Vedashreee, Lecturer in Economics Sadvidya P U College

Contents
No. Chapters Page No.
MICRO ECONOMICS

1 Introduction 2

2 Theory of Consumer Behaviour 10

3 Production and Costs 27

The Theory of The Firm Under

4 40
Perfect Competition

5 Market Equilibrium 49

6 Non-Competitive Markets 59

MACRO ECONOMICS

7 Introduction 69

8 National Income Accounting 74

9 Money and Banking 86

Determination of Income and

10 97
Employment
Government Budget and The
11 106
Economy

12 Open Economy Macro Economics 118

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Vedashreee, Lecturer in Economics Sadvidya P U College

MICRO ECONOMICS
CHAPTER-1
INTRODUCTION
I. Choose the correct answer (each question carries 1 mark).
1. The scarce resources of an economy have
a) Competing usages b) Unlimited usages
c) Single usages d) None of the above
2. Which of the following is an example of micro economic study?
a) National Income b) Consumer behaviour
c) Unemployment d) Foreign trade
3. Which of the following is a macro economic variable?
a) Individual demand b) Aggregate demand
c) Firms output d) Market Price of a good
4. Central Problems of an economy includes
a) What to produce b) How to produce
c) For whom to produce d) All of the above
5. Traditionally, the subject matter of economics has been studied under the following
broad branches.
a) Micro & Macro Economics b) Positive & Normative Economics
c) Deductive & Inductive d) None of the above
Ans: 1) a 2) b 3) b 4) d 5) a
II. Fill in the blanks : (Each question carries 1 mark)
1. Scarcity of resources gives raise to ____________
2. In a centrally planned economy all important decisions are made by ___________
3. In reality, all economics are ____________
4. _____________ is a set of arrangements where economic agents can freely exchange
their endowments or products with each other. (Added)
Ans : 1) Choice 2) Government 3) Mixed Economics 4) Market Economy

III. Match the following: (Each question carries 1 mark)

A B
1. Market economy a. Government
2. Service of a Teacher b. Private sector
3. Centrally planned economy c. Skill
4. Positive economics d. Evaluate the Mechanism
5. Normative economics e. Functioning of Mechanism

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Vedashreee, Lecturer in Economics Sadvidya P U College
Solutions
A B
1. Market economy Private sector
2. Service of a Teacher Skill
3. Centrally planned economy Government
4. Positive economics Functioning of Mechanism
5. Normative economics Evaluate the Mechanism

IV. Answer the following questions in a sentence/word. (Each question carries 1 mark).
1. Why does the problem of choice arise?
An economic problem arises because we have to satisfy unlimited wants out of limited
resources having alternative uses.
2. What is market economy?
An economy, in which, the means of production are owned, controlled and operated by the
private sector is called market economy.
3. What do you mean by centrally planned economy?
An economy in which, means of production are owned, controlled and operated by the
government is called centrally planned economy.
4. Give the meaning of micro economics.
The study of the economic behaviour of individual agents, such as particular price,
particular demand, supply, individual savings etc., is called micro economics.
5. What do you mean by positive economics?
The study of what was and what is under the given set of circumstances is called positive
economics.
6. What is normative economics?
A normative economics is one which studies the rightness and wrongness of things, it also
tells how things ought to be.

V. Answer the following questions in 4 sentences : (Each question carries 2 marks)

1. Mention the central problems of an economy.
1) What is produced and in what quantities
2) How are these goods produced.
3) For whom are these goods produced.
2. Distinguish between Micro and Macro economics.
The following are the important differences between Micro and Macro economics.

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Vedashreee, Lecturer in Economics Sadvidya P U College

Micro Economics Macro Economics

1) Micro Economics is mainly 1) Macro Economics studies the
concerned with the study of the behaviour of aggregates of the
behavior of individual economic economy as a whole.
units of the economy.

2) Micro economics is the price 2) Macro economics is also known as

theory. income and employment theory.
3) Micro economics studies the 3) Macro economics studies the
partial equilibrium in the general equilibrium in the
economy, economy
4) Micro economics is an unrealistic 4) Macro economics is more realistic
study and is not much useful study and used to solve several
economic problems.
3. Distinguish between positive and normative economics.
Positive Economics Normative Economics
1) Positive Economics deals with what 1) Normative Economics deals with
is or how the economic problems are what ought to be or how the
actually solved. economic problems should be
solved.
2) Positive Economics can be verified 2) Normative Economics can not be
with actual data. verified with actual data.

3) Positive Economics aims to make 3) Nonnative Economics aims to

real description of an economic determine the ideals.
activity.
4) Positive Economics is based upon 4) Normative Economics is based
facts, and thus, riot suggestive. upon individual opinion and
therefore, it is suggestive in
nature.
4. What do you mean by production possibility set?
The collection of all possible combinations of the goods and services that can be
produced from a given amount of resources and a given stock of technological knowledge
is called the production possibility set.
5. What is opportunity cost?
Opportunity cost is the cost of next best alternative sacrified in order to produce a
good.
For example:
1) If more of scarce resources are used in the production of com less resources are
available for the production of cotton and vice versa.
2) A plot of land is a resource. This land can be used for different purposes like, for
agriculture, or for constructing a factor}' or a school. If we use the land for agriculture,
the community will be deprived of a factory or a school.

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Vedashreee, Lecturer in Economics Sadvidya P U College
6. What is production possibility frontier?
A gra sentation of all the possible combinations of two goods that can I with the
given resources and technology is called production rontier.
V Answer the following questions in 12 sentences : (Each question carries 4 marks)
1. Briefly explain the production possibility frontier.
Due to scarcity of resources, we cannot satisfy all our wants. Even if an economy uses
all its resources in the best possible manner, it? capabilities are restricted due to scarcity of
resources. As we cannot have everything that we want, we are forced to make economic
decisions. These decisions take the form of choices among alternate goods and services,
that will best satisfy our wants. Thus, the society must decide, what to produce but of an
almost infinite range of possibilities.
Meaning of production posibility frontier.
A graphical representation of all the possible combinations of two goods that can be
produced with the given resources and technology is called production posibility frontier.
Assumptions for Production Possibility Frontier
1. The amount of resources in an economy is fixed, but these resources can be
transferred from one use to another;
2. With the help of given resources, only two goods can be produced;
3. The resources are fully and efficiently utilised;
4. The level of technology is assumed to be constant.
The concept of PPF can be better understood with the help of following imaginary
schedule.
Possibilities Com Cotton
A 0 10
B 1 9
C 2 7
D 3 4
E 4 0
Consider an economy which can produce corn or cotton by using its resources. The
above table gives some of the combinations of com and cotton that the economy can
produce. When its resources are fully utilised.
If all the resources are used in the production of corn, the maximum amount of com
that can be produced is 4 units.
If all resources are used in the production of cotton, at the most, 10 units of cotton
can be produced.
The economy can also produce 1 unit of com and 9 units of cotton or 2 units of com and 7
units of cotton or 3 units of corn and 4 units of cotton.
There can be many other possibilities. The figure illustrates the production possibilities

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Vedashreee, Lecturer in Economics Sadvidya P U College
of the economy.
Any point on or below the curve represents a combination of com and cotton that can
be produced with the economy’s resources. The curve gives the maximum amount of corn
that can be produced in the economy . for any given amount of cotton and vice-versa. This
curve is called the production possibility frontier.
This can be explain with the help of the following diagram.

The above production possibility frontier gives the combinations of com and cotton
that can be produced when the resources of the economy are fully utilised. Note that a
point lying strictly below the production possibility frontier represents a combination of
corn and cotton that will be produced when all or some of the resources are either
underemployed or are utilised in a wasteful fashion.
If more of the scarce resources are used in the production of com, less resources are
available for the production of cotton and vice versa. Therefore, if we want to have more
of one of the goods, we will have less of the other good.
2. Briefly explain the central problems of an economy.
Production, distribution and exchange of goods and services are the basic economic
activities of life. In the course of these activities, every society has to face the problem of
multiplicity of wants, scarcity of resources and problem of choice. Because of this scarcity,
every society has to decide how to allocate the scarce resources.
Economics is the study of the allocation of scarce resources to alternative wants. The
problem of scarcity is due to unlimited wants and limited resources. Therefore, one has to
choose a certain set of wants among unlimited wants, which are to be satisfied with one’s
limited resources.
Every economy weather simple or complex, capitalist or controlled or mixed,
developed or under developed, will have to solve the following three fundamental
economic problems.
1) What is produce and in what quantities?
The first central problem of an economy is to decide what to produce and how
much to produce. The problem “what is produce” is the problem of choice between
commodities and this problem arised due to scarcity of resources.
Every economy has limited resources and thus, cannot produce all the goods. More
of one good or service, usually less of others.
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Vedashreee, Lecturer in Economics Sadvidya P U College
For example:
1) Wheather to produce more of food, clothing, housing or to have more of luxury
goods.
2) Wheather to have more agricultural goods or to have industrial products and
services.
3) Wheather to use more resources in education and health or to use more resources in
building military services.
4) Wheather to have more of basic education or more of higher education.
5) Wheather to have more of consumption goods or to have investment goods which
will boost production and consumption tomorrow.
What goods are to be produced and how much is to be produced depends on the
economic system of the country.
2) How are these goods produced?
The next problem of an economy is to decide as how to produce goods and services.
The problem “how are these goods produced” is the problem of choice of technique.
There are two alternative methods of production. They are,
a) Labour intensive Technique:
Under this technique, more labour is used in production than capital. With this
technique more employment can be generated for the society.
b) Capital intensive technique:
In this technique more capital is used in production than labour. It produces goods
on large scale with the use of high technology.
Each technique has its own merits and demerits. If labour intensive technique is
employment generating, it produces goods of low quality at higher cost.
Thus a society has to choose the right technique of production between these two
techniques depending on the resources and requirements.
3) For whom are these goods produced :
Another basic problem' of the economy is to decide for whom the goods shall be
produced. This problem refers to selection of the category of people who will
ultimately consume the goods, i.e.
1) Whether to produce goods for more poor and less rich or more rich and less poor.
2) Who gets how much of goods that are produced in the economy.
3) Who gets more who gets less.
4) How should the producer of the economy be distributed among individuals in the
economy.
Thus, every economy faces the problem of allocating the scarce resources to the
production of different possible goods and services and of distributing the produced
goods and services among the individuals within the economy. The allocation of scarce
resources and the distribution of the final goods and services are the central problems
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Vedashreee, Lecturer in Economics Sadvidya P U College
of any economy.
3. Write a short note on a centrally planned economy.
An economy in which, means of production are owned, controlled and operated by the
government is called planned economy.
For Examples: North Korea, Cuba, Chaina and Vietnam.
Centrally planned economy is the complete opposite of capitalism. In this system
economic activities will be carried on through a central machineiy or authority. It means in
a centrally planned economy economic activities are controlled by the central government
rather than the private business people. The Govt organises all economic activities and
distributes various goods among the consumers on the basis of its own decisions.

Features of Central Planned Economy :

The important features of centrally planned economy they are:
1) State ownership over means of production : All the means of production are owned by
the government.
2) Decision - making by government: Government takes all the decision regarding
consumption, production and investment.
3) Level of Competition : There does not exist any element of competition under centrally
planned economy.
4) Social welfare motive: All decisions aim to maximize social welfare.
5) Planning Mechanism guides all decisions : All the decisions are taken and coordinated
by the central planning authority. The central planning authority decides what, how and for
whom to produce. Production, allocation and distribution of resources take place through
planning. There is no role for market or price mechanism.
6) The central authority may try to achieve a particular allocation of resources and a
consequent distribution of the final combination of goods and services which is thought to
be desirable for society as a whole.
For example : If it is found that a good or service which is very important for the
prosperity and well-being of the economy as a whole, e.g. education or health service, is
not produced in adequate amount by the individuals on their own, the government might
try to induce the individuals to produce adequate amount of such a good or service or,
alternatively, the government may itself decide to produce the good or service in question.
4. Write a short note on market economy.
An economy, in which, the means of production arc owned, controlled and operated by
the private sector is called market economy.
For Example: USA, Japan, Australia, UK, Canada.
In the market economy, all the means of production are owned by private individuals
and business firms. They will be a complete liberty either to use or not to use these
resources. The one and the only aim of the owners of the property is to earn profits by
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Vedashreee, Lecturer in Economics Sadvidya P U College
utilising this property.

Features of Market Economy :

The important features of market economy are as follows:
1) Private ownership over means of production: All the means of production (i.e., land,
labour; capital and enterprise) are owned and managed by private sector.
2) Independent decision making: Private sector is free to take all decisions regarding
production, consumption and investment independently.
3) Level of Competition: There exists still competition among different private firms.
4) Profit Motive: All the decisions are generally guided by the profit motive.
5) Non-Interference of Government: The government does not interfere in any
economic activity.
6) Price Mechanism guides all decisions: A Market economy works through price
mechanism. It is a process where price is determined by market forces of demand and
supply. It helps in solving central problems (i.e. what, how and for whom to produce)
of economy.

4. Briefly explain, how the Family farm, Weaver, Teacher can use their resources to fulfil
their needs in a simple economy.
Every individual has some amount of only a few of the goods and services that he
would like to use. A family farm may own a plot of land, some grains, farming
implements, may be a pair of bullocks and also the labour services of the family members.
A weaver may have some yarn, some cotton and other instruments required for weaving
cloth. The teacher in the local school has the skills required to impact education to the
students. Some others in society may not have any resources excepting their own labour
services. Each of these decision making units can produce some goods or services by using
the resources that it has and use part of the produce to obtain the many other goods and
services which it needs. For example, the family farm can produce corn, use part of the
produce for consumption purposes and produce clothing, housing and various services in
exchange for the rest of the produce. Similarly, the weaver can get the goods and services
that he wants in exchange for the cloth he produces in his yarn. The teacher can earn some
money by teaching students in the school and use the money for obtaining the goods and
services that he wants. Each individual can thus use his resources to fulfil his needs.

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Vedashreee, Lecturer in Economics Sadvidya P U College
CHAPTER-2
THEORY OF CONSUMER BEHAVIOUR

I. Choose the correct answer: (Each question carries 1 mark)

1. Utility is
a) Objective b) Subjective c) Both a and b d) None of the above
2. The shape of an indifference curve is narmaly
a) Convex to the origin b) Concave to the origin c) Horizantal d) Vertical
3. The consumption bundles that arc avaible to the consumer depend on
a) Colour and Shape b) Price and Income
c) Income and Quality d) None of the above
4. The equation of budget line is
a) Px + P1x1 = M b) M = P0x0 + Px c) P1x1 + P2X2 = M d) Y = Mx + C
5. The demand for these goods increases as income increases
a) Inferior goods b) Giffen goods c) Normal goods d) None of the above
6. A vertical demand curve is
a) Perfectly Elastic b) Perfectly inelastic c) Unitary Elastic d) None of the above
7. Ordinal Utility analysis expresses utility in
a) Numbers b) Returns c) Ranks d) Awards
Ans: 1) b 2) a 3) b 4) c 5) c 6) b 7) c

II Fill in the blanks (each question carries 1 mark).

1. What satisfying capacity of a commodity is ___________
2. Two indifference curves never ___________ each other.
3. As income increases, the demand curve for normal goods shifts towards ___________
4. The demand for a good moves in the ___________ direction of its price.
5. Method of adding two individual demand curve is called ___________
6. An equation xy = C gives us __________ hyperbola.
Ans : 1) Utility 2) Intersect 3) Rightwards 4) Opposite
5) Horizontal summation 6) Rectangle

III Match the following: (each question carries 1 mark).

A B
1. Demand curve a. d(P) = a - bp
2. Linear demand curve b. Down ward sloping
3. Unitary elasticity of demand c. Pen & ink
4. Complementary goods d. A family of indifference curve
5. Indifference Map e. | ed | = 1

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Vedashreee, Lecturer in Economics Sadvidya P U College
Solutions
1. Demand curve Down ward sloping
2. Linear demand curve d(P) = a - bp
3. Unitary elasticity of demand | ed | = 1
4. Complementary goods Pen & ink
5. Indifference Map A family of indifference curve

IV. Answer the following questions in a sentence/word. (Each question carries 1 mark).
1. What is budget line?
A graphical representation of all possible combinations of two goods which can be
purchased with given income and given prices is called budget line.
2. What do you mean by cardinal Utility Analysis?
Possible to measure utility in a cardinal numbers such as 1,2,3,4 etc is called cardinal
utility approach analysis.
3. Give the meaning of marginal utility?
The utility derived from the consumption of an additional unit of commodity is called
marginal utility analysis.
4. What is Utility?
Want satisfying power of a commodity or service is called Utility.
5. Expand MRS.
Marginal Rate of Substitution.
6. What do you mean by Indifference curve?
The graphical representation of various alternative combinations of goods which provide
the same level of satisfaction to the consumer is called Indifference Curve.
7. What is demand?
The quantity of a good that a consumer purchases in a market at a particular price, at a
particular time is called Demand.

V. Answer the following questions in 4 sentences : (Each question carries 2 marks)

1. What is MRS?
The rate of substitution of one commodity for another is known as marginal rate of
substitution.
The indifference curve analysis is based on the law of diminishing marginal rate of
substitution (MRS). It means, how much of commodity Banana (Y) the consumer is ready
to fore go inorder to have one additional unit of commodity Apple (X), so that he may be
able to get the same level of satisfaction. This is called marginal rate of substitution.
2. What are the differences between budget line & budget set?
The following are the important differences between Budjet Set and Budjet Line:
They are:
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Vedashreee, Lecturer in Economics Sadvidya P U College
Budget Set Budget Line

1. A collection of all bundles available to 1. A graphical representation of all

a consumer at the prevailing market possible combinations of two goods
price at a given level of income is which can be purchased with given
called budget set. income and given prices is called
budget line.
2. Budget set include all the possible 2. Budget line represents all those
bundles which cost less than or equal bundles that the consumer can
to consumer money income. purchase by spending his entire
income at the given prices.
3. The bundles of budget set 1 ie either 3. The bundles of budget line lie only on
on or below the budget line. the budget line.
3. What do you mean by inferior goods? Give example?
A good for which the demand decreases with increase in the income of the
consumer is called inferior goods.
For example: Pearl millet (sajje), finger millet (Ragi) Fox tail millet (Navane) Kode millet
(Araka) etc. These are also called giffen goods.
4. What is monotonic preference?
A rational consumer always prefers more of a commodity as it offers him a higher
level of satisfaction is called monotonic preference.
For example: Consider 2 goods Mango (M) and bananas (B).
Suppose two different bundles are: 1st (10M, 10B); and 2nd (7M, 7B).Consumer’s
preference of 1st bundle as compared to 2nd bundle will be called monotonic preference as
1st bundle contains more of both mangos and bananas.
5. State the law of demand
The law of demand states that other things remaining constant, when the price of a
good decreases, the demand for good increases and when the price increases, the demand
for the good decreases. There is a negative relationship between quantity of demand and
price.
6. Mention two different approaches which explain consumer behaviour.
1) Cardinal Utility Analysis
2) Ordinal Utility Analysis
7. What do you mean by price elasticity of demand?
The percentage change in demand for the good divided by the percentage change in
its price is called price elasticity of demand.

VI. Answer the following questions in 12 sentences (Each question carries 4 marks)
1. Write the differences between Total utility and Marginal utility.
The following are the important differences between marginal utility and total utility. They

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Vedashreee, Lecturer in Economics Sadvidya P U College
are:
Total Utility Marginal Utility
1. The total satisfaction obtained from the 1. The utility derived from consumption of
consumption of all possible units of a an additional unit of a commodity is
commodity is called total utility called marginal utility.
2. Total utility increases as more of a 2. Marginal utility decreases as more of a
good consumed good consumed
3. Total utility is expressed as 3. Marginal utility can be expressed as
TU = Mu1+Mu2+ Mu3+Mu4+Mus under MUn=TUn-TUn-l
4. After total utility reaches maximum it 4. When total utility is maximum, marginal
does not rise further, it starts falling. utility is zero, when total utility falls,
marginal utility becomes negative.
5. Total utility curve increases at a 5. Marginal utility curve diminishes from
diminishing rate. the beginning.

2. Briefly explain the budget set with the help of a diagram.

The set of all bundles available to a consumer at the prevailing market price at a given
level of income is called budget set.
The budget set is thus the collection of all bundles that the consumer can buy with his
income at the prevailing market prices.
Suppose, a consumer has an income of Rs 20. He wants to spend it on two
commodities: like X1 and X2 and both are priced at Rs 5 each.
1) The bundles that this consumer can afford to buy : (0, 0), (0, 1), (0, 2), (0, 3), (0, 4),
(1, 0), (1, 1), (1, 2), (1, 3), (2, 0), (2, 1), (2, 2), (3, 0), (3, 1) and (4, 0).
2) Among these bundles, (0, 4), (1, 3), (2, 2), (3, 1) and (4, 0) cost exactly Rs 20 and
all the other bundles cost less than Rs 20.
3) The consumer cannot afford to buy bundles like (3,3) and (4,5) because they cost
more than Rs. 20 at the prevailing prices.
If both the goods are perfectly divisible, the consumer’s budget set would consist of
all bundles (x1, x2) such x1 and x2 are any numbers greater than or equal to 0 and
p1x1+p2x2  M.
The budget set can be represented in the following diagram.

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Vedashreee, Lecturer in Economics Sadvidya P U College

In the above diagram quantity of bananas is measured along the X axis and quantity
of mangos measured the Y axis. All bundles in the positive quadrant which are on or
below the line are included in the budget set.

3. Explain the derivation of slope of the budget line with help of diagram.
Budget line is locus of different combinations of the two goods which the
consumer consumes and which cost exactly his income.
Let us understand the concept of budget line with the help of an example.
Suppose, a consumer has an income of Rs. 20 and he wants to spend it on two
commodities Banana (X1) and Mango (X2) and both are priced at 5 each. Now, the
consumer has three options to spend the entire income.
1) Buy 4 Units of Banana (X1)
2) Buy 4 Units of Mango (X2)
3) Buy 2 Units of Banana (X1) and 2 Units of Mango (X2)
It means, possible bundles can be (4. 0) (0. 4) (2. 2). When all these three bundles
are represented graphically, we get a downward sloping straight line, known as
Budget line or price line. Budget line is also known as Budget constraint.
The slope of the budget line measures the amount of change in mangoes required per
unit of change in bananas along the budget line. Consider any two points (x1, x2) and
(x1+x1, x2+x2) on the budget line.
It must be the case that
p1x1 + p 2 x 2 = M

and, p1 ( x1 + x1 ) + p2 ( x2 + x2 ) = M

Subtracting from above formula we obtain p1x1 + p 2 x 2 = 0 . Slope of budget line can
be represented in the following diagram.

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Vedashreee, Lecturer in Economics Sadvidya P U College

In the above diagram ox axis represents banana oy axis represents mangoes. The
absolute value of the slope of the budget line measures the rate at which the consumer is
able to substitute bananas for mangoes when he spends his entire budget.

4. Explain the indifference map with a diagram.

A set of indifference curves for two commodities showing different levels of
satisfaction is called indifference map.
An indifference curve represents all the combinations, which provide same level of
satisfaction. However, every higher or lower level of satisfaction can be shown an
different indifference curves. It means, infinite number of indifference curves can be
drawn.
In the indifference map, it should be clearly understood that a higher indifference curve
denotes higher level of satisfaction and lower indifference curve represents lower level of
satisfaction.
Being rational, a consumer always chooses a higher indifference curve to get maximum
level of satisfaction, other things remaining equal.
Indifference map can be explained with the help of following diagram.

In the above diagram OX axis represents banana and OY axis represents of mangoes.
In the diagram IC4 give a higher level of satisfaction compared to IC3 and IC2, IC1. IC3
yields greater amount of satisfaction than IC2 but lower than IC4. The consumer is better of
when we moves from a lower to a higher indifference curve, it is called Monotonic
preference.

5. Write the differences between substitutes and complements,

a) Substitutes goods
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Vedashreee, Lecturer in Economics Sadvidya P U College
Those goods which can be used in the place of other goods for the satisfaction of a
particular want is called substitute goods.
For example: Tea and coffee, pepsi and cocacola, electricity and solar. If the price of
coffee increases the consumer can shift to tea, and therefore the demand for tea is likely to
go up. If the price of coffee decreases, the demand for tea is likely to come down,
b) Complimentary goods :
Those goods which arc used together to satisfy a particular want is called
complimentary goods.
For example: Petrol and car, pen and ink, tea powder & sugar etc. For example : If
the price of petrol falls,' the demand for car •increases and if the price to petrol increases,
the demand for car decreases.
The following are the important differences between substitute goods and complement
goods.
Substitute Goods Complementary Goods
1) Substitute goods refer to those 1) Complementary goods refer to those
goods which can be used in goods which are used together to
place of one another to satisfy a satisfy a particular want.
particular want.
2) Substitute goods have 2) Complementary goods have joint
competitive demand. demand.
3) Price of one substitute good has 3) Price of a complementary good has
positive relationship with negative relationship with quantity
quantity demanded of another demanded of another complementary
substitute good. good.
4) Examples for Substitute goods 4) Examples for complementary good
are Tea and Coffee, Pepsi and are Tea and Sugar, Car & Petrol
Mirinda. vegetables, fruits, cloth etc.

6. Explain the differences between normal and inferior goods with examples.
a) Normal Goods
Those goods whose demand increases with rise in income, decreases with fall in
income is called normal goods.
For example: Most of the daily use goods such as vegetables, fruits, cloth etc.
b) Inferior goods :
A good for which the demand decreases with increase in the income of the
consumer is called inferior goods.
For example: Pearl millet (sajje), finger millet (Ragi) Fox tail millet (navane) Kode millet
(Araka) etc. These are also called giffen goods.
The following are the important differences between normal goods and inferior goods.

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Vedashreee, Lecturer in Economics Sadvidya P U College

Normal Goods Inferior Goods

1) Normal goods refer to those 1) Inferior goods refer to those goods
goods whose demand increases whose demand decreases with an
with an increase in income. increase in income.
2) Income effect is positive in case 2) Income effect is negative in case of
of normal goods. inferior goods.
3) There is a direct relation 3) There is an inverse relation ship
between income and demand for between income and demand for
normal goods. inferior goods.
4) Examples for normal goods are 4) Examples for inferior goods pearl
vegetable, fruits, cloth etc. millet, finger millet, fox tail millet,
kode millet etc.

VII. Answer the following questions in 20 sentences (each question carries 6m arks)
1. Explain the Law of Diminishing Marginal Utility with the help of a table and diagram.
The law of diminishing marginal utility is one of the important laws of utility analysis.
It deals with consumer behaviour in an intensive manner. Based on the suitable character
of human wants, economists formulated the law of diminishing marginal utility. A German
economist H.H. Gosscn was the first to explain this law. Later Prof. Alfred Marshall the
founder of neo classical school, popularised the law of diminishing marginal utility.
The law of diminishing marginal utility states that “if a consumer goes on consuming a
particular commodity one after another without any time gap, the marginal utility derived
by him from every successive units goes on diminishing”.
For Ex: When a person goes on eating mangoes one after another continuously, the
first mango gives him more utility, the second mango gives him a little less utility, the
third gives him still less utility and so on.
The law of diminishing marginal utility can be explain with the help of an imaginary
utility schedule which is as follows,
No. of Consumed Total Utility Marginal Utility
oranges TU MU
1 12 12
2 18 6
3 22 4
4 24 2
5 24 0
6 22 -2
As is clear from the above table, when the consumer consumes the first mango he gets
a marginal utility of 12 units and the total utility also becomes 12 units. The second mango
gives him 6 units of marginal utility which is less than that of the first mango. If he
continues to consume the third, fourth, units of mango the marginal utility diminishes to
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Vedashreee, Lecturer in Economics Sadvidya P U College
4, 2 units respectively. When he consumes the fifth unit, his total utility remains at 24 units
and marginal utility becomes zero. If he consumes sixth mango the marginal utility
becomes negative and the total utility starts diminishing.
The law of diminishing marginal utility can also be explained with the help of a
diagram which is as follows,

In the above diagram OX axis represents the number of mangoes consumed and OY
axis measures the utility. MU curve is the marginal utility curve. This curves slopes
downwards from left to right. Total utility increasing at a diminishing rate.
In the above diagram MU becomes zero at a level when TU remains constant. In the
example, TU does not change at 5th unit of consumption and therefore MU5 = 0.
Thereafter. TU starts falling and MU becomes negative.

2. Explain the features of indifference curves with the help of diagrams.

An indifference curve is curve that represents all those combinations of two goods
which give equal satisfaction to the
consumer. Indifference curves have certain features. They are,
1) Indifference curve slopes downwards from left to right:
Indifference curves should always downwards from left to right. An indifference curve
has a negative slope.
The reason underlying this property is that, if the consumer has to stay at the same
level of satisfaction the quantity of one commodity must decrease when the quantity of the
other commodity increases. This can be shown with the help of a diagram.

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2) Higher indifference curve gives greater level of utility:
Every indifference curve falling to the right indicates a higher level of satisfactions
since it is at a higher level than the earlier curve. This can be explained with the help of
following schedule.
Combination Quantity of Quantity of
bananas Mangoes
A 1 10
B 2 10
C 3 10
In the above schedule there are three combinations. Compare to combination A, B
combination gives more satisfaction. Again combination C gives more satisfaction than B.
Because C has higher banana than A and B. This can be explained with the help of
following diagram.

In the above diagram there are three indifference curves in an indifference map. The
second indifference curve will be yielding more satisfaction than the first, the third
indifference curve will be yielding more satisfaction than the second.
The above diagram combinations of A, B and C consist of same quantity of mangoes
but different quantities of bananas. Since combination B has more bananas than A. B will
provide the individual a higher level of satisfaction than A. Therefore, B will lie on a
higher indifference curve than A, depicting higher satisfaction. Likewise, C has more
bananas than B (quantity of mangoes is the same in both B and C). Therefore, C will provide
higher level of satisfaction than B, and also lie on a higher indifference curve than B.
A higher indifference curve consisting of combinations with more of mangoes, or more
of bananas, or more of both, will represent combinations that give higher level of
satisfaction.
3) Two Indifference curve never intersect each other :
Indifference curve never intersect one another, because they represent two different
sets of combination of two goods providing unequal level of satisfaction.
This can be explained with the help of diagram.

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In the above diagram A and B combination lie on the same indifference curve IC1,
utilities derived from combination A and combination B will give the same level of
satisfaction.
Similarly, as points A and C lie on the same indifference curve IC2, utility derived from
combination A and from combination C will give the same level of satisfaction.
From this, it follows that utility from point B and from point C will also be the same.
But this is clearly an observed result, as on point B, the consumer gets a greater number of
mangoes with the same quantity of bananas. So consumer is better off at point B than at
point C. Thus, it is clear that intersecting indifference curves will lead to conflicting
results. Thus, two indifference curves cannot intersect each other.

3. Explain the derivation of demand curve in the case of a single commodity.

Cardinal utility analysis can be used to derive demand curve for a commodity. The law
of demand shows the relationship between the price of a good and the quantity demanded.
The law of demand is based on the law of diminishing marginal utility.
The quantity of a commodity that a consumer is willing to buy and is able to afford,
given prices of goods and income of the consumer, is called demand for that commodity.
Demand for a commodity x, apart from the price of x itself, depends on factors such as
prices of other commodities income of the consumer and tastes and preferences of the
consumers.
The law of demand states that other things remaining constant, when the price of a
good decreases, the demand for good increases and when the price increases, the demand
for the good decreases.
The law of demand can be explained with the following individual schedule.
Price X Quantity of demanded X
10 55
20 30
30 15
40 5
The above table reavels higher the price, lower will be the demand, lower the price
higher will be the demand. In the above table the price of X comodity was Rs 10, the
quantity demanded was 55. When price of X increses from 10 to 40, quantity demanded
decreases to 5.
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Vedashreee, Lecturer in Economics Sadvidya P U College
A graphic presentation of various quantities of a commodity that a consumer is willing
to buy at different prices of the same commodity while holding constant prices of other
related commodities is called demand curve.
The law can be explained with the help of following demand curve.

Quantity of DemandIn the above diagram ox axis represents quantity of demanded of

X, oy axis represents price of X comodity. The downward sloping demand curve shows
that at lower prices, the individual is willing to buy more of commodity x, at higher prices,
he is willing to buy less of commodity x. Therefore, there is a negative relationship
between price of a commodity and quantity demanded. An explanation for a downward
sloping demand curve rests on the notion of diminishing marginal utility.

4. Explain the optimal choice of consumer with the help of a diagram.

Consumer equilibrium refers to a situation, in which a consumer derives maximum
satisfaction, with no intention to change it and subject to given prices and his given
income.
The point of maximum satisfaction is achieves by studying indifference map and
budget line together. On an indifference map higher indifference curve represents a
higher level of satisfaction than any lower indifference curve. So, a consumer always tries
to remain at the highest possible indifference curve, subject to his budget constraint.
The consumer is in equilibrium where the slope of the price line is equal to the slope
of the indifference curve.
Assumptions :
The following are the assumptions of consumer equilibri um under indifference curve
analysis.
1) Income of the consumer is given
2) Consumer is rational and wants to maximise his or her satisfaction from his/her
limited income.
3) Consumer is aware of the indifference map
4) All goods are homogeneous and divisible
Consumer equilibrium can be explained with the help of follow-

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Vedashreee, Lecturer in Economics Sadvidya P U College

In the above diagram there are three indifference curves IC1, IC2 and IC3. PQ is the
budget line. With the constant of budget line, the highest indifference curve, which a
consumer can reach, is IC2
The budget line is tangent to indifference curve IC2 at point ‘E’. This is the point of
consumer equilibrium, where the consumer purchases OM quantity of commodity of
banana (X) and ON quantity of commodity of Mango (Y).
Any other points like B, C and E cannot be considered an optimum point because they
lie on lower indifference curve IC1. Any point lying of IC3 like D is beyond the reach of
the consumer. Therefore D is not an optimal choice.
Thus, we can say that the consumer is in equilibrium position. When the price line is
tangent the indifference curve or when the marginal rate substitution of banana (X) and
Mango (Y) is equal to the price ratio between the price of two goods.

5. Explain the movement along the demand curve and shift in demand curve with the
help of two diagrams.
The quantity of a good that the consumer demands is dependent on the price of the
good, the prices of other goods, income of the consumer, and his tastes and preferences.
We have drawn the demand curve on the assumption that the consumer’s income, the
prices other related goods and the preferences of the consumer are constant, what happens
to the demand curve when any of these things changes.
Changes in demand can be described in two ways. They are:
1) Movements along the demand curve (Change in price)
2) Shifts in the demand curve (Other than price)
1) Movements along the demand curve
When change in quantity demand of a commodity is only due to change in its price, it
is called movement along the demand curve.
The demand function is a relationship between the quantity of good and its price, when
other thing remain constant. The demand curve is a graphical representation of the demand
function. When the price is less, the demand is more and when the price is more, the
demand is less. Thus, any change in price leads to movements along the demand curve.
Movements along the demand curve can be explained with the help of diagram.
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In the above diagram ox axis represents quantity demanded, oy axis represents price.
DD curve is demand curve. Change in the price leads to an upward or downward
movement along the same demand curve.
When price rises from op to op2 quantity demanded falls from oq to oq2 leading to an
upward movement from A to C along the same demand curve (decrease of demand)
On the otherhand, fall in price from OP to op1 leads to an increase in quantity
demanded from oq to oq1, resulting in a downward movement from A to B along the same
demand curve DD. (Increase in demand)
2) Shift in Demand Curve
When the change in demand of a commodity is not due to change in the price but due
to other factors like income, tastes etc it is called shift in demand curve.
When the demand of a commodity changes due to change in any factor other than the
own price of the commodity it is known as change in demand. It is expressed as a shift in
demand curve.
Except price, changes in any of the other things leads to shift in the demand curve. That
is, changes in factors other than price causes shift in the demand curve. For example,
consider the change in income of the consumer.
This can be explained with the help of following diagram.

Other things remaining constant, if the income of a consumer increases, the demand for
the good increases at each price and hence there is a right ward shift in the demand curve.
If the income of the consumer decreases the demand for the goods decreases at each
price and hence there is a leftward shift in the demand curve. This can be shown with the
help of following diagram.

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Vedashreee, Lecturer in Economics Sadvidya P U College

6. Give the meaning and formula of price elasticity of demand and explain the elasticity
along a linear demand curve.
The degree of responsiveness of demand for a commodity to change in the
price of such commodity is called price elasticity of demand.
Price elasticity of demand calculated by dividing the percentage change in demand by the
percentage change in price. It can be measured with the help of the following formula.
Q
100
Q Q p
ed = = 
P Q p
100
P
Let Us consider a linear demand curve q = a - bp Note that at any point on the demand
curve, the change in demand per unit change in the price
q
Substituting the value of = −b
p
q
We obtain
p
p
ed = − b
q
bp
ed = −
a − bp
Elasticity along a linear demand curve can be shown in the following diagram.

In the above diagram ox axis represent quantity of demand, oy axis represent price.
It is clear that the elasticity of demand is different at different points on a linear demand
curve.

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Vedashreee, Lecturer in Economics Sadvidya P U College
1) At p = 0, the elasticity is 0.
2) At q = 0, Elasticity is 
a
3) At p = The elasticity is 1.
2b
a
4) At any price greater than 0 and Less than elasticity is less than 1
2b
a
5) At any price greater than elasticity is greater than 1.
2b
7. Explain the derivation of the demand curve from indifference curve and budget
constraints.
A change in demand caused by the a change in purchasing power of consumer is called
income effect and a change in demand cause by change
in the prices of substitute goods is called substitution effect. On the basis of these two
effects the derivation of demand curve from indifference curve and budget constraints can
be explained as follows:
Consider an individual consuming bananas (X1) and mangoes (X2), whose income is M
and market prices of banana (X1) and mangoes (X2) are (P1) and (P2) respectively.
In the diagram (a) depicts her consumption equilibrium at point C, where she buys X 11
and X 21 quantities of bananas and mangoes respectively. In panel (b) diagram, we plot P11
against X 11 which is the first point on the demand curve for X 11

Suppose the price of banana (X1) drops to P1 and M remaining constant. The budget set
in panel (a), expands and new consumption equilibrium is on a higher indifference curve at
point D. where he buys more, of bananas ( X1  X11 ) . Thus, demand for bananas increases

as its price drops. We plot P1 against X1 in panel (b) of diagram to get the second point on
the demand curve for X1
Likewise the price of bananas can be dropped further to P̂1 , resulting in further increase
ˆ , Pˆ , plotted against X̂ gives us the third point on the
in consumption of bananas to X1 1 1

demand curve. Therefore, we observe that a drop in price of bananas results in an increase
in quality of bananas purchased by an individual who maximises his utility. The demand

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Vedashreee, Lecturer in Economics Sadvidya P U College
curve for bananas is thus negatively sloped.
The negative slope of the demand curve can also be explained in terms of the two
effects namely, substitution effect and income effect that come into play when price of a
commodity changes, when bananas become cheaper, the consumer maximises his utility
by substituting bananas for mangoes in order to derive the same level of satisfaction of a
price change, resulting in an increase in demand for bananas.
8. Explain the market demand with the help of diagrams.
The market demand for a good at a particular price is the total demand of all
consumers taken together. The market demand for a good can be derived from the
individual demand curves. Suppose there are only two consumers in the market for a good.
Suppose at price p’, the demand of consumer 1 is q’1 and that of consumer 2 is q’2. Then
the market demand of the good at p’ is q’1 + q’2. Similarly, at price p̂ , if the demand of
consumer 1 is q̂1 and that of consumer 2 is q̂ 2 , the market demand of the good at p̂ is q̂1
+ q̂ 2 . Thus the market demand for the good at each price can be derived by adding up the
demands of the two consumers at that price. If there are more than two consumers in the
market for a good, the market demand can be derived similarly.

The market demand curve of a good can also be derived from the individual demand
curves graphically by adding up the individual demand curves horizontally.

VIII. Assignment and Project oriented Questions. (Each question carries 5 marks)
1. A Consumer wants to consume two goods. The price of Bananas is Rs. 4 and the price
of Mangoes is Rs. 5. The consumer income is Rs. 20.
a) How much Bananas can she consumes if she spend her entire income oh that good?
5
b) How much mangoes can she consumes if she spend her entire income on that good?
4
c) Is the slope of budget line downward or upward?
Downward Sloping Budget line
d) Are the bundles on the budget line equal to the consumer’s income or not?
The budget line is equal to consumer’s income
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Vedashreee, Lecturer in Economics Sadvidya P U College
e) If you want to have more of Bananas you have to give up Mangoes. Is it true?
Yes. If you want to have more banana’s we have to give up mangoes.

2. A consumer wants to consume two goods. The price of Bananas is ₹ 5 and the price of
Mangoes is ₹ 10. The consumer income is ₹ 40.
a) How much Bananas can she consumes if she spends her entire income on that
good?
b) How much Mangoes can she consumes if she spends her entire income on that
good?
c) Is the slope of budget line downward or upward?
d) Are the bundles on the budget line equal to the consumer’s income or not?
e) If you want to have more of Bananas you have to give up Mangoes. Is it true?
Answer:
a) If consumer’s income is ₹ 40 and Price of Banana is ₹ 5, consumer can consume 8
Bananas by spending his entire income.
M=PXQ
40 = 5 X Q
40 = 5Q
Q = 40/5 = 8 Q = 8
b) If consumer’s income is ₹ 20 and Price of mango is ₹ 10, consumer can consume 4
mangoes by spending his entire income.
M=PXQ
40 = 10 X Q
40 = 10Q
Q = 40/10 = 4 Q = 4
c) Budget line slopes downward.
d) All the combinations on the budget line are equal to the consumer’s income.
e) Yes, in order to get one additional unit of Banana some amount of Mangoes has to be
forgone.

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Vedashreee, Lecturer in Economics Sadvidya P U College
CHAPTER – 3
PRODUCTION AND COSTS
I. Choose the correct answer (each question carries 1 mark).
1. The formula of production function is
a) q = f(L,K.) b) q = d(p) c) y=f(x) d) None of the above
2. In the short run, a firm
a) Can change all the inputs b) Cannot vary all the inputs
c) Can keep the inputs fixed d) None of the above
3. The change in output per unit of change in the input is called,
a) Marginal product b) Average product c) Total product d) Product
4. Cobb-Douglas production function is
a) q = (x, x) b) q = (x1 ,x2) c) q = ( x1 , x2 ) d) q = (0)
5. TC=
a) TVC b) TFC c) TFC + TVC d) AC + MC
Ans: 1) a 2) b 3) a 4) c 5) c

II. Fill in the blanks (each question carries 1 mark).

1. In the long run, all inputs are___________
2. ___________is defined as the out put per unit of variable input.
3. Marginal product and Average product curves are___________ in shape.
4. SMC curve cuts the AVC curve at the___________point of AVC curve form below.
5. ___________is the set of all possible combinations of the two inputs that yield the same
maximum possible level of output.
Ans : 1) Variables 2) Average product 3) Inverse U shape
4) Minimum 5) Isoquant Curve
III. Match the following: (each question carries 1 mark).
A B
1. CRS a. ATC/AQ
2. SAC b. Long Run Average Cost
3. LRAC c. Short Run Average Cost
4. TFC+TVC = d. Constant Returns to scale
5. SMC e. TC
Solutions
1. CRS Constant Returns to scale
2. SAC Short Run Average Cost
3. LRAC Long Run Average Cost
4. TFC+TVC = TC
5. SMC ATC/AQ

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Vedashreee, Lecturer in Economics Sadvidya P U College
IV. Answer the following questions in a sentence/word. (Each question carries 1 mark).
1. What do you meant by Total product?
The total volume of goods and services produced during a specified period of time generally
a year is called total product.
2. What is Average product?
Per unit production of the variable factor is known as Average Product.
3. Give the meaning of Marginal product.
Change in output per unit of change in the input when all other inputs are held constant is
called Marginal product.
4. Write the meaning of cost function of the firm.
The functional relationship between cost and output is called cost function. ,
5. What is total fixed cost.
Those cost which do not vary directly with the level of output is called fixed cost.
6. What is average fixed cost?
The per unit of Fixed Cost of Production is called Average Fixed Cost.

V. Answer the following questions in 4 sentences. (Each question carries 2 marks)

1. What is Isoquant?
The set of all possible combinations of the two inputs that yield the same maximum
possible level of output is called isoquants.
For example: When factors of production such as labour and capital are combined in
different proportions and put to use, they yield the same level of output. Since any
combination of these factors yields the same level of output.
2. Give the meaning of the concepts of short run and long run.
A period in which output can be changed by changing only variable factors is called short
period.
In the short run, production can be changed by increasing variable factors like unskilled
labour, raw materials, fuel etc.
A period in which output can be changed by changing all factors of production is called long
period.
In long run firm can change its factory size, adopt to new techniques of production, purchase
of new machinary etc.
3. Mention the types of Returns to scale.
There are three types of Returns to scale. They are,
1) Increasing Returns to Scale (IRS)
2) Constant returns to scale (CRS)
3) Decreasing Returns to Scale (DRS)
4. Name the short run costs.
1) Total fixed cost 2) Total Variable Cost
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Vedashreee, Lecturer in Economics Sadvidya P U College
3) Total Cost 4) Average Fixed Cost
5) Average variable Cost 6) Average Cost
7) Marginal Cost
5. What are long run costs?
The cost of output in the long run is called long run costs.
In the long run since all factors are variable, therefore all costs are variable. The distintion
between fixed and variable cost disapears in the long run.

VI. Answer the following questions in 12 sentences. (Each question carries 4 marks)
1. Explain Isoquant with the help of the diagram.
The set of all possible combinations of the two inputs that yield the same level of output is
called isoquants.
Isoquants curve indicates different combinations of two factors of production which can
yield equal level of output to the producer of a given period.
For example: When factors of production such as labour and capital are combined in
different proportions and put to use, they yield the same level of output. Since any
combination of these factors yields the same level of output, producer will be indifferent
among them. Because of this reason, equal product curve is also called production
indifference curve.
The isoquant can be explain with the help of following diagram.

In the diagram there are three isoquants curves, when labour and capital are combined in
different proportions and put to use. In the above diagram two input combinations (L,, K 2)
and (L2, K,) give us the same level of output q,.
If we fix capital at K, and increase labour to L3, output increases and we reach a higher
isoquant q,. When marginal products are positive, with greater amount of one input, the same
level of output can be produced only using lesser amount of the other. Therefore, isoquants
are negatively sloped.
2. Explain TP, MP and AP with the examples.
The concept of product can be looked at from three different angles.
1) Total Product
2) Average Product
3) Marginal Product
1) Total Product (TP):
The total volume of goods and services produced during a specified period of time

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Vedashreee, Lecturer in Economics Sadvidya P U College
generally a year is called total product.
Total product can be increased by increasing the supply of variable factors in the short period.
However, in the longrun, total product can be raised by increasing both fixed and variable
factors.
Total product can be calculated with the help of following formula.
Tp =MP
1) Total product produced by 4 units of labour and capital are 70 units. They are sum of
marginal product of 1, 2, 3 and 4th units of labour and capital.
TP = MP
70 = 25 + 20 +15 +10
2) Average Product (AP):
Per unit production of the variable factor is known as Average Product.
When we divided total output by the quantities of a variable factor, we get average
product. The following formula is used to calculate ayerage product.
TPL
APL =
L
1) Total product produced by 4 units of labour and capital is 70 calculate average
product.
TPL
APL =
L
70
APL =
4
APL = 17.5
3) Marginal Product (MP):
The addition to total product by the employment of an additional unit of a factor is called
marginal product.
Marginal product can be calculated by following formula
MPL =TPL-TPL
Here, MPL = Marginal Production
TPL = Total Product of ‘n’ units
TPL-1 = Total product of n-1 units
1) If the total product produced by 4 units of labour and capital is 7Q and total product
produced by 5 units of labour and capital is equal to 75 units. Calculate marginal
product.
MPL =TPL-TPL-1
= 75-70
= 5 units
3. Write a brief note on returns to scale.
The behaviour of production or returns when all the productive factors are increased

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Vedashreee, Lecturer in Economics Sadvidya P U College
or decreased simultaneously in the same ratio is called returns to scale.
The study of changes in output as a consequence of changes in the scale is the subject
matter of the returns to scale. In this laws of returns to scale, all productive factors or inputs
are increased or decreased in the same proportion simultaneously.
Stages of returns to scale :
When all the inputs are increase in the same proportion. The following three types of
situations in output are observed. They are:
1) Increasing Returns to Scale (IRS)
2) Constant Returns to Scale (CRS)
3) Diminishing Returns to Scale (DRS)
1) Increasing returns to scale (IRS)
When a proportional increase in all inputs results in an increase in output by a larger
proportion, is called Increasing Returns to Scale.
For example: If 50% increase in all the factors by a firm results in more than 50%
increase in total output, it is a case of increasing returns to scale. If it is more than doubled,
then IRS holds.
2) Constant returns to scale (CRS).
When a proportional increase in all inputs results in an increase in output by the same
proportion, is called Constant returns to scale.
For example : If the inputs are doubled, then the output becomes double. If increase in all
the factors by 50%, results in 50% increase in total output. It can be an example for constant
returns to scale. If the output gets doubled, the production function exhibits CRS.
3) Diminishing returns to scale (DRS)
When a proportional increase in all inputs results in an increase in output by a
smaller proportion is called Decreasing Returns to Scale.
For example: 50%, increase in all the factors causes 40% increase in output. If output is
less than doubled, then DRS holds,

4. Explain the long run costs.

The time period in which all inputs needed for production can be changes is called
long-run.
All factors are available in the long run. There are no fixed costs. The total cost and the
total variable cost therefore, coincide in the long run.
There are two types of Long run cost. They are,
1) Long run average cost (LRAC) :
Cost per unit of output in the long run is called Long run average cost.
TC
LRAC =
Q

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Vedashreee, Lecturer in Economics Sadvidya P U College
2) Long run marginal cost (LRMC):
The change in the total cost per unit of change in output is called Long run marginal
cost.
LRAC = TCq1 − TCq1−1

Just like the short run cost curves, the LAC and LMC are also U- shaped. Their U shape
can be explained by the economies and diseconomies of scale. Initially, when a firm increases
its scale of production, it enjoys economies of scale and as a result LAC starts declining. But
beyond apoint, further increase in scale of production results in diseconomies of scale and
LAC starts rising.
In general, LAC and LMC curves are U-shaped and the LMC curve cuts the LAC at its
minimum point. The reason for being U-shaped is the operation of law of returns to scale, not
the law of diminishing return. We can summarise it like this:
Increasing returns to scale - LAC decreases with output Constant returns to scale - LAC does
not change with output Decreasing returns to scale - LAC increases with output
5. The following table gives the TP schedule of labour. Find the corresponding average
product and marginal product schedules.
TPL 0 1 35 50 40 48
L 0 1 2 3 4 5

L TPL APL MPL

0 0 0 0
1 15 15 15
2 35 17.5 20
3 50 16.67 15
4 40 10 10
5 48 9.6 8

1) In the above table AP can be calculated with the help of following formula.
TPL
APL =
L
2) In the above table MP can be calculated with the help of following ’ formula.
MP = TPL – TPL-1

VII. Answer the following questions in 20 sentences (each question carries 6marks)
1. Explain the various short run costs with the help of a table.
In short run there are some factors which are fixed, while other are variable. Similarly short
run cost can be divided into following types.
1) Fixed Cost
2) Total Variable Cost
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Vedashreee, Lecturer in Economics Sadvidya P U College
3) Total Cost
4) Average Fixed Cost
5) Average variable Cost
6) Average Cost
7) Marginal Cost
1) Fixed Cost :
Those cost which do not vary directly with the level of output is called fixed cost.
For example: Rent of the factory, salaries of permanent employees, maintenance of
building, license fee etc.
2) Total Variable Cost (TVC) :
Those costs which vary directly with the level of output is called variable cost.
For example: Wage of temporary labourers, cost of electricity, raw materials etc.
3) Total Cost (TC) :
The total expenditure incurred by a firm on the factors of production required for the
production of a commodity is called total cost.
TC is the sum of total fixed cost (TFC) and total variable cost at various levels'of output.
Total cost can be written as,
TC = TFC + TVC
4) Average Fixed Cost (AFC) :
The per unit of Fixed Cost of Production is called Average Fixed Cost.
We can obtain average fixed cost by dividing the total fixed cost by the number of units
produced. So,
TFC
AFC =
Q
5) Average variable Cost (AVC) :
The per unit of variable cost of production of a commodity is called average variable cost.
It is calculated by dividing TVC by total output.
TVC
AVC =
Q
6) Average Cost (AC) :
The per unit of total cost of production is called average cost.
We can obtain average cost by dividing cost by the number of units produced. So,
TC
AC =
Q
7) Marginal Cost (MC) :
The cost of producing an extra unit of a commodity is called marginal cost.
Marginal cost can be calculated with the help of following formula.
MC = TCn − TCn −1
Different cost concept can be explained in the following table.
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Vedashreee, Lecturer in Economics Sadvidya P U College
Output TFC TVC TC AFC AVC SAC SMC
(units) (Rs) (Rs) (Rs) (Rs) (Rs) (Rs) (Rs)
0 20 0 20 -
1 20 10 30 20 10 30 10
2 20 18 38 10 9 19 8
3 20 24 44 6.67 8 14.67 6
4 20 29 49 5 7.25 12.25 5
5 20 33 53 4 6.6 10.6 4
6 20 39 59 3.33 6.5 9.83 6
7 20 47 67 2.86 6.7 9.57 8
8 20 60 80 2.5 7.5 10 13
9 20 75 95 2.22 8.33 10.55 15
10 20 95 115 2 9.5 11.5 20
In the above table the marginal product, marginal cost also is undefined at zero level of
output. It is important to note here that in the short run, fixed cost cannot be changed. When
we change the level of output, whatever change occurs to total cost is entirely due to the
change in total variable cost. So in the short run, marginal cost is the increase in TVC due to
increase in production of one extra unit of output.

2. Explain the shapes of long run cost curves.

The time period in which all inputs needed for production can be changes is called
long-run.
All factors are available in the long run. There are no fixed costs. The total cost and the
total variable cost therefore, coincide in the long run. There are two types of Long run cost.
They are,
1) Long run average cost (LRAC) : Cost per unit of output in the long run is called
Long run average cost.
2) Long run marginal cost (LRMC): The change in the total cost per unit of change in
output is called Long run marginal cost.
Returns to scale can be shown in the LRAC curve. There are three types of returns to
scale. They are,
1) Increasing returns:
If we increase all the inputs by a certain proportion, output increases by more than
that proportion is called increasing returns.
With the input prices given, cost also increases by a lesser proportion. It must be the case
that as long as IRS operates, average cost falls as the firm increases output.
2) Decreasing returns:
If we want to increase the output by a certain proportion, inputs need to be
increased by more than that proportion is called decreasing returns.
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Vedashreee, Lecturer in Economics Sadvidya P U College
As a result, cost also increases by more than that proportion. So, as long as DRS operates,
the average cost must be rising as the firm increases output.
3) Constant returns:
If we want to increase the output by certain proportion inputs, output increased to the
same proportion is called constant returns.
CRS implies a proportional increase in inputs resulting in a proportional increase in
output. So the average cost remains constant as long as CRS operates.
It is argued that in atypical firm IRS is observed at the initial level of production. This is
then followed by the CRS and then by the DRS. Accordingly, the LRAC curve is a ‘U’-
shaped curve. Its downward sloping part corresponds to IRS and upward rising part
corresponds to DRS. At the minimum point of the LRAC curve, CRS is observed.
This can be shown with the help of following diagram.

In the above diagram ox axis represents output, oy axis represents cost.

Let us check how the LRMC curve looks like. For the first unit of output, both LRMC and
LRAC are the same. Then, as output increases, LRAC initially falls, and then, after a certain
point, it rises. As long as average cost is falling, marginal cost must be less than the average
cost. When the average cost is rising, marginal cost must be greater than the average cost.
LRMC curve is therefore a ‘U’-shaped curve. It cuts the LRAC curve from below at the
minimum point of the LRAC. In the diagram shows the shapes of the long run marginal cost
and the long run average cost curves for a typical firm.
LRAC reaches its minimum at q,. To the left of q,, LRAC is falling and LRMC is less
than the LRAC curve. To the right of q,, LRAC is rising and LRMC is higher than LRAC.

3. Explain the shapes of TP, MP and AP curves.

1) Total Product (TP):
The total volume of goods and services produced during a specified period of time
generally a year is called total product.
Total product can be increased by increasing the supply of variable factors in the short
period. However, in the longrun, total product can be raised by increasing both fixed and
variable factors.
An increase in the amount of one of the inputs keeping all other inputs constant results in

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Vedashreee, Lecturer in Economics Sadvidya P U College
an increase in output. The total product curve in the input-output plane is a positively sloped
curve. The following diagram shows the shape of the total product curve for a typical firm.

We measure units of labour along the horizontal axis and output along the vertical axis.
With L units of labour, the firm can at most produce q, units of output.
2) Marginal Product (MP):
The addition to total product by the employment of an additional unit of a factor is
called marginal product.
According to the law of variable proportions, the marginal product of an input initially
rises and then after a certain level of employment, it starts falling. The MP curve therefore,
looks like an inverse ‘U’-shaped curve.
3) Average Product (AP):
Per unit production of the variable factor is known as Average Product.
When we divided total output by the quantities of a variable factor, we get average
product. The shape of AP and MP curve can be shown in the following diagram.

In the above diagram ox axis represents labour, oy axis represents marginal and average
product. For the first unit of the variable input, one can easily check that the MP and the AP
are same. Now as we increase the amount of input, the MP rises. AP being the average of
marginal products, also rises, but rises less than MP.
Then, after a point, the MP starts falling. However, as long as the value of MP remains
higher than the value of the AP, the AP continues to rise. Once MP has fallen sufficiently, its
value becomes less than the AP and the
AP also starts falling. So AP curve is also inverse ‘U’-shaped.
As long as the AP increases, it must be the case that MP is greater than AP. Otherwise,
AP cannot rise. Similarly, when AP falls, MP has to be less than AP> It, follows that MP

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Vedashreee, Lecturer in Economics Sadvidya P U College
curve cuts AP curve from above at its maximum.
The above diagram shows the shapes of AP and MP curves for a typical firm.
The AP of factor 1 is maximum at L. To the left of L. AP is rising and MP is greater than
AP. To the right of L, AP is falling and MP is less than AP.

4. A Firms SMC schedule is shown in the following table. TFC is Rs. 100. Find TVC, TC,
AVC & SAC schedules of the firm.
Q 0 1 2 3 4 5 6
SMC - 500 300 200 300 500 800

Output in units SMC TFC TVC TC AVC SAC

0 100 0 100 - -
1 500 100 500 600 500 600
2 300 100 800 900 400 450
3 200 100 1000 1100 333.33 366.67
4 300 100 1300 1400 325 350
5 500 100 1800 1900 360 380
6 800 100 2600 2700 433.33 450

To calculation of TVC we use the following formula :

1) TVC = ESMC
To calculation of TC we use the following formula:
2) TC = TFC + TVC
To calculation of AVC we use the following formula :
3) AVC = TVC / Output
To calculation of TVC we use the following formula :
4) SAC = TC / Output

5. Explain the law of variable proportions with the help of a diagram.

Law of variable proportions is one of the most important laws of production. It shows the
nature of rate of change in output due to a change in variable factors. In the short run, when
one input is variable and all other inputs are fixed, the firms production function exhibits the
law of variable proportions. This law shows the nature of rate of change in output due to
change in only one variable factors of production.
Statement of law :
Law of variable proportions states that, as we increase quantity of only one input,
keeping other inputs fixed, total product initially increases at an increasing rate, then at
a decreasing rate. This can be explained with the help of following table.

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Vedashreee, Lecturer in Economics Sadvidya P U College
Land Labour Total Output (TP) Marginal Output (MP) Average Output (AP)
4 0 0 - -
4 1 10 10 10
4 2 24 14 12
4 3 40 16 13.33
4 4 50 10 12.5
4 5 56 6 11.2
4 6 57 1 9.5
In the first stage from the above table it is clear that when one unit of labour is employed
TP, AP and MP become 10 units. When 2 units of labour are used, total production increases
to 24 units. It means TP is more than doubled when unit of labour used doubles. Here MP
increase by 14 units and AP is 12 units. When 3 units of labour are employed TP increases to
40 units. Here MP is 16 units and AP is 13.33 tonnes. It means till the employment of 3rd
unit of labour TP increase at an increasing rate.
Notice that the MP first increases (upto 3 units of labour) and then begins to fall. This
tendency of the MP to first increase and then fall is called the Law of variable proportions
or the law of diminishing marginal product. Law of variable proportions say that the
marginal product of a factor input initially rises with its employment level. But after reaching
a certain level of employment, it starts falling.
In the second stage from the above table that when 4th unit of labour is used TP increase
to 50 units. But MP decreases 10 units and AP decreases to 12 units. When 5th unit of labour
is used TP increases to 56 units and MP decreases to 6 units and AP decreases to 11.2 units at
diminishing rate. Here both MP and AP remain positive.
This can be explained with the help of following diagram.

In the above diagram, in the first phase, every additional variable factor adds more and
more to the total output. It means. TP increases at an increasing rate and MP of each variable
factor rises in a part and then falls. The average product curve rises throughout and remains
below the MP curve.
As we hold one factor fixed and keep increasing the other, the factor proportions change.
Initially, as we increase the amount of the variable input, the factor proportions become more
and more suitable for the production and marginal product increases. But after a certain level

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Vedashreee, Lecturer in Economics Sadvidya P U College
of employment, the production process becomes too crowded with the variable input. So the
output added by each additional worker is now proportionately less, the marginal product
begins to fall.

VIII. Assignment and Project oriented Questions. (Each question carries 5 marks)
1. Find the Missing products in the following table
Factor 1 TP MP1 AP1
0 n n 0
1 10 - 10
2 24 - 12
3 40 16 13.33
4 - 10 -
5 - 6 11.2
6 57 1 9.5
Solutions
Factor 1 TP MP1 AP1
U 0 0 0
1 10 10 10
2 24 14 12
3 40 16 13.33
4 50 10 12.5
5 56 6 11.2
6 57 1 9.5

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Vedashreee, Lecturer in Economics Sadvidya P U College
CHAPTER-4
THE THEORY OF FIRM UNDER PERFECT COMPETATION
I. Choose the correct answer (each question carries 1 mark):
1. In a perfect competition each firm produces and sells
a) Hetrogenous products b) Homogeneous Products c) Luxury goods d) Necessary goods
2. The increase in total revenue for a unit increase in the output is
a) Marginal Revenue b) Average Revenue c) Total Revenue d) Fixed Revenue
3. The firm’s profit is denoted by
a)  b)  c)  d) 
4. When the supply curve is vertical the elasticity of supply is
a) es = 1 b) es > 1 c) es = 0 d) ex = 
5. The revenue per unit of output of a firm is called as
a) TR b) MR c) AR d) None of the above
Ans: 1) b 2) a 3) d 4) c 5) c

II. Fill in the blanks (each question carries 1 mark):

1. Price taking behaviour is the single most distinguishing characteristic of ________Market.
2. ________is a tax that the government imposes per unit sale of output.
3. For a price taking firm marginal revenue is equal to ________
4. The point of minimum AVC where the SMC curves cuts the AVC curves is called
5. ________cost of some activity is the gain forgone from the second best activity.
Ans : 1) Perfect competition 2) Unit tax 3) Market Price
4) Shutdown point of the firm 5) Opportunity

III. Match the following: (each question carries 1 mark).

A B
1. TR = a. Perfect information
2. 71 b. Zero profit
3. AR = c. PxQ
4. Normal Profit d. TR - TC
5. Perfect competition e. ΔTR/ΔQ
6. MR TR
f.
Q

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Vedashreee, Lecturer in Economics Sadvidya P U College
Solutions
1. TR = a. PxQ
2. 71 b. TR - TC
3. AR = TR
c.
Q
4. Normal Profit d. Zero profit
5. Perfect competition e. Perfect information
6. MR f. ΔTR/ΔQ
IV. Answer the following questions in a sentence/word : (Each question carries 1 mark)
1. Define marginal revenue.
The additional revenue generated from the sale of an additional unit of the commodity is
called marginal revenue.
2. To which side does supply curve shift due to the technological progress?
Supply curve shift from left to right due to the technological progress.
3. Write the formula to calculate average revenue.
TR p  q
AR = = =P
q q
4. What is normal profit?
The minimum level of profit that is needed to keep a firm in the existing business is called as
normal profit.
5. Give the meaning of super normal profit.
Profit that a firm earns over and above the normal profit is called the super normal profit.
6. What does market supply curve show?
The market supply curve shows the output levels that firms in the market produce in
aggregate corresponding to different values of the market price.

V. Answer the following questions in 4 sentences (each question carries 2 marks)

1. Mention the conditions needed for profit by a firm under perfect competition.
1) The price, (P), must equal MC
2) Marginal cost must be non-decreasing at q0
3) For the firm to continue to produce, in the short run, price must be greater than the average
variable cost (p  AVC);
In the long run, price must be greater than the average cost (p AC).
2. Give the meaning of shut down point.
The point where SMC curve cuts AVC curve at the minimum is called the short run shut
down point of the firm.
A firm continues to produce as long as the price remains greater than or equal to the minimum
of AV C. Below the minimum point of AV C there will be no production. Because firm
incurring losses.
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Vedashreee, Lecturer in Economics Sadvidya P U College
3. Write the meaning of opportunity cost with an example.
Opportunity cost is the next best alternative foregone.
For example: Aplot of land is a resource. This land can be used for different purposes like,
for agriculture, or for constructing a factory or a school. If we use the land for agriculture, the
community will be deprived of a factory or a school.
4. Mention the two determinants of a firm’s supply curve.
1) Technological progress
2) Input prices
5. Give the meaning of price elasticity of supply and write its formula.
The percentage change in quantity supplied due to a one percent change in the market price of
the goods is called price elasticity of supply.
Q
100
Q Q p
es = = 
P Q p
100
P

VI. Answer the following questions in 12 sentences: (Each question carries 4 marks)
1. Write a short note on profit maximisation of a firm under the following conditions
a) P = MC
b) MC must be none decreasing at q0.
1) Condition 1 (P = MC)
The difference between total revenue and total cost is called profit.
Both total revenue and total cost increase as output increases. Notice that as long as the
change in total revenue is greater than the change in total cost, profits will continue to
increase. Recall that change in total revenue per unit increase in output is the marginal
revenue; and the change in total cost per unit increase in output is the marginal cost.
Therefore, we can conclude that as long as marginal revenue is greater than marginal cost,
profits are increasing. By the same logic, as long as marginal revenue is less than marginal
cost, profits will fall. It follows that for profits to be maximum, marginal revenue should equal
marginal cost.
In other words profits are maximum at the level of output for which MR = MC
For the perfectly competitive firm, we have established that the MR= R So the firm’s
profit maximizing output becomes the level of output at which P = MC.
Condition 2 MC must be none decreasing at q0.
Consider the second condition that must hold when the profit-maximising output level is
positive. This can be explained with the help of a following diagram. Note that at output
levels q, and q,, the market price is equal to the marginal cost. However, at the output level q,,
the marginal cost curve is downward sloping. We claim that q, cannot be a profit-maximising
output level.

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Vedashreee, Lecturer in Economics Sadvidya P U College

Observe that for all output levels slightly to the left of q,, the market price is lower than the
marginal cost. Immediately implies that firm’s profit at an output level slightly smaller than
q,, exceeds that corresponding to the output level q,. This being the case, q (cannot be a profit-
maximising output level.

2. Explain the determinants of a firm’s supply curve.

A firm’s supply curve is a part of its marginal cost curve. Thus, any factor that affects a
firm’s marginal cost curve is of course a determinant of its supply curve. The following are
the two important determinants of a firm supply curve.
1. Technological Progress
Technological changes influence the supply of a commodity. Advanced and improved
technology reduces the cost of production, which raises the profit margin. It induces the seller
to increase the supply.
However, technological degradation and outdated technology will increase the cost of
production and it will lead to decrease in supply.
It is expected that this will lower the firm’s marginal cost at any level of output; that is,
there is a righward (or downward) shift of the MC curve. AS the firm’s supply curve is
essentially a segment of the MC curve, technological progress shifts the supply curve of the
firm to the right. At any given market price, the firm now supplies more units of output.
2. Input Prices
A change in input prices also affects a firm’s supply curve. If the price of an input (say, the
wage rate of labour) increases, the cost of production rises. The consequent increase in the
firm’s average cost at any level of output is usually accompanied by an increase in the firm’s
marginal cost at any level of output; that is, there is a leftward (or upward) shift of the MC
curve. This means that the firm’s supply curve shifts to the left: at any given market price, the
firm now supplies fewer units of output.

3. Explain the features of perfect competition.

A market situation in which there are a large number of buyers and sellers who buy and
sell homogneous products at a uniform price is called perfectly competitive market.
Feature of Perfect competitive market :
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Vedashreee, Lecturer in Economics Sadvidya P U College
The following are the main features of perfectly competitive market.
1) Large number of buyers and sellers :
In perfect competition market, there will be large number of buyers and sellers. The
number would be so large, that no individual firm would have enough capacity to influence
the price, demand and supply. The price of the commodity is determined by the combined
actions of all the firms and buyers in the market.
2) Homogeneous product :
The producers under perfect competion produce homogeneous product. There should not
be any differentiation of products by way of quality, colour* design etc.
3) Single price (uniform price)
In perfect competition market commodity is sold at uniform price all over the market.
Price is determined by the joint efforts of buyers and sellers. So all the firms will have to
follow the same price.
4) Free entry and exit of firms :
Under perfect competition market there is no restriction of the entry of new firm in the
industry or exit of the existing firms from the industry. If the existing firms earn huge profit in
the short run, new firms can enter the market. On the other hand if an Individual firm incur
losses in the short run it might leave the industry.
5) Complete Knowledge :
In perfect competition the sellers and buyers will have complete knowledge of market
conditions. Therefore, the same price would be inforce in this market. Because of the
complete knowledge of the market there will not be much about the advertisement.
6) Price taking behaviour :
Price taking is often thought to be a reasonable assumption when the market has many
firms and buyers have perfect information about the price prevailing in the market where each
firm in the market charges the same price. Suppose now that a certain firm rises its price
above the market price. Observe that since all firms produce the same good and buyers are
aware the market price the firm in question losses all its buyers.
Further more as these buyers switch their purchases to other firms no adjustments problem
arises, their demand is readily accommodated when there are so many firms in the market.

4. Explain the average revenue or price line of a firm under perfect competition with the
help of a diagram.
The amount of revenue per unit sold is called average revenue.
Average revenue can be obtained by dividing the total revenue by the quantity of sold.
If a firms output is q and the market price is p, then TR equals p x q Average revenue can
be calculated with the help of following formula;
TR p  q
AR = = =p
q q

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Vedashreee, Lecturer in Economics Sadvidya P U College
In other words, for a price taking firm, average revenue equals the market price.
The average revenue or price line of a firm under perfect competition can be explain with the
help of following diagram.

In the above diagram ox axis represent output and oy axis represent price. Since the market
price is fixed at p, we obtain a horizontal straight line that cuts the y-axis at a height equal to
p. This horizontal straight line is called the price line. It is also the firm’s AR curve under
perfect competition. The price line also depicts the demand curve facing a firm. Observe that
the demand curve is perfectly elastic. This means that a firm can sell as many units of the
good as it wants to sell at price p.

VII. Answer the following questions in 20 sentences : (Each question carries 6marks)
1. Explain the short run supply curve of a firm with the help of diagram.
A period in which output can be changed by changing only variable factors is called short
run.
In the short run fixed inputs like plant machinery, building etc can not be changed. Short run
supply curve of a firm can be explained with the help of two parts. They are:
1) When the market price is greater than or equal to the minimum AVC.
2) When the market price is less than the minimum AVC.1: Price is greater than or equal to
the minimum AVC
Suppose the market price is p1, which exceeds the minimum AVC. In the following
diagram ox axis represents output, oy axis represents price and cost. We start out by equating
p, with SMC on the rising part of the SMC curve; this leads to the output level q.. Note also
that the AVC at q, does not exceed the market price, p2. Thus, all three conditions highlighted
in section 3 are satisfied at q1 Hence, when the market price is p2 the firm’s output level in the
short run is equal to q1.

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Vedashreee, Lecturer in Economics Sadvidya P U College
2 : Price is less than the minimum AVC
Suppose the market price is p2, which is less than the minimum AVC. We have argued that
if a profit-maximising firm produces a positive output in the short run, then the market price,
p2, must be greater than or equal to the AVC at that output level. But notice in the above
diagram that for all positive output levels, AVC strictly exceeds p2. In other words, it cannot
be the case that the firm supplies a positive output. So, if the market price is p2, the firm
produces zero output.

2. Explain market supply curve with the help of diagram.

A graphical representation of market supply schedule is called market supply curve.
It is obtained by horizontal summation of individual supply curves. It is a horizontal
summation of all the individual supply schedules that shows supply curve of an entire industry
at different prices, at a particular time in a specified market.
Let us now construct the market supply curve geometrically with just two firms in the
market: firm A and firm B. The two firms have different cost structures. Firm A will not
produce anything if the market price is less than p, while firm B will not produce anything if
the market price is less than p2. Assume also that p2 is greater than p,.

In panel (a) of we have the supply curve of firm A, denoted by SA; in panel (b), we have
the supply curve of firm B, denoted by SB. Panel (c) of shows the market supply curve,
denoted by Sm.
When the market price is strictly below p1, both firms choose not to produce any amount
of the good; hence, market supply will also be zero for all such prices.
For a market price greater than or equal to p1, but strictly less than p2. only firm A will
produce a positive amount of the good. Therefore, in this range, the market supply curve
coincides with the supply curve of firm A. For a market price greater than or equal to p2, both
firms will have positive output levels.
For example: Consider a situation where in the market price assumes the value p3. Given
p3, firm A supplies q3 units of output, while firm supplies q4 units of output. So, the market
supply at price p3 is qs, where q5 = q3 + q4.
Notice how the market supply curve. Sm, in panel (c) is being constructed: we obtain Sm by
taking a horizontal summation of the supply curves of the two firms in the market. SA and SB.

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Vedashreee, Lecturer in Economics Sadvidya P U College
3. Explain the long run supply curve of a firm with the help of diagram.
A period in which output can be changed by changing all factors of production is called
long run.
In the long run all factors of productions are variable and hence all costs are variable. Let
us turn to and derive the firm’s long run supply curve. As in the short run case, we split the
derivation into two parts. They are:
1) The firm’s profit-maximising output level when the market price is greater than or equal
to the minimum (long run) AC.
2) The firm’s profit-maximising output level when the market price is less than the
minimum (long ran) AC.
1: Price greater than or equal to the minimum LRAC
Suppose the market price is p,, which exceeds the minimum LRAC. Upon equating p, with
LRMC on the rising part of the LRMC curve, we obtain output level q r Note also that the
LRAC at q, does not exceed the market price, p,. Thus, all three conditions are satisfied at q,.
Hence, when the market price is p,, the firm’s supplies in the long run become an output equal
to q,. In this situation firm earning maximum profit.

2: Price less than the minimum LRAC

In the above diagram ox axis represents price and cost. Suppose the market price is p2,
which is less than the minimum LRAC. We have argued that if a profit-maximising firm
produces a positive output in the long run, the market price, p2, must be greater than or equal
to the LRAC at that output level. In the above diagram that for all positive output levels,
LRAC strictly exceeds p2. in this situation firm incurring loss. So, when the market price is p2,
Because LRAC is greater than price. So, The firm produces zero output.

4. Write about shutdown point, Normal profit and Break-even Point.

Shutdown Point: In the short run minimum point of AVC at which SMC curve cuts the AVC
curve is the shutdown point of firm. In the long run minimum point of LRAC at which LRMC
curve cuts the LRMC curve is the shutdown point of the firm.
Normal Profit: The minimum level of profit that is needed to keep a firm in the existing
business is defined as Normal profit. A firm that does not make normal profit is not going to

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Vedashreee, Lecturer in Economics Sadvidya P U College
continue in business. Normal profits are therefore a part of the firm’s total costs. Profit that a
firm earns over and above the normal profit is called the super-normal profit.
Break-even point: The point on the supply curve at which a firm earns only normal profit is
called the break-even point of the firm. In the short run the point of minimum average cost at
which the supply curve cuts the SAC curve is the break-even point of the firm. In the long run
the point of minimum average cost at which the supply curve cuts the LRAC curve is the
break-even point of the firm.

5. Explain the Total Revenue and Average Revenue of a firm under perfect competition
with the help of diagrams.
Total Revenue: A firm earns revenue by selling the good that it produces in the market.
Let the market price of a unit of the good be p. Let q be the quantity of the good produced,
and therefore sold, by the firm at price p. Then Total Revenue (TR) of the firm is defined as
the market price of the good (p) multiplied by the firm’s output (q).
TR = p × q
For example, let the market for candles be perfectly competitive and let the market price of
a box of candles be Rs 10. For a candle manufacturer, the relationship of total revenue with
the output is shown in the following table and diagram.

Total Revenue curve is upward sloping, which shows that as output increases the Total
Revenue increases and as output decreases the Total Revenue decreases.
Average Revenue: The average revenue (AR) of a firm is defined as total revenue per unit of
output. Average revenue can be obtained by dividing the total revenue.
TR p  q
AR = = =p
q q
Under the perfect competition average revenue is equal to the market price. Therefore average
revenue curve is horizontal straight line which is also called ‘Price Line’. This price curve is
also depicts the demand curve facing a firm. Here the demand curve is perfectly elastic. This
means that a firm can sell as many units of the good as it wants to sell at price p.

VIII. Assignment and Project oriented Questions. (Each question carries 5 marks) ,
1. Compute the total revenue, marginal revenue and average revenue schedules in the
following table when market price of each unit of goods is Rs. 10.
Quantity sold TR MR AR
0

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Vedashreee, Lecturer in Economics Sadvidya P U College
1
2
3
4
5
6

Solutions
p Q TR=PQ AR= MRn=TRn-TRn-l
10 0 0 0 0
10 1 10 10 10
10 2 20 10 10
10 3 30 10 10
10 4 40 10 10
10 5 50 10 10
10 6 60 10 10

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Vedashreee, Lecturer in Economics Sadvidya P U College
CHAPTER - 5
MARKET EQUILIBRIUM
I. Choose the correct answer (each question carries 1 mark).
1. In perfect competition, buyers & sellers are
a) Price makers b) Price takers c) Price analysts d) None of the above
2. A situation where the plans of all consumers and firms in the market match.
a) Inequilibrium situation b) Equilibrium situation
c) Maximisation situation d) Partial Equilibrium situation
3. As a result of increase in the number of firms there is an increase in supply, then supply curve,
a) Shifts towards left b) Shifts towards Right
c) Shifts towards Both sides d) None of the above
4. The firms earn super normal profit as long as the price is greater than the minimum of
a) Marginal cost b) Total cost c) Average cost d) Fixed cost
5. The government imposing upper limit on the price of goods and services is called
a) Price ceiling b) Selling price c) Price floor d) None of the above
6. The government imposed lower limit on the price of goods and service is called
a) Goods floor b) Service floor c) Price floor d) None of the above
Ans: 1) a 2) b 3) b 4) c 5) a 6) c

II. Fill in the blanks (each question carries 1 mark).

1. In a perfectly competitive market, equilibrium occurs when market demand market supply.
2. If the supply curve shifts rightward and demand curve shifts leftward equilibrium price will be
3. is determined at the point where the demand for labour and supply of labour curves intersect.
4. In labour market are the suppliers of labour.
5. Due to rightward shifts in both demand and supply curves the equi librium price returns
6. It is assured that, in a perfectly competitive market an is at play.
Ans: 1) Equal to 2) Increases 3) Wage
4) family 5) May increase or decrease or remain unchanged 6) Invisible hand

III. Match the following: (each question carries 1 mark).

A B
1. Adom Smith a. Attraction of new firms
2. Price certing b. Operation of invisible hand
3. Market equilibrium c. Lower limit on price
4. Posibility of supernormal profit d. Upper limit on price
5. Price floor e. QD = QS

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Vedashreee, Lecturer in Economics Sadvidya P U College
Solutions
A B
1. Adom Smith Operation of invisible hand
2. Price certing Upper limit on price
3. Market equilibrium QD = QS
4. Possibility of supernormal profit Attraction of new firms
5. Price floor Lower limit on price

IV. Answer the following questions in a sentence/word : (each question carries 1 mark).
1. Define market equilibrium.
The situation when the quantity demanded of a commodity becomes equal to the quantity
supplied is called Market Equilibrium.
2. What is equilibrium price?
The price at which the quantity demanded of a commodity is equal to the quantity supplied is
called Equilibrium Price.
3. When do we say that, there is an excess demand in the market?
A Situation when the quantity demanded is more than the quantity supplied at the preavailing
market price is called Excess Demand.
4. What is price ceiling?
Fixing the maximum of a commodity at a level lower than the equilibrium price is called Price
Ceiling.
5. What is price floor?
The minimum price (above the equilibrium price), fixed by the government, which the
producers must be paid for their produce is called Price Floor.
6. Through which legislation, the government ensures that the wage rate of the labourers
docs not fall below a particular level?
Minimum wage policy

V. Answer the following questions in 4 sentences. (Each question carries 2 marks)

1. Define equilibrium price and quantity.
The price at which quantity demanded of a commodity is equal to the quantity supplied is
called equilibrium price.
The quantity demanded and supplied at the equilibrium price is called equilibrium quantity.
2. How price is determind, when fixed number of firms exist in perfect competition.
The price is determind by the interaction of the demand and supply curves in the market. If
there any imbalances in the equilibrium price invisible hand guides both producers and
consumers towards equilibrium.

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3. Write any two possible ways in which simultaneous shift of both demand and supply
curves.
1) Both supply and demand curves shift rightwards.
2) Both supply and demand curves shift leftwards.
4. What is marginal Revenue product of labour (MRP, )
An aditional benefit equal to marginal revenue times marginal product which is called
marginal revenue product of labour.
5. Distinguish between excess demand and excess supply.
A Situation when the quantity demanded is more than the quantity supplied at the prevailing
market price is called Excess Demand.
A situation when the quantity supplied more than the quantity demanded at the prevailing
market price is called Excess Supply.
6. How wage is determined in the labour market?
With an upward sloping supply curve and downward sloping demand curve, the equilibrium
wage rate is determined at the point where these two curves interesect. Where the labour that
the households wish to supply is equal to the labour that the firm wish to hire.

VI. Answer the following questions in 12 sentences (each question carries 4 marks)
1. What is the implication of free entry and exit of firm on market equilibrium Briefly
explain.
The market equilibrium was studied under the assumption that there is a fixed number of
firms. In this section, we will study market equilibrium when firms can enter and exit the
market freely. Here, for simplicity, we assume that all the firms in the market are identical.
This assumption implies that in equilibrium no firm earns supernormal profit or incurs loss
by remaining in production; in other words, the equilibrium price will be equal to the
minimum average cost of the firms.
Suppose at the prevailing market price, each firm is earning supper normal profit. The
possibility of earning super normal profit will attract some new firms.This causes market price
to fall. As prices fall, supernormal profits are eventually wiped out. At this point, with all
firms in the market earning normal profit, no more finns will have incentive to enter.
Similarly, if the firms are earning less than normal profit at the prevailing price, some
firms will exit which will lead to an increase in price, and with sufficient number of firms, the
profits of each, firm will increase to the level of normal profit. At this point no more firm will
want to leave since they will be earning normal profit here. Thus with free entry and exit, each
firm will always earn normal profit at the prevailing market price.
The firms will earn supernormal profit so long as the price is greater than the minimum
average cost and at prices lessthan minimum average cost, they will earn less than normal
profit. Therefore, at prices greater than the minimum average cost, new firms will enter, and at
prices below minimum average cost, existing firms will start exiting.
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Vedashreee, Lecturer in Economics Sadvidya P U College
At the price level equal to the minimum average cost of the firms, each firm will earn
normal profit so that no new firm will be attracted to enter the market. Also the existing firms
will not leave the market since they are not incurring any loss by producing at this point. So,
this price will prevail in the market.
Therefore, free entry and exit of the firms imply that the market price will always be equal
to the minimum average cost, that is
p = minAC
This can be explained with the help of following diagram.

In the above diagram ox axis represent quantity of demand oy axis represent price.
From the above diagram, it follows that the equilibrium price will be equal to the
minimum average cost of the firms. In equilibrium, the quantity supplied will be determined
by the market demand at that price so that they are equal. Where the market will be in
equilibrium at point E at which the demand curve DD intersect the P Q = min AC line such that
the market price is PQ and the total quantity demanded and supplied is equal to q0.
At P0=minAC each firm supplies same amount of output, say q0f Therefore, the
equilibrium number of firms in the market is equal to the number of firms required to supply
q0 output at P0, each in turn supplying q0f amount at that price. If we denote the equilibrium
number of firms by n0, then
q0
n0 =
qof

2. Write a table to show the impact of simultaneous shifts on equilibrium.

Shift in Shift in
Quantity Price
Demand Supply
Leftward Leftward Decreases May increase, decrease or
remain unchanged
Rightward Rightward Increase May increase, decrease or
remain unchanged
Leftward Rightward May increase, decrease or Decreases
remain unchanged
Rightward Leftward May increase, decrease or Increases
remain unchanged

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Vedashreee, Lecturer in Economics Sadvidya P U College
3. Write a note on price ceiling and price floor.
1. PRICE CEILING
Fixing the maximum of a commodity at a level lower than the equilibrium price is
called Price Ceiling.
Government plays an important role in controlling the prices of essential commodities
(wheat, sugar, kerosene etc.) when the equilibrium price determined by free play of demand
and supply is too high for the poor people.
In the diagram, demand curve DD and supply curve SS of wheat intersect each other at
point E and, as a result, equilibrium price of OP is determined.

Let us clear this point by considering the commodity ‘wheat’ and its price determination in
the following diagram.
• Suppose, the equilibrium price of OP is very high and many poor people are unable to
afford wheat at this price.
• As wheat is an essential commodity, government interferes and fixes the maximum price
(known as Price ceiling) at OP, which is less than the equilibrium price, OP.
• At this controlled price (OP), the quantity demanded (OQD) exceeds the quantity supplied
(OQS) by QSQD.
• It creates a shortage of MN and some consumers of wheat go unsatisfied. To meet this
excess demand, government may enforce the rationing system.
• Rationing is a technique adopted by the government to sell a minimum quota of essential
commodities at a price less than equilibrium price to supply goods to the poor community
at a cheaper price. Under this system, consumers are given ration cards/coupons to buy
commodities at a cheaper price from ration shops.
But, price ceilling through rationing system has certain drawbacks.
1. Black Markets: Black markets exist because consumers are ready
to pay a price more than the price fixed by the government to get more of the limited amount
of commodity available.
2. Difficulty obtaining goods from ration shops: Consumers have to
stand in long queues to buy goods from ration shops.

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Vedashreee, Lecturer in Economics Sadvidya P U College
2. PRICE FLOOR OF MINIMUM SUPPORT PRICE (MSP)
The minimum price (above the equilibrium price), fixed by the government, which the
producers must be paid for their produce is called Price Floor.
Government also intervenes in the process of price determination through Price Floor. The
minimum price (above the equilibrium price), fixed by the government, which the producers
must be paid for their produce.
• When government feels that the price fixed by the forces of demand and supply is
not remunerative from the producer’s point of view, then it fixes a price (known as
price floor) which is more than the equilibrium price.
• Most well-known examples of imposition of price floor are,
1) Agricultural price support programmes.
2) Minimum wage legislation.
• Indian Government maintains a variety of price support programmes for various
agricultural products like wheat, sugarcane etc. and the floor is normally set at a
level higher than the market determined price for these goods.
The effect of floor price can be better understood with the help of

As seen in the diagram, equilibrium is determined at point E when demand

curve DD and supply curve SS of wheat interesect each other. The equilibrium
price of OP is determined.
• Suppose, to protect the producer’s interest and to provide incentive for further
production, government declares OP2 as the minimum price (known as Price Floor)
which is more than the equilibrium price of OP.
• At this support price (OP2), the quantity supplied (OQs) exceeds the quantity
demand (OQD) by QSQD-
• This creates a situation of surplus in the market which is equvalent to MN in the
diagram. The excess supply may be purchased by the government either to increase
its buffer stocks or for exports.

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Vedashreee, Lecturer in Economics Sadvidya P U College
VII. Answer the following questions in 20 sentences (each question carries 6marks)
1. Explain the simultaneous shifts of demand and supply curve in perfect competition with
the help of diagrams.
Demand and Supply model is very easy to use, when there is a change in either demand or
supply. However, in reality, there are number of situations which lead to simultaneous
changes in both demand and supply. To predict whether the equilibrium price and the
equilibrium quantity rise or fall in such cases, we need to know the magnitude of changes in
both demand and supply. Let us study following 4 cases of simultaneous shifts in demand and
supply curves:
(i) Both Demand and Supply decrease
(ii) Both Demand and Supply increase
(iii) Demand decreases and Supply increases
(iv) Demand increases and Supply decreases
(i) Both Demand and Supply Decrease
When decrease in demand is proportionately equal to decrease in supply, then leftward shift in
demand curve from DD, to DD0 is proportionately

Original Equilibrium is determined at point E, when the original demand curve DD and the
original supply curve SS intersect each other. OQ is the equilibrium quantity and OP is the
equilibrium price. The effect of decrease in both demand and supply on equilibrium price and
equilibrium quantity can be better analysed with the help of diagram. equal to leftward shift in
supply curve from SS1 to SS0. The new equilibrium is determined at F. As demand and supply
decrease in the same proportion, equilibrium price remains same at OP, but equilibrium
quantity falls from OQ1 to OQ.
(ii) Both Demand and Supply Increase
The effect of simultaneous increase in demand and increase in supply on equilibrium price
and equilibrium quantity is analysed in the following diagram.

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Vedashreee, Lecturer in Economics Sadvidya P U College
Original Equilibrium is determined at point E, when the original demand curve DD 0 and
the original supply curve SSQ intersect each other. OQ is the equilibrium quantity and OP is
the equilibrium price. The effect of increase in both demand and supply on equilibrium price.
(iii) Demand decreases and Supply increases
The effect of simultaneous decrease in demand and increase in supply on equilibrium price
and equilibrium quantity is analysed in the following diagram.

When decreasee in demand is proportionately equal to increase in supply, then leftward

shift in demand curve from DDQ to DD, is proportionately equal to rightward shift in supply
curve from SSQ to SS,. The new equilibrium is determined at F, equilibrium quantity remains
the same at OQ, but equilibrium price falls from OP0 to OP,.
iv) Demand increases and Supply decreases
The effect of increase in demand and decrease in supply on equilibrium

When increasee in demand is proportionately equal to decrease in supply, then rightward

shift in demand curve from DD0 to DD1 is proportionately equal to leftward shift in supply
curve from SSQ to SS1. The new equilibrium is determined at F. As the increase in demand is
proportionately equal to the decrease in supply, equilibrium quantity remains the same at OQ,
but equilibrium price rises from OP0 to OP1.

2. Explain the market equilibrium with the fixed number of firms with the help of
diagram.
The price at which the amount demanded and amount supplied are equal is known as
equilibrium price.
Literally, equilibrium means balance. In other words equilibrium means a state of rest it is
a position from which there will not be a tendency to move. An equilibrium price, quantity of
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Vedashreee, Lecturer in Economics Sadvidya P U College
demand and supply will be equal. Both the buyers and sellers objectives are satisfied.
This process of determination of price by supply and demand forces is called 'price
mechanism’ Prof Adam Smith calls this price mechanism as ‘invisible hand’. According to
Adam Smith ‘invisible’ hand is always at work, if there is any imbalances in directs and
guides both the producers and the consumers towards equilibrium and brings natural order
through demand and supply forces.
This can be explained with the help of following diagram.

In the above diagram ox axis represents quantity of demand and supply oy axis represents
price. SS is the supply curve DD is the demand curve. ‘E’ is the intersection point, where the
quantity demanded is OM and the quantity supplied is also OM. This the equilibrium quantity.
OP is the equilibrium price. If price falls to OP1 D>S. Demand is excess by KL, the sellers
want to supply only OM1 quantity of supply but demand will be OM2. The buyers now
complete with each other in order to obtain the goods and are ready to pay a higher price than
OP1. So, price starts rising till OP level is reached, where the quantity supplied will be equal
to the quantity demanded.

3. Suppose the demand and supply curves of wheat are given by qD= 200 - P and qS=120+P.
Let us consider the example of a market consisting of identical farms producing same
quality of wheat. Suppose the market demand curve and the market supply curve for wheat
are given by:
qd = 200 - p
qs = 120 + p
First we must calculate equilibrium price.
Market Demand (qd) = Market Supply (qs)
qd = (p) = qs = (p)
200 -p = 120 - p
200-120 = p + p
80 =2p
80
p=
2

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Vedashreee, Lecturer in Economics Sadvidya P U College
P=40 (equilibrium price)
Now substituting this value of price we can get the equilibrium quantity of demand and
supply.
qd = 200 - p
qd= 200 – 40
qs= 120 + p
qs= 120 + 40
qs = 160
If price is less than 25. There will be excess demand suppose p = 25
qd = 200-p
qd = 200 - 25
qd = l75
qs = 120+ p
qs = 120 + 25
qs = 145
qd = 175 and qs = 145, therefore qd > qs
If price is greater than 40 there will be excess demand. Suppose p = 45
qd = 200 - p
qd = 200 - 45
qd = 155
qs = 120 + p
qs= 120 + 45
qs = 165
Here qs = 165 and qd = 155 therefore qs > qd
Demand and supply are equilibrium price of 40.
a) Find the equilibrium price
40
b) Find the equilibrium quantity of demand and supply.
Equilibrium demand = 160
c) Find the quantity of demand and supply when P > equilibrium price.
Equilibrium Supply = 160
d) Find the quantity of demand and supply when P < equilibrium price.
P > equilibrium price, equilibrium demand is 155, equilibrium supply is 165
P < equilibrium price, equilibrium demand is 175 and equilibrium supply is 145

4. Write a note on price ceiling.

The government imposed upper limit on the price of a good or service is called price
ceiling. Price ceiling is generally imposed on necessary items like Wheat, Rice, Kerosene,

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Vedashreee, Lecturer in Economics Sadvidya P U College
Sugar and it is fixed blow the market-determined price, Since at the market-determined price,
some section of the population will not be able to afford these goods.

In the diagram demand curve DD and supply curve SS mutually intersected and
equilibrium price p* and equilibrium quantity q* determined. When government imposes
price ceiling at PC, which is lower than equilibrium price level, demand increased to qc, but
supply decreased to qc1, this one causes for shortage of the good and to distribute it to
everyone ration coupons are issued to consumers. So that, everyone can buy stipulated
amount of good by ration shops, which are also called fair price shops.
Adverse consequences of price ceiling
a) Each consumer has to stand in long queues to buy the good, from ration shops.
b) This may result in the creation of black market.

5. Write a note on price floor

The government imposed lower limit on the price of a good or service is called Price floor.
Most well-known examples of imposition of price floor are agricultural price support
programmes and the Minimum Wage Legislation. Through an agricultural price support
programme the government imposed a lower limit on the purchase for some of the agricultural
goods and floor is normally set at a level higher than the market-determined price for these
goods. Similarly, through the Minimum Wage Legislation, the government ensures that the
wage rate of the labourers does not fall below a particular level and here also the minimum
wage rate is set above the equilibrium wage rate.

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Vedashreee, Lecturer in Economics Sadvidya P U College

In the diagram demand curve DD and supply curve SS mutually intersected and equilibrium price
p* and equilibrium quantity q* determined. When government imposes a price floor at Pf which
is higher than the market determined equilibrium price, supply increased to qf1 and demand
decreased to qf. In the case of agricultural support, to prevent price from falling because of excess
supply, government needs to buy the surplus at the predetermined price.

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Vedashreee, Lecturer in Economics Sadvidya P U College
CHAPTER - 6
NON COMPETITIVE MARKETS
I. Choose the correct answer (each question carries 1 mark).
1. A Market structure which produces heterogeneous products is called
a) Monopoly b) Monopolistic competition
c) Perfect competition d) None of the above
2. The change in TR due to the sale of an additional unit is called
a) Total Revenue b) Average Revenue c) Marginal Revenue d) Revenue
3. When the price elasticity of demand is more than one, MR has a
a) Negative value b) Decreasing value c) Constant value d) Positive value
4. Profit =
a) pxQ b) TR-TC C) TFC+TVC d) TR/Q
Ans : 1) b 2) c 3) d 4) b

II. Fill in the blanks (each question carries 1 mark).

1. The monopoly film’s decision to sell a larger quantity is possible only at ________
2. Competitive behavior and competitive market structure are in general ________ related.
3. In monopoly market, the goods which are sold has no _________
4. TR = _________
5. The Revenue received by the firm per unit of commodity sold is called _______
6. With the zero production cost, when the total revenue of monopoly firm is maximum, the
profit is _________
Ans : 1) Lower Price 2) Opposite 3) Substitutes
4) P x Q 5) Average Revenue 6) Maximum

III. Answer the following questions in a sentence/word. (Each question carries 1 mark).
1. What is monopoly
A market situation where there is a single seller selling a product which has no close
substitutes is called monopology.
2. Write the equation of a demand function.
q = 20 - 2p.
3. Give the meaning monopolistic competition.
A market situation in which there are large number of firms which sell closely related, but
differentiated products is called monopolistic competition.
4. Give the meaning of oligopoly market.
A market situation in which there are a few firms selling homogeneous or differentiated
products is called oligopoly market.
5. What is duopoly?
The market situation where there are only two firms operating in the market is called duopoly
market.
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Vedashreee, Lecturer in Economics Sadvidya P U College
IV. Answer the following questions in 4 sentences. (Each question carries 2 marks)
1. Mention the requirements of a monopoly market structure.
For the purpose of price discrimination monopoly market requirement is very essential. This
type of market structure helps to the maintain equality among the different class of the society
and give social justice to the people.
2. State the meaning of Average Revenue and Marginal revenue.
The amount of revenue per unit sold is called average revenue.
The additional revenue generated from the sale of an additional unit of the commodity is
called marginal revenue.
3. State the relationship between marginal revenue and price elasticity of demand.
1) It is sufficient to notice only one aspect - price elasticity of demand is more than 1 when
the MR has a positive value.
2) Becomes less than the unity when MR has a negative value.
4. Write the meaning of monopolistic competition and give an example.
A market situation in which there are large number of firms which sell closely related, but
differentiated products is called monopolistic competition.
Examples of Monopolistic competition
Market products like soaps, toothpaste, face creams, cool drinks ect...
5. Write the features of monopoly.
1) Single producer (Seller)
2) Restriction on the entry of new firms.
3) Absence of close substitute.
4) Price discrimination or Uniform price.

V. Answer the following questions in 12 sentences. (Each question carries 4 marks)

1. What is market demand curve? Draw a market demand curve for a monopoly firm.
A graphical representation of market demand shedule is called market demand curve.
A monopolist can sell more output only if he lowers the price, therefore its demand curve
slopes downwards from left to right.
The aggregate demand of all buyers of the product of a monopolist is the demand of the
monopolist. We know that the demand curve of an individual slopes downward from left to
right. Since the demand curve of the monopolist is the summation of the demand curves of all
buyers of the product sold by monopolist, demand curve of the monopolist slopes downward
from left to right, it means that a monopolist can sell more of his/her output at a lower price.
On the contrary if he raises the price of this product, sales will be reduced.
Market demand curve of monopoly market can be explained with the help of following
diagram.

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In the above diagram ox axis represent quantity of production, oy axis represent price. DD
is demand curve of a monopoly firm its slopes negatively as shown in the diagram. In the
diagram if the market price is at P0, consumers are willing to purchase the quantity q0. On the
other hand, if the market price is at the lower level P,, consumers are willing to buy a higher
quantity q,. That is, price in the market affects the quantity demanded by the consumers. This
is also expressed by saying that the quantity purchased by the consumers is a decreasing
function of the price.
The monopoly firm’s decision to sell a larger quantity is possible only at a lower price.
Conversely, if the monopoly firm brings a smaller quantity of the commodity into the
market for sale it will be able to sell at a higher price. Thus, for the monopoly firm, the price
depends on the quantity of the commodity sold. The same is also expressed by stating that
price is a decreasing function of the quantity sold. Thus, for the monopoly firm, the market
demand curve expresses the price that consumers are willing to pay for different quantities
supplied. This idea is reflected in the statement that the monopoly firm faces the market
demand curve, which is downward sloping.

2. Calculate TR and MR from the following table.

Q l 2 3 4 5 6 7 8 9 10
P 100 90 80 70 60 50 40 30 20 10

Q P TR = P x Q MR=TRn-TR n-l
1 100 100 100
2 90 180 180 -100 =80
3 80 240 240-180 =60
4 70 280 280-240 =40
5 60 300 300-280 =20
6 50 300 300-300 =0
7 40 280 280-300 =-20
8 30 240 240-280 =-40
9 20 180 180-240 =-60
10 10 100 100-180 =-80
1) TR can be calculated with the help TR = P x Q
2) MR can be calculated MR = TRn - TRn-1

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3. Briefly explain the monopolistic competitive market.
In real world, neither pure competition nor pure monopoly exists, rather a mix of two is
found in actual market.
A market situation in which there are large number of firms which sell closely
related but differentiated products is called monopolistic competitive market.
Examples of monopolistic market products: Soap, Toothpastes, Shampoos etc.
1) Existance of large number of buyers and sellers:
In monopolistic competition, there will be a large number of producers (firms).
Eventhough the number of firms are large, they will be of smaller size. Each firm decides its
own price, output policy without considering the reactions of rival firms. Similarly, the
number of buyers is fairly large in monopolistics competition.
2) Product differentiation:
Product differentiation referes to differentiating the products on the basis of brand,
size, colour, shape etc. Product differentiation is the second characteristic of monopolistic
competition.
For example: There is a very large number of biscuit producing firms. But many of the
biscuits being produced are associated with some brand name and are distinguishable from
one another by these brand names and packaging and are slightly different in taste. The
consumer develops ataste for a particular brand of biscuit over time, or becomes loyal to a
particular brand for some reason, and is, therefore, not immediately willing to substitute it for
another biscuit. However, if the price difference becomes large, the consumer would be
willing to choose a biscuit of another brand.
3) Downward sloping demand curve:
Monopolistic competition has a highly elastic demand curve. It is because of the reason
that the product has more close substitutes. A small fall in price can attract a large number of
buyers. It is for this reason AR and MR showing negative sloping demand curve are more
elastic as shown in adjacent diagram:
Here AR and MR are negatively sloping elastic demand curves that show a small change
in price can bring a greater change in demand. If producer wants to sell its more product, he
will have to lower the price.
4) Free entry and free exit of firms :
Another characteristic of the monopolistic competition is the freedom of entry and exist of
firms. In this market there is no restriction upon the firm to enter or leave the industry. If the
existing firms are earning huge profits, some new firms may join to share the profits and in
case of losses to the working firms,some of them may exit out of the industry.
4. Show the relationship between average revenue and marginal revenue of a monopoly
market with the help of diagrams.
The revenue of per unit of commodity sold is called average revenue.
Average revenue is obtained by dividing the total revenue by the number of unit sold.
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Vedashreee, Lecturer in Economics Sadvidya P U College
The additional revenue generated from the sale of an additonal unit of output is
called marginal revenue.
It is the change in TR from sale of one more unit of a commodity.
The relationship between AR and MR can be explained with the help of following
diagram.
In the above diagram ox axis represent output and oy axis represent AR and MR. When
firms can increase their volume of sales only by decreasing the price, then AR falls with
increase in sale. It means, revenue from every additional unit (i.e. MR) will be less than AR.
As a result, both AR and MR curves slope downwards from left to right.
If the AR curve is less steep, the vertical distance between the AR and MR curves is
smaller. In the above diagram (a) shows a flatter AR curve while in the diagram (b) shows a
steeper AR curve. For the same units of the commodity, the difference between AR and MR
in the diagram (a) is mailer than the difference in diagram (b)

5. Explain the market demand curve for a monopoly firm with the help of a diagram.
The market demand curve shows the quantities of a commodity that consumers as a whole
are willing to purchase at different prices. Monopoly market is a single seller market. The
demand curve of this market is as follows.

The demand curve of monopoly market slopes down from left to right, it means the firm
can sell large quantity at a lower price and less quantity at a higher price. In the diagram
quantity is measured on OX axis and price is measured on OY axis. Consumers purchase less
quantity q0 at a high level price P0, and purchase a high level quantity q1 at a less level price
P1.

6. Explain how the firms behave in oligopoly. (Added)

A market structure consisting more than one seller but the number of sellers is few is
called Oligopoly market. The special case of oligopoly, where there are exactly two
sellers, is called Duopoly market.
Oligopoly firms produce and sale homogeneous product, each firm is relatively large when
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Vedashreee, Lecturer in Economics Sadvidya P U College
compared to the size of the market and thus influence the market price. For example, if the
two firms in a duopoly are equal in size and one of them decided to double its output, the
total supply in the market will increase substantially, causing the price to fall, this fall in
price affects the profits of all firms in the industry. Other firms will respond to such a
move in order to protect their own profits by taking fresh decisions regarding how much to
produce. Therefore, in the industry the level of output, the level of prices, as well as the
profits are outcomes of how firms are interacting with each other.
In the oligopoly market, firms’ behaviour can be identified in two types as shown below.
1) Mutual Dependence of firms: Firms could decide to collude with each other to
maximise collective profits. In this case the firms form a ‘Cartel’ that acts as a monopoly.
The quantity supplied collectively by the industry and the price charged are the same as a
single monopolist would have done.
2) Competition between firms: Firms could decide to compete with each other. A firm
may lower its price a little below the other firms, in order to attract their customers. If
other firms retaliate by doing the same, the market price keeps falling as well as firms keep
undercutting each others’ prices, this process continues until marginal cost becomes equal
to the price. Further no one firm cuts the price because it is impossible to supply when
price is less than marginal cost.

VI.Answer the following questions in 20 sentences (each question carries 6marks)

1. Explain the short run equilibrium of a monopoly firm with the help of the simple case of
zero cost.
This is a monopoly situation when the cost of production is zero TC = 0. This is very rare
case. Let us suppose that there is a village which i? situated far away from the other village. In
that village, we assume there is only one well. All the village people completely depend for
their water needs on this well.
We assume that this well is owned by a particular individual and he has the exclusive right
over the use of the well. The owner of the well does not

In the above diagram ox axis represent output and oy axis represent AR and MR. When
firms can increase their volume of sales only by decreasing the price, then AR falls with
increase in sale. It means, revenue from every additional unit (i.e. MR) will be less than AR.

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Vedashreee, Lecturer in Economics Sadvidya P U College
As a result, both AR and MR curves slope downwards from left to right.
If the AR curve is less steep, the vertical distance between the AR and MR curves is
smaller. In the above diagram (a) shows a flatter AR curve while in the diagram (b) shows a
steeper AR curve. For the same units of the commodity, the difference between AR and MR
in the diagram (a) is mailer than the difference in diagram (b)

VI. Answer the following questions in 20 sentences (each question carries 6marks)
1. Explain the short run equilibrium of a monopoly firm with the help of the simple case of
zero cost.
This is a monopoly situation when the cost of production is zero TC=0. This is very rare
case. Let us suppose that there is a village which i? situated far away from the other village. In
that village, we assume there is only one well. All the village people completely depend for
their water needs on this well.
We assume that this well is owned by a particular individual and he has the exclusive right
over the use of the well. The owner of the well does not
allow any villager to draw water from this well without paying for it Thus, he enjoys
monopoly and can charge any price that he wishes. There is no production cost for water. That
is production cost is zero. Now we shall explain the equilibrium situation.
Monopoly market attains equilibrium when the profit is maximum. Profit of a monopoly firm
is given by the difference between TR and TC.
Symbolically,  =TR-TC
Where = Profit, TR = Total revenue, TC = Total cost.
Then, the profit of a monopoly firm with zero cost is
 = TR - TC
 = TR-0 = TR
If the TC is zero the maximum profit is total revenue. So when TR is maximum profit also
reaches maximum. This situation is explained dia-grammatically.

TR represents Total Revenue Curve, AR and MR represents Average Revenue Curve and
Marginal Revenue Curve respectively. The AR curve is the demand curve and depicts the
price charged per unit of water. It can be observed from the diagram that the TR curve is
maximum at point k. The price at which the buyers demand the output is given by the AR
Curve.

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Vedashreee, Lecturer in Economics Sadvidya P U College
Corresponding to the point k, the price charged by the monopolist is OP. The
corresponding quantity is equilibrium output OQ. The amount of total revenue (TR) is OP x
OQ. It is represented by shaded area OPEQ.
Symbolically, (Profit) n = TR - TC

= (AR x q) - 0 where (TR = pq = AR x q)

= OP x Oq
= OPEQ The shaded portion in the diagram.
Equilibrium output=OQ Equilibrium price=OP
2. Explain the short run equilibrium of a monopolist firm, when the cost of production Is
positive by using TR & TC curves with the help of a diagram.
The level of output where monopolist earns maximum profit is called equilibrium
situation. According to this approach a monopoly firm attains its equilibrium. According to
this approach a monopoly firm attains its equilibrium when it maximises its profits i.e., when
he maximises the difference between the total revenue (TR) and the total cost (TC).
A firm attains the stage of equilibrium when it maximises its profits, i.e. when he
maximises the difference between TR and TC. After reaching such a position, there will be no
incentive for the producer to increase or decrease the output and the producer will be said to
be at equilibrium.
According to TR-TC approach, producer ’s equilibrium refers to stage of that output level
at which the difference between TR and TC is positively maximized and total profits fall as
more units of output are produced.
So, two essential conditions for producer’s equilibrium are;
1. The difference between TR and TC is positively maximized;
2. Total profits fall after that level of output.
We analyse this profit maximising behaviour to determine the quantity produced by a
monopoly firm and price at which it is sold is shown in the following diagram.

The profit received by the firm equals the total revenue minus the total cost. In the diagram
we can see that if quantity q, is produced, the total revenue is TR1 and total cost is TC1. The
difference, TR1 – TC1 is the profit received. The same is depicted by the length of the line
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Vedashreee, Lecturer in Economics Sadvidya P U College
segment AB, i.e„ the vertical distance between the TR and TC curves at q1 level of output. It
should be clear that this vertical distance changes for different levels of output.
When output level is less than q2, the TC curve lies above the TR curve, i.e., TC is greater
than TR, and therefore profit is negative and the firm makes losses.
The same situation exists for output levels greater than q3 Hence, the firm can make
positive profits only at output levels between q2 and q3, where TR curve lies above the TC
curve. The monopoly firm will choose that level of output which maximises its profit. This
would be the level of output for which the vertical distance between the TR and TC is
maximum and TR is above the TC, i.e., TR - TC is maximum. This occurs at the level of
output q0.
If the difference TR - TC is calculated and drawn as a graph, it will look as in the curve
marked ‘Profit’ in. It should be noticed that the Profit curve has its maximum value at the
level of output q0.
The price at which this output is sold is the price consumers are willing to pay for this q
quantity of the commodity. So the monopoly firm will charge the price corresponding to the
quantity level q0 on the demand curve.

3. Explain how the firms behave in oligopoly.

A market situation in which there are a few firms selling homogeneous or differentiated
products is called oligopoly market.
Oligopoly is, sometimes, also known as competition among the few as there are few
sellers in the market and every seller influences and is influenced by the behaviour of other
firms.
The following points explain the behaviour of the firms in oligopoly market,
1) Few large firms in oligopoly market each firms is in a position to affect the total
supply:
There are few firms in oligopoly market but each firm is relatively large when compared to
the size of the market. As a result each firm is in a position to affect the total supply in the
market, and thus influence the market price.
For example: If the two firms in a duopoly are equal in size, and one of them decides to
double its output, the total supply in the market will increase substantially, causing the price to
fall. This fall in price affects the profits of all firms in the industry. Other firms will respond to
such a move in order to protect their own profits, by taking fresh decisions regarding how
much to produce. Therefore the level of output in the industry, the level of prices, as well as
the profits, are outcomes of how firms are interacting with each other.
2) Firms could decide to collude with each other:
At one extreme, firms could decide to ‘collude’ with each other to maximize collective
profits. In this case, the firms form a ‘cartel’ that acts as a monopoly. The quantity supplied
collectively by the industry and the price charged are the same as a single monopolist would
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Vedashreee, Lecturer in Economics Sadvidya P U College
have done.
3) Firms could decide to compete with each other in oligopoly market:
At the other extreme, firms could decide to compete with each other. For example: Afirm
may lower its price a little below the other firms, in order to attract away their customers.
Obviously, the other firms would retaliate by doing the same. So the markefprice keeps falling
as long as firms keep undercutting each others prices. If the process continues to its logical
conclusion, the price will have fallen till the marginal cost.
In practice, cooperation of the kind that is needed to ensure a monopoly outcome is often
difficult to achieve in die real world.
Price Rigidity:
A situation in which price tends to stay fixed irrespective of changes in demand and
supply conditions is called price regidity.
Under oligopoly firms are in a position to influence the prices. However they try to avoid
price competition for the fear of price war, they follow the policy of price rigidity. The price
rigidity implies that prices are difficult to change. Firms use other methods like advertising,
better services to customers etc., to compete with each other.
If a firm tries to reduce-the price, the rivals will also react by reducing their prices.
However, if it tries to raise the price, other firms might not do so. It will lead to loss of
customers for the firm, which intended to raise the price. So, firms prefer non price
competition instead of price competition.
4. The market demand curve for a commodity and the total cost for a monopoly firm
producing the commodity is given by the schedules below. Use the information to
calculate the following :
Quantity (Q) 0 1 2 3 4 5 6 7 8
Price (P) 52 44 37 31 26 22 19 16 13

Quantity 0 1 2 3 4 5 6 7 8
Total Cost 10 60 90 100 102 105 106 115 125
a) The MR & MC schedules.
b) The quantity for which the MR & MC are equal.
c) The equilibrium quantity of output and the equilibrium price of the commodity.
d) The total revenue, Total cost and Total profit in equilibrium.
TR = MC
Quantity in units (Q) Price in Rs. (P) TC MR = TRn-TRn,
pxq n‘ n-l
TC TC

0 52 10 0 - -
1 44 60 44 44 50
2 37 90 74 30 30
3 31 100 93 19 10
4 26 102 104 . 11 2

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Vedashreee, Lecturer in Economics Sadvidya P U College
5 22 105 110 6 3
6 19 109 114 4 4
7 16 115 112 -2 6
8 13 125 104 -8 10
For the calculation of above problem we must follow following formulas:
1) TR can be calculated with the help of TR=p x q
2) MR can be calculated with the help of MR = TRn-TRn-1
3) MC can be calculated with the help of MC=TCn - TCn-1
1) MR can be calculated with the help of TR and MC can be calculated with the help
of value of TC
2) When quantity of production is 6 M R = MC
3) The equilibrium quantity of output is 6 and equilibrium price is 19
4) Total Revenue is (TR) = U4, Total Cost(TC)=109 and
Total Profit is =TR-TC=114– 109

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Vedashreee, Lecturer in Economics Sadvidya P U College
PART – B : MACRO ECONOMICS
CHAPTER -1
INTRODUCTION

I. Choose the correct answer: (Each question carries 1 mark)

1. The individuals or institutions which take economic decisions arc.
a. Economic Variables b. Economists
c. Economic Agents d. none of the above
2. In 1936 British economist J.M. Keynes published his celebrated book
a. wealth of nations
b. General theory of employment interest and Money.
c. Theory of Interest d. Theory of Employment
3. All the labourers who are ready to work will find employment and all the factories will
be working at their full capacity, this school of thought is known as
a. Modem thought b. Contemporary thought
c. Classical thought d. None of the above
4. The year of Great Depression
a. 1920 b. 1889 c. 1929 d. 2018
5. In a capitalist country production activities are mainly carried out by
a. Private enterprises b. Government authority
c. Planning authority d. None of the above
Answers: 1) c 2) b 3) c 4) c 5) a

II. Fill in the blanks: (Each question carries 1 mark)

1. Macro economics tries to address situation facing the economy _______
2. A part of the revenue is paid out as _______ for the service rendered by land.
3. The domestic country may sell goods to the rest of the world. These are called________
4. __________will be called as firms.
5. ___________policies are pursued by the state itself or statutory bodies like the RBI, SEBI etc.
6. ____________ tries to address situations facing the economy as a whole.
Answers: 1) As a whole 2) Rent 3) Export trade
4) Production units 5) Macro Economic 6) Macro economics

III. Answer the following questions in a sentence/word. (Each question carries 1 mark)
1. Who are economic agents?
1) Consumers
2) Producers
3) Government, Corporation, Banks ect.

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Vedashreee, Lecturer in Economics Sadvidya P U College
2. What does classical school of thought say?
All the labourers who are ready to work will find employment and all the factories will be
working at their full capacity. This school of thought is known as the classical tradition.
3. Give the meaning of imports.
Purchase of goods and services by the domestic country to the rest of the world is called
import trade.
4. Name the well known work of Adam Smith.
An Enquiry in to the nature and cause of the wealth of nations. (1776)
5. What do you mean by wage rate.
Sale and Purchase of labour services at a price is called the wage rate.

IV. Answer the following questions in 4 sentences. (Each question carries 2 marks)
1. What are the features of capitalistic economy?
The following are important features of capitalistic economy.
1) There is a private ownership of means of production.
2) Production takes place for selling the output in the market.
3) There is sale and purchase of labour services at a price.
2. Name and write the meaning of two kinds of trade in external sector.
Trade with the external sector can be of two types. They are,
1) Export trade 2) Import trade
1) Export trade:
Sale of goods and services by the domestic country to the rest of the world is called export
trade.
2) Import trade:
Purchase of goods and services by the domestic country to the rest of the world is called
import trade.
3. Who arc the macro economic Decision makers?
The macro economic decision makers are,
1) Consumers: Consumers who decide what and how much to consume.
2) Producers : Producers of goods and services who decide what and how much to produce.
3) Government, Corporation and banks ect.: Government, corporation, banks which also
take different economic decisions like how much to spend, what interest rate to charge on the
credits, how much to tax, etc.
4. Mention the factors of production.
1) Land 2) Labour 3) Capital 4) Organation

V. Answer the following questions in 12 sentences. (Each question carries 4 marks)

1. Briefly explain in what way Macro Economics is different from Micro Economics.
Micro and macro analysis are mutually complimentary. It is wrong to assume that they
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Vedashreee, Lecturer in Economics Sadvidya P U College
compete with each other. They are so mutually inter dependent to the extent that analysis of
one will not be complete without the help of the others. Any observation simply reveals
involvement of micro aspects in macro economic problems. Hence, without combining these
two methods of analysis it will not be possible to perfectly understand the working of the
economy.
Prof. Samuelsons words in this context are realy meaningful. “There is no opposition
between micro and macro economics, you will be half educated if you understand the
one and neglect the other.”
Micro and Macro Economics are not one and the same. They are distinguished on the
following grounds.
2. Explain the working of the economy of a capitalist country.
Micro Economics Macro Economics
1) Micro Economics is mainly concerned 1) Macro Economics deals with large segments
with the study of the behavior of of the economy such as aggregate demand
individual economic units such as a and supply, general price level, national
firm, an industry, a consumer, a income, aggregate employment etc.
household unit etc. 2) Macro Economics deals with the aggregates
2) Micro economics studies the of the
individual parts of the
economy for the purpose of intensive economy, rather than with particular units. It
study. For example, price of a lumps up the individual units together into
commodity, behavior of a consumer, big lumps for the purpose of brief study.
functioning of a firm, behavior of a
producer etc. This method is called
slicing method.
3) In micro economics, each individual 3) Macro economics, economic agenets are
economic agent thinks about its own different from the individual economic
interest and welfare. agents and their aim is to get maximum
welfare of a country.
4) Micro economics studies the partial 4) Macro economics studies the general
equilibrium in the economy, such as equilibrium in the economy, such as
consumer equilibrium, producer equilibrium in the general price level,
equibilrium and equilibrium of a market equilibrium, equilibrium in the
particular firm of an industry etc. aggregate output level etc.
5) Micro economics comprises the 5) Macro economics comprises the theories
theories such as theory of consumer’s like the theory of income, output and
behavior, the theory of production and employment consumption function,
cost, the theory of rent, wages, interest investment function, business cycles, price,
and profits. inflation, deflation and inflation, etc.
6) Micro economics is an unrealistic 6) Macro economic is more realistic study and
study and is not much useful. used to solve several economic problems of
the economy.

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Vedashreee, Lecturer in Economics Sadvidya P U College
A country in which most of the production and productive activities carried out by
capitalist firms is called capitalist economy.
The working of the economy of capitalist country is as follows.
1. In a capitalist country production activities are mainly carried out by capitalist enterprises.
2. A typical capitalist enterprise has one or several entrepreneurs.
3. They may themselves supply the capital needed to run the enterprises or they may borrow
the capital.
4. To carry out production, they also need natural recources - a part consumed in the process
of production (raw materials) and a part fixed (plots of land)
5. They need the most important eliment of human labour to carry out production. This we
call labour.
6. After producing the help of factors of production like land, labour and capital, the
entrepreneur sells the product in the market. The money that is earned is called revenue.
7. Part of the revenue is paid out as rent for the service rendered by land, part of it is paid to
capital as interest and part of is goes to labour as wages. The rest of the revenue is the
earning of the entrepreneurs and it is called profit.
8. Profits are often used by the producers in the next period to buy new machinery are to
build new machines. So that production can be expanded. These expenses which raise
productive capacity.
In this way capitalist economy is working.

3. Explain the role of the Government (State) and household sector in both developed and
developing countries.
Working of a modem economy is extremely complex and complicated. Here millions of
people participate and contribute to its working in different ways and in different capacities.
In modem economy, economic activities of different people are interrelated and
interdependent. This is reflected in their interaction co operation and competition.
The economic agents (sectors), in a simplified model of a modern economy can be mainly
classified into
1) Government 2) Households
1) Government :
The state, which maintains law and order in the country, imposes taxes and fines,
makes laws and promotes the economic well being of the citizens is called Government.
The important sector of the modem economy is the government. The govt, provides the
frame work of rules and laws for households and firms to operate within the economy. It
develops infrastructure, gives subsidies apart from collecting taxes. Apart from imposing
taxes and spending money on building public infrastructure, running schools, colleges,
providing health services etc. These economic functions of the state have to be taken into
account when we want to describe the economy of the country.
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Vedashreee, Lecturer in Economics Sadvidya P U College
2) Households :
The families or individuals who supply factors of production to the firms and which
buy the goods and services from the firms is called households.
Apart from the firms and the government, there is another major sector in an economy
which is called the household sector. A household is one of the decision making units.
Households are the owners of the factors of production, like land, labour, capital and
organization. Factors of production are resources used to produce goods and services.
These people work in firms as workers and earn wages. They are the ones who work in the
government departments and earn salaries, or they are the owners of firms and earn profits.
Indeed the market in which the firms sell their products could not have been functioning
without the demand coming from the households.

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Vedashreee, Lecturer in Economics Sadvidya P U College
CHAPTER-2
NATIONAL INCOME ACCOUNTING

I Choose the correct answer: (Each question carries 1 mark)

1. The Study of National Income is related to
a. Micro economies b. Macro economics
c. Both Micro & Macro d. None of the above
2. NNP=GNP-
a. Deduction b. Depreciation c. Investment d. None of the above
3. The value of GDP at the current prevailing prices is
a. Real GDP b. GDP at Factor cost
c. Nominal GDP d. NDP
4. By deducting undistributed profit from national income, we get
a. Personal Disposable Income b. Personal Income
c. Private income d. Subsidies
5. 5. Measuring the sum total of all factor payments will be called
a. Product method b. expenditure method
c. Income method d. None of the above
Answers : 1) b 2) b 3) c 4) b 5) c

II Fill in the blanks: (Each question carries 1 mark)

1. _________are defined at a particular point of time.
2. _________goods will not pass through any more stages of production.
3. _________is an annual allowance for wear and tear of a capital good.
4. _________is a stock variable.
5. Pollution is an example for _________ externalities.
6. The net contribution made by a firm is called its _________
Answers : 1) Stock 2) Final goods 3) Depreciation costs
4) Inventory 5) Negative 6) Value added
III Match the following (each question carries 1 mark)
A B
1. Labour a. Non - Monetany exchange
2. GDP b. Personal Disposable Income
3. Inventory c. Gross Domestic Product
4. PDI d. Stock variable
5. Domestic service e. Wages

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Vedashreee, Lecturer in Economics Sadvidya P U College
Solutions
A B
1. Labour a. Wages
2. GDP b. Gross Domestic Product
3. Inventory c. Stock variable
4. PDl d. Personal Disposable Income
5. Domestic service e. Non - Monetany exchange

IV. Answer the following questions in a sentence/word, (each question carries 1 mark)
1. What do you mean by final goods?
Those goods which do not under go any further transformation in the production process is
called final goods.
2. Expand CPI.
Consumer Price Index.
3. Expand GNPmp
Gross National Product at Market Price.
4. How do you get net value added?
If we deduct the value of depreciation from gross value added the obtain net value added.
5. Give the meaning of GDP.
Aggregate value of goods and services produced within the domestic territory of a country is
called GDP.
6. Give the meaning of Intermediate goods.
Goods which are used up during the process of production of other goods is called
intermediate goods.
7. What is Depreciation?
Wear and tear or depletion which capital stock under goes to over a period of time is called
depreciation.
8. How do we get personal Disposable income?
Actual income which can be spent on consumption after deducting direct taxes is called
personal disposable income.
9. Write the equation of GVA at market prices.
GVA at market prices = GVA at basic prices + Net product taxes.
10. What is GDP deflator?
The ratio of nominal to real GDP is called GDP deflator.

V. Answer the following questions in 4 sentences, (each question carries 2 marks)

1. What are the four factors of production? Mention their rewards.
1) Land: Rent
2) Labour: Wages
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Vedashreee, Lecturer in Economics Sadvidya P U College
3) Capital: Interest
4) Organisation: Profit

2. Distinguish between stock and flow. Give example.

The following are the important differences between Stock and Flow.
Stock Flow
1) Stock variable refers to that 1) Flow variable refers to that variable,
variable, which is measured as a which is measured over a period of time.
particular point of time. 2) Flow is a dynamic concept.
2) Stock is a static concept 3) Flow has a time dimension as his
3) Stock does not have a time magnitude can be measured over a period of
dimension. time
4) Example : Bank deposits, wealth, 4) Example: National income, import,
food grains etc. export etc.

3. What is the difference between consumer goods and capital goods? Differences between
Consumption goods and Capital Goods.
The following are the important differences between Consumption goods and Capital Goods.
Consumtion Goods Capital Goods
1. Consumer goods satisfy human want 1. Capital goods satisfy human wants
directly, so, such goods have direct indirectly, so, such goods have derived
demand demand
2. Consumption goods do not promote 2. Capital goods help in raising production
production capacity capacity
3. Most of the consumption goods have 3. Capital goods generally have an expected
limited expected life life of more than one year
4. Examples of consumption goods are 4. Examples of capital goods are machinery,
food, drinks, clothing, mobile phones tools, roads, trucks etc.,
etc.,

4. Mention 3 Methods of measuring GDP (National Income)

1) The product or value added method.
2) Expenditure method.
3) Income method.

5. What do you mean by externalities? Mention its two types.

Un intentional consequences of an economic action of a firm or any entity, good or bad,
which accures to another person or firm is called externalities. There are two types of
externalities they are:
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1) Positive Extemolities 2) Negative Extemolities

6. Write the equation of GDPMP and GDPFC.

GDPMP = C + I + G+X-M.
GDPFC=GDPMP - NIT.
7. Write the difference between nominal and real GDP.
The total money value of goods and services produced in a country during a year expressed at
the current prices is called nominal GDP.
The national income expressed interms of abase year price index is called real GDP

VI. Answer the following questions in 12 sentences, (each question carries 4 marks)
1. Write a short note on the concept of final good.
Those goods which are purchased for final use are final goods. For example:
Furniture, sweets, television, car, sugar etc.
While computing national income, the value of only those final goods and services which
enter the market is added, because the value of raw materials and intermediate goods is
included in the final goods. Therefore, counting them separately will lead to the error of
double counting.
The distinction between intennediate goods and final goods is made on the basis of the use
of product and not on the basis of product itself.
For example: 1) Sugar is intermediate good when it is used for making sweets. However if it
is used by the consumers, then it becomes a final good.
2) Similarly milk is an intennideate good. When it is used in diaiy shop for resale. However it
become a final good when it is used by the households.
Totally if end use of a good is consumption or investments then it is a final good.
Features Final Goods:
The following are the important features of final goods.
1. Those goods which are used for the production of other final goods
2. Final goods are included in both national and domestic income
3. Final goods have a direct demand as they satisfy the wants directly
4. Examples of final goods are television, watch, sugar car etc.,
5. Final goods are ready for use by their final users ie. no value has to be added to the final
goods.
6. Final goods have crossed the production boundary.
7. Milk purchases by households for consumption, Car purchases as on investment are the
examples of final goods.

2. Explain the circular flow of income of an economy.

The process whereby the national income and expenditure of an economy flows in a
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circular manner continuously between different sectors is called circular flow of income.
There are in innumarable number of producers and households in an economy. There is a
continuous flow of economic activities like production, consumption, exchange and
distribution, national income and expenditure flow in a circular manner. In any economy, both
commodities and factor of production are being exchanged constantly for money. The
households get money in payment for the sale of their services. This money is spent again to
get goods from the firms: This goes on circular manner.
A simple economy is a closed economy in which there is no government, for external
trade or savings. Let us now study how circular flow of income takes place in a simple
economy. A simple two-sector model economy is based on the following assumptions.
1) There are only two sectors in the economy. They are the household sector and firms or
producers.
2) Households are the owners of factors of production. And firms buy these factors from
households.
3) Households receive income by selling the factor services and spend their entire income on
consumption. There are no savings.
4) Firms sell their entire produce to the households. There are no inventories.
5) The economy is a closed economy, without government or external trade.
The circular flow of income can be explained with the help of chart.

In the above diagram the household sector supplies factors such as land, labour, capital
and organization to firms. And the firms produce and supply goods and services to
households.
Firms make factor payments such as rent, wages, interest and profit to households as
reward for factor services. In this way, production generates factor income, which is
converted into expenditure. Thus, production is a continuous activity, because human wants
are unlimited. This makes the flow of income circular.
1. The uppermost arrow, going from the households to the firms, represents the spending the
households, undertake to buy goods and services produced by the firms.
2. The second arrow going from the firms to the households is the counterpart of the arrow
above. It stands for the goods and services which are flowing from the firms to the
households.

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3. The lower most arrow going from the households to the firms symbolises the services that
the households are rendering to the firms.
Using these services the firms are manufacturing the output.
4. The arrow above this, going from the firms to the households, represents the payments
made by the firms to the households for the services provided by the latter.
In the above diagram we can calculate national income at three points, namely A, B and C.
Point - A: If we measure the flow at point A that is aggregate spending on goods and services
it will be called expenditure method.
Point - B: If we measure the aggregate value of final goods and services produced by all the
firms, at point B. it will be called product method.
Point - C: If we measure the flow at point C by adding the some total of all factor payments it
will be called income method.

3. Write a note on externalities.

Un intentional consequences of an economic action of a person or firm that accrues to
another person or firm is called externalities.
There are two types of externalities they are:
1) Positive externalities 2) Negative externalities
1) Positive externalities :
The externalities which are increases welfare of the individuals and society is called
positive externalities.
Positive externalities increases the welfare of the society.
For example: Let us suppose there is an oil refinery which refines crued petrolium and
sells it in the market. The output of the refinery is the amount of oil it refines! We can
estimate value added of the refinery by deducting the value of intermediate goods used by the
refinery from the value of its output. The value added of the refinery will be counted as part of
the GDP of the economy.
2) Negative externalities
The externalities which are decreases welfare of the individuals and society is called
negative externalities.
For example: Carrying out the production the refinery may also be polluting the near by
river this may cause harm to the people who use the water of the river hence their well being
will fall. Pollution will also kill fish or other organism of the river on which fishservive. As a
result the fishermen of the river may be lossing their livelyhood. Such harmful effects that the
refinery is inflicting others, for which it will not bear any cost are called externalities. In this
case the GDP is not taking into account such negative externalities.

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4. Illustrate unplanned accumulation and decumulation of inventories with an example.
An unexpected fall in sales, the firm will have unsold stock of goods which it had not
anticipated, this is called unplanned accumulation of inventories.
This can be illustrated with the help of the following example.
Suppose a firm produces shirts. It starts the year with an inventory of 100 shirts. During
the coming year it expects to sell 1,000 shirts. Hence, it produces 1,000 shirts, expecting to
keep an inventory of 100 at the end of the year. However, during the year, the sales of shirts
turn out to be unexpectedly low. The firm is able to sell only 600 shirts. This means that the
firm is left with 400 unsold shirts. The firm ends the year with 400 + 100 = 500 shirts. The
unexpected rise of inventories by 400 will be an example of unplanned accumulation of
inventories.
Where there is unexpected rise in the sales there will be unplanned decumulation of
inventories.
If, on the other hand, the sales had been more than 1,000 we would have unplanned
decumulation of inventories.
For example, if the sales had been 1,050, then not only the production of 1,000 shirts will
be sold, the firm will have to sell 50 shirts out of the inventory. This 50 unexpected reduction
in inventories is an example of Unexpected decumulation of inventories.
5. Explain the examples of planned accumulation and decumulation of inventories.
Change in the stock of inventories which has occurred in a planned way is called
planned inventories.
Suppose the firm wants to raise the inventories from 100 shirts to 200 shirts during the
year. Expecting sales of 1,000 shirts during the year (as before), the firm produces 1000 + 100
= 1,100 shirts. If the sales are actually 1,000 shirts, then the firm indeed ends up with a rise of
inventories. The new stock of inventories is 200 shirts, which was indeed planned by the firm.
This rise is an example of planned accumulation of inventories.
On the other hand if the firm had wanted to reduce the inventories from 100 to 25 (say),
then it would produce 1000 - 75 = 925 shirts. This is because it plans to sell 75 shirts out of
the inventory of 100 shirts it started with (so that the inventory at the end of the year becomes
100 - 75 = 25 shirts, which the firm wants). If the sales indeed turn out to the 1000 as
expected by the firm, the firm will be left with the planned, reduced inventory of 25 shirts.

VII. Answer the following questions in 20 sentences. (Each question carries 6 marks)
1. Explain the macro economic identities.
National income is an important concept of macroeconomics. There are various aggregates
or identities of national income. Each aggregate has a specific meaning, method of
measurement and use. The various identities of national income are,

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1) Gross Domestic Product (GDP) :
The aggregate value of final goods and services produced within the country during a
year is called Gross Domestic Product.
The concept of GDP does not consider the value of goods and services produced by the
nationals working in foreign countries. This means that it ignores the value of goods and
services produced by the non resident Indians working in foreign countries but considers the
same when it is produced by foreigners working in India. Thus.
GDP=C+I+G + X-M
Where, C = Gross final consumption expenditure
I = Gross private sector investment
G = Government’s consumption and investment expenditure
X-M = Net export
2) Gross National Product (GNP) :
The aggregate money value of all final goods and services produced by a country in a
year including net income from abroad is called gross national product.
The term gross national product is a wider concept than gross domestic product. GNP
measures the total money value of all final goods and services produced in a nation in a
particular year, plus income earned by its non-residents, minus income earned by foreigners
staying in that country'. Thus
Hence, GNP = GDP + Net factor income from abroad
3) Net Domestic Product (NDP) :
The aggregate money value of all final goods and services produced within the
country less depreciation is called net domestic product.
When depreciation allowance is subtracted from GDP we get NDP
Hence, NDP = GDP - Depreciation cost
4) Net National Product (NNP) :
Aggregate money value of all final goods and services produced by country in a year
minus depreciation is called net national product.
If we deduct depreciation cost from the total value of the goods and services, we get net
national product. So -
NNP = GNP - Depreciation
In NNP Indirect tax should be deducted from and subsidies should be added to the NNP to
calculate net national income at factor cost of national income.
5) Net National Product at factor cost : (NNPFC:)
The sum of income earned by all factors in the production int he form of wages, profits,
rent and interest etc. belonging to a country during a year is called NNPFC.
NNPFC = NDPFC + NFIA
NFIA = Net Factors income from abroad

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6) Personal Income (PI) :
The sum of all the incomes that are actually received by households from all the
sources is called personal income.
Therefore, personal income is that part of national income of a country which is received by
people or households. Thus.
PI = National Income - undistributed corporate profits - Net Interest payment made by
the house holds - corporate tax + transfer payents to the households from the govt, and
the firms
6) Personal Disposable Income :
Actual income which can be spent on consumption after deducting direct taxes is
called personal disposable income.
The whole of the personal income cannot be spent on consumption because taxes have to
be paid on the income. Therefore, the actual income which can be spent on consumption after
deducting direct taxes is disposable income. Thus,
PDI = PI - Personal Tax payments - Nontax payments
Disposable income can either be spent entirely or a part of the income can be saved.
Therefore.
PDI = Consumption Expenditure + Savings

2. Briefly explain the expenditure method of measuring GDP.

The total final expenditure incurred on goods and services is added up is called
expenditure method of calculation of national income.
Expenditure method looks at the demand side of the products. Consumers, investors and
governments purchase goods and services. If we add the gross expenditures made in a year we
get national income. Hence we get the GDP by adding up all consumption expenditure made
by all individuals, institutions and the government during a year.
Firm i can make the final expenditure on the following accounts.
1. The final consumption expenditure on the goods and services produced by the firm. We
shall denote this by G. We may note that mostly it is the households which undertake
consumption expenditure. There may be exceptions when the firms buy consumables to
treat their guests or for their employees.
2. The final investment expenditure. I. incurred by other firms on the capital goods produced
by firm i. Observe that unlike the expenditure on intermediate goods which is not included
in the calculation of GDP, expenditure on investments is included. The reason is that
investment goods remain with the firm, whereas intermediate goods are consumed in the
process of production.
3. The expenditure that the government makes on the final goods and services produced by
firm i. We shall denote this by G. We may point out that the final expenditure incurred by
the government includes both the consumption and investment expenditure.
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4. The export revenues that firm i earns by selling its goods and services abroad. This will be
denoted by X.
Thus the sum total of the revenues that the firm i, earns is given by RV. = Sum total of
final consumption, investment, government and exports expenditures received by the firm i.
= Ci + Ii + Gi + Xi
If there are N firms then summing over N firms we get

N
i =I
RVi = Sum total of final consumption, investment, government and exports expenditures
received by all the firms in the economy.
We know, GDP=Sum total of all the final expenditure received by the firms in the
economy.
In other words

N
i =I
RVi = C + I + G + X-M
The above Equation expresses GDP according to the expenditure method. It may be noted
that out of the five variables on the right hand side, investment expenditure, I, is the most
unstable.

3. Explain a numerical example to show that all the three methods of estimating GDP gives
us the same answer.
While calculating national income we use three methods like Expenditure Method,
Product Method and Income Method. But all methods gives same results. This can be
explained with the following example.
Example: There are two firms, A and B. Suppose A uses no raw material and produces
cotton worth Rs 50. A sells its cotton to firm B, who uses it to produce cloth. B sells the
cloth produced to consumers for Rs. 200.
1. GDP in the phase of production or the value added method:
Recall that value added (VA) = Sales - Intermediate Goods
Thus, VAa= 50-0 = 50
VAB = 200 - 50 = 150
Thus, GDP = VAA + VAB
200 = 50 + 150
Distribution of GDPs for firms A and B
Firm A Firm B
Sales Intermediate 50 200
consumption 0 50
value added 50 150
2.GDP in the phase of disposition or the expenditure method:
Recall that GDP = Sum of final expenditure or expenditures on goods and services for end
use. In the above case, final expenditure is expenditure by consumers On cloth. Therefore,

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GDP = 200.
3. GDP in the phase of distribution or income method :
Let us look at the firms A and B again.
Now, of this 50 received by A, the firm gives Rs. 20 to the workers as wages, and keeps the
remaining 30 as its profits. Similarly, B gives 60 as wages and keeps 90 as profits.
Firm A Firm B
Wages 20 60
Profits 30 90
Recall that GDP by income method = sum total of factor incomes, which is equal to total
wages received (workers of A and B) and total profits earned (by A and B), which is equal to
80 + 120 = 200.

4. Write down some of the limitations of using GDP as an index of

welfare of a country.
Economic welfare of an individual depends on the amount of goods and services which he
consumes. An increase in national income causes an improvement in economic welfare, if it is
equally distributed among the people. Therefore, national income is treated as the indicator of
the welfare of the people. Countries in which national income is high, people are enjoying
greater welfare. But this may not be taie always. National income is not a reliable index of
economic welfare for certain reasons.
GDP is not a barometer of economic welfare. National income is not a reliable index of
economic welfare for certain reasons. The following are the main reasons.
1) Distribution of GDP - How uniform is it:
The distribution of increased income is another important factor to be taken into
consideration. If the increased national income is not equitably distributed economic welfare
as a whole may be reduced. Countries with unequal distribution of income may have
relatively high percapita GNP. While the majority of countries citizens have relatively low
level of income, due to concentration of wealth in the hands of a small fractions of the
population. In this case, welfare of the majority decreases even though the
GDP increases. Therefore, national income is not aright index of welfare.
2) Non-monetary exchanges:
Many activities in an economy are not evaluated in monetary terms. For example, the
domestic services of women perform at home are not paid for. In the developing countries,
where many remote regions are underdeveloped, barter exchanges do take place, but it is not
registered as part of economic activity and they are generally not counted in the GDPs of
these countries. This is a case of underestimation of GDP. Hence GDP calculated in the
standard manner may not give us indication of the well being of the country.

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3) Externalities:
Unintentional consequences of an economic action of a person or firm that accrues to
another person or firm is called externalities.
There are two types of externalities. They are,
1) Possitive extenalities
2) Negative extenalities.
Positive extranalities increased welfare and negative extranalities decrease welfare. While
measuring national income such extranalities are not considered.
For example; Oil refinery which refines the crude petroleum. From this we can calculate
value added but for the production refinery may also polluting the nearby river and it harmful
for those people who use this water. Hence their utility will fall. Therefore it we take GDP as
a measure of welfare of the economy we shall be over estimating the actual welfare.
Considering all these points we may conclude that GDP is not a barometer of economic
welfare. It is only a rough indictor. Inspite of these limitations national income occupies a
very important place in the formulation of economic policy.

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CHAPTER - 3
MONEY AND BANKING

I. Choose the correct answer (each question carries 1 mark)

1. The main function of Money is
a. Saving b. Expenditure
c. Medium of exchange d. Investment
2. The Bank which acts as Monetary authority of India,
a. RBI b. NABARD c. RRB d. IDBI
3. The Banks which are a part of the money creating system of the economy are
a. Bankers b. Commercial Banks c. RBI d. None of the above
4. The rate at which the RBI lends money to commercial banks against securities
a. Bank rate b. Repo rate c. Reverse Repo rate d. None of the above
5. The important tool by which RBI influences money supply is
a. Open market operation b. Closed market operation
c. Money operation d. None of the above
Answers : 1) c 2) a 3) b 4) b 5) a

II. Fill in the blanks (each question carries 1 mark)

1. Economic exchanges without the use of money are referred to as ________
2. ________is the only institution which can issue currency in India.
3. ________ Issues coins in India.
4. The principal motive for holding money is to carry out ________
5. M, and M, are known as ___________
Answers : 1) Barter system 2) RBI 3) Government of India
4) Transaction 5) Narrow money

III. Match the following (each question carries 1 mark)

A B
1. SLR a. Government of India
2. Circulation of coin b. Statutory Liquidity Ratio
3. Money c. Broad money
4. M3 and M4 d. Repo
5. Repurchase agreement e. Medium of Exchange

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Solutions
A B
1. SLR a. Statutory Liquidity Ratio
2. Circulation of coin b. Government of India
3. Money c. Medium of Exchange
4. M3 and M4 d. Broad money
5. Repurchase agreement e. Repo

IV. Answer the following questions in a sentence/word, (each question carries 1 mark)
1. What do you mean by barter system
The direct exchange of goods for goods is called Barter System.
2. Give the meaning money.
Anything that is commonly accepted as a medium of exchange for goods and services and
also acts as a measure of value is called money.
3. What is time deposit?
Those deposits in which the amount is deposited with the bank for a fixed period of time is
called time deposit.
4. What is Fiat Money?
Money with no intrinsic value is called Fiat money.
5. Write the meaning of ‘High powered Money’.
The currency issued by the central bank can be held by the public or by the commercial banks
is called high powered money.
6. Expand CRR.
Cash Reserve Ratio.
7. What is Bank Rate?
The rate of interest charged by the RBI for providing loans to the commercial banks as the
lender of last resort is called bank rate.

V. Answer the following questions in 4 sentences. (Each question carries 2 marks)

1. Mention any two functions of money.
1) Medium of exchange 2) Measure of value
2. Give the meaning of CRR and SLR.
A certain portion of total deposits of a commercial bank, which it has to keep with the RBI in
the form of cash reserves is called cash reserve ratio.
A certain portion of total deposits of commercial banks which it has to keep with itself in the
form of cash reserves is called statutory liquidity ratio.
3. State the credit control instruments of RBI.
Credit control instruments are broadly classified in to two types.
A) Quantitive Methods
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1) Reserve ratios (SLR and CRR)
2) Open market operation (OMO)
3) Bank rate policy
B) Qualitative Methods
1) Margin requirements
2) Discourage or Encourage Lending which is done through moral suasion.
4. Mention the two motives of demand for money.
1) The transaction motive 2) The speculative motive
5. How does bank rate influence money supply?
The rate of interest charged by the RBI for providing loans to the commercial banks as the
lender of last resort is called bank rate.
By expensive; this reduces the reserves held by the commercial bank and hence decreases
money supply. A fall in the bank rate can increase the money supply.
6. What role of RBI is known as ‘Lender of Last Resort’.
Reserve bank is the only institution which can issue currency. When commercial banks need
more finds, in order to be able to create more credit, they may go to market for such funds or
go to the Central Bank. Central bank provides them funds through various instruments. This
role of RBI, that of being ready to lend to banks at all times is another important function of
the central bank, and due to this central bank is said to be the lender of last resort.

VI. Answer the following questions in 12 sentences, (each question carries 4 marks)
1. Briefly explain the functions of money.
Refer Main Question No. VII Q.No. 1
2. Briefly explain the functions of RBI.
RBI is the supreme and also Central Bank of India. It was established 1 in April 1935.
Today the RBI plays an important in the development strat- S egy of the Govt, of India. As
Central Bank of the country, RBI performs . certain primary and traditional functions. Similar
to that of the central banks of other countries. The functions of RBI are as follows:
1) Issuing currency notes :
The RBI has the sole right to issue of currency notes of all denominations of Rs. 10, 20,
50, 100, 200, 500 and 2000 in the country. The r government (Ministry of Finance) issues,
coins and currency notes of Rs. 1,2,5, and 10 Rs. coins. The RBI follows minimum reserve
system while issuing currency notes since 1956.
2) Controller of Credit :
The important function of the RBI is the control of credit. It is necessary that the supply of
credit and the use of credit should be in appropriate amount and direction. For this purpose, it
uses various credit control measures such as bank rates, open market operations, variable
reserve ratio and selective credit controls etc.
3) Bankers to the Government:
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The RBI act as a banker, agent and advisor to the Government. The RBI performs the
following functions to the Government.
a) RBI receives deposits from the government and advances loans to it when it is in need.
b) RBI tyceives and makes all payments on behalf of the government.
c) RBI transfers government funds from one place to another place, from one account to
another account.
d) RBI gives useful advice to the government on important economic matters.
4) Custodian of Foreign Exchange Reserves :
RBI is the supreme and also Central Bank of India. It was established as a private
shareholders bank in April 1935. After independance the RBI was nationalised by the govt, on
1 st January 1949. Today the RBI play an important role in the development strategy of the
Govt, of India.
The RBI acts as a custodian of foreign exchange reserves. RBI preserves and protects the
precious foreign exchange of the country. It has continuous contacts with intematioanl
monetary institutions.
The RBI has a separate exchange control department to supervise and control foreign
exchange reserves.
5) Bankers Bank :
The activities of all commercial banks are controlled and managed by the RBI. The
regulation of banks may be related to their licensing, branch expansions, liquidity of assets
etc. Every commercial bank has to maintain certain portion of its total deposits in the form of
cash reserve with the RBI.
The cash reserves with the RBI help for commercial banks in times of financial difficulty.
RBI also gives credit to the banks by discounting bill and advancing money on various
securities from time to time. RBI also gives direction and advise to banks on their
transactions.
6) Lender of last resort :
Reserve bank is the only institution which can issue currency. When commercial banks
need more funds in order to be able to create more credit, they may go to market for sueh
funds or go to the Central Bank. Central bank provides them funds through various
instruments. This role of RBI, that of being ready to lend to banks at all times is another
important function of the central bank, and due to this central bank is said to be the lender of
last resort.

3. The total stock of money in circulation among the public at a particular point of time is
called money supply.
Money supply, like money demand, is a stock variable. RBI publishes figures for four
alternative measures of money supply, viz.
M1, M2, M3 and M4
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M1 It includes currency with public, demand deposits. It is termed as narrow money. It is
measured as follows :
M1 = CU + DD
Where, CU - Represents Currency with public
DD - Represents Demand Deposits with commercial banks.
M2 It includes all the components of M1 and savings deposits with post office. It is measured
as follows:
M2 = M1+ POSBD
POSBD - Represents Post Office Savings Deposits.
Here, M2 includes the following
CU = Represents Currency with public
DD = Represents Demand Deposits with commercial banks.
M3 It includes all the components of M1 along with the time deposits of all banks. It is a
‘broad money’: concept. It is measured as follows.
M3 = M1 + TD
Here, CU = Represents Currency with public
DD = Represents Demand Deposits with commercial banks.
TD-Time deposit with all banks
M4 It includes all the components of M3 and total deposits with post office savings deposits
(excluding National Savings Certificated). It is measured as follows:
M4 = M3 + TPOD
CU= Represents Currency with public
DD = Represents Demand Deposits with commercial banks.
TD = Time deposit with all banks
TOPD - Represents Total Post Office Deposits (Excluding NSCs).

4. Write the meaning of Transaction Motive and Speculative motive of demand for money
and Liquidity trap.
1) TRANSACTION MOTIVE:
Holding cash to meet daily transactions is called transaction demand formoney.
We incur some or the other expenditure to fulfill our day-to-day needs such as food,
shelter, clothing etc. Thus transaction motive relates to the demand for money for the day to
day expenditure of individuals and business firms. The need for holding cash arises because
there is a time-gap between receipt of income and the consumption expenditure.
The transaction demand for money of the economy is again a fraction of the total volume
of transactions in the economy over the unit period of time.
In general, therefore, the transaction demand for money in an economy. Mdr, can be
written in the following form
Mdr = k.T
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Where, T is the total value of (nominal) transactions in the economy over unit
period and k is a positive fraction.
2) SPECULATIVE MOTIVE:
The demand for money that people hold as idle cash balance to speculate with the
aim of earning capital gains and profit is called speculative motive.
Besides cash, people also tend to hold wealth in the form of property, gold, bonds, shares,
etc. The bonds are issued by the firms to borrow from the general public.
On the contrary, when interest rate that prevails is high, the speculative demand for money
would below. Hence the speculative demand for money is inversely related to the expected
rate of interest.
Hence speculative demand for money is inversely related for money can be written as
rmax − r
MSd =
r − rmin
In this formula r=rate of interest
rmax> = Maximum rate of interest
rmin = Minimum rate of interest.
3) Liquidity Trap
Everyone in the economy will hold their wealth in money balance and if I:, additional
money is injected within the economy it will be used up to satiate people’s craving for money
balances without increasing the demand for I bonds and without further lowering the rate of
interest below the floor rmin.
Such a situation is called a liquidity trap. The speculative money demand I function is
infinitely elastic here.

5. ‘Money acts as a convenient unit of account’ explain this sentence with the example.
For smoothen the transactions an intermediate good is necessary which is acceptable to
both parties is called money. Let us see how the money acts as a convenient unit of account as
follows.
The value of all goods and services can be expressed in monetary units. When we say that
the value of a certain wrist watch is Rs 500 we mean that the wrist watch can be exchanged
for 500 units of money, where a unit of money is rupee in this case. If the price of a pencil is
Rs 2 and that of a pen is Rs 10 we can calculate the relative price of a pen with respect to a
pencil, viz. a pen is worth 10/2=5 pencils. The same notion can be used to calculate the value
of money itself with respect to other commodities. In the above example, a rupee is worth
1/2=0.5 pencil or 1/10=0.1 pen. Thus if prices of all commodities increase in terms of money
i.e., there is a general increase in the price level, the value of money in terms of any
commodity must have decreased–in the sense that a unit of money can now purchase less of
any commodity. We call it deterioration in the purchasing power of money.

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VII. Answer the following questions in 20 sentences. (Each question carries 6 marks)
1. Explain the functions of Money. How does money overcome the short comings of a
barter system?
Anything that is commonly accepted as a medium of exchange for goods and services and
also acts as a measure of value is called money. Money serves as the great instrument of
commerce and industry in the economy by performing a number of functions. The functions
of money as given by professor Kinley, classified into mainly two categories,
1) Primary Functions 2) Secondary Functions
1) PRIMARY FUNCTION:
Primary functions include the most important functions of money which is must
performing every country. These are;
1) Medium of exchange :
The fundamental function of money is to serves as a medium of exchange. It facilitates
exchange through a common medium i.e., money. It aids in buying and selling.
This function of money has helped in overcoming the major defect of the barter
system of double coincidence of wants. Now money is generally accepted as a means of
payment for any transactions.
2) Measure of Value :
The values of various goods and services can be expressed in terms of money. Hence, it is
called measure of value. Money has provided a common yardstick to measure the value of all
commodities and services in a common unit known as price.
This function has helped in overcoming the defect of the barto system of lack of a
common measure of value.2) SECONDARY FUNCTIONS:
The secondary functions of money are called derived functions, because these functions
are the product of primary functions. They are as follows:
1) Store of value :
Money is used as a store of value. Money is the generalised purchasing power and it can
be used in the present as well as in future. People save and store money for all types of
transactions in future. Any asset other than money can also act as a store of value.
Example: Gold, landed property, houses or even bonds. However, they may not be easily
convertible to other commodities and do not have universal acceptability.
Barter system had difficulties in storing of value, but money has helped in
overcoming this problem by its role as an efficient store of value.
2) Standard of deferred payments :
Barter system lacks suitable standard of deferred payments which creates difficulty in
credit transactions. Money acts as a standard of deferred payments. Modern economic
transactions are widely based on credit transactions and money has helped in future payments
and receipts.
Money has simplified the harrowing and lending operations and encouraged capital
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Vedashreee, Lecturer in Economics Sadvidya P U College
formation. In this way money solve the problem of barter system.
3) Transfer of Value :
Money acts as a transfer of value. With the help of money values and wealth can be
transferred from one place to anoher easily or from one person to another. The easy and quick
transfer of value with the help of money has helped in numerous transactions. A person can
dispose his properties at one place and can purchase other properties at another place is
possible with the help of money.
This type of transfer of value was not possible in barter system. This type of problem
solved by tranction of money.

2. Write the story of Gold smitv Lala on the process of deposit and loan (credit) creation by
commercial banks.
The process of deposit and loan (credit) creation by banks is explained below, in order to
understand this process, let us discuss a story.
Once there was a goldsmith named Lala in a village. In this village, people used gold and
other precious metals in order to buy goods and services. In other words, these metals were
acting as money. People in the village started keeping their gold with Lala for safe-keeping. In
return for keeping their gold. Lala issued paper receipts to people of the village and charged a
small fee from diem. Slowly, over time, the paper receipts issued by Lala began to circulate as
money. This means that instead of giving gold for purchasing wheat, someone would pay for
wheat or shoes or any other good by giving the paper receipts issued by Lala. Thus, the paper
receipts started acting as money since everyone in the village accepted these as a medium of
exchange.
Now, let us suppose that Lala had 100 Kgs of gold, deposited by different people and he
had issued receipts corresponding to 100 kgs of gold. At this time Ramu comes to Lala and
asks for a loan of 25 kgs of gold. The 100 kgs of gold with him already has claimants.
However, Lala could decide that everyone with gold deposits will not come to withdraw their
deposits at the same time and so he may as well give the loan to Ramu and charge him for it.
If Lala gives the loan of 25 kgs of gold. Ramu could also pay Ali with these 25 kgs of gold
and Ali could keep the 25 kgs of gold with Lala in return for a paper receipt. In effect, the
paper receipts, acting as money, would have risen to 125 kgs now. It seems that Lala has
created money out of thin air! The modem banking system works precisely the way Lala
behaves in this example.
Commercial banks mediate between individuals or firms with excess funds and lend to
those who need funds, people with excess funds can keep their funds in the form of deposits
in banks and those who need funds, borrow funds in form of home loans, crop loans, etc.
People prefer to keep money in banks because banks offer to pay some interest on any
deposits made. Also, it may be safer to keep excess funds in a bank, rather than at home, just
as people in the example above preferred to keep their gold with Lala instead of keeping at
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home. In the modem context, given cheques and debit cards, having a demand deposit makes
transactions more convenient and safer, even when they do not earn any interest.
3. Explain the open market operation.
The purchase and sale of variety of assets such as foreign exchange, government
securities by the central bank in the open market is called open market operation.
The purchase and sale is entrusted to the central bank on behalf of the government. Sale of
securities by central bank reduces the reserves of commercial banks. It adversely affects the
bank’s ability to create credit and therefore decrease the money supply in the economy.
Purchase of securities by central bank increases the reserves and raises the bank’s ability to
give credit.
There are two types of open market operations. They are,
1) Outright 2) Repo
1) Outright
Outright open market operations are permanent in nature: when the central bank buys
these securities without any promise to sell them later. Similarly, when the central bank sells
these securities it is without any promise to buy them later. As a result, the
injection/absorption of the money is of permanent nature.
2) Repo
Repo rate is the rate at which the central bank of a country (RBI in case of India)
lends money to commercial banks in the event of any shortfall of funds.
The central bank advances loans against approved securities or eligible bills of exchange.
RBI has been actively using repo rate to control credit. An increase in repo rate increases*the
costs of borrowing from the central bank. It forces the commercial banks to increase their
lending rates, which discourages borrowers from taking loans. It reduces the ability of
commercial banks to create credit. A decrease in the repo rate will have the opposite effect.
The Reserve Bank of India conducts repo and reverse repo operations at various
maturities: overnight, 7-day, 14- day, etc.

4. Requirement of reserves acts as a limit to money (credit) creation.

Explain.
Suppose Mr. Tejas comes to this bank for a loan of Rs. 500. Can our bank give this loan?
If it gives the loan and Mr. Tejas deposits the loan amount in the bank itself, the total bank
deposits and therefore, the total money supply will rise. It seems as though the banks can go
on creating as much money as they want.
But is there a limit to money or credit creation by banks? Yes, and this is determined by
the Central bank (RBI). The RBI decides a certain percentage of deposits which every bank
must keep as reserves. This is done to ensure that no bank is 'over lending’. This is a legal
requirement and is binding on the banks. This is called the' Required Reserve Ratio’ or the
'Reserve Ratio’ or 'Cash Reserve Ratio’ (CRR).
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Apart from the CRR, banks are also required to keep some reserves in liquid form in the
short term. This ratio is called statutory' liquidity Ratio or SLR.
In our fictional example, suppose CRR=20 per cent, then with deposits J of Rs 100, our
bank will need to keep Rs 20 (20 percent of 100) as cash ' reserves. Only the remaining
amount of deposits, i.e., Rs 80 (100 - 20 = I 80) can be used to give loans. The statutory
requirement of the reserve ratio acts as a limit to the amount of credit that banks can create.
We can understand this by going back to our fictional example of an economy with one
bank.
Let us assume that our bank starts with a deposit of Rs 100 made by Chandu. The reserve
ratio is 20 percent. Thus our bank has Rs 80 (100- I 20) to lend and the bank lends out Rs 80
to Revanth which shows up in the bank’s deposits in the next round as liabilities, making a
total of Rs 180 as , deposits. Now our bank is required to keep 20 percent of 180 i.e. Rs 36 as
cash reserves. Recall that our bank had started with Rs 100 as cash. Since it is required to
keep only Rs 36 as reserves, it can lend Rs 64 again h (100 - 36 = 64). The bank lends out Rs
64 to Harshitha.
This in turn shows up in the bank as deposits. The process keeps [ repeating itself till all
the required reserves become Rs 100. The required reserves will be Rs 100 only when the
total deposits become Rs 500. This
I is because for deposits of Rs 500, cash reserves would have to be Rs 100 E (20 percent
of500 = 100). The process is illustrated.
Money Multiplier Process
Column 1 Column 2 Column 3 Column 4
Round Deposit in Bank Required Reserve Loan made by Bank
1 100.00 20.00 80.00
2 180.00 36.00 64.00
3 244 48.80 51.2
4 - - -
The first column lists each round. The second column depicts the total deposits with the
bank at the beginning of each round. Twenty percent of these deposits need to be
deposited with the RBI as required reserves. What the bank lends in each round gets added
to the deposits with the bank in the next round. Column 4 indicates the loans made by the
banks.
Balance Sheet of the Bank
Assets Rs. Liabilities Rs.
Reserves 100 Deposits 500
(100+400)
Loans 400
Total 500 Total 500

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Since the bank is only expected to keep 20 percent of its deposits as reserves, thus,
reserves of Rs 100 (20 percent of500 = 100) can support the deposits of Rs 500. In other
words, our bank can give a loan of Rs 400. The above Table demonstrates its balance
sheet.
M1 = Currency + Deposits = 0 + 500 = 500
Thus, money supply increases from Rs 100 to Rs 500.

VIII. Assignment and project oriented questions (carries 5 marks)

1. Write a note on Demonetisation
The withdrawal of a coins and notes from the use as legal tender is called
demonetisation.
Demonetisation was a new initiative taken by the Government of India
in November 2016 to tackle the problem of corruption, black money, terrorism and circulation
of fake currency in the economy.
Steps taken by the government for demonitisation :
The following are the important steps taken by the government for demonitisation.
1) Old currency notes of Rs 500, and Rs 1000 were no longer legal tender. New currency
notes in the denomination of Rs 500 and Rs 2000 were launched.
2) The public were advised to deposit old currency notes in their bank account till 31
December 2016 without any declaration and upto 31 march 2017 with die RBI with
declaration.
3) Further to avoid a complete breakdown and cash crunch, notes government had allowed
exchange of Rs 4000 old currency the by new currency per person and per day.
4) Further till 12 December 2016, old currency notes were acceptable as legal tender at petrol
pumps, government hospitals and for payment of government dues, lilce taxes, Electric
bills, etc.
Criticism of Demonitisation:
The following are the important Criticisms of demonitisation.
1) There were long queues outside banks and ATM booths.
2) The shortage of currency in circulation had an adverse impact on the economic activities.
However, things improved with time and normalcy returned.
Appriciation of Demonitisation:
The following are the important appreciations of demonitisation.
1) It improved tax compliance as a large number of people were bought in the tax ambit.
2) The savings of an individual were channelised into the ibnnal financial system. As a result,
banks have more resources at their disposal which can be used to provide more loans at
lower interest rates.
3) It is a demonstration of State’s decision to put a curb on black money, showing that tax
evasion will no longer be tolerated.
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4) Tax evasion will result in financial penalty and social condemnation.
5) Tax compliance will improve and corruption will decrease.
6) Demonetisation could also help tax administration in another way, by shifting transactions
out of the cash economy into the formal payment system.
7) Households and firms have begun to shift from cash to electronic payment technologies.

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CHAPTER - 4
DETERMINATION OF INCOME AND EMPLOYMENT

I. Choose the correct answer (each question carries 1 mark)

1. Consumption which is independent of income is called
a. Induced consumption b. Autonomous consumption
c. Wasteful consumption d. Past consumption
2. Value of MPC lies between
a. 1 and 2 b. 0 and 1 c. 2 and 4 d. 0 and 0.5
3. The point where ex-ante aggregate demand is equal to ex-ante aggregate supply will be
a. Equilibrium b. Disequilibrium c. Excess demand d. Excess supply
4. Easy availability of credit encourages
a. Saving b. Investment c. Rate of interest d. None of the above
5. In the situation of excess demand
a. Demand is less than the level of output
b. Demand is more than the level of output
c. Supply is less than the level of output
d. Supply is more than the level of output
Answers : 1) b 2) b 3) a 4) b 5) b
II. Fill in the blanks (each question carries 1 mark)
1. cY shows the dependence of consumption on _______
2. Savings is that part of income that is ________
3. Average propensity to consume (APC) is the consumption per unit of __________
4. __________is defined as addition to the stock of physical capital.
5. Size of the multiplier depends on the value of _______
6. I is a positive constant which represents the ________ investment in the economy.

Answers: 1) Income 2) Not consumed 3) Income 4) Investment

5) Marginal propensity to consume 6) Autonomous

III Match the following (each question carries 1 mark)

A B
1. Savings a. APC (Average Propensity to consume)
2. Raw material b. C +1 + c.Y
3. Consumption per unit of income c. Intermediate good
4. Aggregate demand for final d. Leads to rise in the prices in the long run
goods
5. Excess demand e. Y-C

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Solutions
A B
1. Savings a. Y - C
2. Raw material b. Intermediate good
3. Consumption per unit of income c. APC (Average Propensity to consume)
4. Aggregate demand for final goods d. C + I + cY
5. Excess demand in the long run e. Leads to rise in the prices

IV. Answer the following questions in a sentence/word. (Each question carries 1 mark)
1. Write the meaning of autonomous consumption.
Minimum level of consumption, which is needed for survival, i.e. consumption of zero level
of national income is called autonomous consumption.
2. Give the meaning of Marginal propensity to save (MPS).
The change in savings per unit change in income is called marginal propensity to save.
3. Define Average Propensity to save (APS)
The savings per unit of income is called average propensity to save.
4. Write the meaning of full employment level of income.
The level of income were all the factors of production are fully employed ' in the production
process is called full employment level of income.
5. Mention two fiscal variables which influence aggregate demand.
l) Tax 2) Governament expenditure
6. Write the formula of MPC.
C
MPC =
Y
AC = Change in consumption
AY=Change in income.

V. Answer the following questions in 4 sentences. (Each question carries 2 marks)

1. Write the meaning of excess demand and deficient demand.
The situation when aggregate demand is more than the aggregate supply corresponding to full
employment level of out put in the economy is called excess demand.
The situation when aggregate demand is less than the aggregate supply corresponding to the
full employment level of out put in the economy is called deficient demand.
2. Give the meaning of investment multiplier. Write its formula.
The ratio of the total increment in equilibrium value of final goods output to the initial
increment in autonomous expenditure is called investment multiplier.
Y I I
The investment multiplier = = =
A I − c S
3. Give the meaning of Paradox of thrift.

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If all the people of the economy increase the proportion of income they save, the total value of
savings in the economy will not increase - it will either decline or remain unchanged. This
result is known as the Pardox of Thrift.
4. What are the factors which cause change in aggregate demand?
The total value of final goods and services which all the sectors of an economy are
planning to buy at a given level of income during a period of one accounting year is called
aggregate demand.
There are two factors which cause change in aggregate demand. They are 1) Consumption
2) Investment.

VI. Answer the following questions in 12 sentences. (Each question carries 4 marks)
1. Give the meaning of Aggregate demand function. How can it be obtained graphically?
The functional relationship between aggregate demand changes and equlibrum level
of income changes is called aggregate demand function.
The total value of final goods and services which all the sectors of an economy are
planning to buy at a given level of income during a period of one accounting year is
called aggregate demand.
The Aggregate demand function shows the total demand (made up of consumption +
investment) at each level of income. Graphically it means the aggregate demand function can
be obtained by vertically adding the consumption and investment function.

Here, OM = C
OJ = I
OL = C + I
The aggregate demand function is parallel to the consumption function
i.e., they have the same slope c.
It may be noted that this function shows exante demand.

2. Briefly explain consumption function.

The functional relationship between consumption and income is called consumption
function.
The simplest consumption function assumes that consumption changes at a constant rate as

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Vedashreee, Lecturer in Economics Sadvidya P U College
income changes. Of course, even if income is zero, some consumption still takes place. Since
this level of consumption is independent of income, it is called autonomous consumption. We
can describe this function as:
C = C + cY
The above equation is called the consumption function. Here C is the consumption
expenditure by households.
There are two types of consumption. They are,
1) Autonomous consumption
2) Induced consumption (cY).
1) Autonomous consumption:
Minimum level of consumption, which is needed for survival,
i.e. consumption of zero level of national income is called autonomous consumption.
Autonomous consumption is denoted by C and shows the consumption which is
independent of income. If consumption takes place even when income is zero, it is because of
autonomous consumption.
2) Induced consumption (cY)
The level of consumption is dependent on income this is called induced consumption.
The induced component of consumption, cY shows the dependence of consumption on
income. When income rises by Re 1. induced consumption rises by MPC i.e. c or the marginal
propensity to consume. It may be explained as a rate of change of consumption as income
changes.

3. Explain consumption and investment function with the help of graphs.

1) Consumption Function : The functional relationship between consumption and
income is called consumption function.
The simplest consumption function assumes that consumption changes at a constant rate as
income changes. Of course, even if income is zero, some consumption still takes place. Since
this level of consumption is independent of income, it is called autonomous consumption. We
can describe this function as:
Using die same logic, the consumption function can be shown as follows:
2) Investment Function : The functional relationship between investment and income is
called investment function.
Where,
C =intercept of the consumption function
c = slope of consumption function = tan a

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Consumption function,
In a two sector model, there are two sources of final demand, the first is 1) consumption
and the second is 2) investment.
The investment function was shown as I = I
Graphically, this is shown as a horizontal line at a height equal to I above the horizontal axis.

In this model, I is autonomous which means, it is the same no matter whatever is the level of
income.

4. Explain the investment function with the help of graphs.

The functional relationship between investment and autonomous investment is called
investment function. Investment function can be shown as I=I̅ , here I̅ is a positive constant
which represents the autonomous investment in the economy in a given year.

The investment function shown in the above graph as a horizontal line at a height
equal to I̅ above the horizontal axis. In this diagram, I̅ is autonomous which means, it is the
same no matter whatever is the level of income.

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VII. Answer the following questions in 20 sentences, (each question carries 6 marks)
1. Explain the effect of an autonomous change in aggregate demand on income and output.
We have seen that the equilibrium level of income depends on aggregate demand. Thus, if
aggregate demand changes, the equilibrium level of income changes. This can happen in any
one or combination of the following situations:
1. Change in consumption: This can happen due to (i) change in C (ii) change inc.
2. Change in investment : We have assumed that investment is autonomous. However, it just
means that it does not depend on income. There are a number of variables other than income
which can affect
investment. They are;
1) Availability of credit: Easy availability of credit encourages investment.
2) Interest rate: interest rate is the cost of investible funds, and at higher interest rates, firms
tend to lower investment.
Now, let investment rise to 20. It can be seen that the new equilibrium will be 300. This
can be explain with the help of following diagram.

In the above diagram OX axis represents income OY axis represents aggregate demand.
This increase in income is due to rise in investment, which is a component of autonomous
expenditure here.
When autonomous investment increases, the AD1 line shifts paralled upwards and assumes
the position AD2. The value of aggregate demand at output Y*1 is Y*1F, which is greater than
the value of output OY*1 = Y*1 E1 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.
Thus, E1 no longer represents the equilibrium.
To find the new equilibrium in the final goods market we must look for the point where
the new aggregate demand line, AD2, intersects the 45° line. That occurs at point E2, which is,
therefore, the new equilibrium point. The new equilibrium values of output and aggregate
demand areY*2 and AD*2, respectively.
Note that in the new equilibrium, output and aggregate demand have increased by an
amount E1G=E2Q which is greater than the initial increment in autonomous expenditure,

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Vedashreee, Lecturer in Economics Sadvidya P U College
I=E1F=E2J. Thus, an initial increment in the autonomous expenditure seems to have a
multiplier on the equilibrium values of aggregate demand and output.

2. Explain the supply side of macro economic equilibrium.

In microeconomic theory, we show the supply curve on a diagram with price on the
vertical axis and quantity supplied on horizontal axis.
In the first stage of macroeconomic theory, we are taking the price level as fixed. Here,
aggregate supply or the GDP is assumed to smoothly move up or down since they are unused
resources of all types available.
Whatever is the level of GDP, that much will be supplied and price level has no role to
play. This can be explain with the help of following

In the above diagram supply situation is shown by a 45° line. Now, the 45° line has the
feature that every point on it has the same horizontal and vertical coordinates.
In the diagram GDP is Rs. 1,000 at point A. How much will be supplied? The answer is
Rs. 1000 worth of goods. How can that point be shown? The answer is that supply
corresponding to point A is at point B which is obtained at the intersection of the 45° line and
the vertical line at A.

3. Explain the multiplier mechanism

The ratio of the total change in income to the initial change in investment is known as
multiplier.
The concept of multiplier is an important contribution of Kenynes to economic analysis. It
occupies an important place in the Keynesian model of employment. The concept of
multiplier was first originated by Lord. R.F. Kahn. Keynes has successfully implemented it, in
his employment theory.
Y
K=
I
Therefore, Y=increase in income
I=increase in investment
K=multiplier
Multiplier and Marginal Propensity to Consume:

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There is a direct relationship between MPC and the value of multiplier. Higher the MPC
more will be the value of multiplier, and vice-versa. The multiplier effect of an initial,
increase in investment depends upon marginal propensity to consume. The Value of multiplier
is determined by MPC. If MPC is higher, multiplier will also be higher. But the value of
multiplier is always more than one. The multiplier can be calculated by the following formula
1
K=
1 − MPC

Working of Multiplier:
A given new investment will create an additional income by the same amount. The process
however does not end there. The increase in income will lead to an increase in consumption;
the additional consumption expenditure become the basis of new income and therefore, new
consumption expenditure and so on. Let us assume that new investment is Rs. 100 crores.
This leads to an additional income of Rs. 100 crores. The additional income is expected to be
spend on consumption expenditure Let us assume that marginal propensity to consume is 50%
or 0.5. In other words, out Rs. 100 crore of income, Rs.50 crore are spent for consumption and
the remaing amount of Rs. 50 crores is saved. This amount of Rs. 50 crores investment will be
income for other people. Out of this income, those people will spent Rs. 25 crore This process
will go on until the consumption becomes zero. The total income so far created is
100+50+25+... =200 crores.

4. Discuss the Paradox of thrift.

If all the people of the economy increase the proportion of income they save (i.e. if the
mps of the economy increases) the total value of savings in the economy will not increase
- it will either decline or remain unchanged. This result is known as the Paradox of
Thrift.
People become more thrifty they end up saving less or same as before. This result, though
sounds apparently impossible, is actually a simple application of .the model we have learnt.
Let us continue with the example. Suppose at the initial equilibrium of Y=250, there is an
exogenous or autonomous shift in peoples expenditure pattern, - they suddenly become more
thrifty. This may happen due to a new information regarding an imminent war or some other
impending disaster, which makes people more circumspect and conservative about their
expenditure. This can be regarded as an autonomous reduction in consumption expenditure.
But as aggregate demand decreases by 75, there emerages an excess supply equal to 75 in
the economy. Stocks are piling up in warehouses and ' producers decide to cut the value of
production by 75 in the next round to restore equilibrium in the market. But that would mean
a reduction in factor payments in the next round and hence a reduction in income by 75.
As income decreases people reduce consumption proportionately but, this time, according
to the new value of mpc which is 0.5. Consumption expenditure, and hence aggregate

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Vedashreee, Lecturer in Economics Sadvidya P U College
demand, decreases by 75, which creates again an excess supply in the market.
In the next round therefore, producers reduce output further by 75. Income of the people
decreases accordingly and consumption expenditure and aggregate demand goes down again
by 75. The process goes on. However, as can be inferred from the dwindling values of the
successive round effects, the process is convergent.
Paradox of Thrift can be explained with the help of following diagram.

In the above diagram OX axis represents income, OY axis represents aggregate demand.
When A changes the line shifts upwards or downwards in parallel. When c changes,
however, the line swings up or down. An increase in mps, or a decline in mpc, reduces the
slope of the AD line and it swings downwards.

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CHAPTER - 5
GOVERNMENT BUDGET AND THE ECONOMY

I. Choose the correct answer (each question carries 1 mark)

1. The Taxes on Individual and firms are
a. Direct Taxes b. Indirect Taxes
c. Fixed Taxes d. Non Tax Revenues
2. Duties Levied on goods produced with in the country
a. Service Tax b. Estate Duties
c. Excise Duties (Taxes) d. Customs duties
3. The Tax acts as an automatic stabiliser
a. Qualitative income Tax b. Income Tax
c. Quantitative Tax d. Proportional income Tax
4. Which of the following is an example for ‘Paper taxes’.;
a. Income Tax b. Excise Taxes
c. Wealth Tax d. Customs Taxes
5. When Demand exceeds the available output under conditions of high level of
employment, this may give rise to
a. Inflation b. Deflation c. Stabilisation d. None of the above
Answers : 1) a 2) c 3) d 4) c 5) a

II. Fill in the blanks (each question carries 1 mark)

1. Non paying users of public goods are known as
2. Financial year runs from to in India.
3. Taxes imposed on goods imported into and exported out of India are called
4. The Government may spend an amount equal to the revenue it collects. This is know as
5. Revenue dificit=Revenue expenditure -
Answers: 1) Free rider 2) April 1st to March 31st
3) Export Import tax 4) Balanced budget 5) Revenue Income

III. Answer the following questions in a sentence/word. (Each question carries 1 mark)
1. What are public goods?
Those goods which are cannot be provided by the market mechanism
i.e. by exchange between indivual consumers and producers is called Public goods.
2. Who are ‘free-riders’?
Non paying users of public services are known as free riders.
3. What do you meant by public provision?
Those provision which are financed through the budget and can be used without any direct

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payment is called Public provision.
4. Give the meaning of progressive Tax.
A tax system in which the rate of tax increases as income increases is called progressive cost.
5. What are Revenue receipts?
Revenue earned by the government from tax and non-tax sources is called revenue receipts.
6. Write the meaning of capital receipts.
Those receipts of the government which create liability or lending to reduction in assets is
called capital receipts.
7. Give the meaning of Revenue expenditure.
The expenditure Incurred for purposes, other than the creation of physical or financial assets
of the central government is called revenue expenditure.
8. Give the meaning of capital expenditure.
The expenditure incurred on the acquisition of assets such as land, building, machinery and
equipments, etc. is called capital expenditure.
9. Expand FRBMA.
Fiscal Responsibility and Budget Management Act.
10. What is primary deficit?
The excess of fiscal deficit over interest payments is called primary deficit.

IV. Answer the following questions in 4 sentences. (Each question carries 2 marks)
1. Write the difference between Public provision and Public production.
Public provision Public production
1) Those provision which are financed through 1) When goods are produced directly
the budget and can be used without any by die government is called public
direct payment is called Public provision. production.
2) Public provision can be obtain without any 2) Public goods produced by the
direct payment. government can be obtain with
payment.
2. Who are ‘Free riders’? Why are they called so?
Non paying users of public services are known as free riders.
The following are the causes responsible to call the free riders.
1) Consumers will not voluntarily pay for what they can get for free.
2) For which there is no exclusive title to the property being enjoyed.

3. Distinguish between surplus budget and deficit budget.

The following are the differences between surplus budget and deficit budget.

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Surplus Budget Deficit Budget
1. Estimated receipts are more than 1. Estimated expenditure is more than
the estimated expenditure is estimated receipts is known as deficit
known as surplus budget budget.
2. Surplus budget indicates financial 2. Deficit budget indicates deleberate
soundness of the government excessive expenditure by the
government
3. Usually governments of developed 3. Usually governments of developing
countries plan for a surplus budget countrires plan for a deficit budget
4. It has a negative implication, in 4. It has a positive implication interms of
terms of the welfare of the society the welfare of the society.

4. Why public goods must be provided by the Government?

Public goods must be provided by the government, because,
1) There is no feasible way of excluding anyone from enjoying the benefits of the good.
2) Public goods are called non-excludable for anyone.
3) Even if some users do not pay, it is difficult and some times impossible to collect fees for
the public good.
4) Production of some goods are not profitable. In this situation private people are not come
forward to produce this type of product. In this situation govt, must produce this type of
goods.
5. Mention the non-tax revenues of the Central Government.
1) Interest receipts
2) Profit from the public sector under takings.
3 ) Fees, fines, and penalties
4) Grants-in-aids from foreign countries and international organisations
6. Why the proportional income tax acts as automatic stabiliser?
The proportional income tax, thus, acts as an automatic stabiliser - a shock absorber
because it makes disposable income, and thus consumer spending, less sensitive to
fluctuations in GDP.
When GDP rises, disposable income also rises but by less than the rise in GDP, because a part
of it is siphoned off as taxes. This helps limit the upward fluctuation in consumption spending.
During a recession when GDP falls, disposable income falls less sharply, and consumption
does not drop as much as it otherwise would have fallen had the tax liability been fixed.

V. Answer the following questions in 12 sentences, (each question carries 4 marks)

1. Distinguish between Revenue expenditure and capital expenditure.
The following are important differences between revenue expenditure and capital expenditure.

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Revenue expenditure Capital Expenditure
1) The expenditure Incurred for 1) The expenditure incurred on the
purposes other than the creation of acquisition of assets such as land,
physical or financial building, machinery
assets of the central government is and equipments, etc. is called capital
called revenue expenditure. expenditure.
2) Revenue expenditure neither 2) Capital expenditure either creates an asset
creates any asset nor reduces or reduces a any liability of the
liability of the government government.
3) It is incurred for normal running of 3) It is incurred mainly for acquisition of
government departments and assets and granting of loans and advances.
provision of various services
4) It is recurring in nature as such 4) It is non-recurring in nature, activities
expenditure is spent by government
on day-today
5) Salary, pension, interest, etc. 5) Repayment of borrowings; Expenditure on
acquisition of capital asset, etc.

2. Write the chart of the Government budget.

3. Briefly explain the revenue deficit and fiscal deficit.

The excess of budgetary expenditure over its budget receipts is called budget deficits.
It is expressed as
Budget deficits = total expenditure - Total receipts.
There are 3 types of budget deficits important among them are:
1) Revenue Deficit :
The excess of government revenue expenditure over its revenue receipts is called
Revenue Deficit.

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It signifies that government’s own revenue is insufficient to meet the normal running of
the government. Revenue deficit results in borrowing. It can be expressed as
Revenue Deficit = Revenue expenditure - Revenue receipts Revenue Deficit in 2015-16 was
2.8 percent of GDR The revenue deficit includes only such transactions that affect the current
income and expenditure of the government. 1) When the government incurs a revenue deficit,
it implices that the government is dis saving and is using up the savings of the other sectors of
the economy to finance a part of its consumption expenditure.
2) This situation means that the government will have to borrow not only to finance its
investment but also its consumption requirement.
3) This will lead to a build up of stock of debt and interest liabilities and force the
government.
2) Fiscal Deficit :
The difference between the governments total expenditure and its total receipts
excluding borrowings is called Fiscal Deficit.
It indicated the total amount of borrowing of the government in a fiscal year. It can be
expressed as
Fiscal Deficit = Total expenditure - Revenue receipts + Non-debt creating capital receipts.
Non-debt creating capital receipts are those receipts which are not borrowings and,
therefore, do not give rise to debt. Examples are recovery of loans and the proceeds from the
sale of PSUs. The fiscal deficit will have to be financed through borrowing. Thus, it indicates
the total borrowing requirements of the government from all sources. From the financing side.
Gross fiscal deficit = Net borrowing at home + Borrowing from RBI + Borrowing from
aborad
Net borrowing at home includes that directly borrowed from the public through debt
instruments or example, the various small savings schemes and indirectly from commercial
banks through Statutory Liquidity Ratio (SLR). The gross fiscal deficit is a key variable in
judging the financial health of the public sector and the stability of the economy.
From the way gross fiscal deficit is measured as given above, it can be seen that revenue
deficit is a part of fiscal deficit.

4. Docs public debt impose a burden? Explain.

The borrowing of the government to meet budget deficits is called public debt.
Public debt is used as an effective instrument of fiscal policy to control inflation and deflation.
Public debt and budget deficit are inter related.
Internal debt does not matter much, because we owe it to ourselves. This is because although
there is a transfer of resources between people, purchasing power remains within the country.
There are two interlinked aspects of the issue.
1) Whether government debt is a burden.
2) Issue of financing the debt.
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The burden of debt must be discussed keeping in mind that what is true of one small trader’s
debt may not be true for the government’s debt.
Effects of Public debt
The following are the important effects of public debt.
1) The burden of reduced consumption on future generations.
By borrowing, the government transfers the burden of reduced consumption on future
generations. This is because it borrows by issuing bonds to the people living at present but
may decide to pay off the bonds some twenty years later by raising taxes. These may be levied
on the young population that have just entered the work force, whose disposable income will
go down and hence consumption. Thus, national savings, it was argued, would fall.
2) Reduces the savings available to the private sector
Also, government borrowing from the people reduces the savings available to the private
sector. To the extent that this reduces capital formation and growth, debt acts as a ‘burden’ on
future generations.
3) Causes for more expenditure of consumers
When a government cuts taxes and runs a budget deficit, consumers respond to their after-
tax income by spending more. It is possible that these people are short-sighted and do not
understand the implications of budget deficits. They may not realise that at some point in the
future, the government will have to raise taxes to pay off the debt and accumulated interest.
Even if they comprehend this, they may expect the future taxes to fall not on them but on
future generations.
4) Domestic countries control by foreign countries
External debt should be considered seriously. Because, when we borrow from other
countries purchasing power will transfer from our country to another through debt payment
and interest payments.

5. Write a short note on the Ricardian equivalence.

A counter argument is that consumers are forward looking and will base their spending not
only on their current income but also on their expected future income. They will understand
that borrowing today means higher taxes in the future. Further, the consumer will be
concerned about future generations because they are the children and grand children of the
present generation and the family which is the relevant decision making unit, continuous
living. They would increase savings now, which will fully offset the increased government
dissaving so that national savings do not change. This view is called Ricardian equivalence
after one of the greatest nineteenth century economists.
David Ricardo, who first argued that in the face of high deficits, people save more. It is
called equivalence because it argues that taxation and borrowing are equivalent means of
financing expenditure. When the government increases spending by borrowing today, which
will be repaid by taxes in the future, it will have the same impact on the economy as an
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increase in government expenditure that is financed by a tax increase today.
It has often been argued that ‘debt does not matter because we owe it to ourselves’. This is
because although there is a transfer of resources between generations, purchasing power
remains within the nation. However, any debt that is owed to foreigners involves a burden
since we have to send goods abroad corresponding to the interest payments.

VI. Answer the following questions in 20 sentences, (each question carries 6 marks)
1. Explain the classification of receipts.
Receipts of the govt, classified into two types. They are
1) Revenue Receipts 2) Revenue Expenditure
A) Revenue Receipts :
Revenue earned by the government from tax and non-tax sources is called revenue
receipts.
Revenue receipts of the government are generally classified under 2 types:
1) Tax Revenue 2) Non Tax Revenue
1) Tax Revenue :
A tax is a compulsory payment made by the people to the government without expecting
any direct returns.
Tax revenue comprises direct taxes and indirect taxes.
1) Direct Taxes :
The tax in which the incidents and impact are borne by the same person is called direct
taxes. It is imposed on the income and wealth. The important direct taxes are
a) Personal Income Tax :
Taxes levied on income from salaries, business, profession, property and other sources of
individuals.
b) Wealth Tax:
It is levied on the wealth accumulated by individuals.
c) Corporation Tax:
It is levied on the income of companies and business corporation.
d) Wealth Tax, Gift tax, and estate duty :
Wealth tax, gift tax and estate duty (now abolished) have never brought in large amount of
revenue and thus have been referred to as paper taxes.
2) Indirect Taxes :
The tax in which the incidents and impact arc borne by different individuals is callcd
indirect taxes. The burden of such tax can be shifted on to others. The important indirect
taxes are:
a) Excise Duty :
Central excise is imposed on the production of sugar, cotton, cloth, tobacco, match boxes,
cement and spirit etc.
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b) Customs Duties:
It is leveled on the imported goods. It is the source of revenue and also protects our industries.
c) Service Tax:
This tax is levied by the government on different types of services. The redistribution
objective is sought to be achieved through progessive income taxation, in which higher the
income, higher is the tax rate. Receipts of the government from all sources other than
those of tax receipts is called Non tax revenue.
The important non tax revenues are
1) Interest receipts :
Government receives interest on loans given by it to state governments, union territories,
private enterprises and general public.
2) Profits of Public sector undertakings:
Government earns profit through public sector undertakings like Indian railways, LIC, BHEL
etc.
3) Fees, Fines and Penalties :
Those payments which are imposed on law breakers is called fines and penalties.
4) Grants-in-Aid from foreign countries and international organization'
B) Capital Receipts :
Those receipts of the government which create liability or lending to reduction in assets
is called capital receipts.
The important source or capital receipts are:
1) Rising loans from the market, central bank, foreign government and international
institutions.
2) Loans raised from public by issuing bonds, unit certificates etc.
3) Recoveries of Loans granted to local governments
4) Public provident fund
5) Receipts obtained from disinvestment of public sector units.

2. Explain the classification of expenditure.

For the purpose of the development of the economy government expenditure is very essential.
Expenditure of the government broadly classified in to two types. They are,
1) Revenue expenditure
2) Capital expenditure
1) Revenue Expenditure :
The expenditure which neither creates any asset nor causes reduction in any liability of
the government is called revenue expenditure.
Revenue expenditure classified in to plan revenue expenditure and non plan revenue
expenditure.
1) Plan revenue expenditure :
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It relates to the expenditure incurred on implementation of economic plans. The government
provisions to assist the plans of local governments etc. The important plan expenditure are:
1) Plan Expenditure relates to central plans.
2) Central assistance for state
3) Union territory plans
2) Non Plan revenue expenditure :
Non plan expenditure are the important component of the revenue expenditure. It relates to the
expenditure incurred on defence service law and order, interest payments, salaries, subsidies,
pensions, tax collection etc.
Important Nonplan Expenditure are:
1) Expenditure on Defence and Law and order
2) Expenditure on subsidy and grants
3) Expenditure on interest payment
4) Expenditure on pension and salaries etc.
Interest payments on market loans, external loans and from various reserve funds
constitute the single largest component of non-plan revenue expenditure. Defence
expenditure, is committed expenditure in the sense that given the national security concerns,
there exists little scope for drastic reduction. Subsidies are an important policy instrument
which aim at increasing welfare.
Apart from providing implicit subsidies through under-pricing of public goods and
services like education and health, the government also extends subsidies explicitly on items
such as exports, interest on loans, food and fertilisers.
2) Capital Expenditure of the Government :
The expenditure incurred on the acquisition of assets such as land, building,
machinery and equipment, etc. is called capital expenditure.
Capital expenditure is also categorized in to two groups
1) Plan capital expenditure:
Expenditure incurred for creating permanent revenue yielding assets is called plan
capital expenditure.
Plan expenditure, like its revenue counter part, relates to central plan and central assistance
for state and union territory plans.
2) Non plan capital expenditure :
Non plan capital expenditure covers various general, social and economic services
provided by the government. It relates to the expenditure incurred on compensation,
rehabitation facilities during natural calamities etc.

3. ‘The fiscal deficit gives borrowing requirements of the government’. Elucidate.

Fiscal deficit is adverse effect on the economy in different ways.
1) Inflation : Government mainly borrows from Reserve Bank of India (RBI) to meet its
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fiscal deficit. RBI prints new currency to meet the deficit requirements. It increases the money
supply in the economy and creates inflationary pressure.
2) Foreign Dependence: Government also borrows from rest of the world, which raises its
dependence on other countries.
3) Hampers the future growth: Borrowings increase the financial burden for future
generations. It adversely affects the future growth and development prospects of the country.
4) Debt Trap: Borrowings not only involve repayment of principal amount, but also require
payment of interest. Interest payments increase the revenue expenditure, which leads to
revenue deficit. It creates a vicious circle of fiscal deficit and revenue deficit, wherein
government takes more loans to repay the earlier loans. As a result, country is caught in a debt
trap.

4. Discuss the issue of deficit reduction.

Government deficit can be reduced by an increase in taxes or reduction in expenditure. In
India, the government has been trying to increase tax revenue with greater reliance on direct
taxes. There has also been an attempt to raise receipts through the sale of shares in PSUs.
If government reduce the difficit there are several advers effect on the economy. They are,
1) Reduction in basic infrastructure
To change the scope of the government by withdrawing from some of the areas where it
operated before. Cutting back government programmes in vital areas like agriculture,
education, health, poverty alleviation, etc. would adversely affect the economy.
2) Reduced the economic growth
Governments in many countries run huge deficits forcing them to eventually put in place
self-imposed constraints of not increasing expenditure over pre-determined levels. These will
have to be examined keeping in view the above factors. We must note that larger deficits do
not always signify a more expansionary fiscal policy.
3) Reduction in the production of different sectors
Deficit budget helpful to the development of different sector of the economy. If dificit of
the budget decreases attomaticaly the investment decreses. When investment decreses
production of the nation also decreses.
4) Decreases employment oppotunities
If deficit of the budget decreses investment decreses. There fore the employment
oppumities to the people of the country also decreses.
5) Demand for commodities decreases
If deficit of the budget decreses the income of the people also decreses. When income
decreses the demand fot different types of commodities in the economy is decreses.

5. Explain the Changes in taxes with the help a diagram.

We consider the effects of increasing government purchases (G) keeping taxes constant.
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When government purchases (G) exceeds tax (T), the government runs a deficit. Because
government purchases (G) is a component of aggregate spending, planned aggregate
expenditure will increase. The aggregate demand schedule shifts up to AD. At the initial level
of output, demand exceeds supply and firms expand production.
The government spending multiplier is derived as follows.
Y I − c
= = =1
G I − c
This can be explained with the help following diagram.

Income and Output

In the above diagram ox axis represents income and output, oy axis represents aggregate
demand. Suppose, government increases its public expenditure, keeping taxes constant.
Excess of government expenditure over taxes will lead to deficit in government budget.
Increase in government expenditure will raise the aggregate demand (as government
expenditure is a part of AD). In the diagram, it will shift the aggregate demand from AD1 to
AD1. As demand exceeds supply, firms will expand production. The new equilibrium is
determined at E1. So, increase in government expenditure leads to rise in equilibrium income
from OY to OY1.
When change in the tax rate, disposable income also change. If tax rate increases
disposable income decreases. If rate oftaxes decreases disposable income increases. Therefore
there is a opposite relationship between tax rate and disposable income. Y

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Y" Y Income and Output

A change in the tax structure by the government adversely affects the level of disposable
income. So, an increase in taxes will cause reduction in consumption and output. Higher tax
payments will reduces the disposable income and it will decrease the aggregate demand in the
economy. In the diagram, aggregate demand shifts down from AD to AD11. As supply
exceeds demand, firms will reduce the production and new equilibrium is determined at E 11.
Thus, increase in taxes decreases the equilibrium income from OY to OY".

VII. Assignment and project oriented questions. (Carries 5 marks)

1. Prepare a budget on monthly income and expenditure of your family.
Income Expenditure
1) Income from 1) Expenditure on 20,000 education
20,000 salary 2) Monthly Ration 10,000 and other expenses
2) Income from 5,000 Agriculture 3) Electricity, Milk 5,000 paper etc
3) Income from 10,000 Business 4) Petrol 5,000
4) Income from 10,000 Rent 5) Savings 5,000
Total 45,000 Total 45,000

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CHAPTER - 6
OPEN ECONOMY

I. Choose the correct answer. (Each question carries 1 mark)

1. The consumers and producers can choose between domestic and foreign goods, this
market linkage is called
a. Financial Market linkage b. Output Market linkage
c. Labour Market linkage d. None of the above
2. The exchange rate is determined by the market forces of demand and supply is called as
a. Fixed exchange rate b. Dirty floating exchange rate
c. Flexible exchange rate d. None of the above
3. The balance of payments (BOP) record these transactions between residents and with
the rest of the world
a. Goods b. Services c. Assets d. All of the above
4. The rate at which the price of one currency in terms of Foreign Currency is called
a. Exchange Control b. Interest Rate c. Foreign Exchange Rate d. None of the above
5. In this standard all currencies were defined in terms of gold
a. Metal standard b. Silver standard
c. Gold standard d. None of the above
Answers: 1) b 2) c 3) d 4) c 5) c

II. Fill in the blanks (each question carries 1 mark)

1. ___________is the record of trade in goods and services and transfer payments.
2. _________account records all international transactions of assets.
3. The price of foreign currency in terms of Domestic currency has increased and this is
called____________ of domestic currency.
4. _________is a mixture of a flexible and fixed exchange rate system.
5. __________The bretton woods conference held in the year
Answers: 1) Current account 2) Capital account
3) Depreciation 4) Managed floating 5) 1944

III Match the following (each question carries 1 mark)

A B
1. SDR a. Dirty floating
2. Balance of payment b. Flexible exchange rate
3. Balance of trade c. Paper gold
4. Floating exchange rate d. Trade in goods
5. Managed floating e. Trade in goods and service

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Solutions
A B
1. SDR a. Paper gold
2. Balance of payment b. Trade in goods and service
3. Balance of trade c. Trade in goods
4. Floating exchange rate d. Flexible exchange rate
5. Managed floating e. Dirty floating

IV. Answer the following questions in a sentence/word, (each question carries 1 mark)
1. What do you mean by open economy.
An economy which lies economic relations with other countries is termed as open economy.
2. What is Balance of payment?
The difference between total value of visible and invisible exports and imports in a given
period of time is called balance of payment.
3. What is balance of trade?
The difference between the value of visible items of exports and imports during a year is
called balance of trade.
4. What do you mean by fixed exchange rate?
An exchange rate between the currencies of two or more countries that is fixed at some level
and adjusted only infrequently is called fixed exchange rate.
5. Give the meaning of official reserve sale.
Total of a nations holding of tradable foreign currencies, gold "reserves, and SDRs sale with
dollar is called official reserve sale.
6. Give the meaning of managed floating.
A mixture of flexible and fixed exchange rate system is called managed floating exchange
rate.

V. Answer the following questions in 4 sentences. (Each question carries 2 marks)

1. Mention the three linkages of open economy.
1) Output market linkage
2) Financial market linkage
3) Labour market linkage

2. What is the difference between current account and capital account?

The following are the important differences between Current Account and Capital Account.

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Current Account Capital Account
1) Current account transa- 1) Capital transactions bring about a
ctions bring a change in change in the capital stock of a
the current level of a country.
country’s income
2) It is a flow concept as it 2) It is a stock concept as it includes
includes all items of flow all items expressing changes in
nature. stock.
3) Current Account=Visible 3) Capital Account= Borrowings and
Trade + Unilateral lendings to and from abroad
transfers + Income Investments to and from abroad +
Receipts and payments Change in Foreign Exchange
Reserves.
3. When do surplus and deficit arises in Capital Account?
Surplus in capital account arises when credit items are more than debit items. It indicates net
inflow of capital.
Deficit in capital account arises when debit items are more than credit items. It indicates net
outflow of capital.
4. Write the meaning of balanced, surplus and deficit BOT.
There are three types of balance of trade. They are:
1) Balanced Balance of Trade :
If the value of visible exports is equal to the value of visible imports is called balanced
balance of trade.
Balanced balance of trade = Value of exports=value of imports
2) Surplus balance of trade :
If the value of visible exports is more than the value of visible imports is called surplus
balance of trade.
Favourable balance of trade=Value of exports > Value of imports
3) Deficit balance of trade :
If the value of visible imports exceeds the value of visible exports is called deficit balance of
trade.
Deficit balance of trade = Value of exports < Value of imports
5. Why do people demand foreign exchange?
People demand foreign exchange because,
1) They want to purchase goods and services from other countries.
2) They want to send gifts abroad.
3) They want to purchase financial assets of a certain country.

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6. What is foreign exchange rate.
The rate at which one currency is exchanged for the other is called exchange rate.
Foreign exchange rate regulates international costs and prices. It is also the rate at which
exports and imports of a country are valued at a given point of time. Thus, the rate of foreign
exchange refers to the number of units of foreign currency, which one unit of home currency
can purchase.
For example: An exchange rate of $1 = Rs. 62. It means that one dollar buys 62 Indian rupees.

7. Differentiate between depreciation and devaluation.

The following are the important differences between depreciation and devaluation
Depreciation Devaluation
1) Depreciation refers to fall in market 1) Devaluation refers to reduction in price
price of domestic Currency in of domestic Currency h terms of all
terms of a foreign currency under foreign currencies under fixed exchange
flexible exchange rate regime. rate regime.
2) It takes place due to market forces 2) It takes place due to Government.
of demand and supply.
3) It takes place under flexible 3) It takes place under fixed exchange rate
exchange rate system.: system.

8. What are the types of balance of trade?

There are three types in balance of trade they are as follows:
➢ Balanced balance of trade: When the value of exports of goods is equal to the value
of imports of goods is called balanced balance of trade.
➢ Surplus balance of trade: when the value of exports of goods is more than the value
of imports of goods is called surplus balance of trade.
➢ Deficit balance of trade: when the value of exports of goods is less than the value of
imports of goods is called deficit balance of trade.

VI. Answer the following questions in 12 sentences. (Each question carries 4 marks)
1. Write a note on balance of trade.
The difference between the value of visible items of exports and imports during a year is
called balance of trade.
The movement of such goods between countries is known as visible trade, because such a
movement is open and can be verified by the custom officials and their values are recorded in
the custom returns.
Export of goods is entered as a credit item in BOT, whereas import of goods is entered as a
debit item in BOT. It is also known as Trade Balance. Types of Balance of Trade :
There are three types of balance of trade, they are:
1) Favourable (Surplus) balance of trade.

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2) Unfavrourable (deficit) balance of trade.
3) Balanced balance of trade.
1) Surplus balance of trade :
If the value of visible exports is more than the value of visible imports is called surplus
balance of trade.
Favourable balance of trade=Value of exports > Value of imports
2) Deficit balance of trade :
If the value of visible imports exceeds the value of visible exports is called deficit balance of
trade.
Deficit balance of trade = Value of exports < Value of imports
3) Balanced Balance of Trade :
If the value of visible exports is equal to the value of visible imports is called balanced
balance of trade.
Balanced balance of trade = Value of exports = value of imports
2. Write the chart of components of Current account.

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3. Write the chart of components of capital account.

4. Briefly explain the effect of an increase in demand for imports in the foreign exchange
market with the help of a diagram.
The foreign rate or rate of exchange refers to the rate at which one currency is exchanged for
another. Thus rate of exchange is the price of one currency expressed in terms of another
currency. In the foreign exchange market at a particular time there exists not one unique
exchange rate but depending upon the use of credit instruments in the transfer of currencies a
variety of rates are found.
Suppose the demand for foreign goods and services increases due to increased
international travelling by Indians, then as depicted in the demand curve shifts upward and
right to the original demand curve.
The effect of an increase in demand for imports in the foreign exchange market can be
explain with the help of a diagram.

In the above diagram ox axis represents demand and supply for foreign exchange and
oy axis represents exchange rate. An increase in demand for foreign exchange will shift

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the demand curve towards right from DD to D1D1. In the diagram there is an excess
demand of oq1 at the original exchange rate of OR as a result exchange rate rises OR1. It
shows that per unit price of US dollar (In terms of Rs.) has increased, i.e., domestic
currency has depreciated.
The increase in demand for foreign goods and services result in a change in the
exchange rate.

5. Explain the merits and demerits of Flexible and fixed exchange rate system.
The rate which is determined by forces of supply and demand in the foreign
exchange market is called flexible exchange rate.
Flexible exchange rate is a system in which exchange rate keeps on changing. Under this
system exchange rates are determined by market forces.
Merits of flexible exchange rate
1) The major advantage of flexible exchange rates is that movements in the exchange rate
automatically take care of the surpluses and deficits in the BoP.
2) Countries gain independence in conducting their monetary policies, since they do not have
to intervene to maintain exchange rate which are automatically taken care of by the
market.
3) Flexible exchange rate is self-adjusting and automatically removes the disequilibrium in
the balance of payments (BOP).
4) There is no need for the government to hold large foreign exchange receives.
Demerits of flexible exchange rate
1) It encourages speculation.
2) There can be wide fluctuations in exchange rate which may hamper foreign trade etc.
3) It generates inflationary trends in the economy, when there is increase in the prices of
imports due to depreciation of the currency.
The rate which is officially fixed by the government or monetary authority on daily or
monthly basis is called fixed exchange rate.
Fixed exchange rate is also known as stable exchange rate. Under this system a country will
officially fix a specific exchange rate between currency of a country with its own currency
which is maintained over a period of time.
Merits of fixed exchange rate
1) It provides stability to the foreign exchange market.
2) It creates conditions for smooth flow of foreign capital between nations.
3) It eliminates speculative activities in foreign exchange market.
4) This system attracts foreign capital investments which promotes economic growth.
5) It creates confidence among the people that the existing rate will continue in future. As a
result, foreign trade of a country flows more quickly and smoothly. .
Demerits of fixed exchange rate
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1) As exchange rate is fixed by the government, it eliminates the possibility of speculative
transactions in foreign exchange.
2) Fixed exchange rates are not permanently fixed.
3) It is very difficult to determine the level at which the exchange rate should be fixed.

VII. Answer the following questions in 20 sentences. (Each question carries 6 marks)
1. Write a note on balance of payment.
The difference between total value of visible and invisible exports and imports in a given
period of time is called balance of payment.
Balance of payment is a statement of systamatic record of all economic transactions between
the country and the rest of the world during a year. It shows what is sent to foreign countries
by nations and what is received by them in return.
There are two main accounts in the balance of payments they are:
1) Current Account 2) Capital Account
1) Current Account :
An account which records all the transaction relating to export and import of goods and
services and unilateral transfers during a given period of time is called current account.
2) Capital Account :
Capital Account balance of payment records all those transactions between the residents of
a country and rest of the world, which cause a change in the assets or liabilities of the
residents of the country or its govemmnt.
Types of Balance of Payments :
There are three types of balance of payments they are:
1) Favourable or surplus balance of payment.
2) Unfavourable or deficit balance of payment.
3) Balanced balance of payment.
1) Favourable or Surplus balance of payment :
When the value of visible and invisible items of exports exceeds the value of imports is
known as surplus balance of payment.
Favourable balance of payment = Exports > Imports
2) Unfavourable or Deficit balance of payment :
If the value of visible and invisible items of imports exceeds the value of exports is known as
deficit balance of payment.
Unfavourable balance of payment = Exports < Imports
3) Balanced Balance of Payment :
The value of visible and invisible exports may be equal to imports, such a situation is
called balanced balance of payment.
Balanced balance of payment = Exports = Imports
Totally balance of payments shows the international economic position of the country in
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Vedashreee, Lecturer in Economics Sadvidya P U College
making decisions of monetary and fiscal policies, foreign trade, foreign exchange and
international payment to the govt, authorities.

2. Briefly explain the foreign exchange market with fixed exchange rates with the help of a
diagram.
An exchange rate between the currencies of two or more countries that is fixed at
some level and adjusted only in frequently is called fixed exchange rate.
Fixed exchange rate is also known as stable exchange rate. Under this system a country
will officially fix a specific exchange rate between currency of a country with its own
currency which is maintained over a period of time.
Under fixed exchange rate the exchange rate is fixed by the monetary authority. In this
case exchange rate is fixed at a particular level. Any deviation from the pre determined level
of exchange rate would be corrected by the immediate invention of central bank and it would
be brought back to the previously fixed level.
The foreign exchange market with fixed exchange rates with the help of a diagram.
In the above diagram ox axis represents demand and supply of foreign exchange, oy axis
represents foreign exchange rate.

In this exchange rate system, the Government fixes the exchange rate at a particular level.
In the above diagram, the market determined exchange rate is e. However, let us suppose that
for some reason the Indian Government wants to encourage exports for which it needs to
make rupee cheaper for foreigners, it would do so by fixing a higher exchange rate, say Rs 70
per dollar from the current exchange rate of Rs 50 per dollar. Thus, the new exchange rate set
by the Government is e1, where e1 > e. At this exchange rate, the supply of dollars exceeds the
demand for dollars.
The RBI intervenes to purchase the dollars for rupees in the foreign exchange market in
order to absorb this excess supply which has been marked as AB in the figure. Thus, through
intervention, the Government can maintain any exchange rate in the economy. But it will be
accumulating more and more foreign exchange so long as this intervention goes on.
On the other hand if the government was to set an exchange rate at a level such as e 2, there

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would be an excess demand for dollars in the foreign exchange market. To meet this excess
demand for dollars, the government would have to withdraw dollars from its past holdings of
dollars. If it fails to do so, a black market for dollars may come up. From around 1870 to the
outbreak of the First World War in 1914, the prevailing system was the gold standard which
was the epitome of the fixed exchange rate system. All currencies were defined in terms of
gold; indeed some were actually made of gold. Exh participant countiy committed to
guarantee the free convertibility of its currency into gold at a fixed price. This also made it
possible for each currency to be convertible into all others at a fixed price. Exchange rates
were determined by its worth in terms of gold.
For example, if one unit of say currency A was worth one gram of gold, one unit of
currency B was worth two grams of gold, currency B would be worth twice as much as
currency A. Economic agents could directly convert one unit of currency B into two units of
currency A, without having to first buy gold and then sell it. The rates would fluctuate
between an upper and a lower limit. These limits being set by the costs of melting, shipping
and recoining between the two Curencies.
The question arose - would not a country lose all its stock of gold if it imported too much
(and had a BoP deficit)? The mercantilist explanation was that unless the stage intervened,
through tariffs or quotas or subsidies, on exports, a country would lose its gold and that was
considered one of the worst tragedies.
David Hume, a noted philosopher writing in 1752, refuted this view and pointed out that if
the stock of gold went down, all prices and costs would fall commensurately and no one in the
country would be worse off. Also, with cheaper goods at home, imports would fall and
exports rise The country from which we were importing and making payments in gold would
face an increase in prices and costs, so their now expensive exports would fall and their
imports of the first country’s now cheap goods would go up.
The equilibrium is stable and self-correcting, requiring no tariffs and state action. Thus,
fixed exchange rates were maintained by an automatic equilibrating mechanism.
Several crises causes the gold standard to break down periodically. The gold supply would
have to increase by 4 per cent per year to keep prices stable. With mines not producing this
much gold, price levels were falling all over the world in the late nineteenth century, giving
rise to social unrest. For a period, silver supplemented gold introducing ‘bimetallism’. Also,
fractional reserve banking helped to economise on gold. Paper currency was not entirely
backed by gold; typically countries held one-fourth gold against its paper currency.

VIII Assignment and project oriented questions, (carries 5 marks)

1. Name the curencies of any five countries of the following.
USA, UK, Germany, Japan, China, Argentina, UAE, Bangladesh, Russia.
Countries Currency

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1) U.S.A Dollar
2) U.K Pound Sterling
3) Germany Euro
4) Japan Yen
5) Chaina Renminbi
6) Arjantaina Peso
7) U.A.E Diram
8) Bangladesh Thaka
9) Russia Rubel

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Vedashreee, Lecturer in Economics Sadvidya P U College
II PUC Economics (22)
Model Question Paper - 2018
Time: 3-15 hours. Max Marks : 100
Total Questions: 49
Instructions:
1) Write the question Numbers legibly in the Margin
2) Answer for a question should be continuous.
PART-A
I. Choose the correct answers : (Each question carries 1 mark) 51=5
1. Which of the following is a Macro Economic variable?
a. Individual demand b. Aggregate Demand c. Firms output d. Price of a good
2. In perfect competition, buyers and sellers are
a. Price makers b. Price takers c. Price analysis d. None of the above
3. In 1936 British economist J.M. Keynes published his celebrated book.
a. Wealth of nations
b. General theory of employment interest and Money.
c. Theory of Interest d. Theory of Employment
4. The value of GDP the current prevailing prices is
a. Real GDP b. GDP at Factor cost c. Nominal GDP d. NDP
5. The rate at which the RBI lends money to commercial banks against securities
a. Bank rate b. Repo rate c. Reverse Repo rate d. None of the above

II. Fill in the blanks (each question carries 1 mark) 5x1=5

6. _____________is a tax that the government imposes per unit sale of output
7. ___________is determined at the point where the demand for labour and supply of labour
curves intersect.
8. A part of the revenue is paid out as____________for the service rendered by land.
9. Savings is that part of income that is___________
10. Financial year runs from_________to________in India.

III. Match the following (Total 5 marks) 5x1=5

11. A B
1. Complimentary goods a. Trade in goods and service
2. CRS b. intermediate good
3. Raw material c. Operation of invisible hand.
4. Adamsmith d. Constant returns to scale
5. Balance of payment e. Pen and Ink

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Vedashreee, Lecturer in Economics Sadvidya P U College
IV. Answer the following questions in a word/sentence. (Each question carries 1 mark)
5x1=5
12. What is Market economy?
13. What does market supply curve show?
14. What do you mean by cardinal utility analysis?
15. Define Average Propensity to save (APS).
16. What do you mean by Duopoly?
PART - B
V. Answer the following any 9 questions in 4 sentences.
(Each question carries 2 marks) 9x2=18
17. Mention the types to returns to scale.
18. Write the meaning of opportunity cost with an example.
19. Distinguish between excess demand and excess supply.
20. State the relationship between marginal revenue and price elasticity of demand.
21. Distinguish between consumer goods of capital goods.
22. What are the four factors of production? Mention their rewards.
23. Mention any two functions of money.
24. Write the meaning of excess demand and deficient demand.
25. Write the features of Monoply.
26. Give the meaning of paradox of thrift.
27. Distinguish between surplus budget and deficit budget.
28. What is foreign exchange rate.
29. What is the difference between current account and capital account?
PART-C
VI. Answer the following any 8 questions in about 12 sentences.
(Each question carries 4 marks) 8x4=32
30. Briefly explain the central problems of an economy.
31. Explain the indifference map with a diagram.
32. Explain total, production, average production and marginal production with the examples.
33. The following table gives the TP schedule of labour. Find the corresponding average product
and marginal product schedules.
TPL 0 1 35 50 40 48
L 0 1 2 3 4 5
34. Write the short note on profitmaximisation of a firm under the following conditions.
a) P = MC
b) MC must be none decreasing at q0.
35. Explain the average revenue or price line of a firm under perfect competition with the help of
a diagram.
36. Briefly explained what way Macro Economics is different from Micro Economics.
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Vedashreee, Lecturer in Economics Sadvidya P U College
37. Explain the circular flow of income of an economy.
38. Write a note on balance of payment.
39. Briefly explain the functions of RBI.
40. Briefly explain consumption function.
PART-D
VII. Answer the following any 4 questions in about 20 sentence.
(Each question carries 6 marks) 4x6=24
41. Explain the law of Diminishing Marginal Utility with the help of a table and Diagram.
42. Explain the simultaneous shifts demand and supply curve in perfect competition with the help
of diagram.
43. The market demand curve for a commodity and the total cost for a monopoly firm producing
the commodity is given by the schedules below. Use the information to calculate the
following:
Quantity 0 1 2 3 4 5 6 7 8
Price 52 44 37 31 26 22 19 16 13
a) The MR & MC schedules.
b) The quantity for which the MR & MC are equal.
c) The equilibrium quantity of output and the equilibrium price of the commodity.
d) The total revenue, Total cost and Total profit in equilibrium.
44. Briefly explain the expenditure method of measuring GDR
45. Write the story of Gold Smith Lala on the process of deposit and loan (credit) condition by
commercial banks.
46. The fiscal, deficit gives borrowing requirements of die government Elucidate.
PART-E
VIII. Answer any two of the following Assignment and project oriented questions
(each question carries 5 marks) 2x5=10
47. A Consumer wants to consume two goods. The price of Bananas is Rs. 4 and the price of
Mangoes is Rs. 5. The consumer income is Rs. 20.
a) How much Bananas can she consumes if she spend her entire income on that good?
b) How much mangoes can she consumes if she spend her entire income on that good?
c) Is the slope of budget line downward or upward?
d) Are the bundles on the budget line equal to the consumer’s income or not?
e) If you want to have more of Bananas you have to give up Man goes. Is it true?
48. Write a short note on demonetisation.
49. Name the currencies of any five countries of the following.
U S A, UK, Germany, Japan, China, Argentina, U AE, Bangladesh, Russia

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