UPSC Mains Answer PYQ 2022: Economics Optional Paper 1 (Part- 1) | Economics Optional Notes for UPSC PDF Download

Q1(a): Explain briefly Chamberlin’s concept of excess capacity in monopolistic competition.
Ans: Excess capacity is a condition that occurs when demand for a product is less than the amount of product that a business could potentially supply to the market. 
Monopolistic Competition and Excess Capacity:
In monopolistic competition, the demand curve slopes downward, meaning it cannot be tangent to the Long-Run Average Cost (LAC) curve at its minimum. Consequently, there will always be excess capacity, unlike in perfect competition.

In the above diagram qc is perfect competition output, qp is monopolistic competition output under price competition, and qn is monopolistic competition output under non-price competition.
Chamberlain argues that perfect competition does not represent the ideal output level for monopolistic competition. In a monopolistic competition scenario, the ideal output will fall to the left of the minimum point of the Long-Run Average Cost (LAC) curve due to the downward-sloping demand curve.
When there is both price competition and unrestricted market entry, the point where a firm's demand curve is tangent to the LAC curve would ideally indicate no excess capacity. This is essentially a reflection of the costs associated with product differentiation.

Q1(b): Discuss the concept of ‘liquidity trap’ in the liquidity preference model of interest.
Ans:When interest rates are very low and there are expectations of future increases, people tend to hold onto money rather than invest in bonds. This behavior renders monetary policy ineffective and is referred to as a liquidity trap.
Liquidity Trap Occurrence:
According to liquidity prefrence model there are two motives to hold money. One for transaction purpose and other for speculation of future interest. Bond prices are inversely proportional to the interest rate.
When interest rates are low, there is a possibility that they might rise, leading to a decrease in bond prices. If the potential capital loss from falling bond prices exceeds the interest earned, investors will prefer to hold money instead. This behavior is known as speculative demand for money.

When interest rates are above the critical level (rc), speculative demand for money is low. Conversely, when rates are below this level, speculative demand is high. As a result, any increase in the money supply will be held for speculative reasons, rendering monetary policy ineffective.

Q1(c): In demand for money, what are the major differences between the ‘transaction approach’ and ‘cash balance approach’?
Ans:The transaction approach and cash balance approach are important theories of demand for money. 
Major Differences in the Transaction Approach and Cash Balance Approach:

1. The transaction approach highlights the importance of money supply, whereas the cash balance approach concentrates on the demand for holding cash and considers both the demand and supply of money.
2. The transaction approach highlights the medium of exchange function of money, whereas the cash balance approach focuses on the store of value function of money.
3. The transaction approach regards money supply as a flow concept, while the cash balance approach considers it as a stock concept.
4. The transaction approach focuses on the velocity of money circulation, whereas the cash balance approach is concerned with the economic factors that influence how much of their wealth people choose to keep in the form of money.
5. The transaction approach can be represented by the equation P = MV/T (Fisher Equation), while the cash balance approach can be represented by the equation P = M/KT (Cambridge Equation).
6. In explaining trade cycles, the variable K in the Cambridge equation is more important than the variable V in Fisher’s equation. During inflation, individuals reduce their cash holdings (K), which leads to a decline in the value of money and an increase in the price level.

Q1(d): Discuss the Factor Endowment theory of trade in terms of ‘abundance in factor prices’ and ‘factor abundance’.
Ans: Factor endowment describes the extent to which a country possesses and can readily access factors of production such as land, labor, and capital. The Heckscher-Ohlin (HO) model illustrates how trade occurs between goods with varying factor intensities and between nations with differing relative factor endowments.
In Terms of Factor Abundance:
A country is relatively capital-abundant if it possesses a greater proportion of capital to labor compared to another country. It can be represented as
(K/L)_A> (K/L)_B
Here, country A is relatively capital-abundant and country B is relatively labor-abundant. 

In Terms of Factor Price:
Factor prices are determined by the supply and demand of factors. Let’s assume that the demand for a factor is given. In this situation, a capital-rich country has relatively lower capital prices, while a labor-abundant country has relatively lower labor prices.
(w/r)_A> (w/r)_B
Here, country A is relatively capital-abundant and country B is relatively labor-abundant. 

Q1(e): According to Hirschman, unbalanced growth can be achieved through ‘Social Overhead Capital (SOC)’ or ‘Direct Productive Activities (DPA)’. Discuss.
Ans: Hirschman’s unbalanced growth suggests deliberate unbalancing of the economy. Rather than investing in all sector, there should be investment in selected sectors.
As per unbalance growth theory, growth can be either through social overhead capital or direct productive activities.

First sequence of development is EF1FG1 and second sequence is EE1F2G. First sequence is development via shortages of SOC and other sequence is development via excess capacity of SOC. However the end path OX is actually balanced growth path.
Hirscham argues that development via shortages compels further investment while development via excess capacity nearly permits further investment. His argument is correct in the scenario where there is large resistance to change. Thus he favored growth through DPA.

Q2(a): Consider a duopoly market,
P= 100 – 2Q, MC = 10 and Q=q1 + q2
where P: Market price
Q: Total output or the sum total of both firms’ output
q1 &: q2 Firm 1 and Firm 2’s output respectively
MC: Marginal cost
Suppose Firm 1 is the market leader and Firm 2 is the follower. Firm 1 decides its output first and then Firm 2 takes its output decision. Find the equilibrium output, price, and profit of both the firms.
Ans: Given problem can be solved with Stackleberg duopoly model.
P= 100 – 2Q
P = (100 – 2(q1 + q2))
TR1 = P*q1 = (100 – 2(q1 + q2))*q1 ————————— (1)
Similarly,
TR2 = P*q2 = (100 – 2(q1 + q2))*q2
The reaction curve for firm 2 can be calculated as follows
MR2 = MC2
100 – 2q1 – 4q2 = 10
q2 = (45 – q1)/2 ————————— (2)
Firm1 is first mover thus it uses reaction curve of firm 2 to decide its output
Hence from equation (1) & (2) we get
TR1 = P*q1 = (100 – 2(q1 + (45 – q1)/2))*q1
MR1 = 100 – 45 + 2q1 – 4q1
MC1 = 10
In equilibrium MR1 = MC1
Hence
55 – 2q1 = 10
q1 = 45/2 ————————— (3)
Firm 2 takes output decision later thus using equation (3) and (2) we can get quantity q2
Hence q2 = 45/4
Hence P = 100 – 2(q1 + q2)
P = 32.5
Profit1 (Π1) = TR1 – TC1
Π1 = P*q1 – 10*q1
506.25
Profit2 (Π2) = TR2 – TC2
Π2 = P*q2 – 10*q2
Π2 = 253.125

Q2(b): Do you think Firm 1 would have had the first mover advantage if it had gone for the price adjustment? Explain your answer.
Ans:Under Bertrand duopoly, firms adjust their prices until they reach the level of marginal cost (MC). This results in the equilibrium price being equal to the MC. In this scenario, both Firm 1 and Firm 2 will engage in price competition.
Bertrand equilibrium can be given as follow

Here MC = 10 is same for both the firms.  Therefore each firm has incentive to cut price and capture market share. This will lead to price war. AS firms are not learning from past experience, price war will continue till prices fall to marginal cost (MC).
Thus market price P will be 10 and both total output Q will be as follow
P = 100 – 2Q
Q = 90/2 = 45
Each firm will produce q1 = q2 = Q/2 = 45/2
Hence, in the price adjustment approach firm 1 has lost first mover advantage.

Q2(c): A competitive equilibrium is both Pareto efficient and equitable. Do you agree? Justify your answer.
Ans: Pareto efficiency is said to occur when it is impossible to make one party better off without making someone worse off.
Competitive equilibrium and Pareto Optimality
Efficiency in consumption
The required condition is that the marginal rate of substitution between any two products must be the same for every individual who consumes it.

At point E MRSxy for consumer a and consumer b is different. Thus both will exchange goods such that they move to either of point P, Q or R where (MRSxy)a = (MRSxy)b.
In perfect competition (MRSxy)a = (MRSxy)b = p1/p2
Efficiency in production:
The required condition is that the marginal rate of technical substitution between labor and capital should be equal for both the producer. It can be given as (MRTSLK)a = (MRTSLK)b
In perfect competition (MRTSLK)a = (MRTSLK)b = w/r
Efficiency in product-mix:
For equilibrium both product and consumption market should be simultaneously in equilibrium. It happens when marginal rate of substitution (MRS) between two products must equal the marginal rate of transformation (MRT) between them.  I

In the above diagram only at point E market will be in equilibrium where (MUx/MUy)a = (MUx/MUy)b = (MRTxy)a = (MRTxy)b
In perfect competition (MUx/MUy)a = (MUx/MUy)b = (MRTxy)a = (MRTxy)b = p1/p2
Thus competitive equilibrium is Pareto optimal
Competitive equilibrium and Equitability:
Equitability refers to fairness. A division of resources is considered equitable if all partners perceive the same subjective value, meaning each partner is equally satisfied with their share. However, a Pareto optimal allocation may not always be equitable or socially desirable.
If the initial distribution is equitable, then a Pareto optimal competitive equilibrium will maintain this equitability. However, if the initial distribution is unequal, the resulting Pareto optimal equilibrium may achieve efficiency but will not necessarily be equitable.
This is where the need for rectifying the distributional inequities arises. This led to the development of Developmental Economics.

Q3(a): IS curve is the locus of equilibrium points in the commodity market. What do the points above and below the IS curve signify?
Ans:The IS curve shows equilibrium in the goods market.
Assumption

• Policy variables, including the money supply, government spending, and taxes, are fixed at some levels.
• Investment is exogenous.
• Money pays no interest.
• All financial assets can be divided into two groups, viz., money and homogeneous bonds.
• For simplicity, assume a closed economy and G & T zero.

Derivation of IS Curve
The condition for equilibrium in the product market is
Y = C + I + G
Y = C + S + T
Hence I + G = S + T
But G & T is zero thus
I(r) = S(r)
Now the IS curve gives the equilibrium value of r & Y where saving and investment are equal.

Points above IS Curve:
At points above the IS curve, the interest rate is higher than required for equilibrium. Thus, investment demand will be lower.
Therefore, points above the IS curve represent situations where aggregate supply exceeds aggregate demand (Ys > Yd) and savings are greater than investment (S > I).
Points below IS Curve:
At points below the IS curve, the interest rate is insufficient for equilibrium, leading to increased investment demand. Consequently, these points indicate scenarios where aggregate demand surpasses aggregate supply (Y_s < Y_d) and investments exceed savings (I > S).

Q3 (b) Compare the deposit multiplier with the money multiplier. Is there any impact on the money multiplier arising out of massive use of credit and debit cards? Justify your answer.
Ans: he deposit multiplier explains the basic money supply creation process that is determined by the fractional reserve banking system. While the money multiplier reflects the amplified change in the money supply that ultimately results from the injection into the banking system of additional reserves.
Deposit multiplier (d) = 1/r
Money Multiplier (m) =  (1+k)/(r+k)
Where r is cash reserve ratio and k is currency deposit ratio.
The money multiplier is important in macroeconomics because it determines the money supply. While a deposit multiplier minimizes the risk of a bank not having enough cash on hand to satisfy day-to-day withdrawal requests from its customers.
The deposit multiplier provides the basis for the money multiplier, but the money multiplier value is ultimately less, due to excess reserves, savings, and conversions to cash by consumers.
Impact on money multiplier due to rise in credit and debit card use
Use of credit and debit card will reduce the currency hold by public. Thus it will reduce currency deposit ratio. Hence value of money multiplier will increase.

Q3(c): Discuss the effectiveness of the monetary policy in an open economy with a flexible exchange rate and perfect capital mobility. Will this policy remain effective with a fixed exchange rate also, while other things remain the same? Explain.
Ans:
Under the perfect capital mobility, capital flow will be highly elastic. In this circumstances BP curve will be horizontal.
Flexible Exchange Rate

With expansionary monetary policy LM curve will shift outward. It will decrease interest rate. At decreased interest rate there will be high capital outflow. Under flexible exchange rate it will depreciate the domestic currency. Depreciation of currency will increase export, shifting IS to rightwards. The new equilibrium will be established at F where output is increased.
Thus under flexible exchange rate system monetary policy is completely effective.
Fixed Exchange Rate

Lets say to increase the output central bank increases money supply. It will shift LM curve rightwards. The new LM’ curve will interest IS curve at E”. At this point due to lower interest rate there will be large outflow of capital. It will put pressure on currency. To keep exchange rate  stable central bank will sell dollar and buy rupee. It will lead fall in money supply which will shift LM’ curve again to leftward (LM).  Equilibrium will re establish at E and there will be no change in output.
Thus under fixed exchange rate system monetary policy is completely ineffective.

Q4(a): State the canons of taxation. Do you think that direct taxes are less burdensome than indirect taxes in generating equal amount of tax revenue ? Justify your answer.
Ans: canons of taxation  mean the characteristics which a good tax system should possess.
Canons of Taxation

1. Canon of equality or equity:  Burden of taxation must be distributed equally or equitably in relation to the ability of the tax payers.
2. Canon of Certainty: The tax which an individual has to pay should be certain and not arbitrary with respects to the time of payment, the manner of payment, the quantity to be paid (tax liability) etc.
3. Canon of Economy: The cost of collecting a tax should be as minimum as possible.
4. Canon of Convenience: Taxes should be levied and collected in such a manner that it provides the greatest convenience not only to the taxpayer but also to the government.
5. Canon of Productivity: A tax is said to be a productive one only when it acts as an incentive to production.
6. Canon of Elasticity: An ideal system of taxation should be fairly flexible in nature in accordance with the requirement of the country.
7. Canon of Simplicity: The system of taxation should be made as simple as possible as complicated tax is bound to yield undesirable side-effects.
8. Canon of Diversity: There should be a multiple tax system of diverse nature rather than having a single tax system.
9. Canon of Expediency: Tax should be determined on the ground of its economic, social and political expediency.

Direct Taxes and Indirect Taxes:
Lets say intially a person is consuming at P. Lets say equal amount of direct and indirext tax is imposed which reduces income of a person by AZ. Now, with direct taxes person will be consuming at point P2 while with indirect taxes person will be consuming at point P1.
Thus, it can be concluded that direct taxes are less burdensome than the indirect taxes.

Q4(b): Give economic rationale for public expenditure on elementary education — a merit good.
Ans:
Merit goods are deemed to be socially desirable, and which are likely to be under-produced and under-consumed through the market mechanism. Merit goods have positive externalities.
Economic Rationale for public expenditure on elementary education

Free market equilibrium for elementary education has output Q1 and price P1. Here private marginal cost (PMC) is equated with private marginal benefits (PMB). But, social efficiency occurs at Q2 where social marginal benefits equates with social marginal cost. Society would benefit from increasing output until Q2. Thus public expenditure in can help to increase consumption of elementary education.

Amartya Sen’s Approach:
Amartya Sen suggested development by capability development. In his approach education plays important role in capability development. Thus, investment in elementary education can help in improving human capital.

Internation Experience:
Productivity is a measure of efficiency of a person completing a task. Productivity of labor force can be increased using skilling and training. A skilled population will able to generate more value in the economy than the unskilled population.
ASEAN, South Korea and Japan’s experience suggest that investment in human capital ensures sustainable development in the long run. These countries extensively invested in education.
India’s public expenditure on education is around 2.5% of GDP. India should focus on increasing it to 4-6% of GDP.

Q4(c): What will be the shape of the aggregate supply curve in the Classical and Keynesian models? Give a detailed explanation.
Ans:Aggregate supply is the total supply of goods and services produced within an economy at a given overall price level in a given time period.  In classical model supply curve is vertical while in Keynesian model it is horizontal till full employment level and then onward it becomes vertical.

Classical Model:
It is a classical model where wags are flexible. Lets say initially market is at equilibrium. Now there is fall in demand and thus prices decreases from 3P1 to 2P1. At lower prices labor demand will shift leftward. However labor will immediately understand fall in prices and thus increase in real wages (W/P). It will shift labor supply curve rightward from Ns(3P1) to NS(2P1). Money wages will fall. Equilibrium will re-establish at level where real wages(W/P) are constant. Thus full employment and  output will  restore at higher prices. Hence aggregate supply curve will be vertical in the classical Model

Keynesian Model:
In the Keynesian model, wages are rigid.  Now let’s say due to some shock aggregate demand was reduced.  Now unlike the classical model wages will not reduce. Thus at a given price level supplier can supply any amount of output till the full employment level. Thus supply curve will be horizontal till full employment level.
After full employment level, there will be pressure on wages. Wages will increase with respect to changes in price. Thus, same like classical model supply curve will become vertical.

Q5(a): Stating major assumptions in the Kaldor model of disbribution, establish that share of profits in national income depends on the ratio of investment to total output
Ans: Kaldor presented his income distribution theory as a Keynesian theory.

Assumption of Kaldor Model

1. Two factors of production capital and labour.
2. Investment is taken as independent variable.
3. Marginal propensity to consume (MPC) is constant, and it is greater for workers than capitalist.
4. full employment assumption

Model
Y = W + P ;
Where, Y is national Income, W are wages, P are Profit
S = Sw + Sp,
S is saving, Sw is saving by labor and Sp is saving by capitalist
I = S ;
I is investment
Sw = sw*W
sw is saving rate for labor
Sp = sp*P
sp is saving rate for capitalist
Thus
S = sw*W + sp*P
S= sw*(Y-P) + + sp*W
Solving we get
P/Y = I/Y * (sp-sw) – sw/(sp-sw)
Thus P/Y = f(I/Y)
That is P/Y is function of I/Y
Thus, share of profits in national income depends on the ratio of investment to total output

Q5(b): Explain the quantitative methods of credit control adopted by the central bank.
Ans: Central bank controls monetary policy through quantitative and qualitative tools. Quantitative tools directly affects availability and cost of credit in the market.
Open Market Operations:
In open market operations RBI  itself directly and buys or sells short-term securities in the open market. Buying of securities increases money supply in the economy and selling of securities reduces money supply in the economy. It is most preferred instrument.
The Liquidity Adjustment Facility (LAF):
It is an indirect instrument for monetary control. It controls the flow of money through repo rates and reverse repo rates. Increase in repo rate decreases money supply in the economy.
Bank Rate:
It is usually higher than the repo rate. It is rate at which the RBI lends money to commercial banks without any security or collateral. If the RBI were to increase the bank rate, money supply will reduce.
Variable Reserve Requirement:
RBI can change cash reserve ratio and statutory liquidity ratio to change money supply. Increase in CRR and SLR will reduce money supply in the economy. This instrument is least preferred.

Q5(c): Under Partial equilibrium analysis, discuss the consumption and revenue effects of tariffs.
Ans: Let’s assume that a country is small and imposes tariffs on imported commodity.

Consumption Effect:
The imposition of import tariff on a particular commodity has the effect of reducing consumption. In the above figure a country was consuming at quantity OQ1. After imposing tariff (PP1) prices increases to OP1. It reduces consumption to OQ2. Thus net reduction in consumption is Q2Q1.

Revenue Effect:
The import tariff provides revenues to the government. At original price OP does not include any tariff and no revenue receipts become available to the government. Subsequently when PP₁ per unit tariff is imposed, the revenue receipts of the government can be determined by multiplying per unit tariff PP₁ (or BF) with the quantity imported Q₃Q₂ or (EF). Thus the revenue receipts due to tariff amount to 
PP₁ x Q₃Q₂ = BF x EF = BCEF. This is revenue effect of tariff.

Q5(d): Show that in Domar’s growth model, in equilibrium, path of investment is exponential.
Ans: Domar model wanted to determine unique rate at which investment and income must grow such that full employment level is maintained for longer time. According to Domar, investment raises productive capacity on the one hand and on the other hand it raises total demand in terms of total income.
Capacity Effect of Investment
σ = ∆Y/∆K
∆K = I
∆Y = Iσ
∆Y/Y = g = σs
Demand Effect of Investment
∆Y = ∆I/s
In equilibrium demand effect of investment should be equal to the capacity effect of investment.
g = (∆y/y) = (∆I/I) = s.σ
Hence, in Domar’s growth model, in equilibrium, path of investment is exponential.