IGNOU Solved Question Papers: EEC - 11 (December' 2013)

Term-End Examination December, 2013
Time : 3 hours Maximum Marks : 100
Note : Answer questions from all sections as per instructions.
Attempt any two questions from this section in about 500 words each. 2x20=40
1. Define an indifference curve. What are its properties ? Explain and state clearly the conditions of consumer's equilibrium with the help of indifference curves.
Ans: Refer Below
2. What is a consumption function ? State the level of consumption the factors that determine in an economy. Also bring out the relationship between APC and APS.
3. What do you understand by balance of payments ? What are the components of a balance of payments account ?
Ans: Refer Above
4. Explain different forms of market. How does a perfectly competitive firm achieve short – term equilibrium ? Will the firm invariably earn maximum profit in such a situation ? 

Attempt any four questions from this section in about 300 words each. 4x12=4f
5. Bring out the relationship between Average Cost and Marginal Cost. Can average cost be rising while marginal cost falls ?
6. What are three stages of production ? Explain in brief the reasons for operation of the law of diminishing marginal returns.
Ans: Three Stages of Production
A graphic description of the production function is shown in following figure 4.1. The total, marginal and average product curves in Figure 4.1, demonstrates the law of variable proportions. The figure also shows three stages of production associated with law of variable proportions. The total product curve is divided into three segments popularly known as three stages of production, which are as follows:
Stage I: The figure 4.1 shows stage 1 as the segment from the origin to pointX2. Here, total product (TP) rises at an increasing rate. At this point, the marginal product (MP) of X equals its average product (AP). X2 is, also the point at which the average product is maximised. In this stage, the production function is characterised first by increasing marginal returns from the origin to point X1and then by diminishing marginal returns, from X1to X2. It should not be assumed that in stage 1, only increasing marginal returns take place. Because increasing returns may occur until a certain point, and thereafter diminishing returns may take place. Stage I should not therefore be identified with increasing marginal returns only. Here, both AP and MP increase. In this stage, a firm can move towards optimum combination of factors of production and increasing returns, by adding more and more variable units to fixed factors.
Stage II: The stage II is depicted by the figure in the range from X2 to X3. In other words, stage II begins where the average product of the variable factor is maximised. It continues till the point at which total product is maximised and marginal product is zero. Here, TP rises at diminishing rate. This stage is thus, called the stage of diminishing returns, where a firm decides its level of production.
Stage III : Finally, we have stage III, which is depicted by the area beyond X3 where the total product curve starts decreasing. Here, too much variable input is being used as related to the available fixed inputs and thus variable inputs' are overutilized. The efficiency of both variable inputs and fixed inputs decline throughout this stage. In this range, the marginal product of the variable factor is negative. It starts from the point where MP is nil and TP is maximum and covers the whole range of negative marginal productivity. The following Table 4.2 shows the various stages.
7. Distinguish between transfer earnings and actual earnings. Under what conditions the difference between the two will be the maximum ?
8. What do you mean by demand for money ? State in brief the Keynesian theory of demand for money.
Ans: Refer above Keynes demand for money
9. What do you mean by gains from trade ? How are these measured ?
10. Is discriminating monopoly bad ? Explain fully giving reasons.
11. Describe the wireman - peacock hypothesis about increase in public expenditure over time.
Attempt both the questions of this section. 2x6=12
12. Clarify any two of the following concepts :
(a) Externalities
(b) Methods employed in measuring output in registered manufacturing sector
(c) Keynesian Inflationary Gap
(d) Relationship between GNPmp and NDPFc
13. Distinguish between any two of the following :
(a) Real and nominal rates of interest
(b) Value of output and value added
(c) Real flows of income and money flows of income.

Term-End Examination June, 2014
Time : 3 hours Maximum Marks : 100 (Weightage 70%)
Note : The paper contains three Sections A, B and C. Attempt the questions as per instructions given in each section.
Attempt any two questions from this section in about 500 words each. 2x20=40
1. Define an indifference curve. What are the important properties of indifference curves ? Explain consumer's equilibrium with the help of indifference curves. 2+8+10=20
Ans. Meaning and Indifference Curve : The technique of indifference curve was introduced as an alternative approach to the utility analysis to explain consumer’s behaviour. Indifference curve approach is based on the concept of scale of preferences, which means that a consumer can conveniently arrange the various combination of two or more goods available to him in order of his preferences. An indifference curve is a curve on which all combinations of two commodities give a consumer equal satisfaction. The consumer therefore, becomes indifferent among that combination.
Properties of Indifference curve : - There are three main properties of indifference curves, these are as follows:
(i) Indifference curves always slope down wards from left to right. Indifference curve indicates that if a consumer wants to have more quantity of X he will have to be contended with lesser quantity of Y in order to derive the same level of satisfaction.
(ii) Indifference curve can never cut each other. The reasoning behind this assumption is that:
(a) Each indifference curve represent a different level of satisfaction, and
(b) each point on an indifference curve gives a level of equal satisfaction.
(iii) Indifference curves are always convex towards the origin. The convexity of indifference curves represents the diminishing marginal rate of substitution between two goods. By diminishing marginal rate of substitution we mean that the consumer will initially offer larger quantity of commodity Y for an additional quantity of another commodity X. But at a later stage, be will offer lesser units of Y for the additional units of commodity X. As a result indifference curves will be convex to the origin point.
There are two conditions for consumer’s equilibrium:
(1) The Budget Line should be Tangent to the Indifference Curve: Given these assumptions, the first condition for consumer’s equilibrium is that his budget line should be tangent to the highest possible indifference curve, as shown in Fig. 17. In Fig. 17, the consumer wants to be at I2 consumption curve but it is not possible because it is beyond the reach of his given income and prices of X and Y goods which is clear from the price-income (budget) line BL. He can consume them at both Q or S points of I curve but none of these points is an optimum point. Such a point can be only one on his budget line BL and above the curve I. This is the point E where the BL line is tangent to the highest possible curve and the consumer gets maximum satisfaction by purchasing OX units of X and OY units of Y.
When the budget line is tangent to the indifference curve, it means that at the point of equilibrium, tire slope of the indifference curve and of the budget line should be equal: The slope of budget line = Px /Py
The slope of the indifference curve = MRSxy. Thus Px/Pr – MRSxy at point E in Fig. 17. This is a necessary but not a sufficient condition for consumer’s equilibrium.
Consumption Curve
(2) Indifference Curve should be Convex to the Origin: Therefore, the last condition is that at the point of equilibrium, the marginal rate of substitution of X for Y must be felling for equilibrium to be stable. It means that the indifference curve must be convex to the origin at the equilibrium point. If the indifference curve, I1, is concave to the origin at the point R, the MRSxy increases. The consumer is at the minimum point of satisfaction at R on Fig. 18.
Indifference Curve should be Convex to the Origin
A movement away from R toward either axis along PQ would lead him to a higher indifference curve. Point S on the curve I2is, in fact, the point of maximum satisfaction and of stable equilibrium.
2. State and explain the Law of Variable Proportions with the help of a diagram. Why do increasing returns to a factor obtain when the units employed keep increasing ? 12+8=20
3. Critically examine the quantity theory of money, making clear the distinction between Fisher's equation of exchange and cash balances approach. 20
Ans: Criticisms of the Theory: The Fisherian quantity theory has been subjected to severe criticisms by economists.
1. Truism: According to Keynes, “The quantity theory of money is a truism.” Fisher’s equation of exchange is a simple truism because it states that the total quantity of money (MV+M’V’) paid for goods and services must equal their value (PT). But it cannot be accepted today that a certain percentage change in the quantity of money leads to the same percentage change in the price level.
2. Other things not equal: The direct and proportionate relation between quantity of money and price level in Fisher’s equation is based on the assumption that “other things remain unchanged”. But in real life, V, V and T are not constant. Moreover, they are not independent of M, M’ and P. Rather, all elements in Fisher’s equation are interrelated and interdependent. For instance, a change in M may cause a change in V.
Consequently, the price level may change more in proportion to a change in the quantity of money. Similarly, a change in P may cause a change in M. Rise in the price level may necessitate the issue of more money.
3. Fails to Measure Value of Money: Fisher’s equation does not measure the purchasing power of money but only cash transactions, that is, the volume of business transactions of all kinds or what Fisher calls the volume of trade in the community during a year. But the purchasing power of money (or value of money) relates to transactions for the purchase of goods and services for consumption. Thus the quantity theory fails to measure the value of money.
4. Neglects Interest Rate: One of the main weaknesses of Fisher’s quantity theory of money is that it neglects the role of the rate of interest as one of the causative factors between money and prices. Fisher’s equation of exchange is related to an equilibrium situation in which rate of interest is independent of the quantity of money.
5. Unrealistic Assumptions: Keynes in his General Theory severely criticised the Fisherian quantity theory of money for its unrealistic assumptions. First, the quantity theory of money for its unrealistic assumptions. First, the quantity theory of money is unrealistic because it analyses the relation between M and P in the long run. Thus it neglects the short run factors which influence this relationship. Second, Fisher’s equation holds good under the assumption of full employment. But Keynes regards full employment as a special situation. The general situation is one of the under-employment equilibrium. Third, Keynes does not believe that the relationship between the quantity of money and the price level is direct and proportional.
Rather, it is an indirect one via the rate of interest and the level of output. According to Keynes, “So long as there is unemployment, output and employment will change in the same proportion as the quantity of money, and when there is full employment, prices will change in the same proportion as the quantity of money.” Thus Keynes integrated the theory of output with value theory and monetary theory and criticised Fisher for dividing economics “into two compartments with no doors and windows between the theory of value and theory of money and prices.”
6. Neglects Real Balance Effect: Don Patinkin has critcised Fisher for failure to make use of the real balance effect, that is, the real value of cash balances. A fall in the price level raises the real value of cash balances which leads to increased spending and hence to rise in income, output and employment in the economy. According to Patinkin, Fisher gives undue importance to the quantity of money and neglects the role of real money balances.
4. The principle of effective demand forms the basis of the Keynesian theory of employment. How is it determined ? Discuss its role in the determination of equilibrium level of income in an economy. 20
Ans: The principle of effective demand lies at the heart of Keynes’ general theory of employment. The dictum of the theory is that the volume of employment depends on the level of effective demand in an economy. A corollary, thus, may be drawn that unemployment is due to a deficiency of total demand (i.e., effective demand). Hence, Keynes’ employment theory may be described as the demand efficiency theory.
Broadly speaking, Keynes designated the term “effective demand” to denote ’the total demand of goods and services (both for consumption and investment) by the people in a community. In a money economy, thus, effective demand manifests itself in the spending of income or the flow of expenditure.
The flow of expenditure in turn determines the flow of income, as one man’s spending becomes the income of another. In real terms, the expenditure flow in a community consists of consumption expenditure and investment expenditure — expressing the total demand for goods and services. To meet such demand, people are employed either in producing consumption goods (consumption demand) or in producing capital goods (investment demand).
Employment increases only when the total demand either from the consumption side or from the investment side increases. A fundamental principle is that consumption increases with an increase in income, but less proportionately. As a result, there will be a widening gap between income and consumption; hence to sustain the flow of expenditure, the gap must be filled up by appropriate investment expenditure.
This means that the level of effective demand and resulting employment can be sustained only if investment demand increases with an increase in income. Thus a deficiency in effective demand is caused when investment inadequately fills up the gap between income and consumption.
This results in creating unemployment in the country’s economy. Hence, it may be concluded that in order to promote employment, effective demand should be increased by increasing investment in the economy. Since Keynes sought to explain the point of effective demand in a capitalist economy, free from government intervention, he considered consumption and investment expenditure of the community relating to private individuals and enterprises only.
But, in modern times, a capitalist economy is actually a mixed economy due to the government’s interference and the existence of public sector. Thus, government expenditure is also a significant determinant of effective demand in a modern economy.
Modem economists, therefore, define effective demand as:
Effective demand = С + I = G, where,
С = Consumption expenditure of the households.
I = Investment expenditure of private firms.
G = Government’s expenditure on consumption and investment goods.
It must, however, be noted that government expenditure is autonomous. Thus, it is the outcome of government’s value judgement and policies based on political and social considerations rather than on economic forces.

Answer any three questions from this section in about 250 words each. 3x10=30
5. (a) Distinguish between price elasticity of demand and income elasticity of demand. Can income elasticity of demand be negative ?
Ans: Difference between price elasticity and income elasticity of demand:
  1. The proportionate (percentage) change in quantity demanded of a product due to proportionate(percentage) change in its price is measured by the price elasticity of demand.
  2. The coefficient of Price Elasticity of demand is always negative due to inverse relation between price and quantities demanded (Though it is stated as a positive number).
  3. The coefficient of price elasticity shows different degrees of price elasticity like elastic, inelastic and unitary demand.
  1. Income Elasticity of demand is the proportionate (percentage) change in quantity demanded of a product as a result of proportionate (percentage) change in income of the consumer.
  2. The coefficient of income elasticity is positive for basic goods, comfort goods and luxuries due to direct relation with the income (It is negative only for inferior goods).
  3. The coefficient of income elasticity of demand is useful in categorizing the commodities into basic goods, comfort goods, luxuries and inferior goods.
2nd Part: Inferior goods have a negative income elasticity of demand - the quantity demanded for inferior goods falls as incomes rise. For example, the quantity demanded for generic food items tends to decrease during periods of increased incomes.
(b) A consumer buys 50 units of a good at a price 4 per unit. When its price falls by 25 per cent, its demand rises to 100 units. Find out price elasticity coefficient of demand. 5
6. Examine with the help of a graph the relationship between average variable cost, average cost and marginal cost.10
Ans: Relationship between AC, AVC and MC: The relationship between AC, AVC and MC can be better illustrated with the help of following schedule and diagram.
Output (units)
TVC (Rs.)
AC (Rs.)
AVC (in Rs.)
MC (in Rs.)
1. When MC is less than AC and AVC, both of them fall with increase in the output.
2. When MC becomes equal to AC and AVC, they become constant. MC curve cuts AC curve (at ‘A’) and AVC curve (at ‘B’) at their minimum points.
3. When MC is more than AC and AVC, both rises with increase in output.

7. A perfectly competitive firm is a price-taker firm. Who is the price-maker ? How does he work ? 10
Ans: By definition a perfectly competitive market is one in which no single firm has to influence either the equilibrium price of the market or the  total quantity supplied in the market. Thus, a firm operating in a competitive market has no incentive to supply at a price lower than market equilibrium price, as it can sell all it wants to supply at equilibrium. At the same time, the firm cannot sell at price higher than the market price, because it will be able find no buyers at that price, and its sales volume will drop down to zero. Thus, a firm operating in perfectly competitive market has to accept whatever is the market equilibrium price, and therefore it is called a price taker.
In contrast, a monopoly firm is the only supplier in the market and therefore has full control over the market prices and total market supplies. Therefore, a firm operating in a monopoly market fixes its price in such a way that for the quantity demanded by customers at that market price the marginal revenue of the firm is equal to its marginal costs. In this way it decides the market price as well as the total quantity if a commodity supplied in the market, and therefore it is called a price maker.
8. Define and explain briefly the different degrees of price discrimination. 10
Ans: Ans: Price Discrimination: Price discrimination, may be defined as the practice by a seller of charging different prices to the same buyer or to different buyers for the same commodity or service without corresponding difference in the cost. It is also known as differential pricing. Differences in rates are somewhat related to the in costs. For example, it may cost less to serve one class of customers than another to sell in large quantities than in smaller lots. Rates or prices are proportional to cost, some buyers will pay more and others less, but this will not take place in price discrimination. In such a situation, charging uniform price will amount to discrimination. There are three classes of price discrimination, which are as follows:
  1. First-degree discrimination: The seller charges, the same buyer a different price, for each unit bought. For example, prices that are determined by bargaining with individual customers or prices, which are quoted for tenders floated by government authorities.
  2. Second degree discrimination: The seller charges different prices for blocks of units, instead of, for individual units. For example, different rates charged by an electricity undertaking for light and fan, for domestic power and for industrial use.
  3. Third degree discrimination: The seller segregates buyers according to income, geographic location, individual tastes, kinds of uses for the product, etc. and charges different prices to each group or market despite of charging equivalent costs from them. If the demand elasticities among different buyers are unequal, it will be profitable for the seller to put the buyer into separate classes according to elasticity and thereby, to charge each class a different price. It is also referred as market segmentation and involves dividing the total market into homogeneous sub-groups according to some economic criterion, usually the demand elasticity.
9. Examine in brief the Loanable Fund theory of interest rate determination. 10
Ans: Ans: According to the Loanable Funds Theory of Interest, the rate of interest is calculated on the basis of demand and supply of loanable funds present in the capital market. The concept formulated by Knut Wicksell, the well-known Swedish economist, is among the most important economic theories.
The Loanable Funds Theory of Interest advocates that both savings and investments are responsible for the determination of the rates of interest in the long run. On the other hand, short-term interest rates are calculated on the basis of the financial conditions of a particular economy. The determination of the interest rates in case of the Loanable Funds Theory of the Rate of Interest, depends essentially on the availability of loan amounts. The availability of such loan amounts is based on certain factors like the net increase in currency deposits, the amount of savings made, willingness to enhance cash balances and opportunities for the formation of fresh capitals.
According to the loanable funds theory of interest the nominal rate of interest is determined by the interaction between the demand and supply of loanable funds. Keeping the same level of supply, an increase in the demand for loanable funds would lead to an increase in the interest rate and the vice versa is true. Conversely an increase in the supply of loanable funds would result in fall in the rate of interest. If both the demand and supply of the loanable funds change, the resultant interest rate would depend much on the magnitude and direction of movement of the demand and supply of the loanable funds.
Now, the demand for loanable funds is basically derived from the demand from the final goods and services. These final goods and services are again generated from the use of capital that is financed by the loanable funds. The demand for loanable funds is also generated from the government.
Answer all questions in this section as indicated. 2x15=30
10. Explain any three of the following concepts : 3x5=15
(i) Inferior goods
Ans: An inferior good is a type of good whose demand declines when income rises. In other words, demand of inferior goods is inversely related to the income of the consumer. For example, there are two commodities in the economy -- wheat flour and jowar flour -- and consumers are consuming both. Presently both commodities face a downward sloping graph, i.e. the higher the price the lesser will be the demand and vice versa. If the income of consumer rises, then he would be more inclined towards wheat flour, which is a little costly than jowar flour.
(ii) Income effects
Ans: In term of indifference curves analysis, an income effect measures consumer's movement from one optimal consumption combination to another, on her/his indifference map, as a result of change in the income. Changes in the level of income lead the consumer to change her/his consumption, in order to maximize the utility of spendable income. Income rise on account of situations such as professional advancement, tax cuts, bonus, windfall financial gains etc. or fall in income caused by loss of job, imposition of new taxes, financial loss etc. influence consumer's consumption decisions. The analysis of income changes on consumption, therefore, is an important part of the theory of consumer's behavior.
(iii) Phillip's curve
Ans: The inverse relationship between unemployment rate and inflation when graphically charted is called the Phillips curve. William Phillips pioneered the concept first in his paper "The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957,' in 1958. This theory is now proven for all major economies of the world. The theory states that the higher the rate of inflation, the lower the unemployment and vice-versa. Thus, high levels of employment can be achieved only at high levels of inflation. The policies to induce growth in an economy, increase in employment and sustained development are heavily dependent on the findings of the Phillips curve.
(iv) Investment multiplier
Ans: The concept of investment multiplier was propounded by Prof. J.M. Keynes. Investment multiplier is the ratio of change in income due to a given change in investment. It measures the change in national income as a result of change in investment. The value of multiplier varies from unity to infinity.
When investment increases by a certain amount, aggregate income increases by a multiple of that investment. Thus, investment multiplier is based on the change in income due to the change in investment. The change in income is determined by marginal propensity to consume. It is denoted by K.
(v) Gains from international trade
Ans: The benefits of international trade are:
  1. Optimum use of resources
  2. Growth of economy
  3. Economies of large scale
  4. Increased employment opportunities
  5. Stabilisation of prices
  6. Increase in standard of living
  7. Enhancement of competition
  8. Global understanding
  9. Opportunity to import the essential goods.

11. Distinguish between any three of the following: 3x5=15
(i) Monopoly and Monopolistic Competition
Ans: Refer above
(ii) Price effect and Substitution effect
Ans: Refer Above
(iii) Ricardian Theory of Rent and Modern Theory of Rent
Ans: Comparison between the Ricardian Theory and the Modern Theory of Rent:
In Ricardo’s theory, the surplus is due to superiority (or natural differential advantage) of the land in question over the marginal one. The superiority may be due to either quality of the land or better situation. Also both theories of rent have the same concept of land, i.e. a natural factor rather than a man-made factor like capital, but then where is the difference between the two theories.
The difference between two is basic and it lies in this that while Ricardo takes agricultural land (the cultivation of which is subject to the law of diminishing returns sooner or later), the modern economists, on the other hand, do not confine the concept of rent to agricultural land only.
(iv) Inflation and Deflation
Ans: Inflation vs. Deflation
  1. Inflation, though it leads to increase in prices and redistribution of income in favor of the rich, is a lesser of the evil than deflation.
  2. Inflation does not lead to lowering of national income which deflation does.
  3. Deflation causes wide scale unemployment which inflation does not.
  4. As deflation causes profits to tumble, pessimism sets in thus leading to a slowing down of economy and output
  5. It is possible to control inflation through many monetary policies while it is very difficult to reverse the process of deflation
(v) Balance of Trade and Balance of Payments

Ans: Refer Above