Economy Test

40 Marks
Section-A
Microeconomics
Unit Name of the Unit Marks
1. Introduction 4
2. Consumer’s Equilibrium and Demand 13
3. Producer Behaviour and Supply 13
4. Forms of Market and Price Determination 10
under Perfect Competition with Simple Applications
Total 40
CBSE Syllabus Unit 3: Producer Behaviour and Supply

• Production function– short run and long run
Unit 1: Introduction • Total product, average product and marginal product
• Meaning of microeconomics and macroeconomics, positive • Returns to a factor
and normative economics • Cost: short run costs–total cost, total fixed cost, total
• What is an economy? variable cost, average cost, average fixed cost, average
• Central problems of an economy: what, how, and for variable cost and marginal cost (meaning and their
whom to produce relationship)
• Concept of opportunity cost • Revenue: total, average and marginal revenue–meaning
• Production possibility frontier and their relationships
• Producer’s equilibrium: meaning and its conditions in terms
Unit 2: Consumer Equilibrium and Demand
of marginal revenue-marginal cost
• Consumer’s equilibrium– meaning of utility, marginal
• Supply, market supply, determinants of supply, supply
utility, law of diminishing marginal utility, conditions of
schedule, supply curve and its slope, movements along
consumer’s equilibrium using marginal utility analysis
and shifts in supply curve
• Indifference curve analysis of consumer’s equilibrium–
• Price elasticity of supply: measurement–percentage change
the consumer’s budget (budget set and budget line),
method
preferences of the consumer (indifference curve,
indifference map) and conditions of consumer’s Unit 4: Forms of Market and Price Determination
equilibrium under Perfect Competition with Simple Applications
• Demand, market demand, determinants of demand, • Perfect competition–features
demand schedule, demand curve and its slope, • Determination of market equilibrium and effects of shifts
movement along and shifts in the demand curve in demand and supply
• Price elasticity of demand– factors affecting; • Other market forms–monopoly, monopolistic competition,
measurement: percentage change method oligopoly: their meaning and features
• Simple applications of tools of demand and supply: price
ceiling, price floor
Exam Handbook in Economics-XII – by Subhash Dey 1

4 Marks
Unit 1 Introduction
1.1 Scarcity and Central Problems of an Economy
What is an Economy?
Economy refers to the whole collection of production units in an area by which people get their living.
Positive and Normative Economics
Positive economics deals with economic issues as they are. It is based on facts and actual data. In positive
economic analysis, we study how the different mechanisms function. Examples: (i) Growth rate is 5%. (ii) Industrial
output is likely to grow by 3%.
Normative economics deals with economic issues as they ‘ought to be’. It is based on opinions/value judgements
and is suggestive in nature. In normative economic analysis, we try to understand whether the mechanisms are
desirable or not. Example: The unemployment rate should be reduced.
Microeconomics and Macroeconomics
In microeconomics, we study the economic behaviour of an individual economic agent, i.e. a consumer, a
producer, etc. Example: Price determination of a commodity through demand and supply.
In macroeconomics, we study the economic behaviour of the economy as a whole, e.g. aggregate demand,
aggregate supply, levels of income, employment and price in the economy.
Economic Problem: Meaning and Causes
Economic problem means the problem of making choice among alternative uses of resources. Economic problem
arises because: (a) wants are unlimited, (b) resources are limited and (c) resources have alternative uses.
Central Problems of an Economy (Problem of allocation of resources)
Central problems are economic problems faced by each and every economy. They arise due to:
(a) Scarcity of resources: Human wants are unlimited and available resources in relation to same are scarce and limited.
(b) Alternate uses of resources: Available resources can be put to multiple uses, hence, the economy has to make
a choice amongst alternative uses of available resources.
There are three central problems of an economy:
1. What to produce and in what quantity? The economy has to decide which goods and services should be
produced with given resources, which are scarce, and have alternative uses.
With fixed resources, the economy can produce several combinations of different goods and services.
The problem is which combination should be produced— Whether to produce more of consumption goods (food,
clothing, etc.) or investment goods (like machines, tools and equipments).
2. How to produce? The central problem of ‘how to produce’ is the problem relating to the choice of technique
of production.
Broadly, the choice is between the two types of techniques– labour intensive technique and capital intensive
technique.
The technique which uses more labour and less capital is labour intensive technique and the technique which uses
more capital and less labour is capital intensive technique.
3. For Whom to produce? The central problem of ‘for whom to produce’ is the problem relating to the distribution
of final goods and services produced in the economy.
Since income gives people purchasing power, these goods and services can be bought only by those who have
income.
Clearly, the problem amounts to how should the national income be distributed among people.
2 Exam Handbook in Economics-XII – by Subhash Dey

1.2 Opportunity Cost and Production Possibilities Frontier
Concept of Opportunity Cost
Opportunity cost is defined as the value of the next best alternative foregone in availing the best.
Example: Suppose an individual is offered three jobs of `10000, `8000 and `6000 per month. He will avail `10000
a month job. In availing the best, he foregoes the next best job of `8000 which is the opportunity cost of choosing
the best.
Concept of Marginal Opportunity Cost Representation of Increasing MOC/MRT
Marginal Opportunity Cost (MOC) can be defined as the ratio of Combination Good X Good Y MOC/MRT
number of units of a good sacrificed (Good Y) to produce an A 0 10 –
additional unit of another good (Good X). It is also known as
B 1 9 1Y : 1X
Marginal Rate of Transformation (MRT). MRT = DY/DX
Example: The schedule shows that if the economy shifts from C 2 7 2Y : 1X
combination A to B, MOC/MRT is 1Y : 1X. Similarly, if the economy D 3 4 3Y : 1X
shifts from combination B to C, then MOC/MRT is 2Y : 1X and so on. E 4 0 4Y : 1X
Production Possibilities Curve (PPC)
Production Possibilities Curve (PPC) is the curve which shows different Y
Good Y
combinations of the two goods which an economy can potentially produce,
A
i.e. with full and efficient utilisation of its given resources and technology. 10
B
PPC is drawn on the following assumptions: (i) The resources 9 S
available are fixed. (Therefore, point S is not obtainable) (ii) The technology C
remains unchanged. (iii) The resources are fully employed. (iv) The 7
resources are efficiently employed. (v) No resource is equally efficient in

production of all goods. So, if resources are transferred from production of 4 U
D
one good to another, the marginal opportunity cost (MOC) increases.
Characteristics/Properties of Production Possibilities Curve
1. PPC is downward sloping from left to right (negatively sloped) because E
to produce more of a good (Good X), the economy has to sacrifice some O
X
1 2 3 4 Good X
production of other good (Good Y). It is because of the limited resources
in the economy.
2. PPC is concave to the origin because of increasing Marginal Rate of Transformation (MRT) as we move downwards
along the PPC curve from left to right. MRT increases because it is based on the assumption that no resource is
equally efficient in production of all goods. So, if resources are transferred from Good Y to Good X, more and more
units of Good Y are to be sacrificed to produce every additional unit of Good X, i.e. MRT increases. Thus, concavity
of PPC implies increasing MRT.
Does production always take place on the PP curve?
No, because if the resources are under-utilised/inefficiently utilised, production in the economy is below its potential.
So production will take place at any point below the PP curve. Thus, any point below the PP curve (e.g. Point U)
highlights the problem of unemployment and inefficiency in the economy.
Can a production possibilities curve be a straight line?
Yes; if marginal rate of transformation (MRT) is constant, i.e. if we assume that all the resources are equally
efficient in production of all goods. The schedule/diagram shows that MRT remains constant 1Y : 1X. Therefore,
PPC is downward sloping straight line.
Good Y
Y
Constant MRT–Downward sloping
A
straight line PPC
3
Combination Good X Good Y MOC/MRT
B
2 A 0 3 –
C B 1 2 1Y : 1X
1
C 2 1 1Y : 1X
D
X D 3 0 1Y : 1X
O 1 2 3 Good X
Can the production possibilities curve shift?
PPC may shift away from origin (to the right) due to:
(i) Increase in resources available to an economy (natural, physical or human resource) (e.g. more labour, more capital
goods, inflow of foreign capital, skill development due to education and training, etc.)

(ii) Improvement in technology Y
Good Y
These factors increase the production potential of the economy leading to C
economic growth. So, PPC shifts rightwards away from the origin (from AB
to CD). A
Similarly, PPC may shift towards left due to: E
(i) Decrease in resources available to an economy (natural, physical or
human resource), e.g. due to earthquake, famine, flood, etc.
(ii) Technological obsolescence
These factors reduce the production potential of the economy. So, PPC X
shifts leftwards towards the origin. (from AB to EF). O F B D Good X
Application, HOTS, Evaluation and Multi-Disciplinary Questions

1. Which of the following is a statement of normative nature in economics? (CBSE SQP 2018) (1)
(a) Economics is study of choices/alternatives.
(b) Government should be concerned with how to reduce unemployment.
(c) According to an estimate, in spite of severe shortage, more than 10% of the houses in Indian cities are
lying vacant.
(d) Accommodation of Refugees is posing a big problem for the Europe.
Ans. (b)
2. Do rich countries also face central problems ? Give reasons for your answer. (CBSE 2015) (1)
Ans. Yes, even in rich countries resources are scarce, having alternative uses and wants are unlimited.
3. Diagrammatically, what does the slope of the PPC measure? (1)
Ans. The slope of the PPC is a measure of the marginal rate of transformation (MRT).
4. Name the technical term used to denote the rate at which the quantity of output of one good is sacrificed to
produce one more unit of the other good. (1)
Ans. Marginal Rate of Transformation (MRT)
5. Assuming that no resource is equally efficient in production of all goods, name the curve which shows
production potential of the economy. (CBSE 2016) (1)
Ans. The curve is called Production Possibilities Curve (PPC).
6. What is the effect on MRT as we move downwards along a PPC? (1)
Ans. As we move downwards along a PPC, Marginal Rate of Transformation (MRT) increases.
7. What is the effect of unemployment on the production possibilities curve? Explain. (3)
Ans. There will be no effect on the PPC because a PPC shows only what an economy can potentially produce, and not what it
actually produces. Unemployment in the economy implies under-utilisation of resources. So, production takes place at any
point below the PPC. That is, production in the economy is below its potential.
8. State giving reason whether the following statement is true or false: (1)
The PP curve is a graphical medium of highlighting the central problem of ‘How to produce’.
Ans. False: The PP curve is a graphical medium of highlighting the central problem of ‘what to produce’.
9. What is likely to be the impact of efforts towards reducing unemployment on the production potential of the
economy? Explain. (CBSE 2015) (3)
Ans. Reducing unemployment has no effect on the production potential of the country. Unemployment indicates that the country
is operating below potential. Reducing unemployment simply helps in reaching potential.
10. Explain the likely impact of large scale outflow of foreign capital on Production Possibilities curve of the
economy. (CBSE 2015) (3)
Ans. Large scale outflow of foreign capital from the economy will reduce resources and thus production potential of the country
will fall. So, PPC shifts to the left towards the origin.
11. Production in an economy is below its potential due to unemployment. Government starts employment
generation schemes. Explain its effect on production possibilities curve. (CBSE 2013) (3)
Ans. Production below the potential means that production in the economy is somewhere below the PPC. When the government
starts employment generation schemes, the economy moves forward towards the PPC. It will help the economy in realising
its production potential.
12. The government has started promoting foreign capital. What is its effect on Production Possibilities
Frontier? (CBSE 2014) (3)
Ans. It will increase inflow of foreign capital. It implies increase in resources. This will increase the production potential in the
economy leading to economic growth. So, PPC will shift to the right.
13. Large number of technical training institutions have been started by the government. State its economic
value in the context of production possibilities frontier. (3)
Ans. Technical training raises the production potential of the country by raising the efficiency of the labour. So, PPC of the
economy will shift rightwards. It leads to economic growth.
14. A country’s resources are fully and efficiently employed. The problem of scarcity exists. What advice will be
given to raise the efficiency level of the human resource to fight scarcity? (1)
Ans. Spread of education and training.

15. Economic slowdown in some parts of the world has adversely affected demand for Indian exports. What will
be its effect on the production possibilities frontier of India? Explain. (3)
Ans. There will be no effect on the Production Possibilities Frontier (PPF) of India. Slowdown by reducing demand for Indian
exports, may ultimately bring down output. Therefore, production will take place at a point somewhere below the PPF.
However, there is no effect on PPF.
16. Giving reason, comment on the shape of Production Possibilities curve based on the following schedule:
(CBSE 2015) (3)
Good X (units) Good Y (units) Ans. Good X (units) Good Y (units) MRT (DY/DX)
0 16 0 16 —
1 12 1 12 4Y:1X
2 8 2 8 4Y:1X
3 4 3 4 4Y:1X
4 0 4 0 4Y:1X
PPC will be a straight line since marginal rate of transformation (MRT) is constant.
13 Marks
Consumer’s Equilibrium
Unit 2 and Demand
2.1 Consumer’s Equilibrium – Cardinal Utility Approach
Utility refers to satisfaction from the consumption of goods. Or, Utility is the want-satisfying capacity of a
commodity.
Cardinal utility analysis assumes that level of utility can be expressed in numbers. For example, 12 units of utility
(satisfaction) from consuming 1 unit of a commodity X.
Total utility (TU): TU means the total satisfaction derived from consuming a given quantity of the commodity X.
More of commodity X provides more total utility (TU) to the consumer.
Marginal utility (MU): MU is the change in total utility due to consumption of one additional unit of the commodity
X. Or, MU is the utility derived from the last unit of a commodity consumed.
TU and MU are related in the following way:
MUn = TUn – TUn–1
TUn = MU1 + MU2 + … + MUn–1 + MUn
Law of Diminishing Marginal Utility states that marginal utility from consuming each additional unit of a
commodity declines as its consumption increases. It is because having obtained some amount of the commodity,
the desire of the consumer to have still Representation of Law of
more of it becomes weaker. diminishing MU
Relationship between TU and MU: Quantity TU MU
1. TU increases (at a decreasing rate) as 1 12 12
long as MU is positive.
2 18 6
2. MU becomes zero at a level when TU
3 22 4
remains constant.
3. Thereafter, TU starts falling and MU 4 24 2
becomes negative. 5 24 0
6 22 –2

Consumer’s equilibrium in case of one commodity
Consumer’s equilibrium means maximum satisfaction level of the consumer, given his money income and prices of
the two goods in the market.
The two conditions of consumer’s equilibrium are:
1. Marginal utility (in rupees) is equal to the price of the good.
2. MU of the good falls as more of it is consumed.
Explanation:
1. Given the market price of good X how many units of it to buy, the consumer decides this by comparing (MU) with
price (P). The consumer buys so long as MU > P. As the consumer buys more units, MU falls due to the operation
of the Law of Diminishing Marginal Utility. The consumer stops buying when MU = P. If the consumer buys more
units after MU = P, then MU < P, and it makes buying more units disadvantageous to the consumer.
2. Unless MU falls as more of good X is consumed the consumer will not reach equilibrium.
Consumer’s equilibrium in case of two commodities
Given his money income, suppose a consumer consumes only two goods X and Y, whose prices are Px and Py
respectively. The two conditions of consumer’s equilibrium are:
1. Per rupee MU from consumption of each good is same, i.e. MUx/Px = MUy/Py. (Law of Equi-Marginal Utility)
2. MU falls as more units of a good are consumed.
Explanation:
1. If MUx/Px > MUy/Py, the consumer will not be in equilibrium because the satisfaction derived by consuming
good X is greater than the satisfaction derived by consuming good Y. The consumer will reallocate his income by
spending more on good X. As he will consume more units of good X, marginal utility derived from consumption of
good X diminishes and alternate proposition occurs for good Y. This process will continue till MUx/Px becomes equal
to MUy/Py and the consumer is in equilibrium.
2. Unless MU falls as more of a good is consumed, the consumer will not reach the equilibrium.
2.2 Consumer’s Equilibrium – Indifference Curve Analysis

Ordinal utility analysis assumes that the consumer does not measure Y
utility in numbers, but he ranks various consumption bundles, e.g. utility Good Y
derived from the consumption bundle 10X + 8Y is more than that from the
bundle 8X + 8Y. 20 A
Indifference curve is the locus of all the combinations of the two goods,
B
each combination providing the same level of satisfaction. 15
Marginal rate of substitution (MRS) 11

C
D
MRS is the ratio of units of good Y that the consumer is willing to sacrifice 8
to get an additional unit of good X, so that his total utility remains constant. IC
In other words, MRS is the rate at which the consumer is willing to trade-off
or substitute good X for good Y, so that his total utility remains constant. O
1 2 3 4 Good X X
MRSxy = DY/DX. (MRS measures the slope of indifference curve.)
Law of Diminishing Marginal Rate of Substitution states that the consumer will be willing to sacrifice lesser
units of good Y, so as to gain each additional unit of the good X. This Representation of Law of Diminishing MRS
is an extension of law of diminishing marginal utility. This is because
as the consumption of good X increases, the marginal utility (MU) Bundle Good X Good Y MRS = DY/DX
derived from each additional unit of good X falls due to the Law of A 1 20 —
Diminishing Marginal Utility. So, with increase in the quantity of good X, B 2 15 5Y : 1X
the consumer will feel the inclination to sacrifice lesser units of good Y.
C 3 11 4Y : 1X
Shape of an Indifference Curve: A typical indifference curve is
convex to the origin (as shown in figure on page no. 6) because of the D 4 8 3Y : 1X
law of Diminishing Marginal Rate of Substitution (MRS).
Shape of an Indifference Curve in case of goods being perfect substitutes: In case of goods being perfect
substitutes (Five-Rupee notes and Five-Rupee coins), the marginal rate of substitution(MRS) does not diminish.
It remains constant (as shown in the schedule that MRS is constant 1Y:1X). Therefore, the indifference curve will be a
straight line.

Y
Quantity of five-rupee coins (Qy)

Representation of Law of Constant MRS
4 A
Bundle Quantity of Five- Quantity of Five- MRS(DY/DX)
Rupee notes(Qx) Rupee coins (Qy) 3 B
A 1 4 – 2 C
B 2 3 1Y:1X D
1
C 3 2 1Y:1X IC
O
D 4 1 1Y:1X 1 2 3
Quantity of five-rupee notes (Qy)
4 X
Indifference Map and Monotonic Preferences

Indifference Map is the set (or family) of indifference curves representing Y
different levels of satisfaction for the consumer.
Good Y
Monotonic Preferences: A consumer’s preferences are monotonic if between any
two bundles, the consumer prefers the bundle which has more of at least one of the
goods and no less of the other good as compared to the other bundle. For example, 10
A B C
a consumer’s preferences are monotonic if between any two bundles (3, 10) and IC3
(2,10), the consumer prefers (3,10) to (2,10) because the first bundle (3,10) has more IC2
units of good X and no less of good Y, and thus the consumer gets more total utility. IC1
Properties or characteristics of indifference curve O 1 2 3 Good X X

1. Indifference curve slopes downwards from left to right (i.e. negatively sloped) because in order to
have more of good X, the consumer has to forego some units of good Y, so that his total utility level remains the
same and he remains on the same indifference curve. (This is based in the assumption of monotonic preferences.)
2. Higher indifference curve (an indifference curve to the right) gives greater level of utility
(satisfaction) because a higher indifference curve consists of combinations with more of good X, or more of
good Y, or more of both. As long as marginal utility of a commodity is positive, more goods will increase the level
of total utility. (This is based in the assumption of monotonic preferences.) A consumer will Y
prefer a combination which contains more of at least one good and no less of the other.
Good Y
3. Two indifference curves never intersect each other because two indifference
curves intersecting each other will lead to conflicting results. As points A and B lie
on IC1, combinations A and B will give the same level of utility. Similarly, as points
A and C lie on IC2, combinations A and C will give the same utility. So, utility from A(7, 10)
combinations B and C will also be the same. But on point B, the consumer gets more B(9, 7)
IC1
units of good Y with same units of good X. So he is better off at point B than C. Thus, C(9, 5) IC2
two indifference curves cannot intersect each other. O
X Good X
Budget set and Budget Line
Budget set is the collection of all bundles that the consumer can buy with his income at the prevailing market
prices. Budget set includes those bundles which cost less than or equal to his income (M). Budget set is represented
by the inequality: Px.Qx + Py.Qy ≤ M (budget constraint). This inequality says that the total expenditure on the two
goods must be less than or equal to the consumer’s income.
Budget line: From the budget set if only such bundles are taken on which Y
total expenditure equals the consumer’s income and plotted on a graph, we A
M/Py
get a line called the budget line. In other words, budget line consists of all
bundles which cost exactly equal to the consumer’s money income.
Good Y
Px
The equation of the budget line is Px.Qx + Py.Qy = M.

.Q
x
The slope of the budget line is (–) Px/Py.

+
Py
Price Ratio (Px/Py) measures the rate at which the consumer is able to
.Q
y
Budget Set
=
exchange good X for good Y in the market when he spends his entire income.
M
So, Px/Py is called market rate of exchange.

B
The horizontal intercept (M/Px) represents the quantity of good X when the O X
M/Px Good X
consumer spends his entire income on good X. Similarly, the vertical intercept
(M/Py) represents the quantity of good Y when the consumer spends his entire income on good Y.
Properties of budget line
1. Budget line is negatively sloped (downward sloping) because to buy more quantity of one good the
consumer must give up some quantity of the other good. It is because the consumer’s income is fixed.

2. Budget line is a straight line because the prices of the two goods are constant. It makes the market rate of
exchange (Px/Py) between the two goods constant. Market rate of exchange measures the slope of budget line,
which is constant.
Changes in the Budget Set and Budget Line
Changes in the Budget Set: A budget set is dependent on income of the consumer and the prices of the two
goods in the market. Thus, a change in income of the consumer or change in price of one good or both the goods
can lead to a change in budget set.
Causes of change in budget line
1. Change in income of the consumer: Increase (decrease) in Y Y
income shifts the budget line parallel outward (inward) because
Good Y
C
Good Y
consumer can now buy more or less of both the goods X and Y in
the same proportion. Since prices of the two goods (Px and Py) A A
remain unchanged, therefore the slope of the new budget line

remains the same. So, there is a parallel shift of the budget line. E
2. Change in prices of one or both the goods: Change in prices of

one or both the goods changes the maximum quantity of one or B D F B
both the goods which the consumer can buy, and thus changing O Good X X
O
Good X X
one or both the intercepts (ends) of the budget line.
Suppose the price of good X. The consumer will be able to buy Y Y
more of good X in same money income pushing the X-intercept
Good Y
Good Y
of the budget line away from origin, keeping the Y-intercept A A
constant. The budget line rotates outwards and becomes flatter.

Suppose the price of good X rises.The consumer will be able
to buy less of good X in same money income pushing the
X-intercept of the budget line towards the origin, keeping the B C D B
Y-intercept constant. The budget line rotates inwards and O Good X X
O
Good X X
becomes steeper.
Conditions of consumer’s equilibrium
Let the two goods be X and Y, whose prices are Px and Py respectively. The two conditions of consumer’s
equilibrium under Indifference Curve Analysis/Ordinal Utility Analysis are:
1. Marginal Rate of Substitution (MRS) and Price Ratio must be equal, i.e. MRS = Px/Py
2. MRS must be diminishing as consumption of good X increases.
Explanation:
1. If MRS > Px/Py, it means that the consumer is willing to sacrifice more of Good Y than he is actually required to
sacrifice in the market for an extra unit of Good X. The consumer will buy more and more of X. As consumption of
Good X increases, its marginal utility diminishes due to the Law of Diminishing Marginal Utility. Thus, MRS will fall.
This will continue till MRS = Px/Py and consumer is in equilibrium.
2. MRS must be diminishing as consumption of good X increases, symbolises fall in marginal utility due to which the
consumer will not further increase its consumption. If it does not fall, he will keep on increasing the consumption
of good X and will not reach equilibrium.
Diagrammatical Presentation
Diagrammatically, the two conditions for consumer’s equilibrium are :
1. Budget line is tangential to a particular indifference curve at a point, Y
where the slope of the indifference curve and the slope of budget line are
Good Y
A
equal (i.e., MRS = Px/Py).
C
2. The indifference curve is strictly convex to the origin at equilibrium (Since,
MRS diminishes as consumption of good X increases).
The budget line AB is tangent to IC2 at point E. This is the point of consumer’s Qy E
equilibrium. The equilibrium consumption bundle is (Qx, Qy).
IC3
The consumer cannot get satisfaction level higher than IC2 because his IC2
D
income does not permit him to move above the budget line AB on the higher IC1
indifference curve IC3. O Qx B Good X X
The consumer will not like to purchase any other bundle on the budget line
AB, for example the bundle at C and D, because they all lie on the lower indifference curve, and give him lower
satisfaction.

2.3 Demand and Price Elasticity of Demand
Demand, Market Demand, Demand Schedule, Demand Curve and its Slope
Demand for a commodity refers to the quantity of the commodity that a consumer is willing to buy and is able to
afford at a given price during a period of time, other factors remaining unchanged.
Market demand is the sum of quantity demanded which all the consumers are willing to buy at a given price
during a period of time.
Factors affecting market demand of a commodity: (i) Number of consumers Demand Schedule of Good X
of the commodity in the market (ii) Price of the commodity (iii) Income of its Price (`) Demand (units)
buyers (iv) Prices of the substitute goods (v) Price of the complementary good
(vi) Tastes and preferences of the consumers. 50 5
Market demand curve is derived by the horizontal summation of individual 45 10
demand curves in the market. 40 15
Demand schedule is a tabular presentation showing the different quantities
of a good that a consumer is willing and able to buy at different prices during a Y
period of time, other factors remaining unchanged. a/b
D
Demand curve is a graphical presentation of various quantities of a commodity
Price
that a consumer is willing and able to buy at different prices during a period of
qD
p
time, other factors remaining unchanged.
=
a
Slope of a linear demand curve
–
p1
bp
A linear demand curve is given by qD = a – bp.
‘–b’ is the slope of the demand curve. It measures the rate at which demand D
changes due to change in its price, i.e. Dq/Dp. O q q1 a X
Law of demand Quantity Demanded
Law of Demand states that other factors remaining unchanged, there is a
negative (or inverse) relation between price of a commodity and its quantity demanded. In other words, when
price of the commodity increases, demand for it falls and when price of the commodity decreases, demand for it
rises, other factors remaining unchanged. Due to negative relation between price of a commodity and its quantity
demanded, the demand curve of a normal good is negatively sloped.
Derivation of law of demand from the law of diminishing marginal utility
The law of diminishing marginal utility states that each successive unit of a good consumed provides lower
marginal utility. So, a consumer buys each additional unit only at a lower price. Hence, the law of diminishing
marginal utility explains why demand curves have a negative slope.
Explanation using ‘MU = Price’ principle: A consumer buys a good only up to the point where MU = Price.
Now, suppose price falls. Now, MU > Price. This induces the consumer to buy more of the good. This establishes
the inverse relationship between price of a good and its quantity demanded.
Explanation using the law of equi-marginal utility: Suppose a consumer consumes only two goods X and Y,
whose prices be Px and Py. The consumer is in equilibrium when: MUx/Px = MUy/Py. Now, suppose Px falls. Now,
MUx/Px > MUy/Py. It means that per rupee MU from consumption of X is greater than from consumption of Y. This
induces the consumer to buy more of X and less of Y. The consumer now demands more of X. This establishes the
inverse relationship between price of a good and its quantity demanded.
Derivation of Demand Curve from Indifference Curves and Budget Constraints
Suppose a consumer consumes two goods X and Y whose prices are Px and Py, and his income is M. Panel (a) in the
diagram depicts equilibrium at point M, where budget line AB is tangent to the indifference curve IC1. The consumer buys
the bundle (Qx, Qy). In panel (b), we plot price Px against Qx which is the first point on the demand curve for good X.
Suppose the price of good X falls to Px1. The budget line rotates outwards and the new equilibrium is on a higher
indifference curve (IC2) at point N, where the consumer
buys more of good X (Qx1 > Qx). Thus, demand for
good X rises as its price falls. So, the demand curve for
good X is negatively sloped.
Income effect: When price of good X falls, the
purchasing power (real income) of the consumer
increases as he will be able to purchase more
quantity of the good with the same money income.
This phenomenon is called income effect, one of the
reasons for negative slope of demand curve.
Substitution effect: When price of good X falls, it becomes relatively cheaper than good Y. So, the consumer
maximises his utility by substituting good X for good Y. Thus, demand for good X rises. This phenomenon is called
substitution effect, one of the reasons for negative slope of demand curve.
Change in Demand and Change in Quantity Demanded
Change in demand refers to rise/fall in quantity demanded due to change in any factor, other than the own price
of the good. Here, rise in quantity demanded is called ‘increase in demand’ whereas the fall in quantity demanded
is called ‘decrease in demand’.
Diagrammatically, a change in demand implies
a shift in the demand curve. Increase
(decrease) in demand leads to a rightward
(leftward) shift in the demand curve.
Change in quantity demanded refers to a
increase (decrease) in quantity demanded due
to fall (rise) in own price of the good, other
things remaining unchanged. Here, increase
in quantity demanded is called ‘expansion
of demand’ whereas decrease in quantity
demanded is called ‘contraction of demand’.
Diagrammatically, a change in quantity demanded implies a movement along the demand curve. A fall (rise)
in the price of the good leads to downward (upward) movement along the demand curve.
Determinants of Demand (Shift factors)
1. Change in income of the consumer: The effect of change in income on demand for a good depends on
whether it is a normal good or an inferior good for the consumer.
Normal good is any good whose demand increases as the consumer’s income increases, and decreases as the
consumer’s income decreases.
Inferior good is any good whose demand falls as the consumer’s income increases, and as the consumer’s income
decreases, the demand for it rises. Examples of inferior goods include low quality food items like toned milk, coarse
cereals, etc.
Increase in consumer’s income results in increase in demand for a normal good and decease in demand for an
inferior good. Explanation: A rise in income increases the consumer’s disposable income. So, he is able to spend
more on the normal good X. Therefore, the price-demand curve of the normal good X shifts to the right at the
same price. On the other hand, rise in income increases the consumer’s ability to buy normal goods. So he prefers
to buy less quantity of the inferior good Y. Therefore, the price-demand curve of the inferior good Y shifts to the
left at the same price.
(Note: The same good can be inferior for one person and normal for another. Whether a good is normal or inferior is determined
by the income level of the consumer. A good which is a normal good for a consumer with a lower income, may become an inferior
good for a consumer with higher income. For example, coarse cloth may be a normal good for a low income consumer, but for
a high income consumer it may be an inferior good as he can afford a better quality cloth. Also, when a consumer moves to a
higher income level, he may consider coarse cloth as being below their income status, and has the ability to buy more expensive
fine cloth, thus considering coarse cloth as being inferior.)
2. Change in prices of related goods: Related goods are either substitutes or complements. Substitute goods
are those goods which can be used in place of one another, for satisfaction of a given want, e.g., Tea and Coffee.
Complementary goods are those goods which are consumed (or used) jointly to satisfy a given want, e.g., Tea and Sugar.
There is a direct relation between change in price of a substitute good and change in demand for the given good.
For example, an increase in price of a substitute good (Coffee) makes the given good (Tea) relatively cheaper. As
a result, demand for tea increases at the same price, and hence demand curve shifts rightwards.
There is an inverse relation between price of the complementary good and demand for the given good. For
example, an increase in price of the complementary good (Sugar) reduces its demand, which in turn decreases the
demand for the given good (Tea) at the same price. As a result, demand curve of tea shifts leftwards.
3. Change in taste and preference for the good: Due to favourable (unfavourable) change in taste and
preference for the good X, the consumer demands more (less) quantity demanded of it at the same price. So, the
demand curve of good X will shift to the right (left).
Price Elasticity of Demand
Price elasticity of demand measures the degree of responsiveness of quantity demanded of good to change in its
price. Price elasticity of demand (eD) for a good is defined as the percentage change in quantity demanded for the
good divided by the percentage change in its price.

eD = Percentage change in quantity demanded/Percentage change in price
or, eD = (Dq/q × 100)/(Dp/p × 100) = Dq/Dp × p/q
Price elasticity of demand has a minus sign because there is negative (inverse) relation between price and quantity
demanded of a good, other factors remaining the same.
• When the percentage change in quantity demanded of a good is equal to the percentage change in price,
then demand for the good is unitary elastic (eD = 1). (Unitary elastic demand curve has the shape of a rectangular
hyperbola because for any point on this demand curve, the area under the demand curve, i.e., total expenditure on the good
remains unchanged).
• When due to change in price there is no change in quantity demanded of a good X, its demand is perfectly
inelastic (eD = 0). The demand curve’s shape is: Vertical demand curve.
• When the buyers of a good are willing to buy any quantity of it at the same price, the demand is perfectly elastic,
eD = ∞ (infinity). Demand curve is a horizontal line.
• When the percentage change in Y Y Y
D
quantity demanded of a good is
Price
Price
Price
D
less than the percentage change in e =1 D
e =
price, then demand for the good is p C
e =0 p
D
D
price-inelastic (eD < 1).
D
• When the percentage change in

quantity demanded of a good is D
more than the percentage change
O O
in price, then demand for the good q X q X O X
Quantity Demanded Quantity Demanded Quantity Demanded
is price-elastic (eD > 1).
Factors affecting Price Elasticity of Demand
1. Nature of the good: If the good is a necessity like food, its demand is not likely to be affected much by change
in its price. So, demand for necessities is price-inelastic. On the other hand, demand for luxuries, e.g. a luxury car
is price-elastic, because with rise in price, consumers may reduce demand for luxuries.
2. Availability of close substitutes of the good: If close substitutes are easily available, e.g. pulses; if the
price of a variety of pulses rises, consumers can shift to some other variety of pulses which is a close substitute.
So, demand for such a good is price-elastic. On the other hand, if close substitutes are not available, e.g. salt,
water etc., the demand is price-inelastic.
3. Proportion of income spent on the good/Own price of the good: Higher the proportion of income spent
on a good, higher is its price elasticity of demand. It is because a change in price of a high priced good (e.g. mobile
phone etc.) has substantial effect on the budget of the consumer. So, demand is price-elastic. On the other hand,
demand for a low priced good (e.g. salt etc.) is price-inelastic because a very small proportion of a consumer’s
income is spent on it.
4. Time period of response: Longer the time period of response, more elastic the demand because habits
change but normally over longer periods. When a consumer is habituated to consuming a good and its price rises,
it is very difficult for the consumer to reduce the consumption of the good immediately. Thus, demand is price-
inelastic in the short period. However, over a longer time period, the consumer may change habits. Thus, demand
is relatively more price-elastic in the long run.

1. A consumer consumes only two goods X and Y and is in equilibrium. Price of X falls. Explain the reaction of
consumer through the marginal utility analysis. (CBSE 2012) (3)
Ans. According to the marginal utility analysis, the consumer is in equilibrium when MUx/Px = MUy/Py.
Now, given that Px falls, then MUx/Px > MUy/Py. Since per rupee MUx is greater than per rupee MUy, it means that
satisfaction derived from consumption of good X is greater than the satisfaction derived from consumption of good Y. This
will induce the consumer to buy more of X by reducing expenditure on Y.
Buying more of X reduces MUx. The alternate proposition occurs in case of good Y.
The change continues till MUx/Px becomes equal to MUy/Py and the consumer is in equilibrium.
2. A consumer consumes only two goods X and Y whose prices are `4 and `5 per unit respectively. If the
consumer chooses a combination of the two goods with marginal utility of X equal to 5 and that of Y equal
to 4, is the consumer in equilibrium? Give reasons. What will a rational consumer do in this situation? Use
utility analysis. (CBSE 2015) (4)
Ans. MUx/Px = 5/4 = 1.25 and MUy/Py = 4/5 = 0.8
Since MUx/Px > MUy/Py, therefore, the consumer is not in equilibrium.
Here, MUx/Px > MUy/Py. It means that the satisfaction a consumer derives from spending a rupee on Good X is greater
than the satisfaction derived from spending a rupee on Good Y. This will induce the consumer to buy more of X by reducing

expenditure on Y. Buying more of X reduces MUx. The alternate proposition occurs in case of good Y. The change continues
till MUx/Px becomes equal to MUy/Py and the consumer is in equilibrium.
3. A consumer consumes only two goods X and Y. His money income is `24 and the prices of Goods X and Y are
`4 and `2 respectively. Answer the following questions:
(i) Write two such combinations of X and Y which lie on the budget line. Also write two such combinations of X
and Y which are part of his budget set but do not lie on his budget line.
(ii) What is the equation of budget line and its slope?
(iii) How much of the good X can the consumer have by spending his entire income on that good? How much of
the good Y can the consumer have by spending his entire income on that good?
(iv) How does the budget line change if consumer’s income increases to `48 but the prices remain unchanged?
(v) How does the budget line change if price of good X falls by `1 but the price of good Y and income remain
unchanged?
(vi) What will be the MRS when the consumer is in equilibrium? Explain. (6)
Ans. (i) Two combinations of X and Y which lie on the budget line 3X + 6Y, 5X + 2Y
Two such combinations of X and Y included in budget set but do not lie on his budget line 3X + 2Y, 4X + 3Y
(ii) Equation of the budget line is PxQx + PyQy = M
Substituting Px = 4, Py = 2 and M = 24, we get the equation of budget line: 4Qx + 2Qy = 24
Slope of budget line = (–) Px/Py = – 4/2 = – 2
(iii) Qx = M/Px = 24/4 = 6, i.e. if the consumer spends his entire income on good X he can have 6 units of it.
Qy = M/Py = 24/2 = 12, i.e. if the consumer spends his entire income on good Y he can have maximum 12 units of it.
(iv) Px =4, Py = 2, M’ = 48
Equation of new budget line: 4Qx + 2Qy = 48.
The consumer can buy more of both the goods at prevailing market prices. Therefore, the new budget line shifts outward
to the initial budget line. Since prices of the two goods remain unchanged the slope of the new budget line is the same
as the slope of the initial budget line and hence, the new budget line will shift parallel to the initial budget line.
(v) P’x = 3, Py = 2, M =24
Equation of new budget line: 3Qx + 2Qy = 24.
Since price of good X falls, the consumer will be able to buy more of good X in same money income pushing the X-intercept
of the budget line away from origin, keeping the Y-intercept constant. The budget line rotates outwards and becomes flatter.
(vi) When the consumer is in equilibrium, MRS = Px/Py
Substituting Px = 4, Py = 2, we have MRS = 4/2 = 2 : 1
4. What happens to MRS when consumer moves downwards along the indifference curve? (CBSE 2011) (1)
Ans. MRS diminishes as consumer moves downwards along the indifference curve due to the law of diminishing marginal rate
of substitution.
5. (i) Suppose a consumer is indifferent of the bundles (5, 6) and (6, 6). Are his preferences monotonic?
(ii) Suppose a consumer’s preferences are monotonic. What can you say about his preference ranking over
the bundles (10, 10), (10, 9) and (9, 9)?
(iii) Suppose a consumer’s preferences are monotonic. Can he be indifferent between the bundles (10,8)
and (8, 6)? (3)
Ans. (i) No, the consumer’s preferences are not monotonic since the bundle (6, 6) should give him more utility than the bundle
(5, 6) whereas he is indifferent towards these consumption bundles.
(ii) The consumer’s ranking of preferences (10, 10) > (10, 9) > (9, 9) are monotonic.
(iii) No, bundle (10, 8) should be preferred as it contains more of both the goods.
6. Suppose a consumer can afford to buy 6 units of good X and 8 units of good Y if she spends her entire
income. The prices of two goods are `6 and `8 respectively. How much is the consumer’s income? (3)
Ans. Px = 6, Py = 8, Qx = 6, Qy = 8. Equation of budget line is PxQx + PyQy = M
M = 6 × 6 + 8 × 8 = 36 + 64 = 100. Therefore, the consumer’s income = `100
7. Why should marginal rate of substitution diminish for a stable consumer’s equilibrium? (CBSE SQP 2019) (3)
Ans. Marginal rate of substitution (MRS) is the rate at which consumer is willing to trade-off one good for the other. It depends
on the quantity of the two goods s/he is consuming. A rational consumer will sacrifice lesser units of Good Y so as to
acquire additional units of Good X, due to the application of law of diminishing marginal utility. MRS should be diminishing
as additional consumption of Commodity X, symbolises fall in marginal utility due to which the consumer will not further
increase its consumption. If it does not fall, s/he will keep on increasing the consumption of Commodity-X and will not reach
a stable equilibrium.
8. A consumer consumes only two goods X and Y both priced at `3 per unit. If the consumer chooses a
combination of these two goods with Marginal Rate of Substitution equal to 3, is the consumer in equilibrium?
Give reasons. What will a rational consumer do in this situation? Explain. (CBSE 2015) (4)
Ans. The consumer is in equilibrium when MRS = Px/Py. Since Px = 3 and Py = 3, therefore, Px/Py = 3/3 = 1. MRS = 3
Since MRS > Px/Py, therefore, the consumer is not in equilibrium. Since MRS > Px/Py, to obtain one extra unit of good X
the consumer is willing to sacrifice more units of good Y than what he is required to sacrifice in the market. The consumer
gains and buys more quantity of good X. As he goes on obtaining more and more units of good X, marginal utility of good
X goes on declining due to the operation of the law of diminishing marginal utility. Therefore, the consumer is willing to
sacrifice less and less of good Y each time he obtains one extra unit of good X. In other words, MRS continuously falls. The
process continues till MRS becomes equal to Px/Py and the consumer is in equilibrium.

9. State giving reason whether the following statement is true or false: (1)
A budget set is the collection of all bundles of goods that a consumer wants to buy.
Ans. False: A budget set is the collection of all bundles of goods that a consumer can afford to buy with his given income and
the prices of the goods in the market.
10. (a) Arrange the following coefficients of price elasticity of demand in ascending order:
–0.87, –0.53, –3.1, –0.80
(b) Comment upon the degree of elasticity of demand for commodity X, if the price of the commodity falls from
`28 per unit to `23 per unit and its quantity demanded rises from 50 units to 100 units. (CBSE SQP 2018) (4)
Ans. (a) –0.53, –0.80, –0.87, –3.1 (minus sign only represents the inverse relation between price and quantity demanded.
(b) p = 28, Dp = 23 – 28 = – 5, q = 50, Dq = 100 – 50 = 50
Price elasticity of demand, eD = Dq/Dp × p/q = 50/–5 × 28/50 = –5.6 (minus sign is ignored as it only represents the
inverse relation between price and quantity demanded.)
eD = 5.6 (eD > 1, relatively more elastic demand)
11. Market demand for a good at `4 per unit is 1000 units. The price rises. As a result, the market demand falls
by 25%. Find the new price if demand is unitary elastic. (3)
Ans. Price elasticity of demand, eD = –1
eD = percentage change in quantity demanded/percentage change in price –1 = –25/percentage change in price
Percentage change in price = 25%. Therefore, new price = 4 + 25% = 4 + 1 = `5 per unit.
12. Demand curve of a good is a rectangular hyperbola. At a given price, a consumer buys 60 units of it. How
many units will he buy if price falls by 10%? (3)
Ans. Price elasticity of demand, eD = –1 (since demand curve is a rectangular hyperbola)
eD = percentage change in quantity demanded/percentage change in price
–1 = percentage change in quantity demanded/–10
\ Percentage change in demand = 10%, i.e., demand for the good rises by 10%.
\ New quantity demanded = 60 + 10% = 60 + 6 = 66 units
13. When price of commodity X falls by 10 per cent, its demand rises from 150 units to 180 units. Calculate its
price elasticity of demand. How much should be the percentage fall in its price so that its demand rises from
150 to 210 units? (CBSE 2017) (6)
Ans. percentage change in price = – 10%, percentage change in demand = (180 – 150)/150 × 100 = 20%
Price elasticity of demand, eD = percentage change in quantity demanded/percentage change in price
eD = 20%/–10% = –2 (minus sign is ignored as it only represents the inverse relation between price and quantity
demanded.) eD = 2 (eD > 1, relatively more elastic demand).
Now, if demand rises from 150 to 210 units, percentage change in demand = (210 – 150) × 100 = 40%
eD = percentage change in quantity demanded/percentage change in price
–2 = 40%/percentage change in price
Percentage change in price = –20%. Thus, price of commodity X must fall by 20%.
14. What can be elasticity of a constant elasticity demand curve? (1)
Ans. Price elasticity of a constant elasticity demand curve may be: eD = 0 or eD = 1.
15. Giving reason, state the impact of the following on demand curve of normal good ‘X’ if
(i) Price of its complementary good falls.
(ii) News reports claims that consumption of product X has harmful effect on human health. (CBSE SQP 2018) (3)
Ans. (i) Demand of the good X will increase, hence demand curve of good X shifts towards right.
(ii) Demand of Good X may decrease as people may be inclined to consume less due to media reports of harmful effect of
the good X. As a result, demand curve may shift towards left.
16. What policy initiatives can the government undertake to increase the demand of milk in the country?
Mention any one. (CBSE SQP 2015) (1)
Ans. Give subsidies to reduce price/Undertake health campaigns to promote the positive effects of milk consumption.
17. Ceteris Paribus, if the government provides subsidies on electricity bills, what would be the likely change in
the market demand of desert coolers? (CBSE SQP 2016) (1)
Ans. Demand for desert coolers will increase.
18. Suggest any one economic measure by which the government can promote consumption of ‘Khadi’.
(CBSE 2015) (1)
Ans. Reduce price by giving subsidy.
19. What economic measure can be Government take to reduce demand for commodity X which is harmful for
health? (CBSE 2015) (1)
Ans. Put a tax on it so that its price rises.
20. Give reasons why demand for salt or water bottle is inelastic? (3)
Ans. Demand for salt or water bottle is inelastic because: (i) It has no close substitute. (ii) It is a necessity. (iii) A very small
proportion of a consumer’s income is spent on its purchase.

13 Marks
Producer Behaviour
Unit 3 and Supply
3.1 Production Function: Returns to a Factor
Production Function
Production function refers to a mathematical relationship between physical inputs used and physical output
produced by a firm. For various quantities of inputs used, it gives the maximum quantity of output that can be
produced.
Short run production function shows the behaviour of output when only one factor input is varied and the
other factor inputs are held constant. Assuming that there are only two factors of production – Labour (L) and
Capital (K), in order to increase the output level the firm can increase only quantity of the variable factor (say
labour) while keeping the quantity of the fixed factor (capital) unchanged.
Long run production function, on the other hand, shows the behaviour of output when all the factor inputs are
varied. The firm can increase output by increasing both the factor inputs (labour and capital) simultaneously and
in the same proportion.
Total Product, Average Product and Marginal Product
Suppose we vary a single factor input (say labour) and keep the other factor input (capital) constant. Then for
different levels of the variable input (labour) we get different levels of output, which is referred to as Total
Product (TP) or Total Physical Product (TPP) of the variable input.
Average product (AP) is defined as the output per unit of the variable input (labour). (AP = TP/L)
Marginal product (MP) is defined as the change in output per unit of change in the variable input (labour) when
all other inputs are held constant. (MPL = DTP/DL) MP is also called marginal physical product (MPP).
Law of Variable Proportions (Law of returns to a factor or Law of diminishing MP)
Returns to a factor refers to change in output when only one factor input is changed, keeping all other factor
inputs unchanged.
Law of variable proportions says that the marginal product of a factor input initially rises with its employment
level. But after reaching a certain level of employment, it starts falling.
There are three phases of production:
Representation of the Law of Variable Proportions
Labour TP MP Phases of Returns
Production to a Factor
0 0 –
1 2 2 Increasing
Phase I Returns to a
2 5 3 Factor
3 9 4
4 12 3
5 14 2
Phase II Diminishing
6 15 1 Returns to a
Factor
7 15 0
8 14 –1 Phase III

Increasing returns to a factor (Phase I)
Phase I: TP increases at increasing rate and MP increases. (In schedule, up to 3 units of labour and in figure, up to point
A on TP curve and up to point C on MP curve) Reason: Initially variable input (labour) is too small as compared to the
fixed input (capital). When units of labour are increased, the factor proportions become more suitable for the
production because efficient utilisation of capital takes place. This leads to rise in productivity of the variable factor
input. Therefore, MP increases and hence, TP increases at increasing rate.
Diminishing returns to a factor (Phase II and III)
Phase II: TP increases at decreasing rate and MP falls but remains positive. (In schedule, at labour units 4 to 7, where
MP becomes zero at 7th unit of labour. In figure, between points A and B on TP curve and between points C and D on MP curve)
Reason: After a certain level of employment of the variable factor input (labour), the production process becomes
crowded with the variable factor input. There is pressure on fixed input (capital). This leads to fall in productivity
of labour. Therefore, MP starts falling and hence, TP increases at decreasing rate.
Phase III: TP falls; MP falls and becomes negative. (In schedule, when 8th unit of labour is employed. In figure, after point
B on TP curve and after point D on MP curve) Reason: The amount of variable factor input (labour) becomes too large
in comparison to the fixed input (capital) causing decline in TP and hence MP becomes negative.
Shapes of TP, AP and MP curves
Shape of TP curve: In phase I of production, TP increases at increasing rate. Therefore, TP curve is convex in
this phase. In phase II, TP increases at decreasing rate. Therefore, TP curve is concave in this phase. In phase III,
TP falls. Therefore, TP curve is downward sloping in this phase. Thus, the TP curve looks like a S-shaped curve.
Shape of MP curve: According to the law of variable proportions, initially MP of a variable factor rises. Then, after
a certain level of employment of the variable factor, MP starts falling. Thus, the MP curve looks like an inverse
U-shaped curve in the input-output plane.
Shape of AP curve: As we increase the units of the variable factor, initially MP rises. So, AP also rises but rises
less than MP. Then, after a point, MP starts falling. However, as long as MP > AP,
AP continues to rise. When MP < AP, AP starts falling. So AP curve is inverse ‘U’-
shaped like MP curve.
Relationship between AP and MP
1. When MP > AP, AP rises.
2. When MP = AP, AP is constant and maximum.
3. When MP < AP, AP falls.
At what point does the MP curve cut AP curve?
When AP rises, MP > AP. Otherwise, AP cannot rise. Similarly, when AP falls,
MP < AP. It follows that MP curve cuts AP curve from above at its maximum point
where MP = AP.
3.2 Cost: Short Run Costs (Meaning and their Relationship)

Meaning of Cost in Economics
Cost in economics refers to the sum of actual money expenditure on inputs and the imputed (i.e., estimated)
expenditure in the form of inputs supplied by the owners including normal profit.
Explicit cost is the actual money expenditure on inputs. For example, expenditure on purchase of raw materials,
payment of wages and salary, interest paid on borrowed funds, rent of premises, depreciation, etc. Explicit cost is
shown in accounts because the owner actually pays for it.
Implicit cost is the imputed (estimated) expenditure in the form of inputs supplied by the owners including normal
profit. For example, imputed salary of the owner, imputed rent of the owner’s building, imputed interest of own
money, etc. Implicit cost is not shown in accounts because the owner actually does not pay for it. But it is a cost.
Short run costs
The cost which does not change with the change in output is called fixed cost, e.g. Rent of premises, salary of
permanent staff, interest paid on borrowed funds, licence fees, etc.
The cost which changes with change in output is called variable cost, e.g. Wages,
expenditure on raw materials, etc.
Total fixed cost (TFC) is the cost that a firm incurs to employ the fixed inputs.
It remains constant at all levels of output (even at zero output). So, TFC curve is a
horizontal straight line.
Total variable cost (TVC) is the cost that a firm incurs to employ the variable inputs.
TVC is zero at zero output. So, TVC curve starts from the origin.

As output increases, TVC increases because in order to increase the production of output, the firm must employ
more of the variable inputs.
As output increases, TVC initially increases at decreasing rate, then at increasing rate due to the Law of Variable
Proportions. Therefore, TVC curve is inverse S-shaped.
Total cost (TC) is the sum of TFC and TVC. As output increases, TC initially increases at decreasing rate, then at
increasing rate due to the Law of Variable Proportions. Therefore, TC curve is inverse S-shaped like TVC curve.
Since TC – TVC = TFC and TFC is constant at all levels of output, therefore the vertical
distance between TC and TVC curves remains the same, i.e. TC and TVC curves remain
parallel to each other.
Average fixed cost (AFC) is the per unit fixed cost of output. AFC = TFC/q. As
output increases, AFC decreases continuously because TFC is constant at all levels of
output. AFC curve is a rectangular hyperbola. If we multiply any level of output with
its corresponding AFC, we always get a constant, namely TFC.
Marginal cost (MC) is defined as the change in total cost per unit change in output.
MC = DTC/Dq or MCq = TCq – TCq–1. Since TFC remains constant when we change the
level of output, whatever change occurs to TC is entirely due to the change in TVC. So, MC is the increase in TVC
due to increase in production of one extra unit of output. (MCq = TVCq – TVCq–1)
Shape of MC curve: According to the law of variable proportions, initially, the marginal product of a factor increases
as employment increases, and then after a certain point, it decreases. This means initially to produce every extra
unit of output, the requirement of the factor becomes less and less, and then after a certain point, it becomes
greater and greater. As a result, with the factor price given, initially the MC falls, and then after a certain point, it
rises. MC curve is, therefore, ‘U’-shaped.
Relationship between TC/TVC and MC
1. When MC falls, TC/TVC rises at decreasing rate.
2. When MC is constant, TC/TVC rises at constant rate.
3. When MC rises, TC/TVC rises at increasing rate.
Average variable cost (AVC) is the per unit variable cost of output. (AVC =
TVC/q). Since TVC is the sum of all marginal costs, therefore AVC is the average
of all marginal costs.
Shape of AVC curve: As output increases, MC falls. AVC being the average of
marginal costs, also falls, but falls less than MC. Then, after a point, MC starts
rising. AVC, however, continues to fall as long as MC < AVC. But when MC > AVC,
AVC starts rising. Thus, AVC curve is ‘U’-shaped.
Relationship between MC and AVC: (i) When MC < AVC, AVC falls. (ii) When MC = AVC, AVC is constant. (iii) When
MC > AVC, AVC rises.
At what point does the MC curve cut the AVC curve?: As long as AVC is falling, MC < AVC. As AVC rises, MC > AVC.
So, the MC curve cuts the AVC curve from below at the minimum point of AVC.
Average cost (AC) or Average Total Cost (ATC) is defined as per unit cost of output. (AC = TC/q)
Since TC = TFC + TVC, therefore, AC = (TFC + TVC)/q = TFC/q + TVC/q = AFC + AVC. Thus, AC is the sum of
AFC and AVC.
Shape of AC curve: Initially, both AVC and AFC decrease as output increases. Therefore, AC initially falls. After a
certain level of output, AVC starts rising, but AFC continuous to fall. Initially the fall in AFC is greater than the rise
in AVC. So, AC is still falling. But, after a point, rise in AVC becomes larger than the fall in AFC. So, AC is rising.
Therefore, AC curve is ‘U’-shaped.
(• AC – AVC = AFC and AFC = TFC/q. Since AFC falls as output increases, the difference between AC and AVC decreases
with increase in output. However, AC and AVC can never be equal because AFC can never be zero since TFC is positive. • The
minimum point of AC curve lies to the right of the minimum point of AVC curve.)
Relationship between MC and AC: Relation between MC and AC
(i) When MC < AC, AC falls. Output TC MC AC
(ii) When MC = AC, AC is constant. 1 60 60 60
(iii) When MC > AC, AC rises. 2 110 50 55
At what point does the MC curve intersect AC curve?
3 162 52 54
As long as AC is falling, MC < AC. When AC is rising, MC > AC. So, MC curve
4 216 54 54
cuts the AC curve from below at the minimum point of AC.
Can AC fall when MC is rising? 5 275 59 55
Yes, AC falls when MC is rising as long as MC < AC.

3.3 Revenue and Producer’s Equilibrium
Revenue
Revenue in economics refers to the market value of output produced or the receipts from sale of output produced.
Total revenue is defined as price of the good multiplied by the output produced. (TR = P × Q)
Average revenue means per unit revenue of output sold. (AR=TR/Q)
Since TR = P × Q, therefore AR =( P ×Q)/Q=P. Thus, Average Revenue is always equal to price under all market
forms. (AR curve is the demand curve under all market forms.)
Marginal revenue is defined as the increase in Total Revenue for a unit increase in output produced.
(MRq = TRq – TRq–1) When change in units sold is more than one, then: MR = DTR/DQ
Relation between MR and AR: (i) When MR < AR, AR falls (ii) When MR = AR, AR is constant (iii) When
MR > AR, AR rises
Shape of Revenue Curves under Perfect Competition
Under perfect competition, a firm can sell more quantity of output at the same price, i.e. price (=AR) is constant.
Therefore, AR curve is a horizontal straight line TR, AR and MR
(parallel to X-axis). (The horizontal straight line is under Perfect Competition
called Price Line, which depicts the demand curve of a
P (= AR) Q TR MR
perfectly competitive firm.)
Since AR is constant, MR = AR. Therefore, MR 10 0 0 –
curve is also the AR curve, i.e. a horizontal line. 10 1 10 10
Shape of TR curve: When output is zero, TR is 10 2 20 10
also zero. So, TR curve passes through origin. TR
increases as output increases. Since price (P) is 10 3 30 10
constant, TR = P × Q increases at a constant 10 4 40 10
rate. Thus, TR curve is upward sloping straight 10 5 50 10
line passing through origin.
Shape of TR, AR and MR Curves under Imperfect Competition
A firm can sell more quantity of output by lowering price, i.e. Price (= AR) falls. From AR – MR relationship, when
AR falls, MR < AR. Since additional units of output are successively sold at lower price, therefore, MR falls and may
become zero or negative.
Relationship between MR and TR
(i) When MR is positive, TR rises. TR curve TR, AR and MR under
Imperfect Competition
is an upward sloping. MR curve is downward
sloping and AR curve (or demand curve) is also P (= AR) Q TR MR
downward sloping. 9 0 0 –
(ii) When MR is zero, TR is constant and 8 1 8 8
maximum. TR curve is a horizontal line (parallel 7 2 14 6
to X-axis). MR curve is downward sloping and AR 6 3 18 4
curve (or demand curve) is also downward sloping. 5 4 20 2
(iii) When MR is negative, TR falls. TR curve is
4 5 20 0
downward sloping. MR curve is downward sloping
(below the X-axis). AR curve (or demand curve) is 3 6 18 –2
also downward sloping but above the X-axis since AR (price) cannot be zero or negative.
Producer’s Equilibrium: Meaning and Conditions under MC = MR approach
Producer’s equilibrium (firm’s equilibrium) is that level of output where its profits are maximised. (Profit = TR – TC).
The two conditions of producer’s equilibrium under MC = MR approach are:
1. MC = MR
2. MC should be rising at equilibrium (i.e. MC > MR after ‘MC = MR’ level of output)
Explanation:
1. When one additional unit of output is produced MR is the benefit in terms of the revenue earned on it and MC
is the cost incurred on it.
• When MC < MR, it is profitable for the firm to produce more units till MC = MR.
• When MC > MR, it is profitable for the firm to produce more or less depending upon the relative changes in MC
and MR till MC = MR.
2. MC = MR is a necessary condition but not a sufficient condition to ensure the firm’s equilibrium. Given
MC = MR, if one more unit is produced, MC < MR. So, it will be profitable for the firm to produce more. Thus,

though MC = MR, the producer is not in equilibrium. However, if after MC = MR output level, if MC > MR,
production of each additional unit is sold at a loss. Then, it will be most advantageous for the firm to produce only
up to MC = MR.
Diagrammatically, the two conditions of producer’s equilibrium become:
(i) MC curve must intersect MR curve (MC = MR).
(ii) MC curve must be rising at the point of equilibrium.
Representation of firm’s equilibrium where more output can be sold at the same price
Q MC MR
1 14 > 10
2 10 = 10
3 7 < 10
4 10 = 10
5 14 > 10
Representation of firm’s equilibrium where more output can be sold by lowering the price
Q MC MR
1 14 > 10
2 10 > 8
3 7 > 6
4 4 = 4
5 6 > 2
3.4 Supply and Price Elasticity of Supply

Supply and Law of Supply
Supply means the quantity of a commodity which a firm (producer) is willing to produce at a given price during a
period of time, assuming that technology and factor prices remains constant.
Market supply refers to the sum total of quantity supplied a commodity by all its producers at a given price during
a period of time, assuming that technology and factor prices remain constant.
Market supply schedule shows the total quantities of a good which all the firms will supply at different prices.
Individual supply schedules when added horizontally give us market supply schedule.
Market supply curve refers to a graphical representation of market supply
Representation of Law of Supply
schedule. It is obtained by taking a horizontal summation of the supply curves
of all the firms in the market. Price (`) Quantity Supplied
If the number of firms producing the commodity increases (decreases), its supply will (units)
increase (decrease). 10 100
Law of supply states that ‘other things remaining the same’, an increase
15 200
in the price of a commodity leads to an increase in its quantity supplied and
vice-versa. In other words, more of a commodity is supplied at higher prices Y
than at lower prices. Thus, there is a direct (or positive) relationship between
Price
price and quantity supplied of a commodity. Therefore, the supply curve of

S
a commodity is upward sloping. Reason: An increase in price leads to higher 20
profit margin of the producer, inducing him to produce more quantity of the
15
commodity. Similarly, when the price of the commodity falls, it leads to reduced
profit margin of the producer, forcing him to produce lesser quantity. 10
Supply schedule is a tabular presentation showing the different quantities of a S
good that a firm is willing to supply at different prices during a given period of time.
Supply curve is a graphical presentation which shows the quantities of a O
100 200 300 X
commodity supplied at various prices during a given period of time. Quantity Supplied

Slope of the supply curve: A linear supply curve can be written as: qs = a + bp, where ‘b’ is the slope of the
supply curve, which measures the rate at which quantity supplied changes due to change in price, i.e., Dq/Dp.
Change in Supply and Change in Quantity Supplied
Change in Supply refers to increase/decrease in supply due to a change in any factor other than the own price
of the good. • Increase in supply means supply increases due to favourable change in factors affecting supply
other than the own price of the good. • Decrease in supply means supply decreases due to unfavourable change
in factors affecting supply other than the own
price of the good. Diagrammatically, change in
supply means shift of supply curve. Increase
(decrease) in supply leads to a rightward
(leftward) shift of the supply curve.
Change in quantity supplied refers
to rise/fall in supply due to change in
own price of the good, other factors like
technology and the prices of factors of
production remaining constant. • Increase
in quantity supplied means expansion of
supply due to rise in own price of the good, other factors remaining constant. • Decrease in quantity
supplied means contraction of supply due to fall in own price of the good, other factors remaining
constant. Diagrammatically, change in quantity supplied means movement along the supply curve.
Expansion (contraction) of supply leads to upward (downward) movement along the same supply curve.
Factors affecting Supply of a commodity
1. Change in own price of the good: • Other factors remaining constant, an increase in the price of a commodity
leads to an increase in quantity supplied (Expansion of Supply). This is because an increase in price leads to higher
profit margin of the producer, inducing him to produce more quantity of the commodity. There will be upward
movement along the same supply curve. • When the price of the commodity falls, it leads to reduced profit margin
of the producer, forcing him to produce lesser quantity. (Contraction of Supply). There will be downward movement
along the same supply curve (towards the origin).
2. Technological progress: Technological progress (improvement in technique of production) raises productivity
and brings down per unit cost of production. So, the profit margin of the producer rises and hence the producer
will be induced to produce more quantity of the commodity at the given price. It is called increase in supply. Supply
curve of the commodity will shift rightwards.
3. Change in prices of factors of production (Change in input prices): • When price of factor input
producing the commodity rises, profit margin of the producer falls, forcing him to produce less quantity of the
commodity at the given price. It is called decrease in supply. Supply curve of Good X will shift leftwards. • When
price of factor input falls, profit margin of the producer rises, inducing him to produce more quantity of the good
at the given price. It is called increase in supply. Supply curve of the good will shift rightwards.
Causes of Increase in supply of a commodity (Causes of rightward shift of supply curve):
(i) Technological progress (ii) Fall in prices of factors of production (fall in input prices) (iii) Increase in number of
firms producing the commodity
Causes of Decrease in supply of a commodity (Causes of leftward shift of supply curve):
(i) When the technique of production becomes obsolete (ii) Rise in prices of factors of production (rise in input
prices) (iii) Decrease in number of firms producing the commodity
Price Elasticity of Supply
Price elasticity of supply is a measure of the degree of responsiveness of supply of a good to change in its price. It
is defined as the percentage change in supply of the good divided by the percentage change in its price.
Price elasticity of supply, eS = percentage change in quantity supplied/percentage change in price
or eS = (Dq/q × 100)/(Dp/p × 100) = Dq/Dp × p/q
Price elasticity of supply will always have a plus sign because of the direct relationship between price and quantity
supplied of a commodity.
• If the percentage change in supply of a good is less than the percentage change in the price, then eS < 1 and
the supply of the good is said to be price-inelastic.
• If the percentage change in supply of a good is greater than the percentage change in the price, then eS > 1 and
the supply of the good is said to be price-elastic.
• If the percentage change in supply of a good is equal to the percentage change in the price, then eS = 1 and the
supply of the good is said to be unitary elastic.
• When the supply of the good does not change with change in its price, it is called perfectly inelastic supply, eS = 0.
Supply curve is vertical (i.e., parallel to Y-axis).
• When the producers of a good are willing to supply any quantity of it at the given market price, it is called
perfectly elastic supply, eS = ∞ (infinity). Supply curve is horizontal (i.e., parallel to X-axis).

1. Let the production function of a firm be q = 5 L1/2 K1/2. Find out the maximum possible output that the firm
can produce with 100 units of L and 9 units of K. (3)
Ans. Substituting L = 100 and K = 9 in the given production function q = 5 L1/2 K1/2 maximum possible output that the firm can
produce, Q = 5(100)1/2 (9)1/2 = 5 × 10 × 3 = 150 units.
2. Complete the following production schedule: (CBSE SQP 2019) (4)
Labour TPP APP MPP Ans. Labour TPP APP MPP

1 10 10 — 1 10 10 10
2 — 11 12 2 22 11 12
3 — — 8 3 30 10 8
4 35 — — 4 35 8.75 5
5 — — –5 5 30 6 –5
3. Identify giving reason the three phases of the Law of Variable Proportions: (6)
Units of Variable Input 1 2 3 4 5

Total Physical Product (Units) 10 22 30 35 30
Ans.
Variable Input TPP MPP Phases hase I: TP increases at increasing rate. MP increases.
P
1 10 10 (Up to 2 units of the variable input)
I phase Phase II: TP increases at decreasing rate. MP falls but
2 22 12
remains positive. (from 3 to 4 units of the variable input)
3 30 8 Phase III: TP falls. MP falls and becomes negative. (at
II phase
4 35 5 5th unit of the variable input)
5 30 –5 III phase
4. When the Average Product (AP) is maximum, the Marginal Product (MP) is: (CBSE 2018) (1)
(a) Equal to AP (b) Less than AP (c) More than AP (d) None of these
Ans. (a) Equal to AP
5. What type of production function is this in which only one input is increased and others kept constant? State
the behaviour of total product in this production function. (3)
Ans. Short run production function or Law of variable proportions
If only one input is increased and other inputs are kept constant, initially total product (TP) increases at increasing rate,
then TP increases at decreasing rate and finally TP falls.
6. State giving reasons whether the following statements are true or false. (4)
(a) Under diminishing returns to a factor, total product continues to increase till marginal product reaches
zero.
(b) When total product is constant, average product will fall.
Ans. (a) True: Under diminishing returns to a factor, MP falls. TP increases till MP is positive and when MP becomes zero, TP is
maximum and constant.
(b) True: AP = TP/L. Since TP is constant and variable input (L) increases, AP will fall. TP is constant and maximum when
MP = 0. Here, AP must be falling.
(a) Under diminishing returns to a factor, marginal product and total product both increase at a diminishing
rate.
(b) Average product falls only when marginal product is less than average product.
Ans. (a) False: Although TP increases at diminishing rate, but MP falls under diminishing returns to a factor.
(b) True: Because AP, like an average, falls if the MP, the marginal value, lower than AP.
(a) When there are diminishing returns to a factor, total product always decreases.
(b) Total product will increase only when marginal product increases.
(c) When marginal product is zero, total product is maximum.
Ans. (a) False: Diminishing returns to a factor means diminishing MP, and so long as MP is positive, TP increases even though
MP is falling.
(b) False: When MP decreases TP will increase so long as MP is positive.

(c) True: Zero marginal product means that change in total product is zero, i.e., total product has stopped increasing and
is maximum.
(a) Under diminishing returns to a factor, total product continues to increase till marginal product reaches
zero.
(b) Increase in total product always indicates that there are increasing returns to a factor.
(c) When there are diminishing returns to a factor marginal and total product both always fall.
Ans. (a) True: Under diminishing returns to a factor, total product (TP) continues to increase till marginal product reaches zero,
though TP increases at decreasing rate.
(b) False: TP also increases when there are diminishing returns to a factor so long as MP is positive.
(c) False: MP falls (i.e., diminishing returns), TP can rise so long as MP is positive.
(a) Average product will increase only when marginal product increases.
(b) Total product always increases whether there is increasing returns or diminishing returns to a factor.
(c) When there are diminishing returns to a factor, total product first increases and then starts falling.
Ans. (a) False: Average product rises as long as marginal product is greater than average product. Here, marginal product could
be rising or falling.
(b) False: When there is diminishing returns to a factor, total product (TP) can decrease when marginal product (MP) of the
variable factor becomes negative.
(c) True: When there are diminishing returns to a factor, TP first increases (though at decreasing rate when MP falls but is
positive) and then TP starts falling when MP becomes negative.
(a) When marginal product falls, average product will also fall.
(b) When average product is maximum, marginal product is greater than average product.
(c) Average product can rise even when marginal product starts declining.
Ans. (a) False: When MP falls, AP may rise so long as MP > AP.
(b) False: When average product is maximum, marginal product will be equal to average product.
(c) True: As long as marginal product is more than average product, average product can rise even when marginal product
starts declining.
12. An individual undertakes retail business in the premises taken on rent. The business is financed by his own
savings. He also manages the business himself. What are the explicit costs and implicit costs in it directly
identifiable ? Give reasons for your answer.
Ans. (i) Rent of business premises is explicit cost because the owner of the firm actually pays it and is shown in accounts.
(ii) Imputed interest on self-finance (own savings or funds) is implicit cost because the owner actually does not pay interest
but it is a cost.
(iii) Imputed salary of the owner is implicit cost because the owner actually does not receive any salary. No such payment is
shown in accounts but it is a cost.
13. Complete the following table: (4)
Q AFC MC TC Ans. Q TFC AFC TVC AVC TC AC MC

1 – – – 1 120 120 24 24 144 144 24
2 – 20 164 2 120 60 44 22 164 82 20
3 40 16 – 3 120 40 60 20 180 60 16
4 – – 198 4 120 30 78 19.5 198 49.5 18
5 24 20 – 5 120 24 98 19.6 218 43.6 20
Q MC AVC AFC AC Ans. Q MC TVC AVC TFC AFC AC TC

1 – – – 140 1 50 50 50 90 90 140 140
2 – 45 45 – 2 40 90 45 90 45 90 180
3 45 – 30 – 3 45 135 45 90 30 75 225
4 – 48 22.5 – 4 57 192 48 90 22.5 70.5 282
5 – 52 18 – 5 68 260 52 90 18 70 350
15. What is the relation between marginal cost and average variable cost when marginal cost is rising and
average variable cost is falling? (CBSE 2016) (1)
Ans. Marginal Cost is less than Average Variable Cost.
16. What is the relation between marginal cost and average cost when average cost is constant? (CBSE 2016) (1)
Ans. Marginal Cost is equal to Average Cost.

17. What is the relation between Average Variable Cost and Average Total Cost, if Total Fixed Cost is zero?
(CBSE 2016) (1)
Ans. Average Variable Cost is equal to Average Total Cost.
18. What happens to the difference between Average Total Cost and Average Variable Cost as output in
increased? (CBSE 2016) (1)
Ans. The difference between Average Total Cost and Average Variable Cost is Average Fixed Cost, which decreases as output is
increased.
19. What happens to the difference between Total Cost and Total Variable Cost as output in increased?
(CBSE 2016) (1)
Ans. The difference between Total Cost and Total Variable Cost is Total Fixed Cost, which remains constant as output increases.
20. Which of the following is a variable cost? (CBSE SQP 2019) (1)
(a) Salary of permanent staff (b) rent of premises
(c) license fees (d) wages
Ans. (d) wages
21. In the short run, with the decrease in output, average fixed cost .................... . (1)
(a) increases (b) remains fixed
(c) decreases (d) increases initially, then decreases
Ans. (a) increases
22. What is the behaviour of TVC when MC falls? (1)
(a) TVC falls (b) TVC rises at decreasing rate
(c) TVC rises at increasing rate (d) TVC rises at a constant rate
Ans. (b) TVC rises at decreasing rate
23. Minimum point of MC curve comes before the minimum point of: (1)
(a) AC curve (b) AVC curve (c) Both (a) and (b) (d) Neither (a) nor (b)
Ans. (c) Both (a) and (b)
24. State the reason why Total Variable Cost (TVC) curve and Total Cost (TC) curve are parallel to each other.
(CBSE SQP 2019) (1)
Ans. Total fixed cost, which remains constant at all levels of output, is the reason behind vertical parallel distance between TVC
curve and TC curve.
25. State the reason behind U-shape nature of Average Variable Cost curve. (CBSE SQP 2019) (1)
Ans. Law of Variable Proportions
26. Why does the difference between ATC and AVC decrease as output increases? (3)
Ans. ATC – AVC = AFC and AFC = TFC/Output. As output increases AFC decreases because TFC remains constant. So, the
difference between AC and AVC decreases with increase in output.
27. Why does minimum point of AC curve fall towards right of minimum point of AVC curve? (3)
Ans. AC is the sum of AFC and AVC. The minimum point of AC curve fall towards right of minimum point of AVC curve because
after a certain level of output AVC starts rising but AC still falls due to decrease in AFC. AC falls because fall in AFC is greater
than the rise in AVC.
(a) With increase in level of output, average fixed cost goes on falling till it reaches zero.
(b) As soon as marginal cost starts rising, average variable cost also starts rising.
Ans. (a) False: With increase in level of output, average fixed cost (AFC) goes on falling but it can never be zero because AFC
= TFC/output and TFC is positive.
(b) False: When marginal cost (MC) starts rising, AVC can continue to fall as long as MC is less than the AVC.
(a) Total cost can never be constant.
(b) Average cost falls only when marginal cost falls.
(c) The difference between average total cost and average variable cost is constant.
Ans. (a) True: Total Cost can be constant only when Marginal Cost is zero, which is not possible.
(b) False: After a certain level of output, MC starts rising but AC continues to fall as long as MC is less than the AC.
(c) False: ATC – AVC = AFC and AFC = TFC/output. Therefore, as output increases AFC falls since TFC is constant at all
levels of output.
(a) The difference between total cost and total variable cost falls with increase in output.
(b) Average variable cost can fall even when marginal cost is rising.
(c) TVC curve is an upward rising straight line curve.
Ans. (a) False: TC – TVC = TFC, which remains constant at all levels of output. TFC does not fall with increase in output.
(b) True: After a certain level of output, MC starts rising but AVC continues to fall as long as MC is less than the AVC.
(c) False: TVC curve is inverse S shaped curve. This is because as output increases TVC first increases at decreasing rate
and then TVC increases at increasing rate.
(a) Total cost rises only when marginal cost rises.
(b) Average cost can rise even when marginal cost is falling.

Ans. (a) False: Total cost can rise (at decreasing rate) even when marginal cost falls.
(b) False: When marginal cost falls, AC will fall.
32. If total variable cost and total fixed cost of producing 10 units are `500 and `200, the value of average cost
would be? (CBSE SQP 2019) (1)
(a) `50 (b) `70 (c) `20 (d) `80
Ans. (b) `70
33. When the total fixed cost of producing 100 units is `30 and the average variable cost `3, total cost is :
(CBSE 2018) (1)
(a) `3 (b) `30 (c) `270 (d) `330
Ans. (d) `330
34. The total cost at 5 units of output is `30. The fixed cost is `5. The average variable cost at 5 units of output
is: (1)
(a) `25 (b) `6 (c) `5 (d) `1
Ans. (c) `5
35. A firm producing 6 units of output has average total cost of `150 and has to pay `240 to its fixed factors of
production. What will be the average variable cost at 6 units of output? (1)
(a) `150 (b) `900 (c) `110 (d) `1440
Ans. (c) `110
36. A firm is producing 20 units. At this level of output, ATC and AVC are respectively equal to `40 and `37. What
will be the total fixed cost of the firm? (1)
(a) `77 (b) `97 (c) `60 (d) `3
Ans. (c) `60
37. Total cost of producing 9 units of output is `85. If average total cost of producing 10 units is `10, then what
will be the marginal cost of producing 10th unit of output? (1)
(a) `15 (b) `75 (c) `95 (d) `10
Ans. (a) `15
Output Price TR MR Ans. Output Price TR MR
4 9 36 – 4 9 36 –
5 – – 4 5 8 40 4
6 – 42 – 6 7 42 2
7 6 – – 7 6 42 0
8 – 40 – 8 5 40 –2
39. On the basis of information given below, determine the level of output at which the producer will be in
equilibrium. Use the marginal cost–marginal revenue approach. Give reasons for your answer. Also, find the
profit at equilibrium. (6)
Q AR TC Ans. Q AR TR TC MR MC
1 7 8 1 7 7 8 7 8
2 7 15 2 7 14 15 7 7
3 7 21 3 7 21 21 7 6
4 7 26 4 7 28 26 7 5
5 7 33 5 7 35 33 7 7
6 7 41 6 7 42 41 7 8
Producer of the good is in equilibrium, i.e., he maximises profits at 5 units of output because at this level of output both
the conditions of equilibrium are satisfied:
(i) MC = MR (ii) MC > MR after ‘MC = MR’ level of output
Profits at equilibrium = TR – TC = 35 – 33 = `2
40. What is the behaviour of average revenue in a market in which a firm can sell more only by lowering the
price? (CBSE 2012) (1)
Ans. Since price falls and average revenue means price, therefore, average revenue (AR) falls.
41. What is the behaviour of Marginal Revenue in a market in which a firm can sell any quantity of the output it
produces at a given price? (CBSE 2012) (1)
Ans. Marginal revenue (MR) remains constant and is equal to the market price.
42. How are the total revenue of a firm, market price, and the quantity sold by the firm related to each other?
(NCERT) (1)
Ans. Total Revenue (TR) = Market Price (P) × Quantity sold (Q).
43. What is the relation between market price and marginal revenue of a price-taking firm?
(NCERT) (1)
Ans. For a price-taking firm, market price is equal to marginal revenue.

44. In an imperfectly competitive market, if TR is maximum, MR will be ......... (CBSE SQP 2018) (1)
Ans. Zero
45. MR curve of a firm which can sell more output at the same price is the same as the ......... . (1)
(a) AR curve (b) Demand curve (c) Price line (d) All of these
Ans. (d) All of these
46. A firm can sell more output at the same price `10. What will be MR by selling 20th unit? (1)
(a) `2 (b) `200 (c) `210 (d) `10
Ans. (d) `10
47. If average revenue curve is a horizontal straight line, then marginal revenue curve will be: (1)
(a) Downward sloping (b) Horizontal line (c) Upward sloping (d) Inverse S-shaped
Ans. (b) Horizontal line
48. When MR remains same, TR increases at: (1)
(a) Constant rate (b) Decreasing rate (c) Increasing rate (d) None of these
Ans. (a) Constant rate
49. When total revenue is constant, what will be the effect on average revenue? (1)
(a) AR will fall (b) AR will increase (c) AR will be constant (d) No effect on AR
Ans. (a) AR will fall
50. If TR curve is a horizontal straight line parallel to X-axis, then MR curve will: (1)
(a) Coincide with X-axis (b) Slope downwards (c) Slope upwards (d) horizontal line
Ans. (b) Slope downwards
51. What changes will take place in MR when TR increases at increasing rate? (1)
Ans. MR rises
52. What would be the shape of demand curve, so that TR curve is: (NCERT) (3)
(i) a positively sloped straight line passing through the origin; (ii) a horizontal line?
Ans. (i) Demand curve or AR curve will be a horizontal straight line parallel to the X-axis because positively sloped straight line
TR curve passing through the origin indicates that price (or AR) remains constant at all levels of output.
(ii) Demand curve or AR curve will be downward sloping because horizontal TR curve indicates that TR is constant. It is
possible when price (or AR) falls as more output is sold.
53. Comment on the shape of the MR curve in case the TR curve is a (NCERT) (4)
(i) positively sloped straight line, (ii) horizontal straight line.
Ans. (i) MR curve will be a horizontal straight line parallel to the X-axis because positively sloped straight line TR curve indicates
that price remains constant as more output is sold. Since price = AR, it means AR is constant. From the AR – MR
relationship, when AR is constant, MR = AR. It means MR is also constant. Therefore, MR curve is a horizontal straight line
parallel to X-axis.
(ii) Horizontal straight line TR curve indicates that TR is constant and maximum. It is possible when MR falls and becomes
zero. Here, MR curve is downward sloping.
(a) Total revenue curve always starts from the origin.
(b) When marginal revenue is zero, average revenue will be constant.
(c) Marginal revenue is always the price at which the last unit of a commodity is sold.
Ans. (a) True: Total revenue (TR) curve starts from the origin since TR is zero at zero output.
(b) False: MR = 0 is possible when TR is constant and as TR is constant, AR will fall as output is increased.
(c) False: MR can be less than price (AR) when a firm can sell more units of a commodity only by lowering the price.
(a) When marginal revenue is constant and not equal to zero, then total revenue will also be constant.
(b) When total revenue is maximum, marginal revenue is also maximum.
(c) When marginal revenue is positive and constant, average and total revenue will both increase at constant
rate.
Ans. (a) False: When marginal revenue (MR) is constant and not equal to zero, then total revenue (TR) will increase at a
constant rate.
(b) False: When total revenue (TR) is maximum, marginal revenue (MR) is zero.
(c) False: When MR is positive and constant, TR will increase at a constant rate but AR will be constant and will be equal to MR.
(a) When total revenue is constant average revenue will also be constant.
(b) At the state of producer’s equilibrium, marginal cost of the firm should be rising.
(c) When marginal revenue falls to zero, average revenue becomes maximum.
Ans. (a) False: When TR is constant, MR = 0 and AR falls.
(b) True: If marginal cost (MC) is falling, then it is possible to increase profits by producing more. So, MC should be rising
at the state of producer’s equilibrium.
(c) False: When MR falls to zero, AR falls.
(a) When MR is falling but positive, TR will also be falling and positive.

(b) Average revenue and marginal revenue curves slope downwards when more output can be sold by
reducing the prices.
(c) Marginal Revenue can never be negative.
Ans. (a) False: When MR is falling but positive, TR must be rising.
(b) True: Since price falls, AR falls (as price = AR). Therefore, AR curve is downward sloping. Since AR falls, MR < AR.
Therefore, MR curve is also downward sloping.
(c) False: When a firm can sell more output only by lowering the price, it is possible that MR becomes negative when TR
falls.
(a) Total Revenue increases with every increase in output.
(b) When total revenue is constant, average revenue falls.
(c) Marginal Revenue can never be zero.
Ans. (a) False: When a firm can sell more output only by lowering the price, after a level of output sold, total revenue falls when
MR becomes negative.
(b) True: AR = TR/Output. When TR is constant (when MR = 0), AR (or price) must fall with rise in output.
(c) False: Marginal Revenue can be zero when total revenue is maximum and constant.
59. If the Total Revenue of a firm increases by `45000 due to an increase in sale of Good X from 50 units to 65
units, then marginal revenue willbe ..........................? (CBSE SQP 2019) (1)
Ans. `3000
60. A firm earns a revenue of `50 when market price is `10. If price increases to `15, the firm now earns a
revenue of `150. What is the price elasticity of the firm’s supply curve? (NCERT) (3)
Ans.
Price (P) TR (P × Q) Supply (Q) Price elasticity of supply,
eS = Dq/Dp × p/q = 5/5 × 10/5 = 2
10 50 5
eS > 1 (Price-elastic supply)
15 150 10
61. At price `10, a firm supplies 4 units of God X. If price rises by `20, what quantity will the firm supply if price
elasticity of supply = 1.25? (NCERT) (3)
Ans.
Price (`) Supply (units) Price elasticity of supply, eS = Dq/Dp × p/q
1.25 = Dq/20 × 10/4
10 4
Dq = 1.25 × 8 = 10
10 + 20 = 30 ? Quantity supplied at price `30 = q + Dq = 4 + 10 = 14 units
62. Market price of a good X changes from `5 to `20. As a result, the quantity supplied by a firm increases by 15
units. If price elasticity of supply is 0.5, find the initial and final output levels of the firm. (NCERT) (3)
Ans. p = 5, Dp = 20 – 5 = 15, Dq = 15. Price elasticity of supply, eS = Dq/Dp × p/q
0.5 = 15/15 × 5/q ⇒ q = 5/0.5 = 10. Thus, initial output level, q = 10 units
Final output level q1 = 10 + 15 = 25 units
10 Marks
Forms of Market and

Unit 4 Price Determination
4.1 Perfect Competition
Market Equilibrium under Perfect Competition
An equilibrium is defined as a situation where the plans of all consumers and firms in the market match and the
market clears. A perfectly competitive market is in equilibrium when market demand equals market supply.
The price at which market demand equals market supply (QD = QS) is called equilibrium price and the quantity
bought and sold at equilibrium price is called equilibrium quantity.
When market price is lower than the equilibrium price: It is a situation of excess demand in the market.

Excess demand refers to a situation when quantity demanded is more than quantity supplied at the prevailing
market price. (ED = QD – QS) There will be competition among the buyers. The market price would tend to rise.
Rise in price leads to contraction of demand and extension of supply. This process will continue till price rises to
the equilibrium price at which market demand equals market supply.
When market price is greater than the equilibrium price: It is a situation of excess supply in the market.
Excess supply refers to a situation when quantity supplied is more than quantity demanded at the prevailing
market price. (ES = QS – QD) There will be competition among the sellers. Some firms will not be able to sell their
desired quantity of output. So, they will lower the price to clear the unsold stock. Fall in price leads to expansion of
demand and contraction of supply. This process will continue till price falls to the equilibrium price at which market
demand equals market supply.
Market Equilibrium under Perfect Competition
Price Market Market Market Situation
per Demand Supply
unit (QD) (QS)
(in `) (in units) (in units)
10 1000 > 200 Excess demand = 800
11 800 > 400 Excess demand = 400
12 600 = 600 Equilibrium
13 400 < 800 Excess supply = 400
14 200 < 1000 Excess supply = 800
Maximum Price Ceiling

(Maximum) Price Ceiling refers to imposition of upper limit on the price of a good
by the government. Price ceiling is generally imposed on essential commodities
needed by masses, like wheat, rice, sugar etc. The main reason for imposing
price ceiling is to protect the interests of the consumers in situations in which
they are not able to afford needed essential commodities.
Price ceiling is imposed below the equilibrium price
Consequences of Price Ceiling
• Since price ceiling is below equilibrium price, there is excess demand/
shortages in the market. So, the government may resort to rationing of the
commodity.
• With shortages, sellers tend to hoard the product (hoarding).
• It could also lead to black marketing, a situation whereby the commodity is illegally sold at a higher price. It may
arise due to the presence of some consumers who may be willing to pay higher price for the commodity.
Price Floor (Minimum Price Ceiling)
Price floor (minimum price ceiling) refers to imposition of a lower limit on the
price of a good by government. The main reason for imposing the price floor
policy is the welfare of the producers/farmers. Examples: (i) The minimum
support price (ii) Minimum Wage Legislation
Price floor is fixed above the market determined equilibrium price. This
creates excess supply/surplus in the market.
This in turn may lead to illegal selling below the minimum price ceiling
as the producers are not able to sell what they desire to sell. In order to
maintain the minimum support price, the government may design some
programmes to enable producers to dispose off their surplus stocks. One
such programme can take the form of buffer stock. Government may purchase the surplus to store or sell it at
subsidised prices in situation when the production of the supported commodity suffers. Government may also use
it as aid and send it to other countries.
Effects of Shifts in Demand
Chain effects of increase in demand
Increase in demand means more quantity demanded of the good at the same price due to change in any factor other
than the own price of the good, for example, increase in the number of its buyers, increase in income of its buyers
(in case of a normal good), etc. Increase in demand creates excess demand at the given equilibrium price. The

excess demand leads to competition between
consumers. It will result in rise in price. This
process will continue till new equilibrium point
is attained with a higher equilibrium price and
a higher equilibrium quantity.
Thus, both equilibrium price and equilibrium
quantity increase.
Chain effects of decrease in demand
Decrease in demand means less demand of
the good at the same price due to change in
any factor other than the own price of the
good. Decrease in demand creates excess supply at the given equilibrium price. The excess supply leads to
competition between producers. It will result in fall in price. This process will continue till new equilibrium point is
attained with a lower price and lower quantity. Thus, both equilibrium price and quantity decrease due to decrease
in demand.
Effects of Shifts in Supply
Chain effects of increase in supply
Increase in supply means more supply of the good at the same price due to change in any factor other than the
own price of the good, for example, increase in number of firms producing the good, technological progress, etc.
Increase in supply creates excess supply at the given equilibrium price. The excess supply leads to competition
between producers. It will result in fall in price.
This process will continue till new equilibrium
point is attained with a lower price but a
higher quantity. Thus, equilibrium price falls
but equilibrium quantity rises.
Chain effects of decrease in supply
Decrease in supply means less supply of the
good at the same price due to change in any
factor other than the own price of the good,
for example, an increase in the price of an
input used in the production of the good. Decrease in supply creates excess demand at the given equilibrium
price. The excess demand leads to competition between consumers. It will result in rise in price. This process will
continue till new equilibrium point is attained with a higher price but lower quantity.
Thus, equilibrium price rises but equilibrium quantity falls.
Effects of increase in both market demand and market supply
(i) If the relative increase in demand is more
than the relative increase in supply, it is a
situation of excess demand. There will be
competition among the buyers. It will result
in rise in price. This process will continue
till new equilibrium point is attained.
Both equilibrium price and equilibrium
quantity will increase in the market.
(ii) If the relative increase in demand is less than the relative increase in supply, it is a situation of excess supply.
There will be competition among the sellers, to clear the unsold stock. It will result in fall in price. This process will
continue till new equilibrium point is attained. Equilibrium price decreases whereas equilibrium quantity increases.
(iii) If the relative increase in demand is equal to the relative increase in supply: Increase in demand creates
excess demand. Increase in supply, on the other hand, creates excess supply. Since the relative increase in
demand is equal to the relative increase in supply, there is neither excess demand nor excess supply in the market.
Equilibrium price remains unchanged. However, equilibrium quantity increases.
Effects of decrease in both market demand and market supply
(i) If the relative decrease in demand is greater than the relative decrease in supply, it is a situation of excess
supply. Both equilibrium price and equilibrium quantity decrease.
(ii) If the relative decrease in demand is less than the relative decrease in supply, it is a situation of excess demand.
Equilibrium price will increase whereas equilibrium quantity will decrease.

(iii) If the relative decrease in demand is equal to the relative decrease in supply, equilibrium price remains
unchanged. However, equilibrium quantity decreases.
Effects of decrease in demand and increase in supply
It is a situation of excess supply in the market. The equilibrium price falls. However, equilibrium quantity may
increase, decrease or remain unchanged.
(i) If the relative decrease in demand is less than the relative increase in supply, equilibrium quantity increases.
(ii) If the relative decrease in demand is greater than the relative increase in supply, equilibrium quantity decreases.
(iii) If the relative decrease in demand is equal to relative increase in supply, equilibrium quantity will remain unchanged.
Effects of increase in demand and decrease in supply
It is a situation of excess demand in the market. The equilibrium price rises. However, equilibrium quantity may
increase, decrease or remain unchanged.
(i) If the relative increase in demand is greater than the relative decrease in supply, the equilibrium quantity increases.
(ii) If the relative increase in demand is less than the relative decrease in supply, the equilibrium quantity decreases.
(iii) If the relative increase in demand is equal to the relative decrease in supply, equilibrium quantity remains unchanged.
Features of perfect competition and their implications
In terms of the unique end result of these features, a perfectly competitive market is one in which an individual
firm cannot influence the prevailing market price of the product on its own.
The following are the main features of Perfect Competition:
1. Large number of buyers and sellers:  The feature ‘large number of buyers’ signifies that the number of
buyers is so large that an individual buyer is not in a position to influence the market price on its own. It is because
the proportion of demand of an individual buyer in the total market demand of the good is insignificant (negligible).
If the single buyer buys more or less, market price is not affected. He is a price-taker.  The feature ‘large number
of sellers (firms)’ signifies that the number of sellers is so large that an individual seller cannot influence the market
price on its own. It is because the individual seller’s share in the total market supply is negligible/insignificant. If an
individual firm supplies more or less, market price is not affected. The seller has no option but to accept the market
determined price. It makes the seller a ‘price-taker’. The firm can sell more quantity of output at the same price.
2. Homogeneous Products: ‘Homogeneous products’ means that the product of each firm is identical. The
implication of this feature is that since the buyers treat the products of all firms as identical they will pay the same
price for the products of all the firms in the industry. On the other hand, an attempt by a firm to sell its product at
a higher price will fail. Thus, ‘homogeneous products’ feature ensures a uniform price for the products of all the
firms in the industry.
3. Perfect knowledge about markets for outputs and inputs:  All the buyers and sellers have full knowledge
about the price, quality etc. about the product, as well as the market. There is no ignorance factor operating in the
market. The implication is hat no firm can charge a price higher than the market price determined by the industry
and no buyer is willing to pay the price higher than the market price. Thus, a uniform price prevails in the market.
 All the firms have perfect knowledge about the inputs market. This implies that each firm has as equal access to
the technology and the inputs used in the technology. Cost structure of all the firms is the same.
Since a uniform price prevails in the market and all the firms have a uniform cost structure, therefore, all the firms
earn uniform profits.
4. Freedom of entry and exit of firms: Freedom of entry and exit of firms under perfect competition means
that there are no cost or barriers a firm faces to enter or exit the market (in the form of patent rights, legal
restrictions, huge capital expenditure, government rules, labour laws etc.). The implication of this is that in the
long run each firm earns only normal profit. (Price = minimum AC)  Suppose in the short run, existing firms are
earning abnormal profits (supernormal profits). New firms enter the industry. So, the industry’s output (market
supply) increases. Market price falls. Firms’ profits reduce. This process continues till profits reduce to normal
levels in the long run.  The opposite occurs if the existing firms are earning losses in the short run. Some firms
will exit (leave) the industry. This reduces industry’s output. Market price rises. Firms’ losses reduce. This process
continues till losses get wiped out and the remaining firms earn only normal profit in the long run.
4.2 Monopoly, Monopolistic Competition and Oligopoly

Monopoly
A market structure in which there is a single seller is called monopoly. Following are the main features of monopoly:
1. Only one seller of a commodity: There is only one single seller (called monopolist) of a particular commodity.
There are no close substitutes for the monopoly firm’s product.
2. Price Discrimination: The monopolist may charge different set of prices of the commodity from different set
of consumers. Monopolist, being the only seller in the market, can exercise this feature by charging different prices
(for the products which are homogeneous or otherwise) from different consumers. For example, the electricity
distribution companies might charge different prices from domestic and commercial electricity users.
3. Barriers to entry: Sufficient restrictions prevent new firms to enter the market. Sources of restricted entry
under monopoly, may be: (i) Government License (ii) Patents, Trademarks and copyrights (iii) Ownership of scarce
resource. Therefore, the monopolist earns abnormal profits in the long run.
4. Monopolist is called a ‘price-maker’: Since the monopolist is the only producer, he can always exercise
significant influence over market price by changing the supply. For example, suppose if the monopolist brings
a smaller quantity of the commodity into the market for sale it will be able to sell at a higher price. It makes
monopolist a price maker.’ However, a monopolist’s decision to sell a larger quantity is possible only at a lower
price. He cannot sell more quantity at a higher price. Therefore, demand curve is downward sloping. Since there
are no close substitutes for the monopoly firm’s product, a change in price does not affect quantity demanded
too much. Consumers have no choice other than buying the product. Thus, the monopoly firm faces a downward
sloping inelastic demand curve.
5. The monopoly firm faces the market demand curve: For the monopolist, the price depends on the
quantity of the commodity sold. For instance, if the monopolist brings a smaller quantity of the commodity into the
market for sale it will be able to sell at a higher price. Thus, the monopoly firm faces the market demand curve.
Monopolistic Competition
Monopolistic competition is a market structure where the number of firms is large, there is freedom of entry and
exit to firms, but the goods produced by them are not homogeneous. Main features of monopolistic competition
are as follows:
1. Large number of firms: There are large number of firms selling similar and closely related, but differentiated
products. For example, there is a large number of biscuit producing firms. Many of the biscuits being produced are
distinguishable from one another by brand names and packaging and are slightly different in taste.
Demand curve of a firm’s product under monopolistic competition is downward sloping because more quantity can
be sold only at a lower price. Also, the demand for a firm’s product is elastic since there are many close substitutes
available for the firm’s product. If the firm raises the price of its product, many consumers will shift to the other
brand(s) with lower price(s).
2. Differentiated products/Product differentiation: Firms produce differentiated products. The significance of
this feature is that the consumers differentiate between the product produced by different firms. The consumers develop
a taste for a particular brand and is, therefore, willing to pay a higher price for it. Thus, an individual firm has influence
over the price of its product to some extent. In other words, there is some element of monopoly enjoyed by a firm.
3. Freedom of entry and exit to firms: Under monopolistic competition, new firms have freedom to enter the
market with their products; and the existing loss-making firms can exit the market. This ensures that a firm earns
just normal profits in the long-run.  If the firms are earning excess profits in the short-run, this will attract new
firms to start producing the commodity. As output of the commodity expands, prices in the market will tend to fall
till profits become normal.  Conversely, if firms are facing losses in the short-run, some firms would stop producing
the commodity and the fall in total quantity produced will lead to a higher price till firms begin to earn normal profits.
Oligopoly
Oligopoly is a market situation in which an industry has only a few firms, which are mutually dependent for taking
decisions about price and output.
Types of Oligopoly
1. Perfect oligopoly: If in an oligopoly market, the firms produce homogeneous products, it is called perfect oligopoly.
2. Imperfect oligopoly: If in an oligopoly market, the firms produce differentiated products, it is called imperfect oligopoly.
3. Collusive, or cooperative oligopoly: If in an oligopoly market, the firms cooperate with each other in determining
price and output, it is called collusive, or cooperative oligopoly.
4. Non-collusive, or non-cooperative oligopoly: If in an oligopoly market, the firms compete with each other in
determining price and output, it is called a non-collusive, or non-cooperative oligopoly.
5. Duopoly: When there are only two firms producing a product, it is called duopoly. It is a special case of oligopoly.
Features of Oligopoly
1. Few firms: ‘Few firms’ means either only a few firms in number or a few big firms producing most of the output
of the industry. The exact number of firms is not defined. The word ‘few’ implies that the number of firms is
manageable enough to make a guess of the likely reactions of rivals by a firm.
2. Barriers to entry: The main reason why the number of firms is few in an oligopoly market is that there are certain
barriers to the entry of new firms in the industry, e.g. (i) Requirement of large capital (ii) Patents and copyrights
(iii) Government Licences (iv) Control over important raw material.

These barriers may prevent a new firm to enter the oligopolistic market. Firms which are able to cross these
barriers are able to enter the industry.
3. Non-price competition: In oligopoly, there are only few firms. If they compete on the basis of price, there is likely to
be price war and the firms may loose. So, the firms adopt measures other than price for competing with each other such
as customer care, after sale services to customers, better advertising, free gifts, etc. This is non-price competition.
4. Firms are mutually interdependent: Under oligopoly as there are only a few big firms competing in the market,
each firm has knowledge as to how its rivals operate. When a firm changes the price and quantity of its product,
it expects reactions from the rival firms. Therefore, each firm in deciding price and output, takes into account the
expected reactions by the rival firms. In this way, the firms are interdependent.
5. Price rigidity: Price rigidity is the tendency of oligopolistic firms to stick to the ongoing price of the product,
with a view to avoid any sort of price war. Price of the product is fixed after deliberations and negotiations by the
oligopolistic firms.
6. Indeterminateness of Demand Curve: In an oligopoly form of market no single firm can predict its prospective
sales with perfection. This is because any given change in the price or output decision by any firm would initiate a
series of actions, reactions and counter actions by the rival firms. Thus, there is no certain nature and position of
demand curve under oligopoly form of market for a firm. Hence, demand curve is indeterminate.

1. Suppose the demand and supply curves of a commodity-X is given by the following two equations
simultaneously: Qd = 200 – p and Qs = 120 + p
(a) Find the equilibrium price and equilibrium quantity.
(b) If market price is `25, what changes will take place in the market? Explain.
(c) If market price is `45, what changes will take place in the market? Explain. (NCERT) (6)
Ans. (a) We know that the equilibrium price and quantity are achieved at: Qd = Qs
200 – p =120 + p ⇒ (–)2p = (–)80 ⇒ p = 40
Therefore, Equilibrium Price p = `40 and Equilibrium Quantity Q = 200 – 40 = 160 units
(b) At price p1 = `25, Qd = 200 – 25 = 175 and Qs = 120 + 25 = 145. Therefore, at p1 = `25, Qd > Qs which means that
there is excess demand at this price. Algebraically, excess demand can be expressed as:
ED = Qd – Qs = 200 – p – (120 + p) = 80 – 2p
The excess demand leads to competition between consumers causing price to rise. Rise in price leads to contraction of
demand and extension of supply. These changes continue till price rises to the original equilibrium level `40, at which
market demand is equal to market supply and the excess demand becomes zero.
(iii) At price p2 = `45, Qd = 200 – 45 = 155 and Qs = 120 + 45 = 165. Therefore, at p2 = `45, Qs > Qd which means that there
is excess supply at this price. A lgebraically, excess supply can be expressed as:
ES = Qs – Qd = 120 + p – (200 – p) = 2p – 80
The excess supply leads to competition between producers causing price to fall. Fall in price leads to expansion of demand
and contraction of supply. These changes continue till price falls to the original equilibrium level `40, at which market
demand is equal to market supply and the excess supply becomes zero.
2. Suppose the market determined rent for apartments is too high for
common people to afford. If the government comes forward to help
those seeking apartments on rent by imposing control on rent, what
impact will it have on the market for apartments? Use diagram. (6)
Ans. Rent control refers to imposition of upper limit on rent of apartments. The reason being
the market determined rent for apartments is too high for common people to afford.
Ceiling on rent is fixed below the market determined equilibrium rent for apartments.
For example, suppose market determined rent is `5000 per month. The
government finding it too high fixes the maximum rent at `3000 per month.
Since government imposed ceiling on rent is lower than the market determined
rent, it will create excess demand for apartments. There will be shortages
of apartments (= AB = n1n2) and many people will not be able to get
apartments on rent at `3000 per month. It could also lead to illegal hiring of
apartments on a rent greater than `3000 per month, as fixed by government.
3. Suppose the equilibrium market wage rate is `14000 per month. The Minimum
government finding it low fixes minimum wage rate at `18000 per Wage Rate
month. Examine the implications of this decision. Use diagram. (6)
Ans. Through the minimum wage legislation, the government ensures that the wage
rate of the labour does not fall below a particular level. The minimum wage rate is
fixed above the equilibrium wage rate. Payment of wage rate (`18000) higher than
equilibrium wage rate (`14000) leads to excess supply of labour/surplus labour in
the labour market as shown in the diagram, equal to AB (= L1L2). Since supply of
labour is greater than demand for labour, it may lead to unemployment equal to L1L2.

4. Suppose the value of demand and supply curves of a Commodity-X is given by the following two equations
simultaneously: Qd = 200 – 10p and Qs = 50 + 15p
(a) Find the equilibrium price and equilibrium quantity of commodity X.
(b) Suppose that the price of a factor inputs used in producing the commodity has changed, resulting in the
new supply curve given by the equation: Qs’ = 100 + 15p
Analyse the new equilibrium price and new equilibrium quantity as against the original equilibrium price
and equilibrium quantity. (NCERT) (6)
Ans. (a) We know that the equilibrium price and quantity are achieved at: Qd = Qs
200 – 10p = 50 + 15p ⇒ 150 = 25p ⇒ p = 6
Therefore, equilibrium price p = `6 and equilibrium quantity Q = 200 – (10) (6) = 140 units.
(b) If the price of factor of production has changed, then under the new conditions: Qd = Qs’
200 – 10p = 100 + 15p ⇒ 25p = 100 ⇒ p = 4
Therefore, Equilibrium Price p = `4 and equilibrium Quantity Q = 200 – (10) (4) = 160 units.
Thus, the equilibrium price is decreasing and the equilibrium quantity is increasing.
5. Suppose the demand curve of commodity X in a perfectly competitive market is given by: QD = 700 – p
There is free entry and exit of the firms producing commodity X. Assume the market consists of identical
firms producing commodity X. Let the supply curve of single firm be explained as:
Qsf = 8 + 3p for p > 20 = 0 for 0 < p < 20
(a) What is the significance of p = `20?
(b) At what price will the market for X be in equilibrium? State the reason for your answer.
(c) Calculate the equilibrium quantity and number of firms. (NCERT) (6)
Ans. (a) In the long run, the firms will never produce below price p = `20, i.e., minimum AC because otherwise they will incur
loss from production and will exit the market.
(b) With free entry and exit of the firms, equilibrium price = minimum AC = `20.
(c) At this price p = `20, market will supply that quantity which is equal to the market demand, which is equal to 700 – 20
= 680 units. At p = `20, each firm supplies qsf = 8 + 3(20) = 68 units. Therefore, number of firms = 680/68 = 10
6. Market for good X is in equilibrium. Suppose price of its substitute good Y falls. What will be the effect on
its equilibrium price? (1)
Ans. Equilibrium price will fall.
7. What happens to equilibrium price if demand curve shifts rightwards and supply curve shifts leftwards? (1)
Ans. Equilibrium price increases.
8. What happens to equilibrium price if there is decrease in demand and increase in supply? (1)
Ans. Equilibrium price decreases.
9. An increase in income results in a higher equilibrium price and quantity when the good is ............... . (1)
(a) a normal good (b) an inferior good (c) a necessity (d) All of these
Ans. (a)
10. Equilibrium price of an essential medicine is too high. Explain what possible step can be taken to bring
down the equilibrium price but only through the market forces. Also explain the series of changes that will
occur in the market. (CBSE 2013) (4)
Ans. To bring down the equilibrium price, supply of the medicine must increase. So, the government should reduce tax on
medicine. Due to reduction in tax rates on medicine, cost of production falls. Fall in cost leads to rise in profits which
induces the producers to increase the supply. As a result, market supply i.e. industry’s output will increase.
There will be excess supply in the market at the given equilibrium price. Competition emerges between the producers
leading to fall in price of medicine. Poor consumers may now afford it. Thus, their welfare increases.
11. Cigarette smoking is injurious to health. How can the government reduce its consumption but only through
the normal market forces. Explain the chain of effects of government’s action. (4)
Ans. Cigarette smoking is injurious to health. The government can reduce its consumption by taking steps to decrease the
supply of cigarettes. This may be possible when the government imposes heavy taxation on cigarettes.
Decrease in supply will create excess demand in the market at the equilibrium price. Competition emerges between
consumers leading to rise in price. This may discourage cigarette smoking, thus increasing welfare of people.
12. The following headline appeared in the Hindustan Times on 2nd August, 2018: “Crop damaged in Himachal
sent tomato prices roaring in Delhi.” Use a diagram and economic theory to analyse the statement.
(CBSE SQP 2015) (6)
Ans. When the tomato crop was damaged in Himachal the supply of tomatoes decreases. This Y
S
Price per Kg
D 1
means that the supply curve shifts leftward from SS to S1S1. S

At the prevailing market price (OP), there was an excess demand. In this situation, buyers
would have competed to raise the market price. This process would have continued till
E 1
P 1
a new equilibrium price was reached at OP1, where market demand is equal to market P E
supply. OP1 is higher than the old price of tomatoes.

This explains how prices in Delhi rose when the tomato crop got damaged in Himachal. S 1
13. On 20 August 2018, the following news item was printed in the Economic S
D
Times: “Households in Southern India prefer to eat oranges for breakfast as O

banana plantations in Kerala have been destroyed and price of apples and Q Q
Quantity demanded
1 X
grapes have also risen.” and supplied of tomatoes

Use a diagram and economic theory to analyse the impact of the rise in price of apples and grapes on the
market of oranges. (CBSE SQP 2015) (6)
Ans. When the price of apples and grapes rises, consumers will substitute with these fruits Y
with the relatively cheaper oranges. Thus, demand for oranges will increase and the D
Price per unit

1
S
demand curve shifts rightwards from DD to D1D1. D
At the prevailing market price (OP), there was an excess demand. In this situation, buyers E
would react by competing with each other and raise the market price. This process will
1
P 1
E
continue till a new equilibrium price is reached at OP1, where market demand is equal to P
market supply. OP1 is higher than the old price of oranges.

Therefore, the equilibrium price of oranges increases and the equilibrium quantity also 1 D
D
increases when the price of apples and grapes rises in Southern India. S
14. State giving reason whether the following statements are true or false: (4) O Q Q
(a) When equilibrium price of a good is less than its market price, there will 1
Quantity demanded
X
be competition among the sellers. and supplied of oranges
(b) Price floor causes excess demand in the market.

Ans. (a) True: When equilibrium price of a good is less than its market price, market supply will be greater than market demand
at the market price. It is a situation of excess supply. Excess supply will lead to competition among the sellers because they
are not in a position to sell all what they want to sell at the given market price.
(b) False: When the government imposes a floor higher than the equilibrium price of the good, the market supply is
greater than the market demand at that price, thereby leading to an excess supply or surplus in the market.
15. Following is the market demand and supply schedule of a good.
Price (`) Market Demand (units) Market Supply (`) Ans. T

he market is in equilibrium when price is
`6 per unit because at this price market
10 100 400
demand equals market supply. Therefore,
8 200 300 equilibrium price is `6 per unit and
6 250 250 equilibrium quantity is 250 units.
4 300 200
Identify the equilibrium price and quantity. Give reason. (1)
16. ‘Homogeneous Products’ is a characteristic of: (1)
(a) Perfect Competition only (b) Perfect Oligopoly only
(c) Both (a) and (b) (d) None of the above
17. There is an inverse relation between price and demand for the product of a firm under: (1)
(a) Monopoly only (b) Monopolistic Competition only
(c) Both under Monopoly and Monopolistic Competition (d) Perfect Competition only
Ans. (c) Both under Monopoly and Monopolistic Competition
18. Differentiated Product is a characteristic of: (1)
(a) Monopolistic Competition only (b) Oligopoly only
(c) Both Monopolistic Competition and Oligopoly (d) Monopoly
Ans. (c) Both Monopolistic Competition and Oligopoly

40 Marks
Section-B
Macroeconomics
Unit Name of the Unit Marks
5. National Income and Related Aggregates 10
6. Money and Banking 6
7. Determination of Income and Employment 12
8. Government Budget and the Economy 6
9. Balance of Payments 6
Total 40
CBSE Syllabus Unit 7: Determination of Income and Employment

• Aggregate demand and its components
Unit 5: National Income and Related Aggregates • Propensity to consume and propensity to save (average
• Some basic concepts: consumption goods, capital goods, and marginal)
final goods, intermediate goods; stocks and flows; gross • Short-run equilibrium output
investment and depreciation • Investment multiplier and its mechanism
• Circular flow of income (two sector model) • Meaning of full employment and involuntary unemployment
• Methods of calculating national income–Value Added or • Problems of excess demand and deficient demand;
Product method, Expenditure method and Income method measures to correct them– change in government
• Aggregates related to national income: Gross National spending, taxes and money supply
Product (GNP), Net National Product (NNP), Gross and Net
Domestic Product (GDP and NDP)–at market price, at factor Unit 8: Government Budget and the Economy
cost • Government budget–meaning, objectives and components
• Real and Nominal GDP; GDP and welfare • Classification of receipts – revenue receipts and capital
receipts
Unit 6: Money and Banking • Classification of expenditure – revenue expenditure and
• Money – meaning and supply of money – Currency capital expenditure
held by the public and net demand deposits held by • Measures of government deficit – revenue deficit, fiscal
commercial banks deficit and primary deficit: their meaning
• Money creation by the commercial banking system
Unit 9: Balance of Payments
• Central bank and its functions (example of the Reserve
• Balance of payments account– meaning and components;
Bank of India) : Bank of issue, Govt. Bank, Banker’s Bank,
balance of payments deficit–meaning
Controller of Credit through Bank Rate, CRR, SLR, Repo
Rate and Reverse Repo Rate, Open Market Operations, • Foreign exchange rate– meaning of fixed and flexible
Margin requirement. rates and managed floating
• Determination of exchange rate in a free market

10 Marks
National Income and

Unit 5 Related Aggregates
5.1 Some Basic Concepts of National Income Accounting
Final Goods and Intermediate Goods
Goods are classified as final goods and intermediate goods on the basis of the end use.
• If goods are purchased for final consumption, i.e., for satisfaction of wants, or final investment, these are called
final goods, for example, (i) Machine purchased by a firm for installation in factory, (ii) Milk or bread purchased
by households, (iii) Printer purchased by a lawyer for office use, etc.
Goods and services purchased by a production unit from other production units with the purpose of reselling or
with the purpose of using them completely during the same year are called intermediate goods (or single use
producer goods), for example, (i) Raw materials such as steel sheets used for making automobiles and copper used
for making utensils, (ii) Mobile sets purchased by a mobile dealer, (iii) Chalks, dusters, etc. purchased by a school,
(iv) Paper purchased by a publisher, (v) Purchase of rice by a grocery shop, (vi) Fertilisers used by the farmers, etc.
Problem of Double Counting
Problem of double counting arises when the value of certain goods and services are counted more than once while
estimating National Income. This happens when the value of intermediate goods is counted in the estimation of
National Income along with the value of final goods and services. Including intermediate goods separately will lead
to overestimation of national income.
There are two methods to avoid the problem of double counting: (i) To consider only the final value of output
produced. (ii) To consider only the value added of the output produced. (Value added = Value of output – Cost of
intermediate goods used)
Final Expenditure and Intermediate Expenditure
Final expenditure refers to the expenditure on goods and services meant for final consumption and investment,
for example, (i) Expenditure on purchase of car/furniture/sewing machine/refrigerator by a household is a final
expenditure on consumption. (ii) Expenditure on purchase of a car/furniture/machine/refrigerator for use by a
firm is a final investment expenditure. Final expenditures on consumption and investment are included in national income.
Intermediate expenditure refers to the expenditure incurred by a production unit on purchasing those goods
and services from other production units, which are meant for resale or for using up completely during the same
year, for example, (i) Payment of electricity bill by a school, (ii) Payment of fees to a Chartered Accountant/a
Mechanic by a firm, (iii) Purchase of uniforms for nurses by a hospital, (iv) Expenditure on engine oil by a car
service station, etc. Intermediate expenditures are not included in national income.
Consumption Goods and Capital Goods
• The final goods which are consumed (or used) for satisfaction of wants by the consumers are called consumption
goods (or consumer goods), e.g., food, clothing, TV sets, refrigerators, etc. (Those consumer goods like television sets,
automobiles, home computers, etc. which are of durable character are called consumer durables. Those consumer goods like
food, clothing, etc. which are extinguished by immediate or short period consumption are known as consumer non-durable goods,
e.g. food, clothing, etc.) • The final goods of durable character which are used in the production of other goods and
services are called capital goods (or investment goods or durable use producer goods) e.g., machines and equipments.
Stocks and Flows
Stocks are economic variables measured at a given point of time, e.g. Capital, Wealth, Money supply, Inventories,
Buildings and machines in a factory, Balance in a bank account, etc. Flows are economic variables measured over
a period of time, e.g, National income or GDP or Production or Output, Sales, Savings, Expenditure, Profits, Losses,
Exports, Imports, Net capital formation or Net Investment, Depreciation, Interest, Change in inventories, Change
in money supply, Value added, etc.

Gross Investment and Depreciation
• Addition to capital stock of an economy is called gross investment. A part of the capital goods produced goes
for maintenance or replacement of existing capital goods. • New addition to capital stock in an economy is called
net investment (or net capital formation). (Net Investment = Gross investment – Depreciation)
Depreciation is an annual allowance for normal wear and tear and foreseen obsolescence of a fixed capital asset.
Depreciation is also defined as Value of consumption of fixed capital/Annual maintenance and replacement cost of
fixed capital assets/Cost of the fixed capital good divided by number of years of its useful life.
(Unexpected/unforeseen obsolescence or sudden destruction of capital assets is called capital loss.)
Concepts of Domestic Territory and Resident—their Implications
Domestic territory (or Economic territory) is the geographical territory administered by a government within
which persons, goods and capital circulate freely. For example, (i) Branch of an American Bank in India, (ii)
Embassies located abroad, e.g. Indian embassy in America, etc. are included in the domestic territory of India.
Resident is a person or an institution whose centre of economic interest lies in the domestic territory of the
country in which he lives, for example, Indian officials working in the Indian Embassy in USA, etc. are normal
residents of India.
Implications: Domestic product includes production activity of the production units located in the economic
territory irrespective of whether carried out by the residents or non-residents, for example, (i) Profits earned by
a foreign company or a foreign bank in India (ii) Salaries paid to Koreans working in Indian embassy in Korea
(iii) Compensation of employees to the residents of Japan working in Indian embassy in Japan are included in
domestic product as it is a factor income earned in domestic territory of the country. National product includes
production activities of residents irrespective of whether performed within the economic territory or outside it, for
example, (i) Salaries received by Indian residents working in Russian Embassy in India (ii) Dividend received by an
Indian from his investment in shares of a foreign company are included in national product as it is a factor income
earned by Indian residents from abroad.
Net factor Income from Abroad (NFIA)
Net factor income from abroad (NFIA) = Factor income from abroad (residents’ contribution to production outside the
economic territory) – Factor income to abroad (non-residents’ contribution to production inside the economic territory)
National product = Domestic Product + Factor income from abroad – Factor income to abroad
• Factor income received from abroad is added to domestic product because this contribution of residents is in
addition to their contribution to domestic product. • Factor income paid to abroad is subtracted because this part
of domestic product does not belong to the residents.
NFIA is negative when factor income from abroad is less than factor income paid to abroad (Net factor income paid to abroad).
Circular flow of income in a two sector economy
Households are owners of factors of production. They provide factor
services (in the form of labour, capital, land and entrepreneurship) to the firms
(producing units). Firms provide factor payments (in the form of wages and
salaries, interest, rent and profit). So, factor payments flow from firms to
households.
Households spend the entire factor income to purchase goods and services
from firms for which they make payment to them. So, consumption
expenditure (i.e., spending on goods and services) flows from households
to the firms. Thus, Aggregate factor payments = Aggregate final
consumption expenditure.
(Nominal Flow/Money Flow is the flow of factor payments and payments for goods and services between households and firms.
Real Flow is the flow of factor services and the flow of goods and services between households and firms.)
5.2 Estimation of National Income

Production Method (or Value Added Method)
Steps for calculation of national income by product method
Step 1: Estimation of value of output produced by each firm in all the sectors of the economy during the year.
Value of output = Output produced (in units) × Market price
(a) If a firm had no initial unsold stock in the beginning of the year: Value of output = Sales + Value of unsold stock
• Sales = Output sold (in units) × Market price • Sales = Sale of goods and services to domestic buyers + Exports
(b) It a firm had some unsold stock in the beginning of the year: Value of output = Sales + Net change in inventories
Or, Value of output = Sales + Closing stock – Opening stock

Step 2: Calculation of Value Added (VA) and Gross Domestic Product at market price (GDPmp)
Value added of a firm is the net contribution made by the firm in the production process.
Value added = Value of output – Intermediate consumption
Example: Suppose that there are only two producers in the economy – farmer and baker. Farmer grows wheat
worth `100 with no intermediate costs. He sells `50 worth of wheat to the baker, who produces `200 worth of
bread. Value added by farmer (GVAmp) = Value of wheat produced – Intermediate costs = 100 – 0 = `100.
Value added by baker (GVAmp) = Value of bread produced – Cost of wheat used = 200 – 50 = `150.
• Intermediate consumption = Purchase of raw materials etc. + Imports of raw materials etc.
Sum of GVAmp of all firms in the economy is GDPmp, i.e. market value of all final goods and services produced in
the economy. Why GDPmp is called ‘Gross’ and ‘at market price’? GDPmp is what buyers pay, not what production
units actually receive. Out of GDPmp production units have to make provision for depreciation and payment of
indirect taxes and receive subsidy from government. Thus, GDPmp is called ‘gross’, because no provision has
been made for depreciation. GDPmp is called ‘at market price’ because it includes net indirect taxes (indirect taxes
– subsidies). What production units actually receive is not the ‘market-price’ but “market price – indirect taxes +
subsidies = Factor payments (or factor costs)”.
Step 3: Calculation of Net Domestic Product at factor costs (NDPfc)
NDPfc (domestic factor income) = GDPmp – Depreciation – Indirect taxes + Subsidies
NDPfc is what production units actually receive and hence, distributed as wages and salaries, interest, rent and profits.
Step 4: Calculation of National Income (NNPfc): National income (NNPfc) = NDPfc + NFIA
Gross Domestic Product (GDP) – Depreciation = Net Domestic Product (NDP)

Gross Domestic Product at market price (GDPmp) – Net Indirect Taxes = Gross Domestic Product at factor cost (GDPfc)
Net Domestic Product at factor cost (NDPfc) + NFIA = Net National Product at factor cost (NNPfc), i.e. National Income
Net product taxes (product taxes – product subsidies): Product taxes and subsidies are paid or received per unit of product,
e.g., excise tax, service tax, export and import duties etc. Net production taxes (production taxes – production subsidies):
Production taxes and subsidies are paid or received in relation to production and are independent of the volume of production
such as land revenues, stamp and registration fee.
• Market prices – Net Product taxes = Basic prices • Basic prices – Net Production taxes = Factor cost
Precautions in calculating national income by production method (or value added method)
1. Avoid double counting. Value of intermediate goods is not included in the estimation of value added because
value of intermediate goods is reflected in the value of final goods. So, avoid double counting of goods and services
as these tend to inflate national income estimates.
2. Do not include sale of second hand goods. Value of second hand goods being sold should not be included in national
income as their value was accounted for at the time of first production. However, any brokerage or commission paid
to sell the second hand goods is a fresh production activity, so brokerage or commission is included.
3. The imputed value of production for self consumption should be included since output has been produced during
the year, e.g., a farmer consuming a part of his own produce.
4. The imputed value of owner occupied dwellings should be included in national income as these provide housing services.
Income Distribution Method
Steps for calculating national income by income method
Step 1: Estimate the factor payments by each firm in the economy. The sum of factor payments equals Net Value
Added at Factor Cost (NVAfc) of a firm.
Step 2: Take the sum total of NVAfc by all firms to arrive at NDPfc.
NDPfc = Compensation of employees + Operating surplus + Mixed income
1. Compensation of employees: It includes (a) Wages and salaries in cash and in kind, e.g. bonus, free medical
facilities, free meals, house rent allowance, etc. (b) Social security contributions by the employers, e.g., provident
fund or insurance premium paid by employers.
2. Operating surplus: Operating surplus is defined as the sum of rent, royalty, interest and profits. (Profit = Corporation
tax + Dividend + Retained earnings)
3. Mixed income of self-employed: The income of self employed people like doctors etc. has two or more factor
incomes; total income is estimable, but not its different components. So, mixed income is another factor payment.
Step 3: National income (NNPfc) = NDPfc + NFIA
Thus, components of National income (NI) are Compensation of employees, Operating surplus, Mixed income of
self employed and NFIA.
Precautions in making estimates of national income by income method
1. Avoid transfers. National income includes only factor payments, i.e. payment for the services rendered to the
production units by the owners of factors of production. Any payment for which no service is rendered is called a
transfer, e.g. gifts, donations, charity, etc. Since transfers are not a production activity it must not be included in NI.
2. Avoid capital gain. Capital gain refers to the income from the sale of second hand goods and financial assets. So,
income from sale of old cars, old house, etc. is not included since these are not production transactions. Similarly,
income from sale of financial assets, e.g., shares, bonds, debentures, etc. are not included since financial assets
are neither goods nor services, hence not a production activity.
3. Include income from self-consumed output, e.g. when a house owner lives in that house, he does not pay any
rent. But imputed rent should be included in national income since the house provides housing services.
4. Include imputed value of free services provided by the owners of the production units, e.g. imputed salary of
owners, imputed interest on own capital, imputed rent of own building, etc.
Expenditure Method
Steps for calculating national income by expenditure method
Step 1: We take the sum of final expenditures on consumption and investment in the economy. This equals
GDPmp. Its components are:
1. Private final consumption expenditure, e.g. purchase of a car by a household, expenditure on education of
children by a family, etc.
2. Government final consumption expenditure, e.g. free services provided on education, heath, police service,
defense services, etc. and provision of public goods such as roads, parks, street lighting, sanitation, etc.
3. Gross domestic capital formation (= Net domestic fixed capital formation + Closing Stock – Opening Stock + Depreciation)
Alternately, Gross investment = Fixed business investment (Addition to the machinery, factory buildings, and equipments)
+ Residential investment (Addition of housing facilities) + Change in stocks (Addition to the stock of capital)
4. Net exports (= Exports – Imports). Exports, though purchased by non-residents, are produced within domestic
territory, hence included in GDPmp. Imports are deducted because imports are not produced within the domestic
territory of the country.
GDPmp = Private final consumption expenditure + Government final consumption expenditure + Gross domestic capital
formation + Net exports (or – Net imports)
Step 2: NDPfc = GDPmp – Depreciation – Net indirect taxes
Step 3: National income (NNPfc) = NDPfc + NFIA
Precautions in making estimates of national income by expenditure method
1. Avoid intermediate expenditure. Only final expenditures, i.e. expenditure on consumption and investment are
included in national income. Intermediate expenditure like that on raw materials, etc. in not included.
2. Do not include expenditure on second hand goods and financial assets because buying second hand goods is
not a fresh production activity and financial assets are neither goods nor services.
3. Avoid transfer expenditures. A transfer payment is a payment against which no services are rendered, e.g. charities,
donations, gifts, scholarships, etc. Since no production takes place, therefore, not included in national income.
4. Imputed rent of self occupied houses is included in the national income because self-occupied houses provide
housing services similar to those as rented houses.
5.3 Real and Nominal GDP; GDP and Welfare

Nominal and Real GDP
• When Gross Domestic Product (GDP) of the current year is estimated on the basis of current year’s prices, it is
called Nominal GDP. Nominal GDP may increase even if there is no increase in the flow of goods and services
in the economy, due to rise in prices during the current year. • When GDP of the current year is estimated on the
basis of base year prices, it is called Real GDP. Real GDP will only increase when there is an increase in the flow
of goods and services in the economy. Thus, Real GDP is an indicator of economic welfare.
Example: Suppose an imaginary country produces bread only. In 2017, it had produced 100 units of bread, price
was `10. Therefore, Nominal GDP = 100 units × `10 = `1000. In 2018, it produced 110 units of bread at price `15.
Therefore, nominal GDP in 2018 = 110 units × `15 = `1650 and Real GDP =110 units × `10 = `1100.
The ratio of nominal GDP to real GDP of current year is a well known price index, called GDP Deflator. It gives
the change in price level between the base year and current year. GDP Deflator (in %) = Nominal GDP/Real GDP
× 100 = 1650/1100 × 100 = 150%. That is, price level has risen by 50% between the base year and current year.
Nominal and Real Income
• When national product of the current year is estimated on the basis of prices prevailing in the current year, it
is called nominal national income (or national income at current prices) whereas when national product of the
current year is estimated on the basis of prices prevailing in the base year, it is called real national income (or
national income at constant prices).

• Nominal national income may increase due to increase in prices of goods and services during the current year
without increase in the flow of goods and services in the economy. Real national income reflects the real growth
of an economy because it increases only when there is an increase in real national output over a period of time.
Given Nominal Income, we can find Real Income by eliminating the effect of change in prices between the base
year and the current year in the following way:
Real Income = (Nominal Income/Price Index of Current Year) × Price Index of Base Year
If the price index of the base year is taken as 100, then: Real Income = (Nominal Income/Price Index) × 100
Is GDP a perfect index of economic welfare?
No, GDP cannot always be taken as a perfect index of economic welfare. Following are some of the limitations of
using GDP as an index of welfare of a country:
1. Distribution of GDP: If the GDP of the country is rising, the welfare of people may not increase if there is
inequalities in the distribution of GDP. Increase in inequalities means that rich become richer and poor become poorer.
Since utility of money is higher among poor and lower among the rich, therefore, if the distribution of GDP is not
uniform, inequalities may not lead to increase in welfare of people.
2. Non-monetary exchanges (or non-monetary production): Non-monetary exchanges are those activities in
an economy which cannot be evaluated in terms of money due to non-availability of data. For example, domestic
services of a housewife/family members, barter exchanges, etc. But these activities do contribute to welfare of the
people. Since GDP does not account for such activities, it is major cause of underestimation of GDP in the economy.
As result, welfare of the people is also underestimated.
3. Externalities: Externalities refer to the harms (or benefits) a firm or an individual causes to another for which
they are not penalised (or not paid).
Negative externalities: (i) Air pollution caused by vehicles and smoke out of chimneys of factories (ii) Traffic jams.
Such externalities may cause harm to the people. Hence, their welfare will fall. However, GDP does not account for
such negative externalities. Thus, GDP overestimates the actual welfare.
Positive externalities: (i) Introduction of metro rail has saved the time and money of general public and has
provided safe means of transport. (ii) Saving of commuting time due to construction of a fly-over.
Positive externalities increase welfare of people or general public. However, GDP does not account for such positive
externalities. Thus, GDP as an index underestimates welfare.
Giving reason state how the following are treated in estimation of national income:
1. Payment of indirect taxes by a firm
Ans. No, it is not included in national income because an indirect tax paid to the government is a transfer payment as no good
or service is provided in return.
2. Payment of corporate tax by a firm
Ans. No, it is not included as it is a transfer payment. Corporate tax accrues to the government. It is not received by the owners
of factors of production. Hence, it is not a factor income.
3. Payment of interest on a loan taken by an employee from the employer/Payment of interest by an individual
to a bank on a loan to buy a car/Interest received on loans given to a friend for purchasing a car.
Ans. No, it is not included in national income because the individual is a consumer, and the loan is taken to meet consumption
expenditure. There is no contribution to production of goods and services. Therefore, it is not a factor payment.
4. Payment of interest by banks to its depositors/Payment of interest by a firm to households.
Ans. Yes, it is included in national income because it is a factor income paid by a production unit (bank or firm). Banks borrow
for carrying out banking services/The firms borrow money for carrying out production.
5. Payment of interest by a firm (government firm or a private firm) to a bank
Ans. Yes, it is included in national income because it is a factor payment by the firm. The firm borrows money for carrying out
production of goods and services.
6. Interest received on loan given to a foreign company in India.
Ans. Yes, it will be included in the national income as it is a part of factor income from abroad.
7. Interest received on debentures.
Ans. Yes, it will be included in the national income because interest received on debentures is a factor income because debenture
is a sort of loan taken by a production unit, which uses the money in producing goods and services.
8. Money received by a family in India from relatives working abroad, i.e., remittances from abroad/Scholarship
given to Indian students studying in India by a foreign company/Free meals to beggars/Financial help
received by flood victims/Expenditure on old age pensions by government/Gift received from employer, e.g.
festival gift, gifts on independence day, etc.
Ans. No, it will not be included in the national income as it is a transfer income or transfer payment, which is received or paid
without any contribution to production of goods and services. It is not a factor income.
9. Free medical facilities or free meals or house rent allowance or leave travel allowance paid by the employer/
Rent-free house given to an employee by an employer/Expenditure on medical treatment of employee’s
family/Payment of bonus by a firm to its employees/ Contribution to provident fund by employer
Ans. Yes, it will be included in the national income as it is a part of the compensation of employees.
10. Contribution to provident fund or insurance premium paid by employees
Ans. No, it is not included in national income because it is paid out of compensation of employees, which is already included.
11. Compensation given by insurance company to an injured worker.
Ans. No, as compensation is given by insurance company to the employee and not by employer.
12. Prize won in a lottery.
Ans. No, because it is a windfall gain, not a factor income.
13. Receipts from sale of land.
Ans. No, it will not be included as land is a free gift of nature and cannot be produced.
14. Dividend received by shareholders.
Ans. Yes, it will be included in the national income as it is a part of the profits of production units, which is distributed to the
owners. Hence, it is a factor income.
15. Rent received by Indian residents on their buildings rented out to foreigners in India.
Ans. Yes, it will be included in the national income as it is a part of the factor income from abroad.
16. Royalty
Ans. Yes, it will be included in the national income as royalty is a productive income.
17. Fees received from students
Ans. Yes, it will be included in the national income as it is a part of the private final consumption expenditure.
18. Purchase of goods by foreign tourists
Ans. Yes, it is included in national income as these are exports produced in the domestic territory, an item of final expenditure.
19. Expenditure on maintenance of factory building by a firm
Ans. No, it will not be included in the national income as it is an intermediate expenditure of the firm.
20. Transport expenses by a firm/ Expenditure on advertisement and scientific research by a firm
Ans. No, it will not be included in the national income as it is an intermediate expenditure.

1. Refrigerator purchased by a confectionery shop is addition to the stock of capital is a flow variable as it
an example of: (1) takes place over a period of time.
(a) Final good (b) Intermediate good For example, suppose a tank is being filled with water
(c) Capital good (d) Both (a) and (c) coming from a tap. The amount of water which is flowing
Ans. (d) Both (a) and (c) into the tank from the tap per minute is a flow. On the
2. State giving reasons whether the following other hand, how much water there is in the tank at a
statements are True or False: (6) particular point of time is a stock.
(a) National income of a country is a stock variable. 5. Which one of the following is not a part of a country’s
(b) Capital goods are used up to produce other goods. Net Domestic Product at market price’? (1)
(c) National income is always more than the (a) Depreciation (b) Indirect tax
domestic income. (c) Net exports (d) Net change in stocks
Ans. (a) False: National income is flow variable since it is Ans. (a) Depreciation
measured over a period of time. 6. National income is the sum of factor incomes
(b) False: Capital goods like machines make production accruing to: (1)
of other goods feasible, but they themselves don’t get (a) Nationals (b) Economic territory
transformed in the production process, i.e., they are not (c) Residents (d) Both residents and non-residents
used up to produce other goods. Ans. (c) Residents
(c) False: National income can be less than domestic 7. National income at current prices is higher than
income when net factor income from abroad (NFIA) is national income at constant prices during a
negative. National income can also be equal to domestic period of: (1)
income if NFIA is zero. (a) Rising prices (b) Falling prices
3. ‘Machine purchased is always a final good.’ Do (c) Constant prices (d) Both (a) and (b)
you agree? Give reasons for your answer. (3) Ans. (a) Rising prices
Ans. Whether ‘machine’ is a final good or not depends on 8. State giving reason whether the following
how it is being used. • If the machine is bought by a statement is True or False: (1)
household, then it is a final good because it is used for Real gross domestic product can be equal to
final consumption. • If the machine is bought by a firm nominal gross domestic product.
for its own use, then also it is a final good because it is Ans. False: Nominal GDP can be less than real GDP, if prices in
used for investment. • If the machine is bought by a firm the current year are less than the prices in the base year.
for re-sale, then it is an intermediate good. 9. Suppose a ban is imposed on consumption of
4. Between net investment and capital which tobacco. Examine its likely effects on gross
is a stock and which is a flow? Compare net domestic product and welfare. (CBSE 2017) (3)
investment and capital with flow of water into a Ans. Ban on consumption of tobacco will bring down
tank. (NCERT) (4) production of tobacco. Since it is counted in GDP, GDP
Ans. Capital is a stock variable as it is measured on a particular will fall. The ban will improve the health in general. It will
day, i.e., at the beginning of the year or at the end of thus increase welfare.
the year. On the other hand, net investment, i.e., net

10. Government incurs expenditure to popularise 15. Calculate GVA at factor cost of a firm: (`)
yoga among the masses. Analyse its impact (i) Net production taxes 600
on gross domestic product and welfare of the (ii) Product taxes 400
people. (CBSE 2016) (3) (iii) Price per unit of output 10
Ans. Government expenditure on popularising yoga raises (iv) Net change in stocks (–)50
GDP because it is government’s final consumption (v) Purchases of raw materials 10000
expenditure. It also raises welfare of the people because (vi) Import of raw materials 3000
yogic exercises improve health and thus, raise efficiency (vii) Import of machines 20000
of the people. (viii) Product subsidies 100
11. Sale of petrol and diesel cars is rising particularly Additional information: Output sold is 2000 units.
in big cities. Analyse its impact on gross domestic Ans. GVA at factor cost = Sales (Output sold × Price per unit)
product and welfare. (CBSE 2016) (3) + (iv) – (v) – Net product taxes (ii – viii) – (i)
Ans. Sale of cars raises GDP, because sales are of final = 2000 × 10 + (– 50) – 10000 – (400 – 100) – 600
products. Cars provide convenience in transportation but = 20000 – 50 – 10000 – 300 – 600 = `9050
at the same time, it causes traffic jams, air pollution and 16. Find NVA at factor cost of a firm. (ìn lakh)
noise pollution, which reduces the welfare of the people. (i) Durable use producer goods
Pollution has bad effects on the health of the people. with a life span of 10 years 10
12. Suppose in an imaginary economy GDP at market (ii) Single use producer goods 5
price in a particular fiscal year was `4000 crore, (iii) Sales 20
National Income was `2500 crore, Net Factor (iv) Unsold output produced during the year 2
Income paid by the economy to Rest of the World (v) Net indirect taxes 1
was `400 crore and the value of Net Indirect Taxes Ans. NVA at factor cost = (iii) + (iv) – (ii) – Depreciation – (v)
is `450 crore. Estimate the value of consumption = 20 + 2 – 5 – 10/10 – 1 = 20 + 2 – 5 – 1 – 1 = `15 lakh
of fixed capital for the economy from the given 17. Calculate national income: (ìn crore)
data. (NCERT) (4) (i) Compensation of employees 2000
Ans. National Income (NNPfc) = GDPmp – Consumption of (ii) Interest paid by production units 500
fixed capital – Net indirect taxes – Net factor income paid (iii) Rent 700
by the economy to rest of the world (iv) Profits 800
2500 = 4000 – Consumption of fixed capital – 450 + – 400 (v) Employers’ contribution to social
Consumption of fixed capital = 4000 – 450 – 400 – 2500 security schemes 200
= `650 crore (vi) Dividends 300
13. In an economy, following transactions took place. (vii) Consumption of fixed capital 100
(i) Firm A sold to firm B goods of `80 crore; to firm C (viii) Net indirect taxes 250
`50 crore; to households `30 crore and goods of (ix) Net exports 70
value `10 crore remains unsold. (x) Net factor income to abroad 150
(ii) Firm B sold to firm C goods of `70 crore; to firm (xi) Mixed income of self-employed 1500
D `40 crore; goods of value `30 crore were Ans. National income = (i) + (ii) + (iii) + (iv) + (xi) – (x)
exported and goods of value `5 crore was sold to = 2000 + 500 + 700 + 800 + 1500 – 150 = `5350 crore
government. 18. Calculate Gross National Product at market price.
Calculate: (i) Value of output of Firm A and Firm B. (ìn crore)
(ii) Value added by Firm B (CBSE SQP 2019) (4) (i) Compensation of employees 2500
Ans. (i) Value of output of Firm A = Total sales + Value of (ii) Profit 700
unsold stock (iii) Mixed income of self-employed 7500
= (Sales to Firm B + Sales to Firm C + Sales to (iv) Net addition to capital stock 400
Households) + Value of unsold stock (v) Rent and royalty 400
= (80 + 50 + 30) + 10 = `170 crore (vi) Interest 350
Value of output of Firm B = Sales to Firm C + Sales to (vii) Factor income from abroad 150
Firm D + Exports + Sales to Government (viii) Indirect taxes 200
= 70 + 40 + 30 + 5 = `145 crore (ix) Gross investment 470
(ii) Value added by Firm B = Value of output of Firm B – (x) Net exports 40
Purchases by Firm B from Firm A = 145 – 80 = `65 crore (xi) Factor income paid to abroad 100
14. In a single day, Raju, a barber, collects `500 from (xii) Subsidies 50
haircuts. Over this day, his equipment depreciates Ans. GNPmp = (i) + (ii) + (iii) + (v) + (vi) + (vii) – (xi) +
in value by `50. Of the remaining `450, Raju pays Depreciation (ix – iv) + (viii) – (xii)
sales tax `30, takes home `200 and retains `220 = 2500 + 700 + 7500 + 400 + 350 + 150 – 100 + (470
for improvement and buying of new equipment. – 400) + 200 – 50 = `11720 crore
He further pays `20 as income tax. Based 19. Compute National Income. (ìn crore)
on this information, calculate Raju’s contribution (i) Private final consumption expenditure 900
to GDP, NDP and National Income. (ii) Government final consumption expenditure 400
Ans. Raju’s contribution to: (iii) Net imports 30
(i) GDP = Value of haircuts service produced by him = `500 (iv) Gross domestic capital formation 250
(ii) NDP = GDP – Depreciation of equipment = 500 – 50 = `450 (v) Change in stock 50
(iii) National Income (NNP at factor cost) = NDP – Sales Tax (vi) Net domestic fixed capital formation 180
= 450 – 30 = `420 (vii) Net indirect taxes 100

( viii) Net factor income from abroad (–)40 on cloth, therefore, GDP = `200 lakh
(ix) Profits 100 hus, all the three methods give the same value of GDP.
T
Ans. National income = (i) + (ii) + (vi) + (v) – (iii) – (vii) + 23. Suppose only one Product X is produced in the
(viii) = 900 + 400 + 180 + 50 – 30 – 100 + (– 40) country. Its output during the year 2017 and 2018
= `1360 crore was 100 units and 110 units respectively. The
20. Calculate Net National Product at market price. market price of X during the years 2017 and 2018
(ìn crore) were `50 and `55 per unit respectively. Calculate
(i) Gross domestic fixed capital formation 350 the percentage change in real GDP and nominal
(ii) Private final consumption expenditure 8000 GDP in year 2018 using 2017 as the base year.
(iii) Government final consumption expenditure 3000
(iv) Value of output produced in the economy 150 Ans. Year Output Price Real GDP Nominal GDP
(v) Current replacement cost of fixed capital 40 2017 100 50 5000 5000
(vi) Net exports (–)60 2018 110 55 5500 6050
(vii) Net factor income from abroad 80
(viii) Sales by all firms in the economy 100 Percentage change in Real GDP
Ans. NNPmp = (ii) + (iii) + (i) + Change in stocks (iv – viii) + = D in real GDP/Base year real GDP × 100
(vi) – (v) + (vii) = 8000 + 3000 + 350 + (150 – 100) + = 500/5000 × 100 = 10%
(– 60) – 40 + 80 = `11380 crore Percentage change in Nominal GDP
21. Calculate Net Domestic Product at factor cost. = D in nominal GDP/Base year nominal GDP × 100
(ìn crore) = 1050/5000 × 100 = 21%
(i) Private final consumption expenditure 8000 24. Use the following information of an imaginary country:
(ii) Government final consumption expenditure 1000 Year 2016 2017 2018
(iii) Exports 70
Nominal GDP 6.5 8.4 9
(iv) Imports 120
(v) Annual allowance for wear and tear of capital GDP deflator 100 140 125
stock 60 (i) For which year is real GDP and nominal GDP same
(vi) Fixed business investment 300 and why?
(vii) Residential investment 200 (ii) Calculate real GDP for the given years. Is there
(viii) Change in stock 100 any year for which real GDP falls?
(ix) Factor income to abroad 40 (CBSE SQP 2018) (4)
(x) Factor income from abroad 90 Ans. (i) For the year 2016, real GDP and nominal GDP are
(xi) Net product taxes 400 same as it is the base year and thus, GDP deflator is 100.
(xii) Net production taxes 250
Ans. NDPfc = (i) + (ii) + (vi) + (vii) + (viii) + (iii) – (iv) – (v) (ii) Year 2016 2017 2018
– (xi) – (xii) = 8000 + 1000 + 300 + 200 + 100 + 70 – Nominal GDP 6.5 8.4 9
120 – 60 – 400 – 250 = `8840 crore GDP deflator 100 140 125
22. Suppose there are only two firms, A and B in an
imaginary economy. Firm A uses no raw material Real GDP = (Nominal GDP/ 6.5 6 7.2
and produces cotton worth `50 lakhs. Firm A gives GDP deflator) × 100
`20 lakhs to the workers as wages and keeps the The real GDP declined in the year 2017. It is due to high
remaining `30 lakhs to be distributed as rent, rate of inflation. Price level has risen by 40% between
interest and profits. Firm A sells its cotton to firm 2016 and 2017.
B, who uses it produce cloth. Firm B sells the cloth 25. The value of the nominal GNP of an economy
produced to consumers for `200 lakhs and gives was `2500 crore in a particular year. The value
`60 lakhs as wages and keeps the remaining of GNP of that country during the same year,
income generated as profits. evaluated at the prices of base year, was `3000
Assuming no depreciation and indirect taxes or crore. Calculate the value of the GNP deflator of
subsidies, calculate GDP by three methods. the year in percentage terms. Has the price level
(NCERT) (6) risen between the base year and the year under
Ans. (i) GDP by Value Added Method consideration? Comment on the result.
Value added (VA) = Value of output – Intermediate Ans. GNP Deflator = (Nominal GNP/Real GNP) × 100
consumption = 2500/3000 × 100 = 83.33%
VA by Firm A = 50 – 0 = `50 lakh Thus, the price level has fallen by 16.67% between the
VA by Firm B = 200 – 50 = `150 lakh base year and the year under consideration.
GDP = VA by Firm A + VA by Firm B = 50 + 150 26. If National Income at constant prices is `200
= `200 lakh crore, Price Index of base year is 80 and Price
(ii) GDP by Income Method Index of current year is 120, calculate National
= Sum total of factor incomes paid by Firms A and B Income at current prices. (3)
= Total wages received by workers of Firms A and B + Ans. National Income at constant prices = (National Income
Total operating surplus distributed by Firms A and B at current prices/Price Index of current year) × Price
= (20 + 60) + (30 + 90) = 80 + 120 = `200 lakh Index of base year
(iii) GDP by Expenditure Method = Sum of final expenditures, 200 = (National Income at current prices/120) × 80
i.e. expenditures on goods and services for end use National Income at current prices = (200 × 120)/80 =
Here, the final expenditure is expenditure by consumers `300 crore

6 Marks
Unit 6 Money and Banking

6.1 Money, Supply of Money and Money Creation by Banks
Money and Supply of Money
Anything which is commonly accepted as a medium of exchange is called money.
Money supply refers to the total quantity of money in circulation in the economy at a given point of time. Thus,
it is a stock variable. It has two components:
(i) Currency held by the public (CU): The currency issued by the central bank (Reserve Bank of India) can be
held by the public or by the commercial banks, and is called the high-powered money. • Coins are issued by the
Government of India. • Currency notes and coins are called fiat money because RBI will be responsible for giving
purchasing power equal to the value printed on the note or coin. • Currency notes and coins are called legal
tenders as they cannot be refused by any citizen of the country for settlement of any transaction.
(ii) Net demand deposits held by commercial banks (DD): Demand deposits are the deposits which can be withdrawn
from banks on demand by writing cheques, e.g. current account and savings account deposits. • Demand deposits
are created by the commercial banks and are called bank money. (The word ‘net’ implies that money supply includes only
deposits of the public held by the banks, not inter-bank deposits).
Time deposits are those deposits in banks which have a fixed period of maturity, e.g., Fixed Deposits (FD).
Money Creation by Commercial Banking System (Working of money multiplier)
Money creation or Money multiplier refers to the process of deposit creation (or credit creation) by commercial
banks, with the help of initial deposit and the legal reserve ratio (LRR).
Total credit creation (or deposit creation) = Initial deposit ×1/LRR, where Money Multiplier = 1/LRR.
Since bank deposits are a part of money supply, it is also called money creation.
We assume that there is only one bank in the economy.
Rounds Deposits (`) Loans (`) Reserves (`)
Initially, customer deposits ` 10000 and LRR is 20%. Bank
I 10000 8000 2000
keeps ` 2000 as reserves to meet customers’ obligations and
give loans of ` 8000. Those who borrow will spend this money II 8000 6400 1600
and same ` 8000 will come back to bank as fresh deposits. III 6400 5120 1280
Out of these ` 8000, bank keeps 20%, i.e. ` 1600 as reserves    
and give loans of ` 6400. In this way, in every round 80% of Total 50000 40000 10000
loans are converted into fresh deposits.
Total deposits creation (or credit creation or money creation) = Initial deposits × 1/LRR
= 10000 × 1/0.2 = 10000 × 5 = ` 50000
Therefore, Money multiplier = 1/LRR = 1/0.2 = 5
Relation between LRR and Money Multiplier: Money multiplier = 1/LRR. Lower the LRR, higher will be the
value of money multiplier. For example, with initial deposit of ` 10000 if the LRR is decreased by the Central Bank
from 20% to 10%, value of money multiplier increases from 1/0.2 = 5 to 1/0.1 = 10.
6.2 Central Bank and its Functions

Functions of the Central Bank
The Central Bank is the apex institution of a country’s monetary system. India’s central bank is the ‘Reserve Bank
of India’. It is the apex bank engaged in regulating commercial banks. Four main functions of Central Bank are:
1. Currency authority/Bank of issue: The Central Bank is the sole authority for the issue of currency in the
country. It promotes efficiency in the financial system. Firstly, because this leads to uniformity in the issue of
currency. Secondly, because it gives Central Bank direct control over money supply.

2. Government’s Bank: Banker to the government means that the Central Bank gives the same banking facilities
to the government which commercial banks give to the general public. The Central Bank does not give such facilities
to the general public. • The Central Bank keeps accounts of government and accepts deposits from government.
• It gives loan to the government and also manages public debt. • It accepts receipts and makes payments for
the government. • It carries out exchange, remittance and other normal banking operations for the government.
3. Bankers’ Bank: • As bankers’ bank, the Central Bank holds a part of their deposits as cash reserves (called
cash reserve ratio). • It gives loans to banks when they are in need of funds. (When commercial banks need more funds
in order to be able to create more credit, they may go to market for such funds or go to the Central Bank (RBI). It provides them
funds through various instruments. This role of RBI, that of being ready to lend to banks at all times is another important function
of the central bank, and due to this Central Bank is said to be the ‘lender of last resort’.)
4. Controller of Credit: Policy adopted by the Central Bank of a country in the direction of credit control or
money supply is known as Monetary Policy. Instruments of Monetary Policy are:
(i) Bank Rate Policy: Bank rate is the rate of interest at which commercial banks can borrow from the Central Bank.
Increasing bank rate makes loans taken by commercial banks more expensive. So, they also increase their lending
rates. People borrow less. Thus, credit creation by banks decline and money supply decreases in the economy.
(ii) Open Market Operations (OMO): It refers to the sale and purchase of government securities in the open market by
the Central Bank (RBI). • By purchasing government securities, Central Bank releases liquidity in the economy since
it pays for it by giving a cheque. This cheque increases cash reserves with banks and thus increases bank’s ability to
create credit and hence increases money supply in the economy. • By selling such securities the Central Bank soaks
liquidity from the economy because those who buy make payments by cheques to the Central Bank. This reduces the
reserves of commercial banks and adversely affects bank’s ability to create credit and hence decreases the money
supply in the economy.
(iii) Legal Reserve Requirements: There are two components of Legal Reserve Ratio (LRR): Cash Reserve Ratio
(CRR) and Statutory Liquidity Ratio (SLR). CRR is the fraction of deposits that commercial banks must keep as cash
reserves with the Central Bank. SLR is the fraction of deposits that commercial banks must keep as cash reserves with
themselves. When the central bank raises CRR or SLR or both, less money is left with commercial banks for lending.
As lending decreases, the money creation decreases and money supply in the economy decreases.
(iv) Repo Rate: Repo Rate is the rate at which commercial banks borrow money from the Central Bank for a short
period by selling their financial securities. Raising Repo Rate makes borrowings by banks costly. So, banks also raise
their lending rates. People borrow less. Thus, credit creation by banks declines and money supply decreases in the
economy.
(v) Reverse Repo Rate: Reverse Repo Rate is the rate at which Central Bank borrows money from commercial banks.
Increase in Reverse Repo Rate encourages banks to transfer more surplus funds to the Central Bank and hence
reduces banks’ ability to create credit.
(vi) Margin Requirement on Loan: Margin Requirement on loan refers to the difference between current value of
the security offered and amount of loan granted. Lowering margin requirement enables borrowers to secure larger
amount of funds from the banks, thereby increases money supply in the economy.

1. Which of the following is not included in money supply? (1)
(a) High powered money (b) Bank money (c) Time deposits (d) Inter-bank deposits
Ans. (d) Inter-bank deposits
2. Deposit creation by banks comes to an end when ..................... . (1)
(a) fresh deposits with banks become zero (b) legal reserve ratio becomes zero
(c) money multiplier becomes zero (d) total reserves equal initial deposits
Ans. (d) total reserves equal initial deposits
3. ..................... is the main source of money supply in an economy. (CBSE 2018) (1)
(a) Central bank (b) Commercial banks (c) Both (a) and (b) (d) Government
4. If the initial deposit with banks ` 500000, and CRR is 12% and SLR is 8%, then calculate total money
creation in the economy. (3)
Ans. LRR = CRR + SLR = 12 + 8 = 20%. Total money creation = Initial deposit × 1/LRR = 500000 × 1/0.2 = `2500000.
5. If an economy is to control recession, which of the following can be appropriate: (CBSE SQP 2016) (1)
(a) Reducing Repo Rate (b) Reducing CRR (c) Both (a) and (b) (d) None of (a) and (b)
6. Why are the banks required to keep only a fraction of deposits as cash reserves? (3)
Ans. Since not all depositors approach the banks for withdrawal of money at the same time, and there is a constant flow of new
deposits into the banks, therefore, to meet the daily demand for withdrawal of cash, it is sufficient for banks to keep only
a fraction of deposits as cash reserves.

12 Marks
Determination of
Unit 7 Income and Employment
7.1 Consumption, Savings and Investment Functions
Ex-ante and Ex-post Measures
The planned values of the variables–consumption, investment or output of final goods–are called their ex-ante
measures whereas the actual or realised value of the variables is called their ex-post measures. The ex-ante
variables (ex-ante consumption and ex‑ante investment) are the basis of determination of national income.
Consumption Function and Savings Function
Consumption function describes the relation between consumption and income. Consumption function: C = C
+ bY. This consists of two components: (i) Autonomous consumption (C): It refers to the consumption expenditure
which does not depend upon the level of income, i.e. the consumption at zero income. (ii) Induced consumption
(bY): It is directly determined by the level of income. Clearly, bY shows dependence of consumption on income.
For example, if the consumption function equation is C = 100 + 0.8Y, C = 100 and MPC = 0.8, so when income
rises by `100, induced consumption rises by ` 80 (0.8 × 100).
Savings is that part of income that is not consumed. In other words, S = Y – C.
Marginal propensity to consume (MPC) is the change in consumption per unit change in income. It is denoted by b and
is equal to DC/DY. When income changes, change in consumption (DC) can never exceed the change in income (DY).
Therefore, the maximum value of MPC can be 1. Generally, MPC lies between 0 and 1 (inclusive of both values). This means
that as income increases either the consumers do not increase consumption at all (MPC = 0) or use entire change in
income on consumption (MPC = 1) or use part of the change in income for changing consumption (0< MPC<1).
Marginal propensity to save (MPS) is the change in savings per unit change in income, i.e. DS/DY. It is denoted by s and
is equal to 1 – MPC. It implies that the sum of MPC and MPS is equal to 1. Explanation: Since S = Y – C, therefore MPS = DS/DY
= D(Y – C)/DY = DY/DY – DC/DY = 1 – MPC.
Average propensity to consume (APC) is the consumption per unit of income, i.e. C/Y.
Average propensity to save (APS) is the savings per unit of income, i.e. S/Y.
The sum of APC and APS is equal to one. Explanation: Y = C + S. Dividing both sides of the equation by Y, Y/Y = C/Y
+ S/Y fi 1 = APC + APS. Therefore, APS = 1 – APC and APC = 1 – APS.
(Significance of the 45° line from origin: It establishes the relation of Y = C + S. At every point on it consumption is equal to income.)
• Break-even point is the point at which consumption is equal to income (i.e., C = Y fi S = 0. Then APC = 1 and
APS = 0. However, APC can never be zero because consumption cannot be zero even at zero income.).
• When the consumption curve lies above the 45° line, consumption is greater than income (i.e., C > Y fi saving
is negative. Then, APC > 1 and APS is negative).
• When the consumption curve lies below the 45° line, consumption is less than income (i.e., C < Y fi saving is
positive. Then, APC < 1 and APS is positive).
Derivation of savings curve from consumption curve Step 1: Take OS1 equal
to OC because at zero income, negative savings is exactly equal to the autonomous
consumption. Step 2: From the break-even point B, we draw a perpendicular on X-axis
which cuts the X-axis at B1. At OB1 level of income, savings must be zero because at
this level of income consumption equals income. Step 3: Join S1 and B1 and extend it
by a straight line to get the savings curve S1S.
Investment Function
Autonomous investment refers to the investment expenditure which is
independent of income, i.e. investment expenditure is fixed (I). So, investment
schedule/curve will be a horizontal line. Induced investment refers to the
investment expenditure which is dependent on the level of income, market rate
of interest etc.

7.2 Short Run Equilibrium Level of Income or Output
Aggregate Supply and Aggregate Demand
Aggregate Supply (AS) refers to the ex-ante, i.e. planned output produced in the economy. It is equal to the
National Income and is represented by a 45 degree line from origin because at every point on it, AS = Y.
Aggregate Demand (AD) means total expenditure planned to be incurred on final goods and services. Its
components are: (i) Private final consumption expenditure (C)—It refers to ex-ante, i.e. planned consumption
expenditure on final goods in the economy. (ii) Final investment expenditure (I): It refers to ex-ante investment
expenditure on final goods in the economy. (iii) Government’s final expenditure (G) (iv) Net exports.
In a two sector economy, AD = C + I fi AD = C + bY + I fi AD = A + bY, where A = C + I = Autonomous expenditure.
In reality, these two components of autonomous expenditure behave in different ways. C remains more or less
stable over time. However, I undergoes periodic fluctuations. We have assumed that investment is autonomous,
which means that it does not depend on income. But, investment may increase at lower interest rates.
Equilibrium Level of Income or Output (C + I approach or AD-AS approach)
Equilibrium income/output (or effective demand) refers to that level of income/output where Aggregate demand is
equal to the Aggregate supply, i.e. AD = AS. Since AS = Y, therefore the economy is in equilibrium if Y = AD fi
Y = C + I. AD curve is parallel to the consumption curve because they have the
same slope, i.e. MPC. At point E, C + I curve intersects the 45° line.
At E, Y = AD. Equilibrium level of income/output is OY.
• When AD < Y, it means buyers are planning to buy less goods and services than
producers are planning to produce. Thus, there will be unplanned accumulation of
inventories. As a result, producers will plan to cut down production. This reduces
output and income till Y = AD.
• When AD > Y, it means buyers are planning to buy more goods and services than
producers are planning to produce. Thus, inventories in hand with the producers
will start falling. As a result, producers will plan to raise the production. This will
increase the level of output and income till Y = AD.
Savings-Investment Approach: Derivation from Determination of Equilibrium Income or Output
C+I Approach (C = 100, MPC = 0.8 and I = 300).
Under C + I approach Y C S I AD (C + I) AS
that equilibrium level of
income is determined 0 100 –100 < 300 400 > 0
where AD = Y, or 1000 900 100 < 300 1200 > 1000
Y = C + I ...(i). 2000 1700 300 = 300 2000 = 2000
Also Y = C + S ...(ii)
3000 2500 500 > 300 2800 < 3000
From (i) and (ii), we
have C + S = C + I 4000 3300 700 > 300 3600 < 4000
fi S = I.
Thus, equilibrium level of income is that level of income at which planned savings and investment are equal.
• S > I, it implies AD < Y. There is unplanned accumulation of inventories. Producers plan to cut down production. This reduces
output and income till Y = AD and hence, S = I. • S < I, it implies AD > Y. Inventories start falling. Producers plan to raise the
production. This raises output and income till Y = AD and hence, S = I.
7.3 Investment Multiplier and its Mechanism or Working

Investment Multiplier (k) is a measure of the effect of an initial increase in investment on increase in final income
based on MPC. [k = 1/(1 – MPC)]. Investment multiplier is the ratio of the change in income due to a given
change in initial investment, i.e. k = DY/DI.
Numerical Example: Suppose increase in investment by government for a bullet train Rounds DY DC DS
project, DI = `1000 crore and MPC = 0.8. • In Ist round, this additional investment I 1000 800 200
will generate an extra income of `1000 crore. • Since MPC is 0.8, people will spend II 800 640 160
`800 crores (0.8 × 1000), which in return becomes additional income of other III 640 512 128
people during second round (as one man’s expenditure is another man’s income).    
• Similarly, in third round `640 crores of additional income is generated. • This Total 5000 4000 1000
process will go on infinitely till the total increase in income is equal to multiplier times
Ê 1 ˆ Ê 1 ˆ 1
the initial investment. Total increase in income, DY = DI ◊ Á
Ë 1 - MPC ¯˜
= 1000 ¥ Á
Ë 1 - 0.8 ¯˜
= 1000 ¥
0.2
= 1000 ¥ 5 = `5000 crores
Value of multiplier, k = DY/DI = 5000/1000 = 5
Relation MPC and MPS with investment multiplier
k = 1/(1 – MPC) Direct/Positive relation between MPC and investment multiplier (k): If MPC rises, value of multiplier
increases. For example, if MPC of an economy increases from 0.6 to 0.8, value of multiplier increases from 2.5 to
5. Thus, investment multiplier carries direct relation with rate of growth in an economy.
k = 1/MPS. Inverse/Negative relation relation between MPS and investment multiplier: If MPS rises, value of
multiplier decreases. Thus, rising MPS hampers the rate of growth in the economy. So, economists are concerned
with rising MPS.
Minimum value of investment multiplier can be 1 when MPC = 0
Maximum value of multiplier can be • (infinity) when MPC = 1
However, 0 < MPC < 1, therefore, 1 < k < • (Investment multiplier ranges between one and infinity.) fi k > 1 fi
DY > DI (Initial change in investment causes a multiple change in final income.)
7.4 Problems of Deficient Demand and Excess Demand

Meaning of involuntary unemployment and Full employment
Involuntary unemployment exists when willing and able bodied people do not get employment at prevailing
wage rate. Full employment is a situation in which all the factors of production are fully employed in the
production process. Equilibrium level of output determined by the equality, Y = AD does not necessarily mean the
full employment level of output.
Deficient demand and deflationary gap
When aggregate demand is less than aggregate supply
at full employment, it is a situation of deficient
demand. Deflationary Gap is the amount by which
the aggregate demand falls short of aggregate supply
at full employment. It is called deflationary because it
leads to decline in prices in the long run.
Excess demand and inflationary gap
When aggregate demand is more than the aggregate
supply at full employment, it is a situation of excess demand. Inflationary Gap is the amount by which the
aggregate demand exceeds aggregate supply at full employment. It is called inflationary because it leads to rise
in prices in the long run, called demand pull inflation, i.e., an aggregate demand induced rise in the price level.
Remedy to correct the situations of deficient demand and excess demand
Fiscal policy measures: • In situation of deficient demand, government should increase its own expenditure and
reduce taxes to leave more personal disposable income. Then, aggregate demand will increase to correct the deflationary
situation. • In situation of excess demand, government should reduce its own expenditure and increase taxes.
Monetary policy measures: • In situation of deficient demand, Central Bank aims to increase the money supply by
reducing Bank Rate, Legal Reserve Requirements, Repo Rate, Reverse Repo Rate and Margin Requirement on loan,
and purchasing government securities in the open market. It will cause increase in aggregate demand until the
deflationary gap is eliminated. • In situation of excess demand, Central Bank aims to reduce the money supply by
raising Bank Rate, Legal Reserve Requirements, Repo Rate, Reverse Repo Rate and Margin Requirement on loan,
and selling government securities in the open market. These measures will cause decrease in aggregate demand
until the inflationary gap is eliminated.

1. Currency is issued by the Central Bank, yet we say 2. Government of India launched ‘Jan-Dhan Yojna’,
that commercial banks create money. Explain. which aimed at every household in the country
How is this money creation by commercial banks to have at least one bank account. Explain how
likely to affect the national income? Explain. deposits made under the plan are going to affect
(CBSE 2015) (4) national income of the country. (CBSE 2015) (4)
Ans. • Money supply has two components: Currency and Ans. • Opening more bank accounts means more bank
demand deposits with commercial banks. Currency is deposits. • More deposits means increase in the lending
issued by the central bank while deposits are created capacity of the commercial banks. • More lending by
by commercial banks by lending money to the people. banks means more investment in the country. • The rise
In this way commercial banks also create money. in investment in the economy leads to rise in national
• Commercial banks lend money mainly to investors. income through the multiplier effect.
The rise in investment in the economy leads to rise in
national income through the multiplier effect.

3. In the situation of inflation, more credit creation (a) If MPC is double the MPS, value of investment
by commercial banks has negative impact on the multiplier will be 2.
economy. How? (3) (b) When MPC is equal to MPS, increase in
Ans. Credit creation by commercial banks in inflationary national income will be twice the initial increase
situation in the economy increases the money supply in investment.
and hence aggregate demand. It creates the situation (c) When investment multiplier is 1, the value of
of excess demand and inflationary gap if aggregate marginal propensity to consume is zero.
demand exceeds the full employment level of output/ Ans. (a) False: MPC = 2MPS ; MPC + MPS = 1 ⇒ 2MPS +
income. MPS =1 ⇒ 3MPS = 1 ⇒ MPS = 1/3
4. State giving reasons whether the following Value of investment multiplier, k = 1/MPS = 3
statements are True or False: (6) (b) True: Equality between MPC and MPS signifies that
(a) Average propensity to consume can never be both of them are equal to 0.5 (as MPC + MPS = 1).
zero. Therefore, value of investment multiplier (k) = 1/MPS
(b) Average propensity to save is always greater = 1/0.5 = 2. It means that increase in income in the
than zero. economy will be twice the initial increase in investment.
(c) The value of marginal propensity to save can (c) True: k = 1/(1 – MPC). Since k = 1, therefore, 1 =
never be negative. 1/(1 – MPC) ⇒ 1 – MPC = 1 ⇒ MPC = 0
Ans. (a) True: APC = C/Y and APC will be zero if consumption 8. State giving reason whether the following
(C) is zero which is not possible. Even if income is zero, statements are true or false: (6)
there is some consumption expenditure to survive (called (a) An increase in the bank rate is effective to
autonomous consumption). combat inflation.
(b) False: APS = S/Y. At low levels of income, (b) In situation of deficient demand, the central
consumption (C) exceeds income (Y). So, saving (S) is bank raises cash reserve ratio.
negative. Therefore, APS is negative. Also, when C = Y, Ans. (a) True: During inflation, the Central bank increases the
S = 0. Then APS = 0. Thus, APS can be zero or negative. bank rate. Therefore, commercial banks also increase
(c) True: MPS = DS/DY. When income increases (DY their lending rates. This will discourage people to take
is positive), savings also increases (DS is positive); so loans. This will reduce the money supply and the level of
MPS is positive. Also, when income decreases (DY is aggregate demand in the economy to combat inflation.
negative), savings also decreases (DS is negative); so (b) False: In situation of deficient demand, the Central
MPS is positive. bank decreases the cash reserve ratio (CRR). As a
5. Giving reason state whether the following result, banks are required to hold smaller fraction of
statements are True or False: (CBSE 2018) (6) their deposits as cash reserves with the central bank.
(i) Average propensity to save cannot be negative. Therefore, the lending capacity of the banks increases.
(ii) Value of marginal propensity to consume can It leads to an increase in money supply. This will raise
be greater than one. the level of aggregate demand and correct the situation
(iii) Average propensity to consume can be of deficient demand.
greater than one. 9. Calculate autonomous consumption and induced
Ans. (i) False, average propensity to save can be negative at consumption from the following:
a level when consumption is greater than income. National income = `1000 crore, MPS = 0.25 and
(ii) False, value of marginal propensity to consume Consumption expenditure = `850 crore (3)
cannot be greater than one as change in consumption Ans. C = C + bY, where b = MPC = 1 – MPS = 1 – 0.25 = 0.75
cannot be greater than change in income. Therefore, 850 = C + 0.75 × 1000
(iii) True, average propensity to consume can be greater 850 = C + 750 ⇒ C = 100
than one, when consumption is greater than income. (i) Autonomous consumption C = `100 crore
6. State giving reason whether the following (ii) Induced consumption, bY = `750 crore
statements are true or false: (6) 10. Given the consumption function of an economy
(a) Value of investment multiplier varies between C = 100 + 0.8Y.
zero and infinity. (a) Derive the corresponding savings function.
(b) When marginal propensity to consume is zero, (b) What is the value of MPS?
the value of investment multiplier will also be zero. (c) Show that in this economy as income
(c) When marginal propensity to consume is increases, APC declines and APS increases.
greater than marginal propensity to save, the value (d) What is the level of income at Break-Even
of investment multiplier will be greater than 5. Point?
Ans. (a) False: Value of investment multiplier, k = 1/(1–MPC). Ans. (a) C = 100 + 0.8Y
Since 0 < MPC < 1, therefore, value of multiplier ranges S = Y – C = Y – (100 + 0.8Y) = –100 + 0.2Y.
between 1 and ∞ (infinity). (b) From the consumption function, MPC = 0.8.
(b) False: Value of investment multiplier, k = 1/(1–MPC). Therefore, MPS = 1 – MPC = 1 – 0.8 = 0.2.
When MPC = 0, k = 1/(1 – 0) = 1/1 = 1 (c) Y C S APC APS
(c) False: When MPC = MPS, MPS = 1/2 (since MPC +
MPS = 1). Value of multiplier = 1/MPS = 2 1000 900 100 0.9 0.1
Therefore, when MPC > MPS, MPS < 1/2; Therefore, k > 2. 2000 1700 300 0.85 0.15
7. State giving reason whether the following 3000 2500 500 0.83 0.17
statements are true or false: (6)

The table shows that as income increases from 1000 to S = –200 + 0.25(2000) = –200 + 500 = ` 300 crore
3000, APC declines from 0.9 to 0.83 but APS increases At equilibrium, planned savings and planned investment
from 0.1 to 0.17. expenditure are equal. So, investment expenditure at
(d) At Break even point, C = Y equilibrium level of income I = ` 300 crore
100 + 0.8Y = Y ⇒ 0.2Y = 100 (ii) From the Savings function S = –200 + 0.25Y, we get
Y = 100/0.2 = 500 dissavings at zero income = ` 200 crore, which is equal
Break even level of income = `500 crore to autonomous consumption.
11. Complete the following table: Therefore, autonomous consumption = ` 200 crore.
16. Measure the level of ex-ante aggregate demand
Income APS MPC Consumption
when autonomous investment and consumption
1000 0.50 – 500 expenditure (A) is ` 50 crore, and MPC is 0.8
2000 0.55 – – and level of income (Y) is ` 4000 crore. State
2500 0.60 – – whether the economy is in equilibrium or not
(cite reasons). (NCERT)
Ans. Y DY C DC S APS MPC Ans. Sum of autonomous investment (I) and autonomous
1000 – 500 – 500 0.5 – consumption (C) = A = ` 50 crore, MPC = b = 0.8 and
national income (Y) = ` 4000 crore
2000 1000 900 400 1100 0.55 0.4
Ex-ante aggregate demand, AD = C + I
2500 500 1000 100 1500 0.6 0.2 = C + bY + I = (C + I) +bY = A + bY
12. Complete the following table: = 50 + 0.8 × 4000 = `3250 crore
Since AD (` 3250 crore) is less than National Income
Income Consumption APS MPS (Y = ` 4000 crore), therefore, the economy is not
400 240 0.4 equilibrium. The economy is in equilibrium when AD = Y.
800 440 – – 17. In an economy the autonomous investment is `
60 crore and the marginal propensity to consume
– 520 0.48 –
is 0.8. If the equilibrium level of income is ` 400
Ans. Y DY C DC S DS APS APC MPS crore, then the autonomous consumption is ` 30
400 – 240 – 160 – 0.4 0.6 – crore. True or False? Justify your answer.
Ans. At equilibrium, Y = C + I
800 400 440 200 360 200 0.45 0.55 0.5
Y = C + bY + I
1000* 200 520 80 480 120 0.48 0.52 0.6 400 = C + 0.8 × 400 + 60
*APC = C/Y. When APC = 0.52, C = 520 400 = C + 320 + 60
Therefore, 0.52 = 520/Y ⇒ Y = 520/0.52 = 1000 Autonomous consumption C = ` 20 crore
13. In an economy, the ratio of average propensity The given value of autonomous consumption (` 30
to consume and average propensity to save is 5 : crore) is incorrect.
3. The level of income is ` 6000. How much is the 18. From the data given below about an economy,
savings? Calculate. calculate investment expenditure and
Ans. APC/APS = 5/3 ⇒ (C/Y)/(S/Y) = 5/3 ⇒ C/S = 5/3 consumption expenditure:
(Y – S)/S = 5/3 ⇒ (6000 – S)/S = 5/3 ⇒ S = 2250 Equilibrium level of income ` 5000 crore
Therefore, savings in the economy are ` 2250 crore. Autonomous consumption ` 500 crore
14. If in an economy consumption function is given Marginal propensity to consume 0.4
by C = 100 + 0.75 Y, and autonomous investment Ans. Equilibrium income Y = ` 5000 crore, Autonomous
is ` 150 crore. Estimate (i) Equilibrium level of consumption C = ` 500 crore, MPC = b = 0.4
income by C + I approach and (ii) Consumption Consumption expenditure C = C + bY
and Savings at the equilibrium level of income. = 500 + 0.4(5000) = 500 + 2000 = ` 2500 crore
Ans. C = 100 + 0.75Y; I = ` 150 crore At equilibrium income Y = C + I
(i) At equilibrium level of income: Y = C + I 5000 = 2500 + I
Y = 100 + 0.75Y + 150 ⇒ Y – 0.75Y = 250 I = 5000 – 2500 = 2500
0.25Y = 250 ⇒ Y = 250/0.25 = 1000 \ Investment expenditure I = ` 2500 crore
Equilibrium level of income Y = ` 1000 crore 19. Calculate Autonomous consumption expenditure
(ii) Consumption at the equilibrium level of income: from the following data about an economy which
C = 100 + 0.75Y = 100 + 0.75 (1000) is in equilibrium:
= 100 + 750 = ` 850 crore National income ` 1200 crore
Savings at the equilibrium level of income: Marginal propensity to save 0.20
S = Y – C = 1000 – 850 = ` 150 crore Investment expenditure ` 100 crore
15. The savings function of an economy is S = –200 Ans. Since MPS = 0.20, therefore, MPC = b = 1 – MPS = 1 –
+ 0.25Y. The economy is in equilibrium when 0.20 = 0.80
income is equal to ` 2000 crore. Calculate: Consumption function equation C = C + bY = C + 0.80Y
(i) Investment expenditure at equilibrium level of At equilibrium level of national income Y = C + I
income and (ii) Autonomous consumption. Y = C + 0.80Y + I
Ans. (i) Equilibrium level of income Y = ` 2000 crore, Savings 1200 = C + 0.80 × 1200 + 100
function S = –200 + 0.25Y 1200 = C + 960 + 100 ⇒ C = 140
Savings at equilibrium level of income Autonomous consumption expenditure = ` 140 crore

20. If in an economy savings function is given by S = (iv) Value of multiplier = 4
(–) 50 + 0.2 Y and Y = ` 2000 crore; consumption 24. In an economy the equilibrium level of income is
expenditure for the economy would be ` 1650 ` 12000 crore. The ratio of marginal propensity
crore and the autonomous investment is ` 350 to consume and marginal propensity to save is
crore and the marginal propensity to consume 3 : 1. Calculate the additional investment needed
is 0.8. True or False? Justify your answer with to reach a new equilibrium level of income of
proper calculations. `20000 crore.
Ans. Level of income Y = ` 2000 crore Ans. Required increase in income DY = 20000 – 12000 =
Savings S = –50 + 0.2Y 8000, MPC : MPS = 3 : 1
= –50 + 0.2(2000) = –50 + 400 = ` 350 crore MPC/MPS = 3/1 ⇒ MPC = 3MPS
Consumption expenditure C = Y – S = 2000 – 350 = MPC + MPS = 1 ⇒ 3MPS + MPS = 1
`1650 crore (Which is true.) ⇒ 4MPS = 1 ⇒ MPS = 1/4
From the savings function equation, MPS = 0.2 k = 1/MPS = 4
MPC = 1 – MPS = 1 – 0.2 = 0.8 (Which is true.) k = DY/DI ⇒ 4 = 8000/DI ⇒ DI = 8000/4 = 2000
At equilibrium level of income, Savings = Investment = Therefore, additional investment needed = ` 2000 crore
` 350 crore (Which is also true.) 25. If in an economy C = 500 + 0.9 Y and I = `1000
Thus, all the given values are correct. crore. (Where C = Consumption expenditure, Y =
21. Calculate Marginal Propensity to Consume from National income, I = Investment)
the following: Calculate the following :
Equilibrium income ` 350 (i) Equilibrium level of income
Consumption expenditure at zero income ` 20 (ii) Value of investment multiplier (CBSE 2018)
Investment ` 50 Ans. (i) Equilibrium level of income will be determined when
Ans. Consumption expenditure at zero income (Autonomous Y = C + I
consumption) C = 20, Y = 500 + 0.9Y + 1000
Equilibrium income Y = 350, Investment I = 50 Y – 0.9Y = 1500
Consumption function equation Y = 1500/0.10 = `15000 crore.
C = C + bY = 20 + 350b (ii) From the consumption function C = 500 + 0.9Y, MPC
At equilibrium level of national income Y = C + I = 0.9
350 = 20 + 350b + 50 ⇒ 350 = 70 + 350b Therefore, value of Investment Multiplier = 1/(1 – MPC)
350b = 350 – 70 = 280 = 1/(1 – 0.9) = 1/0.1 = 10
b = 280/350 = 4/5 = 0.8 26. In an economy, autonomous consumption is `100
\ Marginal propensity to consume = 0.8 crore and autonomous investment is `60 crore.
22. In an economy 75% of the increase in income is In this economy, with every increase in income,
spent on consumption. Investment is increased 80% of it is spent on consumption. Calculate the
by ` 1000 crore. Calculate: additional investment required to reach the full
(i) Total increase in income employment level of income `1000 crore.
(ii) Total increase in consumption expenditure Ans. Autonomous consumption C = 100, MPC = b = 80% =
(iii) Change in savings 0.8, Autonomous investment I = 60
Ans. In the economy 75% of the increase in income is spent Consumption function equation C = C + bY = 100 + 0.8Y
on consumption, i.e., MPC = 75% = 0.75 At equilibrium level of income, Y = C + I
Increase in investment DI = ` 1000 crore ⇒ Y = 100 + 0.8Y + 60 ⇒ Y – 0.8Y = 160
k = 1/(1 – MPC) = 1/(1 – 0.75) = 1/0.25 = 4 ⇒ 0.2Y = 160 ⇒ Y = 160/0.2 = 800
k = DY/DI ⇒ 4 = DY/1000 ⇒ DY = 4000 Therefore, equilibrium level of income = `800 crore
MPC = DC/DY ⇒ 0.75 = DC/4000 ⇒ DC = 3000 Full employment level of income = `1000 crore.
DS = DY – DC = 4000 – 3000 = 1000 Since equilibrium level of income is less than full
(i) Increase in income = ` 4000 crore employment level of income, it is a situation of deficient
(ii) Increase in consumption expenditure = ` 3000 crore demand. Therefore, required increase in income to
(iii) Change in savings = ` 1000 crore combat deflationary gap DY = 1000 – 800 = `200
23. An increase of ` 250 crore in investment in an k = 1/(1 – MPC) = 1/(1 – 0.8) = 1/0.2 = 5
economy results in income increasing by three k = DY/DI ⇒ 5 = 200/DI ⇒ DI = 200/5 = 40
times more than the increase in investment. Hence, additional investment required to reach the full
Calculate: employment of level of income = `40 crore
(i) Marginal propensity to consume 27. In an economy the equilibrium level of income is `800
(ii) Change in savings crore whereas the full employment level of income is
(iii) Change in consumption expenditure `800 crore. The marginal propensity to consume is
(iv) Value of multiplier 0.75. Calculate the decrease in investment required
Ans. DI = 250, DY = 250 + 3 × 250 = 1000 to combat the inflationary gap.
k = DY/DI = 1000/250 = 4 Ans. Inflationary gap = 800 – 500 = `300 crore. Thus,
k = 1/(1 – MPC) ⇒ 4 = 1/(1 – MPC) ⇒ MPC = 3/4 required decrease in income DY = (–)`300 crore
DC = MPC × DY = 3/4 × 1000 = 750 k = 1/(1 – MPC) = 1/(1 – 0.75) = 1/0.25 = 4
DS = DY – DC = 1000 – 750 = 250 k = DY/DI ⇒ 4 = –300/DI ⇒ DI = –300/4 = –75
(i) Marginal propensity to consume = 3/4 = 0.75 Thus, required decrease in investment required to
(ii) Change in savings = ` 250 crore combat the inflationary gap = `75 crore
(iii) Change in consumption expenditure = ` 750 crore

6 Marks
Government Budget
Unit 8 and the Economy
8.1 Meaning and Objectives of Government Budget
Government Budget is a financial statement of planned receipts and planned expenditure of the government
during a fiscal year.
Objectives/Functions of Government Budget
1. Allocation of resources (Allocation function): Government can influence allocation of resources through
taxes, subsidies and expenditure. (a) Taxation policy: By imposing taxes at higher rates, it can discourage those
occupations which are not beneficial to society, e.g. liquor, cigarettes, tobacco, etc. (b) Subsidies/Tax concessions:
By giving subsidies and tax concessions, government can encourage certain industries which are beneficial to
people, for example, to the enterprises who are willing to undertake electricity generation, especially in backward
areas. (c) Expenditure policy/Direct participation in production: Government can directly produce goods and services
normally ignored by the private sector due to lack of enough profits and huge investment expenditure involved,
e.g. water supply, sanitation, law and order, national defence, etc. These are called public goods. Government
expenditure raises welfare of the people. (Why public goods must be provided by the government? (i) Public goods are
non-rivalrous: The benefits of public goods are not limited to one particular consumer, as in the case of private goods, but become
available to all. For example, if we consider a public park or measures to reduce air pollution, the benefits will be available to all.
(ii) Public goods are non-excludable: In case of public goods, e.g., street lighting, roads, etc. there no feasible way of excluding
anyone from enjoying the benefits of the good. Since non-paying users usually cannot be excluded, it becomes difficult to collect
fees for the public goods. This leads to the ‘free-rider’ problem.)
2. Reduction in income inequalities or Redistribution of income (Distribution function): Inequalities
of income and wealth reflect a section of society being deprived of even basic necessities. Thus arises the need
for reducing income inequalities in the society, i.e. reducing the gap between rich and poor. Through its taxation
and expenditure policy, the government attempts to bring a fair distribution of income. (a) Progressive taxation
Policy: The government puts a higher rates of taxation on incomes of the rich people and lower rates of taxation
on lower income groups. This will reduce the inequalities of income as the difference between disposable incomes
of higher income and lower income groups will fall. (b) Increasing government’s expenditure and Subsidies: The
amount collected through taxes can be used by the government for spending on welfare of the poor people. It can
provide them transfer payments and subsidies. For example: (i) Providing free education and health, (ii) Providing
essential food grains almost free, (iii) Free LPG kitchen gas connections and subsidised LPG gas, etc. It will reduce
the income inequalities and raise their standard of living.
3. Economic stability or Price stability (Stabilisation function): Economic stability (or price stability) means
absence of large-scale fluctuations in general price level in the economy. Too much fluctuations in prices is not good
for the economy as they create uncertainties in the economy. Government uses taxation policy and expenditure policy
in controlling the prices. (a) Under inflationary situations: Inflationary tendencies emerge due to aggregate demand
being higher than aggregate supply. Therefore, government can increase taxes and decrease its own expenditure.
To raise aggregate supply, tax concessions and subsidies can also be used. (b) Under deflationary situations: During
deflationary situation, government can reduce taxes and increase its own expenditure to leave more disposable
income in the hands of people, thereby increasing aggregate demand to combat deflationary situation.
4. Economic growth: Economic growth implies a sustainable increase in real GDP of an economy, i.e., an increase
in volume of goods and services produced in an economy. Government budget can be an effective tool to ensure the
economic growth in a country.  If the government provides tax rebates and other budgetary incentives for productive
ventures and projects, it will stimulate savings and investments in the economy.  Spending on infrastructure in the
economy promotes the production activities across different sectors. Government expenditure is a major factor that
generates demand for different types of goods and services, which induces economic growth in the country.

8.2 Components of Government Budget
Revenue Budget (or Revenue Account): It includes those receipts and expenditure that relate to the current financial year only
(i.e., revenue receipts and revenue expenditure).Capital Budget (or Capital Account): It includes those receipts and expenditure
that concern the assets and liabilities of the government (i.e., capital receipts and capital expenditure). Major components of
Government Budget: (i) Revenue Receipts (ii) Capital Receipts (iii) Revenue Expenditures (iv) Capital Expenditures.
Revenue Receipts: Revenue Receipts are those receipts that neither create a liability nor lead to reduction in
assets. It has two components: (i) Tax revenues: A tax is a legally compulsory transfer payment made by people to
the government. (ii) Non-tax revenues: Examples: Interest receipts on loans advanced by the Central Government,
Dividends and profits on investments made by the Central Government, Fees and other receipts for services
rendered by the government, Cash grants in aid from foreign countries and international organisations, etc.
Tax revenues are classified into direct and indirect taxes: (i) Direct taxes: Direct tax is a tax whose burden and
liability to pay fall on the same person. It is collected directly from the income earners, e.g., personal income tax,
corporation tax, Interest tax, Wealth tax, Gift tax (ii) Indirect taxes: Indirect tax is a tax whose burden and liability
to pay fall on different persons, e.g. GST, Entertainment tax, Sales tax, Excise tax, Customs duties, Service tax, etc.
Capital Receipts: Capital Receipts are those receipts which either create a liability (e.g. borrowings) or lead to
reduction in assets (e.g. recovery of loans). Its components are: (i) Debt creating capital receipts, i.e borrowings,
e.g. market borrowings, borrowing from RBI and borrowing from abroad. (ii) Non-debt creating capital receipts —
those receipts which are not borrowings and therefore, do not give rise to debt. For example, proceeds from sale
of shares in PSUs (i.e., PSU disinvestment) and Recovery of loans. (iii) Other sources of capital receipts such as
small savings (Post Office Savings Accounts, National Savings Certificates, etc.) and Provident Funds
Revenue Expenditure: Revenue Expenditure is an expenditure which neither leads to any creation of asset
nor reduction in liability, e.g. Interest payments, Grants given to state governments and other parties (even though
some of the grants may be meant for creation of assets), Defence services expenditure, Salaries and pensions,
Expenditure on education and health, Subsidies, etc.
Capital Expenditure: Capital Expenditure is an expenditure which either leads to creation of assets (e.g.,
construction of school buildings, hospitals, etc.) or reduction in liabilities (e.g., repayment of loans). Other
examples include investment in shares, loans and advances given to state and UT governments, etc.
8.3 Budget Deficits

When the government’s planned expenditure equals its planned revenues, it is called a balanced budget. 
When government’s planned revenues exceed planned expenditure, it is called a surplus budget.  When government’s
planned expenditure exceeds planned revenues, it is called a deficit budget.
Revenue Deficit: Revenue Deficit refers to the excess of government’s revenue expenditure over revenue
receipts. (Revenue deficit = Revenue expenditure – Revenue receipts) It indicates that government will not be able
to meet its revenue expenditure from its revenue receipts. It implies that government is dissaving and borrowing
to meet consumption expenditure. The government may have to cut productive capital expenditure or welfare
expenditure, which could have lower growth and adverse welfare implications.
Fiscal Deficit: Fiscal Deficit refers to the excess of the government’s total expenditure over its total receipts
excluding borrowings.
Fiscal deficit = Total expenditure (Revenue expenditure + Capital expenditure) – Total receipts net of borrowings (Revenue
receipts + Non-debt creating capital receipts) = Revenue deficit + Capital expenditure – Non-debt creating capital receipts
Clearly, revenue deficit is a part of fiscal deficit. So a large share of revenue deficit in fiscal deficit indicates that a large
part of borrowings is being used to meet the government’s consumption expenditure needs rather than investment.
Fiscal deficit indicates total borrowing requirements of the government from all sources. Fiscal Deficit
= Net borrowing at home + Borrowing from RBI + Borrowing from abroad. A large fiscal deficit means large
amount of borrowings. This creates a large burden of interest payment and repayment of loans in the future. Such
borrowings are generally financed by issuing new currency which may lead to inflation. However, if the borrowings
are for infrastructural development this may lead to capacity building and may not be inflationary.
Primary Deficit: Primary Deficit equals fiscal deficit minus interest payments. (Primary deficit = Fiscal deficit –
Interest payments) Fiscal deficit is nothing but total borrowings of the government during the current year. Therefore,
primary deficit indicates borrowing requirements of the government other than to make interest payments. Thus,
goal of measuring primary deficit is to focus on present fiscal imbalances.

1. Name any one step that the government can Besides the objective of raising more revenue, the
take through its budget to check inflation that is proposals also serve some welfare objectives: (i) Allocation
causing hardships to the people. (CBSE 2013) (1) of resources (ii) Redistribution of income (Explain)
Ans. Government can reduce its own expenditure to leave 8. Can there be a fiscal deficit without revenue
less disposable income in the hands of people. deficit? (4)
2. Government raises its expenditure on producing Ans. Yes, there can be a fiscal deficit in a government budget
public goods. Which economic value does it without a revenue deficit in the following situations:
reflect? (CBSE 2014) (3) (i) When revenue budget is balanced (revenue
Ans. Increased expenditure by government on public goods expenditure = revenue receipts) and capital budget shows
like defence, maintaining law and order etc. increases a deficit (capital expenditure > non-debt capital receipts).
their availability to the people of the country. Any such (ii) When there is a surplus in the revenue budget
expenditure raises welfare of the people. (revenue receipts > revenue expenditure) but the deficit
3. Tax rates on higher income group have been in capital budget is greater than this surplus.
increased. Which economic value does it reflect? 9. A government budget shows a primary deficit of `
Explain. (CBSE 2014) (3) 4400 crore. The revenue expenditure on interest
Ans. This will reduce the inequalities of income. (Explain) payment is ` 400 crore. How much is the fiscal
4. Government has started spending more on deficit? (1)
providing free services like education and Ans. Fiscal deficit = Primary deficit + Interest payment
health to the poor. Explain the economic value it = 4400 + 400 = ` 4800 crore
reflects. (3) 10. From the following data about a Government
Ans. Spending on free services to the poor raises their budget, find out (a) Revenue deficit, (b) Fiscal
standard of living and at the same time helps in reduction deficit and (c) Primary deficit: (CBSE 2011) (4)
in income inequalities. It also helps in raising production (` in arab)
potential of the country by raising the efficiency level of (i) Capital receipts net of borrowings 95
the working class among the poor. (ii) Revenue expenditure 100
5. The government decides to give budgetary (iii) Interest payments 10
incentives to investors for making investments (iv) Tax revenue 60
in backward regions. Explain these possible (v) Non tax revenue 20
incentives and the reasons for the same. (vi) Capital expenditure 110
(CBSE 2015) (6) Ans. (a) Revenue deficit = (ii) – (iv + v) = 100 – (60 + 20) =
Ans. Possible Budgetary Incentives: (i) Tax concessions– ` 20 arab
it aims at reducing cost and thus raising profits. (b) Fiscal deficit = (ii + vi) – (iv + v + i)
(ii) Subsides–it aims at reducing prices of products to = (100 + 110) – (60 + 20 + 95) = ` 35 arab
encourage sales and earning more profits. Reasons: (c) Primary deficit = Fiscal deficit – Interest payments
(i) Allocation of resources (ii) Economic Growth (Explain) = 35 – 10 = ` 25 arab
6. The Government, under Ujjwala Yojana, is 11. From the following data about a government
providing free LPG kitchen gas connections to the budget find (a) Fiscal deficit and (b) Primary
families ‘below the poverty line’. What objective deficit : (4)
the government is trying to fulfill through the (` in crore)
government budget and how? Explain. (6) (i) Revenue expenditure 70000
Ans. By providing free LPG kitchen gas connections to the (ii) Borrowings 15000
families ‘below the poverty line’, the objective which the (iii) Revenue receipts 50000
government is trying to fulfill is ‘Reduction in inequalities (iv) Interest payments 25% of revenue deficit
of income and wealth.’ (Explain) Ans. (a) Fiscal deficit = Borrowings = ` 15000 crore
7. In the Government of India’s budget, the Finance (b) Primary deficit = Fiscal deficit – Interest payments*
Minister proposed to raise the excise duty on = 15000 – 5000 = ` 10000 crore
cigarettes. He also proposed to increase income *Revenue deficit = (i) – (iii) = 70000 – 50000 = 20000
tax on individual earning more than ` one crore Interest payments = 25% of 20000 = 5000
per annum. 12. From the following data about a government
Identify and explain the types of taxes proposed budget calculate Primary deficit : (4)
by the Finance Minister. Was the objective only to (` in arab)
earn revenue for the government? What possible (i) Revenue deficit 40
welfare objectives could the Government be (ii) Non-debt creating capital receipts 190
considering? (6) (iii) Tax revenue 125
Ans. Excise duty — Indirect tax (Indirect tax is a tax where the (iv) Capital expenditure 220
payer and the bearer of the tax are different people.) (v) Interest payments 20
Income tax — Direct tax (Direct tax is a tax where the Ans. Primary deficit = Fiscal deficit* – Interest payments
payer and bearer of the tax is the same person.) = 70 – 20 = ` 50 arab
*Fiscal deficit = (i) + (iv) – (ii) = 40 + 220 – 190 = 70

6 Marks
Unit 9 Balance of Payments

9.1 The Balance of Payments (BoP)
The Balance of Payments (BoP) is defined as the statement of accounts of a country’s inflows and outflows of
foreign exchange in a fiscal year. (Foreign exchange refers to any currency other than the domestic currency.)
There are two main accounts in the BoP–the current account and the capital account.
• Any transaction which results in outflow of foreign exchange is recorded on the debit side in the balance of
payments accounts (the current account and the capital account), e.g. imports. • Any transaction which leads to
inflow of foreign exchange is recorded on the credit side in the balance of payments accounts, e.g. exports.
The Current Account
The Current Account is the record of trade in goods and services and transfer payments. It has three components:
1. Trade in goods: It includes (i) exports of goods and (ii) imports of goods.
2. Trade in services: Services trade includes both factor income and non-factor income transactions.
• Factor income includes net international earnings on factors of production (like labour, land and capital). For example,
net income from compensation of employees and net investment income, e.g., profits from investments made abroad.
• Non-factor income is net sale of service products like shipping, banking, tourism, software services, etc.
3. Transfers payments: The receipts which the residents of a country get for ‘free’, e.g. gifts, remittances and grants.
Components of Balance on Current Account
1. Balance of Trade (BoT)/Trade Balance: The difference between the value of exports and imports of goods
of a country in a given period of time. • Trade surplus will arise if country exports more goods than imports. • Trade
deficit will arise if a country imports more goods than exports.
2. Balance on Invisibles: The difference between the value of exports and imports of invisibles of a country in
a given period of time. Invisibles include services, transfers and flows of income.
Current Account Surplus (CAS) is a situation that arises when the receipts on current account are more than the payments
on current account. In simple words, CAS arises when the value of exports of goods and services is more than the value of
imports of goods and services. CAS signifies that the nation is a lender to the rest of the world.
Current Account Deficit (CAD) is a situation that arises when the receipts on current account are less than the payments on
current account. In simple words, CAD arises when the value of exports of goods and services is less than the value of imports
of goods and services. CAD signifies that the nation is a borrower from the rest of the world.
The Capital Account

The Capital Account records all international transactions of assets, e.g. money, stocks, bonds, government debt,
etc. It has three components:
1. Foreign Investments: (i) Direct Investment, e.g. Foreign Direct Investments (FDIs) (ii) Portfolio Investment,
e.g. Foreign Institutional Investments (FIIs).
2. External Borrowings, e.g. External Commercial Borrowings, Short-term Debt.
3. External Assistance, e.g. Government Aid, Inter-governmental, Multilateral and Bilateral Loans.
Surplus in capital account arises when capital inflows (like receipt of loans from abroad, sale of assets or shares in foreign
companies) are greater than capital outflows (like repayment of loans, purchase of assets or shares in foreign countries).
Deficit in capital account arises when capital inflows are lesser than capital outflows.
How Current Account Deficit (CAD) is financed?—by selling assets or by borrowing abroad. It is financed by a capital
account surplus so that: Balance on Current account + Balance on Capital account = 0. Alternatively, RBI could sell foreign
exchange reserves in the foreign exchange market (official reserve sale).

Balance of Payments Surplus and Deficit
The transactions recorded in the balance of payments accounts can be categorised as autonomous transactions
and accommodating transactions.
A BoP transaction independent of the state of BoP, i.e. undertaken on its own, is autonomous transaction
whereas a BoP transaction influenced by the state of BoP, i.e. to cover deficit or surplus in BOP is accommodating
transaction.
Significance of this distinction: a deficit / surplus in BoP equals deficit/ surplus in autonomous transactions only. The
balance of payments is in surplus (deficit) if autonomous receipts are greater (less) than autonomous payments.
Official Reserve Transactions
Official Reserve Transactions are the transactions carried on by monetary authorities of a country, which causes
changes in official reserves.
The importance/significance of such transactions is to cover a deficit or surplus on Balance of Payments.
• The Central Bank may finance a deficit through official reserve sale.
• It may use surplus to purchase foreign securities, foreign currency, gold etc. (increase in official reserves).
Thus, decrease (increase) in official reserves is called the overall balance of payments deficit (surplus).
9.2 Foreign Exchange Rate

Foreign Exchange Rate (also called Forex Rate) is the price of one currency in terms of another.
Flexible or floating exchange rates
The Exchange Rate (Rupees/$)

Y
An exchange rate determined by the forces of demand and supply in the foreign D
S
exchange market is flexible or floating exchange rate. The central banks do not
intervene in the market. Therefore, there are no official reserve transactions.
Equilibrium exchange rate is the rate at which market demand and supply of E
e*
foreign exchange are equal. As depicted in diagram, the equilibrium exchange
rate is e (` 70/$).
Sources of demand for foreign exchange: (i) Imports of goods and services
(ii) Foreign transfer payments (e.g., sending gifts, grants or remittances) S D
(iii) Investments abroad, e.g. purchase of shares, bonds, etc. abroad (iv) O q X
Foreign travel say, for sight-seeing etc. Amount of Foreign Exchange ($)
These are sources of demand because these lead to outflow of foreign exchange.
Sources of supply of foreign exchange: (i) Exports of goods and services (ii) Foreign Investments such as
Foreign Direct Investment, Portfolio Investments, etc. (iii) Foreign tourists coming to India (iv) Factor income
earned from abroad (v) Remittances from abroad.
These are sources of supply because these lead to inflow of foreign exchange.
Effect of a rise in price of foreign exchange on demand and supply of foreign exchange
A rise in price of foreign exchange causes decrease in demand and increase in supply of foreign exchange.
Explanation: A rise in price of foreign exchange will increase the cost of purchasing a foreign good. For example, if
rupee-dollar exchange rate rises from ` 70/$ to ` 75/$, Indians have to pay more rupees to import US goods. This
reduces demand for imports and thus, there is less outflow of foreign exchange. Therefore, demand for foreign
exchange (Dollars) decreases, other things being equal.
A rise in price of foreign exchange will make domestic goods cheaper for the foreign nationals, i.e., the international
competitiveness of the goods of the nation gets better. This increases exports and thus, there is more inflow of
foreign exchange. Therefore, supply of foreign exchange (Dollars) increases, other things remaining constant.
Effects of increase in demand for foreign exchange: Rise in imports, purchasing more financial assets
abroad, etc. will cause increase in demand for foreign exchange. Supply of foreign exchange remaining same,
the exchange rate is likely to rise. It implies ‘depreciation’ of domestic currency
The Exchange Rate (Rupees/$)
Y D’
(rupees). Depreciation means fall in the value of domestic currency relative D
S
to a foreign currency caused by a rise in the exchange rate under the flexible
exchange rate system.
Depreciation encourages exports as domestic goods become cheaper for the
e1
e*
foreign nationals, i.e., the international competitiveness of the goods of the
nation gets better. However, depreciation will make imports of foreign goods
costlier. So, imports fall. Since exports rise and imports fall, therefore, Net D’
Exports (Exports – Imports) will increase. Net Exports is a component of S D
Aggregate Demand. Therefore, aggregate demand will increase. Thus, national O

income is likely to rise.
X
Amount of Foreign Exchange ($)

Appreciation of Domestic Currency means a rise in the value of domestic currency when the price of foreign
currency in terms of domestic currency falls in a flexible exchange rate system. Appreciation decreases exports
since domestic goods become costlier for the foreign nationals. However, it will make imports cheaper for the
Indian residents since they have to pay less domestic currency to buy imported goods. So, imports rise. Since
exports fall and imports rise, therefore, Net Exports, Aggregate Demand and National Income may fall.
Fixed Exchange Rates
In a fixed exchange rate system, the Government fixes the exchange rate at a particular level. The Central Bank
actively uses its foreign currency reserves to maintain the officially determined exchange rate.
Suppose the market determined exchange rate is ` 70/$. However, the Indian Government wants to encourage
exports. So, it fixes a higher exchange rate, say ` 75/$. At this exchange rate, there will be excess supply of dollars
in the market. RBI intervenes to purchase the dollars for rupees to absorb this excess supply and maintain the
exchange rate at ` 75/$.
• In a fixed exchange rate system, when the government increases the exchange rate (thereby, making domestic
currency cheaper) is called Devaluation.
• In a fixed exchange rate system, when the government decreases the exchange rate (thereby, making domestic
currency costlier) is called Revaluation.
Managed Floating Exchange Rates (also called dirty floating)
Exchange rate is determined by the forces of demand and supply of foreign exchange, but the Central Bank may
intervene to buy or sell foreign currency to control the exchange rate fluctuations. Official reserve transactions are,
therefore, not equal to zero. Thus, it is a mixture of a flexible exchange rate system (the float part) and a fixed
exchange rate system (the managed part).

1. In which sub-account and on which side of balance Ans. Increasing import duty on gold will make imports of
of payments account, will Profits received from gold costly. It will reduce demand for import of gold
investments abroad be recorded? Given reasons. and consequently of foreign exchange. Supply of foreign
(3) exchange remaining unchanged, foreign exchange rate
Ans. It is recorded in the current account since it is an is likely to fall.
investment income (factor income). It will be recorded 6. Visits to foreign countries for sightseeing etc. by
on the credit side of the current account since it leads to the people of India is on the rise. What will be its
inflow of foreign exchange. likely impact on foreign exchange rate and how?
2. Giving reason explain how the following will be (CBSE 2014) (3)
entered in (i) current account or capital account Ans. It will raise demand for foreign exchange for spending
and (ii) on credit side or debit side of balance of the same in foreign countries. Supply of foreign exchange
payments : remaining unchanged, exchange rate is likely to rise.
(a) Imports of machinery 7. How does giving incentives for exports influence
(b) Investments from abroad (CBSE 2018) (6) foreign exchange rate? Explain. (CBSE 2014) (3)
Ans. (a) (i) Recorded in the current account, because it is Ans. Incentives for exports are aimed at increasing exports.
simply an import of a good. (ii) Recorded on debit side Increase in exports will bring more foreign exchange into
because it leads to outflow of foreign exchange. the country (i.e. increase in supply of foreign exchange).
(b) (i) Recorded in capital account because it is a Demand for foreign exchange remaining unchanged,
transaction in assets. (ii) Recorded on credit side exchange rate is likely to fall.
because it leads to inflow of foreign exchange. 8. Foreign exchange rate in India is on the rise
3. Which of the following is likely to raise the foreign recently. What impact is it likely to have on
exchange rate? (1) exports and imports? How ? (3)
(a) Govt. gives incentives for exports. Ans. Rise in foreign exchange rate means depreciation of
(b) Govt. doubled the import duty on gold. domestic currency. It makes Indian exports cheaper to
(c) Govt. promotes foreign direct investment. the foreign buyers. This is likely to increase exports.
(d) Visits to foreign countries by people increase. When foreign exchange rate rises, it makes the country’s
Ans. (d) Visits to foreign countries by people increase. imports costlier.The importers have to pay a higher price
4. Other things remaining unchanged, when in a in terms of domestic currency for the goods and services
country the price of domestic currency rises, imported. This may reduce demand for imports.
national income is: (1) 9. Suppose the present foreign exchange rate is
(a) Likely to rise (b) Likely to fall 1 $= ` 70. It rises to 1 $ = ` 74 leading to rise
(c) Likely to rise and fall both (d) Not affected in prices of imports of essential goods. How can
Ans. (b) Likely to fall Reserve Bank of India help in bringing down the
5. Recently Government of India has doubled the foreign exchange rate which is very high?
import duty on gold. What impact is it likely to (CBSE 2013) (3)
have on foreign exchange rate and how? Ans. Rise in exchange rate from 1 $ = ` 70 to 1 $ = ` 74
(CBSE 2014) (3) means depreciation of Indian currency. Foreign goods

become costlier. Prices of imports of essential goods rise. (a) In which sub-account and on which side of the
So, imports decrease. The Reserve Bank of India should Balance of Payments such lending is recorded?
sell US Dollars from its foreign exchange reserves. As a Give reasons.
result, supply of foreign exchange (dollars) in the foreign (b) Explain the impact of this lending on foreign
exchange market increases. It will lead to fall in the exchange rate.
foreign exchange rate. Ans. (a) Indians lending abroad is recorded in capital account
10. Government takes measures to restrict of the Balance of Payments because it is an international
autonomous imports of gold. Explain the economic transaction of assets. It is recorded on the debit side
values desired to be achieved from this. (3) because it leads to outflow of foreign exchange.
Ans. Restricting autonomous imports of gold reduces (b) Lending abroad increases demand for foreign
autonomous foreign exchange payments. So, BoP deficit exchange. Supply of foreign exchange remaining
decline and thus making improvement in the BoP position. unchanged, the exchange rate may rise.
11. How does foreign exchange speculation affect 17. What is the effect of rise in interest rates at home
the exchange rate? Explain with an example. (3) on the foreign exchange rate? Explain. (3)
Ans. Foreign exchange speculation will increase the demand Ans. A rise in interest rates at home will attract foreign
for dollars. Supply of foreign exchange remaining investors to invest in the home country. This will lead to
unchanged, increase in demand will cause the exchange inflow of more foreign currency (i.e. increase in supply
rate to rise in the present. of foreign exchange).
12. How can increase in foreign direct investment affect Demand of the foreign exchange remaining unchanged,
the price of foreign exchange and exports? (3) the exchange rate is likely to fall.
Ans. Foreign direct investment (FDI) is a source of supply of 18. Suppose a shirt costs $10 in the US and ` 600 in
foreign exchange as it brings in foreign exchange into India, what will be the effect on exports of India
the country. Demand for foreign exchange remaining if the rupee-dollar exchange rate is ` 70/$? (3)
unchanged, increase in FDI leads to increase in supply of Ans. At the exchange rate ` 70/$, it costs ` 700 per shirt in
foreign exchange. Therefore, exchange rate is likely to fall. the US but only ` 600 in India. That is, international
Fall in exchange rate means that exports become costlier competitiveness of shirts reduced in India gets better.
for the foreign buyers because they will now get less In that case, all foreign customers would buy shirts from
goods and services for each unit of foreign currency. This India. Thus, exports of shirts from India will increase.
will reduce demand for exports. 19. If USA has higher rate of inflation than in India,
13. According to recent media reports: ‘USA has US dollar will be depreciating. Do you agree with
accused China of currency devaluation to promote the given statement? Support your answer with
its exports’. In the light of the given media report an example. (3)
comment, how exports can be promoted through Ans. Yes, the given statement is true.
the Currency devaluation? (CBSE SQP 2019) (3) Example: Suppose a shirt costs $10 in the US and ` 700 in
Ans. USA has a valid point of argument as devaluation of a India, the rupee-dollar exchange rate should be ` 70/$.
currency encourages exports of a country. As exported Suppose prices in India rise by 20 per cent while prices in
goods become cheaper in the international market giving the US rise by 50 per cent. Indian shirts would now cost
a competitive edge for the goods of domestic country ` 840 per shirt while American shirts cost $15 per shirt.
(China). Devaluation of the value of domestic currency For these two prices to be equivalent, $15 must be worth
promotes the exports of the country and may adversely ` 840, or one dollar must be worth ` 56 (840/15). The
impact the production and sale of importing country (USA). dollar, therefore, has depreciated since USA has higher
14. What will be the effect of the following on the rate of inflation.
Balance of Payments of India? (3) 20. If inflation is higher in country A than in country
(a) ‘Make in India’ Programme B, and the exchange rate between the two
(b) Import of Pulses countries is fixed, what is likely to happen to the
Ans. (a) ‘Make in India’ will increase supply (inflow) of foreign trade balance between the two countries? (4)
exchange in India, causing improvement in the balance Ans. Since prices of goods in country A are more than that
of payments position. in country B, its exports to country B will decrease and
(b) Import of pulses will lead to outflow of foreign imports from country B will increase. Thus, country A’s
exchange from the country, causing adverse effect on trade balance (i.e., value of exports of goods – value of
balance of payment position. imports of goods) will show a deficit.
15. Explain the effect of rise in the price of foreign Since price of goods in country B are relatively less than
currency on the Balance of Payment situation. (3) that in country A, its exports to country A will increase
Ans. Rise in price of foreign currency (depreciation of domestic and imports from country A will decrease. Thus, country
currency) will make imports costlier. So imports will fall, B’s trade balance will show a surplus.
i.e., less outflow of foreign exchange from the country. 21. Explain the effect of rise in income at home on the
Also, depreciation causes increase in exports since exchange rate. (4)
international competitiveness of the domestic goods Ans. When income of people of India increases, consumer
gets better. So exports will increase, i.e., more inflow of spending increases. Spending on imported goods is
foreign exchange into the country. Thus, net inflow of also likely to increase. When imports increase, the
foreign exchange increases which has favourable effect demand for foreign exchange rises. Supply of foreign
on the Balance of Payments position. exchange remaining unchanged, the exchange rate is
16. Indian investors lend abroad. Answer the likely to rise.
following questions: (3)

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40 Marks

CBSE Syllabus Unit 3: Producer Behaviour and Supply

Exam Handbook in Economics-XII – by Subhash Dey 1

2 Exam Handbook in Economics-XII – by Subhash Dey

resources are efficiently employed. (v) No resource is equally efficient in

Exam Handbook in Economics-XII – by Subhash Dey 3

Application, HOTS, Evaluation and Multi-Disciplinary Questions

4 Exam Handbook in Economics-XII – by Subhash Dey

Exam Handbook in Economics-XII – by Subhash Dey 5

2.2 Consumer’s Equilibrium – Indifference Curve Analysis

Marginal rate of substitution (MRS) 11

6 Exam Handbook in Economics-XII – by Subhash Dey

Quantity of five-rupee coins (Qy)

Indifference Map and Monotonic Preferences

Properties or characteristics of indifference curve O 1 2 3 Good X X

The equation of the budget line is Px.Qx + Py.Qy = M.

The slope of the budget line is (–) Px/Py.

So, Px/Py is called market rate of exchange.

Exam Handbook in Economics-XII – by Subhash Dey 7

remain unchanged, therefore the slope of the new budget line

2. Change in prices of one or both the goods: Change in prices of

constant. The budget line rotates outwards and becomes flatter.

8 Exam Handbook in Economics-XII – by Subhash Dey

10 Exam Handbook in Economics-XII – by Subhash Dey

• When the percentage change in

Application, HOTS, Evaluation and Multi-Disciplinary Questions

Exam Handbook in Economics-XII – by Subhash Dey 11

12 Exam Handbook in Economics-XII – by Subhash Dey

Exam Handbook in Economics-XII – by Subhash Dey 13

14 Exam Handbook in Economics-XII – by Subhash Dey

3.2 Cost: Short Run Costs (Meaning and their Relationship)

Exam Handbook in Economics-XII – by Subhash Dey 15

16 Exam Handbook in Economics-XII – by Subhash Dey

Exam Handbook in Economics-XII – by Subhash Dey 17

3.4 Supply and Price Elasticity of Supply

price and quantity supplied of a commodity. Therefore, the supply curve of

18 Exam Handbook in Economics-XII – by Subhash Dey

Application, HOTS, Evaluation and Multi-Disciplinary Questions

Labour TPP APP MPP Ans. Labour TPP APP MPP

Units of Variable Input 1 2 3 4 5

20 Exam Handbook in Economics-XII – by Subhash Dey

Q AFC MC TC Ans. Q TFC AFC TVC AVC TC AC MC

Q MC AVC AFC AC Ans. Q MC TVC AVC TFC AFC AC TC

Exam Handbook in Economics-XII – by Subhash Dey 21

22 Exam Handbook in Economics-XII – by Subhash Dey

Exam Handbook in Economics-XII – by Subhash Dey 23

24 Exam Handbook in Economics-XII – by Subhash Dey

Forms of Market and

Exam Handbook in Economics-XII – by Subhash Dey 25

Maximum Price Ceiling

26 Exam Handbook in Economics-XII – by Subhash Dey

Exam Handbook in Economics-XII – by Subhash Dey 27

4.2 Monopoly, Monopolistic Competition and Oligopoly

Exam Handbook in Economics-XII – by Subhash Dey 29

Application, HOTS, Evaluation and Multi-Disciplinary Questions

30 Exam Handbook in Economics-XII – by Subhash Dey

means that the supply curve shifts leftward from SS to S1S1. S

supply. OP1 is higher than the old price of tomatoes.

Times: “Households in Southern India prefer to eat oranges for breakfast as O

grapes have also risen.” and supplied of tomatoes

Exam Handbook in Economics-XII – by Subhash Dey 31

Price per unit

market supply. OP1 is higher than the old price of oranges.

be competition among the sellers. and supplied of oranges