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FOUNDATION COURSE

PAPER - 3

Study Note - 1
BASIC CONCEPTS OF ECONOMICS 1.1 DEFINITION AND SCOPE OF ECONOMICS There are 4 definitions of Economics. (1) Wealth Definition: This definition was produced by Adam Smith. He defined Economics as a science which inquired into the nature and cause of wealth of Nations. According to this definition, Economics is a science of study of wealth only which deals with production, distribution and consumption. Economics studies only material commodities and causes of changes in wealth and changes in Economics dept. Criticisms of this definition: (a) Wealth is of no use unless it satisfies human wants. (b) This definition is not of much importance/important to man and welfare. (2) Welfare definition: It was given by Alfred Marshall. According to Marshall Economics is the study of man in the ordinary business of life. If examines how a person oats his income and how he invests it. Thus on one side it is a study of wealth and the other most important side, it is a study of man. Features of Marshall Definition (a) Economics studies the economic side of man man performs many types of activities social, eco religious. Economics is a study of those activities that are concerned with material welfare of man. (b) Every man works to earn wealth and to spend his earnings to get enjoyment of it. This is the ordinary activity of man Economics studies such an ordinary man. (c) Economics is the study of personal and social activities concerned with material welfare of man. It is the study of such an individual on one hand and social organization on the other hand. (d) Study of material welfare Marshall emphasized on definition of material welfare. This is one major difference of this definition with that given by Adam Smith. You must particularly note that economics is related with one welfare of man which is a material type, study of non-economic welfare is outside and scope of economics. (3) Scarcity definition This definition was put forward by Robbins according to him Economics is a science which studies human behavior as a relationship between ends and scarce means which have alternative uses. According to Robbins man is so situated that on one hand he has unlimited want to satisfy and on the other he has limited resources. Such wants keep on changing with the change of time. As soon as the present wants are satisfied, new wants take their place. It is very difficult to satisfy all wants at all same time, so the more urgent wants are closer to be satisfied tirs followed by less important wants. Are strictly limited by the resources. If all the resources are abundant in supply, like air, sunshine etc, there would have been no economic problem. But, in reality, the means of production are limited in supply, like time, money, physical, mental or other types of energy etc. There arises the Economics problem of choosing the most important or urgent wants for satisfying them on priority basis. (4) Growth Oriented definition This definition was introduced by Paul. A. Samuelson. According to the definition Economics is the study of how man and society choose with or without the use of money to employ the scarce productive resources, which have alternative uses, to produce various commodities over time and distributing them for consumption, how

or in the future among various person or groups in society. It analyses costs and benefits of improving patters of resource allocation. Features (1) Like Robbins, Samuelson had also emphasized on the problem of choice arising out of scarce resource and unlimited wants. (2) The problem of scarcity of resource is not merely confined to present but also to the future. It involves how the expansion and growth of resources is to be used to cope with human wants. (3) Professor Samuelson has adopted a dynamic approach to the study of Economics. By taking economic growth as an integral part of economics. (4) Professor Samuelson has rightly emphasized that the problem of resource allocation is a universal problem of an economy. (5) This definition of Economics is very comprehensive since it is growth oriented as well as future oriented. It includes Marshalls definitions welfare as well as Robbins scarcity. Scope and Subject Matter Economics is a social science. It studies mans behaviour as a rational social animal. For a long time the scope of Economics was kept confined within narrow limits. Traditional economists considered it a science of wealth in relation to human welfare. Earning and spending of income was considered to be end of all economic activities. The mechanism of wealth of nation was lucidly explained Adam Smith in 1776. Alfred Marshall subsequently reduced the taint of gross materialism from economics by bringing human welfare side into its scope. It was redefined as science of wealth in relation to human welfare. According to him the subject is more a study of mans welfare than wealth. Wealth was considered as a means to an end the end being human welfare. The scope pf Economics was however much widened in the hands of Robbins. Setting aside wealth and welfare ideas, he brought into limelight limited means to satisfy unlimited wants that a man or society faces in daily life and how he makes a happy compromise between these two conflicting problems. That constitutes the subject matter in a wider context. The economic problem everywhere is a problem of making a living in the midst of scarcity. In a situation where want fulfilling resources are scares, how an individual, either as a consumer or as a producer, can optimize his goal is what economist can analyse theoretically. In a like manner, the scope of Economics lies in analyzing economic problems and suggests policy measures. Social problems can thus be explained by abstract theoretical tools or by empirical methods. These two approaches are often complementary. In classical discussion we see Economics as a positive science seeking to explain what the problem is and how it tends to be solved. But in modern time it is both a positive and a normative science. Economists of today deal economic issues not merely as they are but also as they should be. In fact, welfare economics and growth economics are more normative than positive. Thus the scope of Economics has widened over the centuries, touching all aspects of a mans or nations life in its economic side. Subject Matter of Economics The subject matter of economics is presently divided into two major branches. Micro Economic and Macro Economics. These two terms have now become of general use in economics. Question : what do you mean by Micro Economics ? Answer : Micro economics studies the economics behaviour of individual economic units and individual economic variable. The unit of study in micro economics is the part of the economy, such as individual households, firms and industries. Thus, the study of economic behaviour of the households, firms and industries form the subject-matter of micro economics. In other words, micro economics is a microscopic study of the economy. For example, micro economics is concerned with how the individual consumer distributes his income among various products

and services so as to maximize utility. Micro economics also seeks to explain ho the individual firms determine the sale price of the product, how much to produce, what amount of product will maximize its profit, and how to minimize the cost of production. In other words, micro economics examines how resources are allocated among various individual firms and industries, how the prices of various product are determined, and how the output produced is shared among those. Micro economics also examines whether resources are efficiently allocated and spells out the conditions for the optimal allocation of resources so as to maximize the output and social welfare. Thus, micro-economics is concerned with the theories of product pricing, factor pricing and economic welfare. Question : what do you mean by Macro Economics ? Answer : Macro Economics is the study of the economy as a whole. The unit of study in macro economics is the entire economy rather than a part of it, and it deals with the problems faced by the entire economy. Thus, macro economics deals with the functioning of the economy as a whole. For example, macro economics seeks to explain how the economys total output of goods and services and total employment of resources are determined and what explains the fluctuation in the level of output and employment. Macro economics explains why at sometimes there is full utilization of the economys productive capacity and why at other times there is under-utilisation of the economys productive capacity. It also seeks to explain why the economy experiences a high rate of economic growth at sometimes and a lower rate of economic growth at other times; why sometimes the economy faces the problem of sharp rise in prices, example., problem of inflation, and what at other times price level remains stable or even falls. In short, macro economics deals with the broad economic aggregates or big issues, such as full employment or unemployment, capacity or under capacity production, a low or high rate of growth, inflation or deflation. In other words, macro economics is the theory of national income, employment, aggregate consumption, savings and investment, general price level and economic growth. Interdependence of Micro Economics and Macro Economics Although we have drawn a sharp distinction between micro economics and macro economics, we should not get an impression from this that the two are independent ways of analyzing the economic issues. Micro Economic analysis and Macro Economic analysis are complementary to each other; they do not supplant but supplement each other. That is why Shapiro says, strictly speaking, there is only one Economics. In practice, analysis of the economy cannot be conducted separately in two watertight compartments. Micro economic variables and macro economic variables, we have to take account of macro economic variables that may affect the micro economic variables, and vice versa. Both micro economic theory and macro economic theory are important in their own ways. When we say that macro economics deals with big issues of economic life, it does not mean that macro economic theory is more important. As we know, small is beautiful. After all, the entire economy is made up of its parts. Therefore, micro economic theory is equally important in its own way. Moreover, the basic goal of both the theories is same: the maximization of the material welfare of the nation. From the micro economic point of view, the nations material welfare will be maximized by achieving optimal allocation of resources. From the macro economic point of view, the nations material welfare will be maximized by achieving full utilisation of productive resources of the economy. Therefore, for you as students of economics, study of both micro economics and macro economics is equally vital so as to have full knowledge of the subject-matter of economics. Otherwise, your description of an elephant by four blind men who gave four different descriptions of the elephant by touching its different parts. Prof. Paul A. Samuelson has rightly remarked, There is really no opposition between micro and macro economics. Both are vital. You are less than half-educated if you understand one while being ignorant of the other. Economists, before 1930, concentrated their attention on micro economics. Macro economics

was regarded as a junior partner. It was, therefore, given a passing reference. The classical economists believed that the economy normally operates at full employment and, therefore, the actual level of output in the economy was simply whatever could be produced with full employment of resources. According to them, the economy could depart from full employment situation only temporarily. They believed that the automatic forces of competition would take the actual level of output back to the full employment. Therefore, these economists were concerned with the problem of unemployment. The fact that there was relatively few situations of prolonged unemployment and depression before 1930 gave support to this belief of classical economists. However, the situation changed dramatically during the 1930s. During this decade, there was widespread unemployment in the advanced capitalist countries of the world. Actual output was only 75 percent of the potential output*, example., 25 percent of the potential output was not produced. It was this which led to the development of macro economic theory by the famous economists J.M. Keynes. Keynes famous book, The General Theory of Employment, Interest and Money provided a theory to explain the phenomenon of depression. Keynes provided a theory of the determination of employment and output. He explained that the economy can operate at any level of employment, with full employment only as one possible level. In fact, according to him, economy normally operates at less than full employment level. Ever since then, economists have shown their concern with macro economics and micro economics has assumed as unprecedented importance. The contemporary economists are concerned with both micro economics and macro economics. Question write the nature of Economics Answer : Nature of economics refers to whether economics is a science or art or both, and if it is a science, whether it is positive science or normative science or both. Economics as a Science While explaining the subject matter of economics we have often stated that economics is a social science. A social science studies various human activities. Economics as a social science studies economic activities of the people. By classifying economics as asocial science, economists have placed their subject in the category of science rather than art. Let us understand why economists regard economics as a science or why we use the title science for economics. The term science implies the following : 1. A systematic body of knowledge which traces the relationship between cause and effect. 2. Observation of certain facts, systematic collection and classification and analysis of facts. 3. Making generalization on the basis of relevant facts and formulating laws or theories thereby. 4. Subjecting the theories to the test of real world observations. Subjects such as Physics, Chemistry, Botany, etc., are regarded as science because they posses all these characteristics. In this sense, economics is also considered to be science since it satisfies all these characteristics of science. Firstly, economics is a systematic body of knowledge as it explains cause and effect relationship between various variables such as price, demand, supply, money supply, production, national income, employment, etc. As in other sciences, one way of making generalisations in economics is through logical deduction. This is the traditional Deduction Method where economic theories are deduced by logical reasoning. In this method certain assumptions are made and by using logical reasoning we arrive at certain logical deductions. From these deductions certain economic laws or themes are formulated. Thus, under the deductive method, logic proceeds from the general to the particular. This method is called abstract or a prior because it is based on abstract reasoning and not on actual facts. Economic laws, like other scientific laws, state what takes place when certain conditions

(assumptions) are fulfilled. For example, Newtons Law of Gravitation in Physics states that every body in the universe attracts every other body with a force. But the gravitational force depends upon the size of the mass and the distance between the two bodies. Therefore, the Gravitation Law states that given the mass of the two objects, the force of gravitation is inversely proportional to the distance between them. In the same way, the law of demand in economics states that a fall in the price of commodity leads to a large quantity being demanded given other things, such as income of the consumer, prices of other commodities, etc., remaining the same. An alternative method to derive economic generalizations is Inductive Method. Under this method, a mass of data is collected from actual experience with regard to economic phenomenon and on the basis of these collected observations certain generalizations are made and conclusions are drawn therefrom. The logic in this approach is from particular to general. The generalizations are based on observation of individual instances. However, the two methods are not mutually exclusive. They are used side by side in any scientific enquiry. Thus, like other sciences, economics possesses the above mentioned characteristics (2) and (3) as well. In economics we collect data, classify and analyse these facts and formulate theories or economic laws. Lastly, we call economics a science because the truth and applicability of economic theories can be supported or challenged by confronting them to the observations of the real world. If the predictions of the theory are refuted by the real-world observations, the theory stands rejected. But if the predictions of the theory are supported by the real-world events, then the theory is formulated. For example, the law of demand, stating the there is an inverse relation between price and quantity demanded, is a scientific economic hypothesis, because it has been corroborated by the real world observations. The method of economics is, therefore scientific and hence it is appropriate to label economics as a science. However, compared with physical and natural sciences, economics is at a disadvantage. Economics cannot claim the precision of the physical sciences because the human and social behaviour is complex and unpredictable. In economics, unlike Physics, Chemistry and Biology, we cannot perform the controlled experiments. We have to depend upon observation of economic events; these observations are not so well behaved and orderly. That is why economy laws are not as accurate, precise and of universal validity as laws of physical and natural scienties are. The laws of economics or economic theories are conditional subject to the condition that other things are equal; Economic theories are seldom precise and are never final; they are not as exact and definite as laws of physical and natural sciences. From the above discussion, we make the following two observations. 1. The laws of physical and natural sciences have universal applicability, but economic laws are not of universal validity. 2. The laws of physical and natural sciences are exact, but economic laws are not that exact and definite. Economics as an Art Art is completely different from science. What is an art? J.M.Keynes defines art as a system of rules for the attainment of a given end. The object of art is to formulate rules to be used for formulation of policies. Thus, as compared to science, which is theoretical, art is practical. A science teaches us to know, an art teaches us to do. Applying this definition of art, we can say that economics is an art. Various branches of economics, like consumption, production, distribution, money and banking, public finance, etc., provide us basic rules and guidelines which can be used to solve various economic problems of the society. Thus, the theory of demand guides the consumer to obtain maximum satisfaction with given income. Similarly, theory of production guides the producer to equate marginal cost with marginal revenue while using resources for production. Thus, economics is an art in

the sense that the knowledge of economic laws helps us in solving practical economic problems in everyday life. To conclude, we can say that economics is both a science and an art. As a science, economics is a systematic body of knowledge which makes generalizations and theories by adopting scientific approach. As an art, it puts this knowledge into practice. It uses economic theories and laws in formulating various economic policies. Thus, economics is science in methodology and art in its application. Corsa observed that science required arts, and arts requires scienceeach being complementary to the other. It is advisable, therefore, to treat economics both as a science and an art. Paul A. Samuelson has rightly stated that economics can be described as the oldest of the arts and the newest of the sciences indeed the queen of social sciences. Positive and Normative Science As explained above, economics is considered as a science. Another question related to nature of economics is whether it is a positive science or a normative science or both. Economics as a Positive Science A positive science is that science in which analysis is confined to cause and effect relationship. In other works, it states What is and not what ought to be. There is a school of thought which believes that economics is only a positive science. It should confine itself to stating the cause and effect relationship. It should not pass any value judgement regarding what is right and what is wrong. Positive economics is concerned with the facts about the economy. It relates to what the facts are, were or will be about various economic phenomena in the economic. It studies the economic phenomena as they exist, finds out the common characteristics of economic events, specifies cause and effect relationship between them, generalize their relationship by formulating economic theories and make predictions about future course of these economic events. For example, positive economics deals with questions like what are the causes of unemployment? How do we account for inflation? Why price of a particular good has increased? and so on. Economics as a Normative Science Economics as a normative science is concerned with what ought to be. Its objective is to examine real economic events from moral and ethical angles and to judge whether certain economic events are desirable or undesirable. It tries to find out and prescribes certain course of action which is desirable and necessary to achieve certain goals. Thus, normative economics involves value judgment. Normative economics deals primarily with economic goals of a society and policies to achieve these goals. It also prescribes the methods to correct undesirable economic happenings. To understand the difference between the positive and normative nature of economics, let us consider some economic events and their positive and normative aspects, in economic studies. For example, how are the prices of foodgrains determined is a question of positive economics, but what should be the prices of foodgrains is a question of normative science. Consider another example. The statement a decrease in taxes will encourage production is a question for positive economics, but should taxes be reduced or not is a question of normative economics. In the past, there was controversy among economists over the nature of economics. Robbins emphasized that economics is purely a positive science. According to him economics should be neutral between ends. It is not for economists to pass value judgement and make pronouncements on the goodness or otherwise of human decisions. Marshall and Pigou, on the other hand, considered economics both a positive and a normative science. However, there is hardly any controversy on this issue now. It is generally agreed not that economics is both a positive and a normative science. Economists believe now that complete neutrality between ends is neither feasible nor desirable. It is not possible because in many matters the economist has to suggest measures for achieving certain economic objectives. He advocates various policies for increasing employment, reducing inflation, etc. While making these suggestions, he is making value judgement.

A mere study or positive facts would not take us very far. Complete elimination of value judgements from the study of economics robs the subject much of its practical utility. In many cases, an economist as a policy formulator and social reformer has to pronounce undesirable effects of certain economic events and has to make suggestions for their removal. When he does this, he is not entirely neutral between ends. Thus, neutrality between ends is not desirable in many cases. Deductive And Inductive Methods Of Economic Analysis In Economics the issues are analysed either by inductive method or by deductive method. The deductive method tries to draw conclusions from certain fundamental assumptions or truths. The logic proceeds from general to the particular. For example, we can deduce from the basic truth that a man will buy more at lower prices. The Law of Demand and the Law of diminishing Marginal Utility have been derived from deductive reasoning. The inductive method, on the other hand, deduce conclusions on the basis of collection and analysis of facts and figures. The Logic proceeds from particular to general. It leads to exact and precise conclusions for policy making. The Deductive method was used by earlier economists. It is a simple method, obviates the need of experimentation and collection of statistical data. But deductive conclusions are based upon assumptions that may turn out to be untrue or partially true. Hence it is unsuitable for policy making as it is dangerous to claim universal validity for economic generalizations. Economics is a Science and an Art Being a systematized body of knowledge and establishing the cause and effect relationship of a phenomenon, Economics is a scientific study. Like other sciences, we in economics deduce conclusions or generalizations after observing or collecting facts and figures. However the laws of economics are conditionalthey assume other things being equal. Economics cannot predict with so much certainly and accuracy as physical can. The reason is obvious. The subject deals with the behaviour of human beings as such controlled experiment is not possible. However some economists prefer to treat economics as an art. An art is a system of rules for attainment of a given endso remarked J.N.Keynes. It implies that the function of an art is to provide rules, norms and maxims to solve human problems. An art teaches us to do. The fact is that every science has an art or a practical side and every art has a scientific side which is theoretical. Economics deals with both theoretical aspects as well as practical side of many economic problems we face in our daily life. The theoretical side teaches us to know and the applied side teaches us to do. Thus, Economics is both science as well as an art. Central Problem of all Economies Prof. Robbins said that human wants are unlimited but the means available to satisfy them are limited. It is also true in case of any economy, whatever the economy required cannot be satisfied fully. This is because economic resources or means of production are limited and they can be put to alternative uses. So every economy faces some common problems. One of them is what to produce? In view of limited resources a country cannot produce all goods. So it has to make a choice between different goods and services. If it gets X it must have to sacrifice Y. Hence, every economy has to decide what goods and services should be produced. The second issue is how to produce? As an economy decides to produce certain goods, it faces the problem to decide how these goods will be produced. The problem arises because of unavailability of some resources. How to produce also involves the choice of technique of production. A country may produce by labour intensive methods or by capital intensive methods of production, depending upon its stock or man power. Thirdly, another central problem is for whom to produce? Goods and services are produced for people specially for those who have the means to pay for them. A country may produce mass consumption goods at a large scale or goods for upper classes. All it depends upon the policies of the government as well as private producing units.

1.2 FEW FUNDAMENTAL CONCEPTS


Wealth By wealth we mean the stock of goods under the ownership of a person or a nation. Personal wealth Personal wealth means the stock of all goods (houses and buildings, furniture, land, money in cash, money kept in banks, clothes, company shares, stocks of other commodities, etc.), owned by a person. Strictly speaking, such things as health, goodwill, etc., can also be considered to be parts of an individuals wealth. In Economics, however, it is only transferable goods (example., goods whose ownership can be transferred to another person), which are considered to be components of wealth. For instance, a house is a transferable good because it can be sold off or given away as a gift. Thus, a persons wealth is defined as the stock of all transferable goods owned by any person. National wealth The national wealth of a country includes the wealth of all the citizens of the country. In calculating national wealth, however, we must be careful on two-points : (i) There are some goods whose benefits are enjoyed by the citizens of the country. But no citizen personally owns these goods. These are public properties. Natural resources (for instance, mineral resources, forest resources, etc), roads, bridges, parks, hospitals, public educational institutions and public sector projects of various types (for instance, public sector industries, public irrigation projects, etc.) are all example of public properties. These are to be included in the nations wealth. (ii) On the other hand, there are some types of personal wealth which are to be deducted from national wealth. For instance, if a citizen of the country holds a Government bond, it is personal wealth. But from the point of view of the Government, it is a liability and, hence, it should not be considered as a part of the nations wealth. Thus, the national wealth of a country is the sum of all public properties in the country. This also takes into account that part of the total personal wealth in the country which is not a liability for the Government. Wealth and welfare By welfare of the society, we mean the satisfaction or the well-being enjoyed by society. Social welfare depends on the wealth of the nation. Wealth, in general, gives rise to welfare, although wealth and welfare are not the same thing. In certain cases, however, wealth and welfare may not go hand in hand. If a nation goes on creating wealth without paying any consideration to the health and the mental peace of the citizens of the country, it is doubtful whether social welfare increases. Again, if an wealth of society increases, but the distribution of the wealth among the citizens of the country is very unequal, this inequality may create social jealousy and tension. In this case too, societys welfare may not increase. Economists, however, assume that when wealth increases, welfare increases too. Even if there is any negative side effect (for instance, social tension due to inequality of wealth distribution), this negative effect is unable to outweigh the positive beneficial effect. The net effect is that, welfare increases. Similarly, when wealth decreases, welfare is assumed to decrease. Money Anything which is widely accepted in exchange for goods, or in settling debts, is regarded as money. Before the emergence of money, goods were exchanges for goods. This was known as Barter System. In that system goods were used as medium of exchange. For example, one horse can be exchanged for two cows. Later on, some valuable metals like gold and silver were used as the medium of exchange. However, the supply of these precious metals could not be increased with the expansion of business activities and growing demand for money. Thus, paper notes were considered to be the medium of exchange. When general acceptability of any medium of exchange is enforced by law, that medium of

exchange in called the legal tender. For example, the rupee notes and coins are legal tenders. However, when some commodity is used as a medium of exchange by custom, it is called customary money. For example, the use of cowrie-shell in ancient India as a medium of exchange. Constituents of money supply In any economy, the constituents of money supply are as follows: (a) Rupee notes and coins with the public, (b) Credit cards, (c) Travellers cheques, etc. Markets : Definition A market in Economics may or may not refer to a particular place where buyers and sellers meet. Rather, it refers to a system by which the buyers and sellers of a commodity can come into touch with each other (directly or indirectly). Thus, when economists talk of the fish market, they may mean a place where buyers and sellers of fish meet. But when they talk about, say, the housing market, they do not mean a place where buyers and sellers of houses meet. They mean the system of buying and selling houses through contacts between the buyers on the one hand and the sellers on the other. Thus, in Economics, a market for a commodity is a system by which the buyers and the sellers establish contact with each other directly or indirectly with a view to purchasing and selling the commodity. Functions of a market The major functions of a market for a commodity are : (1) to determine the price for the commodity, and (2) to determine the quantity of the commodity that will be bought and sold. Both the price and the quantity are determined by the interactions between the buyers and the sellers of the commodity. The market mechanism When economists talk of the market mechanism, they mean the totality of all markets (example., the markets for all the goods and services in the economy). The market mechanism determines the prices and the quantities bought and sold of all the goods and services. Investment : Definition Investment means an increase in the capital stock. For a country, as a whole, investment is the increase in the total capital stock of the country. For an individual, investment is the increase in the capital stock owned by him. Real investment and portfolio investment Economists talk of two types of investment : real investment and portfolio investment. (a) Real investment : Real investment means an increase in the real capital stock, example., an addition to the stock of machines, buildings, materials or other types of capital goods. (b) Portfolio investment : Portfolio investment essentially means the purchase of shares of companies. However, it is only the purchase of new shares issued by accompany that can properly be termed as investment (because the company will use the money for expanding its productive capacity, example., the companys real capital stock will increase). Purchase of an existing share from another shareholder is not an investment because in this case the companys real capital stock does not increase. It is savings that are invested How is investment financed ? Consider, for instance, a producer who wished to make a real investment, example., to increase his capital stock by, say, purchasing a new machine. He would buy the machine by spending his own savings or take a loan or (if the producer has set up a joint stock company) sell shares to the public. In all cases, it is savings which are transformed into investment. If a loan is taken from a bank, the bank would lend the money kept in the bank by the depositors. This money will be nothing but the savings of the depositors. If shares are sold to the public, the purchasers will use their savings to purchase the shares. Thus, for the country as a whole, investment comes from savings. It is the countrys savings which are invested (excepting, of course, in such cases where the country receives foreign investment or foreign

aid). Gross investment and net investment In any economy, the aggregate investment made during any year is called gross investment. The gross investment includes (a) inventory investment and (b) fixed investment. Investment in raw materials, semi-finished goods and finished goods is referred to as inventory investment. On the other hand, investment made in fixed assets like machineries, factory sheds etc. is called fixed investment. It was deduct depreciation cost of capital from the gross investment, we get new investment. So, Net investment = Gross investment depreciation cost. Production : Meaning By production, we mean the creation of goods (or performance of services) for the purpose of selling them in the market. Notice that this definition includes the production of goods as well as that of services. There was a time when production meant the fabrication of material goods only. A tailors activity was considered to be production. He produced shirts, pants, etc. But the activity of the trader who sold clothes to the purchasers was not considered to come under the heading of production, because he did not tailor the clothes himself. But this is not the position taken by economists today. At present, both material goods and services are considered to come within the orbit of production. Thus, production also means creation of service goods or utility. Market sale However, the definition of production states clearly that production must be for the purpose of selling the produced goods (or, services) in the market. When a child makes a doll out of clay for the sheer enjoyment of this activity, it is not called production. But the doll-maker who sells his dolls in the market is engaged in production. Factors of production The goods and services with the help of which the process of production is carried out, are called factors of production. Economists talk about four main factors of production : land, labour, capital and entrepreneurship (or organization). They are also called as the inputs of production. On the other hand, the goods produced with the help of these inputs, are called as the output. Consumption : Definition By consumption, we mean satisfaction of wants. It is because we have wants that we consume various goods and services. Moreover, it is assumed that, if we have wants, these can be satisfied only through the consumption of goods and services. Thus, consumption is defined as the satisfaction of human wants through the use of goods and services. Other determinants of consumption The present income is not the only determinant of consumption. There are other determinants. For instance, consumption is affected by expected future income as well. Most people expect their income to fall in their old ages. They, therefore, try to save for the future. For this reason, people display a low average propensity to consume when they are young and a low propensity to save when they are old. Thus, consumption depends not only on present income but also on expected future income. Again, consumption also depends on wealth. A person may have a low income, but he may be wealthy example., he may have a great amount of accumulated wealth, example., he may have inherited property. In this case, he may have high consumption expenditure. Saving: Definition Saving is defined as income minus consumption. Whatever is left in the hands of an individual after meeting consumption expenditure is the individuals saving. The sum-total of funds in the hands of an individual obtained by accumulating the saving of the past years is called the savings of the individual. Thus, saving is generated out of current income of an individual. But savings are created out of past income of an individual. In a modern society, people either keep their savings in banks or other financial institutions or

invest the savings. Income The income of a person means the net inflow of money (or purchasing power) of this person over a certain period. For instance, an industrial workers annual income is his salary income over the year. A businessmans annual income is his profit over the year. Wealth and income The difference between wealth and income must be clearly understood. A person (or a nation) consumes a part of the income and saves the rest. These savings are accumulated in the form of wealth. Wealth is a stock. It is stock of goods owned at a point of time. Income is a flow; it is the inflow of money (or purchasing power) over a period of time. The Concept of Consumer Surplus The concept was introduced by Prof. Marshall in Economics to show the excess satisfaction or utility that a consumer can enjoy from the purchase of a thing when the price that he actually pays is less than the price he was willing to pay for it. In other words consumers surplus is the difference between individual demand price and market price. Whenever a man goes to purchase a thing he has in his mind a price that he will pay for the thing. The price that he is willing to pay is determined by the marginal utility of the thing to him. Now if market price for the product is less than the price the consumer was ready to pay then the consumer gets the thing plus he also enjoys some surplus satisfaction. It is what is called Consumer Surplus. Marshall defined the concept in this way The excess of the price which a consumer would be willing to pay rather then go without the thing over that which he actually does pay, is the measure of this surplus satisfaction. It may be called consumer surplus. The concept is derived from the Law of Diminishing Marginal Utility. As a man successive units of a commodity, the Marginal Utility from each unit goes on falling. It means that he is willing to pay less and less as he gets more and more units of the thing. But all units are available at the same price in the market. So there arises a difference between Marginal Utility and the price actually paid. Prof. Hicks has redefined the concept as the money income gained by a man arising from a fall in price of goods he purchases. It is often argued that this concept is a theroretical toy. The surplus satisfaction cannot be measured precisely. In case of very essential goods of life, utility is very high but prices paid of them are low giving rise to infinite surplus satisfaction. Further it is difficult to measure the marginal utilities of different units of a commodity consumed by person. The Law of Diminishing Marginal Utility This Law is a fundamental law of Economics. It relates to a mans behaviour as a consumer. It is deduced from actual behaviour of man. The Law states that as a man gets more and more units of a commodity, marginal utility from each successive unit will go on falling till it becomes zero or negative. Prof. Marshall stated the Law as follows The additional benefit which a person derives from a given increase in stock of a thing diminishes with every increase in the stock that he already has. The term marginal utility means the additional utility obtained from one particular unit of a commodity. It is expressed in terms of the price that a man is willing to pay for a commodity. As a man gets successive unit of a commodity, marginal utility from each unit goes on falling. The basis of the Law is satiability of a particular want. Although human wants are unlimited in number yet a particular one can be fulfilled. Fig 1.1 Marginal Utility and Total Utility Curve In this graph the curve MU is Marginal Utility curve. It has a negative slope denoting the fact that as the quantity of a commodity increases, marginal utility goes on following. At Q it is zero and after it, it becomes negative. The Law is based upon certain assumptions. It is assumed that the different unit consumed should be identical in all respects. Further it is assumed that consumers habit, taste, preference

remain unchanged. Thirdly, there should be no time gap or interval between the consumption of one unit and another unit. Lastly, the different units consumed should consist of standard units which are not too small or large in size. Notion of the Law The Law of Diminishing utility is not applicable in some cases. The Law may not apply to articles like gold, money where more quantity may increase the lust for them. Further the Law does not apply to music, hobbies. Thirdly, Marginal utility of a commodity may be affected by the presence or absence of articles which are substitutes or complements. Demand Forecasting In modern business, production is carried out in anticipation of future demand. There is thus a time-gap between production and marketing. So production is done on the basis of demand forecasting. The success of a business firm depends to a large extent upon its successful forecasting. The following methods are commonly used in forecasting demand. (a) Expert opinion method - experts or specialists in the fields are consulted for their opinion regarding future demand for a particular commodity. (b) Survey of buyers intentions generally a limited number of buyers choice and preference are surveyed and on the basis of that the business man forms an idea about future demand for the product it is going to produce. (c) Collective opinion method the firm seeks opinion of retailers and wholesalers in their respective territories with a view to estimate expected sales. (d) Controlled experiments the firm takes into account certain factors that effect demand like price, advertisement, packaging. On the basis of these determinants of demand the firm makes an estimate about future demand. (e) Statistical methods More often firms make statistical calculations about the trend of future demand. Statistical methods comprising trend projection method, least squares method progression analysis etc. are used depending upon the availability of statistical data.

1.3 DEMAND
Definition In the ordinary sense Demand means desires. A child may demand a doll. It means that he desires it. But, in Economics, Demand does not mean mere desire but something more than that. Demand in Economics means both the willingness as well as the ability to purchase a commodity by paying a price and also its actual purchase. A man may be willing to get a thing but he is not able to pay the price. It is not demand in the economic sense. So demand is related to price. Generally demand for a commodity depends upon the price of the commodity. particular commodity goes up, its demand falls and vice-versa; but in exceptional cases the two variables may move in the same direction. Demand for a commodity mainly depends upon its price but not solely. There are other factors that may influence the quantity demanded for a quantity. One such factor is the income of the consumer. If a mans income increases, obviously he will be able to demand more of the goods at a given price. Similarly demand for a commodity depends upon the taste and preference of the consumers, the price of substitute goods etc. Law of Demand : The law of demand expresses the functional relationship between the price of commodity and its quantity demanded. It states that the demand for a commodity tends to vary inversely with its price this implies that the law of demand states- Other things remaining constant, a fall in price of a commodity will lead to a rise in demand of that commodity and a rise in price will lead to fall in demand. ASSUMPTION : 1) Income of the people remaining unchanged.

2) Taste, preference and habits of consumers unchanged. 3) Prices of related goods example., substitute and complementary goods remaining unchanged 4) There is no expectation of future change in price of the commodity. 5) The commodity in question is not consumed for its prestige value. Demand schedule : It is a numerical tabulation, showing the quantity that is demanded at selected prices. A demand schedule can be of 2 types; Individual Demand Schedule, Market Demand Schedule 1) Individual Demand Schedule : It shows the quantity of a commodity that one consumer or a particular household will buy at selected prices. Importance of law of Demand 1) Basis of the Law of Demand : The law of Demand is the basis of law of demand because the consumers are prepared to buy a large quantity of a certain commodity only at a lower price. This results from the fact that consumption of additional units of a commodity reduces the marginal utility to him . 2) Basis of consumption Expenditure : The law of Demand and the law of equi-marginal utility both provide the basis for how the consumer should spend his income on the purchase of various commodity. 3) Basis of Progressive Taxation : Progressive Taxation is the system of Taxation under which the rate of tax increase with the increase in income. This implies that the burden of tax is more on the rich than on the poor. The basis of this is the law of Demand. Since it implies that the marginal utility of Money to a rich man is lower than that to a poor man. 4) Diamond-water paradox : This means that through water is more useful than diamond. Still the price of diamond is more than that of water. The explanation lies in law of diminishing marginal utility. The price of commodity is determined by its marginal utility. Since the supply of water is abundant the Mu of water is very low and so its price. On the contrary, supply of diamond is limited the Mu of diamond is very high, therefore the price of diamond is very high suppose a price of the commodity x is Rs. 100 and its demand is 1 unit and how the price is reduced to Rs. 50, the quantity demanded increases to 2 units as the price kept an falling. The quantity demanded keeps increasing list of such price and quantity demanded of an individual or household is named as Individual Demand Schedule. 2) Market Demand Schedule : When we add the individual demand schedule of various household, we get the market demand schedule for eg. There are 4 households in the market and their demand schedule at different prices are given below : Demand Curve : Demand curve is a diagrametic representation of the demand schedule when we plot individual demand schedule on a graph, we get individual demand curve and when we plot market schedule, we get market curve. Both individual and market demand curves slope downward from left to right indicating an inverse relationship between price and quantity demanded of goods. Fig.1.2 : Demand Curve The demand curve is downward sloping because of the following reasons. 1) Some buyer may simply not be able to afford the high price. 2) As we consume more units of a product, the utility of that product becomes less and less. This is called the principle of diminishing Marginal Utility. The quantity demanded rises with a fall in price because of the substitution effect. A low price of x encourages buyer to substitute x for other product. Determinants of demand 1) Price of the Commodity : There is an inverse relationship between the price of the commodity and the quantity demanded. It impels that lower the price of commodity, larger is the quantity demanded and vice-a-versa. 2) Income of the consumers : Usually there is a direct relationship between the income of the

consumer and his demand. example. as income rises his demand rises and vice-a-versa. The income demand relationship varies with the following 3 types of commodities : a) Normal Goods : In such goods, demand increases with increase in income of the consumer. For eg. demands for television sets, refrigerators etc. b) Inferior Goods : Inferior Goods are those goods whose demand decrease with an increase in consumes income. For example. food grains like Malze , etd. If the income rises demand for such goods to the consumers will fall. c) Necessities : In case of necessities of life like salt, match box, etc. the demand increases with an increase in income and thereafter it remains constant irrespective of the level of income. 3) Consumers Taste and Preference : Taste and Preferences which depend on social customs, habit of the people, fashion, etc. largely influence the demand of a commodity. 4) Price of Related Goods : Related Goods can be classified as substitute and complementary goods. 5) Substitute Goods : In case of such goods, if the price of any substitute of commodity rises, then the commodity concern will become relatively cheaper and its demand will rise. The demand for the commodity will fall if the price of the substitute falls. 6) Complementary Goods : In case of such goods like pen and ink with a fall in the price of one there will be a rise in demand for another and therefore the price of one commodity and demand for its complementary are unversely related. 7) Consumers Expectation : If a consumer expect a rise in the price of a commodity in a near future, they will demand its more quantity in anticipation of a further rise in price. 8) Size and Composition of Population : Larger the population, larger is likely to be the no. of consumers. Besides the composition of population which refers to the children, adults, males, females, etc. in the population. The type of people inhabiting the country will also influence the consumer demand. Determinants of Elasticity of demand a) Nature necessity of a commodity : The demand for necessary commmodity like rice, wheat, salt, etc is highly inelastic as their demand does not rise or fall much with a change in price. On the other demand for luxuries changes considerably with a change in price and than demand is relatively elastic. b) Availability of Substitutes : The Demand for commodities having a large no. of close substitute is more elastic than the commodities having less or no substitutes. If a commodity has a large no. of substitutes its elasticity is high because when there is a rise in its prices, consumers easily switch over to other substitutes. c) Variety of uses : The Product which have a variety of uses like steel, rubber etc. have a elastic demands and if it has only limited uses, then it has inelastic demand. For eg. if the unit price of electricity falls then electricity consumption will increase. More than proportionately as it can be put to use like washing, cooking, as the price will go up, people will use etc. it for important purposes only. d) Possibility of postponed of consumption : The commodities whose consumption can easily be postponed has more elastic demand and the commodities whose consumption cannot be easily postponed has less elastic demand for eg. for expensive jewellery, perfume it is possible to postpone consumption in case the price is high and so such goods are elastic on the other hand, the necessities of life cannot be postponed and so they are inelastic in demand. e) Durable commodities : Durable goods like furnitures, etc, which will last for a longer time have valuably inelastic demand. This is because in such case, a fall in price will not lead to a large increase in demand and a rise in price again will not load to a huge fall in demand. But in case of perishable goods, the demand is elastic is nature. Exceptions to the law of demand. 1) Conspicuous Goods : These are certain goods which are purchases to project the status and

prestige of the consumer. For example. expensive cars, diamond jewellery, etc. such goods will be purchased at a higher price and less at a lower price. 2) Giffen Goods : These are special category of inferior goods whose demand increases even if with a rise in price. For eg. : - coarse grain, clothes, etc. 3) Shares speculative Market : It is found that people buy shares of those company whose price is rising on the anticipation that the price will rise further. On the other hand, they buy less shares in case the prices are falling as they expect a further fall in price of such shares. Here the law of demand fails to apply. 4) Bandwagon effect : Here the consumer demand of a commodity is affected by the taste and preference of the social class to which he belongs to. If playing golf is fashionable among corporate executive, then as the price of golf accessories rises. The business man may increase the demand for such goods to project his position in the society. 5) Veblen Effect : Sometimes the consumer judge the quality of a product by its price. People may have the expression that a higher price means better quality and lower price means poor quality. So the demand goes up with the rise in price for eg. : Branded consumer goods. Causes of downward slope of demand curve : (1) Law of Diminishing Marginal Utility : This law states that when a consumer buyers more units of same commodity, the marginal utility of that commodity continues to decline. This means that the consumer will buy move of that commodity when price falls and when less units are available, utility will be high and consumer will prefer to pay more for that commodity. This means that the consumer will buy move of that commodity when price falls and when less units are available, utility will be high and consumer will prefer to pay none for that commodity. This proves that the demand would be none at lower prices and less at a higher price and so the demand curve is downward sloping. (2) Income effect : As the price of the commodity falls, the consumer can increase his consumption since his real income is increased. Hence he will spend less to buy the same quantity of goods. On the other hand, with a rise in price of the commodities the real income of the consumer will fall and will induce them to buy less of that good. (3) Substitution Effect :When the price of a commodity falls, the price of its substitutes remaining the same, the consumer will buy more of that commodity and this is called the substitution effect. The consumer will like to substitute cheaper one for the relatively expensive one on the other hand, with a rise in price the demand fall due to unfavorable substitution effect. It is because the commodity has now become relatively expensive which forces the consumers to buy less. 4) Goods having no. of uses : Goods which can be put to a number of uses like coal, aluminum, electricity, etc. are eg. of such commodities. When the price of such commodity is higher, it will not used for a variety of purpose but for use purposes only. On the other hand, when price falls of the commodity will be used for a variety of purpose leading to a rise in demand. For eg : if the price of electricity is high, it will be mainly used for lighting purposes, and when its price falls, it will be needed for cooking. 5) Change in no. of buyers : Lower the price, will bringing new buyers and raising of price reduces the buyers. These buyers are known as marginal buyers. Owing to such reason the demand falls when price rises and so the demand curve is downward sloping. Price Elasticity of Demand It is defined as the degree of responsiveness of quantity demanded of a commodity due to change in its price other factor remaining constant. Price elasticity of Demand is usually measured by the following formula : Price elasticity of demand = % Change in Quantity Demand / (divided by ) % Change in Price If elasticity of demand greater then 1, we call it relatively elastic demand. If elasticity of demand is equal 1, we call it unitary elastic demand.

If elasticity of demand lesser then 1, we call it relatively inelastic demand. If elasticity of demand is equal to 8, we call it perfectly elastic demand. If elasticity of demand is equal to 0, we call it perfectly inelastic demand. Types of Price Elasticity a) Perfectly Elastic Demand : That is (elasticity of demand = ] When the quantity demanded of a commodity changes infinitely due to a slight or no decrease in price, such goods are said to have perfectly elastic demand. A perfectly Elastic Demand Curve is a straight line parallel to X axis. b) Relatively Elastic Demand : In such type of goods the percentage change in quantity demanded of a commodity is more than proportionate to the percentage change in price, eg. luxury like car. In the diagram we see that change in qty. demanded qq1 is more than proportionate to the change in price P, P1. (c) Unit Elastic Demand (ed = 1) Here the rate of change in demand is exactly equal to the rate of change in price. Therefore the products or service with unit elasticity are neither elastic nor inelastic A Unit elastic Demand curve is a rectangular - hyperbola as soon above (d) Relatively Inelastic Demand (ed < 1) In this type of goods and services the proportionate change in quantity demand is less than the change in price. These are mostly essential goods of daily use like rice wheat etc. In the diagram change in qty qq1 is less than proportionate to the change in price PP1. (e) Perfectly Inelastic Demand : These are certain goods like salt, match box etc. whose demand neither increase nor decrease with a change in price. Fig.1.7 A perfectly inelastic Demand curve is a vertical straight line parallel to Y axis which shows that whatever may be the change in price the demand will remain constant at OQ. Importance of Price Elasticity of Demand (1) Business Decisions : The concept of price elasticity of demand helps the firm to decided whether or not to increase the price of their product. Only if the product is inelastic in nature, then raising of price will be beneficial. On other hand, if the product is elastic in nature, then a rise in price might lead to considerable fall in demand. Therefore the price of different commodities are determined on the basis of relative elasticity. (2) Importance to monopolist : A monopolist often practices price discrimination. Price discrimination is a process in which a single seller sells the same commodity in two different markets at 2 different prices at the same time. The knowledge of price elasticity of the product to the monopolist is limp because he would charge higher price from those consumers who have inelastic demand and lower price from those consumers who have elastic demand. (3) Determination of Factor Price : The concept of elasticity of demand also helps in determining the price of various factors of production. Factor having inelastic demand gets higher price factors having elastic demand gets lower price. (4) Guidance for International Trade : If demand for exports of a country is inelastic, that country will enjoy a favorable terms of trade while if the exports are more elastic then inputs, then the country will lose in the terms of trade. 5) Importance to the Govt : Elasticity of demand is useful in formulation Govt. Policy particularly taxation policy and the policy of subsides if the Govt. wants to impose excise duty, or sales tax, the Govt. should have an idea about the elasticity of the product. If the product is elastic in nature, then the burden of the tax is shifted to the consumer and the demand might fall remarkably: on the other hand, if the demand is inelastic in nature, then any extra burden of indirect tax will not affect the demand to that extent. Income and Cross Elasticity

(a) Income Elasticity : It expresses the responsiverses of consumer demand of any commodity due to a change in the income of the consumer. It is also defined as a percentage change in quantity demand due to percentage change in money income of the consumers. The income elasticity of demand is positive for all normal goods because the consumer demand for a good changes in the same direction as change in his income. In case of inferior goods, the income elasticity is negative example. as the income rises the demand for inferior goods will fall. The different types of the income elasticity are shown in the following diagram. In case of substitute goods, the cross elasticity of demand is positive example. if the price of one changes the demand for the other changes in the same direction. For eg. if the price of tea reses, the demand for coffee will also rise, since coffee has now become relatively cheaper. The cross elasticity of demand is negative in case of complementary goods. Movement and Shift of Demand (a) Movement of Demand curve or Extension and Constriction of Demand or change in qty. demanded. In the qty. demanded of a commodity increases or decreases due to a fall or rise in the price of a commodity alone, ceteris Paribus. It is called movement along the demand curve which occurs only due to change in price of that commodity, ceterius Paribus, Extension of Demand or movement along the demand curve to the right. When the qty. demanded rises due to fall in price of that commodity, and other parameters remaining constant it is called extension of demand which is shown in the following diagram. (b) Change in Demand or shift of demand or Increase and Decrease in demand : When the qty. dd of a commodity rises or falls due to change in factors like income of the consumer, price of related goods, etc. and keeping the price of the commodity to be constant, it is called shift in Demand. (i) Increase in Demand or Shift of Demand Curve towards the Right : When the qty. dd. of a commodity rises due to change in factors like income of the consumable etc. price of the commodity remaining unchanged it is called increase in demand. (ii) Decrease in Demand or shift of Demand Curve towards the left : When the demand for a commodity falls due to other factors, the price remaining constant, it is termed as decrease in demand or shift of demand curve towards the left.

1.4 SUPPLY
Definition of Supply : Supply is defined as a qty of a commodity offered by the produces to be supplied at a particular price and at a certain time. Individual Supply and Market Supply Individual supply refers to the quantity of a commodity which a firm is willing to produce and offer for sale. On the other hand, the qty. which all produces are willing to produce and sell is known as market supply. An individual supply schedule shows the different qualities of a commodity that a producer of a firm would offer for sale at different prices. A market supply schedule shows the various quantities of a commodity that all the firms are willing to supply at each market price during a specified time period. Factor Determining supply : (1) Price of the commodity: when the price of a commodity in the market and when its price rises, seller increases the price. The cost of production remaining constant the higher will be the profit margin. This will encourage the producers to supply more at higher prices. The reverse will happen when the price fall. (2) Goals of the firm : Firms may try to work on various goals for eg. Profit maximization, sales maximization, employment maximization. If the objective is to maximize profit, then higher the profit from the sale of a commodity, the higher

will be the qty. supplied by the firm and vice-versa. Thus, the supply of goods will also depend upon the priority of the firm regarding these goals and the extent to which it is prepared to sacrifice one goal to the other. (3) Input Prices : The supply of a commodity influence by the raw materials, labour and other inputs. If the price of such inputs rise leading to a lower profit margin. This will ultimately lead to a lower supply. On the other hand, if there is a falls in inputs increases. So in this situation the firm will be ready to supply more than before at a given price level. (4) State of Technology : If improve and advanced technology is used for the production of a commodity, it reduces its cost of production and increases the supply. On the other hand, the supply of those goods will be less whose production depend on unfair and old technology. (5) Government policies : The Govt. policy with reference to production of survey commodities imposition of taxes such as excise duty, sales tax, etc. subsidy policy on influence the supply of a commodity for eg. when the Govt. imposes an excise duty on Goods, the cost rises and therefore decreases the supply. A subsidy on the other hand increases the supply. (6) Expectation about future prices : If the produces expect an increase in the price of a commodity, then they will supply less at the present price and hard the stock in order to sell it at a higher price in the near future. This will be opposite in case they anti capacity fall in future price (eg. fruit seller) (7) Prices of the other commodities : Usually an increase in the prices of other commodities makes the production of that commodity whose price has not risen relatively less attractive we thus, expect that other things remaining the same, the supply of one commodities falls as the price of other goods rises. For eg. Suppose a former produces wheat and pubes in his firm. If the price of pubes increases he grows less wheat. Hence the supply of wheat decrease. (8) No of firms in the market : Since the market supply is the sum of the suppliers made by individual firms, hence the supply various with changes in the no. of firm in the market the supply. An decreases in the no. of firm reduces the supply. (9) Natural factor : In case of natural disorders flood, drought, etc. the supply of a commodity specially agricultural products is adversely affected.

Exceptions to the Law of Supply (1) Agricultural Goods : In case of such goods the supply cannot be adjusted to market conditions. The production of agriculture goods is largely dependent on natural phenomenon and therefore its supply depends upon natural factors like rainfall, etc. Moreover the supply of such goods is mostly seasonal and therefore it cannot be increased with a rise in price. (2) Rare Objects : These are certain commodities like rare coins, classical paintings old manuscripts, etc. whose supply cannot be increased or decreased with the change in price. Therefore, such goods are said to have inelastic supply and the supply curve is a vertical straight line parallel to Y axis. 3) Labour Market : In the labour market, the behavior of the supply of labour goes against the law of supply. In case of such labourers, if the wages rise the workers will work for less hour, so as to enjoy more leisure. This is explain with the following diagram.

In the diagram we measure labour supply along the x-axis and wages along the y axis. When wages was OW the labour supply was OL. Now, when the wages rise to OW1, the labour supply instead of rising falls to OL1. As a result, the supply curve S moves to the left instead of rising any further. Hence the labour market remains an exception to the law of supply. Elasticity of Supply Elasticity of supply is defined as the degree of responsiveness of qty. supplied of a commodity due to change in its price. Elasticity of supply is expressed as : = % changes in qty. supplied / dived by % changes in price Determinants of Elasticity of Supply (1) Nature of the commodity : The supply of durable goods can be increased or decreased effectively in response to change in price and hence durable goods are relatively elastic. On the other hand the perishable goods cannot be stored and thus supply cannot be altered significantly in response to change in their price. Hence the price of the perishable goods are relatively less elastic. (2) Time Factor : A price change may have a small response on the qty supplied because output may change by small quantity in the short period since the production capacity may have been limited. Therefore, in the short run supply tends to be relatively inelastic. On the other hand in the long run production capacity may be increased or supply may also be raised therefore in the long run supply is elastic. (3) Availability of facility for expanding output : If producers have sufficient production facilities such as availability of power, raw materials, etc. They would be able to increase their supply in response to rise in price. On the other hand if there is a shortage of such facilities then expansion of supply will not be possible due to rise in price. (4) Change in cost of production : Elasticity of supply depends upon the change in cost. If an increase of output by a firm in an industry causes only a slight increase in the cost then supply will remain fairly elastic. On the other hand if an increase in output bring about a large increase in cost due to rise in price of inputs etc, then supply will be relatively inelastic. 5) Nature of inputs : Elasticity of supply depend upon the nature of inputs for the production of a commodity. If the production requires inputs that are easily available, then its supply will be relatively elastic. On the other hand, if it uses specialized inputs then its supply will be relatively inelastic. 6) Risk Taking : If entrepreneurs are willing to take risk, then supply will be more elastic and if they are reluctant to take risk than supply would be inelastic. Movment and Shift of Supply Curve The qty. supplied of a commodity may change broadly due to two reasons : When the qty supplied changes due to change in the price of that commodity it is called change in quantity supplied or movement along the supply curve or extension and contraction of supply. On the other hand when the supply changes due to change in other factors, price of the commodity remaining unchanged, such a change in supply curve, increase and decrease of supply or change in supply. (a) Movement along the supply curve or extension or contraction of supply or change in quantity supplied. (i) Extension of Supply : When the quantity supplied of a commodity rises with a rise in price of that commodity other determinants of supply remaining unchanged. It is known as extension of supply or movement along the same supply curve towards

the right. It is called extension of supply. (ii) Contraction of supply : When the quantity supply of a commodity falls with a fall in its price, peribus, it is known as contraction of supply. In here, the qty. supplied as fallen from q1 to q due to a fall in price of the commodity from P1 toP. This is shown by a movement along the supply curve S from pt. a to pt. b (towards the left). (b) Shift of Supply Curve or Increase & Decrease of supply curve or change in supply (i) Increase in Supply : When the qty supplied increase due to other determinants of supply price remaining constant it is called increase in supply In the diagram we see that qty supplied has increased from q to q 1, the price of the commodity remaining constant at OP. This is shown by the shift of the original supply curve S to the right to from a new supply curve S1. (iii) Decrease in Supply : When qty supplied of the commodity decrease due to change in factors determining supply but for price. It is termed as decrease in supply or shift of supply curve towards the left.

1.5 EQUILIBRIUM
The price at which the qty. demanded of a commodity equals the quantity supply is known as equilibrium price. Change in Equilibrium Price due to shift in demand, the supply remaining constant. In crease in Demand rises the price and decrease in demand lowers the price of a commodity, if supply remains unchanged. Change in equilibrium price due to shift in supply where the demand remains constant. (i) Increase in supply lower the price and Decrease in supply raises the supply if demand remains constant. Change in equilibrium priced due to shift in both demand and supply. Situation 1 : If demand and supply change by equal proportion, equilibrium price will remain unchanged.

1.6 THEORY OF PRODUCTION


Production-Function The technical law, relating inputs to outputs, has been given the name of productionfunction, in economics. According to Prof. Lipsey, This (Production-function) is a technological relation showing for a given state of technological knowledge how much can be produced with given amount of input. In simple words, production function expresses the relationship between the physical inputs and physical output of a firm for a given state of technology. Thus, the production-function is a purely technical relation that connects factor-inputs and outputs. Types of Production-Function Before analyzing the types of production-function it will be useful to understand the meaning of following important terms : A. Fixed Factors and Variable Factors Factors of production are broadly classified into two categories example. fixed and variable factors: (1) Fixed Factors The factor inputs which cannot be varied in the short-period, as and when required are called fixed factors.

Examples of Fixed Factors are : Plant, machinery, heavy equipments, factory building, land etc. (2) Variable Factors - The factor inputs which can easily be varied, in the short-period as and when required, are called variable factors. Examples of variable factors are : labour, raw material, power, fuel etc. The distinction between fixed factors and variable factors appears only in the short-period. In the long-run, all the factors of production become variable factors. B. Short period and Long period The time-period during which a firm in order to make changes in its production can change only in its variable factors but not in its fixed factors, is termed as short-period. In the shortperiod, a firm cannot change its scale of plant. The time period in which a firm can change all the factors of production and its scale of plant, is termed as long-period. In economics, we study two types of production-functions. In other words, there are two kinds of input-output relations in production-functions. These are: (a) Short-run Production-functions or the Law of Variable Proportions - In the short period, some factors are fixed and some of them are variable. What happens when additional units of one variable factor of production are combined with a fixed stock of some factors of production, is discussed under short-run production-functions. The law which tells about this relation is called the law of variable proportions or returns to a factor. Since it is related to a short-period, it is called short-run production-function. (b) Long-run Production-function or Returns to Scale In the long run, all factorinputs can be varied. It means, that in the long-run, we can expand or reduce the scale of production as well. The way in which the output varies with the changes in the scale of production is discussed in the long-run productionfunctions. The law which states this relationship is also called returns to scale. Since it is related to the long-period, it is called long-run production-function. In this context we have to define three key terms :(1) Total Product - It refers to the total output of the firm per period of time (2) Avrage Product - Average Product is total output per unit of the variable input. Thus Average Product is total product divided by the number of units of the variable factor. AP =Q/ divided by L where Q is Total Product, L is the quantity of labour. (3) Marginal Product - Marginal Product is the change in total product resulting from using an additional unit of the variable factor. MP = dQ/ divided by dL, where d is the rate of change Now we shall study the laws of production relating to both types of production-functions. 1. The Law of Variable Proportions or Returns to a Factor Meaning and Definition The law of variable proportions has an important place in economic theory. This law exhibits the short-run production-functions in which one factor is variable and others are fixed. The extra output obtained by applying extra unit of a variable factor can be greater than, equal to or less than the output obtained by its previous unit. It is this phenomenon which is expressed in the form of law of variable proportions. If the number of units of a variable factor is increased, the way wherein the output changes is the concern of this law. Thus the law of variable proportions refers to the effect of changing factor-ratio on the output. In short, the law which exhibits the relationship between the units of a variable factor (keeping all other factors as constant) and the amount of output in the shortrun is known as returns to a variable factor.

Thus the law of variable proportions is also named as (or returns to a factor) returns to a variable factor. The law of variable proportions (or returns to a variable factor) states that with the increase in a variable factor, keeping other factors constant, total product increases at an increasing rate, then increases at diminishing rate and finally starts declining. Why is it called the Law of Variable Proportions? The factor- proportion (or factor-ratio) varies as one input varies and all others are constant. This can be understood with the help of an example. Suppose in the beginning 10 acres of land and 1 unit of labour are taken for production, hence land-labour are taken for production, hence land-labour ratio was 10 : 1. Now if the land remains the same but the units of labour increases to 2, now the land-labour ratio would become 5: 1. Thus, this law analyses the effects of change in factor-proportions on the amount of output and is, therefore, called the law of variable proportions. In this example, we assume that land is the fixed factor and labour is a variable factor. The table shows the different amounts of output obtained by applying different units of labour to one acre of land which continues to be fixed. Three Stages of the Law The relation between variable factor and physical output has three stages which are shown in the example and the diagram. We take a very simple explanation of these three stages in terms of TPP and MPP only. These three stages of the law are as under : State 1 In this stage total physical product (TPP) increases at an increasing rate and marginal physical product (MPP) also increases. Since in this stage MPP increases with the increase in the units of a variable factor, it is called the stage of increasing returns. In the example, the stage I of the law runs upto 3 units of labour and in the diagram it is between 0 to L. Stage 2 In this stage total physical product (TPP) continues to increase but at a diminishing rate and marginal physical product (MPP) diminishes but remains positive. In this stage MPP decreases with the increase in the units of a variable factor, it is termed as the stage of diminishing returns. In the example, stage II runs between 4 to 6 units of labour and in the diagram it is between L to M. This stage goes to the point when TPP reaches the maximum (18 in the example and point R in the diagram) and MPP becomes zero. State 3 In this stage total physical product (TPP) starts declining and marginal physical product (MPP) decreases and becomes negative. Since in this stage MPP becomes negative, it is called the stage of negative returns. In the example, stage III runs between 7 to 8 units of labour and in the diagram it starts from the point M onwards. Two ways to explain the Law of Variable Proportions The law of variable proportions can be explained in two separate ways : (1) in terms of total physical product and (ii) in terms of marginal physical product. It is explained as under: (1) Law of Variable Proportions in terms in TPP The law of variable proportions shows the relationship between units of a variable factor and total physical product. According to this law, keeping other factors constant, when we increase the units of a variable factor, the TPP first increases at an increasing rate, then at a diminishing rate, and in the last, it declines. Thus the law has following three stages : Stage I : TPP increases at an increasing rate Stage II : TPP increases at a diminishing rate Stage III : TPP declines. (2) Law of Variable Proportions in terms of MPP The law of variable proportions states that with the increase in the units of a variable factor, keeping all other factors constant, the marginal physical product increases, then decreases and finally becomes negative. Thus this law has three following stages : Stage I : MPP increases

Stage II : MPP decreases but remains positive Stage III : MPP continues to decrease and becomes negative. The law is shown with the help of following example and diagram below : Significance of the Three Stages of the Law What should be the stage of operation for a rational producer? With the knowledge of the three stages of the law, a producer can choose the appropriate stage of its operation. A rational producer would not like to operate in Stage III. It is because in this stage total product declines and marginal product becomes negative. Hence a producer can always increase his output by reducing the amount of variable factor. If he operates in stage III, he incurs higher costs on the one hand, and gets less revenues on the other. Thus, it reduces his profits. Similarly a producer does not operate in stage I. In this stage marginal product increase with the increase in a variable factor. It indicates that there is a scope for more efficient utilization of fixed factors by employing more units of a variable factor. A rational producer would not therefore, like to stop in stage I but will expand further. It is by now very clear that a rational producer never chooses first and third stages for production. He, therefore, likes to operate in the stage II, example, the stage of operate in the stage II, example. the stage of diminishing returns. In this way stage II of the law of variable proportions is the most relevant stage of operation for a producer. Reason for operation of the Law Why does the law of variable proportions (or the law of diminishing marginal returns) operate? We know that in the short-period all factors of production cannot be varied. Here one is variable factor and others are fixed factors. By now it is clear that there is an optimum combination of different factors that gives the maximum output. When there is increase in the units of a variable factor before the point of optimum combination, the factor proportion becomes more suitable and fixed factors are more efficiently utilized, hence it increases the marginal physical product. Thus, in the initial stages the total product may rise at an increasing rate when we employ more units of a variable factor to the fixed factors. But later, when we employ more units of a variable factor beyond this optimum combination, the factor proportion becomes unsuitable and inefficient, hence the marginal product of that variable factor declines. The quantity of the fixed factor-input per unit of the variable input falls as more and more of the latter is put to use. Successive units of the variable input, therefore, must add decreasing amounts to the total output as they have less of the fixed input to work with. Thus, eventually the law of diminishing marginal returns (or the stage of diminishing returns of the law of variable proportions) operates. Return to Scale Meaning In the long run, all factors are variable, hence the expansion of output may be achieved by varying all factor-inputs. When there are changes in all factor-inputs in the same proportion, the scale of production (or the scale of operation) also get changed. Thus, the change in scale means that all factor inputs are changed in the same proportion. Thus, the term returns to scale refers to the changes in output as all factor-inputs change in the same proportion in the long run. Or, in other words, the law expressing the relationship between varying scales of production (example. change of all factor-inputs in the same proportion) and quantities of output is called returns to scale refer to the effects of scale relationships. Now, the question is at what rate the output increases when all factor-inputs are varied in the same proportion. There can be three possibilities in this regard. The increase in output may be more than, equal to, or less than proportional to the increase in factor-inputs. Accordingly, returns to scale are also of three types increasing returns to scale, constant returns to scale and diminishing returns to scale.

Cause for the operation of returns to scale

Returns to scale occur mainly because of two reasons : (1) Division of Labour When tasks are allocated according to the specialization of workers, it is termed division of labour. Thus division of labour and specialization is one and the same thing. Division of labour and specialization are possible more in large-scale operations. Different types of workers can specialize and do the job for which they are more suited. This results in a sharp increase in output per man with the increase in scale in the initial stages. This brings increasing returns to scale. But after a certain level of output, top management becomes eventually overburdened and, hence, less efficient. It brings diminishing returns to scale. In short, with the increase in scale economies of specialization and division of labour brings increasing returns to scale and diseconomies of specialization bring ultimately diminishing returns to scale. (2) Volume Discounts With the increase in the scale of operation certain advantages or economies of large volume or large size may occur. This results in increasing returns to scale. For instance when the scale of operation is increased a firm has to procure raw materials in a larger quantity. In this situation the firm may bargain for more discount on purchase of the large volume of raw materials. Similarly the per unit selling cost may also fall with the increase in output. In short, in the initial stages a firm may receive technical economies, marketing economies and economies related to transport and storage costs etc. All these result into increasing returns to scale. But after a certain limit, diseconomies of volume crop up with the increase in output. This brings diminishing returns to scale. Thus, the main reason for the operation of the different forms of returns to scale is found in economies and diseconomies. When economies exceed the diseconomies, the stage of increasing returns operates; when economies and diseconomies equal each other, it becomes the stage of constant returns to scale; and when diseconomies exceed the economies, then comes the stage of diminishing returns to scale. Distinction between Return to a Variable Factor ( or Law of Variable Proportions ) and Return to Scale The main differences between returns to a variable factor and returns to scale are as indicated below: Returns to a Variable Factor Returns to Scale 1. Operates in the short run or it is 1.Operated in the long-run or it is related related to short-run production-function. to long-run production-function. 2.Only the quantities of a variable 2. All factor-inputs are varied in the same factor are varied. proportion. 3.There is change in the factor-proportion. 3. There is no change in factor-ratio. For Suppose on 1 acre land 1 labour is instance, if a firm is employing 1 unit oflabour employed, then the land labour ratio is 1 : 1. and 2 units of capital, then the labour-capital Now if we add one more unit of labour on ratio is 1 : 2. Now if the firm increases its scale the 1 acre land, then land-labour ratio would of operation and employed 2 units of labour become 1 : 2. and 4 units of capital, the labour-capital ratio still remains the same as 1 : 2. 4.No change in the scale of production. 4.There is change in the scale of production Because here all the factor-inputs are not because here all the factor-inputs are varied in changed. the same proportion. Various Concepts of Cost The term Cost is used in many a sense and hence has many concepts. All these need to be properly and clearly understood. 1. Real Costs The term real cost of production was defined by Prof. Marshall and other neo-classical

economists. In the words of Prof. Marshall, The exertion of all the different kinds of labour that are directly or indirectly involved in making it together with the abstinences or rather the waitings required for saving the capital is used in making it; All these efforts and sacrifices together will be called the real cost of production of the commodity. Thus, real cost included the following two basic elements: (a) exertions of all kinds of labour; (b) waitings and sacrifices required for saving the capital. It is more a psychological concept and cannot be measured. Therefore, it is not applied in actual practice. 2. Economic Costs The total expenses incurred by affirm in producing a commodity are generally termed as its economic costs. Economic costs are generally referred to as production costs as well. The total economic costs include: (1) Explicit Costs Actual payments made by a firm for purchasing or hiring resources (or factorservices) from the factor-owners or other firms are called explicit costs. In other words, explicit costs are actual money expenses directly incurred for purchasing the resources. These are the costs which a cost accountant includes under the head expenses of the firm. Hence explicit costs also. Accounting costs include all costs incurred by the firm in acquiring various inputs from outside suppliers. Thus the examples of explicit costs are: payments for raw materials and power; wages to the hired workers; rent for the factory-building; interest on borrowed money; expenses on transport and publicity, etc. (2) Implicit Costs Implicit costs refer to the imputed costs of the factors of production owned by the producer himself which are generally left out in the calculation of the expenses of the firm. Besides purchasing resources from other firms, a producer uses his own factor-services also in the process of production. He generally does not take into account the costs of his own factors while calculating the expenses of the firm. But these costs should also be taken into account. The cost of using such factors is called implicit costs or imputed costs. They are called implicit costs because producers do not make payment to others for them. For instance, rent of his own land, interest on his own capital, and salary for his own services as manager, etc. are implicit costs. (3) Normal Profit Economists consider an entrepreneur as a separate and independent factor of production. An entrepreneur factor of production. An entrepreneur can engage himself in the work of production of a commodity only when he hopes to get a minimum amount of remuneration as profit. Hence, the minimum amount which is required to keep an entrepreneur in the production is known as normal profit. This normal profit is in a way reward or remuneration for an entrepreneur and, therefore, should be treated as costs. Thus, Total economic costs = Explicit costs + Implicit costs + Normal profit. Generally economic costs include the following : (a) Cost of the raw materials, (b) wages, (c) interest, (d) rent, (e) management costs, (f) depreciation of capital equipment, (g) expenditure on publicity and advertisements, (h) transport costs,

(i) costs of the producers own resources, (j) normal profit, (k) other expenses. 3. The Concept of Opportunity Cost The concept of opportunity cost occupies a very important place in modern economic analysis. It is a well known fact that factors of production are scarce in relation to wants. Hence, when a factor is used in the production of a particular commodity, the society has to forego other goods which this factor could have produced. This gave birth to the notion of opportunity cost in economics. Suppose a particular kind of steel in manufacturing war-goods, it clearly implies that the society has to give up the amount of utensils that could have been produced with the help of this settle. Hence we can say that the opportunity cost of producing war-goods is the amount of utensils forgone. In short, opportunity cost is the cost of the next-best alternative that has been forgone. Form the meaning of opportunity cost two important points emerge: (1) The opportunity cost of anything is only the next-best alternative foregone and not any other alternative. (2) The opportunity cost of a good should be viewed as the next-best alternative good that could be produced with the same value of the factors which are more or less the same. The concept of opportunity cost can better be explained with the help of an illustration. Suppose a price of land can be used for growing wheat or rice. If the land is used for growing rice, it is not available for growing wheat. Therefore the opportunity cost for rice is the wheat crop foregone. This is illustrated with the help of the following diagram. Fig.1.33 Suppose the farmer, using a piece of land can produce either 50 quintals (ON) of rice or 40 quintals (OM) of wheat. If the farmer produces 50 quintals of rice (= ON), he cannot produce wheat. Therefore the opportunity cost of 50 quintals (ON) of rice is 40 quintals (OM) of wheat. The farmer can also produce any combination of the two crops on the production possibility curve MN. Let us assume that the farmer is operating at point A on the production possibility where he produces OD amount of rice and OC amount of wheat. Now he decides to operate at point B on the production possibility curve. In this situation he has to reduce the production of wheat from OC to OE in order to increase the production of rice from OD to OF. It means the opportunity cost of DF amount of rice is the CE amount of wheat. Thus, opportunity cost for a commodity is the amount of other next-best goods which have to be given up in order to produce additional amount of that commodity. Applications of the Concept of Opportunity Cost The concept of opportunity cost has been widely used by modern economists in various fields. The main applications of the concept of opportunity cost are as follows (1) Determination of factor prices - The factors of production need to be paid a price that is at least equal to what they command for alternative uses. If the factor price is less than factors opportunity cost, the factor will quit and get employed in the better-paying alternative. (2) Determination of economic rent The concept of opportunity is widely used by modern economists in the determination of economic rent. According to them economic rent is equal to the factors actual earning minus its opportunity cost (or transfer earnings). (3) Decisions regarding consumption pattern The concept of opportunity cost suggests that with given money income, if a consumer chooses to have more of one thing, he has to have more of one thing, he has to have less of the other. He cannot increase the consumption of all the goods simultaneously. Hence with the help of opportunity cost he decides the consumption pattern, that is, which goods should

be consumed and in what quantities. (4) Decisions regarding production plan With given resources and given technology if a producer decides to produce greater amount of one commodity, he has to sacrifice some amount of another commodity. Thus on the basis of opportunity costs a firm makes decisions regarding its production plan. (5) Decisions regarding national priorities With given resources at its command a country has to plan the production of various commodities. The decision will depend on national priorities based on opportunity costs. If a country decides that more resources must be devoted to arms production then less will be available to produce civilian goods. In this situation a choice will have to be made between arms production and civilian goods. The concept of opportunity cost helps in making such choices. Cost-Function The functional relationship between cost and quantity produced is termed as cost function. C = f(Qx) Here, C = Production-cost Qx = Quantity produced of x goods Cost-function of a firm depends on two things: (i) production-function, and (ii) the prices of the factors of production. Higher the output of a firm, higher would be the production-cost. That is why it is said that the cost of production depends on the quantum of output. Time Element and Cost - Time element has an important place in the analysis of cost of production. In the theory of supply we usually take three kinds of time-period. They are: (1) Very Short-period - Very short-period is defined as the period of time which is so short that the output cannot be adjusted with the change in demand. In this period, the supply of a commodity is limited to its stock, hence during this period supply remains fixed. That is why during very short period output of the commodity does nto respond to the changes in its price. (2) Short Period Short period is defined as the period of time during which production can be varied only by changing the quantities of variable factors and not of fixed factors; in other words, the scale of plant is given and constant. Land, factory building, heavy capital equipment, services of management of high category are some of the factors that cannot be varied in a short period. That is why they are called fixed factors. On the other hand, there are some factor-inputs that can be varied as and when required. They are called variable factors. For instance, power, fuel, labour, raw materials, etc. are the examples of variable factor-inputs. (3) Long Period - Long period is defined as the period which is long enough for the inputs of all factors of production to be varied. In this period not factor is fixed, all are variable factors. Firm has enough time to change its scale of production. It can purchase and install new machinery or it can sell the old one; it can vary the size of factory; it can increase or decrease the number of permanent employees of the firm. Thus in long period, all sorts of changes in the factors of production are possible. SHORT-RUN COSTS In the short-run, a firm employs two types of factors : fixed factors and variable factors. Costs are also of two types : fixed costs and variable costs. (1) Fixed Costs Fixed costs (also known as supplementary costs or overhead costs) are the costs that do not vary with the output. These are the expenses incurred on the fixed factors of production. Examples Rent; interest; insurance premium; salaries of permanent employees, etc. (2) Variable Costs- Variable costs (or prime costs) are the costs that vary directly

with the output. These are the expenses incurred on the variable factors of production. Examples- Expenses on raw materials, power and fuel; wages of daily labourers, etc. Distinctions between Fixed Costs and Variable Costs Fixed Costs Variable Costs 1. Fixed costs do not vary with 1. Variable costs vary with the quantity of output. quantity of output. 2. They are related with the fixed factors. 2. Variable costs They are related with the variable factors. 3. They do not become zero. 3. Variable costs They can become zero when production is remain same even when production is stopped. stopped. 4. A firm can continue production 4. Variable costs Production is carried on when the variable costs are even at the loss of fixed costs. met. Total Cost Curves in the Short Run There are three concepts concerning total cost in the short period : Total fixed cost; total variable cost and total cost. (1) Total fixed Cost (TFC) Total fixed Costs are those costs that do not vary with the output. They continue to be the same even if output is zero or 1 unit or 1 million units. Thus, they are totally unaffected by the changes in the rate of outputs. These costs are also often referred to as supplementary costs or overhead costs or unavoidable costs. Examples of fixed costs are : (1) Initial establishment expenses, (2) Rent of the factory, (3) Expenses on maintenance of Machinery; (4) Wages and salaries of the permanent staff, (5) Interests on bonds, (6) Insurance premium. Total fixed Cost TFC = quantities of the fixed productive service x factor price. (2) Total Variable Cost (TVC) The costs that vary directly with the output, rising as more is produced and falling as less is produced, are called total variable costs. They are also referred to as prime costs or special costs or direct costs or avoidable costs. Examples of variable costs are : (1) wages of temporary labourers; (2) raw materials; (3) fuel; (4) electric power, etc. Total Variable Cost TVC = quantities of the variable factor service x factor price. Our above table and diagram indicate that total variable cost varies directly with the volume of output. TVC curve starts from the origin, up to a certain range remains concave from below and then becomes convex. It shows that in the beginning, total variable cost rises at a diminishing rate and thereafter, it rises at increasing rates. (iii) Total Cost Total Cost means the total cost of producing any given amount of output. When we add total fixed and total variable costs at different levels of output, we get the corresponding total costs. Thus, TC = Total fixed cost tFC + Total Variable Cost TVC Since, fixed costs are constant and variable costs necessarily rise as output rises, total costs also rise with the output or, to put the point more technically, TC is a function of total product and varies directly with it : TC = f(q). TC (Total Cost) curve can be obtained by adding TFC and TVC curves vertically at each point. Again, since the total fixed cost, by definition remains constant, the changes the total costs are entirely due to the changes in total variable costs. In other words, the rate of increase of total cost is the same as of total variable cost, as one of the two components of total cost is the same as of total variable cost, as one of the two components of total cost remains constant. TC and TVC curves, therefore, have the similar shapes, the only difference is that TVC curve starts from origin (O) while TC curve starts above the origin. Unit Cost Curves in Short - Run The main short-run unit cost curves are :

1) Average Fixed Cost (AFC) Average fixed cost can be obtained by dividing total fixed cost (TFC) by the quantity of output (Q), Average Fixed Cost AFC = total fixed cost divided by / the quantity of output Q Since total fixed costs remain the same, as output rises, average fixed cost diminishes but never becomes zero. Features of Average Fixed Cost (a) As output rises, the average fixed cost (AFC) goes on declining. The Average Fixed Cost curve is, therefore, a downward sloping curve, (b) As output approaches zero, average fixed cost approaches infinity, but AFC curve never touches the y-axis. On the other hand, as output reaches very high levels, average fixed cost approaches zero, but it never becomes zero, it always remains positive. Hence the Average Fixed Cost curve never touches the x-axis. Thus it follows that Average Fixed Cost curve never touches either of the axis. Actually Average Fixed Cost curve takes the shape of rectangular hyperbola which shows that the area under the curve (example. total fixed cost) always remains the same. (2) Average Variable Cost (AVC) Average variable cost can be obtained by dividing the total variable cost (TVC) by the quantity of output (Q). AVC = total Variable TVC divid by / quantity of output Q As output rises, the Average variable cost curve first falls, reaches a minimum and then begins to rise. Thus, Average variable cost curve has a U-shape. In above example, AVC falls up to 4 units of output, thereafter, it starts to rise. (3) Average Total Cost (ATC) or Average Cost (AC) Average total cost (ATC) is obtained by dividing the total cost (TC) by the quantity of output (Q). Thus, average cost (AC) is the per unit cost of production of a commodity. Or, alternatively, it can also be obtained by adding average fixed cost (AFC) and average variable cost (AVC). ATC = TC/Q Or, ATC = AFC + AVC From the table and diagram we learn that as output rises, the MC curve first falls reaches a minimum and then begins to rise. Thus, MC curve has a U-shape. The reason behind the Ushape of the MC curve is the operation of the law of variable proportions. The law states that with the increase in a variable factor, keeping other factors constant, the marginal physical product first increases, and then after a certain level of production, it starts to decline. In other words, in the beginning the stage of increasing returns operates which increases the MPP, and after a certain point, the stage of diminishing returns starts to operate which reduces the MPP. On the basis of this in output, initially, the rate of increase in the requirement of variable factor is less and less, and, after a certain point, it is more and more. This implies that initially in the stage of increasing returns marginal cost (example., the rate of increase in the variable cost) diminishes with the increase in output, and then, after reaching a certain limit, in the stage of diminishing returns marginal cost rises with the further increase in output. Thus the marginal cost curve becomes U-shaped. Why are AVC and ATC curves U-shaped? The shapes of AVC and ATC curves are influenced by the shape of MC curve in the short-run. We are aware that the shape of MC curve is U-shaped because of the operation of the law of variable proportions. Consequently, AVC and ATC curves are also U-shaped. Initially, in the stage of increasing returns when marginal cost curve falls, the AVC and ATC curves also fall and after a certain level of output in the stage of diminishing returns when marginal cost curve rises, the AVC and ATC curves also rise. Thus, because of the operation of law of variable proportions as output rises, the AVC and ATC curves first fall, reach their minimum and the begin to rise. In this way we can state that in the short-run, MC curve, AVC curve and ATC

curve all are U-shaped ones. Relationship between AC and MC Recall the meaning of AC and MC which we have discussed earlier. Average Cost is simply the total cost (TC) divided by the number of units produced (Q) or it is the cost per unit. On the other hand, marginal cost is defined as the increment of total cost that comes from producing an increment of one unit of output. The table and diagram reveal the relationship between AC and MC as under : (1) When MC is less than AC (or MC curve remains below AC curve), the AC curve falls. For example units 1 to 5 and diagram up to point B (or OM1 output) show this situation. (2) When MC is equal to AC, AC becomes constant. This is the minimum point of AC, and it is at this minimum point, that MC curve cuts AC from below. In this regard 6th unit in the example and point B in the diagram may be seen. (3) When MC is higher than AC (or MC curve rises above the AC curve), AC starts rising. It is shown as 6th unit and thereafter in the example and point B onwards in the diagram Thus, AC-MC relationship can be summarized as follows: So long as MC is below AC, it keeps on pulling AC down; when MC gets to be just equal to AC, AC neither rises nor falls and is at its minimum; and when MC goes above AC, it keeps on pulling AC up. Long - Run Cost In the long-run, a firm can vary its scale of plant as and when it requires. All factor-inputs are thus variable in this period. Therefore, there are no fixed cost curves in the long-run. All cost curves in the long-run are basically variable cost curves. Here we find the following cost curves : Long-run Total Cost (LTC) curve; Long-run Average Cost (LAC) curve; and Long-run Marginal Cost (LMC) curve. Long-run Average Cost Curve A firm has a fixed scale of plant in the short-run. A short-run Average Cost (SAC) curve corresponds to a particular scale of plant. In the short-run, the firm can operate only on a particular scale of plant. But in the long-run a firm can choose among possible sizes of plant or it can move from one scale of plant to the other scale of plant. Now the question arises : Which scale of plant should be chosen by a firm in the long-run? The answer to this question depends on the quantity of output that a firm wants to produce. A firm would like to produce a given level of output at the minimum possible cost. Hence the firm would like to build its scale of plant in accordance with the quantity of output in such a way that it can minimise its average cost. Suppose a firm can have three possible scales of plant which are shown by SAC1, SAC2 and SAC3 curves in the diagram. In the long-run, a firm can choose any scale of plant out of these three plants. The choice of the scale of plant will depend on the quantity of output. The LAC curve is also called envelop curve since it envelopes a family of short-run average cost curves from the below. Similarly, the LAC curve is also termed as planning curve because a firm plans to choose that short-run plant which allows it to produce the expected output at the minimum cost in the long-run. Long-run Marginal Cost Curve Long-run marginal cost indicates the increase in long-run total cost resulting from one unit increase in output. Thus, Long-run marginal cost LMC = Long-run total cost of n units of output LTCn minus Long-run total cost of n-1 units of output. LTCn-1 Relationship between LAC and LMC Why is LAC curve U-shaped?

The U-shape of LAC curve is because of returns to scale. As we increase the scale of operation in the initial stages we get increasing returns to scale (IRS) as a result of economies of scale. Increasing returns to scale mean that the increase in output is more than proportionate to the increase in factor-inputs. It implies that for a given rate of increase in output (say 20%) the requirement of increase in factor-inputs is definitely less than proportionate (say 15%), Hence the LAC falls as output is increased. It happens in the output range O to M in the diagram. But then beyond a certain point we get decreasing returns to scale (DRS) as a result of diseconomies of scales, hence now LAC rises with the increase in output. It happens at output levels higher than M in the diagram. Thus, increasing returns to scale and economies cause the LAC to fall in the initial stage and after a certain point, decreasing returns to scale and diseconomies cause the LAC to rise. When economies and diseconomies of scale offset each other, it is the stage of constant returns to scale (CRS). In the stage of constant returns to scale, LAC also becomes constant and does not change with the change in output. It happens at M level of output. Economies and Diseeconomies of Scale We have already said that the U-shape of LAC curve is because of returns to scale. And returns to scale is the result of economies and diseconomies of scale. With the expansion of the scale of production firms get certain advantages, these are termed as economies of large scale production. But when the scale of production exceeds a certain limit, it leads to disadvantages or diseconomies of scale to the firms. Thus the firms get economies and diseconomies of scale with the expansion of output. These are termed as economies and diseconomies of large scale production. Economies refer to the saving in per unit cost as output increases. On the other hand, diseconomies refer to the disserving in the per unit cost as output increases. Economies and diseconomies of scale are broadly classified into two groups: (A) Internal economies and diseconomies (B) External economies and diseconomies. These are discussed below: Internal Economies and Diseeconomies Economies and diseconomies that accrue to a firm out of its internal situation when its scale increase are termed as internal economies and diseconomies. Now we shall discuss them in detail. Internal Economies Internal Economies that accrue to a particular firm with the expansion of its output and scale are termed internal economies. Internal economies of a firm are independent of the action of other firms. They are internal in the sense that they are limited to a firm when its output increase. They are not shared by other firms in the industry. Following are the main types of internal economies: (1) Labour Economies These are also known as the economies of specialization and division of labour. Division of labour and specialization are possible more in largescale operations. Different types of workers can specialize and do the job for which they are more suited. A worker acquires greater skill by devoting his attention to a particular job. As a result of this quality and speed of work both improve. This results in a sharp increase in output per man. Thus in short, with growing scale comes, increasing specialization and increasing returns to scale. (2) Technical Economies The main technical economies result from the indivisibilities. Several capital goods, because of the strength and weight required, will work only if they are of a certain minimum size. There is a general principle that as the size of a capital good is increased, its total output capacity increases far more rapidly than the cost of making it. To double the size and output capacity of a blast furnace, for instance, we do not have to double the materials required. Besides this a large scale firm can easily take advantages of the use of superior technique or specialized and

sophisticated machines. A large firm can also enjoy the benefits from linked processes and from the use of by-products. (3) Marketing Economies Marketing economies arise from the large scale purchase of raw materials and other inputs. A firm may receive large discounts on the purchase of bigger volume of raw materials and intermediate goods. For instance, a large clot mill may get more discounts on the purchase of yarn than the small mill. Marketing economies can also be reaped by the firm in its sales promotion activities. Advertising space (in newspapers and magazines) and time (on television and radio), and the number of salesmen do not have to rise proportionately with the sales. Thus per unit selling cost may also fall with the increase in output. (4) Managerial Economies Managerial economies arise from specialization of management and mechanisation of managerial functions. Large firms make possible the division of managerial tasks. This division of decisionmaking in large firms has been found very effective in the increase of the efficiency of management. Besides, large firms apply techniques of management involving a high degree of mechanization, such as telephones, telex machines, television screens and computers. These techniques save time and speed up the processing of information. (5) financial Economies Large firms can easily raise timely and cheap finance from banks and other financial institutions and also from the general public by issue of shares and debentures. (6) Risk-bearing Economies A large firm can more successfully withstand the risks of business. With the product diversification and by operating in several markets a large firm can withstand the risk of changing consumers tastes and preferences. (7) Economies Related to Transport and Storage Costs Large firms are able to enjoy freight concessions from railways and road transport. Because a large firm uses its own transport means and large vehicles, the per unit transport costs would fall. Similarly, a large firm can also have its own storge godowns and can save storage C8) Other Economies A large firm may also enjoy some other economies with the expansion of its output. Prominent among them are economies on conducting research and development activities and economies of employee welfare schemes. As a result of all these internal economies firms long-run average and marginal cost decline with the increase in output and scale of production. Internal Diseconomies Internal Diseconomies are those disadvantages which are internal to the firm and accure to the firm when it over expands its scale of production. The main internal diseconomies of scale are as follows : (1) Management Diseconomies and Diseconomies Related to Division of Labour These diseconomies occur primarily because of increasing managerial difficulties with too large a scale of operations. It becomes difficult for the top management to exercise control and to bring about proper coordination. Increase in the firms plant beyond a certain size involves more bureaucracy and more red tapism. Hence, top management becomes eventurally overburdened and less efficient in its role as coordinator and decision-maker. After a certain point, difficulties arise in the way of division of labour and specialisationalso. (2) Technical Diseconomies If a firm frequently changes in it technologies and uses new technologies and uses new machines, it may increase its costs. After a certain limit, the large size or volume of the plant and machinery may also prove disadvantageous. (3) Risk-taking Diseconomies The business cannot be expanded indefinitely because of the principle of increasing risk. The risk of the firm increases because of

reduction in demand, change in fashion and introduction of new substitutes in the market. (4) Marketing Diseconomies A large firm is forced to spend more on bringing and storing of raw materials and selling of finished goods in the distant markets. (5) Financial Diseconomies A large firm has to borrow a large amount of money even at higher rate of interest. It imposes a burden on the financial position of the firm. Impact of Internal Economies and Diseconomies on the LAC Curve When a firm accrues internal economies with the expansion of its scale of output, the LAC curve would fall : And when after a certain point, a firm receives internal diseconomies with the expansion of its scale of output, the LAC curve would rise. Thus, internal economies causes the LAC to fall and internal diseconomies cause the LAC to rise. Hence the internal economies and diseconomies are responsible for the U-shape of the LAC curve External Economies and Diseconomies Economies which accrue to the firms as a result of the expansion in the output of the whole industry are termed external economies. They are external in the sense that they accrue to the firms not out of its internal situation but from outside it example., from expansion of the industry. Jacob Vinor has defined external economies as those which accrue to particular concerns as the result of expansion of output by the industry as a whole and which are independent of their own individual output. Following are the main forms of external economies. (1) Economies of Localisation/Concentration - When an industry develops in a particular region, it brings with it all the advantages of localization. All the firms of this industry get the following main advantages: (a) Easy availability of skilled manpower; (b) Improvement in transportation and communication facilities; (c) Availability of banking, insurance and marketing services; (d) Better and adequate sources of energy-electricity and power; (e) Development of ancillary industries. (2) Economies of Disintegration/Specialisation The industry can have advantages from the economies of specialization when each firm specializes in different processes necessary for producing a product. For instance in a cloth industry some firms can specialise in spinning, others in spinning, others in printing etc. As a result of specialisation all the firms in the industry would be benefited. (3) Economies related to Information Services Firms in an industry can jointly setup facilities for conducting research, publication of trade journals and experimentation related to industry. Thus, besides providing market information, the growth of the industry may help in discovering and spreading improved technical knowledge. (4) Economies of Producers Organisation Firms of an industry may form an association. Such an association can have their own transport, own purchase and marketing departments, own research and training centres. This will help to reduce costs of production to a great extent and shall be mutually beneficial. External Diseconomies Diseconomies which accrue to the firms as a result of the expansion in the output of the whole industry are termed external diseconomies. The main external diseconomies are as follows: (1) Increase in input price When the industry expands, the demand for factor-inputs increases. As a result the input prices (such as wages, prices of raw materials and machinery equipments, interest rates, transport and communication rates etc.) shoot up. This causes the cost of production to rise. (2) Pressure on Infrastructure Facilities Concentration of firms in a particular region creates undue pressure on the infrastructure facilities transportation, water,

sanitation, power and electricity etc. As a result, bootlenecks and delays in production process become frequent which tend to raise per unit costs. (3) Diseconomies due to Exhaustible Natural Resources Diseconomies may also arise due to exhaustible natural resources. Doubling the fishing fleet may not lead to a doubling of the catch of fish; or doubling the plant in mining or on an oilextraction field may not lead to a doubling of output. (4) Diseconomies of disintegration When the production of a commodity is disintegrated among various processes and sub-process, it may prove disadvantageous after a certain limit. The problem and fault in any one unit may create limit. The problem and fault in any one unit may create problem for whole of the industry. Coordination among different concerns also poses a problem. As a result of external diseconomies, the LAC curve of the firms in an industry shifts upward. Impact of External Economies and Diseconomies on the LAC Curve (1) As a result of external economies, the LAC curve of the firms shifts downwards. It is shown in the diagram above that because of external economies, LAC curve shifts downward from LAC1 to LAC2. (2) As a result of external diseconomies, the LAC curve of the firms shifts upwards. It is shown in the diagram above that because of external diseconomies, LAC curve shifts upwards from LAC1 to LAC3. Thus in short, internal economies and diseconomies of scale affect the shape of the LAC curve and make it U-shaped. On the other hand, external economies and diseconomies cause the LAC curve shift downward or upward, as the case may be.

Study Note - 2
2.1 MEANING OF MARKET IN ECONOMICS
Market

In economics, the term market means a social system with the help of which the sellers and purchasers of a commodity or a service (or a group of commodities and services) can come into contact with each other and complete the act of sale and purchase. Thus market does not refer to a particular place or location. It refers to an institutional relationship between purchasers and sellers. That is market is an arrangement which links buyers and sellers. A market can be of different types. The distinction between different markets can also be made in different ways. The market differ from one another due to differences in the number of buyers, number of sellers, nature of the product, influence over price ,availability of information, conditions of supply etc. Economists discuss four broad categories of market structures 1. Perfect Competion 2. Monopoly 3. Monopolistic Competition 4. Oligopoly

2.2 FEATURES OF PREFECT COMPETITION AND IMPERFECT COMPETITON


Features of Prefect Competition
A market is said to be Perfectly Competitive if it fulfills some characteristics. (1) Large number of buyers and sellers :- Under perfect competition, there exists a large number of sellers and the share of an individual seller is too small in the total market output. As a result a single firm cannot influence the market price so a firm under perfect competition is a price taker and not a price maker. Similarly, there are a large number of buyers and an individual buyer buys only a small portion of the total output available. (2) Homogenous goods :- Under perfect competition all firms sell homogenous goods which are identical in quantity, shape, size, colour, packing etc. So the products are perfect substitutes of each other. (3) Free entry and free exit :- Any firm can enter or leave the industry whenever it wishes. The condition of free entry and free exit ensures that all the firms under perfect competition will earn normal profits in the long run. If the existing firms are earning supernormal profits, new firms would be attracted to enter the industry and increases the total supply. This will reduce the market price and the supernormal profit will not exist. On the other hand if the existing, firm incur supernormal loss then firms would leave the industry, thus reducing the supply. As a result, price will again rise and the loss will be wiped out. (4) Profit maximization :- The goal of all firms is profit maximization (5) No Government regulation :- There is no Government intervention in the maket. (6) Perfect mobility of factors :- Resources can move freely from one firm to another without any restriction. The labours are not unionized and they can move between jobs and skills can be learned. (7) Perfect knowledge :- Individual buyer and seller have perfect knowledge about market and information is given of free cost. Each firm knows the price prevailing in the market and would not sell the commodity which is higher or lower than the market price. Similarly, each buyer knows the prevailing market price and he is not allowed to pay a higher price than that. The firm also has a perfect knowledge about the techniques of productions. Each firm is able to make use of the best techniques of production.

Market
Features of Imprefect Competition
Features of Monopoly

Monopoly refers to the market situation where there is one seller and there is no close substitute to the commodities sold by the seller. The seller has full control over the supply of that commodity. Since there is only one seller, so a monopoly firm and an industry are the same. Feature :(1) Single seller and large number of buyers :- Under monopoly there is one seller and therefore a firm faces no competition from other firms. Though there are large numbers of buyers, no single buyer can influence the monopoly price by his action. (2) No close substitute :- Under monopoly there is no close substitute for the product sold by the monopolist. According to Prof. Boulding a pure monopolist is therefore a firm producing a product which has no substitute among the products of any other firms. (3) Restriction on the entry of new firms :- Under monopoly new firms cannot enter the industry. (4) Price maker :- A monopoly firm has full control over the supply of its products and hence it has full control over its price also. A monopoly firm can influence the market price by varying it supply, for eg., It can make the price of its product by supplying less of it. (5) Possibility of Price Discrimination :- Price discrimination is defined as that market situation where a single seller sell the same commodity at two different prices in two different markets at the same time, depending upon the elasticity of demand on the two goods in their respective market. Under such circumstances a monopolist can charge incur supernormal loss then firms would leave the industry, thus reducing the supply. As a result, price will again rise and the loss will wiped out. Features of Monopolistic Competition It is that form of market in which there are large numbers of sellers selling differentiated products which are similar in native but not homogenous, for eg., the different brands of soap. This are closely related goods with a little difference in odour, size and shape. We separate them from each other. The concept of monopolistic competition was developed by an American economist Chamberline. It is a combination of prefect competition and monopoly. Feature :(1) Large number of sellers and buyers :- In monopolistic competition the number of sellers is large and each other act independently without any mutual dependence. Here the action of an individual firm regarding change in price has no effect on the market price. The firms under monopolistic competition are not price takers. (2) Product Differentiation :- Most of the firms under monopolistic sale products which are not homogenous in nature but are close substitutes. Products are differentiated from each other in the following ways. a) Real Differentiation :- These types of product differentiation arises due to differences in the quality of inputs used in making these products, differences in location of firms and their sales service. b) Artificial Differentiation :- It is made by the sellers in the minds of the buyers of those products through advertisements, attractive packing, etc.. (3) Non-price competition :- Under such a market situation different firms may compete with each other by spending a huge sum of money on advertisements keeping the product prices unchanged (4) Selling Cost :- Expenditure incurred on advertisements and sales promotion by a firm to promote the sale of its product is called selling cost. They are made to persuade a particular product in preference to other products. Some advertisements have become so popular that people use a brand name to describe the product, for eg., brand name is used to describe all types of washing powder. (5) Free entry and free exit :- There are no restrictions on the entry of new firms and

neither do the firms deciding to leave the industry. Every firm under monopolistic competition earns only normal profits in the long run and there arises no supernormal profit nor loses. (6) Independent price policy :- A firm under monopolistic competition can influence the price of the commodity to some extent and hence they face an inverse relationship between price and quantity. In IWS case the price elasticity of demand would be relatively elastic because of the existence of many substitutes. Features of Oligopoly Oligopoly is a market situation in which there are few firms producing either differential goods or closely differential goods. The no. of firms is so small that every seller is affected by the activities of the others. (1) Few Sellers : There are few sellers in oligopoly market, no. of sellers is small that each and every seller is affected by the activities of the others. (2) Interdependence : Interdependence among firms is the most important characteristic under Oligopoly. The no. of sellers is so small in the market that each of these firms contribute a significant portion of the total output. As a result, when any one of them undertakes any measure to promote sales, it directly affect other firms and they also immediately react. Hence every firm decides its policy after taking into consideration the possible reaction of the rival firm. Thus every firm is affected by the activities of the other firms and this is called interdependence of firm. (3) Nature of Product : A firm under oligopoly may produce homogenous goods which is called oligopoly without product differentiation for eg. Cooking gas supplied by Indian & HP. Oligopoly may also produce differential products which is called oligopoly with product differentiation for eg. Automobile Industry. (4) Barrier to Entry : The existence of oligopoly in the long run requires the existence of barrier to the entry of the new firms. Several factors such as unlimited size of the market, requirement of huge initial investment etc. creates such barrier upon the entry of new firms.

2.3 CONCEPTS OF TOTAL REVENUE, AVERAGE REVENUE AND MARGINAL REVENUE


The term revenue refers to the receipts obtained by a firm from the sale of certain quantities of a commodity at various prices. The revenue concept relates to total revenue, average revenue and marginal revenue. (1) Total Revenue (TR)- Total revenue is the total sale proceeds of a firm by selling certain units of a commodity at a given price. If a firm sell 10 units of a commodity at Rs. 20 each, Them TR = 20 x 10 = Rs. 200.00 Thus total revenue its price per unit multiplied by the number of units sold. TR = P into Q where P - Price per unit Q - Quantity sold. (2) Average Revenue (AR) - Average Revenue is the revenue earned per unit of output. Average Revenue is found out by dividing the total revenue by the number of units sold. ) Average Revenue AR = total revenue TR divided by Quantity sold.Q (3) Marginal Revenue - Marginal Revenue is the change in total revenue resulting from sale of an additional unit of the commodity. example If a seller realises Rs. 200.00 after selling 10 units and Rs.225 by selling 11 units, we say MR = (225.00 - 200.00) = Rs. 25.00

2.4 PRICING IN PREFECT COMPETITION AND IMPERFECT COMPETITION


Firms Equilibrium Under Perfect Competition A firm is a small producing unit. It supplies too small portion of the total product to influence

price. By increasing or decreasing its contribution, it can hardly influence total supply therefore price. So a firm is said to be a Price Taker in the sense that it sells at the current market price as determined by the Industry. Price being given a firm determines the output it will produce and sell. It is quantity adjustor. In determining its equilibrium output the firm is guided by the objective of profit maximization. The firms strategy in this respect differs between short period and long period. A Competitive Firm is not a Price Determinator, but an output Adjustor In Perfect Competition there are large numbers of firms producing homogenous goods. An individual firm in such market supplies a very small part of the total market supply. In view of this, by changing its supply it cannot affect the price. Thus the firms have no independent price making power. They cannot fix the price according to their sweet will. Therefore firms are bound to accept the price as determined by the industry. Thus a firm is said to be a price taker because it takes the price from the market as a whole. At that price how much it will produce and sell depends upon the discretion of the individual firm. In this sense the firms are Output Adjustor. A firm will produce that much output where its profit is maximum. In Prefect Competition, price is given and so at the current price the firm can sell as much or as little as it likes. Whether the output is large or small, price per unit will remain the same. It is peculiar feature of such a market. Price being fixed for all the units, the firms price will be equal to average revenue and marginal revenue (P = AR = MR Thus a firm under perfect competition produces up to the point where MR = MC. The equality of MR = MC is a necessary but not a sufficient condition. The sufficient condition is that MC must cut MR from below as it is shown in the above graph. If MC cuts MR from above then the point of intersection will not be the point of equilibrium output as the firm will be able to earn more profit by producing more. Determination of Equilibrium Price and Output of a firm under PC. PC is that market firm which is characterized by many sellers selling homogenous goods at uniform prices. Under such a market a single firm cannot makes its price, where as the price is decided by the industry consisting of all such firms. (1) Short run In order to find out equilibrium price and output of a firm under PC in the short run. There are 2 conditions. (a) MC = MR. (b) MC curve cuts the MR Curve from below. In the short run, there may be a situation of super normal profits or losses. (a) In case of super Normal Profit When the AR of the firm exceeds the AC of the firm (example. when AC lies below the AR curve), Then their arises super normal profit b) Loss : In case of super normal loss the AC of the cost has to be greater than AR. It is explained in the following diagram. In the above diagram we can show that AC curve lies above the AR curve. The equilibrium pt at e where MC = MR & MC Curve cuts the MR Curve form below. Therefore Oq is the equilibrium qty & the amount of loss is calculated as follows : Total Loss = TC minus TR (2) Long Run A Firm is said to be in equilibrium in the long run when P = AR = MR = MC = AC. Therefore under PC in the long run there exists normal profit and no super normal profits or losses exists. Since under PC there is free entry and free exit of firms when there arises super normal profit, more firms will be attracted towards the industry and thus the aggregate supply will rise, price will decrease and the profit will not exist. On the other hand if there is an event of loss then the

existing firms will gradually leave the industry and as a result the supply will fall, price will raise and the super normal loss will be wiped out. Firms Equilibrium Under Imperfect Competition Equilibrium price and output determination under monopoly In case of a monopoly firm or industry there is a downward sloping demand curve or average revenue curve which suggests that a monopolist can reduce his unit price to encourage more sales. In case of monopoly the AR & MR curves are downward sloping and the MR curve lies below the AR curve, as shown below : In a monopoly market the conditions of equilibrium are (1) MC minus MR & (ii) MC curve cuts MR curve from below: a) Super normal profit It a monopoly earns super normal profit the firm earn the profit then the AC curve will lie below the AR curve. b) Loss : In case of loss the AC of the monopolist will be above the AR. 3) No Super normal profit or loss : In this situation the AR = AC and therefore the AR curve is tangent to the AC Curve as shown below. Price discrimination under monopoly Sometimes the monopolist charges different prices to different consumers for the same commodity. A physician may charge different fees for rich and poor patients. A company producing electricity may charge one price for domestic consumers and another for industrial consumers. Sometimes, in order to capture a foreign market, a monopolist keeps the export price lower than the price in the domestic market. (This is called dumping). Sometimes exactly the opposite is done. A low price is charged for domestic consumers but the price is raised when the good is sold to a rich foreign nation. All these are cases of price discrimination. When a monopolist discriminated between consumers, the practice is called price discrimination. Classification of price discrimination : Professor Pigou has classified price discrimination into three different types : (1) Price discrimination of the first degree: In this case, the monopolist discriminates price not only between different consumers but also between the different units of purchase by a given consumer. He extract the maximum possible price for each unit of his output. Here, the monopolist has complete knowledge about the market demand curve. He can charge the maximum price which a consumer is ready to pay for purchasing a given quantity. (2) Price discrimination of the second degree: In this case, price does not differ for each unit of purchase. But the consumer is made to pay one price upto a certain amount of purchase and another price for purchases exceeding this amount. This is known as the principle of block pricing. (3) Price discrimination of the third degree: In this case, a particular consumer pays a particular price, irrespective of the amount of his purchase. But price differs between different consumers (or different groups of consumers). Out discussion here will mainly be confined to this third type of price discrimination. When is price discrimination possible? A monopoly firm can sell the same product at two different prices to two different groups of buyers. This type of price discrimination becomes possible under the following circumstances: (a) Different price elasticities of demand : If the price elasticity of demand is different in two different markets, then such price discrimination becomes easier. The monopolist charges higher price for the product in a market where price elasticity of demand is relatively inelastic. On the other hand, he charges relatively lower price in a market where the price elasticity of demand is relatively elastic. (b) Tariff barrier : If two markets are separated by a tariff wall, the monopolist can follow this principle of price discrimination. For example, the monopolist can sell its product at a lower price in the foreign market, and at a higher price in the domestic

market. If there remains high import tariff then it might not be profitable for the domestic buyers to purchase that product at a lower price from the foreign market because they will have to pay a high import tariff on that imported item. In this situation, products sold by the monopolist will not flow from the low-priced foreign market to the high-priced domestic market. (c) Geographical distance between the markets : Price discrimination is also possible when two markets are separated from one another by geographical distance. In this case, the monopolist can sell its product at a lower price in a distant market and at higher price in the local market. In this case also, any buyer would find it unprofitable to purchase the product from the low priced distant market due to substantial amount of transport cost involved in this process. So, products will not flow from the low-priced distant market to the high-priced local market. (d) Impossibility of resale of a product (particularly service items) : If it is not possible on the part of any buyer to resale the product sold by the monopolist, then the monopolist can easily follow the policy of price discrimination. This happens particularly in case of service items. For example, a renowned doctor can charge different fees for rendering similar service to two different patients. Similarly, a renowned lawyer can fix different service charges for two groups of clients for rendering similar services. Here, such doctors or the lawyers would be regarded as the discriminating monopolists. (e) Ignorance of the consumers : If the consumers remain ignorant about the difference in prices of the same product in two different markets, then also the monopolist can easily follow the policy of price discrimination. (f) Typical behaviour of the consumers : sometimes the consumers do not pay any importance to the small differences in prices (say, a difference of only 20 paise) of the same product sold by the monopolist to different groups of consumers. In that situation it becomes easier for the monopolist to follow this policy. Again in some cases, a group of consumers consider higher price as an indicator of higher quality (the so called veblen effect). Such typical behaviour of the consumers creates an opportunity for the monopolist to follow the policy of price discrimination.

Study Note - 3
3.1 CONCEPT OF NATIONAL INCOME
National Income is nothing but the income of a nation or a country. In real terms a national income is the flow of goods and services produced in an economy in a particular period - a year. A National Sample survey has, therefore,defined national income as - money measures of

the net aggregates of all commodities and services accruing to the inhabitants of a community during a specifed period. Concepts Associated with National Income 1. Gross National Product (GNP) - The GNP of a country in a year is defined as the market value of all final goods and services produced by domestic factors in the country in that year. 2. Net National Product (NNP) - NNP at market price is defined as GNP minus depreciation of capital stock. Why should we deduct the depreciation from GNP ? The productive power of physical capital stock of a country diminish gradually because of the wear and tear that it undergoes in the process of production. When the machine become totally unproductive, it can be replaced by a new machine. So a sum of money is set aside every year and put it into depreciation fund and new machine can be purchased by utiliziing this accumulated sum in the depreciation fund. So depreciation is deducted from GNP in order to get a more accurate measure of the sustainable production of goods and services in a country in a given year. 3. NNP at factor cost or National Income- NNP at factor cost = NNP at market price minus Indirect Business Tax minus Non tax liabilities minus Business Transfer Payments plus Subsidy from Government is equal to = National Income . 4. Gross Domestic Product (GDP) - GDP can be defined as the sum total of values of all goods and services produced within the geographical boundary of the country without adding the factor income received from abroad. Distinction between Gross National Product and Gross Domestic Product Gross National Product is different from Gross Domestic Product in following respects : (a) Gross National Product refers to the total market value of all the final goods and services produced in a country during a given year, plus net factor income from abroad. But Gross Domestic Product refers to the total market value of all the goods and services produced in the given year within the domestic territory of the country. (b) Gross National Product includes all income earned by the country in abroad. But Gross Domestic Product does not include the income earned by the country from abroad. (c) Gross Domestic Product does not include the income earned by the country from foreign investments. (d) G.D.P. includes only those goods and services which can be produced within domestic territory of the country. (e) G.N.P. is a wider concept than the G.D.P. But G.N.P. is more useful than G.D.P.

3.2 MEASUREMENT OF NATIONAL INCOME


There are three alternative ways of estimating National Income of a country. Broadly it may be viewed from income side, output side and expenditure side. Let us discuss these methods: (a) Product method - In simple terms this method implies that by adding the values of output produced and services rendered by different sectors one may find out the national income. The output method is unscientific. In this method only those goods and services are counted which are paid for, that is marketed. But there are many goods and services that do not have market price and are not paid for. Services of a housewife or a teacherfather; food crop, fruits and vegetable grown in family farm would not be counted as part of the GNP. Similar services or goods would become a part of GNP if they are paid for. Thus GNP at market price invariably leads to an underestimate of gross and services. Moreover, there lies possibility of double or even triple counting in this method. Counting

wheat, flour and breads value separately is methodologically incorrect because breads value contains flours value which, in turn., contains wheats value. However, this problem can be overcome if only value of final goods are considered excluding primary and intermediate goods. The problem can be overcome in another wayknow as the value added method whereby only the value added by each firm in the production process is included in the output figure. Thus the value added output of all sectors makes up GNP at factor cost. (b) Income method In this method all income from employment and ownership of assets before taxation received from productive activities to be counted. It is the factor income method. The summation of incomes earned by the factors of production for their contribution to production. To these be added the undistributed profits of the private sector and trading surplus of the public sector corporations. While all those groups of income generated in production, some other are to be excluded. These are known as Transfer Earnings. Examples of such earnings are pensioner benefits, un employment doles, sickness benefits, interest on national debt etc. These are excluded, as they do not arise from productive activities. (c) Expenditure Method By measuring total domestic expenditure we can measure the income of a nation. Broadly, total domestic expenditure comprises two elements. First, consumption expenditure of the household sector on goods and services. It also includes the consumption outlays of business sector and public authorities. Another part of national expenditure is investment expenditure by private sector and public authorities. Expenditure is said to be investment when it is used for making a fixed capital like building, machinery etc. It also means an increase in the stock of inputs and finished products. In measuring total domestic expenditure we have to take some precautions (a) only new goods be considered. Any spending on old goods is a transfer of asset from one hand to another. There is no new asset coming through production (b) Only the final stage of purchase be included because measuring expenditure for intermediate stage may lead to duplication of spending amounts. (c) Residents of country may spend for foreign goods (import) any may also earn by selling goods abroad (exports). Hence it is necessary to exclude spending on imports and to include value of exports. Usefulness of National Income estimates National Income estimates are in a sense social accounting showing economic transactions in terms of which the economy of nation may be studied as a whole made up of parts. National Income data may serve many purposes. Firstly, all such data gives an account of the overall growth of an economy. It Shows how the production is changing, the sectoral contribution and the effects of government policies and programmes. Secondly, in analyzing the relation between input of one industry and the output of the other, NI data is necessary. As in input output analysis so also in economic planning planners must analyse such data to find out deficiencies or excess. Thirdly, an analysis of NI data reveals the distribution of income among economic units. They show how much of total income in going to farmers and workers, and how much among white collar workers and land owing classes. On the basis of such data, government may take corrective actions. Fourthly, such estimates also show the consumption pattern of different economic classes. Changes of tastes and fashions are revealed in NI estimates. They are of immense value to the businessmen in deciding what to produce or for whom to produce. Lastly, NI estimate helps the government in its economic role than any other organization and person. For the perhaps the government of a country spends so much for its estimation. Indeed the basis of most public policies is NI data. They are useful in guiding decisions taking and controlling the economy in right direction. The national income

quantum indicates the ability of a country to pay its share for international purpose example. membership of IMF or World Bank.

3.3 DIFFICULTIES IN ESTIMATING NATIONAL INCOME


The difficulties in the estimation of National Income can be broadly divided into conceptual difficulties and statistical difficulties. Some of the conceptual problems related to precise estimate of national Income are as follows : (a) There are many services for which no remuneration is paid. Similarly there are goods that are marketed sold at a price but are used for self-consumption. But no practicable methods exists for their inclusion in National Income accounting. (b) In estimating National Product we take into account only the so called final goods which are those goods readily available for consumption. But it is not always possible to make a clear distinction between primary, intermediate and final goods. (c) Another problem relates to pricing of products. Prices change overtime and region. The price that should be chosen to determine the money value of National product is a difficult question. (d) There is much debate regarding inclusion of income of foreign companies in National Income estimates since, a large part of such income is remitted out of the country. There are some statistical problems in the computation of national income. (a) Changes in the price level have to be made in comparing national income of different years. It involves the use of Index Number. Index Numbers have their inherent difficulties. (b) Official statistics are not always accurate Much of it is based on guess work and sample survey. (c) Methods of computing NI are not the same in all countries. Statisticians differ in their opinion regarding statistical computation. (d) And the statistical data are often not available. Data relating to unaccounted money, wages of labour in unorganized sector are case in point.

3.4 NATIONAL INCOME AND ECONOMIC WELFARE


Economists like A.C. Pigou, are of the opinion that an increase in wealth means an increase in welfare and a decrease in it implies a loss of welfare. Such causal relationship is heavily discounted by modern writers like Prof. Paul Samuelson. In their view, there is no direct relation between wealth and welfare. Samuelson suggests that to calculate economic welfare we have to correct GNP to allow for disseminates of modern urban living, for enhanced leisure, now enjoyed by the citizens, for household work by wives. We must compute the Net Economic Welfare (NEW) to guage quality of economic life. We must compute the adjusts the conventional measure of GNP to allow for pollution cost, disseminates of modern urban living, leisure etc. Thus Political economy shows how people if they really wish to, can trade off quantity of goods for quality of life. Many things that contribute to human welfare are not included in the GNP. Leisure is an example. Although a shorter work week may make people happier, it will tend to reduce measured GNP. Furthermore, the GNP may not adequately reflect changes in the quality of products. A 1994 TV is a much superior product to a 1984 TV. It is more reliable and has better audio video quality. But GNP measures do not reflect these changes in quality. Also GNP does not allow for the capacity of different goods to provide different satisfactions. Crores of rupees spent on defence products makes the same addition to GNP as crores of rupees spend on a school, a stadium or shopping expenditures that may produce very different level of consumer satisfaction. GNP does not measure the quality of life. To the extent that material output is purchased at the expense of such things as overcrowded cities and highways, polluted environments

defaced country sides, mined accident victims and longer waits for Public Services, GNP measures only part of the total of human well being. This undersirable products are often called bad to distinguish them from goods which are desirable products. The GNP omits certain outputs such as the illegal provision of Products people want; non marketed activities and output in the black economy, some of which clearly add to peoples living standards. Increase in the general price level would bring a fall in the economic welfare. If increase in the size of national income is the result of prolonged working hours, increased employment of female workers and children in production, unhealthy and polluted atmosphere inside the factor premises, such an increase in National Income will not promote economic welfare. If the net National Product has increased on account of more production of capital goods, it will not increase welfare. Welfare also depends upon the distribution of National Income. If the National Income increases and yet if it is not fairly distributed and are concentrated in a fewer hands, it will not promote economic welfare. The law of Diminishing Marginal Utility also applies to accumulation of money. As the rich people get richer the additional unit of money income gives less welfare. The unequal distribution of Nation Income decrease economic welfare. When the distribution of National Income changes in favour of the poor they start getting more commodities and services than before, as a result the economic welfare increases. The philosophy of the National Income statistician might be expressed in the observation Man does not live by bread alone, but it is nevertheless important to know how much bread he has. The National Income figures do not measure everything that contributes to human welfare, nor are they intended to do so.

3.5 CONCEPT OF CONSUMPTION, SAVING AND INVESTMENT


CONSUMPTION Keynes held that current consumption depends upon current gross income minus tax liabilities. He says men are disposed as a rule and on the average, to increase their consumption as their income increases by not by as much as the increase in their income. Symbolically 1> C > 0. This is the psychological law of consumption. Consumption Function The propensity to consume shows income consumption relationship C = F(Y). here c is consumption a dependent variable and Y is an independent variable. It should be noted that propensity to consume does not mean desire to consume but effective consumption. C is an increasing function of income as Y and C move in the same direction. OX measures real income and OY consumption. The C curve represents the propensity to consume. It slopes upward to the right showing consumption rising along with income. At point A while income is zero consumption is positive, and upto CL on the consumption curve, we find that consumption exceeds income. Average Propensity to consume It implies the ratio of total consumption to total income. Marginal propensity to consume This implies the effect of additional income on consumption. It is the ratio of additional consumption to additional income Determinants of consumption Functions Consumption function depends on subjective and objective factors. Among objective factors we may mention a few. a) Tax Policy A higher rate of tax will reduce personal income and to that extent consumption as well. b) The Rate of Interest A higher rate of interest may induce more savings and so less consumption. However a higher interest income may raise consumption by raising total income.

c) Holding of Assets If people want to hold more assets, like property, jewellery etc. they will curtail consumption. d) Windfall Profits or Loss Consumption level of those classes of people changes who gain windfall profit or incur heavy loss. Among subjective factors we may mention some motives that lead individuals to refrain from spending. These are motive of precaution, motive of foresight, motive of improvement, motive of avarice etc.

SAVING
Definition Keynes defined savings as an excess of income over expenditure on consumption. Symbolically S = Y minus C. The unconsumed part of national income of all members of the community represents. National Savings. The total domestic savings are the sum of households savings plus business sectors savings plus governments savings. The first two constitute private savings and the latter public savings. Determinants The size and rate of savings in an economy are determined by many a factor. The most important determinant of savings is income. Savings is functionally related to income S = f(Y). The saving income ration tends to rise with increase in income. The savings function is a stable function of income in the short run. But savings as such is not a stable function of income. So marginal propensity to save (ds/dy) is always greater than zero but less than unity that is, people save part of additional income but not the entire income The saving function is explain by three income concepts in macro economics. (a) Absolute Income Keynes was of the opinion that savings are a function of absolute level of income. That is current savings depend on current disposable income example. income minus taxes paid. (b) Relative Income According to Duesenberry savings out of a given income by an individual depends on his relative income example, upon his percentile position in the total income distribution. (c) Permanent Income According to Friedman, the basis of determining consumption and saving is permanent income. Permanent income is current income plus the expected income received over a period of time. Actual or measure income is the sum of permanent and transitory income. Transitory income implies unanticipated addition or subtractions in income. A second factor influencing savings is the distribution of income. Generally, inequality of income distribution helps the process of savings. In this context we may refer to demonstration effect, that is mans desire to imitate the superior consumption standard of neighbours or relatives. This induces a man to buy expensive goods and so saving decline. Thirdly, savings depend on sound financial institutions and the rate of interest. A higher rate of interest motivates us to save more. So also existence of diverse type of financial instruments gives people incentive to save more. Besides the above objective factors, savings also depend on a host of subjective or psychological factors. A mans attitude towards savings depends on his farsightedness, his desire to bequeath a fortune, to enjoy a better living in future or to possess some physical asset. A strong subjective motive is precautionary in nature. A man saves or insures as a precaution against future uncertainty and insecurity. Savings: A Virtue or a vice According to classical economists savings is a virtue as they believed that what is saved is being automatically invested. But some classical theorists argued that the act of saving leads to under consumption and this diminishes effective demand. In effect, over production and unemployment appear.

While considering savings as a private virtue, Keynes believed it be a social vice. A general increase in savings means a general reduction in consumption expenditure and a fall in effective demand. This will lead to a sharp fall in investment, production and employment. As a result individual income may decline leading to reverse operation of Multiplier. The Keynesian views are based on the concept of income elasticity of saving. As income falls due to contraction of expenditure savings will also decline. This stands in sharp contrast to classical view point where saving was considered as interest elastic. If, however, savings are hoarded they destroy real capital. Thus whether savings is virtue or a vice depends upon its use and its effects on income. INVESTMENT Definition Investment has dual aspect. It implies the production of new capital goods like plants and equipments. Secondly, a change in inventories or stocks of capital of a firm between two periods. Determinants The volume of investment undertaken by private entrepreneurs depends primarily upon two factors (a) the marginal efficiency of capital (MEC) and (b) the rate of interest. The term MEC implies the prospective yield from the capital asset and the supply price of this asset. MEC, in the words of Keynes, is equal to the rate of discount which would make the present value of the series of annuities given by the return expected from the capital asset during its life just equal to its supply price. Symbolically C = Q/P. Where Q is the prospective yield from capital asset and P is the supply of this asset. In considering a particular investment project the investor must have some idea of future returns, that is yields from the real asset in its life span. Suppose for the years 1,2,3, n the net return is current values (example. value in the year they are received) R1, R2, R3,Rn (1) In order to find the present value of all expected future returns we have to discount all future returns. Consequently the stream of returns, as shown in equation (1), has a present value of An investor will compare this present value of return with cost of the real assets (Pc). The condition for the maximization of net returns over costs is that increments has a present value of expected returns which just covers the initial cost. Generally there exists a negative relation between interest rate and investment expenditure. A fall in the rate of interest may induce an increase in investment expenditure whereas a higher rates, investment is likely to be less. At a higher interest rate, a firm instead of using funds for capital equipments may invest in financial assets. Thus the level of investment is a negative function of the rate of return. Investment expenditure also depends on over all economic climate. An optimistic outlook is highly encouraging for investment in capital goods. Risk, uncertainty and instability tend to discourage business to undertake investment projects. Moreover, a firm may expand investment outlay for innovation viz. introducing a new good or a new technique. Such innovations either by increasing sale or by reducing cost may help the innovating firm a larger return on its investment. Finally, investment decisions of a firm are influenced, to no small extent, by the cost of capital goods. A firm normally calculates the initial cost of acquisition, and the subsequent cost of maintenance and operation of capital goods. The present stock of capital goods on hand and their working condition, moreover, determine whether to incur investment for buying the capital or its purchase be postponed. Marginal Efficiency of Capital (MEC) and Marginal Productivity of Capital (MPC). The term MPC or Marginal Productivity of Capital, as used by Marshall, implies the additional physical product obtained due to the employment of one extra unit of capital (do/dc) per unit of time. In other word, it relates to the increment of value received by using one more physical unit of capital. In contrast, MEC

denotes the series of increments in output anticipated over the life of the capital equipment. Thus while MPC example. dQ, MEC is dQ1, dQ2, dQ3, .. dQn. The former (MPC) indicates just the current output, the latter the stream of output over a period of time. The MPC is net current product of the capital good minus the cost of capital good. In other words, the current rate of return over cost MEC, on the other hand, implies the return over cost throughout the life of the capital goods. Thus the basic difference between the two concepts is that, the one (MPC) denotes current yield and the latter implies prospective yields from a capital asset. Investment Multiplier The Keynesian multiplier shows how many times the total income increases by a given amount of initial investment. If dI represents increase in investment, dY represents increase in income and M the multiplier, the M = dY/dI. Thus the Multiplier is the number by which the initial investment is to be multiplied to get the resulting change in income. With the help of the marginal propensity to consume the relation between a given dose of investment and the resulting change in income can be shown. Suppose a firm makes an additional investment of Rs. 1000/- for enlarging its business. The money thus spent by the firm will lead to an equal amount of increase in income of some other men. These income earners will spend a part of the additional income for consumption and save the rest (dY = dC + dS). If we assume marginal propensity to consume to be 0.8, they will spend Rs. 800 out of Rs. 1000 for consumption goods. In effect the producers of these goods will have an extra income of Rs. 800 and they will in turn spend 4/5. That is Rs. 640, which will be the extra income of some other people. Thus there is a chain a income and expenditure generated from the original and autonomous investment. The total increase is the sum of the increase in income at each stage The investment Multiplier thus denotes the ratio of change in income to the change in primary Investment. The value of the multiplier can be calculated by the formula K = 1divided by (1minus - Marginal Productivity of Capital MPC) The value of the Multiplier is the inverse of the MPS (marginal propensity to save). The significance of the concept of Investment Multiplier is that it shows how a given autonomus investment enlarges income. Leakages The multiplying process of income propagation is much weakened by the operation of certain exogenous factors. Indeed it may operate at the reverse direction also causing a cumulative decrease in income and spending. The swelling of income may peter out because of such leakages :(a) A decrease in MPC and an increase in MPS may reduce the value of multiplier because multiplier is the reverse of MPS. If, for example, MPS rises from 1by /5 to , value of the multiplier will fall from 5 to 2, increase in National Income would be less. (b) A part of the extra income may leak out of the income stream if invested in financial assets, naturally consumption expenditure will be less. (c) Similarly if a large part of additional income is invested in financial assets, naturally consumption expenditure will be less. (d) A strong liquidity preference may lead to holding of cash balance in hand instead of spending for consumption goods. (e) An excess of imports over exports causes a net outflow of funds from domestic economy, thus weakening income propagation through earning and spending. (f) A small part of the extra income can be used for consumption expenditure if the rate of taxation is very high. The Acceleration Principle The concept of Multiplier highlights the effects of initial investment upon national income

through changes in consumption expenditure. Such change in output of consumption goods cause investment for production of capital goods used in producing those consumption goods. Thus a given autonomous investment begets a chain of induced investments. The ratio between the net change in consumption outlay and the induced investment is known as acceleration coefficient : a = investment dI by / net change dC, where dI is net change in investment and dC for net change in consumption expenditure and for accelerator. Suppose a net increase of consumption outlay of Rs. 10 lakh induces an additional investment of Rs. 20 lakh then the value of accelerator is 20/ 10 = 2. The value of accelerator depends on capital output ratio example. the amount of capital required to produce a given volume of output. It also depends upon the durability of capital goods. The acceleration effect will be high if capital equipments have more durability and capital output ratio is high. A small change in consumption expenditure, generally speaking, is likely to create a larger induced investment.

3.6 ECONOMIC GROWTH AND FLUCTUATION


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

Different explanations have been offered for periodicity of business cycles. According to classical writers fluctuations in farm products cause business cycles. Some economists believe that expansion and contraction of bank credit cause cyclical fluctuation. But bank credit is more often the effect than the cause of trade cycle. Another explanation is to be found in the Innovation Theory which seeks to explain prosperity by the introduction of new goods and depression by the fall in the demand for old products. Often due to over saving or under consumption of the people, supply remains unsold as a vast majority of the population do not buy them. Lord Keynes explained trade cycle by the changes in the expected profitability of investment or what he called Marginal Efficiency of capital. In Keynesian theory, employment depends on three variables : Propensity to consume, rate of interest and marginal efficiency of capital (MEC). While the former two are more or less stable in the short run, it is the MEC that is the primary determinant of employment. When MEC is high, optimism prevails in the business world, Investment goes on rising and so also income and employment. The economy thus reaches the peak of prosperity. The process is reversed by two retarding factors (a) high cost arising from shortage of resources (b) a falling tendency of the rate of profit due excessive increase in supply. This shows the seed of pessimism and a decline in MEC leading finally to a depression. The economy revives when MEC revives. A ray of optimism appears when the prospect of profit revives. The excess stock of consumer goods is exhausted and growing scarcity of consumer goods lead to higher profit expectation. Anti Cyclical Policy Government of a country may take some measures to control cyclical fluctuations. Through an expansionary or contractionary credit policy the central bank can control business cycle. Raising the rate of interest in boom and lowering it in depression by reducing the volume of investment or encouraging it may reduce the swings of a trade cycle. This may not happen in real life. Even with a low interest rate, investment may not be promoted if expectation of profit is weak. If, on the other hand, expectation of profit is quite high, businessmen will borrow for investment despite higher interest rate. A contra cyclical fiscal policy can be used to eliminate trade cycle. In a period of depression government should spend more and tax less with the object of increasing effective demand that is buying power of people. In prosperity phase government should spend less and tax more so as to leave less in the hands of people. Keynes advocated deficit spending for a depressionary economy. The socialists think that cyclical fluctuations are the outcome of a capitalistic economy where profit motive is the main driving force. The problem can be uprooted if the system move from capitalism to socialism with state ownership of the means of production. Economic Growth Definition By the term economic growth is meant the expansion in the capacity of an economy to produce goods and services over a period of time. It implies an outward shift of production possibilities frontier of an economy showing the different maximum possible combinations of quantities of two goods if it employs all its available resources full and given the existing state of technology. Measurement Different methods have been suggested for measuring economic growth. One measure is a countrys over all capacity to produce goods and services. The money value of GNP can change because of change in price. Hence it is necessary to measure economic growth rate by using constant Rupees, or real income. An increase in real GNP if followed by a higher rate of growth of population may lead to a deterioration or no change in the standard of living of the population. The problem can be overcome by raising per capital national income. Secondly, if GNP increases owing to an increase

in arms and ammunitions, ships, engines etc. the quality of life of people would remain the same. Thirdly, an increase in GNP may not help growth if its not distributed fairly and equally. Fourthly, if increase in GNP is achieved by more efforts and exertions on the part of the labour force then welfare is likely to diminish. Real GNP per capital = Real GNP/ Population If the numerator (GNP) grows faster then the denominator (Population), real GNP per capita will grow and quality of life will improve. On the contrary, if GNP grows at a rate lower than population, real GNP per capita goes down. But changes in real GNP per capita does not tell us any thing about distribution of income or the quality of goods and service that compose GNP. Components of Economic Growth The growth of economys total output depend generally on four components (1) the size of the population (P) (2) fraction of population that constitute labour force L/P (L = PX) (3) the total number of labour hours actually worked by the labour force L into x H = P x L/P x H (4) Output per labour example labour productivity. This is equal to total output Q divided by the total number of Labour hour example. Q/(L x H). Thus the economys full employment total output Q may be expressed as Q = (L x H x Q)/(L x H) (a) Population : Population helps economic growth by enlarging demand on the one hand and paves the way for producing large quantity of output on the other. (b) The fraction of total population engaged in productive activities constitutes Labour force. Obviously if this proportion (L/P) is high more will be productive capacity of an economy and vice versa. (c) The length of the average work hour of the labour force generally seems to have a direct impact on the rate of economic growth. It may also be argued that a decline in the average work-week may indicate a good life provided by economic growth. (d) Growth in productivity is said to be the primary element of economic growth. Productivity that is, output per labour hour has a direct bearing on the level of GNP. The more productive labour, the more will be the total output of an industry. Economic history of different developed economies support this contention. Labour force acquires skill through proper training and education, and also on the quality and quantity of capital as also the technology. Relation between Stability and Growth In the 30s, the committee on Finance and Industry in England spoke of avoidance of the trade cycle and the stability of the price level as the goals to be pursued by the Bank of England. These works are as true today as they were when uttered in 30s. Indeed financial stability is essential for economic growth. First, if a countrys currency is not stable, people will be much reluctant to save for fear of further fall in the value of currency. Such slowing down of savings would tend to retard progress. Secondly, a stable economy can help the formation of capital by stimulating the inflow of foreign capital. Stability of currency, thirdly, is necessary to stimulate a rapid increase in productivity. If prices are not stable, firms can make easy profit and repay their old debts in depreciated currency. This is likely to depress businessmans incentive to innovate, the desire to take risks and such other finer qualities of business enterprises. But in a situation of financial stability firms can no longer make that easy profit. They are compelled to improve their methods of production and over all organizations.

Finally, the existence of well-organised financial institutions is likely to quicken economic growth by mobilizing savings for investment purposes. These institutions thrive in a climate of financial stability.

Study Note - 4
THEORY OF EMPLOYMENT 4.1 LABOUR
Definition

Labour is an important ingredient of production. Without labour, the other factor inputs cannot be activated Labour helps production in two ways As a producer and as a consumer. Things are produced because they are consumed. Labour is defined as any exertion of body and mind undertaken wholly or partly with some object other than the pleasure derived from the labour itself. Thus labour includes both manual and intellectual, and the exertion of body or mind should be not for pleasure but for earning money. Features of Labour Labour as a factor of production has some characteristics that distinguish it from other factors. Labour is a perishable factor. A days labour lost cannot be recovered. Hence the workers often are exploited because they cannot preserve their labour power for future. Secondly labour cannot be separated from labourer. Labour sells his work and he himself remains his property. Thirdly labour is a mobile factor. Apparently workers can move from one job to another or from one place to another. But, in reality there are many obstacles in the way of free movement of labour from job to job or from place to place. Fourthly highly skilled labour are specific factors while highly unskilled workers are nonspecific in the sense they can be used for any type of manual work. Another feature of labour is that the supply of labour in terms of hours of work decreases when wage rates are high. For this the individual supply curve of labour is backward bending after a point. Thus while the supply of commodities increases when their price rises, the individual labour supply (in terms of hours of work) decreases with an increase in the price of labour.

4.2 POPULATION THEORIES


A. Malthusian Theory of Population Growth In 1978, Thomas Robert Malthus expressed his views on the population growth in his Essay on the Principle of Population. His arguments on the pattern of population growth in an economy are as follows : (1) In any country, total population grows at a faster rate than the total food grain production. According to him, the production of foodgrains increases at an arithmetical progression (example., 2,3,4,5,6 etc.) while population grows in geometrical progression (example., 2, 4, 8, 16, 32 etc). (2) Within a short period, the total population becomes larger than the size of the foodgrain production example., foodgrain production per capita comes down to a low level. At this stage, the country is said to be overpopulated. The signs of such overpopulation, according to Malthus, are as follows : (a) Large-scale poverty; (b) Large-scale starvation and malnutrition; and (c) Emergence of various diseases and epidemics. He also believes that this excess pressure of population is automatically reduced due to some natural calamities like floods, droughts, wars etc. In this way, the nature through its own forces, tries to maintain a balance between the population and foodgrains productions. These are called positive checks. Malthus also believes that the people should also take some preventive measures to check such growing pressure of population. (For instance, population control methods, prevention of early marriage etc.), These are called the preventive checks. Malthuss doctrine is illustrrated below : Malthus Theory of Population Critical Evaluation : The population theory of Malthus has been criticized from different angles. (1) Population may not grow in a geometrical progression : Many economists are of the view that population may not grow in a geometrical progression. In fact, population

of different developed countries of the world has increased at a slow pace during the late 19th and 20th centuries. Thus, there is an interdependence between the level of economic development achieved and the population growth in a country. (2) Law of diminishing product may not be operative : Malthusian theory shows that the production of foodgrains in a country grows in an arithmetical progression. The implicit logic behind such argument was the operation of the law of diminishing marginal productivity. That is to say, given the supply of cultivable land, growing population pressure on land leads to an increase in production at a decreasing rate. However, this law of diminishing product may not be operative if better seeds, fertilizers, irrigation, agricultural implements, etc. are introduced in agriculture. Population increases in a GP - 1,2,4,8,16,32........ Food increases in AP - 1,2,3,4,5,6,........ Imbalance leads to overpopulation Corrected by Preventive Checks - late marriage, moral restraint etc Positive Checks - misery, war, famine, flood etc Thus, the Malthusian theory has not taken into account the technological revaluation in agriculture. (3) Growth rate of foodgrains production may be higher : The rate of growth of population may not be greater than of foodgrains production in a country. For instance, population of India has increased by about 185 per cent during 1951-2001, but foodgrains production of India has increased by about 258 per cent during the said period. (4) Increased supply of labour facilitates economic growth : The population problem of a country should not analysed only in terms of foodgrains production. Increased population not only raises the demand for foodgrains, but also the supply of labour in a country. If this labour force can be made more skilled and educated then they contribute to the growth of total output in the country to a great extent. If the country can produce different export items then the country would be able to import even foodgrains from abroad, because the import bill can easily be met from the export earnings. (5) Overpopulation is not the only cause of poverty : Growing incidence of starvation may not be the only indicator of overpopulation. This theory shows that a situation of overpopulation is only responsible for such growing incidence of poverty and starvation. But, inequality in the distribution of income and wealth can also create such a situation. B. Optimum Theory of Population In 30s a new theory of population was worked out which is known as the Optimum Theory of Population. The core of the theory is a concept called Optimum Population. It was held that for every economy there is an optimum level of population growth. IT is the level where maximum returns can be obtained. The Optimum Population simply is the size of population that a country can support without any stress and strain. Thus in this theory the danger of over population was considered not in the context of food supply but the total wealth of a country. The test of over population or under population were not the shortage or surplus of foodgrain but the maximization of national wealth and welfare. If at any time the actual population of a country exceeds its optimum point the country will

face different economic problems and its returns will be less than maximum. On the other hand, if the actual population is less than optimum, National output will also be less because of under-utilisation of productive capacity. Only when actual population is equal to optimum population that the country will enjoy the greatest good of the greatest number. A formula for estimating deviation of actual population from the optimum has been suggested. It is An economy is said to be under populated if A < O and Overpopulated when A > O. Only when A = O that resources of the economy are used in the best possible way to secure the highest possible return for manpower. One feature of this Theory is that unlike Malthusian theory it is not pessimistic about the growth of population. The Theory highlights the fact that population may help or hinder economic development of a country depending upon the availability complementary resources. Further unlike Malthusian theory, it is not narrow. It does not consider the growth of population with the growth of food supply. Instead it considers demographic growth with the growth of national resources as a whole. Moreover the Theory is important in another respect. It suggests that under population is as much harmful as overpopulation for a country. Malthus only considered the dangers of overpopulation ignoring the case of under population. The Rich countries of the World are nowadays suffering from the problem of under-population and this is one of the vital reasons for which they cannot fully utilize their productive capacity. The most important problem of this Theory is that it is very difficult to ascertain what is the optimum number of population that a country can support. Even if the optimum can be determined, it will vary from time to time because of any change in the resource composition, technology, trade of an economy so the concept of optimum as envisaged in this theory is not a static one. It will vary from time to time and from country to country. Further the term Optimum may be interpreted in many ways. It may mean the size of population that maximizes the average product or income per head. It may also mean the size of population that maximizes net social welfare or it may mean the size of population that maximizes total product. The theory however considers Optimum Population as the maximum population that is supportable with existing resources of a country. C. Theory of Demographic Transition Almost all demographers (who study demography or population theories) and social scientists agree that population growth in every country passes through many stages. Each stage has its own peculiarity. This theory indicates that particular types of demographic phases are associated with particular stages of industrialization. On the basis of the economic history of many countries of the world, this theory wants to establish that movement of a country from a traditional agricultural system to a highly industrialized urban economy, also signifies its travel from a stage of high fertility (and mortality) to a state of low fertility (and mortality). According to Prof. O.P.Walker, there are five stages of such demographic transition: 1st Stage : At this stage, both the death rate and the birth rate remain very high, but the former exceeds the latter. As a result, population does not increase to a great extent. This is called a high stationary stage. 2nd Stage : At this stage, the birth rate does not come down but the death rate starts falling due to improvements in health facilities. As a result, population increases rapidly. This is called an early expanding stage. 3rd Stage : Both birth and death rates decrease at this stage. Though the birth rate exceeds the death rate, the distance between them becomes less. This happens when the country attains a certain level of agricultural development and steps towards urbanization. This is called the late expanding stage. Here the population size grows slowly. 4th Stage : At this stage, the death rate reaches its lowest and at the same time birth rate also comes to a low level. Growth in population becomes stagnant. But, unlike

the first stage, it is called low stationary stage. 5th Stage : At this stage, the death rate becomes more than the birth rate, and it may be regarded as a declining stage. While reviewing these stages, Prof. Thompson and Notestein opined that the first and fifth stages were unusual. According to them, only the three intermediate stages are relevant. They named these three intermediate stages (viz., the second, the third and the fourth stages) as the pre-transition stage, transition stage and post-transition stage respectively. The explanation of Karl Sax about the demographic transition also shows four stages of such transition also shows four stages were similar to the explanation given by Walker about the first four stages of transition in his own theory. In Fig. -2, the time paths of birth rate and death rate have been shown. Population growth is determined by the gap between these two curves. The first stage (stage I) of demographic transition becomes visible up to the time period To. Similarly, the second (stage II) and the third (stage III) stages of demographic transition are discernible within the time horizon ToT1 and T1T2 respectively. Let us assume that points X and Y represent two countries having the same current rate of population growth (example., AB = CD). But, it is observed that, incase of country Y, population growth will soon slow down because the falling death rate has almost reached its minimum and has been accompanied by a falling birth rate. However, in country X, the population is expected to rise in future because of the increase in the gap between birth rate and death rate. Thus, two countries having the same observed population growth rate at present, may indicate radically different future prospects.

4.3 UNEMPLOYMENT
Employment The classical economists were not very much concerned with employment or unemployment. It was because they believed in Says Law. J.B.Says law stated that supply creates its own demand that is every good produced in the market is born with a demand tied round its neck. From the law follows that there can never be more than frictional unemployment or sectional overproduction. It was believed that private enterprise would always employ all available factors of production, provided prices and wages were sufficiently flexible. Thus they ruled out the possibility of general over production, as the demand for all goods taken together will always be sufficient to sell them. If it is so, restricting of output in general is not necessary. If a general over supply is impossible, production will continue upto the point where all factors are fully employed. It was the logic underlying the assumption of full employment. The classical economists also believed that one mans income depended on another mans expenditure and that if some people refused to spend a part of their income, the real resources left over by the former would always be used by some businessman for the creation of capital equipment. In other words, what is saved is being automatically invested. In mid 30s the classical conclusions regarding employment were criticised by Keynes and his followers. At times, there may be deficiency of aggregate demand in the society arising out of lack of purchasing power in the hands of the people. In such a situation supply cannot create its own demand. It can create demand but not effective demand. So excess produce may exist with unsatisfied demand. Demand deficiency may thus throw an economy out of full employment. This happens in a situation of depression.

Kenesian Theory of Employment According to Keynes the aggregate volume of output, during a certain period, depends on the

effective demand of the people. Effective demand of the people depends on total expenditure for goods and services. The total expenditure is formed of consumption expenditure and investment expenditure. Total expenditure is equal to total income. Hence, Y = C + I. The total of consumption and investment expenditure determined of output and employment. Hence the determinants of consumption and investment are the determinants of output and employment. Consumption expenditure means spending of money for purchasing goods and services for utility. Investment expenditure, on the other hand, implies spending for new capital asset. Consumption according to Keynes depends upon objective and subjective factors. Income is the most important factor influencing consumption c = f(y). The definite relation that exists between income and consumption is known as Consumption Function. When income increases consumption expenditure also increases but not by full amount. In other words, consumption is less than unity (c<1) but greater than zero (c>0). That part of additional income people do not spend for consumption is their savings. Therefore dY = dc + ds. Not only does current consumption depends on current income but on past savings as well. Investment Function Investment expenditure is normally business sectors expenditure with the aim of securing profit. Expected profitability of a given dose of investment depends on the margin between Return from and cost of investment. The cost of investment is the cost of credit viz. Rate of interest. The volume of investment varies inversely with rate of interest (r).

Unemployment - Causes and Forms


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

cultivation. In traditional agriculture, another type of unemployment can be seen. It is disguised unemployment causing much harm to poor economies. It implies that a large part of the workforce engaged in agriculture could be removed without reducing total output. It is applicable in case of family farming where all family members (that multiply generation after generation) grip a given plot of land and if some of them do not participate total product would not diminish. In other words, many members marginal contribution or marginal product is zero. They are surplus labour. The causes of such joblessness are (a) family farming (b) existence of surplus labour (c) lack of alternative job facilities. The growth of capitalist sector can absorb such surplus manpower. And rural development activities initiated by the government can also eradicate this type of unemployment. Industrial nations face generally two types of unemployment; technological and cyclical Technological unemployment arises out of a change in the techniques of production from labour intensive to capital intensive. Further the industrial sector also faces a type of unemployment called cyclical unemployment. In times of recession and depression industries experience a fall in the volume of production. Therefore the demand for labour also decreases. Even some of the workers already employed are thrown out of employment. Another type of unemployment is Frictional unemployment. Such unemployment happens when the workers leave one job to get a better one. So it is also temporary. There is also Natural rate of unemployment that every country faces. Some men everywhere remain jobless for some reason.

4.4 THE CONCEPT OF FULL EMPLOYMENT


The concept of Full employment has been variously defined by different writers. Sir William Beveridge has defined it as having always more vacant jobs than men. Lord Keynes says it the absence of involuntary unemployment. So defined, the concept of full employment is compatible with (a) voluntary un employment, (b) frictional un employment. Thus a full employment economy is one which has the minimum of involuntary un employment in transition from one job to some other. It implies a situation whereby the labour market transforms from a buyers market to a sellers market. The Policies for achieving Full Employment The classical economists believed that an economy achieves full employment automatically. If supply creates its own demand, as stated by Say, an stated by Say, an economy can go on producing till all factors are fully absorbed, provided wages and prices are flexible. Thus general over production and unemployment were ruled out. A state of full employment was supposed to be inevitable. There may be under employment equilibrium. It is the level of income (OY1) in total income is equal to total expenditure of goods and services (Y = C + I). A M, C + I curve intersects the 45o curve. That is equilibrium point but at that level of income, the economy is under full employment. Then, how to achieve full employment? Graphically if C + I curve shifts upwards and intersect Y = C + I curve at a point (P) that level of income (OY2) all labour may be fully employed. It is how full employment may come about (see graph 4.1) It thus appears that the way to achieve full employment is a constant increase in total expenditure (C + I) whose deficiency keeps an economy at less than full employment. Any policy for realizing this goal should attempt to raise total spending. When private spending for consumption and investment goods are inadequate, the government is called upon to play a more positive role example. to spend more by printing new money.

Role of Government A vigorous monetary fiscal mix example., a combination of monetary policy and fiscal policy is essential for lifting an economy from depression and unemployment to full employment. Anti cyclical monetary policy It is formulated by the Central bank. It is known as Cheap Money Policy. Money is said to be cheap, when it can be obtained at a very low rate of interest. If liquidity preference function remains unchanged, an increase in total money supply (cash + credit) will go to reduce interest rate. Naturally investment expenditure of the private sector will go up. A fall in interest rate will lead to a rise in price of bonds, securities etc. This will increase household sectors investment in financial assets too. The Net National Product, in effect, will go up. Increase in money supply may continue till NNP reaches the full employment level. So long there are unemployed factors, injection of more money will lead to an increase in output and employment. Investment of created money will activate the idle factors. In this way once the economy reaches full employment zone, any more increase in money will lead to inflationary price rise. At less than full employment, investment may activate idle resources. So an increase in NNP. But at full employment there lies no such scope. Thus an increase in investment may generate an output effect at less than full employment situation and price effect after (or at) full employment level of output. Fiscal Policy Governments tax and expenditure policy for realizing the goal of full employment is compensatory in nature. It seeks to compensate the shortfall in private spending (C + I) which is supposed to be the cause of deviation from full employment. Fiscal policies need to be two edged taxing less and spending more. Taxing less is same as leaving more in the hands of the people so that they can spend more. Expenditure by government for public works or welfare activities may raise private effective demand, also. The new and excess government outlay injected into body economy may generate an income more than the initial sum pumped in. Hence, Keynes advocated creation of new money by the government. The easiest way to do so is to borrow money from central bank against its securities. This method is known as Deficit Spending. Limitations 1) It may retard private investment. Easy and cheap credit may be harmful to the business sector as they will find no incentive to raise resources internally. 2) More spending by the government may raise the effective demand of few and the effective demand of many may remain unchanged. So the character of effective demand is as important as its level. 3) A vast public expenditure may not achieve full employment of labour for shortage of some complementary resources like technical personnel, foreign exchange etc.

4.5 CAPITAL
Definition Unlike Land and Labour, Capital is not an original factor of production. It is said to be a produced means of production. It is means of production produced by labour on resources supplied by Nature. As a factor of production, Capital thus depends upon both Land and Man. It is known as producers goods goods that help further production. In a broad sense, Capital implies physical goods like machines and tools that render repeated service in production. It also means money capital and debt capital consisting of equity and bonds which yield income. Thus capital includes all those physical and financial assets that yield an income or aid the production of income. Man invests in Capital assets for the sake of obtaining income repeatedly. Nowadays man is also considered as a sort of capital. Just as physical and finance capital brings income after their owner invest fund, so also investment in human capital in the form of education makes a man skilled worked and he earns more

repeatedly. As an agent of production capital increases the productivity of labour. Man can produce more when he uses sophisticated machines and tools. Not only does its use raise the volume of output but secures continuity in production also. Further the use of capital makes production round about. Labour first produces capital goods like machines and tools and then with the help of such goods, consumption goods are produced. Capital helps in bringing about continuity in production. Growth of Capital Physical Capital and Financial Capital are essential for production. The more the stock of capital, the more will be the volume of production in an economy. This highlights the need for the growth of capital in a country. Capital grows out of savings. It implies generation of surplus a surplus of income over consumption. The size of the surplus that forms capital is the difference between current income and current consumption. Therefore the growth of capital depends on the size of income and the proportion of income spent for consumption. Surplus is generated from household sector, corporate sector and the Government sector. Of these the role of the household sector in generating surplus is very much important in most of the countries of the world. Saving may be of three typesvoluntary saving, involuntary saving and forced saving Generally the households save a part of their current income voluntarily in the sense that they may not save it also if they so like. Some times savings becomes involuntary. In a period of inflation, as prices of goods used by household increases so with their fixed income they can now consume less than before. Naturally there is saving but it is not voluntary. Thirdly, people are forced to reduce consumption out of a given income if a large part of the income is taken away by the Government in the form of direct taxes. It is the case of forced saving. Saving of the house hold sectors are related to family income and family consumption expenditure. It is only when people abstain from current consumption, that they are able to save and such saving helps the growth of capital. The propensity to save of the household sector depends upon a variety of factors. The business sector also creates surplus. The surplus of the capitalist sector is reinvested in physical assets for further production and employment. According to Lewis the growth of capital is low in poor countries not because their people are poor but because their capitalist sector is so small. Growth of capital thus depends upon the growth of large scale industries that generate large amount of surplus for further investment.

4.6 CAPITAL FORMATION


Capital formation means the process whereby a nation creates capital assets that generate a continuous flow of income in future. The creation of such capital assets involves large scale investments and such investable resources come from surplus. Thus the essence of capital formation is creation of surplus or savings. Surplus generation is possible only when the nation does not use the entire production for current consumption but keeps a part of it for future production thus capital formation needs current sacrifice for future prosperity that is to-days pain for tomorrows gain. In a word Capital Formation is the process of creation of savings and its productive investment. In a wider context the formation of capital thus not merely means the growth of savings and investment but a qualitative change in mans attitudes and motives that may help development in the long run. Prof. W.W. Rostow opined, capital formation is not merely a matter of maximizing profit. It is a matter of a societys effective attitude towards science, applied science, risk taking as well as the adaptability of the working force. Thus capital formation has a quantitative as well as a qualitative aspect. The former is the growth of investment resources while the latter involves a qualitative change in human resources. Steps in Capital Formation

Capital formation is a long drawn process. It passes through three important stages. The first step in Capital formation is Creation of Surplus. Simply speaking, creation of surplus means increasing the ratio of saving to income. Out of a given income a country should save more if it want s to generate surplus. Savings can be increased in two ways. 1. If the level of personal income increases some increase in savings is quite natural. 2. Saving can also increase if people abstain from current consumption to a larger extent. While the ability to save depends upon the size of a mans income, his family liabilities, his standard of living etc., it also depends upon his willingness to save. The willingness to save is influenced by some personal qualities that motivate a man to save and these motives may vary from person to person. Not only the household sector but also the corporate sector and the public sector can contribute to the creation of savings. A Budgetary surplus is an important source of surplus generation in the Government sector. The private corporate sector too can contribute to surplus generation if they operate with efficiency. Thus the most important condition for Capital Formation is Creation of Surplus. The second step is mobilization of the surplus created. It implies the surplus resources should be activated and they should not remain idle. Mobilisation of savings depends upon the financial network of an economy. Banks and other financial institutions play an important role in the mobilization process. These institutions collect the surplus from the surplus units and lend them to the deficit units like businessmen, industrialists, traders etc. who are in need of fund. Thus they play an intermediary role connecting savers with the users of capital. The Financial systems can mobilize capital actively if they are safe and sound. The interest rate they offer may induce people to save more and to deposit it with the financial institutions. Thus the financial system of a country plays an important role in capital formation. The last step in capital formation is effective investment of the surplus. Funds offered by financial institutions are taken by those who invest them with the object of earning income, from investment of such funds in trade, commerce and industry. If the borrowed fund is used for unproductive and speculative purposes, it may bring windfall profit but without helping the creation of capital assets for future income. Such investment is not desirable. What is essential is that money must be invested for productive purposes purposes from which the investor can get a continuous earning over a period of time.

Study Note - 5
5.1 MONEY
Definition Money may be defined both broadly and narrowly. In a wider context money is what money does. It means that anything that performs the functions of money may be said to be money. This requires a discussion of the essential functions of money.

In a narrow sense it is defined as medium of exchange or payment whose acceptance the law required in discharge of debt may be called money. From this definition it follows that money is a medium of exchange. With the help of money any exchange of goods and services can take place. Besides this another feature of money is its general acceptability as a means of payment. The thing considered to be money must be accepted by all parties for transaction. Lord Keyens has emphasized another feature of money. Among all the assets of a man money is said to be the most liquid asset as it readily passes from one hand to another easily. Because of its general acceptability and because of this liquid characteristic of money, people prefer to hold it. Keynes called this liquidity preference. Generally money is created by the Central Bank or by the Government of a country. These are known legal tender money because there is legal compulsion for their acceptance. Such money is also called Cash Money. Besides cash money in a modern economy there is a considerable flow of Credit Money. Such money is created by the commercial banks by their loan transactions. These two together constitute the total monetary resources of a country. Functions of Money The functions discharged by money are many are varied. They may be classified as static and dynamic functions. The static functions are follows : Money is a matter of functions four A medium, a measure, a standard and a Store. (1) Medium of Exchange Money everywhere acts as a common medium of exchange. A man earns money not for its own sake but to purchase required goods and services in exchange of it. Thus in an exchange economy money has an intermediary role. In a barter economy, goods were exchanged for goods. But such direct exchange system encountered many difficulties. The origin of money lies in the inconveniences of the barter system. The invention of money has made the exchange system smooth and convenient. (2) Measure of value Money measures exchange value of goods and services. Things are said to be cheap or expensive on the basis of amount of money required for their possession. This makes exchange mutually profitable. (3) Standard of deferred payment Money as a standard of deferred payment implies the role of money in borrowing and lending. Money taken as loan is usually repaid after a time gap. This delayed payment is done through money. (4) Store of value Money gives a man command over goods and services because of its purchasing power. This purchasing power of money can be stored by keeping a part for future use. Not being perishable, value of money can be preserved for a long time. Simply this function implies monetary savings. Current income can be used for current consumption as well as future consumption by savings. Money plays a dynamic role in a modern economy. It lubricates the wheels of trade and commerce. Money is the life blood of industry. Money activated idle resources and puts them into productive channels. It thus, helps in increasing output, employment and income. Moreover money helps in converting savings into investment. Excess money income of the personal sector can be used by the business sector for purchasing inputs. It is Real investment. Besides, governments of modern economies can spend more than what they can. This by creating new money. Money, thus, is a potent factor in making governments economic goal more varied and dynamic. Like production, money helps in the distribution of national income among different classes of people. The power or purse is that it gives a man command over goods and services. In a word, money has made production, distribution and exchange system dynamic. Money is one of the assets possessed by a man. It is a valuable thing and its value lies in its purchasing power. Value of money means Exchange Value how much of goods and services can be obtained in exchange of a unit of money. Suppose price of a book is Rs. 10.

Then value of Rs. 10 is a book and value of a unit of a money (RE. 1) 1/10. In other words value of money is inverse of price (1/P). So when price level increases, the value of money decrease and vice versa. What we stated above is internal value of money. But money has its external value too. It means how much foreign currency can be obtained in exchange of a unit of domestic currency. It is the foreign rate of exchange. So while internal value of money is expressed in physical terms, its external value is expressed in terms of foreign exchange. Forms of Money The total money supply of a country can broadly be classified into two groupsCash Money and Credit Money. Besides it also includes all other financial assets. But the degree of moniness vary widely from asset to asset. Hence, it is necessary to discuss the components of money supply. Paper Money and Coins Paper Money and Coins known as Currency is issued by the Central bank or Government is the most important component of the money supply since they have cent per cent acceptability as a means of payment. Their acceptability is based on a promise to pay bearer gold and foreign exchange in exchange, if necessary. Equally important is Demand deposit with commercial banks. A bank is legally bound to pay money on demand. Currency and demand deposits can be used for almost all transactions much more easily than any other asset. Hence their moniness is highest. The other components of money supply consist of Near Money or money substitute. The well known near money is bank cheque (savings account). A bank cheque is a means of payment for transaction. If it is accepted it is as good as currency. But cheques may not be accepted because there is no legal compulsion behind their acceptance as that of currency. Hence they cannot be said to be money proper. Less liquid than savings bank deposit is the Term deposit of different maturities. They cannot be used before a fixed period say six months or five years. Other forms of financial assets Other forms of financial assets issued by non-bank financial intermediaries (NBFI) have moniness but they are not so much liquid as bank deposits are. Mortgaging units of UTI. Insurance Policy etc. one can have a car or building. But such transactions are rare and difficult. It is easier to get them by paying bank cheque or currency. As a means of payment, currency is most popular yet bulk of financial transactions are done by bank cheque. This is because is case of high valued goods like car, land, jewellery etc. payments are made by cheque instead of currency.

5.2 GRESHAMS LAW


The Law states that bad money drives good money out of circulation. This is true in case of bimetallism where two metal standard (gold and silver) operate side by side. In such a case one metal currency drives the other out of circulation. If also means cheap money drives out dear money. If a country uses both paper money as well as metal money, people will use the paper money and hold the metal money.

5.3 QUANTITY THEORY OF MONEY


The theory seeks to explain the relationship between money supply and price level. Irving Fisher used an equation to show that the relationship between money supply and price level as direct and proportional. It means money supply and price level move in the same direction and at the same proportion. Fishers equation is MV = PT...................(1) M stands for total Money Supply, V means velocity of circulation money which implies the average number of times that a unit of money changes hand during a particular period, P is Price level example. average price of GNP. T is Total National output.

The equation seeks to explain the proportional relation between M and P. That is to say, if in an economy M increases 5 fold, P will also increase at the same proportion. In other words the rate of change in money supply (dM/M) is equal to rate of change in P (dP/P). The proof is : M1V = P1T..................(2) M2V = P2T................(3) Now deducting equation (3) from equation (2) we obtain (M1 M2) V = (P1 P2) T dM.V = dP.T Dividing both sides by MV we obtain dM.V/MV = dP.T/MV Since Fishers equation states MV=PT Thus dM.V/MV = dP.T/PT Or, dM/M = dP/P Graphically the curve showing the relation between M and P will be a 45 degree line passing through the origin.

Money
Fishers theory is based upon three assumptions The relation between M and P will be proportional only when there are no changes in the value of V and T example. V and T are constant variables. (a) Velocity of circulation of money depends on the spending habit of people. Spending habit of people is, more or less, stable. Hence V will be constant normally. (b) T or GNP will be constant in situation of full employment when all the available factors of production are fully employed. At less than full employment, more money will lead to more output by utilizing unused factor. Hence P will not rise. (c) Fishers theory assumes that money is demanded for the transaction purposes only. People spend their entire income instantly for transaction. Criticisms (a) Fishers equation is abstract and mathematical truism. It does not explain the process by which M affects P. (b) It is presumed that entire M is used up in buying T instantly. It is unreal. No one spends all money the moment he earns it. Keynes pointed out that money is demanded for transaction purposes, precautionary purpose and also speculative purpose. Fisher does not explain the last two roles of money. (c) The concept full employment is myth. There is what is called Natural rate of unemployment in every country. (d) Even with full employment, a country can rise national output by bringing those factors which are not available within economy from abroad. (e) It is presumed that money is used for transactions only. Hence the theory is often referred to as Cash Transaction Theory. This ignores the other roles of money. Q.T.M. Cash Balance Approach The Cash Balance Approach states that it is not total money but that portion of cash balance people spend that influences price level. True people hold cash balance in their hands instead of spending the entire amount all at once. The new equation is M = PKT. Here the proportion of M that people use for purchasing T influences P. PK constitutes demand for money and M is money supply. Fishers Quantity Theory of Money differs from the Cambridge Equation in some respects. Firstly, in the Fishers version demand for money is to exchange goods. People demand money for transactions only. In the Cambridge version the demand for money is primarily as a store of value. Secondly, Fisher explains the value of money for a period of time, while the Cambridge

Theory considers it at a point of time. Thirdly, in the Fishers version emphasis is on velocity of circulation of money while in the other theory the emphasis is on idle cash balances representing a part of the total income. Velocity is the exact opposite of idleness. The Quantity Theory by Keynes Keynes reformulated the Quantity Theory of Money. In his opinion the quantity of money does not directly affect price level. But it does so indirectly through a long process of event. A change in the quantity of money may lead to a change in the rate of interest. With a change in the rate of interest the volume of investment is quite likely to change. A change in investment will lead to a change in income, output and employment and also a change in cost of production. This will lead to the change in prices of goods and services. According to Keynes the basic weakness of the orthodox quantity theory is that it fails to pay adequate attention to the influence of money on the rate of interest and the consequent influence on output and employment. Thus the Keynesian version of the Quantity Theory integrates monetary theory with the general theory of value. The value of money is not determined solely by its supply but by all other variables in the economy.

5.4 INFLATION
Definition Generally when price level of an economy goes on rising continuously it is known as inflation. So the symptom of inflation is rising price level. More precisely it is Open inflation. But an economy may suffer from inflation without any apparent rise in prices. This is Repressed inflation. Inflationary forces are being repressed by policy measures. According to classical writers inflation is a situation when too much money chases too few goods. In other words it is an imbalance between money supply and Gross Domestic Product. Whereas according to Keynes inflation is an imbalance between aggregate demand and aggregate supply. In an economy if the aggregate demand for goods and services exceeds aggregate supply, then prices will go on rising. Causes The primary causes of inflation may arises from either demand side or supply side. Accordingly we find two types of inflation. Demand Pull Demand pull inflation is a situation when in an economy aggregate demand exceeds aggregate supply. Aggregate demand may increase due to an increase in money supply, or money income or public expenditure. The idea of demand inflation is associated with full employment when supply cannot be altered. Cost Push Inflation may originate from supply side also. Aggregate demand remaining unchanged, a fall in aggregate supply due to exogenous cause, may lead to increase in price level. Price is related to cost. If cost rises price are bound to increase. The cost structure may rise because of (a) wage increase not associated with productivity rise, (b) rise in profit margin (c) high import price (d) shortage of essential inputs. Often inflation is caused by structural maladjustment and unbalanced growth of the different sectors of an economy. A faster rate of growth of the industrial sector and a very slow growth of the primary sector may lead to an increase in food prices which may ultimately lead to an increase in the general price level. This is called Structural Inflation, which is generally found in the less developed countries of the world. Let us now discuss in detail the various causes that may bring about inflation. Since inflation is either of the demand-pull or of the cost-push type, it is obvious that these causes always have

something to do with either an increase in aggregate demand or an increase in aggregate demand or an increase in cost of production. (1) Increase in public spending : Spending by the Government is an important part of total spending in any modern economy. It is a total spending that determines a total demand. Thus, Government expenditure is an important determinant of aggregate demand. In most of the less developed economies in recent decades. Government expenditure has shown an upward trend. In India, for instance, ever since the beginning of planning, the amount of government spending has increased by leaps and bounds. (Some of this was wasteful spending and could easily have been avoided.) This has created inflationary pressure on the economy. (2) Deficit financing of Government spending: If the increase in government spending is financed by taxation, the problem would not have been so severe. Because, taxation would have taken money away from the hands of the people and would have lessened the pressure of demand in the market. However, in practice, Government spending increases beyond what can be financed by taxation. In order to be able to incur the extra expenditure, the Government resorts to deficit financing. For instance, it prints money and spends it. This adds to the pressure of inflation. (3) Increased velocity of circulation : The total use of money in the market is the amount of money supply by the Government multiplied by the velocity of circulation of money (example., the rate at which money changes hands among the people). During the boom phase of the business cycle, people spend money at a faster rate. The velocity of circulation of money increases. This also creates inflationary pressures on the economy. (4) Population growth : Growth of population also obviously increases total demand in the market. If the supply of goods and services does not keep pace with demand, the pressure of excess demand will create inflation. (5) Hoarding : Excess demand is sometimes artificially created by hoarders. They stockpile commodities and do not release them to the market. Naturally, this leads to excess demand and inflation. (6) Genuine shortage : Sometimes, of course, the shortages are not artificial but genuine. If, for some reason, the factors of production are in short supply, production will be affected. Since supply will be less than demand, prices will rise. (7) Exports : Sometimes, exports create shortages in the domestic economy. Suppose that the total output of a commodity is not sufficient to meet both domestic and foreign demand. It can be either exported or domestically consumed. Under these circumstances, exports will create inflation in the domestic economy. (8) Trade unions : Sometimes, trade unions contribute to inflationary pressures. By demanding an increase in the wage rate, they increase the cost of production. This creates cost-push inflation. (9) Tax reduction : In democratic societies, Governments sometimes reduce taxes (particularly income-taxes) in order to gain popularity among the voter. This happens, particularly, in election years. Since this leaves more money in peoples hands, this leads to inflation if there is no corresponding increase in production. (10) Imposition of indirect taxes : If the government imposes indirect taxes (such as excise duty, value-added tax etc.) then producers or sellers raise the product prices to keep their profits unchanged. This leads to inflation. (11) Price-rise in the international market : If the price of some commodities or factors of production, which are imported, rise in the world market then it would lead to inflation in the domestic market (of the importing country). (12) Non-economic reasons : Finally, we should note that sometimes inflation takes place due to some non-economic reasons. For instance, at times of natural calamities, (example., floods) crops are destroyed, reducing the supply of agricultural products. Prices of these

commodities tend to increase. This brings about an increase in the general price level. Forms of Inflation Inflation may be of different forms. On the basis of origin, inflation may be classified into two typesDemand Pull and Cost Push. The former implies a situation when aggregate demand for goods and services exceeds aggregate supply. It is a situation of imbalance between aggregate demand and aggregate supply. Cost push inflation, on the other hand, is the type of inflation which is caused by increase in cost structure. The structure of cost of production in a country can increase either because of an increase in the wage level not matched by increase in labour productivity or it may be caused by increase in profit margin earned by monopoly firms. Inflation may again be classified into two formsOpen inflation and Repressed inflation. In case of Open inflation the continuous rise in price level is visible in the naked eye. One can see the annual rate of increase in the price level. But in case of Repressed inflation, there is excess demand but that excess demand is prevented from increasing price level by some repressive measures taken by the government like price control, rationing etc. On the basis of the degree of price rise inflation can be classified into three groups Hyper inflation, Creeping inflation an Moderate inflation. In case of Hyper inflation the price level goes on rising at a very fast rate. Often there happens hourly increase in price level. It often leads to demonetization. On the other hand, in a period of Creeping inflation the price level increases very slowly over a period of time. In between these two extreme forms of inflation there is Moderate inflation when the rise in price level is neither too fast nor too slow. Further inflation may be True inflation or Semi-inflation. According to Keynes, True inflation takes place after full employment of all factor inputs in an economy. In a situation of full employment, the National output becomes perfectly inelastic. In such a situation more money will lead to higher prices and not more output. But even before full employment, a country may experience inflation arising from bottlenecks. There may be inflationary price rise in some sectors of the economy. It is what is called Semi-inflation. Effects of inflation on different groups in a society Inflationary pressure in an economy my generate good effects on the economy, particularly in case of creeping or walking inflation. Favourable impacts : (a) Higher profits : Profits of the producers are generally favourably affected by inflation, because they can sell their products at higher prices. (b) Higher investment : The entrepreneurs and investors get added incentives to invest in productive activities during inflation, since they can earn higher prices. (c) Higher production : If productive investment grows during inflation, it would lead to higher production of various goods and services in the economy. (d) Higher employment and income : Increase in the output of different goods during inflation would also mean increasing demand for various factors of production. So, it is expected that employment and income opportunities will also increase during inflation. (e) Possibility of higher income for the share-holders : During inflationary periods, if the companies earn higher profits, they can declare dividends for their share-holders. Hence, the dividend income of the share-holders may also rise during inflation. (f) Gain for the borrowers : Inflation means a decrease in the value or purchasing power of money. If the rate of interest to be paid by the borrower is less than the inflation rate, the borrower will gain. Because the real value of the money returned by the borrower is actually less than that of the money borrowed earlier. Unfavourable consequences : (a) Fall in the real income of fixed-income groups : Real income means purchasing power of money income [Real income = (money income ) / (price level).] Given the money

income of the fixed-income groups, the real income will fall during inflation. Hence, inflation affects workers, salaried people and pension-earners adversely. (b) Inequality in the distribution of income : The profit incomes of businessman and entrepreneurs increasing during inflation while the real income of the common salaried people declines. So, inequality in the distribution of income become acute during inflation. (c) Upsets the planning process : Inflationary pressure may also upset the entire planning process in an economy. When prices of goods, materials, and factor services increase continuously, then more money has to be spent for the completion of any investment project taken up during any planning period. If more financial resources cannot be raised by the Government (through savings or taxation), plan targets are to be curtailed. (d) Increase in speculative investment : If the price level rises at a fast rate, speculative investment (say, purchasing shares, land, gems, etc., just for speculative purposes) may increase in the economy for earning quick profits. These types of investments do not help in the creation of productive capital in the economy. (e) Harmful impact on capital accumulation : If the price-rise becomes chronic, people prefer goods to money (because the real value of money will fall in future). They also prefer immediate consumption to consumption in future. So, their desire to save is reduced. At the same time, their ability to save also becomes less because, with their given money income, they have to spend more for purchasing the same quantity of goods and services. When both ability and willingness to save become less, a smaller amount of fund becomes available for further investment. As a result, it creates a harmful impact on capital accumulation, since capital accumulation in an economy depends on the growth of investment. (f) Lenders will lose : We have already indicated that borrowers will gain during inflation For this same reason, lenders will lose during inflation. Because, they are actually receiving an amount having lower value (or purchasing power) than before. (g) Harmful impact on export income : If the prices of export items also increase during inflation, their demand in the foreign market may fall. This leads to a fall in the export income of a country. Control of inflation If we want to control inflation (example., to stabilize prices) we must first know what caused the inflation in the first place. The treatment of the disease must depend on its cause. There are two reasons behind inflations. Firstly, if demand for a commodity in the market exceeds its supply, the excess demand will push up the price. This type of inflation is called demandpull inflation. Secondly, if factor prices rise, costs of production rise. Hence, the price of produced goods rise. (The rise in factor prices may not have any relation to demand.) For instance, wages may increase under trade union pressure. This second type of inflation is called cost-push inflation. These two types of inflation cannot be controlled by the same types of policies. For controlling demand-pull inflation we have to ensure a fall in demand. This can be done in mainly two ways : (1) Monetary measures : If the supply of money in the economy can be decreased, prices will fall. The quantity of money and the price level change in the same direction. Hence, if the quantity of money decreases, the price level will fall. Now, the supply of money can be decreased in different ways. If the government withdraws paper notes and coins from circulation, the money supply will decrease. But usually this is not how money supply is reduced. The lions share of the total money supply is bank deposits or bank credit. Only if we can reduce the rate of lending by banks, we can reduce the total supply of money significantly. The Central bank of a country can reduce the lending of commercial

banks in different ways, for instance, by raising the bank rate and reserve requirements of banks, by open market sales of securities, etc. These are called quantitative credit control policy of the Central Bank. . (2) Fiscal policy : Fiscal policy, example., the policy of changing tax rates or the rate of Government expenditure, can also be adopted. If the tax rate is increased, less money will be left in peoples hands. As a result, demand in the market will go down. If the Government reduces its own expenditure, then, too, the demand in the market will fall because Government expenditure creates demand in the market [For instance, Government employees meet their costs of living out of their salaries. Again, if the Government purchases an input for the purposes of a development project (example., cement), this Government demand is added to the private demand for this input in the market]. An inflationary gap arises when aggregate demand exceeds the maximum potential supply in an economy. To overcome this situation, the following types of fiscal measures can be undertaken (1) A decrease in the Government expenditure; or, (2) A decrease in the Government transfer payments (example., pension payments by the Government, unemployment benefits paid by the Government); or, (3) An increase in taxes imposed by the Government; or, (4) A combination of all these measures. These are regarded as contractionary fiscal policies. These contractionary fiscal policies reduces the employment and income opportunities within the economy. For instance, an increase in the tax rate reduces the disposable income of the consumers. Hence, these policies restrict the growing demand for goods and services within the economy, help in controlling the inflationary pressure. But these methods of controlling inflation by reducing demand apply only to the case of demand pull inflation; cost-push inflation does not have any relation to demand. Even if demand falls, this latter type of inflation will continue. To control this type of inflation, one must resort to direct control. (3) Direct control : By direct control we mean such measures as wage freeze, putting upper limits on the prices of such important inputs as electricity, coal, steel, etc. (4) Other measures : The three measures discussed above play the major part in controlling inflation. Sometimes, however, other measures are taken. These measures are : augmenting the supplies of commodities in the domestic market by increasing imports, increasing domestic production, etc. However, these other measures are not given much importance. If imports exceed exports, the country will face balance of payments problems. Increasing domestic production is easier said than done. Since inflation arises in the first place because demand has outstripped supply, it must be the case that it is difficult to increase production. Otherwise, output would have automatically increased under demand pressure.

5.5 DEFLATION
Deflation is an economic phenomenon. It is a situation when the price level of an economy goes on falling continuously. Thus it is the reverse of inflation. In a period of demand pull inflation, an economy enjoys prosperity. Its employment, output and income go on rising. But in a period deflation the country suffers from all round depression. There is large-scale unemployment, unused productive capacity and a fall in National Income. Further in a period of inflation the working class suffers because their real wages fall. Now they can have smaller quantity of wage goods in view of high prices and fixed income. In a period of Deflation workers are not likely to suffer from such consequences. Yet in a period of deflation the workers suffer because as production decreases workers are thrown out of

employment. Thus both inflation and deflation are harmful for the working class. Further in a period of inflation the income of the industrialist, businessmen, traders to on rising and these classes of people have a higher propensity to save. This is helpful for capital formation. But in a period of depression these classes of people suffer most. Their income falls leading to a fall in investment, production and employment.

5.6 INVESTMENT AND RATE OF INTEREST


By investment we mean a change in the stock of capital over a period of time. The rate of interest is a significant factor in investment decisions of a firm. Generally investments are undertaken upto the point at which the yield from an asset cover the cost of investment. While the return is expected, the cost is actual. The condition for maximization of net return from investment is that the present value of expected returns is equal to the initial cost. The rate of interest represents the cost side of investment. A change in the rate of interest(r) has a direct impact on the return on a sum of money lent and so the rate of accumulation of the capital stock. An increase in the rate of interest leads to future incomes being discounted more heavily. The effect is that some investments are not undertaken, as they now fail to cover the cost. Some less productive investment are thus abandoned. And those investments that yielded net returns now becomes marginal investment in the sense that their returns at the margin just cover cost. Thus the level of planned investment is inversely related to interest rate, assuming other variables unchanged (dI/dr) < 0. The graph shows the investment function I = f(r). It is often said that at a very low rate of interest, investment decisions will be interest inelastic example. at low rates of interest marginal changes in the rate will not affect investment plans. If this were true then the curve showing I = f (r) would not be down ward sloping but be vertical below a certain rate since then dI/dr = 0. To sum up, while the classical economists were of the opinion that investment was sensitive to interest, Keynes thought that this was small. The more important factor was future cash flows.

Study Note - 6
BANKS
6.1 COMMERCIAL BANK
A bank is said to be a financial intermediary. It stands midway between the savers and the

users of fund. The decision to save and the decision to invest are ruled by separate set of motives. A banks major role is ironing out the differences between two rival factions. There are different types of bank having some common and some special functions. Banks may be of various types such Central Bank, commercial banks, development banks, cooperative banks, rural banks etc. Of these the Central Bank, the commercial banks and the development banks are of primary importance. Definition and Functions of Commercial Banks A commercial bank is a financial intermediary. It solicits deposits from the surplus units and lends financial resources to the deficit units. Its central objective is commercial that is, profit making. It takes money by paying a low rate of interest and lends the same fund at a higher rate of interest and thus makes profit It is said to be a dealer in credit. It may be organized privately or by the Government. The two primary functions of such a bank are Deposit function and Loan function. Bank accepts deposits from the public, and offers interest to the depositors. Deposits may be of three types : Demand or current, Savings and Fixed or Time deposit. Demand deposit is the fund that a depositor can withdraw on demand and it bears no interest. It is as useful as cash money. Savings deposits is notice deposit in case a large sum is withdrawn a bank must be given prior notice. The depositors earn interest on their savings. Time deposits imply deposit of funds for a fixed period say, one year. Bank is not bound to pay the sum before the expiry of the period. Such deposits carry higher rate of interest. The longer the period the higher the rate of interest bank offers. Generally, deposits are chequable accounts in the sense that a depositor can withdraw funds by cheque and can also settle transactions by the use of his bank cheque. But chequable transaction has one danger. A man may have given an amount of money deposited with a bank (say Rs. 500). But if he draws a cheque lack general acceptability as a means of payment. It is only the commercial banks that are pure depository institutions. They take Demand deposits. The funds thus obtained from various classes of people are pooled together and lend to users of capital. Banks do not lend the entire sum of deposit. But keep a portion in the form of cash. This is called Cash Reserve Ration (CRR) in order to meet the unforeseen demand of some depositors. CRR is the most liquid among all assets of a bank but it is zero yielding. Total deposited amount minus CRR is what bank can lend to private sector and invests in government securities. In its loans and advances, banks maintain a diversified portfolio in order to seek a balance between liquidity and profitability. A commercial bank is a dealer in short term securities That is it lends money for short term as it mainly accepts deposits that are payable on demand or at short notice. Banks perform some other functions that enhance their yield. They keep valuables in their custody, collect chequable amounts, in the purchase and sell of shares, debenture they act as agents of their customers. Besides they act as trustee and executors of wills, pay bills of customers. Functions of a Commercial Bank Modern commercial banks perform a variety of functions and provide a number of services to their customers. Traditional functions performed by commercial banks are : acceptance of deposits from the public and provisions of credit to different sectors of the economy. However, with the growth of modern banking, the banks have started providing a variety of services to their customers. Modern banks are regarded as departmentalstore banks because they provide a wide variety of services to their customers. Various functions performed by commercial banks are as follows: 1. Acceptance of deposits - The most important function of a commercial bank is to accept deposits from the public. People who have surplus funds with them would like to deposit these with commercial banks for one reason or the other. Banks accept mainly three types of deposits :

(a) Current Account : Deposits in current account are payable on demand. That is why current accounts are also known as demand deposits. These deposits can be drawn upon by cheque without any restriction on the amount or number of withdrawals made. These accounts are mostly held by traders and businessmen who use them for making business payments. Bank do not pay any interest on these accounts. Banks provide various services to the current account holders. Such as making payment through cheques, collection of payment of cheques, issuing drafts on behalf of the account holders. Etc. Banks, in fact, levy certain service charges on the customers for the services rendered by them. (b) Savings Bank Account : Savings account deposits (Savings bank accounts) are payable on demand and money can be withdrawn by cheques. But there are certain restrictions imposed on the depositors of this account. Banks impose a limit on the amount and number of withdrawals during a particular period. These accounts are held by households who have idle cash for a short period. Deposits in this account earn interest at nominal rates. (c) Fixed Deposits : The money in these accounts is deposited for a fixed period, viz., 6 months, one year, two years, five years or more. These deposits are not payable on demand. They do not enjoy cheque facilities, example., cheques cannot be issued against them for making payments. These deposits are also known as time deposits since the money deposited in them cannot be withdrawn before the maturity of the period for which the deposit is made. For instance, if a person has deposited money in this account for a period of 2 years, legally and technically, he cannot withdraw the money before the expiry of the 2 year period. In practice, however, banks allow the depositors to withdraw funds from such deposits even before the maturity period, provided they are willing to lose a part of interest. These deposits are made by persons who have funds to spare for some time. Fixed deposits are interest-earning deposits. The interest on these deposits in higher than saving deposits. The rate of interest varies with the length of time for which the deposit has been made. Thus, the rate of interest on a two-year deposit is higher than that on a one-year deposit. For example, at present a one-year deposit earns an interest of 6.25 per cent, but for a deposit of three years or more, the rates is 6.5 per cent per year. Recurring (or cumulative) deposits are one type of fixed deposits. In this case, a depositor makes a regular deposit of a given sum (say, Rs. 2,000 per month) for a specified period (say, 2 years). Such deposits are designed to motivate the small savers to save a particular amount regularly. 2. Advancing of Loans The second primary function of the commercial banks is to extend loans and advances. Lending is the most profitable business of a bank. Banks charge interest from the borrowers which is more than the interest they pay to their depositors. Commercial banks act as intermediaries between the depositors and the borrowers. They make profit out of these transactions. Banks these days extend loans and advances to their customers in the following ways (1) Outright Loans (Term Loans) : Banks provide outright loans for a fixed period. In this case, the entire amount of the loan sanctioned is credited to the borrowers current account. The borrower pays interest on the entire amount he has borrowed. (2) Cash credit : In this case, the entire sanctioned amount of loan by the bank is not given to the borrower at a particular time. The bank opens an account of the borrower and allows him to withdraw the borrowed amount as and when he required the money. The bank charges interest, not on the amount of loan

sanctioned, but on the actual amount withdrawn from the bank. Cash credit is very popular with the Indian businessman. (3) Overdraft facilities : In many cases, banks provide overdraft facilities to their customers. When a customer gets an overdraft facility from a bank, this means that he is allowed to draw cheques in excess of the balance standing to his credit to the extent of the amount of overdraft. For instance, if a bank has provided overdraft to the extent of Rs. 10 lakh to a businessman, he can draw cheques in excess of the amount of his own deposits with the bank to the tune of Rs. 10 lakh. The bank charges interest only on the amount overdrawn. For a businessman, the overdraft facility is the easiest and most convenient method of borrowing from banks. (4) Discounting Bills of Exchange : An important form of bank lending is through discounting or purchasing the bills of exchange. A bill of exchange is drawn by a creditor on the debtor specifying the amount of debt and also the date when it becomes payable. Such bills of exchange are normally issued for a period of 90 days. This means that the creditors cannot get it encashed from the debtors before the maturity of the 90 days period. However, if the creditor needs money before the expiry of this 90days period, he can sell it, example., he can get it discounted from a commercial bank. The bank makes payment to the creditor after deducting its commission. When the bill matures, the bank will get payment from the debtor. Thus, by discounting bills, the bank pays money to the creditor when be needs it and allows the debtor to make payment only when the bill is due for payment. Discounting of bills of exchange is, therefore, really one form of bank lending. 3rd. Facilitation of payments through cheques Banks have provided a very convenient system of payment in the form of cheques. The cheque is the principal method of payment in business in recent times. It is convenient, cheap and safe means of making payments. 4th. Transfer of funds Banks help in the remittance or transfer of funds from one place to another through the use of various credit instruments like cheques, drafts, mail transfers and telegraphic transfers. 5. Agency Functions Banks provide various agency functions for their customers. The banks charge commission or service charge for such functions. The main agency functions are : (a) The commercial banks collect cheques, drafts, bills of exchange, hundies and other financial instruments for their customers. (b) They make and collect various types of payments on behalf of their customers, such as insurance premia, pensions, dividends, interest, etc. (c) The commercial banks act as agents for the customers in the sale and purchase of securities. They provide investment services to the companies by acting as underwriters and bankers for new issues of securities to the public. (d) They render agency services of various types, such as obtaining foreign currency for customers and sale of foreign exchange on their behalf, sale of national savings certificates and units of U.T.I. (e) The commercial banks act as trustees and executors. For instance, they keep the wills of their customers and execute them after their death. 6. Miscellaneous Services Commercial banks provide various miscellaneous services, such as provision of locker facilities for safe custody of jewellery and other valuables, issue of travelers cheques, gift cheques, provision of tax assistance and investment advice, etc. 7. Credit Creation A very important and unique function of the commercial banks is that they have the power of credit creation. In the process of acceptance of deposit and granting of loans, commercial banks are able to create credit. This means that they are

able to grant more loans than the amount of initial or primary deposits made by the customers. This function is discussed below in detail. In short, commercial banks perform a large variety of functions in the modern economics. Essentials of a sound banking system A sound banking system promotes all round economic development of an economy. A good bank must have the following features : (a) Adequate Liquidity A bank must keep sufficient cash in hand to meet the claim of depositors, otherwise they would be insolvent. A bank failure not only affects depositors but banks also. People would not more keep funds with bankers. It ensures safety of a bank. Unless a bank is safe it cannot render its social services. (b) Expansion of banking Banking facilities should spread throughout the economy. It must also cover all sections of people in need of funds and all productive activities. The less-developed regions should get more banking facilities than others. Thus, diffusion of banking offices is essential. (c) Investment and Loan policies A sound banking system must have a sound investment policy whereby it can optimize the twin goals of liquidity and profitability. If loan and investments are wrong, a bank suffer loss or face liquidity shortage. A prudent banker should carefully determine the composition and character of its loans and advances so as to optimize earning without endangering safety and solvency. (d) Human Factor The soundness of a bank depends much on the quality of banker. Banking being a practical affair, rigid application of bank laws are not always fruitful. Much depends on the discretion of men piloting the ship. Sound banking thus, depends more on banking personnel than on banking laws. Credit Creation by Commercial Bank A commercial bank is called a dealer of credit. But it is more than that. It can create credit example. can expand the monetary base of a country. It does so not by issuing new money but by its loan operations. Banks do not create money out of air. But on the basis of the cash deposit. The process of credit creation is that the depositors think they have so much money with banks and borrowers from bank say they have so much money with them. Summing the two, we find an amount more than the cash deposit. Suppose a bank receive a sum of Rs. 1000 as deposit, keeps with it 20% (Rs. 200) as CRR and lends and rest. Depositor will claim he has Rs. 1000 and bank borrower too possesses Rs. 800. Thus total money supply appears to be Rs. 1800 only. It is the credit creation by a single bank. The above example can be extended to cover the banking system as whole. Suppose Rs. 800 is deposited to another bank. This banks base will now expand. It will keep 20% of Rs. 800 (Rs. 160) as cash reserve and will lend Rs. 640. This sum is redeposited to a third bank which keeps 20% of 640 (Rs. 128) grants a loan of Rs. 512. This process will continue and the amount of fresh deposit will go on falling. A time will come when deposited sum will be equal to CRR. The process will then come to an end. Limitations of Credit Creation : The multiple credit creation process depends on some factors : (a) Much depends on the size of the cash reserve ratio. If it is cent percent multiplier will be zero. Thus an inverse relation exists between CRR and the size of the multiplier. So credit creation is inversely related to CRR. (b) Credit creation depends upon the amount of loan given. If society does not borrow, as it happens in a period of economic depression, bank can neither lend, nor can create credit. If borrowers cannot offer security against loan, bank

cannot lend. (c) Size of the cash deposit is also important in this context. The smaller the cash base the smaller scope a bank gets for credit creation. If people prefer physical assets or prefer to keep cash in their hand, bank deposits suffer much. So bank cannot lend much. (d) A bank can lend money against acceptable securities. A borrower gets a loan from a bank only against some securities the value of which must be equal to the amount of the loan. If a bank does not get an acceptable security it cannot lend money even though it may have large amount of cash money for credit creation. (e) The Credit creating power of commercial banks is substantially controlled by the Central Bank. A Central Bank possesses certain instruments by the use of these it can increase or decrease the volume of credit created by banks. It can also control the purpose and direction of credit given by banks. The banks accept the Central Banks directions because the Central Bank is their lender of last resort.

6.2 CENTRAL BANK


Central Bank may be defined as an institution charged with the responsibility of managing the expansion and contraction of the volume of money supply for general Economic Welfare. The Central Bank is the apex institution in the banking and financial structure of the country. Functions of Central Bank: Central Bank plays a leading role in organizing, running, supervising, regulating and developing the banking and financial structure of the country. 1. Monopoly of Note Issue : The Central Bank enjoys the exclusive power of note issue. In India the RBI issues all notes except Re 1 notes and coins. Re 1 notes are issued by the Government of India under the guidance of RBI. The currency notes issued by the Central Bank are declared unlimited legal tender throughout the country. The Central Bank has to keep reserve of Gold, Silver and foreign securities for issuing notes. 2. Banker, agent, advisor to the Government : The Banking A/c of the government both central and state are maintained by the Central Bank as the commercial bank does for its customers. As a banker and to the government it helps the government in short term loans and advances for temporary requirements and floats public loans for the government. As an advisor to the government the Central Bank advices on monetary and Economic matters. It also advices on the ground as to how to maintain the internal and external value of money. 3. Bankers Bank : All commercial banks keep part of their cash balances as deposits with the Central Bank of the country. This is either because of convention or legal compulsion. The commercial banks regularly draw currency during the busy season and paying in surplus during the slack season. Part of these balances are meant for clearing purposes example.; all commercial banks keep deposit account with the Central Bank. The deposit balances of the Central Bank is considered as cash reserves for general purpose. Under the Banking Regulations Act of 1949, the Central Bank of India have been empowered with the right to supervise and control the activities of various scheduled commercial banks. These powers are related to licensing, branch expansion, liquidity of assets and methods of working of the Bank. 4. Clearing House Facility : By virtue of its unique position in dealing with domestic and foreign funds the Central

Bank has a special position for conducting a) clearing house Operation; b) Inter bank Transfer of funds; c) Settlement of accounts. Clearing house facility means providing an opportunity to member commercial banks to settle their claims on each other mutually. Example. : Indian Bank has to pay to SBI a sum of 2 lakh and SBI has to pay to Indian bank Rs. 1,50,000. This can be settled with a check of Rs. 50,000 by Indian Bank on the RBI in favour of SBI. As a result Indian Banks accounts will be debited and SBIs account will be credited. 5. Custodian of Foreign Exchange Reserves : Under this system the RBI controls both receipts and payments of foreign exchange. A country have in its foreign trade favourable or unfavourable balance. Favourable balance helps to bring foreign exchange to the country while unfavourable balance means paying foreign exchange out. As custodian of Foreign Exchange Central Bank keeps a constant watch on the same so that the value of the home currency does not rise or fall adversely in relation to foreign currency. During times of emergency the Central Bank may impose restrictions to control on buying or selling of foreign currencies in the market. 6. Credit Control : In order to ensure price stability and Economic growth of a country, the Central Bank undertakes the responsibility of controlling credit. The Central Bank ensures price stability and avoids inflationary and deflationary tendencies by several monetary methods such as regulation of Bank rate, open market operation, change in variable reserve ratio, etc.

Credit Control by Central Bank


Credit money created by commercial banks and other non-banking financial institutions constitutes a significant portion of total money supply in an economy. Their shortages and excesses may have profound impact upon an economy. Hence the flow of credit be regulated in such a way that they may rise or fall according to the needs of an economy. This is what we generally means by credit control. This is done by the central bank in its role of a bankers bank. The objective of credit control is generally two fold. A central bank either encourages member banks to expand credit or it may restrict credit-creating power of banks and non-banks. The former is known as expansionary monetary policy, which is adopted to lift an economy out of depression and unemployment. The latter is restrictive policy to fight inflation and to achieve financial stability. In the context of growth with stability a central bank is to deal with both aspects increasing credit flow for more investment and, at the same time, restrict flow of credit so that it may not generate inflation. The task is, after all, very difficult.

Control Weapons
A central bank possesses a number of instruments for controlling credit money. These are of two types Quantitative and Qualitative. Quantitative techniques seek to regulate total quantity of credit while qualitative measures affect the availability of credit. Second, quantitative measures do not take into account the need or use of credit at the micro level. The qualitative controls, on the other hand, are intended towards sectoral deployment of credit. They are directional rather than general. The qualitative techniques, moreover, are selective and purposive. They affect the use of credit for selected purpose. While quantitative control measures affect credit at all levels and for all purposes. Orthodox control techniques are basically quantitative in nature. They seek to regulate the volume of credit in two ways by altering the cost of credit and also its total quantity. In this category fall three techniques Bank Rate, Open Market Operations and variantion of Reserve Ratio (VRR).

A. Quantitative Methods : 1. Bank Rate Policy As a bankers bank, a central bank lends money or rediscounts the bills of commercial banks. The rate of interest charged by the central bank is known as Bank Rate or Discount rate. By manipulating Bank Rate central Bank can regulate the credit creating power of member banks. If Bank rate is raised by the Central Bank, commercial banks are to borrow at a higher cost. Naturally they will increase their lending rate. This rate is known as the Market Rate. The commercial banks market rate is higher than Bank Rate of the central bank. The difference between Market Rate and Bank Rate is the profit margin of commercial banks. So when bank rate rises market rate also rises and vice versa. If the objective of the central bank is to restrict credit, it will raise Bank Rate. As Bank Rate rises Market Rate will rise. That means a rise in the cost of credit. Demand for bank loan will reduce. On the other hand, for credit expansion, Bank Rate is reduced. This is the process of Bank Rate manipulation A change in Bank Rate effects aggregate level of credit and it does so by influencing the cost of credit. The effectiveness of this technique depends on the extent to which commercial banks depend on central bank for loan and rediscounting. If banks can collect funds from other sources at relatively cheaper rate, they need not depend on central bank credit. Secondly, if investment opportunities are not present market demand for credit is weak, a fall in the bank rate may not raise the level of bank credit. 2. Open market operations It is a quantitative tool used by the central bank with the primary objective of influencing the volume of bank credit. It implies purchase and sale of securities in the stock market. When the central bank appears in the market as a seller of Government securities, people buy such securities by withdrawing money from banks or the banks themselves invest in such securities instead of granting loan to public. In either case the powers of creating credit will be restricted. On the other hand, if central bank buys securities money flows out thus enlarging the cash base of members banks. Thus open market operations pumpin or pump-out money from circulation. The volume of credit can be substantially affected by this technique money from circulation. The volume of credit can be substantially affected by this technique because of multiple credit expansion or contraction. The extent of sale operation depends on peoples willingness to buy securities. It may not also reduce banks deposit and loan if people purchase securities from unaccounted or hoarded money. Secondly even if the central bank injects more funds, banks may not lend. Credit expansion depends upon external business environment and borrowers attitudes over which banks have no influence. 3. Variation of Reserve Ratio Commercial banks are legally bound to keep a portion of their deposits in the form of Cash Reserve. It is the most liquid asset in their hand and at the same time it is zero earning asset. The size of the credit multiplier example. the extent to which the banking system can create credit out of a given amount of deposit, depends inversely on Cash Reserve Ratio. Usually the ratio is fixed by the central bank of an economy. Naturally by altering the CRR, the central bank can expand or reduce the funds bank can lend. There exists an inverse relation between the size of cash reserve and the amount of credit given by a bank, assuming a given amount of deposit. It is the easiest way of changing banks lending capacity. Not only easiest but a quick way too. Its effects are immediate., Therefore in underdeveloped money market this technique is more suitable than open market operation or Bank Rate policy. It has no side effects like a change in security prices.

B. Qualitative credit controls The three controls discussed earlier seek to control the total volume and cost of credit by affecting over all bank reserves. A central bank also possesses certain techniques by which it can control the direction and distribution of credit-purpose wise or areas wise. Such techniques are called selective or qualitative measures as they seek to influence the quality of credit or its selective and purposive use. Such control techniques are two-edged. They may be used for restricting the flow of credit to inessential and less desirable purpose but giving concessions to productive sectors or sectors with priorities. Broadly, the purpose of selective controls is the rational allocation of scarce bank credit and its economic utilization. Further sectorial deployment of credit and controlling in other directions serve the purpose of preventing speculative activities with the help of bank finance and favouring productive activities. These techniques are very helpful in a less-developed economy where overall credit restriction may hinder growth by preventing the flow of credit for investment. By allowing free flow of credit to productive sectors. They promote growth and by curtailing it to speculative and unproductive sectors check the danger of instability. Moral Suasion Moral suasion is a qualitative technique. By this measure, the central bank requests banks to lend more or not to lend in some sectors. There are no legal compulsion behind their acceptance. Generally if a request is not carried out by the member bank, the guardian of the banking system may take such steps as banks are forced to accept. The central bank is often empowered to issue Directives to member banks. Such direct orders are in the form of directional control, prohibiting loans of particular type or giving advice to grant loan priority sectors. Distinction between the Central Bank and the Commercial Bank The Central Bank differs from the commercial banks in several respects mentioned as under : (a) The Central Bank acts as the supreme monetary authority of the country with wide powers control credit and currency of the country. But a commercial bank has no such powers. (b) The Central Bank does not exist to make profits for its owners. But commercial banks are organized for profits for their owners. (c) The Central Bank is the ultimate source of money supply. But a commercial bank is not so. (d) The Central Bank acts as the banker to the government, but other banks do not act as a rule in this capacity. They are bankers to private industries and institutions. (e) A Commercial bank undertakes risky business activities and many fail. But the Central Bank never fails. (f) The Central Bank does neither accept deposits nor lend to the public, but this is the most important functions of commercial banks. (g) The Central Bank is subordinate to the state and as such most of the Central Banks in the world are now state owned and state managed. But commercial bank in most of the countries are privately owned and privately managed; there is however a growing trend towards the nationalization of even commercial banks in many countries as in India. (h) The Central Bank issues paper notes in fact it enjoys the monopoly power in this matter. But other banks do not enjoy this power. They create credit. (i) The basis of credit money is cash deposit while what of cash money is gold and foreign reserve.

6.3 FINANCIAL INSTITUTIONS


With the introduction of planned development in India in the early 50s, need for specialized financial institutions for supplying credit to industry, agriculture, etc. was felt essential and necessary. Over the years their number has multiplied. These institutions are known as Development Banks as they grant long-term development finance. Their spheres of activity are limited. They look after specific sector only. Hence they are of a specialized type. They are said to be non-bank financial intermediaries as they cannot raise money in the form of demand deposits. These banks are owned and managed by government. Through these institutions government offers fund to private economic activities for development. Not only do they grant funds for development and expansion directly but also guarantee corporate sectors deferred payment program and loans taken from elsewhere. They also underwrite or subscribe to shares and debentures of the public limited companies. Besides finance they offer technical and managerial advices. The priority sectors of a developing economy can thus get intensive care from such Development Banks of a specialized nature. INDUSTRIAL FINANCE CORPORATION OF INDIA (IFCI) Industrial Finance Corporation of India was set up in July 1, 1948. It is the pioneer development bank in India. The objective of the IFCI is to make medium and longterm credits more readily available to industrial concerns in India, particularly in circumstances where normal banking accommodation is inappropriate or recourse to capital issue method is impracticable. This is what was laid down in the preamble to the IFCI Act, 1948. The authorized share capital of IFCI is now Rs. Twenty crores. The scheduled banks insurance companies, investment trusts, cooperative banks are its share holders. After the establishment of Industrial Development Bank of India (IDBI) in 1964 it became a subsidiary of IDBI. On 24th March, 1993 the IFC (Transfer of undertaking and repeal) bill was passed in order to privatize the IFC. It would now be free to raise resources from the open market. Over the years the activities of IFC have progressively increased. It is authorized to perform the following functions: (a) granting loans and advances, (b) subscribing to the shares and debentures floated by industrial concerns, (c) guaranteeing loans taken from capital market, (d) granting loans in foreign currencies, (e) guarantee deferred payment in respect of imports of capital goods by approved concerns. The corporation can now grant loan to single unit upto Rs. 1 crore and for a period not exceeding 25 years. The policies pursed by the IFC in granting loans and advances show a preference to finance (1) a new project (2) projects exploring new areas of technology (3) projects involved in producing inputs for agriculture, (4) projects producing essential goods for consumption. It grants assistance sector wise, industrywise, state/territory wise, and to less developed areas. Working. Starting on a modest scale in 1948, the lending operations of these institutions have grown both scope and size. While in 1970-71 loan sanctioned was Rs. 32.2 Crores, in 1998 it reached to Rs. 8684 crores. The accumulative assistance sanctioned by IFCI as at

the end of March 1999 stood at Rs. 47,245 crore. It has offered assistance to allThe private sector, the public sector and the cooperative sector. It has actively participated in the financing of Industrial cooperatives. Of the total financial assistance of Rs. 8684 crore sanctioned in 1998-99, Rs. 5926 crore was in the form of Rupee loan, Rs. 321 crore in the form of foreign currency loans and Rs. 1530 crore in the form of guarantees. It has set up Merchant Banking and Allied Services department. INDUSTRIAL CREDIT AND INVESTMENT CORPORATION OF INDIA (ICICI) The objective behind the establishment of this corporation were :(a) to provide foreign currency loans (b) to develop underwriting facilities (c) to help private sector units (d) privately owned example. no participation in its share capital by government or semigovernment institutions. The ICICI differs from two other All-India development banks, mainly, the IFCI and IDBI in respect of ownership, management and lending operations. The ICICI is a private sector development bank. It provides underwriting facilities. The main function of the ICICI are : (1) expansion of private sector industries (2) to give loans or guarantee of loans either in Rupees or foreign currency, (3) to underwrite shares and debentures and subscribe directly to share issues (4) to encourage and promote private capital (5) to promote private ownership of industrial investment along with the expansion of investment markets. The financial resources have two component parts. Rupees resources and foreign currency resources. The former comprises (1) reserve (2) government of India loans (3) advances from IDBI (4) issuing of debentures of public, The latter consist of (a) Credit from World Bank (b) Sterling loan from British government (c) Funds from US AID (d) Issue of bonds in Swiss-Francs Activities Since its inception in 1955, the ICICIs financially sanctioned assistance has increased from 145.8 crores in 1961-62 to Rs. 34,220 crore in 1998-99. It has offered financial assistance in the form of (a) Rupee loan (b) Foreign currency loan (c) Underwriting of shares and debentures (d) Direct subscription to shares and debentures (e) Other services in the form of leasing, instalment sale, asset credit etc. Of the total loan sanctioned in 1998-99 33% went to corporate finance, 29% to infrastructure 19.5% each to oil, gas and petrochemicals. Originally it was set to provide finance to private sector industries. But now its scope of operations has been enlarged by including the industries in the joint, public and cooperative sectors. Industries such as chemicals petrochemicals, heavy engineering have obtained huge sums of assistance from this organization. INDUSTRIAL DEVELOPMENT BANK OF INDIA (IDBI)

In July 1964 the Industrial Development Bank of India was set up. It was a wholly owned subsidiary of the Reserve Bank of India till 1976. But it was delinked from the Bank and was taken over by the Government of India. Since then it is working as an autonomous corporation. What was the justification for establishing a separate institution when there were some all India and State level institutions to cater to the requirements of large and small industries? First, the institutional framework was not adequate either in magnitude or in range for promoting a widely diffused process of industrialization. Further, the existing framework lacked a coordinating machinery which could establish working relationship with the existing ones in the field. In other words, the IDBI was to act as a central development institution for providing dynamic leadership in the field of institutional finance of industries. With effect from February 16, 1975 the ownership and control of IDBI passed from Reserve Bank of India to the government of India. It is now managed by a separate Board of Directors. Its members are representatives of public sector banks, other financial institutions and experts from different fields. Functions The IDBI has the following functions to discharge : (a) IDBI is working as a central coordinating agency for establishing a harmonious relationship among the term lending agencies. (b) It provides direct finance by granting loan and advances, guarantees loans taken from banks, subscribes or underwrites share, bond, debentures. Besides it can convert its loans into equity shares of the concerned industry. (c) When an industrial unit cannot procure funds in the normal course, the IDBI assists such units from a special fund known as Development Assistance Fund. (d) To assist in the creation, expansion and modernization of industrial units lying within private sector. (e) To encourage and promote private ownership of industrial investment along with the expansion of investment markets. (f) It provides export finance through the scheme of direct participation, overseas buyers credit etc. Working Established three and a half decades ago the assistance given so far by the IDBI as measured in quantitative terms looks quite impressive. Not only the magnitude of assistance but also its range and pattern have changed. Total assistance sanctioned by the IDBI in 1998-99 was to the tune of Rs. 25555 crores. Of this the share of Direct assistance was 96.7%, refinance of loans 0.4%. The total amount of assistance disbursed by the IDBI till the end of March of 1999 from the date of its inception has been Rs. 1,07,264 crores. It has initiated certain Financial and Non-financial measures for development of industries in backward regions. For this it offers loans at concessional rates concessional refinance assistance and special concessions to North Eastern areas under Bill rediscounting Scheme. Further its non-financial measures help potential entrepreneurs in identifying and formulating viable projects. Thus the IDBI enjoys a unique position in Indias development banking system. It occupies same place in the field of development banking as occupied by the RBI in the field of commercial banking. STATE FINANCIAL CORPORATIONS Three years after the establishment of IFCI, in 1951, State Financial Corporations (SFC) were set-up in various states as regional institutions to cope with the requirements of

medium and small scales industries. The first SFC was in Punjab, set up in 1953. The scope of activities of the SFCs is wider than that of the IFCI since industrial concerns is used in a broader sense to include private companies, public limited companies, partnership and preparatory concerns. The authorized capital of such corporation can vary within Rs. 5 crores. The sum is raised by issuing shares of equal value. The public can hold can hold 25% of the share and the rest is held by State. Government, schedule banks, the Reserve Bank, investment trustee, insurance companies, cooperative banks etc. besides, these corporations can sell bonds and debentures, and accept term deposits from public. Besides general capital, the SFCs can issue a special class of shares, contributed by the state governments and the IDBI, that does not carry any obligation to minimum dividend. This special class of share capital was created in 1972 for granting soft loans to weaker small scale units. Function of STATE FINANCIAL CORPORATIONS Some important functions of the SFIs are (1) to guarantee loans raised by industrial units to be repaid within 20 years, (2) to grant loans and advances repayable within 20 years, (3) to subscribe, shares bonds and debentures of industrial concerns. Activities The SFCs have emerged as an important source in Indian industrial set up. Financial assistance provided by them is higher than that of IFCI or IDBI. The total amount of assistance granted by 18 SFCs was of the order of Rs. 11,950 crores between 1971 to 1991. The factors that contributed to the expansion of financial operations of the SFCs are a rise in the interest rate structure of banks has been responsible for a shift to borrowings from whose lending rates are lower than those of banks; (ii) the small sector being a priority sector there has been a conscious effort to increase financial assistance of this sector by the SFCs, (iii) the availability of foreign currency loans has contributed to the expansion of assistance of the SFCs. Another feature of the financial operations of the SFCs is that almost the entire resources of these institutions is in form of loan. Although they can and do in fact extend funds by way of underwriting or direct subscription the amount of such assistance has been nominal. The reason for this is that SFCs deal with small and medium enterprises which generally are proprietary concerns or partnership enterprises. Before 1966, the SFCs primarily catered to the needs of medium enterprises. This trend has since been reversed. The SFCs have liberalized the terms of lending to the smallscale units. Moreover since 1970, the SFCs have been granting assistance to enterprises located in areas that are industrially backward. Moreover, SFCs cover divergent fields from artisans to firms manufacturing chemicals, fertilizer, transport equipments etc. Since 1970-71 they are offering assistance to ventures started by Technician Entrepreneurs under self-employment scheme on liberal terms. The SFCs are providing foreign exchange to small and medium units. A new orientation in the operations of SFCs is the seed capital assistance from their special share capital to needy small entrepreneurs. STATE INDUSTRIAL DEVELOPMENT CORPORATIONS There are 24 State Industrial Development corporations in India established with the objective of rapid industrialization of the State. These institutions are providing assistance to small entrepreneurs and those industrial undertakings that are setup in backward regions. The total amount of loan sanctioned upto March 1991 by SIDCs was Rs. 5670 crores. INDUSTRIAL RECONSTRUCTION BANK OF INDIA

This Bank was established in 1985 with the object of rehabilitating sick industrial units with an authorized capital of Rs. 2.5 crores. Its functions are (a) providing financial, managerial and technical assistance to the sick enterprises directly; (b) providing merchant banking services for merger, amalgamation etc. (c) securing finance from other institutions and government agencies for the revival of sick industries. In March 1985, the IRCI was converted into a statutory corporation with an authorized capital of Rs. 200 crores. It was renamed as Industrial Reconstruction Bank of India (IRBI). Its paid up capital is Rs. 50 crores. At the end of March, 1992 it disbursed Rs. 923 crores. BOARD OF INDUSTRIAL AND FINANCIAL RECONSTRUCTION In January 1987 this Board (BIFR) was set up under the Sick Industrial Companies (Special Provision) Act., 1985. The Board became operational on May 15, 1987. The Board consists of seven members. At the end of 1991, public sector enterprises were brought within its purview. It is obligatory on the part of management of a sick unit to inform the BIFR about sickness. The Board will then enquiry. If found sick, it will (a) Change management or sale or leasing out of a part or the entire unit, (b) Take measures for merger or amalgamation with sound unit (c) Give the sick unit time for overcoming the problem on its own. Upto the end to December 1992, the BIFR has reviewed 1972 cases of these in 394 case revival schemes were sanctioned. UNIT TRUST OF INDIA Under the Unit Trust Act, 1963, the Unit Trust of India was set up on 1st February, 1964. The main objective of UTI is to encourage and mobilized savings of the community and channelise them into productive corporate investments so as to promote the growth and diversification of the countrys economy. Its initial capital was statutorily fixed at Rs. 5.0 crores, contributed by the Reserve Bank of India (Rs. 2.5), the Life Insurance Corporation (Rs. 0.75), banks and other financial institutions (Rs. 1.0 crores). The two objectives of the UTI are : (a) to mobilize the savings of the relatively small investors and (b) to make available the benefits of equity investment to small investors through indirect holding of securities. Organisation The UTI is managed by a Board of Trustee. The chairman of the Board is appointed by the central government in consultation with the IDBI. The Executive Trustee is appointed by IDBI. While RBI nominates one Trustee, four trustees by IDBI. Activities The total number of unit holders registered with the Trust, till June 92, was about 10 million. The total investment by the unit holders was to the tune of Rs. 22,000 crores of its total investment 59% was invested in equities of corporate sector and the rest is in the form of bank deposits. Besides initial capital, the UTI gets unit capital by sell of units to the public. It sells units under different schemes for mobilizing the savings of all classes in the household sector. The tremendous increase in unit capital obtained by UTI can be explained by many a factor. First, in order to provide liquidity to the investors the UTI repurchases its units at repurchases prive Secondly, it offers types of benefit and concession to investors. Besides a steadily rising dividend, insurance facility, reinvestment of dividend plan, monthly income plan etc. are some of the attractive schemes of the UTI. Thirdly, to encourage savings in the form of units, relief from taxation is available both to the UTI

and unit holders. Thus units are safe, high yielding and marketable these three qualities have made them the most popular among a large section of savers, both personal and private sector. The investment by the UTI is much flexible. It maintains a balanced portfolio comprising both equity and fixed income securities. Its area of operations is primarily the securities of industrial enterprises. The security portfolio of the UTI consists of subscription to new capital issued and purchases on the stock markets. Thus, the UTI occupies a pivotal position in the Indian capital market in mobilizing savings of heterogeneous investors and channeling into productive investment the savings it mobilizes, providing support to new issue market. EXPORT IMPORT BANK OF INDIA The Export Import bank of India commenced operations on March 1, 1982. It is a non-bank financial intermediary confined its area of operations to foreign trade of India. It is a fully statutory company owned by the Government of India with an authorized capital of Rs. 200 crores and paid-up capital of Rs. 50 crores. It is empowered to borrow from RBI and also from foreign economies. It is a lead bank in the finance and promotion of exports and also an apex body for co-ordinating the working of similar organization engaged in promoting our export and import trade. Functions and Activities of EXIM Banks The EXIM Banks business is exclusively devoted to Indias international activity. The aggregate loans and outstanding reached Rs. 16.16 billion during the first decade of its operation. In annual terms, the business is said to have grown at a rate of 30 per cents. The Bank has developed a three dimensional strategy for export promotion. Firs, the Bank offers fund for product development, long-term export credit, investment capital. Second gives export advisory services. Research on exports and market opportunities is a third component in the strategy. Export bids have increased annually by 44 per cent and export contracts financed exceed Rs. 60 billion. Penetration into new markets has been possible because of a variety of lending program of the Bank, it rendered services in product export, project export and services export. When the Bank commenced operation in early 1982 its catalytic role was mainly confined to granting of post shipment term export credit. Now its horizons have expanded. Now its horizons have expanded. Now it lends product development finance, pre shipment finance, marketing finance, finance for joint ventures, investment capital for export production in addition to term export credit. The Bank is thus involved in more than export finance. In other program include (a) Export Bills Re-discounting (b) Refinance of Suppliers credit (c) Bulk Import finance (d) Foreign currency Pre shipment credit (e) Product equipment finance program (f) Business Advisory and technical Assistance (BATA). NATIONAL BANK FOR AGRICULTURE AND RURAL DEVELOPMENT (NABARD) The NABARD was setup in July 1982. It is the apex body in the sphere of rural credit system, taking over the functions of agricultural credit department of the RBI and Agricultural Refinance and Development Corporation (ARDC). The functions NABARD discharges are (a) It provides all sorts of reference to cooperatives, commercial banks and also Regional Rural Banks (RRB) (b) It inspects the above three agencies and advises the government thereon

(c) It makes loans to State Governments to enable them to subscribe to the share capital of cooperative Banks. (d) It helps in prompting research in agriculture and rural development. (e) NABARD undertakes evaluation and monitoring projects financed by it. (f) It is responsible for the development, operation and coordination relating to rural credit. NABARD started working with Rs. 100 crores. It has got the power to borrow from Union Government. It is also empowered to borrow foreign currency. It has two funds, the National Rural Credit (long-term) operations Fund and the National Rural credit (Stabilisation) Fund. It operates through 16 Regional offices. Activities In the first year of its operation the NABARD sanctioned Rs. 1677 crores. Since then the credit limit has increased by leaps and bounds. Short-term credit is sanctioned for seasonal agricultural operations. Medium term for approved agricultural purposes. And long term credit to state governments for purchasing share capital of cooperatives. A lions share of NABARDs credit has been routed through commercial banks and RRBs. Next comes the cooperative agencies and Land Development Banks. It has taken care of less developed and under banked regions in granting agricultural investment. It has asked banks to offer a stipulated proportions of credit for helping small and marginal farmers and other weaker sections. It has refinanced banks for implementing the National programmers of Mass Assistance of Small and marginal Farmers. It also refinance development activities of the handloom sector. Moreover, it extends refinance to state cooperative Banks to provide Block Capital to industrial cooperative societies and rural artisans against state governments guarantee. LIFE INSURANCE CORPORATION OF INDIA The Life Insurance Corporation of India (LIC) was set up in 1956 by nationalizing 245 insurance companies. The primary objective of nationalization was to protect the interest of policy holders against misuses and embezzlement of funds by private insurance companies. Secondly, the object of nationalization was to direct investment of funds in government securities, leaving a meager part for the private sector. What marks and distinguishes the LIC from other long term financial institutions is this that it discharges the tow fold function of mobilization of long term savings and their effective channelisation as well. The other agencies are supplies of fund obtained from government and the Reserve Bank of India. Role of LIC The activities of the LIC can be broadly classified into two categories. First, it mobilizes long term contractual savings. Its policy holders view the LIC as a trustee of their funds, a source of emergency fund to guard against any financial misfortune and a way to accumulate funds by the time of retirement from work. As an agency it is designed to for the inculcation of savings for the sake of rainy days. During the last forty years of its operation, there has been concentration of colossal funds in hands of this monolithic state owned corporation. The resources thus obtained by the LIC from policy holders are in vested in diverse ways for different purposes. Basically LIC is an investment institution. It is a big investor of funds in government securities. Since April, 1975 the amended section 27A of the Insurance Act, 1938 the LIC is required to invest to not less than 50% of its accruals of premium income in government marketable securities. Of this not less than 25% in central government securities. Besides it has to give loans to approved authorities like electricity boards or state government for socially oriented schemes like electricity, housing, water supply etc. These loans and investments should not exceed 87.5 percent

of accretion to the controlled fund of the LIC. The remaining 12.5 percent can be made to the private sector directly in the form of purchase of shares and debentures. Besides it grants loans to the private corporate sector and finances projects by subscribing shares and debentures of private industries. Its contribution to financing of industries in the private corporate sector is also indirect. The investment in the share capital and bonds of IFCI, SFCs, UTI and IDBI flow back to private sector in the form of direct loans. The LIC is also engaged in underwriting new issues. The LIC plays an important role in the securities market in India. It purchases even when the market is dull (bearish) and prices are low in order to reap the benefit of future price appreciation. Nor does it usually sell shares from its stock when the market is spturn at higher prices. Although Income tax concessions provide incentive to higher income groups trough LICs policies, the insuring public does not get the real value of its long term savings because of chronic inflation. Barring risk coverage, the rate of return offered by LIC is much lower compared to other savings media. It is true LIC has grown at a fast speed bet it can grow at a faster rate if it can make the message of life insurance more attractive by its operational efficiency and innovative attitude. GENERAL INSURANCE COMPANIES The General Insurance Corporation of India (GIC) was formed as a government company in 1972 under the General Insurance Business (Nationalisation) Act 1972. Before nationalization a few big companies and about 100 small companies were in this business. All these units were merged together and reorganized into four subsidies of GIC. They are (1) National Insurance Company (2) New India Assurance Company (3) Oriental Fire and general Insurance Company (4) United India Fire and General Insurance Company. On January 1, 1973 of all the Indian insurance companies were transferred to the GIC. The feature of the GIC is this that it sell insurance service against some forms of risk like loss of physical assets of various kinds from fire or accident and against personal sickness and accident. The insurer just purchases a service and not any financial asset. They draw vast resources in the form of premiums and returns from investments. As a financial intermediary, the GIC invests funds in a prudent way looking after national priorities and meeting unforeseen claims under their policies. The GIC is required by law to hold central government securities to the tune of 25 percent of new accrual and at least 10% in other approved securities. The companies can invest in the shares and debentures of the corporate sector. But shall not exceed 5% of the subscribed capital of a single company. It also participates in the underwriting of new issues and in granting term loans to industries. SECURITIES AND EXCHANGE BOARD OF INDIA The Securities and Exchange Board of India (SEBI) was set up in 1988. It got statutory recognition in 1992. The purposes for which the SEBI was set up are as follows : (a) Regulating the business in Stock Markets and other securities markets, (b) Prohibiting fraudulent and unfair trade practices relating to securities markets, (c) Regulating the working of collective investment schemes, improving Mutual Funds d) Prohibiting insider trading insecurities, e) Regulating large acquisition of shares and takeover of companies The institution has got wide ranging powers. Firstly, all stock exchanges in the country have been brought under the annual inspection of SEBI for orderly growth of stock

markets and also to protect the interest of investors. Secondly, to oversee the constitution as well as the operations of mutual funds of both private sector and joint sector. Thirdly, since May 1992, SEBI has been made the regulatory authority in regard to new issues of companies. It has also been empowered to regulate new intermediaries in the capital markets. Two other institutions have been set up for regulating the capital market. They are National Stock Exchange of India (NSEI) and the other is National Securities Clearing Corporation (NSCC). The former was set up in November 1992, and the latter in 1996. THE ASIAN DEVELOPMENT BANK The Asian Development Bank started functioning in December 1966. It is engaged in promoting the socioeconomic progress of its member countries in Asia and Pacific. It is owned by the governments of 37 countries from the region and 16 from outside the region. Its head quarters is in Manila, Philippines. The Principal functions of the Bank are: (a) to make loans and equity investment for the socioeconomic advancement of its member countries (b) to provide technical assistance for the preparation and execution of development projects, and advisory services (c) to promote investment of private and public capital for development purposes (d) to respond to requests for assistance in coordinating development plans and policies of member countries. Besides, the bank is required to give special attention to the needs of the smaller or less developed member countries. The banks highest policy making body is the Board of Governors. The President is elected by the Board for five years. He is the chairman of the Board of directors and he conducts the business of the Bank under its directions. He is assisted by three VicePresidents, appointed by the Board of Directors on the recommendation of the President. The Board of Directors is composed of 12 Directors 8 from region countries and 4 from non region countries. While the Board of Governor is the highest policy formulating body, the direction of banks general operations is the main task of the Board of Directors. The Banks fund consist of subscribed capital, reserves and funds raised through borrowing. Special Funds are formed of contribution made by member countries, amounts set aside from the paid in capital, and accumulated net income. It has raised capital from capital markets of Asia, Middle East, Europe and USA. The Banks callable capital backs its borrowing in the capital markets. Activities Banks activities comprise lending activities, and technical assistance. Lending activities, again are of two major categories : Ordinary and special operations. The Bank has three special funds for the latter purpose. They are Asian Development Fund (ADF), the technical assistance Special fund (TASF) and the Japan Special Fund (JSF). These special funds are contributed funds from member countries which are granted on concessional terms to the Banks lesser developed economies like Nepal, Burma, Bangladesh etc. They are repayable over 40 years including a grace period of 10 years. Both the ordinary and special loans are intended to cover the foreign exchange requirements of the projects financed by the Bank. The Bank also grants blended loans from ordinary funds and ADF if the need of ADF eligible countries for development financing exceed what can be provided from ADF resources and they have the capacity to absorb such resources. The Bank also provides multi-project loans for packages of small projects. It also grants project loans. Such loans are quickly disbursed to support policy reforms and institutional changes which will

enhance economic efficiency and growth. Further whether a project is not large enough to warrant the direct supervision of the Bank, loans are given to national development banks for disbursement. An important means by which the Bank grants a direct loan is co-financing. Co-financing has been bilateral or multilateral official agencies, banks, export credit source. Bank invests its funds in the equity capital of enterprises operating in member countries. The Bank also provides loans without government guarantees to help the private institutions. It, in selected cases, guarantees loans from private financial institutions. An important aspect of Banks development role is the provision of technical assistance to overcome gaps in technical know-how and expertise. The Bank has expanded the scope and coverage of its technical assistance operations over the years. Technical assistance operations help the Bank to replenish its pipeline of loan proposal. Such activities are financed from special funds known as TASF and ADF and JSF. New Role of ASIAN DEVELOPMENT BANK Poverty reduction is now ADBs main mission rather than one of five strategic objectives. The other promoting economic growth, supporting human development, protecting the environment, and improving the status of women are still being vigorously pursued, but in ways that contribute effectively to reducing poverty. A comprehensive poverty analysis and projects that promote pro-poor, sustainable economic growth; social development; and good governance are the pillars on which ADBs poverty reduction strategy is built. The starting point for reducing poverty is a comprehensive country poverty analysis. Key stakeholders will discuss the findings of the analysis in a participatory high-level forum. The outcome of these discussions will form the basis of ADBs new country operatonal strategies. A partnership agreement between the government and ADB will then identify ADBS operations for helping to reduce poverty in each country. Top borrowers of ASIAN DEVELOPMENT BANK in the year 1999 _________________________________________________________________ US$0 Million % _________________________________________________________________ Peoples Republic of China 1,258.5 25.3 Indonesia 1,020.0 20.5 India 625.0 12.5 Pakisthan 402.8 8.1 Thailand 363.8 7.3 Bangladesh 332.0 6.7 Vietnam 195.0 3.9 Srilanka 183.8 3.7 Papua New Guinea 108.8 2.2 Combodia 88.0 1.8 Philippines 88.0 1.8 Other Development member Countries 312.9 6.2 __________________________________________________________________ Total 4,978.6 100.0 __________________________________________________________________ THE INTERNATIONAL MONETARY FUND (IMF) Origin At an International Monetary conference held at Bretton Woods it was proposed to create an international Monetary Fund (IMF) as the most practical method of securing international monetary cooperation. The object of setting up of such an agency was to administer a code of fair practice in the sphere of foreign exchange and to grant short

term loans to economies experiencing temporary deficit in their balance of payments. It commenced operation in march 1947. Functions of INTERNATIONAL MONETARY fund The Principal functions of the IMF are :(a) It provides short term credit (b) It functions as a leading institution in foreign exchange. (c) It grants loans for current transactions and not capital transaction. (d) It helps for the orderly adjustment of exchange rates (e) It acts as a store house of foreign exchange rates which is likely to improve the balance of payment position of member countries. Objectives The objective for which the IMF was set up and act are as follows : (a) To foster international monetary cooperation through joint action of its members (b) To promote foreign trade by avoiding restrictive currency practices. (c) To secure stability of foreign exchange rate. (d) To recur multilateral convertibility example., a borrower nation can borrow the currency of any other member nation. Structure The quotas of all the member countries taken together constitute the total financial resources. What is quota? It is the member countrys contribution fixed in terms of its national income and foreign trade. Members are required to subscribe to quota partly in gold (25% of quota) and partly in domestic currency. The size of determines a member countrys borrowing power and voting right. Generally national currency is paid in the form of deposit in favour of IMF held in the Central Bank of the member country. Lending Operations Any member country suffering from shortages of foreign currency may get it from the IMF by its national currency. The fund permits a member to draw up the amount of gold contribution. The Fund grants temporary loan to tide over a temporary shortage of foreign exchange. Exchange Rate Members of the Fund had to declare the Parvalue of national currency in terms of gold or American Dollars. Once the par value of different currencies are fixed, it becomes easy to determine the rate of exchange between two countries. If a country faces a fundamental disequilibrium in its balance of payments it can change its par value example., devaluation with the approval of the Fund. Exchange Control Under the IMF system there should be no restriction in ordinary trade and other currency transactions. But it allows their use to control international capital movement especially capital flight. Exchange controls are permitted in the case currencies declared scarce by the fund. Special Drawing Rights (SDR) About two decades ago a new international money was created by the IMF for two reasons. First to overcome the shortage of gold in the world economy leading to fall in international reserves. Second, to avoid the movement of gold across national boundaries. This new international currency is known as Special Drawing Rights (SDR) held with the IMF. The origin of SDR thus lies in the shortage of international liquidity all over the world in the wake of acute shortage of American Dollar in the 60s and early 70s which was then the main reserve currency. The SDR was first introduced in 1969. Under this scheme the IMF grants its member government special drawing rights from Special Drawing Account (SDA). They are

like coupons which can be exchanged for currencies required by its holder for making international payments. They are also, besides gold and key currencies, a component of international reserve of an economy. Each member of the fund was assigned an SDR quota that was granted in terms of a fixed value of gold. Hence they have been aptly described as Paper Gold. The member countries are required to provide their currency in exchange for SDR when called upon. The use of SDR would mean a reduction in the countrys foreign reserve and a corresponding increase in the SDR holding of the country receiving it. The mechanism of the SDR system is an economy in need of foreign exchange has to apply to the Fund for the use of SDR. The Fund would designate another country having a sound foreign exchange resources to meet the need of the former. So the debtor countrys SDR decreases and that of the creditor increases. The former have to pay interest at 1.5% per annum to the latter country. A designated (creditor) country can not pay more than the amount equal to twice the amount of SDRs allotted to the country. The scheme is flexible in that each country can use its quota to have an equivalent amount of convertible foreign exchange to overcome balance of payment difficulties. THE WORLD BANK The World Bank has the following objectives before it :(1) To help reconstruction of member countries damages due to the Second World War. (2) To facilitate the investment of foreign capital for productive purpose. (3) To promote balanced growth of international trade and to maintain equilibrium in the balance of payment. (4) To promote private foreign investment by means of guarantee to loans and investments made by private investors. It will make loans out of its resources when private loans are not sufficient. Thus the bank supplements rather than replace private investment. Capital Structure Beginning with an authorized capital of $ 10,000 million, the capita stock of the Bank has more than doubled. Each share is for $100,000. 2 percent of the paid up has to be subscribed in gold and 98% in members domestic currency. The capital stock can be increased if three-fourths total voting power agreed. INTERNATIONAL DEVELOPMENT ASSOCIATION (IDA) The IDA was started in 1960. It is affiliated to World Bank. Legally and financially distinct from the Bank, IDA is administered by the same staff. The objective behind the setting up of a separate Institute were to provide assistance to primarily poor countries those with an annual per capita gross national product of less than $520 (in 1975). Second, it was to grant credit on cheap terms compared to Bank loans. The Capital Funds of the IDA come from subscription of member countries, special contribution from its richer members, transfer from the net earnings of the World Bank and general replenishment from its more industrialized members. It functions as a development agency supplementing the Banks development activities. It is to support projects which will contribute to the development of the country even if they are not directly productive. IDA credit is development credit to LDCs. Moreover, it grants such credit to government are 50 years maturities and no interest. But an annual service charge of 0.75 percent on the sum disbursed. The IDA loans can be used to finance both foreign exchange and local currency costs.

Study Note - 7
INTERNATIONAL TRADE
International trade is the exchange of goods and services among different countries or trade across political frontiers. It is a highly organized form of barter and is the outcome of territorial division of labour.

7.1 FEATURES OF INTERNATIONAL TRADE


1. The world market is heterogeneous on account of differences in climate, language, level of national income etc. 2. The mobility of factors of production is higher within the country than that between countries. International mobility of labour and capital is strictly restricted by governments. When resources are comparatively immobile, there is no automatic influence equalizing price and cost. 3. It involves the use of different types of currencies. Hence arises the question of foreign rate of exchange. 4. Foreign trade may be free or not. It is free when a country can buy and sell any good or service from world market without any obstruction. In most countries much free flow in and flow out is restricted by the government, looking after the broader national interest. 5. International trade has its impact on a countrys gross national product and national income while domestic trade leads to transfer of goods from one region to another and no change in the size of GDP. Distinction between Internal Trade and International Trade Internal Trade is simply exchange of goods and services between two individuals or firms or States in the same country, that is to say within the same political boundary. It is also called regional or domestic trade. International Trade, on the other hand, is the trade that takes place between different countries across political frontiers. There are some points of distinction between these two forms of trade. (a) Internal Trade takes between different regions within political boundaries of the same country. International Trade is trade between two or more Nations. International Trade may be unilateral, bilateral or multilateral according to the number of country with which the country is trading. (b) In internal trade transactions are carried out with the same currency as it is taking place within a particular economy. But in case of International Trade the use of different types of currencies becomes essential. The poorer countries are to procure foreign exchange for paying their Import bills. They cannot pay it with domestic currency. (c) Internal Trade occurs within the same political unit. As such a common trade or an exchange policy is followed by the trading partners. But interregional trade occurs between different political units with different currencies and different foreign exchange policies. Thus it is much more complicated than domestic trade.

7.2 BASIS OF TRADE


Why do countries participate in international trade? According to classical writers, a country takes part in international trade not because of the fact that it cannot produce the goods domestically. Rather it should produce those to which it has comparative cost advantage and abandon others to which has comparative disadvantage. The surplus goods produced may be exported and, in turn can import from world market other goods, whose production it has abandoned, at a greater quantity. Thus the classical economist believed that a country gains more by trade than what it can produce domestically. Thus the basis of international trade, according to Ricardo, is the comparative costs differences. The question remains how this comparative cost difference arises. Some modern economist suggest that trade takes place on account of different relative price of different goods in different economics. The relative price of goods differ between countries as a result of differences in factor price differences. And factor cost differences occur because of different factor endowments in different countries.

7.3 GAINS FROM FREE TRADE

As an economist has aptly remarked, the gain from trade is the difference between the value of things that are got and the value of things that are given up. In the classical comparative cost model, trade is mutually profitable. Specialisation on the basis of comparative advantage enables to obtain foreign goods more cheaply in terms of real resources forgone than domestic production. Through the international division of labour one is supposed to get more than one gives up. The above are called Static gains. But trade has certain Dynamic benefits also. First, an increase in export trade will widen the countrys total market. Production of more goods will lead to lower cost per unit and lower price. Secondly, for a poor economy with no trade there is very little scope for industrialization. Because specialization is limited by the extent of the market. But with trade such an economy enjoys some prospect of industrialization. Thirdly, it consists of the stimulus to competition, the acquisition of new knowledge and new ideas, and the possibility of capital flows. Fourthly, trade acts as an engine of growth. It transmits growth from one part of the world to another. For example the demand in Britain for raw materials brought prosperity to Australia, Canada, New Zealand etc. With the increase in demand for their commodities, investment in these countries also increased. Benefits of Restricted Trade International Trade may be free or restricted. It is said to be restricted only when the Government of a country imposes barriers on the way of free-flow of goods and services from abroad. It is a matter of governments trade policy. It may impose heavy Impost Duty of foreign goods so as to check their use within the country with a view to help domestic production. It may take liberal measures to increase the volume of exports so as to earn more foreign exchange. There are some arguments in favour of restricted trade. (1) To protect the newly established industries of a country from foreign competition, the government should prevent the entry of foreign products. But such protection on domestic industries need not be given for an indefinite period. Hence it is said, Nurse the baby, protect the child and free the adult. Such argument is known as infant industry argument. Thus restricted trade is necessary for the growth of domestic industries in the poorer countries of the world. (2) Once the domestic industries are sheltered by not allowing foreign goods to enter, employment of labour and other resources will increase. Thus restricted trade is likely to have a favourable impact upon domestic employment, income and output. (3) Protection of domestic industries is also essential for the defence of the country. No country should depend upon other for arms and ammunitions. These must be produced domestically and the country should not import it. Defence is much more important than opulence, so said Adam Smith. (4) It is also argued that if imports of foreign goods are restricted then the country need not pay any money to meet its import bill. This will save domestic money. Thus protection may help in keeping money within the country. There will be no economic drain.

7.4 BALANCE OF PAYMENTS


Balance of payments (BOP) is a systematic record of all economic transactions undertaken on international trade account of an economy during a given period of time. International Trade is a two-way traffic. A country sells abroad and also purchases from abroad. The former operations are known as Export trade and the latter Import. While exports lead to earning, imports lead to spending of money for paying the prices of foreign goods and services. So BOP of a country has its credit side (earning) and debit side (spending). If the total earnings from exports is equal to total spending for imports example. debit and credit sides are equal, BOP is said to be balanced. If, on the other hand, they are not equal then either E > M or E< M indicating

a surplus or a deficit in the BOP. Normally a country exports and imports many items of diverse nature. These are broadly grouped into two groups visible items and invisible items. All sorts of goods exported and imported in the Trade Account. The invisible account comprises items of invisible transactions. They include : (a) Insurance Premiums and payments of claims (b) Transit expenses (c) Investment incomes such as interest, rent, dividends. (d) Migration remittances, donation etc (e) Repayment of commercial credit (f) Travel (for education, business, health, pleasure) (g) Contractual amortization and depreciation of direct investment (h) Miscellaneous service such as commission, patent fees, royalties, pension, subscriptions etc. The above mentioned visible and invisible items constitute what is called Current Account. Besides current account, BOP has a Capital Account. In a word, the capital Account deals with debts and claims. The items are : (a) Private non-banking loans short term and long-term (b) Private Banking loans, excluding central bank (c) Official Loans, Amortisation, Reserves and miscellaneous. Broadly the capital account consists of (i) private capital account (ii) international institutional capital account (iii) Special account and (iv) Government capital account. Balance of Trade and Balance of Payments Balance of Payments of an economy shows Total Debits (imports) and Total Credits (export) with the rest of the world. The totals may be segregated into two parts : visible items exported and imported and the invisible items. Balance of Trade (BoT) shows credit and debit arising from merchandise trade example. goods exported or imported only. On the other hand, BoP gives the total picture of a countrys transactions with the rest of the world, Thus BoT is merely a part of BoP. Balance of Payments always Balances In the accounting sense, BoP of an economy must always balance. It means that the two sides of the account must show the same total. In order to understand the mechanism of such equality between debit and credit in the BoP, we have to know Autonomous Transactions and Accommodating Transactions. All the items both visible and invisiblein a BoP account are autonomous in the sense that they are undertaken independently with some objective. For example, goods are exported for earning profit and they are imported for the utility they give, Similarly capital is exported for higher returns and imported to ward off its shortage. Now if an economy experiences a gap between autonomous credit and debit a surplus or deficit in the autonomous export and imports appears. The accommodating transactions accommodate such gaps. The accommodating payments would not be needed if no gap persists between receipt and payments in the Autonomous Account. But when a gap in the form of a deficit occurs, it is financed by the movement of gold, accumulation or dissimulation of foreign exchange holdings or loans. There are the residual money that flow in the BoP to make it technically balanced. In economic sense, BoP may not be balanced. In fact, in real life, we find economics either enjoying a surplus or suffering from chronic deficit in their BoP. They are facing a disequilibrium in their BoP. It, therefore, follows that an apparent balance in BoP (in an accounting sense) does not mean a state of equilibrium in BoP of a country.

7.5 FEATURES OF EXPORT


International Trade is said to be a two way traffic in the sense that a participating country not only exports visible and invisible items but imports too. Thus exports and imports constitute two sides of the same coin. Export or sale operation helps an economy to earn income from world market. In an open economy, national income originates not from world market. In an open economy, national income originates not only from within but from favourable foreign trade as well (E minus M). When export earning exceed import spending (E greater than > M), resources flow in from outside. It encourages savings and capital formation. Secondly, exports increase the supply potential of the economy by opening a more extensive market. Export earnings also stimulate effective demand in the domestic market. Thirdly, exports permits import. A countrys capacity to import increases as its export earnings increases. It supplements shortage of domestic capital goods and through their superior efficiency exert a favourable impact on the economy at large. Fourthly, exports encourages savings in different ways. Exports affect savings through their effects on output and because of the fact that export sector has a higher propensity to save. Besides export taxes constitute an important source of government savings. Fifthly, the capacity to export of an agricultural economy is limited. The income elasticity of demand for most farm products, particularly food crops is lower than that for manufactured goods. This results in a decrease in proportion of income spent on such goods. This means that for a given growth of world income the exports of primary product economies will automatically go down vis--vis the exports of industrial countries producing and exporting manufactured goods. Sixthly, export trade of a country depends on a host of factors. Exports basically depend on the exporting countrys ability to cater to the requirements of a heterogenous markets. Exports can increase by innovation introducing a new good at a relatively cheaper rate. Besides such economic factors, export trade of a country is influenced by political ideology, government policies relating to trade and exchange rate. Lastly, with economic development and a higher rate of growth of income, export earnings have a tendency to rise steeply compared to imports. And the country becomes a net exporter of capital.

7.6 FEATURES OF IMPORT


The trade policies of the government of a country are, by and large, guided by two considerations on the one hand, to promote exports and to control imports, on the other. That is the easy way of enjoying a net surplus from trade. The classical economists advocated import on the ground that by import a country can get more than what it can produce domestically. The gain from trade is the difference between the value of things that are got and the value of things that are given up. Imports, as Adam Smith believed, may satisfy a part of their wants and increase their enjoyments. By exporting its surplus capital goods, England can have more of wine from Portugal. Besides making the product composition diversified, imports had another role of importance. Imports can be regarded as substitutes for domestic capital. If domestic saving is less than the level necessary to achieve a given rate of growth, growth is said to be investment limited. Traditionally the role of import (of foreign capital) was to supplement the shortfall in domestic savings.. Imports render another valuable service in the growth process. Many goods or inputs required for growth may not be available within the economy. They must therefore be imported without

which a part of domestic resources might go unutilized. If such minimum import requirement necessary to achieve the target rate of growth is greater than maximum feasible exports there is said to exist an export imports gap. Import of foreign capital is thus necessary for proper utilization of some domestic resources having higher import component. Moreover by pursuing a liberal import policy a country may permit easy entry of foreign goods in the domestic market. In a competitive environment, the domestic producers must become more efficient and cost conscious. This helps in improving the quality of products and maintaining a reasonable price. Import of capital in the form of foreign loan or consumption goods of prestige value are burdensome or harmful. But the case is different when a country imports foreign technology or technical and managerial services or patent right. In the long run such imports yield rich dividend to the importing country. Imports, like exports, depend upon many factors, the principal determinant being the importing countrys capacity to pay either by its exports or by foreign exchange. However too much reliance on imports is not desirable.

7.7 THEORIES OR BASIS OF INTERNATIONAL TRADE


One of the basic questions that the theory of international trade has to answer is why countries specialize in different goods and enter into international trade has to answer is why countries specialize in different goods and enter into international trade. In simple words, what determines international trade? The answer to this question gave rise to the theory of international trade. Two important theories of international trade are explained below: I. Adam Smiths Theory of Absolute Advantage Before analyzing the theory of comparative advantage, it will be useful to understand the theory of absolute advantage. The theory of absolute advantage of international trade was propounded by Adam Smith. According to him international trade is the natural outcome of international specialization and division of labour. The principle of division of labour suggests that each country specializes in the production of only those goods in which she enjoys some special advantage. Adam Smith believed that foreign trade is advantageous only if the country concerned has an absolute advantage in the production of some commodity. The concept of absolute advantage implies that the country concerned must be able to produce, with given factor endowments, a larger amount of the commodity than any other country. According to Adam Smiths theory of absolute advantage, trade between two countries will take place only if one of commodity and the other country enjoys the same advantage in the production of some other commodity. This can be explained with the help of the following example : Labour Days Required for Production Commodity U.S.A. India x (one Unit) 10 20 y (one unit) 20 10 The above table informs that to produce one unit of x commodity in the U.S.A., 10 labour-days and in India 20 labour-days are required. On the other hand, to produce one unit of y commodity in the U.S.A., 20 labour-days and in India 10 labour-days are required. Thus, the U.S.A. has an absolute advantage in the production of x commodity and India has an absolute advantage in the production of y commodity. Adam Smith showed that the two countries would benefit and world output will increase if the two countries specialize in the production of goods in which they have absolute advantage and trade with each other. Thus, according to this theory, trade depends on absolute advantage. However, Adam Smiths views do not carry us very far in the realm of international trade. For example, if a backward country does not possess absolute advantage in any line of production, should it follow the policy of free trade only to ruin its industries from foreign competition? Adam Smiths analysis fails to deal with situations of this type. In fact, his analysis is not capable of explaining the causes underlying the international trade. He only emphasized the

fundamental basis of all international trade, example., the division of labour on an international basis. It was Ricardo who attempted a precise and general theory of international trade. It is popularly known as the theory of comparative cost. It is discussed below. II. Ricardos Theory of Comparative Advantage or Comparative Cost It is obvious that if one country has an absolute advantage over the other country in one line of production and the other country has an absolute advantage over the first country in a second line of production, both countries can gain by trading. But what if one country is more productive than another country in all lines of production? If country A can produce all goods with less labour cost than country B, does it still benefit the countries to trade? Ricardos answer was yes. For this, Ricardo gave the theory of comparative advantage (or the theory of comparative cost) of international trade. According to him, comparative advantage explains the existence of international trade. A detailed explanation of the theory of comparative advantage is given below: Assumptions Ricardos theory of comparative advantage is based on the following assumptions: (1) It is assumed that there are only two countries in the world. And each country can produce two goods. Thus, this theory is carried out only in two country two commodity model. (2) There is perfect competition both in the commodity market and the factor market. (3) There is only one factor of production and that is labour. It implies that he cost is expressed in terms of labour only and the value of the commodity depends only on its labour cost. (4) Factors of production are assumed to be perfectly mobile within the country but perfectly immobile between different countries. (5) The law of constant returns to scale prevails in the economy. (6) There are no transport costs between the two countries. Explanation Ricardo has explained that a country can benefit from trade even if it is absolutely more efficient (or absolutely less efficient) than other countries in the production of every good. Say country A enjoys advantages over country B in the production of both the commodities, yet country A will specialize and export that commodity in which it enjoys relatively more advantages. On the other hand, country B has disadvantages over A in the production of both the commodities, yet B will specialize and export that commodity in which it has relatively less disadvantages. Thus, in this situation also there will be trade between these two countries and both will gain. Indeed, the theory of comparative advantage is simply an application of the principle of division of labour to different countries. This we can understand with the help of an example. Suppose an individual can do a number of jobs but he cannot be equally efficient in all the jobs. Take the case of a lawer who is more efficient in both legal work and typing work than his typist. What should he do? Should he do both the jobs? The answer is very simple. He should concentrate on the job where he is relatively more efficient. So he will work as lawyer and will appoint a typist for typing work. He knows that the time which he will spend in typing can be more remuneratively employed by doing legal work. The work of typing can be done by a low-paid person, while he can earn much more as lawyer. Or look at it from typists point of view. He is absolutely less efficient than the lawyer both in legal work and in typing, but he is relatively more efficient (or relatively less inefficient) in typing. In this scenario, the greatest efficiency will occur when the lawyer specializes in legal work and the typist concentrates on typing. The same logic can be applied on nations. A country can produce numerous goods efficiently, but it will not produce all of them. It should select those commodities in which the comparative costs are lower or in which it enjoys comparative advantage. Thus, the principle of comparative

advantage holds that each country will benefit if it specializes in the production and export of those goods that it can produce at relatively low cost and imports those goods which it produces at relatively high cost. Now let us explain the theory of comparative advantage with the help of a numerical example. Suppose there are two countries : U.S.A. and India. They are producing two commodities x and y with the help of labour. Labour costs of production (in terms of labour units) of both the commodities in U.S.A. and India are also given. What is labour Cost? The units of labour required to produce one unit of output is called labour cost or labour coeffieient. The labour-cost informations of two countries are given in the following table : Labour Costs Country Labour Cost of Production (in units of labour) 1 unit of x 1 unit of y U.S.A. 5 2 India 20 4 Before analyzing the table and Ricardian theory of international trade, it will be useful to understand the difference between absolute advantage and comparative advantage. The concept of absolute advantage means that a country can produce a good absolutely more efficiently than the other country. It further implies a unit of a commodity with lesser factor-endowments (say labour units or labour costs) than any other country. For example, according to our table, U.S.A. can produce a unit of x with 5 labour units while India requires 20 labour units for the same. It means U.S.A. has an absolute advantage over India in the production of x commodity. On the other hand, the concept of comparative advantage implies that a country is relatively more efficient (or relatively less inefficient) in the production of one commodity over the other in comparison to other country. Comparative advantage can be found out with the help of labour cost ratio. For example, according to our table, the labour cost ratio of x to y in the U.S.A. is 5/2 = 2.5, whereas, it is 20/4 = 5 in India. Hence it is clear the U.S.A. has comparative advantage in the production of x commodity over y. Now we can explain the theory of comparative advantage with the help of our above-mentioned example. It is clear that U.S.A. has an absolute advantage in the production of both the commodities x and y, because the labour cost of production for each unit of the two commodities is less in U.S.A. than in India. It also means that India has an absolute disadvantage in less in U.S.A. than in India. It also means that India has an absolute disadvantage in both the commodities. Does this mean that U.S.A. will import nothing or there will be no export from India? Does this mean that there is no scope for mutual trade between U.S.A. and India? According to Ricardian theory, it is the comparative advantage and not the absolute advantage that determines the course of international trade. So let us compare the comparative advantage (or comparative cost) between U.S.A. and India. It can be done with the help of labour cost ratios. It is clear from the table, that in U.S.A. labour cost ratio of x to y is 2.5 (5/2), whereas as India it is 5(20/4). So it is clear that U.S.A. has lower labour cost ratio of x to y, hence it has comparative advantage over India in the production of x than of y. In order to know comparative advantage we can also use the concept of opportunity cost. The opportunity cost for a good x is the amount of other goods (say y good) which have to be given up in order to produce one additional unit of x. The opportunity costs for producing x and y goods in U.S.A and India have been calculated in the table below on the basis of the information given in the above-mentioned table. Opportunity Costs Country x y U.S.A. 5/2 = 2.5 2/5 India 20/4 = 5 4/20 = 1/5 A country has a comparative advantage in producing a good if the opportunity cost for

producing a good if the opportunity cost for producing the good is lower at home than in the other country. The above table shows that U.S.A. has the lower opportunity cost of the two countries in producing x good (so, 2.5 < 5), while India has the lower opportunity cost in producing y (so, 1/5 < 2/5). Thus U.S.A. has a comparative advantage in the production of x good and India has a comparative advantage in the production of y good. As long as the two countries opportunity costs for one good differ, one country has a comparative advantage in the production of one of the two goods, while the other country has a comparative advantage in the production of the other good. As long as this is the case, both countries will gain from trade, regardless of the fact that one of the countries might have an absolute advantage in both the lines of production. Gains from Trade What is the gain from international trade? As we have already said that in the situation of international trade and international specialization different countries specialize in the production of different commodities. The effects (or gains) of trade can be seen by comparing no trade situation and the situation of trade. This is explained below; Example, Production of 20 labour units U.S.A. 4x or 10y India 1x or 5y Now suppose both U.S.A. and India employ 40 labour units in the production of goods. In the situation of no trade (or no specialization) In this situation, U.S.A. and India both of them produce both the goods and they employ equal labour units (example., 40 units) in the production of x and y goods. So, Production of 40 labour units U.S.A. 4x + 10y India 1x + 5y Total production 5x + 15y In the situation of trade (or specialization) In this situation, U.S.A. employs all its labour units (example., 40 units) in the production of x and India employs all its labour units in the production of y good. So, Production of 40 labour units U.S.A. 8x India 10y Total production 8x + 10y The difference between production with specialization and production without specialization and production without specialization is equal to (8x + 10y) - (5x + 15y) = 3x - 5y. If the value of this is positive then only international trade (or specialization) will be beneficial. This we can calculate on the basis of domestic exchange ratios of x and y goods in the domestic economy of the country. Since in U.S.A. 4x = 10y Hence the domestic exchange ratio is 1x = 2.5y in U.S.A. Now if we substitute this value of x in 3x - 5y = 7.5y - 5y = 2.5y Thus, from U.S.A.s point of view the total output in the situation of specialization will increase equivalent to 2.5y and this is the gain of trade. In India 1x = 5y, so this is the domestic exchange ratio in India. Now put this value in 3x 5y. Thus, from Indias point of view the gain of trade is equivalent to 10y. Thus, the world can have more production or can enjoy more consumption in the situation of trade in comparison to no trade situation. Criticisms of Ricardian Theory of Comparative Cost The theory of comparative cost has been attacked on many fronts by many economists from

time to time. Some of the important criticism are given below. 1. Wrong assumption of labour cost It is based on the labour theory of value. This theory estimates cost of production on the basis of labour cost. But the total costs include non-labour costs as well, because labour is not the only factor of production. Hence, critics assert that it is not labour cost but money cost alone that can serve as the basis of comparison. 2. Unrealistic model of two countries two commodities The Ricardian model is restrictive in operation as it relates to two commodities and two countries only. In actual practice, international trade is among many countries with many commodities. A rational theory should not have such limitations. 3. Unrealistic assumption of the law of constant cost It assumes constant returns to scale and thus constant costs of production in both the countries. But in actual practice, the law of constant cost cannot be in operation for all times. Eventually we find the operation of the law of diminishing returns (example., the law of increasing costs). 4. Unrealistic assumption of full employment The main drawback of the theory of comparative cost is that it is based on the assumption of full employment. In the real world we find the state of under-employment. 5. Wrong imagination regarding factor mobility The theory assumes that factors of production are perfectly mobile within the country, but perfectly immobile among the countries. Ohlin does not agree to it. Immobility of factors is not a special feature of international trade, it is also prevalent within the different regions of the same country. 6. Transport costs ignored Transport costs are assumed to be absent. However, in actual life, transport cost may be more than the production cost in the case of some commodities. To ignore transport costs in determining comparative cost differences is a serious defect of the theory. In fact, for international trade, comparative costs advantage must exceed transport costs. 7. One sided The Ricardian theory of comparative cost is a one-sided theory of international trade, as it takes no account of the demand aspect. 8. Unrealistic The theory is unrealistic in the context of the modern world. It assumes free and perfect competition which is only a myth. 9. Static theory The theory is static in nature. It assumes full employment, no change in price, wage-rate and the quantities of factors of production. All these assumptions can be true only in a static economy. But the real world economy is a dynamic one. 10. Not applicable in underdeveloped economies The theory of comparative cost does not conform to the conditions prevailing in under-developed countries. This theory only seeks to maximize current national output. But the problems of underdeveloped countries refer to the maximization of the rate of growth. Despite these limitations the theory has a stand. It has narrated the truth that comparative advantage is definitely an advantage which should be gainfully exploited in international trade.

Study Note - 8
PUBLIC FINANCE 8.1 INTRODUCTION
It relates to the earning and spending activities of public authorities viz. Government. A government not only earns money in diverse ways it can also create new money for its spending by borrowing from central bank. Apparently, therefore government has no fixed budget constraint as private sector unit faces. It is not forced to cut its coat according to cloth. Rather the level of public spending determines public revenues to be acquired. Herein lies the basic difference between Public Finance and Private Finance. A private household or a corporate body cuts its coat according to its cloth that is, its spending is influenced by its earning. Another point of contrast between Private Finance and Public Finance is that, private individual or corporate body can earn as much as possible. But the government not only earns money in different ways but it has the power to create new money to bridge the gap between its normal earning and spending. Against its securities the Central Bank can grant the Government loan by the creation of new money.

8.2 TAXATION
Tax revenue is the vital source of public income. A tax is a compulsory contribution collected from citizens for which the tax payers cannot expect any quid pro quo example. direct benefit from the payee. Its compulsory nature and absence of benefit to payers are two features by which taxes differ from non tax revenues like fees, fines etc. Taxes are sources of public income but that is not all. They are used for bringing distributive justice, controlling inflation, achieving full employment, curtailing consumption etc. Objectives of Taxation According to classical writers every tax is an evil. J.B. Say stated that The very best of all plans of finance is to spend little and the best of all taxes is that which is least in amount. This is because the classical economists believed in the golden rule of zero income and zero expenditure by the government. But after the Great Depression of 30s a great change has taken place in our conception to the ideal for which government should tax. Firstly, the primary objective of taxing is to raise resources from private hands in order to carry out diverse activities of the public authorities. With the passage of time the activities of modern governments have increased substantially, Accordingly the need for finance has also increased. The easiest way of raising resources is by the use of tax mechanism. If fact, tax revenue every where in the world exceeds the other sources of public revenue. Thus tax is an important way of diversion of resources for socio-economic purpose by the government from private hands. Secondly, some taxes are imposed with the object of restricting the use of some obnoxious goods. An excise duty on wine restricts its use which is socially desirable. Similarly a tax on import may lead to a restriction of import and thus may help in saving foreign exchange. Thirdly, taxes are also used with the objective of controlling inflation or cyclical fluctuations in the society. In a period of Demand pull inflation, the government may leave less in the hands of the people by imposing heavy Direct Taxes. As a result peoples disposable income will be less and so the excess demand will be curtailed to some extent. Similarly in a period of Economic prosperity, the government can tax at a high rate and the money thus obtained may be used in a period of depression and unemployment.

Lastly, tax is an important source of development finance. The poorer countries need large amount of fund for investment in diverse growth oriented projects. One way of financing such development activities is by widening and also by increasing the rate of taxation. It leads to involuntary savings on the part of the population and is an import source of capital formation.

8.3 DIRECT AND INDIRECT TAXES


Tax payers do not always pay the money from their own pockets. In some cases they do so and bear the burden of taxation example. the hardships of paying the tax. In some other cases, the recorded payers of a tax pay it after collecting the money, partly or wholly, from some one else. In other words, in the former cases the tax burden is not shiftable while in the latter cases they are shiftable. An Income Tax payer pays the taxable money from his own income. On the other hand, a seller of products pays Sales Tax after collecting it from buyers in the form of higher price (Cost Price + Local Taxes). So Income Tax payers cannot shift the tax burden while the sales tax payers can. A direct tax is a tax whose burden cannot be shifted example., Income Tax, Wealth Tax etc. A tax is said to be indirect whose burden is shiftable from the tax payers to some other person example., Salea Tax, Amusement Tax, Excise Duty etc. Further in Direct Tax impact and incidence fall on the same person. The tax payer himself has to pay the money from his own pocket. The burden of such a tax cannot be shifted either backward or forward. So, the basis of classifying taxes into direct and indirect is the shiftability of tax. Choice between direct and indirect taxes is difficult. They have theit respective merits and demerits. Merits of Direct Taxes Firstly, generally the rate of tax increases as Income or value of property increase in direct taxation. That is such taxes are progressive in character. Those who are supposed to have higher ability to pay are required to do so. Secondly, such taxes can be used for redistribution of income and wealth. The disparity between the income of different income groups and of inherited wealth can be reduced by a graded system of Direct Taxes. Thirdly, such taxes are economical and easy to collect. The cost of collection is not very high. Fourthly, the prayers pay such taxes consciously. He gets enough time for its payment. Lastly, such taxes are highly productive. They bring more revenue to the public Authorities. Demerits A direct tax is not a rose without thorns. It has its blemishes too. They are supposed to have a positive disincentive effect on work, income and savings. It is but quite natural that people may not like to work hard and earn more if they are forced to pay off a large part of hard earned income. Similarly, people may get disincentive to invest in building and property if inheritors are to pay high death duties. Secondly, heavy burden and not being shiftable, such taxes may create a desire to evade them by payers. This may create black wealth and unaccounted income. Public revenue is likely to be less. Thirdly, the tax axe falls more heavily on salaried class who cannot conceal their income while those who earn excessive windfall income like trader, business men, speculators can conceal their income. This is unfair and unjust. The total burden of such tax falls on a small percent of population and a vast majority could remain outside tax net. Merits of Indirect Taxes Indirect Taxes have some merits. Firstly, Widening the tax base is possible. A small amount of tax per head can be

collected from a large section of the population. Naturally the total revenue will be large enough. Secondly, the scope for evasion is lesser than Direct Taxes. Thirdly, they encounter lesser public resistance as tax payers may not be aware of their existence. Fourthly, such taxes imposed on imported goods and harmful goods like drug or wine by curtailing their use may serve social interest. Fifthly, in poor economics the scope of raising large resources from direct taxes is limited. For this, such taxes are imposed widely for meeting Public revenue requirements. Sixthly, such taxes do not have much disincentive effects on earning and enterprise. Demerits of Indirect Taxes The greatest weakness of Indirect Taxes is that they are, by and large, regressive in nature. A given amount of tax on a commodity hurts the small income group more than the richer one. In this sense, their burden fall more on poor than on rich. Thus such taxes do not conform to ability to pay and equal sacrifice principles of taxation. Secondly, as indirect Taxes are added with the price of a commodity, they raise actual price far above cost price. They are thus a contributory factor to inflation. Thirdly, commodity taxes hurt the consumers as they are forced to pay a higher price and sellers, far from gaining may suffer a loss as their sales may diminish in view of price rise. In conclusion it can be said that the coexistence of direct and indirect isessential for they serve as mutual compliments. The weakness of one can be corrected by the other. Moreover the two together can bring more revenue than any one. Hence they are equally preferable. Proportional, Progressive and Regressive Taxation On the basis of the rate of tax, taxes are classified into three forms proportional, progressive and regressive. A tax is said to be proportional when it is charged at a flat rate on all. If a man with an income of Rs. 100 pays a tax of Rs. 5 and a man with an income Rs. 10000 pays a tax of Rs. 500 then the rate of tax is 5% in both cases. It is proportional tax. In case of progressive tax, the rate of tax goes on increasing along with the increase in income or value of assets of a tax payer. When the rate of taxation decreases with the increase in income or asset value it is called regressive taxation. The most important argument infavour of proportional tax is that it leaves the relative status of taxpayers unchanged. Further it is uniformly applicable and simple. Nowadays governments prefer progressive taxation because it has certain virtues. The arguments in favour of such taxation are many. We discuss some of them. Firstly A rise in tax rates with increase in capital and income is necessary because the capacity to produce and consume increases faster than wealth and income. So, a higher rate from the higher income group will not affect them too much. Secondly, progressive taxation is also defended on the ground of diminishing marginal utility of income. As a mans net income increases marginal utility of it goes on diminishing. As successive increments of income will lead to diminishing utility so it can be argued that the richer class have greater capacity to pay taxes. Thirdly, progressive taxation is an instrument used by the government for equitable distribution of income and wealth among different classes of people. Those who are able to pay more should be taxed at a higher rate than those who are not able to pay. The money thus collected may be used for the benefit of weaker classes. This will lead to a rise in economic welfare.

8.4 CANONS OF TAXATION


Tax is a delicate instrument in the hands of the government. Just as a drug deadly when taken in large doses may have a reviving effect on the body to which it is administered with caution, so also taxation. How can tax be properly administered? Economists have suggested certain principles which the government can follow for ideal tax administration. Adam Smith long ago propounded four such principles, which he called canons as guiding stars of tax authorities. (a) Cannon of Ability Smith was of the view that subjects of a state ought to contribute in proportion to their respective abilities example., in proportion to the revenues they respectively enjoy. A proportional tax, as Smith advocated, implies equality of sacrifice. (b) Cannon of Certainty This cannon lays down that taxes be certain and not arbitrary. Prior intimation as regards the amount and time of payment was thought necessary for reducing trouble and difficulties of tax payers. (c) Cannon of Convenience According to Smith taxes be collected according to the convenience of the payers. It should be levied at the time or in the manner in which it is most likely to be convenient. (d) Cannon of Economy Smith suggested that tax system be so framed as both to take out and to keep out of the pockets of the people as little as possible over and above what it brings into the pubic treasure. This implies least cost collection. Even with taking as little as possible from tax payers, tax revenue can be large if small amount is used up for their collection. Barring the first, all the cannons put emphasis on administrative side of taxation. The ability to pay implied proportionality. But now it is interpreted in terms of progressiveness. As a natural sequence to proportionality is equality of sacrifice on the part of tax payers. But modern thinking is not equal sacrifice but least aggregate sacrifice. After Smith many other principles have been developed looking after the conflicting interests of government and taxpayers. (a) Principle of Least Sacrifice Payment of taxes involves a certain burden of sacrifice upon each taxpayer. What should determine the distribution of tax burden. Some hold that the aggregate sacrifice should be least, while other opine that the sacrifice borne by the taxpayers be equal. But the problem is that sacrifice example., real burden of taxes can hardly be measured. (b) Cost and Benefit Principle This principle holds that whenever costs are incurred for the benefit some individuals or groups of men, such people should pay such costs in the form of taxes. The Benefit principle states that tax burden should be proportionate to the amount of benefit enjoyed by different people. It is very difficult to measure costs and benefits. Some services provided for all and cannot be specifically charged for. Similarly, most benefits are of general type. Hence it is difficult to ascertain who are the real beneficiaries. Moreover, a rigid adherence to this principle will rule out many of the general functions of a government. Relief of the poor, unemployment dole cannot be undertaken, as cost cannot be borne by the beneficiaries. In a word, this principle is abstract and impracticable. (c) Ability Principle The principle states that distribution of tax burden will be ideal if taxes are levied on the basis of payers ability to pay. It

seems to be just and equitable principle. But by what test can we measure a mans ability. The answer simply is that by the size of his income. Heaviest burden should be placed upon the broadest back. But Income cannot always be a criterion of ability (i) people with same income may have different personal obligations (ii) unearned income (income from inherited property) involves less sacrifice than hard earned income. So income is not a sound test of ability. Can it be measured by the size of expenditure? Some believe that personal expenditure indicates how much a man is taking out form the stock of goods and services of the society. To think that no man spends unless he is able to do so, is not always correct. A man may be compelled to spend more because of family liabilities. Moreover it is very difficult to ascertain expenditure, especially consumption expenditure. A third test of ability may be property. Property in its wider sense implies all income yielding assets. Possession of more property means more ability to pay. But there are certain difficulties. First, men with no property may earn high income and with property may earn less. Obviously the former is able to pay more than the latter. Secondly, inherited property and property acquired by individual effort and sacrifice cannot be the same. To tax them equally, will be unjust. Thirdly, all properties do not bring a regular flow of income. A house for ones own living or jewellery yield no income.

8.5 EFFECTS OF TAXATION


The imposition of a tax may set in motion a series of effects and adjustments in society. Broadly they relate to production and distribution. Production The impact of tax on production may be favourable or unfavourable, depending upon its effects on willingness and ability to work as well on the distribution of economic resources between different regions and economic activities. Apparently a tax is likely to reduce the desire to work and earn. Actually it need not be so. Tax on unearned incomes and unexpected incomes may not have an adverse effect. Secondly, a high rate of tax may induce people to work hard and earn more to compensate the loss of income caused by taxation. Taxation affects production in another way. A discriminatory tax may divert capital from more heavily taxed industries to one less heavily taxed. However such diversion is often socially desirable channels. On the other hand, tax may cause harmful diversion of resources. A tax on an essential goods or service by checking production may cause harm to the society. Similarly capital may flow out of a country if its tax rates are relatively higher. A tax on a particular type of industry, in general, checks production and diverts capital away from that line of production. But the tax proceeds, if used judiciously, may provide stimulus to production in some other industries of high social value. Distribution The effects of taxation on distribution of income depend on the nature of tax. Inheritance tax, property tax, a tax on windfall earnings may go a long way in reducing inequality of income and wealth. Again, tax on necessary goods used by all classes of people, poll tax are said to be regressive in nature in the sense that they hurt the poor class more than the richer one. Similarly a system of taxation which is proportional that is, a uniform rate of tax is imposed on all irrespective of the size of their income or property have a tendency to create inequality in the distribution of income among various groups. Taxes have their redistributive effect good or bad and the government can use them to serve its goal. Fiscal Policy and Monetary Policy

Fiscal policy is a policy of the government relating to public expenditure, revenue, borrowing etc. It includes taxation policy, subsidies, deficit financing etc. Monetary policy, on the other hand, is one which is used to control the supply of money in circulation or to control bank credit in a country. (a) Fiscal policy is formulated and implemented by government while monetary policy is executed by the central bank (b) Fiscal policy has wider scope compared to monetary policy. Monetary policy is mainly used to control the money supply so as to secure financial stability. Its objective is often to allocate bank credit rationally. Fiscal policy is used to promote public welfare and economic development. It also seeks to achieve greater equality in the distribution of income and wealth among various classes of people. Another objective of Fiscal policy is to control import and to promote export. (c) The various tools of Fiscal policy are taxation, public expenditure, public borrowing, deficit financing, licensing. The various tools of Monetary policy are Bank Rate policy, open market operation, variation of reserve ratio, selective credit control etc. (d) Monetary policies can be implemented easily and they have quick reaction. But Fiscal measures can be taken after debate and discussion in Parliament. Hence they are time consuming. Nor are their effects upon the economy very quick. Both of them are applied to serve some common objectives like controlling inflation or business cycle. Hence the two policies are more often used together. This is called Monetary Fiscal Mixes.

8.6 DEFICIT FINANCING


When government spending exceeds its earnings the budget is said to be deficit, and to bridge the gap if government borrows money from the central bank or run down its accumulated reserves, it leads to a net addition to money supply. This way of financing a deficit budget is what is called Deficit Financing. Thus deficit financing denotes more spending by the government through created money. Purpose Lord Keynes advocated deficit financing for lifting up of an economy from business depression and unemployment. According to him demand deficiency was the root cause of these problems. Hence the prescription to raise private expenditure comprising consumption and investment. The total expenditure of the private sector cannot increase on its own in a depressionary economy. It needs external push. This is what the government should do through a policy of budgetary deficit financed by new money. Why the deficit be not covered up by taxation and borrowing? In that case, private spending power will diminish. So total expenditure will not increase. It is only creation of new money and its injection into the economy can raise the C + I + G curve upward to a level where unused and unemployed resources may be gainfully employed. An excess spending by the government by created money, will lead to a corresponding increase in private sectors earning and spending ( I + C). Thus, the shortfall in demand can be overcome. So long there are unemployed men and resources, creation of new money and its spending by the government can cause more output and more employment by activating those idle resources. But once resources are fully employed more spending by the Government will lead to inflationary rise in price. Merits The aforesaid discussion shows that financing of a deficit budget by the creation of new money has a helpful role (1) The new money added with the old ones increase the total liquidity of an

economy thus increasing total money income and effective demand. (2) This enhances the total spending power both C and I. Thus effective demand increases. (3) At less than full employment, a raise in effective demand activates the unemployed factors. (4) With such activisation, national output and employment will go on rising. (5) Ultimately the economy may achieve full employment and optimum output. (6) In the poor economies this method of financing plays an important role as a source of development finance. In order to come out of the vicious circle of poverty originating from low income and large unemployment, planners finance planned investment by creating more and more new money. Demerits. A large amount of new money created by the government may be dangerous. It is argued that deficit financing leads to inflation. Deficit financing creates excess demand. But there may not be an excess supply due to the unavailability of certain factors of production. This may lead to demand full inflation. This is generally likely to happen in poor economies where raising of effective demand through large scale public investment may not increase output and employment on account of bottlenecks. Deficit financing thus generates inflation which persists along with unemployment. This situation is known as Stagflation. Secondly, new money issued by the government may be used by the private sector for speculative and unproductive purpose. In such a situation it will cause more harm than good.

Study Note - 9
FORMS OF BUSINESS ORGANISATION 9.1 INTRODUCTION During the life time human being has to undertake numerous and varied activities. The nature, propensity and the motivating force behind them are not similar in all cases. The infinite human activities are of two kinds. (1) economic activities and (2) non economic activities. Economic activities are those which are inspired by the desire to earn money or livelihood. For example a worker is working in a factory, a clerk is attending to his duties in office, a teacher is teaching in the class. Non economic activities are those which are undertaken not for earning money but out of love, patriotism, humanity, social and religion, customers etc. Economic activities are those human activities which are related to the production, exchange, distribution and unlimited consumption of wealth. They are inspired mainly by economic consideration and result in the production of economic goods and services. These activities belong to the domain of business. Hence all human activities related with the earning and spending of wealth fall under the category of economic activities. Economic activities are also identified with occupations. Business is an occupation in which organized production and exchange of goods and services are undertaken with a view to earn profits. There are different types of business activities. A grocery shop is as a much a business enterprise as a giant company like Reliance Industries or Maruti Udyog Ltd. Business is an economic activity involving the production or procurement and sale of certain good and services for the satisfaction of human need in the society. All the business activities fall under three difference categories (1) Industry (2) Trade (3) Commerce. Industry, Trade and Commerce are closely related to each other. They are interdependent. Industry depends upon commerce for the distribution of goods and services and commerce has to depend upon the industry for the supply of goods. Trade provided support to industry and commerce. A modern businessman desires that his activities should be well organized and planned so as to active maximum success. In order to fulfil this desire a number of forms of business organization have been evolved to suit different situations and purposes. For example, when the business is of a local nature and on a small scale, a sole proprietorship would be found to be suitable whereas if export and import on large scale is to be undertaken by a concern a joint stock company may have to be formed. Each form of business organization has its own merits and demerits. Different types of business entities along with their advantages and limitations have been depicted in the following pages.

9.2. SOLE-PROPRIETORSHIP
9.2.1 Introduction Sole proprietorship is the oldest, the simplest and, in some respects, the most natural form of business organization. In such an undertaking, the proprietor brings in his own capital, manages the business himself, bears all the risks alone and takes all business decisions. Here, the proprietor uses his own skill and intelligence in the management of its affairs with almost unlimited freedom. The proprietor is entitled to receive all the profits and assumes all the risks of ownership. The competence of the proprietor determines the prospect of the business. The proprietor is, in fact, the sole organizer, manager, controller and master of his business. 9.2.2 Meaning and definitions of sole proprietorship

The sole proprietorship is a form of business that is owned, managed and controlled by an individual. This organization is also called a single ownership or single proprietorship. The sole proprietorship form of business is generally operated on a small-scale basis. At present, it is the most popular form of organization. Definitions given by eminent management experts : (a) Sole proprietorship is an informal type of business owned by one person. [James L. Lundy] (b) Sole proprietorship is a type of business unit where one person is solely re sponsible for providing the capital, for bearing the risk of the enterprise and for the management of the business. [J.L.Hanson] (c) Sole proprietorship form of ownership, a single individual organizes and op erates the business in his own name. He is not only responsible for its manage ment but also for its risks. [Kimbell and Kikbell] (d) Under the sole proprietorship form of ownership, a single individual orga nizes and operates the business in his own name. He is not only responsible for its management but also for its risks. [J.M.Shubin] Thus, sole proprietorship is a one-man show where an individual by his cleverness, courage, ability, honesty, education and co-operation tries on business exclusively by and for himself. The proprietor not only bears all the risks but also receives the entire gains form the business. 9.2.3 Characteristics of the sole proprietorship form of business. The main characteristics of a sole proprietorship business are as follows : (1) Capital contribution : The proprietor alone has to arrange for necessary capi tal and other assets essential for starting and subsequent operation of his busi ness. The proprietor provides the entire capital, either from his private re sources or by borrowings from relatives and friends. (2) Management and control : The proprietor has full authority over the affairs of the business. He is free to take decisions. There is no need for consultation with any other person. The working of the concern is entirely based on his own dis cretion and decision. (3) Unlimited liability : The liability of a proprietor is always comprehensive and unlimited. He is liable for all the debts and loans of the business. If the assets of the business are not sufficient to meet the liabilities, in that case his personal property can be attached. (4) Limited area of operation : The scope of operation of a sole proprietor is limited because of limited capital, limited managerial ability and limited space. (5) Free from legal formalities : A sole proprietor is free from any legal formalities to be complied with in the establishment of the business. Sole proprietor ship is subject to minimum legal formalities and Government restrictions. (6) Distribution of profit : The sole proprietor receives all the profits of his business alone. Moreover, he bears all the losses of the business (if any). So, there is a direct relationship between effort and reward. A sole proprietor gen erally puts in his heart and soul to increase his profits. (7) Flexibility in operations : A sole proprietor enjoys the maximum flexibility in his business. He can easily change, expand or reduce business according to his discretion. (8) No separate entity : This form of business does not have an entity separate from the owner. The proprietor and the business enterprise are not the same. (9) Discretionary start and end : A proprietor can start the business at any time without any legal formalities. Similarly, he can terminate the business with out waiting for legal compliance. (10) Trade secrecy : The proprietor keeps all his trade secrets only to himself. In

this way, he avoids competitors by retaining business secrets. (11) Freedom in selection of trade : A proprietor can start any business according to his own will. There is no binding on him. He is not supposed to consult any person while making a selection of his trade. (12) Personal relations : A sole trader has always direct relations with his custom ers. The business, which requires personal service and attention, is generally established under this form of organization. 9.2.4 Legal position of a sole proprietor The following points are worth considering with regard to the legal position of a sole proprietor : (1) There is no legal restriction in the establishment of a sole proprietorship form of business. (2) There is no specific law under which this business required registration. (3) Licenses are, in some cases, obligatory [example., to open a wine shop]. (4) This business is subject to the general laws of the country. (5) The liability of the sole proprietor is unlimited. (6) The proprietor and his business have one personality. The business exists only with the sole proprietor. 9.2.5 Merits ( or advantages) of sole proprietorship form of business The sole proprietorship form of business possesses the following significant merits : (1) Easy formation : The sole proprietorship business can be established very easily. No legal formality or other complicated procedure is required to be followed. A person can start business operations as and when he desires. Only a licence is needed in some special cases (example., opening a wine shop, etc.) (2) Prompt decisions : A proprietor can take quick decisions regarding his business affairs (example., price policy, credit policy, discount policy, disposal of surplus funds, etc.). He can take spot decisions as and when required. (3) Smooth functioning : There is none to oppose his decisions. Therefore, he can function smoothly. He can control his business affairs personally. (4) Incentives for hard work : There is always a direct relationship between the efforts and the rewards in the case of a sole proprietorship. Therefore, the more a proprietor will work, the more he will earn. It provides incentives to work hard, efficiently and honestly. (5) Flexibility in operations : This form of business can easily adapt to the changing conditions of the market. The line of the business can easily be changed or modified according to change in socio-economic conditions. A proprietor can easily change, expand or reduce his business on account of change of market conditions. Thus, he enjoys the maximum flexibility in his business. (6) Maintenance of business secrecy : Maintenance of secrecy is very vital in a smallscale business. A proprietor can maintain secrecy regarding his business as he has not to consult anyone on business decisions. Possibilities of maintaining complete secrecy give him a greater competitive strength. (7) Intimate contacts with customers : The proprietor develops close and personal contacts with his customers. This enables him to cater to the exact requirements of his customers. He can easily ascertain the nature of tastes, habits and attitudes of his customers. He can also know their difficulties, complaints easily by keeping personal contact with the customers. (8) Inexpensive management : The management of a sole proprietor is not expensive at all. All supervisory and management activities are performed by the proprietor himself, thus minimizing the additional expenditure on managerial staff. Moreover, overhead costs of management are relatively low. This leads to a good deal of

savings. (9) Efficiency in management : The proprietors personal interest is involved in his business. He tries, heart and soul, to eliminate all sorts of wastages in order to reduce costs and maximize profits. (10) Freedom regarding selection of business : A sole proprietor can select the business of his choice and he is not required to seek permission from anyone else for this purpose. He can also change his business acoording to business requirements and changing circumstances. (11) Minimum Government regulations : The business activities of a sole proprietor are least regulated by law and the Government. A sole proprietorship business has to comply with mainly labour laws and tax laws. There is no other interference in the day-to-day running of the business from the Government. (12) Tax advantage : A sole proprietorship business enjoys the minimum tax burden as compared to other forms of business organizations. A proprietor is taxed as an individual an not as a business unit separately. Income tax authorities make no difference between the proprietor ad the business regarding the assessment of income tax. 9.2.6 Demerits Limitations of sole proprietorship form of Business The sole proprietorship form of business suffers from the following drawbacks : (1) Unlimited liability and risk : The principles of unlimited liability for the owner puts the proprietor at great risk in times of losses. The proprietor will always be haunted by the fear of losing his private property in case of failure of his business. (2) Limited financial resources : The capital and other resources of an individual are always limited. An individual proprietor cannot offer much security to raise funds from financial institutions. Therefore, there appears to be a limited capacity of expansion of business operations. (3) Limited managerial capability : It is not possible for a single individual to posses expertise in all fields (example., production, finance, personnel, marketing, etc.) So, the decisions of the proprietor may not be balanced due to limited managerial ability. (4) Instability of the business : The continuity and existence of a sole proprietorship form of business is most uncertain. Any uncertain events happening in the personal life of the proprietor are surely to disturb the smooth working of the business. The business may suddenly come to an end with the death or physical incapacity of the proprietor. (5) Uncertainty in purchase and sales : The proprietor is unable to get full advantage of bulk purchases and increased sales, as he carries on his business on a small-scale. This may lead to a rise in the cost of business operations. This form of business cannot enjoy the benefits of large-scale production. (6) Weak bargaining position : The proprietor cannot control the market because of his limited financial resources. Thus, his bargaining power is weak, both as a purchaser and seller. (7) Limited scope for employees : A sole proprietor cannot attract trained and qualified persons for reasons of limited career opportunities. Moreover, a proprietor cannot offer financial incentives to attract skilled employees because his activities are on a small-scale. (8) No check and control : A sole proprietor is the monarch of his business. No outsider can question him on his acts and deals. Moreover, there is nobody to help and guide him. There are no checks and controls on the activities of the p proprietor. (9) Too much secrecy causes suspicion : Secrecy is desirable for business operations but too much secrecy leads to suspicion by outsiders. The outsiders are unable to asses the soundness of a proprietorship form of business because it is not required

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

9.3 JOINT HINDU FAMILY BUSINESS


The Joint Hindu Family business is a peculiar form of business organization, operating in our country. It is a form of business organization is which the family possesses some inherited property and the head of the family, known as Karta, manages its affairs. It is possible only in those parts of India where the Mitakshara System (Hindu Law) of inheritance is in operation. It means that no Joint Hindu Family is possible in Bengal and Assam where Dayabhaga system of inheritance prevails. Again, the joint family business is confined to those persons who constitute the coparcenaries interests. Previously, female members and their relations did not have coparcenaries interest; only male members had the interest. Under the Hindu Succession Act, any female relative of deceased (male) coparcener is entitled to get a share of the coparcenery interests at the time of death of such coparcener. The rights and liabilities of coparceners are

determined by the general rules of the Hindu Law. Thus, joint family business is created by the operation of Hindu Law and does not arise out of contract between the coparceners. 9.3.1 Characteristics (1) Status. The membership of the family business is the result of status arising form birth in the family. Hence the majority or minority in age of the members is immaterial. (2) Only male members. Female members are excluded from the class of coparceners. Only male members can be coparceners. (3) No Registration. For the purposes of enforcing its claims and right it does not require registration like partnership. (4) Management. The business is managed by Karta, the head of the family. Other family members have no rights of arrangement over the business and they cannot contract any loans on mortgages binding on the joint family property. (5) Liability. The liability of all members of the family, except the Karta, is limited to the value of their individual interests in the joint property. The liability of Karta is unlimited. (6) Fluctuating share. The share of each members interest in the family property including business is always fluctuating in character. The members interest increase by death of existing coparcener and decreases by birth of a new coparcener. (7) Continuity. The existence of the business is not affected by the death or insolvency of a coparcener of the Karta. (8) Supremacy of karta. Karta is supreme authority in the business. The members cannot question the judgment of Karta in the conduct of the business. If they are aggrieved, they can ask for the partition of family and business property. But they cannot ask the Karta for an account of past profits and losses. 9.3.2 Merits Following are the Merits or Advantages of Joint Hindu Family Business :(1) Assured of a share in profits. Every coparcener is assured of a share in the profits of the business, irrespective of his contribution to the successful running of the business. (2) Freedom of action. Karta can cake quick decisions and can also act without any interference by others. (3) Limited liability. The liability of all the coparceners except that of Karta is limited. (4) Insurance against contingencies. It serves as an insurance cover for maintaining the children, widows, ailing or invalid members of the family. (5) Cooperative efforts. The duties of the business are divided among the members in accordance with their capabilities and resourcefulness. (6) Inclusion of finer values of life. Every member of the family gets an opportunity for participation in the business and the qualities of duty, sacrifice and discipline become embedded in them. 9.3.3. Demerits Following are the demerits or disadvantages of joint family business : (1) Lack of motivation- Members do not fell motivated to work hard because there is lack of direct relationship between benefits and efforts. (2) Scope for misuse- Since Karta has full freedom and authority tomanage the business, he may misuse this freedom for his personal benefits and gains. (3) Limited resources- It has limited resources at its disposal for investment in business. (4) Family quarrels- Small family quarrels may lead to its disintegration. This form of organization is declining because of the strains on joint family system due to preference for individual family living.

9.4. PARTNERSHIP FIRM


The partnership firm of business organization grew out from the limitations of sole proprietorship.

When the business expands, one man is unable to arrange the financial resources and bear the risks. He cannot supervise and manage all the functions of business personally. Therefore, two or more persons joint hands and combine their capital and skill to start and run a business, Partnership is thus an extension of sole proprietorship. 9.4.1 Meaning and Definitions of Partnership A partnership is a voluntary association of two or more persons who agree to carry on some business jointly and share its profits and losses. They combine their funds and skills to carry on business together. Some popular definitions of partnership are as follows: Partnership is the relation existing between persons competent to make contract, who agree to carry on a lawful business in common with a view to private gain. L.H. Haney A partnership or firm as it is often called is, then a group of men who have joined capital or services for the prosecuting of some enterprise. Kimball Partnership is the relation between persons who have agreed to share profits of a business carried on by all or any one of them acting for all. The Partnership Act A partnership is a form of business organization in which two or more persons upto a maximum twenty join together to undertake some form of business activity. J.L.Hanson Two or more individuals may form a partnership by making a written or oral agreement that they will jointly assume full responsibility for the conduct of business. John shubin. The persons who enter into partnership with the one another are individually called partners and collectively a firm. The name under which they carry on business is called the firm name. 9.4.2 Essential elements (or features) of partnership The essential elements of a partnership contract are enumerated as follows : (i) Lawful business : The term business includes all trades, professions or occupations. The purpose of a partnership agreement is to carry on a lawful business and nothing else. (ii) Name of the business : The partnership firm must have its own name. The name in which the business is carried on is called the firm name. (iii) Association of persons : At least two persons are needed to make a partnership. Indian Partnership Act is silent about the maximum number of members. The Indian Companies Act provides that maximum number of member as then (in case of a Banking business) and as twenty (in other cases). (iv) Profit motive and sharing of profits : Partnership business is formed with the object of earning profit. The earned profit is to be distributed among the partners as per an agreed ratio. (v) Contractual relationship : Partnership is a contractual relationship between the persons who are competent to enter into a contract. Relationship between partners arises from contract and not from status. (vi) Mutual trust and confidence : The successful working of a partnership depends on mutual trust and confidence of its partners. Partners have the duty to observe utmost good faith in business dealings. (vii) Principal-agent relationship : It is not necessary that the business should be managed by all the partners. Any one or more partners can run the business on behalf of all the partners. Each partner is an agent of the firm and his activities bind the firm. (viii) Restrictions on transfer of share. No partner can transfer his share in the partnership without the prior consent of all the other partners. Thus, a partner cannot transfer his interest at his own will. (ix) Unlimited liability : Partnership is based on the principle of unlimited liability. The personal property of the partners can be attached to satisfy the claims of

creditors of the firm, if the assets of the firm are insufficient to meet the claim of the creditors. (x) Management and control : Every partner has a right to take an active part in the management of the firm. The unanimous consent of all partners is required to take any major decision. (xi) Financing : Ordinarily, each partner is required to contribute capital on a profitsharing ratio. However, in some cases, a partner with special technical skills and ability may not contribute at all towards the capital of the firm. 9.4.3 Kinds of Partners We can classify partners into various categories, depending on the role played by them in their day-to-day business activities. (i) Based on extent of participation : (a) Active partner; (b) Sleeping partner. (ii) Based on sharing of profits : (a) Nominal partner; (b) Partner in profits only. (iii) Based on liabilities : (a) Limited partner; (b) General partner (iv) Based on the nature of behaviour : (a) Partner by estoppel; (b)Partner by holding out. (v) Other partners : (a) Secret partner; (b) Silent partner. (i) Based on extent of participation : (a)Active partner (or Working partner) : An active partner is a partner who not only contributes capital but also takes an active part in the conduct of the business of the firm. He is a full-fledged partner in the real sense of the term. The active partner is also known as a working partner. (b) Sleeping partner (or Dormant partner) : A partner who does not take active part in the management of the business is called a sleeping partner. A sleeping partner only contributes his capital to the business and shares in the profits or losses of the firm. (ii) Based on sharing of profits : (a) Nominal partner (or, Quasi/Ostensible partner) : Nominal partner is a person who neither contributes capital not takes an active part in the conduct of the business of the firm. He only lends his name and reputation for the benefit of the firm. He is not entitles to receive any benefit or share of profits from the firm. (b) Partner in profit only : A partner in profit is a person who gets a share of profits but does not share any losses of the firm. Such a partner is not allowed to take part in the management but will have to bear all liabilities to third parties. (iii) Based on liabilities : (a) Limited partner : A limited partner is a partner who has the right to take part in the affairs and management of the firm. The liability of such a partner is limited to the extent of the capital contributed by him. In a partnership firm, all the partners cannot have limited liability. At least one partner must have unlimited liability. (b) General partner : In case of a general partnership, the liability of all they partners is unlimited. A general partner is entitled to participate in the management of the business. (iv) Based on nature of behaviour : (a) Partner by estoppel : A partner by estoppel is a person who has neither contributed any capital nor takes any part in the management of the firm. But he conducts himself in such a manner which leads third parties to believe that he is a partner of the firm. If fact, he is not a partner of the firm. He is held liable for the debts of the

firm to such third parties who might heave entered into contract with the firm under such an impression. (b) Partner by holding out : if a person is declared by other as a partner of the firm and he does not contradict it immediately and remains silent, he would be treated as a partner by holding out. He is liable to such third parties who enter into contract with the firm in the belief that he is a partner of that firm. (v) Other partners : (a) Secret partner : A partner who wants that his name should be kept secret is called a secrete partner. Such a partners is, however, liable for the debts of the firm. (b) Silent partner : A partner who does not have any voice in the management of the firm is called a silent partner. Such a partner, however, shares the profits or losses of the firm and bears the burden of its debts. 9.4.4 Kinds of partnership The partnership business has been divided into different categories as follows: According to aims : (a) Partnership at will; (b) Particular partnership. According to time : (a) Fixed term partnership; (b) Flexible partnership. According to legality : (a) Legal partnership; (b) Illegal partnership. According to nature : (a) General partnership; (b) Limited partnership. According to aims : (a) Partnership at will : When a partnership is formed to conduct the business for an undefined period, it is called partnership at will. The life of such a partnership depends on the will of the partners. The partnership can be dis solved at the desire of any partner on giving due notice. Such a partnership firm is formed to carry on lawful business for an indefinite period. (b) Particular partnership : When a partnership is formed to conduct a particular business of a temporary nature or only for a certain period, it is called particular partnership. Such a firm is dissolved immediately on the completion of a particular venture or on the expiry of a certain period. (ii) According to time : (a) Fixed term partnership : The partnership which can be formed for a fixed period of time is called fixed term partnership. On the expiry of that fixed period, the partnership is automatically dissolved. (b) Flexible partnership : When a partnership is formed neither for a fixed period nor for any particular venture, it is called flexible partnership. Such a partnership firm continues its operation till any contingent happening (under which dissolution is compulsory). (iii) According to legality : (a) Legal partnership : When a partnership firm is established under the conditions of the Indian Partnership Act, 1932, it is known at legal partnership. Here, the minimum number of partners is two and maximum is twenty (but in a Banking Business, the maximum number is ten). (b) Illegal partnership : When the business of a firm becomes (or is declared) illegal, violating the provisions of any law of the country, it is called an illegal partnership. When the number of partners, either reduces to less than two or increases to more than twenty, then also the partnership becomes illegal. (iv) According to nature : (a) General partnership : In a general partnership, the liability of each partner is unlimited.

In India, all partnership firms are general partnerships. In the absence of an agreement, the provisions of the Indian Partnership Act, 1932, will be applicable for general partnership. Each partner of a general partnership is entitled to take an active part in the management of the firm, unless otherwise decided by the other partners. (b) Limited partnership : A limited partnership is a partnership consisting of some partners whose liability is limited to the amount of capital contributed by each. In a partnership firm, all the partners cannot have limited liability. At least one partner must have unlimited liability. Minor as a partner. A minor is a person who has not completed 18 years of age. A minor cannot become a partner because he is not qualified to enter into a contract. But he may be admitted to the benefits of partnership with the mutual consent of all the partners. On being so admitted, a minor becomes entitled to a share in the profits of the firm. He can inspect and copy the books of account of the firm but he cannot take active part in the firms management. His liability is limited to the extent of his share in the capital and profits of the firm. He cannot file a suit against the firm or its partners to get his share except when he wants to disassociate himself from the firm. After becoming a major, the minor must give a public notice within six months if he wants to break off his connections with the partnership firm. If he does not give such a notice within six months or if he decides to remain in the firm, he comes liable to an unlimited extent for the debts of the firm from the date he was admitted to the benefits of partnership. He also becomes entitled to take active part in the management of the firms business. Rights and Liabitities of a Minor Partner : 1. A minor is entitled to a share in the profits of the firm. 2. A minor may be admitted with the benefits of partnership with the mutual con sent of all the partners. 3. A minor has got the right to inspect and copy the books of accounts of the firm. 4. A minors liability is limited to the extent of share in the capital of the firm. 5. Being a minor he cannot file a suit against the firm or its partners to get his share except when he wants to leave the partnership. If he does not express anything in writing, his existence as a partner will be implied and he will be subject to unlim ited liability like the other partners. 6. After he becomes a major he also becomes entitled to take part in the manage ment of the firms business. 9.4.5 Partnership Deed. It is a document containing the terms and conditions of a partnership. It is an agreement in writing singed by all the partners duly stamped and registered. If defines the rights, duties and obligations of partners and governs relations among them in the conduct of business affairs of the firm. It is not a public document. The partnership deed must not contain stated in partnership deed can be changed with the consent of all the partners. Partnership deed usually contains the following clauses : 1. Name of the firm. 2. Nature of the firms business. 3. The principal place of business. 4. Duration of partnership, if any. 5. Names and address of partners. 6. Amount of capital to be contributed by each partner. 7. Amount which can be withdrawn by each partner. 8. The profit-sharing ratio. 9. Rate of interest, if any, on capital and drawings. 10. Amount of salary or commission payable to partners. 11. Allocation of work among partners.

12. Mode of valuation of goodwill. 13. Procedure for admission, retirement, etc. of a partner. 14. Procedure for maintaining accounts and getting them audited. 15. Procedure to be followed in the event of dissolution of the firm and settlement of accounts. 16. Arbitration clause in case of disputes among partners. 17. Loans and advances by partners and rate of interest payable on them. 9.4.6 Registration of Partnership Registration of a partnership firm is not compulsory under law. The Partnership Act 1932 provides that if the partners so desire they may register the firm with the Registrar of Firms of the State in which the main office of the firm is situated. A firm may be registered at the time of its formation or at any time thereafter. Procedure for Registration In order to get a partnership firm registered an application in the prescribed form must be filed with the Registrar of Firms. The application should contain the following information : (i) The name of the firm. (ii) The principal place of business of the firm. (iii) Names of the other places where the firms business is carried on. (iv) Names in full and permanent addresses of the partners. (v) The date on which each partner joined the firm. (vi) Duration of partnership, if any. The application should be signed and verified by each partner. Then it is submitted to the Registrar of Firms of the area in which the principal place of the firms business is situated or proposed to be situated. A small amount of registration fee is also deposited along with the application. The application submitted to the Registrar is examined. If the Registrar is satisfied that everything is in order and all legal formalities have been observed, the Registrar shall make an entry in the registrar of firms. He will also issue a certificate of registration. Any change in the information submitted at the time of registration should be communicated to the Registrar. Registration does not provide a legal entity to the partnership firm. 9.4.7 Rights and Obligations of Partners The rights and obligations of partners are generally laid down in the partnership deed. In case the partnership deed not specify them, then the partners will have rights and obligations prescribed in the Partnership Act. These are given below: Rights of Partners 1. Every partner has a right to take part in the conduct and management of the firms business. 2. Every partner has a right to be consulted and express his opinion on any matter related to the firm. In case of difference of opinion, the decision has ordinarily to be taken by a majority. But vital issues like admission of a new partner, change in the firms business, alteration of profitsharing ratio, etc., must be decided by unanimous consent of all the partners. 3. Every partner has a right to have access to, inspect and copy any books of accounts and records of the firm. 4. Every partner has the right to an equal share in the profits of the firm unless otherwise agreed by the partners. 5. Every partner has the right to receive interest on loans and advances made by him to the firm. The rate of interest should be 6 per cent unless otherwise agreed by the partners. 6. Every partner has the right to be indemnified for the expenses incurred and losses sustained by him in the ordinary conduct of the firms business. 7. Every partner has a right to continue in the firm unless expelled in accordance with the terms of the partnership agreement.

8. Every partner has a right to retire in accordance with the terms of the partnership agrement.or with the consent of other partners. Duties and Liabilities of Partners 1 Every partner must act diligently and honestly in the discharge of his duties to the maximum advantage of all the partners. 2. Every partner must act in a just and faithful manner towards each other. 3. Every partner must act within the scope of the authority entrusted to him. 4. Every partner is bound to share the losses of the firm equally unless otherwise agreed. 5. Every partner must indemnify the firm against losses sustained due to his willful negligence in the ordinary course of business. 6. No partner can transfer or assign his interest in the firm to others without the consent of other partners. 7. Every partner must maintain and render true and correct accounts relating to the firms business. 8. No partner must engage himself in a business in competition with the firm, otherwise he will be liable for any loss suffered by the firm. He will have to surrender private profits to the firm. 9. Every partner should use the firms property only for the firm business and interest. 10. No partner should make secret profits by way of commission or otherwise from the firms business. He is liable to account for and pay to the firm any private profit from the transaction of the firm or from the use of its property or goodwill. 11. Every partner is liable jointly with all the other partners and also severally for all the debts of the firm. The liability of a partner to third parties is unlimited. Implied Authority of A Partner Every partner has the implied authority to bind the firm and other partners by his acts done in the name of the firm, in the ordinary course of the firms business and with the intention to bind the firm. A partner has the implied authority to do the following acts on behalf of his firm. (i) To buy, sell and pledge goods on behalf of the firm. (ii) To raise loans on the security of such assets. (iii) To receive payments of debts due to the firm. (iv) To accept, make and issue bills of exchange, promissory notes, etc., on the behalf of the firm. (v) To engage servants for the firms business. (vi) To take on lease a premises on behalf of the firm. However, a partner has no implied authority, unless otherwise expressed in the partnership deed, in the following matters : (a) To submit a dispute relating to the firm to arbitration. (b) To compromise or relinquish any claim or a portion of claim made by the firm. (c) To withdraw a suit or proceeding filed on behalf of the firm. (d) To admit any liability in a suit or proceeding against the firm. (e) To open a bank account on behalf of the firm in his own name. (f) To acquire or purchase immovable property for and on behalf of the firm. (g) To transfer or sell immovable property belong to the firm; and (h) To enter into partnership with others on behalf of the firm. 9.4.8. Dissolution of Partnership Firms A partnership firm is said to be dissolved when it ceases to carry on business, its assets are sold and its liabilities are paid off. The firm discontinues its activities and none of the partners has any relation of partnership with other partners. Dissolution of the firm should be differentiated from dissolution of partnership. In dissolution of partnership the original partnership agreement is terminated due to the admission, insolvency.

Retirement or death of a partner. But the other partners continue the business by entering into a new agreement. A partnership can be dissolved without dissolving the firm. Dissolution of partnership implies change in partnership whereas dissolution of firm means discontinuance of business. The dissolution of the includes dissolution of partnership too. A partnership firm may be dissolved in any of the following ways :1. Dissolution by agreement. A partnership firm maybe dissolved with the mutual consent of all the partners or in accordance with the terms of the agreement. 2. Dissolution by notice. In case of partnership-at-will, a firm may be dissolved if any partner gives a notice in writing to other partners indicating his intention to dissolve the firm. In such a case, the dissolution takes place with effect from the date mentioned in the notice. If no date is mentioned, the firm would be dissolved with effect from the date of receipt of the notice by other partners. When such a notice is given to other partners, it cannot be withdrawn without their consent. 3. Contingent dissolution. A firm may be dissolved on the happening of any of the following contingencies : (i) On the expiry of the term, if it is for a fixed period. (ii) On the completion of the venture for which the firm was constituted. (iii) On the death of a partner. (iv) On the adjudication of a partner as insolvent. 4. Compulsory dissolution. A firm stands automatically dissolved in the following cases: (i) When all partners or all but one partner are declared insolvent. (ii) When the business of the firm becomes unlawful due to the happening of an event. 5. Dissolution through Court. Court may order the dissolution of a firm in the follow ing cases: (i) When a partner becomes of unsound mind. (ii) When a partner becomes permanently incapable of performing his duties as a partner. (iii) When a partner is guilty of misconduct which is likely to affect preju dicially (example. moral turpitude, misuse of money) the business of the firm. (iv) When a partner willfully and persistently commits breach of the partnership agreement. (v) When a partner unauthorized transfers the whole of his interest or share in the firm to a third person. (vi) When the business of the firm cannot be carried on except at a loss. (vii) When in the opinion of the court it is just and equitable that the firm should be dissolved. 9.4.9. Merits of a partnership form of business The following are the merits of a partnership form of business: (i) Simple formation : It can be formed easily without much expense and legal formalities. Only an agreement between the partners is required. Registration is also not compulsory. (ii) Sufficient resources : A partnership has larger resources as compared to a sole trader. The combined resources of many individuals would certainly be larger than the limited capital of a sole trader. Moreover, new partners can be admitted to secure more capital, managerial ability and organizing capacity. (iii) Flexibility of operations : A partner can introduce any changes that he consid ers desirable to meet the changing circumstances. There is no legal restriction as long as the firm carries on a lawful business. (iv) Specialization in management : A partnership enjoys all the advantages of di

vision of labour. Division of work among partners is done on the basis of their specialization. It helps in increasing the efficiency of the business, resulting in more profits. (v) Benefits of combined ability : Under a partnership, several persons pool their capital, resources, skills, expertise, experience, services, etc. This helps to ex pand the activities of the firm. (vi) Prompt and balanced decisions : A partnership firm is a combination of abili ties, experience and judgment of different persons. Such a combination of skills facilitates the making of balanced and sound decisions. (vii) Caution for unlimited liability : Fear of unlimited liability encourages cation and care on day-to-day activities. Partners are discouraged to take hasty and reckless business decisions in the conduct of the business. (viii) Democratic organization. Every partner can participate in the operation of the business of a partnership firm. Moreover, all the partners are consulted before taking any decision. (ix) Protection of minority interest : The views and voices of each partner carries equal weight. All the partners have a rights to take part in the day-to-day management. Thus, a partnership firm protects the minority interests. (x) Business secrecy : A partnership firm is not expected to publish its final ac counts for the general public. Thus, the partners can keep their business se crets to themselves. The competitors do not have to know anything about the exact position of the business. (xi) Close supervision : Partners have direct access to the employees and they can encourage workers to improve production. Thus, the partners can directly minimize costs in order to maximize profit by reducing wastage. (xii) Protection to minor partner: A minor partner can be taken into a firm with limited liability. He shares the profits of the business only. He may or may not be a partner after attaining maturity. (xiii) Risk and reward are fairly balanced : There is always a direct relationship between effort and reward in the case of partnerships. This motivates parners to work harder in order to enjoy higher profits. (xiv) Good personal relations with customers and employees : Every partner can be made to develop healthy and cordial relationship with employees and cus tomers. The fruits of such relationships may be reflected in better accomplish ment and larger profits. (xv) Easy dissolution : It is easy and inexpensive to dissolve a partnership. The partnership can be dissolved on insolvency, lunacy or death of a partner. No legal formalities are required at the time of dissolution. So, it is easy to start as well as dissolve a partnership concern. 9.4.10 Demerits of partnership The following are the demerits of a partnership form of business organization : (i) Unlimited liability: The liability of the partners is unlimited and they are jointly responsible for all acts and debts. The creditors can make any or all of the partners liable and recover their dues even form the private property of partners. (ii) Uncertain continuity: There is always an uncertainty in continuing this type of organization. Death, insolvency, insanity of one of the partners may lead to dissolution of the firm. In an atmosphere of uncertainty, long range plan ning and innovations are not possible. (iii) Limited resources : A partnership firm may not be able to raise adequate capital for expansion beyond a certain limit. Though the capital is more in a

partnership than in a sole proprietorship form of business, still it is not suffi cient for large-scale operations. (iv) Lack of harmony : It is difficult task to maintain harmony among the part ners for a long time. There is a possibility of differences of opinion amongst themselves. Mutual conflicts and lack of team spirit among partners may lead to loss of reputation and dissolution of the firm. (v) Lack of public confidence: It may not enjoy the confidence of the public because its accounts are kept secret and there is an absence of publicity. More over, the affairs of the firm are not legally controlled. Therefore, the public may not place much confidence in such firms. (vi) Risk of dishonest co- partners : A dishonest partner may cause injury to the other partners. One partner may be made to suffer heavy losses due to the dishonesty of another. (vii) Restricted transferability of the partners interest : A partner cannot trans fer or assign his share in the firm to a third person without the consent of the other partners. He, thus, loses the liquidity of his investment. (viii) Risk of implied authority : Each partner of the firm has the implied author ity to act on behalf of the firm and all other partners. A partner may abuse his implied authority for personal gain. (ix) Absence of professional management: Modern business needs the expert services of those who have acquired managerial skills and render their ser vices to business undertakings as salaried officers. In partnership firms, we witness the absence of professional management. Suitability : Despite its weakness, partnership form of organization is suitable for small and medium-sized business. It is highly appropriate for professional services like chartered accountants, solicitors, doctors, etc. which require pooling of specialized skills and direct contact with the clients. Partnership is also popular in wholesale and retail trade.

9.5COMPARISON BETWEEN PARTNERSHIP AND SOLE PROPRIETOR SHIP


1. Number of members. Sole proprietorship is owned and controlled by one person. The number of partners in a firm can be upto ten in banking business and twenty in other cases. At least two persons are required to form a part nership. 2. Agreement. No agreement is required in a sole proprietorship. On the other hand, there must be an express or implied agreement among partners in or der to constitute a partnership. 3. Registration. A sole proprietorship need not be registered except under the Shops and Establishment Act. A partnership firm should be registered other wise it will not be able to enforce its rights in the court of law. 4. Capital. The entire capital of a sole proprietorship is contributed by one man, the owner of business. In a proprietorship, several persons contribute capital. There fore, a partnership firm can raise larger financial resources than a pro prietor. 5. Management. The management of sole proprietorship lies exclusively with its owner. He is the supreme authority in the business. But in a partnership, every partner has a right to take part in the management of the firm. There is pooling of knowledge and judgment. Work can be divided among partners according to their skills and aptitudes. 6. Secrecy. Secrets of sole proprietorship are known only to its owner. In part nership, secrets are shared among the partners. Therefore, a sole proprietor is

in a better position to retain the secrets of business. 7. Quick decisions. In sole proprietorship one man takes all the decisions. But in partnership decisions are taken though mutual consultation between the partners. Therefore, sole proprietorship can take decisions more quickly than a part nership. But decsionsm taken in a partnership are likely to be less reck less and hasty than those of a proprietor. 8. Governing law. There is no specific law governs sole proprietorship. Partner ship is governed under the Partnership Act 1932. 9. Sharing of profits. There is no profit sharing in a sole proprietorship and all prof its belong to the owner. In a partnership profits are shared between all the parners. 10. Flexibility of operation. Proprietorship is a one man show whereas partner ship is carried on by two or more persons. Therefore, there is greater flexibility of operations in sole proprietorship. 11. Mutual agency. In proprietorship there is no mutual agency. But in a part nership every partner is an implied agent of the firm and of other partners. 12. Scale of operations. Sole proprietorship is suitable for small scale business, while partnership is suitable for medium sized business. Scope for expansion is greater under partnership. 13. Risk. The owner alone bears all the risks of sole proprietorship. In a partner ship risks are shared by all the partners. 14. Continuity. The life of a partnership is more uncertain than that of sole propri etorship. Lack of mutual trust and unity among the partners can result in un timely dissolution of partnership.

9.6COMPARISON BETWEEN JOINT HINDU FAMILY AND PARTNEERSHIP


The distinction between partnership and Joint Hindu Family business may be put as under: 1. Partnership is the result of an agreement between the members while Joint Hindu Family business is not the result of an agreement but the result of status. 2. The death of a member will bring about the dissolution of the partnership firm but joint Hindu family firm is not dissolved by the death of any male member. 3. A member of either sex can be partner in a firm while it is only male members that can be members of a joint family firm. 4. A new partner can be admitted into the partnership firm only with the consent of the other partners while in case of joint family firm, there are constant and automatic additions by the birth of male children. 5. Every partner has the right to pledge the credit or the firm or the partnership business but it is only the manager (Karta) of the Joint family firm that can contract a debt so as to bind the other members. 6. The liability of the partners in a firm is always unlimited and they are personally liable for the debts. But the members of a joint family firm except the Karta are liable only to the extent of their interest in the joint family firm. The Karta is personally liable for the firms debts. 7. Every partner can ask for dissolution and accounts of the firm but only right of a member of joint family business is to ask for partition of the existing assets, and not to demand an account from the manager for his dealings in past. 8. A minor cannot become a partner in the firm. However, a minor can be admitted to the benefits of the partnership. But in a joint family business, a minor male becomes its members by his birth in the family. 9. Every partner enjoys the authority to act and to bind the other partners by his acts. All the partners can take active part in the management of the business of the firm. In the joint Hindu family firm, only the Karta of the family enjoys

these. 10. In partnership the number of partners is limited to 10 in case of banking business and to 20 in the case of other business but in case of Joint family business there is no such restriction.

9.7 CO-OPERATIVES
Just as limitations of a sole proprietorship led to the rise of the partnership form of business organization, the limitations of partnership too gave rise to larger forms of business organization like cooperatives and companies. A co-operative society is a voluntary association of persons who join together to safeguard their own interests. It is a business activity without having any profit motive, but for benefiting themselves through self-help and co-operation. The primary objective of forming a co-operative is to protect economically the weaker sections of the society from the oppression of the economically organized strong segment of the society. It is a democratic organization run by its members for serving their own interests. The basic philosophy of a co-operative organization is four fold : (i) Service in place of profits; (ii) Mutual help in place of competition; (iii) Self-help in place of dependence; and (iv) Moral solidarity in place of unethical business practices. Thus, co-operative organizations are generally started by the economically weak sections to promote their common economic interests through business propositions. The primary object of any co-operative organization is to render service to its members. Definitions given by eminent management experts : (a) Co-operative is a form of organization, wherein persons voluntarily associate to gether as human beings on the basis of equality for the promotion of the economic interests of themselves. [Prof. E.H.Calvert] (b) Co-operative is joint enterprise of those who are not financially strong and there fore, come together not with a view to get profits but to overcome disability arising out of the want of adequate financial resources. [H.N.Kunzen] (c) Co-operative is an association of individuals to secure a common economic goal by honest means. [Sir Horace plunkett] Definition as per Co-operative Societies Act, 1912: Co-operative society is a voluntary association of individuals which has its objectives in the promotion of economic interests of its members in accordance with co-operative principles. [Section 4 of the Indian Co-operative Societies Act, 1912] From the definitions, certain definite features of a cooperative could be noted as follows: 9.7.1 Features (a) Voluntary association. The membership of co-operatives is open to all freely and voluntarily. There are no conditions laid down on the basis of caste or creed and colour. There is neither compulsion or denial to any one desiring to become member of the cooperative. (b) Service motive. The purpose of the co-operatives is not making profit. The cooperative societies are formed with a motive of service. The members are inter ested in helping each other. The co-operatives are for ensuring social justice. It does not mean that co-operatives do not make profit. In business the profit is many times regarded as the acid test of the efficiency of working units. How ever, the members of co-operatives do not believe in profit making through exploitation. (c) Equality. Every members of a co-operative society enjoys equal status. No one has special voting rights. The members may be holding different number of shares but all the members have equal voting right. No one is enjoying any special privileges.

(d) Democratic management. Every member of a co-operative society is allowed to express his views and is also free to criticize the working of the cooperative. The management is democratic. Like political democracy, here also the man agement is of the members, by the members and for the members. The members elect their representatives and like the board of directors of a company these representatives manage the affairs of the co-operative on behalf of the mem bers. (e) Cash transactions. The business of co-operatives is generally carried on Cash basis. The members are discouraged to have credit facilities with a view to avoid ing bad debts. This safeguards the interests of all the members. (f) Corporate status and state control. Like a Joint Stock Company, a Co-opera tive Society also is required to be registered in law and it is also treated as an independent legal entity. The Government regulations are binding on it. It can sue and get sued in law and also can purchase or sell any asset or property. (g) Religious and political neutrality. The cooperatives believe in fraternity. All the members are brothers and sisters and therefore, the religious or political view of the members do not find any place in the affairs of the cooperative. (h) Education. The co-operatives believe in educating their members about the prin ciple of cooperative. There is a feeling of togetherness. The benefits are to be shared by all equally. (i) Limit on shares. Usually, it is decided by the co-operatives as to what would be the maximum limit of the shares that could be held by any member. The capital is made available by the members at practically no cost. The interest if any is distributed out of surplus but in most of the cases the interest is waived by the members contributing the capital. (j) The distribution of surplus. All the members are entitled to an equitable share of the surplus. There is a limit of the dividend that could be paid by a Coopera tive Society. (k) Political and religious neutrality : The membership of a cooperative society is open to all, irrespective of religion, caste, political affiliations and beliefs. A cooperative represents universal brotherhood and it should not lose its path in political contradictions. Co-operative societies are neutral as far as political and religious affiliations are concerned. (l) Legal status : A cooperative society is required to be registered under the Cooperative Societies Act, 1912. It has its separate legal entity and perpetual suc cession. With the change in the status of its members, the structure of a coop erative society is not changed. (m) Transfer of shares : The shares of a cooperative society are not freely transfer able. A member can surrender his shares to the society with the permission of the societys office bearers. (n) Liability of members : The liability of the members of the co-operative society is restricted to the extent of subscribed shares. But, for this purpose, the society will have to write the work Limited after its name. (o) Government regulation and control : A co-operative society is governed by the Indian Co-operative Societies Act, 1912. A society can be registered only if it satisfies the conditions laid down by the statute for this purpose. The co-opera tive societies are to follow certain rules and regulations framed by the Govern ment. There is a control of Central and State Governments on the working of co-operative societies in India. 9.7.2 Types of co-operative undertakings Co- operative societies are classified into different types, according to the nature ofservices

rendered by them. The following are them main types of co-operative : (i) Consumers co-operatives; (ii) Producers co-operatives; (iii) Marketing co-operatives; (iv) Credit co-operatives; (v) Housing co-operatives; (vi) Industrial co-operatives societies. (i) Consumers co-operative societies : Consumers co-operative societies are established by the consumers of a certain locality for the purpose of social upliftment of their members. These co-operatives are formed to ensure a steady supply of essential commodities of standard quality to the members at fair prices. The consumers co-operatives purchase the goods on a wholesale basis and sell these goods on a retail basis to the members at fair prices. The profits of the society are distributed among the members in also utilized for providing social services (example., medical aid, education, sanitary improvements, etc.) These co-operatives are run by the members themselves through an elected team of office bearers. The objectives of consumers co-operative societies are : (a) Availability of consumer goods of higher quality at a cheap rate. (b) Eliminating the middlemen by establishing a direct link with the producers. (c) Maintaining stability in the prices of essential commodities. (d) Avoiding black marketing and hoarding practices. e) Avoiding the evil effects of inflation as far as possible. (f) Establishing equality of status among the members. (g) Enhancing the purchasing power of the members. (h) Providing incentives to the members in the form of bonus on purchases made from co-operatives. (ii) Producers co-operative societies : These societies are formed for the benefit of small producers, who have difficulty in collecting various factors of production and face market problems. The objectives of producers co-operative societies are : (a) To stimulate higher production. (b) To improve the quality of the products. (c) To make full use of the available industrial skills of individuals. (d) To help in tackling the problems of unemployment and underemployment. (e) To utilize idle man-power. (f) To strengthen the position of small-scale artisans or crafts. Thus, producers co-operatives are voluntary associations of small producers, who join hands to face powerful capitalists. These societies are formed for the benefit of small producers who cannot easily collect various items of production and face some problems in marketing. These co-operatives provide raw-materials, tools, technical guidance, etc., to the members, so as to enable them to produce specified goods. Profits of the society are disbursed among the members as per rules. Producers co-operatives may be of two categories : (1) Production co-operatives, and (2) Industrial service co-operatives. (iii) Marketing co-operative societies : These societies are formed to enable their members to secure fair prices for their goods. In other words, these co-opera tives are associations of producers for selling their products at remunerative prices. The production of different members is pooled and the society under takes to sell these products by eliminating middlemen. The objectives of these societies are :

(a) to ensure a ready, steady and favourable market for the production of differ ent members; (b) to undertake centralized selling of the produce contributed by their members; (C) to eliminate middlemen and reduce the costs of marketing; (d) to provide services like assembling, grading, storing, packing etc; (e) to provide loans to producers against the deposit of their goods; (f) to improve the bargaining position of the producers; (g) to ensure the supply of standard goods at reasonable prices; (h) to control the flow of supplies and thus influence prices; (i) to collect marketing information and supply it to the members for their ben efit; (iv) Credit co-operative societies : These societies are formed in rural and urban ar eas to attract the small savings of its members. These societies are estab lished by agriculturists, industrial workers, salary earners, artisans, etc., on the basis of col lective interests for the purpose of mutual assistance. These societies provide loans to their members on easy terms of interest, security and repayment. The aim of a credit society is to grant credit to its members for productive purposes at a very low rate of interest. The society educates its members with the habit of thrift. The society collects savings of its members and gives short loans to members (in need) from time to time at cheaper rates. The credit co-operative societies may be of two types : (1) Agricultural credit societies and (2) Non-agricultural credit societies. Agricultural credit society may be of three types: (a) Primary credit societies (at the village level); (b) Central co-operative banks (at the district level); (C) State co-operative banks (at the State level). (v) Housing co-operative societies: These societies are organized to provide resi dential accommodation to their members, either on an ownership basis or at fair rents. The members of the society contribute their savings to the common fund of the society with borrowed money from banks to buy a plot of land in order to construct a building for their dwelling purposes. The purpose of these societies is to help the members in purchasing land and constructing houses. State Housing Boards help economically weaker sections of the society in owning their houses and paying the price in easy. (vi) Industrial Cooperatives Industrial co-operative means an association of artisans, craftsmen, industrial workers, small businessmen for co-operative and collective interest. Industrial co-operative may be defined as an undertaking of craftsmen or skilled workers engaged in a cottage or small scale industry to undertake production, purchase of supplies and raw materials, marketing of products and supply other services to members. The need for such an organization is felt due to the individual financial and managerial limitations. The members of a co-operative pool their resources to carry on the business and thus to provide employment. The objectives of this type of organization could be classified under two heads. Social objectives and Economic objectives. The following are the main objectives of an industrial co-operative : 1. To promise industrial development of rural areas. 2. To increase production and productivity. 3. To purchase in bulk raw materials, tools and equipments and to supply to members.

4. To provide marketing facilities to the members. 5. To arrange for training of members in managerial matters. 6. To raise loans from members and non-members. 7. To provide gainful employment to rural masses. 8. To grant loans and advances to members. 9. To safeguard the weaker sections from exploitation of large producers and sellers. 10. To purchase machinery and other equipments and to give them on hire to mem bers. 11. To make optimum use of the available resources. 12. To improve financial position of artisans and craftsmen by selling their goods at best prices. 13. To take advantage of combined managerial and technical expertise. 14. To secure large contracts from Government agencies and public bodies. As indicated earlier, the industrial co-operatives could be related to production or service activities or they may manage industrial estates. They are observed to be suffering from a number of problems. Some of these problems are : (a) Poor planning, (b) Inadequate finance, (c) Non availability of raw materials (d) Non availability of expertise due to poor service conditions. (e) Competition in the area of marketing. (f) Political interference as in case of sugar co-operative in the State of Maharashtra (g) Inadequate supervision and control. (h) Hostile attitude of merchants and traders. 9.7.3 Advantages of co-operative undertakings The advantages of a co-operative form organization can be enumerated as follows: (i) Easy formation : A co-operative society is a voluntary association of persons. It does not require long and complicated legal formalities at the time of forma tion. Any ten persons may form a co-operative society for the promotion of their economic interests. (ii) Limited liability : The liability of the members is limited to the extent of capital contributed by them as mentioned in the bye-laws of the society. (iii) Open membership : Any person can become a member of the society and avail of its advantages. The minimum number of members required is ten but there is no limit to the maximum number of members. A member can leave the society by returning his share whenever he likes. (iv) Democratic management : A co-operative society is managed in a democratic way on the basis of equal voting rights. Thus, every member is able to have a voice in its management. Every member has an equal say in formulating the policies of the society. (v) Perpetual succession : It is a separate legal entity and its life is not affected by the death, insolvency or conviction of its members. It has a fairly stable life and it continues to exist for a longer period. (vi) State patronage : The policy of the Government is to encourage co-operatives in every field. Co-operatives are given financial assistance and loans at much lower rates of interest. Co-operatives are exempted from paying stamp duties and reg istration fees. As regards income-tax, co-operatives are offered several conces sions and reliefs. (vii) Service motive : Co-operative societies are started, not for profit, but for ser vice. The members are provided with financial help and goods and services at concessional rates. A feeling of co-operative is created among the members.

(viii) Economic advantages : It provides financial assistance to agriculturists and low income group members. It also provides loans for productive purposes. More over, credit co-operatives protect the members from exploitation by money lenders. (ix) Social advantages : With the establishment of co-operative societies, the feel ing of co-operation and democracy increases in the society. Economic power is decentralized. The poor people can get the advantages of their efficiency by becoming members of a co-operative society. (x) Moral advantages : Mutual help, self-help, hard work, education, self-depen dence, savings, etc., are considered as the basic principles of co-operative soci eties. It is for avoiding social tensions, litigation and mutual distrust. Co-opera tive systems attempt to achieve a wide-based rural development and rural in dustrialization. (xi) Political advantages : It is based on the principles of equal distribution of wealth. It puts effort to eliminate vested interests, to create delegated leader ship and teach members the need of self-governance. (xiii) Low management cost: Some of the expenses of the management are saved by the voluntary service of the members. Members take active interest in the working of the society. So, the society does not require to spend large amounts on managerial personnel. 9.7.4 Disadvantages of co-operative undertakings Co-operative undertakings suffer from the following drawbacks: (i) Limited resources : Co-operative societies always suffer due to lack of capi tal. Societies are not able to raise huge amounts of capital because their mem bers are persons of meager income. Therefore, societies are not able to take advantage of large-scale production. (ii) Inefficient management : The societies are not managed efficiently because they do not get specialized and professional managers as they cannot afford to pay high remunerations. The members usually lack experience and mana gerial capability. Thus, management here is generally inefficient due to lack of specialization. (iii) Lack of direct incentive : There is no direct relationship between effort and reward. Honorary office bearers often do not have incentives to work hard. (iv) Lack of secrecy : The affairs of co-operatives are generally exposed to the members. It becomes quite difficult for them to maintain secrecy in business affairs. Business secrecy is leaked out to the members and office bearers of the society. (v) Lack of business elasticity : There is a lack of business elasticity in such cooperative societies. These societies are unable to compete with other private enterprises. (vi) Lack of savings by the members : The progress of co-operatives mainly de pends on savings. But in our country, the members are not in the habit of saving. That is why co-operatives may not be able to mobilize adequate capi tal for large-scale and risky businesses. (vii) Lack of competition : Co-operatives, generally, do not face any stiff competi tion. Markets for their goods and services are more or less ready and assured. Hence, there is possibility of slackening of efforts. (viii) Limited considerations : Profits earned by societies are very low. Proper and adequate returns on capital employed are not possible. That is why people are not interested in becoming members of the society. (ix) Excessive government interference : Excessive State regulations interfere with

the flexibility of its operations and the efficiency of the management. Exces sive State interference is detrimental to the development of co-operatives in Indian. (x) Corruption : One of the most important drawbacks of co-operatives is the prevalence of corrupt practices in the management and functioning of such societies. Corruption is an obstacle in the growth, progress and development of a co-operative society. (xi) Other drawbacks : (a) Non co-operation among members; (b) Absence of motivation; (c) Inflexibility in operations; (d) Groupism in management (e) Conservatisms and illiteracy of the members; (f) Improper maintenance and checking of accounts.

9.8. JOINT STOCK COMPANY


A company is an artificial person created by law, having a separate legal entity, with a perpetual succession and a common seal. It is an association of individuals for the purpose of earning profit. It has a capital divided into a number of shares, of which each member possesses one or more shares and which are transferable by its owners. Joint stock company has been defined by many eminent authors, eminent jurists and institutions. From a study point of view, we can divide these definitions into the following three categories : Definitions given by eminent authors : (i) A company is an artificial person created by law, having a separate legal entity, with a perpetual succession and a common seal. [L.H. Haney] (ii) A company is an association of many persons who contribute money or moneys worth to common stock and employ it in some trade or business and who share the profits or losses arising therefrom. [James Stephenson] Definitions given by eminent jurists : (i) A company is an artificial being, invisible, intangible and existing only in the eyes of law. [Chief Justice Marshall] (ii) Company means an association of persons united for a common object. [Justice James] (iii) A company is an association of many persons who contribute money to a com mon stock and employ it for a common purpose. [Justice Lord Lindley] Definitions given by the Indian Companies Act : According to Section 3(1)(i) of the Companies Act, 1956, a company means an artificial entity which is formed and registered under this Act or existing company. Thus, a company is an incorporated association created by law, having a distinctive name, a common seal, perpetual succession, limited liability, etc., formed to carry on business for profit. 9.8.1. Characteristics (or features) of joint stock company The most distinguishing features of a joint stock company may be stated as follows : (i) Incorporated association : A company is an incorporated association. It comes into existence only after registration under the Companies Act. (ii) Voluntary association : A company is an association of many persons on a voluntary basis. So, a company is formed by the choice and consent of the members. Shareholders can withdraw their investments from the company at any time they desire. (iii) Artificial legal person : A company has a legal personality and, as such, it is regarded by law as an artificial legal person. A company has the right to ac quire and dispose of the property. It can into contract with third parties in its

own name. It can sue and be sued in its own name. (iv) Separate legal entity : A company has a legal entity distinct from its mem bers. It is an artificial person having an independent existence. The principle of separate legal entity was established in the case of Solomon Vs. Solomon & Company Limited. (1897). (v) Common seal : The common seal with the name of the company engraved on it. It is used as a substitute for its signature. The company cannot sign any document as it is an artificial person. Documents issued by a company must bear a common seal and it must be witnessed by at least two directors of the company. (vi) Perpetual succession : The company has perpetual succession as its existence is not affected in any way by the death, insolvency or exit of any shareholder. A company comes to an end only when it is liquidated according to the provi sions of the Companies Act. (vii) Transferability of shares : The shareholders are at fully liberty to dispose of their shares to any person of their choice. Transferability of shares enables a shareholder to increase or decrease his investment in a company at any time. It ensures the safety of investment in the shares of a company. (viii) Limited liability : Liability of the members of a limited company is restricted to the face value of the shares purchased by them. The personal property of the members of a company cannot be attached to satisfy the claims of credi tors of a company. (ix) Separation of ownership from management : The company is not managed by all the members because, the number of members may be large. The au thority to manage the whole of the affairs is conferred to elected representa tives of members known as directors. A company acts through its directors. Thus, directors are the hands and brains of the company. Members of the company have no direct control over the day-to-day activities of the com pany. (x) Statutory regulations and Government control : A company is governed by the Companies Act and it has to follow various provisions of the aforesaid Act. Moreover, accounts of the company must be audited by a chartered ac countant. In addition to this, a company has to submit a number of returns to the Government. In this way, a company has to comply with numerous statu tory requirements. (xi) Rigidity of objects : The type of business in which the company would par ticipate must be mentioned in the object clause of its Memorandum of Asso ciation. The company cannot take up any new business without changing the object clause. A company cannot work beyond its Memorandum and Articles of Association. (xii) Strict legal formalities to commence business : A company is to follow some strict formalities to commence its business. In order to form a company, it is necessary to submit certain documents to the Registrar of Companies (such as memorandum of association, articles of association, prospectus, list of direc tors, consent of directors, etc). (xiii) Social benefits : Company form of business enables better utilization of avail able resources. It is needless to say that with the increase in production and improvement in quality, all classes of the society have benefited. (xiv) Accountability to shareholders : All the affairs of the company are to be dis closed to the shareholders so that they may come to know about the prospects and other problems of the company as a whole. Therefore, a company is re

sponsible for its accountability to the shareholders. (xv) Public confidence : Audit of accounts of the company is compulsory under the Indian Companies Act, 1956. The financial statements of a company are published every year. Thus, public remains acquainted with the activities of the company. Moreover, there are some legal restrictions of the activities of a company. In these way, a company enjoys greater public confidence. (xvi) Scope for expansion : A company is better placed as regards the facilities of the growth, development and expansion of its business. It can expand its managerial capacities and financial resources easily. It has great potential for growth and expansion. 9.8.2 Advantages (or merits) of a company form of organization The following are the merits of a joint stock company : (i) Accumulation of huge financial resources: The company form of business facilitates mobilization of large amounts of capital for investment in indus tries. The company by its widespread appeal to investors of all classes, can raise huge capital required for large-scale operations. In addition, it can bor row from banks and financial institutions to a larger extent. (ii) Economies of large-scale production: The company form of business can enjoy all the benefits of large-scale production, such as minimum cost of production and maximum profit. Economies in purchase, production, selling and distri bution, etc., would provide goods to the consumer at a cheaper price. Large capital enables the size of the business to be extended and permits the use of expert knowledge and specialization of functions. Thus, production is increased and efficiency is enhanced. (iii) Scope for expansion: A company can easily expand its managerial capacities and financial resources. It has great potential for diversification and growth. It can expand its business by issuing new shares and debentures as there is not restriction to the maximum number of members in a public company. (iv) Stability of existence : The organization of a company as a separate legal entity gives it a character of continuity. As a incorporated body, a company enjoys perpetual existence. Thus, a company, because of its continuity and stability, can build up a power of endurance and a high level of efficiency. (v) Transferability of shares : The shares of a public company are freely trans ferable. The shareholders are at full liberty to dispose of their shares to any person they desire. In other words, shareholders can withdraw their invest ments from the company at any time they like. Transferability of shares pro vides maximum protection to those shareholders who are in the minority group. (vi) Democratic control : The company is managed on the principle of democ racy. The Board of Directors who manage the company are elected by the shareholders. The directors are responsible and accountable to the sharehold ers. Because of separation between ownership and management, persons with managerial ability can occupy positions of control. (vii) Managerial efficiency : A company can secure the services of highly quali fied persons who are experts in different fields of business management. Through the company, capital and business ability may be linked together for the benefit of both the individual investor and the community as a whole. (viii) Stimulation to savings and investments : The company is an effective media of mobilizing the scattered savings of the community and investing these sav ings for commercial purposes. Insurance companies, banks and other finan cial institutions invest their money in the shares of different joint stock compa nies. It channelises public small savings into industry.

(ix) Tax relief : The company enjoys greater tax relief as compared to other forms of business. Company pays lower tax on a higher income as it pays tax on the flat rates. Moreover, a company gets some tax concessions, if it establishes itself in backward area. Some tax incentives are available for export promo tion also. (x) Diffused risks : The membership of a public company is large. The business risk is divided among several members of the company. This encourages in vestment of small investors. (xi) Statutory regulation and control : Formation and working of companies are well regulated by the provisions of the Companies Act. These strict regula tions safeguard the interests of shareholders and people who deal with the company. Statutory regulations make the management healthy, fair and just for all the activities of the company. (xii) Public confidence and popularity: A company is guided and controlled by strict regulations and Government control. These ensure public confidence with regard to investment in shares and debentures. Since the companys financial accounts are published and circulated, the public has enough faith on the activities of the company. Thus, at present, a company enjoys greater pub lic confidence, better prestige and reputation in the business world as a whole. (xiii) Capacity of afford maximum risks : A company can bear high risks, because of its large financial resources. Companies in many industries are progressing day by day because of their capacity to afford high risks. (xiv) Social responsibilities: Due to the existence of the company form of busi ness, society is benefited in respect of: (a) opportunity in employment; (b) de velopment of large-scale industries; (c) facility of huge capital formation; (d) increased Government revenue; (e) improvement in standard of living, etc. 9.8.3 Disadvantages (or limitations) of a company form of organization The following are the disadvantages of a joint stock company : (i) Adherence of too many legal formalities : The formation of a company re quires adherence of too many legal formalities. The establishment and run ning of a company would prove to be troublesome, because of complicated legal regulations. Moreover, the formation and management of the company is expensive too. (ii) Concentration of power in few hands : Shareholders of the company have practically no say in the affairs of the company. The directors of the company become self-centered and they do not care for the shareholders. In most of the cases, directors try to formulate policies in order to promote their own inter ests. Thus, the company form of organization has helped concentration of economic power in few hands. (iii) Excessive Government control : A company has to observe too many provi sions of different laws imposed by the Government. This affects the smooth functioning of the company. (iv) Undue speculation in shares of the company : Undue speculation in shares of a company is injurious to the interests of the shareholders. Sometimes, di rectors indulge in speculation by misusing inner information of the company for speculative purposes and personal gain. (v) Fraudulent management : The promoters and directors may indulge in fraudu lent practices. The unscrupulous directors may present a rosy picture of the company in its annual report. In this way, the innocent and ignorant inves tors are duped. (vi) Bureaucratic control : Quick decisions and prompt action are absent in the

management of a company. It makes a company an inflexible enterprise. As a result, officers and their assistants do not enforce any decision promptly. Op portunities may be lost because of delay in decision-making. (vii) High nepotism : In companies, employees are selected not on the basis of ability but on the basis of personal interest of the management. There is scope for a high degree of favoritism and nepotism and as a result worthless people join in the company. (viii) Inflexibility in management : A company cannot quickly adjust with the changing conditions in the market, because of its complex structure and legal obligations. It has, therefore, less flexibility in management. (ix) Monopolistic control and exploitation of consumers : Joint stock companies facilitate formation of business combinations which ultimately lead to mo nopolistic control and exploitation of consumers. (x) Social abuses : Evils of factory system like insanitation, pollution, congestion of cities are attributed to the company form of organization. Moreover, the close and cordial relationship between the management and employees is dif ficult to maintain. It brings about strikes, lock outs, retrenchment, closure, etc., in the business.

9.9. PUBLIC UTILITY SERVICES AND STATE ENTERPRISES


The enterprises which are owned, managed and controlled by the state on behalf of peoplearecalled State Enterprises. In the earlier period it was felt that the principle of Laissezfaire would work in the best interest of the people. It was thought that if there is no interference from the Government, everybody would try to maximize his individual welfare and it will result in maximum social welfare collectively. In practice, however, it was observed that different interests in any society are likely to clash with each other and as such the total social welfare cannot increase to its maximum. In fact, after the break of the First World War there was acute shortage of a number of essential things and the Government had to accept more active role in economic and industrial activities. State has not only abandoned the principle of laissez-faire but has also accepted the role of a Welfare State. This is an outcome of Socialistic ideas. A large number of glaring defects were seen in Capitalism and it was felt that it was necessary to remove these defects by taking active interest in the ownership and management of Utility Services and some other Enterprises. As a matter of Industrial Policy in most of the countries, the basic and key industries, defence industries and Public Utility Services are nationalized. It is also true that many countries have found a Mixed Economy as a better solution and India perhaps, is not an exception. In other words, in India the Private Sector Industries and Public Sector Industries have been working together. 9.9.1. Merits of State Enterprise. (i) A check and prevention on the formation of private monopolies. A large number of countries in the world have found that due to lust of economic and political power there is a tendency to form monopolies. These monopolies se riously affect the Social interest in the sense that the monopolist charges exor bitant prices, makes enormous profit, provides lower quality of goods and creates artificial scarcity by hoarding. (ii) Acceleration of economic growth. The industrialization in a country is faster with the state enterprises functioning actively. The rate of economic growth is also accelerated. The profits of state enterprises are further invested in indus tries. Various schemes for economic development can get financial support from the state enterprises. Because of such surplus, it is not necessary for the Government to levy heavy taxes.

(ii) Economy. It is possible to avail of economies of large scale operation when a number of enterprises are brought under the State umbrella. This can also result in proper co-ordination between various industries. There is then no fear of discord. The capital at the disposal of the State can always be big and therefore, it becomes easier to retain the services or experts for proper advice and also conduct research in various areas for reduction in cost. (iv) Object to render service rather then making profit. The concept of State enterprises is an outcome of the idea to provide services to consumers or the members of public. A State enterprise is supposed to be interested in Social welfare and not making profit. If therefore, believes in providing good quality service at the most reasonable prices. Hoarding with a view to making enor mous profit is just out of question. A State enterprises does not believe in Black marketing as a Private Undertaking may. (v) Efforts to provide full employment. Generally, unemployment can arise be cause the resources are not fully utilized or when the capacity is underutilized. In case of State enterprises, since a large number of units or industries are under the State control, it is possible to provide maximum employment to the people. In other words, a State aims at full employment-it is opined that only under socialized production, the fullest employment is possible for all the able bodies adults to have work according to their aptitude, training and skill. It is also observed that in case of employment with the State enterprises there are no violent ups and downs which are so common with Private Sector. (vi) Encouragement to the balanced regional development. It is the duty of any State to ensure the there is a balanced regional development otherwise only some parts of the State may progress leaving others behind. The uneven de velopment can create a number of problems. The Status usually encourages growth of undeveloped or underdeveloped region by offering concessions and many other facilities. Lopsided development is never in the interest of all the people. The Government is interested in ensuring that the fruits of pros perity are enjoyed by all. (vii) Justice and Equality for all the employees. The Private enterprises are many times accused of exploitation of the employees, uncertainty of jobs, payment of wages at a lower rate and miserable conditions of work. A State enterprise is on the other hand away from exploitation of workers. It tries to provide security of jobs and justice to its employees. The relations between the Gov ernment undertakings and their employees are usually cordial. (viii) Planned production and equitable distribution. State enterprises believe in planned production and not overproduction, particularly because they are guided with the service motive. The responsibility of equitable distribution also rests on the shoulders of the Government undertakings. 9.9.2 Demerits of State Enterprises State enterprises have their own limitations too. They suffer from the following demerits :(a) Lack of efficiency. The employees of State Enterprises are generally observed to lack any initiative in their work. They also lack flexibility in operation and efficiency. On the other hand incase of Private Sector the maximum premium is paid to efficiency, creativity and initiative. The State Enterprises have service as their motive whereas in case of private undertakings, maximum weightage is given to Profit making. The decision making process in State Enterprises is comparatively very slow and implementation also is delayed. This results in loss of many opportunities. Private sector is dynamic and progressive. Even the cost of administration of the State Enterprises is on the higher side.

(b) Political interference. In case of state enterprises, the worst difficulty is the political interference. The ministers and other political influences affect the scientific and rational decision making. Undue weightage is granted to people who know little in business. The smooth and efficient working is therefore not guaranteed with Government in business. (c) Regimentation. The Private Sector Undertakings usually believe that the consumers are kings and that they must be served well. They cannot take customers for a joy ride. The resistance from the customers could create serious problems for conducting business. On the other hand, in case of State Enterprises, there is virtually a monopoly. The consumers have no choice. This is against the principle of democracy and the State is many times tempted to take unfair advantage of the situation. (d) Open to public criticism. The working of Public Sector undertakings is always exposed to public criticism. Sometimes, the criticism is unfair too. In such situation, the executives of Public Utilities generally lose interest in work. They cease to show any initiative and become virtually Time Killers. (e) Rigid control. The State Enterprises are subject to strict control from various agencies. People, Parliament, Ministers, Financial Agencies and the Auditors criticize and exercise direct or indirect control. It is not, therefore, to enjoy autonomy in decision making or policy implementation. Thus the efficiency is always at stake. In spite of such demerits, the state enterprises and public utilities have to play a significant role in India where the mixed economy is prevailing for quite a long time.

9.10 LIMITED LIABILITY PARTNERSHIP


A limited partnership is a partnership consisting of some partners whose liability is limited to the amount of capital contributed by each. The personal property of a limited partner is not liable for the firms debts. He cannot take part in the management of the firm. His retirement, insolvency, lunacy or death does not cause dissolution of the firm. There is at lest one partner having unlimited liability. A limited partnership must be registered. There is a proposal to permit the formation of a limited partnership in India. But in Europe and the U.S.A. limited partnership is allowed. For example, in England limited partnership can be formed under the Limited Partnership Act, 1907 and under the Partnership Act, 1890 in the U.S.A. the chief characteristics of a limited partnership are as follows: 1. There must be at least one partner with unlimited liability. The liability of the r maining partners is limited to their capitals in the firm. Thus, a limited partnership consists of two types of partners, general partner and limited partner. 2. The limited partner cannot take part in the management of the firm. He has no implied authority to represent and bind the firm. However, he is allowed to inspect the books of accounts of the firm. 3. The limited or special partner cannot assign his share to an outsider without the consent of the general partner. 4. The limited partner cannot withdraw any part of his capital. 5. A limited partnership must be registered. 9.10.1 Advantages. Limited partnership offers the following benefits: (i) It enables people to invest in a business without assuming unlimited risk and without devoting much time and attention in management of business. (ii) It permits the mobilization of larger financial resources from cautious and conservative investors. (iii) It provides an opportunity to able and experienced persons to manage the business without any interference from other partners. Complete control and personal supervision help to ensure prompt decisions and uniform actions. (iv) It is more stable than general partnership because it is not dissolved by the insolvency,

retirement, incapacity or death of limited partner. 9.10.2 Disadvantages. Limited partnership suffers from the following drawbacks: (i) The limited partners are deprived of the right to manage. They remain at the mercy of the general partner. (ii) The general partner may misuse his power to exploit the limited partners. (iii) A limited partnership enjoys little credit standing as the liability of some partners is limited. It has to be registered.

Study Note - 10
10.1. TYPES OF COMPANIES
10.1.1. On the basis of mode of incorporation Companies may be divided into three categories on the basis of mode of incorporation as shown below: (i) Chartered Company : A chartered company is incorporated under Royal Charter issued by the King or Head of the State. Before the enactment of the Companies Act, the formation of a company was made under a special Charter by the King. The East India Company, Chartered Bank of England, etc., are important examples of chartered companies. This type of company is not found in India at present. (ii) Statutory Company : A statutory company is established by a special Act of Parliament. Generally, public utility concerns are established in this way for the purpose of performing certain important economic functions. Examples of statutory companies are : (i) Reserve Bank of India; (ii) Damodar Valley Corporation; (iii) State Bank of India; (iv) Industrial Finance Corporation of India. (iii) Registered Company : A company which is formed by registration under the Companies Act is known as a registered company. All existing companies in India (except statutory companies) have been formed and registered under the Companies Act. The workings and continuity of registered companies are governed by the relevant provisions of the Companies Act. Registered companies may be of three types: (i) company limited by shares; (ii) company limited by guarantee, and (iii) unlimited liability company. 10.1.2. On the basis of the extent of liability Companies may be divided into three categories on the basis of the extent of liability as shown below: (i) Company limited by shares : A company limited by shares is registered under the provisions of the Companies Act. It has a specified amount of capital di vided into a definite number of shares. Liability of the members is limited to the extent of the face value of the shares they have purchased. Most of the compa nies formed in India are of this class. A company limited by shares may be of two types : (a) public company, and (b) private company.

(ii) Company limited by guarantee : A company limited by guarantee is such a registered company where the extent of liability of members is specified in the Memorandum of Association. The liability of its members, in case of need, may exceed the face value of shares held by them. The guarantee liability is enforceable only at the time of winding up of the company. It implies that, if a company cannot pay for its liabilities in full at the time of winding-up, the existing members would be required to contribute for meeting debts and liabili ties of the company. A guaranteed company may be with share capital or without share capital. Companies limited by guarantee are usually formed to promote art, literature, sports, education, religious or other charitable purposes. In other words, non-profit earning companies are mostly registered with a guaranteed capital. (iii) Company with unlimited liability : This is a company having no limit on the liability of its members. In this company, members are personally liable to pay the debts of the company in proportion to their interest. Members are under the obligation to satisfy in full, all the claims of the third parties on the com pany. An unlimited liability company is just like a big partnership firm. Nowa days, such company is not found in the field of business. 10.1.3 On the basis of transferability of shares Companies may also be divided into two categories on the basis of transferability of shares as shown below: (i) Private company : A private company is an incorporated body, registered under the Companies Act (with a minimum paid-up capital of rupees one lakh), with four important restrictive provisions in its Articles of Association. Therefore, a private company is one which: (i) restricts the rights of its members to transfer their shares in the company; (ii) limits the number of its members to fifty (excluding its employee shareholders); (iii) prohibits any invitation to the public to subscribe for any shares or debentures of the company; (iv) prohibits any invitation or acceptance of deposits from persons other than its members, directors or their relatives. (ii) Public company : A public company means a company which : (i) is not a private company; (ii) has minimum paid up capital of rupees five lacs; and (iii) is a subsidiary of a company which is not a private company. In other words, a public company is one which is not a private company. It is an association consisting of seven or more members, which is registered under the Companies Act. 10.1.4. On the basis of jurisdiction of functioning Companies may be divided into three categories on the basis of jurisdiction of functioning as shown below: (i) Indian company : A company which is registered and incorporated in India is called an Indian Company. This company is registered under the provisions of the Indian Companies Act with its registered office in India. (ii) Foreign company : A foreign company is a company which is incorporated outside the country but carries on business in this country through agents or branches. The provisions of the Indian Companies Act are equally applicable to foreign companies carrying on business in India. (iii) Multinational company : A company whose management, ownership and control are spread over more than one country is known as multinational company. Therefore, a service facilities outside the countrys origin. A multinational company takes decisions in a global context. A multinational company organizes its operations in

different countries through either of the following five alternatives : (i) Subsidiary companies; (ii) Joint venture companies; (iii) Branches; (iv) Franchise holders and (v) Turn-key projects. The examples of multinational companies are : (a) Philips; (b) Coca-Cola; (c) Bata; (d) IBM; (e) Siemens; (f) Imperial Chemical Industries; (g) Union Carbide; (h) Nestle; (i) Unilever, etc. 10.1.5. On the basis of the extent of ownership and control Companies may be divided into three categories on the basis of the extent of ownership as shown below: Government company : A Government company is a company in which at least 51% of the paid up share capital is held by the Government (Central Government or State Government). Government companies are also registered under the Companies Act. Examples of Government companies are : (i) Bharat Electronics Ltd.; (ii) Steel Authority of India Ltd.; (iii) Coal Mines Authority Ltd., etc. Holding company : A holding company is one that directly or indirectly holds more than 50% of equity share capital or controls the composition of the Board of Directors of some other companies. A company may become a holding company of another company in any of the following three ways : by holding more than 50% of the paid up equity share capital of another copany,or by holding more than 50% of the voting rights of another company; or by holding the right to appoint the majority of the Directors of another company. Subsidiary company : A subsidiary company is one : (i) in which more than 50% of the paid up equity share capital is held by another company; or (ii) whose majority of the Directors are appointed by anther company ; or (iii) where more than 50% of the voting powers are exercised by another company.

10.2.PRIVATE COMPANY
10.2.1.Definition of a private company A private company is an incorporated body, registered under the Companies Act (with a minimum paid-up capital of rupees one lakh), with four important restrictive provisions in its Articles of Association. Therefore, a private company is one which: (i) restricts the rights of its members to transfer their shares in the company; (ii) limits the number of its members of fifty (excluding its employee shareholders); (iii) prohibits any invitation to the public to subscribe for any shares or debentures of the company; (iv) prohibits any invitation or acceptance of deposits from persons other than its members, directors or their relatives. 10.2.2. Features of a private company (i) A private company can select any name, but the words Private Limited must be added at the end of its name. (ii) It must have a minimum of two members and a maximum of fifty members (excluding employee shareholders). (iii) It can start its business just after its registration. It does not require a commencement certificate. (iv) It cannot issue shares to the public. Moreover, a restriction is imposed on the transferability of its shares. (v) It need not require to file a prospectus or a statement in lieu of prospectus to the Registrar of Companies. (vi) It need not require to hold a statutory meeting or file a statutory report. (vii) It does not restrict any investment in the same group of companies.

10.2.3. Privileges and exemptions allowed to a private company The following are some of the privileges and exemptions allowed to private companies as compared to public companies : (1) Exemptions in formation of a company : (i) A private limited company can be formed by two persons only. (ii) It can start its business just after its registration. It does not require a commencement certificate. (iii) It need not require to file a prospectus or a statement in lieu of prospectus to the Registrar of Companies. (2) Exemptions regarding holding of meetings : (i) It need not require to hold a statutory meeting or file a statutory report to the Registrar of the Company. (ii) Provisions of the Companies Act, regarding quorum, voting rights, counting of votes and information of meetings can be relaxed in case of a private company. (3)Exemptions regarding appointment, removal, etc., of Directors : (i) Minimum number of Directors required in a private company is two, while in case of public company, it is three. (ii) The rules regarding appointment, retirement, etc., of Directors do not apply to a private company. (iii) The rules regarding qualifying shares of Directors do not apply to a private company. (iv) Loans and financial help can be given to the Directors of the private company without permission of the Central Government. (v) The approval of the Central Government is not required regarding increase in the number of Directors of a private company. (vi) There is no limit on remuneration of Directors and Managing Director of a private company. (4) Exemptions regarding managerial remuneration : Remuneration payable to Directors and Managing Directors of a private company is not restricted to 11% of the net profits. (5) Exemptions regarding appointment of Managing Directors : (i) A Managing Director can be appointed even for more than five years. (ii) No approval of the Central Government is required in case of appointment of Managing Director. (6) Exemptions regarding share capital : (i) It can enhance its capital without observing the legal provisions regarding further issue of capital applicable to public companies. (ii) The provisions regarding voting rights and the distribution of share capital into preference and equity shares do not apply in the case of a private limited company. (7) Exemptions from various legal formalities : A private limited company is not bound to observe the restrictions under the Companies Act with regard to publication of accounts, issue of right-shares, investment of company funds in the same group of companies, etc. 10.2.4. Advantages (or merits) of private companies The main advantages of a private limited company are as follows: (i) Easy formation due to lesser formalities : A private company is easy to form as two or more persons are required to form it. A private company can start its operations immediately after its incorporations. There is no need to get the certificate of commencement of business. It is neither required to issue a prospectus nor to call a statutory meeting.

(ii) Maintenance of secrecy of business affairs : A private limited company is better placed to maintain secrecy of the affairs of business. A private company does not have to show its accounts and financial statements before the registrar of Companies and the public. (iii) Promptness of decisions : Policy decisions can be implemented quickly in the case of private companies as compared to public companies. The management is also in a few hands who manage the day-to-day affairs effectively. (iv) Direct encouragement : There is no difference between owners and management of a private company. The members and management, thus, get more incentive to work. (v) Greater elasticity : Private companies have been granted exemptions from the applications of various important provisions of company law. Thus, a private company is required to perform a few number of legal formalities as compared to public companies. 10.2.5 Disadvantages (or limitations) of private companies Main disadvantages of a private limited company are as follows: (i) Limited membership : A private company cannot have more than fifty members (excluding employee-shareholders). So, the financial resources of such companies are limited. Therefore, possibilities of expansion and diversification become limited. (ii) Interests of the shareholders are not safeguarded : Provisions of the Companies Act regarding safety of shareholders do not apply to private companies (example., working of Directors, limit of managerial remuneration, etc.) Moreover, non-transferability of shares puts the minority at the mercy of the majority. (iii) State priorities to public companies : Public companies are always preferred as compared to private companies in matters of tax relief, financial assistance, managerial assistance, etc. Generally, the Central Government gives preference to public companies in matters of granting licences. (iv) Dissatisfaction among minority shareholders : The minority shareholders cannot dispose of their shares even when they are dissatisfied with the affairs of the company. 10.2.6 Private company deemed to be a public company A private company is deemed to be a public company : (i) Where at least 25% of the paid-up share capital of a public company is held by a private company; (ii) Where at least 25% of the paid-up share capital of a private company is held by one or more bodies corporate; (iii) Where a private company accepts public deposits; (iv) Deemed public companies have become inoperative as per Companies (Amendment) Act, 2000.

Company Organisation and Management 10.3 PUBLIC COMPANY


10.3.1Definition of a public company A public company means a company which : (i) is not a private company; (ii) has a minimum paid up capital of rupees five lakh; and (iii) is a subsidiary of a company which is not a private company. In other words, a public company is one which is not a private company. It is an association consisting of seven or more members, which is registered under the Com panies Act. 10.3.2 Features of a public company: (i) It requires a minimum of seven persons to form a public company. There is no

restriction on the maximum number of members. (ii) It can offer shares to the general public in order to raise huge financial resources. (iii) Shares of a public company are freely transferable like movable property. (iv) Shareholders have no control over the management of the company. (v) A public company can choose any name, but it must add the word Limited at the end of its name. (vi) It cannot commence its operations until it obtains a Certificate to Commence Business in addition to the Incorporation Certificate from the Registrar of Companies. 10.3.3. Advantages (or merits) of a public company The following are the advantages of a public company (i) Limited liability : The liability of each member is limited to the extent of the face value of shares purchased. (ii) Large membership : There is no upper limit as to the number of members. This diffuses the risk of investment in shares. (iii) Mobilisation of huge financial resources : This form of organization can obtain large amounts of capital for carrying out large-scale operations. (iv) Economies of large-scale production : Huge financial resources lead to a phenomenal growth in the size of the company. This will result in greater division of labour, specilisation, more effective use of resources, bulk purchase of raw materials at lower prices, etc. (v) Professional management : The large size enables the company to acquire services of professional people in various field like accounting, finance, production, sales, etc. Thus, greater specilisation is possible in various fields of operation. (vi) Transferability of shares : Shares of a public company are freely transferable. Transferability of shares enables an investor to increase or decrease his investment in a company at any time. Transferability of shares reduces the risk of investment. (vii) Safeguarding interest of shareholders : Strict legal regulations safeguard the interests of the shareholders and people who deal with public companies. (viii) Social benefit : Increase in production, improvement in quality and providing goods and services at a cheaper rate ensures betterment of the society. 10.3.4 Disadvantages (or limitations) of a public company The following are the disadvantages of a public company: (i) Legal complexities : The formation of a public company is complex and expensive. (ii) Separation of ownership and management : The management of the business is controlled, not by the shareholders in mass, but by their representatives called the Board of Directors. Thus, management and ownership become separated. (iii) Oppression of minority shareholders interests : All the affairs of a public company are controlled by a set of Directors. The directors can do anything within the limits of the Companies Act. Minority shareholders are oppressed and have no say in the management of the company. (iv) Delay in decision-making : It is rather difficult to take quick decisions on account of disagreements among the Directors. Moreover, a public company has to observe a good deal of legal formalities. As a result, there appears to be a huge delay in decision-making. (v) Speculation in shares : Very often Directors indulge in speculation of shares for their personal interest. Speculation can create chaos in the stock exchange and can destabilize the company.

10.4. INCORPORATION OF A COMPANY


The following documents are to be filed with the Registrar of Companies of the State in which the registered office of the company is to be situated :

(i) Memorandum of Association; (ii) Articles of Association; (iii) List of persons agreeing to act as Directors (their full address and occupations); (iv) Statement of consent signed by each Director, (v) A statement of Authorized Capital; (vi) Address of the companys registered office; (vii) An undertaking by each Director to hold and pay for the qualification shares; (viii) A statutory declaration by a chartered accountant or an advocate that all the legal requirements of the Companies Act have been complied with. The Registrar of Companies scrutinizes the above documents. If the documents are found to be in order, the name of the company is entered in the register. Then the Registrar issues a certificate of incorporation in favour of the company. This certificate gives birth to a company with a separate legal entity. A private company can commence its business just after getting a commencement certificate to start its operations in addition to an Incorporation certificate. 10.4.1. Raising of capital (for public companies only) Capital subscription (example., raising of capital) is the third stage of formation of the company. A private limited company does not require this stage as it does not collect funds by selling shares to the public. A capital subscription stage is required for public companies as they are to collect funds form the members of the public at large by selling its shares and securities. So, with a view to raising funds, a public company, soon after its incorporation, has to arrange a meeting to deal with the following matters : (i) Issue of a prospectus or a statement in lieu of prospectus; (ii) Appointment of bankers; (iii) Appointment of a brokers for underwriting shares; (iv) Appointment of a pro tem secretary; (v) Conform to the guidelines issued by SEBI from time to time. A public company issues a prospectus in order to invite the public to subscribe to the issue of shares. A public company cannot allot shares to the public, unless the amount mentioned as minimum subscription is received within 120 days of the date of the issue of the prospectus. The restriction of minimum subscription is meant to prevent the formation of companies with an inadequate capital. In other words, the companies which can raise enough capital to meet the minimum requirements are allowed to start their business. A company can allot shares to the public provided the minimum subscription (as disclosed in the prospectus) has been raised within 120 days from the date of issue of the prospectus. 10.4.2. Commencement of business of a public company A public company cannot start the business without having a certificate of commencement from the Registrar. A certificate of commencement is issued in favour of a public company by the Registrar when the following conditions are fulfilled : (i) A declaration that a prospectus or a statement in lieu of prospectus has been filed with the Registrar. (ii) A declaration that the amount of minimum subscription (as specified in the pro spectus) has been received. (iii) A declaration that the Directors of the company have paid for their qualification shares. (iv) A certificate by a Director or the secretary of the company that all the formalities relating to the commencement of the business have been fulfilled. If the Registrar is satisfied that all the conditions have been fulfilled, he issues a certificate of commencement in favour of the public company. No public company can start its operations without obtaining a commencement certificate.

10.5.PROMOTION OF A COMPANY
Promotion is the discovery of business opportunities and the subsequent organization of funds, property and management ability into a business concern for the purpose of making profits therefrom. Promotion is the first stage in the formation of a company. Promotion means various initial steps to be taken for the establishment of a company, before it comes into existence. 10.5.1.Definitions given by eminent authors : (1) Promotion is the process of organizing and planning the finances of a business enterprise under the corporate form. [L.H.Haney] (2) Promotion starts with the conception of the idea from which the business is fully ready to begin operations as a going concern. [Guthman and Dougall] Promotion is an idea which is developed into a concrete project accomplished by the incorporation and floatation of a company. All the initial activities undertaken before the company is registered are called promotional efforts. Persons who help in the promotion of a company are called promoters. These promoters are experts in the work of company formation. 10.5.2 Meaning and definitions of promoter There is no statutory definition of a promoter. But in simple terms, a promoter is one who usually performs the preliminary duties necessary to bring a company into existence and float it. A promoter undertakes to form a company with reference to a given project and performs various formalities required for starting a company. A promoter may be : (a) an individual; (b) a firm; (c) an association of persons; (d) a company. Every individual connected with the formation of a company cannot be called a promoter. Thus, the persons who assist the promoters in performing the various legal formalities, are not promoters (example., accountants, solicitors, professional advisors, tax consultants, etc.). Definitions given by eminent jurists ; (1) A promoter is one, who undertakes to form a company with reference to a given object and sets it going and takes the necessary steps to accomplish that purpose. [Justice C. J. Cokburn] (2) A promoter is one, who conceives a business opportunity and assembles resources to translate a possibility into a reality. [Justice Bowen] A promoter is one, who identifies a business opportunity, analyses its prospects and takes the initiative to form a company, taking into consideration the opportunities available. 10.5.3 Types of promoters Depending on the nature of the promotion work, promoters can be classified as follows: (i) Professional promoters : They are specialists in forming a new corporate enterprise. After promoting an enterprise, they eventually hand over the control and management to the shareholders of the company. (ii) Occasional promoters : Promoters who are not involved in promotion work on a regular basis are called occasional promoters. Promotion is not their main occupation, and after promoting a company, they go back to their original profession. (iii) Financial institutions as promoters : Some financial institutions or financiers may take up the promotion of a company. After the incorporation of the company, financiers get their fixed remuneration and leave it. Banking and insurance companies have been engaged as institutional promoters. These promoters provide technical, managerial and financial assistance for the promotion of new enterprises. (iv) Enterpreneuring promoters : These promoters conceive and idea of the new business unit, do the necessary preliminary work in setting up the business unit and ultimately control and manage the same. In India, most of the promoters belong to this category. (v) Technical firms as promoters : Engineers and technical experts sometimes pick up

the lucrative idea of business promotions. They are not in the promotional work on a regular basis. They take up the promotion of some company and then go back to their earlier profession. (vi) Government as a promoter : Since independence, the Government of India has emerged as a big promoter of enterprises. The Government (Central or State or both) have become promoters for public sector undertakings, economic organizations, defence industries, oil and natural gas, etc. (vii) Specialised institutions as promoters : The Government has set up special institutions to promote corporate enterprises in order to fill in the gaps in the industrial structure of the country. National Industrial Development Corporation (NIDC), Industrial Bank of India, etc., are examples of such institutions. These institutions provide technical, managerial and financial assistance for the promotion of new enterprises. 10.5.4 Functions (or role) of a promoter The functions of a promoter may be summed-up as follows: (i) A promoter selects the line to business of a proposed company. (ii) He studies the future possibilities of the business of the proposed company. (iii) He decides the name of the company, objects of the company and also to decide where its registered office should be situated. (iv) He prepares the memorandum of association and articles of association and files these documents with the Registrar of Companies. (v) He takes necessary steps to get the company registered. (vi) He makes necessary arrangements for the initial capital of the proposed company. (vii) He selects the first Director of the proposed company. (viii) He appoints the banker, auditors, brokers and legal advisors for the proposed company. (ix) He enters into preliminary contracts with different parties (example. vendors, underwriters, etc.) (x) He makes necessary arrangements for the allotment of shares and secrities. 10.5.5 Qualities of a promoter In order to perform the task of promotion successfully, a promoter must have several essential qualities. A promoter must be well-acquainted with the social, economic, political and business conditions of the place where the business is to be established. He must be a person with imagination, organizing ability and resources. In brief, a successful promoter must possess the following qualities: (i) Organising ability; (ii) Farsightedness; (iii) Tactfulness and laborious; (iv) Self-confidence; (v) Perseverance and consistency; (vi) Risk-bearing capability; (vii) Honesty; (viii) Knowledge of company law and other related laws. (ix) Resourcefulness; (x) Salesmanship. 10.5.6 Legal status of a promoter
Company law has not given any legal status to a promoter. In other words, legally, a promoter occupies a peculiar position, as company law is silent in this regard. A promoter is neither a trustee nor an agent of the company which he promotes.

Truly speaking, a promoter stands in a fiduciary position towards the company. The fiduciary position of a promoter may be discussed as follows: (i) The promoter must not make any profit from the company that he has promoted. (ii) The promoter must not take advantage of his position in order to make any secret profit. (iii) The promoter must not indulge in any undue influence or fraud. (iv) The promoter must give to the company the benefit of any negotiations or contracts into which he enters. 10.5.7 Stages of promotion There are six stages in the promotion of a company, which are as follows:

(i) Discovery of business opportunities : A promoter conceives the idea of forming a company. A promoter is to discover the business opportunities, considering the availability of human and non-human resources. He is to consider whether the idea is practical or feasible in the light of the proposed risks and profitability. (ii) Detailed investigation of the idea conceived : Detailed investigation regarding commercial feasibility is absolutely essential before capital is invested to implement the idea conceived. Detailed investigation may relate to : (a) Market conditions (b) Demand for the product to be manufactured; (c) Estimated cost of production ; (d) Estimated profit margin, and (e) Capital requirement of the proposed business. Such an investigation gives a critical appraisal of the idea conceived and reveals whether the idea is commercially feasible or not. The services of experts may be needed to prepare a project report. (iii) Verification of the results of investigation : The reports submitted by the investigators must not be accepted without getting them verified by a separate team of impartial experts. (iv) Assembling of different elements of the business : When the results of the investigation is favourable, the promoter should go ahead with the promotion of a company (iii) verification of the results of investigation : The reports submitted by the investigators must not be accepted without getting them verified by a separate team of impartial experts. (iv) Assembling of different elements of the business : When the results of the investigation is favourable, the promoter should go ahead with the promotion of a company. (v) Preparation of a financial plan for the business project : After considering all the factors, the promoters proceed with the preparation of a financial plan for the proposed company. The Promoters are to decide what amount of capital is required at the initial state. For this purpose, they are to approach banks, financial institutions and underwriters. A company raises its capital through the issue of shares and debentures. While preparing the financial plan, promoters have to keep in mind that adequate funds should be provided to launch the company. (vi) Submission of necessary documents required for incorporation : It is necessary to submit certain documents to the Registrar of Companies in order to incorporate a joint stock company. The documents involved are : (a) the memorandum of association; (b) the articles of association; (c) the prospectus; (d) the list of Directors; (e) the consent of Directors; (f) the address of the companys registered office; (g) statutory declarations, etc. 10.5.8 Other relevant concepts (a) Minimum subscription: Minimum subscription means the minimum amount of capital which a company requires for the starting of the business. The minimum subscription should be received within 120 days after the date of the issue of the prospectus. A company cannot allot any shares unless the minimum subscription has been raised through the application for shares. If this minimum amount is not collected within the stipulated period, the amount received from the applicants must be returned within the next 10 days (example., within 130 days after the issue of shares). Minimum subscription is necessary to cover the following expenses : (i) preliminary expenses; (ii) underwriting commissions on sale of shares; (iii) working capital; (iv) the cost of any property purchased or to be purchased; (v) payment of any money borrowed for the above purpose; (vi) any other necessary expenditure. (b) Certificate of incorporation: This is certificate issued by the Registrar of Companies to

a company, whereby the incorporation of the company is recognized. In order to obtain the certificate of incorporation, a limited company has to file with the Registrar of Companies the following documents: (i) Memorandum of Association; (ii) Articles of Association; (iii) List of first Directors; (iv) Written consent of Directors to act as such; (v) Address of the registered office of the proposed company; (vi) Statutory declaration that the requirements of the Companies Act have been complied with. On the filing of the above documents and the payment of necessary registration fees, if the Registrar is satisfied that everything is in order, he will register the name of the company and issue a Certificate of Incorporation. After this is done, the company comes into existence. (c) Certificate of commencement: A private company can commence business immediately after the grant of the Certificate of Incorporation. A public company cannot commence business until it obtains a Certificate of Commencement in addition to the Incorporation Certificate from the Registrar of Companies. The Certificate of Commencement is issued in favour of a public company by the Registrar only when the following conditions are fulfilled : (i) a prospectus or a statement in lieu of prospectus has been filed with the Registrar; (ii) the minimum subscription has been raised; (iii) the Directors have paid for their qualifications shares; (iv) a certificate by a Director or the Secretary of the company that all the requirements of the Companies Act regarding commencement of business have been complied with. The Registrar issues the Certificate of Commencement in favour of a public company when he is satisfied that all the conditions (mentioned above) have been fulfilled. (d) Preliminary expenses : Expenses incidental to the formation of a company are known as preliminary expenses. These expenses are of a capital nature, but they do not represent any tangible assets. Thus, preliminary expenses are treated as fictitious assets and these expenses are to be written off against Profit & Loss Account over a certain period. The following items of expenses are usually treated as preliminary expenses : (i) cost of preparing and printing the Memorandum and the Articles of association; (ii) cost of preparing, printing and circulating the prospectus; (iii) cost of registering the company (example., filing necessary documents, fees and stamp duties, etc.); (iv) cost of preliminary agreements; (v) cost of preparing and printing the letter of allotment; (vi) valuers fees for reports, certificates, etc.

10.6 BASIC DOCUMENTS OF THE COMPANY


10.6.1.Introduction In the company form of organization, a large number of legal documents and papers are prepared and filed with the Registrar of Companies. However, the following documents are considered most important : (A) Memorandum of Association; (B) Articles of Association; (C) Prospectus or statement in lieu of prospectus. Now we shall discuss briefly each one of these documents:

10.6.2. Memorandum of Association The Memorandum of Association is a document which contains the fundamental rules regarding the constitution and activities of a company. It lays down the objects and scope of activities of the company. A memorandum also states the limits to which a company can move. If a company moves beyond the limits mentioned in the memorandum, it shall be considered ultra vires. Thus, a Memorandum of Association is the charter of a company. Definition according to the Indian Companies Act : Memorandum means the Memorandum of Association of a company, as originally framed or as altered from time to time in pursuance of any previous Companies Act. [Section 2(28) of Indian Companies Act, 1956] The memorandum governs the relationship of the company with the outside world. The company has to work within the limits laid down in the memorandum. The memorandum is the foundation upon which the superstructure of the company is built. 10.6.3 Importance of Memorandum of Association (1) Basis of incorporation : It is the basis of incorporation of a company. A company cannot be registered without filing this document. (2) Informing the name, address, object, capital and liability of the company to outsiders : Every outsider can easily obtain information about the company regarding its name, address, object, capital and liability, etc., through the Memorandum of Association. (3) Determining the extent of working of the company : It lays down the objects and scope of activities of the company. It also states the limits up to which a company can move. Any activity outside the scope of the memorandum will be ultra vires and void. (4) Unalterable document : The provisions of this document cannot be changed without passing a special resolution (passed by 75% majority). In certain cases, the changes can be made by seeking permission from the Company Law Board or Central Government. (5) Determining the relationship between the company and others : It enables outsides to know whether the company is authorized to enter into a particular transaction or not. 10.6.4 Contents (or clauses) of the Memorandum of Association The Memorandum of Association contains the following clauses : (i) Name clause; (ii) Registered office (example., domicile) clause; (iii) Object clause; (iv) Liability clause; (v) Capital clause; and (vi) Association (or subscription) clause. (i) Name Clause : The name of the proposed company is mentioned in this clause. The name of a company must end with the word Limited in the case of a public company and the words Private Limited in the case of a private com pany. The name should not be identical with the name of any existing com pany. The name should not create an impression that the company is carrying on the business of some other existing company. The name should not be mis leading (example., creating confusion regarding its nature of business). (ii) Registered office (example., domicile) clause : The name of the State in which the registered office of the company is to be situated is mentioned in this clause. This clause determines the jurisdiction of the Registrar of Companies and the court. This clause also ascertains the nationality of the company (whether the company is an Indian company or a foreign company). The full address of the registered office must be communicated to the Registrar of Companies for future communication. (iii) Object Clause : This clause states the object with which the company is pro posed to be established. A company is not legally entitled to do any business other than that specified in its object clause. The object clause should include

(i) main objects to be pursued after incorporation; (ii) incidental objects ancillary to the attainment of the main objects; (iii) other objects not included in (i) and (ii) above. The object clause must not include anything which is : (i) illegal or opposed to the public interest; (ii) against the general law of the country; and (iii) contradictory to the Companies Act itself. (iv) Liability clause: This clause states the nature of liability of the members of the company (example., whether limited by shares or by guarantee or unlimited) : (i) In case of a company limited by shares, members liability is limited to the face value of the shares. (ii) In case of a company limited by guarantee, the liability clause must state the extent of liability of each individual member in the event of its being wound up. (iii) In case of an unlimited company, the liability clause does not appear in the memorandum of association. (v) Capital clause : This clause states the total capital of the proposed company. The amount of capital as stated in the memorandum is known as the autho rized capital of the company. A company cannot collect funds exceeding the authorized capital. The division of capital into equity share capital and preference share capital should also be mentioned. The number of shares in each category and their value should be given in the memorandum. (vi) Association (or subscription) clause : The names, addresses, signatures and descriptions of the signatories to the memorandum are given in this clause. This clause also states the amount and number of shares taken by the signatories of the memorandum. The number of signatories to the memorandum shall not be less than : (i) Seven (in case of a public company), and (ii) two (in case of a private company). 10.6.5 Alteration of the Memorandum of Association The different clauses of the memorandum can be altered according to the procedure and mode laid down in the Companies Act, by passing an ordinary or special resolution. Under certain circumstances, the approval of the Government is necessary to alter the memorandum. (1) Alteration of name clause : A company can change its name in the following ways (a) By a special resolution at a general meeting with the written approval of the Central Government. (b) If the name registered by it is identical to the name of an existing company, the registered name can be changed by passing an ordinary resolution and by obtaining a written consent of the Central Government. (2) Alteration of registered office : A company may change its registered office : (a) within the same city; (b) one city to another city within the same State, and (c) from one State to another. (2) If the registered office is to be shifted from one locality to another within the same city, an ordinary resolution will be sufficient. (2) If the registered office is to be shifted from one city to another city within the same State a special resolution is required. (3) If the registered office is to be shifted from one State to another State a special resolution as well as sanction of the court is required. (3) Alteration of the object clause : The object clause cannot be altered as a routine affair. The object clause of a company may be changed by passing a special resolution and by obtaining the sanction of the court on the following grounds :

(1) to carry on its business more economically or efficiently; (2) to enlarge the area of its operations; (3) to attain its main purpose by new or improved means; (4) to sell the whole or part of the companys property; (5) to amalgamate with any other company; (6) to restrict any of the objects specified in the memorandum. (4) Alteration of capital clause : A limited company, having a share capital, may alter its capital clause by passing an ordinary resolution in the general meet ing for the following purposes : (i) increasing its share capital; (ii) consolidating and dividing its capital into shares of larger amounts; (iii) converting its fully paid up shares into stock; (iv) reconverting stock into fully paid up shares; (v) sub-dividing its shares into shares of smaller amounts. But, for the deduction of share capital, a special resolution and confirmation by the court are necessary. (5) Alteration of liability clause : The liability clause cannot be changed so as to make the liability of the members unlimited. However, if the members of a public limited company are reduced to below seven, the liability of the mem bers automatically becomes unlimited. Liability of the Directors, and manag ing Director may be made unlimited by altering the articles of associations. 10.6.6 Articles of Association The Articles of Association is a document which contains the rules and regulations for the internal management of the company. It prescribes bye-laws for the general management of the company. It lays down the rules by which the objects of the company are to be carried out. The articles define the duties, the rights and powers of the governing body as between themselves and the company at large. Every company is required to file its articles of association along with its Memorandum of Association with the Registrar of Companies at the time of its registration. 10.6.7 Definition according to the Indian Companies Act : Articles mean the Articles of Association of a company as originally framed or as atered from time to time in pursuance of any previous Companies Act. [Section 2(2) of Indian Companies Act, 1956] Articles are concerned with matters in the routine conduct of the affairs of the company. The articles must not contain anything ultra vires the memorandum and contrary to the provisions of the Companies Act. 10.6.8 Contents of Articles of Association Some of the important contents of the Articles of Association are as follows: (1) Matters relating to shareholders : (1) types, number and denominations of shares; (2) the respective rights of different types of shares; (3) methods of making an issue of share capital; (4) procedure for making calls and allotment of shares; (5) procedure for issue of share certificates and share warrants; (6) conversion of shares into stock, lien of shares, etc.; (7) alteration of share capital; (8) voting powers of the shareholders; (9) procedure of forfeiture, re-issue and surrender of shares; (10) the amount of minimum subscription; (11) procedure regarding company meetings; (12) procedure for transfer and transmission of shares. (question 2) write the Matters relating to Directors :

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

carrying out the objects of the company. 4. Alteration in the document Memorandum cannot be altered easily. It requires court confirmation. Articles of Association can easily be altered without the confirmation of the court. 6. Registration Registration of Memorandum is compulsory for any company. Registration of Articles of Association is not necessary in case of a public company. Public company may opt for Table-A of Schedule-1 for its incorporation purposes. 7. Application of rules Memorandum of association is based on the doctrine of constructive notice. Articles of Association are based on the doctrine of indoor management. 8. Provision and its observations Memorandum cannot contains anything contrary to the provisions of the Companies Act. Articles of Association are subsidiary to both the Memorandum and Companies Act. Articles cannot contain anything contrary to both. 9. Violation Company cannot violate the clauses of the Memorandum. There is no remedy for ultra vires acts. Company may go beyond the scope of the Articles (but within its powers). Outsiders may presume that Articles are complies with. 10. Necessity This document is a must for getting a company registered. All companies are not required to have their own Articles of Association of Association. Public companies may adopt Table A of Schedule1 of Companies Act. But Articles are a must for a private company.

10.6.11 Prospectus A prospectus is a document inviting the general public to subscribe to the share capital of a public company. A prospectus is issued by a public company after obtaining the certificate of incorporation from the Registrar. The facts and figures stated in the prospectus are meant to

persuade the public to purchase shares or debentures of the company. A private company need not require to issue a prospectus, as it cannot invite the public to subscribe to its shares. A prospectus is the only window through which the potential investors can look into the soundness of the companys venture. The prospectus is placed before the public for raising necessary funds. The investors must, therefore, be given a complete picture of the companys future activities, efficiency and integrity of its Directors and the profitability of investment. A prospectus must be dated and signed by the Directors. A company must get its minimum subscription within 120 days from the issue of prospectus. 10.6.12 Characteristics of a prospectus The important characteristics of a prospectus are as follows: (1) It is a document described or issued as a prospectus. (2) It includes any notice, circular, advertisement, etc., inviting deposits from the public. (3) It is an invitation to the public to subscribe to the shares or debentures of the company. (4) It is a document through which the company secures the capital required for carrying on its business. 10.6.13 Purposes for the issue of a prospectus The following are the main objects of issuing a prospectus : (1) A prospectus brings to the notice of the public that a new company has been formed. (2) It provides detailed information about the company to the general inves tors. (3) It outlines the terms and conditions of issue of shares and debentures. (4) It highlights the present position and the future prospects of the company. (5) It reflects the business policies and programmes of the company. (vi) It identifies the person who can be held responsible for misstatements in the prospectus. 10.6.12 Contents of a prospectus A prospectus should contain information on the following matters : (1) Name and full address of the company. (2) Existing and future activities of the company. (3) Composition of the Board of Directors. (4) Qualification shares of the Directors and their remuneration. (5) Capital of the company, the number of shares and the amount of each share. (6) Rights and dividends attached to different classes of shares. (7) Preliminary expenses incurred by the company. (8) Minimum subscription and the amount payable on application, allotment and calls on shares. (9) Remuneration of the Managing Director. (10) Names and address of auditors and underwriters of the company. (11) Restrictions on the powers of the Directors. (12) Full particulars of the promoters, brokers, bankers, etc. (13) Nature and extent of interests of each Director in the companys promotion. (14) Details regarding the agreement to purchase property for the company and names of the vendors. (15) The amount of minimum subscription to be received before allotment of shares. (16) Inspection of books of accounts of the company. (17) Amount payable on application on an allotment and on different calls. (18) Time of opening and closing the subscription list. (19) Revaluation and reduction of share capital.

10.6.15 Statement in lieu of a prospectus If a public company does not issue a prospectus, it can issue a statement in lieu of prospectus. The statement in lieu of prospectus is drafted in accordance with the form set out in Part I of Schedule III of the Companies Act. It contains almost the same information as is contained in the prospectus. It should not contain any misleading or untrue statement. A statement in lieu of prospectus must be signed by every person named therein as a Director. 10.6.16 Liability for false statement in the prospectus A prospectus is an open invitation to the public to subscribe to the shares or debentures of a company. It must disclose all relevant facts and figures very clearly. Greatest care should be taken to prepare a prospectus. Information provided in the prospectus should not be false and misleading. It is the duty of the persons who are responsible for the issue of a prospectus not to disclose all relevant facts but also to see that any fact which may be relevant should not be omitted. If there is any false statement in the prospectus, it creates civil and criminal liability on the part of those who are responsible to publish the same. Persons authorizing the issue of the prospectus can be held liable for punishment with imprisonment up to two years and/or for a fine up to Rs. 50,000 for misstatement in the prospectus. If the Directors have submitted certain false information with a fraudulent intention, they will be liable for a fine up to Rs. 1,00,000 and/or imprisonment up to five years. 10.6.17 Misleading Prospectus and its Consequences A prospectus constitutes the basic of the contract between the company and the shareholder and therefore, it must disclose all material facts (example., facts likely to influence the judgment of a prospective investor in deciding whether to take shares or debentures or not) very accurately. It must not misrepresent or conceal material facts and thereby improperly influence and mislead the prospective investor into becoming an allottee of shares or debentures and in consequence suffer loss (Peed vs. Gurney). A prospectus containing false, misleading, ambiguous or fraudulent statement of material facts, is termed as misleading prospectus and in that case a misled investor (original allottee of share who had relied in the prospectus and not a buyer in the open market) is entitled to proceed against those who misled him. What is a false or untrue statement? A general commendation even if too highly coloured is not a false statement, but to say that something has been done, when it is not so, is a misstatement of fact (Karbergs Case). If there is omission of material facts from a prospectus or/and where the statement is ambiguous in the form and context in which it is included, the prospectus shall be deemed to be untrue. (Sec. 65). Hence a prospectus should be honestly framed and should not by any half statement of the truth or ambiguous phraseology give a false impression or mislead the investor for, the whole prospectus is to be read, and if, as a whole, if be misleading, those who issue it cannot escape on the ground that there is not a single statement which standing alone, can be challenged as false. It must however, be observed that in order to call a prospectus a misleading prospectus, there must be misrepresentation of facts and not of law or expectation. For example, if a prospectus represents that the companys shares will be issued at half their nominal value, whereas section 79 prohibits the issue of share at a discount exceeding ten percent. It is a misrepresentation of law and a person deceived by it will have no remedy. The facts of Shiromani Sugar Mills Ltd. v. Debi Prasad case was also similar. The prospectus in this case, stated that the managing agents with their friends, promoters and directors have already promised to subscribe shares worth six lakhs rupees. But they actually subscribed much lesser number of shares. It was held that there was no misrepresentation of facts and the prospectus was not misleading because, the only fact asserted was the existence of promiseand the existence of promise is not falsified by the breaking of it. A person who subscribes for shares based on the misleading prospectus has certain remedies separately against the company as well as against the directors, promoters and experts.

10.7 SHARES
The shares capital of a company is divided into shares distinguished by its appropriate numbers. The shares shall be movable property transferable in the manner provided by the articles of the company and subject to provision of the Companies Act, 1956. The share capital of a company limited by shares shall be of three kinds only, namely : (a) Equity share; (b) Preference share; and (c) Sweat equity shares. Preference capital means that part of the share capital which fulfils both the following requirements, namely (a) that in respect of dividends, it carries or will carry a preferential right to be paid a fixed amount or an amount calculated at a fixed rate, which may be either free of or subject to income tax; and (b) that in respect of capital it carries or will carry on a winding up or repayment of capital a preferential right to the payment of either or both of the following amount, namely (1) any money remaining unpaid in respect of the amount specified in clauses (a) up to the date of the winding up or repayment of capital and (2) any fixed premium. Sweat Equity Shares Sweat equity shares mean equity shares issued at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called. A company may issue sweat equity shares of a class of shares already issue if the following conditions are fulfilled : (a) the issue of sweat equity shares is authorized by a resolution passed by the company in the general meeting; (b) the resolution specifies the number of shares the value and the classes of direc tors or employees to whom such equity shares are to be issued; (c) not less than one year has at the date of issue elapsed since the date on which the company was entitled to commence business; (d) the sweat equity shares are issued in accordance with the regulations made by the securities and Exchange Board of India in this behalf. Every holder of shares in a company may at any time nominate in the prescribed manner of shares upon the production of such evidence as many required by the Board may: (a) register himself as holder of the share, or (b) transfer of the share as the deceased share holder could have been made. Distinction Between Preference and Equity Shares The important distinctions are (a) Preference shares are entitled to a fixed rate of dividend on and amount calcu lated at a fixed rate as a percentage of the face value of the shares. Equity shares on the other hand are entitled to a varying rate of dividend depending upon profits of the company. (b) Preferences shares can be cumulative. In other words during the year when the company does not make profits, the arrear dividends accumulate. In case of equity shares the accumulation of the arrears dividends does not arise. This is because the entitlement to dividend is contingent upon the making of the profit by the company. (c) The holders of the preference shares have a priority over the holders of the equity shares to dividends. In other words, when a company does make profit

and declare dividends, the dividends payable to the preference shareholder including the arrears of the dividend should be paid first before any dividends can be declared to the equity shareholders. (d) Preference shareholder also have a priority over the equity shareholder to wards the repayment of capital in the event of winding up of the company. Preference share are redeemable after a specified periods of time. In other words, preference shares are entitled to get back their investment from the company after a fixed period of time as specified in the terms of issue of the preference share. (e) The preference shareholder do not have a right to vote at the meeting of the shareholders of the company unless it is a matter in which their rights are affected. On the other hand equity shareholder have voting right on every resolution which comes up before the meeting. The voting right of the equity shareholder are proportionate to the number of share held by them. An exception to the rule denying the voting right on account of dividends being on arrears the voting right of the preference shareholder also would be proportional to the capital paid up in respect of the preference shares bears to the total paid up equity capital of the company. Redemption of Preference Shares If so authorized by its articles, preferences shares are liable to be redeemed at the option of the company. After the coming into force of the companies (Amendment) Act, 1988 redemption of the preference shares has been made mandatory. No company limited by shares after the commencement of the Companies (Amendment) Act, 1996 issue any Preference Shares which is redeemable or is redeemable after the expiry of a period of 20 years from the date of its issue. Preference shares shall be redeemed subject to the following conditions, namely :(a) No such shares shall be redeemed except out of profit of the company which would otherwise be available for dividend or out of the proceeds of a fresh issues of shares made for the purposes of the redemptions: (b) No such shares shall be redeemed unless they are fully paid. (c) The premium if any payable on redemption shall have been provided for out of the profits of the company or out of the companys shares premium account before the shares are redeemed. (d) Where any such shares are redeemed otherwise than out of the proceeds of a fresh issue, there shall out profits which would otherwise have been available for dividend, be transferred to a reserve fund to be called the capital redemption reserve account, a sum equal to the nominal amount of the shares redeemed and the provision of the Companies Act relating to the reduction of the shares capital of a company shall except as provided in this section apply as if the capital re demptions reserve account were paid-up shares capital of the company. However the redemptions of preference shares will not attract the problems of redemption of capital. Issue of Shares at a Premium Where a company issues shares at a premium whether for cash or otherwise, a sum equal to the aggregate amount or value of the premiums on those shares shall be transferred to an account, to be called the shares premium account and the provisions of the companies relating to the reduction of share capital of a company shall except as provided herein apply as if shares premium account were paid on share capital of the company. The share premium account may be applied by the company : (a) in paying up unissued shares of the company to be issued to members of the company as fully paid bonus shares. (b) in writing off the preliminary expenses of the company.

(c) in writing off the expenses of or the commission paid or discount allowed on any issue of the shares or debentures of the company. (d) in providing for the premium payable on the redemption of any redeemable pref erence shares or of any debentures of the company. Right Shares Whenever a company proposes to increase the subscribed capital by issue of further shares at any time after the expiry of two years from the formation of the company or at any time after the expiry of one year from the allotment of shares by that company made for the first time after its incorporation whichever is earlier. It shall offer such shares to holder of equity shares of the company as on the date of the offer in proportion to the capital paid up as on that date. As the existing holders of equity shares are given the right of preemption these shares are called the Right Shares. A private company or a deemed private company which retains the restrictive clauses of a private company in the Articles need not offer to the existing shareholders. When a special resolution is passed by the company in general meeting to the effect that further shares may be allotted at the discretion of the board of directors to persons other than the holders of equity shares the shares can be offers to the general public. However, the issue of right shares will take place in accordance with the guidelines of the Securities and Exchange Board of India. Bonus Shares The issue of bonus shares by a company is a common feature. When a company is prosperous and accumulates a large surplus, it converts this surplus into capital and divides the capital among the members in proportion to their right. This is done by issuing fully paid shares representing the increased capital. The shareholders to whom shares are allotted have to pay nothing. The purpose is to capitalize profit which may be available for division or to utilise quasi-capital gains. Bonus share go by the modern name of capitalization shares The company transfers before declaring dividends for a financial year certain portion of the profit as prescribed by the companies (Transfer of Profit to Reserve) Rules, 1975 to the reserve of the company. The company shall ensure strict compliance with the following financial parameters for determining the quantum of the bonus issue :(i) that the bonus issue is made out of the free reserves built out of the genuine profits or shares premium collected in cash only; (ii) that Reserve created by revaluation of fixed assets or without accrual of cash resources are not capitalized. The bonus issue could not be made until the expiry of 12 months from any public or right issue and there is no restriction as to the timing of one bonus issue and another. The bonus issue should be made within a period of 6 month from the date of approval of the Boards of Directors thereof and the company has no option of changing that decision. The SEBI has issued guidelines for the capitalization of reserves and issue of bonus shares. The Articles should provide the issue of bonus shares by capitalization of reserves. If there is no such provision the Articles are to be altered suitably. Further it is be observed that the expanded capital after the issue is within the authorized share capital of the company. Otherwise the authorized capital is to be increased suitably. Depository System in India Over the last decade, the capital markets has been growing by leaps and bounds, India has the largest number of listed companies in the world today. As a result investors have to face a lot of inconvenience in effective registration of securities in their favour and to ensure that they receive their rightful share of dividend, bonus, right and other benefits. The large numbers in the Capital Market have also given rise to a large amount of paper work, bringing with it the associated problems.

The physical movement of (share) certificates and their transfer are fraught with a number of problems and are usually cumbersome and time consuming. Further with the increase in the volumes of trading, there has been an increase in the number of bad deliveries and this has introduced increased risk in settlement of trade. The threat of wrong/forged signatures, stolen shares, fake certificates etc. need to be contained if the investors are not to shy away from trading and investing in the India market. All these factors served as barriers to the entry of an investor in to the market. This failure gave the idea of setting up of an electronics system with scripless trading and quick settlement cycles. The Government of India promulgated the Depositories Ordinance in September 1995. Securities and Exchange Board of India (SEBI) notified Regulations under the ordinance in May, 1996, in order to provide the regulatory framework for the depositories. National Securities Depository Limited (NSDL) was registered on the 7th June 1996, with the SEBI as the first depository in the country. This new system of keeping ownership record in the form of electronic holdings has a number of advantages over the existing system of physical securities. In the new system, the Physical movement of securities would be replaced by a book entry system, under which the ownership would be transferred by electronics entries. The Depositories Act, 1956 makes a provision for the setting up of multiple depositories in India. The investor has been granted the option of holding securities in a physical or dematerialized form. Thus it is matter of choice for the investor as to whether he wants to avail of the depository services. All rights with respect to the securities held in the depository will with the beneficial owner (investor) and not with the depository. The depository acting as the registered owner only. When transacting through a depository, the investor will not be required to pay stamp duty on transfer of shares or the unit of mutual funds within the depository. The depository will interface with the investor through market intermediaries called Depository Participants (DP). The depository will hold beneficial owner-level information through its networks of DP. This will facilitate proper distribution of benefits arising out of the investors holding such as dividend, interest, bonus and right as on a given record date by the issuer company of its registrar and transfer agent. The SEBI (Depository and Participants) Regulations, 1996 specify the norms for the functioning and operations of depositories. The regulations have selected various categories of market participants who are eligible to become depository participants.

10.8 DEBENTURES
Debentures constitute a valid instrument by which long term and medium term financial needs are met by raising loans from the public. Debentures represent loan capital and the debentures and transferable securities as in the case of shares through stock exchanges. The debentures offer a predetermined fixed return by way of interest and are redeemed after a stipulated period. They may be offered privately without public announcement in the newspaper. Debenture is defined to include debenture stock, bond and other instruments of company whether constituting a charge on the assets of the company or not. A debenture shall not cease to be so merely because it is not secured by charge. There is no precise definition of the term and it can only be concluded that any instruments that creates or acknowledges a debts is a debentures. In CIT v. Cochin Refineries Ltd. (1982) it was held that where a company issued notes to secure a dollar loan, such notes and loan. Since a debenture means a document which creates or acknowledges a debt the distinction between a debenture and loan can be understood from the following passage : The substance of a loan is a right in the creditors to demand repayment and the substance of a debt is a liability upon the debtor to replay the money [per Chakravarty J. in Ram Ratan

Karmakar v. Amulya Charan Karmakar]. The debentures have the following features namely : 1. It is an instrument issued by the company acknowledging debt. 2. It provides for the payment of or acknowledging the indebtedness in a specified nominal value or face value of the debenture. 3. It carries a specified rate of interest. The debentures may be registered debentures or bearer debentures. Registered debentures are debentures which are payable to the holder thereof whose name is registered in the registered of debenture holders. Registered debentures certificates are transferred by executing a deed of transfer as in the case of shares. A bearer debenture is transferred by simple delivery. Debentures could be secured or unsecured. But normally most of the debentures are secured. Repayment of the indebtedness by way of debenture is secured by a charge on the assets of the company. Debentures could be redeemable or irredeemable. Redeemable connotes that the borrowing will be repaid by the company within a fixed term. In case of irredeemable debentures there is no obligation on the part of the company to repay the amount of the borrowing raised by way of debentures. Debentures may be convertible into shares. This indicates that after a particular period of time of issue of debentures, the debentures may be converted into shares at a specific rate of conversion. In other words till the date of conversion of the debentures into shares debenture holders would be earning interest from the company at a specific rate of interest . On conversion of the debenture, debenture would be cancelled and shares would be issued in favour of the debenture holders. After such conversion the debenture holders become the shareholder of the company and will not be entitled to may fixed return by way of interest but will be entitled to the dividends that may be declared by the company. Since the debentures are corporate securities akin to the shares, almost all the rules, regulations and restrictions in respect of issue of shares are applicable to debenture. Some of the important statutory provisions relating to the debentures are discussed below : 1. The power to issue debenture shall be exercised by the board of directors at a meeting [s. 292(1) (d)] 2. No company shall issue any debenture carrying voting right at any meting of the company whether generally or in respect of particulars classes of business. [s. 117] 3. Debentures which have been issued and redeemable may be kept alive for reissue [s.121] 4. Every debenture holder is entitled to a copy of the debenture trust deed within 7 days of making a request for such deed. 5. A contract to take up and pay for debentures can be enforced by a degree for specific performance [section 122] 6. The holders of the debenture have a priority under section 530 of the Act, if winding up were to take place. If the debenture are secured by floating charge on the assets of the company the creditors with fixed charges will be paid first and the debenture holders with a floating charge on the assets will get next preference in the list of priorities for repayment. 7. Every company shall keep a register of debenture holders in the same manner as the register of members. 8. A debenture holder is not entitled to the balance sheet and profit and loss account of the company [section 219] Every holder of debenture of a company may at any time nominate in the prescribed manner a person to whom his debenture of the company shall vest in the event of his death.

10.9 BOARD OF DIRECTORS


Introductin - when a Company is incorporated under the companies Act 1956, it becomes a legal entity capable of exercising all its function. For example, a company can own property, enter into contracts and even be guilty of certain offences. The company can only act throught some human agency. It being impracticable for all the member of company to conduct its affairs; they elect their representative for this purpose. These elected representatives are usually known as Directors. Every public company (other than a public company which has become such by virtue of sec 43-A) must have at least three Directors. Every other company must have at least two Directors. Directors of a company collectively are referred to as the Board of Directors. Nobody corporate association or firm shall be appointed director of a company. Only an induividual can be a director of a company. How director exercise their powers? Subject to any special provisions in the articles, powers delegated by a company to its directors must be exercised at properly convened meeting referred to as Board Meeting. In the case of every company a meeting of its Board of Directors shall be held at least once in every 3months and at least four such meetings shall be held in every year. Provided that the Central Government may, by notification in the official Gazette, direct that the provisions of this section shall not apply in relation to any class of companies or shall apply in relation thereto subject to such exceptions, modifications or conditions as may be specified in the notification. Notice- Notice of every meeting of the Board of Directors of a company shall be given in writing to every director for the time being in India; and at his usual addres in India to every other director. Quorum - A quorum is the preseribed minimum number of qualified persons authorized to transact the business at meeting. In relation to Board Meeting- quorum implies fully qualified and disinterested director who must be present at the meeting so as to enable the Board to legally transact the business thereat. Accordingly by the quorum for a meeting of the Board of Directors of a company shall be 1/3rd of its total strength (any fraction contained in that 1/3rd being rounded off as one) or two directors whichever is higher. Certain powers to be exercised by Board only at meeting The Board of Directors of a company shall exercise the following power on behalf of the company and it shall do only by means of resolution passed at meeting of the Board (a) the power to make calls on sharehloders in respect of money unpaid on their shares; (b) the power to issue debentures (c) the power to borrow moneys otherwise than on debentures (d) the power to invest the funds of the company (e) the power to make loans.

10.10 MEETINGS
We are here concerned with general meetings of members/share holders. The general meetings of members are of vital importance in the working of a company. For although general power of management of a company are vested in the Board of Directors the consent of members on such major issues as specified in Section 293 has to be obtained in their general meeting. Otherwise also it is fair to provide an opportunity to the shareholders to come together ad review the working of the company. Hence the companies Act has provided for various types of meetings of the shareholder of a company. 10.10.1 Types of general Meetings There are three types of general meetings of shareholder :

1. Statutory meeting. 2. Annual general meeting. 3. Extraordinary general meeting. In addition to the above types of meetings, sometimes a meeting of a particular class of shareholder may also be held. Such meetings are called class meetings. They are convened either by the company or by the court to affect variations in the right of that particular class of shareholders [Sec. 106] or in connection with a scheme of arrangement [Sec. 394] or at the time of winding up of the company. A class meeting is not a general meeting but similar rules relating to convening and conducting of a meeting apply to it [Sec. 170]. 10.10.2 Statutory Meeting
It is the first official general meeting of the shareholders. All public companies having a share capital except unlimited companies are required to hold a statutory meeting compulsory. It implies that private companies, unlimited companies and companies limited by guarantee but not having shares capital are not required to hold such a meeting. Statutory meeting must be held after one month but within six months of obtaining the certificate to commence business [Sec. 165(1)]. Unlike other types of general meetings, this meeting is held only once in the lifetime of company. The object of the statutory meeting is to provide an opportunity to the members, as early as possible, of acquainting themselves with the assets and properties acquired so far and to discuss the success of the flotation. The members are free to discuss any matter relating to the formation of the company or arising out of the statutory report. But they cannot pass any resolution without previous notice of at least 21 days.

10.10.3 Statutory Report In order to enable the members to make the best use of this opportunity the directors are required to prepare and send to every member a document known as the statutory report at least 21 days before the day on which the meeting is to be held. If the report is sent later it will still be valid if it is so agreed to by a unanimous vote of the members entitled to attend and vote at the meeting [Sec 165(2)]. The report should be certified as correct by at least two directors, one of whom shall be the managing director where there is one, and must also be certified by the auditors [Sec. 165(4)]. A copy of this report must be filed with the Registrar forthwith at the time of sending it to members [Sec. 165(5)]. 10.10.4.The statutory report must set out the following information : (1) The total number of shares allotted, distinguishing those issued otherwise than for cash and stating in the case of partly paid up shares, the extent to which they are so paid; (2) The total amount of cash received by the company in respect of all the shares allotted; (3) An abstract of the receipts and payments up to a date within seven days of the report and the balance in hand. The abstract must show under distinc tive head ings the receipts of the company from shares, debentures and other sources and shall give an account or estimate of the prelimi nary expenses of the company showing separately any commission or discount paid or to be paid on the issue or sale of shares or debentures; (4) The names, addresses and occupations of the companys directors, auditors, man aging director or manage secretary and the changes, if any, that have occurred since incorporation. (5) The particulars of any contract to be submitted to the meeting for approval and its modification done or proposed, if any; (6) The extent to which any under writing contract has not been carried out and the reasons therefore; (7) The details of arrears of calls due from directors and managing director are man agers;

(8) The particulars of any commission or brokerage paid or to be paid to directors and manager in connections with the sale of shares or debenturesof the company. If any default is made in filing the statutory report with the Registrar or in holding the statutory meeting, every officer of the company responsible for the default shall be punishable, with a fine up to Rs 500 [Sec. 165(a)]. Further if the statutory meeting is not held in time, the court may under section 433 order the compulsory winding up of the company on a petition filed by any member after the expiry of 14 days from the date an which statutory meeting was to be held. 10.10.5 Annual General Metting Every company must in each year hold in addition to any other meeting a general meeting as its annual general meeting [Sec 166(1)]. It is the most important meeting of the members of a company. It is held each year with a view to reviewing and evaluating the overall progress of the company during a year. The annual general meeting is sometimes called ordinary general meeting as usually it deals with the so called ordinary business. The following ordinary business must be transacted at the annual general meeting of a public company and a subsidiary thereof [Sec 173(1)]. (1) The consideration of the Annual Accounts, Balance sheet and the Reports of the Board of Directors and Auditors. (2) The declarations of a dividend. (3) The appointment of directors in place of those retiring, and (4) The appointment of and the fixation of the remuneration of the auditors. Any other business on agenda except that listed above shall be considered as special business. It is to be noted that in the case of extraordinary general meeting all business shall be treated as special business [Sec 173(1)(b)]. It is relevant to state that the ordinary business required an ordinary resolutions while the special business may require ordinary or special appointment of auditors although it is an item of ordinary business in the case of a company in which not less than 25% of the subscribed share capital is held whether singly or jointly by a public financial institutions or a Government Company or Central Government or any State Government or a nationalized bank or a general insurance company. It may be noted that an independent private company may make its own provisions by its articles in respect of ordinary business to be transacted at an annual general meeting. 10.10.6 Other Statutory Requirements (1) The first annual general meeting of a company must be held within 18 months from the date of its incorporation, and if such general meeting is held within that period, it shall not be necessary for the company to hold any annual gen eral meeting in the year of its incorporation or in the following year. It may be noted that there can be no extension of period beyond 18 months in case of this meeting even by the Registrar. (2) Subsequent annual general meeting must be held each year within six months of the end of the companys financial year; but the interval between any two annual general meeting must not be more than fifteen months. The Registrar may, however, for any special reason extend the above lime by a period by exceeding three months. In connection with subsequent annual general meetings it is worth noting that the holding of an annual general meeting in each calendar year is a statutory necessity, and it is not enough that they are held within fifteen months of each other. There should be one meeting per year and as many meeting as there are years. Further, though the annual general meeting of a company may be adjourned to a subsequent date and the adjourned meeting is to be deemed to be a continuation of the earlier meeting, the adjourned meeting too must be held within fifteen months of the previous meeting.

(3) The annual general meeting must be held on a working day during business hours at the registered office of the company or at some other place within the city where the registered office of the company is situated. (4) At least twenty-one days written notice to call an annual general meeting must be given to every shareholder, directors, and auditors of the company, and to every such person on whom the shares of any deceased or insolvent member may have devolved. The meeting may be held with a shorter notice, if it is so agreed unanimously by all members entitled to vote in such a meeting. An inde pendent private company may, however, by its articles make its own regula tions as regards length of period of notice and to whom it should be given. A copy of Directors Report, audited Annual Accounts and Auditors Report must be annexed to every such notice. The holding of annual general meeting is also governed by Sections 171 to 186 which contain provisions relating to convening and conducting of all types of general meeting under the Act. 10.10.7 Default in Holding the Annul General Meeting If a company fails to call an annual general meeting within the prescribed time limits, the Company Law Board may, on the application of any member of the company, call or direct the calling of the meeting and give such ancillary consequential directions as it thinks expediter in relation to the calling, holding and conducting of the meeting. The directions that may be given by the Company Law Board may include a direction that one member of the company present in person or by proxy shall be deemed to constitute a meeting. Further the company and every officer who is in default is liable to a fine which may extent to five thousand rupees and in the case of a continuing default, with a further fine which may extend to Rs. 250 for every day after the first during which such default continues. 10.10.8. Extraordinary General Meeting All general meetings other than the statutory and annual general meetings are called extraordinary general meetings. Regulation 47 of Table A defines : All general meetings other annual general meeting shall be called extraordinary general meeting. These meetings may be convened by the company at any time. The business transacted at an extraordinary general Meeting comprises anything which cannot be postponed till the next annual General Meeting example. changes in memorandum and articles of association reduction and reorganization of share capital, issue of debentures, etc. All business transacted at this meeting is called special business [Sec. 173 (1) (b)] The convening and conducting of this meeting is governed, like the annual general meeting by Sections 171 to 186. Extraordinary general meeting may be called (1) By the directors. The directors may, whenever they think fit, convene a meeting by passing a resolution to that effect in the Boards meeting. (2) By the directors on requisition [Sec. 469]. The directors must convene an extraordinary general meeting on the requisition (written demand) of members holding not less than 1/10th of the total voting rights on the matter of requisition. The requisition must state the matters for the consideration of which the meeting is to be called. It must be signed by the requisitionists and deposited at the regis tered office of the company. The directors should, within 21 days from the date of the deposit of a valid requisition, move to call a meeting and should give 21 days notice to members for calling such a meeting and the meeting should actu ally be held within 45 days from the date of the requisition. It maybe noted that the requisitionists are not bound to disclose reasons for the resolution they propose to move at the meeting. Further, no business other than the business for which the meeting has been expressly convened can be trans acted at the requisitioned meeting. (3) By the requisitionists themselves. If the directors fail to call the meeting within

afore mentioned time-limits, the requisitionists, or such of the requisitionists as represent not less than 1/10th of the total voting rights of all the members, may them selves convene a meeting within three month of depositing requisition. Such a meeting should be called in the same manner, as nearly as possible, as that in which meeting are called by the Board. Any reasonable expenses incurred by the requisitionists must be repaid to them by the company, and any sum so paid shall be retained by the company out of-any sums due or likely lo become due to the directors in default. (4) By the Company Law Board [Sec. 186]. If for any reason it is impracticable lo call or conduct an extraordinary general meeting, the Company Law Board may, either of its own motion or on the application of any director or any member who would be entitled to vote, order a meeting to be called, held and conducted in such manner as the Company Law Board thinks fit and may give such direc tions as it thinks expedient, including a direction that one member present in person or by proxy shall be deemed to constitute a meetings. It may be noted that unlike an annual general meeting, an extraordinary general meeting can be convened on a public holiday and at a place other than the registered office of the company or the city in which the registered office is situated. 10.10.9 Proxies A proxy is a members authorized agent for the purpose of voting. The term is also applied to the instrument by which the appointment to act on his behalf is made by the members. As per Section 176 the provisions relating to proxies are as follows : (1) Members of a company having share capital have a statutory right to appoint proxies, notwithstanding anything to the contrary in the articles. In other words proxies may be appointed if allowed in the articles. (2) Unless the articles otherwise provide, a proxy shall not be allowed to vote except on a poll. (3) Unless the articles otherwise provide, a member of a private company is not en titled to appoint more than one proxy to attend on the same occasion. (For every resolution poll is taken separately and for every resolution separate proxy may be appointed in a public company). (4) A proxy must be in writing, in the proper form duly signed by the appointer and stamped. If the appointer is a body corporate, the instrument of proxy should be under its seal and be signed by a duly authorized officer. (5) A proxy may be lodged at the companys office not later than 48 hours before the commencement of the meeting. If the articles of a company other than an inde pendent private company require a longer period than 48 hours, that will be in operative and shareholder will have the right to deposit proxies 48 hours before the meeting. (6) For each meeting a separate proxy is required. (7) A proxy need not be a member of the company. (8) A proxy shall not have any right to speak at the meeting. (9) Every notice calling a general meeting must suit with reasonable prominence that a member is entitled to appoint a proxy and that the proxy need not be a member. If default is made in complying with this provision every defaulting officer is pun ishable with fine which may extend to one thousand rupees. (10) No invitation to appoint any person as proxy shall be issued at companys ex pense and idea if any such invitation is issued every officer of the company who is knowingly in default shall be punishable with fine which may extend to one thou sand rupees. (11) After giving three days notice to the company, members may inspect proxies lodged

with the company during 24 hours (within business hours) before the time fixed for the meeting and till the conclusion of the meeting. (12) Subject lo the provisions in the articles, a proxy can be revoked by intimating the company, at any lime, before it is acted upon. Death or insanity of the principal also revokes the authority of the proxy but proper intimation to the company is necessary. Moreover, a member can prevent the proxy from exercising the right to vote by himself attending and voting at the meeting. (13) Where a company is a member of another company or where Government is a member of a company, their properly appointed representative enjoys all the rights of a member. He can speak at the meeting and vote on a show of hands as well as on a poll [Sees. 187(2) 1 and 187A (2)]. It may be noted that a private company which is not subsidiary of a public company is free to make its own provisions by its articles as regards proxies and the provisions of Section 176 (as stated above under points I to II) shall apply to such a company only if its articles do not other wise provide [Sec. 170(1)(ii)].

10.11 RESOLUTION
A Proposed Resolution or motion when passed by requisite majority of votes by the shareholder become a company resolution. Thus a resolution may be defined as the formal decision of a meeting on any proposal before it. The Companies Act provided for three kinds of resolutions that may be passed at the general meeting of a company : 1. Ordinary resolution. 2. Special resolution. 3. Resolution requiring special notice. The Companies Act and the Articles of Association lay down the type of resolutions required for any particular matter. 10.11.1. Ordinary Resolution A resolution shall be an ordinary resolution when the votes cast in favour of the resolution by members present in person or where proxies are allowed, by proxy, exceed the votes, if any, cast against the resolution 189(1). In other words, this is a resolution passed by simple majority of votes of members present in person or by proxy. Those absenting or remaining neutral arc not counted. An ordinary resolution is normally used for the so-called ordinary business done in the Annual General Meeting. example.. to pass the annual accounts, to declare dividend, to appoint director in the place of those retiring and to appoint auditors. It is relevant to state that a special resolution is required for any appointment of auditors at an annual general meeting, although it is an item of ordinary business, in the case of a company in which at least 25 per cent of the subscribed share capital is held, whether singly or jointly, by Central Government or a nationalized bank or a general insurance company or a public financial institutions or a Government company (Sec 224A). Certain items of special business also require ordinary resolutions under the Companies Act. For example: issue of shares at a discount [Sec. 79(3)] the alteration of the share capital [Sec. 94(2)]., appointment of sole selling agents (sec. 294) etc. It may be added that an ordinary resolution will suffice unless expressly provided otherwise in the Companies Act or the Articles of the company. An ordinary resolution usually does not require filing with the Registrar. However, a copy of ordinary resolution conferring power upon the directors under Section 293 must be filed with the Registrar within 30 days of the date of its passing. The usual notice of at least 21 days is, however, required for passing an ordinary resolution. 10.11.2 Special Resolution A resolution shall be a special resolution when the votes cast in favour of the resolution by

members present in person or, where proxies are allowed, by proxy, are not less than three times the number of votes, if any, cast against the resolution and the has been duly specified in the notice calling the meeting [Sec 189(2)]. In other words, this is a resolution passed by a majority of at least 75 per cent of votes of members present in person or by proxy and a mention of the fact that the resolution shall be passed as a special resolution must have already been made in the notice of the meeting and the notice should have been duly given at least 21 days before the date of the meeting. The articles of the company may specify purposes for which a special resolution is required. The Companies Act has also specified certain matters, for which a special resolution must be passed, for example (1) to alter the memorandum of the company (Sec. 17), (2) to alter the articles of the company (Sec. 31), (3) to issue further shares with preemptive rights (Sec. 81), for creation of Reserve Capital (Sec. 99), (4) to reduce the share capital (Sec. 100), (5) to pay interest out of capital to members (Sec. 208), (6) authorizing a director to hold an office or place of profit (Sec. 314), (7) voluntary winding up of a company (Sec. 484), A copy of special resolution must be filed with the Registrar within 30 days of the date of its passing. 10.11.3 Resolution Requiring Special Notice A resolution requiring special notice is not actually an independent class of resolutions. It is a kind of ordinary resolution, with the difference that the mover of the proposed resolution is required to give special notice at least 14 days to the company before moving the resolution and the company in turn, is required to give the notice of the resolution to the shareholder at least seven days before the meeting either individually or through advertisement in an appropriate newspaper (Sec 190). This provision is a sort of concession to the mover of a proposed resolution, because otherwise he is required to intimate the company about the proposed resolution he intends to move before the company issues Notice of the meeting. So that the same may be included in the Notice and Agenda of the meeting as an item of business It may be recalled that a notice of at least twenty-one clear dyas is required for calling a general meeting. The articles of a company may specify purposes in respect of which special notice is required. Under the Act a special notice is required before moving a resolution relating to the following matter : (a) Appointment of an auditor other than the retiring auditor (Sec. 225). (b) Provision that a retiring auditor shall not be re-appointed (Sec. 225). (c) Removal of a director before the expiry of his term. (Sec. 284). (d) Appointment of another person as a director in place of the director removed (Sec. 284). 10.11.4 Minutes of Meetings The term minutes means a concise and accurate official record of the business transacted at company meetings. It normally includes only the resolutions actually passed. It is not necessary to record therein the discussion which preceded the adoption of a resolution. Minutes are more analogous to a telegram than to a latter. Section 193 requires every company to keep minutes of the proceedings of both General and Board meetings in books kept for that purpose within 30 days of every much meeting. The pages of the minutes books must be consecutively numbered and into case there should be attached by pasting or otherwise any extra page. Each page of every such book shall be signed and the last page of the record of proceedings of each meeting in such books shall be dated and signed

(a) in the case of the Board or Committee meetings, by the Chairman of the meeting of the next succeeding meeting; (b) in the case of a general meeting, by the Chairman of the same meeting within a period of 30 days of the conclusion of the meeting or in the event of death or inability of the Chairman within that period, by a director duly authorized by the Board for that purpose [Sec. 193(IA)]. The minutes of each meeting shall contain a fair and correct summary of the proceedings there at. The chairman shall, however, enjoy an absolute discretion in regard to non-inclusion of any matter in the minutes which in his opinion is defamatory of any person, is irrelevant or detrimental to the interests of the Board or of a Committee of the Board, the minutes must include the names of the directors present at the meeting and the names of the directors, if any dissenting from the resolution passed at the meeting. The minutes of meetings kept in accordance with the above provisions are prima facie evidence of the proceedings recorded therein (Sec. 194) and the meeting to which such minutes relate shall be deemed to have been duly called and held, the proceedings to have duly taken place and the appointments, of directors or liquidators made at the meeting shall be deemed to be valid, until the contrary is proved (Sec. 195). The minute books of general meetings are to be kept at the registered office of the company and be open to inspection for at least two hours a day during business hours to any member without charge. Members are also entitled to obtain copies of minutes on request within seven days on payment of rupee one. The Company Law Board is also empowered to order inspection of the minutes books or direct to deliver the copy required thereof, if the company fails to comply with the provisions of this Section (Sec. 196).

Study Note - 11
11.1 BUSINESS OBJECTIVES
11.1.1 Introduction to Business Objectives An aimless pursuit of anything is likely to end in a waste of energy, time and possibly money too. Every activity is supposed to be with a purpose or an objective. An objective is a target towards which a rational activity is directed. An organization is expected to be with some

definite objectives and all the available resources are necessarily to be utilized to reach or achieve them. WHY is one of the most important questions that one should ask himself before one thinks of starting the activity. It is true that the purposes for which the business activity is to be carried on, may change from Organisation to Organisation, place to place and also from time to time but the fact remains that the choice of right task or objective at the right time is the key of business success. It is indeed a difficult task for a businessman to set proper objectives and though he may be guided by parallel experiences of others, it is necessary for him to scientifically analyse the situation and decide the objectives. Peter Drucker opines that objectives in the key areas are the instruments necessary to pilot the business enterprise. Without them the management files by the Seats of its planes. without land marks to steerby, without having flown the route before. A businessman, at any juncture of time, compares his actual achievements with the decided objectives and feels happy if the results are positive. In the modern dynamic business world, the objectives are likely to be affected positively or negatively with various social, political or economic forces as a result of which today the business environment plays an important part for deciding or changing the objectives. Business can give social status. It can enable the businessman to earn money or profit. It can offer the joy of achievement. For a long time, it was felt that profit making is the only objective of any business activity. Nowadays however, it is felt that profit making is the only objective of any business activity. Nowadays however, it is felt that profit making is one of the objectives of business but there could be a number of other objectives which could justify the existence of a business activity. Management is getting work done through the people and all the functions of management example. planning, organizing, staffing, directing, co-coordinating, controlling, reporting or budgeting, have to center round the pre-decided objectives. 11.1.2. Characteristics of Objectives It is interesting to note various characteristics of objectives. Some of the important characteristics are: 1. Multiplicity 2. Tangibility or intangibility 3. Primacy 4. Hierarchy 5. Clashing or supporting tendency 6. Network 7. Time- boundedness 8. Clarity and understandability 9. Concreteness or specific nature. Peter Drucker has justified eight key areas in which the objectives of a business could be set. According to him these key areas are: Productivity, Physical and financial resources. Profitability, Market standing, Innovation, Managerial performance and development, workers performance and attitude and the Social Responsibility. The various other characteristics of business objectives could be illustrated thus : The tangible objectives can be expressed in terms of quantity such as financial resources. For example, the share capital to be raised should be 20 lakhs rupees. On the other hand some objectives are expressed in terms of numbers or percentages, for example, the labour turnover should not be more than 5% or workers morale should be higher are statements indicating intangible objectives. Some objectives get priority over the others. Thus in the initial stages a business should give priority to survival as compared to profitability. The important objectives stand first and they are followed by the less important ones. Business is more important than personal convenience or inconvenience.

When there are some objectives which differ in nature when compared, it becomes necessary to reconcile and achieve larger interest of the business. A network of various objectives is to be set for achieving greater success. When specific goals or targets are to be achieved, it becomes necessary to coordinate. Larger production must be coordinated with larger sales otherwise there would be piling of stocks and it may prove to be a graveyard for management. The objectives may vary in the context of a period of time. The objectives may thus be classified into short term, medium term and long term objectives. Thus the short term objectives are generally to be achieved within a period of one year, the medium range objectives could be achieved within a period of two to four years and the long term objectives could be achieved within a period of five years or more. It is necessary that the objectives should be clear and easily understandable. If the objectives are ambiguous, the personnel responsible for achieving them is perplexed. The understandable and reasonable objectives are likely to be achieved with fullest cooperation of workers. The objectives should be expressed in specific terms. For example, when the Production Manager states that it is desired to increase the production by 30% in the current year, his workers understand as to what is expected of them. Ideal objectives are clear, acceptable by all concerned, supporting one another, precise and measurable. 11.1.3 Advantages of Objectives When the objectives are rationally pre-decided, they help the business to channelise various available resources for achieving the goals. The objectives, in fact, are the basis for all kinds of planning. The policies, strategies, and procedures are based on the objectives. They can serve as the motivating factors for the employees and different departments concerned. The activities of different departments could then be coordinated. The controlling becomes feasible. The businessman can lead, guide, direct and get work done as per specifications. A proper communication of the objectives can ensure lesser conflicts, misunderstanding or disputes among the concerned employees. Peter Drucker feels that Management by objectives (MBO) is based on the acceptance of objectives after discussion by the superiors and subordinates sitting together. The traditional way was that all the objectives were decided by the Top Management and the lower cadre was required to accept them without objection or suggestions. MBO on the other hand believes in mutual conversation, discussion and acceptance of the objectives by the Top Management and the representatives of the Lower management at the same table. Objectives, in this manner, are specifically decided by all concerned and this can ensure maximum cooperation from all. 11.1.4 Various Business Objectives. The various objectives of business could be classified as follows: 1) Economic objectives 2) Social objectives 3) Human objectives 4) National objectives 5) Organic objectives The Economic objectives are : a) Earning of adequate profit b) Production of tangible form of wealth c) Creation of market or creation of customers d) Innovation e) Best use of available scarce resources. The Social objectives are : f) Providing quality goods and services g) Charging reasonable prices

h) Generation of employment i) Avoiding antisocial practices and profiteering j) Creating and maintaining better environment. The Human objectives are : k) Giving a fair deal to the employees l) Ensuring job satisfaction m) Treating employees as partners to prosperity n) Development of human resources The National objectives are : o) Producing goods and providing services as per national priorities p) Development of small enterprises q) Guaranteeing social justice r) Export promotion The Organic objectives are : s) Survival t) Growth, expansion and diversification u) Creating goodwill, prestige and recognition. Casting a cursory glance at the above mentioned objectives it could be said that these objectives have relevance to the period and the environment under which the business is functioning. Thus earning adequate profit is obviously one of the most important economic objectives. Even in the socialistic countries, it has been accepted that generating a surplus out of any business activity is a sign of efficient use of the available resources. The profit may be utilized differently under different economic systems but there should be a break even as early as possible and it should be followed by a surplus too. The production of tangible form of wealth for the benefit of community is equally important. The business can generate profit by providing people various goods and services, which they need. The customers are to be created and the potential markets must be tapped. Peter Ducker believes that the only valid definition of business purpose is to create a customer who is the foundation of business and who helps it to survive and grow. Change is the order of the day in the modem business world. The business which cannot change according to the changing trends is likely to perish. Innovation, in other words, becomes a MUST with better machines, and improved technology. Since business is the specific organ of growth, expansion and change, exploring and discovering ways and means for making the production and services more useful for the customers is inevitable. The optimum use of the available resources is the duty of every businessman in the individual as well as social context. Unnecessary waste of material and energy must be avoided. The society has its own expectations about the business. It demands that the quality goods and services must be provided regularly and at reasonable prices. A business should generate employment and provide welfare to the employees. Better working conditions should be provided and a fair return on the investment should be available to the owners. The human considerations require that the employees should be paid fair wages and offered an opportunity to participate. They must get job satisfaction. Similarly, from the point of a nation, the scarce resources should be utilized to produce goods and services to which the nation gives a priority and not a few individuals, the small scale industries which provide employment to many should be encouraged. Exports should be promoted for earning valuable foreign exchange and the social justice should also be ensured. From the point of view of an organization, the first and the foremost objective is the survival of the business in the adverse circumstances. The survival should be followed by expansion and growth. If necessary diversification should also be resorted to, for earning legitimate higher profit. Similarly, in course of time, Goodwill, Prestige and Recognition should also be the goals

of a successful business. These are called organic goals. To discuss the question of business objectives further, as Peter Ducker has suggested, one could concentrate on KRAT example. KEY RESULT AREAS TECHNIQUES. These 8 different areas are : 1. Market Standing 2. Innovation 3. Productivity 4. Profitability 5. Physical and financial resources 6. Managerial performance and development 7. Workers performance and attitude 8. Public or Social Responsibility. 11.1.5 The Concept of Social Responsibility As mentioned earlier, modern businessmen have started accepting that profit making is no more the only objective of business. In marketing also it is said A sale is not made at the counter or by a salesman, it is made in the mind of the buyer. In other words, just as for sale of a product or service the most important person is a buyer, similarly, for achieving all the other objectives of business, it is the society which is the most important factor and a business cannot survive or prosper without a Society. It must therefore be realized that a business has also some responsibility towards Society. The obligations of a business towards society could be classified under two heads : a. The socio-economic obligations and b. The socio-human obligations. It is the socio-economic obligation of a business that its activity should not adversely affect the economic welfare of people. When a business generates employment, it adds to the welfare of the society. It can help to raise the standard of living of the people. This should be accepted as one of the responsibility towards society though it cannot be insisted that one must start business to create employment opportunities. Similarly, competition should be accepted and not curbed because it can force a business to maintain quality and control overhead costs. A business should also try to hold the price line and curb inflation. On the other hand nurturing and developing human values such as morale, cooperation, motivation etc. comes under the socio-human values of a business. The social responsibilities of a business thus should be studied and appreciated under the following heads : 1. objectives which protest consumer interests; 2. objectives which protect the interests of workers, and 3. objectives which protect the interests of the society. It is felt necessary now that continuous efforts should be made to improve the benefits to the consumers. This involves the following : (a) Adequate and efficient supply of goods and services (b) Reasonable prices charged (c) Productivity improvement by reducing cost and price, by optimum utilization of national resources, by remunerating workers better for improving competitiveness of the enterprise and for increasing the profitability. (d) Reduction of costs by other methods. (e) Quality improvement (f) Product development (g) After sales service (h) Product safety

(i) Disclosures about the products like risks, expiry dates, ingredients, precautions etc. (j) Handling of complaints and grievances. Workers interests could be safeguarded by : (a) Payment of fair wages (b) Providing better working conditions (c) Providing labour welfare (d) Promoting self development to employees (e) Promoting healthy industrial relations (f) Helping workers to be shareholders of the company. Social interest could be taken care of by : 1. Protecting ecology of the surrounding locality 2. Helping overall development of the locality 3. Rehabilitating the population displaced by the operation of the business, if any. 4. Conserving scarce resources and developing substitutes; 5. Improving productivity; 6. Helping the national causes like earning foreign exchange, developing backward regions, assisting weaker sections of the society etc; 7. Promoting ancillary and small scale industries; 8. Contributing to research and development; and 9. Helping social causes like education, health, entertainment, etc. It is necessary for any business to strike a harmonious balance between Social and Economic objec tives.

11.2 BUSINESS ENVIORNMENT


Any business depends upon certain internal factors and is also influenced by certain external factors. The external factors are generally uncontrollable factors and are referred to as Business Environment. Business environment refers to all those external forces such as economic, social, political, regulatory, technological, natural and competitive factors which affect the business. Every businessman goes in for analyzing all the factors by resorting to what is known as a SWOT ANALYSIS. S stands for Strength, W for Weaknesses, O for the opportunities and T for threats. Strength and weaknesses are internal factors whereas Opportunities and Threats are external factors. Any change in a business environment may imply an increase in opportunities or in threats. The same environment may offer opportunities to some firms and threats to some other Firms. Thus liberalization policy of the Government of India may result in opening of new opportunities to some Indian firms while it may result into threats to the existence or growth of some other firms. A duty reduction in the Central Government Budget may result into a boost to some industries. The reduction of subsidies to the fertilizer industry may result into an increase in the prices of fertilizers and also reduction of demand for them. The demand for sunflower oil may increase because of the medical reports that it helps keeping the heart healthy. 11.2.1 Economic Environment Economic environment includes the factors like the nature and level of development of the economy, economic resources, size of the economy, economic system and economic policies, current economic conditions, trends in the GNP, growth rate and per capita income, nature of and trends in foreign trade, domestic supply and demand conditions etc. All these factors affect business favorably or unfavourably. For example, a developing economy will offer more opportunities for business for businessmen in the advanced countries. On the other hand, if the income is very low, some of the commodities considered to be essential in advanced countries will have no demand in the backward countries. If the taxation is on the higher side, the prices will shoot and the demand will fall, Because of

the shortage of foreign exchange, the Government may put restrictions on the import of foreign goods or raw material as a result of which the quality of the goods manufactured will be lower as compared to that produced with the foreign imported ingredients. If the growth rate is satisfactory and the per capital income has started growing, the demand for luxuries will slowly start growing. Similarly, a number of developing countries are offering new opportunities because of faster growth in population, existence of large unsatisfied demand, growing democratization and individual freedom together with fairly good growth of the economy. The developed economies are characterized by high levels of income, consumption and competition in business sector. In case of countries where income is low, the businessmen may be required to reduce other costs such as packaging. It is observed that less fuel consuming cars were required to be produced because of the prices of oil, shooting high. The inflation and depression or the changing phases of trade cycle do affect the business. Diversification can help a firm to combat with the recession in some industries. In short a business has to consider various economic factors in the stages of survival, stability and growth. 11.2.2 Social Environment The social or cultural environment includes customs, traditions, religious beliefs, tastes and preferences, social institutions, buying and consumption habits etc. and all these do affect a business. The food habits of people in South India differ from those of people in North India. Some of the foreign companies have failed in India because they could not appreciate the cultural values of people in India. The advertising and publicity firms have consider these factors. The language can be a barrier or an aid depending how it serves as a vehicle of thought. Social inertia and associated factors may come in the way of the promotion of certain products, services or ideas. Certain social stigmas in the marketing of family planning ideas, use of bio-gas for cooking, etc. do create barriers for business activity. The success of some of the business ventures depend upon the success of changing social attitudes or value systems. The demographic factors, such as the age and sex composition of population, family size, habitat, religion etc. also influence business. Louis L. Stem has observed in his article Consumer Protection via Self-Regulation in the Journal of Marketing, that more the educated the society become more discretionary the use of its resources, the more marketing will become enmeshed in social issues. The number of married couples in India these days, are having a double earning, as a result of which the demand for domestic electric appliances has stated growing. It may, therefore, be concluded that the social environment of different markets will be different and the difference will also be observed within the market making it necessary to have business strategies suitable to any particular type of Social environment. 11.2.3 Political Environment The political policies, the nature of the Constitution and the government system, the government environment encompassing the economic and business policies and regulations have very important implications for business. The Industrial Policy decisions have been taken by the successive governments. Pandit Jawaharlal Nehru had a different economic scenario as compared to the one which Smt. Indira Gandhi had. The liberalization policy adopted by the Government is likely to have long reaching repercussions. Besides, as compared to the previous politicoeconomic decisions of nationalization of banks and insurance, the latest trend appears to be more towards privatization. Disinvestments of Government holdings in public sector enterprises have gained momentum. All over the world, the political environment has definite effect on business. 11.2.4 International Environment With the rapid Industrial, Commercial and Computer Revolutions, the world has becomes smaller. The rapid changes cannot allow any country to be economically independent. The

trade and commerce is no more restricted to national boundries. It is International Trade obviously therefore, the business world of today cannot be in isolation and any political or economic change on the world map is bound to increase or decrease the volume of business. WTO example. World Trade Organisation for example, is bound to be discussed in the business circles because its repercussions on different industries is bound to be different and serious. The NRI, the Multinationals etc. are likely to shape the Indian business differently. The International Environment, thus can affect the business radically. The Russia or the Germany, as markets, are now presenting a changed picture. The Kashmir Tourists Trade is seriously hampered by the strained relationship between India and Pakistan. Therefore, we may conclude that the economic, political, social, regulatory, competitive, technological or international environment must be studied in proper perspective before any business decisions could be taken.

Study Note 12
12.1. STOCK MARKET (STOCK EXCHANGE)
12.1.1 Introduction Then are two stages involed in the purchase and sale of securities. In the first stage, the securities are acquired from the issuing company themselves from the issuing comany thenselves and in the second stage, the securities are purchased and sold continuously among the investors without any involvement of the companies.Thus the industrial securities market is divided into two parts namly NIM and Stock Market. The NIM deals with new securities that is, securities which were not previously available and are offered to the investing public for the first time. The stock market covers the second stage of dealing in securities. The Stock Exchanges, therefore, provide a regular and continuous market for buying and selling of securities.

The Securities Contracts Regulation Act, 1956 defines stock exchanges as an association, organization or body of individuals whether incorporated or not, established for the purpose of assisting, regulating and controlling business in buying, selling, and dealing insecurities. A close review of the well known definition brings out the following features of the stock market 1. Stock market is an organized market where securities of government and semigovernment bodies and corporate enterprises are bought and sold. 2. Stock market deals in second hand or existing securities. 3. Individuals alone can buy and sell securities. The stock market does not provide this facility to corporations and partnership firms. 4. In the Stock market only those securities which are listed in the stock market are transacted. Unlisted securities are not permitted to be dealt in the market. 5. Stock market may be a registered or unregistered body. It is not always necessary for a stock exchange to incorporate it under the Companies Act. 6. Transactions in the stock market must adhere to the rules and byelaws framed by the stock exchange to regulate its day-to-day operations. 12.1.2 Important Ingredients of a Stock Exchange Following are important ingredients of a stock exchange: 1. Provisions of the place for the buyers and sellers of securities for transacting their dealings. 2. Existence of brokers and other intermediaries to assist their client investors in finalizing their deals. 3. Scope for genuine and legitimate speculation and allied transactions so as to make the market continuously responsive to the basic forces of demand and supply. 4. Framing of regulations of ensure transactions in such a manner as to avoid undue fluctuation in the value of securities and prevent unfair dealings. 12.1.3 Functions and Services of Stock Exchanges Stock exchanges play an important role in capitalistic countries. It is indispensable for the proper functioning of joint stock companies. The importance of a stock exchange will be clear from the study of its functions and services. A stock exchange performs the following economic functions and services: 1. Provides ready and continuous market : Stock exchanges provide a ready and continuous market where anybody can purchase or sell the securities during the business hour. Therefore, it provides liquidity, price continuity and marketability to the capital locked up in the investments. This facility of marketability helps a person in choosing shares or debenture for investment. He feels confident that he would be able to dispose of the shares to his best advantage in the shortest pos sible time and convert them into cash, when necessary 2. Facilitates regular valuation of securities : In a stock exchange, evaluation of the listed securities is carried on continuously. That way it is able to determine the price of the securities as close as possible to their investment values based on present and future income-yielding prospects of the various enterprises. A well regulated and efficient stock exchange performs this function of evaluation cheaply and quickly. 3. Encourages capital formation : Stock exchanges contribute to a considerable ex tent to capital formation in the country. It inculcates the habit of saving, investing and risk taking in the investor. The publicity that the stock exchange gives to the different kinds of securities and their price induces all persons to take interest in corporate and government securities and their surplus funds in such securities. The saving that are put at the disposal to industries and government are used effective and dividends and interest are paid on the investments. More often, the dividends and interest earned are again invested in similar securities. This process

of funds in corporate or government securities earning of dividend and interest on such securities and reinvestment of the whole or part of such income in similar leads to capital formation. 4. Provides proper direction to invest capital : The securities of companies with good profits are popular in the stock exchanges. Investors are attracted towards those securities. The securities of companies which are not profitable are bearing no response in the stock exchange, In this way. Stock exchange gives proper di rection to invest the capital of investors. Because of this, stock exchange is called a sensitive barometer of business activity. 5. Ensures wide ownership of securities : A stock exchange ensures wider distri bution of securities. If a companys securities are listed in different stock markets of the country, its securities will be bought and sold by persons scattered all over the country and ownership of securities is widely diffused. 6. Facilitates distribution of new securities : Stock exchange is primarily a market for dealings in second hand securities. But it helps, in marketing the shares and debentures of a new company also. If the securities are listed on the stock ex change for the purpose of their trading, they attract investors from different parts of the country. 7. Ensures safety of funds : Stock exchanges ensure safety of investible funds be cause they have to operate under set rules which seek to check over-trading, ille gitimate speculation and manipulation etc. They would strengthen the investors confidence and stimulate larger investment in business securities. 8. Regulates company management and performance : The companies which want to get their securities listed have to follow certain rules and fulfill prescribed re quirements. Through then the stock exchange yields influence on the working of those companies in the public interest. Further, as the stock exchange publishes the ruling prices of securities constantly, it indirectly induces the companies to improve their performance. Otherwise inefficiency would soon become public. 9. Disseminates information : A stock exchange disseminates information relating to the capital, management earnings and dividends of listed companies through information bureau. Some stock exchanges publish year books giving history and financial position of listed companies. Thus it provides necessary data for decid ing on investment. 10. Facilitates speculation : Stock exchanges provide facilities for speculation in the securities. Healthy speculation tends to equate demand and supply and regulates their prices to a substantial extent. 11. Mirror of business cycle : Stock exchanges mirror the phases of business cycle, that is the changing conditions of economic health of a country Booms and depressions find their echoes in the dealings on stock exchanges. The above account of the various functions performed by a stock exchange shows that it is really an important institution of a country. Briefly, community savings, productive investments, capital formation, industrial growth, economic development and individual prosperity are the integrated chain of benefits that may be derived from the efficient working of stock exchanges in a country. Services A well organized and efficient stock exchange renders services of considerable importance. Such services can be examined under three heads, example., to the community, to the investor and to the corporation. Services to the Community 1. The stock market is an important institution to finance the economic development of a country. It is no exaggeration to say that the sharp increase in industrial

activity in the past two decades and more would not have been possible but for the important part played by the stock exchanges particularly in Mumbai, Kolkata and Chennai. 2. It encourages highly profitable enterprises. It places a premium on efficiency. It diverts funds from unprofitable and unproductive channels to profitable and productive ones. 3. It encourages capital formation by extending facilities for productive investment of surplus funds available with the people. 4. It helps the government to borrow funds from the public and utilize the same on projects of national importance. 5. By providing facilities for the sale and purchase of shares and the publication of reports regarding the conditions of the stock market from time to time, it encour ages even persons of small means with little or no knowledge of corporate finance to acquire shares in large concerns in the hope of earning a good return on them. This function of the stock exchange has the effect of socializing the capital of large corporation. 6. On the basis of information provided by the bulletins issued by stock brokers and reports published by the stock exchanges, investors are able to buy shares in con cerns operating in different parts of the country or even in different parts of the world. Services to investors 1. The investors are assured of already and continuous market for the securities owned by them and, thus the liquidity of the investment is ensured by the stock market. 2. They may secure credits on the basis of the security owned by them easily as the stock market provides negotiability to the securities. 3. An investor may be assured of safety of investment and fair dealing in them when they are dealt with through a well regulated and well organized stock exchange. 4. They may easily find the variations in the value of their investments as the stock exchanges publish daily or periodically the quotations of listed securities. Thus, they are able to assess the value of their holdings. 5. The risk in the investment is minimized and safety is well ensured by the presence of the continuous market, negotiability, correct evaluations and facility for liqui dating the investment. Services to the Corporation 1. Easy marketability of securities help companies to enjoy a wide market for their shares. 2. If the securities of a company are listed in a stock exchange it gives an impression of a sound concern. It will improve its good will and credit standing. 3. If the securities of a company are offered through a stock exchange they get good response from public. 4. Since fluctuations in the prices of securities are minimized, the company enjoy the confidence of the public. 5. Generally the market prices of listed securities are higher in relation to earnings. This help the companies at the time of merger and amalgamation. 6. Regulation of company management and performance is ensured.

12.2 STOCK EXCHANGES IN INDIA


12.2.1 Brief history Growth of stock exchange in India has been linked with the growth of joint stock companies. The organized stock exchange in the country started in Bombay in 1877. By 1939, there were seven stock exchanges. By 1945, they increased to 21, operation of too many stock Exchanges

was considered undesirable. It was felt that their diverse rules and policies may lead to unsettled conditions resulting in perverse speculative dealing injurious to genuine investment activity. Hence the government of India as per the recommendations of Gorwala Committee enacted Securities Contracts (Regulation) Act in 1956 to regulate formation, operation and trading roles of stock exchanges in the country. Following are some of the stock exchanges recognized under the Act. 1) Bombay Stock Exchange. 2) Calcutta Stock Exchange. 3) Madras Stock Exchange. 4) Delhi Stock Exchange. 5) Ahmedabad Stock Exchange. 6) Hyderabad Stock Exchange. 7) Indore Stock Exchange. 8) Bangalore Stock Exchange. Bombay Ahmedabad and Indore stock exchanges are organized as voluntary associations while Calcutta and Delhi stock exchanges have been incorporated as public limited companies and Hyderabad, Madras and Bangalore stock exchanges as companies limited by guarantee. Major operations of prominent stock exchanges, are found to be in specific securities, For example, cotton textiles and bank shares are predominant in Bombay; coal, jute tea, bank and engineering securities are more popular in Calcutta Stock Exchange; textile shares are dominant in Ahmedabad while Madras stock exchange abounds in plantations and textiles. 12.2.2 Management Each stock exchange is managed by a committee of management whose condition and powers are governed by its own byelaws. This committee is entrusted with the responsibility of overall control and guidance. This is given different names in different exchanges. In Bombay, it is called the Governing Board, in Calcutta, it is known as the Committee, and in other places the council of management. Their day-to-day management is vested in a number of sub-Committees such as Listing Committee, Defaulters Committee, Arbitration Committee and so on. Each Exchange has its own rules for the conduct of business. The Securities Contracts (Regulation) Act provides for a general system control over stock exchanges. 12.2.3 Membership of the Stock Exchange The regulations Governing the admission of members of the recognised Stock Exchanges are uniform in terms of the provisions of the Securities Contracts (Regulation) Rules, 1957. These statutary Rules provide that no person shall be eligible to be elected as a member, if he is less than 21 years of age; if not a citizen of India; or has been adjudged bankrupt or proved to be insolvent or has compouded with his creditors; or has been convicted of an offence involving fraud or dishonesty, or is engaged as principal or employee in any business other than that of securities; or is a member of any other association in India where dealings in securities are carried on; or is a director, partner or employee of any company whose principal business is that of dealing in securities. Firms and companies are not eligible for membership of a recognized Stock Exchange and individuals are ordinarily not deemed to be qualified unless they have at least 2 years market experience as an apprentice or as a partner or authorized assistant or authorized clerk or remisier of a member. Jobbers and Brokers (Members of the London Stock Exchange) The London Stock Exchange has two types of members viz. jobbers and brokers. Every member has to declare at the beginning of each year whether he proposes to act as a jobber or a broker during the year. Once the declaration made it holds good for the entire year and it cannot be changed during the course of the year. The classification is maintained rigidly by the exchange. A Jobber is a dealer in securities. He is prohibited from dealing directly with the public. He

deals with the brokers who are engaged by the public. Thus, the jobber buys securities from and sells them to members who are operating on the exchange as brokers. The Broker functions as a commission agent. He deals in securities on behalf of the investing public. He is an intermediary between the jobber and the outside public. The jobber occupies a very important position in the London Exchange. Every transaction must pass through jobber. Every jobber quotes two price when he receives enquiry from a broker. The first is the prices at which he is willing to buy the security and the second at which he will sell it. For example, in response to an enquiry regarding the price of the shares of a certain company he may declare I will make you Rs. 100 to Rs. 105. This implies that be is willing to buy the security at Rs. 100 or he will sell it at Rs. 105. The jobber is always ready to buy and sell any number of shares. He is not interested to know whether the broker wants to buy or sell securities. If the broker is satisfied with the quotation he discloses the nature of the transaction and strikes the bargain. The quotation by the jobber is called the double quotation or the double barreled quotation. The difference between the two prices quoted will be the profit for the jobber. It is also called the Jobbers turn. Tarawaniwalas and Brokers Members of the Bombay Stock Exchange are unofficially classified as Tarawaniwalas, those who take away the cream of the business, and commission brokers. A commission broker is one who transacts business on behalf of members or non-members on commission basis. He may appoint a number of sub brokers to secure business for him A Tarawaniwals, on the other hand, is a dealer in securities. He transacts business in his own name and on his own behalf. He specializes in the purchase and sale of specific securities. He resembles the Jobber of London Stock Exchange. But, he is not prohibited from acting as a broker too. Remisiers and Authorised Clerks Only members, who are given full right and privileges of conducting business on the stock exchange, are permitted to enter the building of the stock exchange. There are also others who are permitted for reasons of convenience, to enter the building of the exchange and act on behalf of members. They are given limited rights and privileges. They are called the Remisiers and Authorised clerks. Remisiers : Remisiers act as sub brokers. They act as agents to the members to secure business for them. Since they are not members they cannot carry on the business for their own name. A remisier is a half commission man and gets remuneration for the work done for his principal payment is made to him in accordance with the rules and regulations of the stock exchange. Usually, the commission does not exceed 40% of the commission received on the business. Authorised clerks : Members require the assistance of others to carry on trading activities. They cannot be present always on the floor. Hence they are permitted to employ a specified number of authorized clerks or member assistants to transact dealings on their behalf. The Bombay Exchange permits 5 clerks, the Calcutta Exchange allows maximum of 8 clerks and the Madras exchange permits up to 3 clerks to be appointed by a member. Members are held liable for the dealings made by their respective authorized clerks or assistants. Besides salary, the authorized clerks are paid a commission up to 50% of the brokerage earned on transaction put through by them. Members have to pay entrance fee, annual subscription at prescribed rate for each of their authorized clerk. Stock exchange maintain an up-to-date register of all authorized clerks appointed by the members. Members can remove the clerks from office by informing the concerned stock exchange. 12.2.4 Listing of Securities A stock exchange does not deal in the securities of all companies. Only securities which are included in the official trade list of the stock exchange can be bought and sold on it. Therefore, listing of securities means, the inclusion of securities in the official list of a stock exchange. The securities can be listed, only if the company furnishes details of its organization and the working to stock exchange and fulfils the conditions laid down in the rules and regulations of the

exchange by listing the securities of a company, the stock exchange does not guarantee the financial soundness of the company or recommend it shares to the public. It is not the function of the stock exchange to advise the investors in the selection of securities. Objective of Listing The objectives of listing may be as under : 1. To assure constant marketing facilities. 2. To ensure liquidity. 3. To facilitate negotiability, and 4. To regulate the dealings in securities according to the interests of the investors. Conditions for Listing : A company desiring its securities to be listed must apply in the prescribed form with the following documents and information : 1. Copies of the memorandum and articles, prospectus, statement in lieu of prospec tus, directors report, balance sheet and agreement with underwriters. 2. Specimen copies of shares and debentures, certificates, letter of allotment accep tance etc. 3. Particulars regarding its capital structure. 4. A statement showing the distribution of shares. 5. Particulars of the dividends and cash bonus declared during the last 10 years. 6. Particulars of shares and debentures for which permission to deal is applied for. 7. A brief history of the companys activities since its inception. While scrutinizing the application the stock exchange will examine the following carefully. 1. Whether the articles of the company contain the following provisions a) Use of common transfer form. b) Fully paid up shares must be free from companys lien. c) Calls paid in advance may carry interest, but shall not confer a right to dividend. d) Unclaimed dividends shall not be forfeited before the claim becomes time barred. e) Option to call on shares shall be given only after sanction by the general meeting? 2. Whether at least 49% of each class of securities issued was offered to the public for subscription through newspapers for not less than 3 days? 3. Whether the company is of a fair size has a broad based capital structure and there is a sufficient public interest in its securities? they call upon the company to execute the Listing Agreement. Classification of Listed Securities Listed Securities may be classified into two categories, viz, (1) Cleared Securities, and (2) Non-cleared Securities. Cleared securities are also known as securities on forward list and non-cleared securities as securities on cash list. It is to be noted that for ward transactions are possible only in case of cleared securities. Conditions for the Inclusion of Securities in the Cleares Securities. There are certain conditions to be fulfilled before securities are included in the cleared securities list. These conditions are. 1. The securities must be fully paid up equity shares of a company, other than a banking company. 2. They must have been admitted for dealings for at least three years on any stock exchange. 3. They must not be included in the cleared securities list of any other stock ex change. 4. The company must be of sufficient public importance and the subscribed capital represented by the securities must be at least Rs. 25 lakhs and their value at the ruling market price must at least be one crore rupees. 5. There must be adequate public interest in the company and at least 40% of the

capital represented by the securities must be held by public and such holdings are to be evenly distributed among a large number of shareholders. Advantages of Listing 1. Listing gives the company a higher status, contributes to expansion of activities and helps its growth by making future finance easier. It enables a company to enjoy the confidence of the investing public. 2. Listing helps in widening the market for the securities issued. 3. The listed company gets some tax advantages. 4. The investors are also benefited by the listing of securities. These securities may be used for obtaining bank credit as they command higher collateral value. They stand to gain in respect of income tax. Wealth tax, estate duty and other taxes payable by them. They can be sure that there is no fraud in the issue of shares. Listing insists on due notice in advance of closure of the transfer books Thus, it offer facilities to them for transfer, registration of right fair and equitable allot ment. 5. Listing safeguards the interest of the general public too as it enforces timely dis closure of proper information regarding dividends, bonus shares, new issues of capital etc. Limitations of Listing 1. Listing amount to encroachment on secrecy of the companys operations. Listing regulations compel the company to disclose certain information like sales, remu neration to personnel besides profits, dividends etc., which may prove to be ad vantageous to its trade-rivals, trade unions. 2. Speculation in stock exchange creates erratic oscillations in the market price of the listed securities. Due to such blind changes, the listed securities may be affected. This will injure the credit worthiness of the company from the point of view of banks and other financial institutions. 3. Listed securities may become a victim of depressions or wide fluctuations in their values. This would degrade the companys image in the eyes of the public and the financial institutions. 4. The free negotiability of listed securities may induce certain group of persons to own substantial shares of a company with a view to capturing the management of the company in their hands. 5. Listed security tempt the speculators to manipulate the value in such a way as may prove to be detrimental to the interest of the company. Even the directors and other key functionaries in the management of the company indulge in specu lations of listed securities misusing the inside information available to them. 12.2.5 Methods of Trading The way in which the securities are transacted in a stock exchange is much different from trading in ordinary goods. A person who wants to purchase or sell securities cannot do it himself. He is not allowed to enter into the hall of the stock exchange and thus he can not carry on transaction personally. He has to depend upon the brokers. There are two types of trading on the stock exchange viz. 1. Ready delivery contracts, and 2. Forward delivery contracts. They are also called cash transaction or cash trading and forward trading or dealing for the account. The stock exchanges at Hyderabad, Indore and Bangalore are established for trading in ready delivery contracts only and they are called the cash markets. The other stock exchanges are permitted to adopt both the methods of trading. Ready delivery contractors are presumed to be investment transactions and forward contract

are deemed to be speculative transactions. Of course, the speculative transactions are also associated with ready delivery contract. There are some important points of distinction between ready delivery contracts and forward contracts. In the first place, ready delivery contracts are settled either on the date of the transaction or within 14 days from the date of the contract If the transactions are to be settled on fixed settlement days occurring at periodic intervals. Secondly the ready delivery contracts must be settled within, the specified time limit, whereas the forward contracts can be carried forward to the next settlement day, if the buyer or the seller desires to do so. This facility is popularly known as the Badla facility. Thirdly, ready delivery contract can be made in respect of all securities. The forward contracts are confined to those securities which are included in the forward list. Trading procedure Let us briefly discuss the various steps involved in completing a transaction through stock exchange brokers. (1) Choice of a broker : A person who wants to buy or sell security, contracts the broker either directly or through his banker. The choice of the broker may be made on the advice of the banker. It is desirable to deal with the broker directly because it will ensure quick action. Before dealing with a new party a broker always insists on a formal introduction or a bank reference so that the broker may rely on the hon esty and financial standing of the client If he is satisfied with the reference given he intimates his willingness to act on behalf of he client. (2) Placing the Order : The investor has to select the securities in which he wants to invest his savings. This he can do in consultation with the broker. He then places an order with the broker. The order must be clear and it should not contain ambiguous terms. There are several methods of placing an order with the brokers. Various methods of placing an order with the brokers are as follows : (a) Fixed Price Order. In this order the client specifically mentions the price at which specific securities are to be bought or sold. Here the broker has no discretion except to buy on lower than the price fixed by the clients order. In case of sales order, the broker has to sell the securities at or above the price mentioned in the clients order. The broker has to wait until market swings around the price levels specified by the client. Example : Buy 10 Brooke Bond Ltd Equity at Rs. 17/-. IT means as that the shares must be purchased if the price of the share is Rs. 17 or below. (b) Limit Price Order. A limit price order indicates the upper or lower limit of prices. It is generally worked thus : Buy under 16 or sell over 18. The broker is expected to buy at the lowest price and sell at the highest price. (c) Bargain Price Order. The bargain price order does not specify any price but in structs the broker to buy or sell immediately at the best price obtainable in the market. Example : Buy 20 DCM at best. (d) Stop-loss Order. A stop loss order is an order which protects the client against 1 heavy fall or rise in the price. It aims at reducing the amount of loss on the previ ous purchase or sale of securities by indicating the stopping point in the price movements. If the order is Buy Hindustan Motors at Rs. 15 stop, the broker must wait till the price reaches this limit. As soon as it reaches Rs. 15 and begins to rise, the broker would buy the shares at the best possible price. If a client has purchased the share at Rs. 15 and be wants to sell it, he may instruct the broker to Sell at Rs. 13 stop thereby limiting his loss to Rs. 2 per share. As soon is the price reaches Rs. 13 and shows a tendency to decline the broker will execute the order and save the client from incurring further loss.

(e) Discretionary Order. Discretionary order is one which gives the broker com plete freedom to buy and sell certain inactive securities. The client place such an order when he has full confidence in his broker. (vi) Open Order. Open order is one where the client does not prescribe any time limit for the execution of the order. It is kept in operation so long as it is not cancelled by the client. On receipt of the order, the broker notes it down in his memorandum book. Later, it is transferred to the order book. Big brokers arrange for execution of order through authorized clerks. Small brokers execute the orders personally. (3) Executing the Order : The authorized clerks of the brokers transact the deals at proper time as per clients instructions. The brokers or their clerks operate on the floor of the exchange. These dealings are first recorded in the respective rough pads. Purchases are entered on debit side and sales are recorded on the credit side with particulars of the scripts number, value and names of the parties from whom bought or to whom sold. These dealings are made in prescribed lot under the rules of the stock exchange. On the basis of these records, contract notes are prepared in prescribed forms. Separate contract notes are complied for cash and forward delivery contracts. These are exchanged between the concerned parties. The broker sends the contract note to the other party and a copy of it to his client also. It is stamped and signed by the broker and contains particulars of securities, names of parties, brokerage charged etc., is sent to the client along with the contract note. (4) Settlement of Transactions: There are two methods of settlement of transactions. In the case of ready delivery transactions payment has to be made immediately on the transfer of the securities or within a period of one to seven days. The settle ment may be made either through the clearing house or by hand delivery be tween the members without the intervention of the clearing house. Usually ready delivery contracts are entered into by outsiders or genuine investors. In the case of forward delivery contracts the settlement is made on a fixed day-in the Bombay Stock Exchange, settlement day is once in a week and in London it is fortnightly. All forward contracts are cleared through the clearing house which simplifies payment for, and delivery of securities. If the transactions of two members of a stock exchange are equal, they are crossed out; if however, they are not equal, the net balance alone is paid for or received. Moreover, there is the system of carry over to the next settlement day if agreed upon by the two parties. If the buyer desires to carry over, he has to pay a premium or consideration to the seller known as contango but if the seller desires to carry over he pays a premium to the buyer known as backwardation. Stock Exchange Clearing House Important stock exchanges maintain a clearing house. It functions on the lines of a bankers clearing house. The clearing house facility exists in Bombay, Madras, Delhi, Calcutta and Ahmedabad. The clearing house serves as a useful link between buyers and sellers of securities. It pools together all the bargains of a member and ascertains his net position. The member can settle all his accounts by a single transaction, example., the receipt or payment of the net amount. Advantages of Clearing House Settlement : Settlement through clearing house has following advantages: 1. Settlement becomes prompt and easy. 2. It is economical as intermediaries are eliminated. 3. It amounts to saving of currency-payment because only the net dues are settled in cash. 4. It decreases the demand for bank credit for payments towards securities pur

chased. Investors and Speculators Purchasers and sellers of securities on stock exchange are classified as investors and speculators. Investors are those who buy securities in order to earn a fair or fixed return. They intend to hold them more or less permanently. They are interested in the safety of their capital and constant yield thereon in the form of dividends or interest offered by respective companies. They select sound securities to ensure safety and fair return in respect of their investments. Investors may sell their holdings if they desire liquidity of funds. Otherwise they prefer to become permanent shareholders or debenture holders. Speculators are those who deal in securities in order to make a profit out of their price differentials. They buy the securities with a view to sell them with a profit. They do not hold on to the securities bought by them but mark time to dispose of them of at higher price to earn profit. They do not usually take delivery of the securities purchased or give delivery of those sold by them but only pay or receive the difference between buying and selling prices. The price spread is their profit margin. It is of course difficult to find pure investor and pure speculator in practice as many as time investors too would be tempted by the prospects of capital appreciation and earning quick gains and speculators may be compelled to hold on to their purchases to avoid losses. Types of Speculators There are different types of speculators dealing in a stock exchange. There are named after some animals, as they behave like wild animals. Their classification depends upon the nature of their activities in the stock exchange and in general, they are of four types, viz. bulls, bears, lame ducks and stags. Bull. A bull is speculator who expects a rise in the price of shares of a company. He is an optimist. He aims at making profit out of an expected rise in the price of a particular share. For this purpose he purchases the security for future deliv ery. Generally, he has no intention of taking delivery on the fixed date or settlement day. He may sell before the settlement day He may receive or pay the difference between the purchase price and sale price either on or before the settlement day. Let us explain how a bull speculator makes profit out of expected rise in the price of a security. Suppose a speculator expects that the price of equity shares of X company would rise. Suppose he purchases 1,000 shares of X company for future delivery at the present market price of Rs. 150 and suppose the price rises to Rs. 160 on or before the settlement day, he will sell at that price. Thus he makes a profit of Rs. 10,000 out of the rise in the price of the security. It should be noted that if his expectation goes wrong. He will incur a loss. Bear. A bear is a speculator who expects a fall in the price of a security. He is a pessimist and he forecasts a fall in price. He aim at making profit out of an expected fall in the price of a particular share. For this purpose he sells the security for future delivery. He may or may not posses the security. Generally, he has no intention of giving delivery on fixed date or the settlement day. He may purchase before the settlement day or settle the transaction on the settlement day. He may receive or pay the difference between the purchase price and the sale price. Let us explain how a bear speculator makes profit out of an expected fall in the price of securities. Suppose he expects that price of equity shares of Z company would fall and he sells 1,000 shares of that company Rs. 150 for future delivery and let us further suppose that the price fall to Rs. 140 on or before the settlement day. He will purchase at the price and he receives the difference of Rs. 10 per share. Thus he makes a profit of Rs. 10,000 out of a fall in the price of

the security. It should be noted that if his expectation go wrong he will incur a loss. Lame Duck. In case the bear is unable to strike the bargain immediately, he is said to be struggling like a lame duck. This may happen on account of the fact that the security which has been agreed to be sold may not be available in the market and in that case the commitment cannot be fulfilled. If the other party agrees to postpone the deal, there would be no trouble but if he does not agree to postpone such a situation would arise. Stag. Sometimes the shares to be issued by new company may be unofficially quoted at a premium. This happens when the prospectus of the new company. Are expected to be excellent. Some persons may apply for more shares than actually needed. Their object is to sell the shares at a high one as soon as they are allotted by the new company and thus make quick profit. So stag is a person who applies for shares of a new company with a view to selling the shares allotted to him at a profit. Stags may suffer loss. This happens when the public applies for less number of shares than offered for. Then the stags will be allotted at the number of shares applied for and the shares may be quoted at a discount in the market. Under such circumstances stags will incur a loss, if they sell the allotted shares. The operations of stag create artificial scarcity of shares of the new company. 12.2.6 Stock Exchange Terminology The following terms usually applied in the stock exchange dealings needs further clarification for benefit of the students : Arbitrage This is the business of buying securities in one stock exchange for selling them in another, to take advantage of price differential that may exist between the two Contract Note. It is the evidence about the transaction betwen buyer and his broker. The court will not accept any petition without the valid contract note. Quotation List : The stock exchange usually publish the price of their listed securities from time to time so that the investors may know the real worth of their holdings. Some exchanges communicate to their members regular reports of their activities and dealings. The quotation list is also published in newspapers to make it public and enlighten the investing public about the dealing pattern of various securities. Cum dividend or C.D. : Shares are said to be bought and sold cum-dividend when the buyer acquires the right to receive the amount of dividend which has been declared but not paid by the company. The price paid by the buyer includes the amount of dividend and is naturally higher than the price that would have to be paid without that right (or dividend). For example, if the cum-dividend price of a security is quoted at Rs. 115, the company has already quoted a dividend of 35% on the face value of this share of Rs. 10 example. Rs. 3.50 per share. In such transaction the buyer is entitled to receive this dividend of Rs. 3.50 on each along with the possession of the security. Government Securities are always quoted and traded at cum-dividend and the rate of interest there on is fixed. The quoted price includes the amount of net interest (example. gross interest due less tax deducted therefrom). Thus the cum-dividend quotation indicates that the buyer has a right to receive the dividend or interest declared/due there on. Ex-dividend (or Ex-div.) : Shares are said o be bought or sold ex-dividend when the buyer acquired the shares without any right to receive the dividend declared (interest due in case of debentures and bonus). It is only the seller who gets the dividend or interest there on.

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

Study Note 13 COMMUNICATION


13.1. Meaning of Communication Communication is a process by which send information and feelings to recipients through one or more channels. It is an change of ideas, facts, opinions, information and understanding between two or more persons. It may also be regarded as the process of meaningfully transferring information from one person to another. The success of a business depends to a great extent on effective communication. It has become an essence of management. It is not only a link function but is alternative in the entire process of management Communication is the lifeblood of modern business and industry. It is a systematic and continuous process that leads to proper running of the business. A few noteworthy definitions are enumerate below : Communication is the process of passing information and understanding from one person to another. [Keith Davis] Communication is the act of making one ideas and opinions known to others [Fred G. Meyer] Communication is the conveying of information from one person to another. [Cyril L. Hudson] Communication is an exchange of facts, ideas, opinions, emotions, etc., be tween two or more persons. [Newmen and Summar] Communication is the act of inducing others to interpret an idea in the manner intended by the speaker or writer. [Edwin Brown Flippo] Communication is a systematic and continuous process of telling, listening and understanding. [Louis A. Alley]

Communication is a systematic and continuous process of telling, knowledge, etc., by speech, writing or signs. [Oxford Dictionary] Communication means an interchange of thoughts, opinions and information. [Websters Dictionary] Thus, communication refers to the exchange of ideas, feelings, emotions, knowledge and information between two or more persons. It is an attempt to achieve an accurate understanding between two or more persons. It is an act characterized by a desire to exchange information. It involves a systematic and continuous process of telling. Listening and understanding. Communication is one of the most important functions of management. The success of business, depends upon the effectiveness of communication. It is said to be the nervous system of an enterprise. 13.1.2.Elements in the process of communication Sender Encoding Message Medium Feedback Receiver Decoding (1) Sender (example., communicator) : The sender is a person who initiates the process of communication. The sender may be a superior, a subordinate, a fellow member, a customer or any other outside person. (2) Encoding : This refers to preparing the subject-matter of communication in a suit able language. The purpose of encoding is to translate the thought of the sender into a language or code that can be easily understandable to the receiver of the message. (3) Message : This refers to the encoded subject-matter of the communication which is to be transmitted. The message may be regarded as a subject matter of commu nication. (4) Medium (or channel) : This is a path in which the message is transmitted from one person to another. It serves as a link between the sender and the receiver. (5) Decoding : This refers to the conversion of the message by receiver into meaning terms so as to make communication understandable. The effectiveness of commu nication depends on how much the receivers decoding matches with the senders message. (6) Receiver (or communicate) : The receiver is a person who receives the message of the sender. For communication to be effective, it must be receiver-oriented. (7) Feedback : This refers to the actual response of the receiver to the message com municated to him. It is a reversal of the communication process, in which the r e ceiver expresses his reactions to the sender of the message. 13.1.3. Characteristics (or features) of communication The characteristics of communication are explained as follows: (1) Co-operative process : It is a co-operative process involving the participation of at least two persons (one who transmits the message and the other who receives the message and responds to it). (2) Continuous process : It is a continuous process. It is required by superiors, subordinates and fellow-members on a continuous basis to keep operations running smoothly. (3) Two-way process : It is a two-way process. It involves both sending the message and receiving the response to that message. It is not complete unless the receiver has understood the message. Understanding is the end result of communication. (4) Flow of information : The purpose of communication is to pass on information in order bring about commonness of interest and effort. (5) Pervasive function : It is regarded as a pervasive function because it is required at all levels of management (top, middle, lower) and in all departments (manufacturing, finance, marketing, personnel, etc.) of an organization.

(6) Circular process : It becomes a circular process when the response to the message (example, feedback) requires another message to be communicated by the sender. Here, the response indicates the impact o the communication. (7) Flows in all directions : Communication flows downward from a superior to his subordinates. It flows upward from the subordinates to a superior. It may flow horizontally between persons occupying similar ranks in different departments. It may also flow diagonally between persons at different levels in different departments. Therefore, it flows in all directions. (8) Influencing human behaviour : The primary purpose of communication is to influence human behavious. It is a means of motivating people by proper timing of communication. (9) Conveying a message : A communication must convey some message. A message is the subject-matter of communication. If there is no message, there is no communication. (10) Establishing interpersonal relations : Interpersonal relations are created by a regu lar interaction with subordinates on several aspects of work. By sharing feelings and exchanging information with subordinates, they are made more loyal, sincere and faithful to their superiors. 13.1.4 Steps in the process of communication The process of communication includes the following steps : Step 1 : To have a clear idea about facts, opinions, information, etc., on the part of the communicator. Step 2 : To secure the participation of other persons involved in the decision to communicate a message. Step 3 : To decide what to communicate, with whom to communicate, when and how to communicate. Step 4 : To prepare the subject-matter of communication in a suitable language (example., encoding the message). Step 5 : To select a suitable medium for the transmission of the message (example., telephone, telegraph, television, etc.). Step 6 : To transmit the message to the communicate (example., receiver). Step 7 : To ensure the correct interpretation of the message by the communicate (example., receiver). Step 8 : To motivate the receiver to behave as desired by the sender of the message. Step 9 : To evaluate the effectiveness of communication through response or feedback. Step 10 : To evaluate the nature of impact of the communication. 13.1.5 Importance of communication in management Management functions cannot be performed efficiently without an effective network of communication in the organization. The overall functioning of the whole organization is supported by an effective communication network. It is said to be the nervous system of an enterprise. The importance of communication in management may be explained as follows : (1) Facilitates sound planning : It facilitates planning by providing such informa tion as is needed by the planners. Through communication, the mangers get the required and relevant information which helps them to formulate proper plans and programmes for the company. It also helps in the proper implementation of plans and policies of the management. (2) Provides proper information : It helps management by providing information about the duties, responsibilities, authority, positions and jobs. Delegation and decentralization of authority is accomplished in an organization through effective communication. (3) Facilitates co-ordination : Co-ordination can be maintained among various re lated departments by making an exchange of information on a regular basis. Coordination of various efforts becomes easy if communication is effective. It binds the people together and is really an aid to co-ordination.

(4) Facilitates decision-making : It helps the management in arriving at vital deci sions. The quality of any decision depends largely on the quality of information available to the decision-maker. Effective communication helps in implementing the decisions of the management. (5) Creates inter-personal relationships : It helps in improving relationships between the superior and his subordinates by providing clear and accurate information in time. These relations can be created through an exchange of ideas, opinions, in formation, directives, suggestions and other instructions between them. (6) Creates mutual trust and confidence : It creates mutual trust and confidence between the management and the employees. It is essential for healthy industrial relations. It is helpful in boosting the morale and motivation of employees work ing in the organization. Prompt redressal of employees grievances by top-level managers motivates employees to work efficiently. (7)Facilitates directing functions : It facilitates directing functions by providing proper interaction between managers and their subordinates. It improves supe rior-subordinate relationships by providing opportunities to employees to express their opinions and viewpoints. (8)Ensures democratic management : It is the basis of democratic management. It ensures co-operation through understanding. It facilitates effective leadership main tenance of man-to-man relationships. (9) Facilitates controlling functions : It facilitates controlling functions by providing a feedback of actual performance against planned targets. It acts as a tool for effective control. It ensures attainment of enterprise objectives according to preconceived and planned actions. (10) Improves public relations : Public relations are improved though proper com munication. Effective communication helps the management in maintaining good relations with customers, suppliers, shareholders, the Government and the com munity at large. It helps in developing a good public image of the organization. (11) Helps to cope with the changing environment : It helps the organization to cope with a rapidly changing business environment. It also helps managers in devising suitable strategies for meeting future challenges. (12)Helps in conducting global economic operations : Globalisation of business op erations have increased the need and importance of communication. For a suc cessful executive, it has become necessary to be aware of different cultures which are prevailing in various countries. Thus, communication helps in the smooth conduct of global economic operations. (13)Increases managerial efficiency : It contributes a great deal to higher efficiency in job performance. The efficiency of a manager depends upon his ability to com municate effectively with his subordinates. Effective communication will make the employees feel more secure and more interested in their work. Everyone in volved in an organization must know clearly his duties, responsibilities and pow ers. (14)Establishes team-spirit : It establishes a cordial and friendly atmosphere in the organization. It helps members in establishing a closer link with each other. It satisfies employees organization work like a team to achieve the targets assigned to them. 13.1.6 Principles of effective communication Effective communication systems are essential and important in all forms of business. The following are the essential elements of an effective communication system : (1) Clarity of message : The subject-matter which is to be communicated, must be clear. No ambiguous (or confusing) terms should be used so that the purpose of

communication is deviated. (2) Unbiasness : It should be free from personal prejudices. It must take into account the interests of the other parties. (3) Reciprocal communication : Both the communicator and the communicate should participate in the communication. There should be a reciprocal effect (example., twoway communication). (4) Consistency : The communication should be consistent. The communicator should communicate the message which he believes to be true and proper. There should not be any gap between what he says and what he does. (5) Correct channel : The correct channel of communication is to be chosen in order to make communication effective. The channel to be chosen depends on the na ture and purpose of communication. (6) Speed : The communication system should be capable of carrying messages speed ily. However, speed of communication should not impair the accuracy of the information to be transmitted. (7) Accuracy : The communication system should ensure accuracy in the transmis sion of information. (8)Safety : The communication system should ensure safety of the contents of com munication from loss in transit (or miscarriage) (9) Flexibility : The communication system should be amenable to change according to the needs of business. It should absorb new techniques of communication with little resistance. (`10) Human and physical conditions : A good communication system must take into accunt all the human and physical conditions to make communication effective. (11) Sense of understanding : Both the communicator and the communicate should have a sense of understanding about what they intend to convey. (12) Feedback : This refers to the actual response of the receiver to the message com municated to him. Feedback is a reversal of communication. It makes communi cation more effective. (13) Listening carefully : Listening to verbal messages carefully implies an active process. Half-hearted attention to the communication is often the cause of misunder standings and confusion. (14) Restraint over emotions : Strong feelings and emotional stress are serious handicaps in the communication process. It should be avoided as far as practi cable. 13.1.7 Objectives of communication The following are the objectives of communication : (1) Promotion of managerial efficiency : Communication is the lubricant fostering the smooth operation of the management process. It keeps people working in accordance with the decisions of the management. (2) Co-operation through understanding : It induces human beings to put forth genuine efforts in work performance. It inculcates the understanding of employ ees and leads them to greater efforts. It ensures efficiency in work in all respects. (3) Motivation to employees : It helps in moulding employees behaviour favourably. It encourages the employees to accept new ideas for completion of the work systematically. It leads to better employer-employee relations. (4) Basis of leadership action : Effectiveness of leadership is greatly influenced by the adequacy and clarity of communication. Personal communication is essen tial for maintaining man-to-man relationships in leadership. (5) Job satisfaction to employees : The employees get better education, training and knowledge about the modern methods of production due to modern com

munication systems. The employees are trained to increase their productive power. This enhances the mutual trust and confidence between the management and workers. Job satisfaction of employees promotes their loyalty towards the enter prise. (6) Quick implementation of decisions : Effective communication systems help the management to implement decisions quickly. Moreover, such systems help the members to adjust quickly to changing circumstances. 13.1.8 Written communication Written communication means transmission of information through written words. It may consist of messages in the form of letters, circulars, notes, notices, telegrams, bulletins, reports, memoranda, etc. Written communication provides a permanent record for future reference. It enables information to be conveyed far and wide. It should be clear, concise, complete and correct in order to make it effective. Advantages of written communication : The advantages of written communication are as follows : (1) It may be transmitted to numerous persons simultaneously. (2) It provides a permanent record for future reference. (3) It is more effective than oral communication. (4) It is an ideal way of transmitting lengthy messages. (5) It is a formal communication and it carries more weight. (6) It can be quoted as legal evidence in the case of any dispute. Disadvantages of written communication : The demerits of written communication are as follows : (1) It is an expensive and time-consuming method of communication. (2) It is very formal and lacks a personal touch of sophistication. (3) Written communication finds it difficult to maintain secrecy. (4) It may be unsuited if unknown words and unfamiliar phrases are used. (5) It encourages red-tapism and involves too many formalities. 13.1.9 Verbal (oral) communication. Oral communication means transmission of information through the spoken word. It may be in the form of (a) face to face communication; (b) through electronic devices (like telephone, intercom, etc.); (c) lectures; (d) interviews; (e) public speeches, etc. It is found useful where a detailed explanation of a message is required. It is a flexible method of communication, where the message can be changed to suit the needs of the receiver. Advantages of verbal communication : The merits of verbal (oral) communication are as follows: (1) It is an effective and a natural method of communication. (2) It is easily understandable. (3) It is less expensive and quicker as compared to written communication. (4) It removes distances and barriers between the communicator and the communicate. (5) It ensures better understanding of the message communicated. (6) It is a flexible method where messages can be changed to suit the needs of the re ceiver. Disadvantages of verbal communication : (1) It provides no record for future reference. (2) It has a tendency of being distorted. (3) It may create legal problems in future. (4) It may generate communication gaps. (v) It is difficult to act on it due to missing details. Different methods of oral communication

Oral communication can take place in two ways, namely, (1) Face-to-face communication; and (2) Mechanical-device based communication. Face-to-face communication This refers to direct speech between two persons or between small group of persons. This is the most natural form of conveying messages and needs no equipment. Here, facial expressions and gestures can be used to reinforce the spoken words. This method of communication promotes better understanding and ensures co-operation. It is the most effective and easiest way of transmission of information. It helps in prompt decision making in case of solving urgent problems. The purpose of this communication is to communicate (a) orders; (b) requests; (c) instructions; (d) information and observation. Face-to-face communication includes the following kinds : (1) Direct personal talk : This refers to personal talk between two individuals or among a small group of persons. Here, the speaker can explain the matter keep ing in view the reactions of the listeners. It is the most flexible form of oral com munication and is suitable for confidential matters. (2) Meeting (example. Joint consultation) : This is a process whereby concerned people meet together to discuss the matters of general interest so as to arrive at decisions. Meetings are conducted with previous notice to transact certain business and to arrive at various decisions. (3) Interview : It is a face-to-face conversation to see and judge the personality of a person. It is a two-way communication in the sense that both parties make state ments about their respective positions and ask questions. An interview can be successful only when it is held in a relaxed atmosphere. (4) Lectures : It is a face-to-face communication which is used to provide knowledge to students, trainees etc. Hence, the teacher (or trainer) delivers a lecture to stu dents (or trainees) on any relevant topic. 13.1.10 Latest developments in communication media : Electronic mail (e-mail) This involves sending written messages through telecommunication links. The message to be sent through e-mail is typed on the computer and is transmitted on the internet address (example., website) of the receiver. It is a latest device to send written messages anywhere in the world with the help of internet. E-mail is the fastest method of communicating written messages anywhere in the world at the least cost. E-mail is the quickest means of transmitting messages. It provides the facility of sending and receiving the messages anytime during the day and night. E-mail message can be sent to a large number of people simultaneously, depending upon the requirement. It does not require any stationary (such as pen, pencil, paper, stamp, etc.) to be used. The messages sent or received through e-mail can be stored for future reference. Moreover, e-mail messages are supposed to be highly confidential and secure. It is suitable for any type of message whether it is a letter, picture, design, etc. It ensures instant feedback provided both the receiver and the sender of the message are simultaneously sitting at their computer terminals. The steps involved in sending e-mail message are as follows : (1) Connect internet and start an internet browser (Outlook Express, Internet Ex plorer, etc.) (2) Type the e-mail address of the person to whom you want to send message. (3) Type the message in the provided message box. (4) Type senders name and his e-mail address. (5) Take the mouse pointer at the send button and click the mouse once. Video conferencing This is a system by which people staying at different places can discuss certain issues of common

interest. This method of communication is very effective for executives, political leaders, consultants, etc. With the help of this facility, people can hold conferences and can both hear and see on another on television screen. A typical video conferencing system consists of a set-top box, high quality digital camera, coder/decoder hardware, external microphones, telephone, satellite connection and other components. These facilities enable the participants in distant locations to take part in a conference by means of electronic sound and video communication. It reduces time, distance and cost of exchanging views. It improves the quality of timely decisions. When conferencing is conducted with the help of a computer, we can call it computer conferencing. For this conferencing, we require a computer, telephone, internet facility and web camera. This conferencing can be used for seminars, meetings, consultations and recruitment. In this era of globalization when multinational corporations are simultaneously operating in several countries, video conferencing can prove to be a very effective means of mutual consultation. It can lead to substantial saving, both in terms of money and executive time. Short Message Service (SMS) The mobile telephone is capable of displaying short messages on the screen SMS provides a mechanism for transmitting short messages to and from mobile phones. SMS is similar to paging which can be availed anytime and anywhere. It enables the transmission of messages speedily and at much lower costs. It facilitates the delivery of messages to multiple subscribers (having mobile phones) at a time. It facilitates communication in a wide geographical area. Anyone who knows the mobile number of a receiver, can send short messages through his mobile phone. SMS is a globally accepted seamless message service that guarantees speedy delivery of information (text as well as numerical messages). An active mobile handset is capable of receiving or submitting a short message at any time to any subscriber of mobile set. Recording of messages in the memory facilitates storage of information which can be retrieved as and when required. It helps the receiver of message to react instantly to any business situation or otherwise. 13.1.11 Measures to improve communication Effective communication is vital for managing the people in the organization. In order to make the communication process more effective and responsive, the barriers (or obstacles) are to be handled effectively. The following are the measures to overcome the barriers to communication :(1) Regulating the flow of communication : Effective communication should in volve determining the priority of messages to be communicated. Incoming communication should be edited and condensed. Otherwise there is a possibility of managers being overloaded with the tasks of communication. (2) Handling language differences : Language differences can be handled by ex plaining the meaning of technical (or unconventional) terms in a simple language. Vague expressions should be avoided. As far as possible, use of ambiguous words should be avoided. (3) Control over emotions : Both the sender and the receiver of the message should have control over their emotions. They should ensure that the content of the mes sage is not affected by any negative impact of emotion. Emotional stress is a seri ous handicap in the communication process. (4) Feedback : Feedback means the response or reaction to the initial message. It may include receivers acceptance and his behavioural response. Along with each communication, there is a need for feedback. It is a reversal of the communica tion process. (5) Importance of listening carefully : A receiver of the message should listen to verbal messages carefully so as to avoid misunderstandings and confusion. A receiver of the message has to be patient and mentally composed while receiving the message. A sender, on the other hand, should also be prepared to listen to what the receiver has to say and respond to his questions, if any.

(6) Clarity and completeness of message : The message should be adequate and appropriate for the purpose of communication. It is very essential to know the audience for whom the message is meant. It may not be possible to achieve per fect communication unless the purpose of communication is clearly defined. (7) Sound organization structure : The organization structure must be sound and appropriate to make communication effective. Attempt must be made to shorten the channel for conveying information. The channels should be straight-forward to reduce delay and distortion in communication. (8)Mutual trust and faith : The parties involved in communication should have mutual trust and faith between themselves. They should feel free to make sugges tions and correct each others views without there being any misunderstandings. (9) Physical layout of work place : In a modern organization, it is also found that the physical layout of the work place influences the communication pattern. The layout of an office should be designed in such a way so as to facilitate frequent interaction. (10) Use of informal channel of communication : It helps to improve managerial decisions and makes communication more effective. For effective communication, formal channels must be supplemented with the use of informal channels. Characteristics of a good business letter Business people have to communicate with their customers, suppliers, debtors, creditors, public authorities and the public at large for the purpose of exchanging their views and for sending and receiving information. Written communication is called correspondence. Commercial correspondence means correspondence by business people on matters of commerce. Following are the characteristics of a good business letter : (1) Clarity : The language shall be clear so that the ideas are properly expressed and the reader can understand them in the correct sense. (2) Conciseness : A letter shall not be unnecessarily long. It must be concise and precise. (3) Completeness : A business letter shall be complete in every sense. The points must be arranged sys tematically and logically and then a complete and clear picture emerges. (4) Unambiguous : A business letter must be free from ambiguity. (5) Courtesy : A business letter must be courteous. This means that the letter should be polite in its form. (6) Well-planned : Effectiveness of a letter depends on its good planning. The form of a business letter contains the following : (a) Heading : Name, address, telephone number and telex are generally printed; reference number should be given on the left side on top and the date should be given on the right side. (b) Inside Address : The official designation of the addressee is given on the left side. Circular letters do not require inside address. (c) Opening Salutation or Greeting : Dear Sir in case of the singular and Dear Sirs in case of the plural should be used. In the case of a circular letter, either Dear Sirs or Gentlemen may be the salutation. (d) Body of the Letter : This includes three parts :

(1) Introduction : This is to draw the attention of the reader and it may contain a reference to a previous letter. (2) Middle portion : This contains the principal information or message to be set out in one or more paragraphs. (3) Conclusion : This contains the action to be taken by the recipient. The letter must end with Thank You or With Thanks or With regards, etc. (e) Complimentary Close : Complimentary Close should be matched with the style of salutation, for example, Yours faithfully or Yours sincerely or Yours truly, etc. (f) Signature and Date : Every business letter must be signed by the authorized person and dated.

Sketch of Layout of a Letter (A The heading ) Telephone No. Name of the Sender , Telex No. ,Address of the Sender , Telegraphic Address ,Nature of business , Reference No. , Date, (B The inside address) Name/Designation of Addressee Address of Addressee (C Opening Salutation ) Opening Salutation (Dear Sir/ Sirs, etc.) (D) Re Subject Matter : (E Main Body of letter divided into paragraph) explanation (F Complimentary Close ) Yours faithfully, Complimentary Close (For (G ) Signature of sender Designation. (H) Enclosure : Kinds of Business Letters There are many varieties of business letters depending on the subject matter or the purpose for which these are being written. Some common varieties, suitably grouped, are indicated as follows : (1) Offers, Quotations and Orders; (2) Confirmation, Refusal and Cancellation of orders; (3) Claims, Complaints and Adjustments; (4) Collection letters; (5) Agency letters; (6) Status enquiry letters; (7) Recommendation and credit letters; (8) Banking and Insurance letters; Offers, Quotations and Orders An offer is an invitation extended by a trader to the public or to a particular customer to place orders for his products sold by him. The object of making an offer is to increase the sales of the products in the market. When an offer is being made against a particular enquiry, it is known as a quotation. An offer or quotation should contain the following particulars :

(1) Description an quality of the goods; (2) Unit of measurement of weight; (3) The price per unit; (4) The terms of payment, (5) The place, mode and time of delivery. A few specimen of such letters are given below : Specimen 1 Offer to a retailer in respect of Clean Well Liquid Cleansing Soap XYZ COMPANY LTD. 5, Brabourne Road, Kolkata 700 001 Telephone : 37-9128 Telex A501 Telegraphic Address OFAG Dated : 19th August, 2001 Code A.X.Y. Ref. No. BL/5409/01 To Messrs Elite Stores, Darjeeling, West Bengal Dears Sirs, Re: Clean Well Liquid Cleansing Soap We have pleasure in sending you today a sample packet of Clean Well, which has recently been introduced in the market. The product is the result of a number of years of tireless effort by our research staff. We forward herewith a few copies of our leaflets so that your can distribute them for the purpose of advertisement. It will be observed from the leaflets that the various qualities of the product are really unique. We also enclose a few copies of the price lists and you will appreciate that the prices quoted are very competitive. As per our terms, you will be allowed two months credit and a discount of 20% on the catalogue price. Thanking you. Yours faithfully, For XYZ Company Ltd. Enclosures : (1) Leaflets Prabhat Das 2) Catalogue Director Specimen 2 Asking for Catalogue and Trade Terms Dated : 31st January,2001 (As per layout sketched) Dear Sirs, We take this opportunity to introduce ourselves to you. We are one of the leading book sellers of this city, having stocks of all types of books. We have trade terms with a number of publishing houses, both Indian and foreign, whose books we sell. We would like to stock your publications. We, therefore, request you to send us your latest catalogue and state your trade terms. Please let us know whether it will be possible for you to give us goods on credit, if we give satisfactory trade and bank references. It would be convenient for us to settle the account quarterly. Expecting a favourable reply, Yours faithfully, Specimen 3 Reply to the above 15th February, 2001 (As per Layout sketched)

Dear Sirs, We thank you for your inquiry dated 31st January,2001. We are glad to know that you are interested in our publications and desire to stock them. We are sending our latest catalogue and price-list under separate cover. We allow a trade discount of 20 per cent on the printed prices. Our terms are cash in general but we can still grant credit for one month at the maximum. We trust you will find these terms suitable and hope you will favour us with your orders. Yours faithfully, Specimen 4 Asking for quotations of cloth 10h February, 2001 (As per Layout sketched) Dear Sirs, We are interested in placing orders for the supply of Khaki Drill cloth required for N.C.C. uniforms. It would be appreciated if you could kindly send at your earliest the particulars of Khaki Drill cloth manufactured by you. As it is likely that our requirements may be quite heavy, it is hardly necessary to remind you of the benefits likely to accrue to you by offering competitive prices. Our needs would be mainly for this particular item and we should appreciate samples in various weights. We await an early response from you, so that we may be able to place orders with you in time and you may execute these orders expeditiously. Yours faithfully, Specimen 5 Reply to the above 21st February, 2001 (As per Layout sketched) Dear Sirs, We thank you for your inquiry of 10th February and have the pleasure in quoting Diamond Khaki Drill fast colour 45 metres at Rs. 4.25 per metre. You will find that this drill is absolutely unshrinkable and extremely hardwearing. The special quality it possesses is its resistant to the action of daily use. Orders will be executed promptly from stock, but of course, a reasonable period of notice would be required for unusually large quantities. We trust we shall have the pleasure of supplying your needs. Yours faithfully,

Business Communication
Specimen 6 An order for the supply of Toys 5th February, 2001 (As per Layout sketched) Dear Sirs, We have pleasure to introduce ourselves as your old customers for toys. We gave you good business two years ago in toys manufactured by you, having sold them for about Rs. 20,000/-. For some reasons beyond our control, we could not find it possible to arrange the sales and could not place orders with you for the supply of the same. But this year, we have decided to come into the field again and would expect you to favour us with special consideration for our orders as you did earlier. Kindly book our order for the supply of toys as per details given below: (1) Plastic toys of different kinds and sizes, Rs. 15,000

(2) Paper toys of different kinds and sizes, Rs. 12,000 (3) Glass toys of different kinds and sizes, Rs. 10,000 (4) Clay toys of different kinds and sizes, Rs. 5,000 Total Rs. 42,000 Please see that the toys are properly packed and delivered to our destination F.O.R. as before. Your firm will bear the responsibility for any damage due to breakage, etc. A prompt response is awaited. Yours faithfully, Specimen 7 A Reply to the above 15th February, 2001 (As per Layout sketched) Dear Sirs, With reference to your order dated February 5, 2001 for the supply of toys worth Rs. 42,000/-, we are sorry to inform you that at present we are not in a position to meet your full requirements, as we have to comply with the outstanding orders received from many concerns of the neighboring States of Rajasthan, Madhya Pradesh, Haryana and the Union Territory of Delhi. However, we would like to recommend a well reputed manufacturing concern The Taj Toys of the local market, with which you may place your order and receive the supply in time. Had we known before hand that you would place with us such a large order, we could have made some arrangement, rather than missing our esteemed customer. However, we would like to assure you that, in future, you will have no need to complaint to us for orders, regardless of the worth. Willing to serve you at all times, Yours faithfully, Specimen 8 Placing an order for Radios 22nd March, 2001 (As per Layout sketched) Dear Sirs, With reference to your quotation Number SY/74/01, dated 10th February, 2001, we have pleasure in placing an order for the supply of : (1) One dozen, 3 Band, Retheim radio Sets, and (2) Two dozen, 2 Band Transistor sets Model no. 35 Priya. Please ensure the proper packing of the goods and arrange to dispatch them by passenger train within a fortnight of the issue of this order, as the items of this order are urgently required. Please dispatch the goods at an early date, as these items are in heavy demand these days due to the World Cup Football. Thanking you, Yours faithfully, Specimen 9 Reply to the above 30th March, 2001 (As per Layout sketched) Dear Sirs, We thank you for your order dated 22nd March, 2001 for the supply of one dozen redio sets and two dozen transistor sets. In view of the urgency shown by you, we have forthwith executed the order and the goods are already on their way to you by passenger train. We thank you very much for your brisk business and particularly congratulate you on

your success in disposing of your goods to our mutual advantage. Yours faithfully, Confirmation, Refusal and Cancellation of an order Confirmation : As soon as an order is received, it should be immediately acknowledged and confirmed. When the order is executed immediately, no confirmation is, however, necessary. But where there is any possibility of delay in executing the order, the confirmatory letter must be issued in respect of the order. Refusal : At times, orders are to be refused on various grounds. Orders may be refused for lack of stocks or, where the customer is financially unsound, etc. The refusal letter should be polite and generally the reason for refusal should be stated. Cancellation : Sometimes it becomes necessary to cancel an order already placed by the party due to some unforeseen circumstances. It may be due to undue delay in the execution of the order, sudden fall in the market price or bankruptcy of the customer. The letter cancelin such an order should clearly state the reasons for such cancellation. A few specimen of such letters are given hereunder : Specimen 1 Expressing inability to execute order 25th July, 2001 (As per Layout sketched) Dear Sir, We sincerely thank you for your order of the 2nd July, 2001 for some of our publications, but we regret to say that we are unable to execute your order at present, as our stock of these books is exhausted. The books ordered are being reprinted and we expect them to be ready for sale by the end of this month. We are, therefore, keeping your order before us and, unless we hear from you to the contrary, we shall be glad to execute your order as an when the books We greatly regret the inconvenience caused to you. Assuring you of out best co-operation always. Yours faithfully, Specimen 2 Asking for extension of time 4th August, 2001 (As per Layout sketched) Dear Sir, We thank you for your order of the 20th July, 2001 for five tones of coconut oil for delivery by the 15th of this month. Owing to a sudden strike in our Mills during the previous month, our stocks are exhausted and fresh supplies are expected to be ready for delivery within a fortnight. We hope that your requirements are not so urgent as to render an immediate delivery. We may, therefore, request you to wait for a further three weeks, by which time we shall be in a position to comply with your order. If you can see your way to extend the date of delivery to 30th August, 2001 we shall be able to accept your order and ensure its execution within the time stated above. An early reply will be appreciated. Yours faithfully, Specimen 3

Cancelling order due to undue delay in execution 20th August, 2001 (As per Layout sketched) Dear Sir, We placed an order with you on 5th July for the supply of 500 sets of pistons and rings, which were to be delivered by the 5th August. But to our surprise we have received neither the goods nor any intimation from you. Sine the time of delivery has long expired, we are complelled to cancel the order under reference. This may kindly be noted. Thanking You .Yours faithfully, Specimen 4 Cancelling order due to bankruptcy of customer 25th April, 2001 (As per Layout sketched) Dear Sirs, We placed an order with you on the 22nd of this month for the supply of 200 dozen handloom bedsheets with pillow covers, but we very much regret that we have to cancel this order as our customer for whom these goods were intended has now become bankrupt. We shall, therefore, request you to make a note of this and stop dispatching the goods. However, we may assure you that we will make goods the loss of this order within a short time. Thanking you, Yours faithfully, Claims, Complaints and Adjustments Claims and Complaints: At times the buyers are not satisfied with the quality of the goods supplied. There may also be discrepancies in respect of the quantity, terms and conditions of payment, delivery, etc. As a result, the buyers raise different claims on the suppliers. Both the letters raising such claims and the replies thereto, should be written tactfully, avoiding an unpleasant situation. Adjustments : When the claims as mentioned above are substantiated, some letters of adjustment are required to b issued to the purchaser in order to rectify the error and settle any dispute amicably. The supplier should always try to settle the matter amicably, even at his own cost, as the customers are valuable assets of a concern. A few specimen of such letters are given below: Specimen 1 Complaints regarding delay in delivery 17th September, 2001 (As per Layout sketched) Dear Sirs, We regret to point out that, although you acknowledged our order dated 4th August, 2001 the goods have not yet reached us. This has been causing us considerable inconvenience, and we have been put to substantial loss. The orders were placed with your on the explicit understanding and your promise that you could execute the orders within a fortnight. The fact that you have taken undue time and have not yet delivered the orders, has put us at a great loss in business, for which we may claim compensation from you. However, we have no intention of exercising this right and we propose to wait for the execution of the order till the end of this month.

Prompt action is expected from you. Thanking you, Yours faithfully, Specimen 2 Reply to the above 25th September, 2001 (As per Layout sketched) Dear Sirs, We have received your letter of the 17th September,2001, complaining of the delay in the delivery of goods for which order was placed on the 4th August, 2001. We are really very sorry that you have had to face some inconvenience on our could not be executed. However, we shall try to expedite things and every effort shall be made to deliver the supplies in time in future. Once again we very much regret the inconvenience caused to you and assure you of the delivery of the present supply before the end of the month. We fully appreciate the indulgence you have shown to us in extending the date of delivery and hope that you will accept our apologies for the delay and continue the same friendly relationship which existed in the past. With thanks, Yours faithfully, Specimen 3 Complaint about receipt of wrong goods 5th August, 2001 (As per Layout sketched) Dear Sir, Today we have received delivery of the consignment sent by you on 25th July, 2001. On opening the parcel, we were surprised to discover that the contents of the same were entirely different from those ordered by us vide our letter no. R25/CA dated 10th July, 2001. A statement of the goods received is enclosed for your perusal. While comparing them, you yourself would find that none of them were ordered by us. Please look into the matter immediately and let us have your reply by return post. Yours faithfully, Specimen 4 Reply to the above 10th August, 2001 (As per Layout sketched) Dear Sirs, We thank you for your letter of 5th August, 2001, and are sorry to learn that by an oversight of our dispatch section, you have received the wrong consignment. The consignment received by you was meant for M/S. Hari Prakash & Bros., Sadar Bazar, Meerut, who have in turn received your consignment. We have received a letter from them also. We have requested M./S, Hari Prakash & Bros., Meerut, to deliver that parcel to your per passenger train and you are also requested to dispatch their goods to them directly. Expenses incurred by you exchanging these goods will be borne by us, and you are requested to draw a bill on us. We very much regret the inconvenience caused to you on this account. Thanking your and assuring you of our best co-operation, Yours faithfully, Specimen 5 Complaint about damaged goods 15th July, 2001

(As per Layout sketched) Dear Sir, We very much regret to inform you that the consignment delivered by you on 5th July, 2001, has been received in an entirely damaged condition and to our surprise not a single packet is in a saleable condition. Will you, therefore, look into the matter and send us a fresh consignment of the goods, for which we placed an order with you. On receipt of these goods, we shall return this damaged consignment to you by passenger train. The cost incurred in returning the damaged goods will be borne by you. Please replace the goods of the consignment urgently. An early reply is awaited. Yours faithfully, Specimen 6 Reply to the above 20th July, 2001 (As per Layout sketched) Dear Sir, Your letter dated July, 15, 2001 complaining about damaged goods has been duly received. We sorry to learn that, by some negligence on the part of our packing department, and partly due to the mishandling of goods by the railways, you have received the consignment in a damaged condition. While we are arranging to send a fresh consignment of your order within this week, we would suggest that you may dispose of the tea (already with you) in loose form. We would allow you an additional discount of 10% on this lot to cover the loss your may incur in this regard. We regret once again the inconvenience caused to you and would like to assure you that such mistakes will not occur in future. Thanking you, Yours faithfully, Specimen 7 Complaint of inferior quality 11th March, 2001 (As per Layout sketched) Dear Sir, We thank you for your prompt delivery of distemper wall paint manufactured by you. However, we are sorry to note that the quality of this consignment does not tally with that of the previous one supplied by you on 10th February, 2001. The paints you have supplied this time are of rather inferior quality and are not so fast as the previous ones. We may, however, retain the goods on the condition that an allowance of 10% is made in the price, failing which goods will be kept pending till the receipt of instructions from you as to how best they should be disposed of. Expecting your prompt attention, Yours faithfully, Specimen 8 Reply to the above 20th March, 2001 (As per Layout sketched) Dear Sir, We are in receipt of your letter of 11th March, 2001, regarding supply of inferior quality wall paints. We very much regret that the goods are not to your satisfaction. We thank you very much for this act of kindness as we are always anxious to improve the quality of the goods manufactured by us. If the goods are not to your satisfaction, you are requested

to send the consignment back to us at our cost so that we may find out where the fault lies. Thanking you, Yours faithfully, Specimen 9 Complaint of shortage of goods 31st January, 2001 (As per Layout sketched) Dear Sir, We are in receipt of the books sent under the cover of your invoice No. 437/AX dated 25th January, 2001 and thank you for the same. In this connection, we may state that books of item no. 4 were found short of the order. You have sent only 20 copies of these books instead of 30 copies as per our order. We presume that this mistake has crept in inadvertently and you may either issue us a Credit Note or send us by post the copies in short supply. Your prompt attention is requested. Thanking you, Yours faithfully, Specimen 10 Reply to the above 5th February, 2001 As per Layout sketched) Dear Sir, Your letter dated January 31, 2001 has been duly received. We are sorry to note that some books were found short in item 4 of our Invoice No. 437/AX dated 25th January, 2001. This mistake seems to have occurred due to the negligence of some newly appointed persons of our packing section and we have taken them to task. We are sending 10 copies of the book of this item under separate cover by registered book post in order to cover the shortage. The inconvenience so caused is very much regretted. We assure you of our best services and co-operation at all times. Thanking you, Yours faithfully, Collection Letters Business is carried on mostly on credit. Therefore, collection of money and issuing reminders for payment are a regular features of business. In drafting collection letters, necessary care should be taken not to wound the sentiments of the customers. Sometimes, it may be necessary to issue several reminders for nonpayment. A few specimen of such letters are given below : Specimen 1 Fixing a date of payment 1st March, 2001 (As per Layout sketched) Dear Sir, We are surprised to find that you have taken no notice of our letters of 3rd and 18th February, 2001 asking for settlement of your account of Rs. 5000, which is now long overdue. As we are unable to allow the account to stand over longer, we must insist on its payment by the 10th March at the latest, failing which we shall be compelled, much to our regret, to take further steps to have the account settled. Yours faithfully,

Specimen 2 Threatening legal action 15th March, 2001 (As per Layout sketched) Dear Sir, We have written to you three times for the settlement of our account, but much to our regret, you have not only failed to settle outstanding but have taken no notice of it. We now inform you that, unless we have a remittance from you within the next seven days, we shall be compelled, of course against our desire, to place the matter in the hands of our lawyers. We trust, that you will not compel us to take such an unpleasant step. Yours faithfully, Specimen 3 Asking a customer to take advantage of cash discount 25th February, 2001 (As per Layout sketched) Dear Sir, Kindly refer to our letter of February 3, 2001 enclosing a statement of account of Rs. 5000/ - (Rupees five thousand only) outstanding against you. You are one of our esteemed customers who invariably settle their accounts promptly and take advantage of our cash discount 2% for payment within seven days or net cash for one month. As your account for November is still unpaid, we think it our duty re remind you that you are entitled to the discount only if your remittance reaches us by the end of this month. Yours faithfully,

Agency Letters An agent is a person or a firm who has been appointed by someone to act for him. The person appointing an agent is known as the principal. The against are generally entitled to get a commission. When the agent is to give guarantee for bad debts, he is also entitled to get Del-credere Commission in addition to the usual commission. When writing to an agent, the principal must be careful to make the subject matter of the letter unambiguous and convincing. He should, in no case, write a letter in a dictatorial tone, because his business depends on the co-operation of his agent. A few specimen of such letters are given below : Specimen 1 Offering agency 10th January, 2001 (As per Layout sketched) Dear Sir, We are contemplating to appoint a commission agent for the sale of our products in your State, and your name has been kindly given to us by our business friend M/s. Hariram & Sons, Chandni Chowk, Delhi. At present, we are not in production of all the woolens mentioned in our list. We have specialized in different woolen garments like pull-overs, cardigans and socks. These products have become very popular in Punjab, Haryana, Delhi and Uttar Pradesh. We now seek markets in other parts of northern India as well. In case you wish to co-operate with us, will you be good enough to inform us whether, in the event of your appointment as our agents, you will be free to act for us in that capacity? On receipt of your concurrence, we will furnish you with our terms and conditions. Thanking you, Yours faithfully,

Specimen 2 Complaint of inferior quality 15th January, 2001 (As per Layout sketched) Dear Sir, We feel that there is an excellent market in Bihar for our milk products, and we should be glad to know whether you are prepared to represent our firm there, as our sole agent. As our preparations are in great demand in other States of northern India, we are inclined to believe that you will find no difficulty in introducing them to your State. Your efforts will, of course, be backed by an advertisement campaign, a plan of which is enclosed, and we are prepared to consider your suggestions for any improvement in this direction. We will also maintain, at our cost, a showroom under your supervision and control for the display of our products. We shall be willing to allow you a trade commission of 10% on net sales and undertake to re-imburse all expenses resulting from this representation. We would like to send you a formal agreement form on hearing from you. Kindly reply at your earliest. Yours faithfully, Specimen 3 Applying for agency 15th January, 2001 (As per Layout sketched) Dear Sir, We have been informed by our business friends M/s. Harsuk Lal & Sons, Nagpur, that you have no representation in Delhi. You will be pleased to note that we have an established agency business at Delhi with a standing of 25 years, and we are prepared to offer our services to act as your local agent. We are specialized in this line and we represent several reputed firms in Kolkata and Mumbai. We believe that we would succeed in introducing your products in this area. Our terms are 5% commission on net sales, and the refund of all our disbursements, should there be any. For reference, you may write to Bombay Trading Corporation, Mumbai and our bankers, Indian Overseas Bank, Chandni Chowk, Delhi. Should you decide to entrust the representation of your firm to us, we would use our best efforts to promote your business in this area. Yours faithfully, Specimen 4 Letters accepting agency 7th February, 2001 (As per Layout sketched) Dear Sir, Thank you very much for your letter of January 15, 2001. We have noted with keen interest the contents contained therein. We have pleasure in informing you that we are prepared to accept your agency on the terms and conditions stated in your letter and hope that we would be able to develop a substantial business for you here. We may point out that most of our principals bear the cost of our cables to them regarding the agency work. We hope you would also not mind to do so. You will be glad to know that we also represent a reputed and renowned firm manufacturing woolen garments and you may kindly introduce us to an interested party, if you have contacts. Thanking you,

Yours faithfully, Specimen 5 Letter informing of termination of agency 5th January, 2001 (As per Layout sketched) Dear Sir, It has been necessary for us to terminate the agency with M/s. Govind Shai & Sons, Kanpur, who represented us in Uttar Pradesh and we must accordingly ask you to ignore the party entirely should they attempt to inform you that they are still acting on our behalf. Despite our best efforts, we have not been able to find a suitable party, and we should be obliged if you would very kindly excuse us for the inconvenience incidental to the absence of our agency in your area. We are sure that you would assist us materially by forwarding your orders directly to us, unless a visit from a representative is essential, in which case we shall be glad to make some special arrangement. We are sorry for any inconvenience you may suffer on account of the present change. Yours faithfully, Status Enquiries Every businessman is to take some risk in selling his goods on credit to various types of customers. But the prudent way to minimize this risk is to verify the creditworthiness of the new customers before allowing them any credit. Information regarding the financial standing and reputation of credit worthiness of a new customer should be obtained from various sources, like business friends, credit information agencies and mainly from banks. Status enquiries should always be made confidentially. The language asking for any information must be polite. The information supplied should be accurate and factual. The answer should indicate that the information is given in confidence and without any liability. A few specimen of such letters are given below: Specimen 1 Asking for Bank reference 20th March, 2001 (As per Layout sketched) Dear Sir, We are much obliged to you for your order of 12th March, 2001. As this is our first transaction with you, we would request you to furnish us with the name of your banker as a reference and a couple of other trade references. We invariably follow this convention in handling new accounts. We shall be executing your order while this routine matter is settled. We hope this to be the beginning of a long and cordial relationship between our firms. Yours faithfully, Specimen 2 Asking for names of reverences 10th March, 2001 (As per Layout sketched) Dear Sir, We thank you for your order of 20th February, 2001 and it is engaging our attention. It is our invariable practice, when opening new accounts, to ask for a couple of trade references. As we have not had the pleasure of doing business with you previously, it will be appreciated if you could very kindly furnish two trade references. Always ready to serve you, Yours faithfully,

Specimen 3 Favourable Reply 5th April, 2001 (As per Layout sketched) Dear Sir, Your letter of 10th March, 2001 regarding the financial standing and general reputation of M/s. Jamuna Lal & Sons, has been duly received. In this connection we have the pleasure to inform you that we have been in business with the aforesaid firm for over then years and we have not had any occasion to create any doubt regarding their financial soundness. We personally would be quite willing to allow them credit even in excess of the amount you mention. This information, however, is supplied in confidence and without any responsibility on our part. Yours faithfully, Specimen 4 Favourable reply 6th April, 2001 (As per Layout sketched) Dear Sir, We have your inquiry dated 30th March, 2001 and are glad to inform you that the firm in question enjoy a good reputation and confidence in the local market. We have been doing business with this firm for about ten years and we have all along found them prompt in payment. So far as we know, they are financially quite sound, though we cannot give you any definite idea about their financial capacity. They have been a valued customer of ours and we feel no hesitation in giving them credit for an amount beyond the sum you have mentioned. Yours faithfully, Specimen 5 Unfavourable reply 5th April, 2001 (As per Layout sketched) Dear Sir, In reply to your letter of 30th March, 2001, we have to inform you that the firm about which you have inquired has been undergoing a bad time lately, and more than once, we have had to press them for payment of our bills. We would ourselves hesitate to extend them credit to the extent you mention. We are giving this information to you in confidence and would request you to treat it as such. However, we would like to add that our firm is not guided by any prejudices in matters like this. Yours faithfully, Specimen 6 Letter refusing credit 9th April, 2001 (As per Layout sketched) Dear Sir, With reference to your letter of 23rd March, 2001, we regret to state the information received by us from private sources about your firm is not complete enough to permit us to meet your wishes in the matter of credit. We trust that this position will change in the near future so as to allow us to open an account with you. Meanwhile, we suggest that you may order the goods on C.O.D. basis. We hope that taking into account the high quality of our goods, our low prices and our

cash discount of two per cent you will accept our suggestions. We regard the inconvenience caused to you. Yours faithfully, Recommendation and Credit Letters Sometimes, letters of recommendation are issued either for the purpose of introducing an applicant for a job or for introducing a businessman to others in the same line of business. When a person, besides introducing a certain person, requests the recipients to pay a certain amount of money to the person introduced, the letter written by him in such a case is called, Letter of Credit. Generally, banks issue different types of letters of credit to their customers to facilitate traveling and international trade. Every letter of credit must contain the name and address of the person to whom it is to be presented for payment. It should also contain the name, address and specimen signature of the person in whose favour it is issued, the amount to be paid or the limit, if any, and the period of validity of the Letter of Credit. Two specimen of such letters are given hereunder: Specimen 1 Regarding loss by fire 15th January, 2002 (As per Layout sketched) Dear Sir, We have pleasure in introducing Mr. Mahesh Kumar, the bearer of this letter, who is our business friend. He is one of the senior partners in the firm M/s Mahesh Kumar Suresh Kumar, who deal in textile goods in the city. They want to make new business connections in Mumbai and with this end in view, they are sending Mr. Mahesh Kumar on a tour to that State. We shall be glad if you could kindly help him with the addresses of respectable firms as also with your valuable advice in business matters. We will regard every service you render to Mr. Mahesh Kumar as a personal favour. We shall always be ready to be of service to you in similar matters. Thanking you, Yours faithfully, Specimen 2 Acknowledging claim for damage 17th January, 2002 (As per Layout sketched) Dear Sir, We have pleasure in introducing to you the bearer of this letter, Sri Hari Krishan Seth, a business friend of our firm. He starts today on a business tour through the State of Uttar Pradesh to establish new business connections in brass ware. Sri Hari Kishan Seth is a pertner in the firm of M/s. Seth & Sons, Station Road, Moradabad, who are well-known for the manufacture of quality brass ware. We shall be glad if you could assist him with your kind advice regarding the standing firms in your area. Sri Seth is well equipped with funds for the tour; still, if he stands in need of money, please help him with the necessary funds to the extent of Rs. 2,000 and draw on us a bill for the same. Please take a receipt in duplicate from Sri Seth for the money advanced to him and forward one copy of the same along with the bill drawn on us. We shall always be willing to reciprocate any service you may render to Sri Hari Kishan Seth, whose signatures are given and attested below. Thanking you,

Yours faithfully, Attested Signature of Sri Hari Kishan Seth Banking and Insurance Letters Banks are indispensable in modern business. The primary functions of a bank are : (a) receiving deposits from customers; (b) making payments against deposits to customers; (c) granting loans and advances for earning interest through overdrafts, credits, loans, advances, etc. Banking letters must be of a very high standard and should be carefully worded, as customers are often touchy in money matters. Correspondence about customers accounts should be treated as confidential. Banking letters should avoid ambiguity, must be courteous and respectful. There are generally three forms of insurance Life, Fire and Marine. All letters in connection with Life Insurance must contain reference to Policy No. or Proposal No., name of the life assured, mode of payment, amount of premium, etc. Correspondence regarding Fire Insurance generally is made of a proposal for a policy, acceptance or refusal of the proposal, rate of premium, claims and their settlement. Correspondence regarding Marine Insurance generally includes a proposal to insure, acceptance or refusal of the proposal, quotation for premium, claims and acceptance or refusal of claims. A few such letters are given below: Specimen 1 Letter refusing credit 15th January, 2002 (As per Layout sketched) Dear Sir, We have to inform you with great regret that a fire broke out last night in our godown situated at 23/27 Loha Mondi, Agra, Thana hariparwat. The cause of the fire could not be established even by the police, who have been to the site this morning. The fire was seen by the watchman in the store where paper is stocked. He immediately informed the fire brigade which arrived within minutes. I also reached the spot as soon as I received the telephonic message from the watchman. Despite the best efforts put in by the fire brigade, nothing could be saved. We estimate the loss worth Rs. 40,000/- and request you to please send you Surveyor or Inspector to assess the loss and let us know what formalities are to be completed for putting up a claim for the loss. Yours faithfully, Specimen 2 Acknowledging claim for damage 17th January, 2002 (As per Layout sketched) Dear Sir, We are in receipt of your letter of 15th January, 2002 informing us of the loss due to the fire which occurred at your godown at 23/27 Loha Mondi, Agra, on 14th January, 2001. We have instructed our surveyor, Sri A.G.Sharma, to survey the loss and we shall proceed in the matter on getting his report. In the meantime, please fill in the enclosed claim form and return it to us at your earliest convenience. Yours faithfully, Specimen 3 Enclosing cheque in settlement of claim 25th January, 2002 (As per Layout sketched)

Dear Sir, In continuation of our Letter of 17the January, 2002 we have to inform you that we received the surveyors report which assesses the damage at Rs. 85,000/-. We enclose our cheque No111. dated 1.1.12. on the State Bank of India, M.G.Road, Agra for Rs. 85,000/-, together with a voucher and shall thank you to return the same to us duly signed. Yours faithfully, Specimen 4 Letters asking for Overdraft facilities 3rd February, 2002 (As per Layout sketched) Dear Sir, We wish to have overdraft facilities for which we are prepared to deposit with you State Government Securities of the face value of Rs. 50,000/-. We shall very much appreciate your sending us the necessary forms for signature. In case any further particulars are required, the undersigned would be glad to call on you personally. Yours faithfully, Specimen 5 Reply to the above 4th February, 2002 (As per Layout sketched) Dear Sir, We are in receipt of your letter dated February 3, 2002 asking for overdraft facilities. It this connection, we have to inform you that we shall be allowing you overdraft facilities, subject to certain restrictions, which are mentioned in the book of rules and regulations, a copy of which is being enclosed. Kindly go through the rules and act accordingly. Necessary forms and promissory notes are enclosed. Please fill in the same and sign at the places marked with red ink. Government securities duly endorsed in our favour along with the forms may then be sent to us to enable us to give you necessary overdraft facilities. Yours faithfully, Specimen 6 Letter disclaiming liability 25th January, 2002 (As per Layout sketched) Dear Sir, We are in receipt of your letter dated 15th January, 2002 informing us of a fire which broke out on the night of 14th January in your godown at 23/27 Loha Mondi, Agra and destroyed goods therein. In this connection, we wish to state that the above policy was issued for six months ending 31st December, 2001, and had to be renewed to cover the risk further. You were advised of the same by our letter No. SA/24 dated 1st December, 2001, but you failed to renew the policy and the policy stood lapsed. Under the circumstances, we regret that we cannot entertain your claim for loss. Yours faithfully,

13.3 REPORT WRITING Reporting or a feed back is very essential in business, particularly because a timely action can enable the Management to avail of some opportunities or save the organization from a possible loss. In fact, the communication process is not considered to have been completed without a feed back.

A Report may be oral, visual or written, formal or informal. It could be a document in which a particular situation is analysed or a particular problem is examined with a view to offering information to the Receiver. It may include the facts, figures, findings and may also be supplemented with recommendations. Majority of the reports are Routine Reports called Work Reports or they are investigation reports. Reports help Managers to carry out their functions better. They can plan, evaluate and take decisions faster. Timely reporting in a scientific manner can free the supervisors advise the subordinates regarding the desired action. The superiors can also take a note of such reports for further reference. The information submitted in a report by technical experts can help the Management to correct flows in the working if any. A good Report is: Timely submitted information A well written document Properly organized, drawing attention to important facts and is Cost-effective. The usual classifications of reports could be: 1) Function a) informational b) Interpretative c) Analytical 2) Length Short or long. 3) Period or Time Monthly, Bimonthly, Quarterly, Six-monthly, Annual Progress or Special. 4) Importance Routine, Important, Emergency. 5) Subject Management, Financial, Accounting, Insurance, Sales, Tax, Production, Miscellaneous. 6) Ares Internal, External. 7) Presentation Written or oral by Individual or Committee. The written report could be in a letter format or Schematic format. In case of the latter, it is presented in a particular order with subheadings. We have newspaper reports informing us about some events concerning business stated as a news or reports like a Stock Exchange Report providing us facts and figures with an analysis and observations.

13.4 DIRECTORS REPORT


The report of the Directors is prepared in accordance to the provisions of Sec. 217 of the Companies Act. This report should contain information on the following matters :(a) The state of the companys affairs. (b) The amounts, if any, which is proposed to be carried to any reserves in the balance sheet. (c) The amount of dividend recommended if any. (d) Material changes and commitments affecting the financial position of the company which have occurred between the last date of the balance sheet and the date of the directors report. (e) Certain mandatory informations relating to steps taken in respect of conservation of energy, technology absorption, foreign exhange earnings and outgo etc. The Board of Directors Report also contains information relating to any change in the nature of business of the company or the business of the subsidiary companies. In addition, the Directors report also contains information relating to the remuneration received by employees beyond a prescribed amount. The following specimens will help understanding the practices followed. An Investigation Report (in letter format) 22nd April 2001

The Chairman, Prosperous Steel Limited Tagore Street. Kolkata 700 001 Sir, In accordance with your letter dated 18th June 2000, instructing me to carry out an investigation into the services provided by the canteen at our factory at Shrirampur, I would like to submit as follows : 1. The Procedure : I visited the factory on 19th and 20th April 2001 and conducted personal interviews of representative staff working in our factory, at both day and night shifts. Earlier, I had a spot checking of the kitchen and the Service Hall of the FACTORY CANTEEN. I also had prepared a questionnaire (Appendix A) which was filled in by 87 workers availing of the canteen facility. 2. Finding : (a) The services provided by the Factory Canteen are far from being satisfactory. The kitchen was found to be most dirty with solid waste dumped in a corner. (b) The uniforms of the canteen boys appeared to have not been washed for several days. While serving the food, minimum health care is not being taken. (c) During the night shift, tea was not available and the canteen boys were replying rudely. It appears that the Canteen Manager is running a hotel nearby and the surplus stale food items are brought to our Factory Canteen for disposal. (d) The crockery used is of the Third Grade and also not sufficient for catering to our 250 employees. (e) The rates of the foodstuff provided, have been reused steeply upwards, without notice and discussion with us. 3. Recommendations (a) Considering the fact that majority of our employees depend upon our canteen and that there is no other substitute facility for the night shift workers, the Canteen Manager be asked to improve hygienic conditions at Canteen immediately. (b) If should be insisted upon the Canteen Manager that all the food served every day, should be fresh and that under no circumstances, the outside stuff be brought for disposal in our Factory Canteen. (c) The Canteen Manager should be asked to reduce the rates of the food items immediately, by at least 20% since we have been providing him canteen subsidy. The tea should be available to the night shift employees regularly and they should not be charged more than Rs. 1.50 per cup. (d) The Canteen contract will come to an end on 15th July 2001. If there are no immediate improvements and if clean uniforms are not provided to the Canteen Boys, the contract should not be renewed. (e) The Canteen Manager be called for a personal explanation at the Head Office during the next fortnight. Yours faithfully, John Roberts

13.5 DIRECTORS REPORT TO THE MEMBERS


Your Directors have pleasure in presenting their Thirty-sixth Annual Report and the Audited Accounts for the year ended 31st March 2002. Financial Results : Year ended Year ended 31st March02 31st March01 Rs. in lakhs Rs. in lakhs Sales 13655.24 12744.73

Profit before tax 1519.81 1350.28 Less Provision for taxation 814.00 413.00 Profit after tax 705.81 637.28 Add Taxation adjustments for earlier years 2.31 23.13 Profit and Loss Account surplus Brought forward .. 325.00 770.00 1033.12 770.43 Appropriations: General Reserves 111.24 83.80 Dividend (proposed) 421.88 361.63 Balance carried over 500.00 325.00 1033.12 770.43 2. Operations: The Companys sales for the year amounted to Rs. 136.55 crores for the previous year, recording a growth of 7.4%. During the year under review, sales of Chloramphencol products were adversely affected due to the continued dumping of L. Base (drug intermediate for Chloramphenicol) by China at considerably lower prices. But for the reduction in sales of Chloramphenicol products as compared to last year, the growth in sales would have been higher. Profit before tax amounted to Rs. 15.2 crores compared to Rs. 13.5 crores in the previous year, registering an increae of 12.6%. Profit after tax at rs. 7.06 crores has registered a growth of 10.8% over the previous years net profit of Rs. 6.37 crores. 3. Dividend : Your Directors recommend payment of a dividend of Rs. 3.50 per share (35%), subject to deduction of tax at source. The dividend payout would be Rs. 4.22 crores. 4. Exports : The Companys Export (on F.O.B. basis) was Rs. 1.72 crores during the year under review as compared to Rs. 2.07 crores in the previous year. 5. Fixed Deposits : Deposits of an aggregate amount of Rs. 7.38 lakhs which had matured remained unclaimed as on 31st March, 2002. 6. Directors : Mr. X.Y.Z. ceased to be a Whole-Time Director of the Company on his resignation from the Board effective 30th June 2002. Your Directors wish to place on record their appreciation for the valuable rendered by him during his tenure of office. In accordance with the Articles of Association of the Company, Messrs P.Q.R. and S.T.U. retire by rotation and being eligible offer themselves for reappointment. 7. Employee Relations : Employee relations were satisfactory during the year. Your Directors record their appreciation of the contributions made by employees at all levels to the operations of the Company during the year. 8. Cost Auditor : Pursuant to the provision of Section 233-B of the Companies Act, 1956, necessary applications have been submitted to the Department of Company Affairs for the appointment Messrs. MNC & Company as Cost Auditors to audit the cost accounts maintained by the Company in respect of bulk drugs as well as formulations for the year ending 31st March, 2003. 9. Auditors :

The Auditors Messrs. Honest and Loyal retire and offer themselves for reappointment. On Behalf of the Board Bombay Venugopal Shetty 29th June 2002 CHAIRMAN

13.6 TELEGRAPHIC MESSAGES


Telegraphic communication is one of the fastest way of reaching information. This service is managed by the Indian Post and Telegraphs Department with a network spread all over the country. The telegraphs could be Ordinary or Express. The charges for Express telegraps are usually double the rate of an ordinary telegraph. A concessional rate is charged for the standard phrases telegrams. A telegraphic message is required to be brief because each word after the minimum words (Ten words), is charged extra, However, the message to be telegraphed should never be economized at the cost of the meaning, otherwise there would be misunderstanding or miscommunication. Usually telegrams are sent to convey urgent information and are followed by a detailed communication.

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