UPSC Mains Answer PYQ 2019: Economics Optional Paper 1 (Part - 1) | Economics Optional Notes for UPSC PDF Download

Q1(a): Under competition cost function is given as C(y) = y² + 1, where y is output. Derive the inverse supply curve and show how the supply curve looks like.
Ans: Inverse supply curve give us quantity demanded for given price. Given the competition
Marginal Cost (MC) = P
MC = 2Y
Thus
2Y = P
Hence Inverse supply function is :
P = 2Y
Shape of supply curve 
Shape of supply curve will be a linear straight line with slope of 2.

Q1(b): What determines the degree of price discrimination under monopoly market? 
Ans: In the price discrimination monopolist charges different prices for same product for different set of consumers.
First degree of price discrimination
In this model every consumer is charged different price. It can be practiced when personalized service is provided. For example lawyer and doctor can charge each consumer differently.
Second degree of price discrimination
In this model buyers are divided into different groups and different prices are charged from these groups. It is possible under following conditions.

1. Several group requires differentiated service. For example India railway has AC, Sleeper and general coaches.
2. When two set of consumers are situated in two different geographies & it is expensive to transfer good from cheaper market to dearer market

Third degree of price discrimination
In this model market is divided into different sub markets. Each sub market has different elasticity of demand. According to elasticity of demand price is charged. For example student discounts for movies.

Q1(c): How does ‘carbon trading’ help in reducing environment degradation? (10 Marks)
Ans:  Carbon credit is tradable carbon emission permit. It allows a country or organization to produce a certain amount of carbon emissions and which can be traded if the full allowance is not used.

Help of carbon credit in reducing environmental degradation

• It is cap and trade system. It caps global emission of carbon. If cap followed properly, we can keep our temperature rise below 2 degree celcius.
• It is easy to administered than carbon tax.
• Due to capping it forces countries to invest in green technologies. Hence in longer run it reduces environmental degradation.
• Country which pollutes less will earn revenue by selling carbon credits. In that way it also incentives less pollution.
• Polluter has to buy credit. Thus it also have principle of polluter will pay.

With the growing climate change issues we have to cap our emissions. For that carbon trading mechanism can help us to limit our emission.

Q1(d): How is Human Development Index calculated by UNDP? Can there be a better method of assigning weights to various indicators
Ans: Human development index is yearly published by UNDP. It is based on ideas of Amartya Sen and Mahbub ul haq.
Calculation of HDI 
HDI considers three broad parameters health (Life expectancy at birth), knowledge (Expected year of schooling & Mean year of schooling) and standard of living  (GNP at per capita in PPP terms). Its maximum and minimum value is given in following tables.

Performance in each indicator is calculated according to following formula
Dimension index = (actual value – minimum value) / (maximum value – minimum value)
While calculating knowledge index average of Mean year of schooling index and Expected year of schooling index is calculated.
While calculating income index, instead of absolute value log of income is taken.

Calculating final HDI
Now with above calculation we will have Heath Index (H), Knowledge Index (E) and Income Index (I). HDI is geometric mean of this three indicators.
HDI = (E*I*H)^(1/3)

Different method of assigning weights
In HDI all three indicators are weighted equally. Unequal weights could be assigned to them depending on role of particular indicator in the human development.

Q1(e): Show that in a simple Keynesian model, equal expansion in tax and government expenditure does not always lead to balanced budget theorem. (10 Marks)
Ans: If one rupee rise in government expenditure is compensated by increase in one rupee tax, it increases income by one rupee. This is called as balanced budget multiplier.
Circumstances under which equal expansion of T & G does not lead to balanced budget theorem
Full employment level:

If full employment level reached any change in government expenditure and demand will not increase income. Thus balanced budget theorem won’t work.

Other circumstances 

• Despite increasing tax rate, tax collection may not increase.
• Government expenditure is diverted to corruption.

Balanced budget theorem will only work  when economy is close, efficient and output is below full employment.

Q2(a): Tragedy of the commons’ leads to over-exploitation of resources. Analyze. (15 Marks)
Ans:  The tragedy of the commons is a situation in a shared-resource system. In that where individual users, acting independently according to their own self-interest, behave contrary to the common good of all users. It leads to depletion of common resources.
In Maharashtra sugarcane is grown despite being a water scarce state. Major source of water for sugarcane is tube well. Individual farmers exploited ground water for sugar cane cultivation. Earlier ground level of water was high and everyone was well off. In recent times due to over exploitation ground level water fall. Now it is impacting all the farmers. It has increased farmer distress in Maharashtra. Similar is situation of rice cultivation in Punjab. If farmers have thought about collective welfare, resources would not have exploited.
In some cases the tragedy of the commons can lead to the complete and permanent elimination of the common-pool resource. The extinction of the dodo bird is a good historical example. Dodo made a ready source of meat to feed hungry sailors traveling the southern Indian Ocean. Dodo’s excessive killing led to its extinction. In longer term it affected all the hungry sailors.
Thus it can be said that tragedy of commons leads to over exploitation of resources. Government control, environmental conservation and environmental sensitization are ways to deal with tragedy of commons.

Q2(b): The following data are given for an economy :
Consumption function, C = 250 + 0-5 (Y – T) –  500r
Investment function, I = 250 – 500r
Real money demand function, L /P = 0.5Y – 500r
Nominal money supply, M = 7650
Price level, P = 17
Tax = T = Government expenditure = G = 20
Here Y is Real income, r is Real rate of interest, L – Nominal money demand, P is Price level.
(i) Find the equations for IS and LM curves, and solve for Y and r.
(ii) Find out the multiplier formula for money supply change and then calculate the change in output if money supply changes by 510.
Ans: 
(i) IS – LM derivation 
IS curve derivation 
IS curve gives relation between income and interest rate when good market is in equilibrium.
Y = C + I + G
Y = 250 + 0.5 (Y – T) –  500r + 250 – 500r + G
Here T = G = 20
Y = 250 + 0.5 (Y – 20) –  500r + 250 – 500r + 20
Y = 250 + 0.5Y – 10 – 1000r + 270
0.5Y = 510 – 1000r
IS curve is Y =  1020 – 2000r
LM curve derivation
LM curve gives relation between income and interest rate when money market is in equilibrium.
Nominal money supply = Money demand
Ms/P = 0.5Y – 500r
450 = 0.5Y – 500r
LM curve is Y = 900 + 1000r
IS & LM interaction
In equilibrium IS = LM
1020 – 2000r = 900 + 1000r
r = 0.04
Hence r is 4% &
Y = 1020 – 2000r = 940
(ii) Multiplier Formula
In equilibrium IS = LM
IS curve is Y = 1020 – 2000r
Thus r = (1020 – Y)/2000
LM curve is
Ms = Y/2 – 500r
2Ms = Y – 1000r
Putting r in above equation we get
2Ms = Y – 1000* (1020 – Y)/2000
2Ms = Y – 510 + Y/2
2Ms = 3Y/2 – 510
3Y = 4Ms + 1020
Monetary policy multiplier is ΔY/ΔMs = 4/3
Thus ΔY = (4/3)*ΔMs
When nominal money supply rises by 510, real money supply rises by 30
Hence ΔY = (4/3)*30 = 40
Income rises by 40 when money supply rises by 510

Q2(c): How can controls on foreign trade contribute to the development of developing countries?  (20 Marks)
Ans: Foreign trade control includes tariff barriers and non tariff barriers. Sometimes these controls are essential for development of developing countries.

Infant industry argument 
Nation may have a potential comparative advantage in a commodity. Due to high initial capital & small market industry can not be set up and compete with foreign firms. Temporary trade protection will help this industry to set up. Once there is sufficient growth then even without protection they can compete with foreign firms.
For example recently Indian government restricted Chinese app. India has potential in IT sector. This restriction will help Indian IT apps to grow. 

Industrialization of country
For developing country comparative advantage is mostly in agricultural goods. As economies developed demand for agricultural good become stagnant. It affects welfare of developing nations. Industrialization is important for long run welfare. In that case protection to domestic industry helps.

Tariff wall and development
High tariff rates attracts foreign capital in the country. Tariff wall gives them protection from competition. It helps in domestic development of country.

Protection against anti dumping
Some countries can dump cheaper good in the developing countries. It affects growth of domestic industries. For example steel dumping by China affects growth of Indian steel industry. To restrict dumping anti dumping duty is necessary.

Labor protection and employment
Foreign trade control will increase growth of domestic industries. It will increase number of employments in the market.
Excessive foreign trade control can inhabit growth as well. It can promote inefficiencies and monopoly in the economy. Other countries might also reciprocate with same measures. Thus any foreign trade control should be reasonable and with sunset close.

Q3(a): The role of income and substitution effect is crucial in producing backward bending labour supply curve when a tax is imposed on wages. Do you agree?
Ans: In the backward sloping labor supply curve, till a certain point there is direct relation between labor supply and wages. However after that point higher wages leads to lowering of labor supply. There are two effects determining supply of labor : substitution effect and income effect.

• Substitution Effect: Lower wage makes work less attractive than leisure. It decreases work hours with rising taxes.
• Income Effect: Due to taxes wages reduce. Worker are not getting enough income. Thus rise in taxes increases work hours.

When the Substitution effect dominates the Income effect, the labor supply curve is upward sloping. Thus there is a negative relationship between taxes and labor supplied (Tax reduces wages).
However at a high tax rate, income effects start dominating the substitution effect making labor supply backward bending. From this point onwards labor supply increases with increased taxes (Tax reduces wages).

Wage tax and backward bending labor supply curve 

An increase in wage tax reduces the after-tax real wage for a given value of the pretax real wage. The labor supply curve shifts to the left. Equilibrium moves from point B to point A. Employment and output decrease.

Q3(b): In case of perfect capital mobility, explain the difference of the impact of an increase in money supply on GDP under two alternative exchange rate regimes—one fixed and the other flexible. 
Ans: Under the perfect capital mobility, capital inflow & outflow is highly elastic to the interest rate. It makes BP curve horizontal line.

Perfect capital mobility and fixed exchange rate

With increase in money supply, LM curve will shift rightward. It will reduce equilibrium interest rate. But under perfect capital mobility, capital will start flowing outward. With fixed exchange rate central bank will intervene to keep exchange rate stable. Central bank will start selling dollars in exchange of rupee. It will reduce money supply and shift LM curve back to leftward.
Thus monetary policy will be ineffective under fixed exchange rate.

Q3(c): Reflect on the inefficiency and socially undesirable aspects of monopolistic competition market situation vis-a-vis the perfect competition, both in the short and in the long ran.
Ans: In the monopolistic competition there are multiple sellers selling differentiated goods while in perfect competition there are multiple buyers selling homogeneous product.

Short run inefficiencies of monopolistic competition 
Due to the product differentiation demand curve for the monopolistic competition is downward sloping. Hence in short run monopolistic market works like monopoly. According to demand curve price is set at the quantity at which MC = MR. At this price firms are earning supernormal profit like monopoly.
In the perfect competition demand curve is horizontal line. Hence output will be more than monopolistic competition.

Long run inefficiencies of monopolistic competition 

In the monopolistic competition, by looking at supernormal profits other firms also enters into the market. Which pushes firm demand curve to the left. It also makes demand curve elastic. Entry of firm in the market will continue till supernormal profit is eliminated from the market. Equilibrium is set at quantity where MR = MC and price is equal to AC of firm. In longer run firms do not enjoy monopoly profit.
In the perfect competition, long run equilibrium is established at minimum of long run average cost curve. Thus compared to monopolistic competition, output will be more and prices will be less. Some economist called it excess capacity.

Socially undesirable aspects of monopolistic competition

• In the monopolistic competition product is differentiated. Thus to increase sell seller will use advertisement tactics. In the long run influenced by one seller all will start using advertisement tactics. Thus in longer run there will be gain. It is wasteful resource from social point of view.
• Due to presence of excess capacity there will be unemployment. Also no surplus is there for producer.

However as suggested by Chamberlain, these are not inefficiencies but cost paid for product differentiation. Product differentiation increases social welfare.

Q4(a): What is the follower’s problem in a duopoly model and how does it differ from the leader’s problem?
Ans: Stackelberg’s model of duopoly deals with followers and readers problem.

Assumptions

• There are two firms.
• Output produced is homogenous.
• Marginal cost of firm is 0
• Follower take output of leader as constant and set its profit maximizing price. While leader considers interdependence between firms.

Followers problem 
Let’s say market demand is P = a – bQ
where Q = Q1 + Q2 where Q1 is output of leader and Q2 is output of follower
Follower will decide its output when leader has taken decision about output.
Let MC = 0
then TR2= P*Q2
Thus MR2 = a – bQ1 – 2bQ2
MR2 = MC = 0
a – bQ1 – 2bQ2 = 0
Q2 = (a – bQ1)/2b

Leaders problem 
Leader recognizes its output will influence output of follower
TR1 = aQ1 – b(Q1)^2 – bQ1Q2
TR1 = aQ1 – b(Q1)^2 – bQ1[(a-bQ1)/2b]
Hence MR1 = a/2 – bQ1
MR1 = MC = 0
Q1 = a/2b
Q2 = a/4b

Difference in follower and leader problem

• Follower does not recognize interdependence
• Leader recognizes interdependence
• Leader will sell more output than follower
• Leader will earn more profit than follower

Hence it is evident that being a leader benefits in the above duopoly model.

Q4(b): Can public-private partnership function effectively in the area of physical infrastructure?
Ans: PPP is partnership between government and private enterprises for creation of infrastructure for public purpose. In the recent times use of PPP is increased for infrastructure creation.

Effectiveness of public private partnership

• According to various growth theories capital is important for growth. PPP model augments public and private capital for growth.
• Private player has expertise, it helps in speedy development of infrastructure.
• PPP focuses on output than input. Thus private sector can brings innovation in infrastructure creation.
• Presence of public sector ensures the accountability from private sector. If desired quality of infrastructure not provided then contract can be terminated.
• PPP distributes risk between government and private players. It increases infrastructure creation.

Factors which affects effectiveness of PPP mode

• Corruption in getting contracts is major issue.
• Land acquisition delays infrastructure creation.
• Exploitation of consumers by private players. For example high tolls in road
• Red tapism in approving projects.

PPP is good model which will help is to reduce infrastructure deficit in India. It needs to be reformed to include 4th P that is people to make it more effective.

Q4(c): What are the features based on which the new trade theories are built that are distinctly different from the old theories? (20Marks)
Ans: New trade theories emerges in 1980. They focuses on the role of increasing returns to scale and network effects. Krugman, Brander, Spencer are proponent of new trade theories.

Features of new trade theories which are different from old theories.

1. Old theories assumed constant return to scale. New theories done away with this assumption and focused on increasing return to scale.
2. Old theories focused only on comparative advantage. New trade theories focused on potential comparative advantage by protecting industries.
3. Old theories argued free trade. Some new trade theories argue for protectionist measures to build up a huge industrial base in certain industries such that those sectors to dominate the world market. (Brander–Spencer Model)
4. Old theories assumed perfect competition. New trade theories focused on monopoly and oligopoly. (Shaked and Sutton model assumed oligopoly)
5. Old theories assumed product homogeneity. New theories proposed product differentiation.
6. New trade theories explained intra industry trade which was not explained by old theories.
7. Product cycle theory explained shifting of production of a product from one country to another. Old theories have no such explanation.

New trade theories are significant improvement over old theories. They introduced practical element in trade theories. Particularly for the developing countries new growth theories are significant which were ignored by old trade theories.