Sunday, March 4, 2012

IGNOU MEC-001 Free Solved Assignment 2012


MEC-001: Microeconomic Analysis 
Assignment
Course Code: MEC-001
Marks: 100

Note:   Answer all the questions.  While questions in Section A carry 20 marks each, those of Section B carry 12 marks each.
Section A
                       
1.         Explain the concept of Nash equilibrium. How it is related to (a) Dominant strategy equilibrium and (b) Sub-game perfection?

Ans.     In a ‘n’ player normal form game G = {S1, S2,…..……,Sn; u1, u2,..……….,un}, the strategies (s*1,s*2,…….,s*n) constitute a Nash equilibrium if, for each player I, si is player i’s best response to the strategies specified for the (n-1) other players, (s*1,s*2,………, s*i-1, s*i+1,…….,s*n) :

or U1 (s*1,s*2,………, s*i-1, s*i, s*i+1,…….,s*n) ≥ U1 (s*1,s*2,………, s*i-1, s*i, s*i+1,…….,s*n)             where i = 1,2,…,n

or, for every feasible strategy si in Si; that is s*i solves 

            max U1 (s*1,s*2,………, s*i-1, s*i, s*i+1,…….,s*n)
s*2ЄS*i

Nash equilibrium is strategically stable and self-enforcing because no single player wants to deviate from her predicted strategy.

Dominant Strategy – A player in a simultaneous move game may have nay finite number of pure strategies at her disposal. One of these strategies called as dominant strategies if it outperforms all of her other strategies, no matter what any other player does.
In the normal form game G = {S1, S2,…..……,Sn; u1, u2,..……….,un}, let s1i and s11i be feasible strategies for the player I (i.e s1i and s11i are members of Si). Strategy s11i strictly dominates strategy s1i, if for each possible combination of other players’ strategies, i’s payoff from playing s1i is strictly less than i's payoff from playing s11i. Symbolically,

U1 (s1,s2,………, si-1, s1i, si+1,…….,sn) < U1 (s1,s2,………, si-1, s11i, si+1,…….,sn)
for each (s1,s2,………, si-1, si+1,…….,sn) that can be constructed from other players’ strategy spaces (S1,S2,………, Si-1, Si+1,…….,Sn). Strategy s11i is called strictly dominant strategy for player i. The dominance is said to be weak when there is a weak inequality (≤ rather than <) in the above equality.
                                               





Sub-game perfection – A sub-game is a part of the game, which starts from a singleton information set and stretches up to the end of the game. A configuration of strategies, which induces Nash equilibrium in every sub-game of a game, is called sub-game perfect Nash equilibrium. This is explained in the example given below:




                                                            Tough(-4,-1)


                        Tough
                                                            Accommodating
                                    Coke                            (-3,1)
Pepsi
                                                            Tough (0,-3)
            Accommodating                    
                                                            Accommodating
                                                                        (1,2)
 













                                                              
            Coke will always play Accommodating, and as Pepsi can foresee this. Pepsi will also play accommodating as well. Therefore the Nash equilibrium of the sub-game is (Accommodating, Accommodating) and PSNE (Enter- Accommodating, Accommodating) is the only SPNE (sub-game perfect Nash equilibrium) of the game. Thus, the concept of SPNE is able to eliminate non-credible threat.

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2.         What is indirect utility function? How will you derive an indirect utility function from a direct utility function? Explain Roy’s identity.

Ans.     Let qi denotes commodity I and pi is the price of that commodity. Let y denotes money income of the consumer. Suppose vi = pi/y. The budget constraint written as:
                                                      n    
1 =∑ viqi                                                                      (1)
                                                     i=1  

            Since optimal solutions in the demand functions are homogeneous of degree zero in income and prices, nothing essential is lost by this transformation to ‘normalised’ prices. The utility function U = f(q1,qn) together with equation (1) gives the following first order conditions of utility maximization:
                                    fi – λvi = 0 for all I – 1,….n
                                                      n    
and      1 =∑ viqi                                                                      (2)
                                                     i=1  

Ordinary demand functions obtained by solving equation (2): qi = Di (v1,….,vn)


The indirect utility function g(v1,…..vn) is defined by
            U = f[D1(v1,….,vn),   Dn(v1,….,vn) = g(v1,….,vn)                                           (3)

It gives the maximum utility as a function of normalized prices. The indirect utility function reflects a degree of optimization and market prices.

Applying the composite function rule of calculus to equation (3), we get
                        n                                  n
gj =      ∑ fi (∂qi/∂vi)      =        λ∑ vi (∂qi/∂vj)      j = 1,…..n                           (4)
                        i=1                               i=1

where the second equalities are based on equation (2). Partial differentiation of equation (1) with respect of vj yields
            n                                 
∑ vi (∂qi/∂vj)   = - qj    j = 1,…..n                                                      
            i=1                              
Thus, equation (4) implies
qj = - (gi/ λ)      j = 1,…..n                                                                                (5)       

which is called Roy’s identity. Optimal commodity demands are related to the derivatives of the indirect utility function and optimal value of the Lagrange multiplier (i.e, the marginal utility of income). Substituting equation (5) into the last equation of equation (2) gives
                        n
λ  =      ∑ vigi                                                  
            i=1
              n
and      qj = gi / ∑ vigi                                      j = 1,…..n                               
                          i=1
to provide an alternative form of Roy’s identity.

            The information it gives in contrast to utility function are described by a set of duality theorems. The direct utility function determined by the indirect is same as the direct utility function that determined is indirect. Duality in consumption forges a much closer link between demand and utility functions.


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Section B
Medium Answer questions                                                                                      

3          Derive the elasticity of substitution from the Cob-Douglas production function q=f(K,L) = AKaLb.
Ans      The Cobb-Douglas production function is given by:

            q=f(K,L) = AKaLb ,
where A, a and b are all positive constants.

Iso-quants resulting from the functional form have convex shape. The Cobb-Douglas function can exhibit any degree of returns scale depending on the values of a and b. Suppose all inputs were increased by a factor m. Then,
f(mK,mL) = A(mK)a(mL)b = Ama+b KaLb                                                       (          
                             = ma+b f(K,L)

Hence, in the Cobb-Douglas function
  • a+b = 1, implies constant returns to scale
  • a+b > 1, implies increasing returns to scale
  • a+b < 1, implies decreasing returns to scale

To determine the elasticity of substitution in Cobb-Douglas production function, let us use Allen’s definition

            σ  = ∂q/∂L.( ∂q/k) / q (∂2q/∂L∂K)

When q = AKaL1-a

            σ  = [(1-a).(q/L).a(q/K)] / [q2.{(1-a)(a)/LK)}] = 1
The Cobb-Douglas function is linear in logarithms, i.e,
            log q = log A + a log K + b log L.

As a result, the constant a in above equation is the elasticity of output with respect to capital output, and b is the elasticity of output with respect to labour input. To get the result, take

            eq,K       =  ∂q/∂K . (K/q)
= ∂ log q / ∂ log K) such that
            eq,K       =  a from above eqn. Similarly, we get   eq,L =  b       




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4.         What are the recommendations of Coase to solve the problem of externalities?

Ans.     Ronald Coase asserted that under perfect competition private and social cost will be equal and addressed a well known problem of market externalities, known as the ‘Spillover Effect’. This occurs when someone other than the buyer must share the benefits or costs of a product. The classic example of such a perception is pollution. Factories can either treat pollution – which costs money- or dump it into the air or water for free. If they choose to dump, they may save their customers some money, but citizens who live near the factory will also pay a price in higher death and disease rates, less fertile land, environmental catastrophes, etc. Sometimes the spillover effect is both positive and negative. An airport benefits its customers, but it also subjects the local neighborhood to various externalities eg. noise pollution.

Coase argued that individuals could organise bargains so as to bring about an efficient outcome and eliminate externalities without without government intervention. The government should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result. This result, often known as the “Coase Theorem” requires that:

·   property rights are well defined;
·   the number of people involved is small; and
·   bargaining costs are very small

            Only if all three conditions, apply then individual bargaining will solve the problem of externalities. All that is needed is a common law or statutory rule, which assigns rights over the externality to one party or another. The market/pricing mechanism will then function in the same way as it does for the ordinary goods and services over which rights clearly defined.

            Thus Coase’s theorem has helped in the emergence of numerous policy formulations in the welfare imperatives of societies.



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5.         Explain Arrow’s Impossibility Theorem.

Ans.     The democratic procedure for reaching a social choice or group decision is the expression of their preferences by individuals through free voting. Social choice will be determined by the majority rule. But Arrow has demonstrated through his impossibility theorem that consistent social choices cannot be made without violating the consistency or transitivity condition. The social choice on the basis of majority rule may be inconsistent even if individual preferences are consistent. Arrow first considers a simple case of two alternative social states and proves that in this case group decision or social choice through a majority rule yields a social choice, which can satisfy all the five conditions. But when there are more than two alternatives, majority rule fails to yield a social choice without violating at least one of the five conditions. Thus, Arrow’s theorem says that if the decision-making body has at least two members and at least three options to decide among, then it is impossible to design a social choice function that satisfies all these conditions at once.

Alternative Social States

X
Y
Z
A
3
2
1
B
1
3
2
C
2
1
3





Ranking of Alternatives by Individuals and Social Choices

            In this table three individuals A, B and C who constitutes the society have voted for three alternative social states X, Y and Z by writing 3, against the most preferred alternative, 2 for the next preferred alternative and 1 for the least preferred alternative. Majority rule leads to inconsistent social choices because on the one hand, X has been preferred to Z by the majority and on the other hand, Z has also been preferred to X by majority, which is contradictory or inconsistent.

Arrow has derived three consequences to explain his impossibility theorem. According to Consequence I, whenever the two individuals prefer X to Y, then irrespective of the rank of the third alternative Z, society will prefer X to Y. According to Consequence II, if in a given social choice, the will of individual prevails against the opposition of individual B, then the will of A will certainly prevail in case individual B is different or agrees with A. According to Consequence III, if individuals A and B have exactly conflicting interests in the choice between two alternatives X and Y, then the society will be indifferent between X and Y. It is interesting to note that the simple proof of the impossibility theorem follows from Consequence III. For instance, if individual A prefers X to Y and individual B prefers Y to Z and if society opts for X, then A will be a dictator in as much as her choice will always be social choice. Thus, Arrow’s theorem says that ‘if the decision-making body has at least two members and at least three options to decide among, then it is impossible to design a social choice function that satisfies all these conditions at once. Arrow, therefore concludes that it is impossible to derive a social ordering of different conceivable alternative social states on the basis of the individual ordering of those social states without violating at least one of the value judgments expressed in the five conditions of social choices. This is in essence his impossibility theorem.

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6.         Discuss the concept of asymmetric information. Explain the relation among moral hazard, adverse selection and signaling, giving suitable examples.

Ans.     Asymmetric information signifies a situation in which one party involved in transaction with another, has more or superior knowledge and information than the other. This is often the case between buyer and seller, where seller has more knowledge than buyer. However, the opposite condition can also happen at times. The situation can potentially be harmful as the party with more information can take advantage of other’s lack of knowledge and thereby exploit the other party.

Asymmetric information is the source of two major problems such as the following:
·         Moral Hazard        -  This reflects on the immoral behavior of a party with asymmetric information subsequent to a transaction. For example, some people commit arson purposely to reap benefits from the fire insurance. After being insured, a driver may drive recklessly as damage in the event of accident will be borne by the insurance company.

·         Adverse Selection – In this case, the party displays immoral behavior by taking advantage of the knowledge or asymmetric information prior to transaction. For example, some people secure life insurance aware of the languishing health. A bank may fail to observe the risk-return characteristics of a project. Consequently, it will extend credit facilities to bad projects while rationing credit to good projects.

The presence of asymmetric information creates an adverse selection problem: if consumers cannot tell the quality of a product and are willing to pay only an average price for it, then this price is more attractive for sellers who have bad products than to seller who have good products (hence the term adverse selection). Consequently, more bad products (i.e lemons) will be offered than good products. Now, if consumers are rational, they should anticipate this adverse selection and expect that at any given price, a randomly chosen product is more likely to be a lemon than a good product. Of course, these expectations imply a lower willingness to pay for products and so the proportion of goods products that is actually offered falls further. Eventually, this process may lead to a complete breakdown of the market.

·         Signalling – Initiative taken by individuals of informed category in markets characterized by adverse selection to help identify their true risk category. For example, In the lemons model if sellers of a good product could find some activity that was less costly for them than for seller of a bad product, then it might pay them to undertake this activity as a signal of good quality product. The buyers, too, would learn that the signal was associated with good quality product.


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7.         Do you agree with the proposition that a risk-averse person will optimally buy full insurance if the insurance is actuarially fair? Give reasons in support of your answer.

Ans.     Yes a risk-averse person will optimally buy full insurance if the insurance is actually fair as the expected utility of such consumer rises with the purchase of insurance although expected wealth is unchanged. Since insurance increases the consumer’s welfare, she is willing to pay some positive price in excess of the actuarially fair premium to defray risk. Thus, the agent is trying to equate the marginal utility of wealth across states. Because, the utility of average wealth is greater than the average utility of wealth for a risk averse agent. The agent wants to distribute wealth evenly across states of the world, rather than concentrate wealth in one state. She will attempt to maintain wealth at the same level in all states of the world, assuming that she can costlessly transfer wealth between states of the world (which is what actuarially fair insurance allows the agent to do).

            Let a risk-averse person’s decided to buy insurance by taking the initial endowment wo and L is the amount of the loss from an accident.

                                                Pr(1 – p):U(.) = U(wo),
                                                Pr(p) : U9.) = (wo – L)


If insured, the endowment is:                         Pr(1 – p) : U(.) = U(wo – pA)
                                                            Pr(p):U(.) = U(wo – pA + A – L)

Expected utility is uninsured is :         E(U|I = 0) = (1 – p)U(wo) + pU(wo – L)

Expected utility if insured is :             E(U|I = 1) = (1 – p)U(wo – pA) + pU(wo – L + A – pA))

            The optimal policy that the agent should purchase, differentiate above eqn with respect to A,
                                                     = -p(1 – p)U’(wo – pA) + p(1 – p)U’(wo – L + A – pA) = 0
                                                            U’(wo – pA) = U’(wo – L +A – pA)
                                                            A = L,

which implies that wealth is wo – L in both states of the world (insurance claim or no claim)

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source : Dilli Views

IGNOU MEC-002 Free Solved Assignment 2012



MEC-002 : MACRO ECONOMIC ANALYSIS
(Assignment Code: MEC-002/AST/2011-12)

Section: A

Q.1      What is meant by steady state in the Solow Model? Explain how Golden Rule is different from steady state.

Ans    The Steady State is a condition when the economy does not have to change its capital-labour ratio.

Investment per unit of effective labour equals saving per unit of effective labour i.e

i = sy  {since, y = f(k)}, then i = sf(k)

The rate of growth capital stock is equal to the rate of investment. In per effective labour term, written as
ќ = sf(k), where ќ refers to growth rate in k.
                     
Growth of Capital and Steady State

The Solow model assumes that existing capital depreciates at the rate δ. Thus each year δK amount of capital is depreciated.
Investment and depreciation act in opposite directions and the growth in capital stock is net of the two quantities.
ќ(t) = i(t) - δk(t) {since i= sf(k(t)), then ќ(t) = sf(k(t)) - δk(t)

Capital stock rises when sf(k(t)) > δk(t); falls when sf(k(t)) < δk(t) and remain constant when sf(k(t)) = δk(t).

Population Growth and Steady State
Consider the case where population and the labour force grow at a constant rate n.

ќ(t) = sf(k(t)) – (n+δ)k(t)

For steady state the amount of investment required must not only cover depreciation (δk) but also provide new workers with capital (nk). Break-even investment now would be (n+δ)k. The steady state is achieved at the point of intersection of investment and (n+δ)k curves. Capital Stock(K) and output (Y) keeps on growing at the rate n to keep k and y constant. At steady state both k and y are constant.

Technological Progress and Steady State
The technological progress in the Solow model indicates the quantity of effective labour (AL). The rate of technological progress is g. The change in k over time is now modified as   ќ(t) = sf(k(t)) – (n+g+δ)k(t)   

The analysis of steady state does not change with the inclusion of technological progress. But the break-even investment now is (n+g+δ)k. Out of total investment sf(k), δk is needed to cover depreciation and nk to maintain capital per effective labour constant. However, as a result of technological progress y grown at a rate of g.

The Golden Rule
In economics, we generally assume that the more people consume, the happier they are. So if we want people to be as happy as possible, our aim is to maximize consumption per worker c. The steady state associated with that particular outcome is called the “Golden Rule” (GR) steady state.

Steady State consumption is output net of investment. Thus
c* = y* - i* {since y* = f(k*) and investment (i*) = depreciation ((n+g+δ)k*) }

or c* = f(k*) - (n+g+δ)k*           
As increase in steady state capital has contrasting effect on steady state consumption more capital leads to more output which contributes positively to consumption, but it also means higher bread even investment (n+g+δ)k.

Steady state consumption is the gap between the steady state output and steady state break-even investment, which maximized at k*gold level of capital per effective labour. 

While higher levels of capital mean higher levels of output, they also mean more capital is being “removed” from the economy each year. If the capital stock is below the GR level, the slope of the production function is greater than that of the capital stock curve, and an increase in capital per worker has a greater impact on f(k) than on (n+g+δ)k giving us an increase in consumption. The opposite will hold true when we are above the GR level. The GR steady state occurs when
MPK =  (n+g+δ)                  or
(MPK - δ) = (n+g)

At the golden rule level of capital, the MPK net of depreciation is equal to the rate of growth of total output (n+g).

A planner trying to maximize long-run consumption would then aim to get a savings rate that corresponded with that particular steady state level of capital. Note that in the transition to the GR point, there will be “initial” effects and “long-run” effects. Say were below the GR. As we increase savings, there will be a temporary decrease in consumption, and then a long run increase. Why? Because an increase in savings means less consumption right away (c = y - sy). However, as capital accumulates, output increases, and thus so does consumption. This situation gives us a look into why it’s called the Golden Rule . . . because we sacrifice consumption now for higher consumption for the people of the future. As Mankiw puts it, the welfare of all generations is given equal weight, so sacrifice by this generation is outweighed by the gains of future generations.


                              
Q.2      Explain how the permanent income hypothesis reconciles the difference between long-run and short-run consumption functions?
Ans.     According to the life cycle hypothesis the short-run consumption function shows a decline average propensity to consume (APC) while the long-run consumption function exhibits constant average propensity to consume due to increase in asset base. On the other hand permanent income hypothesis explains the discrepancy in terms of permanent income and transitory income.

            Friedman’s permanent income hypothesis provides an alternative explanation to the apparent discrepancy between cross-sectional and time series data on consumption. Unlike the life-cycle hypothesis, Friedman does not postulate that incomes follow a regular pattern over the life cycle of an individual; he instead argues that individuals experience random and temporary changes in their income from time to time. Accordingly, Friedman views the current income in any period (Yt) as consisting of two components: permanent income (YtP) and transitory income (YtT). Permanent income is that part of the income which prevails over the long run. Friedman interprets this as the long run average income of the individual, i.e.
            YtP  t)

Transitory income is any random deviation from this average, i.e
YtT  t)
A positive transitory income implies that the current income exceeds the permanent income; a negative income implies that the current income is less than the permanent income. Since
            Ct =  A0/T + 1/T ( t) = A0/T + YtP , i.e current consumption of the household depends only on the permanent income, any increase in the transitory part of the current income, which leaves the permanent income unchanged, will have no impact on the level of current consumption.

Friedman’s permanent income hypothesis solves the apparent puzzle in the consumption data. According to Friedman’s hypothesis, the average propensity to consume (Ct / Yt) depends on the ratio of permanent to current income YtP /Yt. Thus when current income temporarily rises above the permanent income the average propensity to consume falls; the opposite happens when current income temporarily falls below the permanent income. The high income group will contain some people with a high transitory income, who will have a lower propensity to consume than the average. Similarly the low income group will contain some people with a low transitory income, who will have a higher propensity to consume that the average. Thus average propensity to consume will fall from lower to the higher income group. Any increase in the long run reflects a permanent increase in the average income level.

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Section – B

Q.3      Policy makers should stick to rules instead of pursuing discretionary policies. Do you agree with the above statement? Substantiate your answer.

Ans      Yes, policy makers should stick to rules instead of pursuing discretionary policies. This is because the greater the deviation from rules that a government displays in undertaking discretionary action even in circumstances where intervention is unanimously demanded, the less will be the credibility of policy rules announced by the government in the future. The credibility of an announced policy rules depends not only on past experience regarding a government’s ability to adhere to commitments but also on a rational evaluation about the future possibility of a government adhering to a policy rule. If the governments have the discretion to change policy at future points in time then an announced policy rule will not be credible unless it is time-consistent, at some point in time it will not be optimal for the government to follow the policy dictated by the rule. A problem might arise because the policy rule which is optimal over the entire time horizon may not be time-consistent.

An obvious way by which the government can commit to a particular policy rule is to enact legislation making it costly to deviate from the rule in the future. However, it might be difficult and time-consuming to amend the legislation if there arises unanticipated eventualities which urgently require deviation from the rule or if it is found that important assumptions make in faming the rule are erroneous. An alternative way by which an optimal policy rule may be made credible without losing the flexibility for using discretion in emergencies if for the government to delegate responsibility for this policy to some autonomous agency which the public perceives as having a different objective function.

In practice policy formulation needs to be based on certain rules or procedures. However, there is a need for revision of policy rules against unanticipated developments which may be time-taking and costly. In order to tackle such eventualities the government can delegate the responsibility to some autonomous body. The possibility of following a sub-optimal policy over time cannot be ruled out.

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Q.4      Explain in brief the salient features of real business cycle theory. In what respects is it different from other theories of business cycle?

Ans.     In real business cycle theory emphasis in given on real shocks such as technological change which shifts the production function. A productivity shock changes the level of output produced by given amount of inputs. The basic tenets of real business cycle theory are as follows:

(a)        An economy is considered as a sea with islands of local markets.

(b)        Buyers and sellers have perfect information about the prices of goods and services on their islands but cannot sample the prices on other islands except by rowing there, a costly activity. But, they form estimates of the general price level, the average of all prices. Thus, an increase in the general price level will be misperceived as an increase in the price of goods on the island, a (small) subset and therefore sub optimal decisions about consumption; production and investment will be taken.

(c)        Each household produces goods and sells them on one and only one of the arrays of these markets.

(d)       Goods differ according to location, physical characteristics and so on.

(e)        Fluctuations in output by means of exogenous shocks. These shocks can originate on the demand side as well as on the supply side.

(f)        A monetary shock leads to an increase in the general price level and a fall in the expected interest rate.

(g)        The greater the uncertainty about money and the general price level, the less prices become useful as the conveyor of information par excellence. Thus, the economy becomes less responsive to changes in fundamentals, shifts in tastes and technology that require optimizing and efficient allocation of resources.

            The Real Business Theory emphasizes on relative prices rather than absolute price level, and believes that money is neutral, and also because it lays emphasis on supply side forces. Real business cycles are fluctuations generated by shock which might not reflect the rhythms of ebb and flow of classical cycles. New Classical Business Cycle research is oriented towards explaining the familiar pattern of boom and slump, one following the other in regular succession. The role of money and finance in both approaches are distinguished. In the former, shocks referred to are changes in technology and taster. Money is a veil. On the other hand, money and finance are part of the model of expansion and contraction developed by New Classical Business Cycle theorists.


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Q.5      Explain why firms may offer a higher wage to workers than the equilibrium wate rate.

Ans.     The efficiency wage theories rationalize the existence of higher than market clearing real wages. Firms pay higher than market-clearing real wages because the benefits accruing from higher wages are more than the cost of paying higher wages. The higher benefits accrue for the following reasons: -

(a)        The benefits come from increased efficiency of workers. The increased efficiency due to increased physical efficiency of workers obtaining higher wages enable higher consumption including higher nutrition.

(b)        A higher than market wage build loyalty and belonging among workers and induce higher effort. Whereas in the context of the opposite situation of a lower wage, which is expected to have affects like generating anger and a desire for revenge, thereby leading even to a sabotage by the workers.

(c)        A higher wage generates incentives for workers to avoid work shirking behavior in situations where the firms cannot monitor the work effort perfectly. Workers will have fear of losing high paying jobs if caught shirking.

(d)       Higher wages get into the pool of workers with a higher reservation wage i.e the minimum wage that should be offered to a worker to induce him to supply his labour on the market. Workers with a higher reservation wage are expected to have superior abilities along directions that cannot be directly observed and duly compensated for on the market. These higher abilities in the pool o employed workers are expected to benefit the firm.

The efficiency wage model not only rationalizes the existence of persistent unemployment, but also produces a larger effect on employment in the short run. The shortcoming of an efficiency wage model using a simple version of the effort function is that it implies that there is no increasing trend in the real wage in the long run. 




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Q.6      Bring out the important issues on which Lucas criticizes Keynesian macroeconomics. To what extent the New-Keynesian economists have accepted these criticisms?

Ans.     One of the most influential economists since the 1970s, he challenged the foundations of macroeconomic theory (previously dominated by the Keynesian economics approach), arguing that a macroeconomic model should be built as an aggregated version of microeconomic models (while noting that aggregation in the theoretical sense may not be possible within a given model). He developed the "Lucas critique" of economic policymaking, which holds that relationships that appear to hold in the economy, such as an apparent relationship between inflation and unemployment, could change in response to changes in economic policy. This led to the development of neoclassical and New Keynesian economics and the drive towards microeconomic foundations for macroeconomic theory.

The development of macroeconomic theory since the 1970s was significantly influenced by the Lucas critique. This critique implies that we cannot apply econometrics using macroeconomic models, which directly assumed certain behavioural relations between macroeconomic variables, in order to check the effects of alternative policies.       
The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking, argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.
The Lucas critique suggests that if we want to predict the effect of a policy experiment, we should model the "deep parameters" (relating to preferences, technology and resource constraints) that govern individual behavior. We can then predict what individuals will do, taking into account the change in policy, and then aggregate the individual decisions to calculate the macroeconomic effects of the policy change.
The Lucas critique was influential not only because it cast doubt on many existing models, but also because it encouraged macroeconomists to build microfoundations for their models. Microfoundations had always been thought to be desirable; Lucas convinced many economists they were essential.
One important application of the critique is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions.
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Q.7      Write short notes on

            (a)        Rational expectation and adaptive expectation
           
            Ans      Expectations are said to be rational when they are formed on the basis of all available information. Under this assumption, expectations are never biased.
              Economic-behavior observation according to which: (1) On average, people can quite correctly predict future conditions and take actions accordingly, even if they do not fully understand the cause-and-effect (causal) relationships underlying the events and their own thinking. Thus, while they do not have perfect foresights, they construct their expectations in a rational manner that, more often than not, turn out to be correct. Any error that creeps in is usually due to random (non-systemic) and unforeseeable causes. (2) In efficient markets with perfect or near perfect information (such as in modern open-market economies) people will anticipate government's actions to stimulate or restrain the economy, and will adjust their response accordingly. For example, if the government attempts to increase the money supply, people will raise their prices and wage demands to compensate for the inflationary impact of the increase. Similarly, during periods of accelerating inflation, they will anticipate stricter credit controls accompanied by high interest rates. Therefore they will attempt to borrow up to their credit capability, thus largely nullifying the controls. This theory was proposed not as a plausible explanation of human behavior, but to serve as a model against which extreme forms of behavior could be compared. It was developed by the US economist Robert Lucas (born 1937) who won the 1955 Nobel Prize for this insight.

Expectations are said to be adaptive when people form their expectations on the basis of past behavior. 
Economic-behavior observation that people form their expectations of economic trends solely on the basis of what was the past magnitude and direction of those trends. If these expectations turn out to be wrong then, depending on the degree of the error, people revise (adapt) their future estimates accordingly.

(b)       Non-accelerating Inflation Rate of Unemployment (NAIRU).    
                                                                                                     
Ans      It is an unemployment rate that is consistent with a constant inflation rate. The NAIRU is the unemployment rate at which the long-run Phillips curve is vertical. When unemployment is equal to NAIRU there will be stability in the rate of inflation. When unemployment departs from NAIRU, there is acceleration or deceleration in inflation rate. Thus if actual unemployment is less than u*, inflation will continue to accelerate higher and higher in subsequent years. Unless unemployment returns to its natural rate inflation spiral will keep on accelerating. When unemployment is more than u*, inflation will tend to fall as long as unemployment is above u*.


                 Inflation                                         LRPC
                                                                                   

                                                     B         
                          I2.3                                       C

                                                                                                SRPC2
                                                  I1                                                A
                                                                                    SRPC1
                                                                                   

                                                                    U*1        Unemployment
                                           Shifts in Phillips Curve

                                   


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