding the value of such goods. This reduces the actual value of national income.

Problem of double counting:
This is because it is very difficult to distinguish between final goods and intermediate goods. Therefore, the problem of double counting cannot be avoided. This causes over estimation of national income

Lack of reliable data:
In developing countries, most of the people are illiterate and so they do not keep proper records of their and so, they do not keep proper records of their production and sales required for the computation of national income.

Lack of occupational specialization:
Sometimes people have engaged two or more occupations. In rural areas, people earn their income partly from farm ownership and partly from manual work in industries in the off-season. This lack of occupational specialization makes estimation of national income difficult.

Question 8.
Explain the macroeconomic identities of national income.
Answer:
GDP (Gross Domestic Product):
GDP is the aggregate value of final goods and services produced within the country during a year.
GDP = C + I + G + net X
Where C = Gross final consumption expenditure
I = Gross Private Sector investment
G = Governments consumption and investment expenditure
Net X = net exports

NDP (Net Domestic Product): It is the aggregate money value of all final goods and services produced within the country less depreciation cost. When depreciation allowances is substracted from GDP we get NDP
Hence, NDP = C + I + G + net X – DC or NDP = GDP – Depreciation cost.
GNP = C + I + G + (X – M) + (R – P)
(R – P) = Income received from abroad (R) and income paid to foreigners(p)
NNP = (Net National Product)

It is the aggregate market value of the final foods and services produced in a country in a year after deducting depreciation charges provided for the replacement of worn out capital assets
NNP = GNP – Depreciation

Personal Income (PI):
Personal income is that part of national income of a country which is received by people or households.
PI-National income-distributed corporate profits-corporate income taxes-social security contributions+transfer payments.

Personal Disposable Income (PDI): It is the income which is at the disposal of a person to spend as he wishes. Thus, PDI = PI – Personal taxes

Disposable income can either be spent entirely or a part of the income can be saved. Therefore, PDI = Consumption+Savings.

Nominal National Income:
When the national income figures are expressed in the prices of current year.

Real National Income:
When the national income is expressed in terms of base year prices or constant prices The real income is calculated as follows.

Real National Income = National income for the current year X
\(\frac{\text { base year price index }}{\text { Current year price index }}\) × 100

Current year price index
Per capita Income:
Percapita income is the average income of the people of a country:
\(\frac{\text { National income of a country }}{\text { Total population }}\)

Exercises

Question 1.
What are the four factors of production and what are the remunerations to each of these called?
Answer:
The four factors of production are:
1. Land- It denotes the natural resources like air, water, soil, etc. The payment that is paid by the firms to acquire these services is called rent.

2. Labour- It refers to the physical and mental effort required to do a work. For example, engineer, manager, worker, etc. The payment made to the labour in exchange of his/her services is called as wage.

3. Capital – Capital is short for goods. These are man-made objects like machinery, equipment, and chemicals that are used in production That’s what differentiates them from consumer goods. For example, capital goods include industrial and commercial buildings, but not private housing. A commercial aircraft is a capital good, but a private jet is not. “ The income earned by owners of capital goods is called interest.”

4. Entrepreneur- It refers to the individual who undertakes the risk to organize the production process. Entrepreneurs are the risk-takers and often are the innovators of new techniques. They receive profit in exchange of their entrepreneurship.

The remunerations paid to the factors of productions are called factor payments or factor incomes. These are the aggregation of rent, wage, interest and profit.

Question 2.
Why should the aggregate final expenditure of an economy be equal to the aggregate factor payments? Explain.
Answer:
In a two sector economy, consisting of households and firms, the only way in which the households can dispose their income is on the goods and services produced by the firms. The factors of production use their remuneration to purchase goods and services. Thus, the income will come back to the producers in the form of sales revenue. So, there is no difference between the amount that firms distribute in the form of factor payments and consumption expenditure incurred by the households.

The same process continues year after year. However, if there has been any leakage in the form of savings, imports or taxes, then there arises a difference between the aggregate consumption expenditure and aggregate factor payments. In the case of some leakage, the households will spend less than their factor incomes. Consequently, the firms will receive lesser amount in the form of revenue, which will reduce the production level and employment level. This process will continue in every successive round and production and employment levels will continue to drop. Thus, the equality between the aggregate consumption expenditure and the aggregate factor payments is very necessary for the smooth functioning of the economy.

Question 3.
Distinguish between stock and flow. Between net investment and capital, which is a stock and which is a flow? Compare net investment and capital with flow of water into a tank.
Answer:

Stock	Flow
1. The variables that arc measured at a particular point of time. For example, bank balance as on 1st Oct 2010 is Rs.5000.	1. The variables that arc measured over an interval of time. For example, incest earned on bank deposits for 1 year, i.e. from 1 Oct 2009 to 30 Sep2010.
2. It has no time dimensions. months, 10 days, etc.	2. it has time dimensions, like 1 year, 6
3. Example: capital, bank deposits, water in Flow	3. Example: capital formation, interest on capital flows in a stream

Question 4.
What is the difference between planned and unplanned inventory accumulation? Write down the relation between change in inventories and the value-added of a firm.
Answer:
The stock of unsold goods (finished and semi-finished), which a firm carries forward from one year to another year is termed as an inventory.

Inventory accumulation can be planned or unplanned. The planned inventory accumulation refers to the inventory that a firm can anticipate or plan. For example, afirm want to raise its inventory from 1000 to 2000 units of denims and expects sales to be 10000units. Thereby, it produces 10000+1000units, i.e. 11000 units (in order to raise the inventory by 1000 units). If, at the end of the year it is found that the actual sales that got realised were also 10000, then the firm experiences the rise in its inventory from 1000 to 2000units. The closing balance of inventory is calculated in the following manner.

Final Inventory = Opening inventory + Production – Sale = 1000 + 11000-10000 = 2000units of denims In this case the inventory accumulation is equal to the expected accumulation. Hence, this is an example of a planned inventory accumulation.

Unplanned inventory accumulation is an unexpected change in an inventory. There is an unplanned accumulation in an inventory when the actual sales are unexpectedly low or high. For example, let us assume, a firm want to raise inventory from Rs 1000 to 2000 and expects sales to be 10000 and thereby produces 11000 units of denims. If, at the end of the year, the actual sales realized were 9000 units only, which were not anticipated by the firm and therefore the inventory rose by 3000 units.

The unexpected inventory accumulation is calculated as:
Final Inventory = Opening inventory + Production – Sale = 1000 + 11000 – 900
= 3000 UNITS OF DENIMS Hence, this is an example of unexpected inventory accumulation.

The relation between value-added and the change in inventory is shown by the given equation:
Gross value added by a firm = Sales + Change in inventory-Value of intermediate goods
It implies that, as inventory increases, the value added by a firm will also increase, thus confirming the positive relationship between the two.

Question 5.
Write down the three identities of calculating the GDP of a country by the three methods. Also briefly explain why each of these should give us the same value of GDP.
Answer:
GDP can be calculated by the following three methods:
(a) Income method
GDP = Total payments made to the factors of production

Σ Wt represents total wages and salaries received by i -th households. ΣPi represents total profit received by i-th households.
Σ Ii represents total Income received by i-th households. Σ Wi represents total Rent received by i-th households.
Equation (1) can be simplified as
GDP = W + R + I + P

(a) Value added or product method’
GDP = Sum of gross value added by all
firms in an economy
or GDP = GVA₁ + GVA₂ +………….. GVA_n
GVA₁ represents gross value added by the 1st firm
GVA₂ – represents gross value added by the 2nd firm and so on GVA_n represents gross value added by the nth firm DP = Therefore,

(b) Expenditure method or final consumption method
GDP = Sum total of revenues that firms earn
Or
GDP = Total consumption+Investment + Government Consumption expenditure + Net exports

As households spend some part of their income on imports, some portion of consumption expenditure also comprises of imports, which are denoted by CM similarly, some part of the investment expenditure and government consumption expenditure is spent on the foreign investment goods and imports. These portions of investment and government consumption expenditure are denoted by and GMrespectively. Thus, the final households’ consumption expenditure, investment expenditure, and final government expenditure that are spent on the domestic firms are denoted by, C-CM, I-IM, and G-GMrespectively.

Substituting these values in the above equation

The three methods give the same result for measuring GDP because what is produced in the economy is either consumed or invested. The three methods depict the same picture of an economy from three different angles. While the product method presents the value-added or total production, the income method depicts the income earned by all the factors, lastly, the expenditure method presents the expenditure incurred by all the factors. In the economy, the producer employs four factors Of production to produce final goods and earns revenue by sale, which is equivalent to the total value added by the firm. The firms pay remunerations to the factors, which act as the income of all die factors.

These remunerations are equivalent to the factors’ contributions to the value addition. These factor incomes are then expended on the goods and services, which verifies the equality between file factor „ income and expenditure. Hence, the three methods will always give the same value of GDP.

Question 6.
Define budget deficit and trade deficit. The excess of private investment over saving of a country in a particular year was Rs 2,000 crores. The amount of budget deficit was (-) Rs 1,500 crores. What was the volume of trade deficit of the country?
Answer:
Budget Deficit:
The excess of government expenditure over government income is termed as the budget deficit
Budget Deficit = G – T
Where ‘G’ represents government expenditure
‘T’ represents government income

Trade Deficit:
The trade deficit measures the excess of import expenditure over the export revenue of a country.
Trade Deficit = M – X
Where ‘M’ represents expenditure on imports
‘X’ represents revenue earned by exports

It is given that,
I- S = Rs.2000 crores.
G – T = (-) Rs. 1500 crores.
Therefore,
= 2000 – [1500] = 500 crores

Question 7.
Suppose the GDP at the market price of a country in a particular year was Rs 1,100 crores. Net Factor Income from abroad was Rs 100 crores. The value of Indirect taxes – Subsidies was Rs 150 crores and National Income was Rs 850 crores. Calculate the aggregate value of depreciation.
Answer:
National Income (NN_pc)= Rs.850 crores GDP Mp = Rs. 1100 crores
Net factor income from abroad = Rs. 100 crores
Net indirect taxes = Rs. 150 crores
NNP_FC = GDP_MP + Net factor income from abroad – Depreciation – Net indirect taxes Putting these values in the formula,
850 = 1100 + 100 – Depreciation -150
850 = 1100 – 50 – Depreciation
850 = 1050 – Depreciation
Depreciation = 1050 – 850 = Rs.200 crores
So, depreciation is Rs.200 crores.

Question 8.
Net National Product at Factor Cost of a particular country in a year is Rs 1,900 crores. There are no interest payments made by the households to the firms/government, or by the firms/government to the households. The Personal Disposable Income of the households is Rs 1,200 crores. The personal income taxes paid by them is Rs 600 crores and the value of retained earnings of the firms and government is valued at Rs 200 crores. What is the value of transfer payments made by the government and firms to the households?
Answer:
NNPFC = Rs. 1900 crores
PDI = Rs. 1200 crores
personal income tax = Rs.600 crores
Value of retained earnings Rs.200 crores
PDI = MNP_FC – Value of retained earnings offirms and government+value of transfer payments-personal tax 200 = 1900 – 200 + Value of transfer payments – 600
1200 = 1100+Value of transfer payments Value of transfer payment = 1200 – 1100 = Rs 100 crores.

Question 9.
From the following data, calculate Personal Income and Personal Disposable Income.

–	Rs (Crore)
(a) Net Domestic Product at factor cost	8,000
(b) Net Factor Income from abroad	200
(c) Undisbursed Profit	o
(d) Corporate Tax	500
(e) Interest Received by Households	1,500
(f) Interest Paid by Households	1,200
(g) Transfer Income	300
(h) Personal Tax	500

Answer:
Personal Income = NDP + Net factor income from abroad (NFIA) + Transfer Income
– Undistributed profit – corporate tax – Net interest paid by households = Rs.8000 crores
NFIA = Rs.200 crores

Transfer Income = Rs.300 crores
Undistributed profit = Rs. 1,000 crores corporate tax = 500 crores
Net interest paid by households = interest paid-interest recieved
= 1200 – 1500 = (-) Rs.300 crores So, puttingthe values in the above formula
PI – 8000 + 200 + 300-1000 – 500 – (300) = 8000 + 200 + 300 – 1000 – 500 + 300
PI = 7300
So, Personal Income=Rs.7300 crores Personal Disposable income = Personal Income – Personal Payments
= 7300 – 500 = Rs.6800 crores

Question 10.
In a single day Raju, the barber, collects Rs 500 from haircuts; over this day, his equipment depreciates in value by Rs 50. Of the remaining Rs 450, Raju pays sales tax worth Rs 30, takes home Rs 200 and retains Rs 220 for improvement and buying of new equipment. He further pays Rs 20 as income tax from his income. Based on this information, complete Raju’s contribution to the following measures of income
(a) Gross Domestic Product
(b) NNP at market price
(c) NNP at factor cost
(d) Personal income
(e) Personal disposable income.
Answer:
(i) GDP_MP= RS.500 [Barber collects from haircut]

(ii) NNP_MP = GDP – Depreciation
= 500 – 50
= Rs.450

(iii) = NNP_FC – Sales tax =Rs420

(iv) PI = – Retained earnings
= 420 – 220 = Rs.200

(v) PDI = PI – Income tax
= 200-20
= Rs.180

Question 11.
The value of the nominal GNP of an economy was Rs 2,500 crores in a particular year. The value of GNP of that country during the same year, evaluated at the prices of same base year, was Rs 3,000 crores. Calculate the value of the GNP deflator of the year in percentage terms. Has the price level risen between the base year and the year under consideration?
Answer:
Nominal GNP=Rs.2500
Real GNP = Rs.3000
FNP = \(\frac{\text { Nominal GNP }}{\text { Real GNP }}\) × 100
So,
GNP deflator = \(\frac{2500}{3000}\) × 100
= 83.33%
No, the price level has fallen down by 16.67% [(100-83.33)%].

Question 12.
Write down some of the limitations of using GDP as an index of welfare of a country.
Answer:
Limitations of using GDP as an indicator are as follows:
1. distribution of GDP is ignored.

2. Inflation: GDP does not take into account the level of prices in a country. Because of inflation, the cost of living increases leading to a decrease in the standard of living. The loss of welfare due to this decrease is not taken into consideration by GDP as an index of welfare.

3. Externalities: Increase in the national income is associated with increased levels of pollution, accidents, disasters, shortage and depletion of natural resources, etc. These factors affect human health and lead to ecological degradation. GDP fails to consider the costs or valuations of such factors.

4. Income pattern: GDP disregards the income distribution pattern. The increase in aggregate national income may be a result of the increase in income of a few individuals. Thus, this may lead to false interpretation of social welfare.

5. Welfare: GDP ignores the welfare component as the goods and services produced may or may not add to the welfare to a society. For example, the production of goods, like guns, narcotic drags, high-end luxurious goods increase the monetary value of producti on, but they do not add to the welfare of the majority of the population.

2nd PUC Economics Important Questions with Answers

Karnataka 2nd PUC Economics Important Questions Chapter 1 Introduction to Macro Economics

Question 1.
Who traced macroeconomics first?
Answer:
‘J.M.Keynes’ traced macroeconomics first.

Question 2.
What do you mean by laissez faire policy?
Answer:
Laissez faire means ‘Leave us alone’ i.e., the government should not intervene or interfere in the market.

Question 3.
Which policy was proved wrong by the Great depression?
Answer:
“Laissey faire policy’ was proved wrong by the Great depression.

Question 4.
Name the book which was published by J.M.Keynes?
Answer:
The book which was published by J.M. Keynes was “The General theory of employment, Interest and Money” in 1936.

Short Answer Type Questions

Question 1.
What do you mean by JMacro- economics?
Answer:
Macro economics refers to the study of aggregates covering the entire economy, such as general employment, general price level and wage level etc.

Question 2.
Define Macro Economics?
Answer:
According to K.E.Boulding, Macro Economics is the study of the nature, relationships and behaviour of aggregates of economic quantities.

Question 3.
What do you mean by nature of macro-economics?
Answer:
The nature of macro-economics explains you the central theme of economy. It studies the economic activities as a whole and it helps us to understand how the economy functions in different situations.

Question 4.
Name any two areas of study under macro-economics?
Answer:
The important areas of study under macro-economics are:

1. National income
2. Aggregate employment
3. General price level
4. Consumption etc.

Question 5.
Who are the pioneers in micro and macro-economics?
Answer:
(a) Alfred Marshall is considered as pioneer of micro-economics
(b) John Maynard Keynes is considered as pioneer of macro-economics. (J.M.Keynes)

Question 6.
How does macro economics depend on micro-economics?
Answer:
Macro-economics variables depend upon the level and behaviour of micro-economic variables in the economy.
Ex: Aggregate demand in the economy is simply the sum of demand at the micro level. *

Question 7.
Name two limitations of macro economics?
Answer:
The two limitations of macro economics are:

1. Excessive generalization
2. No clear picture

Long Answer Type Questions

Question 1.
Explain the cirucumstances for the emergence of macro economic study?
Answer:
Macroeconomics can be traced in the •works of Mercantilists. But the foundation of macro-economics was laid by J.M.Keynes in his most celebrated book. ‘The General theory of Employment Interest, and Money’ published in 1936.

Economic thought and policies, prior to 1930, was dominated by classical economists. They believed in laissez faire policy. The laissez faire advocated to leave the economic activity to the market.

The role government should be minimal as the invisible hands will ensure equilibrium and full employment.
The Great depression of 1930 proved the classical economic policy wrong, the inadequances of automatic functioning was clearly visible. This necessitated new ‘ interpretation and analysis of macro economics. Keynes filled the macro economics with his fresh and revolutionary approach through his “General theory”. It dominated the economic policy till the mid 1970s Later, various schools of thought namely monetarism, neoclassical macro-economics, supply side economics and neo-keynesian economics have strengthened macroeconomics.

Presently, macro-economies lias become inevitable for various policy formulations:

• National income
• Employment
• Poverty
• Fluctuations in economic cycles
• Inflation
• Foreign trade etc

Question 2.
Write four elements about the scope of Macroeconomics?
Answer:
The four elements about the scope of Macroeconomics are:

1. It studies about major sectors of economy.
2. It studies about the generation of National in the country
3. It studies factors like aggregate demand aggregate supply, aggregate consumption, aggregate savings and aggregate investement etc.
4. It helps studies about the International trade.

Question 3.
‘Although macroeconomics has gained maximum popularity, yet it not free from limitations’ Justify this Statement.
Answer:
Limitations of macro-economics are:
Neglects micro study:
Macroeconomics completely neglects micro study. It will not consider individuals, production units, sectors and components of the economy.

No clear picture:
Macroeconomics, as it studies aggregates and averages, will not give a clear picture of the functioning of the economy.

Wrong conclusions:
The macroeconomic study may some time lead to wrong conclusions. Because, what is true’of an economy may not be true of an individual. Thus macro economics may be misleading.

Excessive generalization:
The greatest defect Macroeconomics is its excessive generalization. Its approach, most of the times, is misleading. It may therefore lead to wrong conclusions.

The Problem of aggregation:
Macro economics deals with such aggregates as aggregate of consumption, savings and investment. All these factors consist ofheterogenous elements. Money is a measuring rod of value. But its value keeps on changing. Consequently economic aggregates become immeasurable and incomparable in real terms.

Question 4.
Discuss the nature and scope of macro-economics?
Answer:
The Nature and scope of Macro-Economics:
The natue of macro-economics explains you the central theme of economy. It studies the economic activites as a whole and it helps us to understand how the economy functions in different situations.

The situations which are studied and solved bymacr-economics are:

• How to generate and spend the income though production of goods and services.
• How to allocate the human resources and non-human resources in different economic sector.
• How and what policies regarding production, income, expenditure be formulated for the growth and development of an economy
• What policies should be formulated regarding foreign trade to serve the interest of people at large
• How the different variables like output level, price level and employment bear close relationsip.

Scope of Macroeconomics:
It refers to the areas of study under macro economics. The scope of macro-economics can be explained as follows:

Major sectors:
The economy in a democratic set up has any major interdependent sectors like house hold sector, producer sector, government sector and external sector. While studying the economy, macro economists should consider each sector for the complete study of Macro economics.

National income:
Here we study the various concepts National income such as NDP, GDP, GNP,

Exercises

Question 1.
What is the difference between microeconomics and macroeconomics?
Answer:

Question 2.
What are the important features of a capitalist economy?
Answer:
Capitalist economy is an economic system where the means of production are privately owned. These means of production are driven by the motive of profit-making. This economic structure is also known as free market economy or laissez faire.

Following are the features of a capitalist economy:
1. Role of the government: The government provides the basic framework for the smooth functioning of an economy. It provides the basic framework and is responsible for the maintenance of law and order, justice, growth and stability, defence, etc.

2. Profit motive: The economic agents are driven by the prime motive of profit maximization.

3. Central problems: The central problems of an economy are solved by the market forces of demand and supply, i.e., the law of demand and supply qperates here. The producers will supply only those goods and services that are demanded by the economy.

4. Role of private sector: The role of private individuals is more dominant. The main role of undertaking production and organizing factors of production are played by the private individuals and capitalists.

5. Laissez-faire: This economy is also called ‘laissez faire’. It has minimum interference or restriction from the government.

Question 3.
Describe the four major sectors in an economy according to the macroeconomic point of view?
Answer:
The four major sectors of an economy according to the macroeconomic point of view are:

1. Households
2. Firms
3. Government
4. External sector

These can be represented in the following flow chart:

1. Households: Households buy goods and services for consumption and also supply factors of production like land, labour, capital, and entrepreneur. Households provide the market for the output of the firms.

2. Firms: Firms are economic units that carry out production. They employ and organize the resources and supply goods and services to households.

3. Government: A state/government provides law and order, maintains growth and stability and provides administrative services. The main motive of a government is to undertake developmental projects such as dams, roads, heavy industries that usually have long gestation periods. The government invests in education, health sector and provides these services at a nominal price. The motive of a government is to serve and not to make profits, iv. External sector: This sector is engaged in export and import (external trade) of goods and services. If domestically produced goods and services are sold to the rest of the world, then it is called export. If the goods and services are purchased from the rest of the world, then it is called import.

Question 4.
Describe the Great Depression of 1929.
Answer:
The Great Depression was a severe economic crisis that started in the year 1929. It originated in the United States of America with the crash ofthe stock market and gradually spread to other countries of the world. The main cause behind this crisis was the fall in aggregate demand due to underconsumption and over investment. Due to underconsumption and over investment the stock of finished goods started piling up, which resulted in low price level and consequently the low-profit leveL The money in the economy was converted into unsold stock of finished goods that lead to an acute M in employment and hence income level fell drastically. The demand for goods in the economy was so low that the production was lowered leading to unemployment. In the USA, the rate of unemployment increased from 3% to 25%.

The Great Depression has its own implications and importance in economics, as it leads to the failure of the classical approach of economics. Those who believed in the market forces of demand and supply, paved the way for the emergence of the Keynesian approach. It was this incident that provided the economists with sufficient evidence to recognize macroeconomics as a separate branch of economics.

The cause and effect relationship of the Great Depression can be summed up in this flow chart
Low demand → overinvestment low level of employment, low level of output, low income and low demand.

2nd PUC Economics Important Questions with Answers

Karnataka 2nd PUC Economics Important Questions Chapter 6 Non – Competitive Markets

Question 1.
What is monopoly?
Answer:
Monopoly means a market with a single seller.

Question 2.
What is monopolistic competition?
Answer:
Monopolition is a type of imperfect market In which there are many seller selling differentited products but perfect substitutes.

Question 3.
What is an oligopoly?
Answer:
Oligopoly is the market situation in which there are few firms selling homogeneous or differentiated products.

Question 4.
What is meant by product differentiation?
Answer:
Product differentiation refer to the diferences alone in materials by design or colour etc..

Question 5.
Define profit?
Answer:
The profit refer to the surplus of income over expencess of production.

Question 6.
Define abnormal profit?
OR
Define super normal profit?
Answer:
The abnormal profit refer reffer to when the equilibrium price is greater than the minimum of the AC curve.

Question 7.
Define normal profit?
Answer:
When the equlibrium price becomes equal to minimum point of the AC curve than it is said as the firm is earning normal profits.

Question 8.
Define Price rigidity?
Answer:
Price rigidity implies that price are different to change

Question 9.
From where do you buy electricity for home? What are the characteristicke of that market?
Answer:
We buy electricity from electric office (BESCOM)

The characteristics ofthis market are:

1. Single seller
2. No close substitutes.

Question 10.
Mention the three forms of imperfectely competitive market?
Answer:
The three forms of imperfectly competitive market are:-

1. Monopoly
2. Monopolistic competition
3. Oligopoly

Question 11.
In which market form is there product differentiation?
Answer:
Monopolistic competition market and oligopoly market

Question 12.
What is price discrimination?
Answer:
It refers to charging og different price from different consumes for different units of the same product.

Question 13.
What is the shape of MR curve under monopoly?
Answer:
Under monopoly market MR curve from left to right and it lies below the AR curve.

Question 14.
What is the shape of the TR monopoly?
Answer:
TR curve is invese U- shaped as show below in the diagram:

Question 15.
What will you call that market which was characteristics both of monopoly and perfect completion?
Answer:
Monopolistic competition.

Question 16.
Give four examples of product (soap) differentiation?
Answer:

1. Medimix
2. Santoor
3. Lux
4. Cintholetc.

Question 17.
Which type of market has full control Over price?
Answer:
Monopoly has full control over price.

Question 18.
Which type of market has partial control over price?
Answer:
Monopolistic competition has partial control over price.

Question 19.
Which type of market has no control over price?
Answer:
A competitive firm has no control over price
OR
Perfect competition

Question 20.
On what factor does the price depend for the monopoly firm?
Answer:
For the monopoly firm, the price depends on the quantity of the commodity sold.

Short Answer Type Questions

Question 1.
How does a monopoly differ from a competitive firm?
Answer:
Monopoly

1. Monopoly is a market with single seller
2. Produce different product
3. Price is determined by individual firm
4. Smaller output in higher price.

Competitive firm:

1. Competitive firm is market with many seller.
2. Produce homogeneous product
3. Price is determined by demand & supply
4. Large output and lesser price.

Question 2.
What are selling costs?What is their main objective?
Answer:
Selling costs are those expenses of the producer incurred on marketing of goods produced.
The main objective of the selling costs:

1. The selling cost are very important differ our product from the other products.
2. The selling costs may be attached to particular consumer & particular brand.
3. Give two example of monopolistic competitive industry?

The two example of monopolistic competitive industry

• Soap Industry
• Biscuit Industry
• Paint Industry etc.

Question 4.
Why is the demand curve of monopolistic competitive firm more elastic than that of a monopoly?
Answer:
The demand curve is more elastic in monopotic competition than monopoly because the competition is more than that of monopoly.

Question 5.
Can a monopolist incur loss in the short- run?
Answer:
Yes, monopolist can incure loss, in the situtation where short run average cost exceeds shortrun average revenue i.e SAC > SAR.

Question 6.
Describe the feature of monopoly?
Answer:
The features of monopoly are as follows

1. There will be existence of one seller or single seller.
2. There will be no close substitutes.
3. There will high barriers to entry.
4. monopolist is a price maker
5. Monopolists have perfect knowledge about the market conditions.
6. Monopolist willhave more chance to do price discrimination.

Question 7.
What is oligopoly market? Write down the charactersties of oligopoly market?
Answer:
Oligopoly is a market situtation in which there are few firms selling homogeneous Or differeneiated products.
Features of oligopoly market:

1. There will be existance o few large firms.
2. There will be interdependence among firms.
3. Ologopoly is market with better group behaviour.
4. The only way open to the oligopolist to his sales is either by advertising or improving the quality of the product.
5. The firms under oligopoly produce homogeneous or differentiated products.
6. Under oligopoly prices do not move freels as per the changes in demand.

Question 8.
Write down the features of monopolistic competition?
Answer:
The features of monopolistic competition

1. The number offirms producing a producvt will be large under monopolistic competition.
2. There will be free entry and exit of firms.
3. The most outstanding features of monopolistic competition is product olifferentiation.
4. There will be existence of selling costs.
5. Under monopolistic competition a firm fixes its own price of its product.

Question 9.
Difference between monopoly and monopolistic competition?
Answer:

Monopoly	Monololistic
1. In monopoly there is only one firm.	1. In monopolistic competition there are many firms.
2. There is no closer substitute of the commodity	2. There many close substitutes.
3. There is compete restriction on the entry of the firm.	3. There is freedom of entry.
4. There are homogenous products.	4. There is product diffienciation.

Question 10.
Analyse the effect of firms in price in diffrent markets?
Answer:
1. Perfect competition: In this market, a firm cannot effect the price by the industry because there are large number of buyers and sellers in perfect competition.

2. Monopoly: In this market, firm is the industry. It can effect the price of the commodity to a great extent. The price of the commodity is determined by itself. It can effect the price indirectly by increasing or decreasing the supply of the commodity.

3. Monopolistic competition: In thus market, a firm can effect the price to some extent by changing the brand/size of its product.

Question 11.
Explain the implications of freedom of entry & exit of firms under perfect competition?
Answer:
Implications of freedom and entry and exit of a firm under perfect competition In perfect competition, there is free entry of new firms and exist of existing firms. New firm induced by large profits can enter the industry whereas in case of loss inefficient firm leave the industry. The implication is that no firm can earn abnormal profit in the long run. The firm earns just normal profit i.e minimum profit necessary to remain business.

Question 12.
Giving reason, distinguish between the behaviour of demand curves of firms under perfect competition and monopolistic competition.
Answer:
Under perfect competition, demand curve is perfectly inelastic, whereas under monopolistic competition, demand curve is highly inelastic shown below:

Reason Under perfect competition, a firm is price takes and price of every unit of commodity is the same, on the other hand, more goods can be sold only by lowering the price.

Exercises

Question 1.
What would be the shape of the demand curve so that the total revenue curve is
(a) A Positively sloped straight passing through the origin?
Answer:
The demand curve will be parallel to OX, axis when the total revenue curve is a positively straight line passing through the origin.

(b) A horizontal line.
Answer:
The demand curve will be sloping downward from left to right when the total revenue curve is a horizontal line.

Question 2.
from the schedule provided below calculate the total revenue, demand curve & the price elasticity of demand?

Answer:

Question 3.
What is the value of MR when the demand curve elastic?
Answer:
Demand curve is elasticity is greater than unity. When price elasticity of demand is more than unity cones, then the value of MR is positive.

Question 4.
A monopoly firm has a total fixed cost of Rs 100 and has the following demand schedule

Find the short-run equilibrium quantity, price and total print. What would be the equilibrium in the long run? In case the total cost was Rs 1000, Describe the equilibrium in the short run and in the long run?
Answer:

Short-run equilibrium quantity in units, Price is Rs 50 & Print Rs 200

Question 5.
If the monopolist firm of Excercise 3, was a public sector firm. The government set a rule for its manager to accept government fixed price as given (i.e, to be a price taker and therefore behave as a firm in a perfectly competitive Markets), and the government decide to set the price so that demand and supply in the market are equal. What would be the equilibrium price, Quantity & profit in this case?
Answer:
If the government sets a rule for the firm to accept the government fixed price on given the equlibrium price will be equal to Rs 10 Quantity supplied will 10 ad the profit will be zero.

Question 6.
Comment on the shape of the MR curve is case the TR curve is a
(i) Positively shaped stright line
Answer:
MR curve is a stright line parallel to OX axis when TR curve is a positively shaped stright line.

(ii) Horizontal shaped stright line
Answer:
When TR is horizontal straight line, MR curve is negatively shaped stright line.

Question 7.
The market demand curve for a commodity and the total cost for a monopoly firm producing the commodity is given by the schedule below. Use the information to calculate the following.

(a) The MR and MC schedules.
(b) The quantities for which the MR and MC are equal.
(c) The equilibrium quantity of output and the equilibrium price of the commodity.
(d) The total revenue, total cost and total profit in equilibrium.
Answer:


(a) MR and MC schedule are given in the table.
(b) At 6 quantity, MR = MC(=4)
(c) Equlibirum quantity of output = 6 units and equlibrium price is Rs 19.
(d) At equlibrium, profit = TR – TC
= 114 – 109 = 5

Question 8.
Will the monopolist firm continue to produce in the short run if a loss is incured at the best short run level of output?
Answer:
Yes, the monopolist firm continues to produce in the short run if a loss is incurred at the best short run level of output.

Question 9.
Explain why the demand curve facing a firm under monopolistic competition is negetively shaped?
Answer:
Demand curve facing a firm under monopolistic a difffentiated product. It can influens the price of the commodity to some extent. In this sense it is price maker for its price maker for its product. It can sell more goods at a lower price and less more goods at a higher price. Hence the demand curve facing a firm under monopolistic competition is negetively shape as shown below in the diagram.

Question 10.
What is the reason for the long run equlibrium of a firm in monopolistic competition to be associated with zero profit?
Answer:
In the long run, there is free entiy and exit of firms. If a firm in monopolistic competition earn abnormal profits. New firm will enter the market resulting into increases in supply. Increase in supply will reduce the price and all the existing firm will be deprived at abnormal profit, in other words there will be normal profit.

On the other hand, if firms rupee loss, in the short run, some of the firms reduce or,stop production and quit the industry. As a result supply will be no profit and no loss. Thus in the long equlibrium, the firms earn only normal profit.

Question 11.
List the three diffrent ways in which oligopoly firms may behaves?
Answer:
Different ways in which oligopoly firms may behave:
Oligopoly firms may behave in the following in different ways.

1. Duopoly may collude together and decide not to compete firms together. In such a case, the two firms would behave like a single monopoly firm that has two different factories producing the commodity.
2. Each of two firms[in case a duopoly] may deside how much quantity to produce by maximising its ownprofit assuming that the other firms maximising its own profit assuming that the other firms would not change the quantity that it is supplying.
3. Oligopoly firms may make the market price ofthe commodity rigid i.e. the market price doesnot more freely in response to change in demand.

Question 12.
If duopoly behaviour is one that is described by cournot, the market demand curve is given by the equation q = 200 – 4p and both the firms have zero costs, find the quantity supplied by each firm in equilibrium and equilibrium market price.
Answer:
Market demand equation:
q = 200 – 4p
200 – 4p = 0
-4p = -200
p = \(\frac{-200}{-4}\)
q = \(\frac{200}{50}\) = 4
Number of firms = 2
Quantity supplied by each firm = \(\frac{4}{2}\) = 2

Question 13.
What is meant by prices being rigid? How can oligopoly behaviour lead to such an outcome?
Answer:
Rigid Price: Rigid price means that the market price does not move freely in response to changes in demand. In an oligopolistic market, when a firm lowers the price to promote its sale, it effects other firms also. Hence as a reaction, rival firms may also start to reduce their prices. In this situation, the increase in total quantity sold due to lowering of price is shared by all the firms and the firm that had initially lowered the price is able to achieve only a small increase in the quantity it sells. So this firm experiences an inelastic demand curve and its decision to lower price leads to a lowering of its revenue and profit. Therefore any firm finds ot irrational to change the prevailing price.

Question 3.
What is the value of MR when the demand curve elastic?
Answer:
Demand curve is elasticity is greater than unity. When price elasticity of demand is more than unity cones, then the value of MR is positive.

Question 4.
A monopoly firm has a total fixed cost of Rs 100 and has the following demand schedule

Find the short-run equilibrium quantity, price and total print. What would be the equilibrium in the long run? In case the total cost was Rs 1000, Describe the
Answer:

Short-run equilibrium quantity in units, Price is Rs 50 & Print Rs 200

Question 5.
If the monopolist firm of Excercise 3, was a public sector firm. The government set a rule for its manager to accept government fixed price as given (i.e, to be a price taker and therefore behave as a firm in a perfectly compitititve Markets), and the government decide to set the price so that demand and supply in the market are equal. What would be the equilibrium price, Quantity & profit in this case?
Answer:
If the government sets a rule for the firm to accept the government fixed price on given the equlibrium price will be equal to Rs 10 Quantity supplied will 10 ad the profit will be zero.

Question 6.
Comment on the shape of the MR curve is case the TR curve is a
(i) Positively shaped stright line
(ii) Horizontal shaped stright line
Answer:
(i) MR curve is a stright line parallel to OX axis when TR curve is a positively shaped stright line.
(ii) When TR is horizontal straight line, MR curve is negatively shaped stright line.

Question 7.
The market demand curve for a commodity and the total cost for a monopoly firm producing the commodity is given by the schedule below. Use the information to calculate the following.

(a) The MR and MC schedules.
(b) The quantities for which the MR and MC are equal.
(c) The equilibrium quantity of output and the equilibrium price of the commodity.
(d) The total revenue, total cost and total profit in equilibrium.
Answer:

2nd PUC Economics Important Questions with Answers

Karnataka 2nd PUC Economics Important Questions Chapter 5 Market Equilibrium

Very Short Answer Type Questions

Question 1.
What is price ceiling?
Answer:
It means maximum price of a commodity fixed by the government.

Question 2.
Give two eamples for price ceiling imposed in India?
Answer:
The two examples for price ceiling imposed in India are:

• Wheat
• Rice
• Kerosene oil etc.

Question 3.
What will be the result of imposing price ceiling?
Answer:
It gives rise to excess demand or shortage of a commodity.

Question 4.
What is price floor?
Answer:
It means minimum price fixed by the government for a commodity in market.

Question 5.
What will be the result of imposing price flor?
Answer:
More supply and less demand i.e excess supply or abundance of supply of commodity.

Long Answer Type Questions

Question 1.
How is the equilibrium price and equilibrium quantity of a normal commodity affected by an increase in the income of its buyers? Explain with the help of diagram.
(OR)
How does an increase in demand of a commodity affect its equilibrium price and equilibrium quantity? Explain with the help of a diagram.
Answer:
Effect of increase in the income of the buyers on the equilibrium price and equili brium quantity of a normal commodity:

rightward shift of demand curve as show in the diagram. The rightward shifting of demand curve will raise the equilibrium price and the quantity. In the figure DD and SS are initial demand and supply curve. The increase in income causes shift in the entire demand curve to the right to the new positions while the supply curve remains constant. It will be observed from figure that with the shift in demand curve on at the old price OP excess demand equal to EQA has emerged.This excess demand of goods exerts upward pressure on price. This will result in rise in price to OP1 where again quantity demanded equals quantity supplied and two market equilibrium I is attained and excess of demand is eliminated.

Question 2.
At a given price of a commodity, there is excess demand. Is the price an equilibrium price? If not, how will the equilibrium price be reached? Use diagram.
Answer:

The price with excess demand: The price with excess demand cannot be called as on equihbrium price. Equilibrium price is situation of zero excess and demand and zero excess supply. In the diagram, DD is the demand curve, and SS is supply curve. OP₁ is the market price. At this price, the supply is OQ and the demand is OQ₁ It means the consumers want more than what the producers are willing to supply (i.e. no excess demand and no excess supply). Excess demand will create competition among the buyers and push the price up. The price will go on increasing till excess demand becomes zero. Finally the price reaches OP. OP₁ is the equilibrium price. At this price demanded is equal to supply. Both are equal to OQ₀.

Question 3.
At a given price of the commodity, there is excess supply. Is it equilibrium price? If not how will the equilibrium price be reached? Use diagram.
Answer:
The price with excess supply: The price with excess supply cannot be called as an equihbrium price. Equilibrium price is a situation of zero excess supply and zero excess demand.

In the diagram DD is the demand curve and SS is the supply curve. OP₁ is the market price, the supply in OQ and demand is OQ₁. It means that the consumers want less than what the products are willing to supply. There is excess supply equal to AB or Q₁Q. So given price is not the equilibrium price as at equilibrium price supply is equal to demand (i.e. no excess demand no excess supply). Excess supply will create competition among the suppliers and push down the price. The price will go on decreasing till excess supply becomes zero. Finally, the process reaches OP. OP is the equilibrium price. At this price supply is equal to demand i.e., both demand and supply are equal.

Question 4.
How will an increase in the income of the buyers of ah inferior goods affect its equilibrium quantity? Explain with help of a diagram.
OR
What happens to an equilibrium price and the equilibrium quantity of commodity sold in market when demand for it decreases (demand curve shifts downwards) while the supply curve remained unchanged.
Answer:
When the income of the buyer of inferior goods rises the demand for inferior goods M. In this case, the demand curve shifts leftwards or downwards. This is graphically shown in the figure where original demand curve D₀D₀ interest the supply curve SS at point EQ and determines equilibrium price equal to OPQ and equilibrium quantity OQ. Now with the increase in the income of the buyer, the demand curve for inferior goods will shift to left and the new demand curve will be D₁D₁.

The new equilibrium between demand and supply is attained at price OP₁ and quantity OQ₁ which is lower than initial equilibrium price OPQ price and quantity. With the decrease in demand supply curve remaining unchanged at the original price OPQ, the surplus E₀E₁ of the quantity supplied over the quantity demanded emerges which exerts downward pressure on price. The sellers who cannot sell at the original price will make offers to sell inferior goods at a lower price. As a result, price will fall. As price falls, the quantity of supply of inferior goods is reduced. At the new price OP₂ the quantity demanded and surplus is eliminated.

Question 5.
What will be the impact on market price and the quantity exchanged when:
(a) there is a rightward shift in the demand curve;
Answer:
Due to a rightward shift in the demand curve the market – price, as well as the quantity exchanged, will increase as shown in the following diagram.

(b) the demand curve is perfectly elastic and the supply curve shifts out;
Answer:
The demand curve being perfectly elastic, shifting out of the supply curve right (or left) leads to an increase (or decrease) in the quantity exchanged and no change in market price as shown below in the diagram.

(c) both the demand and supply decrease in the same proportion?
Answer:
The market price will be the same but the quantity exchanged will decrease as shown below in the diagram.

Question 6.
Explain price support.
Answer:
Price support has been laid on the price of such commodities as are covered under the price support measures, producers of these commodities need not set at price lower than the floor price fixed by the Govt.

In the figure, R is the equilibrium point determined by the intersection of demand and supply curves, OQ quantity is being supplied and demanded at OP price.

Suppose, the government decides to improve price support as already stated take the form of floor on price, floors could be fixed at a price

1. lower than the equilibrium price, say at OH,
2. equal to the equilibrium price, OP and
3. more than equilibrium price say at OK

1. If floor is less than equilibrium, it will have no effect on the market. At a lower price say OH, HZ quantity will be supplied the considers on the other hand, would be willing to pay higher price. The price will move upwards towards the equilibrium level.

2. If floor price equals to the equilibrium price OP, it will leave the market unaffected.

3. If floor price is more than the equilibrium price, it will need further attention. Suppose in fig, the government impose the price floor at OK unit. The equilibrium price OP would no longer be legally obtainable. Price must be raised to OK At the higher price OK quantity demanded will contract to KL. But at this price suppliers will be ready to supply KN quantity As a result, the surplus will emerge, surplus is shown by the segment ZN. This surplus may be purchased by the government.

We reach the following conclusions about the effect of price support in a free market.

A consequence of price support:
Composition of floor price above equilibrium price will have following implications:
1. Surplus:
The quantity actually bought and supplied will shrink as a direct consequence price support, as a result, large chunk of producer’s stocks will remain unutilised.

2. Subsidies:
To offset the loss to the consumers the govt may undertake to subsidies the product. By subsidy, we mean that the government purchases the product at the support price and sells the product to consumer below its costs of procurement. The difference between cost and price is borne by the government.

Question 7.
Show the impact of price control and rationing on demand and supply
Answer:
The government has imposed price controls on number of commodities (eg. petrol, kerosene, etc) price control means that a ceiling has been imposed on the prices of such commodities as are covered under the price control measures. Producers of these commodities cannot charge prices higher the ceiling price fixed by government. Fixation of ceilings on price means that the free operation of those forces of demand and supply is being interfered with. Let us see what will happen in such situation.

In figure below, DD and SS are the original demand and supply curves respectively for a commodity. K is the equilibrium point, corresponding to which OQ quantity is being demanded and supplied at the price OP per unit.

suppose, the government decides to interfere with the free operation of the market forces i.e, it decides to impose price controls. Price control, take the form of ceiling on prices, ceiling could be fixed at price:

1. higher than the equilibrium price, say at OK
2. Equal to the equilibrium price, i.e. OP and
3. Less than the equilibrium price, say at OH.

1. If ceiling price is more than the equilibrium price, it will have no effect on the market-At a higher price, say OK, OT quantity of commodity will be demanded. The suppliers, on the other hand, would be waiting in the winds to supply more than the quantity being presently demanded. There will be tendency for the price to fall down to the equilibrium.

2. If ceiling price equals the equilibrium price OP, it will leave a market unaffected.

3. If ceiling price is less than the equilibrium price, it will create conditions which need our fiuther attention. Suppose, in the figure above the government impose ceiling at OH price per unit. The equilibrium price OP, would no longer be logically obtainable. Price must be reduced from OP to OH. At the lower price OH quantity demanded will expand to NH or O W. But at this reduced price, supplies will ready to supply only HL or OT quantity of goods.

As a result, a shortage of this commodity will emerge. This shortage is being represented by the line segment LN.

We reach the folio whig conclusions about the affect of price control in a free market.
1. Shortages:
The quantity actually sold and brought in the market will become less and hence price, will rise and many consumers will go unsatisfied.

2. Problem of allocation of limited supplies among large number of consumers:
In case of shortage of commodities, the scarce product may be disturbed on the basis of first come first served.

To avoid the problem of shortage, the government generally adopt price control with distribution controls. The most effective form of distribution control is rationing. Rationing is ceiling imposed on the quantity which can be bought and consumed by the consumer.

3. Black marketing:
Black marketing is a direct consequence of price controls. Black marketing implies a situation in which the controlled commodity is sold unlawfully below the desk, at a price higher than the lawfully enforced ceiling price.

Question 8.
Equilibrium price may or may not change with shifts in both demand and supply curves. Comment.
OR
Market for a demand is in equilibrium. There is simultaneous increase both in demand and supply of the good. Explain its effect on market price.
OR
Market for a good is in equilibrium. There h simultaneous decrease in demand and supply of the good. Explain its effect on market price.
Answer:
With shifts in both demand and supply curves, equilibrium price many change or may not change. It depends upon the proportion by which these two curves change. First shall discuss these situations under which equilibrium price change and then the situation under which equilibrium price change and than the situation under which equilibrium price does not change.

Case: 1: Equilibrium price changes:
1. Equilibrium price changes when increase in supply is by a higher proportion as compared to the increase in demand show in the diagram.

2. The equilibrium price increases when increases when the increase in supply is by a smaller proportion as compared to the increase in demand as shown below in the diagram.

3. The equilibrium price increases when both demand and supply decreases but supply decreases by a higher proportion as shown below in the diagram.

From the diagram, we come to know that the price increases from OP to OP₁

4. Equilibrium price decreases when both demand and supply decreases but a decrease in demand is more than decrease

From the diagram, we come to know that the equilibrium price decreases from OP to OP₁

Case: 2
No change in equilibrium price.
1. The equilibrium price does not change if both the demand and supply increase by the same proportion as shown below in the diagram:

From the diagram we come to know that equilibrium price remained unchanged,

2. The equilibrium price does not change when both demand and supply decrease, by same proportion as shown below in the diagram:

Question 9.
Explain monopoly firm’s equilibrium with the help of marginal revenue and marginal cost approach.
Answer:
Monopoly firm’s equilibrium with the help of MR and MC approach: There are two necessary conditions that must be fulfilled for a firm to be in equilibrium are:

1. MC = MR
2. MC should cut MR from below

In the figure, the Average Cost (AC) Average Variable Cost (AVC) and Marginal Cost (MC) curves are drawn along with the demand (Average revenle) wive and marginal revenue curve.

Form the diagram we come to know that at quantity level below q(|. The level of MR is higher than the level of MC. This means that the increase in total revenue from selling an extra unit of the commodity is greater than the increase in total cost for producing the additional unit.

This implies that an additional unit of output would create additional profits since change in profit is the change in TR, change in TC. Therefore if the firm producing at a level of output since that would add to its profits. As long as the MR curve lies above the MC curve, the firm would increase its output. This process comes to a halt when the firm reaches an output level of qt since at this MR equal to MC and increasing output would provides no increase in profits.

Question 10.
Calculate the value of AR from the TR curve graphically
Answer:
In order to calculate (find) the value of AR from the TR curve for any level of quantity sold, construct a figure as given below.

Suppose we have to calculate the value of AR of 6 units sold. In this case draw a vertical line passing through the value 6 on the horizontal axis. This will cut the TR curve at the point marked ‘a’ at a height equal to 42. The scope of this ray from the orgin to a point or the TR provides the value of Ar. The slope of this ray is equal to 7. Therefore Ar has the value of 7.

Question 11.
From the data given below, calculate the value of AR of 6 units arithmetically and geometrically / graphically.

Answer:
Calculation of AR arithmetically
AR = \(\frac{\mathrm{TR}}{\text { Units }}=\frac{42}{6}\) = 7

Question 12.
Demand function is iven by the equation q = 20 – 2P
Make prices and revenue table with the values of q from 0 to 13.
Answer:
Substituting q = 20 – 2p
or
2p = 20 – q
or
P = 10 – 0.5
Substituting different values of q from 0 to 13 we get the prices from 0 to 3.5. These are shown in the q and p column

Question 13.
Explain monopoly firm’s equilibrium with that help of total curves.
OR
Explain a monopoly firm’s equilibrium with the help of total cost and total revenue curves.
Answer:
Monopoly firm’s equilibrium with the help of total cost and total Revenue curves. A firms will be in equilibrium with when it earns maximum profits. A firm will obtain maximum profits at the level of output where the vertical distance between total revenue and total cost ins maximum. It has been explain below the help of following diagram.

In the fig. output is measured on X-axis while cost and revenue on X-axis TR and TC and the total revenue curve and total cost curve responsibility. The profits received by the firm figure, we are that equals the total Revenue mihus the total cost in the figure, we see that if quantity q is one produced that total revenue is TR, and the cost is TC₁.

The difference TR₁ – TC₁ is the profit receives the same is depicted by the length of the Line segment AB i.e. The vertical difference between TR and TC curves at q. Level of output. It should be clear that this vertical distance changes for different levels of output. When output level is different levels of output when output level is les than th q₂ The TC curve lies above the TR cure i.e. TC is greater than TR and therefore profit negative and the firm makes lossess.

• The same situation exists for output level greater than q3 Hence the firm can make positive profits only at the output level between q₂ and q₃ where TR curve tees above the T curve. The monopoly firm will be chosen that level of output which maximums is profit. This would be level of output for which the verticals.

Forms of Market and price determination distance between Tr and TC is maximum and TR is above the TC i.e, the TR – TC is maximum. This occurs the level of output q. It is noticed that the profit curve has its maximum value at the level of output q₀.

The price at which this output is sold is the price consumers are willing to pay for this q₀. Quantity of the commodity. So the monopoly firm will charge the price corresponding to the quantity level q₀ on the demand curve.

Question 14.
Write down the features of oligopoly.
Answer:
Features of oligopoly: Following are main feature of oligopoly.
1. Few sellers: The numbers of sellers is the very less in oligopoly. The number of sellers is so small that every seller controls a large share of total market supply by his activities. He also influence other sellers activities and price of the commodity.

2. Nature of products: Products in an oligopoly are may be either homogenous or differentiated.

3. Interdependence: The firms in an oligopoly are interdependent in decision making, This is due to fact that any change in price-output product etc by a firm will have a direct effect on the fortune of its rivals. The rival firms will the react by changing there own prices, output, products as the case may be. It is clear that while taking any decision, a firm must consider not only the market demand for the industries product but also the reactions of the other firms in the industry to any action or decision it may takes.

4. Importance of advertising and selling cost: Due to server competition and interdependence of the firm various sales promotional technique are used in Oligopoly. Selling cost are more important in this type of market.

5. Entry barriers: There are many entry barriers in Oligopoly some of them are patents requirements of large capital control or over curial raw materials etc.

6. Non-price competition: Firms under Oligopoly try to avoid price compeition for the fear of price war. They use other methods like advertis in better services to customers etc to compete with each other.

7. Price – rigidity: Under Oligopoly the firms follow the policy of the price rigidity. Price rigidity refers to situation in which price tends to slay fixed irrespective of changes in demand and supply conditions.

8. Kinked demand curve: Under Oligopoly, the demand curve is indeterminate. No firm can be certain of demand for its product due to unsure reaction of rival firm.

9. Types of Oligopoly: Oligopoly is brodly divided into two types:

1. Collusive Oligopoly &
2. Non-collusive Oligopoly.

Under collusive oligopoly firms collude to forma cartel. The cartel follows common phases relating to price, outputs, profit maximisation and distribution of products.

Question 15.
Distinguish between collusive and non – collusive Oligopoly. Explain how the Oligopoly firms are interdependent in taking price and output decisions. Difference between collusive and non – collusive Oligopoly:
Answer:
There are two types of Oligopoly: Collusive and non-collusive. In collusive Oligopoly, the firms (which are few) decide to avoid competition through a formal agreement. They collude to form a cartel. They fix for themselves output quota and market price. Sometimes a leading firm in the market is accepted by cartel as a price leader.

Interdependence in taking price and output decisions:
In an Oligopoly, there is a lot of interdependence in taking price and output devisions. The reason is that number of firms in Oligopoly is a few. Any change in price, output, product etc. by any firm will have a direct effect on the fortune of its rivals. Hence a monopolist firm must consider not only the market demand for the industry product but also the reactions of the other firms in the industry to any action of decision it may take.

Exercises

Question 1.
Explain Market equilibrium.
OR
Define equilibrium. When is a market said to be in equilibrium?
Answer:
Equilibrium: An equilibrium is a situation where there is no tendency for any change. In case of supply and demand, under equilibrium no tendency for any change. In case of supply and demand, under equilibrium, no one has incentive to change either the quantity demanded or supplied and neither there is any tendency for the price to change.

Market equilibrium: Market is said to be equilibrium when the aggregate quantity that all firms wish to sell equals the quantity that all other words market supply equals market demand. Therefore, in equilibrium: y – y8 Where y and ys denote the market demand and market supply of the commodity respectively. The equilibrium market has zero excess demand and zero excess supply situation.

Question 2.
When do we say there is excess demand for a commodity in the market?
Answer:
If at any price, market demand is greater than market supply we say that there is excess demand in the market at that price.

Question 3.
When do we say there is excess supply for a commodity in the market?
Answer:
If at any price market supply is greater than market demand, we say that there is excess supply in the market at the price.

Question 4.
What will happen if the price prevailing in the market is:
(a) above the equilibrium price
Answer:
In this case, many more firms will enter the market realising that they can earn higher profit here than elsewhere. As a result, at prevailing price, there will be excess supply in the market price and the market price will be equal to the equilibrium price.

(b) below the equilibrium price.
Answer:
In this case many firms who are incurring losses will exit the industry. As a result at prevailing price, there will be excess demand. The excess demand will raise the market price and the market price will be equal to the equilibrium price.

Question 5.
Explain how price is determined in a perfectly competitive market with fixed number of firms.
Or
How is the equilibrium price of a commodity deterimed by demand for supply of a commodity?
Or
Demand and supply are like two blades of pair of scissors’. Explain with reference to equilibrium price.
Answer:
There was a dispute among the earliest economists as to whether it is supply of a good or the demand for and supply of good or the demand for and supply of a commodity are equally important in determining the price of a product.

An eminent English economist Marshall compared the determination of price through demand and supply with the cutting of a piece of paper by the two blades of scissors, the upper and the lower ones. Both the blades are required to do the cutting work. Similarly, both demand and the supply of a good are essential factors for determining its prices.

Equilibrium price: Equilibrium price is the price at which quantity demand of a good equals quantity supplied of it and there is no tendency for the price to rise or fall. At this equilibrium price, the two forces of demand and supply exactly balance each other and therefore there is neither surplus nor shortage of the commodity at this price.

Determination of equilibrium price:
Let us explain how demand for a supply of a commodity determines its equilibrium price. The demand curve of a commodity slope downward. In other words, with an M of price the quantity demanded increases and vice versa. On the other hand, the supply curve of a commodity slopes upward to right. In figure, above the demand curve DD and supply curve SS intersect at point E at which price is OP and quantity demanded and supplied is OQ.

The level of price OP at which demand and supply curve intersect each other will finally come to stay in the market. In other words, the price OP which will come to prevail in market, one at which quantity demanded is equal to quantity supplied. The price OP at which quantity demanded is equal to quantity supplied is therefore equilibrium price because at this price the two forces of demand and supply exactly balance each other. The quantity. OQ of the goods which is purchased and sold at this equilibrium amount. Thus, the intersection of demand and supply curves determines both equilibrium price and quantity.

If Price is greater or less than the equilibrium price, the buyers and sellers, whishes would be inconsistennt. Thus, at any price greater or less than the equilibrium price OP either the buyers would demand more than offered by sellers, or the sellers would be ready to supply more than is determined by the buyers. If price of OH, which is greater than the equilibrium price, it will be seen from the figure that the quantity supplied exceeds quantity demanded.

As a result, surplus of the commodity equal to AB Emerges. It means some of the sellers will not be able to sell the amount of goods they want to supply. The unsatisfied sellers would try to dispose of the unsold amount of the goods by bidding price down. The price will go on declining till OP is reached at which the quantity demanded equals quantity supplied.

On the other hand, if price i s fewer than the equilibrium price, say it is OL, the quantity demanded exceeds quantity supplied. As a result, shortage of the commodity equal to GK appears. As a result, some buyers would not be able to obtain the amount of the goods they want to purchase at prevailing price. They will therefore bid up price in their effort to get all that they desire to buy. The price will go on rising till OP is reached where the quantity demanded and quantity supplied are again equal. We thus see that price which we settle down can be neither greater nor less than the equilibrium price. It is an equilibrium price which will finally come to stay in the market.

Question 6.
Suppose the price at which equilibrium is attained above the minimum average cost of the firms constituting the market. Now if we allow for free entry and exit of firms, how will the market price adjust to it?
Answer:
When equilibrium price at equilibrium quantity is more than the minimum average cost: When the price at the equilibrium quantity is more than minimum average cost then there will be abnormal profit. In this case, immediately many more firms will enter the market realising that they can earn higher profit here than elsewhere. As a result at this price there would be excess supply in the market.

This excess supply will lead the firms to lower their prices that they can sell off their entire output. If at this lowered price, the abnormal profit is still positive more firms will enter the market, but the entry will not stop. The entry of new firms will continue as long as the existing firms are earning an abnormal profit of the lower price. Entry of new firms will stop when the price is equal to minimum average cost of each firm.

Question 7.
At what level of price do the firms in a perfectly competitive market supply when free entry and exit is allowed in the market? How is equilibrium quantity determined in such a market?
Answer:
In perfectly competitive market, the firms will supply at a price which will be equal to minimum average cost. Allowing for entry and exit will imply that the market price will always be equal to the minimum average cost and the equilibrium price will be
P = MinAVC

Determination of equilibrium demanded: The equilibrium demanded is determined at that intersection of the market demand curve with the price line P0 = min AC as shown in the diagram.

In diagram, PQ is minimum AC curve DD is the demand curve which intersect Min AC curve at E. Draw EY₀ ⊥ to OX axis. So OY° is the equilibrium quantity.

Question 8.
How is the equilibrium number of firms determined in a market when entry and exit is permitted?
Answer:
The equilibrium number of firms in the market is determined by dividing the total quantity demanded and supplied by the firm equation.
n° = \(\frac{\mathrm{y}^{0}}{\mathrm{y}^{0} \mathrm{f}}\)

1. n° stands for equilibrium number of firms.
2. y° stands quantity demanded and supplied at the equilibrium price.
3. y°f stands for quantity supplied by each firm.

Suppose total quantity demanded and supplied at equilibrium price is 180 units and each firm supplies 30 units then equilibrium number of firms will be calculated as under:
n = \(\frac{\mathrm{y}^{0}}{\mathrm{y}^{0} \mathrm{f}}=\frac{180}{30}\) = 6

Question 9.
How are the equilibrium price and quantity affected when income of the consumers
(a) increase?
(b) decrease?
Answer:
Effect of Increase in Income on Equilibrium Price and Quantity
The equilibrium price and quantity will increase with increase in income of the consumer as shown in the diagram.

Effect of decrease in income on equilibrium price and quantity :
With the decrease in income the demand will fall resulting in shifting of demand curve on the left side. The shifting of demand curve to the left side will decrease the equilibrium price and quantity as shown in the diagram are those which are used together. Now the price of the shoes increase resulting with fell in demand for shoes as shown in the diagram

Question 10.
Using supply and demand curves, show how an increase in the price of shoes affects the price of a pair of socks and the number of pairs of socks bought and sold.
Answer:
Effect of increase in price of shoes on the price of socks and the number of socks bought and sold: Shoes and socks are complementary goods. Complementary goods are those which are used together. Now the price of the shoes increase resulting with the in-demand for shoes as shown in the diagram.

With the fell in the demand for shoes, the demand for socks also fall. With the fell in the demand for socks, the price of socks will decrease as shown be tow in the diagram.

Question 11.
How will a change in price of coffee affect the equilibrium price of tea? Explain the effect on equilibrium quantity also through a diagram.
Answer:
Effect of change in price of coffee on the equilibrium price of tea and quantity: Tea and coffee are substitute goods which can be used in place of each other. There exists a direct relationship between the price and demand of substitute goods. So the increase in price of coffee will increase demand for tea.

The demand curve will shift to right direction as shown above in the diagram. Now new demand curve which intersect supply curve SS at E. Hence new equilibrium price and quantity are OPj and OQj respectively. Hence, the equilibrium price and quantity of tea will rise.

Now suppose the price of the coffee decreases resulting into increase in demand for coffee. It will cause fell in demand for tea. So the demand curve will shift leftwards as shown in the diagram. With the shifting of demand curve towards left, the equilibrium price and quantity will fell as shown in the diagram.

Now DD₁ is new demand curve that intersects SS supply curve at E₁S₀. New equilibrium price and quantity OP₁ (Less than OP) and OQ₁ (less than OQ). Hence there will be fall in equilibrium price and quantity of tea.

Question 12.
How do the equilibrium price and quantity of a commodity change when price of input used in its production changes?
Answer:
Impact of change in prices of the input used in the production of a commodity on its equilibrium price and quantity:
If the price of inputs decrease, the marginal cost would fall. Therefore, the supply curve would shift to the right. With the rightward shifting of the supply curve, the equilibrium price will fall and quantity will increase as shown below in the diagram.

Now the equilibrium price is P₁ mislead of P and quantity OQ₁ in place of OQ₁

On the other hand if the price of inputs increases then the cost of production or marginal cost would rise. Therefore, the supply curve would shift to the left with the leftward shifting of the supply curve, the equilibrium price

will rise and the quantity of the commodity willful as shown in the diagram.

Question 13.
If the price of a substitute(Y) of good X increases, what impact does it have on the equilibrium price and quantity of good X?
Answer:
If the price of the Y (substitute of good X) increses, its demand will fall and people will start consuming its substitute goods X. Thus the demand for X goods will increase. With the increase in demand for goods X, its demand curve will shift rightwards. With the rightward shifting of demand curve, both the equilibrium price and quantity will increases shown in the diagram.

Question 14.
Compare the effect of shift in demand curve on the equilibrium when the number of firms in the market is fixed with the situation when entry-exit is permitted.
Answer:
Comparision: When the demand curve shifts to right, there will be increase in the equilibrium price when the number of firms is fixed in the market as shown in the figure. On the other hand, if the demand curve shifts-to the left the price will fall as shown in the figure. There will be no increase or decrease in the supply as the number of firms are fixed and there is barrier on the entry and exit of firms.


Now we take that market where entry and exit is permitted. We know that when we permit free entry and exit from the market, then the market at equilibrium always delivers output at minimum average cost of existing firm. Under this condition, even if the demand curve shifts in either direction, at equilibrium the market will supply the desired quantity at the same price in the diagram. In figure, DD₀ is the market demand curve which tells us the quantity demanded by consumers at various prices and P₀ denotes the price at which is equal to minimum average cost of the firms who are still is the market after entry-exit adjustment has been taken place. The initial equilibrium is at point E where the demand curve DD₀ cuts the PQ = min AC line and the total quantity demanded and supplied is Y₀.

Now suppose the demand curve shifts to the right. At price P0, there will be excess demand for the commodity which will push the price up. But the market will be in equilibrium only at PQ. So new firms must enter the market supply this additional demand P and pull the price back to PQ. In the diagram with the new demand curve DD, the equilibrium quantity is Y₁ but the equilibrium price is still PQ. But since the equilibrium can be restored only at P₀ Price, the supply must be eliminated through the exit of some existing firms which will push the price back to PQ. Therefore, at the new equilibrium quantity demanded and supplied will decrease Y₂ whereas the price will remain unchanged at P₀. Now fixed the number of firms will be less.

Conclusion:
In the end, we can say that with entry and exit, shift in demand has a larger effect on quantity than it does with the fixed number of firms. But unlike with a fixed number of firm; here we do not have any effect on equilibrium price.

Question 15.
Ejqdain through a diagram the effect of a rightward shift of both the demand and supply curves on equilibrium price and quantity.
Or
What happens to the equilibrium price and equilibrium quantity of a commodity sold in market when its supply increase (i.e. supply curve shifts downward) while the demand curve remains unchanged.
Answer:

Here, we explain the impact of increase in supply on price and output of a commodity ^ when the demand for commodity remains the same. Suppose in the year there is good monsoon in India yielding bumper crop of wheat. This will increase the supply of wheat in the market causing a shift in its supply curve to the right. This impact of the increase in supply of wheat in the market causing a shift in its suply curve to the right. This impact of increase in supply of wheat on equilibrium price and quantity is graphically depicted in the figure.

Originally demand curve DD and supply curve SS of wheat intersect at point E and determines the equilibrium price of OP and equilibrium quantity OQ exchanged between sellers and buyers. Now due to good monsoon resulting in bumper crop of wheat and causing the supply curve of wheat to shift to the right from SS to the new poition S₁S₁ The new supply curve DD at point E₁ at which the new lower equilibrium price OP and larger equihbrium quantity are determined. Thus, the increase in supply and consequently a rightward shift in the supply curve leads to fell inprice and an increase in equilibrium quantity.

Question 16.
How are the equilibrium price and quantity affected when,
(a) Do both demand and supply curves shift in the same direction?
Answer:

Effect of shifting demand and supply curves ¡n the same direction on the equilibrium price and quantity: Demand and supply curves may shift to rightwards or to leftwards. Suppose demand and supply curves both shift rightwards then the quantity will increase but the equilibrium price may increase, decrease or remain unchanged depending on the ratio between increase in demand and supply increases the same rate, then equilibrium price remains unchanged as shown in diagram.

(b) demand and supply curves shift in opposite directions?
Answer:
If the shift of the demand curve in leftward and that of supply curve in rightward, then the equilibrium price will decrease and the quantity may increase, decrease or remains unchanged as shown below in the diagram. On the other hand if the demand curve thifts rightward and the supply curve shifts leftward then equilibrium price increase, but the quantity may increase, decrease or remain unchanged as shown below in the diagram:

Question 17.
In what respect do the supply and demand curves in the labour market differ from those in the goods market?
Answer:
Difference between supply and demand curves in the labour market and supply and demand curves in goods market: The wages of labourers and prices of goods are determined following a similar mechanism under the forces of demand of supply the basic difference of labour market from the goods market is with respect to the sources of supply and demand. In the goods market, demand comes from household and the firms are suppliers. But in the labour market, households are the suppliers of labour and demand comes from firm. In goods market goods means quantity of goods whereas in labour market labour means the hours of work provided by the labourers and not the number of labourers.

Question 18.
How is the optimal amount of labour determined in a perfectly competitive market?
Answer:
Condition for optimal amount of labour determined in a perfectly compe
tive market : In the labour market, the demand for labour comes from firms. Hereby labour we mean the hours of work provided by the labourers and not the number of labourer. The main motive of each firm is to have the maximum profit. It can earn the maximum profit, if following condition is fulfilled.
W = MRPL
Where, MRPL = MR × MPL.

In perfectly competitive market marginal revenue is equal to price and price is equal to the value of marginal product (VMPL) hence, the condition for the optimal choice of labour is the equality between VMPL and the wage rate. As long as VMPL is greater than the wage rate, the firm will earn more profit by hiring more labour and the firm can increase its profit by reducing the labour employed at any level of labour employment. VMPL is less than the wage rate.

Question 19.
How is the wage rate determined in a perfectly competitive labour market?
Answer:
Determination of wage rate is perfectly labour market: In the labour market households are the suppliers of labour and the demand for labour comes from firms. By labour we mean the hours of work provided by the labourers and not the number of labourer. The wage is determined at the intersection of the demand and supply curve of labour where the demand for and supply of labour balanced.

Here we assume that labour is the only variable factor of production and the labour market is perfectly competitive i.e. each firm takes wages as given. Every firm’s goal is to get the maximum profit. We also assume that the technology of the firm is given and law of diminishing marginal products holds.

As the goal of each firm is given to have maximum profit, so it will always employ labour .upto the point. Where the extra cost incurs for the last labour is equal to the additional benefit it earns from employing the labour. The extra cost of hiring one more labour is the wage rate (W).

The extra output produced by one more labour is the wage rate (W). The extra output produced by one more labour is its marginal product (MPl) and by selling each extra unit of output, the addtional earning of the firm is the marginal revenue (MR) he gets from that unit. Therefore, for each extra unit of labour, it gets a benefit equal to the marginal revenue times marginal product which is called marginal revenue product of labour (MRPL).

Thus firm employes labour upto a point where
W = MRPL
Where, MRPL = MR × MPL

Question 20.
Can you think of any commodity on which price ceiling is imposed in India?
What may be the consequence of price-ceiling?
Answer:
Yes, there is price ceiling on wheat, rice, sugar, kerosene etc.

The government fixes the price lower than the equilibrium price. It will lead to exess demand. It means there is shortage of supply at the control price. There will be some buyers who are willing to pay a higher price than the control price. It will lead to black marketing.

Question 21.
A shift in demand curve has a larger effect on price and smaller effect on quantity when the number of firms is fixed compared to the situation when free entry and exit is permitted. Explain.
Answer:
With the shift in demand curve there is a great change in the price of the goods, but less effect on the quantity. Suppose the demand curve shift rightwards. In this case, there will be great increase in the price, but quantity will be affected as shown in the diagram.

The reason is that the number of firms are fixed. The fixed number of firms can increase production a little. Due to increase in demand the price will rise high as compared to rise in the quantity. But with the rise in price (rise in profit), more firms will enter the industry-leading to increse in the quantity supplied. The entry ofnew firms into the industry will continue till the current price lowers to the equilibrium price. Hence in the market with free entry and exist, the rightward shift of the demand curve, the price will be less affected and quantity will be much affected.

Question 22.
Suppose the demand and supply curve of commodity X in a perfectly competitive market are given by:
q^d = 700 – p
q^s = 500 + 3p for p ≥ 15
= 0 for 0 ≤ p < 15
Assume that the market consists of identical firms. Identify the reason behind the market supply of commodity X being zero at any price less than Rs 15.
What will be the equilibrium price for this commodity? At equilibrium, what quantity of X will be produced?
Answer:
In the question q^d and qs denote the demand and supply respectively and P denotes the price of commodity X, when its price is below Rs. 15. We know that the firms produce a positive quantity of output only when the price is below minium AVC, they produce nothing. Therefore, the minimum average cost of producing commodity X is Rs. 15. Here the price is Rs. 15. At equilibrium from the supply curve we get the quantity of supply. At equilibrium price
q^d = q^s
700 – P = 500 + 3P
Or
– 4P = -200
P = 50
Hence equilibrium price = Rs. 50
Equilibrium price = Rs, 50
Equilibrium quantity=700 – P
= 700 – 50 = 650

Question 23.
Considering the same demand curve as in exercise 22, now let us allow for free entry and exit of the firms producing commodity X- Also assume the market consists of identical firms producing commodity X. Let the supply curve of a single, firm be explained as
q^s = 8 + 3p for p ≤ 20
= 0 for 0 ≤ p < 20
(a) What is the significance of p = 20?
(b) At what price will the market for X be in equilibrium? State the reason for your answer.
(c) Calculate the equilibrium quantity and number of firms.
Answer:
Significance of P = 20 is that the equilibrium price determined by market demand and market supply forces.

At the price of Rs. 20, the market for X will be in equilibrium.

Equilibrium quantity = 700 – P
= 700 – 20 = 680
Quantity produced by a firms = 8 + (3 × 20) = 68
No. of firms = \(\frac{680}{68}\) = 10

Question 24.
Suppose the demand and supply curves of salt are given by:
q^d = 1,000 – p
q^s = 700 + 2p
(a) Find the equilibrium price and quantity.
(b) Now suppose that the price of an input used to produce salt has increased so that the new supply curve is
How do the equilibrium price and quantity change? Does the change confirm your expectation?
(c) Suppose the government has imposed a tax of Rs. 3 per unit of sale of salt. How does it affect the equilibrium price and quantity?
Answer:
(a) At the equilibrium price, the demand is equal to supply. Hence q^d = q^s.
Or
1000 – P = 700 + 2P
Or
-P – 2P = 700 – 1000
Or
-3P = -300
P = 100
Hence equilibrium price = Rs. 100
Equilibrium quantity = 1000 – P = 1000 100 = 900
Equilibrium quantity = 700 + 2p = 700 + 200 = 900

(b) Now 1000 – p(q^d) = 400 + 2p(q^s)
Or
-p – 2p = 400 – 1000
Or
-3p = -600
Or
P = \(\frac{600}{3}\) = 200
Hence, equilibrium price = Rs. 200
Equilibrium quantity=400 + 2p = 400 + 400 = 800 Units.
Increase in price = 200 – 100 = Rs. 100
Decrease in quantity=900 – 800-100

(c) The supply curve will shift to its leftwards.

Question 25.
Suppose the market-determined rent for apartments is too high for common people to afford. If the government comes forward to help those seeking apartments on rent by imposing control on rent, what impact will it have on the market for apartments? Impact on the market for apartments:
Answer:

1. The consumers will get inferior quality houses. This is because the builders getting lower price will in turn produce low quantity goods in order to reduce their cost of production.
2. Due to rent control, there will be excess demand for apartments. Every person desiring of having apartments will not be able to get the apartment on rent. There will be a long waiting list.
3. Since all the persons seeking apartments on rent control will not get the apartments, some of them will be willing to pay higher rent for the apartments. As a result there will be black marketing for apartments on rent.

2nd PUC Economics Important Questions with Answers

Karnataka 2nd PUC Economics Important Questions Chapter 4 The Theory of The Firm and Perfect Competition

Very Short Answer Type Questions

Question 1.
What is market?
Answer:
In Ecnomics ‘Market’ refers to an arrangement where buyers (consumers) and sellers (firms) come in contact with each other directly or indirectly to buy or sell the goods.

Question 2.
Who is a price taker?
Answer:
A “firm” is called as price taker in perfect competition.

Question 3.
What do you mean by revenue?
Answer:
The revenue refers to the money received by a firm from the sale of a given quantity of commodity in the market.

Question 4.
How do you calculate the average revenue?
Answer:
The average revenue can be calculated as
AR = \(\frac{\text { Total Revenue }}{\text { q (Number of Unit Sold) }}\)

Question 5.
Give the meaning of supply?
Answer:
The term supply means the quantity of a commodity offered for sale at a given price at a given period of time.

Question 6.
Write the formula to calculate the price elasticity of supply?
Answer:
Price elasticity supply = \(\frac{\text { proportionate change in supply }}{\text { Proportionate change in price }}\)

Question 7.
MR = TR -?
Answer:
MR = TR_n – TR_n-1

Question 8.
What is meant by price mechanism?
Answer:
The process of determination of price by supply and demand forces is called a price mechanism.

Question 9.
What is equilibrium?
Answer:
Equilibrium means a state of position of rest or state of balance.

Question 10.
What do you mean by equilibrium price?
Answer:
Equilibrium price refers to where quantity of demand and supply will be equal, where both the buyer’s and seller’s objectives are satisfied.

Question 11.
Can MR be negative or zero?
Answer:
Yes, MR can be zero or negative.

Question 12.
What is price line?
Answer:
Price line is the same as AR line and is horizontal to x axis in perfect competition.

Question 13.
Define perfect competition?
Answer:
Perfect competition is a market with large number of buyers and sellers, selling homogeneous product at same price.

Question 14.
What do you mean by abnormal profit?
Answer:
It is the situation for the firm when TR > TC.

Question 15.
Why AR is equal to MR under perfect competition?
Answer:
AR is equal to MR under perfect competition because price is constant.

Question 16.
What is normal profit?
Answer:
Normal profit is the minimum amount of profit which is required to keep an entreprenuer in production in the long run.

Question 17.
What is the break-even price?
Answer:
In a perfectly competetive market, the break-even price is the price at which a firm earns normal proifit (Price = AC).
In the long run, Break – even price is that price where P = AR = MC.

Question 18.
What are advertisement costs?
Answer:
Advertisement cost are the expenditure incured by a firm for the promotion of its sales such as Publicity through TV, Radio, News paper, Magazine’s and Internet etc…

Question 19.
What is short period?
Answer:
Short period refers to that much time period when quantity of output can be changed only by changing the quantity of variable input and fined factors remaining same.

Question 20.
Define long period?
Answer:
Long-period refers to that much time period available to a firm in which it can increase its output by changing its fixed and variable inputs.

Short Answer Type Questions

Question 1.
Distinguish between firm and industry?
Answer:
Firm:

• Firm is a single unit of an industry.
• Each firm is a price taker in perfect competitioa
• Existence only one firm.
• No separete rules and regualtions are formulated for a firm.

Industry:

• Where the industry is a major unit that consists of many small firms.
• Whare an industry is a price maker in perfect competition.
• There can be many firms in one industry.
• Rules and regulations are made for the industry.

Question 2.
Write the three essentials of a market?
Answer:
The three essentials of a market are as follows:

1. Existence of buyers and sellers.
2. Commodity which is dealt with.
3. Prevalance of a price.

Question 3.
List the determinant elements of market structure?
Answer:

1. The number of firms producing a product.
2. Nature of the products – homogenous or heterogenous.
3. A firm’s freedom to enter and exit from the industry.

Question 4.
A firm in a perfect competitive market is a price – taker? Why?
Answer:
Because no single firm is in a position to influence the price level. Each firm must accept the existing market price hence a firm will be a price taker.

Question 5.
What is meant by shut down point?
Answer:
The point where SMC curve cuts AVC curve at the minimum is called the short run shut down point of the firm.

Question 6.
Name any four determinants of supply?
Answer:
The four determinants of supply are:

1. Technological progress.
2. Input prices.
3. Tax policy of the government.
4. Climatic conditions.

Question 7.
State the law of supply?
Answer:
According to the law of supply other things remaining the same, as the price of commodity increases its supply increases and as the price decreases the supply also decreases.

Question 8.
If the price of potato increases from Rs 25 per kg, the quantity offered for sale in the market increases from 100kg to 120 kg. Find the price elasticity of supply.
Answer:

Question 9.
What is invsible hand, according to Adam smith?
Answer:
Adam smith calls price mechanism as ‘Invisible hand’ is always at work, if there is any imbalance it directs and guides both producers and the consumer equilibrium.

Long Answer Type Questions

Question 1.
Why is the average revenue of a firm under perfect competition paralled to x – axis & negatively sloped under monopoly?
Answer:
Shape of average revenue curve under perfect competition:
The price of commodity is determined by the force ofdemand & supply. It is determined by the industry. No industrial firm can make its own price. A firm can sell any amount of the commodity at this price as it is price taker instead of price maker. The marginal revenue equals their average revenue and their curves co inside as it is clear from the following schedule and figure.


Shape of AR curve under monopoly in this a firm can cell more by lowering the price of its output. Thus the firm will have a down ward sloping curve. AR and MR curve would be downward sloping but less elastic. It can be explained with the help of the following table and figure:


A monopoly firm has a less elastic down ward sloping AR curve meaning there by that when such a firm raises the price of its product, demand falls less than proportionetly.

Shape of AR are under monopolistic competition demand (AR) curve of a firm in the monopolistic competition is also negetively sloped indicating that a large amount of the commodity can be sold only at a lower price. In the other words average revenue curve under monopolistic competition is similar to that under monopoly as shown below with the help of a table and a diagram.


(An average curve in a single diagram- Average revenue curves under diflrent market situations have been shown in a single diagram. In perfect competition AR is perfectly elastic.In monopoly it is less elastic & more in monopolistic competition.

Question 2.
Explain producer’s equilibrium with the help of marginal cost & marginal revenue schedule.
Answer:
Producer’s equilibrium: AProducer is at equilibrium when two following conditions are satisfied.

1. Marginal revenue and marginal cost
2. Marginal cost must be increasing at profit maximizing output.

Producers equilibrium has been explained with the help of marginal cost and marginal revenue schedule.

In the above table, MR (Price) is equal to marginal cost at two output units viz 2 units & 6 units. But the producer will be at equlibrium at the level of output which marginal cost increases after being equal to MR. Hence producer will be at equilibrium at 6th output level.

Question 3.
What do you mean by supply? Explain the law of supply schedule & supply curve.
Answer:
Supply : Supply is a quantity of a commodity which a firm is willing to see in the market in a given period of time at a ,given price.

Factors considered constant: Factors like goods of a firm, the price of other commodities, state of technology, prices of factors of production, nature of commodity are considered constatnt while explaining the law of supply.

This can be shown with the help of a schedule
Induvidual schedule supply


The supply schedule & supply curve stated above show that the quantity supplied is increased with rise in price fall with Ms in the price of commodity.

Question 4.
Why does the supply curve slope upwards?
Answer:
Reasons for supply curve sloping upwards: Following are the reasons for supply curve sloping or the operation of law of supply.
1. Rise in profit:
With the increase in the price of a commodity a firm’s profit rises. Consequently a firm produces more quantity of a commodity to increase its amount of profit.

2. Entry of new firms:
A rise in the price increases the profit Increase in profit attracts new firms to enter the industry & adds to the supply of commodity.

3. Keeping low stock:
The increase in price of a commodity induces the sellers to keep a least stock and sell more.

Question 5.
Write down the causes for the increase and decrease in the supply.
Answer:
Causes for increase in supply:

• Fall in the remuneration of factors of production.
• Improvement in technology.
• Change in the good of production.
• Taxation policy of the government.
• Fall in the prices of the other commodities.
• Increase in subsidies.

Causes in decrease in supply

• Rise in the prices of other commodities.
• Rise in the remuneration of factor of production.
• Technology becoming outdated.
• Change in the objectives of producers.
• Taxation policy of goods.
• Decrease in subsidies.

Question 6.
How many methods are there to estimate the elasticity of supply? Explain any one method.
Answer:
There are two methods of measuring elasticity of supply:

1. Proportional method &
2. Geometric method

Geometric method of measuring elasticity of supply: Under this method apoint is taken on the straight line supply curve and is extended to meet the x-axis. Then the supply curve is extendd to meet the x-axis. This distance is divided by the quantity supplied. The quotient will be elasticity of supply. It is mainly explained by taking three different curves.

• In figure a, price elasticity of supply at point A = BC/OC (BC) is distance and OC is quantity supplied.
  Here BC > OC Hence ES > 1
• In figure b, elasticity of supply at point A = BC/OC.
  Here BC=OC Hence Σs = 1
• In fig C, price elasticity of supply at point A= BC/OC
  Here BC< OC, Hence ES < 1

In short we can say that elasticity of supply on straight line supply curve is greater than unit that is ES>1. When the supply curve intersects X-Axus is in negetive range, it is equal to one when the supply curves passes through the origin and it is less than one when the supply curve intersects x-axis in the positive range.

Question 7.
Explain the various types (degrees) of price elasticity of supply.
Answer:
Types or degrees of price elasticity of supply: There are five types (degrees) of price elasticity of supply.
1. Perfectly elastic supply : When there is no change in the price of the commodity, but there is change in the quantity supplied this type of supply curve is obtained in those industries which produces goods under law of constant costs.

Price (Rs)	Quantity (units)
2	200
2	200

2. Perfectly ¡n elastic supply -When there is a change in the price of the commodity, but there is no change in the quantity supplied.

In this case elasticity of supply is zero (ES = 0)

Price (Rs)	Quantity (units)
2	100
3	100

Supply of perisable goods in short period is in elasticity.

3. Unit elasticity supply: (ES = 1): When the percentage change in the quantity supplied is equal to the pecentage change in price, the elasticity of supply is said to be unitary elasticity of supply. It forms an angle, of 450 It means price and supply change is the same proprtion.

Price (Rs)	Quantity (units)
2	100
4	200

4. More than unit elastic supply: In this case, rate of change in quantity offered is greater than rate of change in prce (ES > I)

Price (Rs)	Quantity (units)
2	100
3	200

5. Less than unit elastic supply : In this case, rate of change in quantity is smaller then rate of change in price.

Price (Rs)	Quantity (units)
2	100
4	140

Question 8.
Explain the various factors which affect magnitude of price elasticity Following factors affect the magnitude of price elasticity of supply.
Answer:
1. Nature of the commodity: Perisable commodities have an elastic supply, because their supply cannot be increased or decreased , even when price changes. Supply of durable goods is elastic, because their supply cannot be increased or decreased as a result of increase or decrease in price.

2. Cost of production: If production is subject to the law of increasing costs, then supply of such goods will be in elastic. It is difficult to extend supply due to rise in price.

3. Time: Longer the time period, greater will be the elasticity of supply. On the other hand shorter the time period, small will be the elasticity of supply.

4. Availability of facilites for expanding output: Elasticity of supply also depends on the availibihty of facilities for expanding output. Farmers cannot raise their agricultural output with rise in the price of that output of facilities like seeds, fertilizers or irrigation facilities for expansion are not available, in such a case price elasticity of supply will be less.

5. Risk-taking: The elasticity of supply depends on the willingness of enterpreneurs to take risk. If entrepreneurs are willing to take risk supply will be more elastic, on the other hand, if the enterpereneurs hesitate to take risk the supply will be in elastic.

Exercises

Question 1.
What are the characteristics of a perfectly competitive market?
Answer:
Characteristics of a perfectly competitive firm : following are main charecteristics of a perfectly competitive firm:
1. A large number of buyers & sellers: There are a large number of buyers and sellers of the commodity in this market. Each one of them and it cannot exert perceptible influence on prices.

2. Homogenous product; The output of each firm in the market is homogenous, identical or perfectly standardised. As a result, the buyer cannot distinguish between the output of one firm & that of another & is therefore, indiffrent to the particular firm which he buys.

3. Freedom of entry or exit: Entry or exist of the firms into the market is free in the perfect competition market. This means that any new firm is free to start production, if it so whishe & that any existing firm is free to cease production & leave the industry if it so whishes.

4. Perfect mobility: There is perfect mobility of factors of production, geographically as well as occupationally.

5. Perfect knowledge: There is perfect & complete knowldge on the on the part of the market buyers & sellers about the conditions in the market. For a market to be perfect it is essential that all buyers & sellers should be aware ofwhat is happening in any part of the market.

6. Absence of transport cost: In perfect competition, it is assumed that there is no transport cost for common man who may buy from any firms. This ensures existence of a single uniform price of the product.

7. Perfectly classic demand: Demand AR curve is perfectly classic & paralled to x – axis.

8. Price taker: Firm is price taker and industry is the price maker.

Question 2.
How are the total revenue of a firm market price, and the quality sold by the firm related to each other?
Answer:
Relationship between total revenue of a firm market price and the quantity sold by the firm: Total revenue may be defined as total money receipts of the firm from the sale of its total output in a given period of time. It is calculated by multiplying the price per unit of a commodity with the total number of units sold in the market, for example, if a firm sells 200 fans at the rate of Rs 800 per fan, the total revenue will be Rs 160000. In equation.

TR = Price per unit × No of units sold hence, total revenue increases/decreases with the increase/decrease in price in the units sold in the market. The relationship between total revenue, market price & quantity sold have been shown with the following equation

1. TR=Price for unit [Market Price] × Unit sold.
2. Price per Unit [Market Price] = \(\frac{\mathrm{TR}}{\text { Units Sold }}\)
3. Unit Sold = \(\frac{\text { TR }}{\text { Price per unit [Market Price] }}\)

Question 3.
What is the price line?
Answer:
If in the output price line, we plot the price of the output for different values of output, we get a horizontal straight line. This straight line is known as a price line.

Question 4.
Why is the total revenue curve of a price-taking firm an Upward-Sloping Straight line? Why does the curve pass through the, the origin?
Answer:
Upward shifting straight Line The total revenue curve of price taking firm is upward sloping straight line due to the fact that price of a price taking firm remains constant as shown below:

Question 5.
What is the relation between market price and average revenue for a price taking firm?
Answer:
The price and average revenue for a price-taking firm are equal.

Question 6.
What is the relation between market price and marginal revenue for a price taking firm?
Answer:
For a price taking firm, marginal revenue is equal to price.

Question 7.
What conditions must hold, if a profit maximising firm produces positive output in a competitive market?
Answer:
Following three conditions must hold if a profit maximising firm produces positive output in a competitive market’

1. P = MC
2. MC is rising
3. P ≥ AVC

Question 8.
Can there be a positive level of output that a profit maximising firm produces in a competitive market at which price is not equal to marginal cost? Give an explanation.
Answer:
Yes, there can be a positive level of output that a profit maximising firm produces & in a competitive market at which price is not equal to marginal cost.

Question 9.
Will a profit maximising firm in competitive market ever produce a positive level of output in the range where the marginal cost is falling?
Answer:
A profit maximising firm in a competitive market will produce a positive level at output in the same where marginal cost in falling. Falling MC means that the cost of producing an additional unit of output tends to reduce. Here price is constant as the firm in working in a competitive market in this case. The diferences between firm’s total revenue and TVC [TVC = Σ MC] tends to increase. It means firms profit increase with the level of output. Then why should a competitive firm not increases output when gross profit is rising.

Question 10.
Will a profit – maximising firm in a competitive market produce a positive level of oiitput in the short run if the market price is less than the minimum of AVC?
Answer:
During a short period, a firm may continue its production even if has to incur losses due to fixed cost. But if market price further falls and losses exceed FC. i.e. The firm is not able to cover even variable cost, production is stopped. It means that the profit – maximization firm in a competitive market will not produce a positive level of output in the short run of the market price is maximum of AVC.

Question 11.
Will a profit – maximising firm in a competitive market produce a positive level of output in the long run if the market price is less than the minimum of AC? Give an explantaion.
Answer:
A profit maximising firm in a competitive market will not produce a positive level of output in the long -run, if the market price is less than the maximum AC. If a firm produces at this level total cost will be more than its revenue resulting in a loss.

Question 12.
What is the supply curve of a firm in the short run?
The short run supply curve of a firm is the upward rising part of SMC from & above the minimumAVC.

Question 13.
What is the supply curve of the firm on the long run?
Answer:
The supply curve of a firm in the long run is the upward rising part of LRMC, from and above the minimum LRAC.

Question 14.
How does technological progress affect the supply curve of a firm?
Answer:
With the technological progress, the firm can produce more output with the same levels of Inputs, in other words, to produc a given level of output, the firm now requires loss of inputs. As a result, the marginal costs fall, this results in a right ward shift of MC Curve and Supply curve is essantially a segment of MC. Hence with technological progress, the supply curve ofthe firm shifts to the right.

Question 15.
How does the imposition of a unit tax affect the supply curve of a firm?
Answer:
With the imposition of Unit tax, the cost of production increases. This results in the increases in the marginal cost of every unit of output. As a result the MC curve & hence the supply curve shifts to the left. This imposition of a unit tax shifts the supply curve to the left.

Question 16.
How does an increase in input price effect the supply curve of a firm?
Answer:
If the price of an input increases the cost of production increases. As a result the MC curve & hence the supply curve shift to the left. The firm will now employ less of that input and produce less output. Thus with the increase in the input price the supply curve of a firm shifts to the left.

Question 17.
How does an increase in the number of firms in a market affect the market supply curve?
Answer:
With an increase in the number of firms, the Market supply curve shifts to the right.

Question 18.
What does the price elasticity of supply mean? How do we measure it?
Answer:
Price elasticity of supply means the degree of reponsiveness of a quantity supplied of a commodity to change in its price.

Measurement of price – elasticity of supply.
We measure elasticity of supply by dividing the percentage change in quantity supplied by percentage change in price. In equation:

Question 19.
Compute the total revenue, marginal revenue and average revenue schedules in the following table. Market value of price of each unit of the good is Rs 10.

Answer:

Question 20.
The following table shows the total revenue & total cost of schedule of a compititve firms. Calculate the profit at each level. Determine also the market price of the good.
Answer:

Answer:

Question 21.
The following table shows the total cost schedule of a competitive firm and given that the price of the good is Rs.10 Calculate the total profit at each level of output. Find the profit maximising level of output.

Answer:

Question 22.
Consider a market with two firms. The following table shows the supply schedules of the two firms. SS₁ column gives the supply schedule of firm 1 and the SS₂ column gives the supply schedule of firm-2.
Compute the market supply schedule
Answer:

Question 23.
Consider a market with two firms, in the following table columns labelled as SS₁ and SS₂ give the supply schedules of firm 1 and firm 2 respectively.

Answer:

Question 24.
There are three identical firms in a market. The following table shows the supply schedule of firm 1. Compute the market supply schedule.

Answer:

Question 25.
A firm earns a revenue of Rs.50 when the market price of the good is Rs.10. The price increases to Rs.15 and the firm now earns a revenue Rs.150.

Es = \(\frac{\Delta Q}{\Delta P} \times \frac{P}{Q}\)

Question 26.
The market price of a good changes from Rs 85 to Rs 8.20. As a result the quantity supplied by a firm increases by 15 units. The price elasticity of the firm’s supply curve is 0.5 Find the initial and fmal output levels of the firm.

Answer:

2nd PUC Economics Important Questions with Answers

Karnataka 2nd PUC Economics Important Questions Chapter 3 Production and Costs

Very Short Answer Type Questions

Question 1.
What is average product or average physical product?
Answer:
We may define average product or average physical product as the TPP per unit employment of the variable input.
APP = \(\frac{\mathrm{TPP}}{\mathrm{L}}\)
APP – Average physical pro duct
TPP – Total physical product
L – Where L is the level of employment of the variable input

Question 2.
What is variable input?
Answer:
Variablle input is that input that changes

Question 3.
Give an example for each of fixed factors and variable factors
Answer;
Land and factory building are fixed factors. Where as labour and raw materials are variable factors.

Question 4.
What is meant by production?
Answer:
Transformation of input into output.

Question 5.
What will be M P when TP is maximum?
Answer:
MP will be zero

Question 6.
Define market period, short-run and long run?
Answer:
Refer time period

Question 7.
When there are diminishing return to a factor total product always decreases?
Answer:
False When there is diminishing return to a factor, TPP increases at a decreasing rate

Question 8.
Increase in TPP always indicates that there are increasing return to a factor?
Answer:
False TPP increases even when there are diminishing return to a factor

Question 9.
When there are diminishing return to a factor marginal and total products always?
Answer:
False. Only MPP falls, not TPP In case of diminishing returns to factor, TPP. increases at diminishing rate

Question 10.
Why AFC curve never touches the ‘X’axis though it lies very close to X axis?
Answer:
Because TFC can never be zero

Question 11.
Why AVC and AFC always lie below AC?
Answer:
AC is the summation of AVC & AFC, so AC always lies above AVC & AFC.

Question 12.
Why TVC curve starts from the origin?
Answer:
TV,c is zero at zero level of output.

Question 13.
When TVC is zero at zero level of output? What happens to TFC ‘OR’ why TFC is not Zero level of output?
Answer:
Fixed cost are to be incurred even at zero level of output.

Question 14.
What do you mean by cost of production?
Answer:
Cost of production is the expenditure incurred on the input;

Question 15.
What is meant by fixed or supplementary cost?
Answer:
Fixed cost which do not change when output increases or decreases in the short run, they have to be increased even if the output is 2ero.

Question 16.
Which costs are increased in the fixed cost?
Answer:
Rent for a building / factory/ minimum telephone bill, interest on capital, wages/ salaries to permanent staff are included in the fixed cost.

Question 17.
What is the behaviour of average fixed cost as output increases?
OR
Why does AFC fall as the output rises?
Answer:
AFC is the average fixed cost i,e. FC
AFC = \(\frac{\mathrm{FC}}{\mathrm{Q}}\) with the increase in Q, AFC goes on decreasing.

Question 18.
What is the reson behind ‘U’ shape of MC cruve?
Answer:
The reson behind ‘U’ Shape ofMC curve is operation of law of returns.

Question 19.
When is AC constant and minimum?
Answer:
AC is constant and minimum when MC = AC

Question 20.
What is revenue?
Answer:
Revenue is the money receipts from the sale of the product.

Short Answer Type Questions

Question 1.
Explain the concept of TP, AP and MP with the help of diagram?
Answer:
Total product:
Total product indicates the total volume of goods & services produced during a specified period of time in a given year
We can calculate total product as follows:
TP = ΣMP
Where ,TP = total product,
Σ MP = sum of marginal product

Average product:
Average product refer to per unit product of a variable factor, It is calculated by dividing the total product by the total number of unit of the variable factor

We can calculate the average product as follows
Total Product
AP = \(\frac{\text { Total Product }}{\text { No, of units of variablefactor }}\) OR \(\frac{\mathrm{TP}}{\mathrm{L}}\)

Marginal product:
Marginal product can be defined as the additional to total product by the employment of an additional unit of a factor.
We can calculate marginal product as follows
MP= TP_n – TP_n-1
Where MP- Marginal product
TP_n – Total product of units
TP_n-1 – Total product of n-1 units.

Question 2.
Write down the features of production function?
Answer:
Features of production function:

• The factors of production are substitute to each other
• Factors of production are supplementary to each other
• Some factors of production are specifie for specific goods.

Question 3.
Give the relationship between TP and MP?
Answer:
Relationship between TP and MP:

• When TP is maximum, MP is zero
• When TP increases at an increasing rate, MP is rising
• When TP rises at a diminishing rate MP is felling

Question 4.
What is the relationship between AP and MP?
Answer:
Relationship between AP and MP

• AP increases as a long as MP >AP AP is maximum and constant when MP = AP
• AP falls when MP = AP
• MP can be zero and negative but AP is never zero

Question 4.
Give the relationship between AP & TP?
Answer:
Relationship between AP and TP:
1, When TP increases at the increasing rate, AP increases.
2. When TP increases at a decreasing rate AP decreases.
3. TP and AP will always remain positive.

Question 5.
Give the relation between TP, AP and MP
Answer:
Relationship between TP, AP and MP

• In the intial stage TP AP and MP increase but MP is greater than AP
• When TP is maximum MP = o
• MP can be zero and negative but AP and are always positive.
• When AP is maximum and constant it is equal to MP

Question 6.
What do you mean by laws of returns? Give the types of laws of returns?
Answer:
Law of Returns:
Laws concerning the change in output due to change in inputs are known as the laws of returns. In other words, laws of returns explain the change in output as a result of a change in inputs They study how much change is brought about by the change in inputs.

Types of laws of returns:
There are two types of laws of returns:

1. Laws of returns to a factor and
2. Laws of returns to scale: Laws of returns to a factor are related to short period, whereas laws of returns to scale are related to long period

Question 7.
Make a table showing returns to a factor?
Answer:
Constant returns to a factor

From the table, we come to known that with the increase in the units of labour, total production increases at a constant rate and marginal production remains constant.

Question 8.
Write down three causes of constant returns to a factor?
Answer:
Cause of constant returns to a factor:

1. Optimum utilization of the fixed factor We have the optimum utilization of fixed factors with ther increasing units of variable factor
2. Most efficient utilisation of the variable factor: When more and more units ofthe variable factors are combined with the fixed factor, a stage comes when there is best possible division of labour, variable factor( a labour) is most effiecienty used. Accordingly, its marginal product remains to be constant at its maximum.
3. Ideal factor ratio: With ihe increase in the unit of a factor, we get a stage where we have ideal factor ratio, It leads to constant returns to a factor

Question 9.
Draw TP and MP curves showing increasing returns to a factor?
Answer:

1. From diagram No. 1, we come to know that total production increases at the increasing rate with the increase in the units of labour( Variable factor)

2. From diagram No,2, we come to know that marginal product increases with the increase in the units of labour

Question 10.
Differentiate between internal and external economies?
Answer:
Internal Economics:

1. These are the advantages which accure to a firm with expansion in its scale of production.
2. These benefits are confined and specific to the individual firm arising from individual efforts
3. Internal economies arise to large scale firms only
4. Examples of internal economies are technical economies, Managerial economies marketing economies, risk-bearing economies.

External Economies

1. These are the advantages which accure to a firm as a result of expansion of the industry as whole.
2. These benefits are not Confind and specified to the individual firm.
3. External economies are available to both large and small scale firm.
4. Examples of external economies are the availability of transport facilities, commercial activities, services of banks etc.

Question 11.
What wre explicit and implicit costs? Give two examples of each?
Answer:
Explicit cost: Explicit cost are actually money costs which a firm ensures to make the payment to the hired factor of production According to Leftwich “ Explicit cost are those cash payment which firms make to outsiders for their servics and goods “ These costs include payments made to other and not to the owner himself for self – owned, self-supplied resources. Payment made to hired workers and payment made for raw materials Purchases are the example of explicit cost

Implicit cost:
These are estimated value of inputs supplied by the owner of the production unit. According to Leftwich , “Implicit costs of production are there costs of self – owned, self-employed resources that are frequently over looked in computing the expenses ofthe firms” Interest on the capital provided by the owner, the rent ofthe owners building used for the production units are the examples of implicit costs.

Question 12.
Explain the different between private costs and social costs?
Answer:
Private costs:

1. These costs are incurred by an individual firm in producing commodity
2. It is infact the money co st
3. This cost has nothing to do with society

Social costs:

1. These costs are disadvantages of producing a commodity suffered by the society as a whole.
2. It does not take into consideration the money cost
3. This cost is concerned with society.

Question 13.
Explain the difference between fixed costs and variable costs?
Answer:
Difference between fixed cost and variable cost:

Fixed costs	Variable cost
1. Fixed costs do not increase /decrease with the change in the level of output, i.e. they remain constant.	1. Variable costs change with the change in the level of output, They increase/decrease with the increase /decrease in the level of output.
2. They exist even at the zero levels of output.	2. They do not exist at the zero levels of output.
3. Fixed cost curve is parallel to OX axis	3. Variable cost curve is positively sloping
4. They remain constant	4. They do not remain constant.
5. A firm can continue produce even at the less of fixed costs	5. Production is carried on only when variable costs are met.

Question 14.
Explain the concept of opportunity cost with an example?
Answer:
Opportunity cost:
The concept of opportunity cost is the modem concept of cost. Opportunity cost of a factor refers to its value in its best alternative use. It is the opportunity cost or opportunity foregone in term of the next best alternative use of a factor.

According Prof. Leftwitch,” opportunity cost of a particular product is the value of the forgone alternative products that resources are used in its production could have produced” with reference to opportunity cost, two points must be kept in mind, First the opportuity cost of anything in the next best alternatives that could be Produced using the same amount of money, second the opportunity cost should be calculated on the basis of monetary value. The concept of opportunity cost can be explained with an example:- Suppose a farmes can grow wheat, gram and barley on a piece of land worth Rs.3400, Rs 2500 and Rs 2000 respectively. He grows wheat In this the oppurtunity cost will be Rs 1500 ( the next best alternative is growing gram worth Rs. 2500)

Long Answer Type Questions

Question 1.
Explain the laws of variable proportion Describe its three phases also
OR
What does the law of variable proportions show? State the behaviour of total product according to this law.
OR
What does the law of vaiable proportions show? state the behaviour of marginal product according to this law.
Answer:
Laws of variable proportions. This law states that when the amount of variable factor is increased, given the quantity of other factors, average and marginal product first increase, then after reaching the maximum eventually diminish.

According to the law of variable proportions the production function with one variable factor has been divided into three stages. In stage I we have increasing returns to a factor, in stage 2 we have diminishing return to the factor and then in the stage III we have negative return to the factor. Thus, diminishing returns to a factor is only one phase or stage or the law of variable proportions.

Three stages of the law of vaiable proportion are shown in fig
First Stage: In first stage the total productiqn curve (TP) goes on increasing, first at increasing rate and then at a decreasing rate. The average product curve(AP) of the variable factor in stage I goes on increasing throughout. But marginal product curve of the variable factor rises for a long part in this stage in the beginning but a later part marginal product curve stats diminishing in stage I, but it still remains above about the average product.

Second Stage: In this stage total poduction is increasing all right , but it is increasing with diminishing rate till it reaches its maximum. The average production and marginal production are diminishing till marginal production becomes zero, where total production is maximum This stage is called the stage of law of diminishing marginal returns.

Third Stage: is the stage when total production starts diminishing,„ Marginal production is negative and average production is diminishing. How ever it should be noted that average production curve does not touch the X axis and it is not zero or negative.

Question 2.
Explain the law of returns to a factor with the help of total product and marginal product schedule.
Answer:
Law of returns to a factor: The law states if more and more additional units of a variable factor are employed total physical Product (TPP) increases at increasing rate in the begining thert increase at diminishing rate and finally starts falling. It is a short period concept. It has three phases of production as shown in the schedule Here we have an assumed use oftwo factors in which land is the fixed factor and labour is a vaiable factor. The table shows succesive application of variable factor (labour) to the fixed factor of (land) to and the corresponding changes in output.

Phase-I: In this phase, TPP increase at an increasing rate MPP (marginal product) keeps rising. This phase is called phase of increasing returns.

Phase-II: In this phase, TPP increases at diminishing rate till it reaches its maximum output (18 in the table). MPP falls but remains positive It is called the phase of diminisghing returns to a factor. Out of three phases of production, this is crucial because a firm would always try to operate in this phase.

Phase-III: In this TPP starts declining, so phase III is called the phase of negative return . MPP becomes negative

Question 3.
Classify the following into fixed cost and variable costs. Give reasons.
(a) Rent for a shed
(b) Minimum telephone bill.
(c) Cost of raw material
(d) wages to payment staff
(e) Interest on capital
(f) Payment for transportation of goods
(g) Telephone charges beyond the minimum
(h) Daily wages.
Answer:
(a) Rent for a shed is fixed cost. It does not change with output.
(b) Minimum telephone bill is fixed cost because this payment has to made irrespective of the output produced.
(c) Cost ofraw material is a variable cost as it increases or decreases with the change in the level of output produced.
(d) Wages to permanent staff is a fixed cost as permanent staff will have to be paid | salary whatever may be the output level being produced by the firm.
(e) Interest on fixed capital is a fixed cost because the firm owner has borrowed & invested the sum & now, what ever may be the level of output produced interest on borrowed sum, will have to be paid.
(f) Payment for transportation of goods is vaiable cost, because if the output increases, more would have to be spent on the transportation of this higher output,
(g) Telephone charges beyond the minimum a variable cost as frequency of telephone calls is expected to increase with output.
(h) Daily wages is variable cost because for producing a higher output, one will have to employ more working on daily wages & hence this payment would increase with I output.

Question 4.
What are the total fixed, total variable cost & total cost of a firm? How are they related?
Answer:
Total fixed cost: It refers to that cost that remains constant (unchanged) at different levels of output.
Hence total fixed cost curve is a straight line parallel to the output axis.

Total variable cost: It is the difference between the total cost & variable cost = (TVC = TC – TC)
It increases with the increase in the level of output. It is influenced by the law of proportion.

Total cost: It is the sum total of total fixed cost & total variable cost
Total cost = TFC + TVC

Relationship between total fixed cost, total variable cost & total cost of a firm.
As the input increases total variable cost & hence total cost increases. The total fixed cost, however, is independent of the amount of output produced & remain constant for all levels of production.
At the zero level of output, total cost is equal to total fixed cost.

Question 5.
Explain the meaning of various short-run costs?
Answer:
Total fixed cost( TFC): Total fixed cost is payment for fixed factors in the short run. It does not change with the change in the level of production.

Total variable cost(TVC): Total variable cost includes payment made to the variable factors of production. It changes alohg with the quantity of output.

Total cost (TC): Total cost includes both total variable cost & total fixed cost

Average fixed cost (AFC): It is the per unit fixed cost of production cost a commodity. We can obtain average fixed cost by dividing the total fixed cost by the number of unit produced.

Average variable cost( AVC): Average variable cost is the per unit variable cost of production of a commodity we obtain average variable cost by dividing the total variable cost by the number of unit produced.

Average cost(AC): Average cost is the per-unit total cost of production. We can obtain the average cost by dividing the total cost by the number of unit produced.

Marginal cost: Marginal cost is the cost of producing an extra unit of commodity.

Exercises

Question 1.
Explain the concept of a production function?
Answer:
Production function, explains the relationship between factor input & output under given technology.
OR
According to Watson” production function is the relationship between physical inputs and physical output of a firm”
In symbolically:
Y = f(R, L, K, O….)
Where y = output
R= Land
L= Labour
K= Capital
O = Organisation

Question 2.
What is the total product of an input?
Answer:
Total product indicates the total volume of goods and service produced during a specified period of time generally a year.
In short, it is the sum of marginal products, It is also called total physical product
TP = ΣMP
Where, TP= Total product
Σ MP = sum of marginal product

Question 3.
What is the average product of an input?
Answer:
Average product is defined as the out put per unit of variable input. We calculate it as
OR
AP₁ = \(\frac{\mathrm{TP}}{\mathrm{X}_{1}}=\mathrm{f} \frac{\left(\mathrm{x}_{1}: \overline{\left.\mathrm{x}_{2}\right)}\right.}{\mathrm{x}_{1}}\)
OR
AP₁ = \(\frac{\text { Total Product }}{\text { No. of unit of a variable factor }}\)
OR
\(\frac{\mathrm{TP}}{\mathrm{L}}\)

Question 4.
What is the marginal product of an output?
Answer:
Marginal product is defined as the increase in output due to increase in one extra unit of the variable input to the production process when all other factor input are held constant.

Question 5.
Explain the relationship between the marginal product and the total product of an output?
Answer:
The relationship between the marginal product and total product of an output.
There is a close relationship between the marginal product and total product of an input. For any level of employment of factor input, if we add up the marginal product for every unit of the factor upto that level, we get the total product of that factor at that level of employment.

The relationship between MP and TP has shown with the help of the following table:

Question 6.
Explain the concepts of the shortrun and longrun?
Answer:
In microeconomics, the longrun is the conceptual time period in which there are no fixed factors of production, so that there are no constraints preventing changing the output level by changing the capital stock or entering or leaving an industry.

The shortrun, in which some factors are variable and others are fixed, constraining entry or exit from an Industry,
In the long run, firms change production level in response to economic profits or losses and the land, labour, capital goods and enterpreneurship vary to reach the minimum level of long- run average cost.

Where as in short run all production in real occurs. In the shortrun, a profit maximizing firm will:

• Increase production if MC is lesser than marginal revenue.
• Decrease production if MC is greater than MR.
• Continuing producing if average variable cost is less than price per unit even if average total cost is greater than price.
• Shut down if average variable cost is greater than price, at each of outputs.

Question 7.
What is the law of diminishing marginal product?
Answer:
Law of diminishing marginal product states that if we increase the amount of variable input, the marginal product of that, input after a certain level of employment starts falling.

Question 8.
What is the law of variable proportions?
Answer:
The law of variable proportion explains the relationship between the proportion of first input and variable input on the one hand and output on the other.

Question 9.
When does a production function satisfy constant return to scale?
Answer:
Production friction satisfies constant return fo scale when proportional increase in all inputs result in an increase in input by the same proportion.

Question 10.
When does a production function satisfy increasing returns to scale?
Answer:
A production function satisfies increasing return to scale when a proportional increase in all input return in an increase in output by more than the proportion.

Question 11.
When does a production function satisfy decreasing return to scale?
Answer:
A production function satisfies decreasing returns to scale when a proportional increase in all inputs results in an increase in output by less than the proportion,

Question 12.
Briefly explain the concept of the cost function?
Answer:
Concept of the cost function:
In order to produce output the firm needs to employ input. The firm as to increase some expenses for employing the input. These expenses are known as cost The output-cost relationship is the cost function of the firm These can be led by several different input combinations with which a firm can produce a desired level of output. with the input price given, the firm will choose that combination of input which is least expensive. So for every level of output the firm choose the least-cost input combination.

Question 13.
What are the total fixed cost, total variable cost and total cost of a firm? and how are they related?
Answer:
Total Fixed cost:
Fixed cost is payment made for fixed factors in the short run . It does not change with the change in the level of production.

Total variable cost:
Variable cost includes payment made for the variable factors of production. It changes along with the quantity of output.

Total cost:
It is the total expenditure on the factors and non- factor input in the production of goods& services.

The relationship between TFC,TVC, & TC:-
Total cost includes both total variable cost & total fixed cost, total cost can be written as
TC = TFC + TVC.

Total cost is illustrated in diagram below.

In the diagram, unit of output is measured on OX Axis & the cost on OY Axis, It is clear that TFC of a firm remain same at various levels of output , There is TFC even when the production is Zero. TVC increases with increase in the level of output. It starts from the origin and increases slowly upto the third unit of output. It begins to increase at an increasing rate. Afterwards the TC, which is the sum of TFC and TVC increases with increase in the level of output, There is TC even when production is Zero.

Question 14.
What are the average fixed cost , average variable cost & average cost of a firm? How they are related?
Answer:
Average fixed cost (AFC):
It is per unit fixed cost of production of a commodity. We can obtain average fixed cost by deciding the total fixed cost by the number of unit produced.

Formula:
AFC = \(=\frac{\text { Total Fixed Cost }}{\text { No. of units produced }}\)
OR
AFC = \(\frac{\mathrm{TFC}}{\mathrm{Q}}\)
OR
AFC = \(\frac{\mathrm{TFC}}{\text { Units }}\)

Average variable cost(AVC):
Average variable cost is the per unit variable cost of production of a commodity. We can obtain average variable cost by dividing the total variable cost by the number of units produced

Formula:
AVC = \(\frac{\text { Total variable cost }}{\text { No. of unit produced }}\)
OR
AVC = \(\frac{\mathrm{TVC}}{\mathrm{Q}}\)
OR
AVC = \(\frac{\text { TVC }}{\text { Units }}\)

Average cost(AC):
The average cost is the per-unit total cost of production. We can obtain the average cost by dividing the total cost by the number of units produced.

Formula:
AC = \(\frac{\text { Total cost }}{\text { No. of unit produced }}\)
OR
AC = \(\frac{\mathrm{TC}}{\mathrm{Q}}\)
OR
AC = \(\frac{\text { TC }}{\text { Units }}\)

Relationship between AFC, AVC & AC

• AC = AFC + AVC
• AFC = AC – AVC
• AVC = AC – AFC

Question 15.
Can there be some fixed cost in the long run? If not, why?
Answer:
No, there cannot be any fixed cost in the long run because in the long run that there will be no fixed inputs.

Question 16.
What does the average fixed cost curve look like? Why does it look so?
Answer:
The average fixed cost cruve looks like a rectangular hyperbola. It approches zero but it never become zero . It always remain positive. It is rectangular hyperbola because it shows that the area under the curve (i,e. Total fixed cost) always remain same.

Question 17.
What do the short-run marginal cost, average variable cost, & short-run average cost curve look like?
Answer:
Shortrun marginal average variable cost and short-run cost look like “U” shape. It is due to : Law of variable proportions” it may be shown as under.

Question 18.
Why Does the SMC curve cut the AV C curve at the minimum point of AVC curve?
Answer:
As long as AVC is falling, SMC must be less than the AVC and as AVC rises, SMC must be greater than the AVC. So the SMC curve cuts the AVC curve from below at the minimum point of AVC.

Question 19.
At which point does the SMC curve cut the SAC curve? Give a reason in support of your answer?
Answer:
Similar to the case of AVC & SMC, here too as long as SAC is feeling SMC is less than the SAC and when SAC is rising, SMC is greater than the SAC. SMC curve cuts the SAC curve from below at the minimum point ofSAC.

Question 20.
Why is the short run marginal cost curve ‘U’- shaped?
Answer:
Shortrun marginal cost curve is U- shaped due to operation law of variable proportions. Marginal cost fells in the beginning, than remain constant and ultimately rises. Falling marginal cost is in accordance with rising MP, when these are increasing returns to a factor risinfg MC is in accordance with falling MP when there are diminishing return to a factor.

Question 21.
What do the long run marginal cost and the average cost curve look like?
Answer:
Long run marginal cost and the average cost curve are U- shaped, but they are flatter as shown below:-

Question 22.
The following table gives the total product schedule of labour, find the corresponding average product and marginal products schedules of labour.

L	IPL
0	0
1	15
2	35
3	50
4	40
5	48

Answer:

Question 23.
The following table gives the average product schedule of labour. Find the total product and marginal product schedules. It is given that the total product is zero level of labour employment.

L	APL
1	2
2	3
3	4
4	4.25
5	4
6	3.5

Answer:

Question 24.
The following table gives the marginal product schedule of labour, It is also given that total product of labour is zero at zero level of employment, Calculate the total and average product schedules of labour.

L	MPL
1	3
2	5
3	7
4	5
5	3
6	1

Answer:

Question 25.
The following table shows the total cost schedule of a firm. What is the fixed cost schedule of this firm? Calculate TVC, AFC, AV C, SAC & SMC schedules of the firm?

Y	TC
0	10
1	30
2	45
3	55
4	70
5	90
6	120

Answer:
Total fixed cost schedule of a firms:

At zero level of input, TC = FC. In the table, TC at zero level of output is 10 Hence, FC will be 10. The fixed cost remains constant. So the fixed cost will be 10 at level of output

Finding of all costs:
Calculation:

∴ In such way the simple calculations can be done easily with the help of formula’s.

Question 26.
The following table gives the total cost schedule of a firni It is also given that the average fixed cost at 4 units of output is Rs 5, Find the TVC,TFC, AVC, AFC,SAC and SMC schedules of the firm for the corresponding value of output.

Answer :

Here AFC at 4 unit of output is Rs5, with this information, we will calculate TFC by multiplying 4 × 5, TFC will be Rs 20, at all levels of output TFC will be 20 and TC will also 20 at zero lead of output ;

Question 27.
A firm’s SMC schedules is shown in the following table; The total fixed cost of the firm is RslOO. Find TVC, TC, AVC, and SAC schedules of the firm.

Answer:

Question 28.
Let the production function of a firm be: Q = 5L^1/2 k^1/2. Find out the maximum possible output that the firm can produce with 100 units of L and 100 of K
Answer:
Q = 5L^1/2 k^1/2
OR maximum output
= 5 × 100^1/2 × 100^1/2.
= 5 × 10 × 10 = 50 × 10 = 500

Question 29.
Let the production function of a firm be Q = 2L² K². Find out the maximum possible output that the firm can produce with 5 units of L and 2 units of K, What is the maximum possible output that the firm can produce with zero unit of L and 10units of K?
Answer:
1. Q = 2L²K²
OR output = 2 × 5² × 2²
= 2 × 25 × 4
= 200 units

2. The maximum output would be zero with zero unit of L and 10 unit of K. The reason is that the production function, our assumption is that if any out put becomes zero, then the production would also be zero. Since here labour is zero, the out put would also be zero

Question 30.
Find out the maximum possible output for a firm with zero unit of L and K when its producion function is Q = 5L + 2K
Answer:
In production function, our assumption is that if any input becomes zero the production would also be zero. Since here labour is zero, the out put would also be zero.

2nd PUC Economics Important Questions with Answers