Balance of Payment

Introduction The exchange of goods and services is called trade. In the presence of international trade links, economies have been categorized as closed economy and open economy. Balance of Payments (BOP) is a systematic record of all economic transactions between the residents of a country (including government) and the rest of the world carried out during an accounting year. The structure of balance of payments is comprised of Debit side Credit side There are three categories of balance of payments. They are: Balance of Trade (BOT) Balance of Current Account Balance of Capital Account The components of balance of payments are: current account (visible goods, invisible goods and unilateral transfers) and capital account (private capital, banking capital, official capital and gold and foreign capital). The overall balance in balance of payments can be obtained as sum of current account balance and capital account balance. The overall balance in balance of payments is understood in two ways i.e. accounting sense and operational sense. Balance of payments is said to be in disequilibrium when balance of payments deficit (or even surplus) are of large magnitude and increases over years. The causes of adverse balance of payments are: Fall in foreign demand Inflationary pressure in the economy Developmental expenditures, etc. The measures to correct disequilibrium in the balance of payments are depreciation, devaluation, import control, etc.

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  • Q1

    (a) Explain two causes of increasing returns to a factor. [3]

    (b) Differentiate between real cost and money cost with the help of examples. [3]

    (c) Discuss four determinants of supply of a commodity. [6]

    Marks:12
    Answer:

    (a) Increasing returns to a factor occur because of the following factors:

    1. Fuller Utilisation of the Fixed Factor: At the initial stages, fixed factor (such as office building) remains underutilised. For its fuller utilisation greater application of the variable factor (Labour) is required. Hence, initially (so long as fixed factor remains underutilised) additional units of the variable factor adds more and more to total output, or marginal product of the variable factor tends to increase.

    2. Specification of inputs:As more and more variable factor (Labour) is being used, it enables process based division of labour. Specialised workers may be used for different processes of production. This increases efficiency or productivity of the variable factor. Accordingly, marginal productivity tends to rise.

    (b)

    Real Cost

    Money Cost

    1. It refers to the efforts and sacrifices made by the owners of factors of production used in the production of a commodity.
    1. The concept of real cost has no practical significance because it is a subjective concept that make it difficult to estimate real cost. Marshall called it social cost of production.
    1. It refers to money expenses which the firm has to incur in purchasing or hiring the factor services.
    1. These expenses include the money expenditure of a firm on wages and salaries paid to labour, payments of interest on borrowings, rental payments, payment for rawmaterial etc. It is also called nominal cost.

    (c) The four determinants of supply of a commodity are as follows:


    (i) Price of the commodity: There is a direct relationship between price of a commodity and its quantity supplied. It implies thatat the higher the price, there is higher quantity supplied, and vice versa.

    (ii) Price of Related goods: The supply of a good depends upon the price of related goods because producers have always the possibility of shifting from the production of one commodity to the production of another commodity. Suppose, a firm is producing commodity X. If the prices of other commodities are rising, while the price of commodity X remains constant, producers will find it profitable to produce and sell other commodities. As a result the supply of the commodity X will fall.

    (iii) Input prices: It is one of the important factors for determining the supply. If the producers have to pay higher prices to secure the factors of production needed for producing the commodity, its cost of production will be higher and there will be less quantity supplied.

    (iv) Goal of the Firm: If the goal of the firm is to maximise profits, more quantity of the commodity will be offered at a higher price. On the other hand, if goal of the firm is to maximise sales (or maximise output or employment) more will be supplied even at the same price.

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  • Q2

    (a) Fill in the blanks in the table given below: [3]

    No. of Workers

    T.P.

    A.P.

    M.P.

    1

    2

    3

    230

    150

    120

    (b) What is meant by floor price? Explain its impact on producers. [3]

    (c) Explain any four features of oligopoly market.
    [6]

    Marks:12
    Answer:

    (a)

    No. of Workers

    T.P.

    A.P.

    M.P.

    1

    2

    3

    150

    230

    350

    150

    115

    116.67

    150

    80

    120

    (b)Price floor refers to the minimum price (above the equilibrium price), fixed by the government. This is the price which producers must be paid or received for their produce. Minimum support price is one of the examples of price floor.

    The impacts of price floor on producer are as follows:

    • Several time, the government feels that the price determined by the market forces of demand and supply is not remunerative (or just) from the producer’s point of view. In those cases the government intervenes in the market and fixes the price (known as price floor) which is more than the equilibrium price.
    • The impact can be better understood with the help of an example. Indian Government maintains a variety of price support programmes for various agricultural products like wheat, sugarcane etc. and the floor is normally set at a level higher than the market determined price for these goods.

    A seen in the diagram, equilibrium is determined at point E when demand curve DD and supply curve SS wheat intersect each other. The equilibrium price of OP is determined. Suppose, to protect the producer’s interest and to provide incentive for further production, government declares OP2 as the minimum price (known as Price Floor) which is more than the equilibrium price of OP.

    • The higher price fixed by the government lures the producers to produce more. This helps the government to maintain a buffer stock for exports.

    (c) Oligopoly market structure is the one in which a small number of big firms dominate the market for a product. The principal features of oligopoly are as under:

    1. Small Number of Big Firms: There are only few but big firms in the market. They maintain market dominance through intense advertising which establishes brand loyalty. Established brand loyalty enables the producer to exercise partial control over price. It makes demand for the product relatively less elastic and firms are able to generate extra-normal profits.

    2. Difficult to draw Firm’s Demand Curve: It is difficult to determine firm’s demand curve in oligopoly market structure. It is because of high degree of interdependence among the competing firms. When any firm lowers its price, demand for its product may or may not increase, because the rival firms may lower the price, because of which the buyers shift to the rival firms. Implying that there is no definite response of quantity demanded to change in price.

    3. Entry Barriers: There are barriers to the entry of new firms in oligopoly market structure. Through patent rights, copyright, trademarks, etc. these barriers are created. Owing to these barriers, the existing firms are not much worry about the entry of new firms in the market and they continue to earn super-normal profits.

    4. Non-price Competition: Under oligopoly, firms focus on non-price competition instead of price competition. Example: In India both Coke and Pepsi sell their product at the same price. But, in order to increase its share of the market, each firm takes to aggressive non-price competition.

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  • Q3

    (a) The difference between AC curve and AVC curve decreases with increase in output but the two curves never touch each other. Justify the statement with the help of a diagram. [3]

    (b) Explain any two characteristics of an indifference curve. [3]

    (c) Discuss producer’s equilibrium in perfect competition, using MR and MC approach. [6]

    Marks:12
    Answer:

    (a) The difference between the average total cost curve and the average variable cost curve reduces with increase in production. Initially, the difference between ATC curve and AVC curve is huge because the proportion of average fixed cost is greater in average total cost. It is because the fixed cost remains the same throughout production and with increase in number of units produced, the ratio of fixed cost and number of units produced, average fixed costs keep on reducing. Whereas average variable costs keep on increasing. As a result, ATC curve tends to come closer to AVC at higher levels of output. Notice that ATC curve never touches AVC curve because the average fixed cost is always positive.

    (b) The two characteristics of indifference curve are as follows:

    (i) An indifference curve (IC) always slopes downward: This characteristic implies that in order to increase the consumption of successive units of good X, the consumer has to reduce the consumption of good Y at diminishing rate, so as to remain at the same level of satisfaction. It is shown in the given diagram:

    To increase the quantity of ‘X’ good from OX to OX1, the consumer has to reduce quantity of good ‘Y’ from OY to OY1.

    (ii) Indifference curves are convex to the origin: This property is based on the principle of diminishing marginal rate of substitution. As the consumer substitutes X for Y, the marginal rate of substitution between them goes on diminishing. It is shown in the following figure:

    (c) One of the conditions to firm’s equilibrium is marginal cost must be equal to marginal revenue (MC = MR).

    It is necessary, but not the sufficient condition for equilibrium. This condition should be accompanied with increasing MC. According to marginal analysis, a firm would, therefore, be in equilibrium when the following two conditions are fulfilled.

    1. MC = MR

    2. MC curve cuts MR curve from below.

    In the given figure, PP is a horizontal line at which average revenue, marginal revenue and price are equal.

    It is clear from this figure, that MC curve is cutting MR curve PP line at two points ‘A’ and ‘E’. Point A is not the point of equilibrium of the firm as at point A marginal cost of the firm is still decreasing which indicate that by increasing the level of output firm can increase its profit.

    On the other hand, point E shows that firm is producing OM units of output. If the firm produce more than OM units of output, its marginal cost (MC) will exceed marginal revenue (MR) and it will incur losses. Thus, point ‘E’ will represent equilibrium of the firm. At this point, both the conditions of equilibrium are being fulfilled.

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  • Q4

    (a)Explain with the help of a diagram the relationship between total utility and marginal utility. [3]

    (b)Find the elasticity of demand of x and y on the basis of the demand schedule given below and specify which one is more elastic: [3]

    Good x

    Good y

    Px (₨)

    Dx (units)

    Py (Rs)

    Dy (units)

    8

    4

    10

    12

    8

    6

    10

    25

    (c)Explain any four reasons for the demand curve to be downward sloping. [6]

    Marks:12
    Answer:

    (a) (i)The relationship between total utility and marginal utility is shown in the below given diagram:

    (i) As shown in the figure, total utility increases with an increase in consumption as long as MU is positive.

    (ii) When TU reaches its maximum, MU becomes zero. This is known as point of satiety.

    (iii)When consumption of commodity X is increases beyond the point of satiety, TU starts falling as MU become negative.

    (b)

    (c)The following four are some of the reasons for downward sloping demand curve:

    (i) Law of Diminishing Marginal Utility:

    This law states that as consumption of a commodity increases, marginal utility of each successive unit goes on diminishing for a consumer. Thus, for every successive unit, the consumer is willing to pay less and less price. Thus, there will be more demand at lower price.

    (ii) Income Effect: Income effect refers to change in quantity demanded when real income of the buyer changes due to change in price of the commodity. Any fall in price of a commodity, leads to rise in real income and thereby the demand made by consumers rises.

    (iii) Substitution Effect: Substitution effect refers to substitution of one commodity for the other when it becomes comparatively cheaper. Suppose X and Y are two substitutes. When the price of commodity-X falls, it becomes cheaper in relation to commodity-Y and consumer substitute X for Y. Thus, there will more demand for X at lower price which leads to downward slopping demand curve.

    (iv) Different Uses: A good may have several uses. For example, milk, is used for making curd, cheese and butter. If the price of milk reduces, it will be used for different purposes. Accordingly the demand for milk expands.

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  • Q5

    Answer briefly each of the following questions (i) to (x):

    (i) What is meant by ex-ante demand and ex-post demand?

    (ii) What is short run production function? Explain how short run production function is different from long run production function.

    (iii) Explain one main feature of each:

    1. Monopsony market.
    2. Monopoly Market.

    (iv) How is elasticity of supply different from supply of a commodity?

    (v) What is direct tax?

    (vi) Give two differences between time deposit and demand deposit.

    (vii) Explain with the help of an example, the problem of double counting while calculating national income.

    (viii) Give a reason for each of the following:

    (a) The demand for a good increases when the income of the consumer increases.

    (b) X and Y are substitute goods. A rise in the price of X results in rightward shift of the demand curve of Y.

    (ix) Write any two differences between balance of trade and balance of payment.

    (x) Explain the shape of MC curve.

    Marks:20
    Answer:

    (i)

    Ex ante demand

    Ex post demand

    It refers to the amount of goods that consumers want to or willing to buy during a particular time period.

    It refers to the amount of the goods that the consumers actually purchase during a specific period.

    It is the planned or desired amount of demand.

    It is the amount of the goods actually bought.

    In real life, the amount of the goods bought is exactly not the same that the consumers want (desire) to buy. Suppose, if a commodity is not available in adequate quantity, the quantity actually purchased (ex post demand) will be less than the quantity that the consumers desire to purchase (ex ante demand). Thus, consumers may end up buying more, or lesser quantity of goods than what they had planned to buy.

    (ii) Short run production function shows the relationship between one variable input (as in short run some inputs are assumed to be constant) and output.

    Qx = f(L,K)

    Qx = Output of Good - X

    L = Labour, a variable factor

    K = Capital, a fixed factor

    The difference between short run and long run are as follows:

    Short run production function

    Long run production function

    It is the subject matter of law of variable proportions.

    It is subject matter of laws of returns to scale.

    This function exhibits constant scale of output.

    This function exhibits change in the scale of output

    (iii) (a)The market structure where there is only one buyer of a commodity, is known as monopsony market structure. One of the main features of monopsony market structure is single buyer. It is a case of only one firm purchasing the entire product or factor service.For example: a mining firm or a brick kiln in a village may be practically the sole employer of some specialised labour.

    (b) The market situation where there is only one seller or producer, is called monopoly market structure. One of the main features of monopoly market structure is single seller. It is a case of one firm or producer controlling the supply of the product. For example: State electricity board in a state.

    (iv)Elasticity of supply measures the degree of responsiveness of the quantity supplied of a commodity to a change in its price whereas the supply refers to the quantity of a commodity that a seller is willing to sell corresponding to a given price, at a given point of time.
    Elasticity of supply measures the sensitivity of the quantity supplied to a change in its price.

    (v) The tax which is directly paid by individuals or companies to the government on whose property or income it is imposed. The ‘liability to pay’ the tax (i.e. impact) and ‘actual burden’ of the tax (i.e. incidence lie on the same person, i.e. its burden cannot be shifted to others. Examples: Income tax, Corporate tax, Interest tax, Wealth tax, Death duty, Capital gains tax, etc.

    (vi)

    Demand deposits

    Time deposits

    These deposits can be withdrawn at any time.

    The time deposits can be with-drawn only after the expiry of a specific period.

    Very low or no interest rate is given on demand deposits.

    The time deposits carry comparatively higher interest rate.

    (vii) While calculating national income total value of goods and services produced by the country is taken into consideration. However, this method suffers from the problem of ‘double counting’. Since the output of a production unit may be the input for another unit, it leads to double counting of a commodity. Only final goods are to be included while measuring national income. If intermediate goods were included too, this would lead to double counting: A Farmer sells wheat to a miller for ` 500, the Miller grinds wheat into flour and sells to a baker for ` 600, the Baker makes bread from flour and sells it to a shopkeeper for ` 800, the shopkeeper sells the bread for ` 900. If we take the value of all the final output as ` 500 plus ` 600 plus ` 800 plus ` 900 which amounts to` 2800 then the result obtained will not give the true picture. This is the problem of double counting. To solve this, we should include only the final value of the product i.e. `900 in national income.

    (viii) (a) Income of the consumer is one of the important factors to determine the demand for a commodity. There is a direct relationship between the income of the consumer and his demand for a commodity (in case of normal commodity). The demand for a commodity increases when the income of the consumer increases because purchasing power of the consumer increases and vice versa.

    (b) X and Y are substitute goods. These goods satisfy the same type of need and hence can be used in place of one another to satisfy the given want. A rise in the price of X results in a rightward shift of the demand curve of Y. If price of good X rise, consumer will shift his demand from X to Y good because they can be used in place of one another.

    (ix)

    Balance of Trade (BOT)

    Balance of Payment (BOP)

    1. It refers to difference between amounts of exports and imports of visible items.

    1. BOP includes visible
    items, invisible items,
    unilateral transfers and
    capital transfers.

    3. It does not record any
    transactions of capital
    nature.

    3. It records all transaction
    of capital nature.

    (x) The shape of MC curve is U-shaped (shown in the figure). It shows that as output increases, MC curve slopes downward (up to OQ units), reaches the minimum (at point A) and then starts sloping upward beyond OQ level of output. It is due to the operation of the law of variable proportions. It is negatively sloped in the initial stage of production due to increasing returns to the variable factor and is positively sloped thereafter due to decreasing returns to the variable factor.

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