HOTS (Higher Order Thinking skills)

1. An agriculturist increased his capital and labour by 20% in the cultivation of his land. But he found that the amount of production raised increased by 15% only. (He had actually not employed any improved technology.) Point out which law does account for the phenomenon? The Law of Diminishing Returns 2. Increasing and decreasing returns to scale respectively imply downward and upward sloping portion of the long run average cost curve. Defend or refute. Like the short run average cost curve, the long run average cost curve (LAC) and marginal cost curves (LMC) are U shaped. The LMC curve cuts the LAC curve at its minimum point. The reason behind the U shape of LAC is the pattern of the returns to scale. Increasing returns to scale means that if output is increased at a given rate (say 10%), inputs need to be increased only by less than proportionately (say 7%). This implies that average cost must fall as output expands. Similarly decreasing returns to scale imply that the average cost must rise with output. Finally, if returns to scale are constant, the average cost is constant independent of output. Increasing returns to scale LAC decreases with (IRS) output Constant returns to scale LAC does not change (CRS) with output
Decreasing returns to scale LAC increases with (DRS)
LMC Cost LAC

output

q0 IRS DRS CRS Quantity of output

In the diagram, LAC curve is U shaped. This means that as output is increased starting from a small level,there are increasing returns to scale (in the out-

put range 0 to q0). Therefore LAC falls in the initial stage of production. In other words, the downward sloping portion of LAC curve represents increasing returns to scale. LAC remains constant at output level q0. LAC increases at output levels higher than q0. So we can say that the upward sloping portion of LAC curve shows decreasing returns to scale. 3. In the year 2006, all major domestic airlines in India reduced their air fares for certain sectors. Because they wanted to attract luxury class train passengers and to fill their vacancies. Most airlines have an occupancy rate of between 50 to 60%. Discuss how marginal cost and average cost play an important role in the cost function of these airlines. Marginal cost can be defined as the extra or additional cost of producing one extra unit of output. Average cost is the total cost divided by the total number of units produced. Normally the occupancy rate in the airline industry is only 50 to 60 percent. When we divide the total cost by the number of passengers travelling, we can arrive at the average cost of flying a plane. Here it includes the capital investment (fixed cost) as well as the salary, fuel, etc. (variable cost) involved in flying a plane. So the average cost is very high since the occupancy rate is low. With the addition of more passengers, the marginal cost does not increase but the average cost comes down. When the occupancy rate is low, discounts on air fares increase the occupancy rate, without adding any further cost of flying. As the occupancy rate increases, the average cost per passenger comes down. So even if the airlines give discounts, it does not increase the marginal cost. 4 Considering the rising demand for natural rubber, the Rubber Board encouraged farmers to use more fertilizer for increasing rubber production. But the Farmers Forum warned the farmers about the consequence of heavy doze fertilization. Make your stand in the context of the Law of Diminishing Returns. The Rubber Board encouraged farmers to use more fertilizer to increase rubber production in tune with the rising demand for the natural rubber. But the farmers forum warned the farmers about the use of heavy doze of fertilizers. The reason behind the warn1

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ing is nothing but the Law of Diminishing Returns. Any production unit has a maximum capacity, which can be reached by changing the variable factors of production. Thus an optimum combination will be reached. Beyond such combination returns will become constant and then gradually, start declining. Farmers should keep this in mind while using more fertilizer for increasing rubber production. If they go on increasing one factor of production and keep others constant, finally the rubber production will end up with losses. 1. Definition is the accurate description of an idea or an object. Collect some important definitions of the term Money. Money is what money does - Walker Anything which is commonly used and generally accepted as a medium of exchange or as a standard of value. Kent Money is the pivot around which economic science clusters... the major part of the subject matter of economics is concerned with the functioning and malfunctioning of money. Alfred Marshall. Money is anything that is habitually and widely used as a means of payments and is generally acceptable in the settlement of debts G.D.H. Cole 2. Without money no nation can go ahead towards economic development. Discuss the role of money in economic development. The role of money in promoting economic development is discussed below: 1. Money stimulates productivity and economic growth. 2. Money promotes investments. 3. Money facilitates investments in high yielding assets. 4. Creation of new credit or bank money exploits idle resouces and unemployed human resources that exists in developing economies. 5. Funding on new investment or capital accumulation by creating more mony, causes rise to price in a developing economy. This increase in prices will force people to reduce their present level of consumption. This leads to more savings. 3. The buying of securities by the Central Bank will have an effect on the money supply. What happens to the money supply?
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Ans. Money supply increases. 4. The Reserve Bank of India lends funds as a Lender of last resort to a commercial bank, at a particular interest rate. What this rate is known as? Ans. Bank rate 5. The government adopted the most effective quantitative method to control inflation in our economy. Which method? Ans. Cash Reserve Ratio 6. The Reserve Bank of India decides to print currency notes worth Rs. 500 crore, additionally. Does it require to increase its reserves in this respect? If not, why? Ans.The Reserve Bank of India can print and issue any amount of notes by keeping a statutory minimum reserve, which is Rs. 200 crore. Therefore the reserves need not be increased to print notes worth Rs. 500 crore. 1. Price of a commodity under perfect competition is determined by one of the following: Which? (a) Market forces (b) Firm (c) Buyer Ans: Market forces 2. Point out which type of market structure is the exact opposite of perfect competition. Ans: Monopoly 3. Examine the main features of perfect competition. Perfect competition is an extreme form of market which rarely exists in practice. It is a market situation in which there are a large number of buyers and sellers dealing with homogeneous products. The following are the features of perfect competition: (1) Existence of large number of buyers and sellers: Under perfect competition, the number of buyers and sellers will be large. Each seller sells a very small proportion of the total quantity sold in the market. Because of this reason, a single buyer or seller cannot influence the price of the commodity. (2) Homogeneous product: The commodity bought and sold must be homogeneous or identical in all respects ie, in size, colour, shape, smell, packing, etc. (3) Perfect mobility of goods and factors of production: Under perfect competition, there will be freedom of

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movement for goods and factors of production. Goods can be taken from one place to another and factors of production can freely move between firms and industries. (4) Freedom of entry and exit: Freedom of entry and exit means that new firms can enter the industry and existing firms can leave the industry freely. (5) Perfect knowledge of market conditions: Under perfect competition, buyers and sellers will have complete knowledge about the availability of goods, their costs, prices etc. (6) Absence of transport cost: Absence of transport costs is an important assumption of perfect competition. If prices are to be uniform, we have to assume that transport costs do not enter the price. 4. Under perfect competition, the seller is a pricetaker. Explain. Since there are large number of buyers and sellers under perfect competition, a single seller or buyer cannot influence the price. The price is determined by the market forces of demand and supply. The total demand for the product and the total supply of the product together determine the price. The implication of product being homogeneous is that all firms have to charge the same price for the product. If any one producer happens to charge a price higher than the prevailing price, no one will demand from him. Product homogeneity and the existence of a large number of firms together imply that each firm is very small compared to the whole market and no single firm can influence the market price. Each seller accepts the prevailing market price as determined by market demand and supply. Therefore, a firm under perfect competition is called a price-taker. It is illustrated in the following diagram. In the diagram, equilibrium price determined by the forces of demand and supply is OP. A particular firm only takes the price prevailing in the market. At the equilibrium price, a firm can sell any quantity of the commodity. He has to only decide how much of the commodity he should sell at the market price. Find the odd one out and justify your answer. Bank rate/Open market operation/ Cash Reserve Ratio/ Taxation Taxation : Except this, all others in the group are monetary measures. During inflation government should raise taxes. (True or false, justify your answer) True. To cut personal consumption expenditure the rates of personal corporate and commodity taxes should be raised. Deficient demand leads to deflationery gap. (Say whether True or False, justify your answer) Ans: True: Deficient demand gives rise to deflationary gap which causes the economys income, output and employment to decline, thus pushing the economy into an under employment equilibrium. Mr. Tom found his salary doubled in the last two years. However he could purchase the very same quantity of goods evenafter his increased income. How will you explain this situation? When Mr. Toms salary doubled he could purchase only very same basket of goods. This shows that he has not consumed anything additionally. Therefore, he might have saved the increased portion of the salary. Saving is what is left over after consumption expenditure. Here, the ratio of change in consumption to change in income is MPC (DC/DY) Examine how an increase in input price affect the equilibrium quantity exchanged in the product market? Prices of factors of production influence the supply of commodities. If price of an input increases, the cost of production of a commodity using more of that input increases. Therefore the supply of the commodity will decrease. When the input price rises, the supply curve shifts to the left. An increase in input price, therefore increases the equilibrium price and the equilibrium quantity falls. It is illustrated in the given figure.
3

1.

2.

3.

4.

1.

Price

D S O

S P D Q Output O M Output M1 M2 D

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Y P1 P S1 Price S D S1 S

O Quantity

Q1 Q

2. Show the determination of market equilibrium with the help of demand and supply schedules and a diagram. Equilibrium price is determined by the intersection of demand and supply curves. The point at which demand curve and supply curve intersect with each other is called equilibrium point. The following market demand and supply schedules illustrate the determination of equilibrium price in a market.
Price of Bananas (in Rs.) 18 19 20 21 22 23 Quantity demanded 10,000 8,000 7,000 6,000 5,000 4,500 Quantity supplied 1,000 2,000 4,000 6,000 7,500 8,500

rice etc. were left to the play of free market entirely, poor people would not be able to afford them at the market-clearing price. Hence, for a long time, the government has adopted a system of price control through ration shops for such commodities. In terms of demand and supply curves, price control means fixing price below the equilibrium price. This may lead to rationing system or blackmarketing. Inorder to protect the interest of farmers the government fixes minimum price or support price for commodities. It is fixed above the equilibrium price to insulate farmers from income fluctuations resulting from price variation in the free market.

3. Give one example of direct intervention and indirect intervention in the market mechanism. In a free enterprise economy, price of a commodity is determined by the forces of demand and supply. But in certain situations the government may interfere in price fixation. There are some policies, eg. different kinds of taxes and subsidies, that change the market price indirectly via shifting the demand and supply curves. Sales taxes and excise taxes are common examples. These are called indirect interventions. There are other policies by which prices are fixed directly by the government; these are called direct interventions. Examples of direct intervention are price control on products and support price for commodities. It is thought that if necessary items like sugar,
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4. Equilibrium price may or may not change with shifts in both demand and supply curves. Comment. The equilibrium price and quantity will change if there are changes in demand and supply conditions. It is possible that both demand and supply shifts occur simultaneously. It may be noted that when both demand and supply increase, the equilibrium quantity will increase, and when they decrease, the equilibrium quantity will decrease. But in both cases, the new equilibrium price may rise, fall or remain at the same level depending upon the relative change in demand and supply. The effect of change in both demand and supply is shown in the following diagram.
D P1 P Price S S1
Quantity demanded

D1

>

S1

D Q Q1

D1

>

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In the diagram, the rate of increase in demand is greater than the rate of increase in supply. Therefore, the new equilibrium quantity and equilibrium price will increase. The change in the equilibrium price depends upon the relative changes in demand and supply. A few instances are given below. (1) When increase in supply is equal to increase in demand, the equilibrium price will remain unaffected, while equilibrium quantity will increase. (2) When increase in supply is greater than increase in demand, the equilibrium price will fall while equilibrium quantity will increase. (3) When increase in supply is less than increase in demand, equilibrium price will rise, and quantity will rise. 5. Analyse the determination of equilibrium price with a diagram. In the market, there are two forces, viz. supply and demand. Equilibrium refers to a market where quantity demanded is equal to quantity supplied. The equality of demand and supply determines the equilibrium price. Equilibrium price is the amount at which buyers want to buy and sellers want to sell. The amount is equal. Only at the equilibrium price, wishes of both the buyers and sellers are satisfied. \ Equilibrium D = S Surplus Price E Shortage S > D Excess Supply D = S Equilibrium D > S Excess Demand Equilibrium price P is therefore called market clearing price. Here, price is an outside factor. So, when it changes, equilibrium is disturbed. This leads to equilibrium situations. When price moves up to P1, there is lesser demand and more supply. This leads to excess supply. When price moves down to P2, demand is more than supply. This creates excess demand. These two conditions are called disequlibrium states. Marshall likened the forces of demand and supply to the two blades of a scissors, moving in opposite directions. Just as both the blades moves in the opposite directions to cut a piece of paper, demand and supply moving in opposite ways together and at the same time, determine the equilibrium price. 6. Give one example of direct intervention and indirect intervention in the market mechanism. In a free enterprise economy, price of a commodity is determined by the forces of demand and supply. But in certain situations the government may interfere in price fixation. There are some policies, eg. different kinds of taxes and subsidies, that change the market price indirectly via shifting the demand and supply curves. Sales taxes and excise taxes are common examples. These are called indirect interventions. There are other policies by which prices are fixed directly by the government; these are called direct interventions. Examples of direct intervention are price control on products and support price for commodities. It is thought that if necessary items like sugar, rice etc. were left to the play of free market entirely, poor people would not be able to afford them at the market-clearing price. Hence, for a long time, the government has adopted a system of price control through ration shops for such commodities. In terms of de5

Quantity Demanded Diagrammatic Explanation: When price is P, demand is equal to supply at point E. At this point E, both the quantity demanded and quantity supplied are equal, at Q. ie., Demand = Supply. This is the point of equilibrium, E. At this point, there is no excess supply (D < S) or excess demand (D > S) for the commodity.

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mand and supply curves, price control means fixing price below the equilibrium price. This may lead to rationing system or blackmarketing. In order to protect the interest of farmers the government fixes minimum price or support price for commodities. It is fixed above the equilibrium price to insulate farmers from income fluctuations resulting from price variation in the free market. 7. Examine how an increase in the price of a substitute good in consumption affect the equilibrium price? Equilibrium price is the price at which quantity demanded and supplied are exactly equal. When there is a change in demand or supply condition, the equilibrium price also will be changed. For eg. tea and coffee are substitute goods. Suppose the price of coffee rises for some reason. The demand curve for tea will shift to the right due to increase in the price of coffee. Thus, as the price of a substitute good in consumption rises, the price of a given product rises and its quantity exchanged increases. 1. Budget receipts can be classified into two. Mention those two components and expalin them. Budget receipts may be classified as revenue receipts and capital receipts. (a) Revenue receipts: Revenue receipts may be divided into tax revenue and non-tax revenue. A tax is a compulsory contribution from a person to the government to meet the expenses incurred in the common interest of all. Non-tax revenue consists of all other revenue receipts such as commercial revenue and administrative revenue. (b) Capital Receipts: Capital receipts refer to all money mobilised by the government that either creates a liability of repayment or involves a sale of an asset. The main items of capital receipts are: (i) Loans raised by the government for the public.
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(ii) Borrowing by the government from the RBI through sale of treasury bills. (iii) Loans raised from foreign governments. (iv) Recoveries of loans granted to State and Union territory governments. (v) Small savings and deposits in the public provident fund, etc. 2. The budget is a tool for the government to implement its various policies. Do you agree with this statement? Explain. The budget is an annual statement of the estimated receipts and expenditures of the government over the fiscal year which runs from April 1 to March 31. The government has several policies it wishes to implement in the overall task of performing its functions. Implementation of these policies requires expenditure by the government and some source of funding for that expenditure. The budget is a tool for the government to implement its various policies. The objectives pursued by the government through the budget are the following. 1) Activities to secure a reallocation of resources: The government has to reallocate resources in line with social and economic considerations in case the market fails to do so or does so inefficiently. 2) Redistributive Activities: The government redistributes income and wealth to reduce inequalities by expenditures on social security, subsidies, public works etc. 3) Stabilising Activities: The government tries to prevent business fluctuation and maintain economic stability ie, high level of employment and price stability. 4) Management of public enterprises. Government undertakes commercial activities through its public enterprises. The commercial activities are of the nature of natural monopolies, heavy manufacturing etc. A natural monopoly is a situation

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where there are economies of scale over a large range of output; then one firm can produce at a lower average cost than more than one firm could. Eg. railway, electricity etc. These usually come under state regulation because if left unregulated, there will be a tendency of the monopolist to curtail output in pursuit of profit, thereby lowering social welfare. 1. A monopoly market structure may arise in various ways. How will you justify this statement with the help of examples? In monopoly market structure there is only one seller. This is defined in the context of a given geographical location or space. For example in India before liberalisation in the power sector, the generation and distribution of electricity were in the hands of State Electricity Boards (SEBs). A monopoly market structure emerges because of any of the following reasons: (a) The government gives licence to only one company for producing a product or providing a service in a given locality or space. For instance, till 2002, VSNL had monopoly in India in providing international telephone service. (b) Big private companies engage in research and come up with new products or new technology in producing an existing product. As a reward for their risk and investment in research the government grants patent rights. In other words, monopoly arises because of granting patent certificate or what is called patent rights. (c) Sometimes, firms retain their individual identity but they co-ordinate their outputs and pricing policy so as to act as if it is a monopoly. This is called a cartel. The OPEC (Organisation of Petroleum Exporting Countries) in the 1970s is an example of a cartel that led to virtual monopoly in the world market for oil. 2. The concept of monopolistic competition was introduced by Prof.Chamberlin. In what way you can explain this market situation? The concept of monopolistic competition was introduced by Prof. Chamberlin. Monopolistic competition is a market situation in which both the monopoly element and competitive element are present. In this market situation, many producers produce goods which are close substitutes and engage in acute competition among themselves. The following are the features of monopolistic competition: (1) Large number of buyers and sellers: The number of firms is fairly large though not very large as in perfect competition. For example, there is large number of firms in the market for products like tooth pastes, soaps, etc. The number of firms may vary from industry to industry. (2) Product differentiation: An important characteristic of monopolistic competition is product differentiation. Each firm produces a product which is differentiated from the products of rival firms. Product differentiation means differentiation of the product in terms of colour, shape, sme[ll, packing, taste, brand name etc. For example, toilet soaps like Pears, Rexona, Hamam, Lifebuoy etc. 1. Disequilibrium in the BoP results in favourable (Surplus) or unfavourable (Deficit) BoP. Examine the causes responsible for unfavourable BoP and mention the measures used to correct BoP deficit? Causes responsible for unfavourable BoPs are mainly the following. 1. More demand for consumption goods During post-war period demand for goods increased considerably. Due to demand of tea, oil seeds, and iron ore within the country the exports of these goods went down. Consequently unfavourable balance of trade increased. 2. Imports of machinery and equipments Since independence heavy import of machinery was
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made for the replacement of obsolete machines. We also had to import more machines to satisfy our desire for rapid industrialisation. The imports of machines made our balance of payment unfavourable. 3. Imports of war equipments The Indo-China and Indo-Pak war forced us to import war equipments to defend our country. 4. Setting up of embassies After independence we had to incur heavy expenditure in setting up embassies and high commissions abroad. It also contributed to our unfavourable balance of payments. 5. Increase in foreign competition Our major exports were jute, tea and textiles. But these days we have tough competition from Bangladesh in exports of jute. Sri Lanka and Indonesia are our rivals in the exports of tea. We have also tough competition from Korea and China in the exports of cloth. All these competitions have reduced our exports in these commodities leading to balance of payment deficit. 6. Hike in the petrol prices The price of petrol which was 2 dollar per barrel in 1973 has now increased to 36 dollar per barrel. The continuous rise in the consumption of petrol and its regular hike in price has increased balance of payment deficit. 7. Eruption of gulf war In 1990-91 there was a Gulf war between Iraq and several Western Countries. It increased the price of petrol, on one hand and on the other hand stopped the remittances by Indians working in Gulf area like Kuwait, Iraq etc. This worsend the situation further and increased our balance of payment deficit. 8. Disintegration of USSR. We have very large amount of foreign trade with USSR. Disintegration fatally affected our foreign trade. 9. Payment of interest on foreign trade We had borrowed substantial loan from abroad. Its repayment together with interest thereon mounted very fast. Interest on these loans approximated to Rs. 70,970 crores in 1997-98. It has also resulted in the balance of payment deficit. 10. Slow growth of exports Our exports has not been increasing as fast as the imports are increasing. The trade deficit is still widening. This has also resulted in the balance of payment deficit. The measures used to correct BoP deficit are: 1. Increase in production 2. Promotion of exports 3. Favourable bilateral trade agreements 4. Reduction in imports 5. Deflation 6. Encouragement to foreign investment 7. Devaluation of Indian currency 8. Foreign assistance 9. Import substitution 2. The term trade is commonly understood to mean exchange of goods wares or mechandise among people. How will you distinguish between internal trade and international trade? Trade implies an exchange of goods and services between two individuals or groups of individuals. An exchange of goods and services between two individuals living in the same locality or in two different regions of the same country is internal trade. It is trade with in the same country. International trade is an exchange of goods and services between two individuals or groups of individuals living in two different countries. It is trade between two nations.

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