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
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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
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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.”
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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.
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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.
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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.
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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
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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:

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Unemployment of some resources, particularly labour
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Inefficient allocation and consumption of resources

Coexistence of extreme poverty and wastage of resources
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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.
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
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.
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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.
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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
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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.
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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)
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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.
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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
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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.
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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.
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
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.
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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:
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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
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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
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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:

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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.
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
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.
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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
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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
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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.
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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
?
?
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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.
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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
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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

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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
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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.
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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.
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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).
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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.
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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.
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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.
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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.
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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
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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
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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.
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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.
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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
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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.
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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.
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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:
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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.
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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
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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
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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.
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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.”
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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
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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.
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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.
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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
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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)
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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
@
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
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

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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
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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
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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.
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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,
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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.
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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
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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
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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.
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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
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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)
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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
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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
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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.
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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
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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
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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.
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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

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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
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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
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
Barriers to entry and exit

Mutual interdependence among organisations

Existence of price rigidity

Lack of uniformity in the size of organisations
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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?
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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.
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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.
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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
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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
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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.
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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.
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
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
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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?
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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
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5.12 POST-UNIT READING MATERIAL
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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
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Search information on a joint operating agreement signed by different organisations to take
combined actions in oligopolistic market form.
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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
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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
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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.
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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
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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.
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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
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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
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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
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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.
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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
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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:

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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
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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
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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
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
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.
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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.
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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.
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
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
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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
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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.
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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),
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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
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
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.
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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.
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
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.
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
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
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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.
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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
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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

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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
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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.
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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
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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.
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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.
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
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.
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
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.”
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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
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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.
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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
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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.”
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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.
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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
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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
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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.
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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.
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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.
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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
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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.
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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.
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
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.
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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.
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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
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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)
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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
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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.
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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
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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
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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.
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
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
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
Preparing potential linked credit plans

Monitoring the ground level rural credit
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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
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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
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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
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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:
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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
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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.
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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,
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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

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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
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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
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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
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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.

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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)
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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.
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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,
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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/
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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
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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.
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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:
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
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.
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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.
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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
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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
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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
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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.
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
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.
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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.
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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
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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.
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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
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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
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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.
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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.
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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.
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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.
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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
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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.
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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
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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
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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
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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
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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}
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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
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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.
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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
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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
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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.
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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.
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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.
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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.
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
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
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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
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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
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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
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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,
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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
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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
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
Deutsche Investments India Private Limited

Edelweiss Asset Management Limited

Franklin Templeton Asset Management (India) Private Limited
13.8.7
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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.
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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
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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.
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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.
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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.
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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.
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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.
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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
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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
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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
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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:
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
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.
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
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
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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.
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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.
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
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
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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.
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‘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
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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.
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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.
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
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.
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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.
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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.)
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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
@

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https://www.accountingnotes.net/financial-management/financial-services/5-major-areas-offund-based-activities-in-india/7225
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https://efinancemanagement.com/sources-of-finance/hire-purchase
14.12 TOPICS FOR DISCUSSION FORUMS

Discuss key differences between bill discounting and factoring.
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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
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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.
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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
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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.
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
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.
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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.
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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
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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.
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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.
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
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
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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.
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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

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Discuss the Information Technology Act amendments done recently.