Eco 2014 R Solved PDF

IQRA COMMERCE NETWORK
B.COM PART I (REGULAR) ANNUAL

EXAMINATIONS-2014
PAPER VI ECONOMIC ANALYSIS AND POLICY
MICRO ECONOMICS
Q1 a) How can you justify that Professor HICKs approach is
better approach for analyzing the consumers behavior?
Ans: The indifference curve analysis approach was first introduced by
Slustsky, a Russian Economist in 1915. Later it was developed by J.R.
Hicks and R.G.D. Allen in the year 1928.
These economists have the view that it is wrong to base the theory of
consumption on two assumptions:
(i) That there is only one commodity which a person will buy at one time.
(ii) The utility can be measured.
Their point of view is that utility is purely subjective and is immeasurable.
Moreover an individual is interested in a combination of related goods and
in the purchase of one commodity at one time. So they base the theory of
consumption on the scale of preference and the ordinal ranks or orders his
preferences.
Assumptions:
The ordinal utility theory or the indifference curve analysis is based on
four main assumptions.
(i) Rational behavior of the consumer: It is assumed that individuals are
rational in making decisions from their expenditures on consumer goods.
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(ii) Utility is ordinal: Utility cannot be measured cardinally. It can be,
however, expressed ordinally. In other words, the consumer can rank the
basket of goods according to the satisfaction or utility of each basket.
(iii) Diminishing marginal rate of substitution: In the indifference curve
analysis, the principle of diminishing marginal rate of substitution is
assumed.
(iv) Consistency in choice: The consumer, it is assumed, is consistent in
his behavior during a period of time. For insistence, if the consumer prefers
combinations of A of good to the combinations B of goods, he then remains
consistent in his choice. His preference, during another period of time does
not change. Symbolically, it can be expressed as:
If A > B, then B > A
(iv) Consumers preference not self contradictory: The consumers
preferences are not self contradictory. It means that if combinations A is
preferred over combination B is preferred over C, then combination A is
preferred over combination A is preferred over C. Symbolically it can be
expressed:
If A > B and B > C, then A > C
(v) Goods consumed are substitutable: The goods consumed by the
consumer are substitutable. The utility can be maintained at the same level
by consuming more of some goods and less of the other. There are many
combinations of the two commodities which are equally preferred by a
consumer and he is indifferent as to which of the two he receives.
Example:
For example, a person has a limited amount of income which he wishes to
spend on two commodities, rice and wheat. Let us suppose that the
following commodities are equally valued by him:
Various Combinations:
a)
16 Kilograms of Rice
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Plus
2 Kilograms of Wheat

b)
c)
d)
e)
9 Kilograms of Rice
Plus
Plus
Plus
Plus
It is matter of indifference for the consumer as to which combination he

buys. He may buy 16 kilograms of rice and 2 kilograms of wheat or 9
kilograms of rice and 15 kilograms of wheat. All these combinations are
equally preferred by him.
An indifference curve thus is composed of a set of consumption
alternatives each of which yields the same total amount of satisfaction.
These combinations can also be shown by an indifference curve.
Figure/Diagram of Indifference Curve:
The consumers preferences can be shown in a diagram with an
indifference curve. The indifference showing nothing about the absolute
amounts of satisfaction obtained. It merely indicates a set of consumption
bundles that the consumer views as being equally satisfactory.
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b) Draw an income consumption curve showing that x is a

superior good and y is an inferior good.
Ans: In the consumers equilibrium analysis, it is primarily assumed that the
price of the goods X and Y and the income of the consumer remains
constant. We now examine as to how the consumer reacts as regards to
his purchases of good when his income changes within the indifference
curve frameworks. Income is one of the most important factors affecting the
purchase of commodities.
If the prices of goods, tastes and preferences of the consumer remains
constant and there a change in his income, it will directly affect consumers
demand. This effect on the purchase due to change in income is called
the income effect.
Income Effect When Wheat (x) is superior Good:
In the figure 3.14, it is shown that with the rise in money income, the
purchase of wheat has increased from M1 to M4 indicating positive income
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effect on the purchase of normal good wheat. The income effect on inferior
good is negative. The income consumption curve ICC is starts bending
towards the horizontal axis which shows that wheat is a normal good and
rice is inferior good.
Q2 a) Explain with examples the significance of the value of

goods cross elasticity in relation to its substitutes and
complementary goods.
Ans: Cross Elasticity of Demand:
Definition and Explanation:
The concept of cross elasticity of demand is used for measuring the
responsiveness of quantity demanded of a good to changes in the price of related
goods. Cross elasticity of demand is defined as:
"The percentage change in the demand of one good as a result of the percentage
change in the price of another good".
Formula:
The formula for measuring, cross, elasticity of demand is:
Exy = % Change in Quantity Demanded of Good X
% Change in Price of Good Y
The numerical value of cross elasticity depends on whether the two goods in
question are substitutes, complements or unrelated.
Types and Example:
(i) Substitute Goods. When two goods are substitute of each other, such as coke
and Pepsi, an increase in the price of one good will lead to an increase in demand
for the other good. The numerical value of goods is positive.
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For example there are two goods. Coke and Pepsi which are close substitutes. If
there is increase in the price of Pepsi called good y by 10% and it increases the
demand for Coke called good X by 5%, the cross elasticity of demand would be:
Exy = %qx / %py = 0.2
Since Exy is positive (E > 0), therefore, Coke and Pepsi are close substitutes.
(ii) Complementary Goods. However, in case of complementary such as, goods
such as car and petrol, mobile phones and Sims, cricket bat and ball, a rise in the
price of one good say cricket bat by 7% will bring a fall in the demand for the balls
(say by 6%). The cross elasticity of demand which are complementary to each
other is, therefore, 6% / 7% = 0.85 (negative).
b) Discuss whether the demand for mobile phone is likely to

be elastic or inelastic.
Ans: As a whole, the mobile phone market is pretty elastic - it's not a necessity
and there are already a lot of phones out there, so if prices were to go up fewer
people would buy new phones and fewer people would upgrade their existing
phones (the very definition of elastic).
On the other hand, for certain professions mobile phones are very necessary. Oncall doctors, many upper-level businesspeople, anybody who *must* be
reachable as a part of their work, they all will exhibit inelastic buying behavior.
Whether the phone cost Rs.5000 or Rs.15000, if they have to have it to do their
job, they'll spend the money so they can continue to work.
Q3 a) Draw a supply curve of the firm.

Ans: Short Run Supply Curve of a Price Taker Firm:
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In a competitive market, the supply curve of a firm is derived from its marginal
cost curve. Supply curve is that portion of the marginal cost curve which lies
above the average variable cost curve.
As we already know, the aim of the firm is to maximize profits or minimize losses. The profits
are increased it the difference between total receipts and total costs is maximized. When a firm
undertakes the production of a particular commodity, it has to pay remuneration to all the
factors of production employed. The remuneration or cost of the firm for a short period can be
divided into two parts, fixed costs and variable costs. If from the sale of the commodity
produced, a firm is earning much more than what it has to spend on it. We say a firm is earning
abnormal profits if the total revenue of the firm is equal to total cost, the firm is getting normal
profits. In both these cases, it is profitable for the firm to produce the commodity. But if the
total receipts fall short of total costs, then three situations can arise.
(i) A firm is not in position to meet its variable costs.
(ii) A firm is able to cover its variable costs.
(iii) A firm is covering its full variable costs and a part of the fixed costs.
Let us explain all these situations with the help of a curve.
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(1) In the figure. (15.7) there are three costs curves, AVC curve, ATC curve and MC
curve. ATC curve includes the average variable cost and average fixed cost of a
firm. Average variable cost is represented by the AVC curve which lies below the
ATC curve. Let us suppose now that at price OM, a firm supplies an
output equal to 01 because MR = MC at point I.
The total receipts of the firm at OM price are thus, equal to OILM, while the total
costs are equal to OIKN. At this price, a firm is undergoing too many losses which
are represented by the area MLKN. It is not even meeting its full variable cost as
the AVC curve lies much above this price line. A firm shall have to close down its
operations for minimizing losses in the short run (shut down cases).
(2) At price OF, a firm is in equilibrium at point E where MR = P = AR. It produces
OD amount of output and is just able to cover its variable cost. The total receipts
of the firm at OF price are equal to ODEF and the total cost ODGH. As the total
receipts of-the firm fall short of total cost, so it Is not advantageous for the firm to
carry on production in the short run. The firm shall close down its operation as
the full fixed cost equal to the area FHGE is not met. The point E where MR = MC
= minimum of AVC is also a shut down point of the firm.
(3) In case the price settles somewhere between F and G, then the firm will be
meeting its full variable costs and a part of the fixed costs. It, may prefer to
produce because if the concern is closed down the whole of the fixed cost is to be
met. This, of course can happen in a short period. When the period is long the
total receipts of the firm must be equal to total cost and the firm must earn
normal profit.
(4) If the price in the market is OG, the firm is in equilibrium at point B. Here the
total receipts of the firm, i.e., OABG are equal to the total cost, i.e., OABG. A firm
is earning normal profits and it is profitable for it to carry on production. By
normal profits in economics we mean the level of profit which is just sufficient to
induce an entrepreneur to stay in the industry. The amount is equal to the
remuneration which an entrepreneur can get in alternative occupations. If the
entrepreneur is not paid the amount equal to this normal profit, he will move to
the other alternative industry where he could get this amount.
If price, rises above OG, then firm is getting abnormal profits. For instance, the
firm is producing best level of output by equating MR = MC at point U and selling
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at price OZ, the total revenue of the firm will be OWUZ and total cost OWVP.
There is thus an abnormal profit equal to PVU2.
Summing up, we can say, that if price falls below the lowest point on the AVC
curve, the firm will not produce any output because it is not able to cover even its
total variable costs. But if the price is such that it covers its total variable costs,
then the firm may carry on production for a short period. So is also the case when
it covers its full variable costs and a part of the fixed costs. In the long period, if
the firm does not cover its full costs, it will have to dose down its operations
sooner or later. So we conclude that the supply curve of the firm that can be
regarded as that portion of the MC curve which lies above the AVC curve and not
which lies below the AVC curve because it is only at the lowest point on the AVC
curve that some output is forthcoming and not below this point.
The supply curve of the firm or the rising portion of the MC curve which lies above
the AVC curve can be split up into two parts. One part consists of that portion
which lies above the lowest point of the ATC curve. If the price line representing
MR = AR intersects the MC curve at any point on this rising portion, the firm will
be earning abnormal profit (see fig. 15.7). The second part of the supply curve of
the firm extends from the lowest point of the AVC curve to the lowest, point of
the ATC curve. If price line representing MR = AR passes through the lowest point
of the AVC curve, the firm is covering only total variable costs. If the price line cuts
the MC curve at any point above the lowest point of the AVC curve and below the
lowest point of ATC curve, the firm will be meeting its total variable costs and a
part of the fixed costs but not the total costs. The total costs are met only when
the price line forms a tangent to the ATC curve.
b) When a firm shuts down his business? Discuss with the help
of diagram.
Short Run Shut Down:
The price taker firm in the short-run minimizes losses by closing it down if the
market price is less than average variable cost. The shut down position of a
Competitive firm is explained with the help of a diagram.
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In this figure (15.6) we assume that the market price is OP. The firm, is in
equilibrium at point Z where MR = MC. The firm produces OK output and sells at
OP unit cost. The total revenue of the firm is equal to the area OPZK. Whereas
.the total cost producing OK output is OTFR. The firm is suffering a net loss of total
fixed cost equal to the area PTFZ. The firm at point Z is just covering average
variable costs.
If the price falls below Z, the competitive firm will minimize its losses by closing
down. There is no level of output which the firm can produce and realize a loss
smaller than its fixed costs. It is therefore a shut down point for the firm. Operate
When Price is > average variable cost.
Q4 Give the suitable justification:

i) Why average cost curve locates above on average variable cost curve?
The average total cost curve is U-shaped. Average total cost is relatively
high for small quantities of output, then as production increases, it
declines, reaches a minimum value, then rises.
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Because average total cost is a combination of average variable cost and
average fixed cost, the U-shape of the average total cost curve is a result
of both underlying averages, therefore it locates above on AVC At small
production quantities, both average fixed cost and average variable cost
decline, resulting in a negatively-sloped average total cost curve.
However, because of the law of diminishing marginal returns, average
variable cost eventually increases, which overwhelms the continuing
decline of average fixed cost and results in a positively-sloped average
total cost curve.
Behavior of Average Total Cost:

As the output of a firm increases, average total cost like the average variable cost
decreases in the beginning reaches a minimum and then it increases. The reasons
for decline of ATC in the beginning are that it is the sum of AFC and AVC.
Average fixed cost and average variable costs have both the tendency to fall as
output is increased. Average total cost will continue falling so long average
variable cost does not rise. Even if average variable cost continues rising, it is not
necessary that the average total cost will rise. It can be due to the fact that the
increase in average variable cost is less than the fall in average fixed cost. The
increase in average variable cost is counterbalanced by a rapid fall of average
fixed cost. If the rise in the average variable cost is greater than the fall in average
fixed cost, then the average total cost will rise.
The tendency to rise on the part of average total cost-in the beginning is slow,
after a certain point it begins to increase rapidly.
ii) Why marginal and average revenue curve are downward slope shape in
imperfect competition?
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Revenue Curve of an Individual Firm Under Imperfect Competition:
Under imperfect competition, whether it may take the form of monopoly,
duopoly or oligopoly, the demand curve facing the firm is negatively inclined or we
can say its slopes downward from left to right. This means that a firm can affect the market
price and can sell more goods at lower prices and less at a higher price.
Under imperfect competition, the behavior of MR curve is that it lies below the AR curve. As
production expands, the distance between the two curves increases. The AR line and the price
line is the same as is clear from the schedule given below:
Schedule:
Units Sold Price ($) Total Revenue ($)
Marginal Revenue
($)
Average Revenue
($)
15
15
15
15
14
28
13
14
12
36
12
36
35
-1
30
-5
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lt is clear from the above figure (14.4) that average revenue curve and marginal
revenue curve both have a negative slope. MR curve lies below the AR curve
because the output is solid at the falling prices.
iii) Why law of diminishing return specially applied on agriculture sector?
Operation of Law of Diminishing Returns in Agriculture:
Traditional Point of View. The classical economists were of the opinion that the
law of diminishing returns applies only to agriculture and to some extractive
industries, such as mining, fisheries urban land, etc. The law was first stated by a
Scottish farmer as such. It is the practical experience of every farmer that if he
wishes to raise a large quantity of food or other raw material requirements of the
world from a particular piece of land, he cannot do so. He knows it fully that the
producing capacity of the soil is limited and is subject to exhaustation.
As he applies more and more units of labor to a given piece of land, the total
produce no doubt increases but it increases at a diminishing rate.
For example, if the number of labor is doubled, the total yield of his land will not
be double. It will be less than double. If it becomes possible to increase the. yield
in the very same ratio in which the units of labor are increased, then the raw
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material requirements of the whole world can be met by intensive cultivation in a
single flower-pot. As this is not possible, so a rational farmer increases the
application of the units of labor on a piece of land up to a point which is most
profitable to him. This is in brief, is the law of diminishing returns. Marshall has
stated this law as such:
"As Increase in capital and labor applied to the cultivation of land causes in
general a less than proportionate increase in the amount of the produce raised,
unless it happens to coincide with the improvement in the act of agriculture".
iv) What is the relation between price and total expenditure in the case of
necessary goods?
We know that the price of a good and the demand for the good are
inversely related to each other. So, responsiveness of demand in
relation to change in price (i.e. price elasticity of demand) determines
the change in expenditure.
Total Expenditure Method:
Price Elasticity of demand can also be calculated by Total Expenditure Method.
This method was suggested by Prof. Marshall. This method is also known as Total
Outlay or Total Revenue method. Under this method, price elasticity is measured
by comparing Total Expenditure (TE) on the commodity before and after the
change in price. It has three possibilities:
(i) Ed > 1, if TE is inversely related to the price.
(ii) Ed < 1, if TE is directly related to the price.
(iii) Ed = 1, if TE does not change with change in price.
The three cases are diagrammatically shown in Fig. 4.3.
Limitation of this Method:
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Total Expenditure method suffers from one defect. It fails to give the exact
magnitude of elasticity. By this method, we can only know whether the elasticity
is equal to one, greater than one or less than one. Hence, this method is
restrictive and provides only a rough measure of elasticity.
MACRO ECONOMMICS
Q5) If GNP is 20,000 million rupees. Depreciation cost is
10,000 million rupees, indirect taxes are 50,000 million
rupees, and subsidies are 80,000 million rupees then calculate
the National Income at market price and National Income at
factor cost.
RS
MILLION
GNP
20,000
(10,000)
LESS:
DEPRECIATION
NNP (N.I AT MARKET
PRICE)
INDIRECT
TAXES
ADD:
SUBSIDIES
80,000
N.I AT FACTOR COST
40,000
LESS:
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10,000
(50,000)
b) Why the result of national income remains same either it is

calculated by total production method or total income
method?
Ans: The three approaches used for measuring national income give the same
result. The reason is the market value of goods and services produced in a given
period by definition is equal to the amount that buyers must spend to purchase
them. So the product approach which measures market value of goods and
services produced and the expenditure approach which measures spending
should give the same measure of economic activity.
Now as regards the income approach, the sellers receipts must equal what the
buyers spend. The sellers receipts in turn equal the total income generated by
the economic activity. Thus, total expenditure must equal total income generated
implying that the expenditure and income approach must also produce the same
result.
Q6 a) Mention the qualitative and quantitative tools of

monetary policy and how these tools helpful for controlling
the inflation and deflation problems?
Monetary Policy means the policy by which the government of a country
and the central bank try to control the supply of the money and the
availability of credit in the system , with a view to achieve economic
stability.
There are two instruments of monetary policy:1. Quantitative instruments
2. Qualitative instruments.
Quantitative instruments broadly include the following:SIR KHALID AZIZ
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1. Bank rate: it is the rate at which the central bank of a country is

prepared to give credit to the commercial banks. Increase in bank rate
increases the interest rates, and demand for credit gets reduced. On the
other hand decrease in bank rate lowers the rate of interest and credit
becomes cheap, and demand for credit expands.
2. Open market operations: It refers to purchase and sale of securities in
the open market by the central bank. By selling the securities, central bank
reduces the purchasing power of the system.
3. Change in minimum reserve ratio: Minimum reserve ratio refers to the
minimum percentage of a bank total deposit which is required to be kept
with the central bank. All the banks have to keep with the central bank a
certain percentage of their deposits in the form of cash reserve ratio
4. Change in liquidity ratio: Every bank is required to maintain a fixed
percentage of its assets in the form of cash or other liquid assets called
liquidity ratio. With a view to reducing the flow of credit, in the market
central bank enhances the liquidity ratio. However in case of expansion of
credit liquidity ratio is reducing.
Qualitative Instrument include the following5. Change in margin requirements of loans: the margin requirements of
loans refers to the difference between the current value of the security
offered for loans and the value of loans granted.
6. Rationing of credit: Rationing of credit refers to fixation of credit quotas
for different business activities. Rationing of credit is introduced when the
flow of credit is to be checked particularly for speculative activities in the
economy. The central bank fixes quotas for different business activities.
The commercial bank cannot exceed the quotas limits while granting loans.
7. Direct action: The central bank may initiate direct action against the
member banks in case these do not comply with its directives
8. Moral pressure: sometimes the central bank direct the commercial
banks to follow the rules framed by it to control the credit.
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Q7 a) In country x the value of multiplier is 5 and in country

y it is 1.33, discuss why the value of multiplier are different
in two countries.
Ans: Why the Multiplier Will Vary
As noted above, the multiplier is not a constant, equal to the some particular
value in all countries and under all circumstances. Rather, it is a concept,
expressing a relationship (between changes in GDP and changes in government
spending) which will in general vary across different economies and across
different circumstances in any particular economy. Hence even if one had a good
estimate of what it might be in one particular country under particular
circumstances, one should not assume it would have that some value in another
country or even in the same country under different circumstances.
Specifically, one should expect:
1) The multiplier will vary across countries, depending on the size and structure
of those countries: In a large country such as the US, an increase in spending
(both direct and indirect) will be met primarily by supplies originating in the
US. The multiplier will then be relatively large. In contrast, higher spending in a
small and open economy, such as Monaco to take an extreme example, will be
met primarily by supplies originating elsewhere. The multiplier will then be
relatively small. Most economies are in between these two in size, and one
would expect the multiplier then also to be in between these two in size.
Note that this will depend not only on the size of the economy, but also its
economic structure (the type of goods produced within that economy, as
opposed to imported) and the nature of its trade regime. Some economies are
more open than others.
2) The multiplier will vary depending on the current state of the economy
how far or close the economy is to full employment: If unemployment is
significant, an increase in demand can be met with an increased supply of goods,
and an increase in employment of workers to produce those goods. The
multiplier will be relatively high. In contrast, if the economy is at a time of close
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to full employment, an increase in demand for certain goods can only be met by
reduced production of something else (with a shift in jobs from the latter to the
former), so overall output might not rise by much. In such circumstances the
multiplier will be relatively low.
Hence if one had a good estimate of the multiplier in some particular economy at
a point in time when the economy was close to full employment, one would
greatly underestimate what the multiplier would be in that same economy at a
different time when unemployment was high.
b) Discuss the effects of a change in interest rate on total

expenditure in an economy.
Ans: Interest rates are the annual charge for borrowing funds, usually specified as
a percent of the amount borrowed. Changes in interest rates affect the overall
expense of borrowing and thus expenditures undertaken with the borrowed
funds. Higher interest rates tend to decrease expenditures and lower interest
rates lead to increase expenditures.
Most investment expenditures by the business sector and a fair amount
ofconsumption expenditures by the household sector (especially for durable
goods) are made with borrowed funds and are thus affected by changes in
interest rates.
Businesses typically borrow the funds needed for capital goods, such as
factories and equipment.
Households often borrow the funds used to buy durable goods, such as cars
and furniture.
The expense of borrowing these funds depends on interest rates. Higher interest
rates add to the overall cost of these expenditures. Lower interest rates reduce
the overall cost of these expenditures. This means that changes in interest rates
trigger changes in consumption expenditures and investment expenditures, and
thus aggregate expenditures.
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What It Does
The exhibit to the right presents a standard
Keynesian aggregate expenditures line. Like all
aggregate expenditures lines, this one is
constructed based on several ceteris
paribus aggregate expenditures determinants,
such as interest rates. They key question is:
What happens to this aggregate expenditures
line if interest rates change?
Interest Rates
Lower Interest Rates

Suppose, for example, that the Federal decides
to implement expansionary monetary policy.
Fearing an impending recession on the
business-cycle horizon, they decide to expand
the money with a corresponding decrease in
interest rates.
A decline in interest rates can entice the
business sector to boost investment
expenditures. For example, a 1 percentage
point interest rate decline (such as from 10 percent to 9 percent) can reduce the
total interest cost on a $10 million construction loan by $300,000 over a five-year
repayment period. This saving is bound to convince a few firms to undertake extra
investment expenditures.
While the numbers might be smaller, a decline in interest rates is also likely to
entice the household sector to boost consumption expenditures on durable
goods. For example, a 1 percentage point interest rate decline can reduce the
total interest cost on a $20,000 car loan by $6,000 over a five-year repayment
period. This reduction in cost is also bound to convince a few households to make
extra consumption expenditures.
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To see how lower interest rates affect the aggregate expenditures line, click the
[Lower Rates] button. The lower rates trigger an increase in aggregate
expenditures, which is an upward shift of the aggregate expenditures line.
Higher Interest Rates
Alternatively, the Federal Reserve System might decide to implement contraction
monetary policy. Fearing the onset of higher inflation, the folks at the Fed might
decide to reduce the money supply and subsequently increase interest rates.
Higher interest rates have the opposite effect on both business investment and
household consumption as lower rates. The interest cost of constructing a new
factory is higher. So too is the interest expense of buying a new car.
To see how higher interest rates affect the aggregate expenditures line, click the
[Higher Rates] button. The higher rates trigger a decrease in aggregate
expenditures, which is a downward shift of the aggregate expenditures line.
What Does It Mean?
Changes in aggregate expenditures due to interest rates are important for a
couple of reasons.
Business Cycle: Interest rates tend to rise and fall over the expansions and
contractions of the business cycle. During an expansion, especially near the
end of the expansion, interest rates tend to rise. Then once a contraction
sets it, interest rates tend to fall. In fact, these interest rate changes are
part of the "natural" business cycle mechanism. Higher interest rates during
an expansion cause the decline in aggregate expenditures that result in a
contraction. Lower interest rates during a contraction then cause the rise in
aggregate expenditures that result in an expansion.
Monetary Policy: Interest rates are also affected by monetary policy that is
designed to counter business-cycle instability. Expansionary monetary
policy involves lower interest rates intended to increase aggregate
expenditures and offset a contraction and address the problems of
unemployment. Contractionary monetary policy involves higher interest
rates intended to decrease aggregate expenditures and offset an expansion
and address the problems of inflation.
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Q8)
i) Keynes Psychological law of consumption

Psychological Law of Consumption By J.M Keynes:
J.M. Keynes, in his book General Theory analyzed the consumption behavior of
the community on the basis of human psychology. He propounded a law which is
known as Psychological Law of Consumption.
Statement:
According to this law:
"The household sector spends a major part of its income on the purchase of
consumer goods and services such as food, clothing, medicines, shelter etc., for
personal satisfaction. The expenditure on consumption (C) is the largest
component of aggregate expenditure. Whatever is not consumed out of
disposable income is by definition called saving (S)".
Formula:
Disposable Income = Consumption + Saving
I=C+S
Explanation:
According to Keynes, the level of consumption in a community depends upon the
level of disposable income. As income increases, consumption also increases but
it increases not as fast as income i.e., it increases at a diminishing rate. This
relationship between consumption and disposable income is called consumption
function.
In the words of Keynes:
Men are disposable as a rule and on the average to increases their consumption
as their income increases, but hot by as much as the increases in their income.
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Properties of Consumption Behavior of Community:

The psychological law of consumption brings out the following properties of the
consumption behavior of the community:
(i) The level of consumption is directly functionally related to the level of
disposable income = C = f(y)
(ii) With the rise in the level of income, the consumption level also rises, but at a
decreasing rate = C < y
(iii) As the level of income increases, the households devote a part of the increase
saving. Symbolically: Y = C + S
The Keynesian consumption function is now explained with the help of schedule
and a curve.
Schedule:
($ in billions)
Disposable
Income (Y)
Consumption
(C)
Saving (S)
50
-50
100
100
200
300
APC (C/Y)
MPC (C/Y)
1.00
0.5
150
50
0.75
0.5
200
100
0.67
0.5
In the schedule, it is shown that as the nations disposable income increases, the
aggregate consumption at various levels of income also increases but at a
decreasing rate.
The same data is now shown in graph 30.1 below:
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Diagram/Graph:
Following are the observations about the functional relationship between the
national disposable income and the economys aggregate expenditure.
(i) At every point on the 450 line OY, a vertical line drawn to the income axis is at
the same distance from the origin as a horizontal line drawn to the consumption
axis. The 450 line thus is the line along which expenditure equals real income.
(ii) The consumption function is represented by consumption line (C). The
consumption line C is positively sloped indicating that as the disposable income
increases, the expenditure in the economy also increases.
(iii) The consumption line (C) intercepts at Y axis showing negative saving of $50
billion during a short period.
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(iv) At point B the consumption line (C) intersects the 450 helping line (OY) saving.
At point B, consumption equals disposable income and there is zero saving. B is
called the break even point.
(v) Left to the point B, the consumption line C is above the income line Y. It
indicates negative saving.
(vi) Right to the point B, the consumption line C is below the income line Y. It
denotes positive savings.
Summing up, the relationship between consumption and disposable income is
referred to as consumption function. A consumption function tells how much
households plan to consume at various levels of disposable income.
ii) Responsible factors of propensity to consume

8 essential factors that determines propensity to consume
Objective factors
(1) Income:Income is the most important factor which determines the consumption
expenditure in a society. The greater the level of disposable income, the higher is
the consumption expenditure with a fall in income, the consumption demand of
household goes down.
(2) Distribution of income:

Consumption function depends on the way in which the income is distributed.
Greater the inequality-in income distribution, lower will be the propensity to
consume, greater the equality in income distribution, higher will be the
propensity to consume. An equal distribution of income will raise consumption
function because the poor people will increase their consumption expenditure
more than the expenditure of the rich.
(3) Wage level:
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If the wage rate arises, the consumption function shifts upward. If the rise in price
level is more in proportionate to the rise in wage, the real wage will fall and
consumption function will shift downward.
(4) Rate of interest:
A significant rise in interest rate will induce people to consume less and save
more in order to gain from the higher rate interest. On the contrary, an increase
in tin- interest rate may diminish investment and reduce income. Will the fall in
income saving falls even at a higher rate of interest.
(5) Holding of liquid assets:
The consumption function also influenced by the holding of liquid assets, (Govt,
bond, cash) When people have more liquid assets, they will spend more out of
their current income and that their propensity to consume will increase. An
increase in the real value of their assets will raise consumption expenditure.
(6) Changes in expectation:
Changes in future expectation also affect the consumption function. Expectation
of emergency and fear of shortage of essential goods will induce people to
purchase the goods much in excess of their current needs. This will shift the
consumption upward.
(7) Wind fall gains and losses:
Windfall gains tend to arise the propensity to consume while widespread losses
will shift the consumption function downward.
(8) Fiscal policy:

Heavy indirect taxation, rationing and price control adversely affect the
propensity to consume. Progressive tax shifts the consumption function upward
by bringing about more equitable distribution of income.
Subjective factors:
Subjective factors are indigenous or internal to economic system subjective
factors determine the form of consumption function.
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(i) People save to face the unforeseen contingencies such as Illness, unemployed,
accidents etc.
(ii) People are induced to save because they want to provide for the future needs,
i.e. education of the children, marriages of the children etc.
(iii) To possess power or to get higher social or political status.
(iv) People are motivated to save so that they can accumulate large wealth which
will increase their social states.
(v) To enjoy an enlarged future income by investing funds of current income.
iii) Why the values of MPC and MPS is less than one?
Because both are less than income earned. There's only two options
when you earn a dollar. You can save it or you can spend it. The
marginal propensity to consume (MPC) shows us the change in
consumption when income either decreases or increases.
When you look at a consumption schedule, you will see consumption go
up as income goes up. Consumption only increases by a portion of what
income increases by. This is due to our MPC. We don't spend everything
we earn. This means consumption does not go up as quickly as income.
It should also be noted that the MPC is the slope of the consumption
line.
The slope of income is 1. MPC is a smaller number (I believe it's about
.85 or .95 in the U.S.). If MPC equals 1, then we are spending everything
that we earn. This would mean that the consumption line and the
income line would be identical.
The MPS is everything else that we do not consume. MPS is the slope of
the saving schedule. It increases at a slower rate than consumption and
income.
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MPS + MPC must always equal to 1. For economic purposes, if you are
not spending the money you earned. You are considered to be saving
that money. This means that if MPC is .85 then MPS is .15. This means
that for every dollar you earn, you spend 85 cents and save 15 cents.
iv) Inflationary and deflationary Gap

Inflationary and Deflationary Gaps:
J. M. Keynes in his famous book 'General Theory' put forward an analysis of
unemployment and inflation. The Keynesian theory assumes that a maximum
level of national output can be obtained at any particular time in the economy.
According to him the maximum level of national income is generally referred to as
full employment level of national income. If the equilibrium level of national
income coincides with the full employment, there will be no deficiency of
aggregate demand and hence no dis-equilibrium unemployment (seasonal,
frictional unemployment can exist at this level).
Now if the equilibrium level of income as determined by the AD (aggregate
demand) and AS (aggregate supply) is not equal to the level of full employment,
then two situations can arise. Either this equilibrium level will be below the full
employment level or above the lull employment level. In case, the equilibrium
income is below the potential income, it indicates the presence of recessionary
gap. If it is above the full employment income, it shows the presence of
inflationary gap. Both the situations of deflationary and inflationary gaps are
situations of disequilibrium in the economy. These gaps are now explained with
the help of graphs.
Deflationary Gap/Recessionary Gap:
Deflationary gap is also called re-cessionary gap. When there is an insufficient demand for
goods and services in the economy, the equilibrium will occur at the lower level of full
employment income and to the left of full employment line. In other words, re-cessionary gap
occurs when the aggregate demand is not sufficient to create conditions of full employment.
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The deflationary gap thus is the difference of amount by which aggregate expenditure falls
short of the level needed to generate equilibrium national income at full employment without
inflation.
Example and Diagram/Figure:

The deflationary gap is illustrated in figure below:
In this diagram 31.4, the national income is measured on OX axis and aggregate
expenditure on OY axis. Let us assume initially that the aggregate expenditure
curves AE interests the 45 degree line at point E/ to the left of full employment
line or potential income.
The economy is operating at equilibrium income level of $150 billion which is
below potential income of $250 billion. There is a deficiency of $100 billion in
aggregate expenditures. This shortfall of national expenditure ($100 billion) below
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the potential income or the full employment level of national income is called Recessionary Gap.
Fighting Recession:
When the economy is operating below its potential income, the government
recognizes the re-cessionary gap in aggregate income. It increases its
expenditures to stimulate the economy. The multiplier process takes over. The
increase in government expenditure shifts the AE/ curve from AE to
AE1 increasing aggregate income to the full employment income level. Such
government action is expansionary fiscal policy.
Deflationary gap thus represents the difference between the actual aggregate
demand and the aggregate demand which is required to establish the equilibrium
at full employment level of Income.
Inflationary Gap:
An inflationary gap is just the opposite of deflationary gap. It is said to exist when
equilibrium income exceeds full employment income. It is created due to the
effective demand being in excess of the full employment level. It is the difference
between equilibrium income and full employment income (potential income)
when equilibrium income exceeds the full employment income. Here people are
trying to buy more goods and services than can be produced when all resources
are fully employed. There is too much money chasing too few goods. The result is
that the excess demand pulls up prices and there is inflation. The excess demand
for goods and services is being met in money terms but not real, terms.
Example and Diagram/Figure:
An inflationary gap is explained with the help of figure below:
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In this figure 31.5 aggregate expenditure curve AE intersects the aggregate

production curve (45 degree helping line) at point E/ to the right of potential line
or full employment line (FE).
The equilibrium level of income is $200 billion whereas the potential income is
$100 billion. When the equilibrium income exceeds potential income, there is said
to be inflationary gap which in the diagram is $100 billion. The excess expenditure
of $100 billion causes upward pressure on prices when there is no additional
output produced.
Fighting Inflation:
Whenever there is an inflationary gap in the economy, the government adopts
deflationary fiscal policy of lowering government expenditure or raising taxes. It
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also adopts deflationary monetary policy for reducing the amount of money in
the economy.
Summing Up:
(i) When equilibrium income is below its potential income level, the difference is
called deflationary gap. The government can increase its expenditure to
stimulate the economy.
(ii) When equilibrium income exceeds the potential income, the difference is
called an inflationary gap. To prevent inflation. Keynes believes that the
government should exercise contractionary fiscal policy, cutting government
expenditure, raising taxes etc.
ECONOMIC SYSTEM
Q9) Highlight the features of Islamic Economic
System and why it is better than the other Economic
Systems?
Ans:
1. Allah is the Sustainer
2. God is Real Owner of Everything and Man is Merely a Trustee
3. Everything Created for Service and Use of Man
4. Concept of Halal and Haram
5. System of Sadaqat and Zakat
6. Prohibition of Interest
7. Ban on Hoarding of Wealth
8. Policy of Moderation
9. Condemnation of Monasticism and Materialism
10.Equity and not Equality
Every economic system has its own peculiar features, which form its
foundation and from which it can be distinguished and recognized. Modern
capitalism, which has emerged due to rapid industrialization facilitated by
unprecedented human advancement in science and technology, is based on
free market economy, non-intervention or very limited intervention of state in
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economic affairs, interest and banking. Socialism, which has emerged as a
reaction to capitalism, believes in complete control of state on economy and
full ownership of means of production by the state or community. Feudalism
stands for ownership of land by few persons or families and makes majority of
people tenants or serfs who work on lands either as servants of the landlords
or for meager share in the produce of land.
Islam, on the other hand, believes in justice and fairness in the economic field.
According to it, the man is Gods viceroy or deputy in overall divine scheme
and he has been given limited rights of ownership of means of production. It
recognizes intervention of state in the economic activity for the purpose of
ensuring welfare of its citizens. Abolition of interest, institution of sadaqat and
Zakat, concept of lawful and unlawful, equitable distribution of wealth,
prohibition of hoarding and stress on circulation of wealth, concern for well
being of the poor are the distinctive features of the Islamic economic system.
We will elaborate and discuss some features of Islamic economy in this
chapter as follows:
1- Allah is the Sustainer
One of the major features of Islamic economic system is the concept that
Allah, the Almighty God of universe, is the sustainer and provider. Allah
provides livelihood and subsistence to all of His creatures in the universe. It is
Allah who has created all means and resources through which man earns his
livelihood. Allah, in fact, has committed to feed, sustain and nourish all
creatures including human beings. It is Allah who expands or curtails rizq
(sustenance).
To explain and elaborate this concept further, let us reproduce the relevant
verses of the Holy Qur'an and Ahadith of the Prophet of Islam.
Verses of the Quran:
1- And there is not a beast in the earth but the sustenance thereof
dependeth on Allah. He knoweth its habitation and its repository. All is
in a clear record.
-(11 : 6)
2.
Lo! Thy lord enlargeth the provision for which He will, and straiteneth
it (for whom He will). Lo, He was ever Knower, Seer of His slaves.
-(17 : 30)
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3.
And how many an animal there is that beareth not its own provision!
Allah provideth for it and for you. He is the Hearer, the Knower.
-(29 : 60)
4. Allah maketh the provision wide for whom He will of His bondmen, and
straiteneth it for whom (He will) Lo! Allah is Aware of all things.
-(29 : 62)
5.
O mankind! Remember Allahs grace towards you! Is there any

creator other than Allah Who provideth for you from the sky and the
earth?..
-(35 : 3)
6.
Have yet seen that which ye cultivate? Is it ye who foster it, or are We
the fosterer?
-(56 : 63-64)
7.
Or who is he that will provide for you if He should withhold His

providence?..
-(67 : 21)
Ahadith of Muhammad (PBUH) :

1-
Omar-b-al-Khattab reported : I heard the Messenger of Allah say : If

you all had relied on Allah with due reliance, He would have certainly
given you provision as He supplies provisions to birds who get up
hungry in the morning and return with full belly at dusk.
-----(Tirmizi, Ibn Majah)
2.
Abu Dardaa reported that the Messenger of Allah said: Certainly

provision seeks a servant just as his death seeks him.
-----(Abu Nayeem)
3.
Jabir b. Abdullah reported : The Messenger of Allah (may peace be

upon him) said: O people, Fear God and cut your ambitions of
livelihood, for a man will not court death unless he is provided full
sustenance (decreed) for him even if he restrains himself from it. So,
fear Allah and cut your ambitions in search of livelihood. Take
whatever is lawful and leave whatever is unlawful.
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-----(Ibn Majah)
4.
Ali (Allah be pleased with him) said: I heard the Messenger of Allah
(may peace be upon him) saying: (on the Day of Resurrection) when
there will be no shade except that of the Throne of Allah, the person
who undertakes a journey to earn his livelihood and then returns with
it towards his dependents, will be under the shade of Allahs Throne.
-----(Masnud Zaid bin Ali)
5.
Ali (Allah be pleased with him) said: A person came to the Prophet of
Allah (May peace be upon him) and asked: O Messenger of Allah:
What type of earning is best? The Prophet (may peace be upon him)
said: A mans work with his hand and every business transaction which
is approved, for Allah loves a believer who is a craftsman. A person
who suffers pain to feed his dependents is like a person who fights in
the cause of Allah, the Mighty and Glorious.
-----(Masnud Zaid bin Ali)
The conception of Gods Dispensation does not, however, suggest that one
should sit idle and wait for sustenance which would automatically come to
him. Instead of giving up struggle, Islam rather inspires a person to do his best
in order to earn his livelihood by using all lawful (Halal) and fair means. The
Quran encourages struggle when it says: And that man hath only that for
which he maketh effort, and that his effort will be seen(53 : 39-40). The
revealed book of Islam encourages its followers even on Friday to disperse in
the land after finishing their prayer and seek of the bounty of God (62:10).
Ahadith of Prophet Muhammad (PBUH) also emphasis the importance of
struggle and hard work put in for earning livelihood for oneself and ones
family.
This concept only emphasizes some basic truths, namely: God provides
sustenance to all His creatures by placing sufficient and infinite resources in
the earth, everything has been created by God for service of man, and man
should exploit these resources and things in lawful manner to earn his
subsistence without violating the rights of others.
2- God is Real Owner of Everything and Man is merely a Trustee
The heavens and the earth and everything in the universe belongs to Allah.
God is the real owner of everything, al-though He has given some rights to
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man for use of things required by the latter for his existence on the earth.
However, the rights given to man are very limited, the real position of man
being that of a trustee and a beneficiary. Some of the relevant verses of the
Quran which highlight this concept are given as under:
1.
Unto Allah belonged whatsoever is in the heavens and whatsoever is in

the earth; and unto Allah all things are returned.
-(3 : 109)
2.
Unto Allah belonged whatsoever is in the heavens and whatsoever is in

the earth. Allah ever surrounded all things.
-(4 : 126)
3.
He it is Who hath placed you as viceroys of the earth and hath exalted
some of you in rank above others, that He may try you by (the test of)
that which He hath given you. Lo! Thy Lord is swift in prosecution, and
lo! He is Forgiving, Merciful.
-(6 : 165)
4.
Believe in Allah and His messenger, and spend of that whereof He hath
made you trustees; and such of you as believe and spend (aright),
theirs will be a great reward.
-(57 : 7)
This limited ownership or trusteeship bestowed on man by Allah in respect of

the wealth which is given to him is not without significance. The divine
wisdom underlying this principle of trusteeship is that man should not hoard
his wealth treating it as his absolute ownership and deprive others from its
use. Rather the surplus wealth of man must go to his fellow beings that are in
want. This principle has been made clearer when the Quran says : . and
bestow upon them of the wealth of Allah which He has bestowed upon
you (24 : 33). Thus the whole scheme of circulation of wealth through
charity and Zakat and distribution of wealth through other equitable means
envisaged by Islam is based on mans limited rights as a trustee of wealth
which has been bestowed on him by His Lord.
3- Everything Created for Service and Use of Man
It is God who has created everything in this universe. Many of the things
created by God in the earth are of benefit to man directly or indirectly.
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Animals, plants, minerals, metals, water, air, fire, land, river, mountains, sea,
and even sun, moon, stars, day and night, etc. are all for service to man. Many
economic benefits have been placed by God in these things for man. The
Quran brings this fact to light in its following verses:
1.
He it is Who created for you all that is in the earth. Then turned Him to
the heaven, and fashioned it as seven heavens. And He is Knower of all
things.
-----2:Al-Baqarah:29
2.
And He it is Who hath set for you the stars that ye may guide your
course by them amid the darkness of the land and the sea. We have
detailed our revelations for a people Who have Knowledge.
-----6:Al-Anam:97
3. He it is Who sendeth down water from the sky, whence ye have drink,
and whence are trees on which ye send your beasts to pasture.
Therewith He caused crops to grow for you, and the olive and the datepalm and grapes and all kinds of fruit. Lo! herein is indeed a portent
for people who reflect. And He hath constrained the night and the day
and the sun and the moon to be of service unto you, and the stars are
made subservient by His command. Lo! herein indeed are portents for
people who have sense. And whatsoever He hath created for you in the
earth of diverse hues, lo! therein is indeed a portent for people who
take heed. And He it is Who hath constrained the sea to be of service
that ye eat fresh meat from thence, and thou sees the ships ploughing
it that ye (mankind) may seek of His bounty, and that haply ye may give
thanks. And He hath cast into the earth firm hills that it quake not with
you, and streams and roads that ye may find a way. And landmarks
(too), and by the star they find a way.
-----16:An-Nahl:10-16
4. And Allah hath given you in your houses an abode, and hath given you
(also), of the hides of cattle, tent-houses which ye find light (to carry)
on the day of migration and on the day of pitching camp; and of their
wool and their fur and their hair, caparison and comfort for a while.
And Allah hath given you, of that which He hath created, shelter from
the sun; and hath given you places of refuge in the mountains, and
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have given you coats to ward off the heat from you, and coats (of
armour) to save you from your own foolhardiness. Thus doth He
perfect His favours unto you, in order that ye may surrender (unto
Him).
-----16:An-Nahl:80-81
5.
See you not how Allah hath made serviceable unto you whatsoever is
in heavens and whatsoever is in the earth and hath loaded you with His
favours both without and within? Yet of mankind is he who disputeth
concerning Allah without knowledge or guidance or a Scripture giving
light.
-----31:Luqman:20
4- Concept of Halal and Haram

Islam has introduced concept of Halal (lawful) and Haram (unlawful) in its
economic system. In fact the foundations of the Islamic economy have been
laid on this concept. This concept reigns supreme in the realm of production
as well as consumption. Certain means of earning livelihood and wealth have
been declared unlawful such as interest, bribery, gambling and games of
chance, speculation, short weighing and short measuring, business
malpractices, etc. Unlawful means of earning are strictly forbidden and a
follower of Islam is permitted to earn through lawful and fair means. Similarly
in the field of consumption certain items of food are unlawful such as dead
animals, blood, swine flesh and animals slaughtered in the name other than
that of Allah. Even expenses on certain items such as drinks, narcotics,
debauchery, prostitution, pornography, things that promote obscenity and
vulgarity, lotteries and gambling are strictly inadmissible.
Now let us glance through relevant verses of the Quran and Ahadith of
Muhammad (PBUH), the Prophet of Islam, to highlight in brief the concept of
halal and haram.
1-
O mankind! Eat of that which is lawful and wholesome in the earth,

and follow not the footsteps of the devil. Lo! he is an open enemy for
you.
(2:168)
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2.
O ye who believe! Eat of the good things wherewith We have provided

you, and render thanks to Allah if it is (indeed) He Whom ye worship.
He hath forbidden you only carrion, and blood, and swine flesh, and
that which hath been immolated to (the name of) any other than Allah.
But he who is driven by necessity, neither craving nor transgressing, it
is no sin for him. Lo! Allah is Forgiving, Merciful.
(2:172-173)
3.
And eat not up your property among yourselves in vanity, nor seek by
it to gain the hearing of the judges that ye may knowingly devour a
portion of the property of others wrongfully.
(2:188)
Ahadith of Prophet Muhammad (PBUH):

1.
Abu Hurairah reported that the messenger of Allah said: Verily Allah is
pure. He does not accept but what is pure ..Then he mentioned about
a man disheveled in hair and laden with dust, making his journey long
and extending his hands towards heaven: O Lord! O Lord! while his
food was unlawful, his drink unlawful, his dress unlawful and he was
nourished with unlawful things. How he can be responded for that?
(Muslim)
2.
Abu Masud Al Ansari reported that the messenger of Allah forbade the
price of dogs, earnings of prostitute and foretelling of a soothsayer.
(Bukhari,Muslim)
3.
Jabir reported that the messenger of Allah cursed the devourer of

usury, its payer, its scribe, and its two witnesses. And he said that they
are equal (in sins)
(Muslim)
4.
Abdullah-bin-Amr reported that the messenger of Allah cursed the

bribe taker and the bribe giver.
(Abu Daud)
5.
Jabir reported that the messenger of Allah..forbade the sale of wine,

dead animals, pigs and idols.
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(Bukhari,Muslim)
6. Abdullah-bin-Amr reported that the messenger of Allah prohibited
intoxicants, games of chance, card-playing and Gobairah and he said:
Every intoxicant is unlawful.
(Abu Daud)
5- System of Sadaqat and Zakat
Islamic economic order has introduced a comprehensive system of sadaqat
which comprises: compulsory contributions like Zakah, sadaqatul Fitr,
monetary atonements; and voluntary contributions such as alms-giving,
spending in the way of Allah on the poor, donations to charitable cause, waqf,
etc. Charity and alms giving is sometimes called by the Quran a goodly loan to
God Who Himself would compensate the giver manifold and also reward him
in the Hereafter. Islam has declared that the poor and destitute have due
share in the wealth of the rich and the rich are bound to return the share of
the poor without stint.
The system of sadaqat ensures equitable distribution of wealth in the Muslim
community and makes it certain that the wealth does not remain hoarded in
idle channels. Circulation of wealth in productive channels is ensured by
enhancing the purchasing power of the poor. Concentration of wealth in few
hands is discouraged and the gap between the rich and the poor is bridged.
Some of the verses of the Quran and Ahadith regarding system of sadaqat are
reproduced as follows:
1- Establish worship, pay the poor-due, and bow your heads with those
who bow (in worship).
(2:43)
2. Spend your wealth for the cause of Allah, and be not cast by your own
hands to ruin; and do well. Lo! Allah loved the beneficent.
(2:195)
3. They ask thee what they shall spend. Say : That which ye spend for
good (must go) to parents and near kindred and orphans and the
needy and the wayfarers. And what so ever good ye do, lo! Allah is
Aware of it.
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(2:215)
4. Who is it that will lend unto Allah a goodly loan, so that He may cause it
increase manifold? Allah straiteneth and enlargeth. Unto Him ye will
return.
(2:245)
5. O ye who believe! Spend of that wherewith We have provided you
were a day come when there will be no trafficking, nor friendship, nor
intercession. The disbelievers, they are the wrong-doers.
(2:254)
6. Ye will not attain unto piety until ye spend of that which ye love. And
whatsoever ye spend, Allah is aware thereof.
(3:92)
7. And in their wealth the beggar and the outcast had due share.
51:19
8. Lo ! those who give alms, both men and women, and lend unto Allah a
goodly loan, it will be doubled for them, and theirs' will be a rich
reward.
57:18
Ahadith of the Prophet:
1. Anas reported that messenger of Allah said: verily charity appeases
wrath of the Lord and removes pangs of death.
(Tirmizi)
2. Abdullah bin Masud raising the tradition reported. There are three
whom Allah loves. A man who gets up at night to read the Book of
Allah, and a man giving alms with his right hand which he conceals (I
consider that he said) from his left hand, and a man, being in a
battalion, encounters the enemies, although his companions are
routed.
(Tirmizi)
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3. Marsad bin Abdullah reported: Some of the companions of the Holy
Prophet informed me that he heard the Prophet say: Surely the shade
of the believer on the Resurrection Day will be his charity.
(Ahmad)
4. Ibn Abbas reported that the Holy Prophet sent Muaz to Yemen saying:
Certainly you will come across a people, the People of the Book. Call
them to bear witness that there is no God but Allah and that
Muhammad is the Messenger of Allah. If they submit to that, teach
them that Allah has made obligatory upon them prayer for five times a
day and a night. If they submit to that, teach them that Allah has made
obligatory over them Zakat which will be taken from the rich and will
be given to the poor among them. If they then obey that, avoid taking
the best part of their property and fear the invocation of the
oppressed, because between it and Allah, there is no veil.
-(Bukhari and Muslim)
6.
Ibn Omar reported that the Messenger of Allah made obligatory the
charity of Fitr one Saa of dried dates or one Saa of barley upon the
slave and the free, male and female, young and old from among the
Muslims. He directed its payment before the people go out for the
(Eid) prayer.
-(Bukhari , Muslim)
6- Prohibition of Interest
Interest, which forms the foundation of capitalistic system of economy and
which has not been eliminated even in the socialist system, has been
completely abolished by Islam. Charging of interest is a major sin and the
usurers have been given the notice of war from God and His messenger.
Following are some of the verses of the Quran and Ahadith of Muhammad
(PBUH) dealing with interest.
Verses of the Quran :
1-
Those who swallow usury cannot rise up save as he ariseth whom the
devil hath prostrated by (his) touch. That is because they say : Trade is
just like usury; whereas Allah permitted trading and forbiddeth usury.
He unto whom an admonition from his Lord cometh and (he)
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refraineth (in obedience there to), he shall keep (the profits of) that
which is past, and his affair (henceforth) is with Allah. As for him who
returneth (to usury). Such are rightful owners of the Fire. They will
abide therein. Allah hath blighted usury and made almsgiving fruitful.
Allah loveth not the impious and guilty.
(2:275-276)
2-
O ye who believe ! Observe your duty to Allah, and give up what

remaineth (due to you) from usury, if ye are (in truth) believers. And if
ye do not, then be warned of war (against you) from Allah and His
messenger. And if ye repent, then ye have your principal (without
interest). Wrong not and ye shall not be wronged.
(2:278-279)
3-
O, ye who believe ! Devour not usury, doubling and quadrupling (the

sum lent). Observer your duty to Allah, that ye may be successful.
(3:130)
Ahadith of Muhammad (PBUH):

1-
Jaber reported that the Messenger of Allah cursed the devourer of

usury, its payer, its scribe, and its two witnesses. And he said that they
are equal (in sin).
-(Muslim)
2-
Abdullah-bin-Hanjalah reported that the Messenger of Allah said: A

Dirham of usury a man devours with knowledge is greater than thirtysix fornications.
(Ahmad, Darqutni)
We would, insha Allah, focus on the subject of interest and elaborately discuss
it in an independent chapter in this book.
7- Ban on Hoarding of Wealth
Hoarding of wealth has been condemned by Islam in very clear terms, and
those who hoard wealth and do not spend it for good cause have been
threatened with painful doom. Hoarding of wealth is a great evil as it
tantamounts to obstruction of flow of God-given wealth from the rich to the
poor who are in genuine need of it. Therefore, Islam discourages hoarding of
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wealth and instead encourages circulation of wealth among all the sections of
society. Following verses of the Quran and Ahadith of the Prophet of Islam
throw light on this subject.
Verses of the Quran :
1-
And let not those who hoard up that which Allah hath bestowed upon
them of His bounty think that it is better for them. Nay, it is worse for
them. That which they hoard will be their collar on the Day of
Resurrection
-(Al-Imran 3:180)
2-
...... They who hoard up gold and silver and spend in not in the way of
Allah, unto them give tidings (O Muhammad) of a painful doom. On the
Day when it will (all) be heated in the fire of hell and their foreheads
and their flanks and their backs will be branded therewith (and it will
be said unto them): Here is that which ye hoarded for yourselves. Now
taste of what ye used to hoard!
-----(9:At-Taubah:34-35)
3-
That which Allah giveth as spoil unto His messenger from the people of
the townships, it is for Allah and His messenger and for the near of kin
and the orphans and the needy and the wayfarer, that it become not a
commodity between the rich among you. And whatsoever the
messenger giveth you, take it. And whatsoever he forbiddeth, abstain
(from it). And keep your duty to Allah. Lo! Allah is stern in reprisal.
-----(Al Hashr 59:7)
Ahadith of Prophet Muhammad (PBUH):

1-
Abu Hurairah reported that the Messenger of Allah used to store up

nothing for the morrow.
-(Tirmizi)
2-
Ayesha reported that the Messenger of Allah said: This world is an

abode for one who has got no abode, and a property for one who has
got no property, and one who has got no wisdom hoards for it.
(Ahmad, Baihaqi)
8- Policy of Moderation
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Islam follows policy of middle way or moderation and avoids extremes. The
two extremes of every action are bad and moderation between them is the
best policy according to Islam. Following verses of the Quran and Ahadith of
Muhammad exhort the Muslims to follow the way of moderation.
The verses of the Quran :
1-
O ye, who believe ! Forbid not the good things, which Allah hath made
lawful for you, and transgress not. Lo, Allah loveth not transgressors.
-(5 : 87)
2-
And let not thy hand be chained to thy neck nor open it with a
complete opening, lest thou sit down rebuked, denuded.
-(17 : 29)
3-
And thou (Muhammad) be not loud voiced in thy worship nor

yet silent therein, but follow a way between.
-(17 : 110)
4-
Be modest in thy bearing and subdue thy voice. Lo! the harshest of all
voices is the voice of the ass.
(31 : 19)
Ahadith of the Prophet :

1-
Good manners, delay and moderation form a part out of twenty-four

parts of Prophet hood.
-(Mishkat-ul-Masabih)
2-
Abu Hurairah reported that the Messenger of Allah said: Moderation in

expenditure is half of livelihood, and love for people is half of wisdom,
and good questioning is half of learning.
-(Bukhari)
3-
Matref-b-Abdullah reported that the messenger of Allah said: The best

of affairs is their mean.
The principle of moderation propounded by the above mentioned texts

equally applies in economic field specially in the field of acquisition of wealth
and consumption.
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9- Condemnation of Monasticism and Materialism
Islam condemns Monasticism as well as Materialism and recommends its
followers to adopt middle way between these two extremist ways of life.
A spiritual or a monastic lays all the emphasis on moral and spiritual aspect of
life and ignores completely material aspect. He regards all economic activity
as a vice and economic struggle as a sinful act. The Quran, the revealed
scripture of Islam, expresses its dislike explicitly for the monastic way of life in
its following verses:
1-
O ye who believe ! Forbid not the good things which Allah hath made
lawful for you, and transgress not. Lo! Allah loveth not transgressors.
-(5 : 87)
2-
But monasticism they invented. We ordained it not for them-only

seeking Allahs pleasure, and they observed it not with right
observance. So we give those of them who believe their reward, but
many of them are evil-livers.
-(57 : 27)
The Prophet of Islam has also discouraged the monastic way of life among his
followers. Once he learnt that some companions had taken a vow to fast
during the day, pass the night in worship, abstain from meat and fat and
renounce intercourse with women. Thereupon he (peace be on him) delivered
a sermon in the course of which he observed : This is not my creed. Your
body has rights over you. You should fast, but eat and drink also. Pray at night,
but sleep also. Look at me. I sleep and I pray also. I both keep and omit fasts. I
eat both meat and fat. So whoso does not subscribe to my way, he is not of
mine.[1]
He (peace be on him) then said, What has happened to people that they
have renounced women, good food, perfume, sleep and worldly pleasure? I
have never taught you to be a monk or a priest. In my Deen (Creed) there is
not provision for renunciation of women or meat nor for abandoning the
world. For self-control, I enjoin fast. All the advantages of asceticism can be
had from the Jihad of Islam. Worship Allah and do not associate naught with
him. Perform Hajj and Umra. Establish Namaz, pay Zakat, and keep fasts
in Ramadan. The people who came to ruin before you met this fate because
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they were hard on themselves and Allah was hard on them too. It is the
remnants of these people that you see in monasteries and convents.2
Some other traditions on the same subject relate that the Holy Prophet (peace
be on him) once learned regarding a companion that it was long since he had
gone in to his wife and was engaged in prayer day and night. The Holy Prophet
(peace be on him) summoned him and ordered that he should go in to his wife
at once. I am fasting, submitted the companion. Break your fast and
proceed, the Holy Prophet (peace be on him) told him.3
Thus Islam does not subscribe to the view of monks and ascetics that
satisfaction of physical urges is an impediment in spiritual development.
Rather Islam enjoins upon its followers that the things, which Allah has made
lawful for them, should be enjoyed as enjoyment of them is piety and
renunciation of them is transgression.
On the other hand Islam has expressed in unequivocal and unambiguous
terms its condemnation of Materialism as well. Materialists are those who lay
the entire stress on the material aspect of life. They ignore moral aspect of life
and devote their entire time and energy to the attainment of material ends.
They justify every means, right or wrong, to acquire wealth and comforts of
this life and utterly disregard moral values, noble causes and human virtues.
Following verses of the Quran reject materialism which, in fact, is passion for
wealth and worldly pleasures:
1-
.But of mankind is he who saith: Our Lord ! Give unto us in this

world and he hath no portion in the Hereafter.
-(2 : 200)
2-
Lo ! Those who expect not the meeting with Us but desire the life of
the world and feel secure therein, and those who are neglectful of Our
revelations; Their home will be the Fire because of what they used to
earn.
(10 : 7-8)
3-
Whoso desireth the life of the world and its pomp, We shall repay
them their deeds herein, and therein they will not be wronged. These
are they for whom is naught in the Hereafter save the Fire. (All) that
they contrive here is vain and (all) that they are wont to do is fruitless.
-----(11 : 15-16)
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4-
Whoso desireth that (life) which hasteneth away, We hasten for him
therein that We will for whom We please. And afterward We have
appointed for him hell; he will endure the heat thereof, condemned,
rejected.
-----(17 : 18)
5-
Rivalry in worldly increase distracteth you. Until ye come to the graves.

-(102 : 1-2)
6-
Woe unto every slandering traducer, who hath gathered wealth (of this
world), and arranged it. He thinketh that his wealth will render him
immortal. Nay, but verily he will be flung to the Consuming One. Ah,
what will convey unto thee what the Consuming One is! (It is) the fire
of Allah, kindled.
-(104 : 1-6)
Islam adopts middle way between these two extremist views of life. It advises
its followers that their success lies neither in monasticism nor in pure
materialism. Therefore, they should neither give themselves up entirely to
monasticism or spiritualism disregarding the importance of material means of
life; nor they should go to the other extreme and judge everything by the
materialistic point of view. They should strike balance between these
extremes and follow middle path. The Muslims have been called by the
Quran the people of the middle way and, therefore, they should not be
extremists.
10- Equity and not Equality
Islam establishes equity, fairness and justice in the production and distribution
of wealth, and in ownership of means of livelihood. However it recognises that
like other natural things there is no equality among human beings as regards
the economic means and possession of worldly wealth. This inequality has
been presented by the Quran as a part of Divine Economic order. The Quran
does not consider these inequalities in the distribution of Divine sustenance as
punishment or reward and does not try to eliminate them, because no two
individuals have been blessed with hundred percent equal mental and
physical abilities.
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Taking the existence of inequalities as a part of divine scheme, the Quran
advises its followers not to covet those things in which Allah has made some
of them excess others. By exalting some of you over others in rank or by
favouring some of you over others in provisions, God in fact tries and tests the
human beings whether they are thankful to Him in good circumstances and
patient in bad circumstances.
The Quran highlights these inequalities in its following verses:
1-
And covet not the thing in which Allah hath made some of you exceed
others. Unto men a fortune from that which they have earned, and
unto women a fortune from that which they have earned..
-(4 : 32)
2-
He it is Who hath placed you as viceroys of the earth and hath exalted
some of you in rank above others. That He may try you by (the test of)
that which He hath given you
-(6 : 165)
3-
And Allah hath favoured some of you above others in provision

-(16 : 71)
4-
Lo ! thy Lord enlargeth the provision for which He will, and straiteneth
it (for whom He will).
-(17 : 30)
5-
Is it they who apportion their Lords mercy? We have apportioned

among them their livelihood in the life of the world, and raised some of
them above others in rank that some of them may take labour from
others; and the mercy of thy Lord is better than (The wealth) that they
amass.
-(43 : 32)
The existence of economic inequalities among the people is not only natural
but is also a blessing for the purification of human soul and development of
human personality. Those who have scarce means of sustenance should
thereby learn to be patient and contented and not to be jealous; while those
who have abundant resources should thereby learn to be grateful to God, to
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be kind and benevolent to the poor and to sacrifice their possessions for the
cause of God.
Islam, in fact, teaches the people to regard the existence of differences in
wealth as a test by which God tries them in this world. By granting abundance
of wealth to some, God observes how they spend it; whether they consider it
as their personal property denying the poor any share in that or they consider
themselves as trustees in respect of the wealth bestowed by God and spend it
in the way of God for the welfare of their poor brothers. And God tries the
poor by straitening their sustenance whether they lose their trust in God and
become jealous of the rich or whether they keep their faith in God and remain
patient in the adverse circumstances.
However, Islam does not permit the difference in possession of wealth to
assume such proportions that few lucky persons live in ease and luxury
controlling major portion of communitys wealth while the vast majority of
people possessing negligible share in communitys wealth lives a life of abject
poverty, misery and hunger. According to Islam, difference in wealth must not
exceed natural and reasonable limits, because if it happens the community
invites wrath of God and meets its natural end of self-destruction. The
Prophet of Islam has said : If anyone spent a night in a town and he remained
hungry till morning, the promise of Gods protection for that town comes to
an end. Islam, therefore, does not allow the difference between the rich and
poor reach an uncontrollable limits so as to disturb the peace of society.
Although it does not believe in complete equality in possession of economic
means, yet it perfectly stands for socio-economic justice. It believes in fair and
equitable distribution of incomes and wealth and ensures that the Islamic
state should provide for basic human needs to all of its citizens. Many legal
and economic measures have been provided to bridge the gulf between the
rich and the poor and to establish Islamic welfare state which guarantees
provision of social security and secures basic needs to its less fortunate
citizens. These aspects of Islamic economy we shall study in subsequent
chapters of this book. Here we can safely conclude that Islam believes not in
equal distribution but in equitable and just distribution of resources and
wealth.
Q10) Discuss the merits and demerits of Capitalism.

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Introduction to Capitalist Economy
A capitalist economy is an economic system in which the production and

distribution of commodities take place through the mechanism of free markets.
Hence it is also called as market economy or free trade economy.
Each individual be it a producer, consumer or resource owner has

considerable economic freedom.
An individual has the freedom to buy and sell any number of goods and
services and to choose any occupation. Thus a market economy has no central
coordinator guiding its operation. But self-organization emerges amidst the
functioning of market forces namely supply, demand and price.
The salient features of capitalism
Right to Private Property: Individuals have the right to buy and own
property. There is no limit and they can own any amount of property. They also
have legal rights to use their property in any way they like.
Profit-Motive: Profit is the only motive for the functioning of capitalism.

Production decisions involving high risks are taken by individual only to earn
large profits. Hence, profit-motive is the basic force that drives the capitalist
economy.
Freedom of Choice: The question what to produce? will be determined by

the producers. They have the freedom to decide. The factors of production can
also be employed anywhere freely to get due prices for their services. Similarly
consumers have the freedom to buy anything they want.
Market Forces: Market forces like demand, supply and price are the signals
to direct the system. Most of the economic activities are centered on price
mechanism. Production, consumption and distribution questions are expected
to be solved by market forces
Minimal role of Government: As most of the basic economic problems are

expected to be solved by market forces, the government has minimal role in
the economy. Their role will be limited to some important functions. They
include regulation of market, defence, foreign policy, currency, etc.
Merits of Capitalist Economy
Increase in productivity: In a capitalist economy every farmer, trader or

industrialist can hold property and use it in any way he likes. He increases the
productivity to meet his own self-interest. This in turn leads to increase in
income, saving and investment.
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Maximizes the Welfare: It is claimed that there is efficiency in production
and resource use without any plan. The self-interest of individual also promotes
societys welfare.
Flexible System: The shortages and surpluses in the economy are generally
adjusted by the forces of demand and supply. Thus it operates automatically
through the price mechanism.
Non-interference of the State: The State has a minimum role to play. There
is no conflict between the individual interest and the society. The economic
institutions function automatically preventing the interference of the
government.
Low cost and qualitative products: The consumers and producers have full
freedom and therefore it leads to production of quality products at low costs
and prices.
Technological improvement: The element of competition under capitalism

drives the producers to innovate something new to boost the sales and thereby
bring about progress.
Disadvantages of Capitalist Economy
Inequalities: Capitalism creates extreme inequalities in income and wealth.

The producers, landlords, traders reap huge profits and accumulate wealth.
Thus the rich become richer and the poor poorer. The poor with limited means
are unable to compete with the rich. Thus capitalism widens the gap between
the rich and the poor creating inequality.
Leads to Monopoly: Inequality leads to monopoly. Mega corporate units

replace smaller units of production. Firms combine to form cartels, trusts and in
this process bring about reduction in number of firms engaged in production.
They ultimately emerge as multinational corporations (MNCs) or transnational
corporations (TNCs). They often hike prices against the welfare of consumer.
Depression: There is over-production of goods due to heavy competition.

The rich exploit the poor. The poor are not able to take advantage of the
production and hence are exploited. At another level, over-production leads to
glut in the market and hence depression. This leads to economic instabilities.
Mechanization and Automation: Capitalism encourages mechanization

and automation. This will result in unemployment particularly in labour surplus
economies.
Welfare ignored: Under capitalism, private enterprises produce luxury

goods which give higher profits and ignore the basic goods required which give
less profit. Thus the welfare of public is ignored.
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Exploitation of Labour: Stringent labour laws are enacted for the exclusive
profit-motive of capitalists. Fire and hire policy will become the order of the
day. Such laws also help to exploit the labour by keeping their wage rate at its
lowest minimum.
Basic social needs are ignored:-There are many basic social sectors like
literacy, public health, poverty, drinking water, social welfare, and social
security. As the profit margin in these sectors is low, capitalists will not invest.
Hence most of these vital human issues will be ignored in a capitalist system.
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SIR KHALID AZIZ

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IQRA COMMERCE NETWORK

B.COM PART I (REGULAR) ANNUAL

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It is matter of indifference for the consumer as to which combination he

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b) Draw an income consumption curve showing that x is a

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Q2 a) Explain with examples the significance of the value of

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b) Discuss whether the demand for mobile phone is likely to

Q3 a) Draw a supply curve of the firm.

IQRA COMMERCE NETWORK

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Q4 Give the suitable justification:

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Behavior of Average Total Cost:

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N.I AT FACTOR COST

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b) Why the result of national income remains same either it is

Q6 a) Mention the qualitative and quantitative tools of

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1. Bank rate: it is the rate at which the central bank of a country is

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Q7 a) In country x the value of multiplier is 5 and in country

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b) Discuss the effects of a change in interest rate on total

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Lower Interest Rates

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i) Keynes Psychological law of consumption

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Properties of Consumption Behavior of Community:

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ii) Responsible factors of propensity to consume

(2) Distribution of income:

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(8) Fiscal policy:

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iv) Inflationary and deflationary Gap

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