Category: Classes

UNIT – IV: FORMS OF MARKET AND PRICE DETERMINATION

Market : Market is a place in which buyers and sellers come into contact for the purchase and sale of goods and services.

• Perfect Competition
• Monopoly
• Monopolistic competition
• Oligopoly

Market structure: refers to number of firms operating in an industry, nature of competition between them and the nature of product.

Types of market

1. Perfect competition.
2. Monopoly.
3. Monopolistic Competition
4. Oligopoly.
5. Perfect competition: refers to a market situation in which there are large number of buyers and sellers. Firms sell homogeneous products at a uniform price.
6. Monopoly market: Monopoly is a market situation dominated by a single seller who has full control over the price.
7. Monopolistic competition: It refers to a market situation in which there are many firms who sell closely related but differentiated products.
8. Oligopoly: is a market structure in which there are few large sellers of a commodity and large number of buyers.

Features of perfect competition:

1. Very large number of buyers and sellers.
2. Homogeneous product.
3. Free entry and exit of firms.
4. Perfect knowledge.
5. Firm is a price taker and industry is price maker.
6. Perfectly elastic demand curve (AR=MR)
7. Perfect mobility of factors of production.
8. Absence of transportation cost.
9. Absence of selling cost.

Features of monopoly:

1. Single seller of a commodity.
2. Absence of close substitute of the product.
3. Difficulty of entry of a new firm.
4. Negatively sloped demand curve(AR>MR)
5. Full control over price.
6. Price discrimination exists
7. Existence of abnormal profit.

Features of monopolistic competition

1. Large number of buyers and sellers but less than perfect competition.
2. Product differentiation.
3. Freedom of entry and exit.
4. Selling cost.
5. Lack of perfect knowledge.
6. High transportation cost.
7. Partial control over price.

Main features of Oligopoly.

1. Few dominant firms who are large in size
2. Mutual interdependence.
3. Barrier to entry.
4. Homogeneous or differentiated product.
5. Price rigidity.

Features of pure competition

1. Large number of buyers and sellers.
2. Homogeneous products.
3. Free entry and exit of firm.

DETERMINATION OF PRICE UNDER PERFECT COMPETITION

Equilibrium: It means a position of rest, there is no tendency to change.

Market equilibrium: It means equality between quantity demanded and quantity supplied of a commodity in the market.

Equilibrium price: This is the price at which market demand of a commodity is exactly equal to the market supply.

Market demand: It refers to the sum total demand for a commodity by all buyers in the market.

Market supply: It refers to supply of a commodity by all the firms in the market

Very short answer questions

1. Define perfect competition.

Ans:- Perfect competition is a market with large number of buyers and sellers , selling homogeneous product at same price.

1. Define monopoly.

Ans: Monopoly is a market situation dominated by a single seller who has full control over the price.

1. Define monopolistic competition.

Ans:- It refers to a market situation in which many buyers and sellers selling differentiated product and have partial control over the price.

1. Under which market form firm is a price maker?

Ans: – Monopoly

1. What are selling cost?

Ans:- Cost incurred by a firm for the promotion of sale is known as selling cost. (Advertisement cost)

1. What is oligopoly?

Ans:- Oligopoly is defined as a market structure in which there are few large sellers who sell either homogenous or differentiated goods.

1. In which market form is there product differentiation?

Ans:- Monopolistic competition market and oligopoly market.

1. What is product differentiation?

Ans: It means close substitutes offered by different producers to show their output differs from other output available in the market. Differentiation can be in colour, size packing, brand name etc to attract buyers.

1. What do you mean by patent rights?

Ans:- Patent rights is an exclusive right or license granted to a company to produce a particular output under a specific technology.

1. What is price discrimination?

Ans: – It refers to charging of different prices from different consumers for different units of the same product.

1. What is the shape of marginal revenue curve under monopoly?

Ans:- Under monopoly market MR curve is downwards sloping curve form left to right and it lies below the AR curve.

1. What do you mean by abnormal profits?

Ans:- It is a situation for the firm when TR > TC.

1. Why AR is equal to MR under perfect competition?

Ans:- AR is equal to MR under perfect competition because price is constant.

1. What are advertisement costs?

Ans:- Advertisement cost are the expenditure incurred by a firm for the promotion of its sales such as publicity through TV , Radio , Newspaper , Magazine etc.

1. What is short period?

Ans:- Short period refers to that much time period when quantity of output can be changed only by changing the quantity of variable input and fixed factors remaining same.

1. Define long period.

Ans:- Long period refers to that much time period available to a firm in which it can increase its outputs by changing its fixed and variable inputs.

1. What is market period?

Ans: Market period is defined as a very short time period in which supply of commodity cannot be increased.

1. What is meant by normal profit?

Ans:- Normal profit is the minimum amount of profit which is required to keep an entrepreneur in production in the long run.

1. What is break-even price?

ANs:-In a perfectly competitive market, break- even price is the price at which a firm earn normal profit (Price=AC). In the long run, Break- even price is that price where P=AR=MC

Short Answer Questions: (3 / 4 Marks)

1. Explain any four characteristics of perfect competition market.

Ans:-

1. Large number of buyers and sellers : The number of buyers and sellers are so large in this market that no firm can influence the price.
2. Homogeneous products: Products are uniform in nature. The products are perfect substitute of each other. No seller can charge a higher price for the product. Otherwise he will lose his customers.

iiU Perfect knowledge: Buyers as well as sellers have complete knowledge about the product.

iv) Free entry and exit of firm: Under perfect competition any firm can enter or exit in the market at any time. This ensures that the firms are neither earning abnormal profits nor incurring abnormal losses.

1. Explain briefly why a firm under perfect competition is a price taker not a price maker?

Ans:- A firm under perfect competition is a price taker not a price maker because the price is determined by the market forces of demand of supply. This price is known as equilibrium price. All the firms in the industry have to sell their outputs at this equilibrium price. The reason is that, number of firms under perfect competition is so large. So no firm can influence the price by its supply. All firms produce homogeneous product.

y

y Industry

Demand & Supply

Firm

AR/MR

x

Output

1. Distinguish between monopoly and perfect competition.

Ans:-

Perfect Competition	Monopoly
Very large number of buyers and sellers.	Single seller of the product.
Products are homogenous	Product has no close substitute
Firm is the price taker and not a maker	Firm is price maker not price taker
Price is uniform in the market (price =AR)	Due to price discrimination price is not uniform.
Free entry and exit of firms.	Very difficult entry of new firms.

1. Which features of monopolistic competition are monopolistic in nature?

Ans:- i) Product differentiation

1. Control over price
2. Downward sloping demand curve
3. What are the reasons which give emergence to the monopoly market?

Ans:-i) Patent Rights: Patent rights are the authority given by the government to a particular firm to produce a particular product for a specific time period.

1. Formation of Cartel: Cartel refers to a collective decision taken by a group of firms to avoid outside competition and securing monopoly right.
2. Government licensing: Government provides the license to a particular firm to produce a particular commodity exclusively.
3. Explain the process of price determination under perfect competition with the help of schedule and a diagram.

Ans:-Equilibrium price is that price which is determined by market forces of demand and supply. At this price both demand and supply are equal to each other. Diagrammatically it is determined at the point where demand curve and supply curve intersect each other. At this point price is known as equilibrium price and quantity is known as equilibrium quantity.

0 2 4 6 8

Mkt. Demand & Supply

Price (Rs.)	M.D (Units)	M S (Units)
1	10	2
2	8	4
3	6	6
4	4	8
5	2	10

1. When will equilibrium price not change even if demand and supply increase?

Ans:- When proportionate increase in demand is just equal to proportionate increase in supply. Equilibrium price will not change. It can be shown in the following diagrams.

y S

In the above diagram increase in demand is just equal to increase in supply. Demand curve shift from D to D₁ and supply curve shift from S to S₁ which intersect at point E. Thus equilibrium price remain unchanged at OP though equilibrium quantity increased from OQ to OQ1.

1. How does increase in price of substitute goods in consumption affect the equilibrium price of a good? Explain with a diagram.

Ans:- An increase in price of substitute goods (coke) will cause increase in demand for its related goods (Pepsi) . The demand curve for Pepsi will shift to the right side. The supply curve of Pepsi remains the same. It will lead to an increase in equilibrium price of Pepsi and increase in quantity also.

Y D1

Result: Price increases from OP to OP₁.Quantity demand increases from OQ to OQ₁

1. How does the equilibrium price of a normal commodity change when income of its buyers falls? Explain the chain effects.

Ans:-

• When income falls demand falls
• Supply remaining unchanged .There is excess supply at a given price
• This leads to competition among sellers to reduce the price.
• As a result demand starts rising and supply starts falling.
• These changes continue till a new equilibrium price is established where demand equal supply.
• Equilibrium price falls.

1. Why is the demand curve facing monopolistically competitive firm likely to be very elastic?

Ans:- It is because the product produced by monopolistically competitive firms are close substitute to each other. If the products are closer substitutes to each other the elasticity of demand is high which makes the firm demand curve is elastic.

1. Show with the help of diagram the effect on equilibrium price and quantity when supply is perfectly inelastic and demand increases and decreases?

Ans:-

Y

D1 S

x

When supply is perfectly inelastic and demand increases. Demand curve shift to towards right. The new demand curve D₁ intersects the supply curve at point E₁.

Result : Price increases from OP to OP1 and quantity demand remains unchanged.

O)

u

CL

Y

S

x

In the above diagram demand curve shift left wards from D to D1 Price falls from OP to OP1 , but quantity remains same.

1. Explain the implication of free entry and free exit of a firm in perfect competitive market.

Ans: – If there is free entry and free exit of firms, then no firm can earn abnormal profit in the long run (firm earn zero abnormal profit). Each firm earns just normal profit.

1. Explain the implication of the feature ‘large number of buyers and sellers’ in perfect competition

LONG ANSWER QUESTIONS (6 MARKS)

1. Equilibrium price may or may not change with shifts in both demand and supply curve. Comment.

Ans:- There can be 3 situations of a simultaneous right wards shift of supply curves and demand curves.

1. When demand increases more than supply price and quantity both will increase.

Y

When increase in demand is more than increase in supply price increases from OP to OP1. Quantity increases from OM to OM1. Increase in price is less than increase in quantity.

1. When demand increases less than supply, price will fall but quantity will rise.

CD

u

CL

M kt . D & Su p.

S1

X

When supply increases more than demand price falls from OP to OP1 and quantity demand i: y ases from OM to OM1. Decrease in price is less than increase in quantity. i) When demand and supply increases equally then equilibrium price remain same.

X

When increase in demand is equal to increase in supply price remains unchanged at OP. Quantity exchanged increases from OQ to OQi.

1. Distinguish between collusive and non-collusive oligopoly. Explain the following features of oligopoly.
2. Few firms.
3. Non-price competition.

Ans:- Collusive oligopoly is one in which the firm cooperate with each other in deciding price and output.

Non collusive oligopoly is one in which firms compete with each other.

Few firms: There are few sellers of the commodity and each seller sells a substantial portion of the output of the industry. The number of firm is so small that each seller knows that he can influence the price by his own action and that he can provoke rival firms to react.

Non price competition: The firms are afraid of competition through lowering the price because it may start price war. Therefore they complete through the non price factors like advertising, after sales service etc.

1. With the help of demand and supply schedule explain the meaning of excess demand and its effects on price of a commodity.

Ans:- Demand and supply schedule

Price(Rs)	Market demand (in kg.)	Market supply(in kg.)
10	10	50
9	20	40
8	30	30

The above schedule shows market demand and market supply of the commodity at different prices. At the price of 7 and 6 the market demand is greater than market supply. This is the situation of excess demand. There will be competition among the buyers resulting in a rise in price. Rise in price will result in fall in market demand and rise in market supply. This reduces the excess demand. These changes continue till the price rises to Rs. 8 at which excess demand is zero. The excess demand results in a rise in price of the commodity.

7	40	20
6	50	10

1. Market for a good is in equilibrium. There is increase in demand for the goods. Explain the chain effect of this change.

Ans:-

• Increase in demand shift the demand curve from D to D₁ to right leading to excess demand E E1 at the given price OP.
• There will be competition among buyers leading to rise in price.
• As price rise supply starts rising (along S) demand starts falling.
• These changes continues till D=S at a new equilibrium at E₁
• The quantity rises to OM to OM₁ and price rises OP to OP₁

1. Distinguish between monopoly and monopolistic competition.

Ans:- i) Under monopoly there is single seller / producer of the commodity. Whereas under monopolistic competition there are large numbers of sellers, so the firm under monopoly has greater influence over price than under monopolistic competition.

ii) There is freedom of entry of new firms under monopolistic competition where as there is no such freedom under monopoly. As a result a monopolist can earn abnormal profit in the long run.

1. Under monopolistic competition the product is heterogeneous while under monopoly there is no close substitute of the product.
2. Demand curve in a monopoly market is less elastic than the demand curve under monopolistic competition because under monopoly there is no close substitute of the product.

HOTS

1. How much loss a firm can bear in the short run?

Ans:- A firm can bear losses up to its total fixed cost in the short run.

1. The firms are earning abnormal profits. Will the number of firms in the industry change?

Ans:- If firms are getting abnormal profit new firms will enter the industry.

1. If firms are making abnormal losses will the number of firms in the industry change?

Ans:- When firms are suffering losses, the number of firms in the industry will decrease as some firms may exit from the industry.

1. Why is demand curve facing a monopolistic competition firm likely to be more elastic?

Ans:- In monopolistic competition market the demand curve of a firm is likely to be more elastic, the reason behind this is that all the firm in the industry produce close substitute of each other. If close substitute of any good is available in the market then elasticity of demand is very high because whenever there is a hike in price the consumer will shift to its substitutes. That is why a firm’s demand curve under monopolistic competition is more elastic.

1. Explain how the efficiency may increase if two firms merge.

Ans:- i) When two firms merge then there combined efforts and efficiency brings more output to the firm. Increase in the sale of output and economies of scale can be availed. It leads to division of labour and can get advantage of the specialization. Use of better and advanced technology saves the cost of production.

FREQUENTLY ASKED QUESTIONS – CBSE BOARD EXAMINATION

One Mark Questions (1M)

1. In which market form can a firm not influence the price of the product?
2. What is equilibrium price?
3. Under which market form a firm is a price taker?
4. Define market equilibrium.
5. Define Monopoly.
6. State one feature of Oligopoly.

Three Marks Questions (3M)

1. Why is the number of firms small in an Oligopoly Market? Explain.
2. Explain three features of Monopoly.
3. How is equilibrium price of a commodity affected by a decrease in demand?
4. Why is the demand curve more elastic under monopolistic competition than under

monopoly? Explain.

1. Explain the feature ‘differentiated product’ of a market with monopolistic competition.
2. Explain the effect of ‘large number of buyers and sellers’ in a perfectly competitive

firm.

Four Marks Questions (4 M)

1. Distinguish between Monopoly and Perfect Competition.
2. Draw the Average Revenue Curve of a firm under a) Monopoly and b) Perfect Competition. Explain the difference in these curves, if any.
3. Show with the help of a diagram the effects of an increase in demand for a commodity on its equilibrium price and quantity.
4. Explain with the help of a diagram the determination of price of a commodity under perfect competition.
5. Explain the concept of equilibrium price with the help of market demand and supply schedules.

Six Marks Questions (6 M)

1. Given the market equilibrium of a good. What are the effects of Simultaneous increase in both demand and supply of that good on its equilibrium price and quantity?
2. Distinguish between perfect competition and monopoly. Why is the demand curve facing a firm under perfect competition perfectly elastic?
3. Explain briefly the three feature of perfect competition.
4. Explain the chain of effects on demand, supply and price of a commodity caused by a leftward shift of the demand curve. Use diagram.
5. Explain three feature of Monopolistic Competition.

 

UNIT 3: PRODUCER BEHAVIOUR AND SUPPLY

Production: Combining inputs in order to get the output is production.

Production Function: It is the functional relationship between inputs and output in a given state of technology. Q= f(L,K)

Q is the output, L: Labor, K: Capital

Fixed Factor: The factor whose quantity remains fixed with the level of output.

Variable Factor: Those inputs which change with the level of output.

Capital	Labor	Output
10	1	50
10	2	70
10	3	82
10	4	92
10	5	100

Here units of capital used remain the same for all levels of output. Hence it is the fixed factor. Amount of labor increases as output increases. Hence it is a variable factor.

PRODUCTION FUNCTION AND TIME PERIOD

1. Production function is a long period production function if all the inputs are varied.
2. Production function is a short period production function if few variable factors are combined with few fixed factors.

CONCEPTS

Time period, can be classified as:

1. Very short period or market period
2. Short period / short run
3. Long period / long run

Market period : is that period where supply / output cannot be altered or changed.

Short period /run : is that period where supply / output can be altered / changed by changing only variable factors of production. In other words fixed factors of production remain fixed.

Long period : is that period where all factors of production are changed to bring about changes in output / supply. No factor is fixed.

Difference between short run & long run :

Basis	Short Run	Long Run
Meaning	Only variable factors are changed	All factors are changed
Price Determination	Demand is active.	Both demand & supply play an important role.
Classification	Factors are classified as fixed & variable.	All factors are variable.

Concept of product Refers to volume of goods produced by a firm or an industry during a specific period of time.

Concepts of product:

Total Product- Total quantity of goods produced by a firm / industry during a given period of time with given number of inputs.

Average product = output per unit of variable input.

APP = TPP / units of variable factor

Average product is also known as average physical product.

Marginal product (MP): refers to addition to the total product, when one more unit of variable factor is employed.

MPn = TPn – TPn-1

MP_n = Marginal product of nth unit of variable factor TP_n = Total product of n units of variable factor TP_n-1= Total product of (n-1) unit of variable factor. n=no. of units of variable factor MP = ATP / An

We derive TP by summing up MP TP = £MP

LAW OF VARIABLE PROPORTION OR RETURNS TO A VARIABLE FACTOR

Statement of law of variable proportion: In short period, when only one variable factor is increased, keeping other factors constant, the total product (TP) initially increases at an increasing rate, then increases at a decreasing rate and finally TP decreases.

MPP initially increase then falls but remains positive then 3^rd phase becomes negative.

Explanation of law of variable proportion with a schedule and a diagram

Schedule of Law of variable proportion

Fixed factor	Variable factor	Total product	Marginal product	Phase
Land in acres	Labour	Units	Units
1	0	0	–	I – Increasing returns to a factor
1	1	5	5
1	2	15	10
1	3	30	15
1	4	40	10	II – diminishing returns to a factor
1	5	45	5
1	6	45	0
1	7	40	-5	III – Negative returns to a factor

Diagram

Y

MPP/TPP

Q-

Q-

X

MPP

X

Phase I / Stage I / Increasing returns to a factor.

• TPP increases at an increasing rate
• MPP also increases.

Phase II / Stage II / Diminishing returns to a factor

• TPP increases at decreasing rate
• MPP decreases / falls
• This phase ends when MPP is zero & TPP is maximum

Phase III / Stage III / Negative returns to a factor

• TPP diminishes / decreases
• MPP becomes negative.

Reasons for increasing returns to a factor

• Better utilization of fixed factor
• Increase in efficiency of variable factor.
• Optimum combination of factors Reasons for diminishing returns to a factor
• Indivisibility of factors.
• Imperfect substitutes.

Reasons for negative returns to a factor

• Limitation of fixed factors
• Poor coordination between variable and fixed factor
• Decrease in efficiency of variable factors.

Relation between MPP and TPP

• As long as MPP increases, TPP increases at an increasing rate.
• When MPP decreases, TPP increases diminishing rate.
• When MPP is Zero, TPP is maximum.
• When MPP is negative, TPP starts decreasing.

Short answer questions and Long answer questions

1. What is meant by production?

Ans :- Transformation of Input into Output.

1. What will be MP when TP is maximum?

Ans :- MP will be zero.

1. Define market period, Short run & Long run.

Ans :- Refer time period.

1. Explain the law of variable proportions with the help of a schedule and

a diagram

6 Marks 6 Marks

4 Marks

1. What are the reasons for
2. Increasing returns to a factor
3. Diminishing returns to a factor
4. Negative returns to a factor
5. Explain the difference between MPP & TPP.

HOTS

Giving reasons, state whether the following statements are true or false :

1. When there are diminishing returns to a factor, total product always decreases.

Ans :- False. When there is diminishing returns to a factor, TPP increases at a decreasing rate.

1. TPP increases only when MPP increases.

Ans :- False. TPP also increases when MPP decreases but remains positive.

1. Increase in TPP always indicates that there are increasing returns to a factor.

Ans :- False. TPP increases even when there are diminishing returns to a factor.

1. When there are diminishing returns to a factor marginal and total products always fall.

Ans: – False. Only MPP falls, not TPP. In case of diminishing returns to a factor, TPP increase at diminishing rate.

1. Calculate MP for the following.

Variable factor unit	0	1	2	3	4	5	6
TP (unit)	0	5	13	23	28	28	24

Ans :- MP: 0 5 8 10 5 0 -4

COST

Cost of production : Expenditure incurred on various inputs to produce goods and services. Cost function : Functional relationship between cost and output.

C=f(q)

Where f=functional relationship c= cost of production

q=quantity of product

Money cost : Money expenses incurred by a firm for producing a commodity or service.

Explicit cost : Actual payment made on hired factors of production. For example wages paid to the hired labourers, rent paid for hired accommodation, cost of raw material etc.

Implicit cost : Cost incurred on the self – owned factors of production.

For example, interest on owners capital, rent of own building, salary for the services of entrepreneur etc.

Opportunity cost : is the cost of next best alternative foregone / sacrificed.

Fixed cost : are the cost which are incurred on the fixed factors of production.

These costs remain fixed whatever may be the scale of output. These costs are present even when the output is zero.

These costs are present in short run but disappear in the long run.

Numerical example of fixed cost

Output	0	1	2	3	4	5
TFC Rs	20	20	20	20	20	20

TFC = Total Fixed Cost Diagrammatic presentation of TFC

Y

TFC

to

O

U

X

Output

O

TFC is also called as “overhead cost”, “supplementary cost”, and “unavoidable cost”.

Total Variable Cost : TVC or variable cost – are those costs which vary directly with the variation in the output. These costs are incurred on the variable factors of production.

These costs are also called “prime costs”, “Direct cost” or “avoidable cost”.

These costs are zero when output is zero. Numerical example,

Output	0	1	2	3	4	5
TVC	0	10	16	25	38	55

Diagrammatic presentation of TVC

X

Difference between TVC & TFC

Basis	TVC	TFC
Meaning	Vary with the level of output	Do not vary with the level of output
Time period	Can be changed in short period	Remain fixed in short period
Cost at zero output	Zero	Can never be zero
Factors of production	Cost incurred on all variable factors	Cost incurred on fixed factors of production
Shape of the cost curve	Upward sloping	Parallel to x axis

Total cost : is the total expenditure incurred on the factors and non-factor inputs in the production of goods and services.

It is obtained by summing TFC and TVC at various levels of output.

Relation between TC, TFC and TVC

1. TFC is horizontal to x axis.
2. TC and TVC are S shaped (they rise initially at a decreasing rate, then at a constant rate & finally at an increasing rate) due to law of variable proportions.
3. At zero level of output TC is equal to TFC.
4. TC and TVC curves parallel to each other.

TC

• TC=TFC + TVC
• TFC=TC-TVC
• TVC=TC-TFC

Average cost : are the “cost per unit” of output produced. Average fixed cost is the per unit fixed cost of production. AFC = TFC / Q or output

AFC declines with every increase in output. It’s a rectangular hyperbola. It goes very close to x axis but never touches the x axis as TFC can never be zero.

Average variable cost is the cost per unit of the variable cost of production.

AVC = TVC / output.

AVC falls with every increase in output initially. Once the optimum level of output is reached AVC starts rising.

Average total cost (ATC) or Average cost (AC) : refers to the per unit total cost of production.

ATC = TC / Output AC = AFC + AVC Phases of AC

1. phase : When both AFC and AVC fall , AC also fall
2. phase : When AFC continue to fall , AVC remaining constant AC falls till it reaches minimum.
3. phase : AC rises when rise in AVC is more than fall in AVC.

Important observations of AC , AVC & AFC

1. AC curve always lie above AVC (because AC includes AVC & AFC at all levels of output).
2. AVC reaches its minimum point at an output level lower than that of AC because when AVC is at its minimum AC is still falling because of fall in AFC.
3. As output increases, the gap between AC and AVC curves decreases but they never intersect.

Marginal cost: refers to the addition made to total cost when an additional unit of output is produced.

MCn = TCn-TCn-1 MC = ATC/AQ

Note : MC is not affected by TFC.

Relationship between AC and MC

• Both AC & MC are derived from TC
• Both AC & MC are “U” shaped (Law of variable proportion)
• When AC is falling MC also falls & lies below AC curve.
• When AC is rising MC also rises & lies above AC
• MC cuts AC at its minimum where MC = AC

Important formulae at a glance

1. TFC = TC – TVC or TFC=AFC x output or TFC = TC at 0 output.
2. TVC = TC – TFC or TVC = AVC x output or TVC =£MC
3. TC = TVC + TFC or TC = AC x output or TC = X MC + TFC
4. MCn=TCn – TCn-1 or MCn= TVCn – TVCn-1
5. AFC = TFC / Output or AFC = AC-AVC or ATC – AVC
6. AVC = TVC / Output or AVC = AC-AFC
7. AC = TC / Output or AC=AVC + AFC Short answers and Long Answer questions:
8. What is cost of production?
9. Define cost function.
10. What are money costs?
11. Distinguish between explicit and implicit costs.
12. How do you define an opportunity cost?
13. What difference you find between fixed and variable costs?
14. Why the fixed cost curve is a horizontal straight line to the X axis?
15. Why variable costs are variable?
16. What is average cost? How do you derive it?
17. Explain AVC, AFC & ATC and explain the relationship between these costs.
18. Explain the relationship TC, TFC & TVC.
19. With a diagram describe the various phases of AC.
20. Bring out the relationship between AC & MC

HOTS

1. Why AFC curve never touches ‘x’ axis though it lies very close to x axis?

Ans :- Because TFC can never be zero.

1. Why AVC and AFC always lie below AC?

Ans:- AC is the summation of AVC & AFC so AC always lies above AVC & AFC.

1. Why TVC curve start from origin?

Ans:- TVC is zero at zero level of output.

1. When TVC is zero at zero level of output, what happens to TFC or Why TFC is not zero at zero level of output?

Ans:- Fixed cost are to be incurred even at zero level of output.

Revenue

Revenue: – Money received by a firm from the sale of a given output in the market.

Total Revenue: Total sale receipts or receipts from the sale of given output.

TR = Quantity sold x Price (or) output sold x price
Average Revenue: Revenue or Receipt received per unit of output sold.

o AR = TR / Output sold o AR and price are the same. o TR = Quantity sold x price or output sold x price o AR = (output / quantity x price) / Output/ quantity o AR= price

AR and demand curve are the same. Shows the various quantities demanded at various prices.

Marginal Revenue: Additional revenue earned by the seller by selling an additional unit of output.

• MR_n = TR _n – TR _n-1
• MR _n = A TR _n / A Q
• TR = X MR

Relationship between AR and MR (when price remains constant or perfect competition)

Under perfect competition, the sellers are price takers. Single price prevails in the market. Since all the goods are homogeneous and are sold at the same price AR = MR. As a result AR and MR curve will be horizontal straight line parallel to OX axis. (When price is constant or perfect competition)

Relation between TR and MR (When price remains constant or in perfect competition) When there exists single price, the seller can sell any quantity at that price, the total revenue increases at a constant rate (MR is horizontal to X axis)

y
Revenue		AR- IVIR-ri Ice
o	OUTPUT	x

Y

AR= MR

X

<D

3

>

O

Y

Price line

Price=AR=MR

X

Quantity

Relationships between AR and MR under monopoly and monopolistic competition

(Price changes or under imperfect competition)

• AR and MR curves will be downward sloping in both the market forms.
• AR lies above MR.
• AR can never be negative.
• AR curve is less elastic in monopoly market form because of no substitutes.
• AR curve is more elastic in monopolistic market because of the presence of substitutes.

Relationship between TR and MR. (When price falls with the increase in sale of output)

• Under imperfect market AR will be downward sloping – which shows that more units can be sold only at a less price.
• MR falls with every fall in AR / price and lies below AR curve.
• TR increases as long as MR is positive.
• TR falls when MR is negative.
• TR will be maximum when MR is zero.

X

X

Break-even point: It is that point where TR = TC or AR=AC. Firm will be earning normal profit.

Y

E

Profit

Loss

Shut down p< ⁰ : A situati O utput firm is able to cover only variable costs or TR = TVC

Formulae at a glance:

• TR = price or AR x Output sold or TR = £ MR
• AR (price) = TR ^ units sold
• MR _n = MR _n – MR _n_i

HOTS

1. Can MR be negative or zero.

Ans:- Yes, MR can be zero or negative.

1. If all units are sold at same price how will it affect AR and MR?

Ans:- AR and MR will be equal at levels of output.

1. What is price line?

Ans:- Price line is the same as AR line and is horizontal to X-axis in perfect competition.

1. Can TR be a horizontal Straight line?

Ans:- Yes, when MR is zero.

1. What do you mean by revenue?
2. Explain the concept of revenue ( TR, AR and MR)
3. Define AR
4. Prove that AR = price
5. Prove that AR is nothing but demand curve.
6. Explain the relationships between AR and MR when price is constant and when price falls.
7. Explain the relationships between TR and MR when price is constant.
8. What is break- even point? Explain with a diagram.
9. When the situation of ‘shut – down’ point arises for a firm?
10. What happens to TR when a) MR is increasing, b) decreasing but remains positive and c) MR is negative?

Ans:- a) TR increases at an increasing rate.

1. TR increases at a diminishing rate.
2. TR decreases.
3. Why AR is more elastic in monopolistic competition than monopoly?

Ans:- Monopolistic competition market has close substitutes. Monopoly market does not have close substitutes.

1. Why TR is 45 ⁰ angle in perfect competition market?

Ans:- In perfect competition market the goods are sold at the same price so AR= MR and the TR increases at a constant rate.

1. Can there be Break- even point with AR = AC

Ans:- Yes there can be breakeven point with AR=AC.

CONCEPT OF SUPPLY

1. Individual supply refers to quantity of a commodity that an individual firm is willing and able to offer for sale at each possible price during a given period of time.
2. Market supply: It refers to quantity of a commodity that all the firms are willing and able to offer for sale at each possible price during a given period of time.
3. The supply curve of a firm shows the quantity of commodity (Plotted on the X-axis) that the firm chooses to produce corresponding to two different prices in the market (plotted on the Y-axis)
4. Supply Schedule refers to a table which shows various quantity of a commodity that a producer is willing to sell at different prices during a given period of time.
5. Determinants of supply are a) state of technology b) input prices c) Government taxation policy.
6. Law of supply: It states direct relationship between price and quantity supplied keeping other factors constant.
7. Movement along the supply curve: It occurs when quantity supplied changes due to change in its price, keeping other factors constant.
8. Shift in supply curve: It occurs when supply changes due to factors other than price.
9. Reasons for shift in supply curves: Change in price of other goods, change in price of factors of production, change in state of technology, change in taxation policy.
10. Expansion in supply: It occurs when quantity supplied rises due to increase in price keeping other factors constant.
11. Contraction of supply: It means fall in the quantity supplied due to fall in price keeping other factors constant.
12. Increase in supply refers to rise in the supply of a commodity due to favorable changes in other factors at the same price.
13. Decrease in supply: It refers to fall in the supply of a commodity due to unfavorable change in other factors at the same price.
14. Price elasticity of supply: The price elasticity of supply of a good measures the responsiveness of quantity supplied to changes in the price of a good.
15. Price elasticity of supply = %change in qty supplied/ %change in price.
16. Geometric method:

Fig. 1 Fig. 2 Fig.3

Es at a point on the supply curve = Horizontal segment of the supply curve

Quantity supplied

Fig.1: BC/OC>1 fig. 2: BC/OC=1 fig 3. BC/OC<1

FREQUENTLY ASKED QUESTIONS – CBSE BOARD EXAMINATION

One Mark Questions (1M)

1. Define the law of supply.
2. Define market supply.
3. What do you understand by supply curve of a firm?
4. What do you mean by elasticity of supply?
5. Define supply schedule.
6. Define revenue of a firm? OR give meaning of revenue?
7. Define Marginal Revenue?
8. What is Average revenue?
9. When will the marginal revenue become negative?
10. What happens to total revenue when Marginal revenue is zero?
11. In which market the Average revenue is equal to marginal Revenue?

Three Marks Questions (3M)

1. Give reasons for the rightward shift in supply curve?
2. Give reasons for the leftward shift in supply curve?
3. If the price of the commodity falls by 10 % and consequently the quantity supply decreases by 20 % what will be elasticity of supply?

Four Marks Questions (4 M)

1. Briefly explain the geometric method of measuring price elasticity of supply?
2. Distinguish between change in supply and change in quantity supplied?
3. Explain the movement along the supply curve?

Three OR Four Marks Questions (3M/4M)

1) What changes will take place in marginal Revenue when:

1. TR increase at an increasing rate?
2. TR increases at a diminishing rate?

2) Complete the following table:

Units	1	2	3	4	5	6
Total Revenue	20			56
Average Revenue		18
Marginal Revenue			12		4	0

Six Marks Questions (6 M)

1. Explain the determinants of supply?
2. Explain the relationship between Total Revenue and marginal Revenue using a Schedule and diagram?

UNIT 2: CONSUMER EQUILIBRIUM AND DEMAND KEY CONCEPTS

1. UTILITY
2. MARGINAL UTILITY
3. LAW OF DIMINISHING MARGINAL UTILITY
4. CONDITIONS OF CONSUMER’S EQUILIBRIUM
5. INDIFFERENCE CURVE ANALYSIS
6. THE CONSUMER’S BUDGET
7. BUDGET SET
8. BUDGET LINE
9. PREFERENCES OF THE CONSUMER
10. INDIFFERENCE CURVE
11. INDIFFERENCE MAP
12. CONDITIONS OF CONSUMER’S EQUILIBRIUM
13. DEMAND
14. INDIVIDUAL DEMAND
15. MARKET DEMAND
16. DEMAND SCHEDULE
17. DEMAND CURVE
18. DETERMINANTS OF DEMAND
19. MOVEMENT ALONG THE DEMAND CURVE
20. EXTENSION
21. CONTRACTION
22. SHIFT IN THE DEMAND CURVE
23. INCREASE IN DEMAND
24. DECREASE IN DEMAND
25. MEASUREMENT OF PRICE ELASTICITY OF DEMAND
26. TOTAL EXPENDITURE METHOD
27. PROPORTIONATE METHOD
28. GEOMETRIC METHOD
29. FACTORS AFFECTING PRICE – ELASTICITY OF DEMAND

Utility:- The satisfaction which a consumer gets from using/consuming a good or service.
Total Utility:- The total satisfaction a consumer gets from a given commodity /service.

(°^r)

Sum of marginal utility is known as total utility

Marginal Utility:- An addition made to total utility by consuming an extra unit of commodity. Sum of marginal utilities derived from various goods is known as total utility.

Graph -1: The relationship between TU and MU Law of Diminishing Marginal Utility:-

It states that as the consumer consumes more and more units of a commodity , the marginal utility derived from each successive units goes on diminishing.

Demand for a commodity refers to the quantity of a commodity which a consumer is willing to buy at a given price in a given period of time.

Consumer Equilibrium:

Refers to a situation when he spends his given income on purchase of a commodity ( or commodities) in such a way that yields him maximum satisfaction.

Condition of equilibrium:

MU in terms of money = Price.

MU of product / MU of a Rupee.= Price

Consumer Equilibrium through Indifference Curve:-

Budget Set :- Set of bundles ( combination of goods ) available to consumer

Budget line:- It refers to all combinations of goods which a consumer can buy with his

entire income and price of two goods.

Equation of Budget line: – P₁ X₁ + P₂ X₂ = M

Indifference Curve: –

The combination of two goods which gives consumer same level of satisfaction Properties of IC :- 1. It slopes downwards from left to right

1. It is always convex to the origin due to falling of Marginal Rate of Substitution (MRS)
2. Higher IC always gives higher satisfaction
3. Two IC never intersect each other.

Indifference Map:- Group of indifference curves that gives different levels of satisfaction to the consumer.

Marginal Rate of Substitution (MRS):- It is the rate at which a consumer is willing to give up one good to get another good.

Consumer Equilibrium:-

At a point where budget line is tangent to the indifference curve, MRS = P_X / P_Y ,

1. e., Marginal rate of substitution = ratio of prices of two goods.

Demand:- Quantity of the commodity that a consumer is able and willing to purchase in a given period and at a given price.

Demand Schedule:- It is a tabular representation which shows the relationship between price of the commodity and quantity purchased.

Demand Curve:- It is a graphical representation of demand schedule.

Individual Demand: – Demand by an individual consumer.

Factors Affecting Individual Demand For a Commodity/Determinants of Demand:-

1. Price of the commodity itself
2. Income of the consumer
3. Price of related goods
4. Taste and Preference
5. Expectations of future price change

Demand Function:- Dx = f( Px, Y, Pr, T)

Substitute Goods:- Increase in the price of one good causes increase in demand for other good. E.g., tea and Coffee

Complementary Goods:- Increase in the price of one good causes decrease in demand for other good. E.g:- Petrol and Car

Normal Good:- Goods which are having positive relation with income. It means when income rises, demand for normal goods also rises.

Inferior Goods:- Goods which are having negative relation with income. It means less demand at higher income and vice versa.

Law of Demand:- Other things remains constant, demand of a good falls with rise in price and vice versa .

Demand Scheduler-

PRICE (Rs.)	DEMAND (units)
1	100
2	80
3	60
4	40
5	20

Changes in Demand:-

They are of two types:

1. Change in Quantity Demanded (Movement along the same demand curve)
2. Change in Demand (Shifts in demand)

1) Change in Quantity Demanded: –

Demand changes due to change in price of the commodity alone, other factors remain constant; are of two types;

1. Expansion of demand : More demand at a lower price
2. Contraction of demand : Less demand at a higher price

Change in Quantity Demanded

Due to price change Movement will takes place Extension and contraction

Diagram

Change in Demand

Due to other than price change Shifting will takes place Increase and decrease

Diagram

Demand changes due to change in factors other than price of the commodity, are of two types:

1. Increase in demand:- more demand due to change in other factors, price remaining constant.
2. Decrease in demand:- less demand due to change in other factors, price remaining constant.

Causes of Increase in Demand:-

1. Increase in Income.
2. Increase/ favorable change in taste and preference.
3. Rise in price of substitute good.
4. Fall in price of complementary good.

Note: Increase in income causes increase in demand for normal good Causes of Decrease in Demand:

1. Decrease in Income.
2. Unfavorable/Decrease in taste and preference
3. Decrease in price of substitute good.
4. Rise in price of complementary good.

Note: Decrease in income causes Decrease in demand for normal good Price Elasticity of Demand (Ed):

Refers to the degree of responsiveness of quantity demanded to change in its price. Ed. = Percentage change in quantity demanded/ Percentage change in price Ed. = P/q X Aq/Ap P = Original price Q = Original quantity A = Change

Q. Explain the five degrees of elasticity of demand?

Ans.

1. Perfectly inelastic demand: – Even with change in price, there is no change in the quantity demanded, the demand is said to be perfectly inelastic Ed =0. The demand curve is parallel to OY axis.

Perfectly elastic demand: – Even with no change in price there is a great change in qty. Demanded, then the demand is said to be perfectly elastic. The demand curve is parallel to Ox axis

2.

Y	D	Y	Ed=	¥
		Ed=0
‘h P
		£			D
		D

0 Q 0 Q Q, X

Qty dd Qty dd

decrease in price, there is unit increase or decrease in quantity demanded. The demand curve resembles a rectangular hyperbola.

1. Relatively less elastic: With a unit increase in price, the quantity demanded is proportionately less, then demand is said to be less elastic
2. Relatively more elastic: With a unit increase in the price, there is proportionately more increase in the quantity demanded. The demand is said to be more elastic.

Methods of Measuring Price Elasticity of Demand:-

Proportionate / Percentage Method:

E_d = % change in Quantity demanded = AQ/QQ x 100

% change in price AP/P0 x 100

OR

= D Q/AP x P/Q

Q. The Price of ice cream is Rs.20 per cup and demand is for 200 cup. If the price of ice cream falls to Rs.15 demand increases to 300 cups. Calculate elasticity of demand.

Sol.: P = 20; P₁ = 15 ; D P = 5

Q= 200; Q1 = 300; DQ = 100 Ed = 100_ x 20_ = 2 5 200

Total Outlay Method (Expenditure Method)

If with the fall in price, total outlay increases elasticity of demand is greater than one, if total outlay remain constant, elasticity is equal to one and if the total outlay decreases elasticity is less than one.

Situa-	Price of	Quantity	Total	Effect on Total	Elasticity of
tion	Commodity	(Kg)	Expenditure	Expenditures	Demand
	(Rs)		(Rs)
	2	4	8		Unitary
A				Same Total	Elastic
	1	8	8	Expenditure	Ed=1
	2	4	8	Total	Greater than
B				Expenditure	unitary
	1	10	10	increases	Ed > 1
	2	3	6	Total	Less than
C				Expenditure	unitary Ed <
	1	4	4	decreases	1

Geometric / Point Method: –

This measures the elasticity of demand at different points on the same demand Curve.

E_d = lower segment of the demand curve Upper segment of the demand curve

ONE MARK QUESTIONS AND ANSWERS

1. What do you mean by utility?

Ans Utility is the want satisfying power of a commodity.

1. How is total utility derived from marginal utility?

Ans :- Total utility is the sum total of marginal utilities of various units of a commodity. TUn= MU 1+MU2+MU3 +MUn

1. State the law of equi-marginal utility.

Ans :- It states that a consumer gets maximum satisfaction when the ratio of the marginal utilities of two goods and their prices is equal i.e., MUx / Px = MUy / Py

1. What will you say about MU when TU is maximum?

Ans :- MU is zero when TU is maximum

1. Give the reason behind a convex indifference curve.

Ans :- Diminishing marginal rate of substitution.

HOTS QUESTIONS

1. Give the formula for calculating the slope of the budget line.

Ans :- It is equal to the ratio of the prices of the two commodities , i.e., Px / Py

1. Suppose a consumer’s preferences are monotonic. What can you say about his preference ranking over the bundles (10,10),(10,9) and (9,9)?

Ans :- Consumer will monotonically prefer bundle (10,10) to (10,9) and (9,9) and also prefer bundle (10,9) to (9,9)

1. A rise in the income of the consumer leads to a fall in the demand for commodity ‘x’. What type of good is commodity ‘x’?

Ans Inferior good

1. What do you mean by substitute and complementary goods? Give two examples each.

Ans :- Substitute goods are those goods which can be used in place of each other. Ex. Tea and Coffee. Complementary goods are those goods which are used together to satisfy a given want. Ex : Car and petrol.

1. Mention one factor that causes a leftward shift of the demand curve.

Ans :- Fall in income of a consumer.

1. What causes a movement along the demand curve of a commodity?

Ans :- When the price of a commodity changes and other factors remain constant, there will be movement along the demand curve.

1. What is demand function?

Ans: – A demand function shows the functional relationship between the quantity demanded and the factors on which demand depends on.

1. Draw a demand curve with unitary elasticity.

Price

x

1. Define price elasticity of demand.

Ans :- It refers to the degree of responsiveness of quantity demanded to change in price.

3 AND 4 MARKS QUESTIONS & ANSWERS

1. Explain the law of Diminishing Marginal Utility with the help of a table and a diagram.

Ans :- The law of diminishing Marginal Utility states that as we consume more and more units of a commodity, the MU derived from the successive units of that commodity goes on decreasing. It is explained with the help of following schedule and diagram.

UNITS	TU	MU
1	8	8
2	14	6
3	18	4
4	20	2
5	20	0
6	18	-2

Diagram:

TU

TU/MU

X

Relationship between MU and TU:

1. When MU is positive TU rises.
2. When MU is zero TU is maximum.
3. When MU is negative, TU falls.
4. What is meant by consumer’s equilibrium? State its conditions in case of two commodities approach.
5. Meaning: A consumer is to be equilibrium when he is spending his given income on various goods and services to get maximum satisfaction.
6. Conditions:
7. MUx / Px = MUy / Py (MUs are equal to their prices)
8. PxQx+ PyQy =M
9. M ( Money spent is equal to income)
10. What is the difference between cardinal and ordinal utility analysis.

	Cardinal Utility	Ordinal Utility
1	Given by Prof. Alfred Marshall	Given by Prof. J.R. Hicks
2	Utility can be measured numerically	It cannot be measured numerically
3	Unit of measurement is ‘utils’	Possible for a consumer to scale his preferences.

1. Explain any four determinants of demand for a commodity.

Ans :- Following are the three determinants of demand for a commodity.

1. Price of the commodity:- When the price of a commodity increases the demand for

that commodity decreases and vice versa.

1. Income of the consumer:- When the income increases the demand for normal

commodity also increases and vice-versa.

1. Price of related goods :–
2. In complementary goods demand rises with fall in price of complementary goods.
3. In substitute goods demand for a commodity falls with a fall in the price of other substitute goods
4. Taste & preference of the consumer: With favourable taste, demand increase and unfavourable taste demand decreases for a commodity.
5. Draw a) perfectly elastic demand curve, b) perfectly inelastic demand curve and c) unitary elastic demand curve.

Ans :- a) perfectly elastic demand

y Ed=ro

Price

D

^p

^! >

o q q1 x

Quantity x b). Perfectly inelastic demand

Price

^y

p1

^p

O

D

D

Q

>

x

Ed=’0′

Quantity

c) Unitary elastic demand

Quantity

1. Explain any four factors that affect elasticity of demand.

Ans Following are the factors affecting price elasticity of demand.

1. Availability of close substitutes: If close substitutes of product are available, the commodity tends to be more elastic, If there are not available, they tend to be less elastic.
2. Proportion of total expenditure spent on the product:If the amount spent on a product constitutes a very small fraction of the total expenditure, then the demand tends to be less elastic of the amount spent is high the elasticity of demand tends to be high.
3. Habits: A commodity if it forms an essential part of the individual, the demand tends to be inelastic. It is consumed casually; the demand tends to be elastic
4. Time Period: Longer the time period, the more elastic is the demand for any product the shorter the time period, less elastic is the demand for any products

HOTS

1. Is the demand for the following elastic, moderate elastic, highly elastic? Give

reasons.

1. Demand for petrol
2. Demand for text books
3. Demand for cars
4. Demand for milk

Ans :- i) Demand for petrol is moderately elastic , because when the price of the petrol goes up , the consumer will reduce the use of it.

1. Demand for text books is completely inelastic. In case of text books, even a substantial change in price leaves the demand unaffected.
2. Demand for cars is elastic. It is a luxury good, when the price of the car rises, the demand for the car comes down.
3. Demand for milk is elastic, because price of the milk increases then the consumer purchase less quantity milk.
4. What is the relationship between slope and elasticity of a demand curve?

Ans :- The formula of Ed = AQ / AP * P / Q

The formula for the slope of the demand curve is, slope = AP / AQ

The relationship between slope and elasticity of demand is Ed= 1/slope * P/Q

6 MARKS QUESTIONS

1. How is equilibrium achieved with the help of indifference curve analysis?

Ans :-

a) Definition: In the indifference curve approach, consumer’s equilibrium is achieved at the point at which the budget line is tangent to a particular indifference curve. This is the point of maximum satisfaction.

b) Diagram:

A

O Good x B X

Good ‘y’

1. Explanation of the diagram:
2. ‘AB’ is the budget line.
3. It is sure that consumer’s equilibrium will lie on some point on ‘AB’
4. Indifference map (set of ICi, IC₂, IC₃) shows consumers scale of preferences between different combinations of good ‘x’ and good ‘y’
5. Consumers’ equilibrium will achieve where budget line (AB) is tangent to the IC₂.
6. Essential conditions for consumers equilibrium:
7. Budget line must be tangent to indifference curve i.e., MRS xy = Px / Py
8. Indifference curve must be convex to the origin or MRS xy should decrease.
9. Consumers cannot achieve the following:
10. P and R points on budget line give satisfaction but they lie on lower indifference curve IC₁. Choosing point ‘q’ puts him on a higher IC which gives more satisfaction.
11. He cannot move on IC₃, as it is beyond his money income.
12. Explain the factors affecting the market demand of a commodity.

Ans :- i) Meaning: Market demand is the aggregates of the quantities demanded by all the consumers in the market at different prices.

ii) Factors affecting market demand :

1. Price of the commodity: When the price goes up demand for its falls and vice- versa.
2. Income of the consumers: When the income of the consumers goes up the demand for a commodity also goes up.
3. Price of related goods :

• Complementary goods :The demand for a commodity rises with a fall in the price of its complementary good (Car and petrol)
• Substitute goods: Demand for a commodity falls with a fall in the price of other substitute good (Tea& Coffee).

1. Tastes and preferences: Any favourable change in consumers’ tastes will lead to increase in market demand and any unfavourable change in consumers tastes will lead to decrease in market demand.
2. Consumer’s group: More the consumers more will be market demand and vice- versa.
3. Explain the various degrees of price elasticity of demand with the help of diagrams.

Ans:- There are five degrees of price elasticity of demand. They are,

1. Perfectly elastic demand (Ed r):- a slight or no change in the price leads to infinite changes in the quantity demanded.
2. Perfectly Inelastic demand (Ed=0) :- Demand of a commodity does not change at all irrespective of any change in its price.
3. Unitary elastic demand (Ed=1):- When the percentage change in demand (%) of a commodity is equal to the percentage change in price.
4. Greater than unitary elastic demand (Ed>1):- When percentage change in demand of a commodity is more than the percentage change in its price.
5. Less than unitary elastic demand (Ed<1) :- When percentage change in demand of a commodity is less than the percentage change in its price.

Diagrams

y Ed=ro

^y

Ed=0

A

^y

Ed=1

Price

0 x

0

x

0

>

x

Numerical for practice

1. Derive the total utility schedule from the marginal utility.

Units consumed	Marginal utility
1	12
2	11
3	8
4	6
5	3
6	0

1. A consumer buys 50 units of a good at Rs. 4/- per unit. When its price falls by 25 percent its demand rises to 100 units. Find out the price elasticity of demand.

Ans:- Ed=4

1. Price elasticity of demand for wheat is equal to unity and a household demands 40 Kg of wheat when the price is Rs.1 per kg. At what price will the household demand 36 kg of wheat?

Ans:- The price of wheat rises to Rs. 1.10 per kg.

1. The quantity demanded of a commodity at a price of Rs.10 per unit is 40 units. Its price elasticity of demand is -2. Its price falls by Rs.2/- per unit. Calculate its quantity demanded at the new price.

Ans :- 56 units.

FREQUENTLY ASKED QUESTIONS – CBSE BOARD EXAMINATIONS

1. Define Microeconomics.
2. Why an economic problem does arises?
3. What are the central problems of an economy?
4. Define opportunity cost.
5. Define marginal opportunity cost.
6. Distinguish between ‘micro’ and’ macro’ economics.
7. Why PPC is Concave from the origin.
8. Define Marginal Rate of Transformation (MRT)
9. Explain the problem, of ‘what to produce’ and ‘how to produce.’
10. Explain the central problem of how to produce with the help of an example.
11. What is an indifference curve?
12. Define Utility.
13. What is budget set?
14. Define budget line.
15. Define MRS.
16. A consumer consumes only two goods. Explain the conditions of consumer’s equilibrium with the help of IC analysis.
17. For a consumer to be in equilibrium, why must MRS be equal to the ratio of price of two goods?
18. What is an indifference map?
19. Explain the law of demand with the help of diagram and schedule.
20. Write three causes of increase / decrease in demand
21. Distinguish between the change in quantity demanded and change in demand.
22. Explain any three factors or determinants of demand.
23. Explain any three factors affecting elasticity of demand
24. Explain the price elasticity of demand through geometric method.
25. Explain the price elasticity of demand through expenditure method
26. Explain the properties of indifference curve.
27. Why can not two indifference curves meet each other?
28. Why is indifference curve convex to origin?
29. Why does higher indifference curve gives higher levels of satisfaction?

INTRODUCTORY MICRO ECONOMICS
UNIT 1: INTRODUCTION

KEY CONCEPTS

• MICRO ECONOMICS
• ECONOMY
• TYPES OF ECONOMY
• PLANNED ECONOMY
• MARKET ECONOMY
• CENTRAL PROBLEMS OF AN ECONOMY | BASIC ECONOMIC PROBLEMS
• WHAT TO PRODUCE?
• HOW TO PRODUCE?
• FOR WHOM TO PRODUCE?
• CAUSES OF AN ECONOMIC PROBLEM
• PRODUCTION POSSIBILITY CURVE
• MARGINAL OPPORTUNITY COST -MOC
• MARGINAL RATE OF TRANSFORMATION
• SCARCITY OF RESOURCES
• OPPORTUNITY COST

1. MICRO ECONOMICS: It is a study of behaviour of individual units of an economy such as individual consumer, producer etc.
2. ECONOMY: An economy is a system by which people get their living.
3. TYPES OF ECONOMY:
4. Capitalist economy / Market economy
5. Socialist economy / Planned economy
6. Mixed economy
7. MARKET ECONOMY: It is an economic system, in which all material means of production are owned and operated by the private with profit motive.
8. PLANNED ECONOMY: In this economy all material means of production are owned by the government or by a centrally planned authority. All important decisions regarding production, exchange and distributions, consumptions of goods and services are made by the government or by a centrally planned authority
9. ECONOMIC PROBLEM: “An economic problem is basically the problem of choice” which arises due to scarcity of resources having alternative uses”.
10. CAUSES OF ECONOMIC PROBLEM :
11. Scarcity of resources
12. Unlimited wants
13. Limited resources having alternative uses
14. BASIC (CENTRAL) ECONOMIC PROBLEMS
15. Allocation of resources
16. What to produce?
17. How to produce?
18. For whom to produce
19. . Efficient Utilization of resources

iii.) Growth of resources

1. PRODUCTION POSSIBILITY CURVE (PPC): PP curve shows all the possible combination of two goods that can be produced with the help of available resources and technology.
2. MARGINAL OPPORTUNITY COST: MOC of a particular good along PPC is the amount of other good which is sacrificed for production of additional unit of another good.
3. MARGINAL RATE OF TRANSFORMATION: MRT is the ratio of units of one good sacrificed to produce one more unit of other good.

Unit of one good sacrificed Ay

MRT = = —

More unit of other good produced Ax

1. SCARCITY OF RESOURCES: Scarcity of resources means shortage of resources in relation to their demand.
2. OPPORTUNITY COST: It is the cost of next best alternative foregone.
3. POSITIVE ECONOMICS: Positive economics deals with what is, what was (or) how an economic problem facing the society is actually solved.
4. NORMATIVE ECONOMICS: It deals with what ought to be (or) how an economic problem should be solved.

VERY SHORT ANSWER QUESTIONS (1 MARK)

1. What is economics about?

Ans : – Economics is the study of the problem of choice arising out of scarcity of resources having alternative uses.

1. Define scarcity.

Ans : – Scarcity means shortage of resources in relation to their demand is called scarcity.

1. What is an economy?

Ans : – An economy is a system by which people get their living.

1. Define central problem.

Ans : – Central problem is concerned with the problems of choice (or) the problem of resource allocation.

1. What do you understand by positive economic analysis?

Ans : – It deals with what is (or) how an economic problem facing an economy is solved. It analyses the cause of effect relationship.

1. What do you understand by normative economic analysis?

Ans : – Normative economic analysis deals with what ought to be (or) how an economic problem should be solved.

1. Give one reason which gives rise to economic problems?

Ans : – Scarcity of resources which have alternative uses.

1. Name the three central problems of an economy.

Ans : – i) What to produce?

1. How to produce?
2. For whom to produce?
3. What is opportunity cost?

Ans : – It is the cost of next best alternative foregone.

1. Why is there a need for economizing of resources?

Ans : – Resources are scarce in comparison to their demand, therefore it is necessary to use resources in the best possible manner without wasting it.

1. What is production possibility frontier?

Ans : – It is a boundary line which shows the various combinations of two goods which can be produced with the help of given resources and technology.

1. Why PPC is concave to the origin?

Ans :- PPC is concave to the origin because of increased marginal opportunity cost.

1. Define marginal rate of transformation.

Ans :- MRT is the ratio of units of one good sacrificed to produce one more unit of other goods. MRT = Ay / Ax

1. What does a point inside the PPC indicate?

Ans :- Any point inside the production possibility curve indicate underutilization of resources.

1. What do you mean by the problem of what to produce?

Ans :- It is the problem of choosing which goods and services should be produced in what quantities.

1. What do you understand by the problem of how to produce?

Ans :- It is the problem of choosing technique of production of goods and services.

1. What does the problem for whom to produce indicate?

Ans The problem of for whom to produce refers to the distribution of goods and services produced in the economy.

1. Give two examples each of micro economics & macroeconomics.

Ans :- Microeconomics – Individual demand, individual supply

Macroeconomics – Aggregate demand and aggregate supply

1. What does a rightward shift of PPC indicate?

Ans :- It indicates a) growth of resources b) improvement in technology

1. What is meant by economising of resources?

Ans :- It means making best use of available resources.

SHORT ANSWER QUESTIONS (3 / 4 MARKS)

1. What is production possibility frontier?

Ans :- It is a boundary line which shows that maximum combination of two goods which can be produced with the help of given resources and technology at a given period of time.

Ex: An economy can produce two goods say rice or oil by using all its resources. The different combination of rice and oil are as follows:

Production Possibilities	Rice (quintals)	Oil (litres)
A	0	10
B	1	9
C	2	7
D	3	4
E	4	0

10

9

8

7

6

5

4

Oil

3

E

0 1 2 3 4

Rice

1. Draw a production possibility curve and mark the following situations:
2. underutilization of resources
3. full employment of resources
4. growth of resources

Ans. Every point on PP curve like ABCDEF indicates full employment and efficient uses of resources.

Any point below or inside PP curve like G underutilization of resources.

Any point above PP curves like H indicates growth of resources.

Wheat

F

0 1 2 3 4 5

Cloth

Production Possibility Curve And Opportunity Cost

It refers to a curve which shows the various production possibilities that can be produced with given resources and technology.

Production Possibilities

Production	Commodity	Commodity	Marginal opportunity
Possibility	A	B	cost of commodity A
A	0	15	–
B	1	14	15-14=1

C	2	12	14-12=2
D	3	09	12-9=3
E	4	05	9-5=4
F	5	0	5-0=5

If the economy devotes all its resources to the production of commodity B, it can produce 15 units but then the production of commodity A will be zero. There can be a number of production possibilities of commodity A & B

If we want to produce more commodity B, we have to reduce the output of commodity A & vice versa.

Shape of PP curve and marginal opportunity cost.

1. PP curve is a downward sloping curve.

In a full employment economy, more of one goods can be obtained only by giving up the production of other goods. It is not possible to increase the production of both of them with the given resources.

1. The shape of the production possibility curve is concave to the origin.

The opportunity cost for a commodity is the amount of other commodity that has been foregone in order to produce the first.

The marginal opportunity cost of a particular good along the PPC is defined as the amount sacrificed of the other good per unit increase in the production of the good in question. Example: Suppose a doctor having a private clinic in Delhi is earning Rs. 5lakhs annually. There are two other alternatives for him.

1. Joining a Govt. hospital in Bangalore earning Rs. 4 lakhs annually.
2. Opening a clinic in his home town in Mysore and earning 3 lakhs annually.

The opportunity cost will be joining Govt. hospital in Bangalore.

Increasing marginal opportunity cost implies that PPC is concave.

Shift in PP curve

(1) Upward shift

1. When there is improvement in technology.
2. Increase in resources.

(2) Downward shift

When Resources depletes

Commodity B

3. Distinguish between a centrally planned economy and a market economy.

SNo	Planned Economy	Market Economy
1	All the materials means of production are owned by government.	All the materials means of production are owned by private individuals.
2	Main objectives of production is social welfare	Main objectives of production are maximization of profit.
3	Ownership of property is under government control.	There is no limit to private ownership of property.

4	All the economic problems are solved	All the economic problems are solved
	as per direction of the planning	through price mechanism i.e., demand
	commission.	and supply.

4. Distinguish between micro economics and macroeconomics.

SNo	Micro economics	Macro economics
1	It studies individual economic unit.	It studies aggregate economic unit
2	It deals with determination of price and output in individual markets	It deals with determination of general price level and output in the economy.
3	Its central problems are price determination and allocation of resources.	Its central problem is determination of level of Income and employment in the economy.

HOTS

1. Does massive unemployment shift the PPC to the left?

Ans:- Massive unemployment will shift the PPC to the left because labour force remains underutilized. The economy will produce inside the PPC indicating underutilization of resources.

1. What does the slope of PPC show?

Ans. The slope of PPC indicates the increasing marginal opportunity cost.

1. From the following PP schedule calculate MRT of good x.

Production possibilities	A	B	C	D	E
Production of good x units	0	1	2	3	4
Production of good y units	14	13	11	8	4

Production of good X units	Production of good Y units	MRT = Ay / Ax
0	14	–
1	13	1:1
2	11	2:1
3	8	3:1
4	4	4:1

How are fundamental problems solved in the capitalistic economy.

In a market-oriented or capitalist economy, the fundamental problems are solved by the market mechanism. Price is influenced by the market forces of demand and supply. These forces help to decide what, how and for whom to produce.

How are fundamental problems solved in the planned economy?

In a planned economy all the economic decisions regarding what, how and for whom to produce are solved by the state through planning. Economic planning replaces the price mechanism. The market is regulated by the state. The prices of the various products are fixed by the state called administered prices.

UNIT X: BALANCE OF PAYMENTS AND FOREIGN EXCHANGE RATE

Foreign Exchange refers to all currencies other than the domestic currency of a given country.

Foreign exchange rate is the rate at which currency of one country can be exchanged for currency of another country.

Foreign Exchange Market: The Foreign Exchange market is the market where the national currencies are traded for one another.

Functions of Foreign Exchange Market:

1. Transfer function: It transfers the purchasing power between countries.
2. Credit function: It provides credit channels for foreign trade
3. Hedging function: It protects against foreign exchange risks.

FIXED EXCHANGE RATE SYSTEM: Fixed exchange rate is the rate which is officially fixed by the government, monetary authority and not determined by market forces.

FLEXIBLE EXCHANGE RATE: Flexible exchange rate is the rate which is determined by forces of supply and demand in the foreign exchange market.

DEMAND FOR AND SUPPLY OF FOR FOREIGN EXCHANGE

Demand for foreign exchange:

1. To purchase goods and services from other countries
2. To send gifts abroad
3. To purchase financial assets (shares and bonds)
4. To speculate on the value of foreign currencies
5. To undertake foreign tours
6. To invest directly in shops, factories, buildings
7. To make payments of international trade.

Supply of foreign exchange:

Foreign currencies flow into the domestic economy due to the following reason.

1. When foreigners purchase home countries goods and services through exports
2. When foreigners invest in bonds and equity shares of the home country.
3. Foreign currencies flow into the economy due to currency dealers and speculators.
4. When foreign tourists come to India
5. When Indian workers working abroad send their saving to families in India.

EQUILIBRIUM IN THE FOREIGN EXCHANGE MARKET

The equilibrium exchange rate is determined at a point where demand for and supply of foreign exchange are equal. Graphically interaction of demand and supply curve determines the equilibrium exchange rate of foreign currency.

y

Demand and supply of US$

Managed Floating: This is the combination of fixed and flexible exchange rate. Under this, country manipulates the exchange rate to adjust the deficit in the B.O.P by following certain guidelines issued by I.M.F.

Dirty floating: If the countries manipulate the exchange rate without following the guidelines issued by the I.M.F is called as dirty floating.

BALANCE OF PAYMENTS: MEANING AND COMPONENTS

Meaning: The balance of payments of a country is a systematic record of all economic transactions between residents of a country and residents of foreign countries during a given period of time.

BALANCE OF TRADE AND BALANCE OF PAYMENTS

Balance of trade: Balance of trade is the difference between the money value of exports and imports of material goods (visible item)

Balance of payments: Balance of payments is a systematic record of all economic transactions between residents of a country and the residents of foreign countries during a given period of time. It includes both visible and invisible items. Hence the balance of payments represents a better picture of a country’s economic transactions with the rest of the world than the balance of trade.

STRUCTURE OF BALANCE OF PAYMENT ACCOUNTING

A balance of payments statement is a summary of a Nation’s total economic transaction undertaken on international account. There are two types of account.

1. Current Account: It records the following 03 items.

1. Visible items of trade: The balance of exports and imports of goods is called the balance of visible trade.
2. Invisible trade: The balance of exports and imports of services is called the balance of invisible trade E.g. Shipping insurance etc.
3. Unilateral transfers: Unilateral transfers are receipts which resident of a country receive (or) payments that the residents of a country make without getting anything in return e.g. gifts.

The net value of balances of visible trade and of invisible trade and of unilateral transfers is the balance on current account.

1. CAPITAL ACCOUNT: It records all international transactions that involve a resident of the domestic country changing his assets with a foreign resident or his liabilities to a foreign resident.

VARIOUS FORMS OF CAPITAL ACCOUNT TRANSACTIONS

1. Private transactions: These are transactions that are affecting assets (or) liabilities by individuals.
2. Official transactions: Transactions affecting assets and liabilities by the government and its agencies.
3. Direct Investment: It is the act of purchasing an asset and at the same time acquiring and control of it.
4. Portfolio investment: It is the acquisition of assets that does not give the particular control over the asset.

The net value of balances of direct and portfolio investment is called the balance on capital account.

OTHER ITEMS IN THE BALANCE OF PAYMENT

They are included since the full balance of payments account must balance. These items are as follows.

1. Errors and Omissions: They may arise due to the presence of sampling and due to his honesty.
2. Official reserve transactions: All transactions except those in this category may be termed as autonomous transactions. They are so called because they were entered into with some independent motive. Balance of payments always balance.

AUTONOMOUS AND ACCOMMODATING ITEMS

Autonomous items: Autonomous items in the B.O.P refer to international economic transactions that take place due to some economic motive such as profit maximization. These items are often called above the line items in the B.O.P.

The balance of payments is in a deficit if the autonomous receipts are less than autonomous payments. The monetary authorities may finance a deficit by depleting their reserves of foreign currencies, or by borrowing from I.M.F.

Accommodating items: Accommodating items in the B.O.P. refer to transactions that occur because of other activity with the B.O.P such as government financing. Accommodating items are also referred to as below the line of items.

DISEQUILIBRIUM THE BALANCE OF PAYMENTS

There are a number of factors that cause disequilibrium in the balance of payments showing either a surplus or deficit. These causes are categorized into 3 factors.

1. Economic factors: Large scale development expenditure that may cause large imports.

Cyclical fluctuations in general business activities such as recession or depression.

High domestic prices may result in imports.

1. Political factors: Political instability may cause large capital outflows and hamper the inflows of foreign capital.
2. Social factors: Changes in tastes, preferences and fashions may affect imports and exports.

VERY SHORT ANSWER QUESTIONS.

1. Define foreign exchange rate.

Ans: Foreign exchange rate is the rate at which currency of one country can be exchanged for currency of another country.

1. What do you mean by Foreign Exchange Market?

Ans: The foreign exchange market is the market where international currencies are traded for one another.

1. What is meant by Fixed Exchange Rate?

Ans: Fixed Rate of exchange is a rate that is fixed and determined by the government of a country and only the government can change it.

1. What is equilibrium rate of exchange?

Ans: Equilibrium exchange rate occurs when supply of and demand for foreign exchange are equal to each other.

1. Define flexible exchange rate.

Ans: Flexible rate of exchange is that rate which is determined by the demand and supply of different currencies in the foreign exchange market.

1. What is meant by appreciation of currencies?

Ans: Appreciation of a currency occurs when its exchange value in relation to currencies of other country increases.

1. Define Spot exchange rate.

Ans: The spot exchange rate refers to the rate at which foreign currencies are available on the sport.

1. Define forward market.

Ans: Market for foreign exchange for future delivery is known as the forward market.

1. What is meant by balance of payments?

Ans: Balance of payments refers to the statement of accounts recording all economic transactions of a given country with the rest of the world.

1. What do you mean by balance of trade?

Ans: Balance of trade is the difference between the value of imports and exports of only physical goods.

1. The balance of trade shows a deficit of Rs. 600 crores, the value of exports is Rs.1000 crores. What is value of Imports?

Ans: Balance of Trade = Exports of goods – import of goods

Import of good = Export of goods – (B.O.T)

= 1000- (-600)

= Rs. 1600.

1. What is the balance of visible items in the balance of payments account called?

Ans: – Balance of trade

1. What do you mean by disequilibrium in BOP?

Ans:- Disequilibrium in BOP is means either there is a surplus or deficit in balance of payment account.

1. List two items of the capital account of BOP account.

Ans:- i) external assistance ii) commercial borrowing iii) foreign investment

1. Which transactions bring balance in the BOP account?

Ans:- Accommodating transactions bring balance in the BOP account.

1. Define autonomous items in BOP.

Ans:- Autonomous items in BOP refers to international economic transaction that take place due to some economic motive such as profit maximization. These items are independent of the state of the country balance of payments.

1. What is the other name of autonomous items in the BOP?

Ans:- The other name of autonomous items in BOP is above the line item.

1. When does a situation of deficit in BOP arises?

Ans:- A situation of deficit in BOP arise when autonomous receipts are less than autonomous payments.

1. What is meant by managed floating?

Ans:- It is a system that allows adjustments in exchange rate according to a set of rules and regulations which are officially declared in the foreign exchange market.

1. What is meant by dirty floating?

Ans:- Manipulate the exchange rate without following the guidelines issued by IMF is called dirty floating.

ANSWER QUESTIONS (3 / 4 MARKS)

1. Why is foreign exchange demanded?

Ans:- Foreign exchange is demanded for the following purposes.

1. Payment of International loans
2. Gifts and grants to rest of the world
3. Investment in rest of the world.
4. Direct purchases abroad for goods and services as well as imports from rest of the world.
5. What determines the flow of foreign exchange in to the country?

Ans: – Following factors contribute to the flow of foreign exchange in to the country.

1. Purchases of domestic goods by the foreigners
2. Direct foreign investment and portfolio investment in the home country.
3. Speculative purchase of foreign exchange.
4. When foreign tourists come to India.
5. Why does the demand for foreign exchange rise, when it price falls?

Ans:- With a fall in price of foreign exchange , the exchange value of domestic currency increases and that of foreign currency falls. This implies that foreign goods become cheaper and their domestic demand increases. The rising domestic demand for foreign goods implies higher demand for foreign exchange. So there is inverse relationship between price and demand for foreign exchange.

1. When price of a foreign currency falls, the supply of that foreign currency also fall why?

Ans: When price of a foreign currency falls it makes exports, investment by foreign residents costlier as a result supply of foreign currency falls.

1. Distinguish between autonomous and accommodating transaction of balance of payment account.

Ans: Autonomous transactions are done for some economic consideration such as profit, such transactions are independent of the state of B.O.P. Accommodating transactions are under taken to cover the deficit/surplus in balance of payments.

price

Ans:

Give two examples explain why there is a rise in demand for a foreign currency when its

Sl.	Forms of	Very Short (1	Short Answer	Long	Total
1	Unit 1	1(1)	3(1)	—	4
2	Unit 2	1(2)	3(2), 4(1)	6(1)	18
3	Unit 3	3(1)	3(1), 4(2)	6(1)	18
4	Unit 4	1(1)	3(1)	6(1)	10
5	Unit 5	Not to be tested
6	Unit 6	—	3(3)	6(1)	15
7	Unit 7	1(2)	—	6(1)	08
8	Unit 8	1(2)	4(1)	6(1)	12
9	Unit 9	—	4(2)	—	08
10	Unit 10	1(1)	3(2)	—	07
	Sub Total	10(10)	30(10), 24(6)	36(6)	100

When price of foreign currency falls, imports are cheaper. So, more demand for foreign exchange by importers.

falls.

Tourism abroad is promoted as it becomes cheaper. So demand for foreign currency rises.

Distinguish between fixed and flexible foreign exchange rate.

Ans: When foreign exchange rate is fixed by Central Bank/government, it is called fixed exchange rate. When foreign exchange rate is determined by market forces/mechanism, it is flexible exchange rate.

UNIT IX: GOVERNMENT BUDGET AND THE ECONOMY

KEY CONCEPTS:

• Meaning of the Budget
• Objectives of the Budget
• Components of the Budget
• Budget Receipts
• Budget Expenditure
• Balanced, Surplus and Deficit Budgets
• Types of Deficits

GOVERNMENT BUDGET – A FLOW CHART

1 MARK QUESTIONS AND ANSWERS

1. Define a Budget.

Ans: It is an annual statement of the estimated Receipts and Expenditures of the Government over the fiscal year which runs from April -I to March 31.

1. Name the two broad divisions of the Budget.

Ans: i) Revenue Budget

1. Capital Budget
2. What are the two Budget Receipts?

Ans: i) Revenue Receipts

1. Capital Receipts
2. Name the two types of Revenue Receipts.

Ans: i) Tax Revenue

ii) Non-tax Revenue

1. What are the two types of taxes?

Ans: a) Direct Taxes: i) Income Tax, ii) Interest Tax, iii) Wealth Tax

1. Indirect Taxes: i) Customs duties, ii) Excise duties, iii) Sales Tax
2. What are the main items of Capital Receipts?

Ans: a) Market Loans (loans raised by the government from the public)

1. Borrowings by the Government
2. Loans received from foreign governments and International financial Institutions.
3. Give two examples of Developmental Expenditure.

Ans: Plan expenditure of Railways and Posts

1. Give two examples of Non-Developmental expenditures.

Ans: i) Expenditure on defence ii) Interest payments

1. Define Surplus Budget.

Ans: A Surplus Budget is one where the estimated revenues are greater than the Estimated expenditures.

1. What are the four different concepts of Budget Deficits?

Ans: a) Budget Deficit

1. Revenue Deficit
2. Primary Deficit and
3. Fiscal Deficit

3 AND 4 MARK QUESTIONS AND ANSWERS

1. Explain the objectives of the Government Budget.

Ans: These below are the main objectives of the Government Budget.

1. Activities to secure reallocation of resources: – The Government has to reallocate resources with social and economic considerations.
2. Redistributive Activities: – The Government redistributes income and wealth to reduce inequalities.
3. Stabilizing Activities: – The Government tries to prevent business fluctuations and maintain economic stability.
4. Management of Public Enterprises: – Government undertakes commercial activities that are of the nature of natural Monopolies, heavy manufacturing etc., through its public enterprises.
5. What are the components of the Budget?

Ans: These below are the main components of the Government Budget. They are—

1. Budget Receipts
2. Budget Expenditure

Budget receipts may be classified as:

1. Revenue Receipts and
2. Capital Receipts

Revenue Receipts may be classified as:

1. Tax Revenue and
2. Non-tax Revenue

Budget Expenditure may be classified as

1. Revenue Expenditure and Capital Expenditure
2. Plan Expenditure and Non-Plan Expenditure
3. Developmental and Non-Developmental Expenditure
4. Define Direct Taxes and Indirect taxes and give two examples each.
5. Direct Tax: – These are those taxes levied immediately on the property and Income of persons, and those that are paid directly by the consumers to the state.

Examples: Income Tax, Wealth Tax, Corporation Tax etc.

1. Indirect Taxes: These are those taxes that affect the income and property of persons

through their consumption expenditure. Indirect taxes are those taxes levied on one

person but paid by another person.

Examples: Customs duties, excise duties, sales tax, service tax etc.

1. What are the Non-Tax Revenue receipts?

Ans: These below are the Non-tax revenue receipts:

1. Commercial Revenue: Examples-Payments for postage, toll, interest on funds borrowed from government credit corporations, electricity, Railway services.
2. Interest and dividends
3. Administrative revenue: Examples: Fees, fines, penalties etc.,
4. What are the three major ways of Public Expenditure?

Ans: These below are the three ways of Public Expenditure—

1. Revenue Expenditure and Capital Expenditure
2. Plan Expenditure and Non-Plan Expenditure
3. Development and Non-developmental Expenditure.
4. What do you mean by Revenue Expenditure and Capital Expenditure?

Ans: i) Revenue Expenditure:- It is the expenditure incurred for the normal running of government departments and provision of various services like interest charges on debt, subsidies etc.,

ii)Capital Expenditure:- It consists mainly of expenditure on acquisition of assets like land, building, machinery, equipment etc., and loans and advances granted by the Central Government to States & Union Territories.

1. Define Balanced, Surplus and Deficit Budgets.

Ans: a) Balanced Budget – It is one where the estimated revenue EQUALS the estimated expenditure.

1. Surplus Budget:- It is one where the estimated revenue is GREATER THAN the estimated expenditures.
2. Deficit Budget:- It is one where the estimated revenue is LESS THAN the estimated expenditure.
3. Explain the four different concepts of Budget deficit.

Ans: These are the four different concepts of Budget Deficit.

1. Budget Deficit:- It is the difference between the total expenditure, current revenue and net internal and external capital receipts of the government.

Formulae: B.D = BE > B.R (B.D= Budget Deficit, BE. Budget Expenditure B.R= Budget Revenue

1. Fiscal Deficit:- It is the difference between the total expenditure of the government, the revenue receipts PLUS those capital receipts which finally accrue to the government. Formulae: F.D = B.E – B.R (B.E > B.R. other than borrowings) F.D=Fiscal Deficit,

B.E= Budget Expenditure, B.R. = Budget Receipts.

1. Revenue Deficit: – It is the excess of governments revenue expenditures over revenue receipts.

Formulae: R.D= RE – R.R., When RE > R.R., R.D= Revenue Deficit, R.E= Revenue Expenditure, R.R. = Revenue Receipts.

1. Primary Deficit: – It is the fiscal deficit MINUS Interest payments.

Formulae: P.D= F.D – I.P, P.D= Primary Deficit, F.D= Fiscal Deficit, I.P= Interest Payment.

06 MARK QUESATIONS AND ANSWERS

1. How is tax revenue different from administrative revenue?

Ans:

1. Tax Revenue:-

i) It is the main source of revenue of the government

iil It is the revenue that arises on account of taxes levied by the government.

1. Taxes of two types i.e., Direct and Indirect.
2. Direct taxes are those taxes levied immediately on the property and income of

persons. Examples: Income Tax, Corporate Tax, Wealth Tax etc., Incidence and impact falls on same person.

1. Indirect taxes are those taxes levied on the production and sale of the goods.

Examples: Sales Tax, Excise Duty etc. Tax paid by one person but burden taken by another person.

1. Administrative Revenue:-

i) It is the revenue that arises on account of the administrative function of the Government.

ii) It includes-

1. Fees
2. License fees
3. Fines and penalties
4. Forfeitures of surety by courts
5. Escheat – means claim of the government on the property of a person who dies without having any legal heirs.
6. What is a balanced government budget? Explain the multiplier effect of a balanced budget. Ans:
7. Balanced Budget: – It is one where the estimated revenue of the government equals the estimated expenditure.
8. Effect of Multiplier on the BalancedBudget:-
9. If only source of revenue is a lump sum tax, a balanced budget will then mean that the

amount of tax equals the amount of expenditure (T=E)

1. A balanced budget has an expansionary effect on the economy.
2. Under balanced budget, the increase in income is equalent to the amount of

government expenditure financed by tax revenue (i.e., A Y =AG/AT)

1. The multiplier effect of a balanced budget is ONE (Unitary)
2. A balanced budget is a good policy to bring the economy, which is under employment

to a full employment equilibrium.

HIGHER ORDER THINKING SKILLS (HOTS)

1. What are the three levels at which the budget impacts the economy?

Ans: These below are the three levels at which the budget impacts the economy.

1. Aggregate fiscal discipline:- This means having control over expenditures, given the quantum of revenues. This is necessary for proper macro-economic performance.
2. Allocation of resources: – The allocation of resources based on social priorities.
3. Effective and efficient provision of programmes:- Effectiveness measures the extent to which goods and services the government provides its goals.

NUMERICALS

1. The following figures are based on budget estimates of Government of India for the year 2001 – 2002. Calculate i) Fiscal Deficit ii) Revenue Deficit and iii) Primary deficit.

ITEMS	RS. BILLIONS
A) Revenue receipts	2,31,745
i) Tax Revenue	1,63,031
ii) Non-tax Revenue	68,714
B) Capital receipts	1,43,478
i) Recoveries of loans	15,164
ii) Other receipts	12,000
iii) Borrowings and other	1,16,314

liabilities
C) Revenue expenditure	3,10,566
i) Interest payments	1,12,300
ii) Major subsidies	27,845
iii) Defence Expenditure	1,70,421
D) Capital Expenditure	64,657
E) Total Expenditure	3,75,223
i) Plan expenditure	1,00,100
ii) Non-plan expenditure	2,75,123

1. Ans: Fiscal Deficit = Total expenditure – Revenue receipts – Non-debt capital receipts = 3,75,223 – 2,31,745 – 15,164 – 12,000 = Rs. 1,16,314 billion.
2. Revenue Deficit = Revenue expenditure – Revenue receipts

= 3, 10,566 – 2, 31,745 = Rs. 78,821 billion.

1. Primary deficit = Fiscal deficit – Interest payments

= 1, 16,314 – 1, 12,300 = Rs. 4,014 billion.

2. From the following data about a government budget find

a) Revenue Deficit b) Fiscal Deficit and c) Primary Deficit.

S.No.	Items	Rs. (cr.)
01	Tax revenue	47
02	Capital receipts	34
03	Non-tax revenue	10
04	Borrowings	32
05	Revenue expenditure	80
06	Interest payments	20

Ans: a) Revenue Deficit = Revenue expenditure – (Tax revenue + Non-tax revenue) 80 – (47+10) = 80 – 57 = 23 (cr.)

Fiscal Deficit = Borrowings = 32 (cr.)

Primary Deficit = Borrowings – Interest Payments 32 – 20 = 12 (cr.)

FREQUENTLY ASKED CBSE BOARD QUESTIONS

1. Define full employment? (1)
2. What do you mean by Aggregate Demand? (1)
3. Write any two components of aggregate demand? (1)
4. Define Aggregate Supply? (1)
5. When APC is 0.6, what is the value of APS? (1)
6. If the rate of MPC is 0.75 find the value of multiplier? (1)
7. Define investment multiplier? (1)
8. What are the conditions for equilibrium level of income and employment? (1)
9. What is meant by excess demand? (1)
10. Define inflationary gap. (1)
11. Define deficient demand? (1)
12. Define underemployment equilibrium? (3)
13. What are the monetary measures to correct excess demand? (3)
14. State the fiscal measures to correct excess demand? (3)
15. Explain any two monetary and fiscal measures to correct deficient demand? (4)
16. Define investment multiplier. What is the relationship between MPC and multiplier? (4)
17. State the components of AD. Explain any one. (4)
18. Explain investment multiplier with the help of an example. (4)
19. Derive saving function from consumption function. (4)
20. State the Keynesian psychological law of consumption function. (4)

 

CBSE Class-12 Economics
Macro Economics
Chapter 1 – Introduction
Revision Notes

1. Macro Economics: It deals with the aggregate economic variables of an economy.

The word macro comes from a Greek word ‘Makros’ which means large. It is a branch of economics that studies the economic relationships or issues of an economy as a whole like total consumption, saving etc. It investigates the principles, problems and policies relating to achievement of full employment and expansion of productive capacity. It evolved only after the publication of Keynesian’s book, ‘The Theory of Employment, Interest, and Money’. Macroeconomics takes a top-down approach.

1. Capitalist Country : In a capitalist country production activity are mainly carried out by capitalist enterprises.

“Doing well is the result of doing good. That’s what capitalism is all about.” – Ralph Waldo Emerson

Capitalist economy is an economic system governed by capitalist i.e., where the means of production and distribution are privately or corporately owned. It is primarily run by price mechanism, without any interference of government. Government role is to maintain law and order only. This economy’s main motive is to earn profit. This economic structure is also known as free market economy or laissez faire. Examples of capitalist economies are Hong Kong, Singapore, Canada, UAE, Ireland etc.

Important features of capitalist economy

• Role of the government.
• Profit Motive
• Central Problems
• Role of Private Sector
• Laissez Fare

1. Wage Rate: There is sale and purchase of labour services at a price which is called the v.a. go rate.
2. Wage Labour: The labour which is sold and purchased against wages is referred to as wage labour.
3. Great Depression: Great depression of 1929 and the subsequent year saw the output and employment levels in the countries of the world as well.

The Great Depression was the worst economic downturn in the history of the industrialized world. It began after the stock market crash of October 1929, which sent Wall Street in panic and wiped out millions of investors. In 21 st century, the Great Depression is commonly used as an example of how far an economy can decline. The main cause behind this crisis was the fall in aggregate demand due to under consumption and over investment. Aggregate supply was greater than aggregate demand which resulted into depressing activities. Due to under consumption 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 fall 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 the unemployment. In USA, the rate of unemployment increased from 3% to25%.

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 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 —» Low Demand

1. Enterpreneurs: People who exercise control over major decisions and bear a large part of the risk associated with the firm / enterprise.
2. Revenue: The money that is easned is called revenue.
3. Investment Expenditure: Expensed which raise productive capacity are called inverstment expenditure.

Four Major Sectors of Economy from Macro Economic Point of View:-

The four aggregate macroeconomic sectors that form the foundation for macroeconomic analysis are the Household Sector, the Business Sector, the Government Sector and the foreign sector. These four key functions are responsible for four expenditures on Gross Domestic Product (GDP).

The four major sectors of an economy according to the macroeconomic point of view are:

1. Households
2. Firms / Business
3. Government
4. External sector / Foreign

These can be represented in the following flow chart:

1. Households: Household means a single individual or a group of individuals who independently take decisions regarding their economics activities (i.e., consumption and production). Household sector 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. In short, this sector includes everyone, consumers, people and every member of the society. This sector is responsible for the consumption expenditures role in GDP.

1. Firms: Firms are economic units that carry out the production. They employ and organize factors of production and undertake production process for the motive of profit making. This includes sole proprietorship, partnerships and corporations. This sector is responsible for investment expenditure role in GDP.
2. Government: A state/govemment 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 by imposing taxes. The government invests in education, health sector and provides these services at nominal price. The motive of a government is to serve and not to make profits. Transportation Dept., Environmental Protection agencies are its examples. This sector is responsible for government purchase role in GDP.

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. Apart from export and import of goods, there can be inflow of goods (i.e., a country inviting capital from foreign countries) and outflow of foreign capital (i.e., investing in foreign countries). The expenditure on gross domestic product attributable to the foreign sector is net exports.

Main Objectives of any Macro Economic Policies:-

Key concepts

• Aggregate demand and its components.
• Propensity to consume and propensity to save
• Short run fixed price in product market equilibrium output, investment or output multiplier and the multiplier mechanism.
• Meaning of full employment and involuntary unemployment.
• Problems of excess demand and deficient demand.
• Measures to correct excess demand and deficient demand.
• Change in government spending.
• Availability of credit.
• Autonomous consumption: The consumption which does not depend upon income. (Or) The amount of consumption expenditure when income is zero. C > 0. Even if income is zero consumption cannot be zero. Consumption will take place from past savings for survival.
• Autonomous Investments: It is Investment which is made irrespective of level of income. It is generally run by the government sector. It is income inelastic. The volume of autonomous investment is same at all level of income.

Key points

• Determination of income, output and employment is the core of the subject matter of macroeconomics.
• AD and AS together determine the level of income, output and employment.
• Aggregate demand is the total demand of goods and service in the economy.
• The main components of AD are-

1. House hold consumption expenditure.
2. Investment expenditure.
3. Government consumption expenditure
4. Net export.

• Household consumption expenditure is the expenditure incurred by the household on the purchase of goods and services to satisfy their wants.
• Investment expenditure refers to the expenditure incurred by the private firms and government on the purchase of capital goods such as plant and equipment.
• Government consumption expenditure refers to the expenditure incurred by the government on the purchase of goods and services.
• Net export refers to the difference between export and import.
• AD=C+I+G+(x-m).
• In a two sector economy AD =C+I.
• Aggregate supply is the sum total of consumption expenditure and saving.

AS=C+S

PROPENSITY TO CONSUME AND PROPENSITY TO SAVE.

• The relationship between consumption and income is called propensity to consume or consumption function.

1. C=f(Y).

• Consumption function may be represented by an equation.

C=a+b(Y)

C=consumption, a =consumption at zero level of income b=MPC (slope of the consumption curve) Y=income.

The consumption equation shows the level of consumption for various level of income.

• Propensity to consume is of two types

1. Average propensity to consume (APC)
2. Marginal propensity to consume (MPC).

• APC= ratio of total consumption to total income.

APC=C/Y.

• MPC=AC/AY.
• Propensity to save indicates the tendency of the households to save at a given level of income. It shows the relation between saving and income.
• Propensity to save is also of two types.

1. Average propensity to save (APC)
2. Marginal propensity to save.(MPC)

• Average propensity to save is the ratio of saving to income APC=S/Y.
• Marginal propensity to save is the ratio of change in saving to change in income MPS=AS/AY.
• There is relationship between APC and APS.

APC+APS=1

APC=1-APS.

• There is relationship between MPC and MPS.

MPC+MPS=1

1-MPC=MPS.

Meaning of involuntary unemployment and full employment.

• Involuntary unemployment refers to a situation in which people are ready to work at prevailing wage rate, but do not find work.
• Full employment refers to a situation in which no one is unemployed i.e… .there is no involuntary unemployment.
• According to Keynes full employment signifies a level of employment where increase in aggregate demand does not lead to an increase in the level of output and employment.

Increase in demand beyond full employment causes prices to go up.

DETERMINATION OF INCOME AND EMPLOYMENT.

• The determination of income and employment in the Keynesian theory depends on the level of AD and AS.
• Equilibrium level of income and output is determined where,

1. AD=AS 2) Planned saving =planned investment.

• In a two sector economy Ad=C+I, AS=Y, Y=C+I.
• Suppose that C=40+0.75Y(CONSUMPTION FUNCTION) and I =Rs.60 (investment function)then the equilibrium level of income is obtained as

Y=C+I

Y=40+0.75Y=60

Y-0.75Y=100

1. 25Y=100

Y=10000/25

Y=400crores.

• Investment multipliers and its working.
• Investment multiplier explains the relationship between increase in investment and the resultant increase in income.
• Investment multiplier is the ratio of change in income to change in investment. Multiplier (k) =Ay/AI.
• The value of multiplier depends on the value of marginal propensity to consume (MPC).
• There is direct relationship between k and MPC.
• Multiplier also depends on the marginal propensity to save
• There is inverse relationship between multiplier and MPS.

IMPORTANT FORMULAE.

• AD=C+I (two sector economy).
• APC=C/Y.
• APS=S/Y.
• APC+APS=1
• MPC=AC/AY
• MPS=AS/AY
• MPS+MPC=1 AND 1-MPC=MPS
• K=AY/AC or K=1/MPS or K=I/I-MPC
• C= ^_c+b(Y)
• S= -a+(1-b)Y

^_c= autonomous consumption -a= negative saving (1-b)=MPS

SHORT RUN FIXED PRICE ANALYSIS

Basic Concept

Assumption 1) Fixed Price :

In the short period price is fixed (constant) and elasticity of supply is infinite i.e., supply curve is perfectly elastic. It means the suppliers are willing to supply whatever amount of goods, consumer will demand at that price.

1. Fixed Interest Rate : Interest rate remains constant.
2. Aggregate supply is perfectly elastic at this price.

Under these circumstances equilibrium output will be determined by aggregate demand at this price in the economy. At a fixed price the value of ex-ante aggregate demand for final goods is the sum of ex-ante consumption expenditure C and ex-ante investment expenditure I on final goods.

AD=C+I

Consumption function C =”c + b(Y)

“c = Autonomous consumption

b= marginal propensity to consume due to unit increase in income

In the short period, price and rate of interest remaining constant i.e., ex-ante Investment expenditure is uniform i.e. same amount every year.

Hence, I = I

I = Autonomous Expenditure

we also assume that Aggregate Supply at this cost price is determined by aggregate demand which is known as Effective demand principle. The level of AD required to achieve full employment equilibrium is called effective demand. (or) AD at the point of equilibrium is called Effective demand.

AD = C+I (By substituting the value of consumption function)

AD = C + I + bY

When final good market is in equilibrium, quantity demanded = quantity supplied AD = AS

• = C + I + by
• = A + bY (A = C + I showing total autonomous expenditure

Y – bY = A

Y(l – b) = A

Y = A /l – b

Y depends upon A (C (or) I) or MPC.

Effects of an autonomous change on equilibrium in the product market.

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F	/ 1 / 1 / 1 / 1 / 1 /1 1
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Y1

AS=Y

AD2=A2 + bY AD1=A1 + bY

Output

O

The line AD1 and AD2 correspond to the values of A, via A1 and A2 respectively AS is the 45° line is equal to one

The 45° line represents point at which AD and output are equal.

The AD1 line intersects the 45° line at point E1.

At equilibrium point the equilibrium values of output and aggregate demand are OY1 and AD1.

When autonomous investment increases the AD1 line shifts upwards and assumes the position AD2.

The value of aggregate demand at output OY1 is Y1F which is greater than the value of output OY1 = Y1E1 by an amount E1F

• E1F measures the amount of excess demand that emerges in the economy as a result of the increase in autonomous expenditure: The new AD2 intersects the 45° line at point E2 at the new equilibrium output and AD2 have increased by an amount E2G which is greater than the initial increment in autonomous expenditure E1F.

1 MARK QUESTIONS

1. What is the relation between APC and APS?

Ans. APC+APS=1

1. What is the relation between MPC and MPS?

Ans. MPS+MPC=1.

1. If APC is 0.7 then how much will be APS?

Ans. 1-0.7=0.3

1. If MPC =0.75, what will be MPS?

Ans. MPC+MPS=1 1-0.75=0.25

1. State the important factor influencing the propensity to consume in an economy?

Ans. The level of income (Y) Influences the propensity to consume (c) of an economy.

1. What is meant by investment?

Ans. Investment means addition to the stock of capital good, in the nature of structures, equipment or inventory.

1. What is the investment demand function?

Ans. The relationship between investment demand and the rate of interest is called investment demand function.

1. What is equilibrium income?

Ans. The equilibrium income is the level of income where AD=AS i.e….AD=AS and planned saving equals planned investment.

1. Give the formula of investment multiplier in terms of MPC.

Ans. K=1/1-MPC

1. What can be the minimum value of investment multiplier?

Ans. One.

1. What is the maximum value of investment multiplier?

Ans. Infinity.

1. Give the equation of propensity to consume.

Ans. C=^_a+by.

1. Write down the equation of saving function?

Ans. S= -a+ (1-b) y.

3 AND 4 MARKS QUESTIONS.

1. Explain the components of equation c= ^_a + ^by.

Ans. ‘a’ is called intercept and it represents the amount of consumption when there is a zero level of income i.e. autonomous consumption. The consumption is positive at zero level of income. The coefficient ‘b’ measures the slope of consumption. The slope gives the increase in consumption per unit increase in income. This is called as MPC. Consumption changes by ‘b’ for every one rupee change in income. Consumption changes in the same direction as income.

1. Derive the saving function from the consumption function c=^_a+by.

Ans. Saving is equal to income minus consumption (y=c+s).The saving function relates to the level of savings to the level of income. It is derived from the consumption which is as follows:

Y=C+S

S=Y-C

since C=^_a+bY. therefore,

S=Y-(a+bY)

S= -a+(1-b)Y (SAVING FUNCTION).

1. Explain the components of S= -a+ (1-b) Y.

Ans. The saving function is S= -a+ (1-b) Y.-a represents the intercept term and it represents the amount of savings done when there is zero level of income. The saving is negative at zero level of income because at zero level of income consumption (a) is positive. Negative saving is nothing but dissaving, this means that at zero level of income there is dissaving of amount -a.

The coefficient (1-b) measures the slope of the saving function. The slope of the saving function gives the increase in savings per unit increase in the income. This is known as MPS. Since ‘b’, that is MPC is less than one, it follows that (1-b) i.e. MPS is positive. Saving is an increasing function of income.

1. Can the value of APS be negative? If yes then when?

Ans. The value of APS can be negative when the value of consumption exceeds the value of income. At low level of income saving is negative.

e.g.: if income is Rs 1000 and consumption expenditure is Rs 1200 Y=C+S S=Y-C

1000-12000=-200

APS=-200/1000=0.2 APS=S/Y.

APS=-0.2.

1. Can the average propensity to consume be greater than one? Give the reason for your answer.

Ans. APC can be greater than one when the consumption exceeds the income. At that level APS will be negative .when the APS is negative APC will be greater than one.

e.g.: if the income is 1000 and the consumption is 1200, APC =1200/1000=1.20.

1. When can the APC be equal to one? Give reason for your answer.

Ans. APC can be equal to one when APS =0, i.e when consumption = income.

E.g: y=1000, c=1000.

APC=C/Y 1000/1000=1

APC=1

APC+APS=1

1-APC=APS

1-1=0

1. Explain the meaning of investment multiplier? What can be its minimum value and why?

Ans. Defined as the ratio of change in the income to the change in the investment.

K=AY/AI.

The value of the multiplier is determined by the MPC. It is directly related to MPC.

K=1/1-mpc = 1/1-0 =1

K=1

Minimum value of K is when minimum value of MPC=0, the minimum value of K will be unit one.

1. Explain the working of a multiplier with an example.

Ans. Multiplier tells us what will be the final change in the income, as a result of change in investment. Change in investment results in the change in income. Symbolically: AI^AY^AC^AY

The working of a multiplier can be explained with the help of the following table which is based on the consumption that is, AI=1000 and MPC=4/5.

PROCESS OF INCOME GENERATION.

ROUNDS	AI	AY	AC
1.	1000	1000	4/5xI000=800
2.	–	800	4/5×800=640
3.	–	640	4/5×640=512
4.	–	512	4/5×512=409.6
	TOTAL	5000	4000

As per the table the initial increase in the investment of Rs 1000 there is a total increase in the income by Rs 5000 given MPC=4/5 . Out of this total increase in the income Rs 4000 will be consumed and Rs 5000 be saved.

The sum of total increase in income is also derived as:

Ay= 1000+800=640+512+ infinity.

1000+4/5 x 1000(4/5)² x 1000+(4/5)³ x 1 ooo+ infinity

=1000[1 +4/5+ (4/5)²+(4/5)³+ infinity]

=1000[1/1-4/5] = 1000×5/1=Rs. 5000 cores.

1. Differentiate between ex ante and ex post investment.

Ans. Ex ante is the planned investment which the planner intends to invest at different level of income and employment in the economy.

Ex post investment may differ from ex ante investment when the actual sales differ from the planned sales and the firms thus face unplanned addition or reduction of inventories.

6 MARKS QUESTIONS WITH ANSWERS

1. Draw a hypothetical propensity to consume curve from it draw the propensity curve to save curve

Ans. APC=C/Y APS=S/Y Propensity to save curve Is drawn from propensity to consume curve When Y=C APC=1 Till that point APS is negative at point‘s’

When y>c there is a positive saving

X

1. Explain the determination of income and employment with AD and AS. (Give schedule)

AD= C+I

AS=C+S AS=Y (refers to countries national income)

The equilibrium level of income is determined at a point when AD=AS.

Equilibrium can be achieved at full employment and even at under employment situation. It may not be always at full employment condition in an economy.

y	c	I	AD=C+I	AS=Y
0	50	100	150	0
100	100	100	200	100
200	150	100	250	200
300	200	100	300	300	AD=AS
400	250	100	350	400
500	300	100	400	500

The above schedule shows equilibrium level of income is 300 where AD=AS 300=300.

1. Explain the equilibrium level of income, employment and output with saving and investment approach. What happens when savings exceeds investment?

Ans. Equilibrium is achieved when planned saving is equal to planned investment that is S=I. This can be seen with the help of schedule and a diagram.

INCOME	CONSUMPTION	SAVING	INVESTMENT
Y	C	(S=Y-C)	I
0	50	-50	100
100	100	0	100
200	150	50	100
300	200	100	100	S=I
400	250	150	100

Saving

The equilibrium level of income is s 300 core and at this point S (100) =i (100) the equilibrium may necessarily not be at the full employment level.

I

X

When saving exceeds planned investment means people are consuming less and spending more as a result AD is less than AS.

This will lead to accumulation of more goods with producer .this will make the businessmen to reduce production consequently, output, income & employment will be reduced till the equilibrium level of income.

2. Draw a straight line consumption curve. From it derive a saving curve explaining the process. Show on the diagram.

1. The level of income at which average propensity to consume equal to one.
2. A level of income at which average propensity to save is negative.

Ac is the consumption curve and OA is the consumption expenditure at zero level of income. Income minus consumption is saving.

When income is 0, the economy’s consumption level is OA. The corresponding level of saving is -0A.

So -a is the starting point of saving curve. At OB level of income consumption is equal to income, so saving are zero. so B is another point on saving curve .

Join A and B and extend this line to S, AS is the saving curve.

1. The level of income at which APC is equal to one is OB.
2. A level of income at which APS is negative OY.

NUMERICALS.

1. If in an economy investment increases by Rs 1000 cores to Rs 1200 cores and as a result total income increases by 800 cores calculate capital MPS.

Ans.A 1=1200-1000=200 AY=800

AK=AY/AI=800/200=4

K=1/MPS=4

MPS=1/4=0.25

MPS=0.25

2. IF in an economy the actual level of income is Rs 500crores whereas the full employment the level of income is RS 800 cores. The MPC=0.75 calculate the increase in investment required to achieve full employment income.

Actual income=Rs500 cores Full empl Income = Rs 800 cores

A y = 800 -500 =	300 cores
MPC = 0.75 = 75	= 3
100	4
K = 1	1	1	100	= 4
01-MPC	1 – 0.75	0.25	25

We know that A y = K. A I 300 = 4 x 4 I A I = 75 crores

3. Calculation of APC and MPC given the level of Income and Consumption

Income	consumption	APC = c/y	MPC = Ac/Ay
0	4	–	–
10	12	1.20	0.80
20	20	1.00	0.80
30	28	0.93	0.80
40	36	0.90	0.80

4. Calculation of APS and MPS given		the level of	Income and consumption
Income	consumption	saving	APS	MPS
(Rs in crores)	(Rs in crores)
0	4	-4	–	–
10	12	-2	-0.20	0.20
20	20	0	0.00	0.20
30	28	2	0.07	0.20
40	36	4	0.10	0.20
Clue: APS = s/y	MPS = As/Ay	S=Y – C

1. Suppose the consumption equals c= 40 + 0.75 y, Investment equals I = Rs 60 and Y= C + I. Find i) Equilibrium level of income ii) The level of consumption at equilibrium iii) level of saving at equilibrium

Ans: i) Y= C + I AS = AD

Substituting the value of c and I we get

Y = 40 + 0.75y + 60 Y= C+ I I=60

(Y-0.75y)= 100

(1-0.75)Y=100

0.25Y =100

Y=100/0.25

Y=10000/25

Y=400

Equilibrium level of income = Rs. 400 cr.

1. AS =AD

C= 40 + 0.75y Y = 400

C= 40 + 0.75(400) = 340 C=340

1. Y= C + S So S= Y-C

S= 400 – 340 = 60

S= 60 crores

1. In a two sector economy, the saving and investment functions are:

S= -10 + 0.2Y I = -3 + 0.1Y

What will be the equilibrium level of income?

Ans: Equilibrium level of income S= I -10 + 0.2y = -3 + 0.1y 0.2y – 0.1y = -3 + 10 0.1y =7 y = 70

1. Explain the components of the equation C= 20 + 0.90 y and construct a schedule for consumption where income is Rs 200 , Rs 300 , Rs 350 and Rs 400.

Components of equation c=20 + 0.90y explained in % mark question number 1

The schedule for consumption is as follows

c=20 + 0.90y

Y (Income)

200

250

300

200 c= 20 + 0.9 x 200

245 =20 + 180 = 200

290 c= 20 + 0.9 x250

335 = 20 + 225 = 245

C= 20 + 0.9 x 350 + 335 C= 20 + 0.9 x 400 = 380

1. The consumption function is C= 20 + 0.9y. The value of Income is given as 100,200, 300, 400 and 500. Find out the consumption schedule and draw the consumption curve.

The consumption schedule

Y (Income)	C = 20 + 0.9 Y
0	C=20
100	C=20 + 0.9 (100) = 110
200	C=20 + 0.9 (200) = 200
300	C=20 + 0.9 (300) = 290
400	C=20 + 0.9 (400) = 380
500	C=20 + 0.9 (500) = 470

The consumption curve is shown as

Income

1. How is equilibrium output of final goods determined under short run fixed price?

Under short run fixed price, equilibrium output and equilibrium demand at fixed price and constant rate of interest can be found with the help of following formulas Y= “A

1 – b

Y = Value of equilibrium output

A = Total Autonomous consumption b = MPC

Thus, value of equilibrium output (y) depends on values of A (i.e, c + I) and b i.e AD = AS

Y= C + I + by

• = A + by (A = C + I showing total autonomous expenditure)
• – by = A
• (1-b) = “A Y= “A

1-b

Application level questions

Multiplier

1. In an economy an increase in investment leads to increase in national income which is three times more than the increase in investment (calculate marginal propensity to consume)
2. In an economy the MPC is 0.95 investment is increased by Rs. 100 crores. Calculate the total increase in income and consumption expenditure.
3. Explain with numerical example how an increase in investment in an economy affects the level of consumption.
4. An increase in investment leads to total rise in national income by Rs. 500 crores. If MPC is 0.9 what is the increase in investment? Calculate.
5. In an economy the MPC is 0.8 Investment is increased by Rs.500 crores.

Calculate the total increase in income and consumption expenditure.

1. If in an economy MPC is 0.75 and its investment is increased by Rs.500 crores.

Calculate the total increase in income and consumption expenditure

1. Complete the table

Income MPC Saving APS

0 – -90 –

100 0.6 – –

200 0.6 – –

300 0.6 – –

1. In an economy S= -50 +0.5Y is the saving function (where S=saving and Y=national income) and investment expenditure is 7000. Calculate
2. Equilibrium level of national income
3. Consumption expenditure at Equilibrium level of N.I
4. From the following information about an economy calculate
5. its Equilibrium level of national income and
6. saving at Equilibrium level of N.I Consumption function = 200 + 0.9Y Investment expenditure I=3000.
7. Disposable income is Rs. 1000 crores and consumption expenditure is Rs.750 crores. Find out average propensity to save and average represent to consume.

11 In an economy investment expenditure increased by Rs.700 crores. The marginal propensity to consume is 0.9 calculate total increase income and consumption expenditure

1. Complete the following table

Level of income	Consumption Expenditure	Marginal Propensity	Marginal Propensity to consume
400	240
600	320
700	465

1. In an economy an increase in investment leads to increase in national income which is three times more than the increase in investment calculate marginal propensity to consume.
2. The disposable income is Rs.2500 crores and saving is Rs.500 crores. Find out average propensity to consume
3. In an economy MPC is 0.75 if investment expenditure is increased by Rs.500 crores. Calculate the total increase in income and consumption expenditure
4. As a result of increase investment by 125 crores national income increased by 500 crores. Calculate multiplier, MPC and MPS.
5. Given consumption function C=100+0.75 Y (where C=consumption expenditure and

Y=national income) and investment expenditure Rs.2000 .calculate

1. Equilibrium level of national income
2. Consumption expenditure at equilibrium level of income
3. In an economy S= -50+0.5Y is the saving function (where S=saving and Y=national income) and investment expenditure is 9000 calculate
4. Equilibrium level of national income
5. Consumption expenditure at equilibrium level of national income
6. From the following information about an economy calculate (i) Equilibrium level of N.I (ii) saving at Equilibrium level of income consumption function C=200+0.9Y (where C=consumption expenditure and Y=N.I. Investment expenditure I =5000
7. C=100+0.75 is a consumption function (where C= consumption expenditure and Y= N.I) and investment expenditures =1600 on the basis of this information calculate
8. Equilibrium level of national income
9. Saving at Equilibrium level of NI.
10. Given below is the consumption function in an economy C=100+0.10Y. with the help of a numerical example show that in this economy as income increase APC will decrease.
11. Given below is the consumption function in an economy C=100 +0.5Y with the help of a numerical example show that in this economy as income increases APS will increase.