UPSC Mains Answer PYQ 2022: Economics Optional Paper 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.

Q. 2 (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).