Mb141 - 2003 - 04 (april)

Question Paper Economics (MB141) : April 2003 Part A : Basic Concepts (30 Points) • • • • 1.

Recession is defined as a. b. c. d. e.

2.

Local sales tax Excise duty Personal income tax Import duty Corporate profit tax.

In a deflationary period, the appropriate policy for the RBI would be to a. b. c. d. e.

6.

Known as deflation A result of a stagnant aggregate supply A result of fiscal stimulus Known as stagflation Known as a recession.

In India, which of the following taxes is an example of a proportional tax? a. b. c. d. e.

5.

Real GDP will increase Nominal GDP will increase Real GDP will increase more than nominal GDP Real GDP will fall in proportion to the increase in prices Nominal GDP will be unable to capture the effects of the increase in prices.

Inflation accompanied by a slowing of economic activity is a. b. c. d. e.

4.

Two or more quarters of increasing inflation The period after the trough of a business cycle The period before the peak of the business cycle Two or more quarters of declining output Two or more quarters of declining inflation.

Which of the following is true if prices of all the goods and services in an economy increase in a year? a. b. c. d. e.

3.

This part consists of questions with serial number 1 - 30. Answer all questions. Each question carries one point. Maximum time for answering Part A is 30 Minutes.

Buy government securities in the open market Discourage commercial banks to increase their loans Increase Cash Reserve Ratio Increase bank rate Reduce the credit to government.

The current market rate of interest is 8 percent. Which of the following is true, if equilibrium rate of interest in the economy is 7 percent? a. b. c. d. e.

There is a surplus of loanable funds, and the market rate of interest would increase There is a surplus of loanable funds, and the market rate of interest would decrease There is a shortage of loanable funds, and the market rate of interest would increase There is a shortage of loanable funds, and the market rate of interest would decrease The money market is in equilibrium.

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7.

Banks can create money a. b. c. d. e.

8.

‘Liquidity trap’ refers to a situation wherein a. b. c. d. e.

9.

By printing currency notes By paying interest to their depositors By making loans that result in additional deposits By offering financial services, such as money market accounts By accepting deposits from the public.

There is too much liquidity in the economy The firms in the economy are facing credit crunch Interest rates does not decrease, no matter how much the money supply is expanded The country faces severe shortage of foreign exchange Excessive government borrowing reduces the availability of credit in the market.

The value-added approach to GDP measurement a. b. c. d. e.

Adds up the difference between the value of output and costs of intermediate goods Adds up all income received by the household sector in the economy Removes the effect of inflation from the nominal GDP Adds up all the expenditures incurred on the goods and services produced by the domestic sector Adds the total money value of goods and services purchased by their ultimate buyers.

10. The slope of the consumption function represents a. b. c. d. e.

Average Propensity to Save Marginal Propensity to Consume Marginal Propensity to Save Average Propensity to Consume None of the above.

11. Which of the following is not a transfer payment? a. b. c. d. e.

Invalidity benefit Flood relief Government pensions Salaries paid to Members of Parliament Scholarships.

12. Which of the following is not a component of aggregate expenditure in an economy? a. b. c. d. e.

Consumption Investment Government purchases Net exports Taxes.

13. According to Keynes, the Aggregate Supply curve is a. b. c. d. e.

Vertical Horizontal First horizontal and then vertical First vertical and then horizontal Positively sloped.

14. In an economy Marginal Propensity to Save (MPS) is 0.20. Multiplier for the economy is a. b. c. d. e.

0.20 0.80 1.00 1.25 5.00.

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15. If RBI would like to sterilize a net outflow of foreign exchange, it should a. b. c. d. e.

Increase the bank rate Increase the CRR Buy government securities in the open market Increase the repo rate Sell government securities in the open market.

16. For a firm, Average Cost and Total Variable Cost at various levels of output are given below: Quantity (units) 1 2 3 4 5 6

Average Cost (Rs.) 160 85 60 47.5 40 35

Variable Cost (Rs.) 10 20 30 40 50 60

For the firm, Marginal Cost of producing 4th unit of output is a. b. c. d. e.

Rs. –12.50 Rs.10 Rs.40 Rs.47.5 None of the above

17. Which of the following is not true with respect to a perfectly competitive market? a. b. c. d. e.

There are many sellers in the market. Individual firms are price makers. Products sold by the firms are identical. Anyone can enter or exit the industry without difficulty. Buyers and sellers have perfect information about the market.

18. A market in which a single seller is required for efficient production is called a a. b. c. d. e.

Regulated industry. Natural monopoly. Legal monopoly. Contestable market. Competitive market.

19. Which of the following is/are the reason(s) for using average or arc elasticity to measure the elasticity of demand? a. b. c. d. e.

Most demand curves are shaped like an arc. It measures the elasticity of the entire demand curve, not just over a price range. Because when a single point is chosen to calculate elasticity, its value will change depending on the base, or the starting point. Price elasticity never varies along a straight-line demand curve. Both (a) and (b) above.

20. If sales of CD players increase from 10,000 to 14,000 per month as per capita income increases from Rs. 15,000 to Rs.20,000, which of the following is true? a. b. c. d. e.

Demand for CD players is income inelastic CD player is a Giffin good CD player is an inferior good, but not a Giffin good CD player is a luxury CD player is a necessity.

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21. When marginal utility is negative, total utility is a. b. c. d. e.

Increasing. At a minimum. Equal to zero. Decreasing. At a maximum.

22. Which of the following is false in first-degree price discrimination? a. b. c. d. e.

The monopolist will be able to extract the entire consumer’s surplus The price of each unit will be different By following first degree price discrimination the profit of the monopolist will be more than what he could otherwise earn at a single price The price of the first unit will be less than that of the subsequent units It is another name for perfect price discrimination.

23. At a given price, if quantity demanded of a product is greater than quantity supplied, the market forces will respond by a. b. c. d. e.

Reducing the price of the product and thereby reducing profits of the firms Increasing the price of the product and thereby increasing profits of the firms Reducing the price of the product and thereby increasing profits of the firms Increasing the price of the product and thereby reducing profits of the firms Raising both the price and the quantity demanded of the product.

24. Which of the following is an example of implicit cost? a. b. c. d. e.

Interest payments on an outstanding loan of the firm Salaries paid to the firm's managers Salaries paid to the firm's assembly-line workers Transportation and shipping costs on raw materials Rental income foregone on assets owned by the firm and employed in the business.

25. In the short run a firm should shut down if a. b. c. d. e.

Price is below marginal cost Price is below average fixed cost Price is below average variable cost Price is below average total cost Price is below minimum marginal cost.

26. Floods in Brazil, Columbia, and Bolivia wipe out 30% of the entire world's coffee production. As a result, if the price of coffee rises by 200%, the elasticity of demand for coffee is a. b. c. d. e.

– 6.67 – 67.00 – 3.00 – 0.33 None of the above.

27. Which of the following is true of a straight-line demand curve? a. b. c. d. e.

Elasticity is equal to zero at the midpoint As you move down along the curve, the elasticity falls As you move down along the curve, the elasticity rises, and then falls As you move down along the curve, the elasticity rises The elasticity remains unchanged throughout the curve.

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28. The long-run equilibrium outcome in monopolistic competition and perfect competition is similar, because in both the market structures a. b. c. d. e.

The efficient level of output will be produced in the long run Firms will be producing at their minimum average cost of production Firms will only earn normal profits Firms realize all economies of scale Both (a) and (d) above

29. Refer to the budget line given below. If price of good Y Rs.2, income of the consumer is

0 a. b. c. d. e.

Rs.10 Rs.20 Rs.30 Rs.40. Insufficient information.

30. Total cost function of a firm is TC = 6000 + 10Q. If price of the product sold by the firm is 12 per unit, the break-even sales revenue is a. b. c. d. e.

3000 6000 36000 60000 None of the above. END OF PART A

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Part B : Problems / Caselets (50 Points) • • • • • 1.

2.

This part consists of questions with serial number 1 - 8 Answer all questions. Points are indicated against each question. Detailed workings should form part of your answer. Do not spend more than 110 - 120 minutes on Part B.

Swadeshi Fabric Ltd. manufactures cotton cloth for industrial usage. During the previous year, Swadeshi sold 5 million square yards of cotton cloth at an average price of Rs.6 per yard. During the current year, percapita GDP is expected to increase to Rs.20,000 from Rs.18,500 during the last year. The marketing director expects that the increase in the per capita GDP would increase the sales to 7 million square yards. The marketing director believes that expected increase in the percapita GDP would enable him to maintain the sales at previous year’s sales level even if the price is increased to Rs.6.50 per yard. Required: a. Calculate the income elasticity and price elasticity of demand for cotton. b. If Swadeshi Fabric would like to reach a sales level of 7.5 million square yards of cloth for the current year, what should be the new price? c. Based on your answer in (a) above i. Explain whether cotton is a luxury or a necessity ii. Explain the impact of increase in price on the total revenue. (5 + 2 + 2 = 9 points) Determine whether each of the following production functions exhibits constant, increasing, or decreasing returns to scale: i. Q = 3L + 2K + LK ii.

Q=7

K L

3.

(4 points) Assume that only two goods, Butter and Guns are produced in an economy. The following information pertaining to the economy is available: Year

Number of units of Butter produced

Price of Butter per unit

Number of units of Guns produced

(Rs.)

Price of Gun per unit (Rs.)

1999

1000

40

50,000

6

2002

1250

44

55,000

7

Assuming 1999 to be the base year, you are required to calculate: a. b. c.

Nominal GDP for the years 1999 and 2002. GDP deflator for the year 2002. Average annual inflation over the period. (2 + 2 + 2 = 6 points)

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4.

The following balances are taken from balance sheet of the RBI: Particulars

Rs. cr.

Credit to Government

12,000

Credit to Banks

8,000

Government Deposits

700

Other non-monetary liabilities

1,000

Net worth

4,000

Credit to commercial sector

2,000

Net foreign exchange assets

20,000

Other assets

600

Deposits of banks

9000

Other Deposits

200

The currency/deposit ratio has been ascertained as 0.302. Reserve ratio imposed by the central bank is 7%. The amount of Government money is Rs.100 cr. Required: a. Compute the money supply in the economy. b. If RBI pays a dividend of Rs.500 crore out of reverses to the government, what would be the impact on the money supply? Explain. c. If RBI would like to neutralize the impact of (b) above on the money supply by changing the reserve ratio, what should be the new reserve ratio? (6 + 2 + 2 = 10 points)

Caselet 1 Read the following caselet carefully and answer the following questions: 5. Jane Herbal does not believe in advertisement. In the absence of advertisement, how does it differentiate its products in the market? 6.

(5 points) What type of market structure do you see in the cosmetics industry? What are the characteristics of this type of market?

(5 points) In the last 1980s, using herbal cosmetics with natural ingredients was considered unfashionable. But the entry of Jane Herbal revolutionized the herbal cosmetics market. Jane Herbal looked beyond profit maximization and wanted to explore new territories. To a large extent, the cosmetics industry has to orient itself to its clients’ emotional and psychological needs. The industry sells glamour and beauty, hopes and dreams to the customers along with its products. Jane Herbal sold the concept that “Beauty lies in our own roots” and did not believe in selling products that promised to be the latest in the industry. Normally, it is seen that the cosmetics industry incurs heavy expenditure on advertisement and packaging; these elements account for about 85% of the cost for most cosmetics companies. But, this was not the case with Jane Herbal. This company doesn't believe in advertising. According to Jane Herbal, advertisement only adds to expenditure, and does not add any functional value to the customers. While other cosmetics companies incurred very little expenditure on natural ingredients, this was not the case for Jane Herbal. The company used the natural ingredients in its cosmetics as a selling point, emphasizing the importance of herbs for healthy living. This was unique in the Indian market. Jane Herbal Cosmetics hardly advertised. It was only through the quality of its cosmetics based on India’s rich ayurvedic heritage that it created a niche market in India. The company has developed various products such as ‘Himalayan herbs’, ‘Floral power’ and ‘Gold power’ and has established its reputation in the Indian cosmetics market.

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Caselet 2 Read the following caselet carefully and answer the following questions: 7. What could be the possible reasons for favoring interest rate cut by the Japanese’s policy makers in a situation where the economy is experiencing a ‘liquidity trap’ situation with near zero interest rates? (6 points) 8.

How can the government improve the Aggregate Demand so as to revive the economy? Discuss.

(5 points) Interest rates in Japan are very close to zero. Yet, with continuing deflation and the threat of a banking crisis the Central Bank of Japan is considering lowering interest rates still further. This would bring interest rates below zero. What is a negative interest rate? It occurs when depositors have to pay banks to hold their savings. Interest rates in Japan have been falling since 1991. In 1999, the Bank of Japan started pushing short-term interest rates close to zero and, as a result, savers have earned virtually no interest on their deposits. Ordinary savings accounts presently earn .001 percent annually. Two factors are important in the Central Bank of Japan's deliberations that would bring about below-zero interest rates. The first is Prime Minister Junichiro Koizumi's plan to limit government guarantees on savings to 10 million yen, about $83,000, on each account. Currently, accounts are insured for the entire amount of the deposit. This modification is similar to the Federal Deposit Insurance Corporation's policy in the United States. With confidence in Japan's struggling financial sector ebbing, savers might be willing to pay to guarantee their savings. Another consideration that might lead Japanese savers to actually pay banks to hold their savings is the lack of faith in the stability of the financial sector. One of the key elements in Mr. Koizumi's platform was the proposed reform of the financial sector. Because of the number of bad loans banks are currently carrying, meaningful reforms would entail dissolution of a number of banks. To date, these reforms have not been undertaken and there is concern that a significant number of bank failures may cause significant problems. What makes zero-interest savings somewhat tolerable is Japan's continuing deflation. Accounting for falling prices, real interest rates are actually positive. However, zero-interest savings is a problem for pensioners and others who live off interest income. As their interest income decreases, many cut back on purchases, weakening the economy. The contemplated interest rate cuts will make their position worse. END OF PART B

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Part C : Applied Theory (20 Points) • • • •

9.

This part consists of questions with serial number 9 - 11. Answer all questions. Points are indicated against each question. Do not spend more than 25 -30 minutes on Part C.

Aluminum majors such as Hindalco and Nalco have leveraged their economies of scale to undertake major brown-field expansion (an addition of 1.15 lakh tones by Nalco and 1 lakh tones by Hindalco by) involving financial and operational capability that can hardly be matched by others. These additions to capacity are helping the players play the ‘volumes game’ more effectively even in a depressed market. Briefly discuss the various sources of economies of scale.

(6 points) 10. “The government's failure to rein in fiscal deficit has emerged as a major impediment threatening the economy, nullifying benefits arising out of low inflation, soft interest regime, high foreign exchange reserves and upturn in the performance of the manufacturing sector” says the Economic Survey 2002-03. What do you understand by fiscal deficit? What are the effects of high fiscal deficit? Discuss. (6 points) 11. Write short notes on a. Economic Growth b. Monopoly. (4 + 4 = 8 points) END OF PART C END OF QUESTION PAPER

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Suggested Answers Economics (MB141) : April 2003 1. 2.

3. 4.

5.

6.

7.

8.

9.

Answer : Reason : Answer : Reason :

(d) Recession is, technically, defined as decline in output for two or more consecutive quarters. (b) Real GDP ignores the impact of inflation where as the nominal GDP includes the impact of inflation. When price of all goods and services increase in a year, nominal GDP will surely increase. (a) is not the answer as increase in prices of all the goods and services only increase the inflation and real GDP may not increase (b) is the answer as increase in prices will increase the nominal GDP even if the real output remains the same. (c) is false. This can happen only if price level decreases and real output increases. (d) is false. Real GDP falls only if real output falls. (e) is false. Nominal GDP captures the impact of both the real output and price level. Answer : (d) Reason : Slowing of economic activity accompanied by inflation is defined as stagflation. Answer : (e) Reason : A tax is regressive if the proportion of income paid as tax decrease as the income increases. It is progressive if the proportion of income paid as tax increase as the income increases and it is proportional if the proportion of income paid as tax remains constant as the income increases. All indirect taxes are regressive in nature since the proportion of income paid as tax decrease as the income increases. This is because as the income increase consumption of goods does not increase by the same proportion and hence the tax paid as a proportion to the income decrease. On the other hand, corporate profit tax is proportional as the tax rate is flat irrespective of the level of income. Personal income tax is progressive as the tax rate increases along with the income. Therefore, the answer is (e). Answer : (a) Reason : It would be appropriate for the RBI to pursue a expansionary monetary policy during a period of deflation. Through expansionary monetary policy RBI would like to increase the aggregate demand in the economy thereby causing the prices to increase. Of all the options, only open market purchase of government securities is an expansionary monetary policy. All other options are contractionary monetary policies. Answer : (b) Reason : when the market rate of interest is greater than the equilibrium rate, supply of funds will be more than the demand for funds. Left to itself, market forces will eliminate such a surplus situation by decreasing the market rate of interest. Therefore, the answer is (b). Answer : (c) Reason : Loans are a form of credit, and as they can be used to purchase goods and services they are the equivalent of money. Answer : (c) Reason : Liquidity trap is a situation where the demand for money is infinitely elastic. At the current interest rate the public is willing to absorb any amount of money. Hence, increase in money supply will not decrease the rates of interest. Other options are not correct. Answer : (a) Reason : (a) Value addition is equal to value of output less value of inputs. By summing up all the value additions in the economy GDP of the economy can be computed, which is called value added approach to measuring GDP. Hence the answer is (a). (b) By adding all the incomes of factors of production in the economy, GDP can be computed which is called income approach to measuring GDP. Hence (b) is not the answer.

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(c)

Is not the answer as we get real GDP by removing the effect of inflation from nominal GDP. (d&e)Is not the answer as we get GDP through expenditure approach by summing up all the expenditures incurred by the ultimate buyers on the goods and services produced by the domestic sector. 10. Answer : (d) Reason : Consumption function captures the relation between the consumption and the disposable income. Slope of consumption function indicates how responsive consumption is as income changes. That is, slope of the consumption function is equal to ∆C/∆Y, which is nothing but Marginal Propensity to Consume. (a) Is not the answer. Average Propensity to Save is equal to S/Yd. (b) Is the answer. Marginal Propensity to Consume is equal to ∆C/∆Yd. (c) Is not the answer. Marginal Propensity to Save is equal to ∆S/∆Yd. (d) Is not the answer. Average Propensity to Consume is equal to C/Yd. 11. Answer : (d) Reason : Transfer payments are payments which cannot be regarded as payment for current services or production and therefore do not enter national income. Of the above, invalidity benefit, flood relief, government pensions and Scholarships do not involve any production activity and are transfer payments. Where as, salaries paid to Members of Parliament are compensation to the services rendered by the members, hence it is not a transfer payment. 12. Answer : (e) Reason : Aggregate expenditure in an economy consists of Consumption, Investment, Government purchases and Net exports. Hence the answer is (e). 13. Answer : (c) Reason : (a) Classical economists assume flexible wages in the economy. Flexibility of wages results in full employment of labor in the economy. Hence the aggregate supply curve becomes vertical at the full employment level. Therefore, (a) is not the answer. (b) If Aggregate Supply curve is horizontal, increase in the Aggregate Demand does not exert pressure on the price level and more goods and services are supplied at the same price level. This can happen only if there is very high level of unemployed resources in the economy. Keynes assumes that initially this is the situation and after reaching the full employment level of output the AS curve becomes vertical. Hence, (b) is not the answer. (c) If Aggregate Supply curve is first horizontal and then vertical, it implies Aggregate Supply is perfectly elastic until the full employment level is reached and perfectly inelastic at the full employment level of output. This is what Keynes assumed. Hence, (c) is the answer. (d) Is not the answer. Aggregate Supply curve with such a shape does not exist. (e) Is not the answer. Keynes assumes that AS curve is perfectly elastic until the full employment level of output and becomes perfectly inelastic at full employment level of output. 14. Answer : (e) Reason : Multiplier =

1 1 = = 5 MPS 0.20

15. Answer : (c) Reason : Sterilization means neutralizing the impact of changes in the foreign exchange reserves on the domestic money supply. When foreign exchange reserves decrease (i.e. net outflow of foreign exchange), high-powered money in the economy also decrease thereby decreasing the money supply in the economy. To neutralize this, RBI should take measures to increase the highpowered money. (a). Is not the answer. If bank rate is increased, opportunity cost of reserve money increases and money supply decreases. (b) Is not the answer. If CRR is increased, money supply in the economy decreases. (c) Is the answer. When RBI buys government securities in the open market, reserve money increases thereby increasing the money supply. 11

(d) Is not the answer. If repo rate is increased, cost of short term liquidity increases. (e). Is not the answer. When RBI sells government securities in the open market, reserve money decreases thereby decreasing the money supply. 16. Answer : (b) Reason : MC =

∆TC ∆VC = ∆Q ∆Q

17. Answer : (b) Reason : (a) True. In perfect competition there are many sellers and buyers (b) Not true. In perfect competition firms do not have any price making power as there are many sellers and the product is homogeneous. (c) True. In perfect competition product sold by all the firms is assumed to be homogeneous. (d) True. In perfect competition entry and exit of firms is free. (e) True. In perfect competition buyers and sellers have access unlimited information which is available free of cost. 18. Answer : (b) Reason : (a) Monopoly which is regulated by the government is called a regulated monopoly. (b) Natural monopoly occurs when one firm can supply the entire market at a lower price than two or more firms can. (c) A legal monopoly is a market in which competition and entry is restricted by legal barriers (d) In contestable market potential entry is free. (e) In competitive market there are many sellers. 19. Answer : (c) Reason : (a) Is not the answer as the shape of the demand curve can also be of other shapes, like a straight line. (b) Is not the answer as the arc elasticity measures elasticity over a segment rather than the entire demand curve. (c) Arc elasticity is used to mitigate the problem of dependence of the elasticity on the base chosen for the same set of data. By averaging the prices and quantities, elasticity is estimated at the mid-point. (d) Is not the answer as price elasticity of demand varies along the straight line demand curve. As the price increases, elasticity increases and elasticity decreases as the price decreases. (e) Is not the answer as both (a) and (b) are not the answers. 20. Answer : (d) Reason : When income increases by 33.33%, demand for CD players increase by 40%. Therefore, income elasticity of demand for CD players is 1.20. (a) Is not the answer since the demand is elastic as the income elasticity is 1.20. (b) Is not the answer since the CD player is a normal good as income elasticity is positive. (c) Is not the answer since the CD player is a normal good as income elasticity is positive. (d) Is the answer since income elasticity is positive and greater than one. (e) Is not the answer since income elasticity is greater than one. For necessities income elasticity of demand is positive but less than one. 21. Answer : (d) Reason : Marginal Utility is change in Total Utility when additional unit of the good is consumed. If MU is negative, Total Utility will be decreasing. 22. Answer : (d) Reason : (a) True. Under first degree price discrimination, the monopolist charges the maximum possible price for each unit of output. That is, the consumer actually pays the price what he is willing to pay. Hence, the monopolist would extract the entire consumer’s surplus. (b) True. Since each unit is charged the maximum possible price, price for each unit will be different. 12

23. Answer : Reason :

24. Answer : Reason :

25. Answer : Reason :

26. Answer : Reason :

(c) True. As the monopolist is extracting the entire consumer surplus, profit of the discriminating monopolist would be more than the monopolist charging a single price. (d) False. Since each unit is charged the maximum possible price, price for each unit will be different and subsequent units are charged less and less price. (e) True. Under first degree price discrimination, the monopolist charges the maximum possible price for each unit of output. Hence it is also called perfect price discrimination. (b) The market will be in equilibrium when quantity demanded of a product is equal to the quantity supplied of the product. When the quantity demanded (Qd) is not equal to the quantity supplied (Qs), the market is not in equilibrium and market forces will restore equilibrium by changing the price of the product. If Qd > Qs, there is scarcity of the good and price will increase thereby eliminating the scarcity. If Qs > Qd, there is a surplus which will be eliminated by a fall in the price. Further, profits of the firms will increase (decrease) when price of the product increases (decreases), cetirus paribus. Options (a) and (c) are not correct as the market forces will raise the price when Qd > Qs. Option (d) is not correct because increase in price would increase profits of the firm. Option (e) is not correct because increase in price would decrease the quantity demanded of the product. (e) Implicit costs are opportunity costs which may not involve a cash outgo. Explicit costs are outof-pocket costs which are visible. Options (a), (b), (c) and (d) are explicit costs as they are visible and involve cash outgo. Option (e) is an example of implicit cost as the opportunity cost of the asset is the rent foregone. (c) A firm should shut down if price (P) is less than the average variable cost (AVC). If PAVC, additional production will increase profits or minimize losses. Options (a), (b) and (e) does not imply any decision rules. Option (d) is not the answer as the firm can reduce losses by undertaking production as long as P>AVC. (e) Elasticity of demand measures how responsive the demand is to a given change in the price. In the given situation decrease in supply causes an increase in the price. Hence elasticity of demand cannot be computed and the answer is (e).

27. Answer : (b) Reason : On a straight-line demand curve elasticity of demand at any point is equal to lower segment of the demand curve / upper segment. Option (a) is incorrect as elasticity of demand at midpoint is equal to one. Option (b) is correct as elasticity of demand falls as we move down the demand curve. Option (c), (d) and (e) are incorrect as elasticity of demand falls as we move down the demand curve.

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28. Answer : (c) Reason : Under perfect competition, long-run equilibrium is established when MC=MR=P=AC. This ensures efficiency in production as the AC will be minimum (MC=AC). Under monopolistic competition, long-run equilibrium is established when MC=MR and P=AC.

Equilibrium of a firm under Monopolistic Competition As the demand curve is downward sloping MR ≠ P and equilibrium occurs on the downward sloping portion of the AC curve, and not at the minimum point on the AC. This is called the ‘excess capacity’ problem in the monopolistic competition. (a) is not the answer as the production is not efficient under monopolistic competition. (b) is not the answer as the firm under monopolistic competition produces on falling side of the AC curve (d) is not the answer as the firm under monopolistic competition produces on falling side of the AC curve, hence all economies of scale are not realized. 29. Answer : (b) Reason : Intercept on the Y-axis is equal to Total income / Price of good Y. Therefore, income of the consumer is equal to (Intercept on the Y-axis) x (Price of good Y). That is 10x2 = Rs.20. 30. Answer : (c) Reason : At break-een point, TR = TC ∴ 6,000 + 10Q = 12Q Or, 2Q = 6,000 Or, Q = 3,000 Thus, the break-even sales revenue = 3,000 x 12 = 36,000

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Part B : Problems (MB141) 1.

a.

Income elasticity (eI) Income elasticity (eI) =

% change in quantity % change in income

% change in Quantity =

7−5 = 40% 5

% change in Income =

(20, 000 − 18, 500) = 8.11% 18, 500

40 = 4.93 8.11 Price elasticity (ep)

b.

∴

eI

=

ep

=

% change in quantity % change in price

For the current period, if price remains at Rs.600 quantity demanded would be 7 million square yards. If price is increased to Rs.6.50, demand would remain at 5 million square yards. 5 − 7 −2 = = –28.57% ∴ % change in quantity = 7 7 6.50 − 6.00 % change in price = = 8.33% 6.00 −28.57 ∴ ep = = –3.43 = |3.43| 8.33 If the target sales is 7.5 million square yards (msy), additional sales required is 0.5 msy. That is 0.5 % change in quantity = = 7.14% 7.0 ep

=

% change in quantity % change in price

% change in price

=

% change in quantity ep

7.14 = –2.08% −3.43 New price should be Rs.6 (1 – 0.0208) = Rs.5.875 Cotton is a luxury good since eI > 1 Increase in price would decrease total revenue since demand is elastic i.e. |ep| > 1. =

c.

2.

a.

∴ i. ii.

A production function exhibits constant returns to scale (CRS) if output also changes by the same percentage as the inputs change. It is increasing returns to scale (IRS) if output changes by more than proportionate to the change in inputs and it is decreasing returns to scale (DRS) if output changes by less than proportionate to the change in inputs. i. when L = K = 2 Q = (3 × 2) + (2 × 2) + (2 × 2) = 14 If L = K = 4 Q = (3 × 4) + (2 × 4) + (4 × 4) = 36 Q more than doubles, hence it is IRS. ii. when L = K = 2 2 Q = 7× = 7 2 If L = K = 4 15

4 = 7 4 Q remains constant, hence it is DRS. Q

7×

=

n

3.

a.

Nominal GDP =

∑Q i =1

i

Pi

Where

Qi = Pi = For year 1999:

Number of units of good ‘i’ produced Price of good ‘i’.

Nominal GDP = For year 2002:

(1000 × 40) + (50000 × 6) = Rs.3,40,000

Nominal GDP = (1250 × 44) + (55000 × 7) = Rs.4,40,000 b.

Nominal GDP ×100 Real GDP

GDP Deflator = n

Real GDP =

∑Q i =1

it

Pio

where,

Qit = Number of units of good ‘i’ produced during period ‘t’ Pio = Price of good ‘i’ during the base period i.e. period ‘o’ Real GDP for 2002 = (1250 × 40) + (55000 × 6) = Rs.3,80,000 ∴

c.

GDP Deflator =

Inflation =

4, 40, 000 ×100 = 115.79 3, 80, 000

GDP deflator for the current period –1 GDP deflator for the previous period

GDP deflator for the base year = 100 Inflation our the period of 3 years = Average annual inflation =

4.

a.

15.79% = 5.26%. 3

High powered money = Monetary liabilities of RBI = Financial Assets =

Other Assets Non-monetary liabilities

∴ Monetary liabilities Government money

1115.79 − 1 = 15.79% 100

=

Monetary Liabilities of RBI + Government Money Financial Assets + Other Assets – Non-monetary liabilities Credit to Government + Credit to Banks + Credit to commercial sector + Net Foreign exchange assets 12,000 + 8,000 + 2,000 + 20,000 42,000 600 Government deposits + other non-monetary liabilities + Net worth 700 + 1,000 + 4,000 = 5,700

= =

45,000 + 600 – 5,700 = 36,900 100

= = = =

∴ High powered money (H) = Money Supply =

36,900 + 100 = 37,000 H×m

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Money multiplier (m)

∴ Money Supply in the economy b.

c.

1+ C u 1 + 0.302 1.302 = = = 3.5 Cu + r 0.302 + 0.07 0.372

=

=

37,000 × 3.5

=

Rs.1,29,500 crore.

If a dividend of Rs.500 crore is period out of reserves, Net worth decreases by Rs.500 crore, thereby increasing High Powered money by the same amount. ∴

∆ Money supply = 500 × 3.5 = 1,750

∴

Money supply increase by 1750.

If the impact of dividend on the money supply is to be neutralized, the new money multiplier should 129500 be = 3.453 37500 Therefore, r=

1.302 = 3.453 0.302 + r

1.302 − 0.302 = 0.075 = 7.5%. 3.453

5.

Jane Herbal does not believe in advertisement to promote its goods in the market. It tries to differentiate its products by emphasizing the value of the natural ingredients of its products. As stated above, in the cosmetics industry, more than 85 % of total expenditure is incurred on advertisement and promotional activities. However, Jane Herbal differentiates its products on the basis of their natural ingredients which promote healthy living. The company has developed new products such as ‘Himalayan herbs’, ‘Floral power’ and ‘Gold power’ and has established its uniqueness in the minds of Indian customers.

6.

In the cosmetics industry, the market structure is one of monopolistic competition, as a large number of firms and sellers try to differentiate their product through color, texture, scent, etc. Moreover, in a monopolistic market, sellers try to differentiate their products through advertisement. As stated in the case, in the cosmetics industry, the cost incurred on advertisement and packaging is around 85% of the total expenditure of the average firm. Companies try to differentiate their products on the basis of the quality of the product, the ingredients used, packaging, etc. The market share of each firm in this industry depends on how it differentiates its products.

7.

Government can affect the economy in two ways. One, by changing its spending on goods and services, and two, by changing the tax rate. As the Japanese economy is reeling under recession, the government should increase its spending and/or lower the tax rate. Government spending forms part of aggregate demand (AD), which equals C + I + G + NE. Thus, when the government spending is raised, it would increase the aggregate demand and thereby increase the equilibrium output/income. Graphically, when autonomous government spending is raised, it would shift the aggregate demand function upwards (as shown below) and thereby result in an increase in the equilibrium income. This increase in equilibrium income would be equal to change in G times the multiplier.

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The Japanese Government can also improve its economy by lowering the rate of income tax. When the government reduces the tax, it increases the disposable income of the people. This, in turn, increases consumption and thereby stimulates economy through increased equilibrium output/income. 8.

Japanese policy makers are contemplating a cut in interest rate because of two reasons – deflation, and failures and the threat of banking crisis. With steady deflation in picture, real interest rates are raising continuously. This, in turn, is discouraging interest-sensitive private investment in the economy; adding problems to already shattered economy. Typically, firms borrow to purchase investment goods. Higher interest rate for such borrowing, the less will be willingness to borrow and invest. Another reason behind this consideration could be Japan’s continuing deflation. If interest rates are lowered further, interest rates that are already very close to zero would go below zero. This leads to negative interest rate in the economy. Negative interest rates occur when depositors have to pay banks to hold their savings. Japanese savers would be willing to shell off some money to guarantee their saving as they are rapidly losing confidence on their financial system. This is further strengthen with the announcement of government plans to limit government guarantees on savings.

Part C: Applied Theory 9.

Economies of scale or, more commonly, economies of mass production, explain the down-sloping part of the long-run ATC curve. As plant size increases, a number of factors will for a time lead to lower average costs of production. Labor specialization: Increased specialization in the use of labor is feasible as a plant increases in size. Hiring more workers means jobs can be divided and subdivided; leading to greater specialization and lower costs. Managerial specialization: Large-scale production also means better use of, and greater specialization in, management. A supervisor who can handle twenty workers will be under-used in a small plant hiring only ten people. The production staff can be doubled with no increase in administrative costs. This leads to greater efficiency and lower unit costs. Efficient capital: Small firms often cannot employ the most technologically efficient productive equipment. In many lines of production this machinery is available only in very large and extremely expensive units. Furthermore, effective utilization of this equipment demands a high volume of production, so only largescale producers can afford and operate the best available equipment. By-products: The large scale producer can better use by-products than a small firm. All these technological considerations – greater specialization in labor and management, the ability to use the most efficient equipment, and effective use of by-products – contribute to lower unit costs for the producer able to expand its scale of operations.

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10. The fiscal deficit is equal to “Borrowings and Other Liabilities” of the government. It measures the overall borrowing required to finance Government expenditure. Therefore, fiscal deficit is a net addition to public debt. Large fiscal deficits have implications on money supply, growth, inflation and for the access to resources for private investment. •

•

•

•

11.

a.

Money Supply Growth We expect the government to be able to finance this fiscal deficit with a remarkably small money creation component. When debt is monetized, net RBI credit to government increases which increases the high-powered money in the economy. With the introduction of WMA on April 1, 1997 the component of debt monetized is limited, providing greater autonomy to the RBI in its conduct of monetary policy. Inflation Since the fiscal deficit is not monetized to a large extent, high fiscal deficit does not imply a high growth in money supply. Further, the comfortable position on food grain stocks and foreign exchange reserves give the government levers through which inflation can be kept under control. But, a large part of the fiscal deficit is used to finance current government expenditure, which is unproductive by its nature. This expenditure instantaneously increases the aggregate demand in the economy without any increase in the production/supply. This would finally lead to an inflationary situation in the long run. Crowding-out of Private Investment Continued reliance of government on market borrowings may lead to crowding-out of private investment. When government borrows from the market, liquidity position in the market becomes tight leading to a higher rate of interest. This higher rate of interest is a higher cost of capital which discourages private investment. If the government can monetize a significant portion of its deficit, this may not lead to crowding-out of private investment. This concern is more serious when the private savings are not able to sustain increased government borrowings. Crowding-out of Essential Public Expenditure Fiscal deficit is a net addition to public debt. Increased public debt necessitates more debt service in the form of interest and repayment of borrowings. With increased reliance on market borrowings, cost of debt also increases for the government, which results in increased burden of interest. This increased interest burden crowds-out essential public expenditure on health, education and other social and economic welfare. Economic Growth: Economic growth can be defined as the increase in the economy’s output over time. Graphically, economic growth can be portrayed by an outward shift of Production Possibility Frontier (PPF) for the economy. That is, the economy has increased its physical ability to produce more goods and services. The effect of economic growth on production possibility frontier is shown in the graph below.

In the graph the Production Possibility Frontier has shifted outward signifying the increased productive capability of the economy. In this case, the economy can produce more of both capital and consumer goods because of economic growth. Economic growth can be achieved by an economy through: •

Human resources: Size of labor force, literacy, skills, motivation, etc. (eg. Japan) 19

•

Natural resources: Land, mineral s, fuels, environment quality, etc. (eg. Middle East countries)

•

b.

Capital formation: Machines, factories, infrastructure, social overhead capital, etc. (eg. USA and Canada) • Technology: Science, engineering, management, rewards for innovation, etc. Monopoly: In monopoly, there is only one seller producing and selling a product that has no close substitutes. The monopolist firm is the industry and the demand of the monopolist coincides with the industry demand. As there is no one-to-one correspondence between price and quantity supplied, the supply curve of a monopolist is indeterminable. Entry is totally blocked in a monopoly. The main causes that lead to monopoly are – • • • • • •

Ownership of strategic raw materials or technology Possession of patent rights for a product or for a production process by a single firm Government licensing or the imposition of foreign trade barriers to exclude foreign competitors Adopting ‘limit pricing policy’ by the existing firm. A limit pricing policy aims at the prevention of new entry. The size of the market may not allow the existence of more than a single large plant (i.e. natural monopoly). The monopolist can either change price or quantity, but not both.

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