FOUNDATION COURSEPAPER - 3

Study Note - 1BASIC CONCEPTS OF ECONOMICS1.1 DEFINITION AND SCOPE OF ECONOMICSThere are 4 definitions of Economics.(1) Wealth Definition:This definition was produced by Adam Smith. He defined “Economics as a sciencewhich inquired into the nature and cause of wealth of Nations”. According to thisdefinition, Economics is a science of study of wealth only which deals with production,distribution and consumption. Economics studies only material commodities and causesof changes in wealth and changes in Economics dept.Criticisms of this definition:(a) Wealth is of no use unless it satisfies human wants.(b) This definition is not of much importance/important to man and welfare.(2) Welfare definition:It was given by Alfred Marshall. According to Marshall “Economics is the study of manin the ordinary business of life”. If examines how a person oats his income and how heinvests it. Thus on one side it is a study of wealth and the other most important side, itis a study of man.Features of Marshall Definition(a) Economics studies the economic side of man – man performs many types of activities -social, eco religious. Economics is a study of those activities that are concerned withmaterial welfare of man.(b) Every man works to earn wealth and to spend his earnings to get enjoyment of it. Thisis the ordinary activity of man Economics studies such an ordinary man.(c) Economics is the study of personal and social activities concerned with material welfareof man. It is the study of such an individual on one hand and social organization on theother hand.(d) Study of material welfare – Marshall emphasized on definition of material welfare.This is one major difference of this definition with that given by Adam Smith. You mustparticularly note that economics is related with one welfare of man which is a materialtype, study of non-economic welfare is outside and scope of economics.(3) Scarcity definitionThis definition was put forward by Robbins according to him “Economics is a sciencewhich studies human behavior as a relationship between ends and scarce means which

have alternative uses. According to Robbins man is so situated that on one hand he hasunlimited want to satisfy and on the other he has limited resources. Such wants keep onchanging with the change of time. As soon as the present wants are satisfied, new wantstake their place. It is very difficult to satisfy all wants at all same time, so the moreurgent wants are closer to be satisfied tirs followed by less important wants. Are strictlylimited by the resources. If all the resources are abundant in supply, like air, sunshineetc, there would have been no economic problem. But, in reality, the means of productionare limited in supply, like time, money, physical, mental or other types of energy etc.There arises the Economics problem of choosing the most important or urgent wantsfor satisfying them on priority basis.(4) Growth Oriented definitionThis definition was introduced by Paul. A. Samuelson. According to the definition“Economics is the study of how man and society choose with or without the use ofmoney to employ the scarce productive resources, which have alternative uses, toproduce various commodities over time and distributing them for consumption, howor in the future among various person or groups in society.” It analyses costs and benefitsof improving patters of resource allocation.Features(1) Like Robbins, Samuelson had also emphasized on the problem of choice arising out ofscarce resource and unlimited wants. (2) The problem of scarcity of resource is not merely confined to present but also to thefuture. It involves how the expansion and growth of resources is to be used to copewith human wants.(3) Professor Samuelson has adopted a dynamic approach to the study of Economics. Bytaking economic growth as an integral part of economics.(4) Professor Samuelson has rightly emphasized that the problem of resource allocation isa universal problem of an economy.(5) This definition of Economics is very comprehensive since it is growth oriented as wellas future oriented. It includes Marshalls definition’s welfare as well as Robbins scarcity.Scope and Subject MatterEconomics is a social science. It studies man’s behaviour as a rational social animal. For a longtime the scope of Economics was kept confined within narrow limits. Traditional economists

considered it a science of wealth in relation to human welfare. Earning and spending of incomewas considered to be end of all economic activities. The mechanism of wealth of nation waslucidly explained Adam Smith in 1776. Alfred Marshall subsequently reduced the taint of grossmaterialism from economics by bringing human welfare side into its scope. It was redefined asscience of wealth in relation to human welfare. According to him the subject is more a study ofman’s welfare than wealth. Wealth was considered as a means to an end – the end being humanwelfare.The scope pf Economics was however much widened in the hands of Robbins. Setting asidewealth and welfare ideas, he brought into limelight ‘limited means’ to satisfy ‘unlimited wants’that a man or society faces in daily life and how he makes a happy compromise between thesetwo conflicting problems. That constitutes the subject matter in a wider context. The economicproblem everywhere is a problem of making a living in the midst of scarcity.In a situation where want fulfilling resources are scares, how an individual, either as a consumeror as a producer, can optimize his goal is what economist can analyse theoretically. In a likemanner, the scope of Economics lies in analyzing economic problems and suggests policymeasures. Social problems can thus be explained by abstract theoretical tools or by empiricalmethods. These two approaches are often complementary.In classical discussion we see Economics as a positive science seeking to explain what the problemis and how it tends to be solved. But in modern time it is both a positive and a normativescience. Economists of today deal economic issues not merely as they are but also as they shouldbe. In fact, welfare economics and growth economics are more normative than positive. Thusthe scope of Economics has widened over the centuries, touching all aspects of a man’s ornation’s life in its economic side.Subject Matter of EconomicsThe subject matter of economics is presently divided into two major branches. Micro Economicand Macro Economics. These two terms have now become of general use in economics.Question : what do you mean by Micro Economics ?Answer :

Micro economics studies the economics behaviour of individual economic units and individualeconomic variable. The unit of study in micro economics is the part of the economy, such asindividual households, firms and industries. Thus, the study of economic behaviour of thehouseholds, firms and industries form the subject-matter of micro economics. In other words,micro economics is a microscopic study of the economy. For example, micro economics isconcerned with how the individual consumer distributes his income among various productsand services so as to maximize utility. Micro economics also seeks to explain ho the individualfirms determine the sale price of the product, how much to produce, what amount of productwill maximize its profit, and how to minimize the cost of production. In other words, microeconomics examines how resources are allocated among various individual firms and industries,how the prices of various product are determined, and how the output produced is sharedamong those. Micro economics also examines whether resources are efficiently allocated andspells out the conditions for the optimal allocation of resources so as to maximize the outputand social welfare. Thus, micro-economics is concerned with the theories of product pricing,factor pricing and economic welfare.Question : what do you mean by Macro Economics ?Answer :Macro Economics is the study of the economy as a whole. The unit of study in macro economicsis the entire economy rather than a part of it, and it deals with the problems faced by the entireeconomy. Thus, macro economics deals with the functioning of the economy as a whole. Forexample, macro economics seeks to explain how the economy’s total output of goods and servicesand total employment of resources are determined and what explains the fluctuation in thelevel of output and employment. Macro economics explains why at sometimes there is fullutilization of the economy’s productive capacity and why at other times there is under-utilisationof the economy’s productive capacity. It also seeks to explain why the economy experiences ahigh rate of economic growth at sometimes and a lower rate of economic growth at other times;

why sometimes the economy faces the problem of sharp rise in prices, example., problem of inflation,and what at other times price level remains stable or even falls. In short, macro economicsdeals with the broad economic aggregates or ‘big’ issues, such as full employment orunemployment, capacity or under capacity production, a low or high rate of growth, inflationor deflation. In other words, macro economics is the theory of national income, employment,aggregate consumption, savings and investment, general price level and economic growth.Interdependence of Micro Economics and Macro EconomicsAlthough we have drawn a sharp distinction between micro economics and macro economics,we should not get an impression from this that the two are independent ways of analyzing theeconomic issues. Micro Economic analysis and Macro Economic analysis are complementaryto each other; they do not supplant but supplement each other. That is why Shapiro says,strictly speaking, there is only one Economics. In practice, analysis of the economy cannot beconducted separately in two watertight compartments. Micro economic variables and macroeconomic variables, we have to take account of macro economic variables that may affect themicro economic variables, and vice versa.Both micro economic theory and macro economic theory are important in their own ways.When we say that macro economics deals with ‘big’ issues of economic life, it does not meanthat macro economic theory is more important. As we know, small is beautiful. After all, theentire economy is made up of its parts. Therefore, micro economic theory is equally importantin its own way. Moreover, the basic goal of both the theories is same: the maximization of thematerial welfare of the nation. From the micro economic point of view, the nation’s materialwelfare will be maximized by achieving optimal allocation of resources. From the macroeconomic point of view, the nation’s material welfare will be maximized by achieving fullutilisation of productive resources of the economy. Therefore, for you as students of economics,study of both micro economics and macro economics is equally vital so as to have full knowledgeof the subject-matter of economics. Otherwise, your description of an elephant by four blind

men who gave four different descriptions of the elephant by touching its different parts. Prof.Paul A. Samuelson has rightly remarked, There is really no opposition between micro and macroeconomics. Both are vital. You are less than half-educated if you understand one while being ignorant ofthe other.Economists, before 1930, concentrated their attention on micro economics. Macro economicswas regarded as a junior partner. It was, therefore, given a passing reference. The classicaleconomists believed that the economy normally operates at full employment and, therefore,the actual level of output in the economy was simply whatever could be produced with fullemployment of resources. According to them, the economy could depart from full employmentsituation only temporarily. They believed that the automatic forces of competition would takethe actual level of output back to the full employment. Therefore, these economists wereconcerned with the problem of unemployment. The fact that there was relatively few situationsof prolonged unemployment and depression before 1930 gave support to this belief of classicaleconomists. However, the situation changed dramatically during the 1930s. During this decade,there was widespread unemployment in the advanced capitalist countries of the world. Actualoutput was only 75 percent of the potential output*, example., 25 percent of the potential output wasnot produced. It was this which led to the development of macro economic theory by the famouseconomists J.M. Keynes. Keynes’ famous book, The General Theory of Employment, Interest andMoney provided a theory to explain the phenomenon of depression. Keynes provided a theoryof the determination of employment and output. He explained that the economy can operate atany level of employment, with full employment only as one possible level. In fact, according tohim, economy normally operates at less than full employment level. Ever since then, economistshave shown their concern with macro economics and micro economics has assumed asunprecedented importance.The contemporary economists are concerned with both micro economics and macro economics.Question write the nature of Economics Answer :

Nature of economics refers to whether economics is a science or art or both, and if it is a science,whether it is positive science or normative science or both.Economics as a ScienceWhile explaining the subject matter of economics we have often stated that economics is asocial science. A social science studies various human activities. Economics as a social sciencestudies economic activities of the people. By classifying economics as asocial science, economistshave placed their subject in the category of science rather than art. Let us understand whyeconomists regard economics as a science or why we use the title ‘science’ for economics.The term ‘science’ implies the following :1. A systematic body of knowledge which traces the relationship between cause and effect.2. Observation of certain facts, systematic collection and classification and analysis of facts.3. Making generalization on the basis of relevant facts and formulating laws or theoriesthereby.4. Subjecting the theories to the test of real world observations.Subjects such as Physics, Chemistry, Botany, etc., are regarded as science because they possesall these characteristics. In this sense, economics is also considered to be science since it satisfiesall these characteristics of science.Firstly, economics is a systematic body of knowledge as it explains cause and effect relationshipbetween various variables such as price, demand, supply, money supply, production, nationalincome, employment, etc.As in other sciences, one way of making generalisations in economics is through logicaldeduction. This is the traditional Deduction Method where economic theories are deduced bylogical reasoning. In this method certain assumptions are made and by using logical reasoningwe arrive at certain logical deductions. From these deductions certain economic laws or themesare formulated. Thus, under the deductive method, logic proceeds from the general to theparticular. This method is called abstract or a prior because it is based on abstract reasoning andnot on actual facts.Economic laws, like other scientific laws, state what takes place when certain conditions(assumptions) are fulfilled. For example, Newton’s Law of Gravitation in Physics states that

every body in the universe attracts every other body with a force. But the gravitational forcedepends upon the size of the mass and the distance between the two bodies. Therefore, theGravitation Law states that given the mass of the two objects, the force of gravitation is inverselyproportional to the distance between them. In the same way, the law of demand in economicsstates that a fall in the price of commodity leads to a large quantity being demanded ‘givenother things’, such as income of the consumer, prices of other commodities, etc., remaining thesame.An alternative method to derive economic generalizations is Inductive Method. Under thismethod, a mass of data is collected from actual experience with regard to economic phenomenonand on the basis of these collected observations certain generalizations are made and conclusionsare drawn therefrom. The logic in this approach is from particular to general. The generalizationsare based on observation of individual instances.However, the two methods are not mutually exclusive. They are used side by side in any scientificenquiry.Thus, like other sciences, economics possesses the above mentioned characteristics (2) and (3)as well. In economics we collect data, classify and analyse these facts and formulate theories oreconomic laws.Lastly, we call economics a science because the truth and applicability of economic theories canbe supported or challenged by confronting them to the observations of the real world. If thepredictions of the theory are refuted by the real-world observations, the theory stands rejected.But if the predictions of the theory are supported by the real-world events, then the theory isformulated. For example, the law of demand, stating the there is an inverse relation betweenprice and quantity demanded, is a scientific economic hypothesis, because it has beencorroborated by the real world observations.The method of economics is, therefore scientific and hence it is appropriate to label economicsas a science. However, compared with physical and natural sciences, economics is at adisadvantage. Economics cannot claim the precision of the physical sciences because the human

and social behaviour is complex and unpredictable. In economics, unlike Physics, Chemistryand Biology, we cannot perform the controlled experiments. We have to depend uponobservation of economic events; these observations are not so well behaved and orderly. Thatis why economy laws are not as accurate, precise and of universal validity as laws of physicaland natural scienties are. The laws of economics or economic theories are conditional subject tothe condition that other things are equal; Economic theories are seldom precise and are neverfinal; they are not as exact and definite as laws of physical and natural sciences.From the above discussion, we make the following two observations.1. The laws of physical and natural sciences have universal applicability, buteconomic laws are not of universal validity.2. The laws of physical and natural sciences are exact, but economic laws are notthat exact and definite.Economics as an ArtArt is completely different from science. What is an art? J.M.Keynes defines art as “a system ofrules for the attainment of a given end.” The object of art is to formulate rules to be used forformulation of policies. Thus, as compared to science, which is theoretical, art is practical. Ascience teaches us to know, an art teaches us to do.Applying this definition of art, we can say that economics is an art. Various branches ofeconomics, like consumption, production, distribution, money and banking, public finance,etc., provide us basic rules and guidelines which can be used to solve various economic problemsof the society. Thus, the theory of demand guides the consumer to obtain maximum satisfactionwith given income. Similarly, theory of production guides the producer to equate marginalcost with marginal revenue while using resources for production. Thus, economics is an art inthe sense that the knowledge of economic laws helps us in solving practical economic problemsin everyday life.To conclude, we can say that economics is both a science and an art. As a science, economics isa systematic body of knowledge which makes generalizations and theories by adopting scientificapproach. As an art, it puts this knowledge into practice. It uses economic theories and laws informulating various economic policies. Thus, economics is ‘science’ in methodology and ‘art’

in its application. Corsa observed that science required arts, and arts requires science—each beingcomplementary to the other. It is advisable, therefore, to treat economics both as a science and anart. Paul A. Samuelson has rightly stated that economics can be described as “the oldest of thearts and the newest of the sciences – indeed the queen of social sciences”.Positive and Normative ScienceAs explained above, economics is considered as a science. Another question related to natureof economics is whether it is a positive science or a normative science or both.Economics as a Positive ScienceA positive science is that science in which analysis is confined to cause and effect relationship.In other works, it states ‘What is’ and not ‘what ought to be’. There is a school of thought whichbelieves that economics is only a positive science. It should confine itself to stating the causeand effect relationship. It should not pass any value judgement regarding what is right andwhat is wrong.Positive economics is concerned with the facts about the economy. It relates to what the factsare, were or will be about various economic phenomena in the economic. It studies the economicphenomena as they exist, finds out the common characteristics of economic events, specifiescause and effect relationship between them, generalize their relationship by formulatingeconomic theories and make predictions about future course of these economic events. Forexample, positive economics deals with questions like what are the causes of unemployment?How do we account for inflation? Why price of a particular good has increased? and so on.Economics as a Normative ScienceEconomics as a normative science is concerned with what ‘ought to be’. Its objective is to examinereal economic events from moral and ethical angles and to judge whether certain economicevents are desirable or undesirable. It tries to find out and prescribes certain course of actionwhich is desirable and necessary to achieve certain goals. Thus, normative economics involvesvalue judgment. Normative economics deals primarily with economic goals of a society andpolicies to achieve these goals. It also prescribes the methods to correct undesirable economichappenings.

To understand the difference between the positive and normative nature of economics, let usconsider some economic events and their positive and normative aspects, in economic studies.For example, how are the prices of foodgrains determined is a question of positive economics,but ‘what should be the prices of foodgrains’ is a question of normative science. Consideranother example. The statement ‘a decrease in taxes will encourage production’ is a questionfor positive economics, but ‘should taxes be reduced or not’ is a question of normative economics.In the past, there was controversy among economists over the nature of economics. Robbinsemphasized that economics is purely a positive science. According to him economics shouldbe neutral between ends. It is not for economists to pass value judgement and makepronouncements on the goodness or otherwise of human decisions. Marshall and Pigou, onthe other hand, considered economics both a positive and a normative science.However, there is hardly any controversy on this issue now. It is generally agreed not thateconomics is both a positive and a normative science. Economists believe now that completeneutrality between ends is neither feasible nor desirable. It is not possible because in manymatters the economist has to suggest measures for achieving certain economic objectives. Headvocates various policies for increasing employment, reducing inflation, etc. While makingthese suggestions, he is making value judgement.A mere study or positive facts would not take us very far. Complete elimination of valuejudgements from the study of economics robs the subject much of its practical utility. In manycases, an economist as a policy formulator and social reformer has to pronounce undesirableeffects of certain economic events and has to make suggestions for their removal. When hedoes this, he is not entirely neutral between ends. Thus, neutrality between ends is not desirablein many cases.Deductive And Inductive Methods Of Economic AnalysisIn Economics the issues are analysed either by inductive method or by deductive method. Thedeductive method tries to draw conclusions from certain fundamental assumptions or truths.The logic proceeds from general to the particular. For example, we can deduce from the basic

truth that a man will buy more at lower prices. The Law of Demand and the Law of diminishingMarginal Utility have been derived from deductive reasoning.The inductive method, on the other hand, deduce conclusions on the basis of collection andanalysis of facts and figures. The Logic proceeds from particular to general. It leads to exactand precise conclusions for policy making.The Deductive method was used by earlier economists. It is a simple method, obviates theneed of experimentation and collection of statistical data. But deductive conclusions are basedupon assumptions that may turn out to be untrue or partially true. Hence it is unsuitable forpolicy making as it is dangerous to claim universal validity for economic generalizations.Economics is a Science and an ArtBeing a systematized body of knowledge and establishing the cause and effect relationship ofa phenomenon, Economics is a scientific study. Like other sciences, we in economics deduceconclusions or generalizations after observing or collecting facts and figures. However thelaws of economics are conditional—they assume ‘other things being equal’. Economics cannotpredict with so much certainly and accuracy as physical can. The reason is obvious. The subjectdeals with the behaviour of human beings as such controlled experiment is not possible.However some economists prefer to treat economics as an art. “An art is a system of rules forattainment of a given end”—so remarked J.N.Keynes. It implies that the function of an art is toprovide rules, norms and maxims to solve human problems. An art teaches us to do.The fact is that every science has an art or a practical side and every art has a scientific sidewhich is theoretical. Economics deals with both theoretical aspects as well as practical side ofmany economic problems we face in our daily life. The theoretical side teaches us to know andthe applied side teaches us to do. Thus, Economics is both science as well as an art.Central Problem of all EconomiesProf. Robbins said that human wants are unlimited but the means available to satisfy them arelimited. It is also true in case of any economy, whatever the economy required cannot be satisfiedfully. This is because economic resources or means of production are limited and they can beput to alternative uses. So every economy faces some common problems.

One of them is ‘what to produce?’ In view of limited resources a country cannot produce allgoods. So it has to make a choice between different goods and services. If it gets X it must haveto sacrifice Y. Hence, every economy has to decide what goods and services should be produced.The second issue is ‘how to produce’? As an economy decides to produce certain goods, it facesthe problem to decide how these goods will be produced. The problem arises because ofunavailability of some resources. How to produce also involves the choice of technique ofproduction. A country may produce by labour intensive methods or by capital intensive methodsof production, depending upon its stock or man power.Thirdly, another central problem is ‘for whom to produce? Goods and services are producedfor people specially for those who have the means to pay for them. A country may producemass consumption goods at a large scale or goods for upper classes. All it depends upon thepolicies of the government as well as private producing units.1.2 FEW FUNDAMENTAL CONCEPTSWealthBy wealth we mean the stock of goods under the ownership of a person or a nation.Personal wealthPersonal wealth means the stock of all goods (houses and buildings, furniture, land, money incash, money kept in banks, clothes, company shares, stocks of other commodities, etc.), ownedby a person. Strictly speaking, such things as health, goodwill, etc., can also be considered to beparts of an individual’s wealth. In Economics, however, it is only transferable goods (example., goodswhose ownership can be transferred to another person), which are considered to be componentsof wealth. For instance, a house is a transferable good because it can be sold off or given awayas a gift. Thus, a person’s wealth is defined as the stock of all transferable goods owned by anyperson.National wealthThe national wealth of a country includes the wealth of all the citizens of the country. Incalculating national wealth, however, we must be careful on two-points : (i) There are somegoods whose benefits are enjoyed by the citizens of the country. But no citizen personally ownsthese goods. These are public properties. Natural resources (for instance, mineral resources,

forest resources, etc), roads, bridges, parks, hospitals, public educational institutions and publicsector projects of various types (for instance, public sector industries, public irrigation projects,etc.) are all example of public properties. These are to be included in the nation’s wealth. (ii) Onthe other hand, there are some types of personal wealth which are to be deducted from nationalwealth. For instance, if a citizen of the country holds a Government bond, it is personal wealth.But from the point of view of the Government, it is a liability and, hence, it should not beconsidered as a part of the nation’s wealth.Thus, the national wealth of a country is the sum of all public properties in the country. Thisalso takes into account that part of the total personal wealth in the country which is not aliability for the Government.Wealth and welfareBy welfare of the society, we mean the satisfaction or the well-being enjoyed by society. Socialwelfare depends on the wealth of the nation. Wealth, in general, gives rise to welfare, althoughwealth and welfare are not the same thing.In certain cases, however, wealth and welfare may not go hand in hand. If a nation goes oncreating wealth without paying any consideration to the health and the mental peace of thecitizens of the country, it is doubtful whether social welfare increases. Again, if an wealth ofsociety increases, but the distribution of the wealth among the citizens of the country is veryunequal, this inequality may create social jealousy and tension. In this case too, society’s welfaremay not increase.Economists, however, assume that when wealth increases, welfare increases too. Even if thereis any negative side effect (for instance, social tension due to inequality of wealth distribution),this negative effect is unable to outweigh the positive beneficial effect. The net effect is that,welfare increases. Similarly, when wealth decreases, welfare is assumed to decrease.MoneyAnything which is widely accepted in exchange for goods, or in settling debts, is regarded asmoney. Before the emergence of money, goods were exchanges for goods. This was known asBarter System. In that system goods were used as medium of exchange. For example, one horse

can be exchanged for two cows. Later on, some valuable metals like gold and silver were usedas the medium of exchange. However, the supply of these precious metals could not be increasedwith the expansion of business activities and growing demand for money. Thus, paper noteswere considered to be the medium of exchange.When general acceptability of any medium of exchange is enforced by law, that medium ofexchange in called the legal tender. For example, the rupee notes and coins are legal tenders.However, when some commodity is used as a medium of exchange by custom, it is calledcustomary money. For example, the use of cowrie-shell in ancient India as a medium of exchange.Constituents of money supplyIn any economy, the constituents of money supply are as follows:(a) Rupee notes and coins with the public,(b) Credit cards,(c) Traveller’s cheques, etc.Markets : DefinitionA market in Economics may or may not refer to a particular place where buyers and sellersmeet. Rather, it refers to a system by which the buyers and sellers of a commodity can comeinto touch with each other (directly or indirectly). Thus, when economists talk of the fishmarket, they may mean a place where buyers and sellers of fish meet. But when they talkabout, say, the housing market, they do not mean a place where buyers and sellers of housesmeet. They mean the system of buying and selling houses through contacts between the buyerson the one hand and the sellers on the other. Thus, in Economics, a market for a commodity isa system by which the buyers and the sellers establish contact with each other directly orindirectly with a view to purchasing and selling the commodity.Functions of a marketThe major functions of a market for a commodity are : (1) to determine the price for thecommodity, and (2) to determine the quantity of the commodity that will be bought and sold.Both the price and the quantity are determined by the interactions between the buyers and thesellers of the commodity.The market mechanismWhen economists talk of the market mechanism, they mean the totality of all markets (example., the

markets for all the goods and services in the economy). The market mechanism determines theprices and the quantities bought and sold of all the goods and services.Investment : DefinitionInvestment means an increase in the capital stock. For a country, as a whole, investment is theincrease in the total capital stock of the country. For an individual, investment is the increase inthe capital stock owned by him.Real investment and portfolio investmentEconomists talk of two types of investment : real investment and portfolio investment.(a) Real investment : Real investment means an increase in the real capital stock, example., anaddition to the stock of machines, buildings, materials or other types of capital goods.(b) Portfolio investment : Portfolio investment essentially means the purchase of shares ofcompanies. However, it is only the purchase of new shares issued by accompany thatcan properly be termed as investment (because the company will use the money forexpanding its productive capacity, example., the company’s real capital stock will increase).Purchase of an existing share from another shareholder is not an investment because inthis case the company’s real capital stock does not increase.It is savings that are investedHow is investment financed ? Consider, for instance, a producer who wished to make a realinvestment, example., to increase his capital stock by, say, purchasing a new machine. He would buythe machine by spending his own savings or take a loan or (if the producer has set up a jointstock company) sell shares to the public. In all cases, it is savings which are transformed intoinvestment. If a loan is taken from a bank, the bank would lend the money kept in the bank bythe depositors. This money will be nothing but the savings of the depositors. If shares are soldto the public, the purchasers will use their savings to purchase the shares. Thus, for the countryas a whole, investment comes from savings. It is the country’s savings which are invested (excepting, of course, in such cases where the country receives foreign investment or foreignaid).Gross investment and net investmentIn any economy, the aggregate investment made during any year is called gross investment.

The gross investment includes (a) inventory investment and (b) fixed investment. Investmentin raw materials, semi-finished goods and finished goods is referred to as inventory investment.On the other hand, investment made in fixed assets like machineries, factory sheds etc. is calledfixed investment.It was deduct depreciation cost of capital from the gross investment, we get new investment.So, Net investment = Gross investment – depreciation cost.Production : MeaningBy production, we mean the creation of goods (or performance of services) for the purpose ofselling them in the market. Notice that this definition includes the production of goods as wellas that of services. There was a time when production meant the fabrication of material goodsonly. A tailor’s activity was considered to be production. He produced shirts, pants, etc. Butthe activity of the trader who sold clothes to the purchasers was not considered to come underthe heading of production, because he did not tailor the clothes himself. But this is not theposition taken by economists today. At present, both material goods and services are consideredto come within the orbit of production. Thus, production also means creation of service goodsor utility.Market saleHowever, the definition of production states clearly that production must be for the purpose ofselling the produced goods (or, services) in the market. When a child makes a doll out of clayfor the sheer enjoyment of this activity, it is not called production. But the doll-maker who sellshis dolls in the market is engaged in production.Factors of productionThe goods and services with the help of which the process of production is carried out, arecalled factors of production. Economists talk about four main factors of production : land,labour, capital and entrepreneurship (or organization). They are also called as the inputs ofproduction. On the other hand, the goods produced with the help of these inputs, are called asthe output.Consumption : DefinitionBy consumption, we mean satisfaction of wants. It is because we have wants that we consume

various goods and services. Moreover, it is assumed that, if we have wants, these can be satisfiedonly through the consumption of goods and services. Thus, consumption is defined as thesatisfaction of human wants through the use of goods and services.Other determinants of consumptionThe present income is not the only determinant of consumption. There are other determinants.For instance, consumption is affected by expected future income as well. Most people expecttheir income to fall in their old ages. They, therefore, try to save for the future. For this reason,people display a low average propensity to consume when they are young and a low propensityto save when they are old. Thus, consumption depends not only on present income but also onexpected future income. Again, consumption also depends on wealth. A person may have alow income, but he may be wealthy example., he may have a great amount of accumulated wealth,example., he may have inherited property. In this case, he may have high consumption expenditure.Saving: DefinitionSaving is defined as income minus consumption. Whatever is left in the hands of an individualafter meeting consumption expenditure is the individual’s saving.The sum-total of funds in the hands of an individual obtained by accumulating the saving ofthe past years is called the savings of the individual. Thus, saving is generated out of currentincome of an individual. But savings are created out of past income of an individual.In a modern society, people either keep their savings in banks or other financial institutions orinvest the savings.IncomeThe income of a person means the net inflow of money (or purchasing power) of this personover a certain period. For instance, an industrial worker’s annual income is his salary incomeover the year. A businessman’s annual income is his profit over the year.Wealth and incomeThe difference between wealth and income must be clearly understood. A person (or a nation)consumes a part of the income and saves the rest. These savings are accumulated in the form ofwealth. Wealth is a stock. It is stock of goods owned at a point of time. Income is a flow; it is theinflow of money (or purchasing power) over a period of time.The Concept of Consumer Surplus

The concept was introduced by Prof. Marshall in Economics to show the excess satisfaction orutility that a consumer can enjoy from the purchase of a thing when the price that he actuallypays is less than the price he was willing to pay for it. In other words consumer’s surplus is thedifference between individual demand price and market price. Whenever a man goes to purchasea thing he has in his mind a price that he will pay for the thing. The price that he is willing topay is determined by the marginal utility of the thing to him. Now if market price for theproduct is less than the price the consumer was ready to pay then the consumer gets the thingplus he also enjoys some surplus satisfaction. It is what is called Consumer Surplus. Marshalldefined the concept in this way – “The excess of the price which a consumer would be willingto pay rather then go without the thing over that which he actually does pay, is the measure ofthis surplus satisfaction. It may be called consumer surplus.”The concept is derived from the Law of Diminishing Marginal Utility. As a man successiveunits of a commodity, the Marginal Utility from each unit goes on falling. It means that he iswilling to pay less and less as he gets more and more units of the thing. But all units are availableat the same price in the market. So there arises a difference between Marginal Utility and theprice actually paid.Prof. Hicks has redefined the concept as the money income gained by a man arising from a fallin price of goods he purchases.It is often argued that this concept is a theroretical toy. The surplus satisfaction cannot bemeasured precisely. In case of very essential goods of life, utility is very high but prices paid ofthem are low giving rise to infinite surplus satisfaction. Further it is difficult to measure themarginal utilities of different units of a commodity consumed by person.The Law of Diminishing Marginal UtilityThis Law is a fundamental law of Economics. It relates to a man’s behaviour as a consumer. Itis deduced from actual behaviour of man. The Law states that as a man gets more and moreunits of a commodity, marginal utility from each successive unit will go on falling till it becomeszero or negative. Prof. Marshall stated the Law as follows “The additional benefit which a

person derives from a given increase in stock of a thing diminishes with every increase in thestock that he already has.”The term marginal utility means the additional utility obtained from one particular unit of acommodity. It is expressed in terms of the price that a man is willing to pay for a commodity.As a man gets successive unit of a commodity, marginal utility from each unit goes on falling.The basis of the Law is satiability of a particular want. Although human wants are unlimited innumber yet a particular one can be fulfilled.Fig 1.1 Marginal Utility and Total Utility CurveIn this graph the curve MU is Marginal Utility curve. It has a negative slope denoting the factthat as the quantity of a commodity increases, marginal utility goes on following. At Q it iszero and after it, it becomes negative.The Law is based upon certain assumptions. It is assumed that the different unit consumedshould be identical in all respects. Further it is assumed that consumer’s habit, taste, preferenceremain unchanged. Thirdly, there should be no time gap or interval between the consumptionof one unit and another unit. Lastly, the different units consumed should consist of standardunits which are not too small or large in size.Notion of the Law –The Law of Diminishing utility is not applicable in some cases. The Law may not apply toarticles like gold, money where more quantity may increase the lust for them. Further the Lawdoes not apply to music, hobbies. Thirdly, Marginal utility of a commodity may be affected bythe presence or absence of articles which are substitutes or complements.Demand ForecastingIn modern business, production is carried out in anticipation of future demand. There is thus atime-gap between production and marketing. So production is done on the basis of demandforecasting. The success of a business firm depends to a large extent upon its successfulforecasting.The following methods are commonly used in forecasting demand.(a) Expert opinion method - experts or specialists in the fields are consulted for theiropinion regarding future demand for a particular commodity.(b) Survey of buyers’ intentions – generally a limited number of buyers’ choice andpreference are surveyed and on the basis of that the business man forms an idea

about future demand for the product it is going to produce.(c) Collective opinion method – the firm seeks opinion of retailers and wholesalers intheir respective territories with a view to estimate expected sales.(d) Controlled experiments – the firm takes into account certain factors that effectdemand like price, advertisement, packaging. On the basis of these determinants ofdemand the firm makes an estimate about future demand.(e) Statistical methods – More often firms make statistical calculations about the trendof future demand. Statistical methods comprising trend projection method, leastsquares method progression analysis etc. are used depending upon the availabilityof statistical data.1.3 DEMANDDefinitionIn the ordinary sense Demand means desires. A child may demand a doll. It means that hedesires it. But, in Economics, Demand does not mean mere desire but something more thanthat. Demand in Economics means both the willingness as well as the ability to purchase acommodity by paying a price and also its actual purchase. A man may be willing to get a thingbut he is not able to pay the price. It is not demand in the economic sense. So demand is relatedto price. Generally demand for a commodity depends upon the price of the commodity.particular commodity goes up, its demand falls and vice-versa; but in exceptional cases thetwo variables may move in the same direction.Demand for a commodity mainly depends upon its price but not solely. There are other factorsthat may influence the quantity demanded for a quantity. One such factor is the income of theconsumer. If a man’s income increases, obviously he will be able to demand more of the goodsat a given price. Similarly demand for a commodity depends upon the taste and preference ofthe consumers, the price of substitute goods etc.Law of Demand : The law of demand expresses the functional relationship between the priceof commodity and its quantity demanded. It states that the demand for a commodity tends tovary inversely with its price this implies that the law of demand states- Other things remainingconstant, a fall in price of a commodity will lead to a rise in demand of that commodity and arise in price will lead to fall in demand.ASSUMPTION :1) Income of the people remaining unchanged.

2) Taste, preference and habits of consumers unchanged.3) Prices of related goods example., substitute and complementary goods remainingunchanged4) There is no expectation of future change in price of the commodity.5) The commodity in question is not consumed for its prestige value.Demand schedule : It is a numerical tabulation, showing the quantity that is demanded atselected prices. A demand schedule can be of 2 types; Individual Demand Schedule, MarketDemand Schedule1) Individual Demand Schedule : It shows the quantity of a commodity that one consumer ora particular household will buy at selected prices.Importance of law of Demand1) Basis of the Law of Demand : The law of Demand is the basis of law of demand because theconsumers are prepared to buy a large quantity of a certain commodity only at a lower price.This results from the fact that consumption of additional units of a commodity reduces themarginal utility to him .2) Basis of consumption Expenditure : The law of Demand and the law of equi-marginal utilityboth provide the basis for how the consumer should spend his income on the purchase ofvarious commodity.3) Basis of Progressive Taxation : Progressive Taxation is the system of Taxation under whichthe rate of tax increase with the increase in income. This implies that the burden of tax is moreon the rich than on the poor. The basis of this is the law of Demand. Since it implies that themarginal utility of Money to a rich man is lower than that to a poor man.4) Diamond-water paradox : This means that through water is more useful than diamond. Stillthe price of diamond is more than that of water. The explanation lies in law of diminishingmarginal utility. The price of commodity is determined by its marginal utility. Since the supplyof water is abundant the Mu of water is very low and so its price. On the contrary, supply ofdiamond is limited the Mu of diamond is very high, therefore the price of diamond is very highsuppose a price of the commodity x is Rs. 100 and its demand is 1 unit and how the price isreduced to Rs. 50, the quantity demanded increases to 2 units as the price kept an falling. Thequantity demanded keeps increasing list of such price and quantity demanded of an individual

or household is named as Individual Demand Schedule.2) Market Demand Schedule : When we add the individual demand schedule of varioushousehold, we get the market demand schedule for eg. There are 4 households in the marketand their demand schedule at different prices are given below :Demand Curve : Demand curve is a diagrametic representation of the demand schedule whenwe plot individual demand schedule on a graph, we get individual demand curve and whenwe plot market schedule, we get market curve. Both individual and market demand curvesslope downward from left to right indicating an inverse relationship between price and quantitydemanded of goods.Fig.1.2 : Demand CurveThe demand curve is downward sloping because of the following reasons.1) Some buyer may simply not be able to afford the high price.2) As we consume more units of a product, the utility of that product becomes less and less.This is called the principle of diminishing Marginal Utility.The quantity demanded rises with a fall in price because of the substitution effect. A low priceof x encourages buyer to substitute x for other product.Determinants of demand1) Price of the Commodity : There is an inverse relationship between the price of the commodityand the quantity demanded. It impels that lower the price of commodity, larger is the quantitydemanded and vice-a-versa.2) Income of the consumers : Usually there is a direct relationship between the income of theconsumer and his demand. example. as income rises his demand rises and vice-a-versa. The incomedemand relationship varies with the following 3 types of commodities :a) Normal Goods : In such goods, demand increases with increase in income of theconsumer. For eg. demands for television sets, refrigerators etc.b) Inferior Goods : Inferior Goods are those goods whose demand decrease with anincrease in consumes income. For example. food grains like Malze , etd. If the income risesdemand for such goods to the consumers will fall.c) Necessities : In case of necessities of life like salt, match box, etc. the demand increaseswith an increase in income and thereafter it remains constant irrespective of the level ofincome.3) Consumer’s Taste and Preference : Taste and Preferences which depend on social customs,habit of the people, fashion, etc. largely influence the demand of a commodity.

4) Price of Related Goods : Related Goods can be classified as substitute and complementarygoods.5) Substitute Goods : In case of such goods, if the price of any substitute of commodity rises,then the commodity concern will become relatively cheaper and its demand will rise. Thedemand for the commodity will fall if the price of the substitute falls.6) Complementary Goods : In case of such goods like pen and ink with a fall in the price ofone there will be a rise in demand for another and therefore the price of one commodity anddemand for its complementary are unversely related.7) Consumer’s Expectation : If a consumer expect a rise in the price of a commodity in a nearfuture, they will demand it’s more quantity in anticipation of a further rise in price.8) Size and Composition of Population : Larger the population, larger is likely to be the no.of consumers. Besides the composition of population which refers to the children, adults, males,females, etc. in the population. The type of people inhabiting the country will also influencethe consumer demand.Determinants of Elasticity of demanda) Nature necessity of a commodity : The demand for necessary commmodity like rice, wheat,salt, etc is highly inelastic as their demand does not rise or fall much with a change in price.On the other demand for luxuries changes considerably with a change in price and than demandis relatively elastic.b) Availability of Substitutes : The Demand for commodities having a large no. of closesubstitute is more elastic than the commodities having less or no substitutes. If a commodityhas a large no. of substitutes its elasticity is high because when there is a rise in its prices,consumers easily switch over to other substitutes.c) Variety of uses : The Product which have a variety of uses like steel, rubber etc. have aelastic demands and if it has only limited uses, then it has inelastic demand. For eg. if the unitprice of electricity falls then electricity consumption will increase. More than proportionatelyas it can be put to use like washing, cooking, as the price will go up, people will use etc. it forimportant purposes only.d) Possibility of postponed of consumption : The commodities whose consumption can easily

be postponed has more elastic demand and the commodities whose consumption cannot beeasily postponed has less elastic demand for eg. for expensive jewellery, perfume it is possibleto postpone consumption in case the price is high and so such goods are elastic on the otherhand, the necessities of life cannot be postponed and so they are inelastic in demand.e) Durable commodities : Durable goods like furniture’s, etc, which will last for a longer timehave valuably inelastic demand. This is because in such case, a fall in price will not lead to alarge increase in demand and a rise in price again will not load to a huge fall in demand. But incase of perishable goods, the demand is elastic is nature.Exceptions to the law of demand.1) Conspicuous Goods : These are certain goods which are purchases to project the status andprestige of the consumer. For example. expensive cars, diamond jewellery, etc. such goods will bepurchased at a higher price and less at a lower price.2) Giffen Goods : These are special category of inferior goods whose demand increases evenif with a rise in price. For eg. : - coarse grain, clothes, etc.3) Share’s speculative Market : It is found that people buy shares of those company whoseprice is rising on the anticipation that the price will rise further. On the other hand, 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.4) Bandwagon effect : Here the consumer demand of a commodity is affected by the taste andpreference of the social class to which he belongs to. If playing golf is fashionable amongcorporate executive, then as the price of golf accessories rises. The business man may increasethe demand for such goods to project his position in the society.5) Veblen Effect : Sometimes the consumer judge the quality of a product by its price. Peoplemay have the expression that a higher price means better quality and lower price means poorquality. So the demand goes up with the rise in price for eg. : Branded consumer goods.Causes of downward slope of demand curve :(1) 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. This

means that the consumer will buy move of that commodity when price falls and when lessunits are available, utility will be high and consumer will prefer to pay more for that commodity.This means that the consumer will buy move of that commodity when price falls and when lessunits are available, utility will be high and consumer will prefer to pay none for that commodity.This proves that the demand would be none at lower prices and less at a higher price and so thedemand curve is downward sloping. (2) Income effect : As the price of the commodity falls, the consumer can increase hisconsumption since his real income is increased. Hence 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 fall and will induce them to buy less of that good.(3) Substitution Effect :When the 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 one for the relatively expensiveone on the other hand, with a rise in price the demand fall due to unfavorable substitutioneffect. It is because the commodity has now become relatively expensive which forces theconsumer’s to buy less.4) Goods having no. of uses : Goods which can be put to a number of uses like coal, aluminum,electricity, etc. are eg. of such commodities. When the price of such commodity is higher, it willnot used for a variety of purpose but for use purposes only. On the other hand, when price fallsof the commodity will be used for a variety of purpose leading to a rise in demand. For eg : ifthe price of electricity is high, it will be mainly used for lighting purposes, and when its pricefalls, it will be needed for cooking.5) Change in no. of buyers : Lower the price, will bringing new buyers and raising of pricereduces the buyers. These buyers are known as marginal buyers. Owing to such reason thedemand falls when price rises and so the demand curve is downward sloping.Price Elasticity of DemandIt is defined as the degree of responsiveness of quantity demanded of a commodity due tochange in its price other factor remaining constant. Price elasticity of Demand is usually

measured by the following formula :Price elasticity of demand = % Change in Quantity Demand / (divided by )% Change in PriceIf elasticity of demand greater then 1, we call it relatively elastic demand.If elasticity of demand is equal 1, we call it unitary elastic demand.If elasticity of demand lesser then 1, we call it relatively inelastic demand.If elasticity of demand is equal to 8, we call it perfectly elastic demand.If elasticity of demand is equal to 0, we call it perfectly inelastic demand.Types of Price Elasticitya) Perfectly Elastic Demand : That is (elasticity of demand = ] When the quantity demanded of a commoditychanges infinitely due to a slight or no decrease in price, such goods are said to have perfectlyelastic demand.A perfectly Elastic Demand Curve is a straight line parallel to X –axis.b) Relatively Elastic Demand : In such type of goods the percentage change in quantitydemanded of a commodity is more than proportionate to the percentage change in price, eg.luxury like car.In the diagram we see that change in qty. demanded qq1 is more than proportionate to thechange in price P, P1.(c) Unit Elastic Demand (ed = 1)Here the rate of change in demand is exactly equal to the rate of change in price.Therefore the products or service with unit elasticity are neither elastic nor inelasticA Unit elastic Demand curve is a rectangular - hyperbola as soon above(d) Relatively Inelastic Demand (ed < 1)In this type of goods and services the proportionate change in quantity demand is less than thechange in price. These are mostly essential goods of daily use like rice wheat etc.In the diagram change in qty qq1 is less than proportionate to the change in price PP1.(e) Perfectly Inelastic Demand : These are certain goods like salt, match box etc. whose demandneither increase nor decrease with a change in price.Fig.1.7A perfectly inelastic Demand curve is a vertical straight line parallel to Y –axis which showsthat whatever may be the change in price the demand will remain constant at OQ.Importance of Price Elasticity of Demand(1) Business Decisions : The concept of price elasticity of demand helps the firm to decidedwhether or not to increase the price of their product. Only if the product is inelastic in nature,then raising of price will be beneficial. On other hand, if the product is elastic in nature, then arise in price might lead to considerable fall in demand. Therefore the price of differentcommodities are determined on the basis of relative elasticity.

(2) Importance to monopolist : A monopolist often practices price discrimination. Pricediscrimination is a process in which a single seller sells the same commodity in two differentmarkets at 2 different prices at the same time. The knowledge of price elasticity of the productto the monopolist is limp because he would charge higher price from those consumers whohave inelastic demand and lower price from those consumers who have elastic demand.(3) Determination of Factor Price : The concept of elasticity of demand also helps in determiningthe price of various factors of production. Factor having inelastic demand gets higher pricefactors having elastic demand gets lower price.(4) Guidance for International Trade : If demand for exports of a country is inelastic, thatcountry will enjoy a favorable terms of trade while if the exports are more elastic then inputs,then the country will lose in the terms of trade.5) Importance to the Govt : Elasticity of demand is useful in formulation Govt. Policy particularlytaxation policy and the policy of subsides if the Govt. wants to impose excise duty, or sales tax,the Govt. should have an idea about the elasticity of the product. If the product is elastic innature, then the burden of the tax is shifted to the consumer and the demand might fallremarkably: on the other hand, if the demand is inelastic in nature, then any extra burden ofindirect tax will not affect the demand to that extent.Income and Cross Elasticity(a) Income Elasticity : It expresses the responsiverses of consumer demand of any commoditydue to a change in the income of the consumer. It is also defined as a percentage change inquantity demand due to percentage change in money income of the consumers.The income elasticity of demand is positive for all normal goods because the consumer demandfor a good changes in the same direction as change in his income. In case of inferior goods, theincome elasticity is negative example. as the income rises the demand for inferior goods will fall. Thedifferent types of the income elasticity are shown in the following diagram.In case of substitute goods, the cross elasticity of demand is positive example. if the price of onechanges the demand for the other changes in the same direction. For eg. if the price of tea reses,the demand for coffee will also rise, since coffee has now become relatively cheaper.

The cross elasticity of demand is negative in case of complementary goods.Movement and Shift of Demand(a) Movement of Demand curve or Extension and Constriction of Demand or change in qty.demanded.In the qty. demanded of a commodity increases or decreases due to a fall or rise in the price ofa commodity alone, ceteris Paribus. It is called movement along the demand curve which occursonly due to change in price of that commodity, ceterius Paribus, Extension of Demand ormovement along the demand curve to the right.When the qty. demanded rises due to fall in price of that commodity, and other parametersremaining constant it is called extension of demand which is shown in the following diagram. (b) Change in Demand or shift of demand or Increase and Decrease in demand : When the qty.dd of a commodity rises or falls due to change in factors like income of the consumer, price ofrelated goods, etc. and keeping the price of the commodity to be constant, it is called shift inDemand.(i) Increase in Demand or Shift of Demand Curve towards the Right : When the qty. dd. of acommodity rises due to change in factors like income of the consumable etc. price of thecommodity remaining unchanged it is called increase in demand. (ii) Decrease in Demand or shift of Demand Curve towards the left : When the demand for acommodity falls due to other factors, the price remaining constant, it is termed as decrease indemand or shift of demand curve towards the left.

1.4 SUPPLYDefinition of Supply : Supply is defined as a qty of a commodity offered by the produces to besupplied at a particular price and at a certain time.Individual Supply and Market SupplyIndividual supply refers to the quantity of a commodity which a firm is willing to produce andoffer for sale. On the other hand, the qty. which all produces are willing to produce and sell isknown as market supply.An individual supply schedule shows the different qualities of a commodity that a producer ofa firm would offer for sale at different prices.A market supply schedule shows the various quantities of a commodity that all the firms arewilling to supply at each market price during a specified time period.

Factor Determining supply :(1) Price of the commodity: when the price of a commodity in the market and when itsprice rises, seller increases the price. The cost of production remaining constant thehigher will be the profit margin. This will encourage the producers to supply moreat higher prices. The reverse will happen when the price fall. (2) Goals of the firm : Firms may try to work on various goals for eg. Profitmaximization, sales maximization, employment maximization. If the objective is tomaximize profit, then higher the profit from the sale of a commodity, the higherwill be the qty. 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.(3) Input Prices : The supply of a commodity influence by the raw materials,labour and other inputs. If the price of such inputs rise leading to a lower profitmargin. This will ultimately lead to a lower supply. On the other hand, if there is afalls in inputs increases. So in this situation the firm will be ready to supply morethan before at a given price level.(4) State of Technology : If improve and advanced technology is used for the productionof a commodity, it reduces its cost of production and increases the supply. On theother hand, the supply of those goods will be less whose production depend onunfair and old technology.(5) Government policies : The Govt. policy with reference to production of surveycommodities imposition of taxes such as excise duty, sales tax, etc. subsidy policyon influence the supply of a commodity for eg. when the Govt. imposes an exciseduty on Goods, the cost rises and therefore decreases the supply. A subsidy on theother hand increases the supply.(6) Expectation about future prices : If the produces expect an increase in the price of acommodity, then they will supply less at the present price and hard the stock inorder to sell it at a higher price in the near future. This will be opposite in case theyanti capacity fall in future price (eg. fruit seller)(7) Prices of the other commodities : Usually an increase in the prices of 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 commodities falls as the price of other goods rises. For eg. Suppose aformer produces wheat and pubes in his firm. If the price of pubes increases hegrows less wheat. Hence the supply of wheat decrease.(8) No of firms in the market : Since the market supply is the sum of the suppliersmade by individual firms, hence the supply various with changes in the no. of firmin the market the supply. An decreases in the no. of firm reduces the supply.(9) Natural factor : In case of natural disorders flood, drought, etc. the supply of acommodity specially agricultural products is adversely affected.

Exceptions to the Law of Supply

(1) Agricultural Goods : In case of such goods the supply cannot be adjusted to marketconditions. The production of agriculture goods is largely dependent on naturalphenomenon and therefore its supply depends upon natural factors like rainfall,etc. Moreover the supply of such goods is mostly seasonal and therefore it cannotbe increased with a rise in price.(2) Rare Objects : These are certain commodities like rare coins, classical paintings oldmanuscripts, etc. whose supply cannot be increased or decreased with the changein price. Therefore, such goods are said to have inelastic supply and the supplycurve is a vertical straight line parallel to Y – axis.3) Labour Market : In the labour market, the behavior of the supply of labour goesagainst the law of supply.In case of such labourers, if the wages rise the workers will work for less hour, so as to enjoymore leisure. This is explain with the following diagram.In the diagram we measure labour supply along the x-axis and wages along the y – axis. Whenwages was OW the labour supply was OL. Now, when the wages rise to OW1, the laboursupply instead of rising falls to OL1. As a result, the supply curve S moves to the left instead ofrising any further. Hence the labour market remains an exception to the law of supply.Elasticity of SupplyElasticity of supply is defined as the degree of responsiveness of qty. supplied of a commoditydue to change in its price. Elasticity of supply is expressed as := % changes in qty. supplied / dived by % changes in priceDeterminants of Elasticity of Supply(1) Nature of the commodity : The supply of durable goods can be increased or decreasedeffectively in response to change in price and hence durable goods are relativelyelastic.On the other hand the perishable goods cannot be stored and thus supply cannotbe altered significantly in response to change in their price. Hence the price ofthe perishable goods are relatively less elastic.(2) Time Factor : A price change may have a small response on the qty supplied becauseoutput may change by small quantity in the short period since the productioncapacity may have been limited. Therefore, in the short run supply tends to berelatively inelastic.On the other hand in the long run production capacity may be increased or supplymay also be raised therefore in the long run supply is elastic.(3) Availability of facility for expanding output : If producers have sufficientproduction facilities such as availability of power, raw materials, etc. They wouldbe able to increase their supply in response to rise in price.On the other hand if there is a shortage of such facilities then expansion ofsupply will not be possible due to rise in price.

(4) Change in cost of production : Elasticity of supply depends upon the change incost. If an increase of output by a firm in an industry causes only a slight increase inthe cost then supply will remain fairly elastic.On the other hand if an increase in output bring about a large increase in cost due torise in price of inputs etc, then supply will be relatively inelastic.5) Nature of inputs : Elasticity of supply depend upon the nature of inputs for theproduction of a commodity. If the production requires inputs that are easily available,then its supply will be relatively elastic.On the other hand, if it uses specialized inputs then its supply will be relativelyinelastic.6) Risk Taking : If entrepreneurs are willing to take risk, then supply will be moreelastic and if they are reluctant to take risk than supply would be inelastic.Movment and Shift of Supply CurveThe qty. supplied of a commodity may change broadly due to two reasons :When the qty supplied changes due to change in the price of that commodity it iscalled change in quantity supplied or movement along the supply curve or extensionand contraction of supply.On the other hand when the supply changes due to change in other factors, price of thecommodity remaining unchanged, such a change in supply curve, increase and decrease ofsupply or change in supply.(a) Movement along the supply curve or extension or contraction of supply or change inquantity supplied.(i) Extension of Supply : When the quantity supplied of a commodity rises with arise in price of that commodity other determinants of supply remaining unchanged.It is known as extension of supply or movement along the same supply curve towardsthe right.It iscalled extension of supply.(ii) Contraction of supply : When the quantity supply of a commodity falls with afall in its price, peribus, it is known as contraction of supply.

In here, the qty. supplied as fallen from q1 to q due to a fall in price of the commodityfrom P1 toP. This is shown by a movement along the supply curve S from pt. a to pt.b (towards the left).(b) Shift of Supply Curve or Increase & Decrease of supply curve or change insupply(i) Increase in Supply : When the qty supplied increase due to other determinants ofsupply price remaining constant it is called increase in supplyIn the diagram we see that qty supplied has increased from q to q 1, the price ofthe commodity remaining constant at OP. This is shown by the shift of the original

supply curve S to the right to from a new supply curve S1.(iii) Decrease in Supply : When qty supplied of the commodity decrease due tochange in factors determining supply but for price. It is termed as decrease insupply or shift of supply curve towards the left.1.5 EQUILIBRIUMThe price at which the qty. demanded of a commodity equals the quantity supply is known asequilibrium price.Change in Equilibrium Price due to shift in demand, the supply remaining constant.In crease in Demand rises the price and decrease in demand lowers the price of a commodity,if supply remains unchanged.Change in equilibrium price due to shift in supply where the demand remains constant.(i) Increase in supply lower the price and Decrease in supply raises the supply if demandremains constant.

Change in equilibrium priced due to shift in both demand and supply.Situation 1 : If demand and supply change by equal proportion, equilibrium price will remainunchanged.1.6 THEORY OF PRODUCTIONProduction-FunctionThe technical law, relating inputs to outputs, has been given the name of productionfunction,in economics. According to Prof. Lipsey, “This (Production-function) is atechnological relation showing for a given state of technological knowledge how much canbe produced with given amount of input”.In simple words, production – function expresses the relationship between the physical inputsand physical output of a firm for a given state of technology.Thus, the production-function is a purely technical relation that connects factor-inputs andoutputs.Types of Production-FunctionBefore analyzing the types of production-function it will be useful to understand themeaning of following important terms :A. Fixed Factors and Variable FactorsFactors of production are broadly classified into two categories example. fixed and variablefactors:(1) Fixed Factors — The factor inputs which cannot be varied in the short-period,as and when required are called fixed factors.Examples of Fixed Factors are : Plant, machinery, heavy equipments, factory building,land etc.(2) Variable Factors - The factor inputs which can easily be varied, in theshort-period as and when required, are called variable factors.

Examples of variable factors are : labour, raw material, power, fuel etc.The distinction between fixed factors and variable factors appears only in the short-period. Inthe long-run, all the factors of production become variable factors.B. Short period and Long periodThe time-period during which a firm in order to make changes in its production can changeonly in its variable factors but not in its fixed factors, is termed as short-period. In the shortperiod,a firm cannot change its scale of plant.The time period in which a firm can change all the factors of production and its scale of plant,is termed as long-period.In economics, we study two types of production-functions. In other words, there are twokinds of input-output relations in production-functions. These are:(a) Short-run Production-functions or the Law of Variable Proportions - Inthe short period, some factors are fixed and some of them are variable. Whathappens when additional units of one variable factor of production arecombined with a fixed stock of some factors of production, is discussed undershort-run production-functions. The law which tells about this relation is calledthe law of variable proportions or returns to a factor. Since it is related to ashort-period, it is called short-run production-function.(b) Long-run Production-function or Returns to Scale – In the long run, all factorinputscan be varied. It means, that in the long-run, we can expand or reducethe scale of production as well. The way in which the output varies with thechanges in the scale of production is discussed in the long-run productionfunctions.The law which states this relationship is also called returns to scale.Since it is related to the long-period, it is called long-run production-function.In this context we have to define three key terms :-(1) Total Product - It refers to the total output of the firm per period of time(2) Avrage Product - Average Product is total output per unit of the variableinput. Thus Average Product is total product divided by the number ofunits of the variable factor.AP =Q/ divided by L where Q is Total Product, L is the quantity of labour.(3) Marginal Product - Marginal Product is the change in total productresulting from using an additional unit of the variable factor.MP = dQ/ divided by dL, where d is the rate of changeNow we shall study the laws of production relating to both types of production-functions.1. The Law of Variable Proportions or Returns to a FactorMeaning and DefinitionThe law of variable proportions has an important place in economic theory. This law exhibitsthe short-run production-functions in which one factor is variable and others are fixed. Theextra output obtained by applying extra unit of a variable factor can be greater than, equal to or

less than the output obtained by its previous unit. It is this phenomenon which is expressed inthe form of law of variable proportions.If the number of units of a variable factor is increased, the way wherein the output changes isthe concern of this law. Thus the law of variable proportions refers to the effect of changingfactor-ratio on the output. In short, the law which exhibits the relationship between the units ofa variable factor (keeping all other factors as constant) and the amount of output in the shortrunis known as returns to a variable factor.Thus the law of variable proportions is also named as (or returns to a factor) returns to a variablefactor.The law of variable proportions (or returns to a variable factor) states that with the increase ina variable factor, keeping other factors constant, total product increases at an increasing rate,then increases at diminishing rate and finally starts declining.Why is it called the Law of Variable Proportions?The factor- proportion (or factor-ratio) varies as one input varies and all others are constant.This can be understood with the help of an example. Suppose in the beginning 10 acres of landand 1 unit of labour are taken for production, hence land-labour are taken for production,hence land-labour ratio was 10 : 1. Now if the land remains the same but the units of labourincreases to 2, now the land-labour ratio would become 5: 1. Thus, this law analyses the effectsof change in factor-proportions on the amount of output and is, therefore, called the law ofvariable proportions.In this example, we assume that land is the fixed factor and labour is a variable factor.The table shows the different amounts of output obtained by applying different units oflabour to one acre of land which continues to be fixed.Three Stages of the LawThe relation between variable factor and physical output has three stages which are shown inthe example and the diagram. We take a very simple explanation of these three stages in termsof TPP and MPP only. These three stages of the law are as under :State 1 – In this stage total physical product (TPP) increases at an increasing rate and marginalphysical product (MPP) also increases. Since in this stage MPP increases with the increase in

the units of a variable factor, it is called the stage of increasing returns. In the example, thestage I of the law runs upto 3 units of labour and in the diagram it is between 0 to L.Stage 2– In this stage total physical product (TPP) continues to increase but at a diminishingrate and marginal physical product (MPP) diminishes but remains positive. In this stage MPPdecreases with the increase in the units of a variable factor, it is termed as the stage of diminishingreturns. In the example, stage II runs between 4 to 6 units of labour and in the diagram it isbetween L to M. This stage goes to the point when TPP reaches the maximum (18 in the exampleand point R in the diagram) and MPP becomes zero.State 3 – In this stage total physical product (TPP) starts declining and marginal physicalproduct (MPP) decreases and becomes negative. Since in this stage MPP becomes negative, it iscalled the stage of negative returns. In the example, stage III runs between 7 to 8 units of labourand in the diagram it starts from the point ‘M’ onwards.Two ways to explain the Law of Variable ProportionsThe law of variable proportions can be explained in two separate ways :(1) in terms of total physical product and (ii) in terms of marginal physical product. It isexplained as under:(1) Law of Variable Proportions in terms in TPPThe law of variable proportions shows the relationship between units of a variable factor andtotal physical product. According to this law, keeping other factors constant, when we increasethe units of a variable factor, the TPP first increases at an increasing rate, then at a diminishingrate, and in the last, it declines. Thus the law has following three stages :Stage I : TPP increases at an increasing rateStage II : TPP increases at a diminishing rateStage III : TPP declines.(2) Law of Variable Proportions in terms of MPPThe law of variable proportions states that with the increase in the units of a variable factor,keeping all other factors constant, the marginal physical product increases, then decreases andfinally becomes negative. Thus this law has three following stages :Stage I : MPP increasesStage II : MPP decreases but remains positiveStage III : MPP continues to decrease and becomes negative.The law is shown with the help of following example and diagram below :Significance of the Three Stages of the LawWhat should be the stage of operation for a rational producer? With the knowledge of the three

stages of the law, a producer can choose the appropriate stage of its operation. A rationalproducer would not like to operate in Stage III. It is because in this stage total product declinesand marginal product becomes negative. Hence a producer can always increase his output byreducing the amount of variable factor. If he operates in stage III, he incurs higher costs on theone hand, and gets less revenues on the other. Thus, it reduces his profits.Similarly a producer does not operate in stage I. In this stage marginal product increase withthe increase in a variable factor. It indicates that there is a scope for more efficient utilization offixed factors by employing more units of a variable factor. A rational producer would nottherefore, like to stop in stage I but will expand further.It is by now very clear that a rational producer never chooses first and third stages for production.He, therefore, likes to operate in the stage II, example, the stage of operate in the stage II, example. the stageof diminishing returns. In this way stage II of the law of variable proportions is the most relevantstage of operation for a producer.Reason for operation of the LawWhy does the law of variable proportions (or the law of diminishing marginal returns) operate?We know that in the short-period all factors of production cannot be varied. Here one is variablefactor and others are fixed factors. By now it is clear that there is an optimum combination ofdifferent factors that gives the maximum output. When there is increase in the units of a variablefactor before the point of optimum combination, the factor proportion becomes more suitableand fixed factors are more efficiently utilized, hence it increases the marginal physical product.Thus, in the initial stages the total product may rise at an increasing rate when we employmore units of a variable factor to the fixed factors. But later, when we employ more units of avariable factor beyond this optimum combination, the factor proportion becomes unsuitableand inefficient, hence the marginal product of that variable factor declines.The quantity of the fixed factor-input per unit of the variable input falls as more and more ofthe latter is put to use. Successive units of the variable input, therefore, must add decreasingamounts to the total output as they have less of the fixed input to work with. Thus, eventually

the law of diminishing marginal returns (or the stage of diminishing returns of the law ofvariable proportions) operates.Return to ScaleMeaningIn the long run, all factors are variable, hence the expansion of output may be achieved byvarying all factor-inputs. When there are changes in all factor-inputs in the same proportion,the scale of production (or the scale of operation) also get changed. Thus, the change in scalemeans that all factor inputs are changed in the same proportion.Thus, the term returns to scale refers to the changes in output as all factor-inputs change in thesame proportion in the long run. Or, in other words, the law expressing the relationship betweenvarying scales of production (example. change of all factor-inputs in the same proportion) andquantities of output is called returns to scale refer to the effects of scale relationships.Now, the question is at what rate the output increases when all factor-inputs are varied in thesame proportion. There can be three possibilities in this regard. The increase in output may bemore than, equal to, or less than proportional to the increase in factor-inputs. Accordingly,returns to scale are also of three types – increasing returns to scale, constant returns to scale anddiminishing returns to scale.Cause for the operation of returns to scaleReturns to scale occur mainly because of two reasons :(1) Division of Labour – When tasks are allocated according to the specialization ofworkers, it is termed division of labour. Thus division of labour and specializationis one and the same thing. Division of labour and specialization are possible morein large-scale operations. Different types of workers can specialize and do the jobfor which they are more suited. This results in a sharp increase in output per manwith the increase in scale in the initial stages. This brings increasing returns toscale. But after a certain level of output, top management becomes eventuallyoverburdened and, hence, less efficient. It brings diminishing returns to scale. Inshort, with the increase in scale economies of specialization and division of labourbrings increasing returns to scale and diseconomies of specialization bring ultimatelydiminishing returns to scale.(2) Volume Discounts – With the increase in the scale of operation certain advantagesor economies of large volume or large size may occur. This results in increasingreturns to scale. For instance when the scale of operation is increased a firm has toprocure raw materials in a larger quantity. In this situation the firm may bargainfor more discount on purchase of the large volume of raw materials. Similarly the

per unit selling cost may also fall with the increase in output. In short, in the initialstages a firm may receive technical economies, marketing economies and economiesrelated to transport and storage costs etc. All these result into increasing returns toscale. But after a certain limit, diseconomies of volume crop up with the increase inoutput. This brings diminishing returns to scale.Thus, the main reason for the operation of the different forms of returns to scale isfound in economies and diseconomies. When economies exceed the diseconomies,the stage of increasing returns operates; when economies and diseconomies equaleach other, it becomes the stage of constant returns to scale; and when diseconomiesexceed the economies, then comes the stage of diminishing returns to scale.Distinction between Return to a Variable Factor ( or Law of Variable Proportions ) andReturn to ScaleThe main differences between returns to a variable factor and returns to scale are as indicatedbelow:Returns to a Variable Factor Returns to Scale1. Operates in the short run or it is 1.Operated in the long-run or it is relatedrelated to short-run production-function. to long-run production-function.2.Only the quantities of a variable 2. All factor-inputs are varied in the samefactor are varied. proportion.3.There is change in the factor-proportion. 3. There is no change in factor-ratio. ForSuppose on 1 acre land 1 labour is instance, if a firm is employing 1 unit oflabouremployed, then the land labour ratio is 1 : 1. and 2 units of capital, then the labour-capitalNow if we add one more unit of labour on ratio is 1 : 2. Now if the firm increases its scalethe 1 acre land, then land-labour ratio would of operation and employed 2 units of labourbecome 1 : 2. and 4 units of capital, the labour-capital ratiostill remains the same as 1 : 2.4.No change in the scale of production. 4.There is change in the scale of productionBecause here all the factor-inputs are not because here all the factor-inputs are varied inchanged. the same proportion.Various Concepts of CostThe term “Cost” is used in many a sense and hence has many concepts. All these need to beproperly and clearly understood.1. Real CostsThe term real cost of production was defined by Prof. Marshall and other neo-classicaleconomists. In the words of Prof. Marshall, “The exertion of all the different kinds of labourthat are directly or indirectly involved in making it together with the abstinences or rather thewaitings required for saving the capital is used in making it; All these efforts and sacrifices

together will be called the real cost of production of the commodity”. Thus, real cost includedthe following two basic elements:(a) exertions of all kinds of labour;(b) waitings and sacrifices required for saving the capital.It is more a psychological concept and cannot be measured. Therefore, it is notapplied in actual practice.2. Economic CostsThe total expenses incurred by affirm in producing a commodity are generally termed as itseconomic costs. Economic costs are generally referred to as production costs as well.The total economic costs include:(1) Explicit Costs —Actual payments made by a firm for purchasing or hiring resources (or factorservices)from the factor-owners or other firms are called explicit costs. In otherwords, explicit costs are actual money expenses directly incurred for purchasingthe resources. These are the costs which a cost accountant includes under the headexpenses of the firm. Hence explicit costs also. Accounting costs include all costsincurred by the firm in acquiring various inputs from outside suppliers. Thus theexamples of explicit costs are: payments for raw materials and power; wages to thehired workers; rent for the factory-building; interest on borrowed money; expenseson transport and publicity, etc.(2) Implicit Costs — Implicit costs refer to the imputed costs of the factors ofproduction owned by the producer himself which are generally left out in thecalculation of the expenses of the firm. Besides purchasing resources from otherfirms, a producer uses his own factor-services also in the process of production. Hegenerally does not take into account the costs of his own factors while calculatingthe expenses of the firm. But these costs should also be taken into account. The costof using such factors is called implicit costs or imputed costs. They are called implicitcosts because producers do not make payment to others for them. For instance,rent of his own land, interest on his own capital, and salary for his own services asmanager, etc. are implicit costs.(3) Normal Profit — Economists consider an entrepreneur as a separate andindependent factor of production. An entrepreneur factor of production. Anentrepreneur can engage himself in the work of production of a commodity onlywhen he hopes to get a minimum amount of remuneration as profit. Hence, theminimum amount which is required to keep an entrepreneur in the production isknown as normal profit. This normal profit is in a way reward or remuneration foran entrepreneur and, therefore, should be treated as costs.Thus,Total economic costs = Explicit costs + Implicit costs + Normal profit.Generally economic costs include the following :(a) Cost of the raw materials,(b) wages,(c) interest,(d) rent,

(e) management costs,(f) depreciation of capital equipment,(g) expenditure on publicity and advertisements,(h) transport costs,(i) costs of the producer’s own resources,(j) normal profit,(k) other expenses.3. The Concept of Opportunity CostThe concept of opportunity cost occupies a very important place in modern economic analysis.It is a well known fact that factors of production are scarce in relation to wants. Hence, when afactor is used in the production of a particular commodity, the society has to forego othergoods which this factor could have produced. This gave birth to the notion of opportunity costin economics. Suppose a particular kind of steel in manufacturing war-goods, it clearly impliesthat the society has to give up the amount of utensils that could have been produced with thehelp of this settle. Hence we can say that the opportunity cost of producing war-goods is theamount of utensils forgone.In short, opportunity cost is the cost of the next-best alternative that has been forgone.Form the meaning of opportunity cost two important points emerge:(1) The opportunity cost of anything is only the next-best alternative foregone and notany other alternative.(2) The opportunity cost of a good should be viewed as the next-best alternative goodthat could be produced with the same value of the factors which are more or lessthe same.The concept of opportunity cost can better be explained with the help of an illustration. Supposea price of land can be used for growing wheat or rice. If the land is used for growing rice, it isnot available for growing wheat. Therefore the opportunity cost for rice is the wheat cropforegone. This is illustrated with the help of the following diagram.Fig.1.33Suppose the farmer, using a piece of land can produce either 50 quintals (ON) of rice or 40quintals (OM) of wheat. If the farmer produces 50 quintals of rice (= ON), he cannot producewheat. Therefore the opportunity cost of 50 quintals (ON) of rice is 40 quintals (OM) of wheat.The farmer can also produce any combination of the two crops on the production possibility

curve MN. Let us assume that the farmer is operating at point A on the production possibilitywhere he produces OD amount of rice and OC amount of wheat. Now he decides to operate atpoint B on the production possibility curve. In this situation he has to reduce the production ofwheat from OC to OE in order to increase the production of rice from OD to OF. It means theopportunity cost of DF amount of rice is the CE amount of wheat.Thus, opportunity cost for a commodity is the amount of other next-best goods which have tobe given up in order to produce additional amount of that commodity.Applications of the Concept of Opportunity CostThe concept of opportunity cost has been widely used by modern economists in various fields.The main applications of the concept of opportunity cost are as follows –(1) Determination of factor prices - The factors of production need to be paid a pricethat is at least equal to what they command for alternative uses. If the factor price isless than factor’s opportunity cost, the factor will quit and get employed in thebetter-paying alternative.(2) Determination of economic rent – The concept of opportunity is widely used bymodern economists in the determination of economic rent. According to themeconomic rent is equal to the factor’s actual earning minus its opportunity cost (ortransfer earnings).(3) Decisions regarding consumption pattern – The concept of opportunity costsuggests that with given money income, if a consumer chooses to have more of onething, he has to have more of one thing, he has to have less of the other. He cannotincrease the consumption of all the goods simultaneously. Hence with the help ofopportunity cost he decides the consumption pattern, that is, which goods shouldbe consumed and in what quantities.(4) Decisions regarding production plan – With given resources and given technologyif a producer decides to produce greater amount of one commodity, he has tosacrifice some amount of another commodity. Thus on the basis of opportunitycosts a firm makes decisions regarding its production plan.(5) Decisions regarding national priorities – With given resources at its command acountry has to plan the production of various commodities. The decision will dependon national priorities based on opportunity costs. If a country decides that moreresources must be devoted to arms production then less will be available to producecivilian goods. In this situation a choice will have to be made between armsproduction and civilian goods. The concept of opportunity cost helps in makingsuch choices.Cost-FunctionThe functional relationship between cost and quantity produced is termed as cost function.

C = f(Qx)Here, C = Production-costQx = Quantity produced of x goodsCost-function of a firm depends on two things: (i) production-function, and (ii) the prices ofthe factors of production. Higher the output of a firm, higher would be the production-cost.That is why it is said that the cost of production depends on the quantum of output.Time Element and Cost - Time element has an important place in the analysis of cost ofproduction. In the theory of supply we usually take three kinds of time-period. They are:(1) Very Short-period - Very short-period is defined as the period of time which is soshort that the output cannot be adjusted with the change in demand. In this period,the supply of a commodity is limited to its stock, hence during this period supplyremains fixed. That is why during very short period output of the commodity doesnto respond to the changes in its price.(2) Short Period – Short period is defined as the period of time during which productioncan be varied only by changing the quantities of variable factors and not of fixedfactors; in other words, the scale of plant is given and constant. Land, factorybuilding, heavy capital equipment, services of management of high category aresome of the factors that cannot be varied in a short period. That is why they arecalled fixed factors.On the other hand, there are some factor-inputs that can be varied as and whenrequired. They are called variable factors. For instance, power, fuel, labour, rawmaterials, etc. are the examples of variable factor-inputs.(3) Long Period - Long period is defined as the period which is long enough for theinputs of all factors of production to be varied. In this period not factor is fixed, allare variable factors. Firm has enough time to change its scale of production. It canpurchase and install new machinery or it can sell the old one; it can vary the size offactory; it can increase or decrease the number of permanent employees of the firm.Thus in long period, all sorts of changes in the factors of production are possible.SHORT-RUN COSTSIn the short-run, a firm employs two types of factors : fixed factors and variable factors. Costsare also of two types : fixed costs and variable costs.(1) Fixed Costs – Fixed costs (also known as supplementary costs or overhead costs)are the costs that do not vary with the output. These are the expenses incurred onthe fixed factors of production.Examples — Rent; interest; insurance premium; salaries of permanent employees,etc.(2) Variable Costs- Variable costs (or prime costs) are the costs that vary directlywith the output. These are the expenses incurred on the variable factors ofproduction.

Examples- Expenses on raw materials, power and fuel; wages of daily labourers,etc.Distinctions between Fixed Costs and Variable CostsFixed Costs Variable Costs1. Fixed costs do not vary with 1. Variable costs vary with the quantity of output.quantity of output.2. They are related with the fixed factors. 2. Variable costs They are related with the variable factors.3. They do not become zero. 3. Variable costs They can become zero when production isremain same even when production is stopped.stopped.4. A firm can continue production 4. Variable costs Production is carried on when the variablecosts are even at the loss of fixed costs. met.Total Cost Curves in the Short RunThere are three concepts concerning total cost in the short period : Total fixed cost; total variablecost and total cost.(1) Total fixed Cost (TFC) – Total fixed Costs are those costs that do not vary with the output.They continue to be the same even if output is zero or 1 unit or 1 million units. Thus, they aretotally unaffected by the changes in the rate of outputs. These costs are also often referred to assupplementary costs or overhead costs or unavoidable costs. Examples of fixed costs are : (1)Initial establishment expenses, (2) Rent of the factory, (3) Expenses on maintenance ofMachinery; (4) Wages and salaries of the permanent staff, (5) Interests on bonds, (6) Insurancepremium.Total fixed Cost TFC = quantities of the fixed productive service x factor price. (2) Total Variable Cost (TVC) – The costs that vary directly with the output, rising as more isproduced and falling as less is produced, are called total variable costs. They are also referredto as prime costs or special costs or direct costs or avoidable costs. Examples of variable costsare : (1) wages of temporary labourers; (2) raw materials; (3) fuel; (4) electric power, etc.Total Variable Cost TVC = quantities of the variable factor service x factor price.Our above table and diagram indicate that total variable cost varies directly with the volume ofoutput. TVC curve starts from the origin, up to a certain range remains concave from belowand then becomes convex. It shows that in the beginning, total variable cost rises at a diminishingrate and thereafter, it rises at increasing rates.

(iii) Total Cost – Total Cost means the total cost of producing any given amount of output.When we add total fixed and total variable costs at different levels of output, we get thecorresponding total costs.Thus, TC = Total fixed cost tFC + Total Variable Cost TVCSince, fixed costs are constant and variable costs necessarily rise as output rises, total costs alsorise with the output or, to put the point more technically, TC is a function of total product andvaries directly with it : TC = f(q).TC (Total Cost) curve can be obtained by adding TFC and TVC curves vertically at eachpoint.Again, since the total fixed cost, by definition remains constant, the changes the total costs areentirely due to the changes in total variable costs. In other words, the rate of increase of totalcost is the same as of total variable cost, as one of the two components of total cost is the sameas of total variable cost, as one of the two components of total cost remains constant. TC andTVC curves, therefore, have the similar shapes, the only difference is that TVC curve startsfrom origin (O) while TC curve starts above the origin.Unit Cost Curves in Short - RunThe main short-run unit cost curves are : 1) Average Fixed Cost (AFC) – Average fixed cost can be obtained by dividingtotal fixed cost (TFC) by the quantity of output (Q),Average Fixed Cost AFC = total fixed cost divided by / the quantity of output QSince total fixed costs remain the same, as output rises, average fixed cost diminishes butnever becomes zero.Features of Average Fixed Cost – (a) As output rises, the average fixed cost (AFC) goes on declining. The Average Fixed Costcurve is, therefore, a downward sloping curve, (b) As output approaches zero, average fixedcost approaches infinity, but AFC curve never touches the y-axis. On the other hand, as outputreaches very high levels, average fixed cost approaches zero, but it never becomes zero, italways remains positive. Hence the Average Fixed Cost curve never touches the x-axis. Thus it follows thatAverage Fixed Cost curve never touches either of the axis. Actually Average Fixed Cost curve takes the shape of rectangular hyperbola which shows that the area under the curve (example. total fixed cost) always remains thesame. (2) Average Variable Cost (AVC) – Average variable cost can be obtained by dividing the totalvariable cost (TVC) by the quantity of output (Q).

AVC = total Variable TVC divid by / quantity of output Q As output rises, the Average variable cost curve first falls, reaches a minimum and then begins to rise. Thus, Average variable cost curve has a U-shape. In above example, AVC falls up to 4 units of output, thereafter, itstarts to rise.(3) Average Total Cost (ATC) or Average Cost (AC) – Average total cost (ATC) is obtained bydividing the total cost (TC) by the quantity of output (Q). Thus, average cost (AC) is the perunit cost of production of a commodity. Or, alternatively, it can also be obtained by addingaverage fixed cost (AFC) and average variable cost (AVC).ATC = TC/QOr, ATC = AFC + AVCFrom the table and diagram we learn that as output rises, the MC curve first falls reaches aminimum and then begins to rise. Thus, MC curve has a U-shape. The reason behind the Ushapeof the MC curve is the operation of the law of variable proportions. The law states thatwith the increase in a variable factor, keeping other factors constant, the marginal physicalproduct first increases, and then after a certain level of production, it starts to decline. In otherwords, in the beginning the stage of increasing returns operates which increases the MPP, andafter a certain point, the stage of diminishing returns starts to operate which reduces the MPP.On the basis of this in output, initially, the rate of increase in the requirement of variable factoris less and less, and, after a certain point, it is more and more. This implies that initially in thestage of increasing returns marginal cost (example., the rate of increase in the variable cost) diminisheswith the increase in output, and then, after reaching a certain limit, in the stage of diminishingreturns marginal cost rises with the further increase in output. Thus the marginal cost curvebecomes U-shaped.Why are AVC and ATC curves U-shaped?The shapes of AVC and ATC curves are influenced by the shape of MC curve in the short-run.We are aware that the shape of MC curve is U-shaped because of the operation of the law ofvariable proportions. Consequently, AVC and ATC curves are also U-shaped. Initially, in thestage of increasing returns when marginal cost curve falls, the AVC and ATC curves also falland after a certain level of output in the stage of diminishing returns when marginal cost curve

rises, the AVC and ATC curves also rise. Thus, because of the operation of law of variableproportions as output rises, the AVC and ATC curves first fall, reach their minimum and thebegin to rise. In this way we can state that in the short-run, MC curve, AVC curve and ATCcurve all are U-shaped ones.Relationship between AC and MCRecall the meaning of AC and MC which we have discussed earlier.Average Cost is simply the total cost (TC) divided by the number of units produced (Q) or itis the cost per unit.On the other hand, marginal cost is defined as the increment of total cost that comes fromproducing an increment of one unit of output.

The table and diagram reveal the relationship between AC and MC as under :(1) When MC is less than AC (or MC curve remains below AC curve), the AC curvefalls. For example units 1 to 5 and diagram up to point B (or OM1 output) showthis situation.(2) When MC is equal to AC, AC becomes constant. This is the minimum point of AC,and it is at this minimum point, that MC curve cuts AC from below. In this regard6th unit in the example and point B in the diagram may be seen. (3) When MC is higher than AC (or MC curve rises above the AC curve), AC startsrising. It is shown as 6th unit and thereafter in the example and point B onwards inthe diagramThus, AC-MC relationship can be summarized as follows: So long as MC is below AC, it keepson pulling AC down; when MC gets to be just equal to AC, AC neither rises nor falls and is atits minimum; and when MC goes above AC, it keeps on pulling AC up.Long - Run CostIn the long-run, a firm can vary its scale of plant as and when it requires. All factor-inputs arethus variable in this period. Therefore, there are no fixed cost curves in the long-run. All costcurves in the long-run are basically variable cost curves. Here we find the following cost curves: Long-run Total Cost (LTC) curve; Long-run Average Cost (LAC) curve; and Long-run MarginalCost (LMC) curve.Long-run Average Cost CurveA firm has a fixed scale of plant in the short-run. A short-run Average Cost (SAC) curvecorresponds to a particular scale of plant. In the short-run, the firm can operate only on aparticular scale of plant. But in the long-run a firm can choose among possible sizes of plant orit can move from one scale of plant to the other scale of plant.

Now the question arises : Which scale of plant should be chosen by a firm in the long-run? Theanswer to this question depends on the quantity of output that a firm wants to produce. A firmwould like to produce a given level of output at the minimum possible cost. Hence the firmwould like to build its scale of plant in accordance with the quantity of output in such a waythat it can minimise its average cost. Suppose a firm can have three possible scales of plantwhich are shown by SAC1, SAC2 and SAC3 curves in the diagram. In the long-run, a firm canchoose any scale of plant out of these three plants. The choice of the scale of plant will dependon the quantity of output.The LAC curve is also called ‘envelop curve’ since it envelopes a family of short-run averagecost curves from the below. Similarly, the LAC curve is also termed as ‘planning curve’ becausea firm plans to choose that short-run plant which allows it to produce the expected output atthe minimum cost in the long-run.Long-run Marginal Cost CurveLong-run marginal cost indicates the increase in long-run total cost resulting from one unitincrease in output. Thus,Long-run marginal cost LMC = Long-run total cost of n units of output LTCn minus – Long-run total cost of n-1 units of output. LTCn-1Relationship between LAC and LMCWhy is LAC curve U-shaped?The U-shape of LAC curve is because of returns to scale. As we increase the scale of operationin the initial stages we get increasing returns to scale (IRS) as a result of economies of scale.Increasing returns to scale mean that the increase in output is more than proportionate to theincrease in factor-inputs. It implies that for a given rate of increase in output (say 20%) therequirement of increase in factor-inputs is definitely less than proportionate (say 15%), Hencethe LAC falls as output is increased. It happens in the output range O to M in the diagram. Butthen beyond a certain point we get decreasing returns to scale (DRS) as a result of diseconomiesof scales, hence now LAC rises with the increase in output. It happens at output levels higherthan M in the diagram.Thus, increasing returns to scale and economies cause the LAC to fall in the initial stage and

after a certain point, decreasing returns to scale and diseconomies cause the LAC to rise. Wheneconomies and diseconomies of scale offset each other, it is the stage of constant returns toscale (CRS). In the stage of constant returns to scale, LAC also becomes constant and does notchange with the change in output. It happens at M level of output.Economies and Diseeconomies of ScaleWe have already said that the U-shape of LAC curve is because of returns to scale. And returnsto scale is the result of economies and diseconomies of scale. With the expansion of the scale ofproduction firms get certain advantages, these are termed as economies of large scale production.But when the scale of production exceeds a certain limit, it leads to disadvantages ordiseconomies of scale to the firms. Thus the firms get economies and diseconomies of scalewith the expansion of output. These are termed as economies and diseconomies of large scaleproduction. Economies refer to the saving in per unit cost as output increases. On the otherhand, diseconomies refer to the disserving in the per unit cost as output increases.Economies and diseconomies of scale are broadly classified into two groups:(A) Internal economies and diseconomies(B) External economies and diseconomies.These are discussed below:Internal Economies and DiseeconomiesEconomies and diseconomies that accrue to a firm out of its internal situation when its scaleincrease are termed as internal economies and diseconomies. Now we shall discuss them indetail.Internal EconomiesInternal Economies that accrue to a particular firm with the expansion of its output and scaleare termed internal economies. Internal economies of a firm are independent of the action ofother firms. They are internal in the sense that they are limited to a firm when its output increase.They are not shared by other firms in the industry. Following are the main types of internaleconomies:(1) Labour Economies – These are also known as the economies of specialization anddivision of labour. Division of labour and specialization are possible more in largescaleoperations. Different types of workers can specialize and do the job for whichthey are more suited. A worker acquires greater skill by devoting his attention to aparticular job. As a result of this quality and speed of work both improve. This

results in a sharp increase in output per man. Thus in short, with growing scalecomes, increasing specialization and increasing returns to scale.(2) Technical Economies – The main technical economies result from the indivisibilities.Several capital goods, because of the strength and weight required, will work onlyif they are of a certain minimum size. There is a general principle that as the size ofa capital good is increased, its total output capacity increases far more rapidly thanthe cost of making it. To double the size and output capacity of a blast furnace, forinstance, we do not have to double the materials required. Besides this a large scalefirm can easily take advantages of the use of superior technique or specialized andsophisticated machines. A large firm can also enjoy the benefits from linked processesand from the use of by-products. (3) Marketing Economies – Marketing economies arise from the large scale purchaseof raw materials and other inputs. A firm may receive large discounts on thepurchase of bigger volume of raw materials and intermediate goods. For instance,a large clot mill may get more discounts on the purchase of yarn than the smallmill.Marketing economies can also be reaped by the firm in its sales promotion activities.Advertising space (in newspapers and magazines) and time (on television andradio), and the number of salesmen do not have to rise proportionately with thesales. Thus per unit selling cost may also fall with the increase in output.(4) Managerial Economies – Managerial economies arise from specialization ofmanagement and mechanisation of managerial functions. Large firms make possiblethe division of managerial tasks. This division of decision—making in large firmshas been found very effective in the increase of the efficiency of management.Besides, large firms apply techniques of management involving a high degree ofmechanization, such as telephones, telex machines, television screens and computers.These techniques save time and speed up the processing of information.(5) financial Economies – Large firms can easily raise timely and cheap finance frombanks and other financial institutions and also from the general public by issue ofshares and debentures.(6) Risk-bearing Economies – A large firm can more successfully withstand the risksof business. With the product diversification and by operating in several markets alarge firm can withstand the risk of changing consumer’s tastes and preferences.(7) Economies Related to Transport and Storage Costs – Large firms are able to enjoyfreight concessions from railways and road transport. Because a large firm uses itsown transport means and large vehicles, the per unit transport costs would fall.Similarly, a large firm can also have its own storge godowns and can save storageC8) Other Economies – A large firm may also enjoy some other economies with theexpansion of its output. Prominent among them are economies on conductingresearch and development activities and economies of employee welfare schemes.

As a result of all these internal economies firm’s long-run average and marginalcost decline with the increase in output and scale of production.Internal DiseconomiesInternal Diseconomies are those disadvantages which are internal to the firm and accure tothe firm when it over expands its scale of production. The main internal diseconomies of scaleare as follows : - (1) Management Diseconomies and Diseconomies Related to Division of LabourThese diseconomies occur primarily because of increasing managerial difficultieswith too large a scale of operations. It becomes difficult for the top management toexercise control and to bring about proper coordination. Increase in the firm’s plantbeyond a certain size involves more bureaucracy and more red tapism. Hence, topmanagement becomes eventurally overburdened and less efficient in its role ascoordinator and decision-maker. After a certain point, difficulties arise in the wayof division of labour and specialisationalso.(2) Technical Diseconomies – If a firm frequently changes in it technologies and usesnew technologies and uses new machines, it may increase its costs. After a certainlimit, the large size or volume of the plant and machinery may also provedisadvantageous.(3) Risk-taking Diseconomies – The business cannot be expanded indefinitely becauseof the “principle of increasing risk”. The risk of the firm increases because ofreduction in demand, change in fashion and introduction of new substitutes in themarket.(4) Marketing Diseconomies – A large firm is forced to spend more on bringing andstoring of raw materials and selling of finished goods in the distant markets.(5) Financial Diseconomies – A large firm has to borrow a large amount of moneyeven at higher rate of interest. It imposes a burden on the financial position of thefirm.Impact of Internal Economies and Diseconomies on the LAC CurveWhen a firm accrues internal economies with the expansion of its scale of output, the LACcurve would fall : And when after a certain point, a firm receives internal diseconomies withthe expansion of its scale of output, the LAC curve would rise.Thus, internal economies causes the LAC to fall and internal diseconomies cause the LAC torise. Hence the internal economies and diseconomies are responsible for the U-shape of the LAC curveExternal Economies and DiseconomiesEconomies which accrue to the firms as a result of the expansion in the output of the wholeindustry are termed external economies. They are external in the sense that they accrue to thefirms not out of its internal situation but from outside it example., from expansion of the industry.

Jacob Vinor has defined external economies as ‘those which accrue to particular concerns asthe result of expansion of output by the industry as a whole and which are independent of theirown individual output’. Following are the main forms of external economies.(1) Economies of Localisation/Concentration - When an industry develops in aparticular region, it brings with it all the advantages of localization. All the firms ofthis industry get the following main advantages:(a) Easy availability of skilled manpower;(b) Improvement in transportation and communication facilities;(c) Availability of banking, insurance and marketing services;(d) Better and adequate sources of energy-electricity and power;(e) Development of ancillary industries.(2) Economies of Disintegration/Specialisation – The industry can have advantagesfrom the economies of specialization when each firm specializes in different processesnecessary for producing a product. For instance in a cloth industry some firms canspecialise in spinning, others in spinning, others in printing etc. As a result ofspecialisation all the firms in the industry would be benefited.(3) Economies related to Information Services – Firms in an industry can jointly setupfacilities for conducting research, publication of trade journals andexperimentation related to industry. Thus, besides providing market information,the growth of the industry may help in discovering and spreading improved technicalknowledge. (4) Economies of Producer’s Organisation – Firms of an industry may form anassociation. Such an association can have their own transport, own purchase andmarketing departments, own research and training centres. This will help to reducecosts of production to a great extent and shall be mutually beneficial.External DiseconomiesDiseconomies which accrue to the firms as a result of the expansion in the output of the wholeindustry are termed external diseconomies. The main external diseconomies are as follows:(1) Increase in input price – When the industry expands, the demand for factor-inputsincreases. As a result the input prices (such as wages, prices of raw materials andmachinery equipments, interest rates, transport and communication rates etc.) shootup. This causes the cost of production to rise.(2) Pressure on Infrastructure Facilities – Concentration of firms in a particular regioncreates undue pressure on the infrastructure facilities – transportation, water,sanitation, power and electricity etc. As a result, bootlenecks and delays in productionprocess become frequent which tend to raise per unit costs.(3) Diseconomies due to Exhaustible Natural Resources – Diseconomies may also

arise due to exhaustible natural resources. Doubling the fishing fleet may not leadto a doubling of the catch of fish; or doubling the plant in mining or on an oilextractionfield may not lead to a doubling of output.(4) Diseconomies of disintegration – When the production of a commodity isdisintegrated among various processes and sub-process, it may provedisadvantageous after a certain limit. The problem and fault in any one unit maycreate limit. The problem and fault in any one unit may create problem for whole ofthe industry. Coordination among different concerns also poses a problem.As a result of external diseconomies, the LAC curve of the firms in an industryshifts upward.Impact of External Economies and Diseconomies on the LAC Curve(1) As a result of external economies, the LAC curve of the firms shifts downwards. It isshown in the diagram above that because of external economies, LAC curve shiftsdownward from LAC1 to LAC2.(2) As a result of external diseconomies, the LAC curve of the firms shifts upwards. It isshown in the diagram above that because of external diseconomies, LAC curve shiftsupwards from LAC1 to LAC3.Thus in short, internal economies and diseconomies of scale affect the shape of the LAC curveand make it U-shaped. On the other hand, external economies and diseconomies cause the LAC curve shift downward or upward, as the case may be.

Study Note - 2

2.1 MEANING OF MARKET IN ECONOMICSMarketIn economics, the term market means a social system with the help of which the sellers andpurchasers of a commodity or a service (or a group of commodities and services) can come intocontact with each other and complete the act of sale and purchase. Thus market does not referto a particular place or location. It refers to an institutional relationship between purchasersand sellers. That is market is an arrangement which links buyers and sellers.A market can be of different types. The distinction between different markets can also be madein different ways. The market differ from one another due to differences in the number ofbuyers, number of sellers, nature of the product, influence over price ,availability of information,conditions of supply etc.Economists discuss four broad categories of market structures1. Perfect Competion2. Monopoly3. Monopolistic Competition4. Oligopoly2.2 FEATURES OF PREFECT COMPETITION AND IMPERFECTCOMPETITONFeatures of Prefect CompetitionA market is said to be Perfectly Competitive if it fulfills some characteristics.(1) Large number of buyers and sellers :- Under perfect competition, there exists alarge number of sellers and the share of an individual seller is too small in the totalmarket output. As a result a single firm cannot influence the market price so a firmunder perfect competition is a price taker and not a price maker.Similarly, there are a large number of buyers and an individual buyer buys only asmall portion of the total output available.(2) Homogenous goods :- Under perfect competition all firms sell homogenous goodswhich are identical in quantity, shape, size, colour, packing etc. So the products areperfect substitutes of each other.(3) Free entry and free exit :- Any firm can enter or leave the industry whenever itwishes. The condition of free entry and free exit ensures that all the firms underperfect competition will earn normal profits in the long run. If the existing firms areearning supernormal profits, new firms would be attracted to enter the industryand increases the total supply. This will reduce the market price and the supernormalprofit will not exist. On the other hand if the existing, firm incur supernormal lossthen firms would leave the industry, thus reducing the supply. As a result, pricewill again rise and the loss will be wiped out.(4) Profit maximization :- The goal of all firms is profit maximization

(5) No Government regulation :- There is no Government intervention in the maket.(6) Perfect mobility of factors :- Resources can move freely from one firm to anotherwithout any restriction. The labours are not unionized and they can move betweenjobs and skills can be learned.(7) Perfect knowledge :- Individual buyer and seller have perfect knowledge aboutmarket and information is given of free cost. Each firm knows the price prevailingin the market and would not sell the commodity which is higher or lower than themarket price. Similarly, each buyer knows the prevailing market price and he is notallowed to pay a higher price than that.The firm also has a perfect knowledge about the techniques of productions. Eachfirm is able to make use of the best techniques of production.MarketFeatures of Imprefect CompetitionFeatures of MonopolyMonopoly refers to the market situation where there is one seller and there is no close substituteto the commodities sold by the seller. The seller has full control over the supply of thatcommodity. Since there is only one seller, so a monopoly firm and an industry are the same.Feature :-(1) Single seller and large number of buyers :- Under monopoly there is one sellerand therefore a firm faces no competition from other firms. Though there are largenumbers of buyers, no single buyer can influence the monopoly price by his action.(2) No close substitute :- Under monopoly there is no close substitute for the productsold by the monopolist. According to Prof. Boulding – a pure monopolist is thereforea firm producing a product which has no substitute among the products of anyother firms.(3) Restriction on the entry of new firms :- Under monopoly new firms cannot enterthe industry.(4) Price maker :- A monopoly firm has full control over the supply of its products andhence it has full control over its price also. A monopoly firm can influence the marketprice by varying it supply, for eg., It can make the price of its product by supplyingless of it.(5) Possibility of Price Discrimination :- Price discrimination is defined as that marketsituation where a single seller sell the same commodity at two different prices intwo different markets at the same time, depending upon the elasticity of demandon the two goods in their respective market. Under such circumstances a monopolistcan charge incur supernormal loss then firms would leave the industry, thus reducing

the supply. As a result, price will again rise and the loss will wiped out.Features of Monopolistic CompetitionIt is that form of market in which there are large numbers of sellers selling differentiated productswhich are similar in native but not homogenous, for eg., the different brands of soap. This areclosely related goods with a little difference in odour, size and shape. We separate them fromeach other. The concept of monopolistic competition was developed by an American economist“Chamberline”. It is a combination of prefect competition and monopoly.Feature :-(1) Large number of sellers and buyers :- In monopolistic competition the number ofsellers is large and each other act independently without any mutual dependence.Here the action of an individual firm regarding change in price has no effect on themarket price. The firms under monopolistic competition are not price takers.(2) Product Differentiation :- Most of the firms under monopolistic sale products whichare not homogenous in nature but are close substitutes. Products are differentiatedfrom each other in the following ways.a) Real Differentiation :- These types of product differentiation arises due todifferences in the quality of inputs used in making these products, differencesin location of firms and their sales service.b) Artificial Differentiation :- It is made by the sellers in the minds of the buyers ofthose products through advertisements, attractive packing, etc..(3) Non-price competition :- Under such a market situation different firms may competewith each other by spending a huge sum of money on advertisements keeping theproduct prices unchanged(4) Selling Cost :- Expenditure incurred on advertisements and sales promotion by afirm to promote the sale of its product is called selling cost. They are made to persuadea particular product in preference to other products. Some advertisements havebecome so popular that people use a brand name to describe the product, for eg.,brand name is used to describe all types of washing powder.(5) Free entry and free exit :- There are no restrictions on the entry of new firms andneither do the firms deciding to leave the industry. Every firm under monopolisticcompetition earns only normal profits in the long run and there arises no supernormalprofit nor loses.(6) Independent price policy :- A firm under monopolistic competition can influencethe price of the commodity to some extent and hence they face an inverse relationshipbetween price and quantity. In IWS case the price elasticity of demand would berelatively elastic because of the existence of many substitutes.Features of Oligopoly

Oligopoly is a market situation in which there are few firms producing either differentialgoods or closely differential goods. The no. of firms is so small that every seller is affectedby the activities of the others.(1) Few Sellers : There are few sellers in oligopoly market, no. of sellers is small thateach and every seller is affected by the activities of the others. (2) Interdependence : Interdependence among firms is the most important characteristicunder Oligopoly. The no. of sellers is so small in the market that each of these firmscontribute a significant portion of the total output. As a result, when any one ofthem undertakes any measure to promote sales, it directly affect other firms andthey also immediately react. Hence every firm decides its policy after taking intoconsideration the possible reaction of the rival firm. Thus every firm is affected bythe activities of the other firms and this is called interdependence of firm.(3) Nature of Product : A firm under oligopoly may produce homogenous goods whichis called oligopoly without product differentiation for eg. Cooking gas supplied byIndian & HP. Oligopoly may also produce differential products which is calledoligopoly with product differentiation for eg. Automobile Industry.(4) Barrier to Entry : The existence of oligopoly in the long run requires the existence ofbarrier to the entry of the new firms. Several factors such as unlimited size of themarket, requirement of huge initial investment etc. creates such barrier upon theentry of new firms.2.3 CONCEPTS OF TOTAL REVENUE, AVERAGE REVENUE ANDMARGINAL REVENUEThe term revenue refers to the receipts obtained by a firm from the sale of certain quantities ofa commodity at various prices. The revenue concept relates to total revenue, average revenueand marginal revenue.(1) Total Revenue (TR)- Total revenue is the total sale proceeds of a firm by sellingcertain units of a commodity at a given price.If a firm sell 10 units of a commodity at Rs. 20 each, Them TR = 20 x 10 = Rs. 200.00Thus total revenue its price per unit multiplied by the number of units sold.TR = P into Q where P - Price per unit Q - Quantity sold.(2) Average Revenue (AR) - Average Revenue is the revenue earned per unit of output.Average Revenue is found out by dividing the total revenue by the number of unitssold.) Average Revenue AR = total revenue TR divided by Quantity sold.Q (3) Marginal Revenue - Marginal Revenue is the change in total revenue resulting fromsale of an additional unit of the commodity.

example If a seller realises Rs. 200.00 after selling 10 units and Rs.225 by selling 11 units,we say MR = (225.00 - 200.00) = Rs. 25.002.4 PRICING IN PREFECT COMPETITION AND IMPERFECTCOMPETITIONFirm’s Equilibrium Under Perfect CompetitionA firm is a small producing unit. It supplies too small portion of the total product to influenceprice. By increasing or decreasing its contribution, it can hardly influence total supply thereforeprice. So a firm is said to be a Price Taker in the sense that it sells at the current market price asdetermined by the Industry. Price being given a firm determines the output it will produce andsell. It is quantity adjustor. In determining its equilibrium output the firm is guided by theobjective of profit maximization. The firm’s strategy in this respect differs between short periodand long period.A Competitive Firm is not a Price Determinator, but an output AdjustorIn Perfect Competition there are large numbers of firms producing homogenous goods. Anindividual firm in such market supplies a very small part of the total market supply. In view ofthis, by changing its supply it cannot affect the price. Thus the firms have no independent pricemaking power. They cannot fix the price according to their sweet will. Therefore firms arebound to accept the price as determined by the industry. Thus a firm is said to be a price takerbecause it takes the price from the market as a whole. At that price how much it will produceand sell depends upon the discretion of the individual firm. In this sense the firms are OutputAdjustor.A firm will produce that much output where its profit is maximum. In Prefect Competition,price is given and so at the current price the firm can sell as much or as little as it likes. Whetherthe output is large or small, price per unit will remain the same. It is peculiar feature of such amarket. Price being fixed for all the units, the firm’s price will be equal to average revenue andmarginal revenue (P = AR = MRThus a firm under perfect competitionproduces up to the point where MR = MC.The equality of MR = MC is a necessary but not a sufficient condition. The sufficient conditionis that MC must cut MR from below as it is shown in the above graph. If MC cuts MR from

above then the point of intersection will not be the point of equilibrium output as the firm willbe able to earn more profit by producing more.Determination of Equilibrium Price and Output of a firm under PC.PC is that market firm which is characterized by many sellers selling homogenous goods atuniform prices. Under such a market a single firm cannot makes its price, where as the price isdecided by the industry consisting of all such firms. (1) Short runIn order to find out equilibrium price and output of a firm under PC in the short run.There are 2 conditions.(a) MC = MR.(b) MC curve cuts the MR Curve from below.In the short run, there may be a situation of super normal profits or losses.(a) In case of super Normal Profit — When the AR of the firm exceeds the ACof the firm (example. when AC lies below the AR curve), Then their arises supernormal profitb) Loss : In case of super normal loss the AC of the cost has to be greater than AR. It isexplained in the following diagram.In the above diagram we can show that AC curve lies above the AR curve. The equilibrium ptat e where MC = MR & MC Curve cuts the MR Curve form below. Therefore Oq is the equilibriumqty & the amount of loss is calculated as follows :Total Loss = TC minus – TR (2) Long RunA Firm is said to be in equilibrium in the long run when P = AR = MR = MC = AC. Thereforeunder PC in the long run there exists normal profit and no super normal profits or losses exists.Since under PC there is free entry and free exit of firms when there arises super normal profit,more firms will be attracted towards the industry and thus the aggregate supply will rise, pricewill decrease and the profit will not exist. On the other hand if there is an event of loss then theexisting firms will gradually leave the industry and as a result the supply will fall, price willraise and the super normal loss will be wiped out.Firm’s Equilibrium Under Imperfect CompetitionEquilibrium price and output determination under monopolyIn case of a monopoly firm or industry there is a downward sloping demand curve or averagerevenue curve which suggests that a monopolist can reduce his unit price to encourage moresales. In case of monopoly the AR & MR curves are downward sloping and the MR curve liesbelow the AR curve, as shown below :

In a monopoly market the conditions of equilibrium are – (1) MC minus – MR & (ii) MC curve cuts MRcurve from below:a) Super normal profit – It a monopoly earns super normal profit the firm earn theprofit then the AC curve will lie below the AR curve.b) Loss : In case of loss the AC of the monopolist will be above the AR.3) No Super normal profit or loss : In this situation the AR = AC and therefore theAR curve is tangent to the AC Curve as shown below.Price discrimination under monopolySometimes the monopolist charges different prices to different consumers for the samecommodity. A physician may charge different fees for rich and poor patients. A companyproducing electricity may charge one price for domestic consumers and another for industrialconsumers. Sometimes, in order to capture a foreign market, a monopolist keeps the exportprice lower than the price in the domestic market. (This is called ‘dumping’). Sometimes exactlythe opposite is done. A low price is charged for domestic consumers but the price is raisedwhen the good is sold to a rich foreign nation. All these are cases of price discrimination. Whena monopolist discriminated between consumers, the practice is called ‘price discrimination’.Classification of price discrimination : Professor Pigou has classified price discriminationinto three different types :(1) Price discrimination of the first degree: In this case, the monopolist discriminatesprice not only between different consumers but also between the different units ofpurchase by a given consumer. He extract the maximum possible price for eachunit of his output. Here, the monopolist has complete knowledge about the marketdemand curve. He can charge the maximum price which a consumer is ready topay for purchasing a given quantity.(2) Price discrimination of the second degree: In this case, price does not differ foreach unit of purchase. But the consumer is made to pay one price upto a certainamount of purchase and another price for purchases exceeding this amount. This isknown as the principle of block pricing.(3) Price discrimination of the third degree: In this case, a particular consumerpays a particular price, irrespective of the amount of his purchase. But price differsbetween different consumers (or different groups of consumers). Out discussionhere will mainly be confined to this third type of price discrimination.When is price discrimination possible?A monopoly firm can sell the same product at two different prices to two different groups of

buyers. This type of price discrimination becomes possible under the following circumstances:(a) Different price elasticities of demand : If the price elasticity of demand is differentin two different markets, then such price discrimination becomes easier. Themonopolist charges higher price for the product in a market where price elasticityof demand is relatively inelastic. On the other hand, he charges relatively lowerprice in a market where the price elasticity of demand is relatively elastic.(b) Tariff barrier : If two markets are separated by a tariff wall, the monopolist canfollow this principle of price discrimination. For example, the monopolist can sellits product at a lower price in the foreign market, and at a higher price in the domesticmarket. If there remains high import tariff then it might not be profitable for thedomestic buyers to purchase that product at a lower price from the foreign marketbecause they will have to pay a high import tariff on that imported item. In thissituation, products sold by the monopolist will not flow from the low-priced foreignmarket to the high-priced domestic market.(c) Geographical distance between the markets : Price discrimination is also possiblewhen two markets are separated from one another by geographical distance. In thiscase, the monopolist can sell its product at a lower price in a distant market and athigher price in the local market. In this case also, any buyer would find it unprofitableto purchase the product from the low priced distant market due to substantialamount of transport cost involved in this process. So, products will not flow fromthe low-priced distant market to the high-priced local market.(d) Impossibility of resale of a product (particularly service items) : If it is not possibleon the part of any buyer to resale the product sold by the monopolist, then themonopolist can easily follow the policy of price discrimination. This happensparticularly in case of service items. For example, a renowned doctor can chargedifferent fees for rendering similar service to two different patients. Similarly, arenowned lawyer can fix different service charges for two groups of clients forrendering similar services. Here, such doctors or the lawyers would be regarded asthe discriminating monopolists.(e) Ignorance of the consumers : If the consumers remain ignorant about the differencein prices of the same product in two different markets, then also the monopolist caneasily follow the policy of price discrimination.(f) Typical behaviour of the consumers : sometimes the consumers do not pay anyimportance to the small differences in prices (say, a difference of only 20 paise) ofthe same product sold by the monopolist to different groups of consumers. In thatsituation it becomes easier for the monopolist to follow this policy. Again in somecases, a group of consumers consider higher price as an indicator of higher quality(the so called veblen effect). Such typical behaviour of the consumers creates anopportunity for the monopolist to follow the policy of price discrimination.

Study Note - 33.1 CONCEPT OF NATIONAL INCOMENational Income is nothing but the income of a nation or a country. In real terms a nationalincome is the flow of goods and services produced in an economy in a particular period - ayear. A National Sample survey has, therefore,defined national income as - money measures ofthe net aggregates of all commodities and services accruing to the inhabitants of a communityduring a specifed period.Concepts Associated with National Income1. Gross National Product (GNP) - The GNP of a country in a year is defined as the marketvalue of all final goods and services produced by domestic factors in the country in that year.2. Net National Product (NNP) - NNP at market price is defined as GNP minus depreciation ofcapital stock.Why should we deduct the depreciation from GNP ?The productive power of physical capital stock of a country diminish gradually because of thewear and tear that it undergoes in the process of production. When the machine become totallyunproductive, it can be replaced by a new machine. So a sum of money is set aside every yearand put it into depreciation fund and new machine can be purchased by utiliziing thisaccumulated sum in the depreciation fund.So depreciation is deducted from GNP in order to get a more accurate measure of the sustainableproduction of goods and services in a country in a given year.3. NNP at factor cost or National Income- NNP at factor cost = NNP at market price minusIndirect Business Tax minus Non tax liabilities minus Business Transfer Payments plus Subsidy

from Government is equal to = National Income .4. Gross Domestic Product (GDP) - GDP can be defined as the sum total of values of all goodsand services produced within the geographical boundary of the country without adding thefactor income received from abroad.Distinction between Gross National Product and Gross Domestic Product –Gross National Product is different from Gross Domestic Product in following respects :(a) Gross National Product refers to the total market value of all the final goods andservices produced in a country during a given year, plus net factor income fromabroad.But Gross Domestic Product refers to the total market value of all the goods andservices produced in the given year within the domestic territory of the country.(b) Gross National Product includes all income earned by the country in abroad. ButGross Domestic Product does not include the income earned by the country fromabroad.(c) Gross Domestic Product does not include the income earned by the country fromforeign investments.(d) G.D.P. includes only those goods and services which can be produced within domesticterritory of the country.(e) G.N.P. is a wider concept than the G.D.P.But G.N.P. is more useful than G.D.P.3.2 MEASUREMENT OF NATIONAL INCOMEThere are three alternative ways of estimating National Income of a country. Broadly it may beviewed from income side, output side and expenditure side. Let us discuss these methods:(a) Product method - In simple terms this method implies that by adding the values ofoutput produced and services rendered by different sectors one may find out the nationalincome.The output method is unscientific. In this method only those goods and services arecounted which are paid for, that is marketed. But there are many goods and servicesthat do not have market price and are not paid for. Services of a housewife or a teacherfather;food crop, fruits and vegetable grown in family farm would not be counted aspart of the GNP. Similar services or goods would become a part of GNP if they are paidfor. Thus GNP at market price invariably leads to an underestimate of gross and services.Moreover, there lies possibility of double or even triple counting in this method. Countingwheat, flour and bread’s value separately is methodologically incorrect because bread’svalue contains flour’s value which, in turn., contains wheat’s value. However, this

problem can be overcome if only value of final goods are considered excluding primaryand intermediate goods. The problem can be overcome in another wayknow as thevalue added method whereby only the value added by each firm in the productionprocess is included in the output figure. Thus the value added output of all sectorsmakes up GNP at factor cost.(b) Income method – In this method all income from employment and ownership of assetsbefore taxation received from productive activities to be counted. It is the factor incomemethod. The summation of incomes earned by the factors of production for their contributionto production. To these be added the undistributed profits of the private sectorand trading surplus of the public sector corporations. While all those groups ofincome generated in production, some other are to be excluded. These are known asTransfer Earnings. Examples of such earnings are pensioner benefits, un employmentdoles, sickness benefits, interest on national debt etc. These are excluded, as they do notarise from productive activities.(c) Expenditure Method — By measuring total domestic expenditure we can measure theincome of a nation. Broadly, total domestic expenditure comprises two elements. First,consumption expenditure of the household sector on goods and services. It also includesthe consumption outlays of business sector and public authorities.Another part of national expenditure is investment expenditure by private sector andpublic authorities. Expenditure is said to be investment when it is used for making afixed capital like building, machinery etc. It also means an increase in the stock of inputsand finished products.In measuring total domestic expenditure we have to take some precautions (a) onlynew goods be considered. Any spending on old goods is a transfer of asset from onehand to another. There is no new asset coming through production (b) Only the finalstage of purchase be included because measuring expenditure for intermediate stagemay lead to duplication of spending amounts. (c) Residents of country may spend forforeign goods (import) any may also earn by selling goods abroad (exports). Hence it isnecessary to exclude spending on imports and to include value of exports.Usefulness of National Income estimatesNational Income estimates are in a sense social accounting showing economic transactions interms of which the economy of nation may be studied as a whole made up of parts. NationalIncome data may serve many purposes.

Firstly, all such data gives an account of the overall growth of an economy. It Showshow the production is changing, the sectoral contribution and the effects of governmentpolicies and programmes. Secondly, in analyzing the relation between input of one industry and the output of the other, NI data is necessary. As in input output analysis so also in economic planningplanners must analyse such data to find out deficiencies or excess.Thirdly, an analysis of NI data reveals the distribution of income among economicunits. They show how much of total income in going to farmers and workers, and howmuch among ‘white collar’ workers and land owing classes. On the basis of such data,government may take corrective actions.Fourthly, such estimates also show the consumption pattern of different economic classes.Changes of tastes and fashions are revealed in NI estimates. They are of immense valueto the businessmen in deciding what to produce or for whom to produce.Lastly, NI estimate helps the government in its economic role than any other organizationand person. For the perhaps the government of a country spends so much for itsestimation. Indeed the basis of most public policies is NI data. They are useful in guidingdecisions taking and controlling the economy in right direction. The national incomequantum indicates the ability of a country to pay its share for international purposeexample. membership of IMF or World Bank.3.3 DIFFICULTIES IN ESTIMATING NATIONAL INCOMEThe difficulties in the estimation of National Income can be broadly divided into conceptualdifficulties and statistical difficulties.Some of the conceptual problems related to precise estimate of national Income are asfollows : -(a) There are many services for which no remuneration is paid. Similarly there are goodsthat are marketed sold at a price but are used for self-consumption. But no practicablemethods exists for their inclusion in National Income accounting.(b) In estimating National Product we take into account only the so called final goodswhich are those goods readily available for consumption. But it is not always possibleto make a clear distinction between primary, intermediate and final goods.(c) Another problem relates to pricing of products. Prices change overtime and region.The price that should be chosen to determine the money value of National productis a difficult question.(d) There is much debate regarding inclusion of income of foreign companies in NationalIncome estimates since, a large part of such income is remitted out of the

country.There are some statistical problems in the computation of national income.(a) Changes in the price level have to be made in comparing national income ofdifferent years. It involves the use of Index Number. Index Numbers have theirinherent difficulties.(b) Official statistics are not always accurate Much of it is based on guess work andsample survey.(c) Methods of computing NI are not the same in all countries. Statisticians differ intheir opinion regarding statistical computation.(d) And the statistical data are often not available. Data relating to unaccountedmoney, wages of labour in unorganized sector are case in point.3.4 NATIONAL INCOME AND ECONOMIC WELFAREEconomists like A.C. Pigou, are of the opinion that an increase in wealth means an increase inwelfare and a decrease in it implies a loss of welfare. Such causal relationship is heavily discountedby modern writers like Prof. Paul Samuelson. In their view, there is no direct relationbetween wealth and welfare. Samuelson suggests that to calculate economic welfare we haveto correct GNP to allow for disseminates of modern urban living, for enhanced leisure, nowenjoyed by the citizens’, for household work by wives. We must compute the Net EconomicWelfare (NEW) to guage quality of economic life. We must compute the adjusts the conventionalmeasure of GNP to allow for pollution cost, disseminates of modern urban living, leisureetc. Thus Political economy shows how people if they really wish to, can trade off quantity ofgoods for quality of life. Many things that contribute to human welfare are not included in theGNP. Leisure is an example. Although a shorter work week may make people happier, it willtend to reduce measured GNP.Furthermore, the GNP may not adequately reflect changes in the quality of products. A 1994TV is a much superior product to a 1984 TV. It is more reliable and has better audio videoquality. But GNP measures do not reflect these changes in quality. Also GNP does not allowfor the capacity of different goods to provide different satisfactions. Crores of rupees spent ondefence products makes the same addition to GNP as crores of rupees spend on a school, astadium or shopping expenditures that may produce very different level of consumer satisfaction.GNP does not measure the quality of life. To the extent that material output is purchasedat the expense of such things as overcrowded cities and highways, polluted environments

defaced country sides, mined accident victims and longer waits for Public Services, GNP measuresonly part of the total of human well being. This undersirable products are often calledbad to distinguish them from goods which are desirable products. The GNP omits certainoutputs such as the illegal provision of Products people want; non marketed activities andoutput in the black economy, some of which clearly add to people’s living standards.Increase in the general price level would bring a fall in the economic welfare. If increase in thesize of national income is the result of prolonged working hours, increased employment offemale workers and children in production, unhealthy and polluted atmosphere inside thefactor premises, such an increase in National Income will not promote economic welfare.If the net National Product has increased on account of more production of capital goods, itwill not increase welfare. Welfare also depends upon the distribution of National Income. Ifthe National Income increases and yet if it is not fairly distributed and are concentrated in afewer hands, it will not promote economic welfare. The law of Diminishing Marginal Utilityalso applies to accumulation of money. As the rich people get richer the additional unit ofmoney income gives less welfare. The unequal distribution of Nation Income decrease economicwelfare. When the distribution of National Income changes in favour of the poor theystart getting more commodities and services than before, as a result the economic welfare increases.The philosophy of the National Income statistician might be expressed in the observation—Man does not live by bread alone, but it is nevertheless important to know how much bread hehas. The National Income figures do not measure everything that contributes to human welfare,nor are they intended to do so.3.5 CONCEPT OF CONSUMPTION, SAVING AND INVESTMENTCONSUMPTIONKeynes held that current consumption depends upon current gross income minus tax liabilities.He says “men are disposed as a rule and on the average, to increase their consumption astheir income increases by not by as much as the increase in their income.” Symbolically 1> C >

0. This is the psychological law of consumption.Consumption FunctionThe propensity to consume shows income consumption relationship C = F(Y). here c is consumptiona dependent variable and Y is an independent variable. It should be noted that propensityto consume does not mean desire to consume but effective consumption. C is an increasingfunction of income as Y and C move in the same direction.OX measures real income and OY consumption. The C curve represents the propensity toconsume. It slopes upward to the right showing consumption rising along with income. Atpoint A while income is zero consumption is positive, and upto CL on the consumption curve,we find that consumption exceeds income.Average Propensity to consumeIt implies the ratio of total consumption to total income.

Marginal propensity to consumeThis implies the effect of additional income on consumption. It is the ratio of additionalconsumption to additional income Determinants of consumption FunctionsConsumption function depends on subjective and objective factors. Among objective factorswe may mention a few.a) Tax Policy – A higher rate of tax will reduce personal income and to that extentconsumption as well.b) The Rate of Interest – A higher rate of interest may induce more savings and so lessconsumption. However a higher interest income may raise consumption by raisingtotal income.c) Holding of Assets – If people want to hold more assets, like property, jewelleryetc. they will curtail consumption.d) Windfall Profits or Loss – Consumption level of those classes of people changeswho gain windfall profit or incur heavy loss.Among subjective factors we may mention some motives that lead individuals to refrain fromspending. These are motive of precaution, motive of foresight, motive of improvement, motiveof avarice etc.SAVINGDefinitionKeynes defined savings as an excess of income over expenditure on consumption. SymbolicallyS = Y minus – C. The unconsumed part of national income of all members of the community represents.

National Savings. The total domestic savings are the sum of households’ savings plus businesssector’s savings plus government’s savings. The first two constitute private savings and thelatter public savings.DeterminantsThe size and rate of savings in an economy are determined by many a factor. The most importantdeterminant of savings is income. Savings is functionally related to income S = f(Y). Thesaving income ration tends to rise with increase in income. The savings function is a stablefunction of income in the short run. But savings as such is not a stable function of income. Somarginal propensity to save (ds/dy) is always greater than zero but less than unity that is,people save part of additional income but not the entire incomeThe saving function is explain by three income concepts in macro economics.(a) Absolute Income – Keynes was of the opinion that savings are a function of absolutelevel of income. That is current savings depend on current disposable incomeexample. income minus taxes paid.(b) Relative Income – According to Duesenberry savings out of a given income by anindividual depends on his relative income example, upon his percentile position in thetotal income distribution.(c) Permanent Income – According to Friedman, the basis of determining consumptionand saving is permanent income. Permanent income is current income plus theexpected income received over a period of time. Actual or measure income is thesum of permanent and transitory income. Transitory income impliesunanticipated addition or subtractions in income.A second factor influencing savings is the distribution of income. Generally, inequality of incomedistribution helps the process of savings. In this context we may refer to “demonstration effect”,that is man’s desire to imitate the superior consumption standard of neighbours or relatives.This induces a man to buy expensive goods and so saving decline.Thirdly, savings depend on sound financial institutions and the rate of interest. A higher rateof interest motivates us to save more. So also existence of diverse type of financial instrumentsgives people incentive to save more.Besides the above objective factors, savings also depend on a host of subjective or psychologicalfactors. A man’s attitude towards savings depends on his farsightedness, his desire to bequeatha fortune, to enjoy a better living in future or to possess some physical asset. A strong subjective

motive is precautionary in nature. A man saves or insures as a precaution against futureuncertainty and insecurity.Savings: A Virtue or a viceAccording to classical economists savings is a virtue as they believed that what is saved isbeing automatically invested. But some classical theorists argued that the act of saving leads tounder consumption and this diminishes effective demand. In effect, over production andunemployment appear.While considering savings as a private virtue, Keynes believed it be a social vice. A generalincrease in savings means a general reduction in consumption expenditure and a fall in effectivedemand. This will lead to a sharp fall in investment, production and employment. As a resultindividual income may decline leading to reverse operation of Multiplier.The Keynesian views are based on the concept of income elasticity of saving. As income fallsdue to contraction of expenditure savings will also decline. This stands in sharp contrast toclassical view point where saving was considered as interest elastic. If, however, savings arehoarded they destroy real capital.Thus whether savings is virtue or a vice depends upon its use and its effects on income.INVESTMENTDefinitionInvestment has dual aspect. It implies the production of new capital goods like plants andequipments. Secondly, a change in inventories or stocks of capital of a firm between two periods.DeterminantsThe volume of investment undertaken by private entrepreneurs depends primarily upon twofactors (a) the marginal efficiency of capital (MEC) and (b) the rate of interest. The term MECimplies the prospective yield from the capital asset and the supply price of this asset. MEC, inthe words of Keynes, is “equal to the rate of discount which would make the present value ofthe series of annuities given by the return expected from the capital asset during its life justequal to its supply price”. Symbolically C = Q/P. Where Q is the prospective yield from capitalasset and P is the supply of this asset. In considering a particular investment project the investormust have some idea of future returns, that is yields from the real asset in its life span.

Suppose for the years 1,2,3,……… n the net return is current values (example. value in the year theyare received)R1, R2, R3,………Rn (1)In order to find the present value of all expected future returns we have to discount all futurereturns. Consequently the stream of returns, as shown in equation (1), has a present value ofAn investor will compare this present value of return with cost of the real assets (Pc). Thecondition for the maximization of net returns over costs is that increments has a present valueof expected returns which just covers the initial cost.Generally there exists a negative relation between interest rate and investment expenditure. Afall in the rate of interest may induce an increase in investment expenditure whereas a higherrates, investment is likely to be less. At a higher interest rate, a firm instead of using funds forcapital equipments may invest in financial assets. Thus the level of investment is a negativefunction of the rate of return.Investment expenditure also depends on over all economic climate. An optimistic outlook ishighly encouraging for investment in capital goods. Risk, uncertainty and instability tend todiscourage business to undertake investment projects.Moreover, a firm may expand investment outlay for innovation viz. introducing a new good ora new technique. Such innovations either by increasing sale or by reducing cost may help theinnovating firm a larger return on its investment.Finally, investment decisions of a firm are influenced, to no small extent, by the cost of capitalgoods. A firm normally calculates the initial cost of acquisition, and the subsequent cost ofmaintenance and operation of capital goods. The present stock of capital goods on hand andtheir working condition, moreover, determine whether to incur investment for buying the capitalor its purchase be postponed.Marginal Efficiency of Capital (MEC) and Marginal Productivity of Capital (MPC).The term MPC or Marginal Productivity of Capital, as used by Marshall, implies the additional physical product obtained due tothe employment of one extra unit of capital (do/dc) per unit of time. In other word, it relates tothe increment of value received by using one more physical unit of capital. In contrast, MEC

denotes the series of increments in output anticipated over the life of the capital equipment.Thus while MPC example. dQ, MEC is dQ1, dQ2, dQ3, ….. dQn. The former (MPC) indicates just thecurrent output, the latter the stream of output over a period of time.The MPC is net current product of the capital good minus the cost of capital good. In otherwords, the current rate of return over cost MEC, on the other hand, implies the return over costthroughout the life of the capital goods. Thus the basic difference between the two concepts isthat, the one (MPC) denotes current yield and the latter implies prospective yields from acapital asset.Investment MultiplierThe Keynesian multiplier shows how many times the total income increases by a given amountof initial investment. If dI represents increase in investment, dY represents increase in incomeand M the multiplier, the M = dY/dI. Thus the Multiplier is the number by which the initialinvestment is to be multiplied to get the resulting change in income. With the help of the marginalpropensity to consume the relation between a given dose of investment and the resultingchange in income can be shown.Suppose a firm makes an additional investment of Rs. 1000/- for enlarging its business. Themoney thus spent by the firm will lead to an equal amount of increase in income of some othermen. These income earners will spend a part of the additional income for consumption andsave the rest (dY = dC + dS). If we assume marginal propensity to consume to be 0.8, they willspend Rs. 800 out of Rs. 1000 for consumption goods. In effect the producers of these goods willhave an extra income of Rs. 800 and they will in turn spend 4/5. That is Rs. 640, which will bethe extra income of some other people. Thus there is a chain a income and expenditure generatedfrom the original and autonomous investment. The total increase is the sum of the increasein income at each stageThe investment Multiplier thus denotes the ratio of change in income to the change in primaryInvestment. The value of the multiplier can be calculated by the formulaK = 1divided by (1minus - Marginal Productivity of Capital MPC)The value of the Multiplier is the inverse of the MPS (marginal propensity to save).The significance of the concept of Investment Multiplier is that it shows how a given autonomus

investment enlarges income. LeakagesThe multiplying process of income propagation is much weakened by the operation of certainexogenous factors. Indeed it may operate at the reverse direction also causing a cumulativedecrease in income and spending. The swelling of income may peter out because of such leakages: -(a) A decrease in MPC and an increase in MPS may reduce the value of multiplierbecause multiplier is the reverse of MPS. If, for example, MPS rises from 1by /5 to½, value of the multiplier will fall from 5 to 2, increase in National Income wouldbe less.(b) A part of the extra income may leak out of the income stream if invested infinancial assets, naturally consumption expenditure will be less.(c) Similarly if a large part of additional income is invested in financial assets, naturallyconsumption expenditure will be less.(d) A strong liquidity preference may lead to holding of cash balance in hand insteadof spending for consumption goods.(e) An excess of imports over exports causes a net outflow of funds from domesticeconomy, thus weakening income propagation through earning and spending.(f) A small part of the extra income can be used for consumption expenditure if therate of taxation is very high.The Acceleration PrincipleThe concept of Multiplier highlights the effects of initial investment upon national incomethrough changes in consumption expenditure. Such change in output of consumption goodscause investment for production of capital goods used in producing those consumption goods.Thus a given autonomous investment begets a chain of induced investments. The ratio betweenthe net change in consumption outlay and the induced investment is known as accelerationcoefficient : a = investment dI by / net change dC, where dI is net change in investment and dC for net change inconsumption expenditure and for accelerator. Suppose a net increase of consumption outlay ofRs. 10 lakh induces an additional investment of Rs. 20 lakh then the value of accelerator is 20/10 = 2.The value of accelerator depends on capital output ratio example. the amount of capital required toproduce a given volume of output. It also depends upon the durability of capital goods. Theacceleration effect will be high if capital equipments have more durability and capital output

ratio is high. A small change in consumption expenditure, generally speaking, is likely to createa larger induced investment.

3.6 ECONOMIC GROWTH AND FLUCTUATIONEconomic FluctuationOne of the characteristics of capitalistic economy is economic instability. The business world insuch an economy is said to experience ups and downs in its economic activities. These fluctuationstake the form of Wave like rise and fall in a regular time sequence. In economics, suchmovements are known as Trade Cycle or Business Cycle. As the fluctuations in income employment,output move in a cyclic order, they are known as trade cycle.It has been aptly remarked that all such cycles are members of the same family but not twins. Itmeans that general pattern of the cycles is same. Some cycles are of long-run while others havea shorter duration. Secondly, the impact of fluctuation is often confined to few countries ormay take a world wide shape. The Great Depression of the 30s aptly illustrates the point. Thirdly,cyclical fluctuations may be of different degrees—they may be mild or serve, causing little orviolent disturbances to business.Whatever may be its form or durability, every trade cycle pass through four phases (a) Prosperity(b) Recession (c) Depression and (d) Recovery.(1) The main spring of business prosperity is profit. In a capitalist economy as profitsinflate industrialists and businessmen get necessary incentive to produce moreand invest more. An air of optimism blows from one corner to another. More investmentleads to more employment and so more income more effective demand.Indeed, a virtuous circle engulfs the entire business environment. The economydrives up and reaches the peak of prosperity (P).(2) No business, trade or industry can remain in the peak of prosperity forever.Excessive expansion leads to diseconomies of large scale production, rising cost,higher wages and much shortages. Similarly, demand for bank credit being highand rising, interest rates tend to move up. These diminish profit to a lower level.The economy moves towards contraction either slowly or abruptly. It is the stageof recession .(3) The recessionary trends ultimately pull the economy to the rock bottom level,Income, employment and output decline sharply. Investments fall and enterpriseis discouraged. Pessimism leads to depression and deflation. (4) Depression does not continue for indefinite period. It is an improving stage oftrade. Weaker units are liquidated, old debts are repaid, and enterprises are reorganized.Unemployment rate gradually decreases and income is generated. A good

harvest or the manufacture of a new industrial good may pave the way for recovery.CausesDifferent explanations have been offered for periodicity of business cycles. According to classicalwriters fluctuations in farm products cause business cycles. Some economists believe thatexpansion and contraction of bank credit cause cyclical fluctuation. But bank credit is moreoften the effect than the cause of trade cycle. Another explanation is to be found in the InnovationTheory which seeks to explain prosperity by the introduction of new goods and depressionby the fall in the demand for old products. Often due to over saving or under consumptionof the people, supply remains unsold as a vast majority of the population do not buy them.Lord Keynes explained trade cycle by the changes in the expected profitability of investmentor what he called Marginal Efficiency of capital. In Keynesian theory, employment depends onthree variables :Propensity to consume, rate of interest and marginal efficiency of capital (MEC). While theformer two are more or less stable in the short run, it is the MEC that is the primary determinantof employment. When MEC is high, optimism prevails in the business world, Investment goeson rising and so also income and employment. The economy thus reaches the peak of prosperity.The process is reversed by two retarding factors –(a) high cost arising from shortage of resources(b) a falling tendency of the rate of profit due excessive increase in supply.This shows the seed of pessimism and a decline in MEC leading finally to a depression.The economy revives when MEC revives. A ray of optimism appears when the prospectof profit revives. The excess stock of consumer goods is exhausted and growing scarcityof consumer goods lead to higher profit expectation.Anti Cyclical PolicyGovernment of a country may take some measures to control cyclical fluctuations. Through anexpansionary or contractionary credit policy the central bank can control business cycle. Raisingthe rate of interest in boom and lowering it in depression by reducing the volume of investmentor encouraging it may reduce the swings of a trade cycle. This may not happen in real life.Even with a low interest rate, investment may not be promoted if expectation of profit is weak.

If, on the other hand, expectation of profit is quite high, businessmen will borrow for investmentdespite higher interest rate.A contra cyclical fiscal policy can be used to eliminate trade cycle. In a period of depressiongovernment should spend more and tax less with the object of increasing effective demandthat is buying power of people. In prosperity phase government should spend less and taxmore so as to leave less in the hands of people. Keynes advocated deficit spending for a depressionaryeconomy.The socialists think that cyclical fluctuations are the outcome of a capitalistic economy whereprofit motive is the main driving force. The problem can be uprooted if the system move fromcapitalism to socialism with state ownership of the means of production.Economic GrowthDefinitionBy the term economic growth is meant the expansion in the capacity of an economy to producegoods and services over a period of time. It implies an outward shift of production possibilitiesfrontier of an economy showing the different maximum possible combinations of quantities oftwo goods if it employs all its available resources full and given the existing state of technology.MeasurementDifferent methods have been suggested for measuring economic growth. One measure is acountry’s over all capacity to produce goods and services. The money value of GNP can changebecause of change in price. Hence it is necessary to measure economic growth rate by usingconstant Rupees, or real income.An increase in real GNP if followed by a higher rate of growth of population may lead to adeterioration or no change in the standard of living of the population. The problem can beovercome by raising per capital national income. Secondly, if GNP increases owing to an increasein arms and ammunitions, ships, engines etc. the quality of life of people would remainthe same. Thirdly, an increase in GNP may not help growth if its not distributed fairly andequally. Fourthly, if increase in GNP is achieved by more efforts and exertions on the part ofthe labour force then welfare is likely to diminish.Real GNP per capital = Real GNP/ Population

If the numerator (GNP) grows faster then the denominator (Population), real GNP per capitawill grow and quality of life will improve. On the contrary, if GNP grows at a rate lower thanpopulation, real GNP per capita goes down. But changes in real GNP per capita does not tell usany thing about distribution of income or the quality of goods and service that compose GNP.

Components of Economic GrowthThe growth of economy’s total output depend generally on four components(1) the size of the population (P)(2) fraction of population that constitute labour force L/P (L = PX)(3) the total number of labour hours actually worked by the labour forceL into x H = P x L/P x H(4) Output per labour example labour productivity.This is equal to total output Q divided by the total number of Labour hour example.Q/(L x H).Thus the economy’s full employment total output Q may be expressed asQ = (L x H x Q)/(L x H)(a) Population : Population helps economic growth by enlarging demand on theone hand and paves the way for producing large quantity of output on the other.(b) The fraction of total population engaged in productive activities constitutesLabour force. Obviously if this proportion (L/P) is high more will be productivecapacity of an economy and vice versa.(c) The length of the average work hour of the labour force generally seems to havea direct impact on the rate of economic growth. It may also be argued that adecline in the average work-week may indicate a good life provided by economicgrowth.(d) Growth in productivity is said to be the primary element of economic growth.Productivity that is, output per labour hour has a direct bearing on the level ofGNP. The more productive labour, the more will be the total output of an industry.Economic history of different developed economies support this contention.Labour force acquires skill through proper training and education, andalso on the quality and quantity of capital as also the technology.Relation between Stability and GrowthIn the 30s, the committee on Finance and Industry in England spoke of “avoidance of the tradecycle” and the “stability of the price level” as the goals to be pursued by the Bank of England.These works are as true today as they were when uttered in 30s.Indeed financial stability is essential for economic growth. First, if a country’s currencyis not stable, people will be much reluctant to save for fear of further fall in the value ofcurrency. Such slowing down of savings would tend to retard progress.Secondly, a stable economy can help the formation of capital by stimulating the inflowof foreign capital.

Stability of currency, thirdly, is necessary to stimulate a rapid increase in productivity.If prices are not stable, firms can make ‘easy’ profit and repay their old debts indepreciated currency. This is likely to depress businessman’s incentive to innovate, thedesire to take risks and such other finer qualities of business enterprises. But in a situationof financial stability firms can no longer make that ‘easy’ profit. They are compelled toimprove their methods of production and over all organizations.Finally, the existence of well-organised financial institutions is likely to quicken economicgrowth by mobilizing savings for investment purposes. These institutions thrive in aclimate of financial stability.

Study Note - 4THEORY OF EMPLOYMENT4.1 LABOURDefinitionLabour is an important ingredient of production. Without labour, the other factor inputs cannotbe activated Labour helps production in two ways – As a producer and as a consumer. Thingsare produced because they are consumed. Labour is defined as “any exertion of body andmind undertaken wholly or partly with some object other than the pleasure derived from thelabour itself”. Thus labour includes both manual and intellectual, and the exertion of body ormind should be not for pleasure but for earning money.Features of Labour –Labour as a factor of production has some characteristics that distinguish it from other factors.Labour is a perishable factor. A day’s labour lost cannot be recovered. Hence the workers oftenare exploited because they cannot preserve their labour power for future.Secondly labour cannot be separated from labourer. Labour sells his work and he himselfremains his property.Thirdly labour is a mobile factor. Apparently workers can move from one job to another orfrom one place to another. But, in reality there are many obstacles in the way of free movementof labour from job to job or from place to place.Fourthly highly skilled labour are specific factors while highly unskilled workers are nonspecificin the sense they can be used for any type of manual work.Another feature of labour is that the supply of labour in terms of hours of work decreases whenwage rates are high. For this the individual supply curve of labour is backward bending after apoint. Thus while the supply of commodities increases when their price rises, the individuallabour supply (in terms of hours of work) decreases with an increase in the price of labour.4.2 POPULATION THEORIESA. Malthusian Theory of Population Growth

In 1978, Thomas Robert Malthus expressed his views on the population growth in his “Essayon the Principle of Population”. His arguments on the pattern of population growth in aneconomy are as follows :(1) In any country, total population grows at a faster rate than the total food grainproduction. According to him, the production of foodgrains increases at anarithmetical progression (example., 2,3,4,5,6 etc.) while population grows in geometricalprogression (example., 2, 4, 8, 16, 32 etc).(2) Within a short period, the total population becomes larger than the size of thefoodgrain production example., foodgrain production per capita comes down to a lowlevel. At this stage, the country is said to be overpopulated.The signs of such overpopulation, according to Malthus, are as follows :(a) Large-scale poverty;(b) Large-scale starvation and malnutrition; and(c) Emergence of various diseases and epidemics.He also believes that this excess pressure of population is automatically reduceddue to some natural calamities like floods, droughts, wars etc. In this way, the naturethrough its own forces, tries to maintain a balance between the population andfoodgrains productions. These are called positive checks. Malthus also believes thatthe people should also take some preventive measures to check such growingpressure of population. (For instance, population control methods, prevention ofearly marriage etc.), These are called the preventive checks.Malthus’s doctrine is illustrrated below :Malthus Theory of PopulationCritical Evaluation :The population theory of Malthus has been criticized from different angles.(1) Population may not grow in a geometrical progression : Many economists are of theview that population may not grow in a geometrical progression. In fact, populationof different developed countries of the world has increased at a slow pace duringthe late 19th and 20th centuries. Thus, there is an interdependence between the levelof economic development achieved and the population growth in a country.(2) Law of diminishing product may not be operative : Malthusian theory shows that theproduction of foodgrains in a country grows in an arithmetical progression. Theimplicit logic behind such argument was the operation of the law of diminishingmarginal productivity. That is to say, given the supply of cultivable land, growingpopulation pressure on land leads to an increase in production at a decreasing rate.However, this law of diminishing product may not be operative if better seeds,fertilizers, irrigation, agricultural implements, etc. are introduced in agriculture.Population increases ina GP - 1,2,4,8,16,32........Food increases inAP - 1,2,3,4,5,6,........Imbalance leads tooverpopulation

Corrected byPreventive Checks - latemarriage, moral restraint etcPositive Checks - misery,war, famine, flood etcThus, the Malthusian theory has not taken into account the technological revaluationin agriculture.(3) Growth rate of foodgrains production may be higher : The rate of growth of populationmay not be greater than of foodgrains production in a country. For instance,population of India has increased by about 185 per cent during 1951-2001, butfoodgrains production of India has increased by about 258 per cent during the saidperiod.(4) Increased supply of labour facilitates economic growth : The population problem ofa country should not analysed only in terms of foodgrains production. Increasedpopulation not only raises the demand for foodgrains, but also the supply of labourin a country. If this labour force can be made more skilled and educated then theycontribute to the growth of total output in the country to a great extent. If the countrycan produce different export items then the country would be able to import evenfoodgrains from abroad, because the import bill can easily be met from the exportearnings.(5) Overpopulation is not the only cause of poverty : Growing incidence of starvationmay not be the only indicator of overpopulation. This theory shows that a situationof overpopulation is only responsible for such growing incidence of poverty andstarvation. But, inequality in the distribution of income and wealth can also createsuch a situation.B. Optimum Theory of PopulationIn 30’s a new theory of population was worked out which is known as the OptimumTheory of Population. The core of the theory is a concept called “Optimum Population”. It washeld that for every economy there is an optimum level of population growth. IT is the levelwhere ‘maximum returns’ can be obtained. The Optimum Population simply is the size ofpopulation that a country can support without any stress and strain. Thus in this theory thedanger of over population was considered not in the context of food supply but the total wealthof a country. The test of over population or under population were not the shortage or surplusof foodgrain but the maximization of national wealth and welfare.If at any time the actual population of a country exceeds its optimum point the country willface different economic problems and its returns will be less than maximum. On the otherhand, if the actual population is less than optimum, National output will also be less because of

under-utilisation of productive capacity. Only when actual population is equal to optimumpopulation that the country will enjoy the greatest good of the greatest number.A formula for estimating deviation of actual population from the optimum has been suggested.It isAn economy is said to be under populated if A < O and Overpopulated when A > O. Onlywhen A = O that resources of the economy are used in the best possible way to secure thehighest possible return for manpower.One feature of this Theory is that unlike Malthusian theory it is not pessimistic about the growthof population. The Theory highlights the fact that population may help or hinder economicdevelopment of a country depending upon the availability complementary resources. Furtherunlike Malthusian theory, it is not narrow. It does not consider the growth of population withthe growth of food supply. Instead it considers demographic growth with the growth of nationalresources as a whole. Moreover the Theory is important in another respect. It suggests thatunder population is as much harmful as overpopulation for a country. Malthus only consideredthe dangers of overpopulation ignoring the case of under population. The Rich countries of theWorld are nowadays suffering from the problem of under-population and this is one of thevital reasons for which they cannot fully utilize their productive capacity.The most important problem of this Theory is that it is very difficult to ascertain what is theoptimum number of population that a country can support. Even if the optimum can bedetermined, it will vary from time to time because of any change in the resource composition,technology, trade of an economy so the concept of optimum as envisaged in this theory is nota static one. It will vary from time to time and from country to country. Further the termOptimum may be interpreted in many ways. It may mean the size of population that maximizesthe average product or income per head. It may also mean the size of population that maximizesnet social welfare or it may mean the size of population that maximizes total product. Thetheory however considers Optimum Population as the maximum population that is supportablewith existing resources of a country.C. Theory of Demographic Transition

Almost all demographers (who study demography or population theories) and social scientistsagree that population growth in every country passes through many stages. Each stage has itsown peculiarity. This theory indicates that particular types of demographic phases are associatedwith particular stages of industrialization. On the basis of the economic history of many countriesof the world, this theory wants to establish that movement of a country from a traditionalagricultural system to a highly industrialized urban economy, also signifies its travel from astage of high fertility (and mortality) to a state of low fertility (and mortality).According to Prof. O.P.Walker, there are five stages of such demographic transition:1st Stage : At this stage, both the death rate and the birth rate remain very high, but theformer exceeds the latter. As a result, population does not increase to a greatextent. This is called a high stationary stage.2nd Stage : At this stage, the birth rate does not come down but the death rate starts fallingdue to improvements in health facilities. As a result, population increases rapidly.This is called an early expanding stage.3rd Stage : Both birth and death rates decrease at this stage. Though the birth rate exceedsthe death rate, the distance between them becomes less. This happens when thecountry attains a certain level of agricultural development and steps towardsurbanization. This is called the late expanding stage. Here the population sizegrows slowly.4th Stage : At this stage, the death rate reaches its lowest and at the same time birth ratealso comes to a low level. Growth in population becomes stagnant. But, unlikethe first stage, it is called low stationary stage.5th Stage : At this stage, the death rate becomes more than the birth rate, and it may beregarded as a declining stage.While reviewing these stages, Prof. Thompson and Notestein opined that the first andfifth stages were unusual. According to them, only the three intermediate stages arerelevant. They named these three intermediate stages (viz., the second, the third and thefourth stages) as the pre-transition stage, transition stage and post-transition stagerespectively. The explanation of Karl Sax about the demographic transition also showsfour stages of such transition also shows four stages were similar to the explanation givenby Walker about the first four stages of transition in his own theory.In Fig. -2, the time paths of birth rate and death rate have been shown. Population growth is

determined by the gap between these two curves. The first stage (stage I) of demographictransition becomes visible up to the time period To. Similarly, the second (stage II) and the third(stage III) stages of demographic transition are discernible within the time horizon ToT1 andT1T2 respectively. Let us assume that points X and Y represent two countries having the samecurrent rate of population growth (example., AB = CD). But, it is observed that, incase of country Y,population growth will soon slow down because the falling death rate has almost reached itsminimum and has been accompanied by a falling birth rate. However, in country X, thepopulation is expected to rise in future because of the increase in the gap between birth rateand death rate. Thus, two countries having the same observed population growth rate at present,may indicate radically different future prospects.4.3 UNEMPLOYMENTEmploymentThe classical economists were not very much concerned with employment or unemployment.It was because they believed in Say’s Law. J.B.Say’s law stated that ‘supply creates its owndemand’ that is every good produced in the market is born with a demand tied round its neck.From the law follows that there can never be more than frictional unemployment or sectionaloverproduction. It was believed that private enterprise would always employ all availablefactors of production, provided prices and wages were sufficiently flexible. Thus they ruledout the possibility of general over production, as the demand for all goods taken together willalways be sufficient to sell them. If it is so, restricting of output in general is not necessary. If ageneral over supply is impossible, production will continue upto the point where all factorsare fully employed. It was the logic underlying the assumption of full employment.The classical economists also believed that one man’s income depended on another man’sexpenditure and that if some people refused to spend a part of their income, the real resourcesleft over by the former would always be used by some businessman for the creation of capitalequipment. In other words, what is saved is being automatically invested.In mid 30s the classical conclusions regarding employment were criticised by Keynes and his

followers. At times, there may be deficiency of aggregate demand in the society arising out oflack of purchasing power in the hands of the people. In such a situation supply cannot createits own demand. It can create demand but not effective demand. So excess produce may existwith unsatisfied demand. Demand deficiency may thus throw an economy out of fullemployment. This happens in a situation of depression.

Kenesian Theory of EmploymentAccording to Keynes the aggregate volume of output, during a certain period, depends on theeffective demand of the people. Effective demand of the people depends on total expenditurefor goods and services. The total expenditure is formed of consumption expenditure andinvestment expenditure. Total expenditure is equal to total income.Hence, Y = C + I.The total of consumption and investment expenditure determined of output and employment.Hence the determinants of consumption and investment are the determinants of output andemployment.Consumption expenditure means spending of money for purchasing goods and services forutility. Investment expenditure, on the other hand, implies spending for new capital asset.Consumption according to Keynes depends upon objective and subjective factors. Income isthe most important factor influencing consumption c = f(y). The definite relation that existsbetween income and consumption is known as Consumption Function. When income increasesconsumption expenditure also increases but not by full amount. In other words, consumptionis less than unity (c<1) but greater than zero (c>0). That part of additional income people do notspend for consumption is their savings. Therefore dY = dc + ds.Not only does current consumption depends on current income but on past savings as well.Investment FunctionInvestment expenditure is normally business sector’s expenditure with the aim ofsecuring profit. Expected profitability of a given dose of investment depends on themargin between Return from and cost of investment. The cost of investment is the costof credit viz. Rate of interest. The volume of investment varies inversely with rate of

interest (r).Unemployment - Causes and FormsUnemployment arises when even with the willingness to work at the currentwage, people are unable to get a job. It is involuntary in nature. Unemployment may be voluntaryalso when a person is unwilling to work (idle rich) or unable to work at the current wage rate.According to classical economists, the main cause of unemployment is rigidity of wages. Ifwages were sufficiently flexible, all people will be employed. A general wage cut is what theyprescribed for achieving full employment or near full employment. Like the price of anycommodity, if the price of labour falls its demand will increase. Logically it follows that,according to classical writers, all unemployment is voluntary because man is not willing toaccept current wage as being too low.Lord Keynes views on unemployment can be explained by his general theory of employment.Employment depends upon effective demand made up of consumption expenditure andinvestment expenditure. A deficiency of demand due to fall in expenditure (C + I) will cause afall in output and employment. When the deficiency is high, the economy will experience largescale unemployment and depression, as happened in the 1930’s Great Depression. Keynesadvocated more government investment to overcome the shortfall in private spending that is,deficiency of demand.As has been stated earlier people are said to be unemployed when they remain jobless despitetheir eagerness to work at the current wages. Although there are general explanations for thisstate of affairs, there are specific reasons for various forms of unemployment as well.In agricultural economies, one may find seasonal and disguised unemployment. Crop cultivationis a seasonal occupation. A particular crop is grown during a particular season and notthroughout the year. So after harvest, men are thrown out of employment till the next season.Two broad causes of such unemployment are (i) single cropping (ii) no off-season employmentopportunity.Besides agriculture, this type of joblessness can be found in some non agricultural activities aswell where demand is of a seasonal nature or it varies erratically (woolen goods, umbrella,

dock labour). The seasonally unemployed men may take up some other non farm job for the offseason. A farmer, for example, may make mat or basket when there is no pressure of cropcultivation.In traditional agriculture, another type of unemployment can be seen. It is disguisedunemployment causing much harm to poor economies. It implies that a large part of theworkforce engaged in agriculture could be removed without reducing total output. It isapplicable in case of family farming where all family members (that multiply generation aftergeneration) grip a given plot of land and if some of them do not participate total productwould not diminish. In other words, many members marginal contribution or marginal productis zero. They are surplus labour.The causes of such joblessness are –(a) family farming(b) existence of surplus labour(c) lack of alternative job facilities.The growth of capitalist sector can absorb such surplus manpower. And rural developmentactivities initiated by the government can also eradicate this type of unemployment.Industrial nations face generally two types of unemployment; technological and cyclicalTechnological unemployment arises out of a change in the techniques of production from labourintensive to capital intensive. Further the industrial sector also faces a type of unemploymentcalled cyclical unemployment. In times of recession and depression industries experience a fallin the volume of production. Therefore the demand for labour also decreases. Even some of theworkers already employed are thrown out of employment. Another type of unemployment isFrictional unemployment. Such unemployment happens when the workers leave one job toget a better one. So it is also temporary. There is also Natural rate of unemployment that everycountry faces. Some men everywhere remain jobless for some reason.4.4 THE CONCEPT OF FULL EMPLOYMENTThe concept of Full employment has been variously defined by different writers. Sir WilliamBeveridge has defined it as having always more vacant jobs than men. Lord Keynes says it theabsence of involuntary unemployment. So defined, the concept of full employment is compatiblewith

(a) voluntary un employment,(b) frictional un employment.Thus a full employment economy is one which has the minimum of involuntary un employmentin transition from one job to some other. It implies a situation whereby the labour markettransforms from a buyers market to a sellers market.The Policies for achieving Full EmploymentThe classical economists believed that an economy achieves full employment automatically. Ifsupply creates its own demand, as stated by Say, an stated by Say, an economy can go onproducing till all factors are fully absorbed, provided wages and prices are flexible. Thus generalover production and unemployment were ruled out. A state of full employment was supposedto be inevitable. There may be under employment equilibrium. It is the level of income (OY1) intotal income is equal to total expenditure of goods and services (Y = C + I). A M, C + I curveintersects the 45o curve. That is equilibrium point but at that level of income, the economy isunder full employment.Then, how to achieve full employment? Graphically if C + I curve shifts upwards and intersectY = C + I curve at a point (P) that level of income (OY2) all labour may be fully employed. It ishow full employment may come about (see graph 4.1)It thus appears that the way to achieve full employment is a constant increase in total expenditure(C + I) whose deficiency keeps an economy at less than full employment. Any policy for realizingthis goal should attempt to raise total spending. When private spending for consumption andinvestment goods are inadequate, the government is called upon to play a more positive roleexample. to spend more by printing new money.Role of GovernmentA vigorous “monetary fiscal mix” example., a combination of monetary policy and fiscal policy isessential for lifting an economy from depression and unemployment to full employment.Anti cyclical monetary policyIt is formulated by the Central bank. It is known as Cheap Money Policy. Money is said to be‘cheap, when it can be obtained at a very low rate of interest. If liquidity preference functionremains unchanged, an increase in total money supply (cash + credit) will go to reduce interest

rate. Naturally investment expenditure of the private sector will go up. A fall in interest ratewill lead to a rise in price of bonds, securities etc. This will increase household sector’s investmentin financial assets too. The Net National Product, in effect, will go up. Increase in money supplymay continue till NNP reaches the full employment level.So long there are unemployed factors, injection of more money will lead to an increase inoutput and employment. Investment of created money will activate the idle factors. In this wayonce the economy reaches full employment zone, any more increase in money will lead toinflationary price rise. At less than full employment, investment may activate idle resources.So an increase in NNP. But at full employment there lies no such scope.Thus an increase in investment may generate an ‘output effect’ at less than full employmentsituation and ‘price effect’ after (or at) full employment level of output.Fiscal PolicyGovernment’s tax and expenditure policy for realizing the goal of full employment iscompensatory in nature. It seeks to compensate the shortfall in private spending (C + I) whichis supposed to be the cause of deviation from full employment. Fiscal policies need to be twoedged – taxing less and spending more. Taxing less is same as ‘leaving more in the hands of thepeople’ so that they can spend more. Expenditure by government for public works or welfareactivities may raise private effective demand, also.The new and excess government outlay injected into body economy may generate an incomemore than the initial sum pumped in. Hence, Keynes advocated creation of “new” money bythe government. The easiest way to do so is to borrow money from central bank against itssecurities. This method is known as Deficit Spending.Limitations1) It may retard private investment. Easy and cheap credit may be harmful to thebusiness sector as they will find no incentive to raise resources internally.2) More spending by the government may raise the effective demand of ‘few’ and theeffective demand of many may remain unchanged. So the character of effectivedemand is as important as its level.3) A vast public expenditure may not achieve full employment of labour for shortage ofsome complementary resources like technical personnel, foreign exchange etc.4.5 CAPITALDefinition

Unlike Land and Labour, Capital is not an original factor of production. It is said to be a producedmeans of production. It is means of production produced by labour on resources supplied byNature. As a factor of production, Capital thus depends upon both Land and Man. It is knownas producers’ goods – goods that help further production.In a broad sense, Capital implies physical goods like machines and tools that render repeatedservice in production. It also means money capital and debt capital consisting of equity andbonds which yield income. Thus capital includes all those physical and financial assets thatyield an income or aid the production of income. Man invests in Capital assets for the sake ofobtaining income repeatedly. Nowadays man is also considered as a sort of capital. Just asphysical and finance capital brings income after their owner invest fund, so also investment inhuman capital in the form of education makes a man skilled worked and he earns morerepeatedly.As an agent of production capital increases the productivity of labour. Man can produce morewhen he uses sophisticated machines and tools. Not only does its use raise the volume ofoutput but secures continuity in production also. Further the use of capital makes production‘round about’. Labour first produces capital goods like machines and tools and then with thehelp of such goods, consumption goods are produced. Capital helps in bringing about continuityin production.Growth of CapitalPhysical Capital and Financial Capital are essential for production. The more the stock of capital,the more will be the volume of production in an economy. This highlights the need for thegrowth of capital in a country.Capital grows out of savings. It implies generation of surplus – a surplus of income overconsumption. The size of the surplus that forms capital is the difference between current incomeand current consumption. Therefore the growth of capital depends on the size of income andthe proportion of income spent for consumption.Surplus is generated from household sector, corporate sector and the Government sector. Ofthese the role of the household sector in generating surplus is very much important in most of

the countries of the world.Saving may be of three types—voluntary saving, involuntary saving and forced saving Generallythe households save a part of their current income voluntarily in the sense that they may notsave it also if they so like. Some times savings becomes involuntary. In a period of inflation, asprices of goods used by household increases so with their fixed income they can now consumeless than before. Naturally there is saving but it is not voluntary. Thirdly, people are forced toreduce consumption out of a given income if a large part of the income is taken away by theGovernment in the form of direct taxes. It is the case of forced saving.Saving of the house hold sectors are related to family income and family consumptionexpenditure. It is only when people abstain from current consumption, that they are able tosave and such saving helps the growth of capital. The propensity to save of the householdsector depends upon a variety of factors. The business sector also creates surplus. The surplusof the capitalist sector is reinvested in physical assets for further production and employment.According to Lewis the growth of capital is low in poor countries not because their people arepoor but because their capitalist sector is so small. Growth of capital thus depends upon thegrowth of large scale industries that generate large amount of surplus for further investment.4.6 CAPITAL FORMATIONCapital formation means the process whereby a nation creates capital assets that generate acontinuous flow of income in future. The creation of such capital assets involves large scaleinvestments and such investable resources come from surplus. Thus the essence of capitalformation is creation of surplus or savings. Surplus generation is possible only when the nationdoes not use the entire production for current consumption but keeps a part of it for futureproduction thus capital formation needs current sacrifice for future prosperity that is to-day’spain for tomorrow’s gain.In a word Capital Formation is the process of creation of savings and its productive investment.In a wider context the formation of capital thus not merely means the growth of savings andinvestment but a qualitative change in man’s attitudes and motives that may help development

in the long run. Prof. W.W. Rostow opined, “capital formation is not merely a matter ofmaximizing profit. It is a matter of a society’s effective attitude towards science, applied science,risk taking as well as the adaptability of the working force”. Thus capital formation has aquantitative as well as a qualitative aspect. The former is the growth of investment resourceswhile the latter involves a qualitative change in human resources.Steps in Capital FormationCapital formation is a long drawn process. It passes through three important stages.The first step in Capital formation is Creation of Surplus. Simply speaking, creation of surplusmeans increasing the ratio of saving to income. Out of a given income a country should savemore if it want s to generate surplus. Savings can be increased in two ways.1. If the level of personal income increases some increase in savings is quite natural.2. Saving can also increase if people abstain from current consumption to a largerextent.While the ability to save depends upon the size of a man’s income, his family liabilities, hisstandard of living etc., it also depends upon his willingness to save. The willingness to save isinfluenced by some personal qualities that motivate a man to save and these motives may varyfrom person to person.Not only the household sector but also the corporate sector and the public sector can contributeto the creation of savings. A Budgetary surplus is an important source of surplus generation inthe Government sector. The private corporate sector too can contribute to surplus generation ifthey operate with efficiency. Thus the most important condition for Capital Formation is Creationof Surplus.The second step is mobilization of the surplus created. It implies the surplus resources shouldbe activated and they should not remain idle. Mobilisation of savings depends upon the financialnetwork of an economy. Banks and other financial institutions play an important role in themobilization process. These institutions collect the surplus from the surplus units and lendthem to the deficit units like businessmen, industrialists, traders etc. who are in need of fund.Thus they play an intermediary role connecting savers with the users of capital. The Financialsystems can mobilize capital actively if they are safe and sound. The interest rate they offer

may induce people to save more and to deposit it with the financial institutions. Thus thefinancial system of a country plays an important role in capital formation.The last step in capital formation is effective investment of the surplus. Funds offered by financialinstitutions are taken by those who invest them with the object of earning income, frominvestment of such funds in trade, commerce and industry. If the borrowed fund is used forunproductive and speculative purposes, it may bring windfall profit but without helping thecreation of capital assets for future income. Such investment is not desirable. What is essentialis that money must be invested for productive purposes – purposes from which the investorcan get a continuous earning over a period of time.

Study Note - 55.1 MONEYDefinitionMoney may be defined both broadly and narrowly. In a wider context money is what moneydoes. It means that anything that performs the functions of money may be said to be money.This requires a discussion of the essential functions of money.In a narrow sense it is defined as medium of exchange or payment whose acceptance the lawrequired in discharge of debt may be called money. From this definition it follows that moneyis a medium of exchange. With the help of money any exchange of goods and services can takeplace. Besides this another feature of money is its general acceptability as a means of payment.The thing considered to be money must be accepted by all parties for transaction. Lord Keyenshas emphasized another feature of money. Among all the assets of a man money is said to bethe most liquid asset as it readily passes from one hand to another easily. Because of its general

acceptability and because of this liquid characteristic of money, people prefer to hold it. Keynescalled this liquidity preference.Generally money is created by the Central Bank or by the Government of a country. These areknown legal tender money because there is legal compulsion for their acceptance. Such moneyis also called Cash Money. Besides cash money in a modern economy there is a considerableflow of Credit Money. Such money is created by the commercial banks by their loan transactions.These two together constitute the total monetary resources of a country.Functions of MoneyThe functions discharged by money are many are varied. They may be classified as static anddynamic functions. The static functions are follows :Money is a matter of functions fourA medium, a measure, a standard and a Store.(1) Medium of Exchange – Money everywhere acts as a common medium of exchange.A man earns money not for its own sake but to purchase required goods and servicesin exchange of it. Thus in an exchange economy money has an intermediary role. Ina barter economy, goods were exchanged for goods. But such direct exchange systemencountered many difficulties. The origin of money lies in the inconveniences ofthe barter system. The invention of money has made the exchange system smoothand convenient.(2) Measure of value – Money measures exchange value of goods and services. Thingsare said to be cheap or expensive on the basis of amount of money required for theirpossession. This makes exchange mutually profitable.(3) Standard of deferred payment – Money as a standard of deferred payment impliesthe role of money in borrowing and lending. Money taken as loan is usually repaidafter a time gap. This delayed payment is done through money.(4) Store of value – Money gives a man command over goods and services because ofits purchasing power. This purchasing power of money can be stored by keeping apart for future use. Not being perishable, value of money can be preserved for along time. Simply this function implies monetary savings. Current income can beused for current consumption as well as future consumption by savings.Money plays a dynamic role in a modern economy. It lubricates the wheels of trade andcommerce. Money is the life blood of industry. Money activated idle resources and putsthem into productive channels. It thus, helps in increasing output, employment and income.

Moreover money helps in converting savings into investment. Excess money income of thepersonal sector can be used by the business sector for purchasing inputs. It is Real investment.Besides, governments of modern economies can spend more than what they can. This bycreating new money. Money, thus, is a potent factor in making governments’ economicgoal more varied and dynamic. Like production, money helps in the distribution of nationalincome among different classes of people. The power or purse is that it gives a man commandover goods and services. In a word, money has made production, distribution and exchangesystem dynamic.Money is one of the assets possessed by a man. It is a valuable thing and its value lies in itspurchasing power. Value of money means Exchange Value – how much of goods andservices can be obtained in exchange of a unit of money. Suppose price of a book is Rs. 10.Then value of Rs. 10 is a book and value of a unit of a money (RE. 1) 1/10. In other wordsvalue of money is inverse of price (1/P). So when price level increases, the value of moneydecrease and vice versa.What we stated above is internal value of money. But money has its external value too. Itmeans how much foreign currency can be obtained in exchange of a unit of domesticcurrency. It is the foreign rate of exchange. So while internal value of money is expressed inphysical terms, its external value is expressed in terms of foreign exchange.Forms of MoneyThe total money supply of a country can broadly be classified into two groups—Cash Moneyand Credit Money. Besides it also includes all other financial assets. But the degree ofmoniness vary widely from asset to asset. Hence, it is necessary to discuss the componentsof money supply.Paper Money and CoinsPaper Money and Coins known as Currency is issued by the Central bank or Governmentis the most important component of the money supply since they have cent per centacceptability as a means of payment. Their acceptability is based on a ‘promise to pay bearer’gold and foreign exchange in exchange, if necessary.

Equally important is Demand deposit with commercial banks. A bank is legally bound topay money on demand. Currency and demand deposits can be used for almost alltransactions much more easily than any other asset. Hence their ‘moniness’ is highest.The other components of money supply consist of Near Money or money substitute. Thewell known near money is bank cheque (savings account). A bank cheque is a means ofpayment for transaction. If it is accepted it is as good as currency. But cheques may not beaccepted because there is no legal compulsion behind their acceptance as that of currency.Hence they cannot be said to be money proper.Less liquid than savings bank deposit is the Term deposit of different maturities. Theycannot be used before a fixed period say six months or five years.Other forms of financial assetsOther forms of financial assets issued by non-bank financial intermediaries (NBFI) have‘moniness’ but they are not so much liquid as bank deposits are. Mortgaging units of UTI.Insurance Policy etc. one can have a car or building. But such transactions are rare anddifficult. It is easier to get them by paying bank cheque or currency.As a means of payment, currency is most popular yet bulk of financial transactions aredone by bank cheque. This is because is case of high valued goods like car, land, jewelleryetc. payments are made by cheque instead of currency.5.2 GRESHAM’S LAWThe Law states that bad money drives good money out of circulation. This is true in case ofbimetallism where two metal standard (gold and silver) operate side by side. In such a caseone metal currency drives the other out of circulation. If also means cheap money drivesout dear money. If a country uses both paper money as well as metal money, people willuse the paper money and hold the metal money.5.3 QUANTITY THEORY OF MONEYThe theory seeks to explain the relationship between money supply and price level. IrvingFisher used an equation to show that the relationship between money supply and pricelevel as direct and proportional. It means money supply and price level move in the samedirection and at the same proportion.Fisher’s equation is MV = PT...................(1)

M stands for total Money Supply, V means velocity of circulation money which implies theaverage number of times that a unit of money changes hand during a particular period, P isPrice level example. average price of GNP. T is Total National output.The equation seeks to explain the proportional relation between M and P. That is to say, ifin an economy M increases 5 fold, P will also increase at the same proportion. In otherwords the rate of change in money supply (dM/M) is equal to rate of change in P (dP/P).The proof is : -M1V = P1T..................(2)M2V = P2T................(3)Now deducting equation (3) from equation (2) we obtain(M1 – M2) V = (P1 – P2) TdM.V = dP.TDividing both sides by MV we obtaindM.V/MV = dP.T/MVSince Fisher’s equation states MV=PTThus dM.V/MV = dP.T/PTOr, dM/M = dP/PGraphically the curve showing the relation between M and P will be a 45 degree line passingthrough the origin.MoneyFisher’s theory is based upon three assumptionsThe relation between M and P will be proportional only when there are no changes in thevalue of V and T example. V and T are constant variables.(a) Velocity of circulation of money depends on the spending habit of people. Spendinghabit of people is, more or less, stable. Hence V will be constant normally.(b) T or GNP will be constant in situation of full employment when all the availablefactors of production are fully employed. At less than full employment, more moneywill lead to more output by utilizing unused factor. Hence P will not rise.(c) Fisher’s theory assumes that money is demanded for the transaction purposes only.People spend their entire income instantly for transaction.Criticisms(a) Fisher’s equation is abstract and mathematical truism. It does not explain the processby which M affects P.(b) It is presumed that entire M is used up in buying T instantly. It is unreal. No onespends all money the moment he earns it. Keynes pointed out that money isdemanded for transaction purposes, precautionary purpose and also speculativepurpose. Fisher does not explain the last two roles of money.(c) The concept full employment is myth. There is what is called Natural rate ofunemployment in every country.(d) Even with full employment, a country can rise national output by bringing those

factors which are not available within economy from abroad.(e) It is presumed that money is used for transactions only. Hence the theory is oftenreferred to as Cash Transaction Theory. This ignores the other roles of money.Q.T.M. Cash Balance ApproachThe Cash Balance Approach states that it is not total money but that portion of cash balancepeople spend that influences price level. True people hold cash balance in their hands insteadof spending the entire amount all at once. The new equation is M = PKT. Here the proportion ofM that people use for purchasing T influences P. PK constitutes demand for money and M ismoney supply.Fisher’s Quantity Theory of Money differs from the Cambridge Equation in some respects.Firstly, in the Fisher’s version demand for money is to exchange goods. People demand moneyfor transactions only. In the Cambridge version the demand for money is primarily as a store ofvalue. Secondly, Fisher explains the value of money for a period of time, while the CambridgeTheory considers it at a point of time. Thirdly, in the Fisher’s version emphasis is on velocity ofcirculation of money while in the other theory the emphasis is on idle cash balances representinga part of the total income. Velocity is the exact opposite of idleness.The Quantity Theory by KeynesKeynes reformulated the Quantity Theory of Money. In his opinion the quantity of moneydoes not directly affect price level. But it does so indirectly through a long process of event. Achange in the quantity of money may lead to a change in the rate of interest. With a change inthe rate of interest the volume of investment is quite likely to change. A change in investmentwill lead to a change in income, output and employment and also a change in cost of production.This will lead to the change in prices of goods and services. According to Keynes the basicweakness of the orthodox quantity theory is that it fails to pay adequate attention to the influenceof money on the rate of interest and the consequent influence on output and employment.Thus the Keynesian version of the Quantity Theory integrates monetary theory with the generaltheory of value. The value of money is not determined solely by its supply but by all othervariables in the economy.5.4 INFLATION

DefinitionGenerally when price level of an economy goes on rising continuously it is known as inflation.So the symptom of inflation is rising price level. More precisely it is Open inflation. But aneconomy may suffer from inflation without any apparent rise in prices. This is Repressedinflation. Inflationary forces are being repressed by policy measures. According to classicalwriters inflation is a situation when too much money chases too few goods. In other words it isan imbalance between money supply and Gross Domestic Product. Whereas according to Keynesinflation is an imbalance between aggregate demand and aggregate supply. In an economy ifthe aggregate demand for goods and services exceeds aggregate supply, then prices will go onrising.CausesThe primary causes of inflation may arises from either demand side or supply side. Accordinglywe find two types of inflation.Demand PullDemand pull inflation is a situation when in an economy aggregate demand exceeds aggregatesupply. Aggregate demand may increase due to an increase in money supply, or money incomeor public expenditure. The idea of demand inflation is associated with full employment whensupply cannot be altered.Cost PushInflation may originate from supply side also. Aggregate demand remaining unchanged, a fallin aggregate supply due to exogenous cause, may lead to increase in price level.Price is related to cost. If cost rises price are bound to increase. The cost structure may risebecause of –(a) wage increase not associated with productivity rise,(b) rise in profit margin(c) high import price(d) shortage of essential inputs.Often inflation is caused by structural maladjustment and unbalanced growth of the differentsectors of an economy. A faster rate of growth of the industrial sector and a very slow growthof the primary sector may lead to an increase in food prices which may ultimately lead to anincrease in the general price level. This is called Structural Inflation, which is generally foundin the less developed countries of the world.

Let us now discuss in detail the various causes that may bring about inflation. Since inflation iseither of the demand-pull or of the cost-push type, it is obvious that these causes always havesomething to do with either an increase in aggregate demand or an increase in aggregate demandor an increase in cost of production.(1) Increase in public spending : Spending by the Government is an important part oftotal spending in any modern economy. It is a total spending that determines a totaldemand. Thus, Government expenditure is an important determinant of aggregatedemand. In most of the less developed economies in recent decades. Governmentexpenditure has shown an upward trend. In India, for instance, ever since the beginningof planning, the amount of government spending has increased by leaps and bounds.(Some of this was wasteful spending and could easily have been avoided.) This hascreated inflationary pressure on the economy.(2) Deficit financing of Government spending: If the increase in government spending isfinanced by taxation, the problem would not have been so severe. Because, taxationwould have taken money away from the hands of the people and would have lessenedthe pressure of demand in the market. However, in practice, Government spendingincreases beyond what can be financed by taxation. In order to be able to incur the extraexpenditure, the Government resorts to deficit financing. For instance, it prints moneyand spends it. This adds to the pressure of inflation.(3) Increased velocity of circulation : The total use of money in the market is the amountof money supply by the Government multiplied by the velocity of circulation of money(example., the rate at which money changes hands among the people). During the boom phaseof the business cycle, people spend money at a faster rate. The velocity of circulation ofmoney increases. This also creates inflationary pressures on the economy.(4) Population growth : Growth of population also obviously increases total demand inthe market. If the supply of goods and services does not keep pace with demand, thepressure of excess demand will create inflation.(5) Hoarding : Excess demand is sometimes artificially created by hoarders. They stockpilecommodities and do not release them to the market. Naturally, this leads to excessdemand and inflation.(6) Genuine shortage : Sometimes, of course, the shortages are not artificial but genuine.

If, for some reason, the factors of production are in short supply, production will beaffected. Since supply will be less than demand, prices will rise.(7) Exports : Sometimes, exports create shortages in the domestic economy. Suppose thatthe total output of a commodity is not sufficient to meet both domestic and foreigndemand. It can be either exported or domestically consumed. Under these circumstances,exports will create inflation in the domestic economy.(8) Trade unions : Sometimes, trade unions contribute to inflationary pressures. Bydemanding an increase in the wage rate, they increase the cost of production. This createscost-push inflation.(9) Tax reduction : In democratic societies, Governments sometimes reduce taxes(particularly income-taxes) in order to gain popularity among the voter. This happens,particularly, in election years. Since this leaves more money in people’s hands, thisleads to inflation if there is no corresponding increase in production.(10) Imposition of indirect taxes : If the government imposes indirect taxes (such as exciseduty, value-added tax etc.) then producers or sellers raise the product prices to keeptheir profits unchanged. This leads to inflation.(11) Price-rise in the international market : If the price of some commodities or factors ofproduction, which are imported, rise in the world market then it would lead to inflationin the domestic market (of the importing country).(12) Non-economic reasons : Finally, we should note that sometimes inflation takes placedue to some non-economic reasons. For instance, at times of natural calamities, (example.,floods) crops are destroyed, reducing the supply of agricultural products. Prices of thesecommodities tend to increase. This brings about an increase in the general price level.Forms of InflationInflation may be of different forms.On the basis of origin, inflation may be classified into two types—Demand Pull and Cost Push.The former implies a situation when aggregate demand for goods and services exceeds aggregatesupply. It is a situation of imbalance between aggregate demand and aggregate supply. Costpush inflation, on the other hand, is the type of inflation which is caused by increase in coststructure. The structure of cost of production in a country can increase either because of anincrease in the wage level not matched by increase in labour productivity or it may be caused

by increase in profit margin earned by monopoly firms.Inflation may again be classified into two forms—Open inflation and Repressed inflation. Incase of Open inflation the continuous rise in price level is visible in the naked eye. One can seethe annual rate of increase in the price level. But in case of Repressed inflation, there is excessdemand but that excess demand is prevented from increasing price level by some repressivemeasures taken by the government like price control, rationing etc.On the basis of the degree of price rise inflation can be classified into three groups – Hyperinflation, Creeping inflation an Moderate inflation. In case of Hyper inflation the price levelgoes on rising at a very fast rate. Often there happens hourly increase in price level. It oftenleads to demonetization. On the other hand, in a period of Creeping inflation the price levelincreases very slowly over a period of time. In between these two extreme forms of inflationthere is Moderate inflation when the rise in price level is neither too fast nor too slow.Further inflation may be True inflation or Semi-inflation. According to Keynes, True inflationtakes place after full employment of all factor inputs in an economy. In a situation of fullemployment, the National output becomes perfectly inelastic. In such a situation more moneywill lead to higher prices and not more output. But even before full employment, a countrymay experience inflation arising from bottlenecks. There may be inflationary price rise in somesectors of the economy. It is what is called Semi-inflation.Effects of inflation on different groups in a societyInflationary pressure in an economy my generate good effects on the economy, particularly incase of ‘creeping’ or ‘walking’ inflation.• Favourable impacts :(a) Higher profits : Profits of the producers are generally favourably affected byinflation, because they can sell their products at higher prices.(b) Higher investment : The entrepreneurs and investors get added incentives to investin productive activities during inflation, since they can earn higher prices. (c) Higher production : If productive investment grows during inflation, it would leadto higher production of various goods and services in the economy.(d) Higher employment and income : Increase in the output of different goods duringinflation would also mean increasing demand for various factors of production. So,it is expected that employment and income opportunities will also increase during

inflation.(e) Possibility of higher income for the share-holders : During inflationary periods, ifthe companies earn higher profits, they can declare dividends for their share-holders.Hence, the dividend income of the share-holders may also rise during inflation.(f) Gain for the borrowers : Inflation means a decrease in the value or purchasingpower of money. If the rate of interest to be paid by the borrower is less than theinflation rate, the borrower will gain. Because the real value of the money returnedby the borrower is actually less than that of the money borrowed earlier.Unfavourable consequences :(a) Fall in the real income of fixed-income groups : Real income means purchasing powerof money income [Real income = (money income ) / (price level).] Given the moneyincome of the fixed-income groups, the real income will fall during inflation. Hence,inflation affects workers, salaried people and pension-earners adversely.(b) Inequality in the distribution of income : The profit incomes of businessman andentrepreneurs increasing during inflation while the real income of the common salariedpeople declines. So, inequality in the distribution of income become acute duringinflation.(c) Upsets the planning process : Inflationary pressure may also upset the entire planningprocess in an economy. When prices of goods, materials, and factor services increasecontinuously, then more money has to be spent for the completion of any investmentproject taken up during any planning period. If more financial resources cannot beraised by the Government (through savings or taxation), plan targets are to be curtailed.(d) Increase in speculative investment : If the price level rises at a fast rate, speculativeinvestment (say, purchasing shares, land, gems, etc., just for speculative purposes) mayincrease in the economy for earning quick profits. These types of investments do nothelp in the creation of productive capital in the economy.(e) Harmful impact on capital accumulation : If the price-rise becomes chronic, peopleprefer goods to money (because the real value of money will fall in future). They alsoprefer immediate consumption to consumption in future. So, their desire to save isreduced. At the same time, their ability to save also becomes less because, with theirgiven money income, they have to spend more for purchasing the same quantity ofgoods and services. When both ability and willingness to save become less, a smaller

amount of fund becomes available for further investment. As a result, it creates a harmfulimpact on capital accumulation, since capital accumulation in an economy depends onthe growth of investment.(f) Lenders will lose : We have already indicated that borrowers will gain during inflationFor this same reason, lenders will lose during inflation. Because, they are actuallyreceiving an amount having lower value (or purchasing power) than before.(g) Harmful impact on export income : If the prices of export items also increase duringinflation, their demand in the foreign market may fall. This leads to a fall in the exportincome of a country.Control of inflationIf we want to control inflation (example., to stabilize prices) we must first know what caused theinflation in the first place. The treatment of the disease must depend on its cause. There aretwo reasons behind inflations. Firstly, if demand for a commodity in the market exceeds itssupply, the excess demand will push up the price. This type of inflation is called ‘demandpullinflation’. Secondly, if factor prices rise, costs of production rise. Hence, the price ofproduced goods rise. (The rise in factor prices may not have any relation to demand.) Forinstance, wages may increase under trade union pressure. This second type of inflation iscalled ‘cost-push inflation’.These two types of inflation cannot be controlled by the same types of policies. For controllingdemand-pull inflation we have to ensure a fall in demand. This can be done in mainly twoways :(1) Monetary measures : If the supply of money in the economy can be decreased,prices will fall. The quantity of money and the price level change in the samedirection. Hence, if the quantity of money decreases, the price level will fall.Now, the supply of money can be decreased in different ways. If the governmentwithdraws paper notes and coins from circulation, the money supply willdecrease. But usually this is not how money supply is reduced. The lion’s shareof the total money supply is bank deposits or bank credit. Only if we can reducethe rate of lending by banks, we can reduce the total supply of moneysignificantly. The Central bank of a country can reduce the lending of commercialbanks in different ways, for instance, by raising the bank rate and reserverequirements of banks, by open market sales of securities, etc. These are calledquantitative credit control policy of the Central Bank. .(2) Fiscal policy : Fiscal policy, example., the policy of changing tax rates or the rate ofGovernment expenditure, can also be adopted. If the tax rate is increased, less

money will be left in people’s hands. As a result, demand in the market will godown. If the Government reduces its own expenditure, then, too, the demand inthe market will fall because Government expenditure creates demand in themarket [For instance, Government employees meet their costs of living out oftheir salaries. Again, if the Government purchases an input for the purposes ofa development project (example., cement), this Government demand is added to theprivate demand for this input in the market]. An inflationary gap arises whenaggregate demand exceeds the maximum potential supply in an economy. Toovercome this situation, the following types of fiscal measures can be undertaken(1) A decrease in the Government expenditure; or,(2) A decrease in the Government transfer payments (example., pensionpayments by the Government, unemployment benefits paid by the Government);or,(3) An increase in taxes imposed by the Government; or,(4) A combination of all these measures.These are regarded as contractionary fiscal policies. These contractionary fiscal policiesreduces the employment and income opportunities within the economy. For instance,an increase in the tax rate reduces the disposable income of the consumers. Hence,these policies restrict the growing demand for goods and services within the economy,help in controlling the inflationary pressure.But these methods of controlling inflation by reducing demand apply only to the caseof demand pull inflation; cost-push inflation does not have any relation to demand.Even if demand falls, this latter type of inflation will continue. To control this type ofinflation, one must resort to direct control.(3) Direct control : By direct control we mean such measures as wage freeze, puttingupper limits on the prices of such important inputs as electricity, coal, steel, etc.(4) Other measures : The three measures discussed above play the major part incontrolling inflation. Sometimes, however, other measures are taken. Thesemeasures are : augmenting the supplies of commodities in the domestic marketby increasing imports, increasing domestic production, etc. However, these othermeasures are not given much importance. If imports exceed exports, the countrywill face balance of payments problems. Increasing domestic production is easiersaid than done. Since inflation arises in the first place because demand hasoutstripped supply, it must be the case that it is difficult to increase production.Otherwise, output would have automatically increased under demand pressure.5.5 DEFLATIONDeflation is an economic phenomenon. It is a situation when the price level of an economygoes on falling continuously. Thus it is the reverse of inflation. In a period of demand pullinflation, an economy enjoys prosperity. Its employment, output and income go on rising. Butin a period deflation the country suffers from all round depression. There is large-scale

unemployment, unused productive capacity and a fall in National Income.Further in a period of inflation the working class suffers because their real wages fall. Nowthey can have smaller quantity of wage goods in view of high prices and fixed income. In aperiod of Deflation workers are not likely to suffer from such consequences. Yet in a period ofdeflation the workers suffer because as production decreases workers are thrown out ofemployment. Thus both inflation and deflation are harmful for the working class.Further in a period of inflation the income of the industrialist, businessmen, traders to on risingand these classes of people have a higher propensity to save. This is helpful for capital formation.But in a period of depression these classes of people suffer most. Their income falls leading toa fall in investment, production and employment.5.6 INVESTMENT AND RATE OF INTERESTBy investment we mean a change in the stock of capital over a period of time. The rate ofinterest is a significant factor in investment decisions of a firm. Generally investments areundertaken upto the point at which the yield from an asset cover the cost of investment. Whilethe return is expected, the cost is actual. The condition for maximization of net return frominvestment is that the present value of expected returns is equal to the initial cost.The rate of interest represents the cost side of investment. A change in the rate of interest(r) hasa direct impact on the return on a sum of money lent and so the rate of accumulation of thecapital stock. An increase in the rate of interest leads to future incomes being discounted moreheavily. The effect is that some investments are not undertaken, as they now fail to cover thecost. Some less productive investment are thus abandoned. And those investments that yieldednet returns now becomes ‘marginal investment’ in the sense that their returns at the marginjust cover cost.Thus the level of planned investment is inversely related to interest rate, assuming other variablesunchanged (dI/dr) < 0.The graph shows the investment function I = f(r). It is often said that at a very low rate ofinterest, investment decisions will be ‘interest inelastic’ example. at low rates of interest marginalchanges in the rate will not affect investment plans. If this were true then the curve showing I

= f (r) would not be down ward sloping but be vertical below a certain rate since thendI/dr = 0.To sum up, while the classical economists were of the opinion that investment was sensitive tointerest, Keynes thought that this was small. The more important factor was future cash flows.

Study Note - 6BANKS6.1 COMMERCIAL BANKA bank is said to be a financial intermediary. It stands midway between the savers and theusers of fund. The decision to save and the decision to invest are ruled by separate set of motives.A bank’s major role is ironing out the differences between two rival factions. There are differenttypes of bank having some common and some special functions.Banks may be of various types such Central Bank, commercial banks, development banks,cooperative banks, rural banks etc. Of these the Central Bank, the commercial banks and thedevelopment banks are of primary importance.Definition and Functions of Commercial BanksA commercial bank is a financial intermediary. It solicits deposits from the surplus units andlends financial resources to the deficit units. Its central objective is commercial that is, profitmaking. It takes money by paying a low rate of interest and lends the same fund at a higher rateof interest and thus makes profit It is said to be a dealer in credit. It may be organized privately

or by the Government.The two primary functions of such a bank are Deposit function and Loan function.Bank accepts deposits from the public, and offers interest to the depositors. Deposits may be ofthree types : Demand or current, Savings and Fixed or Time deposit. Demand deposit is thefund that a depositor can withdraw on demand and it bears no interest. It is as useful as cashmoney.Savings deposits is ‘notice deposit’ in case a large sum is withdrawn a bank must be givenprior notice. The depositors earn interest on their savings. Time deposits imply deposit of fundsfor a fixed period say, one year. Bank is not bound to pay the sum before the expiry of theperiod. Such deposits carry higher rate of interest. The longer the period the higher the rate ofinterest bank offers. Generally, deposits are ‘chequable accounts’ in the sense that a depositorcan withdraw funds by cheque and can also settle transactions by the use of his bank cheque.But chequable transaction has one danger. A man may have given an amount of moneydeposited with a bank (say Rs. 500). But if he draws a cheque lack general acceptability as ameans of payment. It is only the commercial banks that are pure depository institutions. Theytake Demand deposits.The funds thus obtained from various classes of people are pooled together and lend to usersof capital. Banks do not lend the entire sum of deposit. But keep a portion in the form of cash.This is called Cash Reserve Ration (CRR) in order to meet the unforeseen demand of somedepositors. CRR is the most liquid among all assets of a bank but it is zero yielding. Totaldeposited amount minus CRR is what bank can lend to private sector and invests in governmentsecurities. In its loans and advances, banks maintain a diversified portfolio in order to seek abalance between liquidity and profitability. A commercial bank is a dealer in short term securitiesThat is it lends money for short term as it mainly accepts deposits that are payable ‘on demand’or ‘at short notice’.Banks perform some other functions that enhance their yield. They keep valuables in theircustody, collect chequable amounts, in the purchase and sell of shares, debenture they act as

agents of their customers. Besides they act as trustee and executors of wills, pay bills of customers.Functions of a Commercial BankModern commercial banks perform a variety of functions and provide a number of services totheir customers. Traditional functions performed by commercial banks are : acceptance ofdeposits from the public and provisions of credit to different sectors of the economy. However,with the growth of modern banking, the banks have started providing a variety of services totheir customers. Modern banks are regarded as departmental—store banks because they providea wide variety of services to their customers.Various functions performed by commercial banks are as follows:1. Acceptance of deposits - The most important function of a commercial bank is toaccept deposits from the public. People who have surplus funds with them would liketo deposit these with commercial banks for one reason or the other. Banks accept mainlythree types of deposits :(a) Current Account : Deposits in current account are payable on demand. That is whycurrent accounts are also known as demand deposits. These deposits can be drawnupon by cheque without any restriction on the amount or number of withdrawals made.These accounts are mostly held by traders and businessmen who use them for makingbusiness payments. Bank do not pay any interest on these accounts. Banks providevarious services to the current account holders. Such as making payment throughcheques, collection of payment of cheques, issuing drafts on behalf of the account holders.Etc. Banks, in fact, levy certain service charges on the customers for the services renderedby them.(b) Savings Bank Account : Savings account deposits (Savings bank accounts) arepayable on demand and money can be withdrawn by cheques. But there are certainrestrictions imposed on the depositors of this account. Banks impose a limit on theamount and number of withdrawals during a particular period. These accounts areheld by households who have idle cash for a short period. Deposits in this account earninterest at nominal rates.(c) Fixed Deposits : The money in these accounts is deposited for a fixed period, viz.,6 months, one year, two years, five years or more. These deposits are not payable ondemand. They do not enjoy cheque facilities, example., cheques cannot be issued against them

for making payments. These deposits are also known as time deposits since the moneydeposited in them cannot be withdrawn before the maturity of the period for which thedeposit is made. For instance, if a person has deposited money in this account for aperiod of 2 years, legally and technically, he cannot withdraw the money before theexpiry of the 2 year period. In practice, however, banks allow the depositors to withdrawfunds from such deposits even before the maturity period, provided they are willing tolose a part of interest. These deposits are made by persons who have funds to spare forsome time.Fixed deposits are interest-earning deposits. The interest on these deposits inhigher than saving deposits. The rate of interest varies with the length of time for whichthe deposit has been made. Thus, the rate of interest on a two-year deposit is higherthan that on a one-year deposit. For example, at present a one-year deposit earns aninterest of 6.25 per cent, but for a deposit of three years or more, the rates is 6.5 per centper year.Recurring (or cumulative) deposits are one type of fixed deposits. In this case, a depositormakes a regular deposit of a given sum (say, Rs. 2,000 per month) for a specified period(say, 2 years).Such deposits are designed to motivate the small savers to save a particular amountregularly.2. Advancing of Loans – The second primary function of the commercial banks is toextend loans and advances. Lending is the most profitable business of a bank. Bankscharge interest from the borrowers which is more than the interest they pay to theirdepositors. Commercial banks act as intermediaries between the depositors and theborrowers. They make profit out of these transactions.Banks these days extend loans and advances to their customers in the following ways(1) Outright Loans (Term Loans) : Banks provide outright loans for a fixed period.In this case, the entire amount of the loan sanctioned is credited to the borrower’scurrent account. The borrower pays interest on the entire amount he hasborrowed.(2) Cash credit : In this case, the entire sanctioned amount of loan by the bank is notgiven to the borrower at a particular time. The bank opens an account of theborrower and allows him to withdraw the borrowed amount as and when herequired the money. The bank charges interest, not on the amount of loan

sanctioned, but on the actual amount withdrawn from the bank. Cash credit isvery popular with the Indian businessman.(3) Overdraft facilities : In many cases, banks provide overdraft facilities to theircustomers. When a customer gets an overdraft facility from a bank, this meansthat he is allowed to draw cheques in excess of the balance standing to his creditto the extent of the amount of overdraft. For instance, if a bank has providedoverdraft to the extent of Rs. 10 lakh to a businessman, he can draw cheques inexcess of the amount of his own deposits with the bank to the tune of Rs. 10lakh. The bank charges interest only on the amount overdrawn. For abusinessman, the overdraft facility is the easiest and most convenient methodof borrowing from banks.(4) Discounting Bills of Exchange : An important form of bank lending is throughdiscounting or purchasing the bills of exchange. A bill of exchange is drawn bya creditor on the debtor specifying the amount of debt and also the date when itbecomes payable. Such bills of exchange are normally issued for a period of 90days. This means that the creditors cannot get it encashed from the debtors beforethe maturity of the 90 – days period. However, if the creditor needs moneybefore the expiry of this 90—days period, he can sell it, example., he can get it discountedfrom a commercial bank. The bank makes payment to the creditor after deductingits commission. When the bill matures, the bank will get payment from the debtor.Thus, by discounting bills, the bank pays money to the creditor when be needsit and allows the debtor to make payment only when the bill is due for payment.Discounting of bills of exchange is, therefore, really one form of bank lending.3rd. Facilitation of payments through cheques — Banks have provided a very convenientsystem of payment in the form of cheques. The cheque is the principal method of paymentin business in recent times. It is convenient, cheap and safe means of making payments.4th. Transfer of funds — Banks help in the remittance or transfer of funds from one placeto another through the use of various credit instruments like cheques, drafts, mailtransfers and telegraphic transfers.5. Agency Functions — Banks provide various agency functions for their customers.The banks charge commission or service charge for such functions. The main agencyfunctions are :(a) The commercial banks collect cheques, drafts, bills of exchange, hundiesand other financial instruments for their customers.(b) They make and collect various types of payments on behalf of theircustomers, such as insurance premia, pensions, dividends, interest, etc.(c) The commercial banks act as agents for the customers in the sale andpurchase of securities. They provide investment services to the companies byacting as underwriters and bankers for new issues of securities to the public.(d) They render agency services of various types, such as obtaining foreigncurrency for customers and sale of foreign exchange on their behalf, sale ofnational savings certificates and units of U.T.I.(e) The commercial banks act as trustees and executors. For instance, they

keep the wills of their customers and execute them after their death.6. Miscellaneous Services – Commercial banks provide various miscellaneous services,such as provision of locker facilities for safe custody of jewellery and other valuables,issue of travelers cheques, gift cheques, provision of tax assistance and investment advice,etc.7. Credit Creation — A very important and unique function of the commercial banks isthat they have the power of credit creation. In the process of acceptance of deposit andgranting of loans, commercial banks are able to create credit. This means that they areable to grant more loans than the amount of initial or primary deposits made by thecustomers. This function is discussed below in detail.In short, commercial banks perform a large variety of functions in the modern economics.Essentials of a sound banking systemA sound banking system promotes all round economic development of an economy. Agood bank must have the following features : —(a) Adequate Liquidity — A bank must keep sufficient cash in hand to meet theclaim of depositors, otherwise they would be insolvent. A bank failure not onlyaffects depositors but banks also. People would not more keep funds withbankers. It ensures safety of a bank. Unless a bank is safe it cannot render itssocial services. (b) Expansion of banking — Banking facilities should spread throughout theeconomy. It must also cover all sections of people in need of funds and allproductive activities. The less-developed regions should get more bankingfacilities than others. Thus, diffusion of banking offices is essential.(c) Investment and Loan policies – A sound banking system must have a soundinvestment policy whereby it can optimize the twin goals of liquidity andprofitability. If loan and investments are wrong, a bank suffer loss or face liquidityshortage. A prudent banker should carefully determine the composition andcharacter of its loans and advances so as to optimize earning without endangeringsafety and solvency.(d) Human Factor — The soundness of a bank depends much on the quality ofbanker. Banking being a practical affair, rigid application of bank laws are notalways fruitful. Much depends on the discretion of men piloting the ship. Soundbanking thus, depends more on banking personnel than on banking laws.Credit Creation by Commercial BankA commercial bank is called a dealer of credit. But it is more than that. It can createcredit example. can expand the monetary base of a country. It does so not by issuing newmoney but by its loan operations.Banks do not create money out of air. But on the basis of the cash deposit. The processof credit creation is that the depositors think they have so much money with banks and

borrowers from bank say they have so much money with them. Summing the two, wefind an amount more than the cash deposit.Suppose a bank receive a sum of Rs. 1000 as deposit, keeps with it 20% (Rs. 200) as CRRand lends and rest. Depositor will claim he has Rs. 1000 and bank borrower too possessesRs. 800. Thus total money supply appears to be Rs. 1800 only. It is the credit creation bya single bank.The above example can be extended to cover the banking system as whole. Suppose Rs.800 is deposited to another bank. This bank’s base will now expand. It will keep 20% ofRs. 800 (Rs. 160) as cash reserve and will lend Rs. 640. This sum is redeposited to a thirdbank which keeps 20% of 640 (Rs. 128) grants a loan of Rs. 512. This process will continueand the amount of fresh deposit will go on falling. A time will come when depositedsum will be equal to CRR. The process will then come to an end. Limitations of Credit Creation :The multiple credit creation process depends on some factors :(a) Much depends on the size of the cash reserve ratio. If it is cent percent multiplierwill be zero. Thus an inverse relation exists between CRR and the size of themultiplier. So credit creation is inversely related to CRR.(b) Credit creation depends upon the amount of loan given. If society does notborrow, as it happens in a period of economic depression, bank can neitherlend, nor can create credit. If borrowers cannot offer security against loan, bankcannot lend.(c) Size of the cash deposit is also important in this context. The smaller the cashbase the smaller scope a bank gets for credit creation. If people prefer physicalassets or prefer to keep cash in their hand, bank deposits suffer much. So bankcannot lend much.(d) A bank can lend money against acceptable securities. A borrower gets a loanfrom a bank only against some securities the value of which must be equal tothe amount of the loan. If a bank does not get an acceptable security it cannotlend money even though it may have large amount of cash money for creditcreation.(e) The Credit creating power of commercial banks is substantially controlled bythe Central Bank. A Central Bank possesses certain instruments by the use ofthese it can increase or decrease the volume of credit created by banks. It canalso control the purpose and direction of credit given by banks. The banks acceptthe Central Banks directions because the Central Bank is their lender of lastresort.6.2 CENTRAL BANKCentral Bank may be defined as an institution charged with the responsibility of managing theexpansion and contraction of the volume of money supply for general Economic Welfare. The

Central Bank is the apex institution in the banking and financial structure of the country.Functions of Central Bank:Central Bank plays a leading role in organizing, running, supervising, regulating and developingthe banking and financial structure of the country.1. Monopoly of Note Issue :The Central Bank enjoys the exclusive power of note issue. In India the RBI issues allnotes except Re 1 notes and coins. Re 1 notes are issued by the Government of Indiaunder the guidance of RBI. The currency notes issued by the Central Bank are declaredunlimited legal tender throughout the country. The Central Bank has to keep reserve ofGold, Silver and foreign securities for issuing notes.2. Banker, agent, advisor to the Government :The Banking A/c of the government both central and state are maintained by the CentralBank as the commercial bank does for its customers. As a banker and to the governmentit helps the government in short term loans and advances for temporary requirementsand floats public loans for the government.As an advisor to the government the Central Bank advices on monetary andEconomic matters. It also advices on the ground as to how to maintain the internal andexternal value of money.3. Banker’s Bank :All commercial banks keep part of their cash balances as deposits with the CentralBank of the country. This is either because of convention or legal compulsion. Thecommercial banks regularly draw currency during the busy season and paying in surplusduring the slack season. Part of these balances are meant for clearing purposes example.; allcommercial banks keep deposit account with the Central Bank. The deposit balances ofthe Central Bank is considered as cash reserves for general purpose.Under the Banking Regulations Act of 1949, the Central Bank of India have beenempowered with the right to supervise and control the activities of various scheduledcommercial banks. These powers are related to licensing, branch expansion, liquidityof assets and methods of working of the Bank.4. Clearing House Facility :By virtue of its unique position in dealing with domestic and foreign funds the CentralBank has a special position for conductinga) clearing house Operation;b) Inter bank Transfer of funds;c) Settlement of accounts.

Clearing house facility means providing an opportunity to member commercial banksto settle their claims on each other mutually. Example. : Indian Bank has to pay to SBI a sumof 2 lakh and SBI has to pay to Indian bank Rs. 1,50,000. This can be settled with a checkof Rs. 50,000 by Indian Bank on the RBI in favour of SBI. As a result Indian Banksaccounts will be debited and SBI’s account will be credited.5. Custodian of Foreign Exchange Reserves :Under this system the RBI controls both receipts and payments of foreign exchange. Acountry have in its foreign trade favourable or unfavourable balance.Favourable balance helps to bring foreign exchange to the country whileunfavourable balance means paying foreign exchange out. As custodian of ForeignExchange Central Bank keeps a constant watch on the same so that the value of thehome currency does not rise or fall adversely in relation to foreign currency.During times of emergency the Central Bank may impose restrictions to controlon buying or selling of foreign currencies in the market.6. Credit Control :In order to ensure price stability and Economic growth of a country, the Central Bankundertakes the responsibility of controlling credit. The Central Bank ensures pricestability and avoids inflationary and deflationary tendencies by several monetarymethods such as regulation of Bank rate, open market operation, change in variablereserve ratio, etc.Credit Control by Central BankCredit money created by commercial banks and other non-banking financial institutionsconstitutes a significant portion of total money supply in an economy. Their shortages andexcesses may have profound impact upon an economy. Hence the flow of credit be regulatedin such a way that they may rise or fall according to the needs of an economy. This is what wegenerally means by credit control. This is done by the central bank in its role of a banker’s bank.The objective of credit control is generally two fold. A central bank either encourages memberbanks to expand credit or it may restrict credit-creating power of banks and non-banks. Theformer is known as expansionary monetary policy, which is adopted to lift an economy out ofdepression and unemployment. The latter is restrictive policy to fight inflation and to achievefinancial stability. In the context of growth with stability a central bank is to deal with bothaspects – increasing credit flow for more investment and, at the same time, restrict flow ofcredit so that it may not generate inflation. The task is, after all, very difficult.Control Weapons

A central bank possesses a number of instruments for controlling credit money. These are oftwo types – Quantitative and Qualitative. Quantitative techniques seek to regulate totalquantity of credit while qualitative measures affect the availability of credit. Second, quantitativemeasures do not take into account the need or use of credit at the micro level. The qualitativecontrols, on the other hand, are intended towards sectoral deployment of credit. They aredirectional rather than general. The qualitative techniques, moreover, are selective andpurposive. They affect the use of credit for selected purpose. While quantitative control measuresaffect credit at all levels and for all purposes.Orthodox control techniques are basically quantitative in nature. They seek to regulate thevolume of credit in two ways – by altering the cost of credit and also its total quantity. In thiscategory fall three techniques – Bank Rate, Open Market Operations and variantion of ReserveRatio (VRR).A. Quantitative Methods :1. Bank Rate PolicyAs a banker’s bank, a central bank lends money or rediscounts the bills of commercialbanks. The rate of interest charged by the central bank is known as Bank Rate or Discountrate. By manipulating Bank Rate central Bank can regulate the credit creating power ofmember banks.If Bank rate is raised by the Central Bank, commercial banks are to borrow at a highercost. Naturally they will increase their lending rate. This rate is known as the MarketRate. The commercial bank’s market rate is higher than Bank Rate of the central bank.The difference between Market Rate and Bank Rate is the profit margin of commercialbanks.So when bank rate rises market rate also rises and vice versa. If the objective of thecentral bank is to restrict credit, it will raise Bank Rate. As Bank Rate rises Market Ratewill rise. That means a rise in the cost of credit. Demand for bank loan will reduce. Onthe other hand, for credit expansion, Bank Rate is reduced. This is the process of BankRate manipulation A change in Bank Rate effects aggregate level of credit and it does soby influencing the cost of credit.

The effectiveness of this technique depends on the extent to which commercial banksdepend on central bank for loan and rediscounting. If banks can collect funds fromother sources at relatively cheaper rate, they need not depend on central bank credit.Secondly, if investment opportunities are not present market demand for credit is weak,a fall in the bank rate may not raise the level of bank credit.2. Open market operationsIt is a quantitative tool used by the central bank with the primary objective of influencingthe volume of bank credit. It implies purchase and sale of securities in the stock market.When the central bank appears in the market as a seller of Government securities, peoplebuy such securities by withdrawing money from banks or the banks themselves investin such securities instead of granting loan to public. In either case the powers of creatingcredit will be restricted. On the other hand, if central bank buys securities money flowsout thus enlarging the cash base of members banks. Thus open market operations pumpinor pump-out money from circulation. The volume of credit can be substantiallyaffected by this technique money from circulation. The volume of credit can besubstantially affected by this technique because of multiple credit expansion orcontraction. The extent of sale operation depends on people’s willingness to buysecurities. It may not also reduce bank’s deposit and loan if people purchase securitiesfrom unaccounted or hoarded money. Secondly even if the central bank injects morefunds, banks may not lend. Credit expansion depends upon external businessenvironment and borrower’s attitudes over which banks have no influence.3. Variation of Reserve RatioCommercial banks are legally bound to keep a portion of their deposits in the form ofCash Reserve. It is the most liquid asset in their hand and at the same time it is zeroearning asset. The size of the credit multiplier example. the extent to which the banking systemcan create credit out of a given amount of deposit, depends inversely on Cash ReserveRatio. Usually the ratio is fixed by the central bank of an economy. Naturally by alteringthe CRR, the central bank can expand or reduce the funds bank can lend. There existsan inverse relation between the size of cash reserve and the amount of credit given by abank, assuming a given amount of deposit.It is the easiest way of changing bank’s lending capacity. Not only easiest but a quick

way too. Its effects are immediate., Therefore in underdeveloped money market thistechnique is more suitable than open market operation or Bank Rate policy. It has noside effects like a change in security prices.B. Qualitative credit controlsThe three controls discussed earlier seek to control the total volume and cost of creditby affecting over all bank reserves. A central bank also possesses certain techniques bywhich it can control the direction and distribution of credit-purpose wise or areas wise.Such techniques are called ‘selective’ or ‘qualitative’ measures as they seek to influencethe quality of credit or its selective and purposive use.Such control techniques are two-edged. They may be used for restricting the flow ofcredit to inessential and less desirable purpose but giving concessions to productivesectors or sectors with priorities. Broadly, the purpose of selective controls is the rationalallocation of scarce bank credit and its economic utilization. Further sectorial deploymentof credit and controlling in other directions serve the purpose of preventing speculativeactivities with the help of bank finance and favouring productive activities. Thesetechniques are very helpful in a less-developed economy where overall credit restrictionmay hinder ‘growth by preventing the flow of credit for investment’. By allowing freeflow of credit to productive sectors. They promote growth and by curtailing it tospeculative and unproductive sectors check the danger of instability.Moral SuasionMoral suasion is a qualitative technique. By this measure, the central bank ‘requests’banks to lend more or not to lend in some sectors. There are no legal compulsion behindtheir acceptance. Generally if a request is not carried out by the member bank, theguardian of the banking system may take such steps as banks are forced to accept. Thecentral bank is often empowered to issue Directives to member banks. Such direct ordersare in the form of directional control, prohibiting loans of particular type or givingadvice to grant loan priority sectors.Distinction between the Central Bank and the Commercial Bank –The Central Bank differs from the commercial banks in several respects mentioned asunder : -(a) The Central Bank acts as the supreme monetary authority of the country withwide powers control credit and currency of the country. But a commercial bankhas no such powers.(b) The Central Bank does not exist to make profits for its owners. But commercialbanks are organized for profits for their owners.

(c) The Central Bank is the ultimate source of money supply. But a commercialbank is not so. (d) The Central Bank acts as the banker to the government, but other banks do notact as a rule in this capacity. They are bankers to private industries andinstitutions.(e) A Commercial bank undertakes risky business activities and many fail. But theCentral Bank never fails.(f) The Central Bank does neither accept deposits nor lend to the public, but this isthe most important functions of commercial banks.(g) The Central Bank is subordinate to the state and as such most of the CentralBanks in the world are now state owned and state managed. But commercialbank in most of the countries are privately owned and privately managed; thereis however a growing trend towards the nationalization of even commercialbanks in many countries as in India.(h) The Central Bank issues paper notes in fact it enjoys the monopoly power in thismatter. But other banks do not enjoy this power. They create credit.(i) The basis of credit money is cash deposit while what of cash money is gold andforeign reserve.6.3 FINANCIAL INSTITUTIONSWith the introduction of planned development in India in the early 50s, need forspecialized financial institutions for supplying credit to industry, agriculture, etc. wasfelt essential and necessary. Over the years their number has multiplied. Theseinstitutions are known as Development Banks as they grant long-term developmentfinance. Their spheres of activity are limited. They look after specific sector only. Hencethey are of a specialized type. They are said to be non-bank financial intermediaries asthey cannot raise money in the form of demand deposits. These banks are owned andmanaged by government. Through these institutions government offers fund to privateeconomic activities for development. Not only do they grant funds for developmentand expansion directly but also guarantee corporate sector’s deferred payment programand loans taken from elsewhere. They also underwrite or subscribe to shares anddebentures of the public limited companies. Besides finance they offer technical andmanagerial advices. The priority sectors of a developing economy can thus get intensivecare from such Development Banks of a specialized nature.INDUSTRIAL FINANCE CORPORATION OF INDIA (IFCI)Industrial Finance Corporation of India was set up in July 1, 1948. It is the pioneerdevelopment bank in India. The objective of the IFCI is “to make medium and longtermcredits more readily available to industrial concerns in India, particularly incircumstances where normal banking accommodation is inappropriate or recourse tocapital issue method is impracticable.” This is what was laid down in the preamble to

the IFCI Act, 1948.The authorized share capital of IFCI is now Rs. Twenty crores. The scheduled banksinsurance companies, investment trusts, cooperative banks are its share holders. Afterthe establishment of Industrial Development Bank of India (IDBI) in 1964 it became asubsidiary of IDBI. On 24th March, 1993 the IFC (Transfer of undertaking and repeal)bill was passed in order to privatize the IFC. It would now be free to raise resourcesfrom the open market.Over the years the activities of IFC have progressively increased. It is authorized toperform the following functions: -(a) granting loans and advances,(b) subscribing to the shares and debentures floated by industrial concerns,(c) guaranteeing loans taken from capital market,(d) granting loans in foreign currencies,(e) guarantee deferred payment in respect of imports of capital goods byapproved concerns.The corporation can now grant loan to single unit upto Rs. 1 crore and for a period notexceeding 25 years.The policies pursed by the IFC in granting loans and advances show a preference tofinance –(1) a new project(2) projects exploring new areas of technology(3) projects involved in producing inputs for agriculture,(4) projects producing essential goods for consumption.It grants assistance sector wise, industrywise, state/territory wise, and to less developedareas.Working.Starting on a modest scale in 1948, the lending operations of these institutions havegrown both scope and size. While in 1970-71 loan sanctioned was Rs. 32.2 Crores, in1998 it reached to Rs. 8684 crores. The accumulative assistance sanctioned by IFCI as atthe end of March 1999 stood at Rs. 47,245 crore. It has offered assistance to all—Theprivate sector, the public sector and the cooperative sector. It has actively participatedin the financing of Industrial cooperatives.Of the total financial assistance of Rs. 8684 crore sanctioned in 1998-99, Rs. 5926 crorewas in the form of Rupee loan, Rs. 321 crore in the form of foreign currency loans andRs. 1530 crore in the form of guarantees. It has set up Merchant Banking and AlliedServices department.INDUSTRIAL CREDIT AND INVESTMENT CORPORATION OF INDIA (ICICI)The objective behind the establishment of this corporation were :-(a) to provide foreign currency loans(b) to develop underwriting facilities

(c) to help private sector units(d) privately owned example. no participation in its share capital by government or semigovernmentinstitutions.The ICICI differs from two other All-India development banks, mainly, the IFCI andIDBI in respect of ownership, management and lending operations. The ICICI is a privatesector development bank. It provides underwriting facilities.The main function of the ICICI are :—(1) expansion of private sector industries(2) to give loans or guarantee of loans either in Rupees or foreign currency,(3) to underwrite shares and debentures and subscribe directly to share issues(4) to encourage and promote private capital(5) to promote private ownership of industrial investment along with the expansionof investment markets.The financial resources have two component parts. Rupees resources and foreigncurrency resources. The former comprises(1) reserve(2) government of India loans(3) advances from IDBI(4) issuing of debentures of public,The latter consist of –(a) Credit from World Bank(b) Sterling loan from British government(c) Funds from US AID(d) Issue of bonds in Swiss-FrancsActivitiesSince its inception in 1955, the ICICI’s financially sanctioned assistance has increasedfrom 145.8 crores in 1961-62 to Rs. 34,220 crore in 1998-99. It has offered financialassistance in the form of —(a) Rupee loan(b) Foreign currency loan (c) Underwriting of shares and debentures(d) Direct subscription to shares and debentures(e) Other services in the form of leasing, instalment sale, asset credit etc.Of the total loan sanctioned in 1998-99 33% went to corporate finance, 29% toinfrastructure 19.5% each to oil, gas and petrochemicals. Originally it was set to providefinance to private sector industries. But now its scope of operations has been enlargedby including the industries in the joint, public and cooperative sectors. Industries suchas chemicals petrochemicals, heavy engineering have obtained huge sums of assistancefrom this organization.INDUSTRIAL DEVELOPMENT BANK OF INDIA (IDBI)In July 1964 the Industrial Development Bank of India was set up. It was a whollyowned subsidiary of the Reserve Bank of India till 1976. But it was delinked from theBank and was taken over by the Government of India. Since then it is working as an

autonomous corporation.What was the justification for establishing a separate institution when there were someall India and State level institutions to cater to the requirements of large and smallindustries? First, the institutional framework was not adequate either in magnitude orin range for promoting a widely diffused process of industrialization. Further, theexisting framework lacked a coordinating machinery which could establish workingrelationship with the existing ones in the field. In other words, the IDBI was to act as acentral development institution for providing dynamic leadership in the field ofinstitutional finance of industries.With effect from February 16, 1975 the ownership and control of IDBI passed fromReserve Bank of India to the government of India. It is now managed by a separateBoard of Directors. Its members are representatives of public sector banks, other financialinstitutions and experts from different fields.FunctionsThe IDBI has the following functions to discharge : -(a) IDBI is working as a central coordinating agency for establishing aharmonious relationship among the term lending agencies.(b) It provides direct finance by granting loan and advances, guarantees loanstaken from banks, subscribes or underwrites share, bond, debentures. Besidesit can convert its loans into equity shares of the concerned industry.(c) When an industrial unit cannot procure funds in the normal course, the IDBIassists such units from a special fund known as Development AssistanceFund.(d) To assist in the creation, expansion and modernization of industrial unitslying within private sector.(e) To encourage and promote private ownership of industrial investment alongwith the expansion of investment markets. (f) It provides export finance through the scheme of direct participation, overseasbuyer’s credit etc.WorkingEstablished three and a half decades ago the assistance given so far by the IDBI asmeasured in quantitative terms looks quite impressive. Not only the magnitude ofassistance but also its range and pattern have changed. Total assistance sanctioned bythe IDBI in 1998-99 was to the tune of Rs. 25555 crores. Of this the share of Directassistance was 96.7%, refinance of loans 0.4%. The total amount of assistance disbursedby the IDBI till the end of March of 1999 from the date of its inception has been Rs.1,07,264 crores.It has initiated certain Financial and Non-financial measures for development ofindustries in backward regions. For this it offers loans at concessional rates concessionalrefinance assistance and special concessions to North Eastern areas under Billrediscounting Scheme. Further its non-financial measures help potential entrepreneursin identifying and formulating viable projects. Thus the IDBI enjoys a unique position

in India’s development banking system.“It occupies same place in the field of development banking as occupied by the RBI inthe field of commercial banking.”STATE FINANCIAL CORPORATIONSThree years after the establishment of IFCI, in 1951, State Financial Corporations (SFC)were set-up in various states as regional institutions to cope with the requirements ofmedium and small scales industries. The first SFC was in Punjab, set up in 1953.The scope of activities of the SFCs is wider than that of the IFCI since industrial concernsis used in a broader sense to include private companies, public limited companies,partnership and preparatory concerns. The authorized capital of such corporation canvary within Rs. 5 crores. The sum is raised by issuing shares of equal value. The publiccan hold can hold 25% of the share and the rest is held by State.Government, schedule banks, the Reserve Bank, investment trustee, insurancecompanies, cooperative banks etc. besides, these corporations can sell bonds anddebentures, and accept term deposits from public.Besides general capital, the SFCs can issue a special class of shares, contributed by thestate governments and the IDBI, that does not carry any obligation to minimum dividend.This special class of share capital was created in 1972 for granting soft loans to weakersmall scale units.Function of STATE FINANCIAL CORPORATIONSSome important functions of the SFIs are –(1) to guarantee loans raised by industrial units to be repaid within 20 years,(2) to grant loans and advances repayable within 20 years,(3) to subscribe, shares bonds and debentures of industrial concerns.ActivitiesThe SFCs have emerged as an important source in Indian industrial set up. Financialassistance provided by them is higher than that of IFCI or IDBI. The total amount ofassistance granted by 18 SFCs was of the order of Rs. 11,950 crores between 1971 to1991.The factors that contributed to the expansion of financial operations of the SFCs are arise in the interest rate structure of banks has been responsible for a shift to borrowingsfrom whose lending rates are lower than those of banks; (ii) the small sector being apriority sector there has been a conscious effort to increase financial assistance of thissector by the SFCs, (iii) the availability of foreign currency loans has contributed to theexpansion of assistance of the SFCs.

Another feature of the financial operations of the SFCs is that almost the entire resourcesof these institutions is in form of loan. Although they can and do in fact extend funds byway of underwriting or direct subscription the amount of such assistance has beennominal. The reason for this is that SFCs deal with small and medium enterprises whichgenerally are proprietary concerns or partnership enterprises.Before 1966, the SFCs primarily catered to the needs of medium enterprises. This trendhas since been reversed. The SFCs have liberalized the terms of lending to the smallscaleunits. Moreover since 1970, the SFCs have been granting assistance to enterpriseslocated in areas that are industrially backward. Moreover, SFCs cover divergent fieldsfrom artisans to firms manufacturing chemicals, fertilizer, transport equipments etc.Since 1970-71 they are offering assistance to ventures started by Technician Entrepreneursunder self-employment scheme on liberal terms. The SFCs are providing foreignexchange to small and medium units.A new orientation in the operations of SFCs is the seed capital assistance from theirspecial share capital to needy small entrepreneurs.STATE INDUSTRIAL DEVELOPMENT CORPORATIONSThere are 24 State Industrial Development corporations in India established with theobjective of rapid industrialization of the State. These institutions are providing assistanceto small entrepreneurs and those industrial undertakings that are setup in backwardregions. The total amount of loan sanctioned upto March 1991 by SIDCs was Rs. 5670crores.INDUSTRIAL RECONSTRUCTION BANK OF INDIAThis Bank was established in 1985 with the object of rehabilitating ‘sick’ industrial unitswith an authorized capital of Rs. 2.5 crores. Its functions are—(a) providing financial, managerial and technical assistance to the sickenterprises directly;(b) providing merchant banking services for merger, amalgamation etc.(c) securing finance from other institutions and government agencies forthe revival of sick industries.In March 1985, the IRCI was converted into a statutory corporation with an authorizedcapital of Rs. 200 crores. It was renamed as Industrial Reconstruction Bank of India(IRBI). Its paid up capital is Rs. 50 crores. At the end of March, 1992 it disbursed Rs. 923crores.BOARD OF INDUSTRIAL AND FINANCIAL RECONSTRUCTIONIn January 1987 this Board (BIFR) was set up under the Sick Industrial Companies (SpecialProvision) Act., 1985. The Board became operational on May 15, 1987. The Board consists

of seven members. At the end of 1991, public sector enterprises were brought within itspurview.It is obligatory on the part of management of a sick unit to inform the BIFR about sickness.The Board will then enquiry. If found sick, it will—(a) Change management or sale or leasing out of a part or the entire unit,(b) Take measures for merger or amalgamation with sound unit(c) Give the sick unit time for overcoming the problem on its own.Upto the end to December 1992, the BIFR has reviewed 1972 cases of these in 394 caserevival schemes were sanctioned.UNIT TRUST OF INDIAUnder the Unit Trust Act, 1963, the Unit Trust of India was set up on 1st February, 1964.The main objective of UTI “is to encourage and mobilized savings of the communityand channelise them into productive corporate investments so as to promote the growthand diversification of the country’s economy”. Its initial capital was statutorily fixed atRs. 5.0 crores, contributed by the Reserve Bank of India (Rs. 2.5), the Life InsuranceCorporation (Rs. 0.75), banks and other financial institutions (Rs. 1.0 crores).The two objectives of the UTI are :—(a) to mobilize the savings of the relatively small investors and(b) to make available the benefits of equity investment to small investors throughindirect holding of securities.OrganisationThe UTI is managed by a Board of Trustee. The chairman of the Board is appointed bythe central government in consultation with the IDBI. The Executive Trustee is appointedby IDBI. While RBI nominates one Trustee, four trustees by IDBI.ActivitiesThe total number of unit holders registered with the Trust, till June ’92, was about 10million. The total investment by the unit holders was to the tune of Rs. 22,000 crores ofits total investment 59% was invested in equities of corporate sector and the rest is inthe form of bank deposits.Besides initial capital, the UTI gets unit capital by sell of units to the public. It sells unitsunder different schemes for mobilizing the savings of all classes in the household sector.The tremendous increase in unit capital obtained by UTI can be explained by many afactor. First, in order to provide liquidity to the investors the UTI repurchases its unitsat ‘repurchases prive’ Secondly, it offers types of benefit and concession to investors.

Besides a steadily rising dividend, insurance facility, reinvestment of dividend plan,monthly income plan etc. are some of the attractive schemes of the UTI. Thirdly, toencourage savings in the form of units, relief from taxation is available both to the UTIand unit holders. Thus units are safe, high yielding and marketable – these three qualitieshave made them the most popular among a large section of savers, both personal andprivate sector.The investment by the UTI is much flexible. It maintains a balanced portfolio comprisingboth equity and fixed income securities. Its area of operations is primarily the securitiesof industrial enterprises. The security portfolio of the UTI consists of subscription tonew capital issued and purchases on the stock markets.Thus, the UTI occupies a pivotal position in the Indian capital market in mobilizingsavings of heterogeneous investors and channeling into productive investment thesavings it mobilizes, providing support to new issue market.EXPORT IMPORT BANK OF INDIAThe Export Import bank of India commenced operations on March 1,1982. It is a non-bank financial intermediary confined its area ofoperations to foreign trade of India. It is a fully statutory company ownedby the Government of India with an authorized capital of Rs. 200 croresand paid-up capital of Rs. 50 crores. It is empowered to borrow from RBIand also from foreign economies. It is a lead bank in the finance andpromotion of exports and also an apex body for co-ordinating the workingof similar organization engaged in promoting our export and import trade.Functions and Activities of EXIM Bank’sThe EXIM Bank’s business is exclusively devoted to India’s international activity. Theaggregate loans and outstanding reached Rs. 16.16 billion during the first decade of itsoperation. In annual terms, the business is said to have grown at a rate of 30 per cents.The Bank has developed “a three dimensional strategy” for export promotion. Firs, theBank offers fund for product development, long-term export credit, investment capital.Second gives export advisory services. Research on exports and market opportunitiesis a third component in the strategy.Export bids have increased annually by 44 per cent and export contracts financed exceedRs. 60 billion. Penetration into new markets has been possible because of a variety oflending program of the Bank, it rendered services in product export, project export andservices export.When the Bank commenced operation in early 1982 its catalytic role was mainly confined

to granting of post shipment term export credit. Now its horizons have expanded. Nowits horizons have expanded. Now it lends product development finance, pre shipmentfinance, marketing finance, finance for joint ventures, investment capital for exportproduction in addition to term export credit. The Bank is thus involved in more thanexport finance. In other program include –(a) Export Bills Re-discounting(b) Refinance of Suppliers credit(c) Bulk Import finance(d) Foreign currency Pre shipment credit(e) Product equipment finance program(f) Business Advisory and technical Assistance (BATA).NATIONAL BANK FOR AGRICULTURE AND RURAL DEVELOPMENT (NABARD)The NABARD was setup in July 1982. It is the apex body in the sphere of rural creditsystem, taking over the functions of agricultural credit department of the RBI andAgricultural Refinance and Development Corporation (ARDC).The functions NABARD discharges are -(a) It provides all sorts of reference to cooperatives, commercial banks andalso Regional Rural Banks (RRB)(b) It inspects the above three agencies and advises the government thereon(c) It makes loans to State Governments to enable them to subscribe to theshare capital of cooperative Banks.(d) It helps in prompting research in agriculture and rural development.(e) NABARD undertakes evaluation and monitoring projects financed byit.(f) It is responsible for the development, operation and coordination relatingto rural credit.NABARD started working with Rs. 100 crores. It has got the power to borrowfrom Union Government. It is also empowered to borrow foreign currency. Ithas two funds, the National Rural Credit (long-term) operations Fund and theNational Rural credit (Stabilisation) Fund. It operates through 16 Regional offices.ActivitiesIn the first year of its operation the NABARD sanctioned Rs. 1677 crores. Since then thecredit limit has increased by leaps and bounds. Short-term credit is sanctioned forseasonal agricultural operations. Medium term for approved agricultural purposes. Andlong term credit to state governments for purchasing share capital of cooperatives. Alion’s share of NABARD’s credit has been routed through commercial banks and RRBs.Next comes the cooperative agencies and Land Development Banks. It has taken care ofless developed and under banked regions in granting agricultural investment. It hasasked banks to offer a stipulated proportions of credit for helping small and marginalfarmers and other weaker sections. It has refinanced banks for implementing the Nationalprogrammers of Mass Assistance of Small and marginal Farmers. It also refinance

development activities of the handloom sector. Moreover, it extends refinance to statecooperative Banks to provide Block Capital to industrial cooperative societies and ruralartisans against state governments guarantee.LIFE INSURANCE CORPORATION OF INDIAThe Life Insurance Corporation of India (LIC) was set up in 1956 by nationalizing 245insurance companies. The primary objective of nationalization was to protect the interestof policy holders against misuses and embezzlement of funds by private insurancecompanies. Secondly, the object of nationalization was to direct investment of funds ingovernment securities, leaving a meager part for the private sector.What marks and distinguishes the LIC from other long term financial institutions isthis that it discharges the tow fold function of mobilization of long term savings andtheir effective channelisation as well. The other agencies are supplies of fund obtainedfrom government and the Reserve Bank of India.Role of LICThe activities of the LIC can be broadly classified into two categories. First, it mobilizeslong term contractual savings. Its policy holders view the LIC as a trustee of their funds,a source of emergency fund to guard against any financial misfortune and a way toaccumulate funds by the time of retirement from work. As an agency it is designed tofor the inculcation of savings for the sake of rainy days.During the last forty years of its operation, there has been concentration of colossalfunds in hands of this monolithic state owned corporation.The resources thus obtained by the LIC from policy holders are in vested in diverseways for different purposes. Basically LIC is an investment institution. It is a big investorof funds in government securities. Since April, 1975 the amended section 27A of theInsurance Act, 1938 the LIC is required to invest to not less than 50% of its accruals ofpremium income in government marketable securities. Of this not less than 25% incentral government securities. Besides it has to give loans to approved authorities likeelectricity boards or state government for socially oriented schemes like electricity,housing, water supply etc. These loans and investments should not exceed 87.5 percentof accretion to the controlled fund of the LIC.The remaining 12.5 percent can be made to the private sector directly in the form ofpurchase of shares and debentures. Besides it grants loans to the private corporate sectorand finances projects by subscribing shares and debentures of private industries. Itscontribution to financing of industries in the private corporate sector is also indirect.The investment in the share capital and bonds of IFCI, SFCs, UTI and IDBI flow back to

private sector in the form of direct loans. The LIC is also engaged in underwriting newissues.The LIC plays an important role in the securities market in India. It purchases evenwhen the market is dull (bearish) and prices are low in order to reap the benefit offuture price appreciation. Nor does it usually sell shares from its stock when the marketis spturn at higher prices.Although Income tax concessions provide incentive to higher income groups troughLICs policies, the insuring public does not get the real value of its long term savingsbecause of chronic inflation. Barring risk coverage, the rate of return offered by LIC ismuch lower compared to other savings media. It is true LIC has grown at a fast speedbet it can grow at a faster rate if it can make the message of life insurance more attractiveby its operational efficiency and innovative attitude.GENERAL INSURANCE COMPANIESThe General Insurance Corporation of India (GIC) was formed as a government companyin 1972 under the General Insurance Business (Nationalisation) Act 1972. Beforenationalization a few big companies and about 100 small companies were in this business.All these units were merged together and reorganized into four subsidies of GIC.They are –(1) National Insurance Company(2) New India Assurance Company(3) Oriental Fire and general Insurance Company(4) United India Fire and General Insurance Company.On January 1, 1973 of all the Indian insurance companies were transferred to the GIC.The feature of the GIC is this that it sell insurance service against some forms of risk likeloss of physical assets of various kinds from fire or accident and against personal sicknessand accident. The insurer just purchases a service and not any financial asset. Theydraw vast resources in the form of premiums and returns from investments.As a financial intermediary, the GIC invests funds in a prudent way looking after nationalpriorities and meeting unforeseen claims under their policies. The GIC is required bylaw to hold central government securities to the tune of 25 percent of new accrual andat least 10% in other approved securities.The companies can invest in the shares and debentures of the corporate sector. But shallnot exceed 5% of the subscribed capital of a single company. It also participates in theunderwriting of new issues and in granting term loans to industries.SECURITIES AND EXCHANGE BOARD OF INDIA

The Securities and Exchange Board of India (SEBI) was set up in 1988. It got statutoryrecognition in 1992. The purposes for which the SEBI was set up are as follows :—(a) Regulating the business in Stock Markets and other securities markets,(b) Prohibiting fraudulent and unfair trade practices relating to securities markets,(c) Regulating the working of collective investment schemes, improving MutualFundsd) Prohibiting insider trading insecurities,e) Regulating large acquisition of shares and takeover of companiesThe institution has got wide ranging powers. Firstly, all stock exchanges in the countryhave been brought under the annual inspection of SEBI for orderly growth of stockmarkets and also to protect the interest of investors.Secondly, to oversee the constitution as well as the operations of mutual funds of bothprivate sector and joint sector.Thirdly, since May 1992, SEBI has been made the regulatory authority in regard to newissues of companies. It has also been empowered to regulate new intermediaries in thecapital markets.Two other institutions have been set up for regulating the capital market. They areNational Stock Exchange of India (NSEI) and the other is National Securities ClearingCorporation (NSCC). The former was set up in November 1992, and the latter in 1996.THE ASIAN DEVELOPMENT BANKThe Asian Development Bank started functioning in December 1966. It is engaged inpromoting the socioeconomic progress of its member countries in Asia and Pacific. It isowned by the governments of 37 countries from the region and 16 from outside theregion. Its head quarters is in Manila, Philippines.The Principal functions of the Bank are: -(a) to make loans and equity investment for the socioeconomic advancement of itsmember countries(b) to provide technical assistance for the preparation and execution of developmentprojects, and advisory services(c) to promote investment of private and public capital for development purposes(d) to respond to requests for assistance in coordinating development plans and policiesof member countries.Besides, the bank is required to give special attention to the needs of the smaller or lessdeveloped member countries.The bank’s highest policy making body is the Board of Governors. The President iselected by the Board for five years. He is the chairman of the Board of directors and heconducts the business of the Bank under its directions. He is assisted by three Vice-

Presidents, appointed by the Board of Directors on the recommendation of the President.The Board of Directors is composed of 12 Directors – 8 from region countries and 4 fromnon –region countries. While the Board of Governor is the highest policy formulatingbody, the direction of bank’s general operations is the main task of the Board of Directors.The Bank’s fund consist of subscribed capital, reserves and funds raised throughborrowing. Special Funds are formed of contribution made by member countries,amounts set aside from the paid in capital, and accumulated net income. It has raisedcapital from capital markets of Asia, Middle East, Europe and USA.The Bank’s callable capital backs its borrowing in the capital markets.ActivitiesBank’s activities comprise lending activities, and technical assistance. Lending activities,again are of two major categories :Ordinary and special operations. The Bank has three special funds for the latter purpose.They are Asian Development Fund (ADF), the technical assistance Special fund (TASF)and the Japan Special Fund (JSF). These special funds are contributed funds from membercountries which are granted on concessional terms to the Banks lesser developedeconomies like Nepal, Burma, Bangladesh etc. They are repayable over 40 years includinga grace period of 10 years. Both the ordinary and special loans are intended to cover theforeign exchange requirements of the projects financed by the Bank.The Bank also grants “blended loans” from ordinary funds and ADF if the need of ADFeligible countries for development financing exceed what can be provided from ADFresources and they have the capacity to absorb such resources. The Bank also providesmulti-project loans for packages of small projects. It also grants project loans. Such loansare quickly disbursed to support policy reforms and institutional changes which willenhance economic efficiency and growth. Further whether a project is not large enoughto warrant the direct supervision of the Bank, loans are given to national developmentbanks for disbursement.An important means by which the Bank grants a direct loan is co-financing. Co-financinghas been bilateral or multilateral official agencies, banks, export credit source. Bankinvests its funds in the equity capital of enterprises operating in member countries. TheBank also provides loans without government guarantees to help the private institutions.It, in selected cases, guarantees loans from private financial institutions.

An important aspect of Bank’s development role is the provision of technical assistanceto overcome gaps in technical know-how and expertise. The Bank has expanded thescope and coverage of its technical assistance operations over the years. “Technicalassistance operations help the Bank to replenish its pipeline of loan proposal.” Suchactivities are financed from special funds known as TASF and ADF and JSF.New Role of ASIAN DEVELOPMENT BANKPoverty reduction is now ADB’s main mission rather than one of five strategic objectives.The other – promoting economic growth, supporting human development,protecting the environment, and improving the status of women – are still beingvigorously pursued, but in ways that contribute effectively to reducing poverty.A comprehensive poverty analysis and projects that promote pro-poor, sustainableeconomic growth; social development; and good governance are the pillars on whichADB’s poverty reduction strategy is built.The starting point for reducing poverty is a comprehensive country poverty analysis.Key stakeholders will discuss the findings of the analysis in a participatory high-levelforum. The outcome of these discussions will form the basis of ADB’s new countryoperatonal strategies. A partnership agreement between the government and ADB willthen identify ADB’S operations for helping to reduce poverty in each country.Top borrowers of ASIAN DEVELOPMENT BANK in the year 1999 –_________________________________________________________________US$0 Million %_________________________________________________________________People’s Republic of China 1,258.5 25.3Indonesia 1,020.0 20.5India 625.0 12.5Pakisthan 402.8 8.1Thailand 363.8 7.3Bangladesh 332.0 6.7Vietnam 195.0 3.9Srilanka 183.8 3.7Papua New Guinea 108.8 2.2Combodia 88.0 1.8Philippines 88.0 1.8Other Development member Countries 312.9 6.2__________________________________________________________________Total 4,978.6 100.0__________________________________________________________________THE INTERNATIONAL MONETARY FUND (IMF)OriginAt an International Monetary conference held at Bretton Woods it was proposed tocreate an international Monetary Fund (IMF) as the most practical method of securinginternational monetary cooperation. The object of setting up of such an agency was to

administer a code of fair practice in the sphere of foreign exchange and to grant shortterm loans to economies experiencing temporary deficit in their balance of payments. Itcommenced operation in march 1947.Functions of INTERNATIONAL MONETARY fundThe Principal functions of the IMF are :-(a) It provides short term credit(b) It functions as a leading institution in foreign exchange.(c) It grants loans for current transactions and not capital transaction.(d) It helps for the orderly adjustment of exchange rates(e) It acts as a store house of foreign exchange rates which is likely to improvethe balance of payment position of member countries.ObjectivesThe objective for which the IMF was set up and act are as follows : -(a) To foster international monetary cooperation through joint action of itsmembers(b) To promote foreign trade by avoiding restrictive currency practices.(c) To secure stability of foreign exchange rate.(d) To recur multilateral convertibility example., a borrower nation can borrowthe currency of any other member nation.StructureThe quotas of all the member countries taken together constitute the total financialresources. What is quota? It is the member country’s contribution fixed in terms of itsnational income and foreign trade. Members are required to subscribe to quota partlyin gold (25% of quota) and partly in domestic currency. The size of determines a membercountry’s borrowing power and voting right. Generally national currency is paid in theform of deposit in favour of IMF held in the Central Bank of the member country.Lending OperationsAny member country suffering from shortages of foreign currency may get it from theIMF by its national currency. The fund permits a member to draw up the amount ofgold contribution. The Fund grants temporary loan to tide over a temporary shortageof foreign exchange.Exchange RateMembers of the Fund had to declare the Parvalue of national currency in terms of goldor American Dollars. Once the par value of different currencies are fixed, it becomeseasy to determine the rate of exchange between two countries. If a country faces afundamental disequilibrium in its balance of payments it can change its par value example.,devaluation with the approval of the Fund.Exchange ControlUnder the IMF system there should be no restriction in ordinary trade and other currency

transactions. But it allows their use to control international capital movement especiallycapital flight. Exchange controls are permitted in the case currencies declared scarce bythe fund.Special Drawing Rights (SDR)About two decades ago a new international money was created by the IMF for tworeasons. First to overcome the shortage of gold in the world economy leading to fall ininternational reserves. Second, to avoid the movement of gold across nationalboundaries. This new international currency is known as Special Drawing Rights (SDR)held with the IMF. The origin of SDR thus lies in the shortage of international liquidityall over the world in the wake of acute shortage of American Dollar in the 60s and early70s which was then the main reserve currency.The SDR was first introduced in 1969. Under this scheme the IMF grants its membergovernment special drawing rights from Special Drawing Account (SDA). They arelike coupons which can be exchanged for currencies required by its holder for makinginternational payments. They are also, besides gold and key currencies, a component ofinternational reserve of an economy.Each member of the fund was assigned an SDR quota that was granted in terms of afixed value of gold. Hence they have been aptly described as “Paper Gold”. The membercountries are required to provide their currency in exchange for SDR when called upon.The use of SDR would mean a reduction in the country’s foreign reserve and acorresponding increase in the SDR holding of the country receiving it.The mechanism of the SDR system is an economy in need of foreign exchange has toapply to the Fund for the use of SDR. The Fund would designate another country havinga sound foreign exchange resources to meet the need of the former. So the debtorcountry’s SDR decreases and that of the creditor increases. The former have to payinterest at 1.5% per annum to the latter country. A designated (creditor) country cannot pay more than the amount equal to twice the amount of SDRs allotted to the country.The scheme is flexible in that each country can use its quota to have an equivalentamount of convertible foreign exchange to overcome balance of payment difficulties.THE WORLD BANKThe World Bank has the following objectives before it :-(1) To help reconstruction of member countries damages due to the SecondWorld War. (2) To facilitate the investment of foreign capital for productive purpose.

(3) To promote balanced growth of international trade and to maintainequilibrium in the balance of payment.(4) To promote private foreign investment by means of guarantee to loansand investments made by private investors. It will make loans out of itsresources when private loans are not sufficient. Thus the banksupplements rather than replace private investment.Capital StructureBeginning with an authorized capital of $ 10,000 million, the capita stock of the Bankhas more than doubled. Each share is for $100,000. 2 percent of the paid up has to besubscribed in gold and 98% in member’s domestic currency. The capital stock can beincreased if three-fourths total voting power agreed.INTERNATIONAL DEVELOPMENT ASSOCIATION (IDA)The IDA was started in 1960. It is affiliated to World Bank. Legally and financiallydistinct from the Bank, IDA is administered by the same staff.The objective behind the setting up of a separate Institute were to provide assistance toprimarily poor countries those with an annual per capita gross national product of lessthan $520 (in 1975). Second, it was to grant credit on cheap terms compared to Bankloans.The Capital Funds of the IDA come from subscription of member countries, specialcontribution from its richer members, transfer from the net earnings of the World Bankand general replenishment from its more industrialized members. It functions as adevelopment agency supplementing the Bank’s development activities. It is to supportprojects which will contribute to the development of the country even if they are notdirectly productive. IDA credit is development credit to LDCs. Moreover, it grants suchcredit to government are 50 years maturities and no interest. But an annual servicecharge of 0.75 percent on the sum disbursed. The IDA loans can be used to finance bothforeign exchange and local currency costs.

Study Note - 7INTERNATIONAL TRADEInternational trade is the exchange of goods and services among different countries or tradeacross political frontiers. It is a highly organized form of barter and is the outcome of territorialdivision of labour.7.1 FEATURES OF INTERNATIONAL TRADE1. The world market is heterogeneous on account of differences in climate,language, level of national income etc.2. The mobility of factors of production is higher within the country than thatbetween countries. International mobility of labour and capital is strictlyrestricted by governments. When resources are comparatively immobile, thereis no automatic influence equalizing price and cost.

3. It involves the use of different types of currencies. Hence arises the question offoreign rate of exchange.4. Foreign trade may be free or not. It is free when a country can buy and sell anygood or service from world market without any obstruction. In most countriesmuch free flow in and flow out is restricted by the government, looking afterthe broader national interest.5. International trade has its impact on a country’s gross national product andnational income while domestic trade leads to transfer of goods from one regionto another and no change in the size of GDP.Distinction between Internal Trade and International TradeInternal Trade is simply exchange of goods and services between two individuals orfirms or States in the same country, that is to say within the same political boundary. Itis also called regional or domestic trade. International Trade, on the other hand, is thetrade that takes place between different countries across political frontiers. There aresome points of distinction between these two forms of trade.(a) Internal Trade takes between different regions within political boundaries ofthe same country. International Trade is trade between two or more Nations.International Trade may be unilateral, bilateral or multilateral according to thenumber of country with which the country is trading.(b) In internal trade transactions are carried out with the same currency as it istaking place within a particular economy. But in case of International Trade theuse of different types of currencies becomes essential. The poorer countries areto procure foreign exchange for paying their Import bills. They cannot pay itwith domestic currency.(c) Internal Trade occurs within the same political unit. As such a common trade oran exchange policy is followed by the trading partners. But interregional tradeoccurs between different political units with different currencies and differentforeign exchange policies. Thus it is much more complicated than domestic trade.7.2 BASIS OF TRADEWhy do countries participate in international trade? According to classical writers, a countrytakes part in international trade not because of the fact that it cannot produce the goodsdomestically. Rather it should produce those to which it has comparative cost advantage andabandon others to which has comparative disadvantage. The surplus goods produced may beexported and, in turn can import from world market other goods, whose production it hasabandoned, at a greater quantity. Thus the classical economist believed that a country gainsmore by trade than what it can produce domestically. Thus the basis of international trade,according to Ricardo, is the comparative costs differences.The question remains how this comparative cost difference arises. Some modern economist

suggest that trade takes place on account of different relative price of different goods in differenteconomics. The relative price of goods differ between countries as a result of differences infactor price differences. And factor cost differences occur because of different factor endowmentsin different countries.7.3 GAINS FROM FREE TRADEAs an economist has aptly remarked, “the gain from trade is the difference between the valueof things that are got and the value of things that are given up”. In the classical comparativecost model, trade is mutually profitable. Specialisation on the basis of comparative advantageenables to obtain foreign goods more cheaply in terms of real resources forgone than domesticproduction. Through the international division of labour one is supposed to get more than onegives up.The above are called Static gains. But trade has certain ‘Dynamic’ benefits also. First, an increasein export trade will widen the country’s total market. Production of more goods will lead tolower cost per unit and lower price. Secondly, for a poor economy with no trade there is verylittle scope for industrialization. Because specialization is limited by the extent of the market.But with trade such an economy enjoys some prospect of industrialization. Thirdly, it consistsof the stimulus to competition, the acquisition of new knowledge and new ideas, and thepossibility of capital flows. Fourthly, trade acts as an engine of growth. It transmits growthfrom one part of the world to another. For example the demand in Britain for raw materialsbrought prosperity to Australia, Canada, New Zealand etc. With the increase in demand fortheir commodities, investment in these countries also increased.Benefits of Restricted TradeInternational Trade may be free or restricted. It is said to be restricted only when theGovernment of a country imposes barriers on the way of free-flow of goods and servicesfrom abroad. It is a matter of government’s trade policy. It may impose heavy ImpostDuty of foreign goods so as to check their use within the country with a view to helpdomestic production. It may take liberal measures to increase the volume of exports soas to earn more foreign exchange.There are some arguments in favour of restricted trade.

(1) To protect the newly established industries of a country from foreign competition,the government should prevent the entry of foreign products. But such protection ondomestic industries need not be given for an indefinite period. Hence it is said, ‘Nursethe baby, protect the child and free the adult.’ Such argument is known as infant industryargument. Thus restricted trade is necessary for the growth of domestic industries inthe poorer countries of the world.(2) Once the domestic industries are sheltered by not allowing foreign goods toenter, employment of labour and other resources will increase. Thus restricted trade islikely to have a favourable impact upon domestic employment, income and output.(3) Protection of domestic industries is also essential for the defence of the country.No country should depend upon other for arms and ammunitions. These must beproduced domestically and the country should not import it. Defence is much moreimportant than opulence, so said Adam Smith.(4) It is also argued that if imports of foreign goods are restricted then the countryneed not pay any money to meet its import bill. This will save domestic money. Thusprotection may help in keeping money within the country. There will be no economicdrain.7.4 BALANCE OF PAYMENTSBalance of payments (BOP) is a systematic record of all economic transactions undertaken oninternational trade account of an economy during a given period of time.International Trade is a two-way traffic. A country sells abroad and also purchases from abroad.The former operations are known as Export trade and the latter Import. While exports lead toearning, imports lead to spending of money for paying the prices of foreign goods and services.So BOP of a country has its credit side (earning) and debit side (spending). If the total earningsfrom exports is equal to total spending for imports example. debit and credit sides are equal, BOP issaid to be balanced. If, on the other hand, they are not equal then either E > M or E< M indicatinga surplus or a deficit in the BOP.Normally a country exports and imports many items of diverse nature. These are broadlygrouped into two groups visible items and invisible items. All sorts of goods exported andimported in the Trade Account. The invisible account comprises items of invisible transactions.They include : -(a) Insurance Premiums and payments of claims

(b) Transit expenses(c) Investment incomes such as interest, rent, dividends.(d) Migration remittances, donation etc(e) Repayment of commercial credit(f) Travel (for education, business, health, pleasure)(g) Contractual amortization and depreciation of direct investment(h) Miscellaneous service such as commission, patent fees, royalties, pension,subscriptions etc.The above mentioned visible and invisible items constitute what is called Current Account.Besides current account, BOP has a Capital Account. In a word, the capital Account deals withdebts and claims. The items are : -(a) Private non-banking loans short term and long-term(b) Private Banking loans, excluding central bank(c) Official Loans, Amortisation, Reserves and miscellaneous.Broadly the capital account consists of –(i) private capital account(ii) international institutional capital account(iii) Special account and(iv) Government capital account.Balance of Trade and Balance of PaymentsBalance of Payments of an economy shows Total Debits (imports) and Total Credits (export)with the rest of the world. The totals may be segregated into two parts : visible items exportedand imported and the invisible items. Balance of Trade (BoT) shows credit and debit arisingfrom merchandise trade example. goods exported or imported only. On the other hand, BoP gives thetotal picture of a country’s transactions with the rest of the world, Thus BoT is merely a part ofBoP.Balance of Payments always BalancesIn the accounting sense, BoP of an economy must always balance. It means that the two sidesof the account must show the same total. In order to understand the mechanism of such equalitybetween debit and credit in the BoP, we have to know Autonomous Transactions andAccommodating Transactions. All the items both visible and invisible—in a BoP account areautonomous in the sense that they are undertaken independently with some objective. Forexample, goods are exported for earning profit and they are imported for the utility they give,Similarly capital is exported for higher returns and imported to ward off its shortage.Now if an economy experiences a gap between autonomous credit and debit a surplus or deficit

in the autonomous export and imports appears. The accommodating transactions accommodatesuch gaps. The accommodating payments would not be needed if no gap persists betweenreceipt and payments in the Autonomous Account. But when a gap in the form of a deficitoccurs, it is financed by the movement of gold, accumulation or dissimulation of foreignexchange holdings or loans. There are ‘the residual money’ that flow in the BoP to make ittechnically balanced.In economic sense, BoP may not be balanced. In fact, in real life, we find economics eitherenjoying a surplus or suffering from chronic deficit in their BoP. They are facing a disequilibriumin their BoP. It, therefore, follows that an apparent balance in BoP (in an accounting sense) doesnot mean a state of equilibrium in BoP of a country.7.5 FEATURES OF EXPORTInternational Trade is said to be a two way traffic in the sense that a participating country notonly exports visible and invisible items but imports too. Thus exports and imports constitutetwo sides of the same coin.Export or sale operation helps an economy to earn income from world market. In anopen economy, national income originates not from world market. In an open economy,national income originates not only from within but from favourable foreign trade aswell (E minus –M). When export earning exceed import spending (E greater than > M), resources flow infrom outside. It encourages savings and capital formation.Secondly, exports increase the supply potential of the economy by opening a moreextensive market. Export earnings also stimulate effective demand in the domesticmarket.Thirdly, exports permits import. A country’s capacity to import increases as itsexport earnings increases. It supplements shortage of domestic capital goods andthrough their superior efficiency exert a favourable impact on the economy at large.Fourthly, exports encourages savings in different ways. Exports affect savingsthrough their effects on output and because of the fact that export sector has ahigher propensity to save. Besides export taxes constitute an important source ofgovernment savings.Fifthly, the capacity to export of an agricultural economy is limited. The incomeelasticity of demand for most farm products, particularly food crops is lower thanthat for manufactured goods. This results in a decrease in proportion of incomespent on such goods. This means that for a given growth of world income the exportsof primary product economies will automatically go down vis-à-vis the exports ofindustrial countries producing and exporting manufactured goods.Sixthly, export trade of a country depends on a host of factors. Exports basicallydepend on the exporting country’s ability to cater to the requirements of a

heterogenous markets. Exports can increase by innovation introducing a new goodat a relatively cheaper rate. Besides such economic factors, export trade of a countryis influenced by political ideology, government policies relating to trade andexchange rate.Lastly, with economic development and a higher rate of growth of income, exportearnings have a tendency to rise steeply compared to imports. And the countrybecomes a net exporter of capital.7.6 FEATURES OF IMPORTThe trade policies of the government of a country are, by and large, guided by two considerations– on the one hand, to promote exports and to control imports, on the other. That is the easy wayof enjoying a net surplus from trade.The classical economists advocated import on the ground that by import a country can getmore than what it can produce domestically. The gain from trade is the difference between thevalue of things that are got and the value of things that are given up. Imports, as Adam Smithbelieved, “may satisfy a part of their wants and increase their enjoyments.” By exporting itssurplus capital goods, England can have more of wine from Portugal.Besides making the product composition diversified, imports had another role of importance.Imports can be regarded as substitutes for domestic capital. If domestic saving is less than thelevel necessary to achieve a given rate of growth, growth is said to be “ investment limited”.Traditionally the role of import (of foreign capital) was to supplement the shortfall in domesticsavings..Imports render another valuable service in the growth process. Many goods or inputs requiredfor growth may not be available within the economy. They must therefore be imported withoutwhich a part of domestic resources might go unutilized. If such minimum import requirementnecessary to achieve the target rate of growth is greater than maximum feasible exports there issaid to exist an export imports gap. Import of foreign capital is thus necessary for properutilization of some domestic resources having higher import component.Moreover by pursuing a liberal import policy a country may permit easy entry of foreign goodsin the domestic market. In a competitive environment, the domestic producers must becomemore efficient and cost conscious. This helps in improving the quality of products andmaintaining a reasonable price.

Import of capital in the form of foreign loan or consumption goods of prestige value areburdensome or harmful. But the case is different when a country imports foreign technology ortechnical and managerial services or patent right. In the long run such imports yield richdividend to the importing country. Imports, like exports, depend upon many factors, theprincipal determinant being the importing country’s capacity to pay either by its exports or byforeign exchange. However too much reliance on imports is not desirable.7.7 THEORIES OR BASIS OF INTERNATIONAL TRADEOne of the basic questions that the theory of international trade has to answer is why countriesspecialize in different goods and enter into international trade has to answer is why countriesspecialize in different goods and enter into international trade. In simple words, what determinesinternational trade? The answer to this question gave rise to the theory of international trade.Two important theories of international trade are explained below:I. Adam Smith’s Theory of Absolute AdvantageBefore analyzing the theory of comparative advantage, it will be useful to understandthe theory of absolute advantage. The theory of absolute advantage of international trade waspropounded by Adam Smith. According to him international trade is the natural outcome ofinternational specialization and division of labour. The principle of division of labour suggeststhat each country specializes in the production of only those goods in which she enjoys somespecial advantage. Adam Smith believed that foreign trade is advantageous only if the countryconcerned has an absolute advantage in the production of some commodity. The concept ofabsolute advantage implies that the country concerned must be able to produce, with givenfactor endowments, a larger amount of the commodity than any other country. According toAdam Smith’s theory of absolute advantage, trade between two countries will take placeonly if one of commodity and the other country enjoys the same advantage in the productionof some other commodity. This can be explained with the help of the following example :Labour Days Required for ProductionCommodity U.S.A. Indiax (one Unit) 10 20y (one unit) 20 10

The above table informs that to produce one unit of x commodity in the U.S.A., 10 labour-daysand in India 20 labour-days are required. On the other hand, to produce one unit of y commodityin the U.S.A., 20 labour-days and in India 10 labour-days are required. Thus, the U.S.A. has anabsolute advantage in the production of x commodity and India has an absolute advantage inthe production of y commodity. Adam Smith showed that the two countries would benefit andworld output will increase if the two countries specialize in the production of goods in whichthey have absolute advantage and trade with each other. Thus, according to this theory, tradedepends on absolute advantage.However, Adam Smith’s views do not carry us very far in the realm of international trade. Forexample, if a backward country does not possess absolute advantage in any line of production,should it follow the policy of free trade only to ruin its industries from foreign competition?Adam Smith’s analysis fails to deal with situations of this type. In fact, his analysis is notcapable of explaining the causes underlying the international trade. He only emphasized thefundamental basis of all international trade, example., the division of labour on an internationalbasis.It was Ricardo who attempted a precise and general theory of international trade. It is popularlyknown as the theory of comparative cost. It is discussed below.II. Ricardo’s Theory of Comparative Advantage or Comparative CostIt is obvious that if one country has an absolute advantage over the other country in one line ofproduction and the other country has an absolute advantage over the first country in a secondline of production, both countries can gain by trading. But what if one country is more productivethan another country in all lines of production? If country A can produce all goods with lesslabour cost than country B, does it still benefit the countries to trade? Ricardo’s answer was yes.For this, Ricardo gave the theory of comparative advantage (or the theory of comparative cost)of international trade. According to him, comparative advantage explains the existence ofinternational trade. A detailed explanation of the theory of comparative advantage is givenbelow:Assumptions

Ricardo’s theory of comparative advantage is based on the following assumptions:(1) It is assumed that there are only two countries in the world. And each country canproduce two goods. Thus, this theory is carried out only in two country – twocommodity model.(2) There is perfect competition both in the commodity market and the factor market.(3) There is only one factor of production and that is labour. It implies that he cost isexpressed in terms of labour only and the value of the commodity depends only onits labour cost.(4) Factors of production are assumed to be perfectly mobile within the country butperfectly immobile between different countries.(5) The law of constant returns to scale prevails in the economy.(6) There are no transport costs between the two countries.ExplanationRicardo has explained that a country can benefit from trade even if it is absolutely more efficient(or absolutely less efficient) than other countries in the production of every good. Say country“A” enjoys advantages over country “B” in the production of both the commodities, yet country “A” will specialize and export that commodity in which it enjoys relatively more advantages.On the other hand, country “B” has disadvantages over “A” in the production of both thecommodities, yet “B” will specialize and export that commodity in which it has relatively lessdisadvantages. Thus, in this situation also there will be trade between these two countries andboth will gain.Indeed, the theory of comparative advantage is simply an application of the principle of divisionof labour to different countries. This we can understand with the help of an example. Supposean individual can do a number of jobs but he cannot be equally efficient in all the jobs. Take thecase of a lawer who is more efficient in both legal work and typing work than his typist. Whatshould he do? Should he do both the jobs? The answer is very simple. He should concentrateon the job where he is relatively more efficient. So he will work as lawyer and will appoint atypist for typing work. He knows that the time which he will spend in typing can be moreremuneratively employed by doing legal work. The work of typing can be done by a low-paidperson, while he can earn much more as lawyer. Or look at it from typist’s point of view. He isabsolutely less efficient than the lawyer both in legal work and in typing, but he is relatively

more efficient (or relatively less inefficient) in typing. In this scenario, the greatest efficiencywill occur when the lawyer specializes in legal work and the typist concentrates on typing. Thesame logic can be applied on nations. A country can produce numerous goods efficiently, butit will not produce all of them. It should select those commodities in which the comparativecosts are lower or in which it enjoys comparative advantage. Thus, the principle of comparativeadvantage holds that each country will benefit if it specializes in the production and export ofthose goods that it can produce at relatively low cost and imports those goods which it producesat relatively high cost.Now let us explain the theory of comparative advantage with the help of a numerical example.Suppose there are two countries : U.S.A. and India. They are producing two commodities x andy with the help of labour. Labour costs of production (in terms of labour units) of both thecommodities in U.S.A. and India are also given. What is labour Cost? The units of labour requiredto produce one unit of output is called labour cost or labour coeffieient. The labour-costinformations of two countries are given in the following table :Labour CostsCountry Labour Cost of Production(in units of labour)1 unit of x 1 unit of yU.S.A. 5 2India 20 4Before analyzing the table and Ricardian theory of international trade, it will be useful tounderstand the difference between absolute advantage and comparative advantage. The conceptof absolute advantage means that a country can produce a good absolutely more efficientlythan the other country. It further implies a unit of a commodity with lesser factor-endowments(say labour units or labour costs) than any other country. For example, according to our table,U.S.A. can produce a unit of x with 5 labour units while India requires 20 labour units for thesame. It means U.S.A. has an absolute advantage over India in the production of x commodity.On the other hand, the concept of comparative advantage implies that a country is relativelymore efficient (or relatively less inefficient) in the production of one commodity over the other

in comparison to other country. Comparative advantage can be found out with the help oflabour cost ratio. For example, according to our table, the labour cost ratio of x to y in the U.S.A.is 5/2 = 2.5, whereas, it is 20/4 = 5 in India. Hence it is clear the U.S.A. has comparativeadvantage in the production of x commodity over y.Now we can explain the theory of comparative advantage with the help of our above-mentionedexample. It is clear that U.S.A. has an absolute advantage in the production of both thecommodities x and y, because the labour cost of production for each unit of the two commoditiesis less in U.S.A. than in India. It also means that India has an absolute disadvantage in less inU.S.A. than in India. It also means that India has an absolute disadvantage in both thecommodities. Does this mean that U.S.A. will import nothing or there will be no export fromIndia? Does this mean that there is no scope for mutual trade between U.S.A. and India?According to Ricardian theory, it is the comparative advantage and not the absolute advantagethat determines the course of international trade. So let us compare the comparative advantage(or comparative cost) between U.S.A. and India. It can be done with the help of labour costratios. It is clear from the table, that in U.S.A. labour cost ratio of x to y is 2.5 (5/2), whereas asIndia it is 5(20/4). So it is clear that U.S.A. has lower labour cost ratio of x to y, hence it hascomparative advantage over India in the production of x than of y.In order to know comparative advantage we can also use the concept of opportunity cost. Theopportunity cost for a good x is the amount of other goods (say y good) which have to be givenup in order to produce one additional unit of x. The opportunity costs for producing x and ygoods in U.S.A and India have been calculated in the table below on the basis of the informationgiven in the above-mentioned table.Opportunity CostsCountry x yU.S.A. 5/2 = 2.5 2/5India 20/4 = 5 4/20 = 1/5A country has a comparative advantage in producing a good if the opportunity cost forproducing a good if the opportunity cost for producing the good is lower at home than in the

other country. The above table shows that U.S.A. has the lower opportunity cost of the twocountries in producing x good (so, 2.5 < 5), while India has the lower opportunity cost inproducing y (so, 1/5 < 2/5). Thus U.S.A. has a comparative advantage in the production of xgood and India has a comparative advantage in the production of y good. As long as the twocountries’ opportunity costs for one good differ, one country has a comparative advantage inthe production of one of the two goods, while the other country has a comparative advantagein the production of the other good. As long as this is the case, both countries will gain fromtrade, regardless of the fact that one of the countries might have an absolute advantage in boththe lines of production.Gains from TradeWhat is the gain from international trade? As we have already said that in the situation ofinternational trade and international specialization different countries specialize in theproduction of different commodities. The effects (or gains) of trade can be seen by comparingno trade situation and the situation of trade. This is explained below;Example,Production of 20 labour unitsU.S.A. 4x or 10yIndia 1x or 5yNow suppose both U.S.A. and India employ 40 labour units in the production of goods.In the situation of no trade (or no specialization)In this situation, U.S.A. and India both of them produce both the goods and they employequal labour units (example., 40 units) in the production of x and y goods. So,Production of 40 labour unitsU.S.A. 4x + 10yIndia 1x + 5yTotal production 5x + 15yIn the situation of trade (or specialization)In this situation, U.S.A. employs all its labour units (example., 40 units) in the production of x andIndia employs all its labour units in the production of y good. So,Production of 40 labour unitsU.S.A. 8xIndia 10yTotal production 8x + 10yThe difference between production with specialization and production without specialization

and production without specialization is equal to (8x + 10y) - (5x + 15y) = 3x - 5y. If the valueof this is positive then only international trade (or specialization) will be beneficial. This wecan calculate on the basis of domestic exchange ratios of x and y goods in the domestic economyof the country.Since in U.S.A. 4x = 10yHence the domestic exchange ratio is 1x = 2.5y in U.S.A. Now if we substitute thisvalue of x in 3x - 5y = 7.5y - 5y = 2.5yThus, from U.S.A.’s point of view the total output in the situation of specialization willincrease equivalent to 2.5y and this is the gain of trade.In India 1x = 5y, so this is the domestic exchange ratio in India. Now put this value in3x – 5y.Thus, from India’s point of view the gain of trade is equivalent to 10y.Thus, the world can have more production or can enjoy more consumption in thesituation of trade in comparison to no trade situation.Criticisms of Ricardian Theory of Comparative CostThe theory of comparative cost has been attacked on many fronts by many economists fromtime to time. Some of the important criticism are given below.1. Wrong assumption of labour cost – It is based on the labour theory of value. Thistheory estimates cost of production on the basis of labour cost. But the total costsinclude non-labour costs as well, because labour is not the only factor of production.Hence, critics assert that it is not labour cost but money cost alone that can serve asthe basis of comparison.2. Unrealistic model of two countries two commodities – The Ricardian model isrestrictive in operation as it relates to two commodities and two countries only. Inactual practice, international trade is among many countries with many commodities.A rational theory should not have such limitations.3. Unrealistic assumption of the law of constant cost – It assumes constant returns toscale and thus constant costs of production in both the countries. But in actualpractice, the law of constant cost cannot be in operation for all times. Eventually wefind the operation of the law of diminishing returns (example., the law of increasing costs).4. Unrealistic assumption of full employment – The main drawback of the theory ofcomparative cost is that it is based on the assumption of full employment. In thereal world we find the state of under-employment.5. Wrong imagination regarding factor mobility – The theory assumes that factors ofproduction are perfectly mobile within the country, but perfectly immobile among

the countries. Ohlin does not agree to it. Immobility of factors is not a special featureof international trade, it is also prevalent within the different regions of the samecountry.6. Transport costs ignored – Transport costs are assumed to be absent. However, inactual life, transport cost may be more than the production cost in the case of somecommodities. To ignore transport costs in determining comparative cost differencesis a serious defect of the theory. In fact, for international trade, comparative costsadvantage must exceed transport costs.7. One sided – The Ricardian theory of comparative cost is a one-sided theory ofinternational trade, as it takes no account of the demand aspect.8. Unrealistic – The theory is unrealistic in the context of the modern world. Itassumes free and perfect competition which is only a myth.9. Static theory – The theory is static in nature. It assumes full employment, no changein price, wage-rate and the quantities of factors of production. All these assumptionscan be true only in a static economy. But the real world economy is a dynamic one.10. Not applicable in underdeveloped economies – The theory of comparative costdoes not conform to the conditions prevailing in under-developed countries. Thistheory only seeks to maximize current national output. But the problems of underdevelopedcountries refer to the maximization of the rate of growth.Despite these limitations the theory has a stand. It has narrated the truththat comparative advantage is definitely an advantage which should begainfully exploited in international trade.

Study Note - 8PUBLIC FINANCE8.1 INTRODUCTIONIt relates to the earning and spending activities of public authorities viz. Government. Agovernment not only earns money in diverse ways it can also create ‘new’ money for its spending

by borrowing from central bank. Apparently, therefore government has no fixed budgetconstraint as private sector unit faces. It is not forced to cut its coat according to cloth. Ratherthe level of public spending determines public revenues to be acquired. Herein lies the basicdifference between Public Finance and Private Finance. A private household or a corporatebody cuts its coat according to its cloth that is, its spending is influenced by its earning.Another point of contrast between Private Finance and Public Finance is that, private individualor corporate body can earn as much as possible. But the government not only earns money indifferent ways but it has the power to create new money to bridge the gap between its normalearning and spending. Against its securities the Central Bank can grant the Government loanby the creation of new money.8.2 TAXATIONTax revenue is the vital source of public income. A tax is a compulsory contribution collectedfrom citizens for which the tax payers cannot expect any quid pro quo example. direct benefit fromthe payee. Its compulsory nature and absence of benefit to payers are two features by whichtaxes differ from non tax revenues like fees, fines etc. Taxes are sources of public income butthat is not all. They are used for bringing distributive justice, controlling inflation, achievingfull employment, curtailing consumption etc.Objectives of TaxationAccording to classical writers every tax is an evil. J.B. Say stated that –“The very best of allplans of finance is to spend little and the best of all taxes is that which is least in amount”. Thisis because the classical economists believed in the golden rule of zero income and zeroexpenditure by the government. But after the Great Depression of 30s’ a great change has takenplace in our conception to the ideal for which government should tax.Firstly, the primary objective of taxing is to raise resources from private hands inorder to carry out diverse activities of the public authorities. With the passage oftime the activities of modern governments have increased substantially, Accordinglythe need for finance has also increased. The easiest way of raising resources is bythe use of tax mechanism. If fact, tax revenue every where in the world exceeds theother sources of public revenue. Thus tax is an important way of diversion ofresources for socio-economic purpose by the government from private hands.Secondly, some taxes are imposed with the object of restricting the use of some

obnoxious goods. An excise duty on wine restricts its use which is socially desirable.Similarly a tax on import may lead to a restriction of import and thus may help insaving foreign exchange.Thirdly, taxes are also used with the objective of controlling inflation or cyclicalfluctuations in the society. In a period of Demand pull inflation, the governmentmay leave less in the hands of the people by imposing heavy Direct Taxes. As aresult people’s disposable income will be less and so the excess demand will becurtailed to some extent. Similarly in a period of Economic prosperity, thegovernment can tax at a high rate and the money thus obtained may be used in aperiod of depression and unemployment.Lastly, tax is an important source of development finance. The poorer countriesneed large amount of fund for investment in diverse growth oriented projects. Oneway of financing such development activities is by widening and also by increasingthe rate of taxation. It leads to involuntary savings on the part of the populationand is an import source of capital formation.8.3 DIRECT AND INDIRECT TAXESTax payers do not always pay the money from their own pockets. In some cases they do so andbear the burden of taxation example. the hardships of paying the tax. In some other cases, the recordedpayers of a tax pay it after collecting the money, partly or wholly, from some one else. In otherwords, in the former cases the tax burden is not shiftable while in the latter cases they areshiftable. An Income Tax payer pays the taxable money from his own income. On the otherhand, a seller of products pays Sales Tax after collecting it from buyers in the form of higherprice (Cost Price + Local Taxes). So Income Tax payers cannot shift the tax burden while thesales tax payers can. A direct tax is a tax whose burden cannot be shifted example., Income Tax,Wealth Tax etc. A tax is said to be indirect whose burden is shiftable from the tax payers tosome other person example., Salea Tax, Amusement Tax, Excise Duty etc.Further in Direct Tax impact and incidence fall on the same person. The tax payer himself hasto pay the money from his own pocket. The burden of such a tax cannot be shifted eitherbackward or forward.So, the basis of classifying taxes into direct and indirect is the shiftability of tax. Choice betweendirect and indirect taxes is difficult. They have theit respective merits and demerits.Merits of Direct TaxesFirstly, generally the rate of tax increases as Income or value of property increase indirect taxation. That is such taxes are progressive in character. Those who aresupposed to have higher ability to pay are required to do so.Secondly, such taxes can be used for redistribution of income and wealth. Thedisparity between the income of different income groups and of inherited wealthcan be reduced by a graded system of Direct Taxes.

Thirdly, such taxes are economical and easy to collect. The cost of collection is notvery high.Fourthly, the prayers pay such taxes consciously. He gets enough time for itspayment. Lastly, such taxes are highly productive. They bring more revenue to thepublic Authorities.DemeritsA direct tax is not a rose without thorns. It has its blemishes too. They are supposed tohave a positive disincentive effect on work, income and savings. It is but quite naturalthat people may not like to work hard and earn more if they are forced to pay off a largepart of hard earned income. Similarly, people may get disincentive to invest in buildingand property if inheritors are to pay high death duties.Secondly, heavy burden and not being shiftable, such taxes may create a desire toevade them by payers. This may create black wealth and unaccounted income.Public revenue is likely to be less.Thirdly, the tax axe falls more heavily on salaried class who cannot conceal theirincome while those who earn excessive windfall income like trader, business men,speculators can conceal their income. This is unfair and unjust. The total burden ofsuch tax falls on a small percent of population and a vast majority could remainoutside tax net.Merits of Indirect TaxesIndirect Taxes have some merits.Firstly, Widening the tax base is possible. A small amount of tax per head can becollected from a large section of the population. Naturally the total revenue will belarge enough.Secondly, the scope for evasion is lesser than Direct Taxes.Thirdly, they encounter lesser public resistance as tax payers may not be aware oftheir existence.Fourthly, such taxes imposed on imported goods and harmful goods like drug orwine by curtailing their use may serve social interest.Fifthly, in poor economics the scope of raising large resources from direct taxes islimited. For this, such taxes are imposed widely for meeting Public revenuerequirements.Sixthly, such taxes do not have much disincentive effects on earning and enterprise.Demerits of Indirect TaxesThe greatest weakness of Indirect Taxes is that they are, by and large, regressive innature. A given amount of tax on a commodity hurts the small income group morethan the richer one. In this sense, their burden fall more on poor than on rich. Thussuch taxes do not conform to ability to pay and equal sacrifice principles of taxation.Secondly, as indirect Taxes are added with the price of a commodity, they raiseactual price far above cost price. They are thus a contributory factor to inflation.Thirdly, commodity taxes hurt the consumers as they are forced to pay a higherprice and sellers, far from gaining may suffer a loss as their sales may diminish inview of price rise.In conclusion it can be said that the coexistence of direct and indirect isessential forthey serve as mutual compliments. The weakness of one can be corrected by theother. Moreover the two together can bring more revenue than any one. Hence

they are equally preferable.Proportional, Progressive and Regressive TaxationOn the basis of the rate of tax, taxes are classified into three forms – proportional,progressive and regressive.A tax is said to be proportional when it is charged at a flat rate on all. If a manwith an income of Rs. 100 pays a tax of Rs. 5 and a man with an income Rs. 10000 paysa tax of Rs. 500 then the rate of tax is 5% in both cases. It is proportional tax.In case of progressive tax, the rate of tax goes on increasing along with the increasein income or value of assets of a tax payer.When the rate of taxation decreases with the increase in income or asset value itis called regressive taxation.The most important argument infavour of proportional tax is that it leaves the relativestatus of taxpayers unchanged. Further it is uniformly applicable and simple.Nowadays governments prefer progressive taxation because it has certain virtues. Thearguments in favour of such taxation are many. We discuss some of them.Firstly A rise in tax rates with increase in capital and income is necessary becausethe capacity to produce and consume increases faster than wealth and income. So,a higher rate from the higher income group will not affect them too much.Secondly, progressive taxation is also defended on the ground of diminishingmarginal utility of income. As a man’s net income increases marginal utility of itgoes on diminishing. As successive increments of income will lead to diminishingutility so it can be argued that the richer class have greater capacity to pay taxes.Thirdly, progressive taxation is an instrument used by the government for equitabledistribution of income and wealth among different classes of people. Those whoare able to pay more should be taxed at a higher rate than those who are not able topay. The money thus collected may be used for the benefit of weaker classes. Thiswill lead to a rise in economic welfare.8.4 CANONS OF TAXATIONTax is a delicate instrument in the hands of the government. Just as a drug deadly when takenin large doses may have a reviving effect on the body to which it is administered with caution,so also taxation. How can tax be properly administered? Economists have suggested certainprinciples which the government can follow for ideal tax administration.Adam Smith long ago propounded four such principles, which he called ‘canons’ asguiding stars of tax authorities.(a) Cannon of Ability – Smith was of the view that subjects of a state oughtto contribute “in proportion to their respective abilities example., in proportionto the revenues they respectively enjoy.” A proportional tax, as Smithadvocated, implies equality of sacrifice.(b) Cannon of Certainty – This cannon lays down that taxes “be certain andnot arbitrary.” Prior intimation as regards the amount and time ofpayment was thought necessary for reducing trouble and difficulties oftax payers.(c) Cannon of Convenience – According to Smith taxes be collected

according to the convenience of the payers. It should be levied “at thetime or in the manner in which it is most likely to be convenient.”(d) Cannon of Economy – Smith suggested that tax system be so framed “asboth to take out and to keep out of the pockets of the people as little aspossible over and above what it brings into the pubic treasure”. Thisimplies least cost collection. Even with taking as little as possible fromtax payers, tax revenue can be large if small amount is used up for theircollection.Barring the first, all the cannons put emphasis on administrative side of taxation. Theability to pay implied proportionality. But now it is interpreted in terms ofprogressiveness. As a natural sequence to proportionality is equality of sacrifice on thepart of tax payers. But modern thinking is not equal sacrifice but least aggregate sacrifice.After Smith many other principles have been developed looking after the conflictinginterests of government and taxpayers.(a) Principle of Least Sacrifice – Payment of taxes involves a certain burdenof sacrifice upon each taxpayer. What should determine the distributionof tax burden. Some hold that the aggregate sacrifice should be least,while other opine that the sacrifice borne by the taxpayers be equal. Butthe problem is that sacrifice example., real burden of taxes can hardly bemeasured.(b) Cost and Benefit Principle – This principle holds that whenever costsare incurred for the benefit some individuals or groups of men, suchpeople should pay such costs in the form of taxes. The Benefit principlestates that tax burden should be proportionate to the amount of benefitenjoyed by different people. It is very difficult to measure costs andbenefits. Some services provided for all and cannot be specifically chargedfor. Similarly, most benefits are of general type. Hence it is difficult toascertain who are the real beneficiaries. Moreover, a rigid adherence tothis principle will rule out many of the general functions of a government.Relief of the poor, unemployment dole cannot be undertaken, as costcannot be borne by the beneficiaries. In a word, this principle is abstractand impracticable.(c) Ability Principle – The principle states that distribution of tax burdenwill be ideal if taxes are levied on the basis of payers ability to pay. Itseems to be just and equitable principle. But by what test can we measurea man’s ability. The answer simply is that by the size of his income.Heaviest burden should be placed upon the broadest back. But Incomecannot always be a criterion of ability (i) people with same income mayhave different personal obligations (ii) unearned income (income frominherited property) involves less sacrifice than hard earned income. Soincome is not a sound test of ability. Can it be measured by the size ofexpenditure? Some believe that personal expenditure indicates how mucha man is taking out form the stock of goods and services of the society.To think that no man spends unless he is able to do so, is not alwayscorrect. A man may be compelled to spend more because of familyliabilities. Moreover it is very difficult to ascertain expenditure, especiallyconsumption expenditure.

A third test of ability may be property. Property in its wider sense implies all incomeyielding assets. Possession of more property means more ability to pay. But there arecertain difficulties. First, men with no property may earn high income and with propertymay earn less. Obviously the former is able to pay more than the latter. Secondly,inherited property and property acquired by individual effort and sacrifice cannot bethe same. To tax them equally, will be unjust. Thirdly, all properties do not bring aregular flow of income. A house for one’s own living or jewellery yield no income.8.5 EFFECTS OF TAXATIONThe imposition of a tax may set in motion a series of effects and adjustments in society. Broadlythey relate to production and distribution.ProductionThe impact of tax on production may be favourable or unfavourable, depending uponits effects on willingness and ability to work as well on the distribution of economicresources between different regions and economic activities. Apparently a tax is likelyto reduce the desire to work and earn. Actually it need not be so. Tax on unearnedincomes and unexpected incomes may not have an adverse effect. Secondly, a high rateof tax may induce people to work hard and earn more to compensate the loss of incomecaused by taxation.Taxation affects production in another way. A discriminatory tax may divert capitalfrom more heavily taxed industries to one less heavily taxed. However such diversionis often socially desirable channels. On the other hand, tax may cause harmful diversionof resources. A tax on an essential goods or service by checking production may causeharm to the society. Similarly capital may flow out of a country if its tax rates are relativelyhigher. A tax on a particular type of industry, in general, checks production and divertscapital away from that line of production. But the tax proceeds, if used judiciously, mayprovide stimulus to production in some other industries of high social value.DistributionThe effects of taxation on distribution of income depend on the nature of tax. Inheritancetax, property tax, a tax on windfall earnings may go a long way in reducing inequalityof income and wealth. Again, tax on necessary goods used by all classes of people, polltax are said to be regressive in nature in the sense that they hurt the poor class morethan the richer one. Similarly a system of taxation which is proportional that is, a uniform

rate of tax is imposed on all irrespective of the size of their income or property have atendency to create inequality in the distribution of income among various groups. Taxeshave their ‘redistributive effect’ good or bad and the government can use them to serveits goal.Fiscal Policy and Monetary PolicyFiscal policy is a policy of the government relating to public expenditure, revenue, borrowingetc. It includes taxation policy, subsidies, deficit financing etc. Monetary policy, on the otherhand, is one which is used to control the supply of money in circulation or to control bankcredit in a country.(a) Fiscal policy is formulated and implemented by government while monetarypolicy is executed by the central bank(b) Fiscal policy has wider scope compared to monetary policy. Monetary policy ismainly used to control the money supply so as to secure financial stability. Itsobjective is often to allocate bank credit rationally. Fiscal policy is used to promotepublic welfare and economic development. It also seeks to achieve greaterequality in the distribution of income and wealth among various classes ofpeople. Another objective of Fiscal policy is to control import and to promoteexport.(c) The various tools of Fiscal policy are taxation, public expenditure, publicborrowing, deficit financing, licensing. The various tools of Monetary policyare Bank Rate policy, open market operation, variation of reserve ratio, selectivecredit control etc. (d) Monetary policies can be implemented easily and they have quick reaction. ButFiscal measures can be taken after debate and discussion in Parliament. Hencethey are time consuming. Nor are their effects upon the economy very quick.Both of them are applied to serve some common objectives like controllinginflation or business cycle. Hence the two policies are more often used together. This iscalled Monetary Fiscal Mixes.8.6 DEFICIT FINANCINGWhen government spending exceeds its earnings the budget is said to be deficit, and to bridgethe gap if government borrows money from the central bank or run down its accumulatedreserves, it leads to a net addition to money supply. This way of financing a deficit budget iswhat is called Deficit Financing. Thus deficit financing denotes more spending by thegovernment through created money.PurposeLord Keynes advocated deficit financing for lifting up of an economy from businessdepression and unemployment. According to him demand deficiency was the root causeof these problems. Hence the prescription to raise private expenditure comprising

consumption and investment. The total expenditure of the private sector cannot increaseon its own in a depressionary economy. It needs external push. This is what thegovernment should do through a policy of budgetary deficit financed by new money.Why the deficit be not covered up by taxation and borrowing? In that case, privatespending power will diminish. So total expenditure will not increase. It is only creationof new money and its injection into the economy can raise the C + I + G curve upwardto a level where unused and unemployed resources may be gainfully employed.An excess spending by the government by created money, will lead to a correspondingincrease in private sector’s earning and spending ( I + C). Thus, the shortfall in demandcan be overcome. So long there are unemployed men and resources, creation of newmoney and its spending by the government can cause more output and moreemployment by activating those idle resources. But once resources are fully employedmore spending by the Government will lead to inflationary rise in price. MeritsThe aforesaid discussion shows that financing of a deficit budget by the creation of newmoney has a helpful role –(1) The new money added with the old ones increase the total liquidity of aneconomy thus increasing total money income and effective demand.(2) This enhances the total spending power both C and I. Thus effective demandincreases.(3) At less than full employment, a raise in effective demand activates theunemployed factors.(4) With such activisation, national output and employment will go on rising.(5) Ultimately the economy may achieve full employment and optimum output.(6) In the poor economies this method of financing plays an important role as asource of development finance.In order to come out of the vicious circle of poverty originating from low income andlarge unemployment, planners finance planned investment by creating more and more‘new’ money.Demerits.A large amount of new money created by the government may be dangerous. It isargued that deficit financing leads to inflation. Deficit financing creates excess demand.But there may not be an excess supply due to the unavailability of certain factors ofproduction. This may lead to demand full inflation. This is generally likely to happenin poor economies where raising of effective demand through large scale publicinvestment may not increase output and employment on account of “bottlenecks”. Deficitfinancing thus generates inflation which persists along with unemployment. Thissituation is known as Stagflation.

Secondly, new money issued by the government may be used by the private sector forspeculative and unproductive purpose. In such a situation it will cause more harm thangood.

Study Note - 9FORMS OFBUSINESS ORGANISATION9.1 INTRODUCTIONDuring the life time human being has to undertake numerous and varied activities. The nature,propensity and the motivating force behind them are not similar in all cases.The infinite human activities are of two kinds.(1) economic activities and(2) non economic activities.Economic activities are those which are inspired by the desire to earn money or livelihood. Forexample a worker is working in a factory, a clerk is attending to his duties in office, a teacher isteaching in the class. Non economic activities are those which are undertaken not for earningmoney but out of love, patriotism, humanity, social and religion, customers etc.

Economic activities are those human activities which are related to the production, exchange,distribution and unlimited consumption of wealth. They are inspired mainly by economicconsideration and result in the production of economic goods and services. These activitiesbelong to the domain of business. Hence all human activities related with the earning andspending of wealth fall under the category of economic activities.Economic activities are also identified with occupations. Business is an occupation in whichorganized production and exchange of goods and services are undertaken with a view to earnprofits. There are different types of business activities. A grocery shop is as a much a businessenterprise as a giant company like Reliance Industries or Maruti Udyog Ltd.Business is an economic activity involving the production or procurement and sale of certaingood and services for the satisfaction of human need in the society.All the business activities fall under three difference categories –(1) Industry(2) Trade(3) Commerce.Industry, Trade and Commerce are closely related to each other. They are interdependent.Industry depends upon commerce for the distribution of goods and services and commercehas to depend upon the industry for the supply of goods. Trade provided support to industryand commerce.A modern businessman desires that his activities should be well organized and planned so asto active maximum success. In order to fulfil this desire a number of forms of business organizationhave been evolved to suit different situations and purposes. For example, when thebusiness is of a local nature and on a small scale, a sole proprietorship would be found to besuitable whereas if export and import on large scale is to be undertaken by a concern a jointstock company may have to be formed. Each form of business organization has its own meritsand demerits. Different types of business entities along with their advantages and limitationshave been depicted in the following pages.9.2. SOLE-PROPRIETORSHIP9.2.1 IntroductionSole proprietorship is the oldest, the simplest and, in some respects, the most natural form ofbusiness organization. In such an undertaking, the proprietor brings in his own capital, manages

the business himself, bears all the risks alone and takes all business decisions. Here, theproprietor uses his own skill and intelligence in the management of its affairs with almostunlimited freedom. The proprietor is entitled to receive all the profits and assumes all the risksof ownership. The competence of the proprietor determines the prospect of the business. Theproprietor is, in fact, the sole organizer, manager, controller and master of his business.9.2.2 Meaning and definitions of sole proprietorshipThe sole proprietorship is a form of business that is owned, managed and controlled by anindividual. This organization is also called a single ownership or single proprietorship. Thesole proprietorship form of business is generally operated on a small-scale basis. At present, itis the most popular form of organization.Definitions given by eminent management experts :(a) “Sole proprietorship is an informal type of business owned by one person”.[James L. Lundy](b) “Sole proprietorship is a type of business unit where one person is solely responsible for providing the capital, for bearing the risk of the enterprise and forthe management of the business”. [J.L.Hanson](c) “Sole proprietorship form of ownership, a single individual organizes and operates the business in his own name. He is not only responsible for its management but also for its risks.” [Kimbell and Kikbell](d) “Under the sole proprietorship form of ownership, a single individual organizes and operates the business in his own name. He is not only responsible forits management but also for its risks”. [J.M.Shubin]Thus, sole proprietorship is a ‘one-man show’ where an individual by his cleverness, courage,ability, honesty, education and co-operation tries on business exclusively by and for himself.The proprietor not only bears all the risks but also receives the entire gains form the business.9.2.3 Characteristics of the sole proprietorship form of business.The main characteristics of a sole proprietorship business are as follows :(1) Capital contribution : The proprietor alone has to arrange for necessary capital and other assets essential for starting and subsequent operation of his business. The proprietor provides the entire capital, either from his private resources or by borrowings from relatives and friends.(2) Management and control : The proprietor has full authority over the affairsof the business. He is free to take decisions. There is no need for consultationwith any other person. The working of the concern is entirely based on hisown dis cretion and decision.(3) Unlimited liability : The liability of a proprietor is always comprehensiveand unlimited. He is liable for all the debts and loans of the business. If theassets of the business are not sufficient to meet the liabilities, in that case hispersonal property can be attached.

(4) Limited area of operation : The scope of operation of a sole proprietor islimited because of limited capital, limited managerial ability and limited space.(5) Free from legal formalities : A sole proprietor is free from any legal formalities to be complied with in the establishment of the business. Sole proprietorship is subject to minimum legal formalities and Government restrictions.(6) Distribution of profit : The sole proprietor receives all the profits of hisbusiness alone. Moreover, he bears all the losses of the business (if any). So,there is a direct relationship between effort and reward. A sole proprietor generally puts in his heart and soul to increase his profits.(7) Flexibility in operations : A sole proprietor enjoys the maximum flexibility inhis business. He can easily change, expand or reduce business according tohis discretion.(8) No separate entity : This form of business does not have an entity separatefrom the owner. The proprietor and the business enterprise are not the same.(9) Discretionary start and end : A proprietor can start the business at any timewithout any legal formalities. Similarly, he can terminate the business without waiting for legal compliance.(10) Trade secrecy : The proprietor keeps all his trade secrets only to himself. Inthis way, he avoids competitors by retaining business secrets.(11) Freedom in selection of trade : A proprietor can start any business accordingto his own will. There is no binding on him. He is not supposed to consult anyperson while making a selection of his trade.(12) Personal relations : A sole trader has always direct relations with his customers. The business, which requires personal service and attention, is generallyestablished under this form of organization.9.2.4 Legal position of a sole proprietorThe following points are worth considering with regard to the legal position of a soleproprietor :(1) There is no legal restriction in the establishment of a sole proprietorship form ofbusiness.(2) There is no specific law under which this business required registration.(3) Licenses are, in some cases, obligatory [example., to open a wine shop].(4) This business is subject to the general laws of the country.(5) The liability of the sole proprietor is unlimited.(6) The proprietor and his business have one personality. The business exists onlywith the sole proprietor.9.2.5 Merits ( or advantages) of sole proprietorship form of businessThe sole proprietorship form of business possesses the following significant merits :(1) Easy formation : The sole proprietorship business can be established very easily.No legal formality or other complicated procedure is required to be followed. Aperson can start business operations as and when he desires. Only a licence is neededin some special cases (example., opening a wine shop, etc.)(2) Prompt decisions : A proprietor can take quick decisions regarding his businessaffairs (example., price policy, credit policy, discount policy, disposal of surplus funds,etc.). He can take spot decisions as and when required.

(3) Smooth functioning : There is none to oppose his decisions. Therefore, he can functionsmoothly. He can control his business affairs personally.(4) Incentives for hard work : There is always a direct relationship between the effortsand the rewards in the case of a sole proprietorship. Therefore, the more a proprietorwill work, the more he will earn. It provides incentives to work hard, efficientlyand honestly.(5) Flexibility in operations : This form of business can easily adapt to the changingconditions of the market. The line of the business can easily be changed or modifiedaccording to change in socio-economic conditions. A proprietor can easily change,expand or reduce his business on account of change of market conditions. Thus, heenjoys the maximum flexibility in his business.(6) Maintenance of business secrecy : Maintenance of secrecy is very vital in a smallscalebusiness. A proprietor can maintain secrecy regarding his business as he hasnot to consult anyone on business decisions. Possibilities of maintaining completesecrecy give him a greater competitive strength.(7) Intimate contacts with customers : The proprietor develops close and personal contactswith his customers. This enables him to cater to the exact requirements of hiscustomers. He can easily ascertain the nature of tastes, habits and attitudes of hiscustomers. He can also know their difficulties, complaints easily by keeping personalcontact with the customers.(8) Inexpensive management : The management of a sole proprietor is not expensiveat all. All supervisory and management activities are performed by the proprietorhimself, thus minimizing the additional expenditure on managerial staff. Moreover,overhead costs of management are relatively low. This leads to a good deal ofsavings.(9) Efficiency in management : The proprietor’s personal interest is involved in hisbusiness. He tries, heart and soul, to eliminate all sorts of wastages in order to reducecosts and maximize profits.(10) Freedom regarding selection of business : A sole proprietor can select the businessof his choice and he is not required to seek permission from anyone else for thispurpose. He can also change his business acoording to business requirements andchanging circumstances.(11) Minimum Government regulations : The business activities of a sole proprietorare least regulated by law and the Government. A sole proprietorship business hasto comply with mainly labour laws and tax laws. There is no other interference inthe day-to-day running of the business from the Government.(12) Tax advantage : A sole proprietorship business enjoys the minimum tax burden as

compared to other forms of business organizations. A proprietor is taxed as an individualan not as a business unit separately. Income tax authorities make no differencebetween the proprietor ad the business regarding the assessment of incometax.9.2.6 Demerits Limitations of sole proprietorship form of BusinessThe sole proprietorship form of business suffers from the following drawbacks :(1) Unlimited liability and risk : The principles of unlimited liability for the ownerputs the proprietor at great risk in times of losses. The proprietor will always behaunted by the fear of losing his private property in case of failure of his business.(2) Limited financial resources : The capital and other resources of an individual arealways limited. An individual proprietor cannot offer much security to raise fundsfrom financial institutions. Therefore, there appears to be a limited capacity of expansionof business operations.(3) Limited managerial capability : It is not possible for a single individual to possesexpertise in all fields (example., production, finance, personnel, marketing, etc.) So, thedecisions of the proprietor may not be balanced due to limited managerial ability.(4) Instability of the business : The continuity and existence of a sole proprietorshipform of business is most uncertain. Any uncertain events happening in the personallife of the proprietor are surely to disturb the smooth working of the business. Thebusiness may suddenly come to an end with the death or physical incapacity of theproprietor.(5) Uncertainty in purchase and sales : The proprietor is unable to get full advantageof bulk purchases and increased sales, as he carries on his business on a small-scale.This may lead to a rise in the cost of business operations. This form of businesscannot enjoy the benefits of large-scale production.(6) Weak bargaining position : The proprietor cannot control the market because ofhis limited financial resources. Thus, his bargaining power is weak, both as a purchaserand seller.(7) Limited scope for employees : A sole proprietor cannot attract trained and qualifiedpersons for reasons of limited career opportunities. Moreover, a proprietor cannotoffer financial incentives to attract skilled employees because his activities areon a small-scale.(8) No check and control : A sole proprietor is the monarch of his business. No outsidercan question him on his acts and deals. Moreover, there is nobody to help andguide him. There are no checks and controls on the activities of the p proprietor. (9) Too much secrecy causes suspicion : Secrecy is desirable for business operationsbut too much secrecy leads to suspicion by outsiders. The outsiders are unable to

asses the soundness of a proprietorship form of business because it is not requiredto publish accounts of the business.(10) Limited scope for expansion : Due to limited capital, limited managerial capabilityand unlimited liability, a sole proprietorship cannot grow and expand to a largesize. Its goodwill and bargaining positions are also weak.9.2.7. COMMON FORMS OF SOLE PROPRIETORSHIP :The business that take the form of sole proprietorship are – retailers, hawkers, bakers, confectioners,restaurants, jewellery shops, furniture shops, printing houses, small machine shops,professional firms (accountants, solicitors, photographers, tax consultants, etc.)9.2.8. Social desirability of sole proprietorshipThe sole proprietorship form of business has a social desirability because of the following reasons:(i) Equal distribution of wealth in the society;(ii) Opportunity for self-employment with limited investment;(iii) Employment to a large number of persons in the society;(iv) Direct and close relations with the customers;(v) Providing goods at low prices due to less overhead burdens;(vi) Providing opportunities to learn the techniques of the business;(vii) Limited risks associated with the business due to the low-scale of operations;(viii) Opportunity to establish cottage and small-scale industries;(ix) Suitable for production of seasonal goods;(x) Producing goods on the basis of customers; choice and preferences;(xi) The absence of middlemen ensures the benefit of both the sole trader and theconsumers; and(xii) Offering an honorable living to those who do not want to work under others.9.2.9. Suitability of sole proprietorshipThe sole proprietorship form of business is considered to be indispensable under the followingcases :(i) It is very suitable for the production of goods of an artistic nature.(ii) It is very suitable in all such cases where :(a) A small amount of capital is required;(b) The risks involved are relatively small;(c) Personal attention towards customers is required;(d) Business is of a small size;(e) The markets are localized and limited.(iii) It is very suitable for a business, which requires greater personal attention to cutomers.(iv) It is very suitable for small-scale business requiring prompt decisions andadjustability with the market conditions.(v) It is very suitable for the business where techniques of precision are essential.9.3 JOINT HINDU FAMILY BUSINESSThe Joint Hindu Family business is a peculiar form of business organization, operating in ourcountry. It is a form of business organization is which the family possesses some inherited

property and the head of the family, known as Karta, manages its affairs. It is possible only inthose parts of India where the Mitakshara System (Hindu Law) of inheritance is in operation. Itmeans that no Joint Hindu Family is possible in Bengal and Assam where Dayabhaga systemof inheritance prevails. Again, the joint family business is confined to those persons who constitutethe coparcenaries interests. Previously, female members and their relations did not havecoparcenaries interest; only male members had the interest. Under the Hindu Succession Act,any female relative of deceased (male) coparcener is entitled to get a share of the coparceneryinterests at the time of death of such coparcener. The rights and liabilities of coparceners aredetermined by the general rules of the Hindu Law. Thus, joint family business is created by theoperation of Hindu Law and does not arise out of contract between the coparceners.9.3.1 Characteristics(1) Status. The membership of the family business is the result of status arising formbirth in the family. Hence the majority or minority in age of the members is immaterial.(2) Only male members. Female members are excluded from the class of coparceners.Only male members can be coparceners.(3) No Registration. For the purposes of enforcing its claims and right it does not requireregistration like partnership.(4) Management. The business is managed by Karta, the head of the family. Otherfamily members have no rights of arrangement over the business and they cannotcontract any loans on mortgages binding on the joint family property. (5) Liability. The liability of all members of the family, except the Karta, is limited tothe value of their individual interests in the joint property. The liability of Karta isunlimited.(6) Fluctuating share. The share of each members interest in the family property includingbusiness is always fluctuating in character. The member’s interest increaseby death of existing coparcener and decreases by birth of a new coparcener.(7) Continuity. The existence of the business is not affected by the death or insolvencyof a coparcener of the Karta.(8) Supremacy of karta. Karta is supreme authority in the business. The members cannotquestion the judgment of Karta in the conduct of the business. If they are aggrieved,they can ask for the partition of family and business property. But theycannot ask the Karta for an account of past profits and losses.

9.3.2 MeritsFollowing are the Merits or Advantages of Joint Hindu Family Business :-(1) Assured of a share in profits. Every coparcener is assured of a share in the profitsof the business, irrespective of his contribution to the successful running of the business.(2) Freedom of action. Karta can cake quick decisions and can also act without anyinterference by others.(3) Limited liability. The liability of all the coparceners except that of Karta is limited.(4) Insurance against contingencies. It serves as an insurance cover for maintainingthe children, widows, ailing or invalid members of the family.(5) Cooperative efforts. The duties of the business are divided among the members inaccordance with their capabilities and resourcefulness.(6) Inclusion of finer values of life. Every member of the family gets an opportunityfor participation in the business and the qualities of duty, sacrifice and disciplinebecome embedded in them.9.3.3. DemeritsFollowing are the demerits or disadvantages of joint family business :(1) Lack of motivation- Members do not fell motivated to work hard because there islack of direct relationship between benefits and efforts.(2) Scope for misuse- Since Karta has full freedom and authority tomanage the business,he may misuse this freedom for his personal benefits and gains. (3) Limited resources- It has limited resources at its disposal for investment in business.(4) Family quarrels- Small family quarrels may lead to its disintegration.This form of organization is declining because of the strains on joint family system due topreference for individual family living.9.4. PARTNERSHIP FIRMThe partnership firm of business organization grew out from the limitations of sole proprietorship.When the business expands, one man is unable to arrange the financial resources andbear the risks. He cannot supervise and manage all the functions of business personally. Therefore,two or more persons joint hands and combine their capital and skill to start and run abusiness, Partnership is thus an extension of sole proprietorship.9.4.1 Meaning and Definitions of PartnershipA partnership is a voluntary association of two or more persons who agree to carry on somebusiness jointly and share its profits and losses. They combine their funds and skills to carry on

business together. Some popular definitions of partnership are as follows:Partnership is the relation existing between persons competent to make contract, who agree tocarry on a lawful business in common with a view to private gain.— L.H. HaneyA partnership or firm as it is often called is, then a group of men who have joined capital orservices for the prosecuting of some enterprise. — KimballPartnership is the relation between persons who have agreed to share profits of a businesscarried on by all or any one of them acting for all. — The Partnership ActA partnership is a form of business organization in which two or more persons upto a maximumtwenty join together to undertake some form of business activity. – J.L.HansonTwo or more individuals may form a partnership by making a written or oral agreement thatthey will jointly assume full responsibility for the conduct of business.—John shubin.The persons who enter into partnership with the one another are individually called ‘partners’and collectively a ‘firm’. The name under which they carry on business is called the ‘firm name’.9.4.2 Essential elements (or features) of partnershipThe essential elements of a partnership contract are enumerated as follows :(i) Lawful business : The term ‘business’ includes all trades, professions or occupations.The purpose of a partnership agreement is to carry on a lawful businessand nothing else.(ii) Name of the business : The partnership firm must have its own name. Thename in which the business is carried on is called the ‘firm name’.(iii) Association of persons : At least two persons are needed to make a partnership.Indian Partnership Act is silent about the maximum number of members. TheIndian Companies Act provides that maximum number of member as then (incase of a Banking business) and as twenty (in other cases).(iv) Profit motive and sharing of profits : Partnership business is formed with theobject of earning profit. The earned profit is to be distributed among the partnersas per an agreed ratio.(v) Contractual relationship : Partnership is a contractual relationship between thepersons who are competent to enter into a contract. Relationship between partnersarises from contract and not from status.(vi) Mutual trust and confidence : The successful working of a partnership dependson mutual trust and confidence of its partners. Partners have the duty to observeutmost good faith in business dealings.(vii) Principal-agent relationship : It is not necessary that the business should bemanaged by all the partners. Any one or more partners can run the business onbehalf of all the partners. Each partner is an agent of the firm and his activities

bind the firm.(viii) Restrictions on transfer of share. No partner can transfer his share in the partnershipwithout the prior consent of all the other partners. Thus, a partner cannottransfer his interest at his own will.(ix) Unlimited liability : Partnership is based on the principle of unlimited liability.The personal property of the partners can be attached to satisfy the claims ofcreditors of the firm, if the assets of the firm are insufficient to meet the claim ofthe creditors.(x) Management and control : Every partner has a right to take an active part in themanagement of the firm. The unanimous consent of all partners is required totake any major decision.(xi) Financing : Ordinarily, each partner is required to contribute capital on a profitsharingratio. However, in some cases, a partner with special technical skillsand ability may not contribute at all towards the capital of the firm.9.4.3 Kinds of PartnersWe can classify partners into various categories, depending on the role played by them in theirday-to-day business activities.(i) Based on extent of participation :(a) Active partner; (b) Sleeping partner.(ii) Based on sharing of profits :(a) Nominal partner; (b) Partner in profits only.(iii) Based on liabilities :(a) Limited partner; (b) General partner(iv) Based on the nature of behaviour :(a) Partner by estoppel; (b)Partner by holding out.(v) Other partners :(a) Secret partner; (b) Silent partner.(i) Based on extent of participation :(a)Active partner (or Working partner) : An active partner is a partner who not onlycontributes capital but also takes an active part in the conduct of the business of thefirm. He is a full-fledged partner in the real sense of the term. The active partner isalso known as a ‘working partner’.(b) Sleeping partner (or Dormant partner) : A partner who does not take active part inthe management of the business is called a sleeping partner. A sleeping partneronly contributes his capital to the business and shares in the profits or losses of thefirm.(ii) Based on sharing of profits :(a) Nominal partner (or, Quasi/Ostensible partner) : Nominal partner is a person whoneither contributes capital not takes an active part in the conduct of the business ofthe firm. He only lends his name and reputation for the benefit of the firm. He is notentitles to receive any benefit or share of profits from the firm.

(b) Partner in profit only : A partner in profit is a person who gets a share of profits butdoes not share any losses of the firm. Such a partner is not allowed to take part inthe management but will have to bear all liabilities to third parties.(iii) Based on liabilities :(a) Limited partner : A limited partner is a partner who has the right to take part in theaffairs and management of the firm. The liability of such a partner is limited to theextent of the capital contributed by him. In a partnership firm, all the partners cannothave limited liability. At least one partner must have unlimited liability. (b) General partner : In case of a general partnership, the liability of all they partners isunlimited. A general partner is entitled to participate in the management of thebusiness.(iv) Based on nature of behaviour :(a) Partner by estoppel : A partner by estoppel is a person who has neither contributedany capital nor takes any part in the management of the firm. But he conductshimself in such a manner which leads third parties to believe that he is a partner ofthe firm. If fact, he is not a partner of the firm. He is held liable for the debts of thefirm to such third parties who might heave entered into contract with the firmunder such an impression.(b) Partner by holding out : if a person is declared by other as a partner of the firm andhe does not contradict it immediately and remains silent, he would be treated as apartner by holding out. He is liable to such third parties who enter into contractwith the firm in the belief that he is a partner of that firm.(v) Other partners :(a) Secret partner : A partner who wants that his name should be kept secret is called asecrete partner. Such a partners is, however, liable for the debts of the firm.(b) Silent partner : A partner who does not have any voice in the management of thefirm is called a silent partner. Such a partner, however, shares the profits or losses ofthe firm and bears the burden of its debts.9.4.4 Kinds of partnershipThe partnership business has been divided into different categories as follows:According to aims :(a) Partnership at will; (b) Particular partnership.According to time :(a) Fixed term partnership; (b) Flexible partnership.According to legality :(a) Legal partnership; (b) Illegal partnership.According to nature :(a) General partnership; (b) Limited partnership.According to aims :(a) Partnership at will : When a partnership is formed to conduct the business foran undefined period, it is called partnership at will. The life of such a partnership

depends on the will of the partners. The partnership can be dis solved at thedesire of any partner on giving due notice. Such a partnership firm is formed tocarry on lawful business for an indefinite period. (b) Particular partnership : When a partnership is formed to conduct a particular businessof a temporary nature or only for a certain period, it is called particular partnership.Such a firm is dissolved immediately on the completion of a particularventure or on the expiry of a certain period.(ii) According to time :(a) Fixed term partnership : The partnership which can be formed for a fixed period oftime is called fixed term partnership. On the expiry of that fixed period, the partnershipis automatically dissolved.(b) Flexible partnership : When a partnership is formed neither for a fixed period norfor any particular venture, it is called flexible partnership. Such a partnership firmcontinues its operation till any contingent happening (under which dissolution iscompulsory).(iii) According to legality :(a) Legal partnership : When a partnership firm is established under the conditions ofthe Indian Partnership Act, 1932, it is known at legal partnership. Here, the minimumnumber of partners is two and maximum is twenty (but in a Banking Business,the maximum number is ten).(b) Illegal partnership : When the business of a firm becomes (or is declared) illegal,violating the provisions of any law of the country, it is called an illegal partnership.When the number of partners, either reduces to less than two or increases to morethan twenty, then also the partnership becomes illegal.(iv) According to nature :(a) General partnership : In a general partnership, the liability of each partner is unlimited.In India, all partnership firms are general partnerships. In the absence ofan agreement, the provisions of the Indian Partnership Act, 1932, will be applicablefor general partnership. Each partner of a general partnership is entitled to take anactive part in the management of the firm, unless otherwise decided by the otherpartners.(b) Limited partnership : A limited partnership is a partnership consisting of somepartners whose liability is limited to the amount of capital contributed by each. Ina partnership firm, all the partners cannot have limited liability. At least one partnermust have unlimited liability.Minor as a partner. A minor is a person who has not completed 18 years of age. A minorcannot become a partner because he is not qualified to enter into a contract. But he may beadmitted to the benefits of partnership with the mutual consent of all the partners. On being so

admitted, a minor becomes entitled to a share in the profits of the firm. He can inspect andcopy the books of account of the firm but he cannot take active part in the firm’s management.His liability is limited to the extent of his share in the capital and profits of the firm. He cannotfile a suit against the firm or its partners to get his share except when he wants to disassociatehimself from the firm.After becoming a major, the minor must give a public notice within six months if he wants tobreak off his connections with the partnership firm. If he does not give such a notice within sixmonths or if he decides to remain in the firm, he comes liable to an unlimited extent for thedebts of the firm from the date he was admitted to the benefits of partnership. He also becomesentitled to take active part in the management of the firm’s business.Rights and Liabitities of a Minor Partner :1. A minor is entitled to a share in the profits of the firm.2. A minor may be admitted with the benefits of partnership with the mutual consent of all the partners.3. A minor has got the right to inspect and copy the books of accounts of the firm.4. A minor’s liability is limited to the extent of share in the capital of the firm.5. Being a minor he cannot file a suit against the firm or its partners to get his shareexcept when he wants to leave the partnership. If he does not express anything inwriting, his existence as a partner will be implied and he will be subject to unlimited liability like the other partners.6. After he becomes a major he also becomes entitled to take part in the management of the firm’s business.9.4.5 Partnership Deed. It is a document containing the terms and conditions of a partnership.It is an agreement in writing singed by all the partners duly stamped and registered. If definesthe rights, duties and obligations of partners and governs relations among them in the conductof business affairs of the firm. It is not a public document. The partnership deed must notcontain stated in partnership deed can be changed with the consent of all the partners.Partnership deed usually contains the following clauses :1. Name of the firm.2. Nature of the firm’s business.3. The principal place of business.4. Duration of partnership, if any.5. Names and address of partners.6. Amount of capital to be contributed by each partner.7. Amount which can be withdrawn by each partner.8. The profit-sharing ratio.9. Rate of interest, if any, on capital and drawings.

10. Amount of salary or commission payable to partners.11. Allocation of work among partners.12. Mode of valuation of goodwill.13. Procedure for admission, retirement, etc. of a partner.14. Procedure for maintaining accounts and getting them audited.15. Procedure to be followed in the event of dissolution of the firm andsettlement of accounts.16. Arbitration clause in case of disputes among partners.17. Loans and advances by partners and rate of interest payable on them.9.4.6 Registration of PartnershipRegistration of a partnership firm is not compulsory under law. The Partnership Act 1932 providesthat if the partners so desire they may register the firm with the Registrar of Firms of theState in which the main office of the firm is situated. A firm may be registered at the time of itsformation or at any time thereafter.Procedure for RegistrationIn order to get a partnership firm registered an application in the prescribed form must be filedwith the Registrar of Firms. The application should contain the following information :(i) The name of the firm.(ii) The principal place of business of the firm.(iii) Names of the other places where the firm’s business is carried on.(iv) Names in full and permanent addresses of the partners.(v) The date on which each partner joined the firm.(vi) Duration of partnership, if any.The application should be signed and verified by each partner. Then it is submitted to theRegistrar of Firms of the area in which the principal place of the firm’s business is situated orproposed to be situated. A small amount of registration fee is also deposited along with theapplication. The application submitted to the Registrar is examined. If the Registrar is satisfiedthat everything is in order and all legal formalities have been observed, the Registrar shallmake an entry in the registrar of firms. He will also issue a certificate of registration. Anychange in the information submitted at the time of registration should be communicated to theRegistrar. Registration does not provide a legal entity to the partnership firm.9.4.7 Rights and Obligations of PartnersThe rights and obligations of partners are generally laid down in the partnership deed. In casethe partnership deed not specify them, then the partners will have rights and obligations prescribedin the Partnership Act. These are given below:Rights of Partners

1. Every partner has a right to take part in the conduct and management of the firm’sbusiness.2. Every partner has a right to be consulted and express his opinion on any matter relatedto the firm. In case of difference of opinion, the decision has ordinarily to be taken by amajority. But vital issues like admission of a new partner, change in the firm’s business,alteration of profitsharing ratio, etc., must be decided by unanimous consent of all thepartners.3. Every partner has a right to have access to, inspect and copy any books of accounts andrecords of the firm.4. Every partner has the right to an equal share in the profits of the firm unless otherwiseagreed by the partners.5. Every partner has the right to receive interest on loans and advances made by him to thefirm. The rate of interest should be 6 per cent unless otherwise agreed by the partners.6. Every partner has the right to be indemnified for the expenses incurred and losses sustainedby him in the ordinary conduct of the firm’s business.7. Every partner has a right to continue in the firm unless expelled in accordance with theterms of the partnership agreement.8. Every partner has a right to retire in accordance with the terms of the partnershipagrement.or with the consent of other partners.Duties and Liabilities of Partners1 Every partner must act diligently and honestly in the discharge of his duties to themaximum advantage of all the partners.2. Every partner must act in a just and faithful manner towards each other.3. Every partner must act within the scope of the authority entrusted to him.4. Every partner is bound to share the losses of the firm equally unless otherwise agreed.5. Every partner must indemnify the firm against losses sustained due to his willfulnegligence in the ordinary course of business.6. No partner can transfer or assign his interest in the firm to others without the consentof other partners.7. Every partner must maintain and render true and correct accounts relating to thefirm’s business.8. No partner must engage himself in a business in competition with the firm, otherwisehe will be liable for any loss suffered by the firm. He will have to surrender privateprofits to the firm.9. Every partner should use the firm’s property only for the firm business and interest.

10. No partner should make secret profits by way of commission or otherwise from thefirm’s business. He is liable to account for and pay to the firm any private profit fromthe transaction of the firm or from the use of its property or goodwill.11. Every partner is liable jointly with all the other partners and also severally for all thedebts of the firm. The liability of a partner to third parties is unlimited.Implied Authority of A PartnerEvery partner has the implied authority to bind the firm and other partners by his acts done inthe name of the firm, in the ordinary course of the firm’s business and with the intention tobind the firm.A partner has the implied authority to do the following acts on behalf of his firm.(i) To buy, sell and pledge goods on behalf of the firm.(ii) To raise loans on the security of such assets.(iii) To receive payments of debts due to the firm.(iv) To accept, make and issue bills of exchange, promissory notes, etc., on thebehalf of the firm.(v) To engage servants for the firm’s business.(vi) To take on lease a premises on behalf of the firm.However, a partner has no implied authority, unless otherwise expressed in the partnershipdeed, in the following matters :(a) To submit a dispute relating to the firm to arbitration.(b) To compromise or relinquish any claim or a portion of claim made by the firm.(c) To withdraw a suit or proceeding filed on behalf of the firm.(d) To admit any liability in a suit or proceeding against the firm.(e) To open a bank account on behalf of the firm in his own name.(f) To acquire or purchase immovable property for and on behalf of the firm.(g) To transfer or sell immovable property belong to the firm; and(h) To enter into partnership with others on behalf of the firm.9.4.8. Dissolution of Partnership FirmsA partnership firm is said to be dissolved when it ceases to carry on business, its assets are soldand its liabilities are paid off. The firm discontinues its activities and none of the partners hasany relation of partnership with other partners.Dissolution of the firm should be differentiated from dissolution of partnership. In dissolutionof partnership the original partnership agreement is terminated due to the admission, insolvency.Retirement or death of a partner. But the other partners continue the business by enteringinto a new agreement. A partnership can be dissolved without dissolving the firm. Dissolutionof partnership implies change in partnership whereas dissolution of firm means discontinuanceof business. The dissolution of the includes dissolution of partnership too.

A partnership firm may be dissolved in any of the following ways :-1. Dissolution by agreement. A partnership firm maybe dissolved with the mutual consentof all the partners or in accordance with the terms of the agreement.2. Dissolution by notice. In case of partnership-at-will, a firm may be dissolved if anypartner gives a notice in writing to other partners indicating his intention to dissolve thefirm. In such a case, the dissolution takes place with effect from the date mentioned inthe notice. If no date is mentioned, the firm would be dissolved with effect from the dateof receipt of the notice by other partners. When such a notice is given to other partners,it cannot be withdrawn without their consent.3. Contingent dissolution. A firm may be dissolved on the happening of any of the followingcontingencies :(i) On the expiry of the term, if it is for a fixed period.(ii) On the completion of the venture for which the firm was constituted.(iii) On the death of a partner.(iv) On the adjudication of a partner as insolvent.4. Compulsory dissolution. A firm stands automatically dissolved in the followingcases:(i) When all partners or all but one partner are declared insolvent.(ii) When the business of the firm becomes unlawful due to the happening of anevent.5. Dissolution through Court. Court may order the dissolution of a firm in the following cases:(i) When a partner becomes of unsound mind.(ii) When a partner becomes permanently incapable of performing hisduties as a partner.(iii) When a partner is guilty of misconduct which is likely to affect preju dicially(example. moral turpitude, misuse of money) the business of the firm. (iv) When a partner willfully and persistently commits breach of the partnershipagreement.(v) When a partner unauthorized transfers the whole of his interest orshare in the firm to a third person.(vi) When the business of the firm cannot be carried on except at a loss.(vii) When in the opinion of the court it is just and equitable that the firm should bedissolved.9.4.9. Merits of a partnership form of businessThe following are the merits of a partnership form of business:(i) Simple formation : It can be formed easily without much expense and legalformalities. Only an agreement between the partners is required. Registrationis also not compulsory.(ii) Sufficient resources : A partnership has larger resources as compared to asole trader. The combined resources of many individuals would certainly belarger than the limited capital of a sole trader. Moreover, new partners can be

admitted to secure more capital, managerial ability and organizing capacity.(iii) Flexibility of operations : A partner can introduce any changes that he considers desirable to meet the changing circumstances. There is no legal restrictionas long as the firm carries on a lawful business.(iv) Specialization in management : A partnership enjoys all the advantages of division of labour. Division of work among partners is done on the basis of theirspecialization. It helps in increasing the efficiency of the business, resulting inmore profits.(v) Benefits of combined ability : Under a partnership, several persons pool theircapital, resources, skills, expertise, experience, services, etc. This helps to expand the activities of the firm.(vi) Prompt and balanced decisions : A partnership firm is a combination of abilities, experience and judgment of different persons. Such a combination of skillsfacilitates the making of balanced and sound decisions.(vii) Caution for unlimited liability : Fear of unlimited liability encourages cationand care on day-to-day activities. Partners are discouraged to take hasty andreckless business decisions in the conduct of the business.(viii) Democratic organization. Every partner can participate in the operation ofthe business of a partnership firm. Moreover, all the partners are consultedbefore taking any decision.(ix) Protection of minority interest : The views and voices of each partner carriesequal weight. All the partners have a rights to take part in the day-to-daymanagement. Thus, a partnership firm protects the minority interests. (x) Business secrecy : A partnership firm is not expected to publish its final accounts for the general public. Thus, the partners can keep their business secrets to themselves. The competitors do not have to know anything about theexact position of the business.(xi) Close supervision : Partners have direct access to the employees and they canencourage workers to improve production. Thus, the partners can directlyminimize costs in order to maximize profit by reducing wastage.(xii) Protection to minor partner: A minor partner can be taken into a firm withlimited liability. He shares the profits of the business only. He may or may notbe a partner after attaining maturity.(xiii) Risk and reward are fairly balanced : There is always a direct relationshipbetween effort and reward in the case of partnerships. This motivates parnersto work harder in order to enjoy higher profits.(xiv) Good personal relations with customers and employees : Every partner canbe made to develop healthy and cordial relationship with employees and customers. The fruits of such relationships may be reflected in better accomplishment and larger profits.(xv) Easy dissolution : It is easy and inexpensive to dissolve a partnership. Thepartnership can be dissolved on insolvency, lunacy or death of a partner. Nolegal formalities are required at the time of dissolution. So, it is easy to start aswell as dissolve a partnership concern.

9.4.10 Demerits of partnershipThe following are the demerits of a partnership form of business organization :(i) Unlimited liability: The liability of the partners is unlimited and they arejointly responsible for all acts and debts. The creditors can make any or all ofthe partners liable and recover their dues even form the private property ofpartners.(ii) Uncertain continuity: There is always an uncertainty in continuing this typeof organization. Death, insolvency, insanity of one of the partners may leadto dissolution of the firm. In an atmosphere of uncertainty, long range planning and innovations are not possible.(iii) Limited resources : A partnership firm may not be able to raise adequatecapital for expansion beyond a certain limit. Though the capital is more in apartnership than in a sole proprietorship form of business, still it is not sufficient for large-scale operations.(iv) Lack of harmony : It is difficult task to maintain harmony among the partners for a long time. There is a possibility of differences of opinion amongstthemselves. Mutual conflicts and lack of team spirit among partners may leadto loss of reputation and dissolution of the firm. (v) Lack of public confidence: It may not enjoy the confidence of the publicbecause its accounts are kept secret and there is an absence of publicity. Moreover, the affairs of the firm are not legally controlled. Therefore, the publicmay not place much confidence in such firms.(vi) Risk of dishonest co- partners : A dishonest partner may cause injury to theother partners. One partner may be made to suffer heavy losses due to thedishonesty of another.(vii) Restricted transferability of the partner’s interest : A partner cannot transfer or assign his share in the firm to a third person without the consent of theother partners. He, thus, loses the liquidity of his investment.(viii) Risk of implied authority : Each partner of the firm has the implied authority to act on behalf of the firm and all other partners. A partner may abuse hisimplied authority for personal gain.(ix) Absence of professional management: Modern business needs the expertservices of those who have acquired managerial skills and render their services to business undertakings as salaried officers. In partnership firms, wewitness the absence of professional management.Suitability : Despite its weakness, partnership form of organization is suitable for small andmedium-sized business. It is highly appropriate for professional services like chartered accountants,solicitors, doctors, etc. which require pooling of specialized skills and direct contactwith the clients. Partnership is also popular in wholesale and retail trade.9.5COMPARISON BETWEEN PARTNERSHIP AND SOLE PROPRIETORSHIP1. Number of members. Sole proprietorship is owned and controlled by oneperson. The number of partners in a firm can be upto ten in banking businessand twenty in other cases. At least two persons are required to form a partnership.2. Agreement. No agreement is required in a sole proprietorship. On the other

hand, there must be an express or implied agreement among partners in order to constitute a partnership.3. Registration. A sole proprietorship need not be registered except under theShops and Establishment Act. A partnership firm should be registered otherwise it will not be able to enforce its rights in the court of law.4. Capital. The entire capital of a sole proprietorship is contributed by one man,the owner of business. In a proprietorship, several persons contribute capital.There fore, a partnership firm can raise larger financial resources than a proprietor.5. Management. The management of sole proprietorship lies exclusively withits owner. He is the supreme authority in the business. But in a partnership,every partner has a right to take part in the management of the firm. There ispooling of knowledge and judgment. Work can be divided among partnersaccording to their skills and aptitudes.6. Secrecy. Secrets of sole proprietorship are known only to its owner. In partnership, secrets are shared among the partners. Therefore, a sole proprietor isin a better position to retain the secrets of business.7. Quick decisions. In sole proprietorship one man takes all the decisions. Butin partnership decisions are taken though mutual consultation between thepartners. Therefore, sole proprietorship can take decisions more quickly thana part nership. But decsionsm taken in a partnership are likely to be less reckless and hasty than those of a proprietor.8. Governing law. There is no specific law governs sole proprietorship. Partnership is governed under the Partnership Act 1932.9. Sharing of profits. There is no profit sharing in a sole proprietorship and allprof its belong to the owner. In a partnership profits are shared between allthe parners.10. Flexibility of operation. Proprietorship is a one man show whereas partnership is carried on by two or more persons. Therefore, there is greater flexibilityof operations in sole proprietorship.11. Mutual agency. In proprietorship there is no mutual agency. But in a partnership every partner is an implied agent of the firm and of other partners.12. Scale of operations. Sole proprietorship is suitable for small scale business,while partnership is suitable for medium sized business. Scope for expansionis greater under partnership.13. Risk. The owner alone bears all the risks of sole proprietorship. In a partnership risks are shared by all the partners.14. Continuity. The life of a partnership is more uncertain than that of sole proprietorship. Lack of mutual trust and unity among the partners can result in untimely dissolution of partnership.9.6COMPARISON BETWEEN JOINT HINDU FAMILY AND PARTNEERSHIPThe distinction between partnership and Joint Hindu Family business may be put as under:1. Partnership is the result of an agreement between the members while Joint HinduFamily business is not the result of an agreement but the result of status.2. The death of a member will bring about the dissolution of the partnership firmbut joint Hindu family firm is not dissolved by the death of any male member.3. A member of either sex can be partner in a firm while it is only male membersthat can be members of a joint family firm.4. A new partner can be admitted into the partnership firm only with the consent

of the other partners while in case of joint family firm, there are constant andautomatic additions by the birth of male children.5. Every partner has the right to pledge the credit or the firm or the partnershipbusiness but it is only the manager (Karta) of the Joint family firm that can contracta debt so as to bind the other members.6. The liability of the partners in a firm is always unlimited and they are personallyliable for the debts. But the members of a joint family firm except the Kartaare liable only to the extent of their interest in the joint family firm. The Karta ispersonally liable for the firm’s debts.7. Every partner can ask for dissolution and accounts of the firm but only right ofa member of joint family business is to ask for partition of the existing assets,and not to demand an account from the manager for his dealings in past.8. A minor cannot become a partner in the firm. However, a minor can be admittedto the benefits of the partnership. But in a joint family business, a minormale becomes its members by his birth in the family.9. Every partner enjoys the authority to act and to bind the other partners by hisacts. All the partners can take active part in the management of the business ofthe firm. In the joint Hindu family firm, only the Karta of the family enjoysthese.10. In partnership the number of partners is limited to 10 in case of banking businessand to 20 in the case of other business but in case of Joint family businessthere is no such restriction.9.7 CO-OPERATIVESJust as limitations of a sole proprietorship led to the rise of the partnership form of businessorganization, the limitations of partnership too gave rise to larger forms of business organizationlike cooperatives and companies.A co-operative society is a voluntary association of persons who join together to safeguardtheir own interests. It is a business activity without having any profit motive, but for benefitingthemselves through self-help and co-operation. The primary objective of forming a co-operativeis to protect economically the weaker sections of the society from the oppression of theeconomically organized strong segment of the society. It is a democratic organization run byits members for serving their own interests.The basic philosophy of a co-operative organization is four fold :(i) Service in place of profits; (ii) Mutual help in place of competition; (iii) Self-help inplace of dependence; and (iv) Moral solidarity in place of unethical business practices.Thus, co-operative organizations are generally started by the economically weak sections topromote their common economic interests through business propositions. The primary objectof any co-operative organization is to render service to its members.Definitions given by eminent management experts :

(a) “Co-operative is a form of organization, wherein persons voluntarily associate together as human beings on the basis of equality for the promotion of the economicinterests of themselves.” [Prof. E.H.Calvert](b) “Co-operative is joint enterprise of those who are not financially strong and therefore, come together not with a view to get profits but to overcome disability arisingout of the want of adequate financial resources.” [H.N.Kunzen](c) “Co-operative is an association of individuals to secure a common economic goalby honest means.” [Sir Horace plunkett]Definition as per Co-operative Societies Act, 1912:Co-operative society is a voluntary association of individuals which has its objectives inthe promotion of economic interests of its members in accordance with co-operative principles.[Section 4 of the Indian Co-operative Societies Act, 1912]From the definitions, certain definite features of a cooperative could be noted as follows:9.7.1 Features(a) Voluntary association. The membership of co-operatives is open to all freelyand voluntarily. There are no conditions laid down on the basis of caste orcreed and colour. There is neither compulsion or denial to any one desiring tobecome member of the cooperative.(b) Service motive. The purpose of the co-operatives is not making profit. The cooperativesocieties are formed with a motive of service. The members are interested in helping each other. The co-operatives are for ensuring social justice. Itdoes not mean that co-operatives do not make profit. In business the profit ismany times regarded as the acid test of the efficiency of working units. However, the members of co-operatives do not believe in profit making throughexploitation. (c) Equality. Every members of a co-operative society enjoys equal status. No onehas special voting rights. The members may be holding different number ofshares but all the members have equal voting right. No one is enjoying anyspecial privileges.(d) Democratic management. Every member of a co-operative society is allowedto express his views and is also free to criticize the working of the cooperative.The management is democratic. Like political democracy, here also the management is of the members, by the members and for the members. The memberselect their representatives and like the board of directors of a company theserepresentatives manage the affairs of the co-operative on behalf of the members.(e) Cash transactions. The business of co-operatives is generally carried on Cashbasis. The members are discouraged to have credit facilities with a view to avoiding bad debts. This safeguards the interests of all the members.(f) Corporate status and state control. Like a Joint Stock Company, a Co-operative Society also is required to be registered in law and it is also treated as anindependent legal entity. The Government regulations are binding on it. It cansue and get sued in law and also can purchase or sell any asset or property.(g) Religious and political neutrality. The cooperatives believe in fraternity. Allthe members are brothers and sisters and therefore, the religious or political

view of the members do not find any place in the affairs of the cooperative.(h) Education. The co-operatives believe in educating their members about the principle of cooperative. There is a feeling of togetherness. The benefits are to beshared by all equally.(i) Limit on shares. Usually, it is decided by the co-operatives as to what would bethe maximum limit of the shares that could be held by any member. The capitalis made available by the members at practically no cost. The interest if any isdistributed out of surplus but in most of the cases the interest is waived by themembers contributing the capital.(j) The distribution of surplus. All the members are entitled to an equitable shareof the surplus. There is a limit of the dividend that could be paid by a Cooperative Society.(k) Political and religious neutrality : The membership of a cooperative society isopen to all, irrespective of religion, caste, political affiliations and beliefs. A cooperativerepresents universal brotherhood and it should not lose its path inpolitical contradictions. Co-operative societies are neutral as far as political andreligious affiliations are concerned.(l) Legal status : A cooperative society is required to be registered under the CooperativeSocieties Act, 1912. It has its separate legal entity and perpetual succession. With the change in the status of its members, the structure of a cooperative society is not changed. (m) Transfer of shares : The shares of a cooperative society are not freely transferable. A member can surrender his shares to the society with the permission ofthe society’s office bearers.(n) Liability of members : The liability of the members of the co-operative societyis restricted to the extent of subscribed shares. But, for this purpose, the societywill have to write the work ‘Limited’ after its name.(o) Government regulation and control : A co-operative society is governed by theIndian Co-operative Societies Act, 1912. A society can be registered only if itsatisfies the conditions laid down by the statute for this purpose. The co-operative societies are to follow certain rules and regulations framed by the Government. There is a control of Central and State Governments on the working ofco-operative societies in India.9.7.2 Types of co-operative undertakingsCo- operative societies are classified into different types, according to the nature ofservicesrendered by them. The following are them main types of co-operative :(i) Consumer’s co-operatives;(ii) Producer’s co-operatives;(iii) Marketing co-operatives;(iv) Credit co-operatives;(v) Housing co-operatives;(vi) Industrial co-operatives societies.

(i) Consumer’s co-operative societies : Consumers co-operative societies are establishedby the consumers of a certain locality for the purpose of social upliftmentof their members. These co-operatives are formed to ensure a steady supply ofessential commodities of standard quality to the members at fair prices. The consumersco-operatives purchase the goods on a wholesale basis and sell these goodson a retail basis to the members at fair prices. The profits of the society are distributedamong the members in also utilized for providing social services (example., medicalaid, education, sanitary improvements, etc.) These co-operatives are run bythe members themselves through an elected team of office bearers.The objectives of consumer’s co-operative societies are :(a) Availability of consumer goods of higher quality at a cheap rate.(b) Eliminating the middlemen by establishing a direct link with the producers.(c) Maintaining stability in the prices of essential commodities. (d) Avoiding black marketing and hoarding practices.e) Avoiding the evil effects of inflation as far as possible.(f) Establishing equality of status among the members.(g) Enhancing the purchasing power of the members.(h) Providing incentives to the members in the form of bonus on purchases madefrom co-operatives.(ii) Producer’s co-operative societies : These societies are formed for the benefit ofsmall producers, who have difficulty in collecting various factors of productionand face market problems.The objectives of producer’s co-operative societies are :(a) To stimulate higher production.(b) To improve the quality of the products.(c) To make full use of the available industrial skills of individuals.(d) To help in tackling the problems of unemployment and underemployment.(e) To utilize idle man-power.(f) To strengthen the position of small-scale artisans or crafts.Thus, producer’s co-operatives are voluntary associations of small producers, who joinhands to face powerful capitalists. These societies are formed for the benefit of small producerswho cannot easily collect various items of production and face some problems inmarketing. These co-operatives provide raw-materials, tools, technical guidance, etc., tothe members, so as to enable them to produce specified goods. Profits of the society aredisbursed among the members as per rules.Producer’s co-operatives may be of two categories :(1) Production co-operatives, and(2) Industrial service co-operatives.(iii) Marketing co-operative societies : These societies are formed to enable theirmembers to secure fair prices for their goods. In other words, these co-operatives are associations of producers for selling their products at remunerative

prices. The production of different members is pooled and the society undertakes to sell these products by eliminating middlemen.The objectives of these societies are :(a) to ensure a ready, steady and favourable market for the production of different members;(b) to undertake centralized selling of the produce contributed by their members;(C) to eliminate middlemen and reduce the costs of marketing;(d) to provide services like assembling, grading, storing, packing etc;(e) to provide loans to producers against the deposit of their goods;(f) to improve the bargaining position of the producers;(g) to ensure the supply of standard goods at reasonable prices;(h) to control the flow of supplies and thus influence prices;(i) to collect marketing information and supply it to the members for their benefit;(iv) Credit co-operative societies : These societies are formed in rural and urban areas to attract the small savings of its members. These societies are estab lished byagriculturists, industrial workers, salary earners, artisans, etc., on the basis of collective interests for the purpose of mutual assistance. These societies provide loansto their members on easy terms of interest, security and repayment. The aim of acredit society is to grant credit to its members for productive purposes at a verylow rate of interest. The society educates its members with the habit of thrift. Thesociety collects savings of its members and gives short loans to members (in need)from time to time at cheaper rates.The credit co-operative societies may be of two types : (1) Agricultural credit societiesand (2) Non-agricultural credit societies.Agricultural credit society may be of three types:(a) Primary credit societies (at the village level);(b) Central co-operative banks (at the district level);(C) State co-operative banks (at the State level).(v) Housing co-operative societies: These societies are organized to provide residential accommodation to their members, either on an ownership basis or at fairrents. The members of the society contribute their savings to the common fund ofthe society with borrowed money from banks to buy a plot of land in order toconstruct a building for their dwelling purposes. The purpose of these societies isto help the members in purchasing land and constructing houses. State HousingBoards help economically weaker sections of the society in owning their housesand paying the price in easy.(vi) Industrial CooperativesIndustrial co-operative means an association of artisans, craftsmen, industrial workers,small businessmen for co-operative and collective interest.Industrial co-operative may be defined as an undertaking of craftsmen or skilledworkers engaged in a cottage or small scale industry to undertake production, purchaseof supplies and raw materials, marketing of products and supply other servicesto members.The need for such an organization is felt due to the individual financial and managerial

limitations. The members of a co-operative pool their resources to carry onthe business and thus to provide employment.The objectives of this type of organization could be classified under two heads.Social objectives and Economic objectives.The following are the main objectives of an industrial co-operative :1. To promise industrial development of rural areas.2. To increase production and productivity.3. To purchase in bulk raw materials, tools and equipments and to supply tomembers.4. To provide marketing facilities to the members.5. To arrange for training of members in managerial matters.6. To raise loans from members and non-members.7. To provide gainful employment to rural masses.8. To grant loans and advances to members.9. To safeguard the weaker sections from exploitation of large producers and sellers.10. To purchase machinery and other equipments and to give them on hire to members.11. To make optimum use of the available resources.12. To improve financial position of artisans and craftsmen by selling their goods atbest prices.13. To take advantage of combined managerial and technical expertise.14. To secure large contracts from Government agencies and public bodies.As indicated earlier, the industrial co-operatives could be related to production or service activitiesor they may manage industrial estates.They are observed to be suffering from a number of problems. Some of these problems are :(a) Poor planning,(b) Inadequate finance,(c) Non availability of raw materials(d) Non availability of expertise due to poor service conditions.(e) Competition in the area of marketing.(f) Political interference as in case of sugar co-operative in the State of Maharashtra(g) Inadequate supervision and control.(h) Hostile attitude of merchants and traders.9.7.3 Advantages of co-operative undertakingsThe advantages of a co-operative form organization can be enumerated as follows:(i) Easy formation : A co-operative society is a voluntary association of persons. Itdoes not require long and complicated legal formalities at the time of formation. Any ten persons may form a co-operative society for the promotion oftheir economic interests.(ii) Limited liability : The liability of the members is limited to the extent of capitalcontributed by them as mentioned in the bye-laws of the society.(iii) Open membership : Any person can become a member of the society andavail of its advantages. The minimum number of members required is ten butthere is no limit to the maximum number of members. A member can leave thesociety by returning his share whenever he likes.

(iv) Democratic management : A co-operative society is managed in a democraticway on the basis of equal voting rights. Thus, every member is able to have avoice in its management. Every member has an equal say in formulating thepolicies of the society.(v) Perpetual succession : It is a separate legal entity and its life is not affected bythe death, insolvency or conviction of its members. It has a fairly stable life andit continues to exist for a longer period.(vi) State patronage : The policy of the Government is to encourage co-operativesin every field. Co-operatives are given financial assistance and loans at muchlower rates of interest. Co-operatives are exempted from paying stamp dutiesand reg istration fees. As regards income-tax, co-operatives are offered severalconces sions and reliefs. (vii) Service motive : Co-operative societies are started, not for profit, but for service. The members are provided with financial help and goods and services atconcessional rates. A feeling of co-operative is created among the members.(viii) Economic advantages : It provides financial assistance to agriculturists andlow income group members. It also provides loans for productive purposes.More over, credit co-operatives protect the members from exploitation by moneylenders.(ix) Social advantages : With the establishment of co-operative societies, the feeling of co-operation and democracy increases in the society. Economic power isdecentralized. The poor people can get the advantages of their efficiency bybecoming members of a co-operative society.(x) Moral advantages : Mutual help, self-help, hard work, education, self-dependence, savings, etc., are considered as the basic principles of co-operative societies. It is for avoiding social tensions, litigation and mutual distrust. Co-operative systems attempt to achieve a wide-based rural development and rural industrialization.(xi) Political advantages : It is based on the principles of equal distribution ofwealth. It puts effort to eliminate vested interests, to create delegated leadership and teach members the need of self-governance.(xiii) Low management cost: Some of the expenses of the management are saved bythe voluntary service of the members. Members take active interest in theworking of the society. So, the society does not require to spend large amountson managerial personnel.9.7.4 Disadvantages of co-operative undertakingsCo-operative undertakings suffer from the following drawbacks:(i) Limited resources : Co-operative societies always suffer due to lack of capital. Societies are not able to raise huge amounts of capital because their members are persons of meager income. Therefore, societies are not able to takeadvantage of large-scale production.(ii) Inefficient management : The societies are not managed efficiently becausethey do not get specialized and professional managers as they cannot affordto pay high remunerations. The members usually lack experience and managerial capability. Thus, management here is generally inefficient due to lack ofspecialization.

(iii) Lack of direct incentive : There is no direct relationship between effort andreward. Honorary office bearers often do not have incentives to work hard.(iv) Lack of secrecy : The affairs of co-operatives are generally exposed to themembers. It becomes quite difficult for them to maintain secrecy in businessaffairs. Business secrecy is leaked out to the members and office bearers of thesociety.(v) Lack of business elasticity : There is a lack of business elasticity in such cooperativesocieties. These societies are unable to compete with other privateenterprises.(vi) Lack of savings by the members : The progress of co-operatives mainly depends on savings. But in our country, the members are not in the habit ofsaving. That is why co-operatives may not be able to mobilize adequate capital for large-scale and risky businesses.(vii) Lack of competition : Co-operatives, generally, do not face any stiff competition. Markets for their goods and services are more or less ready and assured.Hence, there is possibility of slackening of efforts.(viii) Limited considerations : Profits earned by societies are very low. Proper andadequate returns on capital employed are not possible. That is why peopleare not interested in becoming members of the society.(ix) Excessive government interference : Excessive State regulations interfere withthe flexibility of its operations and the efficiency of the management. Excessive State interference is detrimental to the development of co-operatives inIndian.(x) Corruption : One of the most important drawbacks of co-operatives is theprevalence of corrupt practices in the management and functioning of suchsocieties. Corruption is an obstacle in the growth, progress and developmentof a co-operative society.(xi) Other drawbacks :(a) Non co-operation among members;(b) Absence of motivation;(c) Inflexibility in operations;(d) Groupism in management’(e) Conservatisms and illiteracy of the members;(f) Improper maintenance and checking of accounts.9.8. JOINT STOCK COMPANYA company is an artificial person created by law, having a separate legal entity, with a perpetualsuccession and a common seal. It is an association of individuals for the purpose ofearning profit. It has a capital divided into a number of shares, of which each member possessesone or more shares and which are transferable by its owners.Joint stock company has been defined by many eminent authors, eminent jurists and institutions.From a study point of view, we can divide these definitions into the following threecategories :Definitions given by eminent authors :(i) “A company is an artificial person created by law, having a separate legal entity,

with a perpetual succession and a common seal.” [L.H. Haney](ii) “A company is an association of many persons who contribute money or money’sworth to common stock and employ it in some trade or business and who share theprofits or losses arising therefrom.” [James Stephenson]Definitions given by eminent jurists :(i) “A company is an artificial being, invisible, intangible and existing only in theeyes of law.” [Chief Justice Marshall](ii) “Company means an association of persons united for a common object.”[Justice James](iii) “A company is an association of many persons who contribute money to a common stock and employ it for a common purpose.’’ [Justice Lord Lindley]Definitions given by the Indian Companies Act :According to Section 3(1)(i) of the Companies Act, 1956, a company means an artificial entitywhich is formed and registered under this Act or existing company.Thus, a company is an incorporated association created by law, having a distinctive name, acommon seal, perpetual succession, limited liability, etc., formed to carry on business for profit.9.8.1. Characteristics (or features) of joint stock companyThe most distinguishing features of a joint stock company may be stated as follows :(i) Incorporated association : A company is an incorporated association. It comesinto existence only after registration under the Companies Act.(ii) Voluntary association : A company is an association of many persons on avoluntary basis. So, a company is formed by the choice and consent of themembers. Shareholders can withdraw their investments from the company atany time they desire.(iii) Artificial legal person : A company has a legal personality and, as such, it isregarded by law as an artificial legal person. A company has the right to acquire and dispose of the property. It can into contract with third parties in itsown name. It can sue and be sued in its own name. (iv) Separate legal entity : A company has a legal entity distinct from its members. It is an artificial person having an independent existence. The principleof separate legal entity was established in the case of Solomon Vs. Solomon &Company Limited. (1897).(v) Common seal : The common seal with the name of the company engraved onit. It is used as a substitute for its signature. The company cannot sign anydocument as it is an artificial person. Documents issued by a company mustbear a common seal and it must be witnessed by at least two directors of thecompany.(vi) Perpetual succession : The company has perpetual succession as its existenceis not affected in any way by the death, insolvency or exit of any shareholder.A company comes to an end only when it is liquidated according to the provisions of the Companies Act.(vii) Transferability of shares : The shareholders are at fully liberty to dispose oftheir shares to any person of their choice. Transferability of shares enables ashareholder to increase or decrease his investment in a company at any time.

It ensures the safety of investment in the shares of a company.(viii) Limited liability : Liability of the members of a limited company is restrictedto the face value of the shares purchased by them. The personal property ofthe members of a company cannot be attached to satisfy the claims of creditors of a company.(ix) Separation of ownership from management : The company is not managedby all the members because, the number of members may be large. The authority to manage the whole of the affairs is conferred to elected representatives of members known as directors. A company acts through its directors.Thus, directors are the hands and brains of the company. Members of thecompany have no direct control over the day-to-day activities of the company.(x) Statutory regulations and Government control : A company is governed bythe Companies Act and it has to follow various provisions of the aforesaidAct. Moreover, accounts of the company must be audited by a chartered accountant. In addition to this, a company has to submit a number of returns tothe Government. In this way, a company has to comply with numerous statutory requirements.(xi) Rigidity of objects : The type of business in which the company would participate must be mentioned in the ‘object clause’ of its Memorandum of Association. The company cannot take up any new business without changing theobject clause. A company cannot work beyond its Memorandum and Articlesof Association. (xii) Strict legal formalities to commence business : A company is to follow somestrict formalities to commence its business. In order to form a company, it isnecessary to submit certain documents to the Registrar of Companies (such asmemorandum of association, articles of association, prospectus, list of directors, consent of directors, etc).(xiii) Social benefits : Company form of business enables better utilization of available resources. It is needless to say that with the increase in production andimprovement in quality, all classes of the society have benefited.(xiv) Accountability to shareholders : All the affairs of the company are to be disclosed to the shareholders so that they may come to know about the prospectsand other problems of the company as a whole. Therefore, a company is responsible for its accountability to the shareholders.(xv) Public confidence : Audit of accounts of the company is compulsory underthe Indian Companies Act, 1956. The financial statements of a company arepublished every year. Thus, public remains acquainted with the activities ofthe company. Moreover, there are some legal restrictions of the activities of acompany. In these way, a company enjoys greater public confidence.(xvi) Scope for expansion : A company is better placed as regards the facilities ofthe growth, development and expansion of its business. It can expand itsmanagerial capacities and financial resources easily. It has great potential forgrowth and expansion.9.8.2 Advantages (or merits) of a company form of organization

The following are the merits of a joint stock company :(i) Accumulation of huge financial resources: The company form of businessfacilitates mobilization of large amounts of capital for investment in industries. The company by its widespread appeal to investors of all classes, canraise huge capital required for large-scale operations. In addition, it can borrow from banks and financial institutions to a larger extent.(ii) Economies of large-scale production: The company form of business can enjoyall the benefits of large-scale production, such as minimum cost of productionand maximum profit. Economies in purchase, production, selling and distribution, etc., would provide goods to the consumer at a cheaper price. Largecapital enables the size of the business to be extended and permits the use ofexpert knowledge and specialization of functions. Thus, production is increasedand efficiency is enhanced.(iii) Scope for expansion: A company can easily expand its managerial capacitiesand financial resources. It has great potential for diversification and growth.It can expand its business by issuing new shares and debentures as there is notrestriction to the maximum number of members in a public company. (iv) Stability of existence : The organization of a company as a separate legalentity gives it a character of continuity. As a incorporated body, a companyenjoys perpetual existence. Thus, a company, because of its continuity andstability, can build up a power of endurance and a high level of efficiency.(v) Transferability of shares : The shares of a public company are freely transferable. The shareholders are at full liberty to dispose of their shares to anyperson they desire. In other words, shareholders can withdraw their investments from the company at any time they like. Transferability of shares provides maximum protection to those shareholders who are in the minority group.(vi) Democratic control : The company is managed on the principle of democracy. The Board of Directors who manage the company are elected by theshareholders. The directors are responsible and accountable to the shareholders. Because of separation between ownership and management, persons withmanagerial ability can occupy positions of control.(vii) Managerial efficiency : A company can secure the services of highly qualified persons who are experts in different fields of business management.Through the company, capital and business ability may be linked together forthe benefit of both the individual investor and the community as a whole.(viii) Stimulation to savings and investments : The company is an effective mediaof mobilizing the scattered savings of the community and investing these savings for commercial purposes. Insurance companies, banks and other financial institutions invest their money in the shares of different joint stock companies. It channelises public small savings into industry.(ix) Tax relief : The company enjoys greater tax relief as compared to other formsof business. Company pays lower tax on a higher income as it pays tax on theflat rates. Moreover, a company gets some tax concessions, if it establishesitself in backward area. Some tax incentives are available for export promotion also.(x) Diffused risks : The membership of a public company is large. The businessrisk is divided among several members of the company. This encourages investment of small investors.

(xi) Statutory regulation and control : Formation and working of companies arewell regulated by the provisions of the Companies Act. These strict regulations safeguard the interests of shareholders and people who deal with thecompany. Statutory regulations make the management healthy, fair and justfor all the activities of the company.(xii) Public confidence and popularity: A company is guided and controlled bystrict regulations and Government control. These ensure public confidencewith regard to investment in shares and debentures. Since the company’s financial accounts are published and circulated, the public has enough faith onthe activities of the company. Thus, at present, a company enjoys greater public confidence, better prestige and reputation in the business world as a whole.(xiii) Capacity of afford maximum risks : A company can bear high risks, becauseof its large financial resources. Companies in many industries are progressingday by day because of their capacity to afford high risks.(xiv) Social responsibilities: Due to the existence of the company form of business, society is benefited in respect of: (a) opportunity in employment; (b) development of large-scale industries; (c) facility of huge capital formation; (d)increased Government revenue; (e) improvement in standard of living, etc.9.8.3 Disadvantages (or limitations) of a company form of organizationThe following are the disadvantages of a joint stock company :(i) Adherence of too many legal formalities : The formation of a company requires adherence of too many legal formalities. The establishment and running of a company would prove to be troublesome, because of complicatedlegal regulations. Moreover, the formation and management of the companyis expensive too.(ii) Concentration of power in few hands : Shareholders of the company havepractically no say in the affairs of the company. The directors of the companybecome self-centered and they do not care for the shareholders. In most of thecases, directors try to formulate policies in order to promote their own interests. Thus, the company form of organization has helped concentration ofeconomic power in few hands.(iii) Excessive Government control : A company has to observe too many provisions of different laws imposed by the Government. This affects the smoothfunctioning of the company.(iv) Undue speculation in shares of the company : Undue speculation in sharesof a company is injurious to the interests of the shareholders. Sometimes, directors indulge in speculation by misusing inner information of the companyfor speculative purposes and personal gain.(v) Fraudulent management : The promoters and directors may indulge in fraudulent practices. The unscrupulous directors may present a rosy picture of thecompany in its annual report. In this way, the innocent and ignorant investors are duped.(vi) Bureaucratic control : Quick decisions and prompt action are absent in themanagement of a company. It makes a company an inflexible enterprise. As aresult, officers and their assistants do not enforce any decision promptly. Opportunities may be lost because of delay in decision-making. (vii) High nepotism : In companies, employees are selected not on the basis of

ability but on the basis of personal interest of the management. There is scopefor a high degree of favoritism and nepotism and as a result worthless peoplejoin in the company.(viii) Inflexibility in management : A company cannot quickly adjust with thechanging conditions in the market, because of its complex structure and legalobligations. It has, therefore, less flexibility in management.(ix) Monopolistic control and exploitation of consumers : Joint stock companiesfacilitate formation of business combinations which ultimately lead to monopolistic control and exploitation of consumers.(x) Social abuses : Evils of factory system like insanitation, pollution, congestionof cities are attributed to the company form of organization. Moreover, theclose and cordial relationship between the management and employees is difficult to maintain. It brings about strikes, lock outs, retrenchment, closure,etc., in the business.9.9. PUBLIC UTILITY SERVICES AND STATE ENTERPRISESThe enterprises which are owned, managed and controlled by the state on behalf ofpeoplearecalled State Enterprises. In the earlier period it was felt that the principle of Laissezfairewould work in the best interest of the people. It was thought that if there is no interferencefrom the Government, everybody would try to maximize his individual welfare and it willresult in maximum social welfare collectively. In practice, however, it was observed that differentinterests in any society are likely to clash with each other and as such the total social welfarecannot increase to its maximum. In fact, after the break of the First World War there wasacute shortage of a number of essential things and the Government had to accept more activerole in economic and industrial activities.State has not only abandoned the principle of laissez-faire but has also accepted the role of aWelfare State. This is an outcome of Socialistic ideas. A large number of glaring defects wereseen in Capitalism and it was felt that it was necessary to remove these defects by taking activeinterest in the ownership and management of Utility Services and some other Enterprises. As amatter of Industrial Policy in most of the countries, the basic and key industries, defenceindustries and Public Utility Services are nationalized. It is also true that many countries havefound a Mixed Economy as a better solution and India perhaps, is not an exception. In otherwords, in India the Private Sector Industries and Public Sector Industries have been workingtogether.9.9.1. Merits of State Enterprise.

(i) A check and prevention on the formation of private monopolies. A largenumber of countries in the world have found that due to lust of economic andpolitical power there is a tendency to form monopolies. These monopolies seriously affect the Social interest in the sense that the monopolist charges exorbitant prices, makes enormous profit, provides lower quality of goods andcreates artificial scarcity by hoarding.(ii) Acceleration of economic growth. The industrialization in a country is fasterwith the state enterprises functioning actively. The rate of economic growth isalso accelerated. The profits of state enterprises are further invested in industries. Various schemes for economic development can get financial supportfrom the state enterprises. Because of such surplus, it is not necessary for theGovernment to levy heavy taxes.(ii) Economy. It is possible to avail of economies of large scale operation when anumber of enterprises are brought under the State umbrella. This can alsoresult in proper co-ordination between various industries. There is then nofear of discord. The capital at the disposal of the State can always be big andtherefore, it becomes easier to retain the services or experts for proper adviceand also conduct research in various areas for reduction in cost.(iv) Object to render service rather then making profit. The concept of Stateenterprises is an outcome of the idea to provide services to consumers or themembers of public. A State enterprise is supposed to be interested in Socialwelfare and not making profit. If therefore, believes in providing good qualityservice at the most reasonable prices. Hoarding with a view to making enormous profit is just out of question. A State enterprises does not believe in Blackmarketing as a Private Undertaking may.(v) Efforts to provide full employment. Generally, unemployment can arise because the resources are not fully utilized or when the capacity is underutilized.In case of State enterprises, since a large number of units or industries areunder the State control, it is possible to provide maximum employment to thepeople. In other words, a State aims at full employment-it is opined that onlyunder socialized production, the fullest employment is possible for all the ablebodies adults to have work according to their aptitude, training and skill. It isalso observed that in case of employment with the State enterprises there areno violent ups and downs which are so common with Private Sector.(vi) Encouragement to the balanced regional development. It is the duty of anyState to ensure the there is a balanced regional development otherwise onlysome parts of the State may progress leaving others behind. The uneven development can create a number of problems. The Status usually encouragesgrowth of undeveloped or underdeveloped region by offering concessionsand many other facilities. Lopsided development is never in the interest of allthe people. The Government is interested in ensuring that the fruits of prosperity are enjoyed by all.(vii) Justice and Equality for all the employees. The Private enterprises are manytimes accused of exploitation of the employees, uncertainty of jobs, paymentof wages at a lower rate and miserable conditions of work. A State enterpriseis on the other hand away from exploitation of workers. It tries to providesecurity of jobs and justice to its employees. The relations between the Government undertakings and their employees are usually cordial.

(viii) Planned production and equitable distribution. State enterprises believe inplanned production and not overproduction, particularly because they areguided with the service motive. The responsibility of equitable distributionalso rests on the shoulders of the Government undertakings.9.9.2 Demerits of State EnterprisesState enterprises have their own limitations too. They suffer from the following demerits :-(a) Lack of efficiency. The employees of State Enterprises are generally observed tolack any initiative in their work. They also lack flexibility in operation and efficiency.On the other hand incase of Private Sector the maximum premium is paid toefficiency, creativity and initiative. The State Enterprises have service as their motivewhereas in case of private undertakings, maximum weightage is given to Profitmaking. The decision making process in State Enterprises is comparatively veryslow and implementation also is delayed. This results in loss of many opportunities.Private sector is dynamic and progressive. Even the cost of administration ofthe State Enterprises is on the higher side.(b) Political interference. In case of state enterprises, the worst difficulty is the politicalinterference. The ministers and other political influences affect the scientific andrational decision making. Undue weightage is granted to people who know little inbusiness. The smooth and efficient working is therefore not guaranteed with Governmentin business.(c) Regimentation. The Private Sector Undertakings usually believe that the consumersare kings and that they must be served well. They cannot take customers for ajoy ride. The resistance from the customers could create serious problems for conductingbusiness. On the other hand, in case of State Enterprises, there is virtually amonopoly. The consumers have no choice. This is against the principle of democracyand the State is many times tempted to take unfair advantage of the situation.(d) Open to public criticism. The working of Public Sector undertakings is always exposedto public criticism. Sometimes, the criticism is unfair too. In such situation,the executives of Public Utilities generally lose interest in work. They cease to showany initiative and become virtually Time Killers. (e) Rigid control. The State Enterprises are subject to strict control from various agencies.People, Parliament, Ministers, Financial Agencies and the Auditors criticizeand exercise direct or indirect control. It is not, therefore, to enjoy autonomy indecision making or policy implementation. Thus the efficiency is always at stake.In spite of such demerits, the state enterprises and public utilities have to play a significantrole in India where the mixed economy is prevailing for quite a long time.9.10 LIMITED LIABILITY PARTNERSHIP

A limited partnership is a partnership consisting of some partners whose liability is limited tothe amount of capital contributed by each. The personal property of a limited partner is notliable for the firm’s debts. He cannot take part in the management of the firm. His retirement,insolvency, lunacy or death does not cause dissolution of the firm. There is at lest one partnerhaving unlimited liability. A limited partnership must be registered.There is a proposal to permit the formation of a limited partnership in India. But in Europe andthe U.S.A. limited partnership is allowed. For example, in England limited partnership can beformed under the Limited Partnership Act, 1907 and under the Partnership Act, 1890 in theU.S.A. the chief characteristics of a limited partnership are as follows:1. There must be at least one partner with unlimited liability. The liability of the rmaining partners is limited to their capitals in the firm. Thus, a limited partnershipconsists of two types of partners, general partner and limited partner.2. The limited partner cannot take part in the management of the firm. He has noimplied authority to represent and bind the firm. However, he is allowed to inspectthe books of accounts of the firm.3. The limited or special partner cannot assign his share to an outsider without theconsent of the general partner.4. The limited partner cannot withdraw any part of his capital.5. A limited partnership must be registered.9.10.1 Advantages. Limited partnership offers the following benefits:(i) It enables people to invest in a business without assuming unlimited risk andwithout devoting much time and attention in management of business.(ii) It permits the mobilization of larger financial resources from cautious and conservativeinvestors. (iii) It provides an opportunity to able and experienced persons to manage the businesswithout any interference from other partners. Complete control and personalsupervision help to ensure prompt decisions and uniform actions.(iv) It is more stable than general partnership because it is not dissolved by the insolvency,retirement, incapacity or death of limited partner.9.10.2 Disadvantages. Limited partnership suffers from the following drawbacks:(i) The limited partners are deprived of the right to manage. They remain at themercy of the general partner.(ii) The general partner may misuse his power to exploit the limited partners.(iii) A limited partnership enjoys little credit standing as the liability of some partnersis limited. It has to be registered.

Study Note - 1010.1. TYPES OF COMPANIES10.1.1. On the basis of mode of incorporationCompanies may be divided into three categories on the basis of mode of incorporation as shownbelow:(i) Chartered Company : A chartered company is incorporated under Royal Charterissued by the King or Head of the State. Before the enactment of the Companies Act,the formation of a company was made under a special Charter by the King. TheEast India Company, Chartered Bank of England, etc., are important examples ofchartered companies. This type of company is not found in India at present.(ii) Statutory Company : A statutory company is established by a special Act of Parliament.Generally, public utility concerns are established in this way for the purposeof performing certain important economic functions. Examples of statutory companiesare : (i) Reserve Bank of India; (ii) Damodar Valley Corporation; (iii) State Bankof India; (iv) Industrial Finance Corporation of India. (iii) Registered Company : A company which is formed by registration under the CompaniesAct is known as a registered company. All existing companies in India (exceptstatutory companies) have been formed and registered under the CompaniesAct. The workings and continuity of registered companies are governed by the relevantprovisions of the Companies Act. Registered companies may be of three types:(i) company limited by shares; (ii) company limited by guarantee, and (iii) unlimitedliability company.10.1.2. On the basis of the extent of liabilityCompanies may be divided into three categories on the basis of the extent of liability as shownbelow:(i) Company limited by shares : A company limited by shares is registered underthe provisions of the Companies Act. It has a specified amount of capital divided into a definite number of shares. Liability of the members is limited to theextent of the face value of the shares they have purchased. Most of the companies formed in India are of this class. A company limited by shares may be oftwo types : (a) public company, and (b) private company.(ii) Company limited by guarantee : A company limited by guarantee is such aregistered company where the extent of liability of members is specified in the

‘Memorandum of Association’. The liability of its members, in case of need,may exceed the face value of shares held by them. The guarantee liability isenforceable only at the time of winding up of the company. It implies that, if acompany cannot pay for its liabilities in full at the time of winding-up, theexisting members would be required to contribute for meeting debts and liabilities of the company. A guaranteed company may be with share capital orwithout share capital. Companies limited by guarantee are usually formed topromote art, literature, sports, education, religious or other charitable purposes.In other words, non-profit earning companies are mostly registered with aguaranteed capital.(iii) Company with unlimited liability : This is a company having no limit on theliability of its members. In this company, members are personally liable to paythe debts of the company in proportion to their interest. Members are underthe obligation to satisfy in full, all the claims of the third parties on the company. An unlimited liability company is just like a big partnership firm. Nowadays, such company is not found in the field of business.10.1.3 On the basis of transferability of sharesCompanies may also be divided into two categories on the basis of transferability of shares asshown below:(i) Private company : A private company is an incorporated body, registered under theCompanies Act (with a minimum paid-up capital of rupees one lakh), with fourimportant restrictive provisions in its ‘Articles of Association’. Therefore, a privatecompany is one which:(i) restricts the rights of its members to transfer their shares in the company;(ii) limits the number of its members to fifty (excluding its employee shareholders);(iii) prohibits any invitation to the public to subscribe for any shares or debenturesof the company;(iv) prohibits any invitation or acceptance of deposits from persons other thanits members, directors or their relatives.(ii) Public company : A public company means a company which :(i) is not a private company;(ii) has minimum paid up capital of rupees five lacs; and(iii) is a subsidiary of a company which is not a private company.In other words, a public company is one which is not a private company. It is an associationconsisting of seven or more members, which is registered under the Companies Act.10.1.4. On the basis of jurisdiction of functioningCompanies may be divided into three categories on the basis of jurisdiction of functioning asshown below:(i) Indian company : A company which is registered and incorporated in India is calledan Indian Company. This company is registered under the provisions of the IndianCompanies Act with its registered office in India.(ii) Foreign company : A foreign company is a company which is incorporated outsidethe country but carries on business in this country through agents or branches. Theprovisions of the Indian Companies Act are equally applicable to foreign companies

carrying on business in India.(iii) Multinational company : A company whose management, ownership and controlare spread over more than one country is known as multinational company. Therefore,a service facilities outside the country’s origin. A multinational company takesdecisions in a global context. A multinational company organizes its operations indifferent countries through either of the following five alternatives : (i) Subsidiarycompanies; (ii) Joint venture companies; (iii) Branches; (iv) Franchise holders and(v) Turn-key projects.The examples of multinational companies are : (a) Philips; (b) Coca-Cola; (c) Bata;(d) IBM; (e) Siemens; (f) Imperial Chemical Industries; (g) Union Carbide; (h) Nestle;(i) Unilever, etc.10.1.5. On the basis of the extent of ownership and controlCompanies may be divided into three categories on the basis of the extent of ownership asshown below:Government company : A Government company is a company in which at least 51%of the paid up share capital is held by the Government (Central Government orState Government). Government companies are also registered under the CompaniesAct. Examples of Government companies are : (i) Bharat Electronics Ltd.; (ii)Steel Authority of India Ltd.; (iii) Coal Mines Authority Ltd., etc.Holding company : A holding company is one that directly or indirectly holds morethan 50% of equity share capital or controls the composition of the Board of Directorsof some other companies.A company may become a holding company of another company in any of the followingthree ways :by holding more than 50% of the paid up equity share capital of another copany,orby holding more than 50% of the voting rights of another company; orby holding the right to appoint the majority of the Directors of another company.Subsidiary company : A subsidiary company is one : (i) in which more than 50% ofthe paid up equity share capital is held by another company; or (ii) whose majorityof the Directors are appointed by anther company ; or (iii) where more than 50% ofthe voting powers are exercised by another company.10.2.PRIVATE COMPANY10.2.1.Definition of a private companyA private company is an incorporated body, registered under the Companies Act (with a minimumpaid-up capital of rupees one lakh), with four important restrictive provisions in its ‘Articlesof Association’. Therefore, a private company is one which:(i) restricts the rights of its members to transfer their shares in the company;(ii) limits the number of its members of fifty (excluding its employee shareholders);(iii) prohibits any invitation to the public to subscribe for any shares or debentures of

the company;(iv) prohibits any invitation or acceptance of deposits from persons other than its members,directors or their relatives.10.2.2. Features of a private company(i) A private company can select any name, but the words ‘Private Limited’ must beadded at the end of its name.(ii) It must have a minimum of two members and a maximum of fifty members (excludingemployee shareholders).(iii) It can start its business just after its registration. It does not require a commencementcertificate.(iv) It cannot issue shares to the public. Moreover, a restriction is imposed on the transferabilityof its shares.(v) It need not require to file a prospectus or a statement in lieu of prospectus to theRegistrar of Companies.(vi) It need not require to hold a statutory meeting or file a statutory report.(vii) It does not restrict any investment in the same group of companies.10.2.3. Privileges and exemptions allowed to a private companyThe following are some of the privileges and exemptions allowed to private companies ascompared to public companies :(1) Exemptions in formation of a company :(i) A private limited company can be formed by two persons only.(ii) It can start its business just after its registration. It does not require a commencementcertificate.(iii) It need not require to file a prospectus or a statement in lieu of prospectus tothe Registrar of Companies.(2) Exemptions regarding holding of meetings :(i) It need not require to hold a statutory meeting or file a statutory report to theRegistrar of the Company.(ii) Provisions of the Companies Act, regarding quorum, voting rights, countingof votes and information of meetings can be relaxed in case of a private company.(3)Exemptions regarding appointment, removal, etc., of Directors :(i) Minimum number of Directors required in a private company is two, whilein case of public company, it is three.(ii) The rules regarding appointment, retirement, etc., of Directors do not applyto a private company. (iii) The rules regarding qualifying shares of Directors do not apply to a privatecompany.(iv) Loans and financial help can be given to the Directors of the private companywithout permission of the Central Government.(v) The approval of the Central Government is not required regarding increasein the number of Directors of a private company.(vi) There is no limit on remuneration of Directors and Managing Director of aprivate company.(4) Exemptions regarding managerial remuneration :

Remuneration payable to Directors and Managing Directors of a private company is notrestricted to 11% of the net profits.(5) Exemptions regarding appointment of Managing Directors :(i) A Managing Director can be appointed even for more than five years.(ii) No approval of the Central Government is required in case of appointmentof Managing Director.(6) Exemptions regarding share capital :(i) It can enhance its capital without observing the legal provisions regardingfurther issue of capital applicable to public companies.(ii) The provisions regarding voting rights and the distribution of share capitalinto preference and equity shares do not apply in the case of a private limitedcompany.(7) Exemptions from various legal formalities :A private limited company is not bound to observe the restrictions under the CompaniesAct with regard to publication of accounts, issue of right-shares, investment of companyfunds in the same group of companies, etc.10.2.4. Advantages (or merits) of private companiesThe main advantages of a private limited company are as follows:(i) Easy formation due to lesser formalities : A private company is easy to form astwo or more persons are required to form it. A private company can start its operationsimmediately after its incorporations. There is no need to get the certificate ofcommencement of business. It is neither required to issue a prospectus nor to call astatutory meeting.(ii) Maintenance of secrecy of business affairs : A private limited company is betterplaced to maintain secrecy of the affairs of business. A private company does nothave to show its accounts and financial statements before the registrar of Companiesand the public.(iii) Promptness of decisions : Policy decisions can be implemented quickly in the caseof private companies as compared to public companies. The management is also ina few hands who manage the day-to-day affairs effectively.(iv) Direct encouragement : There is no difference between owners and management ofa private company. The members and management, thus, get more incentive towork.(v) Greater elasticity : Private companies have been granted exemptions from the applicationsof various important provisions of company law. Thus, a private companyis required to perform a few number of legal formalities as compared to publiccompanies.10.2.5 Disadvantages (or limitations) of private companiesMain disadvantages of a private limited company are as follows:

(i) Limited membership : A private company cannot have more than fifty members(excluding employee-shareholders). So, the financial resources of such companiesare limited. Therefore, possibilities of expansion and diversification become limited.(ii) Interests of the shareholders are not safeguarded : Provisions of the CompaniesAct regarding safety of shareholders do not apply to private companies (example., workingof Directors, limit of managerial remuneration, etc.) Moreover, non-transferabilityof shares puts the minority at the mercy of the majority.(iii) State priorities to public companies : Public companies are always preferred ascompared to private companies in matters of tax relief, financial assistance, managerialassistance, etc. Generally, the Central Government gives preference to publiccompanies in matters of granting licences.(iv) Dissatisfaction among minority shareholders : The minority shareholders cannotdispose of their shares even when they are dissatisfied with the affairs of the company.10.2.6 Private company deemed to be a public companyA private company is deemed to be a public company :(i) Where at least 25% of the paid-up share capital of a public company is held by aprivate company;(ii) Where at least 25% of the paid-up share capital of a private company is held by oneor more bodies corporate;(iii) Where a private company accepts public deposits;(iv) Deemed public companies have become inoperative as per Companies (Amendment)Act, 2000.Company Organisation and Management10.3 PUBLIC COMPANY10.3.1Definition of a public companyA public company means a company which :(i) is not a private company;(ii) has a minimum paid up capital of rupees five lakh; and(iii) is a subsidiary of a company which is not a private company.In other words, a public company is one which is not a private company. It is anassociation consisting of seven or more members, which is registered under theCom panies Act.10.3.2 Features of a public company:(i) It requires a minimum of seven persons to form a public company. There is norestriction on the maximum number of members.(ii) It can offer shares to the general public in order to raise huge financial resources.(iii) Shares of a public company are freely transferable like movable property.(iv) Shareholders have no control over the management of the company.(v) A public company can choose any name, but it must add the word ‘Limited’ at the

end of its name.(vi) It cannot commence its operations until it obtains a ‘Certificate to Commence Business’in addition to the ‘Incorporation Certificate’ from the Registrar of Companies.10.3.3. Advantages (or merits) of a public companyThe following are the advantages of a public company(i) Limited liability : The liability of each member is limited to the extent of the facevalue of shares purchased.(ii) Large membership : There is no upper limit as to the number of members. Thisdiffuses the risk of investment in shares.(iii) Mobilisation of huge financial resources : This form of organization can obtainlarge amounts of capital for carrying out large-scale operations.(iv) Economies of large-scale production : Huge financial resources lead to a phenomenalgrowth in the size of the company. This will result in greater division of labour,specilisation, more effective use of resources, bulk purchase of raw materials at lowerprices, etc.(v) Professional management : The large size enables the company to acquire servicesof professional people in various field like accounting, finance, production, sales,etc. Thus, greater specilisation is possible in various fields of operation. (vi) Transferability of shares : Shares of a public company are freely transferable. Transferabilityof shares enables an investor to increase or decrease his investment in acompany at any time. Transferability of shares reduces the risk of investment.(vii) Safeguarding interest of shareholders : Strict legal regulations safeguard the interestsof the shareholders and people who deal with public companies.(viii) Social benefit : Increase in production, improvement in quality and providing goodsand services at a cheaper rate ensures betterment of the society.10.3.4 Disadvantages (or limitations) of a public companyThe following are the disadvantages of a public company:(i) Legal complexities : The formation of a public company is complex and expensive.(ii) Separation of ownership and management : The management of the business iscontrolled, not by the shareholders in mass, but by their representatives called theBoard of Directors. Thus, management and ownership become separated.(iii) Oppression of minority shareholders’ interests : All the affairs of a public companyare controlled by a set of Directors. The directors can do anything within thelimits of the Companies Act. Minority shareholders are oppressed and have no sayin the management of the company.(iv) Delay in decision-making : It is rather difficult to take quick decisions on account

of disagreements among the Directors. Moreover, a public company has to observea good deal of legal formalities. As a result, there appears to be a huge delay indecision-making.(v) Speculation in shares : Very often Directors indulge in speculation of shares fortheir personal interest. Speculation can create chaos in the stock exchange and candestabilize the company.10.4. INCORPORATION OF A COMPANYThe following documents are to be filed with the Registrar of Companies of the State in whichthe registered office of the company is to be situated :(i) Memorandum of Association;(ii) Articles of Association;(iii) List of persons agreeing to act as Directors (their full address and occupations);(iv) Statement of consent signed by each Director,(v) A statement of Authorized Capital;(vi) Address of the company’s registered office;(vii) An undertaking by each Director to hold and pay for the qualification shares;(viii) A statutory declaration by a chartered accountant or an advocate that all the legalrequirements of the Companies Act have been complied with.The Registrar of Companies scrutinizes the above documents. If the documents are found to bein order, the name of the company is entered in the register. Then the Registrar issues a ‘certificateof incorporation’ in favour of the company. This certificate gives birth to a company with aseparate legal entity. A private company can commence its business just after getting a ‘commencementcertificate’ to start its operations in addition to an ‘Incorporation certificate’.10.4.1. Raising of capital (for public companies only)Capital subscription (example., raising of capital) is the third stage of formation of the company. Aprivate limited company does not require this stage as it does not collect funds by selling sharesto the public.A capital subscription stage is required for public companies as they are to collect funds formthe members of the public at large by selling its shares and securities. So, with a view to raisingfunds, a public company, soon after its incorporation, has to arrange a meeting to deal with thefollowing matters :(i) Issue of a prospectus or a statement in lieu of prospectus;(ii) Appointment of bankers;(iii) Appointment of a brokers for underwriting shares;(iv) Appointment of a pro tem secretary;(v) Conform to the guidelines issued by SEBI from time to time.A public company issues a prospectus in order to invite the public to subscribe to the issue of

shares. A public company cannot allot shares to the public, unless the amount mentioned asminimum subscription is received within 120 days of the date of the issue of the prospectus.The restriction of ‘minimum subscription’ is meant to prevent the formation of companies withan inadequate capital. In other words, the companies which can raise enough capital to meetthe minimum requirements are allowed to start their business. A company can allot shares tothe public provided the minimum subscription (as disclosed in the prospectus) has been raisedwithin 120 days from the date of issue of the prospectus.10.4.2. Commencement of business of a public companyA public company cannot start the business without having a ‘certificate of commencement’from the Registrar. A ‘certificate of commencement’ is issued in favour of a public company bythe Registrar when the following conditions are fulfilled :(i) A declaration that a prospectus or a statement in lieu of prospectus has been filedwith the Registrar.(ii) A declaration that the amount of minimum subscription (as specified in the prospectus) has been received.(iii) A declaration that the Directors of the company have paid for their qualificationshares.(iv) A certificate by a Director or the secretary of the company that all the formalitiesrelating to the commencement of the business have been fulfilled.If the Registrar is satisfied that all the conditions have been fulfilled, he issues a ‘certificate ofcommencement’ in favour of the public company. No public company can start its operationswithout obtaining a ‘commencement certificate’.10.5.PROMOTION OF A COMPANYPromotion is the discovery of business opportunities and the subsequent organization of funds,property and management ability into a business concern for the purpose of making profitstherefrom. Promotion is the first stage in the formation of a company. Promotion means variousinitial steps to be taken for the establishment of a company, before it comes into existence.10.5.1.Definitions given by eminent authors :(1) “Promotion is the process of organizing and planning the finances of a business enterpriseunder the corporate form.” [L.H.Haney](2) “Promotion starts with the conception of the idea from which the business is fully readyto begin operations as a going concern.” [Guthman and Dougall]

Promotion is an idea which is developed into a concrete project accomplished by the incorporationand floatation of a company. All the initial activities undertaken before the company isregistered are called promotional efforts. Persons who help in the promotion of a company arecalled promoters. These promoters are experts in the work of company formation.10.5.2 Meaning and definitions of promoterThere is no statutory definition of a promoter. But in simple terms, a promoter is one whousually performs the preliminary duties necessary to bring a company into existence and floatit. A promoter undertakes to form a company with reference to a given project and performsvarious formalities required for starting a company.A promoter may be :(a) an individual; (b) a firm; (c) an association of persons; (d) a company. Every individualconnected with the formation of a company cannot be called a promoter. Thus, the personswho assist the promoters in performing the various legal formalities, are not promoters(example., accountants, solicitors, professional advisors, tax consultants, etc.).Definitions given by eminent jurists ;(1) “A promoter is one, who undertakes to form a company with reference to a given objectand sets it going and takes the necessary steps to accomplish that purpose.”[Justice C. J. Cokburn](2) “A promoter is one, who conceives a business opportunity and assembles resources totranslate a possibility into a reality.” [Justice Bowen]A promoter is one, who identifies a business opportunity, analyses its prospects and takesthe initiative to form a company, taking into consideration the opportunities available.10.5.3 Types of promotersDepending on the nature of the promotion work, promoters can be classified as follows:(i) Professional promoters : They are specialists in forming a new corporate enterprise.After promoting an enterprise, they eventually hand over the control andmanagement to the shareholders of the company.(ii) Occasional promoters : Promoters who are not involved in promotion work on aregular basis are called occasional promoters. Promotion is not their main occupation,and after promoting a company, they go back to their original profession.(iii) Financial institutions as promoters : Some financial institutions or financiers may

take up the promotion of a company. After the incorporation of the company, financiersget their fixed remuneration and leave it. Banking and insurance companieshave been engaged as institutional promoters. These promoters provide technical,managerial and financial assistance for the promotion of new enterprises. (iv) Enterpreneuring promoters : These promoters conceive and idea of the new businessunit, do the necessary preliminary work in setting up the business unit andultimately control and manage the same. In India, most of the promoters belong tothis category.(v) Technical firms as promoters : Engineers and technical experts sometimes pick upthe lucrative idea of business promotions. They are not in the promotional work ona regular basis. They take up the promotion of some company and then go back totheir earlier profession.(vi) Government as a promoter : Since independence, the Government of India hasemerged as a big promoter of enterprises. The Government (Central or State or both)have become promoters for public sector undertakings, economic organizations,defence industries, oil and natural gas, etc.(vii) Specialised institutions as promoters : The Government has set up special institutionsto promote corporate enterprises in order to fill in the gaps in the industrialstructure of the country. National Industrial Development Corporation (NIDC),Industrial Bank of India, etc., are examples of such institutions. These institutionsprovide technical, managerial and financial assistance for the promotion of newenterprises.10.5.4 Functions (or role) of a promoterThe functions of a promoter may be summed-up as follows:(i) A promoter selects the line to business of a proposed company.(ii) He studies the future possibilities of the business of the proposed company.(iii) He decides the name of the company, objects of the company and also to decidewhere its registered office should be situated.(iv) He prepares the memorandum of association and articles of association and filesthese documents with the Registrar of Companies.(v) He takes necessary steps to get the company registered.(vi) He makes necessary arrangements for the initial capital of the proposed company.(vii) He selects the first Director of the proposed company.(viii) He appoints the banker, auditors, brokers and legal advisors for the proposed company.(ix) He enters into preliminary contracts with different parties (example. vendors, underwriters,etc.)(x) He makes necessary arrangements for the allotment of shares and secrities.10.5.5 Qualities of a promoter

In order to perform the task of promotion successfully, a promoter must have several essentialqualities. A promoter must be well-acquainted with the social, economic, political and businessconditions of the place where the business is to be established. He must be a person withimagination, organizing ability and resources. In brief, a successful promoter must possess thefollowing qualities:(i) Organising ability; (ii) Farsightedness; (iii) Tactfulness and laborious; (iv) Self-confidence;(v) Perseverance and consistency; (vi) Risk-bearing capability; (vii) Honesty; (viii)Knowledge of company law and other related laws. (ix) Resourcefulness; (x) Salesmanship.10.5.6 Legal status of a promoterCompany law has not given any legal status to a promoter. In other words, legally, a promoter occupiesa peculiar position, as company law is silent in this regard. A promoter is neither a trustee nor an agentof the company which he promotes.Truly speaking, a promoter stands in a fiduciary position towards the company. The fiduciaryposition of a promoter may be discussed as follows:(i) The promoter must not make any profit from the company that he has promoted.(ii) The promoter must not take advantage of his position in order to make any secretprofit.(iii) The promoter must not indulge in any undue influence or fraud.(iv) The promoter must give to the company the benefit of any negotiations or contractsinto which he enters.10.5.7 Stages of promotionThere are six stages in the promotion of a company, which are as follows:(i) Discovery of business opportunities : A promoter conceives the idea of forming acompany. A promoter is to discover the business opportunities, considering theavailability of human and non-human resources. He is to consider whether the ideais practical or feasible in the light of the proposed risks and profitability.(ii) Detailed investigation of the idea conceived : Detailed investigation regardingcommercial feasibility is absolutely essential before capital is invested to implementthe idea conceived. Detailed investigation may relate to : (a) Market conditions(b) Demand for the product to be manufactured; (c) Estimated cost of production; (d) Estimated profit margin, and (e) Capital requirement of the proposed business.Such an investigation gives a critical appraisal of the idea conceived and revealswhether the idea is commercially feasible or not. The services of experts maybe needed to prepare a project report.(iii) Verification of the results of investigation : The reports submitted by the investigatorsmust not be accepted without getting them verified by a separate team ofimpartial experts.

(iv) Assembling of different elements of the business : When the results of the investigationis favourable, the promoter should go ahead with the promotion of a company(iii) verification of the results of investigation : The reports submitted by the investigatorsmust not be accepted without getting them verified by a separate team ofimpartial experts.(iv) Assembling of different elements of the business : When the results of the investigationis favourable, the promoter should go ahead with the promotion of a company.(v) Preparation of a financial plan for the business project : After considering all thefactors, the promoters proceed with the preparation of a financial plan for the proposedcompany. The Promoters are to decide what amount of capital is required atthe initial state. For this purpose, they are to approach banks, financial institutionsand underwriters. A company raises its capital through the issue of shares and debentures.While preparing the financial plan, promoters have to keep in mind thatadequate funds should be provided to launch the company.(vi) Submission of necessary documents required for incorporation : It is necessary tosubmit certain documents to the Registrar of Companies in order to incorporate ajoint stock company. The documents involved are : (a) the memorandum of association;(b) the articles of association; (c) the prospectus; (d) the list of Directors; (e) theconsent of Directors; (f) the address of the company’s registered office; (g) statutorydeclarations, etc.10.5.8 Other relevant concepts(a) Minimum subscription: Minimum subscription means the minimum amount of capitalwhich a company requires for the starting of the business. The minimum subscriptionshould be received within 120 days after the date of the issue of the prospectus. Acompany cannot allot any shares unless the minimum subscription has been raisedthrough the application for shares. If this minimum amount is not collected within thestipulated period, the amount received from the applicants must be returned withinthe next 10 days (example., within 130 days after the issue of shares).Minimum subscription is necessary to cover the following expenses :(i) preliminary expenses;(ii) underwriting commissions on sale of shares;(iii) working capital;(iv) the cost of any property purchased or to be purchased;(v) payment of any money borrowed for the above purpose;(vi) any other necessary expenditure. (b) Certificate of incorporation: This is certificate issued by the Registrar of Companies to

a company, whereby the incorporation of the company is recognized. In order to obtainthe certificate of incorporation, a limited company has to file with the Registrar of Companiesthe following documents:(i) Memorandum of Association;(ii) Articles of Association;(iii) List of first Directors;(iv) Written consent of Directors to act as such;(v) Address of the registered office of the proposed company;(vi) Statutory declaration that the requirements of the Companies Act have beencomplied with.On the filing of the above documents and the payment of necessary registration fees, ifthe Registrar is satisfied that everything is in order, he will register the name of thecompany and issue a Certificate of Incorporation. After this is done, the company comesinto existence.(c) Certificate of commencement: A private company can commence business immediatelyafter the grant of the Certificate of Incorporation. A public company cannot commencebusiness until it obtains a ‘Certificate of Commencement’ in addition to the ‘IncorporationCertificate’ from the Registrar of Companies.The ‘Certificate of Commencement’ is issued in favour of a public company by the Registraronly when the following conditions are fulfilled :(i) a prospectus or a statement in lieu of prospectus has been filed with the Registrar;(ii) the minimum subscription has been raised;(iii) the Directors have paid for their qualifications shares;(iv) a certificate by a Director or the Secretary of the company that all the requirementsof the Companies Act regarding commencement of business have beencomplied with.The Registrar issues the ‘Certificate of Commencement’ in favour of a public companywhen he is satisfied that all the conditions (mentioned above) have been fulfilled.(d) Preliminary expenses : Expenses incidental to the formation of a company are knownas preliminary expenses. These expenses are of a capital nature, but they do not representany tangible assets.Thus, preliminary expenses are treated as fictitious assets and these expenses are to bewritten off against Profit & Loss Account over a certain period.The following items of expenses are usually treated as preliminary expenses :(i) cost of preparing and printing the Memorandum and the Articles of association;(ii) cost of preparing, printing and circulating the prospectus;

(iii) cost of registering the company (example., filing necessary documents, fees and stampduties, etc.);(iv) cost of preliminary agreements;(v) cost of preparing and printing the letter of allotment;(vi) valuers’ fees for reports, certificates, etc.10.6 BASIC DOCUMENTS OF THE COMPANY10.6.1.IntroductionIn the company form of organization, a large number of legal documents and papers are preparedand filed with the Registrar of Companies. However, the following documents are consideredmost important :(A) Memorandum of Association;(B) Articles of Association;(C) Prospectus or statement in lieu of prospectus.Now we shall discuss briefly each one of these documents:10.6.2. Memorandum of AssociationThe Memorandum of Association is a document which contains the fundamental rules regardingthe constitution and activities of a company. It lays down the objects and scope of activitiesof the company. A memorandum also states the limits to which a company can move. If acompany moves beyond the limits mentioned in the memorandum, it shall be considered ultravires. Thus, a Memorandum of Association is the charter of a company.Definition according to the Indian Companies Act :“Memorandum means the Memorandum of Association of a company, as originally framedor as altered from time to time in pursuance of any previous Companies Act.”[Section 2(28) of Indian Companies Act, 1956]The memorandum governs the relationship of the company with the outside world. Thecompany has to work within the limits laid down in the memorandum. The memorandumis the foundation upon which the superstructure of the company is built.10.6.3 Importance of Memorandum of Association(1) Basis of incorporation : It is the basis of incorporation of a company. A companycannot be registered without filing this document.(2) Informing the name, address, object, capital and liability of the company to outsiders: Every outsider can easily obtain information about the company regardingits name, address, object, capital and liability, etc., through the Memorandum ofAssociation.(3) Determining the extent of working of the company : It lays down the objects andscope of activities of the company. It also states the limits up to which a companycan move. Any activity outside the scope of the memorandum will be ultra vires

and void.(4) Unalterable document : The provisions of this document cannot be changed withoutpassing a special resolution (passed by 75% majority). In certain cases, the changescan be made by seeking permission from the Company Law Board or Central Government.(5) Determining the relationship between the company and others : It enables outsidesto know whether the company is authorized to enter into a particular transaction ornot.10.6.4 Contents (or clauses) of the Memorandum of AssociationThe Memorandum of Association contains the following clauses :(i) Name clause; (ii) Registered office (example., domicile) clause; (iii) Object clause; (iv) Liabilityclause; (v) Capital clause; and (vi) Association (or subscription) clause.(i) Name Clause : The name of the proposed company is mentioned in this clause.The name of a company must end with the word ‘Limited’ in the case of apublic company and the words ‘Private Limited’ in the case of a private company. The name should not be identical with the name of any existing company. The name should not create an impression that the company is carryingon the business of some other existing company. The name should not be misleading (example., creating confusion regarding its nature of business).(ii) Registered office (example., domicile) clause : The name of the ‘State’ in whichthe registered office of the company is to be situated is mentioned in this clause.This clause determines the jurisdiction of the Registrar of Companies and thecourt. This clause also ascertains the nationality of the company (whether thecompany is an Indian company or a foreign company). The full address of theregistered office must be communicated to the Registrar of Companies forfuture communication.(iii) Object Clause : This clause states the object with which the company is proposed to be established. A company is not legally entitled to do any businessother than that specified in its object clause. The object clause should include (i) main objects to be pursued after incorporation;(ii) incidental objects ancillary to the attainment of the main objects;(iii) other objects not included in (i) and (ii) above.The object clause must not include anything which is :(i) illegal or opposed to the public interest;(ii) against the general law of the country; and(iii) contradictory to the Companies Act itself.(iv) Liability clause: This clause states the nature of liability of the members of thecompany (example., whether limited by shares or by guarantee or unlimited) :(i) In case of a company limited by shares, members’ liability is limited to the facevalue of the shares.(ii) In case of a company limited by guarantee, the liability clause must state theextent of liability of each individual member in the event of its being wound up.(iii) In case of an unlimited company, the liability clause does not appear in thememorandum of association.(v) Capital clause : This clause states the total capital of the proposed company.The amount of capital as stated in the memorandum is known as the autho

rized capital of the company. A company cannot collect funds exceeding theauthorized capital.The division of capital into equity share capital and preference share capital shouldalso be mentioned. The number of shares in each category and their value should begiven in the memorandum.(vi) Association (or subscription) clause : The names, addresses, signatures anddescriptions of the signatories to the memorandum are given in this clause.This clause also states the amount and number of shares taken by the signatories of the memorandum. The number of signatories to the memorandum shallnot be less than : (i) Seven (in case of a public company), and (ii) two (in caseof a private company).10.6.5 Alteration of the Memorandum of AssociationThe different clauses of the memorandum can be altered according to the procedure and modelaid down in the Companies Act, by passing an ordinary or special resolution. Under certaincircumstances, the approval of the Government is necessary to alter the memorandum.(1) Alteration of name clause : A company can change its name in the following ways(a) By a special resolution at a general meeting with the written approval of theCentral Government.(b) If the name registered by it is identical to the name of an existing company, theregistered name can be changed by passing an ordinary resolution and by obtaininga written consent of the Central Government.(2) Alteration of registered office : A company may change its registered office: (a) within the same city; (b) one city to another city within the same State,and (c) from one State to another.(2) If the registered office is to be shifted from one locality to another within thesame city, an ordinary resolution will be sufficient.(2) If the registered office is to be shifted from one city to another city within thesame State – a special resolution is required.’(3) If the registered office is to be shifted from one State to another State – a specialresolution as well as sanction of the court is required.(3) Alteration of the object clause : The object clause cannot be altered as aroutine affair. The object clause of a company may be changed by passing aspecial resolution and by obtaining the sanction of the court on the followinggrounds :(1) to carry on its business more economically or efficiently;(2) to enlarge the area of its operations;(3) to attain its main purpose by new or improved means;(4) to sell the whole or part of the company’s property;(5) to amalgamate with any other company;(6) to restrict any of the objects specified in the memorandum.(4) Alteration of capital clause : A limited company, having a share capital, mayalter its capital clause by passing an ordinary resolution in the general meeting for the following purposes :(i) increasing its share capital; (ii) consolidating and dividing its capital intoshares of larger amounts; (iii) converting its fully paid up shares into stock;

(iv) reconverting stock into fully paid up shares; (v) sub-dividing its sharesinto shares of smaller amounts.But, for the deduction of share capital, a special resolution and confirmation by thecourt are necessary.(5) Alteration of liability clause : The liability clause cannot be changed so as tomake the liability of the members unlimited. However, if the members of apublic limited company are reduced to below seven, the liability of the members automatically becomes unlimited. Liability of the Directors, and managing Director may be made unlimited by altering the articles of associations.10.6.6 Articles of AssociationThe Articles of Association is a document which contains the rules and regulations for theinternal management of the company. It prescribes bye-laws for the general management ofthe company. It lays down the rules by which the objects of the company are to be carried out.The articles define the duties, the rights and powers of the governing body as between themselvesand the company at large. Every company is required to file its articles of associationalong with its Memorandum of Association with the Registrar of Companies at the time of itsregistration.10.6.7 Definition according to the Indian Companies Act :“Articles mean the Articles of Association of a company as originally framed or as ateredfrom time to time in pursuance of any previous Companies Act.”[Section 2(2) of Indian Companies Act, 1956]Articles are concerned with matters in the routine conduct of the affairs of the company.The articles must not contain anything ultra vires the memorandum and contrary to theprovisions of the Companies Act.10.6.8 Contents of Articles of AssociationSome of the important contents of the Articles of Association are as follows:(1) Matters relating to shareholders :(1) types, number and denominations of shares;(2) the respective rights of different types of shares;(3) methods of making an issue of share capital;(4) procedure for making calls and allotment of shares;(5) procedure for issue of share certificates and share warrants;(6) conversion of shares into stock, lien of shares, etc.;(7) alteration of share capital;(8) voting powers of the shareholders;(9) procedure of forfeiture, re-issue and surrender of shares;(10) the amount of minimum subscription;(11) procedure regarding company meetings;(12) procedure for transfer and transmission of shares.(question 2) write the Matters relating to Directors :

Answer :(a) rules regarding appointment, re-appointment, remuneration, reward, etc., ofthe Directors;(b) rules regarding qualification and disqualification of Directors; (c) procedure for retirement and removal of Directors;(d) rules regarding borrowing power of Directors;(e) rules regarding conducting meeting of Directors;(f) rights and liabilities of Directors;(g) rules for fixation of maximum and minimum Directors, etc.(3) Other matters :(1) procedure for audit of company accounts;(2) procedure of winding-up of the company;(3) rules regarding keeping of books of accounts;(4) borrowing of funds from the public and the rate of interest thereon;(5) commission and brokerage for selling shares to underwriters;(6) rules regarding declaration of dividends and capitalization of reserves;(7) rules regarding use and custody of common seal;(8) interest rates on calls-in-advance and calls-in-arrear.10.6.9 Alteration of Articles of AssociationArticles of Association concern themselves with the internal management of the company.Such matters are not permanent in nature and in course of time the policies of the companymay undergo charges. In such a situation, the company may alter its Articles by passing aspecial resolution.(1) The alteration must be made for the benefit of the company.(2) The alteration can only be made by a special resolution.(3) The alteration must not sanction anything illegal.(4) The alteration must not in any way increase the liability of the existing members.(5) The alteration must not constitute a fraud on the minority.(6) The alteration must not be detrimental to the provisions of the Companies Act.(7) The alteration must not cause any breach of contract with an outsider.(8) The alteration must not contravene any clause of the memorandum.10.9.10 Comparison between Memorandum and Articles of AssociationMemorandum of Association Articles of Association1. Nature ofdocumentsMemorandum is thefundamental charter of acompany. A company functionswithin the limits laid down inthe memorandum.Articles of Association are subsidiary to thecharter. Articles contain bylawsand rules regarding day to-day working of thecompany.2. Scope Memorandum states therelationship between thecompany and an outsider.Articles of Association contain provisions for

internal management of thecompany.3. Objectives Memorandum defines theobjects of the company.Articles of Association define the rules forcarrying out the objects of thecompany.4. Alteration in thedocumentMemorandum cannot bealtered easily. It requires courtconfirmation.Articles of Association can easily be alteredwithout the confirmation of thecourt.6. Registration Registration of Memorandum iscompulsory for any company.Registration of Articles of Association is notnecessary in case of a publiccompany. Public company mayopt for Table-A of Schedule-1 forits incorporation purposes.7. Application ofrulesMemorandum of association isbased on the doctrine ofconstructive notice.Articles of Association arebased on the doctrine of indoormanagement.8. Provision and itsobservationsMemorandum cannot containsanything contrary to theprovisions of the CompaniesAct.Articles of Association are subsidiary to boththe Memorandum andCompanies Act. Articles cannotcontain anything contrary toboth.9. Violation Company cannot violate theclauses of the Memorandum.There is no remedy for ultravires acts.Company may go beyond thescope of the Articles (but withinits powers). Outsiders maypresume that Articles arecomplies with.10. Necessity This document is a must forgetting a company registered.All companies are not requiredto have their own Articles of Association ofAssociation. Public companiesmay adopt Table –A of Schedule-1 of Companies Act. But

Articles are a must for a privatecompany.10.6.11 ProspectusA prospectus is a document inviting the general public to subscribe to the share capital of apublic company. A prospectus is issued by a public company after obtaining the ‘certificate ofincorporation’ from the Registrar. The facts and figures stated in the prospectus are meant topersuade the public to purchase shares or debentures of the company. A private companyneed not require to issue a prospectus, as it cannot invite the public to subscribe to its shares.A prospectus is the only window through which the potential investors can look into the soundnessof the company’s venture. The prospectus is placed before the public for raising necessaryfunds. The investors must, therefore, be given a complete picture of the company’s future activities,efficiency and integrity of its Directors and the profitability of investment. A prospectusmust be dated and signed by the Directors. A company must get its minimum subscriptionwithin 120 days from the issue of prospectus.10.6.12 Characteristics of a prospectusThe important characteristics of a prospectus are as follows:(1) It is a document described or issued as a prospectus.(2) It includes any notice, circular, advertisement, etc., inviting deposits fromthe public.(3) It is an invitation to the public to subscribe to the shares or debentures ofthe company.(4) It is a document through which the company secures the capital requiredfor carrying on its business.10.6.13 Purposes for the issue of a prospectusThe following are the main objects of issuing a prospectus :(1) A prospectus brings to the notice of the public that a new company hasbeen formed.(2) It provides detailed information about the company to the general investors.(3) It outlines the terms and conditions of issue of shares and debentures.(4) It highlights the present position and the future prospects of the company.(5) It reflects the business policies and programmes of the company.(vi) It identifies the person who can be held responsible for misstatements inthe prospectus.10.6.12 Contents of a prospectusA prospectus should contain information on the following matters : (1) Name and full address of the company.(2) Existing and future activities of the company.(3) Composition of the Board of Directors.(4) Qualification shares of the Directors and their remuneration.

(5) Capital of the company, the number of shares and the amount of each share.(6) Rights and dividends attached to different classes of shares.(7) Preliminary expenses incurred by the company.(8) Minimum subscription and the amount payable on application, allotment andcalls on shares.(9) Remuneration of the Managing Director.(10) Names and address of auditors and underwriters of the company.(11) Restrictions on the powers of the Directors.(12) Full particulars of the promoters, brokers, bankers, etc.(13) Nature and extent of interests of each Director in the company’s promotion.(14) Details regarding the agreement to purchase property for the company andnames of the vendors.(15) The amount of minimum subscription to be received before allotment of shares.(16) Inspection of books of accounts of the company.(17) Amount payable on application on an allotment and on different calls.(18) Time of opening and closing the subscription list.(19) Revaluation and reduction of share capital.10.6.15 Statement in lieu of a prospectusIf a public company does not issue a prospectus, it can issue a statement in lieu of prospectus.The statement in lieu of prospectus is drafted in accordance with the form set out in Part –I ofSchedule – III of the Companies Act. It contains almost the same information as is contained inthe prospectus. It should not contain any misleading or untrue statement. A statement in lieuof prospectus must be signed by every person named therein as a Director.10.6.16 Liability for false statement in the prospectusA prospectus is an open invitation to the public to subscribe to the shares or debentures of acompany. It must disclose all relevant facts and figures very clearly. Greatest care should betaken to prepare a prospectus. Information provided in the prospectus should not be false andmisleading. It is the duty of the persons who are responsible for the issue of a prospectus not todisclose all relevant facts but also to see that any fact which may be relevant should not beomitted.If there is any false statement in the prospectus, it creates civil and criminal liability on the partof those who are responsible to publish the same. Persons authorizing the issue of the prospectuscan be held liable for punishment with imprisonment up to two years and/or for a fine upto Rs. 50,000 for misstatement in the prospectus.If the Directors have submitted certain false information with a fraudulent intention, they willbe liable for a fine up to Rs. 1,00,000 and/or imprisonment up to five years.

10.6.17 Misleading Prospectus and its ConsequencesA prospectus constitutes the basic of the contract between the company and the shareholderand therefore, it must disclose all material facts (example., facts likely to influence the judgment of aprospective investor in deciding whether to take shares or debentures or not) very accurately.It must not misrepresent or conceal material facts and thereby improperly influence and misleadthe prospective investor into becoming an allottee of shares or debentures and in consequencesuffer loss (Peed vs. Gurney). A prospectus containing false, misleading, ambiguous orfraudulent statement of material facts, is termed as misleading prospectus and in that case amisled investor (original allottee of share who had relied in the prospectus and not a buyer inthe open market) is entitled to proceed against those who misled him.What is a false or untrue statement? A general commendation even if too highly coloured is nota false statement, but to say that something has been done, when it is not so, is a misstatementof fact (Karberg’s Case). If there is omission of material facts from a prospectus or/and wherethe statement is ambiguous in the form and context in which it is included, the prospectus shallbe deemed to be untrue. (Sec. 65). Hence a prospectus should be honestly framed and shouldnot by any half statement of the truth or ambiguous phraseology give a false impression ormislead the investor for, the whole prospectus is to be read, and if, as a whole, if be misleading,those who issue it cannot escape on the ground that there is not a single statement whichstanding alone, can be challenged as false.It must however, be observed that in order to call a prospectus a ‘misleading prospectus, theremust be misrepresentation of facts and not of law or expectation. For example, if a prospectusrepresents that the company’s shares will be issued at half their nominal value, whereas section79 prohibits the issue of share at a discount exceeding ten percent. It is a misrepresentationof law and a person deceived by it will have no remedy. The facts of Shiromani Sugar Mills Ltd.v. Debi Prasad case was also similar. The prospectus in this case, stated that “the managingagents with their friends, promoters and directors have already promised to subscribe shares

worth six lakhs rupees.” But they actually subscribed much lesser number of shares. It washeld that there was no misrepresentation of facts and the prospectus was not misleading because,“the only fact asserted was the existence of promise…and the existence of promise is notfalsified by the breaking of it”.A person who subscribes for shares based on the misleading prospectus has certain remediesseparately against the company as well as against the directors, promoters and experts.10.7 SHARESThe shares capital of a company is divided into shares distinguished by its appropriate numbers.The shares shall be movable property transferable in the manner provided by the articlesof the company and subject to provision of the Companies Act, 1956.The share capital of a company limited by shares shall be of three kinds only, namely : -(a) Equity share;(b) Preference share; and(c) Sweat equity shares.Preference capital means that part of the share capital which fulfils both the following requirements,namely –(a) that in respect of dividends, it carries or will carry a preferential right to be paida fixed amount or an amount calculated at a fixed rate, which may be eitherfree of or subject to income tax; and(b) that in respect of capital it carries or will carry on a winding up or repayment ofcapital a preferential right to the payment of either or both of the followingamount, namely –(1) any money remaining unpaid in respect of the amount specified in clauses (a)up to the date of the winding up or repayment of capital and(2) any fixed premium.Sweat Equity SharesSweat equity shares mean equity shares issued at a discount or for consideration other thancash for providing know-how or making available rights in the nature of intellectual propertyrights or value additions, by whatever name called.A company may issue sweat equity shares of a class of shares already issue if the followingconditions are fulfilled : -(a) the issue of sweat equity shares is authorized by a resolution passed by thecompany in the general meeting;(b) the resolution specifies the number of shares the value and the classes of directors or employees to whom such equity shares are to be issued;(c) not less than one year has at the date of issue elapsed since the date on whichthe company was entitled to commence business;(d) the sweat equity shares are issued in accordance with the regulations made by

the securities and Exchange Board of India in this behalf.Every holder of shares in a company may at any time nominate in the prescribed mannerof shares upon the production of such evidence as many required by the Board may: (a) register himself as holder of the share, or(b) transfer of the share as the deceased share holder could have been made.Distinction Between Preference and Equity SharesThe important distinctions are –(a) Preference shares are entitled to a fixed rate of dividend on and amount calculated at a fixed rate as a percentage of the face value of the shares. Equityshares on the other hand are entitled to a varying rate of dividend dependingupon profits of the company.(b) Preferences shares can be cumulative. In other words during the year whenthe company does not make profits, the arrear dividends accumulate. In caseof equity shares the accumulation of the arrears dividends does not arise. Thisis because the entitlement to dividend is contingent upon the making of theprofit by the company.(c) The holders of the preference shares have a priority over the holders of theequity shares to dividends. In other words, when a company does make profitand declare dividends, the dividends payable to the preference shareholderincluding the arrears of the dividend should be paid first before any dividendscan be declared to the equity shareholders.(d) Preference shareholder also have a priority over the equity shareholder towards the repayment of capital in the event of winding up of the company.Preference share are redeemable after a specified periods of time. In other words,preference shares are entitled to get back their investment from the companyafter a fixed period of time as specified in the terms of issue of the preferenceshare.(e) The preference shareholder do not have a right to vote at the meeting of theshareholders of the company unless it is a matter in which their rights areaffected. On the other hand equity shareholder have voting right on everyresolution which comes up before the meeting. The voting right of the equityshareholder are proportionate to the number of share held by them.An exception to the rule denying the voting right on account of dividends being on arrearsthe voting right of the preference shareholder also would be proportional to thecapital paid up in respect of the preference shares bears to the total paid up equity capitalof the company.Redemption of Preference SharesIf so authorized by its articles, preferences shares are liable to be redeemed at the option of thecompany. After the coming into force of the companies (Amendment) Act, 1988 redemption ofthe preference shares has been made mandatory. No company limited by shares after the commencementof the Companies (Amendment) Act, 1996 issue any Preference Shares which isredeemable or is redeemable after the expiry of a period of 20 years from the date of its issue.

Preference shares shall be redeemed subject to the following conditions, namely :-(a) No such shares shall be redeemed except out of profit of the company whichwould otherwise be available for dividend or out of the proceeds of a fresh issuesof shares made for the purposes of the redemptions:(b) No such shares shall be redeemed unless they are fully paid.(c) The premium if any payable on redemption shall have been provided for out ofthe profits of the company or out of the company’s shares premium accountbefore the shares are redeemed.(d) Where any such shares are redeemed otherwise than out of the proceeds of afresh issue, there shall out profits which would otherwise have been available fordividend, be transferred to a reserve fund to be called the capital redemptionreserve account, a sum equal to the nominal amount of the shares redeemed andthe provision of the Companies Act relating to the reduction of the shares capitalof a company shall except as provided in this section apply as if the capital redemptions reserve account were paid-up shares capital of the company.However the redemptions of preference shares will not attract the problems of redemptionof capital.Issue of Shares at a PremiumWhere a company issues shares at a premium whether for cash or otherwise, a sum equal to theaggregate amount or value of the premiums on those shares shall be transferred to an account,to be called the shares premium account and the provisions of the companies relating to thereduction of share capital of a company shall except as provided herein apply as if sharespremium account were paid on share capital of the company.The share premium account may be applied by the company :(a) in paying up unissued shares of the company to be issued to members of thecompany as fully paid bonus shares.(b) in writing off the preliminary expenses of the company.(c) in writing off the expenses of or the commission paid or discount allowed on anyissue of the shares or debentures of the company.(d) in providing for the premium payable on the redemption of any redeemable preference shares or of any debentures of the company.Right SharesWhenever a company proposes to increase the subscribed capital by issue of further shares atany time after the expiry of two years from the formation of the company or at any time afterthe expiry of one year from the allotment of shares by that company made for the first timeafter its incorporation whichever is earlier. It shall offer such shares to holder of equity sharesof the company as on the date of the offer in proportion to the capital paid up as on that date.As the existing holders of equity shares are given the right of preemption these shares arecalled the Right Shares.

A private company or a deemed private company which retains the restrictive clauses of aprivate company in the Articles need not offer to the existing shareholders.When a special resolution is passed by the company in general meeting to the effect that furthershares may be allotted at the discretion of the board of directors to persons other than theholders of equity shares the shares can be offers to the general public.However, the issue of right shares will take place in accordance with the guidelines of theSecurities and Exchange Board of India.Bonus SharesThe issue of bonus shares by a company is a common feature. When a company is prosperousand accumulates a large surplus, it converts this surplus into capital and divides the capitalamong the members in proportion to their right. This is done by issuing fully paid sharesrepresenting the increased capital. The shareholders to whom shares are allotted have to paynothing. The purpose is to capitalize profit which may be available for division or to utilisequasi-capital gains. Bonus share go by the modern name of “capitalization shares”The company transfers before declaring dividends for a financial year certain portion of theprofit as prescribed by the companies (Transfer of Profit to Reserve) Rules, 1975 to the reserveof the company.The company shall ensure strict compliance with the following financial parameters for determiningthe quantum of the bonus issue :-(i) that the bonus issue is made out of the free reserves built out of the genuineprofits or shares premium collected in cash only;(ii) that Reserve created by revaluation of fixed assets or without accrual of cashresources are not capitalized.The bonus issue could not be made until the expiry of 12 months from any public or rightissue and there is no restriction as to the timing of one bonus issue and another. Thebonus issue should be made within a period of 6 month from the date of approval of theBoards of Directors thereof and the company has no option of changing that decision. TheSEBI has issued guidelines for the capitalization of reserves and issue of bonus shares.The Articles should provide the issue of bonus shares by capitalization of reserves. If there isno such provision the Articles are to be altered suitably. Further it is be observed that the

expanded capital after the issue is within the authorized share capital of the company. Otherwisethe authorized capital is to be increased suitably.Depository System in IndiaOver the last decade, the capital markets has been growing by leaps and bounds, India has thelargest number of listed companies in the world today. As a result investors have to face a lot ofinconvenience in effective registration of securities in their favour and to ensure that they receivetheir rightful share of dividend, bonus, right and other benefits. The large numbers in theCapital Market have also given rise to a large amount of paper work, bringing with it theassociated problems.The physical movement of (share) certificates and their transfer are fraught with a number ofproblems and are usually cumbersome and time consuming. Further with the increase in thevolumes of trading, there has been an increase in the number of bad deliveries and this hasintroduced increased risk in settlement of trade. The threat of wrong/forged signatures, stolenshares, fake certificates etc. need to be contained if the investors are not to shy away fromtrading and investing in the India market.All these factors served as barriers to the entry of an investor in to the market. This failure gavethe idea of setting up of an electronics system with scripless trading and quick settlementcycles.The Government of India promulgated the Depositories Ordinance in September 1995. Securitiesand Exchange Board of India (SEBI) notified Regulations under the ordinance in May,1996, in order to provide the regulatory framework for the depositories. National SecuritiesDepository Limited (NSDL) was registered on the 7th June 1996, with the SEBI as the first depositoryin the country.This new system of keeping ownership record in the form of electronic holdings has a numberof advantages over the existing system of physical securities. In the new system, the Physicalmovement of securities would be replaced by a book entry system, under which the ownershipwould be transferred by electronics entries.The Depositories Act, 1956 makes a provision for the setting up of multiple depositories in

India. The investor has been granted the option of holding securities in a physical or dematerializedform. Thus it is matter of choice for the investor as to whether he wants to avail of thedepository services.All rights with respect to the securities held in the depository will with the beneficial owner(investor) and not with the depository. The depository acting as the registered owner only.When transacting through a depository, the investor will not be required to pay stamp duty ontransfer of shares or the unit of mutual funds within the depository.The depository will interface with the investor through market intermediaries called DepositoryParticipants (DP). The depository will hold beneficial owner-level information throughits networks of DP. This will facilitate proper distribution of benefits arising out of the investor’sholding such as dividend, interest, bonus and right as on a given record date by the issuercompany of its registrar and transfer agent.The SEBI (Depository and Participants) Regulations, 1996 specify the norms for the functioningand operations of depositories. The regulations have selected various categories of marketparticipants who are eligible to become depository participants.10.8 DEBENTURESDebentures constitute a valid instrument by which long term and medium term financial needsare met by raising loans from the public. Debentures represent loan capital and the debenturesand transferable securities as in the case of shares through stock exchanges. The debenturesoffer a predetermined fixed return by way of interest and are redeemed after a stipulated period.They may be offered privately without public announcement in the newspaper.Debenture is defined to include debenture stock, bond and other instruments of companywhether constituting a charge on the assets of the company or not. A debenture shall not ceaseto be so merely because it is not secured by charge.There is no precise definition of the term and it can only be concluded that any instrumentsthat creates or acknowledges a debts is a debentures. In CIT v. Cochin Refineries Ltd. (1982) itwas held that where a company issued “notes” to secure a dollar loan, such “notes” and loan.Since a debenture means a document which creates or acknowledges a debt the distinctionbetween a debenture and loan can be understood from the following passage :

The substance of a loan is a right in the creditors to demand repayment and the substance of adebt is a liability upon the debtor to replay the money [per Chakravarty J. in Ram RatanKarmakar v. Amulya Charan Karmakar].The debentures have the following features namely :1. It is an instrument issued by the company acknowledging debt.2. It provides for the payment of or acknowledging the indebtedness in a specifiednominal value or face value of the debenture.3. It carries a specified rate of interest.The debentures may be registered debentures or bearer debentures. Registered debentures aredebentures which are payable to the holder thereof whose name is registered in the registeredof debenture holders. Registered debentures certificates are transferred by executing a deed oftransfer as in the case of shares. A bearer debenture is transferred by simple delivery.Debentures could be secured or unsecured. But normally most of the debentures are secured.Repayment of the indebtedness by way of debenture is secured by a charge on the assets of thecompany.Debentures could be redeemable or irredeemable. Redeemable connotes that the borrowingwill be repaid by the company within a fixed term. In case of irredeemable debentures there isno obligation on the part of the company to repay the amount of the borrowing raised by wayof debentures.Debentures may be convertible into shares. This indicates that after a particular period of timeof issue of debentures, the debentures may be converted into shares at a specific rate of conversion.In other words till the date of conversion of the debentures into shares debenture holderswould be earning interest from the company at a specific rate of interest . On conversion of thedebenture, debenture would be cancelled and shares would be issued in favour of the debentureholders. After such conversion the debenture holders become the shareholder of the companyand will not be entitled to may fixed return by way of interest but will be entitled to thedividends that may be declared by the company.Since the debentures are corporate securities akin to the shares, almost all the rules, regulationsand restrictions in respect of issue of shares are applicable to debenture. Some of the importantstatutory provisions relating to the debentures are discussed below :

1. The power to issue debenture shall be exercised by the board of directors at ameeting [s. 292(1) (d)]2. No company shall issue any debenture carrying voting right at any meting ofthe company whether generally or in respect of particulars classes of business.[s. 117]3. Debentures which have been issued and redeemable may be kept alive for reissue[s.121]4. Every debenture holder is entitled to a copy of the debenture trust deed within7 days of making a request for such deed.5. A contract to take up and pay for debentures can be enforced by a degree forspecific performance [section 122]6. The holders of the debenture have a priority under section 530 of the Act, ifwinding up were to take place. If the debenture are secured by floating chargeon the assets of the company the creditors with fixed charges will be paid firstand the debenture holders with a floating charge on the assets will get nextpreference in the list of priorities for repayment.7. Every company shall keep a register of debenture holders in the same manneras the register of members.8. A debenture holder is not entitled to the balance sheet and profit and loss accountof the company [section 219]Every holder of debenture of a company may at any time nominate in the prescribedmanner a person to whom his debenture of the company shall vest in the event of hisdeath.10.9 BOARD OF DIRECTORSIntroductin - when a Company is incorporated under the companies Act 1956, it becomes alegal entity capable of exercising all its function. For example, a company can own property,enter into contracts and even be guilty of certain offences.The company can only act throught some human agency. It being impracticable for all themember of company to conduct its affairs; they elect their representative for this purpose.These elected representatives are usually known as Directors. Every public company (otherthan a public company which has become such by virtue of sec 43-A) must have at least threeDirectors. Every other company must have at least two Directors. Directors of a company collectivelyare referred to as ‘’the Board of Directors.’’Nobody corporate association or firm shall be appointed director of a company. Only aninduividual can be a director of a company.How director exercise their powers?Subject to any special provisions in the articles, powers delegated by a company to its directors

must be exercised at properly convened meeting referred to as Board Meeting.In the case of every company a meeting of its Board of Directors shall be held at least once inevery 3months’ and at least four such meetings shall be held in every year.Provided that the Central Government may, by notification in the official Gazette, direct thatthe provisions of this section shall not apply in relation to any class of companies or shall applyin relation thereto subject to such exceptions, modifications or conditions as may be specifiedin the notification.Notice- Notice of every meeting of the Board of Directors of a company shall be given in writingto every director for the time being in India; and at his usual addres in India to every otherdirector.Quorum - A quorum is the preseribed minimum number of qualified persons authorized totransact the business at meeting. In relation to Board Meeting- quorum implies fully qualifiedand disinterested director who must be present at the meeting so as to enable the Board tolegally transact the business thereat.Accordingly by the quorum for a meeting of the Board of Directors of a company shall be1/3rd of its total strength (any fraction contained in that 1/3rd being rounded off as one) ortwo directors whichever is higher.Certain powers to be exercised by Board only at meetingThe Board of Directors of a company shall exercise the following power on behalf of the companyand it shall do only by means of resolution passed at meeting of the Board(a) the power to make calls on sharehloders in respect of money unpaid on theirshares;(b) the power to issue debentures(c) the power to borrow moneys otherwise than on debentures(d) the power to invest the funds of the company(e) the power to make loans.10.10 MEETINGSWe are here concerned with general meetings of members/share holders. The general meetingsof members are of vital importance in the working of a company. For although generalpower of management of a company are vested in the Board of Directors the consent of memberson such major issues as specified in Section 293 has to be obtained in their general meeting.Otherwise also it is fair to provide an opportunity to the shareholders to come together ad

review the working of the company. Hence the companies Act has provided for various typesof meetings of the shareholder of a company.10.10.1 Types of general MeetingsThere are three types of general meetings of shareholder :—1. Statutory meeting.2. Annual general meeting.3. Extraordinary general meeting.In addition to the above types of meetings, sometimes a meeting of a particular class ofshareholder may also be held. Such meetings are called “class meetings”. They are convenedeither by the company or by the court to affect variations in the right of that particularclass of shareholders [Sec. 106] or in connection with a scheme of arrangement[Sec. 394] or at the time of winding up of the company. A class meeting is not a generalmeeting but similar rules relating to convening and conducting of a meeting apply to it[Sec. 170].10.10.2 Statutory MeetingIt is the first official general meeting of the shareholders. All public companies having a share capitalexcept unlimited companies are required to hold a statutory meeting compulsory. It implies that privatecompanies, unlimited companies and companies limited by guarantee but not having shares capital arenot required to hold such a meeting. Statutory meeting must be held after one month but within sixmonths of obtaining the certificate to commence business [Sec. 165(1)]. Unlike other types of generalmeetings, this meeting is held only once in the lifetime of company.The object of the statutory meeting is to provide an opportunity to the members, as early as possible, ofacquainting themselves with the assets and properties acquired so far and to discuss the success of theflotation. The members are free to discuss any matter relating to the formation of the company or arisingout of the statutory report. But they cannot pass any resolution without previous notice of at least 21days.10.10.3 Statutory ReportIn order to enable the members to make the best use of this opportunity the directors are requiredto prepare and send to every member a document known as the ‘statutory report’ atleast 21 days before the day on which the meeting is to be held. If the report is sent later it willstill be valid if it is so agreed to by a unanimous vote of the members entitled to attend and voteat the meeting [Sec 165(2)]. The report should be certified as correct by at least two directors,

one of whom shall be the managing director where there is one, and must also be certified bythe auditors [Sec. 165(4)]. A copy of this report must be filed with the Registrar forthwith at thetime of sending it to members [Sec. 165(5)].10.10.4.The statutory report must set out the following information : -(1) The total number of shares allotted, distinguishing those issued otherwise thanfor cash and stating in the case of partly paid up shares, the extent to which theyare so paid;(2) The total amount of cash received by the company in respect of all the sharesallotted;(3) An abstract of the receipts and payments up to a date within seven days of thereport and the balance in hand. The abstract must show under distinc tive headings the receipts of the company from shares, debentures and other sources andshall give an account or estimate of the prelimi nary expenses of the companyshowing separately any commission or discount paid or to be paid on the issue orsale of shares or debentures;(4) The names, addresses and occupations of the company’s directors, auditors, managing director or manage secretary and the changes, if any, that have occurredsince incorporation.(5) The particulars of any contract to be submitted to the meeting for approval andits modification done or proposed, if any;(6) The extent to which any under writing contract has not been carried out and thereasons therefore;(7) The details of arrears of calls due from directors and managing director are managers;(8) The particulars of any commission or brokerage paid or to be paid to directorsand manager in connections with the sale of shares or debenturesof the company.If any default is made in filing the statutory report with the Registrar or in holding the statutorymeeting, every officer of the company responsible for the default shall be punishable, witha fine up to Rs 500 [Sec. 165(a)]. Further if the statutory meeting is not held in time, the courtmay under section 433 order the compulsory winding up of the company on a petition filed byany member after the expiry of 14 days from the date an which statutory meeting was to beheld.10.10.5 Annual General MettingEvery company must in each year hold in addition to any other meeting a general meeting asits annual general meeting [Sec 166(1)]. It is the most important meeting of the members of acompany. It is held each year with a view to reviewing and evaluating the overall progress ofthe company during a year. The annual general meeting is sometimes called ordinary general

meeting as usually it deals with the so called ordinary business. The following ordinary businessmust be transacted at the annual general meeting of a public company and a subsidiarythereof [Sec 173(1)].(1) The consideration of the Annual Accounts, Balance sheet and the Reports ofthe Board of Directors and Auditors.(2) The declarations of a dividend.(3) The appointment of directors in place of those retiring, and(4) The appointment of and the fixation of the remuneration of the auditors.Any other business on agenda except that listed above shall be considered as special business.It is to be noted that in the case of extraordinary general meeting all business shall be treated as“special business” [Sec 173(1)(b)]. It is relevant to state that the ordinary business required anordinary resolutions while the special business may require ordinary or special appointmentof auditors although it is an item of ordinary business in the case of a company in which notless than 25% of the subscribed share capital is held whether singly or jointly by a public financialinstitutions or a Government Company or Central Government or any State Governmentor a nationalized bank or a general insurance company.It may be noted that an independent private company may make its own provisions by itsarticles in respect of ‘ordinary business’ to be transacted at an annual general meeting.10.10.6 Other Statutory Requirements(1) The first annual general meeting of a company must be held within 18 monthsfrom the date of its incorporation, and if such general meeting is held withinthat period, it shall not be necessary for the company to hold any annual general meeting in the year of its incorporation or in the following year. It may benoted that there can be no extension of period beyond 18 months in case of thismeeting even by the Registrar.(2) Subsequent annual general meeting must be held each year within six monthsof the end of the company’s financial year; but the interval between any twoannual general meeting must not be more than fifteen months. The Registrarmay, however, for any special reason extend the above lime by a period byexceeding three months.In connection with subsequent annual general meetings it is worth noting that theholding of an annual general meeting in each calendar year is a statutory necessity,and it is not enough that they are held within fifteen months of each other.There should be one meeting per year and as many meeting as there are years.Further, though the annual general meeting of a company may be adjourned to asubsequent date and the adjourned meeting is to be deemed to be a continuationof the earlier meeting, the adjourned meeting too must be held within fifteenmonths of the previous meeting.(3) The annual general meeting must be held on a working day during business

hours at the registered office of the company or at some other place within thecity where the registered office of the company is situated.(4) At least twenty-one days written notice to call an annual general meeting mustbe given to every shareholder, directors, and auditors of the company, and toevery such person on whom the shares of any deceased or insolvent membermay have devolved. The meeting may be held with a shorter notice, if it is soagreed unanimously by all members entitled to vote in such a meeting. An independent private company may, however, by its articles make its own regulations as regards length of period of notice and to whom it should be given.A copy of Directors Report, audited Annual Accounts and Auditor’s Report must be annexedto every such notice.The holding of annual general meeting is also governed by Sections 171 to 186 which containprovisions relating to convening and conducting of all types of general meeting under the Act.10.10.7 Default in Holding the Annul General MeetingIf a company fails to call an annual general meeting within the prescribed time limits, theCompany Law Board may, on the application of any member of the company, call or direct thecalling of the meeting and give such ancillary consequential directions as it thinks expediter inrelation to the calling, holding and conducting of the meeting. The directions that may begiven by the Company Law Board may include a direction that one member of the companypresent in person or by proxy shall be deemed to constitute a meeting.Further the company and every officer who is in default is liable to a fine which may extent tofive thousand rupees and in the case of a continuing default, with a further fine which mayextend to Rs. 250 for every day after the first during which such default continues.10.10.8. Extraordinary General MeetingAll general meetings other than the statutory and annual general meetings are called extraordinarygeneral meetings. Regulation 47 of Table A defines :All general meetings other annual general meeting shall be called extraordinary general meeting.These meetings may be convened by the company at any time. The business transacted atan extraordinary general Meeting comprises anything which cannot be postponed till the nextannual General Meeting example. changes in memorandum and articles of association reductionand reorganization of share capital, issue of debentures, etc. All business transacted at thismeeting is called special business [Sec. 173 (1) (b)] The convening and conducting of this meetingis governed, like the annual general meeting by Sections 171 to 186.

Extraordinary general meeting may be called –(1) By the directors. The directors may, whenever they think fit, convene a meetingby passing a resolution to that effect in the Board’s meeting.(2) By the directors on requisition [Sec. 469]. The directors must convene anextraordinary general meeting on the requisition (written demand) of membersholding not less than 1/10th of the total voting rights on the matter of requisition.The requisition must state the matters for the consideration of which the meetingis to be called. It must be signed by the requisitionists and deposited at the registered office of the company. The directors should, within 21 days from the dateof the deposit of a valid requisition, move to call a meeting and should give 21days notice to members for calling such a meeting and the meeting should actually be held within 45 days from the date of the requisition.It maybe noted that the requisitionists are not bound to disclose reasons for theresolution they propose to move at the meeting. Further, no business other thanthe business for which the meeting has been expressly convened can be transacted at the requisitioned meeting.(3) By the requisitionists themselves. If the directors fail to call the meeting withinafore mentioned time-limits, the requisitionists, or such of the requisitionists asrepresent not less than 1/10th of the total voting rights of all the members, maythem selves convene a meeting within three month of depositing requisition. Sucha meeting should be called in the same manner, as nearly as possible, as that inwhich meeting are called by the Board. Any reasonable expenses incurred by therequisitionists must be repaid to them by the company, and any sum so paid shallbe retained by the company out of-any sums due or likely lo become due to thedirectors in default.(4) By the Company Law Board [Sec. 186]. If for any reason it is impracticable locall or conduct an extraordinary general meeting, the Company Law Board may,either of its own motion or on the application of any director or any memberwho would be entitled to vote, order a meeting to be called, held and conductedin such manner as the Company Law Board thinks fit and may give such directions as it thinks expedient, including a direction that one member present inperson or by proxy shall be deemed to constitute a meetings.It may be noted that unlike an annual general meeting, an extraordinary generalmeeting can be convened on a public holiday and at a place other than the registeredoffice of the company or the city in which the registered office is situated.10.10.9 ProxiesA proxy is a member’s authorized agent for the purpose of voting. The term is also applied tothe instrument by which the appointment to act on his behalf is made by the members. Asper Section 176 the provisions relating to proxies are as follows :(1) Members of a company having share capital have a statutory right to appointproxies, notwithstanding anything to the contrary in the articles. In other wordsproxies may be appointed if allowed in the articles.(2) Unless the articles otherwise provide, a proxy shall not be allowed to vote except

on a poll.(3) Unless the articles otherwise provide, a member of a private company is not entitled to appoint more than one proxy to attend on the same occasion. (For everyresolution poll is taken separately and for every resolution separate proxy may beappointed in a public company).(4) A proxy must be in writing, in the proper form duly signed by the appointer andstamped. If the appointer is a body corporate, the instrument of proxy should beunder its seal and be signed by a duly authorized officer.(5) A proxy may be lodged at the company’s office not later than 48 hours before thecommencement of the meeting. If the articles of a company other than an independent private company require a longer period than 48 hours, that will be inoperative and shareholder will have the right to deposit proxies 48 hours beforethe meeting.(6) For each meeting a separate proxy is required.(7) A proxy need not be a member of the company.(8) A proxy shall not have any right to speak at the meeting.(9) Every notice calling a general meeting must suit with reasonable prominence thata member is entitled to appoint a proxy and that the proxy need not be a member.If default is made in complying with this provision every defaulting officer is punishable with fine which may extend to one thousand rupees.(10) No invitation to appoint any person as proxy shall be issued at company’s expense and idea if any such invitation is issued every officer of the company who isknowingly in default shall be punishable with fine which may extend to one thousand rupees.(11) After giving three days notice to the company, members may inspect proxies lodgedwith the company during 24 hours (within business hours) before the time fixedfor the meeting and till the conclusion of the meeting.(12) Subject lo the provisions in the articles, a proxy can be revoked by intimating thecompany, at any lime, before it is acted upon. Death or insanity of the principalalso revokes the authority of the proxy but proper intimation to the company isnecessary. Moreover, a member can prevent the proxy from exercising the rightto vote by himself attending and voting at the meeting.(13) Where a company is a member of another company or where Government is amember of a company, their properly appointed representative enjoys all the rightsof a member. He can speak at the meeting and vote on a show of hands as well ason a poll [Sees. 187(2) 1 and 187A (2)]. It may be noted that a private companywhich is not subsidiary of a public company is free to make its own provisions byits articles as regards ‘proxies’ and the provisions of Section 176 (as stated aboveunder points I to II) shall apply to such a company only if its articles do not otherwise provide [Sec. 170(1)(ii)].10.11 RESOLUTIONA ‘Proposed Resolution or motion’ when passed by requisite majority of votes by the shareholderbecome a company resolution. Thus a resolution may be defined as the formal decisionof a meeting on any proposal before it.

The Companies Act provided for three kinds of resolutions that may be passed at the generalmeeting of a company :1. Ordinary resolution.2. Special resolution.3. Resolution requiring special notice.The Companies Act and the Articles of Association lay down the type of resolutionsrequired for any particular matter.10.11.1. Ordinary ResolutionA resolution shall be an ordinary resolution when the votes cast in favour of the resolution bymembers present in person or where proxies are allowed, by proxy, exceed the votes, if any,cast against the resolution 189(1). In other words, this is a resolution passed by simple majorityof votes of members present in person or by proxy. Those absenting or remaining neutral arcnot counted.An ordinary resolution is normally used for the so-called ‘ordinary business done in the AnnualGeneral Meeting. example.. to pass the annual accounts, to declare dividend, to appoint directorin the place of those retiring and to appoint auditors. It is relevant to state that a specialresolution is required for any appointment of auditors at an annual general meeting, althoughit is an item of ordinary business, in the case of a company in which at least 25 per cent of thesubscribed share capital is held, whether singly or jointly, by Central Government or a nationalizedbank or a general insurance company or a public financial institutions or a Governmentcompany (Sec 224A). Certain items of ‘special business’ also require ordinary resolutions underthe Companies Act. For example: issue of shares at a discount [Sec. 79(3)] the alteration ofthe share capital [Sec. 94(2)]., appointment of sole selling agents (sec. 294) etc.It may be added that an ordinary resolution will suffice unless expressly provided otherwise inthe Companies Act or the Articles of the company. An ordinary resolution usually does notrequire ‘filing with the Registrar. However, a copy of ordinary resolution conferring powerupon the directors under Section 293 must be filed with the Registrar within 30 days of the dateof its passing. The usual notice of at least 21 days is, however, required for passing an ordinaryresolution.10.11.2 Special Resolution

A resolution shall be a special resolution when the votes cast in favour of the resolution bymembers present in person or, where proxies are allowed, by proxy, are not less than threetimes the number of votes, if any, cast against the resolution and the has been duly specified inthe notice calling the meeting [Sec 189(2)]. In other words, this is a resolution passed by amajority of at least 75 per cent of votes of members present in person or by proxy and a mentionof the fact that the resolution shall be passed as a special resolution must have alreadybeen made in the notice of the meeting and the notice should have been duly given at least 21days before the date of the meeting.The articles of the company may specify purposes for which a special resolution is required.The Companies Act has also specified certain matters, for which a special resolution must bepassed, for example –(1) to alter the memorandum of the company (Sec. 17),(2) to alter the articles of the company (Sec. 31),(3) to issue further shares with preemptive rights (Sec. 81), for creation ofReserve Capital (Sec. 99),(4) to reduce the share capital (Sec. 100),(5) to pay interest out of capital to members (Sec. 208),(6) authorizing a director to hold an office or place of profit (Sec. 314),(7) voluntary winding up of a company (Sec. 484), ‘A copy of special resolutionmust be filed with the Registrar within 30 days of the date of itspassing.10.11.3 Resolution Requiring Special NoticeA resolution requiring special notice is not actually an independent class of resolutions. It is akind of ordinary resolution, with the difference that the mover of the proposed resolution isrequired to give special notice at least 14 days to the company before moving the resolutionand the company in turn, is required to give the notice of the resolution to the shareholder atleast “seven” days before the meeting either individually or through advertisement in an appropriatenewspaper (Sec 190). This provision is a sort of concession to the mover of a proposedresolution, because otherwise he is required to intimate the company about the proposed resolution he intends to move before the company issues Notice of the meeting. So thatthe same may be included in the Notice and Agenda of the meeting as an item of business Itmay be recalled that a notice of at least twenty-one “clear dyas” is required for calling a general

meeting.The articles of a company may specify purposes in respect of which special notice is required.Under the Act a special notice is required before moving a resolution relating tothe following matter :(a) Appointment of an auditor other than the retiring auditor (Sec. 225).(b) Provision that a retiring auditor shall not be re-appointed (Sec. 225).(c) Removal of a director before the expiry of his term. (Sec. 284).(d) Appointment of another person as a director in place of the director removed(Sec. 284).10.11.4 Minutes of MeetingsThe term ‘minutes’ means a concise and accurate official record of the business transacted atcompany meetings. It normally includes only the resolutions actually passed. It is not necessaryto record therein the discussion which preceded the adoption of a resolution. “Minutesare more analogous to a telegram than to a latter”.Section 193 requires every company to keep minutes of the proceedings of both General andBoard meetings in books kept for that purpose within 30 days of every much meeting. Thepages of the minutes books must be consecutively numbered and into case there should beattached by pasting or otherwise any extra page. Each page of every such book shall be signedand the last page of the record of proceedings of each meeting in such books shall be dated andsigned –(a) in the case of the Board or Committee meetings, by the Chairman of the meetingof the next succeeding meeting;(b) in the case of a general meeting, by the Chairman of the same meeting within aperiod of 30 days of the conclusion of the meeting or in the event of death orinability of the Chairman within that period, by a director duly authorized by theBoard for that purpose [Sec. 193(IA)].The minutes of each meeting shall contain a fair and correct summary of the proceedings thereat. The chairman shall, however, enjoy an absolute discretion in regard to non-inclusion of anymatter in the minutes which in his opinion is defamatory of any person, is irrelevant or detrimentalto the interests of the Board or of a Committee of the Board, the minutes must includethe names of the directors present at the meeting and the names of the directors, if any dissentingfrom the resolution passed at the meeting.The minutes of meetings kept in accordance with the above provisions are prima facie evidence

of the proceedings recorded therein (Sec. 194) and the meeting to which such minutesrelate shall be deemed to have been duly called and held, the proceedings to have duly takenplace and the appointments, of directors or liquidators made at the meeting shall be deemed tobe valid, until the contrary is proved (Sec. 195).The minute books of general meetings are to be kept at the registered office of the company andbe open to inspection for at least two hours a day during business hours to any member withoutcharge. Members are also entitled to obtain copies of minutes on request within seven dayson payment of rupee one. The Company Law Board is also empowered to order inspection ofthe minutes books or direct to deliver the copy required thereof, if the company fails to complywith the provisions of this Section (Sec. 196).

Study Note - 1111.1 BUSINESS OBJECTIVES11.1.1 Introduction to Business ObjectivesAn aimless pursuit of anything is likely to end in a waste of energy, time and possibly moneytoo. Every activity is supposed to be with a purpose or an objective. An objective is a targettowards which a rational activity is directed. An organization is expected to be with some

definite objectives and all the available resources are necessarily to be utilized to reach or achievethem. “WHY” is one of the most important questions that one should ask himself before onethinks of starting the activity. It is true that the purposes for which the business activity is to becarried on, may change from Organisation to Organisation, place to place and also from time totime but the fact remains that the choice of right task or objective at the right time is the key ofbusiness success.It is indeed a difficult task for a businessman to set proper objectives and though he may beguided by parallel experiences of others, it is necessary for him to scientifically analyse thesituation and decide the objectives.Peter Drucker opines that objectives in the key areas are the instruments necessary to pilot thebusiness enterprise. Without them the management files by the “Seats of its planes”. – withoutland marks to steerby, without having flown the route before.A businessman, at any juncture of time, compares his actual achievements with the decidedobjectives and feels happy if the results are positive. In the modern dynamic business world,the objectives are likely to be affected positively or negatively with various social, political oreconomic forces as a result of which today the business environment plays an important partfor deciding or changing the objectives. Business can give social status. It can enable the businessmanto earn money or profit. It can offer the joy of achievement. For a long time, it was feltthat profit making is the only objective of any business activity. Nowadays however, it is feltthat profit making is the only objective of any business activity. Nowadays however, it is feltthat profit making is one of the objectives of business but there could be a number of otherobjectives which could justify the existence of a business activity.Management is getting work done through the people and all the functions of managementexample. planning, organizing, staffing, directing, co-coordinating, controlling, reporting or budgeting,have to center round the pre-decided objectives.11.1.2. Characteristics of ObjectivesIt is interesting to note various characteristics of objectives. Some of the important characteristicsare:1. Multiplicity

2. Tangibility or intangibility3. Primacy4. Hierarchy5. Clashing or supporting tendency6. Network7. Time- boundedness8. Clarity and understandability9. Concreteness or specific nature.Peter Drucker has justified eight key areas in which the objectives of a business could be set.According to him these key areas are: Productivity, Physical and financial resources. Profitability,Market standing, Innovation, Managerial performance and development, workers performanceand attitude and the Social Responsibility. The various other characteristics of businessobjectives could be illustrated thus :The tangible objectives can be expressed in terms of quantity such as financial resources. Forexample, the share capital to be raised should be 20 lakhs rupees. On the other hand someobjectives are expressed in terms of numbers or percentages, for example, the labour turnovershould not be more than 5% or workers morale should be higher are statements indicatingintangible objectives.Some objectives get priority over the others. Thus in the initial stages a business should givepriority to survival as compared to profitability. The important objectives stand first and theyare followed by the less important ones. Business is more important than personal convenienceor inconvenience.When there are some objectives which differ in nature when compared, it becomes necessaryto reconcile and achieve larger interest of the business.A network of various objectives is to be set for achieving greater success. When specific goalsor targets are to be achieved, it becomes necessary to coordinate. Larger production must becoordinated with larger sales otherwise there would be piling of stocks and it may prove to bea graveyard for management.The objectives may vary in the context of a period of time. The objectives may thus be classifiedinto short term, medium term and long term objectives. Thus the short term objectives aregenerally to be achieved within a period of one year, the medium range objectives could be

achieved within a period of two to four years and the long term objectives could be achievedwithin a period of five years or more.It is necessary that the objectives should be clear and easily understandable. If the objectivesare ambiguous, the personnel responsible for achieving them is perplexed. The understandableand reasonable objectives are likely to be achieved with fullest cooperation of workers.The objectives should be expressed in specific terms. For example, when the Production Managerstates that it is desired to increase the production by 30% in the current year, his workersunderstand as to what is expected of them.Ideal objectives are clear, acceptable by all concerned, supporting one another, precise andmeasurable.11.1.3 Advantages of ObjectivesWhen the objectives are rationally pre-decided, they help the business to channelise variousavailable resources for achieving the goals. The objectives, in fact, are the basis for all kinds ofplanning. The policies, strategies, and procedures are based on the objectives. They can serveas the motivating factors for the employees and different departments concerned. The activitiesof different departments could then be coordinated. The controlling becomes feasible. Thebusinessman can lead, guide, direct and get work done as per specifications. A proper communicationof the objectives can ensure lesser conflicts, misunderstanding or disputes among theconcerned employees. Peter Drucker feels that Management by objectives (MBO) is based onthe acceptance of objectives after discussion by the superiors and subordinates sitting together.The traditional way was that all the objectives were decided by the Top Management and thelower cadre was required to accept them without objection or suggestions. MBO on the otherhand believes in mutual conversation, discussion and acceptance of the objectives by the TopManagement and the representatives of the Lower management at the same table. Objectives,in this manner, are specifically decided by all concerned and this can ensure maximum cooperationfrom all.11.1.4 Various Business Objectives.The various objectives of business could be classified as follows:1) Economic objectives

2) Social objectives3) Human objectives4) National objectives5) Organic objectivesThe Economic objectives are :a) Earning of adequate profitb) Production of tangible form of wealthc) Creation of market or creation of customersd) Innovatione) Best use of available scarce resources.The Social objectives are :f) Providing quality goods and servicesg) Charging reasonable pricesh) Generation of employmenti) Avoiding antisocial practices and profiteeringj) Creating and maintaining better environment.The Human objectives are :k) Giving a fair deal to the employeesl) Ensuring job satisfactionm) Treating employees as partners to prosperityn) Development of human resourcesThe National objectives are :o) Producing goods and providing services as per national prioritiesp) Development of small enterprisesq) Guaranteeing social justicer) Export promotionThe Organic objectives are :s) Survivalt) Growth, expansion and diversificationu) Creating goodwill, prestige and recognition.Casting a cursory glance at the above mentioned objectives it could be said that these objectiveshave relevance to the period and the environment under which the business is functioning.Thus earning adequate profit is obviously one of the most important economic objectives.Even in the socialistic countries, it has been accepted that generating a surplus out of anybusiness activity is a sign of efficient use of the available resources. The profit may be utilizeddifferently under different economic systems but there should be a break even as early as possibleand it should be followed by a surplus too.The production of tangible form of wealth for the benefit of community is equally important.The business can generate profit by providing people various goods and services, which theyneed. The customers are to be created and the potential markets must be tapped. Peter Ducker

believes that the only valid definition of business purpose is to create a customer who is thefoundation of business and who helps it to survive and grow.Change is the order of the day in the modem business world. The business which cannot changeaccording to the changing trends is likely to perish. Innovation, in other words, becomes aMUST with better machines, and improved technology.Since business is the specific organ of growth, expansion and change, exploring and discoveringways and means for making the production and services more useful for the customers isinevitable.The optimum use of the available resources is the duty of every businessman in the individualas well as social context. Unnecessary waste of material and energy must be avoided.The society has its own expectations about the business. It demands that the quality goods andservices must be provided regularly and at reasonable prices. A business should generate employmentand provide welfare to the employees. Better working conditions should be providedand a fair return on the investment should be available to the owners.The human considerations require that the employees should be paid fair wages and offeredan opportunity to participate. They must get job satisfaction.Similarly, from the point of a nation, the scarce resources should be utilized to produce goodsand services to which the nation gives a priority and not a few individuals, the small scaleindustries which provide employment to many should be encouraged. Exports should be promotedfor earning valuable foreign exchange and the social justice should also be ensured.From the point of view of an organization, the first and the foremost objective is the survival ofthe business in the adverse circumstances. The survival should be followed by expansion andgrowth. If necessary diversification should also be resorted to, for earning legitimate higherprofit. Similarly, in course of time, Goodwill, Prestige and Recognition should also be the goalsof a successful business.These are called organic goals.To discuss the question of business objectives further, as Peter Ducker has suggested, one couldconcentrate on KRAT example. KEY RESULT AREAS TECHNIQUES.These 8 different areas are :1. Market Standing2. Innovation3. Productivity

4. Profitability5. Physical and financial resources6. Managerial performance and development7. Workers’ performance and attitude8. Public or Social Responsibility.11.1.5 The Concept of Social ResponsibilityAs mentioned earlier, modern businessmen have started accepting that profit making is nomore the only objective of business. In marketing also it is said “A sale is not made at thecounter or by a salesman, it is made in the mind of the buyer”. In other words, just as for sale ofa product or service the most important person is a buyer, similarly, for achieving all the otherobjectives of business, it is the society which is the most important factor and a business cannotsurvive or prosper without a Society. It must therefore be realized that a business has also someresponsibility towards Society.The obligations of a business towards society could be classified under two heads :a. The socio-economic obligations andb. The socio-human obligations.It is the socio-economic obligation of a business that its activity should not adversely affect theeconomic welfare of people. When a business generates employment, it adds to the welfare ofthe society. It can help to raise the standard of living of the people. This should be accepted asone of the responsibility towards society though it cannot be insisted that one must start businessto create employment opportunities.Similarly, competition should be accepted and not curbed because it can force a business tomaintain quality and control overhead costs.A business should also try to hold the price line and curb inflation. On the other hand nurturingand developing human values such as morale, cooperation, motivation etc. comes underthe socio-human values of a business.The social responsibilities of a business thus should be studied and appreciated under thefollowing heads :1. objectives which protest consumer interests;2. objectives which protect the interests of workers, and3. objectives which protect the interests of the society.It is felt necessary now that continuous efforts should be made to improve the benefits to theconsumers. This involves the following :(a) Adequate and efficient supply of goods and services(b) Reasonable prices charged

(c) Productivity improvement by reducing cost and price, by optimum utilization ofnational resources, by remunerating workers better for improving competitiveness of the enterprise and for increasing the profitability.(d) Reduction of costs by other methods.(e) Quality improvement(f) Product development(g) After sales service(h) Product safety(i) Disclosures about the products like risks, expiry dates, ingredients, precautionsetc.(j) Handling of complaints and grievances.Workers’ interests could be safeguarded by :(a) Payment of fair wages(b) Providing better working conditions(c) Providing labour welfare(d) Promoting self development to employees(e) Promoting healthy industrial relations(f) Helping workers to be shareholders of the company.Social interest could be taken care of by :1. Protecting ecology of the surrounding locality2. Helping overall development of the locality3. Rehabilitating the population displaced by the operation of the business, if any.4. Conserving scarce resources and developing substitutes;5. Improving productivity;6. Helping the national causes like earning foreign exchange, developing backwardregions, assisting weaker sections of the society etc;7. Promoting ancillary and small scale industries;8. Contributing to research and development; and9. Helping social causes like education, health, entertainment, etc. It is necessary forany business to strike a harmonious balance between Social and Economic objectives.11.2 BUSINESS ENVIORNMENTAny business depends upon certain internal factors and is also influenced by certain externalfactors. The external factors are generally uncontrollable factors and are referred to as BusinessEnvironment. Business environment refers to all those external forces such as economic, social,political, regulatory, technological, natural and competitive factors which affect the business.Every businessman goes in for analyzing all the factors by resorting to what is known as aSWOT ANALYSIS. S stands for Strength, W for Weaknesses, O for the opportunities and T forthreats. Strength and weaknesses are internal factors whereas Opportunities and Threats areexternal factors. Any change in a business environment may imply an increase in opportunities

or in threats. The same environment may offer opportunities to some firms and threats tosome other Firms. Thus liberalization policy of the Government of India may result in openingof new opportunities to some Indian firms while it may result into threats to the existence orgrowth of some other firms. A duty reduction in the Central Government Budget may resultinto a boost to some industries. The reduction of subsidies to the fertilizer industry may resultinto an increase in the prices of fertilizers and also reduction of demand for them. The demandfor sunflower oil may increase because of the medical reports that it helps keeping the hearthealthy.11.2.1 Economic EnvironmentEconomic environment includes the factors like the nature and level of development of theeconomy, economic resources, size of the economy, economic system and economic policies,current economic conditions, trends in the GNP, growth rate and per capita income, nature ofand trends in foreign trade, domestic supply and demand conditions etc.All these factors affect business favorably or unfavourably. For example, a developing economywill offer more opportunities for business for businessmen in the advanced countries. On theother hand, if the income is very low, some of the commodities considered to be essential inadvanced countries will have no demand in the backward countries.If the taxation is on the higher side, the prices will shoot and the demand will fall, Because ofthe shortage of foreign exchange, the Government may put restrictions on the import of foreigngoods or raw material as a result of which the quality of the goods manufactured will belower as compared to that produced with the foreign imported ingredients. If the growth rateis satisfactory and the per capital income has started growing, the demand for luxuries willslowly start growing. Similarly, a number of developing countries are offering new opportunities because of fastergrowth in population, existence of large unsatisfied demand, growing democratization andindividual freedom together with fairly good growth of the economy. The developed economiesare characterized by high levels of income, consumption and competition in businesssector. In case of countries where income is low, the businessmen may be required to reduce

other costs such as packaging.It is observed that less fuel consuming cars were required to be produced because of the pricesof oil, shooting high. The inflation and depression or the changing phases of trade cycle doaffect the business. Diversification can help a firm to combat with the recession in some industries.In short a business has to consider various economic factors in the stages of survival,stability and growth.11.2.2 Social EnvironmentThe social or cultural environment includes customs, traditions, religious beliefs, tastes andpreferences, social institutions, buying and consumption habits etc. and all these do affect abusiness.The food habits of people in South India differ from those of people in North India. Some of theforeign companies have failed in India because they could not appreciate the cultural values ofpeople in India. The advertising and publicity firms have consider these factors. The languagecan be a barrier or an aid depending how it serves as a vehicle of thought. Social inertia andassociated factors may come in the way of the promotion of certain products, services or ideas.Certain social stigmas in the marketing of family planning ideas, use of bio-gas for cooking,etc. do create barriers for business activity. The success of some of the business ventures dependupon the success of changing social attitudes or value systems.The demographic factors, such as the age and sex composition of population, family size, habitat,religion etc. also influence business. Louis L. Stem has observed in his article ConsumerProtection via Self-Regulation in the Journal of Marketing, that more the educated the societybecome more discretionary the use of its resources, the more marketing will become enmeshedin social issues. The number of married couples in India these days, are having a double earning,as a result of which the demand for domestic electric appliances has stated growing.It may, therefore, be concluded that the social environment of different markets will be differentand the difference will also be observed within the market making it necessary to havebusiness strategies suitable to any particular type of Social environment.11.2.3 Political Environment

The political policies, the nature of the Constitution and the government system, the governmentenvironment encompassing the economic and business policies and regulations havevery important implications for business. The Industrial Policy decisions have been taken bythe successive governments. Pandit Jawaharlal Nehru had a different economic scenario ascompared to the one which Smt. Indira Gandhi had. The liberalization policy adopted by theGovernment is likely to have long reaching repercussions. Besides, as compared to the previous politico-economic decisions of nationalization of banks and insurance, the latest trend appearsto be more towards privatization. Disinvestments of Government holdings in publicsector enterprises have gained momentum. All over the world, the political environment hasdefinite effect on business.11.2.4 International EnvironmentWith the rapid Industrial, Commercial and Computer Revolutions, the world has becomessmaller. The rapid changes cannot allow any country to be economically independent. Thetrade and commerce is no more restricted to national boundries. It is International Trade obviouslytherefore, the business world of today cannot be in isolation and any political or economicchange on the world map is bound to increase or decrease the volume of business. WTOexample. World Trade Organisation for example, is bound to be discussed in the business circlesbecause its repercussions on different industries is bound to be different and serious. The NRI,the Multinationals etc. are likely to shape the Indian business differently. The InternationalEnvironment, thus can affect the business radically. The Russia or the Germany, as markets,are now presenting a changed picture. The Kashmir Tourists Trade is seriously hampered bythe strained relationship between India and Pakistan.Therefore, we may conclude that the economic, political, social, regulatory, competitive, technologicalor international environment must be studied in proper perspective before any businessdecisions could be taken.

Study Note – 1212.1. STOCK MARKET (STOCK EXCHANGE)12.1.1 IntroductionThen are two stages involed in the purchase and sale of securities. In the first stage, the securitiesare acquired from the issuing company themselves from the issuing comany thenselvesand in the second stage, the securities are purchased and sold continuously among the investorswithout any involvement of the companies.Thus the industrial securities market is dividedinto two parts namly NIM and Stock Market.The NIM deals with new securities that is, securities which were not previously available andare offered to the investing public for the first time.The stock market covers the second stage of dealing in securities. The Stock Exchanges, therefore,provide a regular and continuous market for buying and selling of securities.The Securities Contracts Regulation Act, 1956 defines stock exchanges as ‘an association, organizationor body of individuals whether incorporated or not, established for the purpose ofassisting, regulating and controlling business in buying, selling, and dealing insecurities’. Aclose review of the well known definition brings out the following features of the stock market1. Stock market is an organized market where securities of government and semigovernmentbodies and corporate enterprises are bought and sold.2. Stock market deals in second hand or existing securities.3. Individuals alone can buy and sell securities. The stock market does not provide

this facility to corporations and partnership firms.4. In the Stock market only those securities which are listed in the stock market aretransacted. Unlisted securities are not permitted to be dealt in the market.5. Stock market may be a registered or unregistered body. It is not always necessaryfor a stock exchange to incorporate it under the Companies Act.6. Transactions in the stock market must adhere to the rules and byelaws framed bythe stock exchange to regulate its day-to-day operations.12.1.2 Important Ingredients of a Stock ExchangeFollowing are important ingredients of a stock exchange:1. Provisions of the place for the buyers and sellers of securities for transacting theirdealings.2. Existence of brokers and other intermediaries to assist their client investors infinalizing their deals.3. Scope for genuine and legitimate speculation and allied transactions so as to makethe market continuously responsive to the basic forces of demand and supply.4. Framing of regulations of ensure transactions in such a manner as to avoid unduefluctuation in the value of securities and prevent unfair dealings.12.1.3 Functions and Services of Stock ExchangesStock exchanges play an important role in capitalistic countries. It is indispensable for the properfunctioning of joint stock companies. The importance of a stock exchange will be clear from thestudy of its functions and services.A stock exchange performs the following economic functions and services:1. Provides ready and continuous market : Stock exchanges provide a ready andcontinuous market where anybody can purchase or sell the securities during thebusiness hour. Therefore, it provides liquidity, price continuity and marketabilityto the capital locked up in the investments. This facility of marketability helps aperson in choosing shares or debenture for investment. He feels confident that hewould be able to dispose of the shares to his best advantage in the shortest possible time and convert them into cash, when necessary2. Facilitates regular valuation of securities : In a stock exchange, evaluation ofthe listed securities is carried on continuously. That way it is able to determine theprice of the securities as close as possible to their investment values based on presentand future income-yielding prospects of the various enterprises. A well regulatedand efficient stock exchange performs this function of evaluation cheaply andquickly.3. Encourages capital formation : Stock exchanges contribute to a considerable extent to capital formation in the country. It inculcates the habit of saving, investingand risk taking in the investor. The publicity that the stock exchange gives to thedifferent kinds of securities and their price induces all persons to take interest incorporate and government securities and their surplus funds in such securities.The saving that are put at the disposal to industries and government are usedeffective and dividends and interest are paid on the investments. More often, the

dividends and interest earned are again invested in similar securities. This processof funds in corporate or government securities earning of dividend and intereston such securities and reinvestment of the whole or part of such income in similarleads to capital formation.4. Provides proper direction to invest capital : The securities of companies withgood profits are popular in the stock exchanges. Investors are attracted towardsthose securities. The securities of companies which are not profitable are bearingno response in the stock exchange, In this way. Stock exchange gives proper direction to invest the capital of investors. Because of this, stock exchange is called a“sensitive barometer of business activity”.5. Ensures wide ownership of securities : A stock exchange ensures wider distribution of securities. If a company’s securities are listed in different stock marketsof the country, its securities will be bought and sold by persons scattered all overthe country and ownership of securities is widely diffused.6. Facilitates distribution of new securities : Stock exchange is primarily a marketfor dealings in second hand securities. But it helps, in marketing the shares anddebentures of a new company also. If the securities are listed on the stock exchange for the purpose of their trading, they attract investors from different partsof the country.7. Ensures safety of funds : Stock exchanges ensure safety of investible funds because they have to operate under set rules which seek to check over-trading, illegitimate speculation and manipulation etc. They would strengthen the investor’sconfidence and stimulate larger investment in business securities.8. Regulates company management and performance : The companies which wantto get their securities listed have to follow certain rules and fulfill prescribed requirements. Through then the stock exchange yields influence on the working ofthose companies in the public interest. Further, as the stock exchange publishesthe ruling prices of securities constantly, it indirectly induces the companies toimprove their performance. Otherwise inefficiency would soon become public.9. Disseminates information : A stock exchange disseminates information relatingto the capital, management earnings and dividends of listed companies throughinformation bureau. Some stock exchanges publish year books giving history andfinancial position of listed companies. Thus it provides necessary data for deciding on investment.10. Facilitates speculation : Stock exchanges provide facilities for speculation in thesecurities. Healthy speculation tends to equate demand and supply and regulatestheir prices to a substantial extent.11. Mirror of business cycle : Stock exchanges mirror the phases of business cycle,that is the changing conditions of economic health of a country Booms and depressions find their echoes in the dealings on stock exchanges.The above account of the various functions performed by a stock exchange shows that it

is really an important institution of a country. Briefly, community savings, productiveinvestments, capital formation, industrial growth, economic development and individualprosperity are the integrated chain of benefits that may be derived from the efficient workingof stock exchanges in a country.ServicesA well organized and efficient stock exchange renders services of considerable importance.Such services can be examined under three heads, example., to the community, to the investor and tothe corporation.Services to the Community1. The stock market is an important institution to finance the economic development of a country. It is no exaggeration to say that the sharp increase in industrialactivity in the past two decades and more would not have been possible but forthe important part played by the stock exchanges particularly in Mumbai, Kolkataand Chennai.2. It encourages highly profitable enterprises. It places a premium on efficiency. Itdiverts funds from unprofitable and unproductive channels to profitable and productive ones.3. It encourages capital formation by extending facilities for productive investmentof surplus funds available with the people.4. It helps the government to borrow funds from the public and utilize the same onprojects of national importance.5. By providing facilities for the sale and purchase of shares and the publication ofreports regarding the conditions of the stock market from time to time, it encourages even persons of small means with little or no knowledge of corporate financeto acquire shares in large concerns in the hope of earning a good return on them.This function of the stock exchange has the effect of ‘socializing’ the capital oflarge corporation.6. On the basis of information provided by the bulletins issued by stock brokers andreports published by the stock exchanges, investors are able to buy shares in concerns operating in different parts of the country or even in different parts of theworld.Services to investors1. The investors are assured of already and continuous market for the securitiesowned by them and, thus the liquidity of the investment is ensured by the stockmarket.2. They may secure credits on the basis of the security owned by them easily as thestock market provides negotiability to the securities.3. An investor may be assured of safety of investment and fair dealing in them whenthey are dealt with through a well regulated and well organized stock exchange.4. They may easily find the variations in the value of their investments as the stockexchanges publish daily or periodically the quotations of listed securities.Thus, they are able to assess the value of their holdings.

5. The risk in the investment is minimized and safety is well ensured by the presenceof the continuous market, negotiability, correct evaluations and facility for liquidating the investment.Services to the Corporation1. Easy marketability of securities help companies to enjoy a wide market for theirshares.2. If the securities of a company are listed in a stock exchange it gives an impressionof a sound concern. It will improve its good will and credit standing.3. If the securities of a company are offered through a stock exchange they get goodresponse from public.4. Since fluctuations in the prices of securities are minimized, the company enjoythe confidence of the public.5. Generally the market prices of listed securities are higher in relation to earnings.This help the companies at the time of merger and amalgamation.6. Regulation of company management and performance is ensured.12.2 STOCK EXCHANGES IN INDIA12.2.1 Brief historyGrowth of stock exchange in India has been linked with the growth of joint stock companies.The organized stock exchange in the country started in Bombay in 1877. By 1939, there wereseven stock exchanges. By 1945, they increased to 21, operation of too many stock Exchangeswas considered undesirable. It was felt that their diverse rules and policies may lead to unsettledconditions resulting in perverse speculative dealing injurious to genuine investmentactivity. Hence the government of India as per the recommendations of Gorwala Committeeenacted Securities Contracts (Regulation) Act in 1956 to regulate formation, operation and tradingroles of stock exchanges in the country. Following are some of the stock exchanges recognizedunder the Act.1) Bombay Stock Exchange.2) Calcutta Stock Exchange.3) Madras Stock Exchange.4) Delhi Stock Exchange.5) Ahmedabad Stock Exchange.6) Hyderabad Stock Exchange.7) Indore Stock Exchange.8) Bangalore Stock Exchange.Bombay Ahmedabad and Indore stock exchanges are organized as voluntary associations whileCalcutta and Delhi stock exchanges have been incorporated as public limited companies andHyderabad, Madras and Bangalore stock exchanges as companies limited by guarantee.

Major operations of prominent stock exchanges, are found to be in specific securities, For example,cotton textiles and bank shares are predominant in Bombay; coal, jute tea, bank andengineering securities are more popular in Calcutta Stock Exchange; textile shares are dominantin Ahmedabad while Madras stock exchange abounds in plantations and textiles.12.2.2 ManagementEach stock exchange is managed by a committee of management whose condition and powersare governed by its own byelaws. This committee is entrusted with the responsibility of overallcontrol and guidance. This is given different names in different exchanges. In Bombay, it iscalled the Governing Board, in Calcutta, it is known as the Committee, and in other places thecouncil of management. Their day-to-day management is vested in a number of sub-Committeessuch as Listing Committee, Defaulters Committee, Arbitration Committee and so on. EachExchange has its own rules for the conduct of business. The Securities Contracts (Regulation)Act provides for a general system control over stock exchanges.12.2.3 Membership of the Stock ExchangeThe regulations Governing the admission of members of the recognised Stock Exchanges areuniform in terms of the provisions of the Securities Contracts (Regulation) Rules, 1957. Thesestatutary Rules provide that no person shall be eligible to be elected as a member, if he is lessthan 21 years of age; if not a citizen of India; or has been adjudged bankrupt or proved to beinsolvent or has compouded with his creditors; or has been convicted of an offence involvingfraud or dishonesty, or is engaged as principal or employee in any business other than that ofsecurities; or is a member of any other association in India where dealings in securities arecarried on; or is a director, partner or employee of any company whose principal business isthat of dealing in securities.Firms and companies are not eligible for membership of a recognized Stock Exchange andindividuals are ordinarily not deemed to be qualified unless they have at least 2 years’ marketexperience as an apprentice or as a partner or authorized assistant or authorized clerk or remisierof a member.Jobbers and Brokers (Members of the London Stock Exchange)

The London Stock Exchange has two types of member’s viz. jobbers and brokers. Every memberhas to declare at the beginning of each year whether he proposes to act as a jobber or abroker during the year. Once the declaration made it holds good for the entire year and itcannot be changed during the course of the year. The classification is maintained rigidly by theexchange.A Jobber is a dealer in securities. He is prohibited from dealing directly with the public. Hedeals with the brokers who are engaged by the public. Thus, the jobber buys securities fromand sells them to members who are operating on the exchange as brokers. The Broker functionsas a commission agent. He deals in securities on behalf of the investing public. He is an intermediarybetween the jobber and the outside public.The jobber occupies a very important position in the London Exchange. Every transaction mustpass through jobber. Every jobber quotes two price when he receives enquiry from a broker.The first is the prices at which he is willing to buy the security and the second at which he willsell it. For example, in response to an enquiry regarding the price of the shares of a certaincompany he may declare “I will make you Rs. 100 to Rs. 105”. This implies that be is willing tobuy the security at Rs. 100 or he will sell it at Rs. 105. The jobber is always ready to buy and sellany number of shares. He is not interested to know whether the broker wants to buy or sellsecurities. If the broker is satisfied with the quotation he discloses the nature of the transactionand strikes the bargain. The quotation by the jobber is called the double quotation or the doublebarreled quotation. The difference between the two prices quoted will be the profit for thejobber. It is also called the ‘Jobbers turn’.Tarawaniwalas and BrokersMembers of the Bombay Stock Exchange are unofficially classified as Tarawaniwalas, thosewho take away the cream of the business, and commission brokers. A commission broker isone who transacts business on behalf of members or non-members on commission basis. Hemay appoint a number of sub brokers to secure business for him A Tarawaniwals, on the otherhand, is a dealer in securities. He transacts business in his own name and on his own behalf. He

specializes in the purchase and sale of specific securities. He resembles the Jobber of LondonStock Exchange. But, he is not prohibited from acting as a broker too.Remisiers and Authorised ClerksOnly members, who are given full right and privileges of conducting business on the stockexchange, are permitted to enter the building of the stock exchange. There are also others whoare permitted for reasons of convenience, to enter the building of the exchange and act onbehalf of members. They are given limited rights and privileges. They are called the Remisiersand Authorised clerks.Remisiers : Remisiers act as sub brokers. They act as agents to the members to secure businessfor them. Since they are not members they cannot carry on the business for their own name. Aremisier is a ‘half commission man’ and gets remuneration for the work done for his principalpayment is made to him in accordance with the rules and regulations of the stock exchange.Usually, the commission does not exceed 40% of the commission received on the business.Authorised clerks : Members require the assistance of others to carry on trading activities.They cannot be present always on the floor. Hence they are permitted to employ a specifiednumber of authorized clerks or member assistants to transact dealings on their behalf. TheBombay Exchange permits 5 clerks, the Calcutta Exchange allows maximum of 8 clerks and theMadras exchange permits – up to 3 clerks to be appointed by a member. Members are heldliable for the dealings made by their respective authorized clerks or assistants. Besides salary,the authorized clerks are paid a commission up to 50% of the brokerage earned on transactionput through by them. Members have to pay entrance fee, annual subscription at prescribedrate for each of their authorized clerk. Stock exchange maintain an up-to-date register of allauthorized clerks appointed by the members.Members can remove the clerks from office by informing the concerned stock exchange.12.2.4 Listing of SecuritiesA stock exchange does not deal in the securities of all companies. Only securities which areincluded in the official trade list of the stock exchange can be bought and sold on it. Therefore,

listing of securities means, the inclusion of securities in the official list of a stock exchange. Thesecurities can be listed, only if the company furnishes details of its organization and the workingto stock exchange and fulfils the conditions laid down in the ‘rules and regulations of theexchange’ by listing the securities of a company, the stock exchange does not guarantee thefinancial soundness of the company or recommend it shares to the public. It is not the function of thestock exchange to advise the investors in the selection of securities. Objective of ListingThe objectives of listing may be as under :1. To assure constant marketing facilities.2. To ensure liquidity.3. To facilitate negotiability, and4. To regulate the dealings in securities according to the interests of the investors.Conditions for Listing : A company desiring its securities to be listed must apply in the prescribedform with the following documents and information :1. Copies of the memorandum and articles, prospectus, statement in lieu of prospectus, director’s report, balance sheet and agreement with underwriters.2. Specimen copies of shares and debentures, certificates, letter of allotment acceptance etc.3. Particulars regarding its capital structure.4. A statement showing the distribution of shares.5. Particulars of the dividends and cash bonus declared during the last 10 years.6. Particulars of shares and debentures for which permission to deal is applied for.7. A brief history of the company’s activities since its inception.While scrutinizing the application the stock exchange will examine the following carefully.1. Whether the articles of the company contain the following provisionsa) Use of common transfer form.b) Fully paid up shares must be free from company’s lien.c) Calls paid in advance may carry interest, but shall not confer a right to dividend.d) Unclaimed dividends shall not be forfeited before the claim becomes time barred.e) Option to call on shares shall be given only after sanction by the general meeting?2. Whether at least 49% of each class of securities issued was offered to the publicfor subscription through newspapers for not less than 3 days?3. Whether the company is of a fair size has a broad based capital structure andthere is a sufficient public interest in its securities?they call upon the company to execute the ‘Listing Agreement’.Classification of Listed SecuritiesListed Securities may be classified into two categories, viz,(1) Cleared Securities, and(2) Non-cleared Securities. Cleared securities are also known as securities on forwardlist and non-cleared securities as securities on cash list. It is to be noted that forward transactions are possible only in case of cleared securities.

Conditions for the Inclusion of Securities in the Cleares Securities.There are certain conditions to be fulfilled before securities are included in the cleared securitieslist. These conditions are.1. The securities must be fully paid up equity shares of a company, other than abanking company.2. They must have been admitted for dealings for at least three years on any stockexchange.3. They must not be included in the cleared securities list of any other stock exchange.4. The company must be of sufficient public importance and the subscribed capitalrepresented by the securities must be at least Rs. 25 lakhs and their value at theruling market price must at least be one crore rupees.5. There must be adequate public interest in the company and at least 40% of thecapital represented by the securities must be held by public and such holdings areto be evenly distributed among a large number of shareholders.Advantages of Listing1. Listing gives the company a higher status, contributes to expansion of activitiesand helps its growth by making future finance easier. It enables a company toenjoy the confidence of the investing public.2. Listing helps in widening the market for the securities issued.3. The listed company gets some tax advantages.4. The investors are also benefited by the listing of securities. These securities may beused for obtaining bank credit as they command higher collateral value. Theystand to gain in respect of income tax. Wealth tax, estate duty and other taxespayable by them. They can be sure that there is no fraud in the issue of shares.Listing insists on due notice in advance of closure of the transfer books’ Thus, itoffer facilities to them for transfer, registration of right fair and equitable allotment.5. Listing safeguards the interest of the general public too as it enforces timely disclosure of proper information regarding dividends, bonus shares, new issues ofcapital etc.Limitations of Listing1. Listing amount to encroachment on secrecy of the company’s operations. Listingregulations compel the company to disclose certain information like sales, remuneration to personnel besides profits, dividends etc., which may prove to be advantageous to its trade-rivals, trade unions.2. Speculation in stock exchange creates erratic oscillations in the market price ofthe listed securities. Due to such blind changes, the listed securities may be affected. This will injure the credit worthiness of the company from the point ofview of banks and other financial institutions.3. Listed securities may become a victim of depressions or wide fluctuations in theirvalues. This would degrade the company’s image in the eyes of the public and thefinancial institutions.4. The free negotiability of listed securities may induce certain group of persons toown substantial shares of a company with a view to capturing the managementof the company in their hands.5. Listed security tempt the speculators to manipulate the value in such a way asmay prove to be detrimental to the interest of the company. Even the directors

and other key functionaries in the management of the company indulge in speculations of listed securities misusing the inside information available to them.12.2.5 Methods of TradingThe way in which the securities are transacted in a stock exchange is much different fromtrading in ordinary goods. A person who wants to purchase or sell securities cannot do ithimself. He is not allowed to enter into the hall of the stock exchange and thus he can not carryon transaction personally. He has to depend upon the brokers.There are two types of trading on the stock exchange viz.1. Ready delivery contracts, and2. Forward delivery contracts.They are also called cash transaction or cash trading and forward trading or dealing for theaccount.The stock exchanges at Hyderabad, Indore and Bangalore are established for trading in readydelivery contracts only and they are called the cash markets. The other stock exchanges arepermitted to adopt both the methods of trading.Ready delivery contractors are presumed to be investment transactions and forward contractare deemed to be speculative transactions. Of course, the speculative transactions are also associatedwith ready delivery contract.There are some important points of distinction between ready delivery contracts and forwardcontracts. In the first place, ready delivery contracts are settled either on the date of the transactionor within 14 days from the date of the contract “If the transactions are to be settled on fixedsettlement days occurring at periodic intervals.Secondly the ready delivery contracts must be settled within, the specified time limit, whereasthe forward contracts can be carried forward to the next settlement day, if the buyer or theseller desires to do so’. This facility is popularly known as the Badla facility.Thirdly, ready delivery contract can be made in respect of all securities. The forward contractsare confined to those securities which are included in the forward list.Trading procedureLet us briefly discuss the various steps involved in completing a transaction through stockexchange brokers.(1) Choice of a broker : A person who wants to buy or sell security, contracts thebroker either directly or through his banker. The choice of the broker may be madeon the advice of the banker. It is desirable to deal with the broker directly because itwill ensure quick action. Before dealing with a new party a broker always insists ona formal introduction or a bank reference so that the broker may rely on the hon

esty and financial standing of the client If he is satisfied with the reference given heintimates his willingness to act on behalf of he client.(2) Placing the Order : The investor has to select the securities in which he wants toinvest his savings. This he can do in consultation with the broker. He then places anorder with the broker. The order must be clear and it should not contain ambiguousterms. There are several methods of placing an order with the brokers.Various methods of placing an order with the brokers are as follows : -(a) Fixed Price Order. In this order the client specifically mentions the price at whichspecific securities are to be bought or sold. Here the broker has no discretionexcept to buy on lower than the price fixed by the client’s order. In case of salesorder, the broker has to sell the securities at or above the price mentioned in theclient’s order. The broker has to wait until market swings around the price levelsspecified by the client.Example : Buy 10 Brooke Bond Ltd Equity at Rs. 17/-. IT means as that the shares must bepurchased if the price of the share is Rs. 17 or below.(b) Limit Price Order. A limit “price order indicates the upper or lower limit of prices.It is generally worked thus : Buy under 16 or sell over 18. The broker is expected tobuy at the lowest price and sell at the highest price.(c) Bargain Price Order. The bargain price order does not specify any price but instructs the broker to buy or sell immediately at the best price obtainable in themarket.Example : “Buy 20 DCM at best”.(d) Stop-loss Order. A stop loss order is an order which protects the client against 1heavy fall or rise in the price. It aims at reducing the amount of loss on the previous purchase or sale of securities by indicating the stopping point in the pricemovements. If the order is “Buy Hindustan Motors at Rs. 15 stop”, the brokermust wait till the price reaches this limit. As soon as it reaches Rs. 15 and beginsto rise, the broker would buy the shares at the best possible price. If a client haspurchased the share at Rs. 15 and be wants to sell it, he may instruct the broker to“Sell at Rs. 13 stop” thereby limiting his loss to Rs. 2 per share. As soon is theprice reaches Rs. 13 and shows a tendency to decline the broker will execute theorder and save the client from incurring further loss.(e) Discretionary Order. Discretionary order is one which gives the broker complete freedom to buy and sell certain inactive securities. The client place such anorder when he has full confidence in his broker.(vi) Open Order. Open order is one where the client does not prescribe any time limitfor the execution of the order. It is kept in operation so long as it is not cancelledby ‘the client’.On receipt of the order, the broker notes it down in his memorandum book. Later, it is transferredto the order book. Big brokers arrange for execution of order through authorized clerks.Small brokers execute the orders personally.

(3) Executing the Order : The authorized clerks of the brokers transact the deals atproper time as per client’s instructions. The brokers or their clerks operate on thefloor of the exchange. These dealings are first recorded in the respective roughpads. Purchases are entered on debit side and sales are recorded on the creditside with particulars of the script’s number, value and names of the parties fromwhom bought or to whom sold. These dealings are made in prescribed lot underthe rules of the stock exchange.On the basis of these records, contract notes are prepared in prescribed forms. Separate contractnotes are complied for cash and forward delivery contracts. These are exchanged betweenthe concerned parties. The broker sends the contract note to the other party and a copy of it tohis client also. It is stamped and signed by the broker and contains particulars of securities,names of parties, brokerage charged etc., is sent to the client along with the contract note.(4) Settlement of Transactions: There are two methods of settlement of transactions.In the case of ready delivery transactions payment has to be made immediatelyon the transfer of the securities or within a period of one to seven days. The settlement may be made either through the clearing house or by hand delivery between the members without the intervention of the clearing house. Usually readydelivery contracts are entered into by outsiders or genuine investors.In the case of forward delivery contracts the settlement is made on a fixed day-inthe Bombay Stock Exchange, settlement day is once in a week and in London it isfortnightly. All forward contracts are cleared through the clearing house which simplifiespayment for, and delivery of securities. If the transactions of two members ofa stock exchange are equal, they are crossed out; if however, they are not equal, thenet balance alone is paid for or received. Moreover, there is the system of carry overto the next settlement day if agreed upon by the two parties. If the buyer desires tocarry over, he has to pay a premium or consideration to the seller known as ‘contango’but if the seller desires to carry over he pays a premium to the buyer knownas ‘backwardation’.Stock Exchange Clearing HouseImportant stock exchanges maintain a clearing house. It functions on the lines of abanker’s clearing house. The clearing house facility exists in Bombay, Madras, Delhi,Calcutta and Ahmedabad. The clearing house serves as a useful link between buyersand sellers of securities. It pools together all the bargains of a member and ascertainshis net position. The member can settle all his accounts by a single transaction, example., thereceipt or payment of the net amount.

Advantages of Clearing House Settlement : Settlement through clearing house hasfollowing advantages:1. Settlement becomes prompt and easy.2. It is economical as intermediaries are eliminated.3. It amounts to saving of currency-payment because only the net dues are settled incash.4. It decreases the demand for bank credit for payments towards securities purchased.Investors and SpeculatorsPurchasers and sellers of securities on stock exchange are classified as investors and speculators.Investors are those who buy securities in order to earn a fair or fixed return. They intend tohold them more or less permanently. They are interested in the safety of their capital andconstant yield thereon in the form of dividends or interest offered by respective companies.They select sound securities to ensure safety and fair return in respect of their investments.Investors may sell their holdings if they desire liquidity of funds. Otherwise they prefer tobecome permanent shareholders or debenture holders.Speculators are those who deal in securities in order to make a profit out of their price differentials.They buy the securities with a view to sell them with a profit. They do not hold on to thesecurities bought by them but mark time to dispose of them of at higher price to earn profit.They do not usually take delivery of the securities purchased or give delivery of those sold bythem but only pay or receive the difference between buying and selling prices. The price spreadis their profit margin.It is of course difficult to find pure investor and pure speculator in practice as many as timeinvestors too would be tempted by the prospects of capital appreciation and earning quickgains and speculators may be compelled to hold on to their purchases to avoid losses.Types of SpeculatorsThere are different types of speculators dealing in a stock exchange. There are named aftersome animals, as they behave like wild animals. Their classification depends upon the natureof their activities in the stock exchange and in general, they are of four types, viz. bulls, bears,lame ducks and stags.Bull. A bull is speculator who expects a rise in the price of shares of a company. He

is an optimist. He aims at making profit out of an expected rise in the price ofa particular share. For this purpose he purchases the security for future delivery. Generally, he has no intention of taking delivery on the fixed date orsettlement day. He may sell before the settlement day He may receive or paythe difference between the purchase price and sale price either on or beforethe settlement day.Let us explain how a bull speculator makes profit out of expected rise in theprice of a security. Suppose a speculator expects that the price of equity sharesof ‘X’ company would rise. Suppose he purchases 1,000 shares of ‘X’ companyfor future delivery at the present market price of Rs. 150 and suppose the pricerises to Rs. 160 on or before the settlement day, he will sell at that price. Thus hemakes a profit of Rs. 10,000 out of the rise in the price of the security. It shouldbe noted that if his expectation goes wrong. He will incur a loss.Bear. A bear is a speculator who expects a fall in the price of a security. He is a pessimistand he forecasts a fall in price. He aim at making profit out of an expectedfall in the price of a particular share. For this purpose he sells the security forfuture delivery. He may or may not posses the security. Generally, he has nointention of giving delivery on fixed date or the settlement day. He may purchasebefore the settlement day or settle the transaction on the settlement day.He may receive or pay the difference between the purchase price and the saleprice.Let us explain how a bear speculator makes profit out of an expected fall in theprice of securities. Suppose he expects that price of equity shares of ‘Z’ companywould fall and he sells 1,000 shares of that company Rs. 150 for futuredelivery and let us further suppose that the price fall to Rs. 140 on or before thesettlement day. He will purchase at the price and he receives the difference ofRs. 10 per share. Thus he makes a profit of Rs. 10,000 out of a fall in the price ofthe security. It should be noted that if his expectation go wrong he will incur aloss.Lame Duck. In case the bear is unable to strike the bargain immediately, he is said to “bestruggling like a lame duck”. This may happen on account of the fact that thesecurity which has been agreed to be sold may not be available in the marketand in that case the commitment cannot be fulfilled. If the other party agrees topostpone the deal, there would be no trouble but if he does not agree to postponesuch a situation would arise.Stag. Sometimes the shares to be issued by new company may be unofficially quotedat a premium. This happens when the prospectus of the new company. Areexpected to be excellent. Some persons may apply for more shares than actuallyneeded. Their object is to sell the shares at a high one as soon as they are allottedby the new company and thus make quick profit. So stag is a person who appliesfor shares of a new company with a view to selling the shares allotted tohim at a profit.Stags may suffer loss. This happens when the public applies for less number ofshares than offered for. Then the stags will be allotted at the number of sharesapplied for and the shares may be quoted at a discount in the market. Undersuch circumstances stags will incur a loss, if they sell the allotted shares. Theoperations of stag create artificial scarcity of shares of the new company.

12.2.6 Stock Exchange TerminologyThe following terms usually applied in the stock exchange dealings needs further clarificationfor benefit of the students :ArbitrageThis is the business of buying securities in one stock exchange for selling them in another, totake advantage of price differential that may exist between the twoContract Note.It is the evidence about the transaction betwen buyer and his broker. The court will not acceptany petition without the valid contract note.Quotation List :The stock exchange usually publish the price of their listed securities from time to time so thatthe investors may know the real worth of their holdings. Some exchanges communicate totheir members regular reports of their activities and dealings. The quotation list is also publishedin newspapers to make it public and enlighten the investing public about the dealingpattern of various securities.Cum dividend or C.D. :Shares are said to be bought and sold cum-dividend when the buyer acquires the right toreceive the amount of dividend which has been declared but not paid by the company. Theprice paid by the buyer includes the amount of dividend and is naturally higher than the pricethat would have to be paid without that right (or dividend). For example, if the cum-dividendprice of a security is quoted at Rs. 115, the company has already quoted a dividend of 35% onthe face value of this share of Rs. 10 example. Rs. 3.50 per share. In such transaction the buyer isentitled to receive this dividend of Rs. 3.50 on each along with the possession of the security.Government Securities are always quoted and traded at cum-dividend and the rate of interestthere on is fixed. The quoted price includes the amount of net interest (example. gross interest dueless tax deducted therefrom). Thus the cum-dividend quotation indicates that the buyer has aright to receive the dividend or interest declared/due there on.Ex-dividend (or Ex-div.) :Shares are said o be bought or sold ex-dividend when the buyer acquired the shares withoutany right to receive the dividend declared (interest due in case of debentures and bonus). It isonly the seller who gets the dividend or interest there on.

Stock :Stock is a wide term, which includes all types of shares, debentures and bonds, the total priceof those has already been received by the company and which are duly traded in the stockexchange.Spot or ready delivery contracts :A ready delivery contract is one in which the parties intend to take delivery of the securitiesand pay for them. Such a contract is to be settled either on the same day or within a shortperiod of time. The Bombay and madras exchanges allow a period of 7 days for settlement. AtCalcutta exchange only 3 days are allowed for the purpose. There can be no extension of theperiod of settlement or postponement of the date of settlement. A ready delivery contract maybe settled in either of the following two ways.Stock Market in India (i) Actual Delivery : The broker receive delivery of the securities purchased and paythe price in full on behalf of the client. Similarly he may give actual delivery of thesecurities sold and receive the price on behalf of the client.(ii) Squaring up of transaction : The original transaction may be squared up by meansof a fresh purchase or sale at the time of settlement under this system. Only theprice difference is adjusted between the two members.Forward Delivery ContractsThese dealings are for account and settlement takes place at the end of every fortnight throughclearing house only and such transaction can have carry over facilities also. The speculators arethe main parties in these dealing. It is also to be noted here that business on spot deliverycontracts may be in all listed securities whether cleared or non-cleared. But all business foraccount representing forward delivery contract must be only in cleared securities cleared orsettled through clearing house only.Thus forward dealing can be made only in those securities which are placed on the forward listby an exchange. They are meant mostly for the purpose of speculation.Legally speaking all contracts including forward ones are mode with the intention of takingdelivery of securities on cash payment of their price. But in actual practice, forward business isdone not with the intention of taking delivery and making payment, but with the object ofmaking profit from buying and selling securities on the day of settlement either –(1) the delivery is taken,(2) the transaction is reversed through a neutralizing purchase or sale, or

(3) the transaction is carried over to the next settlement day.

Study Note – 13 COMMUNICATION13.1. Meaning of CommunicationCommunication is a process by which send information and feelings to recipients through oneor more channels. It is an change of ideas, facts, opinions, information and understandingbetween two or more persons. It may also be regarded as the process of meaningfully transferringinformation from one person to another. The success of a business depends to a greatextent on effective communication. It has become an essence of management. It is not only a

link function but is alternative in the entire process of management Communication is the lifebloodof modern business and industry. It is a systematic and continuous process that leads toproper running of the business.A few noteworthy definitions are enumerate below : -· “Communication is the process of passing information and understanding fromone person to another”. [Keith Davis]· “Communication is the act of making one ideas and opinions known to others”[Fred G. Meyer]· “Communication is the conveying of information from one person to another.”[Cyril L. Hudson]· “Communication is an exchange of facts, ideas, opinions, emotions,etc., be tween two or more persons.” [Newmen and Summar]· “Communication is the act of inducing others to interpret an idea in the mannerintended by the speaker or writer.”[Edwin Brown Flippo]· “Communication is a systematic and continuous process of telling, listeningand understanding”. [Louis A. Alley]· “Communication is a systematic and continuous process of telling, knowledge,etc., by speech, writing or signs.” [Oxford Dictionary]· “Communication means an interchange of thoughts, opinions and information”.[Webster’s Dictionary]Thus, communication refers to the exchange of ideas, feelings, emotions, knowledge and informationbetween two or more persons. It is an attempt to achieve an accurate understandingbetween two or more persons. It is an act characterized by a desire to exchange information. Itinvolves a systematic and continuous process of telling. Listening and understanding. Communicationis one of the most important functions of management. The success of business,depends upon the effectiveness of communication. It is said to be the nervous system of anenterprise.13.1.2.Elements in the process of communicationSender Encoding Message MediumFeedback Receiver Decoding(1) Sender (example., communicator) : The sender is a person who initiates the process ofcommunication. The sender may be a superior, a subordinate, a fellow member, acustomer or any other outside person.(2) Encoding : This refers to preparing the subject-matter of communication in a suitable language. The purpose of encoding is to translate the thought of the senderinto a language or code that can be easily understandable to the receiver of themessage.(3) Message : This refers to the encoded subject-matter of the communication whichis to be transmitted. The message may be regarded as a subject matter of commu

nication.(4) Medium (or channel) : This is a path in which the message is transmitted fromone person to another. It serves as a link between the sender and the receiver.(5) Decoding : This refers to the conversion of the message by receiver into meaningterms so as to make communication understandable. The effectiveness of communication depends on how much the receiver’s decoding matches with the sender’smessage. (6) Receiver (or communicate) : The receiver is a person who receives the message ofthe sender. For communication to be effective, it must be receiver-oriented.(7) Feedback : This refers to the actual response of the receiver to the message communicated to him. It is a reversal of the communication process, in which the r e -ceiver expresses his reactions to the sender of the message.13.1.3. Characteristics (or features) of communicationThe characteristics of communication are explained as follows:(1) Co-operative process : It is a co-operative process involving the participation of atleast two persons (one who transmits the message and the other who receives themessage and responds to it).(2) Continuous process : It is a continuous process. It is required by superiors, subordinatesand fellow-members on a continuous basis to keep operations runningsmoothly.(3) Two-way process : It is a two-way process. It involves both sending the messageand receiving the response to that message. It is not complete unless the receiverhas understood the message. Understanding is the end result of communication.(4) Flow of information : The purpose of communication is to pass on information inorder bring about commonness of interest and effort.(5) Pervasive function : It is regarded as a pervasive function because it is required atall levels of management (top, middle, lower) and in all departments (manufacturing,finance, marketing, personnel, etc.) of an organization.(6) Circular process : It becomes a circular process when the response to the message(example, feedback) requires another message to be communicated by the sender. Here,the response indicates the impact o the communication.(7) Flows in all directions : Communication flows downward from a superior to hissubordinates. It flows upward from the subordinates to a superior. It may flowhorizontally between persons occupying similar ranks in different departments. Itmay also flow diagonally between persons at different levels in different departments.Therefore, it flows in all directions.

(8) Influencing human behaviour : The primary purpose of communication is to influencehuman behavious. It is a means of motivating people by proper timing of communication.(9) Conveying a message : A communication must convey some message. A message isthe subject-matter of communication. If there is no message, there is no communication.(10) Establishing interpersonal relations : Interpersonal relations are created by a regular interaction with subordinates on several aspects of work. By sharing feelingsand exchanging information with subordinates, they are made more loyal, sincereand faithful to their superiors.13.1.4 Steps in the process of communicationThe process of communication includes the following steps :Step – 1 : To have a clear idea about facts, opinions, information, etc., on the part of thecommunicator.Step – 2 : To secure the participation of other persons involved in the decision to communicatea message.Step – 3 : To decide what to communicate, with whom to communicate, when and howto communicate.Step – 4 : To prepare the subject-matter of communication in a suitable language (example.,encoding the message).Step – 5 : To select a suitable medium for the transmission of the message (example., telephone,telegraph, television, etc.).Step – 6 : To transmit the message to the communicate (example., receiver).Step – 7 : To ensure the correct interpretation of the message by the communicate (example.,receiver).Step – 8 : To motivate the receiver to behave as desired by the sender of the message.Step – 9 : To evaluate the effectiveness of communication through response or feedback.Step – 10 : To evaluate the nature of impact of the communication.13.1.5 Importance of communication in managementManagement functions cannot be performed efficiently without an effective network of communicationin the organization. The overall functioning of the whole organization is supportedby an effective communication network. It is said to be the nervous system of an enterprise.The importance of communication in management may be explained as follows :(1) Facilitates sound planning : It facilitates planning by providing such information as is needed by the planners. Through communication, the mangers get therequired and relevant information which helps them to formulate proper plansand programmes for the company. It also helps in the proper implementation of

plans and policies of the management.(2) Provides proper information : It helps management by providing informationabout the duties, responsibilities, authority, positions and jobs. Delegation anddecentralization of authority is accomplished in an organization through effective communication. (3) Facilitates co-ordination : Co-ordination can be maintained among various related departments by making an exchange of information on a regular basis. Coordinationof various efforts becomes easy if communication is effective. It bindsthe people together and is really an aid to co-ordination.(4) Facilitates decision-making : It helps the management in arriving at vital decisions. The quality of any decision depends largely on the quality of informationavailable to the decision-maker. Effective communication helps in implementingthe decisions of the management.(5) Creates inter-personal relationships : It helps in improving relationships betweenthe superior and his subordinates by providing clear and accurate information intime. These relations can be created through an exchange of ideas, opinions, information, directives, suggestions and other instructions between them.(6) Creates mutual trust and confidence : It creates mutual trust and confidencebetween the management and the employees. It is essential for healthy industrialrelations. It is helpful in boosting the morale and motivation of employees working in the organization. Prompt redressal of employees’ grievances by top-levelmanagers motivates employees to work efficiently.(7)Facilitates directing functions : It facilitates directing functions by providingproper interaction between managers and their subordinates. It improves superior-subordinate relationships by providing opportunities to employees to expresstheir opinions and viewpoints.(8)Ensures democratic management : It is the basis of democratic management. Itensures co-operation through understanding. It facilitates effective leadership maintenance of man-to-man relationships.(9) Facilitates controlling functions : It facilitates controlling functions by providinga feedback of actual performance against planned targets. It acts as a tool foreffective control. It ensures attainment of enterprise objectives according to preconceivedand planned actions.(10) Improves public relations : Public relations are improved though proper communication. Effective communication helps the management in maintaining goodrelations with customers, suppliers, shareholders, the Government and the community at large. It helps in developing a good public image of the organization.(11) Helps to cope with the changing environment : It helps the organization to copewith a rapidly changing business environment. It also helps managers in devisingsuitable strategies for meeting future challenges.

(12)Helps in conducting global economic operations : Globalisation of business operations have increased the need and importance of communication. For a successful executive, it has become necessary to be aware of different cultures whichare prevailing in various countries. Thus, communication helps in the smoothconduct of global economic operations.(13)Increases managerial efficiency : It contributes a great deal to higher efficiencyin job performance. The efficiency of a manager depends upon his ability to communicate effectively with his subordinates. Effective communication will makethe employees feel more secure and more interested in their work. Everyone involved in an organization must know clearly his duties, responsibilities and powers.(14)Establishes team-spirit : It establishes a cordial and friendly atmosphere in theorganization. It helps members in establishing a closer link with each other. Itsatisfies employee’s organization work like a team to achieve the targets assignedto them.13.1.6 Principles of effective communicationEffective communication systems are essential and important in all forms of business. Thefollowing are the essential elements of an effective communication system :(1) Clarity of message : The subject-matter which is to be communicated, must beclear. No ambiguous (or confusing) terms should be used so that the purpose ofcommunication is deviated.(2) Unbiasness : It should be free from personal prejudices. It must take into accountthe interests of the other parties.(3) Reciprocal communication : Both the communicator and the communicate shouldparticipate in the communication. There should be a reciprocal effect (example., twowaycommunication).(4) Consistency : The communication should be consistent. The communicator shouldcommunicate the message which he believes to be true and proper. There shouldnot be any gap between what he says and what he does.(5) Correct channel : The correct channel of communication is to be chosen in orderto make communication effective. The channel to be chosen depends on the nature and purpose of communication.(6) Speed : The communication system should be capable of carrying messages speedily. However, speed of communication should not impair the accuracy of theinformation to be transmitted.(7) Accuracy : The communication system should ensure accuracy in the transmission of information.(8)Safety : The communication system should ensure safety of the contents of com

munication from loss in transit (or miscarriage)(9) Flexibility : The communication system should be amenable to change according to the needs of business. It should absorb new techniques of communicationwith little resistance.(`10) Human and physical conditions : A good communication system must take intoaccunt all the human and physical conditions to make communication effective.(11) Sense of understanding : Both the communicator and the communicate shouldhave a sense of understanding about what they intend to convey.(12) Feedback : This refers to the actual response of the receiver to the message communicated to him. Feedback is a reversal of communication. It makes communication more effective.(13) Listening carefully : Listening to verbal messages carefully implies an activeprocess. Half-hearted attention to the communication is often the cause of misunderstandings and confusion.(14) Restraint over emotions : Strong feelings and emotional stress are serioushandicaps in the communication process. It should be avoided as far as practicable.13.1.7 Objectives of communicationThe following are the objectives of communication :(1) Promotion of managerial efficiency : Communication is the lubricant fosteringthe smooth operation of the management process. It keeps people working inaccordance with the decisions of the management.(2) Co-operation through understanding : It induces human beings to put forthgenuine efforts in work performance. It inculcates the understanding of employees and leads them to greater efforts. It ensures efficiency in work in all respects.(3) Motivation to employees : It helps in moulding employees’ behaviour favourably.It encourages the employees to accept new ideas for completion of the worksystematically. It leads to better employer-employee relations.(4) Basis of leadership action : Effectiveness of leadership is greatly influenced bythe adequacy and clarity of communication. Personal communication is essential for maintaining man-to-man relationships in leadership.(5) Job satisfaction to employees : The employees get better education, trainingand knowledge about the modern methods of production due to modern communication systems. The employees are trained to increase their productive power.This enhances the mutual trust and confidence between the management andworkers. Job satisfaction of employees promotes their loyalty towards the enterprise. (6) Quick implementation of decisions : Effective communication systems help themanagement to implement decisions quickly. Moreover, such systems help themembers to adjust quickly to changing circumstances.13.1.8 Written communication

Written communication means transmission of information through written words. It mayconsist of messages in the form of letters, circulars, notes, notices, telegrams, bulletins, reports,memoranda, etc.Written communication provides a permanent record for future reference. It enables informationto be conveyed far and wide. It should be clear, concise, complete and correct in order tomake it effective.Advantages of written communication :The advantages of written communication are as follows :(1) It may be transmitted to numerous persons simultaneously.(2) It provides a permanent record for future reference.(3) It is more effective than oral communication.(4) It is an ideal way of transmitting lengthy messages.(5) It is a formal communication and it carries more weight.(6) It can be quoted as legal evidence in the case of any dispute.Disadvantages of written communication :The demerits of written communication are as follows :(1) It is an expensive and time-consuming method of communication.(2) It is very formal and lacks a personal touch of sophistication.(3) Written communication finds it difficult to maintain secrecy.(4) It may be unsuited if unknown words and unfamiliar phrases are used.(5) It encourages red-tapism and involves too many formalities.13.1.9 Verbal (oral) communication.Oral communication means transmission of information through the spoken word. It may bein the form of (a) face to face communication; (b) through electronic devices (like telephone,intercom, etc.); (c) lectures; (d) interviews; (e) public speeches, etc.It is found useful where a detailed explanation of a message is required. It is a flexible methodof communication, where the message can be changed to suit the needs of the receiver.Advantages of verbal communication :The merits of verbal (oral) communication are as follows:(1) It is an effective and a natural method of communication.(2) It is easily understandable.(3) It is less expensive and quicker as compared to written communication.(4) It removes distances and barriers between the communicator and the communicate.(5) It ensures better understanding of the message communicated.(6) It is a flexible method where messages can be changed to suit the needs of the receiver.Disadvantages of verbal communication :(1) It provides no record for future reference.(2) It has a tendency of being distorted.(3) It may create legal problems in future.

(4) It may generate communication gaps.(v) It is difficult to act on it due to missing details.Different methods of oral communicationOral communication can take place in two ways, namely,(1) Face-to-face communication; and(2) Mechanical-device based communication.Face-to-face communicationThis refers to direct speech between two persons or between small group of persons. This is themost natural form of conveying messages and needs no equipment. Here, facial expressionsand gestures can be used to reinforce the spoken words. This method of communication promotesbetter understanding and ensures co-operation. It is the most effective and easiest wayof transmission of information. It helps in prompt decision making in case of solving urgentproblems. The purpose of this communication is to communicate – (a) orders; (b) requests; (c)instructions; (d) information and observation.Face-to-face communication includes the following kinds :(1) Direct personal talk : This refers to personal talk between two individuals oramong a small group of persons. Here, the speaker can explain the matter keeping in view the reactions of the listeners. It is the most flexible form of oral communication and is suitable for confidential matters.(2) Meeting (example. Joint consultation) : This is a process whereby concerned peoplemeet together to discuss the matters of general interest so as to arrive at decisions.Meetings are conducted with previous notice to transact certain business and toarrive at various decisions.(3) Interview : It is a face-to-face conversation to see and judge the personality of aperson. It is a two-way communication in the sense that both parties make statements about their respective positions and ask questions. An interview can besuccessful only when it is held in a relaxed atmosphere.(4) Lectures : It is a face-to-face communication which is used to provide knowledgeto students, trainees etc. Hence, the teacher (or trainer) delivers a lecture to students (or trainees) on any relevant topic.13.1.10 Latest developments in communication media :Electronic mail (e-mail)This involves sending written messages through telecommunication links. The message to besent through e-mail is typed on the computer and is transmitted on the internet address (example.,website) of the receiver. It is a latest device to send written messages anywhere in the worldwith the help of internet. E-mail is the fastest method of communicating written messagesanywhere in the world at the least cost.

E-mail is the quickest means of transmitting messages. It provides the facility of sending andreceiving the messages anytime during the day and night. E-mail message can be sent to alarge number of people simultaneously, depending upon the requirement. It does not requireany stationary (such as pen, pencil, paper, stamp, etc.) to be used. The messages sent or receivedthrough e-mail can be stored for future reference. Moreover, e-mail messages are supposedto be highly confidential and secure. It is suitable for any type of message whether it is aletter, picture, design, etc. It ensures instant feedback provided both the receiver and the senderof the message are simultaneously sitting at their computer terminals.The steps involved in sending e-mail message are as follows :(1) Connect internet and start an internet browser (Outlook Express, Internet Explorer, etc.)(2) Type the e-mail address of the person to whom you want to send message.(3) Type the message in the provided ‘message box’. (4) Type sender’s name and his e-mail address.(5) Take the mouse pointer at the send button and click the mouse once.Video – conferencingThis is a system by which people staying at different places can discuss certain issues of commoninterest. This method of communication is very effective for executives, political leaders,consultants, etc. With the help of this facility, people can hold conferences and can both hearand see on another on television screen.A typical video conferencing system consists of a set-top box, high quality digital camera,coder/decoder hardware, external microphones, telephone, satellite connection and other components.These facilities enable the participants in distant locations to take part in a conferenceby means of electronic sound and video communication. It reduces time, distance and cost ofexchanging views. It improves the quality of timely decisions. When conferencing is conductedwith the help of a computer, we can call it computer conferencing. For this conferencing, werequire a computer, telephone, internet facility and web camera. This conferencing can be usedfor seminars, meetings, consultations and recruitment. In this era of globalization when multinationalcorporations are simultaneously operating in several countries, video conferencingcan prove to be a very effective means of mutual consultation. It can lead to substantial saving,both in terms of money and executive time.

Short Message Service (SMS)The mobile telephone is capable of displaying short messages on the screen SMS provides amechanism for transmitting short messages to and from mobile phones. SMS is similar to pagingwhich can be availed anytime and anywhere. It enables the transmission of messages speedilyand at much lower costs. It facilitates the delivery of messages to multiple subscribers (havingmobile phones) at a time. It facilitates communication in a wide geographical area. Anyonewho knows the mobile number of a receiver, can send short messages through his mobilephone. SMS is a globally accepted seamless message service that guarantees speedy delivery ofinformation (text as well as numerical messages). An active mobile handset is capable of receivingor submitting a short message at any time to any subscriber of mobile set. Recording ofmessages in the memory facilitates storage of information which can be retrieved as and whenrequired. It helps the receiver of message to react instantly to any business situation or otherwise.13.1.11 Measures to improve communicationEffective communication is vital for managing the people in the organization. In order to makethe communication process more effective and responsive, the barriers (or obstacles) are to behandled effectively. The following are the measures to overcome the barriers to communication:(1) Regulating the flow of communication : Effective communication should involve determining the priority of messages to be communicated. Incoming communication should be edited and condensed. Otherwise there is a possibility ofmanagers being overloaded with the tasks of communication.(2) Handling language differences : Language differences can be handled by explaining the meaning of technical (or unconventional) terms in a simple language.Vague expressions should be avoided. As far as possible, use of ambiguous wordsshould be avoided.(3) Control over emotions : Both the sender and the receiver of the message shouldhave control over their emotions. They should ensure that the content of the message is not affected by any negative impact of emotion. Emotional stress is a serious handicap in the communication process.(4) Feedback : Feedback means the response or reaction to the initial message. Itmay include receiver’s acceptance and his behavioural response. Along with eachcommunication, there is a need for feedback. It is a reversal of the communication process.(5) Importance of listening carefully : A receiver of the message should listen toverbal messages carefully so as to avoid misunderstandings and confusion. A

receiver of the message has to be patient and mentally composed while receivingthe message. A sender, on the other hand, should also be prepared to listen towhat the receiver has to say and respond to his questions, if any.(6) Clarity and completeness of message : The message should be adequate andappropriate for the purpose of communication. It is very essential to know theaudience for whom the message is meant. It may not be possible to achieve perfect communication unless the purpose of communication is clearly defined.(7) Sound organization structure : The organization structure must be sound andappropriate to make communication effective. Attempt must be made to shortenthe channel for conveying information. The channels should be straight-forwardto reduce delay and distortion in communication.(8)Mutual trust and faith : The parties involved in communication should havemutual trust and faith between themselves. They should feel free to make suggestions and correct each other’s views without there being any misunderstandings.(9) Physical layout of work place : In a modern organization, it is also found thatthe physical layout of the work place influences the communication pattern. Thelayout of an office should be designed in such a way so as to facilitate frequentinteraction.(10) Use of informal channel of communication : It helps to improve managerialdecisions and makes communication more effective. For effective communication, formal channels must be supplemented with the use of informal channels.Characteristics of a good business letterBusiness people have to communicate with their customers, suppliers, debtors, creditors, publicauthorities and the public at large for the purpose of exchanging their views and for sendingand receiving information. Written communication is called correspondence. Commercial correspondencemeans correspondence by business people on matters of commerce.Following are the characteristics of a good business letter :(1) Clarity :The language shall be clear so that the ideas are properly expressed and the readercan understand them in the correct sense.(2) Conciseness :A letter shall not be unnecessarily long. It must be concise and precise.(3) Completeness :A business letter shall be complete in every sense. The points must be arranged systematically and logically and then a complete and clear picture emerges.(4) Unambiguous :A business letter must be free from ambiguity.(5) Courtesy :A business letter must be courteous. This means that the letter should be polite in itsform.(6) Well-planned :Effectiveness of a letter depends on its good planning.The form of a business letter contains the following :

(a) Heading :Name, address, telephone number and telex are generally printed; reference numbershould be given on the left side on top and the date should be given on the right side.(b) Inside Address :The official designation of the addressee is given on the left side. Circular letters do notrequire inside address.(c) Opening Salutation or Greeting :‘Dear Sir’ in case of the singular and ‘Dear Sirs’ in case of the plural should be used. Inthe case of a circular letter, either ‘Dear Sirs’ or ‘Gentlemen’ may be the salutation. (d) Body of the Letter :This includes three parts :(1) Introduction :This is to draw the attention of the reader and it may contain a reference to a previousletter.(2) Middle portion :This contains the principal information or message to be set out in one or more paragraphs.(3) Conclusion :This contains the action to be taken by the recipient. The letter must end with ‘ThankYou’ or ‘With Thanks’ or ‘With regards’, etc.(e) Complimentary Close :Complimentary Close should be matched with the style of salutation, for example, ‘Yoursfaithfully’ or ‘Yours sincerely’ or ‘Yours truly’, etc.(f) Signature and Date :Every business letter must be signed by the authorized person and dated.

Sketch of Layout of a Letter(A The heading ) Telephone No. Name of the Sender ,Telex No. ,Address of the Sender ,Telegraphic Address ,Nature of business ,Reference No. , Date,(B The inside address) Name/Designation of AddresseeAddress of Addressee(C Opening Salutation ) Opening Salutation (Dear Sir/ Sirs, etc.)(D) Re Subject Matter :(E Main Body of letter divided into paragraph) explanation (F Complimentary Close ) Yours faithfully,Complimentary Close(For(G ) Signature of senderDesignation.

(H) Enclosure :

Kinds of Business LettersThere are many varieties of business letters depending on the subject matter or the purposefor which these are being written. Some common varieties, suitably grouped, areindicated as follows :(1) Offers, Quotations and Orders;(2) Confirmation, Refusal and Cancellation of orders;(3) Claims, Complaints and Adjustments; (4) Collection letters;(5) Agency letters;(6) Status enquiry letters;(7) Recommendation and credit letters;(8) Banking and Insurance letters;Offers, Quotations and OrdersAn offer is an invitation extended by a trader to the public or to a particular customer to placeorders for his products sold by him. The object of making an offer is to increase the sales of theproducts in the market.When an offer is being made against a particular enquiry, it is known as a quotation. An offeror quotation should contain the following particulars :(1) Description an quality of the goods;(2) Unit of measurement of weight;(3) The price per unit;(4) The terms of payment,(5) The place, mode and time of delivery. A few specimen of such letters are given below :Specimen – 1Offer to a retailer in respect of “Clean Well” – Liquid Cleansing SoapXYZ COMPANY LTD.5, Brabourne Road, Kolkata – 700 001Telephone : 37-9128Telex – A501Telegraphic Address – OFAG Dated : 19th August, 2001Code – A.X.Y.Ref. No. – BL/5409/01To Messrs Elite Stores,Darjeeling, West BengalDears Sirs,Re: ‘Clean Well’ – Liquid Cleansing SoapWe have pleasure in sending you today a sample packet of ‘Clean Well’, which hasrecently been introduced in the market. The product is the result of a number of years oftireless effort by our research staff.We forward herewith a few copies of our leaflets so that your can distribute them forthe purpose of advertisement. It will be observed from the leaflets that the various qualities

of the product are really unique. We also enclose a few copies of the price lists and you willappreciate that the prices quoted are very competitive. As per our terms, you will be allowedtwo months’ credit and a discount of 20% on the catalogue price.Thanking you.Yours faithfully,For XYZ Company Ltd.Enclosures :(1) Leaflets Prabhat Das2) Catalogue DirectorSpecimen – 2Asking for Catalogue and Trade TermsDated : 31st January,2001(As per layout sketched)Dear Sirs,We take this opportunity to introduce ourselves to you. We are one of the leading booksellers of this city, having stocks of all types of books. We have trade terms with a numberof publishing houses, both Indian and foreign, whose books we sell. We would like tostock your publications. We, therefore, request you to send us your latest catalogue andstate your trade terms. Please let us know whether it will be possible for you to give usgoods on credit, if we give satisfactory trade and bank references. It would be convenientfor us to settle the account quarterly.Expecting a favourable reply,Yours faithfully,Specimen – 3Reply to the above15th February, 2001(As per Layout sketched)Dear Sirs,We thank you for your inquiry dated 31st January,2001. We are glad to know that youare interested in our publications and desire to stock them. We are sending our latestcatalogue and price-list under separate cover.We allow a trade discount of 20 per cent on the printed prices. Our terms are cash ingeneral but we can still grant credit for one month at the maximum.We trust you will find these terms suitable and hope you will favour us with your orders.Yours faithfully,Specimen – 4Asking for quotations of cloth10h February, 2001(As per Layout sketched)

Dear Sirs,We are interested in placing orders for the supply of Khaki Drill cloth required forN.C.C. uniforms. It would be appreciated if you could kindly send at your earliest theparticulars of Khaki Drill cloth manufactured by you.As it is likely that our requirements may be quite heavy, it is hardly necessary to remindyou of the benefits likely to accrue to you by offering competitive prices.Our needs would be mainly for this particular item and we should appreciate samplesin various weights.We await an early response from you, so that we may be able to place orders with youin time and you may execute these orders expeditiously.Yours faithfully,Specimen – 5Reply to the above21st February, 2001(As per Layout sketched)Dear Sirs,We thank you for your inquiry of 10th February and have the pleasure in quoting ‘DiamondKhaki Drill’ fast colour 45 metres at Rs. 4.25 per metre.You will find that this drill is absolutely unshrinkable and extremely hardwearing. Thespecial quality it possesses is its resistant to the action of daily use.Orders will be executed promptly from stock, but of course, a reasonable period ofnotice would be required for unusually large quantities.We trust we shall have the pleasure of supplying your needs.Yours faithfully,Business CommunicationSpecimen – 6An order for the supply of Toys5th February, 2001(As per Layout sketched)Dear Sirs,We have pleasure to introduce ourselves as your old customers for toys. We gave yougood business two years ago in toys manufactured by you, having sold them for about Rs.20,000/-. For some reasons beyond our control, we could not find it possible to arrangethe sales and could not place orders with you for the supply of the same. But this year, wehave decided to come into the field again and would expect you to favour us with specialconsideration for our orders as you did earlier. Kindly book our order for the supply oftoys as per details given below:(1) Plastic toys of different kinds and sizes, Rs. 15,000(2) Paper toys of different kinds and sizes, Rs. 12,000

(3) Glass toys of different kinds and sizes, Rs. 10,000(4) Clay toys of different kinds and sizes, Rs. 5,000Total Rs. 42,000Please see that the toys are properly packed and delivered to our destination F.O.R. as before.Your firm will bear the responsibility for any damage due to breakage, etc.A prompt response is awaited.Yours faithfully,Specimen – 7A Reply to the above15th February, 2001(As per Layout sketched)Dear Sirs,With reference to your order dated February 5, 2001 for the supply of toys worth Rs.42,000/-, we are sorry to inform you that at present we are not in a position to meet yourfull requirements, as we have to comply with the outstanding orders received from manyconcerns of the neighboring States of Rajasthan, Madhya Pradesh, Haryana and the UnionTerritory of Delhi. However, we would like to recommend a well reputed manufacturingconcern “The Taj Toys” of the local market, with which you may place your order andreceive the supply in time. Had we known before hand that you would place with us sucha large order, we could have made some arrangement, rather than missing our esteemedcustomer. However, we would like to assure you that, in future, you will have no need tocomplaint to us for orders, regardless of the worth.Willing to serve you at all times,Yours faithfully,Specimen – 8Placing an order for Radios22nd March, 2001(As per Layout sketched)Dear Sirs,With reference to your quotation Number SY/74/01, dated 10th February, 2001, wehave pleasure in placing an order for the supply of :(1) One dozen, 3 Band, Retheim radio Sets, and(2) Two dozen, 2 Band Transistor sets Model no. 35 ‘Priya’.Please ensure the proper packing of the goods and arrange to dispatch them by passengertrain within a fortnight of the issue of this order, as the items of this order are urgentlyrequired.Please dispatch the goods at an early date, as these items are in heavy demand thesedays due to the World Cup Football.

Thanking you,Yours faithfully,Specimen – 9Reply to the above30th March, 2001(As per Layout sketched)Dear Sirs,We thank you for your order dated 22nd March, 2001 for the supply of one dozen rediosets and two dozen transistor sets.In view of the urgency shown by you, we have forthwith executed the order and thegoods are already on their way to you by passenger train.We thank you very much for your brisk business and particularly congratulate you onyour success in disposing of your goods to our mutual advantage.Yours faithfully,Confirmation, Refusal and Cancellation of an orderConfirmation :As soon as an order is received, it should be immediately acknowledged and confirmed.When the order is executed immediately, no confirmation is, however, necessary. Butwhere there is any possibility of delay in executing the order, the confirmatory letter mustbe issued in respect of the order.Refusal :At times, orders are to be refused on various grounds. Orders may be refused for lack ofstocks or, where the customer is financially unsound, etc. The refusal letter should bepolite and generally the reason for refusal should be stated.Cancellation :Sometimes it becomes necessary to cancel an order already placed by the party due tosome unforeseen circumstances. It may be due to undue delay in the execution of theorder, sudden fall in the market price or bankruptcy of the customer. The letter cancelin such an order should clearly state the reasons for such cancellation. A few specimen of such letters are given hereunder :Specimen –1Expressing inability to execute order25th July, 2001(As per Layout sketched)Dear Sir,We sincerely thank you for your order of the 2nd July, 2001 for some of our publications,but we regret to say that we are unable to execute your order at present, as our stock ofthese books is exhausted.

The books ordered are being reprinted and we expect them to be ready for sale by theend of this month. We are, therefore, keeping your order before us and, unless we hearfrom you to the contrary, we shall be glad to execute your order as an when the booksWe greatly regret the inconvenience caused to you. Assuring you of out best co-operationalways.Yours faithfully,Specimen – 2Asking for extension of time4th August, 2001(As per Layout sketched)Dear Sir,We thank you for your order of the 20th July, 2001 for five tones of coconut oil for deliveryby the 15th of this month.Owing to a sudden strike in our Mills during the previous month, our stocks are exhaustedand fresh supplies are expected to be ready for delivery within a fortnight. Wehope that your requirements are not so urgent as to render an immediate delivery.We may, therefore, request you to wait for a further three weeks, by which time weshall be in a position to comply with your order.If you can see your way to extend the date of delivery to 30th August, 2001 we shall beable to accept your order and ensure its execution within the time stated above.An early reply will be appreciated.Yours faithfully,

Specimen –3Cancelling order due to undue delay in execution20th August, 2001(As per Layout sketched)Dear Sir,We placed an order with you on 5th July for the supply of 500 sets of pistons and rings,which were to be delivered by the 5th August. But to our surprise we have received neitherthe goods nor any intimation from you. Sine the time of delivery has long expired,we are complelled to cancel the order under reference.This may kindly be noted.Thanking You.Yours faithfully,Specimen – 4Cancelling order due to bankruptcy of customer25th April, 2001(As per Layout sketched)Dear Sirs,We placed an order with you on the 22nd of this month for the supply of 200 dozen

handloom bedsheets with pillow covers, but we very much regret that we have to cancelthis order as our customer for whom these goods were intended has now become bankrupt.We shall, therefore, request you to make a note of this and stop dispatching the goods.However, we may assure you that we will make goods the loss of this order within a shorttime.Thanking you,Yours faithfully,Claims, Complaints and AdjustmentsClaims and Complaints:At times the buyers are not satisfied with the quality of the goods supplied. There mayalso be discrepancies in respect of the quantity, terms and conditions of payment, delivery,etc. As a result, the buyers raise different claims on the suppliers. Both the lettersraising such claims and the replies thereto, should be written tactfully, avoiding an unpleasantsituation.Adjustments :When the claims as mentioned above are substantiated, some letters of adjustment arerequired to b issued to the purchaser in order to rectify the error and settle any disputeamicably. The supplier should always try to settle the matter amicably, even at his owncost, as the customers are valuable assets of a concern.A few specimen of such letters are given below:Specimen – 1Complaints regarding delay in delivery17th September, 2001(As per Layout sketched)Dear Sirs,We regret to point out that, although you acknowledged our order dated 4th August,2001 the goods have not yet reached us. This has been causing us considerable inconvenience,and we have been put to substantial loss.The orders were placed with your on the explicit understanding and your promise thatyou could execute the orders within a fortnight. The fact that you have taken undue timeand have not yet delivered the orders, has put us at a great loss in business, for which wemay claim compensation from you.However, we have no intention of exercising this right and we propose to wait for theexecution of the order till the end of this month.Prompt action is expected from you.

Thanking you, Yours faithfully,Specimen – 2Reply to the above25th September, 2001(As per Layout sketched)Dear Sirs,We have received your letter of the 17th September,2001, complaining of the delay in thedelivery of goods for which order was placed on the 4th August, 2001. We are really verysorry that you have had to face some inconvenience on our could not be executed. However,we shall try to expedite things and every effort shall be made to deliver the suppliesin time in future. Once again we very much regret the inconvenience caused to you andassure you of the delivery of the present supply before the end of the month.We fully appreciate the indulgence you have shown to us in extending the date of deliveryand hope that you will accept our apologies for the delay and continue the samefriendly relationship which existed in the past.With thanks,Yours faithfully,Specimen – 3Complaint about receipt of wrong goods5th August, 2001(As per Layout sketched)Dear Sir,Today we have received delivery of the consignment sent by you on 25th July, 2001.On opening the parcel, we were surprised to discover that the contents of the samewere entirely different from those ordered by us vide our letter no. R25/CA dated 10th

July, 2001. A statement of the goods received is enclosed for your perusal. While comparingthem, you yourself would find that none of them were ordered by us.Please look into the matter immediately and let us have your reply by return post.Yours faithfully,

Specimen – 4Reply to the above10th August, 2001(As per Layout sketched)Dear Sirs,We thank you for your letter of 5th August, 2001, and are sorry to learn that by an oversightof our dispatch section, you have received the wrong consignment.The consignment received by you was meant for M/S. Hari Prakash & Bros., SadarBazar, Meerut, who have in turn received your consignment. We have received a letterfrom them also.We have requested M./S, Hari Prakash & Bros., Meerut, to deliver that parcel to your

per passenger train and you are also requested to dispatch their goods to them directly.Expenses incurred by you exchanging these goods will be borne by us, and you are requestedto draw a bill on us.We very much regret the inconvenience caused to you on this account.Thanking your and assuring you of our best co-operation,Yours faithfully,Specimen – 5Complaint about damaged goods15th July, 2001(As per Layout sketched)Dear Sir,We very much regret to inform you that the consignment delivered by you on 5th

July,2001, has been received in an entirely damaged condition and to our surprise not a singlepacket is in a saleable condition. Will you, therefore, look into the matter and send us afresh consignment of the goods, for which we placed an order with you. On receipt ofthese goods, we shall return this damaged consignment to you by passenger train. Thecost incurred in returning the damaged goods will be borne by you.Please replace the goods of the consignment urgently.An early reply is awaited.Yours faithfully,Specimen – 6Reply to the above20th July, 2001(As per Layout sketched)Dear Sir,Your letter dated July, 15, 2001 complaining about damaged goods has been duly received.We sorry to learn that, by some negligence on the part of our packing department,and partly due to the mishandling of goods by the railways, you have received the consignmentin a damaged condition.While we are arranging to send a fresh consignment of your order within this week, wewould suggest that you may dispose of the tea (already with you) in loose form. Wewould allow you an additional discount of 10% on this lot to cover the loss your mayincur in this regard.We regret once again the inconvenience caused to you and would like to assure youthat such mistakes will not occur in future.Thanking you,Yours faithfully,Specimen – 7Complaint of inferior quality11th March, 2001

(As per Layout sketched)Dear Sir,We thank you for your prompt delivery of distemper wall paint manufactured by you.However, we are sorry to note that the quality of this consignment does not tally withthat of the previous one supplied by you on 10th February, 2001. The paints you havesupplied this time are of rather inferior quality and are not so fast as the previous ones.We may, however, retain the goods on the condition that an allowance of 10% is madein the price, failing which goods will be kept pending till the receipt of instructions fromyou as to how best they should be disposed of.Expecting your prompt attention,Yours faithfully,Specimen – 8Reply to the above20th March, 2001(As per Layout sketched)Dear Sir,We are in receipt of your letter of 11th March, 2001, regarding supply of inferior qualitywall paints. We very much regret that the goods are not to your satisfaction. We thankyou very much for this act of kindness as we are always anxious to improve the quality ofthe goods manufactured by us. If the goods are not to your satisfaction, you are requestedto send the consignment back to us at our cost so that we may find out where the fault lies.Thanking you,Yours faithfully,Specimen – 9Complaint of shortage of goods31st January, 2001(As per Layout sketched)Dear Sir,We are in receipt of the books sent under the cover of your invoice No. 437/AX dated25th January, 2001 and thank you for the same.In this connection, we may state that books of item no. 4 were found short of the order.You have sent only 20 copies of these books instead of 30 copies as per our order.We presume that this mistake has crept in inadvertently and you may either issue us aCredit Note or send us by post the copies in short supply.Your prompt attention is requested.Thanking you,

Yours faithfully,

Specimen –10Reply to the above5th February, 2001As per Layout sketched)Dear Sir,Your letter dated January 31, 2001 has been duly received. We are sorry to note thatsome books were found short in item 4 of our Invoice No. 437/AX dated 25th January,2001. This mistake seems to have occurred due to the negligence of some newly appointedpersons of our packing section and we have taken them to task. We are sending 10 copiesof the book of this item under separate cover by registered book post in order to cover theshortage.The inconvenience so caused is very much regretted.We assure you of our best services and co-operation at all times.Thanking you,Yours faithfully,Collection LettersBusiness is carried on mostly on credit. Therefore, collection of money and issuingreminders for payment are a regular features of business.In drafting collection letters, necessary care should be taken not to wound the sentimentsof the customers. Sometimes, it may be necessary to issue several reminders for nonpayment.A few specimen of such letters are given below :Specimen – 1Fixing a date of payment1st March, 2001(As per Layout sketched)Dear Sir,We are surprised to find that you have taken no notice of our letters of 3rd and 18th

February,2001 asking for settlement of your account of Rs. 5000, which is now long overdue.As we are unable to allow the account to stand over longer, we must insist on its paymentby the 10th March at the latest, failing which we shall be compelled, much to our regret, totake further steps to have the account settled.Yours faithfully,Specimen – 2Threatening legal action15th March, 2001(As per Layout sketched)Dear Sir,

We have written to you three times for the settlement of our account, but much to ourregret, you have not only failed to settle outstanding but have taken no notice of it. Wenow inform you that, unless we have a remittance from you within the next seven days,we shall be compelled, of course against our desire, to place the matter in the hands of ourlawyers. We trust, that you will not compel us to take such an unpleasant step.Yours faithfully,Specimen – 3Asking a customer to take advantage of cash discount25th February, 2001(As per Layout sketched)Dear Sir,Kindly refer to our letter of February 3, 2001 enclosing a statement of account of Rs. 5000/- (Rupees five thousand only) outstanding against you. You are one of our esteemed customerswho invariably settle their accounts promptly and take advantage of our cashdiscount 2% for payment within seven days or net cash for one month. As your accountfor November is still unpaid, we think it our duty re remind you that you are entitled tothe discount only if your remittance reaches us by the end of this month.Yours faithfully,

Agency LettersAn agent is a person or a firm who has been appointed by someone to act for him. The personappointing an agent is known as the principal. The against are generally entitled to get a commission.When the agent is to give guarantee for bad debts, he is also entitled to get Del-credereCommission in addition to the usual commission.When writing to an agent, the principal must be careful to make the subject matter of the letterunambiguous and convincing. He should, in no case, write a letter in a dictatorial tone, becausehis business depends on the co-operation of his agent.A few specimen of such letters are given below :Specimen – 1Offering agency10th January, 2001(As per Layout sketched)Dear Sir,We are contemplating to appoint a commission agent for the sale of our products in your

State, and your name has been kindly given to us by our business friend M/s. Hariram &Sons, Chandni Chowk, Delhi.At present, we are not in production of all the woolens mentioned in our list. We havespecialized in different woolen garments like pull-overs, cardigans and socks. These productshave become very popular in Punjab, Haryana, Delhi and Uttar Pradesh. We nowseek markets in other parts of northern India as well.In case you wish to co-operate with us, will you be good enough to inform us whether, inthe event of your appointment as our agents, you will be free to act for us in that capacity?On receipt of your concurrence, we will furnish you with our terms and conditions.Thanking you,Yours faithfully,Specimen – 2Complaint of inferior quality15th January, 2001(As per Layout sketched)Dear Sir,We feel that there is an excellent market in Bihar for our milk products, and we should beglad to know whether you are prepared to represent our firm there, as our sole agent.As our preparations are in great demand in other States of northern India, we are inclinedto believe that you will find no difficulty in introducing them to your State.Your efforts will, of course, be backed by an advertisement campaign, a plan of which isenclosed, and we are prepared to consider your suggestions for any improvement in thisdirection. We will also maintain, at our cost, a showroom under your supervision andcontrol for the display of our products.We shall be willing to allow you a trade commission of 10% on net sales and undertake tore-imburse all expenses resulting from this representation. We would like to send you aformal agreement form on hearing from you.Kindly reply at your earliest.Yours faithfully,Specimen – 3Applying for agency15th January, 2001(As per Layout sketched)Dear Sir,We have been informed by our business friends M/s. Harsuk Lal & Sons, Nagpur, thatyou have no representation in Delhi. You will be pleased to note that we have an established

agency business at Delhi with a standing of 25 years, and we are prepared to offerour services to act as your local agent.We are specialized in this line and we represent several reputed firms in Kolkata andMumbai. We believe that we would succeed in introducing your products in this area.Our terms are 5% commission on net sales, and the refund of all our disbursements, shouldthere be any.For reference, you may write to Bombay Trading Corporation, Mumbai and our bankers,Indian Overseas Bank, Chandni Chowk, Delhi.Should you decide to entrust the representation of your firm to us, we would use our bestefforts to promote your business in this area.Yours faithfully,Specimen – 4Letters accepting agency7th February, 2001(As per Layout sketched)Dear Sir,Thank you very much for your letter of January 15, 2001. We have noted with keen interestthe contents contained therein.We have pleasure in informing you that we are prepared to accept your agency on theterms and conditions stated in your letter and hope that we would be able to develop asubstantial business for you here. We may point out that most of our principals bear thecost of our cables to them regarding the agency work. We hope you would also not mindto do so.You will be glad to know that we also represent a reputed and renowned firm manufacturingwoolen garments and you may kindly introduce us to an interested party, if you have contacts.Thanking you,Yours faithfully,Specimen – 5Letter informing of termination of agency5th January, 2001(As per Layout sketched)Dear Sir,It has been necessary for us to terminate the agency with M/s. Govind Shai & Sons, Kanpur,who represented us in Uttar Pradesh and we must accordingly ask you to ignore theparty entirely should they attempt to inform you that they are still acting on our behalf.

Despite our best efforts, we have not been able to find a suitable party, and we should beobliged if you would very kindly excuse us for the inconvenience incidental to the absenceof our agency in your area.We are sure that you would assist us materially by forwarding your orders directly to us,unless a visit from a representative is essential, in which case we shall be glad to makesome special arrangement.We are sorry for any inconvenience you may suffer on account of the present change.Yours faithfully,Status EnquiriesEvery businessman is to take some risk in selling his goods on credit to various types of customers.But the prudent way to minimize this risk is to verify the creditworthiness of the newcustomers before allowing them any credit.Information regarding the financial standing and reputation of credit worthiness of a newcustomer should be obtained from various sources, like business friends, credit informationagencies and mainly from banks.Status enquiries should always be made confidentially. The language asking for any informationmust be polite. The information supplied should be accurate and factual. The answer shouldindicate that the information is given in confidence and without any liability.A few specimen of such letters are given below:Specimen – 1Asking for Bank reference20th March, 2001(As per Layout sketched)Dear Sir,We are much obliged to you for your order of 12th March, 2001.As this is our first transaction with you, we would request you to furnish us with the name ofyour banker as a reference and a couple of other trade references. We invariably follow thisconvention in handling new accounts.We shall be executing your order while this routine matter is settled.We hope this to be the beginning of a long and cordial relationship between our firms.Yours faithfully,Specimen – 2Asking for names of reverences10th March, 2001(As per Layout sketched)Dear Sir,

We thank you for your order of 20th February, 2001 and it is engaging our attention.It is our invariable practice, when opening new accounts, to ask for a couple of tradereferences. As we have not had the pleasure of doing business with you previously, it willbe appreciated if you could very kindly furnish two trade references.Always ready to serve you,Yours faithfully,Specimen – 3Favourable Reply5th April, 2001(As per Layout sketched)Dear Sir,Your letter of 10th March, 2001 regarding the financial standing and general reputation ofM/s. Jamuna Lal & Sons, has been duly received. In this connection we have the pleasureto inform you that we have been in business with the aforesaid firm for over then yearsand we have not had any occasion to create any doubt regarding their financial soundness.We personally would be quite willing to allow them credit even in excess of theamount you mention.This information, however, is supplied in confidence and without any responsibility onour part.Yours faithfully,Specimen – 4Favourable reply6th April, 2001(As per Layout sketched)Dear Sir,We have your inquiry dated 30th March, 2001 and are glad to inform you that the firm inquestion enjoy a good reputation and confidence in the local market. We have been doingbusiness with this firm for about ten years and we have all along found them prompt inpayment. So far as we know, they are financially quite sound, though we cannot give youany definite idea about their financial capacity. They have been a valued customer of oursand we feel no hesitation in giving them credit for an amount beyond the sum you havementioned.Yours faithfully,Specimen – 5Unfavourable reply5th April, 2001(As per Layout sketched)Dear Sir,

In reply to your letter of 30th March, 2001, we have to inform you that the firm aboutwhich you have inquired has been undergoing a bad time lately, and more than once, wehave had to press them for payment of our bills. We would ourselves hesitate to extendthem credit to the extent you mention.We are giving this information to you in confidence and would request you to treat it assuch. However, we would like to add that our firm is not guided by any prejudices inmatters like this.Yours faithfully,Specimen – 6Letter refusing credit9th April, 2001(As per Layout sketched)Dear Sir,With reference to your letter of 23rd March, 2001, we regret to state the information receivedby us from private sources about your firm is not complete enough to permit us tomeet your wishes in the matter of credit.We trust that this position will change in the near future so as to allow us to open anaccount with you. Meanwhile, we suggest that you may order the goods on C.O.D. basis.We hope that taking into account the high quality of our goods, our low prices and ourcash discount of two per cent you will accept our suggestions.We regard the inconvenience caused to you.Yours faithfully,Recommendation and Credit LettersSometimes, letters of recommendation are issued either for the purpose of introducing an applicantfor a job or for introducing a businessman to others in the same line of business.When a person, besides introducing a certain person, requests the recipients to pay a certainamount of money to the person introduced, the letter written by him in such a case is called,Letter of Credit. Generally, banks issue different types of letters of credit to their customers tofacilitate traveling and international trade.Every letter of credit must contain the name and address of the person to whom it is to bepresented for payment. It should also contain the name, address and specimen signature of theperson in whose favour it is issued, the amount to be paid or the limit, if any, and the period ofvalidity of the Letter of Credit.Two specimen of such letters are given hereunder:Specimen – 1Regarding loss by fire15th January, 2002

(As per Layout sketched)Dear Sir,We have pleasure in introducing Mr. Mahesh Kumar, the bearer of this letter, who is ourbusiness friend. He is one of the senior partners in the firm M/s Mahesh Kumar SureshKumar, who deal in textile goods in the city. They want to make new business connectionsin Mumbai and with this end in view, they are sending Mr. Mahesh Kumar on a tourto that State.We shall be glad if you could kindly help him with the addresses of respectable firms asalso with your valuable advice in business matters.We will regard every service you render to Mr. Mahesh Kumar as a personal favour. Weshall always be ready to be of service to you in similar matters.Thanking you,Yours faithfully,Specimen – 2Acknowledging claim for damage17th January, 2002(As per Layout sketched)Dear Sir,We have pleasure in introducing to you the bearer of this letter, Sri Hari Krishan Seth, abusiness friend of our firm. He starts today on a business tour through the State of UttarPradesh to establish new business connections in brass ware.Sri Hari Kishan Seth is a pertner in the firm of M/s. Seth & Sons, Station Road, Moradabad,who are well-known for the manufacture of quality brass ware.We shall be glad if you could assist him with your kind advice regarding the standingfirms in your area.Sri Seth is well equipped with funds for the tour; still, if he stands in need of money,please help him with the necessary funds to the extent of Rs. 2,000 and draw on us a billfor the same.Please take a receipt in duplicate from Sri Seth for the money advanced to him and forwardone copy of the same along with the bill drawn on us.We shall always be willing to reciprocate any service you may render to Sri Hari KishanSeth, whose signatures are given and attested below.Thanking you,Yours faithfully,Attested Signature of Sri Hari Kishan SethBanking and Insurance LettersBanks are indispensable in modern business. The primary functions of a bank are :(a) receiving deposits from customers;

(b) making payments against deposits to customers;(c) granting loans and advances for earning interest through overdrafts, credits, loans,advances, etc.Banking letters must be of a very high standard and should be carefully worded, as customersare often touchy in money matters. Correspondence about customer’s accounts should be treatedas confidential. Banking letters should avoid ambiguity, must be courteous and respectful.There are generally three forms of insurance – Life, Fire and Marine. All letters in connectionwith Life Insurance must contain reference to Policy No. or Proposal No., name of the lifeassured, mode of payment, amount of premium, etc.Correspondence regarding Fire Insurance generally is made of a proposal for a policy, acceptanceor refusal of the proposal, rate of premium, claims and their settlement.Correspondence regarding Marine Insurance generally includes a proposal to insure, acceptanceor refusal of the proposal, quotation for premium, claims and acceptance or refusal ofclaims.A few such letters are given below:Specimen – 1Letter refusing credit15th January, 2002(As per Layout sketched)Dear Sir,We have to inform you with great regret that a fire broke out last night in our godownsituated at 23/27 Loha Mondi, Agra, Thana hariparwat. The cause of the fire could not beestablished even by the police, who have been to the site this morning. The fire was seenby the watchman in the store where paper is stocked. He immediately informed the firebrigade which arrived within minutes. I also reached the spot as soon as I received thetelephonic message from the watchman. Despite the best efforts put in by the fire brigade,nothing could be saved.We estimate the loss worth Rs. 40,000/- and request you to please send you Surveyor orInspector to assess the loss and let us know what formalities are to be completed forputting up a claim for the loss.Yours faithfully,Specimen – 2Acknowledging claim for damage

17th January, 2002(As per Layout sketched)Dear Sir,We are in receipt of your letter of 15th January, 2002 informing us of the loss due to the firewhich occurred at your godown at 23/27 Loha Mondi, Agra, on 14th January, 2001.We have instructed our surveyor, Sri A.G.Sharma, to survey the loss and we shall proceedin the matter on getting his report. In the meantime, please fill in the enclosed claimform and return it to us at your earliest convenience.Yours faithfully,Specimen – 3Enclosing cheque in settlement of claim25th January, 2002(As per Layout sketched)Dear Sir,In continuation of our Letter of 17the January, 2002 we have to inform you that we receivedthe surveyors’ report which assesses the damage at Rs. 85,000/-.We enclose our cheque No111. dated 1.1.12. on the StateBank of India, M.G.Road, Agra for Rs. 85,000/-, together with a voucher and shall thankyou to return the same to us duly signed.Yours faithfully,Specimen – 4Letters asking for Overdraft facilities3rd February, 2002(As per Layout sketched)Dear Sir,We wish to have overdraft facilities for which we are prepared to deposit with you StateGovernment Securities of the face value of Rs. 50,000/-.We shall very much appreciate your sending us the necessary forms for signature. In caseany further particulars are required, the undersigned would be glad to call on you personally.Yours faithfully,Specimen – 5Reply to the above4th February, 2002(As per Layout sketched)Dear Sir,We are in receipt of your letter dated February 3, 2002 asking for overdraft facilities. It thisconnection, we have to inform you that we shall be allowing you overdraft facilities,subject to certain restrictions, which are mentioned in the book of rules and regulations, acopy of which is being enclosed. Kindly go through the rules and act accordingly.Necessary forms and promissory notes are enclosed. Please fill in the same and sign at the

places marked with red ink. Government securities duly endorsed in our favour alongwith the forms may then be sent to us to enable us to give you necessary overdraft facilities.Yours faithfully,Specimen – 6Letter disclaiming liability25th January, 2002(As per Layout sketched)Dear Sir,We are in receipt of your letter dated 15th January, 2002 informing us of a fire which brokeout on the night of 14th January in your godown at 23/27 Loha Mondi, Agra and destroyedgoods therein.In this connection, we wish to state that the above policy was issued for six months ending31st December, 2001, and had to be renewed to cover the risk further. You were advisedof the same by our letter No. SA/24 dated 1st December, 2001, but you failed torenew the policy and the policy stood lapsed. Under the circumstances, we regret that wecannot entertain your claim for loss.Yours faithfully,

13.3 REPORT WRITINGReporting or a feed back is very essential in business, particularly because a timely action canenable the Management to avail of some opportunities or save the organization from a possibleloss. In fact, the communication process is not considered to have been completed without afeed back.A Report may be oral, visual or written, formal or informal. It could be a document in which aparticular situation is analysed or a particular problem is examined with a view to offeringinformation to the Receiver. It may include the facts, figures, findings and may also be supplementedwith recommendations.Majority of the reports are Routine Reports called Work Reports or they are investigation reports.Reports help Managers to carry out their functions better. They can plan, evaluate andtake decisions faster. Timely reporting in a scientific manner can free the supervisors advisethe subordinates regarding the desired action. The superiors can also take a note of such reports

for further reference. The information submitted in a report by technical experts can helpthe Management to correct flows in the working if any.A good Report is:Timely submitted informationA well written documentProperly organized, drawing attention to important facts and is Cost-effective.The usual classifications of reports could be:1) Function –a) informationalb) Interpretativec) Analytical2) Length – Short or long.3) Period or Time – Monthly, Bimonthly, Quarterly, Six-monthly, Annual Progressor Special.4) Importance – Routine, Important, Emergency.5) Subject – Management, Financial, Accounting, Insurance, Sales, Tax, Production,Miscellaneous.6) Ares – Internal, External.7) Presentation – Written or oral by Individual or Committee.The written report could be in a letter format or Schematic format. In case of the latter, it ispresented in a particular order with subheadings. We have newspaper reports informing usabout some events concerning business stated as a news or reports like a Stock Exchange Reportproviding us facts and figures with an analysis and observations.13.4 DIRECTORS REPORTThe report of the Directors is prepared in accordance to the provisions of Sec. 217 of the CompaniesAct. This report should contain information on the following matters :-(a) The state of the company’s affairs.(b) The amounts, if any, which is proposed to be carried to any reserves in the balancesheet.(c) The amount of dividend recommended if any.(d) Material changes and commitments affecting the financial position of the companywhich have occurred between the last date of the balance sheet and the date of thedirector’s report.(e) Certain mandatory informations relating to steps taken in respect of conservation ofenergy, technology absorption, foreign exhange earnings and outgo etc.The Board of Director’s Report also contains information relating to any change in the natureof business of the company or the business of the subsidiary companies. In addition, theDirector’s report also contains information relating to the remuneration received by employeesbeyond a prescribed amount.

The following specimens will help understanding the practices followed.An Investigation Report (in letter format)22nd April 2001The Chairman,Prosperous Steel LimitedTagore Street.Kolkata – 700 001Sir,In accordance with your letter dated 18th June 2000, instructing me to carry out an investigationinto the services provided by the canteen at our factory at Shrirampur, Iwould like to submit as follows :1. The Procedure : I visited the factory on 19th and 20th April 2001 and conductedpersonal interviews of representative staff working in our factory, at both day andnight shifts. Earlier, I had a spot checking of the kitchen and the Service Hall of the‘FACTORY CANTEEN’. I also had prepared a questionnaire (Appendix A) whichwas filled in by 87 workers availing of the canteen facility.2. Finding :(a) The services provided by the Factory Canteen are far from being satisfactory. Thekitchen was found to be most dirty with solid waste dumped in a corner.(b) The uniforms of the canteen boys appeared to have not been washed for severaldays. While serving the food, minimum health care is not being taken.(c) During the night shift, tea was not available and the canteen boys were replyingrudely. It appears that the Canteen Manager is running a hotel nearby and the surplusstale food items are brought to our Factory Canteen for disposal.(d) The crockery used is of the Third Grade and also not sufficient for catering to our250 employees.(e) The rates of the foodstuff provided, have been reused steeply upwards, withoutnotice and discussion with us.3. Recommendations(a) Considering the fact that majority of our employees depend upon our canteen andthat there is no other substitute facility for the night shift workers, the CanteenManager be asked to improve hygienic conditions at Canteen immediately.(b) If should be insisted upon the Canteen Manager that all the food served every day,should be fresh and that under no circumstances, the outside stuff be brought fordisposal in our Factory Canteen.(c) The Canteen Manager should be asked to reduce the rates of the food items immediately,by at least 20% since we have been providing him canteen subsidy. The teashould be available to the night shift employees regularly and they should not becharged more than Rs. 1.50 per cup.(d) The Canteen contract will come to an end on 15th July 2001. If there are no immediateimprovements and if clean uniforms are not provided to the Canteen Boys, thecontract should not be renewed.

(e) The Canteen Manager be called for a personal explanation at the Head Office duringthe next fortnight.Yours faithfully,John Roberts13.5 DIRECTORS’ REPORT TO THE MEMBERSYour Directors have pleasure in presenting their Thirty-sixth Annual Report and the AuditedAccounts for the year ended 31st March 2002.Financial Results : Year ended Year ended31st March’02 31st March’01Rs. in lakhs Rs. in lakhsSales 13655.24 12744.73Profit before tax 1519.81 1350.28LessProvision for taxation 814.00 413.00Profit after tax 705.81 637.28AddTaxation adjustmentsfor earlier years 2.31 23.13Profit and Loss Account surplusBrought forward ….. 325.00 770.001033.12 770.43Appropriations:General Reserves 111.24 83.80Dividend (proposed) 421.88 361.63Balance carried over 500.00 325.001033.12 770.432. Operations:The Company’s sales for the year amounted to Rs. 136.55 crores for the previous year, recordinga growth of 7.4%.During the year under review, sales of Chloramphencol products were adversely affected dueto the continued dumping of L. Base (drug intermediate for Chloramphenicol) by China atconsiderably lower prices. But for the reduction in sales of Chloramphenicol products as comparedto last year, the growth in sales would have been higher.Profit before tax amounted to Rs. 15.2 crores compared to Rs. 13.5 crores in the previous year,registering an increae of 12.6%.Profit after tax at rs. 7.06 crores has registered a growth of 10.8% over the previous year’s netprofit of Rs. 6.37 crores.3. Dividend :Your Directors recommend payment of a dividend of Rs. 3.50 per share (35%), subject to deductionof tax at source. The dividend payout would be Rs. 4.22 crores.4. Exports :

The Company’s Export (on F.O.B. basis) was Rs. 1.72 crores during the year under review ascompared to Rs. 2.07 crores in the previous year.5. Fixed Deposits :Deposits of an aggregate amount of Rs. 7.38 lakhs which had matured remained unclaimed ason 31st March, 2002.6. Directors :Mr. X.Y.Z. ceased to be a Whole-Time Director of the Company on his resignation from theBoard effective 30th June 2002. Your Directors wish to place on record their appreciation for thevaluable rendered by him during his tenure of office.In accordance with the Articles of Association of the Company, Messrs P.Q.R. and S.T.U. retireby rotation and being eligible offer themselves for reappointment.7. Employee Relations :Employee relations were satisfactory during the year. Your Directors record their appreciationof the contributions made by employees at all levels to the operations of the Company duringthe year.8. Cost Auditor :Pursuant to the provision of Section 233-B of the Companies Act, 1956, necessary applicationshave been submitted to the Department of Company Affairs for the appointment Messrs. MNC& Company as Cost Auditors to audit the cost accounts maintained by the Company in respectof bulk drugs as well as formulations for the year ending 31st March, 2003.9. Auditors :The Auditors Messrs. Honest and Loyal retire and offer themselves for reappointment.On Behalf of the BoardBombay Venugopal Shetty29th June 2002 CHAIRMAN13.6 TELEGRAPHIC MESSAGESTelegraphic communication is one of the fastest way of reaching information. This service ismanaged by the Indian Post and Telegraphs Department with a network spread all over thecountry. The telegraphs could be Ordinary or Express. The charges for Express telegraps areusually double the rate of an ordinary telegraph. A concessional rate is charged for the standardphrases telegrams. A telegraphic message is required to be brief because each word afterthe minimum words (Ten words), is charged extra, However, the message to be telegraphed

should never be economized at the cost of the meaning, otherwise there would be misunderstandingor miscommunication. Usually telegrams are sent to convey urgent information andare followed by a detailed communication.