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ASSIGNMENT SOLUTIONS GUIDE (2018-2019)

E.E.C.-11
Fundamentals of Economics
Disclaimer/Special Note: These are just the sample of the Answers/Solutions to some of the Questions given in the
Assignments. These Sample Answers/Solutions are prepared by Private Teacher/Tutors/Authors for the help and guidance
of the student to get an idea of how he/she can answer the Questions given the Assignments. We do not claim 100%

m
accuracy of these sample answers as these are based on the knowledge and capability of Private Teacher/Tutor. Sample

o
answers may be seen as the Guide/Help for the reference to prepare the answers of the Questions given in the assignment.
As these solutions and answers are prepared by the private Teacher/Tutor so the chances of error or mistake cannot be

c
denied. Any Omission or Error is highly regretted though every care has been taken while preparing these Sample Answers/

.
Solutions. Please consult your own Teacher/Tutor before you prepare a Particular Answer and for up-to-date and exact

t
information, data and solution. Student should must read and refer the official study material provided by the university.

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SECTION-A

i n
a
Long Answer Questions. (Answer in about 500 words each)

d
Q. 1. (a) How does equilibrium level of income is determined? Which factors do changes in the national

a
income?

m e
Ans. Our economy consists of two kinds of spending units, viz., households and firms. The economy produces

y e R
two kinds of commodities and services, i.e., consumer goods and services and investment goods. Consumer
goods and services are sold by firms to the households and investment goods are sold by their producers to other

d
firms. Aggregate spending or demand is, therefore, determined by consumption spending and private investment

i n s
spending. For the time being, we assume that there is no government and no foreign trade in the economy. If

ul k
production or aggregate supply equals aggregate demand we would be able to get equilibrium level of income. We

t n o
have to specify the consumption behaviour of households and investment behaviour of business firms. We will take

O o
s
aggregate supply as being given. At a point where aggregate supply equals aggregate demand, an equilibrium level
of income will be determined.
r - b
.e fo E
Changes in aggregate demand affect the equilibrium level of national income directly. For instance, an increase
in aggregate demand will raise it and a decrease will lead to a fall in the point of equilibrium. This aggregate demand

b d
we
is affected by its components (autonomous investment, government consumption expenditure and export expenditure).

u an
Investment Multiplier: To show the effect of an increase in AD, we assume the autonomous investment with

H
an increase from Rs.150 crore to Rs. 300 crore. The aggregate demand goes up.

w Th
let Y = C+I
so that ∆Y = ∆C + ∆I

w
or, K = ∆Y/∆Y–∆C
i.e., ∆I = ∆Y – ∆c
or, K = ∆Y/∆Y
(dividing both the numerator and denominator by ∆Y)
∆Y/∆Y–∆c/∆Y
Or, K = 1/1–MPC
Or, K = 1/MPS
(Since MPC + MPS = 1, 1–MPC = MPS)

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Y
Y = C + S (AS)
7

5 E (AD 1)
C1 + I1
(AD')
C1 + I
3 C
E
1.02
1 C
.8 45°

m
X
O 1 3 5 7

o
Fig. 1

c
The AD curve shall shift from C1 + I to C1 + I1 because of the increase in investment. This will lead to a shift in

.
the equilibrium from E to E1 and consequently the income shall rise from Rs.5000 crore to 6000 crore.

t
Thus, K = 1000/200 = 5.
There is a relationship between investment multiplier K and MPS or MPC, as K = ∆Y/∆I, where

is high, the value of multiplier will also be high. For example,

a r d
Let MPC = 0.25, K = 1.33 and if MPC = 0.5, K = 2. Also, MPS = 1–MPC. Thus, K = 1/MPS. This means \,i
g
K = multiplier, ∆ = change in income, ∆I = change in investment. We know that K = 1/ (1–MPC). If the value of MPC
n
a
m
higher the MPS, lower shall be the value of K. for example, if MPS = 0.25, K = 4 and if MPS = 0.5, K = 2.

Re
We can also derive K with the help of NY variables. As Y = C + I, where C is consumption expenditure, I is

y
investment expenditure and Y is NY ( if we assume government and rest of the world transactions to be absent). Here

e
d
consumption depends on income. Thus, there exists a direct relationship between C and Y. we may say C = cY, where

n
i ks
c = MPC and thus, Y = cY + I, where I is constant at any level of Y.

u l
Thus, Y–cY = I

t n o
or, Y(I–c) = I

O o
s
and Y = I/1–c ...(i)

b
when investment expenditure rises by ∆1 the income will rise by ∆Y. when we put ∆I and ∆Y in eqn. …(i), we

r -
.e
o
get,

f E
b d
we
1

n
Y + ∆Y = 1– c (1 + ∆I)
u a
H
w Th
1 1
= 1– c I + 1– c ∆I

w
1
By definition Y = 1– c I ,

therefore, Y gets cancelled with

1 1
I and we are left with ∆Y = I
1– c 1– c

∆Y 1
or, = 1– c = K
∆I

Government Expenditure Multiplier

Government expenditure multiplier is equal to ∆Y / ∆G. it is derived as follows;

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Y = C+I+G ... (i)

C = cY
Substituting C = cY in (i) we get,
Y = cY + I + G
or, Y – cY = I+G
or, Y (1–c) = I+G
or, Y = 1/1–c (I+G) ...(ii)
Increasing G by ∆G we get,
Y + ∆Y = 1/1–c (I + G + ∆G) ...(iii)
or, Y + ∆Y = 1/1–c (I + G) + 1∆G/1–c

m
or,1/1–c (I + G) + ∆Y = 1/1–c (I + G) + 1∆G/1–c

o
1
∆Y = (∆G)
1– c

Or,
∆Y
∆I
= 1– c
1

t . c
r g
We can see that investment multiplier is equal to government expenditure multiplier.

i n
a
Tax Multiplier

d
Tax is levied on the income earned by the people. Tax can either be imposed on a lump sum basis or on the basis

a
of a percentage of income. If we say, t = 0.15. this means that 15% of the income will be taxed and thus, the tax

m e
revenue shall be tY. After tax is levied, the disposable income in the hands of the people shall be Y–T, where T is the

y e R
lump sum tax imposed on the income, which can either be consumed or saved. Here, consumption expenditure shall
be defined as:

d
C = c(Y–T)

i n s
u
Where, c = Marginal Propensity to Consume

l
Tax Multiplier = ∆Y/∆T
k
t n o
where, ∆T is the change in income as a result of change in Tax (∆T).

O o
s
Balanced Budget Multiplier

r - b
Balanced budget multiplier can be equated to 1 if ∆G and ∆T, the increment in government expenditure and the

.e fo E
lump sum tax respectively are equal. Symbolically,
∆G = ∆T and,

b d
we u an
Y = C+I+G ...(i)
and C = c( Y – T )

H
w Th
Substituting the value of C = c( Y – T ) in (i) we get
Y = c(Y – T) + I + G
or, Y = cY – cT + I + G

w
or, Y – cY = –cT + I + G
or, Y (1–c) = –cT + I + G
1
or, Y = [–cT + I + G] ...(ii)
1– c
By increasing G to ∆G and T to ∆T as ∆G = ∆T. We get,
1
Y + ∆Y = [–c(T + ∆T) + I + G + ∆G]
1– c
1
or, Y + ∆Y = [–cT–c∆T + I + G + ∆G]
1– c

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1
or, Y + ∆Y =
1– c

c∆T ∆G
[–cT + I + G ] – +
1– c 1– c
Since, ∆T = ∆G.
According to equation (ii),
1
Y = [–cT + I + G]
1– c
1
we cancel Y on the left side with

m
1– c
[–cT + I + G] in the right side

o
c∆T ∆G
We get, ∆Y = – +

c
1– c 1– c

.
∆G ( – c – 2 )
∆Y =

t
1– c
∆G ( – c – 2 )

r g
=

n
1– c

i
a
∆Y 1

d
or, = =1 ...(iii)
∆G 1– c

a
m
This is called balanced budget multiplier. It implies that in case the government expenditure and the lump sum

Re
tax are increased at an equal amount, the national income shall also increase by the same amount. In case, the

y
government expenditure is increased but the lump sum tax is either not increased, or increased at a lower rate, the

e
d
national income shall increase more than the government expenditure.
Export Multiplier
n
i ks
u l
As we know that imports are increasing function of national income and exports are determined exogenously.

t n o
The import function is defined as M = mY and the export multiplier as ∆Y/∆E, where, ∆Y is the change in income

O o
s
and ∆E is the change in exports.
(b) Given Y= C + I + G,
r - b
C = C0 + b Y

.e
o E
I = I0 and G = G0 where C0 = 135,

f
(i) Find the equation for the equilibrium level of income in the reduced form

b d
(ii) Solve for the equilibrium level of income.

we u a n
Ans. Given y = C+I+G ...(i)

H
and c = Co + by

w Th
Putting the value of C in eqn. (i)
y = Co + by + I + G

w
y – by = Co + I + G
y (1 – b) = Co + I + G
Putting I = IO and G = GO
y (1 – b) = Co + Io + Go
1
y = 1 − b (Co + Io + Go) [ The reduced form
Putting Co = 135 and
1
y = 1 − b (135 + Io + Go)
135
y = 1 − b Ans.

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Q. 2. (a) Distinguish between price elasticity of demand and cross elasticity of demand. Explain with
examples the importance of the concept of elasticity of demand.
Ans. Price Elasticity of Demand: The price elasticity of demand measures a magnitude of change in quantity
demanded of a good due to change in its price. It is the degree of responsiveness of demand for the commodity to a
change in its price. By measuring price elasticity of demand, we come to know whether the demand for a commodity
is unitary elastic, greater than unitary elastic or less than unitary elastic.
When the demand is unitary elastic, a proportionate change in price causes an equal and proportionate change in
demand. For example, a 10% change in price will cause a 10% change in demand. The demand curve in such a case
will be a rectangular hyperbola.
When the demand is less than unitary elastic, a proportionate change in price, causes a less than proportionate
change in demand. For example, a 10% change in price will cause less than 10%, say 8% change in demand.

m
When the demand is more than unitary elastic, a proportionate change in price, causes a more than proportionate

o
change in demand. For example, a 10% change in price will cause more than 10%, say 12% change in demand.
Price elasticity of demand is measured as:

c
PED = (∆Q1/Q1) /(∆P1/P1)

.
Where, PED = elasticity of good one with respect to its own price;

t
∆Q1 = change in demand for X1;

r g
Q1 = original quantity demanded for X1;
∆P1 = change in own price of good one;

i n
a d
P 1 = original price of good one.

a
Cross Elasticity of Demand

m e
Cross elasticity of demand can be defined as the degree of responsiveness of demand of a commodity with

y e R
respect to change in price of another commodity, ceteris paribus. This concept explains the relationship between the
price of one commodity and the quantity demanded of another "related" commodity. It can be measured by the

d
formula;

i n s
u
l
Exy =percentage change in quantity demanded of commodity X

k
t n o
Percentage change in price of commodity Y:
The value of cross elasticity of demand helps us to determine whether the goods are substitutes or complementary.

O o
s
If the goods are substitutes, then the fall in price of one, causes are decrease in quantity demanded of another and

r - b
.e
vice-versa.

fo E
If the goods are complementary, the fall in rice of one, causes the increase in quantity demanded of another and

d
vice-versa.

b
we u an
In another words if the value of cross elasticity is positive, the goods are substitutes. If the value is negative, the
goods are complementary. If in a case, the value is zero, the goods are said to be independent of each other.

H
w Th
Importance of the Concept of Elasticity of Demand
The concept of elasticity of demand is important to any decision maker, be it a business firm, and economic

w
planner or a government policy-maker. A business requires the knowledge of direct price elasticity as well as cross
price elasticity in order to fix profit maximizing price of its product. Similarly, a government policy-maker requires the
knowledge of price elasticity as well as income elasticity to determine the tax structure. The economic planners are
required to estimate the income elasticity of demand for various goods to fix the output target during the planned
period.
(b) Given the demand function Q = 75 – 5P find the price elasticity of demand at P =3 and P=5.
Ans. After finding derivation of the demand function w.r.t. p, we get
∆Q
∆P = – 5 { Q = 500 – 5P)
Now when P = 3, Q = 60

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and when P = 5, Q = 50
Price elasticy of demand When P = 3
3
P.E.D. = – 5
60

because = P.E.D. = ( ∆ Q1 / Q 2 ) / ( ∆P1 / P1 )

⇒ P.E.D. = –0.25 Ans. {When p = 3}
and when P = 5
 5
P.E.D. = –  50 

m
P.E.D. = –0.5 Ans. {Where P = 5}

o
SECTION–B
Medium Answer Questions.

c
Q. 3. Explain with diagram the three stages of production. Why does law of diminishing returns operate?

.
Ans. Three Stages of Production: The three stages of production are characterized by the slope and shape of

t
the total product curve. The first stage is characterized by an increasingly positive slope, the second stage by a

r g
decreasingly positive slope and the third stage by a negative slope. Because the slope of the total product curve is

n
marginal product, these three stages are also seen with marginal product. The three stages of short-run production

i
a
are seen with the three product curves–total product, average product and marginal product.
Stage I

a d
Re m
Stage I arises due to increasing marginal returns. As more of the variable input is added to the fixed input, the

y
marginal product of the variable input increases. This is directly illustrated by the slope of the marginal product curve
and because marginal product is the slope of the total product curve, increasing marginal returns is also reflected in

e
d
total product. Figure 2 shows the three stages of production.

n
i ks
t
l
n o u
Stage 2
3
Stage 3

O o
s r b
2

-
Stage 1

.e
Total
fo E1

b d
output

we u a n Units of variable input

H
AP & MP 4 5

w Th
6

w
AP

O
MP Units of variable input
Fig. 2

Stage II
In Stage II, production is characterized by decreasing marginal returns. As more of the variable input is added to
the fixed input, the marginal product of the variable input decreases. Most important of all, Stage II is driven by the
law of diminishing marginal returns.
Stage III
Stage III is a results due to negative marginal returns of production. In this stage of short-run production, the law
of diminishing marginal returns causes marginal product to decrease so much that it becomes negative. Stage III
production is most obvious for the marginal product curve, but is also indicated by the total product curve:

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l The total product curve has a negative slope. It has passed its peak and is heading down.
l Marginal product is negative and the marginal product curve has a negative slope. The marginal product
curve has intersected the horizontal axis and is moving down.
l Average product remains positive but the average product curve has a negative slope.
Why Law of Diminishing Returns Operates?
Law of diminishing returns states that if one factor of production is increased while the others remain constant,
the overall returns will relatively decrease after a certain point. Thus, for example, if more and more labourers are
added to harvest a wheat field, at some point each additional labourer will add relatively less output than his predecessor
did, simply because he has less and less of the fixed amount of land to work with. The principle, first thought to
apply only to agriculture, was later accepted as an economic law underlying all productive enterprise. This concept
is shown in the table 1.

m
Table 1: Diminishing average

o
and Marginal products
Output TP AP MP

. c
1 12 12 –

t
2 26 13 14

r g
3 42 14 16

n
4 60 15 18

i
a
5 46 9.2 14
6 36 6 10

a d
m
7 36 5.14 0
8 34
e 4.25 –2

y e R
Q. 4. Distinguish between demand pull inflation and cost push inflation. Explain with the help of

d
Phillips curve the trade off between the inflation rate and unemployment rate.

n s
Ans. Anti-inflationary Policies: Inflation, if not controlled, can pose a great threat to any economy. Thus, anti

i
l
u k
inflationary measures are indispensible. To find the cure, the causes of the disease must be removed. The reason for

t n o
inflation is either excess of demand, or shortage of supply. If these reasons are either removed or made good for,

O o
inflation shall become controllable.

s r - b AS1

.e
AS 2

fo E
b d
E2

we u an
P1

H
E3 E1 AD1

w Th
P2

AD2

w 0 Y3 Y2

Fig. 3
Y1 Income level

1. Demand-pull Inflation: Excess of demand can create inflationary pressures. This happens due to the increase
in the disposable income with the people. Government, either by decreasing the money supply, or by increasing the
taxes or giving extra incentives on savings, may help in controlling excess demand. Thus, reducing or eliminating the
reasons of increase in demand is possible.

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2. Cost-push Inflation: In case of decrease in the aggregate supply, the government may, by increasing sale
support system (subsidies, etc.,) or decreasing sales tax and excise duties, help reducing the shortage of supply. In
case of natural calamities like floods or draughts, it may allow buffer stock, in order to meet the deficit in supply.
Public distribution system can also help in meeting the shortage of supply.
Deflation
A situation of consistence and persistent fall in prices of goods and services is known as deflation. It is exactly the
opposite of inflation. It is, however, worse in consequences. The great depression in the late 1920s in capitalist
countries is a practical example of deflation.
Stagflation

m
Inflation, accompanied by Stagnation in the economy, is known as stagflation. In this situation, slow growth can be
experienced in the economy. The labour unions are powerful and may bargain for higher wages leading to unproductivity.

o
Usually, a small degree of inflation leads to the development in the economy, but, the advanced economies may

c
show slow growth on account of the maturing of the economy. In case of developing economies, this happens when

.
the aggregate demand rises at a fast rate due to the increased government expenditure and rise in the credit money.

t
The organised labour sector demands a hike in wages leading to a combination of cost-push and demand-pull inflation.

r g
Inflation and Unemployment: the Phillips Curve

n
A.W Phillips defsined a relationship between wage inflation and unemployment. According to him, the rate of

i
a
unemployment and wage inflation is inversely related. There is a positive relationship between the rate of inflation and

d
wage inflation. However, unemployment has an inverse relationship with inflation. This is because, the rise in the

a
Re m
prices of labour (wages) leads to a fall in demand, that is, unemployment. This can symbolically be written as:

y
Wage rate ? Inflation rate
Wage rate ? (1/unemployment rate)

e
d
Therefore: inflation rate ? (1/unemployment rate)
Where, ? = Sign of proportionality
n
i ks
u l
Phillips curve is a downward sloping curve. The X-axis represents unemployment rate and the Y-axis represents

t n o
the inflation rate. This shows that government policies may affect unemployment by accepting a change in the

O o
s
inflation rate.

r - b
.e fo E
b d
we u a n
P1

H
w Th
P2

w 0 U1 U2

Fig. 3
Unemployment Rate

Q. 5. Why do monopolies emerge? Do you agree that a monopolist is not free to determine both price and
quantity to be sold as per his whims and fancy? Give reasons.
Ans. Monopoly is a market situation in which only a single seller or producer supplies a commodity or a service.
The word monopoly is derived from two Greek words, mono which means single, and polein which means seller. In
this type of situation, there are no substitutes for the product or service sold and no serious threat of the entry of a
competitor into the market. This enables the seller to control the price.

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Monopoly is an industry in which there is one seller. Because it is the only seller, the monopolist faces a
downward-sloping demand curve, the industry demand curve. The downward sloping demand curve means that if the
monopolist wants to sell more, it must lower its price.
Causes of Monopoly
There may be different causes for the origin of monopoly power. The factors responsible for the emergence of
monopoly power are as follows:
(1) The firm having full control over the localized raw materials or minerals. (2) Technological capabilities that
allow a single firm to produce at reasonable prices all the output of a particular commodity or service, a situation
sometimes described as a “natural” monopoly; (3) Exclusive control over a patent on a product or on the processes
used to produce the product; and (4) A government franchise that awards a company the sole right to produce a

m
commodity or service in a given area. (5) Certain industry requires heavy investment. Such a condition will restrict
the number of producers which decreases the possibility of entry of new firms.(6) Public monopolies are formed in

o
order to safeguard the interest of public and to prevent them from exploitation for ex-railways.
A monopolist can take market demand curve as its own demand curve. Though, the firm is a price maker, the

. c
monopolist cannot charge a price in the market that a consumer cannot pay. In this way, the price elasticity of the

t
demand curve constraint on the pricing power of the monopolist.
Q. 6. Why does trade take place between the two countries? Explain Heckscher-Ohlin approach in this

r g
regard.

i n
a
Ans. Heckscher-Ohlin Approach

d
Another question arises as to why countries trade in different ways. The solution to this question has been

a
analysed by Heckscher and Ohlin. According to them specialization is also a factor worth consideration. The

m e
shortcomings of Ricardo's theory have been addressed in this approach. Certain considerations are:

y e R
(i) It is not only the labour cost differentials that determine trade.
(ii) The direction of specialisation is determined by the endowments of different resources processed by the

d
trading countries.

i n s
u
(iii) The countries need not to be of the same size.

l k
t
(iv) They need not have similar patterns of consumption, either intermediate or final.

n o
(v) Full specialization need not to be achieved through trade alone.

O o
s
The assumption of this theory is that different countries have different endowments. Every country uses up its

r - b
available resources in a way that it gain maximum efficiency. No matter that the level of technology used is same to

.e fo E
define their mode of production. Thus, we can say that a country employs labour intensive and capital intensive
techniques depending upon its human resource and technological advancements.

b d
we
The above theory is different from Ricardo's theory. However, both of them explain 'why trade takes place' and

u an
the comparative cost. The theory given by Ricardo is not wrong but unsophisticated. The unit of measurement of

H
cost, given by Ricardo is, however, not correct.

w Th
Q. 7. What do you understand by externalities? Explain the Piguobian method and Coase method for
dealing with externalities.

w
Ans.Externalities: Externalities means 'outside'. Externalities are common almost in every area of economic
activity. They are defined as the third party or other agent that effects the production and/or the consumption of goods
and services either positively or negatively.
A positive externality is something that benefits society, but the producer cannot fully gain profit from this situation.
A negative externality is something that costs the producer nothing, but is costly to society in general.
There are standard examples given to illustrate both types of externalities. Pollution is a typical case of negative
externality. Factories along rivers dump lots of harmful waste into the river. This is a terrible cost to people downriver
because, as everyone knows, industrial waste stinks to high heaven.
A positive externality will arise when some of the benefits of an activity are reaped by those not directly involved.
A typical example would be growing a fence or planting some trees around the house. It will benefit the others who
are living nearby; they will have a nicer view and also a healthier environment.

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The other example of externalities is smoking, pollution and littering etc., government has made it illegal to smoke
in the residential or public area. It has poor impact on the health of all human beings as well as animals.
Ways of Coping with Externalities: There are two ways of coping with the problem relating to externalities.
According to one there should not any type of abandoning of existing work in the market but there should be
functioning with that. The other way is using the traditional ways.
The traditional ways are taxing and subsidies.
The British economist has given the solution to cope with these externalities.
Charging tax for a non-market activity that generates negative externalities is a solution to deal with negative
externalities. Factories that are throwing their waste in rivers, big noise pollution are examples of negative externalities.
A Pigovian tax equal to the negative externality is thought to correct the market outcome.

m
In the presence of positive externalities, i.e., public benefits from a market activity; for example vaccination and

o
other health programmes should get subsidies is suggested to correct the market. This increases the market activity.
Hence, if there are externalities in the market a Pareto optimum can't be attained even if there is perfect competition.

c
There must be an assessment of social and private cost on one side and social and private benefit on the other side. If

.
there is presence of externalities social benefit or cost is a combination of private and external benefit or cost. The

t
derivation of relationship is:

r g
MPC = Marginal private cost

i n
a
MEC = Marginal external cost

d
MSC = Marginal social cost

a
Then MSC = MPC + MEC

Re m
Also,

y
MPB = Marginal private benefit
MEB = Marginal external benefit

e
d
MSB = Marginal social benefit

n
i ks
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Then, MSB = MPB + MEB

l
t
For efficiency there should be MSC = MSB for each product. Production should be continued as long as
MSB.MSC.
n o
O o
s
Externalities do not require abandoning all the time but it needs to be treated some other way.

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Ronald Coase refers it in a way that when one considers opportunity cost in its full meaning, no such devices

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are necessary, persons should internalize these externalities themselves through negotiation and then the result will
be best.

b d
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Coase gives a general analysis of externalities, there need not the role of government, private institutions should

u a n
bargain themselves and solve the problems of externalities. He makes three fundamental points. First, externalities

H
are reciprocal. Second, externalities persist only if transactions costs are high. The third is that if transactions costs

w Th
are low, market processes will lead to the same efficient outcomes, irrespective of the assignment of property rights.
SECTION – C

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Short Answer Questions.
Q. 8. Distinguish between any three of the following:
(ii) Multiplier and Accelerator.
Ans. The multiplier and the accelerator are parallel concepts. Multiplier shows the effect of a change in investment
on income and employment whereas accelerator shows the effects of a change in consumption on investment. In
other words, in the case of multiplier, consumption is dependent upon investment, whereas in the case of accelerator
investment is dependent upon consumption. The multiplier concept may be used to show how the use of fiscal policy
to combat unemployment can be very effective. Expansionary fiscal policy may involve an increase in government
expenditure. That will have the effect of shifting the AD curve to the right. Part of the Keynesian argument concerning
the effectiveness of such a policy relates to the multiplier effect. The accelerator principle indicates how changes in
the level of current income will have an accelerated impact on the level of investment and is therefore one explanation
of economic instability and the upward and downward swings of the trade cycle.

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(iii) Positive and normative economics.

Ans. The distinction between positive economics and normative economics may seem simple, but it is not always
easy to differentiate between the two. Positive economics is objective and fact based, while normative economics is
subjective and value based. Positive economic statements must be able to be tested and proved or disproved. Normative
economic statements are opinion based, so they cannot be proved or disproved. In fact, many widely accepted
statements that people hold as fact are actually value based. For example, the statement, "government should provide
basic healthcare to all citizens" is a normative economic statement. There is no way to prove whether government
"should" provide healthcare; this statement is based on opinions about the role of government in individuals' lives, the
importance of healthcare, and who should pay for it. The statement, "government-provided healthcare increases
public expenditures" is a positive economic statement, as it can be proved or disproved by examining healthcare
spending data in countries like Canada and Britain, where the government provides healthcare.
(iv) Direct tax and Indirect tax.

m
Ans. Direct and indirect taxes are levied by the central and state government. Tax is an involuntary fee imposed

o
and collected by the government to pay for the goods and services it provides including schools, infrastructure, law
enforcement and military production. Direct Taxes, as the name suggests, are taxes that are directly paid to the

c
government by the taxpayer. It is a tax applied on individuals and organizations directly by the government e.g. income

.
tax, corporation tax, wealth tax etc. Indirect Taxes are applied on the manufacture or sale of goods and services.

t
These are initially paid to the government by an intermediary, who then adds the amount of the tax paid to the value

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of the goods / services and passes on the total amount to the end user. Examples of these are sales tax, service tax,

n
excise duty etc.

i
a
Q. 9. Write short note on any three of the following:

d
(i) Consumer’s surplus

a
Ans. Consumer’s Surplus Prof. Marshall defined consumer surplus as "The excess of price which a consumer

m e
will be willing to pay rather than go without the thing (commodity), over that which we actually does pay is the

y e R
economic measure of this surplus satisfaction". Match box, newspapers and salt are some of the commodities for
which consumers are ready to pay more than what they actually pay. From these commodities consumers derive a

d
sort of surplus or extra satisfaction. This is called consumer surplus. Thus, we can say, consumer surplus is the

i n s
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difference between what the consumer is willing to pay and what the consumer actually pays.

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Figure 5 shows consumer's surplus. Dx is the demand curve, showing the maximum price per unit of X that the

t n o
consumer is willing to pay. The area under the demand curve Dx until the point Q* (that is OAN*Q*) is the area

O o
s
showing what he is willing to pay. The market price is OP*, so he actually pays OP*N*Q*. Thus the difference, that

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is, the area AP*N* is the consumer surplus.

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A

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Price

N*

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P*

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O O*
Quantity

(ii) Homogeneous production function

Ans. There are two special classes of production functions.The production function Q = f (X1,X2) is said to be
homogeneous of degree n.When n > 1, the function exhibits increasing returns, and decreasing returns when n < 1.
When it is homogeneous of degree 1, it exhibits constant returns.

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A
Capital
B2
B1

B 300
200
100

O Fig. 6 Labour

m
In the figure 6, parallel Iso-product curves are drawn. The highest Iso-prduct curve represents a higher level of
output. A ray (OA) through the origin cuts the Iso-prduct curves at B, B1 and B2 is known as the scale line or

o
expansion path of output.
(iii) Stagflation

. c
Ans. Stagflation: Inflation, accompanied by Stagnation in the economy, is known as stagflation. In this situation,
slow growth can be experienced in the economy. The labour unions are powerful and may bargain for higher wages

t
leading to unproductivity.

r g
Usually, a small degree of inflation leads to the development in the economy, but, the advanced economies may

i n
a
show slow growth on account of the maturing of the economy. In case of developing economies, this happens when

d
the aggregate demand rises at a fast rate due to the increased government expenditure and rise in the credit money.

a
The organised labour sector demands a hike in wages leading to a combination of cost-push and demand-pull inflation.

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