First Year Bachelor of Mass Media

Dr.
Ranga Sai
F.Y.B.M.M Dr. Ranga Sai

Lecture Notes Vaze College,
Mumbai
Introduction to Economics
Revised June 2010
First Year BMM Semester I, Economics (w.e.f. June 2009) 1
Dr.Ranga Sai
As per
First Year Bachelor of Mass Media (wef 2009-2010)
Semester-I: Paper VI
Section I
Basic Concepts of Micro Economics
1. Nature and scope of Micro Economics- Concept of equilibrium – assumptions
of Ceteris paribus
2. Market forces of demand and supply: their determinants- Elasticity’s of
demand and supply
3. Production function: short and long run – various in input proportions and
variations in scale
4. Cost of production: Meaning
• Total revenue, total cost and profit – breakeven analysis
• Concept of opportunity cost
• Various measures of cost: fixed variable cost, average and marginal costs,
production and selling costs
• Economies and diseconomies of scale
3. Introduction to competitive markets-
• Objectives of firms
• Features of perfect competition, monopoly, monopolistic competition and
oligopoly markets
I. Fundamentals of Macro economics
1. Basic concepts of income aggregates:
• National income, Gross domestic product, per capita income,
• State domestic product ( w r t economy of Maharashtra)
2. Introduction to money, banking and public finance
a. Concepts of money supply, velocity of circulation of money supply,
liquidity preference
Monetary policy and fiscal policy, Inflation
Features and phases of trade cycles
b. Banking and non banking financial institutions: features of commercial
banks and central bank, introduction to mutual funds and insurance sector
c. Components and functions of Indian financial system:
• Features and functions of financial markets
• Money and capital markets- characteristics of primary and
secondary markets
• Role of stock exchanges – role of SEBI
d. Introduction to public finance: direct and indirect taxes, Union budget
3. Introduction to external sector:
Balance of trade and balance of payments, exchange rate, foreign direct
investment and foreign portfolio investment
II India in a globalized world Introduction to the concepts of privatization,

liberalization and globalization- Globalization and its impact on Indian economy
– WTO agreements and India’s commitment to WTO
Available for free and private circulation
At www. rangasai.com and www. vazecollege.net

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CONTENT
Section I: Basic Concepts of Micro Economics
1. Nature and scope of Micro Economics-
Concept of equilibrium
Ceteris paribus
Demand Elasticity’s of demand
Supply elasticity of supply
Market equilibrium
Production function: short and long run
Law of variable proportions
Isoquants and producers equilibrium
Laws of returns to scale
Cost concepts
Breakeven analysis
Economies and diseconomies of scale
Objectives of firms
Features of perfect competition, monopoly, monopolistic competition and
oligopoly, duopoly
Section II Fundamentals of Macro economics
National income, Gross domestic product, per capita income,
State domestic product of Maharashtra
Money supply, demand for money,
Liquidity preference
Monetary policy
Fiscal policy, Inflation
Trade cycles
Commercial banks
Central bank,
Mutual funds
Insurance sector
Indian financial system:
Features and functions of financial markets
Money markets-
Capital markets: primary and secondary markets
Role of stock exchanges
SEBI
Introduction to public finance
Direct and indirect taxes
Union budget
Balance of trade and balance of payments,
Exchange rate,
Foreign direct investment and foreign portfolio investment
India in a globalized world
Privatization, liberalization and globalization
Globalization and its impact on Indian economy
WTO agreements and India’s commitment to WTO

Dr.Ranga Sai
Dear Student friends…
During these days of commercialization it becomes very difficult to find

information on web which is relevant, authentic as well as free.
We believe that knowledge should be free and accessible to all those who
need.
With this intention the notes, which are originally intended for the students
of Vaze College, Mumbai, are made available to all, without any restrictions.
These notes will be useful to all F.Y.B.M.M students of University of
Mumbai, who will be writing their Economics First Semester examinations
on or after October 2009.
This is neither a text book nor an original work of research. It is simple
reading material, complied to help the students readily understand the
subject and write the examinations. We no way intend to replace text books
or any reference material.
This is purely for academic purposes and do not have any commercial value.
Feel free to use and share.
We solicit your opinions and suggestions on this endeavor.
Dr. Prof. Ranga Sai

rangasai@rangasai.com
June 2010

Dr.Ranga Sai
1. Nature and scope of Micro Economics

Micro economics is that branch of economics which analyzes the market
behavior of individual consumers and firms to understand the decision-
making process of firms and households.
Microeconomics deals with economics decisions made at individual level.

The individual can be a consumer, the producer/firm, or a household.
"Microeconomics deals with the decision making and market

results of consumers and firms".
In detail the microeconomics deals with decisions at

1. Consumption: The consumer aims at maximizing consumer
satisfaction, he has to optimize his performance within the
limitations of income and prices
2. Production: The producer has to coordinate inputs to produce
goods so that the out put is maximized and the cost is
minimized. The producer has to optimize, costs and factors.
3. Exchange: The buyers and sellers meet at the market. They
have conflicting interests. Depending on the market the prices
are determined which fulfill the consumer objectives as well
as the firm objectives.
4. Distribution: Distribution deals with determinations of factor
prices. It is important in the determinations of factor incomes/
household incomes.
Micro economic theories help in the designing the models of demand

forecasting, consumer behavior models, pricing and determination of factor
prices.
Most micro economic theories are partial equilibriums which provide in

depth details of a specific economic activity.
Economic equilibrium
Equilibrium is a state of rest where there is no urge to change. The
equilibrium is attained by a set of two or more economic forces.
At equilibrium, the objectives of economic activity are achieved.

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• Consumer equilibrium – consumer satisfaction is maximized;

• Producers’ equilibrium – the cost are minimized
• Market equilibrium – the price and quantity are so determined that are
acceptable to both buyers and sellers.
Economic equilibrium is not permanent. The equilibrium is valid as long as

the factors determining it remain unchanged. Any change in any one of the
factor, the equilibrium will undergo a change.
Static equilibrium: In economics static equilibrium refers to rigid models

which do not accept more or changing variables. Subject to the given
set of variables, the equilibrium is attained. Such equilibrium may not
have large policy applications;
e.g. circular flow of incomes- it explains the relationship between various
economic activities
Dynamic equilibrium: It is an advanced economic model which gives

relationships between several economic variables and can also
accommodate change. Such economic models have large application in
policy making
e.g. input-output matrix of national income accounting provide relationships
as well as determinants at each level of economic activity. The output
of one sector becomes the input for the other sector. This is an
advanced model of explaining circular flow of incomes. .
Ceteris paribus
Ceteris paribus is a Latin phrase, which means “all other things being equal
or held constant”
A ceteris paribus assumption is used to formulate scientific laws, for

separating factors which interfere while studying a cause and effect
relationship.
By holding all the other relevant factors constant, a cause and effect
relationship can be studies in greater detail.
In economics the laws are made based on the cause and effect relationship.
These functional relationships relate one dependent variable and several
independent variables.

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Ceteris paribus represent relationships (such as demand and supply) between

two variables (such as price and quantity), holding all other things constant,
(or ceteris paribus), in order to isolate the influence of one independent
variable (such as price) on the dependent variable (such as quantity).
The demand function relates the quantity demanded-Q, as an effect of

several factors like price-P, income-Y, advertising-A, and tax-T.
Quantity demanded, Q = f (P, Y,A,T/F)
Yet while studying the relationship as a law, it assumes all factors to be

constant and isolates one major determinant. The clause of keeping other
factors constant by retaining one major determinant for the purpose of
forming a law is called as ceteris paribus.
2. Market forces of demand and supply
Market forces refer to demand and supply. The prices in a free economy are
determined by demand and supply. In any free market the price transacted
depends on the free will of buyers and sellers. The free will of buyers is
represented by demand and free will of seller is determined by supply.
The Government may impose restrictions on price, demand and supply in a

regulated market. These regulations will be designed as per the social and
economic objectives of an economy.
Demand
Demand refers to
the desire backed by willing ness of the buyer and
willing to pay a price.
The quantity demanded depends on several factors
• Price: Price is major factor determining the quantity
demanded. There is an inverse relationship between piece
and quantity demanded.
• Taste, fashions and preferences: The quantity demanded
depends on tastes that are personal, fashions that are the
external influences on tastes and the preferences that are
selected out of given alternatives.

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• Income: Income and quantity demanded are positively

related. Quantity demanded increases with increasing
income and vise versa.
• Price of related goods: There are two types of related
goods- substitute goods and complementary goods.
Substitute goods are those which give similar utility. The
price of substitute goods directly influences the demand for
good.
Complementary goods are those which give utility in
combination. These are joint good that have
complementary demand
The price of complementary goods indirectly influences the
demand for a good.
• Availability of related goods: The availability of substitute
and complementary goods effect the quantity demanded.
• Taxation: taxation increases the price. The effect is that of
increasing price.
• Advertising: Advertising increases the demand. At the same
price or the consumer may demand more goods.
• Seasons: There are certain goods where the consumption is
seasonal. So the demand changes with changing season.
• Utility: Goods with multiple utility have larger demand. This
is because use and application increase with utility.
Law of demand
The quantity demanded depends on variety of factors. Important among

them is price. The law of demand relates price and the quantity demanded.
According to the law of demand
The quantity demanded and price is inversely related. The quantity

demanded decreases with increasing price and increases with decreasing
price.

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The inverse relationship between quantity demanded and price is because of

three reasons
1. With increasing consumption of a good its marginal utility
decreases. The price is paid as per the marginal utility. So
with increasing quantity the willingness to pay a price
decreases.
2. When the price of a good decrease, the real income of the
consumer increases. Real income is the amount of goods an
consumer can buy with his income. When the real income
increase the consumer demand more goods.
3. When a good becomes cheaper, the consumer tends to
consume more of it by sacrificing a costlier substitute.
The law of demand depends on the following assumptions

• The price alone changes, other factors remain unchanged
• Ceteris paribus- It means that all other factors remain
constant
• The income of the consumer remain unchanged
• The tastes, choice and preferences remain constant
• The utility of the good is given and constant
• The supply is uniform without uncertainties.
Elasticity of Demand
Elasticity of demand measures intensity of changes in the quantity of a

commodity for changes in the price, income or the price of a related

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commodity. Accordingly, it is called price elastic, income elasticity or cross

price elasticity of demand.
Price Elasticity of demand

Price elasticity of demand measures proportionate changes in the quality of a
commodity for proportionate changes in the price.
Price elasticity relates quantity demanded and the price.
Price elasticity is measured as
The price elasticity has a negative value, because the price decreases for an
increase in the quantity demanded.
ep = 1, Unitary elastic, reference elasticity
ep > 1, Relatively elastic, luxury goods
ep < 1, Relatively inelastic, necessary goods
ep = ∞, Perfectly elastic, hypothetical
ep = 0, Perfectly inelastic, hypothetical

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Supply
Supply refers to the
It is the willingness of the produces to make available
goods for sale at a given price.
It is the quantity of goods available for sale at a given price.
Stock of goods refers to the amount of goods available or produced. Supply
is that part of stock which is available for sale at a given price.
Law of supply
According to the law of supply, the quantity of goods supplied increases
with increasing price and decreases with decreasing price.
There is appositive relationship between quantity supplied and the price.
Elasticity of Supply
Elasticity of demand measures intensity of changes in the quantity of a
commodity for changes in the price.
Elasticity of Supply measures proportionate changes in the quality of a

commodity for proportionate changes in the price.
Elasticity of supply is measured as

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The elasticity of supply has a positive value, because the quantity decreases
for a decrease in the supply.
The value of elasticity of supply changes with changing responsiveness of

quantity changes for changes in the price. Larger the responsiveness greater
will be the elasticity. No change in the quantity the elasticity will be zero.
For highly sensitive quantity, the elasticity will be infinity.
es = 1, Unitary elastic, reference elasticity

es > 1, Relatively elastic, luxury goods
es < 1, Relatively inelastic, necessary goods
es = ∞, Perfectly elastic, hypothetical
es = 0, Perfectly inelastic, hypothetical

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Elasticity of supply and time period
Elasticity of supply changes with changing time

1. In the market period the elasticity of supply is zero. The period of time is
so short that the industry does not have any time to change the supply for
any change in the price.
The market period is in turn defined as the shortest time period where the
supply is perfectly in elastic.
2. In the short run the supply becomes relatively elastic. The industry gets
time to make changes in the variable factors of production and change
production in a limited range.
3. Long run is that time period where the industry has enough time to change
the fixed factors as well and bring large changes in the out put.
The supply will be highly elastic in the long run.
Equilibrium with free market

In a free market the price is determined by the market forces of demand and
supply. It is market where the buyers and sellers are equally important in the
determination of price. It is an ideal situation whether both the buyers and
the sellers are equally represented.
Free market is a case of perfect competition. Under such perfect competition

the price is determined by the firms and buyers, no single firm or buyer can
influence the price. The buyers are represented by demand curve and the
firms are represented by supply curve.
The demand curve indicates

The choice and tastes of the consumers
The utility of the good
The utility behavior of the consumer
The capacity and willing of the consumer to pay the price
Similarly, the supply curve indicates
The willing ness of the firm, to sell goods at different
price
The cost conditions
Nature of factor markets

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Supply and demand curve together determine the equilibrium price. The
equilibrium price is the one which is acceptable to both buyers and sellers.
This is determined by the large number of buyers and spellers.
Price Quantity Quantity Supplied Market

demanded
10 600 1000 D<S Surplus
9 700 900 D<S Surplus
8 800 800 D=S Equilibrium
7 900 700 D>S Scarcity
6 1000 600 D<S Scarcity
At P1 D<S, Goods are not being sold, price is high

At P2 D<S, there is scarcity, the firms do not accept low price
At P3 D=S, the price is acceptable to both sellers and buyers
This is the equilibrium price. The price remains unchanged as long as the
demand and supply remain constant.
Nature of market economy:

Demand and supply are both responsible in the determination of equilibrium.
According to classical economics, the equilibrium is a natural process; the
demand and supply get equated automatically.

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Market encourages efficiency of firms. It leads to efficient allocation of

resources.
3. Production function
Production function
A production function provides the relationship between out put and various
factors of production. A production function is a functional relation between
the inputs and out put.
The production function can be classified as per time period. There can be
short run production function and the long run production function. Between
time periods the nature of factors can change.
In the long run all factors change; when all factors change there can be large
changes in the out put can be brought, the technology can change, the cost
structure may be totally renewed. So, the expression of long run production
function will be
Quantity of out put,
Q = f ( Labor, raw material, power, land, buildings, machinery / T)
Where T, is technology; an embedded (associated) factor of production. It is

the qualitative description of capital,
In the short run certain factors are fixed certain other variable. Fixed factors
remain fixed even with changing out put. On the other hand variable factors
change with changes in the out put. So the expression of production function
will have fixed and variable factors.
Q, = f ( labor, raw material, power/ F , T)
Where F represents the fixed factors which remain unchanged in the short
run and T is the level of technology given and constant.

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The short run production function will always carry the expression fixed and
variable, separately.
Law of variable proportions
The law of variable proportions studies the relationship between one

variable factor and the out put. It studies the behavior of out put for changing
variable factor. It deals with a short run production function with one
variable factors with all other factors are given and kept constant.
Q, = f ( labour / F , T)
Where F represents the fixed factors which remain unchanged in the short
run and T is the level of technology given and constant.
According to the law of variable proportions, ‘all other factors remaining

constant, if the usage of one variable factor increases, the out put will
increase rapidly, then slowly and finally decreases’.
Total Average Marginal Production Stages of production

Labour Product Product Product Elasticity
Units TP AP MP
1 5 5 0 Increasing
2 8 4 3 Ep>1 returns
3 15 5 7 I Stage
4 24 6 9
5 30 6 6
6 30 5 0 Ep<1 Diminishing returns
II Stage
7 28 4 -2 Ep<0 Negative returns
III Stage
I Stage: Stage of increasing returns

During the first stage the out put increase rapidly because
a. The variable factors become more and more productive, initially.
b. The fixed factors become more productive.
c. The elasticity of production is more than 1 ( Ep>1)
During the first stage AP, MP and TP are increasing. MP reaches a
maximum called as the point of inflexion. From this point onwards there will
be a change in the level of factor productivity.

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At the end of the stage, AP=MP and TP continues to increase.
II Stage: Stage of diminishing returns

During the second stage the out put increase slowly because
a. The factor substitution becomes limited
b. Other factors become less and less productive
c. The elasticity of production is more less 1 ( Ep<1)
During the second stage AP decreases but it is slower than MP. Further,
MP<AP, MP decreases and TP is increasing, but slowly. At the end of the
stage MP=0
II Stage: Stage of negative returns

During the third stage the out put decreases because
a. There will overcrowding of one variable factor
b. Fixed factors also become less productive.
c. The elasticity of production is less than o ( Ep<0)
During the third stage, AP, MP and TP are all decreasing.
Assumptions:
1. All factors re given and remain constant and only labour changes
2. The level of technology remains same.
3. There is perfect competition in product and factor markets.

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4. Variable factors are of similar productivity.
Isoquants
An isoquant is made up of various combinations of two factors which give
rise to a fixed amount of out put.
Isoquant deals with a production function with two variable factors.
Output = f (K,L / F ,T)

where K - Capital, L – labor, F – fixed factors, kept constant in the short run
and T – the technology given.
Each Isoquant deal with a specific level of out put. Isoquants away from the
origin represent higher out put and isoquants towards the axis represent
lower out put.
The Isoquant depends on the level of factor substitutability. Factors of

production are not perfect substitutes. The ridge lines give the limits of
factor substitutability. The area between the ridge lines is called the
economic zone. This is the area where there is factor substitutability. The
analysis is confined to this area alone. The area out side the ridgelines can
not be used for any study, because the factor substitutability ends.

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The slope of the Isoquant represents the Marginal rate of technical

substitution (MRTS). It is the ratio of change in K for changes in L.
The Marginal rate of technical substitution is the manner one factor is

substituted by the other factor so as to give a fixed output through out the
isoquant. Such slope of isoquant depends on the nature of factors and
intensity of production.
Producers' equilibrium (Least cost combination)
Producers’ equilibrium deals with a least cost combination of producing a

specific level of out put the producer would like to produce.
A producer will be a t a state of equilibrium when he produces a desired
level of out put at a cost which is least. This can be done by using isoquants.
By choosing isoquant we consider a production function with two variable
factors all other factors and technology remaining constant.

Where K - Capital, L – labor, F – fixed factors, kept constant in the short run
and T – the technology given.

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Firstly the producer will determine the level of out put to be produced; the
isoquant is selected. The producers' equilibrium is found at a place where the
slope of the isoquant is same as the factor price ratio line. Mathematically,
the slope of the isoquant is equal to the slope of the price ratio line. Or the
slope of the price ratio line is same as the Marginal rate of Technical
Substitution.
The producers' equilibrium finds the least cost combination. Least cost
combination is the combination of two factors which will produce a given
level of out put at least cost.
There are different least cost combinations for different levels of out put.
Assumptions
1. Producers’ equilibrium considers a production function with two
variable factors.
2. The level of technology remains same
3. All other factors are given and constant
4. There is perfect competition in factor and product markets.
The prices of two factors are given and remain unchanged.
Least cost combinations are found at different levels of out put by following
the condition of producers’ equilibrium. When all the points of equilibriums

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or the least cost combinations at different levels of out put are joined, the
production path or the scale line can be derived.
The shape and position of the scale line will indicate the type of technology
or the intensity of factor usage. If the production path is towards the capital
axis it is capital intensive, if it is toward the labor axis the technology is
labor intensive.
Laws of Returns to Scale
The laws of returns to scale deals with the long run production function.
In the long run all factors change; when all factors change there can be large
changes in the out put can be brought, the technology can change, the cost
structure may be totally renewed. So, the expression of long run production
function will be

Q = f ( Labour, raw material, power, land, buildings, machinery / T)
Where T, is technology; an embedded (associated) factor of production. It is

the qualitative description of capital,
According to the laws of returns to scale -

In the long run when the scale of production increase,

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a. The out put may increase in larger proportions than the inputs used
called Increasing returns to scale
OR
b. The out put may increase in the same proportions as the inputs used
called Constant returns to scale
OR
c. The out put may increase in lesser proportions than the in puts used
called Diminishing returns to scale.
The laws of returns to scale can be explained with the help of isoquants.
By choosing isoquant we consider a production function with two variable
factors all other factors and technology remaining constant.

Where K - Capital, L – labour, F – fixed factors, kept constant in the short
run and T – the technology given.
1. Increasing returns to Scale

According to Increasing returns to scale
In the long run when the scale of production increase, the out put may
increase in larger proportions than the inputs used called increasing returns
to scale
Increasing returns to Scale
- The gap between E1, E2, E3,

and E4 decreases
- Economies of scale
- Decreasing costs

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The out put responds positively because; it operates on economies of scale.

In the long run the firm derives certain advantages called economies of
scale. These economies of scale can come from within called internal
economies or come from out side the firm called external economies.
Due to economies of scale the costs keep on decreasing. This is called
decreasing costs.
In the diagram it can be seen that the gap between the isoquants keep on
decreasing thus showing that lesser and lesser factors are needed for
producing additional output.
2. Constant returns to scale
increase in the same proportions as the inputs used called Constant
returns to scale
Constant returns to Scale
- The gap between E1, E2, E3,

and E4 remains constant
- Neutral Economies of scale
- Constant costs
In case of constant returns to scale the out put increases in the same
proportions as the inputs. The firm is a said to be operating on neutral

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economies. The firms neither get nor loose any advantages due to large scale
production.
In the diagram it can be seen that the gap between the isoquants remain
constant thus showing that same ratio of factors are needed for producing
additional output. The per unit costs remain constant. This is case of
constant costs
3. Diminishing returns to scale.
increase in lesser proportions than the in puts used called Diminishing
returns to scale.
Diminishing returns to
Scale
- The gap between E1, E2,

E3, and E4 increases
- Diseconomies of scale
- Increasing costs
The out put responds discouragingly, because; it operates on diseconomies

of scale. In the long run the firm may face certain disadvantages called
diseconomies of scale. These diseconomies of scale can come from within
called internal diseconomies or come from out side the firm called external
diseconomies.
Due to diseconomies of scale the costs keep on increasing. This is called

increasing costs.

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In the diagram it can be seen that the gap between the isoquants keep on
increasing thus showing that more and more factors are needed for
producing additional output.
Assumptions:
1. It is case of long run production function
2. The scale of production increases
3. Technology remains same
4. There is a perfect completion in factor and product markets.
5. Each isoquant represents a fixed increment of output.
4. Cost of production:
Costs
There are several concepts of cost developed, each suitable for a different
purpose. There are financial cost and social costs, accounting cost and
economic costs, short run and long run costs and the opportunity cost.
1. Accounting cost and economic costs: Accounting costs consider

documentation of expenditure for purpose of future analysis. It is the
analysis in retrospection. The analysis deals with spent money.
As against this, the economic cost study the nature of costs, their
behavior and methods of optimizing cists for minimizing cost of
production and maximizing profits.
2. Financial cost and social costs: Financial costs are private costs, the costs
paid by a firm to procure factors for creating out put. The major
consideration is optimizing usage of factors for cost reduction and
maximizing profits.
On the other hand the social cost deal with the burden of production
on the society, environment, and resource conservation. Most of the
social costs can not be quantified. But these cots are very important in
terms of social objectives and justice.
3. Financial costs and physical costs: Financial costs are economic costs
mentioned in uniform value terms. Since all the factors are mentioned
in uniform terms, it is easy to apply any quantitative or statistical
method for regulating their usage and optimizing for profits.

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Physical costs on the other hand are factors mentioned in dissimilar

units. Since they are dissimilar in expression and quantitative, it is not
easy to apply techniques of quantitative analysis. Yet physical costs
are important for production planning and procurement of factors.
4. Opportunity Cost: Opportunity cost is the cost of a factor in its alternative
use. This is the minimum which needs to be paid to bring a factor in
use. Any payment less than this will make the factor leave the
production function and join an alternative use.
The concept of opportunity cost is useful in determining the factor
price. The factor price needs to be equal to or greater than the
opportunity cost. Larger the opportunity cost higher will be the factor
price.
Economic costs in the short run

1. Total Fixed cost
It is the fixed cost which remains same in the short run irrespective
of out put. In the ling run, the fixed cost also changes.
The fixed cost remains constant in the short run at level of out put.
At zero level of out put the total cost is equal to total fixed cost.
2. Total variable cost:

It is the cost incurred on the variable factors. The use of variable
factor increases with increasing output even in the short run.
The total variable cost increases with increasing cost. At zero level
of out put the variable cost is zero.
3. Total cost
Total cost = Total fixed cost + Total variable cost
The total cost is the sum of total fixed cost and total variable cost. At
zero level of out put the total cost is equal to total fixed cost
4. Average Fixed cost

Average Fixed cost is the fixed cost per unit of out put
Average Fixed Cost = Total fixed cost
Out put
5. Average Variable Cost

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Average Variable Cost is the per unit average variable cost

Average Variable Cost = Total Variable Cost
output
6. Average Cost
Average cost is the cost of unit out put on the aggregate
Average Cost = Total cost
Out put
Or Average Cost = Average Fixed cost + Average Variable
Cost
1. Marginal cost
Marginal cost is the cost of an additional unit of out put. It is
measured as
Marginal cost = TC (n-1) - TC n
Break even Analysis
Break even out refers to the level of output where TR = TC. This is the
minimum out put the firm need to produce its costs. Any output there after
will grant profit to the firm. Usage of break even point for corporate decision
making is called Break even analysis.
At break even point total cost is equal to total revenue. After break even
point the profitability begins. The out put less than break even out put shows
losses.
Every firm aims at break even level of output in the beginning. The break
even level is a no profit no loss condition. In other words it is case of normal
profits. The costs cover only the manager’s remuneration and there is no
surplus over that. It is similar to the condition AR = AC.

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At break even point there are no profits, so TR = TC
Where,
TR is total revenue
TC is total cost
P is price
AVC is average variable cost
TFC is total fixed cost
Q is out put

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Break even analysis is based on the following assumptions

1. The cost and revenue functions are linear functions. This is for the
sake of simplicity.
2. The firm can estimate the cost and revenues in advance.
3. Price remains uniform at all levels of out put.
4. The costs are made up of fixed and variable costs.
Angle of Incidence
The angle of incidence is the angle made by the TR and TC functions at the
break even point. In break even analysis the angle of incidence is very
important in selecting a project among various competing projects.
The angle of incidence decides the nature of break even point.
If the angle of incidence is larger the break even out put will be smaller. In
other words, if the angel of incidence is smaller the break even out put will
be larger.
While comparing competing projects on the basis of break even points, a
project with larger angle of incidence will be selected. Because a firm will
always wishes to keep the Break even out put small so that, it can operate on
profits hat sooner.

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Application of Break even analysis

A firm will firstly, attain the break even out put so that it can be out of losses
and start making profits.
However, the firm needs to allot revenues for different purposes depending
on the earnings of profit or revenue.
Firstly, the firm will slot revenue for depreciation on assets. Depreciation is
a nominal expenditure. It is that part of fixed assets that is consumed during
the year and that part of fixed cost that can be charged to the out put.
Depreciation is the first priority after attaining break even out put.
When a firm makes profits it has to pay taxes. The firm now provides for
taxes after deducting depreciation.
Thereafter, marketing overheads can be deducted. These marketing

overheads are for more than one year. So if the revenue permits the firm may
provide for durable marketing overheads.
Finally, the revenue in excess of all these provisions yield profits that can be
distributed among owners or retained as reserves and surplus.
Limitations

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2. Break-even analysis is only a supply side analysis, as it tells

you nothing about what sales are actually likely to be for the
product at these various prices.
3. It assumes that the price remains uniform at levels of out put
4. It assumes that fixed costs are constant
5. It assumes average variable costs are constant per unit of
output,
6. It assumes that the quantity of goods produced is equal to the
quantity of goods sold
7. In multi-product companies, it assumes that the relative
proportions of each product sold and produced are constant
Economics of Scale
In the long run all factors becomes viable and the firm can increases its scale
of production. When the firm increases the scale of production it gets certain
advantages. These advantages are called economies of scale.
A. Internal economies of scale

These are the advantages the firm gets from the factors within the firm.
These factors are endogenous to the production function.
1. Managerial economies: In the long run the firm will have better
managerial talent in organizing factors for better productivity.
2. Technical economies: The firms will have improved technology in
the long run and the firm will progressively reduce costs.
3. Economies of by product: The firm will be able to develop waste
into marketable by product in the long run. This will add to the
revenues of the firm.
4. Economies of supervision: Better supervision will improve the
factor productivity in the long run.
5. Economies of cost: With improved supply chain and labour
productivity the costs will reduce in the long run.
6. Economies of integration: In case of forward integration the firm
will undertake an additional process of production and add value
o the out put. The revenue will increase
Similarly, backward integration will enable a firm produce such
factors which were earlier bought form the factor markets. This
again reduces the cost and adds to the profit margins.

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7. Risk bearing economies: Firms will greatly increase capacity to

take risk with new products and technologies in the long run.
This is due to established market and strong finances.
8. Economies of specialization: The firm may develop certain
specialization in the long run depending on the production
function and acceptance in the market. This may create niche and
better price.
B. External economies of scale

These are the advantages the firm gets from the factors out side the firm.
These factors are exogenous to the production function.
1. Economies of marketing: The firms will be able to market with
ease due to establishment of brand and dealership network
2. Economies of finance: The firms will have better financial
position in the long run due to accumulated profits. The firm will
also have better institutional axis for raising more finance easily.
3. Economies of environment: In the long run the firm becomes
more environmentally friendly with larger investment on pollution
control and resource conservation
5. Introduction to competitive markets
Objectives of Firm
The firm may have several objectives ranging from, economic, short run,
long run material and non material in nature. All objectives are important.
However the firm may decide its own priorities in objectives. Certain firms
may have material objectives significant certain other firms may have
normative objectives significant. Some objectives are uniformly significant
for all firms.
Following are some of the important objectives of a firm.
a. Economic objectives
Economic objectives are material objectives which may be short as well as
long run. Economic objectives are normally considered by all firms. These
economic objectives can be classified as follows:
1. Profit maximization:

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Each firm tries to maximize profits. This is a universal objective for

firms. The firms aim at maximizing the difference between total
revenue and total cost.
The firm will produce such out put which will give maximum profit.
The gap between TR and TC can be maximized by drawing two
tangents, one on each with same slope.
The slope of TC is MC and slope of TR is MR. By equating slopes;

MC is equated with MR.
So, MC=MR emerges as equilibrium condition for optimizing out put

for a firm.
Firms may aim at maximizing rate of profit or profit. The rate of profit
is maximized by pricing so that there is larger gross profit margin. On
the other hand maximizing profit may be attained by maximizing out
put.
2. Workers welfare

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Workers welfare helps in maintaining harmonious relationships

and also maintaining high levels of productivity and loyalty.
3. Consumer satisfaction
Consumer satisfaction helps in maintaining brand image,
market share, prevents defection of consumers to another brand.
4. Investors benefit
In case of joint stock companies, the firm will aim at increasing
the net asset value of the company. Accordingly, it will have a
investor friendly policy in dividends and bonus.
5. Specialization
Specializing in certain product or service will be useful in
establishing brand image, market share and growth.
6. Creating brand equity
Every firm aims at creating a brand and as large consumer
following as possible. This is in the long run interest of the
firm.
b. Long run objectives

1. Survival
The basic objective of firm is to survive in the long run. In the
long run the competition may increase, in such a market the
basic principle is to survive.
2. Market leadership
The firm wills always aim at being the market leader. This is a
material objective as well as normative objective. In most cases
profit depends on this objective.
3. Increasing market share
The firms will initially aim at increasing market share. This is
the objective before aspiring for market leadership.
4. Growth: forward and backward integration
The firm may go for forward integration thus adopting an
additional process of production or take up backward
integration whereby, produce locally such component which
was earlier brought form the factor market.
c. Non material objective

1. Social responsibility
The forms may assume social responsibility as an important
factor. It is give back from the society from where the firm
makes a living.

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2. Environmental protection
The firm may work in the direction of protecting the
environment. This is dome by being eco-friendly and having
less pollution.
3. Resource conservation
The resource conservation may help in reducing costs but it
also helps in reducing social costs. The society benefits form
resource conservation
4. Creating social infrastructure
The firm may create social infrastructure by constructing
educational institutions, hospitals, townships, and aforestation.
Perfect Competition
Perfect competition refers to a competition between large umber of buyers
and sellers dealing in homogenous product at uniform price.
Features of perfect competition
1. Large number of buyers and sellers

The number of buyers and sellers should be so larger that no firm can
determine the supply or no single buyer can determine demand and no
singe person can determine the price.
2. Homogenous product
The product is homogenous, so that no form has a reason to charge a
different price.
3. Free entry and exit of firms:
When there is free entry and exit of firms, the firms keep joining the
production as long as there are profits. With new firms joining the
super normal profits, get distributed among more and more firms.
At the same time when the profits decrease the less efficient firms
leave the industry. So in the long run, efficient firms which can
operate at normal profits only exist. In the long run the perfect
competition has only firm which operate on normal profits.
4. Perfect knowledge
The buyers and sellers have perfect knowledge of \demand, supply
and price.
5. Free mobility of factors of production

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Free mobility of factors ensures that the cost of factors is same across
all the regions. Equal factor prices give all the firms same opportunity
to make profits and survive. So, efficiency of firms will determine the
profitability of firms.
6. No transport cost
The transport cost should be insignificant as compared wt the cost of
production. This is possible only when the firms cater to local
markets.
7. No advertising
The firms need not advertise, because each firm will have infinite
market at the given price. Advertising will add to cost and reduce
profits
8. Uniform price
Uniform price ensures that the consumers have choice between firms
and the firms have no reason to charge different price due to
homogenous product.
9. No Government restrictions
There are no government interventions by way of taxes or mobility of
goods.
Monopoly
Monopoly refers to an imperfect market situation where a single seller sells
the product in different markets at uniform or discriminating prices.
Monopoly is identified with single firm large number of buyers and the
monopolist as the price maker.
Following are the features of monopoly market.
Features of Monopoly
1. Single seller: The monopoly market has a single firm. There is no

distinction between firm and industry. Since a single firm supplies to
the large number of buyers, the firm tends to be large and specializing
in its production
2. Large number of buyers: There is a large market even under monopoly.
However there may be differences in the elasticity of demand in each
segmented market.
3. Product: The product may be homogenous or even differentiated
depending on the nature of market and division of submarkets.

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4. Monopoly power: The entry into monopoly market for other firms is
restricted. This is due to the monopoly power the firm has. The
monopoly power is got by the firm due to following factors.
a. Legal restriction: The law may prevent other firms from
entering. E.g. Government monopolies on entry
b. Exclusive ownership of technology of production: If the
technology of production is known only to a single
firm the monopoly power remains un effected.
c. Exclusive ownership of raw material: Access to raw material
is held by a single firm, the monopoly power remains intact
d. Registered trade marks and brands: I case of registered trade
marks; firms can not duplicate and compete in a market. It
remains as monopoly.
e. Personal monopolies: Personal monopolies have individual
branding. They can not be duplicated. The personal
monopolies continue
5. Price discrimination: With price discrimination a monopolist sells the
same product at different prices in different markets at the same time.
The objective of price discrimination is profit maximization.
6. A monopolist faces a downward sloping demand curve: Under monopoly,
there is no distinction between firm and industry. The demand is
direct on to the firm. Incase of perfect competition, the industry faces
down ward sloping demand curve and the firm gets the perfectly
elastic demand curve. In case of monopoly the firm directly faced the
downward facing demand curve.
It means that the firm can sell more only by reducing price. With this
difference, the relation ship between AR and MR also changes
Relationship between Average revenue and Marginal revenue

under monopoly
A monopolist faces a downward sloping demand curve, so he can sell more

only by reducing the price. This will change the AR and MR relationship.
Since it is an imperfect market, AR is not equal to MR. It can be seen that
AR is greater than MR. Further, AR and MR are related through elasticity of
demand.

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Q Price TR AR MR
1 10 10 10 -
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
Geometrically, AR curve cuts the plain below AR into two halves. So any
perpendicular drawn on Y axis will show the property, ab = bc
Monopolistic Competition
Monopolistic competition is a case of imperfect competition where limited

number of firms, compete with differentiated product at dissimilar prices.
Following are the features of monopolistic competition:
1. Large number of buyers: The number of buyers is large. It is a large

market where firms compete.

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2. Limited number of firms: The number of firms remains limited due to

intense competition. The entry is not restricted by law, but
competition discourages new firms.
3. The prices need not be uniform. Each firm produces goods as per their
own market, so the product quality, utility differ. In such a case the
prices also differ.
4. Product differentiation
Product differentiation means the same product being projected different, by
modifying with additional utility, quality or term of sale.
The product differentiation is done in flowing ways:
a. By an additional quality: the firm may show a different quality of
the product which may not exist in the market. The quality should
be such that the utility of the product gets enhanced.
b. By an additional quality: The product can be designed with an
additional utility. Products with different utilities have elastic and
larger demand. This is one method of improving the appeal of the
product. It is seen that dual utilities have improved the quality of
the product like the two-in-one products.
c. By different term of sale: the fir may offer a different terms of sale.
It may be by way of guarantees, after sale service, quizzes,
contests, prices, Etc.
The objective of price differentiation is to claim monopoly power in an

imperfect market. This is done by creating unique selling proposition.
Product differentiation means differences in cost. With differences in cost

the price also changes. Firms sell at different prices. The competition
between firms with different prices is called non-price competition. The
firms justify the price by either different image/ brand equity or by different
qualities/utility of the product.
Non-price competition benefits the firms. The consumer is made to pay

higher pries which are falsely justified through advertising.

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5. Selling cost
Selling cost is the cost of generating demand. Under monopolistic

competition, the firms engage in non price competition. The firms charging
different prices justify their prices by advertising, publicity, field campaign
and similar promotional activities.
Selling cot helps in generating demand, brand image and justifying the price.
Selling cost does not give utility. Selling cost is a burden on the consumer.
Production cost on the other hand generates utility. The production cost
decreases with increasing out put in, proportion. This is due to economies of
scale. Whereas, the selling cost increases in larger proportions to increasing
out put. This is because, advertising becomes more and more expensive,
with increasing out put.
Selling cost makes demand elastic and shifts demand curve u wards.
In the diagram it can be seen that, selling cot has increased the average cost.
Yet, the demand curve has shifted upwards and also became elastic. This is
the advantage the firm receives by spending selling cost.
Oligopoly
Oligopoly is an imperfect market condition identified with limited number
of firms with high interdependence competing with differentiated or uniform
product at uniform prices.
Following are the features of oligopoly market

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1. Limited number of firms:

The number of firms is limited due to intense competition. The
industry remains as a small group of firms.
2. Large number of buyers

The number of buyers will be very large. There will be huge market
for which the firms compete.
3. High degree of interdependence between firms

The firms will have high degree of interdependence in terms of price
and product design. The firms almost share the same demand curve.
However, the demand is made elastic or remains inelastic depending
on the nature of advertising.
No firm can deviate and change the product description. Any change
made by the firm will lead to the consumer shifting to other
competing firms. The demand remains very flimsy for a firm. The
demand is maintained carefully by maintaining the same price, similar
product details and advertising.
4. Rigid and uniform prices

The price will remain uniform and rigid. When the price is accepted
by the firms and the buyers, it continues for a long time. A consumer
will not pay a higher price because he can continue to get the same
price from other firms. A firm will not reduce the price because the
consumer is willing to pay the given price. On the other hand
reduction in the price may be treated as a loss of quality. This is called
as price illusion.
5. Advertising
Advertising is an essential part of oligopoly market. Advertising is
essential for registering the product with the consumer. Advertising
allows the product to have the required exposure to the consumer so
that the consumer can include the product in his options.
Further, advertising make the demand elastic. By making the demand
elastic, the firm will be able to sell more goods at the given price.
6. Types of oligopoly
There are different types of oligopoly each based in a different
marketing practices followed to manage competition.

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a. Pure and differentiated oligopoly

Pure oligopoly deals with goods are homogenous
whereas differentiated oligopoly may have apparent
product differentiation. The market offers flexibility the
firms to change the nature of the product keeping the
base utility same. In ace of pure oligopoly it is easy to
maintain price uniformity. With product differentiation,
the price tends to change because of cost variations. Even
in theses conditions the firms need to maintain the
uniform prices. For this reasons the firma can only adopt
apparent product differentiation without changing the
cost structure.
b. Complete and partial oligopoly

Complete oligopoly refers to market where all the firms
are equally placed in terms of competition, price and
market share. Whereas in case of partial oligopoly, there
can be one large firm emerging as the leader. The leader
will have the advantage of giving a lead price to the
product which other firma will follow. The leadership
firm will have the privilege of designing the product,
price and the nature of competition.
Pure oligopoly may at times change to partial oligopoly
by frequent mergers. Firms merge among themselves to
form a large firm so that a leadership role can be
achieved.
c. Collusive and Non collusive oligopoly

Non collusive oligopoly refers to a market where the
forms operate independently, however with
interdependence. In case of collusive oligopoly, the firms
may collide, enter into agreements to lessen competition
and share the market to exploit the consumers.
7. Cartels
Cartels are a case of collusive oligopoly. Firms in market
with intense competition form arrangements to avoid
competition by making agreements so that all firms tend
to benefit at the cot of the consumer. Cartels are harmful

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business organization formed to enhance exploitation and

increase profits.
There can be different types of cartels depending on agreements.

a. In a cartel, the firms with high price may insist that its
price prevail, so that all firms can maximize profits.
b. At the same time the firm with lesser price may insist on
its price to be followed so that larger out put can be sold.
These are price cartels. In both these cases competition is
avoided and market becomes lucid.
c. The firms may divide the market geographically and
restrict mutual entry in respective territory. In this case
the market has one monopoly firm selling the product.
d. The firms may have system of marketing royalties as
consideration for sharing territory for attaining monopoly
power. A firm operating in market as an exclusive
monopolist may have to pay market royalty to other firms
restricting entry.
The cartels can be operating at international levels, where the regions are
shared on the basis of trading currencies or countries. The counter may
form commodity agreements, bilateral agreements, and multilateral
agreements for a specific time. All these agreements where the firms or
the counties get captive markets belong to cartels.
Duopoly
Duopoly is a model of oligopoly market with two firms designed to study
the interdependence of firms for pricing.
Following are the feature of a model duopoly market:
1. Two firms:
The number of firms is limited to two. This is for the purpose of
studying the details of interdependence. Hence it is a model of
oligopoly.
2. Large number of buyers

The number of buyers will be very large. There will be huge market
for which the firms compete.
3. High degree of interdependence between firms

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The two firms will have high degree of interdependence in terms of

price and product design. Two firms almost share the same demand
curve. However, the demand is made elastic or remains inelastic
depending on the nature of advertising.
Single firm can deviate and change the product description. Any
change made by the firm will lead to the consumer shifting to other
competing firm. The demand remains very flimsy for a firm. The
demand is maintained carefully by maintaining the same price, similar
product details and advertising.
4. Rigid and uniform prices

The price will remain uniform and rigid. When the price is accepted
by both the firms and the buyers, it continues for a long time. A
consumer will not pay a higher price because he can continue to get
the same price from other firm. A firm will not reduce the price
because the consumer is willing to pay the given price. On the other
hand reduction in the price may be treated as a loss of quality. This is
called as price illusion.
5. Advertising
Advertising is an essential part of oligopoly market. Advertising is
essential for registering the product with the consumer. Advertising
allows the product to have the required exposure to the consumer so
that the consumer can include the product in his options.
Further, advertising make the demand elastic. By making the demand
elastic, the firm will be able to sell more goods at the given price.
6. Kinky demand curve

The demand curve for the duopoly market is med up of the individual
demand curves of two forms. These are the demand curves made by
the firms by the independent advertising campaigns and publicity.

Dr.Ranga Sai

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Section II
1. Basic concepts of income aggregates
National Income
National income is the total of the value of the goods and the services which
are produced in an economy.
National income estimates are represented as Gross and net, Domestic and
national product and market prices and factor costs
1. Net National Income and Gross National Income

The difference between Net National Income and Gross National
Income is the capital consumption i.e depreciation
Gross National Income – depreciation = Net National Income
2. Gross Domestic product Gross National Product

The difference between GDP and GNP is the net earning from the
external sector
GDP = C + I + G and GNP = GDP + (X-M)
3. National Income at market prices and National Income at factor costs

The difference between factor costs and market prices is the net of
subsidies given to industry and the taxes levied.
National Income at factor costs – subsidies + taxes =National Income at
market prices
Measurement of National Income

There are three approaches through which national income can be calculated
but all these approaches give the same value of the national income.
1. Output approach,
2. Income approach and
3. Expenditure approach
1. Output approach,
Gross Domestic Product: Gross Domestic Product (GDP)
measures the value of output produced within the domestic
boundaries of a country over a given time period.

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The method for calculating National Income by Output method considers the
value of output.
GDP at market price = Value of Output in a year - Intermediate

consumption
NNP at factor cost = GDP at market price - Depreciation +

NFIA (Net Factor Income from Abroad) - Net Indirect Taxes
2. Income approach
The Income Method of calculating GDP (the Sum of Factor Incomes)
GDP is the sum of the incomes earned through the production of
goods and services.
Income from people employment and in self-employment

+
Profits of private sector companies
+
Rent income from land
= Gross Domestic product (by factor income)
This method excludes the following items:

• Transfer payments e.g. the state pension paid to retired
people; income support paid to families on low incomes
• Private transfers of money from one individual to another.
• Income that is not registered. This is known as the parallel
economy where goods and services are exchanged but the
value of these transactions is hidden from the authorities.
3. Expenditure approach
The measurement of National Income by Expenditure Method
considers consumption, investment expenditure and government
expenditure, to this the net earnings from external sector is added.
GDP = C + I + G + (X - M)
Where:
C = Personal consumption expenditures
I = Gross investment
G = Government consumption

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X = Gross exports
M = Gross imports
Maharashtra State Economy

Most industrialized and urbanized State in India Ranks 1st in terms of State
Domestic Product accounting for over 13 percent of the National GDP
Maharashtra’s economy is growing at over 9 percent (9.4 percent in 2006-
07) Contributes over 40 percent of the National fiscal receipts Per Capita
Income is 44 percent higher than the national average 67 percent of the
population is young - below 34 years Literacy is at 77 percent.
State Overview
• Sixth Largest Metropolitan Area in the World and Most
Cosmopolitan City in India
• Generates 5 percent of India’s GDP
• Headquarters of most corporates, banks, FIs and the Reserve
Bank
• Time Zone – is an added advantage
• BSE & NSE account for over 70 percent of the volume
across all Stock Exchanges in the country
• Over 90 percent of commodities turnover transactions
executed from NCDEX and MCX
• 90 percent of all merchant banking activities take place in
Mumbai
• Center of Entertainment – Bollywood
• The only Indian State to feature in the IMD Switzerland’s
World
• Attracted the highest FDI (21 percent of the country’s total)
between 1991-2007 with 3957 proposals having committed
investments of USD 17 Billion
• FICCI FDI Survey 2006 says Maharashtra continues to be
No. 1 State for FDI
Special Economic Zones

The SEZs are earmarked as duty free enclaves and have a flexible and
business-friendly policy regime 93 Special Economic Zones being set
up in various parts of the state both Multi Product and Product

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Specific sectors like Auto, Textiles, Bio Technology, IT and Food

Processing SEZ’s for Power Generation, Free Trade Warehousing
Zone. Port-Based SEZs also being developed
Service Sector
Services contribute 61 percent to the State’s economy 25 percent of
the Top 500 Software Companies present 20 percent of country’s
software exports 32 percent of country’s IT professionals 90 percent
of all merchant banking activities take place In Mumbai Infrastructure
11 percent of National Road Network 9 percent of National Railway
Network 34 percent of international passengers and cargo handled by
Airports 56 percent of container traffic handled by Jawaharlal Nehru
Port in the State 4 international airports and domestic airports at all
major cities India’s only expressway upgrading Mumbai-Pune
connectivity to 10 lane Mumbai
Trends in State Gross Domestic Product
• At the All India level, Gross Domestic Product at constant

prices is expected to grow by 9.2 percent in 2006-07 as
against 9 percent in the previous year.
• In comparison to this the Gross State Domestic Product of
Maharashtra at constant prices is expected to increase by 9.3
percent during 2006-07, as against increase of 9.2 percent in
the previous year.
• The State is moving from fiscal consolidation to fiscal
stabilization stage.
• In 2006-07 revenue growth is estimated at 24.42 percent
against the revenue growth of 18.10 percent in 2005-06.
Revenue receipts are estimated to grow at 13.33 percent in
the year 2007-08, while the revenue expenditure growth is
expected at 6.82 percent.
• The States own tax revenue income in 2006-07 is estimated
to outpace the nominal rate of growth in the Gross State
Domestic Product.
• Containment in non-plan expenditure has been achieved
despite higher allocations for the maintenance of assets. It
has been mainly achieved by containment of the expenditure
on establishment.

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• Growing debt stock and high debt servicing to the revenue

receipts ration has been a matter of concern for the State.
• As a result of better fiscal management, State has been able
to reduce the debt as a percentage of Gross State Domestic
Product to 27.05 percent in 2006-07 as against 28.76 percent
in 2005-06. It is further estimated to decline to 25.53 percent
in the year 2007-08.
• Debt servicing to revenue receipts which was as high as
36.14 percent in 2005- 06 is estimated to decline 30.41
percent in 2006-07 and 29.11 percent in 2007-08.
2. Introduction to money, banking and public finance
Velocity of money
Velocity of money is defined simply as the rate at which money changes

hands.
Velocity refers to how many times a given quantity of money is spent during
the period under consideration, usually one year.
If velocity is high, money is changing hands quickly, and a relatively small

money supply can fund a relatively large amount of purchases.
If velocity is low, then money is changing hands slowly, and it takes a much
larger money supply to fund the same number of purchases.
It is known that GDP = M x V; that is, GDP equals the quantity of money
times its velocity.
By dividing the Gross Domestic Product (GDP) by the Money Supply (M1)
Velocity of Money can be derived.
Velocity of Money = Gross Domestic Product

Money Supply
Factors determining velocity of money

• Change in Price for goods and services.
• Availability of Substitutes

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• Credit Supply
• Rate of Interest
• Banking habits
• Development of banking system
• Inflation
• Future expectations
• Liquidity preference
Constituents of Money supply

The supply of money is the State function. The Central bank possesses the
monopoly of issue of currency. Traditionally the supply of constitutes coins
and currency. There are several approaches to the constituents of money
supply.
1. With ever expanding properties and functions of money the constituents

of money has been rapidly changing. Since David Hume, the
composition of money started including coins and currency
together with demand deposits. The deposits which are chequable
are as liquid as cash. So primarily, money supply should be made
up of:
Coins and currency + Demand deposits
2. Milton Friedman described money with wider coverage and functions.

According to him money supply should comprise coins and
currency, demand deposits and also time deposits. Time deposits
are those which have a time obligation between the bank and the
depositors. They are liquid but with a time prescription.
Coins and currency + Demand deposits + Time deposits
The spending of the house hold is influenced by the cash held by

them. But the time deposits also enhance the spending decisions.
Time deposits can function as liquidity preference thus allowing
households exercise greater spending.
Milton Friedman’s approach is accepted and followed all over the

world as the standard of measuring money supply. This is similar
to the measure M3 followed by Reserve Bank of India.

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3. Gurley and Shaw offer the widest definition of money supply. According
to them, money supply shall include all that can be converted into
cash, depending on convertibility of asset.
However, the assets shall be included in money supply based on

their liquidity. E.g. Cash is cent percent liquid, where as time
deposit has lesser liquidity, loans, securities, gold all have liquidity
which gradually declines. These assets shall be included as per the
weightages assigned to their liquidity.
4. Bank of England follows the method suggested by Radcliffe Committee.

The method has wider coverage; it includes assets depending on
liquidity and convertibility. Reserve Bank of India followed
method similar to this upto 1977, when the II Working Group
suggested an alternative and indigenous method of measuring
money supply.
5. Reserve bank of India
The II Working Group appointed by The Reserve Bank of India suggested

four measures to the money supply. These measures provide better definition
to money supply and provide different estimates for use of monetary policy.
M1 = Coins and currency + Demand deposits of all

Commercial and cooperative Banks
M2 = M1 + Demand deposits of Post office saving

organization
M3 = M1 + Time deposit of Commercial and Cooperative

Banks
M4 = M3 + All deposits of Post office savings organizations
M1 is the measure of basic liquidity. It is this primary level liquidity which

influences the hose hold price index of necessary goods. For control of
inflation based on general price index, M1 is used for policy purposes.
M2 is specially designed for the Indian context. It brings out the strength of
the Post Office Savings Organization in India. India with its kind of spread,

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PO organization is selected as agency of banking facilities in the remote

areas. M2 brings out the role of PO savings organization.
M3 is the international standard of money supply. IMF, World Bank and

WTO use this measure, uniformly, for comparing different economies of the
world. M3 is similar to Milton Friedman’s measure of money supply. M3 is
the measure of aggregate liquidity in the economy. This is an important
measure for monetary targeting by RBI.
M4 is the widest measure of monetary resources in India. It includes the

demand, time and other deposits of commercial banks, cooperative bank and
PO savings organization.
Liquidity preference theory

There are three chief motives for which money is demanded. These are
transactions, precaution and speculation. The first two motives are classical
the third motive of speculation is introduced by Keynes.
1. Transactions Motive:
Money is demanded for regular economic transactions. Both
households and firms have to carry out a variety of transactions
for which they need money.
It is related to the size of the income and type of activities
performed by individuals, households and firms. Demand for
money to satisfy transactions motive is about 50 percent of the
size of an individual or household income.
2. Precautionary motive:
Money demanded to satisfy the precautionary motive is for
meant for unforeseen circumstances. This amount of money
kept aside can be used during times of uncertainty or
emergency. It depends mainly on the size and responsibilities of
the family and size of the income. In the short run these factors
remain constant and hence demand for money also remains
nearly constant.
3. Speculative motive:

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Keynes was the first to identify the role of speculative

activities. Such demand is made to invest in capital market for
buying shares, bonds, securities etc. when their prices are low.
Keeping money in this idle form is known as hoarding of
money. It all depends upon fluctuating prices and market
conditions for securities.
The total demand for money or liquidity can be classified into two parts:
Total demand for money = L = L1 + L2
L1 is that part of money or liquidity demanded to satisfy transactions and

precautionary motives. Keynes calls this the demand for Active Cash
balances or money. Active cash balances depend on the income of the
households. The second part L2 is money demanded made to satisfy the
speculative motive. Keynes has called this as demand for Passive Cash
balances or money. Speculative demand depends upon the prices of
securities.
The negative relationship between rate of interest and liquidity preference is

found only up to a minimum interest rate. There after, the demand for money
becomes infinity. The zone where the demand for money is infinity is called
as the liquidity trap. Any increase in money supply at this level will not have
any effect on the liquidity preference. At liquidity trap the demand for
money tends to be infinity.

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Monetary Policy
Monetary Policy deals with changing money supply and rate of interest for
the purpose of stabilizing the economy at full employment or potential
output level by influencing aggregate demand
The RBI makes use of instruments to regulate money supply and bank credit
so as to influence the level of aggregate demand for goods and services.
The monetary policy has to balance the objectives of economic growth and
price stability.
Economic growth requires expansion in the supply of money so that no

legitimate productive activity suffers due to finance shortage. Price stability
requires control the expansion of credit so that money supply does not cause
inflation.
Changes in the monetary policy can be made anytime during the year. The
Central Bank may adopt an expansionary or contractionary policy
depending on the general economic policy of the Government and
conditions in the economy.
Monetary policy may also be used to influence the exchange rate of the
country’s currency.
Objectives of monetary policy

Control of Inflation:
In a developing country like India, increase in
investment activity puts a pressure on prices. A high
degree of inflation has adverse effects on the economy.
It raises the cost of living, makes exports costlier,
reduces the incentive to save and encourages
nonproductive investment.
RBI increases the SLR which reduces availability of

loanable funds with commercial banks.

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By increasing bank rate, the cost of bank loan is

increased which in turn reduces money supply and
credit which tend to reduce price rise. Price stability
means a reasonable rate of inflation.
Economic Growth:
Accelerating economic growth so as to raise national
income is another objective of the monetary policy. To
promote economic growth availability of bank credit is
increased and the cost of credit is reduced. Promotion
of economic growth needs a liberal monetary policy.
Exchange Rate stability:

Until 1991 India followed fixed exchange rate system.
The policy of floating exchange rate and globalization
of the Indian economy have made the exchange rate
volatile. The RBI attempts to ensure exchange rate
stability. A tight policy will prevent fall in the value of
rupee. Alternatively to prevent depreciation of rupee,
the Reserve Bank releases more dollars from its foreign
exchange reserves.
A floating exchange rate or a flexible exchange rate is a

type of exchange rate regime wherein a currency's
value is allowed to fluctuate according to the foreign
exchange market. A currency that uses a floating
exchange rate is known as a floating currency Many
economists think that, in most circumstances, floating
exchange rates are preferable to fixed exchange rates.
They reduce the shocks and foreign business cycles.
Fiscal Policy
Fiscal policy refers to the

use of government spending, taxation and borrowing to
influence both the pattern of economic activity and also the
level and growth of aggregate demand, output and
employment.

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Fiscal policy has been seen as an instrument of demand management. It

involves changes in government spending, direct and indirect taxation and
the budget.
• The Keynesian feel that fiscal policy can have powerful

effects on aggregate demand, output and employment when
the economy is operating well below full capacity national
output.
• Monetarist economists feel that government spending and

tax changes can only have a temporary effect on aggregate
demand, output and jobs.
The working of fiscal policy

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The fiscal policy is mage up of two components

Government spending
Government (or public) spending each year takes up over 40 percent of
gross domestic product. Spending by the public sector can be broken
down into three main areas:
• Transfer Payments: Transfer payments are
government welfare payments made available through
the social security system including the Jobseekers’
Allowance, Child Benefit, the basic State Pension, Housing
Benefit, Income Support and the Working Families Tax
Credit. They provide a means by which the government can
change the overall distribution of income in a country.
• Current Government Spending: It is spending on state-
provided goods and services.
• Capital Spending: Capital spending would include
infrastructural spending such as spending on new motorways
and roads, hospitals, schools and prisons. It adds to the
economy’s capital stock and clearly can have important
demand and supply side effects in the medium to long term.
Taxation
• Direct taxation is levied on income, wealth and profit. Direct
taxes include income tax, national insurance contributions,
capital gains tax, and corporation tax.
• Indirect taxes are taxes on spending – such as excise duties on
fuel, cigarettes and alcohol and Value Added Tax on many
different goods and services
Effects of Fiscal Policy
Changes in fiscal policy can affect the economy and contribute to long
term economic growth.
Labour market incentives: Cuts in income tax might be used to

improve incentives for people to actively seek work and also
as a strategy to boost labour productivity.
Capital spending. Government capital spending on the national
infrastructure (e.g. improvements to our motorway network
or an increase in the building programe for new schools and
hospitals) contributes to an increase in investment across the
whole economy.

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Entrepreneurship and new business creation: Government

spending can expand the rate of new small business start-ups
Research and development and innovation: Government
spending, tax credits and other tax allowances could be used
to encourage an increase in private business sector research
and development.
Human capital of the workforce: Higher government spending
on education and training and increased investment in health
and transport can also have important supply-side economic
effects in the long run.
Automatic stabilizers and discretionary changes in fiscal policy

Discretionary fiscal changes are deliberate changes in direct
and indirect taxation and government spending
Automatic stabilizers include those changes in tax revenues and
government spending that comes about automatically as the
economy moves through different stages of the business
cycle
Tax revenues: When the economy is expanding rapidly the
amount of tax revenue increases which takes money out of
the circular flow of income and spending
Welfare spending: A growing economy means that the
government does not have to spend as much on means-tested
welfare benefits such as income support and unemployment
benefits
Budget balance and the circular flow: A fast-growing economy
tends to lead to a net outflow of money from the circular
flow. Conversely during a slowdown or a recession, the
government normally ends up running a larger budget
deficit.
Economics of Inflation
According to neoclassical economics inflation refers to increase in the level

of economic activity after full employment.
Presently, inflation is found even with unemployment. This is called

stagflation.
Inflation

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• Inflation is post Keynesian concept. Primarily inflation is

caused by indiscriminate expansion of money supply.
• Inflation means too much money chasing too few goods.
• Increase in monetary resources against stagnant real output
leads to inflation.
• Inflation is a monetary phenomenon.
• Inflation is caused by excess demand pressures on the goods
and factors of production due to increase in monetary
resources.
Types of Inflation
Inflation can be classified based on major causes. Accordingly, there can be

four types of inflation
Budgetary inflation:
This is the inflation caused by expansion of money supply resulting
out of Government’s budgetary activities. The Government may
increase money circulation to meet the deficits in the budget for
financing any contingency.
If Government expands money for non productive purposes it leads to
inflation. During Post Keynesian period, this has been a major cause
for rapid increase in inflation all over the world.
Wartime inflation:
During the emergencies of war, the Government generates resources
by currency expansion. In addition, the prices may incase due to
scarcity followed by hoarding and black marketing.
Such inflation is generally controlled after war. War time inflation is a
common occurrence these days.
Demand Pull Inflation

Demand pull inflation is caused by increasing demand arising out of
excess money supply and increase in demand for factors by the
industry.
Demand pull factors
1. Increase in money supply due to budgetary activity
2. Increase in demand for goods

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3. Increase in demand for factors by the industry
According to Keynes, after full employment E if the aggregate demand

increases to D1, D2, and D3, the real output can not increase and the
equilibrium will be shifting only on the ASF to E1, E2, and E3. As a result
the prices will increase to P1, P2, and P3. This is the inflation driven by
demand pull factors
Demand-pull factors in India

a. The parallel economy creates demand pressures from
unexpected sectors of the economy.
b. The unorganized money markets pump in those additional
resources which cause inflation.
c. Increasing public expenditure creates large amount of incomes.
Public expenditure, which constitutes 43 percent of GNP is a
major source of income.
d. Rapid monetary expansion leads to excess inflationary
pressures. A monetary base of Rs. 2, 65,000 crore generates a
large income and the following demand.
e. Deficit financing create those resources which create inflation.
The deficits create additional resources of around Rs.10,000
crores annually.
f. Due to in appropriate taxation large disposable income is left
causing high rates of inflation.
Cost Push Inflation

Cost push factors

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1. Increasing prices
2. Decrease in the real income (purchasing power)
3. Decreasing in the standard of living.
4. Increase in demand for factors
5. Increase in demand for more wages
6. Wages increase due to strong trade union
7. Increase in the cost of production
8. The prices increase.
Under cost push inflation even with increasing demand the supply can not
shift. Against an inelastic supply curve an increase in demand D1, D2, and
D3 will shift the supply curve. The cost structure undergoes a change and the
equilibrium will be found on the same inelastic supply curve. The real out
put remains same and the value of out put increases to P1, P2, and P3. Hence
the prices will increase. This is cost push inflation.
Trade Cycles
Periodic changes in the level of economic acclivities in the long run are
commonly termed as trade cycles. The level of economic activity
periodically, increases and reaches a peak, shows a change in trend,
decreases and bottoms out and finally, changes trend towards increase. Such
cyclical changes in the level of economic activities constitute the trade cycle.
Trade cycle is a neoclassical concept of macro economics which tries to

explain the changes in the economic activities with respect to time. The
concept of trade cycle was initially developed by Joseph Schumpeter. The

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different phases in the trade cycle are named in relation to the full
employment level.
Accordingly, there are six phases of trade cycle:
1. Inflation
2. Boom
3. Deflation
4. Recession
5. Depression, and
6. Recovery
1. Inflation: When the economic activity increases after full employment

level, it is called inflation. During inflation, the demand pressures will
be high. Increasing demand leads to increasing product prices,
increasing demand for factors, higher wages and then increasing
demand again.
2. Boom: Boom refers to the peak in the level of economic activity after
full employment. The demand pressures will be at the peak. The price
level will be very high.
3. Deflation: It is the downward trend in the economic activities after
boom. At boom level the Government will take corrective measures
due to which the economic activity will show a change in trend.
4. Recession: When the economic activity reduces below full
employment It is called recession. The level employment will
decreases, the prices will decrease and the economic activity shrinks.
5. Depression: This is the lowest level of economic activity. The markets
collapse. Large scale unemployment will lead to poverty and

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suffering. The world experienced Great depression during 1929 and

1933.
6. Recovery: From the lowest levels of economic activity the markets
recover due to positive Government policy. The economic activity
will increase towards full employment. Three will be increase in the
level of employment, incomes, investment and demand.
The reasons for the occurrence for the trade cycle has been not yet explained
satisfactorily. The Sun spot theory relates the level of economic activity with
the number of sun spots. In absence of any other theory, the Sun Spot theory
still holds valid.
Phillips curve is the modern concept which relates unemployment and

inflation. According to Phillip, there is a trade off between inflation and
unemployment; one can be reduced only at the cost of the other. If inflation
is reduced, unemployment increases and if unemployment is reduced
inflation may increase.
In such case the ideal alternative is to find such a point on the curve which is
closest to the origin. By selecting such a combination, both inflation and
unemployment can be maintained at tolerable levels.

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b. Banking and non banking institutions

Indian Banking system:
The Indian banking sector consists of the Reserve Bank of India (RBI),
which is the central bank, commercial banks and co-operative banks.
Commercial banks are of two types:
1. Scheduled, which are subject to statutory requirements and

2. Non-scheduled, which are not.
Scheduled banks can be further classified into

a. Public sector banks comprising of the State bank of India, its seven
associates,
b. Other nationalized banks
b. Regional Rural Banks and
c. Private sector banks, which can be either domestic or foreign.

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Public Sector Banks
a. State Bank of India and its associate banks called the

State Bank group
b. 20 nationalized banks
c. Regional Rural Banks mainly sponsored by Public Sector
Banks
Private Sector Banks
a. Old generation private banks

b. New generation private banks
c. Foreign banks in India
d. Scheduled Co-operative Banks
e. Non-scheduled Banks
Scheduled and Un-scheduled Banks
The commercial banking structure in India consists of:
• Scheduled Commercial Banks in India

• Unscheduled Banks in India
Commercial banking
Section 5b of the Banking Regulations Act, 1949, defines banking as
"Acceptance of deposits of money from the public for the purpose of
lending or investment".
These deposits are repayable on demand or otherwise, and withdrawable
by a cheque, draft, order or otherwise.
Banks are the only financial institutes which can accept demand deposits
(Saving / Current) which can be withdrawn by a cheque. In addition, a bank
performs the following functions:
• Issuing Demand Drafts & Travelers Cheques

• Collection of Cheques, Bills of exchange
• Discounting and purchase of Bills
• Safe Deposit Lockers
• Issuing Letters of Credit & Letters of Guarantee
• Sales and Purchase of Foreign Exchange

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• Custodial Services
• Investment services
• doing all such other things as are incidental or conducive to
the promotion or advancement of the business of the
company;
Role of commercial banking
The finance sector is an important factor of rapid development. The role can
be explained as follows:
a. Commercial banking aids industrialization by providing liberal

trade credit or working capital.
b. Commercial banks through their operations of mobilizing
deposits and extending advances help in redistribution of
resources across regions.
c. By savings mobilization, commercial banks help in capital
formation.
d. Extensive banking sector can improve the banking habits of
people.
e. Entrepreneurship can be promoted by commercial banking
finance.
f. Commercial banking is looked upon as an agent of economic
growth.
Reserve Bank of India

The Hilton Young Commission in 1926 originated the idea of Reserve
Bank of India as the central Bank. This commission came to be known as the
Royal Commission on Indian Currency and Finance. Prior to 1926, the
Presidency Banks had the right of note issue. This was taken over by RBI in
1934 under the Reserve Bank of India Act,
Formally, in 1935 RBI was established as an apex institution and the nation's
monetary authority. It had a division of two separate activities viz. the issue
department and the Banking department.
The Banking Regulation Act of 1949 gave RBI the control and supervision
of commercial Banks. The amendments to RBI Act in 1962 provided the

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RBI right of information from commercial banks regarding their credit

functions.
Currently, RBI has emerged as a potential apex monetary authority with

control over the capital markets, money markets, foreign exchange markets
and the monetary policy.
RBI as an apex institution has the overall control over the monetary policy.
It regulates the monetary economy by sets of guidelines pertaining to interest
rates, liquidity, lending operations of financial institutions etc. It also
promotes financial institutions to augment Government of India.
The basic functions include:
• Regulation of issue of banknotes

• Maintenance of reserves with a view to securing
monetary stability and
• Operating credit and currency system of the country
to its advantage
Reserve Bank of India and its monetary functions:

RBI as an apex institution has a variety of functions in the areas of monetary
issue and banking.
1. Issue Functions: Reserve Bank of India issues currency for denominations

of Rs.2 and upwards. The one rupee currency is issued by the Ministry
of finance, Government of India.
RBI issues currency under the Minimum Reserve system. It maintains

a fudiciary reserve system. It maintains a fiduciary reserve made up
Rs.115 Cr. worth of gold and Rs.85 cr. worth of foreign exchange
reserves. Nearly, Rs.200 cr. of fiduciary balance constitutes the
minimum Reserve for the issue of currency. Annually, the monetary
growth is conditioned by monetary resources; but the growth of
monetary resources reaches the 18 percent mark. This is due to the
deficit financing activities undertaken by the Government.
2. Banking for the Government : Reserve Bank of India is the principle

banker to the Government of India. It maintains the state treasury. The
government finances its activities by issue of treasury bills. These are

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the bills drawn for period ranging from 91 days to 364 days. The
Treasury bill market operated at the RBI discount these bills. The
Treasury bill market is an important part of the Indian money market.
When the bills reach RBI, it retains them: thus RBI is the passive
holder of Treasury bill.
The recent memorandum of understanding between RBI and

Government pegs the treasury bills to Rs.6000 cr. per anum. In excess
of which, the Government has to indulge in commercial borrowings.
On behalf of the Government, RBI maintains the provident fund and

small savings accounts. In case of emergencies these constitute an
important source for financing public expenditure.
RBI also maintains the public debt. On behalf of the Government,

RBI issues instruments of public debt and redemption. It advises the
Government on issues of rescheduling, repayment and now
instruments of Government securities.
3. Bankers' Bank : RBI provides the basic banking functions in addition to

control and regulations. It provides the rediscounting facility. This
rediscount rate is called as the Bank rate. The commercial banks,
depending on their liquidity needs can rediscount the commercial bills
already discounted by them. This way RBI organizes the commercial
Bill market. In the reinforcing Indian Bill market, RBI has a
prominent place. At a bank rate of 10 percent, RBI provides liquidity,
needed by banks.
The commercial banks rediscount bills in bunches of Rs. 50,000 and

denominations of Rs. 5,000. The Narasimham committee provided the
much needed reforms to the Bill market by stipulating realistic
guidelines. For the purpose of bill market operations, the discounting
and finance House of India is being promoted.
RBI maintains the reserves of the commercial banks. The cash

Reserve and statutory liquidity Reserve are the important stipulation
of the functioning of the commercial banks. In this regard the
Narasimham committee suggested that the SLR be reduced to 25
percent progressively from the existing 38 percent. Similarly, the
CRR be reduced to 10 percent from the existing 15 percent.

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4. Forex Reserves : All international transactions are routed through RBI.

Due to this RBI can maintain the needed forex resources. At any point
of time it is expected to maintain, forex position enough for 45 to 90
days import bill. For this purpose RBI can advise the Government to
seek foreign assistance from IMF, World Bank or similar sources.
It also actively participates in the foreign exchange market. The value

of rupee is maintained by RBI. Earlier the value of the currency was
administered by exchange controls. The convertibility of Rupee has
given free hand to the exchange market to determine the value.
However, RBI controls convertibility on current account and capital
account in a restricted way.
RBI may also suggest devaluation to suit the BOP position. At the
instance of RBI, in 1991, devaluation was effected in two rounds, to
the tune of 18 percent.
RBI is the facilitator of exports in co-ordination with the ministry of

commerce. Export promotion measures are also taken up by RBI. The
FERA is effectively implemented by RBI.
5. Credit Control: As the apex authority of monetary policy, RBI controls

credit. The operations of commercial banks are regulated to contain
credit. The position in the capital, money and financial markets is
monitored by the credit policy.
It uses a variety of measures like Bank rate policy, variable reserve

policy and open market operations to control credit. These measures
give rise to rediscounting operations reserve regulations and
government securities trading.
Qualitatively, RBI issues credit regulatory directives to commercial

banks to suit monetary policy.
RBI together with its subsidiaries plays an important role in the

monetary sector. RBI is guided by the general objectives like
controlling inflation, stabilizing investment, sectoral balance,
generation of employment and financing of government projects and
schemes.

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6. Development Functions: RBI is the executive head of the monetary

policy. It has an advisory role is framing monetary policy and
economic legislation for smoother functioning of monetary economy.
RBI may even develop financial infrastructure or promote institutions.
Among the prominent institutions promoted by RBI, important ones

are IDBI, NABARD, Agricultural finance and refinance co-operations
etc.
Its publication department comes out with research reports and data
periodically. RBI is actively engaged in economic research.
It has consultancy function for various commercial, co-operative
banks and term lending institutions.
Thus RBI evolves as a custodian of Indian monetary system,

supporting the policy objectives.
c. Components and functions of Indian financial system
Capital markets
Composition of Capital markets
Gilt-Edged Securities Market:
This market deals with the securities issued by Central Government, State
Government, All-India Financial Institutions like IDBI, ICICI, IFCI, State
Financial Institutions Like SFCs, SIDCs, and other governmental bodies.
The securities are issued in form of bonds and credit notes. The buyers of
such securities are banks, insurance companies, employee’s provident fund,
RBI and even individuals.
These types of securities have the full backing of the Government and as
such they are more secured as compared to other securities in the industrial
securities market. The securities normally issued with different maturity
dates.

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New Issue Market (Primary Market)

It is also called as primary market. There are three ways in which a company
may raise capital in the primary market:
Public Issue: This involves sale of securities, i.e. shares and debentures
to the members of the public.
Rights Issue: This is a method of raising further funds from existing
shareholders.
Private Placement: It involves selling securities to a small group of private
investors.
Secondary Market:
The market for outstanding securities is referred to as secondary market or
stock market. The stock markets are organized markets to trade securities i.e.
shares and debentures of well-established companies. Every day crores of
rupees are changing hands on the stock exchange.
Functions of capital markets

1. Mobilize savings:
The capital markets make it possible to lend funds to various
industrial concerns. Such savings are mobilized and then
utilized for the economic development of the country.
2. Lending of funds:
The capital markets make it possible to lend funds to various
industrial concerns can borrow long - term funds from various
financial institutions in the country.
3. Direct collection of funds:

The primary markets make it possible to collect direct funds
from the market. Interested individuals or corporate bodies
do subscribe for the issue of shares and debentures.
4. Easy liquidity:
The secondary market makes it possible for the investors to
sell off their holdings in form of shares and debentures and
convert them in liquid cash.
5. Link between investors and users of funds:

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The capital market acts a link between the owners of funds

and the users of funds, i.e. A link between investors and
industrial users.
6. Profitable use of funds:

Capital market makes it possible to make productive and
profitable use of funds. This is because the funds that are
lying idle with the owners are utilized by industrial
enterprises in a profitable manner, thus bringing rewards to
the investors, users and the society.
Role and Importance of Capital Markets
1. Accelerates Capital formation though mobilization of resources

Capital market plays a crucial role in mobilizing savings from
people especially the small investors. By providing liquidity
and security, the capital the security, the capital market attracts
masses that bring investment in the capital market.
2. Accelerates Industrial Growth

The resources mobilized by the capital market are utilized by
the industrial sector for productive purposes. Thus it satisfies
the investment requirements demanded by the private and the
public sector. Such activities help in promoting industrial
growth.
Long term capital to the industrial sector

Capital market provides a permanent long-term capital for the
companies.
Better allocation of resources through efficient market system

the capital market ensures the effective allocation of resources
and high productivity.
Ready made market and healthy competition

The primary market provides facilities for new issues of listed
companies while the follow up activities continue in the
secondary market. The secondary market provides a readymade
market for the securities already purchased.

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Foreign capital
The capital market also acts as a source of foreign capital.
Especially, since 1993 onwards, the foreign investors have
turned towards the Indian market.
Encouraging role of financial institutions

The various agencies of capital market such as Industrial
Financial Corporation of India (IFCI), State Finance
Corporation (SFC’s), Industrial Development Bank of India
(IDBI), Industrial Credit and Investment Corporation of India
(ICICI). Unit Trust of India (UTI), Life Insurance Corporation
(LIC) etc. have been rendering useful services to the growth of
industries. They have been financing promoting and
underwriting the functions of the capital market. They extend
assistance to sick units and small units.
Primary Capital markets
The part of the capital market dealing with new securities is known as
Primary Market. It is also known as New Issue Market. Both private and or
public sector organizations can get funds by selling new shares or bonds.
Usually, small or medium scale companies enter into the market of new
securities in order to widen the scope of their business. The selling process
of new securities to investors is called underwriting. The security dealers
earn a commission that is added in the cost of the securities. A lot of
formalities are required to be fulfilled before a security can be sold. Some of
the important features of Primary Markets are as follows:
• It is the market that deals with new long-term securities, not

the existing ones. That is, the securities are sold for the first
time in the Primary Market.
• In the primary market, the securities are sold by the
company directly to the investors. However, it is not so in
the Secondary Market.
• New security certificates are issued to the investors once the
company receives money from them.
• The funds from selling the securities are used by companies
for starting new business or expanding the existing ones.

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• It facilitates capital building in the economy. Thus, affecting

the economic sector to a great extent.
• Primary Market doesn't include other new long-term
external finance sources, like loans from financial
institutions.
In Primary Market, the securities can be issued through any of the

following methods:
• Initial public offering: It refers to the initial sale of securities
by a private company to the public sector. Generally small
and young companies are a part of Primary Market.
However, large-scale private companies that desire to be
publicly traded also become a part of this market.
• Rights issue (for existing companies): It refers to a special
form of shelf offering or shelf registration. Under these
rights, the existing shareholders enjoy the freedom to buy a
specified number of new shares from the firm at a particular
price and time. It is the opposite of Initial public offering
where shares are issued to the general public through stock
exchange.
• Preferential issue: Issue of shares kept aside for the
designated buyers. For example, the employees of the
issuing company.
• The investment banks play key role in Primary Market.
They decide the starting price range for a particular security
and then direct its sale to investors.
• Private capital is converted into public capital. That is, the
securities are released for public. It is known as public issue
or going public. After the initial sale of a security,
Secondary Market deals with the further trading.
Stock Exchange Market
Stock exchange market is a market where stock, shares, gilt-edge, bond and
other securities are bought and sold.

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Some Features of Stock Exchange Market

1. Specialized market: Stock exchange is a specialized market
for the purchase and sale of industrial and financial
securities.
2. Standard guidelines: There are large number of buyers and
sellers who conduct their activities according to rigid rules.
3. Corporate formation. Its activities are controlled by the
company ordinance in our country.
4. Liquidity: Stock exchange offers liquidity, a means of selling
and buying.
5. Price Transparency: Because all trades for a stock flow
through one exchange, this means that everyone sees and
has the opportunity to execute on the same exact price as
everyone else.
6. Corporate Performance: Stock exchange serve as a yard
stick for measuring the performance of company etc.
7. Economic barometer. Stock exchange acts as a barometer; it
forecasts the future economic trends
8. Evaluation of policy: the trends in the stock exchange
evaluates the strength of economic policy
Bombay Stock Exchange

BSE is the oldest stick exchange in India It was established in the year 1857
BSE sensitive index was launched in 1986 with base year 1978-79. It has 30
scrips. There are several other indices like FMCG index, Health care index,
Tech Index.
At the Bombay Stock Exchange the securities are listed in three groups
1. A Group large turnover and high floating stock. There are 150 scrips
2. B1 groups with equity of more than Rs. 3 crore high potential and
trading frequency. There re around 1100 scrips in this group
3. B2 group are like B1 with fortnightly settlement. Low trading
volumes. There are 3200 scrips
New F group was started in 1996 pertaining to debt segment
Launched enterprise market for small and medium enterprises in 2005 to
provide small and medium enterprises an easy access to capital market
BSE introduced trading in derivatives

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National Stock Exchange

NSE was incorporated in 1992 by IDBI and co sponsored by LIC, GIC, SBI
caps and others. Following were the objectives:
• To Establish a nation wide debt market

• To Ensure investors all over the country equal access and
communication
• To provide fair and transparent securities market
• Enable shorter settlement cycles through electronic trading system
• To establish international standards.
NSE provided two segments:

a. Wholesale debt market for Banks, financial institutions
for trading in PSU bonds, Treasury bills, CPs and CDs
b. Capital Market segment dealing with equities,
convertible debentures
RBI empowered NSE for inter-bank security deals. NSE has greater market
capitalization than BSE. However, the Capital Market Segment performs
better than the Wholesale debt market
Securities Exchange Board of India
In 1988 the Securities and Exchange Board of India (SEBI) was established
by the Government of India as a fully autonomous and statutory Board, in
the year in 1992. It replaced the earlier Controller of Capital Issues.
The basic objectives of the Securities and Exchange Board were:
• to protect the interests of investors in securities;

• to promote the development of Securities Market;
• to regulate the securities market.
SEBI has legislative, judicial and executive functions combined into one. It
drafts regulations, conducts investigation and enforcement action, and passes
rulings and orders in its judicial capacity.
SEBI has promoted trading in stock indices (like S&P CNX Nifty and
Sensex) in 2000. Such an index is useful because:

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• It acts as a barometer for market behavior;

• It is used to benchmark portfolio performance;
• It is used in derivative instruments like index futures and
index options;
• It can be used for passive fund management as in case of

Index Funds.
SEBI has to be responsive to the needs of three groups, which constitute the
market:
1. The issuers of securities: In the primary capital markets,
SEBI ensures fair play for the promoting companies as well
as investors.
2. The investors: The retail investor needs to be protected. As
well as the FII need to be regulated and encouraged to pump
in large funds
3. The market intermediaries: The market intermediaries like
banks, and other financial institutions should have a ideal
atmosphere to trade.
Functions
• The Board is responsible for the securing the interests of

investors in securities and to facilitate the growth of and to
monitor the securities market in an appropriate manner.
• To monitor and control the performance of stock exchange
and derivative markets.
• Listing and monitoring the functioning of stock brokers, sub
brokers, share transfer agents, bankers to an issue, trustees
of trust deeds, registrars to an issue, merchant bankers,
underwriters, portfolio managers, investment advisers and
others associated with securities markets by any means.
• Monitoring and Controlling the functioning of venture
capital funds and mutual funds.
• Forbid unjust and dishonest trade practices in the security
markets and forbid insider trading in the security market.
• Undertake periodic audits of stock exchanges, mutual funds,
individuals and self regulatory organizations associated with
the security market.

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SEBI has jurisdiction in the following matters

1. Regulating the business in stock exchanges and any other
securities markets
2. Registering and regulating the working of stock brokers, sub
brokers, share transfer agents, registrars to an issue,
merchant bankers and other intermediaries who may be
associated with securities market in any manner.
3. Registering and regulating the working of collective
investment schemes, including Mutual funds.
4. Promoting and regulating self regulatory organizations
5. Prohibiting Fraudulent and unfair trade practices
6. Promoting investors education and teaching of
intermediaries
7. Regulating substantial acquisition of shares and take over of
companies.
8. Levying fees or other charges for carrying out the purposes
9. Conducting research
Limitations of SEBI
• The regulations of SEBI monitoring capital markets need to
be approved by the Government. This causes delays in
implementations
• SEBI will have to seek prior approval for filling criminal
complaints for violations for the regulations. This will again
cause delay at government level.
• SEBI has not been given autonomy. Its Board of Directors is
dominated by government nominees. Out of 5 directors only
2 can be from outside and these are to represent the
Ministries of Finance, Law and Reserve Bank of India..
Mutual Fund
Securities Exchange Board of India formulated the Mutual Fund

(Regulation) 1993, which for the first time established a comprehensive
regulatory framework for the mutual fund industry. Since then several
mutual funds have been set up by the private and joint sectors.

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In India, the Mutual Fund industry started with the setting up of Unit Trust
of India in 1964, as a single State Monopoly. Twenty-three years later Public
Sector banks and financial institutions were permitted to establish Mutual
Funds in 1987. The Industry was brought under the control of SEBI and
opened for private sector participation in 1993.
The private sector and foreign Institutions began setting up Mutual Funds
thereafter. The fast growing industry is regulated by the Securities and
Exchange Board of India (SEBI). A Mutual fund in India is registered /
incorporated as a public trust. As per Clause 14 of SEBI guidelines-
A mutual fund shall be constituted in the form of a trust
and the instrument of trust shall be in the form of a deed, duly
registered under the provisions of the Indian Registration Act,
1908 (16 of 1908) executed by the sponsor in favor of the
trustees named in such an instrument.
If the Trust Deed so provides the trustees can appoint an Asset Management
Company for the day to day administration of the MF and investment of its
funds.
There are four constituents of a mutual fund in India:

• the sponsor,
• the board of Trustees or Trustee company,
• the asset management company and
• the custodian.
A Mutual Fund is a system where a number of investors come together to

pool their money with common investment goal. Each Mutual Fund is
managed by respective Asset Management Company.
The invested money in a particular scheme of a Mutual Fund is then invested

by fund manager in different types of suitable stock and securities, bonds
and money market instruments. Each Mutual Fund creates a portfolio which
includes stock and shares, bonds, gilt, money-market instruments or
combination of all.
Thus, Mutual Funds are managed by Asset Management Companies formed
by financial institutions, banks, private companies or international firms.
The biggest Indian Asset Management Company is UTI while Alliance,

Franklin Templeton etc are international Asset Management Companies.

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All Mutual Funds are registered with SEBI and they function within the
provisions of strict regulations designed to protect the interests of investors.
The operations of Mutual Funds are regularly monitored by SEBI.
Mutual Funds offer several benefits to an investor such as potential return,

liquidity, transparency, income growth, good post tax return and reasonable
safety. There are number of options available for an investor offered by a
mutual fund.
The advantages of investing in a Mutual Fund are:
1. Professional Management: The investor avails of the

services of experienced and skilled professionals who are
backed by a dedicated investment research team which
analyses the performance and prospects of companies and
selects suitable investments to achieve the objectives of the
scheme.
2. Diversification: Mutual Funds invest in a number of

companies across a broad cross-section of industries and
sectors. This diversification reduces the risk because seldom
do all stocks decline at the same time and in the same
proportion. You achieve this diversification through a
Mutual Fund with far less money than you can do on your
own.
3. Convenient Administration: Investing in a Mutual Fund

reduces paperwork and helps you avoid many problems such
as bad deliveries, delayed payments and unnecessary follow
up with brokers and companies. Mutual Funds save your
time and make investing easy and convenient.
4. Return Potential: Over a medium to long-term, Mutual

Funds have the potential to provide a higher return as they
invest in a diversified basket of selected securities.
5. Low Costs: Mutual Funds are a relatively less expensive

way to invest compared to directly investing in the capital
markets because the benefits of scale in brokerage, custodial
and other fees translate into lower costs for investors.

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6. Liquidity: In open-ended schemes, you can get your money

back promptly at net asset value related prices from the
Mutual Fund itself. With close-ended schemes, you can sell
your units on a stock exchange at the prevailing market price
or avail of the facility of direct repurchase at NAV related
prices which some close-ended and interval schemes offer
you periodically.
7. Transparency: You get regular information on the value of

your investment in addition to disclosure on the specific
investments made by your scheme, the proportion invested
in each class of assets and the fund manager's investment
strategy and outlook.
8. Flexibility: Through features such as regular investment

plans, regular withdrawal plans and dividend reinvestment
plans, you can systematically invest or withdraw funds
according to your needs and convenience.
9. Choice of Schemes: Mutual Funds offer a family of schemes

to suit your varying needs over a lifetime.
10.Well Regulated: All Mutual Funds are registered with SEBI

and they function within the provisions of strict regulations
designed to protect the interests of investors. The operations
of Mutual Funds are regularly monitored by SEBI.
Insurance in India
Over a period of almost two centuries the insurance sector in India has
transformed from being an open competitive market to nationalization and
back to a liberalized market again.
A brief history of the Insurance sector
The business of life insurance in India in its existing form started in India in
the year 1818 with the establishment of the Oriental Life Insurance
Company in Calcutta.
Some of the important milestones in the life insurance business in India are:

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• 1912: The Indian Life Assurance Companies Act enacted as the

first statute to regulate the life insurance business.
• 1928: The Indian Insurance Companies Act enacted to enable
the government to collect statistical information about both life
and non-life insurance businesses.
• 1938: Earlier legislation consolidated and amended to by the
Insurance Act with the objective of protecting the interests of
the insuring public.
• 1956: 245 Indian and foreign insurers and provident societies
taken over by the central government and nationalized. LIC
formed by an Act of Parliament, viz. LIC Act,
• 1956, with a capital contribution of Rs. 5 crore from the
Government of India. The General insurance business in India,
on the other hand, can trace its roots to the Triton Insurance
Company Ltd., the first general insurance company established
in the year 1850 in Calcutta by the British.
Some of the important milestones in the general insurance business in India

are:
• 1907: The Indian Mercantile Insurance Ltd. set up, the first
company to transact all classes of general insurance business.
• 1957: General Insurance Council, a wing of the Insurance
Association of India, frames a code of conduct for ensuring fair
conduct and sound business practices.
• 1968: The Insurance Act amended to regulate investments and
set minimum solvency margins and the Tariff Advisory
Committee set up.
• 1972: The General Insurance Business (Nationalization) Act,
1972 nationalized the general insurance business in India with
effect from 1st January 1973.
• 107 insurers amalgamated and grouped into four companies viz.
the National Insurance Company Ltd., the New India Assurance
Company Ltd., the Oriental Insurance Company Ltd. and the
United India Insurance Company Ltd. GIC incorporated as a
company.

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Insurance sector reforms

Malhotra committee
In India, the insurance business had been completely controlled by the state
through the Life Insurance Corporation of India and the General Insurance
Corporation of India, till August, 2000, when the market opened up.
As a part of its WTO obligations, India was required to open up the

insurance, banking, accounting and legal services sectors by 1st January,
2005 to global competition.
RN Malhotra Committee was formed in 1993 to evaluate the Indian

insurance industry and recommend its future direction.
The Malhotra committee was set up with the objective of complementing

the reforms initiated in the financial sector.
The reforms were aimed at:

• creating a more efficient and competitive financial system
• requirements of the structural changes
• insurance is an important part of the overall financial system
The Insurance Regulatory and Development Authority
Reforms in the Insurance sector started with Insurance Regulatory and

Development Authority Bill in 1999.
The Insurance Regulatory and Development Authority is responsible in

framing regulations and registering the private sector insurance companies.
In India, the insurance business had been completely controlled by the state
through the Life Insurance Corporation of India and the General Insurance
Corporation of India, till August, 2000, when the market opened up.
As a part of its WTO obligations, India is required to open up the insurance,

banking, accounting and legal services sectors by 1st January, 2005 to global
competition.
The banking and accountancy sector opened up without much to-do. The
opposition has been in the legal and insurance sectors. In India, the

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insurance business had been completely controlled by the state through the
Life Insurance Corporation of India and the General Insurance Corporation
of India, till August, 2000, when the market opened up.
d. Introduction to public finance

Traditionally, public finance dealt with the financial operations of the
Government. In the classical system, public finance meant taxation public
expenditure. This was called the laissez faire system in classical economics,
where the Sate had limited functions.
Presently, public finance has evolved as fiscal science with expanding

Government functions and responsibilities. The Government now has the
extended functions.
1. Traditional functions
2. Regulatory functions
3. Stabilization functions
4. Promotional function
5. Social security
1. Traditional functions: Under traditional functions the Government

provides police for law and order, defense against external aggression
and judiciary
2. Regulatory functions: The Government regulates, investment,
employment, prices and flow of foreign exchanges, goods for stable
growth
3. Stabilization functions: The Government stabilized prices, money supply,
and exchange rate for sustained growth
4. Promotional function: The Government may need to promote activities as
per the policy of equitable regional growth, equitable Sectoral growth
an d justice
5. Social security: The Government has emerged as an agency of social
security and social justice. This is the essence of an inclusive
economy.
To perform these functions the Government has several fiscal tools

1. Taxation
2. Public expenditure

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3. Public debt
4. Fiscal/budgetary management
1. Taxation: It is source of revenue for the Government. It is also helps in

equating income distribution.
2. Public Expenditure: The Government spends money for several purposes
like creating infrastructure, granting subsidies, social welfare
programs and similar
3. Public debt: Incase the expenditure exceeds revenue the Government
resorts to debt. The Debt can be raised to reduce monetary pressures
as well.
4. Fiscal/budgetary management: Fiscal management gives rise to fiscal
policy. This is an important instrument for attaining a large variety of
macro economic objectives.
Taxation
Direct and Indirect taxes
Tax constitutes an important source of revenue. Tax is a compulsory
payment to be made by citizens with out quid-pro-quo. It means no
exchange like transaction; the Government is not liable to offer any thing in
return for the tax received.
Taxes are levied for raising revenue for financing public expenditure. It is a
fiscal tool. Tax is an useful component of fiscal policy. It helps in reducing
inflationary pressures, equalize income and generate resources.
Tax is a burden. It reduces the income of the people. So it is essential that

tax is designed with care in such a way that it continues to generate revenue
and yet acceptable to public.
There are two types of tax. Direct tax and indirect tax
Direct tax refers to tax on income and sources of income. It is called direct
because it is levied directly on the income at source. The income after
taxation is called disposable income.
Indirect tax is levied on commodities. It becomes apart of the price, or cost

or the burden of tax is shared by the seller and the buyer.

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The Government uses a combination of direct and indirect taxes to raise

revenue. Direct and indirect taxes have their own merits and demerits.
Direct tax
• Direct tax is levied on the income. So the tax liability is
certain.
• Direct tax can be levied at source of income, so it can not be
evaded.
• Direct tax can offer concessions and exemptions, which may
not be easy with indirect tax.
• Direct tax can be made progressive. That is charging higher
tax from higher income groups and lower tax rates from
lower income groups.
• Direct tax has educational value. It prompts the tax payer
understand and participate in the fiscal exercise.
• In advanced countries, direct tax accounts for greater share
of tax revenues.
However
• Direct tax levies a direct burden, so it may not be acceptable
by the tax payer.
• Tax evasion is easy in case of non salary and business
incomes.
• If the tax burden is larger there is an urge to resist tax, evade
tax and corruption.
Indirect tax
Indirect tax is popular among developing economies as it can generate larger
revue as compared with direct tax. Countries with large income inequalities
and low incomes, direct tax fails to generate large revenue. Direct tax may
be resisted due to lower incomes. Indirect tax becomes more acceptable
because of its nature and characteristics.
• Indirect taxes are universal. The burden of tax falls on all the
citizens
• Indirect tax is considered as a part of consumption
expenditure or cost. So the burden is not clear and direct. It
easily accepted by people.

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• The burden of indirect tax is spread over large number of

transitions, so the burden is not felt heavily at any point of
time.
• Indirect tax can not be easily evaded.
• Indirect tax covers consumption
• It generates largest revenue compared with any other source
of revenue.
However,
• Indirect tax reduces consumer surplus. Tax is added to price
and the consumer pays it. In this process the tax payer spend
without receiving any utility.
• The burden of indirect tax falls heavily on the lower income
groups.
• Indirect tax can not be made progressive. It always
propositional; it is in proportion to spending.
• It causes wrong redistribution of incomes. The tax may be
collected from poorer sections, while spending (repaying
public debt and interest) the incomes may go to higher
incomes. This way, the incomes form poorer sections are
diverted to richer groups.
• It is proved that direct tax implies larger burden on the public
as compared with the same amount of direct tax.
Levy of direct and indirect tax, in fact, is a case of duplication. However, the
governments levy tax for raising revenue for development purposes. In total
the amount of tax collected as a proportion of GDP is called the taxable
capacity. It is the tax liability that has public acceptance. In developing
economies it is as 40 percent. In India it is around 28 percent.
The Union Budget

According to Dimock
“A budget is a financial plan summarizing the financial experience of

the past, stating the current plan and projecting it over a specified
period of time in future.”
The Indian Budget is a schematic plan of India's financial and operational

goals. It is an action plan that facilitates allocation of resources in India.

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The Government of India Budget, also known as the Union Budget, is

primarily made up of the Revenue Budget and Capital Budget.
Revenue Budget: The revenue budget primarily comprises Government

revenue receipts like tax and expenditure met from the revenue. The tax
revenues principally constitute yields of taxes and other duties imposed by
the Government of India.
Capital Budget: The capital budget primarily comprises capital receipts and
payments.
Sources of revenue
Tax Revenues
Direct Tax
Traditionally, these are taxes where the burden of tax falls on the person on
whom it is levied. These are largely taxes on income or wealth. Income tax
(on corporates and individuals), are direct taxes.
Indirect Tax
In the case of indirect taxes the incidence of tax is usually not on the person
who pays the tax. These are largely taxes on expenditure and include
Customs, excise and service tax.
Indirect taxes are considered regressive, the burden on the rich and the poor
is alike. That is why governments strive to raise a higher proportion of taxes
through direct taxes. Moving on, we come to the next important receipt item
in the revenue account, non-tax revenue.
Non-tax Revenues
The most important receipts under this head are interest payments (received
on loans given by the government to states, railways and others) and
dividends and profits received from public sector companies.
Types of public expenditure:

Public expenditure can be classified in terms of its revenue yielding
capacity, self financing nature or direct welfare.
1. Productive and unproductive expenditure

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The expenditure is called productive when the expenditure yields

revenue and is self financing. Capital expenditure on economic
overheads falls under this group.
Unproductive expenditure is the one which does not yield any revenue.
It does not directly generate welfare. Defense expenditure, interest
payment on public debt and the expenditure on calamity and disaster
management and relief fall under this group.
2. Plan and non plan expenditure

Plan expenditure
This is essentially the Budget support to the central plan and the central
assistance to state and Union Territory plans. Like all Budget heads,
this is also split into revenue and capital components.
Non-plan Expenditure
This is largely the revenue expenditure of the government. The biggest
item of expenditure is interest payments, subsidies, salaries, defense
and pension. The capital component of the non-plan expenditure is
relatively small with the largest allocation going to defense.
3. Revenue and capital expenditure

Revenue Receipt/Expenditure:
All receipts and expenditure that in general do not entail sale or creation
of assets are included under the revenue account. On the receipts side,
taxes would be the most important revenue receipt. On the expenditure
side, anything that does not result in creation of assets is treated as
revenue expenditure. Salaries, subsidies and interest payments are good
examples of revenue expenditure.
Capital Receipt/Expenditure:
All receipts and expenditure that liquidate or create an asset would
in general be under capital account.
If the government sells shares (disinvests) in public sector companies,
like the receipts from the sale would go under capital account. On the
other hand, if the government gives someone a loan from which it
expects to receive interest, that expenditure would go under the capital
account. In respect of all the funds the government has to prepare a
Revenue Budget (detailing revenue receipts and revenue expenditure)

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and a capital budget (capital receipts and capital expenditure).
Types of Deficits
Fiscal Deficits
Fiscal deficit is one of the more comprehensive measures of government’s
deficit. It can be looked upon as the sum of budgetary deficit and borrowings
and other liabilities of the government.
When the government's non-borrowed receipts (revenue receipts plus loan

repayments received by the government plus miscellaneous capital receipts,
primarily disinvestment proceeds) fall short of its entire expenditure, it has
to borrow money from the public to meet the shortfall. The excess of total
expenditure over total non-borrowed receipts is called the fiscal deficit.
International Monitory Fund (IMF) usually looks at the country’s fiscal

deficit to determine how healthy the economy is.
In other words, fiscal deficit reflects the indebtedness of the government i.e.
the country’s ability or the inability to repay loans.
Budgetary Deficits
Budgetary deficit is nothing but the difference in total government earnings
(receipts) and the total government expenditure. In India, budgetary deficit is
covered mainly by creation of new money (called deficit financing).
Creation of new money leads to an increase in the money supply and

consequently to inflationary rise in prices. Some economist believe that
Budgetary deficit does not reflect the true picture of a government’s deficit
because it is an accounting entity which can be easily manipulated.
Primary Deficits
The revenue expenditure includes interest payments on government's earlier
borrowings. The primary deficit is the fiscal deficit less interest payments. A
shrinking primary deficit would indicate progress towards fiscal health.
The concept of primary deficit was introduced for the first time in the budget
of 1993-94. This indicates the real posit ion of the government finances after
having paid off the interest burden.

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The fiscal deficit may be large, but if it is small compared to the size of the
economy then it is not such a bad thing. Prudent fiscal management requires
that government does not borrow to consume, in the normal course.
Revenue deficits
The excess of disbursements over receipts on revenue account is called
revenue deficit. This is an important control indicator. All expenditure on
revenue account should ideally be met from receipts on revenue account; the
revenue deficit should be zero. When revenue disbursement exceeds
receipts, the government would have to borrow. Such borrowing is
considered regressive as it is for consumption and not for creating assets. It
results in a greater proportion of revenue receipts going towards interest
payment and eventually, a debt trap.
Monetized Deficit
Monetized deficit is indicated by the increase in holdings of treasury bills by
the Reserve Bank of India and its contribution to the market borrowings of
the government. This it shows the extent of deficit financing (creation of
new money) on the part of government.
4. Introduction to external sector:
Balance Of Payments
Balance of payments is a systematic record of transactions between one
country and rest of the world during a period of time.
Balance of payments emerge as an important feature of modern international

trade, whereby the country can evaluate its position in terms of international
trade, currency movements, terms of trade and strength of the currency.
Balance of payments can also project the development status of the economy
in terms of industrial growth, economic stability and national income.
Balance of payments is a record of transactions under two different heads:

1. Current account:
It deals with the movements of merchandise (goods) by way of
exports and imports. The merchandise may be private or

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Governmental. Merchandise is a major item on the current account.

Other items appearing under current account include :
Transportation, insurance, tourism, and foreign remittances are called
as the invisibles because it involves foreign exchange flows but has no
physical movement of goods. The remittances can be in or out of the
country. Other items are non-monetary gold and miscellaneous head
for non-classified current transactions.
Each one of these items have a credit or debit depending on the

principles of double entry book keeping.
On current account there can be deficit or surplus, depending on the
nature of transactions.
The position on the merchandise account is called the balance of

trade. The difference between exports and imports determine the
position of balance of trade. It is an important indicator because it
will highlight the foreign exchange commitments of the country with
respect to each country and currency.
2. Capital account :
It deals with capital movements between one country and rest of the
world. Capital movements can be private, governmental or
institutional ( IMF, World Bank and others).It can be again classified
as short term and long term capital movements.
Other items include amortization, debt servicing, monetary gold and

miscellaneous. Amortization is the loan liquidated, debt servicing is
the repayment of principle and interest and non-monetary gold is the
payments made in terms of gold.
These capital transactions will also have a debit or credit depending

on the directions of flows. Capital account can show a deficit or a
surplus revealing the strength of the economy. The deficits of the
current account will be financed by the capital account. So there is a
spill over of deficits of current acceptant into capital account.
Finally, the balance of payments will have the deficit or surplus, reflecting
the overall position of all the international transactions.
Important ratios:

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1. Balance of trade:
Balance of trade is an important indicator of the efficiency of export
sector and import substitution sector. It is the position of an
economy in terms of merchandise on current account. It is an
important indicator because it will highlight the foreign exchange
commitments of the country with respect to each country and
currency.
2. Basic balance:
This is the difference between exports + inflow of long term capital
AND imports + out flow of private capital. It is measure of gross
movements in currencies in and out of the economy.
3. Liquidity balance:
In international trade, liquidity is a major consideration in
international payments. Liquidity balance deals with the difference
in the official exchange holdings over a given period of time. High
liquidity balance improves the credit worthiness of a country.
4. Official settlement balance:

It is a gross indicator of financial position arising out of the balance
of payments. It is the difference between exports + all private
capital inflows AND imports + all private out flows. It gives a clear
picture of the balance of payments position pertaining to a given
time period.
Determination of Exchange Rates:

The gold standard method determines the exchange rate up to the end of II
world war. During the reign of gold standards the currencies were fully
convertible into gold. This facilitates international transactions and
liquidity. With increasing demand for currency and inelastic supply of
gold the currency standard change.
During gold standards the exchange rate remained fixed because gold was a
neutral commodity which had no seasonality in supply or demand. The fixed
exchange rate provides stability of value in international transaction.

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The gold standard was replaced with paper Standards. The currency is how
valued on the basis of its purchasing power. The price determines domestic
value of currency as well as exchange rate.
With the exchange rate becomes highly flexible and floating. Such flexible
exchange rate mechanism makes an economy open to the external sector can
be brought about with domestic policy.
The purchasing power is worked out on the basis of prices existing in the
economy for the basket of consumption. With the changing price the
exchange rate also freely changes. The domestic rates of inflation and
monetary policy determines international exchange rate.
Foreign Exchange Market in India
Foreign exchange consists of trading one type of currency for another.

Unlike other financial markets, the FOREX market has no physical location
and no central exchange. It operates "over the counter" through a global
network of banks, corporations and individuals trading one currency for
another. The FOREX market is the world's largest financial market,
operating 24 hours a day with enormous amounts of money traded on a daily
basis.
Foreign Exchange Rate

Exchange rate is the price of one currency expressed in terms of another. It
is the relationship between two monetary units. Exchange rate is the medium
though which one currency is exchanged for another.
The spot and forward exchange markets

In a spot transaction the seller of exchange has to deliver the foreign
exchange he has sold 'on the spot' (usually within 2 days). Similarly the
buyer of exchange will receive the foreign exchange he has bought
immediately.
There is another important market, the Forward Market. In a forward market

when the bargain is settled, the seller agrees to sell at a certain amount of
foreign exchange to be delivered at a future date at a price agreed upon in
advance.

Dr.Ranga Sai
Similarly, a buyer agrees to buy certain amount of foreign exchange at a

future date at a predetermined price. Commonly used forward contracts are
for duration of one month(30 days) 3 months (ninety days),six months (180
days), nine months (270 days) and one year (360 days). The linkage between
the spot and forward exchange rates come from the actions of three groups
of economic agents who use the market, viz. arbitrageurs, hedgers, and
speculators.
Foreign Direct investment

Foreign capital which enters the country in the form of equity capital is
termed as Foreign Direct investment (FDI).
It involves no interest payment, but only a share in the profit to the extent of
shares owned by foreigners. In India equity participation by foreigners is
permissible up to 51 percent of the capital of a project, with higher limits of
investment in selected areas, such as technology, up gradation and exports.
Forms of Foreign Capital
Foreign capital, mostly from the developed countries has been playing an
important role in the development of the Indian economy. It has entered the
country in various forms, both on govt. account and private account. It has
given rise to a number of problems, the most serious being that of debt
servicing. Foreign capital has played an important role in the early stages of
industrialization of most of the advanced countries of today like countries of
Europe & North America. There is a general view that foreign capital, if
properly diverted and utilized, can arrest the economic development of
developing countries like India.
Categories and Composition
Foreign capital so far, used has been both for long - term purposes & short
term needs. Long term capital refers to capital that has maturity of more
than a year, short term capital has a maturity of more than a years, short term
capital has maturity of a one year or less. It has been composed of different
types of capital. The amount of capital under various types has been
different & has varied over times.

Dr.Ranga Sai
Foreign aid
Broadly foreign capital is of two types

1. Loan capital or debt
2. Equity or share capital.
The part of loan available at soft or concessional terms is known as external

assistance or foreign aid. The rate of interest is normally below the market
rate. The period of repayment is usually long.
Equity / Direct Investment

Besides loan capital or debt, the country can get funds as equity capital
known as direct - investment involves no interest payment, but only a share
in the profit to the extent of shares owned by foreigners.
In India equity participation by foreigners is permissible up to 51 percent of

the capital of a project, with higher limits for investment in selected areas
such as technology up-gradation exports.
Non Resident Indian
Under the foreign exchange regulation Act (FERA), a non resident Indian is
one who has gone out of India for business, profit, service, employment, etc.
for an uncertain period of time. Non - Resident of Indian origin are those
who have an Indian citizenship and an Indian passport or having Indian
Parent or Indian wife or husband, etc. Non -resident foreign citizen of Indian
origin are treated on equal terms as the Non -resident Indian citizens.
Portfolio Investment
In 1992, India opened up its economy and allowed Foreign Portfolio

Investment (FPI) in its domestic stock markets. Since then, FPI has emerged
as a major source of private capital inflow in this country.
Portfolio investment includes international investments in equity and debt

securities issued by unrelated non-resident entities, excluding any
instruments classified as direct investments or reserve assets.

Dr.Ranga Sai
Portfolio investment includes flows through issuance of ADRs or GDRs,

which usually denote ownership of equity and investment by FIIs, offshore
funds and others, thus covering the liabilities under portfolio investments.
Advantages
• Inflow of FPI can provide a developing country non-debt creating
source of foreign investment.
• Increased inflow of foreign capital increases the allocative efficiency
of capital in a country.
• FPI affects domestic capital market. It gives an upward thrust to the
domestic stock market prices.
India is still depends on FPI than Foreign Direct Investment (FDI) as a

source of foreign investment. For the period 1992 to 2005, more than 50
percent of foreign investment in India came in the form of FPI.
Foreign Direct Investment refers to international investment in which the

investor obtains a lasting interest in an enterprise in another country.
Most concretely, it may take the form of buying or constructing a factory in

a foreign country or adding improvements to such a facility, in the form of
property, plants, or equipment.
On the other hand, FPI (Foreign Portfolio Investment) represents passive

holdings of securities such as foreign stocks, bonds, or other financial assets,
none of which entails active management or control of the securities' issuer
by the investor.
Portfolio Investment is very easy to sell off the securities and pull out the
foreign portfolio investment. Hence, FPI can be much more volatile than
FDI. For a country on the rise, FPI can bring about rapid development,
helping an emerging economy move quickly to take advantage of economic
opportunity, creating many new jobs and significant wealth.
However, when a country's economic situation takes a downturn, sometimes

just by failing to meet the expectations of international investors, the large
flow of money into a country can turn into a stampede away from it.

Dr.Ranga Sai
II India in a globalized world
Globalization in India
The Indian economy was in major crisis in 1991 when foreign currency
reserves went down to $1 billion and inflation was as high as 17 percent.
That was the time when India underwent a major policy change. The new
economic reform, popularly known as, Liberalization, Privatization and
Globalization aimed at making India grow faster and globally competitive.
Several reforms were initiated with regard to industrial, trade and social
sector to make the economy more competitive. The economic changes had a
effect on the overall growth of the economy.
These reforms made India a global economy.
Privatization : Privatization refers to inducing more and more of private

participation in public sector activities. This is done by systematically
privatization of public sector- commonly called as disinvestment. Such
disinvestment brings in private cap[ital and also allows private managerial
competence and skills.
Liberalization: Liberalization refers to deregulation of Governmental

controls. Up to 1991 Indian industry was under the control regime of the
Government by way of Industrial licensing, MRTP Act and huge customs
duty and import restrictions. By liberalization, the Government allows more
freedom, and market forces to operate. Due to liberalization now exchange
rate and interest rates in the financial markets are determined freely.
Globalization: Globalization refers to adopting such changes which will

enable the country freely, compete in the international markets in terms of
flow of goods capital or other resources.
Such polices of globalization may need pening up of economy for

competition, participation in international organizations like WTO, and
liberalizing external policy.

Dr.Ranga Sai
The Policy Privatization, Liberalization, and Globalization can be seen as:
• Devaluation: The first step towards globalization was taken

with the announcement of the devaluation of Indian
currency by 18-19 percent against major currencies in the
international foreign exchange market.
• Disinvestment-In order to make the process of globalization

smooth, privatization and liberalization policies are
moving along as well. Under the privatization scheme,
most of the public sector undertakings have been/ are
being sold to private sector
• Abolishing Industrial Licensing At present, only six industries

are under compulsory licensing mainly on accounting of
environmental safety and strategic considerations
• Allowing Foreign Direct Investment into industries without any

limit on the extent of foreign ownership. Some of the
recent initiatives taken to further liberalize the FDI,
include opening up of sectors such as Insurance ;
development of integrated townships; defense industry, tea
plantation ; enhancement of FDI limits in private sector
banking,
• Non Resident Indian Scheme for foreign direct investment as

available to foreign investors/ Companies are fully
applicable to NRIs as well.
• To open Industries Reserved for the Public Sector to Private

Participation. Now there are only three industries reserved
for the public sector
• Abolition of the (MRTP) Act, which restricted capacity

expansion earlier
• The removal of quantitative restrictions on imports.

Dr.Ranga Sai
• The reduction of the peak customs tariff from over 300 per cent
prior to the 30 per cent rate that applies now.
• Wide-ranging financial sector reforms in the banking, capital

markets, and insurance sectors, including the deregulation
of interest rates, strong regulation and supervisory systems,
and the introduction of foreign/private sector competition.
Merits and Demerits of Globalization
Merits of Globalization are as follows:

• There is an International market for companies and for consumers
there is a wider range of products to choose from.
• Increase in flow of investments from developed countries to
developing countries, which can be used for economic reconstruction.
• Greater and faster flow of information between countries and greater
cultural interaction has helped to overcome cultural barriers.
• Technological development has resulted in reverse brain drain in
developing countries.
The Demerits of Globalization are as follows:
• The outsourcing of jobs to developing countries has resulted in loss of

jobs in developed countries.
• There is a greater threat of spread of communicable diseases.
• There is an underlying threat of multinational corporations with
immense power ruling the globe.
• For smaller developing nations at the receiving end, it could indirectly
lead to a subtle form of colonization.
Summary
• In respect of market capitalization, India ranks fourth in the world.
• But even after globalization, condition of agriculture has not
improved. The share of agriculture in the GDP is only 17 percent.
• The number of landless families has increased and farmers are still
committing suicide.

Dr.Ranga Sai
WTO and India
From 1947 to 1994, General Agreement on Trade and Tariff (GATT) was
the forum for managing trade barriers. The World Trade Organization
(WTO) was established on 1st January 1995. . The WTO has 148 members,
accounting for over 97 percent of world trade. Around 30 others are
negotiating membership.
Main functions of the WTO:

1. To oversee implementing and administering WTO
agreements;
2. To provide a forum for negotiations; and
3. To provide a dispute settlement mechanism.
These objectives are laid down so as to achieve certain global objectives

like:
• Raising standards of living;
• Ensuring full employment;
• Ensuring large and steadily growing real incomes and demand;
and
• Expanding the production of and trade in goods and services.
Agreements under WTO
WTO prescribes several conditions governing trade agreements in

agriculture, service sector, intellectual property rights, and international
disputes. These are given as agreements.
1. General Agreement on Tariffs and Trade 1994

2. Agreement on Agriculture
3. Agreement on Trade-Related Investment Measures
4. General Agreement on Trade in Services
5. Agreement on Trade-Related Intellectual Property
Rights
General Agreement on Tariffs and trade (GATT) (for goods),
1. Protection to Domestic Industry through Tariffs:

Dr.Ranga Sai
a. The General Agreement on Tariffs and Trade (GATT)

covers international trade in goods. The workings of the
GATT agreement are the responsibility of the Council for
Trade in Goods (Goods Council) which is made up of
representatives from all WTO member countries. GATT
requires the member countries to protect their domestic
industry/production through tariffs only.
b. It prohibits the use of quantitative restrictions, except
in a limited number of situations.
2. Binding of Tariffs: The member countries are urged to

a. Eliminate protection to domestic industry/ production by
reducing tariffs and removing other barriers to trade in
multilateral trade negotiations.
b. The reduced tariffs are bound against further increases by
listing them in each country's national schedule.
c. The schedules are an integrated part of the GATT legal
system.
3. Most Favored-Nation (MFN) Treatment:

a. The rule lays down the principles of non-discrimination
amongst member countries.
b. Tariff and other regulations should be applied to imported
or exported goods without discrimination among countries.
c. Exceptions to the rules i.e., regional arrangements subjected
to preferential or duty free trade agreements, Generalized
System of Preferences (GSP) where developed
countries apply preferential or duty free rates to imports
from developing countries.
4. National Treatment Rule:

The rule prohibits member countries from discriminating
between imported products and domestically produced like goods
in the matter of internal taxes and in the application of internal
regulations.
General Agreement on Trade in Services (GATT)
Services sector represent the fastest growing sector of the global economy
and account for two thirds of global output, one third of global employment

Dr.Ranga Sai
and nearly 20 per cent of global trade. General Agreement on Trade in

Services provides for the following:
• Commitments on market access and national treatment-

Individual countries’ commitments to open markets in specific
sectors. GATS does not require any service to be deregulated.
• International payments and transfers - Once a government has
made a commitment to open a service sector to foreign
competition, it must not normally restrict money being
transferred out of the country as payment for services supplied.
• Progressive liberalization - The goal is to take the liberalization
process further by increasing the level of commitments in
schedules.
• Movement of natural persons - individuals’ rights to stay
temporarily in a country for the purpose of providing a service.
• Financial services - protection of investors, depositors and
insurance policy holders, and to ensure the integrity and
stability of the financial system.
• Telecommunications - Governments must ensure that foreign
service suppliers are given access to the public
telecommunications networks without discrimination
Trade-Related Aspects of Intellectual Property Rights (TRIPS),
The areas covered by the TRIPS Agreement

• Copyright and related rights
• Trademarks, including service marks
• Geographical indications
• Industrial designs
• Patents
• Layout-designs (topographies) of integrated circuits
• Undisclosed information, including trade secrets
(a) Copyrights and related rights;

• Protection of computer programs as literary works and of
compilations of data.
• Recognition of computer programs, and cinematographic
works
• Recognition of a 50 years’ minimum.

Dr.Ranga Sai
(b) Trade marks;

• Protectable subject matter includes any sign, combination of
signs capable of distinguishing the goods or services from
others. Registration depends on distinctiveness end use.
• • Rights on the owners of registered trademark conferred to
prevent third party not having his consent, from using in
course of trade relating to identical goods/ services.
• The minimum term of protection is seven years, indefinitely
renewable.
(c) Geographical Indications;

• Legal means shall be provided to prevent use of an
indication in a manner that misleads the public or when it
constitutes unfair competition, and to invalidate a trademark
if the public is misled as to the true place of origin.
• Additional protection is conferred on geographical
indications for wines and spirits
• Obligations only relate to geographical indications that are
protected in their country of origin.
(d) Industrial Designs;

• Protection to new or original designs.
• Protection for textile designs through industrial design or
copyright law.
• Exclusive rights can be exercised against acts for
commercial purposes, including importation.
• Minimum Term of Protection is ten years.
(e) Patents;
• Patents shall be granted for any inventions, whether products
or processes, in all field of technology, provided they are
new.
• The term of protection shall be at least 20 years from the
date of application.
(f) Layout designs of integrated circuits;

• Protection shall extend to layout designs as such and to the
industrial articles that incorporate them.

Dr.Ranga Sai
• Term of protection is a minimum of 10 years notification.
(g) Protection of undisclosed information (trade secrets).

• Undisclosed information is to be protected against unfair
commercial practices, if the information is secret, has
commercial value and is subject to steps to keep it secret.
Agreement on Agriculture (AoA)
WTO Agreement on agriculture covers
1. Market access: This involves tariffication, and reduction in
tariff and access opportunities. Tariffication means all non-
tariff barriers like quotas, variable levies, minimum support
prices, discretionary licensing and state trading measures
need to be placed with tariffs. This is 24 percent for
developing countries.
2. Domestic support: Policies are subject to reduction, from the
total support given 1986-88. Total Aggregate Measure of
Support (Total AMS) shall be 13 percent.
3. Export subsidies: Export subsidy expenditure to be reduced
to 36 per cent and for developing countries is 24 percent.
As special differential treatment, developing countries are permitted

untargeted subsidized food distribution to meet requirements of urban and
rural poor.
In operation WTO prescribes a four fold approach:
• Green Box: It contains fixed payments to producers for

environmental programs, so long as the payments are not a
part of current production
• Blue Box: Minimum support price and direct payments to
agriculture
• Special and differential box: Investment subsidies
• Amber Box: Contains domestic subsidies that governments
have agreed to reduce but not eliminate. The Blue Box
contains subsidies which can be increased without limit, so
long as payments are linked to production-limiting programs.
India and WTO:

India has undertaken is to bind its tariffs on primary agricultural products
at 100 per cent; processed foods at 150 per cent; and edible oils at 300

Dr.Ranga Sai
per cent. Further, India’s share in total agricultural exports from

developing Asia is 8 per cent
• Maintains quantitative restrictions due to Balance of

Payments reasons
• No commitment regarding market access.
• Green box is considered with development box
• Agricultural exports do not get direct subsidy.
• Indirect subsidy by way of exemption of export profit from
Income tax
• Subsidies on cost of freight on export shipment of fruits,
vegetables, floral products
• Share of Indian agriculture in world market is negligible
except rice
• Subsidies of rich nations does not effect Indian exports
• Indian products are cost effective
• No fear of Indian markets being flooded by imports
• It is important to protect food and livelihood security to
alleviate poverty, rural development and employment
• There is a need to create opportunities for expansion of
agricultural exports with meaningful market access in
developing counties.
Development in various Ministerial meetings

WTO has been blames to be pro developed nations. It is felt universally, that
free trade regime benefits only the developed countries. So all the
agreements have been undergoing reviews in different conferences.
All annual conference of WTO experienced protests and demonstrations

from the third world countries. In each of these conferences major
agreements have been made to improve acceptability of WTO regime.
• The Doha Declaration 2001, brought new round of
negotiations on agricultural subsidies, public health,
environment and labour issues.
• Cancun conference 2003 brought out the issues of
liberalization of agriculture and new multilateral issues.
• Hong Kong conference 2005, discussed cuts in tariff.
(25535) 24-04-2010

Dr.Ranga Sai
Other books in this series
Business Economics Paper I B.Com First Year

Business Economics Paper II B.Com Second Year
Business Economics Paper III B.Com Third Year
Micro Economics First Year B.A.

Micro Economics First Year B.Com Accounting and Finance I Semester
First Year B.Com Banking and Insurance I Semester
Macro Economics First Year B.Com Banking and Insurance II Semester
Second Year BCom Accounting and Finance IIISemester
Based on University of Mumbai curriculum
Available for free and private circulation

At www. rangasai.com and www. vazecollege.net

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Dr.

F.Y.B.M.M Dr. Ranga Sai

II India in a globalized world Introduction to the concepts of privatization,

First Year BMM Semester I, Economics (w.e.f. June 2009) 2

First Year BMM Semester I, Economics (w.e.f. June 2009) 3

Dear Student friends…

During these days of commercialization it becomes very difficult to find

Dr. Prof. Ranga Sai

First Year BMM Semester I, Economics (w.e.f. June 2009) 4

1. Nature and scope of Micro Economics

Microeconomics deals with economics decisions made at individual level.

"Microeconomics deals with the decision making and market

In detail the microeconomics deals with decisions at

Micro economic theories help in the designing the models of demand

Most micro economic theories are partial equilibriums which provide in

First Year BMM Semester I, Economics (w.e.f. June 2009) 5

• Consumer equilibrium – consumer satisfaction is maximized;

Economic equilibrium is not permanent. The equilibrium is valid as long as

Static equilibrium: In economics static equilibrium refers to rigid models

Dynamic equilibrium: It is an advanced economic model which gives

A ceteris paribus assumption is used to formulate scientific laws, for

First Year BMM Semester I, Economics (w.e.f. June 2009) 6

Ceteris paribus represent relationships (such as demand and supply) between

The demand function relates the quantity demanded-Q, as an effect of

Quantity demanded, Q = f (P, Y,A,T/F)

Yet while studying the relationship as a law, it assumes all factors to be

2. Market forces of demand and supply

The Government may impose restrictions on price, demand and supply in a

First Year BMM Semester I, Economics (w.e.f. June 2009) 7

• Income: Income and quantity demanded are positively

The quantity demanded depends on variety of factors. Important among

The quantity demanded and price is inversely related. The quantity

First Year BMM Semester I, Economics (w.e.f. June 2009) 8

The inverse relationship between quantity demanded and price is because of

The law of demand depends on the following assumptions

Elasticity of demand measures intensity of changes in the quantity of a

First Year BMM Semester I, Economics (w.e.f. June 2009) 9

commodity. Accordingly, it is called price elastic, income elasticity or cross

Price Elasticity of demand

Price elasticity is measured as

First Year BMM Semester I, Economics (w.e.f. June 2009) 10

Elasticity of Supply measures proportionate changes in the quality of a

Elasticity of supply is measured as

First Year BMM Semester I, Economics (w.e.f. June 2009) 11

The value of elasticity of supply changes with changing responsiveness of

es = 1, Unitary elastic, reference elasticity

First Year BMM Semester I, Economics (w.e.f. June 2009) 12

Elasticity of supply and time period

Elasticity of supply changes with changing time

Equilibrium with free market

Free market is a case of perfect competition. Under such perfect competition

The demand curve indicates

First Year BMM Semester I, Economics (w.e.f. June 2009) 13

Price Quantity Quantity Supplied Market

At P1 D<S, Goods are not being sold, price is high

Nature of market economy:

First Year BMM Semester I, Economics (w.e.f. June 2009) 14

Market encourages efficiency of firms. It leads to efficient allocation of

Quantity of out put,

Q = f ( Labor, raw material, power, land, buildings, machinery / T)

Where T, is technology; an embedded (associated) factor of production. It is

Quantity of out put,

Q, = f ( labor, raw material, power/ F , T)