Principal of Economics

Unit – I
DEFINITIONS AND CONNOTATIONS

1.1 INTRODUCTION

Economics can be divided into three parts, namely, descriptive economics, economic
theory, and applied economics. In descriptive economics one collects together all the
relevant facts about a particular phenomenon. While economic theory or analysis gives
a simplified version of the way in which an economic system functions. Applied
economics takes the framework of analysis provided by economic theory.

There are three broad assumptions namely assumptions regarding behaviour of

individual. Economists are concerned with people as consumers and as businessmen.
When economists discuss the actions of consumers, they assume that they behave
rationally. It means that they try to maximize their satisfaction with minimum possible
expenditure. In the same manner, economic theories assume that the businessmen try
to maximize their profits. It is their economic rationality.

The second group of assumptions is about the physical structure of the world i.e.
natural conditions. They always remain to be given. It is these conditions give rise to
economic problem because resources are limited in relation to their demand.
Therefore, goods and services are scarce in supply. The scarcity of resources leads to
economic system and economic problem. What is worse is that the scarce resources
have alternative uses. This makes all the more difficult for human being to solve
economic problems.

The third group of assumptions relates to social and economic institutions. Under this
group of assumptions, comes political stability. Without which neither consumers nor
producers attain their goals. For economic prosperity, political stability is a must.
Applied economists are often concerned with ‘test’ theory studying statistical and other
evidence to discover if it appears to support particular economic theory. Hence,
economics is concerned with a study of one of the aspects of human beings. It enquires
into how a human being gets his income to satisfy his unlimited wants with limited
means. It deals with day-to-day activities of human being relating to his efforts of
maximizing his satisfaction. Therefore scope of economics centers around wants –
efforts – satisfaction.
Economic problem begins with human wants and ends with satisfaction of those wants.
Economics is concerned with every human being poor as well as rich. In nutshell it
could be deduced that science of economics enquires into how a consumer attains his
income and spends it in order to achieve maximum satisfaction with minimum efforts
or expenses.

1.2 DEFINITION OF ECONOMICS

A good number of definitions of economics have been numerated but we shall be

dealing with three main definitions given by Adam Smith who is considered to be the
father of economics, Dr. Alfred Marshall and Prof. L. Robbins.

Adam Smith called economics as “Science of Wealth”. He emphasized wealth because

in days of Adam Smith monarchy was in existence. The kings were interested in
amassing wealth for their military operations. Hence, Adam Smith emphasized wealth.
He paid attention exclusively to wealth. He totally neglected role played by man.
Wealth has no significance if there is no man to make use of it. Wealth attains
importance if it is considered in relation to man because wealth is not be all and end all
of human life. It is simply a means to end and the end being the maximum welfare of
the society.

According to Dr. Alfred Marshall “Economic is a study of man’s actions in the ordinary
business of life; it enquires how he gets his income and how he uses it – Thus it is on
one side a study of wealth and on the other, and more important side a part of the
study of man.”

Dr. Marshall in his definition of economics makes it clear that in economics how human
being earns his living by earning income and spending it for maximization of his
welfare. Marshall shifted emphasis from wealth to man. Production of wealth and using
it for his welfare is stressed by Marshall. Thus Marshall’s definition covers consumption,
production, exchange and distribution. Marshall pays more attention to material
welfare of man which is obtained by using economic resources rationally. Thus,
Marshall accords secondary position to wealth. Economics concerns with ordinary men
and women who are motivated by maximum advantages that is welfare. He holds that
it is a social science which studies individual behaviour also. It is therefore economics
ignores non-material aspects.

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However, Marshall’s definition is criticized by Prof. Lionel Robbins on the following
grounds:

1. It is classificatory.
2. It is concerned with material welfare alone narrowing the scope of economics.
3. Marshall’s definition totally neglects the non-material services.
4. No clear-cut distinction is made between ordinary business of life and
extraordinary life.

Wealth and welfare cannot go together. Wealth like poison does not increase the
welfare. Non-material things like love and affection also raises the human welfare,
which Marshall totally neglected. Moreover concept of welfare is subjective. It varies
from person to person, time to time and place to place. The term welfare may land us
in the domain of ethics. Prof. Lionel Robbin held that economics is neutral between
wants. Economics is not concerned with the causes of material welfare as such. It is for
this reason Robbins held that Marshall’s definition is narrow, classificatory and
unscientific.

1.2.1 LIONEL ROBBIN’S DEFINITION

“Economics is a science that studies human behaviour as a relationship between ends

and scarce means which have alternative uses.”

The following are the four pillars of Robbin’s definition:

1. Economic is a science that studies economic aspect of man’s life. From the
social point of view, it is a normative science but from individual point of view, it
is positive science.

2. Wants unlimited
Human wants are unlimited. It is not possible to satisfy them all because means
are limited. If one want is satisfied another crops up. Man is such an animal that
he is never satisfied. He tries for variety and plenty. This applies to his all wants.
Besides his basic wants, he wants to have a number of things such as comforts
and luxuries. Since human wants are countless, as a rational being he or she has
to be selective ones. He chooses to satisfy most urgent wants first postponing
the satisfaction of less urgent wants. Hence, human wants are be all and end of
all of economic activities.

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3. Limited means
Though wants are unlimited, means to satisfy them are limited. Moreover they
have alternative uses. That is why economic problem arises, because all goods
are not free goods. That is why goods are paid to obtain them. Scarcity of
resources gives rise to economic problem because these resources have
alternative uses either for this or that. But one must know that it is not the
absolute scarcity. It is in light of demand for it, is to be considered. For example
rotten egg may be scarce in supply but since nobody demands it, it is plentiful in
supply. Hence scarcity be considered in relation to demand only.

4. Alternative uses of resources

Means or resources are not only limited but they have alternative uses also. It
means that they can be put to number of uses. Had they possessed fixed and
specified use, economic problems would not have arisen. But multiplicity of
uses of scarce means makes things all the more difficult. Hence, scale of
preference of uses is to be made. Most urgent wants are to be satisfied first. In
case of less urgent wants, satisfaction is postponed. This means that a rational
choice is to be made between wants. Hence multiplicity of wants, scarcity of
means and their alternative uses give rise to economic problem. Thus, L.
Robbins held that economics tells us how a man makes use of his scarce
resources having alternative uses for the satisfaction of his countless ends.
Hence it involves choice making it all the more difficult that is why economics is
called as a science of choice.

1.2.2 Superiority of Robbin’s Definitions

Prof. L. Robbins definition of economic preferred to all other definitions. It is called as

scarcity definition. It is considered to be scientific definition because it is independent
of any classification. Secondly, all types of wants social as well as individual fall within
the domain of economics. Thirdly, it has a widened the scope. Marshall had restricted it
only to wealth and activities related to the material welfare of man. Fourthly, Robbins
held that economics is only science and not arts. Lastly it is also held that economics is
neutral between wants. It does not consider moral – immoral consideration. It is for the
consumer to make rational choice between wants. This makes economics is a positive
science.
 Limitations
Robbins definition though it is widely accepted and more scientific yet it is considered
to be colourless, impersonal and neutral between wants. However, from the social
point of view, economics cannot keep aside its normative appearance. The job of
economics is also to advocate and condemn.

It also appears that L. Robbins has reduced economics only to valuation theory.
Economics not only touches upon resource allocation or price determination but also
study how the national income and employment are determined. Thirdly, Robbins
definition does not cover theory of economic growth or development which has
become an important branch of economics. The theory of economic growth deals with
growth of economy but according to Robbins resources are given. He only discusses
their allocation. Further more, Robbins definition does not deal with problem of plenty
and also of unemployment. According to Robbins economics studies only the problem
of scarcity. It also lacks human touch. L. Robbins made economics more abstract and
complex making it more difficult. Hence it goes away from its utility for the common
man because it must be concrete and realistic study.

1.2.3 Modern Views

Of late economic thinking has gone a long way. Lionel Robbins held that economics is
concerned with multiplicity of wants and scarcity of resources having alternative uses.
But in modern times, it is held that economics is much more than merely a theory of
value and allocation of resources. It was Lord J.M. Keynes who brought about a change
in economic thinking by advocating government participation in economic
development of the country. Now economics is looked upon as the study of the
administration of limited resources and of the determinant of employment and
income. Thus, besides, theory of value, it studies how the levels of income and
employment are determined. It means that modern economics studies the causes of
economic fluctuations in order to achieve economic stability. In other words economics
studies the factors affecting the size, distribution and stability of country’s national
income.

Second half of the twentieth century, saw growth theories occupying important place
in the study of economics particularly with reference to poor countries. Therefore, one
can conclude that a satisfactory definition of economics is one which includes in it
theory of income, employment and growth in addition to theory of value or resource
allocation.

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1.3 Scope of Economics

Scope of economics as stated earlier is wants, efforts and satisfaction. Economics

begins with human wants and ends with satisfaction of those wants. Man undertakes
efforts to satisfy his innumerable wants. It studies only one aspect of man’s life. All
activities of man are centred around the satisfaction of his wants. Economics is
concerned with satisfaction of wants. It is a social science and therefore tries to find out
solutions to social problems like unemployment of natural resources, raising national
income through planned economic development. Acceleration of economic growth has
become main thrust of economic development in these days.

Economic is a science. Science is defined as a systematized body of knowledge.

Economics, too, has its rules, regulations and laws in which it binds itself. Now, the
question is whether economics is a positive or normative science. Positive science is
one which deals with the facts as they are while normative science is one which deals
with the facts as they should be or ought to be. Positive economics attempts to
describe and analyze the existing situation rather than suggesting how to change it. But
many times economists do often make normative statements. Instead of explaining
how the economy actually operates, they suggest, how it should operate. Especially,
where problems of the economy are concerned, economists abandon the objectivity of
positive economics and make normative statements. It is in this context, that we
suggest what the government’s economic policy ought to be. How government should
act to raise the level of employment etc. Physics, chemistry, geology and biology are
the positive sciences as they deal with the facts as they are while social sciences like
economics, psychology, sociology, political science etc. deal with the facts as they
should be. Thus, economics is both positive as well as normative science. While dealing
with individual economic problems, it is a positive science and while dealing with social
problem it becomes normative science.

The study of economics incorporates it in its scope, consumption, production, exchange

and distribution of natural resources. It concerns with economic growth leading to
raising national income and its equitable distribution along with balanced economic
development. Now-a-days economics’ scope is widened so much that maximization of
economic welfare has become the main goal of the economic activities.

The knowledge of economics has gone so far that it reached a stage when its facts have
been collected and carefully analyzed and laws or general principles explaining to facts
have been laid down. This makes economics a positive science.

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It is also considered an Art because it lays down and formulates to guide people who
want to achieve a certain aim. The aim may be removal of poverty or raising production
of goods and services in the country. Economics does help us in solving many day-to-
day practical problems. It is not mere a theory. It has great practical use. Therefore,
one can conclude that economics is both a science and an art also.

1.4 Micro-Economics

British Economist named Adam Smith is the founder of micro-economics which deals
with individual behaviour such as markets, firms and households. According to Smith,
economic benefit comes from the self-interested actions of individuals. K.E. Boulding
holds, “Micro-economics is the study of particular firms, households, prices, wages,
incomes, industries and commodities, etc.”. In micro-economic, we study how the
various cells of economics organism namely individual consumers and producers reach
their equilibrium positions. In other words, in micro-economics, we make microscopic
study of the entire economy. However, it must be noted that the micro-economics
does not study the economy in its entirety, instead under this branch of economics, we
study equilibria of thousands of units of the economy. Prof. Lerner rightly observes,
“Micro-economics consists of looking at the economy through a microscope as it were
to see how millions of cells in the body of economics viz. individuals or the firms as
producers play their part in the working of the whole economic organization.

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 Micro Economics

ProductPricing Factor Pricing Economic Welfare

Rent Wages Interest Profit

Theory of Theory of
demand supply

The scope of micro-economics includes in it production, consumption and distribution

or any other activity tends to be carried out with the highest efficiency so as to
maximize social welfare. It also studies every constituents of the circular flow of
income. In other words micro-economics is the application of partial equilibrium
analysis to economic problems. Micro-analysis are useful for price determination and
allocation of resources, determination of economic policies, international trade, linear
programming and optimum utilization of resources.

Limitations of micro-economics – it does not throw any light on the collective activity.
The analysis is based on unrealistic assumptions which may result into doubtful
conclusions.

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1.5 Macro-Economics

It deals with aggregates. It is concerned with total demand, supply, output, income and
so on. Hence macro-economics is a study of aggregates and averages. It is the study of
economic system as a whole. It directly concerns with relations among large aggregate
such as national income, general price level, total output, consumption, employment,
savings, investment, demand and supply. These relations indicate the behaviour of
economic system as a whole. J.M. Keynes holds that macro-economics concerns itself
with those aggregates which relate to the whole economy.
Prof. Paul Samuelson rightly remarks, “There is really no opposition between micro and
macro economics. Both are absolutely vital; and you are only half educated if you
understand one while being ignorant of the other.”

The scope of macro-economics is very wide and it assumed added importance since the
publication of J.M. Keynes, General Theory of Employment, Interest and Money in
1936. It is considered to be policy making economics. The study of macro-economics
includes, the theory of income, employment, general price level, theory of factor
pricing, economic growth and inflation and deflation.

Macro-Economics

The theory of The theory of Theory of The Theory

Income and General Price Factor Pricing Economic
Growth
Employment Level and
Inflation

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 Importance of Macro-Economics

1. The study of macro-economics enables the government to frame the correct

and effective economic policy.
2. It proves to be more helpful in economic planning.
3. It helps developing micro-economic theories.
4. It also enables one to have international comparison.
5. Lastly it is absolutely essential to have knowledge of macro-economics to make
correct decisions.

Limitations

Use of macro-economics analysis complicates the process of the study of prices,

savings, investment, factor pricing etc. Secondly all aggregates are not identical and
therefore macro-study will become rather difficult. Thirdly, statistical data and
techniques are the soul of the study of macro-variables. Therefore, if reliable data is
not available decisions based on such data proved to be wrong. In the fourth place, it
cannot be said that only one variable is affected from the changes leaving all other
variables unaffected.

According to Prof. K.E. Boulding, “Micro-economics follows the method of slicing

whereas macro-economics uses the method of humping.”

1.6 Connotations

If we probe a little deeper, however, we find that economics is really not so much
about money as about some things which are implied in the use of money. Three of
these – exchange, scarcity, and choice are of special importance. Let us take them in
turn.

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1.6.1 Exchange

Money implies exchange. It is in fact the medium of exchange. In a primitive

community, where exchanges are rare, we can dispense with money and resort to
direct barter. Money is unnecessary so long as we are at the stage of trying to satisfy all
our wants by our own efforts, growing our own wheat, milling our own flour, baking
our own bread, and only now and again exchanging, say, wheat for a ploughshare or a
calf for a millstone. But immediately we begin to specialize, and cease to produce
goods for our own use, money becomes indispensable if exchanges are to take place
smoothly. Exchange becomes triangular – we convert goods into money and money
into other goods, instead of simply bartering goods for goods. If exchanges did not take
place in this apparently circuitous way, no one who specialized in making bricks or
bowler hats would relish a morning’s shopping. The grocer might have no use for
bricks, and match-sellers would hesitate to accept the hundredth part of a bowler hat.
A walletful of money goes so much further than other walletfuls!

Nowadays, therefore, exchange rarely takes the form of direct barter. Instead, we do
business with money. We buy what we want with money, sell for money, fix prices in
terms of money, are paid our wages, salaries, or dividends in money, save money, and
measure our wealth in money. But the problems which present themselves to us in
terms of money are exactly similar to the problems raised by direct barter. There is a
surface difference between money-exchange and barter-exchange, but no difference in
principle. Economics, therefore, does not limit itself only to money-problems but
studies exchange-problems of all kinds. It is, in fact, about exchange rather than about
money, for exchange underlies the use of money.

Exchange Implies Interdependence

When one exchange, we have stopped being self-sufficing and have become dependent
in those from whom we buy and to whom we sell. Our fortunes are linked with theirs. If
they are poor or unemployed then we are likely to be in danger of poverty and
unemployment ourselves. Famine and flood in one part of the world can create scarcity
and distress thousands of miles away by cutting off supplies of foodstuffs and raw
materials. We are all within the circle of exchange. Yet this interdependence rarely
occurs to us : it is so easy to overlook the implications of exchange.

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Consider, for example, some everyday event like the purchase of a packet of cigarettes.
I take from my pocket a small piece of metal – probably Mexican silver alloyed with
Canadian nickel – and offer it to a total stranger who accepts it with alacrity. In
exchange, I receive a cardboard packet whose contents are the product of workers
from all over the globe – Norwegian lumbermen, Turkish peasants, Malayan tin-miners,
American inventors. I draw also on the services of British workers scattered over the
country. The packing of the cigarettes has been done in Bristol; the cellophane wrapper
and silver paper come from London; the paper round the cigarettes from Swindon; the
stiffener, or cigarette card, from Glasgow. But about all these workers, through whose
efforts I am able to smoke my cigarettes, I am amazingly ignorant. I do not trouble to
inquiry whether they include cannibals, racketeers, Jew-baiters; whether they are
mean, grasping, or dissolute; or whether their daily earnings are less than 1d or over
£100. Their creed, their way of living, their income, the colour of their skin, do not
interest me. I can drive my bargain with them without even knowing that they exist.
The cash-nexus that binds us is the loosest of bonds. It leaves me free to pursue my
own interest, undeterred by any sense of moral obligation to other workers as fellow-
citizens. They satisfy my wants and earn the means of satisfying theirs. And that, to
most of us, might seem to be the end of the matter.
But not to the economist. It is precisely these exchange-bargains which he sets out to
investigate. Why, he asks, do people exchange at all? What advantages does society
reap from leaving people free to satisfy their wants by exchange? When exchange is
fair and when unfair? Is it in the social interest that exchanges dictated by mutual self-
interest should be left unregulated by the State? Or, if regulation is desirable, on what
principles should the State intervene?

1.6.2 Scarcity

The use of money implies scarcity. Money itself must be scarce or it will cease to be
used. If the supply of money is increased without limit it will soon lose value and in the
end no one will accept it. Whatever passes as money, therefore, must necessarily be
scarce. So also – and this is the important point – must be the things that money will
buy. We only exchange one scarce thing for another. We do not pay for air and earth
and water unless somehow they are stinted just as the supply of money is stinted.

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The fact of scarcity makes it necessary for us to economise, i.e., to make the most of
what we have. We have constantly to be counting the cost, weighing up alternatives,
and going without one thing so as to be able to buy more of another. Nominally it is
money that we economise, for what we have to decide is whether to spend money on
this or on that. What we are really doing, however, is to economise the things that
money will buy. We try to buy, with our limited income, the collection of goods and
services which gives us most satisfaction. We are faced with the fact that these goods
and services are scarce, and we have to accommodate this scarcity as best we can to
our wants and needs. Similarly, in earning money we have to husband our scarce time
and energy in order to obtain as large a return as possible (in money or in amenities
and personal satisfaction) for our efforts. On some men, of course, the pressure of
scarcity and want bears harder than on others. On the millionaire, for example, the
pressure is negligible; he can almost always neglect considerations of cost. But for
others the necessity of making ends meet enforces constant self-denial.

1.6.3 The Economic Problem

What is true of each of us is true also of society as a whole. There is an economic

problem of making the social income go as far as possible. The goods produced and
services rendered in any country in the course, say, of a year, are limited in amount and
insufficient to maintain a standard of more than moderate comfort if equally
distributed amongst the inhabitants of the country. The goods and services at the
disposal of the country in other words, are scarce in relation to the demand for them.
There are very few things that can be provided free of charge, even in a rich country.
We can make as much use as we like of public libraries and parks and roads. But we
cannot help ourselves to books and motor-cars, much less to food and clothing. The
more of one thing is offered to us, the less can we have of other things. We cannot
have more of all simultaneously. If A is free, B will be all the dearer. The provision of
free motor-cars, - for example, would lead to an expansion of the automobile industry
and the transference to it of engineers, materials, and machinery from a host of other
industries. Motor-cars would be more abundant; but other things would be scarcer.
Only if we set a very high value on motor-cars (like the value which we set on good
roads, or schooling, or health services) will we be prepared to face the cost of offering
them free.

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This balance between value and cost is forced on us wherever we are faced with a
shortage of supplies relatively to our wants. The things which we value highly and
which cost little to produce will be provided first and in large quantities. What costs a
great deal and is of comparatively little value will not be produced at all. We have to
decide what commodities, and how much of each, to produce; and our decision will
rest upon our estimates of cost and value. The decision is one that must be taken in
every society, whether it be Russia or the United States, Italy or Malaysia. The way in
which the decision is taken, and the kind of people who take it, are, of course, very
different in different countries. The responsibility may rest with a bureaucracy or with
the mass of “consumers.” One country may have a State Planning Commission; another
may rely on the laws of supply and demand. Whatever the economic system, the
decision is one that cannot be avoided. There is an economic problem which has to be
solved by dictatorships and democracies, “planned” and “unplanned” societies alike.
Want and scarcity are universal, and so, too, is the problem of a accommodating the
one to the other.

In some countries the problem may be solved more satisfactorily than in others. But
there is no question of one social system bringing plenty and another condemning us to
scarcity. Man’s wants are insatiable, and there would continue to be scarcity under any
social system. If, for example, we all had twice as large an income as at present – an
advance which could not be brought about immediately by any conceivable change in
our social system – the annual income of the average British worker would still be
under £600, and from this sum a large slice would be taken in taxation, and a further
slice would have to be put aside as savings. Such an income would probably fall short of
the aspirations of most people and could be reached only by exertions which would be
decidedly irksome. The conflict between scarcity and want would continue to be felt.

Scarcity, like exchange, raises problems for the economist. He tries to formulate the
principles on which our limited productive resources can be used to the fullest
advantage. He studies how unemployment, for example – an obvious waste of labour
power – can be reduced or eliminated; how the community’s savings can be made to
find their way into productive investments, how the land can be cultivated in the best
interests of society. He studies; too, on what principles we should allocate resources
between different industries so as to produce a maximum of all commodities in the
right proportion of each; and how the output of commodities should be distributed
between those who help to make them.

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These are problems which cannot be confined within the narrow bounds of pure
economics. They extend into politics, ethics, and even religion. But we can get a better
view of them from the heights of economic theory than from any other standpoint.
Since this better view will still be coloured by our personal convictions, it will not of
itself remove differences in outlook. But it will give us a wider perspective and open our
eyes to the more remote implications of our problems.

1.6.4 Choice

The use of money also implies choice. We have to choose between the many claims on
our purse when we spend money, and between the many uses to which we might put
our time and energy in earning it. We cannot spend the same evening in the cinema
and in the theatre. We must choose one form of entertainment or the other. We may
have to choose, also, between spending an extra shilling or so on a seat and spending
the same shilling later on cigarettes.

Our choice, of course, is not always made rationally. That is, we do not always weigh up
carefully the possible ways in which we might spend our money. We are much more
lighthearted and irrational in buying sweets, for example, than we are in renting a
house. We buy, very, often, impulsively or through habit or force of example. Or we
may buy because our “sales resistance” has crumpled at the sounding of some
advertiser’s trumpet. It is irrational to pay more than is necessary for a thing; and yet
hardly a day passes but we buy goods without asking their price, or cannot be bothered
to look for cheaper brands. We do not take the trouble to find out where prices are
lowest; or we take excessive trouble to save a trifling sum, like the wealthy man who
walks to save a penny fare. We do not budget for so much on clothes, so much on
amusements, so much on food, so much on our savings account, and so on, but spend
haphazard so long as the money lasts. Or at least that is what large numbers of us do.

Perhaps, however, the careful housewife – and the tradition amongst economists are
to think of housewives, as the persons who hold the purse-strings – is more rational in
her buying. The economic woman may be less of an abstraction than the economic
man!

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The way in which we make a choice is of great importance to the economist. For he
cannot tell how much weight to place on the preferences expressed in the spending
and earning of money until he knows how far these preferences are rational (i.e.,
based on full knowledge and formed after reflection). If for instance, people persist in
buying an expensive brand of cigarette it is important to know whether they buy it out
of a liking for that particular brand or because they are ignorant of cheaper brands with
the same flavour or because of snob-appeal in the advertisements. Until the psychology
of cigarette-smokers is explained to us, we cannot say whether the production and the
sale of these high-priced cigarettes involve a social waste. If smokers are rational there
may still be a waste (for instance the price may be kept high by a monopoly). But if they
are irrational, there is certainly a waste; they are paying more than they would if they
were in possession of all the facts.

In economics we begin by assuming that choice is rational. The so-called “economic

man” is simply one who is completely “rational” in satisfying his wants, and pays no
regard to the interests of others. It is, of course, an abstraction from the facts to
assume that men are self-interested and rational. But to make this kind of abstraction is
the only satisfactory procedure open to us. If we assume that people are self-
interested and rational, we can predict how they will behave given a certain monetary
inducement, and we can work out an analysis of action and reaction.
For instance, if similar goods are on sale at different prices, or similar jobs advertised at
different rates of pay, we know that men will, other things being equal, purchase the
cheaper goods, and apply for the better-paid job. If we could not make such
generalizations, if men were quite irrational, then we should never “get anywhere” in
economics. So we begin by assuming that choice is deliberate and rational, without,
however, overlooking the part played by impulse, custom, and inertia. Later, we may
study the psychology of choice more closely; analyzing what shapes our expectations
and desires, and sifting what is basic in our wants from what is superficial or
conventional. But to begin with, we ignore these difficulties, take people’s desires for
granted, and assume that choice is rational.

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In the economic system as we know it, choice rests largely with the individual. His
preferences go to determine what is to be produced and what is not. Every penny
spent on A is a vote in favour of the production of A; every refusal to buy B is a vote
against the production of B. It is the free choice of individual consumers between the
goods, competing on the market that determines what industries can carry on at a
profit. The industries that cannot show a profit are not carried on at all. Those that
show excessive profits attract competition and expand until people’s wants – as
indicated by the price which they are prepared to pay – are more adequately met.
That is, if competition is possible and effective. But if some commodity is monopolized,
consumers may be powerless to get what they want (and will pay for) in the proper
quantity. They show their readiness to cast votes for more of the commodity by
offering high prices for it. But the election is disregarded. No one is willing to stand
against the monopolist. So he is able to preserve an excessive scarcity by keeping
people out of his line of business. He makes things scarcer than people want them to
be and earns high profits by doing so.

Thus a country like ours does not deliberately decide what industries fit best with its
advantages and needs and on what scale they should be carried on. The decisions that
might otherwise rest with a central planning authority take shape instead in the
market. One industry expands and another contracts as consumers alter their
preferences and purchases. The scarce productive resources of the community are not
always rationed between the different industries by some Planning Commission. They
flow into the channels lubricated by the expenditure consumers.

But is it desirable that the individual should retain so much freedom of choice? What if
consumers are irrational or incapable of judging between competing goods? Would it
be better to appoint a State Planning Commission with power to decide what kind of
goods should be produced and what kind of jobs workers should be encouraged to take
up? Should each man’s daily rations be assigned to him as the average man’s daily work
is at present? With whom should choice rest, and through what agencies is it best
exercised? Here is another batch of problems for the economist.

19
Now it is clear that scarcity is more fundamental than exchange. It is, in fact, as a result
of our efforts to deal with scarcity (i.e. to economise) that exchange arises. We try to
ration our limited means among the innumerable wants that compete for satisfaction
and find that we can make our limited means go farther by striking bargains with our
neighbours. We give what we have in relative abundance – muscle or brain,
professional knowledge or organizing ability – for what is comparatively scarce, what
we could not do, or could not afford to do, ourselves. We sell our time and energies
and spend our earnings on what others have laboured to produce.
In doing so, we are offering goods or services in which our talents show to greatest
advantage (or least disadvantage) for the goods or services which others are specially
fitted to produce. We are supplementing our deficiencies – our imperfect versatility, for
instance – our of the proficiencies of others.

Not only are we able to draw on the skill of others – skill which we may not possess at
all – but we are also able to give our whole energises to a single task – one to which,
either through practice or natural bent, we are far more fitted than those who engage
in it only intermittently. By exchanging, we are making our efforts go further towards
meting our wants. We are reducing the pressure of scarcity and achieving economy.

1.7 SOCIETY’S TECHNOLOGICAL POSSIBILITIES

Each economy has a stock of limited resources – labour, technical knowledge, factories
and tools, land, energy. In deciding what and how things be produced, the economy is
in reality deciding how to allocate its resources among the thousands of different
possible commodities and services. How much land will go into growing wheat? Or into
housing the population? How many factories will produce computers? How many will
make pizzas? How many children will grow up to play professional sports or to be
professional economists or to program computers?

Faced with the undeniable fact that goods are scarce relative to wants, an economy
must decide how to cope with limited resources. It must choose among different
potential bundles of goods (the what), select from different techniques of production
(the how), and decide in the end who will consume the goods (the for whom).

20
1.7.1 Inputs and Outputs

The answer these thee questions, every society must make choices about the
economy’s inputs and outputs. Inputs are commodities or services that are used to
produce goods and services. An economy uses its existing technology to combine inputs
to produce outputs. Outputs are the various useful goods or services that result from
the production process and are either consumed or employed in further production.
Consider the “production” of pizza. We say that the eggs, flour, heat, pizza oven, and
chef’s skilled labour are the inputs. The tasty pizza is the output. In education, the
inputs are the time of the faculty, the laboratories and classrooms, the textbooks, and
so on, while the outputs are educated and informed citizens.

Another term for inputs is factors of production. These can be classified into three
broad categories: land, labour, and capital.
● Land – or, more generally, natural resources – represents the gift of nature to
our productive processes. It consists of the land used for farming or for
underpinning houses, factories, and roads; the energy resources that fuel our
cars and heat our homes; and the non-energy resources like copper and iron ore
and sand. In today’s congested world, we must broaden the scope of natural
resources to include our environmental resources, such as clean air and
drinkable water.

● Labour – consists of the human time spent in production – working in

automobile factories, tilling the land, teaching school, or baking pizzas.
Thousands of occupation and tasks, at all skill levels, are performed by labour. It
is at once the most familiar and the most crucial input for an advanced
industrial economy.

● Capital resources form the durable goods of an economy, produced in order to

produce yet other goods. Capital goods include machines, roads, computers,
hammers, trucks, steel mills, automobiles, washing machines, and buildings. As
we will later see, the accumulation of specialized capital goods is essential to
the task of economic development.
21
Restating the three economic problems in terms of inputs and outputs, a society must
decide –
(1) what outputs to produce, and in what quantity;
(2) how to produce them – that is, by what techniques inputs should be
combined to produce the desired outputs; and
(3) for whom the outputs should be produced and distributed.

1.8 The Production-Possibility Frontier

Societies cannot have everything they want. They are limited by the resources and the
technology available to them. Take defense spending as an example.

Figure 1 : The Production Possibilities in a Graph

This figure displays the alternative combinations of production pairs from Table 1.

Alternative Production Possibilities

Butter Guns
Possibilities (millions of pounds) (Thousands)
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0

Table 1 : Limitation of Scarce Resources Implies the Guns-Butter Tradeoff

22
Scarce inputs and technology imply that the production of guns and butter is limited. As we go
from A to B … to F, we are transferring labour, machines, and land from the gun industry to
butter and can thereby increase butter production.

Countries are always being forced to decide how much of their limited resources go to
their military and how much goes into other activities (such as new factories or
education). Some countries, like Japan allocate about 1% of their national output to
their military. The United States spends 5% of its national output on defense, while a
fortress economy like North Korea spends up to 20% of its national output on the
military. The more output that goes for defense, the less there is available for
consumption and investment.
Let us dramatize this choice by considering an economy which produces only to
economic goods, guns and butter. The guns, of course, represent military spending, and
the butter stands for civilian spending. Suppose that our economy decides to throw all
its energy into producing the civilian good, butter. There is a maximum amount of
butter that can be produced per year. The maximal amount of butter depends on the
quantity and quality of the economy’s resources and the productive efficiency with
which they are used. Suppose 5 million pounds of butter is the maximum amount that
can be produced with the existing technology and resources.

At the other extreme, imagine that all resources are instead devoted to the production
of guns. Again, because of resource limitations, the economy can produce only a
limited quantity of guns. For this example, assume that the economy can produce
15,000 guns of a certain kind if no buster is produced.

There are two extreme possibilities. In between are many others. If we are willing to
give up some butter, we can have some guns. If we are willing to give up still more
butter, we can have still more guns.

A schedule of possibilities is given in Table 1. Combination F shows the extreme where

all butter and no guns are produced, while A depicts the opposite extreme where all
resources go into guns. In between – at E, D, C, and B – increasing amounts of butter
are given up in return for more guns.

How, you might well ask, can a nation turn butter into guns? Butter is transformed into
guns not physically but by the alchemy of diverting the economy’s resources from one
use to the other.

23
We can represent our economy’s production possibilities more vividly in the diagram
shown in Figure 1. This diagram measures butter along the horizontal axis and guns
along the vertical one. We plot point F in Figure 1 from the data in Table 1 by counting
over 5 butter units to the right on the horizontal axis and going up 0 gun units on the
vertical axis; similarly, E is obtained by going 4 butter units to the right and going up 5
gun units; and finally, we get A by going over 0 butter units and up 15 gun units.

If we fill in all intermediate positions with new rust-colored points representing all the
different combinations of guns and butter, we have the continuous rust curve shown as
the production-possibility frontier, or PPF, in Figure 2.

The production-possibility frontier (or PPF) shows the maximum amounts of

production that can be obtained by an economy, given its technological knowledge and
quantity of inputs available. The PPF represents the menu of goods and services
available to society.

Putting the PPF to Work

The PPF in Figure 2 was drawn for guns and butter, but the same analysis applies to any
choice of goods. Thus, the more resources the government uses to build public goods
like highways, the less will be left to produce private goods like houses; the more we
choose to consume of food, the less we can consume of clothing; the more society
decides to consume today, the less can be its production of capital goods to turn out
more consumption goods in the future.

Figure 2 : A Smooth Curve Connects the Plotted Points of the Numerical

Production Possibilities
This frontier shows the schedule along which society can choose to substitute guns for
butter. It assumes a given state of technology and a given quantity of inputs. Points
outside the frontier (such as point I) are infeasible or unattainable. Any point inside the
curve, such as U, indicates that the economy has not attained productive efficiency, as
occurs when unemployment is high during severe business cycles.

24
1.9

Exercise :
1. How would you define Economics? How it is related to human wants?
2. How would you differentiate between Micro-economics and Macro-
economics?
3. What do you understand by Production Possibility Frontier? Explain with
diagram.
4. Explain the role of exchange, scarcity and choice as issues in economics.

/*/*/*/*/*/*/*/**/*

25
 UNIT – II
CONSUMPTION

2.1 INDIFFERENCE CURVES ANALYSIS

The technique of indifference curves was first used by Prof. Edgeworth, but he used it
only to show the possibilities of exchange between the two persons. A decade later
Prof. Irvin Fisher of America tried to develop a theory of consumer’s equilibrium based
on ICs analysis but he did not go beyond substitutes and complementary goods. It is so
because they believed in cardinal measurement of utility. Then Prof. Pareto developed
his theory of demand based on ordinal measurement of utility. But credit goes to Prof.
J.R. Hicks and Dr. R.G.D. Allen of Great Britain of introducing ICs technique in demand
analysis. Prof. J.R. Hicks published a book named ‘Value and Capital (1939) in which he
made use of ICs techniques. This technique is developed to mark an improvement over
utility approach. It is based on new assumptions. After having criticized Marshall, J.R.
Hicks stated ICs approach based on ordinal measurement of utility. Since, utility is
psychic and cannot be measured in cardinal numbers such as 1, 2, 3, 4 etc., Prof. J.R.
Hicks and Dr. R.G.D. Allen made use of ordinal numbers like 1 st, 2nd, 3rd, 4th etc. to
measure the level of satisfaction since utility is subjective and state of mind.

2.2 What is an IC?

The indifference curve is a conceptual curve at which every point represent the
combination of goods at x-axis and y-axis, which would place a consumer at a point of
indifference as to which combination to choose. Every combination at each point of the
curve gives him the equal satisfaction. That is why he is indifferent to any particular
choice and the curve is called indifference curve.

An IC is defined as one which joins all those combinations of two goods such as ‘x’ and
‘y’ goods which yield same level of satisfaction to the consumer or which occupy the
same position in the consumer’s scale of preference. In other words, it is a curve which
joins all those combinations of two goods yielding same level or equal level of
satisfaction to the consumer. The curve which represents all those points on it which
yield equal level of satisfaction is called IC because the consumer is indifferent between
the combinations of two goods since they yield him the same level of satisfaction.

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 The Figure given below depicts the ICs curve yielding equal level of satisfaction from
combinations of ‘x’ and ‘y’ goods.

The combinations of ‘x’ and ‘y’ goods A, B, and C lie on IC, yielding the equal level of
satisfaction to the consumer. Though they yield same level of satisfaction the quantity
of ‘x’ and ‘y’ goods differ at each combinations. As the consumer moves from A to C
combination, he consumes more of ‘x’ and less and less of ‘y’. Similarly, when he moves
from C to A combination he prefers ‘y’ to ‘x’. It all depends upon his tastes and
preferences as to which good is to be consumed more or less.

2.3 Assumptions of ICs Analysis

ICs approach is based on following assumptions:

1. Like Marshallian approach the ICs approach also takes the assumption of
rationality. Rationality implies that the consumer possesses all the relevant
information to make his rational decision of maximization of satisfaction.

2. Ordinal measurement of utility is the second important assumption of ICs. Since

utility cannot be measured in objective cardinal numbers like 1, 2, 3, 4 .. 5 etc.
because it is psychic, it is to be measured in ordinal numbers such as 1 st, 2nd, 3rd,
4th, etc.

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 3. Assumption of continuity - This assumption falls under the domain of geometry,
yet it forms core of ICs analysis. Continuity implies the consumer is capable of
ordering or ranking all the possible combinations of two goods in accordance
with satisfaction they yield to him. He can move from low level of satisfaction to
a high level of satisfaction provided his money income permits him to do so.

4. Assumptions of transitivity - It implies that if the consumer prefers ‘A’

combination of two goods to B and B to C it means he prefers A to C. Similarly if
he is indifferent between A and B. B and C, it means that he is indifferent
between A and C. In other words under this approach, the consumer’s
preference is valid for every successive pairs in the curve.

5. The ICs approach is based on weak ordering form of preference hypothesis. Thus,
the weak ordering form of hypothesis recognizes the relation of preference as well
as indifference. Strong ordering believes in only one relationship and that is
preference.

2.4 The Scale of Preference

The rational consumer always makes his purchases in the light of his scale of
preferences. It refers to valuation of goods and services independent of their market
prices. In short it involves choices of buying goods and services. Each consumer
develops his own scale of preference independent of others. It differs from person to
person based on everybody’s level of income and tastes and preferences.

2.5 IC’s Map

An IC’s map is an important tool of this approach. It represents complete description of

the consumer’s tastes and preferences. As long as consumer’s tastes and preferences
remain constant, IC’s map also remain constant. It refers to a set of ICs or a family of ICs
representing different levels of satisfaction. Each IC represents different level of
satisfaction. A higher IC represents a higher level of satisfaction and a lower IC
represents a lower level of satisfaction, but how much higher or lower is not indicated
because ICs approach is based on ordinal measurement of utility. The scale of
preference of the ICs analysis replaces the utility schedules of Marshall’s approach. The
following ICs map is drawn based on hypothetical tastes and preferences.

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 ICs No.1, 2, 3 and 4 represent different levels of satisfaction. Hence combination ‘A’
represents the lowest level of satisfaction while ‘D’ represents the highest level of
satisfaction.

2.6 Price Line or Budget Line

Price line represents the money income of the consumer given the prices of goods and
services. Prices of goods and money income are the two constraints of the price line. If
the money income changes (rise or fall), prices remaining constant price line shifts
upward or downward as the case may be. If the prices change, money income
remaining constant, price line still changes. Price line is also called as the budget line
because it provides various opportunities to the consumer costing the same money
expenditure.

Assumptions of Budget Line

1. Prices of goods and services are given and remain constant through out.
2. The consumer tries to maximize his satisfaction with given money income and set
of prices of ‘x’ and ‘y’ goods.
3. He has limited income which he spends on ‘x’ and ‘y’.
4. Tastes and preferences of the consumer remain constant.
5. Goods are divisible and their units are homogeneous.

Given the above assumptions, the consumer has to choose that combination of ‘x’ and
‘y’ goods which will lie on the given price line. Any combinations lying on the same
price line, will cost the consumer the same money expenditure though quantity of ‘x’
and ‘y’ goods is different at different combinations.

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 The consumer cannot choose any combination beyond AB price line because his limited
money income does not permit him to do so nor he would choose any combinations

inside the Δ AOB because in that case he may not be spending his entire money
income. Therefore, he would choose that combination which would lie only on price
line AB. In the graph, it is shown the consumer chooses B combination which gives him
maximum satisfaction with the given money income. He does not choose either A or C
combinations because in that case he may not be spending his entire income. At the
same time combination R is beyond reach of the consumer. ‘d’ combination does not
allow him to spend his entire income. Hence, it is out of question. That is why he
chooses B combination which gives him maximum satisfaction and permits him to
spend his entire income on ‘x’ and ‘y’ goods.

The price line shifts if prices of goods change or money income changes prices
remaining constant. The following three diagrams depicts the position of the price line.

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CVSRTA -29
 The slope of the price line is measured and always equal to price ratio of both the
goods.

The slope of price line AB = A

O

2.7 Consumer’s Equilibrium

A consumer is said to be in equilibrium when he is buying such a combination of two

goods as leaves him with no tendency to rearrange his purchases. In other words, he
would choose that combination which would give him the maximum satisfaction with
the given money income and prices of goods and services.

CVSRTA -30
 31

CVSRTA -31
 Assumptions

1. The consumer has his IC map exhibiting his scale of preference

2. The consumer has limited money income which he spends on ‘x’ and ‘y’ goods.
3. The consumer is rational. It means that he knows market conditions. He tries to
maximize his satisfaction.
4. Goods are divisible and their units are identical.
5. Prices of goods are given and they remain constant.

Conditions for Equilibrium

1. The consumer would attain his equilibrium at a point where price line is tangent
to the highest possible IC. In other words, the slope of the price line and IC
curve must be the same at the point of equilibrium. The slope of the price line
Px
is represented by the ratio of prices of represented by MRSxy.
goods i.e. while slope of the IC is
Py

Thus at the point of equilibrium = Px Px

= MRSxy or MRSxy =
Py Py

2. The second condition is that IC curve must be convex at the point of

equilibrium, then only satisfaction of the consumer would be maximum. This is
depicted in the following diagram:

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 Marginal Rate of Substitution (MRSxy)

MRS between two goods is an important tool of ICs analysis. It refers to the rate at
which one good is substituted for another at margin without altering the level of
satisfaction. Thus, MRSxy represents the amount of ‘y’ good which the consumer has
to give up for the gain of one more unit of ‘x’ good so that his level of satisfaction
remains the same. The MRS between two goods always falls as the quantity of one
good is increased.

The consumer is in equilibrium at ‘E’ point where IC 2 is tangent to the price line AB.
The consumer buys ON quantity of ‘y’ good and OM quantity of ‘x’ good maximizes
his satisfaction. At ‘E’ point both conditions of equilibrium are fulfilled i.e. MRSxy =
Px
Py and also MRSxy is declining or IC2 is convex to the origin. That is why the
consumer is in equilibrium at ‘E’ combination. He is not in equilibrium at ‘R’ point

because it is here MRSxy > Px

Px
and in case of ‘S’ combination MRSxy <
.
Py
Py
Combinations ‘R’ and ‘S’ place him on lower IC. Therefore, the consumer is
permanently in equilibrium at ‘E’ point where both the conditions of equilibrium are
fulfilled.

The equality between MRSxy = Px

is essential condition for equilibrium but not
Py
sufficient condition. The sufficient condition is that at the point of equilibrium MRSxy
must be falling or IC must be convex to the origin. Then only the consumer would be
maximizing his satisfaction.

CVSRTA -33
 33

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 2.8 Income Effect

The consumer may become better off or worse off because of a change in his money
income. Prices of goods and services remaining constant. His satisfaction will either
increase or decrease based on larger or smaller size of money income at his disposal.
The result of this type is called as income effect. In other words, it refers to a change in
his level of satisfaction on account of a change in his money income. Under income
effect consumer is allowed to become either better off or worse off as the case may be.
If the income increases he will buy more of both the goods and thus will become better
off. In the same manner his income may fall, as result of which he would buy less of
both the goods, which would reduce his level of satisfaction making him worse off
prices remaining constant. When he becomes better off, he will reach on higher IC and
when he becomes worse off he will be placed on lower IC.

Income effect can be negative also if the commodity is interior. Even after increase in
income he may buy less quantity of the commodity, which is inferior. However it is
difficult to name certain goods to be inferior. What is inferior to one person may not be
inferior to other person. Therefore, taste and preferences along with size of money
income label certain goods as inferior one.

Assumption of Income Effect

1. Money income alone changes; rise or fall.

2. Prices of goods and services remain constant throughout.
3. Consumer is rational and tries to maximize his satisfaction.
4. Tastes and preferences remain constant.
5. The consumer has no control on market conditions.

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 In the light of the above assumptions let us examine the income effect in case of
normal good with a diagram below:

I.C.C. = Income
Consumption
Curve

Income effect is to be studied with the help of ICs’ map and price line. ICs number one
to four represents consumer’s ICs map highlighting his tastes and preferences whereas
price lines AB, CD, EF and GH present different levels of money income. As the money
income of the consumer increases, he moves from IC 1 to IC4 consuming more of both
the goods and becoming better off. And when his money income falls from GH to AB
price line he is shunted to lower and lower ICs, thus making him worse off as he buys
less and less of both the goods. The consumer attains equilibrium at E, E 1, E2 and E3
tangency points on AB, CD, EF, GH price lines as his money income goes on increasing.
He becomes better and better off. When his money income falls he becomes worse off
when he becomes better off, he is placed on higher ICs and in case of worse he is
placed on lower ICs. Thus under income effect the consumer is allowed to become
either better off or worse off.

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 2.9 Income Consumption Curve (I.C.C.)

Since, the price line represents the money income of the consumer or in other words,
his purchasing power, the price line in its each point represents the affordability of the
limited purchasing power within which the means of income. The combination of goods
at E point will give him the maximum satisfaction because, it is at this point it will touch
the indifference curve.
The other points of which are beyond his reach with his limited income. The
combination pf ‘X’ and ‘Y’ goods at point E will be his obvious choice because it satisfies
both his affordability as well as preference. Similar points of intersection can be
considered at the successive price line.
A line which is drawn through all the equilibrium points such as E, E 1, E2 and E3 is called
as income consumption curve. It shows how the consumer’s purchases react to change
in money income when prices remain constant. If the prices were different the ICC
would take different shape and position. It is also defined as the locus of equilibrium
points at different levels of consumer’s money income. It traces out income effect on
the quantity of goods purchased. I.C.C. can be positive or negative. It is positive when
an increase in money income is accompanied by increase in consumption of goods and
services and negative when an increase in money income is accompanied by reduction
in consumption of goods. If I.C.C. slopes backwards towards ’y’ axis, then ‘x’ good is
inferior good and if it slopes towards ‘x’ axis, ‘y’ good is inferior. In case of normal
goods it slopes upwards. The following diagram depicts the shapes of I.C.C.

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 One thing must be noted that IC approach does not tell which goods are inferior. It
merely describe the phenomenon.

2.10 Substitution Effect

While explaining income effect, we held that prices remain constant but it is not a
realistic assumption. Prices always change and therefore consumer’s real income
undergoes changes. It may rise or fall. When prices rise, real income of the consumer
falls, money income remaining constant.
Likewise when prices fall, real income of the consumer rises. But under substitution
effect we shall be analyzing the effect of fall in price of one of the goods, real income
of the consumer keeping it constant. In other words when prices rise or fall, the
consumer’s money income is also changed in such a way that he is neither better off
nor worse off than before so he will find it worth his while to buy more of that good
which has become relatively cheaper.
He will substitute relatively cheaper good for relatively costlier good. The result of this
type is known as a substitution effect.

In substitution effect, the consumer’s real income remains the same but he rearranges
his purchases in such a way that he is neither better off nor worse off than before as a
result of change in price of one of the goods. The following diagram illustrates the
phenomenon.

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 In the above figure, AB is the original price line. IC is tangent at ‘P’ point so the
consumer is in equilibrium at ‘P’ point where both the conditions of equilibrium are
fulfilled. The consumer consumes ON quantity of ‘y’ good and O M quantity of ‘x’
good. Now we suppose the price of ‘x’ falls and ‘y’ remains constant. That is why AB,
new price line is drawn to show fall in price of ‘x’ good. Now ‘x’ has become relatively
cheaper and ‘y’ good relatively costlier. If his money income kept intact, he will
become better off.

But under substitution effect consumer is not allowed to become better off. Therefore,
his money income is cut in such a way that his real income remains the same. So that
he is neither better off nor worse off. To show cut in money income, a new price line C
D is drawn parallel to A B, price line to keep his real income intact. Now he will choose
that combination which will lie on C D price line.
Since ‘x’ has become relatively cheaper he will buy more of ‘x’ good and less of ‘y’
good. In other words, he will substitute relatively cheaper good for relatively costlier
good by rearranging his purchases in accordance with change in prices. Thus, he
substitutes M M’ quantity of ‘x’ good for N N’ quantity of ‘y’ good and attains his new
equilibrium at Q point on C D price line and on the same IC curve. He moves from ‘P’
equilibrium to ‘Q’ equilibrium in favour of ‘x’ good.

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 The amount by which his money income is changed so that he is neither better off nor
worse off than before is called as the compensating variation in income. In other
words, it is a change in money income of the consumer which is just sufficient to
compensate him for a change in the price of ‘x’ good. Hicks Allen substitution effect
takes place on the same IC whereas Slusky’s substitution effect takes place on a
different IC. Substitution effect is always positive. It is positive because general
tendency of the people is that to buy that good more which is relatively cheaper and
that good less which is relatively costlier.

2.11 Price Effect

Price effect studies the effect of a change in real income of the consumer on his
purchases. A change in real income may be either an increase or a decrease in the real
income of the consumer due to fall or rise in prices of goods. Therefore, under price
effect the consumer is allowed to become either better off or worse off as the case
may be.

Assumptions

1. Money income remains constant

2. Prices rise or fall; as result of which real income of the consumer rises or falls
3. The consumer spends his entire money income
4. The consumer is rational
5. Price of ‘x’ falls and price of ‘y’ remain

When price of ‘x’ falls, real income of the consumer rises. This means that with the
same money income he can buy more of both the goods and becomes better off. An
increase in real income produces two effect simultaneously viz. income effect and
substitution effect. Thus the price effect is the combination of income effect and
substitution effect. Under price effect, the consumer is allowed to become either
better off or worse off as the case may be.
We suppose price of ‘x’ falls and price of ‘y’ remains constant. Therefore ‘x’ becomes
relatively cheaper in terms of ‘y’ and ‘y’ costlier in terms of ‘x’. Since substitution effect
is always positive, the consumer will buy more and more of ‘x’ good as price continues
to fall. Price lines AB, AB 1, AB2, AB3 show fall in price of ‘x’ good. Therefore, the
consumer becomes better and better off and reaches higher and higher ICs. The
following diagram illustrates the phenomenon.

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 The curve which passes through all the equilibrium points such as E, E 1 and E2 is called
as price consumption curve. If traces out the price effect on the purchase of the
consumer. It shows how changes in price of ‘x’ good will affect the consumer’s
purchases of ‘x’, price of ‘y’, tastes and preferences and money income remaining
constant. It is locus of equilibrium points at different levels of prices or real income.
The P.C.C. may shift backward towards ‘y’ axis if ‘x’ good becomes inferior or it may
slope downward towards ‘x’ axis if ‘y’ good is inferior and it may slope upward if both
the goods are normal goods.

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 2.12 Breaking up Price Effect

Price effect is combination of income effect and substitution effect. Substitution effect
is always positive but nothing can be said about income effect. It can be negative also.
Therefore, it is necessary to decompose price effect into income effect and
substitution effect. When price of ‘x’ falls, the consumer’s real income increase, money
income remains constant. Therefore, the consumer either buys more quantity of both
the goods or relatively cheaper good and will become better off. When he becomes
better off I.C.C. curve takes him on a higher IC. This shows income effect is positive.
Now, he buys more of both the goods. He reaches second IC. His movement from IC to
IC2 is due to positive income effect. However, he won’t be at ‘R’ point in
Px
equilibrium permanently as MRSxy > at ‘R’ equilibrium. Moreover, substitution
Py
effect is stronger than income effect. Therefore, he substitutes some units of ‘x’ good
for some units of ‘y’ good. It is done because ‘x’ has become relatively cheaper and ‘y’
relatively constlier as a result of fall in price of ‘x’ good. It is a general tendency of the
consumer to buy that commodity more which is relatively cheaper. That is why he
slides down along the IC2 towards right. Now he moves from ‘R’ equilibrium to ‘Q’
equilibrium point on IC2. the movement from ‘R’ to ‘Q’ is due to positive substitution
effect. Thus, price effect is made of income effect and substitution effect.

Price = Income effect + Substitution effect

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 This phenomenon is illustrated in the following diagram:

Price effect = I.E. + S.E.

MM2 = M M1 + M’ M2

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 2.13 Giffen’s Good

In case of Giffen’s good negative income effect is so large that it outweighs completely
positive substitution effect as a result of which consumer buys less than before. The
following diagram depicts the phenomenon.

P
E = Strong negative I.E. + P.S.E.
= – L M + L M’
= – M’ M

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 2.14 Derivation of Demand Curve from the P.C.C.

The P.C.C. of the indifference curve approach does not directly relate price with
quantity demanded. It does not explicitly express price in money terms. It is so
because in the IC analysis price is not explicitly shown on ‘y’ axis. On the other hand
Marshall’s demand curve explicitly relates price with quantity demanded. Thus, the
demand curve showing the relationship between quantity demanded of a good at its
various alternative prices can be derived from the P.C.C. of the indifference curves
approach. Instead of price of a good being measured in terms of money, it is measured
in terms of a good. For example we measure price of ‘x’ good in terms of ‘y’ good and
price of ‘y’ in terms of ‘x’ good.

Thus the P.C.C. also expresses the same relationship i.e. inverse between price and
quantity demanded in case of normal good and direct in case of inferior and Giffen’s
goods. The following diagram depicts the derivation of demand curve from the P.C.C.

Assumptions

1. The consumer possesses Rs.120/- as his money income

2. Price lines AB, AB1, AB2, AB3 are different alternative price lines representing
Rs.15/-, Rs.12/-, Rs.10/- and Rs.8/- per unit.

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 The above graph shows that the P.C.C. curve of the IC analysis is the same as
Marshall’s demand curve. Normally demand curve slopes downward from left to right
due to positive income effect. Both the positive effect extend demand for the good.

Limitations of ICs Analysis

1. Unrealistic assumptions
2. Combination of two goods may lead to absurdity like shoes and shirts.
3. In case of more than two goods, IC analysis cannot be put to use.
4. The assumption of continuity is also not true.
5. No provision for uncertainty.
6. The approach is highly introspective rather than behaviouristic.
7. Prof. Robertson calls the IC approach as old wine in new bottle!

2.15 CONSUMER SURPLUS

2.15.1 Law of diminishing utility:

The concept of consumer surplus is based on theory of diminishing utility. The law of
diminishing utility means that total utility increases at the decreasing rate after a point
is reached in the consumption level. As we consume glasses of water when we are
thirsty, the total utility from consuming second or the third glass of water may reflect in
increase in total utility at an increasing rate. But after point, we are less inclined to take
more water. The fourth glass of water may, therefore, add o our total utility only at
decreased rate. That is what we call the marginal utility is less as we consume fourth
one. The fifth glass of water correspondingly may yield a still less marginal utility. If we
project the rate of decreasing utility in a geometrical curve, it represents the law of
diminishing utility.

The idea of consumer’s surplus was developed by French engineer economist A.J.
Dupuit in 1844. But it was improved and popularized by English economist Dr. Alfred
Marshall in 1879 in his book named “Pure theory of Domestic Values”.

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 2.15.2 Meaning and Definition of Consumer’s Surplus

We buy goods and services because they give us utility. But at the same time we lose
some utility in terms of money. Payment of prices means parting with money in
exchange of goods and services. This causes disutility to the consumer. In the beginning
utility gained is higher than the utility lost. Since the consumer being rational goes on
buying units of the commodity as long as utility gained is higher than utility lost. In
terms money paid. Utility goes on falling, as more units of the same commodity are
consumed but utility of units of money remains constant. Thus a point will reach when
utility gained is equal to utility lost in terms of price. At this point, the consumer stops
purchasing additional units of that commodity. Beyond this point utility lost is greater
than utility gained. In other words, a rational consumer buys the commodity only if he
expects a surplus of utility and this surplus is called consumer’s surplus. It is defined as
the difference between the satisfaction gained and satisfaction lost. The satisfaction
that the consumer obtains from the consumption of a commodity is measured by the
price he would pay for it rather than go without it. While satisfaction he loses in
procuring that commodity is measured in terms of price he actually pays for it.
According to Dr. Alfred Marshall, “the excess of the price which he would be willing to
pay rather than go without the thing over that which he actually does pay, is the
economic measure of this surplus satisfaction. It may be called consumer’s surplus.” In
other words, it can be called as the difference between the expected price for a
commodity in terms of price and the actual price that the consumer pay for it rather
than go without it.

2.15.3 Measurement of Consumer’s Surplus

It is derived from the demand curve or the marginal utility curve. The following diagram
and table illustrate the concept. Let us suppose that our consumer has only five rupees
to spend on apples. Price of apple is hundred paise per unit which remains constant. As
the consumer goes on buying units of apple his utility gained is much more than the
utility lost. At the 5th unit of apple, utility lost (100) becomes equals to utility gained
(100 units). It is at this point he would stop buying further as beyound 5 th unit, the
utility lost would be greater than utility gained.

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 The following table explains the whole thing.

Units of Apple No. Price in Paise Consumer’s Surplus

1 150 100 50
2 130 100 30
3 120 100 20
4 112 100 12
5 100 100 0

Total - 5 Units - 612 - 500 = 112 Consumer’s surplus

The surplus derived by him from five units of apple is 112. The total utility derived is
612 units and utility lost in buying five units is 500. Thus, total consumer’s surplus is
612 - 500 = 112 units.

C.S. = Total utility gained - Total utility lost

= 612 - 500
= 112 units

But one must keep in mind the consumer’s surplus derived from different commodities
is different. Some commodities yield higher surplus than others. For instance, salt,
match box, newspapers etc. People enjoy greater surplus on these commodities than
luxury goods. The concept of individual consumer’s surplus can very well be applied to
the society as a whole.

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 Price is measured along ‘ox’ axis which is hundred paise per unit that remains constant
and quantity demanded along ‘ox’ axis. Demand curve DD is based on MU schedule.
The price of apples assumed to be fixed and remains constant for all units. Therefore,
the consumer loses 100 x 5 = 500 units whereas he gains 150 + 130 + 120 + 112 + 100 =
612 units. Hence consumer’s surplus = Total satisfaction (u) - Total satisfaction scarified

(DO) in buying apples ∴ 612 – 500 = 112 units c.s.

Assumptions
1. The fixed relationship between utility and satisfaction, but utility is different from
satisfaction.
2. MU of money remains constant through out the process of exchange. No
comparison is made in the absence of this assumption and it becomes difficult to
measure the consumer’s surplus.
3. The concept of consumer’s surplus is based on cardinal measurement of utility
which is not true.
4. DD schedule and MU schedule are assumed to be the same but they are not.
5. The concept ignores the differences in incomes, fashions, tastes and preferences
between consumers.

Importance
1. The concept is made use of public finance in the matter of taxation. Taxes are
imposed on those commodities on which people enjoy very high consumer’s
surplus.
2. It helps producers to decide upon pricing policies.
3. It is also helpful to international trade.
4. International comparison of economic welfare can also be possible through
consumer is surplus.
Limitations
1. It is based on certain assumptions which are not tenable in actual life. Therefore,
it is said that the concept is based on unrealistic assumptions.
2. Cardinal measurement of utility is not possible. Utility is psychic and hence
cannot be quantified.
3. Marginal utility of money cannot remain constant.
4. It is also said utility is not independent. It is inter-dependent.
5. Differences in income, tastes and preferences cannot be ignored.
6. There is no definite relationship between utility and satisfaction as visualized by
Marshall.

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 UNIT III
DEMAND AND SUPPLY

3.1 DEMAND
In economics, demand has a distinct meaning. Supposing, you desire to have a car, but
you do not have enough money to buy it. Then desire will remain just a wishful
thinking; it will not be called demand. If you have enough money, you do not want to
spend it on car, demand does not emerge. The desire becomes demand only when you
are ready to spend money to buy the car. Thus, Demand for a commodity refers to the
desire to buy a commodity backed with sufficient purchasing power and willingness to
spend. Hence demand is equal to desire plus purchasing power plus willingness to pay.
Demand for a commodity is always refers to price. At higher price quantity demanded
will be low, and at lower price quantity demanded will be high.

Demand schedule:
It is a numerical tabulation, showing the quantity that is demanded at different prices.
It expresses the relation between price and demand of a commodity. A demand
schedule can be of two types –

▪ Individual Demand Schedule

▪ MarketDemand Schedule

Individual Demand Schedule:

Individual demand schedule is defined as the quantity of a given commodity which a
consumer will buy at all, possible price, at a particular period of time.

Table3.1-Individual demand schedule for Apples

Price of Apples (Rs.) Quantity demanded (Kg)
10 4
20 3
30 2
40 1

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 In the above table we can see that as the price of apples increases, quantity demanded
is decreases.
Market demand Schedule

In every market, there are several consumer of a commodity. Market demand schedule
is one that shows total demand of all the consumers in the market at different price of
the commodity.

Table 3.2 - Market demand schedule for Apples

Price (Rs.) Ravi’s Demand Sahil’s Demand Market Demand
10 4 5 4+5=9
20 3 4 3+4=7
30 2 3 2+3=5
40 1 2 1+2=3

Table 3.2 shows that with the rise in the price of apples the market demand for apples
is decreasing.
Demand Curve

Demand Curve is the graphical representation of demand schedule expressing the

relation between different quantities demanded at different possible prices of the
commodity. There are two type of demand curve:

▪ Individual Demand Curve: It is a curve showing different quantities of a commodity

that one particular buyer is ready to buy at different possible price of the
commodity at a point of time. Individual demand curve is shown in figure 3.1-

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 ▪ Market demand Curve: The market demand consists of the total quantity

demanded by each individual in the market. The market demand curve is formed
by computing the horizontal summation of the individual demand curves for all
consumers. This process is illustrated in Figure 3.2.

▪ We take a hypothetical case in which there are only two consumers in the market

namely, Mr Ravi and Mr Sahil.The total quantity demanded in the market is just
the sum of the quantities demanded by each individual. The market demand curve
is derived by adding together the quantities demanded by all consumers at each
and every possible price.

Both individual and market demand curvesslope downward from left to right indicating
an inverse relationship between price and quantitydemanded of goods.

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 Determinants of demand:
Demand function is show the relation between demand for a commodity and its
various determinants. The determinants are also known as the factors which affect
demand of a commodity. It shows how demand is related to different factors like price,
income etc. the demand function can be expressed as follows-

D = f(P, Pr, Y, T, FE,S,W, )

where,
P – Price of the commodity
Pr – Price of related goods
Y – Income of the consumer
T – Taste and preference
FE – Future expectations of the consumers
S – Size and composition of the population
W – Weather condition

The determinants are explain below -

i) Price of the Commodity: Quantity demanded and the price of the commodity is
inversely related. It means that with the rise in the price of commodity, quantity
demanded decreases and with the fall in the prices there is a rise in the quantity
demanded.

ii) Price of the related goods:Demand for a commodity is also influenced by change in
the price of related goods. There are two types of related goods - Substitutes and
Complements.Substitute Goodsare those goods which can be the goods which can
be used in place of each other, such as tea and coffee. If an increase in the price of
one causes a rise in the demand for the other then the two goods are substitutes.
On the other hand the complementary goods are those goods which are consumed
together.

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 If an increase in the price of one goods causes the reduction in the demand for the
otherthen the two goods are complementary goods. Car and petrol are
complimentary goods.

iii) Income of the consumers:Normally there is a direct relationship between the

income of theconsumer and his demand for the commodity.For a normal good with
the rise in consumer’s income demandwill rise and vice versa. Goods like television
sets, cars, clothes etc are considered normal goods. If the demand for a goods
decreases with the rise in consumers income then that goods are known as Inferior
Goods. For e.g. coarse grain like Jowar, Bajra,Maize, etc. If the income of the
consumer risesshe will reduce the consumption of these goods.
If the demand increaseswith an increase in income and thereafter it remains
constant irrespective of the level ofincome then the goods in question are known as
necessities for example salt, match box, etc.

iv) Consumer’s Taste and Preference:Consumer’s demand for the goods is greatly
influenced by the taste and preferences which in turn dependson social
customs,habits, fashion, etc.

Consumer’s Expectation:If a consumer expects a fall in the price of a commodity in a

nearfuture, then he will postpone his present demand and if he anticipates a rise in
price then he will increase his current demand. For instant if you are thinking about
purchasing a computer and you obtain information that may lead to rise in the future
price then you will buy the computer today itself. However, a reduction in the expected
future price will result in a reduction in current demand.

If expected future income rises, demand for many goods today is likely to rise. On the
other hand, if expected future income falls, individuals may reduce their current
demand for goods so that they can save more today in anticipation of the lower future
income.

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 v) Size and Composition of Population:Larger the population, larger is likely to be the
numberof consumers thus greater will be the demand. The composition of
population refers to number of children, adults, males,females, etc. in the
population. If the number of children are more in the population then more of baby
products will be demanded whereas in an education township like Vallabh Vidya
nagar in Anand district of Gujarat where 50 to 60 per cent of the population is of
students (between the age group of 18 to 24 years) more of stationary, hostels, fast
foods etc will be demanded.The type of people inhabiting the country will also
influencethe consumer demand.Since the market demand curve consists of the
horizontal summation of the demand curves of all buyers in the market, an increase
in the number of buyers would cause demand to increase. As the population
increases, the demand for food, houses, cars and virtually all other commodities, is
expected to increase. A decline in population will result in a reduction in demand.

vi) Weather condition: Another factor which affects demand is the weather
conditions. For example during summer there will be greater demand for sun
glasses, cotton wears, ice creams etc, whereas during rainy season the demand for
umbrellas and raincoats will increase.

Law of Demand: Law of demand expresses the functional relationship between the
price of commodity and its quantity demanded. It states that the demand for a
commodity is inversely related to its price, other things remaining constant. In other
words a fall in price of a commodity will lead to a rise in demand of that commodity
and a rise in price will lead to fall in demand. Thus there is an inverse relationship
between the price of a good and the quantity demanded in a given time period, ceteris
paribus.

Assumption:
The law of demand is based on certain assumptions. These are as follows -
a. There is no change in the Income of the people.
b. Taste, preference and habits of consumers unchanged.
c. Prices of related goods i.e., substitute and complementary goods
remainingunchanged
d. There is no expectation of future change in price of the commodity.

e. The commodity in question is not consumed for its prestige value.

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 As shown in figure 3.3 the relationship between price and quantity demanded is
represented by a demand curve. At price OP the quantity demanded is OQ when the
price increase from OP to OP1 quantity demanded decreases from OQ to OQ1. Thus
when the price increases, demand decreases and vice versa. Demand curve slopes
down ward from left to right showing inverse relationship between price and quantity
demanded. This downward slope of demand curve is expression of law of demand.

Reasons for downward slope of demand curve:

Downward slope of demand curve indicates that consumers buy more of a commodity
at lower prices and vice versa. Thus, there is Negative relationship between price and
quantity demanded. The reasons for downward slope of demand curve are –

(i) Law of Diminishing Marginal Utility: This law states that when a consumer buyers
moreunits of same commodity, the marginal utility of that commodity continues to
decline. The consumer will buy more of that commodity when price falls. When
lessunits are available the utility will be high and consumer will prefer to pay more for
that commodity.Thus the demand would be more at lower prices and less at a higher
price and so thedemand curve is downward sloping.

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 (ii) Income effect: As the price of the commodity falls the real income of the consumer
will increase and consumer can increase hisconsumption.He will spend less to buy the
samequantity of goods. On the other hand, with a rise in price of the commodities the
real income ofthe consumer will reduce and consumer will buy less of that good.

(iii) Substitution Effect: Whenthe price of a commodity falls, the price of its
substitutesremaining the same, the consumer will buy more of that commodity and
this is called thesubstitution effect. The consumer will like to substitute cheaper good
for the relatively expensivegood. On the other hand, with a rise in price the demand
falls due to unfavorable substitutioneffect. It is because the commodity has now
become relatively expensive which forces theconsumer’s to buy less.

iv) Number of uses of a Good: Goods which can be put to a number of uses like milk
which can be used for making tea, curd, cold drinks, paneer etc. When the price of milk
commodity is higher, it willsparingly used. On the other hand, if the price of milk
decreasesconsumer will use it for a variety of purposes leading to a rise in demand.
Thus the demand for the product with the change in price is determined by the number
of uses of a commodity.

v) Change in number of buyers: Lower price will attract new buyers and higher
pricereduces the buyers. Such buyers are known as marginal buyers.

Owing to the above mentioned reasons thedemand falls when price rises and so the
demand curve is downward sloping.

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 Exceptions to the law of demand:
Law of demand has some exceptions as well. There are some goodswhose demand
increases when price rises and decrease when price falls. They are –

i) Conspicuous Goods These are the goods which are purchases by the consumers to
project their status andprestige.Expensive cars, diamond jewellery, etc. are such
goods. The conspicuous goods are purchased more at a higher price and less at a
lower price.

ii) Giffen Goods : Giffen goods named after Sir Robert Giffen. These are inferior
goods whose demand increases evenif there is a rise in price. For e.g.: - coarse
grain, clothes, etc.

iii) Share’s speculative Market : It is often found that people buy shares of those
companies whoseprice is rising in anticipation of further rise in price. Whereas,
they buyless shares in case the prices are falling as they expect a further fall in
price of such shares. Herethe law of demand fails to apply.

iv) Bandwagon effect: Here the consumer demand of a commodity is affected by the
taste and preference of the social class to which he belongs to. If sports car
fashionable amongbusiness community, then as the price of sports cars rises,
these consumers may increasethe demand for such goods to project their position
in the society.

v) Veblen Effect: Many a times consumer judge the quality of a product by its price.
Consumer feels that a higher price means better quality and lower price means
poorquality. So the demand goes up with the rise in price for example branded
consumer goods.

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 3.2 Change in Quantity Demanded and Change in Demand
A change in quantity demanded refers to increase or decreases in quantity purchased
of a commodity in response to decrease or increase in its price, other things remain
constant. It is expressed through movement along the demand curve.On the other
hand achange in demand,refers to increase or decrease in quantity demanded of a
commodity in response to change in factors other than price. It is expressed through
shift in demand curve-forward shift or backward shift.

(a) Movement of Demand curve or Extension and Contraction of Demand or

change in quantitydemanded.
With the change in the price of a commodity the quantity demanded will increases or
decreases depending upon the fall or rise in the price ofa commodity alone, ceteris
paribus.This is called movement along the demand curve or extension or contraction of
Demand. As shown in figure 3.4, when the price increases, other factors affecting
demand remain constant, the quantity demand will decreases and vice versa

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 The figure 3.4 show that when price increases from OP to OP1 the demand decreases
from OQ to OQ1. Thus with the fall in price there is a movement on the demand curve
from point A to point B. Similarly with the rise in price from OP to OP 2 the quantity
demanded decreases from OQ to OQ2 causing a shift from point A to point C on the
demand curve. The increase in demand due to fall in price is also called extension of
demand. The reduction in quantity demanded due to increase in price is known as
contraction.

Change in Demand or shift of demand or Increase and Decrease in demand:

When the quantity demanded a commodity increases or decreases due to change in
factors other than price of the product like income of the consumer, price ofrelated
goods, etc. it is known as change in demand or shift in demand.

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 In Figure 3.5 DD is the original demand curve and the consumer in buying OQ units of
the commodity at price OP. For example with an increase in the income of the
consumer , price of the product remains constant, the demand increases the new
demand curve is D1D1. This new curve is an outward shift in the demand curve and
shows an increase in the demand for the product from OQ to OQ 1. Similarly due to the
fall in the income of the consumer, the demand curve will shift inward from DD to D 2D2.
Quantity of good purchased will reduce from OQ to OQ 2. This is called decrease in
demand.

Thus in the above figure quantity demanded has increased from OQ to OQ 1, the price of
commodityremaining constant at OP. This is shown by a right ward shift of the Original
demand curve toform new demand curve D 1D1. This is called increase in demand in
demand.The left ward shift from the original demand curve DD to D 2D2 is known as
decrease in demand, price of the product remains same at OP.

3.3 THEORY OF SUPPLY

Supply is defined as a quantity of a commodity offered by the produces to besupplied
at a particular price and at a certain time. Same as demand supply has three elements
namely quantity of commodity, particular price and particular time.

The term ‘supply’ is different from ‘stock’ of a commodity. The total amount of the
commodity which a seller can bring out for sale in the market is his stock. However,
producer often does not offer his entire stock for sale in the market.Supply has been
defined as that part of the stock of a commodity which is offered for sale at a particular
price during a period of time. For example a farmer produces 500 tons of potatoes
during a given period. He may offer only 300 tones for sale at Rs 1000 per ton. In this
case the stock of potatoes is 500 tons but supply is only 300 tones at a given price.

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 Individual Supply and Market Supply
Individual supply refers to the quantity of a commodity which a producer is willing to
produce andoffer for sale. On the other hand, the quantity which all producers are
willing to produce and sell isknown as market supply. If, at a given price, producer A is
willing to sell 200 units of a commodity and producer B is willing to sell 500 units, and
then if there are only two firms producing this particular commodity, market supply will
be 700 units.

Law of supply
Law of supply states that, other thing remaining constant, as the price increase quantity
supplied will increase and with the decrease in price the supply will reduce. Thus there
is a positive relationship between price of a commodity and its quantity supplied. More
is supplied at higher price and less at the lower price. The law of supply is based on
following assumptions -

Assumption of the law of supply

(1) Prices of the factors of production are constant.
(2) Price of the related goods remain constant
(3) Technique of production is constant.
(4) No change in the Objectives of the firm
(5) Producers do not expect any change in the future price of the product.

The law can be explained with the help of following supply schedule and supply curve.

Supply Schedule
Supply schedule is a table which shows various quantities of a commodity offered for
sale at different possible prices of that commodity. There are two types of supply
schedule –
(i) Individual supply schedule, and

(ii) Market supply schedule.

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 (iii) An individual supply schedule shows the different quantities of a commodity that
a producer would offer for sale at different prices.

Table 3.3 shows a hypothetical individual supply schedule of apples. When the price of
apples is Rs 10 per Kg the producer is interested in selling only 1 kg of apples. As the
price rises, supply increases. Thus higher the price higher is the supply.

Table 3.3.Individual supply schedule of Apples

Price of Apples (Rs.) Quantity supplied (Kg)

10 1
20 2
30 3
40 4

Market supply schedule: Market supply refers to supply of all the producers in the
market producing a particularcommodity.Firm is an individual unit producing a
commodity. A group of firms producing a similar good is called an Industry. Thus,
market supply schedule is also referred to supply of the industry as whole.
Table 3.4:Market Supply schedule.

Price of Apples Supply by Supply by Market supply

Producer Producer
(Rs.)
‘A’ (Units) ‘B’ (Units)
10 1 0 1+0=1
20 2 5 2+5=7
30 3 10 3+10=13
40 4 15 4+15=19

From the above table we see that when price of apples is Rs.10 per Kg, then the
producer A will supply only 1 kg of apples whereas producer B is not interested any
quantity. When price increase to Rs.20, producer ‘A’ supplies 2 kg and producer ’B’
supplies 5 units.

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 Thus the market supply is 2 + 5 = 7Kg of apples.When the price rise to Rs 30 per kg of
apples market supply increase to 13 kg. Thus at higher price the market supply will
increases.

Supply curve: Supply curve is a graphic presentation of supply schedule. Supply curve
has positive slope which indicates positive relationship between price of a commodity
and its quantity supplied.
Same as the supply schedule supply curve can be divided into
(i) (i)Individual supply schedule and
(ii) Market supply schedule.

An individual supply curve is a graphical representation of supply schedule of an

individual producer in the market. It slopes upwards indicating positive relationship
between price of a product and its quantity supplied. The individual supply curve is
given in figure 3.6

In the above figure SS is the supply curve which has positive slope. It shows that more
of a commodity is supplied at a higher price.

Market supply curve as shown in figure 3.7 is the horizontal summation of all individual
supply curves. This is also known as the supply curve of the industry as a whole. Supply
curve SS is of producer A and S1S1 is the supply curve of producer B.

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 For deriving the market supply curve, same as the market demand curve explained
earlier in this chapter we add the individual supply curves horizontally.

Factor Determining supply or supply function

Supply function represents the functional relationship between supply of a commodity
and its various determinants. The supply of a commodity mainly depend on the
objective of the firm, price of the commodity, price of related goods, price of factors of
production and the state of technology.

Supply function can be written as –

S =f (P, O, Pr, F, T, G,…….)
Where
P- Price of the commodity
O – Objectives of the firm
Pr – Price of related goods
I – Input Prices
T – State of Technology

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 G – Government Policies
E- Future expectation of the prices
F – Number of sellers in the market
N – Natural Factors

The above mentioned determinants of supply are explained below –

(i) Price of the commodity (P): With change in the price of the product the supply
changes. When the price increases, producer increase the supply and vice
versa.With no change in cost of production, higher the price, higher will be the
profit margin. This will encourage the producers to supply larger quantity at
higher prices. When the price decline the supply will also decline.

(ii) Objectives of the firm (O):Firms have several objectives such

asprofitmaximization, sales maximization, employee satisfaction maximization
etc. If the objective is tomaximize profit, then higher the profit from the sale of
a commodity, the higherwill be the quantity supplied by the firm and vice-versa.
Thus, the supply of goods willalso depend upon the priority of the firm
regarding these goals and the extent towhich it is prepared to sacrifice one goal
to the other.

(iii) Expectation about future prices (E): If the produces expect an increase in the
future price of acommodity, then the present supply will reduce as producer will
stock the goods to sell in future at higher prices. On the contrary if he expects a
fall in future prices then he will increase the present supply.

(iv) Input Prices (I):Supply depends upon the prices of inputs like raw
materials,labour and other inputs. Any rise in the input cost will reduce the
profitmargin and ultimately lead to a lower supply. However, with the fall in
inputs prices , profit margin will increase and the supply will also increase.

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 (v) State of Technology (T):An improved and advanced technology is used for the
productionof a commodity will reduce its cost of production and increases the
supply. On the contrary, outdated and old technology will increase the cost of
production and reduced supply.

(vi) Government policies (G):Policies of Government such as fiscal policy which

leads to imposition of taxes,excise duty, sales tax etcwill affect the production
of commodities and supply adversely. Any reduction in the taxes will increase
the supply. Subsidy policy also influences the supply of a commodity. When
government increase the subsidy the profit margin will increase and supply will
increase.

(vii) Prices of the related goods (Pr):An increase in the prices of related goods
othercommodities makes the production of that commodity whose price has
not risenrelatively less attractive we thus, expect that other things remaining
the same, thesupply of one good falls as the price of other goods rises. For
instance a farmer produces bananas as well as potatoes his farm. If the price of
potatoes increases hewill grow more of potatoes and less of bananas. Hence
the supply of bananas will reduce.

(viii) Number of Sellers in the market (F):Market supply is the sum total of the
supply by number of individual suppliers. Larger the number of the firmsin the
market the greater will be the supply. Adecrease in the number of firms reduces
the supply and vice versa.

(ix) Natural factor (N):Natural factors too affect the supply. In case of natural
calamities like flood, drought, earthquake etc. the supply of acommodity
especiallyof agricultural products is adversely affected.

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 Exceptions to the Law of Supply
(i) Agricultural Goods: For agricultural goods it is not possible for the supply to be
adjusted to marketconditions. As the production and supply of agricultural goods
is largely dependent on naturalfactors like rainfall, temperature etc. and it is
mostly seasonal in nature it cannotbe increased with a rise in price.

(ii) Rare Objects:The supply of certain commodities like rare coins, classical paintings
oldmanuscripts, etc. cannot be increased or decreased with the changein price.
Therefore, such goods have inelastic supply.

(iii) Labour Market:with a rise in wages workers will work for less number of hours,and
will prefer leisure over work. Thus the labour market, the behavior of the supply of
labour goesagainst the law of supply.

Change in Quantity Supplied and Change in Supply

A change in quantity supplied refers to change in quantity purchased of a commodity
in response to change in price, other things remain constant. It is expressed through
movement along the Supply curve. On the other hand a change in Supply refers to
change in quantity Supplied of a commodity in response to change in factors other than
price of the commodity. It is expressed through shift in Supply curve-forward shift or
backward shift.

(a) Movement of Supply curve or Extension and Contraction of Supply or change in

quantity Supplied.
With the change in the price of a commodity the quantity Supplied will increases or
decreases depending upon the rise or fall in the price ofa commodity alone, ceteris
paribus.This is called movement along the Supply curve or extension or contraction of
Supply. As shown in figure 3.4, when the price increases, other factors affecting Supply
remain constant, the quantity Supply will decreases and vice versa.

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 The figure 3.8 show that when price increases from OP to OP 1 the Supply increases
from OQ to OQ1. Thus with the rise in price there is a movement on the Supply curve
from point A to point B. Similarly with the fall in price from OP to OP 2 the quantity
Supplied decreases from OQ to OQ2 causing a shift from point A to point C on the
Supply curve. The increase in Supply due to rise in price is also called extension of
Supply. The reduction in quantity supplied due to fall in price is known as contraction.

Change in Supply or shift of Supply or Increase and Decrease in Supply:

When the quantity supplied of a commodity increases or decreases due to change in
factors other than price of the product like price ofrelated goods, prices of inputs etc. it
is known as change in supply or shift insupply.

In Figure 3.9 SS is the original Supply curve and the consumer in buying OQ units of the
commodity at price OP. If the input cost reduces, price of the product remains
constant, the supply will increase,and the new supply curve is S 1S1. This new curve is an
outward shift in the supply and it shows an increase in the supply for the product from
OQ to OQ1. Similarly due to the rise in input cost, price of the product remaining same,
the supply curve will shift inward from SS to S 2S2. Quantity of good purchased will
reduce from OQ to OQ2. This is called decrease in Supply.

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 Thus in the above figure quantity supplied has increased from OQ to OQ 1, the price of
commodityremaining constant at price OP. This is shown by a right ward shift of the
original supply curve toform new supply curve S1S1. This is called increase in supply.
The left ward shift from the original supply curve SS to S 2S2 is known as decrease in
Supply, price of the product remains same at OP.

3.4 EQUILIBRIUM OF DEMAND SUPPLY AND PRICE DERTEMINTION

Equilibrium means a state of balance. The term equilibrium in Economics means the
state in which there is no tendency on the part of consumers and producers to change.
Market equilibrium is a situation of the market in which demand for a commodity is
equal to supply of the commodity at a particular price. Hence when there is equilibrium
between demand and supply of a commodity at a particular price, there is neither
excess demand nor excess supply. At this position the prevailing price is called the
equilibrium price and the corresponding quantity supplied/demand is called
equilibrium quantity

Determination of equilibrium price:

According to Alfred Marshall demand and supply are the two blades of pair of scissors.
Through intersection of demand and supply the equilibrium price and equilibrium
quantity of a commodity is determined.

The force of demand and supply determinethe price of a commodity. There is a conflict
in the aim of producers and consumers. Consumers are interested in buying the goods
at the lowest price to maximize satisfaction and producer aim at selling the goods at
the highest price to maximize profit.Equilibrium price will be determined where
quantity demanded is equal to the quantity supplied. This called market price. The
determination of equilibrium price is explained with the help of a schedule given in
table 3.5 and figure 3.10.

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 Table 3.5 – Equilibrium Price
Price of Quantity Quantity
Apples
(Rs.) demanded supplied
(Kilogram) (Kilogram)
10 4 0
20 3 1
30 2 2
40 1 3

Table 3.5 gives a hypothetical schedule which depicts different price and the respective
quantity demanded and supplied. When the prices increases from Rs 10 to Rs 40, the
quantity demanded decreases from 4 Kg to 1 Kg and the quantity supplied increases
from nothing to 4 Kg respectively. At price Rs 10 the quantity demanded is 4 Kg and
suppliers are not interested in supplying at all. Thus at lower price consumers will
demand more and suppliers will supply less. At price Rs 40 per Kg demand is 1 Kg and
supply is 4 Kg. With an increase in price the demand decrease and supply increases. We
can observe in table 3.5 at price at price Rs 30 the quantity demanded is equal to
quantity supplied, and that is the equilibrium price and equilibrium quantity is 2 Kg. At
prices less than Rs 30 there is an excess of demand over supply and at price higher than
Rs 30 per Kg the supply is more than demand.

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 In figure 3.10 price is measured on Y axis and quantity demanded and supplied taken
on X-axisprice per unit. DD is the demand curve and SS is the supply curve. The demand
curve and supply curve intersect each other at point E. At the equilibrium point E the
quantity demanded is equal to the quantity supplied i.e. PE and therefore the
equilibrium price is OP the equilibrium quantity is OQ.
Above this equilibrium price OP, at OP 1 the quantity demanded decrease to P 1Gand
quantity supplied increase to P1H. At price higher than equilibrium price there is an
excess of supply over demand GH. At price OP 2, which is lower than the equilibrium
price quantity supplied decreases to P2I and quantity demanded increases to P2K. Hence
at price lower than the equilibrium price there is an excess of demand over supply.

Effect of change in supply and demand:

The equilibrium price and quantity changes with the shift in supply curve demand
remaining same or shift in demand curve supply remaining same or shift in both. The
change in equilibrium due to change in demand with no change in supply can be seen
in figure 3.11, which shows price on Y axis and quantity demanded and supplied on x
axis.

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 Demand curve DD intersects supply curve SS at point E, which determines the
equilibrium price OP and equilibrium quantity OQ. With an increase in demand the
demand curve shifts from DD to D1D1. And the new equilibrium is at E1. Thus with the
increase in demand supply remaining same there is an increase in the price to OP 1.
When the demand decreases from DD to D 2D2 an inward shift in the demand curve the
equilibrium shifts to E2 leading to a reduction in the equilibrium price. With the increase
in demand the equilibrium price increase and vice versa.
The effect of change in the supply is shown in figure 3.12, where price on Y axis and
quantity demanded and supplied on x axis.

Demand curve DD intersectssupply curve SS at point E, which determines the

equilibrium price OP and equilibrium quantity OQ. With an increase in supply the
supply curve shifts from SS to S1S1. And the new equilibrium is at E1. Thus with the
increase in supply demand remaining same there is a reduction in the price to OP 1.
When the supply decreases from SS to S2S2 an inward shift in the supply curve the
equilibrium shifts to E2 leading to an increase in the equilibrium price to OP 2.Thus with
the increase in supply the equilibrium price decrease and vice versa.
Thus we learnt that
i) When the demand increases equilibrium price will increase,
ii) When the demand decreases equilibrium price will decrease,
iii) When the supply increase equilibrium price will decrease, and
iv) When the supply decreases equilibrium price will increase.

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 3.5 Importance of Time Element

Marshall, who propounded the theory that price is determined by both demand and
supply, also gave a great importance to the time element in the determination of price.
Time elements is of great relevance in the theory of value, since one of the two
determinants of price, namely supply, and depends on the time allowed to it for
adjustment. It is worth mentioning that Marshall divided time into different periods
from the viewpoint of supply and not from the viewpoint of demand.

Time is short or long according to the extent to which supply can adjust itself. Marshall
felt it necessary to divide time into different periods on the basis of response of supply
because it always takes time for the supply to adjust fully to the changed conditions of
demand.

The reason why supply takes time to adjust itself to a change in the demand conditions
is that nature of technical conditions of production is such as to prohibit instantaneous
adjustment of supply to changed demand conditions. A period of time is required for
changes to be made in the size, scale and organisation of firms as well as of the
industry.

Another point is worth noting. When Marshall distinguished short and long periods he
was not using clock or calendar time as his criterion, but ‘operational’ time in terms of
economic forces at work. In this regard, as said above, supply forces were given the
major attention and a time was short or long according to the extent of adjustment in
the forces of supply. The greater the adjustability of the supply forces, the greater the
length of the time irrespective of the length in clock-time.

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 Time can be divided into following three periods on the basis of response of
supply to a given and permanent change in demand:

1. Market Period:
The market period is a very short period in which the supply is fixed, that is, no
adjustment can take place in supply conditions. In other words, supply in the
market period is limited by the existing stock of the good. The maximum that can
be supplied in the market period is the stock of the good which has already been
produced.

In this period more good cannot be produced in response to an increase in demand.

This market period may be a day or a few days or even a few weeks depending
upon the nature of the good. For instance, in case of perishable goods, like fish, the
market period may be a day and for a cotton cloth, it may be a few weeks.

2. Short Run:

Short run is a period in which supply can be adjusted to a limited extent. During the
short period the firms can expand output with given equipment by changing the
amounts of variable factors employed. Short periods is not long enough to allow
the firm to change the plant or given capital equipment. The plant or capital
equipment remains fixed or unaltered in the short run. Output can be expanded by
making intensive use of the given plant or capital equipment by varying the
amounts of variable factors.

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 3. Long Run:

The long run is a period long enough to permit the firms to build new plants or
abandon old ones. Further, in the long run, new firms can enter the industry and
old ones can leave it. Since in the long run all factors are subject to variation, none
is a fixed factor. During the long period forces of supply fully adjust them to a given
change in demand; the size of individual firms as well as the size of the whole
industry expands or contracts according to the requirements of demand.

From above, it is clear that because of the varying response of supply over a
period of time to a sudden and once-for-all increase in demand Marshall found, it
necessary and useful to study the pricing process in:
a. The market period,

b. The short-run and

c. The long-run depending respectively upon whether the supply conditions have
time to make (i) no adjustment, (ii) some adjustment of labour and other
variable factors, and (iii) full adjustment of all factors and all costs. Therefore,
Marshall explained how the equilibrium between demand and supply was
established in three time periods and determined market price, short-run price
and long-run price.

We thus see that the price that will prevail depends upon the period under
consideration. If a sudden and a once-and-for all increase in demand take place, the
market price will register a sharp increase, since supply cannot increase in the market
period. In this market period, firms can sell only the output that has already been
produced. However, in the short run some limited adjustment in supply will take place
as a result of the firms moving along their short run marginal cost curves by expanding
output with the increase in the amount of variable factors. Consequently, the short run
price will come down from the new high level of the market price.

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 But this short-run price will stand above the level of original market price which
prevailed before the increase in demand occurred. In the long run the firms would
expand by building new plants, that is, by increasing the size of their capital equipment.

In other words, firms would expand along the long-run marginal cost curves. Besides,
the new firms will enter the industry in the long run and will add to the supply of
output. As a result of these long-run adjustments in supply, the price will decline.

Thus the long run price will be lower than the short-run price. But this long-run price
will be higher than the original price which ruled before the increase in demand took
place, if the industry happens to be increasing-cost industry.

The adjustment of supply over a period of time and consequent changes in price is
illustrated in figure above where long-run supply curve LRS of an increasing-cost indus-
try along with the market-period supply curve MPS and the short-run supply curve SRS
have been drawn. Originally, demand curve DD and market-period supply curve MPS
intersect at point E and price OP is determined. Suppose that there is a once- for-all
increase in demand from DD to D’D’.

Supply cannot increase in the market period and remains the same at OM. Market-
period supply curve MPS intersects the new demand curve D’D’ at point Q. Thus, the
market price sharply rises to OP”. Short-run supply curve SRS intersects the new
demand curve D’D’ at point R.

The short-run price will therefore be OP” which is lower than the new market price OP’.
As a result of the long-run adjustment the price will fall to OP’” at which the long-run
supply curve LRS intersects the demand curve D’D’.

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 The new long-run price OP'” is lower than the new market price OP’ and the short-run
price OP”, but will be higher than the original price OP which prevailed before the
increase in demand took place. This is so because we are assuming an increasing-cost
industry. If the industry is subject to constant costs, the long-ran price will be equal to
the original price. Further, if the industry is subject to decreasing costs, the long-run
price will be lower than the original price.

It follows from above that the price which prevails in the market depends upon the
period under consideration. It is thus clear that the time plays an important role in the
determination of price. Another significance of the time-period analysis of pricing is
that it enabled Marshall to resolve the controversy current among economists whether
it is demand or supply which determines price.

Marshall propounded the view that both demand and supply took part in the
determination of price. But, “as a general rate”, said Marshall, “the shorter the period
which one considers the greater must be the share of our attention which is given to
the influence of demand on value, and the longer the period more important will be
the influence of cost of production on value.

Actual value at any time—the market value as it is often called—is often influenced by
passing events and causes whose action is fitful and short-lived than by those which
work persistently. But in the long run these fitful and irregular causes in a larger
measure efface one another’s influence so that in the long run persistent causes
dominate value completely”.

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 From the above quotation from Marshall it follows that in the market period, demand
exercises a predominant influence over price but in the long run it is the supply which is
of overwhelming importance as a determinant of price. Roughly speaking, we can say
that in the market period it is the force of demand which determines price and in the
long period it is the force of supply which governs price.

Thus those economists who held that value was governed by demand were in a way
right and so were those who contended that cost of production (i.e., force working on
the supply side) determines price. The difference in the two views was due to the fact
that one group of economists was emphasising the determination of the market price
over which demand has determining influence and over which cost of production does
not exercise much influence, while the other group was stressing on the determination
of long-run price over which cost of production has got paramount influence. It is thus
clear that Marshall by putting forth the view that both demand and supply determine
price by their interaction brought about synthesis between the views of earlier econo-
mists.

Both the two opposite views of earlier economists were in a way right but each was
one-sided. Each view provided us with a force which governed price. The two forces of
supply and demand furnished by the two opposing views were sufficient determining
factors.

Therefore, Marshall gave equal importance to both demand and supply as

determinants of price, though the influence of the two varied in different time periods.
Marshall introduced time period analysis into pricing process to bring out the varying
influence of each of two forces over price of the product in different time periods.

It follows from what has been said above that Marshall and modern economists
following him study the effect of the varying response in supply in different time
periods on price to a sudden and permanent change in demand conditions.

On the contrary, economists do not study the effect on price of the adjustment in
demand over time in response to a change in supply conditions. The reason why we do
not study adjustment in demand to a change in supply and consequent effect on price
is better brought out in the worlds of Professors Stonier and Hague. “There is no reason
why, if supply conditions change, demand conditions should change as well, or if they
do, why they should change differently in the short run and the long run.

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 Changes in consumer’s tastes are not dependent on technology in the way that supply
conditions are. Admittedly, consumers’ tastes may and probably will change as time
goes on. But this will be a change of data and not a change induced by changed supply
conditions.

There is no necessary reason why the long-run demand curve should differ from the
short-run demand curve, however odd the behaviour of supply has been-we must
expect that the longer is the period during which demand and supply are coming into
equilibrium, the more changes will have time to take place. If we were to study the
changes in demand and supply which would take place in respect to any change of data
during many successive very short periods of time, we should find that we had
introduced unnecessary and intolerable detail into the analysis.”

We shall explain below in detail the market-period equilibrium, short-run equilibrium,

long-run equilibrium between demand and supply and thus the determination of
market price, short-run price and long-run price under conditions of perfect
competition.

3.16 Elasticity of Demand

The law of demand fails to tell us as to what extent demand for a commodity vary
when there is a change in price. In other words, the law of demand merely indicates
the direction to which demand moves when there is a change in price. But concept of
elasticity explains the exact change in demand when there is a change in price. The
price elasticity of demand is defined as “The degree of responsiveness or sensitiveness
of demand to a change in price of a commodity or service.”

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 Algebraically, it is stated as
e(p) =
ΔQ÷ΔP
Q P

Where Δ = means a change

Q = Quantity
P = Price
e(p) = Price elasticity of
demand

There are five cases of price elasticity of demand.

1. Unitary elastic demand (e = 1)

Demand is said to be unitary elastic when proportionate change in price is equal to
proportionate change in quantity demanded of any commodity. The value of the
elasticity is equal to one (e=1) in such cases demand curve is convex to the origin
as shown in the diagram.

e(p) = NP ML OP
ΔQ÷ΔP = ML = 

= 1
Q P OL OP OL NP

2. Relatively elastic demand (e > 1)

Demand for a commodity is said to be elastic when proportionate change in
quantity demanded is greater than proportionate change in price. In such cases
value of the elasticity is greater than one and shape of the demand curve is flatter
as shown in the following diagram.

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 e(p) =
ΔQ÷ Δ P >1
= Q P
P
LM ÷
OM P
'

= LM × O P >1
OM P P'

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 3. Relatively inelastic demand (e<1)
Demand for a commodity is said to be relatively inelastic when proportionate
change in demand is smaller than proportionate change in price of the commodity.
In such cases, value of the elasticity is less than one (e<1) and the demand curve is
steeper. The following diagram exhibits the said demand curve.

e(p) =
ΔQ÷ Δ P <1
Q P
LM P P'
= ÷ OP
OM
O P <1
= LM × P P'
OM

4. Perfectly elastic demand (e= ∞ )

Demand for a commodity is said to be perfectly elastic when a small change (rise
or fall) in price brings about either complete contraction or infinite expansion in
demand. In such cases value of the elasticity is infinity (e= ∞ ) and demand curve is
horizontal to ‘x’ axis. The following figure depicts the same.

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 5. Perfectly inelastic demand (e=0)
Demand for any commodity is said to be perfectly inelastic when there is no
change in demand at a high or low price. The value of the elasticity is zero in such
cases and demand curve is vertical to ‘x’ axis. The following figure depicts the
perfectly inelastic demand.

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 3.17 Determinants of Elasticity
1. Nature of commodity
In case of necessaries of life demand is inelastic while luxuries relatively elastic.

2. Number of uses
In case of large number of uses, demand is relatively elastic and in case a few
uses, it is relatively inelastic.

3. Number of substitutes
If the substitutes are more demand is relatively elastic while less number of substitutes,
demand is relatively inelastic.

4. Durability of goods
Durable goods have relatively elastic demand while perishable goods have
relatively inelastic demand.

5. Low priced commodities

Low priced commodities like salt, newspapers, matchboxes etc. have relatively
inelastic demand.

6. Proportion of income spent

Commodities needing less expenditure generally have relatively inelastic
demand.

3.18 Importance of Elasticity

The concept of elasticity is very much useful in day-to-day life. Firstly, it deeply analyses
price-demand relationship. Secondly, it helps producers in fixing prices of their product.
Thirdly it is helpful to government to declare certain industries as public utility services.
Fourthly it also helps the government to frame economic policies. Fifthly it helps
finance minister in matter of taxation. The concept elasticity explains why there exists
poverty in the midst of plenty. It is also helpful in international trade to determine
terms of trade between the two countries.

3.19 Income Elasticity of Demand

Pr oportionatechange in quantity demanded
e(i) =
Pr oportionatechange in income

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 It is defined as “the degree of responsiveness or sensitiveness of demand to a change in
income.” In other words, it shows a degree of responsiveness of demand to a change in
income.

e(i) =
ΔQ÷ΔI
Q I

3.20 Cross Elasticity

It measures elasticity of demand of related goods. It means that when price of say ‘x’
good changes, the demand for related good say ‘y’ changes. Thus, the cross elasticity of
demand measures the response of the quantity demanded of a particular commodity
to the change in price of some other related commodity. Generally it takes place in
complementary goods and substitutes

Cross Elasticity
= Pr oportionatechange in quantity demanded
of say ' x' good
Pr oportionatechange in price or related
good say ' y' good
The cross elasticity in case of substitutes is always positive but it is negative in case of
complementary goods.

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 3.21 Exercise :
1. What is Law of demand? Explain with the help of schedule and diagram.(10
Marks)
2. What is a demand schedule? (5 Marks)

3. Write a note on demand curve.(5 Marks)

4. What are the exceptions of Law of demand? (5 Marks)
5. Explain the derivation of demand curve with the help of diagram.(5 Marks)
6. Discuss demand function.(10 Marks)
7. State law of supply and explain it with the help of a suitable diagram and
schedule.(10 Marks)
8. Examine the factors affecting supply.(10 Marks)

9. What do you understand by equilibrium price?(10 Marks)

10. Discuss the effect of change in supply and demand on the equilibrium price. (10
Marks)
11. What is elasticity of demand? When does it become perfectly elastic, unitary
elastic and inelastic?

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 UNIT – IV
PRODUCTION

4.1 Introduction

Production virtually means value-addition to natural resources. Men and nature are the
basic elements in the production process. The valuers have to understand that
commodities become saleable in the market after they are produced and every product
acquires new value in this process. The output of production takes the form of goods as
well as services.

In the next unit we shall see how to capture the value added through production. The
product is meant primarily for exchange in return for money. The process of exchange
is called transaction and return in terms of money is called price. The valuer has to
make an estimate of price as it ought to be. In this way price is differentiated from
value. However, value-addition is the goal of production and price is the stage in the
process.

Now, in economics the following agents are usually considered as the factors for
production:-
- Land
- Labour
- Capital
- Organization

We have already stated that men and nature are the primary agents. But in course of
time the production process become more complex. Modern production said to be
capitalistic in the sense that capital plays a predominant role. This takes us to consider
what capital is.

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 3.1.1 Capital :

Capital is produced means of production. In the olden days, at the dawn of human
civilization, man used to produce by working upon natural resources with simple tools
and implements. The farmer used to produce harvest of crops with plough, cobbler
used to produce shoes and other lather products with aid of simple tools, the potter
used turn-out utensils with the help of earth wheels, the weaver used to weave cloths
with the help of an unsophisticated spinning wheel and loom.

But, with the advancement of civilization, growth of population and multiplication of

demand, production has to be augmented many-folds by division of labour and
intervening capital as the dominant media of production. The process of production
also became round-about. Thus, irrigation became a prior need for investment, so that
ultimate scale of production may be augmented, the spindles and looms are come to
be replaced by power looms, weaving machines, etc. The cobbler simple tools became
replaced by machine for mass production. The potter’s simple earthen wheel paved the
way for appropriate machineries. These intermediate machineries and means of
production are again the resultant of initial production, the purpose of which is not
directly to yield consumable items but to fill-in needs for produced means called
capital, which can propel the quantum of ultimate production of consumable items in a
big way. In course of time, this intermediate product called capital has gradually
assumed the centre stage of production, so as to be recognized as a distinctly separate
factor.

3.1.2 Organization :

An organization is the typical task of coordinating and harnessing the functions of other
factors of production. The person or a group of persons who take the leading role of
such organization constitute a distinct class called entrepreneur. They are not simple
labour as to be merged in he concept of men interacting with natural resources to
make production at the primary stage. Just as capital is an offshoot of natural resources
as a distinct agent of production so is an enterprise or an organization, an offshoot of
man or labour.

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 3.1.3 The Future Scenario :

In course of time, the four factor of production, i.e., Land, Labour, Capital and
Organization, are yielding place to more items through split. The factor of capital is
going to be split into tangible capital and intangible capital. The latter consists of
intellectual properties, developed through research and development, which again
relegates the process of production to a more remote region away from directly
turning-out consumable commodities. These intellectual properties are distinctly given
shape as intangible rights in the form of patterns, copyrights, design, trademark, know-
how, trade secret, etc.

Entrepreneurship is gradually being divided into proprietorship and management, the

latter being developed as distinct cadre aiding the process of production and gradually
emerging as an indispensable agent of production.

Labour has to be split-up as skilled and unskilled, as because the role of one is distinctly
different from the other.

Finally, we may for the future generation of valuers, classify the factors of production in
the following manner:-

Land - all natural resources

Labour - skilled and unskilled
Capital - tangible as well as
intangible Entrepreneurship - including management

4.2 ECONOMIC ANALYSIS OF COSTS

4.2.1 Total Cost : Fixed and Variable

Consider a firm that produces a quantity of output (denoted by q) using inputs of
capital, labour, and materials. The firm buys these inputs in the factor markets. A
profit-minded firm will keep an eagle eye on its cost to maintain profitability. The firm’s
accountants have the task of calculating the total dollar costs incurred at each level of
q.

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 Table 1 shows the total cost (TC) for each different level of output q. Looking at
columns (1) and (4), we see that TC goes up as q goes up. This makes sense because it
takes more labour and other inputs to produce more labour and other inputs to
produce more of a good; extra factors involve an extra money cost. It costs $110 in all
to produce 2 units, $130 to produce 3 units, and so forth. In our discussion, we assume
that the firm always produces output at the lowest possible cost.

(1) (2) (3) (4)

Quanti Fixed Variable Total
ty q cost FC cost VC ($) cost TC
($) ($)
0 55 0 55
1 55 30 85
2 55 55 110
3 55 75 130
4 55 195 160
5 55 155 210
6 55 225 280

Table 1 : Fixed, Variable, and Total Costs

The major elements of a firm’s costs are its fixed costs (which do not vary at all when
output changes) and variable costs (which increase as output increase). Total costs are
equal to fixed plus variable costs: TC = FC + VC.
Fixed Cost

Columns (2) and (3) of Table 1 break total cost into two components: total fixed cost
(FC) and total variable cost (VC).

What are a firm’s fixed costs? Sometimes called “overhead” or “sunk costs”, they
consist of items such as rent for factory or office space, contractual payments for
equipment, interest payments on debts, salaries of tenured faculty, and so forth. These
must be paid even if the firm produces no output, and they will not change if output
changes. For example, a law firm might have an office lease which runs 10 years and
remains an obligation even if the firm shrinks to half its previous size. Because FC is the
amount that must be paid regardless of the level of output, is remains constant at $55
in column (2).

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 Variable Cost

Column (3) of Table 1 shows variable cost (VC). Variable costs are those which vary as
output changes. Examples include materials required to produce output (such as steel
to produce automobiles), production workers to staff the assembly lines, power to
operate factories, and so on. In a supermarket, checkout clerks are a variable cost,
since managers can easily adjust the clerks’ hours worked to match the number of
shoppers coming through the store.

By definition, VC begins at zero when q is zero. It is part of TC that grows with output;
indeed, the jump in TC between any two outputs is the same as the jump in VC. Why?
Because FC stays constant at $55 throughout and cancels out in the comparison of
costs between different output levels.
Let us summarize these cost concepts:

Total cost represents the lowest total dollar expense needed to produce each level of
output q-TC rises as q rises.

Fixed cost represents the total dollar expense that is paid out even when no output is
produced: fixed cost is unaffected by any variation in the quantity of output.

Variable cost represents expenses that vary with the level of output – such as raw
materials, wages, and fuel – and includes all costs that are not fixed.
Always, by definition
TC = FC + VC

4.2.2 Definition of Marginal Cost

Marginal cost is one of the key concepts of economics. Marginal cost (MC) denotes the
extra or additional cost of producing one extra unit of outputs. Say a firm is producing
1000 compact discs for a total cost of $10,000. If the total cost of producing 1001 discs
is $10,006, the marginal cost of production is $6 for the 1001 st disc.

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 Sometimes, the marginal cost of producing an extra unit of output czn be quite low. For
an airline flying planes with empty seats, the added cost of another passenger is imply
the cost of the peanuts and snack; no additional capital (planes) or labour (pilots and
flight attendants) is necessary. In other cases, the marginal cost of another unit of
output can be quite high. Consider an electric utility. Under normal circumstances, it
can generate enough power using only its lowest-cost, most efficient plants. But on a
hot summer day, when everyone’s air conditioners are running and electric demand is
high, the utility may be forced to turn on its old, high-cost, inefficient generators. This
added electric power comes at a high marginal cost to the utility.

(1) (2) (3)

Output Total cost Marginal cost
q TC MC
($) ($)
0 55
30
1 85
25
2 110
20
3 130
-
4 160
-
5 210
-

Table 2 : Calculation of Marginal Cost

Once we know total cost, it is easy to calculate marginal cost. To calculate the MC of
the fifth unit, we subtract the total cost of the four units from the total cost of the five
units, i.e., MC = $210 - $160 = $50. Fill in the blank for the marginal cost of the fourth

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 unit

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 Table 2 uses the data from Table 1 to illustrate how we calculate marginal costs. The
rust-colored MC numbers in column (3) of Table 2 come from subtracting the TC in
column (2) from the TC of the subsequent quantity. Thus, the MC of the first unit is $30
( = $85 - $55). The marginal cost of the second unit is $25 (= $110 - $85). And so on.

Figure 1 : The Relationship between Total Cost and Marginal Cost

This figure graphs the data from Table 2. Marginal cost in (b) is found by calculating

the extra cost added in (a) for each unit increase in output. Thus to find the Mcof
producing the fifth unit, we subtract $160 from $210 to get MC of $50. A smooth black
curve has been drawn through the points of TC in (a), and the smooth black MC curve
in (b) links the discrete steps of MC

Instead of getting MC from the TC column, we could get the MC figures by subtracting
each VC number of column (3) of Table 1 from the VC in the row below it. Why?
Because variable cost always grows exactly like total cost, the only different being that
VC must – by definition – start out from 0 rather than from the constant FC level. (Check
that 30 – 0 = 85 – 55, and 55 – 30 = 110 – 85, and so on.)
The marginal cost of production is the additional cost incurred in production one extra
unit of output.

Marginal Cost in Diagrams

Figure 1 illustrates total cost and marginal cost. It shows that TC is related to MC in the
same way that total product is related to marginal product or that total utility is related
to marginal utility.

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 What kind of shape would we expect actual. MC curves to have? Empirical studies have
found that for most production activities in the short run (i.e., when the capital stock is
fixed), marginal cost curves are U-shaped like the one shown in Figure 1 (b). This U-
shaped curve falls in the initial phase, reaches a minimum point, and finally begins to
rise.

4.2.3 Average Cost

We complete out catalogue of the cost concepts important in economics and business
with a discussion of different kinds of average or unit cost. Table 3 expands the data of
Table 1 and 2 to include three new measures average cost, average fixed cost, and
average variable cost.

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 (1) (2) (3) (4) (5) (6) (7) (8)
Average
Marginal Average Average variable
Fixed Variable Total cost cost fixed cost cost
cost cost cost per unit per unit per unit per unit

Quantity FC VC TC FC
TC=FC+VC MC AC = AFC =

VC q q
AVC =

q
q ($) ($) ($) ($) ($) ($) ($)

0 55 0 55 33 Infinity Infinity
Undefined
30
1 55 30 85 27 85 55 30
25
2 55 55 110 22 55 27½ 27½
20
3 55 75 130 21 43⅓ 18⅓ 25
30
4* 55 105 160 40* 40* 13¾ 26¼
50
5 55 155 210 60 42 11 ---

6 55 225 280 80 46⅔ 91/6 37½

90
7 55 ----- 370 100 526/7 76/7 45
110
8 55 ----- 480 120 60 6⅞ 53⅛

Table 3 : All Cost Concepts Derive from Total Cost Schedule

Figure 2 : Firm’s Supply Curve is Its Rising Marginal Cost Curve

For a profit-maximizing competitive firm, the upward-sloping marginal cost (MC)curve
is the firm’s supply curve. For market price at d’d’ , the firm will supply output at
intersection point at A. Explain why intersection points at B and C represent equilibria
for prices at d and d” respectively

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 Rule for a firm’s supply under perfect competition

A firm will maximize profits when it produces at that level where marginal cost equals
price:
Marginal cost = price or MC = P

Figure 2 illustrates a firm’s supply decision diagrammatically. When the market price of
output is $40, the firm consults its cost data and finds that the production level
corresponding to a marginal cost of $40 is 4000 units. Hence, at a market price of $40,
the firm will wish to produce and sell 4000 units. We can find that profit-maximizing
amount in Figure 2 at the intersection of the price line at $40 and the MC curve at point
B.

In general, then, the firm’s marginal cost curve can be used to find its optimal
production schedule the profit-maximizing output will come where the price intersects
the marginal cost curve.

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 We choose the example so that at the profit-maximizing output the firm has zero
profits, with total revenues equal to total costs. (Recall that these are economic profits
and include all opportunity costs, including the owner’s labour and capital). Point B is
the zero-profit point, the production level at which the firm makes zero profits; at the
zero-profit point-price equals average cost, so revenues just cover costs.

What if the firm chooses the wrong output? If the market price were $50, the firm
should choose output at intersection point A in Figure 2. We can calculate the loss of
profit if the firm mistakenly produces at B when price is at $50 by the shaded gray
triangle in Figure 2. This depicts the surplus of price over MC for production between B
and A. Draw in a similar shaded triangle above A to show the loss from producing too
much.

The general rule then is:

A profit-maximizing firm will set its output at that level where marginal cost equals
price. Diagrammatically, this means that a firm’s marginal cost curve is also its supply
curve.

4.5 Exercise

1. What are the different factors of production and how are they
remunerated?
2. Distinguish between fixed cost and variable cost. How marginal cost is
determined?
3. Explain the relationship between marginal product and average product
by referring to a diagram.

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 UNIT – V
PRICING OF PRODUCT

5.1 What is a Market?

5.1.1 Not Chaos, but Economic Order

We usually take for granted the smooth running of the economy. When you go to the
supermarket, the items you want – bread, cereal, and bananas – are usually on the
shelf. You pay your bill, pop the food in you mouth, and have a juicy meal. What could
be simpler?

If you pause for a moment and look more closely, you may begin to appreciate the
complexity of the economic system that provides your daily bread. The food may have
passed through five or ten links before getting to you, traveling for days or months
from every state and every corner of the globe as it moved along the chain of farmers,
food processors, packagers, truckers, wholesalers, and retailers. It seems almost a
miracle that food is produced in suitable amounts, gets transported to the right place,
and arrives in a palatable form at the dinner table.

But the true miracle is that this entire system works without coercion or centralized
direction by anybody. Literally millions of businesses and consumers engage in
voluntary trade, and their actions and purposes are invisibly coordinated by a system of
prices and markets. Nobody decides how many chickens will be produced, where the
trucks will drive, and when the supermarkets will open. Still, in the end, the food is in
the store when you want it.

Markets perform similar miracles around us all the time, as can easily be seen if only
we observe our economy carefully. Thousands of commodities are produced by
millions of people, willingly, without central direction or master plan. Indeed, with a
few important exceptions (like the military, police, and schools) most of our economic
life proceeds without government intervention, and that’s the true wonder of the
social world.

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 5.2 The Market Mechanism
A market economy is an elaborate mechanism for co-ordinating people, activities, and
business through a system of prices and markets. It is a communication device for
pooling the knowledge and actions of billions of diverse individuals. Without central
intelligence or computation, it solves problems of production and distribution involving
billions of unknown variables and relations, problems that are far beyond the reach of
even today’s fastest supercomputer. Nobody designed the market, yet functions
remarkably well. Is a market economy no single individual or organization is responsible
for production, consumption, distribution, and pricing.

How do markets determine prices, wages, and outputs? Originally, a market was an
actual place where buyers and sellers could engage in face-to-face bargaining. The
marketplace – filled with slabs of butter pyramids of cheese, layers of wet fish, and
heaps of vegetables – used to be a familiar sight in many villages and towns, where
farmers brought their goods to sell. In the United States today there are still important
markets where many traders gather together to do business. For example, wheat and
corn are traded at the Chicago Board of Trade, oil and platinum are traded at the New
York Mercantile Exchange, and gems are traded at the Diamond District in New York
City.

More generally, a market should be thought of as a mechanism by which buyers and

sellers can determine prices and exchange goods and services. There are markets for
almost everything, from art to pollution. A market may be centralized, like the stock
market. It may be decentralized, as in the case of houses or labour. Or it may exist only
electronically, as in the case of many financial assets and services which are traded by
computer. The crucial characteristic of a market is that it brings buyers and sellers
together to set prices and quantities.
A market is a mechanism by which buyers and sellers interact to determine the price
and quantity of a good or service.

In a market system, everything has a price, which is the value of the good in terms of
money (the role of money will be discussed in Section B of this chapter), Prices
represent the terms on which people and firms voluntarily exchange different
commodities. When I agree to buy a used Ford from a dealer for $4040, this agreement
indicates that the Ford is worth more than $4050 to me and that the $4050 is worth
more than the Ford to the dealer. The used – car market has determined the price of a
used Ford and, through voluntary trading, has allocated this good to the person for
whom it has the highest value.

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 In addition, Prices serve as signals to producers and consumers. If consumers want
more of any good, the price will rise, sending a signal to producers that more supply is
needed. For example, every summer, as families set out on their vacations, the demand
for gasoline rises, and so does the price. The higher price encourages oil companies to
increase gasoline production and, at the same time, discourages travelers from
lengthening their trips.

On the other hand, if a commodity such as cars becomes overstocked, dealers and
automobile companies will lower their prices in order to reduce their inventory. At the
lower price, more consumers will want cars, and producers will want to make fewer
cars. As a result, a balance, or equilibrium, between buyers and sellers will be restored.

What is true of the markets for consumer goods is also true of markets for factors of
production, such as land or labour. If computer programmers rather than textile
workers are needed, job opportunities will be more favourable in the computing field.
The price of computer programmers (their hourly wage) will tend to rise, and that of
textile workers will tend to fall, as they did during the 1980s. The shift in relative wages
will attract workers into the growing occupation.

The nursing crisis of the 1980s shows the labour market at work. During that decade
the growth in the healthcare sector led to an enormous expansion of nursing jobs with
far too few trained nurses to fill them. Hospitals offered all sorts of fringe benefits to
attract nurses, including subsidized apartments, low-cost on-site child care, and signing
bounces as high as $10,000. One hospital even ran a lottery for nurses, with the prize
being a gift certificate at a nearby department store. But what really attracted people
into the nursing profession was raising wages. Between 1983 and 1992, the pay for
registered nurses rose almost 70 percent, so they were making about as much money
as the average accountant or architect. The rising pay drew so many people into
nursing that by 1992 the nursing shortage had disappeared in most parts of the
country.

Prices coordinate the decisions of producers and consumers in a market. Higher prices
tend to reduce consumer purchases and encourage production. Lower prices
encourage consumption and discourage production. Prices are the balance wheel of
the market mechanism.

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 5.3 Market Equilibrium

At every moment, some people are buying while others are selling; firms are inventing
new products while governments are passing laws to regulate old ones; foreign
companies are opening plants in America while American firms are selling their
products abroad. Yet in the midst of all this turmoil, markets are constantly solving the
what, how, and for whom. As they balance all the forces operating on the economy,
markets are finding market equilibrium of supply and demand.

A market equilibrium represents a balance among all the different buyers and sellers.
Depending upon the price, households and firms all want to buy or sell different
quantities. The market finds the equilibrium price that simultaneously meets the
desires of buyers and sellers. Too high a price would mean a glut of goods with too
much output; too low a price would produce long lines in stores and a deficiency of
goods. Those prices for which buyers desire to buy exactly the quantity that sellers
desire to sell yield equilibrium of supply and demand.

5.4 How Markets Solve the Three Economic Problems

We have just described how prices help balance consumption and production (or
demand and supply) in an individual market. What happens when we put all the
different markets together – gasoline, cars, land, labour, capital, and everything else?
These markets work simultaneously to determine a general equilibrium of prices and
production.

By matching sellers and buyers (supply and demand) in each market, a market
economy simultaneously solves the three problems of what, how, and for whom. Here
is an outline of market equilibrium:

1. What goods and services will be produced is determined by the dollar votes of
consumers – not every 2 or 4 years at the polls, but in their daily purchase
decisions. The money that they pay into businesses’ cash registers ultimately
provides the payrolls, rents, and dividends that consumers, as employees, receive
as income.

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 Firms, in turn, are motivated by the desire to maximize profits. Profits are net
revenues, or the difference between total sales and total costs. Firms abandon
areas where they are losing profits; by the same token, firms are lured by high
profits into production of goods in high demand. A familiar example is Hollywood.
If one film makes huge profits – say, a film about a cute dinosaur and an evil
scientist – other studios will rush to produce imitations.

2. How things are produced is determined by the competition among different

producers. The best way for producers to meet price competition and maximize
profits is to keep costs at a minimum by adopting the most efficient methods of
production. Sometimes change is incremental and consists of little more than
tinkering with the machinery or adjusting the input mix to gain accost advantage,
which can be very important in a competitive market. At other times there are
drastic shifts in technology, as with steam engines displacing horses because steam
was cheaper per unit of useful work, or airplanes replacing rail-roads as the most
efficient mode for long-distance travel. Right now we are in the midst of just such a
transition to a radically different technology, with computers replacing
typewriters, paper, and many white-collar workers.

3. For whom things are produced – who is consuming, and how much – depends, in
large part, on the supply and demand in the markets for factors of production.
Factor markets (i.e., markets for factors of production) determine wage rates, land
rents, interest rates, and profits. Such prices are called factor prices. The same
person may receive wages from a job, dividends from stocks, interest from a
certificate of deposit, and rent from a piece of property. By adding up all the
revenues from factors, we can calculate the person’s market income. The
distribution of income among the population is thus determined by the amounts of
factors (person-hours, acres, etc.) owned and the prices of the factors (wage rates,
land rents, etc.).

Be warned, however, that incomes reflect much more than the rewards for sweaty
labour or abstemious saving. High incomes come also from large inheritances,
good luck, favourable location, and skills highly priced in the marketplace. Those
with low incomes are often pictured as lazy, but the truth is that low incomes are
generally the result of poor education, discrimination, or living where jobs are few
and wages are low. When we see someone on the unemployment line, we might
say, “There, but for the grace of supply and demand, go.”

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 5.5 The demand and Supply Framework

The working of the market mechanism can be most simple illustrated by the apparatus
of demand-supply curves which is employed by economists for a variety of purposes. In
order to introduce the reader to this powerful tool we take a very simple example.

Suppose we want to understand how the price of milk is determined by the market
mechanism. On one side of the market are ‘consumers’ who in this case includes
households as well as makers of sweets and other milk products. On the other side are
producers who may be dairy farmers, and public and privet dairies. Consumers’
demand for milk is determined by, among other things, price of milk, consumers’
incomes, number of consumers, their tastes, prices of product like eggs and meat
which are alternative sources of proteins etc. Now, imagine a hypothetical experiment
in which we confront a group of consumers and enquire what quantity of milk they
would like to purchase per day at a price of, say, Rs. 5 per liter. We repeat the question
with varying prices of milk. All other determinants of demand for milk – consumer
income, price of substitute etc., - are assumed to remain fixed. We will obtain a
schedule of milk price and the quantities the consumers would like to purchase at each
price. This
relationship
between the price of milk and the quantity demanded other thing remaining fixed is
called the demand curve for milk. Note carefully that we are talking of quantity and not
quantity purchased. The former is an expression of consumers’ intentions or desires,
when faced with a set of hypothetical prices. The actual quantity purchased is the result
of the consumers translating their intentions into action when faced with an actual
price asked for milk by the suppliers. The demand curve is depicted in figure below.

Quantities demanded per day are plotted on the horizontal axis (measured in liter)
while prices in rupees per liter are plotted on the vertical axis.

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 As shown in the figure, the curve is downward sloping i.e. as price of milk declines,
other things remaining constant the quantity demanded increases and vice versa. Why
should this be so? While a rigorous argument is outside our scope, we can sketch a
plausible explanation.

First consider a consumer faced with alterative prices. If the price is very high - say
Rs.25 per liter - he might decide to go entirely without milk or decide to purchase the
minimum essential quantity (suppose there is a baby in the family). As the price is
reduced, the consumer would think of satisfying less urgent needs — milk for adding to
tea, coffee, making butter etc. As the price decreases, less and less urgent needs would
come into play. Each additional unit bought is satisfying a lesser (front the consumer’s
point of view) want; the price the consumer would be willing to pay for a unit of milk
would be governed by the consumer’s valuation of the satisfaction to be derived from
consuming that unit which in turn would be a function of the quantity already
consumed. Apart from this, but for similar reasons, more and more consumers would
demand milk as price decreases - a family which cannot afford to buy any milk when
the price is Rs.25 may want to buy some if the price goes down to say Rs.8.

A change in the price of a good has actually two effects. Consider at hypostatical
consumer who consumes only three goods — rice, milk and meat. His monthly budget
is Rs.500 and the prices are Rs.6 per kg of rice, Rs.5 per liter of milk and Rs.40 per kg of
meat. His current consumption pattern is 30 litre of milk, 24 kg of rice and 5 kg of meat
per month. Now suppose the price of milk decreases to Rs.4 per litre. The consumer
can now purchase the same basket of goods (though he may not wish to) and have Rs.
30 left over with which he can purchase additional quantities of some or all of the three
goods. The same effect could have been achieved by keeping the prices at the original
level but giving the consumer an additional income of Rs.30. Thus a price reduction has
an effect which is equivalent to an increase in income. Presumably, some of the extra
income will be spent on milk thus increasing the quantity demanded. There is an
additional effect.

Relative to mea, milk has become cheaper than before; this might include the
consumer to substitute some milk for meat since milk can, at least partly, satisfy similar
needs. Thus, there is a substitution effect- away from the relatively more expensive
goods towards the relatively cheaper good. On both counts the demand for milk
increases as its price decreases.

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 Now, consider the supply side of the market. Production of milk requires a number of
inputs. For some of these, their quantities cannot be varied in the short run e.g., stock
of milch cattle, grazing land, dairy machinery etc. For others, quantities can be varied
e.g., cattle feed, labour, etc.

Consider a typical milk producer. He has a set of fixed inputs which are combined with
varying quantities of variable inputs to produce milk. At a given price how much milk
would he like to supply? It depends upon the behavior of cost of production and the
objectives of the producer. If his goal is to maximise his profits - defined as sales
revenue minus cost of production he will push production upto the point where the
cost of production of the last unit just equals the price, and subsequent units will cost
more. Thus his quantity decision will depend upon the behaviour of incremental or
marginal cost. A well known law in economics, called the law of diminishing marginal
products says that when the increasing quantities of variable inputs are applied to
given quantities of fixed inputs, the incremental output from successive doses of
variable inputs eventually declines. This implies that the incremental cost of production
starts increasing beyond a point and hence the producer will be willing to supply larger
quantity only if the price is higher. Figure below shows the supply curve which is the
relation between the price and quantities which the producers would like to supply at
each price.

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 Now, combine the two sides of the market. In figure given below we have shown a
demand curve and a supply curve. The point at which they intersect, shown as (P E, QE)
is the price – quantity combination at which the producers’ and consumers’ intentions
are simultaneously realized. At any price above P E, the producers would like to supply
more than the consumers would like to purchase. The result would be unsold stocks
(which in the case of milk may have to be simply thrown away). Obviously, this
situation cannot last; the producers will reduce the price and bring a smaller quantity to
the market. At a price below PE there would be a shortage of milk with a number of
consumers unable to buy the quantities they would like to buy at such a price.
The result would be a clamour for larger quantity with willingness to pay a higher price.
The market would be in ‘equilibrium` at (PE, QE) in the sense that neither the
producers nor the consumers would have an incentive to depart from it unless other
factors governing demand and supply change.

There are number of questions regarding the notion of equilibrium. First, there is the
question of what is the actual process by means of which a market finds the
equilibrium. Since individual participants do not know the plans of others, what
mechanism brings about the equality of quantity demanded and quantity supplied?
Second, there is the problem of stability of equilibrium. Suppose the milk market is in
equilibrium at the price-quantity combination (PE QE). Now there is a temporary
disturbance e.g. power failure in a large cold storage facility used to preserve milk.
There is a temporary shortage, price shoots up and long queues are seen at milk
booths. After the disturbance is eliminated, will the market return to its original
equilibrium or move away from it? Related to this is the question of market dynamics.

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 Suppose as a result of increase in consumer income, more milk than before is
demanded at every price. In terms of our demand-supply framework, we show this as a
shift of the demand curve upward and to the right. The new equilibrium is the price-
quantity combination (PE, QE). What is the path of the market as it moves from the old
to the new equilibrium i.e. how do price and quantity adjust to the change in demand?
Can we say anything neither about markets which are nor in equilibrium?

These are some of the questions which have been and are being investigated by
economists. There are no fully satisfactory answers.

The demand supply framework is a convenient representation of the working of the

market mechanism. The notion of equilibrium forms a point of reference. In real life
markets may not be permitted to function in the manner described above because of
price controls, rationing and lack of information about prices and insufficient mobility
of goods and factors of production. Nevertheless, the demand-supply framework has
been found to be a useful analytical device.

Effect of changes in other factors can be depicted in the demand-supply diagram.

Suppose consumers’ incomes increase. At every price, consumers will now demand a
larger quantity than before in figure this is shown as a rightward-upward shift of the
entire demand curve. The result is a higher price and larger quantity in the new
equilibrium. On the other hand suppose a drought causes shortage of fodder with a
resultant increase in its price; the result would be an increase in the cost of production
of milk.

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 At every price producers would be willing to supply a smaller quantity than before. In
figure this is shown as a leftward-upward shift of the entire supply curve resulting in a
higher price and a smaller quantity in the new equilibrium. You must be always careful
to distinguish between movement along a demand or a supply curve, and shifts of
curves.

5.6 Pure Competition

Pure competition is said to exist when the following two conditions are fulfilled:

(1) Large Number of Buyers and Sellers

The first condition is that there should be operating in the market a large
number of buyers and sellers. If that is so no single producer or purchaser will
be able to influence the market price. The output of any single firm is only a
small portion of the total output and the demand of any single purchaser is only
a small portion of the total demand. Hence, the market price has to be taken as
given and unalterable by every purchaser and seller. Thus no individual
purchaser can influence the market price by varying his own demand and no
single firm is in a position to affect the market price by varying its own output.

(2) Homogeneous Product

The second condition is that the articles produced by all firms should be
standardized or identical. In case all farms produce kalian wheat, it is immaterial
for the purchaser as to who has produced it. He can buy it as well from the one
as from the other. This condition ensures that the same price rules in the
market for the same commodity. In case the output is not standardized (i.e., it is
differentiated) each individual firm will be in a position to influence the market
price.

Whether the products are identical or not, has to be looked at from the
purchaser’s angle. Even if the products are identical, the purchaser may have a
prejudice against the output of a particular firm and may consider it different.
That is, if the consumers regard the commodities as different, they should be
considered different for purposes of classification in spite of the fact that they
are actually identical. The consumers generally believe that the products are
different. They generally believe that the commodities that they purchase from
a particular shop are superior, even though they may actually be of the same
quality.

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 When the quality is the same, the commodities are perfect substitutes of one
another and their cross-elasticity is infinity. In these circumstances, if a firm
raises its price, it will lose all customers. It can sell as much as it likes at the
prevailing price. Why should it then think of lowering its price? Hence it cannot
raise its price and it need not lower it. That is why the prevailing market price is
accepted and acted upon by all dealers.

Thus, if the above two conditions, viz., homogeneous products and large
number of buyers and sellers, are found in a market, it is said to be under pure
competition.

Examples of pure competitions are to be found in the case of farm products,

e.g., wheat, cotton, rice. There is a large number of producers, each producing
an insignificant proportion of the total market supply. Their product is similar
and none of them is in a position to influence the market price by his own
individual action. In other fields we seldom come across pure competition.

5.7 Perfect Competition

Perfect competition is wider than pure competition. In addition to the two conditions
of pure competition mentioned above, several other conditions must be fulfilled to
make it perfect competition.

These conditions are:

(1) Free Entry or Exit

There should be no restriction on the firm’s entry into, or exit from, that
industry. This will happen when all the firms are making just normal profit. If the
profit is more, new firms will enter and extra profit will be competed away; and
if, on the other hand, profit is less, some firms will quit, raising the profits for
the remaining firms. But if there are restrictions on the entry of new firms the
existing firms may enjoy super-normal profit. Only when there are no
restrictions on entry or exit, the firms will be in equilibrium.

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 (2) Perfect Knowledge
Another assumption of perfect competition is that the purchasers and sellers
should be fully aware of the prices that are being offered and accepted. In case
there is ignorance among the dealers, the same price cannot rule in the market
for the same commodity. When the producers and the customers have full
knowledge of the prevailing price, nobody will offer more and none will accept
less and the same price will rule throughout the market. The producers can sell
at that price as much as they like and the buyers also can buy as much as they
like.

(3) Absence of Transport Costs

If the same price is to rule, it is necessary that no cost of transport has to be
incurred. If the cost of transport is there, prices must differ in different sectors
of the market.

(4) Perfect Mobility of the Factors of Production

This mobility is essential in order to enable the firms to adjust their supply to
demand. If the demand exceeds supply, additional factors will move into the
industry and in the opposite case, move out. Mobility of the factors of
production is essential to enable the firms and the industry to achieve an
equilibrium position.

5.8 Pure and Perfect Competition Distinguished

As would have become evident from the above discussion, the main difference
between pure competition and perfect competition is that in pure competition there is
no element of monopoly enabling a producer to charge more. If the two conditions of
pure competition are fulfilled, there can be no question of monopolistic control. In
perfect competition, apart from absence of monopoly, other conditions are also
essential, e.g., free entry and exit, absence of transport cost, perfect knowledge, etc.

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 5.9 Imperfect Competition

It refers to conditions which are quite opposite of those that prevail under perfect
competition. For instance, the number of dealers is not large, at any rate not as large as
under perfect competition, the products are not homogeneous; they are on the other
hand differentiated by means of different labels attached to them such as different
brands of toilet requisites. Either in ignorance or on account of transports costs or lack
of liability of the factors of production, same price does not rule in the market
throughout. Rather different prices are charged by different producers of products
which are really similar but are made to appear different through advertisements, high
pressure salesmanship and labeling and branding. The result is that each producer
comes to have a hold on a client from whom he can charge higher prices. In this case
the demand curve or sales curve or what is also called average revenue curve, is not a
horizontal straight line. It is, on the other hand, a downward sloping curve, i.e., the
seller can sell more by reducing price. Under perfect competition, he need not reduce
the price, for he can sell any amount at the prevailing price. He can also charge higher
prices because his customers are attached to him.

He can thus have a price policy of his own whereas a seller under perfect competition
has no price policy; he has merely to accept the market price. The demand for his
product is not perfectly elastic; it is responsive to change in price.

This form of market is a blend of monopoly and competition and has been called
“monopolistic competition” by Chamberlain, an American economist. In the real world,
we have neither monopoly (i.e., absence of competition) nor competition but imperfect
competition, i.e., partly monopoly and partly competition. The products are not
complete substitutes for one another but they are close substitutes. But monopolistic
competition is only one form of imperfect competition where there is a large number
of sellers but products are differentiated. Other forms of imperfect competition are
oligopoly and ordinary monopoly.

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 5.10 Monopolistic Competition

The last category of imperfect competition is monopolistic competition; this occurs

when a large number of sellers produce differentiated products. This market structure
resembles perfect competition in that there are many sellers, none of whom have a
large share of the market. It differs from perfect competition in that the products sold
by different firms are not identical. Differentiated products are ones whose important
characteristics vary; for example, for example, for automobiles, important
characteristics include size, performance, fuel economy, and safety. Because
companies sell slightly different products, they can sell at slightly different prices.

The classic case of monopolistic competition is the retail gasoline market. You may go
to the local Exxon station, even though it charges slightly more, because it is on your
way to work. But if the price at Exxon raises more than a few pennies above the
competition, you might switch to the Mobil station a short distance away.

Indeed, this example illustrates that one important source of product differentiation
comes from location. It takes time to go to the bank or the grocery store, and the
amount of time needed to reach different stores will affect our shopping choices. In
economic language, the total opportunity cost of goods (including the cost of time) will
depend upon how far we live from a store. Because the opportunity cost of local shops
is lower, people generally tend to shop in nearly locations. This consideration also
explains why large shopping complexes are so popular they allow people to buy a wide
variety of goods while economizing on shopping time. The product differentiation that
comes from different locations in an important reason why these tend to be
monopolistically competitive markets.

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 Product quality is an increasingly important part of product differentiation today.
Goods differ in their characteristics as well as their prices. Most IBM compatible
personal computers these days can all run the same software, and there are many
manufacturers. Yet the personal computer industry is a monopolistically competitive
industry, because computers differ in speed, size, memory, repair services, and
ancillaries like CD-ROMs, internal moderns, and sound systems. Indeed, a whole batch
of monopolistically competitive computer magazines is devoted to explaining the
differences between the computers produced by the monopolistically competitive
computer manufacturers!

The main features of monopolistic competition are:-

(i) In monopolistic competition, the number of dealers is quite large but not as
large as under perfect competition.
(ii) The products are not homogeneous; they are, on the other hand, differentiated
by means of different labels attached to them, such as different brands of toilet
requisites.
(iii) Either in ignorance or on account of transport costs or lack of mobility of the
factors of production, the same price does not rule in the market throughout.
Rather different prices are charged by different producers for products which
are really similar but are made to appear different through advertisements, high
pressure salesmanship and labeling and branding. The result is that each
produce comes to have a hold on a clientele from whom the producer can
charge higher prices.
(iv) Under monopolistic competition, the demand curve or sales curve, or what is
also called average revenue curve, is not a horizontal straight line. It is, on the
other hand, a downward sloping curve, i.e., the seller can sell more by reducing
price. Under perfect competition, he need not reduce the price, for he can sell
any amount at the prevailing price. Under monopolistic competition, the seller
can also charge higher prices because his customers are attached to him. He can
thus have a price policy of his own, whereas a seller under perfect competition
has no price policy; he has merely to accept the market price as given.
(v) Under imperfect competition, the demand for the product is not perfectly
elastic; it is responsive to changes in price.

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 This form of market is a blend of monopoly and competition and has been called
monopolistic competition by Chamberlain, an American economist. In the real world,
we have neither monopoly (i.e., absence of competition) nor competition but imperfect
competition, i.e., partly monopoly and partly competition. The products are not perfect
substitutes for one another but they are close substitutes.

5.11 Price – Output Determination under Monopoly Market:

5.11.1 What is Monopoly?

The term monopoly is split up into mono and poly. ‘Mono’ means one and ‘Poly’ means
seller. Thus monopoly means a single seller of the product having complete control on
the supply of the product secondly, there should be no close substitute to monopoly
product or the cross elasticity of demand between monopoly product and other’s
product must be either zero or very small. Zero cross and small elasticity implies total
absence of substitutes and small elasticity implies distant substitute. Thirdly, there
must be strong barriers to the entry of new firms in the market. Under monopoly
condition, no rival firm is allowed to enter the market. Thus a single firm will face the
market demand for the product. Therefore, the single firm constitutes the entire
industry. Hence, there is no difference between firm and industry under monopoly
form of market.

5.11.2 Nature of Demand Curve under Monopoly:

There is a marked difference between the demand curve faced by the firm under
perfect competition and the demand curve faced by a monopoly firm. A firm under
competitive conditions faces perfectly elastic demand curve where as a monopoly firm
faces relatively elastic demand curve. In case of monopoly market, a single firm
constitutes the whole industry. Therefore the market demand for the product is faced
by a single monopoly firm. Since individual demand schedules for the product slope
down ward the monopoly firm faces a down ward sloping demand curve. This means
that if the firm wants to increase sales of its products, it must lower the price.
Monopoly firm can make two decisions viz (i) how much to produce i.e. fixing the size
of output or naming the price for the product. But it can not make both the decisions at
a time. It can make either of the decisions at a time.

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 It means that the firm may either fix the size of output to be produced and leaves it to
consumers to determine the price for the product or it may name the price for the
product and leaves to the consumers to buy whatever quantity they want to buy at that
price.
However, the monopoly firm is a price maker and not merely a quantity adjuster like a
firm under perfect competition. So the problem faced by a monopoly firm is one of
picking up right price – quantity combination which is optimum for the firm.

Demand curve of a monopoly firm is its average revenue curve. Since individual
demand schedules slope downward, the average revenue curve of the monopoly firm
also slopes downward through out its length. The marginal revenue curve lies below
the average revenue curve. It is so because every additional unit of the product is sold
at a lower and lower price. That is why marginal revenue is less than average revenue.
The shape and the relationship between AR and MR are shown and explained in the
following diagram. The MR curve lies below the AR curve because every additional unit
is sold at lower price than the previous one. Though MR is less than AR, they are
related to each other through price elasticity of demand. The price elasticity on AR
curve will tell whether MR is positive or negative at a particular size of output. As long
as price elasticity is positive i.e. between infinity and unity MR is positive and between
unity and zero elasticity, MR is negative. At unity elasticity MR is zero as shown in the
diagram below.

The relationship between AR and MR is explained by the following formula.

MR = AR e-1e

Where (a) MR → Marginal Revenue (b) AR → Average Revenue (c) e = elasticity of

demand. The value of (e – 1)/ e is less than one therefore MR is always less than AR or
Price. So price or AR under monopoly market is always higher than MR. The extent to
which the MR curve lies below the AR curve depends upon the value of the fraction ( e -
1)/e However at infinity on AR curve both are equal, at unity MR is zero, at elasticity
greater than one it is positive and elasticity less than one it is negative. Thus it can be
observed that the higher the elasticity on AR curve, the closer will be the MR curve to
the AR curve and lower the elasticity the farther off will be the MR curve from the AR
curve. Beyond unity, MR becomes negative.

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 5.12 Price – Output Equilibrium Under Monopoly :

Monopoly firm like any other firm keeps before itself two objectives viz (i) Maximistion
of profit or minimisation of losses. It is rather surprising that monopoly firm incurs
losses. Yes, it does when demand for its product is inadequate in the short run.
As we have seen earlier that the monopoly firm makes either of the decisions at a time
that is fixing the size of output or naming the price for its product.
Generally, price for the product is named. Once price is fixed, then it is up to
consumers to buy whatever quantity they want to buy at that price.
The monopoly firm will continue production up to that point at which Marginal cost
(MC) becomes equal to marginal revenue (MR). In other words, the essential condition
for monopoly equilibrium is the equality between MC = MR. However this is essential
condition but not a sufficient condition. The sufficient condition is that the elasticity of
demand on the AR curve must be greater than one at the point of equilibrium. Thus the
monopoly firm will never fix its size of output at that level where the elasticity is less
than one because there after MR becomes negative. Therefore total receipts of the
monopoly firm always falls if it increases its sales. Thus the problem faced by the
monopoly firm is to pick up that price quantity combination which is the best for the
firm i.e. which enables the firm to earn maximum possible profits. The following
diagram depicts the monopoly equilibrium. Revenue and costs are measured along ‘OY’
axis and output along ‘OX’ axis. The diagram indicates MC and MR are equal at OM size
of output and ‘OA’ is the price named by the monopolist.

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 ON is the average cost of production. Thus AN is the profit per unit ( OA – ON = AN).
The firm is in equilibrium at ‘E’ point where MR = MC and elasticity of demand at ‘P’
point on AR curve is also greater than one. The firm makes excess

Profit = TR – TC
= Price X output – Average cost X out put
= AO X OM – ON X OM
= AOMP – NOMR
= ANRP ( shaded Area)

One point is to be noted in the case of monopoly equilibrium is that the monopoly
price is not equal to marginal cost. It is always higher than marginal cost but it stands in
certain relation with MC through elasticity. This relationship is explained with the help
of the formula given by Prof (MS) Joan Robinson, English Economist.
MR = AR e–1
e
.
. . AR = MR e .
e-1

But in equilibrium MR = MC
.
.. AR = MC e .
e-1

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 AR or Price = MC 1
e–1

Since the Value of the fraction e_ is greater than one for a given value of
e–1
elasticity, it follows that under monopoly, price is always greater than MC
AR > MC. However, the extent to which price differs from MC depends upon the value
of the elasticity on AR curve at the point corresponding to the equilibrium. The smaller
the elasticity, the greater is the value of expression e and hence the
e–1
greater the extent to which price would differ from MC. Thus the monopoly price is the
function of marginal cost and the elasticity of demand.
However MC curve which represents the supply curve of the product under perfectly
competitive conditions does not function as such under monopoly. Since MC can never
be negative, equality between MC and MR can not be achieved where elasticity is less
than one because then MR becomes negative. Thus the monopoly equilibrium will
always lie at a point where elasticity is greater than one.

5.13 Price Discrimination or Discriminating Monopoly :

Price discrimination refers to the practice of a seller of selling the same product at
different prices to different buyers or groups of buyers. In other words, the monopolist
sells the same product to different customers at different prices. This he does it to
maximize profit. According to Prof. Stigler, price discrimination refers to “The sales of
technically similar products at prices which are not proportional to marginal cost”. This
implies that the monopolist improves the quality of the product and sells it at a much
higher price than the cost he incurs on improving the product.

There are three types of price discrimination namely personal price discrimination,
local price discrimination and price discrimination according to use of the product.

(1) Personal Price Discrimination : It refers to charging of different prices or fees for
the same services or the product to different persons. This is possible in all personal
services.
(2) Local Price Discrmination : It refers to charging of different prices to customers
living in different localities or places under this type of price discrimination, the
monopolist divides his total market in to various sub-markets based on elasticity of
demand or on the basis of economic conditions of the people.

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 (3) Price Discrimination According to use of the Product : It refers to charging of
different prices for the same product or service in its different uses. For example
electricity charges, or railway fares.

5.13.1 Conditions For Price Discrimination :

(i) Price discrimination takes place only when it is not possible to transfer units of
the product from one market to another. In other words sub-market must be
separated from each other either by a long distance or by tariff walls otherwise
buyers in the dear market may come down to the cheap market and buy the
product or buyer in the cheap market may resell the product in dear market.
Thus, there should be no seepage between the two sub-markets.

(ii) The second condition for price discrimination is that the buyers in the dear
market should not convert themselves into the buyers of cheap market for the
purpose of buying the product. It means that the rich should not pretend
themselves to be the poor. If they do so then in that case price discrimination
will break down.

5.13.2 Price Discrimination is possible in the following cases :

(1) It is possible in all personal services because there is no resale possible.

(2) It is possible when sub-markets are separated by long distance or by tariff walls.
(3) Legal sanction permits the price discrimination. The government allows the
monopolist to charge different prices to different customers for the same
product.
(4) People’s prejudices and preferences for certain products enable the monopolist
to charge different prices to different groups of people for the same product.
(5) Price discrimination is possible on account of ignorance and laziness of the
people.
(6) When several groups of buyers need the same service for clearly differentiated
commodities or use, Price discrimination takes place.

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 5.13.3 When Is Price-Discrimination Possible & Profitable?

Price discrimination is possible, yet it may not be profitable. Price discrimination is

possible only when there is different elasticity of demand in different sub-markets. If
the demand curves in all the sub-markets are iso–elastic, then price discrimination may
not be profitable even though it is possible. It is so because marginal revenue in all the
sub markets at a price will be the same.

This is better explained by the formula

MR = AR e – 1
e

We suppose, that there are two sub – markets namely ‘A’ and ‘B’. Price elasticity in
both the markets is the same i.e. 2. So, at price Rs. 10 per unit MR in both the markets
A and B would be the same. Therefore, it will not pay the monopolist to transfer any
amount of the product from one market to another. He will get same revenue in both
the markets. If he sells one extra unit in either of the markets.

MRa = AR e–1e

MRa = 10 2–1
2

MRa = 10 X ½
MRa = 5
MRb = AR e–1
e

MRb = 10 2–1
2

MRb = 10 X ½

MRb = 5

e = 2, Price Rs. 10/- Per Unit

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 MR in both the market is Rs. 5/- . It is thus clear from the above example that it will not
be profitable for the monopolist to discriminate prices between the sub-markets A and
B. When elasticity is the same in both markets.

But it is possible and profitable only when elasticity of demand in different sub-markets
is different. In such cases, it will be profitable for the monopolist to charge different
prices if elasticity of demand in sub-markets at single monopoly price is not the same.
Monopolist will make maximum profit by discriminating prices in the sub-markets
having different price elasticity of demand. This is better understood by the formula.

MR = AR e–1e

When elasticity is different in sub-markets, MR in different sub-markets is different. Let

us use the same example but elasticity as e = 2 in ‘A’ market and e = 4 in ‘B’ market.
Therefore MR in ’A’ market and MR in ‘B’ market are as follows

Mra = AR e–1e MRb = AR e–1e

MRa = 10 2–1 MRb = AR 4–1

2 4

MRa = 10 X ½ MRb = 10 X 3
4
MRa = Rs. 5/- MRb = 15/2
Mrb = Rs. 7.5

The above example makes clear that MR is higher in ‘B’ market than the MR in ‘A’
market. Thus it is profitable to transfer some quantity of the product from ‘A’ market to
‘ B’ market. If he transfers one unit from A to B market, he will gain 7.5 – 5 Rs. 2.5 per
unit. Thus, he will go on transferring unit of the product from A to B market until MRs.
In both the markets become equal. Now, he will charge different prices for the same
product in A and B markets. A higher price in ‘A’ market and a lower price in ‘B’ market
. Generally a high price is charged in low elasticity market and a low price in a high
elasticity market.

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 5.13.4 Monopoly Equilibrium Under Conditions of Price Discrimination :

To study equilibrium of discriminating monopoly we have to assume that the

monopolist has divided his market in two submarkets. On the basis of elasticity of
demand in each market. Having divided the markets, he has to make two decisions to
attain equilibrium. These decisions are (a) How much out put is to be produced? and
(b) How to share the total output between various sub-markets. In other words, how
much quantity of the product is to be sold in each sub –market and at what prices. To
illustrate the equilibrium under price discrimination, let us suppose that there are only
two sub-markets namely ‘A’ and ‘B’. Market ‘A’ is having low elasticity and market ‘B’ is
having high price elasticity for the monopoly product.

The equality between marginal cost and aggregate marginal revenue will tell the
monopolist how much to produce. It means that the monopolist would continue
production up to a point at which MC = AMR or CMR. AMR or CMR = MRa + MRb +
MRc--- MRnth market. So, AMR refers to aggregate marginal revenue

Which is obtained by adding marginal revenues in all the sub-markets [AMR = MRa +
MRb + MRc … … MRnth]. The seond condition necessary for equilibrium is that MC =
MRa = MRb = MRnth market. The equality between AMR = MC will guide the
monopolist as to how much to produce? And equality between MC and MR revenue in
all the sub-market would tell him as to how much to sell in each sub-market. The AMR
curve show the total output that would be sold in the sub-market taken together
corresponding to each value of the marginal revenue. He will then distribute that total
output in such a way that marginal revenue in the two sub-markets are equal. Marginal
revenues in sub-markets must be equal if profits are to be maximized. The following
diagram depicts the equilibrium of monopolist under discriminating conditions.

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 5.13.5 Conditions For Equilibrium

(i) AMR = MC (ii) MC = MRa = MRb = Mrnth. The above figure shows that the
monopolist attains equilibrium at ‘E’ point where MC = AMR at OQ size of output. So
the total output is OQ. Of the total output, OM quantity is sold in ‘A’ market and OL
quanity in B market OQ = OM + OL. This sharing of OQ output is obtained by equating
MC with MRa and MRb. In market ‘A’ he charges OP price and market ‘B’ he charges
ON price per unit. Op price is higher than On price because price elasticity in ‘A’ market
is lower than that of B market. The shaded area in total market depicts the profit. Thus
it can be said that given the demand for the product and the cost conditions, the
discriminating monopolist will produce OQ size of output and will sell Om part of the
total output in ‘A’ market and OL part in ‘B’ market and thus will maximize profits.

5.13.6 DUMPING – A Special case of Price – discrimination :

Dumping is nothing but price discrimination but it is a special type of price

discrimination. It takes place when monopolist sells his product in two markets; one in
which he faces perfect competitions and monopoly in the other; so demand curve for
his product in perfect market will be perfectly elastic while in monopoly market
relatively elastic or downward sloping demand curve. This happens when a producer is
monopolist in home market and one of the sellers in the world market. In international
market he is one of the sellers and therefore he faces keen competitions there. It is for
this reason; he sells his product in international market at prevailing price. The
international price is much lower than the price charged in domestic market.

Dumping may also refer to the practice of the monopolist to sell his product in the
world market at a price less than the cost of production. He does this to enter and
capture the world market. Secondly he may resort to dumping to clear off his excess
output as domestic market is not large enough to sell his entire output. Thirdly, he may
resort to dumping to earn foreign exchange for modernisation and lastly to maximise
profits. The conditions for equilibrium of dumping monopoly are the same as ordinary
discrimination.

1) MC = AMR 2) MC = MRH = MRw

The second condition complies that MRs in world market as well as home market must
be equal to marginal cost of production. The following diagram show equilibrium of the
monopoly under conditions of dumping.

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 Revenue and costs are measured along ‘OX’ axis and output along OX axis. AR H = MRW
represents average and marginal revenue in home market while AR W = MRW in world
market. ARW = MRW line is perfectly elastic because in the world market monopolist
faces perfect competition. In the home market he faces relatively elastic demand curve.
That’s why ARH and MRH slope downwards. The monopolist attains equilibrium at that
size of output at which MC = AMR or aggregate marginal revenue. This equality is
attained at ‘E’ point at OQ size of output. Now question of sharing of output between
home market and world market arises. The monopolist solves this problem when he
equates MC with MRw and also MRH. Market i.e. ARW = MRW. This condition is fulfilled at
‘R’ point in the diagram. At ‘R’ point MC = MR H that is RM = EQ = MR W. Thus OM size of
output he will sell in the home market and MQ size of output in the world market. Thus
the total output in the market outside. Thus, the total output OQ is divided between
home market (OM) and the world market (MQ) i.e. O = OM + MQ.

The AMR curve, in this case is the composite curve i.e. ARBE which is the lateral
summation of MRH and MRW. Total profit earned is equal to the area APNDE (shaded
Area). He will charge OP price in the home market and ON price in the world market.

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 5.14 MONOPOLISTIC COMPETITON

In reality, there exists neither perfect competition nor pure monopoly. Both are
extreme forms of market. The reality lies between the competition and monopoly. It
was Prof. E. H. Chamberlin who developed this kind of market. It is a blending of
competition and monopoly. This form of market includes some features of monopoly
and some features of competitions. The term monopolistic implies ‘Mono’ means one
and ‘Polistic’ means competitions. Thus, it is the competition among the producers who
produce similar products and not the same product. So each firm faces a keen
competition from its rivals.

Therefore each firm so far as supply of its product is concerned is monopolist because
no one else can supply that product. So, it becomes a single seller of that product. But
it faces competitions from other firms who produce close substitute. In other words,
cross elasticity between the products of the firms under monopolistic market is very
high. Therefore, it is called as the blending of monopoly and competitions.

Product differentiation is the characteristic feature of this market. This means that the
products of different firms are heterogeneous but are closely related to each other.
Product differentiation doesn’t means that the products of different firms are totally
different but they are slightly different. That’s why they are called similar and not the
same. If the degree of product differentiation is greater, the presence of monopoly
element is greater and if the degree of product differentiation is smaller, the greater is
the competitive element. Since this form of market exhibits features of monopoly and
competitions, we call it as monopolistic competitions.

5.14.1 Characteristics of Monopolistic competition :

1) Large numbers of buyers: Like perfect competition there are large number of
buyers. But how large is the number can not be ascertained. Each firm has its own
group of buyers. They are attached to particular brand of product. Therefore, they
follow their own pricing policy. Prices of different products therefore differ.
Because tastes and preferences of the people differ, each firm finds demands for its
products. However the large numbers of buyer are divided among many sellers
supplying the similar products.

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 2) Large numbers of sellers: Existence of large number of sellers is the second
condition of this form of market. Each seller supplies similar products. If the
number of firms is larger, the product differentiation may be smaller., Again, if the
number of firms are smaller differentiation is generally greater. Thus, this form of
market offers an opportunity to everyone who wants to enter the market but on
one condition that the product is differentiated from the existing ones. So, there is
no limit to the number of firms like perfect competitions. In this way, the market
also resembles perfect competition.

3) Product Differentiation: This is the distinguished feature of this market. Each firm
produces non identical product and not the same product. The degree of product
differentiation depends upon the numbers of firms. The larger the number of firms,
the smaller is the difference and vice-versa. However each firm’s product is close
substitute to other firms. Therefore, product differentiation is the soul of this
market. The product differentiation is based on certain characteristic of the product
itself like exclusive patented features, trade marks, trade names, designs, colour,
weight, packaging price etc. also conditions surrounding sales of the product like
making available free home delivery etc. Besides, location of the seller, the way of
doing business seller’s reputation for fair dealing courtesy etc also determine
product differentiation.

4) Free Entry and Exit of Firms: There are no barriers on entry and exit of firms under
this market. But new firms will have to supply differentiated product from the
existing ones. Thus any numbers of firms are welcomed provided they produce
similar products. This brings about automatic adjustment in the supply of the
product. The larger the number of firms, the greater is the competition and vice –
versa.

5) Selling Costs: This is another marked feature of this form of market. There is no
need of advertising either under perfect competitions or under monopoly. But
under, this form of market, without selling costs, no firm can survive. Each firm will
have to advertise its product to inform the consumers about the new product for
creating demand. A skillful and imaginative advertisement is necessary to convince
the consumers to buy the product. Thus, the selling cost refers to the cost incurred
on advertisement. It may be informative or competitive.

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 6) Informative: The purpose of this type of advertisement is to inform the consumers
about the new product. It can be done through newspapers, magazines, sign
boards, radio, T.V. cinema houses etc so that the people know about the new
product. The purpose of this type of advertisement is not to boost demand but to
inform the people about the new product to make their rational choice. It also
enlightens them about the market situation and helps them to make rational
choice.

7) Competitive Advertisement: The objective of this type of advertisement is either to

create demand or boost the demand for the product. Generally, all means moral
immoral are made use of to create demand for the product and rattle down the
rivals. Public media like newspapers, radios, TV, cinema houses, models, window
dressing, sign-boards, magazines etc are used to convince the consumers to choose
a particular product from among many. Even popular figure like film star,
sportsman are employed to advertise the product. This category of advertisement
tries to establish that the advertised product is the best or superior to all and
appeals the consumers to buy that product some times, even free gifts are offered
on purchase of the product.

However, this type of advertisement misleads the consumer. It becomes difficult for
consumer to make correct and rational choice from among host of advertised
products. Many times, they make wrong choice based on false and exaggerated
advertisement. Therefore on moral and economic grounds such advertisement is
not desirable. The selling cost influences the shape and the position of the demand
curve because it influences the elasticity of demand. When demand curve shifts to
the right, it means that the selling cost has proved successful in improving demand
for the product.

5.14.4 CONCEPT OF GROUP

Since all the firms under monopolistic competition produce non – identical products,
therefore they are said to be in a group. The concept of industry is peculiar with perfect
completion only because all firms under perfect competition produce identical
products. But under monopolistic competition each firm produce close substitute to
other is product. It is for this reason within the group firms has greater affinity and their
products become close substitutes. They offer stiff competition to each other. The
larger the number, the keener is the competitions and vice versa.

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 5.14.3 NATURE OF DEMAND CURVE

The shape of the demand curve under this form of market is determined by the tastes
and preference of the consumer, pricing policy of rivals, output, selling costs and
product decision of rivals firms. The problems of monopolistic competitions are
therefore more complicated than those under perfect competition. The demand curve
faced by a firm under monopolistic competition is its average revenue (AR) curve. It is
neither perfectly elastic nor perfectly inelastic. It lies between the two elasticities. It is
more elastic than it is under monopoly and less elastic than the demand curve under
perfect competition.

This makes clear that the demand faced by the firm under this form of market is flatter
and elasticity of demand is greater than one. The degree of elasticity depends upon the
extent of product differentiation and the number of firms operating.

If the degree of product differentiating is greater, then in that case monopoly element
will be larger and so the demand curve will be relatively inelastic. But if the degree of
product differentiation is smaller then in that case competitive element will be greater
and therefore demand curve will be more elastic. Secondly number of firms in the
group also determines the position and shape of the demand curve. If the number is
larger, the smaller is the product differentiation and hence greater is the competitive
element and hence the demand curve will be relatively elastic. If the degree of product
differentiation is smaller then in that case competitive element will be greater and
therefore demand curve will be more elastic. Secondly, the numbers of firms in the
group also determine the position and shape of the demand curve. If the number is
larger, the smaller is the product differentiation and hence grater is the competitive
element and therefore the demand curve will be more elastic. If the number is smaller,
the greater is the product differentiation and therefore greater is the monopoly
element so demand curve will be relatively inelastic. The following diagram depicts the
shape and position of demand curve. Since individual demand schedule slopes
downward, AR curve of the firm also slopes downward. The marginal revenue curve lies
below the AR curve. MR like monopoly is always less than price because additional sale
of output involves cut in price.

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 5.14.4 Production & Selling Costs

Selling costs occupy an important place in marketing the product. In fact, in certain
cases selling cost exceeds the production cost because marketing of the product
becomes difficult. To market the product means to create the demand for the product.
Thus to convince the consumers to buy the product an intensive and skillful
advertisement campaign needs to be undertaken. Many a times a good product does
not get sales for want of proper and effective advertisement.

Therefore, we should know the difference between the two.

1) Production cost is incurred to produce and supply good and services whereas
selling costs are incurred to raise sales of the product.
2) Production cost is generally incurred to satisfy the exiting wants whereas selling
costs are incurred to create future demand.
3) Selling costs change the shape and position of demand curve. It makes it more
elastic but production cost does not do the same.
4) Production costs create utility but selling costs do not create any utility
5) Production costs increase supply of goods and services while selling costs create
or increase demand for the product.
6) Production cost increases national income in real terms whereas selling costs
bring about merely transfer of resources without adding anything to the
national income.

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 5.14.5 NATURE AND SHAPE OF THE AVERAGE SELLING COST:

Average Selling Costs (ASC) refers to the selling cost incurred per unit of sale. It is also U
shaped. Thus in the beginning it is high but as the sales of the product increases, the
average selling cost starts falling. It falls due to operation of the law of increasing sales.
Therefore ASC declines. But this will not happen indefinitely. After having reached the
minimum point, it begins to rise due to the operation of the law of decreasing sales. In
other words, the operation of the law of non – proportional sales is the cause of ASC
being U shaped. The following diagram depicts the shape of ASC.

Total cost of production includes TFC, TVC and total selling costs. Therefore AC of
production is equal to AFC + AVC + ASC. In the following diagram combined AC and MC
are shown.

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 5.14. Exercise
1. What is meant by market in equilibrium? How does the demand curve
and the supply curve enable us to arrive at it? Explain with the diagrams.
2. What are the essentials of pure and perfect competition? When does it
turn imperfect?
3. Explain the main features of monopolistic competition. How product
differentiation helps to distinguish a monopolistic competition?
4. Explain the mechanism of price determination under monopoly with
reference to a diagram where the area of excess profit is shown.
5. Explain the market situation which enables price discrimination possible
& profitable.
6. Write short notes on :-
(a) Dumping
(b) Selling cost
(c) Product differentiation
(d) Discriminating monopoly

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 UNIT – VI
PRICING OF FACTORS
(DISTRIBUTION)

6.1 THE GENERAL THEORY OF DISTRIBUTION

Production is the result of joint endeavor of four factors of production namely land,
labour, capital and entrepreneur. Since their services are economic goods, they are to
be paid for. Thus, the national income is distributed among these factors of production.
The theory, which refers to the distribution of national income among the factors of
production, is called as the general theory of distribution. It deals with the pricing of
the productive resources. It determines the relative share of land, labour, capital and
entrepreneur in the national income. Thus land is paid in terns of rent, labour in wages,
capital in interest and entrepreneur in profits from the national income.

National Income = Rent + wages + interest + profit. Distribution of national income is

studied in two ways namely personal distribution and the functional distribution.
Personal distribution refers to the study of individual incomes. It analyses how much is
earned by individuals in the country. However, it is very difficulty to explain earning of
individual incomes because they earn from different sources. Earning of individual
incomes depends upon social and political structure of the country, system of
ownership, of property and the laws of inheritance. It is for these reasons study of
personal distribution becomes a complex one.

Functional distribution on the other hand deals with the study of factor incomes. It
analyses the relative share of each factor in total national income in terms of rent,
wages, interest and profit. In other words functional distribution of national income
studies pricing of factors in tern\ms of function they perform in producing goods and
services or national income. Thus, the functional distribution is named as the theory of
factor pricing.

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 6.2 MARGINAL PRODUCTIVITY THEORY

The marginal productivity theory of distribution is only an extension of general theory

of distribution. It explains determination of incomes of factors of production. Theory is
associated with names of J. B. Clarke, Wicksteed and others. The theory states that
income of the factor of production is determined by its marginal product. Marginal
product refers to the addition made to the total product by employing one more extra
unit of the same factor of production, quantity of other factors remaining constant.
J. B. Clark, held the view that in a static economy, every factor of production including
entrepreneur receives reward equal to its marginal product. The marginal product can
be measured in marginal physical product or marginal revenue product. Marginal
Physical Product (MPP) refer to the addition made to the total product in physical form
by employing one more unit of the same factor keeping quantity of other factors the
same. While marginal revenue product (MRP) is money value of MPP i.e. MPPX price of
the product. Since factors of production are paid in their revenue productivity, the
theory is studied in terms of revenue productivity.

6.3 THE STATEMENT OF THE THEORY

The marginal productivity theory relates the reward of a factor of production to the
revenue productivity of that factor. Thus price of any factor of production depends
upon its revenue productivity. An employer will continue employing units of a factor up
to the point at which rewards paid to the marginal unit of that factor is equal to the
contribution made to the total production by that unit in terms of money. No rational
producer would go beyond this point of equality because the cost (Reward) exceeds
the contribution (income). At the margin, the reward of the factor is equal to tits
productivity or marginal productivity. Thus, the marginal productivity theory states that
1) rewards of a factor would depend upon the contribution of that factor to the total
production. 2) the reward of a unit of factor of production would be determined by and
would be equal to the marginal productivity of that factor unit. 3) Under certain
conditions, the reward of the factor unit would be equal to both, the average
productivity of factor under consideration.

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 Here two points are to be noted. First the reward which a factor of production receives
is income for that factor but it is the cost to the employer under perfect competition,
rewards which pays is the same for all units of factor. Therefore cost curve of the factor
is horizontal straight line indicating that average cost and marginal cost are the same to
the employer. Secondly that the factors of production are paid in money and not in

what they produce. Therefore, employer is interested in revenue productivity. Physical

productivity is converted into revenue productivity through price mechanism or prices.
Average revenue productivity (ARP) refers to the total revenue divided by number of
units of the factor employed to produce the given output. Marginal Revenue
Productivity (MRP) refers to the net contribution made to the total revenue
productivity by employing one more unit of the same factor. Both revenue productivity
depend upon the law of variable returns that is they increase, reach maximum and
then decline.

The marginal productivity theory of distribution states that under perfect competition
in the long run, the reward paid to the factor units will be equal to both average
revenue productivity as well as marginal revenue productivity. The following figure
show the ARP and MRP curves and the average and marginal remuneration (Cost)
curves under competitive conditions

6.4 EQUILIBRIUM OF THE FIRMS IN FACTOR MARKET

To understand the equilibrium of a firm with regards to employment of factors of

production, one assumption is made i.e. quantity of other factors of production is kept
fixed quantity of one variable factor say labour is increased. In other words, more and
more units of labour are employed until contribution made by the last unit employed
becomes equal to the reward that unit of labour receives from the employer.

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 The following diagram illustrates the firm is equilibrium. Revenue productivity and
costs are measured along vertical axis while labour along horizontal axis.

6.5 CONDITIONS FOR FIRM’S EQUILIBRIUM

The firm would be in equilibrium with regards to employment of factors of production

if the following conditions are fulfilled.

Marginal Revenue productivity (MRP) = Marginal Cost (MC or MW). This is essential
condition but not the sufficient condition for a firm to be in equilibrium. Therefore, the
second sufficient condition for firm’s equilibrium is that the marginal revenue
productivity curve must cut marginal cost curve or marginal wage line from above. If
these two conditions are fulfilled, the firm would be in equilibrium earning maximum
profit.

WW is the supply curve faced by the firm parallel to the OX axis. It depicts the supply
curve of labour to the individual firm. Since there is perfect competition in the labour
market, the firm can hire as many units of labour as it desires at the ruling wage rate
of rupees i.e. OW per worker. Under competitive conditions, the firm would have to
accept the ruling price. The firms demand for labour is so insignificant in comparison
with total demand of the industry that any change in the firm’s demand for labour will
not affect the price anyway. The marginal revenue productivity of labour to the firm is
the firms demand curve for labour. Demand for labour is a derived demand because
labour is hired only for what it produces. So in the following figure the MRP curve
indicates derived demand curve for labour of the firm under consideration.

Conditions for equilibrium

1) MRP = MC = AC = AW = MW
2) MRP curve must cut ARP curve at its highest point from above to maximize the
profit.

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 Where
1) MR = Marginal Revenue
P Productivity
2) AR = Average Revenue
P Productivity
3) AW = Average Wage
4) M = Marginal Wage
W
5) MC = Marginal Cost
6) AC = Avenge Cost

In the above diagram WW’ curve represents both the average and marginal wage. The
average amount of money paid to a worker is OW. Since, the firm is operating under
competitive conditions, what is paid to one worker would be paid to all the workers
employed. Therefore WW wageline is horizontal to ‘x’ axis. The firms will be in
equilibrium and maximizes its profit when the MRP of the factor (ME) unit is equal to
the marginal cost of the factor which is equal to marginal and average wage.
This takes place when OM amount of labour is employed. If less than OM amount of
labour is employed, the firm would suffer unnecessary losses. If it wants to raise its
receipts, it must increase the employment of labour which would go on adding to the
receipts of the firm more than the marginal cost. The MRP exceeds the MW = AW =
MC. In the same way if more than OM amount of labour is employed, the marginal cost
of labour, that is marginal wage would exceed its MRP; the firm would be paying more
to its marginal employees than their contribution. This results into losses.

At OM employment of labour, the firm would be in equilibrium and its profit would be
maximized. It is so because the last unit of labour employed would contribute equal
amount to the firm’s receipts. In other words, the firm would be in equilibrium when it
equates marginal revenue productivity of labour with its marginal cost (MRP = MC =
MW). But this equality must realized at falling MRP.

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 And that is why economists are more keen to show that the MRP must ultimately
decline otherwise equilibrium would be impossible. Assuming rationality on the part of
entrepreneur, a firm will be in equilibrium when MRP of a factor to the firm equals its
marginal cost. Fulfillment of this condition enables the firm to maximize profit. This
condition realizes at OM amount of labour Not only MRP is equal to marginal cost but it
is also equal to average wage and average revenue productivity of labour. This also
implies that the industry is in full equilibrium earning normal profit. Though price of any
factor of production including labour is determined by the demand for and supply of it,
it is always equal to its MRP. The next diagram depicts the industry equilibrium.

Price is measured along ‘OY’ axis and quantity along ‘OX’ axis. With increase in demand
for the factor shown in the diagram above, price of the factor shoots up to ‘ON’. As
soon as price goes up at ‘ON’, the firm will be in equilibrium at ‘Q’ using OZ amount of
that factor earning normal profits. At OZ amount of that factor, the price of it is equal
to its MRP as well as ARP of the factor. At equilibrium point ‘Q’ the firm earns just
normal profits. Thus in the long run under perfect competition in the factor market,
price will always equal to MRP and ARP of the factor.

In other words, long run equilibrium between demand for and supply of the factor is
established at the level where the price of the factor is equal to both MRP as well as
ARP of the factor which means only normal profit is made.

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 6.6 EQUILIBRIUM OF AN INDUSTRY

Industry equilibrium will be attained only when each and every firm constituting that
industry is in equilibrium earning normal profits. This means that each firm would be
equating MRP with marginal wage or marginal cost. If it happens, the whole industry
would be in equilibrium earning normal profits. Diagrammatic representation of the
industry equilibrium is the same as that of equilibrium of a firm. It is also explained in
terms of costs and receipts. For industry equilibrium, it is assumed that the
entrepreneurs are homogenous and each firm would be in equilibrium when ARP curve
is tangential to the wageline.

In short run, some frims will be earning super normal profits while some will be earning
normal profits and some will be minimizing losses by just covering variable cost. But in
long run, this will not happen. Frims incurring losses will quit the industry and if excess
profit is made new firms will enter the industry and compete out the excess profit. This
entry and exit of firms in and out of industry will continue until equilibrium is
established. So, the industry equilibrium will realized when MRP = ARP = MW = AW =
MC. The following diagram depicts the same.

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 The industry equilibrium takes place at employment of OM amount of labour and the
OW wage is paid to every unit of labour. So ‘E’ is the equilibrium point where MRP =
ARP = MW = AW = MC are equal. MRP and ARP curves are tangent to wage line WW.
Industry is earning normal profit. If less than OM amount of labour is employed,
industry will unnecessarily reduce its profits and if more than OM amount of labour is
employed say OM’, the industry will incur losses because its labour cost would be more
than the receipts. Wage rate would exceed receipt. If the wage line shifts down ward
that is W’W’, equilibrium position would change. Now it would be at ‘L’ point at ‘OM’
employment of labour. At ‘L’ point MRP = MW = AW and MC of the firm. But ARP is
M’N which is higher than MRP (L’M) which means that the industry would be making
excess profit. This will invite new firms in the industry which will compete out the
excess profit bringing the industry to the level of normal profit. The entry of new firms
will lower the price of its products and this will bring down the MRP and ARP. Likewise
an increase in demand for labour may raise wages. The ARP curve will fall and wage line
will rise until they are tangent to each other.

6.6.1 Principle of an industry Equilibrium:

MRP of Land = MRP of Labour = MRP of Capital

Rent Wages Interest

= MRP of Entrepreneur
Profit

If this condition is fulfilled, the industry will be in equilibrium earning normal profit.
This is the same principle as the consumer’s equilibrium with regards to more than one
good i.e. the law of substitution. To conclude an entrepreneur employs units of any
factor of production until its MRP becomes equal to the marginal cost.

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 ASSUMPTIONS :

The above stated theory holds good only when certain conditions are fulfilled. These
conditions are the foundation stones of the theory.

1) There exists perfect competition in both the markets, factor as well as

commodity market.
2) All units of labour are homogeneous in all respects.
3) Problem of overtime is ignored.
4) Theory would hold good only in long run.
5) It considers only stationary conditions.
6) There is equal bargaining power on the part of buyer seller.
7) The theory assumes that there is perfect mobility of factor of production.
8) It is based on belief that entrepreneurs can predict and measure MRP of labour
in advance.
9) The theory holds that entrepreneurs always try to maximize profit.
10) No government intervention any where in the process of determing rewards of
factor of production.

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 Criticism / Limitations :

Through the theory is pioneer in explaining as to what determines prices of factors of

productions, it is not free from drawbacks.
1) Perfect competition is not reality. Reality is imperfect markets.
2) Units of labour are not homogeneous; On the contrary, the world is full of
heterogeneity.
3) The theory is static where as problems it attempts to solve is dynamic.
Therefore it is illogical to solve problems of dynamic world with tools of static
theory.
4) The theory is applicable in long run only. But Lord Keynes says that we are all
dead in long run. What concerns us most is the short run.
5) The theory doesn’t solve the problems of individual income.
6) There is no equal bargaining on the part of buyers and sellers. Actually labour is
exploited by the employers.
7) The government interference is in every walks of life. A number of labour laws
shows that there is a great deal of government interference in determing
reward for labour.
8) The theory is not useful in determing reward of such factors which are used in
fixed proportions.
9) According to this theory, trade unions are superfluous and collective bargaining
is a futile activity.
10) Marginal productivity ignores the positive inter relation between rewards of
factors of production and their productivity especially between the wages and
efficiency of labour.
11) The theory is based on the principle of maximization of profit which is not true.
12) The various factors are jointly demanded for the production of a commodity.
13) The theory fails to explain the remuneration of entrepreneur that is profit.
Marginal productivity of a factor can be known if it can be varied by keeping the
other factors fixed. However, the entrepreneur in a firm is only one and
therefore variation in it is not possible.

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 6.6.2 IMPORTANCE OF THE THEROY :

(1) The theory enables us to determine the levels of employment of factors of

production. Price of factor depends upon its demand.
(2) The theory is useful in bring about the efficient and optimum allocation among
their alternative uses. The movement of factors is essential for best and
efficient use of scarce natural resources.
(3) The theory also guides us to determine the incomes of factor owners and
thereby determines the relative share of factors of production in the national
income.

6.7 RENT

Introduction : Land is a primary and original factor of production. Its total supply to the
entire society is perfectly inelastic. It is a free gift of nature. However for an individual
or an industry it is relatively elastic. The reward paid for use of land is called rent. The
economic rent refers to payment for the use of land. It excludes any return on capital
investment. Economic rent is also called as surplus because it does not result from any
exertion on the part of land owner. Adam Smith held,” The landlords like all other men
love to reap where they never sow”. It was Ricardo an English Economist who
explained why rent is paid.

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 6.7.1 Ricardian Concept of Rent :

Ricardo held, “Rent is a return for the use of the original and indestructible powers of
the soil; and high rents are not a sign of the bounty of nature. On the contrary, they are
an indication of the niggardliness of nature.” He defined rent as,” that portion of the
produce of earth which is paid to the landlord for the use of original and indestructible
powers of the soil.” The above definition makes it clear that rent is payment for the use
of land only and it is different from contractual rent. It does not include return on the
capital investment. However, Physiocrats laid great stress on the bounty of nature as
the reason of the rent of land. Ricardo argued that though the land was useful, it was
also scarce. While the productivity of nature may be a sign of its usefulness and of the
bounty of nature, the fact is that the total supply of land is fixed is a sign of nature’s
niggardliness. The contention of Ricardo that rent is a return for the use of the original
and indestructible powers of the soil does not throw any light on the powers of the
land that are said to be original. By the term Original Powers, Ricardo perhaps meant
that it must be distinguished between money spent on improvement of land and the
economic rent.

Though, the land itself can not be destroyed, its fertility can be destroyed . If depends
upon the climatic conditions, use of irrigation, improved farming methods and so many
other factors. Therefore, it would be entirely unreasonable to regard the powers of the
land as indestructible. The Ricardian theory of rent is based on two basic principles viz.
The Law of Diminishing Returns which operate in agriculture and the Mal thus principle
of population. These two principles are the foundation stones of Ricardian theory of
rent.

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 Assumptions of the Theory :

(1) The elasticity of supply of land is zero which means supply of land to the society
is fixed.
(2) The land is used to produce food grains only. No other use of land is considered.
(3) Land differs in fertility. This means that there are different grades of land
differing in fertility.
(4) There exists perfect competition in factor market. This only means that there
are a number of land owners who are willing to rent out their pieces of land at
ruling rate of rent.
(5) The theory operates only in long run.
(6) The concept of marginal piece of land plays a dominant role in the classical
theory of rent.

In the light of above assumptions, it is stated that if the land is of same quality, scarcity
of land in relation to its demand gives rise to rent. Ricardo calls it as the scarcity rent.
And if land differs in quality, then in that case superior quality pieces of land earn rent.
Ricardo calls it as differential rent.

6.7.2 Scarcity Rent Theory :

To explain the scarcity rent theory, it is assumed that a new piece of land is discovered
which was not occupied by man. As the people start occupying this new land, it starts
earning rent because demand for land exceeds supply of land for producing food
grains. As long as vacant pieces of land are available for producing food grains, its
production cost would be equal to average cost of production. So, cost of production
and price of the food grains would be the same. So there would be no surplus. But
once, the entire land is brought under cultivation, further demand for food-grains
would raise the price of food-grains above the average cost of production. This happens
because population goes on increasing. Since there is perfect competition in factor as
well as product markets, the cultivator’s equilibrium will be established at the lowest
point on long run average cost curve. But as the population grows, demand for food
grains also increase but supply can not be increased on account of fixity of supply of
land. This raises, the price and therefore, there appears a difference between price or
average revenue and average cost of production. It is this difference between revenue
and cost Ricardo calls it as the scarcity rent. The following diagram illustrates the
scarcity rent phenomenon. Price is measured along OY axis and output along OX axis.

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 The cultivator is in equilibrium at OQ size of output. At this level of output price of corn
i.e. ON. Is equal to average cost of production i.e. TQ. Thus, at this size of output price
and long run average cost are equal and hence there is no surplus. But as output is
raised to OQ’, price shoots up to OA or EQ’ but the average cost of production remains
at OP or TQ’ level. Thus, there appears a surplus to the extent of APLE rectangle which
Ricardo calls as economic rent. It must be noted that there exists perfect competition
among landlords so it is not possible to earn any rent as long as surplus land exists. As
demand for food grains increases, the vacant pieces of land are brought under
cultivation to produce more food grains to meet increased demand for food grains. But
once entire land is put to use, there is no scope to improve the supply of food grains .
So, demand for food grains exceeds supply of food grains which shoots up the price of
the food grains. Now, price can not fall back to original level that is ON because there is
no idle land to be put to use. Now, cultivator’s equilibrium realizes at ‘E’ point at OQ’
size of output because LMC is equal to new price OA’ but LAC is tQ. So, ‘Et’ or AP
surplus arises which is scarcity rent according to Ricardo. Thus, contention of Ricardo
rent arises, due to niggardliness of nature is true. The classical thinking holds that rent
is a surplus over and above cost of production. They never held rent as a part of cost of
production. Thus scarcity rent arises due to the fixity of supply of land.

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 6.7.3 RENT UNDER INTENSIVE CULTIVATION :

The Ricardian concept of surplus rent applies to intensive cultivation also. Intensive
cultivation refers to usage of same piece of land again and again for the production of
same food grains. In such cultivation fertility of land goes on declining and so additional
doses of labour and capital applied to produce food grains from the same piece of land
yields less and less quantity of food grains. The cost of last dose of labour and capital
must be at least equal to the yield which we get in return from the land to make
application of the dose of labour and capital worth while. So the last dose is called
marginal dose because it simply covers its cost. It doesn’t give rise to any surplus.
Whereas earlier doses produce more than the cost incurred on them. So, it is this
Surplus over and above cost of doses of labour and capital is called rent. Thus Ricardian
theory of rent is true in case of intensive cultivation of land also.

6.7.4 THE DIFFERENTIAL RENT THEORY :

This concept of rent is based on assumption that of land differs in quality or

productivity. So superior pieces of land earns rent when interior quality pieces of land
area brought under cultivation. It is held that on new island people begin cultivating
the best piece of land for production of food grains. But as the population goes on
increasing, interior pieces of land are brought under cultivation to produce more and
more food grains to meet increase demand for food grains. As the inferior pieces of
land are brought under cultivation cost of production increases and therefore price of
food grains. So, there appears a surplus over and above the cost of production in case
of superior pieces of land; and it is this surplus which Ricardo calls a differential rent.

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 The following diagram illustrates the phenomenon.

The cost of production on ‘B’ grade land is higher than that of on A grade land.
Therefore ‘A’ grade land earns rent i.e. a difference between price of food grains and
cost of production. Total rent earned by ‘A’ grade land is equal to shaded area A’NET’.
In case of ‘B’ grade land, there is no rent because price and cost of production are
equal. Hence it doesn’t earn any rent.

6.7.5 RENT UNDER EXTENSIVE CULTIVATION :

Extensive cultivation is defined as the cultivation of different pieces of land of different

quality for the production of same food grains. As inferior quality pieces of land are
brought under cultivation, cost of production rises and so price of food grains. So, there
appears a difference between price of food grains and cost of production of superior
quality pieces of land and it is this difference which is called as differential rent. The
cost on last piece of land must be equal to price to make cultivation of that piece of
land worthwhile. According to classical economists rent does not form a part of the
cost of production. It is an earnings over and above the cost of production of marginal
land which is no rent land. That is why it is said that rent is not price determining but
price determined. David Ricardo contends, “Corn is not high because rent is paid but a
rent is paid because corn is high.” This means that it is the price of food grains that
determines rent. Thus it can be summed up as follows:

(1) Rent is a differential surplus because it is a Surplus over and above cost of
production which arises due to differences in fertility of soil. In other words if all pieces
of land were of equal quality no rent would arise.

(2) Rent is price determined and not price determining.

(3) Rent is peculiar to land alone. It means that other factors of production do not earn
rent.

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 6.7.6 APPRAISAL OF THE RICARDIAN THEORY :-

(1) In modern thinking, it is the interaction between demand for and supply of land
will determine price of land. Rise in population, raise demand for food grains and
so for land. But land is fixed in supply. That is why price of food grains increases
which creates surplus over and above the cost of production. But Ricardian theory
does not explain what determines wages of labour, interest on capital, transport
cost etc.
(2) Ricardo holds that the land has no transfer earnings or it has no alternative use.
But in modern times, it is held that every factor of production has alternative use.
(3) Supply of land for the whole economy is perfectly inelastic but for a firm or a
particular industry supply of land is not fixed. Supply of it can be varied depending
demand for its product. Thus, demand for land also depends upon its marginal
productivity.
(4) The contention of Ricardo that land is indestructible is also not true. In the age of
atomic energy, fertility of land could be destroyed converting it totally barren.
That is why his contention that rent is reward paid for the use of original and
indestructible powers of soid does not hold good.
(5) Two foundation pillars of the Ricardian theory are the Malthusian Principle of
population and the law of diminishing returns. But operation of both the
principles can be postponed with the help of modern technique of cultivation,
irrigation, use of fertilizers and pesticides. Growth of population can also be
controlled. Ricardo failed to take cognizance of it.
(6) Land has transfer earnings. It can be put to alternative uses. Therefore transfer
earnings of land enters into the cost of production and hence determines the
price of the product.
(7) The Ricardian theory is not applicable in short run. But according to J.M. Keynes
we are all dead in the long run in which theory holds good what concerns us most
is the short run and not the long run.
(8) Perfect competition doesn’t exist in the real world. Our world is full of
imperfections.
(9) Ricardo had predicted economic stagnation on the basis of his rent theory. But
modern economists do not agree with his stagnation theory.
(10) Lastly, David Ricardo did not use forces of demand for and supply of to explain the
emergence of rent. He uses them indirectly. The Ricardian model of scarcity rent
can be better and easily explained with the forces of demand and supply.

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 This brings us to the conclusion that demand and supply theory would have been
enough to explain the phenomenon of rent.
In fine, it can be said that from the view point of individual firm or industry or
cultivator, rent enters into the cost of production and therefore determines price.
Ricardo was wrong in contending that the rent does not enter into the price. Rent does
enter into cost of production.

6.7.7 MODERN THEORY OF RENT :-

Surplus payment made to any factor of production over and above its transfer earnings
is called rent in modern theory of economics. This means that labour, capital and even
entrepreneur earn rent which is called as rent of ability. According to Pareto,
“Economic rent means the excess payment to a factor of production over and above
the minimum amount necessary to keep a factor in its present occupation.” Benham
held,” Economic rents are the sum paid to the factors which need not be paid in order
to retain the factors in the industry.” It means that income received by a unit of factor
of production in its present employment or industry in excess of its transfer earnings is
therefore called rent.

Transfer earnings of any factor of production can be defined as the minimum payment
that must be made to a unit of factor of production in order to retain it in its existing
employment and that it must be equal to the earnings of what that unit of factor of
production would earn in the next best alternative use or employment. For individual
farmer the whole rent will be a cost that is cost of preventing the land from transferring
to other uses. Thus, in modern theory, economic rent is not merely confined to land
alone. It refers to the surplus payments made to units of factors of production in excess
of what is necessary to keep them in the present employment or use. Economic rent
emergences when supply of a factor is less than perfectly elastic. According to Joan
Robinson whenever supply of factors units is not perfectly elastic, a part of the earnings
of that factors will consist of surplus or economic rent since the full price they get is not
necessary to make all the units available.

If supply is not perfectly elastic, some units of that factor would be available at lower
price than what it would receive at equilibrium price. The difference between the
actual price and the one necessary to make it available is economic rent. Since land has
no supply cost, entire earnings of it is economic rent.

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 A) PERFECTLY INELASTIC SUPPLY ( e = o) :-

The whole earnings of land is considered as surplus earnings since land is free gift of
nature. The following diagram explains the phenomenon of economic rent. ‘SS curve
represents perfectly inelastic supply curve of land and ‘DD’ is the demand curve.
Intersection of demand and supply curves, determines the price of land i.e OP or EM.
Since transfer earnings are zero, the entire earnings or price will be economic rent per
unit of land. The total earnings or economic rent is OM XOP = POME. (e = o).

Economic rent is defined as payment for any factor whose supply is perfectly inelastic.
This is depicted in the along side diagram. If the quantity of land is in plenty in relation
to its demand, there would be no reward for its use, and therefore no economic rent
will arise. In Ricardian theory land is considered to have specific use only i.e. it is used
only for production of a particular food grains but in real world, land is used for
different commodities. According to modern economists, supply of land is fixed to the
society but not to a particular industry or firm. There are various uses of land
competing with each other. If in its next best alternative use, it earns more than what it
earns in present use, it would get transferred to that use.

(B) RELATIVELY ELASTIC SUPPLY ( e > 1) :-

If supply of land or any other factor is relatively elastic, then in that case, there arises a
difference between actual earnings and its transfer earnings; and it is this difference
which is called rent in modern theory. The following diagram illustrates the
phenomenon. The diagram shows that equilibrium between demand for and supply of
land takes place at ‘E’ point where demand and supply intersect each other. So
equilibrium price is ON.

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 Transfer earnings of last block of land and price are equal that is ON = EM. Hence last
block of land earns no rent. But earlier blocks earn rent because there is difference
between actual earnings and transfer earnings. At ON equilibrium price, total actual
earnings of ‘OM land is NOME (ONXOM) where as transfer earnings is SOME. So the
difference between actual earnings and transfer earnings is NOME – SOME = NSE
(Shaded Area). This difference is economic rent.

(C) PEFECTLY ELASTIC SUPPLY ( e = ∞):-

When supply of land or any other factor is perfectly elastic, no economic rent arises or
earned. To illustrate the point, we suppose all blocks of land are homogeneous in all
respects. So, each block of land will have equal transfer earnings which means supply
curve will be straight line and horizontal to the ‘X’ axis ‘DD” is the demand curve. It cuts
supply curve at ‘E’ point. It means that at ‘E’ point demand for land and supply of land
become equal. ‘ON’ will be the equilibrium price. Since supply of land is perfectly
elastic, price ON and transfer earnings EM will be equal hence there is no rent paid to
any piece of land. This is depicted in the following diagram.

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 Here no rent is paid because transfer earnings and actual earnings are the same.
Hence, there is no difference between the two. That is why no rent is paid. Hence we
can conclude if supply of land or any other factor is perfectly elastic no rent is paid.

6.7.8 CONCEPT OF QUASI – RENT :

It was Dr. Marshall who introduced this concept in economic theory. It is Just expansion
of Ricardian concept of rent to the short run earnings of the capital equipments or
factors of production whose supply is perfectly inelastic (e=0) in short run. It is
therefore quasi-rent is essentially a short run phenomenon. Earnings of specialized
capital equipments depends upon the demand conditions and thus similar to rent of
land. However, supply of fixed capital assets is not perfectly inelastic in long run like
land. Therefore, Dr. Marshall instead of calling this earnings as economic rent called it
as quasi-rent. Quasi rent refers to an excess earnings of any factor of production over
and above its marginal productivity. It is temporary surplus earned by such capital
assets in the short run.

Quasi-rent arises because specialized equipments like machinery has no alternative

use. So its supply is limited in short run. Its transfer earnings will be zero since it has no
alternative use in short run. So entire earnings of such factors will be the surplus since
its transfer earnings of such factors will be the surplus since its transfer earnings is zero.
There may be some maintenance cost to keep it in running conditions. It can be defined
as the short run earnings of a fixed factor or capital assets minus the short run cost of
keeping it in running condition. Supply of capital assets is fixed in short run but not in
long run. That is why this surplus vanishes in long run as supply of fixed factor gets
increased to match increased demand for it. This makes the quasi-rent disappear.
Quasi-rent is also defined as the excess of total revenue earned in the short run over
and above the total variable costs of production.

6.8 WAGES

Introduction :- The term wage has a broad connotation it includes pay, salary,
emoluments, fees, commissions, bonus etc. In other words, it includes all types of
income earned by labour as a factor of production. The term wage may refer to piece-
wage, time wage, money wage, real wage and piece wage. It may be paid per hour, per
day, per week and per month or annum.

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 6.8.1 NOMINAL WAGES & REAL WAGES :

Nominal Wages means money wages. It refers to total amount of money paid to labour
as its price for its service in the process of production. So nominal wages are measured
in terms of money while real wages refer to the amount of purchasing power received
by a labour through his money wages. It refers to the net advantages of labourer’s
remuneration. It means the amount of necessaries, comforts and luxuries of life which
a labour can enjoy in return for his services through his money wages.
It is the real wages which determine the standard of living of the people. Real wages
depend upon the money wages and the general price level. Thus it is stated as

Real wages = Money Wages

Price level

6.8.2 DETERMINANTS OF REAL WAGES :

(1) Price Level :- The Purchasing power of money determines the real wages. But
purchasing power of money depends upon the general Price level in the
economy. The purchasing power refers to amount of goods and services which
a unit of money can buy. There is inverse relationship between general price
level and purchasing power of money. When general price level rises, the
purchasing power falls and vice-versa.
(2) Working Conditions :- The working conditions also determines the real wages. It
includes, number of hours of work put in and number of days worked per years;
educational and recreational and other facilities made available to the labour. If
a worker works in a poorly ventilated, hot and unhealthy surroundings, he
would be dissatisfied and his estimation of real wages would definitely be low.
This brings home that payment of high money wages alone would not raise real
wages.
(3) Trade Expenses :- Jobs requiring high trade expenses tend to reduce real wages.
Doctors, lawyers, C.A. etc need high trade expenses and therefore estimation of
their real wages would be very low.
(4) Incidental Benefits :- There are some jobs in which money wages are low but
other benefits like free lodging and boarding, subsidized canteen facilities, free
transport and free medical treatment etc raise the real wages.
(5) Possibility of Extra-Earnings :- In certain areas, workers may have a plenty of
scope to under take other lucrative work along with their regular work. This
fetches them additional income. This tends to increase their real wages.

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 (6) Period and Cost of Training :- While estimating real wages, the period required
for completion of training and cost incurred on that training is also taken into
account. The longer the period and higher the cost, the lower would be the real
wages.
(7) Nature of Job :- If a Job is precarious or insecured , estimation of real wages in
such jobs would be much low. Estimation of real wages in all risky employment
is very low.
(8) Possibility of Promotion :- An allowance should be made for prospects of
success while estimating real wages. A labourer may be prepared to work on
low wages if he knows that there is a bright prospects of possible promotion in
future. Besides, social prestige attached to jobs, regularity of payment,
permanency of work and uncertainty etc are to be considered while calculating
real wages.

6.8.3 SUPPLY OF LABOUR :

Supply of labour depends upon size and composition of population, skills of workers
and their willingness to work. One must understand one thing and that is supply of
labour can not be adjusted to demand overnight. However advocates of the
subsistence theory of wages believed that the size of population depends upon wage
rate. But it is known fact that apart from wage-rate, size of population depends upon
social, cultural, religious and economic factors. But ability to work and willingness to
work are the most important factor in determining the supply of labour. However
willingness to work is influenced considerably by the wage-rate. Rise in wage rate has a
great effect on supply of labour. Changes in wage-rate has composite effect on supply
of labour that is some may offer more hours of work while others may contract and
women might withdraw and therefore it is said that rise in wage rate has negative
effect on supply of labour because of substitution effect. Workers may substitute more
leisure for work efforts.

That is why supply curve of the labour force slopes backward. It is generally held that
the total supply curve of labour rises up to a certain wage level and then it slopes
backward. The following diagram depicts the backward sloping supply curve of labour.
As the wage rate rises to OW, the total quantity of labour offered increases to OM
amount but beyond OW wage rate say OW’, the total quantity of labour supplied
instead of increasing contracts from OM to OM’.

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 But supply of labour to a particular firm or industry is elastic. If the wage rate is
increased, workers from other industries are attracted and supply will match the
increased demand, supply of labour also depends upon transfer earnings of workers.

Long run supply curve of labour is more elastic than short run supply curve. It is so
because to acquire skill of particular trade or occupation required some time to switch
over to other employments. That is why supply of labour is more elastic in long run
than in the short run.

6.8.4 WAGE DETERMINATION UNDER COMPETITIVE CONDITIONS :

Assuming that there are competitive conditions in both the markets that is labour as
well as commodity markets, we shall take up for discussion wage determination under
competitive conditions, under competitive conditions, wage rate would be determined
by the interaction between demand for labour and supply of labour. In other words,
wage rate is determined by the equilibrium between the demand for and supply of
labour. Demand for labour is governed by marginal revenue product (MRP). The
equilibrium wage rate would be equal to marginal revenue product of labour which is
also equal to average revenue product (ARP). Since there are Competitive conditions in
factors as well as product markets.

This brings home that under competitive conditions a firm would employ that much
amount of labour at which wage-rate would be equal to MRP of the last unit of labour
employed under competitive conditions wage rate would be equal to average revenue
product which is also equal to marginal revenue product. A rational entrepreneur
therefore goes on employing additional unit of labour up to that level at which wage
rate becomes equal to MRP of the last unit of labour employed.

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 In short run, firms can make profit or incur losses but in long run free entry and exit of
the firms will force every firm in the industry to pay wage rate equal to marginal
product of labour which is also equal to average revenue product . At this, the industry
will be earning normal profits Equilibrium position would be attained only when MRP
curve cuts average wage and marginal wage line from above and at this point of cutting
average revenue product curve will be tangent to the wage line (AW=MW). MRP curve
will intersect ARP curve at its highest point from above. At the point of equilibrium
MRP = MW = ARP =AW. When this equality is attained each and every firm in the
industry will be in equilibrium earning normal profits. The following diagram illustrates
the position.

6.8.5 BILATERAL MONOPOLY & WAGE DETERMINATION :

It is a market situation under which a single buyer faces a single seller of the same
commodity. When a single seller of labour and single buyer of it carry on transaction in
buying and selling of labour at an agreed wage-rate; it is called a bilateral monopoly.
There are two limits which could be reached by collective bargaining. They are the
upper and lower limit. The upper limit is set by the trade union of workers and a lower
limit is set by an employer or the employer’s association. However, the actual wage
rate is determined between these two limits. Relative bargaining strength of trade
union and employer’s association would determine whether the wage-rate is nearer to
upper or lower limit. It becomes difficult to predict at what rate the wage-rate is fixed
between these two limits. Therefore wage determination under bilateral monopoly
remains indeterminate. But definitely it would be fixed between the upper and lower
limit. The upper limit can not be higher than MRP of labour and lower limit set by
employers must be acceptable to the union. Thus the range of wage-rate would be
upper and lower limits in which actual wage rate is determined. If entrepreneurs try to
set wage-rate below the acceptable ware-rate to the union, it will ask its members to
go on strike and if wage-rate demanded by union is higher than MRP entrepreneurs
stop employing labour as it meant losses to them.

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 But the concept of lower limit is not clear. It is ambiguous but there would be a certain
minimum wage below which workers will refuse to work. Thus the wage-rate would be
fixed some where between these two limits namely the upper and lower limits as a
result of bargaining powers between the two parties. The distance between the upper
limit and the lower limit indicates the bargaining range within which the wage rate
would be actually set. One can not know exactly at what particular point the wage-rate
would be fixed within the bargaining range. That is why wage determination under
collective bargaining remains indeterminate.

6.8.6 EXPLOITATION OF LABOUR :

Under conditions of imperfections, labour is exploited. If imperfect conditions exist

either in product or factor market labour is exploited. If imperfect market exists in
product market, it is called monopolistic exploitation and in case of imperfections in
labour market, it is called monopolistic exploitation.

Prof (MRS) Joan Robinson defined exploitation of labour as the payment to the labour
less than its value of marginal product. The value of marginal product is equal to price
multiply by MRP of labour i.e. ARX MRP. In the works of Mrs. Robinson, “what is
actually meant by exploitation is usually, that the labour valued at its selling price.” This
means that exploitation of labour does not take place under competitive conditions in
both the markets. When there is imperfect competition in the product market, MR
differs from the price of the product (AR). That is why under such conditions of Market,
MRP of the factor differs from value of the marginal product.

(1) Value of Marginal Product = Marginal Product X Price i.e.

MPP X AR or Price
(2) Marginal Revenue Product = Marginal Product X Marginal Revenue
MPP X MR
Since under imperfect market, average revenue or price is always greater than marginal
revenue, the Value of marginal product (VMP) will be always greater than marginal
revenue product (MRP).
Thus,

(a) MRP = MP X MR
(b) VMP = MP X AR. Since under imperfect market price (AR) of the product is
greater than MR (AR > MR)

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 .
. . VMP > MRP.

But under perfect competition both VMP and MRP are equal since there is no
difference between AR and MR. Therefore, there would be no exploitation of labour
under perfect competition. The following diagram depicts the same. Since wage rate is
equal to MRP as well as VMP under perfect competition, there is no exploitation of
labour under perfect competition. The firm under consideration employs OQ quantity
of labour and pays each labourer wage equal to its MRP or VMP and so there is no
scope for exploitation of labour.

Now let us consider the situation where in there is monopoly in product market and
competition in labour market under such situation labour would be exploited. The
wage line would be perfectly elastic and horizontal to ‘X’ axis. But existence of
monopoly in product market means sloping down ward AR as well as MR curves. There
is a difference between the two. This means that every additional labourer adds more
to the total revenue than what he is paid i.e. he is paid less than what is due to him.
The following diagram depicts the phenomenon.

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 Because there is competition in the labour market wage line would be straight line
horizontal to X axis. But there is a difference between AR and MR and therefore, there
is a difference between VMP and MRP. So labour is exploited to the extent of RQ. It is
also said that exploitation of labour occurs when there are imperfections in labour
market even though there is perfect market in product market.

Imperfections in labour market means monopoly in labour market. In this case, supply
curve of labour (AW) is not perfectly elastic but it slopes down ward. It is for this reason
marginal wage curve would lie above the average wage. Under this situation also
labour is exploited because there is a difference between the value of marginal product
and the wage rate. Because, there is perfect competition in product market MRP and
VMP will be the same. The diagram below explains the situation.

The firm will attain its equilibrium when it equates marginal wage with the marginal
revenue product or the value of marginal product. OM, amount of labour is employed
and ‘OW’ wage is paid. But it is less than the value of marginal product. The value of
marginal product is greater than the wage. The wage-rate is less than the value of
marginal product by RQ amount and this is nothing but exploitation of labour. This kind
of exploitation of labour occurs because the supply curve of labour is not perfectly
elastic and that is why marginal wage line lies above the average wage line.

If imperfections exist in factors as well as product market i.e. it may be monopsony in

labour market and monopoly in product market. In such cases, labour would be doubly
exploited. The following diagram depicts the same.

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 The above diagram shows that labour is exploited to the extent of RQ. It could be split
up as RE monopolistic exploitation and EQ amount as monopolistic exploitation. This
explains why labour is doubly exploited. According to Prof. Pigon and Prof. Joan
Robinson perfect competition is an ideal situation. So, wage-rate determined under it
would be just and fair. Any change in this ware-rate will result in the exploitation of
labour.

However Prof. Chamberlin did not accept Prof. Pigou Robinson concept of exploitation
of labour and has supplied his own concept of exploitation of labour. According to him
all factors of production receive less than the value of their MPP under imperfect
market under conditions of imperfect competition in the product market MRP is always
less than price (AR).

If all factors are paid equal to the value of their marginal product then in that case total
payment to all factors exceed total revenue of the firm. Therefore, it becomes
impossible for a firm to pay all factors equal to their value of marginal product. He
holds the view that labour would be exploited only when he is paid less than his
marginal revenue product. Nevertheless exploitation of labour would be removed by
creating conditions of perfect completion in product market. The government can take
measures to remove imperfections from the product market. In case of monopolistic
exploitation, it can be removed by raising the wage rate through the activities of trade
unions and the government.

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 6.8.7 DIFFERENCES IN WAGES :

It is generally observed that all units of labour do not get same wage rate. Some get
higher while others get lower. Why this happens? Why can’t be there equal wage rate
for all ? Answers to these questions we find in following factors.
(1) Demand Conditions :- Demand for labour is derived demand. So if demand for
the product labour produces is greater, then demand for that kind of labour
would also be greater. This raises its wage-rate as in the short run it is the
demand for labour which plays dominant role in determining the wage rate. That
is why wage rate of such labour is very high.
(2) Non-monetary Factors :- Certain jobs enjoy non-monetary benefits which tend to
reduce wage rate. For example college teacher. He has to work only for 3 to 4
hours a day. Moreover he works comparatively in healthy and decent
atmosphere. In sharp contrast to this a medical practioner will have to work
round the clock. He has to work in unhealthy conditions and all the time in midst
of deadly diseases. Naturally remuneration received by a doctor is always more
than a college teacher. It is so doctor does not get non-monetary benefits like
that of college teacher.
(3) Imperfections In Labour Market :- Imperfections like immobility of labour, cost of
transporting, customs and traditions, social surroundings, climatic conditions, cost
of settling down else where etc. help a unit of labour to move from low paid job
to a high paid job.
(4) Non-Competing Groups :- There are certain trades which do not compete with
each other. Their scale of pay is determined by different principles. This is due to
differences in skills in these trades or professions. Therefore higher payment in
one trade does not lead to the movement of a unit of labour from low paid trade
to a high paid trade. Besides, it is not possible for a person to change his trade in
short run due to high skill. For instance, an engineer can not become a doctor or
lawyer in short run.
(5) Risk and uncertainty :- The higher the risk and uncertainty, the higher would be
payment. In other words, risk and uncertainty involved determines the level of
payment of labour.
(6) Specificity of labour :- If a Person does the same kind of job again and again, his
mobility is restricted. He becomes expert in that kind of job. He can not be then
transferred to any other job. Hence, this brings about the differences in wage-
rate.

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 (7) Customs And Traditions :- Customs and traditions also play a role in fixing fees
and remuneration in certain skilled professions like medicine and law. In these
profession rates of remuneration are based on old established practice and
traditions. So price of labour in these professions is not adjusted by competitive
forces.
(8) Artificial Restrictions :- Certain occupations and professions put some restrictions
on the entry in these professions on the pretex of maintaining high standard of
those professions. For example, Medical Council of India, Bar Councils etc.

6.8.8 COLLECTIVE BARGAINING :

In the past, it was believed that trade unions or collective bargaining could not raise the
wages of labour. They thought that trade unions were superfluous or ineffective in
bettering workers lot. According to them, it was futile undertaking. That is why almost
all the theories which attempted to explain what determines wage-rate neglected
collective bargaining altogether. The subsistence wage theory, the Iron Law of Wages.
The Residual claimant theory of wages and the marginal productivity theory. All these
theories considered that in long run wage-rate would remain equal to the subsistence
level. As per these theories, long run supply curve of labour (LRS) perfectly elastic at
subsistence wage rate. It implies that any attempt by trade unions to raise wages will
be useless. An increase in wage rate above subsistence wage-rate will lead to increase
in population and working force. This will bring down the wage-rate to level of
subsistence because supply of labour would exceed demand for labour. Secondly,
supply curve of labour being perfectly elastic, a change in demand for labour would not
alter the wage-rate. Even marginal productivity theory holds that there is no scope for
collective bargaining. Nevertheless, modern thinking holds that collective bargaining
plays a very important and positive role in bettering the conditions of working class.

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 6.8.9 COLLECTIVE BARGAINING & WAGE RATE

It is widely accepted that marginal productivity curve as the employer’s demand curve
for labour and wage-rate will be settled at the point where MRP will be equal to the
marginal wage. It was argued further that any attempt by trade union to raise wage
rate above MRP will lead to unemployment. This argument is rebutted by saying that
when wage rate goes up, the marginal productivity schedule will shift upward. The
higher wages make the labour force better off which increases their efficiency and it is
this increased efficiency which raises their marginal productivity. So, an increase in
wage-rate would not create unemployment. This is illustrated in the along side
diagram.

At OW wage-rate OM amount of labour is employed. Now we suppose that wage rate

raises to OW due to collecting bargaining by the train unions. If the MRP schedule
remains the same, MM’ amount employment is created. But, increased wage increases
the efficiency of labour, the MRP schedule would shift to NRP’ which would not create
unemployment. The diagram makes clear that the OW wage-rate same amount of
labour is employed. This brings us to the conclusion that a powerful trade union would
prove successful of raising wage-rate without creating any amount of unemployment.

However, one point is to be noted that in case of collective bargaining when the wage
rate is raised, the supply of labour might fall because supply curve of labour is
backward sloping. It means that as the wage-rage goes up, workers contract their
labour. Therefore, the higher wage-rage might create unemployment which would be
due to backward sloping supply curve and not due to collective bargaining. According
to Prof. Rothchild, “the imposition of higher wage-rate may lead initially to some
unemployment but then produce such a change in the determinants of the wage-
employment situation that the unemployment disappears and the higher wage rate
becomes an equilibrium wage rage”

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 6.8 INTEREST

6.8.1 INTRODUCTION
Capital is a man made factor of production. That is why it is considered to be secondary
factor of production. The term capital is defined as “all those instruments of production
which are deliberately made by man to undertake production of goods and services. It
is also called as “Produced means of Production”. Capital is the only factor of
production over which man has a complete control in production. Capital goods have a
complete control in production. Capital goods have a long life and therefore the time of
expenditure and expected receipts from them will have to be carefully predicted in
making decision of creation of them. This makes the problem all the more difficult and
complicated.

Interest is defined as reward paid to the capital for having used its services in
production of goods and services. According to Alfred Marshall. “Interest is nothing but
the price paid for the use of capital in the market.” J.M. Keynes defines, “Interest as the
premium which has to be offered to induce people to hold their wealth in some other
than hoarding.”

Distinction is always made between gross interest and net interest. The total income
received by owner of capital is called gross interest. It includes payment of the loan and
capital, payment to cover risks of loss, payment for the inconvenience of investment
and the last payment for administrative work and worry involved in the process
whereas net interest is a payment for the loan of capital when no rise no inconvenience
and no administrative work is involved. It is a pure income to capital owner. Dr.
Marshall holds, “Net interest is the reward for waiting while gross interest includes
some insurance against risk and the cost of management.”

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 Natural rate of interest refers to that rate of interest at which demand for saving and
the supply of savings are in equilibrium whereas market rate of interest corresponds to
this equilibrium rate of interest. If market rate of interest tends to be higher than
natural rate of interest, supply of savings will exceed the demand for savings at that
rate of interest. This will bring down market rate of interest. Likewise if market rate of
interest tends to be lower than the natural rate of interest, demand for saving would
exceed supply of savings taking market rate of interest upto the level of natural rate of
interest. This shows that there are remote chances of market rate of interest differing
from natural rate interest. However, price stability could guarantee identify between
natural rate and the market rate of interest.

The time preference theory of interest was presented by many economists. Those who
supply capital abstain from current consumption. That’s why interest is regarded as a
compensation for this abstinence. Since lending involves waiting on the part of people,
interest should be paid to induce to wait and delay their consumption until the time
investment becomes fruitful. Normally people prefer present consumption to future
consumption. Secondly, future is always uncertain and thirdly, good in present
command a technical superiority over goods in future, according to senior”, Interest is
the price paid for the use of capital and this price depends upon the forces of demand
for and supply of capital:

6.8.2 THE CLASSICAL THEROY OF INTEREST

The classical economists held MRP of capital as the interest. Rate of interest is the rate
of return over investment in physical capital. It is the role of waiting or time preference.
In determination of interest is more important than anything else. But some economist
held productivity of capital more important. Prof. Fisher and Prof. Bohm Bawerk held
that the determination of rate of interest in terms of demand for and supply of
investible funds. However, classical economists stressed the time preference and
marginal productivity which are called the real factors of determination of rate of
interest. That’s why the classical theory is called as the real theory of rate of interest.
Neo-classical economists developed a new theory called as the Loanable Funds or Neo-
Classical theory of interest. According to them monetary as well as non-monetary
factors determine the rate of interest. But J.M. Keynes holds phenomenon and rate of
interest is determined by the forces of demand for money which he called as liquidity
preference and the forces of supply of money. Interest is the price of parting with
liquidity. All theories which attempt to explain the phenomenon of rate of interest
either take demand side into consideration or supply side.

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 A theory of interest has to answer (1) why is interest paid? And (2) how is the rate of
interest determined? Since capital is one of the factors of production, its price is also
governed by its marginal productivity. But MRP of capital is very difficult to ascertain
because capital has long life. It yields incomes for years. But future is uncertain. People
prefer present to future. Because of number of uncertainties, entrepreneur will have to
take into consideration, all those uncertainties of the future and estimate prospective
yields from capital investment after deducting depreciation charges.

6.8.3 DEMAND FOR CAPITAL

Demand for capital comes from entrepreneurs to be used for production of goods and
services. Since capital is productive, it earns series of income. Therefore, interest is to
be paid to those who supply capital. The price of capital is governed by its MRP. The
higher the MRP, the higher would be the rate of interest offered by entrepreneurs and
vice-versa. As long as MRP of capital exceeds the rate of interest, demand for capital
would continue and would come to an end at that point at which both rate become
equal. A rational entrepreneur will go on demanding capital assets with the borrowed
funds as long as expected net returns from the capital asset would be equal to the price
he pays for the borrowed funds. In other words, it would be the rate of interest paid to
the people for surrendering their liquidity. Investment in capital assets would be worth
while till the rate of interest equates with the prospective rate of return from the
capital asset and at this point of equilibrium investment in capital assets will come to
an end. If the entrepreneur continues to investment beyond equilibrium point, he
would incur losses; the rate of interest being higher than the prospective rate of return.
Since MRP schedule slopes downwards, it would be profitable for an entrepreneur to
purchase more units of capital provided the rate of interest falls. Since rate of interest
is expressed in terms of percentage, both marginal efficiency of capital and rate of
interest schedules follow the same course. But they do not depend upon each other.
They are independent and not interdependent classical economists held the view that
investment demand is interest elastic.

MRP schedule of capital and rate of interest schedule slope downwards from left to
right indicating thereby more will be invested if the rate of interest comes down and as
more and more units of capital are demanded for investment, the return from each
marginal unit of capital goes on falling. So more will be invested if the rate of interest
falls and also MRP of capital declines as more and more units of capital are demanded
for investment. The following diagram shows the MRP schedule of capital.

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 It falls from left to right. ‘OR’ is the market rate of interest. At this rate of interest OM
amount of investment is undertaken. The curve MRP depicts the falling marginal net
expectations as more and more investment is undertaken. Here one must note that
rate of interest becomes equal to MRP of the capital. Now let us suppose that rate of
interest falls from OR to OR 1. This will make further investment more profitable.
Therefore MM1 additional fresh investment is undertaken to equalise MRP with new
rate of interest. It is therefore concluded that investment demand slopes downward
from left to right with a change in rate of interest.

6.8.4 SUPPLY OF CAPITAL

Capital is productive and hence capital owner is required to pay some income to make
it available for producing goods and services. To make people to surrender their savings
or investible funds, they must be offered something and that is rate of interest. The
suppliers of capital prefer present consumption to future consumption. When they lend
their investible funds, they would have to postpone their present consumption of
goods and services. This involves a sacrifice on the part of lenders. Interest is the
reward for this sacrifice or waiting. The investible funds come from general public. They
supply these funds out of their savings. Therefore, savings schedule slopes upward
from left to right indicating the direct relationship between rate of interest and supply
of funds. Thus according to the classicists savings is interest elastic or s = f (r). It means
that it is a function of rate of interest.

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 6.8.5 DETERMINATION OF EQUILIBRIUM RATE OF INTEREST

The classical economists held that interaction between demand for and supply of
investible funds determines the equilibrium rate of interest. According to classical
economists savings is interest elastic. If the demand for investible funds exceeds supply
of investible funds, the rate of interest would shoot up and vice – versa.
The classical economists held to view that the rate of interest is equilibrium force
between demand for and supply of investible funds. This equilibrium rate of interest
demand for savings for investment. If saving exceeds demand for it, the rate of interest
would fall. This would result into a fall in rate of interest and reduction in supply of
savings. So, the rate of interest is the mechanism which brings two into equality. The
classical economists always held.

(1) S = f (r) (2) I = f (r)

where, ‘S’ stands for savings and ‘I’ stands for investment, ‘r’ for rate of interest & ‘f’
for function. So, Savings would be equal to investment always. Aggregate savings and
investment are treated to be flows; and secondly, it is the rate of interest that brings
about equality between the two. The following diagram depicts determination of rate
of interest. The diagram shows DD demand curve is nothing but MRP schedule of
capital.

‘DD’ demand schedule cuts supply schedule at ‘E’ point at ‘OM’ size (MRP) of
investment. Thus OR is the equilibrium rate of interest. If any change either in demand
for or supply of investible funds takes place, a new equilibrium rate of interest would
be established. Thus according to classical economists rate of interest is determined by
the interaction between demand for and supply of investible funds.

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 6.8.6 ASSUMPTIONS OF THE THEORY

1) Existence of full employment of natural resources.

2) Government policy of laissez-faire.
3) Long Run operation.
4) Existence of perfect competition
5) Savings and investment are the function of rate Interest S = f (r), I = f (r)
6) Accepting the marginal productivity theory as the base and rate of interest as a
mechanism which brings savings and investment into equality. The classical theory is
also called as real theory of rate of interest because it is based on real factors like
capital and abstinence form consumption neglecting totally monetary factors.

6.8.7 LIMITATIONS OF THE THEORY

1) Full Employment: The classical theory of rate of interest is based on full

employment. i.e. all natural resources are fully employed. But there can be
cyclical, frictional, voluntary or involuntary unemployment in the economy. So,
assumption is unrealistic.
2) Savings is not interest elastic: The classicists held that savings is the function of
rate of interest. But this is not correct. Saving is basically income elastic and
then interest elastic. It means that savings depends upon the level of national
income which classicists failed to recongnise.
3) Investment is not interest elastic: Though the classical economists held
investment also function of rate of Interest but it is not so. Investment is
primarily function of marginal efficiency of capital or prospective rate of return
over cost. Rate of interest on one side and marginal efficiency of capital on the
other determines the volume of investment in the economy. But classical
economists failed to consider this fact.
4) Monetary Forces Neglected: Another drawback of the theory is that they totally
neglected monetary forces such as bank money, hoardings etc. these factors
equally influence rate of interest. The classicist emphasized only real forces.
5) Rate of Interest Is A Weak Mechanism: The Classical economists held the view
that the equality between savings and investments is brought through rate of
interest. It is so because according to them both are interest elastic. But there
are many other forces which are equally important in bringing about equality
between the two.

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 Whatever may be the drawbacks of the classical theory, it can not be discarded
because it is based on real factors such as productivity, time preference, waiting,
sacrifice etc. Therefore, it is termed as real theory of rate of interest.
6)9.8 THE LOANABLE FUNDS THEROY OF RATE OF INTEREST
This theory of interest associated with the name of Neo-classical economists like
Wicksell, Marshall Robertson etc. This theory holds that rate of interest is determined
by the interaction between the demand for and supply of loanable funds. Not only real
factors but monetary factors also like bank money hoardings, disinvestment etc.
determine the equilibrium rate of interest. So, the loanable funds theory takes much
more broader view of demand for as well as supply of loanable funds.

6.9.9 SUPPLY OF LOANABLE FUNDS

Funds for investment come from four different sources which are as follows :
1) Savings (S) : Savings of general public as well as of institutions forms the major
source of supply of funds. It is interest elastic. The higher the rate of interest, the
greater would be volume of savings and vice-versa. Savings is defined as an excess of
income over consumption expenditure. It depends upon the level of income and the
prevailing rate of interest. Besides, industrial houses accumulates savings out of
undistributed profits and reserved funds. Since savings is interest elastic, saving
function slopes upward from left to right.
2) Dis-hoarding (DH): Hoardings means idle cash balances or money kept out of
circulation. If the rate of interest goes up, people dishoards their hoardings and make
funds available for investment. It is also interest elastic and therefore dishoarding curve
also slopes upward.
3) Bank Money (BM): The credit created by the banking system forms the another
source of loanable funds. The expansion or contraction of credit creation increases or
decreases the supply of funds for investment. The BM function also slopes upward.
4) Dis-investment (DI): Investments which do not remain attractive are liquidated and
funds are made available for fresh investment. Old investment is liquidated because
rate of return over cost is less than the current rate of interest. That is why old
investment is liquidated and funds are made available for new investment. So, the
supply of funds comes from savings, dishoardings, bank money, and dis-investment.

Thus, SL = S + DH + BN + DI

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 6.9.10 DEMAND FOR LOANABLE FUNDS

The demand for loanable funds come from investment, consumption and hoardings.
1) Investment Demand (I): Demand for funds mainly come from investors. The
businessmen borrow funds for the purpose of investment. It depends upon the rate of
interest. So long as the rate of profitability is higher than the current rate of interest,
funds will be demanded for investment. The moment the rate of profitability comes
down to the level of current ate of interest, further demand for funds would come to
an end. The higher the rate of interest, the lower would be the demand for funds for
investment and vice-versa.
2) Consumption Demand (CD): For buying durable goods such as vehicles, houses, air-
conditioners, refrigerators etc. people demand funds. They do so because their current
income may not be sufficient to buy these goods. Demand for funds for this purpose is
also interest elastic. That is why CD function slopes downwards from left to right.
3) Hoardings (H): When people decide to maintain high liquidity when rate of interest
is very low, they demand funds simply for hoardings. In other words they keep funds
idle without making any investment. But at high rate of interest they dishoard it. So the
rate of interest and demand for funds are inversely related.
Thus total demand for funds (DL) = I + CD + H

6.9.11 DETERMINITATION RATE OF INTEREST

The equilibrium rate of interest is determined by the equality between the total
demand for and supply of funds. This equality is reached at the point of intersection
between total supply of funds and total demand for funds. Thus SL and DL curves
intersect at each other at ‘E’ point at which equilibrium rate of interest is determined
as OR and funds demanded supplied are OM. This implies that any other rate of
interest will bring disequilibrium between the SL and DL. The following diagram depicts
the equilibrium rate of interest.

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 LIMITATIONS

1) No clarity about the concept of hoardings.

2) The theory is indeterminate, in the sense that what determines what is not
made clear.
3) National Income never remains constant. It always fluctuates which the
theorists failed to recognize/
4) The assumption of full employment is not true.
5) Saving-Investment are not only interest elastic. They depend upon income and
marginal efficiency of capital.
6) The theory is synthesis of the real theory and liquidity preference theory.
7) It is also states to be static whereas our world is dynamic. We can not solve the
problems of dynamic world with static tools.

6.10 PROFITS

6.10.1 INTRODUCTION

Profit is regarded as the reward for entrepreneur. An entrepreneur means undertaker;

one who undertakes the task of producing goods and services. He hires the services of
factors of production. He also co-ordinates their services to complete the process of
production. In the past, the owner of a business was considered entrepreneur. But in
modern times business enterprises have not remained one man enterprise. Therefore,
it has become more difficult to conceive the proper and clear cut meaning of the term
entrepreneur.
There is a controversy over the meaning and functions of entrepreneur.
Entrepreneurial work is regarded as special type of labour. His job is to hire, combine
and co-ordinate the factors of production. In order to complete the process of
production. All are expected to lead to maximum profit. One point to be noted that all
other factors are hired but entrepreneur can not be hired. The entrepreneur is paid
profit as his reward. However, it is considered as non-contractual income. It is the left
over income. So, profit can be positive as well as negative. But in case of other factors,
their rewards would always be positive. Net profits are calculated after having
deducted imputed values of the land and capital owned by the entrepreneur himself.
He must also deduct the value of his services rendered to the production. There is also
a difference between profit and profits. Profits are those which an entrepreneur hopes
to earn in near future while profit is one which already earned.

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 6.10.2 GROSS PROFIT & NET PROFIT

Gross profit refers to the total income received by an entrepreneur after having
deducted total explicit cost from total earning. Total explicit cost includes all the money
expenditure incurred by a business man to produce a commodity or a service payment
made to outside parties whereas Net profit or pure profit refers to the total revenue
minus total cost inclusive of implicit cost. Gross profit includes, wages, rent and interest
and this imputed value while net profit is a left over income after having made all
contractual and non-contractual payments. it is quite possible, therefore that net profit
may be either positive or negative. It would be positive when total revenue exceeds
total costs including implicit costs. It would be negative when total cost exceed total
revenue. If all the factors of production are paid equal to their MRPs, then that case,
there would not be any net profit. Except perfect competition, there would be always
left over income which goes to entrepreneur.

6.10.3 NORMAL PROFIT

Normal profit can be defined as the minimum profits which entrepreneur must earn to
make him remain or continue in the same business. In other words, it is the transfer
earnings of the entrepreneur. If he fails to get the minimum expected profit in the
existing business, he would transfer his services to some other lucrative business.
Normal profit is treated as a part of total cost. It is regarded as the return for
entrepreneur for managing and bearing uncertainly of the business. While abnormal
profit or excess profit refers to any surplus over and above normal profit. It is residue
surplus which can be referred as rent of ability. Earning of excess profit is not necessary
for continuance of the business.

6.10.4 FUNCTIONS OF ENTREPRENEUR

Profit is closely related with functions of entrepreneur. It is the entrepreneur who hires
the services of other factors of production and pays them fixed contractual
remuneration to them but entrepreneur himself is not employed by any one and is not
paid a fixed salary. Entrepreneurship includes all those productive functions which are
not rewarded in the form of rent, wages and interest. It is a residual income which he
earns for performing special functions.

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 1) ORIGINATING : The entrepreneur introduces new products, new techniques or
processes of production and explores the new opportunities of earning profits.
2) RISK BEARING: It is the entrepreneur who shoulders the entire risk of the business.
He bears all risk because he is the originator and executor of the business.
3) CO-ORDINATING: It is he who hires and employs the services of other factors of
production. He combines and co-ordinates the work of other factors of production so
that production is made possible and goods and services are produced.

6.10.5 PROFITS & UNCERTAINTY

Before production is undertaken, an entrepreneur has to make various decisions on

certain figures of cost and revenue. If his calculations regarding costs and revenue
come true, he will certainly make profits. But these calculations go wrong, he will incur
losses and these calculations vary from entrepreneur to entrepreneur. Therefore, these
estimates regarding costs and revenue are subjective. But if these calculations are not
known then in that case everything becomes uncertain. Therefore, whether he would
earn profits or incur losses, all depends upon his expectations, calculations and guesses.
And if these all come true, he will definitely make profits but unfortunately if these go
wrong, he would incur losses. So, there is a great amount of uncertainty in these
calculations with uncertainty. That is the reason why profits are associated with
uncertainty. However, one thing must be noted that if the world is static, there would
be no uncertainty and so scope for losses. But things may not shape as we want them
to be. That’s why there is uncertainty which gives rise to risk in business. Dr. H.L. Ahuja
holds, “Profits arise due to disequilibrium caused by the changes in demand and supply
conditions.”

6.10.6 RISK & UNCERTAINTY

As other factors of production namely land, labour and capital have their MRP
schedules, in the same manner entrepreneur also has his MRP schedule. It means that
he is also productive like all factors of production. The risks which entrepreneur
shoulders can be insurable and non-insurable. This distinction is of great importance.
There are number of risks and uncertainties that the entrepreneur is confronted with
besides the risk of losing his money invested in the business. These risks take place
partly due to his misjudging the market movements and partly due to natural
uncertainties. The risks like fire, theft, death, earthquakes can be insured against. So
over such risks entrepreneur is not to worry. He has to shoulder those risks which can
not be insured against.

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 These risks are connected with his business decisions about what to produce? Where
to produce? When to produce? Which technique to follow? Etc. predictions regarding
demand conditions are very difficult. These predictions may come true or may go
wrong. Therefore, it is impossible for any insurance company to ensure such risks and
uncertainties. If an entrepreneur uses his own capital, land and his own labour he is
entitled to rent, wages and interest. Such payments are called as imputed values.

6.10.7 PROFIT AS A DYNAMIC SURPLUS

J.B. Clarke developed this theory of profit. He holds that profits are a dynamic surplus.
In a static economy where there are no changes in conditions of demand and supply,
remuneration paid to the factors of production on the basis of their MRP would
exhaust the total revenue and hence no profit would occur to the entrepreneur. Profit
results when total revenue is in the excess of total cost of production.

In a competitive market, in the long run price equals average cost (AR = AC) and no
profit. Profits arise due to disequilibrium caused by the changes in demand and supply
conditions and therefore there would be no profit since both demand and supply
forces balance each other. The size and composition of population, incomes, tastes and
preferences, existence of substitutes, changes in government, economic and fiscal
policies bring about change in demand conditions. Similarly, introduction of a new
commodity or a new technique or a process of production or a new method of selling
or a change in supply which cause disequilibrium leading to profit. But in a static
economy demand and supply are taken to be constant hence cost and price do not
change and so no profit.

But in reality, everything is subject to changes or uncertainty. Nothing can be

anticipated before hand. A dynamic economy is one in which demand and supply
conditions undergo change constantly. These changes lead to profit or losses. Thus,
disequilibrium between demand and supply causes profit or losses. Like internal
changes, there are external changes which affect entire manufacturing units in the
economy. These changes are, war, inflation and depression, change in monetary and
fiscal policies, change in the technique of production, change in spending habits of the
people and lastly statutory changes. These changes either bring changes in demand or
supply conditions resulting into disequilibrium leading to either profits or losses.

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 6.10.8 LIMITATION OF THE THEORY

1) According to F.H. Knight, dynamic surplus theory does not make any difference
between a foreseen changes and unforeseen changes. Certain changes can be
predicted in advance. The moment this aspect we take into account, the entire clarkian
thesis based upon the effects of changes falls flat on the ground. Thus, it is not change
as such but uncertainty about this change that gives rise to profit. Uncertainty is the
permanent feature of economic system.
2) The theory ignores completely the role of uncertainty in making profit. He also
rejects the view that profits are nothing but the reward for shouldering risk of the
business. Risk and uncertainty exist in entrepreneurial function. The one can not exist
without other. Therefore, the theory is one sided.
3) Clark’s concept of profit as a dynamic surplus is worked out in the context of static
background and is too mechanical. Nothing is static in the world. Hence, the role of
uncertainty creeps into it. Thus Clark overlooks the active role played by uncertainty
and expectations in shaping the course of things. In the words of professors Stonier and
Hange “In an economy where nothing changes, there can be no profits.” There is no
uncertainty about the future, so there are not risks and no profits.”

6.10.9 INNOVATION THEORY OF PROFIT

It was Joseph Schumpeter who developed the innovation theory of profit. Innovation is
an important factor responsible for the occurrence of profit to the entrepreneur.
According to Schumpeter the main function of the entrepreneur is to introduce
innovations in the economy and profits are reward for performing this function.
Schumpeter held that innovations are not only the cause of profits but also the root
cause of economic fluctuation. He explained the phenomenon of trade cycles in terms
of innovation and the behavior of entrepreneurs. The term innovation is not the same
as invention. Innovation has wider meaning. Any new measure or technique or policy
introduced by an entrepreneur to reduce the costs of production or to increase the
demand for his product is an innovation. So, innovations can be put into two categories
namely cost saving or demand boosting. In either case profit is made.

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 Cost saving innovations do change the production function. These innovations are
introduction of a new machinery, new and cheaper technique or process of production,
exploitation of a new source of raw materials and better method of organizing the
business, etc. The second category innovations are the measures which increase the
demand for the product and these measures alter the utility function. They include
introduction of new product, a new design of product, a new and superior method of
advertisement or discovery of new market etc. If the introduction of an innovation
proves worthwhile or successful in reducing either cost or raising demand for the
product, it would generate profit. One who introduces innovation first will reap the
maximum profit. But later on others will imitate the pioneer entrepreneur and the
profit margin will start declining due to keen competition from other entrepreneurs.

Introduction of innovation which gives rise to profits are temporary. Profits are earned
till the effects of innovation remain. Once that innovation is completely exploited, the
cost of production starts rising and profits come to zero. Economic activity comes to an
end. But if any other entrepreneur introduces a new innovation at the time when the
desirable effects of previous innovation are dying out, he would be monopolist for new
innovation is confined to him. So, he makes profits. Others may try to imitate him but
take some time and during this period the pioneer entrepreneur makes profits. When
others succeed to imitate him, excess profits would be competed out by imitators until
another innovation emergences. It must be noted that innovations appear in cluster i.e.
one after the other and take economic system to its climax. It is so because in a
competitive and progressive economy true and rational entrepreneurs are always after
the new method of production or technique or any device that reduces the cost of
production. Therefore as long as innovations exist, profits continue to emerge out of
them.

LIMITATIONS OF THE THEORY

1) Role of uncertainty is not analysed. He gave all importance to innovation without
considering the role of risk and uncertainty.
2) Joseph Schumpeter denies the much accepted contention that the entrepreneur is
the risk bearer. He says “The entrepreneur is never risk bearer. The one who gives
credit comes to grief if the undertakings fails.” But this is not a correct view. Ultimately
the entire responsibility of business lies on one who makes all the production decisions.
These decisions may go wrong and hence one who makes wrong decisions will have to
face losses. Even introduction of innovation may be wrong time but it may prove
successful who knows? This means uncertainty and risk of making such decisions.

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 6.10.10. PROFIT AS A REWARD FOR RISK BEARING

This theory is developed by Hawley. According to him risk bearing is the main function
of the entrepreneur and this results into profit. Before undertaking any business, the
entrepreneur expects to earn a certain mount of profit because the business involves
some element of risk. The higher the risk, the greater would be the gain. If the gain is
not a proportion to the risk, no entrepreneur would undertake that business. Therefore
to start any business, the entrepreneur is required to be rewarded sufficiently. Thus risk
bearing is an essential function of entrepreneur and therefore is the basis of profits.

LIMITATIONS OF THE THEORY

1) Firstly profits arise because of the reduction of risk in the business by above and
efficient entrepreneur and not by merely shouldering risk.
2) Secondly, it is not true to hold that every risk leads to profits. Some risks can be
insured against whereas others can not. Risks of making production decisions
can not be insured against. It is only these risks which are responsible for
occurrence of profits.

In conclusion, we can add that the root cause of profits is innovation. Profits are the
necessary incentives for entrepreneurs to undertake economic development of the
country. Since innovations generate profits, profits are incentive to introduce
innovations. So both are there as cause and consequences of each other. Both are
required to take up economic system of the country to the level of full employment.

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 Exercise

1. Explain the marginal productivity theory of distribution with special

reference to marginal revenue productivity.
2. What are the conditions of equilibrium of an industry? What are the
assumptions behind it and what are the limitations thereof.
3. Explain the Ricardian concept of “rent” and the assumptions on which it
rests.
4. What is the modern theory of rent? How elasticity of supply of land affect
it? Explain quasi-rent.
5. Distinguish between nominal wage and real wage. How wage is determined
under competitive conditions.
6. Discuss the effect of collective bargaining on wage rate.
7. What is meant by ‘interest’? What determines the equilibrium rate of
interest? Explain with diagram.
8. Explain the theory of profit as a reward for risk bearing. What are the
limitations of the theory?

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 MACROECONOMICS

INRODUCTION

The weightage of utility arising out of consumption is recorded through money. Such
utility arising out of consumption is referable to commodity which means goods as well
as services. The immediate effect of demand and supply of a commodity is recordable
as price and ultimate effect is the value. The aspect of pricing had been our subject
matter of microeconomics. We are concerned with valuation which goes beyond
pricing and analysis the forces as well as the factors that go to determine the ultimate
effect, determining value.

In pricing, we are concerned with behaviuor of demand schedule and supply schedule
under different market conditions – perfect, imperfect and monopoly. In valuation, we
have to take into account various other forces which are deeply laden in
macroeconomics that means monetary polices, distribution of national income, price
level and inflation, demographic patterns, changes in consumer behiviour, rate of
saving and investment, parallel economy, etc., which lie within the domain of
macroeconomics. That is how the study of macroeconomics assumes extreme
importance in the context of valuation.

The goals of macroeconomic policy are:

1. A high and growing level of national output (i.e., of real GDP)

2. High employment with low unemployment
3. A stable or gently rising price level

The Tools of Macroeconomic Policy

Governments have certain instruments that they can use to affect macroeconomic
activity. A policy instrument is an economic variable under the control of government
that can affect one or more of the macroeconomic goals. That is, by changing mone-
tary, fiscal, and other policies, governments can avoid the worst excesses of the
business cycle and can increase the growth rate of potential output.

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 Fiscal Policy. Begin with fiscal policy, which denotes the use of taxes and government
expenditures. Government expenditures come in two distinct forms. First there are
government purchases. These comprise spending on goods and services-purchases of
tanks, construction of roads, salaries for judges, and so forth. In addition, there are
government transfer payments, which boost the incomes of targeted groups such as
the elderly or the unemployed. Government spending determines the relative size of
the public and private sectors, that is, how much of our GDP is consumed collectively
rather than privately. From a macroeconomic perspective, government expenditures
also affect the overall level of spending in the economy and thereby influence the level
of GDP.

The other part of fiscal policy, taxation, affects the overall economy in two ways. To
begin with, taxes affect people's incomes. By leaving households with more or less
disposable or spendable income, taxes tend to affect the amount people spend on
goods and services as well as the amount of private saving. Private consumption and
saving have important effects on output and investment in the short and long run.

In addition, taxes affect the prices of goods and factors of production and thereby
affect incentives and behaviour. For example, the more heavily business profits are
taxed; the more businesses are discouraged from investing in new capital goods. From
1962 until 1986, the United States employed all investment tax credit, which was a
rebate to businesses that buy capital goods, as a way of stimulating investment and
boosting economic growth. Many provisions of the tax code have an important effect
on economic activity through their effect on the incentives to work and to save.

Monetary Policy. The second major instrument of macroeconomic policy is monetary

policy, which government conducts through the management of the nation's money,
credit, and banking system. You may have read how our central bank, the Federal
Reserve System, operates to regulate the money supply. But what exactly is the money
supply? Money consists of the means of exchange or method of payment. Today,
people use currency and checking accounts to pay their bills. By engaging in central-
bank operations, the Federal Reserve can regulate the amount of money available to
the economy.

How does such a minor thing as the money supply have such a large impact on
macroeconomic activity? By changing the money supply, the Federal Reserve can
influence many financial and economic variables, such as interest rates, stock prices,
housing prices, and foreign exchange rates.
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 Restricting the money supply leads to higher interest rates and reduced investment,
which, in turn, causes a decline in GDP and lower inflation. If the central bank is faced
with a business downturn, it can increase the money supply and lower interest rates to
stimulate economic activity.

The exact nature of monetary policy-the way in which the central bank controls the
money supply and the relationships among money, output, and inflation-is one of the
most fascinating, important and controversial areas of macroeconomics.

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 UNIT – VII
NATIONAL INCOME

7.1 CONCEPT OF NATIONAL INCOME

.
The total income of the nation is called "national income." The aggregate economic
performance of the whole economy is measured by the national income data. In fact,
national income data provide a summary statement of a country's aggregate economic
activity.

In real terms, national income is the flow of goods and services produced in an
economy in a particular period - a year.

Modern economy is a money economy. Thus, national income of the country is

expressed in money terms. A National Sample Survey has, therefore, defined national
income as: "money measures of the net aggregates of all commodities and services
accruing to the inhabitants of a community during a specific period."

More elaborately, however, we may say that national Income is a money measure of
value of net aggregate of goods and services becoming available annually to the nation
as a result of the economic activities of the community at large, consisting of
households or individuals, business firms, and social and political institutions.

An important point about national income is that it is always expressed with reference
to a time interval. It is meaningless to speak of the income of an individual without
mentioning the period over which it is earned, say per week, per month, or per year.
Similarly, it is meaningless to talk of national income without mentioning the period
over which it is generated. This is because national income is a flow and not a stock i.e.,
income is generated every year, and at different rates and, therefore, it is necessary to
mention the period during which that income is generated. National income is usually
measured and shown with reference to a year or as annual flow; it is, thus, an amount
of total production per unit of time.

Like many other terms in common use, the concept "national income" has various
connotations. For instance, national income is variously described. Sometimes it is
known as "national income" at other times, "national product", or "national dividend."
As a matter of fact, all these terms mean one and the same thing.

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 In national income accounting, thus, the concept of national income has been
interpreted in three ways, as: (1) National Product, (2) National Dividend, (3) National
Expenditure.

National Product
It consists of all the goods and services produced by the community and exchanged for
money during a year. It does not include goods and services, which are not paid for,
such as hobbies, housewives' services, charitable work, etc.

National Dividend
It consists of all the incomes, in cash and kind, accruing to the factors of production in
the course of generating the national product. It represents the total of income flow
which will exactly equal the value of the national product turned out by the community
during the year.

National Expenditure
This represents the total spending or outlay of the community on the goods and
services (of all types, capital as well as consumption) produced during a given year.
Since income is the source of expenditure, national expenditure constitutes the
disposal of national income, which is evidently equal to it in value or in other words,
National Expenditure equals National Income.

Indeed, one man's income is another man's expenditure. When a person buys milk, it is
his expenditure, but this very expenditure is the milkman's income. When the milkman
spends part of this income in buying sugar, it becomes income for the sugar merchant
and so on. In a sense, therefore, the sum of expenditure of all agents of production is
equal to the total income received by the factors of production during that year.
National Income can, therefore, be also defined as a sum of the expenditure on
producer goods; consumer goods and services of agents of all production.

In fact, there is a fundamental equality between the total income of the community
and its total expenditure, as one's expenditure becomes another's income in the
economy. Hence, there is a large circular flow established in which each expenditure,
creates an income, which in its turn is spent and creates other incomes. Therefore, this
total national income will be equal to the total national expenditure.
Briefly, thus, the identity of the three factors of the flow of national income may be
expressed as follows:
National Expenditure = National Product = National Income or Dividend

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 When we analyse, the above three concepts, we find that national income is nothing
but “the total flow of wealth produced, distributed and consumed." National income is
not a stock but it is a flow. It is not that the income is first earned and then gradually
spent or distributed, or alternatively, it is not that the expenditure first takes place and
then an income is earned. As a matter of fact, the process of income creation and
income distribution goes on at one and the same time.

There are, thus, three alternative definitions of national income. The first definition is
that it is the money value of goods and services produced by agents of production
during the course of a year. We might call this "total production approach.”

The second definition is that it is the sum of incomes of agents of production, profits of
public enterprises, income from government companies. This we might describe as
"income approach."

The third definition is that national income is the sum of total expenditure of agents of
production. We might call it "Total expenditure approach.”

Corresponding to these approaches, we observe that national income has been defined
in three ways in the publications of the United Nations:

(a) "Net National Product" as the aggregate of the net value added in all branches
of economic activity during a specified period, together with the net income
from abroad.

(b) "Sum of the distributive shares" as the aggregate of income accrued to the
factors of production in a specific period, these payments taking the shape of
wages, profits, interest, rent etc.

(c) "Net national expenditure" as the sum of expenditure on final, consumption of

goods and services, plus domestic and foreign investment.

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 Incidentally, Keynes has suggested three approaches to national income, which are
more suitable and practicable in the microanalysis of income and employinent, as
follows:

1. Income-expenditure approach: in which total expenditure on consumption

and investment goods constitute total income.
2. Factor-income approach: in which national income is measured as the
aggregate of incomes received by all the factors of production.
Keynes wrote: Y = F + Ep where, Y stands for national income, F stands for
payments received by land, labour and capital owners, and Ep refers to
entrepreneurial profits.
3. Sales proceeds minus cost approach: in which Keynes considered that
national income is based on aggregate sales minus cost.

In fact, Keynesian analysis has revolutionized thinking of the national income analysis.
Prior to Keynes's General Theory, national income data were not collected officially
from the economic analysis point of view. Keynes developed a theory which showed
how consumption and investment expenditure can affect the national income flow.
From the Keynesian analysis, modern concepts of national income has been evolved
which are more dynamic in content.

Modern economists consider national income as a flow in three forms: income, output
and expenditure. When goods are produced by the firms, factors of production
comprising households are paid income, these income receipts are spent by the
household sector on consumption and their savings are mobilised by the producers for
investment spending. Likewise, a circular flow is constituted between income and
expenditure. Obviously, income, output, and expenditure flows are always equal per
unit of time. There is, thus, a triple identity:
Output = Income = Expenditure

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 7.2 Concepts Associated with National Income Total

7.2.1 Gross National Product (GNP)

In calculating national income, we add up all the goods and services produced in a
country. Such a total represents the gross value of final products turned out by the
whole economy in a year, which is technically called Gross National Product. The word
"gross" indicates the inclusion of the provision for the consumption of capital assets,
i.e., depreciation or replacement allowances.

GNP, thus, may be defined as the aggregate market value of all final goods and services
produced during a given year. The concept of final goods and services stands for
finished goods and services, ready for consumption of households and firms, and
exclude raw materials, semi-finished goods and such other intermediary products.
More specifically, all sales to households, business investment expenditures, and all
government expenditures are treated as final products: But, intermediary goods
purchased by business firms are obviously regarded as final goods. For example, when
a textile mill purchases a machine or showroom, it is regarded as final goods, but when
it buys cotton, it is not regarded as final goods. This is to avoid double counting
because when cotton is transformed into cloth, its value will be included in the price of
cloth.

In an open economy (an economy subject to international trade), GNP may be

obtained by adding up:

1. The value of all consumption goods, which are currently produced.

2. The value of all capital goods produced which is defined as Gross Investment.
Gross investment, in the real sense, here implies the increase in inventories
plus gross products of buildings and equipments. It, thus, includes the provision
for the consumption of capital assets, i.e. depreciation, or replacement
allowances.
3. The value of government services which are measured in terms of govern-
mental expenditure on various goods and services for rendering certain services
to the benefit of the entire community.
4. The value of net products, viz., the difference between total exports and total
imports of the nation. This value may be positive or negative.

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 5. The net amount earned abroad. This represents the difference between the
income received by the nationals from abroad on their foreign investment,
minus the income paid by them abroad on the foreigner’s investment.
GNP at market price, thus, represents:

GNP = C + I + G + (X - M) + (R - P),

Where,
C stands for consumption goods,
I stands for capital goods/or gross investment,
G stands for government services,
X stands for exports,
M stands for imports,
R stands for income receipts from abroad, and
P stands for income paid abroad.

In a closed isolated economy, however, GNP = C + I + G.

GNP is the basic social accounting measure of the total output. It represents the final
products, ready for consumption, valued at current market prices.

7.2.2 Gross Domestic Product (GDP)

When we take the sum total of values of output of goods and services in the country,
without adding net factor incomes received from abroad, the figure so obtained is
called Gross Domestic Product (GDP).
GDP = C + I + G + (X - M).
This is measured at market prices.

A measurement of GNP has been illustrated in the Table 1 below.

Item Value of Current Market Price
(Rs. Crores)
Consumption (C) 6
5
4
Investment (I) 33
4
Government Purchases (G) 12
3
Net Exports (X – M) + 15
Net Income from the rest of world (R – P) + 2
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 Total 1128
Table 1 : Final Output (GNP)

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 In measuring GNP, each finished product is multiplied by its price. Thus, the relative
importance of particular good is expressed by its relative price. Further, with changes
in prices the GNP also changes. During inflation, thus GNP appreciates simply on
account of rising prices. To know the real GNP, therefore, we must deflate a given GNP
total from the market price to the constant price.

GDP at factor cost is obtained as follows:

GDP at market price + (S – T),

Where,
S = Government subsidies,
and
T = Indirect taxes.

GNP represents the measure of the economic output in an economic system. The final
output included in the GNP is composed of the following uses:

1. Consumption,
2. Investment,
3. Government spendings, and
4. Net exports.

As Schultze points out, all output flows to one of these four uses.
The consumption expenditure component of national product constitutes the
expenditure on durable goods, perishable goods, and services which are marketed
during the year.
The investment component implies that part of the current product which is not
consumed but used for adding further or replacing the real capital assets. It refers to
gross investment. Gross investment minus depreciation (for replacement requirement)
is equal to net investment.

Schultze lists the following main categories of investment in the GNP accounts:
1. Fixed investment, relating to the purchase of durable capital goods by firms.
2. Inventory investment, representing that part of output which is absorbed by
firms as an increase in their stocks of finished goods, intermediary products and
raw materials.
3. Residential building constructions for households. Here only new buildings are
to be accounted for.

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 Full employment level of GNP is the potential GNP, Potential GNP is, thus, the value of
final goods and services which a country can produce by operating at a point of its
production possibility frontier by fully exploiting its available resources and industrial
capacities. Actual GNP is rarely equal to potential GNP. Thus, potential GNP minus
actual GNP is the measure of the size of unemployment of excess capacity in the
economy.

7.2.3 Net National Product (NNP)

It refers to the value of the net output of the economy during one year. NNP is
obtained by deducting the value of depreciation or replacement allowance of the
capital assets from the GNP. To put it symbolically :

NNP = GNP - D, Where, D = Depreciation allowances

This value is measured at current prices, while GNP is expressed at current market
prices. Net National Product, in fact, is the value of total consumption plus the value of
net investment of the community.

What is the difference between GNP and NNP? In our definition of Gross National
Product, we have not made any allowance for depreciation, capital appreciation and
obsolescence. Depreciation means wear and tear of machinery in the process of
production. Machines used for production have to be replaced at some future time, as
due to their constant use they become useless over time. In other words, fixed assets
are not everlasting and must be constantly renewed to keep production running
smoothly and steadily. Similarly, some machinery becomes out of date with the
passage of time. This old type of machinery needs to be replaced by an up-to-date one,
if competitive efficiency is to be maintained. Capital appreciation means an increase in
the value of fixed assets like machinery, building, tools, etc. due to rise in their prices. It
usually happens during the period of inflation. A rise in the value of fixed assets does
not mean that there is any increase in national income, because the total quantity of
fixed assets remains the same. Thus, when the amount of estimated depreciation and
obsolescence, i.e., capital consumption, is subtracted from Gross National Product, we
get Net National Product.

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 However, national income, in its technical sense, is obtained by deducting indirect
taxes from the net product measured at current market prices. Such a figure is also
called NNP at factor cost, as it represents payments made to the factors of production
during the process of production.

7.2.4 National Income at Market Price and National Income at Factor Costs

In the national income analysis, usually a distinction is made between national income
at market price and national income at factor costs. National income at market price
means the money value of goods and services produced. It is the price of the aggregate
output and services at current market prices. This price also includes some element of
taxes and subsidies. A simple example will illustrate this point.

Let us suppose that the price of a bottle of beer is Rs.6/-. In this case, the national
income at market price is Rs.6/-. But there is some element of tax in the above price.
Let us suppose, the tax is Rs.2/-. Then, the national income at factor cost is Rs.4/-
because the factor of production which has contributed to the production of one bottle
of beer will get only Rs.4/- and the balance of Rs.2/- will go to the government as tax.

Let us now analyse the implications of the elements of subsidy. Let us suppose the fair
price of a kilogram of sugar is Rs.4/-, but its actual cost of production is Rs.5/-. The
difference of Re.1/- between the actual cost of production (Rs.5/-) and the fair price
shop price (Rs.4/-) is borne by the State. In this case, the national income at market
price is Rs.4/-, but it is Rs.5/- at factor cost because the factors of production would
receive Rs.5/- for the production of one kilogram of sugar.

Gross domestic product at factor cost = Income earned by the factor o

f
production + Depreciation
Net Domestic Product at factor cost = Income earned by the factor o
f
production - +
Depreciation
Taxes - Subsidy

National Income at market price + National Income at factor cost + Taxes - Subsidies
- Depreciation

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 We are now in a position to examine the interrelationship between the three
definitions of national income given above. There is close relation between national
income as a flow of goods, as a flow of expenditure, and as a flow of income. In fact,
they are so interrelated that total production; total income and total expenditure are
described as a circular flow of income activities. The firms hire the factors of
production to produce goods and services. The factors of production create real
income. The factors of production are paid out of this real income, in terms of money
as a reward for their services. They, in turn, spend this income. Thus, income leads to
expenditure, i.e., expenditure creates demand for goods.
This demand, in turn, leads to production. The flow is from production to income
generation to expenditure, and from expenditure to production. National income is,
therefore, the total flow of wealth produced, distributed and consumed by the
economy as a whole during the course of a year. These three things – total production,
total income and total expenditure – are really one and the same thing when reviewed
from different angles. Each approach with suitable adjustment, will give exactly the
same GNP or NNP.

7.2.5 Other related Concepts and Relationships

1. Personal Income
Personal income is the total money income received by individuals in the
community. Personal income is the aggregate earned and unearned income.
Undistributed profits of the corporations reduce the personal income of
individuals to that extent. Thus, personal income (PI = NI - undistributed profits,
(U). Again personal income includes transfer payments made by government as
well as the private business sector to individuals.

Thus, personal income (PI) = NNP + transfer payments (R)

∴ PI = NI + R - U

2. Disposable Personal Income

Disposable personal income is the sum of the consumption and saving of

individuals.

Thus, DI = C + S

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 Disposable personal income (DPI) rather than National Income is the
determinant of consumption, because the consumption of a person depends on
his take home pay.

Disposable income includes an unearned element (transfer payments) which is

excluded in community’s earned income estimates, i.e., national income.
Disposable income is the total income, earned and unearned, of individuals
minus direct taxes.

Thus, DPI or simply DI = PI - Td ,

where Td = direct personal taxes such as income tax, wealth tax, etc.

DPI is also symbolized as Yd by money economists.

PI = Yd = C + S

Keynes, however, assumed that Td = 0.

∴ Y = Yd ∴ Y = C + S

3. Personal Savings

Personal savings refer to the difference between disposable personal income

and personal consumption expenditure.
A bird’s eyeview of the calculation of related concepts in national income data
is presented in Table 2.

Rs. Crores
GNP 500
Capital Consumption - 50
allowance

Net National Product (NNP) 450

Indirect Taxes - 60
Subsidies 10

National Income (NI) 400

Corporate Profits - 70

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 Dividends 15
Government Transfer payments and business transfer
payments 25

Personal Income 370

Personal direct taxes - 70

Disposable personal income (DPI) 300

Personal Consumption expenditure - 275

Personal savings 25

Table 2 : Relation of GNP, NI, Personal Income Saving (Imaginary Data)

7.3 Methods of Estimating National Income

In national income estimates, by definition, we have to count all those goods and
services produced in the country and exchanged against money during a year. Thus,
whatever is produced is either used for consumption or for saving. Thus, national
output can be computed at any of the three levels, viz., production, distribution and
expenditure. Accordingly, we have three methods of estimating national income: (i) the
census of products method, (ii) the census of income method, and (iii) the expenditure
method.

7.3.1 The Census of Products Method or Output Method

This method measures the output of the country. It is also called the inventory method
and involves the assessment, through census, of the gross value of production of goods
and services produced in different economic sectors by all the productive enterprises in
the economy. (For instance, the producing sectors in India are agriculture, forestry,
fisheries, mining, industries, transport, commerce and other services.)

To the aggregated value of total output, real income earned from abroad is added (i.e.
add the net difference between the value of exports and imports). And indirect taxes
like excise and customs duties, plus depreciation allowances are to be reduced from
the total obtained. Thus, to this net difference of the income earned from the rest of
the world, a symbolic expression for this method may be given as follows:

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 Y = (P - D) + (S - T) + (X - M) + (R - p)

Where,
Y = Total income of the nation,
P = Domestic output of all production
sectors,
D = Depreciation allowance,
S = Subsidies,
T = Indirect taxes,
X = Exports
M = Imports
R = Receipt from abroad, and
p = Payments made abroad

Mostly, this method is adopted in the calculation of national income. However, there
are certain precautions against the danger of double counting, etc., which must be
strictly avoided if a correct result is to be achieved.

The following precautions are necessary:

1. To avoid double counting, we must add only the final products. Raw materials
and intermediate goods should not be included, as that would lead to double
counting.
2. Goods for self-consumption by the producer should be excluded; they have not
been marketed, so it is difficult to ascertain their true market value.
3. While evaluating the output, changes in the price levels between the years
must be taken into account. It is usual to denote national income with
reference to prices of a particular year.
4. Indirect taxes, included in prices, are to be deducted for getting the exact value
of the products. Similarly, subsidies given by government to certain products
should be added in evaluation of the product.
5. Add the value of exports or the income earned abroad and deduct the value of
imports.
This method is widely used in the underdeveloped countries, but it is less reliable
because the margin of error in this method is large. However, in India, this method is
applied to agriculture, mining and manufacturers, including handicrafts. But the census
of product method is not applied for the transport, commerce and communication
sectors in India.

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 Value Added vs. Final Goods Approach

There are two approaches to avoid the possibility of double counting in the
measurement of GNP:

(i) Final goods method, and

(ii) Value added method.

In the final goods method of estimating GNP, only final values of goods and services are
computed, ignoring all intermediate transactions. Intermediate goods are involved in
the process of producing final goods – the final flow of output purchased by
consumers. Thus, the value of final output includes the value of intermediate products.
Hence, to avoid double counting, only final values relating to final demand of the
consumers should be reckoned.

For example, the price of bread incorporates the cost of wheat, flour etc. Wheat and
flour are both intermediate products and are not treated as the final consumer’s
demand. Their values are paid up during the process of production. In the value of final
product, bread, the values of these intermediate goods are hidden. Hence, a separate
accounting of the values of intermediate goods, along with the accounting of the value
of final product, would mean double counting. To avoid this, the computation of the
value of final products only has been suggested.

Another method, however, is the “value added” method in which a summation of the
increase in value (the value added), at each separate production stage, leading to
output in final form, gives the value of GNP.

To avoid double counting of intermediate goods, one must carefully estimate the value
added at each stage, of the production process. From the total value created at a given
stage, we should thus subtract all the costs of materials and intermediate goods not
produced in the stage.
Or, the value of inputs, at a given stage, should be deducted from the value of output.
Even the value of inputs purchased from other firms or sectors should be subtracted.
In short, GNP is obtained as the sum total of the values added by all the different
stages of the production process till final output is reached in the hands of consumers
to meet the final demand. The point may be clarified further with the help of an
illustration as given in Table 3.

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 (1) (2) (3) (4) (5)
Production Firm Sales Cost of Value added
Stages Receipts intermediate (Net Income)
(3) - (4)
1. Wheat Farmer 500 0 500
2. Flour Flour Mill 700 50 + 200
0
3. Bread Baker 900 70 + 200
0
4. Trading Merchant 1000 90 + 100
0 0

Total : Sum of value = 100

added 0

Table 3 : Value Added Method

In Table 3 we have assumed a much simplified method or model of an economy,

producing only a single final product, bread. In satisfying the consumer final demand
for bread, it is assumed that there are four productive stages. First, a farmer cultivates
wheat and sells it at Rs.500/-. Thus, Rs.500/- is the value added to the economy’s
output. We assume that this wheat is purchased by the flour mill to grind into flour.
The mill sells the flour to the baker and fetches Rs.700/-. So, its net income is Rs.700/-
- Rs.500/- = Rs.200/-. Thus, in turning wheat into flour (that is, the creation of form
utility), the value added is Rs.200/-. The baker bakes a quantity of bread out of the
flour and sells it to the merchant for Rs.900/-. In the process, the value added is
Rs.200/-. The merchant renders trading service of creating place and time utility, and
thus sells the stock of bread to the final consumer at Rs.1,000/-. The net income of the
merchant is Rs.100/- which is his profit for merchandise business, a “productive”
activity. Thus, the value added is Rs.100/- in the economic system. Obviously, the sum
total of value added at each stage of production, Rs.500/- + Rs.200/- + Rs.200/- +
Rs.100/- = Rs.1,000/- is the final value.

Evidently, the value of that product is derived by summation of all the values added in
the path of the productive process. To avoid double counting, either the value of the
final output should be taken in the estimate of GNP or the sum of values added should
be taken. Value added is the difference between value of output and input at each
given stage of production. The final product method reckons the quantum of goods
and services and the aggregate of their values (measured at market prices) at the end
of the year, while the value added method measures the flow of output and takes the

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 sum total of net values created at each production stage during the year.

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 Apparently, both the methods given the same results, because both relate to the same
phenomenon, though each in a different manner. Some economists, however, prefer
the value added method on the following counts:

(i) It provides a method to check up or tally the accuracy of GNP estimates.

(ii) It enables us to know the contribution of each productive sector to the creation
of GNP. Thus, national income at industrial origin can be easily compiled from
the value added approach. Again, it is also helpful in constructing the input-
output table and trading inter-industry transactions.

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 Circular Flow of Activity
Incidentally, the economic system contains the flow of goods and services in the
transactions between two economic sectors: households and firms. There is a circular
flow of economic activity. Households buy the final goods and services produced by the
firms. Thus, households’ total expenditure becomes the income of the firms which is
equal to the value of final output by the firms. The range of transactions which take
place within the boundaries of firms – “the productive area” – are regarded as
intermediate transactions or inter-industry relations. Values are created in the
productive area. All net values added together determine the value of the final output,
i.e., GNP. The final output flows from the productive area of firms to the consumption
area of households. This point has been illustrated diagrammatically in Figure 1.

Figure 1: Circular Flow of Activity

In Figure 1, one can observe that intermediate transactions occur within the productive
area or firms. It represents intermediate transactions from the farmer (F) to the flour
mill (M), to the baker (B), to the trader or merchant (T) – all taking place within the
boundaries of the firms. The firms sell their final output to consumers – the
households. Thus, there is a flow of final goods from the productive area or firms to the
consumption are of households. Households’ total expenditure = the value of final
output - the income of the firms’ sector. Again, there is a flow of productive services of
factors from households to firms. The factors are rewarded in the form of rent, wages,
interest and profits. The total factor income = the aggregate value of factor services =
the total expenditure of firms = the total income of households. In short, total
expenditure of firms = total income of households and total expenditure of households
= total income of firms = the value of final output. Thus, the final value of output is just
the same as final expenditure. It follows thus:

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 Total output = Total expenditure
Again, total expenditure = Total income
∴ Total output = Total income

7.3.2 Census of Incomes Method

In this method, income of all factors of production is added together. The data are
compiled from books of accounts, reports, and published accounts. The following
classification of incomes is considered as comprehensive:

(a) Wages and salaries,

(b) Supplemental labour income (social security, etc.),
(c) Earnings of self-employed or professional incomes,
(d) Dividends,
(e) Undistributed profits,
(f) Interest,
(g) Profit of state enterprises.

However, transfer payments like gift subsidies etc. are to be deducted from the total of
factor incomes. Thus, National Income is equal to the factor incomes minus transfer
payments.

This method is also called the Factor Cost Method. Thus, the national income of a
country, at factor cost, is equivalent to the sum total of the disbursements of their
(factors) income. The symbolic expression of this method is as follows:
Y = ( w + r + i + n ) + (X - M) + (R - P)
Where,
w = wage
s
r = rent
I = intere
st
n = profit
s
However, certain precautions are necessary while following this method.

1. All transfer payments (government and personal) like gifts, pension etc., are to
be deducted. Similarly, gambling, being transfer activity, is to be excluded.
2. All unpaid services (like services of housewife) are to be excluded. Thus, only
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 those services for which payments are made should be included.

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 3. Financial transactions and sales of old property (including land) are to be
excluded, as they do not add anything to the real national income. Thus, all
capital gains and losses which are related to wealth, but not to real income,
should be excluded.
4. Direct tax revenue to the government should be subtracted from the total
income as it is only a transfer of income. Or else, it should not be reckoned at
all.
5. Similarly, government subsidies should be deducted.
6. Add the value of exports and deduct the value of imports.
7. Add undistributed profit of companies, income from government property, and
profits from public enterprises.

In India, the National Income Committee used the income method for adding up the
net income from trade, transport, public administration, professional and liberal arts,
and domestic services. Since, under Indian conditions, due to lack of popularity of
personal accounting practices, it is difficult to ascertain the personal income of
individuals, the income method is not wholly practicable

7.3.3 The Expenditure or Outlay Method

National income on the expenditure side is equal to the value of consumption plus investment. In
this method, we have to :
(i) estimate private and public expenditure on consumer goods and services.
(ii) add the value of investment in fixed capital and stocks, with due consideration
for net positive or negative inventories, and
(iii) add the value of exports and deduct the value of imports.

This method is not as popular as the previous ones.

To express it in symbolic terms,

Y = (C + I + G) + (X - M) + (R - P)
Where,
C = Consumption
expenditure,
I = Investment expenditure, a
n
d
G = Government purchases

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 201

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 The Bowley-Robertson Committee has suggested the adoption of the Census of
Products Method for major sectors of India, and the Census of Income Method for
some minor sectors, while the National Income Committee relied mainly upon the
Census of Income Method. However, none of the above methods alone is perfect.
Therefore, an integrated computation of them will give a wider perspective of the
estimate.
The proess of calculation of national income (by using the above discussed three
methods) has been illustrated in a summarized way, with hypothetical data of an
imaginary economy, in Table 4 (A, B and C).

A. Income Method Rs. (Crores)

Income: Wages, salaries, etc. 1,000
Profits: Private and Public operations 500
Rent 200
Interest 100

Total domestic income : 1,800

Less: Stock appreciation - 250
Residual error - 50
Net property income from abroad 100

FNP 1,600
Less: Capital consumption - 150

National Income 1,450

B. Expenditure Method Rs. (Crores)

Consumer’s expenditure (C) 1,100
Public authorities’ current expenditure on goods/services (G) 600
Gross Capital formation (Investment) at home including
increase in stocks (I) 500

Total domestic expenditure at market prices 2,200

Plus: Exports and income from abroad 600
Minus: Imports and income paid abroad - 200
Less: Taxes in expenditure - 1,000
Plus: Subsidies 50

GNP at factor cost 1,600

Less: Capital consumption - 150

National Income 1,450

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 C. Output Method Rs. (Crores)
Agriculture, Forestry and Fishing 250
Mining and quarrying 100
Manufacturing 200
Construction 100
Gas, electricity and water 50
Transport and communication 200
Distributive traders 300
Insurance, banking and finance 200
Public administration and defence 150
Other services 100

Total domestic output 1,80

0
Less: Stock appreciation - 250
Residual error - 50
Net property income from abroad 100

GNP at factor cost 1,60

0
Less: Capital consumption - 150

National Income 1,450

Table 4 : Estimate of the National Income of Country X during a given year

To be more realistic on this account, we have purposely assumed that the results in
these three methods are not identical due to incomplete information. Thus, the
expenditure statistics are taken as data. The difference between expenditure statistics
and income and output statistics is regarded as a residual error in the above table.

7.4 Difficulties in National Income Estimate

While estimating national income statisticians and economists usually encounter the following
sets of difficulties :
(i) conceptual and
(ii) statistical or practical

The conceptual problem relates to how and what is to be included and what is not in
the measurement of national income. Logically, the concept of national income would
imply that everything that is produced must be reckoned.

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 However, by definition, we consider only those things which are exchanged for money
or carry some price. By convention, on the basis of the availability of information,
certain guidelines have been laid down in the process of national income estimates.

A few of them are:

1. Farm products kept for self-consumption. These are to be included as national

income and estimated by a guess and at the rate of market price of agricultural
products that have been marketed.
However, output of food from domestic poultry keepings or vegetables grown
in the home or terrace gardens etc. are not included in national income, as no
accurate estimate of their production is available.

2. Services of housewives. These are not to be included in national income as they

have no price and no market for the services rendered for their own household
work. But the value of the services of domestic servants are to be considered as
national income. Obviously then, a person who marries his maidservant reduces
the national income to that extent.

3. Unpaid services are not reckoned as national income.

4. Defence services, being indirectly productive must be included as national

income. Their value will be equivalent to the defence expenditure incurred by
the government.

There are statistical problems too. Great care is required to avoid double counting,
otherwise there will be an exaggerated valuation of national output. Again, statistical
data may not have perfect reliability when they are compiled from numerous sources.
Skill and efficiency of the statistical staff and co-operation of people at large are also
equally important in estimating national income.

In India, a special conceptual problem is posed by the existence of a large, unorganized

and non-monetised subsistence sector where still barter system prevails for transacting
goods. Here, a proper valuation of output is very difficult. A large part of India’s
national income is, therefore, as guess work without much accuracy.

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 Further, rural folk in India have no specific employment. Their occupation is of
divergent nature. A person is a farmer as well as a carpenter at one and the same time.
So, it is very difficult to decide the structure of national income by industrial origin.

Further, in a country like India, statistical difficulties are still more severe. Some of
these are:
1. Accurate and reliable data are not adequate, as far as output in the subsistence
sector is not completely informed. Small-scale and cottage industries also do
not report their targets. Indigenous bankers do not furnish reliable data and so
on.
2. India, is a country with large regional diversities. Thus, different languages,
customs, etc. also create a problem in computing the estimates.
3. People in India are indifferent to the National Income Committee’s inquiries.
They are non-co-operative also.
4. Statistical staff is also untrained and inefficient.

Therefore, national income estimates in our country are not very accurate nor are they
adequate.

7.5 Method of Deflating National Income

Usually, national income estimates are computed at current market prices. To know
the real changes, therefore, we have to deflate them. That is, convert the given
national income figures at market prices into constant prices.

Deflation is done with the help of wholesale price index number or the cost of living
index number. Usually, cost of living indices are used for deflating per capita income
series.

The following formula may be used for the purpose:

R = P0
× Y
Where,
Pt
P0 = base year price index
Pt = current year price index
Y = national income, or GNP at current price for the current year

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 The following illustration clarifies the point:

Example: Deflate the following:

Year 1970 1971 1972 1973 1974
National Income (Rs. ’00 crores) 250 280 300 350 360
Wholesale price index 100 120 150 160 180
Solution: National
income at
P0 cons tan t
Year γ R= ×γ prices
P
Pt

1970 250 100 = 250.00

100 100 × 250

1971 280 100 = 233.00

120 × 280
120

1972 300 100 = 200.00

150 × 300
150

1973 350 100 = 218.75

160 × 350
160

1974 360 100 = 200.00

180 × 360
180

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 206

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 7.6 Importance of National Income Data

Thus, national income data are a collection of facts or estimates of the total real
income of a country expressed in terms of money. They provide a quantitative
measurement of the country’s economic activity during a defined period. They are the
most important statistical measures of the economic activity of a nation and are very
useful in analyzing current economic conditions. National income data furnish a
comprehensive view of the country’s economic functioning.

The national income statistics may be said to be the index numbers of the economic
progress of a nation. A continuous series of annual estimates of national income would
suggest the trend of economic growth of the nation and how rapidly it is taking place.
National Income trend clearly reveals the basic changes in the country’s economy in
the past and suggests trends for the future.

Simon Kuznets says: “Since the end product of each country’s economic system is an
index of its producing power, national income estimates furnish a comparison of the
productivity of nations, per capita income figures, especially when adjusted for
differences in the purchasing power of money, appear to measure the nation’s
economic welfare.”

National income statistics contain data on consumption and investment expenditure.

Hence, for studying changes in the disparities, the standard of living can easily be
compared with the help of such statistics. Fiscal authorities can use them to study the
incidence of taxation as well as for projecting the tax yields. For the purpose of
economic planning, national income data furnish information about the aggregate and
per capita income, the rate of capital formation and industrial sectional breakdown and
the relative contribution of each sector.

7.7 National Income Accounts

National income accounts are the systematic records and presentation of national
income statistics. Thus, national income accounting, also known as “economic
accounting” or “social accounting,” transcends the mere compilation and publication of
statistical information. Its purpose is to present data in such a form that interrelations
among items are most easily discerned from the structure of statements.

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 Thus, national income accounts and statistics are two related but different things.
Statistics are a collection of facts which are useful in themselves but which do not
depend uniquely on the values expressed in other statistical collections. An accounting
statements, on the other hand, is an integral grouping of statistical series, each of
which is functionally connected to all others. National income accounts or social
accounting means a systematic arrangement of data relating to the economic activity
of the country.

A social accounting framework is useful for economists a well as policy-makers, as it

represents the major economic flows and statistical relationships among the various
sectors of the economic system. It is of particular interest and significance to the policy-
makers because by studying national income series over a period of time, it becomes
possible to forecast the trends of the economy more accurately. In many countries,
annual economic planning is in the form of national budgets which are in fact nothing
but forecasts of social accounts.

7.8 Social Accounting Method

Recently, with the development of social accounting, national income is also being
measured by the social accounting method. In the social accounts, transactions among
various sectors such as firms, households, governments, etc. are recorded and their
interrelationships are traced. From the total value of these transactions recorded in
matrix form, the national income value is known.

The social accounting framework is useful for economists as well as for policy-makers,
because it represents the major economic flows and statistical relationships among the
various sectors of the economic system. It is of particular interest and significance to
the policy-makers because by studying the national income series over a period of time,
it becomes possible to forecast the trends of economy more accurately. In many
countries annual economic planning is in the form of national budgets which are, in
fact, nothing but forecasts of social accounts for the following years.

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 Sectors for Social Accounts

In social accounting, the economy as a whole is divided into certain parts called
“sectors.” “Sector” is a group of individuals or institutions having common interrelated
economic transactions. Thus, sectors are usually delineated in such a manner that
economic entities whose functions are similar are contained in one group. Thus, sectors
are distinguished on a functional basis and not on any institutional criterion.

Conventionally, under the scheme of social accounting, the economy is divided into the
following sectors:

(i) Firms,
(ii) Households,
(iii) Government,
(iv) Rest of the world, and
(v) Capital sector.

“Firms” are producing entities of the economy. They undertake productive activities.
Thus, they are all organizations which employ the factors of production to produce
goods and services.

“Households” are consuming entities and represent the factors of production, who
receive payments for services rendered to firms. Households consume the goods and
services that are produced by the firms.

Thus, firms make payments to households for their services. Households spend money
income so received, again on the goods/services produced by the firms. There is, thus,
a circular flow of money between these two groups.

“The Government sector” refers to the economic transactions of public bodies at all
levels, center, state and local. In their work concerning social accounting, Edey and
Peacock have defined government as a “collective person” that purchases goods and
services from firms. These purchases may be financed through taxation, public
borrowings or any other fiscal means. The main function of the government is to
provide social goods like defence, public health, education, etc. means to satisfy the
collective wants of society. However, public enterprises like post offices and railways
are separated from the government sector and included as “Firms.”

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 “The rest of the world sector” refers to saving and investment activities. It includes the
transactions of banks, insurance corporations, financial houses, and other agencies of
the money market. These are not included as firms. These agencies merely provide
financial assistance to the firms’ activities.

The System of Social Accounts

Social accounting is based on double-entry book-keeping principles. Like debit and
credit sides, each sector account contains a balancing item (credit) of one sector is the
allocation item (debit) of the other related sector.

A Firm’s account usually contains the following items:

Debit side
1. Payments to factors of production – households in the form of wages, interest,
rent, dividend, profits.
2. Imputed cost retained by the firm such as depreciation allowances and
undistributed profits.
3. Payment of corporate taxes, excise duties and licence fees, etc. to the
government sector.
4. Payment to the government for buying its factor services.
5. Payment to firms for buying raw materials, machines etc.

Credit side
1. Households spending on goods and services produced by firms.
2. A firm’s items sold to other firms.
3. Government spending in buying goods from the firms.
4. Net export earnings.
5. Net income earned from abroad.

A Household account usually contain –

Debit side
1. Payment to firms for buying their goods and services.
2. Tax payment to government.
3. Transfer payments.
4. Individual saving.

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 Credit side
1. Income received by selling factor services to the firms.
2. Transfer payment made by the government to individuals.
3. Transfer payment made from a foreign country.

A Government sector account usually contains the following items:

Debit side
Public spending on goods and services of firms.
1. Government payment to administrative staff.
2. Amount of subsidies given to producers.
3. Debt servicing charges.
4. Transfer payments to individuals.
5. Transfer payments made abroad.

Credit side
1. Taxes received from firms and households.
2. Collection of fees, penalties, etc.
3. Interest, rent, dividend, etc. receipts of the government.
4. Foreign aid.

A Capital sector account will have the following items:

Debit side
1. Firms’ savings
2. Households’ savings.
3. Savings of the government.
4. Net external public borrowings.

Credit side
1. Aggregate expenditure on capital assets (investment in capital goods industries).
2. Net change in business inventories.

Assuming a close economy with only two sectors, firms and households, we may
illustrate the sectoral accounting as shown in Table 5.

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 (Rs. Crores)
Firms’ Account
Payments (Dr. Receipts (Cr.)
) Rs.
Rs.
Purchase of factors Sale of consumption goods
services 1,0 and services to households 1,000
00
from households
Households’ Account
Payments (Dr. Receipts (Cr.)
) Rs.
Rs.
Purchase of consumption Sale of factor
Goods and services from firms 1,0 services 1,000
00
to firms
Table 5 : Sectoral Accounts

Another method is to present these data in the form of a matrix, a rectangular

arrangement of entries into a set of rows and columns. Receipts or credit items of a
sector are placed in the rows of the matrix, while payments or debit items are
presented in the columns. A single matrix may be used for all sectoral items.

The above given data can be represented in a matrix form as shown in Table 6.
(Rs. Matrix
Crores)
Receipts by: Firms Payments by: Household Total
(1) (2) (3)
(a) Firms - 1,000 1,000
(b) Households 1,000 - 1,000
(c) Total 1,000 1,000 2,000
Table-6 : Matrix
Matrix is very important for tracing the inter-relationship between different economic
entities or sectoral transactions.

While measuring the national income of any country, it must be remembered that –

(i) Income is a “flow” concept. Thus, we do not measure the stock of economic
goods or wealth at a given moment of time, but we measure the flow of
economic goods produced by the nation in a year. Actually, there is a
continuous flow production. But we, for the sake of convenience, take a time
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 interval of one year into account and measure national income every year.
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 (ii) The national income is measured as a “realized” flow. Thus, final goods which
have already been produced during the year are to be accounted for. The value
of incomplete goods are therefore to be excluded. We should not predict the
values of the goods yet to come. We measure only what has already been
produced. Remember, national income is a realized flow of goods and services.
Thus, we can estimate national income for the year 1981 only in 1982, because
then only can we have data of production between January, 1981 and
December, 1981.

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 Exercise :
1. What is ‘national income’ interpreted in terms of (1) national product, (2)
national dividend and (3) national expenditure?
2. What is Gross National Product as distinguished from Net National Product?
3. What is Disposable Personal Income? Is it relevant in the field of determination
of National Income? Explain the difficulties of estimating National Income.
4. Explain the method of measuring National Income by the social accounting
process system based on double-entry book-keeping principles.
5. Write short notes :-
(a) Base year price index
(b) Personal Savings
(c) National Income at Factor Costs
(d) Circular flow of activities

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 UNIT – VIII
THEORY OF MONEY

8.1 What is money?

‘Money’ is a generic term which denotes primarily the currency in vogue in any
particular country.

History of the world indicates that man found it necessary to use money at an early
stage of man’s development because of the difficulties and inconveniences of exchange
by direct barter. The inconvenience of barter system could be avoided by the use of
money. Money is demanded because it is useful and does away with difficulties of
barter system. Therefore, money is regarded as one of the most important discoveries
of mankind. Since money represents generalized purchasing power, it has been the
object of man’s desire through ages.

Prof. Walker defines money as “Money is what money does”.

Robertson defines it as “A commodity which is used to denote anything which is widely

accepted in payment for goods or in discharge of other business obligations.”

Economists stress that a thing which could be considered as money should be such that
it should command general acceptability. Without general acceptability there could be
no free and smooth exchange transactions.

Crowther holds “Anything that is generally acceptable as a means of exchange and that
at the same time acts a measure and as a store of value is money”. The analysis of this
definition implies that money should perform three important functions, namely, it
should be capable of being used as a medium of exchange, as a measure of value and a
store of value. That does not mean that the role of money ends with the performance
of these functions. In addition to these three functions, it performs other functions, the
important among which is that also action the standard of deferred payment. Thus,
primarily money is said to have functions four - medium, measure, standard and store.

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 (i) Medium of Exchange
The quality of general acceptability of money facilitates exchange. People want
goods and services for various purposes. They can obtain them in exchange of
money. Under the barter system, goods were exchanged against goods.
However, it was very inconvenient to people from various angles such as lack of
double coincidence of wants, difficulty of divisibility, storing of value etc.
Consequently, the system had to be replaced by money. Money has removed all
these difficulties. That’s why now with the use of money buying and selling of
goods has become easy and possible.

(ii) Measurement of Value

The another important function of money is the measurement of value of
various goods and services which are exchanged. Money is the common
measure of value. This has facilitated the determination of rate of exchange
between money on one side and goods and services on the other. Now-a-days
prices of various goods and services are expressed in terms of money which is
an indication of the fact that money has been accepted as a common measure
of value of goods and services.

(iii) Store of Value

Money serves as a store of value of goods and services. Man wants to provide
for the future out of rewards he receives for his labour. He wants to keep some
part of his earnings for tomorrow. This would possible only if the means
through which savings is to be made is non-perishable not only physically but
also from the point of its future value. Money has become a convenient means
through which savings can be done easily. This facilitates capital formation too
which is essential for economic development of the country. Thus, money plays
a paramount role in capital formation and standard of storage of savings.

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 (iv) Standard of Deferred Payment
Payments which are made at some future dates are made in money since the
value of money remains stable over a period of time. Lending involves future
payment. Development of trade and commerce has also necessitated future
payments. Thus, deferred payments have become a normal feature of modern
commercial world. Since money remains stable in value and is non-perishable
along with its general acceptability, deferred payment becomes possible. Thus,
the money acts as a standard of deferred payment and thereby it has made a
great contribution not only to modern commercial world but to transactions
promoting human civilization.

8.2 CONTINGENT FUNCTIONS

There are also some contingent functions that money perform in an economic world.

(i) Equalization of Marginal Utilities

A rational person tries to spend his limited money income in such a
manner that he obtains the maximum satisfaction or utility there from. If
he were to spend his money on only one commodity, the problem would
have been easy. But he has to spend his money upon a choice over
various goods and services as well as various purposes in such a way that
the spending yields maximum satisfaction to him. This could be done by
equalizing marginal utilities in all directions as derived from consumption
of various commodities. A principle of equi-marginal utility has to be
applied and in doing so, money comes to our rescue because prices are
measured in terms of money.

(ii) Equalization of Marginal Productivity

Producer is concerned with the marginal productivity. He would
maximize production and profit when marginal productivity of factors of
production is equalized. Even here, money plays an important role in
determining rewards of the factors of production because factors of
production are paid in terms of money equal to their marginal
productivity.

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 (iii) Distribution of National Income
Distribution of national income is also undertaken in terms of money.
National Income is generated by the four factors of production. It is to
be distributed among the factors in accordance with their contribution.
This is done in terms of money. Thus rent wages, interest and profit, as
the share of remuneration for land, labour, capital and entrepreneurship
is respectively determined in terms of money out of generated national
income.

(iv) Development of Credit System

In the modern economic system with fast growing industrialization
credit system has become very important. It is this credit system that
gave rise to rapid development of industrial and commercial
advancement. In business and commercial activities, instrument of
credit is at the center and money is the basis of the credit system. Thus,
money plays a great role in the development of credit system and also
the banking system.

8.3 RESIDUARY FUNCTIONS

(i) Capital is given liquid form

Money is the most liquid form of capital. Money imparts liquidity to other forms
of capital. People need to keep capital in liquid form for various purposes or
motives such as transaction, precautionary and speculative. All this become
possible because of money.

(ii) Full utilization of resources

It is also possible to ensure full utilization of various resources by means of
money. Idle resources can be mobilized and harnessed for the productive
purpose with the help of money. If these resources are not mobilized, they
cannot be properly utilized so as to increase production of goods and services.
In the light of functions of money discussed above, one would come to know
the importance and dynamic role played by money. Economic and commercial
development in modern times is made possible by the introduction of money.
Through suitable changes in monetary policy of the country desired direction
can be given to the economy to achieve socio-economic objectives. Thus money
has occupied extra-ordinary place in the modern economy and so in the life of
people.

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 8.4 INFLATION
Types and Causes of Inflation
Basically, there are two types of inflations. They are also termed as the causes
of inflation because of changes in demand have been identified, namely:

Demand-pull inflation
Cost-push inflation

Demand-pull Inflation:

This type of inflation is caused by an increase in the conditions of demand. It

may be defined as a situation where total monetary demand persistently
exceeds total supply of goods and services at current prices, so that prices are
pulled upwards by the continuous upward shift of the aggregate demand
function. It arises as a result of an excessive aggregate effective demand
function and aggregate supply of goods and services in a slowly growing
economy. Supply of goods and services will not match with rising demand. The
productive ability of the economy is so poor that it is difficult to increase the
supply at a quicker rate to match the increase in demand for goods and
services.

In the above diagram on X axis we are measuring national income or level of

output produced and on Y axis we are measuring price level. SS is the aggregate
supply curve of economy. In the initial level the aggregate demand curve D
intersects the aggregate supply curve SS at point F which is equilibrium position
and equilibrium price is determined at OP level and Oy indicates the supply of
goods and services.

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 As aggregate demand increases further, supply being constant, the price level
will start increasing from OP to OP1 and OP2. But output will remain Oy as it
indicates the full capacity utilization.
FOLLOWING ARE THE FACTORS THAT CAUSE THE INCREASE IN THE AGGREGATE
DEMAND

1. Increase in money supply:Supply of money in circulation increases on

account of the following reasons; deficit financing by government, expansion in
public expenditure, expansion in bank credit and repayment of past debt by the
government to the people, increase in legal tender money.

2. Increase in disposable income: Aggregate effective demand rises when

disposable income of the public increases. Disposable income rise due to;
reduction in the tax rate, increase in national income while tax level remains
constant and decline in the level of savings.

3. Increase in private consumption expenditure and investment expenditure: An

increase in the private expenditure, both on consumption and investment leads
to the emergence of excess demand in an economy. When business is
prosperous, business expectations are optimistic and prices are rising, more
investment is made by private entrepreneurs causing an increase in factor
prices. When the income rise, expenditure on consumer good rises.

4. Increase in Exports: An increase in the foreign demand for a country’s exports

reduces the stock of goods available for home consumption. This creates
shortage in the country leading to the price rise in the country.

5. Existence of Black Money:The existence of black money in the country due to

corruption, tax evasion, black marketing etc. increases the aggregate demand.
People spend such unaccounted money extravagantly thereby creating
unnecessary demand for goods and services, causing inflation.

6. Increase in population growth causes an increase in the demand for

everything in a country.

7. High rates of indirect taxes would lead to rise in prices.

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 8. Reduction in the rates of direct taxes would leave more cash in the hands of
people including them to buy more goods and services leading to an
increase in prices.

9. Reduction in the level of savings creates more demand for goods and
services.

Cost-push Inflation: Cost-push inflation arises from anything that causes the
conditions of supply to decrease. Some of these factors include a rise in the cost
of production, an increase in the government taxation and a decrease in the
quantity of goods produced. It refers to the situation where the prices are rising
on account of increasing cost of production. Thus in this case, the rise in price is
initiated by the growing factor costs. Such a price rise is termed as “Cost Push
Inflation” as prices are being pushed by the growing factor costs. There are
number of factors causing the increase in cost of production.Cost-push inflation
may occur due to wage-push or profit-push.
1.

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 Demand for higher wages by the labour class.
2. Fixing up of higher profit margins by the manufacturers.
3. Introduction of new taxes and raising the level of old taxes.
4. Increase in the prices of different inputs in the market.
5. Rise in administrative prices by the government etc.

These factors in turn cause prices to rise in the market. Out of many causes, rise
in wagesis the most important one. It is estimated and believed that wages cons
titute nearly 70%of the total cost of production.
A rise in wages leads to a rise in the total cost of production and a consequentri
se in the price level. Thus cost- push inflation occurs due to wage push or profit
push.

The phenomenon of cost-push inflation is graphically illustrated in above figure.

In the above figure, the D curve represent the aggregate demand function, and
the S curves, the aggregate supply function. The full-employment level of
income is Oy, which can be maintained only at rising price levels, P, P1 and P2.

Now, if we begin with price level P, F is the point of intersection of the

aggregate supply curve; SS and D. Let us assume that the aggregate supply
function shifts upward as S1, which becomes a vertical straight line at point E,
and merges with the SF line (the previous supply curve at full-employment
level). The leftward shift in the supply curve may be due to either an increase in
money wages due to trade union’s successful collective bargaining, or to the
profit-motivated monopolists or oligopolists, who might have raised the prices
of goods.

As the aggregate supply curve shifts to S1, the new equilibrium point A is
determined through the intersection of S1 and Dand Oy’ will be thelevel of real
output, which is less than the full-employment level. This means that with a rise
in the price level, unemployment increases. It is regarded as the cost of holding
the price level close to P.

Similarly, a further shift in the aggregate supply curve to S2 on account of a

further wage-push implies a new equilibrium point B. This causes the income
level to fall further to y’’, and prices to rise to P2.

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 However, if the government or the monetary authority is committed to
maintain full employment, there will be more public spending or more credit
expansion, causing the price level to rise to much more – such as from P to P3
and P4. In the case, the sequence of equilibrium points become F-G-H.

K) Effects of Inflation

Inflation affects different people or economic agents differently. Broadly, there

are two economic groups in every society, the fixed income group and the
flexible income group. During inflation, those in the first group (fixed income)
lose while those in the second group (flexible income) gain. The reason is that
the price movement of different goods and services are not uniform. During
inflation, most prices rise, but the rates of increase of individual prices differ.
Prices of some goods and services rise faster than others while some may even
remain unchanged.

The poor and the middle classes suffer because their wages and salaries are
more or less fixed but the prices of commodities continue to rise. On the other
hand, the businessmen, industrialists, traders, real estate holders, speculators
and others with variable incomes gain during rising prices. The persons with
flexible income become rich at the cost of the fixed income group. There is
transfer of income and wealth from the poor to the rich.

To further determine the effect of inflation on individuals, it will be necessary

to discuss the effect of inflation on different groups:

a) Creditors and Debtors: When there is inflation, creditors are generally worse
off because, the real value of their future claims is reduced to the extent of the
rate of inflation. On the other hand, when inflation occurs, debtors tend to pay
less in real terms than they had borrowed. Therefore, it could be said that
inflation favours debtors at the detriment of creditors.
b) Salaried Persons: Those with white-collar jobs lose during inflation because
their salaries are slow to adjust when prices are rising.

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 c) Wage Earners: Wage earners may gain or lose depending on the speed with
which their wages adjust to rising prices. If their union is strong, they may get
their wages linked to the cost of living index. In this way, they may be able to
protect themselves from the negative effects of inflation. Most often in real life
there is a time lag between the rise in the wages of employees and the rise in
price.
d) Fixed Income Group: These are recipients of transfer payments such as
pensions, unemployment insurance, social security, etc. Recipients of interest
and rent also live on fixed incomes. These people lose because they receive
fixed payments while the value of money continues to fall with rising prices.
e) Equity Holders and Investors: These group of people gain during inflation as
the rising prices expand the business activities of the companies and,
consequently, increase profit. Thus, dividends on equities also increase.
However, those who invest in debentures, bonds, etc, which carry fixed interest
rates, lose during inflation because, they receive fixed sum while purchasing
power is falling.
f) Businessmen: Producers, traders, and real estate holders gain during periods
of rising prices. On the contrary, their costs do not rise to the extent of the rise
in prices of their goods. When prices rise, the value of the producer’s
inventories rise in the same proportion. The same goes for traders in the short
run. The holders of real estates also make profit during inflation because the
prices of landed property increase much faster than the general price level.
However, business decisions are difficult in an environment of unstable price. In
the long-run, there could be an increase in wages which will reduce profit
thereby, having an adverse effect on future investment.

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 g) Agriculturalists: Agriculturalists are of three types, namely, landlords,
peasant proprietors and landless agricultural workers. Landlords lose during
rising prices because they get fixed rents. Peasant proprietors who own and
cultivate their farms gain. Prices of farm products increase more than the cost
of production. Prices of inputs and land revenue do not rise to the same extent
as the rise in the prices of farm products. On the other hand, the wages of the
landless agricultural workers are not raised by the farm owners, because trade
unionism is absent among them. But the prices of consumer goods rise rapidly.
So landless agricultural workers are losers.
h) Government: Inflation will have both positive and negative effects on the
government. The government as a debtor gains at the expense of households
who are its principal creditors. This is because interest rates on government
bonds are fixed and are not raised to offset expected rise in prices. The
government in turn levies less tax to service and retire its debt. With inflation,
even the real value of taxes is reduced. Inflation helps the government in
financing its activities through inflationary finance. As the money income of
people increases, government collects that in the form of taxes on incomes and
commodities. So the revenue of the government increases during rising prices.
i) Measures to Control Inflation
Inflation is caused by the failure of aggregate supply to equal the increase in
aggregate demand. Therefore, inflation can be controlled by increasing the
supplies of goods and reducing money income. The various measures to control
inflation are discussed below:

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 Monetary Measures:The monetary measures to control inflation generally aims
at reducing money incomes. These are:

(a) Credit Control: The central bank could adopt a number of methods to
control the quantity and quality of credit to reduce the supply of money. For
this purpose, it raises the bank rates, sells securities in the open market, raises
reserve ratio, and adopts a number of selective credit control measures, such
as raising margin requirements and regulating consumer credit.

(b) Demonetization of Currency: Another monetary measure is to demonetize

currency of higher denominations. Such a measure is usually adopted when
there is abundance of black money in the country.

(c) Issue of New Currency: The most extreme monetary measure is the issue of
new currency in place of the old currency. Under this system, one new note is
exchanged for a number of the old currency. Such a measure is adopted when
there is an excessive issue of notes and there is hyperinflation in the economy.

Fiscal Measures: Monetary policy alone cannot control inflation. Therefore, it

should be supplemented by fiscal measures. The principal fiscal measures are
discussed below.

(a) Reduction in Unnecessary Expenditure: The government should reduce

unnecessary expenditure on non-development activities in order to curb
inflation.

(b) Increase in Taxes: To cut personal consumption expenditure, the rates of

personal, corporate and commodity taxes should be raised and even new taxes
should be levied, but the rates of taxes should not be too high as to discourage
saving, investment and production.

(c) Increase in Savings: Another measure is to increase savings on the part of

the people so that their disposable income and purchasing power would be
reduced. For this the government should encourage savings by giving various
incentives.

(d) Surplus Budgets: An important measure is to adopt anti-inflationary

budgetary policy. For this purpose, the government should give up deficit
financing and instead have surplus budgets. It means collecting more in
revenues and spending less.

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 (e) Public Debt: In addition, the government should stop repayment of
public debt and postpone it to some future date till inflationary
pressures are controlled. Instead, the government should borrow more
to reduce money supply with the public.

Other (Direct) Measures

Other measures to control inflation generally aims at increasing aggregate

supply and reducing aggregate demand directly. These are:

(a) To Increase Production. The following measures should be adopted to

increase production:

(i) The government should encourage the production of essential consumer

goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.

(ii) All possible help in the form of latest technology, raw materials, financial
help, subsidies, etc. should be provided to different consumer goods sectors to
increase production.

(b) Rational Wage Policy: Another important measure is to adopt a rational

wage policy. The best course for this is to link increase in wages to increase in
productivity. This will have a dual effect. It will control wage and at the same
time increase production of goods in the economy.

(c) Price Control: Price control and rationing is another measure of direct
control to check inflation. Price control means fixing an upper limit for the
prices of essential consumer goods.

(d) Rationing: Rationing aims at distributing consumption of scarce goods so as

to make them available to a large number of consumers. It is applied to
essential consumer goods such as wheat, rice, sugar, kerosene oil, etc. It is
meant to stabilize the prices of necessaries and assure distributive justice.

Conclusion: From the various monetary, fiscal and other measures, discussed
above, it becomes clear that to control inflation, the government should adopt
all measures simultaneously.

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 8.4 DEMAND FOR MONEY

According to J.M. Keynes, money is demanded by the people to fulfill three

important motives. These motives are the transaction motive, precautionary motive
and speculative motive.
1. The Transaction Motive
People receive their income monthly, quarterly or even yearly. They spend this
money income at much shorter intervals. Individual is required to spend money
on his various wants throughout the month but income he receives once a
month. Therefore, he needs to have stock of money to meet his all needs until
the next pay day. The transaction motive can be sub-divided into (i) income
motive and (ii) business motive.
(i) Income motive
The amount of money which a consumer holds to satisfy the transaction
motive depends upon (i) the size of his income and (ii) the interval of
payment. If the size of income is larger he would keep larger amount of
his income for this motive and vice-versa. Similarly, it depends upon the
length of the interval of time between successive pay days. The greater
the interval, the larger is demand for money for transaction motive. In
conclusion, it can be said community’s demand for money under the
income motive is the function of the size of personal incomes and of the
average time between successive pay days.

(ii) Business motive

Business men also wish to hold a certain amount of money to meet day-
to-day requirement of money. This stock of money held would be used
for payment of raw materials, wages, transport and other current
expenses incurred by the businesses. The amount of money held for this
purpose is the function of the turnover of the firm. The larger the
turnover, the greater would be the amount of money, the firm needs. It
would be proportional to the total volume of business transactions
carried out. However, the demand for money for transaction motive is a
constant function of rate of interest. It is not affected by the changes in
rate of interest.

2. The Precautionary Motive

The money people demand for this purpose arises out of its function as store of
value. Money held under this motive is kept to provide for uncertainties and

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 emergencies. The individual needs a certain amount of money to keen
provisions against unemployment, sickness, accident and many other
eventualities. The amount of money held for this purpose depends upon the
individual and on the conditions in which he lives. How much money is held for
this motive depends upon social security measures of the government, size of
income and man’s attitude towards safety of future. It is also a constant
function of rate of interest. What is true in case of individual, it is as well as true
in case of firms also.

3. The Speculative Motive

Money held under the speculative motive constitutes a store of value just as
money held under the precautionary motive does, but it is a store intended to
fulfill a different purpose. It constitutes a liquid store of value. The money
demanded for this motive is generally used for gambling to make speculative
gains. Therefore, it is a negative or decreasing function of rate of interest. More
liquidity is demanded at a low of rate of interest and less at a high rate of
interest.

8.5 SUPPLY OF MONEY

The constituents of Money Supply

Money is just like one of the commodities but its supply cannot be increased like any
other commodities. The supply of money is adamantly determined by the monetary
authority of the country i.e. central bank of the country and treasury department. The
supply of money depends upon the decision of the monetary authority whether to
increase or decrease the quantity of money in the economy. In case of money, instead
of supply getting adjusted to demand, demand will get adjusted to the supply of
money. The total money in the economy refers to the total volume of money held by
the people in the form of coins and currency notes, bank money and other such liquid
assets. Total of all these constitutes the supply of money in the economy. Bank money
includes demand deposits, time deposits and current deposits.

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 Supply of money indicates the demand for goods and services because money
represents purchasing power. Under bank money, ready cash held by all the banks is
not included because it forms the basis of credit. Likewise, stock monetary gold with
Central Bank is also excluded from the total supply of money. It is because gold
reserves forms the basis of international money supply and it is not permitted to
circulate in the country. In the same manner, ready cash with Central Bank and the
government is also not included in money supply of the country. The reason is that it
constitutes the reserves on which the demand deposits of the public are supported.
Lastly, the liquidity preference of the people also influence money supply in the
economy. If it is high, then in that case volume of bank deposits will get reduced and
vice-versa. So, even the general public can influence supply of money depending upon
their liquidity preference.

Deflation – concept, causes, effects and Measure to control Deflation.

The concept of deflation is opposite to inflation. It is defined as a situation when the

general income level and price level are falling. It is also known as negative inflation.
During deflation the income level falls against the available supply of goods and
services. The stage of deflation arises when -
● Prices are falling continuously

● People prefer to hold money with them and do not keep goods.

● The available supply of goods does not dispose off on the prevailing prices.

● People expect more reduction in prices thus reduce their consumption to bring
prices down.

The main causes of deflation are -

● Primary causes are fall in demand for goods and services.

● People due to one reason or the other reduce their consumption on the
purchase of goods & services due to which prices start falling.
● Sometime people start saving more than before which causes reduction in the
aggregate demand and the available supply is sold at falling prices.
● If due to some reason the level of investment in all economy is falling. It will
negatively affect the economy. The demand for capital goods will fall and prices
will tend to come down.

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 ● Decline in incomes of the people can also cause deflation in the economy. Due
to reduction in the income level of the people the aggregate demand for goods
services falls short of the aggregate supply, thus prices start falling.

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 ● Excess of supply due to some reasons can also cause deflation because in this
case the aggregate supply will exceed the aggregate demand hence the price
level will fall.

Effects of Deflation
Consistent fall in the general price level in the economy (deflation) might not be good
for the economy. Effects of long term deflation are as follows

Cyclical unemployment: Deflation usually happens due to a fall in Aggregate Demand

in the economy. This will lead to businesses cuting the output levels which will result in
retrenchment/laying off of workers. Moreover, if consumers delay spending in
anticipation of falling prices economic activity falls, unemployment increases.

Bankruptcies: As the value of money is increasing, it becomes difficult for debtors to

repay the load. Moreover, during deflation firms will be having lower profits due to
falling prices and will find it difficult to meet their liabilities. This might lead to greater
number of bankruptcies. Businesses see profits fall; as they do so dividends and
investment returns fall and so share prices fall.

Deflationary spiral: Consistent fall in prices may trigger deflationary spiral. As firms
make less revenue, this leads to less profits, they might not be willing or able to invest
which will have negative implications on the economic growth. Further, as firms cut
cost by lay off of employees, there is less income for the households and the aggregate
demand might fall. Due to a fall in consumer and business confidence the economy
might fall into a deflationary spiral.

The principle problem of deflation is that it leads to a rise in the real value of debt. In
the early stages low interest rates and low prices encourage borrowing but as the real
weight of the borrowing is recognised so borrowing is reduced.
It is sometimes difficult to control deflation and Monetary policy can prove ineffective
when interest rates (nominal) are already low.

Measure to control Deflation

Following are the remedies suggested to control deflation.

● If the central bank reduces the interest rate then the commercial banks will also
advance loans at a lower interest rate which will boost up the investment,
resulting increase in demand for capital goods and employment. Thus incomes
will increase price level will start rising.

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 ● In order to increase the aggregate demand the government has to increase its
expenditures. By increasing expenditures incomes of the people will rise and
price level will tend to move upward.
● By Printing extra money through the central bank and injecting in the economy
the government can increase the aggregate demand which will further enhance
the price level.
● By encouraging the private sector for investment through various immunities
like subsides or tax reduction the aggregate demand can be used
● People should start using their savings on consumer goods or investment.

● To increase exports and reduce the imports, the income level of the people and
prices level can be raised

Exercise :
1. Define and explain the concept of money.
2. What are the functions fo money?
3. Explain the role of ‘money’ in an exchange economy. What are it’s
contingent and residuary functions?
4. Discuss various motives for demand of money.
5. Wht is inflation? What are the types and causes of inflation?
6. Discuss the effects of inflation.
7. Explain measures to control the inflation?
8. What do you understand by deflation? Explain its causes, effects and
suggest remedies to solve the problem of deflation.

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 UNIT – IX
SAVING, INVESTMENT AND BANKING

8.1 THE CONCEPT OF SAVINGS

Saving means economic surplus. It may be defined as an accounting difference between

current income and current consumption. Keynes defined savings as an excess of
income over expenditure of consumption.

In the case of an individual, saving is that part of income which is not consumed by him.
And in the case of the community, the aggregate of the unconsumed part of the
community, the aggregate of the unconsumed part of national income of all members
of the community represents saving. Symbolically,

S=Y-C
where, S - denotes saving
Y - stands for income, and
C - stands for consumption.

This symbolic expression of saving is applicable both to the individual as well as to the
community.

According to Keynes, saving is the function of income, i.e., S = f(Y). That is to say, as
income increases, saving also increases and vice versa. Saving depends on the
propensity to save, which can be derived from the propensity to consume.

Thus, propensity to save (S/Y) is equal to' one minus the propensity to consume (C/Y)
symbolically, therefore:
S/Y = 1 – (C/Y)
According to Keynes, the consumption function (or the propensity to consume) is a
stable function of income in the short period. It follows from this that the saving
function (or the propensity to save) would also be a stable function of income.

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 It should be noted that though the propensity to save is stable function of income,
saving (individual or aggregate) is an increasing function. Thus, the marginal propensity

to save (ΔS/ΔY) is always greater than zero, but less than unity

Symbolically, 1 > (ΔS/ΔY) > 0.

Aggregate domestic savings are the sum of savings made by the households, firms and
government.

(1) Household's saving = Disposable personal income - Consumption

expenditure.
(2) Firms' saving = Profits (or gross income)- (Dividends+ Business taxes).
(3) Government's saving = Public revenue - current expenditure.

Savings of households and firms taken together constitute private savings.

Government's savings constitute public savings. Therefore, Total Saving = private saving
+ public savings. Again, personal savings or household savings is the vital component of
aggregate savings. According to RBI's report of Currency and Finance, in India, in 1980-
81, of the total savings in the country, the household sector accounted for 80.3 per
cent, domestic private corporate sector 5.4 per cent, and government sector 14.3 per
cent.

8.1.1 Personal Savings

The household sector's savings are called personal savings or the savings of individuals.
Professor Irwin Fisher defines individual's savings as "the difference between their
current income and their current expenses, the latter including personal tax payment
as well as consumption expenditures."

While considering the sum of individuals' savings, it must be noted that there are
savers and dissavers. Usually, young people save and old people dissave. A
considerable part of all personal saving is done with a view to future liquidation. People
save with a view to have assets to spend after retirement or to provide financial help to
their dependents in the event of their deaths, which means liquidation of savings in the
future.

Therefore, Net individuals' saving of the community = Total personal saving – Total
dissavings.
In a modern society, personal savings may take one or more of the following forms.

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 (i) Contractual saving such as life insurance premiums, contributions to
provident funds, etc. These kinds of savings are obligatory in nature. They
are relatively stable.
(ii) Holding of liquid assets. Individuals may increase their holdings of liquid
assets such as cash balances, bank deposits, shares, bonds and securities.
(iii) Liquidation of old debts. When an individual pays a sum of money to his
creditor for cancellation of a debt, it amounts to a saving of his income.
(iv) Direct investments. Some individuals may invest part of their income
directly in farm activity, business or purchasing a home. This is also saving.
In rural areas, such savings are found in the form of land improvements, irrigation
works, construction of dwellings, etc.

8.2 DETERMINANTS OF SAVINGS

The rate and size of savings in an economy are determined by a multitude of factors. A
humble attempt is made to analyse a few of them which are vital determinants.

8.2.1 The Level of Income

As Keynes stresses, saving is basically a function of income. Saving increases with

income. Of course, there can hardly be a proportionate relationship between the size
of income and savings, but empirical evidence has proved that there is a marked
correlation between the two. However, the amount of personal savings depends
primarily on the disposable income. Thus, the saving income ratio (S/Y) tends to rise
with an increase in income. It has been observed that the marginal propensity to save

(ΔS/ΔY) tends to be high in high-income group sectors of community. Indeed, in

developed countries, where per capita income is high, the saving income ratio is also
high. According to the world Economic Survey 1960, gross domestic saving in the U.S.A.
amounted to 18.6 per cent and that of India less than 7 per cent.

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 (i) Absolute Income Hypothesis: According to Keynes, saving is a function of the
absolute level of income. Other things being equal, a rise in absolute income
causes an increase in fraction of that income to be saved. The absolute income
hypothesis of savings was further developed by J. Tobin and A. Smithies as "Drift
Hypothesis." In the "Drift Hypothesis", it has been argued that the level of
National Income increases over a period of time and along with it, the average
propensity to consume tends to diminish so that average propensity to save
increases over a period of time.
(ii) Relative Income Hypothesis: Rose Friedman and Dorothy Brady have tried to
furnish an answer to this inconsistency by propounding the concept of relative
income hypothesis. According to them, the rate of savings depends on the
relative position of the individual on the income scale rather than on his
absolute level of income. That is to say, the consumption spending of a family
depends on its relative position in the income distribution of approximately
similar families.
(iii) Permanent Income Hypothesis: Keynes believed that the current income
determines current consumption and savings. Modern economist to like Milton
Friedman, however, observe that the expectations of income in the future do
have a significant bearing upon the present consumption spending and savings
out of a given income of community. Kisselyoff, for instance, mentions that the
present dissaving among those people who expect their incomes to rise in
future is found to be more frequent. In view of this, Mr. Friedman propounded
the "Permanent Income Hypothesis". Friedman holds that the basic
determinant of consumption and savings is permanent income. The relationship
between saving and permanent income is proportional. A person's permanent
income, in any particular year, is not revealed by his current income in that
year, but is dependent upon the expected income to be received over a long
period of time. Permanent income is the amount which the consumer unit could
consume (or believes that it could) while maintaining its wealth intact. Friedman
states that permanent income may be interpreted as the mean income
regarded as permanent by the consumer unit in consideration. Permanent
income depends on the far-sightedness of a person. Indeed, a person's actual
income, in any specific year, may be greater than or less than his permanent
income.

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 8.2.2 Income Distribution
Aggregate savings rate also depends upon the distribution of income and wealth in the
community. If there is a greater degree of inequality of income among the people, that
aggregate savings rate, would tend to be high, as the richer section of the community
has a high propensity to save. A country with a low per capita income and a fair
distribution of national income would imply a low savings rate. Thus, with an
improvement in the distribution of income or correction of income inequalities through
fiscal and other measures, the aggregate savings rate may tend to decline in the initial
stage. Thus, the egalitarian goal of redistribution of income and wealth may come in
the way of capital formation by causing a reduction in the domestic aggregate savings.
Nonetheless, the ideal of just and fair income distribution cannot be sacrificed on this
ground.

8.2.3 Consumption Motivations

Saving is the residual part of income left after consumption. Thus, to know the factors
affecting saving, we must know what factors determine consumption. The consumption
of the community depends upon a variety of factors and motivations. According to
Duesenberry, the consumption pattern and its size are determined by (i) the
consumption of certain types of goods required by physically and socially generated
needs, (ii) these needs can be satisfied alternatively by a large number of qualitatively
different kinds of goods, (iii) these different kinds of goods have qualitative variations
and ranking which form the community's scale of preference.
In fact, the pattern of consumption and its volume depends, in general, upon the
standard of living of the people. Duesenberry, thus, states that "the level of saving
actually achieved by anyone represents the outcome of the conflict between his desire
to improve his current standard of living and his desire to obtain future welfare by
saving." In this context, therefore, motivations regarding saving and consumption
expenditure must be analysed. Duesenberry points out that usually while choosing
consumption goods, people prefer higher quality goods to lower quality goods with a
view to improve their standard of living. A person's physical needs usually remain the
same. But, his social need vary from time to time. The social needs of a person depend
upon his age, occupation, social position, marginal position and marginal status. The
consumption of certain goods – especially ostentatious articles - is caused by
maintenance of self-esteem or the acquisition of prestige. In a society where there is a
system of differential social status, this is a vital determinant of consumption
expenditure.

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 In short, the consumption pattern of a person is based on his budget constraint and the
desire to save. However, any rational balancing in consumption decisions is far from
frequent.

8.2.4 Wealth
Holding of wealth or liquid assets by a person also affects his consumption decisions.
Out of current income a person would consume more and save less if he possesses
adequate amount of liquid assets like cash balances, bank deposits, etc. and feels that
his life in future is well secured. Similarly, an appreciation in the value of financial
assets also would induce the person to consume and save less.

8.2.5 Habit
Habit is a major determinant of consumption pattern. As a matter of fact, at anyone
moment, a consumer already has a well-established set of consumption habits. The
habit of consumption is formed by taste, likings, fashion, and other psychological
influences on the minds of consumers. By nature of his habit, when a person is a
spendthrift, his saving will be relatively less out of a given income than that of a person
who considers saving as a virtue. Thus, aggregate saving in an economy depends upon
the types of habits of the people in general.

Habit conforms to the standard of living of the community. Habit, in the long run, may
not be a very constant factor. It is subject to change. In general, people want to
improve their standard of living by improving the quality of the goods they consume.
Public policies are also devised to improve the living standards of the masses. With an
increase in income or otherwise, through dissaving, there may be a drive to spend
more on superior goods. There is always a psychological impact of "superior
effectiveness" of certain goods such as comfort, convenience, beauty, etc. which
induces people to spend more and save less, in due course of time.

In this context, Duesenberry mentions that the "demonstration effect" in modern

society serves as a powerful habit-breaker. The "demonstration effect" refers to an
increase in consumption is reduction in saving through imitation of superior standards.
According to Duesenberry the widespread imitation of superior standards causes an
upward shift in the aggregate consumption function, thereby reducing the rate of
saving.

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 The "demonstration effect" implies that a high frequency of contact of a person with
superior consumption by others will break his habits and induce him to spend more on
expensive goods by weakening his desire for saving. It has been observed that when
people habitually use one set of goods, they tend to be dissatisfied if there is a
demonstration of superior consumption by others. More knowledge of the existence of
superior goods is not an effective habit-breaker. It is the demonstration effect which is
a powerful habit-breaker. One may be reminded of a common saying here that "what
you don't know won't hurt you, but what you do know does hurt you. '

Poor countries are saving-deficient. Their problem of low saving rate is further
accentuated by their desire to imitate the superior consumption standard of developed
nations induced by international demonstration effect.

8.2.6 Population
A high growth of population has an adverse effect on the per capita income which
causes an adverse effect on the saving-income ratio.

Again, the age distribution of the population also affects the volume of aggregate
saving in the economy. Aggregate personal saving depends upon the dissaving of old,
retired people and the saving of the young group. A community's aggregate saving
would be zero when the positive saving of the young people is just balanced off by the
dissaving of the retired people to maintain their consumption expenses. If a society has
a large proportion of young people in relation to old people, net aggregate saving will
be positive. Thus, the aggregate saving ratio in a community tends to vary with the age
structure of its population, even with constant per capita income. It follows thus that
when the population is stable in all respects, net saving will rise with the increasing per
capita income in an economy.

8.2.7 Objective and Institutional Factors

There are a number of objective factors - mostly institutional by nature which affects
the capacity and willingness to save of the people at large. Political stability and
security of life and property encourage people to save more. Similarly the existence of
a good banking system and other developed financial institutions of money and capital
market such as Unit Trust, Life Insurance Corporation, financial houses, shares of good
corporations, government bonds and securities, etc. induce people to save more under
the economics of interest-earning motive by providing a wide range of remunerative
investment opportunities.

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 The taxation structure and fiscal policy also affect savings in the economy. A vigorously
progressive direct taxation leads to a reduction in voluntary personal saving. Similarly,
high and widespread indirect taxes will force the consumer to spend more on
maintaining his given standard of living. This will cause a reduction in his personal
saving. Similarly, high corporate taxation will reduce the net profit of business houses
and curb their capacity to save.

On the other hand, certain concessions provided in the taxation schemes can help in
promoting voluntary saving. For instance, exemption of interest-earning from bank
deposits, outright deductions of life insurance premium, contribution to provident
fund, etc. serve as good stimuli to saving.
Price stability or check on inflation by governmental effort can also sustain saving,
while hyper inflation may lead to dissaving or reduction in saving.

Likewise, windfall gains and losses also effect saving. The former will lead to a rise in
savings and the latter will induce dissaving.

8.2.8 Subjective Motivations for Savings

People are induced to save more when there are strong subjective factors which
motivate them to save. Keynes enlisted the following main motives which lead to
individuals to save:
(1) Precaution - to build up a reserve against unforeseen contingencies.
(2) Foresight - to provide for future needs.
(3) Calculation - to enjoy interest and a larger real consumption at a future
date.
(4) Improvement - to improve standard of living gradually.
(5) Independence - to enjoy a sense of independence and the power to do
things with accumulated savings.
(6) Enterprise - to make speculation or undertake business projects.
(7) Pride - to bequeath a fortune.
(8) Avarice - to satisfy pure miserliness. .

Likewise, savings of business firms are induced by the following motives:

(i) Enterprise - to carry out further capital investment.
(ii) Liquidity - to meet emergencies of business.
(iii) Improvement - to expand business investments.
(iv) Prudence - to have financial prudence in discharging debts.

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 8.2.9 Rate of Interest

According to classical economists, saving is the direct function of the rate of interest.
To put it symbolically:
S=f (i)

where S stands for saving and i stands for the rate of interest. It suggests that saving
tends to rise with an increase in the rate of interest and vice versa. Keynes, however,
did not agree with this view. He asserted that saving is a function of income.

But, it remains a fact that the personal saving of some individuals who are motivated by
economic considerations is certainly induced to save more when the rate of interest
rises. They may be willing to curtail their consumption or try to earn more income in
order to save more. But, a mere rise in the rate of interest is not enough. Income also
must rise. Income is the basic determinant of one's capacity to save. Saving comes out
of income and not from rate of interest. But a high rate of interest may give a
psychological push to the economic motive behind saving.

However, the rate of interest is an important factor in the mobilisation of saving.

People would be induced to pass on their saving to those institutions which offer a high
rate of interest. Thus, from the point of view of holding of near money assets, the rate
of interest constitutes a significant influence. A person would like to keep his savings in
that type of bond from which the relative yields will be highest as against any other
type available.

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 8.3 SAVING-INVESTMENT RELATIONS
In Keynes's view, investment does not depend significantly upon the level of income. It
mainly depends on dynamic factors such as population growth, territorial expansion,
and progress of technology and above all, business expectations of the entrepreneur.
Thus, it is unpredictable, unstable and autonomous as against savings which is stable,
predictable and induced. Thus, it is fluctuations in investment that cause variations in
income which in turn bring about equality between saving and investment. According
to Keynes, varying levels of income cannot be sustained in an economy unless the
amounts of savings at these levels of income are offset by an equivalent amount of
investment. Thus, Keynesian theory draws the equilibrium relations between income,
saving and investment. According to Keynes, varying levels of income cannot be
sustained in an economy unless the amounts of savings at these levels of income are
offset by an equivalent amount of investment. Thus, Keynesian theory draws the
equilibrium relations between income, saving and investment. It stresses that the
equilibrium level of income is realised where saving out of income is just equal to the
actual amount of investment. This is depicted in Figure.

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 In Figure, I-I is the original investment schedule which is a horizontal straight line
showing that investment is completely autonomous in the sense that it does not vary
much with income. This is the fundamental postulate of Keynesian theory. 1-1 is the
new investment schedule indicating a shift in the I-function due to the forces of certain
dynamic factors. The curve SS is the saving schedule showing how the amount of saving
increases with income. But, it is a stable phenomenon and, therefore, usually, there
cannot be a shift in its curve. From the diagram it appears that the income is
determined by the saving and investment schedules. Initially, 1schedule and S-schedule
intersect at point E, and we have an income level OY, where obviously S=I. Thus, the
Keynesian theory of shifting equilibrium shows the S and I equality at varying levels of
income.

Of course, the Keynesian formulation of saving-investment relationship in its functional

sense admits the divergences between saving and investment, but only at virtual levels
and not at observable levels of income. The equilibrium level of national income is
obviously the observable level of income where there is corresponding equality
between "observable" savings and "observable" investment. And, for given savings and
investment schedules, there is, of course, only one equilibrium level of income
corresponding to the equality between S and I. In a static Keynesian system, there can
be divergence between savings and investment only when the economy is not in
equilibrium.

8.4 UNDEREMPLOYMENT EQUILIBRIUM

The classical economists held that saving being a function of the rate of interest; it
automatically flows into an equal amount of investment, led by changes in the rate of
interest which tend to generate a full employment level of income in the economy.
Thus, in classical economics, full-employment condition was assumed to be a normal
phenomenon. Keynes, however, pointed out that in a modern capitalist economy,
usually, the saving-investment equality takes place at an income level which may be
significantly below the full-employment level. Thus, more realistically, a modern free-
enterprise economy tends to have under-employment equilibrium as its normal
feature.

The Keynesian idea of "underemployment" equilibrium has been elucidated by

Professor Kurihara in terms of .the following strategic functions in the Keynesian theory
of employment: (i) the interest-inelastic function, (ii) the interest-inelastic liquidity
function.

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 Kurihara observes that from empirical investigation, it has been found that there is no
significant correlation between the interest rate and the quantum of investment. Thus,
a mere adoption of a cheap money policy cannot be very effective in stimulating the
level of investment such that a rise in saving is automatically transmitted into
investment to establish the saving-investment equilibrium at full-employment level.

Similarly, the saving schedule is income-elastic, but it is interest inelastic in practice.

The interest-inelasticity in saving function suggests that with a fall in interest rate, in
view of insufficient investment, demand for liquidity, however, cannot cause a decline
in the propensity to save. As such, saving-investment equilibrium is likely to take place
at less than full-employment level.

It has been said that drastic changes in the rate of interest can affect the saving
schedule. This is true. But, here the liquidity function comes in the way. Kurihara points
out that at a very low rate of interest, the liquidity function becomes perfectly interest-
elastic, which has two unhealthy influences: (i) it tends to discourage inducement to
invest, by its depressing effect on the marginal efficiency of capital of high rate of
interest, which is essential to overcome a strong liquidity preference of some people,
and (ii) it is neither feasible nor advisable for the monetary authority to expand money
supply indefinitely and lower the rate of interest to the bottom, just for the sake of
stimulating private investment. Consequently, the investment functions at a point of
full-employment level. The point of effective demand, thus, tends to materialise at an
under-employment equilibrium level in a real economy. It must be noted that
Keynesian theory refers here to privately induced investment only. Public investment
which is autonomous depends on the plan and public policy can be shifted upward up
to the full-employment ceiling in a decided manner.

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 8.5 Indian Capital Market

8.5.1 MEANING AND FUNCTIONS OF CAPITAL MARKET

Capital market is a growing component of the financial, system in India. The capital
market differs from the money market in terms of maturity, structure and liquidity. The
money market comprises financial instrument having a maturity period of one year or
less than one year. It involves short-term transactions.

Capital market contains financial instruments of maturity period exceeding one year. It
involves long-term transactions. Capital market instruments are relatively less liquid in
comparison to the money market instruments. Capital market in a broad sense
encompasses all kinds of arrangements and financial institutions involved in long term
funding. Capital market is, however, commonly referred to the stock markets in the
country. From the stock markets point of view, capital market comprises both primary
and secondary market. The primary market deals with new issues made by the
companies. The secondary market relates to the trading in the existing securities. An
investor can buy securities in the primary market, but can sell only in the secondary
market.

Functions of Capital Markets

Capital market is the financial pillar of industrialized country. It is the catalysts agent of
development. It renders several functions, such as:

● Transformation of savings into investment. Capital market mobilizes savings

from the households to the producers who are the investors. It provides inter-
mediation between savers and investors on a long-term basis.
● Flow of funds. It channelises the allocation of the funds from less profitable to
more profitable channels. It thus leads to optimum utilization of resources. It
enables surplus and idle funds to be used more effectively, efficiently and
productively.
● Macro-economics financial balancing. Capital market mobilises funds from
surplus units to deficit units through appropriate financial inter-mediation.
● It facilitates the project financing and growth of corporate sector.

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 ● It provides better returns to the savers by offering numerous alternatives in the
portfolio investments.

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 India is heading on to the growing private sector in its mixed economy. As such, private
savings and capital plays pivotal role in its growth process. A healthy growth of capital
market is, therefore, essential to promote expanding savings and investment in the
country.

8.5.2 STRUCTURE OF THE INDIAN CAPITAL MARKET

Usually, capital markets are classified in two ways:

- On the basis of issuer,
- On the basis of instruments.

In terms of issuer type, these are:

(a) Markets for corporate securities, and
(b) Markets for government securities.

In terms of instruments, these are:

(a) Equity markets, and
(b) Debt markets.

Over the years, there has been a substantial development of the Indian capital market.
It comprises various sub-markets. In recent years, its structure has grossly changed.
Various new instruments and new institutions have cropped in. Broadly speaking, there
are the following sub-markets:

(1) Corporate market for both securities (both new and old);
(2) Government securities market;
(3) Debt instrument market; and
(4) Market for institutional schemes. (Such as mutual funds, etc).

There are both primary and secondary markets for all kinds of these markets. The
primary market is the source of raising funds directly from the public. The secondary
market is meant to provide liquidity and trading facilities.
The Indian secondary market structure comprises:

● Regular stock exchanges. Presently 21 in numbers in major Indian cities.

● Over the Counter Exchange of India (OCEI). This is meant for smaller companies.
It has no trading ring.
● National Stock Exchange.

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 8.5.3 CAPITAL MARKET FOR CORPORATE SECURITIES

There has been a growing trend of corporate sector in India. Nearly 2 lakh companies
have registered in the country. Exceeding 8,000 companies are listed on all stock
exchanges of the country.

Companies enter into the capital market for the following reasons:

● Modernization

● New projects

● Expansion

● Assets acquisition

● Capital restructuring

● For listing their securities on stock exchanges

Sub-brokers

With the establishment of Securities and Exchange Board of India (SEBI) and abolition
of Controller of Capital Issues, there has been a remarkable shift from 'control' to
'regulatory' system in the Indian capital market.

8.5.4 CAPITAL MARKET FOR GOVERNMENT SECURITIES

Indian government is a big borrower. It borrows through gilt-edged securities - i.e.,

repayments of principal and interest is totally secured with budgetary provisions.

The government securities are of three types:

(i) Long-term : exceeding 10 years;

(ii) Medium-term : ranging between 5-10 years;
(iii) Short-term : between 1-5 years.

Government securities are held in the form of:

● Stock Certificates

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 ● Bearer Bonds

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 Stock certificate certifies that the holder is registered in the book of the Public Debt
Office of the government. It also indicates interest rate. Bearer bond certifies the
entitlement to specified sum. It also indicates the interest rate.
Besides, the government of India floats securities called:
(i) Social security certificate,
(ii) Capital investment certificate,
(iii) Deposit certificates,
(iv) Annuity certificates,
(v) Annuity deposit certificates,
(vi) Zamindary compensation bonds and rehabilitation grant bonds,
(vii) National savings certificates,
(viii) National defense certificates, and
(ix) National deposit certificates.

The growth of government securities market depends on the public debt programme of
the government.

8.5.5 GROWTH PROSPECTS OF INDIAN CAPITAL MARKET

Indian capital market has a vast growth potential. Presently it has captured only about
10 percent of household savings in mobilisation for the corporate sector. In other
developed countries more than 20-25 percent of household savings are tapped by their
capital markets. Moreover, over 25 percent population goes for share holdings in these
countries. In India such percentage is just less than 5.

In 1997-98, however, of the household sectors savings, 2 percent claimed by the UTI ,
shares and debentures, 12.4 percent by government securities, and 4.3 percent by the
non-banking deposits. On the other hand, 45.6 percent share claimed by the bank
deposits. This means bank-deposits are still popular avenues in India.
Liberalisation, financial regulations and activities of SEBI as well as positive industrial
policy would help in attracting more funds into the Indian capital market.

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 Characteristics of Indian Capital Market

Indian capital has the following main features that may favour more savings
mobilisation:

● Fast growth of mutual funds

● Banks subsidiaries for. financial services into the capital market

● Growth of the merchant banking

● Floatation of mega issues

● Growing debt instruments Issue of debentures

● Avoidance of underwriting

● Increased transparency through SEBI's regulations

● Liberalisation policy of the government

● Emerging new financial instruments such as convertible bonds, foreign currency

rates, zero coupon bonds, discount bonds, warrants, etc.

Current Scenario

The SEBI is playing active role in its regulatory reform to further strengthen investors'
protection and monitoring and modernising the Indian capital market. There has been
enhancement of integrity, transparency and efficiency of operations of the securities
market.

The government has established the National Venture Fund for Software and IT
industry (NVFSIT) in the year 2000. It is managed by the Small Industry Development
Bank of India (SIDBI) Venture Capital Ltd. (VCL).
In short, capital market in India is an important source of funds for public as well as
private sector undertaking.

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 8.6 Commercial Banking

8.6.1 EVOLUTION OF BANKING

Banking, in its crude from, is an age-old phenomenon. It was in existence even in

ancient times. Revilpout, a French writer, for instance, mentions about bank and bank
notes in Babylon 600 B.C. In India, the references to money lending business are found
in the Manu Smriti also. Chaldean, Egyptian and Phoenician history also records the
existence of rudimentary banking in early days.

Prof. Marshall in his book, Money, Credit and Commerce, (1923) writes about the
activities of money-changers in the temples of Olympia and other sacred places in
Greece, around 2,000 B.C. To quote him, "Private money-changers began with the task
of reducing many metallic currencies, more or less exactly, to a common unit of value,
and even to accept money on deposit at interest, and to lend it out at higher interest
permitting meanwhile drafts to be drawn on them."

As a matter of fact, the origin of banking lies in the business of money changing in
ancient days.Another factor that supported the emergence of banks in the early period
was the need for borrowing by the monarchical governments from finance companies.
In the Middle Age, in Italy the first bank called the 'Bank of Venice' was established in
1157, on this ground, particularly, when the authorities of the state of Venice were in
financial trouble due to war.

In England, however, the bankers of Lombardy had taken the initiative to start modern
banking along with their trading activities in London. But, commercial banking began
there only after 1640, when goldsmiths started receiving deposits from the public for
safe custody and issued receipts for the acknowledgments which were being used as
bearer demand notes later on.

Crowther, thus, speaks about three ancestors of a modern commercial bank, viz., the
merchant, the money-lender and the goldsmith. The merchants or traders issued
documents like 'hundi' to remit the funds. Modern banks introduced cheques, or
demand drafts for remittance purposes. Money-lenders gave loans. Bankers too gave
loans. Goldsmiths received deposits and created credit. Banks also received deposits
and adopted the process of credit in a similar fashion, by issuing cheques.

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 In short, the evolution of commercial banking is related to the practice of safe-keeping
of gold and other valuables by the people with merchants/goldsmiths/ money-lenders.

Etymologically, however, the word 'bank' is derived from the Greek word banque, or
the Italian word banco both meaning a bench - referring to a bench at which money-
lenders and money-changers used to display their coins and transact business in the
market place.

In England, initially the Bank of England was established in 1694 on Italian lines to
support government with finance.

Modern joint-stock commercial banks, however, came into the picture with the
passage of the Banking Act of 1833 in England.

In India, however, modern banking started when the English agency houses in Calcutta
and Mumbai began to serve as bankers to the East India Company and the Hindustan
Bank was the first banking institution of its kind to be established in 1779.

8.6.2 WHAT IS A BANK?

Commercial banks are the most important source of institutional credit in the money
market.

A commercial bank is a profit-seeking business firm, dealing in money and credit. It is a

financial institution dealing in money in the sense that it accepts deposits of money
from the public to keep them in its custody for safety. So also, it deals in credit, i.e., it
creates credit by making advances out of the funds received as deposits to needy
people. It thus, functions as a mobiliser of saving in the economy.

A bank is, therefore, like a reservoir into which flow the savings, the idle surplus money
of households and from which loans are given on interest to businessmen and others
who need them for investment or productive uses.

A bank is an important institution of the money market as it gives short-term loans to

its customers.

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 Definition of Bank
On account of the multifarious activities of a modern bank, it becomes very difficult to
give a precise definition of the world "Bank". The Oxford Dictionary defines a bank as
"an establishment for the custody of money, which it pays out on a customer's order."
This, however, is not a very satisfactory definition, since it ignores the most important
function of a bank that of creating money or creating credit.

Most commonly, than, banks have been defined as dealers in debt. This definition, of
course, more aptly describes a bank's activities. Sayers more clearly states: "We can
define bank as an institution whose debts (bank deposits) are widely accepted in
settlement of other people's debts to each other." Crowther, thus, puts it: "The
banker's business is then, to take debts of other people, to offer his own in exchange
and thereby to create money."

A banking company in India has been defined in the Banking Companies Act, 1949 as
one "which transacts the business of banking which means the accepting, for the
purpose of lending or investment, of deposits of money from the public, repayable on
demand or otherwise and withdrawable by cheque, draft, order or otherwise. "

Acceptance of chequable demand deposits and lending them to others are the two
distinctive features of a banking institution. On this account, Post Office Saving banks
are not regarded as banks in the true sense of the term, since they do not lend money,
even though some of them have introduced the cheque system. Similarly, there are
other financial instiutions like the Unit Trust of India (UTI), the Life Insurance
Corporation (LIC), the Industrial Finance Corporation of India (IFCI);-the Industrial
Development Bank of India (IDBI), etc. which lend money to others but do not accept
chequable demand deposits. Therefore, they are not regarded as banks. They are called
non-banking fmancial institutions.

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 Difference between Banking and Money-lending

A banking business is, however, distinct from a pure money-lending business. A money-
lender usually advances his own funds. A bank accepts deposits from the public, which
are withdrawable by cheques, and the funds so accumulated are lent to its needy
customers against goods or securities or by discounting bills. Further, the bank pays
interest to its depositors, and the deposits are withdrawable by cheques. Money-
lenders generally do not receive deposits from public, and even if they receive such
deposits, it is not obligatory on their part to pay a uniform interest rate on such
deposits; and these deposits are not chequable. Further, very often; when there is
credit stringency, bankers may borrow from other banks or central bank to lend to their
customers. Money-lenders obviously do not do so.

8.6.3 KINDS OF BANKS

Financial requirements in a modern economy are of a diverse nature, distinctive variety

and large magnitude. Hence, different types of banks have been instituted to cater to
the varying needs of the community.

Banks in the organised sector may, however, be classified into the following major
forms:
(1) Commercial banks; (2) Co-operative
banks;
(3) Specialised banks, and (4) Central bank.

(1) Commercial Banks

Commercial banks are joint stock companies dealing in money and credit. A commercial
bank may be defined as a financial institution that accepts chequable deposits of
money from the public and also uses the money with it for lending. The most distinctive
function of a commercial bank is that it accepts deposits called demand deposits from
the public which are chequable, i.e., withdrawable by means of cheques. Acceptance of
chequable deposits alone, however, does not give it the status of a bank. Its another
essential function is to make use of these deposits for lending to others.

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 Commercial banks usually give short-term loans and advances. They occupy a dominant
place in the money market. They, as a matter of fact, form the biggest component in
the banking structure of any country. The commercial banks in India are governed by
the Indian Banking Regulation Act, 1949 brought up to date to include additional rules
thereto. Under the law, commercial banks are not supposed to do any other business,
except banking.

In capitalist countries, like the UK and the USA, commercial banks are usually in the
private sector, owned by shareholders. In socialist countries like Russia, they are
completely nationalised. In France, however, though it has a capitalist economy, all
commercial banks are state-owned.

Commercial Banks in India

In India, however, there is a mixed banking system. Prior to July 1969, all the
commercial banks-73 scheduled and 26 non-scheduled banks. except the State Bank of
India and its subsidiaries - were under the control of private sector. On July 19, 1969,
however, 14 major commercial banks with deposits of over 50 crores were
nationalised. In April, 1980, another six commercial banks of high standing were taken
over by the government.

At present, there are 20 nationalised banks plus the State Bank of India and its 7
subsidiaries constituting public sector banking which controls over 90 per cent of the
banking business in the country.

(2) Co-operative Banks

Co-operative banks are a group of financial institutions organlsed under the provisions
of the Co-operative Societies Act of the states. These banks are essentially co-operative
credit societies organised by members to meet their short-term and medium-term
financial requirements..
The main object of co-operative banks is to provide cheap credit to their members.
They are based on the principles of self-reliance and mutual co-operation.

The co-operative banking system in India is, however, small sized in comparison to the
commercial banking system, Its credit outstanding is just less than one-fifth of the total
credit outstanding of the commercial banks. Nonetheless, cooperative credit system is
the main institutional source of rural, especially, agricultural finance in India.

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 Co-operative baking system in India has the shape of a pyramid i.e., a three-tier
structure, constituted by: (i) primary credit societies; (ii) central co-operative banks;
and (iii) state co-operative banks.
Primary credit societies lie at the total or base level. In rural areas there are primary
agricultural credit societies (PACs), which cater to the short and medium-term credit
needs of the farmers.

In urban areas, to provide non-agricultural credit, urban co-operative banks and

employees' credit societies are formed. Urban banks usually provide short-term loans
to their members, who are small borrowers. They also accept deposits from members
and non-members, too. Thus, their functions and working are more or less similar to
those of commercials banks. But by nature, their form is only co-operative and that is a
major distinction between these and commercial banks which are joint stock
companies.

The Central Co-operative Banks (CCBs) are federations of primary societies belonging to
a specific district. By furnishing credit to the primary societies, central co-operative
banks serve as an important link between these societies and the money market of the
country. No central co-operative bank lends to individuals. It lends to societies only.
The State Co-operative Banks (SCBs) lie at the apex of the entire co-operative credit
structure. Every State Co-operative Bank's basic function is to furnish loans to the
central co-operative banks in order to enable them to help and to promote the lending
activities of the primary credit societies. The State Cooperative Banks, thus, serve as the
final link between the money market and the cooperative sector of the country.

(3) Specialised Banks

There are specialised forms of banks catering to some special needs with this unique
nature of activities. There are, thus, foreign exchange banks, industrial banks,
development banks, land development banks etc.

Foreign Exchange Banks or simply exchange banks are meant primarily to finance the
foreign trade of a country. They deal in foreign exchange business, buying and selling of
foreign currencies, discounting, accepting and collecting foreign bills of exchange. They
also do ordinary banking business such as acceptance of deposits and advancing of
loans, but in a limited way. In India, there are 15 foreign commercial banks basically
undertaking such activities only.

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 Industrial Banks are primarily meant to cater to the financial needs of industrial
undertakings. They provide long-term credit to industries for the purchase of
machinery, equipments etc.

In India, there are some special financial institutions which are called "development
banks". Presently, at the all-India level, there are five such industrial development
banks: (i) the Industrial Development Bank of India (IDBI), (ii) the Industrial Finance
Corporation of India (IFCI), (iii) the Industrial Reconstruction Corporation of India (IRCI),
for large industries, (iv) the Industrial Credit and Investment Corporation of India
'(ICICI), and (v) the National Small Industries Corporation (NSIC) catering to the needs of
the small industries. All these institutions have been founded by the Government,
except the ICICI which is owned by the private sector.

Similarly, at the state level, there are: (i) the State Financial Corporations (SFCs), (ii) the
State Industrial Development Corporations (SIDCs), and (iii) the State Industrial
Investment Corporations (SIICs) serving as industrial development banks.

Land Development Banks (LDBs) are meant to cater to the long and medium-term
credit needs of agriculture in our country. They are mainly district level banks. Since the
LDBs give loans to their members on the mortgage of land, previously they were called
land mortgage banks. There are state land development banks at the top level and
primary land development banks at the base or local level.

Agricultural Refinance and Development Corporation (ARDC) is a kind of agricultural

development bank which provides medium and long-term finance to agriculture in our
country. ARDC operates by making provisions of refinance to State Land Development
Banks, State Co-operative Banks and Scheduled Commercial Banks which are its
shareholders.

The Export-Import Bank of India (EXIM BANK) has been instituted for planning,
promoting and developing exports and imports of the country.
In Western countries, there are specialised banks such as discount houses, investment
banks, labour banks etc., catering to the specialised needs of the people.

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 (4) Central Bank
A central bank is the apex financial institution in the banking and financial system of a
country. It is regarded as the highest monetary authority in the country. It acts as the
leader of the money market. It supervises controls and regulates the activities of the
commercial banks. It is a service-oriented financial institution primarily concerned with
the ordering, supervising, regulating and development of the banking system in the
country. As the central bank is able to influence monetary and credit conditions and
financial developments in a country, it is charged with the responsibility of carrying out
the monetary and credit policies.

India's central bank is the Reserve Bank of India, established in 1935.

A central bank is usually state-owned. But it may also be a private organisation. For
instance, the Reserve Bank of India (RBI), was started as a shareholders' organisation in
1935, however, it was nationalised after Independence, in 1949.

Although the central bank is state-owned, it functions as a semi-government

institution, free from parliamentary control.

8.6.4 FUNCTIONS OF COMMERCIAL BANKS

Commercial banks perform several crucial functions, which may be classified into two
categories: (a) Primary functions, and (b) Secondary functions.

Primary banking functions of the commercial banks include:

1. Acceptance of deposits from the public;
2. Lending of funds;
3. Use of cheque system; and
4. Remittance of funds.

1. Acceptance of Deposits from the Public

Accepting deposits is the primary function of a commercial bank. By receiving deposits

from the public, commercial banks mobilise savings of the household sector.

Banks generally accept deposits in three types of accounts: (i) Current Account, (ii)
Savings Account, and (iii) Fixed Deposits Account.

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 Deposits in Current Account are withdrawable by the depositors by cheques for any
amounts to the extent of the balance at their credit, at any time without any prior
notice. Deposits of current account are, thus, known as demand deposits. Such
accounts are maintained by commercial and industrial firms and businessmen, and the
cheque system is the most convenient and very safe mode of payment.

Savings Accounts are maintained for encouraging savings of households. Withdrawals

of deposits from savings accounts are not freely allowed as in the case of current
account. There are some restrictions on the amount to be withdrawn at a time and also
on the number of withdrawals made during a period. Indian commercial banks have,
however, relaxed these rules of savings accounts to a certain extent in recent times.
Banks pay a rate of interest on the savings account deposits as, prescribed by the
central bank.

Deposits in fixed account are time deposits. In the normal course, deposits cannot be
withdrawn before the expiry of the specified time period of the deposits. A premature
withdrawal is, however, permitted only at the cost of forfeiture of the interest payable,
at least partly. On these deposits commercial banks pay higher rates of interest, and
the rate becomes higher with the increase in duration.

By creating such varieties of deposits, banks motivate savers and depositors in a variety
of ways and encourage savings in the economy. Further, by keeping deposits with
banks, depositors' money is not only secured and remains in safe custody, but it yields
interest also. Moreover, banks' demand deposits are in the form of liquid cash, for they
serve as money to the business community and, therefore, is called bank money.

2. Lending of Funds

Another major function of commercial banks is to extend loans and advances out of the
money which comes to them by way of deposits to businessmen and entrepreneurs
against approved such as gold or silver bullion, government securities, easily saleable
stocks and shares, and marketable goods.

Bank advances to customers may be made in many ways: (i) overdrafts, (ii) cash credits,
(iii) discounting trade bills, (iv) money-at-call or very short-term advances, (v) term
loans, (vi) consumer credit, (vii) miscellaneous advances.

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 (i) Overdraft: A commercial bank grants overdraft facility to an accountholder by which
he is allowed to draw an amount in excess of the balance held in the account" up to the
extent of stipulated limit. Overdraft is permissible in current account only, Suppose, a
customer has Rs.50,000 in his current account with the bank. Bank grants him overdraft
facility up to Rs.10,000. Then, this customer is entitled to issue cheques up to Rs.60,000
on his account. Obviously, the overdraft facility sanctioned up to Rs.10,000 by the bank
in this case is as good as credit granted by the bank to that extent.

(ii) Cash Credit: Banks give credit in cash to business firms in industry and trade, against
pledge or hypothecation of goods, or personal guarantee given by the borrowers. It is
essentially, a drawing account against credit sanctioned by the bank and is operated
like a current account on which an overdraft is sanctioned. It is the most popular mode
of advance in the Indian banking system.

(iii) Discounting Trade Bills: The banks facilitate trade and commerce by discounting
bills of exchange called trade bills. Traders often draw bill of exchange to meet their
obligations in business transitions. Such a trade bill is payable in cash on maturity, after
a stipulated date. But many times the holder of such bills may be in urgent need of cash
before the maturity period. In such circumstances, he may seek help from the bank.
Since trade bills are negotiable instruments, the bank will discount them. That is, the
bank will pay cash to the endorser of trade bills, equivalent to the amount of bills minus
the aount of discount. And, when the bill matures, the bank will claim the amount from
the drawee (the person who is liable to honour the bill). Obviously, discounting of bills
by the bank amounts to granting of credit to the parry concerned till the maturity date
of the bill. This method of bank lending is widely adopted for two reasons: (i) such loans
are self-liquidatory in character; and (ii) these trade bills are rediscountable with the
central bank.

(iv) Money at Call or Very Short-term Advances: Bank also grant loans for a very short
period, generally not exceeding 7 days to the borrowers, usually dealers or brokers in
stock exchange markets against collateral securities like stock or equity shares,
debentures, etc., offered by them. Such advances are repayable immediately at short
notice hence, they are described as money at call or call money.

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 (v) Term Loans: Banks give term loans to traders, industrialists and now to agriculturists
also against some collateral securities. Term loans are so-called because their maturity
period varies between 1 to 10 years. Term loans as such provide intermediate or
working capital funds to the borrowers. Sometimes, two or more banks may jointly
provide large term loans to the borrower against a common security. Such loans are
called participation loans or consortium finance.

(vi) Consumer Credit: Banks also grant credit to households in a limited amount to buy
some durable consumer goods such as television sets, refrigerators, etc., or to meet
some personal needs like payment of hospital bills, etc. Such consumer credit is made
in a lump sum and is repayable in installments in a short time. Under the 20-point
programme, the scope of consumer credit has been extended to cover expenses on
marriage, funeral etc., as well.

(vii) Miscellaneous Advances: Among other forms of bank advances there are packing
credits given to exporters for a short duration, export bills purchased/ discounted,
import finance - advances against import bills, finance to the self-employed, credit to
the public sector, credit to the cooperative sector and above all, credit to the weaker
sections of the community at concessional rates.

(3) Use of Cheque System

It is a unique feature and function of banks that they have introduced the cheque
system for the withdrawal of deposits.

There are two types of cheques: (i) the bearer cheque, and (ii) the crossed cheque. A
bearer cheque is encashable immediately at the bank by its possessor. Since. it is
negotiable, it serves as good as cash on transferability. A crossed cheque, on the other
hand, is one that is crossed by two parallel lines on its face at the left hand corner and
such a cheque is not immediately encashable. It has to be deposited only in the payee's
account. It is not negotiable.
In modern business transactions, the use of cheques to settle debts is found to be
much more convenient than the use of cash. Commercial banks, thus, render an
important service by providing an inexpensive medium of exchange such as cheques. In
fact, a cheque is also considered as the most developed credit instrument.

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 (4) Remittance of Funds

Commercial banks, on account of their network of branches throughout the country,

also provide facilities to remit funds from one place to another for their customers by
issuing bank drafts, mail transfers or telegraphic transfers on nominal commission
charges. As compared to the postal money orders or other instruments, bank drafts
have proved to be a much cheaper mode of transferring money and have helped the
business community considerably.

In addition to these, commercial banks perform a multitude of other non-banking

functions which may be classified as (a) agency service, and general utility services.

Agency Services
Bankers perform certain functions for and on behalf of their clients, such as:
(a) To collect or make payments for bills, cheques, promissory notes, interest,
dividends, rents, subscriptions, insurance premia, etc. For these services, some
charges are usually levied by the banks.
(b) To remit funds on behalf of the clients by drafts or mail or telegraphic transfers.
(c) To act as executor, trustee and attorney for the customers will.
(d) Sometimes, bankers also employ income-tax experts not only to prepare
income-tax returns for their customers but also to help them to get refund of
income-tax in appropriate cases.
(e) To work as correspondents, agents or representatives of their clients.
Often, bankers obtain passports, traveler’s tickets, secure passages for their customers,
and receive letters on their behalf.

General Utility Service

Modern commercial banks usually perform certain general utility services for the
community, such as:
(a) Letters of credit may be given by the banks at the behest of the importer
in favour of the exporter.
(b) Bank drafts and traveler’s cheques are issued in order to provide
facilities for transfer of funds from one part of the county to another.
(c) Banks may deal in foreign exchange or finance foreign trade by
accepting or collecting foreign bills of exchange.
(d) Banks may act as referees with respect to the financial standing,
business reputation, and respectability of customers;
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 (e) Shares floated by government, public bodies and corporations my be
underwritten by banks;
(f) Certain banks arrange for safe deposit vaults, so that customers may
entrust their securities and valuables to them for safe custody.
(g) Banks also compile statistics and business information relating to trade,
commerce, and industry. Some banks may publish valuable journals or
bulletins containing. research on financial, economic and commercial
matters.

Banks Play an Important Role in a Modern Economy

(1) They constitute the very life-blood of modern trade, commerce and industry, as
they provide the necessary funds for their working capital such as to buy raw
materials, to pay wages, to incur current business expenses in marketing of
goods, etc
(2) Banks encourage people's savings habit through their various savings deposit
schemes.
(3) They also mobilise idle saving resources from household to business people for
productive use.
(4) They transmit money from place to place with economy and safety.
(5) Their agency services are, no doubt, of immense value to the people at large, as
they case their difficulties, save their time and energy and provide them safety
and security.

8.7 Central Bank and Instruments of Credit Control

Central banking is a comparatively new phenomenon. In most countries, except

England, the central bank is a twentieth century financial institution. In the U.S.A., the
Central Bank of the Federal Reserve System was estabhshed in 1913; in India, the
Reserve Bank of India was set up in 1935.

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 8.7.1 CENTRAL BANK: AN APEX FINANCIAL AUTHORITY

The essential feature of a central bank is its discretionary control over the monetary
system of the country. A bank is called a central bank because it occupies a pivotal
position in the monetary and banking structure of the country in which it operates.
Thus, the central bank acts as the leader of the money market and in that capacity; it
supervises, controls and regulates the activities of the commercial banks. It is
recognised as the apex monetary institution or the highest financial authority.

The central bank has been defined by R.P. Kent as "institution charged with the
responsibility of managing the expansion and contraction of the volume of money in
the interest of the general public welfare. Thus, we may define the central bank as an
institution whose main function is to help, control and stabilise the monetary and
banking system of the country in the national economic interest.

The above stated definition of a central bank clearly justifies its need and importance.
The banking system can work as a system only if there is an institution at the top to
direct its activities. Without such a direction, the system would be nothing but a
collection of unconnected units, each following an independent policy, often
contradictory to one another. Thus, the central bank is essential to regulate the
activities of commercial banks, integrate them, and direct their policies according to
the best national economic interest.

8.7.2 FUNCTIONS OF A CENTRAL BANK

The powers and range of functions of central banks vary from country to country. But
there are certain functions which are commonly performed by the central banks:

1. It issues the currency notes of the country.

2. It is the custodian of the foreign exchange reserves of the country.
3. It serves as banker to the government.
4. It serves as banker to commercial banks.
5. Being a monetary authority, it regulates the banks' credit creation
activity and performs the function of a controller of credit.
6. If promotes the economic development of the country.

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 1. Central Bank as a Bank of Note Issue

The central bank is legally empowered to issue currency notes - legal tender.
Commercial banks cannot issue currency notes. The central bank's right to issue notes
gives it the sole or partial monopoly of note issue, while in India, the Reserve Bank of
India has a partial monopoly of note issue, for example, one rupee notes are issued by
the Ministry of Finance, but the rest of the notes are issued by the Reserve Bank.

According to De Kock, following are the main reasons for the concentration of the right
of note issue in the central bank:
(a) It leads to uniformity in note circulation and its better regulation.
(b) It gives distinctive prestige to the note issue.
(c) It enables the State to exercise supervision over the irregularities and
malpractices committed by the central bank in the issue of notes.
(d) It gives the central bank some measure of control over undue credit
expansion by the commercial banks, since expansion of credit obviously
leads to an increased demand for note currency.
The central bank keeps three considerations in mind while issuing currency notes,
namely, uniformity, elasticity and security. The right of note issue is regulated by law.
According to law, every note issued must be matched with an asset of equal value
(assets such as, government securities, gold and foreign currencies, and securities). This
is necessary to inspire public confidence in paper currency.

2. Central Bank as a Custodian of Foreign Exchange Reserves

The central bank holds all foreign exchange reserves - key currencies such as U.S.
dollars, British pounds, and other prominent currencies, gold stock, gold bullion, and
other such reserves - in its custody. This right of the central bank enables it to exercise
a reasonable control over foreign exchange, for example, to maintain the country's
international liquidity position at a safe margin and to maintain the external value of
the country's currency in terms of key foreign currencies.

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 3. Central Bank as Banker to Government

As the government's banker, the central bank maintains the banking accounts of
government departments, boards, and enterprises and performs the same functions as
a commercial bank ordinarily performs for its customers. It accepts deposits of
commercial banks and undertakes the collection of cheques and drafts drawn on the
bank; it supplies government with the cash required for payment of salaries and wages
to their staff and other cash disbursements and transfer funds of the government from
one account to another or from one place to another. Moreover, it also advances short-
term loans to the government in anticipation of the collection of taxes and raises loans
from the public. It also makes extraordinary advances during periods of depression,
war, or other national emergencies. In addition, the central bank renders a very useful
banking exchange required to meet the repayment of debts and service charges or for
the purchase of goods and other disbursements abroad, and by buying any surplus
foreign exchange which may accrue to the government from foreign loans or other
sources.

The central bank also serves as an agent and adviser to the government. As agent of
the government, it is entrusted with the task of managing the public debt and the issue
of new loans and treasury bills on behalf of the government. It also underwrites unsold
government securities. Moreover, the central bank is the fiscal agent to the
government and receives taxes and other payments on government account. By acting
as financial adviser to the government, the central bank discharges another important
service: it advises the government on important matters of economic policy such as
deficit financing, devaluation of currency, trade policy and foreign exchange policy.

The central bank also functions as a representative of the State in international

financial matters. It is entrusted with the task of maintaining the nation's reserves of
international currency.

4. Central Bank as Banker to Commercial Banks

Broadly speaking, the central bank functions as banker to commercial banks in three
capacities: (i) as custodian of cash reserves of commercial banks; (ii) as lender of last
resort; and (iii) as clearing agent.

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 Thus, the central bank acts, as a conductor and leader of the banking system of the
country. It acts as a friend, philosopher, and guide to commercial banks.
(i) Custodian of cash reserves of commercial banks: Commercial banks find it
convenient to keep their reserve requirements with the central bank because its notes
command the greatest confidence and prestige and the government's banking trans-
actions are conducted by this institution. Thus, in every country, commercial banks
keep a certain percentage of their cash reserves with the central bank by custom or by
law.

In fact, the establishment of central banks makes it possible for the banking system to
secure the advantages of centralised cash reserves. The significance of centralised cash
reserves lies in the following facts:

(a) Centralisation of cash reserves in the central bank is a source of great

strength to the banking system of the country as it inspires the
confidence of the public in the commercial banks.
(b) Centralised cash reserves can form the basis of a much longer and more
elastic credit structure than those scattered among numerous individual
commercial banks. .
(c) Centralised cash reserves enable the central bank to provide additional
funds to those banks which are in temporary difficulties. In fact, the
central bank can function as lender of the last resort on the basis of the
centralized cash reserves with it.
(d) Centralisation of cash reserves is conducive to the growth of the
economy and to the increased elasticity and liquidity of the banking
system in particular and of the credit structure in general. .
(e) Centralisation of cash reserves also enables the central bank to influence
and control credit creation of commercial banks by increasing or
decreasing the cash reserves of the latter, that is, through the technique
of the variable reserve ratio.

(ii) Lender of the last resort: As lender of last resort, in periods of credit stringency, the
central bank gives temporary financial accommodation to commercial banks by
rediscounting their eligible bills. The central bank is the ultimate source of money in the
modern credit system. The function of the lender of last resort implies that the central
bank assumes the responsibility of meeting directly or indirectly all reasonable
demands for accommodation from commercial banks.

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 The central bank's function as lender of last resort has evolved out of its rediscounting
function during emergency periods. The real significance of rediscount functions
according to De. Kock, lies in the fact that it increases the elasticity and liquidity of the
entire credit structure.
By providing a ready medium for the conversion in cash of certain assets of banks. It
helps to maintain their liquidity. It also makes possible a considerable degree of
economy in the use of cash reserves, since commercial banks can conduct a large
volume of business with the same reserve and capital.

(iii) Clearing Agent: As the central bank becomes the custodian of cash reserves of
commercial banks, it is but logical for it to act as a settlement bank or a clearing house
for other banks. As all banks have their accounts with the central bank, the claims of
banks against each other are settled by simple transfers from and to their accounts.
This method of settling accounts through the central bank, apart from being
convenient, is economical as regards the use of cash. Since claims are adjusted through
accounts, there is usually no need for cash. It also strengthens the banking system by
reducing withdrawals of cash in times of crisis. Furthermore, it keeps the central bank
of informed about the state of liquidity of commercial banks in regard to their assets.

5. Central Bank as Controller of Credit

By far the most important of all functions of the central bank in modern times is that of
controlling credit operations of commercial banks. Credit, the source of many blessings
in a modern economy, also may become, unless we control it, a source of confusion
and peril. The social and economic consequences of changes in the purchasing power
of money are serious and since credit plays a predominant part in the settlement of
business transactions, it is essential that it should be subjected to control. Monetary
policy is implemented by the central bank through the weapon of credit control.

6. Central Bank as Promoter of Economic Development

The modern central bank accomplishes a number of development and promotional

functions. Today, the central bank is regarded as an inevitable agency for promoting
the economic growth of a country. It is an institution responsible for the maintenance
of economic stability and for assisting the growth of the economy within the
framework of the general economic policy of the State. Thus, the central bank has to
take all such steps as are necessary, to meet the economic requirements of economic
development of the country.
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 It is responsible for the development of an adequate and sound banking system to
cater to the needs not only of the trade and commerce but also of agriculture and
industry. The central bank has to ensure, in the interest of economic progress, that the
commercial banks operate on a reasonably sound and prudent basis.

Thus, the major task of the central bank lies in the development of highly organised
money and capital markets that many help accelerate economic progress by assisting
the huge investment activities in capital formation and other productive sectors. During
the planning era, the central bank's role as adviser to government on economic matters
in general, and on financial matters in particular, is of considerable importance.

Thus, the central bank of a developing country has an important role to play in the
process of development. In underdeveloped countries, the central bank has not only to
provide adequate funds and to control inflation, through credit regulation, but it also
has to undertake the responsibility of spreading banking facilities, providing credit at
cheap rates to agriculture and industry, protecting the market for government
securities and channeling credit into desirable avenues. Moreover, in underdeveloped
countries, there are institutional gaps in the money and capital markets which hinder
economic growth. The banking system is not properly organised as a large section of
the money market consists of unorganised, indigenous bankers. Thus, promotion of
sound, organised, well-integrated institutions and agencies of money and capital
market becomes an important function of a central bank in a developing economy.
From deficiency of non-existence of institutions such as savings banks, agricultural
credit agencies, insurance companies, and the like to collect and mobilise savings and
make them available for productive investments is the main cause of the low rate of
capital formation. Hence, the growth of such institutions in these countries is a
precondition for capital formation which is a key to economic development. Evidently,
therefore, the central bank of a developing country has a vital role to play in building
such financial infrastructure for rapid economic development.

As the Planning Commission of India puts it, central banking has to take "a direct and
active role, first, in creating or helping to create the machinery needed for financing
development activities allover the country and secondly, in ensuring that the finance
available flows in the directions intended."
The central bank also collects and disseminates economic statistics of a wider range. As
such, the government of the country has to lean heavily upon the central bank for
seeking economic and financial advice in the course of development planning.

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 In addition, the central bank may also undertake miscellaneous functions such as
providing assistance to farmers through co-operative societies by subscribing to their
share capital, promoting finance corporations with a view to providing loans to large-
scale and small-scale industries, and publishing statistical reports on trends in the
money and capital markets.
In short, a central bank is an institution which always works in the best economic
interests of the nation as a whole.

In view of all these functions, as discussed above, it follows that a modern central bank
is much more than a Bank of Issue.
Chart 1 summarises the functions of a central bank.

Chart I: Functions of Central Bank

Functions of Central Bank

|
Monopoly of Note Issue
|
Custodian of Exchange Reserves
|
Banker to the Government
|
Banker to Commercial Banks
|
Controller of Credit
|
Promoter of Economic Development

8.7.3 FUNCTIONS OF RESERVE BANK OF INDIA

The Reserve Bank of India was set up on 1st April, 1935. The central office of the bank is
located in Bombay.
The Reserve Bank of India renders all the functions of a good central bank. Its major
functions are as follows:
1. Monetary Management
The Reserve Bank of India is mainly constituted as an apex authority for monetary
management.

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 According to the Preamble to the Reserve Bank of India Act, 1934, the basic function of
the bank is to "regulate the issue of bank notes and the keeping of reserves with a view
to securing monetary stability in India and generally to operate the currency and credit
system of the country to its advantage."

The Reserve Bank controls and regulates the flow of credit in the economy. It uses
quantitative controlling weapons, such as bank rate policy, open market operations,
and the reserve ratio requirement. Since 1956, it has increasingly relied on and
resorted to selective credit controls for accelerating the rate of growth and for checking
inflationary spurts.

2. Issue of Bank Notes

The Reserve Bank has the sole right to issue currency notes, except one rupee notes -
which are issued by the Ministry of Finance. The RBI follows a minimum reserve system
in note issue. Initially, it used to keep forty per cent of gold reserves in its total assets.
But, since 1957, it has to maintain only Rs. 200 crores of gold and foreign exchange
reserves.

3. Custodian of Exchange Reserves

The Bank has been entrusted with the responsibility of maintaining the exchange value
of the rupee. It has the custody and management of the country's international
reserves.

4. Banker to the Government

It is obligatory for the RBI to transact government business. It has to maintain and
operate the government's deposit accounts. It collects receipts of funds and makes
payments on behalf of the government. It represents the Government of India as the
member of the IMF and the World Bank.

5. A Banker's Bank
According to the Banking Companies' Act of 1949, originally, each scheduled bank has
to maintain with the Reserve Bank of India a balance equal to five per cent of its
demand liabilities and two per cent of its time liabilities. The Act, amended in 1962,
specifies that three per cent of the total liabilities should be kept as reserve
requirement.
The Reserve Bank of India also serves as lender of last resort, by rediscounting eligible
bills of exchange of commercial banks, during the period of credit stringency.

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 6. Promoter of Development
The bank performs a number of developmental and promotional functions. Apart from
credit regulation, the Reserve Bank effectively channelises credit, especially to priority
sectors, such as agriculture, exports, transport operations, and small-scale industries. It
makes institutional arrangements for rural and industrial finance. For instance, special
agricultural credit cells have been set up by the bank. The Industrial Development Bank
of India has been set up to solve the allied problems of the industries.

The bank also assists the government in its economic planning. The bank's credit
planning is devised and coordinated with the five year plans of the country. The bank
also collects statistical data and economic information through its research
departments. It compiles data on the working of commercial and co-operative banks,
on balance of payments, company and government finances, security markets, price
trends, and credit measures. It publishes a monthly bulletin, with weekly statistical
supplements and annual reports, which present a good deal of periodical reviews and
comments pertaining to general economic, financial and banking developments,
including the bank's monetary policy and measures, adopted for the qualitative and
quantitative monetary management.

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 8.7.4 CENTRAL BANK AND MONETARY MANAGEMENT

The significance of a central bank lies in its function of managing the monetary system
of the country. It also maintains the monetary standard for the country, internally as
well as externally. In the absence of a central bank, the management of the monetary
system lies in the hands of the government. But the government cannot carry out this
function of monetary management as well as a central bank can, because the
government does not have the requisite facilities, in the absence of an apex monetary
institution, to know the money market intimately and to recognise its requirements
under various changing conditions. Moreover, the government may pursue a monetary
policy which is politically biased, and which is, therefore, undesirable in the general
interest of the nation. Again, under a democratic set-up, the party in government is
subject to change so that it is quite likely that there will be lack of continuity in the
pursuit of a uniform and continuous monetary policy. Also, every political party has its
own rationale, on fiscal and monetary objectives. Very rarely in history has a country
been as fortunate as to be blessed with major political parties which have held nearly
identical views on such objectives. This has been a characteristic of human life from the
beginning but differences of opinion have deepened since the middle of the 19th
century. This political disharmony has traveled like a tidal wave and, today, every
country suffers from the uncertainty of a uniform fiscal and monetary policy. A
discontinuous, irrational monetary policy followed by the government harms the nation
as a whole. Thus, a permanent body, a financial institution, like the central bank acting
as an autonomous organisation is inevitable. A central bank though it is nationalised in
most cases and is a semi-government institution, is free from the influence of political
parties or motives. By the nature of its business, it is intimately connected with the
banking system and money market of the country and can definitely regulate the
monetary system of the country in the general interest of the nation. Hence, a central
bank is an indispensable institution for monetary and financial management in any
economy. The mere establishment of a central, autonomous financial authority,
however, does not guarantee freedom from political influences. Such an authority can
only be created by statute, i.e. a law of the national legislature. This financial authority,
therefore, is called a Statutory Body. However, a party in power, at a given time, can
always amend, rescind or replace the statute by a new statute which will specify
regulation aimed at making the central financial authority a functionary of government
(i.e., a party in a democracy) in power and not a functional institution. This is the
present position as it exists today.

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 The modern economy is a credit economy. Credit has assumed increasingly wide
significance in sustaining the base of the modern economic system. The entire financial
structure of the present money economy is founded upon the base of the credit
system.

Although credit is a concomitant of modern economic advancement, it is like money, a

weapon, the misuse of which spells disaster to the system. Credit, the source of many
blessings in a modern economy, also becomes, unless we can control it, a source of
confusion and peril. The social and economic consequences of changes in the
purchasing power of money are serious and, since credit plays a predominant part in
settlement of business transactions, it is essential that credit should be subjected to
control. On the need for control of credit De Kock writes, "For many years it has been
almost universally accepted that the creation and distribution of credit, under the
intricate economic organisation existing in most counties, should be subjected to some
form of control. The main reason for this was that comes to play a predominant part in
the settlement of monetary and business transactions of all kinds, and thus to
represent a powerful force for good or evil."

The control of credit is recognised as the main function of a central bank. It is a

function which embraces, the most important questions of central banking policy. In
fact, the heart of monetary policy lies in control, i.e., monetary management.

Objectives of Credit Control

The important objectives of credit control may be listed as follows:

1. Stabilisation of the general price level. The traditional objective of credit
control was that of keeping exchange rates stable through the medium
of a mono-metallic or bi-metallic standard. But, in recent times, greater
importance is attached to the stabilisation of prices as the ultimate goal
of a central bank's credit control policy. Stabilisation of the general price
level and hence stability of the value of money were considered
essential for the smooth operation of the economic system and for
national economic welfare.

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 2. Stabilisation of the money market: Some economists stress that the
credit control policy of a central bank should aim at the stabilisation of
the money market. Credit control should be such that demand and
supply be adjusted at all times. However, this objective has not been
widely recognised because it is incompatible with the goal of stabilising
the other phase of economic activity.

3. Promoting economic growth. It is widely realised that credit control

should be conducive to economic growth. It should not act as an
inhibitory factor. It should promote and maintain a high level of
employment and income.

8.7.5 INSTRUMENTS OF CREDIT CONTROL

Under the monetary management of the central bank, credit control stimulates
expansion of credit at one time and checks it at another. The principal instruments of
credit control, at the disposal of the central bank, may be classified as:

(1) quantitative or general, and (2) qualitative or selective.

The general instruments are directed towards influencing the total volume of credit in
the banking system, without special regard for the use of which it is put. Selection or
qualitative instruments of credit control, on the other hand, are directed towards the
particular use of credit and not its total volume.

Quantitative weapons of credit control consist of (a) bank rate policy; (b) open market
operations; and (c) variable reserve ratios.
These methods have a quantitative or a general effect on credit regulation. They are
used for changing the total volume of credit or the terms on which bank credit is
available, without regard for the purpose for which credit is used by borrowers. But the
central bank today, also, makes use of certain qualitative or selective methods by which
it controls, in addition to the aggregate volume of credit, the flow of credit in particular
directions.
Selective credit control aims at regulating (stimulating or restricting) the uses to which
credit are put. The main methods of selective credit control are: (a) margin
requirements; (b) regulation of customer's credit; (c) control through directives; (d)
rationing of credit; (e) moral suasion and publicity; and (f) direct action.

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 7.6 BANK RATE POLICY (BRP)

The bank rate is a traditional weapon of credit control used by a central bank. In order
to perform its function as lender of last resort to commercial banks, it will discount
first-class bills or advance loans against approved securities.

A specific idea regarding the technique of bank rate can be had from the Reserve Bank
of India's definition of the bank rate policy which consists of varying the terms and
conditions under which the market may have temporary access to the central bank
through discounts of selected short-term assets or through secured advances. Thus, the
bank rate policy seeks to influence both the cost and availability of credit to members
of the bank. Cost, of course, is determined by the discount rate charged, and the
availability depends largely upon the statutory requirements of eligibility of bills for
discounting and advances, as also the maximum period for which the credit is available.

The bank rate obviously is distinct from the market rate. The former is the rate of
discount of the central bank, while the latter is the lending rate charged in the money
market by the ordinary financial institutions.

The "Modus Operandi" of Bank Rate

The bank rate policy signifies manipulation of the rate of discount by the central bank in
order to influence the credit situation in the economy. The principle underlying the
bank rate policy is that changes in bank rate are generally followed by corresponding
changes in the money market rates, making credit costlier or cheaper, and affecting its
demand and supply.

If the bank rate is raised, its immediate effect is to cause an increase in bank's deposit
and lending rates. The prices which bankers are prepared to pay on the amounts
deposited with them by their customers increase, so that the volume of the bank
deposits increases. Commercial banks employ a substantial proportion of the funds
deposited with them to form the basis of loans and advances that they make to their
customers, and in as much as the banks are now paying more for these deposits, they
must charge higher rates for loans and advances made to their customers. So when the
central bank raises the bank rate, the cost of borrowing of the commercial banks will
increase, so that they will also charge higher rates for loans and advances made to their
customers.

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 So when the central bank raises the bank rate, the cost of borrowing of the commercial
banks will increase, so that they will also charge a higher interest rate on loans to their
customers and, thus, the market rate of interest will go up. This means that the price of
credit will increase. As many business operations are normally conducted on the basis
of bank loans, the price (interest) which has to be paid for this accommodation is, of
course, a charge against profit to the business. In consequence, the sudden increase in
the interest rate will reduce or wipe out the profit of the business, so that industrial
and commercial borrowers reduce their borrowings.

In other words, increased market rate or increase in the cost of borrowing will
discourage business activity, i.e., their demand for credit falls. As a result of the
contraction of demand for credit, the volume of bank loans and advances is appreciably
curtailed. This, in effect, will check business and investment activity so that
unemployment will ensue. Consequently, income in general will fall, people's
purchasing power will decrease and aggregate demand will fall. This, in turn, will affect
the entrepreneurs adversely. When demand falls, prices will come down, and, as a
result, profit will decline. The rate of investment is basically determined by the rate of
profitability, and thus, in view of falling profits, investment activities will contract
further. So, a cumulative, downward movement in the economy sets in.

In brief, an increase in the bank rate leads to a rise in the rate of interest and
contraction of credit, which, in turn, adversely affects investment activities and
consequently, the economy as a whole.

Similarly, a lowering of the bank rate will have a reverse effect. When the bank rate is
lowered, the money market rates fall. Credit, then, becomes cheaply available and the
business community will come forward to borrow more. Thus, the expansion of credit
will increase investment activities, leading to an increase in employment, income and
output. Aggregate demand will increase, prices will rise, and profits will increase which,
in turn, will boost production and investment activities further. Consequently, a
cumulative upturn of the economy will develop.

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 Limitations of Bank Rate Policy

The following are the chief limitations of bank rate policy:

(i) Existence of an Organised and Developed Money Market. Efficacy of the bank
rate in controlling credit requires a close correspondence between the bank
rate and the structure of interest rates in the money market, so that changes in
the bank rate will be followed by changes in the market rates. This presupposes
the existence of a highly organised money market. Unfortunately, most
underdeveloped countries do not have an organised money market. The wide
range and multiplicity of money rates in such an organised money market will
make the success of the bank rate policy doubtful. The absence of any
conventional relationship between the central bank and other segments of the
money market will further add to the ineffectiveness of the bank rate policy.

(ii) Existence of Well-developed Bill Market. The canons of eligibility for

rediscounting bills by the central bank presupposes, in the operation of
the bank rate policy, a soundly developed bill market. Underdeveloped
bill markets, thus, limit the bank rate operations. Further, in an
unorganised money market like that of India, where the indigenous,
unorganised monetary sector lies beyond the ambit of control of the
central bank.
(iii) Banks' Need for Rediscounting. The need for commercial banks to
approach the central bank for rediscounting facilities is an important
factor in determining the successful working of the bank rate policy. But
commercial banks will have no need to approach the central bank when
they have ample liquid resources at their disposal, i.e., when they have
enough excess resources.
(iv) Practice of Free Exchange Rate System. The successful operation of the
bank rate policy in correcting the balance of payments disequilibrium of
the country presupposes an economic system in which prices, wages,
and interest levels are readily movable, i.e., the economic structure is
elastic, the country is on the gold standard and there are no artificial
exchange restrictions on the international flow of capital. Obviously, due
to the world-wide suspension of the gold standard, government control
over prices, wages etc. and artificial exchange restrictions have
considerably limited the influence of the bank rate policy.

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 (v) Business Expectations. The psychological reaction to a change in the
bank rate should also be considered for the effectiveness of the bank
rate policy. If, in a boom period, businessmen are unduly optimistic,
their demand for credit will be interest-inelastic and the bank rate will
be ineffective. Similarly, during a depression, when businessmen are
pessimistic, they will not respond favourably to the incentive of low
interest rates.
(vi) Interest-inelasticity of Bank Deposits. The axiom that a rise in the bank
rate and, thus a rise in interest rates payable on deposits by commercial
banks will cause an increase in bank deposits is questionable. A large
majority of people save because of the precautionary motive, and their
savings depend on their earning capacity, i.e., their income. These savers
do look for a rise in the interest rates on deposits, but they usually
deposit with banks for the purpose of safety. Thus, it is actually the
increases in income rather than interest rate that promote savings by
the people which augment bank deposits.

Again, rediscounting of bills by commercial banks is a precondition for the effective

working of the bank rate. If rediscounting is a regular practice, it will result in the
establishment of a sensitive connection between the market rates and the bank rate. If
the practice is only occasional, the market rates may be out of tune with the bank rate.
In unorganised money markets, banks usually operate with high cash reserves, so that
they do not feel the need to borrow from the central bank. In predominantly
agricultural underdeveloped countries, with unorganised money markets, commercial
banks find it difficult to secure sound proposals for the investment of their funds; to
that extent they are forced to keep their cash balances idle. As a result, they do not
need to borrow from the central bank. Besides, the lack of adequate papers eligible for
rediscounting in underdeveloped countries also severely limits the significance and
operational of the bank rate as a discount rate.

Moreover, commercial banks in such countries are accustomed to rely on themselves

to ensure liquidity of their assets because of wide seasonal fluctuations and this has
necessitated their keeping high cash reserves. A historical reason for this is that in most
of these countries, the central banks were started in the thirties, when a cheap money
policy had to be followed, for revival after the Great Depression, and conditions were
not favourable to the growth of the practice of rediscounting.

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 The demand for bank advances being very low, banks had enough cash balances which
rendered rediscounting or borrowing from the central bank unnecessary and
superfluous. Prof. Sen summarises this fact in the following words: "The absence of
rediscounting practices is, therefore, to be explained by the pursuit of a cheap money
policy, the habit of banks of keep comparatively large cash reserves, and the lack of
demand for bank advances following the onset of the world trade depression of the
thirties."

Furthermore, in undeveloped money markets, the bank rate is not generally a "penal"
rate, because interest rate in the indigenous banking sector are higher than the bank
rate. Thus, the axiom that money rates should follow the bank rate scarcely
materialises under such conditions.

Another important factor is that the efficacy of the bank rate demands sufficient
elasticity in the economic system, so that cost reduction, prices, and trade tend to
adjust with changed conditions. This condition is, however, rarely fulfilled even if
developed economies. It is, therefore, meaningless to expect such an economic
condition in underdeveloped countries with their bottlenecks and imperfections.

Sir Mitra has observed: "In developing nations with planned economies where the
public sector accounts for the larger part of the nation's Investment is equipped with a
set of more direct and powerful instruments, the bank rate loses much of its
importance and is, in fact, relegated to a secondary place."

Anyway, the Bank rate has great psychological value as an instrument of credit control
and enhances the prestige of the central bank. The bank rate is generally a reflection of
the central bank's opinion of the credit situation and economic position in the country.
As Gibson said, a rise in the bank rate may be regarded as "the amber coloured light" of
warning to commercial credit and business activities while a fall in bank rate may be
looked upon as "the green light" indicating that the coast is clear and the ship of
commerce may proceed on her way with caution."
In conclusion, although it must be admitted that the bank rate policy has very limited
significance in underdeveloped as well as developed money markets in view of the
present day conditions and government policies, it has nevertheless a useful function
to perform in conjunction with other measures of credit control. Central banks of the
present day, however, have to rely more upon other instruments of credit control than
the bank rate policy alone in regulating the cost, availability and supply of credit
money.

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 8.7.7 OPEN MARKET OPERATIONS

Open market operations imply deliberate direct sales and purchases of securities and
bills in the market by the central bank on its own initiative to control the volume of
credit. In a broad sense, open market operations simply imply the purchase or sale by
the central bank of any kind of eligible paper like government securities or any other
public securities, or trade bills, etc. In practice, however, the term is applied, in most
countries, to the purchase or sale of government securities (short-term as well as long-
term) only by the central banks.

Working of Open Market Operations: When the central bank sells securities in the open
market, other things being equal, the cash reserves of the commercial banks decrease
to the extent that they purchase these securities; by selling securities, the central bank
also reduces, other thing being equal, the amount of customers' deposits with
commercial banks to the extent that these customers acquire the securities sold by the
central bank. In effect, the credit-creating base of commercial bank is reduced and
hence credit contracts.

In short, the open market sale of securities by the central bank leads to a contraction of
credit and reduction in the quantity of money in circulation. Conversely, when the
central bank purchases securities in the open market, if makes payments to the sellers
by cheques drawn on itself, the sellers usually being commercial banks or customers of
commercial banks. The banker's accounts are credited and, therefore, there is an
increase in the commercial banks' cash reserve (which is the base of credit creation)
and as also an increase in the customers' deposits with commercial banks (which is the
principal constituent of money supply.)

In short, open market purchases of securities by the central bank lead to an expansion
of credit made possible by strengthening the cash reserves of the banks. Thus, on
account of open market operations, the quantity of money in circulation changes. This
tends to bring about changes in money rates. An increase in the supply of money
through open market operations causes a downward movement in the money rates,
while a decrease of money supply raises money rates. Open market operations,
therefore, directly affect the loanable resources of the banks and the rates of interest.
Changes in rates of interest in turn tend to bring about the desired adjustments in the
domestic level of prices, costs, production and trade.

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 In short, the central bank follows a policy of open market selling of securities when
contraction of credit is desired, especially during a boom period when the stability of
the money market is threatened by the over-expansion of credit by commercial banks.
Conversely, during a depression when the money market is tight and expansion of
credit is desired, the central bank follows the policy of open market buying of
securities.

Limitations of Open Market Operations

The following are the major limitations of open market operations:

1. Lack of well-developed securities market. There must be a broad, strong and

active securities market for large-scale and successful open market operations.
Lack of such a market renders open market policy ineffective.
2. Contradictions between bank rate and open market operation. The sale of
securities by the central bank may prove ineffective in curbing the loanable
resources of the banks so long as the possibility of rediscounting leaves the door
open to replenish the reserve as before.
3. Restricted dealings. The success of open market operations is limited by the
preparedness of the central bank to incur losses. In the case of short-term
securities, the loss is relatively less. Therefore, open market operations are
often restricted to dealings in short-term securities only.
4. Difficulties in execution. To execute a purchase policy by the central bank is not
as difficult as the sale of securities in open market operations. Similarly, for
commercial banks, a policy of credit contraction is easier to implement than a
policy of expansion. Thus, by the operation of money factors alone, "open
market operations can stop booms but cannot prevent slumps."
5. Precautions for stabilising the government securities market. Another drawback
of the open market operations policy is that when a large-scale of securities is
effected by the central bank, the prices of securities adversely affect bank assets
and upset the government's borrowing programme. In such conditions, the
central bank has to stabilise the securities market and, to that extent, the scope
of open market operations to influence the credit situation is limited.

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 6. Assumption of a constant velocity. The theory of open market operations
assumes that the circulation of bank deposits and legal tender money has a
constant velocity. However, in practice, these conditional relationships are
difficult to obtain always. In the first place, neither will the cash reserve of
commercial banks, nor the quantity of money in circulation always increase or
decrease in proportion to the purchase or sale of securities respectively by the
central bank. This can happen if there is another disturbing factor operating
simultaneously. For instance, the effect of the purchase of securities by the
central bank on the supply of bank cash may be neutralised, partly or fully, by
the outflow of capital, or by an unfavourable balance of payments or by the
withdrawal of deposits by the public for hoarding purposes. Likewise, an inflow
of capital or dishoarding may neutralise the effect of the sale of securities by the
central bank. .

Secondly, commercial banks do not always either expand or contract credit in

accordance with the change in their cash reserves. According to De Kock, "there are
many circumstances of money, economic or political nature, which may deter a
commercial bank from employing increased cash reserves fully, if at all or from
contracting credit when its resaves are reduced." Moreover, with regard to the relation
between an increase in the credit base, i.e., cash reserves, and the creation of credit,
there are certain technical factors which must be taken into consideration by all banks.
For instance, unless the banking system, as a whole, adopts a policy of credit
expansion, the expanding banks would tend to lose some part of their cash reserves to
the non-expanding banks and might, thus, be compelled to contract again.
In many countries, a rigid cash ratio is not maintained by the commercial banks and
hence, open market operations are not effective. Thus, under favourable conditions of
credit expansion and insufficient demand for credit on the part of borrowers, an
increase in the cash reserves cannot produce its proportionate effect on credit
expansion.

Notwithstanding these limitations, open market operations are a useful instrument of

monetary policy. They constitute a more direct and effective way of controlling credit
than the bank rate policy.

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 Usefulness of Open Market Operations

The open market operations policy of the central bank can serve the following
purposes:

(1) As a complementary to the bank rate policy it tends to enhance the

efficacy of the bank rate. It may be used to prepare the ground for
changes in the bank rate. When credit contraction is desired, the central
bank may raise bank rates as well as sell securities in the open market,
so that the cash reserves (credit base) of banks are also reduced.
Conversely, when central bank may, at the same time, buy securities in
the open market and, thus, provide additional cash to commercial banks
to enable them to increase their advances.
(2) It assists government borrowings. By purchasing government bills and
bonds and such other securities when the prices are low and selling
them when their prices are high, the central bank can maintain stability
in the prices of government securities and thereby promote public
confidence in the instruments of public debt.
(3) It may be useful in contracting extreme trends in business by buying
securities during periods of slack business and selling them in period of
inflationary boom.
(4) It may be adopted to influence the balance of payments position
favourably. Open market sales operations, for instance, will have a
contractionary effect on credit and a deflationary situation will develop
so that the domestic price level will fall. Exports will be encouraged due
to increased foreign demand on account of lower prices, whereas,
imports will be restricted due to high costs of foreign goods. Thus, a
favourable balance of payments will follow.

On these accounts, open market operations have come to be recognised as an

important technique of monetary management. The growing importance of open
market operations is due to the decline of bank rate as an instrument of credit control
after the first war and the consequent need for another and more direct method. In the
thirties, open market operations became necessary in order to implement the policy of
cheap money.

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 Superiority of Open Market Operations

As a method of influencing money supply, open market operations are superior to bank
rate because the initiative lies in the hands of the monetary authority, in the case of the
former, while it rests with the commercial banks in the case of the latter. In other
words, while bank rate policy is only an indirect way of controlling credit, open market
operations are more direct. Moreover, the bank rate directly affects only short-term
interest rates; long-term rates are affected only indirectly. Open market operations, on
the other hand, have a direct influence on the prices of long-term securities and,
therefore, on long-term interest rates. They have a direct and immediate effect on the
supply of money and credit and, therefore, on money and interest rates. Thus, this
method is largely used nowadays to influence interest rates in the country and prices of
government securities in the market.

In the opinion of some economists, however, open market operations can achieve
little. They can be successful only as a supplement to the discount rate policy. Keynes,
on the other hand, maintains that open market operations, undertaken extensively and
skillfully, could achieve the purpose without a discount rate policy, if they are
supplemented by state organisation of investment or, failing this, by compensatory
planning or public works. However, the general opinion is that open market operations
must always be supplementary to the bank rate policy.

Relation between BRP and OMO

Both these weapons of credit control have their merits and demerits (as discussed
above). Each, by itself, will not succeed in producing the desired result, and, therefore,
must be supplemented by the others in order to be effective. For instance, when the
bank rate is raised, with a view to controlling credit, open market sales of securities
should follow so that credit contraction will be more effective. However, if the bank
rate is raised and the open market purchase policy is adopted simultaneously, the rise
in the bank rate will prove to be ineffective, because banks will then increase their cash
reserve by selling securities.
They will not, then, feel the necessity of rediscounting bills. Conversely, if the open
market purchase policy is adopted, with a view to credit expansion, a simultaneous
decrease in the bank rate will help in achieving the desired goal.

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 In fine, therefore, it can be said that the efficiency of the bank rate and of the open
market policy are interrelated. Open market operations are generally undertaken to
prepare the market for changes in the bank rate, which has far reaching influence over
the market. .

However, as the Reserve Bank of India itself admitted, open market operations in India
have not been solely designed to suit the role of a full fledged instrument of credit
control. But, open market operations can be carried out for sundry purposes and some
of these may achieve success in the underdeveloped money markets of the backward
countries. These countries may very well undertake open market operations in order to
neutralise seasonal movements in the economy. In busy seasons, the credit stringency
can be relaxed by releasing excess liquidity through open market purchase operations.

In India, open market operations have been resorted to more for the purpose of
assisting the government in its borrowing operations and for maintaining orderly
conditions in government securities market than for influencing the availability and
cost of credit. The objectives of what is called grooming the market, such as acquiring
securities nearing maturity to facilitate redemption and to make available on tap a
variety of loans to broaden the gilt-edged market, have been more striking features of
the open market operations in India.

8.7.8 VARIABLE CASH RESERVE RATIO (VCRR)

The variable cash reserve ratio is comparatively new method of credit control used by
central banks in recent times. In 1935, the U.S.A.'s Federal Reserve System adopted it,
for the first time. In countries where the money market is unorganised or
underdeveloped, increasing recourse is now taken to this method of credit control.
The variable reserve ratio device springs from the fact that the central bank, in its
capacity as Bankers’ Bank, must hold a part of the cash reserves of commercial banks.
The minimum balances to be maintained by the member banks with the central bank
are fixed by law and statutory powers have been conferred on the central bank to alter
the quantum of these minimum reserves. The customary minimum cash reserve ratio is
an important limitation on the lending capacity of banks. Thus, variations in the reserve
ratio reduce of increase the liquidity and, consequently, the lending power of the banks
also. Therefore, the cash reserve ratio is raised by the central banks also. Therefore, the
cash reserve ratio is raised by the central bank when credit contraction is desired and
lowered when credit is to be expanded.

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 Thus, like other techniques of monetary control, the variation of cash reserve
requirements has a dual purpose; requirements can be lowered as well as increased. A
reduction of reserve requirements immediately and simultaneously augments the
lending capacity of all the banks. Conversely, raising a cash reserve ratio immediately
and simultaneously reduces the lending capacity of all member banks. The funda-
mental assumption of this method is that the excess cash reserve (being the base of
credit) realised through the lowering of the minimum reserve ratio, results in the
expansion of credit, and similarly, the contraction of cash reserve due to the raising of
minimum, cash reserve requirements will result in the contraction of credit.

Therefore, the reserve requirement ratio is a powerful instrument which affects the
volume of excess reserve with commercial banks as well as credit creation multiplier of
the banking system. To clarify the point, suppose commercial banks have Rs. 10 crores
of total reserve funds with the central bank and that the legal cash reserve ratio is 10
per cent of the total deposits. If, with the existing deposits, the required reserves of the
banks are Rs. 3 crores, the excess reserves amounting to Rs. 7 crores will support a
tenfold (the multiplier being ten, as the reserve ratio is ten percent) increase in the
deposits, i.e.,Rs. 70 crores of credit creation {Rs. 7 x (100/70) crores}. If, on the other
hand, the reserve ratio is doubled, i.e., if it is raised to 20 per cent, the required cash
reserves are Rs. 6 crores, and the excess reserves would be Rs. 4 crores only. This
excess reserve of Rs. 4 crores, with the 20 per cent reserve requirements, would
obviously support only a fivefold (the multiplier now being 5) increase in the bank
deposits i.e., Rs. 20 crores of credit creation only {i.e., Rs. 4 x (100/20) crores}. Thus,
raising of the reserve requirements affect credit contraction, and conversely, a
reduction in the reserve ratio brings about credit expansion.

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 OMO versus VRR

The variable reserve ratio, as an instrument of monetary control, is regarded as

decidedly superior to open market operations in the following particulars:

(i) The variable reserve ratio is a straight direct method of credit control. It can give
results more promptly than open market operations. The cash reserves of a
bank can be altered by just a stroke of the pen. A declaration by the central
bank that commercial banks must maintain a large percentage of their deposit
liabilities as balances with the central bank than they have been doing
immediately decreases their deposits. Likewise, an expansion of credit can be
promptly attained by reducing the minimum cash reserves to be maintained
with the central bank.
Thus, the variations in reserve ratio reduce the time lag in the transmission of
the effect of monetary policy to the commercial banking system. Aschheim,
therefore, opines that "If results of the variation of reserve requirements were
the same as the results of open market operations in all respects by the speed
of transmission preference for the former weapons over the latter would be
quite plausible."

(ii) The successful working of open market operations requires a broad-based,

developed, securities market. The variable reserve ratio has no such limitations.
Thus, in countries where the securities market is not extensively developed, the
variable reserve ratio has greater significance as a technique of monetary
control.

(iii) Large-scale open market operations may affect the value of government
securities and, thus, there are chances of loss being incurred by the central
government and commercial banks, because their assets consist of a large stock
of government securities. The variations in reserve ratios, on the other hand,
yield the desired results in the controlling credit, without tear of any such loss.

Unlike the open market operations, the variable reserve ratio is capable of
functioning without "ammunition." Thus, it does not tend to increase or
decrease the supply of earning assets of the central bank, a fear which is very
significant from the point of view of central banking policy and treasury
financing.

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 (iv) The variable reserve ratio is applicable simultaneously to all commercial banks
in influencing their potential credit-creating capacity. Open market operations
affect only those banks which deal in securities.

Thus, some economists consider that the variable reserve ratio is "a battery of the most
improved type" that a central bank can add to its armory. On the other hand, there are
economists who opine that the variable ratio reserve has not yet developed as a
delicate and sensitive instrument of credit control. To them, as compared to open
market operations, the variable reserve ratio lacks precision in the sense that it is
inexact, uncertain or rather clumsy as regards changes not only in the amount of cash
reserve but also in relation to the place where these changes can be made effective.
The changes in reserve involve larger sums than in the case of open market operations.
Further, open market operations can be applied to a relatively narrow sector.

The variable reserve ratio is comparatively inflexible in the sense that changes in
reserve requirements cannot be well adjusted to meet or localise situations of reserve
stringency or superfluity. Moreover, the variable reserve ratio is discriminatory in its
effect. Banks with a large margin of excess reserves would be hardly affected, while
banks with small excess reserves would be hardly affected, while banks with small
excess reserve would be hard pressed. This means that the variable reserve ratio
always causes injustice to the small banks, often without reason. On this account, many
economists favour open market operations rather than the variations in reserve ratio
for achieving monetary control.

It has been suggested, however, that open market operations and the variable reserve
ratio should be complementary to each other. A judicious combination of both will
overcome the drawbacks of each weapon when used individually and produce better
results. Thus, the suggestion is that the increase in reserve requirements, for instance,
may be combined with an open market purchase policy rather than open market sales
policy.

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 8.8 OBJECTS AND FUNCTIONS OF THE RBI

8.8.1 Objectives

The Preamble to the Reserve Bank of India Act, 1934 spells out the objectives of the
Reserve Bank as: "to regulate the issue of bank notes and the keeping of reserves with
a view to securing monetary stability in India and generally to operate the currency and
credit system of the country to its advantage."

Prior to the establishment of the Reserve Bank, the Indian financial system was totally
inadequate on account of the inherent weakness of the dual control of currency by the
Central Government and of credit by the Imperial Bank of India. The Hilton-Young
Commission, therefore, recommended that the dichotomy of functions and division of
responsibility for control of currency and credit and the divergent policies in this
respect must be ended by setting-up of a central bank called the Reserve Bank of India
- which would regulate the financial policy and develop banking facilities throughout
the country. Hence, the Reserve Bank of India was established with this primary object
in view.
Another object of the Reserve Bank has been to remain free from political influence
and be in successful operation for maintaining financial stability and credit.

The fundamental object of the Reserve Bank of India is to discharge purely central
banking functions in the Indian money market, i.e., to act as the note-issuing authority,
bankers' bank and banker to government, and to promote the growth of the economy
within the framework of the general economic policy of the government, consistent
with the need of maintenance of price stability.

A significant object of the Reserve Bank of India has also been to assist the planned
process of development of Indian economy. Besides the traditional central banking
functions, with the launching of the five-year plans in the country, the Reserve Bank of
India has been moving ahead in performing a host of developmental and promotional
functions, which are normally beyond the purview of a traditional central bank.
As has been stated by the First Five Year Plan document, "central banking in a planned
economy can hardly be confined to the regulation of the overall supply of credit or to a
somewhat negative regulation of the flow of bank credit. It would have to take on a
direct and active role, firstly, in creating or helping to create the machinery needed for
financing developmental activities allover the country and secondly, ensuring that the
finance available flows in the directions intended."

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 The Reserve Bank of India, as such, aims at the promotion of monetisation and
monetary integration of the economy, filling in the "credit gaps" and gaps in the
financial infrastructure, catering to the financial needs of the economy with appro-
priate sectorial allocation, as well as supporting the planners in the efficient and
productive deployment of investible funds with a view to attain the macro-economic
goals of maximisation of growth with stability and social justice.

Functions

The Reserve Bank of India performs all the typical functions of a good central bank. In
addition, it carries out a variety of developmental and promotional functions attuned to
the course of planning in the country.

Its major functions may be stated as follows:

(1) Issuing currency notes, i.e., to act as a currency authority.

(2) Serving as banker to the government.
(3) Acting as bankers' bank and supervisor.
(4) Monetary regulation and management.
(5) Exchange management and control.
(6) Collection of data and their publication.
(7) Miscellaneous developmental and promotional functions and activities.
(8) Agricultural finance.
(9) Industrial finance.
(10) Export finance.

8.8.2 THE RBI AS CURRENCY ISSUING AUTHORITY

The Reserve Bank has the sole right to issue currency notes, except one rupee notes
which are issued by the Ministry of Finance. The RBI follows a minimum reserve system
in the note issue. Initially, it used to keep 40 per cent of gold reserves in its total assets.
But, since 1957, it has to maintain only Rs. 200 crores of gold and foreign exchange
reserves, of which gold reserves should be of the value of Rs. 115 crores. As such, India
has adopted the "managed paper currency standard."
As a currency authority, the Reserve Bank provides different denominations of currency
for facilitating the transactions of the Central and State Governments, and caters to the
exchange and remittance needs of the public, banks as well as the Government
departments.

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 The bank has established 14 offices of the Issues Department for the discharge of its
currency functions. At all the other centres of the country, the currency requirements
are met by the Bank through currency chests. Currency chests are maintained by the
bank with the branches of the SBI group, Government Treasures and Sub-Treasures,
and public sector banks

Currency Chest
A currency chest is a pocket edition of the Issue Department. The stock of notes and
coins kept in the currency chests varies as per the needs of the respective areas served
by the Treasury or an agency of the bank.

The following advantages are claimed for maintaining currency chests by the bank:

1. The currency chests provides remittance facilities to banks and the

public.
2. They facilitate treasuries and bank branches to function by keeping rela-
tively small cash balances.
3. They facilitate the exchange of rupee coins for notes, as well as the issue
of new for old/soiled notes.

Above all, the Banking Department of the Reserve bank manages seasonal variations in
currency circulation. In the busy season, the currency flow is expanded, in the slack
season, it is contracted. During the busy season when there is an increased demand for
cash from the public. It is first reflected in the depletion of the cash balances of the
commercial banks and through them in the cash balances of the Banking Department.
The Banking Department then transfers eligible securities to the Issue Department, on
the basis of which the Issue Department issues more currency notes. This is how the
currency expansion takes place. During the slack season, the process is reversed.

The following are the important provisions made under the RBI Act, 1934 regarding the
issue of currency notes by the Reserve Bank:

(i) The Issue Department of the Bank alone can issue notes of Rs. 2 and
those of higher denominations.
(ii) The assets of the Issue Department should be completely segregated
from those of the Banking Department of the Reserve Bank.
(iii) All the notes issued by the Reserve Bank of India are legal tender and are
guaranteed by the Central Government.

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 (iv) The design, form and material of the notes issued by the RBI should have
the approval of the Central Government.
(v) The Central Government is empowered to demonetise any series of the
notes issued by the RBI.
(vi) No stamp duty is payable by the RBI in respect of notes issued by it.
(vii) The Central Government has to circulate rupee coins through the RBI
only.
(viii) The RBI is obliged to supply rupees coins in exchange for bank and
currency notes or bank and currency notes in exchange for coins.

8.8.3 THE RBI AS A BANKER TO GOVERNMENT

The Reserve Bank of India serves as a banker to the Central Government and the State
Governments. It is its obligatory function as a central bank. It provides a full range of
banking services to these Governments, such as:
(i) Maintaining and operating of deposit accounts of the Central and State
Government.
(ii) Receipts and collection of payments to the Central and State Govern-
ments.
(iii) Making payments on behalf of the Central and State Governments.
(iv) Transfer of funds and remittance facilities to the Central and State
Governments.
(v) Managing the public debt and the issue of new loans and Treasury Bills
of the Central Government.
(vi) Providing ways and means advances to the Central and State
Governments to bridge the interval between expenditure and flow of
receipts of revenue. Such advances are to be repaid by the government
within three months from the date of borrowal.
(vii) Advising the Central and State Governments on financial matters, such
as the quantum, timing and terms of issue of new loans. For ensuring the
success of government loan operations, the RBI plays an active role in
the gilt-edged market.

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 (viii) The bank also tenders advice to the government on policies concerning
banking and financial issues, planning as well as resource mobilisation.
The Government of India consults the Reserve Bank on certain aspects
of formulation of the country's Five Year Plans, such as financing pattern,
mobilisation of resources, institutional arrangements regarding banking
and credit matters. The government also seeks the bank's advice on
policies' regarding international finance, foreign trade and foreign
exchange of the country. The Reserve Bank has constituted a sound
research and statistical organisation to carry out its advisory functions
effectively.
(ix) The Reserve Bank represents the Government of India as member of the
International Monetary Fund and the World Bank.

8.8.4 THE RBI AS A BANKER'S BANK AND SUPERVISOR

The Reserve Bank of India serves as a banker to the scheduled commercial banks in
India. All the scheduled commercial banks keep their accounts with the Reserve Bank.

According to the Banking Companies' Act of 1949, originally, each scheduled bank had
to maintain with the Reserve Bank of India a balance as cash reserves equal to 5 per
cent of its demand liabilities and 2 per cent of its time liabilities. The Act, amended in
1962, specifies that 3 per cent of the total liabilities should be kept as reserve
requirement.

The Reserve Bank of India serves as a clearing agent for commercial banks. It provides
clearing and remittance facilities to the scheduled commercial banks at centres where
it has offices or branches.

The Reserve Bank of India also serves as 'a lender of last resort' by rediscounting
eligible bills of exchange of commercial banks during the period of credit stringency.
The bank can, however, deny rediscounting facility to any bank without assigning any
reason therefore.

In recent years, however, to contain inflationary pressures and to check heavy

borrowings by commercial banks, the Reserve Bank with its tight and discretionary
lending policy has been operating as a lender of 'regular resort' rather than of 'last
resort.'

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 Supervision of Banks

Apart from being the bankers' bank, the Reserve Bank is also entrusted with the
responsibility of supervision of commercial banks.
Under the Reserve Bank of India Act and the Banking Regulation Act, 1949, the Reserve
Bank of India has been vested with a wide range of powers of supervision and control
over commercial and co-operative banks.

The various aspects of the supervisory/regulatory functions exercised by the Reserve

Bank may be briefly mentioned as under:

1. Licensing of Banks. There is a statutory provision that a company starting

banking business in India has first to obtain a licence from the Reserve
Bank. If the Reserve Bank is dissatisfied on account of the defective
features of the proposed company, it can refuse to grant the licence. The
bank is also empowered to cancel the license of a bank when it will
cease to carry on banking business in India.
2. Approval of Capital, Reserves and Liquid Assets of Banks. The Reserve
Bank examines whether the minimum requirements of capital, reserve
and liquid assets are fulfilled by the banks and approves them.
3. Branch Licensing Policy. The Reserve Bank exercises its control over
expansion of branches by the banks through its branch licensing policy.
In September 1978, the RBI formulated a comprehensive branch
licensing policy with a view to accelerate the pace of expansion of bank
offices in the rural areas. This was meant to correct regional imbalance
of the banking coverage in the country.
4. Inspection of Banks. The Reserve Bank is empowered to conduct inspec-
tion of banks. The inspection may relate to various aspects such as the
banks' organisational structure, branch expansion, mobilisation of
deposits, investments, credit portfolio management, credit appraisal,
profit planning, manpower planning, as well as assessment of the
performance of banks in developmental areas such as deployment of
credit to the priority sectors, etc. The bank may conduct investigation
whenever there are complaints about major irregularities or frauds by
certain banks.The inspections are basically meant to improve the
working of the banks and safeguard the interests of depositors and
thereby develop a sound banking system in the country.

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 5. Control Over Management. The Reserve Bank also looks into the man-
agement side of the banks. The appointment, re-appointment or
termination of appointment of the chairman and chief executive officer
of a private sector bank is to be approved by the Reserve Bank. The
bank's approval is also required for the remuneration, perquisites and
post retirement benefits given by a bank to its chairman and chief
executive officer. The Boards of the public sector banks are to be
constituted by the Central Government in consultation with the Reserve
Bank.
6. Control Over Methods. The Reserve Bank exercises strict control over
the methods of operation of the banks to ensure that no improper
investment and injudicious advances are made by them.
7. Audit. Banks are required to get their Balance Sheets and Profit & loss
Accounts duly audited by the auditors approved by the Reserve Bank. In
the case of the SBI, the auditors are appointed by the Reserve Bank.
8. Credit Information Service. The Reserve Bank is empowered to collect
information about credit facilities granted by individual banks and supply
the relevant information in a consolidated manner to the banks and
other financial institutions seeking such information.
9. Control Over Amalgamation and Liquidation. The banks have to obtain
the sanction of the Reserve Bank for any voluntary amalgamation. The
Reserve Bank in consultation with the Central Government can also
suggest compulsory reconstruction or amalgamation of a bank. It also
supervises banks in liquidation. The liquidators have to submit to the
Reserve Bank returns showing their positions. The Reserve Bank keeps a
watch on the progress of liquidation proceedings and the expenses of
liquidation.
10. Deposit Insurance. To protect the interest of depositors, banks are
required to insure their deposits with the Deposit Insurance
Corporation. The Reserve Bank of India has promoted such a corporation
in 1962, which has been renamed in 1978 as the Deposit Insurance and
Credit Guarantee Corporation.
11. Training and Banking Education. The RBI has played an active role in
making institutional arrangement for providing training and banking
education to the bank personnel, with a view to improve their efficiency.

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 8.8.5 EXCHANGE MANAGEMENT AND CONTROL

Under Section 40 of the Reserve Bank of India Act, it is obligatory for the bank to
maintain the external value of the rupee.

The Reserve Bank of India is the custodian of the country's foreign exchange reserves. It
has authority to enter into foreign exchange transactions both on its own and on behalf
of the government. It is obligatory for the bank to sell and buy currencies of all the
member countries of the International Monetary Fund to ensure smooth and orderly
exchange arrangements and to promote a stable system of exchange rates.

The Reserve Bank of India has resorted to the technique of exchange control to allocate
its limited foreign exchange resources according to a scheme of priorities.

In India, exchange control was introduced under the Defence of India Rules in
September, 1939. It was, however, statutorily laid down by the Foreign Exchange
Regulation Act of 1947. This has been again stipulated by the Foreign Exchange
Regulations Act, 1973.

Objectives of Exchange Control in India

The primary objective of exchange control in India is to regulate the demand for foreign
exchange for various purposes against the supply constraints. When the government
finds a shortage of foreign exchange due to the low level of external reserves on
account of deficit in the balance of payments, exchange control becomes necessary.
Exchange control implies a kind of rationing of foreign exchange for the various
categories of demand for it.

The Reserve Bank of India implements exchange control on a statutory basis. The
Foreign Exchange Regulation Act, 1973 empowers the bank to regulate investments as
well as trading, commercial and industrial activities in India, of foreign concerns (other
than banking), foreign nationals and non-resident individuals. Moreover, the holding of
immovable property abroad and the trading, commercial and industrial activities
abroad by Indian nationals are also regulated by the Bank under exchange control.

The Reserve Bank manages exchange control in accordance with the general policy of
the Central Government.
In India, exchange control is grossly related to and supplemented by trade control.

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 While trade control is confined to the physical exchange of goods, exchange control
implies supervision over the settlement of payments - financial transactions pertaining
to the country's exports and imports. Comparatively, exchange control is more
comprehensive than trade control, since it covers all exports and imports as well as
invisible and capital transactions of the country's balance of payments.

Under the present exchange control system, the Reserve Bank does not directly deal
with the public. The bank has authorised foreign exchange departments of commercial
banks to handle the day-to-day transactions of buying and selling a foreign exchange.
Further, the bank has given money changer's licences to certain established firms,
hotels, shops, ete. to deal in foreign currencies and traveler’s cheques to a limited
extent.

The Reserve Bank has issued some directions to the authorised dealers and money
changers in dealing with foreign exchange which are published in the Exchange Control
Manual.
Under exchange control, there is check on foreign travel. An Indian visiting abroad is
given a fixed sum of foreign exchange only. The present limit is U.S. $ 500.

There is exchange control on exports, whereby all exporters are required to make a
declaration on the prescribed from the customs/postal authorities that foreign
exchange only representing the full export value of the goods has been or will be
disposed of in a manner and within a period specified by the Reserve Bank and shall
receive payment by an approved method. To facilitate export promotion, however, the
bank issues blanket foreign exchange permits for lump sums for specified purposes to
eligible registered exporters.

Similarly, all non-resident accounts are also governed by the exchange control
regulations. There are various categories of non-resident accounts such as: (a) non-
resident accounts, (b) ordinary non-resident accounts, (c) non-resident (external)
accounts, and (d) blocked accounts.

"Non-resident bank accounts" refers to the accounts of the overseas branches and
correspondents of authorised dealers.

"Ordinary non-resident accounts" are those which are maintained by Indians who have
gone abroad for the purpose of employment, business or vacation. Balances in these
accounts cannot be transferred abroad without the Reserve Bank's approval.
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 "Non-resident (External) Accounts" are meant to encourage Indians abroad to remit
their savings to India.

"Blocked account" implies that the Reserve Bank is empowered to "block" the accounts
in India if any person whether an individual, firm or company, resident outside India
and to direct that payment of any sums due to that person may be made to such
blocked account. In the normal course, balances in the blocked account cannot be
invested in India.

The Foreign Exchange Regulation Act, 1973 also puts a check on foreign investment in
India.
In short, in our country, the scheme of exchange control is largely governed by the
Foreign Exchange Regulation Act, 1973.

Exercise :
1. What is meant by saving? What are the determinants of savings as identified
by Keynes?
2. Explain the Saving-Investment relations as viewed by Keynes. What is the
role of rate of interest in it?
3. Give an idea of the structure of the Indian Capital Market? What are the
prospects of its growth?
4. What is the role of Banks in a modern economy? How many kinds of Banks
generally exist in a modern economy?
5. What are the functions of a Central Bank? What is the importance of Central
bank in monetary management?
6. State the functions of the Reserve Bank of India as the central banking
agency in our country.
7. Write short notes on :-
(a) Open market operation
(b) Variable cash reserve ratio
(c) Weapons of credit control
(d) Exchange control

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 UNIT – X
PARALLEL ECONOMY

10.1 MAGNITUDE OF POVERTY IN INDIA

Poverty is a plague affecting all parts of the world and it has many faces and
dimensions. One of the most important and most common manifestations of poverty is
the denial of access to the basic necessities of human existence.

10.1.1 'Absolute' and 'Relative' Poverty

Poverty is multidimensional.

'Absolute' poverty is poverty below the breadline. Those who suffer from 'absolute
poverty have no guarantee that they will be able to meet the fundamental costs of
living as a human being The World Bank has fixed the norm of one dollar one person
per day for this purpose.

A situation of need can also be expressed in terms of the living and working conditions
of other members of the same society at the same time. In this sense, poverty is
'relative' to disparity of wealth and income. It is the extreme form of inequality in
standards of living and degree of protection against insecurity. In this case, poverty
applies to individuals and families whose income and other resources, including living
conditions and the rules governing poverty, employment and labour, are distinctly
below the average level of the society in which they live.

10.1.2 Extent of Poverty in India

In India, poverty has been defined as that situation in which an individual fails to earn
income sufficient to buy him bare means of subsistence.

To quantify the extent of poverty and measure the number of ’poor’ in the country,
professional economists have made use of the concept of 'poverty line', (The concept
of the 'poverty line' was introduced in Indian economic analysis in l971, it was first
defined at the end of the nineteenth century in Great Britain.

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 Among these economists we may specifically mention the studies conducted by
Bardhan, Minhas, Dandeknt and Ruth, Ojha, Ahluwalia, Veidyanathzm, Blmttyd lain and
Tendulkar, Ravallion and Datt.

All of these studies do not look so much at the whole spectrum of income distribution
in India as at the problem of poverty as such. More specifically, the question that has
attracted attention most is whether the proportion of the population living below the
’poverty level' has increased or decreased in recent years.

Line of Poverty and Head-Count Ratio: In order to define the 'poverty line', all of these
studies –

● have determined the minimum nutritional level of subsistence,

● have estimated the cost of this minimum diet,

● on the basis of the per capita consumption expenditure, have delineated the
line of poverty.

Where changes in the magnitude of poverty have to be estimated between two

different years, account has been taken of changes in the price level by using deflators
of one type or another. Roughly, the same procedures are used in the various studies.

Most of these use the data generated by the NSSO through is consumption expenditure
surveys, in which households are asked how much of different goods they consume.
These surveys are expected to be representative as they are large surveys. Based on
these surveys, NSSO publishes data which says how many persons have a monthly per
capita consumption expenditure of say Rs. 0 Rs. 30, Rs. 31-50, Rs. 51-70, etc. Using this
distribution one can estimate how many consumed less than the normative poverty
line. Such estimates of poverty are also known as "Head-count ratio".

A problem with the head-count ratio is its insensitivity to the intensity of poverty. In
other words, a head-count ratio simply measures the number of poor below the
poverty line. It does not tell us anything about the income shortfall of the poor.

It may be desirable to group the poor into, say, three distinct categories, viz. (i) the
most destitutes, (ii) the destitutes, and (iii) the poor. There are a number of analytical
and policy uses to which the disaggregated information can be put to.

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 The discrepancy between the structures of minimum wages and the poverty line can be
easily calculated,

If the official poverty line may be deemed to define the society's norm of subsistence, it
would be possible to determine with fair precision the two lower levels of subsistence,

The other correlates of poverty, such as, low calorie intake resulting in low physical
strength, perhaps also insufficient development of mental faculties which go with poor
education and low educational potential, and low trainability, can be scientifically
investigated to determine at least the magnitude of the problem of those families
which lie deeply entrapped in these kinds of vicious circles and have lost the ability to
escape.

A large body of economists also seems to share this view. What is required is a
measure of poverty that includes fulfillment of certain basic human needs.

10.2 How to Measure Inequality among Income Classes

How can we measure the degree

of income inequality? At one
pole, if incomes were absolutely
equally distributed, there would
be no difference between the
lowest 20 per cent and the
highest percent of the
population: Each would receive
exactly 20 percent of the total
income. That’s what absolute
equality means.
The reality is far difference. The
lowest fifth, with 20 percent of
the households, garners less
We see that the solid rust-colored actual distribution-of
than 4 percent of the total incomec u r v e l i e s b e t w e e n t h e t w o e x t r e m e s
income. Mean while the of absolute equality andabsolute
inequality. The shaded area of this Lorenz
situation is almost reversed for curve (as apercentage of the triangle’s
area) measures relative inequality
the top 5 percent of house holds, ofincome. (How would the curve have
looked back in the roaring1920s when
who get more than 20 percent of
the income.

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 We can show the degree of inequality in a diagram known as the Lorenz curve, a widely
used device for analyzing income and wealth inequality. Figure - 1 is a Lorenz curve
showing the amount of inequality listed in the columns of Table-A; that is, it contrasts
the patterns of (1) absolute equality, (2) absolute inequality, and (3) actual 1995
American inequality.

Absolute equality is depicted by the gray column of numbers in column (4) of Table-A.
When they are plotted, these become the diagonal dashed rust-colored line of Figure
1’s Lorenz diagram.

At the other extreme, we have the hypothetical case of absolute inequality, where one
person has all the income. Absolute inequality is shown in column (5) of Table A and by
the lowest curve on the Lorenz diagram—the dashed, right-angled black line.

Any actual income distribution, such as that for 1995, will tall between the extremes of
absolute equality and absolute inequality. The rust-colored column in Table-A presents
the data derived from the first two columns in a form suitable for plotting as an actual
Lorenz curve. This actual Lorenz curve appears in Figure 1 as the solid rust-colored
intermediate curve. The shaded area indicates the deviation from absolute equality,
hence giving us a measure of the degree of inequality of income distribution. A
quantitative measure of inequality that is often used is the Gini coefficient, which is 2
times the shaded area.

Distribution of Wealth
One source of the inequality of income is inequality of ownership of wealth, which is
the net ownership of financial claims and tangible property. Those who are fabulously
wealthy - whether because of inheritance, skill, or luck - enjoy incomes far above the
amount earned by the average household. Those without wealth begin with an income
handicap.

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 (1) (2) (3) (4) (5) (6)
Income class Percentage of Percentage of Percentage of Income received by this class
of and
households total income households in lower ones
received by this class and Absolute Absolute Actual
households in lower ones equality Inequality distribution
this class
0 0 0.0
Lowest fifth 3.7 20 20 0 3.7
Second fifth 9.1 40 40 0 12.8
Third fifth 15.2 60 60 0 28.0
Fourth fifth 23.3 80 80 0 51.3
Highest fifth 48.7 100 100 100 100.0
Table A : Actual and Polar Cases of Inequality
By cumulating the income shares of each quintile shown in column (2), we can compare in column (6)
the actual distribution with polar extremes of complete inequality and quality.

In market economies, wealth is much more unequally distributed than is income, as

Figure 2(b) shows in the United States; 1 percent of the house-holds own almost 40
percent of all assets. Studies by New York University’s Edward Wolff show that the
distribution of wealth has become much more unequal. Because of the booming stock
market, the share of wealth held by the top 1 percent of people has doubled over the
last two decades. Given the sharp and growing increases in wealth inequality, Wolff,
along with legal scholars Bruce Ackerman and Anne Alston, have proposed that the
United States consider instituting a progressive wealth tax to go along with its
progressive income tax.

The vast disparities in ownership of wealth have spurred radicals over the ages to
propose heavy taxation of property income, wealth, or inheritance Revolutionaries
have agitated for expropriation by the state of great accumulations of property. In
recent years, a more conservative political trend has muted the call for redistribution of
wealth. Economists recognize that excessive taxation of property income and wealth
dulls the incentives for saving and may reduce a nation’s capital formation. Particularly
in a world of open borders, countries with high tax rates on wealth may find that the
wealth has fled across the borders to tax havens or Swiss bank accounts.

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 Poverty is caused primarily by unemployment. As a matter of fact, poverty and
unemployment go together. The concept of employment is however a complex
phenomenon. This is because it has to be related by some notion of value of the work
accomplished. The question of valuation is thus very important in this context.
Employment cannot always be defined in terms of physical activity only.
The production may arise in the intellectual field or in the aesthetic field, provided it
has demand in the commercial sense. The complexity in the field of employment is
further aggravated by the fact that a host of activities in an under-developed economy
take place in the sphere of self employment that does not bear any record.

Widespread are the “unpaid family labour” for an economy of peasants and artisans
where the concept of employment practically loses its straightforward meaning and
economic activities merges into the wider complex of family based production. Thus, a
huge non-money economy exists side by side with exchange economy but nevertheless
adds to the G.N.P.

According to economists, there are three important aspects of employment – the (i)
income aspects, the (ii) production aspects and the (iii) recognition aspects. On the one
hand, employment begets income to the labour, it generates production for the
consuming society and again it gives a recognition or position in the society to the
person concerned. Without employment, a person virtually is pushed out of the
economic world as a participant. Employment can thus be a factor in self-esteem and
indeed in esteem by others.

Full Employment
The concept of full employment is not easy to define. In a very simple version, it may
mean that the total available supply of labourer is completely absorbed in gainful
employment. There is voluntary unemployment in every society. There is frictional
unemployment too.

According to Lerner, full employment means that those, who want to work at the
prevailing wage rate are able to find work. Beveridge on the other hands defines full
employment in way which means, having always more vacant jobs than unemployed
man. It means that jobs are at fair wages, of such kind and so located and the
unemployed man can reasonable be expected to take them.

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 Mrs. John Robinson categorically says that frictional unemployment cannot be
considered as being consistence with full employment. In her opinion it is difficult to
demarket unemployment which is due to frictions and unemployment which is due to
deficiency of effective demand. However, in macroeconomic analysis, full employment
is viewed as an equilibrium situation in which sum of demands in all labour markets
tends to be equal to the sum of the supplies, though of course, there may be excess or
deficiency in some pockets.

Unemployment may be open or disguised. The term ‘disguised unemployment’, is a

common feature of an under-developed economy. It refers to a situation of
employment with surplus man power in which some workers have such low marginal
productivity that their removal from services will not affect the volume of total output;
on the contrary, it may leave the aggregate product even increasing.

THREE SECTORS OF ECONOMY

It is necessary to understand that value-addition takes place in the region where
employment is created for the purpose of production. Thus, if raw material is produced
in one country but industrially processed for value-addition in another country, the
other country is enriched by way of employment and addition to G.D.P. In this way the
rural sector of economy generally produces the primary products, by operating on
natural resources in the sphere of agriculture, animal husbandry, forestry, poultry,
pisci-culture, etc. Thus, it is called the primary sector of economy.

In the next place, the secondary sector comprises value-addition in manufacture or

industries by transforming primary products into improved consumable items. This
operation mostly takes place in urbanized regions and are said to constitute the
secondary sector of the economy. But, that is not all. In order that consumable items
reaches the doors of the consumers, some more inputs become necessary, like
transportation, wholesale and retail shopping, financing of all the productive ventures,
settlement of disputes, maintenance of law and order and requirement of
governmental administration. All these purposes are served by services rendered in the
third sector of economy known as the tertiary sector. Since an appropriate stage of
density of population as well as bigger size of human settlement is required to sustain
such activities, the tertiary sector is a marked feature of the urban region.

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 Thus, the entire issue of division of economy in different sectors – primary, secondary
and tertiary, has to be understood in the context of demographic patterns, reflected in
level of urbanization together with economic factor like level of industrialization and
the social factor reflected in level of education, health, motivation and efficiency of the
people in the performances of production as well as rendering of services.

From valuation point of view all these factors are extremely important in-as- much as
the valuation of real estate or plant and machinery depends upon the productivity of
the different agents of production like land, labour, capital and organization. In
assessing a long-term view of the prospect of value-addition considered in the
perspective of the forces at work in the above demographic, economic or social fields
and even the political scenario at large claim serious consideration. The treatment of
the entire micro economic as well as macro economic issues thus deserves particular
focus from the valuation angle.

10.3 PARALLEL ECONOMY (Black Economy)

A particular feature that holds back the economic progress of the country of the third
world requires also to be discussed in the realm of economics. As we have seen the
urban-rural relationship is an important factor in economic analysis, since rural areas
have predominantly primary sector to thrive on, while the urban sector comprises the
economic activities in the secondary and tertiary sectors. In the modern world,
urbanization is taken as an index of economic development as it means the harbouring
of a growing secondary sector and fast growing tertiary sector therein. A note of
warning need be added while increasing the rate of urbanization as a marked feature of
developing countries.

The growing urbanization of developing countries means high rate of inmigration of

population from rural to the urban sectors. Two classes of people are generally marked
out as migrants – the upper class comprising the richer section in quest of better
amenities of life and the poorer section in search of employment driven by loss of work
in the rural hinterland. These people of the poorer section find accommodation in the
informal sector of economy comprising day labours, masons, hawkers, vendors,
pavement sellers and similar segment who struggle to ekeout a living.

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 While the flight of richer section deprives the rural economy of adequate purchasing
power to sustain a healthy market in the rural sector, the flight of poorer section only
deteriorates the urban-economic scenario by swelling an informal sector which remains
out of tax net and frustrates monetary measures initiated by the government. However
pitiable are the condition in general, there are quite a few who escape the tax-net
along with other businessmen and traders in no small measure.

Let us now discuss the parallel economy that is known as underground economy
comprising the unreported transactions, the magnitude of which is a major headache.

The parallel economy arises out of the following manner of distorted growth pattern.
The economy gets divided in the three following sectors:

(i) Formal sector

(ii) Informal sector
(iii) Illegal sector

The formal sector is suppose to comprise all transactions that are exposed to fiscal
intervention and line within the ambit of the influence of the monetary policy pursued
by the government. Here, too parallel economy has made a headway by underhand
dealings in bribery, corruption and other abuses that have become a part of civic life.
Donations to political parties from unaccounted sources constitute another big threat.
In this way, the parallel economy grows by abusing the formal sector by using an illegal
sector that comprises disbanded activities like drug trafficking, arms selling, etc. and by
tolerating an informal sector which has become an unavoidable imperative to provide
self-employment at large to helpless people who cannot be employed otherwise.

10.4 BLACK ECONOMY IN INDIA

10.4.1 Meaning

It is well known that there is a large amount of money income and wealth which has
been and is being made and / or owned which is unaccounted in our tax system and,
therefore, has not suffered tax. This unaccounted economic sector is referred to as
black economy (alias the parallel economy, the underground economy, the unreported
economy etc.).

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 We might distinguish here between 'black money' and ‘black income'. While black
money is a stock at a point of time, black income is a flow over a period of time. For
policy purposes, the correct concept is that of black income, rather than black money

The black economy in India has been a matter of concern for a number of years. It has
grown to enormous dimensions. It has become a threat to the ability of the official
monetary—credit policy mechanisms to manage demand and prices in several
vulnerable sectors of the economy. The fact is that it has permeated every section of
society.

10.4.2 Magnitude of Black Economy

A number of efforts have been made to estimate the quantitative dimensions of the
problem in the economy: A numerical review of the estimates given by the various
economists and others reveals that almost all of them show a growing quantity of black
income relative to GNP as well as in absolute terms. The aggregate of black income
generated is estimated to have gone up from Rs. 50,977 crores in 1980-81 to
Rs.10,50,000 crores in 2006-07. The process has only further accelerated due to
ongoing liberalisation.
Raja J. Chelliah has estimated that black money is generated at the rate of 20 per cent
of country's GDP. The corresponding figures were between 0 and 20 per cent for the
EU, 15 per cent for U.S.A., 30 per cent for Italy and 25 per cent for France.

10.4.3 Causes of Black Economy

More important causes of black economy can be discussed as follows:

Level and Structure of Taxation: High effective rates of taxation are a major
contributory factor to tax evasion and black income generation in India. Improved tax
compliance can result from significant and sustained reductions in the effective tax
burdens of those who are liable to tax.
As regards the composition of tax structure, it is generally believed that indirect taxes
on commodities are more difficult to evade than direct taxes on income and wealth.
That is why countries at earlier stages of development normally rely much more heavily
on indirect taxes than more developed nations. Thus, there is some presumption that
as a country develops over time the composition of its tax revenue would gradually
shift in favour of direct taxes. It is urgent to increase the tax-net rather than enhance
the tax-net.

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 Weaknesses in Tax Administration: The performance of the tax administration in India
has been poor by international standards and has been deteriorating over the years. A
recent study on the subject identifies the following as the causes of this:
● Information system. lt is primitive and tamper-prone.

● Organisational structure. Functional specialisation is lacking leading to failure to

integrate various information sources available in assessments and prosecution.
● Manpower policies. No serious efforts have been made to adopt incentive systems
that induce tax officials to detect or attempt to prosecute tax evasion.
● Penalty and prosecution. These are increasingly oriented towards the punishment
of technical violations rather than tax evasion.

Pervasive Controls: The controls violate basic economic law of demand and supply and
create artificial scarcities by curtailing production, and (or supply) by inducing excessive
demand by purchasers. They become a bee-hive af black income dealers, and
producers in black markets; administrators of controls get their share in black incomes.

Public Expenditure Programmes: The black-market economy has also received

sustenance from the poor design and faulty administration of many public expenditure
programmes in India, usually through illegal leakages in these expenditures. Public
savings have been cheated of taxes on these ill-gotten income, and the programmes'
unit costs have also increased.

Inflation: Inflation generates black income in several ways.

● With a progressive income (and wealth) tax structure, defined with respect to
nominal values, inflation increases the effective burden of taxation at any given
level of real income (and wealth), and hence the incentive to evade.
● General inflation encourages illegitimate transactions. lt is usually accompanied by
pronounced scarcities and windfall gains in certain sectors which are unlikely to be
fully declared to the tax authorities.
● Inflation hits hard fixed salaried income groups which include govemment
servants. The pinch of inflation reduces their real income and as such they start
misusing their official position by accepting bribes, etc, This generates black
money.

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 Political finance It is widely believed that black money has become an important
operational component of the Indian economy with many diverse links with the
political system. The functioning of the political parties and system of election laws had
been identified as a significant factor in black income generation by the various expert
committees.

Standards of Public Morality: There has been a general deterioration in our moral
standards. We may quote Prof B.B. Bhattacharya in this context, when he remarks:
"Before 1991, money making was not considered a virtue. The significant change since
liberalisation is that being rich is now all important and people, whether a professor, a
musician or an industrialist, are evaluated in income earnings". This change is
motivating people to be corrupt.

High Cash-intensity: The cash-GDP ratio in India, called cash—intensity, works out to
about 10 per cent (against 3 to 4 per cent in advanced countries like UK, France,
Switzerland, Germany, Japan, Belgium, Netherlands, etc.). The greater the cash
transactions in an economy, the greater is the scope for money laundering without
detection.

In addition, a peculiar phenomenon which is associated with the black money is the
constant interchange between the black and white economies. The extent of this
change too is very high. Various methods are adopted to convert black money into
white and vice-versa.

10.5 Effects of Black Economy

Effect of black money on the state of economy can broadly be discussed under the
following heads:

Misinformation About the Economy: The most obvious effect of substantial black
money is misinformation about the actual state of the economy because it remains
outside the purview of the economic policies. The presence of a sizeable black money
casts doubts on the validity of the· data on national income estimates, distribution of
incomes, consumption, savings and the distribution of investment between public and
private sectors. The economic planning loses effectiveness and important economic
decisions are rendered meaningless because they are based on macroeconomic
indicators which ignore the large black money component.

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 Impact an Fiscal System: Evasion of taxes has serious consequences for the economy's
fiscal system. The most obvious effect is that the Government is deprived of large
amounts of tax revenue.

The long-run consequence of such revenue loss is to reduce the built-in elasticity of the
tax system. To raise a given target of revenue the Government is obliged to depend
increasingly on discretionary hikes in tax rates or to expand the array of taxes. Both the
measures have undesirable effect on the economy. While, as the first measure gives
inducement to avoidance and evasion of tax, the second measure is bound to make an
already complex tax structure more complicated.

Implications for Resource Allocation: It distorts resource allocation in the economy

and often leads to wasteful use of money. Black money leads to conspicuous
consumption and in turn results in the diversion of large funds to unproductive
channels which ultimately put the economy out of gear.

Effects on Income Distribution: The household with a higher proportion of black

income are more likely to understate their true incomes and to do so to a greater
degree. With the given progressive structure of income taxation, the incentive to make
black income through under statement of legal source incomes clearly increases with
increase in income. So we should expect richer households to earn proportionately
greater black incomes through this means. In this way, the distribution of income
becomes even more skewed in favour of the rich with the growth of black money. The
last manifestation of this is the Report of the IMF that over Rs. 1,800 crores are stashed
away illegally in secret accounts in one country, Switzerland, by Indian nationals.

Implications for Monetary Policy: As regards stock dimensions of black money it is

related to the stock of 'black liquidity'. The stock of 'black liquidity' is defined as the
accumulation of black savings (from black incomes) in the form of cash and other
readily convertible assets such as gold and silver. It is this 'black liquidity' which creates
a lot of problems for monetary authorities to regulate the economy. Even the selective
credit control measures which aim at regulating the flow of credit into particular uses
and diverting credit from the less urgent to the more urgent uses in the economy are
rendered ineffective owing to the existence of sizable ’black liquidity' in our country. In
fact, it renders all the anti-inflationary policies of the monetary authorities ineffective.

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 Black Income and Inflation: Black income is more a cause and less an effect of inflation.
Black operation lie at the root of fiscal deficit of the government, which is largely
responsible for "excessive" increases in high-powered money and so in money supply in
India year after year.

Above all, what Wanchoo Committee observed more than three decades ago still holds
true: "One of the worst consequences of black money and tax evasion is, in our
opinion, their pernicious effect on the general fibre of society. They put integrity at a
discount and place a premium on vulgar and ostentatious display of wealth. It is,
therefore, no exaggeration to say that black money is like a cancerous growth in the
country's economy which, if not checked in time, is sure to lead to its ruination."

10.6 Remedies
The various measures adopted by the government to deter income tax evasion and
unearth black income can be studied under three parts, viz. (1) measures to deter tax
evasion, (2) measures to unearth black money, and (3) new measures for dealing with
black money.

Measures to Deter Tax Evasion

The statutory obligations of taxpayers include compulsory filing of tax returns by
everyone with a taxable income, compulsory maintenance of accounts by businessmen
and professionals and their compulsory auditing if income or turnover exceeds a
specific limit, compulsory canalising of transactions involving payment exceeding Rs.
20,000 through banks, etc. However, in actual sense, these statutory provisions have
not made much difference. The self-employed continue to escape the tax net either by
not filing returns or by filing false returns with grossly under reported incomes.

Use of PAN
All income-tax payers are required to get a permanent account number (PAN) from the
income tax department. A provision has been made for the compulsory mention of
PAN or GIR in certain high value transactions. With increased usage of computerisation
the data will be fully utilised for increasing the tax base and for preventing the leakage
of revenue.

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 Surveys
To bring new assessees into the tax net and strengthen the information base for the
detection of tax evasion by existing assessees, a general survey is conducted by the
income tax department. While the surveys have increased substantially the number of
taxable new assessees each year, the realised gain is much below the expected
potential.

Tax Raids and Seizures

Raids are conducted from time to time, by the tax enforcement machinery, on the
premises of the people who are suspected of possessing black money. After the raids,
wide publicity is usually given to the amount of money, or other assets that are seized.
But a large part of these have to be returned to the owners, presumably because
acceptable evidence incriminating the owners cannot be produced in the court of law.
Hence, raids fail to make the desired impact.

Penalties and Prosecutions

To discourage tax evasion, tax laws also provide for monetary penalties and for the
prosecution (and imprisonment) of tax evaders. However, in actual practice, penalties
have been imposed on only a very small proportion (less than one per cent) of total
Assessments and these, too, have been pitiably small.

The Settlement Commission

Following the recommendations of the Wanchoo Committtee (1971), the Settiement
Commission was established in 1976. Its objective was to provide a mechanism for the
quick and final disposal of those cases where a tax evader was willing to make a
confession and face the consequences.

Monitoring of Banks' Transactions

In a bid to curb black money transactions in the banking system, the RBI has directed all
commercial banks to submit details of all cash deposits and withdrawals of Rs. 10 lakh
and above to the central bank.
It is urgent to release the country from the octopus grip of a black economy so that a
healthy foundation of economic growth can be laid amidst a globalised world.

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 Exercise :

1. Define proverty in “absolute” and “relative” terms. Depict proverty as

measured in the Lorenz Curve shown in the diagram.
2. Describe how the economy is usually said to comprise in three sectors. How
this division in three sectors matches with the level of urbanization?
3. What do you understand by ‘informal sector’ in an economy? Explain how
the growing urbanization lead to an informal sector in the developing
countries.
4. What do you understand by ‘parallel economy’? How does it arise?
5. What are the effects of a parallel economy or black economy and how to
combat it in the situation prevailing in our country?
6. Write short notes on :-
(a) Full employment
(b) Illegal sector
(c) Black income

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