HSSM3204: Engineering Economics & Costing

Module-I: (12 hours)

Engineering Economics Nature and scope, General concepts on micro & macro economics.
Theory of demand, Demand function, Law of demand and its exceptions, Elasticity of demand,
Law of supply and elasticity of supply. Determination of equilibrium price under perfect
competition (Simple numerical problems to be solved). Theory of production, Law of variable
proportion, Law of returns to scale.
Module-II: (12 hours)
Time value of money Simple and compound interest, Cash flow diagram, Principle of
economic equivalence. Evaluation of engineering projects Present worth method, Future worth
method, Annual worth method, internal rate of return method, Cost-benefit analysis in public
projects. Depreciation policy, Depreciation of capital assets, Causes of depreciation, Straight line
method and declining balance method.
Module-III: (12 hours)
Cost concepts, Elements of costs, Preparation of cost sheet, Segregation of costs into fixed and
variable costs. Break-even analysis - Linear approach (Simple numerical problems to be solved).
Banking: Meaning and functions of commercial banks; functions of Reserve Bank of India.
Overview of Indian Financial system.
Text Books:
1. Riggs, Bedworth and Randhwa, Engineering Economics, McGraw Hill Education India.
2. D. M. Mithani, Principles of Economics.
Reference Books:
1. Sasmita Mishra, Engineering Economics & Costing, PHI
2. Sullivan and Wicks, Engineering Economics, Pearson
3. R.Paneerselvam, Engineering Economics, PHI
4. Gupta, Managerial Economics, TMH
5. Lal and Srivastav, Cost Accounting, TM

Introduction to Engineering Economics

Economics:
Economics is the social science that studies the production, distribution, and consumption of
goods and services. The term economics comes from the Greek word oikonomia, ("management
of households) from (oikos, "house") + (nomos, Custom or "law"). Thus, it refers to managing
a household with limited funds.
All economic activities start from the existence of human wants. With the help of resources a
person fulfils his wants and gets satisfaction. Thus, economics is the study of wants, efforts and
satisfaction. In modern economy, wants, efforts and satisfaction are linked through money.
Economics is growing very rapidly as the years pass. As new ideas are being discovered and the
old theories are being revised, it is not possible to give a definition of economics which has a
general acceptance.
The set of definitions given by various economists are generally classified under four heads:
Economics as a science of wealth.
Economics as a science of material welfare.
Economics as a science of scarcity and choice.
Economics as a science of growth and efficiency.

Economics as a Science of Wealth/Classical View:

Adam Smith, the founder of economics, described Economics as a body of knowledge which
relates to wealth. Accordingly to him if a nation has larger amount of wealth, it can help in
achieving its betterment. He defined economics as The study of nature and causes of generating
wealth of a nation. He emphasized the production and expansion of wealth as the subject matter
of economics.
Criticisms:
The definitions give primary importance to wealth and secondary importance to man. The
fact is that the study of man is more important than the study of wealth.
The word wealth in the definitions means only material goods such as chair, book, pen,
etc. These do not include services of doctors, nurses, soldiers etc. In modern economics,
the word wealth includes material as well as non-material goods.
According to the definitions, man works only for his self-interest and social interest is
ignored.
The definitions ignore the importance of mans welfare. Wealth is not be all and the end
of all human activities.
The definitions lay emphasis on the earning of wealth as an end in itself. They ignore the
means which are scare for the earning of wealth.

Economics as a Science of Material Welfare/Neo-Classical View:

Alfred Marshall in his book, 'Principles of Economics' defined Economics as: Study of mankind
in the ordinary business of life. It examines that part of individual and social actions which is
closely connected with the attainment and with the use of material requisites of well being. This
definition clearly states that Economics is on the one side a study of wealth and on the other and
more important side a part of the study of man.
Robbins's Criticisms:
The word Material in the definitions considerably narrows down the scope of
economics. There are many things in the world which are not material but they are very
useful for promoting human welfare e.g., the services of doctors, lawyers, teachers,
engineers, professors, etc., satisfy our wants and are scarce in supply.
There are many activities which do not promote human welfare, but they are regarded
economic activities, e.g., the manufacturing and sale of alcohol goods or opium, etc. Here
Robbins says, Why talk of welfare at all? Why not throw away the mask altogether?
In his opinion welfare is a vague concept as it is purely subjective. Moreover, he says
what is the use of a concept which cant be quantitatively measured and on which two
persons cant agree as to what is conducive to welfare and what is not e.g., manufacturing
of guns, tanks and other war heads, production of opium, liquor etc., are not conducive to
welfare but these are all economic activities.
The definition of welfare is of theoretical nature. It is not possible in practice to divide
mans activities into material and non-material.
The word Welfare' in the definition involves value judgment and the economists
according to Robbins, are forbidden to pass any verdict.

Economics as a Science of Scarcity and Choice:

Lionel Robbins in his book Nature and Significance of Economics Science' defined Economics
as "A science which studies human behavior as a relationship between ends and scarce means
which have alternative uses".
Main Pillars of Robbins's Definition:
Human wants referred to as ends by Robbins are unlimited. They increase in quantity and
quality over a period of time. They vary among individuals and over time for the same
individual. It is not possible to find a person who will say that his wants for goods and
services have been completely satisfied. This is because of the fact that when one want is
satisfied, it is replaced by another and there is then no end to it.
The ends or wants are of varying importance. They are ranked in order of importance as:
(a) necessaries (b) comforts and (c) luxuries. Man generally satisfies his urgent wants
first and less urgent afterwards in order of their importance.
The resources (Land, labor, capital and entrepreneurship) at the disposal of man are
scarce. They are not found in as much quantity as we need them. Scarcity means that we
do not and cannot have enough income or wealth to satisfy our every desire. Scarcity

exists because human wants always exceed what can be produced with limited resources
and time that Nature makes available to man at any one time.
The scarce resources available to satisfy human wants have alternative uses. They can be
put to one use at one time e.g., if a piece of land is used for the production of sugarcane,
it cannot be utilized for the growth of another crop at the same time. Man, therefore, has
to choose the best way of utilizing the scarce resources which have alternative uses. The
scarce resources and choices are the key problems confronting every society.
Criticisms on Robbins Definition:

Robbinss definition restricts the scope of economics by treating it as a positive

Science only while in reality it is both a positive and a normative science.
It has widened the scope of economics by covering the whole of economic life, while it is
concerned with that part of human life which is connected with the market price.
Robbins made economics colorless, impersonal and abstract. It is in fact a definition of
economics for economist only.
The study of economic growth process remains outside the scope of economics while it is
through economic growth that living standards improve.

Economics as a Science of Growth and Efficiency:

If we define Economics as a science of administration of scare resources, then its scope becomes
too wide and includes the whole of economics life and not merely that part of it which is
connected with the market price.
The modern economists define economics as "A science of growth and efficiency". According to
Samuelson, "Economics is the study of how people and society end up closing, with or without
the use of money, to employ scarce productive resources that could have alternative uses, to
produce various commodities and distribute them for consumption now or in the future among
various persons and groups in society". It analyses the cost and benefits of improving patterns of
resource allocation.
Efficiency here implies technical efficiency and economic efficiency in the use of scarce
resources for producing a given level of output. The term efficiency also relates to the efficiency
of whole economics system. If one section of the society is made better off without making the
other section worse off, we can say the economic system is operating efficiently".
Thus, Economics can be defined as A social science which is concerned with the proper use and
allocation of resources for the achievement and maintenance of growth with stability and
efficiency.

Scope of Economics:
The scope of economics is the area or boundary of the study of economics. In scope of
economics we answer and analyze the following questions:
What is the subject matter of economics?

What is the nature of economics?

Subject Matter of Economics:

There is a difference of opinion among economists regarding the subject-matter of economics.
Adam Smith, the father of modern economic theory, defined economics as a subject, which is
mainly concerned with the study of nature and causes of generation of wealth of nation.
Marshall introduced the concept of welfare in the study of economics. According to Marshall;
economics is a study of mankind in the ordinary business of life. It examines that part of
individual and social actions which is closely connected with the material requisites of well
being. In this definition, Marshall has shifted the emphasis from wealth to man. He gives primary
importance to man and secondary importance to wealth.
The Robbinsians concept of the subject-matter of economics is that: economics is a science
which studies human behavior as a relationship between ends and scarce means which have
alternative uses. According to Robbins (a) human wants are unlimited (b) means at his disposal
to satisfy these wants are not only limited, (c) but have alternative uses. Man is always busy in
adjusting his limited resources for the satisfaction of unlimited ends. The problems that centre
round such activities constitute the subject-matters of economics.
Paul and Samuelson, however, includes the dynamic aspects of economics in the subject matter.
According to them, "economics is the study of how man and society choose with or without
money, to employ productive uses to produce various commodities over time and distribute them
for consumption now and in future among various people and groups of society.
Nature of Economics:
The economists are also divided regarding the nature of economics. The following questions are
generally covered in the nature of economics.
Is economics a science or an art?
Is it a positive science or a normative science?
Economics is both a science and an art. Economics is considered as a science because it is a
systematic knowledge derived from observation, study and experimentation. An art is the
practical application of knowledge for achieving definite ends. For example, there is inflation in
a country. This information is derived from positive science. The government takes certain fiscal
and monetary measures to bring down general level of prices in the country. The study of these
fiscal and monetary measures to bring down inflation makes the subject of economics as an art.
After arriving at a conclusion that economics is both a science as well as an art. Here arises
another controversy. Is economics a positive science or a normative science?
Lionel Robbins and his followers have described economics as a positive science. They opined
that economics is based on logic. Marshall, Pigou, Hawtrey, Keynes and many other economists
regard economics as a normative science. According to them, the real function of the science is

to increase the well-being of man. They have given suggestions in their works for promotion of
human welfare.
Economics, in fact, is both a positive and a normative science.

Basic Economics Problems:

Economic problem of mankind owes its origin to the fact that human wants are numerous and of
different kinds. The resources to satisfy the multifarious human wants are limited or scarce. If the
time or resources at our disposal are unlimited so that we could satisfy all our wants, then no
economic problem would have arisen at all. The economic problem has arisen simply because as
one want is satisfied, another want appears on the scene. As wants are unlimited and the means
to satisfy them limited, therefore, in order to get maximum satisfaction we have to fix up a list of
priority. So the two foundation stones on which the subject of Economics rests are:
(1) Multiplicity of human wants.
(2) Scarcity of resources.
Every economy has to solve the following four inter related problems:
What goods to produce? The first function of the society is to decide which goods are to
be produced and in how much quantity. Since the resources at the disposal of the society
are scarce, it has to make a choice between guns or bread, or a choice between
necessities and luxuries. The decision about the allocation of resources between
consumer goods and capital goods; their quality and quantity is of utmost importance
from the point of view of economic growth.
How to produce? There are various alternative methods or techniques of producing
goods. The society has to choose the least cost combination of producing the goods. For
instance, cloth can be produced with either handlooms (labor intensive technique) or
power looms (capital intensive technique). The society, depending upon its resources and
the state of technology available to it should use the most efficient method of production.
How to distribute the national income? The distribution of national income among the
members of the community is a burning issue both in the field of economics and politics.
The socialists are of the view that all the people should get fair share by redistribution of
national income. The other view is that, in a free enterprise economy, each individual
should get his share from the total output of goods according to the income available to
him through his genuine efforts.
How to ensure growth? The economic growth can be attained by (a) increasing the rate of
investment (b) replacement of capital goods and (c) by improving the technical processes
of production, A society, therefore, shall have to take timely decisions for allocating
scarce resources for investment, replacement and technological progress. In case a part of
the resources are not diverted for capital accumulation and technological progress, the
rate of growth will go down. The standard of living of the people will fall.

We, thus, conclude that economic problem arises because of scarcity of resources that people
want for the satisfaction of goods. The scarcity of resources involves the problems of choice or
allocation of resources among the competing ends. Economics, in short, is a science of efficiency
in the use of scarce resources.

Basic Economic Problems Facing India Today:

High Inflation Rates - Fueled by rising wages, property prices and food prices, inflation
in India is an increasing problem. With economic growth of 7 % 8 % per annum,
inflationary pressures are likely to increase, especially with supply side constraints such
as infrastructure.
Poor Infrastructure - Many Indians lack access to basic amenities. Indian public services
are cracking under the strain of bureaucracy and inefficiency. Over 40% of Indian fruit
rots before it reach the market thanks to the supply constraints and inefficiency facing the
Indian economy.
High Levels of Debts - Buoyed by a property boom, the amount of lending in India has
grown by 30% in the past year. However there are concerns about the risk of such loans.
If interest rates rise because of inflation, it will potentially reduce consumer spending in
future.
Inequality Has Risen - So far economic growth of India has been highly uneven
benefiting the skilled and wealthy disproportionately. Many of Indias rural poor are yet
to receive any tangible benefit from the Indias economic growth.
Large Budget Deficit - India has one of the largest budget deficits in the developing world
amounting to nearly 8% of GDP. It thus allows little scope for increasing investment in
public services like health and education.

Micro-Economics and Macro-Economics:

Economics is grouped under two broad categories Micro-economics and Macro-economics in
order to analyze and understand the economic issues and problems. Micro-economics deals with
operational/internal issues where as macro-economics handles environmental/external issues.
Microeconomics focuses on the markets supply and demand factors that determine the
economys price levels. In other words, microeconomics concentrates on the ups and downs
of the markets for services and goods, and how the price affects the growth of these markets. Its
main importance is to analyze the economic forces, consumer behavior, and methods of
determining the supply and demand of the market. On the other hand, the focus of
macroeconomics is basically on a countrys income, and the position of foreign trades, with the
study of unemployment rates, GDP and price indices. Macroeconomists are often found to make
different types of models, and relationships, between factors such as output, national income,
unemployment, consumption, savings, inflation, international trade, and investment. Overall,
macroeconomics is a vast field that concentrates on two areas, economic growth and changes in
the national income.
There are differences between microeconomics and macroeconomics. As the names imply,
microeconomics facilitates decisions of small groups of individuals such as households, firms
and industries, individual prices and incomes. Macroeconomics, on the other hand, focuses on

entire economy. These two economies are mutually dependent, and together, they develop the
strategy for the overall growth of an organization.

Engineering Economics:
Economics as a science, studies the economic aspects of human life. Engineers, today play an
important role in fulfilling the ultimate aim of economics i.e. to give maximum satisfaction with
minimum use of resources. The job of an engineer, at present is to improve wealth of the country
and proper utilization of resources thus providing maximum utility to the society.
Before 1940, engineers were mainly concerned with the design, construction, and operation of
machines and processes. Many factors like accounting, finance, micro-economics also contribute
to the expansion of engineers responsibilities. This field, today, unlike past remains highly
dynamic. Engineers, today act as planners, problem solvers, managers, and decision makers.
Engineering Economics comprise of two parts viz. Engineering and Economics. Engineering
while involves the study and practice of mathematics and natural sciences applied with a view to
economically utilize materials and forces of nature to the benefit of mankind, Economics
involves making decisions in the presence of scarce resources.
Engineering economics, thus, is the discipline that involves application of economic principles to
the engineering problems e.g. comparing costs of two alternative investment projects. The
techniques and models of engineering economics assist engineers to make crucial decisions.

Why Should An Engineer Study Economics?

The increased diversity of technologies, resources and design requires that engineers have
a firm grasp of economics. Economic forces not only provide a rational approach to the
choice among many alternatives in complex situations, but serve to stimulate inventive
process on which so much of the new technology is dependent on.
Engineers in diverse fields need to understand the technicalities of areas beyond their
expertise to effectively communicate such that synergy prevails. Through clear
communication, can only an engineering project be successfully completed.
Engineers need to manage lots of information. An engineer must have a fundamental
understanding of economics to benefit from such shared information.
While money is the medium of exchange, measure of value and means of storing wealth,
engineers should understand that all technical projects take shape with some kind of
finance. Knowledge of economic principles gives engineers means to bring ideas to form.
Studying economics helps engineers develop intellectual creativity. For the engineer who
understands economics, innovation will come more naturally.

Engineering Economics and Costing:

After deciding to invest in a project, the next imperative is to know the expected financial results.
The accounting procedures which properly use financial information achieve the objective of
cost control and other desired financial goals. From the perspective of engineering economic
analysis, cost accounting is more important in the sense, it is concerned with decision making.

Utility Analysis
Cardinal Utility Analysis:
Human wants are unlimited and they are of different intensity. The means at the disposal of a
man are not only scarce but they have alternative uses. As a result of scarcity of recourses, the
consumer cannot satisfy all his wants. He has to choose which want to satisfy first and he is
confronted in making a choice e.g., a man is thirsty. He goes to the market and satisfies his thirst
by purchasing coca cola instead of tea. The consumer buys a commodity because it gives him
satisfaction. In technical term, a consumer purchases a commodity because it has utility for him.
Utility is thus, defined as: "The power of a commodity or service to satisfy human want". e.g.,
cloth has a utility for us because we can wear it. Pen has a utility who can write with it. The
utility is subjective in nature. It differs from person to person. The utility of a bottle of wine is
zero for a person who is non drinker while it has a very high utility for a drinker. Similarly,
poison is injurious to health but it gives subjective satisfaction to a person who wishes to die.

Total Utility and Marginal Utility:

"Total utility (TU) is the total satisfaction obtained from all units of a particular commodity
consumed over a period of time". For example, a person consumes eggs and gains 50 utils of
total utility. This total utility is the sum of utilities from the successive units (30 utils from the
first egg, 15 utils from the second and 5 utils from the third egg).
"Marginal utility (MU) is the change in total utility that results from unit change in consumption
of the commodity within a given period of time". For example, when a person increases the
consumption of eggs from one egg to two eggs, the total utility increases from 30 utils to 45 utils.
The marginal utility here would be the15 utils of the 2nd egg consumed.
As a person consumes more and more units of a commodity, the marginal utility of the additional
units begins to diminish but the total utility goes on increasing at a diminishing rate. When the
marginal utility comes to zero or the point of satiety is reached, the total utility is maximum. If
consumption is increased further from this point of satiety, the marginal utility becomes negative
and total utility begins to diminish.
The relationship between total utility and marginal utility is now explained with the help of
following schedule and a graph.
Schedule:
Units of Apple Consumed/ Day Total Utility in Utils/Day Marginal Utility in Utils/Day

1
7
7
2
11
4 (11-7)
3
13
2 (13-11)
4
14
1 (14-13)
5
14
0 (14-14)
6
13
-1 (13-14)
The above table shows that when a person consumes no apple, he gets no satisfaction. His total
utility is zero. In case he consumes one apple a day, his total utility is 7 and his marginal utility is
also 7. In case he consumes second apple, he gains extra 4 utils. Thus, his total utility is 11 utils
from two apples. His marginal utility has gone down from 7 utils to 4 utils because he has a less
craving for the second apple. Same is the case with the consumption of third apple. In case the
consumer takes fifth apple, his marginal utility falls to zero utils and if he consumes sixth apple
also, marginal utility becomes negative and total utility has diminished.
Curve:

(i)
(ii)
(iii)
(iv)

TU curves starts at the origin as zero consumption of apples yield zero utility.
TU curve reaches at its maximum or a peak of M when MU is zero.
MU curve falls through the graph. A special point occurs when the consumer
consumes the fifth apple. He gains no marginal utility from it. After this point,
marginal utility becomes negative.
MU curve can be derived from the total utility curve. It is the slope of the line joining
two adjacent quantities on the curve. For example, the marginal utility of the third
apple is the slope of line joining points a and b.

Law of Diminishing Marginal Utility:

The law of diminishing marginal utility describes a familiar and fundamental tendency of human
behavior. It states that As a consumer consumes more and more units of a specific commodity,
the utility from the successive units goes on diminishing. This law is based on Three Facts:
Total wants of a man are unlimited but each single want can be satisfied. As a man gets
more and more units of a commodity, the desire of his for that good goes on falling. A
point is reached when the consumer no longer wants any more units of that good.

 Different goods are not perfect substitutes for each other in satisfying various particular
wants. As such the marginal utility will decline as the consumer gets additional units of it
The marginal utility of money is constant given the consumers wealth.
The basis of this law is a fundamental feature of wants. It states that when people go to the
market for the purchase of commodities, they do not attach equal importance to all the
commodities which they buy. In case of some of commodities, they are willing to pay more and
in some less.
There are two main reasons for this difference in demand:
The liking of the consumer for the commodity and
The quantity of the commodity which the consumer has with himself.
The more one has of a thing, the less he wants the additional units of it. In other words, the
marginal utility of a commodity diminishes as the consumer gets larger quantities of it. This is
the axiom of law of diminishing marginal utility.
This law can be explained by taking an example. Suppose, a man is very thirsty. He goes to the
market and buys one glass of water. The first glass of water has great utility for him. If he takes
second glass of water after that, the utility will be less than that of the first one. It is because the
edge of his thirst has been blunted to a great extent. If he drinks third glass of water, the utility of
the third glass will be less than that of second and so on. The utility goes on diminishing with the
consumption of every successive glass of water till it drops down to zero. This is the point of
satiety. It is the position of consumers equilibrium or maximum satisfaction. If the consumer is
forced further to take a glass of water, it leads to disutility causing total utility to decline. The
marginal utility will become negative. A rational consumer will stop taking water at the point at
which marginal utility becomes negative even if the good is free.
Schedule:
Units
Total Utility
Marginal Utility
1st glass
20
20
2nd glass
32
12
3rd glass
40
8
4th glass
42
2
5th glass
42
0
6th glass
39
-3
From the above table, it is clear that in a given span of time, the first glass of water to a thirsty
man gives 20 units of utility. When he takes second glass of water, marginal utility goes down to
12 units; When he consumes fifth glass of water, the marginal utility drops down to zero and if
the consumption of water is forced further from this point, the utility changes into disutility (-3).
Diagram:

In the figure (2.2), along OX we measure units of a commodity consumed and along OY is
shown the marginal utility derived from them. The marginal utility of the first glass of water is
called initial utility. It is equal to 20 units. The MU of the 5th glass of water is zero. It is called
satiety point. The MU of the 6th glass of water is negative (-3). The MU curve here lies below
the OX axis. The utility curve MM / falls from left down to the right showing that the marginal
utility of the successive units of glasses of water is falling.
Assumptions of the Law of Diminishing Marginal Utility:
(i)
Rationality: In the cardinal utility analysis, it is assumed that the consumer is rational.
He aims at maximization of utility subject to availability of his income.
(ii)
Constant marginal utility of money: Marginal utility of money for purchasing goods
remains constant. If the marginal utility of money changes with the increase or
decrease in income, it cant yield correct measurement of the marginal utility of good.
(iii)
Diminishing marginal utility: The utility gained from the successive units of a
commodity diminishes in a given time period.
(iv)
Consumption to be continuous: The consumption of a commodity should be
continuous. If there is interval between consumption of same units of the commodity,
the law may not hold good. E.g., if one takes one glass of water in the morning and
the 2nd at noon, the marginal utility of the 2nd glass of water may increase.
(v)
No change to fashion: If there is a sudden change in fashion or customs or taste of a
consumer, it can than make the law inoperative.
(vi)
No change in the price of the commodity: There shouldnt be any change in the price
of the commodity as more units of it are consumed.

The Law of Equi-Marginal Utility:

The law of equi-marginal utility is simply an extension of law of diminishing marginal utility to
two or more than two commodities. This law is stated in the following words: The household
maximizing the utility will so allocate the expenditure between commodities that the utility of
the last penny spent on each item is equal.
As we know, every consumer has unlimited wants. However, the income at his disposal at any
time is limited. The consumer is, therefore, faced with a choice among many commodities that

he would like to pay. He, therefore, consciously or unconsciously compresses the satisfaction
which he obtains from purchase of the commodity and the price which he pays for it. If he thinks
the utility of the commodity is greater or at least equal to the loss of utility of money, he buys
that commodity. As he buys more and more of that commodity, the utility of the successive units
begins to diminish. He stops further purchase of the commodity at a point where the marginal
utility of the commodity and its price are just equal. If he pushes the purchase further from his
point of equilibrium, then the marginal utility of the commodity will be less than that of price
and the household will be loser.
A consumer will be in equilibrium with a single commodity symbolically:
MUx = Px
A prudent consumer in order to get the maximum satisfaction from his limited means compares
not only the utility of a particular commodity and the price but also the utility of the other
commodities which he can buy with his scarce resources. If he finds that a particular expenditure
in one use is yielding less utility than that of other, he will try to transfer a unit of expenditure
from the commodity yielding less marginal utility. The consumer will reach his equilibrium
position when it will not be possible for him to increase the total utility by uses. The position of
equilibrium will be reached when the marginal utility of each good is in proportion to its price
and the ratio of the prices of all goods is equal to the ratio of their marginal utilities.
The consumer will maximize total utility from his income when the utility from the last rupee
spent on each good is the same. Algebraically, this is:
MUa / Pa = MUb / Pb = MUc / Pc = MUn = Pn
Here: (a), (b), (c). (n) are various goods consumed.
Assumptions of Law of Equi-Marginal Utility:
(i)
Independent utilities. The marginal utilities of different commodities are independent
of each other and diminish with more and more purchases.
(ii)
Constant marginal utility of money. The marginal utility of money remains constant to
the consumer as he spends more and more of it on the purchase of goods.
(iii)
Utility is cardinally measurable.
(iv)
Every consumer is rational in the purchase of goods.
The principle of equi-marginal utility can be explained by taking an example. Suppose a person
has Rs. 5 with him whom he wishes to spend on two commodities, tea and coffee. The marginal
utility derived from both these commodities is as under:

Units of Money
1
2

Schedule:
MU of Tea
10
8

MU of Coffee
12
10

3
6
8
4
4
6
5
2
3
Rs. 5
Total Utility = 30
Total Utility = 39
A rational consumer would like to get maximum satisfaction from Rs. 5. He can spend money in
three ways:
(i) Rs. 5 may be spent on tea only.
(ii) Rs. 5 may be utilized for the purchase of coffee only.
(iii) Some rupees may be spent on the purchase of tea and some on the purchase of cigarettes.
If the prudent consumer spends Rs. 5 on the purchase of tea, he gets 30 utility. If he spends Rs. 5
on the purchase of coffee, the total utility derived is 39 which is higher than tea.
In order to make the best of the limited resources, he adjusts his expenditure.
(i) By spending Rs. 4 on tea and Rs. 1 on coffee, he gets 40 utility (10+8+6+4+12 = 40).
(ii) By spending Rs. 3 on tea and Rs. 2 on coffee, he derives 46 utility (10+8+6+12+10 = 46).
(iii) By spending Rs. 2 on tea and Rs. 3 on coffee, he gets 48 utility (10+8+12+10+8 = 48).
(iv) By spending Rs. 1 on tea and Rs. 4 on coffee, he gets 46 utility (10+12+10+8+6 = 46).
The sensible consumer will spend Rs. 2 on tea and Rs. 3 on coffee and will get maximum
satisfaction. When he spends Rs. 2 on tea and Rs. 3 on coffee, the marginal utilities derived from
both these commodities is equal to 8. When the marginal utilities of the two commodities
equalize, the total utility is then maximum, i.e., 48 as is clear from the schedule given above.
Curve:

In the figure 2.3 MU is the marginal utility curve for tea and KL of coffee. When a consumer
spends OP amount (Rs. 2) on tea and OC (Rs. 3) on coffee, the marginal utility derived from the
consumption of both the items (Tea and Coffee) is equal to 8 units (EP = NC). The consumer gets
the maximum utility when he spends Rs. 2 on tea and Rs. 3 on coffee.

We now assume that the consumer spends Rs. 1 on tea (OC / amount) and Rs. 4 (OQ/) on coffee.
If CQ/ more amounts are spent on coffee, the added utility is equal to the area CQ / N/N. On the
other hand, the expenditure on tea falls from OP amount (Rs. 2) to OC / amount (Rs. 1). There is a
loss of utility equal to the area C/PEE. The loss in utility (tea) is maximum satisfaction except the
combination of expenditure of Rs. 2 on tea and Rs. 3 on coffee.
This law is known as the Law of maximum Satisfaction because a consumer tries to get the
maximum satisfaction from his limited resources by so planning his expenditure that the
marginal utility of a rupee spent in one use is the same as the marginal utility of a rupee spent on
another use.
It is known as the Law of Substitution because consumer continuously substituting one good for
another till he gets the maximum satisfaction.

Demand Analysis
Meanings and Definition of Demand:
Demand in economics means a desire to possess a good supported by willingness and ability to
pay for it. If somebody has desire to buy a certain commodity, say a car, but he/she doesnt have
the adequate means to pay for it, it will simply be a wish, a desire or a want and not demand.
"Demand means the various quantities of goods that would be purchased per time period at
different prices in a given market".
Characteristics of Demand:
Demand is the amount of a commodity for which a consumer has the willingness and also
the ability to buy.
Demand is always at a price. If we talk of demand without reference to price, it will be
meaningless. The consumer must know both the price and the commodity.
Demand is always per unit of time. The time may be a day, a week, a month, or a year.

Law of Demand:
For every rational consumer, when prices of the commodities fall, they are tempted to purchase
more commodities and when the prices rise, the quantity demanded decreases. There is, thus,
inverse relationship between the price of the commodity and quantity demanded. The economists
have named this inverse relationship between demand and price as the law of demand.
The law of demand states that "Other things remaining the same, the quantity demanded
increases with every fall in the price and decreases with every rise in the price". The functional
relationship between quantity demanded and the price of the commodity can be expressed
mathematically as:
Qx = f (Px)

Where Qx = Quantity demanded of commodity x.

Px = Price of commodity x.
Demand Schedule:
The demand schedule of an individual for a commodity is a list or table of different amounts of
the commodity that are purchased at different prices per unit of time. An individual demand
schedule for a good say shirt is presented in the table below:
Individual Demand Schedule for Shirts:
Price per shirt (Rs.)
100
80
60
x
Quantity demanded per year Q
5
7
10

40
15

20
20

10
30

According to this demand schedule, an individual buys 5 shirts at Rs.100 per shirt and 30 shirts
at Rs.10 per shirt in a year.
Demand Curve/Diagram:
Demand curve is a graphic representation of the demand schedule.

In figure (4.1), the quantity demanded of shirts is plotted on X-axis price is measured on Y-axis.
Each price-quantity combination is plotted as a point on this graph. If we join the price quantity
points a, b, c, d, e and f, we get the individual demand curve for shirts.
Assumptions of Law of Demand:
There should not be any change in the tastes of the consumers for goods
The purchasing power of the typical consumer must remain constant
The price of all other commodities should not vary
Limitations/Exceptions of Law of Demand:
Prestige goods: There are certain commodities like diamond, sports cars etc., which are
purchased as a mark of distinction in society. If the price of these goods rises, the demand
for them may increase instead of falling.
Price expectations: If people expect further rise in price of a particular commodity, they
may buy more in spite of rise in price. The violation of the law here is only temporary.
Ignorance of the consumer: If the consumer is ignorant about the rise in price of goods,
he may buy more at a higher price.

Giffen goods: If the prices of basic goods, (potatoes, sugar, etc) on which poor spend a
large part of their incomes declines, they increase demand for superior goods. Hence
when the price of giffen good falls, its demand also falls.

Market Demand for a Commodity:

The market demand for a commodity is obtained by adding up the total quantity demanded at
various prices by all the individuals over a specified period of time in the market. It is described
as the horizontal summation of the individuals demand for a commodity at various possible
prices in market.
In the schedule given below, the amount of commodity demanded by four buyers (which we
assume constitute the entire market) differs for each price. When the price of a commodity is Rs.
10, the total quantity demanded is 40 thousand units per week. At price of Rs. 2, the total
quantity demanded increases to 180 thousand units.
A market Demand Schedule in a Four Consumer Market:
Price Quantity
Quantity
Quantity
Quantity
Total Quantity
(Rs.) Demanded
Demanded
Demanded
Demanded
Demanded Per Week
(in thousands)
First Buyer Second Buyer
Third Buyer
Fourth Buyer
10
8
6
4
2

10
15
25
40
60

13
20
30
35
50

6
9
10
15
30

11
16
20
30
40

40
60
85
120
180

.
Market Demand Curve:

The market demand curve DD/ for a commodity, like the individual demand curve is negatively
sloped, (figure 4.2). It shows that, other things remaining the same, there is an inverse
relationship between the quantity demanded and its price.

At price of Rs. 10, the quantity demanded in the market is 40 thousand units. At price of Rs. 20,
it increases to 180 thousand units. In. other words, the lower the price of the good X, the greater
is the demand for it.

Movement Vs Shifts of Demand Curve:

Demand is a multivariable function. If income and other determinants of demand such as tastes
of the consumers, changes in prices of related goods, income etc., remain constant and there is a
change only in price of the commodity, then we move along the same demand curve. In this case,
the demand curve remains unchanged. When, as a result of change in price, the quantity
demanded increases or decreases, it is technically called extension and contraction in demand.
The demand curve, which represents various price-quantities, has a negative slope. Whenever
there is a change in the quantity demanded of a good due to change in its price, there is a
movement from one point price-quantity combination to another on the same demand curve.
Such a movement from one point price quantity combination to another along the same demand
curve is shown in figure (4.3).
Diagram/Figure:

Here the price of a commodity falls from Rs. 8 to Rs. 2. As a result, the quantity demanded
increases from 100 units to 400 units per unit of time. There is extension in demand by 300 units.
This movement is from one point price quantity combination (a) to another point (b) along a
given demand curve. On the other hand, if the price of a good rises from Rs. 2 to Rs. 8, there is
contraction in demand by 300 units. We, thus, see that as a result of change in the price of a
good, the consumer moves along the given demand curve. The demand curve remains the same
and does not change its position. The movement along the demand curve is designated as change
in quantity demanded.
When there is a change in demand due to one or more than one factors other than price, it results
in the shift of demand curve. For example, if the level of income in community rises, other
factors remaining the same, the demand for the goods increases. Consumers demand more goods
at each price per period of time (Increase in demand). The demand curve shifts upward from the
original demand curve indicating that consumers at each price purchase more units of
commodity per unit of time.

If there is a fall in the disposable income of the consumers or rise in the prices of close substitute
of a good or decline in consumer taste or non-availability of good on credit, etc, etc., there is a
reduction in demand (fall or decrease in demand). The fall or decrease in demand shifts the
demand curve from the original demand curve to the left. The lower demand curve shows that
consumers are able and willing to buy less of the good at each price than before.

P (Rs.)
12
6
4

Q
100
250
500

Schedule:
Rise in Qx
300
500
600

Fall in Qx
50
200
300

In figure (4.4), the original demand curve is DD /. At a price of Rs. 12 per unit, consumers
purchase 100 units. When price falls to Rs. 4 per unit, the quantity demanded increases to 500
units. Let us assume now that level of income increases in a community. Now consumers
demand 300 units of the commodity at price of Rs. 12 per unit and 600 at price of Rs. 4 per unit.
Diagram/Figure:

As a result, there is an upward shift of the demand curve DD 2. In case the community income
falls, there is then decrease in demand at price of Rs. 12 per unit. The quantity demanded of a
good falls to 50 units. It is 300 units at price of Rs. 4 unit per period of time. There is a
downward shift of the demand to the left of the original demand curve.

Determinants of Demand:
The law of demand states that, other things remaining the same, demand for a commodity varies
inversely with price per unit of time. The other things have an important bearing on the demand
for a commodity. They bring about changes in demand independently of changes in price. These
non-price factors or shift factors or determinants which influence demand are as follow:

1) Changes in population: If population of a country increases, demand for various kinds of

goods will increase even if prices remain same. The demand curve will shift upward to
the right. The nature of commodities demanded will depend on the taste of consumers. If
percentage of children to the total population increases in a country, there will be greater
demand for toys, children food, etc. Similarly, if the percentage of old people to the total
population increases, demand for walking sticks, artificial teeth, etc. will increase.
2) Changes in tastes: Demand for a commodity may change due to changes in tastes and
fashions e.g., people develop a taste for coffee. There is then a decrease in the demand for
tea. The demand curve for tea shifts to the left of the original demand curve. Similarly
women's fashions are usually ever changing. So, whenever there is a change in their hair
style (say), the demand for hairpins, hair nets, etc. is greatly affected.
3) Changes in income: Increase in the income of consumers generally leads to an increase
in demand for some commodities and a decrease in demand for other commodities. For
example, when income of people increases, they begin to spend money on those which
were previously regarded by them as luxuries, or semi-luxuries and reduce the
expenditure on inferior goods. Take the case of a man whose income has increased from
Rs. 5000 to Rs. 50,000 per month. His consumption of wheat will go down because he
now spends more money on superior food such as cake, fish, daily products, fruits, etc.
4) Changes in the distributions of wealth: If an equal distribution of wealth is brought
about in a country, then there will be less demand for expensive luxuries goods. There
will be more demand for necessaries and comfort items.
5) Changes in the price of substitutes: If the price of a particular commodity rises, people
may stop further purchase of that commodity and spend money on its substitute which is
available at a lower price. Thus we find, a change in demand can also be brought about
by a change in the price of the substitute.
6) Changes in the state of trade: The total quantity of goods demanded is also affected by
the cyclical fluctuations in economic activities. If the trade is prosperous, the demand for
raw material, machinery, etc., increases. If on the other hand, the trade is dull, demand for
producer goods will fail sharply as compared to the demand for consumer goods.
7) Climate and weather conditions: The climate and weather conditions have an important
bearing on the demand of a commodity. For instance, the consumer's demand for woolen
clothes increases in winter and decreases in summer.

Why Demand Curves Slope Downwards?

Law of diminishing marginal utility: The law of demand is based on the law of
diminishing marginal utility. According to the cardinal utility approach, when a consumer
purchases more units of a commodity, its marginal utility declines. The consumer,
therefore, will purchase more units of that commodity only if its price falls. Thus a
decrease in price brings about an increase, in demand. The demand curve, therefore, is
downward sloping.

 Income effect: Other things being equal, when the price of a commodity decreases, the
real income or the purchasing power of the household increases. The consumer is now in
a position to purchase more commodities with the same income. The demand for a
commodity thus increases not only from the existing buyers but also from the new buyers
who were earlier unable to purchase at higher price. When at a lower price, there is a
greater demand for a commodity by the households; the demand curve is bound to slope
downward from left to right.
Substitution effect: The demand curve slopes downward from left to right also because
of the substitution effect. For instance, the price of meat falls and the prices of other
substitutes say poultry remain constant. Then the households would prefer to purchase
meat because it is now relatively cheaper. The increase in demand with a fall in the price
of meat will move the demand curve downward from left to right.
The demand for any commodity at a given price is the quantity of it which will be bought per
unit of time at the price. Conceptually, the term demand implies a desire for a commodity
backed by ability and willingness to pay for it. Then, it becomes effective demand which only
figures in economic analysis and business decisions.

Elasticity of Demand
What is Price Elasticity of Demand?
The law of demand tells us when the price of a good rises, its quantity demanded will fall, all
other things held constant. The law however, does not indicate as to how much the quantity
demanded will fall with the rise in price or how much responsive the demand is to a price rise.
The economists here use the concept of elasticity of demand.
Price elasticity of demand measures the degree of responsiveness of the quantity demanded of a
good to a change in its price. It is also defined as: "Proportionate change in quantity demanded
caused by a given proportionate change in price". Symbolically price elasticity of demand is
expressed as:
Ed = (Q/Q) / (P/P)
Where Ed stands for price elasticity of demand
Q stands for original quantity
P stands for original price
stands for a small change.
The price elasticity of demand tells us the relative amount by which the quantity demanded will
change in response to a change in the price of a particular good. For example, if there is a 10%
rise in the price of a tea and it leads to reduction in its demand by 20%, the price elasticity of
demand will be:
Ed = -20 / +10 = -2.0

Degrees of Elasticity of Demand:

The variation in demand is, however, not uniform with a change in price. In case of some
products, a small change in price leads to a relatively larger change in quantity demanded. For
example, a decline of 1% in price leads to 8% increase in the quantity demanded of a
commodity. In such a case, the demand is said to be elastic. There are other products where the
quantity demanded is relatively unresponsive to price changes. A decline of 8% in price, for
example, gives rise to 1% increase in quantity demanded. Demand here is said to be inelastic.
The economists group various degrees of elasticity of demand into five categories.
(1) Perfectly Elastic Demand (Ed = ):
A demand is perfectly elastic when a small increase in the price of a good brings its quantity
demanded to zero. Perfect elasticity implies that individual producers can sell all they want at a
ruling price but cannot charge a higher price. If any producer tries to charge even one penny
more, no one would buy his product. People would prefer to buy from another producer who
sells the good at the prevailing market price.
A perfect elastic demand curve is illustrated in fig. 6.1.

The demand curve DD/ is a horizontal line which indicates that the quantity demanded is
extremely (infinitely) responsive to price. Even a slight rise in price (say Rs. 4.02), drops the
quantity demanded of a good to zero. The curve DD/ is infinitely elastic.
(2) Perfectly Inelastic Demand (Ed = 0):
When the quantity demanded of a good dose not change at all to whatever change in price, the
demand is said to be perfectly inelastic or the elasticity of demand is zero. For example, a 30%
rise or fall in price leads to no change in the quantity demanded of a good.

In figure 6.2 a rise in price from OA to OC or fall in price from OC to OA causes no change
(zero responsiveness) in the amount demanded.
(3) Unitary Elasticity of Demand (Ed = 1):

When the quantity demanded of a good change by exactly the same percentage as price, the
demand is said to have a unitary elasticity. For example, a 30% change in price leads to 30%
change quantity demanded.
In figure (6.3) DD/ demand curve with unitary elasticity shows that as the price falls from OA to
OC, the quantity demanded increases from OB to OD. On DD / demand curve, the percentage
change in price brings about an exactly equal percentage in quantity at all points a, b. The
demand curve of elasticity is, therefore, a rectangular hyperbola.
(4) Elastic Demand:
If a one percent change in price causes greater than a one percent change in quantity demanded
of a good, the demand is said to be elastic. Alternatively, we can say that the elasticity of demand
is greater than 1. For example, if price of a good change by 10% and it brings a 20% change in
demand, the price elasticity is greater than one.

In figure (6.4) DD/ curve is relatively elastic along its entire length. As the price falls from OA to
OC, the demand of the good extends from OB to ON i.e., the increase in quantity demanded is
more than proportionate to the fall in price.
(5) Inelastic Demand:
When a change in price causes a less than a proportionate change in quantity demanded, demand
is said to be inelastic. The elasticity of a good is here less than 1. For example, a 30% change in
price leads to 10% change in quantity demanded of a good, then Ed = 1/3

In figure (6.5), DD/ demand curve is relatively inelastic. As the price fall from OA to OC, the
quantity demanded of the good increases from OB to ON units. The increase in the quantity
demanded is here less than proportionate to the fall in price.

Point Elasticity Method:

"The measurement of elasticity at a point on the demand curve is called point elasticity". The
point elasticity of demand is defined as: "The proportionate change in the quantity demanded
resulting from a very small proportionate change in price".
The price elasticity of demand can also be measured at any point on the demand curve. If the
demand curve is linear (straight line), it has a unitary elasticity at the mid point. The total
revenue is maximum at this point. Any point above the midpoint has elasticity greater than 1.
Here, price reduction leads to an increase in the total revenue. Below the midpoint elasticity is
less than 1. Price reduction leads to reduction in the total revenue of the firm.
Graph/Diagram:

(1) Elasticity of demand at point D = DG/DA = 400/400 = 1 (Unity).

(2) Elasticity of demand at point E = GE/EA = 200/600 = 0.33 (<1).
(3) Elasticity of Demand at point C = GC/CA = 600/200 = 3 (>1).
(4) Elasticity of Demand at point A is infinity.
(5) At point G, the elasticity of demand is zero.

If the demand curve is non linear, then elasticity at a point can be measured by drawing a tangent
at the particular point. This is explained with the help of a figure given above. In figure 6.10, the
elasticity on DD/ demand curve is measured at point C by drawing a tangent at point C:
Ed = BM/MO = BC/CA = 400/200 = 2 (>1).
Here elasticity is greater than unity. Point C lies above the midpoint of the demand curve DD /. In
case the demand curve is a rectangular hyperbola, change in price will have no effect on the total
amount spent on the product. As such, the demand curve will have unitary elasticity at all points.

Arc Elasticity Method:

Normally the elasticity varies along the length of the demand curve. If we are to measure
elasticity between any two points on the demand curve, then the Arc Elasticity Method is used.
Arc elasticity is a measure of average elasticity between any two points on the demand curve. It
is defined as: "The average elasticity of a range of points on a demand curve". Arc elasticity is
calculated by using the following formula:
Ed
Where,

= (q/ p) X (p1 + p2) / (q1 + q2)

q denotes change in quantity.
p denotes change in price.
q1 signifies initial quantity.
q2 denotes new quantity.
P1 stands for initial price
P2 denotes new price.

Graphical presentation of measuring Elasticity using the Arc Method:

In fig. (6.11), it is shown that at a price of Rs. 10, the quantity demanded of apples is 5 Kg. per
day. When its price falls from Rs. 10 to Rs. 5, the quantity demanded increases to 12 Kg. of
apples per day. The arc elasticity of AB part of demand curve DD/ can be calculated as under:
Ed = (7/5) X (10 + 5) / (12 + 5) = 1.23
The arc elasticity is more than unity.

Types of Elasticity of Demand:

The quantity of a commodity demanded per unit of time depends on various factors such as price
of a commodity, the money income, the prices of related goods, the tastes of the people, etc.
Whenever there is a change in any of the variables stated above, it brings about a change in the
quantity of the commodity purchased over a specified period of time. The elasticity of demand
measures the responsiveness of quantity demanded to a change in any one of the above factors
by keeping other factors constant.
The three main types of elasticity of demand are now discussed in brief.
Price Elasticity of Demand:

Price elasticity of demand is defined as: "The ratio of proportionate change in the quantity
demanded of a good caused by a given proportionate change in price".
Ed = (q / p) X (P / Q)
Let us suppose that price of a good falls from Rs. 10 per unit to Rs. 9 per unit in a day. The
decline in price causes the quantity of the good demanded to increase from 125 units to 150 units
per day. The price elasticity will be:
Ed = (q / p) X (P / Q)
q = 150 - 125 = 25
p = 10 - 9 = 1
Original Quantity = 125
Original Price = 10
Ed = 25 / 1 X 10 / 125 = 2
Income Elasticity of Demand:
Income is an important variable affecting the demand for a good. When there is a change in the
level of income of a consumer, there is a change in the quantity demanded of a good, other
factors remaining the same. The degree of change or responsiveness of quantity demanded of a
good to a change in the income of a consumer is called income elasticity of demand. Income
elasticity of demand can be defined as: "The ratio of percentage change in the quantity of a good
purchased, per unit of time to a percentage change in the income of a consumer".
Ey = Percentage change in quantity demanded / Percentage change in Income
Let us assume that the income of a person is Rs. 4000 per month and he purchases six CD's per
month. Let us assume that the monthly income of the consumer increase to Rs. 6000 and the
quantity demanded of CD's per month rises to eight. The elasticity of demand for CD's will be
calculated as under:
q = 8 - 6 = 2
p = Rs. 6000 Rs. 4000 = Rs. 2000
Original quantity demanded = 6
Original income = Rs. 4000
Ey = 2 / 200 X 4000 / 6 = 0.66
Cross Elasticity of Demand:
Cross elasticity of demand is defined as: "The percentage change in the demand of one good as a
result of the percentage change in the price of another good".
Exy = % Change in Quantity Demanded of Good X / % Change in Price of Good Y

When two goods are substitute of each other, such as coke and Pepsi, an increase in the price of
one good will lead to an increase in demand for the other good. The numerical value of goods is
positive. Therefore, Coke and Pepsi are close substitutes. However, in case of complementary
goods such as car and petrol, cricket bat and ball, a rise in the price of one good say cricket bat
by 7% will bring a fall in the demand for the balls (say by 6%). The cross elasticity of demand
which are complementary to each other is, therefore, 6% / 7% = 0.85 (negative).

Factors Determining Price Elasticity of Demand:

The price elasticity of demand is not the same for all commodities. It may be high or low
depending upon number of factor. These factors which influence price elasticity of demand, in
brief, are as under:

Nature of the Commodities - In developing countries, per capital income of the people
is generally low. They spend a greater amount of their income on the purchase of
necessities of life such as wheat, milk, cloth etc. They have to purchase these
commodities whatever be their price. The demand for goods of necessities is, therefore,
less elastic or inelastic. The demand for luxury goods, on the other hand is greatly elastic
e.g., if the price of burger falls, its demand in the cities will go up.

Availability of Substitutes - If a good has greater number of close substitutes available

in the market, the demand for the good will be greatly elastic e.g., if the price of Coca
Cola rises in the market, people will switch over to the consumption of Pepsi Cola, which
is its close substitute. So the demand for Coca Cola is elastic.

Proportion of Income Spent on the Good - If proportion of income spent on the

purchase of a good is very small, the demand for such a good will be inelastic e.g., if the
price of a box of matches or salt rises by 50%, it will not affect the consumers demand
for these goods. The demand for those therefore will be inelastic. On the other hand, if
the price of a car rises from Rs. 6 lakhs to Rs. 9 lakhs and it takes a greater portion of the
income of the consumers, its demand would fall. The demand for car is, therefore, elastic.

The Period of Time The period of time plays an important role in shaping the demand
curve. In short run, when the consumption of a good cant be postponed, its demand will
be less elastic. In long run if the price rise persists, people will find out methods to reduce
the consumption of goods. So the demand for a good in long run is elastic, other things
remaining constant. For example if price of electricity goes up, it is very difficult to cut
back its consumption in short run. However, if the rise in price persists, people will plan
substituting with gas heater, fluorescent bulbs etc. so that they use less electricity. So the
elasticity of demand will be greater (Ed = > 1) in the long run than in the short run.

Number of Uses of a Good - If a good can be put to a number of uses, its demand is
greater elastic (Ed > 1) e.g., if price of coal falls, its quantity demanded will rise
considerably because demand will be coming from households, industries, railways etc.

Importance of Elasticity of Demand:

Important in taxation policy - When finance minister levies tax on certain commodities,
he has to see whether the demand for that commodity is elastic or inelastic. If the demand
is inelastic, he can increase the tax and thus can collect larger revenue. But if the demand
of a commodity is elastic, he is not in a position to increase the rate of a tax. If he does so,
the demand for that commodity will go down and hence, total revenue will reduce.
Price discrimination by monopolist - If the monopolist finds that the demand for his
commodities is inelastic, he will at once fix the price at a higher level in order to
maximize his net profit. In case of elastic demand, he will lower the price in order to
increase his sale and derive the maximum net profit.
Important to businessmen - The concept of elasticity is of great importance to
businessmen. When the demand of a good is elastic, they increases sale by towering its
price. In case the demand is inelastic, they are then in a position to charge higher price for
a commodity.
Help to trade unions - The trade unions can raise the wages of the labor in an industry
where the demand of the product is relatively inelastic. On the other hand, if the demand,
for product is relatively elastic, the trade unions cant press for higher wages.
Determination of rate of foreign exchange - The rate of foreign exchange is also
considered on the elasticity of imports and exports of a country.
Guideline to the producers - The concept of elasticity provides a guideline to the
producers for the amount to be spent on advertisement. If the demand for a commodity is
elastic, the producers shall have to spend large sums of money on advertisements for
increasing sales.
Use in factor pricing - The factors of production which have inelastic demand can obtain
a higher price in the market then those which have elastic demand. This concept explains
the reason of variation in factor pricing.

Supply Analysis
Supply is of the scarce goods. It is the amount of a commodity that sellers are able and willing to
offer fore sale at different prices per unit of time.

Law of Supply:
There is direct relationship between the price of a commodity and its quantity offered fore sale
over a specified period of time. When the price of a goods rises, other things remaining the same,
its quantity increases and as price falls, the amount available for sale decreases. This relationship

between price and quantities which suppliers are prepared to offer for sale is called law of
supply. The law of supply thus states that ceteris paribus, sellers supply more goods at a higher
price than they are willing at a lower price.
The supply function can also be expressed in symbols.
QxS = (Px, Tech, Si, X ...)
Where,Qxs = Quantity supplied of commodity x by the producers.
Px = Price of commodity x.
Tech = Technology.
S = Supplies of inputs.
X = Taxes/Subsidies.
The law of supply can be explained with the help of a schedule and a curve.
Market Supply Schedule of a Commodity (In Rupees)
Px
4
3
2
1
S
Qx
100
80
60
40
In the table above, the produce are able and willing to offer for sale 100 units of a commodity at
price of Rs. 4. As the price falls, the quantity offered for sale decreases. At price of Re. 1, the
quantity offered for sale is only 40 units.
Supply Curve/Diagram:

In figure (5.1), price is plotted on the vertical axis OY and the quantity supplied on the horizontal
axis OX. The four points d, c, b, and a show each price quantity combination. The supply curve
SS/ slopes upward from left to right indicating that less quantity is offered for sale at lower
price and more at higher prices. The supply curve is usually positively sloped.

Determinants of Supply:
Changes in Factor Price - The rise of fall in supply may take place due to changes in the
cost of production of a commodity. If prices of various factor of production increase of a
commodity, then total cost of production will rise. There will be reduction in supply of

that commodity at each price because the amount demanded decreases with rise in price.
Conversely, if the prices of the various factors of production fall down, it will result in
lowering the cost of production and so an increase in the supply.
Changes in Technique - The supply of a commodity may also be affected by progress in
technique. If an improvement in technique takes place in a particular industry, it will help
in reducing its cost of production. This will result in greater production and so an increase
in supply of commodity. The supply curve will shift to the right of original supply curve.
Improvement in the Means of Transport - The supply of commodity may also increase
due to improvement in the means of transport. If the means of transport are cheep and
fast, then supply of the commodity can be increased at a short notice at lower price.
Climatic Changes in case of Agricultural Products - The supply of agricultural products
is directly affected by the weather conditions and the use of the better methods of
production. If rain is timely, plentiful and well-distributed; and improved methods of
cultivation are employed then other things remaining the same, there will be bumper
crops. It would then be possible to increase the supply of the agriculture products.
Political Changes - The increase or decrease in supply may also take place due to
political disturbances in a country. In such situations, the channels of production are
disorganized. It results in the decrease of certain goods and the supply curve shifts to the
left of originals curve.
Taxation Policy - If a government levies heavy taxes on the import of particular
commodities, then the supply of these commodities is reduced at each price. The supply
curve shifts to the left. Conversely if the taxes on output in the country are low and
government encourages the import of foreign commodities, then the supply can be
increased easily. The supply curve shifts to the right of originals supply curve.

Difference between Shift and Movement in Supply Curve:

As price rises, the quantity supplied increases and as price falls the quantity supplied increases
provided other things remain the same. This change in the quantity supplied of a commodity is a
movement of one price quantity combination to another on the same supply curve. Such a
movement at varying prices is now illustrated with the help of supply curve given in figure 5.2.
In the figure (5.2) given below, at price "aT" (Rs. 3), 50 units of quantity is supplied. When price
rises to dL (Rs. 7), the quantity supplied by the producers increases to 110. The change in
quantity supplied at varying prices is referred to as movement along the same supply curve.
Diagram/Figure:

If due to one or a combination of non-price factors, less quantity is brought into the market for
sale at each price, the supply is said to have fallen. In case of fall in supply, the supply curve
shifts to the left of the original supply curve. The rise and fall of supply curve (shifts in supply
curve) is explained with the help of an imaginary schedule and a diagram.
Price per shirt(Rupees)

Schedule of Supply Curve:

Original quantity supplied per Week Rise in supply

Fall in supply

50

200

320

140

40
30

160
100

200
150

100
70

20

39

100

15

Figure of Shifts in Supply Curve:

In figures (5.3), SS/ is the original supply curve. S2S2 to the right of the original supply curve
shows an increase in the quantity supplied at each price. S3S3 supply curve to the left of original
supply curve indicates a decrease in supply at each price over a specified period of time.

Equilibrium of Demand and Supply

In economic sense, market is a system in which buyers and sellers bargain for price of a product,
settle the price and transact their business. The determination of price of a commodity depends
on the number of sellers and a number of buyers. The number of sellers in a market determines
the nature and degree of competition i.e. structure of the market.
The market structure is broadly classified into the following four types:
Perfect competition Large number of sellers selling a homogenous product.
Monopoly Single seller of a product without a close substitute.
Oligopoly Small number of big sellers selling the same product
Monopolistic competition Fairly large number of sellers selling differentiated products.

Characteristics of perfect competition

Large number of sellers and buyers The number of sellers and buyers is so large that
share of each seller in total supply and share of each buyer in total demand is negligibly
small and hence the market price determined by the forces is acceptable to both.
Homogeneity of products Products supplied by various firms are so identical in
appearance and use that buyers hardly can distinguish between them. No firm can gain
competitive advantage over other firms nor do the firms distinguish between the buyers.
Perfect mobility of factors of production For a market to be perfectly competitive,
there should be perfect mobility of resources that is factors of production must move
freely into or out of an industry and from one firm to another.
Free entry and free exit of firms There is no restriction, legal or otherwise on the
firms entry into or exit from the industry.
Perfect knowledge There is perfect dissemination of information about the market
conditions and both buyers and sellers are fully aware of the nature of product, its
availability and the price prevailing in the market.
Absence of collusion or artificial restraint There is no collusion between sellers like
sellers unions nor is there any kind of collusion between buyers like consumer forum.
Sellers and buyers act independently and firms enjoy freedom of independent decisions.

Price Determination under Perfect Competition:

Demand for a commodity is "The total quantity of that commodity which buyers will take at
different prices per unit of time" while supply of a commodity refers to "That quantity of the
commodity which sellers are willing to offer for sale at different prices per unit of time".
Under perfect competition, there is a single ruling market price the equilibrium price
determined by the interaction of forces of total demand (of all the buyers) and total supply (of all
the sellers) in the market. Thus, both the market or equilibrium price and the volume of
production in a market under perfect competition are determined by the intersection of total
demand and total supply.

In the market, there are large number of buyers and sellers. It is the desire of every buyer in the
market to purchase a commodity at the lowest possible price while the sellers wish to sell it at the
highest possible price. When buyers compete among themselves for the purchase of particular
commodity, the price of that commodity goes up and when there is competition amongst the
sellers, the price comes down. The price of a commodity tends to settle at a point where the
quantity demanded is exactly equal to the quantity supplied. The price at which the buyers and
sellers are willing to buy and sell an equal amount of commodity is called the, equilibrium price.
Lets illustrate the above proposition with the help of a schedule and a curve.

Quantity Supplied (Cooking Oil Kg)

Per Week
800
600
500
450
350
100

Schedule:
Price (Rupees)
19
18
17
16
15
14

Quantity Demanded
(Cooking Oil Kg) Per Week
100
250
400
450
500
700

When the price of cooking oil is Rs. 16 per Kg, the total quantity demanded in a week is exactly
equal to the total quantity supplied. So Rs. 16 is the equilibrium price for the period and the
equilibrium amount, i.e. the quantity demanded and offered for sale is 450 Kgs. of cooking oil is:
Qd = Qs
If the conditions assumed above remain the same, then there can be no equilibrium price other
than Rs. 16 e.g., if the price of cooking oil happens to rise to Rs. 18 per Kg. At this price, the
sellers are anxious to sell 600 Kgs. of ghee but the buyers are willing to buy only 250 Kgs. The
sellers will compete with one another to dispose off this surplus stock. The competition among
the sellers will result in lowering the price. When the price comes down to Rs. 16 (i.e. the
equilibrium price), then the whole of the stock will be sold. Conversely, if the price happens to
fall to Rs. 14 per kilogram, the buyers would like to buy 700 Kgs. of cooking oil, but the sellers
are willing to sell only 100 Kgs. The buyers, in order to buy more cooking oil at a lower price
will compete among themselves. This competition among the buyers will increase the price of
ghee. Finally, the price will be reestablished at the equilibrium price which is Rs. 16.
In the figure (8.1) DD/ is the demand curve which, represents the different amount of .the
commodity that are purchased in the market at different prices, SS / is the supply curve which
indicates the amount of the commodity that is offered for sale at different prices per unit of time.
MN is the equilibrium price i.e., Rs. 16 and ON 450 kg. is the equilibrium amounts. If the price
is below the equilibrium price (Rs. 16), there is upward pressure on price due to the resulting
shortage of good. In case, the price is above the equilibrium, there is a downward pressure on
price caused by the resulting surplus of good. If is only at price MN, the buyers take of the
market exactly what sellers place on the market.

Diagram/Figure:

Alfred Marshall was the first economist who pointed out that the pricing problem should be
studied from the view point of time. He distinguished three fundamental time periods in the
determination of price:
(1) Market period price.
(2) Short run normal price.
(3) Long run normal price.

Market Period Price:

The market period is very short period during which it is practically impossible to alter output or
increase stock. Thus, supply of a commodity tends to be perfectly inelastic. The market period
price is determined by interaction of market period demand and supply as shown in fig. 15.13.
Schedule:
Price (in Rs.) Per Kg. Amount Supplied Per Day
50
50
40
50
30
50
20
50
10
50

Quantity in Kg. Demanded Per Day

1
10
15
23
50

As in a perfect market, there can be only one price for a particular commodity, so the buyers who
are willing to buy at higher price, enjoy consumer's surplus. In the graph (15.13), quantity is
measured along OX axis and price along OY axis. As the supply of a commodity is fixed and
cannot be held back, hence, the market period supply curve, SS will be a vertical straight line.
The market demand curve DD' intersects the market supply curve at point M. MS (Rs. 10) is the
market price at which the total quantity of the commodity is sold in the market. If demand for the
commodity rises, the new demand curve D1D1 intersects the market supply curve at point LLS
which is equal to Rs. 50 will be new market price. If the demand falls, the new demand curve
D2D2 cuts the supply curve at point R, Rs. 30 which is the new equilibrium price.

Short Period Price:

In the short run, the size of a firm and the number of firms comprising an industry remain the
same. The time is considered to be so short that if demand for product increases, the old firm can
use their existing equipments more intensively and increase the supply to a limited extent, but
new firms cannot enter into the industry. As such the supply curves will tend to be relatively
inelastic. The short run normal price is established at a point where the short period supply curve
and the demand curve intersect each other.
The short run supply curve of the industry is the lateral summation of the short period marginal
cost curves of all the firms. The market demand curve is a falling curve. The determination of
price and output in the short run can be explained with the help of the above diagrams.

In fig. 15.15(a), the short run supply curve (SRSC) of the industry intersects the market demand
curve at point E. The price will be OL and the quantity supplied OT. Suppose the demand for the
commodity has gone up. The new demand curve D1D1 intersects the market supply curve (MSC)
at point F. The price rises from OL to OR without affecting the output which remains OT as
before. The entrepreneur lured by higher prices will use the fixed capital equipment more
intensively. The old machines will also be repaired and the production expanded. The new
demand curve then intersects the short period supply curve SRSC at point Q.
In fig 15.15(b), ON will be the short run normal price which is higher than the original market
price OL but lower than the raised market price OR. ON thus is the short run normal price of an
industry. This price cannot be changed by the action of an individual firm as it produces an
insignificant portion of the total supply of the output. It will have to adjust its product
accordingly. At price ON, the firm is earning abnormal profits because the price is higher than
the normal price OL.
If the market demand falls, the new demand curve D2D2 intersects the market period supply
curve at point G. OZ then is the new equilibrium market price which is lower than the original
OL market price. The fall in the market price will affect the supply of the commodity. The firms
will reduce their output by decreasing the variable factors.

Long Period Price:

Long run is the period in which the factors of production can be adjusted to changes in demand.
Thus, in long-run, the supply curve of an industry tends to become relatively elastic. In long run,
the price will be determined at a point where demand curve and the long run supply curve
intersect each other.

In fig. 15.16, market supply curve (MSC), short period supply curve (SPC), long period supply
curve (LPSC), pass through the point P. The market price, short period price and the long run
normal price thus is equal to ON.
Let us suppose that there is an increase in the market demand. The new demand curve D 1D1
intersects the market supply cure, short period supply curve, and long period supply curve at
points Z, R, A, respectively. The new market price will be equal to OD, the short period price
equal to OC and long period price equal to OE. The market price OD is higher than short period
normal price and long run normal price. The short period normal price OC is lower than the
market price but higher than long run normal price. The long run normal price OE is the lower of
the two but is higher than the original market price ON. How much the long run price will differ
from the market price depends upon the supply condition in a particular industry.
In long-run, as compared to the demand force, the supply force becomes a dominant factor in
determining the equilibrium price.

Changes in Equilibrium Price:

Any change in the demand condition or the supply condition or simultaneous change in the
conditions of both demand and supply would lead to change in equilibrium price.
Effects of Changes in Demand on Equilibrium Price:
It is assumed that no change takes place in the supply schedule, i.e., it remains fixed. This can
also be illustrated in the following diagram.

In the figure (8.2) DD/ is the original demand curve. PM is the equilibrium price and OM the
equilibrium amount. When demand rises, supply remaining the same, the equilibrium amount
increases from OM to OG and the equilibrium price rises from PM to FG. In case of fall in
demand, which is indicated by D2D2 curve, the quantity demanded decreases from OM to OK
and the equilibrium price falls from PM to LK.

If the supply is perfectly elastic, a rise in demand will increase the quantity but will not affect the
price. If the supply is perfectly inelastic, then a rise in demand will affect the price but not the
quantity. This can be shown with the help of the fig. 8.3. When demand rises, the supply
increases from OK to OI with further rise in demand D2D2 the supply increases from OI to ON.

In fig. 8.4, supply is perfectly inelastic. A rise in demand affects the price which rises from RM
to KM and with the further rise in demand to LM. The quantity supplied remains the same OM.
If elasticity of supply is equal to unity, the quantity and price change in equal proportion with a
rise in demand as is clear in fig. 8.5.

If elasticity of supply greater than unity, a rise in demand will affect the supply which will
change in greater proportion than the price as is obvious from the following fig. 8.6. When
demand rises, KL quantity supplied is greater in proportion than PN price.

If the elasticity of supply is less than unity, a rise in demand will change the price in greater
proportion than the quantity as shown in fig. 8.7.The proportionate change in quantity demanded
KL is less than the change in price RN.

Effects of Shifts in Supply on Equilibrium Price:

Here the demand curve remains fixed and a change takes place in the supply of a commodity.

In the diagram (8.8) the demand curve DD/ is assumed as fixed and change takes place only in
supply curve. PM is the initial position of the equilibrium price and OM the initial equilibrium
amount. When supply increases, OK becomes the new equilibrium amount and NK the new
equilibrium price. When supply falls, OD is the new equilibrium amount and FD the new
equilibrium price.

If demand is perfectly elastic, as in fig. (8.9), the price will not be affected and quantity
demanded will, however, increase with the increase in supply. The price remains unaltered OD.
If the demand is perfectly inelastic, then with a fall in supply, the quantity demanded will remain
unaffected and the price will go up.

With inelastic demand curve, when supply decreases there is no change in the quantity. It
remains OM (figure 8.10). The price, on the other hand, rises from ML to MK and then with
further fall in supply, it increases to MZ. In practice, the elasticity of demand is neither perfectly
elastic nor perfectly inelastic. It is either equal to unity, greater than unity or less than unity.
Effect of Shift in Both Supply & Demand on Equilibrium Price and Quantity:

In the figure (8.11), DD/and SS/ are the original demand and supply curves. When demand rises,
the demand curve DD1 shifts upward and it intersects the old supply curve SS / at point F. The
new equilibrium price is now equal to FK. But if supply also increases with the rise in demand,
the new equilibrium price will be established at a point where the new supply curve intersects the
new demand curve. When changes in both supply and demand take place, the new equilibrium

price is established at point N. NT becomes new equilibrium price and OT the new equilibrium
amount.
If the rise in supply is greater than the rise in demand, the price will be lower than the original
price. In Fig. (8.12), the price has fallen from EQ to E/Q/.

If the change in demand is relatively higher than that of supply, the new equilibrium price will be
higher than the original price as is shown in fig. 8.13. The equilibrium price has increased from
EQ to E/Q/.

Theory of Production
Production of goods requires resources or inputs. These inputs are called factors of production
named as land, labor, capital and organization. A rational producer is always interested to get the
maximum output from the set of resources or inputs available to him. He would like to combine
these inputs in a technical efficient manner so that he obtains maximum desired output of goods.
The relationship between the inputs and the resulting output is described as production function.
A production function shows the relationship between the amounts of factors used and the
amount of output generated per period of time.
Q = f (x1, x2... xn)
Q is the maximum quantity of output and x 1, x2, xn are quantities of various inputs. The
functional relationship between inputs and output is governed by the laws of returns.

The analysis of production function is generally carried with reference to time period which is
called short period and long period. In short run, production function is explained with one
variable factor and other factors of productions are held constant. This production function is
called as the Law of Variable Proportions or the Law of Diminishing returns. In long run,
production function is explained by assuming all factors of production variables. There are no
fixed inputs in the long run. Here the production function is called the Law of Returns to Scale.
As it is difficult to handle more than two variables in graph, the Law of Returns is explained by
assuming only two inputs i.e., capital and labor and study how output responds to their use.

Law of Variable Proportion/Law of Diminishing Returns:

The short run is a period of time in which only one input (say labor) is allowed to vary while
other inputs land and capital are held fixed. In the short run, therefore, production can be
increased with one variable factor and other factors remaining constant. In the short run, the law
of variable proportion governs the production behavior of a firm. The law shows the direction
and rate of change in the output of firm when the amount of only one factor of production is
varied while other factors of production are held constant.
The law states that when more and more units of a variable input are applied to a given quantity
of fixed inputs, the total output may initially increase at an increasing rate and then at a constant
rate but it will eventually increase at diminishing rates. That is, the marginal increase in the total
output eventually decreases when additional units of variable factors are applied to a given
quantity of fixed factors.
This law holds good under the following assumptions:
(i) Short run
(ii) Constant technology
(iii) Homogeneous factors
The law of variable proportions is, now explained with the help of table and graph.

Fixed Inputs
(Land &
Capital)
30
30

Variable
Resource
(labor)
1
2

30
30
30
30
30
30

Schedule:
Total Produce (TP Marginal Product
Quintals)
(MP Quintals)

Average
Product (AP
Quintals)
10
12.5

10
25

10
15

Increasing marginal
return

3
4
5
6
7

37
47
55
60
63

12
10
8
5
3

Diminishing marginal 12.3

returns
11.8
11.0
10.0
9.0

63

Negative marginal

7.9

30
9
62
-1
returns
6.8
In the table above, it is assumed that a farmer has only 30 acres of land for cultivation. The
investment on it in the form of tube wells, machinery etc., and (capital) is also fixed. Thus land
and capital with the farmer is fixed and labor is the variable resource.
As the farmer increases units of labor from one to two to the amount of other fixed resources
(land and capital), the marginal as well as average product increases. The total product (TP) also
increases at an increasing rate from 10 to 25 quintals. It is the stage of increasing returns. This
stage of course, does not last long. With the employment of 3rd labor at the farm, the marginal
product (MP) and the average product (AP) both fall but MP falls more speedily than the AP. The
fall in MP and AP continues as more men are put on the farm. The decrease, however, remains
positive up to the 7th labor employed. On the employment of 7th worker, TP remains constant at
63 quintals. The MP is zero. If more men are employed, MP becomes negative. It is the stage of
negative returns. The behavior of MP is shown in three stages. In the first stage, it increases, in
the 2nd it continues to fall and in the 3rd stage it becomes negative.
These stages can be explained with the help of graph below:

(i) Stage of Increasing Returns - The first stage of the law of variable proportions is generally
called the stage of increasing returns. In this stage as a variable resource (labor) is added to fixed
inputs of other resources, the total product increases up to a point at an increasing rate as is
shown in figure 11.1. The total product from the origin to the point K on the slope of the total
product curve increases at an increasing rate. From point K onward, during the stage II, the total
product no doubt goes on rising but its slope is declining. This means that from point K onward,
the total product increases at a diminishing rate. In the first stage, marginal product curve of a
variable factor rises in a part and then falls. The average product curve rises throughout .and
remains below the MP curve.
The phase of increasing returns starts when the quantity of a fixed factor is abundant relative to
the quantity of the variable factor. As more and more units of the variable factor are added to the
constant quantity of the fixed factor, it is more intensively and effectively used. This causes the
production to increase at a rapid rate. Another reason of increasing returns is that the fixed factor
initially taken is indivisible. As more units of the variable factor are employed to work on it,
output increases greatly due to fuller and effective utilization of the variable factor.

(ii) Stage of Diminishing Returns. This is the most important stage in the production function.
In stage 2, the total production continues to increase at a diminishing rate until it reaches its
maximum point (H) where the 2nd stage ends. In this stage both the marginal product and
average product of the variable factor are diminishing but are positive.
The 2nd phase of the law occurs when the fixed factor becomes inadequate relative to the
quantity of the variable factor. As more and more units of a variable factor are employed, the
marginal and average product decline. Another reason of diminishing returns in the production
function is that the fixed indivisible factor is being worked too hard. It is being used in nonoptimal proportion with the variable factor.
(iii) Stage of Negative Returns. In the 3rd stage, the total production declines. The TP curve
slopes downward (From point H onward). The MP curve falls to zero at point M and then is
negative. It goes below the X axis with the increase in the use of variable factor (labor). The 3rd
phase of the law starts when the number of a variable, factor becomes too excessive relative to
the fixed factors. A producer cannot operate in this stage because total production declines with
the employment of additional labor.
rational producer will always seek to produce in stage 2 where MP and AP of the variable
factor are diminishing. At which particular point, the producer will decide to produce depends
upon the price of the factor he has to pay. The producer will employ the variable factor (say
labor) up to the point where the marginal product of the labor equals the given wage rate in the
labor market.
A

Production function establishes a physical relationship between output and inputs. It describes
what is technically feasible when the firm uses each combination of input. The firm can obtain a
given level of output by using more labor and less capital or more capital and less labor.
Production function describes the maximum output feasible for a given set of inputs in technical
efficient manner.

Long Run Production with Variable Inputs:

The long run is the lengthy period of time during with all inputs can vary. There is no fixed
output in the long run. All factors of production are variable inputs.
We now analyze production function by allowing two factors say labor and capital to vary while
all others are held constant. With both factors variable, a firm can produce a given level of output
by using more labor and less capital or more capital and less labor. A firm continues to substitute
one input for another while continuing to produce same level of output. If two inputs say labor
and capital are allowed to vary, resulting production function can be illustrated in figure 12(a).

In this figure each curve (called an Isoquant) represents a different level of output. The curves
which lie higher and to the right represent greater output levels than curves which are lower and
to the left. For example, point D represents a higher output level of 250 units than point A or B
which shows output level of 150 units.
The curve isoquant which represents 150 units of output illustrate that the same level of output
(150 units) can be produced with different combinations of labor and capital. Combination of
labor and capital represented by A can employ OL 1 quantity of labor and OC1 units of capital to
produce 150 units of output. The combination of labor and capital represented by point B will
use only OL2 units of labor and OC1 of capital to produce the same level of output. The isoquant
through points A and B shows all different combinations of labor and capital that can be used to
produce 150 units of output.
The concept of isoquant or equal product curve can be better explained with the help of schedule
given below:
Combinations
Factor X
Factor Y
Total Output
A
1
14
100 METERS
B
2
10
100 METERS
C
3
7
100 METERS
D
4
5
100 METERS
E
5
4
100 METERS
In the table given above, it is shown that a producer employs two factors of production X and Y
for producing an output of 100 meters of cloth. There are five combinations which produce the
same level of output (100 meters of cloth). The factor combination A using 1 unit of factor X and
14 units of factor Y produces 100 meters of cloth. The combination B using 2 units of factor X
and 10 units of factor Y produces 100 meters of cloth. Similarly combinations C, U and E,
produce 100 units of output, each. The producer, here, is indifferent as to which combination of
inputs he uses for producing the same amount of output.
The alternative techniques for producing a given level of output can be plotted on a graph.

The figure 12.1 shows the five factor combinations of X and Y plotted and shown by points a, b,
c, d and e. if we join these points, it forms an 'isoquant'.
An isoquant therefore, is the graphic representation of an iso-product schedule. All the factor
combinations of X and Y on an iso-product curve are technically efficient combinations. The
producer is indifferent as to which combination he uses for producing the same level of output.
In the figure 12.1, iso-product curve represents the various combinations of the two inputs which
produce the same level of output (100 meters of cloth).
Properties of Isoquants:
An isoquant slopes downward from left to right
An isoquant that lies above and to the right of another represents a higher output level
Isoquants cannot cut each other
Isoquants are convex to the origin
Iso-cost Lines:
A firm can produce a given level of output using efficiently different combinations of two inputs.
For choosing efficient combination of the inputs, the producer selects that combination of factors
which has the lower cost of production. The information about the cost can be obtained from the
iso-cost lines.
An iso-cost line shows all the combinations of labor and capital that are available for a given
total cost to the producer. Just as there are infinite numbers of isoquants, there are infinite
numbers of iso-cost lines, one for every possible level of a given total cost. The greater the total
cost, the further from origin is the iso-cost line.
The iso-cost line can be explained easily by taking a simple example.

Let us examine a firm which wishes to spend Rs. 100 on a combination of two factors labor and
capital for producing a given level of output. We suppose further that the price of one unit of
labor is Rs. 5 per day. This means that the firm can hire 20 units of labor. On the other hand if the
price of capital is Rs. 10 per unit, the firm will purchase 10 units of capital. In fig. 12.7, the point
A shows 10 units of capital used whereas point T shows 20 units of labor hired at the given price.
If we join points A and T, we get a line AT, called iso-cost line.
Let us assume now that there is no change in the market prices of the two factors labor and
capital, but the firm increases the total outlay to Rs. 150. The new price line BK shows that with
an outlay of Rs. 150, the producer can purchase 15 units of capital or 30 units of labor. The new
price line BK Shifts upward to right. In case the firm reduces the outlay to Rs. 50 only, the isocost line CD shifts downward to the left of original iso-cost line and remains parallel to the
original price line.
Marginal Rate of Technical Substitution (MRTS):
MRTS is "The rate at which one factor can be substituted for another while holding the level of
output constant". The slope of an isoquant shows the ability of a firm to replace one factor with
another while holding the output constant. For example, if 2 units of factor capital (K) can be
replaced by 1 unit of labor (L), marginal rate of technical substitution will be thus:
MRS = K / L = 2 / 2 = 1
The concept of MRTS can be explained easily with the help of the table and the graph, below:
Factor
Units of
Units of
Units of Output of
MRTS of Labor for
Combinations
Labor
Capital
Commodity X
Capital
A
1
15
150
B
2
11
150
4:1
C
3
8
150
3:1
D
4
6
150
2:1
E
5
5
150
1:1

It is clear from the above table that all the five different combinations of labor and capital that is
A, B, C, D and E yield the same level of output of 150 units of commodity X. As we move down
from factor A to factor B, then 4 units of capital are required for obtaining 1 unit of labor without
affecting the total level of output (150 units of commodity X). The MRTS is 4:1. As we step
down from factor combination B to factors C to D to E, then MRTS decreases.
In figure 12.8, all the five combinations of labor and capital which are A, B, C, D and E are
plotted on a graph. The points A, B, C, D and E are joined to form an isoquant.

The decline in MRTS along an isoquant for producing the same level of output is named as
diminishing marginal rates of technical substitution.
Optimum Factor Combination:
In the long run, all factors of production can vary. The profit maximization firm will choose the
least cost combination of factors to produce at any given output level. The least cost
combination or the optimum factor combination refers to the combination of factors with which a
firm can produce a specific quantity of output at the lowest possible cost. The least cost
combination of factors for any level of output is that where the iso-product curve is tangent to an
iso-cost curve.
The least cost combination of factors is now explained with the help of figure 12.9.

Here the iso-cost line CD is tangent to the iso-product curve 400 units at point Q. The firm
employs OC units of factor Y and OD units of factor X to produce 400 units of output. This is the
optimum output which the firm can get from the cost outlay of Q. In this figure, any point below
Q on the price line AB is desirable as it shows lower cost, but it is not attainable for producing
400 units of output. As regards points RS above Q on iso-cost lines GH, EF, they show higher
cost. These are beyond the reach of the producer with CD outlay. Hence point Q is the least cost
point.

Law of Returns to Scale:

The law of returns to scale operates in the long period, explains the production behavior of the
firm with all variable factors. There is no fixed factor of production in the long run. The law
describes the relationship between variable inputs and output when all the inputs or factors are
increased in the same proportion. The law analyzes the effects of scale on the level of output.
It has been observed that when there is a proportionate change in the amounts of inputs, the
behavior of output varies. The output may increase by a great proportion, by in the same
proportion or in a smaller proportion to its inputs. This behavior of output with the increase in
scale of operation is termed as increasing returns to scale, constant returns to scale and
diminishing returns to scale.
(1) Increasing Returns to Scale:
If the output of a firm increases more than proportionate increase in all inputs, the production is
said to exhibit increasing returns to scale. For example, if the amount of inputs are doubled and
the output increases by more than double, it is said to be an increasing returns to scale. When
there is an increase in the scale of production, it leads to lower average cost per unit produced as
the firm enjoys economies of scale.
(2) Constant Returns to Scale:
When all inputs are increased by a certain percentage, and the output increases by the same
percentage, the production function is said to exhibit constant returns to scale. For example, if a
firm doubles inputs, it doubles output. The constant scale of production has no effect on average
cost per unit produced.
(3) Diminishing Returns to Scale:
The term 'diminishing' returns to scale refers to scale where output increases in a smaller
proportion than the increase in all inputs. For example, if a firm increases inputs by 100%, but
the output decreases by less than 100%, the firm is said to exhibit decreasing returns to scale. In
case of decreasing returns to scale, the firm faces diseconomies of scale. The firm's scale of
production leads to higher average cost per unit produced.
The three laws of returns to scale are now explained with the help of a graph below:

The figure 11.6 shows that when a firm uses one unit of labor and one unit of capital (point a), it
produces 1 unit of quantity. When the firm doubles its outputs by using 2 units of labor and 2
units of capital, it produces more than double from q = 1 to q = 3. So the production function has
increasing returns to scale in this range. Another output from quantity 3 to quantity 6. At last,
doubling point c to point d, the production function has decreasing returns to scale. The doubling
of output from 4 units of input causes output to increase from 6 to 8 units increases of two units.
Internal Economics of Scales:
These arise within the firm as a result of increasing the scale of output of the firm. A firm secures
these economies from the growth of the firm independently. The main scale economies are:
Technical Economies - When production is carried on a large scale, a firm can afford to
install up to date and costly machinery and can have its own repairing arrangements. As
the cost of machinery will be spread over a very large volume of output, the cost of
production per unit will therefore, be low. A large firm can also secure the services of
experienced entrepreneurs and workers which a small firm cannot afford. In a large
establishment there is much scope for specialization of work, so the division of labor can
be easily secured.
Managerial Economies - When production is carried on a large scale, the task of manager
can be split up into different departments and each department can be placed under the
supervision of a specialist of that branch. The difficult task can be taken up by the
entrepreneur himself. Due to these functional specializations, the total return can be
increased at a lower cost.
Financial Economies - Financial economies arise from the fact that a big establishment
can raise loans at a lower rate of interest than a small establishment.
Risk Bearing Economies - A big firm can undertake risk bearing economies by spreading
the risk. In certain cases the risk is eliminated altogether. A big establishment produces a
variety of goods in order to cater the needs of different tastes of people. If demand for a
certain type of commodity slackens, it is counter balanced by increasing demand of other
commodities produced by the firm.
Economies of Scale - As a firm grows in size, it is possible for it to reduce its cost. The
reduction in costs, as a result of increasing production is called economies of scale.

Internal Diseconomies of Scale:

The extensive use of machinery, division of labor, increased specialization and larger plant size
etc., no doubt entail lower cost per unit of output but the fall in cost per unit is up to a certain
limit. As the firm goes beyond the optimum size, the efficiency of the firm begins to decline. The
average cost of production begins to rise.
The main factors causing diseconomies eventually leading to higher per unit cost are as follows:
Lack of co-ordination - As a firm becomes large scale producer, it faces difficulty in
coordinating the various departments of production. The lack of co-ordination in the
production, planning, marketing personnel, account, etc., lowers efficiency of the factors
of production. The average cost of production begins to rise.
Loose control - As the size of plant increases, the management loses control over the
productive activities. The misuse of delegation of authority, the redtapism bring
diseconomies and lead to higher average cost of production.
Lack of proper communication - The lack of proper communication between top
management and the supervisory staff and little feedback from subordinate staff causes
diseconomies of scale and results in the average cost to go up.
Lack of identification - In a large organizational structure, there is no close liaison
between the top management and the thousands of workers employed in the firm. The
lack of identification of interest with the firm results in per unit cost to go up.
External Economies of Scale:
These economies are not specially availed by any firm. The main external economies are:
Economies of localization - When an industry is concentrated in a particular area, all the
firms situated in that locality avail some common economies such as skilled labor,
transportation facilities, banking and insurance facilities etc.
Economies of vertical disintegration - The vertical disintegration implies the splitting up
the production process in such a manner that some jobs are assigned to specialized firms
e.g., when an industry expands, repair work of the various parts of the machinery is taken
up by the various firms specialists in repairs.
Economies of information - As the industry expands, it can set up research institutes. The
research institutes provide market information, technical information etc for the benefit of
alt the firms in the industry.
Economies of by products - All the firms can lower the costs of production by making use
of waste materials.
External Diseconomies:
The diseconomies of large scale production are (i) Diseconomies of pollution, (ii) Excessive
pressure on transport facilities, (iii) Rise in the prices of the factors of production, (iv) Scarcity of
funds, (v) Marketing problems of the products, (vi) Increase in risks etc.
Optimum firm is that firm which fully utilizes its scale of operation and produces optimum
output with the minimum cost per unit production.

Cost of Production & Cost Curves

"Production costs are those which must be received by resource owners in order to assume that
they will continue to supply them in a particular time of production".

Analysis of Short Run Cost of Production:

Short run is a period of time over which at least one factor must remain fixed. For most of the
firms, the fixed factors which cant be increased to meet the rising demand of the good is capital
i.e., plant and machinery. Short run, then, is a period of time over which output can be changed
by adjusting the quantities of resources such as labor, raw material, fuel but the size or scale of
the firm remains fixed.
In long run there is no fixed resource. All the factors of production are variable. The length of the
long run differs from industry to industry depending upon the nature of production e.g., a balloon
making firm can change the size of firm more quickly than a car manufacturing firm.

Total Costs:
The total cost of a firm in the short run is divided into two categories:
(1) Total Fixed Cost (TFC): TFC occur only in short run. It is the cost of firm's fixed resources.
Fixed cost remains the same in short run regardless of how many units of output produced. We
can say that fixed cost of a firm is that part of total cost which does not vary with changes in
output per period of time. Fixed cost is to be incurred even if the output of the firm is zero. For
example, the firm's resources which remain fixed in the short run are building, machinery and
even staff employed on contract for work over a particular period.
(2) Total Variable Cost (TVC): TVC is the cost of variable resources of a firm that are used
along with the firm's existing fixed resources. Total variable cost is linked with the level of
output. When output is zero, variable cost is zero. When output increases, variable cost also
increases and it decreases with the decrease in output. For example, wages paid to the labor
engaged in production, prices of raw material which a firm incurs on the production of output are
variable costs. A firm can reduce its variable cost by lowering output but it cannot decrease its
fixed cost. These expenses remain fixed in the short run. In the long run there are no fixed
resources. All resources are variable. Therefore, a firm has no fixed cost in the long run. All long
run costs are variable costs.
(3) Total Cost (TC): It is the sum of fixed cost and variable cost incurred at each level of output.
TC = TFC + TVC
Where,TC = Total cost
TFC = Total fixed cost
TVC = Total variable cost
Short run costs of a firm are now explained with the help of a schedule and diagrams.

Units of Output (in Hundred)

Schedule :( in Rupees)
Total Fixed Cost Total Variable Cost

Total Cost

1000

1000

1000

60

1060

1000

100

1100

1000

150

1150

1000

200

1200

1000

400

1400

1000

700

1700

7
1000
1100
2100
The short run cost data of the firm shows that total fixed cost TFC, column (2) remains constant
at Rs. 1000 regardless of the level of output. The column (3) indicates variable cost which is
associated with the level of output. Total variable cost is zero when production is zero. Total
variable cost increases with the increase in output. The variable cost does not increase by the
same amount for each increase in output. Initially the variable cost increases by a smaller amount
up to 3rd unit of output and after which it increases by larger amounts. Column (4) indicates total
cost which is the sum of TFC and TVC. The total cost increases for each level of output. The rise
in total cost is sharper after the 4th level of output. The concepts of costs, i.e., (1) total fixed cost
(2) total variable cost and (3) total cost can be illustrated graphically.
Total Fixed Cost Curve/Diagram:

In diagram (13.1), the total fixed cost of a firm is assumed to be Rs. 1000 at various levels of
output. It remains the same even if the firm's output is zero.
Total Variable Cost Curve/Diagram:

In figure (13.2), the total variable cost curve (TVC) increases with the higher level of output. It
starts from the origin, and then increases at a diminishing rate up to the 4th units of output. It
then begins to rise at an increasing rate.
Total Cost Curve Curve/Diagram:

In figure (13.3), total cost curve which is the sum of the total fixed cost and variable cost at
various levels of output has nearly the same shape. The difference between the two is by only a
fixed amount of Rs. 1,000. The total variable cost curve and the total cost curve begin to rise
more rapidly as production is increased. The reason for this is that after certain output, the
business has passed its most efficient use of its fixed costs in the form of machinery, building
etc., and its diminishing return begins to set in.

Average Costs:
The entrepreneurs are no doubt interested in the total costs but they are equally concerned in
knowing the cost per unit of the product. The unit cost figures can be derived from the total fixed
cost, total variable cost and total cost by dividing each of them with corresponding output.
(1) Average Fixed Cost (AFC): It is found out by dividing total fixed cost by the corresponding
output.
AFC = TFC / Q
For instance, if the total fixed cost of a shoes factory is Rs. 5,000 and it produces 500 pairs of
shoes, then the average fixed cost is equal to Rs. 10 per unit. If it produces 1,000 pairs of shoes,
the average fixed cost is Rs. 5 and if the total output is 5,000 pairs of shoes, then the average
fixed cost is Re. 1 pair of shoe.

The concept of average fixed cost can be explained with the help of the curve. In the diagram
(13.4), the AFC curve gradually falls from left to right showing the level of output. The larger the
level of output, the lower is the AFC and smaller the level of output, greater is the AFC. The
AFC never becomes zero.
(2) Average Variable Cost (AVC): It is obtained by dividing the TVC by the total output.
AVC = TVC / Q
For instance, if the total variable cost for producing 100 meters of cloth is Rs. 800, the average
variable cost will be Rs. 8 per meter.
When a firm increases its output, the average variable cost decreases in the beginning, reaches a
minimum and then increases. In the beginning, a firm is not producing to its full capacity and
hence various factors of production employed for the manufacture of a particular commodity
remain partially absorbed. As the output of the firm increases, they are used to its fullest extent.
So the AVC begins to decrease. When the plant works to its full capacity, the AVC is at its
minimum. If the production is pushed further from the plant capacity, then less efficient
machinery and less efficient labor may have to be employed. This results in the rise of AVC. The
AVC can also be represented in the form of a curve.

The shape of the AVC curve (Fig. 13.5) is like a flat U-shaped curve. It shows that when the
output increases, there is a steady fall in the AVC due to increasing returns to variable factor. It
reaches its minimum when 500 meters of cloth are produced. When production is increased to
600 meters of cloth or more, AVC begins to rise due to diminishing returns to the variable factor.
(3) Average Total Cost (ATC): It is obtained by dividing the total cost by the total number of
commodities produced by the firm.

ATC = TC / Q
As the output of a firm increases, ATC like the AVC decreases in the beginning reaches a
minimum and then it increases. AFC and AVC have both the tendency to fall as output increases.
ATC will continue to fall so long as AVC does not rise. Even if AVC continues to rise, it is not
necessary that the ATC will rise. It can be due to the fact that the increase in AVC is less than the
fall in AFC. The increase in AVC is counter balanced by a rapid fall of AFC. If the rise in the
AVC is greater than the fall in AFC, then the ATC will rise.
The tendency to rise on the part of average total cost in the beginning is slow, after a certain
point it begins to increase rapidly.
Diagram/Curve:

The average total cost is represented here by a U-shaped curve in Fig. (13.6). The average total
cost curve is also like a U-shaped curve. It shows that as production increases from 100 meters to
200 meters of cloth, the cost falls rapidly, reaches a minimum but then with higher level of
output, the average fixed cost begins to increase.

Short Run and Long Run Average Cost Curves:

In the long run, all costs of a firm are variable. The factors of production can be used in varying
proportions to deal with an increased output. The firm having time period long enough can build
larger scale or type of plant to produce the anticipated output. The shape of the long run average
cost curve is also U-shaped but is flatter than that of the short run curve as is illustrated in the
following diagram:

In diagram 13.7 given above, there are five alternative scales of plant SAC 1, SAC2, SAC3, SAC4
and, SAC5. In the long run, the firm will operate in the scale of plant which is most profitable to
it. For example, if the anticipated rate of output is 200 units per unit of time, the firm will

choose the smallest plant. It will build the scale of plant given by SAC 1 and operate it at point A.
This is because of the fact that at the output of 200 units, the cost per unit is lowest with the plant
size 1 which is the smallest of all the four plants. In case, the volume of sales expands to 400
units, the size of the plant will increase and the desired output will be attained by the scale of
plant represented by SAC2 at point B. If the anticipated output rate is 600 units, the firm will
build the size of plant given by SAC 3 and operate it at point C where the average cost is Rs. 26
and also the lowest. The optimum output of the firm is obtained at point C on the medium size
plant SAC3. If the anticipated output rate is 1000 per unit of time, the firm would build the scale
of plant given by SAC5 and operate it at point E. If we draw a tangent to each of the short run
cost curves, we get the long-run average cost (LAC) curve. The LAC is U-shaped but is flatter
than the short run cost curves.

Marginal Cost (MC):

Marginal Cost is governed only by variable cost which changes with changes in output.
Marginal Cost =
Change in Total Cost =
TC
Change in Output
q
The various types of costs and their relationship can be shown in the table given below:
Units of Output
TFC
TVC
ATC
AFC
AVC
MC
Rs.
Rs.
Rs.
Rs.
Rs.
Rs.
1
30
15
45
30
15
15
2
30
16.9
23.4
15
8.4
1.9
3
30
18.4
16.1
10.1
6.1
1.5
4
30
19.4
12.3
7.5
4.8
1
5
30
20
10
6
4.0
0.6
6
30
22
8.7
5
3.7
2
7
30
25
7.8
4.3
3.6
3
8
30
30
7.5
3.7
3.7
5
9
30
36
7.3
3.3
4
6
10
30
43
7.3
3
4.3
7
11
30
60
8.2
2.7
5.5
17
12
30
90
10
2.5
7.5
30
13
30
125
11.9
2.3
9.6
35
14
30
165
13.9
2.1
11.8
40
15
30
210
16
2
14.8
45
16
30
270
18.7
1.9
16.7
60
As production increases, the average total cost and the marginal cost both begin to decrease. The
average total cost goes on decreasing up to the 9 th unit and then after 10th unit, it begins to rise.
The marginal cost goes on falling up to 5th unit and then it begins to increase. So long as the
average total cost does not rise, the marginal cost remains below it. When average total cost
begins to increase, the marginal cost rises more than the average total cost.

In fig.13.10, AVC goes on falling up to the 7th unit, and then it steadily moves upwards. On the
other hand the MC falls up to the 5th unit and then rises more rapidly than average variable cost.
Diagram/Figure:

Time Value of Money

The value / purchasing power of money at a particular time is called time value of money. A
rupee today is worth more than a rupee to be received tomorrow. The time value of money is a
tool to understand the effective rates on business loans or true return on an investment by helping
the manager determine the actual value of money now and in the future based on interest rates,
discount rates, expected costs and expected sales. Through targeted analysis, organizations are
able to use this information to decide whether projects, big or small, simple or complex, are
going to be beneficial to the company. By observing various tools and indicators such as future
value, present value, future/present value of an annuity, companies can determine the expected
return on an investment to ensure that it will result in increased profits. The time value of money
demonstrates that it may be better to have money now rather than later.
A rupee is worth more today than tomorrow for the following reasons:
An invested rupee can earn interest over time
The future always involves uncertainty and receiving a rupee in future involves risk
A rupee is subject to inflation thus lessening its purchasing power
The notations used in various interest formulas calculations are as follows:
P
n
i
F
A
G

= principal amount
= No. of interest periods
= interest rate (It may be compounded monthly, quarterly, semiannually or annually)
= Future amount at the end of year n
= equal amount deposited at the end of every interest period (Annuity)
= uniform amount which will be added/subtracted period after period to/ from the amount
of deposit at the end of period 1

Interest is the cost of borrowing money. An interest rate is the cost stated as a percentage of
the amount borrowed per period of time, usually one year.

SIMPLE INTEREST:
Simple interest is calculated on the original principal only. Accumulated interest from prior
periods is not used in calculations for the following periods.
S.I. = P x i x n
Ex:

A man borrowed Rs. 10,000 at 12% p.a. for 3 years. How much he has to pay after 3
years?

Sol:

Here, P = Rs. 10,000

i = 12% = 0.12
n = 3 years
S.I. = 10,000 x 0.12 x 3 = Rs. 3,600
Amount to be paid after 3 years = 8,500 + 3,600 = Rs. 12,100
COMPOUND INTEREST:
Compound interest is calculated each period on the original principal and all interest
accumulated during past periods. Although the interest may be stated as a yearly rate, the
compounding periods can be yearly, semiannually, quarterly, or even continuously. In this case,
the interest earned in each period is added to the principal of the previous period to become the
principal for the next period.
C.I. = P {(1 + i) n 1}
Ex:

If Rs. 50,000 is invested for 10 years at 10% interest compounded annually, calculate the
amount to be received after 10 years.

Sol:

Here, P = Rs.50, 000

i = 10% = 0.10
n = 10 years
The amount to be received after 10 years = 50,000 (1.1) 10 = Rs. 1, 29, 700

NOMINAL and EFFECTIVE INTEREST RATES:

The annual rate of interest is called Nominal Interest Rate. When the interest is compounded
more than once in a year e.g. monthly, quarterly or semi-annually; the corresponding annual rate
of interest is called Effective Interest Rate. The formula used to calculate effective interest rate
from given nominal interest rate is:
i eff = {(1 + r/m) m 1}
Where,r = nominal interest rate
m = number of compounding in a year
Ex:

What is effective interest rate of nominal interest rate of 18% compounded semi-annually

i eff = {(1 + r/m) m 1} = {(1 + 0.18/2) 2 1} = 18.8%

Sol:

CONTINUOUS COMPOUNDING:
The ultimate limit for the number of compounding periods in one year is called continuous
compounding. The effective interest rate under such situations is calculated as follows:
i
=
lim
{(1 + r/m) m 1}
=
lim
[{(1 + r/m) m/r} r 1]
m
m
m/r r
=
[lim {(1 + r/m) } ] 1 =
er-1
m
Ex:

Calculate the effective interest rate of nominal interest rate of 18.23% if the interest is
compounded continuously.

Sol:

i=er1

= e 0.1823 1

= 20%

Time-Value Equivalence:
Two things are equivalent when the produce the same effect. The comparison of various
alternative projects necessitates the use of equivalence principle, wherein receipts and payments
occurring at different time periods are expressed on an equivalent basis. In fact, equivalence is
the heart of making engineering economic decisions.
Ex:

i) Rs 100 today is equivalent to Rs. 108 after 1 year at 10% interest compounded annually
ii) Rs. 100 today is equivalent to Rs. 23.74 received at the end of each year for the next 5
years.
iii) Rs. 23.74 received at the end of each year for the next 5 years is equivalent to a lump
sum of Rs. 179.1 received 10 years from now.
iv) Rs. 23.74 received at the end of each year for the next 5 years is equivalent to Rs.
31.77 at the end of years 6, 7, 8, 9 and 10.

Cash Flow Diagrams

A cash flow diagram is a pictorial representation of all cash inflows and outflows along a time
line. The time line is the horizontal scale, which is divided into time periods, usually in years.
Cash inflows and cash outflows are then located on the time-line in adherence to problem
specifications by drawing vertical lines above the axis and below the axis respectively.

Compound Interest Factors:

Single-Payment Compound Amount / Future value of an amount:
Here, the objective is to find the-single future-sum (F) of the initial payment
(P) made at time 0
F
after n periods at an interest rate i compounded every period.
0
P

i%

Fig 1: Cash flow diagram of single-payment compound amount

The formula to obtain the single-payment compound amount is:
F = P (1+i) n = P (F/P, i, n)
Where, (F/P, i, n) is called as single-payment compound amount factor
Ex:

A person deposits a sum of Rs. 20,000 at the interest rate 18% compounded annually for
10 years. Find the maturity value after 10 year.

Sol:

P
i
n
F

= Rs. 20,000
= 18% compounded annually
= 10 years F
= P (1 + i) n = P (F/P, i, n) = 20,000 (F/P, 18%, 10)
= 20,000 x 5.234
= Rs. 1, 04, 680
The maturity value of Rs. 20,000 invested now at 18% compounded yearly is equal to
Rs.1, 04, 680 after 10 years.

Single Payment present worth amount:

Here, the objective is to find the present worth amount (P) of a single future (F) which will be
received after n periods at an interest rate of compound at the end of every interest period.
F

0
P

i%

Fig 2: Cash flow diagram of single-payment present worth amount

The formula to obtain the present worth is:
P = F / (1+i) n = F (P/F, i, n)
Where, (P/F, i, n) is called as single-payment present worth factor
Ex:

A person wishes to have a future sum of Rs. 1, 00, 000 for his sons education after 10
years from now. What is the single-payment that the deposit now so that he gets the
desired amount after 10 years? The bank gives 15% interest rate compounded annually.

Sol:

F
i
n
P

= Rs.1.00.000
= 15%, compounded annually
= 10 years
= F/ (1+i) n
= F (P/F, i, n) = 1, 00, 000 (P/F, 15%, 10)

= 1, 00, 000 x 0.2472

= Rs. 24,720
The person has to invest Rs.24, 720 now so that he will get a sum of Rs.10, 000 after 10
years at 15% interest rate compounded annually.
Equal-Payment Series Compound Amount / Future value of an annuity:
The objective is to find the future worth of n equal payments which are made at the end of every
interest period till the end of the n th interest period at an interest rate of compounded at the end of
each period.
i%
0

n
-

Fig 3: Cash flow diagram of equal-payment series compound amount.

The formula to get F is:
F = A [(1+i) n 1] / i = A (F/A, i, n)
Where, (F/A, i, n) is termed as equal-payment series compound amount factor.
Ex:

A person who is not 35 years old is planning for his retired life. He plans to invest an
equal sum of Rs.10, 000 at the end of every year for the next 25 years starting from the
end of the next year. The bank gives 20% interest rate, compounded annually. Find the
maturity value of his account when he is 60 years old.

Sol:

A
n
i
F

= Rs. 10,000
= 25 years
= 20%
= A [(1+i) n 1] / i
= A (F/A, i, n) = 10,000 (F/A, 20%, 25)
= 10,000 x 471.981 = Rs. 47, 19, 810
The future sum of the annual equal payments after 25 years is equal to Rs. 47, 19,810.

Sinking Fund Amount:

In this type of investment mode, the objective is to find the equivalent amount (A) that should be
deposited at the end of every interest period for n interest periods to realize a future sum (F) at
the end of the nth interest period at an interest rate of i.
i%
0

n
-

Fig 4: Cash flow diagram of equal payment series sinking fund

The formula to get F is:

A = F [i / {(1+i) n 1}]
= F (A/F, i, n)
Where, (A/F, i, n) is called sinking fund factor.
Ex:

A company has to replace a present facility after 15 years at an outlay of

Rs.5, 00, 000. It plans to deposit an equal amount at the end of every year for the next 15
years at an interest rate of 18% compounded annually. Find the equivalent amount that
must be deposited at the end of every year for the next 15 years.

Sol:

F
n
i
A

= Rs. 5, 00, 000

= 15 years
= 18%
= F [i / {(1+i) n 1}] = F (A/F, i, n)
= 5, 00, 000 (A/F, 18%, 15)
= 5, 00, 000 X 0.0164 = Rs.8, 200
The annual equal amount which must be deposited for 15 years is Rs.8, 200.
Equal Payment Series Present worth amount:
The objective is to find the present worth of an equal payment made at the end of every interest
period for n interest periods at interest rate of i compounded at the end of every interest period.
The formula to compute P is:
P = A [(1+i) n 1] / i (1+i) n = A (P/A, i, n)
Where, (P/A, i, n) is called equal-payment series present worth factor.
P

i%
1

n
-

Fig 5: Cash flow diagram of equal-payment series present worth amount.

Ex:

Sol:

A company wants to set up a reserve which will help company to have an annual
equivalent amount of Rs. 10, 00, 000 for the next 20 years towards its employees welfare
measures. The reserve is assumed to grow the rate of 15% annually. Find the singlepayment that must be made now the reserve amount.
A
= Rs.10, 00, 000
i
= 15%
n
= 20 years
P
= A [(1+i) n 1] / i (1+i) n
= A (P/A, i, n) = 10, 00, 000 x (P/A, 15%, 20)
= 10, 00, 000 X 6.2593
= Rs. 62, 59, 300
The amount of reserve which must be set-up now is equal to Rs. 62, 59, 300

Equal-Payment Series Capital Recovery Amount:

The objective is to find the annual equivalent amount (A) which is to be recovered at the end of
every interest period for n interest periods for a loan (P) which is sanctioned now at an interest
rate of i compounded at the end of every interest period.
P
n
A

Fig. 6: Cash flow diagram of equal-payment series capital recovery amount.

The formula to compute P is as follows:
A = P [i (1+i) n / {(1+i) n 1}] = A (P/A, i, n)
Where,(A/P, i, n) is called capital recovery factor.
Ex:
A bank gives a loan to a company to purchase an equipment worth Rs. 10, 00, 000 at an
interest rate of 18% compounded annually. This amount should be repaid in 15 yearly
equal installments. Find the installment amount that the company has to pay to the bank.
Sol: P
= Rs. 10, 00, 000
i
= 18%
n
= 15 years
A
= P [i (1+i) n / {(1+i) n 1}] = A (P/A, i, n) = 10, 00, 000 x {AIP, 18%, 15)
= 10, 00, 000 x (0.1964)
= Rs. 1, 96, 400
The annual equivalent installment to be paid by the company to bank is Rs. 1, 96, 400.
Uniform gradient series factor (A/G, i, N):
In some cases, the periodic payments don't occur at an equal series. They may increase or
decrease by a constant amount. For example a series of payments would be uniformly increasing
in Rs. 200, 250, 300 and 350 occurring at the end of the first, second, third and fourth years.
Similarly a uniformly decreasing series will be Rs. 200, 150, 100, 50 occurring at the end of first,
second, third and fourth years. In each case, an equal payment series provides the base with a
constant annual increase or decrease at the end of the second year.
350

300
250
200
0

2G

G
2

3G

Fig 7

The pattern of an arithmetic gradient is then A', A' + G, A' + 2G ... A' + (N-l) G where N is the
duration of the series. The calculation can be made simple by converting the series to an

equivalent annuity of equal payments A. The formula for the translation is developed by
separating the series in two parts:
1) First for base annually designated A
2) Second for an arithmetic gradient series increasing by G each period.
(1)
(2)
(3)
(4)
End of year Gradient series
Set of series equivalent
Annual series
to gradient series
0
0
0
0
1
0
0
A
2
G
G
A
3
2G
G+G
A
:
:
:
:
:
:
n-1
(n-2) G
G+G+G+G
A
n
(n-1) G
G+G+G.+G+G
A
F
= G (F/A, i, n 1) + (F/A, i, n-2) + G (F/A, i, 2) + (F/A, i, 1)

G
1 i n1 1 i n 2 .... 1 i 2 1 i n 1
i
G

1 i n 1 1 i n 2 ... 1 i 2 1 i 1 nG
i
i

The bracket terms constitute the equal payment series compound amount factor for n years.
Therefore,
G 1 i 1
nG

i
i
i

= G (A/G, i, n)

Thus, A = A + G (A/G, i, n)

Annuity with an unknown:

Annuity is characterized by:
(1)
Equal payments (A)
(2)
Equal periods between payment N and
(3)
The first payment occurring at the end of the first period.
Ex:
Sol:

We purchased a machine by paying Rs 10,000 to reduce the cost of production. The

machine's life time is 5 years and has no resale value and the machine reduces the cost of
production by Rs. 3000. Find out what rate of return will be earned on the investment.
A
= 2000
N
=5
P
= 10,000
P
= A (P/A, i, 5)
P/ A

10,000
3.3333
3000

For i = 15,
(P/A 15, 5)
For i = 16,
(P/A, 16, 5)
By interpolation:

= 3.3572
= 3.2743

 3.3333 3.2743
15 0.753 = 15.75%.
3.3522 3.2743

i = 15 1

Annuity due:
A series of payment made at the beginning instead of the end of each period is referred as
annuity due. In this case, calculation will be as follows:
1.
The series should be divided in to two equal parts.
2.
First payment should be treated separately
3.
Remaining payment should follow the rule of general annuity calculation.
Ex:
What is the present worth of a series of 10 years end payments of Rs 1000 each, when the
first payment is due today and the interest rate is 5%?
Sol: A
= Rs 1000
P
= A + A (P/A, 5, 9) = 1000 +1000 (7.1078)
= 1000 + 7107.8
= Rs. 8107.8

Deferred annuity:
In case of deferred annuity the first payment doesn't begin until some date later than the end of
the first period.
Procedure:
i)
Divide the series in to two equal parts.
ii)
One part is number of payment paid which follow the general annuity calculation
iii)
Second part is the number of period
iv)
Find out present worth of annuity, and then discount these values through pre-annuity
period.

Evaluation of Engineering Projects

Project can be defined as a temporary endeavor to create a unique product or service e.g.
designing a new product, building a plant etc. Project contains a combination of organizational
resources pulled together to create something which did not previously exist. All projects involve
capital expenditure which is nothing but an initial fund requirement at present, mostly, and
resulting in expected future benefit patterns.
Capital budgeting is a process used to determine whether a firms proposed investments or
projects are worth undertaking or not. This is a strategic asset allocation process and
management needs to use capital budgeting techniques to determine which project will yield
more return over a period of time.
A Project whose cash flows have no impact on the acceptance/rejection of other projects is
termed as Independent Project. A set of projects from which at most one will be accepted is
termed as Mutually Exclusive Projects.
Following are the capital budgeting techniques:
Present worth method / Net Present Value method

Future worth method

Equivalent Annual Worth method
Internal Rate of Return method
Profitability Index
Payback Period

Capital budgeting techniques give same acceptance or rejection decisions regarding independent
projects but conflict may arise in case of mutually exclusive projects. In such cases, net present
value method should be given priority due to its more conservative or realistic reinvestment rate
assumption. The Net Present Value and Internal Rate of Return, both methods are superior to the
payback period, but Net present Value is superior to even Internal Rate of Return.

Present Worth Method (PW):

Under this method, the present worth of all cash inflows (revenues) is compared against the
present worth of all cash outflows (costs) associated with an investment project. The cash flow of
each alternative will be reduced to time zero at discount rate i. Then, depending on the type of
decision, the best alternative will be selected by comparing present worth amounts of the
alternatives. The difference between the present worth of the cash flows (inflows outflows)
referred to as Net Present Worth (NPW) determines whether or not the project will be accepted.
For Independent Projects:
If PW > 0, then select the proposal
If PW < 0, then reject the investment project.
If PW = 0, remain indifferent to the investment.
For mutually exclusive alternatives, PW of cash flows can be calculated by either revenue
based present worth method or cost based present worth
In a revenue dominated cash flow diagram, the profit, revenue, salvage value (all inflows) will
be assigned with positive sign. The costs (out flows) will be assigned with negative sign. In a
cost dominated cash flow diagram, the costs (out flows) will be assigned with positive sign and
the profit, revenue; salvage value (all inflows) will be assigned with negative sign. In case the
decision is to select the alternative with maximum profit, then the alternative with the maximum
PW will be selected. If the decision is to select the alternative with the minimum cost, then the
alternative with the least PW will be selected.
S
Revenue dominated cash flow diagram
R1
R2
R3
Rn
0
P

Where,P is the initial investment

R n is the net revenue at the end of nth year.
i is the interest rate compounded annually
S is the salvage value at the end of the nth year.
The present worth expression is:
PW (i) = -P + R1 (P/F, i, 1) + R2 (P/F, i, 2) + . + R n (P/F, i, n) + S (P/F, i, n)
If it is a uniform series or equal payment series then the formula will be
PW (i) = -P + R (P/F, i, n) + S (P/F, i, n)
Cost dominated cash flow diagram
0
1
2
3
4

S
5

P
C1
C2
C3
C4
C5
Cn
Where,P is the initial investment
C n is the net cost of operation and maintenance at the end of the nth year
S is the salvage value at the end of the nth year
C n is the discounted rate of interest
The present worth expression is:
PW (i) = P + C1 (P/F, i, 1) + C2 (P/F, i, 2) + . + C n (P/F, i, n) - S (P/F, i, n)
If it is a uniform series or equal payment series then the formula will be
PW (i) = P + C (P/F, i, n) - S (P/F, i, n)
Ex:
Given the following information, suggest which technology should be selected based on
present worth method, assuming 15% interest rate compounded annually.
Technology
A
B
Sol:

Initial Cost (Rs.)

4,00,000
5,00,000

Service Life
15 Years
15 Years

Annual O & M Cost

25,000
29,000

The cash flow diagram of technology A is:

0

.
Rs. 25,000

14

15

Rs. 4, 00, 000

PW (15%) A = 400000 + 25000 (P/A, 15, 15)
= Rs. 4, 00, 000 + Rs. 1, 46, 185
The cash flow diagram for technology B is:
0
1
2
3
.
Rs. 29,000
Rs. 5, 00, 000

= Rs. 400000 + Rs. 25,000 (5.8474)

= Rs. 5, 46, 185
14

15

PW (15%) B

= Rs. 500000 + Rs. 29000 (P/A, 15, 15)

= Rs. 5, 00, 000 + Rs. 1, 69, 575

= Rs. 500000 + Rs. 29,000 (5.8474)

= Rs. 6, 69, 575

Since PW amount of technology A is lower, hence technology A is to be selected.

Comparison of Projects having Unequal Lives:
In order that projects are comparable, they must be made co-terminated i.e. their termination
point be made same. Projects are made co-terminated by using either Common Multiple Method
or Study Period Method.
In common multiple method, LCM of lives of various projects is calculated and projects are
repeated as many times till their LCM is reached. Suppose, three projects have lives respectively
2, 3 and 4 years, then their LCM is 12 which means the 1 st project would be repeated 5 more
times, 2nd for 3 more times and the 3rd for 2 more times to make all projects co-terminated.
In study period method, a limited period which is same for both projects is selected and cash
flows during the period are considered while all cash flows beyond the period are ignored.
Ex:

The data of two lease options (A & B) are given below:

A
B
First Cost (Rs.)
-150, 000
-1, 80, 000
Annual Lease Cost (Rs.)
-35, 000
-31, 000
Annual Returns (Rs.)
10, 000
20, 000
Lease Term (years)
6
9
(a) Determine which lease option should be selected if the interest rate is 15%?
(b) If the study period of 5 years is used, which option should be selected?

Sol:

(a) LCM of the lives of two lease options i.e. of 6 and 9 is 18.
PW A = -1, 50,000 [1 + (P/F, 15, 6) + (P/F, 15, 12)] 35,000 (P/A, 15, 18)
+ 10,000 [(P/F, 15, 6) + (P/F, 15, 12) + (P/F, 15, 18)]
= Rs. 4, 50, 360
PW B = -1, 80,000 [1 + (P/F, 15, 9)] 31,000 (P/A, 15, 18)
+ 20,000 [(P/F, 15, 9) + (P/F, 15, 18)]
= Rs. 4, 13, 840
Since PW B > PW A, Option B is selected.
(b) For 5-year study period:
PW A = -1, 50,000 35,000 (P/A, 15, 5) + 10,000 (P/F, 15, 5)
PW B = -1, 80,000 31,000 (P/A, 15, 5) + 20,000 (P/F, 15, 5)
Since PW B < PW A, Option A is selected.

Comparisons of Projects having Infinite Lives:

= -2, 62, 360

= -2, 73, 970

There are some projects like dams, bridges, rail roads etc. whose life is very difficult to
determine. In such cases, projects are compared by finding their capitalized costs. Capitalized
Cost is the sum of first cost and the present worth of disbursements assumed to last forever.
Capitalized cost
= P + A (P/A, i, n), n
= P+ A/ i
A is the difference between annual receipts and annual disbursements
Ex:

A grant of Rs. 6, 00,000 was given for the construction of a dam. Annual maintenance
cost is estimated at Rs. 20,000. In addition, Rs. 30,000 will be required in every 10 years
for major repairs. Find out the initial cost if annual rate of interest is 5%.

Sol:

First cost

= Capitalized cost Annual disbursement / i

= 6, 00,000 [20,000 + 30,000 (A/F, 5, 10)] / 0.05
= 6, 00,000 4, 47,700
= Rs. 1, 52,300
Advantages of PW Method:
It recognizes time value of money and suitable to apply even to uneven cash flow streams
It takes into account the earning over the entire life of the project
It considers the objective of maximum profitability
Disadvantages of PW Method:
It is very difficult to determine appropriate discount rate
PW calculation is very sensitive to discount rate
It wholly excludes the value of any real options that may exist within the investment

Future Worth Method (FW):

Future worth method is particularly useful in an investment situation where we need to compute
the equivalent worth of a project at the end of its investment period rather than at its beginning.
For a single project:
If FW > 0, accept the project
If FW < 0, reject the investment proposal
If FW = 0, remain indifferent to the investment.
For a mutually exclusive alternatives future worth cash flows can be calculated by
i)
Revenue based future worth - alternative with the maximum future worth amount should
be selected as the best alternative.
ii)
Cost based future worth - alternative with the minimum future worth amount should be
selected as the best alternative.
The formula for the future worth for a given interest rate i is
FW(i) = - P (F/P, i, n) + R1 (F/P, i, n-1) + R2 (F/P, i, n-2) + . + R n + S
If it is equal payment series then the formula will be
FW (i) = - P (F/P, i, n) + R (F/P, i, n) + S

If the cash flow stream is cost-based, then the future worth is given by
FW (i) = P (1 + i)n + C1 (1 + i)n-1 + C2 (1 + i)n-2 + ..+ C n S
= P (F/P, i, n) + C1 (F/P, i, n-1) + C2 (F/P, i, n-2) + . + C n - S
In equal payment series the formula will be
FW (i) = P (F/P, i, n) + C (F/P, i, n) - S
Ex:

Sol:

Given the following particulars, which machine should be selected based on future worth
method, assuming 20% interest rate, compounded annually?
Particulars
Machine A
Machine B
Initial cost (Rs.)
80,00,000
70,00,000
Life (years)
12.0
12.0
Annual O & M cost (Rs.)
8,00,000
9,00,000
Salvage value (Rs.)
5,00,000
4,00,000
Cash flow diagram of machine A is:
S = Rs. 5, 00, 000
i = 20%
0
1
2
3
4 12
Rs. 8, 00, 000
Rs. 80, 00, 000
FW (20%) A

= 80, 00,000 (F/P, 20, 12) + 8, 00,000 (F/A, 20, 12) -5, 00,000
= Rs. 10, 24, 92, 800

Cash flow diagram of machine B is:

S = Rs. 4, 00, 000
0

i = 20%
2

4 12

Rs. 9, 00, 000

Rs. 70, 00, 000
FW (20%) B

= 70, 00, 000 (F/P, 20, 12) + 9, 00, 000 (F/A, 20, 12) - 4, 00, 000
= Rs. 9, 76, 34, 900

The future worth (cost) of machine B is less than that of machine A. So machine B should
be selected.
Ex:

Which alternative from the following should be selected based on future worth method of
comparison assuming 12% interest rate compounded annually.
Alternative A
Alternative B
Initial cost (Rs.)
4,00,000
8,00,000
Useful life (year)
4.0
4.0

Salvage value (Rs.)

Annual cost (Rs.)
Sol:

2,00,000
40,000

5,50,000
- Nil -

Cash flow diagram of alternative A is:

S = Rs. 2, 00, 000
0

i = 12%
2

Rs. 40, 000

Rs. 4, 00, 000
FW (12%) A

= Rs. 4, 00, 000 (F/P, 12%, 4) + Rs. 40, 000 (F/A, 12%, 4) - Rs. 2, 00, 000
= Rs. 6, 20, 760

Cash flow diagram of alternative B is:

S = Rs. 5, 50, 000
0

i = 12%
2

Rs. 8, 00, 000

FW (12%) B = Rs. 8, 00, 000 (F/P, 12%, 4) - Rs. 5, 50, 000
= Rs. 7, 09, 200
The alternative A should be selected as it involves less future worth (cost).

Equivalent Annual Worth Method (EAW):

In this method, all the receipts and disbursements occurring over a period are converted to an
equivalent uniform yearly amount. A large number of engineering economic decisions are based
on annual comparison like cost accounting procedures, depreciation charges, tax calculations etc.

R1
0

R2

1
C1

2
C2

Cost

Receipt

Diagram of EAW
R3

Rn

3
C 3
.
.

n
Cn

The term equivalent annual worth (EAW) is used when costs and receipts are both present.

Costs Receipt
s

Diagram of EAC

C1

C2

C3

C 4 .C n

The term equivalent annual cost (EAC) is used to designate comparison involving only costs.
For single alternatives if
EAW > 0, Accept the investment proposal
EAQ < 0, Reject the investment proposal
EAW = 0, Remain indifferent to the investment.
For multiple alternatives or mutually exclusive alternatives if all the alternatives are revenue
dominated, the alternative with higher EAW will be selected. If all the alternatives are cost based,
the alternative with least EAW will be accepted.
Ex:

Consider a machine that costs Rs.40, 000 and a 10 year useful life. At the end of 10 years,
it can be sold for Rs.5, 000 after tax adjustment. If the firm could earn after-tax revenue
of Rs.10, 000 per year with this machine, should it be purchased at interest rate of 15%,
compounded annually?

Sol:

Initial cost (P) = Rs.40, 000/Useful life (n) = 10 years

Salvage value = Rs. 5, 000/Revenue
= Rs.10, 000/i
= 15%, compound annually
Case I: PW (15%)

= -P + R (P/A, i, n) + S (P/F, i, n)
= - 40, 000 + 10, 000 (P/A, 15%, 10) + 5, 000 (P/F, 15%, 10)
= - 40,000 + 10, 000 (5.0188) + 5000 (0.2472)
= Rs. 11, 424

Case II: EAW (15%) = PW (i) (A/P, i, n)

= Rs. 11424 (0.1993)
Since EAW (15%) > 0, so the project is accepted.
Ex:

Sol:

= Rs. 11424 (A/P, 15%, 10)

= Rs. 2277

Suggest which machine should be purchased at 15% interest rate based on annual
equivalent worth method.
Machine A
Machine B
First Cost
Rs.3,00,000
Rs.6,00,000
Life period
4 years
4 years
Salvage value
Rs.2,00,000
Rs.3,00,000
O & M Cost
Rs.30,000
Rs.0
The cash flow diagram of machine A is shown below.
2, 00, 000
0

30, 000

3, 00, 000
EAC (15%) A = P (A/P, i, n) + C S (A/F, i, n)
= 3, 00, 000 (A/P, 15%, 4) + 30, 000- 2, 00, 000 (A/F, 15%, 4)
= Rs. 95, 033
The cash flow diagram of machine B is shown below.
3, 00, 000
0

6, 00,
000 = P (A/P, i, n) S (A/F, i, n)
EAC
(15%)
B
= 6, 00, 000 (A/P, 15%, 4) 3, 00, 000 (A/F, 15%, 4))
= Rs. 1, 50, 090
Since the equivalent annual cost of Machine A is less than that of Machine B, it is
advisable to purchase Machine A.

Rate of Return Method:

The rate of return is a percentage that indicates the relative yield on different uses of capital.
Three rates of return appear frequently in engineering economy studies:

The minimum acceptable rate of return (MARR) is the rate set by an organization to
designate the lowest level of return that makes an investment acceptable.

Internal rate of return (IRR) is the rate on the unrecovered balance of the investment in a
situation where the terminal balance is zero. It is a discount rate at which NPV = 0.

External rate of return (ERR) is the rate of return that is possible to obtain for an
investment under current economic conditions. For example, suppose analysis of an
investment shows that it will realize an IRR of 50 percent. Rationally, it is not reasonable
to expect that we can invest in the external market and get that high a rate. In engineering
economy studies, the external interest rate most often set to the MARR.
Minimum Acceptable Rate of Return (MARR):
The minimum acceptable rate of return, also known as the minimum attractive rate of return, is a
lower limit for investment acceptability set by organizations or individuals. It is a device
designed to make the best possible use of a limited resource. Rates vary widely according to the
type of organization, and they vary even within the organization. Historically, government
agencies and regulated public utilities have utilized lower required rates of return than have
competitive industrial enterprises. Within a given enterprise, the required rate may be different
for various divisions or activities. These variations usually reflect the risk involved. For instance,
the rate of return required for cost reduction proposals may be lower than that required for
research and development projects in which there is less certainty about prospective cash flows.

Internal Rate of Return Method (IRR):

The internal rate of return, represented by i in the traditional interpretation of interest rates, is the
rate of interest earned by an alternative investment on the unrecovered balance of an investment.
The internal rate of return can be calculated by equating the annual, present, or future worth of
cash flow to zero and solving for the interest rate (IRR) that allows the equality. While solving
for the interest rate, it may result in a polynomial equation which may result in multiple roots of
the equation. In such cases the IRR may or may not be one of the equation roots.

Calculation of IRR:
IRR is The Discount rate at which the costs of investment equal to the benefits of the
investment. Or in other words IRR is the Required Rate that equates the NPV of an investment
zero. The ascertainment of IRR involves trial and error method and if IRR falls between two
interest rates, then it is found out using interpolation.
If IRR exceeds firms MARR, then the project is accepted, otherwise, it is rejected. For mutually
exclusive projects, project with highest IRR is selected.
Ex:

A person is planning a new business. The initial outlay and cash flow pattern for the new
business are as listed below. The expected life of the business is five years. Find the rate
of return for the new business.
Period
0
1
2
3
4
5
Cash flow (Rs.)
-1,00,000 30,000 30,000 30,000 30,000 30,000

Sol:

Initial investment
Annual equal revenue
Life

= Rs. 1, 00, 000

= Rs. 30, 000
= 5 years

PW(i)

= -1, 00, 000 + 30, 000 (P/A, i, 5)

When i = 10%, PW (10%)

= -1, 00, 000 + 30, 000 (P/A, 10%, 5)

= -1, 00, 000 + 30, 000(3.7908)
= -1, 00, 000 + 30, 000 (P/A, 15%, 5)
= -1, 00, 000 + 30, 000 (3.3522)
= -1, 00, 000 + 30, 000 (P/A, 18%, 5)
= -1, 00, 000 + 30, 000 (3.1272)

When i = 15%, PW (15%)

When i =18%, PW (18%)

= Rs. 13, 724

= Rs. 566
= Rs. -6, 184

= 15% + 0.252%

= 15.252%

Therefore, the IRR for the new business is 15.252%.

Ex:

A firm has identified three mutually exclusive investment proposals whose details are
given below. The life of all the three alternatives is estimated to be five years with
negligible salvage value. The minimum attractive rate of return for the firm is 12%.
Alternative
A1
A2
A3
Investment
Rs. 1,50,000
Rs. 2,10,000
Rs. 2,55,000
Annual net income
Rs. 45,570
Rs. 58,260
Rs. 69,000
Find the best alternative based on the rate-of return method of comparison.

Sol:

Alternative A1
Initial outlay = Rs. 1, 50, 000
Annual profit = Rs. 45, 570
Life
= 5 years
PW (i)

= -1, 50, 000 + 45, 570 (P/A, i, 5)

PW (12%)

= -1, 50, 000 + 45, 570 (P/A, 12%, 5)

= -1, 50, 000 + 45, 570 (3.6048)

PW (15%)
PW (18%)

= -1, 50, 000 + 45, 570 (P/A, 15%, 5)

= -1, 50, 000 + 45, 570 (3.3522)
= -1, 50, 000 + 45, 570 (P/A, 18%, 5)
= -1, 50, 000 + 45, 570 (3.1272)

= Rs. 14, 270.74

= Rs. 2, 759.75
= Rs. -7, 493.50

Therefore, IRR of the alternative A1 is

= 15.81%
Alternative A2
Initial outlay
= Rs. 2, 10, 000
Annual profit
= Rs. 58, 260
Life of alternative A2 = 5 years
PW (i)

= -2, 10, 000 + 58, 260 (P/A, i, 5)

PW (12%)

= -2, 10, 000 + 58, 260 (P/A, 12%, 5)

= -2, 10, 000 + 58, 260 (3.6048)

= Rs. 15.65

= -2, 10, 000 + 58, 260 (P/A, 13%, 5)

= -2, 10, 000 + 58, 260 (3.5172)

= Rs. -5, 087.93

PW (13%)

Therefore, IRR of alternative A2 is

= 12%
Alternative A3
Initial outlay = Rs. 2, 55, 000
Annual profit = Rs. 69,000
Life of alternative A3 = 5 years
PW (i)

= -2, 55, 000 + 69, 000 (P/A, i, 5)

PW (12%)

= -2, 55, 000 + 69, 000 (P/A, 12%, 5)

= -2, 55, 000 + 69, 000 (3.6048)

= Rs. -6, 268.80

= -2, 55, 000 + 69, 000 (P/A, 11%, 5)

= -2, 55, 000 + 69, 000 (3.6959)

= Rs. 17.1

PW (11%)

Therefore, IRR of alternative A3 is

= 11%
From the above data, it is clear that the rate of return for alternative A3 is less than the
minimum attractive rate of return of 12%. So, it should not be considered for comparison.
The remaining two alternatives are qualified for consideration. Among the alternatives A1
and A2, the rate of return of alternative A1 is greater than that of alternative A2. Hence,
alternative A1 should be selected.
IRR Misconceptions:
IRR method for project evaluation leads to conflicting results under following conditions:
(i) The pattern of cash inflows plays an important role in project evaluation while using IRR
method. i.e. the cash flows of one project may increase over time, while those of others
may decrease and vice versa. The major drawback with the IRR method is that for
mutually exclusive projects, it can give contradictory investment decision when
compared with NPV. Consider the following example.

In the above example A and B are mutually exclusive projects. Both projects require an
initial outlay of $ 1,000,000 but the pattern of cash inflows is different. Cash inflows for

Project A are increasing over the period of time while for Project B these are declining.
IRR decision rule leads to select Project A as Project A IRR > Project B IRR. But
decision on the basis of NPV evaluation implies that project B is more viable. Thus on
the basis of mere IRR the company may select less profitable project.
(ii) The cash outflow of the projects may differ. i.e. a project may need capital outlay not
only at the time of investment but after regular intervals during its expected life.
Consider the following example:
Project A requires an initial outlay at the beginning of the project while Project B needs
cash outflow in year 2 and year 4 also. Decision based on IRR method leads to select
project B but NPV of project B is less than of Project A. again under such circumstances
IRR method plays a deceive role.

Summarizing the above discussion the timings and pattern of cash flows can produce
conflicting results in the NPV and IRR methods of project evaluation.

Public Projects and Cost-Benefit Analysis:

Public projects are undertaken by the Government to enhance the standard of living and welfare
of citizens. Activities such as police forces, health care services, education system belong to
public projects. While evaluating the private projects, the focus is on maximizing profit, in case
of public projects, the objective might be providing goods/services to public at minimum cost
The basic measure of accepting a public project is a benefit-cost (B/C) ratio.
B/C ratio
= PW of Benefits / PW of Costs
= FW of Benefits / FW of Costs
= EAW of Benefits / EAW of Costs
Like private projects, cash flows in public projects are also discounted at a suitable rate known as
Social Discount Rate.
For Independent Projects,
If
B/C ratio > 1, Accept the project
B/C ratio < 1, Reject the project
B/C ratio = 1, Depends on the Govt.

For Mutually exclusive projects, one involving higher B/C ratio is selected. Here, incremental
analysis can also be used to compare carious alternative projects.
Benefits of a public project can be of two types:
i) Primary benefits availability of water, electricity, irrigation etc.
ii) Secondary benefits recreational benefits, other benefits.
For example, benefits from a dam include:
a) water supply for domestic as well as industrial use
b) flood control
c) hydro-power generation
d) recreation
Costs in a public project are all resources required to achieve stated objectives which are:
i) Imputed costs of existing assets employed on another project besides the current use of it.
ii) Preliminary costs of investigation and technical services required to start a project.
iii) Spillover costs which constitute all significant adverse effects caused by the project.
Ex:

In a particular locality of a state, the vehicle users take a roundabout route to reach
certain places because of the presence of a river. This results in excessive travel time and
increased fuel cost. So, the state government is planning to construct a bridge across the
river. The estimated initial investment for constructing the bridge is Rs. 40, 00, 000. The
estimated life of the bridge is 15 years. The annual operation and maintenance cost is Rs.
1, 50, 000. The value of fuel savings due to the construction of the bridge is Rs. 6, 00,
000 in the first year and it increases by Rs. 50, 000 every year thereafter till the end of the
life of the bridge. Check whether the project is justified based on BC ratio by assuming
an interest rate of 12%, compounded annually.

Sol:

Initial investment = Rs. 40, 00, 000

Annual operation and maintenance = Rs. 1, 50, 000
Annual fuel savings during the first year = Rs. 6, 00, 000
Equal increment in fuel savings in the following years = Rs. 50, 000
Life of the project = 15 years
Interest rate = 12%
Total present worth of costs
= Initial investment (P) + Present worth of annual operating and maintenance cost (CP)
= Rs. 40, 00, 000 + 1, 50, 000 (P/A, 12%, 15)
= Rs. 40, 00, 000 + 1, 50, 000 x 6.8109
= Rs. 50, 21, 635
Present worth of fuel savings (BP):
A1
= Rs. 6, 00, 000
G
= Rs. 50, 000
n
= 15 years
i
= 12%
Present worth of the fuel savings (BP)

= [A1 + G (A/G, 12%, 15)] (P/A, 12%, 15)

= [6, 00, 000 + 50, 000 (4.9803)] (6.8109)
BC Ratio

= Bp / (P + Cp)

= Rs. 57, 82, 556

= 57, 82, 556 / 50, 21, 635

= 1.1515

Since the B/C ratio > 1, the construction of the bridge across the river is justified.
Ex:

Two mutually exclusive projects are being considered for investment. Project Al requires
an initial outlay of Rs. 30, 00, 000 with net receipts estimated as Rs. 9, 00, 000 per year
for the next 5 years. The initial outlay for the project A2 is Rs. 60, 00, 000, and net
receipts have been estimated at Rs. 15, 00, 000 per year for the next seven years. There is
no salvage value associated with either of the projects. Using the benefit cost ratio, which
project would you select? Assume an interest rate of 10%.

Sol:

Alternative A1
Initial cost (P)
= Rs. 30, 00, 000
Net benefits / year (B) = Rs. 9, 00, 000
Life (n)
= 5 years
Annual equivalent of initial cost
= P x (A/P, 10%, 5) = 30, 00, 000 x 0.2638
B/C ratio

= Rs. 7, 91, 400

=
= 9, 00, 000 / 7, 91, 400

Alternative A2
Initial cost (P)
= Rs. 60, 00, 000
Net benefits / year (B) = Rs. 15, 00, 000
Life (n)
= 7 years
Annual equivalent of initial cost
= P x (A/P, 10%, 7) = 60, 00, 000 x 0.2054
= 15, 00, 000 / 12, 32, 400

= 1.137

= Rs. 12, 32, 400

= 1.217

The B/C ratio of alternative A2 is more than that of alternative A1 and hence, alternative
A2 is selected.
Limitations of Cost-benefit analysis:
Difficulties in benefit assessment
Arbitrary social discount rate
Ignores opportunity cost
Difficulties in cost assessment

Payback Period Method (PBP):

It is defined as the time period required for a project to return back the capital employed in it. For
example, an investment of Rs. 50,000 which returns Rs. 10,000 per year will have a five year
payback period. Shorter PBPs are more desirable for investors than longer PBPs.
Thus, PBP

= First Cost / Net Annual Savings

Discounted Payback Period:

One of the limitations in using payback period is that it does not take into account the time value
of money. However, the discounted payback period solves this problem. This technique is
somewhat similar to payback period except that the expected future cash flows are discounted for
computing payback period. If discounted payback period is smaller than some pre-determined
number of years then an investment is worth undertaking.
For example an initial investment of Rs. 10,000 (Year 0) generates cash flows from Years 1-6 as
given below:
Year Cash Flows
PV of Cash Flows
Cumulative Cash Flows
0

-$10,000

-$10,000

$-10,000

1500

1389

-8611

2500

2143

-6468

4000

3175

-3293

3000

2205

-1088

3000

2042

+954

6
3000
1891
+2845
The Payback Period occurs in Year 4, when the cash flow turns from a Negative (-1088) to a
Positive (+954).
Thus, Discounted Payback Period = 4 Years + (1088 / 2042) = 4.53 Years

Depreciation Analysis
Depreciation is the decrease in value of physical properties with the passage of time and use.
Production equipment gradually becomes less valuable through wear and tear. This lessening in
value is recognized in accounting practices as an operating expense. Instead of charging the full
purchase price of a new asset as one time expense, the outlay is spread over the life of the asset
in the accounting records. Annual depreciation deductions are intended to match the yearly
fraction of value used by an asset in the production of income over the assets actual economic
life. The actual amount of depreciation can never be established until the asset is retired.
Fixed assets are assets having long-term perspective such as plant, building, machinery etc.
Depreciation is a permanent continuing and gradual shrinkage in book value of a fixed asset.
Current assets are never depreciated. Moreover, depreciation is always charged on book value of
the asset and not on market value of it.

Causes of Depreciation:
1. Physical depreciation: It is caused mainly from wear and tear when the asset is in use
and from corrosion, rust, rot and decay from being exposed to wind, rain, sun and other
elements of nature.
2. Economic Factors: These cause the asset to be put out of use even though it is in good
physical condition. These arise due to obsolescence (Assets become outdated as a result
of introduction of new model of it) and inadequacy (termination of the use of an asset
because of growth and change in size of the firm).
3. Time factors: There are some assets, which loses its values after a particular time period.
Assets having lease, copyrights and patents right loses its value after the time is over.
4. Depletion: Consumption of exhaustible natural resources to produce product or services
is termed as depletion. Removal of oil, timber, rock or minerals from a site decreases the
value of the holding.
5. Accident: Sometimes due to accident or sudden failure the asset loses its technological
characteristic inherent in it.

Need For Providing Depreciation:

To know the true profits: As depreciation is an expense, it is desirable to charge
depreciation on fixed assets for earning purposes. Depreciation amount must be deducted
out of the income earned in order to calculate true net profit/loss of business enterprises.
To show true financial position: Financial position can be studied from the balance
sheet which contains assets and liabilities of a business. If depreciation is not charged on
fixed assets, then their values are overstated which will not show the true financial
position of a business.
To make provisions for replacement of assets: If depreciation is not provided, profits
are overstated and are distributed as dividends to the shareholders. Provision for
depreciation is a charge to P/L account and the accumulated amount provides additional
working capital besides providing sum for replacement of the asset.

Depreciation Methods:
Terminologies:
P
= Purchase price (unadjusted basis) of assets.
S
= Salvage value or future value at end of assets life. It is the expected selling price of a
property when the asset can no longer be used by its owner.
N
= useful (tax) life of asset. This is the expected period of time that a property will be used
in a trade or business or to produce income.
N
= number of years of depreciation
D t (n) = Annual depreciation charges.
B t (n) = Book value shown on accounting records at end of year.
B t (0) = p
Straight line method (SL):

The most widely used and simplest method for the calculation of depreciation is straight line
method. The straight line method assumes that the value of an asset decreases at a constant rate.
Thus if an asset has a first cost of Rs.5, 000 and an estimated salvage value of Rs. 500, the total
depreciation over its life will be Rs. 4, 500. If the estimated life in 5 years, the depreciation per
year will be 4, 500 5 = 900. This is equivalent to a depreciation rate of 1/5 = 20% per year.
The depreciation in any year is DT

PF
n

PF

The book value is BT P t

And the depreciation rate per year is

1
n

Ex:

Initial cost of the asset = Rs. 5000

Life time = 5 years
Salvage value = 0
From the following data find out
a)
The depreciation charge during year 1
b)
The depreciation charge during year 2
c)
The depreciation reserve accumulated by the end of year 3
d)
The book value at the end of year 3

Sol:

(a) & (b): In case of straight line method as the depreciation charge is constant, the
depreciation charges for year 1 and 2 is constant.
DT (1) DT (2)

P F 5000

= 1000 per year

n
5

(c) The depreciation reserve at the end of the third year is the sum of the annual
depreciation charges for the first three years and is equal to 3 (1000) = Rs. 3000
5000
2000
5

(d) The book value at the end of third year is 5000 3

Declining balance Method (DB):

Value of an asset diminishes at a decreasing rate. The declining balance depreciation assumes
that an asset decreases in value faster early rather than in the latter portion of its service life. By
this method a fixed percentage is multiplied times the book value of the asset at the beginning of
the year to determine the depreciation charge for that year. Thus as the book value of the asset
decreases through time, so does the size of the depreciation charge. For example,
First cost = Rs. 5, 000
Salvage value = Rs. 1, 000
Life of the asset = 5 years and
Depreciation rate is 30% per year.
End of year
0
1

Declining Balance method

Depreciation charge during year
Book value at end of year
5000
(0.30) (50000) = 1,500
3,1500

2
(0.30) (3,500) = 1,050
2,450
3
(0.30) (2,450) = 735
1,715
4
(0.30) (1,7115) = 515
1,200
5
(0.30) (1,200) = 360
840
For a depreciation rate a, the general relationship expressing the depreciation charge in any year
for declining balance depreciation is:
D (t) = a. BV (t-1)
BV (t) = BV t-1 D t
Therefore, declining-balance depreciation
BV (t) = BV t-1 a. BV t-1
Thus, D (t) = a (1-a) t-1 P
And BV (t) = (1 - R) P
= P (1-a) t
Double Declining Balance method (DDB):
If the declining balance method of depreciation is used for income tax purposes the maximum
rate that may be used is double the straight line rate that would be allowed to a particular asset
being depreciated. Thus for an asset with an estimated life of N years, the maximum rate that
may be used with this method is R = 2/N. Many firms and individuals choose to depreciate their
assets using declining balance depreciation with maximum allowable rate. Such a depreciation
method is commonly known as the Double Declining Balance method of depreciation.
Ex:

Initial cost = 5000

N = 5 years
S = 0.
Find D t (1), D t (2) and depreciation reserves at the end of year 3, and B t (3).

Sol:

The depreciation rate a

2
2 / 5 0.4
N

D t (1) = [B t (0)] (0.4)

= 5000 (0.4)
D t (2) = [B t (l)] (0.4)
= (5000 - 2000) (0.4)
The depreciation reserve at the end of year 3 is
D t (l) + D t (2) + [B t (2) (0.4)]
= 2000 + 1200 + 720
B t (3) = P - depreciation reserve
= 5000 - 3920

= 2000
= 1200
= 3920
= 1080

Switch From DB/DDB to SL depreciation

A difficulty may arise with the use of declining balance depreciation because in the above
example salvage value is zero. After the end of life time or at the end of year 5, we find that:
B t (5) = P (1 R) N = 5000 (0.6) 5 = 388.88
It is not uncommon for the book value with DB/DDB depreciation to exceed the assets value at
the end of its life. It is allowable under the tax law to depreciate an asset over the early portion of
its life using DB depreciation and then switching to SL depreciation for the remainder of the

assets life. The switch usually occurs when the next periods SL depreciation amount on
undepriciated balance of the asset exceeds the next periods DB depreciation charge.
Suppose, an asset has first cost of 5000, a five year useful life and no salvage value. Determine
an accelerated depreciation schedule. Applying the double declining balance method as was done
for Rs. 5000 and N values.
We know book value B t (5) = 388.8 is higher than the zero salvage value. Therefore to make
book-value zero, we have to switch to straight line method.
End of year

DDB
charges

Book value
SL depreciation on
Book value
with DDB
undepreciated balance
DDB SL
0
5000
5000
1
2000
3000
5000/5 = 100
3000
2
1200
1800
3000/4 = 750
18000
3
720
1080
1800/3 = 600
1080
4
432
648
1080/2 = 540
540
5
259.2
388.8
540
0
At the end of year 2, the book value resulting from DDB depreciation is 1800 which equal the
undepreciated balance because S = 0.
Then the SL charges for the last 3 years would be

= 1800/3

= 600

Since this annual charge is less than DDB charge for 3 rd year, (720), accelerated depreciation is
continued another year. Thus B t (3) = 1080 and the SL depreciation charge for each of the last 2
years 1080/2 = 540. This is larger than the DDB depreciation charge for year 4 (432) and signals
the time to switch.
Sum - of the - years - Digits Method:
To compute the depreciation deduction by the SYD method, the digits corresponding to the
number for each permissible year of life are first listed in reverse order. The sum of these digits is
then determined. The depreciation factor for any year is a number from the reverse ordered
listing for that year divided by the sum of the digits. For example for a property having a
depreciable life of five years, SYD depreciation factors are as follows:
Year
Number of the year in Reverse order
SYD Depreciation Factor
1.
5
5/15
2.
4
4/15
3.
3
3/15
4.
2
2/15
5.
1
1/15
The depreciation for any year is the product of the SYD depreciation factor for that year and the
difference between the cost basis (B) and the estimated final SV.
Ex:

The cost of a vehicle is Rs. 1, 00,000 and the salvage value after 4 years of its useful life
is Rs. 20,000. Calculate the depreciation charges and book value of the asset every year
using sum-of-years-digit method.

Sol:

SYD = 1 + 2 + 3 + 4 = 10
Depreciable Amount = 1, 00,000 20,000 = Rs. 80,000
End of Year
SYD depreciation rate
Depreciation Charge
1
4/10
32,000
2
3/10
24,000
3
2/10
16,000
4
1/10
8,000

Book Value
68,000
44,000
28,000
20,000

Modified Accelerated Cost Recovery System (MACRS):

To determine depreciation schedule appropriate for depreciable property, MACRS has defined
various property classes (life of the asset) and all assets fall into any of the categories. Assets
having life more than or equal to 15 years are depreciated at 150%/N and assets below 15 years
life are depreciated at 200%/N where N is the assets property class.

Procedure for calculation of MACRS Declining balance depreciation

1.
Divide the appropriate percentage (either 200 or 150 per cent) by the number of years
in the recovery period to calculate MACRS depreciation rate.
2.
Divide the result from step 1 by 2 to convert the percentage to the half year
convention for the first year of services.
3.
The percentage for the second year of service is calculated by multiplying the
remaining basis (the current book value) by the base rate.
4.
The procedure is continued until a switch to the straight line methods allowed in order
to reach the terminal salvage value. Since the mid-year convention is used in MACRS,
the remaining life at the end of the year is determined by N K + 0.5 for K = 1, 2 ..N,

Ex:
Sol:

Straight line depreciation for the remaining year is calculated as

D (k) = BV (k) / (N k + 0.5)
Switch from declining balance to straight line Depreciation in MACRS of a 7-year
property class asset having purchase price of Rs. 10,000 with no salvage value
The base rate is 200% / 7
= 28.57
Depreciation charges and book values for different periods are presented below:
End of
year
0
1
2
3
4
5
6

MACRS to Straight line

MACRS
Declining
Straight line
Depreciation rate
balance
deduction
deduction
14.29
24.29
17.49
12.49
8.93
8.93

1429
2429
1749
1249
893
637

1333
1319
1113
972
893
893

Book value
after
depreciation
10,000
8571
6122
4373
3124
2231
1338

7
8.93
455
893
445
8
4.45
325
445
0
th
In the above table up to 4 year, straight line depreciation is less than declining balance
deduction. In the fifth year straight line deduction is equal to dealing balance deduction.
From that year we will switch over to straight line deduction such that book value is zero.

After-tax Economic Evaluations:

Most of the firms pay different types of taxes and one of the most important taxes is income tax
which is levied on the net income of the person. But tax most of the time influences a decision. A
simple adjustment of rate of return calculated without regard for taxes gives an approximation to
the after tax rate of return.
IRR after tax = IRR before tax (1 - effective income tax rate)
For after tax comparisons, following table can be prepared.
Column heading
Column number
Arithmetic computation in column
Investment year
1
Before tax operating cash flow
2
Book value before depreciation 3
MACRS depreciation rate
4
Depreciation charge
5
4 x original basis
Book value after depreciation
6
(3) (5)
Cash flow for debt
7
Cash flow for debt interest
8
Taxable Income
9
(2) (5) (8)
Cash flow for taxes
10
Tax rate x (9)
After tax cash flow
11
(2) (7) (10)
After tax comparison can be made by any comparison methods like PW, EAW or IRR.
Ex:

Initial investment on a machine is 60, 000, i = 15% (After taxes). The Machine is 5 years
MACRS recovery property. Over six years, investment estimated to save 25,000/year.
Annual operating cost is 5,000. It will be depreciated by MACRS method and will have
no salvage value. Income tax rate is 40%. Does the proposal to invest on the machine
satisfy the firms new minimum acceptable rate of return?

Sol:

Lets find out IRR before tax

PW = - 60,000 + (20,000) (P/A, i, 6)
PW (25%)
= - 60, 000 + (20, 000) (2.9514)
PW (23%)
= - 60, 000 + 61, 846
Using interpolation,

1846
2%
1846 (972)

IRR = 23%

=0
= - 60, 000 + 59, 028
= 1, 846

= 23% + [0.655] 0.02

Thus, IRR after tax

= (23.14%) (1 - 0.40) = 13.84%
It will be rejected as if it is below 15%

= 23.14

= -972

After - tax flows (After depreciation)

Investment Before tax Depreciation
Taxable
Taxes 40%
year
cash flow
charge
loan
0
-60,000
1
20,000
12,000
8,000
3,200
2
20,000
19,200
800
320
3
27,000
11,520
8480
3392
4
20,000
6912
13088
5235.2
5
20,000
6912
13088
5235.2
6
20,000
3456
19,644
7857.6
IRR after-tax
= 15.87 %

After taxes
cash flow
-60,000
16,800
19,680
16608
14764.8
14764.8
12142.4

As it is more than 15%, investment can be made on the machine.

Costing
The cost accounting consists of two words: Cost and Accounting. Cost means the resources
sacrificed for the production of a commodity and accounting refers to the financial information
system. Cost accounting system can be described as measurement and reporting of resources
used in monetary terms. Cost accounting is the branch of accounting dealing with the
classification, recording, allocation, summarization and reporting of current and prospective cost.

Costing and cost accounting

We use costing and cost accounting interchangeably. But they should not be. Costing refers to the
technique and process of ascertaining cost. The technique consists of the principles and rules for
the determining the costs of products and services.
Cost accounting on the other hand, is defined as the process of accounting for cost from the point
at which expenditure is incurred. It is that specialized branch of accounting which involves
classification, accumulation, allocation, absorption and control of costs.
According to CIMA, cost accounting is the application of costing and cost accounting principles,
methods and techniques to the science, art and practice of cost control. It includes the
presentation of information derived those from for the purpose of managerial decision making:
a)

b)

c)

Cost Ascertainment: Ascertaining the cost of goods produced and services rendered has
been the chief function of cost accounting. This purpose is some times referred to as
product costing or cost accumulation.
Cost Analysis: Cost analysis is one of the important functions of cost accounting as it
helps in decision making. While making decision, we require information about cost,
revenue and other information. So we have to analyze the cost.
Cost Control: To control the cost is chief motive of every management. Cost information
shows the performance of the organization. There are two types of cost control method:

Standard Costing and Budgetary Control. Actual costs are compared to the budgeted cost.
This help in controlling the cost.

Objectives of cost accounting

1.
2.
3.
4.
5.
6.
7.

The cost accounting helps in ascertaining the cost of production of every units, job,
operation process, department and service.
It indicates management any inefficiency and extent of various forms of waste, whether
in material, time, expense or in the use of machine, equipment and tools.
It provides actual figures of cost for comparison with estimates and to assist the
management in their price fixing policy.
It present comparative cost data for different periods and different volumes of production
and assist the management in budgetary control.
It record and report to the concerned manager how actual costs compare with standard
cost and possible causes of differences between them.
It indicates exact cause of increase/decrease in profit/loss shown by financial accounts.
It provides data for comparison cost within firm and also between similar firms

Cost Centre vs. Cost Unit:

A cost centre is a location (department), person (salesman) or item of equipment (machine) in
relation to which cost may be ascertained. The main purpose of ascertaining cost of a cost centre
is control of cost. For example, in the functional area of marketing, it may become necessary to
distinguish between selling costs which become the responsibility of one area sales manager with
those for which another area manager is responsible. Therefore, in order to relate costs to the
managers concerned and compare the profitability of different areas, a sales territory may be
constituted as a cost centre.
The ascertainment of cost necessitates the determination of unit in terms of which costs are
ascertained. The unit of product/service chosen for the purpose is called a cost unit. The choice
of a cost unit depends on what is being produced, whether goods or services and what is relevant
to the purpose of cost ascertainment. Some of the examples of cost units are given below:
Industry
Cement
Bricks
Nursing home
Electricity
Transport
Printing press
Carpets
Hotel

Cost Unit
Tonne
1000 bricks
Bed per day
Kilowatt hour
Passenger kilometer
Thousand copies
Square foot
Room per day

Elements of Cost:
Following are the three broad elements of cost:

MATERIAL - The substance from which a product is made is known as material. It can be
direct as well as indirect. The material which becomes an integral part of a finished product and
which can be conveniently assigned to specific physical unit is termed as direct material. Some
of the examples of direct material are components specifically purchased, primary packing
materials, partly produced components etc. The material which is used for purposes ancillary to
the business and which cannot be conveniently assigned to specific physical units is termed as
indirect material. Consumable stores, oil and waste, printing and stationery material etc. are
some of the examples of indirect material.
LABOR - For conversion of materials into finished goods, human effort is needed and such
human effort is called labor. Labor can be direct as well as indirect. The labor which actively and
directly takes part in the production of a particular commodity is called direct labor. Direct labor
costs are, therefore, specifically and conveniently traceable to specific products. The labor
employed for the purpose of carrying out tasks incidental to goods produced/services provided, is
indirect labor. It cannot be practically traced to specific units of output. Wages of storekeepers,
foremen, Directors fees, salaries of salesmen etc, are examples of indirect labor costs.
EXPENSES All costs other than materials and labor are termed as expenses. These may be
direct or indirect. Direct expenses can be directly, conveniently and wholly allocated to specific
cost centers/cost units. Examples of such expenses are hire purchase of machinery, cost of
defective work etc. Indirect Expenses are those which cant be directly, conveniently and wholly
allocated to cost centers or cost units. Examples of such expenses are rent, lighting, insurance
charges etc.
Overhead - The term overhead includes indirect material, indirect labor and indirect expenses.
Thus, all indirect costs are overheads. Overheads may be incurred in a factory or office or selling
and distribution divisions. Thus, overheads may be of three types:
Factory Overheads: They include the following things:
Indirect material used in a factory such as lubricants, oil, consumable stores etc.
Indirect labor such as gatekeeper, timekeeper, works managers salary etc.
Indirect expenses such as factory rent, factory insurance, factory lighting etc.
Office and Administration Overheads: They include the following things:
Indirect materials used in an office such as printing and stationery material, brooms etc.
Indirect labor such as salaries payable to office manager, office accountant, clerks, etc.
Indirect expenses such as rent, insurance, lighting of the office
Selling and Distribution Overheads: They include the following things:
Indirect materials used such as packing material, printing and stationery material etc.
Indirect labor such as salaries of salesmen and sales manager etc.
Indirect expenses such as rent, insurance, advertising expenses etc.
Various components of total cost can be depicted with the help of the table below:
Direct material plus Direct labor plus

Prime cost or direct cost or first cost

Direct expenses
Prime cost plus works overheads

Works or factory cost or manufacturing cost

Works cost plus office and

administration overheads

Office cost or total cost of production

Office cost plus selling and

distribution overheads

Cost of sales or total cost

Cost Sheet:
Cost sheet is a document that provides for the assembly of an estimated detailed cost in respect
of cost centers and cost units. It analyzes and classifies in a tabular form the expenses on
different items for a particular period.
Example: Following information has been obtained from the records of XYZ Ltd. for the period
from June 1 to June 30, 1998. Prepare a statement of cost.
Cost of raw materials on June 1,1998

30,000

Purchase of raw materials during the month

4,50,000

Wages paid

2,30,000

Factory overheads

92,000

Cost of work in progress on June 1, 1998

12,000

Cost of raw materials on June 30, 1998

15,000

Cost of stock of finished goods on June 1, 1998

60,000

Cost of stock of finished goods on June 30, 1998 55,000

Selling and distribution overheads

20,000

Sales

9,00,000

Administration overheads

30,000

Solution:
Statement of cost sheet of XYZ Ltd. for the period ending on June 30, 1998.
Opening stock of raw materials
Add-- purchase

30,000
4,50,000
-----------4,80,000

15,000

Less-- closing stock of raw material

Value of raw materials consumed
Wages
Prime cost
Factory overheads
Add-- opening stock of work in progress
Less-- closing stock of work in progress
Factory cost
Add-- Administration overhead
Cost of production of goods manufactured
Add--opening stock of finished goods
Less-- closing stock of finished goods
Cost of production of goods sold
Add-- selling and distribution overheads
Cost of sales
Profit
Sales

4,65,000
2,30,000
6,59,000
92,000
7,87,000
12,000
7,99,000
--7,99,000
30,000
8,29,000
60,000
8,89,000
55,000
8,34,000
20,000
8,54,000
46,000
9,00,000

Classification of Cost:
Cost may be classified into different categories as follows:
1. Fixed, Variable and Semi-Variable Costs:
The cost which varies directly in proportion with every increase or decrease in the volume of
output or production is known as variable cost (Direct cost). For example wages of laborers, cost
of direct material, power etc. The cost which does not vary but remains constant within a given
period of time and a range of activity in spite of the fluctuations in production is known as fixed
cost (Indirect cost). Some of its examples are rent, insurance charges, managers salary etc. The
cost which does not vary proportionately but simultaneously does not remain stationary at all
times is known as semi-variable cost. Some of its examples are depreciation, repairs etc.
2. Product Costs and Period Costs:
The costs which are a part of the cost of a product rather than an expense of the period in which
they are incurred are called as product costs. They become an expense at that time. These costs
may be fixed as well as variable, e.g., cost of raw materials and direct wages, depreciation on
plant and equipment etc.
The costs which are not associated with production are called period costs. They are treated as an
expense of the period in which they are incurred. They may also be fixed as well as variable.

Such costs include general administration costs, salaries salesmen and commission, depreciation
on office facilities etc.
3. Decision-Making Costs and Accounting Costs:
Decision-making costs (future costs) are special purpose costs that are applicable only in the
situation in which they are compiled. They have no universal application. Accounting costs
(historical costs) are compiled primarily from financial statements. They have to be altered
before they can be used for decision-making.
4. Relevant and Irrelevant Costs:
Relevant costs are those which change by managerial decision. Irrelevant costs are those which
do not get affected by the decision. For example, if a manufacturer is planning to close down an
unprofitable retail sales shop, this will affect the wages payable to the workers of a shop. This is
relevant in this connection since they will disappear on closing down of a shop. But prepaid rent
of a shop is irrelevant costs which should be ignored.
5. Shutdown and Sunk Costs:
A manufacturer or an organization may have to suspend its operations for a period on account of
some temporary difficulties, e.g., shortage of raw material, non-availability of requisite labor etc.
During this period, though no work is done yet certain fixed costs, such as rent and insurance of
buildings, depreciation, maintenance etc., for the entire plant will have to be incurred. Such costs
of the idle plant are known as shutdown costs. Sunk costs are the past costs which have been
created by a decision that was made in the past and cant be changed by any decision that will be
made in future. Investments in plant and machinery, buildings etc. are examples of such costs.
6. Out-of-Pocket Costs
Out-of-pocket cost means the present or future cash expenditure regarding a certain decision that
will vary depending upon the nature of the decision made. For example, a company has its own
trucks for transporting raw materials and finished products from one place to another. It seeks to
replace these trucks by keeping public carriers. In making this decision, of course, the
depreciation of the trucks is not to be considered but the management should take into account
the present expenditure on fuel, salary to driver and maintenance. Such costs are termed as outof-pocket costs.
7. Opportunity Cost
Opportunity cost refers to an advantage in measurable terms that have foregone on account of
not using the facilities in the manner originally planned. For example, if a building is proposed to
be utilized for housing a new project plant, the likely revenue which the building could fetch, if
rented out, is the opportunity cost which should be taken into account while evaluating the
profitability of the project.
8. Cost Estimation and Cost Ascertainment
Cost estimation is the process of pre-determining the cost of a certain product job or order. Such
pre-determination may be required for several purposes such as budgeting, measurement of
performance efficiency, preparation of financial statements, make or buy decisions etc. Cost
ascertainment is the process of determining costs on the basis of actual data. Hence, the

computation of historical cost is cost ascertainment while the computation of future costs is cost
estimation.
9. Cost Allocation and Cost Apportionment
Cost allocation refers to the allotment of all the items of cost to cost centers or cost units whereas
cost apportionment refers to the allotment of proportions of items of cost to cost centers or cost
units Thus, the former involves the process of charging direct expenditure to cost centers/cost
units whereas the latter involves the process of charging indirect expenditure to cost centers/cost
units. For example, the cost of labor engaged in a service department can be charged wholly and
directly but the canteen expenses of the factory cant be charged directly and wholly. Its
proportionate share will have to be found out. Charging of costs in the former case will be
termed as allocation of costs whereas in the latter, it will be termed as apportionment of costs.
10. Cost Reduction and Cost Control
Cost reduction and cost control are two different concepts. Cost control is achieving the cost
target as its objective whereas cost reduction is directed to explore the possibilities of improving
the targets. Thus, cost control ends when targets are achieved whereas cost reduction has no
visible end. It is a continuous process.
11. Marginal Costing and Absorption Costing
Marginal costing is formally defined as the accounting system in which variable costs are
charged to cost units and the fixed costs of the period are written-off in full against the aggregate
contribution. Absorption costing on the other hand, charges all costs, both variable and fixed, to
the cost centers/cost units.

Marginal Costing:
The ascertainment of marginal cost is based on the classification and segregation of cost into
fixed and variable cost. Marginal cost is the cost of the marginal or last unit produced. In this
connection, a unit may mean a single commodity, a dozen, or any other measure of goods. For
example, if a manufacturing firm produces X unit at a cost of Rs. 300 and (X + 1) units at a cost
of Rs. 320, the cost of an additional unit will be Rs. 20 which is marginal cost. The marginal cost
varies directly with the volume of production and marginal cost per unit remains the same. It
consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does
not contain any element of fixed cost which is kept separate under marginal cost technique.
Marginal costing may be defined as the technique of presenting cost data wherein variable costs
and fixed costs are shown separately for managerial decision-making. Marginal costing
technique has given birth to a very useful concept of contribution where contribution is given by:
Contribution = Sales revenue less variable cost (marginal cost)
Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution
goes toward recovery of fixed cost and profit, and is equal to fixed cost plus profit. In case a firm
neither makes profit nor suffers loss, contribution will be just equal to fixed cost. This is known
as break even point.

Break-even Analysis:
The break-even analysis (BEA) also known as Cost-Volume-Profit (CVP) analysis has
considerable significance for economic research, business decision-making, investment analysis
etc. This technique traces relationship between costs, revenue and profit at varying levels of
output. In BEA, the break-even point (BEP) is located at the level of output at which the net
income or profit is zero. At this point, total cost is equal to the total revenue. Hence, BEP is the
no-profit-no-loss point.
The term marginal cost is usually applied to the variable cost of a unit of product/service
Marginal costing is a form of management accounting based on the distinction between:
a) the marginal costs of making selling goods or services, and
b) fixed costs, which should be the same for a given period of time, regardless of the level
of activity in the period.
Suppose that a firm makes and sells a single product that has a marginal cost of Rs. 5 per unit
and that sells for Rs. 8 per unit. For every additional unit of the product that is made and sold, the
firm will incur an extra cost of Rs. 5 and receive income of Rs. 8. The net gain will be Rs. 3 per
additional unit. This net gain per unit, the difference between the sales price per unit and the
marginal cost per unit, is called contribution. Contribution means making a contribution towards
covering fixed costs and making a profit. Before a firm can make a profit in any period, it must
first of all cover its fixed costs.
Cost-Volume-Profit (C-V-P) Relationship:
In marginal costing, marginal cost varies directly with the volume of production or output. On
the other hand, fixed cost remains unaltered regardless of the volume of output. If volume is
changed, variable cost varies as per the change in volume. Apart from profit projection, the
concept of C-V-P is relevant to virtually all decision-making areas, particularly in the short run.
The relationship among cost, revenue and profit at different levels may be expressed in graphs
such as breakeven charts, profit volume graphs, or in various statement forms. Profit depends on
a large number of factors, most important of which are the cost of manufacturing and the volume
of sales. Both these factors are interdependent. Volume of sales depends upon the volume of
production and market forces which in turn is related to costs. Management has no control over
market. In order to achieve certain level of profitability, it has to exercise control and
management of costs, mainly variable cost. This is because fixed cost, a non-controllable cost is
dependent on such factors as Volume of production, Product mix, Productivity of the factors of
production, Technology, Size of plant etc.
Thus, the cost-volume-profit analysis furnishes the complete picture of the profit structure. This
enables management to distinguish among the effect of sales, fluctuations in volume and the
results of changes in price of product/services.

Assumptions:
Following are the assumptions on which the theory of CVP is based:
The changes in the level of various revenue and costs arise only because of the changes in
the number of product (or service) units produced and sold.
Total costs can be divided into a fixed component and a component that is variable with
respect to the level of output.
There is linear relationship between revenue and cost.
The unit selling price, unit variable costs and fixed costs are constant.
The analysis either covers a single product or assumes that the sales mix sold in case of
multiple products will remain constant as the level of total units sold changes.
Limitations of break even analysis:
Selling costs are especially difficult to handle in break-even analysis. This is because the
changes in selling costs are a cause and not a result of changes in output and sales.
Costs in a particular period may not be caused entirely by the output in that period. For
example, maintenance expenses may be the result of past output
Break-even analysis assumes that profits are a function of output ignoring the fact that
they are also caused by other factors such as technological change, improved
management, changes in the scale of the fixed factors of production, etc.
A basic assumption in break-even analysis is that the cost-revenue-volume relationship is
linear. This is realistic only over narrow ranges of output
Break-even analysis is not an effective tool for long-range use and its use should be
restricted to the short run only.

Marginal Cost Equations and Breakeven Analysis:

Sales Marginal cost = Fixed cost + Profit = Contribution
1. Contribution
Contribution is the difference between sales and marginal or variable costs. It contributes toward
fixed cost and profit. The concept of contribution helps in deciding breakeven point, profitability
of products, departments etc.
2. Profit Volume Ratio (P/V Ratio), its Improvement and Application
The ratio of contribution to sales is P/V ratio. It is the contribution per rupee of sales and since
the fixed cost remains constant in short-run, P/V ratio will also measure the rate of change of
profit due to change in volume of sales. The P/V ratio may be expressed as follows:
P/V Ratio = Contribution =
Change in Contribution =
Change in Profit
Sales
Change in Sales
Change in Sales
A fundamental property of marginal costing system is that P/V ratio remains constant at different
levels of activity. A change in fixed cost does not affect P/V ratio.
3. Breakeven Point

Breakeven point is the volume of sales or production where there is neither profit nor loss.
S (sales) V (variable cost) = F (fixed cost) + P (profit)
At BEP P = 0
Thus, Break-even point (BEP) = F / (S -V) = Fixed cost / (Sales Variable cost)
= Fixed cost / Contribution per unit
Break-even Sales = Fixed cost
P/V Ratio
4. Margin of Safety (MOS)
Margin of safety is calculated as the difference between the total sales (actual or projected) and
the breakeven sales. It may be expressed in monetary terms (value) or as a number of units
(volume). A large margin of safety indicates the soundness and financial strength of business.
Margin of safety can be improved by lowering fixed and variable costs, increasing volume of
sales or selling price and changing product mix.
Margin of safety =

Sales at selected activity Sales at BEP =

Profit
P/V Ratio

Problem:
A company producing a single article sells it at Rs. 10 each. The marginal cost of production is
Rs. 6 each and fixed cost is Rs. 400 per annum. You are required to calculate the following:
P/V ratio
Breakeven sales
Sales to earn a profit of Rs. 500
Profit at sales of Rs. 3,000
New breakeven point if sales price is reduced by 10%
Margin of safety at sales of 400 units
Particulars

Amount

Amount

Amount

Amount

Units produced

50

100

400

Sales (units * 10)

10

500

1000

4000

Variable cost

300

600

2400

Contribution (sales- VC)

200

400

1600

400

400

Fixed cost
400
400
P/V Ratio = (Contribution / Sales) x 100 = 0.4 or 40%

Breakeven sales (Rs.) = Fixed cost / (P/V Ratio) = 400/ 0.4 = Rs. 1,000
Sales at BEP = Contribution at BEP/ (P/V Ratio) = 100 units
Contribution at profit Rs. 500 = Fixed cost + Profit = Rs. 900
Sales to earn a profit of Rs. 500 = Contribution / (P/V Ratio) = 900/.4 = Rs. 2,250 (or 225 units)
Contribution at sales Rs. 3,000 = Sales x P/V Ratio = 3000 x 0.4 = Rs. 1,200
Profit at sales of Rs. 3,000 = Contribution Fixed cost = Rs. 1200 Rs. 400 = Rs. 800

New P/V ratio when sales price is reduced by 10% = Rs. 9 Rs. 6 / Rs. 9 = 1/3
Sales at BEP = Fixed cost/PV ratio = Rs. 400 / (1/3) = Rs. 1200
Margin of safety (at 400 units) = (4000 1000) / 4000 x 100 = 75 %
(Actual sales BEP sales/Actual sales x 100)
Problem:
The sales and profits during two years are as follows:
Year
Sales
Profit
2006
1, 00,000
15,000
2007
1, 20,000
23,000
You are required to find out:
a) P/V ratio
b) Fixed cost
c) Profit at an estimated sales of Rs. 1, 25,000
d) Sales required to earn a profit of Rs. 20,000
Solution:
a)
P/V ratio =
Change in profit x 100 =
8,000 x 100
Change in sales
20,000

= 40%

b)

Since contribution is 40% of sales, Variable cost = 60% of sales = Rs. 60,000
Fixed cost = 1, 00,000 60,000 15,000 = Rs. 25,000

c)

Contribution, when sales is Rs. 1, 25,000 = 1, 25,000 x 0.4 = Rs. 50,000

Profit = 50,000 25,000 = Rs. 25,000

d)

Sales required to earn a profit of Rs. 20,000 = (Fixed cost + Desired profit) / (P/V ratio)
= (25,000 + 20,000) / 0.40 = Rs. 1, 12,500

Breakeven Analysis - Graphical Presentation

Breakeven chart is a device which shows the relationship between sales volume, marginal costs
and fixed costs, and profit or loss at different levels of activity. Such a chart also shows the effect
of change of one factor on other factors and exhibits the rate of profit and margin of safety at
different levels. A breakeven chart contains total sales line, total cost line and the point of
intersection called breakeven point.
Construction of a Breakeven Chart
1. Select a scale for sales on horizontal axis and a scale for cost and revenue on vertical axis
2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point parallel
to horizontal axis
3. Plot variable costs for some activity levels starting from the fixed cost line and join these
points. This will give total cost line. Alternatively, obtain total cost at different levels; plot
the points starting from horizontal axis and draw total cost line.
4. Plot the maximum or any other sales volume and draw sales line by joining zero and the
point so obtained.

The following Figure shows a typical break even chart.

Limitations and Uses of Breakeven Charts

A simple breakeven chart gives correct result as long as variable cost per unit, total fixed cost
and sales price remain constant. In practice, all these factors may change and the original
breakeven chart may give misleading results. But then, if a company sells different products
having different percentages of profit to turnover, the original combined breakeven chart fails to
give a clear picture when the sales mix changes. In this case, it may be necessary to draw up a
breakeven chart for each product or a group of products. A breakeven chart does not take into
account capital employed which is a very important factor to measure the overall efficiency of
business. Fixed costs may increase at some level whereas variable costs may sometimes start to
decline. For example, with the help of quantity discount on materials purchased, the sales price
may be reduced to sell the additional units produced etc. These changes may result in more than
one breakeven point, or may indicate higher profit at lower volumes or lower profit at still higher
levels of sales.
Nevertheless, a breakeven chart is used by management as an efficient tool in marginal costing,
i.e. in forecasting, decision-making, long term profit planning and maintaining profitability. The
margin of safety shows the soundness of business whereas the fixed cost line shows the degree of
mechanization. The angle of incidence is an indicator of plant efficiency and profitability of the
product or division under consideration.

Multiple Product Situations:

In real life, most of the firms turn out many products. Here, there is no problem with regard to
the calculation of break-even point. However, the assumption has to be made that the sales mix
remains constant. This is defined as the relative proportion of each products sale to total sales. It
could be expressed as a ratio such as 2:4:6, or as a percentage as 20%, 40%, and 60%.
The calculation of breakeven point in a multi-product firm follows the same pattern as in a single
product firm. While the numerator will be the same fixed costs, the denominator now will be
weighted average contribution margin. The modified formula is as follows:
Breakeven point (in units) = Fixed costs / Weighted average contribution margin per unit
B.E. point (in revenue) = Fixed cost / Weighted average P/V ratio

The weights are assigned in proportion to the relative sales of all products. Here, it will be the
contribution margin of each product multiplied by its quantity.
Example:
A furniture manufacture produces and sells the cabinets, office tables and chairs. The various
details regarding his business are given below:
Product
Selling price per
Variable cost per
% of rupee sales
unit Rs.
unit Rs.
volume
File cabinet
1000
900
20
Office tables
500
400
30
Chairs
200
125
50
Capacity of the firm = Rs 1, 50, 000 of total sale volume
Annual fixed cost
= Rs 20, 000
Calculate
1) S BEP and 2) Profit if firm works at 80% of capacity
Solution:
The contribution towards fixed cost in each case is
a)
File cabinet - Rs 1000 - Rs 900 = Rs 100
b)
Office tables - Rs 500 - Rs 400
= Rs 100
c)
Chairs
- Rs 200 - Rs 125
= Rs 75
Now there contributions are to be converted into percentages of sell prices and the formula is
contribution percentage

Selling Pr ice Variable Cost

x 100
Selling Pr ice

Therefore, the contribution percentage for individual items is

100 900
100
x 100
x 100 10%
1000
1000
500 400
100
x 100
x 100 20%
Office tables
500
500
200 125
75
x 100
x 100 37.5%
Chairs
200
200

File cabinet

To get the total contribution per rupee sales volume for the file cabinet, office tables and chairs,
we multiply the contribution percentage of each of the products by the percentage of sales
volume for that particular product and add the figures so obtained.
Furniture (a)
File cabinet
Office tables
Chairs

Contribution % (b)
10
20
37.5

% of sales in Rs (c)
20
30
50

b x c/100
2000/100=2.00
600/100 = 6.00
1875/100=18.7
26.75 or 27%

27% is the total contribution per rupee of overall sales given the present product sales mix.

Fixed Costs

20000

1) BEP Contribution M arg in ratio 27%

2) Profit = Total revenue Total costs

20000
x100 Rs. 74074
27

Here Total revenue = 80% of the total capacity of the firm (given data in the problem)
Therefore, Profit
= 80% of Rs 1, 50, 000 - (Total fixed cost + Total variable cost)
= 1, 20, 000 - (20,000 + 73% of 1, 20, 000)
= Rs 12, 400

Managerial Uses of Break-even Analysis

Break-even analysis not only highlights the areas of economic strength and weaknesses in the
firm but also sharpens the focus on certain leverages which can be operated upon to enhance its
profitability. Through break-even analysis, it is possible to devise managerial actions to enhance
profitability of the firm. The break-even analysis can be used for the following purposes:

Safety Margin: The break-even chart can help the manager to get a fast idea about the
profits generated at the various levels of sales. But while deciding upon the volume at
which the firm would operate, apart from the demand, manager should consider the
Safety Margin associated with the proposed volume. The safety margin refers to the
extent to which the firm can afford a decline in sales before it starts incurring losses. If
the safety margin is dropping over a period of time, it would mean that the firms
resistance capacity to avoid losses has become poorer. A margin of safety can be negative
as well. In that case, it reveals the percentage increase in sales necessary to reach the BEP
so as at least to avoid losses.
Volume Needed to Attain Target Profit: Break-even analysis may be utilized for the
purpose of determining the volume of sales necessary to achieve a target profit.
Fixed cos t T arg etprofit

Target sales volume = Contributi on m arg in unit

Change in Price: The manager is often faced with a problem of whether to reduce price
or not. Before deciding on this question the manager must consider a number of points. A
reduction in price leads to a reduction in the contribution margin. This means that the
volume of sales will have to be increased to maintain the previous level of profit. The
higher the reduction in the contribution margin, the higher is the increase in sales needed
to ensure the previous profit. However, reduction in price may not always lead to a
proportionate increase in the volume of sales. Assuming that the present conditions
continue, break-even analysis will help the manager to know the required volume of sales
to maintain the previous level of profit. And on the basis of its knowledge and
experience, it will be much easier for the management to judge whether the required
increase in sales will be feasible. The formula for determining the new volume of sales to
maintain the same profit, given a reduction in price, is:
New volume of sales =

Fixed cost + Profit______

Variable cost New Selling price

Change in Costs:
If Variable Costs Change
An increase in variable costs leads to a reduction in the contribution margin. Therefore,
when increases in costs are expected or is unavoidable, a common question which arises
is what total sales volume we need to maintain our present profits without any increase in
price or, in the alternative, what price should be fixed for the product to maintain our
present profit without any change in sales volume. The formula to determine the new
quantity (Q n) when there is a change in variable costs is:
New quantity =

Fixed cost + Profit______

New selling price Variable cost

If Fixed Costs Change

An increase in fixed costs of a firm may be caused either by external circumstances (e.g.,
an increase in machinery costs, taxes, etc) or by a managerial decision (e.g., an increase
in salaries). Then a question arises on what total sales volume do we need to maintain to
have our present profits without any increase in price or in the alternative, what price
should be set if there is no change in sales volume? The formula to determine the new
quantity (Q n) or the new price (SP n3) given a change in fixed costs would be:
Qn Q

FCn FC
SP VC

COMMERCIAL BANKING
A bank is an institution which deals with money and credit. It accepts deposits from the public,
makes the funds available to those who need them, and helps in the remittance of money from
one place to another.
According to the Indian Companies Act, 1949, banking means the accepting for the purpose of
Indian Companies lending or investment, of deposits of money from the public, repayable on
demand or otherwise, and withdrawal by cheques, draft or otherwise.

FUNCTIONS OF COMMERCIAL BANKS OR MODERN BANKS

In the modern world, banks perform such a variety of functions that it is not possible to make an
all-inclusive list of their functions and services. However, some basic functions performed by the
banks are discussed below.

a.

Accepting Deposits:
The first important function of a bank is to accept deposits from those who can save but
cannot profitably utilize this saving themselves. People consider it more rational to
deposit their savings in a bank because by doing so they, on the one hand, earn interest,

and on the other, avoid the danger of theft. To attract savings from all sorts of individuals,
the banks maintain different types of accounts:
(i)
Fixed Deposit Account (Time deposits) - Money in these accounts is deposited
for fixed period of time (say one, two, or five years) and cannot be withdrawn
before the expiry of that period. The rate of interest on this account is higher than
that on other types of deposits. Longer the period, higher will be rate of interest.
(ii)
Current Deposit Account (Demand deposits) - These accounts are generally
maintained by the traders and businessmen who have to make a number of
payments every day. Money from these accounts can be withdrawn in as many
times and in as much amount as desired by the depositors. Normally, no interest is
paid on these accounts.
(iii)
Saving Deposit Account - The aim of these accounts is to encourage and
mobilize small savings of the public. Certain restrictions are imposed on the
depositors regarding the number of withdrawals and amount to be withdrawn in a
given period. Cheques facility is provided to the depositors. Rate of interest paid
on these deposits is low as compared to that on fixed deposits.
(iv)
Recurring Deposit Account - The purpose of these accounts is to encourage
regular savings by the public, particularly by the fixed income group. Generally
money in these accounts is deposited in monthly installments for a fixed period
and is repaid to the depositors along with interest on maturity.

b.

Advancing of loans:
The second important function of a bank is advancing of loans to the public. After
keeping certain cash reserves, the banks lend their deposits to the needy borrowers.
Before advancing loans, the banks satisfy themselves about the creditworthiness of the
borrowers. Various types of loans granted by the banks are discussed below:
(i)
Money at Call - Such loans are very short period loans and can be called back by
the bank at a very short notice of say one day to fourteen days. These loans are
generally made to other banks or financial institutions.
(ii)
Cash Credit - It is a type of loan which is given to the borrower against his
current assets, such as shares, stocks, bonds, etc. The bank opens the account in
the name of the borrowers and allows him to withdraw borrowed money from
time to time up to a certain limit as determined by the value of his current assets.
Interest is charged only on amount actually withdrawn from the account.
(iii)
Overdraft - Sometimes, the bank provides .overdraft facilities to its customers
though which they are allowed to withdraw more than their deposits. Interest is
charged from the customers on the overdrawn amount.
(iv)
Discounting of Bills of Exchange - This is another popular type of lending by the
modern banks. In a bill of exchange the debtor accepts the bill drawn upon him by
the creditor and agrees to pay. After making some marginal deductions (in the
form of commission), the bank pays the value of the bill to the holder. When the
bill of exchange matures, the bank gets its payment from the party which had
accepted the bill. Thus, such a loan is self-liquidating.
(v)
Term Loans - The banks have also started advancing medium-term and long-term
loans. The maturity period for such loans is more than one year. The amount
sanctioned is either paid or credited to the account of the borrower. The interest is

charged on the entire amount of the loan and the loan is repaid either on maturity
or in installments.

c.

Credit Creation:
A unique function of the bank is to create credit. In fact, credit creation is the natural
outcome of the process of advancing loan as adopted by the banks. When a bank
advances a loan to its customer, it does not lend cash but opens an account in the
borrowers name and credits the amount of loan to this account. Thus, whenever a bank
grants a loan, it creates an equal amount of bank deposit. Creation of such deposits is
called credit creation which results in a net increase in the money stock of the economy.

d.

Promoting Cheques System:

Banks also render a very useful medium of exchange in the form of cheques. Through a
cheque, the depositor directs the bankers to make payment to the payee. Cheque is the
most developed credit instrument in the money market. In the modern business
transactions, cheques have become much more convenient method of settling debts than
the use of cash.

e.

Agency Functions:
Banks also perform certain agency functions for and on behalf of their customers:
(i)
Remittance of Funds - Banks help their customers in transferring funds from one
place to another through cheques, drafts, etc.
(ii)
Collection and Payment of Credit Instruments - Banks collect and pay various
credit instruments like cheques, bills of exchange, promissory notes.
(iii)
Execution of Standing Orders - Banks execute the standing instructions of their
customers for making various periodic payments. They pay subscriptions, rents,
insurance premium etc. on behalf of their customers.
(iv)
Purchasing and Sale of Securities - Banks undertake purchase and sale of
various securities like shares, stocks, bonds, debentures etc. on behalf of their
customers.
(v)
Collection of Dividends on Shares - Banks collect dividends, interest on shares
and debentures of their customers.
(vi)
Acting as Representative and Correspondent - Sometimes the banks act as
representatives and correspondents of their customers. They get passports,
travelers tickets, book vehicles, plots for their customers and receive letters on
their behalf.

f.

General Utility Function:

In addition to agency services, the modern banks provide many general utility services as
given below:
(i)
Locker Facility - Banks provide locker facility to their customers. The customers
can keep their valuables and important documents in these lockers for safe
custody.
(ii)
Travelers Cheques - Banks issue travelers cheques to help their customers to
travel without the fear of theft or loss of money. With this facility, the customers
need not take the risk of carrying cash with them during their travels.

(iii)
(iv)

(v)
(vi)
(vii)

Letters of Credit - Letters of credit are issued by the banks to their customers
certifying their creditworthiness. Letters of credit are very useful in foreign trade.
Collection of Statistics - Banks collect statistics giving important information
relating to industry, trade and commerce, money and banking. They also publish
journals and bulletins containing research articles on economic and financial
matters.
Underwriting Securities - Banks underwrite the securities issued by the
government, public or private bodies. Because of its full faith in banks, the public
will not hesitate in buying securities carrying the signatures of a bank.
Gift Cheques - Some banks issue cheques of various denominations (say of
Rs.11, 21, 31, 51.101, etc.) to be used on auspicious occasions.
Foreign Exchange Business - Banks also deal in the business of foreign
currencies. Again, they may finance foreign trade by discounting foreign bills of
exchange.

BANKS AND ECONOMIC DEVELOPMENT

In a modern economy, banks are to be considered not merely as dealers in money but also the
leaders in development. They are not only the store houses of the countrys wealth but also are
the reservoirs of resources necessary for economic development. It is the growth of commercial
banking in the 18th and 19th centuries that facilitated the occurrence of industrial revolution in
Europe. Similarly, the economic progress in the present day developing economies largely
depends upon the growth of sound banking system in these economies.
Commercial banks can contribute to countrys economic development in following ways:

1.

Capital Formation:
Capital formation is the most important determinant of economic development and banks
promote capital formation. Capital formation has three well-defined stages:
(a)
Generation of saving - They stimulate savings by providing a number of
incentives to the savers, such as, interest on deposits, free and cheap remittance of
funds, safe custody of valuables, etc.
(b)
Mobilization of saving - By expanding branches in different areas and giving
various incentives, they succeed in mobilizing savings generated in the economy.
(c)
Canalization of saving in productive uses - They not only mobilize resources
from those who have excess of them, but also make the resources so mobilized
available to those who have the opportunities of productive investment.

2.

Encouragement to Entrepreneurial Innovations:

In underdeveloped countries, entrepreneurs generally hesitate to invest in new ventures
and undertake innovations largely due to lack of funds. Facilities of bank loans enable the
entrepreneurs to step up investment and innovational activities, adopt new methods of
production and increase productive capacity of economy.

3.

Monetization of Economy:

Monetization of the economy is essential for accelerating trade and economic activity.
Banks, which are creators and distributors of money, allow money to play active role in
the economy.

4.

Influencing Economic Activity:

Banks can directly influence economic activity, and hence, the pace of economic
development through its influence on:
(a)
Variations in Interest Rates - A reduction in the interest rates makes the
investment more profitable and stimulates economic activity. An increase in the
interest rate, on the other hand, discourages investment and economic activity.
(b)
Availability of Credit - Bankers can also influence economic activity by the
availability of credit. Through their credit creation activity the banks increase the
supply of purchasing power and hence the aggregate demand. This, in turn,
increases investment, production and trade in the economy.

5.

Implementation of Monetary Policy:

Economic development needs an appropriate monetary policy. But, a well-developed
banking system is a necessary pre-condition for the effective implementation of the
monetary policy. Control and regulation of credit by the monetary authority is not
possible without the active cooperation of the baking system in the country.

6.

Promotion of Trade and Industry:

Economic progress in the industrially advanced countries in the last two hundred years or
so is mainly due to expansion in trade and industrialization which could not have been
made possible without the development of banking system. The use of bank cheque, the
bank draft and the bill of exchange has revolutionized the internal and international trade.

7.

Encouragement to Right Type of Industries:

By granting loans (particularly medium-term and long-term), the banks can provide
financial resources to the right type of industries to secure necessary material, machines
and other inputs. In a planned economy, it is necessary that the banks should formulate
their loan policies in accordance with the broad objectives and strategy of
industrialization as adopted in the plan. This will promote right type of industrialization
in the economy.

8.

Regional Development:
Banks can also play an important role in achieving balanced development in different
regions of the economy. They can transfer surplus capital from the developed regions to
the less-developed regions where it is scarce and most needed. This reallocation of funds
between regions will promote economic development in underdeveloped areas of the
economy.

9.

Development of Agriculture and Other Neglected Sectors:

Underdeveloped economies are primarily agricultural economies and majority of the
population in these economies live in rural areas. Therefore, economic development in
these economies requires the development of agriculture and small-scale industries in
rural areas. So far, banks, in underdeveloped countries have been paying more attention

to trade and commerce and have almost neglected agriculture and industry. Thus,
necessary structural and functional reforms in the banking system of the underdeveloped
countries should be made in older to encourage the banks to play developmental role in
these economics.

TYPES OF BANKS
Banks can be classified into various types on the basis of their functions, ownership, domiciles
etc. The following are the various types of banks:

1. Commercial Banks:
The banks which perform all kinds of banking business and generally finance trade and
commerce are called commercial banks. Since their deposits are for a short period, these
banks normally advance short-term loans to the businessmen and traders. However,
recently, the commercial banks have also extended their areas of operation to mediumterm and long-term finance. Majority of the commercial banks are in the public sector.
But, there are certain private sector banks operating as joint stock companies. Hence, the
commercial banks are also called joint stock banks.

2. Industrial Banks:
Industrial banks also known as investment banks, mainly meet the medium-term and
long-term financial needs of the industries.
The main functions of the industrial banks are:
(a)
They accept long-term deposits
(b)
They grant long-term loans to the industrialists to enable them to purchase land,
construct factory building, purchase heavy machinery, etc.
(c)
They help selling or even underwrite the debentures and shares of industrial firms
(d)
They can also provide information regarding the general economic position of the
economy.
In India, industrial banks, like Industrial Development Bank of India, Industrial Finance
Corporation of India, State Finance Corporations, are playing significant role in the
industrial development of the country.

3. Agricultural Banks:
Agricultural credit needs are different from those of industry and trade. Industrial and
commercial banks normally do not deal with agricultural finance.
The agriculturists require:
(a)
Short-term credit to buy seeds, fertilizers and other inputs, and
(b)
Long-term credit to purchase land, to make permanent improvements on land, to
purchase agricultural machinery and equipment, etc.
In India, agricultural finance is generally provided by co-operative institutions.

4.

Exchange Banks:

Exchange banks deal in foreign exchange and specialize in financing foreign trade. They
facilitate international payments through the sale and purchase of bills of exchange and
thus play an important role in promoting foreign trade.

5. Saving Banks:
The main purpose of saving banks is to promote saving habits among he general public
and mobilize their small savings. In India, postal saving banks do this job. They open
accounts and issue postal cash certificates.

6. Central Bank:
Central bank is the apex institution which controls, regulates and supervises the monetary
and credit system of the country.
Important functions of the central bank are:
(a)
It has the monopoly of note issue
(b)
It acts as the banker, agent and financial adviser to the slate
(c)
It is the custodian of member banks reserves
(d)
It is the custodian of nations reserves of international currency
(e)
It serves as the lender of the last resort
(f)
It functions as the bank of central clearance, settlement and transfer and
(g)
It acts as the controller of credit.

7. Classification on the Basis of Ownership:

(a)
(b)
(c)

8.

Public Sector Banks - These are owned and controlled by the government. In
India, the nationalized banks and the regional rural banks come under these
categories
Private Sector Banks - These banks are owned by the private individuals or
corporations and not by the government or cooperative societies
Cooperative Banks - Cooperative banks arc operated on the cooperative lines. In
India, cooperative credit institutions are organized under the cooperative societies
law and play an important role in meeting financial needs in the rural areas.

Classification on the Basis of Domicile:

(a)
(b)

Domestic Banks - These are registered and incorporated within the country
Foreign Banks - These are foreign in origin and have their head offices in the
country of origin.

9. Scheduled and Non-Scheduled Banks:

In India, banks have been broadly classified into scheduled and non-scheduled banks. A
Scheduled Bank is that which has been included in the Second Schedule of the Reserve
Bank of India Act, 1934 and fulfills the three conditions:
(a)
It has paid-up capital and reserves of at least Rs. 5 lakhs
(b)
It ensures the Reserve Bank that its operations are not detrimental to the interest
of the depositors
(c)
It is a corporation/cooperative society and not a partnership or single owner firm.

The banks which are not included in the Second Schedule of the Reserve Bank of India
Act are non-scheduled banks.

BALANCE SHEET OF A BANK

The balance sheet of a bank is a statement of its liabilities and assets at a particular time.
Liabilities refer to all debit items representing the obligations of the bank or others claims on the
bank. In other words, all those items because of which the bank is liable to pay to others form the
liabilities of the bank. Assets, on the other hand, refer to all credit items representing the banks
claims on others and its ownership of wealth.
Table 1: Balance Sheet of a bank
Liabilities
Assets
1. Share Capital
1. Cash
2. Reserve fund
(a) Cash in hand
3. Deposits:
(b) Cash with central bank
(a) Demand deposits
(c) Cash with other banks
(b) Time deposits
2. Money at call and shot notice
(c) Saving deposits
3. Bills purchased or discounted
4. Borrowings from other banks
4. Investments
5. Acceptance and endorsements.
5. Loans and advances
6. Other liabilities
6. Acceptance and endorsements
7. Buildings and other fixed assets
Total
Total
Thus, the balance sheet shows how a bank raises funds and how it invests them. It is customary
that the liabilities are mentioned on the left side and the assets on the right side of the balance
sheet. The totals on the two sides (i.e., the total liabilities and the total assets) are always equal.

Liabilities of the Bank:

1.

Share Capital:
A joint stock bank initially raises its funds by issuing share capital. In other words, share
capital is the contributions made by the shareholders. Share capital is in the form of:
(a)
Authorized capital - the maximum amount of capital the bank is authorized to
raise in the form of shares
(b)
Issued capital - the part of the authorized capital issued in the form of shares for
public subscription
(c)
Subscribed capital - the part of the issued capital actually subscribed by the
public and part of the subscribed capital actually paid by the subscribers.
(d)
Paid-up capital - It is the actually paid-up share capital which constitutes the
liability of the bank.

2.

Reserve Fund:
Reserve fund is the amount accumulated over the years out of undistributed profits.
Normally, all the profits of the bank are not distributed among the shareholders; some
part is retained undistributed for meeting contingencies. This reserve fund actually
belongs to the shareholders.

3.

4.

5.

Deposits:
Deposits from the public constitute the major portion of the banks working capital.
Various types of deposits accepted by the bank are:
(a)
Demand deposits - the deposits which can be withdrawn at any time and on
which no interest is paid
(b)
Time deposits - the deposits which can be withdrawn after a fixed period of time
and on which high rate of interest is paid and
(c)
Saving deposits - the deposits which can be withdrawn to the limited extent in a
given period and on which some interest is paid.
Borrowings from Banks:
Sometimes, the bank borrows loans from other banks on temporary basis to meet the
increased demand for money. Central bank is the lender of the last resort and provides
loan facilities to the banks in special circumstances. All these borrowings form the
liability of the borrower bank.
Other Liabilities:
Certain other miscellaneous liabilities are incurred by the bank. For example, by acting as
an agent the bank makes collections on behalf of its customers and thus creates liability.
Again, the profits earned by the bank represent the liability because they arc payable to
the shareholders.

Assets of the Bank:

The asset side of the balance sheet shows the manner in which the funds of the bank are utilized.
Given below are various assets of the bank arranged in an ascending order of profitability and
descending order of liquidity:
1.

Cash:
Cash is the most liquid but non-earning asset and is considered as the first line of defense.
Every bank keeps certain amount of cash in order to meet the cash requirements of its
depositors.

2.

Money at Call and Short Notice:

Money at call and short notice refers to loans which are recoverable by the bank on
demand or at a very short notice. These loans are for a maximum period of 15 days. Such
loans are earning as well as highly liquid assets which can be converted into cash quickly
and without loss.

3.

Bills purchased or discounted:

The bank utilizes its funds in trade bills and treasury bills which it discounts. The amount
of the bills is collected by the bank on maturity. The bills discounted are short-term
(normally of 90 days) self-liquidating assets. They are self-liquidating because, at the end
of the commercial transaction, the money will be repaid.
Investments:
Some funds are invested in profit-yielding assets, mainly the government securities.
Government securities arc relatively safe because there is certainty of repayment after
maturity. Moreover, the banks can borrow from the central bank against these securities.

4.

5.

Loans and Advances:

Loans and advances are the most profitable and the least liquid assets of the bank. Banks
provide loans and advances to the businessmen either through overdraft or by discounting
of bills of exchange. The difference between loans and advances is that the advances are
for short period and loans are for relatively longer period. Loans and advances earn high
rate of interest, carry greater risk and are generally non-shiftable.

6.

Building and other Fixed Assets:

Banks assets also include the value of the movable and immovable properties of the
bank, such as office buildings, furniture etc. These assets do not contribute to the income
of the bank and constitute very small properties of the assets of the bank.

The importance of the balance sheet of a bank clearly brings out the following points:
i)
It represents the complete functioning of the bank. It tells how the bank raises money and
how it invests it.
ii)
It throws light on the financial position (i.e., liquidity and solvency position) of the bank
because it contains all information about the liabilities and assets of the bank.
iii)
The progress of the bank over time can be determined by comparing the balance sheet of
different periods
iv)
A comparison of balance sheet of different banks gives comparative picture of financial
position of a bank vis a vis that of others.
v)
It gives an estimate of the confidence of the public in the bank. Increasing saving or time
deposits of bank represent that the confidence of the people in the bank is also increasing.
vi)
It shows the loans and investment policy of the bank.
vii)
It provides information about the interest of various persons, such as shareholders,
debtors, creditors, etc.

NEW TRENDS IN COMMERCIAL BANKING

Drastic changes have been experienced in both theory and practice of commercial banking the
world over especially in the post-war period. Major changes are discussed below:
1.

New Developments in Banking Theory:

Traditional commercial loan theory has now been completely discarded and has given
place to the modern shiftability and anticipated income theories. All these theories
attempt to resolve the liquidity-earning problem of the bank, i.e., how a bank can achieve
the two conflicting objectives of liquidity as well as profitability simultaneously.
According to commercial loan theory, the banks can ensure sufficient liquidity by
granting only short-term self- liquidating loans secured by goods in the process of
production or goods in transit. The shiftability theory requires the banks to solve their
liquidity problem by purchasing highly liquid assets which can be easily shifted to other
banks in times of need for liquidity. According to the recent anticipated income theory,
the banks can solve their liquidity problem even by advancing long-term loans if the
borrowers repay the loans in series of continuous installments.

2.

Term Lending:

Term loans not only increase earnings of the banks, but also improve their liquidity
because such loans are almost always repaid on an installment basis. The term loans are
also beneficial to the borrowers. They are used to purchase machinery and equipment for
the industries where the expected income flow from the investment will not be sufficient
to repay a short-term loan.
3.

4.

Hire Purchase Finance:

Hire purchase finance, which refers to the credit facilities for the purchase of durable
goods on installment basis, is another post-war development in commercial banking. The
dealers selling on hire-purchase get advances from the banks by hypotheticating their
goods to the banks. Hire purchase facilities help the small entrepreneurs to start new
business and the existing small producers to purchase new tools and equipment. The
commercial banks entered into this highly profitable business by acquiring the direct
ownership of, or a partnership in the established hire-purchased finance companies.
Personal Loans:
Another departure from the traditional banking practice is the advancing of personal
loans by commercial banks. This is a direct consequence of post-war policy of
redistribution of income in favor of the working class which was instrumental in
stimulating consumer credit by the banks. Commercial banks started granting personal
loans for meeting expenditures to purchase motor cars, household appliances,
professional equipment, house repairs and decorations, etc.

CHANGING
PATTERNS
DEVELOPING COUNTRIES

OF

COMMERCIAL

BANKING

IN

Quite recently, the commercial banking has undergone a number of structural and functional
changes in developing countries like India. The major changes are mentioned below:
i)
The commercial banks in the developing countries are slowly departing from the
traditional strict self-financing rules favoring risk free self-liquidating loans. They have
now started adhering to the shiftability theory which maintains that as long as the assets
of the commercial banks can be shifted or sold for liquidity, the banks can extend the
period of lending.
ii)
The Indian commercial banks have recently started providing hire-purchase finance.
These banks advance loans for purchasing consumer durables (mainly motor cars) and
producers equipment.
iii)
Some Indian banks grant personal loans to their customers for purchasing consumer
durable, like motor cars, scooters, electric fans, professional equipment, agricultural
equipment, etc. Such loans are made available to the individuals with stable and
continuous income, particularly to the government servants, employees of statutory
bodies and of established industrial, financial, and commercial institutions.
iv)
The structure of commercial bank lending in the developing countries (e.g., India, Ghana,
and Libya) has changes from commerce to industry.
v)
In India, after the nationalization of major commercial banks in 1969, direct lending to
agriculture by the commercial banks has shown notable increases.

RESERVE BANK OF INDIA

The Reserve Bank of India is Indias central bank. It is the apex monetary institution which
supervises, regulates controls and develops the monetary and financial system of the country.
The Reserve bank was established on April 1, 1935 under the Reserve Bank of India Act, 1934.
Initially, it was constituted as a private shareholders bank with a fully paid-up capital of Rs. 5
crore. But, it was nationalized on January 1, 1949.

Organization:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.

Issue Department - Its main function is to issue, and distribute the paper currency.
Banking Department - This department deals with government transactions, manages
public debt and arranges for the transfer of government funds, maintains the cash reserves
Department of Banking Development - It aims at expanding banking facilities in
unbanked and rural areas.
Department of Banking Operations - Its function is to supervise, regulate and control
the working of the banking institutions in the country.
Agricultural Credit Department - It deals with the problems of agricultural credit and
provides facilities of rural credit to state governments and state cooperatives.
Industrial Finance Department - Its main objective is to provide financial help to the
small and medium scale industries.
Non-Banking Companies Department - It supervises the activities of non-banking
companies and financial institutions in the country
Exchange Control Department - It conducts the business of sale and purchase of
foreign exchange.
Legal Department - It provides advice to various departments on legal issues. It also
gives legal advice on the implementation of banking laws in the country.
Department of Research and Statistics. It conducts research on problems relating to
money, credit, finance, production, collect important statistics relating to various aspects
of the economy; and publish these statistics.
Department of Planning and Reorganization - It deals with the formulation of new
plans or reorganization of existing policies for making them more effective.
Economic Department - It is concerned with framing proper banking policies for better
implementation of economic policies of the government.
Inspection Department - It undertakes the function of inspecting various offices of the
commercial banks.
Department of Accounts and Expenditure - It keeps proper records of all receipts and
expenditures of the Reserve Bank.
RBI Services Board - It deals with the selection of new employees, for different posts in
the Reserve Bank.

Management:
The management of the Reserve Bank is under the control of Central Board of Directors
consisting of 20 members:
(a)
The executive head of the Bank is called Governor who is assisted by four Deputy
Governors. They are appointed by the Government of India for a period of five years. The
head office of the Reserve Bank is at Bombay

(b)

(c)

There are four local boards at Delhi, Calcutta, Madras and Bombay representing four
regional areas, i.e., northern, eastern, southern and western respectively. These local
boards are advisory in nature and the Government of India nominates one member each
from these boards to the Central Board
There are ten directors from various fields and one government official from the Ministry
of Finance.

FUNCTIONS OF RESERVE BANK

The Reserve Bank of India performs various traditional central banking functions as well as
undertakes different promotional and developmental measures to meet the dynamic requirements
of the country.
The broad objectives of the Reserve Bank are:
(a)
Regulating the issue of currency in India
(b)
Keeping the foreign exchange reserves of the country
(c)
Establishing the monetary stability in the country and
(d)
Developing the financial structure of the country on sound lines consistent with the
national socio-economic objectives and policies.
Main functions of the Reserve Bank are described below:

1.

Note Issue:
The Reserve Bank has the monopoly of note issue in the country. It has the sole right to
issue currency notes of all denominations except one rupee notes. One rupee notes are
issued by the Ministry of Finance of the Government of India. The Reserve Bank acts as
the only source of legal tender because even the one rupee notes are circulated through it.

2.

Banker to Government:
The Reserve Bank acts as the banker, agent and adviser to Government of India:
(a)
It maintains and operates government deposits
(b)
It collects and makes payments on behalf of the government
(c)
It helps the government to float new loans and manages the public debt
(d)
It provides development finance to the government for carrying out 5- year plans
(e)
It undertakes foreign exchange transactions on behalf of the Central Government
(f)
It acts as the agent of the Government of India in the latters dealings with the
IMF, the World Bank, and other international financial institutions

3.

Bankers Bank:
The Reserve Bank acts as the bankers bank in the following respects:
(a)
Every Bank is under the statutory obligation to keep a certain minimum of cash
reserves with the Reserve Bank. The purpose of these reserves is to enable the
Reserve Bank to extend financial assistance to the scheduled banks in times of
emergency and thus to act as the lender of the last resort.
(b)
The Reserve Bank provide financial assistance to scheduled banks by discounting
their eligible bills and through loans and advances against approved securities
(c)
Under the Banking Regulation Act, 1949 and its various amendments, the Reserve
Bank has been given extensive powers of supervision and control over the
banking system. These regulatory powers relate to the licensing of banks and their

branch expansion; liquidity of assets of the banks; management and methods of

working of the banks; reconstruction and liquidation of banks etc.

4.

Custodian of Exchange Reserves:

The Reserve Bank is the custodian of Indias foreign exchange reserves. It maintains and
stabilizes the external value of the rupee, administers exchange controls and other
restrictions imposed by the government, and manages the foreign exchange reserves. The
Reserve Bank sells and buys foreign currencies in order to achieve the objective of
exchange stability.

5.

Controller of Credit:
As the central bank of the country, the Reserve Bank undertakes the responsibility of
controlling credit in order to ensure internal price stability and promote economic growth.
Through this function, the Reserve Bank attempts to achieve price stability in the country
and avoids inflationary and deflationary tendencies in the country. The Reserve Bank
regulates money supply in accordance with the changing requirements of the economy.

6.

Ordinary Banking Functions:

The Reserve Bank also performs various ordinary banking functions:
(a)
It accepts deposits from the central government, state governments and even
private individuals without interest
(b)
It grants loans and advances to the central government, state governments, local
authorities, scheduled banks and state cooperative banks repayable within 90 days
(c)
It buys and sells securities of the Government of India and foreign securities
(d)
It can borrow from any scheduled bank in India or from any foreign bank
(e)
It can open an account in the World Bank or in some foreign central bank
(f)
It buys and sells gold and silver.

7.

Promotional and Developmental Functions:

The Reserve Bank also performs a variety of promotional and developmental functions:
(a)
By encouraging the commercial banks to expand their branches in the semi-urban
and rural areas
(b)
By establishing the Deposit Insurance Corporation, the Reserve Bank helps to
develop the banking system of the country, instills confidence of the depositors
and avoids bank failures
(c)
Through the institutions like Unit Trust of India, the Reserve Bank helps to
mobilize savings in the country
(d)
Since its inception, the Reserve Bank has been making efforts to promote
institutional agricultural credit by developing cooperative credit institutions
(e)
The Reserve Bank also helps to promote the process of industrialization in the
country by selling up specialized institutions for industrial finance

MONETARY POLICY OF THE RESERVE BANK

Monetary policy refers to the policy of the central bank of a country to regulate and control the
volume, cost and allocation of money and credit with the aim of achieving the objectives of

optimum levels of output and employment, price stability, balance of payment equilibrium, or
any other goal set by the government.
Monetary and fiscal policies are closely interrelated and therefore should be pursued in
coordination with each other. Fiscal policy generally brings about changes in money supply
through the budget deficit. An excessive budget deficit, for example, shifts the burden of control
of inflation to monetary policy. This requires a restrictive credit policy. On the contrary, a fiscal
policy, which keeps the budget deficit at a very low level, frees the monetary authority from the
burden of adopting an anti-inflationary monetary policy.
In a developing economy like India, appropriate monetary policy can play a positive role in
creating conditions necessary for rapid economic growth. Moreover, since these economies are
highly sensitive to inflationary pressures, the monetary policy should also serve to control
inflationary tendencies by increasing savings by the people, checking credit expansion by the
banking system and discouraging deficit financing by the government
In India, during the planning period, the aim of the monetary policy of the Reserve Bank has
been to meet the needs of the planned development of the economy. With this broad aim, the
monetary policy has been pursued to achieve the twin objectives of the economic policy of the
government:
(a)
To accelerate process of economic growth with a view to raise national income,
(b)
To control and reduce the inflationary pressures in the economy.

Policy of Credit Expansion:

The overall trend in the economy during planning period has been that of continuous expansion
of currency and credit with an objective of meeting the developmental needs of the economy.
This expansion has been achieved by adopting the following measures:
1.
Revision of Open Market Operations:
The Reserve Bank revised its open operations policy in October 1956, according to which
it started giving discriminatory support to the sale and purchase of government securities.
2.
Liberalization of the Bill Market Scheme:
Through the bill market scheme, the commercial banks receive additional funds from the
Reserve Bank to meet the increasing credit requirements of their borrowers.
3.
Facilities to Priority Sectors:
The Reserve Bank continues to provide credit facilities to priority sectors such as smallscale industries and cooperatives, even though the general policy of the Bank is to control
credit expansion.
4.
Credit Facilities through Financial Institutions:
The Reserve Bank has also been instrumental in the establishment of various financial
institutions like Industrial Development Bank of India, Industrial Finance Corporation of
India, Industrial Credit and Investment Corporation of India, State Finance Corporations,
and National Bank for Agriculture and Rural Development.
5.
Deficit Financing:
Continuous increase in money supply in the country has been caused by adopting the
method of deficit financing to finance the budgetary deficit of the government. This has
been made possible through changes in the reserve requirements of the Reserve Bank.
6.
Anti-Inflationary Fiscal Policy:

The Seventh Five Year Plan prefers an anti-inflationary fiscal policy to an antiinflationary monetary policy and emphasizes a positive, promotional and expansionary
role for monetary policy.

Policy of Credit Control:

The Reserve Bank has adopted a number of credit control measures to check the inflationary
tendencies in the country:
1.
Bank Rate:
The bank rate is the rate at which the Reserve Bank advances to the member banks
against approved securities. Bank rate is considered as a pace-setter in the money market.
Changes in the bank rate influence the entire interest rate structure.
2.
Net Liquidity Ratio:
In order to check excessive borrowings from the Reserve Bank by the commercial banks,
the Reserve Bank introduced the system of net liquidity ratio in September 1964.
According to this system, a commercial bank can borrow from the Reserve Bank at the
bank rate only if it maintains a minimum net liquidity ratio to its total demand and time
liabilities, and it will have to pay a penal rate of interest to the Reserve Bank, if the net
liquidity ratio falls below the minimum ratio fixed by the Reserve Bank.
3.
Open Market Operations:
Through the technique of open market operations, the central bank seeks to influence the
excess reserves position of the banks by purchasing and selling of government securities.
When the central bank purchases securities from the banks, it increases their cash reserve
position and hence their credit creation capacity. On the other hand, when central bank
sells securities to the banks, it reduces their cash reserves and the credit creation capacity.
4.
Cash-Reserve Requirement (CRR):
The central bank of a country can change the cash-reserve requirement of the bank in
order to affect their credit creation capacity. An increase in the cash- reserve ratio reduces
the excess reserve of the bank and a decrease in the cash-reserve ratio increases their
excess reserves.
5.
Statutory Liquidity Ratio (SLR):
Under the original Banking Regulation Act 1949, banks were required to maintain liquid
assets in the form of cash, gold and unencumbered approved securities equal to not less
than 25% of their total demand and time deposits liabilities.

FINANCIAL MARKET
Financial markets arc functionally classified into:
(a) Money market and
(b) Capital market.

This classification is on the basis of term of credit, i.e., whether the credit is supplied for a short
period or long period. Money market refers to institutional arrangements which deal with shortterm funds. Capital market, on the other hand, deals in long-term funds.
CHART 1
STRUCTURE OF INDIAN MONEY MARKET
Indian Money Market

Organized Sector

Unorganized
Sector
Indigenou
s Bankers

Reserve
Bank
of India

Commerc
ial banks

Scheduled
Commercial
Banks

Public
Sector
Banks

State
Bank
Group

Indian
Banks

Nationaliz
ed banks

P.O.
Saving
Banks

Money
Lenders
Nonbanking
Companies

Nonscheduled
Banks

Foreign
Banks

Regional
Rural
Banks

Cooperativ
e Banks

STRUCTURE OF INDIAN MONEY MARKET

i)

ii)
iii)
iv)

Broadly speaking the money market in India comprises two sectors organized and
unorganized sectors. The organized sector consists of the Reserve Bank of India, the State
Bank of India with its seven associates, twenty nationalized commercial banks, other
schedule and non-scheduled commercial banks, foreign banks, and Regional Rural
Banks. It is called organized because its parts are systematically coordinated by the RBI.
Non-bank financial institutions such as the LIC, the GIC and subsidiaries. The UTI also
operate in this market, but only indirectly through banks, and not directly.
Quasi-government bodies and large companies also make their short term surplus funds
available to the organized marker through banks.
Cooperative credit instructions occupy the intermediary position between organized and
unorganized parts of the Indian money market. These institutions have a three-tier
structure. At the top there are state cooperative banks. At the local level, there are primary
credit societies and urban cooperative banks.

Unorganized Sector of the Indian Money Market

The unorganized segment of the Indian money market is composed of unregulated non-bank
financial intermediaries, indigenous bankers and money lenders which exist even in the small
towns and big cities. Their lending activities are mostly restricted to small towns and villages.
The persons who normally borrow from this unorganized sector include farmers, artisans, small
traders and small scale producers who do not have any access to modern banks. The following
are some of the constituents of unorganized money market in India.
1.
Indigenous Bankers:
Indigenous bankers include those individuals and private firms which are engaged in
receiving deposits and giving loans and thereby act like a mini bank. Their activities are
not at all regulated. During the ancient and medieval periods, those indigenous bankers
were very active. But with the growth of modern banking, particularly after the advent of
British, the business of the indigenous bankers received a set back. Moreover, with the
growth of commercial banks and Co-operative banks the area of operations of indigenous
bankers has again contracted further.
2.

3.

Unregulated non-bank financial intermediaries:

There are different types of unregulated non-bank financial intermediaries in India. They
are mostly constituted by loan or finance companies, chit funds etc. A good number of
finance companies in India are engaged in collecting substantial amount of funds in the
form of deposits, borrowings and other receipts. They normally give loans to wholesale
traders, retailers, artisans, and different self-employed persons at a rate of interest ranging
between 36 to 48%.
Money Lenders:
Money lenders are advancing loans to small borrowers like marginal and small farmers,
agricultural laborers, artisans, factory and mine workers, low paid staffs, small traders
etc. at a very high rate of interest and also adopt various malpractices for manipulating
loan records of these poor borrowers. The money lending operation of the money lenders
is totally unregulated and unsupervised which leads to worst exploitation of the small
borrowers.

Organized Sector of Indian Money Market:

The organized segments of the Indian money market is composed of the Reserve bank of India,
the State Bank of India, Commercial banks, Co-operative banks, foreign banks, finance
corporations and the Discount of Finance House of India Limited. Mumbai, Calcutta, Chennai,
Delhi, Bangalore and Ahmedabad are the leading centers of the organized sector of the Indian
money market. The Mumbai money market is a well organized one, having the head offices of
the RBI and different commercial banks, well developed stock exchange, the bullion exchange
and fairly organized market for Government securities.
The main constituents of the organized sector of Indian money market include:
(i)
The Call Money Market:
The call money market in a most common form of developed money market. The call
money market in India is very much centered at Mumbai, Chennai and Calcutta and out
of which the Mumbai is the most important one. In such market, lending and borrowing
operations are carried out for one day. Normally, scheduled commercial banks, Cooperative banks and the Discount and Finance House of India operate in this market
ii)

(ii)

(iii)

(iv)
(v)

The Treasury bill Market:

Treasury bill markets are markets for treasury bills. In India such treasury bills are short
term liability of the Central Government which is of 91 day and 364 day duration.
Normally, the treasury bills should be issued so as to meet temporary revenue deficit over
expenditure of a Government at some point of time. But, in India, the treasury bills are,
now a day, considered as a permanent source of funds for the Central Government. In
India, the RBI is the major holders of the treasury bills, which is around 90 % of the total.
The Commercial Bill Market:
The Commercial bill market is a kind of sub-market which normally deals with trade bills
or the commercial bills. It is a kind of bill which is normally drawn by one merchant firm
on the other and they arise out of commercial transactions. The purpose for issuing a
commercial bill is simply to reimburse the seller as and when the buyer delays payment.
But, in India, the commercial bill market is not so developed. This is mainly due to
popularity of the cash credit system in bank lending.
The Certificate of Deposit (CD) Market:
The certificate of Deposit (CD) was introduced in India by the RBI in, March 1989 with
the sole objective of widening the range of money market instruments and also to attain
higher flexibility in the development of short term surplus funds for the investors. In
India, six financial institutions, viz,, IDBI, ICICI, IFCI, IRBI, SIDBI and Export and
Import Bank of India were permitted in 1993 to issue for period varying between 1 to 3
years. Banks normally pay high rates of interest on CDs.
The Commercial Paper Market:
In India, the Commercial Paper (CP) was introduced in the money market in January
1990. A listed company having working capital not less than Rs. 5 crore can issue CP.
Money Market Mutual Funds:
In India, the RBI has introduced a scheme of Money Market Mutual Funds (MMMFs) in
April 1992. The main objective of this scheme was to arrange an additional short term
revenue for the individual investors. This scheme has failed to receive much response as

the initial guidelines were not attractive. Thus, in November, 1995, the RBI introduced
some relaxations in order to make the scheme more attractive and flexible. As per the
exiting guidelines, the banks, public financial institutions and the private financial
institutions are allowed to set up MMMFs.
The Indian money market has its distinctive characteristics as it suffers from various defects. The
following are some of its characteristics:
1.
Lack of adequate integration:
There is lack of adequate integration in the Indian money market. The organized and the
unorganized sector of Indian money market are totally separate from each other and they
have independent financial operations of their own. Therefore, activities of one sector
have no impact on the activities of the other sector. It is very difficult to establish a
national money market under such a background. Moreover, the various constituents of
the Indian money market viz., commercial banks, Co-operative banks and foreign banks
are competing among themselves and the competition is much in the countryside.
2.
Shortage of funds:
Another important feature of Indian money market is the shortage of funds. Therefore,
the demand for loanable funds in the money market is much higher than that of its supply.
In recent years, the development of rural banking structure, with the opening rural
branches of commercial banks and with the expansion of Co-operative banks, has
improved the fund position of the Indian money market, to some extent.
3.
Lack of adequate banking facilities:
Indian money market is also characterized by lack of adequate banking facilities. Rural
banking network in the country is still inadequate. In the rural areas, a substantial number
of populations, having small saving potential, have no access to facilities. Under such a
system, a huge amount of small savings are not mobilized which needs to be mobilized.
4.
Lack of rational interest rate structure:
There is lack of rational interest structure which is mostly resulted from lack of coordination among different banking institutions. Recently, there in some improvement in
this regard, particularly after the introduction of standardization of interest rates by the
RBI for its rationalization.
5.
Absence of Organized Bill Market:
There is absence of organized bill market in India although the commercial banks
purchase and discount both inland and foreign bills to a limited extent. Although, the RBI
has introduced its limited bill market under its scheme of 1952 and 1970, but the same
scheme has failed to popularize the bill finance in India.
6.

7.

Existence of Unorganized Money Market:

Another important feature of Indian money market is the existence of its unorganized
character, where one of its segments is constituted by the indigenous bankers and money
lenders. Although the RBI has tried to bring the indigenous bankers under its direct
control but the attempts have failed. Thus, as the indigenous bankers remained outside the
organized money market, therefore, RBIs control over the money market is quite limited.
Seasonal stringency of money and fluctuations in interest rates:
Another important feature of Indian money market is its seasonal stringency of money
and the volatile fluctuation of interest rates. India, being a agricultural country has to face
huge demand for funds during the period of October to June every year so as to meet its

requirement for farm operations and also for trading in agricultural produce. But the
money market is not having sufficient elasticity. Thus it creates seasonal stringency of
funds leading to a rise in the rate of interest. But in the rainy and slack season the demand
for fund slumps down leading to an automatic fall in the rate of interest. Such regular
fluctuations in interest rates are not at all conducive to developmental activities of the
country.

UNDERDEVELOPMENT OF INDIAN MONEY MARKET

Considering the various defects of Indian money market it can be observed that the money
market in India is relatively under-developed. Moreover, in respect of resources, organization
stability and elasticity, the said market cannot be compared with the developed money markets of
London and New York. But among the third world countries India has been maintaining the
most developed banking system. Even then the organization of the money market is still
underdeveloped. The under development nature of Indian money market is mostly determined by
the following shortcomings.
Firstly, Indian money market fails to possess an adequate and continuous supply of short term
assets such as treasury bills, bills of exchange, short term Government bonds etc.
Secondly, this market is lacking the highly organized banking system, so important for the
successful working of a money market.
Thirdly, the sub-markets like acceptance market and the commercial bill market are non-existent
in Indian money market.
Fourthly, Indian money market has totally failed to develop market for short term assets and
accordingly there are no dealers of short term assets who act as intermediaries between the
Government and the entire banking system.
Fifthly, Indian money market in suffering from lack of co-ordination between its different
constituents.
Sixthly, Indian money market again fails to attract any foreign funds.
Finally, Indian money market cannot be termed as a developed one considering its supply of fund
and the liquidity position.
In recent years, serious efforts have been made by the Government and the RBI to remove the
shortcomings of Indian money market. RBI, in the mean time has reduced considerably the
differences between the various constituents of money market. Differences in the interest rates
have also been reduced by the RBI and the monetary stringency has also been reduced by the
RBI through open market operations and bill market scheme.
Even then Indian money market is still very much dependent on the call money market which is
again characterized by high volatility. In the mean time, the RBI has introduced various measures
to reform the money market. The following are some of the important reform measures
introduced to strengthen the Indian money market:
(i)
Remission of Stamp Duty:

In order to remove the major administrative constraint in the use of bill system, the
Government has remitted the stamp duty in August 1989.
(ii)

Deregulation of interest rates:

Another important step to strengthen the money market was to deregulate the money
market interest rates since May, 1989. This will bring interest rate flexibility and
transparency in money market transactions.

(iii)

Introduction of new instruments:

The RBI has introduced certain money market instruments for strengthening the market
conditions. These instruments are 182 days treasury bills, longer maturity treasury bills,
certificates of Deposits (CDs), Commercial Paper (CP) and dated Government securities.
Discount and Finance House of India (DFHI) promoted the 182-day treasury bills
systematically and these bills were the first security sold by auction for financing the
fiscal deficit of the Central Government.

(iv)

DFHI:
The Discount and Finance House of India (DFHI) was setup in April 25, 1988 as a part of
the reform package for strengthening money market. The main function of DFHI is do
bring the entire financial system consisting of the scheduled commercial banks, cooperative banks, foreign banks and all India financial institutions, both in the public and
private sector, within the fold of the Indian money market. This House will normally buy
bills and short term papers from different banks and financial institutions in order to
invest all of their idle funds for short periods.

v)

Money Market Mutual Funds (MMMFs):

The Government announced the establishment of Money Market Mutual Funds
(MMMFs) in April 1992 with the sole objective to bring money market instruments
within the reach of individuals. The MMMFs have been set up by different scheduled
commercial banks and public financial institutions. The shares or units of MMMFs have
been issued only to individuals.

Thus the aforesaid measures to reform Indian money market have helped it to become more
advanced, solvent and vibrant. With the introduction of new instruments, the secondary market
has also been developed considerably. Moreover, with the setting up of DFHI and MMMFs, the
lot of Indian money market has also achieved considerable progress in recent times and is also
expected to achieve further progress in the years to come.

INDIAN CAPITAL MARKET

By the term Capital market we mean a market for long term funds, whereas the money market
constitutes the market for short term funds. Capital market includes all existing facilities and
institutional arrangements developed for borrowing and lending medium and long term funds
available in the market. This is not a market for capital goods; rather it is a market for raising and
advancing money capital for investment purposes. In a capital market, the demand for long term

funds mostly arises from private sector manufacturing industries, agricultural sector and also
from the Government, which are again largely utilized for the economic development of the
country. Even the consumer goods industries usually need a considerable support from the
capital market.
Similarly, both the State and Central Governments, which are engaged in developing infrastructural facilities viz., transport, power, irrigation, and communications etc. along with the
development of basic industries also, need a considerable support from the capital market. In a
capital market, the supply of funds usually comes from individual savers, corporate savings
various banks, insurance companies specialized financial agencies and also the Government.
The following are some of the institutions supplying funds to the Indian Capital market:
i)
Commercial banks in India, which are interested in government securities and on
debentures of companies are considered as important investors;
ii)
The insurance companies like LIC and GIC have also attained growing importance in the
Indian Capital market and are mostly investing in government securities;
iii)
Various special institutions viz., the IDBI, IFCI, ICICI, UTI etc. are giving long form
capital to the private sector of the country, and
iv)
Provident funds of employees which constitute a major volume of savings but their
investments are very much restricted in government securities.
After independence, the rapid growth and expansion of the corporate and public enterprises has
necessitated the development of the capital market in India. The capital market is composed of
the borrowers who demand fund and the lenders who supply fund in the market. A sound capital
market always tries to offer adequate quantity of capital to any industrial and business house at a
reasonable rate which is expected to result high prospective yield to make borrowing worth while

Structure of Development Banks of India

Development banks in India have developed in the post-independence period. The structure of
Indian development banks can be divided into two broad categories:
(a)
Those which promote agricultural development and
(b)
Those which promote industrial development.
1.

Agricultural Development Banks

(i) At All-India Level: National Bank for Agriculture and Rural Development
(ii) At State Level: State Land Development Banks (SLDBs).
(iii)
At Local Level: Primary Land Development Banks (PLDBs), and branches of
State Land Development banks (SLDBs).

2.

Industrial Development Banks

i)
At All-India Level. Industrial Finance Corporation of India (IFCI), Industrial
ii)
Development Bank of India (IDBI), Industrial Credit and Investment Corporation
of India (ICICI), Industrial reconstruction Bank of India (IRBI).
iii)
At State Level. State Finance Corporations (SFCs) and State Industrial
Development Corporations (SIDs).

3.

Industrial Finance Corporation of India (IFCI)

Industrial Finance Corporation is the first industrial development bank set up by the
Government of India in July 1948. It was established with a view to provide medium and

long-term credit to the eligible industrial units in the country. It extends financial
assistance to large and medium sized industrial units in both private and public sectors
and also to cooperatives.
Functions:
The IFCI provides assistance in the following forms:
i)
It grants loans and advances to industrial concerns both in rupees and foreign
currency repayable within 25 years.
ii)
It subscribes to the shares and debentures issued by the industrial concerns.
iii)
It underwrites the issues of stocks, shares, bonds, (debentures of the industrial
concerns subject to the condition that such stocks, shares, etc. are disposed of by
the Corporation within a period of 7 years from the time of acquisition.
In recent years, the Corporation has started asking interest in the promotional activities
such as organizing techno-economic surveys, setting up of technical consultancy
organizations etc.
4.

State Finance Corporations

The Industrial Finance Corporation provides financial assistance to large public limited
companies and cooperative societies and does not cover the small and medium-sized
industries. In order to meet the varied financial needs of small and medium sized
industries, the Government of India passed the State Finance Corporations Act in 1951,
which empowers the state governments to establish such Corporations in their states.
Functions:
Various functions of and types of financial assistance to be provided by the SFCs are
given below:
i) The SFCs have been established to provide long-term finance to small-scale and
medium-sized industrial concerns organized as public or private companies,
corporations, partnership or proprietary concerns.
ii) The SFCs extend loans and advances to the industrial concerns repayable within a
period of 20 years.
iii) The SFCs underwrite the issue of stocks, shares, bonds and debentures by industrial
concerns.
iv) The SFCs are prohibited from subscribing directly to the shares or stock of any
company having limited liability, except for under-writing purposes, and granting
any loan or advance on the security of own shares.

5.

Industrial Development Bank of India (IDBI)

The IDBI is the apex financial institution in the field of development banking in the
country. It was established in July, 1964 with the twin objectives of:
(a)
(b)

Meeting growing financial needs of rapid industrialization in the country

Coordinating the activities and assisting the growth of all institutions engaged in
financing industries.

It is an organization with sufficiently large financial resources which not only provides
direct financial assistance to the large and medium-large industrial units, but also helps

the small and medium industries indirectly by extending refinancing and rediscounting
facilities to other industrial financing institutions.
Functions:
Various types of assistance to be provided by the IDBI are as follows:
(i) Direct Financial Assistance - The IDBI provides direct financial assistance to
industrial concerns in the form of granting loans and advances, and subscribing to,
purchasing or underwriting the issues of stocks bonds or debentures
(ii) Indirect Financial Assistance - The IDBI provides indirect financial assistance to the
small and medium industrial concerns through other financial institution.
(iii)
Development Assistance. The Development Assistance Fund is used to provide
assistance to those industries which are not able to obtain funds in the normal
course mainly because of heavy investment involved or low rate of returns.
(iv)Promotional Function. Besides providing financial assistance, the IDBI also
undertakes various promotional activities such as marketing and investment
research, techno- economic surveys.
6.

Industrial Credit and Investment Corporation of India (ICICI)

The Industrial Credit and Investment Corporation of India was registered as a private
limited company in 1955. It was set up as a private sector development bank to assist and
promote private industrial concerns in the country.
Broad objectives of the ICICI are:
(a)
To assist in the creation, expansion and modernization of private concerns
(b)
To encourage participation of internal and external capital in the private concerns
(c)
To encourage private ownership of industrial investment.
Functions:
The ICICI performs the following functions:
i) It provides long-term and medium-term loans in rupees and foreign currencies.
ii) It participates in the equity capital of the industrial concerns.
iii) It underwrites new issues of shares and debentures.
iv) It guarantees loans raised by private concerns from other sources.
v) It provides technical, managerial & administrative assistance to industrial concerns

7.

Unit Trust of India (UTI)

The Unit Trust of India was established in 1964 as a public sector investment institution.
The main objective of the UTI is to mobilize the savings of the small and medium income
groups and channeling them into productive investment. It thus, the one hand, contributes
to the industrial development and diversification of the economy, on and the other hand,
provides the small savers the opportunity for sharing the benefits of industrial
development by utilizing their savings in profitable and less risky investments.
Functions:
(a)
It sells its units to the investors in small and medium income groups
(b)
It invests the funds so collected through the sale of units in industrial and
corporate securities

(c)
8.

It distributes the annual gross income among the unit-holders in the form of
dividends.

Industrial Reconstruction Corporation of India (IRCI)

Considering the seriousness of the problem of industrial sickness, the Government of
India established the Industrial Reconstruction Corporation of India in April 1973.The
main purpose of the IRCI was to prevent and cure the problem of industrial sickness. It
was expected to provide assistance to the sick units for their rehabilitation and
reconstruction. The IRCI was set up with an authorized capital of Rs. 25 crore, issued
capital of Rs.10 crore and paid-up capital of Rs. 2.5 crore.
The resources of the Corporation have been subscribed by Industrial Development Bank
of India (1DBI), Industrial Finance Corporation of India (IFC1), Industrial Credit and
Investment Corporation of India (1CICI), Life Insurance Corporation (LlC), State Bank
of India (SBI) and the nationalized banks. The Government of India has granted an
interest -free loan of Rs. 10 crore to the Corporation.

9.

Industrial Reconstruction Bank of India (IRBI)

By a special Act passed in March 1985, the Government converted the IRCI into the
IRBI. The 1RB1 has been set up as a statutory corporation with the objective of
functioning as the principal institution for providing financial assistance needed for
rehabilitation of sick industrial concerns. The authorized capital of the IRBI is Rs. 200
crore and paid-up capital as on March, 31, 19S9 was Rs. 112.5 crore. During 1993-94 the
IRBI sanctioned financial assistance of Rs. 425.8 crore of which Rs. 188.6 crore
disbursed. At the end of June 1991, the cumulative financial assistance sanctioned and
disbursed stood at Rs, 1244 and Rs. 919 crore respectively.
IRBI has been converted into a full-fledged development financial institution with a new
name Industrial Investment Bank of India Ltd. (IIBI) with effect from March 27, 1997.

10.

Export-Import (EXIM) Bank of India

The Export-Import (EXIM) Bank of India is the principal financial institution in India for
coordinating the working of institutions engaged in financing export and import trade. It
is a statutory corporation wholly owned by the Government of India. It was established
on January 1, 1982 for the purpose of financing, facilitating and promoting foreign trade.
Functions:
The main functions of the EXIM Bank are as follows:
i)
Financing of exports and imports of goods and services, not only of India but also
of the third world countries;
ii)
Financing of export & import of machinery and equipment on lease basis
iii)
Financing of joint ventures in foreign countries;
iv)
Providing loans to Indian parties to enable them to contribute to the share capital
of joint ventures in foreign countries;
v)
To undertake limited merchant banking functions such as underwriting of stocks,
shares, bonds or debentures of Indian companies engaged in export or import; and

vi)
10.

To provide technical, administrative and financial assistance to parties in

connection with export and import.

Small Industries Development Bank of India (SIDBI)

Small Industries Development Bank of India (SIDBI) was established as wholly owned
subsidiary of Industrial Development Bank of India (IDBI) under the small Industries
Development of India Act 1989. It is the principal institution for promotion, financing
and development of industries in the small scale sector. It also coordinates the functions
of institutions engaged in similar activities. For this purpose, SIDBI has taken over the
responsibility of administrating Small Industries Development Fund and National Equity
Fund from IDBI.
Functions:
SIDBI provides assistance to the small scale industries sector in the country through the
existing banking and other financial institutions, such as, State Financial Corporations,
Stale Industrial Development Corporations, commercial banks, cooperative banks etc.
The major functions of SIDBI are given below:
i)
It refinances loans and advances provided by the existing lending institutions to
the small scale units.
ii)
It discounts and rediscounts bills arising from sale of machinery to and
manufactured by small scale industrial units.
iii)
It grants direct assistance and refinance loans extended by primary lending
institutions for financing export of products manufactured by SSIs.
iv)
It provides services like factoring, leasing, etc. to small units.
v)
It provides financial support to National Small Industries Corporation for
providing; leasing, hire-purchase and marketing help to the small scale units.

11.

Life Insurance Corporation (LIC) of India

Life Insurance Corporation of India (LIC) was established in 1956 to spread the massage
of life insurance in the country and to mobilize peoples savings for nation-building
activities. Main features of LIC are given below:
1.
Saving Institution - Life insurance both promotes and mobilizes saving in the
country. The income tax concession provides further incentive to higher income
persons to save through LIC policies. The total volume of insurance business has
also been growing with the spread of insurance-consciousness in the country.
2.
Term Financing Institution - LIC also functions as a large term financing
institution in the country. The annual net accrual of invested funds from life
insurance business and net income from its vast investment is quite large.
3.
Investment Institutions - LIC is a big investor of funds in government securities.
Under the law, LIC is required to invest at least 50% of its accruals in the form of
premium income in government and other approved securities. LIC funds are also
made available directly to the private sector through investment in shares,
debentures, and loans.
4.
Stabilizer in Share Market - LIC acts as a downward stabilizer in share market.
The continuous inflow of new funds enables LIC to buy shares when the market is

weak. But, the LIC does not usually sell shares when the market is overshot. This
is partly due to the continuous pressure for investing new funds and partly due to
the disincentive of capital gains tax.
12.

General Insurance Corporation (GIC) of India

General Insurance companies sell insurance against specific risks, such as of loss from
fire and accident, to property of various kinds, such as motor vehicles, goods, machinery,
buildings, etc., and also against risk of personal accidents and sickness. The policies of
these companies do not involve saving feature. The purchaser of general insurance simply
buys a service and not any financial asset. In this way, general insurance companies
cannot be considered as financial intermediaries in the true sense. However, they do
accumulate large amounts of funds from premiums and investment income and thus
manage portfolios of assets like other financial institutions.