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

Term-End Examination June, 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. 'Economics is a science of choice-making'. Explain this statement with the help of production Possibility curve.
Ans: Economics is a Science of choice making: Robbins gave a more scientific definition of Economics. His definition is as follows: "Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses". The definition deals with the following four aspects:
(i) Economics is a science: Economics studies economic human behaviour scientifically. It studies how humans try to optimise (maximize or minimize) certain objective under given constraints. For example, it studies how consumers, with given income and prices of the commodities, try to maximize their satisfaction.
(ii) Unlimited ends: Ends refer to wants. Human wants are unlimited. When one want is satisfied, other wants crop up. If man's wants were limited, then there would be no economic problem.
(iii) Scarce means: Means refer to resources. Since resources (natural productive resources, man-made capital goods, consumer goods, money and time etc.) are limited economic problem arises. If the resources were unlimited, people would be able to satisfy all their wants and there would be no problem.

(iv)Alternative uses: Not only resources are scarce, they have alternative uses. For example, coal can be used as a fuel for the production of industrial goods, it can be used for running trains, it can also be used for domestic cooking purposes and for so many purposes. Similarly, financial resources can be used for many purposes. The man or society has, therefore, to choose the uses for which resources would be used. If there was only a single use of the resource then the economic problem would not arise. It follows from the definition of Robbins that Economics is a science of choice.
An important thing about Robbin's definition is that it does not distinguish between material and non-material, between welfare and non-welfare. Anything which satisfies the wants of the people would be studied in Economics. Even if a good is harmful to a person it would be studied in Economics if it satisfies his wants. No doubt, Robbins has made Economics a scientific study and his definition has become popular among some economists.
But his definition has also been criticised on several grounds. Important ones are:
(i) Robbins has made Economics quite impersonal and colourless. By making it a complete positive science and excluding normative aspects he has narrowed down its scope.
(ii) Robbins' definition is totally silent about certain macro-economic aspects such as determination of national income and employment.
(iii) His definition does not cover the theory of economic growth and development. While Robbins takes resources as given and talks about their allocation, it is totally silent about the measures to be taken to raise these resources i.e. national income and wealth.

2. With the help of indifference curves, distinguish between Income Effect and Substitution Effect. Also draw an Income Consumption Curve if one of the two commodities is an inferior good.
Ans: Difference between Income effect and Substitution effect: We saw that a fall in the price of good X, given the price of Y, increases its demand. This is the price effect which has dual effects: a substitution effect and an income effect. The substitution effect relates to the increase in the quantity demand of X when its price falls while keeping the real income of the consumer constant. The consumer substitutes the cheaper good X for the relatively dearer good Y.
The income effect is the increase in the quantity demanded of X when the real income of the consumer increases as a result of the fall in the price of X while the price of Y is held constant. Thus Price Effect = Substitution Effect + Income Effect. Hicks has separated the substitution effect and the income effect from the price effect through compensating variation in income by changing the relative price of a good while keeping the real income of the consumer constant.
Suppose initially the consumer is in equilibrium at point R on the budget line PQ where the indifference curve I is tangent to it in Figure 30. Let the price of good X fall. As a result, his budget line rotates outward to PQ1 where the consumer is in equilibrium at point T on the higher indifference curve I2.
Separation of Substitution and Income Effects from the Price Effect
Income Consumption Curve and Inferior Goods:
Normally, the slope of ICC curve is positive. Such a slope is for both X and Y goods when they are normal or superior, as shown in Fig 19. But if either X good or Y good is normal and the other is inferior, the slope of ICC curve is negative. Inferior good is that whose consumption falls when the income of the consumer increases beyond a certain level and he replaces it by the superior substitute.
Income Consumption Curve and Inferior Goods
He may replace coarse grains by wheat or rice, and coarse cloth by a fine variety. In Fig. 20 good у is inferior and good X is normal (superior). When the income of consumer is PQ, he is in equilibrium at point R on the I Curve. The slope of ICC curve is positive up to point R and beyond that it is negatively inclined as the income of consumer increases to P1Q1and P2Q2 .That is why, the quantity of inferior good purchased by a consumer becomes TX2 with the increase in his income while the amount of good X increases from OX to XXand X1X2. On the other hand in Fig 21, X is inferior good and Y is normal (superior) good.
3. What do you mean by demand for money ? Describe different motives for holding money as propounded by Keynes.
Ans: Demand for Money : Classical view of demand for money contributes that money can not satisfy the holder directly. It is demanded for its purchasing power or its use as medium of buying goods and services which satisfy the holder of money. It is therefore obvious that the demand for money arises from the demand for goods and services to meet the society's requirements. Hence demand for money may be termed as 'derived demand'. The demand for money in a country depend on the volume of transactions taken place in the country; more specially, depends upon the supply of goods and services available in the market. The larger the amount of tradable goods and services in the economy, large is the volume of demand for money.
Motives for Liquidity Preference: Keynes’s Theory: Liquidity preference of a particular individual depends upon several considerations. The question is: Why should the people hold their resources liquid or in the form of ready money when he can get interest by lending money or buying bonds? The desire for liquidity arises because of three motives:
(i) The transactions motive,
(ii) The precautionary motive, and
(iii) The speculative motive.
(i) The Transactions Demand for Money: The transactions motive relates to the demand for money or the need for money balances for the current transactions of individuals and business firms. Individuals hold cash in order “to bridge the interval between the receipt of income and its expenditure”. In other words, people hold money or cash balances for transactions purposes, because receipt of money and payments do not coincide. Most of the people receive their incomes weekly or monthly while the expenditure goes on day by day.
A certain amount of ready money, therefore, is kept in hand to make current payments. This amount will depend upon the size of the individual’s income, the interval at which the income is received and the methods of payments prevailing in the society.
According to Keynes, the transactions demand for money depends only on the real income and is not influenced by the rate of interest. However, in recent years, it has been observed empirically and also according to the theories of Tobin and Baumol transactions demand for money also depends on the rate of interest.
(ii) Precautionary Demand for Money: Precautionary motive for holding money refers to the desire of the people to hold cash balances for unforeseen contingencies. People hold a certain amount of money to provide for the danger of unemployment, sickness, accidents, and the other uncertain perils. The amount of money demanded for this motive will depend on the psychology of the individual and the conditions in which he lives.
(iii) Speculative Demand for Money: The speculative motive of the people relates to the desire to hold one’s resources in liquid form in order to take advantage of market movements regarding the future changes in the rate of interest (or bond prices). The notion of holding money for speculative motive was a new and revolutionary Keynesian idea. Money held under the speculative motive serves as a store of value as money held under the precautionary motive does. But it is a store of money meant for a different purpose. The cash held under this motive is used to make speculative gains by dealing in bonds whose prices fluctuate.

4. Discuss the Ricardian theory of comparative cost advantage of international trade.
Ans:  Ricardo's Theory of Comparative Advantage: David Ricardo stated a theory that other things being equal a country tends to specialise in and exports those commodities in the production of which it has maximum comparative cost advantage or minimum comparative disadvantage. Similarly the country's imports will be of goods having relatively less comparative cost advantage or greater disadvantage.
1. Ricardo's Assumptions: Ricardo explains his theory with the help of following assumptions :-
  • There are two countries and two commodities.
  • There is a perfect competition both in commodity and factor market.
  • Cost of production is expressed in terms of labour i.e. value of a commodity is measured in terms of labour hours/days required to produce it. Commodities are also exchanged on the basis of labour content of each good.
  • Labour is the only factor of production other than natural resources.
  • Labour is homogeneous i.e. identical in efficiency, in a particular country.
  • Labour is perfectly mobile within a country but perfectly immobile between countries.
  • There is free trade i.e. the movement of goods between countries is not hindered by any restrictions.
  • Production is subject to constant returns to scale.
  • There is no technological change.
  • Trade between two countries takes place on barter system.
  • Full employment exists in both countries.
  • There is no transport cost.
On the basis of above assumptions, Ricardo explained his comparative cost difference theory, by taking an example of England and Portugal as two countries & Wine and Cloth as two commodities. As pointed out in the assumptions, the cost is measured in terms of labour hour. The principle of comparative advantage expressed in labour hours by the following table.
England Portugal Wine Cloth Principle Comparative Advantage
Portugal requires less hours of labour for both wine and cloth. One unit of wine in Portugal is produced with the help of 80 labour hours as above 120 labour hours required in England. In the case of cloth too, Portugal requires less labour hours than England. From this it could be argued that there is no need for trade as Portugal produces both commodities at a lower cost. Ricardo however tried to prove that Portugal stands to gain by specialising in the commodity in which it has a greater comparative advantage. Comparative cost advantage of Portugal can be expressed in terms of cost ratio.
Cost ratios of producing Wine and Cloth
Cost ratios of producing wine and cloth
Portugal has advantage of lower cost of production both in wine and cloth. However the difference in cost, that is the comparative advantage is greater in the production of wine (1.5 — 0.66 = 0.84) than in cloth (1.11 — 0.9 = 0.21). Even in the terms of absolute number of days of labour Portugal has a large comparative advantage in wine, that is, 40 labourers less than England as compared to cloth where the difference is only 10, (40 > 10). Accordingly Portugal specialises in the production of wine where its comparative advantage is larger. England specialises in the production of cloth where its comparative disadvantage is lesser than in wine.
Comparative Cost Benefits Both Participants
Let us explain Ricardian contention that comparative cost benefits both the participants, though one of them had clear cost advantage in both commodities. To prove it, let us work out the internal exchange ratio.
Comparative Cost Benefits Both Participants
Let us assume these 2 countries enter into trade at an international exchange rate (Terms of Trade) 1 : 1.
At this rate, England specialising in cloth and exporting one unit of cloth gets one unit of wine. At home it is required to give 1.2 units of cloth for one unit of wine. England thus gains 0.2 of cloth i.e. wine is cheaper from Portugal by 0.2 unit of cloth.
Similarly Portugal gets one unit of cloth from England for its one unit of wine as against 0.89 of cloth at home thus gaining extra cloth of 0.11. Here both England and Portugal gain from the trade i.e. England gives 0.2 less of cloth to get one unit of wine and Portugal gets 0.11 more of cloth for one unit of wine.
In this example, Portugal specialises in wine where it has greater comparative advantage leaving cloth for England in which it has less comparative disadvantage.
Thus comparative cost theory states that each country produces & exports those goods in which they enjoy cost advantage & imports those goods suffering cost disadvantage.

Attempt any four questions from this section in about 300 words each. 4x12=48
5. What is short -run production function ? Explain the law of variable proportions with the help of a diagram.
Ans: Refer above
6. Define inflation. Giving reasons, distinguish between demand -pull inflation and cost-push inflation.
7. Discuss the concept of marginal propensity to consume (MPC). Show diagrammatically the relation between MPC and investment multiplier.
Ans: Marginal Propensity to Consume: The Marginal Propensity to Consume is defined as the proportion of the aggregate raise in pay that is utilised on the consumption of goods and services opposing to the amount being saved. It can also be defined as Induced Consumption as this shows the consumption of goods and services due to increase in disposable incomes. The Marginal Propensity to Consume (MPC) is expressed mathematically as:
MPC = dC / dY
Where dC = Change in Consumption
dY = Change in Disposable Income
The Multiplier & the Marginal Propensity
In economics, the multiplier effect refers to the idea that an initial spending rise can lead to an even greater increase in national income. In other words, an initial change in aggregate demand can cause a further change in aggregate output for the economy.  The multiplier effect is a tool used by governments to restimulate aggregate demand. The size of the multiplier depends on the  marginal propensity to consume. The relation between the Marginal Propensity and the Multiplier may be given as:  Multiplier = 1 / (1 - MPC) = 1 / MPS
With increasing MPC (i.e. : decreasing MPS), the value of the multiplier increases as because themultiplier is equal to the reciprocal of the Marginal Propensity to Save. The greater the Marginal Propensity to Save, the smaller will be the multiplier. The Greater the Marginal Propensity to Consume, the larger would be the multiplier. It gives the idea that every rupee spend, creates more than one rupee in the economic activity. The Effect of MPC on Multiplier can be understood with the help of the following diagram:
C:\Users\office\Desktop\P&B 27.6 Multiplier & Slope of AE.jpg

8. What is National Income ? How is national income in India estimated ?
Ans: National Income consists of the aggregate value of all goods and services produced by the community in a given period, usually a year counted without duplication.
According to the National Income committee of India, “A National Income estimate measures the volume of commodities and services turned out during a given period counted without duplication”.
Correctly, therefore, the national income of a country consists of:
(a) The value of all the goods and services produced a country for a year.
(b) Depreciation and wear and tear should be deducted that is total value is not taken but only the net aggregate value of goods and services, and
(c) Net Income from foreign sources should be included.
Normally three methods are used for the calculation of national income the inventory method, the expenditure method, the income method.
(i) Inventory method: The first method is variously called as the product method in the inventory method or the census method. This method consists or finding out the market value of all goods and services produced by country during a given period of time. The sales of all producers are calculated and an estimate is made for self-consumption as well as for increase in stocks during a given period of time. This constitutes the value of the gross product and from this figure should be deducted the depreciation of equipment used in the process of production as well as the value of the intermediate products such as raw materials consumed, to arrive at the net national product.
(ii) Income method: The second method is known as the income method which consists of adding together all incomes by way of wages, interests, rents and profits. This method derives the national total as a self of net incomes received by individuals and business enterprises. Three types of incomes should be included, viz, incomes received by all individuals by way of wages, interests, rents and profits incomes of business enterprises by way of depreciation allowances and of undistributed profit and of the incomes of the government by way of taxes and profits of government enterprises.
(iii) Expenditure method: Under the expenditure method, the government can make an estimate of the expenditure of individual for perishable and durable consumption goods, the expenditure of institution for investment and construction goods and the expenditure of the govt. on goods and services.
9. 'Is profit a reward for innovation' or is it a reward for bearing risk and uncertainty ?
Ans: The term ‘profit’, though generally regarded as the reward of the last factor of production viz., entrepreneur, is defined in different ways. Some writers have defined it as the percentage return o capital invested or as the reward of ownership. Some others regard it as the residual income which results after all the three factors of production have been paid their remuneration. Thus ‘profit’ in economics, has become a highly controversial term. However for a clearer understanding of the true nature of profits, a distinction may be made between gross profits and net profits.
There are several theories of profit propounded by economists. None of these deal with all aspects of the problem. Each one explains a particular aspect of profit. We shall study some of the theories of profit.
Hawley’s Risk Theory of Profit
This theory was advocated by an American Economist Prof. Hawley. According to him profits arise because the entrepreneur undertakes the risk of the business and he has to e rewarded for that.  He is entitled to receive profits. If the entrepreneur is not rewarded he will not prepared to undertake the risk. According to the theory, higher the risk, greater is the possibility of profit.
Entrepreneur is the most important factor in modern production. Without him, other factors cannot be combined. In employing the factors of production, in looking through the process of production and in selling the commodity in the market, the entrepreneur undertakes risks, and profits are reward for such risks borne by the entrepreneur.
The risk theory has been criticized as follows:
  1. There is no relationship between risk and profit. The entrepreneur may not get higher profits if he undertakes larger risks. The profit is influenced not by risks but by several other factors.
  2. Secondly, Carver says that profit accrues to the entrepreneur not for his ability of risk taking but for his risk avoidance.
  3. According to Prof. Knight, profit cannot be attributed to undertaking the risks of the business. Insurable risks are not at all risks. Only uninsurable risks are real risks.

Knight’s Uncertainty bearing Theory
Knight’s uncertainty baring theory starts on the foundation of Hawley’s risk-bearing theory. Knight agrees with Hawley that profit if a reward for risk-taking. However, the term risk is clarified and there are two types of risk
  1. Foreseeable risk, and
  2. Unforeseeable risk
The latter risk is called uncertainty bearing. If risk can be insured against, it is not risk at all. For instance fire, flood, theft, etc., are risks in business which can be insured and the loss arising out the these will be made good by the insurance company. The premium paid for insurance is included in the cost of production. Insurable risk, thus, does not give rise to profit. So, according to Prof. Knight, profit is due to non-insurable risk. Some of the non_ insurable risks are:
  1. Competitive risk
  2. Technical risk
  3. Risk of government’s intervention, and
  4. Risk arising out of business cycle.

Since these risks cannot e foreseen and measured, they become non insurable and the uncertainties have to be borne by the entrepreneur. According to this theory, there is a direct relationship between profit and uncertainty bearing. Greater the uncertainty bearing, the higher level of the profits. Uncertainty bearing has become so important in business enterprise in modern days.  It has come to be considered as a separate factor of production. Like other factors, it has a supply price and entrepreneurs undertake uncertainty bearing only in the expectation of earning certain level of profit.

10. What are the main characteristics of the oligopoly form of market ? Also explain in brief the concept of 'Cartel' in the given context.
Ans: Oligopoly: Oligopoly is a situation in which few large firms compete against each other and there is an element of interdependence in the decision making of these firms. A policy change on the part of one firm will have immediate effects on competitors, who react with their counter policies.
Features: Following are the features of oligopoly which distinguish it from .other market structures :
1. Small number of large sellers.: The number of sellers dealing in a homogeneous or differentiated product is small. The policy of one seller will have a noticeable impact on market, mainly on price and output.
2. Interdependence: Unlike perfect competition and monopoly, the oligopolists is not independent to take decisions. The oligopolists has to take into account the actions and reactions of his rivals while deciding his price and output policies. As the products of the oligopolists are close substitutes, the cross elasticity of demand is very high.
3. Price rigidity: Any change in price by one oligopolists invites retaliation and counter- action from others, the oligopolists normally sticks to one price. If an oligopolists reduces his price, his rivals will also do so and therefore, it is not advantageous for the oligopolists to reduce the price.
4. Monopoly element: As products are differentiated the firms enjoy some monopoly power. Further, when firms collude with each other, they can work together to raise the price and earn some monopoly income.
5. Advertising: The only way open to the oligopolists to raise his sales is either by advertising or improving the quality of the product. Advertisement expenditure is used as an effective tool to shift the demand in favour of the product. Quality improvement will also shift the demand favorably. Usually, both advertisements as well as variations in designs and quality are used simultaneously to maintain and increase the market share of an oligopolists.
6. Group behaviour: The firms under oligopoly recognise their interdependence and realise the importance of mutual cooperation. Therefore, there is a tendency among them for collusion. Collusion as well as competition prevail in the oligopolistic market leading to uncertainty and indeterminateness.
7. Indeterminate demand curve: It is not possible for an oligopolists to forecast the nature and position of the demand curve with certainty. The firm cannot estimate the sales when it decides to reduce the price. Hence the demand curve under oligopoly is indeterminate.

A cartel is an association of independent firms within the same industry. The cartel follows common policies relating to prices, outputs, sales and profit maximization and distribution of products. Cartels may be voluntary or compulsory, open or secret depending upon the policy of the government with regard to their formation. Thus cartels have many forms and use many devices in order to follow varied common policies depending upon the type of the cartel. We discuss below the two most common types of cartels: (i) joint profit maximization or perfect cartel; and (ii) market-sharing cartel.
11. Distinguish between income elasticity of demand and price elasticity of demand. Income elasticity coefficient for commodity-X is — 0.25 and for commodity-Y it is +0.15. How will you interpret these results ?
Attempt both the questions from this sections. 2x6=12
12. Highlight the 'backward bending supply curve of labour'.
13. Explain any two of the following concepts :
(a) Giffen goods
Ans: Giffen Goods
Giffen goods are the inferior goods that are tied in the mind of individuals to hard times. These inferior goods are known as Giffen goods named after Sir Robert Giffen. Marshall introduced the Giffen's paradox as an exception to the law of demand. in the third edition of his book Principles of Economics. (I895) as, ' There are however some exceptions.
In case of Giffen goods quantity demanded will vary directly with price. Again an increase in income will generally cause the consumption of most goods to increase. But there are a few goods for which the pattern is reversed. It means an increase in income causes a decrease in consumption. Here for a good to be Giffen, the income effect must dominate the substitution effect.

According to J.R. Hicks, for a good to be a Giffen good, following three conditions are essential:
1. The good must be inferior with strong negative income effect.
2. The substitution effect must be small.
3. The proportion of income spent for the inferior good must be very large.

(b) Terms of Trade
Ans: Refer above
(c) Public Goods
Ans: Refer above
(d) Indifference map
Ans: Indifference Map
An indifference map is the collection of indifference curves possessed by an individual.  We can draw more than one indifference curve on the same diagram. This family of curves is called indifference map. We know that right side curve yield higher utility and it goes on increasing as we move righter, While the curve in the left yield lesser utility and it goes on decreasing as we move towards left.  ( the reason is right hand side point means more consumption of either of 2 goods, hence higher satisfaction) .