IGNOU Solved Question Papers: EEC - 11 (December' 2011)

Term-End Examination December, 2011
Time : 3 hours Maximum Marks : 100 (Weightage : 70%)
Note : Answer questions from all sections as per instructions.
Attempt any two questions from this section in about 500 words each : 2x20=40
1.Explain how a discriminating monopolist reaches equilibrium. What are the underlying assumptions for a discriminating monopolist ?
Ans: Equilibrium Under Discriminating monopoly: Under simple monopoly the producer will charge the equilibrium price on the basis of total output and the marginal revenue and marginal cost will decide the equilibrium of the monopoly firm.  In order to discrimination prices, the entire market will be divided into sub-markets on the basis of the elasticity of demand for the product. Only if the elasticity of demand is different, price discrimination will be profitable. After dividing the market, the producer has to decide the supply for each submarket. Here the decision of output for each sub – market depends on the equilibrium condition of each sub-market with the total cost condition and the revenue curves of the sub-market. The monopolist should decide two things on the basis of his cost and revenue curves.
a. How much the total output should produce
b. How the total output should be shared between the sub-markets and what prices should be charged in each of his sub-market.

The following diagram illustrates the revenue curves of the two sub-markets A and B and the aggregate situation in the entire market under his control.

The sub-market A given on the extreme left AR, is the demand curve or the average revenue curve of the market. In sub-market B it is the demand curve or the average revenue curve of the market. Note that the elasticity of demand in these two sub-market is different. In sub-market A the demand curve show inelastic in nature and in sub-market B the curve shows the elastic in nature. The two sub-markets respective marginal revenue curves are shown as MR1 and MR2 .which lie below the average revenue curve of the respective sub-market. The figure on the extreme rite shows the total market where the aggregate conditions of the revenue curves are shown. The total average revenue curves of the two sub-markets have been shown in the total market as AAR. Similarly, the aggregate of the two marginal revenue curves of the sub-markets has been shown as AMR. According to the figure AR1 + AR2 = AAR. MR1+MR2=AMR combined at various levels of output. Since the output is under single control the marginal cost curve in the aggregate figure. MC in the total market shows the marginal cost for the entire production. The level of production is determine at the point where MR=MC. In the total market the aggregate MR curve cuts the MC curve at E and the total output is determine at OM for the two sub-markets. How much of OM goes to each of these markets is found out by drawing from E a line parallel to X-axis. This line indicating marginal cost of output cuts the marginal revenue curves of the sub-markets at E2 and E1. at the point E1 the marginal revenue of the sub-market A and the marginal cost of production are equal. So the equilibrium condition in sub-market A lies at E1 where the quantity of commodity should be OM1. Similarly the equilibrium point in sub-market B lies at the point E2 where the marginal cost level meets the marginal revenue level of that sub-market. The corresponding quantity of the commodity in sub-market B is OM2.
Therefore quantity OM will be sold in sub-market A and quantity OM2 in the sub-market B. At the equilibrium point E1 in sub-market A the price of the commodity will be P1M1 as at the level of equilibrium output the average revenue is P1M1. In submarket B, at the equilibrium output the average revenue P2 M2. So, the price of the commodity in that sub-market will be P2M2.
3.Distinguish between income effect and substitution effect. Show their interaction in the case of a Giffen good.
Ans: Difference between Income and substitution effect:
Price Effect: The price effect shows the effect of a change in the price of a commodity on its quantity purchased by the consumer, when the price of other commodity and consumer’s income remain constant. We study the effect of fall in the price of good X on consumer’s equilibrium.
The substitution effect relates to the change in the quantity demanded resulting from a change in the price of a good due to the substitution of a relatively cheaper good for a dearer one, while keeping the price of the other good and real income and tastes of the consumer as constant.
Substitution and Income Effects for a Giffen Good:
A strongly inferior good is a Giffen good, after Sir Robert Giffen who found that potatoes were an indispensable food item for the poor peasants of Ireland. He observed that in the famine of 1848, a rise in the price of potatoes led to an increase in their quantity demanded. Thereafter, a fall in their price led to a reduction in their quantity demanded.
This direct relation between price and quantity demanded in relation to essential food items is called the Giffen paradox. The reason for such a paradoxical tendency is that when the price of some food article like bread of mass consumption rises, this is tantamount to a fall in the real income of the consumers who reduce their expenses on more expensive food items, as a result the demand for the bread increases. Similarly, a fall in the price of bread raises the real income of consumers who substitute expensive food items for bread thereby reducing the demand for bread.
In the case of a Giffen good, the positive income effect is stronger than the negative substitution effect so that the consumer buys less of it when its price falls. This is illustrated in figure 32. Suppose .Vis a Giffen good and the initial equilibrium point is R where the budget line PQ is tangent to the indifference curve I1. Now the price of X falls and the consumer moves to point T of the tangency between the budget line PQX and the curve I2.
Substitution and Income Effects for a Giffen Good
His movement from point R to T is the price effect whereby he reduces his consumption of X by BE. To isolate the substitution effect, the increased real income due to the fall in the price of X is withdrawn from the consumer by drawing the budget line MN parallel to PQand tangent to the original curve I1 at point H. As a result, he moves from point R to H along the I1 curve. This is the negative substitution effect which leads him to buy BD more of X with the fall in its price, real income being constant.
To isolate the income effect, when the income that was taken away from the consumer is returned to him, he moves from point R to T so that he reduces the consumption of X by a very large quantity DE. This is the positive income effect because with the fall in the price of the Giffen good X, its quantity demanded is reduced by DE via compensating variation in income.
Thus in the case of a Giffen good, the positive income effect is stronger than the negative substitution effect so that the total price effect is positive. That is why, the demand curve for a Giffen good has a positive slope from left to right upwards. Thus Price Effect BE = DE (Income Effect) + (—) BD (Substitution Effect).
4.Explain the theory of rent as propounded by Ricardo.
Ans: The ricardian Theory of rent: This theory was put forward by the well-known British classical economist, David Ricardo in his book ‘Principles of Political Economy and Taxation’. In his theory, Ricardo dealt with differential rent. According to his, rent was a differential surplus which accrued to superior lands over inferior lands, or which was enjoyed by the more fertile lands over the less fertile lands. Differences in fertility of land were the main factor giving rise to rent. The differential nature of rent can be explained both in extensive and intensive cultivation.
Rent and Extensive Cultivation: Following Ricardo, let us suppose that a batch of sellers go to a new country and begin to cultivate the land. At first they would cultivate only the best plots. As long as there is a plentiful supply of best lands, no-body would pay anything for land. Let us next suppose that another batch of settlers go to the country. As the best lands are cultivated, the new settlers must begin to cultivate the next best lands or the second grade land. These plots yield less than the best plots. To the application of the same amount of labour and capital, the best lands yield 35 quintals and the second grade land yields 30 quintals of wheat. When the second grade lands are cultivated, the best lands yield a surplus of quintals above the expenses of production which are the same for both classes of land. This surplus is rent. Similarly if the demand for agricultural produce remains unsatisfied, third and fourth grade lands will have to the cultivated. How rent is differential surplus is illustrated in the following diagram.

In this diagram, A,B,C,D are the four lands represented along OX axis. The output yielded by each of these lands with the application of one dose of labour and capital is represented by the respective rectangles along Y axis. For example, the rectangle on ‘A’ quality and represents the output of 100 tonnes. Similarly, rectangles on ‘B’, ‘C’ and ‘D’ lands represent their output i.e., 80,50,20, tones respectively. Since the ‘D’ quality land is no rent land, the rectangle over it does not indicate the emergence of any rent. The rents on ‘A’, ‘B’ and ‘C’ lands are shown by the shaded portions of their respective rectangles.
Rent and Intensive Cultivation: The best plot of land will be more intensively cultivate as the demand for agricultural produce rises. But as more labour and capital are applied, the law of diminishing returns will come into operation. The second dose of labour and capital will yield less than the first and hence there will be surplus on the earlier doses of labour and capital over the marginal dose. As the best land is thus cultivated more intensively, its rent will rise.
Answer any four questions from this section in about 250 words each. 4x12=48
5.Explain the theory of comparative cost advantage with a suitable example.
Ans: Refer Below
6.Explain how wage rate is determined under marginal productivity theory ?
Ans: Marginal Productivity Theory of Wages: The marginal productivity theory of wages is a theory of wages determination. The theory states that wages tend to be equal to the marginal productivity of labour. In other words, wages will be equal to the marginal product of labour.
The term ‘marginal productivity’ or ‘marginal product’, is used in two senses. First, it means the increase in total output when one more labourer is employed, keeping the other factors constant. Suppose 10 labourers producer 25 units a day. Suppose another labourer is employed and, as a result, total output increases to 27 units a day. The output has increased by 2 units because of the employment of one more labourer. The increase in total output is called marginal physical product or productivity. So, in our example, the marginal physical product of labour is two units. Secondly, marginal product means the increase in the value of total output when one more labourer is employed, keeping the other factors, constant. Suppose the price of a unit in the market is Rs. 4. The value of total output increases from Rs. 100 to Rs. 108 (Rs. 4 X 27), when one more labourer is employed. That is, 11th labourer has added, Rs. 8 to the value of total output. S the value of the marginal product is Rs. 8. It can be found out by multiplying the increase in output when one more labourer is employed by the price of the product .
If the value of marginal product is greater than the wage rate, it is profitable to employ more labour. The reason is increase in value of total output will be greater than the increase in total costs. As more and more labourers are employed, the marginal product of labour diminishes after a certain stage. This happens because of the operation of the law of Diminishing Returns. So the producer will go on employing more and more labour till marginal product becomes equal to wage rate.
7.What is meant by oligopoly ? Explain how equilibrium price is determined in an oligopolistic market in the presence of dominant price leadership.
Ans: Meaning and definition of Oligopoly: “Oligopoly” is a term derived from two Greek words “Oligo” meaning a few “pollein” meaning to sell. Thus Oligopoly refers to that form of imperfect competition where there will be only a few sellers producing either a homogenous product which are close substitutes but not perfect substitutes .Oligopoly is also referred to as “competition among the few” as a few big firms will be producing and competing in the market. The simplest case of Oligopoly is duopoly which prevails when there are only two producers in the market.
Professor Sligter defines Oligopoly as that “selication in which a firm bases its market policy in part on the expected behavior of a few close rivals”. According to professor Leftwich, “An Oligopolistic industry is one in which the number of sellers is small enough for the activities of a single seller to affect other firms and for the activities of other firms to affect him”.
Price determination under dominant price leadership
Price leadership especially of the dominant firms is quite common in real life. Small firms generally follow the price leader either out of fear or of convenience. Dominant firm may establish is leadership by adopting aggressive price policies. The dominant firm fixes the profit maximizing price for its product and other firms will fix the same price. The small firm will consider the leader’s price as their marginal revenue and produce that output at which their marginal cost equals their marginal revenue. The small firm can fix a slightly differ price if products are differentiated.
The oligopoly situation with a dominant price leader and many small firms is sometimes referred to as partial monopoly. The dominant firm is more than a leader but wields monopoly power, it fixes monopoly price, produces monopoly output and secure monopoly profits. But it can escape the provisions of monopoly controls because of the presence of large number of small firms. In many cases the dominant firm may encourage the continuance of small firms since it can escape being branded as a monopolist. The price leader, however, has to work under serious restrictions and limitations such as:
(a) His price policy may fail and he may lose his leadership if he makes a mistake in estimating the reaction of rivals.
(b) The leader may not have full knowledge of demand conditions, naturally he will have to rely on guess work.
(c) The price leader may not be sure of loyalty of the followers. The price leader may not be able to fix a higher price out of fear of new entrants.
(d) The leader may lose part of his market because of price cutting by- followers or expansion of existing small firms or the entry of powerful competitors into the market.
(e) The power of the leader depends upon the difference in cost. A high cost leader who fixed a high price may find his rival’s under-cutting him.
A low cost leader may either fix a low price to eliminate the rivals and thus naturally attract enmity or may fix higher price and get the allegiance of high cost small firms.
8.Explain how household, firm and government interact in circular flow of income ?
Ans: Meaning of circular flow of income: The circular flow of income is a neoclassical economic model depicting how money flows through the economy. In the most simple version, the economy is modeled as consisting only of households and firms. Money flows to workers in the form of wages, and money flows back to firms in exchange for products. This simplistic model suggests the old economic adage, "Supply creates its own demand."
Simply, The circular flow of income describes the flows of money among the five main sectors of an economy. As individuals and firms buy and sell goods and services, money flows among the different sectors of an economy. The circular flow of income describes these flows of rupees.
Interaction of household, firm and government
The circular flow of income is a simple model of the economy showing flows of goods and services and factors of production between firms and households. In the absence of government and international trade this simple model shows that households provide the factors of production for firms who produce goods and services. In return the factors of production receive factor payments, such as wages, which in turn are spent on the output of firms. This basic flow is shown in the diagram below.
Circular flow of income
In reality the households do not spend all their current income. Some is saved. This represents a leakage from the circular flow. In addition to the consumer spending, firms also carry out investment spending. This is an injection to the circular flow of income, as it does not originate from consumers' current income.
In the real world the government and international trade sectors must also be included. Economic systems are in reality three sector open economies. Consequently there will be additional leakages and injections. Government spending will be injected into the circular flow and taxation will leak from it. Export flows will be injected and imports flows leaked. A full circular flow with leakages and injections is shown below.
Circular flow of income
This model of the economy demonstrates that economic activity is a flow. In actual fact it can be considered two flows, one of goods and services and a flow of money. The size of these flows is an indicator of the amount of economic activity. The circular nature of the flows means that there will be a number of different ways of measuring the size of the flow.
9.Discuss the loanable funds theory of interest rate determination.
Ans: Refer Below
10.What is meant by demand for money ? Describe different motives of holding money according to Keynes.
Ans: Refer Below
Answer all questions from this section in about 100 words each. 2x6=12
11. Write short notes on any two of the following :
(a)Kinked demand curve
Ans: “Kinked" demand curves are similar to traditional demand curves, as they are downward sloping. They are distinguished by a hypothesized convex bend with a discontinuity at the bend– "kink". The motivation behind this kink is the idea that in an oligopolistic or monopolistically competitive market, firms will not raise their prices because even a small price increase will lose many customers. This is because competitors will generally ignore price increases, with the hope of gaining a larger market share as a result of now having comparatively lower prices. However, even a large price decrease will gain only a few customers because such an action will begin a price war with other firms.
(b)Income elasticity of demand
Ans: Refer Below
(c)Consumer surplus
Ans: Refer Below
(d)Iso-cost curves
Ans: The isocost line is an important component when analysing producer’s behaviour. The isocost line illustrates all the possible combinations of two factors that can be used at given costs and for a given producer’s budget. In simple words, an isocost line represents a combination of inputs which all cost the same amount. 
12. Distinguish between any two of the following :
(a)Balance of trade and Balance of payments.
Ans: The differences between balance of trade (BOT) and balance of payment (BOP)  are as follows:
Balance of trade (BOT)
Balance of Payments (BOP)
i. It records only merchandise (i.e., goods) transactions.
ii. It does not record transactions of capital nature.
iii. It is a part of current account of BOP.
iv. It may be favourable, unfavourable or in equilibrium.
v. Defect in BOT cannot be met by BOP
vi. It is not true indicator of economic relations or economic prosperity of a country.
(i) It records transactions relating to both goods and services.
(ii) It records transactions of capital nature.
(iii) It includes balance of trade, balance of services, balance of unilateral transfers and balance of capital transactions.
(iv) It always remains in balance in the sense that receipt side is always made to be equal to payment side.
(v) Defect in BOP can be met through BOT.
(vi) It is true indicator of economic performance of an economy.

(b)Average and Marginal propensity to consume
Ans: Marginal propensity to consume can be defined as the ratio of change in consumption to change in income. It indicates that part of additional income which isspent on additional consumption. Mpc is always greater than zero and less than one.
The ratio of total consumption expenditure to total income is called average propensity to consume.  The value of average propensity to consume may be greater than one if past savings are consumed in the current year or borrowings are taken into use for consumption in the current year. In such case consumption may be more than income and the value of APC will be greater than one.
(c)Multiplier and Accelerator
Ans: Multiplier: The multiplier refers to the phenomenon whereby a change in an injection of expenditure (either investment, government expenditure or exports) will lead to a proportionately larger change (or multiple change) in the level of national income i.e. the eventual change in national income will be some multiple of the initial change in spending.
Accelerator: The accelerator principle states that changes in the level of current income, leading to changes in output of consumer goods, will lead to proportionately greater, or accelerated changes, in the output of capital goods, i.e. investment.
(d)Fixed exchange rate and flexible exchange rate systems.
Ans: Fixed Exchange Rate System: Fixed exchange rate is the rate which is officially fixed by the government or monetary authority and not determined by market forces. Only a very small deviation from this fixed value is possible.
Flexible (Floating) Exchange Rate System: The system of exchange rate in which rate of exchange is determined by forces of demand and supply of foreign exchange market is called Flexible Exchange Rate System. Here, value of currency is allowed to fluctuate or adjust freely according to change in demand and supply of foreign exchange.