TermEnd Examination December, 2012
Time : 3 hours Maximum Marks : 100
Note : Answer the questions from all sections as per instructions.
SECTION  A
Attempt any two questions from this section in about 500 words each : 2x20=40
1. Explain the circular flows of income. Explain the roles of household, firm and government in the circular flows.
Ans: Refer above
2. Explain price discrimination in a market structure characterised by monopoly. Provide suitable examples.
3. Explain the equilibrium in commodity and money markets with the help of IS and LM curves.
Ans: Refer above
4. Explain with the help of indifference curves the equilibrium of a consumer in the event of a price decrease.
Ans: Effect of change in Price on Consumer’s Equilibrium: 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.
Assumptions: This analysis is based on the following assumptions:
1. Consumer wants to buy two goods X and Y.
2. Of these goods, the price of good X falls.
3. The price of good Y is given and constant.
4. Consumer’s income remains constant.
5. There is no change in tastes and preferences of the consumer.
Given these assumptions, the price effect is shown in Fig 28. When the price of good X falls, the consumer’s budget line PQ will extend further out to the right as PQ1 showing that the consumer will buy more X than before as X has become cheaper. The budget line PQ1 shows a further fall in the price of X.
Each of the budget lines fanning out from P is a tangent to an indifference curve I1, I2and I3 at R, S and T respectively. The curve PCC connecting the locus of these equilibrium points is called the priceconsumption curve or PCC. PCC curve is defined as the locus of optimum combination of X and Y that result from a change in relative prices, holding money income constant.
In Fig. 28, the PCC curve slopes downward. As the price of X falls, the consumer buys more of X and less of Y. Thus at point S on the PCC curve, he purchases OB of X and OM of Y instead of OA of X and OL of Y at point R. A downward sloping priceconsumption curve thus shows that the two goods X and Y substitutes for one another. If the PCC slopes upward as shown in Fig. 29, X and Y are complementary goods. The consumer purchases larger quantities AB and MN of both the goods at points R and T respectively.
SECTIONB
Answer any three questions from this section in about 250 words each. 3x10=30
5. Explain how Euler's theorem holds good in perfectly competitive markets.
Ans: Refer above
6. What is meant by quantity theory of money ? What are its implications ?
Ans: In the words of Irving Fisher, “Other things remaining unchanged, as the quantity of money in circulation increases, the price level also increases in direct proportion and the value of money decreases and vice versa.” If the quantity of money is doubled, the price level will also double and the value of money will be one half. On the other hand, if the quantity of money is reduced by one half, the price level will also be reduced by one half and the value of money will be twice. Fisher has explained his theory in terms of his equation of exchange:
PT=MV+ M’ V’
Where P = price level, or 1 IP = the value of money;
M = the total quantity of legal tender money;
V = the velocity of circulation of M;
M’ – the total quantity of credit money;
V’ = the velocity of circulation of M;
T = the total amount of goods and services exchanged for money or transactions performed by money.
Implications of Quantity theory of money:
This equation equates the demand for money (PT) to supply of money (MV=M’V). The total volume of transactions multiplied by the price level (PT) represents the demand for money. According to Fisher, PT is SPQ. In other words, price level (P) multiplied by quantity bought (Q) by the community (S) gives the total demand for money. This equals the total supply of money in the community consisting of the quantity of actual money M and its velocity of circulation V plus the total quantity of credit money M’ and its velocity of circulation V’. Thus the total value of purchases (PT) in a year is measured by MV+M’V’. Thus the equation of exchange is PT=MV+M’V’. In order to find out the effect of the quantity of money on the price level or the value of money, we write the equation as: P= MV+M’V’
Fisher points out the price level (P) (M+M’) provided the volume of transaction remain unchanged. The truth of this proposition is evident from the fact that if M and M’ are doubled, while V, V and T remain constant, P is also doubled, but the value of money (1/P) is reduced to half.
Fisher’s quantity theory of money is explained with the help of Figure 65.1. (A) and (B). Panel A of the figure shows the effect of changes in the quantity of money on the price level. To begin with, when the quantity of money is M, the price level is P.
When the quantity of money is doubled to M2, the price level is also doubled to P2. Further, when the quantity of money is increased fourfold to M4, the price level also increases by four times to P4. This relationship is expressed by the curve P = f (M) from the origin at 45°.
In panel В of the figure, the inverse relation between the quantity of money and the value of money is depicted where the value of money is taken on the vertical axis. When the quantity of money is M1 the value of money is HP. But with the doubling of the quantity of money to M2, the value of money becomes onehalf of what it was before, 1/P2. And with the quantity of money increasing by fourfold to M4, the value of money is reduced by 1/P4. This inverse relationship between the quantity of money and the value of money is shown by downward sloping curve 1/P = f (M).
7. Explain the concept of Liquidity trap. What are its implications for policy formulation ?
Ans: Not necessary.
8. Explain the relationship between average cost and marginal cost. Use suitable diagram for your answer.
Ans: Relationship between AC and MC: There exists a close relationship between AC and MC.
 Both AC and MC are derived from total cost (TC). AC refers to TC per unit of output and MC refers to addition to TC when one more unit of output is produced.
 Both AC and MC curves are Ushaped due to the Law of Variable Proportions. The relationship between the two can be better illustrated through following schedule and diagram.
Relationship between AC and MC can be illustrated with the help of following example
Output (units)

TC (Rs.)

AC(Rs.)

MC(Rs.)

Phase

01

1218

18

6

I (MC < AC)

2

22

11

4
 
3

27

9

5
 
4

36

9

9

II (MC = AC)

5

47

9.40

11

III (MC > AC)

9. Explain with the help of diagram the law of variable proportions.
Ans: Refer Above
SECTIONC
Answer all the questions in this section as indicated. 2x15=30
10. Explain any three of the following concepts:
(a) Public goods
Ans: A public good is often (though not always) underprovided in a free market because of its characteristics of nonrivalry and nonexcludability. Public goods have two characteristics:
 Nonrivalry: This means that when a good is consumed, it doesn’t reduce the amount available for others.
– E.g. benefiting from a street light doesn’t reduce light for others, but eating an apple would.  Nonexcludability: This occurs when it is not possible to provide a good without it being possible for others to enjoy. E.g. erecting a dam to stop flooding, or providing law and order.
(b) investment multiplier
Ans: Refer below
(c) income elasticity of demand
Ans: Refer Below
(d) double counting
(e) Comparative advantage
Ans: Refer Below
11. Distinguish between any three of the followings :
(a) Speculative demand and precautionary demand for money
Ans: Refer below various demand for money
(b) nominal GDP and real GDP
Ans:
(c) Fixed cost and variable cost
Ans: Refer above
(d) Indirect tax and direct tax
(e) Stock variable and flow variable.
Ans: Refer above