Solved Paper: Economics Optional Paper 1

(2021)
Important Note: Answers are written such that they can be produced in the exam
like situation in the given time and word limit. This year for paper 1 UPSC
provided 2 sides (1 page) for 10 markers and 3 sides (1 & half page) for 15 & 20
markers. 10 markers should be addressed in 150 words and 15 & 20 markers in
250 words. There was clear guideline that writing less or more than word limit may
lead to reduction in marks.

1.(a) Compare and contrast Marshallian and Walrasian approaches of the

stability in equilibrium.

Answer:

Walrasian Approach is price adjustment approach while  Marshallian Approach is

quantity adjustment approach.

Walrasian Stability Condition

Let us assume, at given price if Quantity demanded (Qd) < Quantity Supplied (Qs)
supplier reduces price and if Qd> Qs supplier increases prices. Under this
condition Walrasian equilibrium is stable if above equilibrium price Qd < Qs and
below equilibrium price Qd > Qs.
Marshallian Stability Condition 

Let us assume, at given quantity if demand price (Pd) > supply price (Ps) supplier
increases output and if Pd < Ps supplier reduces output. Under this condition
Marshallian equilibrium is stable if on left of equilibrium output Pd >  Ps and on
right of equilibrium output Pd < Ps.

Stable Walrasian and Unstable Marshallian

Stable Marshallian and Unstable Walrasian 

NOTE : There could be multiple cases of stability and instability but in exam
neither you have space not time so restict yourself.

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1.(b) Using generalised Lorenz dominance show that lower inequality

represents a higher social welfare state.

Answer:

If one generalized lorenz curve (GL1) lies above another (GL2) in at least some
portion and no where it lies below the other then GL1 dominates GL2 and this is
called generalized lorenz dominance.

Sen’s welfare function is given as follow:

W1 = µ1 * (1 – G1) and W2 = µ2 * (1 – G2) where u1 & u2 is per capita income
and G1 & G2 is Gini coefficient.  If W1 > W2 then W1 represents a higher social
welfare state.

We know G (gini coefficient) is the ratio of area between the diagonal and the
lorenz curve to the area below the diagonal. So 1 – G = ratio of the area below the
lorenz curve to the are below the diagonal.

Consider a generalized lorenz curve. Area below the diagonal in such a curve = 0.5
* base * height = 0.5 * µ (since base = 1 and height = µ). So µ * (1 – G) = 2 * area
below a generalized lorenz curve.
This means that every W = µ * (1 – G) can be represented as a generalized lorenz
curve. So if W1 > W2 it means that area below the generalized lorenz curve of W1
(GL1) > area below the generalized lorenz curve of W2 (GL2). Now it will always
be possible to construct at least one set of generalized lorenz curve in a way that
GL1 will dominate GL2 .

According to Shorrock’s theorem, for the same preferences and strict concavity of
individual utility functions, if a generalized lorenz curve GL1 dominates another
generalized lorenz curve GL2 then GL1 represents a higher social welfare state.
Now invoking Shorrock’s result we can see that GL1 represents a higher state of
welfare than GL2 and thus W1 represents higher welfare than W2.

Note : One of the toughest question. I have borrowed solution form Gaurav
Agarwal’s notes.

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1.(c) Examine the relationship between business cycle and changes in

autonomous expenditure.

Answer:

Autnomous expenditure is level of expenditure which is not determined by the

level of income. It depends on interest rate, economic situation, expected income,
etc.

Real Business Cycle and Autnomous Expenditure 

Lets say goal of economic agent is to maximize his utility in each period of his life.
He gets utility from two sources: consumption (C) and leisure (L).

Thus,
U = F(C, L)

Output in the model is generated by the production function

Y = z*F(K, N)

Where z represents shock to the economy. With positive shock income will
increase and with negative shock income will decrease. Lets say there is positive
economic shock.

Temporary Shock

In case of temporary shock economic agents knows that this will not change future
income. Thus, to allow higher consumption in future he will save.
Permanent Shock

In case of permanent shock agent know that rise in income will last long. So his
incentive to save would be reduced and his incentive to consume increased. Hence
autnomous expenditure will also increase due to change in expected future income.

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1.(d) Does government borrowing always crowd out the private investment ?
Illustrate.

Answer:

In crowding out increase in public spending increases interest rate and thus drive
outs private investment.

Complete crowding out

Lets say money demand is completely interest inelastic.  With rise in fiscal
expenditure transaction demand for money increases there will be only one income
at transaction demand is equal to money supply. Thus interest rate increases such
that increases in government spending compensated by fall in private investment
and consumption.
No crowding out

When interest elasticity of money demand is  infinitely elastic then rise in fiscal
spending will have no effect on interest rate and thus no crowding out.

Partial Crowding out

When interest elasticity of money demand is in between completely inelastic and

infinitely elastic then rise in fiscal spending will increase interest rate such that
private investment is partially crowd out and there is rise in equilibrium income
Thus, government borrowing not always crowd outs private investment.

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1.(e) The slope of the IS schedule will become steeper if the government
reduces the rate of proportional tax but will not change at all if the
government reduces the level of a lump sum tax. True or false ? Explain. 

Answer:

IS curve gives relationship between income and interest rate at which goods market
is in the equilibrium.  For simplicity lets assume closed economy.

IS : Y = C + I + G

Lump Sum Tax Case

C = a + bYd and

I = v – qr (Depends on interest rate)

Now Yd = Y – T (Lump Sum Tax)

Thus

(1-b)Y = a – bT + v – qr + G

Hence d(r)/d(Y) = -(1-b)/q

Thus change in lumpsum tax will not change slope of IS curve

Proportional Tax Case

C = a + b*(1-t)*Y

Where t is proportional tax

(1- b + b*t)Y =  a – b + v – qr + G

d(r)/d(Y) = -(1- b + b*t)/q

Hence reduction in t will flatten the curve.

Thus given statement is partially true and partially false.

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2.(a) Explain the differences between Cournot model of duopoly with similar
product and differentiated product.

Answer:

Cournot’s model is duopoly model. In Cournot each firm acts on the assumption
that its competitor will not change its output irrespective of its decisions.

Cournot Model With Similar Produces 

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.

Cournot Model With Differentiated Product 

In case of differentiated product demand for the each firms will be different. Thus
because of this case output for each firm will be different which was same in the
case of similar Cournot model.

In case of similar product Cournot model they assumed same cost (due to
similarity of product). However, in case of differentiated product cost may also
vary due to differentiation.

Due to different demand function and possibility of cost differentiation reaction

curve will be required to find out equilibrium. The reaction curve of a firm is the
locus of points of highest profits that fir can attain, given the level of output of
rival firm.
Interaction of reaction curve of both the firms will be equlibirum in the
differentiated product Cournot Model.

Note : Here it can be explained mathematically as well but in my opinion no need

to waste time (In exam hall you will get 10 minutes to solve it). They have asked to
explain differences so just explain it.

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2.(b) What type of conjecture is involved in the existence of kinked demand

curve ? Do you think that kinked demand curve model is a price
determination model in an oligopoly market ? Justify your answer.

Answer:
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.

Conjectural Variation in Kinked Demand Curve

Lets say market is at equilibrium at price p* and quantity q*. Now if single firm
decided to increase prices other firms may not follow it (This is conjecture). Thus
firm increasing prices will loose its market share to the other firms. Hence demand
curve is more elastic above price p*.

If single firm decreases price, other firms will also follow it to prevent the loss of
market share (This is conjecture).  Hence demand curve is inelastic below price p*.

Kinked Demand Curve & Price Determination

Kinked demand curve is not model of price determination. Kinked demand curve
just explains price stickiness. However, it fails to explain to determine exact price
and quantiy.

Also in the real world, prices are not static as suggested by Sweezy. Also firms
may not try to maximize profit but to increase market share by price and non price
competition. Due to advertisement a strong customer loyalty can be seen in that
case firms can raise prices without loosing much market. Thus Sweezy’s demand
curve is not providing satisfactory solution to price output decision under
oligopoly.

Note : Second part is of 10 marks but I guess marks are allocated to conceptual
understanding than number of pages written.

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2.(c) Examine how profit, wage and rent in Ricardian system move differently
with the movements in level of income.

Answer:

Ricardian system is classical theory of distribution.

Assumptions

1. Fixed supply of land.

2. Law of diminishing returns applies on land.
3. All workers are paid constant subsistence wages. (Malthusian theory)
4. There is perfect competition.
5. Profit is incentive for capital accumulation and capital accumulation for
growth.
6. There are two sectors of economy,  i.e. agriculture and industry. In
agriculture wages and output is same ie corn. In industry output is money
good while wages are corn.

Model

Rent is surplus over the transfer earning of the land. Thus the difference between
average product and marginal product is paid as rent to the landowners. Now
remaining surplus has to be divided between labors and capitalist. There is constant
subsistence wage rate thus labors are paid w*number of labors. Remaining is profit
of capitalist.
Industry agriculture linkages

At full mobility condition equilibrium is achieved when monetary rate of profit in

industry is equal to the corn rate of profit in agriculture.

Capital Accumulation and stationary state

With the profit and capital accumulation employment increases. Increased

employment declines MP of labor and widens gap between MP and AP of labor.
This increases share of rent. At constant wage level wage fund increases and profit
decreases and thus capital accumulation. This continues till the zero level of profit
is reached. Thus with the rise in income level profit share will decrease and that of
rent will increase.

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3.(a) Show that differences in underlying expectation lead to differences in

Keynesian and classical aggregate supply curve.

Answer:

Supply curve explains relation between price and output in the economy.

Early Kenesian & Classical

Early Keynesican proposed that supply curve is completely horizontal while

classicals proposed that supply curve is completely vertical.
Classical Model

Classical assumed that

1. Flexible money wages

2. Flexible price level
3. Labor market clears

With rise in demand and thus prices increases.  At higher price level with constant
money wages labor demand curve will shift rightward. However labor will
immediately understand fall in real wages and thus labor supply curve will shift
leftward (Change in money wages). Thus output will remain same and just prices
will increase.

Keynesian Model

On contarary to classical model Keynesian assumed

1. Rigid money wages

2. Constant price level
Due to constant price and wages supply curve will be horizontal till full
employment level. After that it will become vertical (Prices will rise for same
output).

Later Kenesian & Classical

Adaptive Expectation Model

Later Keynesian assumed adaptive expectations which forms expectations from

past experiences. According to the Keynesians fiscal policy affects short run
national output and employment.  However in long run labor perceives changed
prices and  initial levels of employment and output are restored at new price levels.
Thus supply curve for them is upward rising in short run.

Rational Expectation Model

Later Classical (New Classical) assumed rational expectations. According to them
labor and economic agents can predict the changes in the economy. They forms
expectations based on all available information. Because of this even in short run
labor changes its labor supply as response to change in the economy. Hence even
in short run supply curve is vertical.

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3.(b) Apply the theory of liquidity preference to explain why an increase in

money supply lowers the interest rate. What does this explanation assume
about the price level ?

Answer:

Liquidity preference is a Keynesian theory. It shows demand for money with the
given interest rate. Keynes said that there are two motives to hold money. One for
transaction purpose and other for speculation of future interest.

At low interest rate there is  a chance of increasing interest rate and thus falling
bond prices. At low interest rate if capital loss outweighs interest rate earned
investor will prefer to hold money. It is called as speculative demand for money.

Thus Money Demand (Md) = F(Y,r)

In Equilibrium MS = Md = F(Y,r)

Rise In Money Supply 

With rise in money supply, MS > MD. To achieve equilibrium demand of the
money should increase. Increase can be either through increase in transaction
demand of money or speculative demand. But income and price level are constant
so transaction demand will not change. Thus speculative demand of money should
increase. Speculative demand can be increased if interest rate falls. Hence, with
rise in money supply interest rate falls to increase speculative demand of money to
match increase in money supply.

Assumption About Price Level 

Here price level is assumed constant. Otherwise, transaction demand of money

may have also changed. This might have kept interest rate unchanged.

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3.(c) Explain how the weaknesses of Keynesian speculative demand for money
have been identified in Regressive Expectations model. 
Answer:

Keynesian throry of money demand divides money demand in two parts. Keynes
said that there are two motives to hold money. One for transaction purpose and
other for speculation of future interest.

At low interest rate there is  a chance of increasing interest rate and thus falling
bond prices. At low interest rate if capital loss outweighs interest rate earned
investor will prefer to hold money. It is called as speculative demand for money.

According to Keynes the demand for money refers to the desire to hold money as
an alternative to purchasing an income-earning asset like a bond. However it was
not able to answeer the question : if bonds earn interest and money does not why
should a person hold money?

Regressive Expectation Model

According to the regressive expectations model a bond holder has an expected

return on the bond from two sources, the bond’s yield and a potential capital gain.
Bond yield is inversely proportional to the bond prices. Thus, above critical
interest rate (rc) speculative demand for money is low so bond is preferred source
of holding wealth. Below rc speculative demand for money is high so money is
preferred source of holding wealth.

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4.(a) Derive short-run aggregate supply curve following Lucas, when

expectations are not realised, assuming that labour market clears. What will
be its shape when expectations are fulfilled ?

Answer:

New classical policy is based on rational expectations about price level.

Assumptions
 1. Flexibility of prices.
2. Flexible wage rates.
3. Perfect labor and goods market.
4. According to the hypothesis of rational expectations, expectations are
formed on the basis of all available relevant information concerning the
variable being predicted

Expectations Are Realized

Lets consider that there is expectation about increasing money supply and thus
prices. Lets say money supply increased and  push prices up from P0 to P1′.
Increase in price level will sift labor demand outward. But as money supply change
is anticipated economic agent react to it adjust accordingly. It results into shift of
labor supply and hence output to leftward. With systematic rise in money supply
will result into same output and employment at increased price level. Thus long
run aggregate supply curve will be vertical line. (In first diagram show vertical
LAS)

Expectations Are Not Realized 

Lets say there is expectations of prices being constant. Unanticipated money

supply increases prices from P0 to P1′. In that case value of marginal output
increases but wages do not increases much due to wrong expectations. And thus in
short run employment increases to N1′ and thus output to Y1′. Thus Aggregate
supply curve would be upward sloping.

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4.(b) Describe high powered theory of money supply in brief. State the
assumptions made in its construction.

Answer:

High powered money refers to that currency that has been issued by the
Government and Reserve Bank of India. H theory of money explains the change in
money supply of economy due to change in high powered money.

Assumptions 

1. High powered money is exogenously decided by the central banks or

government.
2. Banks offer only demand deposits. (No time deposits)
3. Earning of banks is only through loans to commercial borrowers
4. Currency-deposit ratio is exogenous and constant
5. Reserve-deposit ratio of banks is exogenous and determined by the RBI. It is
a constant term.
6. Infinite demand for the bank loans at the going lending rate of banks, so that
banks can remain ‘fully loaned up’ all the time. Thus, banks are generally
not deterred from moving into earning assets out of undesired excess
reserves.
7. There is high monetary transmission in the economy.

Model

Money multiplier is ratio of commercial bank money to the high powered money.

H=C+R

m = M/H

Where H is high powered money, C is currency kept by public, R is reserved kept

with RBI, m is money multiplier and M is money generated by commercial bank.

Now commercial bank money can be divided in currency held by public and
demand deposit (D).

M=C+D

Now C = k*D

Where k is currency deposit ratio

R = r*D
Where r is cash reserve ratio

Hence H = (k+r)*D

and M = (k+1)*D

Hence money multiplier (m) = (1+k)/(r+k)

Thus money supply M = H*[(1+k)/(r+k)]

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4.(c) Do you think that increase in Government spending through borrowing

from public accompanied by fall in required reserve ratio generates recession
in the economy ? Illustrate your answer : (i) in a closed economy with fixed
exchange rate. (ii) in an open economy with fixed exchange rate and without
any capital mobility.

Answer:

Government spending is expansionary fiscal policy thus will lead to outward shift
in IS curve. Decrease in required reserve ration is expansionary monetary policy
leading to outward shift in LM curve.

Closed Economy With Fixed Exchange Rate

In closed economy there will not be any trade nor any capital exchange.
Expansionary fiscal policy will increase income. However it will also increase
transaction demand of money. To compensate it speculative demand of money
should decrease by increase in interest rate.

This rise in interest rate can crowd out private investment. But there is also
expansionary monetary policy which will prevent crowding out (by downward
revision of interest rate). Thus, there will not be recession instead output will
increase in this case.

Open Economy With Fixed Exchange Rate & Without Any Capital Mobility

In the economy without any capital mobility expansionary monetary policy will
not affect external balance. With perfect capital immobility the BP curve is vertical
at the income level at which imports equal exports.
Expansionary fiscal policy will increase income and thus import. On other hand
expansionary monetary policy will not affect capital outflow. Here exchange rate is
also fixed. Thus here there will not be recession but external balance of economy
will be in the disequilibrium.

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5.(a) Explain Rosenstein-Rodan’s view that economic underdevelopment is the

outcome of a massive coordination failure.

Answer:

Rosenstien-Rodan model is a big push Model.  In subsistence economies, people

don’t have the purchasing power to buy new products. Thus the first factory will
not be able to sell all its produce. Its own workers will consume only a part of the
produce. Hence simultaneously multiple factories are needed. Thus there exist
positive externalities which in absence of a coordinated approach may lead to a
failure to achieve an optimal state.
If the wage rate is w1 and if the firm estimates that by switching alone it would be
above point A, it will switch. Since this decision will be made by firms in all
industries, entire economy will switch to modern sector and the overall production
will be much higher.

But if the wage rate is w2 and if the firm estimates that by switching alone it would
be below point B, it will not switch. This is despite the fact that if all firms switch
simultaneously, the economy may reach much above B but still a coordination
failure will happen in the absence of state planning.

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5.(b) Explain how gender sensitive human development index can be

constructed.

Answer:

Gender sensitive human development index measures the gender gap. It can be
constructed as follow.
The gender sensitive human development index is the ratio of the HDIs calculated
separately for females and males using the same methodology as in the HDI. It is a
direct measure of gender gap showing the female HDI as a percentage of the male
HDI.

The GDI shows how much women are lagging behind their male counterparts and
how much women need to catch up within each dimension of human development.
It is useful for understanding the real gender gap in human development
achievements and is informative to design policy tools to close the gap.

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5.(c) Show that the economic integration is the pre-requisite to establish

covered interest rate parity.

Answer:

Covered interest arbitrage refers to the spot purchase of the foreign currency to
make the investment and the offsetting simultaneous forward sale (swap) of the
foreign currency to cover the foreign exchange risk.

To do this, the investor exchanges the domestic currency for the foreign currency
at the current spot rate and at the same time the investor sells forward the amount
of the foreign currency he or she is investing plus the interest he or she will earn so
as to coincide with the maturity of the foreign investment.
If economic integration is not there neither interest arbitrage will work nor
exchange rate arbitrage. It will lead to failure of covered interest rate parity. Thus
for establishing covered interest rate parity economic integration is pre requisit.

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5.(d) Under what condition Real Exchange Rate is synonymous to ‘terms of

trade’ ? Discuss.

Answer:

The real exchange rate (RER) between two currencies is the nominal exchange rate
(e) multiplied by the ratio of prices between the two countries, P/P*. On other hand
Term of Trade is ratio between prices of two countries.

RER = E*(P/P*)

Thus RER is synonumous to term of trade when nominal exchange rate is 1.

Factors That Will Lead to Unit Nominal ER

 1. Full economic integration
2. There is free trade without any obstacles
3. All goods and commodities are traded
4. Both the countries have same currency denomination

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5.(e)Do you agree whether sustainable use of energy ensures economic

sustainability ? Explain. 

Answer:

It is usually said that with increase in economic development energy use also
increases. Hence for ensuring long term economic sustainability sustainable use of
energy becomes important.

Sustainable Use of Energy & Economic Sustainability 

1. Improving energy efficiencies improves production capcities.

2. Sustainable energy resources like solar energy can provided energy to
remote locations. Eg. North East India.
3. Schemes like PM-KUSUM provided additional income to farmers by
production of renewable solar energy.
4. It promotes economic development through research.
5. It will also help in job creations. Eg. Job created in solar panel production
and maintainance of renewable energy plants

Sustainable use of energy will help us to fulfill SDG 7 related to clean and
affordable energy. It can ensure economic development. Thus, future economies
should focus on sustainable use of energy.

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6.(a) Evaluate Kuznets’ inverted U shaped curve hypothesis of income

distribution. Does it hold good for less developed countries as well ?

Answer:

Kuznets hypothesis analyzed effect of growth on distribution of income. According

to Kuznet as income increases inequalities first increase and then decrease.
Causes for increase in inequalities

In the first part, industrial income rises and agricultural income falls. It also creates
disparity between urban and rural area. It is because backwash effect is working for
rural and agricultural sector.

Causes for decreased inequalities

Over the period spread effect starts working in rural area. It raises income in rural
area. Also because of political pressure government might take actions to reduce
inequalities. It together helps in reducing inequalities.

Trend in in income inequalities in developing and developed economies

East Asian economies invalidated Kuznets hypothesis. There inequalities are

decreasing with rising income. Increase in income was well distributed thus it
reduced inequalities. It might be because of active government intervention for
redistribution.

In developed countries after fall in inequalities it started rising again. It might be

because of growth in service sector. Service sector has high income generation
capacity but low employment elasticity. Thus inequalities are increasing with
growth of service sector.

In countries like India and Brazil inequalities have not shown downward trend with
growth. Inequalities kept rising with growth. It might be because of weak
manufacturing sector and strong service sector. Another reason could be high
income inequalities in initial phases. Thus India and Brazil might be taking time to
go on downward path of Kuznet curve.

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6.(b) Does human capital cause economic growth ? Explain how human
capital formation can be enhanced.

Answer:

Human capital have played important role in economic growth. It can be seen in
the Japan, South Korea and South East Asian Countries. Endogenous growth
models also prdicts that human capital can cause economic growth. Romer’s model
also predicts that investment in human capital can lead to growth for longer time.

Human Capital and Economic Growth 

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 so as to assume
away the absence of diminishing returns to capital in the AK production function.

Output per capita is y = Y/L = A*(K/L)= Ak

where k is per capital capital K/L

Now Δk = 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
Enhancing Human Capital Formation 

1. Amartya Sen’s capability development approach could be suitable for the

enhancing human capitla formation.
2. Education playes important role in human capital formation. Government
should focus on ensuring accessibility to quality education at affordable rate.
3. Health ensures that human capital is available for longer time without any
disruption. Thus, government should focus on ensuring accessibility to
quality health at affordable rate.
4. Skilling of population can increase quality of human resource.
5. R&D spending playes important role in enhancement of human capital. Both
private companies and government companies should focus on it.
6. Nutrition ensures the availibility of healthy human capital.

Thus by focusing on health, education and skilling human capital can be enhanced
in the country.

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6.(c)  Explain how Harrod’s warranted rate of growth is similar to Domar’s

required rate of growth. How has Solow improved upon Harrod-Domar’s
growth model ?

Answer:

Harrod – Domar model wanted to determine unique rate at which investment and
income must grow such that full employment level is maintained for longer time.

In Harrod’s model warranted growth rate is growth rate which induces enough
investment to match planned saving. It is given by

Warranted growth rate (gw) = s/Vr

where s is saving rate and Vr is warranted capital output ratio.

While in Domar model required rate of growth is given as follow

Gy (∆y/y) = (∆I/I) = s.σ

Where s is MPS and σ if output capital ratio.

So in the steady state or rate of growth of investment is equal to the rate of growth
of GDP is equal to s.σ. It is same as the Harrod’s warranted growth rate.

Solow’s improvement upon Harrod Domar Model

Knife Edge Problem

In Harrod’s model equilibrium is achieved when gn = gw = g. Any deviation from

this will lead to either chronic depression or chronic inflation. It occurs because
production function is assumed as fixed coefficients production. Because of it
labor can not be substituted for capital. It brings rigidity to Vr. Also MPS is
constant. Thus there is no way to achieve equilibrium but at gn = gw = g

Dropping assumption of fixed coefficients production function (Solow Swan

Solution)

If capital grows faster than labor i.e. gw > gn, labor will become scarcer, wages
will increase and technological innovations will take place in labor saving
techniques. Thus Vr will increase (since now more capital is required to produce
same output) and this will lower gw. If however, labor grows faster than capital
then gw < gn, and labor redundancy will depress real wages and shift will be made
towards labor intensive technologies. Thus Vr will fall and gw will increase.

Hence dropping assumption of fixed coefficient production function can solve

problem of knife edge.

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7.(a) Discuss the theory of acquired advantage in international trade using

suitable examples.

Answer:

Acquired advantage means the ability of a country to produce a good or service

with fewer resources using knowledge or skills that are acquired over time. Theory
of acquired advantage can be explained using product cycle model.

Acquired Advantage & Product Cycle Model 

Product life cycle model explains that intially develope country innovates a
product. Over the time developing country acquires comparative advantage in that
product and starts dominating innovating country.
Stages of product life cycle model

1. In stage I (time OA), the product is produced and consumed only in the
innovating country.
2. In stage II (AB), production is perfected in the innovating country and
increases rapidly to accommodate rising demand at home and abroad.
3. In stage III (BC), the product becomes standardized and the imitating
country starts producing the product for domestic consumption.
4. In stage IV (CD), the imitating country starts underselling the innovating
country in third markets, and in stage V (past point D) in the latter’s market
as well.

Case Studies 

1. Japan acquired comparative advantage in autombiles.

2. South Korea and China acquired comparative advantage in electronics.

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7.(b) Do you think that movement of the nominal exchange rate of Rupee
represents a corresponding movement of Indian goods vis-a-vis foreign
goods ? Explain your position.

Answer:

Since 2000 India have seen gradual depreciation of Indian currency. International
trade theories suggests that depreciation of currency increases export of the
currency and decreases import. In India this movement can be seen.
As currency depreciate export increased but however import have also shown
increasing trend. Rise in import increased due to following reasons.

1. Import dependence on oil

2. Import of raw material from countries like China
3. Craze for imported goods.
4. Rise in income led to rise in import

Because of these factors despite of depreciation of currency India have trade

deficit. In a country like India trade is not only factor which determines nominal
exchange rate. India is one of the attractive destination for the foreign capital
inflow. Foreign inflow also affects nominal exchange rate. Central bank of India
(RBI) also intervenes in foreign exchange markets to ensure exchange rate
stability.

Thus, it can be observed that nominal exchange rate of Rupee do represents a

corresponding movement of Indian goods vis-a-vis foreign good but it is not
complete due to other factors like RBI intervention, import dependence and foreign
capital flow.

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7.(c)  What are the different categories of trade blocks ? Are trade blocks
beneficial to less developed economies ? Justify your answer.

Answer:

A trade bloc is a trade agreement among governments that are typically within a
shared geographical region. The agreement is entered into as a means of protecting
member nations from excessive imports of non-member nations. And to encourage
trade among member states, tariffs, taxes, and other trade barriers among them are
often reduced or abolished.

Types of Trade Blocks 

1. Free-Trade Area: All barriers to import and export of goods and services
among member countries are removed. For e.g. North American Free Trade
Agreement (NAFTA).
2. Customs Union: Free-trade area + all member countries adopt a common set
of trade restrictions with non-members.
3. Common Market: Customs union + all barriers to the movement of labor
and capital goods among member countries are removed.
4. Economic Union: Common market + member countries establish common
institutions and economic policy. For e.g. European Union (EU).
5. Monetary Union: Economic union + member countries adopt a single
currency. For e.g. European Zone

Trade Block & Less Developed Countries 

1. The ASEAN free trade aea have played important role in the development
of ASEAN countries. It increased economic development, job creation &
reduced poverty.
2. African free trade agreement is playing important role in the development of
African continent. UNECA estimates that AfCFTA will boost intra-African
trade by 52.3% once import duties and non-tariff barriers are eliminated.
3. However, usually less developed countries gains less in free trade agreement
due to their low negotiation power and limited production capacities.
4. In South Asia, SAFTA have limited success.
5. However, ASEAN free trade area have also created problems like 1999
currency crisis which affected economies of ASEAN countries.
Thus it can be said that effect of trade blocks on less developed countries is mixed.

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Note : Almost no one attempted this question 8.

8.(a) If the government raises taxes on labour income and interest income,
explain how potential GDP and economic growth are affected.

Answer:

Potential GDP is an estimate of the highest level of output an economy can sustain
over a period of time. It assumes that an economy has achieved full employment
and that aggregate demand does not exceed aggregate supply.

Determinants of Potential GDP 

1. Size of labor force

2. Productivity of labor force
3. Investment 
4. Infrastructure

Effect of Increased Labor Income Tax & Inerest Income Tax on Potential
GDP

Increase in labor income tax will reduce wages for the labor. This will discourage
labor force participation. Thus, labor supply curve will shift inward. Thus labor
supply will decrease and hence potential GDP 
Increase in tax on interest income will affect investor sentiments. It will discourage
overall investment which will further affect potential GDP in the economy. 

If the government raises taxes on labour income and interest income, potential
GDP and economic growth of the country will lower. 

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8.(b) Examine the effects of providing public service by a private agency at a
lesser price than earlier one on (i) a closed economy with fixed wages. (ii) a
closed economy with flexible wages.

Answer:

When private agency provides public service at low price, value of marginal
product for the labor will change. It will generate different effect in the economy in
case of fixed wages and flexible wages .

(i) Fixed Wage Case 

This is a Keynesian case. Fall in prices will increase real wages. As shown in
below figure it will result into the involuntary unemployment RT. Labor market
won’t be in equilibrium. Employment and output  will be less than natural level. 

(ii) Flexible Wage Case 

This is a classical case. Now service is provided at lesser price. Lets assume that
there is no government subsidies. So in such case value of marginal product of
labor will decrease and real wages will increase. Thus labor demand curve will
shift dowanward (Nd(P1) to Nd(P0)). Labor will get to know increase in real
wages. As the wages are flexible there will be downward revision of nominal
money wages. It will shift labor supply curve outward. Hence, equilibrium will be
reestablish at the initial employment and output level.
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8.(c) What is Buchanan’s criticism of Arrow’s theorem ? Show how A. K. Sen

proved Arrow’s theorem without the overall consistency of social choice to
avoid the criticism.  

Answer:

Arrow’s impossibility theorem is a social-choice paradox illustrating the

impossibility of having an ideal voting structure to translate individual preferences
into social preferences without violating one of the following axioms :
Nondictatorship, Pareto Efficiency, Independence of Irrelevant Alternatives,
Unrestricted Domain and Social Ordering.

Buchanan’s Criticism of Arrow’s Theorem

1. It argues that it is silly to think that there might be social preferences that are
analogous to individual preferences
2. Social prefrences should not be used in social welfare theorem 
 3. Arrow’s Theorem to emphasize the chaotic, untrustworthy nature of
democracy. 

Sen’s Modification

Amartya Sen extended Arrow’s framework to take into account not only ordinal
information about people’s preferences among pairs of alternatives, but
also cardinal information about the utility they derive from each one.

In this way he was able to investigate the consequences of other assumptions than
Arrow’s about the measurability and interpersonal comparability of individual
preferences.

Note : Most difficult question of the 2021 Paper. Not sure about exact solution.
Even after googling you will not find exact solution.

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Note :  Complete solutions of Economics Optional Past Year Papers (1995-2021)

are available here.