UPSC Mains Answer PYQ 2020: Economics Optional Paper 1 (Part - 1) | Economics Optional Notes for UPSC PDF Download

Q1(a): Explain how equilibrium rate of interest and income are determined with the interaction of both product and money market.
Ans: Equilibrium rate of interest and income in the interaction of product and money market can be determined by IS-LM approach

Money market equilibrium : LM curve
LM curve gives value of interest rate and income where money demand is equal to money supply.

Goods market equilibrium : IS curve
IS curve gives equilibrium value of r & Y where saving and investment is equal .

The IS And LM Schedules Combined
IS curve shoes goods market equilibrium. LM curve shows money market equilibrium. Thus interaction of IS and LM curve shows level of income and interest rate where both money market and goods market is in equilibrium.
Such equilibrium is achieved at equilibrium point E. In case of deviation from this point goods and money market works together to achieve equilibrium again.Q1(b): Distinguish between post-Keynesian approaches to horizontalist and structuralist theory of endogenous money supply.
Ans: Horizontalist and structuralist theory of endogenous money supply are post Keynesian approaches to money supply.
In horizontalist approach the supply of monetary base is horizontal at the policy determined money market interest rate. Banks satisfy all loan demand forthcoming at that rate. Thus in horizontalist approach interest rates as exogenously set. Also thisinterest rate determination is the absence of any role for liquidity preference. Thus Structuralist theory ignored money demand.
Above two characteristics of Horizontalist theory was criticized by structuralist. The structuralist model addresses both of these concerns by introducing money demand and additional interest rates that are endogenously determined

Q1(c): Explain how renewable resources will play a role in future economics.
Ans: Renewable energy, often referred to as clean energy, comes from natural sources or processes that are constantly replenished. For example: wind energy, solar energy, etc. It is going to play important role in future economics.
Future economics is going to be energy driven economics. Thus renewable energy is going to fulfil major part of energy demand. Future economics is also going to be sustainable development oriented. Research and growth in renewable energy will help to achieve goal of sustainable development.
Renewable energy sources like biofuels can promote economic activities in the tribal areas. For example biofuels production from minor forest products like Mahua.
Solar energy, wind energy, etc. requires advance machineries and equipment. Growth of renewable energy will promote growth of these industries and thus in return growth of employment.
Thus it can be said that renewable energy sources could be engine of growth for the future economies

Q1(d): Mention the classification of assets held by a commercial bank. Discuss the problems faced by commercial bank due to rise in NPAs.
Ans: Narsimhan committee classified the assets held by commercial banks in different categories and rates of %age for provisioning.

Classification of assets held by commercial banks

1. Standard assets – Standard assets are those assets which are running good without any default.
2. Substandard assets – Requires a provision of 15% on secured portion and 25% on the unsecured exposure.
3. Doubtful assets category 1 – Requires a provision of 25% on secured portion and 100% on the unsecured portion
4. Doubtful assets category 2.  Requires a provision of 40% on the Secured portion and 100% on the unsecured portion
5. Doubtful assets category 3 – Requires 100% provision
6. Loss assets – Requires100% provision

Problems faced by banks due to NPA

1. High NPA affects profitability of banks.
2. It creates twin balance sheet problem. That means both the banks and the corporate sector have stressed balance sheet and causes halting of the investment-led development process.
3. Trust in banking system might reduce.
4. Very high level of NPA might affect sustainability of banks.

High level of NPA affects not just banking but overall economy. Thus government and overall banking system should focus on reducing the level of NPA in the economy.

Q1(e): Explain Myrdal’s cumulative causation theory as the theory for development.
Ans: Myrdal gave the theory of cumulative causation based on the observation of the Western country’s development. Myrdal’s cumulative causation depends on two effects, spread effect and backwash effect.
Spread refers to the situation where the positive impacts on nearby localities and labor markets exceed the adverse impacts. Backwash occurs if the adverse effects dominate and the level of economic activity in the peripheral communities declines.
In the backward economies there will be center of investment where most of the investment is attracted. Investment helps to industrialize the region. As an effect income of people increases there. It raises demand for industrial good than agricultural good (Engle effect). Prosperity of center attracts people and capital from periphery. It leads to capital and brain drain to periphery. Thus center grows at the cost of periphery.
Over the time negative externalities increases in center like pollution, unavailability of land, increased cost of living. Thus now capital and labor moves to periphery. Spread effect starts working. It leads to development of the periphery as well.

Q2(a): What is conjectural variation? Show how some models of oligopoly are derived on the basis of it.
Ans: In oligopoly theory, conjectural variation is the belief that one firm has an idea about the way its competitors may react if it varies its output or price.

Bertrand Model and Conjectural Variation
In Bertrand model, firm assumes that other firm will keep its prices unchanged irrespective of first firms decision about pricing (This is conjectural variation).  Lets assume that cost function is equal and constant then quantity sold by firm is given as
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).

Cournot’s Model and Conjectural Variation
In Cournot’s model each firm acts on the assumption that its competitor will not change its output irrespective of its decisions (This is conjectural variation). Lets say firm A enter into market first. Then he will behave as monopoly and start selling quantity OA.  Now firm B enters into market it will assume that A will keep producing OA. Hence it considers its own demand curve as CD’

With CD’ curve it maximizes output by producing AB. Now A will realize that price has fall. He will assume that firm B will keep producing same output. And adjust output accordingly. He will produce (Total output – Output of B)/2. Similarly By seeing rise in prices B will react assuming constant output of A. This pattern of action reaction continue till each firm produces equal output that is 1/3 rd of total output.

Q2(b): Show that systematic monetary and fiscal policies are ineffective in controlling output and price level.
Ans: According to rational expectation hypothesis proposed by Lucas, even systematic monetary and fiscal policies are ineffective in controlling output and price level.

Assumptions

1. People form rational expectation on the basis of all available information
2. People are able to judge impact of systematic policies

Model
Lucas  said that economic agent will form expectation on the basis of all available information.

Now lets say initial equilibrium is at Price level P₀ and output Y₀ with employment N₀. Lets consider that there is systematic change in fiscal policy or monetary policy.  Increase in money supply will affect demand and push prices up from P₀ to P₁′.  Similarly, increase in fiscal stimulus will also affect demand and push prices up from P₀ to P₁′.
Increase in price level will increase value of marginal product. It will sift labor demand outward.  It will lead to rise in employment. But money supply change or fiscal policy change is systematic. Thus it will be anticipated by agent. Economic agent react to it to adjust accordingly. It results into shift of labor supply and hence output to leftward. Hence systematic monetary and fiscal policies are ineffective in controlling output and price level.

Q2(c): (i) What makes technical progress endogenous? Do you think that technology is a ‘non-rival’ good?
(ii) Show that if the research becomes more successful, the growth rate will increase and hence the standard of living
Ans:
(i) The endogenous growth models emphasise technical progress resulting from the rate of investment, the size of the capital stock, and the stock of human capital. Let’s understand this by Romer model.
Romer assumes creation of knowledge as a side product of investment. He takes knowledge as an input in the production function of the following form
Y = A(R) F (R_i,K_i,L_i)
Where Y is aggregate output; A is the public stock of knowledge from research and development R; R_i is the stock of results from expenditure on research and development by firm i; and K_i and L_i are capital stock and labour stock of firm i respectively. Thus rate of investment, the size of the capital stock, and the stock of human capital will affect technical progress thus technical progress becomes endogenous factor.
Technology is nonrival because  once the costs of creating the technology has been incurred, the technology can be used over and over again at no additional cost. However, due to patent restrictions even technology might show rival characteristics.

(ii) The production function with constant returns can be expressed as follow
Y = AK
Where A is a positive constant it represents the level of technology. Here K  is treated in a broad sense to include both physical and human capital . With the research level of technology A will increase.
Output per capita is y = Y/L = A*(K/L)= Ak
where k is per capital capital K/L
Now ∆k = I = Saving (S) – Depreciation (D)
We know that S = sY & D = dK
∆K = I = sY – dK
We can rewrite this as
sY = K(∆K/K) + dK
At steady stage ∆K/K = ∆Y/Y  = n
Thus sY = (n+d)K
but Y/K = A
Hence  sA = (n + d)
With AK model increase in capital increases income with constant proportion. Now if sA > n + d then k grows in perpetuity. Thus technological progress, driven by investment in human capital formation and R & D, offsets diminishing returns to physical capital. Thus as the research becomes more successful, the growth rate will increase and hence the standard of living

Q3(a): Suppose that we have only two firms in the market with constant marginal costs of C1 and C2 respectively such that C1 >C2 What is the Bertrand equilibrium in this market? How is it different from the competitive equilibrium? .
Ans: In Bertrand model, firm assumes that other firm will keep its prices unchanged irrespective of first firms decision about pricing. Let us assume that there is no capcity constrain.
Bertrand Nash equilibrium prices are P1 = P2 = max[C1,C2].  Now if C1 > C2 then firm 2 is the low cost firm and it will be able to charge a markup of C1 – C2 and thus set a price of C2 < P1 < C1 and make positive profits. Firm 1 sells nothing, and firm 2 sells an amount equal to D(P1).
The Nash equilibrium of the Bertrand model is the same as the perfectly competitive outcome. Price is set to marginal cost.  Now when C1>C2 at price less than C1 and greater than C2 firm 2 will be making profit. At that level of price firm 1 will be in loss. However looking at profit of firm 2 new firms will be attracted . Entry of new firms will reduce price to C2. Thus in competitive equilibrium price will be set to C2 and firms will earn zero profit.

Q3(b): “Even green energy is not always green.” Do you agree? Illustrate your answer taking biofuels as an example.
Ans: Green energy is form of energy that don’t harm the environment through factors such as releasing greenhouse gases into the atmosphere. Biofuels are usually classified as green energy. However biofuels might not always green.
Burning biomass, whether directly as wood or in the form of ethanol or biodiesel, emits carbon dioxide just like burning fossil fuels. In fact, burning biomass directly emits a bit more carbon dioxide than fossil fuels for the same amount of generated energy. But most calculations claiming that bioenergy reduces greenhouse gas emissions relative to burning fossil fuels do not include the carbon dioxide released when biomass is burned. They exclude it based on the assumption that this release of carbon dioxide is matched and implicitly offset by the carbon dioxide absorbed by the plants growing the biomass.
According to world resource institute biofuels and bioenergy take up finite land resources at the cost of food production and carbon storage and doesn’t guarantee carbon emissions cuts. Also fertilizers are used in the production of biofuels crops. Excessive use of fertilizers affects environment. Thus net emission might not be zero.
Palm trees are one of the important resource for biofuels production. In Malaysia and Indonesia large tropical rain forest were cut to increase palm oil production. It affected biodiversity in the region.
Thus from above arguments it can be confirmed that “Even green energy is not always green.”

Q3(c): You are given the data on the following variables in an economy :
Government spending = 300
Planned investment = 200
Net exports = 50
Autonomous taxes = 250
Income-tax rate = 0.1
Marginal propensity to consume = 0.5
(i) Consumption (C) is 600, when income (Y) is equal to 1500.Solve for autonomous consumption.
(ii) Solve for the equilibrium levels of output denoted (respectively by Yw and Ywo) in the two scenario presence and absence of income tax in the economy.
(iii) Solve for the change in net exports that would bring the equilibrium output level in the economy with the income tax to the level of Yw that you found in (ii). Specify both the magnitude and sign of the change.
[Figures are in rupee 000 crore, obviously except tax rate and MPC]
Ans:
(i) C = a + bYd
& Yd = (1-t)*(Y – T)
where
C is consumption,
Yd is disposable income,
b is MPC,
a is autnomous consumption ,
t is income tax,
and T is autnomous tax
Now C = 600, b = 0.5, t = 0.1, T = 250 & Y = 1500
600 = a + 0.5*(0.9*1500-250)
a = 50
Thus autnomous consumption is 50000 cr

(ii) In the absence of income tax
Equilibrium level of output given by equation
Y = C + I + G  + X – M
Y = a + b(Y-T) + I + G  + X – M
(1-b)Y = a -bT + I + G + X – M
0.5Y = 50 – 0.5*250 + 200 + 300 + 50
Y= 950000 cr
In the presence of income tax
Y = C + I + G – T + X – M
Y = a + b( (1-t)*Y – T) + I + G  + X – M
Y = a + bY-b*t*Y – b*T + I + G + X – M
(1-b + b*t)Y =  a – b*T + I + G + X – M
0.55Y = 50 – 0.5*250 + 200 + 300 + 50
0.55Y = 475
Y = 863000 cr
(iii) (1-b + b*t)Y =  a – b*T + I + G  + X – M
0.55Y = 50 – 0.5*250 + 200 + 300 + (X-M)
0.55Y = 425 + (X-M)
Now Y = 950
Hence (X-M) = 97.5
Thus net change in net export is 97.5- 50 = 47.5
Thus, net export increased by 47500 cr.

Q4(a): Many countries subsidize some of their export industries. Use a partial equilibrium model under perfect competition to illustrate the following effects of an export subsidy for a large country :
(i) Welfare effects of an export subsidy
(ii) Which group is winning and which is losing from the subsidy?
Ans: Export subsidies are given to domestic exporters to improve their competitiveness in the global market. As a country is large export subsidy will affect world prices as well.

Lets say initially pw is equilibrium world price where foreign import demand is met by home export supply. Now lets say a country gives export subsidies. In large country case it will increase export supply in the world market. Thus, export supply curve will shift outward.  It pushes down equilibrium prices to p*.
(i) Now in domestic market exporter will sell only at the price p*+subsidy. Hence it will increase domestic price. In domestic market consumer welfare loss is a+b, producer welfare gain is a+b+c and cost of govt subsidy is b+d+e. Thus overall change of welfare is c-(b+d+e) . If c< ( b+d+e) then there will be overall welfare loss.
(ii) Export subsidies increases welfare of domestic producer at the same time it affects welfare of domestic consumers. Thus domestic producers are winning in the subsidies and domestic consumers are loosing.

Q4(b): Briefly state the Kaldor’s theory of distribution in determining the share of profit and the share of wages in national income. Explain the mechanism behind Kaldor’s model.
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
Kaldor showed that P/Y ie profit to output ratio is function of I/Y given by,
P/Y = I/Y * (sp-sw) – sw/(sp-sw)
Thus P/Y = f(I/Y)
At full employment level rise in I/Y should be compensated by rise in S/Y. Thus according to Kaldor with constant MPS, only way to increases S/Y is  through a shift in the distribution of real income from low saving groups to the high saving groups. If this does not happen the price level will increase in the economy.
With this analysis Kaldor tried to improve on rigidity of Harrod Domar model. However due to its restrictive assumptions it can not be generalised for more than two sector and for the output below full employment.

Q4(c): Show how the idea of monopolistic competition becomes intrinsic to the endogenous growth theory as postulated by Romer.
Ans:
Endogenous growth theory of Romer
In Romer’s model technology is taken as endogenous factor. Its equation is given as.
ΔA = F(Ka, Ha, A)
where
ΔA  is change in technology
Ka is amount of capital invested in new technology
Ha is amount of human capital invested in new technology
A is existing technology
When more human capital is employed for R&D, change in technology (ΔA) will be more. Also technology is non rival and thus will have positive impact on other sectors as well. Thus investment in R&D leads to increase in economic development.
In the new growth model R&D is important factor of production. Government and private sector should focus on investment in R&D to increase the economic development.
A key feature of Romer’s monopolistic competition model is the recognition that ideas, while non-rival, are not pure
public goods. Moreover, each firm that owns a design and manufactures a producer durable maximizes profits. Thus each producer of intermediates is a monopolist with an eternal patent. Hence it can be said that idea of monopolistic competition becomes intrinsic to the endogenous growth theory as postulated by Romer.