EEC 11 2016 17 IgnouAssignmentGuru PDF

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EEC-11: Fundamentals of Economics

Assignment (TMA)
Programme Code: BDP
Course Code: EEC-11
Assignment Code: EEC-11/TMA/2016-17
Maximum Mark: 100
Note: All questions are compulsory
Section A
A) Long Answer Questions (Answer in about 500 Words each) 20 2 = 40
1. Distinguish between price elasticity of Demand and Cross elasticity of Demand with graphical
presentation. How can you measure the elasticity of demand? Explain with example how the
concept of elasticity of demand is useful for an industry in its decision making process?
2. State the constituents of National Income in three phases viz production, income and
expenditure. How National income is measured in India? Explain the problems and difficulties
encountered in computation of National Income in India.
Section B
B) Medium Answer Questions (Answer in about 250 Words each) 4 12 = 48
3. Explain the relationship between average product and average variable cost curve? Why the
short run average cost curve is of U shape?
4. What is price discrimination? How does a price discriminating monopoly firm decide total
output and price to be charged in each market?
5. Do you agree that wage rate becomes indeterminate in a situation when monopolistic producer
bargains with monopolistic trade union? Give reasons in support of your answer.
6. Explain the difference between Keynesian and Friedmans versions of demand for money.
Section C
C) Short Answer Questions (Answer in about 100 Words each) 2 6 = 12
7. Distinguish between any three of the following: 1
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i) Demand and demand function
ii) Fiscal deficit and Revenue deficit
iii) Commodity terms of trade and income terms of trade
iv) Multiplier and Accelerator
v) Partial and general equilibrium
8. Explain any three of the followings:
i) Opportunity cost
ii) Liquidity trap
iii) Philips curve
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iv) Externality
v) Marginal propensity to consume
vi) Substitution effect
Answers
Section A
A) Long Answer Questions (Answer in about 500 Words each) 20 20 = 40
1. Distinguish between price elasticity of Demand and Cross elasticity of Demand with graphical
presentation. How can you measure the elasticity of demand? Explain with example how the
concept of elasticity of demand is useful for an industry in its decision making process?
Ans.:A lfred Marshall introduced the concept of elasticity in 1890 to measure the magnitude of
percentage change in the quantity demanded of a commodity to a certain percentage change in
its price or the income of the buyer or in the prices of related goods .In this section we look at
the sensitivity of demand for a product to a change inthe product's own price.Since Price
Elasticity of Demand is predominantly used in economic analysis it is alternatively referred to as
Elasticity of Demand.
Income elasticity of demand has been argued as measuring how much of a change in consumers'
income that affects the demand for such goods or services if its price and all other factors
remained constant. Below is the formula for calculating income elasticity of demand:
EY= Percentage change in the quantity demanded
Percentage change in the income
As divided into three, Zero income elasticity shows that a change in the consumers' income will
have no significant effect on the quantity that is demanded of such goods. Good examples are
salts, matches and cigarettes. Next is negative income elasticity that shows that an increase in the
incomes of consumers will lead to the decrease in the quantity that is demanded of such goods.
This situation mostly occurs in inferior goods. Last is positive income elasticity that means an
increase in the incomes of consumers will lead to the increase in quantity that is demanded of
such goods.
Diagrammatic representation Of Price Elasticity Of Demand
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There are number of factors which determine the price elasticity of demand. Let us consider
some of these factors.
Firstly if close substitutes are available then there is a tendency to shift from one
product to another when the price increases and demand is said to be elastic. For
example, demand for two brands of tea. If the price of one brand A increases then the
demand for the other brand B increases. In other words greater the possibility of
substitution greater the elasticity.
Secondly how much of the income is spent on a commodity by the consumer. Greater
the proportion of income spent on the commodity greater will be the elasticity.
Thirdly the number of uses to which the commodity can be put is important factor
determining elasticity. If the commodity can be put to many uses then the elasticity
will be greater.
Fourthly if two commodities are consumed jointly then increase in the price of one will
reduce the demand for both.
Fifthly time element has an important role to play in determining the elasticity of
demand . Demand is more elastic if time involved is long. In the short run , it is
difficult to substitute one commodity for another.
Sixthly Cost of switching between different products and services.There may be
significant transaction costs involved in switching.In this case demand tends to be 4
relatively inelastic.For example ,mobile phone service providers may include penalty
clauses in their contracts.
Seventhly Who makes the payment, Where the purchaserdoes not directlypay for the
goodthey consume, such as perks enjoyed by employees,demand is likely to be more
inelastic.
Finally Brand Loyalty,An attachment to a certain brand either out of tradition or
because of propriety barriers can override sensitivity to price changes, resulting in
more inelastic demand.
Price elasticity can be measured by dividing the percentage change in quantity demanded in
response to a small change in price ,by the percentage change in price. The definition and the
numerical example disussed earlier explains the percentage method. Mathematically , price
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elasticity of demand ha s a negative sign since the change in quantity demanded is in opposite
direction to the change in its price.Only goods which do not confirm to the Law of Demand like
Veblen good or Giffen good have positive price elasticity of demand.Hence for sake of
convenience in understanding the magnitude of response of quantity demanded of a good to a
change in its price we ignore the negative sign and take into account only the numerical value of
the elasticity.The accuracy of the percentage method is questioned on the ground that the value
of the elasticity depends on which value is taken as the starting point in the calculation of
percentage. For example, if quantity demanded increases from 10 units to 15 units, the
percentage change is 50%, i.e., (15 10) 10 (converted to a percentage). But if quantity
demanded decreases from 15 units to 10 units, the percentage change is 33.3%, i.e., (15 10)
15.Two alternative measures avoid or minimise the shortcoming of the percentage method. Now
we proceed to understand the Point elasticity method.
The price elasticity of the demand is also very relevant for business in determining the value of
their substitute, this is because when the commodity price increases the actual demand for the
product substitutes also increases automatically even if the products prices generally remained
unchanged.
Businessmen are also able to know that increasing the price of their goods would only be
beneficial if:
The demand for their products is less elastic
The demand for their product's substitutes is also much less elastic.
Finally, the usefulness of elasticity of demand also stands in its ability established the required
quantitative relationships that exist between the quantity demanded of a product and its price or
any other determinants of demand.
2. State the constituents of National Income in three phases viz production, income and
expenditure. How National income is measured in India? Explain the problems and difficulties
encountered in computation of National Income in India.
Ans.: A variety of measures of national income and output are used in economics to estimate
total economic activity in a country or region, including gross domestic product (GDP), gross
national product (GNP), net national income (NNI), and adjusted national income (NNI*
adjusted for natural resource depletion). All are specially concerned with counting the total 5
amount of goods and services produced within some "boundary". The boundary is usually
defined by geography or citizenship, and may also restrict the goods and services that are
counted. For instance, some measures count only goods & services that are exchanged for
money, excluding bartered goods, while other measures may attempt to include bartered goods
by imputing monetary values to them.
National income is the total value of production of a countrys economy during a Given year. It
can be estimated alternatively and equally in three ways:
The value of expenditures
The value of inputs used in production
The sum of value added at each level of production
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That the first two estimates are identical can be seen by considering that any goodsay, a loaf
of breadcan be equally valued as either the price that is paid for it in the market by the final
consumer or as the distributed factor paymentsto labor (wages) and to capital (rent, interest,
and profit)used in its production. Since national output is the sum of all production, the total
value will be the same whether added up by final expenditure or by the value of inputs
(including profit) used in their production. The equivalence of the last measure can be seen by
noting that the value of every final good is simply the sum of the value added at each stage of
production. Again, consider a loaf of bread: Its value is the sum of the value of labor at each
successive stage of production and other ingredients added by the farmer (wheat production), the
miller (grinding flour), the baker (flour plus other ingredients), and the grocer (distribution
services).
The broadest and most widely used measure of National income is gross domestic product
(GDP), the value of expenditures on final merchandise and services at market prices produced
by domestic factors of production (labor, money, materials) during the year. It is also the market
value of these domestic-based factors (adjusted for indirect business taxes and subsidies)
entering into production of final merchandise and services. Gross implies that no deduction
for the reduction in the stock of plant and equipment due to wear and tear has been applied to the
measurements and survey-based estimates. Domestic means that the GDP includes only
production by factors located in the countrywhether home or foreign owned. GDP includes the
production and earnings of foreigners and foreign-owned property in the home country and
excludes the production and earnings s of the countrys own citizens or their property located
abroad. Product refers to the measurement of output at final prices as observed in market
transactions or of the market value of factors (inclusive of taxes less subsidies) used in their
creation. Only newly produced merchandiseincluding those that increase inventoriesare
counted in GDP. Sales of used merchandise and sales of inventories of merchandise produced in
prior years are excluded, but the services of dealers, agents, and brokers in implementing these
transactions are included.
Estimated by expenditures, GDP is the sum of merchandise and services produced during the
period. Total output comprises four groups purchases of final merchandise and services:
households purchase consumption merchandise; businesses purchase investment merchandise
(and retain unsold production as inventory increases); governments purchase merchandise and
services used in public administration and wellbeing transfers; and foreigners purchase (net)
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exports. There is substantial uniformity in the shares of consumption and investment (the sum of
capital expenditures and inventories) across nations with quite disparate earnings levels. As the
table shows, household consumption accounts for the largest share of GDP, an average of 65
percent of the nine countries considered; when added to government consumption, the share
approximates 80 percent. Investment (gross capital formation plus increases in inventories)
typically accounts for around 20 percent, although rapidly developing countries such as Thailand
have higher investment and lower consumption shares. With few exceptionsfor example, oil-
exporting countries such as Nigerianet exports are typically within plus or minus 5 percent of
GDP
Section B
B) Medium Answer Questions (Answer in about 250 Words each) 4 12 = 48
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3. Explain the relationship between average product and average variable cost curve? Why the
short run average cost curve is of U shape?
Ans.: Average variable cost is the total variable cost per unit of output incurred when a firm
engages in short-run production. It can be found in two ways. Because average variable cost is
total variable cost per unit of output, it can be found by dividing total variable cost by the
quantity of output. Alternatively, because total variable cost is the difference between of total
cost and total fixed cost, average variable cost can be derived by subtracting average fixed cost
from average total cost.
In general, average variable cost decreases with additional production at relatively small
quantities of output, then eventually increases with relatively large quantities of output. This
pattern is illustrated by a U-shaped average variable cost curve.
Average variable cost, when combined with price, indicates whether or not a firm should shut
down production in the short run. If price is greater than average variable cost, then the firm is
able to pay all variable cost and a portion of fixed cost. Even though it might be incurring an
economic loss, it will lose less by producing that by shutting down production. If, however, price
is less than average variable cost, then the firm is better off shutting down production.
The average variable cost curve is U-shaped. Average variable cost is relatively high at small
quantities of output, then as production increases, it declines, reaches a minimum value, then
rises. This shape of the average variable cost curve is indirectly attributable to increasing, then
decreasing marginal returns (and the law of diminishing marginal returns).
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This graph is the average variable cost curve for the short-run production of Wacky Willy
Stuffed Amigos (those cute and cuddly armadillos and tarantulas). The quantity of Stuffed
Amigos production, measured on the horizontal axis, ranges from 0 to 10 and the average
variable cost incurred in the production of Stuffed Amigos, measured on the vertical axis, ranges
from a high of $5 to a low of $2.50, before rising again.
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The average variable cost curve is most important to the analysis of a firm's decision to shut
down production in the short run. If price is greater than average variable cost, then a firm may
or may not be receiving an economic profit, but it is better off producing in the short run than
shutting down production. Shutting down production entails a loss equal to total fixed cost.
However, with price greater than average variable cost, sufficient revenue is generated to pay
ALL variable cost and some fixed cost, making the operating loss less than fixed cost.
If price is less than average variable cost, then a firm incurs a loss greater than total fixed cost by
producing. Its operating loss includes both fixed cost, plus part of the variable cost not covered
by the price. As such, the firm is better off shutting down production and awaiting better times.
4. What is price discrimination? How does a price discriminating monopoly firm decide total
output and price to be charged in each market?
Ans.: Price discrimination is a microeconomic pricing strategy where identical or largely similar
goods or services are transacted at different prices by the same provider in different markets.
Price differentiation is distinguished from product differentiation by the more substantial
difference in production cost for the differently priced products involved in the latter strategy.
Price differentiation essentially relies on the variation in the customers' willingness to pay and in
the elasticity of their demand.
Price discrimination is the practice of charging a different price for the same good or service.
There are three types of price discrimination first-degree, second-degree, and third-degree
price discrimination.
discrimination, alternatively known as perfect price discrimination, occurs when a firm charges a
different price for every unit consumed.
The firm is able to charge the maximum possible price for each unit which enables the firm to
capture all available consumer surplus for itself. In practice, first-degree discrimination is rare.
A monopolist can charge different prices from different buyers for its product. This act selling
same product at different prices to different buyers is known as price discrimination. A
monopolist pursue the policy of price discrimination is called discriminating monopoly. A
monopolist can charge different prices from different individuals in the same market or can
charge different prices in different markets or can charge different prices on the basis of use of
goods. Accordingly, there may be different types of price discrimination such as personal price
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discrimination, geographical price discrimination, price discrimination based on time and price
discrimination based on use of the goods produced by the monopolist. Personal price
discrimination may occur because of ignorance of consumers about the market price and when
the price difference or quantity difference in the market is very small. Geographical price
discrimination mainly occurs in case of international trade where a monopolist charge higher
price for its product in the domestic market and lower price in the international market owing to
competition. It is known as dumping. A monopolist can also charge different price for the same
good for different uses. The best example in this case is electricity charges in India. The
electricity tariff for industrial use is much higher compared the domestic use.
5. Do you agree that wage rate becomes indeterminate in a situation when monopolistic producer
bargains with monopolistic trade union? Give reasons in support of your answer.
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Ans.: Collective bargaining by trade union with an employer or, if it is industry-wide bargaining,
with the employers association represents a situation where a single seller (i.e., monopolist)
faces a single buyer. Trade union of the firm or industry acts as a single voice representing the
workers so that trade union becomes a single seller of labour to the employer.
In other words, trade union has the monopoly of selling labour. On the other hand, the employer,
if he is monopsonist or the employers association is a single buyer of labour. Thus in such a
bilateral monopoly a single buyer of labour faces a single seller of labour.
Therefore, we are confronted here with a special case of bilateral monopoly and wage
determination under trade unions. In this case collective bargaining becomes a special case of
price determination under bilateral monopoly.
Analysis of wage determination under bilateral monopoly as of product under bilateral
monopoly does not theoretically lead us to a certain particular wage at which agreement will be
reached. Analysis of bilateral monopoly only brings out two limitsthe upper limit sought by
the union and the lower limit set by the employer within which range the wage will be fixed.
Actual wage rate fixed in a bilateral monopoly will lie within that range and whether it will be
more nearer to the upper limit or to the lower limit depends upon the relative bargaining
strengths of the union and the employer. Apart from pointing to the range within which the wage
will be determined, economic theory cannot lead us to conclude at which particular wage the
agreement will be reached.
Theoretically, the wage determination under bilateral monopoly or collective bargaining within
the range between upper and lower limits is indeterminate; wage may be set at any level within
the range between the two limits.
However, it is useful to analyse the two limits or the range within which wage rate will be fixed
under collective bargaining. A difficulty which crops up in the beginning of the analysis is in
regard to the union behaviour. Just as economists have built up many models of oligopoly
depending upon the assumptions in regard to the behaviour of the oligopolists, similarly many
models of collective bargaining have been constructed depending upon the different assumptions
in regard to the goal and behaviour of the union.
6. Explain the difference between Keynesian and Friedmans versions of demand for money.
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Ans.: The economic terminology of demand-side economics is synonymous to Keynesian
economics. Keynesian economists believe the economy is best controlled by manipulating the
demand for goods and services, although, these economists do not completely disregard the role
the money supply has in the economy and on affecting gross domestic product, or GDP. They
do, however, believe it takes a great amount of time for the economic market to adjust to any
monetary influence.
In his well-known book, Keynes propounded a theory of demand for money which occupies an
important place in his monetary theory. It is also worth noting that for demand for money to hold
Keynes used the term what he called liquidity preference. How much of his income or resources
will a person hold in the form of ready money (cash or non-interest-paying bank deposits) and
how much will he part with or lend depends upon what Keynes calls his liquidity preference.
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Liquidity preference means the demand for money to hold or the desire of the public to hold
cash.
Keynesian economists believe in consumption, government expenditures and net exports to
change the state of the economy. Fans of this theory may also enjoy the New Keynesian
economic theory, which expands upon this classical approach. The New Keynesian theory
arrived in the 1980s and develops some concepts the classical theory did not, such as
government intervention and the behavior of prices. Both theories are a reaction to depression
economics.
In his reformulation of the quantity theory, Friedman asserts that the quantity theory is in the
first instance a theory of the demand for money. It is not a theory of output, or of money income,
or of the price level. The demand for money on the part of ultimate wealth holders is formally
identical with that of the demand for a consumption service. He regards the amount of real cash
balances (M/P) as a commodity which is demanded because it yields services to the person who
holds it. Thus money is an asset or capital good. Hence the demand for money forms part of
capital or wealth theory.
Section C
C) Short Answer Questions (Answer in about 100 Words each) 2 6 = 12
7. Distinguish between any three of the following:
ii) Fiscal deficit and Revenue deficit
Ans.: Generally fiscal deficit takes place due to either revenue deficit or a major hike in capital
expenditure. Capital expenditure is incurred to create long-term assets such as factories,
buildings and other development. A deficit is usually financed through borrowing from either the
central bank of the country or raising money from capital markets by issuing different
instruments like treasury bills and bonds.
A mismatch in the expected revenue and expenditure can result in revenue deficit. Revenue
deficit arises when the government's actual net receipts is lower than the projected receipts. On
the contrary, if the actual receipts are higher than expected one, it is termed as revenue surplus.
A revenue deficit does not mean actual loss of revenue.
Let's take an hypothetical example, if a country expects a revenue receipt of Rs 100 and 10
expenditure worth Rs 75, it can result in net revenue of Rs 25. But the actual revenue of Rs 90 is
realised and an expenditure is Rs 70. This translates into net revenue of Rs 20, which is Rs 5
lesser than the budgeted net revenue and called as revenue deficit.
iii) Commodity terms of trade and income terms of trade
Ans.: Commodity terms of trade of a country are defined as the unit value (price) of exports of
the country divided by its unit value (price) of imports. Commodity terms of trade between two
regions, say, the North (industrially developed) and the South (less developed), is defined as the
unit value (price) of exports of the North to the South divided by the unit value (price) of exports
of the South to the North. The commodity terms of trade index measures unit gains from the
trade amountimports (i.e., the volume of imports) that are available for one unit of exports.
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The income terms of trade (ITT) is an index of the value of exports divided by the unit value
(price) of importsthe value of exports measured in terms of import goods. It corresponds to the
commodity terms of trade multiplied by the volume of exports. ITT measures the purchasing
power of exportsthe amount of imports that can be financed by the total exports.
iv) Multiplier and Accelerator
Ans.: The multiplier concept may be used to show how the use of fiscal policy to combat
unemployment can be very effective. Expansionary fiscal policy may involve an increase in
government expenditure. That will have the effect of shifting the AD curve to the right. Part of
the Keynesian argument concerning the effectiveness of such a policy relates to the multiplier
effect.
The argument is that the government's own expenditure provides only the first round of
increased expenditure. The recipients of increased government contracts or government salaries
increase their consumption demand, and the recipients of this increased purchasing power are in
turn able to increase their demand for goods and services and so on.
How economies tend to grow in cycles - we called this the trade cycle or business cycle. One of
the major factors contributing to this cycle is the instability of investment. When the economy is
doing well, firms will invest to provide the extra capacity they need for increased production.
However, when growth starts to slip, firms will tend to stop investing - in fact investment may
become negative. Why invest if there is no need for extra capacity and you cannot even sell what
you are currently making! The changes in investment during the different phases of the trade
cycle may therefore be several times that of the rise or fall in income.
So we can see that investment depends not so much on the level of income and consumer
demand, but on their rate of change. Firms are investing to provide production capacity and so
they will invest according to how much demand is growing, not according to the actual level of
demand. This link between investment and the rate of change of demand is called the accelerator
theory. Fluctuations in investment will be much greater than those in income, but because
investment is an injection into the circular flow of income they will have a multiplied effect and
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this will magnify the ups and downs of the trade cycle.
The accelerator principle states that changes in the level of current income, leading to changes in
output of consumer goods, will lead to proportionately greater, or accelerated changes, in the
output of capital goods, i.e. investment.
8. Explain any three of the followings:
i) Opportunity cost
Ans.: An opportunity cost refers to a benefit that a person could have received, but gave up, to
take another course of action. Stated differently, an opportunity cost represents an alternative
given up when a decision is made. This cost is therefore most relevant for two mutually
exclusive events, whereby choosing one event, a person cannot choose the other.
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The word opportunity in opportunity cost is actually redundant. The cost of using something
is already the value of the highest-valued alternative use. But as contract lawyers and airplane
pilots know, redundancy can be a virtue. In this case, its virtue is to remind us that the cost of
using a resource arises from the value of what it could be used for instead.
The term was coined in 1914 by Austrian economist Friedrich von Wieser in his book Theorie
der gesellschaftlichen Wirtschaft.
ii) Liquidity trap
Ans.: The liquidity trap is the situation in which prevailing interest rates are low and savings
rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to
avoid bonds and keep their funds in savings, because of the prevailing belief that interest rates
will soon rise. Because bonds have an inverse relationship to interest rates, many consumers do
not want to hold an asset with a price that is expected to decline.
Liquidity trap is the extreme effect of monetary policy. It is a situation in which the general
public is prepared to hold on to whatever amount of money is supplied, at a given rate of
interest. They do so because of the fear of adverse events like deflation, war.
In its original conception, a liquidity trap refers to the phenomenon when increased money
supply fails to lower interest rates. Usually central banks try to lower interest rates by buying
bonds with newly created cash. In a liquidity trap, bonds pay little or no interest, which makes
them nearly equivalent to cash. Under the narrow version of Keynesian theory in which this
arises, it is specified that monetary policy affects the economy only through its effect on interest
rates. Thus, if an economy enters a liquidity trap, further increases in the money stock will fail to
further lower interest rates and, therefore, fail to stimulate.
iii) Philips curve
Ans.: The Phillips curve is a single-equation empirical model, named after A. W. Phillips,
describing a historical inverse relationship between rates of unemployment and corresponding
rates of inflation that result within an economy. Stated simply, decreased unemployment, (i.e.,
increased levels of employment) in an economy will correlate with higher rates of inflation.
While there is a short run tradeoff between unemployment and inflation, it has not been observed 12
in the long run. In 1968, Milton Friedman asserted that the Phillips curve was only applicable in
the short-run and that in the long-run, inflationary policies will not decrease unemployment.
Friedman then correctly predicted that, in the 197375 recession, both inflation and
unemployment would increase. The long-run Phillips Curve is now seen as a vertical line at the
natural rate of unemployment, where the rate of inflation has no effect on unemployment.
Accordingly, the Phillips curve is now seen as too simplistic, with the unemployment rate
supplanted by more accurate predictors of inflation based on velocity of money supply measures
such as the MZM ("money zero maturity") velocity, which is affected by unemployment in the
short but not the long term.

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EEC-11: Fundamentals of Economics

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