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Question Paper
Economics (MB141) : July 2003
Part A : Basic Concepts (30 Points)
• This part consists of questions with serial number 1 - 30.
• Answer all questions.
• Each question carries one point.
• Maximum time for answering Part A is 30 Minutes.
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1. Cartel agreements tend to be unstable because
Answer >
a. Cartel agreements tend to lower profits
b. A firm can increase its profits by cheating on the agreement
c. Agreements become unnecessary as the number of firms in the cartel increases
d. Cutting output and raising prices will benefit each firm in the cartel
e. Cartels are not legally permitted.
<
2. When the Central Bank of a country resorts to contractionary or expansionary monetary policies to
neutralize the change in money supply caused by changes in foreign exchange reserves, it is Answer >
referred to as
a. Transmission mechanism
b. Sterilization
c. Stabilization
d. Monetary mechanism
e. Exchange rate mechanism.
<
3. Which of the following is considered to be the most appropriate measure for the standard of living
of a country, like India? Answer >

a. GDP at market prices

b. GNP at factor cost
c. Per capita GDP
d. National income
e. Personal income.
<
4. In a two-sector economy the consumption function (C) is equal to 8 + 0.7Y and autonomous
investment is equal to 22. The equilibrium level of income in the economy is Answer >

a. 21
b. 30
c. 43
d. 100
e. None of the above.

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<
5. Which of the following is an example of a government transfer payment? Answer >
a. Salary paid to a soldier
b. Purchase of a new car for the Ministry of Finance
c. Funding of a clinic to provide free vaccinations
d. Free food coupons issued to persons in an anti-poverty program
e. Funding of a new bridge in an urban area.
<
6. All entries in the balance of payments statement should collectively sum to Answer >
a. GDP of the country
b. GNP of the country
c. Foreign exchange reserves of the country
d. Zero
e. Exports of the country.
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7. If the Average Propensity to Save (APS) is negative, then the Average Propensity to Consume Answer >
(APC) is

a. Negative
b. Zero
c. Positive but less than one
d. One
e. Greater than one.
<
8. Which of the following would you suggest to counter a recession? Answer >
a. Decrease in government expenditure
b. Decrease in transfer payments
c. Decrease in the bank rate
d. Decrease in the money supply
e. Increase in the tax rate.
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9. Large government borrowings to finance its deficit will
Answer >
a. Increase the supply of loanable funds
b. Exert downward pressure on interest rates
c. Have no impact on interest rates
d. Put upward pressure on interest rates
e. Makes it easier for the commercial sector to borrow money.
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10. Which of the following is not a stock variable?
Answer >
a. Foreign exchange reserves
b. Public debt
c. Wealth of a country
d. Inflation
e. Money supply.

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<
11. GDP of a country is 8000. Value of output produced in the domestic country by foreign factors of
Answer >
production is 200 and value of the output produced by domestic factors of production in foreign
countries is 100. GNP of the country is

a. 7700
b. 7800
c. 7900
d. 8100
e. 8200.
<
12. Omar has just completed his graduation in commerce. He is looking for a suitable job, but the only
Answer >
job that he can find is that of a cook in a restaurant. This situation can be described as

a. Frictional unemployment
b. Structural unemployment
c. Cyclical unemployment
d. Natural unemployment
e. Disguised unemployment.
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13. From the following information, compute subsidies
Answer >
GDP at factor cost = Rs.2000 cr.
Net factor income from abroad = Rs.200 cr.
Indirect taxes = Rs.542 cr.
GNP at market prices = Rs.2292 cr.

a. Rs. 50 cr
b. Rs.342 cr
c. Rs.450 cr
d. Rs.292 cr
e. Rs.742 cr.
<
14. Subhash Pvt. Ltd., an Indian company, has a fully owned subsidiary in the USA. The profits earned
Answer >
by the subsidiary in the USA is recorded in

a. GDP of India and GNP of the USA

b. GNP of both India and the USA
c. Neither GDP nor GNP of India
d. GNP of India and GDP of the USA
e. GDP of both India and the USA.
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15. Which of the following variables will be at low levels during boom phase of a business cycle?
Answer >
a. Bank reserves
b. Wage rates
c. Bank credit
d. Inventory
e. Cost of production.

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<
16. Which of the following cost curves is not ‘U’ shaped?
Answer >
a. Long run average cost curve
b. Long run marginal cost curve
c. Short run average cost curve
d. Average variable cost curve
e. Average fixed cost curve.
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17. Which of the following represents the marginal rate of technical substitution (MRTS)?
Answer >
a. Slope of the isocost curve
b. Slope of the indifference curve
c. Slope of the isoquant curve
d. Slope of the budget line
e. Slope of the average cost curve.
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18. Among the following goods which has the highest income elasticity of demand?
Answer >
a. Tea
b. Ice cream
c. Milk
d. Rice
e. Water.
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19. The Government of India is expecting tax collections (net) to the tune of Rs.1,84,169 crore during
the year 2003-04. The borrowings and other liabilities are expected to be Rs.1,53,637 crore. If the Answer >
non-plan revenue expenditure of the government is Rs.2,89,384 crore (inclusive of interest
payments of Rs.1,23,223 crore), the fiscal deficit for the year 2003-04 is
a. Rs.1,53,637 crore
b. Rs.1,35,747 crore
c. Rs.1,05,215 crore
d. Rs.30,414 crore
e. None of the above.
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20. An implicit cost can be defined as the
Answer >
a. Payment to the non-owners of the firm for the resources they supply
b. Money payment which the self-employed resources could have earned in their best
alternative employment
c. Costs which the firm incurs but does not disclose
d. Costs which do not change over a period of time
e. None of the above.
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21. The difference between additional revenue gained by a firm from selling a unit and the additional
cost incurred for producing the unit is Answer >

a. Average profit
b. Average revenue
c. Marginal profit
d. Marginal revenue
e. None of the above.

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<
22. Which of the following is not true?
Answer >
a. Indifference curve describes all the possible combinations of two goods which give
equal satisfaction to the consumer
b. Total utility is the sum of marginal utilities of all units of a good consumed
c. When price of a product increases, demand for its complement increase
d. Utility is a psychological concept and therefore cannot be precisely measured
e. Consumer surplus of a good and its economic value are different.
<
23. Suppose that the market equilibrium monthly rent per room in a city is Rs.3,000. At this rent 8000
rooms per year are rented. If a local rent control ordinance establishes a ceiling of Rs.3,500 per Answer >
room, which of the following is true?
a. Shortage of rooms as the quantity of housing demanded increases
b. Shortage of rooms as the quantity of housing supplied decreases
c. The equilibrium remains unaffected
d. Surplus of rooms as the quantity of housing demanded decreases
e. Surplus of rooms as the quantity of housing supplied increases.
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24. A consumer consumes three units of a product. Marginal utilities derived from the three units are
Rs.200, Rs.175 and Rs.150, respectively. If the price of the good is Rs.100 per unit, the consumer Answer >
surplus is
a. Rs. 50
b. Rs. 75
c. Rs.100
d. Rs.225
e. Rs.525.
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25. The total cost (TC) schedule of a firm is
Answer >
Output TC
1 100
2 150
3 190
4 250
5 340
Marginal cost of the third unit is
a. 30
b. 40
c. 150
d. 60
e. 190.
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26. A firm will shut down its operations in the short run if
Answer >
a. It incur losses
b. Fixed costs exceed its revenue
c. Variable costs exceed its revenue
d. Total revenue falls short of total cost
e. Total fixed cost exceeds its total variable costs.

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<
27. A profit maximizing firm seeks to maximize the difference between
Answer >
a. Marginal revenue and marginal cost
b. Marginal revenue and average cost
c. Total revenue and marginal revenue
d. Total revenue and average cost
e. Average revenue and average cost.
<
28. If the demand curve for product B shifts to the right as the price of product A declines, it can be
concluded that Answer >

a. A and B are substitute goods

b. A and B are complementary goods
c. A and B are not related goods
d. A is a superior and B an inferior good
e. B is a superior and A an inferior good.
<
29. The demand function for a product is P = 20 – 2Q. If the current market price is Rs.10, what is the
price elasticity of demand? Answer >

a. -1
b. -2
c. 1.5
d. -3
e. None of the above.
<
30. Average productivity of labor for a firm is 25 when labor employed is 50 units. When labor
employed is increased to 52 units, average productivity of labor declines to 24 units. At current Answer >
input level the marginal productivity of labor is
a. -1 unit
b. -2 units
c. 1 unit
d. 2 units
e. None of the above.

END OF PART A

Part B : Problems/Caselets (50 Points)

This part consists of questions with serial number 1 – 9.
Answer all questions.
Points are indicated against each question.
Detailed workings should form part of your answer.
Do not spend more than 110 - 120 minutes on Part B.
1. The average total production function of a firm is given below:
APL = 400/L – 150 + 25L
You are required to determine:
a. The maximum possible average production.

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b The maximum possible total production.

(3 + 2 = 5 points) < Answer >
2. Supply and demand functions in a perfectly competitive industry are
Qs = 100P – 8,750
Qd = 40,000 – 50P
A firm operating in the industry has the following cost function:
TC = 500 + 425Q – 5Q2
Required:
a. Determine the equilibrium price and output for the industry.
b. Determine the profit maximizing output for the firm and compute the profit earned by the firm.
c. Is the industry in equilibrium? Explain.
(2 + 4 + 2 = 8 points) < Answer >
3. The following balances are taken from the National Accounts of an economy.
Particulars MUC
NDP at market prices 5,000
NNP at factor cost (National income) 4,200
Personal saving 1,075
Gross domestic investment 800
Corporate profits (profit before tax) 750
Transfer payments by the government 75
Subsidies 100
Net domestic investment 650
Corporate profit tax 350
Personal tax payments 350
Indirect taxes 950
Government budget deficit 300
Dividends 150
You are required to determine:
a. Net Factor Income Earned from Abroad (NFIA).
b. The value of GDP at factor cost.
c. Personal income.
(2 + 2 + 3 = 7 points) < Answer >

4. The following balances are taken from balance sheet of the Central Bank of an economy.

Particulars Million units of currency (MUC)

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Credit to Government 950

Credit to Bank 350
Government Deposits 20
Other non-monetary liabilities 5
Net worth 500
Credit to commercial sector 125
Net foreign exchange assets 25
Other assets 65
The currency/deposit ratio has been ascertained as 0.20.
The amount of Government money is 10 million units of currency. Total money supply in the economy is
4000 million units of currency.
Required:
a. Calculate the reserve ratio imposed by the Central Bank.
b. If there is an increase of 100 MUC in Central Bank Credit to Government accompanied by
Government purchase of foreign exchange worth 10 MUC from the Central Bank, calculate the increase in
money supply in the economy.
c. If the Central Bank desires to contain the money supply at the original level even after the
transaction in (b), and for this purpose alters the reserve ratio, compute the new reserve ratio.
(5 + 3 + 2 = 10 points) < Answer >

Caselet 1
Read the following caselet carefully and answer the following questions:
5. How are fixed costs in the telephone industry impacted by the development of mobile phones rather than
landline phones?
(3 points) < Answer >
6. “Spreading overhead” can be defined as the ratio of total fixed costs to total output (or average total fixed
cost). How does the size of a market impact this?
(3 points) < Answer >
7. How does the change from fixed landline phone to mobile phone impact whether or not the telephone
industry is a monopoly? Discuss.
(4 points) < Answer >
The market for mobile phones has been booming in Africa. The fact that mobile phones do not require land lines to be
installed means that there are fewer fixed costs to start up a business. Therefore, African entrepreneurs have been able
to start up mobile phone companies where they could not start up phone companies based on more infrastructure
intensive "land lines." All of Sub-Saharan Africa has fewer fixed telephone landlines than Manhattan alone. The lack of
infrastructure required also means that the industry has been less vulnerable to the recent natural catastrophes and war
that have plagued the continent.
The African market has a number of "fierce competitors," and even low-income Africans have been able to use mobile
phones using different low cost plans. Mobile phones have become so ubiquitous that African consumers spend a larger
fraction of their income on phone services than Europeans. The number of consumers is considerable: 8 million in

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South Africa alone (although other African countries reported have somewhere between 23,000 and 340,000).
Seemingly, the greatest barrier facing entrepreneurs in this market is not economics but politics. One company
president has had problems establishing his company in his home country of Zimbabwe. Despite service in six other
African countries, operations in Zimbabwe have been held up due to politics with the President of Zimbabwe, Robert
Mugabe. One of Mr. Mugabe's nephews was involved with a rival company, and the company had to go to court in
order to challenge a government block of an application to run a network. Although the company eventually gained
access to the market, this example underlines the potential costs of doing business in Africa: the lack of legal
infrastructure and rule of law may be larger barriers than physical infrastructure and market setting.
Caselet 2
Read the following caselet carefully and answer the following questions:
8. “Deflation does a lot more damage than inflation and is far harder to defeat”. Do you agree? Explain.
(5 points) < Answer >
9. Why is it felt that central bankers may be ill prepared to fight it off the current deflation? What do you
suggest to pull the economies out of the deflationary spiral? Explain.
(5 points) < Answer >
Inflation in the developed world is at its lowest in almost half a century. This should be a moment of triumph for
inflation-busting central banks. Yet instead, many economists are fretting that they have succeeded too well. Prices
have been falling in Japan since 1995; in America and Germany the risk of deflation is greater than at any time since
the 1930s. If the longer growth remains below the potential, the inflation will fall further. History argues that, once
entrenched, deflation does a lot more damage than inflation, and is also far harder to defeat. But today's central bankers
may be ill prepared to fight it off.
A more fundamental question is whether central banks might themselves have aggravated the risk of deflation, by
aiming for a needlessly low target for inflation. Everybody agrees that high inflation is bad for growth, because it
distorts relative prices and hence the allocation of resources. But there is room for disagreement about how low
inflation ought to be.
A decade or so ago, when inflation still loomed large, some argued that 0-2% was the right inflation goal for central
banks. However, there is little evidence that pushing inflation below, say, 3% will raise growth. Indeed, there is plenty
of academic support for the view that a little bit of inflation is better for growth than none at all. Seeking a little bit of
inflation was, after all, like wanting to be a little bit pregnant: it could quickly get out of hand. At that time, when the
priority was to reduce inflationary expectations and deflation was confined to dusty old textbooks, this made sense.
Today, with Japan so clearly demonstrating the perils of deflation, central banks need to aim a little higher.

END OF PART B

Part C : Applied Theory (20 Points)

This part consists of questions with serial number 10 - 11.
Answer all questions.
Points are indicated against each question.
Do not spend more than 25 -30 minutes on Part C.
10. The Reserve Bank of India (RBI) has been pursuing a medium-term objective of reducing cash reserve ratio
(CRR) of banks to the statutory minimum level of 3.0 percent. In this direction, it has reduced CRR further from
4.75 percent to 4.50 percent in its recent monetary policy. With this reduction, CRR would have been reduced by

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4.0 percentage points in the last three years. Briefly explain how reduction in CRR affects the following variables,
ceteris paribus, in the country.
i. Money supply
ii. Aggregate demand
iii. Inflation.
(10 points) < Answer >
11. Taxi drivers have been against the proposal to increase fares at night. If the cab drivers are worried about the
likely impact of the increase in taxi fare on total revenue, what must be the nature of the price elasticity of demand
for taxi rides? Discuss the factors affecting price elasticity of demand.
(10 points) < Answer >

END OF PART C

END OF QUESTION PAPER

Suggested Answers
Economics (MB141) : July 2003
Part A : Basic Concepts

1. Answer : (b) <

TOP >
Reason : Cartels are aimed at increasing profits. But for any individual firm the incentive of
huge profits by breaking away from or cheating the Cartel and charging a price less than the Cartel price
make Cartels unstable.
a. Cartels tend to maximize profits by avoiding competition.
b. Cartels agreements tend to be unstable because the member firms want to
maximize their profits by cheating on the agreement.
c. When the number of firms increases cartel become unstable, but it does not
mean that they are unnecessary.
d. It is true that cutting output and raising prices benefit each firm in the cartel.
But this will not lead to instability of cartels.
e. Not all cartels are legally restricted.
2. Answer : (b) <
TOP >
Reason : Sterilization means neutralization of changes in the money supply caused by changes
in the foreign exchange reserves of a country.
3. Answer : (c) <
TOP >
Reason : In developing and underdeveloped countries population pressures is tremendous. In

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many of these countries growth rate of population is more than the growth rate of GDP. In such cases
living standard of the people, in fact, declines in spite of the growth in the real GDP. Any economy,
ultimately, is interested in the well-being of its people. Therefore, per capita output and income can
better capture the economic growth achieved by an economy. GDP at market prices, GDP at factor cost,
national income and personal income are all macro aggregates and does not show average of each
individual’s income or output. Hence the correct answer is (c).
4. Answer : (d) <
TOP >
Reason : C = 8 + 0.7Y
S = –8 + 0.3Y
At equilibrium, S = I
–8 + 0.3Y = 22
0.3Y = 30
Y = 100
5. Answer : (d) <
TOP >
Reason : Transfer payments are payments which do not have any production activity associated
with the payment and are not considered as income in National income accounting. In the given
examples food coupons are issued free of cost and hence a transfer payment. All other payments
involve some production activity for the period under consideration.
6. Answer : (d) <
TOP >
Reason : Preparation of BoP statement is based on double-entry system of book keeping. Hence,
all debt items should equal credit items, and the balance is zero.
7. Answer : (e) <
TOP >
Reason : APS + APC = 1
If APS < 0 , APC > 1.
8. Answer : (c) <
TOP >
Reason : To counter the recession the fiscal and monetary policies should be expansionary.
a. Decrease in government expenditure is a contractionay fiscal policy. This
measure will worsen the recessionary situation.
b. Decrease in government expenditure is a contractionay fiscal policy. This
measure will worsen the recessionary situation.
c. Decrease in the discount rate increase money supply in the economy and is an
expansionary monetary policy. This will counter the recession by increasing the aggregate demand in
the economy.
d. Decrease in money supply is a contractionay monetary policy. This measure
will worsen the recessionary situation.
e. Increase in the tax rate is a contractionay fiscal policy. This measure will
worsen the recessionary situation.
9. Answer : (d) <
TOP >
Reason : Keeping the supply of loanable funds at the same level increase in government

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borrowings increase the demand for loanable funds and put upward pressure on the rate of interest
10. Answer : (d) <
TOP >
Reason : A variable is defined as a stock variable if it is measured at a point of time and as a
flow variable if it is measured over a period of time. Of all the variables listed, only inflation is
measured over a period of time and hence is a flow variable.
11. Answer : (c) <
TOP >
Reason : GNP = GDP + NFIA
NFIA = Factor income received from abroad – Factor income paid abroad.
= 100 – 200
= – 100
∴ GNP = 8000 – 100
= 7900.
12. Answer : (b) <
TOP >
Reason : Structural unemployment arises when the regional or occupational pattern of the job
vacancies does not match the pattern of workers availability and suitability. Unemployment that arises
when there is general downturn in business activity is called cyclical unemployment. Unemployment
that is caused by constant changes in the labor market is called frictional (natural) unemployment. Omar
is facing unemployment in the form of unavailability of decent job that meets his qualifications and
hence is considered has structural unemployment.
13. Answer : (c) <
TOP >
Reason : GNPmp = GDPfc + NFIA + Indirect taxes – Subsidies
2292 = 2000 + 200 + 542 – X
X = – 2292 +2200 + 542
= Rs.450 cr.
14. Answer : (d) <
TOP >
Reason : GDP of a country is the value of all final goods and services produced in the
boundaries of the country within a given period. GNP, on the other hand, is the value of all final goods
and services produced by the factors of production (i.e. capital, labor, land, entrepreneurship) of the
country. Since profits are earned within the boundaries of the USA, the GDP of the USA includes the
annual earnings of the company’s subsidiary. The GNP of India includes the profit of the subsidiary
because the profits are earned by using the factors of production owned by Indians.
15. Answer : (d) <
TOP >
Reason : a. During a boom bank reserves will be high as the bank credit is high to support
the increased economic activity
b. Wage rate will be high as demand for labor increase during the boom phase
c. As the economic activity increase during the boom bank credit also increases
d. During a boom demand increased at a faster rate and inventories tend to be low.
All other variables tend to increase during a boom.

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e. Cost of production will be high as demand for factors of production will be

relatively high during the boom phase.
16. Answer : (e) <
TOP >
Reason : a. Long run average cost (LAC = LTC/Q) is U-shaped because of economies of
scale initially and diseconomies of scale at later stages of production.
b. Long run marginal cost (LMC = ∂LTC/∂Q) is U-shaped as cost of producing
additional units reduces at the beginning because of economies of scale, but raises later due to
diseconomies of scale.
c & d. Short run average cost (SAC = STC/Q) and AVC (= TVC/Q) falls and raises due to
operation of ‘law of diminishing marginal productivity’.
e. Average fixed cost (AFC = TFC/Q) falls at a decreasing rate with the
increase of output because of constant total fixed cost.
17. Answer : (c) <
TOP >
Reason : The slope of the isoquant represents the Marginal Rate of Technical Substitution
(MRTS) between labor (L) and capital (K). MRTS is equal to the ratio of the marginal productivities of
two factors.
a. The slope of the isocost curve represents ratio of wages (w) and interest (r).
b. The slope of the indifference curve signifies marginal rate of substitution of goods (MRS).
c. The slope of the isoquant curve signifies the marginal rate of technical substitution (MRTS)
between labor and capital.
d. The slope of the budget line represents ratio of price of good X and good Y.
e. The slope of the average cost curve only shows the rate of change in average
cost curve with respect change in output.
18. Answer : (b) <
TOP >
Reason : Tea, milk, rice and water are necessary because of their importance in daily life. Ice
cream is considered to be luxury. For luxuries the income elasticity of demand will be high.
19. Answer : (a) <
TOP >
Reason : Fiscal deficit = Borrowings and other liabilities of the government = Rs.153,637 Cr.
20. Answer : (b) <
TOP >
Reason : Implicit cost is also known as opportunity cost. These costs are not paid out-of-the
pockets. It refers to income that could have been earned by factor input in their best alternative use.
a. Payments to the non-owners of the firm for the resources they supply constitute an out-of-the-
pocket cost. Hence (a) is not correct.
b. Implicit cost is also known as opportunity costs. It refers to income that could have earned by
factor input in their best alternative use. Money payment, which the self-employed resources could
have earned in their best alternative employment, signifies opportunity cost of self-employed
resources.
c. An undisclosed cost does not constitute implicit costs.

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d. Fixed cost is the cost that remains same during a period of time. Fixed costs consist of both
implicit and explicit costs.
e. Is not the answer because (b) is correct.
21. Answer : (c) <
TOP >
Reason : The difference between marginal revenue gained by a firm and the marginal cost
incurred for producing the good indicates the additional profit the firm has gained by selling one
additional unit; which is known as marginal profit.
a. Net revenue = Total revenue – Total cost = Profits. Hence is not the correct answer.
b. Average revenue = Total revenue/Quantity sold.
c. Marginal profit = Marginal revenue – marginal cost
d. Marginal revenue = change in total revenue/change in units sold.
22. Answer : (c) <
TOP >
Reason : (a) True. Indifference curve is various combinations of two goods which give the
same level of total utility
(b) True. Total utility is the sum of marginal utilities of all the goods consumed.
(c) False. When price of a product increases demand for the product decreases. As
complimentary goods are consumed together, demand for the compliment also decreases.
(d) True. Utility is subjective and varies from individual to individual and from
time to time for the same individual, hence cannot be measured precisely.
(e) True. Consumer surplus is the difference between what the consumer is willing
to pay and what he actually pays. Economic value is the market value of a good.
23. Answer : (c) <
TOP >
Reason : Price ceiling inevitably result in shortages when they are set below market equilibrium
price. Because the rent ceiling is more than the market equilibrium rent, it will not have any impact on
the equilibrium rent, quantity of house demanded and supplied.
24. Answer : (d) <
TOP >
Reason : Consumer surplus = (200 – 100) + (175 – 100) + (150 – 100) = 225.
25. Answer : (b) <
TOP >
Reason : Marginal cost = Change in the total cost as a result of producing one additional unit of
output. Thus, marginal cost of producing third unit is equal to total cost of producing three units ‘minus’
total cost of producing two units = 190 – 150 = 40.
26. Answer : (c) <
TOP >
Reason : When the variable costs of the firm exceed its revenue, it can reduce the losses by
shutting down its operations. Even if its fixed costs exceed its revenue, the firm may not shut down its
operations because the firm can reduce its fixed cost loss through sales.
a. In the short run, the firms will continue their operations even though they incur losses.
b. If the revenue is more than variable costs, it can reduce the losses caused by fixed costs.

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c. When the variable costs of the firm exceed its revenue, it can reduce the losses by shutting down
its operations
d. If total revenue is more than total costs it signifies losses. In the short run, the firms will continue
their operations even though they incur losses.
e. Revenue is more important to take a decision on continuation of operation.
27. Answer : (e) <
TOP >
Reason : The profit of a firm refers to the difference between total revenue and total cost. Hence,
to maximize the profits, the firm should maximize the difference between total revenue and total cost.
The difference between average revenue (AR) and average cost (AC) represents the average profit of
the firm. Hence maximization of difference between average revenue and average cost also indicates
profit maximization. A firm maximizes its profit when it produces and sells an output at which marginal
revenue (MR) is equal to marginal cost (MC).
28. Answer : (b) <
TOP >
Reason : (a) When goods A and B are substitutes, decrease in price of product A will lead to
leftward shift in the demand curve for product B. This is because, when price of product A decrease
consumers tend to substitute good A for good B and demand for product B decrease.
(b) When goods A and B are compliments, decrease in price of product A will lead to rightward shift
in the demand curve for product B. This is because, when price of product A decrease consumers tend
to consume more of product A and also product B along with product A. Hence demand for product B
increases.
(c) When goods A and B are unrelated, decrease in price of product A will not have any impact on
the demand curve for product B.
(d) The given information is inadequate to comment on the nature of the goods
(e) The given information is inadequate to comment on the nature of the goods
29. Answer : (a) <
TOP >
Reason : Price elasticity of demand = ∂Q/∂P × P/Q
Given P = 10
Demand function: P = 20 – 2Q
Or, 2Q = 20 – P
Or, Q = 10 – 0.5P
Thus, ∂Q/∂P × P/Q = -0.5 × 10/5 = -1
30. Answer : (a) <
TOP >
Reason : TP (when labor = 50 units) = 50 x 25 = 1250
TP (When labor = 52 units) = 52 x 24 = 1248
Thus, MP = (1248 – 1250)/(52 – 50) = -2/2 = -1 unit.

Part B : Problems

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1. a. Average production will be at maximum, when MP = AP.

Marginal Production function: TP / L = –150 + 50L
Where TPL = APL x L = (400/L – 150 + 25L) L = 400 – 150L + 25L2
Thus, –150 + 50L = 400/L – 150 + 25L
50L = 400/L + 25L
Or, 25L = 400/L
Or, 25L2 = 400
Or, L2 = 16
Or, L = 4
When L = 4, AP = 400/4 – 150 + 25(4) = 50 units.
b. Total product will be maximum when MP = 0,
Thus, –150 + 50L = 0
Or, L = 3
When L = 3, TP = 400 – 150(3) + 25 (3) (3)
= 400 – 450 + 225 = 175 units.
< TOP >
2. a. At equilibrium Qd = Qs
40,000 – 50P = 100P – 8750
150P = 48,750
P = Rs.325
∴ Q = 40000 – (50 × 325) = 23750.
b. A firm in a perfectly competitive market is a price taker, which is determined by the market demand
and supply. Since a firm is a price taker, MR = P.
To maximize profit, a firm should equate MR and MC, or P = MC
Thus, 325 = 425 – 10Q
Where MC = = 425 – 10Q
or, 10Q = 100 Q = 10
when Q = 10, profits of the firms = TR – TC
= (P × Q) – (500 + 425Q – 5Q2)
= (325 × 10) – (500 + 425 × 10 – 5 × 102)
= 3250 – 4250 = (1000) loss
c. Since the existing firm is getting losses firms will leave the industry. Thus, the industry is not in
equilibrium.
< TOP >
3. a. NFIA = NNPMP – NDPMP
NNPMP = NNPFC + Indirect Taxes – Subsidies = 4200 + 950 – 100 = 5050
Thus, NFIA = 5050 – 5000 = 50.

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b. GDPFC = NDPMP + Depreciation – Indirect Taxes + Subsidies

5000 + (800 – 650) – 950 + 100 = 4,300 MUC.
c. Personal Income (PI) (i.e. income received by the households) = NI – Corporate profit +
Dividends + Transfer payments = 4200 – 750 + 150 + 75 = 3675.
< TOP >
4. a. High powered money = Monetary Liabilities of RBI + Government Money
Monetary liabilities of RBI = Financial Assets + other Assets – Non-monetary liabilities.
Financial Assets = Credit to Government + Credit
to Banks + Credit to commercial sector + Net Foreign exchange assets
= 950 + 350 + 125 + 25
= 1450
Other Assets = 65.
Non-monetary liabilities = Government deposits + other non-monetary liabilities + Net worth
= 20 + 5 + 500
= 525
∴ Monetary liabilities = 1450 + 65 – 525 = 990
Government money = 10
∴ High powered money = 990 + 10 = 1000
Money Supply = H×m
m = money multiplier =
4000 = 1000 × m
m = = 4.
=4
=4
1.2 = 0.8 + 4r
∴ r = = 0.10 = 10%.

b. When the Central Bank credit to Government is increased by 100 MUC and simultaneously
Government purchases foreign exchange worth 10 MUC from the Central Bank, the net increase in the
financial assets of the Central Bank is 90 MUC. Hence high powered money will increase by 90 MUC.
Given, the money multiplier = 4
Increase in money supply = 90 × 4 = 360 million units of currency.

c. If the Central Bank wants to contain the money supply at the original level of 4000 millions,
Money supply = H x m
4000 = (1000 + 90) × m
m = = 3.6697
= = 3.6697
= = 3.6697
r =

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= 0.127 = 12.7%.
< TOP >

5. The development of mobile phones considerably reduced the amount of fixed cost requirement in the
telephone industry. Mobile phones do not require landlines, unlike landline phones. This reduces the huge
infrastructure requirements and fixed costs associated with the industry.
Presence of huge infrastructure requirements and huge fixed costs leads to creation of monopoly by forming
formidable entry barriers to new companies. Lower entry costs associated with mobile phones made African
entrepreneurs to start up mobile phone companies wherever they could not start up phone companies based on
more infrastructure intensive ‘landlines’.
< TOP >
6. The fixed costs are those costs, which do not vary with the changes in the output of a product. They are
associated with the existence of a firm’s plant and, therefore, must be paid even if the firm’s level of output is
zero. As the total fixed costs remain same, average total fixed cost decreases with the increase of output level. The
AFC is therefore a monotonically decreasing function of the level of output and the shape of the AFC is
rectangular hyperbola. Thus, when the size of market grows, the total fixed costs remain constant but the average
total fixed cost comes down by largely ‘spreading the fixed overheads’.
< TOP >
7. Contrasting to landline phones, mobile phones do not require huge infrastructure requirements in the form of
landline installations. This reduces initial costs and fixed costs associated with the industry which otherwise could
become high entry barriers. When entry barriers are high, an industry may have few firms with limited pressure to
compete. But, lower infrastructure requirements made African entrepreneurs to start up mobile phone companies
where they could not start up phone companies based on more infrastructure intensive ‘land lines’. When new
firms can enter freely there will be no likelihood of formation of monopoly in the telephone industry in Africa.
< TOP >
8. Deflation is particularly harmful when an economy has lots of debt, because falling prices swell the real debt
burden. This can lead to a vicious circle as heavily indebted firms are forced to reduce costs, and jobs and
spending are cut across the economy, pushing prices lower still. Moreover, deflation makes consumers to postpone
their purchases, causing further fall in demand.
Economists view deflation as a far more serious threat than inflation because the central bank's primary tool
for boosting economic activity - a reduction in interest rates – might have only a limited impact on the psyche of
consumers and businesses. However, deflation is not always bad. If caused by rapid productivity growth, it can go
hand in hand with robust growth. But if prices are falling because of a slump in demand, deflation can be
dangerous. Today the world exhibits both sorts of deflation, but the vast amount of excess capacity suggests that
most of it is the bad sort.
< TOP >
9. It is true that central bankers are not fully prepared to combat the current deflation. The central banks have,
in deed, taken policies targeting a very low inflation and thereby aggravated the risk of deflation. Deflation
reduces the ability of central banks’ policy instruments in regulating the economy. If the market reaches a stage
where interest rate movements have very little or no impact (i.e. liquidity trap), policy tools of monetary policy
becomes worthless. The developed countries such as America and Japan already have low interest rates, which
will make it difficult for the central banks to operate its monetary policies which are primarily depend on interest
rate changes. The option that is available for central banks right now is to increase the money supply in the system
by reducing bank rate, reserve requirement and by buying government securities. But, the effectiveness of these
tools will be minimal given the scenario and at the same time, as interest rates are close to zero, the central bank

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have only little leeway to bring down the interest rate.

Other major policy available is fiscal policy where the government can regulate the economy through
changing its spending and tax rate. The government should increase it’s spending and simultaneous reduce the tax
rate to boost the aggregate demand and the prices in the economy, which is reeling under deflationary recession.
< TOP >

Part C: Applied Theory

10. The Central Bank stipulates the statutory limits of cash reserve requirements for commercial banks. It asks
banks to maintain a minimum percentage of their deposits as reserves. The central bank can regulate money
supply by simply changing the reserve requirements of commercial banks. If the central bank reduces the reserve
requirements, banks will have more reserves to support their deposit holders and more funds available to provide
credit, which in turn, increases the money supply in the system. This relationship can also be known from the
following money supply equation.
Money supply (Ms) = High-powered money x {(1 + Cu)/(Cu + r)}
Where Cu = currency deposit ratio and r = reserve ratio
When money supply is increased, the interest rate falls, causing greater investment demand and
consumption. As investment demand and consumption demand form part of aggregate demand, the increase of
these demands results in increase in aggregate demand. However, if production remains same, the increased
demand leads to increase in price levels in the economy. (Note that inflation refers to general rise in the price
levels over a period of time)
Thus, the reduction in CRR will have the following effect on the money supply, aggregate demand and
inflation.
a. Money supply: When CRR is reduced, the banks have to park lesser amount with RBI towards reserve
requirements. This increases the lending capacity of banks. With higher amount of lending, the money supply
in the country increases.
b. Aggregate demand: When money supply in the economy increases with the reduction of the CRR,
the interest rates in the economy falls. Lower interest rates increases the investment and consumption
demand in the country. As investment and consumption form part of aggregate demand, the aggregate
demand increases with the reduction of the CRR.
c. Inflation: Higher aggregate demand with no spurt in production increases the prices of goods and
services in the country. Thus, lower CRR increases aggregate demand, leading to higher price levels in the
country (i.e. higher inflation).
< TOP >

11. With law of demand in operation, the percentage change in total revenue will be positive (negative) if the
percentage change in quantity sold is more (less) than the percentage change in price. If the demand for a product
is unit elastic, any given percentage change in the price will result in an equal but opposite percentage in quantity
demanded. The net effect would be no change in total revenue because the downward force would exactly offset
the upward force on revenue. But, if the demand is elastic, the percentage decline in quantity demanded caused by
price increase would be larger than the percentage increase in price, which causes reduction in total revenue. As
cab drivers are worried about the likely impact of the increase in taxi fare on total revenue, we can deduce that the
price elasticity of demand for taxi rides is elastic.
Many factors such as time period, nature of good and closeness of substitutes affect the price elasticity of
demand.

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a. Closeness of substitutes: The closer the substitutes for a good or service, the more elastic are the
demand for it.
b. Nature of good: In general, it is seen that luxury items are price elastic whereas necessary items
are price inelastic. This is because, changes in the price level affects the necessary goods comparatively less
to the luxury goods.
c. Time period: The greater the time lapse since a price change, the more elastic is the demand.
When a price changes, consumers often continue to buy similar quantities of good for a while. But given
enough time, they find acceptable and less costly substitutes.
d. Proportion of income spent: When the proportion of income spent on the good is high, a small
percentage price changes affect the individual greatly. Hence, higher the proportion of income spent, the
higher will be the elasticity of demand.
< TOP >
< TOP OF THE DOCUMENT >

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