Basics of Economics: Chapter test

Economists distinguish stocks from flows by their units of measurement. A stock is measured at one specific point in time and represents a quantity existing at that moment, which may have accumulated in the past. A flow is measured over an interval of time, so it is expressed per unit of time, such as per month or per year; it is roughly analogous to a rate or speed. Item 1 is the capital stock on a particular date, the total value of equipment, buildings and other productive assets existing then, so it is a stock. Item 2, fixed investment during a year, is a flow: it is the amount added to the capital stock over that period. In fact, the capital stock available at any time is increased by the flow of new investment and depleted by the flow of depreciation. Item 3, savings during a month, is a flow, because saving is the part of income not spent over a period. Item 4, wealth on a given date, is a stock, the accumulated result of past saving. GDP and income are flows; money, financial assets, inventories and human capital are stocks. So only two of the four, items 2 and 3, are flow variables.

NCERT's Class X chapter 'Sectors of the Indian Economy' groups activities by their nature. When a good is produced by exploiting natural resources, the activity belongs to the primary sector; it is called primary because it forms the base for all other products. Cultivation, dairy (which depends on the biological process of animals), fishing, forestry and minerals all fall here, which is why it is also called the agriculture and related sector. Statement 1 is correct. The secondary sector covers activities in which natural products are changed into other forms through ways of manufacturing; the product is not produced by nature but has to be made, and the process may take place in a factory, a workshop or at home, as when cotton is spun into yarn or sugarcane turned into gur. Statement 2 is correct. Statement 3 is wrong: tertiary activities by themselves do not produce a good. They help the other two sectors through transport, storage, communication, banking and trade, and include essential services such as teaching, health and administration. Because they generate services rather than goods, the tertiary sector is also called the service sector.

NCERT's Class XI book Indian Economic Development compares the two kinds of capital in a box on human and physical capital. Physical capital, such as a machine, is tangible, can be separated from its owner and can be sold in the market. Human capital is intangible: it is built into the body and mind of its owner, and so it is inseparable from its owner. It is therefore not sold in the market; only the services of human capital are sold, as when a worker is paid for her skills. Statement 1 is correct. Statement 2 is wrong. NCERT notes that both forms of capital depreciate with time: a machine wears out with use and becomes obsolete with changes in technology, while human capital depreciates with ageing, and the decline can be reduced, to a large extent, through continuous investment in education and health. Statement 3 is correct: NCERT names the sources of human capital as investment in education, health, on-the-job training, migration and information. Statement 4 is correct: an educated and healthy person benefits not only herself but also society, because the gains spread to others, so human capital generates external benefits. That is one reason why governments invest in education and health.

Economic growth depends on adding to a country's capital stock. Capital formation means net additions to the capital stock during an accounting period; it takes place when savings are used for investment rather than consumption. A classic UPSC question (2013) asked under which condition growth in a country must necessarily occur, and capital formation was the answer. But how the new capital relates to the workforce matters. Capital deepening is a situation in which the capital per worker is increasing in the economy, also described as a rise in capital intensity and often measured by the rate of change of the capital stock per labour hour. Each worker then has more and better equipment, so productivity per worker rises. Capital widening, by contrast, is the case in which the capital stock grows at the same rate as the labour force, after allowing for depreciation, so the capital per worker stays constant; the economy expands but output per worker does not rise. In models such as Solow's, capital deepening alone cannot raise growth indefinitely, because of diminishing returns and depreciation, which is why technological progress matters too. Capital consumption is another name for depreciation, and capital flight is a rapid outflow of money and assets from a country.

The factors of production are the inputs used to produce goods and services. The basic factors are usually listed as land, labour, capital and entrepreneurship, and each earns a characteristic reward: rent for land, wages for labour, interest for loaned capital and profit for the entrepreneur, who combines the other factors and bears the risk of the enterprise. In this framework land is much wider than a plot of soil. It covers naturally occurring resources used in production, such as water, minerals, flora, fauna and climate, as well as the site of production; statement 1 is correct. Capital means the stock of human-made goods used in the production of other goods, such as machinery, tools and buildings. It is itself produced, unlike land, and is often divided into fixed capital, like machines, and working capital, like raw materials. Statement 2 is correct. Statement 3 is wrong. Classical economists did use the word capital for money as well, but money was not considered a factor of production in the sense of a capital stock, because it is not used to directly produce any good. A bank deposit becomes productive only when it finances the purchase of real capital goods. Modern usage also distinguishes human capital, the knowledge and skills of the workforce, from raw labour.

The cross-price elasticity of demand measures how the quantity demanded of one good responds to a change in the price of another good. It is calculated as the percentage change in the quantity demanded of good A divided by the percentage change in the price of good B, other things being equal. Statement 3 inverts this ratio, putting the price change in the numerator and the quantity change in the denominator, so it is wrong. The quantity responds; the price of the other good is the cause, and the cause always goes in the denominator of an elasticity. The sign of the cross elasticity tells us how the goods are related. For substitutes, such as tea and coffee, a rise in the price of coffee raises the demand for tea, so both changes have the same sign and the cross elasticity is positive; statement 1 is correct. For complements, such as tea and sugar, a rise in the price of sugar lowers the demand for tea, so the changes have opposite signs and the cross elasticity is negative; statement 2 is correct. When the cross elasticity is zero, the goods are independent: a change in the price of one has no effect on the demand for the other.

NCERT uses three different criteria. Primary, secondary and tertiary sectors are classified by the nature of activity; organised and unorganised sectors by the conditions of employment, that is, whether work is regular and protected; and public and private sectors by ownership of assets and responsibility for delivering services. Statements 1 and 2 are therefore correct. The organised sector covers enterprises or places of work where the terms of employment are regular and people have assured work. They are registered by the government and have to follow its rules and regulations, given in laws such as the Factories Act, the Minimum Wages Act, the Payment of Gratuity Act and the Shops and Establishments Act; workers enjoy security of employment, fixed hours, paid leave, provident fund and gratuity. Statement 3 is correct. The unorganised sector is characterised by small and scattered units largely outside the control of the government, with low-paid, often irregular work. NCERT explicitly places in it people working on their own, such as farmers who work on their own land and hire labour as required, street vendors and repair persons. Statement 4 is therefore wrong.

The worker's real wage, the quantity of goods and services her pay can buy, has actually fallen. Roughly, a 5 per cent rise in the money wage against an 8 per cent rise in prices means a real wage cut of about 3 per cent; more exactly, 1.05 divided by 1.08 is about 0.972, a fall of about 2.8 per cent. Feeling better off because the number on the pay slip is higher is the cognitive bias called money illusion: thinking of money in nominal rather than real terms, mistaking the face value of money for its purchasing power. The term was coined by the American economist Irving Fisher, who later wrote a book on the subject, The Money Illusion (1928), and it was popularised by John Maynard Keynes. Many monetary economists dispute how widespread it is, arguing that people act rationally with regard to their wealth. Money illusion matters because it can make nominal wages sticky, as workers resist money-wage cuts but accept real-wage cuts through inflation. The other options describe different ideas. The demonstration effect refers to behaviour caused by observing the actions of others; the ratchet effect, to the difficulty of reversing a course of action once it has occurred; and the substitution effect, to switching between goods when relative prices change.