LECTURE NOTES

AEE101
FUNDAMENTALS OF AGRICULTURAL ECONOMICS

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DEFINITIONS OF ECONOMICS
The word economics has been derived from the Greek word “OIKONOMICAS” with “OIKOS”
meaning a household and “NOMOS” meaning management. It is understood that the beginning was made
by the Greek Philosopher, Aristotle who in his book “Economica” focused that the field of economics deals
with household management.
The concepts on which various definitions of economics given are
1) Wealth
2) Welfare
3) Scarcity
4) Growth.
‘Wealth’ Definition of Economics
Adam Smith (1776) who is regarded as “Father of Economics” in his book entitled “Wealth of Nations”
defined economics as “An enquiry into the nature and causes of the wealth of nations”.
‘Welfare’ Definition of Economics
Alfred Marshall defined economics as “A study of mankind in the ordinary business of life; it examines
that part of individual and social action which is most closely connected with the attainment and with the
material requisites of wellbeing”.
‘Scarcity’ Definition of Economics
“Economics is the science which studies human behaviour as a relationship between ends and scarce means
which have alternative uses” according to Robbins.
‘Growth’ Definition of Economics
Keynes defined economics as “The study of the administration of scarce resources and of the determinants
of employment and income.

Economics - a Social Science

Economics studies human beings as members of the society participating in the economic activities. It does
not study humans as isolated individuals. He is interdependent. Thus economics is a social science.

Is Economics a Science or an Art?

By definition, science is a systematized body of knowledge having an empirical correspondence.
Analogous to science, an art is also systematized body of knowledge. It directs through a system of
procedures to attain a given objective or goal it tells us how to do a thing.
Treating economics as a science, a given theory is formed through conduct of experiments, recording
observations, analysis of data recorded, drawing the conclusions and finally testing them. In economics also
the same procedure is followed to present any principle or theory. Hence economics is as good as any
science.
As an art, economics shows solutions to the problems. It helps us how to do a thing. The role of
economics as an art can be found in any sphere of economic activity. For example, it advocates how to
maximize the profits of a firm given the resource constraints. Given a problem, the field of economics
guides us to solve the same. Thus, the field of economics has the attributes of science and art. Economics
therefore is a science as well as an art.

Economics –Positive Science or Normative-Science.

In economic theory, we make an effort to explain the nature of economic activity and predict the
events in the economy as facts change. Such an effort helps us to know the environment in which we live
and what part is related to others and what causes what.
Positive economics is completely objective and is limited to the cause and effect relationship of
economic activity. It is simply concerned with the way the economic relationships are present in different
economic activities (what they are).
Normative economics studies the way that economic relations ought to be. Normative economics
evaluates. Policy making, a conscious intervention in the economy for the welfare of the people is
essentially a normative in character.

Traditional and modern approaches of economics

Traditional Approach
Traditionally, the subject matter of economics can be studied under four divisions. These are consumption,
production, exchange and distribution.
Consumption
It means the use of wealth to satisfy innumerable wants. It also means the destruction of utility. All the
goods that are produced are consumed immediately or some time in future. Through the consumption
activity, we use utilities hence consumption represents using up of utilities.
Production
It is an activity that helps to create utility. It simply means the addition of utilities. Hence production is
defined as the creation of utility. Through the process of production one set of goods is transformed into the
other. In the economic sense mere creation of utilities is not treated as production, and in fact the goods that
are produced should have value too. In the production process, inputs or resources are transformed into
products.
Exchange
The word exchange of goods implies transfer of goods from one person to the other. Exchange of goods
takes place among groups of individuals, countries, markets, regions and so on. The exchange of goods
leads to an increase in the welfare of the individuals through creation of higher utilities for goods and
services.
Distribution
If refers to the sharing of wealth produced by the community among the agents of production. Proper
distribution of wealth and resources leads to growth and economic welfare of the people in the nation.

Modern Approach:
Microeconomics and Macroeconomics
As has been mentioned earlier, it is only an old approach to divide Economics in to these four
divisions. The modern approach is different. The study of Economics is now usually divided in to two parts:
a) income theory or Macro-Economics; and b) price theory or Micro- Economics.
The term “microeconomics” has been derived from the Greek word “MICROS” meaning small. In
other words micro means a millionth part. It is otherwise known as price theory. It focuses on price
determination. Microeconomics fundamentally deals with economic behaviour of individual economic units
such as consumer, resource owners and business firms. It is concerned with the flow of goods and services
from business firms to consumers and also the flow of resources or their services from resource owners to
business firms. Microeconomics covers theory of consumer behaviour, theory of value (product pricing and
factor pricing) and theory of economic welfare.
The term macroeconomics has been derived from the Greek word “MACROS” meaning large.
Macroeconomics otherwise is called income theory. It treats the economic system as a whole, rather than
treating the individual economic units of which it is composed. Macroeconomics is concerned with the value
of the overall flow of goods and the value of the overall flow of resources. Thus, it covers theory of income
and employment, theory of money and prices, banking, theory of economic growth macro theory of
distribution, general equilibrium analysis, policy formulation and analysis, etc. Thus, it is concerned with the
study of aggregates.

Agricultural economics
“ The science in which the principles and methods of economics are applied to the special conditions of
agriculture industry”- Prof. Gray
“Agricultural economics is the study of relationships arising from the wealth getting and wealth using
activity of man in agriculture”- Prof. Hibbard
Importance
1. Uses theoretical concepts of economics to provide answers to the problem of agriculture.
2. Determine how the commodities are produced and marketed in line with the consumption need.
3. Information regarding problems in production, finance, marketing and government policies and their
impact on production and distribution.

Role of Agriculture in the Economic Development of a Country

(1) By providing food and raw material to non agricultural sectors of the economy,
(2) By creating demand for goods produced in non-agricultural sectors, by the rural people on the strength of
the purchasing power, earned by them on selling the marketable surplus,
(3) By providing investable surplus in the form of savings and taxes to be invested in nonagricultural sector,
(4) By earning valuable foreign exchange through the export of agricultural products,
(5) Providing employment to a vast army of uneducated, backward and unskilled labour. As a
matter of fact, if the process of economic development is to be initiated and made self sustaining, it must
begin for agricultural sector.

Economic Systems
The economic system can be broadly categorized into
a) Capitalism
Capitalism is a system of economic organization characterized by the private ownership and use of capital
with profit motive. The most important feature of capitalism is the existence of private property. Every one
has the freedom to form any firm anywhere he likes, provided he has the requisite capital and ability. It is
based on the doctrine of laissez faire which would mean that the state interference in economic activity
should be kept down to the minimum.
Top Characteristics
1. Two-class system: Historically a capitalist society was characterized by the split between two classes of
individuals—the capitalist class, which owns the means for producing and distributing goods (the owners)
and the working class, who sell their labor to the capitalist class in exchange for wages. The economy is run
by the individuals (or corporations) who own and operate companies and make decisions as to the use of
resources. But there exists a “division of labor” which allows for specialization, typically occurring through
education and training, further breaking down the two class system into sub-classes (e.g., the middle class).
2. Profit motive: Companies exist to make a profit. The motive for all companies is to make and sell goods
and services only for profits. Companies do not exist solely to satisfy people's needs. Even though some
goods or services may satisfy needs, they will only be available if the people have the resources to pay for
them.
3. Minimal Government Intervention: Capitalist societies believe markets should be left alone to operate
without government intervention. However, a completely government-free capitalist society exists in theory,
only. Even in the United States--the poster child for capitalism, the government regulates certain industries,
such as the Dodd-Frank Act for financial institutions. By contrast, a purely capitalist society would allow the
markets to set prices based on demand and supply for the purpose of making profits.
4. Competition: True capitalism needs a competitive market. Without competition, monopolies exist, and
instead of the market setting the prices, the seller is the price setter, which is against the conditions of
capitalism.
5. Willingness to change: The last characteristic of capitalism is the ability to adapt and change.
Technology has been a game changer in every society, and the willingness to allow change and adaptability
of societies to improve ineficiencies within economic structures is a true characteristic.

b) Socialism
Socialism is an economic system in which the means of production (capital equipment, buildings and land)
are owned by the state. The main aim of socialism is to run the economy for social benefit rather than
private profit. It emphasizes on work according to one’s ability, and equal opportunities for all regardless of
caste, class and inherited privileges.
Communism is a form of socialism. It was followed in the erstwhile Soviet Union. Communism means an
idealistic system in which all means of production and other forms of properties are owned by the
community as a whole, with all members of the community sharing in its work and income. People are
supposed to work according to their capacities and get according to their needs. The aim is to create a
classless society and the state machinery is utilized to crush all opposition to achieve this end. The main
difference between communism and socialism is that the former believes and adopts violent revolutionary
methods to capture the machinery of the government while the latter believes in peaceful and parliamentary
methods.
Following are the main characteristics of socialism
Public Ownership
It has the public ownership of all the means of production and distribution. This is also known as collective
ownership whereby all means are owned, controlled and regulated by the state. In socialist economic system
the basic motive of government is not profit but to get targeted objectives.
Planned Economy
State is responsible to plan all the economic activities like production, exchange, distribution and
consumption which have great importance in socialism. Since the laws to demand and supply do not operate
in this system, the country is more likely to incur speedy economic growth and since the state is solely
responsible for the distribution of wealth, the society as a whole prospers.
Classless Society
In a capitalist economic system there are different living standards like upper, middle and lower class.
Structure of capitalist society is determined through financial and economic position of members. However
in a true socialist society everyone is equal as far as economic status is concerned.
State is Responsible for Basic Necessities of Life
Mainly there are six basic needs in life and such needs are promised by central authority i.e state. Those
needs are food, shelter, clothing, health, education and employment. In this economic system stated needs
will be provided without any discrimination.
Socialism Provides Equal Opportunity
Although there may not be a complete guarantee of income equality, socialism guarantees to provide equal
opportunity. Every potential individual will take into account as per the skills, talent and ability which will
determine their success. Thus, their economic rights are automatically protected by their duties and no one is
deprived of their basic needs.
Non-existence of Competition and Limited Choice of Consumer Products
Under the socialist economic system there is absence of competition in the market. The state has full control
over production of goods and services. Moreover since this system focuses on necessities in life, choice in
consumer products is limited and only confined to the essentials.
Pricing Mechanism
The pricing process does not freely but works under the control and regulation of the central planning
authority. In socialist economy price have vital importance. Two types of prices prevailing the in this
economic system one is market prices and other is accounting prices. Market prices are for consumer goods,
while accounting prices helps managers to take decision about production of consumer and investment
goods and production method.

c) Mixed Economy
It is neither pure capitalism nor pure socialism but a mixture of the two. In this system, we find the
characteristics of both capitalism and socialism. Both private enterprises and public enterprises operate
mixed economy. The government intervenes to regulate private enterprises in several ways. Generally, the
basic and heavy industries like industries producing defense equipments, atomic power, heavy engineering
goods etc. are put in the public sector. On the other hand, the consumer goods industries, small and cottage
industries, agriculture etc. are assigned to the private sector. It is realized that in the under developed
countries, like India, economic development cannot be achieved at the desired rate of growth without any
active government help and guidance. Hence, the government in such countries actively participates in
economic activities in order to minimize the evils of capitalism and to accelerate economic growth.
A mixed economy possesses the following features:
1. Public Sector:
The public sector is under the control and direction of the state. All decisions regarding what, how and for
whom to produce are taken by the state. Public utilities, such as rail construction, road building, canals,
power supply, means of communication, etc., are included in the public sector. They are operated for public
welfare and not for profit motive. The public sector also operates basic, heavy, strategic and defence
production industries which require large investment and have long gestation period. But they earn profits
like private industries which are utilised for capital formation.
2. Private Sector:
There is a private sector in which production and distribution of goods and services are done by private
enterprises. This sector operates in farming, plantations, mines, internal and external trade, and in the
manufacture of consumer goods and some capital goods.
This sector operates under state regulations in the interest of public welfare. In certain fields of production,
both public and private sectors operate in a competitive spirit. This is again in the interest of the society.
3. Joint Sector:
A mixed economy also has a joint sector which is run jointly by the state and private enterprises. It is
organised on the basis of a joint stock company where the majority shares are held by the state.
4. Freedom and Control:
A mixed economy possesses the freedom to hold private property, to earn profit, to consume, produce and
distribute, and to have any occupation. But if these freedoms adversely affect public welfare, they are
regulated and controlled by the state.

5. Economic Planning:
There is a central planning authority in a mixed economy. A mixed economy operates on the basis of some
economic plan. All sectors of the economy function according to the objectives, priorities and targets laid
down in the plan. In order to fulfill them, the state regulates the economy through various monetary, fiscal
and direct control measures. The aim is to check the evils of the price mechanism.

Basic Concepts in Economics

Basic concepts in the field of economics are discussed below:
Goods
Anything that satisfies a human want is called good. Goods are tangible and material outcome of production.
Examples: Food grains, pulses, oilseeds, machinery, implements, seeds, fertilizers, cloth, book, pen, etc.
Service
A service is any act or performance that one party can offer to another i.e., essentially intangible and does
not result in the ownership of any thing. Services are intangible, non-material, inseparable, variable and
perishable. The services rendered by doctors, teachers, lawyers, engineers, labourers, etc., are the examples.
Classification of goods
Goods are categorized based on four criteria viz., supply, transferability, consumption, and durability as
given below:
Based on Supply
Based on supply, goods are classified into economic goods and free goods. Economic goods are
those goods, which are produced through human efforts and are to be purchased at a given price. Supply is
less than demand. They have value in use and value in exchange. Buildings, machinery, furniture and a host
of other goods of our daily use are the economic goods. Free goods are the free gifts of nature. Their supply
is more than demand and one can get to the extent they need. No efforts are needed to be put forth by
humans to secure free goods. Since these are freely available in nature, no price needs to be paid. They have
value in use but no value in exchange. Examples are, air, sunshine, rainfall, etc.
Though a clear distinction is made between free goods and economic goods based on their distinct
characteristic features, the distinction between the two is lost under certain situations. Water, which is a free
good near the canals and rivers for the consumers, becomes and economic good in the water scarcity places.
Similarly, sand which is a free good in riverbeds becomes an economic good in the places of house
construction activities.

Based on Transferability:
As given by Marshall Goods are classified as follows

Based on Consumption
Based on consumption, goods are classified into consumer goods and producer goods. Consumer
goods are those from which consumers directly derive the satisfaction using the goods. These are otherwise
known as goods of first order in view of their ability to give direct satisfaction. Food, cosmetics, clothes,
books, pens, etc., are the examples of consumer goods.
Producer goods are those that help to produce other goods. They can be used by consumers or
producers or both, because it depends upon how the good is used. From the consumers’ point of view they
give satisfaction indirectly. The examples are machines, factory buildings, raw material, etc. The chance of a
producer good to become a consumer good is possible based on its usage. For instance, electricity when
used at home, it becomes a consumer good and the same becomes a producer good when used in industry.

Based on Durability
Based on durability goods are classified into mono period goods and poly period goods. Those goods which
are used only once to satisfy a need are called mono period goods. They cease to exist once their use was
over. Examples: All food items and productive resources like seeds, fertilizers, etc.
Durable goods are those goods, which are used time and again. They can be made use of several times.
Here the relevant examples are machinery, implements, buildings, etc.

Utility
The capacity of a good that satisfies a human want. In other words, utility is the want satisfying power of a
good. Also it means the power of a commodity to satisfy a human want.
Kinds or Types of Utility
Utilities are classified into different kinds. A particular kind or type of utility for a commodity is found in a
particular situation. The kinds of utilities are
1) Form utility
2) Place utility
3) Time utility
4) Possession utility.
1. Form Utility
By changing the form of a good, greater utility is created. It does not mean that before change of form of
good, there was no utility. It means that change in the form offers greater utility to the good. Examples: the
transformation of a log of wood in to a piece of furniture, Processing of paddy into rice, wheat into flour,
coffee seeds into coffee powder, butter into ghee, cotton into cloth, etc.
2. Place Utility
Utility can also be increased by transporting a good from one place to another. Such utility is called place
utility. Spatial movement of the goods i.e., moving a good from one place or market to another place or
market increases its utility. Mostly the goods are transported from the places of production down to the
places of consumption and also from the places of surplus production to the places of scarcity. For example,
cement is transported from the places of production to the areas of consumption; Apples from Himachal
Pradesh, the area of abundant production are transported to Southern and Western parts of the country (non
producing areas), thereby increasing the utility of apples.
3. Time Utility
Any time lag between production and consumption of commodities creates time utility. Through storage
over time, greater utility is created for the products. Storage helps to create time utility. Agricultural
production being season bound with consumption spreading throughout the year, the commodities need to
be made available to the consumers as and when required. The storage helps us to perform this function.
Agricultural commodities like paddy, wheat, oilseeds, pulses, etc., are stored to make them available for the
regular use of consumers throughout the year.
4. Possession Utility
Commodities in the transaction process change the hands from one person to another person. Commodities
in the hands of producers have some utility and by the time they reach consumers through the traders their
utility is increased. Such utility due to possession or transfer of ownership of the commodity is called,
possession utility. For example, paddy in the hands of producers, i.e., farmers are having less utility
compared to that of consumer in the form of rice. Similarly any other commodities like fruits, vegetables,
livestock products, etc., would have higher utility when these goods change hands from farmers
Characteristics of Utility
1. Utility is Subjective: Utility is not satisfaction by itself; it is subjective to the interest of an individual. It
depends on the individual’s frame of mind. Hence a given commodity need not bring the same utility to all
the consumers. Utility varies from person to person. For example, a blind man cannot see a picture and it has
no utility for him. A non-vegetarian food to a vegetarian, alcohol to a teetotaler, motorcycle to a child, etc.,
give zero utility. Utility varies with a regular smoker when compared with an occasional smoker and
similarly for a regular non-vegetarian to an occasional non-vegetarian. Utilities derived by the occasional
users of a good are greater than those of regular users.
2. Utility Varies with Purpose: Depending upon the purpose for which a commodity is used, utility of the
same varies. For example, utility derived from water varies from its use as drinking water against its use as
irrigation or for power generation or for industrial use, etc.
3. Utility Varies with Time: A particular commodity gives different utilities for the same person in
different time periods. Cool drinks and ice-creams provide greater utility to the same individual in summer
than in winter. The wine stored over time in scientific warehouses would have higher utilities and fetch
higher price.
4. Utility Varies with Ownership: Ownership of a good creates far greater utility from a good than that
when it is hired. For a farmer, land ownership brings higher utility over leasing in the land. Similarly, owing
farm machinery offers greater utility than hiring in, for a farmer.
5. Utility Need not be Synonymous with Pleasure: Utility derived from a commodity need not be
associated always with pleasure for the consumer, Consuming items of our taste brings in the utility one
expects. Similarly, buying an asset also gives the desired utility. These are all the pleasures enjoyed by the
consumer from the goods. As against this, consumption of a good is a painful feeling for an individual
though it possesses utility. For example, for a sick man, bitter medicines are difficult to swallow.
6. Utility does not Mean Satisfaction: Utility is not satisfaction by itself. Utility is the quality of a good by
virtue of which it gives satisfaction to an individual. The question of obtaining satisfaction from a good
depends on the consumer’s choice for the same.

Wealth
Wealthy consists of all potentially exchangeable means of satisfying human wants (J.M. Keynes).
Characteristics of Wealth
1. Wealth should Possess Utility: Wealth must be cap0able of satisfying human wants.
2. Wealth must be Scarce: Scarcity is the binding factor for exchange. Economic goods are exchangeable.
Since wealth represents economic goods, it must be scarce.
3. Wealth Must Transferable: Transferability implies changing the ownership of a good from one to
another. It is nothing but exchangeability.
4. Wealth Must be External to Person: This quality of wealth enables for exchange.
Types of Wealth: These are:
1. Individual Wealth: Individual wealth consists of all tangible and intangible possessions of the
individuals, besides loans due to them. Land, buildings, vehicles, shares, bonds, deposits, commodities for
sale, cash, etc., are the tangible possessions. Goodwill of a business, copyrights, patents (non-material
external goods), etc., are intangible possessions. From the total value of all these possessions, loans owed to
others are to be deducted to arrive at the individual wealth.
2. Social wealth: It is wealth, which is collectively used by all the people in a nation. Hence it is also termed
as collective wealth or communal wealth. Common properties of the community like roads, railways, public
parks, libraries, Government hospitals, Government colleges. Etc., represent the social wealth.
3. National Wealth: National wealth is an aggregate of all individuals’ wealth and collective wealth of the
country. To this amount the loans due to people and loans due to the Government from foreign countries
should be added. From this amount so arrived at the debts that the people and the Government owed to
foreign countries should be deducted. Economists like Marshall feel the inclusion of free gift of nature like
mountains, rivers, etc., in national wealth.
4. Cosmopolitan Wealth: Here the wealth belongs to the world but not to one country. Rivers, oceans,
forests, etc., extending over the nations are the examples of cosmopolitan wealth. It is the sum total of
wealth of all nations.
5. Negative Wealth: Negative wealth is the exclusive debts owed by the individuals and the nation.
Human Wants
“Man is a bundle of desires”. His wants are infinite in variety and number. Some of his wants are organic
and natural. He must have some food to live, some clothing to cover his body and some sort of shelter to
protect himself against the inclement of weather, and also against his enemies. With out these things man’s
life would be impossible.
Characteristics of Human Wants
1. Wants are Unlimited: Wants are continuously cropping up in the minds of the humans. If one want is
satisfied, immediately another want emerges. They go on multiplying. There is no end to human desires,
hence unlimited.
2. Wants Recur: If one want is satisfied at a point of time, the same want again repeats in the future. It can
be satisfied for that moment only and it is again ready to be fulfilled. Wants like hunger, recreation, etc.,
need to be satisfied time and again because of their recurrence.
3. A given Want is Satiable: Though human wants are unlimited, a given want at particular point of time is
completely satisfied. For example, for a man who is thirsty, adequate potable water completely satisfies his
thirst.
4. Wants are Complimentary: Goods are required in pairs or groups to satisfy human wants. For example,
bread and butter, tractor and driver, fertilizer and irrigation water, pen and paper, etc., can serve as
complimentary goods to satisfy human wants.
5. Wants are Competitive: Wants are unlimited but means to satisfy them are limited. Wants compete
among themselves and hence given preference. This compels the consumer to choose the most urgent wants
keeping in view of the limited income.
6. Wants have Alternative means: There is more than one way of satisfying a certain want. A given want
can be satisfied with alternative goods. If a man is thirsty, he can be satisfied with water or cool drink or
coconut water or cool drink or coconut water, etc.
Classifications of Wants
Wants are broadly divided into three categories:
1. Necessaries
Necessaries are those wants which must be satisfied. The goods which are used to satisfy basic needs of
humans are called necessaries. They are further classified into necessaries of existence, necessaries of
efficiency and conventional necessaries.
a) Necessaries of Existence: These are the necessaries which are essential for living. Human existence is
not possible without fulfilling the necessaries of existence. Examples: Food, water, clothes, shelter; etc.
b) Necessaries of Efficiency: These are not as essential as those of necessaries of existence, but at the same
time essential in improving the efficiency of an individual. Examples: Nutritious diet, table and chair to a
student, class rooms with good ventilation, etc.
c) Conventional Necessaries: These are the necessaries, which arise out of customs or habits. The customs
prevailing in a society influence the individuals to follow them. Examples: Customs like celebration of
functions and habits like smoking, drinking, gambling, etc.
2. Comforts
Comforts are those which fall between necessaries and luxuries. Man is not satisfied with fulfilling
necessaries only. The comforts also increase the efficiency. Examples: Cushion chairs in a classroom,
revolving chair in the saloons, fans in house/office, etc.
3. Luxuries
Luxuries are those which satisfy superfluous wants of individuals. These are neither essential for life nor
increase the efficiency. Luxuries represent wasteful expenditure of the individuals. Luxuries are further
classified in to harmless luxuries, harmful luxuries and defense luxuries. Harmless luxuries are those, the
expenditure on which will not cause any harm to the individuals. For example, well furnished bungalow,
expensive food habits, etc., fall under harmless luxuries. Harmful luxuries on the other hand are injurious to
the health of the users. Examples: Alcohol, smoking, etc. Defense luxuries are those which protect the users
during the period of crisis. Expenditure on gold ornaments, jewellery, etc. though appears to be luxurious, at
the same time it would help the individuals during the periods of crisis.

Law of Diminishing Marginal Utility

The law of diminishing marginal utility is a generalization drawn from the characteristics of human wants,
H.H Gossen was the first to formulate this law in 1854. Marshall has stated the law of diminishing marginal
utility as follows “The additional benefit which a person derives from a given increase of his stock of a thing
diminishes with every increase in the stock that he already has”. In other words, the law simply states that
other things being equal, the marginal utility derived from successive units of a given commodity goes on
decreasing. Hence the more we have of a thing; the less we want of it, because every successive unit gives
less and less satisfaction.
Assumptions :
1) All the units of the given commodity are homogenous i.e. identical in size shape, quality,
quantity etc.
2) The units of consumption are of reasonable size. The consumption is normal.
 3) The consumption is continuous. There is no unduly long time interval between the consumption
of the successive units.
4) The law assumes that only one type of commodity is used for consumption at a time.
5) Though it is psychological concept, the law assumes that the utility can be measured cardinally
i.e. it can be expressed numerically.
6) The consumer is rational human being and he aims at maximum of satisfaction.

The above table shows that when a person consumes no apples, he gets no satisfaction. His total utility is
zero. In case he consumes one apple, he gains seven units of satisfaction. His total utility is 7 and his
marginal utility is also 7. In case he consumes second apple, he gains extra 4 utils (MU). Thus given him a
total utility of 11 utils from two apples. His marginal utility has gone down from 7 utils to 4 utils because he
has a less craving for the second apple. Same is the case with the consumption of third apple. The marginal
utility has now fallen to 2 utils while the total utility of three apples has increased to 13 utils (7 + 4 + 2). In
case the consumer takes fifth apple, his marginal utility falls to zero utils and if he consumes sixth apple
also, the total utility starts declining and marginal utility becomes negative. Total utility and marginal utility
from the successive utits of the commodity are plotted in the figure below:
Importance of the Law:
1) Basic of economic law and concepts: This law of DMU forms the basis of law of demand, law of
Equi-marginal utility, elasticity of demand etc.
2) Public finance: The Govt. can impose and justify progressive income tax on the ground of this law,
as the income increases, the MU of income diminishes.
3) Businessmen: A businessman or producer can increase the sale of his product by fixing a lower
price. Since consumers tend to buy more to equate MU with price, a producer can expect a rise in
sale.
Exceptions
1) Hobbies: In case of certain hobbies like stamp collection or old coins, every addition unit gives
more pleasure. MU goes on increasing with the acquisition of every unit.
2) Drunkards: It is believes that every does of liquor Increases the utility of a drunkard.
3) Miser: In the case of miser, greed increases with the acquisition of every additional unit of
money.
4) Reading: reading of more books gives more knowledge and in turn greater satisfactions.
LAW OF EQUI-MARGINAL UTILITY
This law is also known as the law of substitution. “The law implies that if a person has a thing which he can
put to several uses, he will distribute it between those uses in such a way that it has the same marginal utility
in all” (Marshall).
Assumptions
1. The consumer behaves rationally.
2. He has full knowledge about the commodities, their attributes, prices, etc., in the market.
3. Utility is measurable cardinally in terms of utils.
4. Commodities that are chosen are divisible and substitutable.

Explanation of the Law

Explanation of the Law

Given the income constraint, the consumer makes prudent decisions in his purchases such that the allocation
so made ensures him maximum satisfaction. Let us assume that the consumer has got Rs. 25 to spend. He
has the options of spending this amount on three vegetables viz., potato, tomato and ridge gourd. The
marginal utilities that are derived from the consumption of these vegetables and the amounts of money spent
are presented in table. The marginal utilities are derived from the consumption of three vegetables by
spending a unit of money (each unit of money is equal to Rs. 5). First unit of Rs. 5 on potato gives a
marginal utility of 19 utils, second unit 16 utils, third 14 utils and so on. Now to maximize the satisfaction
from the three vegetables the consumer has to spend Rs. 25 in such a way that the marginal utility of the last
unit of money is equal in all uses. Given the marginal utilities derived from the three vegetables, the
consumer has to spend first three units on tomato, one unit each on potato and ridge gourd respectively. The
total utility through this combination would be 100 (22+21+20+19+18). No other combination of vegetables
gives as high as 100 utils. Diagrammatic representation is shown below.

Practical Importance of Law of Equi- marginal Utility

1. Consumption: A rational consumer follows this law, while planning his expenditure. He spends in such a
way that marginal utility deriver from each unit of money gives nearly equal utility in the various goods he
purchases.
2. Production: A rational producer allocates his limited resources among various possible enterprises in
such a way that the marginal value product derived from each unit of resource on various enterprises is the
same.
3. Marketing: The consumer should keep in mind that marginal utility of the commodity and price of the
commodities from should be equal in purchasing the commodities from the markets. Thus this law guides
the consumers to spend the given amount efficiently on different goods which provide utilities.
4. Distribution: The share of each factor of production is determined on the basis of marginal value
productivity.
5. Prices: When the price of a commodity goes up in view of shortfall in supply, consumer prefers that
commodity which is relatively less scarce. This preference of consumer brings down the price of the
commodity.
Limitation of the Law of Equi- Marginal Utility
1) Ignorance: If a consumer is ignorant and blindly follows custom, he will may not make wrong use
of money.
2) Inefficient organizer: The inefficient business organizer will final to achieve the best result from
the land, labour and capital that he employs.
3) Unlimited resources: When the resources are sample this law will be meaning less.
4) Hold of custom and fashion: It the purchase is strongly influence by customer and fashion he will
not obtain maximum satisfaction.
5) Frequent changes in prices of different goods and services are occurred the observance of this law is
difficult.
Indifference Curve
The basic tool of Hicks - Allen ordinal analysis of demand is the indifference curve that represents all those
combinations of goods that give same satisfaction to the consumer. In other words, all combinations of the
goods lying on a consumer’s indifference curve are equally preferred by him. Indifference curve is also
called Iso-utility curve. Indifference schedule is the tabular statement that shows the different combinations
of two commodities yielding the same level of satisfaction.

Properties of Indifference Curve

1) ICs of two goods are negatively sloped
2) Indifference curves can never intersect
3) Indifference curves of two goods are convex to the origin
4) The higher the IC , the higher the utility (U3 > U2 > U1).
Price Line or Budget Line- price line shows all those combinations of two goods which the consumer can
buy by spending his given money income on the two goods at their given prices. Suppose, a consumer has
Rs.50 to spend on goods X and Y. Let the prices of goods X and Y be Rs.10 per unit and Rs. 5 per unit
respectively. If he spends his whole income (Rs.50) on X, he would buy 5 units of X, and if he spends his
whole income on Y, he would buy 10 units of Y. If a straight line joining 5 units of X and 10 units of Y is
drawn, we get what is called the price line or budget line.
CONSUMER’S SURPLUS
The concept of consumer’s surplus was first introduced by Alfred Marshall. the difference between the
amount of money that a consumer actually pays for buying certain quantity of commodity and the amount
he would be willing to pay for the same quantity rather than go without it. When a consumer is prepared to
buy a commodity, he always calculates the utility he is going to derive from its consumption. Every rational
consumer compares the utility he derives from the consumption of a commodity, against the price he has to
pay. If the utility is more than the price paid, he prefers it and if it is vice-versa, he does not buy the same
good. The surplus of utility he derives is consumer’s surplus. In a nutshell, consumer’s surplus is the
difference between what the consumer is willing to pay and what he actually pays.
Assumptions of the Consumer’s Surplus
1. Marginal utility of money for the consumer is assumed to be the same throughout the process of
exchange.
2. Commodity does not have substitutes.
3. In the market at the given point of time there are no differences of income, tastes, preferences and
fashions among the consumers
4. Each commodity is considered independent of others
Explanation

In explaining the consumer’s surplus, the law of diminishing marginal utility is recapitulated here. The
particulars presented in table reveals that when a person prefers for purchase of mangoes at a price of Rs. 5
each, the marginal utility derived is equivalent to Rs. 20 from the first mango, at which marginal utility and
price are equal. Consumer will not go beyond the 4th mango because at this level the price of a mango is
equal to marginal utility obtained by the consumer. From the consumption of first three mangoes, the
consumer enjoys a surplus utility of Rs. 30. This is the total consumer’s surplus. There is no consumer’s
surplus for the fourth unit. The diagrammatic representation of consumer’s surplus is shown.
Along X-axis units of commodity are measured and along Y-axis marginal utility in terms of money
is measured, DD is the demand curve. At OP Price the number of mangoes purchased is OQ. At price OP,
the total amount paid for OQ units of commodity (mango) is OP*OQ and in graph the area is represented as
OQRP. But the actual amount the consumer is willing to pay for OQ units is OQRD. The consumer’s
surplus therefore is OQRD – OQRP i.e., DRP. Increase in price causes a reduction in consumer’s surplus,
while a fall in price leads to an increase in consumer’s surplus.
Importance of Consumer’s Surplus
1. Conjunctural Importance: When the people enjoy larger consumer’s surplus, it does not indicate that
they are better off. Thus is serves as an index of economic betterment.
2. Useful to the Monopolist: The monopolist can freely raise the prices of the goods if they bring in higher
consumer’s surplus, without any fear of foregoing the sales.
3. Helps in Public Finance and Taxation: More taxes can be imposed by the Government to get more
revenue, on those goods for which consumer’s surplus are high.
4. Helps to Measure Benefits from International Trade: in the international trade, those commodities
which are cheaper in the foreign markets are imported. Before their imports the consumers were paying
higher price. With the availability of imported goods which are cheaper, the consumers get surplus of
satisfaction. Greater surplus indicates, larger benefits from international trade.

Producer surplus
Producer surplus is a measure of producer welfare. It is measured as the difference between what producers
are willing and able to supply a good for and the price they actually receive.
DEMAND
The various quantities of a given commodity or service which consumers would buy in one market in a
given period of time at various prices, or at various incomes, or at various prices of related goods.
Individual Demand Schedule
The various quantities of a commodity that a consumer would be willing to purchase at all possible prices in
a given market at a given point in time, other things being equal is called individual demand. Individual
demand schedule is merely a list of prices together with the quantities that will be purchased by a consumer.
It is pairing of quantity and price relationship.
At Rs. 20, the consumer will purchase 0.25 kg, at Rs. 16, 0.50 kg and at Rs. 12, 0.75 kg and so on. As the
price of the commodity decreases the quantity demanded will increase.
Market Demand
Market demand is the sum of the demand of all the consumers in a market for a given commodity at a
specific point of time. Assume that in a market there are only three consumers, viz., A, B and C, with
individual demand schedules as presented in the Table below. A look at the table indicates different pairs of
quantity and price relationship.

Autonomous Demand and Derived Demand

The goods, whose demand is not linked with the demand of other goods are supposed to have autonomous
demand. Consumer goods are the examples here. The demand for certain goods is related with the demand
for other goods, which is called derived demand. The demand for fertilizers, pesticides, etc., is a derived
demand, for it is linked with the demand for agricultural products. Thus the goods which are demanded for
their own sake have autonomous demand, while the goods that are required to produce other goods have
derived demand.
KINDS OF DEMAND
1. Price Demand: It refers to various quantities of a good or service that a consumer would be willing to
purchase at all possible prices in a given market at a given point in time, ceteris paribus.
2. Income Demand: It refers to various quantities of a good or service that a consumer would be willing to
purchase at different levels of income ceteris paribus.
3. Cross Demand: It refers to various quantities of a good or service that a consumer would be willing to
purchase not due to changes in the price of the commodity under consideration, but due to changes in price
of related commodities.

LAW OF DEMAND
The law of demand explains the functional relationship between the quantity demanded of a commodity and
its unit price, i.e., a rise in the price of a commodity or service is followed by a reduction in the quantity
demanded and a fall in the price is followed by an extension in demand, with other conditions remaining the
same.

Exceptions to the law of Demand

Following are the exceptional cases, where, the law of demand does not hold good.
1. Giffen Goods (Inferior Goods): This phenomenon which is explained below was given by Sir Robert
Giffen. It was named after him as Giffen paradox. This phenomenon says that rise in price is followed by an
extension of demand, while a fall in price is followed by a reduction in demand for the good.
2. Prestigious Goods: When the possession of a good brings in social distinction, consumer would go for
the same even if its price is higher. An example to be cited here is the diamonds that the rich people
purchase, as the possession of the same is prestigious to them.
3. High Priced Commodities: When the consumers view that those products which are superior are sold at
higher prices, they do not mind to buy more of the same at higher prices.
4. Fear of Shortage: If the existing price is higher and it is expected to increase further, consumers would
buy more of it even at higher price, fearing for the shortage.
ELASTICITY OF DEMAND
The law of demand says that demand varies inversely with the price, other things being equal. From the law
of demand, we know the direction in which quantity and price are moving. What is not known is the extent
by which quantity demanded is responsive to changes inprice. This is the information, which is precisely
needed by businessmen and policy-makers. Alfred Marshall developed the concept of elasticity of demand
which measures the responsiveness of quantity demanded to changes in price.
Types of Elasticity of Demand
There are three types of elasticities of demand
1. Price Elasticity of Demand (Ed)
This shows there responsiveness of quantity demanded of a commodity, when price of that commodity
changes, with other factors being constant.

2. Income Elasticity of Demand (EI)

It measures the responsiveness of demand due to changes in the income of the income of the consumers in
terms of percentage, when other factors influencing demand viz., price of the commodity, l price of
substitutes, tastes, preferences, etc., are kept at constant level.
3. Cross Elasticity of Demand (Exy)
Demand for one good (X) is also influenced by the price of other related good (Y). These may be substitutes
or complements. It is the ratio of percentage change in quantity demanded of commodity (X) and percentage
change in price of related commodity (Y).

DEGREES OF ELASTICITY OF DEMAND

Based on the magnitudes of elasticity of demand, it can be categorized into five degrees as given below.
Perfectly Elastic Demand
A slightest change in price of a commodity leads to an infinite change in quantity demanded. The demand in
such a situation is said to be perfectly elastic. The demand is hypersensitive and the elasticity of demand is
infinite. Here the demand curve will be a horizontal line parallel to X-axis. It is mostly a theoretical concept.

Perfectly in elastic demand

It is the situation in which change in price of a commodity leaves the demand unaffected. The price of the
commodity may increase or decrease, but the quantity demanded remains the same. The demand here is
insensitive. Elasticity of demand is zero. The demand curve is vertical to X axis. The case of perfectly
inelastic demand is also a theoretical concept.
Relatively Elastic Demand
It means that lesser proportionate change in the price of a commodity is followed by a larger proportionate
change in the quantity demanded. A small proportionate fall in the price is accompanied by a larger
proportionate increase in demand and Vice versa. Elasticity of demand is greater than unity.

Relatively Inelastic Demand

It means that large proportionate change in the price of a commodity is followed by a smaller proportionate
change in the quantity demanded. This is to say that a large proportionate fall in the price is followed by a
smaller proportionate increase in the quantity demanded and vice verse. Elasticity of demand is less than
unity.
Unitary Elastic Demand
When a given proportionate change in price results in the same proportionate change in the quantity
demanded of commodity, the demand is said to be unitary elastic. A given proportionate fall in price is
followed by the same proportionate increase in demand and vice versa. Elasticity of demand is one.
Stock and supply
Supply means the quantities that a seller is willing and able to sell at different prices. It is obvious that if the
price goes up, he will offer more for sale. But if the price goes down, he will be reluctant to sell and will
offer to sell less. Supply thus varies with price. Just as we cannot speak of demand without reference to price
and time, similarly we cannot speak of supply without reference to price and time. Supply is always at a
price. The supply of any good may then be defined “as a schedule of respective quantities of the good which
people are ready to offer for sale at all possible prices”.
Supply schedule: Individual Supply Schedule
Supply schedule depicts the list of quantities—price relationships of a commodity in a market at a specific
point of time by an individual seller. In other words, it reveals the mind of sellers in offering various
quantities of a given commodity against corresponding prices.
Market supply
It is the sum of the quantity of commodity that is brought into a market for sale by the sellers in a given
market at a specific point of time. Assume that there are three sellers in a market viz., A, B and C with
individual supply schedules as shown in below.

LAW OF SUPPLY
The law of supply indicates the functional relationship between the quantity supplied of a commodity and its
unit price. The law signifies the positive relationship i.e., as the price of a commodity raises its supply
extends and as the price fall its supply contracts, with other things remaining the same. Producers normally
tend to increase the supplies in the wake of rising prices and reduce the same when the prices are on the
lower side. Supply varies directly with the price.
Factors Causing Changes in Supply
The factors that are responsible for changes in supply are discussed below:
1. Changes in Technology: Technological innovations viz., new varieties of crops and their consequent
increased yields per unit area, help to increase the supply of the commodity.
2. Reduction in Resource Prices: When the prices of input factors become cheaper than before, it
encourages producers to use more of them in producing more output. Supply curve shifts towards the right
side.
3. Reduction in the Relative Prices of Other Products: A reduction in relative prices of other related
products come the producers to increase the production of that particular commodity whose prices are
relatively higher.
4. Market Infrastructure: When good communication and transport network increase, the supply of the
commodity also increases.
5. Number of Producers: Changes that are found regarding number of producers producing a given
commodity influence the supplies. More the number of producers, greater the supply and vice versa.
6. Producers, Expectations about Future Prices: Price expectations influence the sales strategies of the
producers positively.

ELASTICITY OF SUPPLY
Elasticity of supply of a commodity is the responsiveness, or sensitiveness of supply to the changes in price.
Supply is said to be elastic, if a small change in price causes considerable change in the quantity supplied.
The supply is inelastic when a given change in price leads to little or less change or no change in the
quantity supplied. In short, elasticity measures the adjustability of supply of a commodity to price. Elasticity
of supply (Price elasticity of supply) is expressed as the ratio of percentage change in the quantity of good
supplied and percentage change in price of the good.

Degrees of Elasticity of Supply

There are five degrees of elasticity of supply. They are as follows:
Perfectly Elastic Supply
When the supply of commodity increases to infinite quantity or unlimited quantity, even though there is
invisible rise or minute rise in the price, the elasticity of supply is said to be infinity (Es = α).
Perfectly Inelastic Supply
It means that the quantity supplied is not responsive to change in prices. Elasticity of supply in this case is
zero (Es = O).

Relatively Elastic Supply

Supply is referred as relatively elastic, when the percentage change in quantity supplied is more than the
corresponding percentage change in price. It is also called elastic supply. Elasticity of supply is more than
one (Es >1)
Relatively Inelastic Supply
Supply is said to be relatively inelastic, when the percentage change in quantity supplied is less than the
corresponding percentage change in price. In this case the elasticity of supply is less than one (Es < 1).

Unitary Elastic Supply

When percentage change in quantity supplied equals the percentage change in price, it is called unitary
elastic supple. Here the elasticity of supply is equal to one (Es = 1).
MARKET
Market can be viewed as the context within which voluntary exchanges among buyers and sellers take place.
Essentials of marketing:
1. A place
2. Goods and services
3. Buyers and sellers
4. Communication
CLASSIFICATION OF MARKETS
Markets are classified based on various criteria as presented here under:
1) On the Basis of Number of Commodities
a. General Markets: In general markets all types of commodities are sold. These commodities for example
range from foodgrains to textile goods and so on.
b. Specialized Markets: Specialized market deals with a specific commodity. The markets are named after
such commodities. For example, if vegetables are sold in the market, we call such markets as vegetable
markets. Similarly, markets transacting goods like wool, cotton, jute and fish are called wool market, cotton
market, jute market and fish market respectively.
2) On the Basis of Market Area
a. Local Markets: These markets are also called village markets or primary markets or hats. The area
covered by the market is limited to some group of villages, which are nearby or close to each other. In these
village markets, perishable commodities like vegetables, fruits, fish, milk, etc., are being transacted.
Shandies, fairs etc., which are held occasionally on special important days would also come under local
markets or primary markets. In some areas, local markets are being conducted daily, while in other areas,
these are conducted once in a week or twice in a week. Tribal markets in Madhya Pradesh are a sort of
primary markets. Cattle markets, sheep markets etc., come under primary markets.
b. Regional Markets: Here the area of operation of the market is relatively larger than that of local market.
This market covers four to five districts. Sometimes regional markets cover a State. Food grain markets are
the examples to be cited under regional markets. Fruit markets operated in the State are called regional
markets. They are regular in conduction business transactions in notified commodities.
c. National Markets: These markets cover the entire country in their operation. National markets are found
for commodities having demand over the entire country. Textile markets, jute markets, tea markets etc., are
the relevant examples.
d. International Markets: Here the commodities are sold in all the nations of the world. The market area of
operation is extended over the entire globe. These markets exist for commodities like cashew, coffee, tea,
spices and condiments, gold, silver, diamonds, machinery, etc. Recently, even textiles, rice, wheat, sugar,,
cut flowers, fruits, processed products , etc., have international market.
3) On the Basis of Location
a. Village Markets : The area of operation of these markets is confined to a small village or a group of
villages. Major transactions of goods and services take place among the buyers and sellers of these villages.
Such markets may be regular or occasional in their operation.
b. Primary Wholesale Markets: These are located in big towns or taluks or mandal headquarters. All types
of agricultural commodities from the village markets are pooled here. Transactions take place between the
producers and the traders.
c. Secondary Wholesale Markets: These markets are found in the district headquarters dealing with major
agricultural commodities like rice, pulses, oilseeds, chillies etc. Wholesalers and village traders are the main
participants in these markets. Bulk of the arrivals comes from primary wholesale markets or village markets.
Transactions of the commodities take place in large quantities. We find many commission agents, brokers,
hamalies, weighmen, etc., working in these markets for facilitating the marketing operations.
d. Terminal Markets. These are located in big cities/State capitals/seaports. These are well –organized
markets and controlled by the Government to see that all modern methods of marketing operations take
place. Processing and storage activities are predominant in these markets. Consumers, wholesalers and
marketing agents are seen in these markets with rigorous transaction activities. Future marketing or forward
marketing takes place in these markets. These are situated in big cities like Chennai, Bangalore, Mumbai,
etc.
e. Seaboard Markets: These are primarily meant for export and import of commodities. Scientifically
standardized and graded commodities are transacted. These are located in Mumbai, Chennai, Kolkata,
Visakhapatnam, etc.
4) On the Basis of Time
a. Short Period Markets: These are held for a brief period in a day. Here the supply of commodity is fixed.
Fish market in a particular place i.e., village or town or city, vegetables markets, flower markets, etc., are to
be cited here. Since supply is fixed here, we can notice price variation based on demand in a day in the
transaction of these commodities. Here the supply is zero elastic.
b. Long Period Markets: Durable commodities, which can be stored for some time, are transacted in these
markets. The prices for the products are governed by supply and demand. The examples are foodgrains, oil
seeds, etc.
c. Secular Markets: These are permanent markets. Manufactured goods, machinery, etc., are transact6ed in
these markets. Godown facilities and processing facilities are highly developed in these markets. These are
well organized markets. They deal with the export and import transactions.
5) On the Basis of Volume of Business
a. Wholesale Markets: When large quantities of a commodity are brought and sold in the market among
the traders, such markets are called wholesale markets.
b. Retail Markets: These are the markets in which retailers sell commodities to the consumers in very small
quantities as per their requirements. Producers, retailers and consumers are seen in these markets.
6) On the Basis of Nature of Transaction
a. Cash Markets: If there are cash transactions in buying and selling of the goods, such markets are called
cash markets or spot markets.
b. Future marketing: These are the markets in which future sales and purchase of commodities take place
at the current time. This process is called hedging.
7) On the Basis of Competition
On the basis of competition, the markets are categorized into perfectly competitive markets and imperfectly
competitive markets.
8) On the Basis of Government Intervention and Regulation
a. Regulated Markets: The statutory market committees govern regulated markets and the Government
from time to time makes marketing acts. The marketing costs, margins, fee, etc., are standardized.
Marketing practices are regulated and facilities created for the smooth conduct of marketing. Prices
prevailing in different markets are displayed through various mass media.
b. Unregulated Markets: In unregulated markets, business is conducted without and supervision. Their is
absence of rules and regulations. The middlemen exploit the farmers and the consumers to the maximum
extent. Sometimes producers are put to loss as middlemen exploit them in weighment, measurement,
payment, etc. to loss as middlemen exploit them in weighment, measurement, payment, etc.
9) On the Basis of Nature of Commodity
a. Commodity Markets: Commodity markets deal with the buying and selling of the commodities.
Examples are cotton market, wheat market, chillies market, cattle market, bullion market, etc.
b. Capital Markets: Capital markets are those markets in which shares, securities, bonds, etc., are being
purchased and sold. Share market and money market are the specific examples.
10) On the Basis of Vision
a. Black Market or Invisible Markets: In these markets the goods are not place in the shops, but they are
kept in the godown of the market. Hence, the name black market. The goods cannot be seen by the naked
eye. On demand, the goods are delivered to the buyer on cash transaction. Any good, which is in short of
supply and anything which is having high effective demand will be sold in the black market. During wars,
 drought, floods, catastrophes, etc., there is a rigorous black marketing activity for scarce goods. Black
markets are closed markets.
b. Open Markets or Visible Markets: These are visible markets and transactions take place between
buyers and sellers and sellers and the price is determined by demand and supply.
Market Structure
The firm’s price and output decisions are made in a given market. The term market is used
indifferent ways. Market can be viewed as the context within which voluntary exchanges among buyers and
sellers take place. The most common method of classifying markets is on the basis of number of sellers and
buyers and the homogeneity or degree of differentiation of the product.
The term competition always specifies the presence in a specific market of two or more sellers and
two or more buyers of a definite commodity, each seller acting independently of every other seller and each
buyer acting independently of buyer. Perfect competition is a market in which every firm is too small to
affect the market sellers (and buyers) transacting a homogeneous product.
In real world, business people use the word competition similar to that of rivalry. In economic
theory, perfect competition means no rivalry among the sellers. The perfectly competitive market is
characterized by a complete absence of rivalry among the sellers. The perfectly competitive market is
characterized by a complete absence of rivalry among the firms (sellers).
Perfect Competition is a market structure where a large number of buyers and sellers are present,
and all are engaged in the buying and selling of the homogeneous products at a single price prevailing in the
market.

1. Large number of buyers and sellers: In perfect competition, the buyers and sellers are large enough, that
no individual can influence the price and the output of the industry. An individual customer cannot influence
 the price of the product, as he is too small in relation to the whole market. Similarly, a single seller cannot
influence the levels of output, who is too small in relation to the gamut of sellers operating in the market.
2. Homogeneous Product: Each competing firm offers the homogeneous product, such that no individual has
a preference for a particular seller over the others. Salt, wheat, coal, etc. are some of the homogeneous
products for which customers are indifferent and buy these from the one who charges a less price. Thus, an
increase in the price would let the customer go to some other supplier.
3. Free Entry and Exit: Under the perfect competition, the firms are free to enter or exit the industry. This
implies, If a firm suffers from a huge loss due to the intense competition in the industry, then it is free to
leave that industry and begin its business operations in any of the industry, it wants. Thus, there is no
restriction on the mobility of sellers.
4. Perfect knowledge of prices and technology: This implies, that both the buyers and sellers have complete
knowledge of the market conditions such as the prices of products and the latest technology being used to
produce it. Hence, they can buy or sell the products anywhere and anytime they want.
5. No transportation cost/ Perfect mobility of resources: There is an absence of transportation cost, i.e.
incurred in carrying the goods from one market to another. This is an essential condition of the perfect
competition since the homogeneous product should have the same price across the market and if the
transportation cost is added to it, then the prices may differ.
6. Absence of Government and Artificial Restrictions: Under the perfect competition, both the buyers and
sellers are free to buy and sell the goods and services. This means any customer can buy from any seller, and
any seller can sell to any buyer.Thus, no restriction is imposed on either party. Also, the prices are liable to
change freely as per the demand-supply conditions. In such a situation, no big producer and the government
can intervene and control the demand, supply or price of the goods and services.

Imperfect Competition- Any deviation from the conditions of perfect competition in a market leads to the
existence of imperfect competition.
1. Few number of buyer and seller
2. Heterogeneous product
3. Restricted entry and exit of firms
4. Govt. Regulation
5. Less mobility of resources
6. Less knowledge

Types of imperfect competition

1. Monopoly- One seller
 2. Duopoly- Two seller
3. Oligopoly- More than two but few sellers
4. Monopsony- One buyer
5. Duopsony- Two buyer
6. Oligospony- More than two but few buyers
7. Bilateral monopoly- One buyer and one seller
8. Monopolistic competition- Many sellers with heterogeneous products.

MONOPOLY
Monopoly is a market condition, wherein the entire supply of a commodity is concentrated in the
hands of a single firm. There exist no close substitutes for the product produced by a monopolist. The cross
elasticity of demand is very low for the product. In monopoly, the firm and the industry are the same.
Though he controls both price and output policies, he cannot adopt the same simultaneously, because the
monopolist has the choice of fixing its own price, but cannot sell the expected quantity at the chosen price.
Normally he decides the output and fixes the price for the product. He chooses between two options. He has
to produce either more output to sell at a lower price or produce less output to sell at a higher price.
Monopoly is of two types, viz., pure monopoly and imperfect monopoly.
The cross elasticity of demand for the product under pure monopoly is zero. The existence of pure
monopoly is of theoretical interest only. It is far from reality in the real world situation. As against pure
monopoly, imperfect monopoly is a condition which is found is reality with the following features.
(1)Product with a very low cross elasticity of demand.
(2)Intentions to maximize profits.
(3)No role of individual consumer influencing the price.
(4)Uniform price for all the consumers, and
(5)Absolutely no threat from the other firms.

DUOPOLY
Duopoly is a market situation in which there are only two sellers. It is very close to oligopoly in all
respects barring the number of firms. Each firm keeps a close watch on the actions of the other firms as a
chain reaction is imminent since the policy of one is immediately challenged by the other. This sort of
rivalry goes ahead in duopoly. So as to continue in the business, one firm has to make an intelligent guess of
rival’s actions. Hence, the stiff competition exists between the two firms. If each seller feels that the
competition in which there are locked in is going to ruin their fortunes, a mutual agreement is arrived at for
the benefit of both the firms. Thus, in duopoly, competitions as well as co-operation coexist.

OLIGOPOLY
It represents the presence of a few firms in the market, producing either a homogeneous product or products
which are close but not perfect substitutes to each other. Oligopoly can be divided into two forms, viz.,
perfect oligopoly, wherein a few firms produce a homogenous product and imperfect oligopoly wherein
there are a few firms producing heterogeneous products. The examples are televisions, two wheelers, four
wheelers, types, cigarettes, textiles, etc.

MONOPSONY
Monopsony means the presence of a single buyer for the products produced by the firms. The example that
can be cited is sugar factory. Farmers who are registered as sugarcane growers under factory’s jurisdiction
are supposed to sell the cane to sugar factory only. Tobacco board and coffee board can be cited as other
relevant examples.

OLIGOPSONY
It is from the buyer’s side in a market. There are only few in number buying sizeable quantities of a product.
Each individual buyer is so powerful that his buying behavi0our influences the market price. The relevant
examples are gas and iron ores. These are purchased by a few firms in the country and final products are
supplied to the market through these oligopsonies, viz., Tata Company for purchases iron ore, Hindustan
Petroleum Corporation buys the gas from Government or supplies to consumers after refinement etc.

MONOPOLISTIC COMPETITION
It is a market situation in which the transacted products of various firms are not perfect substitutes.
Firms in the industry produce heterogeneous products. Products look rather similar but possess some
distinguishing features. They are not identical. Thus product differentiation is an important feature of
monopolistic competition. Another feature is the production of goods under different brand names. There
are large number of firms so that no single firm is in a position to influence the industry through its output
and price policies.
Under competition of this nature, since every good satisfies a given want of the consumers, the
quality aspects of the product of a given firm catch the attention of the consumers over the same type of
product produced by other firms. Some consumers don’t mind to pay premium prices for certain quality
products of a given firm. Sales promotion activity viz., advertisement and propaganda is another feature of
monopolistic competition.

Price determination under perfect market situation:

The interaction between these two forces of demand and supply determines price in the market. It is
not the demand and supply of the single buyer and firm respectively that determine price but it is the
demand of all the buyers taken together and the supply of all the firms taken together that determine the
price by their interaction.
The price at which demand and supply are equal is known as an equilibrium price, since at this price
the forces of demand and supply are balanced, or are in equilibrium. The quantity bought and sold (or
the amount supplied or demanded) at this equilibrium price is known as equilibrium amount.
If the equality between quantity demanded and supplied does not hold for some price, buyers’ and
sellers’ desires are divergent: either the amount demanded by buyers is more than that offered by sellers, or
the amount offered for supply by sellers is greater than the amount demanded by buyers. In either case, the
price will change so as to bring about equality between quantity demanded and quantity supplied.
Diagrammatic Representation. An example in terms of both schedules and curves will make the whole
thing clear. The table given below gives the demand and supply schedules relating to a variety of cotton
cloth, and in Fig below DD is the demand curve and SS is the supply curve. A glance at the table and the
figure will show how the price is determined by demand and supply.
It will be seen that, when price is Rs. 15 per metre, 12 million metres are supplied and 12 million metres are
demanded; the quantity demanded is equal to the quantity supplied. Rs. 15 per metre, therefore, is the
equilibrium price. Price is in equilibrium at Rs. 15 or price of Rs. 15 will persist in the market, because at
this level there is no tendency for it to rise or fall. Of course this equilibrium price may not be reached at
once. There may have to be an intitial period of trial and error or oscillations around this equilibrium level
before price finally settles down and supply balances demand.

Equilibrium of the Firm and Industry under Perfect Competition

It is essential to know the meaning of firm and industry before analysing the two. Firm is an organisation
which produces and supplies goods that are demanded by the people with the goal of maximising its profits.
Industry is a group of firms producing homogeneous products in a market.
Output Decisions of the firm-short run equilibrium
The interaction of demand and supply curves determines the market equilibrium price and output. A
perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market
price. Short run is the planning period during which the rate of output can be changed by intensive use of
existing plant. The total curves approach and the marginal and average curves approach are used in the
choice of profit maximizing level of output.
Total curves approach:
A firm is in equilibrium when it has no tendency to change its level of output i.e., the firm needs neither
expansion nor contraction. In equilibrium, the firm maximizes its profits, which by definition is the
difference between total revenue (TR) and total cost (TC). A perfectly competitive firm is in equilibrium
when it produces the output that maximizes the difference between TR and TC.

Fig: Determination of profit maximizing output in the short run, total curves approach
The profit maximizing or optimal output is determined where the vertical distance between TC and TR is the
greatest.
Marginal curves approach:
A firm in perfect competition can sell any amount of goods without affecting the price. Hence the demand or
average revenue (AR) curve is a horizontal line at the height of the market price. Any additional output can
be sold at a given market price and hence marginal revenue is equal to the price. Hence in perfect
completion, MR = AR = Price

Fig: Determination of profit maximizing output in the short run, marginal curves approach
Conditions of Equilibrium of firms in short run:
A firm would be in equilibrium when the following two conditions are fulfilled:
1. MC = MR.
2. MC curve cuts MR curve from below.
Consider the Fig. 8.1 in which price 0P is prevailing in the market. Marginal cost curve cuts MR
curve at two different points E0 and E1 and marginal cost and marginal revenue are equal at these two
points. E0 cannot be the position of equilibrium since at E0 second condition of the firms equilibrium is not
satisfied.
The firm can increase its profits by increasing production beyond E0 because marginal revenue is
greater than marginal cost. The firm will be in equilibrium at point E1 or output 0Q1 since at E1 marginal
cost equals to marginal revenue as well as marginal cost curve cuts marginal revenue curve from below.

Long run equilibrium of the firm:

Long run is the planning period during which a firm can make more adjustments than in the short run. In the
long run, the firm can adjust its plant capacity or its scale of operations. Hence all costs are variable in the
long run. Firms must earn normal profits. If the price is more than long run average cost (LAC), the firms
can earn supernormal profits. Attracted by these profits, new firms will enter the industry and supernormal
profits will be competed anyway. If the price is less than LAC, firms incur losses and some of the firms
leave the industry so that no firms earn more than normal profits.
The condition for long run equilibrium of the firm is that marginal cost equals the price and the long run
average cost.
LMC = LAC = Price
At equilibrium, the short run marginal cost is equal to the long run marginal cost and the short run average
cost is equal to the long run average cost.
SMC = LMC = LAC = SAC = P = MR
Long run equilibrium of the industry:
The industry is in long run equilibrium, when all firms are earning normal profits. Under these conditions
there is no entry or exit of firms in the industry. The firm is in equilibrium at the level of output where
LMC = SMC = P = MR

Shut down point: In the short run, a firm will continue to produce only if it covers variable costs. If it fails
to cover the variable costs, it will close down the operations to minimize losses. The point at which the firm
covers its variable costs is called shut down or closing down point. Hence the firm would like to close down
the operations if the price of the product is less than its AVC. However, if the price is greater than AVC but
less than ATC or AC, then the firm would continue its production in the short run because contribution of
profits can be made to fixed costs.
Break-even point: The break-even point (BEP) in economics is the point at which total cost and total
revenue are equal, i.e. "even". There is no net loss or gain. In short, all costs that must be paid are paid, and
there is neither profit nor loss. It represents the sales amount in either unit (quantity) or revenue (sales) terms
that is required to cover total costs, consisting of both fixed and variable costs to the company. Total profit
at the break-even point is zero. It is only possible for a firm to pass the break-even point if the value of sales
is higher than the variable cost per unit.

FACTORS OF PRODUCTION
These mean the production resources required to produce a given product. Fraser defined factor of
production as “a group or class of original productive resources”. The factors of production have been
traditionally classified as land, labour, capital and organization, the details of which are presented below:
LAND
According to Marshall, land means “the materials and forces which nature gives freely for man’s aid, in land
and water, in air and light and heat”. Land refers to soil used for cultivation of construction. But in
Agricultural economics land means the materials and the forces which nature gives freely for man’s aid, in
land and water, in air and light, and heat (Marshall) {i.e. many things such as sunshine, rain, wind,
waterfalls, seas, rivers, minerals, magnetism, forests, animals etc., given free by the nature and economically
useful to mankind are included in it}.

Characteristics/peculiarities of land:
1. Land is free gift of nature and not man made i.e. land has no cost of production of the society.
2. The quantity/ extent is finite or given i.e. limited in supply. Its supply can be neither increased not
decreased by human effort and is a permanent resource. Hence economists’ remark that land has no supply
price i.e. supply of land is inelastic.
3. Land is heterogeneous (Ex: Fertility status, productivity etc.,)
4. Land has multiple uses (Ex: Cultivation, dairy farming, sheep rearing, building construction, playground
and so on. As it has multiple uses, its demand exceeds the supply, boosting its value to a very high level.
5. Land subject to the operation of law of diminishing returns (The constant and continuous cultivation
with more labour & capital results in diminishing yield year by year).
Factors affecting land productivity:
1. Natural factors: Like climate, slope of land, chemical and biological properties of soil, rainfall etc.,
2. Irrigation potentials: The land with more irrigation potential will be more productive. Artificial means
of irrigation viz., wells, tube wells, tanks, canals etc.. helps in supply of water.
3. Organization: An efficient and capable organizer will judiciously use the land resulting in increasing
productivity.
4. Location: Ex: Nearness to irrigation source, market access etc.,
5. Ownership: Owners always take much interest in increasing the productivity but it is reverse with the
temporary settlers.
6. Availability of capital: The productivity can be increasing with the availability of seed, fertilizers,
machines etc., Intensive cultivation gives more productivity, which is possible with availability of capital.
7. Proper use: Suitability for a particular use need to be known in prior. Ex: Land use for paddy, if used for
pulses, gives decreased productivity.
8. Availability of lavour: If labour is efficient, trained and capable to employ techniques, the land
productivity can be increased.
9. Government policy: Ex: Adoption of proper agricultural policy, providing require assistance to farmers,
etc.,
10. Agricultural research: Adoption of improved package of practices results in increase productivity.

LABOUR
The term, labour has wide and diversified meaning in economics. It can be physical work or mental work
that is done by a person with an aim of earning money. It includes the work done by farmers, workers, the
service of teachers, doctors, actors, etc. In the words of Marshall, labour is defined as “any exertion of mind
or body undergone partly or wholly with a view to earn some good other than the pleasure derived directly
from the work”. Any work that is done for pleasure does not come under labour.
Characteristics of Labour
1. Labour is Inseperable from Labourer: The worker has to sell his labour in person and he has to be
physically present, while delivering the work. He cannot deliver the work in absentia. It varies from labourer
to labourer depending on races, climate, physical and mental alertness of labourer.
2. Labour is Perishable: Labour cannot be preserved which means that labourer has no reserve price. He
has to sell the work without really minding the wages, fork, a day’s work lost is a loss forever. In other
words, it is a flow resource.
3. Labour has Very Weak Bargaining Power: Perishability of labour is a prime factor for the labourer,
which rather forces him to accept whatever the wage that is offered. The weak bargaining power of the
labourer is taken as an advantage by the employer.
4. Lack of Free Mobility: Compared to capital, labour is less mobile. No doubt labourers move from one
place ot another and from one occupation to another, but it is not a common feature. Thus, labour lacks
horizontal and geographical mobility. This leads to a variation in wages among the occupations as well as
spatially.
5. Supply of Labour is Independent of Demand: Supply of labour depends on the population in a country.
Population is one factor which can neither be increased nor decreased overnight. The increase or decrease is
a slow process and supply of labour is independent of demand.
6. Supply of Labour Peculiarly Changes with the Wages: Normally the seller of a good sells more when
the price per unit of commodity is higher and vice versa. But regarding labour a fall in wages leads to an
increased supply of labour. A fall in wages leads to a reduction of their incomes. So to make good this fall in
income, family members who were not working earlier also work to supplement the family income.

Efficiency of Labour
According to economists efficiency of labour means “the ability of labour by virture of which it is
productive” It indicates the qualitative and quantitative performance of the labourer. No doubt, it is a
relative term, but when one person puts up a better performance over others, we say that he is more efficient.
All individuals are not equally efficient, because of several factors which are examined below:
1. Racial and Hereditary Characters: Some races are known for their physical and some are for their
intellectual qualities. This emerges out of climate and natural environment. Pattans are well built and
physically very strong. The Punjabies and Rajpupts are hard working compared to other Indians.
2. Literacy and Training: Education brightens the outlook of labourers and builds up character. Training
imparted to the labourers make them more efficient to do specialized works.
3. Environment: The working environment must be congental for the labourers to put up an impressive
performance. Environment refers to conditions in the work place in which the labourers have to work and
the equipment and machinery which they handle. Better physical facilities, modern machinery and
equipment encourage to get best out of them.
4. Working Hours: Long working hours retard the performance and the efficiency of labourers. The
working hours should facilitate them to relax. Short working hours keep them fresh and help to rejuvenate
their energies.
5. Fair and Prompt Payment: Wages influence the performance of labour. Fair and prompt payments of
wages encourage them to put their heart and soul into the job.
6. Capability of Organization: Organization has to plan to allocate the right people at right places for the
right work. Assignment of work as per the capabilities of labour leads to expected output and maximum
profits.
7. Social and Political Factors: Social securities for the labourers and concern of State towards their
conditions will be quite encouraging to improve their efficiency.
8. Personal Qualities: Personal qualities like intelligence, alertness, honesty, health etc., improve the
efficiency of labourers.
9. Incentives: Incentives like extra payment, and some perquisites for a good performance encourage them
to be more devoted to the work.

Division of Labour
In modern production activity, the production of a good is divided into several sub-processes, and each sub-
process is entrusted to a group of workers. This is what division of labour implies. Division of labour is
meant to improve the efficieny of labourers.
There are three different types of division of labour; and (3) Territorial division of labour.
1. Simple Division of Labour
It is also known as occupational specialization. This means that people in a society undertake various
occupations to make their livelihood. The choice of an occupation depends on the suitability of an individual
in serving the society. That is how we have in a community, some are doctors, others are lawyers, some
others are teachers and we have blacksmiths, goldsmithys and others craftsmen. They execute duties
regularly and help the society to develop by helping themselves through their professions. Some professions
like dry-cleaning, tailoring, etc., have become of late very prosperous and lucrative professions. Hotelling
and mechanical weaving have become gaint industries, which were earlier to be taken up by only certain
sections of the people as profession. From all these things we can conclude that division of labour is fast
growing with full adoption of requisite technology and providing employment to milions of people.
2. Complex Division of Labour
It is assigning the work by task. The task here is a sub-process that is found in producing a commodity. Each
group of people is given a task in which it is considered as specialists. For example, in making silk cloth,
many sub-processes such as reeling, weaving, dyeing, etc., are involved and for all these sub-processes such
as reeling, weaving, dyeing, etc., are involved and for all these sub processes we require sophisticated
technology and trained people to run the silk industry. Similarly, in the manufacturing of tractors, electric
motors, TVs, etc., many sub processes are involved.
3. Territorial Division of Labour
It refers to localization of industries. Certain areas or regions specialize in production of a commodity. The
examples are textile mills in Bombay and Ahmedabad, silk sarees in Kanchi, jute mills in Kolkata, leather in
Kanpur, etc.

Merits of Division of labour

1. Increases Productivity
2. Improvement in Dexterity
3. Saving of Time
4. Saving in Tools and Implements
5. Employment of Specialists
6. Large-scale Production
Demerits of Division of Labour
1. Monotony
2. Retards Human Development
3. Lack of General Responsibility

Measurement of unemployment
Chronic Unemployment or Usual Principal Status of Unemployment.
It is measured in terms of number of persons I.e., persons who remained unemployed for major part of the
year. This measure is more appropriate to those, who are in search of regular employment. Example:
Educated and skilled persons, who may not accept casual work. It is also referred to as ‘open
unemployment’.
1. Weekly Status Unemployment: this is measured in number of persons i.e., persons who did not find
even an hour of working during the survey week.
2. Daily Status Unemployment: It is measured in person days or person years i.e., persons who did not find
work on a day or some days during the survey week.
3. Under Employment: It is a very common phenomenon in less developed economies in general and rural
areas in particular. Under employment represents people employed on part time basis, seasonal basis or even
as casual labourers. In jobs of this nature their productivity as well as incomes are low.
4. Visible Under-employment: It indicates the shorter than normal periods of work. Persons involuntarily
work less than the labour time they are available for gainful employment.
5. Invisible Under-employment: It is the characteristic of persons whose working time is not abnormally
reduced, but whose earnings are abnormally low or whose jobs do not permit full use of their capabilities or
skills or who are employed in the establishment of economic unit whose productivity is abnormally low.
6. Involuntary Unemployment: This is defined as the unemployment due to non availability or
insufficiency of work during periods say a few weeks, a few months, or even a few years, when the worker
in question wants to work.
7. Disguised Unemployment: This means that people are engaged in occupations, where their marginal
productivity is very low (if not zero or negative). A shift to alternative occupations will improve their
marginal productivity and add to the national income.

CAPITAL
Capital is not an original factor like land, but it is the result of manmade efforts. Man makes the capital
goods to produce other goods and services. For example, machinery, raw material, transport equipment,
dams, etc., are considered as capital goods.
Definitions
1. Capital is produced means of production.
2. According to Karl Marx, capital is ‘crystallized labour’. This is indicated in his book, ‘Das Kapital’.
All capital is necessarily wealth but all wealth is not necessarily capital. Money when used for the purchase
of capital goods, then only it becomes capital. For instance, residential buildings are the wealth of the
individuals, but these are not considered as capital.
Characteristics of Capital
1. Capital is not a free gift of nature. It is the result of man-made efforts. Machinery, implements, etc., are
considered as capital goods.
2. Capital is productive, as it helps in enhancing the overall productivity of all the resources employed in
the production process. Invested capital also fetches interest for its productive capacity. Farm machinery
when used with skilled labourers enhances the productivity of land. Irrigation dam is considered as the
capital good and with its water; we can bring out complementary effect on the productivity of other
resources such as fertilizers, seeds, etc.
3. It is also prospective as its accumulation rewards income in future. Savings and investment in the
economy leads to growth and development of the economy due to accumulation of capital over time.
4. Capital is highly mobile as it possesses the characteristic of territorial mobility. For example, capital
goods like tractor can be taken to different.
5. Capital is supply elastic as its supply can be altered according to the need. Based on demand, supply of
the capital goods can be changed.
Classification of Capital
Capital is classified based on several criteria the details of which are given below:
1. Based on Nature of Ownership
a) Individual Capital or Private Capital: These are the assets which are owned by the individuals in the
business.
b) National Capital: It is the capital that is owned by the community. Examples: Airways, Railways, etc.
2. Based on Durability
a) Fixed Capital: It is the capital which is used time and agai8n in the production of other goods. Examples:
Machinery, tools, etc.
b) Circulating Capital or Working Capital: It is the capital that is used once and exhausts after a single
use. Examples: Fertilizers, seeds, feeds, etc.
3. Based on the Scope of Alternative Uses
a) Sunk Capital or Specific Capital: These are the capital goods, the use of which is confined to a specific
purpose. Examples: Plough, seed drill, harvester, transplanter, winnower, etc.
b) Floating capital: It is the capital good that can be used for different purposes at any time. Examples:
Electricity, coal, etc.
4. Based on Incentives
a) Remunerative Capital: The capital when used for the payment of wages in the production process, is
called remunerative capital. Examples: Liquid money or case, Foodgrains, etc.
b) Auxiliary Capital: It represents the various capital goods that help the labourers in the production
process. Examples: Machinery, tools, etc.
5. Based on Usage
a) Production Capital: These are the capital goods which help the labourers directly in the production
activity. Examples: Food grain, cloth, money used for consumption, etc.
b) Consumption capital: these are the goods which are consumed by the labourers. These indirectly assist
in the process of production, Examples: Food grains cloth money used for consumption etc.
6. Based on Place
a) Internal Capital: The capital that is generated from the domestic savings of the public in a nation. Ex:
Public roads, etc.
b) External Capital: This is the capital generated from the external source. Examples: Funds received from
World Bank, aid from UNO, etc.
Capital formation
Murray and Nelson says that capital formation is the investment. Capital formation means increasing
the stock of real capital in a country. In other words capital formation involves making of more capital
goods such as Machines, tools, factories, transport equipment, materials, electricity etc, which are all used
for future production of goods. For making additions to the stock of capital, savings and investment are
essential.
The amount which a community adds to its stock of capital during a year is called capital formation
in that year savings is equal to total output – consumption during the year. It represents surplus of
production over consumption.
S=Y-C
where S= Savings
Y= Total output
C = Consumption
In any form of Economy where socialist like Russia or capitalists like America, capital formation is a must
for economic development.
Stages of Capital formation.
In order to accumulate capital goods, some current consumption has to be sacrificed, so that it can be
diverted to new capital formation savings and investment are so consolidated to have capital formation.
Capital formation takes place in stages.
1. Creation of savings
2. Mobilisation of savings
3. Investment of savings
1. Creation of savings:
Savings are done by:
i) Individual/household/voluntary organizations
ii) Business enterprises
iii) Government on compulsory basis
The level of saving in particular country depends up on
1) Power to save
2) Will to save
Power to save depends up on
1) Average level of Income
2) Distribution of National Income
A part from the power to save, the total amount of savings depends up on the will to save various personal,
family and national/considerations induce the people to save people save in order to provide against old age,
unforeseen emergencies. Some people desire to save a large amount to start new business or to expand the
existing business moreover people want to make provision for education, Marriage and to give a good start
in business for their children.
Savings are of two types:
1. Forced savings: Tax imposed by Government represents forced savings.
2. Voluntary savings: The savings which people do of their own free will. Business people save by
retaining a part of their profits in the form of undistributed profits. They use these profits for investment in
real capital. Government increases savings by collecting taxes and profits from public undertaking to build
up new capital goods like factories.
2. Mobilisation of savings
The amount that was saved by individuals, business man and Government should be transferred to
businessmen (or) entrepreneurs who require them for investment. In the capital market funds are supplied by
the individuals investors, banks, investment trusts, insurance companies, finance corporations, Governments
etc., If the rate of capital formation is to be stepped up the development of capital market is very necessary a
well developed capital market will ensure that the savings of the society will be mobilized and transferred to
the businessmen for investment.
3. Investment of savings:
For savings to results in capital formation, they must be invested by business men who are honest and
dynamic in the country, who are able to take risk and bear uncertainty of production.
Factors affecting Capital formation:
1) Per capital income will influence the capital formation
2) Technology
3) Productivity
4) Government policies
5) Tradition/ customs of Society
6) Desire for saving the amount for old age Needs.
7) Desire for saving the amount for meeting children education, Marriages etc.
8) Good infrastructural facilities (Roads, Railways, etc.)
Causes for low capital formation
1. Low Income of Individual
2. Poor technology is being existed
3. Low productivity
4. Domestic savings are very small
5. Inducement to investment is very weak.
Why capital formation is essential:
1. For higher production & productivity
2. For higher level of Income
3. For better employment
4. For high standard of living
5. For better Economic condition
6. For high infrastructural facilities
Suggestions for improvement of Capital formation
1. Production should be increased by developing Agriculture, trade, Industry, transport, banking, insurance
2. Compulsory insurance scheme should be implemented
3. Provident fund scheme should be extended
4. Tax reliefs should be given to industries which are producing capital goods.
5. Safety of life and property Guaranteed
6. Capital market should be well established
7. Population should be controlled
8. The working of stock exchanges should be improved
9. Small saving drive should be intensified

ORGANIZATION
In any business activity, there is always a person who guides and controls its function. He also coordinates
and regulates all the factors which are employed in the business activity. Apart from monitoring it, he takes
the responsibility of the outcome. We call such a person, an entrepreneur (organizer) and the business
activity which he is doing is called an enterprise or organization. The performance of organization depends
upon the capabilities of the organizer or entrepreneur. Through proper allocation of resources, the
entrepreneur would be in a position to maximize productivity of the resources that are used. Hence, the
success or failure of enterprise depends on the role of the entrepreneur in any business activity. Following
are the prime functions of an entrepreneur.
Functions of Entrepreneur
1. Identification and Initiation: Entrepreneur is the person who identifies a particular business activity and
initiates the idea of commencing the business. At this stage the nature of enterprise to be started is decided
by the entrepreneur. He has to venture and assume full risk for maximizing profits from his chosen business
enterprise.
2. Location of the Enterprise: The place where the business unit is proposed to be set up is finalized by the
entrepreneur. He considers both absolute and relative advantage of enterprise in choosing a particular place.
3. Organizing: At the outset arrangements are made to raise the required finance to commence the business.
Later, the work is divided into various functions, viz., production, financing, marketing, etc. This division of
functions allows for increasing the efficiency of the individuals. Once the divisions are made, the concerned
persons are given adequate authority to enable them to perform their functions efficiently. Delegation of
authority to a person makes him more responsible and scrupulous. Authority and responsibility always go
together.
4. Supervision: It is overseeing the work of the subordinates so as to ensure the desired results. Supervision
includes whether the persons and their subordinates are keeping time schedules, whether the work is
performed as per the requirements, and also helping them in solving their problems.
5. Introduction of Innovation: The entrepreneur is always on the look out for bringing innovations. It may
be in terms of bringing out a variety of products, introduction of new methods of production, improving the
existing method of production, making inroads into new market, etc.
6. Risk Taking: The entrepreneur is quite prepared to accept the outcome of all his actions. In the business
he may get substantial profit from organization or at times unexpectedly he may incur loss as well. He
accepts them with poise, because he is responsible for all the happenings. All entrepreneurs, infact should
have risk bearing ability.

FORMS OF BUSINESS ORGANIZATION

Individual Enterprise or Single Proprietorship or Sole Trader or the Sole Proprietorship
The individual enterprise is the most common form of business organization. Many small business
enterprises belong to this form. These enterprises are owned and operated by a single person, who takes all
the responsibilities of outcome of the business. These enterprises are found to be small with a few
exceptions here and there. This is more or less a family proprietorship with all the family members
participating in the business affairs. As far as the size of the business is concerned, it is left to the desire of
the entrepreneur keeping in view of the resources at his disposal.
Merits
The owner of the business enjoys absolute freedom without the inter4ference of anybody in the business.
The firms are called by the name of the entrepreneurs and some times by the name of Gods. The owner or
proprietor enjoys all the profits received from the business. Capital requirements are less. Capital is supplied
from the owner’s funds (equity funds) and often times there is not much distinction between personal and
business assets. This type of business is more flexible allowing changes in various business decisions like
investment, sales, diversifying the business activities, expanding size of the business, etc. In this form of
business organization, there is the possibi8lity of direct contact with the customers, so that the entrepreneur
gets continuous feed-back. The entrepreneur controls the entire business, unless and otherwise delegated to
somebody else. This type of business is very easy to start and easy to terminate.
Demerits
Since proprietor’s funds are by far the sole source of funds, there would be limited amount of capital for the
business to expand. Though funds from institutional agencies are available, the amount is restricted in view
of the limited securities. Unlimited liabililty is the negative factor of this type of business. This means that in
the event of failure of the business, creditors (lenders) are empowered to exercise every right to attach not
only the assets of the business, but also the personal property of owners to make good the unpaid debts.
Since the power is concentrated in the hands of single owner of the business, there is no scope for those
employees of the firm who are well trained and motivated to contribute their knowledge to the business
growth. This leaves a situation of discontentment among the employees, the attitude of which will not
contribute to the growth of the business. Besides, employees always will have a lurking fear that their fate
depends upon the skill of one individual. The continuity of the business is also questioned, as the death of
owner brings the business to a grinding halt.

PARTNERSHIP
It is an association of two or more individuals who join together as co-owners to share profits or losses in
agreed proportions. Partnership comes into existence based on the goals of the coowners. To safeguard the
business interests of the partners, normally a written partnership agreement is made covering various
dimensions of business viz., capital contribution, managerial responsibilities, sharing of profit and losses,
withdrawal from the business, termination of the business, etc. There are two kinds of partnership, viz.,
general partnership and the limited partnership. General partnership is the most common in partnership
dealings. Every partner, irrespective of the percentage of capital contributed to the business, has equal
say in the management of business. Each partner has equal rights and liabilities. In limited partnership, any
number of limited partners are allowed, but there should be at least on general partner. Liability of each
member is limited to the extent of investment made only. Profits are also distributed among the partners
according to the contribution of capital in the business.
Merits
The basic advantage of partnership is generation of greater financial resources coupled with diversified
managerial talents. Partners pool their resources to attract larger capital to invest in the business. It can
command great amount of credit from the institutional agencies in view of its large equity capital.
Management element is also strengthened as partners possess varied managerial skills. Simplicity of the
business is also another feature, for it is easy to dissolve as compared to a joint stock company. It also
enjoys the freedom from Government control. Risk of the business is shared by the partners and hence
relatively it has less business risk.
Demerits
Unlimited liability is the major disadvantage of partnership. All the partners are responsible for the loss
arising from the partnership business. The partners stand to lose their personal assests in the event of
liquidation. As against the individual enterprise, the ownership0 is divided in partnership business. Every
partner has equal right in the business activities. Partnership has a limited size of business and uncertain life.
Partnership may vertically split due to disagreement on a particular decision. The retirement, death of a
partner, bankruptcy etc., may bring termination of the business according to law. Besides dishonest member
may spoil the business with his dishonesty activities and make other partners to be responsible of his
actions. It is not that much easy to find qualifies and agreeable partners for managi8ng the business on
partnership. Since the decisions are taken by the consensus of all the partners, more often it is difficult to
convince all the partners on certain decisions.

JOINT STOCK COMPANY

The drawbacks of individual enterprise and partnership business gave rise to the organization of another
form called Joint Stock Company. More specifically the discouraging aspects of unlimited liability closely
followed by limitation of funds in the above forms were taken care of by Joint Stock Company. Joint Stock
Company has the limited liability and the involvement of large number of persons. This helps it to have
adequate capital. Limited liability implies that in the event of loss for the company, shareholder is
responsible to the extent of his shares only. A joint stock company is a corporate body owned by a large
number of shareholders and managed by a Board of Directors elected by the shareholders. According to
Prof. L.H. Hany “A joint stock company is a voluntary association of individuals for profit, having a capital
divide into transferable shares, the ownership of which is the condition of membership”. In India the first
Companies Act was passed in 1850 and limited liability was incorporated in 1857. Broadly there are two
types of joint stock companies. These are 1) Joint stock private limited company and 2) Joint stock public
limited company. To start a joint stock company, two documents, viz., memorandum of association and
articles of association are to be submitted to the registrar of joint stock companies. Memorandum of
association contains the name of the company, the location of the head office, its aims, share capital
particular, kind and value of shares and declaration of limited liability. Rules and regulations for the
establishment of Joint Stock Company are incorporated in the articles of association.
Joint Stock Private Limited Company
The minimum number of members is two but the number cannot exceed 50. There is no need for the private
limited company to call for a statutory meeting. Similarly, the company need not submit its annual balance
sheet to the registrar of joint stock companies. The transfer of share is generally restricted by articles. It
cannot issue prospectus inviting the public to subscribe to the share capital. The word ‘Pvt. Ltd’ must be
used with the name of the company.
Joint Stock Public Limited Company
The business can be started with seven persons and there is no maximum limit for members. The business
shall commence only after getting the certificate of incorporation from the registrar of joint stock
companies. The public limited company must issue a prospectus inviting the public to contribute to the share
capital. A statutory meeting must be held within a prescribed period and its annual balance sheet must be
submitted to the registrar of joint stock companies. The main sources of finance for the company are through
shares and borrowings. The shares are freely transferable. A shareholder can sell his shares at any time he
prefers. The company will not return the shares to the shareholder till it winds up the business, but
shareholders can easily sell their shares through stock exchange.
Merits
1. Large-scale Resource Mobilization. It facilitates mobilization of large scale resources. Large sum of
capital can be raised from large number of shareholders. There is no limit as a far as the number of share
holders are considered in a public company. If more funds are required the number of share holders can be
increased.
2. Efficient Management: The elected board of directors and expert managers provide the needed business
expertise. The efficient management of the joint stock company provides the needed impetus for business
growth.
3. Limited Liability: Limited liability encourages many individuals to invest in shares.
4. Less Risk for the Shareholder: Because of limited liability even in the event of company incurring
losses, the loss for the share. Hence there is less risk for the shareholder.
5. Perpetual Existence: It is an organization with perpetual succession. The shareholders keep on changing
from time to time. But the business of the company is not affect the existence of the company.
6. Democratic Management: The directors are elected by the share holders; hence there is no scope for the
continuation of undesirable directors. Moreover, every individual whomsoever wants to become a
shareholder, he is welcome and shareholders come from all walks of life and places.
7. Social Benefits: The savings of the people which are otherwise scattered are well mobilized by
companies and productively invested. Thus the society gains from the investment activities in the form of
getting the goods and services they need.
8. Economies of Scale: Since the companies are large-scale organizations, they enjoy economies of scale
and produce goods at lower costs and receive more profits.
Demerits
1. Concentration of Economic Powers: The owners of the company are shareholders but management is
done by different individuals. The administration is concentrated in a few hands. The shareholders, who are
scattered all over, cannot influence the management. They are either powerless or not interested to act as per
their desires.
2. Fraudulent Management: The management of the company exhibits vested interests and shows little
concern for the shareholders.
3. Delays in Decision-making: Decisions cannot be taken quickly and they are to be taken in the meeting of
board of directors or general body. It is not very easy to convene the meetings and they are time-consuming.
These delays may cause further delays and result in deferred decisions.
4. Excessive State Regulation: The companies are governed by a number of rules of the Government. It is
infact compulsory, because huge public funds are invested in the companies. Since non-compliance leads to
penalties, companies have to give a lot of attention for these rules. Consequently, the main objective of the
company is likely to be diverted.
5. Evils of Factory System: The evils of factory system like insanitation, pollution, congestion, etc., are
attributed to joint stock companies.
6. Problems in Formation of Companies: As a matter of fact a number of stages are involved in the
promotion of a company by Government. Getting right persons in sufficient number for the company is a
difficult proposition. A number of legal formalities are to be followed at the time of registration apart from
the risks in promotion of the company.

CO-OPERATIVE ORGANIZATION
The term, co-operation implies the self help made effective through mutual help. The philosophy behind co-
operative movement embodies in a slogan called “all for each and each for all”. The basic objective of co-
operation is protecting weaker sections of the society so that they fulfill their needs.
Merits
1. Membership is open to every person. None can prevent any person willing to join the societies.
2. Management of the co-operatives is democratic. The members among themselves elect the board of
management. Every member has equal right in electing the members irrespective of the number of shares.
3. The co-operatives purchase goods from producers directly and sell them to consumers directly. In this
process the middlemen are eliminated.
4. The motto of co-operatives is service, but not profits. Cooperatives aim at spreading the virtues of
discipline, integrity, honesty, mutual help, fairness in dealings, etc.
Demerits
1. They suffer from timely and capital inadequacies. Societies aim at the betterment of weaker sections and
the shares raised from them are of small magnitude. This limitation stands in the way of initiating a large
scale enterprise.
2. Since there is no bar in entering into a society for anybody, the members are drawn from different
sections of the society. This creates lack of understanding among the members. The members as a result do
not take much interest and leaves everything to paid workers.
3. The transactions of the society are in cash and no credit sales are allowed. Since the members come from
poorer sections of the society, they cannot always transact business with cash. Credit facilities which are
found with private traders attract them to buy their requirements.
4. Societies function under the regulation of the Government. Government even nominates members to the
management committee. In nominating the members of political parties take a major role and the business
atmosphere suffers.

STATE OR PUBLIC ENTERPRISE

State enterprise is an undertaking, owned and controlled by the local or State or central Government. Entire
investment or major part of the investment is done by the Government. The major considerations for
the States to undertake the business are heavy investment requirements, need to protect weaker sections
against economically strong, and when private traders are hesitant to venture into the enterprise. State
enterprises are found in manufacturing, trading and service activities. These enterprises are managed by the
Government programmes are implemented through State enterprises.
Merits
1. Industrial development is possible through State enterprises. Private sector does not show much concern
for initiating projects requiring huge capital and long gestation periods.
2. Planned and balanced growth is possible through the entry of Government. Private enterprises show their
preference for establishing industries in developed areas. Government is prepared to establish industries
even in underdeveloped areas which ensure balanced growth in all spheres of activities.
3. Government takes over the sick units, and run them as State enterprises in the interest of the nation.
4. The profits obtained by the State concern are ploughed back into the business for further expansion and
diversification and also for the welfare of the community in general.
5. Government enterpri9ses encourage socialistic pattern of society which reduce economic disparities.
6. There is an attraction for the aspiring qualified individuals to join the Government service. It commands
superior talents.
7. The employees feel greatly secured in Government service.
Demerits
1. The proposed projects by the Government are plagued by undue delays. This is due to the complicated
procedural formalities coupled with non-release of funds in time. These delays make the planned estimates
go topsy-turvy, consequently the expected benefits would not be forthcoming timely.
2. Another demerit of public concern is high overhead costs. These arise out of large amounts of expenditure
on unproductive items coupled with high investment on amenities for employees even before the profit is
earned.
3. State enterprises when compared to private enterprises are not managed efficiently resulting in losses.
4. The security of the job of an employee in a State organization makes him not to bother too much to
deliver the goods, for he gets hid pay regularly.
5. Manpower planning is a lacuna in State enterprises and they employ persons disproportionate to their
needs. This results in over staffing leading to inefficiency and lethargy.
6. Red tappism is prevalent in State enterprises.
7. These are by far service oriented rather than profit oriented.

Production Function
Production is the result of co-operation of four factors of production viz., land, labour, capital and
organization. This is evident from the fact that no single commodity can be produced without the help of any
one of these four factors of production. Therefore, the producer combines all the four factors of production
in a technical proportion. The aim of the producer is to maximize his profit. For this sake, he decides to
maximize the production at minimum cost by means of the best combination of factors of production.
In simple words, production function refers to the functional relationship between the quantity of a
good produced (output) and factors of production (inputs).
In this way, production function reflects how much output we can expect if we have so much of
labour and so much of capital as well as of labour etc. In other words, we can say that production function is
an indicator of the physical relationship between the inputs and output of a firm. Mathematically, such a
basic relationship between inputs and outputs may be expressed as:
Q = f( L, C, N )
Where Q = Quantity of output
L = Labour
C = Capital
N = Land.
Hence, the level of output (Q), depends on the quantities of different inputs (L, C, N) available to the firm.
In the simplest case, where there are only two inputs, labour (L) and capital (C) and one output (Q), the
production function becomes.
Q =f (L, C)
Features of Production Function:
1. Substitutability: The factors of production or inputs are substitutes of one another which make it possible
to vary the total output by changing the quantity of one or a few inputs, while the quantities of all other
inputs are held constant. It is the substitutability of the factors of production that gives rise to the laws of
variable proportions.
2. Complementarity: The factors of production are also complementary to one another, that is, the two or
more inputs are to be used together as nothing will be produced if the quantity of either of the inputs used in
the production process is zero. The principles of returns to scale is another manifestation of complementarity
of inputs as it reveals that the quantity of all inputs are to be increased simultaneously in order to attain a
higher scale of total output.
3. Specificity: It reveals that the inputs are specific to the production of a particular product. Machines and
equipment’s, specialized workers and raw materials are a few examples of the specificity of factors of
production. The specificity may not be complete as factors may be used for production of other commodities
too. This reveals that in the production process none of the factors can be ignored and in some cases
ignorance to even slightest extent is not possible if the factors are perfectly specific.
Law of Variable Proportions
Law of Variable Proportions occupies an important place in economic theory. This law is also known as
Law of Proportionality.
“An increase in some inputs relative to other fixed inputs will in a given state of technology cause output to
increase, but after a point the extra output resulting from the same additions of extra inputs will become less
and less.” Samuelson
Assumptions:
(i) Constant Technology: The state of technology is assumed to be given and constant. If there is an
improvement in technology the production function will move upward.
(ii) Factor Proportions are Variable: The law assumes that factor proportions are variable. If factors of
production are to be combined in a fixed proportion, the law has no validity.
(iii) Homogeneous Factor Units: The units of variable factor are homogeneous. Each unit is identical in
quality and amount with every other unit.
(iv) Short-Run: The law operates in the short-run when it is not possible to vary all factor inputs.
Explanation of the Law:
By keeping land as a fixed factor, the production of variable factor i.e., labour can be shown with the help of
the following table:

From the table it is clear that there are three stages of the law of variable proportion. In the first stage
average production increases as there are more and more doses of labour and capital employed with fixed
factors (land). We see that total product, average product, and marginal product increases but average
product and marginal product increases up to 40 units. Later on, both start decreasing because proportion of
workers to land was sufficient and land is not properly used. This is the end of the first stage.
The second stage starts from where the first stage ends or where AP=MP. In this stage, average
product and marginal product start falling. We should note that marginal product falls at a faster rate than
the average product. Here, total product increases at a diminishing rate. It is also maximum at 70 units of
labour where marginal product becomes zero while average product is never zero or negative.
The third stage begins where second stage ends. This starts from 8th unit. Here, marginal product
is negative and total product falls but average product is still positive. At this stage, any additional dose
leads to positive nuisance because additional dose leads to negative marginal product.
Graphic Presentation:

In figure, on OX axis, we have measured number of labourers while quantity of product is shown on OY
axis. TP is total product curve. Up to point ‘E’, total product is increasing at increasing rate. Between points
E and G it is increasing at the decreasing rate. Here marginal product has started falling. At point ‘G’ i.e.,
when 7 units of labourers are employed, total product is maximum while, marginal product is zero.
Thereafter, it begins to diminish corresponding to negative marginal product. In the lower part of the figure
MP is marginal product curve. Up to point ‘H’ marginal product increases. At point ‘H’, i.e., when 3 units of
labourers are employed, it is maximum. After that, marginal product begins to decrease. Before point ‘I’
marginal product becomes zero at point C and it turns negative. AP curve represents average product.
Before point ‘I’, average product is less than marginal product. At point ‘I’ average product is maximum.
Up to point T, average product increases but after that it starts to diminish.
Three Stages of the Law:
1. First Stage: First stage starts from point ‘O’ and ends up to point F. At point F average product is
maximum and is equal to marginal product. In this stage, total product increases initially at increasing rate
up to point E. between ‘E’ and ‘F’ it increases at diminishing rate. Similarly marginal product also increases
initially and reaches its maximum at point ‘H’. Later on, it begins to diminish and becomes equal to average
product at point T. In this stage, marginal product exceeds average product (MP > AP).
2. Second Stage: It begins from the point F. In this stage, total product increases at diminishing rate and is
at its maximum at point ‘G’ correspondingly marginal product diminishes rapidly and becomes ‘zero’ at
point ‘C’. Average product is maximum at point ‘I’ and thereafter it begins to decrease. In this stage,
marginal product is less than average product (MP < AP).
3. Third Stage: This stage begins beyond point ‘G’. Here total product starts diminishing. Average product
also declines. Marginal product turns negative. Law of diminishing returns firmly manifests itself. In this
stage, no firm will produce anything. This happens because marginal product of the labour becomes
negative. The employer will suffer losses by employing more units of labourers. However, of the three
stages, a firm will like to produce up to any given point in the second stage only.

Law of Returns to Scale

In the long run all factors of production are variable. No factor is fixed. Accordingly, the scale of production
can be changed by changing the quantity of all factors of production.
Definition:
“The term returns to scale refers to the changes in output as all factors change by the same proportion.”
Koutsoyiannis
Explanation:
In the long run, output can be increased by increasing all factors in the same proportion. Generally, laws of
returns to scale refer to an increase in output due to increase in all factors in the same proportion. Such an
increase is called returns to scale.

The above stated table explains the following three stages of returns to scale:
1. Increasing Returns to Scale: Increasing returns to scale or diminishing cost refers to a situation when all
factors of production are increased, output increases at a higher rate. It means if all inputs are doubled,
output will also increase at the faster rate than double. Hence, it is said to be increasing returns to scale.
2. Diminishing Returns to Scale: Diminishing returns or increasing costs refer to that production situation,
where if all the factors of production are increased in a given proportion, output increases in a smaller
proportion. It means, if inputs are doubled, output will be less than doubled. If 20 percent increase in labour
and capital is followed by 10 percent increase in output, then it is an instance of diminishing returns to scale.
3. Constant Returns to Scale: Constant returns to scale or constant cost refers to the production situation in
which output increases exactly in the same proportion in which factors of production are increased. In
simple terms, if factors of production are doubled output will also be doubled.

Factor Market
A factor market is a marketplace for the services of a factor of production. A factor market facilitates
the purchase and sale of services of factors of production, which are inputs like labor, capital, land and raw
materials that are used by a firm to make a finished product. A factor market is distinct from the goods and
services market, which is the market for finished products or services.
For example, in the appliances market, the market for refrigerators and dishwashers would be the goods
market. The market for workers who are skilled in refrigerator and dishwasher assembly would be an
example of a factor market. Another example of a factor market would be the market for raw materials like
steel and plastic, which are two of the materials used for refrigerators and dishwashers.
Factor Pricing:
Factors of production can be defined as inputs used for producing goods or services with the aim to make
economic profit. In economics, there are four main factors of production, namely land, labor, capital, and
enterprise. The price that an entrepreneur pays for availing the services of these factors is called factor
pricing. An entrepreneur pays rent, wages, interest, and profit for availing the services of land, labor, capital,
and enterprise respectively. The theory of factor pricing deals with the price determination of different
factors of production.
 The determination of factor prices is always assumed to be similar to the determination of product
prices. This is because in both the cases, the prices are determined with the help of demand and supply
forces. Moreover, the demand for factors of production is similar to the demand for products. However,
there are two main differences on the supply side of factors of production and products. Firstly, in product
market, the supply of a product is determined by its marginal cost of production. On the other hand, in factor
market, it is not possible to determine the supply of factors on the basis of marginal cost.
For example, it is difficult to ascertain the exact cost of production for factors, such as land and
capital. Secondly, the supply of factors of production cannot be readily adjusted as in the case of products.
For instance, if the demand for a land increases, then it is not possible to increase its supply immediately.
There are two aspects of each factor ofproduction, which are as follows:
i. Price Aspect: Refers to the aspect in which an organization pays a certain amount to avail the services of
factors of production. For example, wages, rents, and interests constitute the price of factors of production.
ii. Income Aspect: Refers to another aspect in which a certain amount is received by a factor of production.
For instance, rents received by a landlord and wages received by labor constitute the income generated from
the factors of production. Generally, it is assumed that factor pricing theory is similar to product pricing
theory.
However, there are differences in the nature of demand and supply of factors of production with
respect to that of products. The demand for factors of production is derived demand, while demand for
products is direct demand. Moreover, the demand for the factors of production is joint demand. This is
because a product cannot be produced using a single factor of production. On the other hand, the supply of
products is closely related with the cost of production, whereas there is no cost of production for factors. For
example, there is no cost of production for land, labor, and capital. Therefore, the factor pricing is separated
from product pricing.

Rent:
In simple words, ‘ rent’ is used as a part of the produce which is paid to the owner of land for the use of his
goods and services.
Types of Rent:
The main types of rent are as under:
1. Economic Rent: Economic rent refers to the payment made for the use of land alone. But in economics
the term rent is used in the sense of economic rent. In the words of Ricardo and other classical economists,
economic rent refers to the payment for the use of land alone It is also called Economic Surplus because it
emerges without any effort on the part of landlord. Prof. Boulding termed it “Economic Surplus”.
2. Gross Rent: Gross rent is the rent which is paid for the services of land and the capital invested on it.
Gross rent consists of:
(1) Economic rent. It refers to payment made for the use of land.
(2) Interest on capital invested for improvement of land.
(3) Reward for risk taken by landlord in investing his capital.
3. Scarcity Rent: Scarcity rent refers to the price paid for the use of the homogeneous land when its supply
is limited in relation to demand. If all land is homogeneous but demand for land exceeds its supply, the
entire land will earn economic rent by virtue of its scarcity. In this way, rent will arise when supply of land
is inelastic. Prof. Ricardo opined that land was beneficial but it was also scarce. Productivity of land was
indicative of the generosity of nature but its total supply remaining more or less fixed symbolized
niggardliness of nature.
4. Differential Rent: Differential rent refers to the rent which arises due to the differences in the fertility of
land. In every country, there exists a variety of land. Some lands are more fertile and some are less fertile.
When the farmer’s are compelled to cultivate less fertile land the owners of more fertile land get relatively
more production. This surplus which arises due to difference in fertility of land is called the differential rent.
This type of rent arises under extensive cultivation. According to Ricardo, “In order to increase production
on same type of land, more units of labour and capital are employed.”
5. Contract Rent: Contract rent refers to that rent which is agreed upon between the landowner and the user
of the land. On the basis of some contract, which may be verbal or written, contract rent may be more or less
than the economic rent.

Wages:
The price paid to labour for its contribution to the process of production is called wages. Labour is an
important factor of production. If there is no labour to work, all other factors, be it land or capital, will
remain idle.
Types of Wages:
1. Piece Wages: Piece wages are the wages paid according to the work done by the worker. To calculate the
piece wages, the number of units produced by the worker are taken into consideration.
2. Time Wages: If the labourer is paid for his services according to time, it is called as time wages. For
example, if the labour is paid Rs. 35 per day, it will be termed as time wage.
3. Cash Wages: Cash wages refer to the wages paid to the labour in terms of money. The salary paid to a
worker is an instance of cash wages.
4. Wages in Kind: When the labourer is paid in terms of goods rather than cash, is called the wage in kind.
These types of wages are popular in rural areas.
5. Contract Wages: Under this type, the wages are fixed in the beginning for complete work. For instance,
if a contractor is told that he will be paid Rs. 25,000 for the construction of building, it will be termed as
contract wages.
Concepts of Wages:
A. Money Wages or Nominal Wages: The total amount of money received by the labourer in the process
of production is called the money wages or nominal wages.
B. Real Wages: Real wages mean translation of money wages into real terms or in terms of commodities
and services that money can buy. They refer to the advantages of worker’s occupation, i.e. the amount of the
necessaries, comforts and luxuries of life which the worker can command in return for his services. An
example will make the things clear. Suppose ‘A’ receives Rs. 500 p.m. as money wages during the year.
Suppose also that midway through the year the prices of commodities and services, that the worker buys, go
up, on the average, by 50%. It means that though the money wages remain the same, the real wages
(consumption basket in terms of commodities and services) are reduced by 50%. Real wages also include
extra supplementary benefits along with the money wages.

Interest :
Interest is a payment made by a borrower to the lender for the money borrowed and is expressed as a rate
percent per year.
Types of Interest:
There are two types or kinds of Interest:
(a) Net Interest: The payment made exclusively for the use of capital is regarded as net Interest or pure
Interest. According to Prof. Chapman—“Net Interest is the payment for the loan of capital when no risk, no
inconveniences apart from that involved in saving and no work is entailed on the lender.”
Thus, Net Interest = Gross Interest – (payment for risk + payment for inconvenience + cost of
administering credit)
i.e., Net Interest = Net Payment for the use of capital.
(b) Gross Interest:
Gross Interest according to Briggs and Jordan has said—“Gross Interest is the payment made by the
borrowers to the lenders is called Gross Interest or Composite Interest.” It includes payments for the loan of
capital payment to cover risks for loss which may be:
(i) A personal risks or
(ii) Business risks, payment for inconveniences of the investment and payment for the work and worry
involved in watching—investments, calling them in and investing.
According to Prof. Marshall: Gross Interest is that “Interest of which we speak when we say that interest is
the earning of capital simply or the reward of waiting simply, is net Interest but what commonly passes by
the name of interest, includes other elements besides this and may be called gross interest.”
Thus, Gross Interest = Net Interest + payment of risk + payment for inconvenience + cost of
administrating credit
Profit or Economic Profit
An economic profit or loss is the difference between the revenue received from the sale of an output
and the opportunity cost of the inputs used. In calculating economic profit, opportunity costs are deducted
from revenues earned. Opportunity costs are the alternative returns foregone by using the chosen inputs, and
as a result, a person can have a significant accounting profit with little to no economic profit.
Economic profit or loss is most useful when comparing multiple outcomes and making a decision
between these outcomes. This is especially true for decisions with multiple variables that affect and do not
affect accounting profit. For instance, one decision may result in a higher accounting profit, but after other
variables are considered, the economic profit of another decision may be higher.
Economic profit is a measurement of opportunity cost. Opportunity cost is the value of the trade-of
when a decision is made. For example, an individual may consider returning to school to get a degree but in
doing so, needs to quit his current job. The individual should consider not only the cost of tuition and books
but the income he forgoes by pursing a degree. This lost opportunity to make money, or opportunity cost, is
the underlying purpose of calculating economic profit.
Example of Economic Profit
An individual starts a business and incurs startup costs of $50,000. During the first year of operation, the
business earns a profit of $75,000. If the individual had stayed at his previous job, he would have made
$20,000. In this example, the accounting profit is $25,000, or $75,000 - $50,000. However, because the
individual had the potential to earn income at another location while retaining the startup costs of the
business, an economic profit of $5,000, or $30,000 - $25,000, is incurred.

Agricultural and public finance

The government has to perform some functions. To carry out these functions, it needs funds. Everyone has
to contribute something. So the public finance deals with why the government takes money, how it gets
money and where it spends money?
Distinction between public and private finance:
1. An individual’s income determines his expenditure, while a state’s proposed expenditure determines its
income. The state first decides the nature and scale of its expenditure and then proceeds to find funds to
meet it. An individual knows his income and he has to plan out his expenditure accordingly. An individual
adjusts his expenditure to his income, whereas the state adjusts its income to its expenditure.
2. A public authority can vary the amount of its income and expenditure within limits. An individual cannot
easily double his income or halve his expenses even if he would be better off that way. But this is not so
difficult in the case of governments.
3. A public authority usually does not discount the future at as high a rate as an individual: the reason is
obvious. The life of a man is limited in years and his foresight is limited. A state is supposed to live forever.
4. There is no fixed period of time over where an individual balance his budget: State budgets are generally
made for one year. But the income and expenditure of an individual are continuous and cover the whole
period of his life.
5. The individual finance is kept a secret where as a state finance is made public.
6. A state can raise an internal loan, an individual cannot. Nobody can borrow from himself. But state can
borrow from its own citizen.
7. The state can issue paper currency in order to meet its expenditure. But no such course is open to a private
individual.
8. No equi- marginalizing of utilities: An individual tries to maximize satisfaction from his income by
distributing his expenditure in such a manner as to have equi –marginal utility in every case but the state
expenditure is done by the finance Department in an objective manner.
9. The private individual lacks the coercive authority which a government has. A govt. has simply to pass a
law and compel the citizens to pay a tax or subscribe to compulsory loan i.e. compulsory deposits, but an
individual cannot do anything of the kind.
10. An individual after meeting his needs saves something to lay buy. Not so with a state.

Importance of public finance:

1. It is one of the most effective investments of the state control over the economy. It is not merely means of
collecting state revenues and making disbursement.
2. The state activities which have to be financed by public revenues are over expanding. This has added to
the importance of public finance manifold.
3. Growing significance of fiscal policy in tackling economic problems has increased the importance of
public finance.
4. The study of public finance is especially important for the underdeveloped countries. Only a prudent
management of state finance is essential to break the vicious circle of poverty in which the underdeveloped
countries are involved. Fiscal policy is a powerful tool for increasing capital formation, accelerating growth,
increasing national income and raising the level of employment.

Role or functions of public finance:

1. Allocative functions: It refers to the process by which total resource use is divided between private and
social goods by which the mix of social goods is chosen. This is done by budgetary policy.
2. Distributive functions: the budgetary policy also affects the distribution of income in the community. The
tax and expenditure measures are adopted to modify the existing distribution with a view to reducing
economic inequalities. In this way optimal income distribution is brought about.
3. Stabilization function: The budgeting policy can also be used to maintain a high level of employment,
reasonable degree of price level stability, an appropriate rate of economic growth and stability in the balance
of payments.

Micro v/s Macro finance

Micro finance
1) A micro finance is a narrow concept which includes the various services like micro credit, micro
savings, micro insurance and many more schemes.
2) The purpose of micro finance is to help the small section of a society like low-income level people or
a below poverty line who are not able to serve their needs just because of unavailability fund.
3) Those who are not able to take a financial help by the conventional way of putting a security as a
guarantee.
4) A micro finance helps people to start their own business by proving finance with a low rate of
interest and help to make them independent.

Macro finance
1) Macro finance is a broad concept and works on a large scale and its advantages are widespread.
2) Macro finance is an initiative which deals with the large section of an economy and covers all the
financial need and how to provide it to the needed one.
3) A macro finance includes the drafting policy, subsidies, multi-year expansion plans.
4) The main aim of macro finance is to help an economy to grow and to generate employment and
expand an economy.
5) A government provides macro finance in any form to the business like tax benefits or a subsidy
because it will benefit the economy in future.
Basis Micro finance
Meaning Micro finance is an individual
based concept to furnish
financial services to low-
income individuals who have
no access to finance in a
conventional way.
Concept A micro finance is a narrow
concept and focuses on the
need of an individual.
Macro finance
Macro finance is a whole
economy based concept, which
is not framed for any particular
group, to grow the economy at a
national level.
A macro finance is a broad
concept and focuses the whole
nation.

By whom A micro finance is provided by A macro finance involves a large

micro finance companies, self- entity like governments, big
help groups, and non- corporation, banks, and some
government organizations. big private lenders.

Money In micro finance, the money The amount of money involved

involved involved is in a small amount. is in a large portion.

Time period A micro finance is an endless A macro finance is for a specific

activity which goes on and on.
Risk level In a micro finance, there is a
risk of default that an individual
may not pay.
time period like 2 years or a 3
year. It means it has a
predefined tenure.
There is no risk at all because
the main aim is to give benefit to
the economy.

Effect A micro finance has a direct A macro finance has a direct

effect on an individual. effect on the whole economy
which indirectly affects the
whole population.

Public expenditure:
There are two important aspects of Public Finance, viz., Public Revenue and Public Expenditure, This
department of public finance received scant attention at the hands of writers on public finance throughout
the 19th century. Attention was almost exclusively focused on public revenues. It is only in the present
century that it came to be realized that public expenditure is no less important in its implications and bearing
on public welfare than public revenue. The main reason for the early neglect of the subject of public
expenditure seems to be that the amount of public expenditure was very small as the field of governmental
activity was restricted. Now public expenditure has reached astronomical figures.
In recent times, public expenditure has increased enormously. The main reason is that the functions of the
state have increased manifold. In the past, the state was regarded only as a police state concerned with
defence from foreign aggression and maintenance of law and order within the State. Now the State is
regarded as a Welfare State which is concerned with promoting the welfare of its citizens. As such, it has to
provide not only social security but it has also to look to economic stability and economic growth which
calls for ever increasing investment expenditure.

Revenue and capital expenditure

Public expenditure can be classified as Revenue Expenditure and Capital Expenditure.
Revenue expenditure: It is ordinary routine type of expenditure incurred in running the administration. It is
current expenditure and includes the expenditure incurred in running the administration or in supplying
routine services or in the collection of taxes, duties, fees, assessments, etc. as well as interest on public debt.
Revenue expenditure of Government of India;
1) Expenditure on civil administration
2) Defence services
3) Debt services-Pensions
4) Social and development services
5) Other miscellaneous expenditures
Revenue expenditures of States in India;
1) Social; and development expenditure on education
2) Medical and public health
3) Agriculture
4) Veterinary and co-operation
5) Electricity schemes
6) Rural and community development
7) Civil works
8) Industries and supplies
9) Other Developmental expenditure
It also includes non- developmental expenditure as a collection of taxes, debt services, civil administration,
famine etc.
Capital expenditure: This expenditure is of extra ordinary nature. The capital expenditure represents
capital outlay both developmental and non developmental
1) Acquisitions or creation of an asset
2) Undertaking new multipurpose projects.
3) To fight a war
The governments of India incurs same capital expenditure on defence, payment of commuted value of
pensioners, State trading schemes railway construction extension and improvement of post and telegraph
facilities civil aviation, irrigation and discharge of permanent debt, advances to state and other loans and
advances.
Similarly, in the case of State Government capital expenditure includes capital outlay as
1) Multipurpose river valley schemes
2) Irrigation and navigation
3) Schemes of agricultural improvement and research
4) Electricity schemes
5) Road transport
6) Buildings, road and water works
7) Industries development
This is the developmental capital expenditure but there is no n- development capital expenditure as an state
trading, compensation to land owners, discharge of permanent debt repayment of loans to the central and of
other loans as well as loans and advances by the State Government.
Principles of public expenditure:
Just as there are well-known principles or canons of taxation, similarly it is possible to formulate some
principles to which prudent public expenditure should conform. These principles are:
1) Principle of Maximum Social Benefit
It is necessary that all public expenditure should satisfy one fundamental test, viz., that of Maximum Social
Advantage. That is, the government should discover and maintain an optimum level of public expenditure
by balancing social benefits and social costs. Every rupee spent by a government must have as its aim the
promotion of the maximum welfare of the society as a whole. Care has to be taken that public funds are not
utilized for the benefit of a particular group or a section of society. The aim is the general welfare.
Government exists for the benefit of the governed and the justification of the government expenditure is,
therefore, to be sought in the benefit of the community as a whole.
2) Canon of Economy
Although the aim of public expenditure is to maximize the social benefit, yet it does not exonerate
government from exercising utmost economy in its expenditure. Economy does not mean niggardliness. It
only means that extra vagrancy and waste of all types should be avoided. Public expenditure has great
potentially for public well but it may also prove injurious and wasteful. Thus, if revenue collected from the
tax payer is heedlessly spent, it would be obviously uneconomical. To satisfy the canon of economy, it will
be necessary to avoid all duplication of expenditure and overlapping of authorities. Further, public
expenditure should not adversely affect saving. In case government activity damaged the individual’s will or
power to save, it would go against the canon of economy.
3) Canon of Sanction
Another important principle of public expenditure is that before it is actually incurred it should be
sanctioned by a competent authority. Unauthorized spending is bound to lead to extravagance and over-
spending. It also means that the amount must be spent on the purpose for which it was sanctioned. Allied to
the canon of sanction, there is another viz., auditing. Not only is previous sanction of public expenditure
essential but a post-mortem examination is equally imperative. That is, all the public accounts at the end of
the year should be properly audited to see that the amounts have not been misspent or misappropriated.
4) Canon of Elasticity
Another sane principle of public expenditure is that it should be fairly elastic. It should be possible for
public authority to vary the expenditure according to need or circumstances. A rigid level of expenditure
may prove a source of trouble and embarrassment in bad times. Alteration in the upward direction in not
difficult. It is easy, rather tempting, to increase the scale of expenditure. But elasticity is needed tempting, to
increase the scale of expenditure. But elasticity is needed most in the downward direction. When the
economy axe is applied it is a very painful process. Retrenchment of a wide-spread character creates serious
discontent.
It is very necessary, therefore, that when the scale of public expenditure had to be increased, it should be
increased gradually. A short spell of prosperity should not lead to long-term commitments. A fair degree of
elasticity is essential if financial breakdown is to be avoided at a time of shrinking revenue.
5) No Adverse Influence on Production or Distribution
It is also necessary to ensure that public expenditure should exercise a healthy influence both on production
and distribution of wealth in the community. It should stimulate productive activity so that income and
employment of the living. But this object of raising of living standards of the masses will be served only if
wealth is evenly distributed. If newly created wealth goes to enrich the already rich, the purpose is not
served. Public expenditure should aim at reducing the inequalities of wealth distribution.
6) Principle of Surplus
It is considered a sound or orthodox principle of public expenditure that as far as possible public expenditure
should be kept well within the revenue of the State so that a surplus is left at the end of the year. In other
words, the government should avoid deficit budget, But the modern economists, especially Keynes, do not
regard surplus budgeting as a virtue, rather
deficit budgeting is more useful in raising the levels of income and employment in the under-developed
countries. All the same, budget deficits running over a series of years are considered bad for the financial
stability of the country and they cause inflation which is injurious to the health of the economy.
7) Promotion of Economic Growth and Stability
In modern times, a very important principle of public expenditure is that it should promote economic
development and economic stability, directly or indirectly. No public expenditure should impair the
economy’s potentialities for economic growth. In all public expenditure requirements of economic growth
and economic stability (avoiding economic fluctuations) are kept in the forefront.

Public Revenue
The following points highlight the nine main sources of government revenue. The sources are:
Source # 1. Tax:
A tax is a compulsory levy imposed by a public authority against which tax payers cannot claim anything. It
is not imposed as a penalty for only legal offence. The essence of a tax, as distinguished from other charges
by the government, is the absence of a direct quid pro quo (i.e., exchange of favour) between the tax payer
and the public authority.
Tax has three important features:
(i) It is a compulsory contribution, to the state from the citizen. Anyone refusing to pay tax is punished
under law. Nobody can object to taxation on the ground that he is not getting the benefit of certain state
services,
(ii) It is the personal obligation of the individual to pay taxes under all circumstances,
(iii) There is no direct relationship between benefit and tax payment.
Source # 2. Rates:
Rates refer to local taxation, i.e., taxation levied by (or for) local rather than central government. Normally
rates are proportional to the estimated rentable value of business and domestic properties. Rates are often
criticised as being unrelated to income.
Source # 3. Fees:
Fee is a payment to defray the cost of each recurring service undertaken by the government, primarily in the
public interest.
Source # 4. Licence fee:
A licence fee is paid in those instances in which the govern-ment authority is invoked simply to confer a
permission or a privilege.
Source # 5. Surplus of the public sector units:
The government acts like a business- person and the public acts like its customers. The government may
either sell goods or render services like train, city bus, electricity, transport, posts and telegraphs, water
supply, etc. The government also earns revenue from the production of commodities like steel, oil, life-
saving drugs, etc.
Source # 6. Fine and penalties:
They are the charges imposed on persons as a punishment for contravention of a law. The main purpose of
these is not to raise revenue from the public but to force them to follow law and order of the country.
Source # 7. Gifts and grants:
Gifts are voluntary contribution from private individu-als or non-government donors to the government fund
for specific purposes such as relief fund, defence fund during war or an emergency. However, this source
provides a small portion of government revenue.
Source # 8. Printing of paper money:
It is another source of revenue of the govern-ment. It is a method of creating extra resources. This method is
normally avoided because if once this method of financing is started, it becomes difficult to stop it.
Source # 9. Borrowings:
Borrowings from the public is another source of govern-ment revenue. It includes loans from the public in
the form of deposits, bonds, etc. and also from the foreign agencies and organisations.

Taxes
A tax (from the Latin taxo) is a compulsory financial charge or some other type of levy imposed upon a
taxpayer (an individual or legal entity) by a governmental organization in order to fund various public
expenditures. A failure to pay, along with evasion of or resistance to taxation, is punishable by law.
Kinds of taxes:
Taxes may be
1) Proportional
2) Progressive
3) Regressive
4) Digressive
A proportional tax: is one which takes out of the pockets of every person exactly the same percentage of
income. Such a tax is very simple and does not change the nature of distribution of wealth in the country.
For instance, a tax on all incomes, big or small, at a flat rate of says 5%. But obviously poorer people with
smaller incomes are hit harder in this system. Consequently, in modern taxation, proportional taxes have
been given up in favour of progressive taxes.
A progressive tax: This tax tries to distribute the sacrifice in a more just manner. The higher incomes are
changed tax at a higher rate. Since marginal utility of money falls with its increase, richer people have a
greater capacity to pay taxes. Besides, progression reduces inequalities in wealth to some extent. India has
adopted it.

A regression tax: is one which is charged from the poor at a higher rate than from the rich. There is no
justification for taxing higher incomes at lower rate. This system is obviously unjust. It has only one thing in
its favour and that is that as poorer people are more in number, such a tax brings in greater revenue. But
regressive taxes are bad in principle and should be
avoided as for as possible. In fact they do not figure in the tax system of modern states e.g. land rent paid by
poor people.

A digressive tax: is one which increases as incomes rises, but the rate do not increase in the same
proportion as the income. It is so to say, a milder form of progression which means that larger incomes make
a lower relative sacrifice than smaller incomes.

Direct and indirect taxes: Another distinction of no less importance is the one between direct and indirect
taxes. Generally taxes on income are direct and those on goods indirect.
A direct tax is one which is really paid by the person on whom it is legally imposed.
An indirect tax is imposed on one person but is paid partly or wholly by another (Dalton)
Advantages and disadvantages of direct taxes:
Direct taxes have the following advantages in their favour:
(i) Equitable: The burden of direct taxes cannot be shifted. Hence equality of sacrifice can be attained
through progression.
(ii) Economical: The cost of collection of direct taxes is low. They are mostly collected at the source. The
employer acts as an honorary tax collector. This means great economy.
(iii) Certain: The payers know how much is due from them and when. The authorities also know the
amount of revenue they can expect.
(iv) Elastic: The yield from income tax or death duties can be easily increased by raising their rate.
(v) Productive: As a community grows in numbers and prosperity, the return from direct taxes expands
automatically. The direct tax yields large revenue to the state.
(vi) A means of developing civic sense: The tax payer claims the right to know how the Government uses
his money and approves or criticizes it. Civic sense is thus developed. He behaves as a responsible citizen.
Direct taxes have the following disadvantages in their favour:
(i) Inconvenient: It pinches the payer and thus very inconvenient to pay. Nobody can help feeling the pinch.
(ii) Evadable: The assessed can submit a false return of income and thus evade the tax.
Advantage and Disadvantages of Indirect Taxes:
Indirect taxes have advantages of their own.
(i) The poor can contribute: The poor are always exempted from paying direct taxes. They can be reached
only through indirect taxation.
(ii) Convenient: They are convenient to both the tax-payer and the state.
(iii) Broad-based: As indirect taxes can be spread widely, they are more beneficial and suitable.
(iv) Easy Collection: collection takes place automatically when goods are bought and sold.
(v) Non Evadable: They cannot be evaded as they are a part of the price.
(vi) Elastic: They are very elastic in yield, if imposed on necessaries of life which have an inelastic demand.
(vii) Equitable: When imposed on luxuries on goods consumed by rich, they are equitable.
(viii) Check harmful consumption: By being imposed on harmful products, they can check consumption
of harmful commodities.
Indirect taxes have some disadvantages too, which are as follows.
(i) Regressive: Indirect taxes are not equitable.
(ii) Uncertain: when the thing is not purchased, the question of the tax payment does not arise.
(iii) Raising price unduly: They cause the price of an article to rise by more than tax.
(iv) Uneconomical: The cost of collection is quite heavy.
(v) No civic consciousness: These taxes do not develop civic consciousness, because many times the tax-
payer does not even know that he is paying a tax.
(vi) Harmful to industries: They discourage industries if raw materials are taxed.

Canons of taxation
Adam Smith laid down four principles to guide the taxing authority.
The principles of canons of taxation enunciated by Adam Smith were so important that they have become
classic. They are:
(1) Canon of equality: The subjects of every state,” Smith asserted, ought to contribute towards the support
of the Government as nearly as possible in proportion to their respective abilities, that is, in proportion to the
revenue which they respectively enjoy under the protection of the State. Equality here does not mean that all
tax-payers should pay an equal amount. Equality here means quality or justice. It means that the broadest
shoulders must bear the heaviest burden. It lays the moral foundation of tax system.
(2) Canon of Certainty: Adam Smith further said, the tax which each individual has to pay ought to be
certain and not arbitrary. The individual should know exactly what, when and how he is to pay a tax;
otherwise it will cause unnecessary suffering. Similarly the State should know much it will receive from a
tax.
(3) Canon of Convenience: Smith wrote, “Every tax ought to be levied at the time or in the manner which it
is most likely to be convenient to pay it.”
(4) Canon of Economy: Lastly, Adam Smith held that “every tax ought to be so contrived as both to take
out and keep out of the pockets of the people as possible over and above what it brings into the public
treasury of the State. “ This means that the cost of collection should as small as possible. If the bulk of the
tax is spent on its collection, it will take much out of the people pockets but bring very little into the State’s
pocket. It is not a wise tax.
Other canons of taxation:
(5) Canon of Productivity: This canon emphasizes that a tax should bring in a substantial amount of money
to the state. After all the main object of the taxing authority is to secure funds. It is much better to have a
few taxes which yield good revenue instead of many taxes yielding a little.
(6) Canon of Elasticity: This canon points out that a tax should automatically bring in more revenue as the
country’s population or income increases. There should be an automatic link between the needs of the State
and resources of the people. If, in an emergency, an increase in the rate of the tax brings in increased
income, the tax is elastic.
(7) Canon of Simplicity: It argues that the tax system should be simple; otherwise there would be confusion
and worse still corruption. During the war and after, certain taxes, e.g., on the sale of cloth and other
essential supplies in India resulted in corruption mainly because they lacked in simplicity.
(8) Canon of Variety: It is also necessary that the tax system of a country should be diversified. Reliance
on just a few taxes is risky. In order to be just, a tax system must be broad-based. In order to be adequate, it
must be diversified, having a wide coverage over commodities and persons.
(9) Canon of Flexibility: Flexibility connotes the absence of rigidity in the tax system. A flexible tax
quickly adjusts to the new conditions. Presence of flexibility is a pre-condition for elasticity. Lack of
flexibility in a tax can cause financial troubles to a State.

National Income
Output and employment in a country depend on the size of national income Dr Alfred Marshall defines
National income (or National Divided) thus: Labour and capital of a century acting on its natural resources,
produce annually a certain net aggregate of commodities material and immaterial including services of all
kinds. The word net means that from the gross value of the output deprecation of capital must be deducted.
The concept of national income has three interpretations.
1) It represents a receipts total
2) It represent an expenditure total
3) It arises out of the fact that every expenditure at the same time is a receipt by another and if goods or
services bought are valued at their sales prices, we have three fold identities that the value received equals
the value paid, equal the value of goods and services given in exchange.
Definition of national income: According to present ideas, national income may be defined as the
aggregate factor income (i.e. earnings of labour and property) which arises from the current production of
goods and services by the nation's economy.
There are three measures of national income of a country:
a) As the sum of all incomes, in cash and kind, accruing to factors of production in a given time period, i.e.
the total of income flows;
b) As the sum of net output arising in several sectors of the nation's production;
c) As the sum of consumer's expenditure, government expenditure on goods and services and net
expenditure on capital goods.
Concept of national income: Five important concepts of national income, viz., the Gross National Product,
Net National Product, National Income, Personal Income, and Disposable Income can be studied
1. Gross National Product (GNP): This is the basic social accounting measure of the total output or
aggregate supply of goods and services. Gross National Product is defined as the total market value of all
final goods and services produced in a year. It is a measure of the current output of economic activity in the
country.
Two things must be noted in regard to gross national product:
(i) It measures the market value of the annual output. In other words, GNP is a monetary measure.
(ii) For calculating the gross national product accurately all the goods and services produced in any given
year must be counted once but not more than once.
Another important thing to be born in mind while calculating the GNP is that non productive transactions
should be excluded. These are purely financial transactions or transfer payments like old-age pension, or
unemployment doles which are merely grants or gifts or transactions relating to existing shares or second
hand shares.
GNP= wages and salaries + rents + interests + profits of unincorporated firms + dividents +
undistributed corporate profits + corporate taxes + indirect taxes + depreciation – transfer of
payments
2. Net National Product (NNP): When charges for depreciation are deducted from the gross national
product, we get net national product. It means the market value of all final goods and services after
providing for deprecation. Therefore, it is called national income at market prices. Thus
NNP= GNP – depreciation
3. National Income or National Income at Factor cost (NI): It means the sum of all incomes earned by
the resource suppliers for their contribution of land, labour, capital and entrepreneurial ability which go into
year's net production. National Income shows how much costs society, in terms of economic resources, to
produce net output. It is really the national income at factor cost for which we use the term "National
Income". Thus, national income (or national income at factor cost) is equal to net national product minus
indirect taxes plus subsidies.
National Income = NNP- indirect taxes + subsidies
4. Personal Income (PI): It is the sum of all incomes actually received by all individuals or households
during a given year.
Personal Income = National income – Social security contributions – Corporate income taxes-
Undistributed corporate profits + Transfer payments.
5. Disposable Income (DI): After a good part of personal income is paid to government in the form of
personal taxes like income tax, personal property tax, etc, what remains of personal income is called
disposable income
Disposable Income = Personal income- Personal taxes
Disposable income can either be consumed or saved. Therefore,
Disposable Income = consumption + saving

Measurement of national income: There are three possible measures of national income:
1. Total income flow
2. Net outputs, and
3. Final expenditures
All these methods arrive at the same result. Which of these methods is adopted in actual practice i.e.
calculating the national income of a country depends on the nature and conditions of its economy as well as
purpose of undertaking this exercise?
1. Production or output method: According to this method the economy is divided into different sectors
such as agriculture, mining, manufacturing, small enterprises, commerce, transport, communication and
other services. Then, the gross product is found out by adding up net values of all the production that has
taken place in these sectors during a given year.
The aggregate or net value of production of all the industries and sectors of the economy plus the net income
from abroad will give us the gross national product. By subtracting the total amount of depreciation from the
figure of gross national product, we get the net national product or national income.
This method can be used where these exists a census of production for the year. The one great advantage of
this method is that it reveals the relative importance of the different sectors of the economy by showing their
respective contribution to the national income. This method is called national income by industrial origin.
2. Income method: According to this method national income is obtained by summing up of the incomes of
all the individuals in the country. Therefore, national income is calculated by adding up the incomes of land,
wages and salaries of employees, interest on capital, profits of entrepreneurs (including undistributed profits
of joint stock companies) and income of self employed people. This method has the great advantage of
indicating the distribution of national income among different income groups such as land lords, capitalists,
workers etc., therefore, this is called national income by distributive shares.
3. Expenditure method: According to this method we can get the national income by summing up all
consumption expenditure and investment expenditure made by all individuals as well as government of a
country during the year. Hence, the gross national product is found by adding up:
1. What private individuals spend on consumer goods and services? This is called personal consumption
expenditure.
2. What private businesses spend on replacement, renewals and new investment? This is called gross
domestic private investment.
3. What the government spends on the purchase of goods and services i.e., government purchases.
4. What the foreign countries spend on the goods and services of the national economy over and above what
this economy spends on the output of the foreign countries i.e. exports minus imports.

Difficulties of measurement: There are some conceptual problems that crop up when we start measuring
the national income of a country.
1. The first problem relates to the treatment of non- monetized transactions such as the services of
housewives to the members of their families and farm output consumed at home. On this point, the general
agreement seems to be to exclude the services of housewives while including the value of farm output
consumed at home in the estimate of national income. This however, gives rise to certain anomalies.
2. The second difficulty arises with regard to the treatment of the government in national income accounts.
3. The third major problem arises with regard to the treatment of income arising out of activities of the
foreign firm in a country. Should their income/ income of foreign firms form a part of the national income of
the country in which they are located or should it belong to the national income of the country owing the
firms? On this point, the IMF view point is that production and income arising from an enterprise should be
ascribed to the territory in which production takes place. However, the profits earned by foreign branches
and subsidies are credited to the parent concern.

Barter system of exchange and its problems

A system in which goods and services are directly exchanged for other goods without the use of money is
called barter system. In other words it is the direct exchange of goods for goods. According to Prof Standy,
barter economy is such an economy in which there is no use of a generally acceptable medium of exchange.
Before the emergence of money the this system was in practice. Now-a-days it is not completely eliminated
from the economy however its use has become limited. Even in modern times during monetary crisis, or
hyperinflation, the system has replaced the use of Money.
Disadvantages of Barter System
Lack of Double Coincidence of Wants
For a successful transaction of goods, satisfaction of both the parties is must. It means that a person having
some good and looking for its exchange with the other good must get that. For example a person has a piece
of cloth and he wants to exchange it with wheat, first of all he will have to search for such a person who
possesses it and secondly he is willing for exchange. This exercise usually takes a long time and consumes
energy therefore this system did not succeed.
Lack of Common Measure of Value
The second important drawback is the lack of common measure of value. If two persons come across each
other to willingly exchange their goods, then what will be the common yardstick to measure the value of
different goods for the purpose of exchange? For example if one person has meat and the other has fruit,
then how would this exchange take place as both these goods are measured in different units. Furthermore
for every new transaction the determination of value will be required afresh.
Lack of Store of Value
It means people cannot store the value of goods because majority of goods when stored are either worn out
or become less useful. For example wheat, rice, sugar, etc. cannot be stored for a long time. However in the
case of money the value of any kind of good can be stored.
Inconvenience in Lending and Borrowing
In the system due to the time lapse, the value of goods may decrease which affect those who generally lend
because at the time when they lend the goods may be of high value but it is quite possible when the goods
are returned after some time, it may not have the value as it had before.
Transfer of Wealth
Under the direct exchange, it is difficult to transfer certain goods from one place to another which in the
case of money is quite easy. A person having a house cannot shift it from one place to another while he can
transfer its value in the form of money.
Inconvenience in Government Receipts and Payments
Under the barter system it is extremely difficult for a government to collect taxes because there are certain
issues like types of taxes, different goods, collection and storage problems, similarly payment to government
servants in the form of goods would also be extremely difficult.

Money
Anything which is widely acceptable in discharge of obligations

Development of Money
Commodity Money- The earliest form of money consisted of goods like rice, wheat, cattle, etc
Metallic Money- the metals such as gold, silver, bronze etc were used to make coins. The government kept
the right to issue coins and certify their quality and weights.
Paper Money- It was introduced to supplement metallic money. When it was introduced it was backed up
by same amount of gold but now it only a proportional of that.
Bank Money- Paper money has been supplemented or replaced by bank money. It leads to bank deposits,
credit card, debit cards etc
Kinds of Money
Standard money- For such type of money, intrinsic value (real value) is equal to face value( the value
written on the coins).
Token Money- Its face value is greater than its intrinsic value. The rupee is a standard unit of money in
India, but its face value is greater than its real value

Characteristics of Money
Cognisability- The money should be easily recognized by all.
Utility- The money for the best alternative purpose
Portability- Easy carrying
Durability- coins are more durable than paper currencies
Indestructibility- money should not be disfigured easily
Stability- value of money should not be changing
Homogeneity- use of same metal or paper
Universal Acceptability- should be accepted in all state of country.

Functions of Money
Medium of exchange- it facilitates the buying and selling of goods and services as a medium of exchange.
A unit of account- It is used as the measures of value of all goods and services.
Standard of deferred Payments- Money facilitates the settlement of debts and future transaction.
Store of Value- It is a form of holding wealth. If one feels money is more he saves and use as and when
required
Transferable- it facilitates the easy transfer of value. The disposal and purchase of assets can be done very
easily

INFLATION
A situation of rising prices of goods. The rate of inflation is defined as the rate of change of the price level.
Inflation and other forms
Deflation- Decrease in level of prices.
Reflation- Moderate degree of controlled inflation
Disinflation- decline in rate of inflation
Stagflation- Inflation Accompanied by stagnation on the development

Causes of inflation
A. Factors causing increase in demand
Increase in money supply
Increase in disposable income
Increase in community aggregate spending on consumption
Increase in exports
Increase in salaries, wages
Increase In population
B. Factor causing decrease in supply
Deficiency of capital requirement
Scarcity of other complementary factors of production
Decrease in imports
Hording by traders
Natural Calamities

Types of Inflation:
1. Suppressed Inflation: Deliberate policies are adopted to prevent price rise, but the impact of these
policies is only temporary, since prices rise as soon as these are relaxed. Here is a situation in which the
Government does not tackle the factors causing inflation; it only imposes controls to check the price rise.
2. Creeping Inflation. A sustained rise of less than 3 per cent in prices per annum is called creeping
inflation. It is not considered serious for the economy.
3. Walking Inflation: When the rise in prices falls in the range of 3 per cent to 6 percent, it is called
walking inflation.
4. Running Inflation: When the sustained rise in prices is about 7-10% per annum, it is called walking
inflation. This type of inflation is a cause of concern for the Government and warrants remedial measures.
5. Galloping or Hyperinflation: This is the most dangerous type of inflation and prices rise by more than
10% per annum. This type of inflation should not be allowed to persist.
6. Open Inflation: Inflation is said to be open when the market forces are allowed to operate freely, for the
prices of goods and services set without abnormal interruption by the authorities. The Government does not
take any steps to check the rise in the prices.
7. Suppressed or Repressed Inflation: Suppressed inflation refers to a situation when, the Government
actively intervenes to check the rise in the price level through the use of price control measures and
rationing of scarce items in the economy.
8. Comprehensive Inflation: This type of inflation occurs when prices of all the commodities register a rise
in the economy.
9. Sporadic Inflation: It is a sectoral inflation. Under this ty0pe of inflation only the prices of a few
commodities who an upward trend.
10. Demand Pull Inflation or excess Demand Inflation: It is often described as “too much money chasing
too few goods” It occurs as a result of excessive demand for goods and services which pull prices upward.
11. Demand – shift Inflation: It is a special case of demand-pull inflation. This occurs when shifts take
place in demand for different goods and services with total demand remaining unchanged. This arises as a
result of households reducing the demand for good A, while increasing demand for B, by an equal rupee
amount.
12. Cost-push Inflation: Enforcement of wage increase by unions and increase of profits by employers lead
to cost push inflation. Here the money wages rise more rapidly than the productivity of labour, as a result of
which the cost of production of commodities rises, employers, in turn increase the prices of the
commodities. Higher wages enable workers to buy as much as before, even in the light of higher prices. On
the other hand unions demand higher wages in view of higher prices. In this way, the wage cost spiral
continues leading to cost-push inflation to prevail.
13. Mixed Demand-pull and Cost –push Inflation: This situation is termed as hybrid form of inflation. It
is a situation in which some elements of demand-pull inflation and cost-push inflation are found. In reality
excess demand and cost-push forces operate simultaneously and interdependently in an inflationary process.
In years of poor harvest the prices of agricultural commodities rise as the demand is more than supply. The
rise in the price of farm commodities causes the cost of living index to increase as farm commodities carry
substantial weights. In view of rise in the cost of living index, wages rise in industries causing cost-push
inflation.

Banking role in modern economy

Banks play a very useful and crucial role in the economic life of every nation. They have control over a
large part of the supply of money in circulation, and they can influence the nature and character of
production in any country.
1) Removing the deficiency of capital formation
In any economy, economic development is not possible unless there is an adequate degree of capital
accumulation (or) formation. Deficiency of capital formation is the result of low saving made by the
community. The serious capital deficiency in developing economies is reflected in small amount of capital
equipment per worker and the limited knowledge, training and scientific advance. At this juncture, banks
play a useful role. Banks stimulate saving and investment to remove this deficiency. A sound banking
system mobilizes small savings of the community and makes them available for investment in productive
enterprises. The important implications of this activity include Banks mobilise deposits by offering
attractive rates of interest and thus convert savings into active capital. Otherwise that amount would have
remained idle. Banks distribute these savings through loans among productive enterprises which are helpful
in nation building. It facilitates the optimum utilization of the financial resources of the community.
2) Provision of finance and credit
Banks are very important sources of finance and credit for industry and trade. It is observed that credit is the
lubricant of all commerce and trade. Hence, banks become nerve centers of all trade activities and therefore
commerce and trade could function in the presence of sound banking system. The banks cover foreign trade
transactions also. Big banks also undertake foreign exchange business. They help in concluding deferred
payments, arrangements between the domestic industrial undertakings and foreign firms to enable the
former import machinery and other essential equipment.
3) Extension of the size of the market
Commercial bankers help commerce and industry in yet another way. With the sound banking system, it is
possible for commerce and industry for extending their field of operation. Commercial banks act as an
intermediary between buyers and the sellers. Goods are supplied on bank guarantees, making it viable for
industry and commerce to cultivate and locate markets for their products. The risks are undertaken by the
bank. When the risks have been set free by the banks, the industry can look forward to derive economies of
the large size of the market.
4) Act as an engine of balanced regional development
Commercial banks help in proper allocation of funds among different regions of the economy. The banks
operate primarily for profits. When the banks lend their funds for more productive uses, their profits will be
maximized. Introduction of branch banking makes it possible to choose between different regions. A region
with growth potential attracts more bank funds. But in recent years, the approach of banks towards regional
growth has been undergoing a change. Banks help create infrastructure essential for economic development.
Thus banks are engines of balanced regional development in the country.
5) Financing agriculture and allied activities
The commercial bank helps the farmers in extending credit for agricultural development. Farmers require
credit for various purposes like making their produce, for the modernization and mechanization of their
agriculture, for providing irrigation facilities and for developing land. The banks also extend their financial
assistance in the areas of animal husbanding, dairy farming, sheep breeding, poultry farming and
horticulture.
6) For improving the standard of living of the people
The standard of living of the people is estimated on the basis of the consumption pattern. The banks advance
loans to consumers for the purchase of consumer durables and other immovable property, which will raise
the standard of living of the people.
Different Types of Banks in India
Commercial banks:
Commercial banks are the most important types of banks. The term ‘commercial’ carries the significance
that banking is a business like any other business. In other words, commercial banks are essentially profit
making institutions. They collect deposits from the public and lend money to business firms, traders, farmers
and consumers. Commercial banks normally meets the working capital needs of trade and industry and are a
part of the money market. The current account deposits of commercial banks are used as a medium of
exchange, i.e., for making transactions. Deposits of other banks are not so used. These are specialized
institutions which give loans tovarious sectors of the economy.
Development banks:
Development banks are parts of a country’s capital market. In India they are called public financial
institutions. They are specialized financial institutions which supply long-term finance to large and medium
industries. They also perform various promotional functions for accelerating the rate of capital formation in
the country. In this way they promote industrial development in particular and economic development in
general. IFCI, IDBI and ICICI are examples of such banks. These institutions have assumed a crucial
importance in providing an ever-increasing proportion of industrial finance and various types of
development assistance to business enterprises in India.
Co-operative banks:
The co-operative banks are set up under the provisions of the co-operative society’s laws of a country. In
India such banks have been set up to provide credit to primary agricultural credit societies at low rates of
interest. However, some co-operative banks also function in rural areas.
Land development banks:
These banks (called land mortgage banks in India) provide long-term credit to farmers for land
development. They also give long-term loans to farmers for acquiring new land.
Investment banks:
When a corporate entity wants to issue new equity or debt securities, an investment bank serves the role of
an intermediary. They sometimes also make investment in these companies through purchase of equity
shares.
Merchant banks:
A merchant bank helps a company to sell its new shares to the general public. The main job of a merchant
bank is raise money to lend to industry. They do not lend money themselves but instead help circulate
money from those who want to lend to firms who wish to borrow.
Foreign banks:
There are many foreign banks in India like the Citi Bank, the Hong Kong and Sanghai Bank and the Bank of
America. These are not nationalized institutions like Indian commercial banks.
Central bank:
The central bank is the bankers’ bank and is also the banker to the government. It controls the entire banking
system of the country. The Reserve Bank of India (RBI) is India’s central bank and the Bank of England is
that of England

Functions of commercial and central bank

A. Commercial banks
1. Receiving Deposits: The first and foremost function of commercial bank is to receive or collect deposits
from the public in different forms of accounts e.g. current, savings, term deposits. No interest is charged in
the current account, lower rate of interest is charged in the savings account and comparatively higher interest
rates charged in fixed deposits. Thus, commercial bank builds up customer network.
2. Accommodation of loans and advances: Commercial Bank attaches much importance to providing
loans and advances at a higher rates than the deposit rates and thus earns profits on it. Working capital is
accommodated to the borrower for expansion and smooth running of business. In the similar manner,
commercial bank extends financial accommodation for the development of agriculture and industry. Credit
accommodation is provided to the entrepreneurs for reviving sick and old industries as per Govt. directives.
Thus, commercial bank also extends welfare services to the people at large.
3. Creation of Loan Deposits: Commercial Bank not only receives deposits from public and accommodates
loans to public but also creates loan deposits. For example: while disbursing loans as per sanction
stipulation, the amount of loan is credited to the borrower’s account. The borrower may not withdraw the
full amount at a time. The residual amount i.e. balance left in the account creates loan deposits.
4. Creation of medium of exchange: Central Bank has got exclusive right to issue notes. On the other
hand, Commercial Bank creates medium of exchange by issuing cheques. Like notes, cheque is transferrable
being popularly used in the banking transactions.
5. Contribution in foreign trade: Commercial Bank plays a vital role in expediting foreign exchange and
foreign trade business e.g. import, export etc. It contributes greatly in the economy through import finance
and export finance and thus, earn foreign exchange for the country.
6. Formation of capital: Commercial Bank extends financial assistance for the formation of capital in the
trade, commerce and industry in the country which expedites its economic development.
7. Creation of Investment Environment: Commercial Bank plays a significant role in creating investment
environments in the country.
8. Safe custody of valuables: Commercial Bank introduces ‘locker’ services to the customers for safe
custody of valuables e.g. documents, shares, securities etc.
9. Act as a Referee: Commercial Bank acts as a referee for and on behalf of the customers.
10. Act as an Adviser: Commercial Bank provides valuable advice to the customers on different products,
business growth and development, feasibility of business and industry.
11. Maintenance of secrecy: Maintenance of secrecy is one of the most important functions of commercial
bank.
12. Economic Development and Welfare activities: Commercial Bank contributes much for the welfare
and economic development of the country.
B. Central Bank
1. Issue of notes and coins: The first and foremost function of central bank is to issue notes and coins as per
needs of the public and requirement of business and commerce. As per rules, notes are issued against gold,
silver and foreign currency. Bangladesh Bank (Central Bank) keeps foreign currency reserves as security
against issuance of notes. Bangladesh Bank unilatarilly reserves the right to issue notes.
2. Government Bank: Central Bank acts as banker and economic adviser of the Government. The central
bank conducts and maintains Government accounts for all Government receipts and payments.
3. Banker’s Bank: Central Bank acts as banker’s bank. As a rule, all scheduled and commercial banks have
to maintain Statutory Liquidity Reserve
4. Lender of the last Resort: In case of financial crisis of the commercial banks, central bank acts as a
lender of the last resort through lending against first class securities, bill of exchange etc.
5. Reservoir of foreign currency: Central Bank maintains Foreign Currency Reserve.
6. Clearing House: Central Bank acts as a Clearing House for settlement of inter bank transactions.
7. Control Currency Market: Central Bank acts as a controller and guardian of the currency market. For
the purpose of formation, control and maintenance of currency market and for its overall development,
central bank is the pioneer.
8. Stabilize Exchange Rate:
Central Bank maintains stability of the foreign currency exchange rates by means of controlling credit.
Stable exchange rates position helps create favourable balance of trade and acceptability of stable currency
gets momentum in the international market.
9. Maintain Gold Standard: Central Bank is responsible for maintenance and control of gold reserve.
10. Stabilize Price-Level: Fluctuations and frequent changes of price-level affect economic growth. With a
view to making good of the economic imbalances and crisis situations, central bank takes necessary
measures for stabilizing price-level.
11. Development of Agriculture and industry sector: Central Bank formulates policy for expansion of
Agri and industry sector for the purpose of economic upliftments in the country.
12. Development of natural resources: Central Bank plays vital role for tapping natural resources which
may lead to economic growth.
13. Adviser and Representative of Government: Central Bank advises Government on economic issues
and sometimes acts as a representative of the Government.

Population
The Malthusian Theory of Population
The Malthusian Theory of Population is the theory of exponential population growth and arithmetic food
supply growth. The theory was proposed by Thomas Robert Malthus. He believed that a balance between
population growth and food supply can be established through preventive and positive checks.
Major Elements of the Malthusian Theory
Population and Food Supply
The Malthusian theory explained that the population grows in a geometrical fashion.
The population would double in 25 years at this rate. However, the food supply grows in an arithmetic
progression. Food supply increases at a slower rate than the population. That is, the food supply will be
limited in a few years. The shortage of food supply indicates an increasing population.

Checks on Population
When the rise in population is greater than the food supply, there is a condition of disequilibrium. As a
result, people will not get enough food even for survival. People will die due to lack of food supply. People
will be subjected to wars, epidemics, famines, starvation, and other natural calamities which are named as
positive checks by Malthus. On the contrary, there are man-made checks known as preventive checks.
Positive Checks
Nature has its own ways of keeping a check on the increasing population. It brings the population level to
the level of the available food supply. The positive checks include famines, earthquakes, flood, epidemics,
wars, etc. When humans fail to control excessive population growth, nature plays its role.
Preventive Checks
The preventive measures such as late marriage, self-control, simple living, help to balance the population
growth and food supply. This measure can not only check the population growth but can also prevent the
catastrophic effects of the positive checks.
The Optimum Theory of Population
The theory state it as “Given the natural resources, stock of capital and the state of technical knowledge,
there will be a definite size of population with the per capita income. The population which has the highest
per capita income is known as optimum population”.
Under Population:
If the actual population in a country is less than the optimum or ideal population, there will not be enough
people to exploit all the resources of the country fully. Thus, the population and the per capita income will
be lower. In other words, if the per capita income is low due to too few people, the population is then under
population.
Over Population:
If the actual population is above the level of optimum population, there will be too many people to work
efficiently and produce the maximum goods and the highest per capita income. As a result, the per capita
income becomes poorer than before. This is the stage of over population. In other words, if the per capita
income is low due to too many people, the population under these circumstances would be over population.
Prof. Dalton expresses the theory in the form of a formula which is given below:

If M is zero, population is optimum, when M is positive, it is over population, when M is negative, it is

under population. Therefore, optimum population is not fixed and a rigid one. It is rather variable and
relative to resources and technology. Optimum population is not just an economic concept but qualitative in
nature. Prof. Cannan has correctly remarked, “It is being perpetually altered by the progress of knowledge
and other changes affecting the economic system. It is, thus, a dynamic concept. It may be higher or lower
as different methods of production are used.”