UNIT 01 The Economic Way of Thinking Names of Sub-Units Introduction to Economics: Concept of Scarcity-trade-offs, Opportunity Cost, Basic Economic Problems, Microeconomics and Macroeconomics, Managerial Economics – Meaning and Nature Overview The unit begins by explaining the meaning of economics and its nature. Further, it discusses the two main branches of economics, which are microeconomics and macroeconomics. The unit explains the application of economic concepts and tools in business decision making. It also discusses the basic problems of an economy which are problem of scarcity and problem of choice. Learning Objectives In this unit, you will learn to: Explain the meaning of economics Describe the nature of economics Discuss two main branches of economics State the importance of managerial economics Enlist the problems of scarcity and choice JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Learning Outcomes At the end of this unit, you would: Assess the importance of economics Appraise the tools and concepts of micro and macro economics Evaluate the application of economic concepts in business Analyse the problems of scarcity Examine the opportunity cost associated with decisions Pre-Unit Preparatory Material https://icmai.in/upload/Students/Syllabus-2012/Study_Material_New/Foundation-Paper1.pdf 1.1 INTRODUCTION Human wants are infinite or unlimited. However, not all wants are equally urgent and important. Therefore, people have to make choices between wants with a limited amount of money. Economics deals with the calculated decisions on how to use the limited money resources to satisfy maximum of one’s needs. For example, Vinod Gawre wants to take a 3-BHK flat on rent in Mumbai. However, he cannot afford the high rental price in the areas of his choice. He likes the apartment of Maithri Rawat. Although it is a 2-BHK flat, he decides to rent it as he likes the neighbourhood. To make up for the rental budget, he decides to reduce his expenses on entertainment and eating out. Similarly, Maithri had initially set a very high price of ` 50,000 per month for her apartment, but she did not find anyone interested in that price. She subsequently reduced the price to ` 35,000 per month, which was closer to what other landlords in the area were charging. Similarly, businesses also have limited time and money. They also make thousands of big and small decisions to get the best outcome, which usually is about maximising profit. These countless choices or decisions that individual consumers, households, businesses and governments make on a daily basis to satisfy their wants with scarce resources is the root of economics. 1.2 OVERVIEW OF ECONOMICS Economics is a science that understands and examines the economic behaviour of people. In other words, economics attempts to study how people allocate their limited resources to their alternative uses to produce and consume goods to satisfy their unlimited wants and maximise their gains. To do so, they make a number of choices on how to use their resources and spend their earnings. A need for making choices arises due to the following three fundamental economic reasons: 2 Human wants are infinite or unlimited: The three terms demand, want and desire are often used interchangeably. However, in economics, each of these terms has a different meaning. Let us understand the difference between these three terms with the help of an example. Suppose an individual is willing to purchase a personal computer for his/her work, it becomes his/her desire. If the individual has purchasing power to buy the computer but is not willing to sacrifice his/her UNIT 01: The Economic Way of Thinking JGI JAIN DEEMED-TO-BE UNI VE RSI TY money, it becomes a want. However, if the individual is willing to use the money to purchase the computer, it becomes demand. However, not all wants are equally urgent and important. Satisfying some wants gives more pleasure than others. Therefore, people have to make choices between wants. There are only scarce resources to satisfy human wants: These resources can be natural resources (land), human resources (labour), man-made resources (capital) and entrepreneurship (those who organise the above three resources and assume risk in business) time and information. All of these resources are limited with respect to their demand. This scarcity of resources in relation to infinite human wants gives rise to economic problems and forces people to make choices. The problem of choices also arises due to alternative uses of resources; each alternative use gives different returns or earnings. For example, a land in Mumbai used to set up a factory will give more earnings or income than when used as a residential building. Humans want to maximise their gains: People make choices between alternative uses of their scarce resources with the objective of maximising their gains. To do so, they evaluate the cost and benefit of alternative options while making their decisions. In conclusion, economics is a social science because it deals with human behaviour, i.e., how people deal with the economic problem of scarcity. It studies economic behaviour of the people and its implications. However, some economists believed economics as a study of money, while others had a notion that economics deals with problems, such as inflation and unemployment. In such a case, there was no proper definition of economics given. Therefore, for simplifying the concept, economics is defined by taking four viewpoints, which are explained as follows: 1. Wealth viewpoint: This is the classical perspective of economics. According to Adam Smith, economics is a science of wealth. He is regarded as the father of economics and wrote a book entitled “An enquiry into the Nature and the Causes of Wealth of Nation” in 1776. In his book, he stated that the main purpose of all economic activities is to gain maximum wealth as possible. Therefore, he advocated that economics is mainly concerned with the production and expansion of wealth. Further, this definition was followed by various classical economists, such as J.B. Say, David Ricardo, Nassau Senior and F.A Walker. Although wealth definition was an innovative work of Adam Smith, it was not free from criticism. His definition was criticised mainly due to two reasons. Firstly, Adam Smith, in his definition, focused only on maximising wealth rather than means of earning wealth. Secondly, he gave primary importance to wealth and secondary to man. However, wealth cannot be earned or maximised without human efforts. In this way, he disregarded the position of human beings. 2. Welfare viewpoint: It is a neo-classical standpoint of economics. Alfred Marshall, a neoclassical economist, associated the term economics with man and his welfare. He wrote a book “Principles of Economics” in 1980. In his book, he stated that economics is a science of welfare. According to him, “Political economy or economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing.” His definition was a great improvement in the definition of wealth as Marshall elevated the position of man. However, his definition was not free from criticism. This is because Marshall laid emphasis on welfare, but the meaning of welfare is different to different individuals. Moreover, the definition includes only materialistic welfare and ignores non-materialistic welfare. 3. Scarcity viewpoint: This the pre-Keynesian thought of economics. Lionel Robbins defined economics as a science of scarcity or choice in his book “An Essay on the Nature and Significance of Economic Science”, which was published in 1932. According to him, “Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.” 3 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets The definition provides three basic features of existence of human beings, namely unlimited wants, limited resources and alternative uses of limited resources. According to Robbins, an economic problem arises because of unlimited human wants and limited resources. His definition was criticised because it ignored economic growth. 4. Growth viewpoint: Indicates the modern perspective of economics. The main contributor of this definition was Paul Samuelson. He provided the growth-oriented definition of economics. According to him, “Economics is a study of how men and society choose with or without the use of money, to employ scarce productive uses resource which could have alternative uses, to produce various commodities over time and distribute them for consumption, now and in the future among the various people and groups of society.” In his definition, he outlined three main aspects, namely human behaviour, allocation of resources and alternative uses of resources. Therefore, his definition was similar to the definition provided by Robbins. 1.2.1 Nature of Economics There are a number of controversial issues related to its nature. Some economists believed economics as a science, while other believed economics as a social science. Economics as a science: Some economists believed that in economics, a problem is solved by adopting a scientific approach, which involves collecting and analysing data and making related laws and theories. For example, various economists examined the concept of employment and framed relevant theories, such as Say’s law, Pigou’s modifications and Keynes theory of employment. Economics is considered as a science because there are similarities between the problem solving process of economics and science. Apart from this, there is another controversial issue related to whether economics is a positive or normative science. Positive science refers to the science that deals with the question of what is, while the normative science deals with the question of what it should be. Positive science is the description of a concept whether it is right or wrong. On the other hand, normative science is the evaluation of a concept. After a very detailed analysis, it is decided that economics is a positive as well as normative science. Economicsasasocialscience:The basicfunctionofeconomics is to study how individuals, households, organisations and nations utilise their limited resources to achieve maximum profit. This function of economics is termed as maximising behaviour or optimising behaviour. In economics, optimising behaviour refers to selecting the most profitable alternative from the available alternatives. Therefore, it can be said that economics is a social science that aims at studying human behaviour with respect to optimal allocation of available resources to achieve maximum profit. For example, economics covers how individuals allocate their resources (income) to purchase different goods and services, so that they can achieve maximum satisfaction. In addition, economics also studies how organisations make their decisions regarding selection of a product to be produced, production technique, plant location and price of the product. Apart from this, economics also covers how nations utilise their resources to fulfil the needs of the society so that economic welfare can be maximised. 1.3 BRANCHES OF ECONOMICS The scope of economics as a subject continues to grow and expand. Several economists claim that it is still in a growing stage and many problems are yet to be addressed. However, it is also considered to be the best developed social science that continues to expand in terms of content and analytical richness. 4 UNIT 01: The Economic Way of Thinking JGI JAIN DEEMED-TO-BE UNI VE RSI TY Regardless, conventional economics is divided into the two main branches, which are shown in Figure 1: Microeconomics Macroeconomics Figure 1: Traditional Classification of Economics 1.3.1 Microeconomics Microeconomics deals with the behaviour of individuals, businesses, commodities and prices at the micro level. It answers the following questions: How do individuals and businesses make choices? How do their choices affect the demand and supply of goods and services? How do their choices impact the prices of goods and services in the market? How do markets function? In business decisions making, microeconomics can be applied to deal with operational issues, which are internal to an organisation. These issues are under the control of management and can be solved by taking appropriate decisions. Basically, an organisation has to deal with internal issues related to type of business and product, size of organisation, technology to be used, price determination, investment decisions and management of inventory. Microeconomics strives to solve these issues, which are generally faced by business organisations. The operational issues can be solved by using the following microeconomic theories: Demand theory: This theory helps managers to determine the factors that affect the buying decisions of consumers and their needs and requirements. In addition, the demand theory helps managers to answer the following questions: Why does a consumer stop consuming certain products? How does a customer react with changes in factors, such as price, tastes and preferences and level of income? Thus, the demand theory is helpful in deciding the type of product to be produced, determining the level of production and making pricing decisions in the present market conditions. Production theory: The production theory mainly deals with the issues related to production. It explains the changes in the cost of a product or service and the effect on the total output with change in a particular factor (input) while keeping the other factors at constant. Apart from this, the production theory deals with maximisation of output (when the resources are limited) and determination of optimum size of output. Therefore, it helps managers to decide the size of an organisation, labour and capital to be employed and total output. Price theory: The price theory is concerned with the analysis of market structure and determination of price. It also enables managers to determine the conditions that are conducive and profitable for price discrimination as well as how advertising would help in increasing the sales of an organisation. Therefore, the price theory and market analysis helps in finalising the pricing policies of an organisation. 5 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Profit theory: It is a well-known fact that the main objective of any organisation is to earn profit. However, an organisation does not always earn the same amount of profit every time due to uncertain business conditions with respect to changes in product demand, prices of input and competition level. There is always a condition of risk even when an organisation has employed the best technique for production. Therefore, managing profit of an organisation helps in minimising the risk factor and predicting the actual profit for future. Capital theory: Capital is a scarce resource of an organisation; therefore, it should be allocated efficiently. Generally, managers, while managing capital, face issues related to the selection of investment project and efficient allocation of capital. These issues are dealt with the help of the capital theory. The capital theory helps managers in investment decision making, selecting appropriate projects and capital budgeting. 1.3.2 Macroeconomics Macroeconomics is the branch of economics that studies the economy as a whole. It analyses aggregates of individuals, businesses, prices and outputs. It studies the impact of their choices on the aggregate or total level of economic activities. For instance, it studies the aggregate level of employment, general price level, aggregate savings and investment in the economy. Its main objectives are as follows: Full employment Economic growth Favourable balance of payment Stability of price For example, the topic of general widespread recession due to COVID-19 pandemic and decline in national economies comes under macroeconomics. The macroeconomic theory deals with issues related to the general business environment in which an organisation operates. The environmental issues can be associated with the economic, political and social environment of a country. The economic environment of a country comprises the following factors: The type of economic system of the country The pattern of national income, employment, saving and investment of the country The functioning of the financial sector of the country The structure and nature of foreign trade in the country The trends of labour supply and capital market strength of the country The economic policies of government The value system of society, property rights, customs and habits The political system of the country The functioning of private and public sectors The impact of globalisation on the country 1.3.3 Managerial Economics The subject matter of economics comprises a number of concepts and theories. The application of these concepts and theories in the process of business decision making is known as managerial economics. 6 UNIT 01: The Economic Way of Thinking JGI JAIN DEEMED-TO-BE UNI VE RSI TY In other words, managerial economics undertakes the study of different economic tools that are used in business decision making. Some of the popular definitions of managerial economics are given as follows: According to Mansfield, “Managerial economics is concerned with the application of economic concepts and economics to the problems of formulating rational decision making.” In the words of Spencer, “Managerial economics is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management.” According to Douglas, “Managerial economics is concerned with the application of economic principles and methodologies to the decision-making process within the firm or organisation. It seeks to establish rules and principles to facilitate the attainment of the desired economic goals of management.” As per Haynes, Mote and Paul, “Managerial Economics refers to those aspects of economics and its tools of analysis most relevant to the firm’s business decisions-making process. By definition, therefore, its scope does not extend to macroeconomic theory and the economics of public policy an understanding of which is also essential for the manager.” From the above-mentioned definitions, it can be said that managerial economics serves as a link amid the two disciplines, namely management and economics. The management discipline is concerned with a number of principles that help in business decision making and enhancing the efficiency of business organisations. Alternatively, economics is related to an optimum allotment of limited resources for attaining the set objectives of a business organisation. Consequently, it can be said that managerial economics is a particular discipline of economics that can be functional in business decision making of organisations. Scope of Managerial Economics Managerial economics involves the application of different economic tools, theories and methodologies for scrutinising business problems and decision making. These business problems can be connected to demand and supply viewpoints of an organisation, level of production, pricing, market structure and extent of competition. It helps an organisation in the following ways: Helps in taking decisions related to type of product, investment, pricing and level of production Enables managers to select production techniques and best course of action Helps organisations in making future decisions with respect to economic variables, such as price, demand, supply and cost Applies different economic theories and tools to the real world business environment Enables organisations to determine and analyse factors that affect business decisions Helps in formulating business policies and assessing a relationship between different economic variables, such as demand, supply, income, employment and profit 1.4 PROBLEM OF SCARCITY The root of the economic problem is the scarcity of resources while our wants are infinite. This problem exists in all economies in the world, whether they are rich or poor. To meet the infinite wants of the people by using scarce resources while trying to meet the people’s desire to maximise gains, economies 7 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets must try to achieve efficiency in production and distribution of resources. Societies and governments face three types of problems in achieving efficiency in production and distribution, which are: 1. What to produce: The first question that emerges while producing and allocating resources is what goods and services to produce. This is the problem of the choice of commodity. There are two reasons for this problem: a. Since resources are scarce, it is impossible to produce all goods and services that people want. b. All goods and services have different values in the eyes of consumers from the perspective of utility. Some goods and services give them more satisfaction (utility) than others. Therefore, the problem of choice between goods and services arises because all goods and services cannot be produced with the available resources, and all that is produced may not be purchased by the consumers. The objective of solving this problem is to satisfy the maximum needs of the maximum people. The next question within this context will be ‘how much to produce.’ You need to find the quantity of each product and service to be produced. The root of this problem also lies in resource scarcity. If surplus goods and services are produced, there will be wastage of resources. Therefore, it is important to efficiently allocate input resources. 2. How to produce: Once you have decided what to produce, you need to decide ‘how to produce it.’ This is the problem of the choice of technique. You have to decide the best combination of inputs (labour and capital) to produce goods and services. The scarcity of resources adds to the severity of the problem, as you cannot afford to waste them in employing wrong production techniques. If resources were infinite, then you could use any combination of labour and capital to produce a commodity. However, due to the scarcity of resources, you have to use the most economical production techniques. The problem ‘how to produce’ also arises because a specific quantity of a good or a service can be produced with alternative combination of inputs. For example, a given quantity of wheat can be produced by using more labour (men) and less capital (machinery). The same quantity of wheat can also be produced by employing less labour and more capital. Such alternative technologies are available for most goods or services. However, each alternative technology requires a different cost. This gives rise to the problem of ‘how to produce.’ 3. For whom to produce: This problem arises due to difficulties in matching the supply pattern with the demand pattern. The aim is to provide the good or service to those consumers only who have the ability and the willingness to pay for it, and that there is no surplus production leading to wastage. To determine the demand pattern, firms often use consumers’ pattern of selection, preference and income distribution. The income distribution, in turn, is determined by the employment pattern and resource (or factor) prices. The resource prices are decided in the resource market by the demand and supply forces for resources. The product resource prices and the number of resources gives the share of each resource in the national income. The resource owners who own a large quantity of expensive resources are able to claim a higher share in the national output. These households relatively consume a bigger chunk of the national output as compared to those who own low-priced resources. In a capitalist or a free enterprise economy, the supply (or production) pattern should perfectly match with the demand pattern by the ‘invisible’ hands of the market. However, that is seldom the case due to all pervasive market imperfections, such as: 8 Unemployment of some resources, particularly labour UNIT 01: The Economic Way of Thinking Inefficient allocation and consumption of resources Coexistence of extreme poverty and wastage of resources JGI JAIN DEEMED-TO-BE UNI VE RSI TY These problems of market imperfections exist in almost all the economies today. 1.5 OPPORTUNITY COST – AN ECONOMIC PROBLEM As you already know, resources are scarce and we have infinite wants and needs. If we cannot have everything we want, then we have to make choices. This creates the economic problem of ‘choice.’ Suppose you want to purchase new headphones, but your motorcycle also needs servicing. Now, you do not have the money to do both, so you must decide what you would like to do the most. If you service your bike, it means that you cannot buy headphones; you must give up this opportunity. The cost of this lost opportunity is called opportunity cost. You can, therefore, say that the opportunity cost of servicing your bike is buying headphones. This means that when you have chosen the bike, the next best alternative is the headphones. Opportunity cost is defined as the next best alternative that is given up when you make a choice. It is a subjective issue. When you are making a choice, only you can identify the most attractive alternative. However, it should be kept in mind that you may rarely know the actual value of the opportunity lost, because that opportunity is the one you did not choose. For example, you give up on the opportunity of watching television to read this chapter. Then, you will never know the exact value of the TV programme you missed. You know only what you expected, which was that the value of reading this chapter is more than the value of watching the television. For example, assume that Vandana has planned to go for a vacation to Goa and wants to purchase some clothes and footwear for her stay in Goa. However, she has a limited budget of ` 10,000. The average cost of one garment is ` 1,000 and the average cost of one pair of footwear is ` 250. She has already selected 8 pairs of footwear and 8 garments. Then, she decides that since, she has to travel for 9 days, she should have a new garment for each day. Now, if Vandana wants to buy an extra garment, the opportunity cost in this case will be 4 pairs of footwear that cost ` 1,000. Conclusion 1.6 CONCLUSION Economics is a science that understands and examines the economic behaviour of people. To meet their unlimited wants and maximise their gains, people make a number of choices on how to use their resources and spend their earnings. Some economists believed economics as a study of money, while others had a notion that economics deals with problems, such as inflation and unemployment. To simplify the concept, economics is defined by taking four viewpoints, namely wealth viewpoint, welfare viewpoint, scarcity viewpoint and growth viewpoint. Some economists believed economics as a science, while others believed economics as a social science. Conventional economics is divided into the two main branches, namely microeconomics and macroeconomics. Microeconomics deals with the behaviour of individuals, businesses, commodities and prices at the micro level. Macroeconomics is the branch of economics that studies the economy as a whole. 9 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets The application of economic concepts and theories in the process of business decision making is known as managerial economics. The root of the economic problem is the scarcity of resources while our wants are infinite. This problem exists in all economies in the world whether they are rich or poor. Opportunity cost is defined as the next best alternative that is given up when you make a choice. It is a subjective issue. 1.7 GLOSSARY Capital: The human-made tools used in the economy, such as machinery, buildings and vehicles Economy: A set of activities involved in the production and distribution of goods and services for the welfare of a human society Entrepreneurship: The bringing together of land, labour and capital into productive units Microeconomics: A study of economic problems of an individual consumer, organisation, or industry Macroeconomics: A study of problems of an economy as a whole 1.8 CASE STUDY: CHOICE MAKING BETWEEN ENVIRONMENTAL QUALITY AND ECONOMIC GROWTH Case Objective This case study highlights the choice that the Canadian citizens had to make between economic development as promised by the Conservative Party and greater economic growth as promised by the New Democratic Party (NDP). The former Prime Minister of Canada, Stephen Harper, was the head of the Conservative Party. In Canada’s parliamentary system, he had walked a political tightrope for five years. During that time period, he worked as the leader of the minority government. His opponents were upset by some of the policies. One such policy was a reduction in corporate tax rates. In 2011, his opponents strived for a no-confidence vote in parliament. It passed the parliament tremendously. It not only brought down Harper’s government, but also forced national elections for a new parliament. This political victory was momentary as the Conservative Party won the elections held in May 2011. This party had appeared as the ruling party in Canada. This ruling party had allowed Mr. Harper to continue practising the policy of deficit and tax reduction. This Conservative Party was opposed by the New Democratic Party (NDP) and the moderate Liberal Party at that time. These opposition parties strived for higher corporate tax returns and less deficit reduction as compared to the ruling party. In 2010, the deficit had fallen by one-third under the rule of Mr. Harper. At that time, he had promised a surplus budget by 2015. In 2011, the unemployment rate in Canada was 7.4% as compared to the US rate, which was 9.1% in the month of May. In 2010, the GDP growth rate was 3.1% in Canada. In the first quarter of 2011, the Bank of Canada planned for 4.2% of growth rate as compared to the US which planned for 1.8% of growth rate. In 2008, Canada was dealing with the state of recession. To deal with this state, Mr. Harper had made great efforts in 2010 and 2011. These efforts helped him in producing substantial reductions in the deficit. 10 UNIT 01: The Economic Way of Thinking JGI JAIN DEEMED-TO-BE UNI VE RSI TY All his efforts made Canadians decide and make a choice that resulted in lower taxes and less spending. But this issue was not considered to be prominent in the campaign held in 2011. With the development of huge oil deposits in Alberta, Canada is at the third place in the world for oil reserves. The NDP promised to reduce the greenhouse gas emissions in Canada, whereas Mr. Harper and the Conservative Party had promised to work towards the development of Canada’s economic growth. Source: https://2012books.lardbucket.org/books/macroeconomics-principles-v2.0/s04-economics-the-studyof-choice.html Questions 1. What was the criterion for choice making in this case study? (Hint: Economic growth and environment quality) 2. What was the aim of Mr. Harper? (Hint: Reduction in tax and deficit and ultimately the growth of the economy) 3. Identify any ‘free’ election promises, which are promised to people during elections. Find out the opportunity costs associated with them and identify who in the end actually paid for those things. (Hint: Free healthcare, free transport, free water supply, etc.) 4. Do you think the free promises are actually free? (Hint: Taxpayers have to pay for it) 5. Can you recall any desirable good or service for which you have to make choice? (Hint: Luxury car, lavish house) 1.9 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. Economics can be defined in a few different ways. At its core, economics is the study of how individuals, groups, and nations manage and use resources. What is Economics? 2. Microeconomics is one of the two branches of the study of economics, and is often considered as a foundation on which the other branch is built. Write a short note on microeconomics. 3. Macroeconomics, another branch of economics, attempts to assess how well an economy is performing and understand how performance can be improved. Define macroeconomics. 11 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets 4. Scarcity is a basic economic problem that indicates the gap between limited resources and limitless wants. Explain the problem of scarcity at length. 5. Opportunity cost is fundamental concept of economics that represent the potential benefits an individual, investor or business misses out on when choosing one alternative over another. Discuss opportunity cost as an economic problem in detail. 1.10 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS A. Hints for Essay Type Questions 1. Economics is a study of reconciling unlimited wants with limited resources. Basically, economics attempts to study how humans make decisions in the face of scarcity. Refer to Section Overview of Economics 2. Microeconomics is the study of decisions made by people and businesses regarding the allocation of resources, and prices at which they trade goods and services. Refer to Section Branches of Economics 3. Macroeconomics is the branch of economics that studies the economy as a whole. It analyses aggregates of individuals, businesses, prices and outputs. Refer to Section Branches of Economics 4. To meet the infinite wants of the people by using scarce resources while trying to meet the people’s desire to maximise gains, economies must try to achieve efficiency in production and distribution of resources. Refer to Section Problem of Scarcity 5. Opportunity cost is defined as the next best alternative that is given up when you make a choice. It is a subjective issue. Refer to Section Opportunity Cost - An Economic Problem @ 1.11 POST-UNIT READING MATERIAL https://2012books.lardbucket.org/books/theory-and-applications-of-economics/ https://www.infoplease.com/business/economy/overview-economics-what-economics-and-whocares 1.12 TOPICS FOR DISCUSSION FORUMS 12 Discuss some microeconomics decisions that you make on a day-to-day basis. UNIT 02 Demand & Supply Analysis and Estimation Names of Sub-Units Demand Analysis – Meaning of Demand, Determinants of Demand, Demand Equation, Law of Demand, Elasticity of Demand, Types of Elasticity (Numerical), Measurement of Elasticity, Demand Forecasting – Meaning, Types and Measurement, Supply – Meaning, Determinants, Law of Supply, Market Equilibrium Overview The unit explains the concept of demand and its types. It further explains the different determinants of demand and the law of demand. It also covers the elasticity of demand and its types. In addition, the unit explains the concept of demand forecasting and supply. Learning Objectives In this unit, you will learn to: Define demand Explain the types of demand Discuss the law of demand Describe the law of demand Discuss the concept of supply JGI JAIN DEEMED-TO-BE UNIVERSIT Y Principles of Economics and Markets Learning Outcomes At the end of this unit, you would: Assess the importance of demand and supply Measure the elasticity of demand Analyse how to forecast demand Examine the law of demand Evaluate the market equilibrium Pre-Unit Preparatory Material https://www.cfainstitute.org/-/media/documents/support/programs/cfa/prerequisite - economics-material-demand-and-supply-analysis-intro.ashx 2.1 INTRODUCTION A market is an arrangement where individuals, households and businesses are engaged in the buying and selling of products and services through various modes. The working of a market is governed by two forces, which are demand and supply. These two forces play a crucial role in determining the price of a product or service and the size of the market. The demand and supply forces operating in a market naturally set the price of goods and services traded in the market. Theoretically, demand can be defined as a quantity of a product an individual is willing to purchase at a specific point of time. Demand for a product implies a desire to acquire, willingness to pay and ability to buy it. Therefore, it helps organisations to know how much quantity would be demanded in the market as producers will produce only as many goods or services as the consumers demand. 2.2 CONCEPT OF DEMAND Demand for a commodity is defined as the quantity of the commodity, which a consumer wants to buy, at a given price, per unit of time. In a market, the behaviour of buyers can be analysed by using the concept of demand. Demand is a relationship between various possible prices of a product and the quantities purchased by consumers at each price. In this relationship, price is an independent variable and the quantity demanded is the dependent variable. In simple terms, demand can be defined as the quantity of a product that a buyer desires to purchase at a specific price and time. The demand for a product is influenced by several factors such as the price of the product, change in customers’ preferences and standard of living of people. The demand for a product is driven by three main components, which are: 1. Desire: The consumer must have a desire to buy a commodity at the given quantity. For example, you want to buy ice cream of a specific flavour or brand. 2. Ability: The consumer must have sufficient money or the ability to buy the commodity. 3. Willingness to pay: Finally, the consumer must be willing to pay for the commodity. 18 UNIT 02: Demand & Supply Analysis and Estimation JGI JAIN DEEMED-TO-BE UNIVERSIT Y The following points should be considered while defining the term demand: Desire, want and demand is different from each other. The quantity demanded is the amount that a customer is willing to purchase. However, the quantity demanded is not always equal to the actual purchase. This is because the commodity or service may not be available in the required quantity. Demand is always referred to in terms of price and bears no meaning if it is not expressed with price. For example, an individual may be willing to purchase a shirt at a price of ` 500 but may not be willing to purchase the same shirt if it is valued at ` 1000. In addition, different quantities of a commodity are demanded at different prices. Demand is always referred in terms of a time period and bears no meaning if it is not expressed with a time period. For example, a garment manufacturer has a demand for 200 metres of cloth in a month or 2400 metres of cloth in a year. 2.2.1 Types of Demand The demand for a particular product can be different under different situations. Therefore, organisations need to be aware of the type of demand that arises for their products under different situations. Demand can be categorised into the following types: Individual demand and Market demand: Individual demand is the quantity of a product or a service that an individual consumer is willing to purchase at a given price over a specific period (such as per day and per week). Market demand, on the other hand, is the total quantity that all the consumers of a product are willing to purchase at a given period over a specific period. The market demand is the sum of individual demands. Derived demand and Direct demand: Derived demand is the demand for the product, which is associated with the demand for another product. For example, furniture demand for your house is a direct demand, whereas the demand for wood would be considered as the derived demand for the manufacturing of the furniture. Similarly, a rise in the demand for lithium is derived from the rise in demand for mobile phones (as lithium is used to manufacture mobile phone batteries). Direct demand for a product, on the other hand, is independent of the demand for another product. For example, the demand for furniture and mobile phones is autonomous and therefore its direct demand. 2.2.2 Determinants of Demand Determinants of demand are the factors that influence the decision of consumers to purchase a commodity or service. Organisations need to understand the relationship between the demand and its each determinant to analyse and estimate the individual and market demand for a commodity or service. The quantity demanded a commodity or service is influenced by various factors, such as price, consumers’ income and preferences and growth of population. For example, the demand for apparel changes with changes in fashion as well as tastes and preferences of consumers. According to the demand theory, the quantity demanded of a commodity is influenced by certain factors called the determinants of demand. Therefore, demand for an item x (D x) is a function of the following factors: Price of the item x (Px) Price of substitutes (Py) 19 JGI JAIN Principles of Economics and Markets DEEMED-TO-BE UNIVERSIT Y Price of complements (PZ) Price expectation of the consumer (E) Income of the consumer (B) Taste or preference of the consumer (T) Advertisement expenditure (A) Other factors (U) This relationship can be expressed through the following equation: Dx = f(Px, Py, Pz, E, B, T, A, U) Let us understand how these factors impact demand for an item x, i.e., (Dx). Effect of the price of the item (Px) on demand (Dx): The price of a commodity or service is generally inversely proportional to the quantity demanded while other factors are constant. This implies that when the price of the commodity or service rises, its demand falls and vice versa. As the price of an item, x, will increase, its demand will decrease. Thus, Dx is inversely related to Px: Dx 𝖺 1 Px This effect is also called the price effect on demand. Effect of the price of the substitute (Py) on demand (Dx): The price of a commodity or service is generally inversely proportional to the quantity demanded while other factors are constant. This implies that when the price of the commodity or service rises, its demand falls and vice versa. If item y is a substitute for the item x, then as the price of item y increases, the demand for item x will increase. For example, y is coffee and x is tea. Both are substitutes for each other. Therefore, if the price of coffee will increase, demand for tea will increase, as the coffee drinkers will switch over to tea. Thus, Dx is directly related to Py: D x 𝖺 Py This effect is also called the substitution effect on demand. Effect of the price of the complement (Pz) on demand (Dx): Complementary goods are used jointly; for example, car and petrol. There is an inverse relationship between the demand and price of complementary goods. This implies that an increase in the price of one good will result in a fall in the demand of the other good. If item z is a complement of item x, then as the price of the item z decreases, its demand will increase. This in turn will increase the demand for item x. Let’s understand this through an example. Bread and butter are complements. If the price of the bread decreases, then its demand will increase. This, in turn, will trigger an increase in the demand for butter. Thus, Dx is inversely related to Pz: Dx 𝖺 1 Px This effect is also called the complementary effect on demand. 20 Effect of consumer’s price expectation (E) on demand (Dx): Demand for commodities also depends on the consumers’ expectations regarding the future price of a commodity, availability of the commodity, changes in income, etc. Such expectations usually cause a rise in demand for a product. This relationship is subjective depending on the psychology of the consumer. JGI UNIT 02: Demand & Supply Analysis and Estimation JAIN DEEMED-TO-BE UNIVERSIT Y Effect of consumer’s income (B) on demand (D x): The level of income of individuals determines their purchasing power. Generally, income and demand are directly proportional to each other. This implies that a rise in the consumers’ income results in a rise in the demand for a commodity. However, the relationship depends on the type of commodities. As the consumer’s income will rise, he/she will purchase more normal goods, such as tea, sugar, cornflakes, noodles, watches and branded clothes. This effect is called the positive effect. Thus, the demand for an item is directly related to the consumer’s income, if the item is a normal good: Dx 𝖺 B, if x is a normal good At the same time, the consumer will purchase less inferior goods, such as low-quality rice, jowar and second-hand goods. This effect is called negative effect. Thus, demand for an item x is inversely related to consumer’s income, if the item is an inferior good: D 𝖺 x 1 , if x is an inferior good B Effect of consumer’s taste or preference (T) on demand (Dx): Consumers’ tastes or preferences are socio-psychological determinants of demand, and hence difficult to explain theoretically. Effect of advertisement expenditure (A) on demand (Dx): An increase in advertisement expenditure will increase the demand for the item, but up to a certain point only. Therefore, demand for an item x is directly related to advertisement expenditure: Dx 𝖺 A 2.3 LAW OF DEMAND Among all the determinants that influence the demand for a commodity, the price factor is the most important. The law of demand represents a functional relationship between the price and quantity demanded of a commodity or service. The law states that the quantity demanded of a commodity increase with a fall in the price of the commodity and vice versa while other factors like consumers’ preferences, level of income, population size, etc., are constant. Demand is a dependent variable, while the price is an independent variable. Take the example of an individual, who needs to purchase soft drinks. In the market, a pack of three soft drinks is priced at ` 120 and the individual purchases the pack. In the next week, the price of the pack is reduced to ` 105. This time the individual purchases two packs of soft drinks. In the third week, the price of the pack has risen to ` 130. This time the individual does not purchase the pack at all. It is a common observation that consumers purchase a commodity in greater quantities when its price is low and vice versa. This inverse relationship between the quantity demanded and the price of a commodity is called the law of demand. Therefore, demand is a function of price and can be expressed as follows: D = f (P) Where, D = Demand P = Price f = Functional Relationship 21 JGI JAIN Principles of Economics and Markets DEEMED-TO-BE UNIVERSIT Y The law of demand follows the assumption of ceteris paribus, which means that the other factors remain unchanged or constant. As mentioned earlier, the demand for a commodity or service not only depends on its price but also on several other factors such as the price of related goods, income as well as consumer tastes and preferences. In the law of demand, other factors are assumed to remain constant while only the price of the commodity changes. The law of demand is based on the following assumptions: The income of the consumer remains constant. Consumer tastes and preferences remain constant. The price of related goods remains unchanged. Population size remains constant. Consumer expectations do not change. Credit policies remain unchanged. Income distribution remains constant. Government policies remain unchanged. The commodity is a normal commodity. The law of demand can be understood with the help of certain concepts, such as demand schedule, demand curve and demand function. 2.3.1 Demand Schedule A demand schedule is a tabular representation of different quantities of commodities that consumers are willing to purchase at a specific price and time while other factors are constant. Table 1 shows an imaginary demand schedule representing the price of sanitisers (P s) and the related number of sanitisers demanded (Qs) by a household per month: Table 1: Demand Schedule for Sanitisers Ps (Price) Qs (Quantity Demanded Per Month) 800 1 600 3 400 4 300 5 200 6 100 8 800 1 The data in Table 1 indicates that the demand for sanitisers (Q s) increases as the price of sanitisers (Ps) increases. For example, at the price of ` 800, only 1 sanitiser is demanded per month. When the price declines to ` 400, the demand for sanitisers increases to 3 units per month. When the price reduces to ` 100, the demand rises up to 8 units per month. This inverse relationship between the price and the quantity demanded for the sanitisers per month is the demand schedule for sanitisers. 22 JGI UNIT 02: Demand & Supply Analysis and Estimation JAIN DEEMED-TO-BE UNIVERSIT Y The law of demand can also be represented graphically with the help of a demand curve, which is discussed in the next section. 2.3.2 Demand Curve A demand curve is a graphical representation of the law of demand. The demand schedule can be converted into a demand curve by graphically plotting the different combinations of price and quantity demanded of a product. Thus, it can be said that the demand curve is the pictorial representation of the demand schedule. The demand curve represents different quantities of a commodity demanded at a specific price and time while other factors remain constant. Figure 1 shows the demand curve that is obtained from plotting the demand schedule (Table 1): 900 800 D 700 I 600 P R 500 I 400 C E 300 K L M 200 D' 100 0 1 3 4 5 6 8 Quantity Demanded Figure 1: Demand Curve In Figure 1, the demand curve slopes downwards to the right, indicating an inverse relationship between the price and quantity demanded of a commodity. The demand curve DD’ slope is negative, indicating the inverse relationship between the price of sanitiser and its quantity demanded. The downward movement on the demand curve from point D towards D’ indicates that the demand for sanitisers increases with the decrease in its price. Similarly, an upward movement on the demand curve from point D’ to D indicates that the demand for sanitisers falls as its price increases. The demand curve DD’ slopes downward to the right because of the following reasons: Income effect: It is the increase in the demand of a commodity due to an increase in the real income of consumers. When the price of sanitisers decreases, the real income or purchasing power of its consumers increases because they need to pay less for the same quantity. This induces them to buy more sanitisers. This effect is called the income effect. However, note that this effect is negative if the goods are inferior. If the price of an inferior good, such as a lower quality sanitiser, falls substantially, then the real income of consumers increases. As a result, they substitute the inferior good for a normal good, such as a good quality sanitiser. Thus, the income effect on the demand for inferior goods becomes negative. 23 JGI JAIN DEEMED-TO-BE UNIVERSIT Y Principles of Economics and Markets Substitution effect: When the price of sanitisers decreases, it becomes cheaper relative to its substitutes, provided their prices remain constant. Consequently, the substitutes of the sanitiser will become more expensive. This will induce rational consumers to substitute the sanitiser in place of its normal substitutes, which have become costlier. The increase in demand of sanitiser due to this factor is called the substitution effect. Diminishing marginal utility: Consumers purchase commodities to derive utility out of them. The law of Diminishing Marginal Utility (DMU) states that as consumption increases, the utility that a consumer derives from the additional units (marginal utility) of a commodity diminishes constantly. Therefore, a consumer would purchase a larger amount of a commodity when it is priced low as the marginal utility of the additional units decreases. Marginal utility is the satisfaction or the utility derived from the marginal unit consumed of a commodity. 2.3.3 Exceptions to the Law of Demand There are some instances when the fundamental law of demand does not apply. Some of these exceptions are as follows: Expectations regarding future prices of a commodity: When consumers expect that the price of a durable commodity will keep on increasing continuously, they will buy more of that commodity despite the increase in its price. They do so to avoid paying even higher prices for that commodity in the future. Likewise, when consumers expect a major decline in the price of a commodity in the future, they will postpone buying it and wait for its price to come down further. These decisions are contrary to the law of demand. Veblen goods: Veblen goods are luxury or prestigious items such as gold, precious stones, rare paintings and antiques. The law of demand does not apply to these goods. Exceptionally rich consumers buy Veblen goods because they serve as a status symbol. They purchase these goods due to their exceptionally high prices so that they can boost their social prestige by displaying them as symbols of their wealth and affluence. Giffen goods: These goods are cheap commodities that have very few close substitutes. It is considered to be opposite to a normal good. It is mostly consumed by poor households and constitutes a substantial percentage of their income. The law of demand does not apply to these goods. Therefore, if the price of a Giffen good increases (and the price of its substitute remains constant), its demand will increase instead of falling. For example, suppose a poor household consumes 30 kg of food grains per month, which includes 20 kg of bajra (an inferior good) and 10 kg of wheat (a superior good). The price of bajra is ` 5 per kg, while that of wheat is `10 per kg. At these prices, the monthly expenditure of the household on food grains is `200. This is the maximum price that the poor family can afford to spend. Now, suppose the price of bajra increases to ` 6 per kg. This will compel the household to reduce its consumption of wheat by 5 kg and increase that of bajra by 5 kg to meet its minimum monthly consumption requirement of ` 200 per month. Thus, the quantity demanded by the household for the bajra will increase from 20 kg to 25 kg per month, while that for the wheat will decrease from 10 kg to 5 kg. This indicates that the demand for the Giffen good, i.e., bajra, will increase despite the increase in its price, which is against the law of demand. 2.4 ELASTICITY OF DEMAND The elasticity of demand is the degree of responsiveness of consumers to the change in any of the determinants of demand, including the price of a good, consumers’ income and price of the substitutes and complements of the good. 24 JGI UNIT 02: Demand & Supply Analysis and Estimation JAIN DEEMED-TO-BE UNIVERSIT Y Figure 2 displays the demand curve of electricity: Price 1.92 1.6 Demand Quantity 98 100 Figure 2: Demand Curve of Elasticity At the price of ` 1.6 per unit, the quantity of electricity demanded is 100 million units. When the price increases by 20%, from ` 1.6 per unit to ` 1.92 per unit, the quantity demanded drops by only 2%, i.e., from 100 million units to 98 million units. Electricity is an inelastic good because changes in price witness only modest changes in the quantity demanded. Such inelastic goods or services to price tend to be things of daily use. 2.4.1 Price Elasticity of Demand The price elasticity of demand measures the responsiveness of the quantity demanded of a good to change in its price when other determinants of demand are constant. In other words, it can be defined as the ratio of the percentage change in quantity demanded to the percentage change in price. The formula for calculating the price elasticity of demand is as follows: ep Percentage change in quantity demanded Percentage change in price Q P Q P Where, ep = Price elasticity of demand P = Initial price ΔP = Change in price Q = Initial quantity demanded ΔQ = Change in quantity demanded Example 1: Assume that a business firm sells a good at the price of `450. The firm has decided to reduce the price of the good to ` 350. Consequently, the quantity demanded for the good rose from 25,000 units to 35,000 units. In this case, the price elasticity of demand is calculated as follows: 25 JGI JAIN Principles of Economics and Markets DEEMED-TO-BE UNIVERSIT Y Here, P = ` 450 ΔP = ` 100 (a fall in price; ` 450 – ` 350 = ` 100) Q = 25,000 units ΔQ = 10,000 (35,000 – 25,000) units By substituting these values in the above formula, we get: Percentage change in quantity demanded ep Percentage change in price 10,000 100 450 25,000 =9/5 = 1.8 Thus, the absolute value of elasticity of demand is greater than 1. 2.4.2 Cross-Elasticity of Demand The cross elasticity of demand can be defined as a measure of a proportionate change in the demand for goods as a result of change in the price of related goods. In the words of Ferguson, the cross elasticity of demand is the proportional change in the quantity demanded of good X divided by the proportional change in the price of the related good Y. The cross elasticity of demand is the measure of the responsiveness of demand for a good to the changes in the price of its substitute and complementary goods, with other determinants being constant. If the given good is X and its substitute or complementary good is Y, then the formula of cross elasticity of demand for X with respect to Y is: eY,X P QX % change in quantity demanded for X QX /Q X Y. % change in price of Y PY / PX Q X PY Similarly, the formula of cross elasticity of demand for Y with respect to X is: eY,X P QY % change in quantity demanded for Y QY /Q Y X. % change in price of X PX / PX Q Y PX Let us consider the cross elasticity of demand for two substitute goods, such as tea and coffee. Suppose the price of tea increases from ` 225 to ` 235 per kg. As a result, the demand for coffee increases from 20,000 kg to 30,000 kg per week, the price of coffee remaining constant. By substituting these values in the above equations, you get the cross-elasticity of demand for coffee with respect to tea, as follows: e C,T PT QC QC PT 225 1000 . 11.25 20000 10 Note that cross elasticity of demand for substitute goods will always be positive. This is because an increase in the price of one good will lead to an increase in the demand for the other. If the price of tea increases, there will be a fall in its demand, as consumers would readily substitute it for coffee. Thus, the 26 UNIT 02: Demand & Supply Analysis and Estimation JGI JAIN DEEMED-TO-BE UNIVERSIT Y percentage increase in the price of tea will cause the quantity demanded of coffee to move in the same direction. Therefore, the coefficient of cross elasticity of demand for substitutes is positive. Now, let us consider the cross elasticity of demand for two complementary goods, such as bread and butter, electricity and electrical gadgets, petrol and car, etc. The cross elasticity of demand for these complementary goods is always negative. This is because an increase in the price of one good will lead to a decrease in the demand for its complementary good(s). For example, if the price of bread increases, then there will be a drop in the quantity demanded of bread as well as in the quantity demanded of butter. Thus, a change in the price of one good will cause the quantity demanded of its complements to move in the opposite direction. In conclusion, you can derive the following results: If the cross elasticity of demand between any two goods is positive, these goods are substitutes. The higher their (positive) cross elasticity, the closer the substitutes are to each other. If the cross elasticity of demand between two goods is negative, these goods are complements for each other. The higher their (negative) cross elasticity, the higher their degree of complementarity. If the cross elasticity of demand between two goods is zero, these goods are unrelated to each other. 2.4.3 Income Elasticity of Demand In addition to the price of a good, the demand for the good is also affected by the consumer’s income. The income elasticity of demand measures the degree to which the quantity demanded for a good responds to a change in the consumer’s disposable income, other factors being constant. Disposable income or Disposable Personal Income (DPI) refers to the amount of money that an individual can spend as per his discretion. DPI is calculated as the amount of money left with an individual after deducting the personal income tax from personal income of the individual. DPI = Personal Income − Personal Income Taxes For example, suppose your income increases by 5%. Now let us consider how this percentage change in income will affect your demand for two goods, salt and clothing. Due to an increase in income, your demand for clothing will increase relatively more than that for salt. This is because salt is an item of necessity. An increase or decrease in your income will not affect your consumption of salt. However, an increase in income may persuade you to spend more on clothing so that your dressing style reflects your improved lifestyle. Therefore, you can say that clothing has more income elasticity of demand (responsiveness of demand) as compared to salt. Thus, income elasticity of demand enables you to compare the responsiveness (or sensitivity) of demand for various goods from the same change in income. From this definition, the formula of income elasticity of demand for a good with respect to change in income is: ei Percentage change in quantity demanded Q /Q M Q . Percentage change in income M / M Q M In the above equation, M = Disposable money income ∆M = Change in disposable income Q = Quantity demanded of the good ∆Q = Change in quantity demanded for the good 27 JGI JAIN DEEMED-TO-BE UNIVERSIT Y Principles of Economics and Markets A notable difference between the price elasticity of demand and income elasticity of demand is that the former is negative (except for Giffen goods), whereas the latter is positive due to a positive relationship between income and quantity demanded. However, in case of inferior goods, the income elasticity of demand is negative. This is because as the consumer’s income increases, his demand for inferior goods decreases, as he/she replaces them with superior goods. For example, when the income of a household increases, the household members will start to buy more rice and wheat (normal goods) rather than bajra, ragi, etc. (inferior goods). Similarly, when the income of a household increases, the members will start to use more of train and airlines services and less of bus service for travelling long distances. For normal goods (such as rice, wheat, clothing and cigarettes), the income elasticity of demand is positive. This is because the percentage increase in income causes a percentage increase in the quantity demanded for a normal good and vice versa. Therefore, as income rises, there will be an outward shift of the demand curve in the case of normal goods. However, for inferior goods (such as bajra, poor quality rice, cheap alcohol and artificial jewellery), the income elasticity of demand is negative. This is because the percentage increase in income causes a percentage decrease in the quantity demanded inferior goods and vice versa. 2.5 DEMAND FORECASTING An organisation faces several internal and external risks, such as high competition, failure of technology, labor unrest, inflation, recession and change in government laws. Therefore, most of the business decisions of an organisation are made under the conditions of risk and uncertainty. An organisation can lessen the adverse effects of risks by determining the demand or sales prospects for its products and services in the future. Demand forecasting is a systematic process that involves anticipating the demand for the product and services of an organisation in the future under a set of uncontrollable and competitive forces. Some of the popular definitions of demand forecasting are as follows: According to Evan J. Douglas, “Demand estimation (forecasting) may be defined as a process of finding values for demand in future time periods.” In the words of Cundiff and Still, “Demand forecasting is an estimate of sales during a specified future period based on proposed marketing plan and a set of particular uncontrollable and competitive forces.” Demand forecasting enables an organisation to take various business decisions, such as planning the production process, purchasing raw materials, managing funds and deciding the price of the product. An organisation can forecast demand by making own estimates called guess estimate or taking the help of specialised consultants or market research agencies. Demand plays a crucial role in the management of every business. It helps an organisation to reduce risks involved in business activities and make important business decisions. Apart from this, demand forecasting provides an insight into the organisation’s capital investment and expansion decisions. The significance of demand forecasting is shown in the following points: 28 Fulfilling objectives: Implies that every business unit starts with certain pre-decided objectives. Demand forecasting helps in fulfilling these objectives. An organisation estimates the current demand for its products and services in the market and moves forward to achieve the set goals. For example, an organisation has set a target of selling 50, 000 units of its products. In such a case, the organisation would perform demand forecasting for its products. If the demand for the organisation’s products is low, the organisation would take corrective actions, so that the set objective can be achieved. UNIT 02: Demand & Supply Analysis and Estimation JGI JAIN DEEMED-TO-BE UNIVERSIT Y Preparing the budget: Plays a crucial role in making the budget by estimating costs and expected revenues. For instance, an organisation has forecasted that the demand for its product, which is priced at `10, would be 10,00,00 units. In such a case, the total expected revenue would be 10× 100000 = `10,00,000. In this way, demand forecasting enables organisations to prepare their budget. Stabilising employment and production: Helps an organisation to control its production and recruitment activities. Producing according to the forecasted demand of products helps in avoiding the wastage of the resources of an organisation. This further helps an organisation to hire human resource according to requirements. For example, if an organisation expects a rise in the demand for its products, it may opt for extra labour to fulfil the increased demand. Expanding organisations: Implies that demand forecasting helps in deciding about the expansion of the business of the organisation. If the expected demand for products is higher, then the organisation may plan to expand further. On the other hand, if the demand for products is expected to fall, the organisation may cut down the investment in the business. Taking management decisions: Helps in making critical decisions, such as deciding the plant capacity, determining the requirement of raw material and ensuring the availability of labour and capital. Evaluating performance: Helps in making corrections. For example, if the demand for an organisation’s products is less, it may take corrective actions and improve the level of demand by enhancing the quality of its products or spending more on advertisements. Helping government: Enables the government to coordinate import and export activities and plan international trade. 2.6 CONCEPT OF SUPPLY A market economy is made up of buyers and sellers. The buyers constitute the demand side of a good or service, whereas the sellers constitute the supply side. Thus, supply is defined as the specific quantity of a good that a producer is willing and is able to offer to consumers at a specific price at a given time period. It can be defined as an association between price and quantity supplied. The quantity supplied is the amount of a good offered for sale at a given price for a specific time period. It can be said that supply has three important aspects, which are as follows: 1. Supply is always referred in terms of price. The price at which quantities are supplied differs from one location to the other. For example, Fast Moving Consumer Goods (FMCG) are usually supplied at different places at different prices. 2. Supply is referred in terms of time. This means that supply is the amount that suppliers are willing to offer during a specific period of time (per day, per week, per month, biannually, etc.) 3. Supply considers the stock and market price of the good. The stock of a good refers to the quantity of the good available in the market for sale within a specified point of time. Both the stock and market price of a good affect its supply to a greater extent. If the market price of a good is more than its cost price, the seller would increase the supply of the good in the market. However, a decrease in the market price as compared to the cost price would reduce the supply of goods in the market. Let us understand the concept of supply with an example. For example, a seller offers a good at ` 100 per piece in the market. In this case, only goods and prices are specified; thus, it cannot be considered as supply. However, there is another seller who offers the same good at ` 110 per piece in the market for the next six months from now on. In this case, goods, price and time are specified, thus it is supply. 29 JGI JAIN DEEMED-TO-BE UNIVERSIT Y Principles of Economics and Markets Supply can be classified into two categories, namely individual supply and market supply. Individual supply is the quantity of goods a single producer is willing to supply at a particular price and time in the market. In economics, a single producer is known as a firm. On the other hand, market supply is the quantity of goods supplied by all firms in the market during a specific time period and at a particular price. The market supply is also known as industry supply as firms collectively constitute an industry. 2.6.1 Determinants of Supply Supply does not remain constant all the time in the market. Many factors influence the supply of a good. Generally, the supply of a good depends on its price and cost of production. Thus, it can be said that supply is the function of price and cost of production. The supply of a good is influenced by the following factors or determinants: Input price: It is the cost incurred on the manufacturing of goods that are to be offered to consumers. When the input prices reduce, the use of inputs will rise. Increased use of inputs will increase the supply of goods. Similarly, when the input prices increase, the supply of goods will decrease. Price of substitutes: The prices of substitutes and complementary goods also influence the supply of a good to a large extent. For instance, if the price of tea increases, the firm would produce more tea and less coffee. As a result, there will be a reduction in the supply of coffee in the market. Nature and size of the industry: If the industry of good is monopolised (i.e., under the hands of a few large players only), the supply of the good will be limited. On the other hand, if the industry is competitive (i.e., a healthy competition of small and large companies), the supply of the good in the market will increase. The supply of the good will also increase when new producers join the industry, increasing the industry size. Therefore, the supply of goods is also dependent on the structure of the industry in which a firm operates. Government policy: The good’s production decreases in the face of restrictive policies by the government, such as import quota on resources and rationing on the supply of resources. Consequently, the supply of the good decreases. The government’s tax policies also act as a regulating force in supply. If the rates of taxes levied on goods are high, the supply will decrease. This is because high tax rates increase overall production costs, which makes it difficult for suppliers to offer goods in the market. Similarly, a reduction in taxes on goods will lead to an increase in their supply in the market. Natural conditions: The supply of certain goods is directly influenced by climatic conditions. For instance, the supply of agricultural goods increases when the monsoon comes well on time. On the contrary, the supply of these goods reduces at the time of drought. Some of the crops are climatespecific and their growth purely depends on climatic conditions. For example, Kharif crops are well grown during summers, while Rabi crops are produced well in the winter season. Transportation conditions: Transport is always a constraint to the supply of goods. Better transport facilities increase the supply of goods. On the contrary, goods are not available on time due to poor transport facilities. Therefore, even if the price of a good increases, the supply would not increase. Other factors: These factors include all those factors that adversely affect the production and supply of goods. They include labour strikes, lockdowns, lock out, wars, communal riots, drought, floods, epidemics, pandemics, etc. These factors also include climatic and weather conditions in case of agricultural goods. 2.6.2 Law of Supply The law of supply explains the direct relationship between the price and supply of a good. According to the law of supply, the quantity supplied increases with a rise in the price of a good and vice versa while 30 JGI UNIT 02: Demand & Supply Analysis and Estimation JAIN DEEMED-TO-BE UNIVERSIT Y other factors remain constant. The other factors may include customer preferences, size of the market, size of the population, price of substitutes, input price, government policies, etc. For example, if the price of a good increases, sellers would prefer to increase the production of that good to earn high profits. As a result, there will be an increase in supply. Similarly, if the price of a good reduces, the supplier also reduces the supply of the goods in the market and waits for a rise in the price of the good in the future. 2.7 MARKET EQUILIBRIUM Buyers and sellers have different perspectives on prices. Buyers demand a good or a service and pay the price for it, while sellers receive the price. Therefore, buyers want to pay the lowest possible price, while sellers want the price to be as high as possible. As the price of a good increases, the buyers reduce the quantity demanded along the demand curve. On the contrary, the sellers increase their quantity supplied along the supply curve with an increase in price. This conflict between buyers and sellers is sorted out in markets. A market consists of all arrangements used to purchase and sell a specific good or service. Buyers (demanders) and sellers (suppliers) come together in a market for a good or service. The market provides them information about the price, quantity and quality of the good or service. In doing so, the market reduces the costs of the transaction of a good or service. For instance, you are looking for a job. One approach is that you go from employer to employer asking for opening. However, not only this approach is time-consuming, it may not yield the desired results. A more efficient approach would be to go to an online job site or classified ads in a local newspaper and look for job openings. These online job sites and classified ads are elements of the job market, which reduce your transaction costs by bringing you closer to potential employers. Markets allow these forces of demand and supply to coordinate and set the price of a good or service on their own. These impersonal market forces are what the economist Adam Smith called the “invisible hands” of demand and supply. A market where forces of demand and supply take their course without any external control on price, demand or supply is called a free market. Let’s understand how demand and supply forces strike a balance in a market. In economic terms, the term equilibrium means a state of the market in which: Quantity demanded of a good = Quantity supplied of that good In other words, market equilibrium refers to a situation when the quantity supplied equals the quantity demanded at the market price. At market equilibrium, the price and quantity do not tend to change. The price at market equilibrium is called equilibrium price and the quantity supplied and demanded is called equilibrium quantity. Let’s understand the concept of market equilibrium with the help of an example. Table 2 shows the demand and supply schedule for pizza: Table 2: Market Schedule for Pizza Price per Pizza (in `) Quantity Demanded per Month (in thousands) Quantity Supplied per Month (in thousands) Surplus or Shortage Effect on Price of Pizza 100 80 10 Shortage Rise 200 55 28 Shortage Rise 300 40 40 Equilibrium Stable 400 28 50 Surplus Fall 31 JGI JAIN Principles of Economics and Markets DEEMED-TO-BE UNIVERSIT Y Price per Pizza (in `) Quantity Demanded per Month (in thousands) Quantity Supplied per Month (in thousands) Surplus or Shortage Effect on Price of Pizza 500 20 55 Surplus Fall 600 15 60 Surplus Fall In the above market schedule, there is only one price of pizza (` 300) at which demand and supply are at par. At all the remaining prices, the pizza market is in a state of imbalance between demand and supply. At all prices below ` 300, demand exceeds supply indicating the shortage of pizzas in the market. At the prices above ` 300, supply exceeds demand indicating the surplus of pizzas in the market. Now this imbalance itself will create the condition for equilibrium automatically. Let us see how. The initial price of a pizza is at `100. At this price, the quantity demanded exceeds the quantity supplied by 70,000 pizzas. This shortage of pizzas will induce buyers to purchase the desired quantity of pizzas at a higher price. This gives an incentive to the pizza makers to raise the price of the pizza in anticipation of a higher profit. This trend continues till the price of pizza reaches `300. At this price, the buyers are willing and able to buy 40,000 pizzas, and the sellers are willing and able to sell 40,000 pizzas. Therefore, `300 is the equilibrium price, where the market forces of demand and supply are in balance. Likewise, at all prices of about `300, there is surplus supply of pizzas in the market, forcing the pizza sellers to reduce the price. Therefore, fewer pizzas will be supplied in the market. On the other hand, more customers will be attracted to purchase the pizza at a lower price. Therefore, the price of the pizza continues to fall till it reaches `300 (equilibrium price). This process of interaction between the demand and supply forces to determine the equilibrium price is called the market mechanism. Conclusion 2.8 CONCLUSION Demand for a commodity is defined as the quantity of that commodity, which a consumer wants to buy, at a given price per unit of time. For a demand to be effective, it must have the consumer’s desire, ability to buy and willingness to pay. Demand can be categorised as individual demand, market demand, derived demand and direct demand. Demand for a commodity is influenced by the price of the commodity, price of its substitutes and complements, price expectation of the consumer, income of the consumer, taste or preference of the consumer, advertising expenditure and other factors. Supply is defined as the specific quantity of a good that a producer is willing and able to offer for sale to consumers at a specific price over a given period, other things being constant. The determinants of supply are the price of inputs, technology, price of good substitutes, nature and size of the industry, supplier expectations, government policy and other factors. According to the law of supply, the quantity supplied is usually directly related to its price and production cost, other factors being constant. 32 JGI UNIT 02: Demand & Supply Analysis and Estimation JAIN DEEMED-TO-BE UNIVERSIT Y 2.9 GLOSSARY Elasticity: A measure of the responsiveness of demand (or supply) of a good to change in price, consumer’s income, price of substitutes and other factors Quantity demanded: The amount demanded at a specific point, which is shown by a point on the demand curve Cross elasticity: The responsiveness of demand of one good to a change in the price of another good 2.10 CASE STUDY: GHI SUPERCAM ESTABLISHED ITS DEMAND-SUPPLY EQUILIBRIUM Case Objective This case study discusses how GHI SUPERCAM established its demand-supply equilibrium. GHI Electrical and Electronics Co. is a Delhi-based company that manufactures various electrical and electronic products. It was established in the year 2000. It has a workforce of 500 people. Recently, GHI introduced a new electronic product into the market. The product is a home security camera that can store footage for two weeks and can be fixed anywhere. The company has named this camera as SUPERCAM. It has various unique features which help in keeping homes safe and guarded. The camera has an ability to recognise family members. If any unknown person tries to enter a home, it raises an alarm. Since this was a newly introduced product with better features than its competing products, GHI wanted to determine the price at which the supply and demand would be equalised. Hence, GHI analysed that the price of this product should be kept at 1.75 times the price of its competing products. Therefore, it was initially priced at `3,500 per piece. At this price, GHI was supplying 10,000 pieces per month. GHI is a successful and renowned company. Therefore, it thought that SUPERCAM would be readily accepted in the market and its demand would actually rise. However, things did not favour GHI and it analysed that the demand for SUPERCAM was only 2,000 pieces per month. During this phase, GHI incurred a huge amount of loss. To avoid such situations again, GHI reduced the price of SUPERCAM to ` 2,800 per piece. Along with it, GHI also reduced the supply to 7,000 pieces per month. Due to the reduced prices, the demand went up to 5,000 pieces per month. After this, GHI further reduced the price to ` 2,500 per piece and increased the supply to 8,000 pieces per month. At this stage, the demand and supply of SUPERCAM became equal. GHI also started earning high profits. It ultimately fixed the price and the supply quantity of SUPERCAM at ` 2,500 per piece and 8,000 pieces per month, respectively. Questions 1. After going through the above case study thoroughly, complete the given table: Price (in `) Demand Supply Surplus/ Shortage Price Rise or Fall? 3,500 2,000 10,000 ? ? ? 5,000 ? ? ? 2,500 8,000 8,000 ? ? 33 JGI JAIN Principles of Economics and Markets DEEMED-TO-BE UNIVERSIT Y Hint 2. Price (in `) Demand Supply Surplus/ Shortage Price Rise or Fall? 3,500 2,000 10,000 Surplus Fall 2,800 5,000 9 ? 9 2,500 8,000 8,000 ? ? What was the price of the competing products of SUPERCAM? (Hint: The price of competing products of SUPERCAM was `3,500/1.75 = `2,000.) 3. Why did GHI face losses? (Hint: High prices of products) 4. What was the initial demand of the product? (Hint: 2,000 pieces per month) 5. At which stage did the demand and supply of SUPERCAM become equal? (Hint: At price ` 2,500 per piece and supply to 8,000 pieces per month) 2.11 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. Demand is a relationship between various possible prices of a product and the quantities purchased by consumers at each price. Explain the concept of demand. 2. Derived demand is the demand for the product, which is associated with the demand for another product. Discuss different types of demands. 34 UNIT 02: Demand & Supply Analysis and Estimation JGI JAIN DEEMED-TO-BE UNIVERSIT Y 3. The law of demand represents a functional relationship between the price and quantity demanded of a commodity or service. Discuss. 4. Explain the concept of supply with suitable examples. 5. Explain the law of supply. 2.12 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS A. Hints for Essay Type Questions 1. Demand for a commodity is defined as the quantity of the commodity, which a consumer wants to buy, at a given price, per unit of time. In a market, the behaviour of buyers can be analysed by using the concept of demand. Refer to Section Concept of Demand 35 JGI JAIN DEEMED-TO-BE UNIVERSIT Y Principles of Economics and Markets 2. Demand can be categorised as individual demand and market demand as well as derived demand and direct demand. Refer to Section Concept of Demand 3. The law of demand states that the quantity demanded of a commodity increases with a fall in the price of the commodity and vice versa while other factors like consumers’ preferences, level of income, population size, etc., are constant. Demand is a dependent variable, while the price is an independent variable. Refer to Section Law of Demand 4. A market economy is made up of buyers and sellers. The buyers constitute the demand side of a good or service, whereas the sellers constitute the supply side. Thus, supply is defined as the specific quantity of a good that a producer is willing and is able to offer to consumers at a specific price at a given time period. Refer to Section Concept of Supply 5. The law of supply explains the direct relationship between the price and supply of a good. According to the law of supply, the quantity supplied increases with a rise in the price of a good and vice versa while other factors remain constant. Refer to Section Concept of Supply @ 2.13 POST-UNIT READING MATERIAL https://www.economicsdiscussion.net/law-of-demand/law-of-demand-schedulecurve-functionassumptions-and-exception/3429 https://businessjargons.com/types-of-demand.html 2.14 TOPICS FOR DISCUSSION FORUMS 36 Identify commodities in which demand is not affected by prices. UNIT 03 Production Analysis & Cost Analysis Names of Sub-Units Production – Meaning, Production Function, Laws of Production-Law of Variable Proportions and Laws of Returns to Scale, Isoquants, Economies of Scale; Cost Analysis – Meaning of Cost, Cost Concepts (Problems), Cost Function – SR & LR, LAC Curve; Breakeven Analysis – BEP (Numerical), Cost & Economies of Scale Overview This unit begins by explaining the meaning of production. The unit further differentiates between short-run and long-run production functions. In addition, the unit explains the law of variable proportion, isoquant analysis and the law of returns to scale. The unit also discusses different types of costs and cost functions. Towards the end, the unit sheds light on break-even analysis and economies of scale. Learning Objectives In this unit, you will learn to: Define production Explain short-run production function Describe long-run production function Explain basic cost concepts and cost function Define break-even analysis and economies of scale JGI JAIN D E E M E D- T O - B E U N I V E R S I T Y Principles of Economics and Markets Learning Outcomes At the end of this unit, you would: Analyse the short-run and long-run production function Discuss different costs Understand the cost function Analyse break-even point Evaluate the advantages of economies of scale 3.1 MEANING OF PRODUCTION Production can be defined as a process of converting inputs into outputs. Inputs include land, labour and capital, whereas output includes finished goods and services. In other words, production is an act of creating value that satisfies the wants of individuals. Organisations engage in production for earning a maximum profit, which is the difference between the cost and revenue. Therefore, the production decisions of organisations depend on the cost and revenue. The main aim of production is to produce maximum output with given inputs. Let us understand the concept of production with the help of an example. Suppose a farmer decides to grow sugarcane. Then, sugarcane is an output of the production process. To grow sugarcane, the farmer will have to use different inputs (also called factors of production), including: Land: He will grow the sugarcane on land. Labour: The sugarcane will be planted and harvested using labour. Capital: The farmer will use tractors, spades, hoes, irrigation ditches, sacks, fertilisers and pesticides. Similarly, a sugarcane firm decides to produce sugar. The output will be sugar and the inputs of production will be sugarcane, capital and labour. Production is not just about physical outputs such as cloth, rice and mobile phones. It also includes the services of doctors, teachers, nurses, consultants, etc. For attaining the maximum output, inputs are combined in more than one way. The most efficient combination is chosen from different combinations. The decisions for choosing combinations depend upon the purchase of inputs, distribution of budget among inputs, allocation of inputs and combination of output. Production is considered important by organisations because of the following reasons: Helps in creating value by applying labour on land and capital Improves welfare as more commodities mean more utility Generates employment and income, which develops the economy Helps in understanding the relation between cost and output Economists usually refer to periods of production as either short run or long run. Short run is defined as a period in which some factors of production (such as land and capital) are in fixed supply, while other factors, such as labour, are in variable supply. The long run, on the other hand, is defined as a period in which all factors of production are in variable supply. 40 JGI UNIT 03: Production Analysis & Cost Analysis JAIN DE E M E D- T O -B E U NI V E R S I T Y For example, RK Designs might want to expand its production. For this, it can get its weavers and tailors to work longer hours through overtime or shifts. The shop can also purchase more raw materials. Thus, the supply of labour and raw materials is variable. However, the shop has only a fixed amount of space in a building and a fixed number of machines on which its workers can work. This fixed capital places a constraint on RK Designs on how many jackets it can produce. This is a case of short-run production. In the long-run production, Ragini can move her production unit into a larger factory and purchase more machines, as well as employ more labour and use more raw materials. Doing so will increase the production capacity of her manufacturing unit, provided the technology does not change. In the very long-run production, the state of technology can change. For example, Ragini might be able towork withrobots and increase her production capacity tremendously at lower costs. There is no standard length of time for short-run or long-run production. Usually, in the garment industry, a short-run production period can be from 1-3 years. A food stall owner in a market who hires everything from the stall to the cooking stove and keeps no stock, the short-run production may be of 1 day, when he needs to hire equipment and sell his stock. 3.1.1 Production Function The production function can be defined as a relationship between output and different levels and combinations of inputs. It is the process of getting maximum output from the given inputs in a specific period. It includes only technically sound combinations of inputs, whichminimises the cost of production. The production function is generally expressed through the following equation: X = f (L, K, S) Here, X = Level of output L = Labour (physical and mental efforts of workers) K = Capital (factories, machines, equipment and other human manufactured aids to production) S = Land (soil, raw materials, etc.) For example, adairyneeds 50 cows and 1 labourer toproduce 50 litres of milk per day, then the production can be shown as: 50X = L + 50K Here, 50X is the number of litres of milk, L is the number of workers and K is the capital input (number of cows). The production function assumes that the state of technology is fixed. Any change in the state of technology will change the production function. For example, artificial intelligence has enabled IT firms to produce software with fewer engineers and less capital. 3.1.2 Factors of Production Factors of production are the inputs that are used for producing the final output with the main aim of earning an economic profit. Every factor is important and plays a distinctive role in the organisation. 41 JGI JAIN Principles of Economics and Markets D E E M E D- T O - B E U N I V E R S I T Y The factors of production can be: Fixed: The inputs whose quantity cannot be changed during a specific period of production are called fixed factors of production. Examples include land, equipment, machinery, factory, etc. The supply of these inputs remains fixed during short-run production. Variable: The inputs whose quantity can be changed during a specific period of production are called variable factors of production. Examples include raw materials, labour, electricity, fuel, etc. The supply of these inputs remains variable during short-run or long-run production. 3.2 SHORT-RUN PRODUCTION FUNCTION: LAW OF VARIABLE PROPORTION The short-run refers to a time period in which the supply of inputs, such as plant and machinery is fixed. Only the variable inputs, such as labour and raw materials, can be used to increase the production of goods. Suppose a firm, such as RK Designs, uses only two factors of production: Land (S) – Fixed Labour (L) – Variable The short-run production function of the firm can be expressed as: X = f(S, L) The law of production studied under short-run production is called the law of variable proportions or the law of diminishing marginal returns. What will be the output of the firm as it continues to employ more and more labour? To know the answer, let us first understand the concepts of Total Product (TP), Average Product (AP) and Marginal Product (MP). Total Product (TP): This is the total quantity of output produced by a firm during a specific period. It is expressed in physical terms and not in money terms. For example, the total product of 1000 weavers in the garment industry over a year might be 30,000 jackets. It is also known as the total physical product. Average Product (AP): It refers to the ratio of the total product to the variable input used for obtaining the total product. It is the product produced per unit of variable input employed when fixed inputs are held constant. The average product is calculated as: Average Product = Total Product/Variable inputs employed It determines how much output each labour produces on average. For example, the output per worker would be 30 jackets per year. AP can be expressed as: AP = L 42 Total Product Labour Input = TPL L Marginal Product (MP): Marginal product refers to the product obtained by increasing one unit of input. In terms of labour, the change in the total quantity of product produced by including one more worker is termed as the marginal product of labour. This is the change in TP produced by an extra unit of a variable factor (labour). JGI UNIT 03: Production Analysis & Cost Analysis JAIN DE E M E D- T O -B E U NI V E R S I T Y For example, if the addition of an extra weaver increases the output to 30,004, then the MP would be 4 jackets. MP can be expressed as: MP = L Change in Total Product Change in Labour Input = TPL L The following formula can be used to calculate: MPL f or nth unit: TPn – TP(n-1) Here, n = Number of labour units Now, consider Table 1 In this example, the land is fixed at 1 unit, while labour input is in variable supply: Table1: TP AP MP in Short Run Land Labour Total Product of Labour (TPL) Average Product of Labour (APL) Marginal Product of Labour (MPL) 1 0 0 0 – 1 1 4 4 4 1 2 10 5 6 1 3 18 6 8 1 4 24 6 6 1 5 28 5.6 4 1 6 30 5 2 1 7 30 4.3 0 1 8 28 3.5 -2 1 9 25 2.7 -3 Table 1 indicates that: If no workers are employed, the total output will be zero. The first worker produces 4 units of output. So, the marginal product of the first worker is 4 units. The second worker produces an extra 6 units of output. So, the marginal product of the second worker is 6 units. The total output of two workers is 4 + 6 = 10 units. The average output is 10/2 or 5 units per worker. The third worker produces an extra 8 units of output. Thus, the total output with three workers is 4 + 6 + 8 = 18 units. The average output is 18/3 = 6 units per worker. The Marginal Product (MPL) initially rises but the fourth worker produces less than the third. The diminishing marginal returns, therefore, set in between the third and fourth workers. The Average Product (APL) also rises at first and then decreases, but the turning point is the fifth worker instead of the fourth worker (later than for the marginal product). Therefore, the diminishing average returns set in between the fourth and fifth workers. 43 JGI JAIN Principles of Economics and Markets D E E M E D- T O - B E U N I V E R S I T Y Now, let us plot the values of TPL, APL and MPL on the graph, as shown in Figure 1: TPL TPL Maximum A B TPL Inflextion Point C QL(land) O APL MPL C' Power of diminishing margin al returns Power of diminishing average returns A' APL B' MPL =0 QL(land) O MPL APL Figure 1: Total, Average and Marginal Product Source: Principles of Economics: Deepashree As Figure 1 shows, the TPL curve starts from the origin, increases at an increasing rate, then increases at a diminishing rate, reaches a maximum, and then starts to fall. This means that as more and more labour units are employed, TPL increases but at a diminishing rate. APL and MPL curves are derived in the lower panel of Figure 1. Relationship between TPL and APL curves APL at any point on the TPL curve is the slope of the straight line from the origin to that point on the TPL curve. It is positive as long as TPL is positive. The APL curve is in the shape of an inverted U. It initially rises, reaches a maximum and then falls. 44 JGI UNIT 03: Production Analysis & Cost Analysis JAIN DE E M E D- T O -B E U NI V E R S I T Y Relationship between TPL and MPL curves MPL at any point on the TPL curve is the slope of the TPL curve at that point. MPL between two points on the TPL curve is the slope of the line connecting the two points on the TPL curve. The slope increases till point C and then decreases. At maximum TPL the slope is zero and then it is negative. The MPL curve initially rises, reaches a maximum when the slope of the tangent is highest, and then falls. When TPL is maximum, MPL is zero (point B to B’). When TPL declines, MPL is negative. This means that an extra worker results in a fall of output (or slows down the production process). Thus, the MP of that worker is negative. The area under the MPL curve is TPL. MPL is positive as long as is TPL positive, but it becomes negative when TPL starts to decrease. Relationship between APL and MPL curves Both APL and MPL curves rise initially; the MPL curve increases at a faster rate than the APL curve. This is because for the average product to increase, the marginal product must be more than the previous average product. Both the curves rise till the fixed factor land is fully utilised. Post that, both curves start to fall. The MPL curve declines at a faster rate than the APL curve. From point C’ to A’, the APL curve is rising even though the MPL curve is falling. At point A’, the APL curve neither rises nor falls. At this point, MPL = APL. Mathematically, the relationship between the two curves is as follows: TPL = AP L. L MP = L TPL L = (APL . L) L = AP + L (slope of AP curve) L L Thus, when the slope of curve is: Equal to 0 MPL = APL More than 0 MPL > APL Less than 0 MPL < APL This law is a short-run phenomenon that operates when the total output or production is increased by increasing units of a variable factor. Another name of this law is the Law of Diminishing Marginal Returns. The law of diminishing returns is an important concept of economic theory. The law of diminishing returns is a short run concept where some factors are fixed and some are variable. It explains that when more and more units of a variable input are employed at a given quantity of fixed inputs, the total output may initially increase at an increasing rate and then at diminishing rates. It implies that the total output initially increases with an increase in variable input at a given quantity of fixed inputs, but it starts decreasing after a point of time. Statement: When the total output or production of goods increases by using more of a variable factor (while keeping other factors constant), then after some point the increase in total production becomes smaller and smaller. 45 JGI JAIN D E E M E D- T O - B E U N I V E R S I T Y Principles of Economics and Markets This law is based on the following assumptions: The state of technology remains unchanged. All units of variable factor (labour) are of the same quality. There must always be some fixed factor and diminishing returns must result from limitations on the use of this factor. The law of variable proportions can be split into three specific stages of production in the short-run: 1. Stage of increasing returns: It refers to the stage of production in which the total output increases initially with the increase in the number of labours. This stage of production is from the origin to point b, where APL is maximum. In this stage: a. The TPL curve starts from the origin and increases at an increasing rate. Then, from the point of inflexion C, it starts increasing at a decreasing rate. b. The APL curve starts from the origin and increases throughout in this stage. c. The MPL curve increases initially, reaches a maximum and then starts to fall. The APL and MPL curves increase because the fixed factor of land is not fully utilised. These increasing returns are due to the following reasons: Underutilisation of a fixed factor: The fixed factor (land) is underutilised in relation to the labour employed on it. This helps in better use of land, which, in turn, will increase the TPL curve at an increasing rate. Indivisibility of factors: The factors employed in the production process cannot be divided further into smaller units. Therefore, when more units of variable factor (i.e., labour) are mixed with the fixed factor (i.e., land), the returns will keep on increasing. Specialisation and division of variable factor: As the units of the variable factor (labour) are increased, their specialisation and division will give increasing returns. A rational producer will not operate in this stage because he always has an incentive to expand through labour in this stage. 2. Stage of diminishing returns: It refers to the stage of production in which the total output increases, but marginal product starts declining with an increase in the number of workers. This stage of production is from point b (where APL is maximum) to point d (where is MPL zero). It refers to the stage of production in which the total output increases, but marginal product starts declining with the increase in the number of workers. At this stage: a. The TPL curve increases at a decreasing rate till it reaches the maximum point. b. The APL curve falls continuously. c. The MPL curve falls continuously till it is equal to zero. The diminishing returns are due to the following reasons: Utilisation of the fixed factor at an optimal capacity: When the quantity of the fixed factor (land) is efficiently utilised in relation to the quantity of the variable factor (labour employed on it), the returns will start increasing at a decreasing rate. Perfect substitution between factors: All factors of production will be in scarce supply. When one factor can be perfectly replaced with another factor, then returns start increasing at a diminishing rate. A rational producer will always operate at this stage to get maximum efficiency or profits for his firm. 46 JGI UNIT 03: Production Analysis & Cost Analysis JAIN DE E M E D- T O -B E U NI V E R S I T Y 3. Stage of negative returns: It refers to the stage of production in which the total product starts declining with an increase in the number of workers. This stage of production is from point downward (where MPL is negative). In this stage: a. The TPL curve falls. b. The APL curve falls continuously. c. The MPL curve is negative. It is a non-economic and inefficient stage. Since a producer can increase his output by using less labour, he will not have any incentive to operate in this stage. Let us consider Figure 2 to understand these three stages: Product Stage I TP L Stage II Stage II I C AP O L d b MP L Figure 2: Stages of Short-Run Production Source: Principles of Economics: Deepashree If we consider Table 2 again concerning these three stages, then: Table 2: TP, AP, MP In Short-Run Land Labour Total Product of Labour (TPL) Average Product of Labour (APL) Marginal Product of Labour (MPL) Stage of Production 1 0 0 0 - 1 1 4 4 4 Stage I of Increasing Returns 1 2 10 5 6 1 3 18 6 8 1 4 24 6 6 1 5 28 5.6 4 Stage II of Diminishing Returns 47 JGI JAIN Principles of Economics and Markets D E E M E D- T O - B E U N I V E R S I T Y Land Labour Total Product of Labour (TPL) Average Product of Labour (APL) Marginal Product of Labour (MPL) 1 6 30 5 2 1 7 30 4.3 0 1 8 28 3.5 -2 1 9 25 2.7 -3 Stage of Production Stage III of Negative Returns 3.3 LONG-RUN PRODUCTION FUNCTION: ISOQUANT ANALYSIS The long run is the period in which the supply of labour and capital is elastic. It implies that labour and capital are variable inputs. In the long-run production function, all factors of production are variable. Suppose a firm has two factors of production: labour and capital. Both of these factors are variable. Then, the long-run production function can be expressed through the following equation: X = f (L, K) Here, X = Level of output L = Labour (physical and mental efforts of workers) K = Capital (factories, machines, equipment and other human manufactured aids to production) In the long run, the relation between input-output is studied by the laws of returns to scale (long-run laws of production). The laws of returns to scale can be explained with the help of an isoquant curve. 3.3.1 Isoquant Curve An isoquant is the graphical representation of a long-run production function. The word ‘iso’ means constant and the word ‘quant’ means quantity. An isoquant is defined as a line that shows the various combinations of factors of production (labour and capital) which yield a given quantity of output. According to Cohen and Cyert, an isoquant is a curve “along which the maximum achievable production is constant.” It represents the flexibility of a firm when it makes production decisions. Consider Table3 that shows the Labour and Capital data for different levels of output. Table 3: Labour and Capital Data for Different Levels of Output 48 Combination Labour Capital Output A 5 10 100 B 10 6 100 C 20 3 100 D 7 12 200 E 12 8 200 F 22 5 200 G 9 15 300 H 15 11 300 I 25 8 300 JGI UNIT 03: Production Analysis & Cost Analysis JAIN DE E M E D- T O -B E U NI V E R S I T Y Using the data from Table 3.3, isoquant curves are drawn as shown in Figure 3: PRODUCTION ISOQUANT Units of Capital 16 9, 15 14 12 10 8 6 4 2 0 7, 12 15, 11 5, 10 A 12, 8 25, 8 13 10, 6 22, 5 B 0 5 10 15 20 20, 3 12 11 25 30 Units of Labour Figure 3: Production Isoquants In Figure 3, suppose isoquant I1 shows that a firm can produce 100 kg of output using 10 units of capital and 5 units of labour (combination A), 3 units of capital and 20 units of labour (combination B) or any other combination which lies on isoquant I1. Note, however, that you cannot determine which combination the firm uses to produce the output, it only shows the technically possible combinations of factor inputs that can produce 100 kg of output. Combination A, which requires more units of labour but few units of capital, is a capital-intensive method of production. On the other hand, combination B, which requires fewer units of capital but more units of labour, is a labour-intensive method of production. Figure 3 shows three isoquants: Isoquant I1: Suppose it shows 100 kg of output. This output can be produced by using either combination A or combination B or any other combination on this isoquant. The firm or the producer is indifferent between any of these combinations that lay on the isoquant I1. Isoquant I2: This isoquant shows a higher quantity of output, say 150 kg. Isoquant I3: This isoquant represents the even higher quantity of output, say 200 kg. Therefore, a movement along an isoquant curve represents the constant level of output and different ratios of inputs (capital to labour). On the other hand, a movement from one isoquant to another means that the level of output changes. An isoquant closer to the point of origin will indicate a lower level of output (such as Isoquant I1), whereas a higher isoquant will represent a higher level of output (such as Isoquant I3). There are four main characteristics or properties of an isoquant curve: 1. An isoquant slopes downward from left to right in the relevant range: Isoquants are downward sloping as shown in Figure 3. This means that if a firm wants to use more units of labour, it must use less units of capital to produce the same units of output to remain on the same isoquant curve. Such behaviour can only be satisfied through a downward sloping isoquant because it only shows the substitution of one factor with the other. Therefore, the slope of the isoquant curve is negative. 2. An isoquant is convex to the origin: It implies that factor inputs are not perfect substitutes. This property shows the substitution of inputs and diminishing marginal rate of technical substitution of isoquant. The marginal significance of one input (capital) in terms of another input (labour) diminishes along with the isoquant curve. 49 JGI JAIN Principles of Economics and Markets D E E M E D- T O - B E U N I V E R S I T Y 3. A higher isoquant depicts a higher level of output: The greater the distance of an isoquant curve from the point of origin, the higher output it represents. As Figure 4 shows, combination B on isoquant Q2 represents more of both input factors, OK2 + OL2 as compared to point A on isoquant Q1, which represents OK1 + OL1. Since the marginal factor productivities across the isoquant remain positive, the point B indicates a higher level of output than point B: Y Units of Capital B K2 A K1 Q2 Q1 O L1 X L2 Units of Labour Figure 4: Isoquant Curves Source: https://www.microeconomicsnotes.com/production-function/isoquant/isoquantconcept-characteristics-and-type-productionfunction-economics/15331 4. Two isoquants never intersect each other: Two isoquants, which represent different levels of output cannot intersect. For example, consider Figure 5. Suppose isoquant Q1 (= 100 units) and isoquant Q2 (= 200 units) intersect each other at point A: Y Units of Capital A K Q 2(=200) Q 1(=100) O L Units of Labour X Figure 5: Intersecting Isoquants Source: https://www.microeconomicsnotes.com/production-function/isoquant/isoquant-concept-characteristics-and-type-productionfunction-economics/15331 According to Figure 5, at point A, the combination of factors OK + OL can produce both 100 units as well as 200 units of output. This is an illogical situation. Therefore, two isoquants cannot intersect each other. 50 JGI UNIT 03: Production Analysis & Cost Analysis 3.3.2 JAIN DE E M E D- T O -B E U NI V E R S I T Y Iso-cost Curve An iso-cost curve is the locus of points of all different combinations of labour and capital that an organisation can employ, given the price of these inputs. The iso-cost line represents the price of factors along with the amount of money an organisation is willing to spend on factors. In other words, it shows different combinations of factors that can be purchased at a certain amount of money. The slope of the iso-cost line depends upon the ratio of the price of labour to the price of capital. The Algebraic equation of the linear iso-cost line is as follows: C = PL × L + PK × K Where, PL = Price of labour (i.e., wages – w) PK = Price of capital (i.e., interest – r) Therefore, C = w × L + r × K For example, a producer has a total budget of `120, which he wants to spend on the factors of production, namely X and Y. The price of X in the market is `15 per unit and the price of Y is `10 per unit. Table4 depicts the combinations: Table 4: Combination of X and Y Combinations Unit of X Unit of Y Total Expenditure A 8 0 120 B 6 3 120 C 4 6 120 D 2 9 120 E 0 12 120 The iso-cost line is shown in Figure 6: X 10 8 T 6 1 Iso-cost Line 2 H 0 2 Y 4 6 8 10 12 Figure 6: Iso-cost Line 51 JGI JAIN D E E M E D- T O - B E U N I V E R S I T Y Principles of Economics and Markets As shown in Figure 6, if the producer spends the whole amount of money to purchase X, then he/she can purchase 8 units of X. On the other hand, if the producer purchases Y with the whole amount, then he/she would be able to get 12 units. If points H and L are joined on X and Y axes, respectively, then a straight line is obtained, which is called the iso-cost line. All the combinations of X and Y that lie on this line, would have the same amount of cost that is `120. Similarly, other iso-cost lines can be plotted by taking cost more than `120, in case the producer is willing to spend more amount of money on the production factors. With the help of isoquant and iso-cost lines, a producer can determine the point at which inputs yield maximum profit by incurring the minimum cost. Such a point is termed as producer’s equilibrium. 3.3.3 Producer’s Equilibrium Producer’s equilibrium implies a situation in which a producer maximises his/her profits. In the long run, the producers can vary all the factors of production. The producers or the firms usually aim at maximising their profits by selecting the least cost combination of factors to produce a given level of output. The combination of factors of production using which an organisation can produce a given quantity of goods at the lowest cost or at which the total cost of producing a given output is minimum is known as least cost combination or the optimum factor combination. The producers always strive to maximise their profit at least cost by choosing an optimum combination of inputs. If it is assumed that an organisation is using two factors of production namely capital and labour to produce a certain level of output; then, the optimum combination of factors of production can be explained by two methods which are: i. Marginal Product approach; and ii. Isoquant/Iso-cost approach Here, we will discuss the producer’s equilibrium using isoquant approach. A given level of output can be produced by various combinations of factors. For maximising profit, the producer must choose a combination of factors that produce the given level of output at least cost/outlay. For any level of output, such a least cost combination of factors occurs where the isoquant curve is tangent to an iso-cost curve. Producer’s equilibrium using iso-quant approach is based on the following assumptions: Only two factors of production namely X and Y are considered All the units of factors of production are homogenous Price of factors of production are stated and are constant Total cost is also given and is constant Perfect completion exists When all these assumptions are true; then, a producer is said to be in equilibrium when the following two conditions are fulfilled: The isoquant must be convex to the origin. The slope of the isoquant equals the slope of the iso-cost line. 52 JGI UNIT 03: Production Analysis & Cost Analysis JAIN DE E M E D- T O -B E U NI V E R S I T Y Producer’s equilibrium using isoquant approach is shown in Figure 7: Y G Factor Y E C M O B D F R S ∆y ∆x A N = Px P y Q L P 400 H Factor X Figure 7: Isoquant Approach In Figure 7, note that the isoquant curve (for product quantity = 400 units) is tangent to iso-cost line CD. Here, the cost outlay is Q units. At point Q, the two conditions required for producer’s equilibrium are satisfied as follows: The isoquant curve is convex at the origin. At Q, the slope of the isoquant (= ΔY/ΔX) is equal to the slope of the iso-cost line (=Px/Py). 3.4 LAW OF RETURNS TO SCALE Returns to scale imply the behaviour of output when all factor inputs are changed in the same proportion given the same technology. In other words, the law of returns to scale explains a proportional change in output with respect to a proportional change in inputs. In the long-run production, the output can be increased by increasing the scale of operations. The scale of operations in turn can be increased by increasing all factors of production at the same time and by the same proportion. For example, a firm can increase its scale of operations in the long run by doubling the factors of capital and labour. The scale of operations is governed by a law called the Law of Returns to Scale. This law always refers to long-run production, where all factors of production are in variable supply. Statement: When all factors of production are increased in the same proportion and at the same time, the output will increase. However, an increase may be at an increasing rate or constant rate or decreasing rate. Thus, there are three stages of returns to scale: Increasing returns to scale Constant returns to scale Diminishing returns to scale 3.4.1 Increasing Returns to Scale It is a situation in which output increases by a greater proportion than the increase in factor inputs. For example, to produce a particular product, if the quantity of inputs is doubled and the increase in output is more than double, it is said to be an increasing return to scale. When there is an increase in the scale of production, the average cost per unit produced is lower. This is because at this stage an organisation enjoys high economies of scale. 53 JGI JAIN Principles of Economics and Markets D E E M E D- T O - B E U N I V E R S I T Y During this stage, the output increases more than proportionately to the increase in factors of production. For example, capital (K) and labour (L) are the only two factors of production in a firm. To produce 100 Q units of output, the firm needs 3 units of K and 3 units of L. If both these factors are doubled from 3 to 6 units, then 300 Q is produced, which is more than double of 100 Q. This more than double output is represented by point B in Figure 8, which lies on a higher isoquant than point A: K B 6 Q 300 Q A 3 100 Q 0 3 L 6 Figure 8: Increasing Returns to Scale Source: http://ebooks.lpude.in/commerce/mcom/term_1/DECO405_MANAGERIAL_ECONOMICS_ENGLISH.pdf Increasing returns to scale happen because when a firm increases its scale of operations, there will be: Greater division of labour and specialisation Use of more specialising and productive machinery Increasing returns to scale are because of technical and/or managerial indivisibilities. As the scale of production increases, mass production methods (such as assembly lines) are used to produce large levels of output. Instead of multitasking, each worker specialises in performing a simple, repetitive task. This will increase labour productivity. Moreover, the firm will use more productive specialised machinery to increase its scale of operations. 3.4.2 Constant Returns to Scale A constant return to scale implies the situation in which an increase in output is equal to the increase in factor inputs. For example, in the case of constant returns to scale, when the inputs are doubled, the output is also doubled. During this stage, the output increases by the same proportion as the increase in factors of production. For example, consider Figure 9. To produce 100 Q units of output (point A), 3 units each of K and L are used. If 6 units of K and 6 units of L are used, then the output produced is 200 Q (point B), which is double the initial output. Similarly, if the factors of production are trebled, then the treble output will be produced, and so on. K B 6 200 Q A 3 100 Q 0 3 6 L Figure 9: Constant Returns to Scale Source: 54 http://ebooks.lpude.in/commerce/mcom/term_1/DECO405_MANAGERIAL_ECONOMICS_ENGLISH.pdf JGI UNIT 03: Production Analysis & Cost Analysis 3.4.3 JAIN DE E M E D- T O -B E U NI V E R S I T Y Diminishing Returns to Scale Diminishing returns to scale refers to a situation in which output increases in a lesser proportion than the increase in factor inputs. For example, when capital and labour are doubled, but the output generated is less than double, the returns to scale would be termed as diminishing returns to scale. During this stage, the output increases by less proportion than the increase in factors of production. For example, in Figure 10, both capital and labour are doubled from 3 units to 6 units, but the output rises by less than double—from 100 Q to 150 Q. K B 6 150 Q 3 A 100 Q 0 3 6 L Figure 10: Decreasing Returns to Scale Source: http://ebooks.lpude.in/commerce/mcom/term_1/DECO405_MANAGERIAL_ECONOMICS_ENGLISH.pdf Decreasing returns to scale mainly arises due to a difficulty in managing a firm as its scale of operations increases. As the scale of operations increases, the management diseconomies also increase. The management of the firm becomes overburdened and their efficiency in decision making and coordination activities suffers. Difficulties in communication also make it harder for them to run a business effectively. The decreasing returns to scale may also arise due to exhaustible natural resources. If the capacity of a mining plant or an oil extraction field is doubled, then it will not lead to double output, as natural resources have limited supply. In reality, the forces of increasing or decreasing returns to scale usually operate side-by-side. At small levels of output, the increasing returns to scale play a dominant role, whereas the decreasing returns to scale play a significant role at very large levels of output. 3.5 BASIC COST CONCEPTS In economics, cost analysis involves measuring the cost-output relation. In other words, cost analysis involves determining the costs incurred for inputs and how they affect the output or productivity of a company. Cost analysis also involves breaking down a total cost into its different constituents and studying each cost component. Cost analysis also involves the comparison of costs for making improvements in future. For example, comparing the standard cost with actual cost. Certain cost concepts are used by accountants while some are used by economists. The cost concepts used by economists are basically to analyse the cost of production for the year which has to be budgeted. The economists are more focussed on rearranging the input cost and output cost to increase the profitability of the business. 55 JGI JAIN D E E M E D- T O - B E U N I V E R S I T Y Principles of Economics and Markets 3.5.1 Types of Costs Various costs involved in the cost of production include actual and opportunity costs, implicit and explicit costs, fixed and variable costs, accounting and economic costs, private and social costs and short-run and long-run costs. Let us understand these costs in detail. Actual and Opportunity Costs Actual costs are the costs incurred on producing a certain quantity of goods or providing a certain service. The costs incurred by a business for manufacturing a product or providing a service are actual costs which include costs incurred on purchasing raw materials and selling the final products to customers. In the case of services, operations cost is the actual cost. These costs are recorded in the books of accounts and are used for financial analysis. Implicit and Explicit Costs Implicit costs, as the name suggests, are implied costs. This means an implied cost is not an actual expense or cost incurred but a reduction in revenue. This reduction in revenue is a loss incurred due to the event or an action. However, as there is no actual money spent, it does not get recorded in the books of accounts. For example, due to the COVID-19 pandemic, many employees were asked to work from home, which reduced the revenue of organisations. There was no actual money spent but the revenue decreased due to employees working from home. Implicit cost can also be called opportunity cost. For example, if a fixed deposit of ` 5,00000 is kept for 5 years, it will fetch ` 50,000 interest. But if the deposit is withdrawn before the required period for investing in a project, it would yield `10,000 per month. In this case, the interest of `50,000 is lost which is the opportunity cost or the implicit cost. Explicit costs are the actual expenses or costs incurred and these are recorded in the books of accounts. They are also called actual costs. For example, costs incurred on the purchase of raw materials, paying wages and salaries to workers, and paying rent. In other words, explicit costs are measurable expenses of a business that are recorded in its books of accounts. For example, if a business hires 10 new workers, it has to pay salaries to these 10 new workers which will increase the expenses on salaries in the profit and loss account. However, if new employees are given training by the existing workers, the training expenses of these 10 workers will be included as implicit costs and will not be recorded in the books of accounts. However, if an external training and development consultant is hired for providing training, the costs would be explicit. Fixed and Variable Costs The total expenses incurred by businesses are classified into two main categories, i.e., fixed costs and variable costs. Fixed costs are expenses that are fixed in nature. It means that fixed costs do not fluctuate according to production and are incurred by the business even if it is not producing anything. For instance, rent of the building is a fixed cost. Variable costs are the costs that vary with the amount of production or output. These costs can include raw materials, water, labour, etc. It depends on the usage. For example, a construction site requires more workers while constructing the building. But once the structure has been built, only interiors need to be done which requires half the number of workers. Therefore, wages salaries to workers on a site are variable costs for a construction company as they vary every month. On the contrary, the salary of the office staff of the construction company, such as engineers, accountants, site supervisors, office boys 56 UNIT 03: Production Analysis & Cost Analysis JGI JAIN DE E M E D- T O -B E U NI V E R S I T Y and salespersons, is fixed cost. Every business incurs both fixed and variable costs. Some of the costs of the business are fixed in nature and some vary according to the nature of the business. Similarly, if a business gets a new project, it would hire more workers or existing workers will have to work overtime. Also, more electricity will be used. Hence, the costs would vary accordingly till the project is completed and again it will come back to normal while the rent will remain the same. Accounting and Economic Costs Accounting costs also called money costs, include all actual expenses, depreciation expenses and all regulatory expenses as per law. Economic costs include opportunity costs, implicit costs in addition to the actual and explicit costs. In case the office space is owned by the business, the accounting cost would show zero rent for the space used. But the economic cost will show the rent of the office space as opportunity cost foregone as the space used by the business and has not earned rent if it would have let it out. The business owner works full time for the business but does not take a salary. The accounting cost will show zero as the business owner’s salary. However, economic cost will show the implicit cost of the salary that should be paid to the business owner for the skills and time he uses for the business. Accounting cost applies tax rules to ascertain the amount of depreciation and accordingly values assets. On the other hand, with respect to the economic cost view, the actual market value of the asset is taken and only that amount of depreciation according to the actual wear and tear of the asset is considered. Short-run and Long-run Costs Short-run and long-run costs are costs involved in different time periods in an economy. In short-run, one factor of production is fixed. Short-run is usually considered for up to one year. For example, if the capital employed (factor of production) is fixed, then, for increasing production in short-run, the business cannot increase its capital but it will have to increase the number of workers or machinery, etc. It is also possible that the business would rent machinery instead of purchasing the machinery. Thus, in the short-run, the business would observe a rise in marginal costs resulting in diminishing marginal returns. This will affect the price of the product or the cost of labour. For example, due to the COVID-19 pandemic, the cost of all essentials went up because there was an increase in demand but supply could not be increased in the short run. In the long-run, none of the factors of production is fixed, they are all variable. The time period for longrun is usually more than a year. Here the business has to consider the long-run impact and plan accordingly. For example, during 2020, all educational institutes had to be closed. These schools and colleges thought the first lockdown period will be able to eradicate the COVID-19 pandemic and they will be able to reopen in the next academic year. However, they did not consider the long-term impact of the pandemic and plan accordingly for the long run. Variable costs related to creating virtual classrooms, preparing online study materials and student support systems had to be borne. Also, fees had to be varied or deferred. Thus, the price elasticity of demand varied as the students and the parents have to get used to the new way of learning and ready to pay for the fees associated with it. 3.6 COST FUNCTION A cost function is a mathematical function that shows how production costs change at different output levels. It represents the relation between inputs and outputs. The cost function calculates the value of 57 JGI JAIN Principles of Economics and Markets D E E M E D- T O - B E U N I V E R S I T Y output given certain inputs. Businesses use the cost function to minimise cost and maximise production efficiency. 3.6.1 Short-run (SR) Cost Function In the short-run, only one cost is fixed and the cost of production varies with the output produced. The short-run cost function is mathematically written as: C = f (X) The cost of production is denoted as C and the level of output is denoted as X. The fixed cost curve is a straight line parallel to the horizontal axis for the cost of output and the variable cost is an S-shaped curve. Every business incurs fixed cost as well as variable cost which results in total cost. Total Cost (TC) =Total Fixed Cost (TFC) +Total Variable Cost (TVC) In the long-run cost, no factor of production is fixed. Hence, all factors of production have variable costs. Therefore, here fixed costs are zero and total costs are equal to the total of variable costs. TC = TVC The total cost curve will be the summation of the total fixed cost curve and total variable cost curve. Figure 11 shows the graphical presentation of the total fixed cost curve, total variable cost curve and total cost curve: Y TC TVS TVS TFC TC TFC X Output Figure 11: Total Fixed Cost Curve, Total Variable Cost Curve and Total Cost Curve From Figure 11, observe that: The TFC curve is parallel to the X-axis. TFC shows the cost of output is fixed even if the output is zero. The TVC curve is an S-shaped curve. Initially, the increase in cost gives the increased value of output but after a point with every increase of variable cost, the marginal cost diminishes giving the curve an S shape. The TVC curve starts from the origin as when the output is zero, the variable cost is also zero. The TC is the sum of TFC and TVC. The shape of the TC curve is similar to the shape of the TVC curve but it does not start from the origin instead it starts at the point of the fixed cost curve. 58 JGI UNIT 03: Production Analysis & Cost Analysis 3.6.2 JAIN DE E M E D- T O -B E U NI V E R S I T Y Long-run (LR) Cost Function In the long-run, fixed costs are zero and all the costs are variable. It means that there would be a minimum cost of production for a given level of output. Therefore, it is observed that long-run costs are never more than short-run costs but will always be lower or equal to short-run average costs. If we try to depict this graphically, you will find that the minimum points of all short-run total cost curves at different levels when joined, gives us the long-run total cost curve. The long-run average cost curve is the average cost per unit of production in the long-run. Mathematically, it is calculated by dividing the long-run total cost by the output level. This is shown in Figure 12: Y E2 SAC 1 SAC 2 SAC 3 E1 E E3 Cos t LAC R O M2 M4 M1 M3 X Output Figure 12: Envelope Curve In Figure 12, each short-run average cost curve belongs to a particular machinery capacity. The capacity of the machinery is fixed but the input can vary in the short-run. However, in the long-run, the business has the opportunity to minimise its cost for the output it wants to produce in the year. Therefore, OM1 is the level of output when the machinery capacity is SAC2. In the long-run, if the business tries to operate at a cost of SAC2 to produce OM2 output, the costs will increase. In the long-run, the business can have an output planned at a capacity of the machinery which will minimise the costs. Figure 12 shows the minimum points of all SAC curves. When all these minimum points are joined, the LAC curve is obtained. The LAC is also known as the envelope curve. The business owner, thus, decides the scale of operation or the size of the firm. To make this decision, the owner needs to know the cost of production for a certain level of output. 3.7 BREAK-EVEN ANALYSIS Break-even analysis is a method that is used by most of the organisations to determine a relationship between costs, revenue and their profits at different levels of output. It helps in determining the point of production at which revenue equals the costs. Break-even analysis is also called as profit contribution analysis. Some of the popular definitions of break-even analysis are as follows: According to Matz, Curry and Frank, “a break-even analysis indicates at what level, cost and revenue are in equilibrium.” 59 JGI JAIN Principles of Economics and Markets D E E M E D- T O - B E U N I V E R S I T Y According to Keller and Ferrara, “the break-even point of a unit of a company is the level of sales income which will equal the sum of its fixed costs and its variable costs.” According to Charles T. Homogreen, “the break-even point of activity (sales volume) is where total revenue and total expenses are equal. It is the point of zero profit and zero loss.” The important aspect of understanding break-even analysis is the break-even point, at which, there is no net loss or gain of an organisation as expenses equal revenue. The break-even analysis is done under two conditions, which are as follows: Linear cost and revenue relationship Non-linear cost and revenue relationship Based on these two conditions, there are several methods for performing break-even analysis. Some of these methods are shown in Figure 13: Break-Even Analysis Linear Cost and Revenue Relationship Graphical Method Non-linear Cost and Revenue Relationship Contribution Analysis Algebric Method Profit Volume Ratio Figure 13: Methods of Break-Even Analysis The methods of break-even analysis are explained as follows: Graphical Method: Shows a linear break-even analysis. When the price of a product remains the same, the organisation expands its production, thus, total revenue is linear to the output. Let us learn this method through Figure 14: TR Break-even point Revenue and cost TC TFC E F O Qb Output Figure 14: Graphical Method of Break-Even Analysis As shown in Figure 14, TFC is equals to FE, which is a fixed cost line. The vertical distance between TC and TFC line equals TVC. As the quantity of output increases, the vertical distance between TC and TFC increases. This implies that TVC increases with change in TC and TFC. Until Qb of the quantity 60 JGI UNIT 03: Production Analysis & Cost Analysis JAIN DE E M E D- T O -B E U NI V E R S I T Y is produced, the total cost exceeds the total revenue, which implies that an organisation will suffer losses if it produces less than Qb. At Qb output level, total revenue equals total cost. At this point, an organisation never makes a profit nor loss implying that it is a break-even point. Thus, Qb is a breakeven level of output. Producing more than Qb will be profitable for organisations as TR is greater than TC. Algebraic Method: Helps in decision making problems of the organisation. We know that profit is equal to the difference between total revenue and total cost. π = TR - TC TR=P*Q TC = TVC+TFC TC = AVC*Q + TFC (TVC is the variable cost per unit multiplied by the output produced and sold) Let Qb is the break-even quantity at which TR=TC. TR = TC P.Qb = TFC +AVC.Qb P.Qb – AVC.Qb = TFC (P – AVC)Qb = TFC Qb = TFC/(P – AVC) Thus, from the above equation, it can be said that the break-even quantity of output is determined by TFC, price and variable cost per unit of output. Contribution Analysis: Refers to the analysis of incremental or additional revenue and costs of a business. Contribution is the difference between total revenue and variable costs. Let us discuss this through Figure 15: TR Profit Contribution Cost and Revenue TC FC VC O Q Output Figure 15: Contribution Analysis Method of Break- Even Analysis Fixed costs are an addition to variable costs. Thus, the TC line is parallel to the variable costs line. In Figure 15, OQ is the break-even point. TC minus VC equals FC. Below OQ, the contribution is less than fixed cost whereas, beyond OQ, contribution exceeds the fixed cost. The shaded portion between TR and VC is the contribution. 61 JGI JAIN D E E M E D- T O - B E U N I V E R S I T Y Principles of Economics and Markets Profit volume (PV) ratio: Refers to another method to find break-even point. The formula for profit volume ratio is: PV ratio = (S – V)/ S * 100 S = Selling price V = Variable costs 3.8 ECONOMIES OF SCALE Economies of scale are advantages that result due to large-scale production. When costs are saved due to an increased level of production, it is a case of economies of scale. Economies of scale are caused by the following factors: Specialisation: When a business operates at a higher scale, it has greater opportunities to specialise in that field irrespective of the job performed by men or machines. At a large scale, the business can afford to divide the work and allot specialised tasks to different groups of people. Specialisation ensures good finesse to goods or services. Inputs at reduced costs: Businesses require raw materials in large quantities due to which suppliers provide materials at large discounts resulting in a favourable purchase price. By-products: Usually, large-scale businesses create by-products in the process of production of the main product. These by-products can be reutilised or recycled or sold which results in effective and efficient use of resources. A small-scale business may not be able to take an advantage of byproducts due to limited capacity. For example, in sugar factories, sugar is produced as the main product whereas molasses and bagasse are produced as by-products. Conclusion 3.9 CONCLUSION Production can be defined as the process of converting the inputs into outputs. Inputs include land, labour and capital, whereas output includes finished goods and services. Factors of production are the inputs used by a firm in the production process. These can be fixed (land, equipment) or variable (labour, electricity) during short-run production. Short run is defined as a period in which some factors of production (such as land and capital) are in fixed supply, while others such as labour are in variable supply. Long run, on the other hand, is defined as a period in which all factors of production are in variable supply. According to the law of variable proportions, when the total output or production of a good increases by using more of a variable factor (while keeping other factors constant), then after some point the increase in total production becomes smaller and smaller. An isoquant is defined as a line that shows various combinations of the factors of production (labour and capital) which yield a given quantity of output. An isoquant curve is downward sloping in the relevant range and convex to the origin. The iso-cost or the equal-cost line shows various combinations of labour and capital that a firm can hire or rent within the given total cost. Cost analysis involves determining the costs incurred for inputs and how they affect the output or productivity of a company. Economies of scale are advantages that result due to large-scale production. When costs are saved due to an increased level of production, it is a case of economies of scale. 62 UNIT 03: Production Analysis & Cost Analysis JGI JAIN DE E M E D- T O -B E U NI V E R S I T Y 3.10 GLOSSARY Production: The process of conversion of inputs into outputs Isoquant: A curve that displays different combinations of factors of production (labour and capital) with which a firm can produce a given quantity of output Production function: The functional relationship between inputs and outputs of production Iso-cost line: A line that displays different combinations of labour and capital, which a firm can buy, given total cost and prices of other factors 3.11 CASE STUDY: HOW DO NEAR-EMPTY RESTAURANTS OPERATE? Case Objective This case study analyses when to open the restaurant and when to close it so that the restaurant remains profitable, using the short-run production theory. Background The Darbar Restaurant is a Mughlai restaurant in New Delhi. If you were to walk to the restaurant during lunch time on a weekday, you will find it almost empty. The restaurant has a seating capacity of around 50 people. It is luxuriously decorated as any Mughal durbar of a bygone era. There are also classical instrumental musicians playing live music at one side of the restaurant. On the other side, buffet tables are laid out, with an assortment of continental and Indian food. As you pick up a delicious spoonful of gravy on your plate, you wonder why the restaurant even bothers to stay open when there are only a couple of customers (including yourself). It would seem that the revenue from these couple of customers cannot possibly cover the cost of running the restaurant. Analysis The Darbar restaurant gets a fair crowd during the evenings. The weekend evenings are particularly busy. However, when the restaurant owner decides whether to open the restaurant for lunch, he must consider the difference between fixed and variable costs. Most costs of the restaurant are fixed, which include: Rent Kitchen equipment Tables and chairs Plates and cutlery If the restaurant is closed during lunchtimes, these costs would not be reduced. This means that these fixed costs are sunk in the short run. When deciding to open the restaurant for serving lunch, the owner must only consider variable costs, including: Price of additional food The wage of extra waiters and servers 63 JGI JAIN Principles of Economics and Markets D E E M E D- T O - B E U N I V E R S I T Y Result The owner will decide to close the restaurant at lunchtime only if the revenue from the few customers during that time fails to cover the variable costs of the restaurant. Conclusion In the short run production, the supply curve of the restaurant is its Marginal Cost curve (MC) above Average Variable Cost (AVC). If the restaurant has to be profitable, then its revenue must be more than its variable costs. As shown in Figure A, it must supply food in the quantity at which MC is equal to the price of the food. If the price is less than the AVC, then it would be better to shut down the restaurant and not serve any food. Costs Firm's short-run supply curve MC ATC AVC Firm shuts down if P < AVC 0 Quantity Figure A: Short-Run Supply Curve of a Competitive Firm (Source: Economics by N. Gregory Mankiw. Mark K Taylor) Questions 1. Suppose you operate a miniature golf course in a hill station. You decide to open the golf course for business only during the busy summer season and keep it closed during the off-season. What is the reason for this decision when you have invested so much in the golf course? (Hint: Since revenue varies from season to season, you must decide when to keep the golf course open and when to close it. The golf course should ideally be kept open only during those times when its revenue exceeds its variable costs.) 2. What are the fixed costs associated with the miniature golf course? (Hint: Fixed costs include the costs of purchasing the land and building the golf course.) 3. What variable costs must the owner consider when deciding to open the restaurant for serving lunch? (Hint: Price of additional food, wage of extra waiters and servers) 64 UNIT 03: Production Analysis & Cost Analysis JGI JAIN DE E M E D- T O -B E U NI V E R S I T Y 3.12 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. Production can be defined as a process of converting inputs into outputs. Inputs include land, labour and capital, whereas output includes finished goods and services. What is production? Differentiate between fixed and variable factors of production with examples. 2. What is the difference between short-run and long-run production? 3. Implicit costs, as the name suggests, are implied costs. Differentiate between implicit and explicit costs. 4. Explain break-even analysis. 5. What do you understand by economies of scale? 3.13 ANSWERS TO SELF-ASSESSMENT QUESTIONS A. Hints for Essay Type Questions 1. Production is an act of creating value that satisfies the wants of individuals. Organisations engage in production for earning a maximum profit, which is the difference between the cost and revenue. Therefore, the production decisions of organisations depend on the cost and revenue. The main aim of production is to produce maximum output with given inputs. Refer to Section Meaning of Production 2. The short run refers to a time period in which the supply of inputs, such as plant and machinery is fixed. Only the variable inputs, such as labour and raw materials, can be used to increase the production of goods. The long run is the period in which the supply of labour and capital is elastic. It implies that labour and capital are variable inputs. In the long-run production function, all factors of production are variable. Suppose a firm has two factors of production: labour and capital. Both of these factors are variable. Refer to Section Short-Run Production Function: Law of Variable Proportion 3. Implicit costs, as the name suggests, are implied costs. This means an implied cost is not an actual expense or cost incurred but a reduction in revenue. This reduction in revenue is a loss incurred due to the event or an action. However, as there is no actual money spent, it does not get recorded in the books of accounts. Refer to Section Basic Cost Concepts 4. Break-even analysis is a method that is used by many organisations to determine a relationship between costs, revenue and their profits at different levels of output. It helps in determining the point of production at which revenue equals the costs. Refer to Section Break-even Analysis 5. Economies of scale are advantages that result due to large-scale production. When costs are saved due to an increased level of production, it is a case of economies of scale. Refer to Section Economies of Scale @ 3.14 POST-UNIT READING MATERIAL 65 JGI JAIN D E E M E D- T O - B E U N I V E R S I T Y Principles of Economics and Markets http://economics.fundamentalfinance.com/micro_costs.php https://www.economicsdiscussion.net/production/cost-of-production/difference-betweeneconomic-cost-and-accounting-cost/16344 3.15 TOPICS FOR DISCUSSION FORUMS 66 Search on the Internet and find out the significance of law of diminishing returns. UNIT 04 Profit-Maximisation under Competitive Markets Names of Sub-Units Types of Markets: Perfect Competition, Monopoly, Monopolistic Competition and Oligopoly; Profitmaximisation – Alternative Forms of Organisation; Marginal Revenue, Marginal Cost and Profit Maximisation, Profit Maximisation by a Competitive Firm: Short-run Profit Maximisation by a Competitive Firm and Long-run Profit Maximisation Overview In this unit, you will study about four basic types of market structures, namely perfect competition, monopoly, monopolistic competition and oligopoly. The unit explains perfect competition and its features. Thereafter, you will study about the monopoly market structure and its characteristics. In addition, the unit will shed light on the meaning and features of the monopolistic competition and oligopoly market structures, respectively. The later sections of the unit explain profit maximisation as the prime objective of business organisations. Learning Objectives In this unit, you will learn to: Explain the meaning and features of perfect competition Describe the meaning and characteristics of monopoly Discuss the characteristics of monopolistic competition Describe the meaning and characteristics of oligopoly Discuss profit as a prime business objective JGI JAIN D EE M E D- T O -B E U N I V E R S I T Y Principles of Economics and Markets Learning Outcomes At the end of this unit, you would: Assess the features of different market structures Analyse output and price determination under various market structures 4.1 INTRODUCTION In simple terms, ‘market’ refers to a physical place where goods and services are exchanged between buyers and sellers at a particular price. However, in the economic sense, the market does not require a physical location or personal contact between buyers and sellers for the transaction of a product. In economics, a market is defined as a set of buyers and sellers who are geographically separated from each other but are still able to communicate to finalise the transaction of a product. The market for a product can be local, regional, national or international. A market can have several interconnected characteristics, including the level of competition, number of sellers and buyers, type of products and barriers to entry and exit. These interlinked characteristics are combined to form a market structure. Among various characteristics of a market, the level and nature of competition contribute a significant part to the classification of market structure. Depending on the degree and type of competition, market structures can be grouped into three main categories, namely, purely competitive market, perfectly competitive market and imperfectly competitive market. A purely competitive market thatis characterised by a large number of independent sellers and buyers dealing in standardised products. A perfectly competitive market is a wider term than a purely competitive market. In a perfectly competitive market, a large number of buyers and sellers are involved in the transaction of homogenous products. In this type of market, buyers and sellers are fully aware of the prices of products. Therefore, the market price of a product is fixed in a perfectly competitive market. However, this type of market structure cannot exist in the real world. On the other hand, an imperfectly competitive market is defined as a market in which buyers and sellers deal in differentiated products. Moreover, in an imperfectly competitive market, sellers have the power of influencing the market price of products. 4.2 MARKET STRUCTURE A market refers to any physical or virtual place where buyers and sellers meet. In a market, the price of a product is fixed by the demand for the product and the supply of the product. Virtual markets refer to online marketplaces. For instance, after the spread of the COVID-19 pandemic, many people purchase their daily essential requirements through virtual markets or shops. The presence of online marketplaces increases the scope of operations and they can operate at local or global levels under perfect conditions or imperfect conditions. Today, there exists a large and integrated network of markets. Different markets have different market structures and offer a variety of products and services. Understanding the market structures is quite essentialto determine product prices and to maximise profits. Market structures are categorised majorly based on the nature of the market and levels of competition existing in the market. 4.2.1 Perfect Competition Perfect competition is a theoretical model of a market structure where all the firms sell homogenous or identical products and the firms are price takers. Perfect competition represents an ideal situation of 70 UNIT 04: Profit-Maximisation under Competitive Markets JGI JAIN D EE M E D- T O -B E U N I V E R S I T Y how a market must operate. But, a lot of factors affect the market at all times which makes it difficult for the creation of a perfect competition market to exist. Features of Perfect Competition As already stated, perfect competition is an idealistic model. It is based on certain key assumptions or features, which are as follows: Large number of buyers and sellers: Under this market structure, the number of buyers and sellers is large enough. This implies that their position in the market is a drop in the ocean; hence, they are unable to influence the market price of the product. In this market structure, firms are deemed to be the price takers. Homogeneous products: Under perfect competition, the products offered in the market are close substitutes or homogeneous. This means that high competition prevails in the market and no competitor enjoys a competitive advantage over the rival firms. Freedom of entry and exit: There are no financial, technological and legal restrictions prevalent in the market for the entry and exit of the firms under this market structure. Perfect mobility of factors of production: Under perfect competition, the factors of production are free to move in or out of any firm or industry. However, this is a purely theoretical assumption. Perfect knowledge: The buyers and sellers have perfect knowledge about the product’s nature, availability and market price under perfect competition. This implies that the buyer has a clear idea about what can be bought at what price and seller has the idea of what can be sold at what price. Absence of artificial constraints: Collusions between the sellers or the buyers do not take place under this market structure. Both the buyers and the sellers act independently and take decisions on their own. No government intervention: The working of the market system is not controlled by the government under perfect competition. This implies that there is no licencing system that controls the entry of the firms, no control over the market prices, no control over the supply of the product, etc. 4.2.2 Monopoly In perfect competition, there are many buyers and sellers. But, in the monopoly market structure, there is either one seller or only one buyer. Since there is only one seller, he can influence the entire market and is usually in a strong position to dictate the terms and market prices. In case, there is only one buyer and many sellers, the buyer is usually in a strong position and dictates the market prices. Characteristics of Monopoly The unique characteristics of monopoly market structure are as follows: A monopoly always maximises profits for itself as there is no competition in the market. A monopoly firm can dictate the prices and maximise its revenues. A monopoly also decides how much to sell at what price to maximise profits. A monopoly restricts the entry of other sellers. The industry is comprised of only one firm. 71 JGI JAIN D EE M E D- T O -B E U N I V E R S I T Y Principles of Economics and Markets For example, Google and Microsoft are the best examples of monopoly. There is no competitor close enough to these two IT giants in terms of the product range and the services they provide. Therefore, the prices are determined and dictated by these firms. Other examples of a monopoly include Facebook, WhatsApp, Twitter, Indian Railways, etc. Since the Indian Railways do not have any competition, the railway tickets pricing and the number of trains to be allotted are decided by the Indian Railways. There is also an entry barrier for other players. Price Discrimination under Monopoly Price discrimination is when the monopoly decides or offers different prices to different customers or a group of customers which do not depend on the cost of production or product/service variation. For example, if you book Ola Cabs, the prices are different during peak hours and general hours for the same destination. Similarly, Cinema Ticket prices vary for the same movie run at different times. Similarly, special discounts are offered for loyal customers by beauticians and hairdressers. Price discrimination can be done by a monopoly for various reasons: To retain loyal customers To create barriers for new entrants To improve its revenue To improve its cash flow To clear its stock through the sale Price discrimination depends on trade use. For instance, electricity used for domestic consumption is charged at a different price than electricity used for commercial use. Various conditions for price discrimination are as follows: Different price elasticity of demand for different consumers or group of consumers: When there is a different price elasticity of demand for each consumer or group of consumers, only the monopoly firm can charge different prices. It will charge high prices to consumers where there is price inelastic demand and less prices to consumers where there is price elastic demand. In this way, the monopoly firm can increase its revenues and profits. Thus, the monopoly firm identifies the segments of markets with price inelastic demand and price elastic demand to set prices that will give it overall marginal revenue equal to the marginal cost. Encouraging consumer loyalty: The monopoly prevents consumers from choosing other market players over itself by offering superior services or unique services or giving free consulting or accessories with the product. For instance, people prefer to use the services of the same beauticians or doctors as they trust them for the unique and personalised service provided by them. The monopoly can also set a new price at certain times. For instance, during peak travel seasons, flight tickets are quite expensive, whereas, during off-seasons, the tickets are sold at cheap rates. Educational institutes also charge different fees from different categories of students such as General, SC, ST and OBC students demonstrating scholarly performance. Customised product: When the goods are tailor-made as per the requirements of the customer and there is no similar product available in the market, the monopoly sells at its discretionary prices. 4.2.3 Monopolistic Competition In a monopolistic competition market structure, there are many sellers in the market but every seller’s product is unique or distinct. Many small and medium businesses represent monopolistic competition, 72 UNIT 04: Profit-Maximisation under Competitive Markets JGI JAIN D EE M E D- T O -B E U N I V E R S I T Y as they try to attract the same group of customers. For example, in any market, there are multiple beauticians, hairdressers, garment sellers, electronic goods shops and mobile phones of different companies. However, the products and services offered by each market player vary. Characteristics of Monopolistic Competition The name monopolistic competition is derived from the two market structures namely monopoly and perfect competition. A monopolistically competitive market structure exhibits the following characteristics: Presence of many buyers and sellers No entry and exit barriers Presence of similar but differentiated products Demand curve is downward sloping The key feature of a monopolistic competition market structure is the presence of differentiated products. Differentiation is of four major types: 1. Physical product differentiation: This differentiation exists where the products look different. For example, different models of mobile phones, motorbikes and cars. Product differentiation may also occur in shape, size, colour, design and performance. 2. Marketing differentiation: Differentiation in products can also be done in terms of the promotional techniques and packaging used. For example, Maggi Noodles, Amul Butter and Tide all have unique packaging and marketing techniques. 3. Human capital differentiation: At times, there are certain products and services where employee skills matter. For example, the level of skills of the employee of banks, insurance companies and e-learning software have a lot of influence on customers’ satisfaction. 4. Distribution differentiation: When different firms use different logistics and operations, distribution differentiation occurs. Firms can create a high level of consumer satisfaction using distribution differentiation. For example, Flipkart and Amazon use different distribution practices. 4.2.4 Oligopoly You studied that, in monopoly, there is only one firm in the industry. In oligopoly, there are a few firms in the industry. Although there are not many sellers, the number is more than one. For example, airlines such as Indigo, Spice Jet, Air India and Vistara are a part of oligopoly. Similarly, LPG gas providers such as Bharat Gas and HP are part of oligopoly. Oligopoly markets are highly concentrated markets and the concentration ratios can be calculated by using the Herfindahl-Hirschman Index. The H-H Index is calculated by adding together the squared values of the percentage market shares of each firm operating in the Oligopoly market. For example, if there are three firms in the Oligopoly market A, B and C and the percentages of their market shares are a, b and c, then, Herfindahl-Hirschman (H-H) Index = a2 + b2 + c2 The market is highly concentrated if the index is above 2000, concentrated if above 1000 and below 2000 and not concentrated if it is below 1000. 73 JGI JAIN D EE M E D- T O -B E U N I V E R S I T Y Principles of Economics and Markets Features of Oligopoly An oligopoly is a market structure that is dominated by a few large firms. Some of the major features of an oligopoly are as follows: Few sellers: The entire market industry is dominated by the existence of a few sellers. The few sellers affect the prices of each other. Also, there are a large number of buyers in the oligopoly market structure. Entry and exit barriers: Oligopoly market structure restricts the entry of new firms into the industry with various legal, technological and social barriers. These entry barriers distinguish the oligopoly market from monopolistic competition. The existing organisations hold full control over the market. Neither the entry nor the exit is easy in oligopoly market. Mutual interdependence: It is one of the most important characteristics of the oligopoly market structure. Interdependencies among the sellers influence various important decisions related to price, supply and output. In other types of market structures, such as perfect market or monopoly, organisations do not get affected by the pricing of others so they do not take the reactions and decisions of the rival organisations into consideration. However, in the case of oligopoly market, firms are not able to make independent decisions since a small number of sellers are competing with each other. Hence, the sales and prices of one organisation depend upon the moves of the competitors. This is the distinctive feature that makes oligopoly a different market structure altogether. Lack of uniformity: Organisations in oligopoly market structure are of different sizes, i.e., some are very large, while others are very small. There is no uniformity in the size of the organisations. For example, in the small car segment, Cielo and Tata have very less market share in comparison to Maruti Udyog which has 86% market share. Price rigidity: Generally, in oligopoly market, firms do not prefer to change product prices because it would not be beneficial. In case, if a firm decreases its price, the competitors will also reduce its prices accordingly. It would affect the profits of both organisations. Also, in case the firm increases its price, it would lose its buyers. Differentiated or identical product: Firms in oligopoly are required to produce either differentiated products or identical products, which is similar in the case of perfect competition. In case, the organisation produces identical products such as bricks, concrete and cement, then it is known as a perfect or pure oligopoly. Whereas differentiated products, such as automobiles, are categorised under imperfect or differentiated oligopoly. Apart from these, some other features of an oligopoly are as follows: Complete information may not be available. Oligopoly firms may compete or collude with each other. Oligopoly firms generally do not engage in price wars as all of them would experience reduction in revenues. Oligopoly firms generally follow the cost-plus pricing method for calculating product prices. You will study oligopoly in more detail in the next chapter. 4.3 PROFIT-A PRIME BUSINESS OBJECTIVE The term profit has a distinct meaning for different people, such as businessmen, accountants, policymakers, workers and economists. Profit simply means a positive gain generated from business 74 JGI UNIT 04: Profit-Maximisation under Competitive Markets JAIN D EE M E D- T O -B E U N I V E R S I T Y operations or investment after subtracting all expenses or costs. In economic terms, profit is defined as a reward received by an entrepreneur by combining all the factors of production to serve the needs of individuals in the economy faced with uncertainties. In a layman language, profit refers to an income that flows to investors. In accountancy, profit implies an excess revenue overall paid-out costs. Profit in economics is termed as a pure profit or economic profit or just profit. Profit differs from the return in three respects namely: Profit is a residual income, while the return is total revenue. Profits may be negative, whereas returns, such as wages and interest are always positive. Profits have greater fluctuations than returns. According to modern economists, profits are the rewards of purely entrepreneurial functions. According to Thomas S.E., “pure profit is a payment made exclusively for bearing risk. The essential function of the entrepreneur is considered to be something that only he can perform. This something cannot be the task of management, for managers can be hired, nor can it be any other function which the entrepreneur can delegate. Hence, it is contended that the entrepreneur receives a profit as a reward for assuming final responsibility, a responsibility that cannot be shifted on the shoulders of anyone else.” 4.3.1 Marginal Cost and Marginal Revenue Conceptually, in the short run, the quantity of at least one input is fixed and the quantities of the other inputs can be varied. In the short-run period, factors, such as land and machinery, remain the same. On the other hand, factors, such as labor and capital, vary with time. In the short run, the expansion is done by hiring more labor and increasing capital. The existing size of the plant or building cannot be increased in case of the short run. Following are the cost concepts that are taken into consideration in the short run: Total Fixed Costs (TFC): These are the costs that remain fixed in a short period. These costs do not change with the change in the level of output. For example, rents, interest and salaries. In the words of Ferguson, “Total fixed cost is the sum of the short run explicit fixed costs and implicit costs incurred by the entrepreneur.” Fixed costs have implications even when the production of an organisation is zero. These costs are also called supplementary costs, indirect costs, overhead costs, historical costs and unavoidable costs. TFC remains constant with respect to change in the level of output. Therefore, the slope of the TFC curve is a horizontal straight line. Figure 1 depicts the TFC curve: Cost TFC Output Figure 1: TFC Curve 75 JGI JAIN Principles of Economics and Markets D EE M E D- T O -B E U N I V E R S I T Y As shown in Figure 1, the TFC curve is horizontal to x- axis. From Figure 1, it can be seen that TFC remains the same at all the levels with respect to change in the level of output. Total Variable Costs (TVC): These costs change with the change in the level of production. For example, costs incurred on purchasing raw material, hiring labor and using electricity. According to Ferguson, “total variable cost is the sum of amounts spent for each of the variable inputs used.” If the output is zero, then the variable cost is also zero. These costs are also called prime costs, direct costs and avoidable costs. Figure 2 shows the TVC curve: Cost TVC Output Figure 2: TVC Curve In Figure 2, it can be seen that the TVC curve changes with the change in the level of output. Total Cost (TC): It involves the sum of TFC and TVC. It can be calculated as follows: Total Cost = TFC + TVC TC also changes with the changes in the level of output as there is a change in TVC. Figure 3 shows the total cost curve derived from the sum of TVC and TFC: Cost TC TVC TFC Output Figure 3: TC Curve It should be noted that both TVC and TC increase initially at a decreasing rate and then they increase at an increasing rate. Here, decreasing rate implies that the rate at which cost increases with respect to output is less, whereas increasing rate implies the rate at which cost increases with respect to output is more. 76 JGI UNIT 04: Profit-Maximisation under Competitive Markets JAIN D EE M E D- T O -B E U N I V E R S I T Y Average Fixed Costs (AFC): These are the per unit fixed costs of production. In other words, AFC implies the fixed cost of production divided by the quantity of output produced. It is calculated as: AFC= TFC/Output Cost As discussed earlier, TFC is constant as production increases, thus AFC falls. Figure 4 shows the AFC curve: AFC O Output Figure 4: AFC Curve In Figure 4, the AFC curve is shown as a declining curve, which never touches the horizontal axis. This is because the fixed cost can never be zero. The curve is also called rectangular hyperbola, which represents that total fixed costs remain the same at all the levels. Average Variable Costs (AVC): These are per unit variable costs of production. It implies organisation’s variable costs divided by the quantity of output produced. It is calculated as: AVC= TVC/ Output Initially, AVC decreases as output increases. After a certain point of time, AVC increases with respect to an increase in output. Thus, it is a U- shaped curve, as shown in Figure 5: Cost AVC O Output Figure 5: AVC Curve Average Cost (AC): It is the total cost of production per unit of output. AC is calculated as: AC=TC/ Output 77 JGI JAIN Principles of Economics and Markets D EE M E D- T O -B E U N I V E R S I T Y AC is also equal to the total of AFC and AVC. AC curve is also a U-shaped curve as average cost initially decreases when output increases and then increases when output increases. Figure 6 shows the AC curve: AC Cost AVC AFC O Output Figure 6: AC Curve Marginal Cost: It is the addition to the total cost for producing an additional unit of the product. Marginal cost is calculated as: MC = TCn – TCn-1 n = Number of units produced It is also calculated as: MC = ∆ TC/ ∆Output MC curve is also a U-shaped curve as marginal cost initially decreases as output increases and afterwards, rises as output increases. This is because TC increases at decreasing rate and then increases at an increasing rate. Figure 7 shows the MC curve: Cost MC AC AVC AFC O Output Figure 7: MC Curve Revenue can be defined as receipts or returns from the sale of products of an organisation. In other words, revenue is the income that an organisation receives from normal business activities. According to Dooley, “The Revenue of a firm is its sales receipts or money receipts from the sale of a product.” Total Revenue (TR) equals the quantity of output multiplied by the price per unit. TR = Price (P) × Total output (Q) 78 UNIT 04: Profit-Maximisation under Competitive Markets JGI JAIN D EE M E D- T O -B E U N I V E R S I T Y For instance, if an organisation sells 1000 units of a product at the price of ` 10 per unit, the total revenue of the organisation would be ` 10000. Total revenue is a function of output, which is mathematically expressed as: TR= f (Q) From the aforementioned equation, it can be seen that the value of a dependent variable (total revenue) is determined by the independent variable (output). In economic analysis, different types of revenue are taken into account, which is discussed as follows: Average Revenue: Average Revenue (AR) can be defined as revenue per unit of output. In the words of McConnell, “Average revenue is the per unit revenue received from the sale of a commodity.” AR is calculated as: AR= TR/Q Therefore, from the aforementioned equation, it can be said that AR is the rate at which output is sold, where the rate refers to the price of the product. We know that TR equals P×Q, thus, AR = (P×Q)/Q AR=P Hence, it can be said that AR is nothing, but the price of the product. Marginal Revenue: Marginal revenue (MR) can be defined as additional revenue gained from the additional unit of output. In the words of Ferugson, “Marginal revenue is the change in total revenue which results from the sale of one more or one less unit of output.” It can be calculated as follows: MR =∆ TR/ ∆Output Or MR = TRn – TRn-1 Let us understand the concept of MR with the help of an example. For instance, if 10 units of a good are sold for ` 100 and 11 units for ` 108, calculate MR. It is calculated as: Total units sold = n = 11 units Total units less last unit sold = n – 1 = 10 units MR = TRn – TRn-1 =TR11-TR10 = 108- 100 =`8 4.3.2 Maximisation of Profit—Short-run and Long-run Profit maximisation is the most important assumption used by economists to formulate various economic theories, such as price and production theories. According to conventional economists, profit maximisation is the only objective of organisations. Therefore, profit maximisation forms the basis 79 JGI JAIN Principles of Economics and Markets D EE M E D- T O -B E U N I V E R S I T Y of conventional theories. It is regarded as the most reasonable and productive business objective of an organisation. Apart from this, profit maximisation helps in determining the behaviour of business organisations as well as the effect of various economic factors, such as price and output, in different market conditions. The Total Profit (TP) of a business organisation is calculated by taking the difference between Total Revenue (TR) and Total Cost (TC). TP =TR – TC The profit would be maximum when the difference between the total revenue and total cost is maximum. Two conditions must be fulfilled for profit maximisation, namely, the first order condition and second order condition. The first order condition requires that Marginal Revenue (MR) should be equal to Marginal Cost (MC). Marginal revenue is defined as revenue obtained from the sale of the last unit of output, whereas marginal cost is the cost incurred due to the production of one additional unit of output. Both TR and TC functions involve a common variable, which is output level (Q). The first order condition states that the first derivative of profit must be equal to zero. We know TP = TR – TC Taking its derivative with respect to Q, ∂TP / ∂Q = ∂TR/ ∂Q – ∂TC/ ∂Q= 0 This condition holds only when ∂TR/ ∂Q = ∂TC/ ∂Q ∂TR/ ∂Q provides the slope of the TR curve, which, in turn, gives MR. On the other hand, ∂TC/ ∂Q gives the slope of the TC curve, which is the same as MC. Thus, the first-order condition for profit maximisation is MR=MC. Second order condition requires that the first order condition must be satisfied in case of decreasing MR and rising MC. This condition is shown in Figure 8: Marginal Revenue and Cost C R P1 MC P2 MR O Q1 Q2 Output Figure 8: Marginal Conditions of Profit Maximisation As shown in Figure 8, MR and MC curves are derived from TR and TC functions. It can be seen from Figure 8 that MR and MC curves intersect at points P 1 and P2. MR is less than MC at point P2, thus, the second order condition is satisfied at point P2. 80 JGI UNIT 04: Profit-Maximisation under Competitive Markets JAIN D EE M E D- T O -B E U N I V E R S I T Y Numerically, the second order condition is given as: ∂ 2 TP / ∂Q 2 = ∂ 2 TR/ ∂Q 2 -- ∂ 2 TC/ ∂Q 2 ∂ 2 TR/ ∂Q 2 -- ∂ 2 TC/ ∂Q 2 & lt; 0 ∂ 2 TR/ ∂Q 2 & lt; ∂ 2 TC/ ∂Q 2 Slope of MR & lt; Slope of MC From aforementioned equation, it can be concluded that MC must have a steeper slope than MR or MC must intersect from below. Thus, profit is maximised when both first and second order conditions are satisfied. 4.3.3 Profit Maximisation and Perfect Competition A firm always seeks to maximise its profits. Profit is earned when the total revenue is more than the total costs incurred. Therefore, to maximise profits, the firm needs to increase its revenue and minimise costs. A firm can maximise its profits when it produces a quantity where marginal revenue is equal to marginal cost. Figure 9 shows the profit maximisation of a firm under perfect competition: Profit Maximisation 8 7 MC 6 5 4 3 2 MR 1 2 3 4 5 6 7 8 Q Figure 9: Profit Maximisation of a Firm under Perfect Competition In Figure 9, it is observed that at price 4.5 and output 5, maximum profit is achieved. We see that the combination of price 4.5 and output 5 is derived when MC and MR intersect each other. Beyond this point, if output 6 is produced, the MC increases and marginal revenue with that one output produced falls. At output 4, marginal cost will be lower than marginal revenue which means that production is not done at full capacity and that there is scope for increasing production. Figure 10 shows that the firm can achieve maximum profit at quantity 5: Total Profit Profit increasing MR>MC 1 2 3 4 Profit decreasing MR<MC 5 6 7 8 Q Figure 10: Profit Maximisation at Output 5 81 JGI JAIN D EE M E D- T O -B E U N I V E R S I T Y Conclusion Principles of Economics and Markets 4.4 CONCLUSION Market structures are categorised majorly based on the nature of the market and levels of competition existing in the market. There are four basic types of market structure: perfect competition, monopoly, monopolistic competition and oligopoly. In perfect competition, there are a large number of buyers and sellers. In perfect competition, the demand curve is perfectly elastic, represented as a line running parallel to the X-axis. The firm makes normal profits when average revenue meets average cost. Profit is earned when the total revenue is more than the total costs incurred. In the monopoly market structure, there is either one seller or only one buyer. A monopoly can do price discrimination, i.e., offer the same goods or services at different prices to different groups of consumers. In a monopolistic competition market structure, there are many sellers in the market but every seller’s product is unique or distinct. In oligopoly, there are a few firms in the industry. Therefore, they are concentrated markets and concentration ratios are calculated by the Herfindahl-Hirschman (H-H) index. The H-H Index is calculated by adding together the squared values of the percentage market shares of each firm operating in the oligopoly market. A firm always seeks to maximise its profits. Profit is earned when the total revenue is more than the total costs incurred. Therefore, to maximise profits, the firm needs to increase its revenue and minimise costs. A firm can maximise its profits when it produces a quantity where marginal revenue is equal to marginal cost. 4.5 GLOSSARY Entry barrier: An obstacle that prevents new firms from entering into a market Price fixing: The practice of setting the price of a product or service Price war: A competitive situation where rival firms keep decreasing their prices to capture more market and to drive out the rival firms 4.6 CASE STUDY: PERFECT COMPETITION IN CREDIT CARD INDUSTRY Case Objective The case study explains the level of competition in the credit card industry. Credit cards are the medium of money exchange that allows the customers to charge purchases rather than making them pay cash at the time of transaction. In the case of credit cards, no interest is charged if payment is made within 30 days. These cards are the source of credit through which people can defer payment for purchase for an extended period by paying an interest rate. As per the number of banking players offering credit 82 UNIT 04: Profit-Maximisation under Competitive Markets JGI JAIN D EE M E D- T O -B E U N I V E R S I T Y card services, it is a perfect competition industry wherein the competition should decrease the rate of interest drawn on credit cards. The majority of customers prefer Visa, Mastercard and American Express, which are offered by a large number of banks and credit unions. Credit cards are homogenous products and mostly similar in appearance and used for the same purposes. Entry and exit from the credit card industry are easy which is the reason why there are so many institutions offering this service. However, a new firm may find it challenging to enter into the market but a financially stable bank or even modest size banks or credit union can obtain the right to issue Visa card or Mastercard from the parent companies with little difficulty. In case of exit, banks can exit the field by selling their accounts to other suppliers of credit cards. Therefore, the credit card industry holds most of the characteristics of a perfectly competitive market. Source: http://bkmiba.blogspot.com/2015/08/case-study-perfect-competition-in.html Questions 1. Which characteristics make the credit card industry a perfectly competitive market? (Hint: Large number of players, high competition, availability of substitutes, etc.) 2. What is the reason behind the decreasing interest rate on credit cards? (Hint: High competition, a large number of buyers, etc.) 3. Why are many institutions offering credit card services? (Hint: Easy entry and exit) 4. How can a well-established bank enter the credit card industry? (Hint: By obtaining the right to issue cards from parent companies) 5. How can a bank exit from the credit card industry? (Hint: By selling their accounts to other suppliers of credit cards) 4.7 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. Perfect competition is a theoretical model of a market structure where all the firms sell homogenous or identical products and the firms are price takers. Write a short note on perfect competition and its features. 2. Monopoly always maximises profits for itself as there is no competition in the market. Explain the meaning and characteristics of a monopoly. 3. What do you understand by monopolistic competition? Explain its major characteristics. 4. What is oligopoly? Discuss its characteristics. 83 JGI 5. JAIN D EE M E D- T O -B E U N I V E R S I T Y Principles of Economics and Markets Write short notes on the following: a. Average Cost and Marginal Cost b. Average Revenue and Marginal Revenue 4.8 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. The perfect competition represents an ideal situation of how a market must operate. But, a lot of factors affect the market at all times which makes it difficult for the creation of a perfect competition market to exist. Refer to Section Market Structure 2. In perfect competition, there are many buyers and sellers. But, in the monopoly market structure, there is either one seller or only one buyer. Since there is only one seller, he can influence the entire market and is usually in a strong position to dictate the terms and market prices. In case, there is only one buyer and many sellers, the buyer is usually in a strong position and dictates the market prices. Refer to Section Market Structure. 3. In a monopolistic competition market structure, there are many sellers in the market but every seller’s product is unique or distinct. Many small and medium businesses represent monopolistic competition, as they try to attract the same group of customers. Refer to Section Market Structure 4. In an oligopoly, there are a few firms in the industry. Although there are not many sellers, the number is more than one. For example, airlines such as Indigo, Spice Jet, Air India and Vistara are a part of an oligopoly. Similarly, LPG gas providers such as Bharat Gas and HP are part of an oligopoly. An oligopoly is a market structure that is dominated by a few large firms. Refer to Section Market Structure 5. AC is also equal to the total of AFC and AVC. AC curve is also a U-shaped curve as average cost initially decreases when output increases and then increases when output increases. Refer to Section Profit-A Prime Business Objective @ 4.9 POST-UNIT READING MATERIAL https://www.georgebrown.ca/sites/default/files/uploadedfiles/tlc/_documents/market_structures. pdf https://learn.saylor.org/course/view.php?id=8&sectionid=62 4.10 TOPICS FOR DISCUSSION FORUMS 84 Calculate the H-H index for four telecom firms, Firm I, Firm V, Firm A, Firm J, having market shares of 23%, 47%, 34% and 56%. UNIT 05 Oligopoly Market Names of Sub-Units Oligopoly – Price Searchers – Meaning, Cartels, Conditions for Cartel Success; Advanced PricingExtensions of Oligopolistic Pricing: Limit Entry Pricing, Price Rigidity and Kinked Demand; Price Leadership, Volume Pricing Overview The unit begins by explaining indeterminate price and output in oligopolistic market forms. Further, the unit discusses cartels and conditions for their success. Towards the end, you will be familiarised with extensions of oligopolistic pricing, namely limit entry pricing, price rigidity and kinked demand; price leadership and volume pricing. Learning Objectives In this unit, you will learn to: Explain oligopoly and its features Discuss indeterminate price and output in oligopoly Examine the nature of pricing Discuss the features of oligopoly State various types of pricing in an oligopoly JAIN JGI DEEMED-TO-BE UNIVE RSI TY Principles of Economics and Markets Learning Outcomes At the end of this unit, you would: Assess what is oligopoly market Discuss cartels and conditions for their success Evaluate limit entry pricing Analyse what is price rigidity and kink demand Appraise what is volume pricing 5.1 INTRODUCTION Oligopoly refers to a market form in which a particular market is dominated by a small group of sellers. In other words, oligopoly can be defined as a market situation that is characterised by few sellers dealing either in identical or differentiated products. Moreover, under oligopoly, there are restrictions to the entry and exit of organisations. One of the most important characteristics of an oligopoly market is the mutual interdependence of organisations. This implies that each organisation operating under oligopoly must take into account the expected reactions of other organisations in the market while making pricing and output decisions. For example, in oligopoly, if an organisation lowers down its prices, then it is most likely to capture the highest market share. Consequently, the sales of the organisation would increase. However, this would adversely affect the sales of other organisations existing in the market. As a result, other organisations would also lower down their prices. Therefore, price and output are said to be indeterminate under oligopoly. Generally, the price and output of an organisation are determined by considering two market forces, namely, demand and supply. In other market structures, such as perfect competition, organisations make decisions without taking into account the behaviour of rival organisations. However, the pricing and output decisions of an oligopolistic organisation are influenced by the decisions of rival organisations. Therefore, there is no specific theory propounded by economists that can explain price and output determination under oligopolistic market situations. Although economists have developed certain models that help organisations to make efficient pricing and output decisions under oligopoly. Some of the popular models of oligopoly include Sweezy’s kinked demand curve model, collusion model and price leadership models. 5.2 INDETERMINATE PRICE AND OUTPUT IN OLIGOPOLY The term oligopoly has been derived from two Greek words, ‘oligoi’ means few and ‘poly’ means control. Therefore, oligopoly refers to a market form in which there is a control of few sellers on the market. These sellers deal either in homogenous or differentiated products. Oligopoly is one of the forms of an imperfectly competitive market. In India, the aviation and telecommunication industries are the perfect examples of oligopoly market form. The aviation industry has only a few airlines, such as Kingfisher, Air India, Spice Jet and Indigo. On the other hand, there are few telecommunication service providers, including Airtel, Vodafone, MTS, Dolphin and Idea. These organisations are closely interdependent. This is because each organisation formulates its pricing policy by taking into account the pricing policies of other competitors existing in the market. Following are the characteristics of oligopoly: Few sellers and many buyers Homogeneous or differentiated products 90 UNIT 05: Oligopoly Market Barriers to entry and exit Mutual interdependence among organisations Existence of price rigidity Lack of uniformity in the size of organisations JGI JAIN DEEMED-TO-BE UNIVE RSI TY In an oligopolistic market situation, a small number of organisations compete with each other. The sales of each organisation under oligopoly depend on the price charged by it as well as the price charged by other organisations in the market. As discussed earlier, if an organisation lowers down its prices, its sales would increase. However, the sales of other organisations in the market would decrease. In such a scenario, other organisations would also lower down their prices. Therefore, the price and output are indeterminate under oligopoly. In other market structures, such as perfect competition and monopoly, price and output are determined by taking into account demand, supply, revenue and cost factors. In such types of market structures, the actions and reactions of other organisations related to any pricing decision are ignored. According to Miller, “in a perfectly competitive model, each firm ignores the reaction of other firms because each firm can sell all that it wants at the going market price. In the pure monopoly model, the monopolist does not have to worry about the reaction of rivals since by definition they are none. However, there is interdependence of firms in the oligopoly. Hence, the decisions of a firm will affect the other firms, which in turn will react in way that affects the initial firm. This causes uncertainty. Thus, it is a difficult task to draw the demand curve of an oligopolist.” The main reasons for indeterminate price and output under oligopoly are as follows: Different behaviour patterns: Imply that under oligopoly, the behaviour patterns differ from organisation to organisation. For example, under oligopoly, organisations may cooperate in setting the pricing policy or they may act as competitors. According to Baumol, “under the circumstances a very wide variety of behaviour patterns becomes possible. Rivals may decide to get together and co-operate in the pursuit of their objectives so far as the law allows, or at the other extreme they maytrytofighteachothertothedeath.” Thus, under oligopoly, the price and output of organisations differ in different behaviour patterns. Indeterminate demand curve: Implies that the demand curve is unknown under oligopoly due to different behaviour patterns of organisations. Under oligopoly, every organisation keeps an eye on the actions of rivals and makes strategies accordingly. Therefore, the demand curve under oligopoly is never stable and shifts in response to the actions of rivals. According to Baumol, “the firm’s attempts to outguess one another are then likely to lead to interplay of anticipated strategies and counter strategies which is tangled beyond hope of direct analysis.” Non-profit motive: Implies that under oligopoly, organisations are not only indulged in maximising profit but also compete with each other for the non-profit motive. For example, organisations use advertising and other tools to promote their sales. These motives lead to indeterminate price and output under oligopoly. 5.2.1 Is Oligopoly a Price Searcher? In market economics, a price searcher is a person or a business that sells products, goods or services and therefore influences the price of the commodity in the market based on the number of units of that item sold. The demand curve in such a case does not increase or decrease because many other people on the market are selling the same product and hence change does not take place in the curve. Now the question arises whether oligopoly is a price taker or a price searcher? 91 JGI JAIN DEEMED-TO-BE UNIVE RSI TY Principles of Economics and Markets Oligopoly is a system in economics where certain individuals or businesses decide the prices of the commodity over which they have their respective monopoly, hence oligopoly is a price searcher because businesses have control over the price they charge. They can raise the price of their good and still sell some of the goods they produce. The barriers to entry are significant where new entrants are restricted to enter the market with their products. Oligopolistic firms are, therefore, price searchers and not price takers as they can raise the price of their goods and still sell some, or all, of their product because only a few firms account for a large percentage of sales. Price takers do not have this privilege and they are the ones who price their products based on the forces of the market. 5.3 CARTELS In oligopolistic market situations, organisations are indulged in high competition with each other, which may lead to price wars. For avoiding such types of problems, organisations enter into an agreement regarding a uniform price-output policy. This agreement is known as collusion, which is opposite to competition. Under collusion, organisations are involved in collaboration with each other to take combined actions for keeping their bargaining power stronger against consumers. Some of the popular definitions of collusion are as follows: According to Samuelson, “Collusion denotes a situation in which two or more firms jointly set their prices or output, divide the market among them, or make other business decisions.” In the words of Thomas J. Webster, “Collusion represents a formal agreement among firms in an oligopolistic industry to restrict competition to increase industry profits.” Collusion helps oligopolistic organisations in many ways. Some of the benefits of collusion are as follows: Helps organisations to increase their performance Helps organisations in preventing uncertainties Provides opportunities to prevent the entry of new organisations The agreement of collusion formed may be tacit or formal. A formal agreement formed among competing organisations is known as cartel. In other words, cartel can be defined as a group of organisations that together make pricing and output decisions. Some of the management experts have defined cartel in the following ways: According to Leftwitch, “the firms jointly establish a cartel organization to make price and output decisions, to establish production quotas for each firm, and to supervise market activities of the firms in the industry.” According to Khemani and Shapiro, “Cartels are productive structures involving multiple producers acting in unison that allow producers to exercise monopoly power.” In the words of Boyce and Melvin, “A cartel is an organization of independent firms, whose purpose is to control and limit production and maintain or increase prices and profits.” According to Webster, “A cartel is a formal agreement among firms in an oligopolistic industry to allocate market share and/or industry profit.” Under cartels, the price and output determination are done by the common administrative authority, which aims at equal profit distribution among all member organisations under the cartel. The total profits are distributed in proportion as decided among member organisations. The most famous example of a cartel is Organization of the Petroleum Exporting Countries (OPEC), which has shared control of petroleum markets. 92 UNIT 05: Oligopoly Market JGI JAIN DEEMED-TO-BE UNIVE RSI TY Let us understand price and output decisions under cartels with the help of an example. Assume that two organisations have formed a cartel. The price and output decisions of these two organisations are shown in Figure 1: Organization A MC1 Organization B MC2 AC1 P P E1 Industry MC AC2 P E E2 AR = D MR O Q1 (a) O Q2 (b) O Q (c) Figure 1: Cartel – Price and Output Determination In Figure 1 (c), AR is the aggregate demand curve of both the organisations and MC curves are the addition of MC1 and MC2 curves of organisations A and B, respectively. The total output of the industry is determined according to the MR and MC of the industry. In Figure 1 (c), OQ and OP are the equilibrium price and output of the industry. Now, this output will be allocated among the organisations. This can be done by drawing a horizontal line from equilibrium point E of industry, towards MC curves of organisations A and B. The points of intersection E1 and E2 are the equilibrium levels of the organisations, A and B, respectively. OQ 1 is the equilibrium output of organisation A and OQ2 is the equilibrium output of organisation B. Thus, OQ1 +OQ2 = OQ. These levels of outputs ensure the maximum joint profits of member organisations. 5.3.1 Conditions for Cartel Success Cartels in the case of a business happen when oligopoly becomes too big that market factors no longer affect the operations of the business and require strong government intervention. Cartels in business generally happen with those products that only a very limited number of firms produce with a tight barrier to prevent any disturbance in their business growth. While the average duration of cartels across a range of examples is about 5 years, many cartels break up very quickly (i.e., in less than a year). But others last between 5 to 10 years and only a few last decades. Limited evidence suggests that cartels can increase prices and profits, to varying degrees. Cartels also affect other non-price variables, including advertising, innovation, investment, barriers to entry and concentration. Cartels break up due to cheating caused by greed, lack of effective monitoring or egos of the firms and individuals coming between the business and their operations. But the biggest challenges cartels face are entry and adjustment of the collusive agreement in response to changing economic socio-political and market conditions. Cartels that are flexible with a robust and responsive organisational structure respond to the changing conditions and are more likely to survive and also grow given their size. Price wars that erupt are often the result of bargaining or profit related issues that arise in such circumstances. Sophisticated cartel organisations are also able to develop multipronged strategies to monitor one another that prevents cheating and a variety of interventions aimed at increasing barriers to entry for any new firm/individual. 93 JGI JAIN DEEMED-TO-BE UNIVE RSI TY Principles of Economics and Markets 5.4 LIMIT ENTRY PRICING Limit Pricing is a pricing strategy where firms in an oligopoly or a monopolist may use to discourage the entry of new firms/individuals into their market. It is done so that only the profit acquired from the industry goes straight to the limited number of firms in the market and that they are protected from the threat that a new business would bring with them. Limit entry pricing is therefore pricing done to limit entry. If a monopolist sets its profit maximising price (where MR=MC) the level of supernormal profit would be so high it will eventually attract new firms into the market. Limit pricing involves reducing the price sufficiently enough to prevent the entry of new players into the market. It leads to less profit than possible in short-term, but it can enable the firm to retain its monopoly position and long-term profitability by allowing them to gain the maximum percentage of market share. 5.4.1 Evaluation of Limit Pricing A large multinational may be willing to enter a market – even if it is unprofitable in the short-term. However, if the multinational can absorb losses and operate in the market then they can gain a substantial amount of market share and earn profits in the long run. To do so the large multinational can use its reserves and profit it has earned elsewhere to subsidise a loss-making entry somewhere else till the time that loss making entry does not gain a foothold in the market and start generating revenue. For example, Google entered the market for mobile phones – despite no experience but managed to gain a foothold as it applied its expertise and profits to support its mobile phone development unit and slowly gained relevance. Limit pricing is not effective if new firms can absorb losses. Rather than limit pricing, a firm may opt to set the profit maximising price where the goal is to price the goods in a way that generates the maximum level of profits, but then react when a new firm enters. If a new firm enters, it lowers the price to make it difficult. The established firm therefore could go to an extreme and engage in predatory pricing – setting the price below average cost to force the rivals out of business. Predatory pricing is illegal that is why firms choose limit pricing instead. Limit pricing will be more effective in industries with substantial economies of scale – for example, industries, such as steel and aeroplane manufacturers because the cost of production and inputs required for manufacturing, sales, distribution is very high for any new firm. Another example is that of oil and military armament production where certain firms have monopolistic control over the market and pricing. This type of pricing hence gives an advantage to the incumbent and disadvantage to potential new firms. For industries, with few economies of scale, such as restaurants and bars, limit pricing will not be effective. 5.5 PRICE RIGIDITY AND KINKED DEMAND The kinked demand curve of oligopoly was developed by Paul M. Sweezy in 1939. Instead of emphasizing price-output determination, the model explains the behavior of oligopolistic organisations. The model advocates that the behavior of oligopolistic organisations remain stable when the price and output are determined. This implies that an oligopolistic market is characterised by a certain degree of price rigidity or stability, especially when there is a change in prices in the downward direction. For example, if an organisation under oligopoly reduces the price of products, the competitor organisations would also follow it and neutralise the expected gain from the price reduction. On the other hand, if the organisation increases the price, the competitor organisations would also cut down their prices. In such a case, the organisation that has raised its prices would lose some part of its market share. The kinked demand curve model seeks to explain the reason for price rigidity under oligopolistic market situations. Therefore, to understand the kinked demand curve model, it is important to note the reactions 94 UNIT 05: Oligopoly Market JGI JAIN DEEMED-TO-BE UNIVE RSI TY of rival organisations on the price changes made by respective oligopolistic organisations. There can be two possible reactions of rival organisations when there are changes in the price of a particular oligopolistic organisation. The rival organisations would either follow price cuts, but not price hikes or they may not follow changes in prices at all. A kinked demand curve represents the behaviour pattern of oligopolistic organisations in which rival organisations lower down the prices to secure their market share, but restrict an increase in the prices. Following are the assumptions of a kinked demand curve: Assumes that if one oligopolistic organisation reduces the prices, then other organisations would also cut their prices Assumes that if one oligopolistic organisation increases the prices, then other organisations would not follow the increase in prices Assumes that there is always a prevailing price A kinked demand curve model is explained with the help of Figure 2: MC’ MC d D P X O D’ Y Q d’ C Figure 2: Kinked Demand Curve Model The slope of a kinked demand curve differs in different conditions, such as price increase and price decrease. In this model, every organisation faces two demand curves. In the case of high prices, an oligopolistic organisation faces a highly elastic demand curve, which is dd’ in Figure 2. On the other hand, in the case of low prices, the oligopolistic organisation faces an inelastic demand curve, which is DD’ (Figure 2). Suppose the prevailing price of a product is PQ, as shown in Figure 2. If one of the oligopolistic organisations makes changes in its prices, then there can be three reactions of rival organisations. Firstly, when the oligopolistic organisation would increase its prices, its demand curve would shift to dd’ from DD’. In such a case, consumers would switch to rivals, which would lead to a fall in the sales of the oligopolistic organisation. In addition, the dP portion of dd’ would be more elastic, which lies above the prevailing price. On the other hand, if the price falls, the rivals would also reduce their prices, thus, the sales of the oligopolistic organisation would be less. In such a case, the demand curve faced by the oligopolistic organisation is PD’, which lies below the prevailing price. Secondly, rival organisations will not react with respect to changes in the price of the oligopolistic organisation. In such a case, the oligopolistic organisation would face the DD’ demand curve. Thirdly, the rival organisations may follow price cut, but not price hike. If the oligopolistic organisation increases the price and rivals do not follow it, then consumers may switch to rivals. Thus, the rivals would gain control over the market. Thus, the oligopolistic organisation would be forced from dP demand curve to DP demand curve, so that it can prevent losing its customers. This would result in producing the kinked demand curve. On the other 95 JGI JAIN DEEMED-TO-BE UNIVE RSI TY Principles of Economics and Markets hand, if the oligopolistic organisation reduces the price, the rival organisations would also reduce prices for securing their customers. Here, the relevant demand curve is Pd’. The two parts of the demand curve are DP and Pd’, which is DPd’ with a kink at point P. Let us draw the MR curve of the oligopolistic organisation. The MR curve would take the discontinuous shape, which is DXYC, where DX and YC correspond directly to DP and Pd’ segments of the kinked demand curve. The equilibrium point is attained when MR = MC. In Figure 2, the MC curve intersects MR at point Y where at output OQ. At point Y, the organisation would achieve maximum profit. Now, if cost increases, the MC curve would move upwards to MC’. In such a case, the oligopolistic organisation cannot increase the prices. This is because if the organisation would increase the prices, the rival organisations would decrease their prices and gain the market share. Moreover, the profits would remain the same between point X and Y. Thus, there is no motivation for increasing or decreasing prices. Therefore, price and output would remain stable. However, the kinked demand curve model is criticised by various economists. Some of the major points of criticism are as follows: Lays emphasis on price rigidity, but does not explain price itself. Assumes that rival organisations only follow price decrease, which does not hold empirically. Ignores non-price competition among organisations. Non-price competition can be in terms of product differentiation, advertising and other tools used by organisations to promote their sales. Ignores the application of price leadership and cartels, which account for a larger share of the oligopolistic market. 5.6 PRICE LEADERSHIP In certain situations, organisations under oligopoly are not involved in collusion. There are several oligopolistic organisations in the market, but one of them is the dominant organisation, which is called price leader. Price leadership takes place when there is only one dominant organisation in the industry, which sets the price and others follow it. Sometimes, an agreement may be developed among organisations to assign a leadership role to one of them. The dominant organisation is treated as a price leader because of various reasons, such as the large size of the organisation, large economies of scale and advanced technology. According to the agreement, there is no formal restriction that other organisations should follow the price set by the leading organisation. However, sometimes agreement is formal. Price leadership is assumed to stabilise the price and maintain price discipline. This also helps in attaining effective price leadership, which works under the following conditions: When the number of organisations is small Entry to the industry is restricted Products are homogeneous Demand is inelastic or less elastic Organisations have similar cost curves 5.6.1 Volume Pricing Volume pricing isamethod by which the overallprice of items bought is lowered when increased quantities of the same item are purchased. In volume pricing, the marginal cost for a customer decreases with a gradual increase in the number of units purchased. Volume pricing is also called volume discounting. 96 UNIT 05: Oligopoly Market JGI JAIN DEEMED-TO-BE UNIVE RSI TY Volume discounting is offered in B2B purchases, it is useful as many businesses purchase the licences for the product in large numbers so that they can use their bulk. Volume discounting incentives for SaaS businesses is larger because there are fewer costs that are involved when allowing another customer to access the product. The following are the benefits of implementing volume discounting to the SaaS pricing model: Helps one to compete in the market: Businesses function dynamically with the ever-changing needs of the customer competition and the market. To successfully thrive and compete in the market, it is very important to have a well-planned pricing strategy that will prove attractive and valuable to the customer’s needs and provides a competitive edge to the business in the market. Providing volume discounting to favour the customers now and then helps the business to add value to the brand and increases the market share at the same time. Providing volume discounting only as and when needed to keep the customer engaged with the product will help the business to increase the perceived value of the product in the eyes of customers. Attracts a huge customer base: In pricing strategy and promotion, volume discounting is a key concept. Leveraging it and offering prospective customers volume discounts that cater to their requirements and also add something extra will create affinity and loyalty towards one’s brand and product. Encourages the customers to buy more: When volume discounts are usually offered it encourages the customers to buy more of the products because they get more items at a combined price that is less than the individual purchase of the same item multiple times. Sometimes they might choose pricing plans which they might need in the future for bulk purchases as it’s affordable and will be useful as they scale. This in turn helps the business generate more cash flow and ensure a prospect of earning revenue. Conclusion 5.7 CONCLUSION Oligopoly can be defined as a market situation that is characterised by few sellers dealing either in identical or differentiated products. One of the most important characteristics of an oligopoly market is the mutual interdependence of organisations. The sales of each organisation under oligopoly depend on the price charged by it as well as the price charged by other organisations in the market. The price and output are indeterminate under oligopoly because they are unaffected by the forces of the market. Oligopolistic firms are price searchers and not price takers as they can raise the price of their good and still sell some, or all, of their products because only a few firms account for a large percentage of sales. Collusion helps organisations to increase their performance, prevent uncertainties, prevent the entry of new organisations. The firms jointly establish a cartel organisation to make price and output decisions, establish production quotas for each firm and supervise market activities of the firms in the industry. Cartels that are flexible with a robust and responsive organisational structure respond to the changing conditions and are more likely to survive and also grow given their size. Limit Pricing is a pricing strategy where firms in an oligopoly or a monopolist may use to discourage the entry of new firms/individuals into their market. 97 JGI JAIN Principles of Economics and Markets DEEMED-TO-BE UNIVE RSI TY The kinked demand curve model seeks to explain the reason for price rigidity under oligopolistic market situations. Volume pricing is a method by which the overall price of items bought is lowered when increased quantities of the same item are purchased. 5.8 GLOSSARY Oligopoly: A market structure in which few organisations are selling the same or differentiated product Price leader: An oligopolist who fixes the price and output of the industry Price follower: An oligopolist who follows the price leaders 5.9 CASE STUDY: COLLUSION OF NEWSPAPER ORGANISATIONS Case Objective This case study discusses about collusion of newspaper organisations. A town has two newspaper organisations A and B. Demand for both the papers depends on their price as well as the price of the rival. The demand functions of both the newspaper organisations are as follows: Newspaper A = Q A = 21 – 2P A + P B Newspaper B = Q B =21 + P A – 2P B Each paper treats MC equals to zero and maximises its revenue without considering the price of rival organisations. Suppose these two organisations enter into a joint operating agreement to take combined actions for setting the prices so that revenue can be equally distributed among them. Now, estimate how much each organisation raises its prices to earn equal revenue? Solution: Q A = 21 – 2P A + P B Q B =21 + P A – 2P B TR = PQ TR A = P A (21 – 2P A + PB) = 21P A – 2P A 2 + P B .P A MR = 21 – 4 P A + P B TR B = P B (21 + P A – 2PB) = 21 P B + P B .P A – 2P B 2 MR = 21+P A – 4P B MC = 0 Thus, MR = MC = 0 (for both newspapers) 21 – 4 P A + P B = 0 ........................................................................ equation 1 21 + P A – 4P B = 0 ......................................................................... equation 2 98 UNIT 05: Oligopoly Market JGI JAIN DEEMED-TO-BE UNIVE RSI TY From equation 2: P B = (P A + 21)/4 Inserting value of P B in equation 1: 21 – 4 PA + (PA + 21)/4 = 0 PA=7 PB=7 If organisations cooperate, then prices will remain the same (PA = PB): Q A +Q B = Q = 21 – 2P + P + 21 + P – 2P Q = 42 – 2P TR = 42P – 2P 2 MR = 42 – 4P MR = MC = 0 42 – 4P = 0 P = 10.5 Thus, the price rises from 7 to 10.5 with the increase of 3.5. Questions 1. Which features of the newspaper industry make it the oligopoly industry? (Hint: Few sellers, identical products) 2. Why A and B depend on the price of the product sold by the rival? (Hint: Few sellers and high competition) 3. How can revenues be equally distributed among both A and B? (Hint: A joint operating agreement to take combined actions) 4. What will happen if A and B cooperate? (Hint: Prices will remain the same) 5. Give examples of some other industries which are characterised by oligopoly competition. (Hint: Automobile, telecommunications, etc.) 5.10 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. One of the most important characteristics of an oligopoly market is the mutual interdependence of organisations. What is oligopoly? 2. Is oligopoly a price searcher or price taker? 99 JGI JAIN DEEMED-TO-BE UNIVE RSI TY Principles of Economics and Markets 3. Limit entry pricing is therefore pricing done to limit entry. Explain limit entry pricing. 4. The relationship between Price rigidity and Kinked demand can be explained by the Kinked Demand Curve model. What is the relationship between price rigidity and kinked demand? 5. Explain volume pricing. 5.11 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS A. Hints for Essay Type Questions 1. Oligopoly refers to a market form in which a particular market is dominated by a small group of sellers. In other words, oligopoly can be defined as a market situation that is characterised by few sellers dealing either in identical or differentiated products. Under oligopoly, there are restrictions to the entry and exit of organisations. One of the most important characteristics of an oligopoly market is the mutual interdependence of organisations. Refer to Section Indeterminate Price and Output in Oligopoly. 2. Oligopoly is a price searcher because the businesses have control over the price they charge. They can raise the price of their good and still sell some of the goods they produce. The barriers to entry are significant where new entrants are restricted to enter the market with their products. Oligopolistic firms are therefore price searchers and not price takers as they can raise the price of their goods and still sell some, or all, of their products because only a few firms account for a large percentage of sales. Price takers do not have this privilege, they are the ones who price their products based on the forces of the market. Refer to Section Indeterminate Price and Output in Oligopoly 3. Limit Pricing is a pricing strategy where firms in an oligopoly or a monopolist may use to discourage the entry of new firms/individuals into their market. It is done so that only the profit acquired from the industry goes straight to the limited number of firms in the market and that they are protected from the threat that a new business would bring with them. Refer to Section Limit Pricing 4. The kinked demand curve model seeks to explain the reason for price rigidity under oligopolistic market situations. The model advocates that the behaviour of oligopolistic organisations remains stable when the price and output are determined. Refer to Section Price Rigidity and Kinked Demand 5. Volume pricing is a method by which the overall price of items bought is lowered when increased quantities of the same item are purchased. In volume pricing, the marginal cost for a customer decreases with a gradual increase in the number of units purchased. Volume pricing is also called volume discounting. Volume discounting is offered in B2B purchases, it is useful as many businesses purchases the licences for the product in large numbers so that they can use their bulk. Volume pricing helps a business to compete in the market. It attracts a huge customer base. It further encourages a customer to buy more. Refer to Section Price Leadership @ 5.12 POST-UNIT READING MATERIAL https://www.toppr.com/guides/business-economics/determination-of-prices/kinked-demand- curve/ https://www.economicsdiscussion.net/oligopoly/price-leadership-under-oligopoly-withdiagram/3778 5.13 TOPICS FOR DISCUSSION FORUMS 100 UNIT 05: Oligopoly Market JGI JAIN DEEMED-TO-BE UNIVE RSI TY Search information on a joint operating agreement signed by different organisations to take combined actions in oligopolistic market form. 101 UNIT 06 Introduction to the Indian Economy Names of Sub-Units Characteristics of the Indian Economy as a Developing Economy, Economic Growth vs. Economic Development, Causes and Solutions for Economic Development, Measurement of Development— Human Development Index (HDI) and other Measurements Overview The unit begins by explaining the concept of economic growth. Further, the unit explains the concept of economic development. Also, it discusses different measures of economic development like Human Development Index (HDI), Human Poverty Index (HPI), Gender-Related Development Index, Social Progress Indicator (SPI), Genuine Progress Indicator (GPI) and Green Index. A clear distinction between economic growth and development is given in the unit. Learning Objectives In this unit, you will learn to: Explain the concept of economic growth Discuss the concept of economic development List the problems faced by a developing country JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Learning Outcomes At the end of this unit, you would: Explore the concept of economic growth Evaluate the measures of economic development Differentiate between economic growth and development 6.1 INTRODUCTION The Indian economy is a mixed economy. A mixed economy refers to an economy that possesses the elements of socialist as well as capitalist systems. In a mixed economy, privately owned and stateowned enterprises coexist. The Indian economy is characterized by the slow growth of capital, economic disparity, low living standard, unemployment and underemployment, over-dependence on agriculture, lack of industrialization, and lack of capital. However, various problems of the Indian economy are being addressed and solved by favourable government policies. Moreover, globalization has opened the door to foreign investment in India. Now, it is all set to play a major role in the world economy in the coming decades. 6.2 ECONOMIC GROWTH Economic growth means the transformation of an economy from a state of underdevelopment to a state of development, from an agrarian to highly industrialized society, from a low saver to a high saver and from rural to urban. This transformation is mainly reflected in a sustained and steady rise in national and per capita income. The important factors that stimulate the growth process are classified into three groups: 1. Fundamental factors are those which attempt to define the potential for production of any economy in a fundamental sense. They include: a. the quantity and quality of national resources, b. the quantity and quality of real capital, c. the quantity and quality of labour force, and d. the level of technological attainment of the society. 2. The socio-economic factors are those which are related to the socio-economic structure of the society. These include: a. the distribution of income and wealth, b. the sociological and cultural structure, c. the legal structure of the country, and d. the dominant forms of business organisations. 3. Intermediate factors refer to those factors which enter into the determination of the level of aggregate demand. 6.3 ECONOMIC DEVELOPMENT Economic development means economic growth with structural changes in favour of non-agricultural activities. This implies that the share of agriculture in GDP should decline and the share of the industrial 106 JGI UNIT 06: Introduction to the Indian Economy JAIN DEEMED-TO-BE UNI VE RSI TY sector and services should increase. This is a reflection of changing demand for goods and services on the one hand and changing demand for labour by production technology in different sectors on the other. According to various economists, a need for attitudinal changes arises. In other words, a change in terms of traditional value system to modern value system is becoming a necessity today. In this context, economic development can be defined as economic growth plus, that is, something more than, economic growth. There were attempts to emphasize the technological dimension of development. Then we could define economic development as economic growth accompanied by a rise in productivity. In order to measure economic development, various tools or measures have been developed. Some of the most popular and commonly used tools are: Human Development Index Human Poverty Index Gender-Related Development Index Social Progress Indicator Genuine Progress Indicator Green Index Let us discuss these measures in detail in the next sections. 6.4 ECONOMIC GROWTH VS. ECONOMIC DEVELOPMENT Table 1 distinguishes between economic growth and economic development: Table 1: Distinction between Economic Growth and Economic Development Point of Distinction Economic Growth Economic Development Meaning Economic growth signifies an increase in Economic development refers to changes in the real output of goods and services in income, savings and investment along with the country. progressive changes in the socio-economic structure of a country (institutional and technological changes). Factors Growth relates to a gradual increase in one of the components of Gross Domestic Product consumption, government spending, investment and net exports. Measurement Economic growth is measured by The qualitative measures such as HDI quantitative factors such as an increase (Human Development Index), genderin real GDP or per capita income. related index, Human Poverty Index (HPI), infant mortality, literacy rate, etc., are used to measure economic development. Effect Economic growth brings quantitative changes in the economy. Relevance Economic growth reflects the growth of Economic development reflects progress in national or per capita income. the quality of life in a country. Development relates to the growth of human capital, decrease in inequality figures and structural changes that improve the quality of life of the population. Economic development leads to qualitative as well as quantitative changes in the economy. 107 JGI 6.4.1 JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Causes and Solutions for Economic Development Today, developing countries are mostly facing structural problems which include the geographical positioning of the countries. Small countries with less population are not able to transition into a developed country due to the over-proportionate population prevailing in the location, which poses a constraint on the growth process. Thus, the geographical positioning causes a hindrance in accessing the global market. Similarly, the countries that are landlocked are not able to integrate with the global markets effectively and, thus, unable to develop. On the contrary, the countries with good geographical positioning and demography are also not able to develop effectively. This is because of their internal problems, such as poverty, hunger, high mortality rates, unsafe water supplies, poor education system, unemployment, over-population, corrupt governments, war and poor sanitation. All these problems pave the way to a poverty trap that should be broken for the proper and effective development of an economy. With sturdy policies in the government, these poverty traps can be broken. In the UN’s development program, the World Bank says, “While geography can pose challenges, it does not define a country’s destiny.” In addition, the World Bank asked developing countries to focus on the following areas: Investment in education and health Increment in productivity of small farms Improvement in infrastructure Promotion of industrial manufacturing Promotion of democracy and human rights Protection of environment 6.4.2 Measurement of Development In order to measure economic development, various tools or measures have been developed. Some of the most popular and commonly used tools are: Human Development Index Human Poverty Index Gender-Related Development Index Social Progress Indicator Genuine Progress Indicator Green Index Let us discuss these measures in detail in the next sections. Human Development Index (HDI) HDI refers to a composite statistic used to rank nations by the level of “human development”. It is also measured by standards of living and classifies countries as “very high human development”, “high human development”, “medium human development” and “low human development” nations. HDI is 108 UNIT 06: Introduction to the Indian Economy JGI JAIN DEEMED-TO-BE UNI VE RSI TY a relative measure of life expectancy, learning, education and standards of living for every country. It is a standard means of measuring well-being and distinguishing whether the country is developed, developing or underdeveloped. It also measures the effect of economic policies on the quality of life. There are HDI for states, cities and villages. The annual Human Development Reports of the United Nations Development Programme (UNDP) present HDI. These are planned and launched by Pakistani economist Mahbub ul Haq in 1990 with an explicit purpose “to shift the focus of development economics from national income accounting to people-centred policies”. Mahbub ul Haq worked together with a group of well-known economists such as Paul Streeten, Frances Stewart, Gustav Ranis, Keith Griffin, Sudhir Anand and Meghnad Desai. However, it was Amartya Sen who provided the underlying conceptual framework. Human Poverty Index (HPI) While the HDI measures average achievement, the HPI guarantees deprivations in the three basic dimensions of human development which are captured in the HDI as follows: A long and healthy life Knowledge and the adult illiteracy rate A decent standard of living Calculating HPI is easier than calculating the HDI. The indicators to measure the deprivations are normalised between 0 and 100. Thus, there is no requirement to create dimension indices as for the HDI. Gender-Related Development Index (GDI) GDI adjusts the average achievement to show the disparities between men and women to the following dimensions: A long and healthy life, as measured by life expectancy at birth. Knowledge, as measured by the adult literacy rate and the combined primary, secondary and higher gross enrolment ratio A decent standard of living as measured by estimated earned income GDI can be calculated by ensuring three steps, which are as follows: 1. Calculating female and male indices, which can be calculated using the following formula: DI = (Actual Value – Minimum Value)/(Maximum Value – Minimum Value) 2. Calculating equally distributed index. The female and male indices in each dimension are combined in a way that disciplines the differences that come in achievement between men and women. The resulting index is calculated according to the following formula: Equally distributed index = [{Female population share (Female index1–Є)) + Male population share (Male index1–Є)}]–1 Є measures the aversion to inequality. In the GDI, Є = 2. Thus, the general equation becomes: Equally distributed index = [{Female population share (Female index – 1)} + {Male population share (Male index – 1)}] – 1 which gives the harmonic mean of the female and male indices. 109 JGI 3. JAIN Principles of Economics and Markets DEEMED-TO-BE UNI VE RSI TY Calculating GDI by combining the three equally distributed indices as an unweighted average. Table 2 shows the maximum and minimum values of different indicators of economic growth and development: Table 2: Maximum and Minimum Value of Different Indicators of Economic Growth and Development S. No. Indicator Maximum Value Minimum Value 1. Life expectancy at birth (years) 85 25 2. Adult literacy rate (%) 100 0 3. Combined gross enrolment ratio (%) 100 0 4. GDP per capita (PPS$) 40,000 100 Social Progress Indicator (SPI) SPI refers to social progress defined at the individual level in three dimensions, which are as follows: Durability or potential lifetime Consumption of goods Access to public facilities such as clean water, sanitation, safety and transportation Genuine Progress Indicator (GPI) GPI includes more than 20 aspects of our economic life that add value to human progress and reduce those which obstacle progress. The latter set of activities includes crime, defence expenditure, degradation of resources, contributions of household economy and voluntary work. Green Index The World Bank’s environmentally sustainable development division has established a new index called Green Index. This new indicator attaches a dollar value to the three components, which are as follows: i. Produced assets ii. Natural resources iii. Human resources This index puts a price tag on produced assets. In other words, it assigns economic value to land, water, woods, minerals and all natural resources. It also takes into account the available human resources, education level and range of skills. It helps in calculating the true approximation of a nation’s wealth while taking into account all such resources which are not usually visible on traditional economic indicators. 6.5 INDIA: A DEVELOPING COUNTRY After 64 years of independence, India is still a developing country due to the following reasons: High level of population Low level of per capita income 110 UNIT 06: Introduction to the Indian Economy JGI JAIN DEEMED-TO-BE UNI VE RSI TY Increasing poverty High level of unemployment Illiteracy of a large portion of the population High level of corruption from the individual level to the government level Regionalism and casteism are still prevalent in the society Lack of fundamental rights to women; lack of usage of the existing fundamental rights due to the male-dominant society Safety of people, especially women, is not up to the mark The above-stated societal problems pose a major hurdle to the growth and development of a country. India cannot become a developed nation until and unless these problems are eradicated. Conclusion 6.6 CONCLUSION Economic growth means the transformation of an economy from a state of underdevelopment to a state of development, from an agrarian to highly industrialized society, from a low saver to a high saver and from rural to urban. Economic development means economic growth with structural changes in favour of nonagricultural activities. HDI is a relative measure of life expectancy, learning, education and standards of living for every country. The World Bank’s environmentally sustainable development division has established a new index called Green Index. 6.7 GLOSSARY Economic Growth: An increase in the productive capacity of an economy Economic Development: Overall welfare (including standard of living and environmental sustainability) of the stakeholders of an economy Human Development Index (HDI): A composite statistic used to rank nations by the level of “human development” Human Poverty Index: An indicator of the standard of living in a country, which reflects the extent of deprivation in that country 6.8 CASE STUDY: CONTRACTION OF THE INDIAN ECONOMY AS PER IMF Case Objective This case study highlights why the International Monetary Fund (IMF) forecasted a prominent negative deviation in macroeconomic variables with respect to India for the year 2020. The International Monetary Fund (IMF) prepares and releases data related to the economic development of its member countries in a report titled World Economic Outlook (WEO). In the WEO Report, 2020, the 111 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets International Monetary Fund (IMF) projected that the Indian economy is likely to contract by 10.3% in 2020. This could be India’s worst economic performance after the independence. This slowdown can be attributed to the COVID-19 pandemic and the subsequent nationwide lockdown. However, the IMF also predicted that India is likely to surpass China’s projected growth rate of 8.2% with a remarkable growth rate of 8.8%. Further, the report also said that global growth would contract by 4.4% in 2020 but would climb back to 5.2% in 2021. The report further stated that the US economy was likely to contract by 5.8% in 2020 and would grow by only 3.9% in the next year. Ironically, according to the report, China, which is the birthplace of the COVID-19 pandemic, would be the only major economy to record a positive growth rate of 1.9% in 2020. In October 2020, the World Bank had made similar gloomy forecasts and projected that for 2020, India’s GDP is likely to contract by 9.6%. Further, the World Bank said that the situation is worse in India – more than ever before. It called the current situation an exceptional situation and said that the economy has a very dire outlook. Moreover, the job loss crisis unleashed by the novel coronavirus is unprecedented in world history. According to the International Labour Organization (ILO) and the Asian Development Bank (ADB’s) joint report in August 2020, 41 lakh youth in India lost jobs due to the COVID-19 pandemic with most job losses recorded in the construction and farm sectors. Even the Global Financial Crisis of 2008, which led to a global unemployment rate of 6%, pales in comparison to the 7.2% unemployment rate worldwide caused by the COVID-19 pandemic. COVID-19 has severely affected industries such as travel, entertainment and food. Questions 1. What does IMF do? (Hint: Prepares and releases data related to economic developments of its member countries) 2. Why did the IMF predict the contraction of the Indian economy? (Hint: Slowdown can be attributed to the COVID-19 pandemic and the subsequent nationwide lockdown.) 3. What effect has the coronavirus pandemic brought to the job situation in the Indian market? (Hint: 41 lakh youth in India have lost their jobs) 6.9 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. What do you understand by the term “economic growth”? 2. Write causes and solutions for economic development. 3. What is HPI? 4. Write a short note on the green index. 5. What are the problems faced by a developing country? 6.10 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS 112 UNIT 06: Introduction to the Indian Economy JGI JAIN DEEMED-TO-BE UNI VE RSI TY A. Hints for Essay Type Questions 1. Economic growth means the transformation of an economy from a state of underdevelopment to a state of development, from an agrarian to highly industrialized society, from a low saver to a high saver and from rural to urban. This transformation is mainly reflected in a sustained and steady rise in national and per capita income. Refer to Section Economic Growth 2. Small countries with less population are not able to transition into a developed country due to the over proportionate population prevailing in the location, which poses a constraint on the growth process. Thus, the geographical positioning causes a hindrance in accessing the global market. Refer to Section Economic Development 3. While the HDI measures average achievement, the HPI guarantees deprivations in the three basic dimensions of human development which are captured in the HDI as follows: A long and healthy life Knowledge and the adult illiteracy rate A decent standard of living Calculating HPI is easier than calculating the HDI. The indicators to measure the deprivations are normalised between 0 and 100. Thus, there is no requirement to create dimension indices as for the HDI. Refer to Section Economic Growth vs. Economic Development 4. The World Bank’s environmentally sustainable development division has established a new index called Green Index. This new indicator attaches a dollar value to the three components, which are as follows: i. Produced assets ii. Natural resources iii. Human resources Refer to Section Economic Growth vs. Economic Development 5. Today, developing countries are mostly facing structural problems, which include the geographical positioning of the countries. Small countries with less population are not able to transition into a developed country due to the over-proportionate population prevailing in the location, which poses a constraint on the growth process. Thus, the geographical positioning causes a hindrance in accessing the global market. Similarly, the countries that are landlocked are not able to integrate with the global markets effectively and thus, unable to develop. Refer to Section Economic Growth vs. Economic Development @ 6.11 POST-UNIT READING MATERIAL https://nios.ac.in/media/documents/SrSec318NEW/318_Economics_Eng/318_Economics_Eng_ Lesson3.pdf http://hdr.undp.org/en/content/human-development-index-hdi 6.12 TOPICS FOR DISCUSSION FORUMS Make a group of your friends and discuss the concept and importance of the Human Development Index. 113 UNIT 07 Policy and Economic Reforms in India Names of Sub-Units Economic Policies – New Economic Policy (LPG); Monetary Policy, Fiscal Policy; Industrial Policy, Foreign Trade Policy, FDI, Economic Reforms – Current Economic Reforms (SAP – Structural Adjustment Programs), Privatization, Disinvestment, Demonetisation, GST Overview The unit begins by explaining the monetary policy, fiscal policy and industrial policy of India. Further, the unit explains various economic reforms such as the Liberalisation, Privatisation and Globalisation (LPG) model of India, SAP, disinvestment, demonetisation and GST. Learning Objectives In this unit, you will learn to: Describe the monetary and fiscal policies of India Discuss the foreign trade and industrial policies of India Explain economic reforms like LPG, SAP disinvestment, demonetisation, etc. Learning Outcomes At the end of this unit, you would: Analyse economic policies of India Review economic reforms of India JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets 7.1 INTRODUCTION The modern macroeconomic policies involve fiscal policy and monetary policy. These policies are responsible for macroeconomics management of the economic system. Monetary policy is laid down by the central bank to control the supply of money in the financial system to meet the objectives relating to promotion of economic growth, maintaining inflation and ensuring smooth money supply in the economy. The RBI is the in charge of money market which takes requisite measures to implement monetary policy of the country. As the central bank, the RBI is responsible for regulating the money market in India and it injects liquidity in the banking system, when it is deficient or contracts contracting the same in the opposite situation. The money market provides leverage to the RBI to effectively implement and monitor its monetary policy. For example, a developed bill market strives to make the monetary system of an economy more elastic. Wherever the country needs more cash, the banks can get the bills rediscounted from the RBI and, therefore, can increase the money supply. Therefore, monetary policies along with fiscal policy streamline the macroeconomic condition of a nation. 7.2 ECONOMIC POLICIES The government regulates and develops the economy through its various economic policies. These include monetary policy, fiscal policy, industrial policy, agricultural policy, trade policy, foreign exchange management act, competition act among others. 7.2.1 Monetary Policy Monetary policy refers to the use of monetary policy instruments which are at the disposal of the central bank to regulate the availability, cost and use of money and credit so as to promote economic growth, price stability, optimum levels of output and employment, balance of payments equilibrium, stable currency or any other goal of government’s economic policy. A monetary policy involves policies that influence the following: Cost of credit, i.e., rate of interest: In times of boom, as the economy heats up and prices rise, to streamline the economic condition, the central bank will charge lower interest rates. This will encourage people to save more money and spend less and so prices will come down. However, during depression, to revive economic activity, the central monetary authority will lower down the interest rates. As interest rates fall, investment will be encouraged. As investment rises, output, employment and income will increase, bringing the economy out from the depths of depression. Availability of credit: When the central bank wants to revive economic activity, it will release more money into the economy. As people have excess cash balances, they will react by spending more. As consumption increases, investment will also rise and national income will increase. During boom time, the reverse happens. Though multiple objectives are pursued, the most commonly pursued objectives of monetary policy of the central banks across the world has become maintenance of price stability (or controlling inflation) and achievement of economic growth. The objectives of monetary policy are summarised are as follows: 118 Price stability: This is the core objective of many countries monetary policies. If there is a steep increase in prices, then the purchasing power of money will fall. This results in fall of real incomes. As real incomes fall, people will feel impoverished since on one hand while money incomes remain constant, on the other hand, they are able to buy lesser and lesser goods and services with the same money income. Furthermore, if prices rise persistently and steeply, they will have to draw on their savings. Once savings get exhausted the poorest sections of the society will be faced with the situation UNIT 07: Policy and Economic Reforms in India JGI JAIN DEEMED-TO-BE UNI VE RSI TY of either outright political revolt or starvation death. For instance, Venezuela’s hyperinflation increased from 929,790% in 2018 to 10 million per cent in 2019. For instance, a cup of coffee costs 1.55m bolivares, an increase of 6,639% in the 12 months to 3rd December 2020. Cumulative GDP declined by 65% since 2013. The government of President Nicolás Maduro and the opposition are engaged in a bitter power struggle. Opposition leaders have been banned from contesting for elections, some have been arrested while others have gone into exile. More than five million Venezuelans have left the country in recent years. Credit availability and economic growth: As you studied in the previous chapters, investment is one of the key variables in determining national income and thereby economic growth. Private sector cannot invest the huge amounts of resources on their own since they do not have large-scale funds available with them. Therefore, they need banks and other financial institutions to lend them money. For banks to lend money, they need a supportive monetary policy. The monetary authority should not only regulate interest rates but also increase money supply to the financial system when required. How can banks raise this money? By accepting more savings from people, by increasing non-interest incomes and when government prints more currency and gives it to them by repos or through buying treasury bills, bonds and other designated instruments. Exchange rate stability: Countries use international currencies for all their international transactions such as exports and imports and capital flows. It is the monetary policy which can ensure that there is exchange rate stability. For instance, if a country’s currency appreciates relative to other currencies, then its exports will fall while imports will rise. This is because foreigners have to pay more money for the same quantity of goods. On the other hand, we have to pay more to foreigners for the same amount of goods that we were importing earlier. This creates a current account deficit, and hence we will be forced to borrow more to finance the deficit. This eventually results in the country being mired in a debt trap. Conversely, if the currency depreciates, our exports will become cheaper and foreigners will buy more, and thus it is a win situation. However, if our imports are more than exports then you will end up paying more to foreigners. As a result, current account deficit and debt trap will ensue. Financial stability: When prices rise steeply, the costs of inputs will also rise. As costs of production rise, but at the same time consumers buy less unable to afford the high prices, businessmen will face losses. As losses pile up, they will fail to repay loans. As bad debts mount, banks will go bankrupt and the entire financial system will collapse. This is called as systemic crisis. In today’s globalised world, where countries have strong trade and currency linkages, a crisis can through a domino effect spread from country to country quickly evolving into a global contagion (think COVID-19). Something similar to this happened in the US 2008 economic crisis and which quickly became a global depression. Monetary Policy Instruments Monetary policy instruments are the various tools that a central bank can use to influence money market and credit conditions and pursue its monetary policy objectives. There are direct instruments such as cash reserve ratios and liquidity reserve ratios and indirect instruments such as repos and open market operations. There are two types of monetary policy instruments which are as follows: 1. Quantitative instruments: These instruments affect the total volume of credit by influencing the credit creating capacity of the commercial banks. They do this directly by impounding or releasing resources with the banks and also indirectly through mopping excess resources of the banks. 2. Qualitative/ selective instruments: These instruments affect the types of credit extended by the banks. It affects the composition of bank portfolio and channelises the resources to priority sectors 119 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets by restricting its allocation to unproductive and speculative sectors and regulating the amount and terms of credit. Let us first look at the quantitative instruments which directly impact the quantity of money supply in the economy. Cash Reserve Ratio (CRR): CRR refers to that proportion of total bank liabilities required to be kept as cash in hand or as balances with the central bank of a country. It is imposed for: the safety and liquidity of banks, helps the central bank in maintaining liquidity, and regulates money supply. As CRR falls, required reserves decline resulting in decline of excess reserves with banks. As a result, credit and money supply will fall. Limitations of CRR It is ineffective in regulating money supply in a scenario of increasing interest rates and in the presence of excess reserves. This is because of an increased opportunity cost of holding excess reserves and investing in business. Since businessmen can earn higher profits and pay back the relatively low interest rates, they ignore the higher interest rates. For example, if rate of interest is 15% and profit margin is 35% during boom, businessmen still have a margin of 25% left, and hence will not be afraid to borrow money. In a recessionary scenario, there is a lack of demand for funds. Therefore, reverse is true in case of depression. If the profit margin is 5% and rate of interest is also 5%, they are not motivated to borrow and invest. Banks will circumvent the impact of higher CRR by utilising their excess reserves for extending credit. The logic works same as in the earlier case. Banks will borrow more money from the RBI and maintain high CRR levels and still increase credit supply. Brings in inefficiencies in the system since it reduces the manoeuvrability of banks in portfolio allocation. There will be capital flight from productive sectors to speculative sectors. It imposes implicit tax on the banking system: Statutory reserves often do not carry any interest. Therefore, banks feel that they are burdened with an unwanted tax. This implicit tax is in fact often passed on to the borrowers in terms of higher interest rates in turn burdening them. Minimum and maximum restrictions on CRR limit the use of it for policy purpose. Bank Rate (BR): It is the minimum rate at which the Central Bank of a country lends to the financial institutions against the securities of the government and other approved securities. It affects the cost of funds which gets passed on the customers in the form of higher interest rate and affects the entire gamut of interest rates. It acts as a barometer of economic activities and indicates the stance of the monetary policy. An increase in bank rate hints at too much liquidity and the central bank responds with tight monetary policy. While decrease hints at liquidity shortage in the system which the central bank of the country wants to control by adopting an easy money policy. When bank rate increases, borrowing rate of interest increases. Limitations of BR 120 In a boom: the increase in the bank rate may not discourage borrowing if the higher prospects of profit keep the demand for funds very high. In a slump: the reduction in the bank rate may not encourage borrowing if the poor prospects of profits keep the demand low. For instance, as we saw in the opening case, in Japan, since the consumer demand was low, zero interest rates and even negative interest rates could not revive the economy. UNIT 07: Policy and Economic Reforms in India JGI JAIN DEEMED-TO-BE UNI VE RSI TY Base rate: It includes all those elements of the lending rates that are common across all categories of borrowers. Actual rate charged to the borrower consists of Base Rate plus borrower specific charges. It is the minimum rate. Actual rate cannot be below this rate. BR replaced BPLR in India on 1st July 2010 to bring in more transparency. It consists of: Cost of deposits Cost of complying with the CRR and SLR requirements General overhead costs Profit margin Open Market Operations (OMOs): OMOs consist of two types of operations – outright sale and purchase of government securities and repo – buying/ selling of securities with promise to buyback/ resell. Let us discuss these two categories in detail: 1. Outright OMO: It refers to the sale or purchase by the central bank of variety of assets such as foreign exchange, gold and government securities. In boom economic expectations of higher profitability may not restrict the bank lending to the private sector and motivate them to participate in OMOs. In slump economic expectations of lower demand may not encourage the bank lending to private sector and motivate them to participate in OMOs. When the sale of government securities increases, bank reserves fall since all the money is used up to buy government, bonds. Hence, credit falls and money supply falls. This will reduce inflation. 2. Repo/Reverse repo: Repurchase Agreement also referred to as buy back is a contract in which a participant acquires funds by selling the securities and simultaneously agrees to buy them back or repurchase the same at a specified time and price/ repo rate. It involves collateralised lending and borrowing which is backed by underlying transactions in securities. It is a short-term instrument with strong links with other money market instruments, securities and derivative market and carries low credit risk. It is a flexible instrument for liquidity management. Repo/reverse repo is defined from the side of the market participants. It leads to an injection of liquidity in the system and signals the stance of monetary policy. Reverse repo is a mirror image of repo. It implies a purchase of securities with an agreement to sell it at a stipulated period of time and at a stipulated price. It leads to absorption of liquidity from the system when performed by the central bank. Monetary Policy of India The primary objective of Monetary Policy of India is to maintain price stability, with sustainable economic growth. The government of India sets an inflation target every five years. RBI introduced a consultation process for inflation targeting. Furthermore, there are fixed reserve requirements in case of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) which banks have to keep and maintain at all times. CRR is the reserve which banks have to keep with RBI. The current CRR rate is 4% and is prescribed according to the guidelines of the central bank of a country. The basic purpose is to ensure that banks do not run out of money to satisfy the demands of their depositors. CRR is an important monetary policy tool and is used for controlling money supply in an economy. On the other hand, SLR is the reserve which banks have to maintain with themselves, thereby restricting the flow of money market instruments. Apart from CRR, banks have to maintain a certain portion of their deposits in the form of liquid assets such as cash, gold and non-mortgaged securities. Further, banks which subscribe to treasury bills, issued by RBI on behalf of the Government, qualifies their SLR requirements. 121 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets The current SLR rate is 20%. Features of RBI’s Monetary Policy include: RBI has flexible inflation targeting framework as it introduced flexible inflation targeting framework since 2016. The inflation target is set by the Government of India, in consultation with the Reserve Bank, once every five years. The Central Government has set 4% as the target Consumer Price Index (CPI) inflation for the period August 5, 2016 - March 31, 2021, within the range of 2-6%. The monetary policy framework sets the policy repo rate based on an assessment of the current and evolving macroeconomic conditions and liquidity situations and work towards pegging the money market rates to the repo rate. The monetary policy transmission mechanism of India facilitates repo rate transmission through the money market channel to the entire financial system. This, in turn, influences aggregate demand and thereby inflation and growth. Repo rate is announced quarterly. However, RBI undertakes liquidity management on a day-to-day basis. It aims at tying the Weighted Average Call Rate (WACR) to the repo rate. The policy interest rate required to achieve the inflation target is decided by the Monetary Policy Committee (MPC). MPC consists of six-member committee constituted by the Central Government. It is required to meet at least four times a year. The quorum for the meeting of the MPC is four members. Each member of the MPC has one vote and in the event of a tie, the Governor casts the final vote. Once in every six months RBI publishes the Monetary Policy Report to announce its stance. The Monetary Policy Committee (MPC) consists of the following departments/committees: Monetary Policy Department (MPD): It assists the MPC in formulating the monetary policy. Views of key stakeholders in the economy and RBI’s macroeconomic statistics are considered for arriving at the policy repo rate. The Financial Markets Operations Department (FMOD): It operates the monetary policy through day-to-day liquidity management. The Financial Market Committee (FMC): It meets daily to review the liquidity conditions to ensure that the weighted average lending rate or the Weighted Average Call Rate (WACR) is aligned with the policy repo rate. RBI’s Monetary Policy Instruments include: Repo rate: Repo rate refers to the rate at which commercial banks borrow money by selling their securities to the RBI to maintain liquidity, in case of shortage of funds or due to CRR requirements. It is one of the main tools of inflation under the Liquidity Adjustment Facility (LAF). Reverse repo rate: Reverse Repo Rate is when the RBI borrows money from banks, against eligible government securities. This happens when there is excess liquidity in the market. The banks receive interest for their holdings with the central bank, under the LAF scheme. Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo auctions. RBI is conducting variable rate repo auctions with a range of tenors. This is to develop an inter-bank term money market, which in turn can help set benchmark interest rates for loans and deposits. This will enhance the effectiveness of the transmission of monetary policy. 122 UNIT 07: Policy and Economic Reforms in India JGI JAIN DEEMED-TO-BE UNI VE RSI TY Marginal Standing Facility (MSF): This is a facility under which commercial banks can borrow additional amount of overnight from RBI by tapping their Statutory Liquidity Ratio (SLR) portfolio up to a certain limit, without attracting a penal rate of interest. MSF acts as a safety valve against unanticipated liquidity shocks to the banking system. Corridor: The MSF rate and reverse repo rate together form the corridor for the upper and lower limits for the range of the weighted average call money rate, on a daily basis. Bank rate: It is the rate at which the RBI buys or rediscounts bills of exchange or other commercial papers. The Bank Rate is aligned to the MSF rate and changes in tandem with the MSF rate and policy repo rate. Cash Reserve Ratio (CRR): It refers to the average daily balance that a bank is required to maintain with the RBI as a proportion of its Net Demand and Time Liabilities (NDTL). Statutory Liquidity Ratio (SLR): It refers to the proportion of NDTL that a bank is required to maintain in safe and liquid assets, such as unencumbered government securities, cash and gold. Open Market Operations (OMOs): These include both, outright purchase and sale of government securities. Market Stabilisation Scheme (MSS): Surplus liquidity of a more long-term nature arising from large capital inflows is absorbed through the sale of short-dated government securities and treasury bills. The mobilised cash is held in a separate government account called MSS with the Reserve Bank. 7.2.2 Fiscal Policy Fiscal policy is defined as the use of tax policies and government expenditure to affect the economic situation of a nation. The economic conditions that get affected by the fiscal policy are aggregate demand, inflation, employment and economic growth. The government uses taxes and government spending to manipulate the demand of certain goods and services or the aggregate demand. The main aim of fiscal policy is to achieve a high rate of economic growth with increased employment. There are three components of fiscal policy: Changes in tax rates: Tax rates are changed every year to control the spending of people. Government imposes both direct and indirect taxes for revenue generation. Changes in public spending: The government plans to spend on certain sectors every year. There are two types of government expenditure which are capital expenditure and revenue expenditure. For example, construction of roads, bridges and building. Automatic stabilisers: There are two processes called fiscal drag and fiscal boost which stabilises the economic cycle. It involves subsidy, welfare expenditure, etc. Objectives of Fiscal Policy The main aim of fiscal policy is to achieve a high rate of economic growth with increased employment. For a developing country such as India, the objective of fiscal policy is: Full employment: To create maximum employment, government can introduce public expenditure and public sector investment. Best laid out investment plans can increase the income, output and thus create employment. This will further increase demand and act has a multiplier to take the economy to full employment. Private investments can be encouraged by giving tax reliefs, concessions and 123 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets lower rate of interest on loans, granting of subsidies, etc. Encourage domestic industries in rural areas by giving appropriate training and skills and help them market their products. Price stability: Developing economies usually face inflation as there is a more public expenditure which creates demand more than the supply. This creates an inflationary gap. This price rise is due to the demand pull and cost push which widens the gap further. If this situation is not controlled, it can turn into hyperinflation. Fiscal policies need to get rid of these bottlenecks and rigidities which create imbalance in the economy. It has applied controls on essential commodities, grant concessions, subsidies and protect the economy. Accelerating the rate of economic development: Fiscal policies like taxation, public borrowing and deficit financing, etc., have to be used effectively so that there is no adverse effect on production, consumption and distribution. The entire economy benefits result in the growth of national income and per capital income. Optimum allocation of resources: The economy gains momentum in underdeveloped countries when the government increases public expenditure on infrastructure projects provides subsidies and incentives that can influence businesses and the general public to allocate certain resources into the desired channels. Tax tools such as exemptions and concessions also help some industries to allocate their resources appropriately as desired. High taxes take away resources for certain sectors. Consumption of certain products that are socially harmful and not productive helps mobilise the resources. This also is the best way of controlling inflation. In underdeveloped countries, the policy of protection is a very helpful tool. Some of the saving tools are direct physical control, increasing the rate of existing taxes, the introduction of new taxes, public borrowing of non-inflationary nature, deficit financing. Equitable distribution of income and wealth: A suitable fiscal policy of the government devised to bridge the gap in the different income groups of the society. The government invests in such channels that bring up the lower income groups. Thus, redistributive expenditure helps in economic development and human capital development. Regional disparities are eliminated by providing incentives to backward regions. Heavy taxation is imposed on richer sector and exemptions are given to the poorer sections. Luxurious items are taxed more than the basic essentials. Economic stability: Fiscal measures like flexible budgetary system helps to compensate the income and expenditure of the government, thus helping to control the rise or fall of the nation’s income. Fiscal policies thus help create economic stability. The instabilities that are created by the external and internal forces are corrected by the fiscal policies, by way of tariff policy. The international cyclical fluctuations are checked by imposing export and import duties. Increased taxes and import duties on consumer and luxurious goods restrict additional spending. Capital formation and growth: Any developing country requires balanced growth to break the vicious circle of poverty, this is possible only with a higher rate of capital formation. Since the country has to come out of its backwardness and stimulate investments. Thus, the fiscal policy mainly focuses on raising the ratio of saving to income and controlling consumption or expenditure. Encouraging investment: The fiscal policy to increase investment gives an attractive rate of interest on savings so that people are encouraged to save. It also gives a safe environment and regulated environment in the share market so that the public at large can invest in companies and bring out a better growth for the overall economy. Instruments of Fiscal Policy The instruments of fiscal policy are the tools that help in government decisions and plans for the social and economic development of the country. Taxes, expenditures, public debt and the budget are some of 124 UNIT 07: Policy and Economic Reforms in India JGI JAIN DEEMED-TO-BE UNI VE RSI TY the tools of the fiscal policy. Changes made to these automatically affect the cash flow of the country and thus help restricting private expenditures on consumption and investments. Public revenue: It means revenue of the government. The government earns its income from the public by charging taxes on income from different sources, on purchase of goods, use of public goods. It sells public services, such as electricity, water, railway and road transports, postal services, etc. It sells public goods like food grains, artefacts, agricultural products, etc. It also collects fines and contributions. Hence, these are the main sources of the government’s income. Taxation policy is a very powerful tool used in fiscal policy as the changes in taxes directly effect the disposable income, consumption of goods and investments. Public expenditure: The government has to actively participate in the economic activities of the country, and thus has made its expenditure a vital fiscal tool. Government spending in appropriate areas brings about more effective changes than taxes. When government increases its spending, it becomes the income source for many unemployed and lower salary group and increases their standard of living and investments. In the same way, when government decreases its expenditure, this reduces economic activity and also less money in the economy. Public debt: Public debt is another very effective tool to fight inflation and depression. It involves all the liabilities that are borrowed by the government in order to meet its development budget. This helps in bringing full employment and economic stability. Public debt involves the following: Public borrowing: The government does not borrow from banks, but takes money from the general public by issuing its bonds. People buy these bonds as they are tax saving bonds with attractive interest rates. These bonds are for fixed periods so withdrawal is restricted. People will save more and these kinds of borrowings do not cause inflation. If the government does not issue bonds and borrow money from the people, these would be invested in private investments causing inflation. Hoarded money gets circulated in the economy by investments in attractive government bonds by individuals. Borrowings from individuals are recommended in inflation and avoided in deflation. But since the contribution of individuals is not so significant, it does not have a very huge effect on the economy. Bank borrowing: Government borrows from banking institutions during the time of deflation. Banks have excess cash as private companies do not borrow during this period as it is unprofitable for them. The government, therefore, borrows this unused money lying idle with the banks so that it creates employment opportunities by spending on public works programme and thus increase income. During inflation, borrowing from banks will dry up the funds for private investors and will not allow the boom in business activities. Business would like to borrow more to increase production to meet the rising demand. Therefore, banks do not have funds to lend to the government. Therefore, borrowings from banks are desirable only during the depression and not desirable during inflation. Treasury withdrawal: The government may choose to use the funds from the treasury for financing its budgetary deficit. However, the government withdraws a very small amount from the treasury for day to day requirements. Therefore, it does not have a significant effect on the economy. Printing of money: When the government needs to influx money in the economy and there is no other way to do so, it would as a last resort print money to manage the deficits in the public expenditure. New money printed adds up to the money already in circulation and is used by the government for its projects. But this can cause inflation. But this kind of deficit financing is required to help the economy to raise the level of income and employment. But using this kind of tools raises objection as this tool could be used to lower the interest rates, supply money easily and register a quick revival system. 125 JGI JAIN Principles of Economics and Markets DEEMED-TO-BE UNI VE RSI TY Fiscal Policy of India The fiscal policy of India is drawn by the Finance Ministry. The fiscal policy of India is very vital as it is the guiding document that helps the government to determine the amount of revenue that it could earn for a period and accordingly plan its spending. It also guides the government to analyse what should be its revenue to run the entire economy for a year without any hindrances and the projects that need to be prioritised. Thus, as the world moves faster the fiscal policy has gained more importance to achieve economic growths for India and as well as the entire world. The Government of India has formulated key goals of fiscal policy and one of them is to attain rapid economic growth. The fiscal policy of a country plays a very important role in the functioning of its economy. Controlling tax revenues and public expenditure to navigate the economy is the main feature of the fiscal policy of India. There is a surplus, if revenue is more than expenditure and there is deficit if the expenditure is more than the revenue. In such a deficit condition, the government can borrow domestically or from overseas to meet the additional expenditure. The government can also withdraw from its reserves created from foreign exchange profits or print additional money. The privatisation of banks and globalisation infused higher economic growth in India. Table 1 shows the trends in Central and State fiscal deficits since 1990: Table 1: Central and State Fiscal Deficits (% of Gdp) Year Center States Consolidated Total Revenue Primary 1990-91 6.6 3.3 9.4 4.2 5.0 1991-92 4.7 2.9 7.0 3.4 2.3 1992-93 4.8 2.8 7.0 3.2 2.1 1993-94 6.4 2.4 8.3 4.3 3.3 1994-95 4.7 2.7 7.1 3.7 1.9 1995-96 4.2 2.6 6.5 3.2 1.6 1996-97 4.1 2.7 6.4 3.6 1.3 1997-98 4.8 2.9 7.3 4.1 2.1 1998-99 5.1 4.2 9.0 6.4 3.7 1999-00 5.4 4.6 9.6 6.3 3.9 2000-01 5.7 4.3 9.8 6.6 4.0 2001-02 6.1 4.2 9.9 6.9 3.7 2002-03 5.9 4.7 10.1 6.7 3.6 2003-04 4.8 N.A. N.A. N.A. N.A. The table shows that the fiscal deficit began to rise in 1997-98. India’s current fiscal situation is not that good and the financial deficit seem to remain constant due to pandemic, and it could lead to an economic crisis (fiscal, monetary and/or external) with severe short-term losses of output and even political turmoil. 7.2.3 Industrial Policy of India An industrial policy is a government’s action to influence the ownership and structure of the industry and its performance. It takes the form of paying subsidies or providing finance in other ways, or of regulation. An industrial policy involves procedures, principles (i.e., the philosophy of a given economy), 126 UNIT 07: Policy and Economic Reforms in India JGI JAIN DEEMED-TO-BE UNI VE RSI TY policies, rules and regulations, incentives and punishments, the tariff policy, the labour policy, government’s attitude towards foreign capital, etc. The main objectives of the industrial policy of the government in India are to: Maintain a sustained growth in productivity; Enhance gainful employment; Achieve optimal utilisation of human resources; Attain international competitiveness; and Transform India into a major partner and player in the global arena. 7.2.4 Foreign Trade Policy of India India’s Foreign Trade Policy (FTP) provides the basic framework of policy and strategy for promoting exports and trade. It is periodically reviewed to adapt to the changing domestic and international scenario. The Department of Commerce has the mandate to make India a major player in global trade and assume a role of leadership in international trade organisations commensurate with India’s growing importance. The Department devises commodity and country-specific strategy in the medium term and strategic plan/vision and India’s Foreign Trade Policy in the long run. The Department is also responsible for multilateral and bilateral commercial relations, Special Economic Zones (SEZs), state trading, export promotion and trade facilitation, and development and regulation of certain export oriented industries and commodities. The current Foreign Trade Policy (2015-20) focuses on: improving India’s market share in existing markets and products as well as exploring new products and new markets helping exporters leverage benefits of GST monitoring export performances, improving ease of trading across borders increasing realisation from India’s agriculture-based exports and promoting exports from MSMEs and labour intensive sectors The DoC has also sought to make states active partners in exports. As a consequence, state governments are now actively developing export strategies based on the strengths of their respective sectors. 7.3 ECONOMIC REFORMS Economic reform refers to the changes implemented in the economy of a country for its growth and development. After independence, India has adopted the mixed economy, which is a combination of socialist and capitalist economy. With the introduction of economic reforms, the economy of India is shifting towards market economy. The process of economic reforms was initiated in 1991 for overcoming the economic problems and increasing the rate of growth and development of India. The government introduces economic reforms to meet various objectives. Some of these objectives are as follows: Boosting the private investment Inviting foreign investment Eradicating unproductive controls Providing linkage to connect the Indian economy with the world’s economy Reducing fiscal deficits 127 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Enhancing the foreign exchange reserves Increasing the rate of economic growth Increasing the competitiveness of industrial sector Reducing poverty and inequality 7.3.1 Principles of Economics and Markets Liberalisation, Privatisation and Globalisation (LPG) Liberalisation Liberalisation refers to release the economy from the bureaucratic system for making it more competitive. Liberalisation provides the organisations a freedom to incorporate any business and can freely do business activities around the world. With liberalisation, organisations need not to take any approval while establishing a business rather they need to fulfil certain conditions to get into the industry. The benefits provided by liberalisation to the organisations are as follows: Remove the requirement of license for establishing a business Provide freedom to organisation for identifying the scale of their business activities Eradicate the restrictions on the transportation of goods from one place to another Provide the organisations the freedom of establishing prices for their goods and services Decreases the tax rates on businesses Increases foreign investment Increases merger, amalgamation, and takeovers Provide simple exit policies to organisations Privatisation Privatisation is a process through which some of the public undertakings are either partially or completely brought under the private ownership. In a broader sense, the establishment of new ventures in the private sector for enlarging its scope in the growth of economy is termed as privatisation. The different forms of privatisation are discussed as follows: Total de-nationalisation: Refers to the complete transfer of a public undertaking into a private undertaking. For example, Allwyn Nissan was a public organisation that is completely undertook by a private player, Mahindra. Joint venture: Refers to the partial transfer of ownership from a public sector organisation to a private sector organisation. In joint venture, a private sector organisation has 25% or 50% ownership in a public sector organisation on the basis of the nature of organisation and the state policy with respect to the joint ventures. Worker’s cooperative: Refers to a form of privatisation in which the ownership of a loss making organisation is transferred to its workers. In worker’s cooperative, the workers receive wages as well as get a share in the ownership dividend. In such a case, worker’s work hard to increase the profits of the organisation as their personal interest gets associated with the organisation’s interest. Token privatisation: Refers to a form of privatisation in which the public sector organisation has 5% to 10% of shares in the market. The main aim of token privatisation is to get revenue for decreasing the budget deficit. 128 UNIT 07: Policy and Economic Reforms in India JGI JAIN DEEMED-TO-BE UNI VE RSI TY Globalisation World economy has witnessed a frequent shift in organisational structure, trade patterns, and culture. Earlier, countries were confined to its national territory only and restricted to cross-border trading. Now, the scenario has changed entirely as open economy and relaxation in trade barriers have led the free flow of capital, goods, services, human resources, and technologies across nations. This integration of different economics into an international economy through exchange of trade, FDI, and flow of capital is called globalisation. In other words, globalisation can be defined as an assimilation of different countries through cross-border exchange of ideas, financial resources, information, and goods and services. This cross-border integration can be social, economic, cultural, or political. Globalisation has marked a significant contribution in the Indian economy. It has played a crucial role in generating employment opportunities with the expansion of markets. Globalisation has both positive and negative impacts of economies of different countries. Globalisation can be seen through many perspectives, including market and production. The market perspective of globalisation refers to the merging of historically distinct, separate, and isolated national markets into a large global marketplace. Relaxation in trade barriers and adaptation of cultures across nations has made it possible for organisations to sell their standardised products and serve almost same quality in all countries. For example, consumer products, such as Citibank credit cards, Pepsi Co. soft drinks, Sony PlayStation video games, Apple iPod, and McDonald’s hamburgers, have held the same quality and standards throughout the world. However, the production perspective refers to the sourcing of raw materials, parts and components, and services from different countries. This helps to gain the advantage of national differences in cost and quality of factors of production, such as labour, energy, land, and capital. For example, IBM ThinkPad X31 Laptop was designed by the most efficient IBM engineers in the most conducive environment of the United States. Thailand manufactured the computer case, keyboard, and hard drive; South Korea contributed the display screen and memory; Malaysia provided the built-in wireless card; whereas the United States manufactured the microprocessor. Finally, the laptop was assembled in Mexico and shipped to the United States for sale. This whole process segregates the manufacturing process into various operations and locates these operations in the nations where the respective operations can be performed in the most cost effective way with cheap labor and raw materials. Other very common examples are Business Process Outsourcing (BPO) and Knowledge Process Outsourcing (KPO) that have gained advantage of national differences in cost and quality of factors of production. 7.3.2 Structural Adjustment Programs (SAP) A structural adjustment is a set of economic reforms that a country must adhere to in order to secure a loan from the International Monetary Fund and/or the World Bank. Structural adjustments are often a set of economic policies, including reducing government spending, opening to free trade, and so on. Structural adjustments are commonly thought of as free market reforms, and they are made conditional on the assumption that they will make the nation in question more competitive and encourage economic growth. The International Monetary Fund (IMF) and World Bank, two Bretton Woods institutions that date from the 1940s, have long imposed conditions on their loans. However, the 1980s saw a concerted push to turn lending to crisis-stricken poor countries into springboards for reform. Structural adjustment programs have demanded that borrowing countries introduce broadly freemarket systems coupled with fiscal restraint—or occasionally outright austerity. Countries have been required to perform some combination of the following: Devaluing their currencies to reduce balance of payments deficits. Cutting public sector employment, subsidies, and other spending to reduce budget deficits. 129 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Privatising state-owned enterprises and deregulating state-controlled industries. Easing regulations in order to attract investment by foreign businesses. Closing tax loopholes and improving tax collection domestically. 7.3.3 Disinvestment Disinvestment indicates to the process, in which, the shares of a public enterprise is sold either partially, or in full, to financial institutions, workers, general public, mutual funds, or sole bidder. On the other hand, privatisation indicates to the process, through which some of the public undertakings are completely brought under private ownership. In a broader sense, the establishment of new ventures in the private sector for enlarging its scope in the growth of economy is termed as privatisation. Disinvestment is a form of privatisation. However, it should be noted that disinvestment may or may not result in a privatisation. 7.3.4 Demonetisation Demonetisation refers to the act of stripping a currency unit of its status as legal tender. It occurs when there is a change of national currency. Under this act, the current form or forms of money is pulled from circulation and retired, often to be replaced with new notes or coins. Sometimes, a country completely replaces the old currency with new currency. Removing the legal tender status of a unit of currency is a drastic intervention into an economy as it directly affects the medium of exchange used in all economic transactions. It can help stabilise existing problems, or it can cause chaos in an economy, especially if undertaken suddenly or without warning. That said, demonetisation is undertaken by nations for a number of reasons. 7.3.5 GST GST, also known as the Goods and Services Tax, is an indirect tax introduced in India. GST has replaced many indirect taxes in India such as the excise duty, VAT, services tax, etc. The Goods and Service Tax Act was passed in the Parliament on 29th March 2017 and came into effect on 1st July 2017. In other words, GST is levied on the supply of goods and services. Goods and Services Tax Law in India is a comprehensive, multi-stage, destination-based tax that is levied on every value addition. GST is a single domestic indirect tax law for the entire country. Conclusion 7.4 CONCLUSION A monetary policy involves policies that influence the cost of credit and availability of credit. Major monetary policy objectives include price stability, credit availability and economic growth, exchange rate and financial stability. The primary objective of Monetary Policy of India is to maintain price stability, with sustainable economic growth. Fiscal policy is defined as the use of tax policies and government expenditure to affect the economic situation of a nation. The economic conditions that get affected by the fiscal policy are aggregate demand, inflation, employment and economic growth. There are three components of fiscal policy: changes in tax rates, changes in public spending and automatic stabilisers. 130 UNIT 07: Policy and Economic Reforms in India JGI JAIN DEEMED-TO-BE UNI VE RSI TY The objectives of fiscal policy are to obtain full employment, price stability, capital formation and growth and encouraging investment. The instruments of fiscal policy are public revenue, public expenditure and public debts. Economic reform refers to the changes implemented in the economy of a country for its growth and development. After independence, India has adopted the mixed economy, which is a combination of socialist and capitalist economy. Liberalisation refers to release the economy from the bureaucratic system for making it more competitive. Liberalisation provides the organisations a freedom to incorporate any business and can freely do business activities around the world. Privatisation is a process through which some of the public undertakings are either partially or completely brought under the private ownership. Globalisation can be defined as an assimilation of different countries through cross-border exchange of ideas, financial resources, information, and goods and services. A structural adjustment is a set of economic reforms that a country must adhere to in order to secure a loan from the International Monetary Fund and/or the World Bank. Disinvestment indicates to the process, in which, the shares of a public enterprise is sold either partially, or in full, to financial institutions, workers, general public, mutual funds, or sole bidder. Demonetisation refers to the act of stripping a currency unit of its status as legal tender. It occurs when there is a change of national currency. Under this act, the current form or forms of money is pulled from circulation and retired, often to be replaced with new notes or coins. GST, also known as the Goods and Services Tax, is an indirect tax introduced in India. GST has replaced many indirect taxes in India such as the excise duty, VAT, services tax, etc. The Goods and Service Tax Act was passed in the Parliament on 29th March 2017 and came into effect on 1st July 2017. 7.5 GLOSSARY Deficit Financing: A budgetary situation wherein the government expenditure is higher than the revenue Subsidies: A form of financial aid or government incentive to the economy in order to promote economic and social policy Inflation: Rise in the price level in an economy over a period of time Depression: A state of an economy wherein extreme recession exist 7.6 CASE STUDY: MANAGING ECONOMIC CRISIS Case Objective This case study shows the changes in the economy through fiscal policies. Background In the year 2007, Spain was a growing economy with the housing prices at their peak and the construction sector accounted for 12% of the country’s gross domestic product. Many of Spain’s local and commercial banks were financed by the German Banks. At the end of 2007, the builders of the country employed 131 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets 13% of the Spanish workforce. The housing sector was booming in the country, which brought down the unemployment and also attracted migrant workers. During the period between 1996 and 2007, there were 4.3 million migrants who came to Spain to work in the construction industry. Problem In 2007, economic crisis hit Spain which was created due to the decade-long estate boom and the collapse of the estate sector. The bubble of the housing sector burst when the fund’s inflow into the housing market stopped and the government had to take various austerity measures for tackling the impact of the crisis. The economy of Spain suffered a major setback due to the bursting of the housing bubble that resulted in increase in unemployment up to 27%. Spain was Europe’s fourth-largest economy and it fell deep into the crisis which engulfed the entire country and its economy. It increased unemployment, collapsing of the banking system, and weakened the construction and housing sector with the total deterioration of the economy of Spain. The government had to make several austerity measures for reducing the public deficit. In May 2010, the Prime Minister of Spain, José Luis Rodríguez Zapatero approved a €16 billion austerity measure through its fiscal policy for effectively covering the public deficit. This was considered to reduce the public deficit from 11% of GDP to 6% by 2011. It required a cost-cutting plan that needed to cut down salaries by 5% in the public sector, suspension of automatic inflation adjustment for pensions, cutting the payout to parents for the birth of children, and reducing the funding of regional governments by €1.2 billion. There was the restructuring of many regional banks or ‘cajas’, and a fund was created consolidating the financial system of the economy. There was a rescue package for the Spanish banks and several small banks were merged. Conclusion Thereafter the country moved out of a two-year recession in the first quarter of 2010. By 2013, the country was a little stable and was considered to be out of recession but not out of the crisis. Remarkable progress was noticed with changes in fiscal policies and the prices of the houses along with the changes in the private debt and external balance corrections. Questions 1. Explain how the growing economy fall into crisis. (Hint: Funds inflow into the housing market stopped, ending of the housing bubble resulted in huge unemployment that went up to 27%, collapsing of the banking system) 2. How did Spain manage to come out of its crisis? (Hint: The government had to take various austerity measures, cost-cutting plan by cutting down on salaries, reducing the funding of regional governments by €1.2 billion) 7.7 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. What do you understand by the term globalisation? 2. List the main objectives of monetary policy and explain their relevance. 3. What is a fiscal policy? Describe the instruments of fiscal policy. 132 UNIT 07: Policy and Economic Reforms in India JGI JAIN DEEMED-TO-BE UNI VE RSI TY 4. Discuss ‘equitable distribution of income and wealth’ and ‘economic stability’ as objectives of fiscal policy. 5. Discuss the fiscal policy of India. 7.8 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS 133 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets A. Hints for Essay Type Questions 1. Globalisation can be seen through many perspectives, including market and production. The market perspective of globalisation refers to the merging of historically distinct, separate, and isolated national markets into a large global marketplace. Refer to Section Economic Reforms 2. Monetary policy refers to the use of monetary policy instruments which are at the disposal of the central bank to regulate the availability, cost and use of money and credit so as to promote economic growth, price stability, optimum levels of output and employment, balance of payments equilibrium, stable currency or any other goal of government’s economic policy. Refer to Section Economic Policies 3. Fiscal policy is defined as the use of tax policies and government expenditure to affect the economic situation of a nation. The economic conditions that get affected by the fiscal policy are aggregate demand, inflation, employment and economic growth. Refer to Section Economic Policies 4. A suitable fiscal policy of the government devised to bridge the gap in the different income groups of the society. The government invests in such channels that bring up the lower income groups. Thus, redistributive expenditure helps in economic development and human capital development. Regional disparities are eliminated by providing incentives to backward regions. Refer to Section Economic Policies 5. The fiscal policy of India is drawn by the Finance Ministry. The fiscal policy of India is very vital as it is the guiding document that helps the government to determine the amount of revenue that it could earn for a period and accordingly plan its spending. It also guides the government to analyse what should be its revenue to run the entire economy for a year without any hindrances and the projects that need to be prioritised. Thus, as the world moves faster the fiscal policy has gained more importance to achieve economic growths for India and as well as the entire world. The Government of India has formulated key goals of fiscal policy and one of them is to attain rapid economic growth. The fiscal policy of a country plays a very important role in the functioning of its economy. Refer to Section Economic Policies @ 7.9 POST-UNIT READING MATERIAL https://www.researchgate.net/publication/5169836_Monetary_Policy_From_Theory_to_Practices https://www.imf.org/external/pubs/ft/fandd/2009/09/pdf/basics.pdf 7.10 TOPICS FOR DISCUSSION FORUMS 134 Discuss with your friends the current bank rate, SLR, CRR, repo rate and reverse repo rate. UNIT 08 Economic Planning in India Names of Sub-Units Need for Finance Commission, Role and Functions of Finance Commission of India, Need and Importance of NITI Aayog, Functions of NITI Aayog Overview The unit begins by explaining the concept of economic planning. It also details the concept of economic planning in India. Further, the unit explains the major controversies on planning in India. Towards the end, the unit discusses the roles and significance of the Finance Commission of India and NITI Aayog at length. Learning Objectives In this unit, you will learn to: Explain the concept of economic planning Describe the importance of economic planning Discuss the functioning of the Finance Commission of India State the importance of NITI Aayog List the objectives of NITI Aayog JGI JAIN DEEMED-TO-BE UNIVERSIT Y Principles of Economics and Markets Learning Outcomes At the end of this unit, you would: Assess the economic planning in India Identify the major controversies in economic policy in India Evaluate the roles of the Finance Commission of India Analyse the functioning of NITI Aayog 8.1 INTRODUCTION Planning is important for both the organisation as well as for those directly or indirectly associated with it. Planning, if executed properly, can help in minimising the effort, energy, and wastage of resources as well as maximise results. In other words, planning follows the 80/20 rule, which says that 80% of the time is wasted on 20% of the output if it is not done correctly. The reverse of this rule is also true that 80% of the output can be produced in 20% of the time invested if planning is done in a correct manner. 8.2 CONCEPT OF ECONOMIC PLANNING Economic planning means the allocation of limited resources among different uses in such a way that it would bring about the maximum welfare for the people. It consists of two basic elements. One is the determination of objectives and the second is the provision of means for the achievement of the objectives. The detailed scheme is called an economic plan. The fundamental objective of planning is to accelerate the economic development of a country by bringing about optimum utilisation of its resources so that the masses can have a reasonably high standard of economic wellbeing. The Directive Principles laid down in the Indian Constitution aim at creating a society in which all have equal opportunity, right to work, and where there is no exploitation of the economically weak by the strong, thereby reducing the disparities in income and wealth to the minimum. 8.2.1 Economic Planning in India The first attempt at systematic planning in India was made by Sh. M. Visvesvaraya when he published his book Planned Economy for India in 1934. Three years later, in 1937, the Indian National Congress set up the National Planning Committee (under the chairmanship of Pt. Jawaharlal Nehru), which submitted its report as late as in 1948, since the Second World War and abnormal political developments in the country supervened. In the meantime, eight leading Bombay industrialists came out in 1943 with ‘a plan for Economic Development in India’, popularly known as ‘Bombay Plan’. The plan aimed at increasing per capita income by 100% (from ` 65 to ` 130) within 15 years. This can be attained by increasing agricultural production by 130% and the industrial output by 500%. It rendered top importance to core industries. Along with the Bombay Plan, People’s Plan is also implemented, which had a time period of ten years and involved a total expenditure of ` 15,000 crores. This plan gave priority to agriculture and consumer goods industries instead of basic industries. Apart from these non-official attempts, the Government of India also realised the need for planning and accordingly a Department of Planning and Development was set up in 1944, which took into account the short-term plans for making the economic environment normal after the war and long-term plans for economic development. 138 UNIT 08: Economic Planning in India JGI JAIN DEEMED-TO-BE UNIVERSIT Y However, the real beginning of planning in India was made in March 1950 when the Indian Planning Commission was set up with Pt. Jawaharlal Nehru as its chairman. In July 1951, the Planning Commission offered the First Five-Year Plan which covered the period from 1951 to 1956. In the first eight Five-Year Plans, the focus of the government was on the growing public sector and huge investments in core and heavy industries. However, with the Ninth Plan of 1997, the focus was changed from the public sector to the indicative nature of planning. Following are some of the major objectives of economic planning in India: To achieve a sizable increase in national income and per capita income To improve agricultural production for: Achieving self-sufficiency in food grains production Meeting the needs for industry and export To achieve industrialisation with special reference to basic and heavy industries To provide more employment opportunities To reduce inequalities in income and wealth distribution To achieve self-reliance To eradicate poverty To achieve economic growth and maintain price stability 8.2.2 Major Controversies on Planning in India In view of the many failures of the development efforts made so far as well as to meet the high aspirations of the people, a debate persists in the country as to how to carry out planning which must suit the present Indian situation. Some of the major controversies on planning in India are: Centralised Planning: The issues relating to centralised planning and decentralised planning are being discussed on two accounts. On one account, the controversy revolves around the pros and cons of the devolution of the political power of formulating and finding the plans from the centre to the states and, on another account, the arguments for and against one being given in respect of the use of the market in making and executing plan decisions as against government or a centralised agency like the Planning Commission doing both these jobs. Centralised planning is not a new way of resource use. In fact, planning first came on the world scene with this sort of planning in many of the socialist countries, beginning with the erstwhile USSR. It came to be adopted in a number of less-developed countries beginning with 1940. As such, planning came to comprehend all the inputs and outputs and incorporated innumerable details in respect of resources/factors and commodities and services. The non-socialist, less-developed countries which adopted this type of planning too went in for comprehensive plans. These plans encompassed the different units owning resources like private companies, cooperatives, individuals, and also the public sector. There is another core element of comprehensive planning, normally the use of implementing instruments largely nonmarket in character. The use of these instruments or means has yielded the administrations. Structuralist View: This type of planning got powerful support from those who held what may be called the structuralist view of development. According to this view, the less developed countries are characterised by a number of rigidities that inhibited or prevented these countries from undergoing any change. In other words, there was no growth. The underdeveloped countries which were found stuck into the mere subsistence living readily accepted this description of their state of affairs. They 139 JGI JAIN DEEMED-TO-BE UNIVERSIT Y Principles of Economics and Markets also readily embraced the solution. The structuralist view enables countries practising such planning to predetermine the use pattern of resources and also implement the same with predetermined means. The input–output system as one powerful tool could provide a picture of the economy in terms of its flow into production and flow out of it in terms of final commodities and servicing. A number of the less-developed countries, even though all were not socialist, also benefited a lot from this type of planning. Many of them were those newly liberated from colonial rule. They found in this method of planning a way to pool their resources so that these together looked big. While centralised planning was beneficial in various fields, the successes were only apparent. High costs are also involved when enterprises, both public and private, remain underutilised when these fall sick. Decentralised Planning: While the successes of centralised planning are acknowledged, its shortcomings are taken as ample evidence to do with this sort of planning. It is argued that the tight regime it involves cannot be accepted by the people who seek freedom in every sphere. In India and countries in a similar frame, a case is made out for decentralised planning. It is claimed that under this type of planning, the decision-making process is dispersed and the implementation of plans is carried through prices and incentives. The basic philosophy of decentralised planning involves the dispersal of planning, both in respect of the formulation of plans and their implementation. The central government and, to an extent, the state government, should shed off a part of their panning responsibilities and pass on the same to lower-level government of the district, blocks and villages under Panchayati Raj institutions. The motive behind this move is to ensure that the public would participate in the government and, through its representatives, shape the plan process. 8.3 FINANCE COMMISSION OF INDIA The Finance Commission of India was constituted by the President under article 280 of the Constitution, mainly to give its recommendations on the distribution of tax revenues between the Union and the States and amongst the States themselves. The Commission has two main objectives: 1. Redressing the vertical imbalances between the taxation powers and expenditure responsibilities of the centre and the States respectively 2. Maintaining equality of all public services across the States 8.3.1 Functions of Finance Commission of India Following are the functions of the Finance Commission of India: The distribution between the Union and the States of the net proceeds of taxes which are to be, or maybe, divided between them and the allocation between the States of the respective shares of such proceeds; Measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats in the State on the basis of the recommendations made by the Finance Commission of the State; Measures needed to augment the Consolidated Fund of a State to supplement the resources of the Municipalities in the State on the basis of the recommendations made by the Finance Commission of the State; Solution of any other matter referred to the Commission by the President in the interests of sound finance. The Commission determines its procedure and has such powers in the performance of their functions as the Parliament may by law confer on them. 140 UNIT 08: Economic Planning in India JGI JAIN DEEMED-TO-BE UNIVERSIT Y 8.4 IMPORTANCE OF NITI AAYOG The Government of India constituted the National Institution for Transforming India, also known as NITI Aayog, to replace the Planning Commission, which had been instituted in 1950. This step was taken to better serve the needs and aspirations of the people. An important evolutionary change, NITI Aayog acts as the quintessential platform of the Government of India to bring the States to act together in the national interest, thereby fostering cooperative federalism. It was formed through a resolution of the Union Cabinet on 1 January 2015. It is the premier policy think tank of the Government of India providing directional and policy inputs. Apart from designing strategic and long-term policies and programmes for the Government of India, NITI Aayog also provides relevant technical advice to the Centre, States and Union Territories. The Governing Council of NITI Aayog is chaired by the Hon’ble Prime Minister and comprises Chief Ministers of all the States and Union Territories with legislatures and Lt. Governors of other Union Territories. The Governing Council was reconstituted vide a notification dated 19 February 2021 by the Cabinet Secretariat. Objectives To evolve a shared vision of national development priorities, sectors and strategies with the active involvement of States. To foster cooperative federalism through structured support initiatives and mechanisms with the States on a continuous basis, recognising that strong States make a strong nation. To develop mechanisms to formulate credible plans at the village level and aggregate these progressively at higher levels of government. To ensure, on areas that are specifically referred to it, that the interests of national security are incorporated in economic strategy and policy. To pay special attention to the sections of our society that may be at risk of not benefiting adequately from economic progress. To design strategic and long-term policy and programme frameworks and initiatives, and monitor their progress and their efficacy. The lessons learnt through monitoring and feedback will be used for making innovative improvements, including necessary mid-course corrections. To provide advice and encourage partnerships between key stakeholders and national and international like-minded think tanks, as well as educational and policy research institutions. To create a knowledge, innovation and entrepreneurial support system through a collaborative community of national and international experts, practitioners and other partners. To offer a platform for the resolution of inter-sectoral and inter-departmental issues in order to accelerate the implementation of the development agenda. To maintain a state-of-the-art Resource Centre, be a repository of research on good governance and best practices in sustainable and equitable development as well as help their dissemination to stakeholders. To actively monitor and evaluate the implementation of programmes and initiatives, including the identification of the needed resources so as to strengthen the probability of success and scope of delivery. 141 JGI JAIN DEEMED-TO-BE UNIVERSIT Y Principles of Economics and Markets To focus on technology upgradation and capacity building for the implementation of programmes and initiatives. To undertake other activities as may be necessary in order to further the execution of the national development agenda, and the objectives mentioned above. 8.4.1 Functions of NITI Aayog NITI Aayog is developing itself as a state-of-the-art resource centre, with the necessary resources, knowledge and skills, that will enable it to act with speed, promote research and innovation, provide strategic policy vision for the government, and deal with contingent issues. NITI Aayog’s entire gamut of activities can be divided into four main heads: 1. Design Policy & Programme Framework 2. Foster Cooperative Federalism 3. Monitoring & Evaluation 4. Think Tank and Knowledge & Innovation Hub The different verticals of NITI Aayog provide the requisite coordination and support framework for NITI Aayog to carry out its mandate. The list of verticals is as below: 1. Agriculture 14. Natural Resources & Environment 2. Health 15. Science & Technology 3. Women & Child Development 4. Governance & Research 16. State Coordination & Decentralised Planning (SC&DP) 5. HRD 17. Social Justice & Empowerment 6. Skill Development & Employment 18. Land & Water Resources 7. Rural Development 19. Data Management & Analysis 8. Sustainable Development Goals 20. Public–Private Partnerships 9. Energy 21. Project Appraisal and Management Division (PAMD) 10. Managing Urbanisation 11. Industry 12. Infrastructure 22. Development Monitoring and Evaluation Office 23. National Institute of Labour Economics Research and Development (NILERD) 13. Financial Resources Conclusion 8.5 CONCLUSION Economic planning means the allocation of limited resources among different uses in such a way that it would bring about the maximum welfare for the people. Economic planning consists of two basic elements. One is the determination of objectives and the second is the provision of means for the achievements of the objectives. The fundamental objective of planning is to accelerate the economic development of a country by bringing about optimum utilisation of its resources so that the masses can have a reasonably high standard of economic well-being. 142 UNIT 08: Economic Planning in India JGI JAIN DEEMED-TO-BE UNIVERSIT Y The major controversies on planning in India include centralised planning, structuralist view of development and decentralised planning. The Finance Commission was constituted by the President under article 280 of the Constitution, mainly to give its recommendations on the distribution of tax revenues between the Union and the States and amongst the States themselves. The Government of India constituted the National Institution for Transforming India, also known as NITI Aayog, to replace the Planning Commission which had been instituted in 1950. This step was taken to better serve the needs and aspirations of the people. 8.6 GLOSSARY Centralised planning: A complete central control over major parts of the economic activities Decentralised planning: The execution of the plan from the grassroots Economic planning: Allocation of limited resources among different uses in such a way to bring about maximum welfare of the people 8.7 CASE STUDY: PARTNERSHIP BETWEEN NITI AAYOG AND IBM Case Objective This case study explains the functioning of NITI Aayog. The Indian government’s policy think tank, NITI Aayog decided in May 2018 to partner with IBM to develop a crop yield prediction model. The programme is targeting 10 districts and plans to use Artificial Intelligence (AI) to provide farmers with advisories in real time. According to the government’s press release, “bringing in future technologies like Artificial Intelligence into practical use will have tremendous benefits for the practice of agriculture in the country, improving efficiency in resource-use, crop yields and scientific farming. The ten Aspirational Districts chosen will be invigorated with cutting-edge technological support to leap-frog development of agri-based economies.” From the Press Information Bureau of the Government of India: “The partnership aims to work together towards the use of technology to provide insights to farmers to improve crop productivity, soil yield, and control agricultural inputs with the overarching goal of improving farmers’ incomes. The scope of this project is to introduce and make available climate-aware cognitive farming techniques and identifying systems of crop monitoring, early warning on pest and disease outbreak based on advanced AI innovations. It also includes deployment of weather advisory, rich satellite and enhanced weather forecast information along with IT and mobile applications with a focus on improving the crop yield and cost savings through better farm management.” Firstpost reports that the “first phase of the project will focus on developing a model for 10 backward districts — branded as aspirational districts by NITI Aayog — across Assam, Bihar, Jharkhand, Madhya Pradesh, Maharashtra, Rajasthan and Uttar Pradesh.” The press release adds that “IBM will be using Artificial Intelligence to provide all the relevant data and platform for developing technological models for improving agricultural output and productivity for various crops and soil types, for the identified districts. NITI Aayog, on its part, will facilitate the inclusion of more stakeholders on the ground for effective last-mile utilisation and extension, using the insights generated through these models.” 143 JGI JAIN DEEMED-TO-BE UNIVERSIT Y Principles of Economics and Markets Questions 1. How will the partnership help farmers? (Hint: Providing insights to farmers to improve crop productivity, soil yield, control agricultural inputs with the overarching goal of improving farmers’ incomes) 2. What is the scope of this project? (Hint: To introduce and make available climate-aware cognitive farming techniques and identifying systems of crop monitoring) 8.8 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. The fundamental objective of planning is to accelerate the economic development of a country. What is economic planning? Discuss economic planning in India. 2. The controversy revolves around the pros and cons of the devolution of the political power of formulating and finding the plans from the centre to the states. Explain major controversies on planning in India. 3. The Finance Commission determines its procedure and has such powers in the performance of their functions as the Parliament may by law confer on them. What are the functions of the Finance Commission of India? 4. Explain the importance of NITI Aayog. 5. What are the objectives of NITI Aayog? 8.9 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS A. Hints for Essay Type Questions 1. Economic planning means the allocation of limited resources among different uses in such a way that it would bring about the maximum welfare for the people. Economic planning consists of two basic elements. One is the determination of objectives and the second is the provision of means for the achievements of the objectives. The detailed scheme is called an economic plan. Refer to Section Concept of Economic Planning 2. In view of the many failures of the development efforts made so far as well as to meet the high aspirations of the people, a debate persists in the country as to how to carry out planning which must suit the present Indian situation. Refer to Section Concept of Economic Planning 3. The Finance Commission of India is responsible for the distribution between the Union and the States of the net proceeds of taxes which are to be, or maybe, divided between them and the allocation between the States of the respective shares of such proceeds. Refer to Section Finance Commission of India 4. The Government of India constituted the National Institution for Transforming India, also known as NITI Aayog, to replace the Planning Commission, which had been instituted in 1950. This step was taken to better serve the needs and aspirations of the people. An important evolutionary change, NITI Aayog acts as the quintessential platform of the Government of India to bring the States to 144 UNIT 08: Economic Planning in India JGI JAIN DEEMED-TO-BE UNIVERSIT Y act together in the national interest, thereby fostering cooperative federalism. Refer to Section Importance of NITI Aayog 5. NITI Aayog aims to foster cooperative federalism through structured support initiatives and mechanisms with the States on a continuous basis, recognising that strong States make a strong nation. Refer to Section Importance of NITI Aayog @ 8.10 POST-UNIT READING MATERIAL https://byjus.com/free-ias-prep/ias-preparation-economy-planning-in-india/ https://nios.ac.in/media/documents/SrSec318NEW/318_Economics_Eng/318_Economics_Eng_ Lesson2.pdf 8.11 TOPICS FOR DISCUSSION FORUMS Find information on the current Five-Year Plan of India. 145 UNIT 09 Business Cycle Names of Sub-Units Business Cycle – Features, Phases, Causes and Measures for Controlling Business Cycles, Concept of Inflation, Deflation, FDI, National Income – Concepts and Measurements Overview The unit begins by explaining the concept of business cycles, its features, causes and different phases. The unit further explains the concept of inflation, its causes and measurement. Towards the end, the unit discusses the concept of national income and ways to express national income. Learning Objectives In this unit, you will learn to: Explain business cycles List different stages of business cycles Describe the concepts of inflation and deflation Explain the meaning and significance of national income Discuss three ways of expressing national income Learning Outcomes At the end of this unit, you would: Assess the effects of business cycles on an economy Analyse the causes of inflation Evaluate national income JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets 9.1 INTRODUCTION Business cycles can be defined as recurring and fluctuating levels of economic activity of a country. In other words, business cycles refer to ups and downs in aggregate economic activity, measured by fluctuations in various macroeconomic variables, such as Gross Domestic Product (GDP), employment, and rate of consumption. Generally, an economy experiences business cycles over a long period of time. Earlier, business cycles were thought to be periodic with anticipated durations. However, in recent times, business cycles are widely believed to be irregular features of an economy, varying in frequency, degree, and time interval. For example, the period of Great Depression in the 1930s experienced a decline in economic activity for more than 40 months. However, since World War II, most of the business cycles have persisted for the period of three to five years. A business cycle is characterised by a sequence of five phases, namely, expansion, peak, recession, trough, and recovery. When an economy enters into the expansion phase, there is an increase in various economic factors, such as output, national income, employment, prices, and profits. In addition, in the expansion phase, there is also a rise in the standard of living. After a certain point of time, expansion reaches its maximum level and economic factors become stable. This situation is termed as the peak phase of a business cycle. Gradually, there is a decline in the economic activities, which marks the beginning of the recession phase of a business cycle. In the recession phase, entrepreneurs become pessimistic about their growth and avoid any type of investments. In addition, they start slashing costs by laying off people and discontinuing replacement of capital goods. Consequently, the increased rate of unemployment causes a rapid decline in income and aggregate demand. This decline in economic factors reaches a certain limit after which there is no further fall in economic factors. This is known as the trough phase of a business cycle. In the trough phase, individuals and organisations assume that after a decline in economy there would be expansion, thus, develop an optimistic approach. As a result, the economic activities start expanding, which is the starting of the recovery phase. When an economy moves from expansion phase to recovery phase, it marks the completion of a business cycle. 9.2 CONCEPT OF BUSINESS CYCLE Business cycles, also called trade cycles or economic cycles, refer to perpetual features of the economic environment of a country. In simple words, business cycles can be defined as fluctuations in the economic activities of a country. The economic activities of a country include total output, income level, prices of products and services, employment, and rate of consumption. All these activities are interrelated; if one activity changes, rest of them would also show changes. These changes in the economic activities together produce a bigger change in the overall economy of a nation. This overall change in an economy is termed as a business cycle. Business cycles are generally regular and periodical in nature. Some of the management experts have defined business cycles in the following ways: According to Arthur F. Burns and Wesley C. Mitchel, “Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; in duration, business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar characteristics with amplitudes approximating their own.” According to Parkin and Bade’s, “The business cycle is the periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real GDP and other macroeconomic variables. A business cycle is not a regular, predictable, or repeating phenomenon like the swing of the pendulum of a clock. Its timing is random and, to a large degree, unpredictable.” 148 UNIT 09: Business Cycle JGI JAIN DEEMED-TO-BE UNI VE RSI TY According to Keynes, “Trade Cycle is composed of periods of good trade characterized by rising price and low unemployment percentage altering with periods of bad trade characterized by falling price and high unemployment percentage.” From the aforementioned definitions, business cycles are characterised by boom in one period and collapse in the subsequent period in the economic activities of a country. Business cycles affect the business decisions of organisations to a large extent and set future business trends. For example, the period of boom opens up several investment, production, and credit opportunities for organisations. On the other hand, period of economic slump reduces business opportunities for organisations. Therefore, an organisation needs to analyse the economic environment of a country before making any business decisions. 9.2.1 Features of Business Cycle The following are the features of business cycle: Periodic occurrence: Business cycles are not constant features of an economy. Their time periods vary according to the nature of industries and the economic conditions. Their duration may vary from anywhere between 2-10 years. Even the intensity of the phases is different. For example, the firm may see tremendous growth followed by a shallow short-lived depression phase. Synchronous: Business cycles are not restricted to one firm or one industry. They originate in the free economy and are pervasive in nature. A disturbance in one industry quickly spreads to all the other industries and finally affects the economy as a whole. For instance, a recession in the plastic industry will set off a chain reaction until there is a recession in the entire economy. All sectors are affected: All major sectors of the economy face the adverse effects of a business cycle. Some industries like the capital goods industry, consumer goods industry may be disproportionately affected. So the investment and the consumption of capital goods and durable consumer goods face the maximum brunt of the cyclic fluctuations. Non-durable goods do not face such problems generally. Complex phenomenon: Business cycles are complex and dynamic phenomenon. They do not have any uniformity. There are no set causes for business cycles as well. So it is nearly impossible to predict or prepare for these business cycles. Affect all departments: Business cycles are not only limited to the output of goods and services. It affects all other variables as well, such as employment, the rate of interest, price levels, investment activity etc. Global effect: Business cycles are contagious. They do not limit themselves to one country or one economy. Once they start in one country they will spread to other countries and economies via trade relations and international trade practices. 9.2.2 Phases of Business Cycle As discussed earlier, business cycles are characterised by boom in one period and collapse in the subsequent period in the economic activities of a country. These fluctuations in the economic activities are termed as phases of business cycles. The fluctuations are compared with ebb and flow. The upward and downward fluctuations in the cumulative economic magnitudes of a country show variations in different economic activities in terms of production, investment, employment, credits, prices, and wages. Such changes represent different phases of business cycles. 149 JGI JAIN Principles of Economics and Markets DEEMED-TO-BE UNI VE RSI TY The different phases of business cycles are shown in Figure 1: Phases of Business Cycles Expansion Peak Recession Trough Recovery Figure 1: Different Phases of a Business Cycle There are basically two important phases in a business cycle that are prosperity and depression. The other phases that are expansion, peak, trough and recovery are intermediary phases. Figure 2 shows the graphical representation of different phases of a business cycle: Peak Expansion Steady Growth Line Recession Expansion Prosperity Prosperity Depression Recovery Line of Cycle Trough Figure 2: Representation of Phases of a Business Cycle As shown in Figure 2, the steady growth line represents the growth of economy when there are no business cycles. On the other hand, the line of cycle shows the business cycles that move up and down the steady growth line. The different phases of a business cycle (as shown in Figure 2) are explained in the next sections. Expansion The line of cycle that moves above the steady growth line represents the expansion phase of a business cycle. In the expansion phase, there is an increase in various economic factors, such as production, employment, output, wages, profits, demand and supply of products, and sales. In addition, in the expansion phase, the prices of factors of production and output increase simultaneously. In this phase, debtors are generally in a good financial condition to repay their debts; therefore, creditors lend money at higher interest rates. This leads to an increase in the flow of money. In expansion phase, due to increase in investment opportunities, idle funds of organisations or individuals are utilised for various 150 UNIT 09: Business Cycle JGI JAIN DEEMED-TO-BE UNI VE RSI TY investment purposes. Therefore, in such a case, the cash inflow and outflow of businesses are equal. This expansion continues till the economic conditions are favourable. Peak The growth in the expansion phase eventually slows down and reaches to its peak. This phase is known as peak phase. In other words, peak phase refers to the phase in which growth rate of business cycle achieves its maximum limit. In peak phase, the economic factors, such as production, profit, sales, and employment, are higher, but do not increase further. In peak phase, there is a gradual decrease in the demand of various products due to increase in the prices of input. The increase in the prices of input leads to an increase in the prices of final products, while the income of individuals remains constant. This also leads consumers to restructure their monthly budget. As a result, the demand for products, such as jewellery, homes, automobiles, refrigerators and other durables, starts falling. Recession As discussed earlier, in peak phase, there is a gradual decrease in the demand of various products due to increased input prics. When the decline in the demand of products becomes rapid and steady, the recession phase takes place. In recession phase, all the economic factors, such as production, prices, saving and investment, starts decreasing. Generally, producers are unaware of decrease in the demand of products and they continue to produce goods and services. In such a case, the supply of products exceeds the demand. Over the time, producers realise the surplus of supply when the cost of manufacturing of a product is more than profit generated. This condition firstly experienced by few industries and slowly spread to all industries. This situation is firstly considered as a small fluctuation in the market, but as the problem exists for a longer duration, producers start noticing it. Consequently, producers avoid any type of further investment in factor of production, such as labor, machinery, and furniture. This leads to the reduction in the prices of factor, which results in the decline of demand of inputs as well as output. Trough During the trough phase, the economic activities of a country decline below the normal level. In this phase, the growth rate of an economy becomes negative. In addition, in trough phase, there is a rapid decline in national income and expenditure. In this phase, it becomes difficult for debtors to pay off their debts. As a result, the rate of interest decreases; therefore, banks do not prefer to lend money. Consequently, banks face the situation of increase in their cash balances. Apart from this, the level of economic output of a country becomes low and unemployment becomes high. In addition, in trough phase, investors do not invest in stock markets. In trough phase, many weak organisations leave industries or rather dissolve. At this point, an economy reaches to the lowest level of shrinking. Recovery As discussed in the previous section, in trough phase, an economy reaches the lowest level of shrinking. This lowest level is the limit to which an economy shrinks. Once the economy touches the lowest level, it happens to be the end of negativism and beginning of positivism. This leads to reversal of the process of business cycle. As a result, individuals and organisations start developing a positive attitude toward the various economic factors, such as investment, employment, and production. This process of reversal starts from the labour market. Consequently, organisations discontinue laying off individuals and start hiring, but in limited number. At this stage, wages provided by organisations to individuals is less as compared to their skills and abilities. This marks the beginning of the recovery phase. In the 151 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets recovery phase, consumers increase their consumption rate , as they assume that there would be no further reduction in the prices of products. As a result, the demand for consumer products increases. In addition, in recovery phase, bankers start utilising their accumulated cash balances by declining the lending rate and increasing investment in various securities and bonds. Similarly, adopting a positive approach other private investors also start investing in the stock market. As a result, security prices increase and rate of interest decreases. Price mechanism plays a very important role in the recovery phase of economy. As discussed earlier, during recession, the rate at which the price of factor of production falls is greater than the rate of reduction in the prices of final products. Therefore, producers are always able to earn a certain amount of profit, which increases at trough stage. The increase in profit also continues in the recovery phase. Apart from this, in recovery phase, some of the depreciated capital goods are replaced by producers and they maintain some. As a result, investment and employment by organisations increases. As this process gains momentum, an economy again enters into the phase of expansion. Thus, a business cycle gets completed. 9.2.3 Causes of Business Cycle Business cycles in an economy can be caused by many factors in combination. These factors can be internal to an organisation or external (which may lead to a boom or bust of an economy). Let us discuss these causes of business cycles. Internal causes: These internal factors can lead to changes in the phases of the firm and the economy in general. Some of these internal causes are explained as follows: 9.2.4 Changes in demand Fluctuations in investments Changes in economic policies Supply of money External causes: Some of these external causes are explained as follows: Contingencies like wars Technology shocks Natural factors like floods, droughts, hurricanes, etc. Population expansion Measures for Controlling Business Cycles Business cycles can have positive or negative effects on an economy. For example, in the expansion phase, there can be a rapid economic growth, whereas unemployment and poverty may exist in a country during the recession period. Therefore, government and economists strive to take different measures for controlling economic fluctuations and make the economy run back on growth path. These measures came into existence after 1930s, when the whole world was facing the great depression. Before great depression, economists had a view that market forces work automatically to make the economy stable. However, great depression proved that the market forces do not work automatically otherwise depression would not take place. Therefore, government formulates certain policies and takes measures for increasing and maintaining the growth rate of economy. These measures help in controlling severe fluctuations in an economy. 152 UNIT 09: Business Cycle JGI JAIN DEEMED-TO-BE UNI VE RSI TY Preventing the economy from severe fluctuations is termed as stabilisation of economy. A stabilised economy is characterised by relatively an increased level of employment, output, and consumption. In addition, in a stabilised economy, the government plays a major in controlling the business activities of public and private sectors. The main problem of developing countries in stabilising their economy is to control prices, whereas in developed countries, the problem is to control the further decline of growth rate. The main goals of policies formulated for stabilising the economy are as follows: Avoiding extreme fluctuations in the economy and encouraging fluctuations that are required for economic growth Making optimum utilisation of available resources Inspiring free competitive enterprise that would not affect the overall market economy Preventing dispute between internal and external economy The two most commonly used stabilisation policies are fiscal and monetary policies. In case these two policies fail to overcome the economic problem, then the government uses various direct control measures. 9.3 CONCEPT OF INFLATION It is easy to measure the changes in the price of one product at a time but people do not use only one product at a time in an economy, there are multiple products and services that are exchanged for money or money’s value. Therefore, measuring inflation is not easy as every product or services would have different rates of increase in prices depending on various factors. Inflation rate is therefore the average price change for all the set of products and services in an economy over a period of time and a single value representation is acceptable by all. The impact of inflation is that the currency value decreases, prices increase and in exchange of the same units of currency lesser goods and services could be bought. This affects the cost of living of people and brings down economic growth. There is a sustained inflation happens when the supply of money is more than the economic growth. The country’s monetary authority generally is the central bank, takes appropriate measures to manage the supply of money to maintain the inflation rate within the limits and allow smooth functioning of the economy. Inflation is measured according to the types of goods and services considered. The main cause of inflation is the rise in prices due to increase in the supply of money. The supply of money increases due to the different mechanism operational in the economy. The main reason for increase in the supply of money could be due to fiscal policies of the government where more currency is printed to give to the individuals legally and thus decreasing the value of the currency. More money is made available by granting loans and creating reserve accounts in banks. There are three main reasons for inflation: 1. Demand pull inflation: The situation where there are not enough goods and services produced to match the supply and price increases is called demand pull inflation. 2. Cost push inflation: The situation where cost of production of goods and services increases, the price of the finished goods and services also increases is called cost push inflation. 3. Built in inflation: This is also called as “wage-price spiral”- where manpower becomes expensive due to rising cost of living, the prices of the finished goods and services increases. 153 JGI 9.3.1 JAIN Principles of Economics and Markets DEEMED-TO-BE UNI VE RSI TY Measuring Inflation The goods and services are categorised in multiple types of goods and services and are calculated and tracked as price indexes. The most common price indexes used are Consumer Price Index (CPI) and the Whole sale Price Index (WPI). Consumer Price Index (CPI): this is the weighted average price of a collection of goods and services that the primary needs of the consumers. Some examples of these kinds of goods and services are all the food and medical items, transportation. The price change of each item of food, medicine, transport is taken and they are averaged out on the basis of their relative weight in the entire collection of goods and services. Here retail prices are considered (consumer price). Thus CPI is also an indicator of the cost of living of the economy. Thus it is most commonly used to measure inflation or deflation. In some countries like US CPI is reported on a monthly basis. Wholesale Price Index (WPI): as the name suggests this includes the price changes at the wholesale level and not at the retail level. Here all the items included are at the business level that is produced or wholesale level. Some examples are cotton prices for raw cotton, cotton yarn, cotton gray goods and cotton clothing. Most countries use but some countries like US use a similar kind of variant which is called Producer Price Index (PPI). Producer Price Index (PPI): the average change in selling prices received by domestic producers of intermediate goods and services over a period of time. Therefore changes in the price are considered from the point of view of the seller. In all the above variants, it may happen the rise in price of one particular good can set off the price decrease of some other good. For example, the rise in the price of petrol may compensate the decrease in the price of wheat to some extent. Each index is an average weighted price change for its basket of goods and services in the economy. Formula for Measuring Inflation The above price indexes are used to calculate the value of inflation between two comparative months or years. Nowadays, there are a lot of automatic inflation calculators available on various websites and portals, but one should know how to calculate to develop better understanding. The formula of inflation mathematically is: Percent Inflation Rate = Final CPI Index Value Initial CPI Value × 100 If the purchasing power of ` 10000 changes from January 1975 and January 2020. Then you need to find the price index data in a tabular form. Take the CPI figures for the given two months i.e. January 1975 and January 2020 and use it in the above formula. Per cent Inflation Rate = (252.439/54.6) × 100 = (4.6234) × 100 = 462.34% Therefore, ` 10000 of January 1975 will be 10000 × 462.34% more. Change in currency value = 4.6234 × ` 10,000 = ` 46,234 Therefore, ` 10000 in January 1975 is now worth ` 46234. Therefore, the basket of goods will now be with this value. 154 UNIT 09: Business Cycle 9.3.2 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Deflation Inflation is opposite of deflation where there is a decline of prices. Deflation happens when the inflation rate is below 0%. Deflation refers to a general decline in prices for goods and services, typically associated with a contraction in the supply of money and credit in the economy. During deflation, the purchasing power of currency rises over time. Deflation causes the nominal costs of capital, labour, goods, and services to fall, though their relative prices may be unchanged. Deflation has been a popular concern among economists for decades. On its face, deflation benefits consumers because they can purchase more goods and services with the same nominal income over time. 9.4 NATIONAL INCOME National income is defined as the market value of all final goods and services produced in a country during a year, accounted for any duplication. The national income equation is as follows: Y/NY = C +I + G + X – M Where Y/NY stands for income/national income, C for consumption, I for investment expenditure, G for government expenditure and X – M is exports less imports – that is net of foreign trade. With respect to national income, some points need to be highlighted as follows: GDP refers to total market values. That is only those goods that are recorded in market transactions will be considered for national income. We aggregate output from different sectors by multiplying the quantity of output with their prices. For example, if 1 lakh pens were produced last year and sold at `10 per unit, then the national income from this industry is 1,00,000 × ` 10 = 10,00,000 or ` 10 lakhs. National income includes only final goods, i.e., only those goods that go into the hands of final consumers are considered. Intermediate products are not considered. Whether a good is final good or intermediate product depends on whether it is being used for consumption or for further processing in production. For example, if cotton has been purchased by a consumer for giving first aid, then it is a final product. However, if the same cotton is purchased by a textile factory for stitching it into a cotton shirt, then it becomes an intermediate product. The reference period is the accounting year of that country. However, countries typically publish quarterly and half-yearly data as well, just for information purpose. Without duplication means avoiding double counting. For instance, in the above example, if we count the value of cotton as a raw material when it was purchased as an intermediate product and again add its value in the final price of the shirt, then we are doing the mistake of double counting. This will push up national income figures and give us erroneous results. The reason for the differences in the standard of living of countries is due to their ability to produce goods and services. Productivity, defined as the quantity of goods and services produced from each factor unit, will determine a country’s prosperity. The higher the productivity, the richer the country will be. In the four-sector model consisting of households, businesses, governments and the rest of the world, the participation of economic factors in producing goods and services, creates the various underlying transactions and inter-relationships. The households are the consumers. To consume goods and services, they need to buy goods and services. To buy these goods, they need money. To earn money, they offer their factor services. Businesses also need money to survive. They need consumers to buy what they 155 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets produce. They also need people who will help them in producing these goods and services. At the same time, we need a government that not only protects its people from internal disturbances and external aggression but also plays a pivotal role in the economic development of a country. Such a role is made possible by its expenditure on various activities such as building roads, bridges, granting subsidies and producing public goods. However, to fund these activities, it also needs money. Taxes and debts are the two instruments used by the government to fund its operations. Today, no country is isolated and there are hardly any closed economies. Every country is dependent on some other country as well as buys and sells various goods and services. We buy what we need and we sell what others need, thereby generating incomes from and to the rest of the world. All this creates complex interrelationships that help in the functioning of the economy. The usefulness of the national income estimate can be explained using the following points: National income (NY) accounts indicate the prosperity of a nation. Growth in national income means an increase in economic prosperity. It indicates the standard of living of the people of a country. The per capita income levels help us to compare the levels of development of all the countries. Countries can be classified as ‘developed’, ‘developing’ and ‘underdeveloped’ based on their per capita income. NY estimates are very useful to the Finance Minister in making decisions about taxation and budgets. It is useful to compare the prosperity of one country at different times so that the government can gauge whether the economy is growing, slowing or stagnant. Important policy actions can be taken on the basis of such information. It provides an instrument of economic planning. It indicates the trends of inflation and deflation. Proper corrective action can be taken against whom? 9.5 THREE WAYS OF EXPRESSING NATIONAL INCOME The three ways of expressing national income are explained as follows: 1. Gross and Net Concepts: Gross less depreciation gives net figures. The reduction in the value of capital goods over a period of time due to physical wear and tear or obsolescence is called depreciation or capital consumption allowance. Every year, capital goods such as buildings and machinery undergo wear and tear, which results in a decrease in their book values (that is the price at which they were bought and recorded in the accounts books). This decrease in value should be recorded so that we have a true value of the capital good. For instance, the gross domestic product minus depreciation gives us the net domestic product, gross national product minus depreciation gives us the net national product. Therefore, the first rule to be remembered is any gross minus depreciation gives us net. G–D=N Or Gross product – Depreciation = Net product 2. National and Domestic Concepts: The national product includes the income earned by resident Indians and excludes the income earned in India by non-residents. The domestic product refers to the total market value of all final goods and services produced by factors of production located within a nation’s borders. 156 UNIT 09: Business Cycle JGI JAIN DEEMED-TO-BE UNI VE RSI TY The second rule is any national product less net factor income earned from abroad is equal to domestic product. NP – NFIA = DP Or National product – Net factor income earned from abroad = Domestic Product Net factor income is derived by deducting the incomes earned by Indians abroad from incomes earned by foreigners in our country. It is net of these two incomes. 3. Market Prices and Factor Costs: Market prices less indirect taxes give factor costs. The national income at the market price differs from the national income at factor cost because it excludes the indirect business taxes such as sales taxes and including business subsidies. When goods are sold in the marketplace, their purchase price is typically distorted by some sort of sales tax. These taxes on production and imports do not represent payment to factors of production. Therefore, all such taxes have to be deducted to know the actual costs of production. Similarly, when paying out subsidies, a part of the costs of production are borne by the government to support some sectors such as agriculture, small scale industries, export companies, subsidised ration shops and petrol. All these have to be added back because only then we will get the correct costs of production figures. This brings us to the third rule. Market prices less indirect taxes plus subsidies are equal to the factor costs. MP – IT + S = FC Or Market prices – indirect taxes + subsidies = Factor costs 9.6 BASIC CONCEPTS OF NATIONAL INCOME Before studying how national income accounting is done, it is important to be acquainted with the basic concepts related to national income. GDP: GDP is defined as the total market value of all final goods and services produced by factors of production located within a country’s borders. Net Domestic Product (NDP): Gross Domestic Product less depreciation equals Net Domestic Product. We have already discussed that depreciation is the capital consumption allowance set aside to compensate for the reduction in the value of capital goods over a one-year period due to physical wear and tear or obsolescence. NDP = GDP – Depreciation GDP = C + I + G + X - M NDP = C + Net I + G + X – M Where Net Investment = Gross I – Depreciation Or domestic investment minus an estimate of the wear and tear on the existing capital stock. Gross National Product (GNP): Gross national product (GNP) is the sum total of all incomes earned by a nation’s permanent residents (called nationals). You have already studied that GNP includes the income earned by resident Indians and excludes the income earned by foreigners in India. In other words, GNP less net factor income earned from abroad is equal to GDP. 157 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Net National Product (NNP): Net National Product (NNP) is the total income of the nation’s residents (GNP) minus losses from depreciation. That is GNP – Depreciation = NNP Personal Income: The income received by households before the payment of personal taxes is called personal income. PI = NY – Indirect taxes – corporate profits – interest and miscellaneous payments – social security taxes + transfer payments + capital income (capital gains/losses) Private Income: Private income is defined as the total income including transfer incomes received by private sector. Private sector consists of private enterprises and households located within and outside the country. Private income includes NFIA. It means that private income includes not only factor incomes earned within the domestic territory and abroad but also all current transfers from government and the rest of the world. Private Income = Income from domestic product earned by private sector + Net factor income from abroad + All types of transfer incomes. The difference between personal income and private income is Personal income = Private income – Corporate tax – Undistributed profit That is personal income is broader than private income. Personal Disposable Income (PDI) and National Disposable Income (NDI): Personal income less personal taxes is equal to personal disposable income. PDI = PI – PT DI = C + S Where DI stands for disposable income, PI for personal income and PT for personal taxes. DI is the sum of consumption plus savings. They do not receive all incomes earned by an individual. This is because personal income is reduced for indirect taxes, corporate profits, interest and miscellaneous payments, social security taxes, which are not paid out to the individual. Similarly, transfer payments representing those incomes that are received but not earned by the individual are added to PI because they are now part of the individual’s income and so will be considered for income tax. However, all incomes received by the individuals, logically speaking will also not be spent totally. A part of it will be consumed and a part of it will be saved. Therefore, DI equals consumption plus savings. Let us see a numerical example of how personal outlay (PO) is derived from GDP National Disposable Income (NDI): It is defined as the net national product at market prices (NNPMP) plus net current transfers from the rest of the world. National disposable income = National income + Net indirect taxes + Net current transfers from the rest of the world NDI is the income that is at the disposal of the nation as a whole for spending. Real Income: Real income refers to the purchasing power of money. It is calculated as money income less inflation. For instance, if your money income stays constant at ` 10000 per month, but if prices continue to rise then your real income will fall, i.e., the amount of goods and services which money income can buy denoted as real income has fallen. 9.7 NATIONAL INCOME AGGREGATES To determine the actual performance of an economy, economists rely on the use of national income (macro) aggregates. There are various types of national income aggregates as discussed in the upcoming sections. 158 UNIT 09: Business Cycle JGI JAIN DEEMED-TO-BE UNI VE RSI TY Various national income aggregates are as follows: Gross Domestic Product at Factor Cost (GDP-FC): GDP at factor cost refers to the sum of domestic factor incomes and consumption of fixed capital. Mathematically, GDP at factor cost is calculated as: GDPfc = GDPmp – IT + S Or GDPfc = GNPfc – NFIA Gross Domestic Product at Market Price (GDP-MP): GDP at market price refers to the market value of all goods and services produced in the country. Mathematically, GDP at market price is calculated as: GDPmp = GDPfc + Indirect Taxes Or GDPmp = GNPmp – NFIA Net Domestic Product at Factor Cost (NDP-FC): It is calculated as: NDPfc = NDPmp – Indirect Taxes Or NDPfc = GDPfc – Depreciation Net Domestic Product at Market Prices (NDP-MP): It is calculated as: NDPfc = NDPmp – Indirect Taxes Or NDPmp = GDPmp – Depreciation Gross National Product at Factor Cost (GNP-FC): It is calculated as: GNPfc = GNPmp – Indirect Taxes Or GNPfc = GDPfc + NFIA Gross National Product at Market Prices (GNP-MP): It is calculated as: GNPmp = GNPfc + Indirect Taxes Or GNPmp = GDPmp + NFIA Net National Product at Factor Cost (NNP-FC)/National Income (NI): It is calculated as: NNPfc = NNPmp – IT + S Or NNPfc = GDPfc – Depreciation NNPfc is the country’s true national income among all the eight concepts. National Income is the total income earned by a nation’s residents in the production of goods and services. NNP at factor cost differs from NNP at market price by excluding indirect business taxes (such as sales taxes) and including business subsidies. 159 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Net National Product at Market Prices (NNP-MP): It is calculated as: NNPmp = NNPfc + Indirect Taxes Or NNPmp = GDPmp – Depreciation Conclusion 9.8 CONCLUSION Business cycles, also called trade cycles or economic cycles, refer to perpetual features of the economic environment of a country. In simple words, business cycles can be defined as fluctuations in the economic activities of a country. The five phases of business cycles are expansion, peak, recession, trough and recovery. Inflation rate is the average price change for all the set of products and services in an economy over a period of time and a single value representation is acceptable by all. The main cause of inflation is the rise in prices due to increase in the supply of money. The supply of money increases due to the different mechanism operational in the economy. There are three main reasons for inflation: Demand pull inflation, cost push inflation and built in inflation. National income is defined as the market value of all final goods and services produced in a country during a year, accounted for any duplication. National income accounts are useful in several ways. National income (NY) accounts indicate the prosperity of a nation. Growth in national income means an increase in economic prosperity. By comparing the standard of living of the people of a country using per capita income levels countries are classified as ‘developed’ and ‘developing’ and ‘underdeveloped’. Gross less depreciation gives net figures. The reduction in the value of capital goods over a period of time due to physical wear and tear or obsolescence is called as depreciation or capital consumption allowance. National product refers to the total income earned by a country’s residents. National product includes the income earned by resident Indians and excludes the income earned, in India, by nonresidents. Domestic product refers to the total market value of all final goods and services produced by factors of production located within a nation’s borders. Market prices less indirect taxes give factor costs. Market prices product differs from factor cost product by excluding indirect business taxes such as sales taxes and including business subsidies. 9.9 GLOSSARY Disposable income: The income that remains after deducting taxes from the income received by an individual or entity Factor cost: The total cost of all factors of production that are used in the production of goods or services Inflation rate: The average price change for all the set of products and services in an economy over a period of time 160 UNIT 09: Business Cycle JGI JAIN DEEMED-TO-BE UNI VE RSI TY 9.10 CASE STUDY: THE BUSINESS CYCLE OF ABC COUNTRY Case Objective This case study explains different phases of business cycles in ABC country. ABC country was facing a downturn in its economy. All the economic factors, such as production, prices, savings, and investment, of the country started decreasing. In the initial phases of downturn, businessmen were not able to recognise it. They considered it minor fluctuations in the economy, which market forces can easily handle. Therefore, they continued to produce goods and services at the same rate as they were doing earlier. As a result, the supply of goods and services exceeded the demand. Gradually, businessmen realised that they had overinvested. This problem of one industry spread in other industries, due to interlink among different industries. At this time, businessmen stopped any type of further investment in consumer and capital goods. Consequently, they started reducing the cost on labour, machinery, furniture, and other factors of production. As a result, various economic factors, such as consumption, savings and employment, started decreasing. In addition, debtors were not able to repay their debts and creditors were not ready to lend more money. Apart from this, individuals and businesses were not ready to invest in stock markets. Many weak organisations left industries or dissolved. At this point of time, the economy had reached its bottom level and from this point, individuals and organisations tried to become optimistic. Therefore, organisations started hiring employees at low wages. Employees accepted the amount of salary provided to them by organisations because they wanted to fulfil their basic needs. In addition, consumers also believed that the price of products and services would not fall now. Therefore, they started increasing their consumption rate. This consumption rate stimulated the demand and consequently the production. As a result, the investment and bank credit also increased. Thus, the economy started running back on the growth path. Questions 1. What are the phases of business cycle explained in the case study? (Hint: Recession, trough, and recovery) 2. What are the main causes of recession in ABC country? (Hint: Unawareness of businessmen about the decline in economy.) 3. When did businessmen realise that they overinvested? (Hint: When supply exceeded demand) 4. What happened when businessmen started decreasing cost on labour, machinery, furniture, and other factors of production? (Hint: Various economic factors, such as consumption, savings and employment, started decreasing) 5. Why did employees accept the amount of salary provided to them by organisations? (Hint: To fulfil their basic needs) 161 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets 9.11 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. What are business cycles? Discuss the causes of business cycles. 2. What are the phases of business cycles? 3. Explain measures for controlling business cycles. 4. Define inflation. What are the three main reasons of inflation? 5. What is national income? Discuss three ways of expressing national income. 9.12 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS A. Hints for Essay Type Questions 1. Business cycles can be defined as fluctuations in the economic activities of a country. The economic activities of a country include total output, income level, prices of products and services, employment, and rate of consumption. All these activities are interrelated; if one activity changes, rest of them would also show changes. Refer to Section Concept of Business Cycle 2. Business cycles are characterised by a boom in one period and collapse in the subsequent period in the economic activities of a country. These fluctuations in the economic activities are termed as phases of business cycles. The fluctuations are compared with ebb and flow. The upward and downward fluctuations in the cumulative economic magnitudes of a country show variations in different economic activities in terms of production, investment, employment, credits, prices, and wages. Such changes represent different phases of business cycles. Refer to Section Concept of Business Cycle 3. Business cycles can have positive or negative effects on an economy. For example, in the expansion phase, there can be a rapid economic growth, whereas unemployment and poverty may exist in a country during the recession period. Therefore, government and economists strive to take different measures for controlling economic fluctuations and make the economy run back on growth path. These measures came into existence after 1930s, when the whole world was facing great depression. Before great depression, economists had a view that market forces work automatically to make the economy stable. However, great depression proved that the market forces do not work automatically otherwise depression would not take place. Refer to Section Concept of Business Cycle 4. The impact of inflation is that the currency value decreases, prices increase and in exchange of the same units of currency lesser goods and services could be bought. This affects the cost of living of people and brings down economic growth. There is a sustained inflation happens when the supply of money is more than the economic growth. The monetary authority of the country generally is the central bank, takes appropriate measures to manage the supply of money to maintain the inflation rate within the limits and allow smooth functioning of the economy. Inflation is measured according to the types of goods and services considered. Inflation is opposite of deflation where there is a decline of prices. Deflation happens when the inflation rate is below 0%. Refer to Section Concept of Inflation 5. National income is defined as the market value of all final goods and services produced in a country during a year, accounted for any duplication. Refer to Section National Income 162 @ 9.13 POST-UNIT READING MATERIAL UNIT 09: Business Cycle JGI JAIN DEEMED-TO-BE UNI VE RSI TY https://www.businessinsider.in/finance/news/business-cycles-chart-the-ups-and-downs-of-aneconomy-and-understanding-them-can-lead-to-better-financial-decisions/articleshow/77793878. cms https://www.vedantu.com/commerce/national-income 9.14 TOPICS FOR DISCUSSION FORUMS Visit the IMF website World Economic Outlook, October 2020: A Long and Difficult Ascent (imf.org) and download the report on “World Economic Outlook, October 2020: A Long and Difficult Ascent”. Try and understand the reasons why IMF is predicting a tough year ahead for the global economy. 163 UNIT 10 Sectoral Composition of Indian Economy Names of Sub-Units Contribution of Agriculture, Industry and Services Sector towards Economic Development, Government Initiatives to boost up each sector Overview The unit begins by explaining the contribution of agriculture in Indian economy. Further, the unit explains the role of Indian industry and services sector towards economic development. Towards the end, you will be familiarised with government’s initiatives to boost up each sector. Learning Objectives In this unit, you will learn to: Explain the scenario of Indian agriculture Describe the functions of NABARD Discuss how different industrial sectors contribute to economic development Explain initiatives taken by the government for different sectors JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Learning Outcomes At the end of this unit, you would: Assess institutional reforms in Indian agriculture Explore sources of growth in agriculture Evaluate the Indian industry and services sector towards economic development Analyse the initiatives taken by the government for different sectors 10.1 INTRODUCTION Agriculture plays a very important role in the all-round economic and social development of the country. The growth rate of the agriculture sector in India grew after independence as the government emphasised on this sector in its five-year plans. Green revolution gave a major boost to the agricultural sector in irrigation facilities, provision of agriculture subsidies and credits and improved technology. This in turn enhanced the agriculture growth rate in India’s GDP. Further, the government has taken many initiatives to revive the agricultural sector by forming various institutions, such as National Bank for Agriculture and Rural Development, Agricultural Finance Consultancy Ltd., and Land Development Banks. The industrial sector plays a crucial role in the economic growth of the country. It has made a significant contribution in production, exports, and employment generation in the country. Many institutions are set up for helping the industrial sector flourish. Some of them are Industrial Finance Corporation of India, Industrial Development Bank of India, Industrial Reconstruction Bank of India (IRBI), State Finance Corporations (SFCs), State Industries Development Corporations, and Small Industries Development Bank of India (SIDBI). 10.2 INDIAN AGRICULTURE India is an agricultural economy and one-third of the national income of India comes from agricultural activities (excluding allied agricultural activities). India has many banks such as Regional Rural Banks (RRBs) dedicated to rural agriculture activities. Government has also set up agencies such as Food Corporation of India to purchase the farm produce directly from the farmers at government rates so that the intermediaries may not fleece the farmers. It has also introduced many Rural Finance Institutions to educate farmers about the management of the funds and make them less hesitant to come to bank for parking their money rather than going to a moneylender. Banks also provide many other services such as no-frills accounts for farmers, short-term credit for financing crop production programs, and medium/long-term credit for financing capital investment in agriculture. Loans are also available for storage, processing, and marketing of agricultural products. Banking system supports agricultural finance through a multi-agency network consisting of Commercial Banks (CBs), Regional Rural Banks (RRBs) and Cooperatives. For providing short term and medium term credit, following institutions are opened: 100,000 village-level Primary Agricultural Credit Societies (PACS) 368 District Central Cooperative Banks (DCCBs) with 12,858 branches 30 State Cooperative Banks (SCBs) with 953 branches 168 UNIT 10: Sectoral Composition of Indian Economy JGI JAIN DEEMED-TO-BE UNI VE RSI TY For providing long-term credit, following institutions are opened: 19 State Cooperative Agricultural and Rural Development Banks (SCARDBs) with 2609 operational units comprising of 788 branches 772 Primary Agricultural and Rural Development Banks (PA&RDBs) with 1,049 branches In June 2004, Government of India announced a comprehensive credit policy, which contained measures to increase the credit flow to farmers. This policy also provides debt relief to farmers affected by natural calamities. The major points of this policy are as follows: Increase in credit flow to agriculture sector by 30 per cent per year Restructuring and rescheduling the outstanding loans of distressed farmers Making one time settlement scheme for old loan accounts of small farmers Extending financial assistance for redeeming the loans taken by farmers Refinements in Kisan Credit Cards (KCCs) and fixing scale of finance 10.2.1 Contribution of Agriculture in India Agriculture plays an important role in the economic growth and development of India. The various areas in which agriculture plays a vital role are discussed as follows: Share in national income: Refers to one of the important contribution of agriculture in economic development. In 1950, the contribution of agriculture to national income was 57%. However, with the advancement in industrial sector and other important sectors, this share has been reduced to 26%. Source of employment: Implies that almost 60% of the total population of India are dependent on agriculture directly or indirectly. Importance in industrial development: Implies that agriculture-based industries such as cotton, jute, and sugar industries receive raw materials from agriculture sector. In addition, the people of India are majorly dependent on agriculture for their food. Importance in international trade: Implies that agriculture plays a vital role in the international trade. The agriculture products, such as tea and coffee, are the main constituents and 15% of the total Indian exports. In this way, agriculture helps in obtaining the foreign exchange, which enables the government to import the required products and technology. Revenue to the government: Implies that agriculture provides a significant amount of revenue to the state government in the form of land revenue, irrigation charges, and agricultural income tax. In addition, the central government generates good amount of revenue from export duties on the agricultural production. Moreover, the government can also generate revenue by introducing agricultural income tax. However, it is quite difficult due to certain political issues. Internal trade: Refers to the exchange of domestic products and services within a country. Agricultural products are the major constituents of the internal trade as 90% of Indian spends 60% of their income on these products. 10.2.2 Sources of Growth in Agriculture The following factors impact the growth of agriculture to a large extent: Better Irrigation Facilities: Helps in expanding the area under cultivation and encourage farmers to grow different types of crops. This would improve the quantity and quality of agriculture of production, which further helps in the growth of agriculture. 169 JAIN JGI DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Good seeds, Manure and Fertilisers: Helps in increasing the level of production. Good quality seeds and sufficient amount of manure and fertilisers not only help in increasing the productivity of agriculture but also raises the income level of farmers. Therefore, it helps in the growth of agriculture as well as farmers. Accurate Agricultural Equipment: Helps in increasing the agriculture productivity. The agricultural equipment, such as tractors and thrashers help in reducing the time and cost involved in tilling, plugging, and harvesting. This would enable the farmers to increase their agricultural production. Superior Agricultural Technology: Helps in crop rotation, selection of quality of seeds, use of proper manure, treatment of soil, selection of crops, and dry farming. This would increase the agricultural productivity. Ceilings on Landholdings: Refers to fixing of maximum size of holdings and to take away surplus for distribution among other people, such as small farmers, tenants, and landless labourers. This would increase the level of employment and productivity of agriculture. Soil Conservation: Involves the regulation of land use, afforestation, and contour bunding. Soil conservation along with the utilisation of surplus helps in increasing the agricultural productivity. Agricultural Marketing: Guarantees the farmers to get fair price by selling their agricultural products. When farmers get good price for their products then they would put more effort to increase the crop production, which would increase the agricultural productivity. 10.2.3 NABARD— An Institutional Reform in Indian Agriculture National Bank for Agriculture and Rural Development (NABARD) is an apex development bank, planning and operating in the field of agriculture and its allied activities. It provides credit facilities to farmers, small-scale industries, and other related organisations working for the development of the agricultural sector. It was established in 1982 through an Act of Parliament to integrate the development of rural sector with the growth of other sector. NABARD grants short-term loans to both the farming and non-farming sectors for technically and financially feasible projects. Some of the important functions performed by NABARD are: Refinancing: Refers to the financial assistance provided to the lending institutes working for the development of the agricultural sector. It extends the date of maturity of the loans to the lending institutes on the basis of their credit ratings, which are associated with the development of the rural sector. With the help of refinancing, the loan structure is modified and lower rate of interest is imposed on the loan so that lenders can return them on time. Promote Rural Development: Refers to the promotional scheme launched by NABARD to promote rural development by providing financial assistance to farmers to earn their livelihood. Evaluate and Monitor the Client Bank: Refers to the supervision function of NABARD towards its client banks. It is the responsibility of NABARD to evaluate, monitor, and inspect the working of the client banks time-to-time. Assist RBI and Government Bodies: Refers to the assistance provided by NABARD to RBI and different government bodies in implementing various schemes related to the rural development. NABARD’s credit functions include the following: Framing policies and guidelines for rural financial institutions Providing credit facilities to rural financial institutions 170 UNIT 10: Sectoral Composition of Indian Economy Preparing potential linked credit plans Monitoring the ground level rural credit JGI JAIN DEEMED-TO-BE UNI VE RSI TY The developmental and promotional functions of NABARD include the following: Preparing development action plans for cooperative banks and regional rural banks Helping regional rural banks to enter into memorandum of understanding that help in improving their operations Monitoring implementation of development action plans of banks and fulfillment of obligations under MoUs Providing technical assistance to regional rural banks Providing financial assistance for the training institutes of cooperative banks Giving training for senior and middle level executives of banks Creating awareness among the borrowers on ethics of repayment Building improved management information system, computerisation of operations and development of human resources NABARD also supervises the activities of regional rural banks and cooperative banks. Apart from these, it also supervises the following institutions: Undertaking State Cooperative Agriculture and Rural Development Banks (SCARDBs) and apex non-credit cooperative societies on a voluntary basis Undertaking portfolio inspections, systems study, besides off-site surveillance of cooperative banks and regional rural banks Administering credit monitoring arrangements The objectives of supervision by NABARD include the following: Protecting the interest of the present and future depositors Ensuring that the business conducted by these banks is in conformity with the provisions of the relevant acts/rules, regulations/bye-laws Ensuring that rules and guidelines formulated by NABARD/RBI/Government are followed by banks Evaluating the financial soundness of the banks The supervisory functions of NABARD include the following: Giving directions and guidance on matters relating to supervision and inspection Reviewing the inspection findings and suggesting appropriate measures Reviewing the follow-up action taken by Department of Supervision (DoS) on matters of frauds Identifying the supervisory issues in the functioning of cooperative banks/RRBs Recommending appropriate training for inspecting officers of NABARD for imparting necessary skills and knowledge Suggesting measures for strengthening of DoS Recommending issue of directions by RBI 171 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets 10.3 INDIAN INDUSTRY AND SERVICES SECTOR TOWARDS ECONOMIC DEVELOPMENT The industrial sector plays a crucial role in the economic growth of the country. It has made a significant contribution in production, exports, and employment generation in the country. There are number of institutions built up for the industrial sector. Some of them are Industrial Finance Corporation of India (IFCI), Industrial Development Bank of India (IDBI), Industrial Reconstruction Bank of India (IRBI), State Finance Corporations (SFCs), State Industries Development Corporations (SIDC) and Small Industries Development Bank of India (SIDBI). Small-Scale Enterprises (SSEs) face a number of problems due to inadequate capital, low productivity and lack of infrastructure facilities. Therefore, the Government of India has formed the Ministry of Micro, Small & Medium Enterprises (MSME), which focuses on the growth and development of the smallscale sector. The ministry formulates various policies and schemes for the development and promotion of SSEs in India. It also monitors and evaluates the performance of SSEs in India. The Ministry of MSME provides special facilities and support services to SSEs through its central and state level institutions. These institutions provide marketing assistance, financial support, business promotion, technical guidance, training, and consultancy services to SSEs. The main objective of these institutions is to enhance the competitiveness of SSEs in the market. Some of these institutions include Khadi and Village Industries Commission (KVIC), Micro, Small, and Medium Enterprises Development Organization (MSMEDO), State Directorate of Industries (SDIs), and Small Industries Development Bank of India (SIDBI). According to economic experts, India is going to come forward as the third power in the global economy after USA and China. It is estimated that the GDP of India would rise from 6% to 18% by 2025 while the GDP of USA would decline from 21% to 18%. USA has been the largest economy of world for more than a century. However, with the significant changes in the world economy, the focus has shifted from USA to India, China, and some other countries of Europe. In 2004, the Index of Industrial Production (IIP) shows a growth rate of 10.1% in comparison with the index rate of 2003, which was 6.2%. The increase in IIP is accompanied by the growth in manufacturing sector, mining and quarrying and electricity generation. The textiles industry is one of the oldest industries in the Indian economy. The share of textile industry in the total exports of India is around 30% and 14% in the total industrial production of India. It is estimated that till 2010 textile industry would be able to generate 12 million new jobs at the value of US$ 85 billion. Earlier, the textile sector is governed through general policies of industry. However, with the determination of the importance of textile industry, a separate policy statement is formed in 1985. The aim of textile policy framed in 2000 is to attain the goal of exporting US $ 50 billion textiles and apparels by 2010. In addition, the policy also emphasises on offering good quality product at reasonable prices for the population of the country. This would aid the sustainable employment and economic growth of a nation. It also acts as a weapon to compete in the global market. Apart from the textile industry, automobile industry has also shown a significant growth. The pharmaceutical and IT industry are the two upcoming industries in Indian economy. Among all these industries, the pharmaceutical industry has seen various changes during its growth period in India. With the involvement of WTO in India, the pharmaceutical organisations try to adopt the strategy of research and development on the basis of innovative growth. The exports for Indian pharmacy are ` 14000 crore and contributes more than a third of industry’s turnover. Pharmacy industry provides outsourcing of clinical research along with the manufacturing of drugs. The expertise of Indian people 172 UNIT 10: Sectoral Composition of Indian Economy JGI JAIN DEEMED-TO-BE UNI VE RSI TY in medical treatment & health care is one of the strengths of the country. India can take advantage from this strength by providing patent protection to the researchers. 10.4 GOVERNMENT INITIATIVES FOR DIFFERENT SECTORS The following are the initiatives taken by the government for different sectors: Industrial Policies for Small Enterprises The development of SSEs in India is the result of conscious policy and promotional support given by the government to them. In the initial years of post-independence, the main focus of the government was to develop SSEs. The small-scale sector was considered as the productive sector, directly involved in generating self-employment. The initial policies were characterised by protective measures. For example, more than 900 items were reserved for exclusive production by SSEs, which was reduced to 500 later on under the impact of liberalisation of the Indian economy. The development of the small-scale sector through the policy measure has been undertaken with the following objectives: Generating immediate employment opportunities with relatively low investment Promoting more equitable distribution of national income Mobilising effectively untapped capital and human skills Dispersing manufacturing activities all over the country, leading to the growth of village, small towns, and far-flung economically lagging areas The objectives and intentions of the Government of India towards SSEs can be understood by Industrial Policy Resolutions (IPR). These resolutions were announced in 1948, 1956, 1977, 1990, and 1991. Since independence, India has several industrial policies to its credit. Lawrence A. Veit tempted to say that “If India has as much Industry as it has industrial policy, it would be a far well-to-do nation.” Industrial Licensing Policy Industrial licensing policy is defined as a policy that eradicates the industrial licensing system in India except for some specific industries that are related to security and strategic concerns, social reasons, hazardous chemical, overriding environmental reasons, and items of enlist consumption. Therefore, for all the industries, the industrial licensing has abolished except for the following industries: Arms and defence equipment Atomic energy Coal and lignite Mineral oils Mining of iron ore, manganese ore, chrome ore, gypsum, sulphur, gold, and diamond Mining of copper, lead, zinc, tin, molybdenum, and wolfram Minerals mentioned in the Schedule to the Atomic Energy Order, 1953 Railway transport 173 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Monopolies and Restrictive Trade Practices (MRTP) Act In capitalist economy, the existence of monopolies is very common. The main concerns of the government related to monopolies are to eradicate the evils of monopoly, monitor the existing economy, and avoid the further growth of monopolies. Almost all industrialist economies have enacted various laws to monitor the prices of monopolies and restrict their further growth. In India, the concept of monopoly came into existence at the time of colonial rule in the country. After independence, the economic and industrial structure of India was characterised by the growth of monopolies and concentration of the economy. However, various provisions were made in the Directive Principles of the Indian Constitution for the reduction of economic concentration, but no particular action was taken till 1970. Consequently, the monopolies and economic concentration kept on increasing at a rapid pace. This further resulted in the emergence of private monopolies and confinement of economic power in the hands of few people and organisations. The growth of monopolies hampers economic development in the following manner: Limiting the level of production: Refers to the fact that private monopolies limit their capacity of production below their potential. In this way, these private monopolies confine the supply of goods and services below their efficiency. In such a situation, private monopolies sell their goods and services relatively at higher prices to earn maximum profit. This hampers the economic welfare of the society. Limiting the level of output: Hampers the welfare of the economy to a large extent. Private monopolies, by limiting the level of output, also reduce employment opportunities and generation of income in the society. This leads to the reduction of consumer surplus and welfare of economy. Limiting the level of competition: Refers to the fact that monopolies restrict competition by concentrating economic power in few industries. This further reduces the production capacity that can be achieved in a competitive business environment. MRTP Act was enacted in 1969 to ensure that concentration of economic power in hands of few rich. The act was there to prohibit monopolistic and restrictive trade practices. Foreign Exchange Regulation Act (FERA) The Foreign Exchange Regulation Act (FERA) was established in 1973 at the time when India was not earning enough foreign exchange. As per this act, all the foreign exchange earned by any resident of India was to be reserved and surrendered to the government. The rules under FERA were very stringent and the violation of any rule was considered as a criminal offence. The Act laid down by the government is given as follows: 1. This Act may be called the Foreign Exchange Regulation Act, 1973. 2. It extends to the whole of India. 3. It applies also to all citizens of India outside India and to branches and agencies outside India of companies or bodies corporate, registered or incorporated in India. 4. It shall come into force on such date as the Central Government may, by notification in the Official Gazette, appoint in this behalf: 174 UNIT 10: Sectoral Composition of Indian Economy JGI JAIN DEEMED-TO-BE UNI VE RSI TY Provided that different dates may be appointed for different provisions of this Act and any reference in any such provision to the commencement of this Act shall be construed as a reference to the coming into force of that provision. Foreign Exchange Management Act (FEMA) On 1st June 2000, the Foreign Exchange Management Act (FEMA) replaced FERA because the changes were required in the post-liberalisation process of the foreign exchange transactions. The FEMA also follows the framework as laid down by the World Trade Organisation and supports the prevention of money laundering activities. As per the Ministry of Finance, FEMA extends to the whole of India. It applies to all branches, offices and agencies outside India owned or controlled by a person who is a resident of India and also to any contravention there under committed outside India by any person to whom this Act applies. Except the general or special permission of Reserve Bank of India, no person can Receive any payment by order or on behalf of any person residing outside India in any manner; through an authorised person Reasonable restrictions for current account transactions as may be prescribed Any person may sell or draw foreign exchange to or from an authorised person for a capital account transaction. Reserve Bank may, in consultation with the Central Government, specify any class or classes of capital account transactions that are permissible. It also specifies the limit up to which foreign exchange shall be admissible for such transactions. Conclusion 10.5 CONCLUSION India is an agricultural economy and one-third of the national income of India comes from agricultural activities (excluding allied agricultural activities). Agriculture plays an important role in the economic growth and development of India. National Bank for Agriculture and Rural Development (NABARD) is an apex development bank, planning and operating in the field of agriculture and its allied activities. The industrial sector plays a crucial role in the economic growth of the country. It has made a significant contribution in production, exports, and employment generation in the country. The major goals of MRTP Act are to monitor the concentration of economic power in the society and restrict monopolies and evil trade practices. 10.6 GLOSSARY National Bank for Agriculture and Rural Development: A bank that credit facilities to farmers, small-scale industries, and other related organisations working for the development of the agricultural sector Agricultural Finance Consultancy Ltd.: A public limited company that facilitates growth of Indian agriculture 175 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets 10.7 CASE STUDY: A TALE OF TWO NATIONS – INDIA AND CHINA Case Objective This case study discusses a tale of two nations, i.e., India and China, which will help you to understand how different sectors of an economy work. An ironic fact is that until 1990, our country’s GDP per capita income was higher than that of China. However, according to the World Bank’s 2019 data, India’s per capita income is one-fifth of China’s. While China’s GDP per capita is $10,000, India’s GDP per capita stands at $2000-that is one-fifth of China’s. That means in a matter of thirty years, we became quite poor since GDP per capita is a measure of the standard of living of the people of a country. Going back in time, in 1990, the per capita income of China was $318, while that of India’s was slightly higher at $368. Even more, ironically, only $6 separated per-capita income of India and China in 1960. In 2018, China’s GDP was $11t of China compared to $2t of India. In the 1980’s, the poor in India were half of China’s. Today, the number of poor people is 10 times more to that of China (270 million poor in India vs 25 million poor in China). The 1990s marked the rise of China as an economic powerhouse. China never looked back after that. Let us try and understand why this happened. Borrowing its philosophy from Economics textbooks that “trade is an engine of growth”, China adopted an aggressive export strategy. In the early 1990s, China became the industrial outsourcing hub of the western world, which helped companies to drastically reduce costs. As compared to 2018 Chinese exports stood at $2.64 t, while that of India stood merely at $0.54 t. This is due to the ground-breaking market liberalisation reforms undertaken by China, which transformed it from a predominantly agriculture-dependent economy to an industrial superpower. China is the country which manufactures about 80 per cent of the world’s air conditioners, 45 per cent of ships, 50 per cent of steel, 70 per cent of phones, 74 per cent of solar cells, 60 per cent of shoes and branded luxury goods, as well as 50 per cent of coal. The reason for the spectacular increase in Chinese exports was because it started playing a key part in the global supply chains of large western companies, which India missed out on. China’s share of global manufacturing exports was 20% in 2018, while India’s was a mere 1%. China’s physical infrastructure is also far superior to India’s, making it an attractive investment destination. For instance, it takes 16 hours to go from Mumbai to Delhi (1334km), while it takes just 5 hours to go from Shanghai to Beijing (a comparable distance of 1318km). Route length of Chinese railways is 92,000 kms, while India’s is 64,600 km (that is 150% less than China). In 1978, Chinese President Xiaoping’s adopted the economic liberalisation measures and the 1979 Equity Joint Venture Law that paved the way for Foreign Direct Investment (FDI) and entry of foreign firms. This transformed the economy from an archaic crumbling economy into a dynamic and vibrant economy. Another important measure was removing agriculture from under state control. What changed positively in India, however in the last three decades is that we have done fairly well in services exports. In 2018, while China’s services exports were at $233.6 billion, India’s were at $205 billion. That means, at least in the sector of service exports, we are playing catch up. 176 UNIT 10: Sectoral Composition of Indian Economy JGI JAIN DEEMED-TO-BE UNI VE RSI TY The primary reason for our good performance in the service sector is owing to the IT/ITES sector which has been performing consistently well. Software firms in India, displayed visionary leadership to capitalise on the global opportunity to grow into market leaders. This was ably supported by the government policy which brought in the much-needed liberalisation to this industry. Also, it adopted an industry-friendly policy, which provided the IT/ITES sector with the required finances and infrastructure. However, the Indian manufacturing sector has been a constant area of concern except for two-wheeler, industry. Instead of export promotion, companies in India are stuck in an import-substitution mind-set of the pre-1990s era. Therefore, they failed to compete with foreign firms. That is why we are forced to import even basic products. For instance, in 2019-20, 97% of goods imported from China consisted of manufactured products. Also, our agricultural sector is ridden with multiple problems in production and distribution. Questions 1. What was the reason for an increase in the per capita income of China? (Hint: Aggressive export strategy) 2. What attributes to the good performance of the Indian services sector? (Hint: Consistent performance of the IT/ITES sector) 10.8 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. Agriculture is the primary source of livelihood for about 58% of India’s population. Write a short note on Indian agriculture. 2. What is the contribution of agriculture in India? 3. NABARD grants short-term loans to both the farming and non-farming sectors for technically and financially feasible projects. Explain the functions of NABARD. 4. The industrial sector plays a crucial role in the economic growth of the country. Explain the role of Indian industry towards economic development. 5. The growth of monopolies hampers economic development. Discuss. 10.9 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS A. Hints for Essay Type Questions 1. India is an agricultural economy and one-third of the national income of India comes from agricultural activities (excluding allied agricultural activities). India has many banks such as Regional Rural Banks (RRBs) dedicated to rural agriculture activities. Government has also set up agencies such as Food Corporation of India to purchase the farm produce directly from the farmers at government rates so that the intermediaries may not fleece the farmers. Refer to Section Indian Agriculture 2. Agriculture plays an important role in the economic growth and development of India. The various areas in which agriculture plays a vital role are share in national income, source of employment, 177 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets industrial development, international trade, revenue to the government and so on. Refer to Section Indian Agriculture 3. National Bank for Agriculture and Rural Development (NABARD) is an apex development bank, planning and operating in the field of agriculture and its allied activities. Refer to Section Indian Agriculture 4. The industrial sector has made a significant contribution in production, exports, and employment generation in the country. There are number of institutions built up for the industrial sector. Some of them are Industrial Finance Corporation of India (IFCI), Industrial Development Bank of India (IDBI), Industrial Reconstruction Bank of India (IRBI), State Finance Corporations (SFCs), State Industries Development Corporations (SIDC) and Small Industries Development Bank of India (SIDBI). Refer to Section Indian Industry and Services Sector Towards Economic Development 5. The growth of monopolies hampers economic development by limiting the level of production, level of output and level of competition and so on. Refer to Section Government Initiatives for Different Sectors @ 10.10 POST-UNIT READING MATERIAL https://www.ibef.org/industry/agriculture-india.aspx https://byjus.com/free-ias-prep/difference-between-fera-and-fema/ 10.11 TOPICS FOR DISCUSSION FORUMS 178 Discuss with the owner of any small enterprise the financial problems faced by enterprise in its growth and schemes availed off if any. UNIT 11 Overview of the Indian Financial System Names of Sub-Units Overview of the Financial System, Financial Institutions, Financial Markets, Financial Instruments and Services, Role of Financial Intermediaries, Source of Funds, Application of Funds, Role of Financial Regulatory and Promotional Institutions, such as RBI, SEBI, IRDA and PFRDA Overview This unit explains the concept of the financial system and its importance in an economy. The unit lists various functions of the financial system and its components in detail. Further, you will study different types of financial markets, the meaning of financial instruments and financial services and the regulatory aspects of the financial markets. In addition, the unit describes short-term, mediumterm and long-term sources of finance. Learning Objectives In this unit, you will learn to: State the importance of the financial system List the functions of the financial system Classify financial markets Discuss different sources of finance Describe the role of financial regulatory and promotional institutions JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Learning Outcomes At the end of this unit, you would: Assess the importance of the financial system Analyse the functions of financial markets Examine the significance of financial instruments Evaluate different sources of funds Recognise the initiatives in strengthening the financial infrastructure by regulators 11.1 INTRODUCTION The financial system is the entire financial framework of an economy that enables lenders and borrowers to exchange funds systematically. An effective financial system ensures the availability of sufficient funds for all economic activities with comparatively low transaction costs. Through an efficient financial system, the enhancement of economic activities leads to increased production of goods and services, improved level of national income and enhanced living standards of individuals in a country. The financial system of an economy is divided into various segments, such as financial institutions, financial markets, financial instruments and financial services. The efficiency of each segment adds to the efficiency of the whole financial system of an economy. Financial markets and securities markets are important for the growth, development and strengthening of market economies. The maturity of a market economy is determined based on the robustness of the securities market of an economy. In the globalised world, every economy needs to have an effective financial system in place to come out as an emerging economy. This requires the adoption of a more liberalised approach towards the financial framework of an economy. A liberalised financial system helps in attracting international investors, which increases the money supply in the domestic economy. The flow of funds in the financial markets is multi-directional based upon liquidity concerns, interest rate factors, risk rate patterns, yield profile, arbitrage probabilities, regulatory impositions, etc. Since the economy in India gets integrated with the global environment backed by accelerated and advanced information and technology systems, there is a great need for experienced professionals to entrust significant roles in all the regions of the financial market activity. 11.2 OVERVIEW OF THE FINANCIAL SYSTEM The overall economic development of an economy is dependent upon the existence of a well-organised financial system. The financial system is responsible for supplying the necessary financial inputs to cater to the production needs of goods and services, which, in turn, leads to the well-being and improved standard of living of the people of a country. Therefore, the financial system is a wider concept that brings under its umbrella the financial markets and the financial institutions meant to support the system. Efficient financial systems are an indelible part of an economy to ensure speedy economic development. Every economy runs based on a sound financial system. A sound financial system assists in capital formation and overall economic growth by spurring savings habits, mobilising savings from households 182 UNIT 11: Overview of the Indian Financial System JGI JAIN DEEMED-TO-BE UNI VE RSI TY or corporate and apportioning such savings into productive channels of trade and commerce. The financial system of an economy is a combination of sub-markets of capital, commodity and money. According to Dr. Prasanna Chandra, the Director of Centre for Financial Management and a renowned author, the financial system consists of a variety of institutions, markets and instruments related systematically, and provide the principal means by which savings are transformed into investments. A financial system entails both credits as well as cash transactions. The financial transactions are carried out either through cash movement or through the issue of negotiable instruments, such as cheques or bills of exchange. Nowadays, new-age digital payment methods, such as IMPS, NEFT, RTGS and digital wallets are quite popular means of carrying out financial transactions. A financial system is often referred to as a set of institutional arrangements that enables the mobilisation of financial surpluses from the resource generating surplus income and transferring the same to other resources in need of them. It comprises several activities, such as production, distribution and exchange of different financial assets between the financial institutions, banks and other intermediaries of the market. The financial system constitutes financial markets, financial assets, financial services, financial institutions and the related regulatory bodies, such as RBI, IRDA and SEBI. Thus, a financial system acts as an intermediary between borrowers and lenders of an economy. A sound financial system helps in facilitating the flow of funds from the place where they are in excess to the place where they are in shortage. The three key components of a financial structure include financial markets, products and market participants. 11.2.1 Functions of Financial System One of the most important functions of a financial system is to mobilise the savings of individuals so that capital formation can take place in an economy. The functions of a good financial system broadly comprise regulation of currency, banking functions, the performance of agency services and custody of cash reserves as well as the management of the national reserves of the international currency. The financial system also assists in credit control, administering national, fiscal and monetary policy to ensure the stability of the economy, supply and deployment of funds for productive use and maintaining liquidity. Some of the important functions of the financial system are discussed as follows: Saving function: The financial system plays a significant role in mobilising the savings of households, individuals or business organisations. It channelises their savings into commercial productive activities, which, in turn, influences the pace of the economic development of a country. Liquidity function: The financial system provides liquidity to active savers and borrowers participating in the markets. Liquidity implies that an asset can be exchanged for money to purchase other assets or can be exchanged for other goods and services. Liquidity acts as a benefit, which allows individuals or firms to respond quickly to new opportunities or unexpected events. Payment function: The financial system strengthens the efficient functioning of the payment mechanism in an economy. All transactions between the lenders and borrowers or between the buyers and sellers of goods and services are smoothly performed due to convenient modes of payments existent in the financial system, such as cheque system and credit card system. Information function: Rational investment decision-making depends to a great extent on accurate and timely information related to the financial system. The financial system allows for 183 JAIN JGI DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets the dissemination of various types of information related to different securities at a lower cost. The price-related information is valuable to the participants in the market for making informed decisions about investment, reinvestment, disinvestment, etc. Transfer function: The financial system operates as a network of financial institutions, financial markets and financial instruments to facilitate the transfer of funds. Through the services provided under the financial system, the funds are transferred from one party to another, i.e., from individuals and groups who have saved money to individuals and groups who want to borrow money. Reformatory function: The financial system undertakes the performance of functions of introduction, development and restructuring of financial instruments, assets and services to cater to the needs of investors. The financial system also helps in the price discovery of financial assets through the interaction between buyers and sellers of assets/securities and through the intervention of demand and supply forces in the market. Production, trade and investment function: A financial system offers a platform that facilitates the investment process. Investors can invest in their money by purchasing various kinds of securities, such as shares, debentures and fixed deposits as per their convenience. The financial system smoothens trade-related activities by ensuring the availability of adequate funds across the economy. In other words, it works as an effective moderator for the optimum allocation of financial resources in an economy. 11.2.2 Financial Institutions To fulfil the need for project financing, the Indian government established various financial institutions from time to time. These financial institutions have been classified as follows: All India Financial Institutions (AIFIs): IFCI, ICICI, IDBI, SIDBI and IIBI, all were public sector financial institutions except ICICI. ICICI was a joint venture which fulfilled its capital needs from the RBI, some foreign banks and financial institutions. Indian government funded the public sector financial institutions. By the 1980s and early 1990s, due to the popularity of Indian banks and the stock market, it was easier for the corporate world to tap cheaper capital from these segments of the capital market. The rate of interest was fixed in the case of AIFIs as compared to the banks which could mobilise cheaper deposits to lend cheaper capital. Due to this, the AIFIs seemed to look irrelevant. In recent years, AIFIs has declined sharply. At this junction, a decision was taken by the Indian government to convert these AIFIs into Development Banks based on the suggestion of the Narsimham committee. These are known as All India Development Banks (AIDBs). In 2000, the ICICI was reverse merged with the ICICI Bank which resulted in the emergence of the first AIDB without any obligation of project financing. Similarly, IDBI also went on to reverse merging with the IDBI Bank in 2002 and then, the second AIDB emerged with the obligation of carrying its project financing duties. There was a proposal of merger of the FIs merging the IFCI and IIBI with the nationalised bank PNB by the NDA government. This would have resulted in the emergence of India’s first Universal Bank. But changing political mandate at the centre has side-lined the proposal. 184 Specialised Financial Institutions: In the late 1980s, the central government established two new financial institutions to finance the risk and innovation in the area of industrial expansion. These are: Risk Capital and Financial Corporation Ltd. (RCFC) Tourism Finance Corporation of India Ltd. (TFCI) UNIT 11: Overview of the Indian Financial System JGI JAIN DEEMED-TO-BE UNI VE RSI TY In 1998, RCFC became IVCF and the first venture capital fund of India was established. It was the single one in the public sector. Its full name is the Industrial Finance Corporation of India Venture Capital Fund where ‘I’ stands for the IFCI, its promoter. Investment Institutions (IIs): Three investment institutions also came into existence, namely the LIC, the UTI and the GIC. These are other kinds of financial institutions which are no more considered as FIs. The LIC has been converted to a public sector insurance company in the life segment, GIC has been converted to a public sector re-insurance company and UTI has been converted to a mutual fund company in 2002. State Level Finance Institutions (SLFIs): Since states are also involved in industrial development, the central government permitted the states to establish their financial institutions. These are: State Finance Corporations (SFCs): These SFCs came into existence in Punjab first. 18 SFCs are working right now. State Industrial Development Corporations (SIDCs): It is a fully dedicated state public sector financial institution responsible for industrial development in the concerned states. First SIDCs was established in Andhra Pradesh and Bihar. Almost all the SFCs and SIDCs are running in huge losses. 11.2.3 Financial Markets The term ‘market’ refers to a place where interaction between buyers and sellers of a certain product or service takes place. A financial market is a place where people indulge in transactions of financial securities, financial instruments, commodities and other items. Investors can invest their funds in the financial market by purchasing any securities and the lender can borrow funds by issuing or selling any securities. For achieving the efficient transfer of resources from those holding idle resources to those who are in acute need of them, financial markets act as an important contributor. In other words, financial markets are those channels that aid in the allocation of savings towards investment options. Financial markets offer a wide variety of financial assets to savers and several forms in which borrowers can raise funds. The savers and borrowers are constrained by the economy’s ability rather than by their abilities to lend and borrow, respectively. The transactions between savers and seekers of capital, that take place in the financial markets contribute to the country’s economic development to the extent that the latter depends on the rates of savings and investment. Financial markets are markets where financial assets and financial liabilities are bought and sold. These markets, execute the basic function of channelising funds from savers of funds to seekers of funds either through direct finance or through indirect finance. Under direct finance, borrowers borrow funds directly from lenders by selling them securities. Under indirect finance, a financial intermediary is involved who stands between the lender and the borrower and helps in transferring funds from one to the other. This process of channelising the funds improves the economic welfare of all members of the society since it enables the funds to move from people who have no productive investment opportunities to those who have such opportunities. This ultimately contributes to increased efficiency in the whole economy. There are two major components of the financial markets, namely the money market and the capital market. 185 JGI JAIN Principles of Economics and Markets DEEMED-TO-BE UNI VE RSI TY The types of financial markets are as shown in Figure 1: Financial Markets Money Market Capital Market Securities Market New Issues Market Other Forms of Lending and Borrowing Secondary Market Figure 1: Types of Financial Markets The kinds of financial markets are explained in detail in the following subsections of this chapter. Money Market The money market is a kind of market wherein the lenders and borrowers of funds, exchange their short-term funds with each other to satisfy their liquidity needs. Some of the important money market instruments include financial claims, holding low default risk, the maturity period of one year and a high level of marketability. Money market instruments are characterised by liquidity, quick conversion into money, low transaction cost and no loss in value. Excess funds capital is employed in the money market, which, in turn, is utilised for meeting temporary shortages of cash obligations. The money market acts as a wholesale debt market for low-risk, highly liquid and short-term instruments to enable the availability of funds in this market for periods ranging from a single day up to a year. The major functions of the capital market are as follows: To provide access to lenders and borrowers of short-term finance to satisfy their investments and borrowing requirements respectively at an efficient market transaction price To offer an equilibrating mechanism to stabilise short-term liquidity, surpluses and deficits and facilitate the operations of monetary policy To act as a major point of central bank intervention and balancing mechanism for short-term surpluses and deficiencies impacting liquidity in the economy To contribute towards effective implementation of the monetary policy Capital Market The capital market is a kind of market for all kinds of financial investments, whether they represent direct or indirect claims towards the capital. It is much wider than the securities market, and includes all forms of lending and borrowing. It constitutes the summation of varied institutions and mechanisms through which medium-term funds and long-term funds are pooled, exchanged and made available to individuals, corporate associates and government undertakings. Moreover, the capital market also comprises the process through which securities already lying outstanding are dealt with. The capital market, especially the stock exchange, is referred to as the barometer of the economy. Generally, the capital market deals with long-term securities that have a maturity limit of more than one year. There are majorly three kinds of participants in the capital market, 186 UNIT 11: Overview of the Indian Financial System JGI JAIN DEEMED-TO-BE UNI VE RSI TY i.e., the issuers of securities, the investors in securities and the intermediaries. The major functions of the capital market are as follows: To channel and mobilise resources for investments to enterprises, both private and government To facilitate the buying and selling of securities and offer an effective source of investment in the economy To facilitate the process of efficient price discovery To assist in the proper settlement of transactions following the pre-specified time schedules To provide a medium for risk management by allowing the diversification of risk in the economy To foster long-term growth prospects by mobilising savings for investment in productive assets and facilitate in converting the economy into a more efficient and competitive marketplace The capital market may be segregated into two types, namely securities market and other forms of lending and borrowing. The securities market refers to the market for industrial securities, such as equity shares, preference shares, debentures or bonds. The market deals in financial instruments/claims/ obligations that are commonly and readily transferable by sale, allowing the industrial organisations to raise their capital or debt by issuing appropriate instruments. The securities market can be further subdivided into two types, i.e., primary market or new issues market and secondary market or stock exchange. The primary market gives the channel for the sale of new securities. In the primary market, the issuers of securities/companies sell the securities to raise resources for investment and for meeting some obligatory requirements. In other words, through the primary market, funds move from investors to businesses for productive purposes. On the other hand, the secondary market acts as the marketplace for the sale of shares or securities previously issued. The secondary market allows investors holding securities to materialise their security holdings in response to variations in risk and return assessment and, therefore, ensures free tradability, negotiability and price discharge. It essentially comprises stock exchanges that provide a platform for the purchase and sale of securities by investors and where securities are traded after being initially offered to the public in the primary market. Other forms of lending and borrowing take place through the government securities market and longterm loans market. Also called gilt-edged securities market, the government securities market is a market where short-term and long-term government securities are traded and most the institutional investors tend to retain these securities until maturity. While the long-term securities are traded in this market, the short-term securities are traded in the money market. Similarly, development banks and commercial banks play an important role in the long-term loans market by supplying long-term loans to corporate customers in the form of term loans, mortgages and financial guarantees markets. 11.2.4 Financial Instruments Every market is operated based on two components, namely money and objects/commodities. A transaction can take place in any market if both these components are present. An object or commodity of the financial market is called a financial instrument. These instruments (securities and claims) are issued for raising money in the market. For a lender/supplier of funds, financial instruments are financial assets, while for the borrower/supplier of securities, they are financial liabilities. Lenders invest their money by purchasing financial instruments for earning economic returns in the future in the form of interests and dividends. There are a set of economic units in the financial markets that demand financial assets/securities instead of funds and others who supply such financial assets/ 187 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets securities for funds. Investments in the financial system are linked to a wide range of financial products comprising ‘securities’ which is defined in the Securities Contracts (Regulation) Act, 1956 to include shares, scrips, stocks, bonds, debentures, debenture stocks, or other marketable securities of like nature in or of any incorporated company or body corporate, government securities, derivatives of securities, units of a collective investment scheme, security receipts, interest and rights in securities, or any other instruments so declared by the central government. Financial instruments can be classified on several aspects, such as transferability, associated risks and return. Some of the financial instruments that are tradable/transferable include equity shares, debentures, government securities and bonds. Others are non-tradable/non-transferable and include bank deposit, post office deposit, insurance policies, National Savings Certificates (NSCs), provident funds and pension funds. Financial instruments available in the capital market include equity shares, preference shares, warrants, debentures and bonds. These instruments are characterised by a comparatively low degree of associated liquidity as the maturity period of these instruments is more than a year. On the other hand, the instruments of the money market include treasury bills, commercial papers, call money, short notice money, certificates of deposits and commercial bills. Securities of the money market are associated with a high degree of liquidity as the maturity period of these instruments is less than a year. 11.2.5 Financial Services Over the past years, the service sector of the Indian economy has emerged as the major contributor to the Gross Domestic Product (GDP) of India. Almost every industry is coming out with the ideas of a wide range of services designed for customers to meet their expectations. The financial sector has also come up with an array of financial services that integrates the domestic economy with the global economy systematically and efficiently. The prime objective of this financial services sector is to intermediate and facilitate financial transactions of individuals and institutional investors. Some of the major financial services include lease financing, banking, hire purchase, insurance, merchant banking, factoring, forfeiting, etc. 11.2.6 Role of Financial Intermediaries The financial market does not exist in a vacuum; in fact, it requires the functionalities/services of a wide variety of intermediaries, such as merchant bankers and brokers, to bring together the suppliers of funds and suppliers of securities for executing several transactions. It is not that the suppliers of funds and suppliers of financial assets/securities meet each other directly and exchange funds for securities. Financial markets are run through some market participants of the financial system or intermediaries. These intermediaries may execute their functions as agents to match the needs of suppliers of funds and suppliers of securities and assist them in the issuance and sale of securities. The intermediaries may also purchase the securities issued by the suppliers of securities and, in turn, sell their own securities to the suppliers of funds. Thus, market participants include all types of financial institutions and investing institutions which facilitate the running of transactions in financial markets. 11.3 SOURCES OF FUNDS The capital invested by an individual to start a business is always insufficient to meet the company’s financial needs. As a result, businesses look for a way to produce revenue. A thorough examination of financial needs and possibilities for meeting those needs is conducted with the express purpose of keeping the business running. The basic needs of a business include purchasing a plant or apparatus, purchasing raw materials, expanding a firm to attract new customers, paying workers, etc. Ideally, all 188 UNIT 11: Overview of the Indian Financial System JGI JAIN DEEMED-TO-BE UNI VE RSI TY businesses need finances for daily operations, and this is what makes the concept of finance important for organisations. Finance is a need for the establishment of every business. The most crucial weapon for bridging the gap between production and sales is money. A firm requires funds to: Cover specific risks and any unforeseen issues that may develop Promote sales Take advantage of any commercial possibilities that may arise 11.3.1 Types of Funds There are three types of finance options available for a firm that are long-term, medium-term and short-term finance. Long-term finance is generally needed for the purchase of fixed assets. On the other hand, medium-term finance may be required to modernise machinery and improve other facilities. Short-term finance is generally required for meeting expenses incurred on day-to-day operations. Short-term Finance The requirement of short-term finance depends upon the size, market conditions and nature of the business. Previously, there were only two sources of short-term finance, such as indigenous bankers and commercial banks. However, today many new sources of finances are available in the market, which has made short-term financing an easy process. Some of the sources of short-term financing are: Trade credit: It refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods or components. Usually, business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered, but payments are not made until the expiry of the period of credit. When businesses enter into a trade credit arrangement with their suppliers, a certain credit term is usually set. Cash/cheque payments made within this term may get a certain discount. If payments are not made within this term, all receivables are required to be settled within a period as specified. Some advantages of trade credit are as follows: Trade credit is a flexible and reliable source of financing. Trade credit may be readily offered if the seller is aware of the consumers’ creditworthiness. If a firm wants to raise its inventory to meet a projected increase in sales volume shortly, it can do so with trade credit without the burden of immediate payment. It does not place a lien on the firm’s assets while providing financing. Some limitations of trade credit are as follows: Overtrading may occur as a result of the availability of simple and flexible trade credit arrangements, increasing the firm’s risks. Trade credit can only create a limited quantity of revenue. Customer advances: When the purchase order quantity is quite large or things ordered are very costly, businesses insist their customers make some payment in advance. Customer advances represent advances received from customers for goods or services expected to be delivered within the following year. Customers, generally agree to make advances when such goods are not easily available in the market or there is an urgent need for goods. A business can meet its short-term requirements with the help of customers’ advances. 189 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Some advantages of customer advances are as follows: The amount offered as advance is interest-free. Therefore, funds are available without involving financial burden. No tangible security is required while seeking advance from the customer, making assets free of charge. Funds received as advance is not to be refunded; therefore, there are no repayment obligations. Some limitations of customer advances are as follows: Customer advances are available to only those businesses, which have goodwill in the market. In other words, it is available to those businesses whose product demand is high in the market. The period of customers’ advance is limited up to the delivery of goods and cannot be extended further. The amount advanced by the customer is subject to the value of the order, although, the borrowers’ need may be more than the amount of advance. Bank credits: Short-term finance granted by commercial banks to businesses is known as bank credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at one time or in parts as and when needed. These are secured for which interest is to be paid regularly. These loans help in increasing the profit of an organisation as it is a part of expenses, which is deducted from tax. Bank credits have a short maturity period, which is generally less than a year. Some advantages of bank credit are as follows: Banks aid businesses promptly by supplying funds as and when they are required. If borrowers fulfil the bank’s lending criteria, they could avail the benefit of a lower rate of interest as well as easy repayment terms. However, the main limitation of bank credit is that banks do a thorough investigation of the company’s affairs, financial structure and other factors, and may also request asset security and personal sureties. As a result, acquiring finances is a little more challenging. Instalment credit: Instalment credit is a form of finance in which a set amount of money is borrowed for a set period. The borrower agrees to make a predetermined number of monthly instalments in a certain amount. The payback duration for an instalment credit loan might range from months to years until the loan is paid off. The most common types of instalment loans are working capital loans, term loans, letters of credit and equipment finance. Some advantages of instalment credit are as follows: 190 Instalment credit gives borrowers a fixed monthly payment amount for a certain period, which makes budgeting easier. Instalment loans can also be extended over time, resulting in reduced monthly payments that may be more in line with monthly cash flow requirements. In terms of interest rates and user fees, instalment credit might be less expensive than revolving credit for qualifying consumers. Instalment credit lenders, on the other hand, charge lower interest rates, ranging from 2% for secured loans to 18% for unsecured loans. Using the reduced interest rate paid on instalment credit to pay down revolving debt can help a borrower to save a huge amount over the life of the loan. In addition, revolving debt might have high costs for late payments, exceeding credit limits and annual maintenance; on the other hand, instalment credit does not have these expenses. UNIT 11: Overview of the Indian Financial System JGI JAIN DEEMED-TO-BE UNI VE RSI TY Although using instalment credit to pay off more expensive, variable revolving debt has some advantages, it also has significant disadvantages. Some disadvantages of instalment credit are as follows: Some lenders especially starters are usually not able to pay off the loan early. In such a case, penalties or additional interest are imposed by the lenders. Instalment credit facilitates the purchase of assets or equipment and does not make cash available, which can be utilised for all needful purposes. Medium-term Finance A medium-term is required to fill up the gap between long-term and short-term. They come with the advantage of both short-term and long-term sources of finance, however with their inherent limitations. Medium-term sources of finance are those sources of funds that a company pays back in 1 to 5 years. Some of the sources of medium-term finance are as follows: Lease finance: It is a source of finance where the funds are obtained not in cash, but the form of machinery, equipment and other capital assets. That is, in lease finance, the company seeking funds contacts a leasing company, which provides the desired capital assets to the former for use during the specified period. The leasing company purchases the assets from the market and the user company pays rent for use of the assets. The complete ownership of the asset is with the leasing company. This source transfers nearly all the risks and rewards of ownership of assets to the lessee for the duration of the lease. The lessee is responsible for the maintenance of the asset and the lessor’s investment is assured because the lease cannot be cancelled. Hire purchase: Hire purchase is a method of financing the purchase of a fixed asset by paying for the asset in instalments over an agreed period. In this source, the purchase price of the asset is paid in instalments, and ownership is transferred after the payment of the last instalment. Venture capital finance: Venture capital finance is a private or institutional investment made into early-stage/ start-up companies. By definition, a venture is a new activity that involves risk or uncertainty in the expectation of a substantial gain. Venture capital finance is money invested in businesses that are small or in their initial stages but have considerable potential to grow. A team of financial experts or an individual who professionally invests venture capital is called a venture capitalist. A venture capital investment is made when a venture capitalist provides funding to a small or growing business despite the risks associated with the company’s future profits and cash flow. The venture capitalist risks losing money if the venture does not succeed or takes a long time to return profits. Rather than being given out as a loan, venture capital is invested in exchange for an equity stake in the business. Public deposits: They refer to the system of the general public depositing its funds with companies at a specified rate of interest for a specified period, and the latter accepting it for meeting its mediumterm requirement of funds. Public deposits are a popular form of finance because this system is simpler and cheaper than bank credit. Debentures/bonds: In case a company requires funds but does not want to increase its share capital, it can borrow from the general public by issuing certificates for a specified period at a fixed rate of interest. These certificates issued by a company making an acknowledgement of debt are known as debentures. Debentures are issued to the public for subscription similar to the issue of equity shares. Debentures are issued under the common seal of the company acknowledging the receipt of money. 191 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Long-term Finance The long-term sources of finance fulfil the financial requirements of a business entity for periods exceeding five years and can be in the form of shares, debentures, loans from financial institutions and long-term borrowings. In general, these sources of finance are used for investing in long-term projects that are going to generate returns for the company in the future years. Long-term funds are paid back during the lifetime of the organisation. There are several different sources available with a business concern to meet its long-term financial needs. These sources of long-term finance broadly include share capital (equity shares and preference shares) and debt capital (i.e., bonds and debentures, long-term borrowings or other debt instruments). Equity shares: Equity shares, also known as common shares, represent the ownership capital in a company. Equity shareholders are the legal owners of the company and they have an unlimited claim on the income and assets of the company and enjoy complete voting power in the company. Ownership benefits come with their share of risks, and as such equity shareholders bear the risk of ownership; equity dividend is paid after preference dividend has been paid. Also, the rate of dividend on equity shares is not fixed and depends on the availability of divisible profits and the intent of the board of directors. Equity shares may receive a higher rate of dividend when the company performance is good and a low rate when performance is poor. By the issue of ordinary equity shares, a public limited company can raise capital/funds from its promoters or the general investing public. Such capital is known as the owner’s capital or equity capital. Equity shares also include bonus shares and sweat equity shares. Preference shares: Preference shares also commonly known as preferred stock, is a special type of share, where dividends are paid to shareholders before the issuance of common stock dividends. Preference shares are suitable for investors who want a steady source of income without taking on the risks of volatility in the common shares. Preference shareholders also give up the upside potential of common shares as preference shares do not change their value substantially in any given holding period. For preference shareholders, the dividend is fixed; however, they do not hold voting rights as opposed to common shareholders. Preference shares are a special kind of shares. Preference shareholders enjoy priority, both concerning the fixed payment of dividends and also towards the repayment of capital invested in the company in case of winding up or liquidation. Preference share capital is also a source of longterm finance. Retained earnings: They are a feasible option as a source of long-term finance for a company that has been operating for some time. An existing company can plough back its profits by not distributing all of it as dividends but reinvesting a part in the business known as retained earnings. This is an internal or self-financing method. Loans: Many specialised institutions and banks offer long-term financial assistance to industries. Long-term loans can be obtained from national financial institutions such as Industrial Finance Corporation of India (IFCI), State Financial Corporations (SFCs), Industrial Development Bank of India (IDBI), National Industrial Development Corporation (NIDC), Life Insurance Corporation of India (LIC), Unit Trust of India (UTI), Industrial Reconstruction Bank of India (IRBI) and more. State Financial Corporations and State Industrial Development Corporations have been established at the state level to provide loans to businesses. The maturity period of long-term loans provided by banks and financial institutions can be between 5 to 10 years. The lending institution and borrower negotiate the terms and conditions of these loans at the time of loan disbursal. Asset securitisation: It is the process of converting the receivables of an organisation into debt securities and then trading these securities in the same way as stocks, bonds and futures contracts. In other words, asset securitisation is a process where a company consolidates several of its assets 192 UNIT 11: Overview of the Indian Financial System JGI JAIN DEEMED-TO-BE UNI VE RSI TY into securities and then issues these securities to the investors, who earn interest. It is a means of converting the illiquid assets into liquid assets to free up the blocked capital. These small assets would not sell individually so they are consolidated into a special purpose vehicle (SPV). Through asset, securitisation companies can raise finance by selling assets or income streams into the SPV. 11.4 ROLE OF FINANCIAL REGULATORY AND PROMOTIONAL INSTITUTIONS Besides intermediaries, like any other system, the financial system also needs regulatory authorities to make rulesandguidelinesforgoverningthefinancialframeworkofaneconomy. In India, manyregulatory bodies are responsible for managing the activities of financial institutions and markets, and the issuing of financial instruments and services. These bodies are the Ministry of Finance of India, Company Law Board, Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI), Insurance Regulatory and Development Authority (IRDA), Department of Economic Affairs, Department of Company Affairs, etc. These bodies are responsible for administering, legislating, supervising, monitoring and controlling the financial system. Various rules and regulations have been passed from time to time to meet the objective of ensuring the smooth functioning of the financial markets to attain continuous economic growth. In India, the financial market was well-segmented until the commencement of 1992-93 reforms on account of a range of regulations and administered prices comprising barriers to entry. The reform process was initiated with the establishment of SEBI. The main legislations to govern the financial market are as follows: The SEBI Act, 1992 is established to protect the interests of investors in securities, to promote the development of the securities market, and to regulate the securities market. The Securities Contracts (Regulation) Act, 1956, SC(R) Act regulates transactions in securities through control over stock exchanges, provides direct and indirect control of almost all segments of securities trading and seeks to keep a check on undesirable transactions in securities. The Depositories Act, 1996 establishes standards for electronic maintenance and transfer of ownership of dematerialised securities in the depository mode to achieve free transferability of securities with speed, accuracy and security. The Companies Act, 2013 sets out the code of conduct for the corporate sector concerning issue, allotment and transfer of securities and disclosures to be made in public issues to strengthen the regulatory framework on corporate governance. 11.4.1 RBI The RBI is the most important participant in the money market which takes requisite measures to implement the monetary policy of the country. As the central bank, the RBI is responsible for regulating the money market in India and injecting liquidity in the banking system when it is deficient or contracting the same in the opposite situation. The money market provides leverage to the RBI to effectively implement and monitor its monetary policy. For example, a developed bill market strives to make the monetary system of an economy more elastic. Wherever the country needs more cash, the banks can get the bills rediscounted from the RBI and, therefore, can increase the money supply. 11.4.2 SEBI SEBI was established in 1988 as a regulator for the Indian securities market. SEBI performs several functions so that the financial system of India can contribute significantly towards the growth of the 193 JAIN JGI DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets country’s economy. It provides a healthy and amicable financial framework by ensuring the availability of accurate and correct information. This helps issuers raise finance easily, investors to make the right investment decisions and intermediaries to play their roles fairly in any transaction that takes place between issuers and investors. The major policy initiatives taken by SEBI include control over issuing of capital, reassurance of safety to undertake transactions in securities, exercising nationwide online fully automated screen-based trading system, risk management, setting up of trade and settlement guarantee funds, fostering investor education, spreading security market awareness, and improving the standards of corporate governance through Clause 49 of the Listing Agreement. The prime objective of SEBI is to protect the interests of investors and promote the development of the stock exchange by regulating the activities of the stock market. The other objectives of SEBI are to: Regulate the functioning of the stock exchange Protect the rights of investors by ensuring safety against their investment Prevent fraudulent practices by implementing various rules and regulations Develop a code of conduct for various participants of the financial system that includes companies, brokers and underwriters 11.4.3 IRDA At present, the Insurance Regulatory and Development Authority (IRDA), is the statutory body entrusted with the responsibility of streamlined regulation of operations of the insurance companies as well as strengthening continual development and growth of insurance business in India. The primary concern of the IRDA is the protection of the policyholder’s interest. The Insurance Regulatory and Development Authority Act, 1999, is to provide for the establishment and regulation of an authority to protect the interests of holders of insurance policies, to regulate, promote and ensure orderly growth of the insurance industry in the country and for matters connected therewith or incidental thereto, and further to amend the Insurance Act, 1938, the Life Insurance Corporation Act, 1956 and the General Insurance Business (Nationalisation) Act, 1972. This was done to end the monopoly of the Life Insurance Corporation of India (for the life insurance business) and General Insurance Corporation and its subsidiaries (for the general insurance business) in the country. The Act was published in the Gazette of India on 29th December 1999 and extends to the whole of India. Since 1st September 1956, transacting life insurance business in India was the exclusive privilege of the nationalised insurance company, namely LIC. However, with the passing of the IRDA Act, 1999, the life insurance sector has been thrown open to private players in the country. 11.4.4 PFRDA Pension Fund Regulatory and Development Authority (PFRDA) is a statutory regulatory body set up under PFRDA Act enacted in February 2014. The authority was established to promote old age income security and protect the interests of National Pension Scheme (NPS) subscribers. NPS is a defined contribution pension system introduced by PFRDA wherein subscribers’ contributions are collected and accumulated in an individual pension account using various intermediaries. Under NPS, individual contributions are pooled together into a pension fund, which is invested as per approved investment guidelines. PFRDA, asalreadymentioned, isthepensionregulatorandworkstowardsitspromotionanddevelopment. It is a Central autonomous body and is a quasi-government organisation and has executive, legislative 194 UNIT 11: Overview of the Indian Financial System JGI JAIN DEEMED-TO-BE UNI VE RSI TY and judicial powers similar to other financial sector regulators in India such as the Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI), Insurance Regulatory and Development Authority (IRDA) and, Insolvency and Bankruptcy Board of India (IBBI). PFRDA administers and regulates the National Pension System (NPS) and also administers Atal Pension Yojana. The following are the functions of PFRDA: Regulating the applicable NPS and pension schemes Establishing, developing and monitoring pension funds Protecting the interest of pension fund subscribers Registering and regulating intermediaries Approving schemes, terms and conditions, and laying down norms for management of corpus of pension funds Establishing the grievance redressal mechanism for subscribers Promoting a professional organisation connected with the pension system Settling disputes among intermediaries and also between intermediaries and subscribers Training intermediaries and educating subscribers and the general public concerning pension, retirement savings and related issues Conducting inquiries and audits of intermediaries and other entities connected with pension funds Conclusion 11.5 CONCLUSION The overall economic development of an economy is dependent upon the existence of a wellorganised financial system. The financial system is responsible for supplying the necessary financial inputs to cater to the production needs of goods and services, which, in turn, leads to the well-being and improved standard of living of the people of a country. Thus, a financial system acts as an intermediary between borrowers and lenders of an economy. A sound financial system helps in facilitating the flow of funds from the place where they are in excess to the place where they are in shortage. One of the most important functions of a financial system is to mobilise the savings of individuals so that capital formation can take place in an economy. One of the most important functions of a financial system is to mobilise the savings of individuals so that capital formation can take place in an economy. Some of these institutions are All India Financial Institutions (AIFIs), Specialised Financial Institutions, Investment Institutions (IIs) and State Level Finance Institutions (SLFIs). Financial markets are markets where financial assets and financial liabilities are bought and sold. There are two major components of the financial markets, namely the money market and the capital market. The capital invested by an individual to start a business is always insufficient to meet the company’s financial needs. As a result, businesses look for a way to produce revenue. A thorough examination of financial needs and possibilities for meeting those needs is conducted with the express purpose of keeping the business running. 195 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Sources of finance are divided into three types; namely short-term, medium-term and long-term. The financial system needs regulatory authorities to make rules and guidelines for governing the financial framework of an economy. Some of these authorities are RBI, SEBI, IRDA and PFRDA. 11.6 GLOSSARY Financial institution: An intermediary that mobilises savings done by one section of an economy and allocates that to another section of the economy requiring funds for accomplishing economic activities Financial market: An arrangement in which financial institutions are engaged in selling and buying financial instruments and services Financial system: A system that moves funds across the economy and which creates a link between borrowers and lenders by mobilising funds from one sector (having surplus) to others (having a shortage) Government securities: The bonds and other securities that are issued by the government of a country Primary market: The part of the capital market in which the securities are offered for sale for the first time, such as in case of public issues, offer for sale, rights issue and bonus issue Secondary market: The part of the capital market in which securities, such as shares, debentures and commercial papers, are traded among all the traders, for example, the general public. Stock exchange: An organisation or platform where stock traders (people and companies) can trade in stocks 11.7 CASE STUDY: DEPOSITORY SYSTEM IN INDIA Case Objective This case study explains the importance of the depository system of India. The Indian financial mechanism is characterised by the depository system. In India, as per the Depositories Act, 1996, a depository organisation is the one that holds securities of investors, such as shares, debentures, bonds, government securities, mutual fund units, etc., in electronic form at the request of the investors through the aid of registered depository participants. The execution of the depository system in India has led to the trading of shares in which book entries are done electronically and it does not require paperwork. The Indian depository model is backed by a holistic multi-depository system wherein several entities are capable of radically offering depository services. According to the Depositories Act, 1996, a depository should be a company formed under the Companies Act, 2013 and should have been granted a certificate of registration under the Securities and Exchange Board of India Act, 1992. At present, there are two SEBI-registered depositories namely, National Securities Depository Limited (NSDL) and Central Depository Services Limited (CDSL). The physical form of securities is extinguished and, now, shares and other securities are only held in their electronic forms. Such dematerialised financial transactions enable the transfer of securities held in dematerialised form from one party to another freely through an electronic book-entry mechanism. The depositories render their services to investors through the help of their agents/depository participants. 196 UNIT 11: Overview of the Indian Financial System JGI JAIN DEEMED-TO-BE UNI VE RSI TY Such participants are appointed in accordance with the conditions stipulated under the Securities and Exchange Board of India (Depositories and Participants) Regulations, 1996. Dematerialisation is an important endeavour in the direction of attaining a fully paper-free securities market and it enables the physical certificates of an investor to be translated into electronic form. Such share certificates are credited to the account of the depository participant. Moreover, the ownership or control of securities held in dematerialised is segregated between the registered owner and the beneficial owner. As per the Depositories Act, 1996, a ‘registered owner’ means a depository whose name is entered as such in the register of the issuer. On the other hand, a ‘beneficial owner’ means a person whose name is recorded as such with the depository. Although the shares are registered in the name of the depository (NSDL/CDSL), all the rights, liabilities and benefits concerning such securities held by the depository rest with the beneficial owner itself. Also, once the securities are held in the dematerialised form, they lose their uniqueness. They no longer bear any notable mark like a distinctive number, folio number or share certificate number. Therefore, all securities belonging to the same class become identical and interchangeable. Questions 1. Which are the two depositories registered with SEBI at present? (Hint: NSDL and CDSL) 2. What are some of the key features of the depository system in India? (Hint: Multi-depository system, depository services through depository participants, dematerialisation, registered owner/beneficial owner and free transferability of shares.) 3. What did the depository system in India lead to? (Hint: The execution of the depository system in India has led to the trading of shares) 4. What is dematerialisation? (Hint: Dematerialisation is an important endeavour in the direction of attaining a fully paperfree securities market and it enables the physical certificates of an investor to be translated into electronic form.) 5. How is the ownership or control of securities held in dematerialised is segregated? (Hint: Segregated between the registered owner and the beneficial owner) 11.8 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. The financial system operates as a network of financial institutions, financial markets, and financial instruments to facilitate the transfer of funds. What are the functions of a financial system? 2. The term ‘market’ refers to a place where interaction between buyers and sellers of a certain product or service takes place. What do understand by the term financial markets? 3. The capital market is a kind of market for all kinds of financial investments, whether they represent direct or indirect claims towards the capital. What is the capital market? Write its functions. 197 JGI 4. JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Write short notes on the following: a. Trade credit b. Instalment credit 5. What are the main legislations that govern the financial market? 11.9 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS A. Hints for Essay Type Questions 1. Important functions of the financial system are saving function, liquidity function, payment function, information function, transfer function, etc. Refer to Section Overview of the Financial System 2. The term ‘market’ refers to a place where interaction between buyers and sellers of a certain product or service takes place. A financial market is a place where people indulge in transactions of financial securities, financial instruments, commodities and other items. Investors can invest their funds in the financial market by purchasing any securities and the lender can borrow funds by issuing orselling any securities. Refer to Section Overview of the Financial System 3. The capital market is a kind of market for all kinds of financial investments, whether they represent direct or indirect claims towards the capital. It is much wider than the securities market and includes all forms of lending and borrowing. It constitutes the summation of varied institutions and mechanisms through which medium-term funds and long-term funds are pooled, exchanged and made available to individuals, corporate associates and government undertakings. Refer to Section Overview of the Financial System 4. Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, or components. Refer to Section Sources of Funds 5. The main legislations to govern the financial market are as follows: The SEBI Act, 1992 is established to protect interests of investors in securities, to promote the development of the securities market, and to regulate the securities market. The Securities Contracts (Regulation) Act, 1956, SC(R) Act regulates transactions in securities through control over stock exchanges, provides direct and indirect control of almost all segments of securities trading and seeks to keep a check on undesirable transactions in securities. The Depositories Act, 1996 establishes standards for electronic maintenance and transfer of ownership of dematerialised securities in the depository mode to achieve free transferability of securities with speed, accuracy and security. The Companies Act, 2013 sets out the code of conduct for the corporate sector concerning issue, allotment and transfer of securities and disclosures to be made in public issues to strengthen the regulatory framework on corporate governance. Refer to Section Role of Financial Regulatory and Promotional Institutions @ 11.10 POST-UNIT READING MATERIAL https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/financial-markets/ https://efinancemanagement.com/sources-of-finance 198 UNIT 11: Overview of the Indian Financial System JGI JAIN DEEMED-TO-BE UNI VE RSI TY 11.11 TOPICS FOR DISCUSSION FORUMS Prepare a critical analysis report on the measures taken by the Government of India to liberalise various norms of the Indian financial system. Also, with the help of various sources, find out any three countries having a strong position in the international financial system. 199 UNIT 12 Financial Markets-I Names of Sub-Units Monetary Policy – Tools, Goals and Targets, the Structure of Interest Rates – Nominal and Real Interest Rate, Money Market – Instruments, Utility, Eligibility: Call, Notice & Term Money Market, Commercial Bills, Commercial Paper, Certificate of Deposits, T-Bills Issue & Yield-Computation, Repo, Market for Financial Guarantees, Discount Market, Government (Gilt-edged) Securities Market & Design, Commercial Banks, Cooperative Banks, Insurance Companies Overview This unit covers the regulatory issues in the Indian money market and explores the role of monetary policy and money supply. The unit further discusses the concept of money market, the importance of money markets and different money market instruments such as treasury bills, commercial bills, commercial papers and certificate of deposit. Towards the end, the unit sheds light on the discount market, government securities market, commercial banks, cooperative banks, and insurance companies. Learning Objectives In this unit, you will learn to: Describe the basics of the money market Discuss the role of different money market instruments Explain the regulatory aspects of the money market State the importance of the monetary policy JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Learning Outcomes At the end of this unit, you would: Identify the activities in the money market and the collection of submarkets prevalent in the money market Evaluate the role of the RBI in organising the money market and taking requisite measures to implement monetary policy in the economy Appreciate the distinctive characteristics of the money market and its varied instruments with exceptional maturity and risk profiles to meet the demand of several market players Pre-Unit Preparatory Material https://ncert.nic.in/textbook/pdf/lebs202.pdf 12.1 INTRODUCTION The financial market provides numerous services, such as fundraising, risk distribution, international trade, and capital formation. It is divided into capital market and money market to differentiate longand short-term finance sources. SEBI regulates the capital market and the money market is regulated by Reserve Bank of India (RBI). The money market acts as a centre in which financial institutions come together to deal with monetary assets in an impersonal manner. On a broader spectrum, the money market can be defined as a market for short-term money and financial assets near substitutes for money. The term “short-term”’ means generally a period up to one year, and near substitutes to money is used to refer to any financial asset which can be quickly converted into cash with minimum transaction cost. The money market ensures the movement of funds for the short-term and, thus, facilitates the liquidity factor in the economy. After liberalisation, many instruments/services/institutions have been introduced for enhancing the strength of the financial system with the help of the money market. The instruments traded under the money market are treasury bills, commercial bills, call/notice money, commercial papers and Certificate of deposit. The Indian money market is divided into organised money market and unorganised money market. The various challenging issues in the money market are limited instruments, the multiplicity of the interest rates, lack of integration, etc. Nevertheless, the Indian money market is quite well developed and extensive. The average size of the Indian money market is USD 1738.61 million. Similarly, Russia and China’s size of money markets is USD 100 billion and USD 1 trillion, respectively. 12.2 MONETARY POLICY AND MONEY SUPPLY The measures of money supply vary from country to country, from time to time, and from purpose to purpose. However, the high-powered money and the credit money broadly constitute the most common measure of money supply or the total money stock of a country. High-powered money is the source of all other forms of money. The second leading source of the money supply is the banking system of the economy. Money created by commercial banks is called”credit money”. Measurement of the money supply is essential from a monetary policy perspective because it enables a framework to evaluate whether the stock of money in the economy is consistent with the standards for price stability to understand the 204 UNIT 12: Financial Markets-I JGI JAIN DEEMED-TO-BE UNI VE RSI TY nature of deviations from this standard and study the causes of money growth. The reserve money is also called the central bank money, base money or high-powered money and acts as a determinant of the country’s level of liquidity and price level. Banks are generally the significant sources of funds in the money market. Commercial banks are the leading supplier of funds in money market instruments and the RBI performs the primary role of issuing treasury bills on behalf of the Government of India. In the Indian money market, the demand for money or funds is seasonal.Since India is a predominant agriculture country, therefore, the need for money is generated from the agricultural operations carried out therein. During the busy season, mainly between October and April, more agrarian activities ultimately leads to a higher demand for money. Monetary policy refers to the use of monetary policy instruments which are at the disposal of the central bank to regulate the availability, cost and use of money and credit to promote economic growth, price stability, optimum levels of output and employment, the balance of payments equilibrium, stable currency or any other goal of Government’s economic policy. Though multiple objectives are pursued, the most commonly pursued monetary policy objectives of the central banks across the world have become the maintenance of price stability (or controlling inflation) and the achievement of economic growth. Monetary policy instruments are the various tools that a central bank can use to influence money market and credit conditions and pursueits monetary policy objectives. In addition, there are direct instruments such as cash reserve ratios, liquidity reserve ratios and indirect instruments, i.e., and open market operations. The RBI is the most important participant of the money market which takes requisite measures to implementthe country’s monetary policy. As the central bank, the RBI is responsible for regulating the money market in India and injecting liquidity in the banking system when it is deficient or contracting the same in the opposite situation. The money market provides leverage to the RBI to effectively implement and monitor its monetary policy. For example, a developed bill market strives to make the financial system of an economy more elastic. Wherever the country needs more cash, the banks can get the bills rediscounted from the RBI and, therefore, can increase the money supply. Furthermore, there are fixed reserve requirements in the case of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR), which banks have to keep and maintain at all times. CRR is the reserve that banks have to keep with RBI. The current CRR rate is 4% and is prescribed according to the guidelines of the central bank of a country. The essential purpose is to ensure that banks do not run out of money to satisfy the demands of their depositors. CRR is an important monetary policy tool and is used for controlling the money supply in an economy. On the other hand, SLR is the reserve that banks have to maintain with themselves, thereby restricting the flow of money market instruments. Apart from CRR, banks have to keep a specific portion of their deposits in liquid assets such as cash, gold, and non-mortgaged securities. Further, banks that subscribe to treasury bills, issued by the RBI on behalf of the Government, qualify their SLR requirements. 12.3 STRUCTURE OF INTEREST RATES Interest rates act as an indicator of economic performance and an instrument for its control. The term ”structure of interest rates”, i.e. market interest rates at various maturities, is a vital input into the valuation of many financial products. In other words, the term structure of interest rate shows various yields currently offered on bonds of different maturities. It enables investors to quickly compare the yields offered on short-term, medium-term, and long-term bonds. The reading aims to explain the term structure and interest rate dynamics—that is, the process by which the yields and prices of bonds evolve over time. 205 JGI 12.3.1 JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Real Interest Rate A real interest rate is one that takes inflation into account. This implies that the real rate adjusts for inflation and gives the real rate of a bond or loan. To calculate the real interest rate, the nominal interest rate is required. The real interest rate can be calculated using the nominal interest rate minus the actual or expected inflation rate. Suppose a bank provides a loan of `200,000 to a person to purchase a house at a rate of 3%—the nominal interest rate not factoring in inflation. Assume the inflation rate is 2%. The real interest rate the borrower is paying is 1%. The real interest rate the bank is receiving is 1%. That means the purchasing power of the bank only increases by 1%. 12.3.2 Nominal Rate A nominal interest rate is the interest rate before taking inflation into account. It is the interest rate quoted on bonds and loans. The nominal interest rate is a simple concept to understand. For example, if you borrow `1000 at a 6% interest rate, you can expect to pay `60 in interest without considering inflation. The disadvantage of using the nominal interest rate is that it does not adjust for the inflation rate. Central banks decide short-term nominal interest rates. These rates are the basis for other interest rates that banks and other institutions charge to consumers. Central banks may choose to keep nominal rates at low levels to spur economic activity. Low nominal rates encourage consumers to take on more debt and increase their spending. 12.4 MONEY MARKET INSTRUMENTS The money market in India is an essential source of finance to industry, trade, commerce, and the Government sector for facilitating both the national and the international trade through bills–treasury/ commercial, commercial papers and other financial instruments and provides an opportunity to the banks to deploy their surplus funds to reduce their cost of liquidity. Some of the important instruments which are traded in the money market are explained in the next sections. 12.4.1 Call/Notice Money The call money market, or inter-bank call money market, is a segment of the money market where scheduled commercial banks lend or borrow on call, namely, overnight or at short notice, i.e., for periods up to 14 days to manage the day-to-day surpluses and deficits in their cash flows. These day-to-day surpluses and deficits arise due to the very nature of their operations and the peculiar nature of the portfolios of their assets and liabilities. The call money market is one of the most volatile segments of the Indian money market. The call money is characterised by the maturity of the very short period, i.e., of few hours. Call money involves the process of borrowing or lending the funds for a day. On the other hand, notice money consists of borrowing or lending funds from 2 days to 14 days. Call money is the most liquid money market and is the prime driver of daily interest rates in the market. If the call money rates fall, there is a rise in the liquidity, and if the call money rates increase, the liquidity falls. 206 UNIT 12: Financial Markets-I 12.4.2 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Commercial Bills Commercial bills are considered a vital source of availing finance for firms. The firms use commercial bills for buying and selling of materials. A commercial bill is an instrument that arises out of an authentic business trade transaction, i.e., credit transaction. As soon as products are sold on credit basis, the seller draws a bill on the buyer for the amount due. The buyer accepts it immediately to showcase his agreement to pay the amount mentioned therein after a specified date. Thus, a bill of exchange comprises a written order from the creditor to the debtor to pay a certain sum of money for goods supplied to a specific person after the expiry of a particular period. Bill financing is the core component of meeting the working capital needs of corporates in developed countries. The RBI has made its efforts towards the development of bill culture in India, keeping in view the peculiar benefits of commercial bills such as self-liquidating in nature, awareness of actual date transactions, offering recourse to two parties, or transparency of business activities. 12.4.3 Commercial Paper In the early 1990s, commercial paper became a popular source of short-term financing in our country. Commercial paper is an unsecured promissory note that a company issues to raise capital for a limited period time, usually 90 to 364 days. It is distributed to other businesses, insurance companies, pension funds, and banks by a single company. The sum raised by CP is usually rather substantial. Because the debt is completely unsecured, only companies with a solid credit rating can issue a CP. The Reserve Bank of India is responsible for its regulation. Some advantages of a commercial paper are as follows: A commercial paper is sold without any restrictions and is sold on an unsecured basis. It has high liquidity because it is a freely transferable instrument. In comparison to other sources, it delivers more significant funds. A commercial paper delivers a steady flow of cash. This is due to the fact that their maturity can be customised to meet the needs of the issuing corporation. In addition, maturing commercial paper can be repaid by the sale of new commercial paper. Businesses can invest their spare cash in commercial paper and make a decent return on it. Some limitations of commercial paper are as follows: Commercial papers can only be used to raise funds by financially sound and highly rated companies. This strategy cannot be used by new or modestly rated businesses to raise financing. The amount of money that can be generated through commercial paper is restricted by the amount of excess liquidity available with fund sources at any given time. Commercial paper is a faceless form of borrowing. As a result, extending the maturity of commercial paper is not possible if a company is unable to redeem its paper due to financial difficulties. 12.4.4 Certificate of Deposits The Certificate of deposit is a negotiable term-deposit accepted by commercial banks from bulk depositors at market- related rates. It is generally issued in dematerialised form or as part of a usance promissory note. All scheduled banks (barring Regional Rural Banks and Cooperative banks) are eligible to issue the Certificate of deposit. These instruments can be issued to investors, including individuals, business corporates, trusts, funds and associations. 207 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets The CD is a negotiable financial instrument which has a term-based maturity value. These deposits are short-term promissory notes having a maturity period of not less than three months and not more than one year. The various banks offer interest on the CD at the prevailing market rates. There is a sharp distinction between fixed deposit of the commercial banks and Certificate of deposit. While the fixed deposits are non-transferable, the CD is transferable and, therefore, it can be traded in the secondary market. The CD can be issued at a discount price on the face value/par value of the Certificate of deposit. The discount may be either at the front end or rear end. If the discount is at the front end, the effective rate of discount is more than the quoted rate whereas in case of the rear end, the discount rate is lower than the quoted price. Also, there is no lock- in period for the Certificate of deposit. 12.4.5 Treasury Bills (T-Bills) Treasury bills are the Government securities that are issued to raise funds for financing short-term Government projects. The RBI issues treasury bills to raise funds for the Government. These are issued as promissory note at a discounted price. The difference between the issue price and the redemption price is the interest received on treasury bills. The yield in the case of the Treasury bill is assured yield and the risk of default is almost zero or negligible. More relevant to the money market are the treasury bills issued as T-91, T-182 or T-364. Here, ”T” represents the treasury bill while the number represents the days of maturity. The maturity period for treasury bills ranges from 14 days to 364 days. While the RBI does not participate in the auctions of 14 days and 364 days treasury bills, it will be at its liberty to participate in the auctions and to buy part or the whole of the amount notified concerning 91 days treasury bills. Also, treasury bills are transferable by proper endorsements. Treasury bills are issued at a discounted price and are later redeemed at their face value, similar to the other money market instruments. T-bills are of two types, namely, regular and ad hoc bills. The regular T-bills are sold to the general public and the various banks. The ad hoc bills are issued for the state Government, semiGovernments, and other Government agencies to provide them temporary investment options for their surpluses and are not sold to the general public and banks. However, ad hoc bills were abolished in the year 1997. 12.4.6 Repo A repurchase agreement (Repo) is a short-term loan where both parties agree to the sale and future repurchase of assets within a specified contract period. For example, the seller sells a Treasury bill or other Government security with a promise to repurchase it at a specific date and at a price that includes an interest payment. Repurchase agreements are typically short-term transactions, often literally overnight. However, some contracts are open and have no set maturity date, but the reverse transaction usually occurs within a year. Dealers who buy repo contracts are generally raising cash for short-term purposes. Managers of hedge funds and other leveraged accounts, insurance companies, and money market mutual funds are active in such transactions. 12.5 GOVERNMENT (GILT-EDGED) SECURITIES MARKET Gilt-edged securities refer to high-grade bonds issued by certain Government. In the past, these instruments referred to the Certificates issued by the Bank of England (BOE) on behalf of the Majesty's Treasury, so named because the paper they were printed on customarily featured gilded edges. 208 UNIT 12: Financial Markets-I JGI JAIN DEEMED-TO-BE UNI VE RSI TY By nature, a gilt edge denotes a high-quality item whose value remains relatively constant over time. As an investment vehicle, this equates to high-grade securities with relatively low yields compared to riskier, below-investment-grade securities. For that reason, gilt-edge securities were once solely issued by blue-chip companies and national Governments with proven track records of turning profits. Aside from conventional gilts, the British Government issues index-linked gilts that offer semi-annual coupon payments adjusted for inflation. Although reliable Government bodies and large corporations offer gilt-edged securities, they present certain drawbacks. Primarily, the bonds tend to fluctuate with interest rates, where rate hikes will cause the price of gilt to decline and vice versa. With global economic conditions improving, rates are poised to bounce off near-zero levels, which means gilt funds are likely to experience a tumultuous ride. For this reason, investors looking to generate substantial returns may source better value in index funds. The most significant advantage of gilt-edge securities is the fact that these instruments are typically tied to interest rates. Consequently, they are ideal investments for retirees seeking reliable returns with minimal risk. 12.6 YIELD COMPUTATION The term”yield” refers to the earnings generated and realised on an investment over a particular period. It is expressed as a percentage based on the invested amount, current market value or face value of the security. In addition, it includes the interest earned or dividends received from holding a particular security. Depending on the valuation (fixed vs. fluctuating) of the deposit, yields may be classified as known or anticipated. In other words, it can be said that yield is an income-only return on investment calculated by taking dividends, coupons, or net income and dividing them by the value of the investment, expressed as an annual percentage. Yield provides a fair idea to investors on how much income will be earned by them each year relative to their investments’s market value or initial cost of their investment. 12.7 FINANCIAL GUARANTEES A financial guarantee refers to a non-cancellable promise given by a third party to guarantee investors that principal and interest payments will be made. The individual or entity providing a financial guarantee is referred to as the guarantor of the debt obligation. Its purpose of financial guarantees is to reduce or mitigate risks for the lender or investor who provided the money borrowed. A common example of a financial guarantee is when an insurance company guaranteesbonds issued by a company for financing. As a result, the insurance company ensures that the bond purchasers will be paid back their principal investment and the interest due to them, even if the company issuing the bonds defaults on repaying them. 12.7.1 Discount Market The Discount market is the section of the financial market which deals in discounted bills of exchange. Under the bill discounting method of finance, banks or financial institutions purchase a bill or invoice that has been drawn by a creditor (seller or a supplier or drawer) on his/her debtor (drawee). In most cases, the purchase is made based on a Letter of Credit (LC). Banks purchase the bills or invoices from the sellers at a discounted rate and, in turn, give them the amount after discount. The amount so discounted is the commission and a source of revenue for the bank. The amount of commission or discounting rate depends on the time left before the due date, the amount of the bill, and the risk involved. Before 209 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets discounting any bill, banks or the financial institution assesses the reputation and past payment records of both the seller and the buyer. In this type of arrangement, sellers get their money instantly and can provide their customers a considerable amount of credit period. Bill discounting is one of the most widely used practices for working capital finance. On or after invoice’s due date, banks present the bill or invoice to the buyer (drawee) and collect the whole amount from them. If the buyer delays the payment, the bank imposes a predetermined penalty interest on the supplier. The bank or financial institution that has purchased a bill from the seller may sell it further to another bank or financial institution to fulfil cash flow requirements. In this way, it can be endorsed multiple times. Bill discounting is essential. and the prime reason for the development of this type of financing arrangement is due to differences in the objectives of sellers and buyers. Selling companies want to get paid for goods/services supplied by them as soon as possible, but the buyers usually prefer buying from those sellers who provide more extended credit periods. In such circumstances, bill discounting creates a win-win situation because the seller is paid back his money immediately, and the buyer enjoys an extended credit period. A bill can be discounted only if the following conditions are met: A bill should be a usance bill. A bill must be drawn by the seller and endorsed by the drawee. A bill must have been accepted and should bear two good signatures. Bill discounting is always with recourse which means that the seller has to repay the amount in the case of non-payment by the drawee or the buyer. Bill discounting affects the seller’sbalance sheet because the receivables and the credit are both shown in its balance sheet. Some crucial advantages of bill discounting are as follows: Credit available at lower rates Better fund management Riskless lending Easier claim enforcement The rediscounting option creates liquidity The value of the bill does not change 12.8 COMMERCIAL AND COOPERATIVE BANKS Commercial Banks Commercial banks are those banks that are created primarily for commercial purposes and to gain profits. These banks carry out everyday banking functions such as accepting deposits, granting loans, etc. These banks provide banking services to individuals and businesses. No activity of the bank should adversely affect the interest of depositors. The Banking Regulation Act, 1949 govern it. Its area of operation is quite large. and it operates for profit motive. The account holders of a bank can borrow from the bank. Apart from deposits and loans, it offers a wide range of other banking products and services. 210 UNIT 12: Financial Markets-I JGI JAIN DEEMED-TO-BE UNI VE RSI TY The interest rate offered by these banks is less as compared to Cooperative banks. Some commercial banks are as follows: Public Sector Banks: Public sector bank refers to a bank wherein the majority stake (>50%) is held by the Government. The SBI, IDBI, and some nationalised banks are public sector banks. The list of nationalised banks is as follows: Bank of Baroda Bank of India Bank of Maharashtra Canara Bank Central Bank of India Indian Bank Indian Overseas Bank Punjab and Sind Bank Punjab National Bank State Bank of India UCO Bank Union Bank of India Private Sector Banks (Old and New): Private sector banks are those where private shareholders hold majority of the shares. Some prominent private commercial banks are Axis Bank, HDFC Bank, ICICI Bank, Kotak Bank, etc. Cooperative Banks Cooperative banks are registered as cooperative credit institutions under the Cooperative Societies Act, 1965. Scheduled Cooperative Banks are those banks that provide finance to agriculturists and rural industries. They also offer finance to trade and industries in urban areas but a limited extent. Cooperative banks are those banks that are created primarily for service motives. These banks provide banking services to individuals and businesses. Its area of operation is small, and it operates for profit motive. Member shareholders of the bank can borrow from the bank. Although it offers certain banking products and services, its variety is less than offered by commercial banks. The interest rate offered by these banks is relatively higher as compared to commercial banks. Cooperative banks rely on cooperation, open membership, democratic- decision making, mutual help, etc. Cooperative banks are further divided into Urban and Rural Cooperative Banks. The Urban Cooperative Banks (UCBs) are also known as primary Cooperative banks. The UCBs are registered as cooperative societies under the provisions of either the State Cooperative Societies Act of the concerned state or the Multi- State Cooperative Societies Act, 2002. The UCBs are regulated by dual authorities of RBI and the Registrar of Cooperative Societies (RCS) of State concerned or by the Central Registrar of Cooperative Societies (CRCS). The Rural Cooperative Banks work specifically in the rural areas. 12.9 INSURANCE COMPANIES The Indian insurance industry is one of the oldest industries in India. Oriental Life Insurance Company was the first organisation, which started in Kolkata in 1818. The Indian insurance industry is segmented into life and non-life insurance sectors. The Government of India nationalised the life insurance business 211 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets under Life Insurance Corporation of India in 1956 and non-life insurance business under General Insurance Corporation of India in 1972. In 1991, the Indian economic reforms opened the insurance sector to the private sector because the percentage of the insurance sector to Indian GDP was deficient compared to other developing countries. As a result Insurance Regulatory and Development Authority (IRDA) was set up as a regulatory authority to match the regulations with the global norms. The reforms have guided the entry of foreign players in the Indian insurance market through joint ventures with Indian insurance companies. The major foreign players are AIG, New York Life, Allianz, Standard Life, and Prudential. This has widened the insurance market. Earlier, there was less knowledge provided to customers; therefore, the importance of insurance was ignored. Howevernumerous advertising campaigns by insurance organisations have led to the improved awareness levels among Indian customers after reforms. Still, there is a lot of scope for expansion in this industry. The insurance organisations offer various products with lots of benefits. The entry of global players in the Indian insurance sector has also brought the insurance best services. The insurance organisations focus on providing customised insurance policies with better-trained insurance advisors. A few years back, the insurance policies were distributed only through agents; however, now, the customers can also buy the policies through the Internet. However, the potential of rural insurance market is still not tapped fully. Therefore, various organisations adopt innovative means, such as using gramsevaks instead of agents, to distribute insurance policies in different villages. After reforms, the growth of the Indian insurance industry has been entirely satisfactory. Every player wants to lure customers. They use different positioning choices, such as variety-based positioning (which involves selling different policies) and need-based positioning (which involves selling policies according to different needs of customers). However, making a positioning choice does not ensure the right strategic choice. In addition to positioning options, there are other activities, such as selection of product type, product price, services offered to customers, and distribution channel, which form the basis of a good strategic choice. Increasing competition in the insurance sector has made the insurance field more complex. Moreover, the Internet has also become a pressure for insurance organisations. This is because today customers can do their own research about the features of different policies and select the best policy. Apart from this, customers can calculate premiums through online premium calculators to identify the best costsaving policy for them. In India, the leading player in the insurance industry is Life Insurance Corporation (LIC). When the financial sector was centralised, LIC enjoyed a monopoly and did not care about attracting or retaining customers. However, after the deregulation of the financial sector, private players also entered the insurance market, which forced LIC to shift its focus toward customers. Thus, nowadays, most insurance organisations strive to make continuous innovation in their products and shift their focus from productcentric to customer-centric. Insurance organisations are required to maintain data related many policies as well as customers. Therefore, these organisations need to deploy appropriate technology and software to automate business processes. Therefore, most insurance organisations use an online servicing system that enables policyholders to have real-time access to their policy status and other relevant information. Moreover, these organisations have also implemented various technologies that help policyholders make online payments of their premiums. This reduces the time and efforts of customers. For instance, LIC has given 212 UNIT 12: Financial Markets-I JGI JAIN DEEMED-TO-BE UNI VE RSI TY a unique facility to its policyholders to make online payments of their premiums without any additional charges and check their policy details. Apart from this, technologies, such as Wide Area Network (WAN) and Interactive Voice Response System (IVRS) help integrate the functions of different branches of an insurance organisation with its head office and enable customers to get information any time. The top 10 insurance companies of India are: 1. Life Insurance Corporation of India (LIC) 2. Bajaj Allianz General Insurance 3. ICICI Prudential Life Insurance 4. ICICI Lombard General Insurance 5. Birla Sun Life Insurance 6. Tata AIG General Insurance 7. New India Assurance Co. 8. Iffco Tokio General Insurance 9. Oriental Insurance Co. 10. HDFC Standard Life Insurance Conclusion 12.10 CONCLUSION The financial system of each country is the combination of various submarkets, namely, money, capital and forex markets. The role of money market in the economy’s overall financial system is significant. In particular, the money market refers to the demand for short-term funds, usually ranging from overnight to a year. It assists in meeting the short-term and very short-term requirements of banks, financial institutions, firms, companies, and the Government. The money market in India is an essential source of finance to industry, trade, commerce, and the Government sector for facilitating both the national and the international trade through bills–treasury/commercial, commercial papers, and other financial instruments and provides an opportunity to the banks to deploy their surplus funds to reduce their cost of liquidity. The call money market, or inter-bank call money market, is a segment of the money market where scheduled commercial banks lend or borrow on call, namely, overnight or at short notice, i.e., for periods up to 14 days to manage the day-to-day surpluses and deficits in their cash-flows. Treasury bills are the Government securities that are issued to raise funds for financing short-term Government projects. The RBI issues Treasury bills to raise funds for the Government. These are issued as promissory note at a discounted price. A commercial bill is an instrument that arises out of an authentic business trade transaction, i.e., credit transaction. As soon as the products are sold on credit basis, the seller draws a bill on the buyer for the amount due. A Certificate of deposit is a negotiable term-deposit accepted by commercial banks from bulk depositors at market related rates. These deposits are generally issued in dematerialised form or as part of a usance promissory note. The RBI is the most important participant of the money market which takes requisite measures to implement the country;s monetary policy. As the central bank, the RBI is responsible for regulating 213 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets the money market in India.It injects liquidity in the banking system, when it is deficient or contracts the same in the opposite situation. Commercial banks are those banks that are created primarily for commercial purposes and to gain profits. These banks carry out everyday banking functions such as accepting deposits, granting loans, etc. Cooperative banks are are registered as cooperative credit institutions under the Cooperative Societies Act, 1965. Scheduled Cooperative Banks are those banks that provide finance to agriculturists and rural industries. They also provide finance to trade and industries in urban areas but a limited extent. The Indian insurance industry is one of the oldest industries in India. In 1991, the Indian economic reforms opened the insurance sector to the private sector because the percentage of the insurance sector to Indian GDP was very low as compared to other developing countries. 12.11 GLOSSARY Call money market: The market wherein the activities are confined generally Commercial paper: An unsecured negotiable promissory note through Notice money market: The market wherein the activities forming a small Treasury bill: The bills which provide a temporary outlet for short-term amount of business are transacted side by side with call money with a can deploy their short-term surpluses at relatively high return Government of India for a maturity period of 91 days, 182 days and 364 days maximum period of 14 days surplus as also provide financial instruments of varying short-term maturities to facilitate a dynamic asset-liabilities management and are issued by the inter-bank business, predominantly on an overnight basis which a highly rated company can derive cheaper funds. 12.12 CASE STUDY: RECENT DEVELOPMENT IN MONEY MARKET – DEBT SECURITISATION Case Objective This case study explains the importance of debt securitisation. The current buzzword in the money market is debt securitisation, which denotes converting retail loans into wholesale loans and they are reconverting into retail loans. Debt securitisation refers to the process whereby illiquid assets are pooled together into marketable securities to become saleable to the investors. Such a process of debt securitisation results in the creation of financial instruments secured by or representing an ownership interest in an income- producing asset or a pool of several assets. Such investments are usually secured by personal or real property loans such as automobiles and equipment, and can also be unsecured in few deals. Let us understand debt securitisation with the help of an example. Suppose a finance company that issues car/automobile loans further desires to raise more cash to issue more loans. For this purpose, it may sell all its existing car loans. However, this may not be feasible because of the absence of liquidity in the secondary market for individual car loans. Therefore, the finance company can pool many individual car loans and sell such asset pool’s interest to the prospective investors. Such process of pooling of assets enables the finance company to raise more funds, disburse other loans, and get its car loans off 214 UNIT 12: Financial Markets-I JGI JAIN DEEMED-TO-BE UNI VE RSI TY the statement of financial position. Additionally, debt securitisation is also beneficial for prospective investors because it gives them an attractive option of a liquid investment in a diversified pool of assets, i.e., car loans. The complete procedure of debt securitisation is executed in such a manner that the ultimate debtors, i.e., car owners shall not be aware of the same and will continue to make payments as earlier provided that these payments shall reach to the new investors instead of the finance company from where they had financed their automobiles from. The signalling factor behind the arrangement is that an individual body cannot go on a lending sizable amount for a more entended period continuously. However, when the loan amount is divided into small pieces and made transferable similar to negotiable instruments in the secondary market, it becomes easier to finance large projects having long gestation period. The experiment has already been enforced in India by the Housing Development Finance Corporation (HDFC) by selling a part of its loan to the Infrastructure Leasing and Financial Services Ltd. (ILFS) and has, thus, become a trendsetter for other kinds of debt securitisation as well. Questions 1. What is debt securitisation? (Hint: Debt securitisation refers to the process whereby illiquid assets are pooled together into marketable securities so that they become saleable to the investors.) 2. Name a few financial companies which have been following the route of debt securitisation for financing. {Hint: The Industrial Credit and Investment Corporation of India (ICICI) and the Housing Development Finance Corporation (HDFC).} 3. How does debt securitisation help? (Hint: By creating financial instruments secured or by representing an ownership interest in an income- producing asset or a pool of several assets.) 4. What types of assets are secured under debt securitisation? (Hint: Automobiles and equipment) 5. SEL Finance Company undertook the process of debt securitisation. The finance manager performed the process through the execution of the following tasks as explained hereunder: A. Securities (or asset pools) are sold on the undertaking without recourse to the seller B. Loans are divided into homogeneous pools C. Asset pools are transferred to a trustee D. Trustee issues securities that investors purchase What is the correct sequence of steps for debt securitisation? a. A – B – C – D b. B – C – D – A c. A – D – C – B d. C – D – A – B (Hint: b. B – C – D – A} 215 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets 12.13 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. Write a short note on monetary policy. 2. Explain the role of RBI in money market. 3. Central banks decide short-term nominal rates. These rates are the basis for other interest rates that banks and other institutions charge to consumers. Explain real interest rate and nominal rate. 4. Commercial banks are those banks that are created primarily for commercial purposes. What are the roles of commercial banks? 5. In 1991, the Indian economic reforms opened the insurance sector to the private sector. Write a short note on insurance companies. 12.4 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS A. Hints for Essay Type Questions 1. Monetary policy refers to the use of monetary policy instruments that are at the disposal of the central bank to regulate the availability, cost, and use of money and credit to promote economic growth, price stability, optimum levels of output and employment, the balance of payments equilibrium, stable currency or any other goal of Government’s economic policy. Refer to Section Monetary Policy and Money Supply 2. The RBI is the most important money market participant which takes requisite measures to implement the country’s monetary policy. As the central bank, the RBI is responsible for regulating the money market in India and injecting liquidity in the banking system when it is deficient or contracting the same in the opposite situation. The money market provides leverage to the RBI to effectively implement and monitor its monetary policy. For example, a developed bill market strives to make the monetary system of an economy more elastic. Wherever the country needs more cash, the banks can get the bills rediscounted from the RBI and, therefore, can increase the money supply. Refer to Section Monetary Policy and Money Supply 3. A real interest rate is one that takes inflation into account. This implies that the real rate adjusts for inflation and gives the real rate of a bond or loan. To calculate the real interest rate, the nominal interest rate is required. The real interest rate can be calculated using the nominal interest rate minus the actual or expected inflation rate. Refer to Section Structure of Interest Rates 4. Commercial banks carry out normal banking functions such as accepting deposits, granting loans, etc. These banks provide banking services to individuals and businesses. No activity of the bank should adversely affect the interest of depositors. It is governed by the Banking Regulation Act, 1949. Refer to Section Commercial and Cooperative Banks 5. Indian insurance industry is one of the oldest industries in India. Oriental Life Insurance Company was the first organisation, which started in Kolkata in 1818. Indian insurance industry is segmented into life and non-life insurance sectors. The Government of India nationalised the life insurance business under Life Insurance Corporation of India in 1956 and non-life insurance business under General Insurance Corporation of India in 1972. Refer to Section Insurance Companies 216 UNIT 12: Financial Markets-I @ JGI JAIN DEEMED-TO-BE UNI VE RSI TY 12.15 POST-UNIT READING MATERIAL https://www.icsi.edu/media/webmodules/publications/Full%20CC&MM.pdf https://fintech.neu.edu.vn/Resources/Docs/SubDomain/fintech/[Jeff_Madura]_Financial_ Markets_and_Institutions_11.pdf 12.16 TOPICS FOR DISCUSSION FORUMS Research on the Internet and prepare a report on some critical issues about the Indian money market, such as the multiplicity of interest rates or the lack of organised bill market. 217 UNIT 13 Financial Markets-II Names of Sub-Units Equities Market – Primary Markets – SEBI Norms (ICDR Regulations), Exit Routes, Introduction to Public Issues, Types of Issues, Appointing Merchant Bankers & Other Intermediaries, Their Role & Responsibilities, Filing DRHP & Types of Prospectus, Book Building Mechanism, Types of Investors, and ASBA Secondary Markets – Purpose & Procedures for Listing (post-IPO); SEBI Framework, Role of Stock Exchanges – NSE, BSE, Role of Secondary Market Intermediaries, Depositories, Overview of Bond Market and Recent Developments Overview This unit throws light on the functions of the primary market and the secondary market as well as the different types of issues in the primary market. This unit highlights the significance of various financial intermediaries functioning in the capital market. The roles, responsibilities and SEBI regulations governing the conduct of each of the capital market intermediaries are discussed in the unit. Learning Objectives In this unit, you will learn to: State the importance of the financial system List the functions of the financial system Classify financial markets Discuss different sources of finance Describe the role of financial regulatory and promotional institutions JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Learning Outcomes At the end of this unit, you would: Justify the interrelationship between the primary as well as the secondary markets Evaluate the structure and organisation of the secondary market in India, including its regulatory aspects Identify the need for services provided by merchant bankers, brokers, share transfer agents, registrars and bankers to an issue, underwriters, portfolio managers, custodians and debenture trustees Explore the SEBI regulations peculiar to each category of capital market intermediaries and rules/ guidelines applicable to them 13.1 INTRODUCTION The securities market can be further subdivided into two types, i.e., primary market or New Issues Market and Secondary Market or Stock Exchange. The primary market gives the channel for the sale of new securities. In the primary market, the issuers of securities/companies sell the securities to raise resources for investment and for meeting some obligatory requirements. In other words, through the primary market, funds move from investors to businesses for productive purposes. On the other hand, the secondary market acts as the marketplace for the sale of shares or securities previously issued. The secondary market allows investors holding securities to materialise their security holdings in response to variations in risk and return assessment and, therefore, ensures free tradability, negotiability and price discharge. It essentially comprises stock exchanges that provide a platform for the purchase and sale of securities by investors and where securities are traded after being initially offered to the public in the primary market. 13.2 PRIMARY MARKETS The primary market, also known as the new issues market or the IPO (Initial Public Offering) market, is a market wherein new stocks and securities of a company are traded, i.e., bought and sold for the first time. In other words, the market where the first initial offering of equity shares or convertible securities to the general public by a corporation takes place, followed by the listing of such shares on a recognised stock exchange, is known as the primary market. The new issues market also comprises issuing of further share capital by a corporation whose shares have already been listed on the stock exchange. Several types of intermediaries operate in this segment of the capital market and play a crucial role by providing a variety of services. These intermediaries are regulated by SEBI and include merchant bankers, brokers, portfolio managers, registrars to issues, share transfer agents, bankers to issues, debenture trustees, etc. The main role of the primary market is to facilitate the economy’s capital formation by channelising the funds of individual savers into proper productive investments. The issuing of securities in the primary market is made to the prospective shareholders through the use of a prospectus. The primary market is responsible for encouraging investors to invest their money in the new issues floated by companies. The three main functions of the primary market are as follows: 1. Origination: In the primary market, origination involves the investigation and evaluation of a new project proposal in terms of its economic, legal, technical and financial aspects. The process of origination begins before a new issue is launched in the market. Origination takes place with the help of merchant bankers, which can include banks, financial institutions or private investment 222 JGI UNIT 13: Financial Markets-II JAIN DEEMED-TO-BE UNI VE RSI TY firms. In origination, various sponsoring institutions are involved. These provide advisory services, such as a reduction of the price and the methods of issue. 2. Underwriting: It refers to guaranteeing the sale of a fixed number of shares at a particular price. Generally, a group of specialised banks or financial institutions underwrites a new issue to ensure its success. In case the underwriter is unable to sell shares to the public, it has to purchase the shares by itself. Therefore, underwriters ensure the success of a new issue by ensuring a minimum level of subscriptions of the issue. Underwriters are paid a commission for underwriting a new issue. If the issue is fully subscribed, no liability would be left for underwriters. 3. Distribution: The success of a new issue depends on the level of subscription of the issue. Various primary market participants, such as brokers and agents maintain direct contact with the supreme investors to distribute shares to the investors through their networks. 13.2.1 Types of Issues The issues made by Indian corporates may be primarily categorised into four divisions, viz., public issue, rights issue, bonus issue and private placement. Although the rights issue and the public issue comprise a detailed regulatory process, the bonus issue and private placement are comparatively simpler. The different kinds of securities issued in the primary market are shown in Figure 1: Different Kinds of Securities Issued in the Primary Market Public Issue Initial Public Offer Rights Issue Further Public Offer Bonus Issue Private Placement Preferential Issue Qualified Institutional Placement Institutional Placement Programme Figure 1: Different Kinds of Securities Issued Let us discuss these different types of securities issued. Public Issue/Public Offer (IPO and FPO) When an issue or offer of shares or convertible securities is given to the new investors for gaining ownership in the issuing company or for coming into their shareholders’ family, it is referred to as a public issue. The public issue or public offer can be categorised into the following: Initial Public Offer (IPO): An IPO is where an unlisted company goes for a fresh issue of shares or gives an offer for its existing shares for sale or both to the general public for the first time. Such an IPO leads to the listing and trading of the issuer company’s shares on the stock exchange. Further Public Offer (FPO) or Follow-on Public Offer: An FPO is where an already listed company goes for a fresh issue of shares to the public or gives an offer for sale to the general public. 223 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Rights Issue and Bonus Issue Rights issue is where an issuer corporation issues shares or securities to its existing shareholders on a specified fixed date known as the record date. The rights shares are given in a pre-specified ratio to the number of shares held by the existing shareholders as on the record date. The right shares are primarily issued to the existing equity shareholders at a discounted price to raise more capital from the market. On the other hand, bonus issue is where an issuer corporation issues shares or securities to its existing shareholders without any consideration in return, depending upon a particular proportion to the number of shares already held by them as on the record date. Bonus shares are issued by the company from out of its free reserves or share premium balance. Private Placement Private placement is where an issuer corporation issues shares or securities to a selected group of investors privately (not exceeding 200 members in a financial year) and not to the open market. It is neither a rights issue nor a public issue. It can be of three types, namely preferential allotment, Qualified Institutional Placement (QIP) and Institutional Placement Programme (IPP). Preferential Issue: Preferential issue or preferential allotment is made by a listed company to issue shares or convertible securities to selected individuals, venture capitalists, corporates or other persons on a preferential basis. Preferential allotment is to be made in compliance with the provisions of Chapter VII of SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009. The issuer company is needed to comply with several provisions concerning pricing, disclosures in the notice, lock-in, etc. Qualified Institutional Placement (QIP): Qualified Institutional Placement (QIP) is made by a listed company to issue equity shares, convertible debentures or other convertible securities other than warrants to qualified institutional buyers only. This issue is to be made in compliance with the provisions of Chapter VIII of SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009. It is a cost-effective issue as it does not comprise many of the common procedural requirements, such as the submission of pre-issue filings to the market regulator. Institutional Placement Programme (IPP): Institutional Placement Programme (IPP) is where a listed company goes for further public issue or offer for sale of shares by promoter/promoter group to raise additional share capital to achieve minimum public shareholding requirements. Here, the offer, allocation and allotment of securities are made only to qualified institutional buyers in accordance with the provisions of Chapter VIII-A of SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009. 13.3 SEBI NORMS (ICDR REGULATIONS) SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR Regulations”) mandates that the promoters of the issuer company shall maintain ‘Minimum Promoters’ Contribution’ (“MPC”) which shall be locked-in for a stipulated period of time. However, the requirements of MPC and lock-in are not applicable if the funds are raised through following modes: 1. Rights issue 2. in case of a IPO/FPO – where the issuer does not have any identifiable promoter; 3. in case of a FPO – on a condition that the equity shares of the issuer are frequently traded for a period of at least three years and the issuer is dividend paying company. 224 UNIT 13: Financial Markets-II JGI JAIN DEEMED-TO-BE UNI VE RSI TY SEBI, in its agenda of Board Meeting dated 16th December, 2020 to discuss amendment in ICDR Regulations proposed to do away with the MPC and lock-in requirements for a listed company making an FPO, where shares are listed for past three years, without linking it to its dividend paying capacity. The rationale for the proposed amendment was that an issuer raising funds through an FPO, is already a listed company and has fulfilled the obligation of MPC at the IPO stage. Further, all the information/ disclosures about the issuer is available in the public domain and the investors willing to subscribe in the FPO have sufficient knowledge to take an informed decision. Thus, SEBI vide notification dated 8th January, 2021 issued SEBI (Issue of Capital and Disclosure Requirements) (Amendment) Regulations, 2021 (“Amendment Regulations”). 13.4 TYPES OF PROSPECTUS A prospectus refers to a legal document for market participants and investors to pursue, detailing the features, prospects and promises of a financial product. It is mandated by the law to be supplied to prospective customers. For example, in an IPO, the prospectus tells potential shareholders about the company’s plans and business model. The company provides a prospectus with capital raising intention. Prospectus helps the investors to make a well-informed decision because of the prospectus all the required information of the securities which are offered to the public for sale. There are four types of the prospectus as mentioned in the Companies Act, 2013, which are explained as follows: 1. Abridged prospectus: As the name suggests, an abridged prospectus is the summarised offer document that contains salient features of an ordinary prospectus. It is issued together with the company’s application form of pubic issue. 2. Red herring prospectus: It is a prospectus used when there is a book built public issue. It consists of all material facts and information excluding the price or quantum of the securities offered for sale. These facts are related to the company’s operations and prospects, but the relevant details about the offering are not mentioned. 3. Shelf prospectus: This prospectus is issued by any public financial institution, company or bank for one or more issues of securities or class of securities as mentioned in the prospectus. When a shelf prospectus is issued, the issuer need not issue a separate prospectus for each offering he can offer or sell securities without issuing any further prospectus. 4. Deemed prospectus: When a company offers securities for sale to the public, allots or agrees to allot securities, the document will be considered as a deemed prospectus through which the offer is made to the public for sale. A deemed prospectus has been stated under section 25(1) of the Companies Act, 2013. The document is deemed to be a prospectus of a company for all purposes and all the provision of content and liabilities of a prospectus will be applied upon it. 13.4.1 Book Building Mechanism SEBI guidelines defines Book Building as “a process undertaken by which a demand for the securities proposed to be issued by a body corporate is elicited and built-up and the price for such securities is assessed for the determination of the quantum of such securities to be issued by means of a notice, circular, advertisement, document or information memoranda or offer document”. Book building is a process used in Initial Public Offer (IPO) for finding an efficient price. It is a mechanism where, during the period for which the IPO is open, bids are collected from investors at various prices, which are above or equal to the floor price. The offer price is determined after the bid closing date. 225 JAIN JGI DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets As per SEBI guidelines, an issuer company can issue securities to the public though prospectus in the following manner: 100% of the net offer to the public through book building process 75% of the net offer to the public through book building process and 25% at the price determined through book building. The Fixed Price portion is conducted like a normal public issue after the Book Built portion, during which the issue price is determined. The concept of book building is relatively new in India. However, it is a common practice in most developed countries. 13.4.2 Filing DRHP A Draft Red Herring Prospectus (DRHP), also known as an offer document, is the preliminary registration document prepared by merchant bankers for prospective IPO-making companies in the case of book-building issues. The document contains information on the company’s business operations, promoters, financials, its standing in the industry it deals in and listed or unlisted peers. The document also provides the reasons for why a company wants to raise money from the public, how the money will be used and the risks involved in investing in the company. It does not contain details of either price or number of shares being offered or the amount of issue. This means that in case the price is not disclosed, the number of shares and the upper and lower price bands are disclosed. On the other hand, an issuer can state the issue size and the number of shares is determined later. The price cannot be determined until the bidding process is completed. In the case of book-built issues, such details are not shown in the red herring prospectus filed with ROC in terms of the provisions of the Companies Act. The role of the merchant banker, in this case, is to take care of the legal compliance issues and ensure that prospective investors are aware and kept in the loop of public issues. 13.5 APPLICATIONS SUPPORTED BY BLOCKED AMOUNT (ASBA) ASBA is an application containing an authorisation to block the application money in the bank account, for subscribing to an issue. If an investor is applying through ASBA, his application money shall be debited from the bank account only if his/her application is selected for allotment after the basis of allotment is finalised or the issue is withdrawn/failed. It is a supplementary process of applying in Initial Public Offers (IPO), right issues and Follow on Public Offers (FPO) made through book-building route and co-exists with the current process of using cheque as a mode of payment and submitting applications. The following are the benefits of ASBA: An investor need not pay the application money by cheque rather block his/her bank account to the extent of the application money, thus continue to earn interest on application money. The investor does not have to bother about refunds, as in ASBA only an amount proportionate to the securities allotted is taken from the bank account when his/her application is selected for allotment after the basis of allotment is finalised. The application form is simpler. The investor deals with the known intermediary, i.e., his or her bank. No loss of interest, since the application amount is not debited to the savings account on the application. 226 UNIT 13: Financial Markets-II JGI JAIN DEEMED-TO-BE UNI VE RSI TY Since the amount is available in the account, it is considered for the calculation of the Average Quarterly Balance (AQB). The customer can revise/withdraw the bid before the end of the Issue in the prescribed format with the Bank. 13.6 TYPES OF INVESTORS Most start-ups depend on investors for funding in their new businesses. Irrespective of the fact whether the company is introducing a new product, conducting an upgrade on equipment, or expanding operations, the investor’s capital can offer tremendous support for the company. It is common for startups to seek the help of investors that would help them give a proper base to their project and plan. There are four main kinds of investors for start-ups which include: 1. Personal investors: Most business owners depend on their close acquaintances, friends or family to help them by investing in their business generally at the initial stages. These types of investors are called personal investors. Although these investors can assist with funding, there is a limit to how much they can invest in a company. 2. Angel investors: Angel investors are those who put their money in small start-ups or new entrepreneurs. This is the most popular type of investor. An angel investor might even be close to the start-up owner, like friends or family. Angel investment is normally either a one-time off funding for the business to propel or an ongoing investment to support and take the company ahead in the initial stages. Angel investors usually offer much more favourable terms as compared to the other type of investors. The reason is that angel investors invest in the entrepreneur opening a business, and not the viability of the company. In short, angel investors are always focused on helping the start-ups to grow in the initial stages instead of obtaining a profit from it. 3. Venture capitalist: A venture capitalist is an institutional investor who has the access to liquid funds and is ever willing to part with talented start-ups and innovative entrepreneurial enterprises that need that extra bit of hand holding and support. A Venture Capital Fund (VCF), as opposed to a venture capitalist, is a firm that functions as an investment fund having pooled resources from several self-styled and serious venture capitalists and is seeking a private equity stake in startups and innovative enterprises. Before deciding to finance, the venture capitalists follow a strict selection criterion based on the evaluation of the start-up, its promoters, its mission and vision, the numbers in terms of estimated cash flows, estimated profits, breakeven point and a whole lot of similar parameters. 4. Peer-to-peer lenders: They are groups or individuals who provide capital to small business owners. However, to obtain this capital from these types of investors, the owners would need to apply with companies that are experts in peer-to-peer lending. As soon as the owner’s application gets approved by the company, the lenders would then determine if the company is right for their investment or not. 13.7 SECONDARY MARKET According to the original issuance of stocks and securities in the primary market, where an investor buys a security from another investor rather than from the issuer/issuing company, it is known as the secondary market. The secondary market is of two types, namely the stock exchange and the overthe-counter market. The stocks and securities are said to be traded in the secondary markets when they are transferred from the first holder to another investor of the securities. The secondary market is the market wherein the securities issued in the primary market are traded. These securities include government securities, shares, bonds and debentures. It acts as a platform where the interaction of 227 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets the demand and supply of shares and securities takes place. The functions performed by the secondary market are as follows: Liquidity and marketability of securities: The basic role of the stock market is to create a continuous market for securities, enabling such securities to be liquidated, where investors can convert their securities into cash at any time at the prevailing market price. Also, the investors hold the opportunity to change their portfolio as and when they want to change, i.e., enabling them to sell one security and purchase another at any time, thus giving them marketability. Many institutional investors, such as banks and insurance companies invest their money in a large number of securities. These securities can be converted into cash as and when required by the institutions. Thus, it adds liquidity to the economy by providing marketable securities. Economic indicator: The changes taking place in the economy owing to government policy interventions or any other national/international event have a direct bearing on the stock exchange. Thus, the stability of the economy is indicated more or less by the state of transactions in the secondary market. Contributes to economic growth: The stock exchange plays a major role in facilitating money movement for productive purposes across the economy. Thus, it plays a pivotal role in the growth of the economy. Funds are allocated to the most efficient sectors through disinvestment or reinvestment processes. Valuation of securities and fair price determination: The secondary market works on the price mechanism and evaluates the price of securities based on demand and supply. The constant quoting of the market price by stock exchanges allows investors to be aware of the current market values of the security. On this basis, the production of various indexes takes place. This further indicates the market and economic trends. Therefore, it is also termed as a barometer of the economy. Higher demand will be noticed for the securities of growth-oriented companies that are doing good in comparison to the securities of companies that are not doing good. As a consequence, the share prices of growth-oriented companies shall be high. Safety and measure of fair dealing: The secondary market provides a rigid set of rules for all participants to safeguard the investors’ trust. This helps investors in making a fair judgement of securities. Therefore, the company is required to disclose all the material facts to its shareholders. Moreover, the transactions executed in the secondary market are safe as all trading takes place in an electronically managed system, which is highly secure. 13.8 PRIMARY AND SECONDARY MARKET INTERMEDIARIES Market intermediaries operate as a connecting link between the providers of capital/finance and the seekers of capital/finance. Every person functioning in the capital market other than the issuer of securities and the investor can be regarded, market intermediary. In the era of closed markets, intermediaries were not common since buyers and sellers entered into transactions with each other nearby and the need for a middleman was not felt. However, with the expansion and maturity of financial markets, it was no longer feasible for buyers and sellers to transact directly. As a result, contemporary capital markets in India are substantially dependent upon the services of market intermediaries. The issuers and investors in the capital market act as providers and consumers of products or services. Such services are rendered by the intermediaries wherein the investors are considered as consumers (they opt for and trade in stocks) of securities granted by issuers. With a view to providing a product to satisfy the requirements of each investor and issuer, the intermediaries figure out and contemplate more and more complicated products. Capital market intermediaries educate, inform and guide investors and issuers in their dealings and bring them together. The growth of the capital market 228 JGI UNIT 13: Financial Markets-II JAIN DEEMED-TO-BE UNI VE RSI TY has been quite remarkable in India for the past few years. It has been signalled by the earmarks of exponential growth in terms of amount raised from the capital market, market capitalisation, number of stock exchanges, number of intermediaries, number of listed stocks, trading volumes and investors’ population. Moreover, the roles and nature of investors, issuers of securities and intermediaries have also undergone significant changes. Due to the implementation of some prolonged institutional changes in the capital market, it has witnessed a drastic decline in transaction costs, major improvements in efficiency and transparency, and the betterment of safety concerns. Major intermediaries involved in the capital market are as follows: Merchant bankers Portfolio Managers Underwriters Registrar and Transfer Agent (RTA) Brokers Depository Bankers to an Issue Custodians Debenture Trustees Clearing Houses The roles and functions of each of these capital market intermediaries are discussed in detail in the following subsections of this unit. 13.8.1 Merchant Bankers As per SEBI (Merchant Banker) Regulations, 1992, ‘merchant banker’ is defined as any person who is engaged in the business of issue management, either by making arrangements regarding selling, buying, or subscribing, or acting as a manager, consultant, or advisor, or rendering corporate advisory services in relation to such issue management. It is mandatory to appoint a merchant banker in case of both public issues and rights issues, and his task mainly is that of a facilitator or coordinator. To initiate the process of a public issue, the issuing company has to pass a board resolution for appointing a merchant banker with whom a memorandum of understanding may be entered. Merchant bankers are responsible for coordinating the procedure of issue management by assisting underwriters, registrars and bankers in activities of pricing and marketing of the issue and complying with SEBI rules and guidelines. Merchant bankers, often known as lead managers, also conduct due diligence of pre-issue and post-issue activities of public the issue. However, merchant bankers are prohibited from executing some activities, such as acceptance of deposits, leasing and discounting of bills. Moreover, they cannot borrow any money from the market. They are deterred from indulging in activities of purchase and sale of securities on a commercial basis. Merchant bankers may belong to the public sector, private sector or to any foreign sector. Some of the prominent merchant bankers in India are as follows: Axis Bank Bajaj Capital Bank of America Barclays Securities (India) Citigroup Global Markets India Goldman Sachs (India) Securities ICICI Securities 229 JAIN JGI DEEMED-TO-BE UNI VE RSI TY IFCI Financial Services Kotak Mahindra Capital Company Morgan Stanley India Punjab National Bank Reliance Securities SBI Capital Markets Tata Capital Markets Yes Bank 13.8.2 Principles of Economics and Markets Underwriters An underwriter is an individual/entity who is engaged in the business of underwriting the public issue of securities of a particular company. Underwriting is an arrangement in which a SEBI-registered underwriter gives an undertaking to the issuing company that in case the company’s public issue is not fully subscribed, the underwriter will purchase the unsubscribed portion of the public issue. For public issue of securities, underwriting is a compulsory exercise and the company cannot completely rely on promotional advertisements to attain full subscription. This is so because it is mandatory for a public company inviting public subscription for its shares/securities to ensure that 90% of its public issue is fully subscribed; otherwise, the whole issued amount needs to be refunded back. Wherever there is any under-subscription of the issue, it has to be compensated or nullified by the underwriters by purchasing the unsubscribed shares. Moreover, the underwriting agreement is to be executed in advance of the opening of public issue of securities. The underwriters of an Initial Public Offer (IPO) are usually investment banks employing IPO experts on their panel. The underwriters contact a wide array of institutional investors including mutual funds and insurance companies to secure their investment interest in the company. The quantum of interest received from them enables the underwriters to set the IPO price for the company’s stock. The underwriters guarantee a particular number of shares that will be sold at that initial price and will buy any surplus lying unsubscribed. Some of the underwriting companies in India include: Aarnik Securities Private Limited Adroit Corporation Private Limited Ajel Infotech Limited Choksh Infotech Limited Apollo Industries & Projects Limited Arihant Corporate Services Limited 13.8.3 Brokers Stock brokers are persons who buy and sell shares and other securities for their clients through a stock exchange. Stock brokers need to be registered with SEBI and are governed by the rules of the SEBI Act, 1992 and the Securities Contracts (Regulation) Act, 1956. Brokers need to hold good knowledge about the securities market, have fair interpersonal skills and oversee all the important details. Stock brokers need to comply with the prescribed code of conduct defined by SEBI. Brokers are important intermediaries in the stock market as they bring buyers and sellers together. However, 230 UNIT 13: Financial Markets-II JGI JAIN DEEMED-TO-BE UNI VE RSI TY the brokerage on transactions varies from broker to broker. The maximum allowable brokerage is 2.5% of the contract price. In other words, a broker is an individual or entity who charges a fee or commission for exercising ‘buy and sell’ orders submitted by an investor in the stock market. Some of the leading stock brokers in India include India Infoline Limited, ICICI Direct, Share Khan, India Bulls, Kotak Securities Limited, Geojit Securities, HDFC, Reliance Money, Religare and Angel Broking Limited. Sub-brokers are persons who are not trading members of a stock exchange. However, they function on behalf of trading members as an agent. The task of a sub-broker is to assist investors in dealing with securities through trading members, i.e., brokers. A few differences between brokers and sub-brokers are as follows: Brokers are trading members of the stock exchanges whereas sub-brokers are not. Brokers are registered or affiliated with the stock exchanges, whereas the sub-brokers must be affiliated with the brokers. Individual stock exchanges may require sub-brokers to get a certificate for conducting their business. Brokers can charge brokerage fees, but the sub-brokers cannot. 13.8.4 Bankers to an Issue A banker to an issue means a scheduled bank performing any one of the tasks, namely acceptance of application money, acceptance of allotment or call money, refund of application money, payment of dividend or interest warrants. A banker to the issue carries out the important task of ensuring that the funds are collected and transferred to the escrow accounts belonging to the issuer/issuing companies. The banks do a great favour to the companies in the mobilisation of capital. Generally, merchant bankers act as the banker to the issue. 13.8.5 Debenture Trustees A debenture trust deed is a written document prepared by the company wherein debenture trustees are appointed to protect the interests of the debenture, holders holding debentures in such a company. As per the SEBI Act, 1992, the entities which can be appointed as debenture trustees include scheduled banks carrying on commercial activity, public financial institutions, insurance companies, or a body corporate. Moreover, an entity to perform as a debenture trustee should be registered with SEBI. The debenture trust deed entered into with the debenture trustee must mention the rate of interest, date of interest payments, and the amount of principal repayments. According to the SEBI (Debenture Trustees) Regulations, 1993, the duties of the debenture trustees include the following: (a) Call for periodical reports from the body corporate, i.e., issuer of debentures (b) Take possession of trust property in accordance with the provisions of the trust deed (c) Enforce security in the interest of the debenture-holders (d) Ensure on a continuous basis that the property charged to the debenture is available and adequate at all times to discharge the interest and principal amount payable in respect of the debentures and 231 JAIN JGI DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets that such property is free from any other encumbrances except those which are specifically agreed with the debenture trustee (e) Exercise due diligence to ensure compliance by the body corporate with the provisions of the Companies Act, the listing agreement of the stock exchange or the trust deed (f) To take appropriate measures for protecting the interest of the debenture-holders as soon as any breach of the trust deed or law comes to his notice (g) To ascertain that the debentures have been converted or redeemed in accordance with the provisions and conditions under which they are offered to the debenture-holders (h) Inform the Board immediately of any breach of trust deed or provision of any law (i) Appoint a nominee director on the board of the body corporate when required Some of the companies registered with the SEBI and acting as debenture trustee are as follows: Allahabad Bank Andhra Bank Axis Bank Ltd. (formerly UTI Bank Limited) Bank of India Bank of Maharashtra Beacon Trusteeship Limited Canara Bank Catalyst Trusteeship Limited Centbank Financial Services Ltd. 13.8.6 Portfolio Managers As per SEBI Act, 1992, a portfolio manager is a body corporate who, pursuant to a contract or arrangement with a client, advises or directs or undertakes on behalf of the client (whether as a discretionary portfolio manager or otherwise), the management or administration of a portfolio of securities or the funds of the client. In other words, a portfolio manager is a person holding the responsibility of making investments from a fund’s assets, monitoring the investment strategy and carrying out day-to-day trading. Portfolio managers handle mutual funds and other investment funds, such as hedge or venture funds. The portfolio manager might be an experienced investor, a broker, a fund manager, or a trader holding good knowledge of industry and having a proven record of generating good results. Prior to minimum two days before running into an agreement with the client, the portfolio manager furnishes a disclosure document to the client. Such disclosure document comprises details of amount and manner of payment of fees by the client, full disclosures in relation to transactions entered with related parties, portfolio risks, the audited financial statements of the portfolio manager for the preceding three years’ period, etc. List of portfolio managers registered with the SEBI are as follows: 4A Securities Bellwether Capital Private Limited Centrum Alternatives LLP 232 UNIT 13: Financial Markets-II Deutsche Investments India Private Limited Edelweiss Asset Management Limited Franklin Templeton Asset Management (India) Private Limited 13.8.7 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Registrar and Transfer Agent (RTA) As per SEBI (Registrars to an Issue and Share Transfer Agents) (Amendment) Regulations 2018, ‘Registrar to an Issue’ means a person who is involved with the following activities: (a) Collecting applications on behalf of the investors and keeping a proper record of monies received from investors or paid to the seller of the securities. (b) Helping the company which has issued shares in determining the basis of allotment of the securities in consultation with the stock exchange. (c) Finalising the list of persons entitled to allotment of securities. (d) Processing and dispatching of allotment letters, share certificates, refund orders and other related documents in respect of the issue. ‘Share Transfer Agent’ means a person who on behalf of the issuer company maintains the records of holders of securities issued by such company. Both registrars to an issue and share transfer agents act as one of the most essential intermediaries operating in the primary market. They assist the issuing company in mobilising new capital and ensure that proper records concerning the details of the investors are adequately maintained so that the decisions in regard to the basis for allotment and the number of securities to be allotted can be implemented smoothly. Some of the RTAs registered with the SEBI are as follows: 3I Infotech Limited (formerly ICICI Infotech Ltd.) Apollo Tyres Ltd. BGSE Financials Ltd. Canbank Computer Services Ltd. Data Software Research Company P. Ltd. Finolex Industries Limited Gujarat Narmada Valley Fertilizers Co. Ltd. 13.8.8 Depositories In simple terms, depository is a place where stocks and securities are kept safely. With reference to the stock market, it is an organisation that holds securities in electronic form securely and assists in the transfer of ownership of securities. As per Section 2(e) of the Depositories Act, 1996, ‘Depository means a company formed and registered under the Companies Act, 2013 and which has been granted a certificate of registration under the Securities and Exchange Board of India Act, 1992.’ Under the depository system, the transactions in shares and securities are made completely on a paperless or electronic basis. In case of a depository, an investor who is willing to invest in the stock market opens a ‘Demat Account’ with a depository. Whenever shares are allotted to him, his particular account shall get credited and whenever any securities are sold by the investor, his ‘Demat Account’ shall get debited with the number of securities sold. 233 JAIN JGI Principles of Economics and Markets DEEMED-TO-BE UNI VE RSI TY Some of the benefits offered by a depository system are as follows: The settlement cycle has become quicker. It eliminates the risks present in the physical certificate, for example, forgery, delays, mutilation, theft and damage of share certificates. Electronic transfer of securities enables the investor to get dividend, bonus shares and rights shares quickly. The depository system enables a company to maintain and update its shareholding pattern on a periodical basis. This is so because the company has knowledge of the beneficial ownership and their holdings at all times. The cost of issue of securities also gets lowered because of the dematerialisation of securities. The transfer process under the depository system is quick and without any kind of defects. Thus, complaints against the company by investors have been greatly minimised in this regard. Use of the depository system has gravitated foreign institutional investors in huge numbers. In India, there are two depositories, namely the National Securities Depository Ltd. (NSDL) and the Central Depository Services India Ltd. (CDSL). There are hundreds of participants in each of the depository known as depository’s participants. 13.8.9 Custodians Custodians play an important role in the securities market. The SEBI (Custodian of Securities) Regulations, 1996 were implemented for the proper conduct of their operations. According to SEBI regulations, custodial services in relation to securities of a client or gold/gold-related instrument held by a mutual fund or title deeds of real estate assets held by a real estate mutual fund mean safekeeping of such securities or gold/gold related instruments or title deeds of real estate assets and providing related services. The ancillary services provided by custodians include the following: Maintaining accounts of the securities of a client Collecting the benefits/rights accruing to the client in respect of securities Keeping the client informed of the actions taken by the issuer of securities Maintaining and reconciling records of the services referred to as above Some of the custodians registered with the SEBI are as follows: Axis Bank Ltd. Citi Bank N.A. BNP Paribas DBS Bank India Limited 13.8.10 Clearing House A clearing house is an exchange-associated body responsible for executing the function of ensuring or guaranteeing the financial integrity of each trade. In other words, orders are cleared through the channel of the clearing houses, which act as the buyer to all sellers and as the seller to all buyers. Clearing houses offer a variety of services in relation to the guarantee of contracts, clearance and settlement of trades and assessment of risk factors for their members and connected exchanges. The role of the clearing houses is to ensure adherence to the system and procedures for smooth trading, to minimise credit risks by acting as a counter-party to all trades, to involve daily recording/accounting of all gains 234 UNIT 13: Financial Markets-II JGI JAIN DEEMED-TO-BE UNI VE RSI TY or losses, to ensure delivery of payment for assets on the maturity dates for all outstanding contracts, and to monitor the maintenance of speculation margins. In India, there are only a few clearing houses, such as India International Clearing Corporation (IFSC) Limited, Indian Clearing Corporation Ltd. and Metropolitan Clearing Corporation of India Ltd. 13.9 ROLE OF STOCK EXCHANGES Stock markets offer a variety of facilities and services to individual investors and companies. Some services provided by stock exchanges to individual investors are as follows: Acts as collateral: Investments made in stock market instruments can be kept as collateral for seeking loan from a bank. Offers safe investments: The securities that are listed for trade are put up on stock exchanges only after they are duly scrutinised by exchange authorities. This ensures that only the securities of companies with strong financials are listed on exchanges. Boosts the growth of industry: The investors’ money that they spend to buy shares is used by companies to further their growth. When industries in an economy grow, this contributes in the growth of the economy also. Provides a buy/sell facility: The investors can buy and sell securities according to the latest market trends. Provides liquid investments: The investments made by an investor can be liquidated within a short period of time. Some services provided by stock exchanges to companies are as follows: Provides financial support: Companies whose stocks are listed on stock exchanges can raise finance for various purposes, such as promotion, expansion and modernisation. Creates goodwill: Companies whose stocks are listed on stock exchanges enjoy better goodwill and reputation in the market as compared to their unlisted counterparts. Facilitates the pricing of listed securities: Stock markets determine the value of each listed security using a sound price discovery mechanism. The price of listed securities is usually higher than unlisted ones. Supports fast selling of securities: The shares of listed companies are sold on the stock exchanges easily. Some important facilities provided by stock exchanges to investors include: Trading: Most stock exchanges provide trading platforms that can be accessed using an automated user interface. Over this trading platform, buyers and sellers can see the trading position of all the stocks and can place their order for buying or selling securities according to their requirements. Clearing and settlement: All the sell and buy trades that are executed in the entire day over a stock exchange are cleared and settled after trading hours. The stock exchanges in India operate according to a well-defined settlement procedure and the settlement cycle is fixed. The stock exchanges work responsibly and there are no deviations from the procedures. Stock exchanges net-off all the aggregated trades and positions that took place during the trading hours to determine the liabilities of all the trading members. Indian stock exchanges operate according to the T+2 settlement cycle, which means that the transfer of securities and funds is completed two days after the day on which the trade was executed. 235 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Margin Trading Facility (MTF): Under this facility, the investors can buy stock market securities even if they do not have the total amount required for purchasing the securities. In margin trades, the investor has to pay only a fraction of the total transaction value known as margin. The margin can be paid in the form of cash or shares can be kept as collateral. The remaining amount of the transaction is paid for by the investor. Not every security can be bought using margin trades. The SEBI and stock exchanges regularly revise the securities that are eligible for trade using MTF and the margin requirements are also prescribed by them on regular intervals. 13.9.1 BSE and NSE In India, there are two main stock exchange markets namely National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). Bombay Stock Exchange (BSE) BSE was established in 1875 and was formerly known as ‘The native share and stock brokers association’. However, after 1957, the Government of India recognised this stock exchange as the premier stock exchange of India, under the Securities Contract Regulation Act, 1956. SENSEX was also introduced in 1986 as the first ever equity index of India to offer an identifying base for top 30 exchange trading companies. In 1995, BSE on-line trading (BOLT) was established, and at that time, its capacity amounted to 8 million transactions per day. BSE is the first stock exchange of Asia, and it offers varied services such as market data services, risk management and CDSL (Central Depository Services Limited) depository services. National Stock Exchange (NSE) NSE is located in Mumbai and is India’s leading stock exchange market. It first came into existence in 1992 and brought with it an electronic exchange system in India, which led to the removal of the paper-based system. NSE introduced Nifty 50 in 1996 as the identifying base for top 50 stock index, and it is extensively utilised as Indian capital markets’ barometer and by Indian investors. NSE became a stock exchange recognised company by 1993, and in 1992, it was incorporated as a tax paying company under Securities Contracts Act, 1956. Formation of NSDL (National Securities Depository Limited) took place in 1995 to offer investors a safe platform for transferring and holding their bonds and shares electronically. National Stock Exchange is the 10th biggest stock exchange marketplace, and as of March 2017, its market capitalisation reached over $1.41 trillion. 13.10 OVERVIEW OF BOND MARKET AND RECENT DEVELOPMENTS The bond market, generally called the debt market, fixed-income market or credit market, is the collective name given to all trades and issues of debt securities. Governments typically issue bonds to raise capital to pay down debts or fund infrastructural improvements. Central banks have multiple interests in the development of bond markets. At the fundamental level, the government bond markets help to fund budget deficits in a non-inflationary way; thus, enhance the effectiveness of monetary policy. In 2020, India stood out with $13.7 billion worth of outflows from its bond market even as most of its Asian peers saw record inflows. The country’s equity market continues to see record dollar inflows but foreign investors are still exiting bonds. Mint takes a deep dive. 236 UNIT 13: Financial Markets-II Conclusion JGI JAIN DEEMED-TO-BE UNI VE RSI TY 13.11 CONCLUSION The Indian capital market is basically divided into two parts, viz., primary market and secondary market. The primary market, also known as the new issues market or the IPO (Initial Public Offering) market, is a market wherein the new stocks and securities of a company are traded, i.e., bought and sold, for the first time. The main role of the primary market is to facilitate the economy’s capital formation by channelising the funds of individual savers into proper productive investments. Pursuant to the original issuance of stocks and securities in the primary market, where an investor buys a security from another investor rather than from the issuer/issuing company, it is known as secondary market. The issues made by Indian corporates may be primarily categorised into four divisions, viz., public issue, rights issue, bonus issue and private placement. Market intermediaries operate as a connecting link between the providers of capital/finance and the seekers of capital/finance. The major intermediaries involved in the capital market are merchant bankers, registrars to an issue and share transfer agents, underwriters, bankers to an issue, debenture trustees, portfolio managers, stock brokers and sub-brokers, depositories, custodians and clearing houses. After the initiation of reforms in 1991, the secondary market has adopted a system constituting regional stock exchanges, the National Stock Exchanges (Bombay Stock Exchange–BSE and National Stock Exchange–NSE), Over the Counter Exchange of India (OTCEI) and the Interconnected Stock Exchange of India (ISE). The NSE was set up in 1994 and was the first stock exchange in India to bring in new technology, new trading practices, new institutions and new products. 13.12 GLOSSARY Bonus Issue: The issue of new shares out of the accumulated profits of a company to its existing shareholders without any consideration Initial Public Offering (IPO): An issue where an unlisted company makes a public issue for the first time to get the shares listed on the stock exchange Rights Issue: An additional issue where the existing shareholders are entitled to apply for new shares in direct proportion to the number of shares held by them Trading: The transactions of purchase and sale of securities among investors in the secondary market Underwriting: The investment specialists who contact a large network of investment organisations to gauge investment interest in the company’s shares to meet the minimum subscription requirements 13.13 CASE STUDY: MARGIN TRADING IN THE SECONDARY MARKET Case Objective The case study explains the benefits of margin trading in the secondary market. 237 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Margin trading is a facility provided to investors, wherein they can invest in shares by part financing from the bank. In other words, investors can provide some amount of money from their pocket to invest in shares, and the rest of the amount will be financed by the banks. Margin trading allows investors to purchase shares by providing 40% of the total value as margin while borrowing 60% from the banks. An investor wants to purchase 20,000 shares worth ` 2,00,000 (price of one share being ` 10). However, he can invest only ` 80,000 out of his own pocket. But, under margin trading, the prospective shareholder can purchase as many as 20,000 shares worth ` 2,00,000 from his broker by paying ` 80,000 as margin money and by borrowing the remaining balance of ` 1,20,000 from a bank through the services of his broker. In lieu of the loan amount, the broker pledges 20,000 shares with the bank. The bank has collateral security of ` 2,00,000 backing the loan amount of ` 1,20,000 provided. The current market price of equity share rises from ` 10 to `15. So, by utilising the facility of margin trading, the shareholder can sell his entire shareholding of 20,000 shares in the market and pocket a profit of ` 1,00,000 (20,000 shares × ` 15 – 20,000 shares × `10). Conversely, in the absence of margin trading, the investor would have purchased only 8,000 shares due to paucity of funds. On the other hand, if the market price of shares falls below ` 10, the bank will give a margin call under which the investors will have to furnish additional funds/securities for the broker to pass on to the bank. Margin trading gives a unique opportunity to the bank to lend-short term funds at a high rate of interest. However, banks have to evolve a suitable risk management mechanism to safeguard the loans given by them against the collateral of securities. Questions 1. What is the benefit of margin trading to investors? (Hint: Margin trading provides a facility to the investors to borrow money from the bank and invest it in the share market.) 2. Assess what would have been the gain to the investor with price rise, if he had not availed the facility of margin trading? (Hint: If the investor had not availed the facility of margin trading, he would have been able to sell only 8,000 shares in the market and would have pocketed a profit of ` 40,000 only.) 13.14 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. What are primary markets? Explain the three main functions of primary markets. 2. Explain private placement. 3. What is prospectus? Discuss its types. 4. Write a short note on DRHP. 5. Write a short note on merchant bankers. 238 UNIT 13: Financial Markets-II JGI JAIN DEEMED-TO-BE UNI VE RSI TY 13.5 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS A. Hints for Essay Type Questions 1. The primary market, also known as the new issues market or the IPO (Initial Public Offering) market, is a market wherein new stocks and securities of a company are traded, i.e., bought and sold for the first time. Refer to Section Primary Markets 2. Private placement is where an issuer corporation issues shares or securities to a selected group of investors privately (not exceeding 200 members in a financial year) and not to the open market. It is neither a rights issue nor a public issue. It can be of three types, namely preferential allotment, Qualified Institutional Placement (QIP) and Institutional Placement Programme (IPP). Refer to Section Primary Markets 3. A prospectus refers to a legal document for market participants and investors to pursue, detailing the features, prospects and promise of a financial product. It is mandated by the law to be supplied to prospective customers. Refer to Section Types of Prospectus 4. A draft red herring prospectus (DRHP), also known as offer document, is the preliminary registration document prepared by merchant bankers for prospective IPO-making companies in the case of book-building issues. The document contains information on the company’s business operations, promoters, financials, its standing in the industry it deals in and listed or unlisted peers. Refer to Section Types of Prospectus 5. As per SEBI (Merchant Banker) Regulations, 1992, ‘merchant banker’ is defined as any person who is engaged in the business of issue management, either by making arrangements regarding selling, buying, or subscribing, or acting as a manager, consultant, or advisor, or rendering corporate advisory services in relation to such issue management. Refer to Section SEBI Norms (ICDR Regulations) @ 13.16 POST-UNIT READING MATERIAL https://www.educba.com/primary-market-vs-secondary-market/ https://www.icsi.edu/media/webmodules/publications/Full%20CC&MM.pdf 13.17 TOPICS FOR DISCUSSION FORUMS Using the Internet, study the launch of some recent IPOs in India and the issues faced by them. Make a report of your findings. 239 UNIT 14 Financial Services Names of Sub-Units Small Savings, Provident Funds, Pension Funds, Insurance Companies, Mutual Funds and NBFC NonBank Financial intermediaries – Leasing, Hire Purchase, Credit Rating, Factoring, Forfaiting, NonBanking Statutory Financial Organisations Overview The unit begins by explaining various financial products, such as provident funds, pension funds and mutual funds. The unit also discusses four important non-fund-based financial services, namely leasing, hire-purchase, factoring and forfaiting. In addition, you will be familiarised with the roles of non-banking statutory financial companies (NBFCs). Learning Objectives In this unit, you will learn to: Discuss the importance of provident funds State the significance of pension funds Describe mutual funds Explain the role of NBFCs Outline the concept of factoring JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Learning Outcomes At the end of this unit, you would: Assess the impact of financial services on investment decisions Explore the areas in which leasing arrangements can be best used Plan for purchasing items that can be bought using hire purchase 14.1 INTRODUCTION In any economy, the presence of a good financial system is considered essential to ensure a systematic and smooth exchange of funds and other financial transactions. A sound financial system is characterised by the presence of sufficient funds and ease of transacting. Productive economic activities, such as the production of goods and services, usually lead to increased levels of national income and standards of living and are facilitated by an efficient financial system. A wide range of financial services is offered by financial institutions which also help in the effective integration of the Indian economy with the global economy. Banking services, such as account opening and extending of loans, are the most basic and traditional type of financial services. However, due to innovation, globalisation and technology advancement, various innovative financial services have been developed. These include leasing, bill discounting, factoring and hire purchase. All these are different forms of finance. 14.2 PROVIDENT FUNDS A provident fund, better known as PF, is a compulsory, government-managed retirement savings scheme used in India. Employees need to give a portion of their salaries to the provident fund and employers must contribute on behalf of their employees. The money in the fund is then held and managed by the government and eventually withdrawn by retirees or, in certain countries, their surviving families. In some cases, the fund also pays out to the disabled who cannot work. Each national provident fund sets its minimum and maximum contribution levels for workers and employers. Minimum contributions can vary depending on a worker’s age. Some funds allow individuals to contribute extra to their benefit accounts, and for employers to also do so, to further benefit their workers. Governments set the age limit at which penalty-free withdrawals are allowed to begin. Some preretirement withdrawals may be allowed under special circumstances, such as medical emergencies. For example, in Covid-19 Pandemic situations, many people lost their jobs and it became difficult for them to bear expenses. In such a case, the Indian allowed employees to withdraw money from their PF accounts. 14.3 PENSION FUNDS A pension fund, also known as a superannuation fund in some countries, refers to a plan, fund or scheme that provides retirement income. Pension funds are pooled monetary contributions from pension plans set up by employers, unions or other organisations to provide for their employees’ or members’ retirement benefits. Pension funds are the largest investment blocks in most countries and dominate the stock markets where they invest. When managed by professional fund managers, they constitute the institutional investor sector along with insurance companies and investment trusts. Typically, pension 244 JGI UNIT 14: Financial Services JAIN DEEMED-TO-BE UNI VE RSI TY funds are exempt from capital gains tax and the earnings on their investment portfolios are either taxdeferred or tax-exempt. In India, the pension funds are divided into two stages. The first stage is the accumulation stage wherein an individual pays or invests in the pension plan throughout their active work years until the retirement age. Once the individual attains the retirement age, the second stage begins, which is the vesting stage. In this stage, the individual starts getting annuities until death. 14.3.1 Types of Pension Funds in India In India, the pension plans are broadly categorised into three types, which are: 1. Funds sponsored by an insurance company: In the fund, the investor’s money is invested in debts alone and is best suited for conservative and low-risk investors. 2. Unit linked plans: These plans invest funds in both debt funds and equities. It is one of the most popular pension funds and lets investors create a balanced portfolio. 3. National Pension Scheme: It is a government-sponsored fund. Under this scheme, the funds are either invested in government securities or debt securities. One of the most important benefits of pension funds is that they save for the long term. Irrespective of the fact whether one selects a scheme that requires the one to invest a lump sum amount or smaller amounts, the guaranteed savings are assured. 14.4 MUTUAL FUNDS A mutual fund can be defined from two perspectives, namely, a mutual fund trust or a particular scheme rolled out by a mutual fund company. A mutual fund trust is a professionally managed body that pools in the money (investment) of various investors and invests the entire money collected (corpus) into various securities, such as stocks, bonds, money market securities, gilt securities, commodities and precious stones. In this way, it acts as a financial intermediary between financial markets and investors. On the other hand, in the context of a scheme, a mutual fund is a type of financial instrument in which investors and the general public can invest their savings to meet their investment objectives. The working of the mutual fund is explained better with the help of Figure 1: Investors invest in That earns Return redistributed to Mutual Fund which, in turn, invests in Securities like shares, debentures Figure 1: Working of Mutual Fund A mutual fund is a pool of funds derived from a diverse cross-section of society that provides benefits of scale and professional management of funds to investors, which otherwise would not have been available to such investors. The rationale behind any pooling of service is two-fold, i.e., affordability and convenience. Office commuters may choose to go to the office by their vehicle or taxi cab, which is the 245 JAIN JGI DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets synonym for do-it-yourself in the context of investments. Another way of doing the office commute is by public transport, such as bus or train, which essentially is the pooling concept, bringing transport within the reach of those persons who cannot afford an own vehicle. The synonym here is the mutual fund. To be more precise, it is not just affordability due to which people may take to public transport, there could be reasons, viz., saving the hassles of maintaining and driving own vehicle. The other benefit in the mutual fund context is professional management and tracking of investments. A mutual fund is the most suitable investment for the common man as well as high-net-worth individuals. This is so because it imparts an opportunity to invest money in a diversified and professionally managed portfolio of different securities at a relatively low cost. 14.4.1 Types of Mutual Fund Schemes There are various types of mutual funds in India. These mutual funds are classified based on two categories, which are: 1. Based on maturity period: On this basis, mutual funds are classified into the following: Open-ended funds: It is a commonly used term in the mutual fund industry. Most of the funds or schemes are open-ended and are the ones that are available for purchase from an Asset Management Company (AMC) and redemption with the AMC on an ongoing basis, round the year on all working days, till it is wound up. For the investor, there is liquidity round the year since such funds can be purchased anytime and can be sold or redeemed anytime. Listed openended funds can be sold at the Exchange as well, however, in case of redemption with the AMC, liquidity is assured. There is no additional cost for this liquidity as AMCs do not charge any premium for redemption. The implication of open-ended funds for the AMC is fund (or Scheme) corpus size volatility, i.e., fund size increases when investors purchase units from the AMC and fund size comes down when investors redeem units. An open-ended fund comes into existence through the New Fund Offer (NFO) process and the Fund (or Scheme) parameters are decided by the NFO documents – Scheme Information Document (SID) and Key Information Memorandum (KIM). There is another document called Scheme Additional Information (SAI). Close-ended funds: Close-ended funds are those which are available for subscription only during the New Fund Offer (NFO) period and not beyond that. In the case of close-ended funds, the initial subscription amount is collected from investors and the fund is ‘closed’ after the NFO closure date wherein no further purchase is allowed. Also, there is no redemption possible with the AMC. Hence, from the AMC’s perspective, the fund (or Scheme) corpus size is stable and there is no need to manage ‘liquidity’ in the fund or there is no need to keep some portion in liquid form or easily marketable securities to meet sudden redemption pressure. Close-ended funds may have a defined maturity date, for example, fixed maturity plans (FMPs) that hold a maturity date. On the other hand, in an open-ended mutual fund structure, it is practically not feasible to have a maturity date since it is meant to be available for investment and redemption on an ongoing basis. Close-ended funds are listed at the Exchange but are not as liquid as openended funds as there is no defined liquidity, such as redemption with the AMC. 2. Based on objectives: On this basis, mutual funds can be classified into the following types: 246 Equity funds: These are mutual funds whose objective is to provide long-term growth of investments made by investors. Such funds invest the entire corpus of money in high-growth securities such as stocks. Debt funds: These mutual funds provide a consistent stream of income to investors. Such funds invest the entire corpus only in debt or fixed income securities such as debentures. UNIT 14: Financial Services JGI JAIN DEEMED-TO-BE UNI VE RSI TY Money market funds: These mutual funds provide short-term and fixed income to investors. Such funds invest the entire corpus in short-term debt or short-term fixed income securities such as gilt securities having a maturity of up to 1 year. Balanced funds: These are hybrid mutual funds whose objectives are to provide investors with optimised returns. Such funds usually invest the entire corpus in a mix of long and short-term debt and equity instruments. 14.4.2 Advantages and Disadvantages of Mutual Funds Some of the advantages of mutual funds are as follows: Except for a few large corporate investors having dedicated treasury departments, investors can’t replicate the expertise and professional fund management skills of mutual funds. The process of buying and selling an instrument in the secondary market is quite cumbersome in comparison to the process of investing/redeeming in a mutual fund. Hence, for a similar and comparable return, the investors would rather go for an easier process. Mutual funds are easy to access through distributors, online, acceptance centres, etc. In mutual funds, liquidity is just redemption away. Nowadays, it can be done online and the money gets credited to your bank account. There are several categories of mutual funds designed to suit one’s requirement, managed by professionals. However, such is not the case with direct investment in equity stocks and bonds. Some of the disadvantages of mutual funds are as follows: The payments of market analysts and fund managers are derived from investors. One of the first parameters to consider when choosing a mutual fund is the total fund management charge involved. If investors are running their portfolio, they can run their investment strategies. However, in mutual funds, investors are following the fund manager. Turnover, churning and window dressing can take place if the mutual fund managers are trying to misuse their authority. This can take the form of unnecessary trading, excessive replacement, etc. Some mutual funds hold long-term lock-in periods varying between five years to eight years. Exiting from those funds before maturity can be quite expensive. A certain portion of the fund is always kept in liquid form to pay out an investor who wants to exit such a fund. Such a portion cannot earn interest for investors. 14.5 NON-BANKING FINANCIAL COMPANIES Non-Banking Financial Companies (NBFCs) are the companies (financial institutions) registered under the Companies Act, 1956 or 2013. These NBFCs are usually engaged in the business of granting loans and advances, and the acquisition of shares, stocks, bonds, debentures and securities issued by the government or any other local authority. These may also acquire other marketable securities of similar nature, such as those related to leasing, hire purchase, insurance and chit fund business. NBFCs do not extend loans and advances to any institution whose principal business is related to agricultural activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/purchase/construction of the immovable property. Section 45-I (c) of the RBI Act defines a non-banking financial company as a company carrying on the business of a financial institution. It is governed by the Ministry of Corporate Affairs as well as the 247 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Reserve Bank of India. As per Section 45-IA (1) of the RBI Act, 1934, no NBFC is entitled to commence or carry on the business of a Non-Banking Financial Institution (NBFI) if it does not fulfil the following two conditions: 1. Obtaining a certificate of registration issued in accordance with chapter –IIIB of the RBI Act 2. Having a net owned fund of ` 2,00,00,000 (`2 crores) NBFCs are also financial intermediaries like banks. These NBFCs can accept only term deposits and are not a part of the payment and settlement mechanism. The principal business of an NBFC is to accept term deposits other than demand deposits. NBFCs can decide to offer any interest rate that it considers correct and beneficial for its business. Although NBFCs offer the rate of interest greater than the rate offered by banks, they cannot offer an interest rate greater than the maximum or the ceiling rate that is prescribed by the RBI regularly. At present, the maximum rate prescribed by the RBI is 12.5% p.a. These NBFCs are also not allowed to offer any gifts or incentives or any other benefits to depositors. The NBFCs must have a credit rating that lies in the investment grade. Some prominent NBFCs in India are as follows: Power Finance Corporation Limited L&T Finance Limited Aditya Birla Finance Limited Shriram Transport Finance Company Limited Bajaj Finance Limited Mahindra and Mahindra Financial Services Limited Muthoot Finance Limited HDB Financial Services Cholamandalam Investment and Finance Company Limited Tata Capital Financial Services Limited NBFCs facilitate the economic development of the country in the following ways: Helps in the mobilisation of funds or savings: NBFCs help in mobilising the savings of households into the financial system where they are put to use and the households can earn an interest rate that is usually greater than the interest offered by commercial banks. Facilitates capital formation: When some amount is invested in productive activity, it leads to the generation of profits and, hence, capital formation. This is also called wealth generation. Provides long-term credit: NBFCs usually fund requirements of industries, such as infrastructure, commerce and trade. These industries usually require credit for long-time periods. Generates employment opportunities: NBFCs grant loans to MSMEs and private industries by lending them loans, which helps in generating employment. Also, as a chain effect, when people are employed, their consumption, purchasing power and standard of living start increasing. Enhances and strengthens financial markets: Start-ups and small-sized organisations are specifically dependent upon NBFCs for grant of loans to those individuals and organisations to whom commercial banks do not lend money. Attracts foreign investments: 100% FDI is allowed in NBFCs. This means that NBFCs are an important source of attracting foreign investments in India. 248 UNIT 14: Financial Services 14.5.1 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Leasing A lease is a type of agreement under which there are two parties. One party is usually a financial institution and the other party is a company. The agreement terms may vary from one agreement to the other but in general, under a lease agreement, the company acquires a right to use the asset and in return, the company has to pay a rental fee to the financial institution. Under a leasing arrangement, there are two parties, the lessor (owner of an asset) and the lessee (company/individual who uses the asset). In this arrangement, the lessee pays rent to the lessor and in return, the lessee gets the right to exclusive use of the asset for a particular period. Usually, the type of lease involved determines the impact of leasing on the balance sheet of a company. For instance, in usual cases of leasing, the assets are not owned by the company due to which it cannot claim depreciation and investment. However, the rental charge that the company pays for use of the asset is written-off from the profits for taxation. There are multiple forms of lease agreements, which are as follows: Financial lease: In a financial lease, risks and rewards related to the asset being leased are transferred to the lessee. It is a long-term lease. The ownership of the asset remains with the lessor for a period of the lease but the lessee also has the option to purchase the asset at the end of the lease term. A financial lease is treated like a loan and it appears on the balance sheet of the lessee. This also means that the lessee can claim both the interest and the depreciation. In a financial lease, the lease term is usually equal to the economic life of the asset. The lessee has to bear all expenses such as maintenance, insurance and taxes. Plant, office, machinery, equipment and land, are usually taken on a financial lease. Operating lease: In an operating lease, the lessor purchases an asset and leases it out to a lessor for a particular period. The lessee can use the asset but the ownership remains with the lessor during and after the lease term has ended because there is no option for the purchase of the asset at end of the lease term. The term of the lease is usually less than its useful economic life. The lessee has to pay only the rent and other expenses such as insurance and maintenance, are to be paid by the lessor. The expense that the lessee incurs on the lease is written-off from the profits. The lessor has the authority to sell the asset and the lessee has the option of cancelling the contract. Sale and leaseback: This is a specific case of a finance lease. A sale and leaseback is a type of lease in which the owner of an asset sells the asset to another party for consideration and after that, it takes back the asset on lease from the new owner. It must be noted that there is no physical transfer of the asset but the ownership of the asset is transferred to the new owner. The new owner is called a lessor and the old owner who leases the asset is called a lessee. The possession of the asset remains with the lessee who uses it for economic use. This method is beneficial because it increases liquidity for the company and results in tax savings. Leveraged lease: In certain cases, the lessor is not able to arrange funds to buy the asset to be leased. In such a case, the lessor involves a financier who gives the lessor the remaining amount he/ she needs to buy the asset as a loan or debt. In turn, the lessor links the rent with the loan provided. The rent paid by the lessee is paid in two parts. One part is paid to the lessor and the other part is paid to the financier for the payment of interest and instalment. Conveyance type lease: Conveyance type leases are for extremely long periods. Such lease intends to convey the title on the property. This is the most common type of lease in the case of immovable property and usually is made for 99 or 999 years. Net and non-net lease: A net lease is a type of lease in which the lessor only provides the asset for use and rest all expenses such as servicing, repair, maintenance, purchasing parts/accessories, insurance, renewal and registration, are to be borne by the lessee. The opposite of such a lease arrangement is the non-net lease. 249 JAIN JGI Principles of Economics and Markets DEEMED-TO-BE UNI VE RSI TY Consumer lease: It is a type of leasing associated with consumer durable goods such as televisions, refrigerators and two-wheelers. In such a lease, after the expiration of the lease term and after all the lease rentals have been paid, the ownership of the asset is transferred to the lessee. Sales aid lease: It is a type of lease in which the lessor leases his/her asset to a lessee and also enters into an agreement with the lessee for providing sales and support. Import lease: In an import lease, the asset that is being leased is imported. In such a lease, a specialised asset finance company purchases an asset for the lessee and leases it back to the lessee. Here, the lessor company and the lessee may belong to different or the same countries. Operating lease and finance (capital) lease are the two most common types of lease. Figure 2 shows differences and similarities between these leases: Operating Lease Capital Lease Treated as lessee’s asset Recorded in the balance sheet Recored depreciation and interest expense Transfer of ownership possible Granting and asset or service in the exchange of compensation Accounting method Tax advantages Treated as periodic operational expenses Recorded in the income statement Does not depreciate Lease payments can be tax deductible Bargain purchase option Figure 2: Differences and Similarities between Operating and Finance (Capital) Leases Source: https://whyunlike.com/difference-between-capital-lease-and-operating-lease/ 14.5.2 Hire Purchase Hire purchase finance is usually conducted using Hire Purchase Agreements (HPAs). In an HPA, the owner of the asset (the creditor) lets the asset on hire in exchange for regular instalment payments that are paid by the hirer. These payments are called hire charges. The hirer has an option to purchase the asset from the creditor at the end of the agreement term. Periodic payments to be paid by the hirer to the creditor are decided in such a way as to recover the total cost of the asset in addition to an interest charged for the use of the asset. HPAs are similar to rent-to-own and instalment plans. Such an arrangement ensures that the hirer’s liquidity position does not get affected considerably. For the creditors, it is one of the most secure forms of credit sales. HPAs ensure that the asset that a hirer wants to purchase is available for use on an immediate basis but the price to be paid is paid in small instalments over some time. After the hirer has paid all the instalments, the ownership of goods is transferred to him/her. Although such HPAs can be concluded between two individuals; these are most common in the case of financing companies (the creditor) and the companies seeking loans (hirer). This 250 UNIT 14: Financial Services JGI JAIN DEEMED-TO-BE UNI VE RSI TY type of finance is best suited to the needs of MSMEs and small entrepreneurs. Various items, such as vehicles, equipment and machinery, are financed using HPAs. Some important characteristics of hire purchase finance are as follows: Hire charges are paid in periodic instalments spread over some time. HPAs may contain specific terms and conditions. The asset is made available to the hirer immediately. The hirer gets possession of the asset after making the last payment. The hirer is not authorised to sell, mortgage or pledge the asset. The hirer may terminate the HPA before the ownership is transferred to him. The frequency of payments is decided in terms and conditions of the agreement. Some of the advantages of hire purchase finance are: Assets available for use immediately without making full payment Latest technological assets available to be purchased by the hirer Easier budgeting due to fixed hire charges Secured type of financing The hirer has the option to buy or not buy the asset and he/she may base his/her decision on the rate of depreciation of the asset. There are certain disadvantages of hire purchase finance too. The hire charge is designed in a way as to recover the total cost and the cost of use of the asset over the useful life of the asset which means that the hirer ends up paying much more than the actual cost of the asset. Rental payments are usually spread over a long period. The hirer gets the ownership rights only at the end of the hire purchase term. Some important clauses in an HPA include: Alteration Delivery of equipment Indemnity clause Inspection Location Nature of agreement Registration and fees Repairs Risk Schedule of hire charges Termination 14.5.3 Credit Rating In general, credit rating refers to the evaluation of the creditworthiness of an individual, a business concern or an instrument of business. Such an evaluation is based on relevant factors showcasing the ability and willingness to pay obligations as well as net worth. 251 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets ‘Encyclopedia of Banking & Finance’ by Charles J. Woelfel states that a credit rating is a letter or number used by a mercantile or other agency in reports and credit rating books to denote the ability and disposition of various businesses (individual, proprietorship, partnership or corporation) to meet their financial obligations. It also states that ratings are used as a guide to the investment quality of bonds and stocks, based on security of principal and interest (or dividends), earning power, mortgage position, market history and marketability. Credit rating is defined as an assessment made from credit-risk evaluation translated into a current opinion as on a particular date on the quality of specific debt security issued or on an obligation undertaken by an enterprise in terms of the ability and willingness of the obligator to meet principal and interest payments on the rated debt instrument promptly. In simple words, credit rating is concerned with an expression of opinion of a credit rating agency. Such opinion is provided regarding a debt instrument and is given as on a specific date. The opinion provided by a credit rating agency is dependent on the results of risk evaluation. The opinion is ultimately dependent upon the probability of interest and principal obligations being met timely by the enterprise issuing debt instruments. It must be kept in mind that credit rating is a continuous process and as new information is derived, an earlier rating can stand revised. Although the rating is usually debt instrument specific, certain credit rating agencies also undertake to conclude the credit assessment of borrowers for use by banks and financial institutions. Some of the common types of credit rating are banks and financial institution ratings, IPO grading, structured finance ratings, sub-sovereign ratings, issuer rating, insurance/CPA ratings, corporate ratings, infrastructure ratings, corporate governance ratings and fund credit quality rating. Origin of Credit Rating Agencies The first and foremost mercantile credit agency was formed in New York in the year 1841. The credit rating guide of the said agency was published by Robert Dun in the year 1859. Another major rating corporation established on similar grounds was brought up by John Bradstreet which published its specific rating guide in the year 1857. These two credit rating agencies were amalgamated to form Dun and Bradstreet in the year 1933, which thereafter acquired Moody’s Investor Service in 1962. Credit rating agencies started to be set up in India around 1990. The most important ones among them that are recognised by SEBI include the following: Credit Rating Information Services of India Limited (CRISIL): Being incorporated in the pre-reform era, CRISIL has grown tremendously in size, structure and strength over the past years to become one of the top five globally credit-rated agencies. It has a tie-up with Standard and Poor’s (S&P) of USA holding a 10% stake in CRISIL. CRISIL has also established CRISIL– RISC, a subsidiary company for offering information and ancillary services across the Internet and operates online news and digital information service. CRISIL – RISC stands for CRISIL – Risk and Information Solutions Company Limited. CRISIL’s record of ratings has been known to cover 1800 companies and over 3600 specific debt instruments. Investment Information and Credit Rating Agency (ICRA): ICRA began to run its operations in 1991. Leading financial institutions and banks are its major shareholders. Moody’s Investor Services through the holdings of their Indian subsidiary, Moody’s Investment Company India (P) Limited is the single largest shareholder of ICRA. ICRA’s record of ratings covers over 2500 specific instruments and is headquartered in Gurugram in India. Credit Analysis and Research Limited (CARE): CARE was established in 1993 and is headquartered in Mumbai. UTI, IDBI and Canara Bank are among the major promoters of CARE. CARE has over 252 UNIT 14: Financial Services JGI JAIN DEEMED-TO-BE UNI VE RSI TY 2500 specific instruments under its belt and it retains a pivotal position as a global credit rating entity. Fitch Ratings India (P) Limited: The Fitch Group, an internationally recognised statistical credit rating agency has established its business in India through Fitch Rating India (P) Limited as a 100% subsidiary of the parent organisation. Its credit rating services are not limited to governments, structured financial arrangements and debt instruments but also extend to a variety of corporates. Necessity of Credit Rating Credit rating services are useful for both investors and issuers of securities. Both of these stakeholders need the services of credit rating companies for different purposes. For instance, the opinions rendered by credit rating agencies are relevant to investors due to the increase in the number of capital issues and are all the more important in the presence of newer financial products, namely, asset backed securities and credit derivatives. Similarly, the credit rating is important for the issuer of securities due to various reasons, such as reduction in cost of public issues or low cost of borrowing. Some of the important needs and objectives served by credit rating for investors and other users include the following: Credit rating helps in guiding investors regarding the risk of investing in debt security concerning the timely repayment of interest obligations and principle amounts. Credit rating helps in creating confidence in the minds of investors. Credit rating aids in investment decisions of investors. Credit rating offers the analysts in mutual funds to use such ratings as one of the valuable inputs and information to their independent evaluation mechanism. Some of the important needs and objectives served by credit rating for the issuers of securities are as follows: Credit rating enables the companies to be quality conscious regarding their securities and helps in creating a positive pressure on them to fulfil their debt obligations properly. Credit rating assists in the rating of debt obligations and the IPOs of companies. Credit rating services help in the creation of a conducive environment that facilitates debt rating in financial markets. Credit rating enables issuers to meet the requirements of complying with the regulatory obligations as per SEBI guidelines. Credit rating enables issuers to raise debt/equity capital. 14.5.4 Factoring Factoring service is a combination of financial and management support that is extended to a client. Under factoring, the non-productive and inactive assets (receivables) are converted into productive assets (cash) by selling receivables to a factoring company. Factoring companies have expertise in the collection and administration of receivables. If a seller organisation sells its product to a buyer organisation on credit, it will not receive the cash amount till the credit period. Therefore, all this while, it would be shown as a current asset but it remains illiquid. This cannot be used for fulfilling any business need. In such a situation, a ‘factor’ (factoring organisation) enables the conversion of its receivables into cash. 253 JGI JAIN Principles of Economics and Markets DEEMED-TO-BE UNI VE RSI TY In a factoring arrangement, three parties are involved. First is the seller of goods (client of factor), second is the buyer of the goods (customer or client) and third is the factor who purchases the bills receivables. When a seller presents the bills receivables to a factor, the factor gives the seller a discounted amount of money and in turn, gets the title to receivables. The factor becomes responsible for the credit control, debt collection from buyers and sales ledger administration. Factoring is an ongoing activity and as soon as bills are generated, they are taken by the factor and the sellers are given the proceeds (discounted amounts). The factoring process is shown in Figure 3: Sale of goods on credit COMPANY Assignment of receivable DEBTOR Pay the amount after the expiry of the credit period Payment at a discount FACTOR Figure 3: The Process of Factoring Source: http://vinodkothari.com/2018/09/growth-of-factoring-services-in-india/ Some prominent factoring organisations are: Canbank Factors Limited IFCI Factors Limited Drip Capital Food Corporation of India SBI Global Factors Limited Bibby Financial Services (India) Private Limited India Factoring & Finance Solutions Private Limited Siemens Factoring Private Limited Pinnacle Capital Solutions Private Limited Some important characteristics of factoring service are as follows: Factoring facility is usually provided for a period of 90 to 150 days. Factoring is an expensive source of finance as compared to other sources. Factoring services should be ideally availed by either start-up organisations or those organisations that do not have a strong bottom line. No factor provides facility for bad debts. 254 UNIT 14: Financial Services JGI JAIN DEEMED-TO-BE UNI VE RSI TY Most factoring organisations conduct credit risk analysis before entering into a factoring agreement with any organisation. Factoring has no impact on the balance sheet of an organisation (off-balance sheet financing). There are various types of factoring, which are as follows: Disclosed factoring: In a disclosed factoring arrangement, the customer of the client is made aware of the said arrangement. The disclosed factoring may be further of recourse or non-recourse type which also decides whether or not the factor will be responsible for the collection of debts. Undisclosed factoring: In an undisclosed factoring arrangement, the customer of the client is not aware of the factoring arrangement between the factor and the client. In such type of factoring, the ledger administration and debt collection are done by the client himself. Recourse factoring: In recourse factoring, credit risk is assumed by the client. If the bills receivable turns bad, it is the responsibility of the client to pay the factor. Factoring with recourse is similar to bill discounting. In such a case, the factor only acts as an agent of the client for debt collection and they do not assume any risk associated with recovery of the debt and interest from the customer. In recourse factoring, factors charge the client for providing sales ledger and debt collection. Additionally, the client also has to pay interest on the amount he draws for the given period. Non-recourse factoring: In non-recourse factoring, the factor assumes all the credit risk. In case a bill receivable turns bad, the factor cannot claim it from the client. Due to the higher risk involved in non-recourse factoring, charges for non-recourse factoring are higher than that charged for recourse factoring. 14.5.5 Forfaiting Forfaiting refers to a method of trade finance wherein exporters are allowed to obtain cash by selling their medium and long-term foreign accounts receivable at a discount on a “without recourse” basis. A forfaiter is a specialised finance firm or a department in a bank that performs non-recourse export financing through the purchase of medium and long-term trade receivables. “Without recourse” or “non-recourse” means that the forfaiter assumes and accepts the risk of non-payment. Similar to factoring, forfaiting virtually eliminates the risk of non-payment, once the goods have been delivered to the foreign buyer following the terms of sale. However, unlike factors, forfaiters typically work with exporters who sell capital goods and commodities, or engage in large projects and therefore need to offer extended credit periods from 180 days to seven years or more. In forfaiting, receivables are normally guaranteed by the importer’s bank, which allows the exporter to take the transaction off the balance sheet to enhance key financial ratios. The current minimum transaction size for forfaiting is $100,000. In the United States, most users of forfaiting are large established corporations, but small and medium-size companies are slowly embracing forfaiting as they become more aggressive in seeking financing solutions for exports to countries considered high risk. The exporter approaches a forfaiter before finalising the transaction’s structure. Once the forfaiter commits to the deal and sets the discount rate, the exporter can incorporate the discount into the selling price. The exporter then accepts a commitment issued by the forfaiter, signs the contract with the importer, and obtains, if required, a guarantee from the importer’s bank that provides the documents required to complete the forfaiting. The exporter delivers the goods to the importer and delivers the documents to the forfaiter who verifies them and pays for them as agreed in the commitment. Since this payment is without recourse, the exporter has no further interest in the financial aspects of the transaction and it is the forfaiter who must collect the future payments due from the importer. 255 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Conclusion Principles of Economics and Markets 14.6 CONCLUSION A provident fund, better known as PF, is a compulsory, government-managed retirement savings scheme used in India. A pension fund, also known as a superannuation fund in some countries, refers to a plan, fund or scheme that provides retirement income. A mutual fund can be defined from two perspectives, namely, a mutual fund trust or a particular scheme rolled out by a mutual fund company. Financial services offered by banks and other financial institutions are primarily categorised into two categories namely fund-based services and non-fund-based services. Non-Banking Financial Companies (NBFCs) are the companies (financial institutions) registered under the Companies Act, 1956 or 2013. These NBFCs are usually engaged in the business of granting loans and advances, and the acquisition of shares, stocks, bonds, debentures and securities issued by the government or any other local authority. Under a lease agreement, the company acquires a right to use the asset and in return, the company has to pay rental fees to the financial institution. There are multiple forms of lease agreements such as sale and leaseback, financial lease, operating lease, leveraged lease, conveyance type lease, net and non-net lease, consumer lease, sales aid lease and import lease. Hire purchase finance is usually conducted by the means of the Hire Purchase Agreements (HPAs). In an HPA, the owner of the asset (the creditor) lets the asset on hire in exchange for regular instalment payments that are paid by the hirer. Factoring service is a combination of financial and management support that is extended to a client. Under factoring, the non-productive and inactive assets (receivables) are converted into productive assets (cash) by selling receivables to a factoring company. Forfaiting refers to a method of trade finance wherein exporters are allowed to obtain cash by selling their medium and long-term foreign accounts receivable at a discount on a “without recourse” basis. 14.7 GLOSSARY Credit sale: A sale in which goods or service is provided to the customer on an immediate basis but the customer can make the payment any time before the agreed credit period Letter of Credit (LC): A letter that is issued by banks and ensures that the sellers would be paid their dues Mortgage: A type of loan given by a bank or any other financial institution to a loan seeker by keeping some valuables such as property as a security which would be retained, sold or auctioned by the financial institution in case of default Written-off: An accounting treatment under which the value of the asset is reduced and at the same time, the liabilities account is also debited 14.8 CASE STUDY: CREDIT RATING AGENCIES AND THE US SUB-PRIME CRISIS Case Objective This case study explains functioning of credit rating agencies and their importance. 256 UNIT 14: Financial Services JGI JAIN DEEMED-TO-BE UNI VE RSI TY Credit rating agencies are known to have executed a very prominent role at varied phases in the US sub-prime crisis. Credit rating agencies have been highly criticised for understating the risk which was involved and co-related with new, complex securities that fuelled the United States housing bubble. Such securities are mainly comprised of Mortgage-backed Securities (MBS) and Collateralised Debt Obligations (CDO). Between 2002 to 2007, an estimate of $3.2 trillion in loans was given to the homeowners, characterised with poor credit and undocumented incomes, for example, sub-prime or Alt-A mortgages. These housing mortgages could be bundled and stretched into MBS and CDO securities, i.e., mortgagebacked securities, which received high ratings, and therefore, could be sold to global investors. Higher ratings were regarded as justified by several credit enhancements comprising overcollateralisation, pledging collateral in excess of debt issued, credit default insurance and equity investors willing to bear the first losses. It was critically claimed that the credit rating agencies were the parties that performed the process of transforming the securities from F-rated to A-rated. The lending banks and financial institutions could not have done what they did without the aid and complicity of the credit rating agencies. This is so because, without the AAA ratings given by credit rating agencies, the demand for these securities would have been considerably less. As of September 2008, banks wrote down their losses on these investments in their books of account, casting to $523 billion in total approximately. The ratings of such securities were recognised as a lucrative business for the credit rating agencies, accounting for almost merely half of Moody’s total ratings revenue in 2007. Through the year 2007, rating companies earmarked a record revenue, profits and share prices. These credit-rating agencies derived earnings as much as three times higher for grading and rating these complicated products than corporate bonds under their traditional businesses. Such rating companies also competed with each other to rate particular MBS and CDO securities issued by investment banks, which is critically argued to be known for contributing to lower rating standards. Questions 1. What was the US sub-prime crisis? (Hint: It existed when banks sold an excessive number of mortgages to meet the demand for mortgage-backed securities selling in the financial markets.) 2. How did credit rating agencies contribute to the US housing bubble? (Hint: The new and complex securities employed to finance sub-prime mortgages could not have been sold without high ratings accorded by the globally renowned credit rating agencies.) 3. For understating which types of risks are the US credit agencies criticised? (Hint: Risks related to new, complex securities that fuelled the United States housing bubble.) 4. Why is it claimed that credit rating agencies perform the process of transforming the securities from F-rated to A-rated? (Hint: Without the AAA ratings given by credit rating agencies, the demand for securities would have been considerably less.) 5. Why was credit rating considered to be a lucrative business traditionally? (Hint: Credit rating agencies derived earnings as much as three times higher for grading and rating these complicated products than corporate bonds under their traditional businesses.) 257 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets 14.9 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. A mutual fund is a type of financial instrument in which investors and the general public can invest their savings to meet their investment objectives. 2. What is the role of NBFCs? Name some prominent NBFCs in India. 3. Discuss the concept of credit rating. 4. What is leasing? 5. Write a short note on factoring. 14.10 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS A. Hints for Essay Type Questions 1. A mutual fund can be defined from two perspectives, namely, a mutual fund trust or a particular scheme rolled out by a mutual fund company. A mutual fund trust is a professionally managed body that pools in the money (investment) of various investors and invests the entire money collected (corpus) into various securities such as stocks, bonds, money market securities, gilt securities, commodities and precious stones. Refer to Section Mutual Funds 2. Non-Banking Financial Companies (NBFCs) are the companies (financial institutions) registered under the Companies Act, 1956 or 2013. These NBFCs are usually engaged in the business of granting loans and advances, and the acquisition of shares, stocks, bonds, debentures and securities issued by the government or any other local authority. Refer to Section Non-Banking Financial Companies 3. Credit rating is defined as an assessment made from credit-risk evaluation translated into a current opinion as on a particular date on the quality of a specific debt security issued or on an obligation undertaken by an enterprise in terms of the ability and willingness of the obligator to meet principal and interest payments on the rated debt instrument promptly. Refer to Section Non-Banking Financial Companies 4. A lease is a type of agreement under which there are two parties. One party is usually a financial institution and the other party is a company. The agreement terms may vary from one agreement to the other but in general, under a lease agreement, the company acquires a right to use the asset and in return, the company has to pay a rental fee to the financial institution. Refer to Section NonBanking Financial Companies 5. Factoring service is a combination of financial and management support that is extended to a client. Under factoring, the non-productive and inactive assets (receivables) are converted into productive assets (cash) by selling receivables to a factoring company. Refer to Section Non-Banking Financial Companies @ 258 14.11 POST-UNIT READING MATERIAL https://www.accountingnotes.net/financial-management/financial-services/5-major-areas-offund-based-activities-in-india/7225 UNIT 14: Financial Services JGI JAIN DEEMED-TO-BE UNI VE RSI TY https://efinancemanagement.com/sources-of-finance/hire-purchase 14.12 TOPICS FOR DISCUSSION FORUMS Discuss key differences between bill discounting and factoring. 259 UNIT 15 Technology in Financial Services Names of Sub-Units Digital Currencies, Emerging Technologies in Financial Market and their benefits, FinTech Operational, Technology, and Regulatory Risks, Block Chain, Crypto Currency and Bitcoins, Cyber-security Law in India, Big Data and Chatbots, Role of Artificial Intelligence Overview The unit begins by explaining the meaning of Fintech and digital currency. Further, it describes the crypto currency and bitcoin. The unit explains the concept of block chain and cyber security laws in India. Learning Objectives In this unit, you will learn to: Explain the meaning of Fintech List down important areas where Fintech is used Define Chatbots Describe the crypto currency Elaborate the cyber security laws in India JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Learning Outcomes At the end of this unit, you would: Assess the Financial technology (Fintech) Evaluate Big data and digital currency Appraise the Block chain and Crypto currencies Examine the use of cyber security laws 15.1 INTRODUCTION Over the past few years, financial technology companies have disrupted virtually all aspect of the financial industry. People 10 years ago had to go to the bank or financial company for applying for a mortgage, loan (business or home loan) or simply transfer funds from one bank to another bank. Today, with the help of financial technology it is possible to invest, borrow, save and transfer funds online by using internet and mobile services without visiting bank or any financial institution. Though institutions that are old were slow to adopt financial technology solutions but both startups and newly established companies are betting on digitised financial services. Fintech is the other name of the financial technology. This term is used to describe any technology which helps in delivering the financial services with the help of software, such as online banking, mobile payment applications or even crypto currency. Fintech is a broad category that encompasses various technologies, but the primary objectives of the Fintech is: To change the way consumers and businesses access their finances To compete with traditional financial services 15.2 WHAT IS FINTECH? The term ‘Fintech’ is made of two types of terms. First one is ‘Finance’ and second is ‘Technology’. Fintech is any business which uses technology for enhancing or automating financial services and processes. The term ‘Fintech’ encompasses a rapidly growing industry which serves the interests of: Consumers Businesses From mobile and internet banking and insurance to crypto currency and investment application, Fintech has a seemingly endless array of applications. 264 JGI UNIT 15: Technology in Financial Services JAIN DEEMED-TO-BE UNI VE RSI TY Figure 1 shows the technologies that contribute to Fintech: Figure 1: Technologies that Contribute to Fintech Source: https://medium.com/ Following are some of the important areas where Fintech is used: Mobile wallets and payment application services: Example of some application are: PayPal Venmo Square Apple Pay Google Pay They allow people to transfer money to each other or merchants receive payments from customers. Crowd funding platforms: Example of crowd funding platforms are: Kickstarter GoFundMe 265 JAIN JGI DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets These platforms have disrupted traditional funding options by allowing platform users to invest their money in businesses, products and individuals. Crypto currency and block chain technologies: There are most scrutinised and well-known examples of Fintech. Coinbase and Gemini, allow users to buy or sell crypto currencies. Block chain technologies can move into industries outside of finance to reduce fraud. Robo-advisors: These have algorithm-based portfolio recommendations and management which reduces the costs and increases efficiency. Example of robo-advising services are: Betterment Ellevest Stock trading applications: Example of stock trading apps are: Robinhood Acorns In these applications, the investors can trade stocks from anywhere by using their mobile device instead of visiting a stockbroker. 15.2.1 Emerging Trends in Fintech and their Benefits Banking and financial services industry is undergoing vast changes from past few decades. Banks have redesigned their lending and banking models. They also have remoulded banking tools of the information age. In the beginning, Fintech started as a fledgling movement and then the sustained efforts finally borne fruit. In 2019, Indian fintech companies surpassed their global counterparts in raising funds. With UPI (Unified Payments Interface, an instant payment system) becoming an increasingly dominant force to facilitate digital payments, the interest of the investor was largely on consumers with mobile payment applications. Neobanks (a type of a digital bank which has no branches) digitised the customer experience by presenting an alternate option to other financial incumbents. We also saw, technology driven insurance companies’ in general insurance space offered insurance at lower rates. NBFCs (Non-Banking Financial Companies) now provide quick and hassle-free access to finance by leveraging the power of technology. Other areas of disruption were: Personalised finance Point-of-Sale (PoS) systems Stock broking Following are a few emerging trends in the Fintech: Customer centric apps for document viewing; file conversion and data capture capabilities Digital tools to provide secure access to files and facilitate collaboration. 266 JGI UNIT 15: Technology in Financial Services JAIN DEEMED-TO-BE UNI VE RSI TY Easy-to-use web-based API (Application Programming Interface) tools. Technology powered with algorithm-based machine learning models Big data management Digital and mobile payments such as Paytm, PhonePe, Pine Labs, Razorpay, BharatPe picking up Banking partnership Robotic process automation to automate backend office processes like customer onboarding, security checks, credit card and mortgage processing Combination of power of blockchain with automated digital contracts Use of Artificial Intelligence with more sophisticated chatbots to address customer queries and fraud prevalent tools Open banking (the practice of allowing third-party financial service providers to avail access to consumer banking, transaction and other financial data from banks and NBFCs) 15.2.2 Digital Currencies Digital currency is digital money or a form of currency which is available only in digital or electronic form. The other name of digital currency is electronic money, electronic currency, or cyber cash. These are intangible in nature and can be owned and transacted via computers or an electronic wallet which has Internet or the designated networks. Table 1 shows the advantages and disadvantages of digital currencies: Table 1: Advantages and Disadvantages of Digital Currencies Advantages Disadvantages Facilitates fast, long-distance transactions without May incur extra costs, such as Paypal fees or Bitcoin compromising credit card or bank account information. transaction fees. Reduces the cost of cash accounting and storage. Digital money is a common target for hacks and scams. In the case of crypto currencies, digital money allows Since there is no central authority, crypto currencies cross-border transactions that cannot be taxed, frozen cannot be recovered if lost or stolen. or censored. 15.2.3 Block Chain Block chain is complicated but a core concept. Block chain is a type of database that record information in a way which makes it complicated or impossible to change, hack or cheat the system. Database refers to the collection of information stored electronically on a computer system. Block chain is considered as a digital ledger of transactions which is duplicated and distributed across the whole network of computer systems on the block chain. Each block in the chain contains a number of transactions, and every time a new transaction occurs on the block chain, a record of that transaction is added to every participant’s ledger. The decentralised database managed by multiple participants is known as the Distributed Ledger Technology (DLT). Therefore, a Block chain is a DLT wherein transactions are recorded with an immutable cryptographic signature called a hash. 267 JGI JAIN Principles of Economics and Markets DEEMED-TO-BE UNI VE RSI TY Figure 2 shows how block chain technology works: 1 7 How Blockchain Technology A transaction is requested Works 4 2 A transaction is now finished 6 The transaction is A verified transaction can 3 5 The new block is added to broadcasted to a peer-toinvolve cryptocurrency, the existing blockchain peer (P2P) network that contracts, records or other (which is permanent and consists of computers information The network of nodes unalterable) (otherwise known as The transaction is combined uses known algorithms to nodes) with other transactions, once validate the transaction verified, to create a new block and user’s status of data for the ledger Figure 2: How Block Chain Technology Works? Source: https://www.peerbits.com 15.2.4 Crypto Currency and Bitcoins A crypto currency refers to the digital or virtual currency which is secured by cryptography. Cryptography makes crypto currency nearly impossible to counterfeit or double-spend. Many crypto currencies are decentralised networks based on block chain technology—a distributed ledger enforced by a disparate network of computers. Crypto currencies are not issued by any central authority, so these are immune to any government interference or manipulation. In 2009, Bitcoin, a digital currency was created. It was launched by an individual or group known by the pseudonym “Satoshi Nakamoto.” Bitcoin promised lower transaction fees in comparison to the traditional online payment mechanisms and, unlike government-issued currencies, it is operated by a decentralised authority. We can say that, Bitcoin is a kind of crypto currency. It is intangible and is not issued or backed by any banks or governments, nor is an individual bitcoin valuable as a commodity. It is a network which runs on a protocol which is known as the block chain. Table 2 shows the difference between block chain and crypto currency Table 2: Difference between Block Chain and Crypto Currency Basis Block Chain Crypto Currency Nature It is a technology that records transactions. It is a tool used in the virtual exchanges. Use It is used for recording. transactions It is used for making payments, investments and wealth storage. Value It has monetary value. It has no monetary value. Mobility It can be transferred. It cannot be transferred. 15.2.5 Big Data and Chatbots Big data refers to the large, diverse sets of information which grow at ever-increasing rates. Big data consists of the volume of information, the velocity or speed at which it is created and collected. Big data comes from data mining and arrives in multiple formats. 268 UNIT 15: Technology in Financial Services JGI JAIN DEEMED-TO-BE UNI VE RSI TY Big data can be categorised into two types: Unstructured Structured Structured data has information which is already managed by the organisation in databases and spread sheets. The data is frequently numeric in nature. Unstructured data consists of the organised information which does not fall under predetermined model or format. Structured data includes data which is gathered from social media sources, which help institutions gather information on customer needs. Big data can be collected from various sources: Publicly shared comments on social networks and websites Voluntarily gathered from personal electronics and apps Questionnaires product purchases electronic check-ins The sensors and other inputs in smart devices help in collecting the data across a broad spectrum of situations and circumstances. Big data is stored in computer databases and is analysed with the help of software purposely designed for handling large, complex data sets. A chatbot refers to an applicative solution such as a computer program which is designed to simulate the conversation with human users online. Following are the types of chatbots: Generative Chatbots Retrieval-Based Chatbots Pattern-Heuristics Based Chatbots Machine Learning Chatbots Chatbots make use of language analytics technologies. Some of the technologies used in chatbots are: Natural Language Processing: It is the ability of an application to digest and break down an incoming question message from a user as language, so an application can process it. The ability to analyse the input and construct an answering message in the natural language and post it back to the user. Natural Language Understanding: It is a subset of Natural Language Processing and focuses on how to most effectively structure and model the input for optimal processing by an application. Natural Language Generation: It is the ability to generate a message in the form of natural language. 15.2.6 Role of Artificial Intelligence Artificial Intelligence is the development of computer systems and a branch of science producing and studying the machines aimed at the stimulation of human intelligence processes. We can say the when a machine demonstrate intelligence, it is known as Artificial Intelligence. There are 3 types of Artificial Intelligence: Artificial Narrow Intelligence Artificial General Intelligence Artificial Super Intelligence 269 JGI JAIN Principles of Economics and Markets DEEMED-TO-BE UNI VE RSI TY Figure 3 shows the types of Artificial intelligence: Figure 3: Types of Artificial Intelligence Source: https://www.mygreatlearning.com/ The role of Artificial Intelligence is to help human capabilities and make advanced decisions with farreaching consequences. It help humans live more meaningful lives devoid of hard labour, and help manage the complex web of interconnected individuals, companies, states and nations to function in a manner that’s beneficial to all of humanity. The role of Artificial Intelligence is to simplify human effort and make better decisions. It is used by companies for improving their process efficiencies, automating resource-heavy tasks, and for making business predictions based on hard data rather than gut feelings. 15.3 REGULATORY RISKS AND CYBER SECURITY LAW IN INDIA Technological advancement and its widespread usage have exposed millions of people to critical security vulnerabilities. Use of online payment modes, online shopping, banking etc. has pushed forward the demand for stern cyber laws in India. Online security threats are alarming for both the business leaders and consumers. There is expansion in the Indian cyber security market which ensures India’s stature as one of the leading investment hubs worldwide. The expansion of Indian market demands for stringent regulatory mandates for maintaining the cyber security in India. Increase in the number of cybercrimes leaving the nation astonished and petrified. The Government of India has implemented various regulations for safeguarding its citizens and corporate from the webmishaps. 270 UNIT 15: Technology in Financial Services JGI JAIN DEEMED-TO-BE UNI VE RSI TY The operations of all service providers, data centers, intermediaries come under the Jurisdiction of Information Technology Rules, 2013. Under this Act there is real-time reporting of all cyber security incidents to the Indian Computer Emergency Response Team. The Information Technology Act was tagged as the first landmark in the history of cyber laws in India, but soon the existing rules failed to suffice. There are some loopholes in the legal system which is used by the cybercriminals for escaping post committing dire crimes. Most cybercrimes in India were sufficiently covered under the relevant sections of the Indian Penal Code (IPC) granting comfort and assurance to the investigating bodies. Since India misses out on staunch cyber security laws, several sector-specific regulations were passed by the towering Government bodies. The Department of Telecommunication, Reserve Bank of India and the Securities Exchange Board of India have their individual well-defined cyber security mandates regulating colossal entities such as: Insurance companies Banks Telecoms service providers There are some predominant laws which cover the cyber security: Information Technology Act, 2000: The ITA, enacted by the Parliament of India, highlights the grievous punishments and penalties safeguarding the e-governance, e-banking, and e-commerce sectors. Indian Penal Code (IPC), 1860: The primary relevant section of the IPC covers cyber frauds: Forgery (Section 464) Forgery pre-planned for cheating (Section 468) False documentation (Section 465) Presenting a forged document as genuine (Section 471) Reputation damage (Section 469) Companies Act of 2013: The Companies (Management and Administration) Rules, 2014 prescribes strict guidelines confirming the cyber security obligations and responsibilities upon the company directors and leaders. Cyber security Framework (NCFS), authorised by the National Institute of Standards and Technology (NIST): NIST Cyber security Framework encompasses all required guidelines, standards, and best practices to manage the cyber-related risks responsibly. This framework is prioritised on flexibility and cost-effectiveness. Conclusion 15.4 CONCLUSION The term ‘Fintech’ is made of two types of terms. First one is ‘Finance’ and second is ‘Technology’. Fintech is any business which uses technology for enhancing or automating financial services and processes. 271 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets Some of the important areas where Fintech is used are Mobile wallets and payment application services, Crowd funding platforms, Crypto currency and block chain technologies, Robo-advisors etc. Digital currency is digital money or a form of currency which is available only in digital or electronic form. The other name of digital currency is electronic money, electronic currency, or cyber cash. Block chain is complicated but a core concept. Block chain is a type of database that record information in a way which makes it complicated or impossible to change, hack or cheat the system. Database refers to the collection of information stored electronically on a computer system. The decentralised database managed by multiple participants is known as the Distributed Ledger Technology (DLT). A crypto currency refers to the digital or virtual currency which is secured by cryptography. Bitcoin is intangible and is not issued or backed by any banks or governments, nor is an individual bitcoin valuable as a commodity. Big data refers to the large, diverse sets of information which grow at ever-increasing rates. A chatbot refers to an applicative solution such as a computer program which is designed to simulate the conversation with human users online. Artificial Intelligence is the development of computer systems and a branch of science producing and studying the machines aimed at the stimulation of human intelligence processes. There are some predominant laws which cover the cyber security i.e. ITA, IPC, Companies Act etc. 15.5 GLOSSARY Crypto currency: The digital or virtual currency which is secured by cryptography. Chatbot: An applicative solution such as a computer program which is designed to simulate the conversation with human users online. Artificial Intelligence: A machine demonstrate intelligence 15.6 CASE STUDY: COINSECURE – SPROUTING THE BITCOIN ECOSYSTEM Case Objective The aim of this case study is to explain the role of bitcoin. Coinsecure, a leading Bitcoin trading platform and exchange, as well as the Bitcoin wallet in India, has been reported to raise more than $1.2 million within 4 months since the commencement of their fundraising investment round for Series A. Established during the early years of the Bitcoin inception in India, Coinsecure aimed at creating an ecosystem to support Bitcoin adoption in the country. To fulfill the aim, Coinsecure became a member of the Bitcoin Foundation and also served as a Silver Founding Donor to raise funds for the BitGive Foundation. Coinsecure is the only registered company with an ISO certification that provides Bitcoin wallet and offers services for Bitcoin exchange and trade for merchants and traders. In order to incorporate Bitcoin 272 UNIT 15: Technology in Financial Services JGI JAIN DEEMED-TO-BE UNI VE RSI TY into the mainstream and increase the user base for Bitcoins, Coinsecure not only created a strong platform to buy and sell Bitcoins, but also invested in educating people about the benefits of Blockchain technology. Coinsecure provides an algorithmic trading exchange for Bitcoins along with an explorer for Blockchain. It also provides a wide range of free APIs for its products, on-chain as well as off-chain wallet services, and mock trading platform to enable users to trade without involving real currency. The company also plans to indulge in other applications related to Bitcoin and Blockchain technology via its Research and Development Division located in Bangalore. Coinsecure has numerous integrations with global industry leaders such as Netki. Initially founded by Mohit Kalra and Benson Samuel in the year 2014, Coinsecure commenced operations with its Bitcoin exchange only in January 2015. The conceptualization of Coinsecure was to bring some legitimacy towards the budding technology of cryptocurrencies. With an aim to connect the country with Bitcoins (BTCs), the company is now working full fledged towards creating an ecosystem for Bitcoin and Blockchain technology in India. With robust practices in place to ensure security and compliance, various programmes launched by Coinsecure across India helped schools and colleges in understanding the emerging technology of Bitcoins and Blockchain. Coinsecure is targeting the banking and manufacturing sectors as a new hub for these technologies. Over the past years, Coinsecure has established itself as a reputed name among the Bitcoin exchange service providers with the highest volume and liquidity. Coinsecure maintains completely transparent order books, maintaining records that date back to the first trade reported on January 6, 2015. Currently, Coinsecure handles more than 3000 BTCs per month and the volumes are increasing every month. Coinsecure effectively deals with issues relating to Bitcoins, such as volatility, localization and ease of use. With the funds raised in the Series A round, Coinsecure plans to come up with enterprise solutions based on Blockchain. Questions 1. Summarise the case as per your understanding. (Hint: role of bitcoin, issues relating to Bitcoin) 2. What is the difference between bitcoin and block chain? (Hint: Bitcoin is intangible and is not issued or backed by any banks or governments, Block chain is a type of database) 3. What is the aim of coinsecure? (Hint: creating an ecosystem to support Bitcoin adoption in the country) 15.7 SELF-ASSESSMENT QUESTIONS A. Essay Type Questions 1. Explain the concept of Fintech. 2. What is crypto currency? 3. Describe the laws governing cyber security. 4. Define Block chain. 273 JGI JAIN DEEMED-TO-BE UNI VE RSI TY Principles of Economics and Markets 15.8 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS A. Hints for Essay Type Questions 1. The term ‘Fintech’ is made of two types of terms. First one is ‘Finance’ and second is ‘Technology’. Fintech is any business which uses technology for enhancing or automating financial services and processes. The term ‘Fintech’ encompasses a rapidly growing industry which serves the interests of: Consumers Businesses Refer to Section What is Fintech? 2. A crypto currency refers to the digital or virtual currency which is secured by cryptography. Cryptography makes crypto currency nearly impossible to counterfeit or double-spend. Many crypto currencies are decentralised networks based on block chain technology—a distributed ledger enforced by a disparate network of computers. Crypto currencies are not issued by any central authority, so these are immune to any government interference or manipulation. Refer to Section What is Fintech? 3. There are some predominant laws which cover the cyber security i.e. ITA, IPC, Companies Act etc. Most cybercrimes in India were sufficiently covered under the relevant sections of the Indian Penal Code (IPC) granting comfort and assurance to the investigating bodies. Refer to Section Regulatory Risks and Cyber Security Law in India 4. Block chain is complicated but a core concept. Block chain is a type of database that record information in a way which makes it complicated or impossible to change, hack or cheat the system. Refer to Section What is Fintech? @ 15.9 POST-UNIT READING MATERIAL https://rbsa.in/archives_of_research_reports/RBSA-Advisors-Presents-FinTech-Industry-in-IndiaFebruary2021.pdf 15.10 TOPICS FOR DISCUSSION FORUMS 274 Discuss the Information Technology Act amendments done recently.