BCOG 171 Principles of Micro Economics Solved Question Paper June 2026 for IGNOU B.Com (General) and BBA

Economic systems, central problems, and the substitution and income effects

Question 1 (a): What is an Economic System? Explain the central problems of an economy. (12)

Question 1 (b): Distinguish between substitution and income effects of price rise for a commodity. (8)

(a) Meaning of an economic system

An economic system is the set of institutions, laws and customs through which a society decides how its scarce resources are used, what goods and services are produced with them and how the output is shared among people. It links households, firms and the government into one framework for production, exchange, distribution and consumption.

The need for an economic system arises from scarcity. Human wants are unlimited, but land, labour, capital and enterprise are limited and can be put to alternative uses. Every society must therefore choose, and the economic system is the machinery through which those choices are made.

(a) Types of economic system

1. Capitalist or market economy: resources are privately owned and the price mechanism, working through demand and supply, guides production. The USA is the usual example.
2. Socialist or command economy: the state owns the major means of production and a central planning authority decides output, techniques and distribution, as in the former USSR.
3. Mixed economy: private enterprise and the public sector work side by side, with the government regulating and planning key sectors. India is a mixed economy.

(a) Central problems of an economy

Whatever its system, every economy faces the same basic problems because scarcity forces choice. Paul Samuelson summed up the core ones as what, how and for whom to produce; the problems of full use of resources and growth are usually added to them.

1. What to produce and how much. An economy must decide which goods to make and in what quantities: consumer goods or capital goods, food grains or cash crops, civil goods or defence goods. The production possibility curve shows this choice. Moving along it, more of one good means less of the other, and the output given up is the opportunity cost.
2. How to produce. Once the goods are chosen, the economy must pick a technique. Labour-intensive methods use more workers and less machinery; capital-intensive methods do the reverse. A labour-abundant country like India uses labour-intensive methods in handloom weaving and farming, and capital-intensive ones in oil refining and steel, aiming at the least-cost combination.
3. For whom to produce. This is the problem of distribution: how the national product is shared among households. It depends on how income is divided among the owners of factors as wages, rent, interest and profit, and on who owns assets. Taxes, subsidies and welfare schemes are used to make the division fairer.
4. Full and efficient use of resources. An economy may produce inside its production possibility curve because of unemployed labour or idle capacity. It must also avoid waste by placing each resource in the use where it adds the most value, which is the question of economic efficiency.
5. Growth of productive capacity. Over time the economy must decide how much to save and invest so that the production possibility curve shifts outwards. More capital, better technology and a more skilled workforce raise future output, but they require giving up some consumption today.

These problems are interlinked. The goods chosen affect the technique needed, the technique decides which factors earn income, and those incomes shape who can buy the output. That is why every economic system has to answer all of them together.

(b) Substitution and income effects of a price rise

When the price of a commodity rises, the fall in the quantity demanded (the price effect) is the combined result of two separate forces, the substitution effect and the income effect. In short, price effect = substitution effect + income effect.

Substitution effect. A rise in the price of good X makes it dearer relative to other goods such as Y, so the consumer replaces some X with the now relatively cheaper Y. To isolate this, Hicks gives the consumer just enough extra money (a compensating variation) to stay on the original indifference curve. The move along that same curve is the substitution effect, and for a price rise it always reduces demand for X.

Income effect. The same price rise also cuts the consumer's real income, because the money income now buys less. Taking away the compensating money shifts the budget line inwards, parallel to itself, and the consumer moves to a lower indifference curve. For a normal good this reduces demand for X further; for an inferior good it works the other way and raises demand.

Example. A student spends ₹1,000 a month on tea and coffee, and tea rises from ₹200 to ₹250 per pack. She switches partly to coffee because tea is now relatively costly: that is the substitution effect. She also finds her ₹1,000 buys less of everything, so she cuts tea a little more: that is the income effect.

Conclusion: If the income effect of an inferior good is so strong that it outweighs the substitution effect, demand rises when price rises. This is the Giffen paradox, the main exception to the law of demand explained through these two effects.

Movement along and shift of the demand curve, and the law of diminishing marginal utility

Question 2 (a): Distinguish between movement along a demand curve and movement of the demand curve with examples. (8)

Question 2 (b): State the law of diminishing marginal utility and its limitations. (12)

(a) Movement along a demand curve

Demand for a commodity depends on its own price and on other factors such as the buyer's income, prices of related goods, tastes, expectations and population. A demand curve is drawn assuming these other factors stay constant, and the distinction between the two kinds of movement rests on which factor changes.

When only the commodity's own price changes, the buyer moves from one point to another on the same demand curve. A fall in price that raises quantity demanded is an extension of demand; a rise in price that lowers it is a contraction of demand.

Example. If mangoes fall from ₹100 to ₹80 per kg and a household raises its purchase from 2 kg to 3 kg a week, it moves down the same curve from point A to point B. That is an extension of demand. If the price returns to ₹100, demand contracts to 2 kg again.

(a) Movement of the demand curve (shift)

When any factor other than own price changes, the whole curve moves. A rightward shift is an increase in demand, so more is bought at every price; a leftward shift is a decrease in demand, so less is bought at every price.

Example. If the household's income rises and it now buys 3 kg of mangoes even at ₹100, the demand curve has shifted from D1 to D2. A fall in the price of a substitute such as bananas, or a health scare about mangoes, would shift the curve to the left instead.

In short, a change in own price moves the buyer along the curve, while a change in any other determinant moves the curve itself. The full file carries a labelled two-panel diagram of both cases.

(b) Law of diminishing marginal utility

As a consumer takes more and more units of a commodity in succession, the additional satisfaction (marginal utility) from each extra unit keeps falling, other things remaining the same. (Alfred Marshall)

Total utility still rises, but at a slower rate. Marginal utility is the change in total utility from one more unit, so MU_n = TU_n − TU_n−1. The law is also called the law of satiable wants, because any single want can be satisfied if enough units are consumed.

(b) Assumptions

1. Units are homogeneous, identical in size and quality.
2. Units are of a reasonable size, not so small that they give no real satisfaction.
3. Consumption is continuous, with no long time gap between units.
4. The consumer's tastes, income and the prices of other goods do not change.
5. The consumer is rational and utility can be measured in cardinal numbers (utils).

(b) Illustration

A thirsty person drinking glasses of water on a hot afternoon might record utility as follows.

Marginal utility falls from 10 to 0 and then turns negative. Total utility rises while MU is positive, reaches its maximum of 30 utils at the sixth glass where MU is zero, and falls once MU is negative. On a graph the MU curve slopes downward from left to right, while the TU curve rises, flattens and then declines.

(b) Limitations

The law does not hold, or holds only weakly, in these cases:

1. Rare collections and hobbies: for a collector of stamps or coins, each extra rare piece may give more satisfaction, not less.
2. Money: many economists argue that the desire for more money does not fall like the desire for a single good, because money commands all goods, so its marginal utility falls only very slowly.
3. Addictive goods: with alcohol or tobacco the craving may grow with consumption, so marginal utility appears to rise.
4. Very small units: for a very thirsty person, a second spoonful of water may give more utility than the first.
5. Time gap: if consumption is spread out, like one meal in the morning and another at night, utility from the second unit need not fall.
6. Change in tastes, fashion or income: a new fashion or a rise in income can raise the utility of further units, breaking the other-things-equal condition.
7. Goods used as a set: the second shoe of a pair or the fourth tyre of a car gives more utility than the earlier units, because the good is useful only as a set.
8. Music and poetry: hearing a favourite song or rereading good poetry may increase enjoyment for a while.
9. Cardinal measurement: the law assumes utility can be counted in utils, yet utility is a psychological feeling that cannot be measured exactly, which is why later economists turned to indifference curve analysis.

Conclusion: Despite these limits, the law explains why demand curves slope downwards, underlies the law of equi-marginal utility and consumer's surplus, and supports progressive taxation, since a rupee taken from a rich person costs less utility than a rupee taken from a poor person.