UPSC CSE Topper Mains Answer [Gaurav Agarwal]

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Disclaimer

The answers given below reflect just my understanding and what I may have written. They may not be accurate so please exercise discretion. Your comments on the accuracy of these answers welcome. 🙂

Instructions

There are 8 questions divided into 2 sections. Question no. 1 and 5 are compulsory and out of the remaining 3 are to be attempted with at least 1 from each section.

SECTION – A

Q 1. Answer the following in about 150 words each:- (10 x 5 = 50 marks)

Q 1.a Consider a perfectly competitive exchange economy with no production, and two different goods 1 and 2. Let p1 and p2 be prices of the goods. The economy is populated by 2 people A and B. A’s initial endowment of the two goods is given by (wa1, wa2) and B’s initial endowment is (wb1, wb2). A can choose any bundle (xa1, xa2) and B can choose any bundle (xb1, xb2). In this pure exchange economy write out the conditions for a Walrasian equilibrium. Show that for such an economy for any equilibrium set of prices that the absolute price level is indeterminate.

Ans. 

Initial equilibrium

Let us draw the edgeworth diagram.

Let initially A and B be at e0. Here A’s endowment is (wa1, Wa2) and B’s endowment be (wb1, wb2). They are at indifference curves ICa and ICb respectively.

Condition for Walrasian equilibrium

For Walrasian equilibrium, A and B will have to reach a pareto optimum point via exchange. The pareto optimum point will lie on the contract curve. The conditions needed for such an equilibrium are: (MRS1,2)a = (MRS1,2)b = P1/P2. 

Absolute price indeterminacy

As we can see in the diagram, depending upon their relative bargaining strengths, A and B can reach any point between e1 and e2. Let this be e3. But at e3 also, the Walrasian equilibrium condition will only tells us the relative prices i.e. P1/P2 and not the absolute price level because we will only know the slop of the price line. So absolute price level will be indeterminate. (Unfortunately in the exam, I merely showed that multiple points are possible between e1 and e2. So will lose marks on the absolute price section here.)

Q 1.b Kaldor in his theory of distribution argues, unlike Kalecki, that it is not reasonable to neglect the constraint of labor shortage, and analyse a situation of full employment. Show how investment and savings propensities determine distributive shares in the Kaldor approach. Suppose that investment is not exogenous as in Kaldor’s original model but that it varies with profits. What does this mean for the stability of Kaldor model of distribution?

Ans. 

Assumptions of Kaldor

  1. Marginal propensities to save out of wages and profits remain constant. So average propensities to save = savings rate = marginal propensities to save = sw for wages and sp for profits. 
  2. sp > sw.
  3. Investment (I) is exogenously given.
  4. Full employment assumption.

Model

We know that in full employment, planned savings = planned investment.

Planned savings = savings from wages + savings from profits = sw*W + sp*P. This is equal to planned investment. So I = sw*W + sp*P.

Now in economy, let Y be total income. Income = wages + profits. So Y = W + P or W = Y – P. 

Substituting W in 1st equation, I = Sw*(Y-P) + sp*P. A bit of algebra and we will get, P/Y = (1/sp-sw) * I/Y – (sw/sp-sw).

Investment not exogenous

If investment varies positively with profit, then we see that as investment rises, profits rise which fuels investment further which raises demand further and hence inflation. So economy is not stable. Similarly in such a case, demand depression too would spiral down. (I am not sure about this reasoning though and may lose marks in the exam if wrong.)

Q 1.c Explain the determination of output and employment in a macroeconomy under the conditions when individuals are subject to (i) no money illusion, (ii) money illusion).

Ans.

Case 1: No money illusion

Let initial equilibrium be at E. Let the prices fall. This leads to a situation where real wages rise from w0/p0 to w1/p1. Demand for labor is less than supply of labor, so unemployment appears. But workers are under no money illusion, they realise their real wages have gone up. They are open to nominal wage cuts and unemployment pressure will now act to cut the nominal wages. Soon full employment returns where real wages are same as before (w1/p2 = w0/p0). So output too remains at full employment.

Case 2: Money illusion

Here give the above reasoning, but only say that workers are under money illusion, so resistant to nominal wage cuts. So involuntary unemployment prevails.

Note: The above reasoning is when prices fall. Similar reasoning can be given when prices rise and it would be equally correct. When prices rise, in money illusion, firms will produce and employ more thinking their profits have gone up and workers will not reduce their labor thinking their wages have not gone down.

Q 1.d An individual finds that all his receipts (including income) and payment transactions are in the form of money that bears no interest. However, he can convert money into bonds and earn interest income but that involves a fixed cost of each conversion transaction. What are the determinants of the individual’s demand for holding money?

Ans.

This is the Baumol Inventory Model for transaction demand of money.

Let the income be Y. Let he withdraws cash C at a time. Let the transaction cost per transaction be fixed b. Let interest rate be r. 

The individual will now look to minimise his overall costs which is transactions cost + opportunity cost of lost interest.

transaction cost = (Y/C) * b because Y/C gives us the number of times he converts into bonds.

opportunity cost of lost interest = (C/2) * r where C/2 gives us his average cash holding for the period and r is the interest rate on bonds.

So we have to minimise Total Cost = (Y/C) * b + (C/2) * r. Differentiating wrt C and equating to zero, we get C = square root of (2Yb/r).

So the individual’s demand for holding money will increase with the square root of his income, transaction cost. And will decrease with the square root of the interest on bonds.

Q 1.e Suppose an industry is characterised by the following 3 conditions: (i) there area a large number of small firms, each producing a differentiated product and facing a downward sloping demand curve; (ii) each firm ignores the effects of its actions on the decisions taken by other firms; and (iii) new firms producing close substitutes for the product of the existing firms can enter the industry. Then derive the equilibrium conditions of an individual firm and of the industry.

Ans.

This is the Chamberlin’s Monopolistic Competition Model.

Additional Assumptions

  1. Firms show myopic behavior i.e. don’t learn from past mistakes.

Model / Equilibrium conditions

Due to the presence of large number of firms, it is expected that the decisions of a firm on changing its strategy will have negligible effect on each of the other firms so as not to induce any reaction from them. Thus a firm can plan its strategy drawing a demand curve independent of the reactions of other firms. This can give us the firm’s planned demand curve (dd curve). But while a firm plans its actions on dd curve assuming other firms won’t react to its decisions, in reality other firms may also change their strategies (either the same factors which induce this firm to change also induced others to change in order to maximize their own π or some other factors). The market share demand curve (DD) gives the actual demand curve of the firm after incorporating the effects of the changes made by the other firms.

  1. A movement along the DD curve indicates a price competition among the incumbent firms whereas a shift in DD curve indicates free entry / exit. Initially let the firm is @ e1. 
  2. But it is earning supernormal profits. So new entrants will come and DD curve will shift to left (from DD1 to DD2) and the new equilibrium will be @ e2. At this point the DD curve is a tangent to the LAC curve. So all supernormal profits vanish and we would expect this to be the equilibrium. But it is not.
  3. The dd curve of the firm is not a tangent to the LAC curve but lies above it. So the firm would think if it reduces the price further, it would move on the dd2 curve and earn supernormal profits. So it reduces the prices. But all firms think the same and all of them reduce the prices. So instead of moving on dd2 curve the movement is on DD2 curve. The firm moves to e2′ but at this point there is a loss. So firms would begin to exit and the DD curve will shift from DD2 to DD3 such that the new dd3 curve is a tangent to the LAC curve. This is the point of equilibrium.

Q 2.a Under the Bertrand price competition with homogenous products in an oligopoly demonstrate how is the equilibrium price that will prevail is arrived at? (25 marks)

Ans.

Assumptions

  1. 2 π maximizing firms only and they face same demand and cost curves. Product is absolutely homogenous. Entry is restricted. MC = AC = constant.
  2. Both firms have large number of small buyers.
  3. There is no capacity constraint and any firm can meet the entire market demand at any price level.
  4. No state interference and no externalities.
  5. At the beginning of each period, each firm will assume that the other firm will keep its price same as that in last period.

Model

  1. Let initially firms divide the market among themselves. They will assume monopoly power within their market and act like a monopolist.
  2. But in the next round, the rival firm will realise that if it prices its product just below the other firm, it can capture the entire market share. It does that and captures whole market. In the next round, the other firm will do the same.
  3. It is clear there will be a price war (since by undercutting the price of the rival under the assumption that it will not change its price) any firm can capture the whole market. The price war will continue until the price becomes equal to the unit cost of production below which no firm will have the incentive to cut. 
  4. If at such a situation a firm raises the price to the monopoly price level again, it will face the risk of losing its entire market share and selling zero. This is because the firms are assumed to have infinite capacity and the product is supposed to be homogenous. So it will not raise its prices and the Bertrand equilibrium is when no firm earns a supernormal profit where price = average cost and there is no incentive to either cut the price or raise it.

Q 2.b Let the market demand curve for carbonated water be given by P = 20 – 9Q/2 where P is the price and Q is the market output. Let there be 2 firms producing carbonated water, each with a constant marginal cost of INR 2 or c1 = c2 = 2.

What is the market equilibrium price and quantity when each firm behaves as a Cournot duopolist? What are the firms’ profits?

What is the marekt equilibrium price and quantity when each firm behaves as a Bertrand duopolist? What are the firms’ profits? (25 marks)

Ans.

Cournot equilibrium

  1. Production on reaction curve: A firm will always produce on its reaction curve. This is because it wants to make the highest possible profit for any given production by the rival. We know that isoprofit lines closest to the axis gives the highest profit. So for any given production by B, A would like to chose an isoprofit line which just touches B i.e. for which B is the highest point. This is nothing but A’s reaction curve so A will always produce on its reaction curve. Similar argument can be run for B.
  2. Thus any equilibrium can be reached only where both reaction curves intersect i.e. point e. But @ e the industry profits are not maximized and pareto improvement is possible. Point p which is the point of tangency can be one pareto optimal point.

Total revenue of Firm A = P * Q1 = (20 – 4.5Q1 – 4.5Q2) * Q1. Marginal revenue MR = 20 – 9Q1 – 4.5 Q2 (by simple differentiation of total revenue wrt Q1). A reaction curve maximises profit, so on the reaction curve MC = MR. In our case, 20 – 9Q1 – 4.5 Q2 = 2 or 2Q1 + Q2 = 4. 

Since both firms have identical costs, reaction curve of firm B will be, 2Q2 + Q1 = 4. Solving these 2 together, we get, Q1 = Q2 = 1.33333. P = 8. Profit of each firm = (8-2) * 1.3333 = 6 * 1.3333 = Rs. 8

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Bertrand equilibrium

In Bertrand, Price = unit cost. In our case, unit cost = Rs. 2. So price = 2. This gives Q = 4. Since both firms are identical, Q1 = Q2 = Q/2 = 4/2 = 2. Profit of each firm = (2-2) * 2 = 0.

Q 3.a If workers supply labor on the basis of an expected real wage, how is the aggregate supply of output determined in the economy? Suppose aggregate demand and supply are below the natural rate of unemployment and output. Would the New Classical economists advocate any particular policy intervention when the economy is in such a situation? (25 marks)

Ans.

Note: I didn’t attempt this question.

Determination of AS and output

First part is the standard New Classical Model. Here one has to define Rational Expectations hypothesis and first i.e. workers would make ‘best’ use of all available information and won’t make any systematic mistakes while forming their expectations. They behave as predicted by the relevant economic model. Then one has to give the Continuous Market Clearing hypothesis that markets clear quickly so that full employment is maintained. So if suppose the government tries to lift demand by monetary expansion, AD curve will shift from AD0 to AD1. But economy is already at full employment, so output can’t increase and monetary expansion will only cause more inflation. So workers won’t get fooled and will not offer additional labor. Economy will move from a to b and SAS is vertical as well.

Policy intervention

Here draw a nice Philips curve and also the above diagram, but showing the equilibrium point to the left of full employment. Then say New Classical will suggest no intervention because they believe in policy inefficacy. Wages will quickly fall and full employment restored in such a situation on its own.

Q 3.b What are the main goals of a central bank? What are the instruments by which the central bank manages the liquidity in the financial system and how does it use these instruments to achieve its goals? (25 marks)

Ans.

Note: I didn’t attempt this question.

Main goals (In India)

  1. Price stability.
  2. Maintaining reasonable rate of growth.
  3. Maintaining external balance.
  4. Promoting financial inclusion.
  5. Financial stability of the economy.

Instruments to manage liquidity

  1. LAF – Repo rate, reverse repo, MSF.
  2. Open market operations.
  3. Bank rate (although no more used).
  4. CRR.
  5. SLR.
  6. Direct credit controls.
  7. Prescription of CAR for banks and NBFCs.

Just put 1 line each on how they are used to amnage liquidity.

Q 4.a Macroeconomics is usually approached via the outcomes of economic interaction in the following 4 markets – commodities, money, bonds, and labor markets. The Classical economists focused on which 3 of these 4 markets? In which market does the loanable fund theory of interest rate determination of the Classical economists focus and how is the interest rate determined? The Neo Classical synthesis focuses on which 3 markets? In which market is the interest rate primarily determined in the liquidity preference theory? (25 marks)

Ans. 

Note: I didn’t attempt this question as not sure about some parts.

Classical economists

Focused on commodities, money and labor markets.

Explain the above diagram briefly how labor market determines output (Y = f(L) in short run).

They also followed Classical dichotomy i.e. money is neutral and just determines the price level. Give Fisher’s QTM equation, MV = PY.     

Loanable Funds

Focused on the commodities market. It basically said as people decide to save more, interest rates will fall and investment would increase. Like Say’s law. Draw the diagram here.

Neo-classical synthesis

I thought it focuses on all 4. But anyways, if one has to choose only 3, IS curve focuses on goods market. LM curve focuses on money market. Labor market determines the equilibrium in IS as well. Draw neat diagrams.

Liquidity preference

4

Q 4.b After 2003 till 2008 many emerging economies including India received huge capital inflows. To contain the effect of these flows, the central bank sterilized the inflows. What is sterilization and how does it affect the supply of money in the economy? (25 marks)

Ans.

When foreign funds flow in, people sell $ aniontain these pressures, RBI may conduct sterilization operations where RBI will issue short term bonds to mop up excess INR liquidity. It may also buy INR in spot market and sell in forwards. This is sterilization.

It will reduce the money supply in the economy and push short term interest rates higher.

Now just draw a couple of neat diagrams: One showing IS-LM-BP curve with equilibrium point if IS-LM above BP curve indicating external surplus. Show a dotted LM line to right indicating increased liquidity due to RBI interventions. Then in next figure show the dotted line shifting back up indicating sterilization.

SECTION – B

Q 5 Answer the following in about 150 words each:- (10 x 5 = 50 marks)

Q 5.a What are the 3 basic goals of public finance? Can these goals be coordinated into an overall pattern of policy or they are always in conflict? (10 marks)

Ans.

Basic goals

  1. Equity: People with higher ability to pay should pay more (vertical equity) and those with equal ability to pay should pay equal (horizontal equity). Expenditure should also promote equity.
  2. Development: Tax revenues should be sufficient to finance the development expenditure of the government.
  3. Efficiency: Public finance should increase the efficiency of the economy, make it more competitive, encourage people to work more.

Conflicts

  1. However, these objectives may be conflicting. Eg. a highly progressive may increase equity and satisfy development objective, but hampers economic efficiency. It discourages people with higher income from working.
  2. A general consumption tax may be efficient but violates equity principle since consumption forms a higher part of poors’ incomes.
  3. On specific commodity tax, Ramsey’s rule advocates higher taxes on inelastic items like necessities and lower taxes on elastic items like luxuries. But this violates the equity principle.
  4. Income tax may violate the horizontal equity principle.
  5. Lump sum tax doesn’t cause any efficiency loss but is highly inequitable.

Harmony

  1. A balance among the tradeoffs has to be achieved. 
  2. Taxes on leisure luxury items may encourage people to work more thus increasing efficiency as well as promoting equity and development.
  3. Wealth tax again can promote equity, development and efficiency.
  4. Tax on inelastic land supply also doesn’t compromise on efficiency.

Q 5.b What is an offer curve in international trade? For 2 countries engaged in trade in 2 goods, draw the offer curves such that the offer curve of the home country has a section reflecting inelastic import demand and the foreign country’s offer cure is elastic throughout. Indicate in your diagram which part of the home country’s offer curve is inelastic. What is the reason for this shape of the offer curve? Suppose the home country imposes a tariff on imports. Demonstrate the implications for trade. (10 marks)

Ans.

What is an offer curve

It determines the relative price of commodities at which trade can take place. For any given quantity of a commodity, it shows the amount of the other commodity the country is willing to exchange. Offer curves can be derived from the PPF analysis. In the PPF as can be seen @ price P3, the country is willing to export DE3 amount of Y in exchange of DC3 amount of X. Thus plotting all such points we can get the offer curve. 

Inelastic offer curve

Reason for this shape

Elasticity: σoc = % change in imports / % change in exports   = (∆MM) / (∆X/X). @ E1, (∆M/∆X) = E1N/MN. and (X/M) = ON/E1N.  So σoc = ON/MN. So flatter the offer curve, the more inelastic it is. This also shows that the country’s import demand is so inelastic that it is willing to offer any amount of exports for it.

Imposition of tariff

On trade, tariff imposition will reduce trade volume (offer curve shifts from Oa to Ob) and also increases the terms of trade of the tariff imposing country (if it is a large country).

Q 5.c Summarize the main arguments of the trade optimists and trade pessimists with regard to trade policy for developing countries. Which argument does data tend to support? (10 marks)

Ans.

Arguments for and against

Pretty standard, don’t need to reproduce here.

Data

  1. East Asian economies’ experience is pro trade.
  2. Our own experience post and pre liberalization is pro trade.

Q 5.d State 5 reasons that support government intervention in agricultural markets. (10 marks)

Ans.

  1. Poor and marginal farmers: Hence the need for subsidies and MSPs.
  2. Food security: Due to large poor population, hence need of MSPs and PDS.
  3. Hoarding and inefficiency supply chain.
  4. Encourage cultivation of desired crops: Like pulses, oil seeds etc.
  5. Crowding in: Govt. intervention leaves more money in farmers’ hands who can invest. Govt. investment too crowds in private investment.

Q 5.e Expand on the following explanations for the Kuznets hypothesis bout inequality and development — (i) the cohort size hypothesis, (ii) the effect of openness on inequality, and (iii) the strong versus the weak version of the hypothesis. (10 marks)

Ans.

Note: I didn’t know (i) and (iii) so couldn’t attempt these. Attempted only (ii)

(ii) Effect of openness on inequality: 

  1. A trade liberalization-versus-inequality graph has a measures trade openness along the x-axis and inequality along the y-axis. By studying data from several Latin American countries that have implemented trade liberalization policies in the past 30 years, the Kuznets curve seems to apply to the relationship between trade liberalization and inequality (measured by the GINI coefficient). 

Cohort (means a group )size hypothesis link population in different age groups to earning and income inequality. According to the hypothesis if there is glut in middle age population that is working population than inequality in economy is likely to be lesser. On the other hand when there is fat young cohort or fat old cohort income inequality is likely to be higher. This is because a small proportion of population in middle income earns greater proportion out of total income. However in case of Kuznets hypothesis( KH) inequality solely depends on level of development and is not linked with changing composition of population in different age groups.

In contrary to H-O model prediction with openness that is globalization and liberalization inequality has increased. This can be attributed to movement of factors across the country which H-O model assumed to be absent in the model. Though with openness countries have witnessed development with rising GDP level but inequality has also increased even in the countries like USA which are highly developed in contrary to prediction of KH.

Strong version of KH is completely driven by demand for factors. Thus in initial phase of development structural and technological change tends to favour capital and skills consequently economy uses labour saving technology and inequality increases with surplus of labour unemployed or under employed. However in later phase with increasing skills and trickledown effect inequality decreases. Strong version of KH theory is called so because it is unconditioned on any other factor.

On the other hand weak KH is more sophisticated. It argues demand forces can be reinforced or reduced by other factors if they are sufficiently powerful. For example migration to labour scarce countires like OECD will increase remittances along with reducing surplus labour in country giving room to increase wages consequently reducing income inequality in early stage of development.

Q 6.a Suppose a given yield of tax is to be obtained from an excise on a particular product in a perfectly competitive economy. If the objective is economic efficiency the government would prefer that tax which obtains the desired yield with a lesser increase in the price. Should the government impose a unit tax or an ad valorem tax if the objective is that they should both impose the same burden at the initial price before the imposition of the tax? Demonstrate your answer with a diagram. (25 marks)

Ans. 

No idea whatsoever. Did not attempt.

Q 6.b What is rent seeking? Consider a proposal by a government to levy a proportional tax on income so as to subsidize the consumption of a good. The proportional tax at a rate t reduces the wage received to w*(1-t) which with a standard upward sloping supply of labor curve will reduce the hours of labor worked from say L2 to L1. The net income of the person falls and tax revenue will be twL1. This is transferred as a subsidy which reduces the price of a subsidized good from P to P-S and increases the quantity demanded from Q1 to Q2. What is the valuation of the subsidy by the recipient? Is it equal to the value of taxes paid to finance the subsidy? If the tax payer decides to devote resources to rent seeking to forestall the policy to subsidize the good and the subsidy recipient is also willing to devote resources to encourage the adoption of policy, who will have the advantage in the rent seeking context? (25 marks)

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Ans.

Don’t know apart from drawing one or two figures. Did not attempt.

Q 7.a Suppose the goods, financial, current account and foreign exchange markets are initially in equilibrium. The economy has low or imperfect capital mobility and operates at a fixed exchange rate. The economy is subject to a favorable demand shock that raises expenditure. What is the outcome of the shock on aggregate income and interest rate in the short run? How is the balance of payments equilibrium achieved? Draw a diagram to support your answer. (25 marks)

Ans.

Assumption

  1. Economy has slack i.e. below full employment.
  2. No sterilization by central bank.

Initial equilibrium

@ E, IS (goods market), LM (financial market) and BP (external market) are in equilibrium. BP curve is steeper than LM curve to show imperfect capital mobility.

Favorable demand shock

  1. The IS curve will shift to right (IS –> IS’). It will intersect LM curve at Z’. 
  2. So in short run, aggregate income will rise and interest rate will rise.

BoP equilibrium re-establishment

  1. @ Z’, economy faces BoP deficit. This is because the increase in income has increased the imports more than the additional capital inflows caused by the rise in interest rates. So there will be a BoP deficit, people will buy $, sell INR. But due to its commitment to maintain fixed exchange rate, central bank will have to intervene and sell $, buy INR. This will reduce domestic INR liquidity and make LM curve shift left (LM –> LM’).
  2. We will reach a new equilibrium on BP curve @ F where IS’, LM’ and BP intersect. Thus external equilibrium is re-established.

Q 7.b What is a speculative attack on a currency? Suppose the economy has a fixed exchange rate and the government is following an expansionary macroeconomic policy. The government increases the budget deficit which it finances through a monetary expansion. How does this lead to a crisis? What is the timing of the speculative attack? (25 marks)

Ans.

Speculative attack

This means when speculators and traders start taking big bets against the central bank on a currency for either its massive devaluation or revaluation (devaluation mostly). The bets become so huge that they put so much pressure on the central bank and forces it to devaluate (or revaluate) the currency.

Crisis development

  1. Assumptions
    1. Y < full employment output.
    2. No sterilization by central bank.

Let the economy initially be at E0 where IS, LM, BP curves intersect. Now expansionary fiscal policy takes IS curve to IS’ from IS. We go to E1. Now expansionary monetary policy takes LM curve to LM’ from LM. We go to E2. But at this point, our imports have gone up too much (due to rise in income) but our capital flows are insufficient to cover them. So we have a BoP deficit. The central bank will intervene, sell $< buy INR. But its fx reserves will start to run down and soon speculative attacks will start.

Timing

When the reserves of central bank start to run down or it seems central bank will no longer be able to sustain its current policy.

Q 8.a Explain the Lewis model of structural change from an agricultural economy to a modern industrial economy. State 3 major criticisms of Lewis model. (20 marks)

Ans.

Assumptions

  1. 2 sector dual economy. Agriculture which is primitive, suffers from disguised unemployment and industry which is modern. Disguised unemployment is the employment of labor which has got ≤ 0 or at least < subsistence wage MPPL. This means that a release of labor from agriculture will not reduce the APPL and may even raise it. 
  2. Agriculture is a sector which suffers from diminishing returns (because the total quantity of land is fixed). Thus huge amount of surplus labor exists in the agriculture in the form of disguised unemployment and which is willing to find employment in the higher paying industrial sector in want of higher wages. Thus there is a markup of wages in the industrial sector (Lewis took it @ 30%). The huge surplus labor from agriculture ensures that even when employment in industrial sector goes up, the wages don’t go up.
  3. All wages are consumed and all profits are saved and invested. 
  4. There is sufficient demand always to absorb all the additional production without any fall in prices.
  5. Static technology.

Model

  1. The model shows how the process of industrial expansion or capital accumulation is self sustaining and will absorb all the surplus labor from agriculture.
  2. Let wm be the wages in manufacturing (industrial) sector and wa be the wages in agriculture. In period 1, with some initial investment total production will be the area under the marginal product curve (MP1). Out of this only wm has to be paid out as wages and rest is the surplus which is saved and all of it is reinvested in the economy. Labor employed in period 1 is L1. 
  3. In the next period, the profit from period 1 will be reinvested, new capacity would be setup. As a result the marginal product will go up (from MP1 to MP2) and hence the demand for labor would increase. But the new labor can be hired at the same wage rate (surplus labor assumption). So L2 amount of labor (> L1) would be hired and new surplus would also be higher which would get reinvested in next period and so on. Thus this cycle continues at an increasing rate until all surplus labor is absorbed. 
  4. According to Lewis as industry expands, the share of profits in the national income will also rise. This is because  – (a) Share of profits in industrial sector will rise (such is the case when successive MPPL curves are drawn parallel to each other). (b) Share of industrial sector in GDP itself will rise. The increasing profits serve as an incentive to reinvest them in building new capacity as well as the source to finance it. The increasing profits are guaranteed by constant wages and sufficient demand which will prevent a fall in prices.
  5. When the modern sector expands and workers earn higher wages there will be a rise in prices as the workers are paid out of the new money created. But when the formed capital is put to use output of consumer goods will also increase leading to a stabilization in prices. Further with the expansion of modern sector, not only do output and employment increase but also profits. As the share of profits increase the amount of investment being financed out of the created money diminishes and ultimately the increase in voluntary savings kills inflation.
  6. The expansion stage comes to an end when there is no surplus labor left in the agriculture and now both industry and agriculture begin to compete for labor. @ this point agriculture is said to be commercialized and end of take off stage is defined.

Limitations

  1. Technological changes: Lewis assumes that the surplus will not be invested in labor saving technologies or management techniques and thus increased surplus and investment will necessarily mean increased employment. This has not been the case empirically as is evident from the Indian experience. Since 1993-94, the output growth rate has been very high (specially from modern sectors) but organized employment has been falling at the rate of -0.33% p.a. On the other hand rural to urban migration has increased but this is merely shifting the surplus labor situation from agriculture to unorganized sector.
  2. Demand deficiency and declining terms of trade: Lewis assumes that there will be endless demand for the produce which will prevent a fall in prices. This is clearly not the case in current economy. agriculture’s role as a market for industrial goods is neglected but agriculture consumes a good part of the industrial output. If it doesn’t grow then it will lower the growth in aggregate demand. 
  3. Wage goods gap: It neglects the importance of agriculture in sustaining the capital formation in industrial sector. It must be noted that as labor moves from agriculture to industry, their income will rise and hence demand for food grains (wage goods). If the supply of these food grains is not increased, their prices will rise which will lead to higher wages and hence a collapse of the model itself on its own feet. 

Q 8.b It is said that a characteristic of the Harrod-Domar model is that even for the long run the economy is at best balanced on a knife edge of equilibrium growth. Explain the Harrod-Domar model and the reason for this characteristic. (15 marks)

Ans.

Objective

  1. He asks the question – if changes in income induce investment, what must be the rate of growth of income for plans to invest to equal plans to save in order to ensure a moving equilibrium in a growing economy through time? Moreover, is there any guarantee that the required rate of growth will prevail? If not, what will happen? In static Keynes, if the equilibrium between S & I is disturbed then the economy corrects itself to a new equilibrium level. However, if growth equilibrium is disturbed then will it be self correcting or self aggravating? Also will this equilibrium rate be equal to the maximum rate of growth that the economy is able to sustain given the rate of growth of productive capacity? If not, what will happen?
  2. Thus he wanted to determine that unique rate at which investment and income must grow so that full employment level is maintained over a long period of time i.e. equilibrium growth is achieved. This is only possible if the additional demand generated by the investment is equal to the additional productive capacity created by it.

Assumptions

  1. Economy starts from the full employment point. 
  2. Marginal capital – output ratio (v = ∆K/∆Y) is same as average capital – output ratio (K/Y) and is greater than 1.
  3. Marginal propensity to save (s) is equal to savings rate in the economy (s) i.e. marginal propensity to save remains constant at all levels of income and the intercept term is zero.

Model

Harrod’s 1st Growth Equation

  1. Increase in income (∆Y) depends on increase in stock of capital (∆K) during a period and the actual capital – output ratio (ν = ∆K/∆Y). So ∆Y = (∆K/v).
  2. Now ∆K = I i.e. change in capital stock is nothing but investment. Thus ∆Y = (I/v). To express as growth rate, we rewrite as (∆Y/Y) = (I/Y)/v or Gy = (I/Y)/v where Gy is the actual growth rate. Thus it is clear that growth rate will be higher if investment as a proportion of GDP is higher or capital – output ratio is lower.
  3. In Keynesian framework, actual savings = actual investment. Thus Gy = (S/Y)/v or Gy = s/v.

Harrod’s 2nd Growth Equation

  1. The 1st equation is merely a definitional equation. We need more than a definitional equation to know whether the actual growth rate will provide the basis for a dynamic equilibrium in the sense it keeps the plans to save equal to the plans to invest @ full employment level. This is the warranted growth rate (Gw) which is that growth rate which induces just enough investment to match planned savings and thus keeps capital fully employed (and also labor since full employment assumption) so that manufacturers are willing to carry on investment in the future at the same rate as in past. 
  2. How is the Gw determined? Plans to save at any point in time are given by the Keynesian function: S = sY and this gives us the potential supply of investment goods. The demand for investment goods is given by the acceleration principle Ir = vr.∆Y where the vr is the warranted capital-output ratio and is given by ∆Kr/∆Y. This ratio is determined by technological conditions. Thus we get, s.Y = vr.∆Y or Gw = (∆Y/Y) = s/vr. At this rate expenditure on consumption goods will be equal to production of consumption goods as well.
  3. While vr is the desired capital – output ratio, v is the actual capital – output ratio. Let us consider the case when there is a departure of actual growth rate from the warranted growth rate. If say there are recessionary conditions (i.e. Gy < Gw), it means v > vr or the installed capital is not fully utilized. This means there is a surplus of investment goods and this will depress further investment. But if further investment falls down then the further growth rate will fall down as well and there is no method to ensure Gy increases and becomes equal to Gw again. Similarly in boom conditions (i.e. Gy > Gw), v < vr or the installed capital will be more than fully utilized. This shortage of capital induces the producers to invest more which takes further Gy even higher and away from Gw. Thus any deviation is self aggravating.
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Harrod’s 3rd Growth Equation

  1. Now even if the economy grows at the rate required for full utilization of capital (i.e. Gw) this still doesn’t guarantee the full employment of labor. This is because of 2 reasons – (a) Gw depends on technical factors (say how many machines are required to build one unit of output) while full employment of labor must necessarily depend on labor growth. (b) Harrod assumes labor and capital are not substitutable. Thus he conceives the natural growth rate (Gn) which is equal to the summation of labor growth rate and labor productivity growth rate (thus Gn = n + q where n is the labor growth rate and q is growth rate in its productivity which is made possible by technical considerations). Both n and q are thus exogenously determined.
  2. This natural growth rate defines the equilibrium rate of growth in the long run (clearly in the long run for the full employment equilibrium, Gy = Gn). Also if Gy > Gw then Gy will increase but this expansion can’t go on indefinitely (the availability of labor and natural resources will put a limit to it) and the increase in Gy will stop once it hits Gn. The long run question for the economy, thus, is the relation between Gw and Gn. For the full employment of both labor and capital, the required condition is Gy = Gw = Gn. This is also called Harrod’s golden age.
  3. Knife edge problem: The equality of all growth rates is called the balanced growth equilibrium or the growth rate. But it is seldom achievable. This is because they are determined by s, vr, n and q which are determined quite independently of each other. Gw is determined by s and vr, Gn by n and q. Thus if Gw > Gn there will be a tendency for chronic depression (since Gy = Gn in LR) and the actual growth rate will never be sufficient to stimulate investment demand to match the amount of planned savings. There will be too much of savings. If Gw < Gn then there will be a tendency for chronic inflation because actual growth rate will tend to exceed the warranted rate. There will be too little savings.

Reasons for Knife Edge Instability

  1. Constant savings rate: In the LR, savings rate (s) may change so as to change Gw to bring it in line with the Gn. If Gw > Gn then there will be tendency towards depression which will tend to reduce the share of profits in the LR and hence savings will reduce, thereby lowering Gw. Similarly in opposite condition, there will be boom and share of profits will rise and hence savings and hence Gw. 
  2. Fixed coefficients or L shaped isoquants: If capital grows faster than labor i.e. Gw > Gn, labor will become scarcer, wages will increase and technological innovations will take place in labor saving techniques. Thus vr will increase (since now more capital is required to produce same output) and this will lower Gw. If however, labor grows faster than capital then Gw < Gn, and labor redundancy will depress real wages and shift will be made towards labor intensive technologies. Thus vr will fall and Gw will increase. 

Q 8.c What are the 2 key conclusions of the H-O model of international trade? Under what assumptions are these conclusions arrived at? (15 marks)

Ans.

Key conclusions

  1. International trade can happen on the basis of difference in factor endowments.
  2. A country will export the good which uses its more abundant factor intensely.

In the figure, let autarky productions be at f and e respectively. Now due to trade, countries will specilize in products which use their more abundant factor more intensely. So A moves from f to g while B moves from e to h. A new price line in the world (Px/Py)w will be established and both countries will trade and consume on a higher indifference curve (shown in brown line). Thus trade becomes possible due to differences in factor endowments. Also A exports Y and B exports X – commodities which use their more abundant factor more intesely.

Key assumptions

  1. There are 2 nations (A and B) , 2 commodities (X and Y), 2 factors of production (labor and capital).
  2. Both nations have same technology in production. This means isoquants are identical in both nations for each product and further if say factor prices are same in both nations then both will use exactly the same amount of labor and capital in the production of each commodity. It is another case though that because factor prices are different in both nations then they may use more of the relatively cheaper factor in the production.
  3. Commodity X is labor intensive while commodity Y is capital intensive in both nations. This means that for a given (w/r), (K/L) ratio is higher for commodity Y in both nations than (K/L) ratio for X. This must be true for all possible (w/r) i.e. @ no given w/r should K/L in Y become less than K/L employed in X. It doesn’t mean K/L is same in both nations for Y it just means K/L is higher for Y than X in both nations.
  4. Both commodities are produced under CRS in both countries. It doesn’t mean DRS doesn’t prevail for any one factor. It simply means that taken both factors together CRS prevails.
  5. There is incomplete specialization in both nations. This means none of the nations is very small so as to exclude boundary solutions.
  6. Tastes are equal in both nations. This means for a given commodity price ratio (Px/Py) both nations will consume same proportion of X and Y. Note that this doesn’t imply that they will be on same indifference curve. 
  7. There is perfect competition in both commodity and factor markets in both nations. There is perfect factor mobility within each nation but no international factor mobility. There are no transport costs, tariffs or other obstructions to the free flow of trade. All resources are fully employed in both nations.
  8. International trade between the two is balanced.

Provide an analytical description of growth and change in indian economy from 1950 to 1967

Indian economy at the time of independence – GDP per capita growth rate of less than 0.1%, distorted industrial base in favor of consumer goods, high population pressure on land and exploitative land tenure systems. In comparison, from 1947 – 1967, Indian economy had a GDP growth rate of around 3.5%, developed a strong public sector with wide industrial base and successfully abolished intermediaries as part of land reforms. However, industry failed to act as an engine of employment growth and in 1965 – 1967, India faced serious food crisis leading to adoption of the HYV package technology.

Main body:

Industrial sector

1. The state focused on channelizing private savings for directed, large investments in heavy industry and engineering goods sector. It was an unbalanced growth strategy since this sector had maximum backward and forward linkages. 

2. It was state-led effort. Reflected the socialist leanings of founding fathers. Public sector was also assumed to generate savings. Private sector was seen as unable to overcome the viscious cycles of poverty (Nurkse). The list of industries reserved for public sector grew from IDRA 1951 to IPR 1956. Nehru talked of “commanding heights”, Rakesh Mohan states that the problems of planning were better appreciated in the 1st FYP and focus shifted to micro, quantitative controls leading to License Permit Raj and a rent – seeking economy.

3. Also, since trade was considered as “whirlpool of imperialism”, stringent export control measures were placed. This reflected theories such as Prebisch – Singer hypothesis and adversely affected industrial competitiveness and particularly affected the textile sector. Chakravarty states that Indian planners operated on the assumption of closed economy. First comprehensive critique by Bhagwati and Desai.

4. As a result of massive investments in capital goods sector, it grew by 14% in 2nd FYP and around 11% in the 3rd FYP. The intermediate goods sector also grew by more than 10%.

5. The capital surplus for public investments was largely financed by foreign aid. As a result of operationalization of 2nd FYP, first BoP crisis in 1956. Rupee was devalued. 

6. The competitiveness of industrial sector was adversely affected. Industry could not act as an engine of growth and could not attract migrant labor from agriculture, even in the medium run, as expected under Lewis model. (Strong labor laws, infrastructure bottlenecks, License Permit Raj etc.)

External Sector

1. India’s share in world exports declined from 2.2% in 1947 to less than 1% by the early 1970s. 

2. Export pessimism, import substitution meant that BoP constraint was binding on growth, only relaxed after 1991.

3. In effect, the sheltered industries did not develop as excess capacity was created due to low demand. External demand could not develop and per capita income grew slowly. This is in contrast to E.Asian countries like S. Korea and Japan where first consumer goods industries developed and capital goods sector only developed in 1970s. Indian planners only looked at supply side constraints, ignored demand side constraints.

4. Loss of comparative advantage in consumer goods sector.

Agricultural sector

1. Gandhian vision of developing agro based – SSIs not followed due to inadeqaute public investments. 

2. Planners assumed agri sector would initially create employment due to agro – based SSIs. After gestation lag, industrial employment and migration will take place. This did not occur.

3. Abolition of tenancy led to creation of “pool of informal labor”. Population pressure on land rose and greater insecurity of tenure for these workers. Also, substitution of labor by capital machinery to avoid tenancy by land owners. Thus, artificial mechanization took place.

4. The only successful aspect of land reforms was abolition of intermediaries as they lacked political influence and had colonial sympathies.

5. Land ceilings and redistribution affected only 6% of the land (Appu). It was a failure due to poor political commitment.

6. The scope for land reforms was realized to be limited. Emergence of new class (earlier, land less). All opposed to land reforms.

7. Low levels of public investment in agriculture.

Thus, agri sector grew by around 2.5%. 

Droughts in 1965, 1966. War with Pakistan and suspension of PL – 480 aid by USA. In 1966, domestic production: 12 MT, imports: 10 MT (food grains). 

Peril of depending on imports realized, quest for self – sufficiency. Need to address rural poverty. Imports of HYV variety of wheat developed in Mexico despite public resistance. Self sufficiency attained in 1972 as per Ministry of Agriculture.

Conclusion:

Thus, Indian planners ignored the importance of developing the comparative advantage in consumer goods sector and providing sufficient public investment in agriculture. Despite Indian exports growing slower than even the developing countries, the autarchic policy was continued. The inefficiencies in public sector came in sharper focus in 1970s and 1980s. However, as Deepak Nayyar states, the Indian economy developed on an upward trajectory post independence on the basis of GDP growth rates. Also, a foundation for a strong industrial base were laid and land reforms were carried out with limited success.

Hope that helps. I might have missed out some points. I’ll add a few more points if I come to know of it or if you have some..

🙂