Economics Cptbook

GENERAL
ECONOMICS
The Institute of Chartered Accountants of India

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PREFACE
The activity of seeking wealth is as old as civilisation. Human beings either as individuals or as groups or
as large kingdoms and empires have always been engaged in acquiring and increasing the material wealth.
In fact, all human decisions and activities can be ultimately linked with acquisition of material welfare.
However, a disciplined study of the wealth producing activities was commenced about 230 years back when
Adam Smith, the father of Economics, published “The Nature and Causes of Wealth of Nations”. Economics,
as a discipline, has come a long way since then and it constitutes the most important subject to analyse
activities related to wealth creation and distribution. The dimensions of the subject of Economics are truly
vast and encompass all aspects of our lives. Undoubtedly, Economics has come to be known as the mother of
all social sciences. A study of Economics gives a perspective and a macro attitude while analysing financial
activities. It provides an insight into various economic problems faced by a country and also provides solutions
to solve these problems. Since it deals with problems and questions that affect almost all kinds of individuals
in their capacities as consumers and producers, an adequate knowledge of the science of Economics is a
prerequisite for understanding the economy and its various components. Economics, therefore, has always
been a part of the curricula of Chartered Accountancy course in India.
In the new course it is being taught and tested at the CPT level. The syllabus is systematically planned to
give students an exposure to Micro economics as well as Indian economy. In Micro economics, there are
four chapters namely Introduction to Micro Economics, Theory of Demand and Supply, Theory of Production
and Cost and Price determination in different markets. Similarly, in Indian Economy there are four chapters,
namely, Indian economy – a Profile, Select aspects of Indian economy, Economic Reforms in India and
Money and Banking. Care has been taken to explain the concepts in a lucid and easy language with the help
of diagrams and illustrations. In chapters relating to Indian economy, efforts have been made to provide the
latest data. At the end of each chapter, lots of multiple choice questions have been given to help students test
their understanding of the subject and their skills in applying economic theory to real world situations. It is
hoped that these inputs will further enhance the utility of the book. I appreciate the earnest and sincere efforts
taken by Ms. Prem Bhutani, Deputy Director, BOS, in bringing out this publication, incorporating many
student-friendly features, well in time. Suggestions for further improvements are heartily welcome.
SYLLABUS
General Economics ( 50 Marks )
Objective:
To ensure basic understanding of economic systems, economic behaviour of individuals and organisations.
Contents
(I) Micro Economics
1. Introduction to Micro Economics
(a) Definition, scope and nature of Economics
(b) Methods of economic study
(c) Central problems of an economy and Production possibilities curve.
2. Theory of Demand and Supply
(a) Meaning and determinants of demand, Law of demand and Elasticity of demand – Price, income
and cross elasticity
(b) Theory of consumer ’s behaviour – Marshallian approach and Indifference curve approach
(c) Meaning and determinants of supply, Law of supply and Elasticity of supply.
3. Theory of Production and Cost
(a) Meaning and Factors of production
(b) Laws of Production – The Law of variable proportions and Laws of returns to scale
(c) Concepts of Costs – Short run and longrun costs, Average and marginal costs, Total, fixed and
variable costs.
4. Price Determination in Different Markets
(a) Various forms of markets – Perfect Competition, Monopoly, Monopolistic Competition and
Oligopoly
(b) Price determination in these markets.
(II) Indian Economic Development
5. Indian Economy – A Profile
(a) Nature of the Indian Economy
(b) Role of different sectors – Agriculture, Industry and Services in the development of the Indian
economy, their problems and growth
(c) National Income of India – Concepts of national income, Different methods of measuring national
income, Growth of national income and per capita income in various plans
(d) Basic understanding of tax system of India – Direct and Indirect Taxation.
6. Select Aspects of Indian Economy
(a) Population – Its size, rate of growth and its implication for growth
(b) Poverty – Absolute and relative poverty and main programs for poverty alleviation
(c) Unemployment – Types, causes and incidence of unemployment
(d) Infrastructure – Energy, Transportation, Communication, Health and Education
(e) Inflation
(f) Budget and Fiscal deficits
(g) Balance of payments
(h) External debts.
7. Economic Reforms in India
(a) Features of economic reforms since 1991
(b) Liberalisation, Privatisation and Disinvestment
(c) Globalisation.
8. Money and Banking
(a) Money – Meaning and functions
(b) Commercial Banks – Role and functions
(c) Reserve Bank of India – Role and functions, Monetary policy.
CONTENTS
SECTION - I : MICRO ECONOMICS
Chapter 1 - Introduction to Micro Economics

1.0 What is Economics About? 2
1.1 Definitions and Scope of Economics 3
1.2 Nature of Economics 9
1.3 Methods of Study 10
1.4 Central Economic Problems 12
1.5 Production Possibilities Curve 13
1.6 How Different Economies Solve their Central Economic Problems? 16
Summary
Chapter 2 - Theory of Demand and Supply
Unit 1 : Law of Demand and Elasticity of Demand
1.0 Meaning of Demand 38
1.1 What determines Demand? 38
1.2 Law of Demand 40
1.3 Expansion and Contraction in Demand 44
1.4 Increase and Decrease in Demand 45
1.5 Movements along Demand curve vs. Shift of Demand curve 47
1.6 Elasticity of Demand 47
1.7 Demand Distinctions 58
Summary
Unit 2 : Theory of Consumer Behaviour
2.0 What is Utility? 62

2.1 Marginal Utility Analysis 63
2.2 Indifference Curve Analysis 68
Summary
Unit 3 : Supply
3.0 Introduction 77
3.1 Determinants of Supply 77
3.2 Law of Supply 78
3.3 Shifts in the Supply Curve – Increase or Decrease in Supply 80
3.4 Movements on the Supply Curve – Increase or Decrease in the quantity supplied 80
3.5 Elasticity of Supply 81
Summary
CONTENTS
Chapter 3 -Theory of Production and Cost

Unit 1 : Theory of Production
1.0 Meaning of Production 104

1.1 Factors of Production 105
1.2 Production Function 110
1.3 Economies and Diseconomies of Scale 118
Summary
Unit 2 : Theory of Cost
2.0 Cost Analysis 123
2.1 Cost Concepts 123
2.2 Cost Function 125
2.3 Short run Total Costs 125
2.4 Long run Average Cost Curve 131
Summary
Chapter 4 - Price Determination in Different Markets

Unit 1 : Meaning and Types of Markets
1.0 Meaning of Market 150
1.1 Types of Market Structures 152
1.2 Concepts of Total Revenue, Average Revenue and Marginal Revenue 153
1.3 Behavioural Principles 155
Summary
Unit 2 : Determination of Prices
2.0 Introduction 157
2.1 Determination of Prices – A General View 157
2.2 Changes in Demand and Supply 158
2.3 Simultaneous Changes in Demand and Supply 161
Summary
Unit 3 : Price-output Determination under Different Market Forms
3.0 Perfect Competition 164
3.1 Monopoly 173
3.2 Imperfect Competition-Monopolistic Competition 182
3.3 Oligopoly 186
Summary
CONTENTS
SECTION - II : INDIAN ECONOMIC DEVELOPMENT
Chapter 5 - Indian Economy - A Profile
Unit 1 : Nature of Indian Economy
1.0 India - An Undeveloped Economy 20 8
1.1 India - A Developing Economy 211
1.2 India - A Mixed Economy 213
Summary
Unit 2 : Role of Different Sectors in India
2.0 Agriculture 216
2.1 Industry 224
2.2 Services 233
Summary
Unit 3 : National Income in India
3.0 Basic Concepts in National Income and Output 240
3.1 Methods of Measuring National Income 243
3.2 Trends in India’s National Income Growth and Structure 247
Summary
Unit 4 : Basic Understanding of Tax System in India
4.0 Meaning of Direct and Indirect Taxes 251
4.1 Merits and Demerits of Direct and Indirect Taxes 251
4.2 Tax Structure in India 252
Summary
Chapter 6 - Select Aspects of Indian Economy

Unit 1 : Population
1.0 Meaning of Population 270
1.1 Demographic Trends in India 270
1.2 Causes of the Rapid Growth of Population 275
1.3 Growth of Population in India and its effects on Economic Development 276
1.4 Government Measures for solving the Population Problem 278
Summary
Unit 2 : Poverty
2.0 Absolute Poverty and Relative Poverty 282
2.1 Poverty in India 282
2.2 Causes of Poverty 284
2.3 Government Programmes for Poverty Alleviation 284
Summary
CONTENTS
Unit 3 : Unemployment
3.0 Meaning and Types of Unemployment 288

3.1 Nature of Unemployment in India 289
3.2 Causes of Unemployment in India 290
3.3 Extent of Unemployment in India 290
Summary
Unit 4 : Infrastructural Challenges
4.0 Energy 297
4.1 Transportation 301
4.2 Communication 304
4.3 Health 306
4.4 Education 306
Summary
Unit 5 : Inflation
5.0 Meaning and Types of Inflation 312

5.1 Price Trends in India 313
5.2 Causes of Inflation in India 314
5.3 Measures to Check Inflation 316
Summary
Unit 6 : Budget and Fiscal Deficits in India
6.0 Meaning of Budget and Fiscal Deficits 319
6.1 Trends in India’s Budget and Fiscal Deficits 320
Summary
Unit 7 : Balance of Payments
7.0 Meaning of Balance of Payments and Balance of Trade 323
7.1 Trends in Balance of Payments of India 324
Summary
Unit 8 : External Debt
8.0 External Debts in India 329
Summary
CONTENTS
Chapter 7 - Economic Reforms in India

Unit 1 : Economic Reforms in India
1.0 Background 346

1.1 Industrial Sector 347
1.2 Financial Sector 349
1.3 External Sector 351
1.4 Fiscal Policy 353
1.5 Impact of Economic Reforms on the Indian Economy 355
Summary
Unit 2 : Liberalisation, Privatisation and Disinvestment
2.0 Meaning of Liberalisation, Privatisation and Disinvestment 358
2.1 Privatisation and Disinvestment in India 360
2.2 Methods of Disinvestment 360
2.3 Progress of Disinvestment 361
Summary
Unit 3 : Globalisation
3.0 Meaning of Globalisation 364
3.1 Cases for Globalisation 364
3.2 Cases against Globalisation 365
3.3 Measures towards Globalisation 365
3.4 Effect of Globalisation on Indian Economy 367
3.5 Main Organisations for Facilitating Globalisation 368
Summary
Chapter 8 - Money and Banking

Unit 1 : Money
1.0 Meaning of Money 382

1.1 Functions of Money 382
1.2 Money Stock in India 383
Summary
CONTENTS
Unit 2 : Commercial Banks

2.0 Introduction 386
2.1 Role of Commercial Banks 386
2.2 Functions of a Bank 387
2.3 Commercial Banking in India 388
2.4 Nationalisation of Commercial Banks 388
2.5 Progress of Commercial Banks after Nationalisation 389
2.6 Shortcomings of Commercial Banking in India 390
Summary
Unit 3 : The Reserve Bank of India (RBI)

3.0 Meaning and Functions of a Central Bank 393
3.1 Central Bank Vs Commercial Bank 393
3.2 Role of the Reserve Bank of India 394
3.3 Functions of Reserve Bank of India 394
3.4 Indian Monetary Policy 396
Summary
SECTION - I
MICRO
ECONOMICS
CHAPTER – 1
INTRODUCTION
TO MICRO
ECONOMICS
INTRODUCTION TO MICRO ECONOMICS
Learning Objectives
At the end of this Chapter, you will be able to :
know what Economics is about.

know about the nature of Economics.
understand the various methods of studying Economics.
understand the basic problems of an economy.
understand how different economies solve their basic problems.
get an insight into the tool of Production Possibilities Curve.
1.0 WHAT IS ECONOMICS ABOUT?

Consider the following situation.
It is your birthday and your mother gives you Rs. 500 as birthday gift. You are free to spend the
money as you like. What will you do? You have many options before you, like :
Option 1 : You can give a party to your friends and spend the whole money on them.
Option 2 : You can buy yourself a dress for Rs. 500.
Option 3 : You can go for a movie and eat in some restaurant.
Option 4 : You can buy yourself a book and save some money.
What do you notice? You have so many options before you. You will have to go for one option
or a combination of one or more options. But why can’t you have everything? Given the choice
you would like to spend not only on your friends, but would also like to see movie, eat in the
restaurant, buy a dress and a book and save some money. But you cannot. Why? Because you
have only 500 Rupees with you. Had your mother given you Rs. 1,500, you might have satisfied
more of your demands. Thus you are in dilemma. Similar dilemma is faced by every individual,
every society and every country in this world. Life is like that. Because we cannot have every
thing all at once, we are forever forced to make choices. We can use our resources to satisfy
only some of our wants, leaving many others unsatisfied.
These two fundamental facts that
(i) Human beings have unlimited wants; and
(ii) The means of satisfying these wants are relatively scarce form the subject matter of
Economics. Economics is, thus, the study of how we work together to transform scarce
resources into goods and services to satisfy the most pressing of our infinite wants and
how we distribute these goods and services among ourselves. The term ‘Economics’ owes
its origin to the Greek word ‘Oikonomia’ meaning ‘household’.
2 COMMON PROFICIENCY TEST

This definition of Economics, in terms of using scarce resources to satisfy human wants, is
correct but it is incomplete. It brings to our mind the picture of a society with fixed resources,
skills and productive capacity deciding what specific kinds of goods it ought to produce and
how they ought to be distributed. Yet two of the most important concerns of modern economies
are not fully covered by this concept.
On the one hand, the productive capacity of modern economies has grown tremendously.
Population and labour force have increased, new sources of raw materials have been discovered,
and new and better plant and equipment have been made available on farms and in factories
and mines. Not only has the quantity of available productive resources increased, their quality
has also been greatly improved. Education and newly acquired skills have raised the productivity
of the labour force, and led to the discovery of completely new kinds of natural resources like
petroleum and atomic energy. On the other hand, the resulting growth in production and
income has not been smooth. There have been periods in which output not only failed to grow
but also actually declined sharply. During such periods factories and workers remained idle
due to insufficient demand.
Economics, therefore, concerns itself not just with how a nation allocates to various uses its
scarce productive resources, important as that may be. It also deals with the process by which
the productive capacity of these resources is increased and with the factors which in the past
have led to sharp fluctuations in the rate of utilisation of resources.
In the day-to-day events we come across several economic problems like changes in price of
individual commodities as well as general price level changes; the economic prosperity and
higher standards of living of some people despite general poverty of the masses in India; the
problems of unemployment of certain class of persons or in some areas are some of the matters
connected with economic analysis. The study of Economics will help in analysing the possible
causes contributory to these problems and might suggest a number of alternative courses,
which could be adopted for tackling these problems. However, it is necessary to remember
that most economic problems are of complex nature which are affected by several forces, some
of which are rooted in Economics and some in political set up, social norms, etc. The study of
Economics cannot ensure that all the problems will be tackled but surely it would enable a
student to examine a problem in its right perspective and would help him in finding suitable
measures to tackle those problems.
1.1 DEFINITIONS AND SCOPE OF ECONOMICS

Several definitions of Economics have been given. For the sake of convenience let us classify
the various definitions into four groups :
1. Science of wealth
2. Science of material well-being
3. Science of choice making and
4. Science of dynamic growth and development
We shall examine each one of these briefly.
GENERAL ECONOMICS 3
1. Science of wealth. Some earlier economists defined Economics as follows :

The classical economists defined Economics in terms of “The Science of Wealth”. Adam Smith,
also known as the father of modern Economics, published his masterpiece “An Enquiry into
the Nature and Causes of Wealth of Nations” in the year 1776. He defined Economics as:
“An inquiry into the nature and causes of the wealth of the nations” by Adam Smith.
“Science which deals with wealth” by J.B. Say.
In the above definitions wealth becomes the main focus of the study of Economics. The definition
of Economics, as science of wealth, had some merits. The important ones are :
(i) It highlighted an important problem faced by each and every nation of the world, namely
creation of wealth.
(ii) Since the problems of poverty, unemployment etc. can be solved to a greater extent when
wealth is produced and is distributed equitably; it goes to the credit of Adam Smith (called
the father of Economics) and his followers to have addressed to the problems of economic
growth and increase in the production of wealth.
(iii) By considering the problems of production, distribution and exchange of wealth, classical
economists focused attention on the important issues with which Economics is concerned.
The study of Economics as a ‘Science of Wealth’ has been criticised on several grounds. The
main criticisms levelled against this definition are;
(i) Adam Smith and other classical economists concentrated only on material wealth. They
totally ignored creation of immaterial wealth like services of doctors, chartered accountants
etc.
(ii) The advocates of Economics as ‘science of wealth’ concentrated too much on the production
of wealth and ignored social welfare. This makes their definition incomplete and
inadequate.
2. Science of material well-being. Under this group of definitions the emphasis is on welfare
as compared with wealth in the earlier group. Alfred Marshall, the neo-classicist, raised
Economics from its ignoble position to a noble one. It was he who shifted the emphasis from
wealth to welfare. According to him,
“Economics is a study of mankind in the ordinary business of life. It examines that part of
individual and social action which is most closely connected with the attainment and with the
use of the material requisites of well-being. Thus, it is on the one side a study of wealth and on
the other and more important side a part of the study of the man” Alfred Marshall
Another definition:
“The range of our inquiry becomes restricted to that part of social welfare that can be brought
directly or indirectly into relation with the measuring rod of money” A.C. Pigou
In the first definition Economics has been indicated to be a study of mankind in the ordinary
business of life. By ordinary business we mean those activities which occupy considerable part
of human effort. The fulfilment of economic needs is a very important business which every

man ordinarily does. Professor Marshall has clearly pointed that Economics is the study of
wealth but more important is the study of man. Thus, man gets precedence over wealth. There
is also emphasis on material requisites of well-being. Obviously, the material things like food,
clothing and shelter, are very important economic objectives.
The second definition by Pigou emphasises social welfare but only that part of it which can be
related with the measuring rod of money. Money is general measure of purchasing power by
the use of which the science of Economics can be rendered more precise.
Marshall’s and Pigou’s definitions of Economics are wider and more comprehensive as they
take into account the aspect of social welfare. But their definitions have their share of criticism.
Their definitions are criticised on the following grounds.
(i) Economics is concerned with not only material things but also with immaterial things like
services of singes, teachers, actors etc. Marshall and Pigou chose to ignore them.
(ii) Robbins criticised the welfare definition on the ground that it is very difficult to state
which things would lead to welfare and which will not. He is of the view that we would
study in Economics all those goods and services which carry a price whether they promote
welfare or not.
3. Science of choice making. Prof. Lionel Robbins of the London School of Economics gave
a new definition to Economics in his famous book “Nature and significance of Economics”
which he brought out in 1931. According to Robbins, Economics studies the problems which
have arisen because of the scarcity of resources. Nature has not provided mankind sufficient
resources to satisfy all its wants. Therefore, people have to choose for which ends or for which
wants the resources are to be utilized. Robbins gave a more scientific definition of Economics.
His definition is as follows :
“Economics is the science which studies human behaviour as a relationship between ends and
scarce means which have alternative uses”.
The definition deals with the following four aspects :
(i) Economics is a science : Economics studies economic human behaviour scientifically. It
studies how humans try to optimise (maximize or minimize) certain objective under given
constraints. For example, it studies how consumers, with given income and prices of the
commodities, try to maximize their satisfaction.
(ii) Unlimited ends : Ends refer to wants. Human wants are unlimited. When one want is
satisfied, other wants crop up. If man’s wants were limited, then there would be no
economic problem.
(iii) Scarce means : Means refer to resources. Since resources (natural productive resources,
man-made capital goods, consumer goods, money and time etc.) are limited economic
problem arises. If the resources were unlimited, people would be able to satisfy all their
wants and there would be no problem.
(iv) Alternative uses : Not only resources are scarce, they have alternative uses. For example,
coal can be used as a fuel for the production of industrial goods, it can be used for running
trains, it can also be used for domestic cooking purposes and for so many purposes.
GENERAL ECONOMICS 5
Similarly, financial resources can be used for many purposes. The man or society has,
therefore, to choose the uses for which resources would be used. If there was only a single
use of the resource then the economic problem would not arise.
It follows from the definition of Robbins that Economics is a science of choice. An important
thing about Robbin’s definition is that it does not distinguish between material and non-material,
between welfare and non-welfare. Anything which satisfies the wants of the people would be
studied in Economics. Even if a good is harmful to a person it would be studied in Economics
if it satisfies his wants.
No doubt, Robbins has made Economics a scientific study and his definition has become popular
among some economists. But his definition has also been criticised on several grounds. Important
ones are :
(i) Robbins has made Economics quite impersonal and colourless. By making it a complete
positive science and excluding normative aspects he has narrowed down its scope.
(ii) Robbins’ definition is totally silent about certain macro-economic aspects such as
determination of national income and employment.
(iii) His definition does not cover the theory of economic growth and development. While
Robbins takes resources as given and talks about their allocation, it is totally silent about
the measures to be taken to raise these resources i.e. national income and wealth.
4. Science of dynamic growth and development. Although the fundamental economic
problem of scarcity in relation to needs is undisputed, it would not be proper to think that
economic resources - physical, human, financial are fixed and cannot be increased by human
ingenuity, exploration, exploitation and development. A modern and somewhat modified
definition is as follows :
“Economics is the study of how men and society choose, with or without the use of money, to
employ scarce productive resources which could have alternative uses, to produce various
commodities over time and distribute them for consumption now and in the future amongst
various people and groups of society”.
Paul A. Samuelson
The above definition is very comprehensive because it does not restrict to material well-being
or money measure as a limiting factor. But it considers economic growth over time.
Prof Henry Smith also gave an all inclusive definition of Economics. According to him, Economics,
is the “the study of how in a civilized society one obtains the share of what other people have
produced and of how the total product of society changes and is determined”. By civilized
society it is meant that there are some legal institutions as well as rights of property and other
things in the society.
Jacob Viner has given a pragmatic definition of Economics. According to him, “Economics is
what Economists do”. In other words, what economists do and what they have been doing.

Micro and Macro-Economics
The subject-matter of Economics has been divided into two parts - Micro-Economics and Macro
Economics. In Micro-Economics we study the economic behaviour of an individual, firm or
industry in the national economy. It is thus a study of a particular unit rather than all the units
combined. It is basically concerned with the mechanism of allocation of given resources. Further,
it is a partial equilibrium analysis as it seeks to determine price and output in an industry
independent of those in other industries. The term Micro Economics is derived from the Greek
word mikros, meaning “small”. We mainly study the following in Micro-Economics :
(i) product pricing;
(ii) consumer behaviour;
(iii) factor pricing;
(iv) economic conditions of a section of the people;
(v) study of firms; and
(vi) location of a industry.
Thus, when we are studying how a producer fixes the prices of his products, we are studying
Micro-Economics. Similarly, when we are studying why an industry is located at a particular
place, we are studying Micro-Economics.
The whole content of micro Economics theory is presented in the following chart;
Micro Economic Theory
Factor Pricing
Product Pricing (Theory of Theory of
Distribution) Economic Welfare
Wage Rent Interest Profits

Theory of Theory of
Demand Production
and Cost
GENERAL ECONOMICS 7
The term Macro Economics is derived from the Greek word makros, meaning “large”.
In Macro-Economics, we study the economic behaviour of the large aggregates such as the
overall conditions of the economy such as total production, total consumption, total saving
and total investment in it. It is the study of overall economic phenomena as a whole rather
than its individual parts. It includes :
(i) national income and output;
(ii) general price level;
(iii) balance of trade and payments;
(iv) external value of money;
(v) saving and investment; and
(vi) employment and economic growth.
Thus, when we study why we continue to have balance of payments deficits, or why the value
of rupee vis-à-vis dollar is falling or why saving rates are high or low in a particular country
we are studying Macro-Economics.
The various aspects of macro economic theory are shown in the following chart:
Macro Economic Theory
Theory of
income and Theory of General The Theory of Macro- theory of
employment Price Level and Economic Distribution
Inflation Growth (Relative shares
of wages and
profits)
Theory of Theory of
consumption Investment
function
Theory of
Fluctuations
(Or Business Cycles)

1.2 NATURE OF ECONOMICS
Under this, we generally discuss whether Economics is science or art or both and if it is a
science whether it is a positive science or a normative science or both.
Economics – As a science and as an art :
Often a question arises – whether Economics is a science or an art or both.
(a) Economics is a science : A subject is considered science if
- it is a systematised body of knowledge which studies the relationship between cause
and effect.
- it is capable of measurement.
- it has its own methodological apparatus.
- it should have the ability to forecast.
If we analyse Economics, we find that it has all the features of science. Like science it
studies cause and effect relationship between economic phenomena. To understand, let
us take the law of demand. It explains the cause and effect relationship between price and
demand for a commodity. It says, given other things constant, as price rises, the demand
for a commodity falls and vice versa. Here the cause is price and the effect is fall in quantity
demanded. Similarly like science it is capable of being measured, the measurement is in
terms of money. It has its own methodology of study (induction and deduction) and it
forecasts the future market condition with the help of various statistical and non-statistical
tools.
But it is to be noted that Economics is not a perfect science. This is because
- Economists do not have uniform opinion about a particular event.
- The subject matter of Economics is the economic behaviour of man which is highly
unpredictable.
- Money which is used to measure outcomes in Economics is itself a dependent variable.
- It is not possible to make correct predictions about the behaviour of economic variables.
(b) Economics is an art : Art is nothing but practice of knowledge. Whereas science teaches
us to know art teaches us to do. Unlike science which is theoretical, art is practical. If we
analyse Economics, we find that it has the features of an art also. Its various branches,
consumption, production and public finance etc. provide practical solutions to various
economic problems. It helps in solving various economic problems which we face in our
day-to-day life.
Thus, Economics is both a science and an art. It is science in its methodology and art in its
application. Study of unemployment problem is science but framing suitable policies for reducing
the extent of unemployment is an art.
Economics as Positive Science and Economics as Normative Science
(i) Positive Science : As stated above, Economics is a science. But the question arises whether
GENERAL ECONOMICS 9
it is a positive science or a normative science. A positive or pure science analyses cause and
effect relationship between variables but it does not pass value judgment. In other words,
it states what is and not what ought to be. Professor Robbins emphasised the positive
aspects of science but Marshall and Pigou have considered the ethical aspects of science
which obviously are normative.
Positive Economics is the one that simply states facts and uses empirical evidence. An
example of positive statement is: “According to the law of demand, a lower price will
yield more quantity sold”.
According to Robbins, Economics is concerned only with the study of the economic
decisions of individuals and the society as positive facts but not with the ethics of these
decisions. Economics should be neutral between ends. It is not for economists to pass
value judgments and make pronouncements on the goodness or otherwise of human
decisions. An individual with a limited amount of money may use it for buying liquor and
not milk, but that is entirely his business. A community may use its limited resources for
making guns rather than butter, but it is no concern of the economists to condemn or
appreciate this policy. Economics only studies facts and makes generalisations from them.
It is a pure and positive science, which excludes from its scope the normative aspect of
human behaviour.
Complete neutrality between ends is, however, neither feasible nor desirable. It is because
in many matters the economist has to suggest measures for achieving certain socially
desirable ends. For example, when he suggests the adoption of certain policies for increasing
employment and raising the rates of wages, he is making value judgments; or that the
exploitation of labour and the state of unemployment are bad and steps should be taken
to remove them. Similarly, when he states that the limited resources of the economy should
not be used in the way they are being used and should be used in a different way; that the
choice between ends is wrong and should be altered, etc. he is making value judgments.
(ii) Normative Science : As normative science, Economics involves value judgments. It is
prescriptive in nature and describes ‘what should be the things’. Normative Economics is
the one that takes values into account, and results in statements like: “This tax should be
reduced.” For example, the questions like what should be the level of national income,
what should be the wage rate, how the fruits of national product be distributed among
people - all fall within the scope of normative science. Thus, normative economics is
concerned with welfare propositions. Some economists are of the view that value judgments
by different individuals will be different and thus for deriving laws or theories, it should
not be used.
To conclude, we may say that while laying down laws or theories, Economics may be treated
as pure and positive Economics, but as a tool of practical application it must have some normative
goals in view.
1.3 METHODS OF STUDY

In Economics, there are two methods of deriving generalisations or laws. These are deductive
method and inductive method.

Deductive method : This method is also called abstract, analytical and priori method. Under
this method laws are deduced logically. On the basis of certain fundamental assumptions or
accepted axioms or truths which have been established and handed down from generation to
generation, conclusions and generalisations are drawn. The logic proceeds from general to
particular. This method is called abstract or a priori because it is based on abstract reasoning
and not on actual facts. However, actual situation may differ from what deductive logic suggests
For example, it is assumed that man is rational and on the basis of this it is deduced that he will
buy cheap and sell dear. But in actual situation this may not happen, say, because of absence
of proper knowledge and market conditions.
The principal steps in the process of deriving economic generalizations through deductive
logic are (a) perception of the problem (b) defining the technical terms and making appropriate
assumptions (c) deducing hypothesis and (d) testing of hypothesis deduced.
Many theories and generalisation have been established in Economics with the help of deductive
method such as inverse relationship between price and quantity demanded, the direct
relationship between price and quantity supplied etc. But this method also suffers from certain
handicaps such as (i) assumptions generally turn out to be untrue or partially true (ii) valid
conclusions cannot be drawn in the absence of proper knowledge of the whole situation and
(iii) it is dangerous to claim universal validity for the economic generalisations so deduced.
Inductive Method : Under this method conclusions are drawn on the basis of collection and
analysis of facts relevant to the inquiry. The logic in this case proceeds from the particular to
the general. The generalisations are based on observation of individual examples.
The principal steps in this method are (i) perception of the problem (ii) collection, classification
and analysis of data by using appropriate statistical techniques (iii) finding out the reasons for
the relationship established through statistical analysis and to set rules for the verification of
the principles. Many researches in macro-economics have been obtained through inductive
method such as principle of acceleration describing the factors which determine investment in
an economy, the nature of consumption function describing the relationship between income
and consumption etc. Inductive method is increasingly being used because (i) statistical induction
leads to precise, exact and measurable conclusions (ii) it underlines the importance of relativity
of economic laws (iii) it shows that generalisations are valid only under certain conditions. But
this method suffers from (i) risk of hurried conclusions having being drawn from an insufficient
number of facts (ii) difficulties involved in the collection of facts (iii) the fact that observation
and experimentation have very limited application in a science that deals with human activities.
However, the two methods are not mutually exclusive and are used side by side in any scientific
inquiry. Conclusions drawn from the deductive method of reasoning and are verified by
inductive method of observing concrete facts of life. For example, the hypothesis of rationality
may be tested and verified by the observation of the behaviour of people.
Marshall rightly pointed out, “induction and deduction are both needed for scientific thought
as the right and left foot are both needed for walking”.
GENERAL ECONOMICS 11
1.4 CENTRAL ECONOMIC PROBLEMS

As discussed before, human wants are unlimited and productive resources such as land and
other natural resources, raw materials, capital equipments etc. with which goods and services
are produced to satisfy those wants are scarce. The problem of scarcity of resources is felt not
only by individuals but also by the society as a whole. This gives rise to the problem of how to
use scarce resources to attain maximum satisfaction. This is generally called ‘the economic
problem’. Every economic system, be it capitalist, socialist or mixed, has to deal with this central
problem of scarcity of resources relative to wants for them. The central economic problem is
further divided into four basic economic problems. These are :
(i) What to produce?
(ii) How to produce?
(iii) For whom to produce?
(iv) What provisions (if any) are to be made for economic growth?
(i) What to produce? : Every society has to decide which goods are to be produced and in
what quantities. Whether more guns should be produced or more butter should be produced;
or whether more capital goods like machines, equipments, dams etc., will be produced or
more consumer goods such as bread will be produced. Not only the society has to decide
about what goods are to be produced it has also to decide in what quantities these goods
would be produced. In nutshell, a society must decide how much wheat, how many
hospitals, how many schools, how many machines, how many meters of cloths etc. have
to be produced.
(ii) How to produce? There are various alternative techniques of producing a commodity. For
example, cotton cloth can be produced with either handlooms or power looms or automatic
looms. Production with handlooms involves use of more labour and production with
automatic loom involves use of more machines and capital. A society has to decide whether
it will produce cotton cloth using labour intensive techniques or capital intensive techniques.
Likewise for all goods and services it has to decide whether to use labour intensive
techniques or capital intensive techniques. Obviously, the choice would depend on the
availability of different factors of production (i.e. labour and capital) and their relative
prices. It is in the society’s interest to use those techniques of production that make best
use of the available resources.
(iii) For whom to produce? Another important decision which a society has to take is for whom
to produce. The society can not satisfy all wants of all the people. Therefore, it has to
decide who should get how much of the total output of goods and services. In other
words, it has to decide about the shares of different people in the national cake of goods
and services.
(iv) What provision should be made for economic growth? A society would not like to use all
its scarce resources for current consumption only. This is because if it uses all the resources
for current consumption and no provision is made for future production, the society’s
production capacity would not increase. This implies that incomes or standards of living
of the people would remain stagnant and in future, the levels of living may decline.

Therefore, a society has to decide how much saving and investment (i.e. how much sacrifice
of current consumption) should be made for future progress.
1.5 PRODUCTION POSSIBILITIES CURVE

The nature of basic problems explained above can be better understood with the help of an
important tool of Economics known as Production Possibilities Curve (PPC). Production
possibilities curve graphically represents the alternative production possibilities facing an
economy.
In Economics, a production-possibility curve (PPC) or “transformation curve” is a graph that
shows the different rates of production of two goods that an individual or group can efficiently
produce with limited productive resources. The PPF shows the maximum obtainable amount
of one commodity for any given amount of another commodity or composite of all other
commodities, given the society’s technology and the amount of factors of production available.
In order to understand PPC, let us assume that there are two types of goods – wheat and cloth
which are to be produced. We also assume that (1) there is a given amount of productive
resources and they remain fixed; (2) resources are neither unemployed nor underemployed;
and (3) technology does not change. Now consider the following table :
Table : 1
Alternative Production Possibilities
Production Cloth Wheat
possibilities (in thousand metres) (in thousand quintals) Opportunity cost
A 0 15
B 1 14 1
C 2 12 2
D 3 9 3
E 4 5 4
F 5 0 5
The above table shows various production possibilities between wheat and cloth. If all the
given resources are employed for the production of wheat, 15 thousand quintals of wheat are
produced. On the other hand, if all the resources are employed for the production of cloth, 5
thousand meters of cloth are made. But these two are extreme production possibilities. In
between these two there will be many other production possibilities such as B, C, D and E.
With production possibility B, the economy can produce with given resources one thousand
meter of cloth and 14 thousand quintals of wheat and with production possibility C, it can
produce 2 thousand meters of cloth and 12 thousand quintals of wheat. Thus, as the economy
is moving from one possibility to another, it takes away some resources from wheat and put
them in the production of cloth. Since resources are limited and we have assumed that they
are fully employed, the economy has to give up something of one good to obtain some more of
the other.
The production possibilities shown above can be illustrated diagrammatically also as is shown
in the Figure 1.
Y
A
15 B
14
13 C
12
11
10 D
WHEAT 9
8
7
6 E
5
4
3
2
1 F
1 2 3 4 5 X
O
CLOTH
Fig. 1 : Production Possibilities Curve

The curve AF is called Production Possibilities Curve (PPC) or Production Possibilities Frontier
(PPF). This curve shows the various combinations of two goods which the economy can produce
with a given amount of resources. Since the given resources are fully employed and utilized,
the combination of two goods produce can lie anywhere on the production possibilities curve
AF but not inside or outside it. For example, the combined output of two goods can neither lie
at R nor at S (Figure 2). This is because at point R the economy would not be utilising its
resources fully and at point S, the economy would not have capability to produce with the
given technology.
Y
P
B
S
C
WHEAT
D
R
P
O X
CLOTH
Fig. 2 : Production Possibilities Curve

Opportunity Cost and Production Possibilities Curve
Suppose after completing your chartered accountancy course, you have two options open to
you. One, to join a company which gives you Rs. 8 lakh annually and second, to start your
practice and earn Rs. 6 lakh. Now, if you join the company, you will earn Rs. 8 lakh annually
but you will not get Rs. 6 lakh. This Rs. 6 lakh is your opportunity cost for serving in the
company and not starting your practice. Most generally, the opportunity cost of a given activity
is defined as the value of the next best activity.
In the context of PPC, since there are only two goods, therefore opportunity cost of producing
one good is in terms of sacrifice made of the other good. In table 1, we have found opportunity
cost of producing additional units of cloth in terms of wheat. Thus, as the economy moves
from possibility A to possibility B, it has to give up one thousand quintal of wheat in order to
have one thousand meters of cloth. Thus, first thousand meters of cloth have the opportunity
cost of one thousand quintals wheat to the economy. But as we step up the production of cloth
and move further from B to C, extra two thousand quintals of wheat have to be foregone for
producing extra one thousand meters of cloth. In other words, opportunity cost goes on increasing
as we have more of cloth and less of wheat. It is this principle of increasing opportunity cost
that makes the PPC concave to the origin. If opportunity costs were constant, PPC would be a
straight line. But generally, we get increasing opportunity costs. This is because a given resource
is suitable more for the production of one good than another. Thus, in our example, land is
more suitable for the production of wheat than cloth. As we increase the production of cloth,
resources which are less productive in the production of cloth would have to be pushed in it.
Thus, more units of that resource would be required to produce cloth. In other words, greater
sacrifice would have to be made in terms of production of wheat for every extra production of
cloth. This law holds good if we move from A to F or from F to A on the PPC.
Economic growth and shift in Production Possibility Curve
All points on PPC curve show that goods and services are produced at least cost and no resource
is wasted i.e. an economy is productively efficient. But that does not mean there is no scope of
progress. When the economy makes progress in technology, that is, when scientists and engineers
discover new and better ways of doing things, the production possibilities curve will shift
outward and to the right showing that more of both goods can be produced than before
(see Fig. 3)
Y
P’
WHEAT
0 P P’ X
CLOTH
Fig. 3 : Shift in PPC due to economic growth

Figure 3 shows that technological progress allows the society to produce more of both goods
with a given and fixed amount of resources. Thus, with P’ P’, more amount of wheat and cloth
can be produced than before with the given amount of inputs. It is to be noted that if the
economy is producing at point R (in Fig. 2), then it is not using its resources fully i.e. its resources
are unemployed. A Shift from inside the PPC (Say R) to anywhere on the PPC (Say to B)
indicates that the resources which were lying unutilised are now being utilised fully. But a
movement from one PPC to another PPC on the right indicates economic growth of the economy.
This movement becomes possible because of an improvement in the overall technology, greater
capital formation, an increase in the population growth etc.
1.6 HOW DIFFERENT ECONOMIES SOLVE THEIR CENTRAL

ECONOMIC PROBLEMS?
An economic system refers to the sum total of the arrangements for the production and
distribution of goods and services in a society.
You must be wondering how different economies of the world would be solving their central
problems. In order to understand this, we divide all the economies into three broad classifications
based on their mode of production, exchange, distribution and the role which government
plays in economic activity. These are :
- Capitalist economy
- Socialist economy
- Mixed economy
Capitalist economy : Capitalism is an economic system in which all the means of production
are owned and controlled by private individuals for profit. In short, private property is the
mainstay of capitalism and profit motive is its driving force. The government is not supposed

to interfere in the management of economic affairs under this system. An economy is called
capitalist or a free market economy if it has the following characteristics :
(1) The right of private property : The right of private property means that productive factors
such as land, factories, machinery, mines etc. are under private ownership. The owners of
these factors are free to use them in the manner in which they like. The government may,
however, put some restrictions for the benefit of the society in general.
(2) Freedom of enterprise : This means that everybody engages in any economic activity he
likes. More specifically he is free to set up any firm to produce goods.
(3) Freedom to choice by the consumers : This means people in a capitalist economy are free to
spend their income as they like. This is known as consumer sovereignty. Consumers are
sovereign in the sense producers produce only those goods which consumers wish to buy.
(4) Profit motive : In a capitalist economy it is the profit motive which forces or induces
people to work and produce.
(5) Competition : Competition prevails among sellers to sell their goods and among buyers to
obtain goods to satisfy their wants. Advertisement, price-cutting, discounts etc. are very
common methods of competition in a capitalist economy.
(6) Inequalities of incomes : There is generally a wide gap of income between the rich and the
poor in the economy which mainly arises due to unequal distribution of property in such
economies.
How capitalist economies solve their central problems?
A capitalist economy has no central planning authority to decide what, how and for whom to
produce. In absence of any central authority it looks like a miracle as to how such an economy
functions. If the consumers want cars, producers choose to make cloth and workers choose to
work for the furniture industry, there will be total confusion and chaos in the country. But this
is not so. Such an economy uses the impersonal forces of the market demand and supply or the
price mechanism to solve its central problems.
Deciding what to produce : The aim of an entrepreneur is to earn as much profits as possible.
This causes businessmen to compete with one another to produce those goods which consumers
wish to buy. Thus, if consumers want more cars, there will be an increase in the demand for
cars and as a result their prices will increase. A rise in the price of cars, cost remaining the
same, will lead to more profits. This will induce producers to produce more cars. On the other
hand, if the consumers’ demand for cloth decreases, its price would fall and profits would go
down and hence its production would also go down. Thus, more of cars and less of cloth will
be produced in such an economy. Thus, in a capitalist economy (like the USA, UK, and
Germany) the question regarding what to produce is ultimately decided by consumers who
show their preferences by spending on the goods which they want.
Deciding how to produce : An entrepreneur will produce his goods with that technique of
production which renders his cost of production minimum. If labour is relatively cheap he will
use labour intensive method and if labour is relatively costlier he will use capital intensive
method. Thus, the relative prices of factors of production help in deciding how to produce.
Deciding for whom to produce : Goods and services in a capitalist economy will be produced
for those who have the buying capacity. The buying capacity of an individual depends upon
his income. How much income he will be able to make depends not only on the amount of
work he does and the prices of the factors he owns but also on how much property he owns.
Higher the income, higher will be his buying capacity and higher generally will be his demand
for goods in general.
Deciding about consumption, saving and investment : Consumption and savings are done by
consumers and investments are done by entrepreneurs. Consumers savings, among other
factors, are governed by the rate of interest prevailing in the market. Higher the interest rate,
higher are the savings. Investment decisions depend upon the rate of return on capital. The
greater the profit expectation (i.e. the return on capital), the greater will be the investment in a
capitalist economy. The rate of interest on savings and the rate of return on capital are nothing
but the prices of capital.
Thus, we see above what goods are produced, by which methods they are produced, for whom
they are produced and what provisions should be made for economic growth are all decided
by price mechanism or market mechanism.
Merits of Capitalist economy:
1. To attract the consumer the producer will bring out newer and finer varieties of goods.
2. The existence of private property and the driving force of profit motive results in high
standard of living.
3. Capitalism works automatically through the price mechanism.
4. The freedom of enterprise results in maximum efficiency in production.
5. All activities under capitalism enjoy the maximum amount of liberty and freedom.
6. Under capitalism freedom of choice brings maximum satisfaction to consumers
7. Capitalism preserves fundamental rights such as right to freedom and right to private
property.
8. It rewards men of initiative and enterprise.
9. Country as a whole benefits through growth of business talents, development of research,
etc.
Demerits of Capitalism
1. In capitalism the enormous wealth produced is approtioned by a few. This causes rich,
richer and poor, poorer.
2. Welfare is not protected under capitalism, because here the aim is profit and not the welfare
of the people.
3. Economic instability in terms of over production, economic depression, unemployment,
etc., is very common under capitalism.
4. The producer spends huge amounts of money on advertisement and sale promotion
activities like fair, exhibitions etc.

5. Class conflict arises between employer and employee. They will be paid low wages and
this leads to strikes and lock-outs.
6. Productive resources are misused under capitalism. They are used for the production of
luxuries as they will bring high profits.
7. Capitalism leads to the formation of monopolies.
8. There is no security of employment under capitalism.
Socialist economy : In this economy, the material means of production i.e. factories, capital,
mines etc. are owned by the whole community represented by the State. All members are
entitled to get benefit from the fruits of such socialised planned production on the basis of
equal rights. Some important characteristics of this economy are :
Here, production and distribution of goods are aimed at maximizing the welfare of the
community as a whole.
(i) There is collective ownership of all means of production except small farms, workshops
and trading firms which may remain in private hands. As a result of social ownership,
profit-motive and self- interest are not the driving force of economic activity as it is in the
case of a market economy. The resources here are used to achieve certain socio-economic
objectives.
(ii) There is a central authority to set and accomplish socio-economic goals; that is why it is
called a centrally planned economy. Major economic decisions, such as what to produce,
when and how much to produce, etc., are taken by the central authority.
(iii) Freedom from hunger is guaranteed but consumers’ sovereignty gets restricted by selective
production of goods. The range of choice is limited by planned production. However,
within that range an individual is free to choose what he likes most.
The right to work is guaranteed but the choice of occupation gets restricted because these
are determined by some authority on the basis of certain socio-economic goals before the
nation.
(iv) A relative equality of income is an important feature. Among other things, differences are
narrowed down by lack of opportunities to accumulate private capital. Educational and
other facilities are enjoyed more or less equally; thus the basic causes of inequalities are
removed.
(v) Price mechanism exists in a socialist economy but it has only a secondary role, e.g., to
secure disposal of accumulated stocks. Since allocation of productive resources is done
according to a predetermined plan, the price mechanism as such does not influence these
decisions. In the absence of the profit motive, price mechanism loses its predominant role
in economic decisions. The erstwhile U.S.S.R. is an example of socialist economy. In today’s
world there is no country which is purely socialist.
Merits of Socialism
1. Equitable distribution of wealth and income and provision of equal opportunities for all
help to maintain social justice.
2. In socialistic economy there will be better utilization of resources and it ensures the
maximum production. Socialist economy means planned economy.
3. Waste of all kinds is avoided through strict economic planning.
4. In planned economy unemployment is removed, business fluctuation are eliminated and
stability is brought about and maintained.
5. The absence of profit motive helps the community to develop a co-operative mentality
and avoids classwar.
6. Socialism ensures right to work and minimum standard of living to people.
7. Under socialisms the labourers and consumers are protected from the exploitation by the
employer and monopolies respectively.
Demerits of Socialism
1. Socialism involves the predominance of bureaucracy. Moreover, there may also be
corruption, redtapism, favouritism, etc.
2. It restricts the freedom of individuals as there is state ownership of the material means of
production and state direction and control of economic activity.
3. Socialism takes away such right as the right of private property.
4. It will not provide necessary incentive to hard work in the form of profit.
5. There is no proper basis for cost calculation. In the absence of such practice, the most
economic and scientific allocation of resources and the efficient functioning of the economic
system are impossible.
6. State monopolies created by socialism will sometime become uncontrollable. This will be
more dangerous than the private monopolies under capitalism.
7. Under socialism the consumers have no freedom of choice. Therefore, what state produces
has to be accepted by the consumers.
8. The extreme form of socialism is not at all practicable.
The Mixed Economy
In a mixed economy the aim is to develop a system which tries to include the best features of
both the controlled economy and the market economy while excluding the demerits of both. It
appreciates the advantages of private enterprise and private property with their emphasis on
self-interest and profit motive. Vast economic development of England, the USA etc. is due to
private enterprise. At the same time, it is noticed that private property, profit motive and self-
interest of the market economy may not promote the interests of the community as a whole
and as such the government should remove these defects of private enterprise. For this purpose,
the government itself must run important and selected industries and eliminate the free play of

the profit motive and self-interest. Private enterprise which has its own significance is also
allowed to play the positive role in a mixed economy.
The concept of mixed economy is of recent origin. J.M. Keynes, one of the greatest economists
of the 20th century favoured the idea of a mixed economy as a compromise between socialism
and capitalism.
Features of a mixed economy
The first important feature of a mixed economy is the co-existence of both private and public
enterprise. In fact, in a mixed economy, there are three sectors of industries:
(a) Private sector
Production and distribution are managed and controlled by private individuals and groups.
Industries in this sector are based on self-interest and profit motive. The system of private
property exists and personal initiative is given full scope. However private enterprise may
be regulated by the government directly and or indirectly by a number of policy
instruments.
(b) Public sector
Industries in this sector are not primarily profit-oriented but are set up by the State for the
welfare of the community.
(c) Combined sector
A sector in which both the government and the private enterprises have equal access, and
join hands to produce a commodity, leading to the establishment of joint sectors.
Secondly, a mixed economy is a planned economy, i.e. an economy in which the government
has a clear and definite economic plan. Public sector enterprises have to work according to a
plan and to achieve the objectives laid down. The government has also to create necessary
atmosphere for the private sector to develop on its own. Thus it must prepare plans of
development for both the private and the public sector enterprises. Allocation of resources in a
mixed economy should be better since it attempts to combine the productive efficiency of
capitalism and distributive justice of socialism.
Thirdly, in a mixed economy balanced regional development is expected. Public sector
enterprises may be located in the backward regions so as to ensure its development. Further by
way of subsidies and other incentives private sector may be lured to establish and develop
industries in backward regions.
Fourthly, in a mixed economy, a dual system of pricing exists. In private sector, prices of goods
and factors of production are determined through the free play of market forces of demand
and supply. In public sector, the state determines prices of various products. The state reserves
itself the right to keep different prices for public sector units and private sector units. The state
may also fix the prices of certain essential commodities which are used by the common man.
For example, in India, the prices of essential commodities like diesel, LPG, are fixed by
government. Overall planning is done by the State Authority called Planning Commission in
countries like India who have adopted mixed economy.
Merits of Mixed Economy

1. Mixed economy secures the merits of both capitalism and socialism while avoiding the
evils of both.
2. Mixed economy protects individual freedom. Under the system, individuals have the
freedom of consumption, choice of occupation, freedom of enterprise and freedom of
expression.
3. Price mechanism is allowed to operate under mixed economy.
4. Reducing the inequalities of wealth and class struggle is one of the aims of mixed economy.
5. Economic fluctuations can be avoided due to centrally planned economy.
6. Mixed economy helps under-developed countries to have rapid and balanced economic
development.
Demerits of Mixed Economy
1. Mixed economy is difficult to operate. Balancing and adjusting the public and private
sector is often difficult.
2. Excessive controls and heavy taxes are likely to prevail under mixed economy. These will
discourage production in the private sector.
3. Problems of red-tapism, nepotism, favouritism, officialdom, etc. are also found in this type
of economic system.
4. Mixed economy is described by Schumpeter as “Capitalism in the oxygen tent”. According
to him it is only a trick of the capitalists to cheat the working class by offering them some
temporary advantage like social security, uplift of the depressed classes, etc.
SUMMARY
Economics deals with the laws and principles which govern the functioning of an economy
and its various parts. An economy exists because of two basic facts. Firstly, human wants for
goods and services are unlimited and secondly, productive resources with which to produce
goods and services are scarce. Therefore, an economy has to decide how to use its scarce
resources to obtain the maximum possible satisfaction of the members of the society. It is this
basic problem of scarcity which gives rise to many of the economic problems.
There has been a lot of controversy among economists about the true content of economic
theory or its subject matter. The subject-matter and scope of economics has been variously
defined. Each definition is incomplete and inadequate and because of various conflicting
definitions, some confusion has been created about the nature and scope of economics.
The subject matter of economics has been divided into two parts : - Micro-economics and
Macro-economics. Micro-economics deals with the analysis of small individual units of the
economy such as individual consumers, firms, industries and markets. On the other hand,
macro-economics concerns itself with the analysis of the economy as a whole and its large
aggregates such as total national income, output, employment etc.

The problems of scarcity and choice-making can be depicted using the tool of production
possibilities curve. The basic economic problems of what, how and for whom to produce can
be solved in many ways by an economy. If it gives the whole charge of the economy, to private
ownership we get capitalist economy, to public ownership we get socialist economy and jointly
to private and public ownership we get mixed economy.
MULTIPLE CHOICE QUESTIONS

1. Find the correct match :
(a) An enquiry into the nature and causes of the wealth of the nation : A.C.Pigou.
(b) Science which deals with wealth : Alfred Marshall.
(c) Economics is the science which studies human behaviour as a relationship between
ends and scarce means which have alternative uses : Robbins.
(d) The range of our enquiry becomes restricted to that part of social welfare that can be
brought directly or indirectly into relation with the measuring rode of money : Adam
Smith.
2. The law of scarcity :
(a) does not apply to rich, developed countries.
(b) applies only to the less developed countries.
(c) implies that consumers wants will be satisfied in a socialistic system.
(d) implies that consumers wants will never be completely satisfied.
3. Who expressed the view that “Economics is neutral between end”?
(a) Robbins
(b) Marshall
(c) Pigou
(d) Adam Smith
4. Which of the following is the best general definition of the study of Economics?
(a) Inflation and unemployment in a growing economy.
(b) Business decision making under foreign competition.
(c) Individual and social choice in the face of scarcity.
(d) The best way to invest in the stock market.
5. What implication(s) does resource scarcity have for the satisfaction of wants?
(a) Not all wants can be satisfied.
(b) We will never be faced with the need to make choices.
(c) We must develop ways to decrease our individual wants.
(d) The discovery of new natural resources is necessary to increase our ability to satisfy
wants.
6. Rational decision making requires that :
(a) one’s choices be arrived at logically and without error.
(b) one’s choices be consistent with one’s goals.
(c) one’s choices never vary.
(d) one makes choices that do not involve trade-offs.
7. What is the “Fundamental Premise of Economics”?
(a) Natural resources will always be scare.
(b) Individuals are capable of establishing goals and acting in a manner consistent with
achievement of those goals.
(c) Individuals choose the alternative for which they believe the net gains to be the greatest.
(d) No matter what the circumstances, individual choice always involves a trade-off.
8. Which of the following is a normative statement?
(a) Planned economies allocate resources via government departments.
(b) Most transitional economies have experienced problems of falling output and rising
prices over the past decade.
(c) There is a greater degree of consumer sovereignty in market economies than planned
economies.
(d) Reducing inequality should be a major priority for mixed economies.
9. Which of the following statements would you consider to be a normative one?
(a) Faster economic growth should result if an economy has a higher level of investment.
(b) Changing the level of interest rates is a better way of managing the economy than
using taxation and government expenditure.
(c) Higher levels of unemployment will lead to higher levels of inflation.
(d) The average level of growth in the economy was faster in the 1990s than the 1980s.
10. An example of ‘positive’ economic analysis would be :
(a) an analysis of the relationship between the price of food and the quantity purchased.
(b) determining how much income each person should be guaranteed.
(c) determining the ‘fair’ price for food.
(d) deciding how to distribute the output of the economy.
11. Identify the correct statement :
(a) In deductive method logic proceeds from the particular to the general.

(b) Micro and Macro-Economics are interdependent.
(c) In a capitalist economy, the economic problems are solved by Planning Commission.
(d) Higher the prices lower is the quantity demanded of a product is a normative statement.
12. A study of how increases in the corporate income tax rate will affect the national
unemployment rate is an example of
(a) macro-economics.
(b) descriptive economics.
(c) micro-economics.
(d) normative economics.
13. Which of the following does not suggest a macro approach for India?
(a) Determining the GNP of India.
(b) Finding the causes of failure of X and co.
(c) Identifying the causes of inflation in India.
(d) Analyse the causes of failure of industry in providing large scale employment.
14. Economic goods are considered scarce resources because they
(a) cannot be increased in quantity.
(b) do not exist in adequate quantity to satisfy social requirements.
(c) are of primary importance in satisfying social requirements.
(d) are limited to man made goods.
15. From the national point of view which of the following indicates micro approach?
(a) Per capital income of India.
(b) Underemployment in agricultural sector.
(c) Lock out in TELCO.
(d) Total savings in India.
16. In a free market economy the allocation or resources is determined by
(a) votes taken by consumers.
(b) a central planning authority.
(c) consumer preference.
(d) the level of profits of firms.
17. A capitalist economy uses ____________________ as the principal means of allocating
resources.
(a) demand
(b) supply
(c) efficiency
(d) prices
18. In a free market economy, when consumers increase their purchase of a good and the
level of ________________exceeds ______________ then prices tend to rise.
(a) demand, supply
(b) supply, demand
(c) prices, demand
(d) profits, supply.
19. Which of the following would be considered a disadvantage of allocating resources using
a market system?
(a) Income will tend to be unevenly distributed.
(b) Significant unemployment may occur.
(c) It cannot prevent the wastage of scarce economic resources.
(d) Profits will tend to be low.
20. In a mixed economy,
(a) all economic decisions are taken by the central authority.
(b) all economic decisions are taken by private entrepreneurs.
(c) economic decisions are partly taken by the state and partly by the private
entrepreneurs.
(d) none of the above.
21. The central problem in economics is that of
(a) comparing the success of command versus market economies.
(b) guaranteering that production occurs in the most efficient manner.
(c) guaranteering a minimum level of income for every citizen.
(d) allocating scarce resources in such a manner that society’s unlimited needs or wants
are satisfied as well as possible.
22. Which of the following bundles of goods could not be produced with the resources the
economy currently has?
(a) a
(b) b
(c) c
(d) d

Guns 7 a
6 b d
5 PRODUCTION
POSSIBILITIES
4 CURVE
3
u c
2
1
e
1 2 3 4 5 6 7 8
Butter
23. An economy achieves “productive efficiency” when :

(a) resources are employed in their most highly valued uses.
(b) the best resources are employed.
(c) the total number of goods produced is greatest.
(d) goods and services are produced at least cost and no resources are wasted.
Use the figure at right to answer questions 24-26.
24. Which point on the PPF shows a “productively efficient” level of output?
(a) A
(b) B A
7
CONSUMPTION GOODS
(c) C 6 B E
(d) All of the above. 5 PRODUCTION
POSSIBILITIES
4 CURVE
3
F C
2
1
D
1 2 3 4 5 6 7 8
CAPITAL GOODS
25. Which of the following clearly represents a movement toward greater productive efficiency?
(a) A movement from point A to point B.
(b) A movement from point C to point D.
(c) A movement from point F to point C.

(d) A movement from point E to point B.
26. Which of the following illustrates a decrease in unemployment using the PPF?
(a) A movement down along the PPF.
(b) A rightward shift of the PPF.
(c) A movement from a point on the PPF to a point inside the PPF.
(d) A movement from a point inside the PPF to a point on the PPF.
27. If the PPF is linear, i.e., a straight line, which of the following is true?
(a) As the production of a good increases, the opportunity cost of that good rises.
(b) As the production of a good increases, the opportunity cost of that good falls.
(c) Opportunity costs are constant.
(d) The economy is not at full employment when operating on the PPF.
28. Periods of less than full employment correspond to
(a) points outside the PPF.
(b) points inside the PPF.
(c) points on the PPF.
(d) either points inside or outside the PPF.
29. Which of the following would not result in an rightward shift of the PPF?
(a) an increase in investment in capital stock.
(b) a reduction in the labour unemployment rate.
(c) the discovery of new oil deposits in India.
(d) an increase in the number of people taking management training courses.
30. During presidential election campaigns, candidates often promise both more “gun” and
more “butter” if they are elected. Assuming unemployment is not a problem, what possible
assumption are they making but not revealing to their audience?
(a) There will be a sufficient increase in the supply of natural resources used to produce
“guns” and “butter”.
(b) That there will be an improvement in the technology of both “gun” and “butter”
production.
(c) That there will be an increase in the labour force.
(d) All of the above.

31. What is one of the future consequences of an increase in the current level of consumption
in the India?
(a) Slower economic growth in the future.
(b) Greater economic growth in the future.
(c) No change in our economic growth rate.
(d) Greater capital accumulation in the future.
Use the figure at right to answer questions 32-38.
32. Which of the following represents the concept of trade-offs?
(a) A movement from point A
to point B.
Capital
(b) A movement from point U Goods
A
to point C. 100 B
90 W
(c) Point W.
(d) Point U.
U C
40
0 8 80 90 Consumer
Goods
33. Which of the following would not move the PPF for this economy closer to point W?
(a) A decrease in the amount of unemployed labour resources.
(b) A shift in preferences toward greater capital formation.
(c) An improvement in the overall level of technology.
(d) An increase in the population growth rate.
34. Moving from point A to point D, what happens to the opportunity cost of producing each
additional unit of consumer goods?
(a) It increases.
(b) It decreases.
(c) It remains constant.
(d) It increase up to point B, then falls thereafter.
35. What is the opportunity cost of moving from point A to point B?
(a) 100 units of capital goods.
(b) 8 units of consumer goods.

(c) 90 units of capital goods.
(d) 10 units of capital goods.
36. Unemployment or underemployment of one or more resources is illustrated by production
at point :
(a) A.
(b) C.
(c) U.
(d) W.
37. Which of the following is a reason for the curvature or bowed-out shape of the PPF?
(a) Falling unemployment as we move along the curve.
(b) The economy having to produce less of one good in order to produce more of another
good.
(c) Opportunity costs increase as more of a good is produced.
(d) None of the above.
38. Which of the following is a reason for the negative slope of the PPF?
(a) The inverse relationship between the use of technology and the use of natural resources.
(b) Scarcity; at any point in time we have limited amounts of productive resources.
(c) Resource specialisation.
(d) Increasing opportunity costs.
39. Capital intensive technique would get chosen in a
(a) labour surplus economy.
(b) capital surplus economy.
(c) developed economy.
(d) developing economy.
40. Labour intensive technique would get chosen in a
(a) labour surplus economy.
(b) capital surplus economy.
(c) developed economy.
(d) developing economy.
41. Ram : My corn harvest this year is poor.
Krishan : Don’t worry. Price increases will compensate for the fall in quantity
supplied.

Vinod : Climate affects crop yields. Some years are bad, others are good.
Madhur : The Government ought to guarantee that our income will not fall.
In this conversation, the normative statement is made by
(a) Ram
(b) Krishan
(c) Vinod
(d) Madhur
42. Consider the following and decide which, if any, economy is without scarcity :
(a) The pre-independent Indian economy, where most people were farmers.
(b) A mythical economy where everybody is a billionaire.
(c) Any economy where income is distributed equally among its people.
43. Which of the following is not a microe-conomic subject matter?
(a) The price of mangoes.
(b) The cost of producing a fire truck for the fire department of Delhi, India.
(c) The quantity of mangoes produced for the mangoes market.
(d) The national economy’s annual rate of growth.
44. Which of the following is not one of the four central questions that the study of economics
is supposed to answer?
(a) Who produces what?
(b) When are goods produced?
(c) Who consumes what?
(d) How are goods produced?
45. If the marginal (additional) opportunity cost is a constant then the PPC would be
(a) convex.
(b) straight line.
(c) backward bending.
(d) concave.
46. Larger production of goods would lead to higher
production in future.
(a) consumer goods
(b) capital goods
(c) agricultural goods

(d) public goods
47. The branch of economic theory that deals with the problem of allocation of resources is
(a) micro-economic theory.
(b) macro-economic theory.
(c) econometrics.
48. Which of the following is likely to cause an inward shift in a country’s PPC?
(a) Earthquake destroying resources of the country.
(b) Scientists discovering new machines.
(c) Workers getting jobs in the new metro – project.
(d) The country finds new reserves of crude oil.
49. The various combinations of goods that can be produced in any economy when it uses its
available sources and technology efficiently are depicted by
(a) demand curve.
(b) production curve.
(c) supply curve.
(d) production possibilities curve.
50. In an economy people have the freedom to buy or not to buy the goods offered in the
market place, and this freedom to choose what they buy dictates what producers will
ultimately produce. The key term defining this condition is
(a) economic power of choice.
(b) consumer sovereignty.
(c) positive economy.
(d) producer sovereignty.
51. The term ‘Economics’ owes its origin to the Greek word
a. Aikonomia
b. Wikonomia
c. Oikonomia
d. None of the above
52. Oikonomia means
a. industry
b. household
c. services
d. none of these

53. Adam smith published his masterpiece “An enquiry into the nature and causes of wealth
of nation” in the year
a. 1776
b. 1786
c. 1756
d. 1766
54. The classical economists defined Economics as
a. The science of welfare
b. The science of scarcity
c. The science of wealth
d. The science of wealth and welfare
55. Lionel Robbins Published his famous book “Nature of significance of Economics” in the
year
a. 1935
b. 1933
c. 1931
d. 1937
56. According to ————————— Economics is the “the study of how in a civilized society
one obtains the share of what other people have produced and of how the total product of
society changes and is determined”
a. Jacob Viner
b. Henry Smith
c. Pigou
d. Paul A. Samuelson
57. ‘Economics is what Economists do’ is given by
a. Jacob Viner
b. Henry Smith
c. Pigou
d. Paul A. Samuelson
58. In which economic system all the means of production are owned and controlled by private
individuals for profit.
a. socialism
b. capitalism
c. mixed economy
d. communism
59. Economics may be defined as the science that explains _____________.
a. the choices that we make as we cope with scarcity
b. the decisions made by politicians
c. the decisions made by households

d. all human behavior
60. Scarcity is a situation in which ______________________.
a. wants exceed the resources available to satisfy them
b. something is being wasted
c. people are poor
d. none of the above
61. Economic choices can be summarized in five big questions. They are________________.
a. what, how, who, where, and would you please
b. why not, what, how, when, and where
c. what, how, when, where, and why
d. what, how, when, where, and who.
62. When productivity increases _____________________.
a. prices rise
b. living standards improve
c. there are fewer good jobs
d. living standards deteriorate
63. Macro Economics is the study of ________________________.
a. all aspects of scarcity
b. the national economy and the global economy as a whole
c. big businesses
d. the decisions of individual businesses and people
64. The task of economic science is to _________________________.
a. save the earth from the overuse of natural resources
b. help us to understand how the economic world works
c. tell us what is good for us
d. make moral choices about things like drugs
65. Who among the following gave the definition of Economics as “Science which deals with
wealth”?
a. J.M. Keynes
b. H.C. Dickinson
c. Henry Smith
d. J. B. Say
66. Production Possibilities curve is also know as
a. demand curve
b. supply curve
c. indifference curve
d. transformation curve

67. Socialist economy is a
a. planned economy
b. mixed economy
c. profit oriented economy
d. none of these
68. Freedom of choice is the advantage of
a. socialism
b. capitalism
c. mixed economy
d. communism
ANSWERS
1. (c) 2. (d) 3. (a) 4. (c) 5. (a) 6. (b)
7. (c) 8. (d) 9. (b) 10. (a) 11. (b) 12. (a)
13. (b) 14. (b) 15. (c) 16. (c) 17. (d) 18. (a)
19. (a) 20. (c) 21. (d) 22. (d) 23. (d) 24. (d)
25. (c) 26. (d) 27. (c) 28. (b) 29. (b) 30. (d)
31. (a) 32. (a) 33. (a) 34. (a) 35. (d) 36. (c)
37. (c) 38. (b) 39. (b) 40. (a) 41. (d) 42. (d)
43. (d) 44. (b) 45. (b) 46. (b) 47. (a) 48. (a)
49. (d) 50. (b) 51. (c) 52. (b) 53. (a) 54. (c)
55. (c) 56. (b) 57. (a) 58. (b) 59. (a) 60. (a)
61. (d) 62. (b) 63. (b) 64. (b) 65. (d) 66. (d)
67. (a) 68. (b)
CHAPTER – 2
THEORY OF
DEMAND AND
SUPPLY
Unit 1
Law of Demand
and Elasticity
of Demand
THEORY OF DEMAND AND SUPPLY
Learning Objectives
At the end of this unit, you will be able to :
understand the meaning of demand.

understand what determines demand.
get an insight into the law of demand.
understand the difference between movement in the demand curve and shift of the
demand curve.
know various types of elasticity of demand.
Have you ever wondered why diamonds are very expensive although basically inessential,
while water is important but cheap? Or why does land in Delhi or Mumbai command very
high prices, while desert land in Rajasthan is virtually worthless? The answers to these and a
thousand other questions can be found in the theory of demand and supply. This theory shows
how consumer preferences determine consumer demand for commodities while business costs
determine the supply of commodities. We shall take up the topic of demand in this Unit while
supply will be discussed in Unit-3.
1.0 MEANING OF DEMAND

The concept ‘demand’ refers to the quantity of a good or service that consumers are willing
and able to purchase at various prices during a period of time. It is to be noted that demand in
Economics is something more than desire to purchase though desire is one element of it. A
beggar, for instance, may desire food, but due to lack of means to purchase it, his demand is
not effective. Thus effective demand for a thing depends on (i) desire (ii) means to purchase
and (iii) on willingness to use those means for that purchase. Unless demand is backed by
purchasing power or ability to pay, it does not constitute demand. Two things are to be noted
about quantity demanded. One is that quantity demanded is always expressed at a given
price. At different prices different quantities of a commodity are generally demanded. The
second thing is that quantity demanded is a flow. We are concerned not with a single isolated
purchase, but with a continuous flow of purchases and we must therefore express demand as
so much per period of time – one thousand dozens oranges per day, seven thousand dozen
oranges per week and so on.
In short “By demand, we mean 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”.
1.1 WHAT DETERMINES DEMAND?

There are a number of factors which influence household demand for a commodity. Important
among these are :
(i) Price of the commodity : Ceteris paribus i.e. other things being equal, the demand of a
commodity is inversely related to its price. It implies that a rise in price of a commodity
3 8 COMMON PROFICIENCY TEST

brings about a fall in its purchase and vice-versa. This happens because of income and
substitution effects.
(ii) Price of related commodities : Related commodities are of two types : (a) complementary
goods and (ii) competing goods or substitutes. Complementary goods are those goods
which are consumed together or simultaneously. For example, tea and sugar, automobiles
and petrol, pen and ink are used together. When commodities are complements, a fall in
the price of one (other things being equal) will cause the demand of the other to rise. For
example, a fall in the price of cars would lead to a rise in the demand for petrol. Similarly,
a fall in the price of pens, will cause a rise in the demand for ink. The reverse will be the
case when the price of a complement rises.
Competing goods or substitutes are those goods which can be used with ease in place of
one another. For example, tea and coffee, ink pen and ball pen, are substitutes for each
other and can be used in place of, one another easily. When goods are substitutes, a fall in
the price of one (ceteris paribus) leads to a fall in the quantity demanded of its substitutes.
For example, if the price of tea falls, people will try to substitute it for coffee and demand
more of it and less of coffee i.e. the demand for tea will rise and that of coffee fall.
(iii) Level of income of the household : Other things being equal, the demand for a commodity
depends upon the money income of the household. In most cases, the larger the average
money income of the household, the larger is the quantity demanded of a particular good.
However, there are certain commodities for which quantities demanded decrease with an
increase in money income. These goods are called inferior goods. Even in the case of other
goods, the response of quantities demanded to changes in their prices is not of same
proportions. If goods are such that they satisfy the basic necessities (food, clothing, shelter)
of life, a change in their prices although will cause an increase in demand for these
necessities this increase will be less than proportionate to the increase in income. This is
because as people become richer, there is a relative decline in importance of food and
other non durable goods in the over all consumption pattern and a rise in importance of
durable goods such as a TV, car, house etc.
(iv) Tastes and preferences of consumers : The demand for a commodity also depends upon
tastes and preferences of consumers and changes in them over a period of time. Goods
which are more in fashion command higher demand than goods which are out of fashion.
Consumers may even discard a good even before it is fully utilised and prefer another
good which is in fashion. For example, there is a greater demand for coloured television
and more and more people are discarding their black and white television even though
they could have still used it for some more years.
‘Demonstration effect’ plays an important role in affecting the demand for a product. An
individual’s demand for colour television may be affected by his seeing one in neighbour’s
or friend’s house, either because he likes what he sees or because he figures out that if his
neighbour or friend can afford it, he too can. A person may develop a taste or preference
for wine after tasting some, but he may also develop it after discovering that serving it
enhances his prestige. In any case, people have tastes and preferences and these change,
sometimes due to external and sometimes due to internal causes.
GENERAL ECONOMICS 3 9
(v) Other factors : Apart from the above factors, the demand for a commodity depends upon
the following factors :
(a) Size of population : Generally, larger the size of population of a country or a region,
greater is the demand for commodities in general.
(b) Composition of population : If there are more old people in a region, the demand for
spectacles, walking sticks, etc. will be high. Similarly, if the population consists of
more of children, demand for toys, baby foods, toffees, will be more.
(c) Distribution of income : The wealth of a country may be so distributed that there are
a few very rich people while the majority are very poor. Under such conditions the
propensity to consume of the country will be relatively less, for the propensity to
consume of the rich people is less than that of the poor people. Consequently, the
demand for consumer goods will be comparatively less. If the distribution of income
is more equal, then the propensity to consume of the country as a whole will be
relatively high indicating higher demand for goods.
Apart from above, factors such as class, group, education, marital status, consumer’s
expectations with regard to future price and weather conditions, also play an
important role in influencing household demand.
1.2 LAW OF DEMAND

The law of demand is one of the most important laws of economic theory. According to law of
demand, other things being equal, if the price of a commodity falls, the quantity demanded of
it will rise and if the price of a commodity rises, its quantity demanded will decline. Thus, there
is an inverse relationship between price and quantity demanded, other things being same. The
other things which are assumed to be equal or constant are the prices of related commodities,
income of consumers, tastes and preferences of consumers, and such other factors which
influence demand. If these factors which determine demand also undergo a change, then the
inverse price-demand relationship may not hold good. For example, if incomes of consumers
increase, then an increase in the price of a commodity, may not result in a decrease in the
quantity demanded of it. Thus the constancy of these other factors is an important assumption
of the law of demand.
The law of demand may be illustrated with the help of a demand schedule and a demand
curve.
1.2.0 Demand Schedule : To illustrate the relation between the quantity of a
commodity demanded and its price, we may take hypothetical data for prices and quantities
of a commodity X.

Table 1 : Demand schedule of an individual consumer
Price Quantity demanded
(Rs.) (Units)
A 5 10
B 4 15
C 3 20
D 2 35
E 1 60
When price of commodity X is Rs. 5 per unit, a consumer purchases 10 units of the commodity.
When the price falls to Rs. 4, he purchases 15 units of the commodity. Similarly, when the
price further falls, quantity demanded by him goes on rising until at price Re. 1, the quantity
demanded by him rises to 60 units. The above table depicts an inverse relationship between
price and quantity demanded as the price of the commodity X goes on rising, its demand goes
on falling.
Demand curve : We can now plot the data from Table 1 on a graph with price on the vertical
axis and quantity on the horizontal axis. In Fig. 1, we have shown such a graph and plotted
the five points corresponding to each price-quantity combination shown in Table 1. Point A,
shows the same information as the first row of Table 1, that at Rs. 5 per unit, only 10 units of
X will be demanded. Point E shows the same information as does the last row of the table,
when the price is Re. 1, the quantity demanded will be 60 units.
Fig. 1 : Demand Curve
We now draw a smooth curve through these points. The curve is called the demand curve for
commodity ‘X’. The curve shows the quantity of ‘X’ that a consumer would like to buy at a
each price; its downward slope indicates that the quantity of ‘X’ demanded increases as its
price falls. Thus the downward sloping demand curve is in accordance with the law of demand
which as stated above, describes an inverse price-demand relationship.
1.2.1 Market Demand Schedule : When we add up the various quantities demanded by the
number of consumers in the market we can obtain the market demand schedule. How the
summation is done is illustrated in Table 2. Suppose there are three individual buyers of the
goods in the market. The Table 2 shows their individual demands at various prices.
Table 2 : Market Demand Schedule
Quantity demanded by
Price (Rs.) P Q R Total market demand
5 10 8 12 30
4 15 12 18 45
3 20 17 23 60
2 35 25 40 100
1 60 35 45 140
When we add quantities demanded at each price by consumers P, Q, R we get total market
demand. Thus when price is Rs. 5 per unit, the demand for commodity ‘X’ in the market is 30
units (i.e. 10+8+12). When price falls to Rs. 4, market demand is 45 units. At Re. 1, 140 units
are demanded in the market. The market demand schedule also indicates inverse relationship
between price and quantity demanded of ‘X’.
Fig. 2 : Market Demand Curve
Market Demand Curve : If we plot market demand schedule on a graph we get market demand
curve. Figure 2 shows market demand curve for commodity ‘X’. The market demand curve,
like individual demand curve, slopes downwards to the right because it is nothing but lateral
summation of individual demand curves. Besides, as the price of the good falls, it is very likely
that new buyers will enter the market which will further raise the quantity demanded of the
goods.

1.2.2 Rationale for the Law of Demand : Why does demand curve slope downwards?
(1) When the price of a commodity falls, it becomes relatively cheaper than other commodities.
It induces consumers to substitute the commodity whose price has fallen for other
commodities which have now become relatively expensive. The result is that total demand
for the commodity whose price has fallen increases. This is called substitution effect.
(2) When the price of a commodity falls, the consumer can buy the same quantity of the
commodity with lesser money or he can buy more of the same commodity with the same
money. In other words, as a result of fall in the price of the commodity, consumer’s real
income or purchasing power increases. This increase in the real income induces him to
buy more of that commodity. Thus, demand for that commodity (whose price has fallen)
increases. This is called income effect.
(3) When the price of a commodity falls, more consumers start buying it because some of
those who could not afford to buy it previously may now afford to buy it. This raises the
number of consumers of a commodity at a lower price and hence the demand for the
commodity in question.
1.2.3 Exceptions to the Law of Demand : According to the law of demand, more of a
commodity will be demanded at lower prices than at higher prices, other things being equal.
The law of demand is valid in most of the cases; however there are certain cases where this law
does not hold good. The following are the important exceptions to the law of demand.
(i) Conspicuous goods : Articles of prestige value or snob appeal or articles of conspicuous
consumption are demanded only by the rich people and these articles become more
attractive if their prices go up. Such articles will not conform to the usual law of demand.
This was found out by Veblen in his doctrine of “Conspicuous Consumption” and hence
this effect is called Veblen effect or prestige goods effect. Veblen effect takes place as some
consumers measure the utility of a commodity by its price i.e., if the commodity is expensive
they think that it has got more utility. As such, they buy less of this commodity at low
price and more of it at high price. Diamonds are often given as example of this case.
Higher the price of diamonds, higher is the prestige value attached to them and hence
higher is the demand for them.
(ii) Giffen goods : Sir Robert Giffen, an economist, was surprised to find out that as the price
of bread increased, the British workers purchased more bread and not less of it. This was
something against the law of demand. Why did this happen? The reason given for this is
that when the price of bread went up, it caused such a large decline in the purchasing
power of the poor people that they were forced to cut down the consumption of meat and
other more expensive foods. Since bread even when its price was higher than before was
still the cheapest food article, people consumed more of it and not less when its price went
up.
Such goods which exhibit direct price-demand relationship are called ‘Giffen goods’.
Generally those goods which are considered inferior by the consumers and which occupy
a substantial place in consumer’s budget are called ‘Giffen goods’. Examples of such goods
are coarse grains like bajra, low quality of rice and wheat etc.
(iii) Conspicuous necessities : The demand for certain goods is affected by the demonstration
effect of the consumption pattern of a social group to which an individual belongs. These
goods, due to their constant usage, have become necessities of life. For example, in spite of
the fact that the prices of television sets, refrigerators, coolers, cooking gas etc. have been
continuously rising, their demand does not show any tendency to fall.
(iv) Future expectations about prices : It has been observed that when the prices are rising,
households expecting that the prices in the future will be still higher, tend to buy larger
quantities of the commodities. For example, when there is wide-spread drought, people
expect that prices of foodgrains would rise in future. They demand greater quantities of
foodgrains as their price rise. But it is to be noted that here it is not the law of demand
which is invalidated but there is a change in one of the factors which was held constant
while deriving the law of demand, namely change in the price expectations of the people.
(v) The law has been derived assuming consumers to be rational and knowledgeable about
market-conditions. However, at times consumers tend to be irrational and make impulsive
purchases without any cool calculations about price and usefulness of the product and in
such contexts the law of demand fails.
(vi) Demand for Necessaries: The law of demand does not apply much in the case of necessaries
of life. Irrespective of price changes, people have to consume the minimum quantities of
necessary commodities.
Similarly, in practice, a household may demand larger quantity of a commodity even at a
higher price because it may be ignorant of the ruling price of the commodity. Under such
circumstances, the law will not remain valid.
(vii) Speculative goods: In the speculative market, particularly in stock and shares, more will
be demanded when the prices are rising and less will be demanded when the price declines.
The law of demand will also fail if there is any significant change in other factors on which
demand of a commodity depends. If there is a change in income of the household, or in prices
of the related commodities or in tastes and fashion etc. the inverse demand and price relation
may not hold good.
1.3 EXPANSION AND CONTRACTION IN DEMAND

The demand schedule, demand curve and the law of demand all show that when the price of
a commodity falls its quantity demanded increases, other things being equal. When as a result
of decrease in price, the quantity demanded increases, in Economics, we say that there is an
expansion of demand and when as a result of increase in price, quantity demanded decreases
we say that there is contraction of demand. For example, suppose the price of apples at any
time is Rs. 10 per kilogram and a consumer buys one kilogram at that price. Now, if other
things such as income, prices of other goods and tastes of the consumers remain same but the
price of apples falls to Rs. 8 per kilogram and the consumer now buys two kilograms of apples,
we say that there is a change in quantity demanded or there is an expansion of demand. On
the contrary, if the price of apples rises to Rs. 15 per kilogram and consumer buys only half a
kilogram, we say that there is a contraction of demand.
The phenomena of expansion and contraction in demand are shown in Figure 3. The figure
shows that when price is OP quantity demanded is OM, given other things equal. If as a result
of increase in price (OP”), the quantity demanded falls to OL we say there is ‘a fall in quantity

demanded’ or ‘contraction of demand’ or ‘an upward movement along the same curve’.
Similarly, as a result of fall in price to OP’ the quantity demanded rises to ON, we say that
there is ‘expansion of demand’ or ‘a rise in quantity demanded’ or ‘a downward movement on
the same demand curve.’
Fig. 3 : Expansion and Contraction in Demand
1.4 INCREASE AND DECREASE IN DEMAND

Till now we have assumed that other determinants remain constant when we are analysing
demand for a commodity. It should be noted that expansion and contraction in demand take
place as a result of changes in the price while all other determinants of price viz. income,
tastes, propensity to consume and price of related goods remain constant. These other factors
remaining constant means that the position of the demand curve remains the same and the
consumer moves downwards or upwards on it.What happens if there is a change in, consumers’
tastes and preferences, income, the prices of the related goods or other factors on which demand
depends? Let us consider the demand for commodity X :
Table 3 shows for our example of commodity X, the possible effect of an increase in income of
the consumer.
Table 3 : Two demand schedules for commodity X
Price Quantity of ‘X’ demanded when Quantity of ‘X’ demanded when
(Rs.) average household income is average household income is
Rs. 4,000 per month Rs. 5,000 per month
A 5 10 15 A1
B 4 15 20 B1
C 3 20 25 C1
D 2 35 40 D1
E 1 60 65 E1
Fig. 4 : Figure showing two demand curves with different incomes
These new data are plotted in Figure 4 as demand curve D’D’ along with the original demand
curve DD. We say that the demand curve for X has shifted [in this case it has shifted to right].
The shift from DD to D’D’ indicates an increase in the desire to purchase ‘X’ at each possible
price. For example, at the price of Rs. 4 per unit, 15 units are demanded when average household
income is Rs. 4,000 per month. When the average household income rises to Rs. 5,000 per
month, 20 units of X are demanded at price Rs. 4. A rise in income thus shifts the demand
curve to the right, whereas a fall in income will have the opposite effect of shifting the demand
curve to the left.
Fig. 5(a) : Rightward shift in the Fig. 5(b) : Leftward shift in the
demand Curve demand curve.

(i) A rightward shift in the demand curve : (when more is demanded at each price) can be
caused by a rise in income, a rise in the price of a substitute, a fall in the price of a
complement, a change in tastes in favour of this commodity, an increase in population,
and a redistribution of income to groups who favor this commodity.
(ii) A leftward shift in the demand curve : (when less is demanded at each price) can be
caused by a fall in income, a fall in the price of a substitute, a rise in the price of a
complement, a change in tastes against this commodity, a decrease in population, and a
redistribution of income away from groups who favour this commodity.
1.5 MOVEMENTS ALONG DEMAND CURVE VS. SHIFT OF CURVE

It is important in Economics to make a distinction between a movement along a demand curve
and a shift of the whole demand curve.
A movement along the demand curve indicates changes in the quantity demanded because of
price changes, other factors remaining constant. A shift of the demand curve indicates that
there is a change in demand at each possible price because one or more other factors, such as
incomes, tastes or the price of some other goods, have changed.
Thus, when an economist speaks of an increase or a decrease in demand, he refers to a shift of
the whole curve because one or more of the factors which were assumed to remain constant
earlier have changed. When the economist speaks of change in quantity demanded he means
movement along the same curve (i.e., expansion or contraction of demand) which has happened
due to fall or rise in price of the commodity.
In short ‘change in demand’ represents shift of the demand curve to right or left resulting from
changes in factors such as income, tastes, prices of other goods etc. and ‘change in quantity
demanded’ represents movement upwards or downwards on the same demand curve resulting
from a change in price of the commodity.
1.6 ELASTICITY OF DEMAND

Till now we were concerned with the direction of the changes in prices and quantities demanded.
Now we will try to measure these changes or to say we will try to answer the question “by
how much”?
Consider the following situations :
(1) As a result of a fall in the price of radio from Rs. 500 to Rs. 400, the quantity demanded
increases from 100 radios to 150 radios.
(2) As a result of fall in the price of wheat from Rs. 10 per kilogram to Rs. 9 per kilogram the
demand increases from 500 kilograms to 520 kilograms.
(3) As a result of fall in the price of salt from Rs. 3 per kilogram to Rs. 2.50, the quantity
demanded increases from 1000 kilogram to 1005 kilograms.
What do you notice? You notice that as a result of fall in the price of radios, the demand for
radios increases. But same is the case with wheat and salt. Thus we can say that demand for
the radios, wheat and salt all respond to price changes. Then where is the difference? The
difference lies in the degree of response of demand which can be found out by comparing
percentage changes in prices and quantities demanded. Here lies the concept of elasticity.
Definition : Elasticity of demand is defined as the responsiveness of the quantity demanded of
a good to changes in one of the variables on which demand depends or we can say that it is the
percentage change in quantity demanded divided by the percentage in one of the variables on
which demand depends. These variables are price of the commodity, prices of the related
commodities, income of the consumers and other various factors on which demand depends.
Thus we have price elasticity, cross elasticity, elasticity of substitution and income elasticity. It
is to be noted that when we talk of elasticity of demand, unless and until otherwise mentioned,
we talk of price elasticity of demand. In other words, it is price elasticity of demand which is
usually referred to as elasticity of demand.
1.6.0 Price Elasticity : Price elasticity of demand expresses the response of quantity demanded
of a good to a change in its price, given the consumer’s income, his tastes and prices of all other
goods. In other words, it is measured as percentage change in quantity demanded divided by
the percentage change in price, other things remaining equal. That is
% change in quantity demanded

Price Elasticity = Ep =
% change in Price
Or
Change in quantity
x 100
Original Quantity Change in Quantity Original Price
Ep = OR Ep = x
Change in price Original Quantity Change in Price
x 100
Original Price
Or in symbolic terms
Δq p Δq p
Ep = x = x
q Δp Δp q
Where Ep stands for price elasticity

q stands for quantity
p stands for price
Δ stands for a very small change.
Strictly speaking the value of price elasticity varies from minus infinitity to approach zero from
Δq
the negative sign, because has a negative sign. In other words, since price and quantity are
Δp
inversely related (with a few exceptions) price elasticity is negative. But for the sake of
convenience, we ignore the negative sign and consider only the numerical value of the elasticity.

Thus if a 1% change in price leads to 2% change in quantity demanded of good A and 4%
change in quantity demanded of good B, then we get elasticity of A and B as 2 and 4 respectively,
showing that demand for B is more elastic or responsive to price changes than A. Had we
considered minus signs, we would have concluded that A is more elastic than B, which is not
correct. Hence by convention we take absolute value of price elasticity and draw conclusions.
A numerical example for the price elasticity of demand:
The price of a commodity decreases from Rs.6 to Rs. 4 and quantity demanded for good increases
from 10 units to 15 units. Find the coefficient of price elasticity.
Solution : Point elasicity =
(-) q / p × p/q = 5/2 × 6/10 = (-) 1.5
Point elasticity : In point elasticity, we measure elasticity at a given point on a demand curve.
Point elasticity makes use of derivative rather than finite changes in price and quantity. It may
be defined as :
−dq p
x
dp q
dq
where is the derivative of quantity with respect to price at a point on the demand curve,
dp
and p and q are the price and quantity at that point.
It is to be noted that elasticity is different at different points on the same demand curve. Given
a straight line demand curve tT, point elasticity at any point say R can be found by using
formula
RT lower segment
=
Rt upper segment
Fig. 6 : Elasticity at a point on the demand curve
Using the above formula we can get elasticity at various points on the demand curve.
Y A
P1
arc elasticity
Price
P2 B
D
Q Q1 Q2 Quantity demanded
X
Fig.: 6(a) : Elasticity at different Fig. 7 : Arc Elasticity

points on the demand curve
Thus we see that as we move from T towards t, elasticity goes on increasing. At the mid-point
it is equal to one, at t it is infinity and at T it is zero.
Arc-elasticity : When the price change is some what larger or when price elasticity is to be
found between the two prices [or two points on the demand curve say A and B in figure 7], the
question arise which price and quantity should be taken as base. This is because elasticities
found by using original price and quantity figures as base will be different from the one derived
by using new price and quantity figures. Therefore, in order to avoid confusion, generally
averages of the two prices and quantities are taken as (i.e. original and new) base. The arc
elasticity can be found out by using the formula :
q 1 − q 2 p1 + p 2
Ep = x
q 1 + q 2 p1 − p 2
where p1, q1 are the original price and quantity and p2, q2 are the new ones.
Thus if we have to find elasticity of radios between :
p1= Rs. 500 q1 = 100
p2 = Rs. 400 q2 = 150
We will use the formula
q1 - q 2 p1 + p 2
Ep = x
q1 + q 2 p1 − p 2
50 900
or Ep = x or Ep = 1.8
250 100
Interpreting numerical values of elasticity of demand
The numerical value of elasticity of demand can assume any value between zero and infinity.
Elasticity is zero, if there is no change at all in quantity demanded when price changes i.e.
when quantity demanded does not respond to a price change.

Elasticity is one, or unitary, if the percentage change in quantity demanded is equal to the
percentage change in price.
Elasticity is greater than one when the percentage change in quantity demanded is greater
than the percentage change in price. In such a case, demand is said to be elastic.
Elasticity is less than one when the percentage change in quantity demanded is less than the
percentage change in price. In such a case demand is said to be inelastic.
Elasticity is infinite, when some ‘small price reduction raises the demand from zero to infinity.
Under such a case consumers will buy all that they can obtain of the commodity at some price.
If there is a slight increase in price, they would not buy anything from the particular seller.
This type of demand curve is found in perfectly competitive market
Fig. 8 : Demand curve of zero, unitary, and infinite elasticity
Table 4 : Elasticity measures, meaning and nomenclature
Numerical measure of elasticity Verbal description Terminology

Zero Quantity demanded does not Perfectly (or
change as price changes completely) inelastic
Greater than zero, but less Quantity demanded changes by a Inelastic
than one smaller percentage than does price
One Quantity demanded changes by Unit elasticity
exactly the same percentage as
does price
Greater than one, Quantity demanded changes by Elastic
but less than infinity a larger percentage than does price
Infinity Purchasers are prepared to buy all Perfectly (or
they can obtain at some price and infinitely) elastic
none at all at an even slightly
higher price
Now that we are able to classify goods according to their price elasticity, let us see whether the
goods which we considered in our example on page 39, are price elastic or inelastic.
Sl. No. Name of the Commodity Calculation of Elasticity Nature of Elasticity

(q 1 − q 2 ) (p1 + p2 )
x
(q 1 + q 2 ) (p1 − p2 )
100 − 150 500 + 400

1. Radios x Elastic
100 + 150 500 − 400
= 1.8 > 1
500 − 520 10 + 9
2. Wheat x Inelastic
500 + 520 10 − 9
= 0.37< 1
1000 − 1005 3 + 2.50

3. Common Salt x Inelastic
1000 + 1005 3 − 2.50
= 0.000014 < 1
What do we note in the above hypothetical example? We note that demand for radios is quite
elastic, while demand for wheat is quite inelastic and demand for salt is almost same even after
a reduction in price.
Generally, in real world situation also, we find that demand for goods like radios, TVs,
refrigerators, fans, etc. is elastic, demand for goods like wheat and rice is inelastic, and demand
for salt is highly inelastic or perfectly inelastic. Why do we find such a difference in the behaviour
of consumers vis-a-vis different commodities? We shall explain later at length those factors
which are responsible for the differences in elasticity of demand of various goods. First we will
consider another method of calculating price-elasticity which is called total outlay method.
Total Outlay Method of Calculating Price Elasticity : The price elasticity of demand for a
commodity and the total expenditure or outlay made on it are greatly related to each other. By
analysing the changes in total expenditure or outlay we can know the price elasticity of demand
for the good. However, it should be noted that by this method we can only say whether a good
is elastic or inelastic; we can not find out the exact coefficient of elasticity.
When as a result of the change in price of a good, the total expenditure on the good remains
the same, the price elasticity for the good is equal to unity. This is because total expenditure
made on the good can remain the same only if the proportional change in quantity demanded
is equal to the proportional change in price. Thus if there is a 100% increase in price of a good
and if the price elasticity is unitary, total expenditure of the buyer on the good will remain
unchanged.
When as a result of increase in price of a good, total expenditure made on the good falls or
when as a result of decrease in price, the total expenditure made on the good increases, we say

that price elasticity of demand is greater than unity. In our example of radios, as a result of fall
in price of radios from Rs. 500 to Rs. 400, the total expenditure on radios increases from
Rs. 50,000 (500 x 100) to Rs. 60,000 (400 x 150), indicating elastic demand for radios. Similarly,
had the price of radios increased from Rs. 400 to Rs. 500, the demand would have fallen from
150 radios to 100 radios indicating a fall in the total outlay from Rs. 60,000 to Rs. 50,000 and
showing elastic demand for radios.
When as a result of increase in price of a good, the total expenditure made on the good increases
or when as a result of decrease in price, the total expenditure made on the good falls, we say
that price elasticity of demand is less than unity. In our example of wheat, as a result of fall in
price of wheat from Rs. 10 per kg. to Rs. 9 per kg., the total outlay or expenditure falls from
5,000 (10 x 500) to Rs. 4,680 (9 x 520) indicating inelastic demand for wheat. Similarly we can
show that as a result of increase in price of wheat from Rs. 9 to Rs. 10 per kg. the total outlay
increase from Rs. 4,680 to Rs. 5,000 indicating inelastic demand for wheat.
Determinants of Price Elasticity of Demand : In the above Section we have explained what is
price elasticity and how it is measured. Now an important question is : what are the factors
which determine whether the demand for a good is elastic or inelastic? We will consider the
following important determinants of price elasticity.
(1) Availability of substitutes : One of the most important determinants of elasticity is the
degree of availability of close substitutes. Some commodities like butter, cabbage, Maruti,
Coca Cola, have close substitutes – margarine, other green vegetables, Santro or other
cars, Pepsi or any other cold drink. A change in price of these commodities, the prices of
the substitutes remaining constant, can be expected to cause quite substantial substitution
– a fall in price leading consumers to buy more of the commodity in question and a rise in
price leading consumers to buy more of the substitutes. Other commodities such as salt,
housing, and all vegetables taken together, have few, if any, satisfactory substitutes and a
rise in their prices may cause a smaller fall in their quantity demanded. Thus we can say
that goods which typically have close or perfect substitutes have highly elastic demand
curves. It should be noted that while as a group a good or service may have inelastic
demand, but when we consider its various brands, we say that a particular brand has
elastic demand. Thus while demand for petrol is inelastic, the demand for Indian Oil’s
petrol is elastic. Similarly, while there are no general substitutes for health care, there are
substitutes for one doctor or for a nurse. Likewise, the demand for common salt is inelastic
because good substitutes for common salt are not available.
(2) Position of a commodity in a consumer’s budget : The greater the proportion of income
spent on a commodity, the greater will be generally its elasticity of demand and vice-
versa. The demand for goods like common salt, matches, buttons, etc. tend to be highly
inelastic because a households spend only a fraction of their income on each of them. On
the other hand, demand for goods like clothing, tends to be elastic since households
generally spend a good part of their income on clothing.
(3) Nature of the need that a commodity satisfies : In general, luxury goods are price elastic
while necessities are price inelastic. Thus while the demand for television is relatively
elastic the demand for food and housing, in general, is inelastic.
(4) Number of uses to which a commodity can be put : The more the possible uses of a
commodity the greater will be its price elasticity and vice versa. To illustrate, milk has
several uses. If its price falls, it can be used for a variety of purposes like preparation of
curd, cream, ghee and sweets. But if its price increases, its use will be restricted only to
essential purposes like feeding the children and sick persons.
(5) The period : The longer the time-period one has, the more completely one can adjust. A
homely example of the effect can be seen in motoring habits. In response to a higher petrol
price, one can, in the short run, make fewer trips by car. In the longer run not only can
one make fewer trips but he can purchase a car with a smaller engine capacity when the
time comes for replacing the existing one. Hence one’s demand for petrol falls by more
when one has made long term adjustment to higher prices.
(6) Consumer habits : If a consumer is a habitual consumer of a commodity no matter how
much its price change, the demand for the commodity will be inelastic.
(7) Tied demand : The demand for those goods which are tied to others is normally inelastic as
against those whose demand is of autonomous nature.
(8) Price range : Goods which are in very high range or in very low price range have inelastic
demand but those in the middle range have elastic demand.
1.6.1 Income Elasticity of Demand : Income elasticity of demand is the degree of
responsiveness of quantity demanded of a goods to a small change in the income of consumers.
In symbolic form,
Percentage change in quantity demanded

Ei =
Percentage change on income
There is a useful relationship between income elasticity for a goods and proportion of income
spent on it. The relationship between the two is described in the following three propositions :
1. If the proportion of income spent on a goods remains the same as income increases, then
income elasticity for the goods is equal to one.
2. If the proportion of income spent on a goods increases as income increases, then the income
elasticity for the goods is greater than one.
3. If the proportion of income spent on a goods decreases as income rises, then income elasticity
for the goods is less than one.
Income elasticity of goods reveals a few very important features of demand for the goods in
question. If income elasticity is zero it signifies that the quantity demanded of the goods is quite
unresponsive to changes in income. When income elasticity is greater than zero or positive
then an increase in income leads to an increase in quantity demanded of the goods. This happens
in case of most of the goods and such goods are called normal goods. On the other hand, goods
having negative income elasticity are known as inferior goods and their demand falls as income
increases. Another significant value of income elasticity is that of unity. When income elasticity
of demand is equal to one, then the proportion of income spent on goods remains the same as
consumer’s income increases. This represents a useful dividing line. If the income elasticity for

a goods is greater than one it shows the goods bulks larger in consumer’s expenditure as he
becomes richer. Such goods are called luxury goods. On the other hand, if the income elasticity
is less than one it shows that the goods is relatively less important in consumer’s eye and,
therefore, is called necessity.
The following examples will make the above concepts clear :
(a) The income of a household rises by 10%, the demand for wheat rises by 5%.
(b) The income of a household rises by 10%, the demand for T.V. rises by 20%.
(c) The incomes of a household rises by 5%, the demand for bajra falls by 2%.
(d) The income of a household rises by 7%, the demand for commodity X rises by 7%.
(e) The income of a household rises by 5%, the demand for buttons does not change at all.
Using formula for income elasticity,
Percentage change in quantity demanded

i.e. Ei =
Percentage change on income
we will find income-elasticity for various goods. The results are as follows :
S. No. Commodity Income-elasticity for the Remarks

household
5%
a Wheat = .5 (Ei <1) since 0 < .5 < 1, wheat is a normal good
10%
and fulfills a necessity.
20%
b T.V. = 2 (Ei >1) since 2 > 1, T.V. is a luxurious
10%
commodity.
(-)2%
c Bajra = ( −) .4 (Ei <0) since –.4 < 0, Bajra is an inferior
5% commodity in the eyes of household.
7%
d X = 1 (Ei = 1) since income elasticity is 1, X has unitary
7% income elasticity.
0%
e Buttons = 0 (Ei = 0) Buttons have zero income-elasticity.
5%
The various types of income elasticity explained above are in shown in the following diagram.
a b c
1
Ei <
Ei = 0
Income
=1
Ei
0
Ei <
Ei >1
e
a
Quantity Demanded
Fig. 9 : Income elasticity
Income elasticity of demand will vary widely with different commodities. Generally luxuries
like jewellery and fancy articles will have high income elasticities of demand, whereas ordinary
household goods will have low income elasticity of demand.
It is to be noted that the words luxury, necessity, inferior goods do not signify strict dictionary
meanings here. In economic theory we distinguish them in the manner shown above.
1.6.2 Cross Elasticity :
Price of Related Goods and Demand:
The demand for a particular commodity may change due to the changes of prices of related
goods. These related goods may be either complementary goods or substitute goods. This type
of relationship is studied under ‘Cross Demand’. Cross demand refers to the quantities of a
commodity or service which will be purchased with reference to changes, not of that particular
commodity, but of other inter-related commodities, other things remaining the same. It may be
defined as the quantities of a commodity that consumers buy per unit of time at different
prices of a ‘related article’. ‘Other things remaining the same’ is the assumption which means
that the income of the consumer and also the price of the commodity in question will remain
constant.
Substitutes Product:
In the substitute commodities the cross demand curve slopes upwards (i.e. is positive) showing
that more quantities of a commodity will be demanded whenever there is a rise in price of a
substitute commodity. In the figure, quantity demanded of Tea is given on the X axis. Y axis
represents the price of coffee which is a substitute for a tea. When the price of coffee increases,
the demand for coffee becomes less due to the operation of the law of demand. But the consumers
will go in for ‘tea’ to substitute in the place of coffee. The price of tea is assumed to be constant.
So whenever there is an increase in price of one commodity, the demand for the substitute
commodity will increase.

y
Substitutes
D
p1
Price of p
Coffee
x
O m m1
Quantity Demanded of Tea
Fig. 10 : Substitutes
Complementary Goods
In the case of complementary goods, as shown in the figure, a change in price of a good will
have an opposite reaction on the demand of other commodity which is closely related or
complementary. For instance, an increase in demand for pen will necessarily increase the demand
for ink; so also bread and butter; horse and carriages, etc. Whenever there is a fall in demand
of fountain pens due to the rise in prices of fountain pens, the demand for ink will fall down,
not that the price of ink has gone up, but because the price of fountain pen has gone up. So we
find that there is an inverse relationship between price of a commodity and demand for its
complementary good (other things remaining the same).
y D
P
Complementary
Price of
Pen
P1
D
O M M1 X
Quantity Demanded of Ink
Fig. 11 : Complementary Goods
A change in the demand for one goods in response to a change in the price of another goods
represents cross elasticity of demand of the former goods for the latter goods.
Symbolically,
Δq x p y
Ec = x
Δp y q x
Where Ec stands for cross elasticity.

qx stands for original quantity demanded of X.
Δqx stands for change in quantity demanded of X
py stands for the original price of good Y.
Δpy stands for a small change in the price of Y.
If two goods are perfect substitutes for each other cross elasticity is infinite and if two goods
are totally unrelated, cross elasticity between them is zero.
If the two goods are substitutes (like tea and coffee) the cross elasticity is positive, that is, in
response to a rise in price of one goods the demand for the other goods rises. On the other
hand, when two goods are complementary (tea and sugar) to each other, the cross elasticity
between them is negative so that a rise in the price of one leads to a fall in the quantity demanded
of the other. However, one need not base the classification of goods on the above definitions.
While the goods between which cross elasticity is positive can be called substitutes, the goods
between which cross elasticity is negative are not always complementary. This is because
negative cross elasticity is also found when the income effect on the price change is very strong.
1.7 DEMAND DISTINCTIONS

Certain important demand distinctions are as follows:
a. Producers goods and Consumer’s goods
b. Durable goods and Non-durable goods
c. Derived demand and Autonomous demand
d. Industry demand and Company demand
e. Short-run demand and Long-run demand
a. Producer’s goods and Consumer’s goods:
Producer’s goods are those which are used for the production of other goods- either
consumer goods or producer goods themselves. Examples of such goods are machines,
locomotives, ships etc. Consumer’s goods are those which are used for final consumption.
Examples of consumer’s goods can be readymade clothes, prepared food, residential houses,
etc.
b. Durable goods and Non-durable goods:
Consumer’s goods may be further sub-divided into durable and non-durable goods. The
non-durable consumer goods are those which cannot be consumed more than once; for

example bread, milk etc. These will meet only the current demand. On the other hand,
durable consumer goods are those which can be consumed more than once over a period
of time, example, a car, a refrigerator, a ready-made shirt, and umbrella. The demand for
durable goods is likely to be a derived demand.
c. Derived demand and Autonomous demand
When a product is demanded consequent on the purchase, of a parent product, its demand
is called derived demand. For example, the demand for cement is derived demand, being
directly related to building activity. If the demand for a product is independent of demand
for other goods, then it is called autonomous demand. But this distinction is purely arbitrary
and it is very difficult to find out which product is entirely independent of other products.
d. Industry demand and Company demand
The term industry demand is used to denote the total demand for the products of a
particular industry, e.g. the total demand for steel in the country. On the other hand, the
term company demand denotes the demand for the products of a particular company,
e.g. demand for steel produced by the Tata Iron and Steel Company.
e. Short –run demand and Long-run demand
Short run demand refers to demand with its immediate reaction to price changes, income
fluctuations, etc., whereas long-run demand is that which will ultimately exists as a result
of the changes in pricing, promotion or product improvement, after enough time is allowed
to let the market adjust to the new situation. For example, if electricity rates are reduced,
in the short run, the existing users will make greater use of electric appliances. In the long
run more and more people will be induced to use electric appliances.
SUMMARY
An individual’s demand for a product depends upon the price of the product, income of the
individual and the prices of related goods. But amongst these determinants of demand,
economists single out price of the goods in question as the most important factor governing the
demand for it. Indeed, the function of a theory of demand is to establish a relationship between
price and the quantity demanded of a goods and to provide explanation for it. This relationship
is illustrated graphically by a demand curve that shows how much will be demanded at each
market price.
The demand curve will shift to right by a rise in income (unless the goods is an inferior one), a
rise in the price of a substitute, a fall in the price of a complement, a rise in population and a
change in tastes in favour of this commodity. The opposite changes will shift the demand
curve to the left. As against these when the price of the commodity rises, the consumer goes up
the demand curve and when the price falls, consumer goes down the demand curve.
Price elasticity of demand is a measure of the extent to which the quantity demanded of a
goods responds to a change in its price. When the numerical measure is less than one, we say
that the demand is inelastic when it is greater than one, we say demand is elastic and when it
is equal to one we say demand is unitary. Two special cases are when elasticity equals zero or
infinity. When elasticity is equal to zero, the quantity demanded does not change at all as price
changes, and when elasticity equals infinity, a very small reduction in price increases the
quantity demanded from zero to an infinitely large number. Price elasticity can be measured at
a point or between two points. Here we use the concepts of point elasticity and arc elasticity
respectively. The main determinants of elasticity are the availability of substitutes for the
commodity, number of uses of the commodity, nature of commodity, etc.
Income elasticity measures the response of quantity demanded to a percentage change in income
of the consumer.
Cross elasticity is the percentage change in quantity demanded of a product as a result of
change in the price of its related product.

CHAPTER – 2
THEORY OF
DEMAND
AND SUPPLY
Unit 2
Theory
of
Consumer
Behaviour
Learning Objectives
At the end of this unit you will be able to :
know the meaning of utility
understand how consumers try to maximize their satisfaction by spending on different
goods.
The demand for a commodity depends on the utility of that commodity to a consumer. If a
consumer gets more utility from a commodity, he would be willing to pay a higher price and
vice-versa.
2.0 WHAT IS UTILITY?

All desires, tastes and motives of human beings are called wants in Economics. Wants may
arise due to elementary and psychological causes. Since, the resources are limited; he has to
choose between urgent wants and not so urgent wants.
All wants of human beings exhibit some characteristic features.
1. Wants are unlimited
2. Every wants is satiable
3. Wants are competitive
4. Wants are complementary
5. Wants are alternative
6. Wants vary with time, place, and person
7. Some wants recur again
8. Wants are influenced by advertisement
9. Wants become habits and customs
In Economics wants are classified into three categories, viz., necessaries, comforts and luxuries.
Necessaries:
Necessaries are those which are essential for living. Man cannot do well with barest necessaries
of life alone. He requires some more necessaries to keep him fit for taking up productive activities.
These are called necessaries of efficiency. There is another type of necessaries are called
conventional necessaries. By custom and tradition, people require some wants to be satisfied.
Comforts:
Comforts refer to those goods and services which are not essential for living but which are
required for a happy living. It lies between the ‘necessaries’ and ‘luxuries’.
Luxuries:
Luxuries are those wants which are superfluous and expensive. They are not essential for
living, however, they may add efficiency to the consumer.
Utility is the want satisfying power of a commodity. It is a subjective entity and varies from
person to person. It should be noted that utility is not the same thing as usefulness. Even

harmful things like liquor, may be said to have utility from the economic stand point because
people want them. Thus in Economics, the concept of utility is ethically neutral.
Utility is an anticipated satisfaction by the consumer, and the satisfaction is the actual satisfaction
derived.
Utility hypothesis forms the basis for the theory of consumer’s behaviour. From time to time
different theories have been advanced to explain consumer’s behaviour and thus to explain
his demand for the product. Two important theories are (i) Marginal Utility Analysis propounded
by Marshall, and (ii) Indifference Curve Analysis propounded by Hicks and Allen.
2.1 MARGINAL UTILITY ANALYSIS

This theory which is formulated by Alfred Marshall, a British economist, seeks to explain how
a consumer spends his income on different goods and services so as to attain maximum
satisfaction. This theory is based on certain assumptions. But before stating the assumptions,
let us understand the meaning of total utility and marginal utility.
Total Utility is otherwise known as “Full Satiety”. Marginal Utility is also known as marginal
satiety.
Total utility : It is the sum of the utility derived from an different units of a commodity consumed
by a consumer.
Marginal utility : It is the additional utility derived from additional unit of a commodity.
2.1.0 Assumptions of Marginal Utility Analysis
(1) The Cardinal Measurability of Utility : According to this theory, utility is a cardinal concept
i.e., utility is a measurable and quantifiable entity. Thus a person can say that he derives
utility equal to 10 units from the consumption of 1 unit of commodity A and 5 from the
consumption of 1 unit of commodity B. Since, he can express his satisfaction quantitatively,
he can easily compare different commodities and express which commodity gives better
utility or satisfaction and by how much.
According to this theory, money is the measuring rod of utility. The amount of money
which a person is prepared to pay for a unit of a good rather than go without it is a
measure of the utility which he derives from the good.
(2) Constancy of the Marginal Utility of Money : The marginal utility of money remains
constant throughout when the individual is spending money on a good. This assumption
although not realistic, has been made in order to facilitate the measurement of utility of
commodities in terms of money.
(3) The Hypothesis of Independent Utility : The total utility which a person gets from the
whole collection of goods purchased by him is simply the sum total of the separate utilities
of the goods. The theory ignores complementarity between goods.
2.1.1 The Law of Diminishing Marginal Utility
One of the important laws under Marginal Utility analysis is the Law of Diminishing Marginal
Utility.
The law of diminishing marginal utility is based on an important fact that while total wants of a
person are virtually unlimited, each single want is satiable i.e., each want is capable of being satisfied.
Since each want is satiable, as a consumer consumes more and more units of a good, the
intensity of his want for the good goes on decreasing and a point is reached where the consumer
no longer wants it.
Marshall who was the exponent of the marginal utility analysis stated the law as follows :
“The additional benefit which a person derives from a given increase in stock of a thing
diminishes with every increase in the stock that he already has.”
This law describes a very fundamental tendency of human nature. In simple words it says that
as a consumer takes more units of a good, the extra satisfaction that he derives from an extra
unit of a good goes on falling. It is to be noted that it is the marginal utility and not the total
utility which declines with the increase in the consumption of a good.
Table 5 : Total and marginal utility schedules
Quantity of tea consumed Total utility Marginal utility
(cups per day)
1 30 30
2 50 20
3 65 15
4 75 10
5 83 8
6 89 6
7 93 4
8 96 3
9 98 2
10 99 0
11 95 –4
Let us illustrate the law with the help of an example. Consider Table 5, in which we have
presented the total utility and marginal utility derived by a person from cups of tea consumed
per day. When one cup of tea is taken per day, the total utility derived by the person is 30 utils
(unit of utility) and marginal utility derived is also 30 utils with the consumption of 2nd cup
per day the total utility rises to 50 but marginal utility falls to 20. We see as the consumption of
tea increases to 10 cups per day, marginal utility from the additional cups goes on diminishing
(i.e., the total utility goes on increasing at a diminishing rate). However, when the cups of tea
consumed per day increases to 11, then instead of giving positive marginal utility, the eleventh
cup gives negative marginal utility because it may cause him sickness.
We have graphically represented the data of the above table in Figure 13.
Graphically we can represent the relationship between the total utility and marginal utility.
From the above diagram we can conclude the three important relationships between total
utility and marginal utility

1. When the total utility rises the marginal utility diminishes.
2. When the total utility is maximum then the marginal utility is zero.
3. When the total utility is diminishing then the marginal utility is negative.
TU
Utility
O X
Consumption
MU
Fig. 12 : Total Utility and Marginal Utility
Fig. 13 : Marginal utility of tea consumed
As will be seen from the figure, the marginal utility curve goes on declining throughout. The
diminishing marginal utility curve applies almost to all commodities. A few exceptions however,
have been pointed out by some economists. According to them, this law does not apply to
money, music and hobbies. While this may be true in initial stages, beyond a certain limit these
will also be subjected to diminishing utility.
Limitations of the Law
The law of diminishing marginal utility is applicable only under certain assumptions.
(i) The different units consumed should be identical in all respects. The habit, taste, treatment
and income of the consumer also remain unchanged.
(ii) The different units consumed should consist of standard units. If a thirsty man is given
water by successive spoonfuls, the utility of second spoonful may conceivably be greater
than the utility of the first.
(iii) There should be no time gap or interval between the consumption of one unit and another
unit i.e. there should be continuous consumption.
(iv) The law may not apply to articles like gold, cash where a greater quantity may increase
the lust for it.
(v) The shape of the utility curve may be affected by the presence or absence of articles which
are substitutes or complements. The utility obtained from tea may be seriously affected if
no sugar is available.
2.1.2 Consumer’s Surplus : The concept of consumer ’s surplus was evolved by Alfred
Marshall. This concept occupies an important place not only in economic theory but also in
economic policies of government and decision-making of monopolists.
It has been seen that consumers generally are ready to pay more for the goods than they
actually pay for them. This extra satisfaction which consumers get from their purchase of
goods is called by Marshall as consumer’s surplus.
Marshall defined the concept of consumer’s surplus as “excess of the price which a consumer
would be willing to pay rather than go without a thing over that which he actually does pay,
is the economic measure of this surplus satisfaction........it may be called consumer’s surplus”.
Thus consumer’s surplus = What a consumer is ready to pay - What he actually pays.
The concept of consumer’s surplus is derived from the law of diminishing marginal utility. As
we know from the law of diminishing marginal utility, the more of a thing we have, the lesser
marginal utility it has. In other words, as we purchase more of a good, its marginal utility goes
on diminishing. The consumer is in equilibrium when marginal utility is equal to given price
i.e., he purchases that many number of units of a good at which marginal utility is equal to
price (It is assumed that perfect competition prevails in the market). Since the price is fixed for
all the units of the good he purchases except for the one at margin, he gets extra utility; this
extra utility or extra surplus for the consumer is called consumer’s surplus.
Prof. Hicks has redefined the concepts as the money income gained by a man arising from a
fall in price of goods he purchases.

It is often argued that this concept is a theoretical toy. The surplus satisfaction cannot be measured
precisely. In case of very essential goods of life; utility is very high but prices paid of them are
low giving rise to infinite surplus satisfaction. Further, it is difficult to measure the marginal
utilities of different units of a commodity consumed by person.
Consider Table 6 in which we have illustrated the measurement of consumer’s surplus in case
of commodity X. The price of X is assumed to be Rs. 20.
Table 6 : Measurement of Consumer’s Surplus
No. of units Marginal Utility Price (Rs.) Consumer’s Surplus
1 30 20 10
2 28 20 8
3 26 20 6
4 24 20 4
5 22 20 2
6 20 20 0
7 18 20 –
We see from the above table that when consumer’s consumption increases from 1 to 2 units,
his marginal utility falls from Rs. 30 to Rs. 28. His marginal utility goes on diminishing as he
increases his consumption of good X. Since marginal utility for a unit of good indicates the
price the consumer is willing to pay for that unit, and since price is assumed to be fixed at Rs.
20, the consumer enjoys a surplus at every unit of purchase above 6 units. Thus when the
consumer is purchasing 1 unit of X, the marginal utility is worth Rs. 30 and price fixed is Rs.
20, thus he is deriving a surplus of Rs. 10. Similarly when he purchases 2 units of X, he enjoys
a surplus of Rs. 8 [Rs. 28 – Rs. 20]. This continues and he enjoys consumer’s surplus equal to
Rs. 6, 4, 2 respectively from 3rd, 4th and 5th unit. When he buys 6 units, he is in equilibrium
because here his marginal utility is equal to the

market price or he is willing to pay a sum equal to
the actual market price. Here he enjoys no surplus.
Thus, given the price of Rs. 20 per unit, the total
surplus which the consumer will get, is Rs. 10 + 8 + 6
+ 4 + 2 + 0 = 30.
The concept of consumer ’s surplus can also be
illustrated graphically. Consider figure 10. On the X-
axis is measured the amount of the commodity and
on the Y-axis the marginal utility and the price of the
commodity. MU is the marginal utility curve which
slopes downwards, indicating that as the consumer
buys more units of the commodity, its marginal utility
falls. Marginal utility shows the price which a person Fig. 14 : Marshall’s Measure of
is willing to pay for the different units rather than go Consumer’s Surplus
without them. If OP is the price that prevails in the market, then consumer will be in equilibrium
when he buys OQ units of the commodity, since at OQ units, marginal utility is equal to the
given price OP. The last unit, i.e., Qth unit does not yield any consumer’s surplus because here
price paid is equal to the marginal utility of the Qth unit. But for units before Qth unit, marginal
utility is greater than the price and thus these units fetch consumer’s surplus to the consumer.
In Figure 14, the total utility is equal to the area under the marginal utility curve up to point Q
i.e. ODRQ. But given the price equal to OP, the consumer actually pays OPRQ. The consumer
derives extra utility equal to DPR which is nothing but consumer’s surplus.
Limitations :
(1) Consumer’s surplus cannot be measured precisely - because it is difficult to measure the
marginal utilities of different units of a commodity consumed by a person.
(2) In the case of necessaries, the marginal utilities of the earlier units are infinitely large. In
such case the consumer’s surplus is always infinite.
(3) The consumer’s surplus derived from a commodity is affected by the availability of
substitutes.
(4) There is no simple rule for deriving the utility scale of articles which are used for their
prestige value (e.g., diamonds).
(5) Consumer’s surplus cannot be measured in terms of money because the marginal utility of
money changes as purchases are made and the consumer’s stock of money diminishes.
(Marshall assumed that the marginal utility of money remains constant. But this assumption
is unrealistic).
(6) The concept can be accepted only if it is assumed that utility can be measured in terms of
money or otherwise. Many modern economists believe that this cannot be done.
2.2 INDIFFERENCE CURVE ANALYSIS

In the last section we discussed marginal utility analysis of demand. A very popular alternative
and more realistic method of explaining consumer’s demand is the Indifference Curve Analysis.
This approach to consumer behaviour is based on consumer preferences. It believes that human
satisfaction being a psychological phenomenon cannot be measured quantitatively in monetary
terms as was attempted in Marshall’s utility analysis. In this approach it is felt that it is much
easier and scientifically more sound to order preferences than to measure them in terms of
money.
The consumer preference approach, is, therefore an ordinal concept based on ordering of
preferences compared with Marshall’s approach of cardinality.
2.2.0 Assumptions Underlying Indifference Curve Approach
(i) The consumer is rational and possesses full information about all the relevant aspects of
economic environment in which he lives.
(ii) The consumer is capable of ranking all conceivable combinations of goods according to
the satisfaction they yield. Thus if he is given various combinations say A, B, C, D, E he

can rank them as first preference, second preference and so on. If a consumer happens to
prefer A to B, he can not tell quantitatively how much he prefers A to B.
(iii) If the consumer prefers combination A to B, and B to C, then he must prefer combination
A to C. In other words, he has a consistent consumption pattern behaviour.
(iv) If combination A has more commodities than combination B, then A must be preferred
to B.
2.2.1 What are Indifference Curves? Ordinal analysis of demand (here we will discuss the
one given by Hicks and Allen) is based on indifference curves. An indifference curve is a curve
which represents all those combinations of goods which give same satisfaction to the consumer.
Since all the combinations on an indifference curve give equal satisfaction to the consumer, the
consumer is indifferent among them. In other words, since all the combinations provide same
level of satisfaction the consumer prefers them equally and does not mind which combination
he gets.
To understand indifference curves let us consider the example of a consumer who has one unit
of food and 12 units of clothing. Now we ask the consumer how many units of clothing he is
prepared to give up to get an additional unit of food, so that his level of satisfaction does not
change. Suppose the consumer says that he is ready to give up 6 units of clothing to get an
additional unit of food. We will have then two combinations of food and clothing giving equal
satisfaction to consumer : Combination A has 1 unit of food and 12 units of clothing, combination
B has 2 units of food and 6 units of clothing. Similarly, by asking the consumer further how
much of clothing he will be prepared to forgo for successive increments in his stock of food so
that his level of satisfaction remains unaltered, we get various combinations as given below :
Table 7 : Indifference Schedule
Combination Food Clothing MRS

A 1 12
B 2 6 6
C 3 4 2
D 4 3 1
Now if we draw the above schedule we will get the following figure.
In Figure 15, an indifference curve IC is drawn by plotting the various combinations of the
indifference schedule. The quantity of food is measured on the X axis and the quantity of
clothing on the Y axis. As in indifference schedule, combinations lying on an indifference curve
will give the consumer same level of satisfaction.
Fig. 15 : A Consumer’s Indifference Curve
2.2.2 Indifference Map : A set of indifference curves is called indifference map.

An indifference map depicts complete picture of consumer ’s tastes and preferences. In
Figure 16, an indifference map of a consumer is shown which consists of three indifference curves.
We have taken good X on X-axis and good Y on Y-axis. It should be noted that while the
consumer is indifferent among the combinations lying on the same indifference curve, he
certainly prefers the combinations on the higher indifference curve to the combinations lying
on a lower indifference curve because a higher indifference curve signifies a higher level of
satisfaction. Thus while all combinations of IC1 give same satisfaction, all combinations lying
on IC2 give greater satisfaction than those lying on IC1.
Fig. 16 : Indifference Map

2.2.3. Marginal Rate of Substitution : Marginal Rate of Substitution (MRS) is the rate at
which the consumer is prepared to exchange goods X and Y. Consider Table-7. In the beginning
the consumer is consuming 1 unit of food and 12 units of clothing. Subsequently, he gives up 6
units of clothing to get an extra unit of food, his level of satisfaction remaining the same. The
MRS here is 6. Like wise which he moves from B to C and from C to D in his indifference
schedule, the MRS are 2 and 1 respectively. Thus, we can define MRS of X for Y as the amount
of Y whose loss can just be compensated by a unit gain of X in such a manner that the level of
satisfaction remains the same. We notice that MRS is falling i.e., as the consumer has more and
more units of food, he is prepared to give up less and less units of cloths. There are two reasons
for this.
1. The want for a particular good is satiable so that when a consumer has its more quantity,
his intensity of want for it decreases. Thus, when consumer in our example, has more
units of food, his intensity of desire for additional units of food decreases.
2. Most of the goods are imperfect substitutes of one another. If they could substitute one
another perfectly. MRS would remain constant.
2.2.4 Properties of Indifference Curves : The following are the main characteristics or
properties of indifference curves :
(i) Indifference curves slope downward to the right : This property implies that when the
amount of one good in combination is increased, the amount of the other good is reduced.
This is essential if the level of satisfaction is to remain the same on an indifference curve.
(ii) Indifference curves are always convex to the origin : It has been observed that as more
and more of one commodity (X) is substituted for another (Y), the consumer is willing to
part with less and less of the commodity being substituted (i.e. Y). This is called diminishing
marginal rate of substitution. Thus in our example of food and clothing, as a consumer
has more and more units of food, he is prepared to forego less and less units of clothing.
This happens mainly because want for a particular good is satiable and as a person has
more and more of a good, his intensity of want for that good goes on diminishing. This
diminishing marginal rate of substitution gives convex shape to the indifference curves.
However, there are two extreme situations. When two goods are perfect substitutes of
each other, the indifference curve is a straight line on which MRS is constant. And when
two goods are perfect complementary goods (e.g. gasoline and water in a car), the
indifference curve will consist of two straight line with a right angle bent which is convex
to the origin or in other words, it will be L shaped.
(iii) Indifference curves can never intersect each other : No two indifference curves will intersect
each other although it is not necessary that they are parallel to each other. In case of
intersection the relationship becomes logically absurd because it would show that higher
and lower levels are equal which is not possible. This property will be clear from the
following Figure 17.
Fig. 17 : Intersecting Indifference Curves

In figure 17, IC1 and IC2 intersect at A. Since A and B lie on IC1, they give same satisfaction
to the consumer. Similarly since A and C lie on IC2, they give same satisfaction to the
consumer. This implies that combination B and C are equal in terms of satisfaction. But a
glance will show that this is an absurd conclusion because certainly combination C is
better than combination B because it contains more units of commodities X and Y. Thus
we see that no two indifference curves can touch or cut each other.
(iv) A higher indifference curve represents a higher level of satisfaction than the lower
indifference curve : This is because combinations lying on a higher indifference curve contain
more of either one or both goods and more goods are preferred to less of them.
(v) Indifference curve will not touch the axis
Another characteristic feature of indifference curve is that it will not touch the X axis or Y
axis. This is born out of our assumption that the consumer is considering different
combination of two commodities. If an indifference curve touches the Y axis at a point P
as shown in the figure 18 it means that the consumer is satisfied with OP units of y
commodity and zero units of x commodity. This is contrary to our assumption that the
consumer wants both commodities although in a smaller or larger quantities. Therefore
the indifference curve will not touch either the X axis or Y axis.
P
Good Y
O X
Good X
Fig. 18 : Indifference Curve

2.2.5 Budget Line : A higher indifference curve shows a higher level of satisfaction than a
lower one. Therefore, a consumer in his attempt to maximise satisfaction will try to reach the
highest possible indifference curve. But in his pursuit of buying more and more goods and thus
obtaining more and more satisfaction he has to work under two constraints : firstly, he has to
pay the prices for the goods and, secondly, he has a limited money income with which to
purchase the goods.
These constraints are explained by budget line or price line. In simple words a budget line
shows all those combinations of two goods which the consumer can buy spending his given
money income on the two goods at their given prices. All those combinations which are within
the reach of the consumer (assuming that he spends all his money income) will lie on the
budget line.
Fig. 19 : Price Line

It should be noted that any point outside the given price line, like H, will be beyond the reach
of the consumer and any combination lying within the line, like K, shows under spending by
the consumer.
2.2.6 Consumer’s Equilibrium : Having explained indifference curves and budget line, we
are in a position to explain how a consumer reaches equilibrium position. A consumer is in
equilibrium when he is deriving maximum possible satisfaction from the goods and is in no
position to rearrange his purchases of goods. We assume that :
(i) the consumer has a given indifference map which shows his scale of preferences for various
combinations of two goods X and Y.
(ii) he has a fixed money income which he has to spend wholly on goods X and Y.
(iii) prices of goods X and Y are given and are fixed for him.
(iv) All goods are homogeneous and divisible.
(v) The consumers acts ‘rationally’ and maximizes his satisfaction.
Fig. 20 : Consumer’s Equilibrium
To show which combination of two goods X and Y the consumer will buy to be in equilibrium
we bring his indifference map and budget line together.
We know by now, that the indifference map depicts the consumer’s preference scale between
various combinations of two goods and the budget line shows various combinations which he
can afford to buy with his given money income and prices of the two goods. Consider
Figure 20, in which IC1, IC2, IC3, IC4 and IC5 are shown together with budget line PL for good
X and good Y. Every combination on budget line PL costs the same. Thus combinations R, S, Q,
T and H cost the same to the consumer. The consumer’s aim is to maximise his satisfaction and
for this he will try to reach highest indifference curve.
But since there is a budget constraint he will be forced to remain on the given budget line, that
is he will have to choose any combinations from among only those which lie on the given price
line.
Which combination will he choose? Suppose he chooses R, but we see that R lies on a lower
indifference curve IC1, when he can very well afford S, Q or T lying on higher indifference
curve. Similar is the case for other combinations on IC1, like H. Again, suppose he chooses
combination S (or T) lying on IC2. But here again we see that the consumer can still reach a
higher level of satisfaction remaining within his budget constraints i.e., he can afford to have
combination Q lying on IC3 because it lies on his budget line. Now what if he chooses combination
Q? We find that this is the best choice because this combination lies not only on his budget line
but also puts him on highest possible indifference curve i.e., IC3. The consumer can very well
wish to reach IC4 or IC5, but these indifference curves are beyond his reach given his money
income. Thus the consumer will be at equilibrium at point Q on IC3. What do we notice at
point Q? We notice that at this point, his budget line PL is tangent to the indifference curve IC3.
In this equilibrium position (at Q), the consumer will buy OM of X and ON of Y.
At the tangency point Q, the slopes of the price line PL and indifference curve IC3 are equal.
The slope of the indifference curve shows the marginal rate of substitution of X for Y (MRSxy)

MU x
which is equal to MU while the slope of the price line indicates the ratio between the prices
y
Px
of two goods i.e., P
y
At equilibrium point Q,
MU x P
MRS xy = = x
MU y Py
Thus, we can say that the consumer is in equilibrium position when price line is tangent to the
indifference curve or when the marginal rate of substitution of goods X and Y is equal to the
ratio between the prices of the two goods.
SUMMARY
The theory of consumer’s behaviour seeks to explain the determination of consumer’s equilibrium.
Two famous approaches to consumer’s equilibrium are (i) Marginal Utility Analysis (ii)
Indifference Curve Analysis.
Marginal utilility analysis is framed within the parameters of two laws : Law of diminishing
marginal utility and the law of equi-marginal utility. The law of diminishing marginal utility
states that as a consumer increases the consumption of a commodity, every successive unit of
the commodity gives lesser and lesser satisfaction to the consumer i.e., marginal utility of the
commodity falls.
The indifference curve theory which is an ordinal theory shows the household’s preference
between alternative bundles of goods by means of indifference curves. A single curve joins all
those combinations of goods which give the household equal satisfaction or utility and between
which the household is thus indifferent. The household reaches equilibrium when for a given
money income and given market price, it has reached the highest attainable level of satisfaction.
At such a point, the budget line is tangent to the indifference curve. At the tangency point, the
following condition is satisfied :
MU x MU y MU z
= =
Px Py Pz
The indifference curve analysis is superior to utility analysis : (i) it dispenses with the assumption
of measurability of utility (ii) it studies more than one commodity at a time (iii) it does not
assume constancy of money (iv) it segregates income effect from substitution effect.
CHAPTER – 2
THEORY OF
DEMAND
AND SUPPLY
Unit 3
Supply
Learning Objectives
understand the meaning of supply.

understand what determines supply.
get an insight into the law of supply.
know the difference between movements on the supply curve and shift of the supply
curve.
understand the concept of elasticity of supply.
3.0 INTRODUCTION
As the term ‘demand’ refers to the quantity of a good or service that the consumers are willing
and able to purchase at various prices during a period of time, the term ‘supply’ refers the
amount of a good or service that the producers are willing and able to offer to the market at
various prices during a period of time. Two important points apply to supply :
(i) The supply refers to what firms offer for sale, not necessarily to what they succeed in
selling.
(ii) Supply is a flow. The quantity supplied is so much per unit of time, per day, per week, or
per year.
Supply is defined as “how much of good will be offered for sale at a given time”. Prof. McConnell
defines supply in the following term: “Supply may be defined as a schedule which shows the
various amounts of a product which a producer is willing to and able to produce and make
available for sale in the market at each specific price in a set of possible prices during some
given period”.
3.1 DETERMINANTS OF SUPPLY

Although price is an important consideration in determining the willingness and desire to part
with the commodities, they are many other factors which determine the supply of a product or
a service. These are discussed below :
(i) Price of the good : Other things being equal, the higher the relative price of a good the
greater the quantity of it that will be supplied. This is because goods and services are
produced by the firm in order to earn profits and, ceteris paribus, profits rise if the price of
its product rises.
(ii) Price of the related goods : If the prices of other goods rise, they become relatively more
profitable to the firm to produce and sell than the good in question. It implies, that if the
price of Y rises, the quantity supplied of X will fall. For example, if price of wheat rises, the
farmers may shift lands to wheat production and away from corn and soyabeans.
(iii) Price of the factors of production : A rise in the price of a particular factor of production
will cause an increase in the cost of making those goods that use a great deal of that factor
than in the costs of producing those that use relatively small amount of the factor. For
example, a rise in the cost of land will have a large effect on the cost of producing wheat
and a very small effect on the cost of producing automobiles. Thus a change in the price of
one factor of production will cause changes in the relative profitability of different lines of
production and will cause producers to shift from one line to another and thus supplies of
different commodities will change.
(iv) State of technology : The supply of a particular product depends upon the state of
technology also. Inventions and innovations tend to make it possible to produce more or
better goods with the same resources, and thus they tend to increase the quantity supplied
of some products and to reduce the quantity supplied of products that are displaced.
(v) Government Policy : The production of a good may be subject to the imposition of
commodity taxes such as excise duty, sales tax and import duties. These raise the cost of
production and so the quantity supplied of a good would increase only when its price in
the market rises. Subsidies, on the other hand, reduce the cost of production and thus
provide an incentive to the firm to increase supply.
(vi) Other Factors : The quantity supplied of a good also depends upon government’s industrial
and foreign policies, goals of the firm, infrastructual facilities, market structure, natural
factors etc.
3.2 LAW OF SUPPLY

This refers to the relationship of quantity supplied of a good with one or more related variables
which have an influence on the supply. Normally, the supply is related with price but it can be
related with the type of technology used, scale of operations etc. The law of supply can be
stated as : Other things remaining constant, the quantity of a good produced and offered for
sale will increase as the price of the good rises and decrease as the price falls.
This law is based upon common sense, for the higher the price of the good, the greater the
profits that can be earned and thus greater the incentives to produce the good and offer it for
sale. The law is known to be correct in large number of cases. There is an exception however.
If we take the supply of labour at very high wages, we may find that the supply of labour has
decreased instead of increasing. Thus, the behaviour of supply depends upon the phenomenon
considered and the degree of possible adjustment in supply.
The behaviour of supply curve is also affected by the time taken into consideration. In the short
run, it may not be easy to increase supply but in the long run supply can be easily adjusted in
response to changes in price.
The law of supply can be explained through supply schedule and supply curve. Consider the
following schedule.

Table 8 : Supply Schedule of Good ‘X’
Price (Rs.) Quantity supplied

(per kg) (kg)
1 5
2 35
3 45
4 55
5 65
The table shows the quantities of good X that would be produced and offered for sale at a
number of alternative prices. At Re. 1, for example, 5 kilograms of good X are offered for sale
and at Rs. 3 per kg. 45 kg. would be forthcoming.
We can now plot the data from Table 8 on a graph. In Figure 21, price is plotted on vertical axis
and quantity on the horizontal axis, and various price-quantity combinations of the schedule 8
are plotted.
Fig. 21 : Supply Curve
When we draw a smooth curve through the plotted points, what we get is the supply curve for
good X. The curve shows the quantity of X that will be offered for sale at each price of X. It
slopes upwards towards right showing that as price increases, the supply of X increases and
vice-versa.
The market supply curve for ‘X’ can be obtained by adding horizontally the various firms’
supply curves.
3.3 SHIFTS IN THE SUPPLY CURVE – INCREASE OR DECREASE IN SUPPLY

When the supply curve bodily shifts towards right as a result of a change in one of the factors
that influence the quantity supplied other than the commodity’s own price, we say there is an
increase in supply. When these factors cause the supply curve to shift to left we call it decrease
in supply [See Figures 22(i) and (ii)].
Fig. 22 : Shifts in supply curves
3.4 MOVEMENTS ON THE SUPPLY CURVE – INCREASE OR DECREASE IN THE

QUANTITY SUPPLIED
When the supply of a good increases as a result of an increase in its price we say that there is
an increase in the quantity supplied and there is a upward movement on the supply curve.
The reverse is the case when there is a fall in the price of the good. (See Figure 23).
Fig. 23 : Figure showing change in quantity supplied as a result of a price change

3.5 ELASTICITY OF SUPPLY
The elasticity of supply is defined as the responsiveness of the quantity supplied of a good to a
change in its price. Elasticity of supply is measured by dividing the percentage change in quantity
supplied of a good by the percentage change in its price i.e.,
Percentage change in quantity supplied

EP =
Percentage change in price
Change in quantity supplied

quantity supplied
or
change in price
price
Δq
q Δq p
or = x
Δp Δp q
p
Where q denotes original quantity supplied.
Δq denotes change in quantity supplied.
p denotes original price.
Δp denotes change in price.
Example:
a. Suppose the price of a commodity X increase from Rs. 2,000 per unit to Rs. 2,100 per unit
and consequently the quantity supplied rises from 2,500 units to 3,000 units. Calculate the
elasticity of supply.
Here Δ q = 500 units Δ p = Rs. 100
p = Rs. 2000 q = 2500 units
500 2000
∴ Es = ×
100 2500
=4
∴ Elasticity of Supply = 4.
3.5.0 Type of Supply Elasticity : The elasticity of supply can be classified as under :
(i) Perfectly Inelastic supply : If as a result of a change in price, the quantity supplied of a
good remains unchanged, we say that the elasticity of supply is zero or the good has
perfectly inelastic supply. The vertical supply curve in Figure 24 shows that irrespective of
the price change, the quantity supplied remains unchanged.
Fig. 24 : Supply curves of zero elasticity
(ii) Relatively less-elastic supply : If as a result of a change in the price of a good its supply
changes less than proportionately, we say that the good is relatively less elastic or elasticity
of supply is less than one. Figure 25 shows that the relative change in the quantity supplied
(Δq) is less than the relative change in the price (Δp).
Fig. 25 : Showing relatively less elastic supply
(iii) Relatively greater-elastic supply : If elasticity of supply is greater than one i.e., when the
quantity supplied of a good changes substantially in response to a small change in the
price of the good we say that supply in greatly elastic. Figure 26, shows that the relative
change in the quantity supplied (Δq) is greater than the relative change in the price.

Fig. 26 : Showing relatively greater elastic supply
(iv) Unit-elastic : If the relative change in the quantity supplied is exactly equal to the relative
change in the price, the supply is said to be unitary elastic. Here coefficient of elasticity of
supply is equal to one. In Figure 27, the relative change in the quantity supplied (Δq) is
equal to the relative change in the price (Δp).
Fig. 27 : Showing unitary elasticity
(v) Perfectly elastic supply : The supply elasticity is infinite when nothing is supplied at a
lower price but a small increase in price causes supply to rise from zero to an indefinitely
large amount indicating that producers will supply any quantity demanded at that price.
Figure 28 shows infinitely elastic supply.
Fig. 28 : Supply curve of infinite elasticity
3.5.1 Measurement of supply-elasticity : The elasticity of supply can be considered with

reference to a given point on the supply curve or between two points on the supply curve.
Point-elasticity : Just as in demand, point-elasticity can be measured with the help of the following
formula :
dq p
Es = x
dp q
(Ed) The Supply function is given as q = -100 + 10p. Find the elasticity of supply using point
method, when price is Rs. 15.
dq p
Es = dp × q
dq
Since = 10, p = Rs. 15, q = - 100 + 10 (15)
dp
q = 50
15
∴ E s = 10 ×
50
or Es = 3
dq
Where dp is differentiation of the supply function with respect to price and p and q refer
to price and quantity respectively.

Arc-Elasticity : Arc-elasticity i.e. elasticity of supply between two prices can be found out with
the help of the following formula :
q 1 − q 2 p1 − p 2
Es = ÷
q 1 + q 2 p1 + p 2
or

q 1 − q 2 p1 + p2
Es = x
q 1 + q 2 p1 − p2
Where p1 q1 are original price and quantity and p2 q2 are new price and quantity supplied.
Thus, if we have to find elasticity of supply when p1 = Rs. 12, p2 = Rs. 15, q1 = 20 units and
q2 = 50 units.
Then using the above formula, we will get supply elasticity as :
20 - 50 12 + 15
Es = x
20 + 50 12 − 15
30 27
= x
70 3
= +3.85
SUMMARY
The term ‘Supply’ refers to a schedule of the quantities of a good that will be offered for sale at
different prices. The supply curve is a graphic presentation of the supply schedule. The laws of
supply explain the relation between the quantity supplied of a good or service and the various
factors on which the supply depends like price of the product, technology used, scale of
operations etc. Most important is the relation of the quantity supplied of a good with its price.
It has been observed that quantity supplied of a good increases with a rise in
its price and falls with a fall in its price.
Elasticity of supply is the responsiveness of quantity supplied of a good as a result of a change
in any of the factors on which supply depends. Most important is the responsiveness of the
quantity supplied to a change in the price of the good. Elasticity of supply can be considered
with reference to a given point on the supply curve (point elasticity) or between two points
(arc elasticity).

1. Demand for a commodity refers to :
(a) desire for the commodity.
(b) need for the commodity.
(c) quantity demanded of that commodity.
(d) quantity of the commodity demanded at a certain price during any particular period
of time.
2. Contraction of demand is the result of :
(a) decrease in the number of consumers.
(b) increase in the price of the good concerned.
(c) increase in the prices of other goods.
(d) decrease in the income of purchasers.
3. All but one of the following are assumed to remain the same while drawing an individual’s
demand curve for a commodity. Which one is it?
(a) The preference of the individual.
(b) His monetary income.
(c) Price.
(d) Price of related goods.
4. Which of the following pairs of goods is an example of substitutes?
(a) Tea and sugar.
(b) Tea and coffee.
(c) Pen and ink.
(d) Shirt and trousers.
5. In the case of a straight line demand curve meeting the two axes, the price-elasticity of
demand at the mid-point of the line would be :
(a) 0
(b) 1
(c) 1.5
(d) 2
6. The Law of Demand, assuming other things to remain constant, establishes the relationship
between :
(a) income of the consumer and the quantity of a good demanded by him.
(b) price of a good and the quantity demanded.
(c) price of a good and the demand for its substitute.
(d) quantity demanded of a good and the relative prices of its complementary goods.
7. Identify the factor which generally keeps the price-elasticity of demand for a good low :
(a) Variety of uses for that good.
(b) Its low price.
(c) Close substitutes for that good.
(d) High proportion of the consumer’s income spent on it.
8. Identify the coefficient of price-elasticity of demand when the percentage increase in the
quantity of a good demanded is smaller than the percentage fall in its price :
(a) Equal to one.
(b) Greater than one.
(c) Smaller than one.
(d) Zero.
9. In the case of an inferior good, the income elasticity of demand is :
(a) positive.
(b) zero.
(c) negative.
(d) infinite.

10. If the demand for a good is inelastic, an increase in its price will cause the total expenditure
of the consumers of the good to :
(a) remain the same.
(b) increase.
(c) decrease.
(d) any of these.
11. If regardless of changes in its price, the quantity demanded of a good remains unchanged,
then the demand curve for the good will be :
(a) horizontal.
(b) vertical.
(c) positively sloped.
(d) negatively sloped.
12. The law of demand is :
(a) a quantitative statement.
(b) a qualitative statement.
(c) both a quantitative and a qualitative statement.
(d) neither a quantitative nor a qualitative statement.
13. All of the following are determinants of demand except :
(a) tastes and preferences.
(b) quantity supplied.
(c) income.
(d) price of related goods.
14. A movement along the demand curve for soft drinks is best described as :
(a) An increase in demand.
(b) A decrease in demand.
(c) A change in quantity demanded.
(d) A change in demand.
15. If the price of Pepsi decreases relative to the price of Coke and 7-UP, the demand for :
(a) coke will decrease.
(b) 7-Up will decrease.
(c) coke and 7-UP will increase.
(d) coke and 7-Up will decrease.
16. If a good is a luxury, its income elasticity of demand is :
(a) positive and less than 1.
(b) negative but greater than -1.
(c) positive and greater than 1.
(d) zero.
17. The price of hot dogs increases by 22% and the quantity of hot dogs demanded falls by
25%. This indicates that demand for hot dogs is :
(a) elastic.
(b) inelastic.
(c) unitarily elastic.
(d) perfectly elastic.
18. If the quantity demanded of beef increases by 5% when the price of chicken increases by
20%, the cross-price elasticity of demand between beef and chicken is
(a) -0.25
(b) 0.25
(c) -4
(d) 4
19. Given the following four possibilities, which one results in an increase in total consumer
expenditures?
(a) demand is unitary elastic and price falls.
(b) demand is elastic and price rises.
(c) demand is inelastic and price falls.
(d) demand is inelastic and prices rises.
20. The price elasticity of demand for hamburger is
(a) the change in the quantity demanded of hamburger when hamburger increases by
30 paise per rupee.
(b) the percentage increase in the quantity demanded of hamburger when the price of
hamburger falls by 1 per cent per rupee.
(c) the increase in the demand for hamburger when the price of hamburger falls by 10
per cent per rupee.
(d) the decrease in the quantity demanded of hamburger when the price of hamburger
falls by 1 per cent per rupee.
21. The price elasticity of demand is defined as the responsiveness of :
(a) price to a change in quantity demanded.
(b) quantity demanded to a change in price.
(c) price to a change in income.
(d) quantity demanded to a change in income.
22. Suppose the price of movies seen at a theater rises from Rs. 120 per person to Rs. 200 per
person. The theater manager observes that the rise in price causes attendance at a given
movie to fall from 300 persons to 200 persons. What is the price elasticity of demand for
movies?
(a) .5

(b) .8
(c) 1.0
(d) 1.2
23. Suppose a department store has a sale on its silverware. If the price of a plate-setting is
reduced from Rs. 300 to Rs. 200 and the quantity demanded increases from 3,000 plate-
settings to 5,000 plate-settings, what is the price elasticity of demand for silverware?
(a) .8
(b) 1.0
(c) 1.25
(d) 1.50
24. A discount store has a special offer on CDs. It reduces their price from Rs. 150 to Rs. 100.
Suppose the store manager observes that the quantity demanded increases from 700 CDs
to 1,300 CDs. What is the price elasticity of demand for CDs?
(a) .8
(b) 1.0
(c) 1.25
(d) 1.50
25. If the local pizzeria raises the price of a medium pizza from Rs. 60 to Rs. 100 and quantity
demanded falls from 700 pizzas a night to 100 pizzas a night, the price elasticity of demand
for pizzas is :
(a) .67
(b) 1.5
(c) 2.0
(d) 3.0
26. If electricity demand is inelastic, and electric rates increase, which of the following is likely
to occur?
(a) Quantity demanded will fall by a relatively large amount.
(b) Quantity demanded will fall by a relatively small amount.
(c) Quantity demanded will rise in the short run, but fall in the long run.
(d) Quantity demanded will fall in the short run, but rise in the long run.
27. Suppose the demand for meals at a medium-priced restaurant is elastic. If the management
of the restaurant is considering raising prices, it can expect a relatively :
(a) large fall in quantity demanded.
(b) large fall in demand.
(c) small fall in quantity demanded.

(d) small fall in demand.
28. Point elasticity is useful for which of the following situations?
(a) The bookstore is considering doubling the price of notebooks.
(b) A restaurant is considering lowering the price of its most expensive dishes by 50
percent.
(c) An auto producer is interested in determining the response of consumers to the price
of cars being lowered by Rs. 100.
29. A decrease in price will result in an increase in total revenue if :
(a) the percentage change in quantity demanded in less than the percentage change in
price.
(b) the percentage change in quantity demanded is greater than the percentage change
in price.
(c) demand is inelastic.
(d) the consumer is operating along a linear demand curve at a point at which the price
is very low and the quantity demanded is very high.
30. An increase in price will result in an increase in total revenue if :
(a) the percentage change in quantity demanded is less than the percentage change in
price.
(b) the percentage change in quantity demanded is greater than the percentage change
in price.
(c) demand is elastic.
(d) the consumer is operating along a linear demand curve at a point at which the price
is very high and the quantity demanded is very low.
31. Demand for a good will tend to be more elastic if it exhibits which of the following
characteristics?
(a) It represents a small part of the consumer’s income.
(b) The good has many substitutes available.
(c) It is a necessity (as opposed to a luxury).
(d) There is little time for the consumer to adjust to the price change.
32. Demand for a good will tend to be more inelastic if it exhibits which of the following
characteristics?
(a) The good has many substitutes.
(b) The good is a luxury (as opposed to a necessity).

(c) The good is a small part of the consumer’s income.
(d) There is a great deal of time for the consumer to adjust to the change in prices.
33. Suppose a consumer’s income increases from Rs. 30,000 to Rs. 36,000. As a result, the
consumer increases her purchases of compact discs (CDs) from 25 CDs to 30 CDs. What
is the consumer’s income elasticity of demand for CDs?
(a) 0.5
(b) 1.0
(c) 1.5
(d) 2.0
34. Total utility is maximum when :
(a) marginal utility is zero.
(b) marginal utility is at its highest point.
(c) marginal utility is equal to average utility.
(d) average utility is maximum.
35. Which one is not an assumption of the theory of demand based on analysis of indifference
curves?
(a) Given scale of preferences as between different combinations of two goods.
(b) Diminishing marginal rate of substitution.
(c) Constant marginal utility of money.
(d) Consumers would always prefer more of a particular good to less of it, other things
remaining the same.
36. The consumer is in equilibrium at a point where the budget line :
(a) is above an indifference curve.
(b) is below an indifference curve.
(c) is tangent to an indifference curve.
(d) cuts an indifference curve.
37. An indifference curve slopes down towards right since more of one commodity and less of
another result in :
(a) same satisfaction.
(b) greater satisfaction.
(c) maximum satisfaction.
(d) decreasing expenditure.
38. Which of the following statements is incorrect?

(a) An indifference curve must be downward-sloping to the right.
(b) convexity of a curve implies that the slope of the curve diminishes as one moves from
left to right .
(c) The elasticity of substitution between two goods to a consumer is zero.
(d) The total effect of a change in the price of a good on its quantity demanded is called
the price effect.
39. The second glass of lemonade gives lesser satisfaction to a thirsty boy. This is a clear case
of
(a) Law of demand.
(b) Law of diminishing returns.
(c) Law of diminishing utility.
(d) Law of supply.
40. The consumer is in equilibrium when the following condition is satisfied :
MU x Px
(a) > .
MU y Py
MU x Px
(b) < .
MU y Py
MU x Px
(c) = .
MU y Py

41. In the case of a Giffen good, the demand curve will be :
(a) horizontal.
(b) downward-sloping to the right.
(c) vertical.
(d) upward-sloping to the right.
42. By consumer surplus economists mean
(a) the area inside the budget line.
(b) the area between the average revenue and marginal revenue curves.
(c) the different between the maximum amount a person is willing to pay for a good and
its market price.

43. Which of the following is a property of an indifference curve?
(a) it is convex to the origin.
(b) the marginal rate of substitution is constant as you move along an indifference curve.
(c) marginal utility is constant as you move along an indifference curve.
(d) total utility is greatest where the 45 degree line cuts the indifference curve.
44. When economists speak of the utility of a certain good, they are referring to
(a) the demand for the good.
(b) the usefulness of the good in consumption.
(c) the satisfaction gained from consuming the good.
(d) the rate at which consumers are willing to exchange one good for another.
45. A vertical supply curve parallel to Y axis implies that the elasticity of supply is :
(a) Zero
(b) Infinity
(c) Equal to one
(d) Greater than zero but less than infinity.
46. The supply of a good refers to :
(a) actual production of the good.
(b) total existing stock of the good.
(c) stock available for sale.
(d) amount of the good offered for sale at a particular price per unit of time.
47. An increase in the supply of a good is caused by :
(a) improvements in its technology.
(b) fall in the prices of other goods.
(c) fall in the prices of factors of production.
(d) all of the above.
48. Elasticity of supply refers to the degree of responsiveness of supply of a good to changes in
its :
(a) demand.
(b) price.
(c) cost of production.
(d) state of technology.
49. A horizontal supply curve parallel to the quantity axis implies that the elasticity of supply
is :
(a) zero.
(b) infinite.
(c) equal to one.
(d) greater than zero but less than one.
50. Contraction of supply is the result of :
(a) decrease in the number of producers.
(b) decrease in the price of the good concern.
(c) increase in the prices of other goods.
(d) decrease in the outlay of sellers.
51. Conspicuous goods are also known as
a. prestige goods
b. snob goods
c. veblen goods
d. all of the above
52. The quantity purchased will remain constant irrespective of the change in income. This is
known as
a. negative income elasticity of demand
b. income elasticity of demand less than one
c. zero income elasticity of demand
d. income elasticity of demand is greater than one
53. As income increases, the consumer will go in for superior goods and consequently the
demand for inferior goods will fall. This means:
a. income elasticity of demand less than one
b. negative income elasticity of demand
d. unitary income elasticity of demand
54. When income increases the money spent on necessaries of life may not increase in the
same proportion, This means
a. income elasticity of demand is zero
b. income elasticity of demand is one

c. income elasticity of demand is greater than one
d. income elasticity of demand is less than one
55. The luxury goods like jewellery and fancy articles will have
a. low income elasticity of demand
b. high income elasticity of demand
56. The good which cannot be consumed more than once is known as
a. durable good
b. non-durable good
c. producer good
57. A relative price is
a. price expressed in terms of money
b. what you get paid for babysitting your cousin
c. the ratio of one money price to another
d. equal to a money price
58. The quantity demanded of a good or service is the amount that
a. consumer plan to buy during a given time period at a given price
b. firms are willing to sell during a given time period at a given price
c. a consumer would like to buy but might not be able to afford
d. is actually bought during a given time period at a given price.
59. Demand is the
a. unlimited wants of consumers
b. entire relationship between the quantity demanded and the price of a good
c. willingness to pay for a good if income is larger enough
d. ability to pay for a good
60. If, as people’s income increases, the quantity demanded of a good decreases, the good is
called
a. a substitute
b. a normal good
c. an inferior good
d. a complement
61. The price of tomatoes increases and people buy tomato puree. You infer that tomato puree
and tomatoes are
a. normal goods
b. complements
c. substitutes
d. inferior goods
62. Chicken and fish are substitutes. If the price of chicken increases, the demand for fish will
a. increase or decrease but the demand curve for chicken will not change
b. increase and the demand curve for fish will shift rightwards.
c. not change but there will be a movement along the demand curve for fish.
d. decrease and the demand curve for fish will shift leftwards.
63. Potato chips and popcorn are substitutes. A rise in the price of potato chips will ————
—— the demand for popcorn and the quantity of popcorn will ———————
a. increase; increase
b. increase; decrease
c. decrease; decrease
d. decrease; increase
64. Apple juice and orange juice are substitutes in consumption and apple juice and apple
sauce are substitutes in production. If the price of orange juice———————— or the
price of apple sauce ————————————, then the price of apple juice will ———
—————————
a. increases; increases; increase
b. decreases; decreases; increase
c. decreases; increases; decrease
d. increases; decreases; increase
65. An increase in the demand for computers and an increase in the number of sellers of
computers will
a. increase the number of computers bought
b. decrease the price but increase the number of computers bought
c. increase the price of a computer
d. increase the price and the number of computers bought.

66. When total demand for a commodity whose price has fallen increases, it is due to:
a. income effect.
b. substitution effect
c. complementary effect
d. price effect
67. With a fall in the price of a commodity:
a. consumer’s real income increases
b. consumer’s real income decreases
c. there is no change in the real income of the consumer
68. With an increase in the price of diamond, its demand also increases. This is because it is a:
a. substitute good
b. complementary good
c. conspicuous good
69. The goods that exhibit direct price-demand relationship are called:
a. Giffen goods
b. Complementary goods
c. Substitute goods
70. In Economics when demand for a commodity increases with a fall in its price it is known
as:
a. contraction of demand
b. expansion of demand
c. no change in demand
71. The quantity supplied of a good or service is the amount that
a. is actually bought during a given time period at a given price
b. producers wish they could sell at a higher price
c. producers plan to sell during a given time period at a given price
d. people are willing to buy during a given time period at a given price
72. Supply is the

a. limited resources that are available with the seller
b. cost of producing a good
c. entire relationship between the quantity supplied and the price of good.
d. Willingness to produce a good if the technology to produce it becomes available.
73. In the book market, the supply of books will decrease if any of the following occurs except
a. a decrease in the number of book publishers
b. a decrease in the price of the book
c. an increase in the future expected price of the book
d. an increase in the price of paper used.
74. If the price of a video rental is below the equilibrium price, the quantity supplied is ———
———————— than the quantity demanded. If the price of video rentals is above the
equilibrium price, the quantity supplied is ——————— than the quantity demanded.
a. less; greater
b. greater; greater
c. greater; less
d. less; less
75. An increase in the number of sellers of bikes will increase the
a. the price of a bike
b. demand for bikes
c. the supply of bikes
d. demand for helmets
76. If the supply of bottled water decreases, the equilibrium price ———————————
and the equilibrium quantity ——————————————
a. increases ; decreases
b. decreases; increases
c. decreases; decreases
d. increases; increases
77. An increase in the demand for cameras and an increase in the number of sellers of cameras
will
a. increase the number of cameras bought
b. decrease the price but increase the number of cameras bought

c. increase the price of cameras
d. increase the price and the number of cameras bought.
78. If good growing conditions increases the supply of strawberries and hot weather increases
the demand for strawberries, the quantity of strawberries bought
a. increases and the price might rise, fall or not change
b. doesn’t change but the price rises
c. doesn’t change but the price falls
d. increases and the price rises.
79. Comforts lies between the
a. inferior goods and necessaries
b. luxuries and inferior goods
c. necessaries and luxuries
80. In a very short period the supply
a. can be changed
b. can not be changed
c. can be increased
81. A lower supply curve indicates
a. Smaller supply
b. larger supply
c. constant supply
82. When supply curve moves to rights it means
a. supply increases
b. supply decreases
c. supply remains constant
83. The elasticity of supply is defined as the
a. responsiveness of the quantity supplied of a good to a change in its price
b. responsiveness of the quantity supplied of a good without change in its price
c. responsiveness of the quantity demanded of a good to a change in its price

d. responsiveness of the quantity demanded of a good without change in its price
84. Elasticity of supply is measured by dividing the percentage change in quantity supplied of
a good by ——————————
a. Percentage change in income
b. Percentage change in quantity demanded of goods
c. Percentage change in price
d. Percentage change in taste and preference
85. Elasticity of supply is zero means
a. perfectly inelastic supply
b. perfectly elastic supply
c. imperfectly elastic supply
86. Elasticity of supply is greater than one when
a. proportionate change in quantity supplied is more than the proportionate change in
price.
b. proportionate change in price is greater than the proportionate change in quantity
supplied.
c. change in price and quantity supplied are equal
87. If the quantity supplied is exactly equal to the relative change in price then the elasticity of
supply is
a. less than one
b. greater than one
c. one
88. The price of a commodity decreases from Rs. 6 to Rs. 4 and his demand for goods increases
from 10 units to 15 units, Find the coefficient of price elasticity.
a. 1.5
b. 2.5
c. -1.5
d. 0.5

89. The supply function is given as Q= -100 + 10P. Find the elasticity using point method,
when price is Rs. 15.
a. 4
b. -3
c. -5
d. 3
ANSWERS
1. d 2. b 3. c 4. b 5. b 6. b
7. b 8. c 9. c 10. b 11. b 12. b
13. b 14. c 15. d 16. c 17. a 18. b
19. d 20. b 21. b 22. b 23. c 24. d
25. d 26. b 27. a 28. c 29. b 30. a
31. b 32. c 33. b 34. a 35. c 36. c
37. a 38. c 39. c 40. c 41. d 42. c
43. a 44. c 45. a 46. d 47. d 48. b
49. b 50. b 51. d 52. c 53. b 54. d
55. b 56. b 57. c 58. a 59. b 60. c
61. c 62. b 63. a 64. a 65. d 66. d
67. a 68. c 69. a 70. b 71. c 72. c
73. b 74. a 75. c 76. a 77. d 78. a
79. c 80. b 81. b 82. a 83. a 84. c
85. a 86. a 87. c 88. c 89. d

CHAPTER – 3
THEORY OF
PRODUCTION
AND COST
Unit 1
Theory
of
Production
THEORY OF PRODUCTION AND COST
Learning Objectives
know the meaning of production in Economics.

know about the various factors of production.
understand the difference between short run and long run.
have an insight into the laws of variable proportion and returns to scale.
understand economies and diseconomies of sale.
1.0 MEANING OF PRODUCTION

Production is a very important economic activity. The standard of living in the ultimate analysis,
depends on the volume and variety of goods and services produced in a country. In fact, the
performance of an economy is judged by the level of its production. Those countries which
produce goods in large quantities are rich and those which produce little of them are poor.
Thus, the amount of goods and services an economy is able to produce determines the richness
or poverty of that economy. The U.S.A. is a rich country just because its level of production is
high. India is not so because its level of production is not very high.
What exactly do we mean by production in Economics? In common parlance the term
‘production’ is used for an activity of making something material. The growing of wheat, rice
or any other agricultural crop by farmers and manufacturing of cloth, radio-sets, wool,
machinery or any other industrial product is often referred to as production. But in Economics
the word ‘production’ is used in a wider sense. In Economics, by production we mean the
process by which man utilises or converts the resources of nature, working upon them so as to
make them satisfy human wants. In other words, production is any economic activity which
is directed towards the satisfaction of the wants of the people by converting physical inputs
into the physical output. Whether it is the making of material goods or providing any service,
it is included in production provided it satisfies the wants of some people. So, in Economics, if
making of cloth by an industrial worker is production, the service of the retailer who delivers
it to consumers is also production. Similarly, the work of doctors, lawyers, teachers, actors,
dancers, etc. is production since the services are provided by them to satisfy the wants of those
who pay for them. The satisfying power of goods and services is called utility. Production can
also be defined as creation or addition of utility.
According to James Bates and J.R. Parkinson “ Production is the organized activity of
transforming resources into finished products in the form of goods and services; and the objective
of production is to satisfy the demand of such transformed resources”.
It should be noted that production should not be taken to mean as creation of matter because
according to the fundamental law of science man cannot create matter. What a man can do is
only to create or add utility. When a man produces a table, he does not create the matter of
which the wood is composed. He only transforms wood into a chair. By doing so he adds
utility to the goods.

The money expense incurred in the process of production, i.e., transforming resources into
finished product constitutes the cost of production.
Production consists of various processes to add utility to natural resources for gaining greater
satisfaction from them by :
(i) Changing the form of natural resources. Most manufacturing processes consist of taking
raw material and transforming them into some items possessing utility, e.g., changing the
form of a log of wood into a table or changing the form of iron into a machine. This may
be called conferring utility of form.
(ii) Changing the place of the resources, from the place where they are of little or no use to
another place where they are of greater use. This utility of place can be obtained by :
(a) extraction from earth e.g., removal of coal, minerals, gold and other metal ores from
mines and supplying them to markets.
(b) transferring goods from where they give little or no satisfaction, to places where their
utility is more, e.g., tin in Malaya is of little use until it is brought to the industrialised
centres where necessary machinery and technology are available to produce metal
boxes for packing. Another example is : apples in Kashmir orchards have some use to
farmers. But when the apples are transported to markets where human settlements
are thick and crowded like the city centres, they afford more satisfaction to greater
number of people, rather than to the farmers in the Kashmir apple orchards.
These examples only emphasise the additional utility conferred on all goods, by all forms
of transportation systems, by transport workers and by the agents who assist in the
movement and marketing of goods.
(iii) Making available materials at times when they are not normally available e.g., harvested
foodgrains are stored for use till next harvest. Canning of seasonal fruits is undertaken to
make them available during off season. This may be called conferring of utility of time.
(iv) Making use of personal skills in the form of services, e.g., those of organisers, merchants,
transport workers etc.
The fundamental purpose of all these activities is same, namely to create utility in some manner.
So production is nothing but the creation of utilities in the form of goods and services. For
example, in the production of a woollen suit utility is created in some form or the other. Firstly
wool is changed into woollen cloth at the spinning and weaving mill (utility created by changing
the form). Then it is taken to a place where it is to be sold (utility added by transporting it).
Since woollen clothes are used in winter they will be retained until such time when they are
required by purchasers (time utility). In the whole process, services of various groups of people
are utilised (as that of mill workers, shopkeepers, agents etc.) to contribute to the enhancement
of utility. Thus the entire process of production is nothing but creation of form utility, place
utility, time utility and/or personal utility.
1.1 FACTORS OF PRODUCTION

The process of producing goods in the modern economy is very complex. A good has to pass
through many stages and many hands until it reaches the consumer’s hands in a finished
form. Land, labour, capital and entrepreneurial ability are all the factors or resources which

make it possible to produce goods and services. Even a small piece of bread cannot be produced
without the active participation of these factors of production. While land is a free gift of
nature and refers to natural resources, the human endeavour is classified functionally and
qualitatively into three main components namely labour, capital and entrepreneurial skills.
We may discuss these factors of production briefly in the following paragraphs.
1.1.0 Land : The term ‘land’ is used in a special sense in Economics. It does not mean soil or
earth’s surface alone but refers to all free gifts of nature which would include besides the land,
in common parlance, natural resources, fertility of soil, water, air, natural vegetation etc. It
becomes difficult at times to state precisely to what part of a given factor is due solely to the gift
of nature and what part belongs to human effort made on it in the past. Therefore, as a
theoretical concept, we may list the following characteristics which would qualify a given
factor to be called land :
(i) Land is a free gift of nature. It is neither created nor destroyed by man.
(ii) Land is strictly limited in quantity. It is different from the other factors of production in
that, for practical purposes, it is permanently in being; no change in demand can affect
the amount of land in existence. In other words, the supply of land is perfectly inelastic
from the point of view of the economy. However, it is relatively elastic from the point of
view of a firm.
(iii) According to Ricardo, the production power of soil is indestructible in the sense that the
properties of the land cannot be destroyed. Even if its fertility gets depleted it can be
restored.
(iv) Land cannot be shifted from one place to another place. The natural factors typical to a
given place cannot be shifted to other places. It may, however be noted that man has been
able to shift water from one place to another e.g. Rajasthan Canal. Land can however, be
used for varied purposes though its suitability in all the uses is not the same.
(v) Land is said to be a specific factor of production in the sense that it does not yield any
result unless human efforts are employed. Land varies in fertility and uses.
1.1.1 Labour : The term ‘labour’, means mental or physical exertion directed to produce goods
or services. In other words, it refers to various types of human effort which require the use of
physical exertion, skill and intellect. It is, however, difficult to say that in any human effort all
the three are not required; the proportion of each might vary. Labour, to have an economic
significance, must be one which is done with the motive of some economic reward. Anything
done out of love and affection, although very useful in increasing human well-being, is not
labour in the economic sense of the term. It implies that any work done for the sake of pleasure
or love does not represent labour in Economics. It is for this reason that the services of a house-
wife are not treated as labour, while those of a maid servant are treated as labour. If a person
sings before his friends just for the sake of pleasure, it does not mean labour despite the exertion
involved in it. On the other hand, if a person sings against payment of some fee, then this
activity signifies labour.

Characteristics of labour :
(1) Labour, as compared with other factors is different. It is connected with human efforts
whereas others are not directly connected with human efforts. As a result of this, there are
certain human and psychological considerations which may come up unlike in the case of
other factors.
(2) Labour is highly ‘perishable’ in the sense that a day’s labour lost cannot be completely
recovered because the expenditure on maintenance has to be there. Whatever is lost in a
day cannot be recovered wholly by extra work next day. In other words, a labourer cannot
store his labour and so he has no reserve price for his labour.
(3) Labour is inseparable from the labourer himself. It implies that whereas labour is sold, the
producer of labour retains the capacity to work. Thus, a labourer is the source of his own
labour power.
(4) Labour power differs from labourer to labourer. On the basis of labour power a labour
may be classified as unskilled labour, semi-skilled labour and skilled labour. Labour power
depends upon physical strength, education, skill and upon the motivation to work.
(5) All labour is not productive in the sense that all efforts are not sure to produce resources.
(6) Labour has a weak bargaining power. It is because the labourer is economically weak
while the employer is economically powerful although things have changed a lot in favour
of labour during the 20th century.
(7) A labourer has to make a choice between the hours of labour and the hours of leisure. The
supply of labour and wage rate are directly related. It implies that, as the wage rate increases
the labourer tends to increase the supply of labour by reducing the hours of leisure. However,
beyond a minimum level of income, the labourer reduces the supply of labour and increases
the hours of leisure in response to further rise in the wage rate. That is, he prefers to have
more of rest and leisure than earning more money.
(8) Labour is a mobile factor. Apparently, workers can move from one job to another or from
one place to another. But, in reality there are many obstacles in the way of free movement
of labour from job to job or from place to place.
1.1.2 Capital : We may define capital as that part of wealth of an individual or community
which is used for further production of wealth. In fact, capital is a stock concept which yields
a periodical income which is a flow concept. It is necessary to understand the difference between
capital and wealth. Whereas wealth refers to all those goods and human qualities which are
useful in production and which can be passed on for value, only a part of these goods and
services can be characterised as capital because if these resources are lying idle they will
constitute wealth but not capital. Capital has been rightly defined as ‘produced means of
production’. This definition distinguishes capital from both land and labour because both land
and labour are not produced factors. They are primary or original factors of production but
capital is not a primary or original factor; it is a produced factor of production. It has been
produced by man by working with nature. Therefore, capital may well be defined as man
made instruments of production. Machine tools and instruments, factories, dams, canals,
transport equipment etc., are some of the examples of capital. All of them are produced by
man to help in the production of further goods.

Types of Capital:
Fixed capital is that which exists in a durable shape and renders a series of services over a
period of time. For example tools, machines, etc.
Circulating capital is another form of capital which performs its function in production in a
single use and not available for further use. For example, seeds, raw material, etc.
Real capital refers to physical goods such as building, plant, machines, etc.
Human capital refers to human skill and ability. This is called human capital because a good
deal of investment has gone into creation of these abilities in humans.
Tangible capital can be perceived by senses whereas intangible capital is in the form of certain
rights and benefits which cannot be perceived by senses. For example, goodwill, patent rights,
etc.
Individual capital is the personal property owned by an individual or a group of individuals.
Social Capital is what belongs to the society as a whole in the form of roads, bridges, etc.
Capital formation : Capital formation means a sustained increase in the stock of real capital in
a country. In other words, capital formation involves production of more capital goods like,
machines, tools, factories, transport equipment, electricity etc. which are all used for further
production of goods. Capital formation is also known as investment. The need for capital
formation or investment is realised not merely for replacement and renovation but for creating
additional productive capacity. In order to accumulate capital goods, some current consumption
is to be sacrified and savings of current income are to be made. Savings are also to be channelised
into productive investment. The greater the extent that people are willing to abstain from
present consumption the greater the extent of savings and investment that society will devote
to new capital formation. If society consumes all what it produces and saves nothing, future
productive capacity of the economy will fall as the present capital equipment wears out. In
other words, if the whole of the current present capacity is used to produce consumer goods
and no new capital goods are made, production of consumer goods in the future will greatly
decline. It is prudent to cut down some of the present consumption and direct part of it to the
making of capital goods such as tools and instruments, machines and transport facilities, plant
and equipment etc.. They will not only increase the efficacy of production efforts but also will
make possible the expansion of output of consumer goods in the future.
Stages of capital formation : There are mainly three stages of capital formation which are as
follows :
1. Savings : The basic factor on which formation of capital depends is the ability to save. The
ability to save depends upon the income of an individual. Higher incomes are generally
followed by higher savings. This is because with an increase in income the propensity to
consume comes down, and the propensity to save increases. This is true not only for an
individual but also for the economy as a whole. A rich country has greater ability to save
and thereby can get richer quickly compared to a poor country which has no ability to
save and therefore has limited capacity for growth in national income given the capital
output ratio.

It is not only the ability to save but willingness to save which counts a great deal. Willingness
depends upon the individual’s concern about his future as well as upon the social set-up
in which he lives. If an individual is farsighted and wants to make his future secure he will
save more. Moreover, the government can enforce compulsory savings on the people by
imposing taxes. In recent years, business community’s savings and government’s savings
are also becoming important.
2. Mobilisation of savings : It is not enough that people save money; what is required is that
the saved money enters into circulation and facilitates the process by capital formation.
There should be a wide spread network of banking and other financial institutions to
collect public savings and take them to prospective investors. In this process, the state has
a very important and positive role to play both in generating saving through various
physical and monetary incentives and channelisation of the savings towards priority needs
of the community so that there is not only the capital generation but socially beneficial
type of capital formation.
3. Investment : The process of capital formation get completed only when the real savings
get converted into real capital assets. An economy should have a entrepreneurial class
which is prepared to bear the risk of business and invest savings in productive avenues so
as to create new capital assets.
1.1.3 Entrepreneur : Having explained three factors namely land, labour and capital, we now
turn to the explanation of the fourth important factor, namely, the entrepreneur. It is not
enough to say that production is a function of land, capital and labour. There must be some
factor which mobilises these factors, combines in the right proportion, then initiates the process
of production and bears the risk involved in it. This factor is known as the entrepreneur. He
has also been called the organiser, the manager or the risk taker. But in these days of
specialisation, the task of manager or organiser has become different from that of the
entrepreneur. While organisation and management involve decision-making of routine and
non-routine types, the task of the entrepreneur is to initiate production work and to bear the
risk involved in it.
Functions of an entrepreneur : An entrepreneur performs the following functions in
general :
(i) Initiating a business enterprise and resource co-ordination : The first and the foremost
function of an entrepreneur is to initiate a business enterprise. For this, he has to collect
different factors of production such as labour, capital, land or factory building and bring
about co-ordination among them. These various other factors of production are paid fixed
contractual remuneration : labour at fixed rate of wages, land or factory building at a
fixed rent for its use and capital at a fixed rate of interest. The surplus, if any, after all the
fixed costs and variable costs are met, accrues to the entreprenuer as his reward for his
efforts and risk-taking. Thus the reward for an entrepreneur, that is a profit, is not fixed.
He may earn profits, or incur losses. Other factors get their payment irrespective of whether
the entrepreneur makes profits or losses.

(ii) Risk bearing or uncertainty bearing : The ultimate responsibility for the success and survival
of business lies with the entrepreneur. What is planned and anticipated by the entrepreneur
may not come true and the actual course of events may differ from what was anticipated
and planned. The economy is dynamic and changes occurr everyday. The demand for a
commodity, the cost structure, fashions and tastes of the people, and government’s policy
regarding taxation, credit, interest rate etc. may change. All these changes bring about
changes in the cost or demand conditions of a business firm. It may happen that as a
result of certain broad changes which were not anticipated by the entrepreneur the firm
has to incur heavy losses. Thus, the entrepreneur has to bear these financial risks. Apart
from financial risks, the entrepreneur also faces technological risks which arise due to the
inventions and improvement in techniques of production, making the existing techniques
and machines obsolete. The entrepreneur has to assess and bear the risks. These risks are
different from the risks like risks of fire, theft, burglary etc. which can be insured against.
These risks which cannot be insured are also called uncertainties and the entrepreneur
earns profits because he bears uncertainty in a dynamic economy where changes occur
everyday.
Innovations : One of the important functions of an entrepreneur is to introduce innovations.
Innovations in a very broad sense include the introduction of new or improved production
methods, utilisation of new or improved source of raw-material, adoption of new or
improved forms of organisation, introduction of a new or improved product, opening of
new or improved markets. According to Schumpeter, the task of the entrepreneur is to
continuously introduce new innovations.
1.2 PRODUCTION FUNCTION

Production function states the relationship between inputs and output i.e., the maximum
amount of output that can be produced with given quantities of inputs under a given state of
technical knowledge. It can also be defined as the minimum quantities of various inputs that
are required to yield a given quantity of output. The output takes the form of volume of goods
or services and the inputs are the different factors of production i.e., land, labour, capital and
enterprise.
Production Function:
In short, the production function is a catalogue of output possibilities. The production function
can be algebraically expressed in an equation in which the output is the dependent variable
and inputs are the independent variables. The equation can be expressed as:
q = f (a, b, c, d …….n)
where ‘q’ stands for the rate of output of given commodity a,b,c,d…….n, are different factors
(inputs) and services used per unit of time.
The production function of a firm can be studied in the context of short period or long period.
Short period or short run is that period of time which is too short for a firm to install a new
capital equipment to increase production. It implies capital is a fixed factor in the short run

and the production function is studied by holding the quantities of capital fixed, while varying
the amount of other factors (labour, raw material etc.) Symbolically, Q = T (K, L). This is done
when the law of variable proportion is derived. The production function can also be studied in
the long run. The long run is a period of time (or planning horizon) in which all the factors of
production are variable. It is a time period when the firm will be able to install new machines
and capital equipments apart from increasing the units of labour. The behaviour of production
when all factors are varied is the subject matter of the laws of returns to scale.
Assumptions of Production Function:
The production function is based on the certain assumptions;
1. It is related to a particular unit of time.
2. The technical knowledge during that period of time remains constant.
3. The factors of production are divisible into most viable units.
4. The producer is using the best technique available.
Cobb-Douglas Production Function
A famous statistical production function is Cobb-Douglas production function. Paul H. Douglas
and C.W. Cobb of the U.S.A. studied the production function of the American manufacturing
industries. In its original form, this production function applies not to an individual firm but to
the whole of manufacturing in the United States. In this case, output is manufacturing
production and inputs used are labour and capital.
Cobb-Douglas production function
Q = KLa C (1-a)
where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital. ‘K’ and ‘a’ are
positive constants.
The conclusion drawn from this famous statistical study is that labour contributed about 3/4th
and capital about 1/4th of the increase in the manufacturing production. The function is linear
and homogeneous. It shows constant returns to scale.
1.2.1 Law of variable proportions : Before discussing this law, if would be appropriate to
understand the meaning of total product, average product and marginal product.
Total Product (TP) : Total product is the total output resulting from the efforts of all the factors
of production combined together at any time. If the inputs of all but one factor are held constant,
total product will vary with the quantity used of the variable factor. Column (1) and (2) of
Table 1 represent a total product schedule.

Table 1 : Product Schedule
Quantity of labour Total Product Average Product Marginal Product

(TP) (AP) (MP)
(1) (2) (3) (4)
1 100 100.0 100
2 210 105.0 110
3 330 110.0 120
4 430 107.5 100
5 520 104.0 90
6 600 100.0 80
7 670 95.7 70
8 720 90.0 50
9 750 83.3 30
10 760 76.0 10
11 740 67.2 –20
We find that when one unit of labour is employed, the total product is 100 units. When two
units of labour are employed, the total product rises to 210 units. The total product goes on
rising as more and more units of labour are employed. With 10 units of labour, the total product
rises to 760 units. When 11 units of labour are employed, total product falls to 740 units.
Average Product (AP) : Average product is the total product per unit of the variable factor. It is
shown as a schedule in column (3) of Table 1. When one unit of labour is employed, average
product is 100, when two units of labour are employed, average product rises to 105. This goes
on, as shown in Table 1.
Marginal Product (MP) : Marginal product is the change in total product per unit change in the
quantity of variable factor. In other words, it is the addition made to the total production by an
additional unit of input.
The computed value of the marginal product appears in the last column of Table 1. For example,
the MP corresponding to 4 units is given as 100 units. This reflects the fact that an increase in
labour from 3 to 4 units increased output from 330 to 430 units.
Relationship between Average Product and Marginal Product : Both average product and marginal
product are derived from the total product. Average product is obtained by dividing total
product by the units of variable factor and marginal product is the change in total product
resulting from a unit increase in the quantity of variable factor. The various points of relationship
between average product and marginal product can be summed up as follows :
(i) when average product rises as a result of an increase in the quantity of variable input,
marginal product is more than the average product.

(ii) when average product is maximum, marginal product is equal to average product. In
other words, the marginal product curve cuts the average product curve at its maximum.
(iii) when average product falls as a result of a decrease in the quantity of variable input,
marginal product is less than the average product.
Table 1 and Figure 1 confirm the above points of relationship.
The law of variable proportions or the law of diminishing returns examines the production
function with one factor variable, keeping quantities of other factors fixed. In other words, it
refers to input-output relationship, when the output is increased by varying the quantity of
one input. This law operates in the short run ‘when all the factors of production cannot be
increased or decreased simultaneously (for example, we cannot build a plant or dismantle a
plant in the short run). The law operates under certain assumptions which are as follows :
1. The state of technology is assumed to be given and unchanged. If there is any improvement
in technology, then marginal and average product may rise instead of falling.
2. There must be some inputs whose quantity is kept fixed. This law does not apply to cases
when all factors are proportionately varied. When all the factors are proportionately varied,
laws of returns to scale are applicable.
3. The law does not apply to those cases where the factors must be used in fixed proportions
to yield product. When the various factors are required to be used in fixed proportions,
then an increase in one factor would not lead to any increase in output i.e., marginal
product of the variable factor will then be zero and not diminishing.
4. We consider only physical inputs and outputs and not economic profitability in monetary
terms.
The law states that as we increase the quantity of one input which is combined with other
fixed inputs, the marginal physical productivity of the variable input must eventually decline.
In other words, 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
addition of extra inputs will become less and less.
The behaviour of output when the varying quantity of one factor is combined with a fixed
quantity of the others can be divided into three distinct stages or laws. In order to understand
these three stages or laws, we may graphically illustrate the production function with one
factor variable. This is done in Figure 1.
In this figure the quantity of variable factor is depicted on the X axis and on the Y-axis is
measured the Total Product (TP), Average Product (AP) and Marginal Product (MP). As the
figure shows TP curve goes on increasing to a point and after that it starts declining. AP and
MP curves first rise and then decline; MP curve starts declining earlier than the AP curve.
The behaviour of these Total, Average and Marginal Products of the variable factor consequent
on the increase in its amount is generally divided into three stages (laws) which are explained
below.

Fig. 1 : Law of variable proportions
Stage 1 : The Law of Increasing Returns : In this stage, total product increases at an increasing
rate upto a point (in figure upto point F), marginal product also rises and is maximum at the
point F and average product goes on rising. From point F onwards during the stage one, the
total product goes on rising but at a diminishing rate. Marginal product falls but is positive.
The stage 1 ends where the AP curve reaches its highest point.
Thus in the first stage the AP curve rises throughout whereas marginal product curve first rises
and then start falling after reaching its maximum. It is to be noted that the marginal product
although starts declining, remains greater than the average product throughout the stage so
that average product continues to rise.
Explanation of the law : The law of increasing returns operates because in the beginning the
quantity of fixed factors is abundant relative to the quantity of the variable factor. As more
units of variable factor are added to the constant quantity of the fixed factors then the fixed
factors is more intensively and effectively utilised i.e., the efficiency of the fixed factors increases
as additional units of the variable factors are added to it. This causes the production to increase
at a rapid rate. For example, if a machine can be efficiently operated when four persons are
working on it and if in the beginning we are operating it only with three persons, production
is bound to increase if the fourth person is also put to work on the machine since the machine
will be effectively utilised to its optimum. This happens because in the beginning some amount
of fixed factor remained unutilised and, therefore, when the variable factor is increased, fuller
utilisation of the fixed factor becomes possible and it results in increasing returns. A question
arises as to why the fixed factor is not initially taken in a quantity which suits the available
quantity of the variable factor. The answer is that generally those factors are taken as fixed
which are indivisible. Indivisibility of a factor means that due to technological requirements a
minimum amount of that factor must be employed whatever the level of output. Thus as more
units of the variable factor are employed to work with an indivisible fixed factor, output greatly
increases due to fuller utilisation of the latter. The second reason why we get increasing returns

at the initial stage is that as more units of the variable factors are employed, the efficiency of
the variable factors itself increases. This is because with sufficient quantity of variable factor
introduction of division of labour and specialisation becomes possible which results in higher
productivity.
Stage 2 : Law of diminishing returns : In stage 2, total product continues to increase at a
diminishing rate until it reaches its maximum point H, where the second stage ends. In this
stage both marginal product and average product of the variable factor are diminishing but
are positive. At the end of this stage i.e., at point M (corresponding to the highest point H of the
total product curve), the marginal product of the variable factor is zero. Stage 2, is known as
the stage of diminishing returns because both the average and marginal products of the variable
factors continuously fall during this stage. This stage is very important because the firm will
seek to produce in its range.
Explanation of the law : The question arises as to why we do get diminishing returns after a
certain amount of the variable factor has been added to the fixed quantity of that factor. As
explained above increasing returns occur primarily because of the more efficient use of fixed
factors as more units of the variable factor are combined to work with it. Once the point is
reached at which the amount of variable factor is sufficient to ensure efficient utilisation of the
fixed factor, then further increases in the variable factor will cause marginal and average
product to decline because the fixed factor then becomes inadequate relative to the quantity of
the variable factor. Continuing the above example, when four men were put to work on one
machine, optimum combination was achieved. Now if the fifth person is put on the machine,
his contribution will be nil. In other words the marginal productivity will start diminishing.
The phenomenon of diminishing returns, like that of increasing returns rests upon the
indivisibility of the fixed factor. Just as the average product of the variable factor increases in
the first stage when better utilisation of the fixed indivisible factor is being made, so the average
product of the variable factor diminishes in the second stage when the fixed indivisible factor
is being worked too hard. Another reason offered for the operation of the law of diminishing
returns is the imperfect substitutability of one factor for one another. Had the perfect substitute
of the scarce fixed factor been available, then the paucity of the scarce fixed factor during the
second stage would have been made up by increasing the supply of its perfect substitute with
the result that output could be expanded without diminishing returns.
Stage 3 : Law of negative returns : In Stage 3, total product declines, MP is negative, average
product is diminishing. This stage is called the stage of negative returns since the marginal
product of the variable factor is negative during this stage.
Explanation the law : As the amount of the variable factor continues to be increased to constant
quantity of the other, a stage is reached when the total product declines and marginal product
become negative. This is due to the fact that the quantity of variable factor becomes too excessive
relative to the fixed factor so that they get in each other’s ways with a result that the total
output falls instead of rising. In such a situation a reduction in the units of the variable factor
will increase the total output.
Stage of operation : An important question is in which stage a rational producer will seek to
produce. A rational producer will never produce in stage 3 where marginal product of the
variable factor is negative. This being so a producer can always increase his output by reducing

the amount of variable factor. Even if the variable factor is free of cost, the rational producer
stops before the beginning of third stage.
The rational producer will also not produce in stage 1 where the marginal product of the fixed
factor is negative. The producer producing in stage 1 will not be making best use of the fixed
factor and he will not be utilising fully the opportunities of increasing production by increasing
quantity of the variable factor whose average product continues to rise throughout stage 1.
Even if the fixed factor is free of cost in this stage, the rational entrepreneur will continue
adding more variable factors.
It is thus clear that a rational producer will never produce in stage 1 and stage 3. These stages
are called stages of economic absurdity or economic non-sense.
A rational producer will always produce in stage 2 where both the marginal product and
average product of the variable factors are diminishing. At which particular point in this stage,
the producer will decide to produce depends upon the prices of factors.
1.2.2 Returns to Scale : We shall now undertake the study of production in the long run. Or
we will study changes in output when all factors of production in a particular production
function are increased together. In other words, we shall study the behaviour of output in
response to a change in the scale. A change in the scale means that all factors of production are
increased or decreased in the same proportion. Changes in scale is different from changes in
factor proportions. Changes in output as a result of the variation in factor proportions, as seen
before, form the subject matter of the law of variable proportions. On the other hand, the
study of changes in output as a consequence of changes in scale forms the subject matter of
returns to scale which is discussed here.
Returns to scale may be constant, increasing or decreasing. If we increase all factors i.e., scale
in a given proportion and output increases in the same proportion, returns to scale are said to
be constant. Thus if a doubling or trebling of all factors causes a doubling or trebling of output,
returns to scale are constant. But if the increase in all factors leads to more than proportionate
increase in output, returns to scale are said to be increasing. Thus if all factors are doubled and
output increases more than a double then the returns to scale are said to be increasing. On the
other hand if the increase in all factors leads to less than a proportionate increase in output,
returns to scale are decreasing. It is needless to say that this law operates in the long run when
all the factors can be changed in some proportion simultaneously.
Constant returns to scale : As stated above, constant returns to scale means that with the increase
in the scale in some proportion, output increases in the same proportion. It has been found
that production function for the economy as a whole corresponds to production function
exhibiting constant returns to scale. Also, it has been found that an individual firm passes
through a long phase of constant returns to scale in its lifetime.
Constant return to scale is other wise called as “Linear Homogeneous Production Function”

Fig. 2 : Linear Homogeneous Production Function
Increasing returns to scale : As stated earlier increasing returns to scale means that output increases
in a greater proportion than the increase in inputs. When a firm expands, increasing returns to
scale are obtained in the beginning. For example, a wooden box of 3 ft. cube contains 9 times
greater wood than the wooden box of 1 foot-cube. But capacity of the 3 foot- cube box is 27
times greater than that of one foot cube. Many such examples are found in real world. Another
reason for increasing returns to scale is the indivisibility of factors. Some factors are available
in large and lumpy units and can, therefore, be utilised with utmost efficiency at a large output.
If all the factors are perfectly divisible, increasing returns may not occur. Returns to scale may
also increase because of greater possibilities of specialisation of land and machinery.
Fig. 3 : Increasing Return to Scale

Decreasing returns to scale : When output increases in a smaller proportion with an increase in
all inputs, decreasing returns to scale are said to prevail. When a firm goes on expanding by
increasing all inputs, then finally diminishing returns to scale set in. Decreasing returns to
scale eventually occur because of increasing difficulties of management, coordination and
control. When the firm has expanded to a very large size it is difficult to manage it with same
efficiency as previously.
Fig. 4 : Decreasing Return to Scale
1.3 ECONOMIES AND DISECONOMIES OF SCALE

The Scale of Production
In the modern days, the size of the business undertakings has greatly increased and production
on a large scale is a very important feature of modern industrial society. Large-scale production
offers certain advantages which help in reducing the cost of production. Economies arising
out of large-scale production can be grouped into two categories; viz., internal economies and
external economies. Internal economies are those economies of production which accrue to
the firm when it expands the output, so that the cost of production would cone down considerably
and place the firm in a better position to compete in the market effectively. Economies arise
purely due to endogenous factors relating to efficiency of the entrepreneur or his managerial
talents or the type of machinery used or the marketing strategy adopted. These economies
arise within the firm and help the firm only. On the other hand external economies are the
benefits accruing to each member firms of the industry as a result of the expansion of the
industry.
Internal Economies and Diseconomies : We saw that returns to scale increase in the initial
stages and after remaining constant for a while, they decrease. The question arises as to why
we get increasing returns to scale due to which cost falls and why after a certain point we get
decreasing returns to scale due to which cost rises. The answer is that initially a firm enjoys
internal economies of scale and beyond a certain limit it suffers from internal diseconomies of
scale. Internal economies and diseconomies are of following main kinds :

(i) Technical economies and diseconomies : Large-scale production is associated with technical
economies. As the firm increases its scale of operations, it becomes possible to use more
specialised and efficient form of all factors, specially capital equipment and machinery.
For producing higher levels of output, there is generally available a more efficient machinery
which when employed to produce a large output yields a lower cost per unit of output.
Secondly, when the scale of production is increased and the amount of labour and other
factors become larger, introduction of a greater degree of division of labour or specialisation
becomes possible and as a result cost per unit declines.
However, beyond a certain point a firm experiences net diseconomies of scale. This happens
because when the firm has reached a size large enough to allow utilisation of almost all
the possibilities of division of labour and the employment of more efficient machinery,
further increase in the size of the plant will bring high long-run cost because of difficulties
of management. When the scale of operations becomes too large, it becomes difficult for
the management to exercise control and to bring about proper coordination.
(ii) Managerial economies and diseconomies : Managerial economies refer to reduction in
managerial cost. When output increases, division of labour can be applied to management.
The production manager can look after production, sales manager can look after sales,
finance manager can look after finance department. If scale of production increases further,
each department can be further sub-divided for e.g. sales can be split into sections for
advertising exports and customer service.
Since individual activities come under the supervision of specialists, management’s
efficiency and productivity greatly improve. Decentralisation of decision making authority
also becomes possible in such a firm which enhances further the efficiency and productivity
of managers. Thus specialisation of management enables large firms to achieve reduction
in managerial costs.
However, as scale of production increases beyond a certain limit, managerial diseconomies
set in. Management finds it difficult to exercise control and bring coordination among
various departments. The managerial structure becomes more complex and is affected by
more bureaucracy, more red tape, lengthening of communication lines and so on. All these
affect the efficiency and productivity of management and the firm itself.
(iii) Commercial economies and diseconomies : Production of big volumes of goods requires
large amount of material and components. This enables the firm to place a bulk order for
materials and components and enjoy lower prices for them. Economies can also be achieved
in selling the product. If the sales staff is not being worked to capacity, additional output
can be sold at little extra cost. Moreover, large firms can benefit from economies of
advertising. As scale of production increases, advertising costs per unit of output fall. In
addition, a large firm may also be able to sell its by-products-something which might be
unprofitable for a small firm.
These economies become diseconomies after an optimum scale. For example, advertisement
expenditure and other marketing overheads will increase more than proportionately after
the optimum scale.

(iv) Financial economies and diseconomies : In raising finance for expansion large firm is in
favourable position. It can, for instance, offer better security to bankers and, because it is
well-known, raise money at lower cost, since investors have confidence in it and prefer
shares which can be readily sold on the stock exchange.
However, these financial costs will rise more proportionately after the optimum scale of
production. This may happen because of relatively more dependence on external finances.
(v) Risk bearing economies and diseconomies : It is said that a large business with diverse and
multi-production capability is in a better position to withstand economic ups and downs,
and therefore, enjoys economies of risk bearing.
However, risk may increase if diversification instead of giving a cover to economic
disturbances, increases these.
External Economies and Diseconomies : The use of greater degree of division of labour and
specialised machinery at higher levels of output are termed as internal economies. They are
internal in the sense that they accrue to the firm due to its own efforts. Besides internal economies,
there are external economies which are very important for a firm. External economies and
diseconomies are those economies and diseconomies which accrue to firms as a result of
expansion in the output of whole industry and they are not dependent on the output level of
individual firms. They are external in the sense they accrue to firms not out of their internal
situation but from outside i.e. expansion of the industry. These are available to one or more of
the firms in the form of :
1. Cheaper raw materials and capital equipment : The expansion of an industry may result
in exploration of new and cheaper sources of raw material, machinery and other types of
capital equipment. Expansion of an industry results in greater demand for the various
kinds of materials and capital equipment required by it. This makes it possible to purchase
on a large scale from other industries. This reduces their cost of production and hence
their prices. Thus, firms using these materials and capital equipment will be able to get
them at a lower price.
2. Technological external economies : When the whole industry expands, it may result in
the discovery of new technical knowledge and in accordance with that the use of improved
and better machinery than before. This will change the technical co-efficient of production
and will enhance productivity of firms in the industry and reduce their cost of production.
3. Development of skilled labour : When an industry expands in an area the labour in that
area is well accustomed to do the various productive processes and learns a good deal
from the experience. As a result, with the growth of an industry in an area a pool of
trained labour is developed which has a favourable effect on the level of productivity and
cost of the firms in that industry.
4. Growth of ancillary industries : With the growth of an industry, a number of ancillary
industries may specialise in production of raw materials, tools and machinery etc. They
can provide them at a lower price to the main industry. Likewise, some firms may get
developed processing the waste products of the industry and making out some useful
product out of it. This will tend to reduce the cost of production in general.

5. Better transportation and marketing facilities : The expansion of an industry resulting
from entry of new firms may make possible the development of transportation and
marketing network to a great extent which will greatly reduce cost of production of the
firms. Similarly, communication system may get modernised resulting in better and speedy
information.
However, external economies may also cease if there are certain disadvantages which may
neutralise the advantages of the expansion of an industry. We call them external diseconomies.
An example of external diseconomies is the rise in some factor prices. When an industry
expands, the requirement of the various factors of production increases; for example, that of
all raw materials, capital goods, skilled labour and so on. This may result in pushing up the
prices of such factors of production specially when they are short in supply. Moreover, too
many firms in an industry at one place may also result in higher transportation cost, marketing
cost and high pollution control cost. The government may also through its locational policy
prohibit or restrict expansion of an industry at a particular place.
SUMMARY
Production means creation or addition of utility. Production does not include domestic work,
voluntary services, leisure time activities etc. For the production process to work, there must
exist factors with which to produce goods and services. Factors of production are classified as
land, labour, capital and entrepreneur. Land includes all those natural resources whose supply
for the economy as a whole is fixed. Labour is any mental or physical exertion directed to
produce goods or services. Capital is a produced means of production and it comprises man-
made machines and materials which are used for further production. Entrepreneur is the
person who bears the risk and uncertainties of business.
Factors of production can be divided into two categories - fixed factors and variable factors.
Fixed factors are those factors whose quantity remains unchanged in the short run. Variable
factors change with a change in the level of output. The production level can be changed by
changing the factor proportions in which variable factors are used. The production-scale can
be changed by changing all factors together. When some factors are kept fixed and others are
varied, the law of variable proportions (or law of diminishing returns) is applicable. The law
states that as increased quantities of one factor are combined with other fixed factors, marginal
physical productivity of the variable input must eventually decline. The law of variable
proportions is applicable in the short-run. In the long-run, all factors are variable and thus
they can be varied easily. When this is done, we may have increasing, constant or diminishing
returns to scale. Returns to scale occur due to economies of scale. Economies of scale are of two
kinds - external economies of scale and internal economies of scale. External economies of
scale accrue to a firm due to factors which are external to it and internal economies of scale
accrue to a firm when it engages in large scale production. Increase in scale, beyond the optimum
level, results in diseconomies of scale.

CHAPTER – 3
THEORY OF
PRODUCTION
AND COST
Unit 2
Theory
of
Cost
Learning Objectives
understand the meaning of cost and various concepts of cost.

understand cost function in the short run and in the long run.
2.0 COST ANALYSIS

Cost analysis refers to the study of behaviour of cost in relation to one or more production
criteria, namely, size of output, scale of operations, prices of factors of production and other
relevant economic variables. In other words, cost analysis is concerned with financial aspects
of production relations as against physical aspects which were considered in production
analysis. In order to have a clear understanding of the cost function it is important to understand
various concepts of costs.
2.1 COST CONCEPTS

Accounting costs and economic costs : When an entrepreneur undertakes an act of production
he has to pay prices for the factors which he employs for production. He thus pays, wages to
workers employed, prices for the raw materials, fuel and power used, rent for the building he
hires, and interest on the money borrowed for doing business. All these are included in his cost
of production and are termed as accounting costs. Thus accounting costs take care of all the
payments and charges made by the entrepreneur to the suppliers of various productive factors.
But it generally happens that an entrepreneur invests a certain amount of capital in his business.
If the capital invested by the entrepreneur in his business had been invested elsewhere it would
have earned certain amount of interest or dividend. Moreover, an entrepreneur devotes time
to his own work of production and contributes his entrepreneurial and managerial ability to
do business. Had he not set up his own business he would have sold his services to others for
some positive amount of money. Accounting costs do not include these costs. These costs form
a part of the economic cost. Thus economic costs include : (1) the normal return on money
capital invested by the entrepreneur himself in his own business; (2) the wages or salary not
paid to the entrepreneur but could have been earned if the services had been sold somewhere
else. Likewise the monetary reward for all factors owned by the entrepreneur himself and
employed by him in his own business are also considered a part of economic costs. Thus,
accounting costs relate to those costs only which involve cash payments by the entrepreneur of
the firm. Economic costs take into account these accounting costs but in addition, they also
takes into account the amount of money the entrepreneur could have earned if he had invested
his money and sold his own services and other factors in the next best alternative uses.
Accounting costs are also called explicit costs whereas the cost of factors owned by the
entrepreneur himself and employed in his own business are called implicit costs. Thus economic
costs include both accounting costs and implicit costs. The concept of economic cost is important
because an entrepreneur must cover his economic cost if he wants to earn normal profits and

abnormal profits are over and above these normal profits. In other words, an entrepreneur is
said to be earning profits (abnormal) only when his revenues are able to cover not only his
explicit costs but also implicit costs.
Outlay costs and opportunity costs : Outlay costs involve actual expenditure of funds on, say,
wages, material, rent, interest, etc. Opportunity cost, on the other hand, is concerned with the
cost of foregone opportunity; it involves a comparison between the policy that was chosen and
the policy that was rejected. For example, opportunity cost of using capital is the interest that
it can earn in the next best use of equal risk.
A distinction between outlay costs and opportunity costs can be drawn on the basis of the
nature of the sacrifice. Outlay costs involve financial expenditure at some time and hence are
recorded in the books of account. Opportunity costs relate to sacrificed alternatives; they are
not recorded in the books of account in general.
The opportunity cost concept is generally very useful, e.g., in a cloth mill which spins its own
yarn, the opportunity cost of yarn to the weaving department is the price at which the yarn
could be sold, for measuring profitability of the weaving operations.
In long-term cost calculation also it is useful e.g., in calculating the cost of higher education, it
is not the tuition fee and books but the earning foregone that should be taken into account.
Direct or traceable costs and indirect or non-traceable costs; Direct costs are costs that are
readily identified and are traceable to a particular product, operation or plant. Even overhead
can be direct as to a department; manufacturing costs can be direct to a product line, sales
territory, customer class etc. We must know the purpose of cost calculation before considering
whether a cost is direct or indirect.
Indirect costs are not readily identified nor visibly traceable to specific goods, services, operations,
etc. but are nevertheless charged to the jobs or products in standard accounting practice. The
economic importance of these costs is that these, even though not directly traceable to the
product, may bear some functional relationship to production and may vary with output in
some definite way. Examples of such costs are electric power, the common costs incurred for
general operation of business benefiting all products jointly.
Fixed and variable costs : Fixed or constant costs are not a function of output; they do not
vary with output upto a certain level of activity. These costs require a fixed expenditure of
funds irrespective of the level of output, e.g., rent, property taxes, interest on loans, depreciation
when taken as a function of time and not of output. However, these costs also vary with the
size of the plant and are a function of capacity. Therefore, fixed costs do not vary with the
volume of output within a capacity level.
Fixed costs cannot be avoided. These costs are fixed so long as operations are going on. They
can be avoided only when operations are completely closed down. We can call them as
inescapable or uncontrollable costs. But there are some costs which will continue even after
operations are suspended, as for example, the storing of old machines which cannot be sold in
the market. Some of the fixed costs such as advertising, etc. are programmed fixed costs or
discretionary expenses, because they depend upon the discretion of management whether to
spend on these services or not.

Variable costs are costs that are a function of output in the production period. For example,
wages and cost of raw materials are variable costs. Variable costs vary directly and sometimes
proportionately with output. Over certain ranges of production they may vary less or more
than proportionately depending on the utilization of fixed facilities and resources during
production process.
2.2 COST FUNCTION

The cost function refers to the mathematical relation between cost of a product and the various
determinants of costs. In cost function, the dependent variable is unit cost or total cost and the
independent variables are the price of a factor, the size of the output or any other relevant
phenomenon which has a bearing on cost such as technology, level of capacity utilization,
efficiency and time period under consideration.
2.3 SHORT RUN TOTAL COSTS

Total, fixed and variable costs : There are some factors which can be easily adjusted with
changes in the level of output. Thus a firm can readily employ more workers if it has to increase
output. Similarly, it can purchase more raw material if it has to expand production. Such
factors which can be easily varied with a change in the level of output are called variable
factors. On the other hand, there are factors such as building, capital equipment, or top
management team which cannot be so easily varied. It requires comparatively longer time to
make changes in them. It takes time to install a new machinery. Similarly, it takes time to build
a new factory. Such factors which cannot be readily varied and require a longer period to
adjust are called fixed factors. Corresponding to the distinction between variable and fixed
factors we distinguish between short run and long run periods of time. Short run is a period of
time in which output can be increased or decreased by changing only the amount of variable
factors, such as labour, raw material, etc. In the short run, quantities of fixed factors cannot be
varied in accordance with changes in output. If the firm wants to increase output in the short
run, it can do so only with the help of variable factors, i.e., by using more labour and/or by
buying more raw material. Thus, short run is a period of time in which only variable factors
can be varied, while the quantities of fixed factors remain unaltered. On the other hand, long
run is a period of time in which the quantities of all factors may be varied. Thus all factors
become variable in the long run.

Total
FC
Fixed
Cost
O X
OutPut
Fig. 5 : Completely Fixed Cost
VC
Total
Variable
Cost
O Output X
Fig. 6 : Completely Variable Cost
Thus we find that fixed costs are those costs which are independent of output, i.e., they do not
change with changes in output. These costs are a “fixed amount” which are incurred by a firm
in the short run, whether the output is small or large. Even if the firm closes down for some
time in the short run but remains in business, these costs have to be borne by it. Fixed costs
include such charges as contractual rent, insurance fee, maintenance cost, property taxes,
interest on capital employed, manager’s salary, watchman’s wages etc. Variable costs on the
other hand are those costs which change with changes in output. These costs include payments
such as wages of labour employed, prices of raw material, fuel and power used, transportation
cost etc. If a firm shuts down for a short period, then it may not use variable factors of production
and will not therefore incur any variable cost.

Y
TC
Variable Cost of
Production
Total
Semi-
Variable
Cost
O X
Output
Fig. 7 : Semi Variable Cost
There are some costs which are neither perfectly variable, nor absolutely fixed in relation to the
changes in the size of output. They are known as semi-variable costs. Example: Electricity
charges include both a fixed charge and a charge based on consumption.
VC
4
Total 3
Variable
Cost 2
O Output X
Fig. 8 : A Stair-step Variable Cost

There are some costs which may increase in a stair-step fashion, i.e., they remain fixed over
certain range of output; but suddenly jump to a new higher level when output goes beyond a
given limit. Eg. Fixed salary of Foreman will have a sudden jump if another foreman is appointed
when the output crosses a limit.

Fig. 9 : Short run Total Cost Curves
Total cost of a business is thus the sum of total variable cost and total fixed cost or symbolically
TC = TFC + TVC. We may also represent total cost, total variable cost and fixed cost
diagramatically.
In the diagram, total fixed cost curve (TFC) is parallel to X-axis. This curve starts from the
point on the Y-axis meaning thereby that fixed cost will be incurred even if the output is zero.
On the other hand total variable cost curve rises upward showing thereby that as output
increases, total variable cost also increases. This curve starts from the origin which shows that
when the output is zero, variable costs are also nil. The total cost curve has been obtained by
adding vertically total fixed cost curve and total variable cost curve. AFC =
Short run average cost
Average fixed cost (AFC) : AFC is the total fixed cost divided by the number of units of output
produced. i.e. where Q is the number of units produced. Thus average fixed cost is
the fixed cost per unit of output. For example, a firm is producing with total fixed cost at
Rs. 2,000/-. When output is 100 units, average fixed cost will be Rs. 20. And now if the output
increases to 200 units, average fixed cost will be Rs. 10. Since total fixed cost is a constant
amount, average fixed cost will steadily fall as output increases. Therefore, if we draw average
fixed cost curve, it will slope downwards throughout its length but not touch the X-axis as
AFC can not be zero. (Fig. 10)
Average variable cost (AVC) : Average variable cost is the total variable cost divided by the
TVC
number of units of output produced, i.e. AVC = where Q is the number of units produced.
Q
Thus average variable cost is variable cost per unit of output. Average variable cost normally
falls as output increases from zero to normal capacity output due to occurrence of increasing
returns. But beyond the normal capacity output, average variable cost will rise steeply because
of the operation of diminishing returns (the concepts of increasing returns and diminishing
returns have already been discussed earlier). If we draw average variable cost curve it will first
fall, then reach a minimum and then rise again. (Fig. 10)

Fig. 10 : Short run Average and Marginal Cost Curves
Average total cost (ATC) : Average total cost is a sum of average variable cost and average
fixed cost. i.e., ATC = AFC + AVC. It is the total cost divided by the number of units produced.
The behaviour of average total cost curve depends upon the behaviour of average variable cost
curve and average fixed cost curve. In the beginning both AVC and AFC curves fall, therefore,
the ATC curve will also fall sharply in the beginning. When AVC curve begins to rise, but AFC
curve still falls steeply, ATC curve continues to fall. This is because during this stage the fall in
AFC curve is greater than the rise in the AVC curve but as output increases further, there is a
sharp rise in AVC which more than offsets the fall in AFC. Therefore, ATC curve first falls,
reaches its minimum and then rises. Thus, the average total cost curve is “U” shape curve.
(Fig. 10)
Marginal Cost : Marginal cost is the addition made to the total cost by production of an
additional unit of output. In other words, it is the total cost of producing t units instead of t-1
units, where t is any given number. For example, if we are producing 5 units at a cost of
Rs. 200 and now suppose 6th unit is produced and the total cost is Rs. 250, marginal cost is
Rs. 250 - 200 i.e., Rs. 50. It is to be noted that marginal cost is independent of fixed cost. This is
because fixed costs do not change with output. It is only the variable costs which change with
a change in the level of output in the short run. Therefore, marginal cost is in fact due to the
changes in variable costs. Symbolically margical cost can be written as :
TC
MC =
Q
= Change in
TC = Total cost
Q = Output
or
MCn = TCn - TC n-1
Marginal cost curve falls as output increases in the beginning. It starts rising after a certain
level of output. This happens because of the influence of the law of variable proportions. The
fact that marginal product rises first, reaches a maximum and then declines ensures that the

marginal cost curve of a firm declines first, reaches its minimum and then rises. In other words
marginal cost curve of a firm is “U” shaped (see Figure 10).
The behaviour of these costs has also been shown in Table 2.
Table 2 : Various Costs
Units of Total fixed Total Total Average Average Average Marginal

output cost variable cost fixed variable total cost
cost cost cost cost per unit
0 150 0 150 – – – –
50
6 150 50 200 25.0 8.33 33.33 = 8.33
6
50
16 150 100 250 9.38 6.25 15.63 = 5.00
10
50
29 150 150 300 5.17 5.17 10.34 = 3.85
13
50
44 150 200 350 3.41 4.55 7.95 = 3.33
15
50
55 150 250 400 2.73 4.55 7.27 = 4.55
11
50
60 150 300 450 2.50 5.00 7.50 = 10.00
5
The above table shows that :
(i) Fixed cost does not change with increase in output upto a given range. Average fixed cost,
therefore, comes down with every increase in output.
(ii) Variable cost increases but not necessarily in the same proportion as the increase in output.
In the above case, average variable cost comes down gradually till 55 units are produced.
(iii) Marginal cost is the additional cost divided by addition units produced. This also comes
gradually till 44 units are produced.
Relationship between Average Cost and Marginal Cost : The relationship between marginal
cost and average cost is the same as that between any other marginal average quantities. The
following are the points of relationship between the two phenomena.
(1) When average cost falls as a result of an increase in output, marginal cost is less than
average cost.
(2) When average cost rises as a result of an increase in output, marginal cost is more than
average cost.
(3) When average cost is minimum, marginal cost is equal to the average cost. In other words,
marginal cost curve cuts average cost curve at its minimum point (i.e. optimum point).

Figure 10 and Table 2 confirm the above points of relationship.
2.4 LONG RUN AVERAGE COST CURVE

As stated above long run is a period of time during which the firm can vary all of its inputs -
unlike short run in which some inputs are fixed and others are variable. In other words, whereas
in the short run the firm is tied with a given plant, in the long run the firm moves from one
plant to another; it can acquire a big plant if it wants to increase its output and a small plant if
it wants to reduce its output. Long run cost of production is the least possible cost of producing
any given level of output when all individual factors are variable. A long run cost curve depicts
the functional relationship between output and the long run cost of production.
In order to understand how long run average cost curve is derived we consider three short run
average cost curves as shown in Figure 11. These short run cost curves (SACs) are also called
plant curves. In the short run the firm can be operating on any short run average cost curve
given the size of the plant. Suppose that these are the only three plants which are technically
possible. Given the size of the plant, the firm will be increasing or decreasing its output by
changing the amount of the variable inputs. But in the long run, the firm chooses among the
three possible sizes of plants as depicted by short run average curve (SAC1, SAC2, SAC3). In
the long run, the firm will examine with which size of plants or on which short average cost
curve it should operate to produce a given level of output so that total cost is minimum. It will
be seen from the diagram that upto OB amount of output the firm will operate on the SAC1,
though it could also produce with SAC2, because upto OB amount of output, the production
on SAC1 results in lower cost than on SAC2. For example, if the level of output OA is produced
with SAC1, it will cost AL per unit and if it is produced with SAC2 it will cost AH and we can
see that AH is more than AL. Similarly, if the firm plans to produce an output which is larger
than OB but less than OD then it will not be economical to produce on SAC1. For this, the firm
will have to use SAC2. Similarly, the firm will use SAC3 for output larger than OD. It is thus
clear that in the long run the firm has a choice in the employment of plant and it will employ
that plant which yields minimum possible unit cost for producing a given output.
Fig. 11 : Short run Average Cost Curves Fig. 12 : Long run Average Cost Curves

Suppose now, the firm has a choice so that a plant can be varied by infinitely small gradations
so that there are infinite number of plants corresponding to which there numerous average
cost curves. In such a case the long run average cost curve will be a smooth curve enveloping
all these short run average cost curves.
As shown in Figure 12 the long run average cost curve is so drawn as to be tangent to each of
the short run average cost curves. Every point on the long run average cost curve will be a
tangency point with some short run AC curve. If a firm desires to produce any particular
output it then builds a corresponding plant and operate on the corresponding short run average
cost curve. As shown in the figure, for producing OM the corresponding point on the LAC
curve is G and the short run average cost curve SAC2 is tangent to the long run AC at this
point. Thus if a firm desires to produce output OM, the firm will construct a plant corresponding
to SAC2 and will operate on this curve at point G. Similarly, the firm will produce other levels
of output choosing the plant which suits its requirements of lowest possible cost of production.
It is clear from the figure that the large output can be produced at the lowest cost with the
larger plant whereas smaller output can be produced at the lowest cost with smaller plants.
For example, to produce OM, the firm will be using SAC2 only; if it uses SAC3 for this, it will
result in higher unit cost than SAC2. But larger output OV can be produced most economically
with a larger plant represented by the SAC3. If we produce OV with the smaller plant it will
result in higher unit similarly if we produce larger output with a smaller plant it will involve
higher cost because of its limited capacity.
It is to be noted that LAC curve is not a tangent to the minimum points of the SAC curves.
When the LAC curve is declining it is tangent to the falling portions of the short run cost
curves and when the LAC curve is rising it is tangent to the rising portions of the short run cost
curves. Thus for producing output less than “OQ” at the lowest possible unit cost the firm will
construct the relevant plant and operate it at less than its full capacity, i.e., at less than its
minimum average cost of production. On the other hand for output larger than OQ the firm
will construct a plant and operate it beyond its optimum capacity. “OQ” is the optimum output.
This is because “OQ” is being produced at the minimum point of LAC and corresponding
SAC i.e., SAC4. Other plants are either used at less than their full capacity or more than their
full capacity. Only SAC4 is being operated at the minimum point.
Long run average cost curve is often called a planning curve because a firm plans to produce
any output in the long run by choosing a plant on the long run average cost curve corresponding
to the given output. The long run average cost curve helps the firm in the choice of the size of
the plant for producing a specific output at the least possible cost.
Explanation of the “U” shape of the long run average cost curve : As has been seen in the
diagram LAC curve is a “U” shape curve. This shape of LAC curve depends upon the returns to
scale. As discussed earlier, as the firm expands, returns to scale increase. After a range of constant
returns to scale, the returns to scale finally decrease. On the same line, the LAC curve first declines
and then finally rises. Increasing returns to scale cause fall in the long run average cost and
decreasing returns to scale result in increase in long run average cost. Falling long run average
cost and increasing economies to scale result from internal and external economies of scale and
rising long run average cost and diminishing returns to scale from internal and external
diseconomies of scale (economies of scale have been discussed earlier at the relevant place).

The long run average cost curve initially falls with increase in output and after a certain point
it rises making a boat shape. Long-run Average cost (LAC) curve is also called the planning
curve of the firm as it helps in choosing a plant on the decided level of output. The long-run
avearge cost curve is called Envelope curve, because it envelopes or supports a family of short
run average cost curves from below.
The above figure depicting long-run average cost curve is arrived at on the basis of traditional
economic analysis. It is flattened ‘U’ shaped. This type of curve could exist only when the state
of technology remains constant. But the empirical evidence shows that the state of technology
changes in the long-run.
Therefore, modern firms face ‘L-shaped’ cost curve than ‘u-shaped’. The L shaped cost curve is
given below. According to the diagram, over AB range, the curve is perfectly flat. Over this
range all sizes of plant have the same minimum cost.
Cost
Output
Fig. 13 : Long-run Average Cost Curve
SUMMARY
The relation between cost and output is called “Cost Function”. Cost function of a firm depends
upon its production function and the prices of factors of production.
In cost analysis a number of cost concepts are employed like accounting costs (costs which are
accounted for), economic costs (costs which are accounted for plus costs which are not incurred
but would have been incurred but for the employment of self services by the entrepreneurs),
direct costs (costs which can be directly traced to a function or product), indirect costs (costs
which cannot be related directly to product or function) and so on. Economists are generally
interested in two types of cost functions, the short run cost function and the long run cost
function and accordingly derive the short run and long run cost curves. Related to short run
and long run periods we have fixed cost concept and variable cost concept.
Fixed cost are not a function of output and they are fixed in the short run. Variable costs, on
the other hand, are variable with the level of output. In the long run all costs become variable.
Cost of production is the most important force governing the supply of a product. It should be
noted that it is assumed that for each level of output, the firm chooses the least cost combination
of factors.


1. Which of the following is considered production in Economics?
(a) Tilling of soil.
(b) Singing a song before friends.
(c) Preventing a child from falling into a manhole on the road.
(d) Painting a picture for pleasure.
2. Identify the correct statement :
(a) The average product is at its maximum when marginal product is equal to average
product.
(b) The law of increasing returns to scale relates to the effect of changes in factor
proportions.
(c) Economies of scale arise only because of indivisibilities of factor proportions.
(d) Internal economies of scale can accrue only to the exporting sector.
3. Which of the following is not a characteristic of land?
(a) Its supply for the economy is limited.
(b) It is immobile.
(c) Its usefulness depends on human efforts.
(d) It is produced by our forefathers.
4. Which of the following statements is true?
(a) Accumulation of capital depends solely on income.
(b) Savings can also be affected by the State.
(c) External economies go with size and internal economies with location.
(d) The supply curve of labour is an upward slopping curve.
5. In the production of wheat, all of the following are variable factors that are used by the
farmer except :
(a) the seed and fertilizer used when the crop is planted.
(b) the field that has been cleared of trees and in which the crop is planted.
(c) the tractor used by the farmer in planting and cultivating not only wheat but also
corn and barley.
(d) the number of hours that the farmer spends in cultivating the wheat fields.
6. The marginal product of a variable input is best described as:
(a) total product divided by the number of units of variable input.

(b) the additional output resulting from a one unit increase in the variable input.
(c) the additional output resulting from a one unit increase in both the variable and fixed
inputs.
(d) the ratio of the amount of the variable input that is being used to the amount of the
fixed input that is being used.
7. Diminishing marginal returns implies:
(a) decreasing average variable costs.
(b) decreasing marginal costs.
(c) increasing marginal costs.
(d) decreasing average fixed costs.
8. The short run, as economists use the phrase, is characterized by:
(a) at least one fixed factor of production and firms neither leaving nor entering the
industry.
(b) a period where the law of diminishing returns does not hold.
(c) no variable inputs – that is all of the factors of production are fixed.
(d) all inputs being variable.
9. The marginal, average, and total product curves encountered by the firm producing in
the short run exhibit all of the following relationships except:
(a) when total product is rising, average and marginal product may be either rising or
falling.
(b) when marginal product is negative, total product and average product are falling.
(c) when average product is at a maximum, marginal product equals average product,
and total product is rising.
(d) when marginal product is at a maximum, average product equals marginal product,
and total product is rising.
10. To economists, the main difference between the short run and the long run is that :
(a) in the short run all inputs are fixed, while in the long run all inputs are variable.
(b) in the short run the firm varies all of its inputs to find the least-cost combination of
inputs.
(c) in the short run, at least one of the firm’s input levels is fixed.
(d) in the long run, the firm is making a constrained decision about how to use existing
plant and equipment efficiently.
11. Which of the following is the best definition of the “production function”?
(a) The relationship between market price and quantity supplied.

(b) The relationship between the firm’s total revenue and the cost of production.
(c) The relationship between the quantities of inputs needed to produce a given level of
output.
(d) The relationship between the quantity of inputs and the firm’s marginal cost of
production.
12. The “law of diminishing returns” applies to :
(a) the short run, but not the long run.
(b) the long run, but not the short run.
(c) both the short run and the long run.
(d) neither the short run nor the long run.
13. Diminishing returns occur :
(a) when units of a variable input are added to a fixed input and total product falls.
(b) when units of a variable input are added to a fixed input and marginal product falls.
(c) when the size of the plant is increased in the long run.
(d) when the quantity of the fixed input is increased and returns to the variable input
falls.
Use the following information to answer questions 14-16.
Hours of Labour Total Output Marginal Product

0 —- —-
1 100 100
2 80
3 240
14. What is the total output when 2 hours of labour are employed?
(a) 80
(b) 100
(c) 180
(d) 200
15. What is the marginal product of the third hour of labour?
(a) 60
(b) 80
(c) 100
(d) 240
16. What is the average product of the first three hours of labour?
(a) 60
(b) 80
(c) 100
(d) 240
17. Which cost increases continuously with the increase in production?
(a) Average cost.
(b) Marginal cost.
(c) Fixed cost.
(d) Variable cost.
18. Which of the following cost curves is never ‘U’ shaped?
(a) Average cost curve.
(b) Marginal cost curve.
(c) Average variable cost curve
(d) Average fixed cost curve.
19. Total cost in the short run is classified into fixed costs and variable costs. Which one of the
following is a variable cost?
(a) Cost of raw materials.
(b) Cost of equipment.
(c) Interest payment on past borrowings.
(d) Payment of rent on building.
20. In the short run, when the output of a firm increases, its average fixed cost :
(a) increases.
(b) decreases.
(c) remains constant.
(d) first declines and then rises.
21. Which one of the following is also known as planning curve?
(a) Long run average cost curve.
(b) Short run average cost curve.
(c) Average variable cost curve.
(d) Average total cost curve.
22. The cost of one thing in terms of the alternative given up is known as:
(a) production cost.

(b) physical cost.

(c) real cost.
(d) opportunity cost.
23. With which of the following is the concept of marginal cost closely related?
(a) variable cost.
(b) fixed cost.
(c) opportunity cost.
(d) economic cost.
24. Which of the following statements is correct?
(a) When the average cost is rising, the marginal cost must also be rising.
(b) When the average cost is rising, the marginal cost must be falling.
(c) When the average cost is rising, the marginal cost is above the average cost.
(d) When the average cost is falling, the marginal cost must be rising.
25. Which of the following is an example of an “explicit cost”?
(a) The wages a proprietor could have made by working as an employee of a large firm.
(b) The income that could have been earned in alternative uses by the resources owned
by the firm.
(c) The payment of wages by the firm.
(d) The normal profit earned by a firm.
26. Which of the following is an example of an “implicit cost”?
(a) Interest that could have been earned on retained earnings used by the firm to finance
expansion.
(b) The payment of rent by the firm for the building in which it is housed.
(c) The interest payment made by the firm for funds borrowed from a bank.
(d) The payment of wages by the firm.
Use the following data to answer questions 27-29.
Output (O) 0 1 2 3 4 5 6
Total Cost (TC) : Rs. 240 Rs. 330 Rs. 410 Rs. 480 Rs. 540 Rs. 610 Rs. 690
27. The average fixed cost of 2 units of output is :
(a) Rs. 80
(b) Rs. 85
(c) Rs. 120
(d) Rs. 205

28. The marginal cost of the sixth unit of output is :
(a) Rs. 133
(b) Rs. 75
(c) Rs. 80
(d) Rs. 450
29. Diminishing marginal returns start to occur between units :
(a) 2 and 3.
(b) 3 and 4.
(c) 4 and 5.
(d) 5 and 6.
30. Marginal cost is defined as :
(a) the change in total cost due to a one unit change in output.
(b) total cost divided by output.
(c) the change in output due to a one unit change in an input.
(d) total product divided by the quantity of input.
31. Which of the following is true of the relationship between the marginal cost function and
the average cost functions?
(a) If MC is greater than ATC, then ATC is falling.
(b) The ATC curve intersects the MC curve at minimum MC.
(c) The MC curve intersects the ATC curve at minimum ATC.
(d) If MC is less than ATC, then ATC is increasing.
32. Which of the following statements is true of the relationship among the average cost
functions?
(a) ATC = AFC – AVC.
(b) AVC = AFC + ATC.
(c) AFC = ATC + AVC.
(d) AFC = ATC – AVC.
33. Which of the following is not a determinant of the firm’s cost functions?
(a) The production function.
(b) The price of labour.
(c) Taxes.
(d) The price of the firm’s output.

34. Which of the following statements is correct concerning the relationships among the firm’s
functions?
(a) TC = TFC – TVC.
(b) TVC = TFC – TC.
(c) TFC = TC – TVC.
(d) TC = TVC – TFC.
35. Suppose output increases in the short run. Total cost will :
(a) increase due to an increase in fixed costs only.
(b) increase due to an increase in variable costs only.
(c) increase due to an increase in both fixed and variable costs.
(d) decrease if the firm is in the region of diminishing returns.
36. Which of the following statements concerning the long-run average cost curve is false?
(a) It represents the least-cost input combination for producing each level of output.
(b) It is derived from a series of short-run average cost curves.
(c) The short-run cost curve at the minimum point of the long-run average cost curve
represents the least–cost plant size for all levels of output.
(d) As output increases, the amount of capital employed by the firm increases along the
curve.
37. The negatively-sloped (i.e. falling) part of the long-run average total cost curve is due to
which of the following?
(a) Diseconomies of scale.
(b) Diminishing returns.
(c) The difficulties encountered in coordinating the many activities of a large firm.
(d) The increase in productivity that results from specialization.
38. The positively sloped (i.e. rising) part of the long run average total cost curve is due to
which of the following?
(a) Diseconomies of scale.
(b) Increasing returns.
(c) The firm being able to take advantage of large-scale production techniques as it
expands its output.
(d) The increase in productivity that results from specialization.
39. A firm’s average total cost is Rs. 300 at 5 units of output and Rs. 320 at 6 units of output.
The marginal cost of producing the 6th unit is :
(a) Rs. 20
(b) Rs. 120

(c) Rs. 320
(d) Rs. 420
40. A firm producing 7 units of output has an average total cost of Rs. 150 and has to pay
Rs. 350 to its fixed factors of production whether it produces or not. How much of the
average total cost is made up of variable costs?
(a) Rs. 200
(b) Rs. 50
(c) Rs. 300
(d) Rs. 100
41. A firm has a variable cost of Rs. 1000 at 5 units of output. If fixed costs are Rs. 400, what
will be the average total cost at 5 units of output?
(a) Rs. 280
(b) Rs. 60
(c) Rs. 120
(d) Rs. 1400
42. A firm’s average fixed cost is Rs. 20 at 6 units of output. What will it be at 4 units of
output?
(a) Rs. 60
(b) Rs. 30
(c) Rs. 40
(d) Rs. 20
43. Which of the following statements is true?
(a) The services of a doctor are considered production.
(b) Man can create matter.
(c) The services of a housewife are considered production.
(d) When a man creates a table, he creates matter.
44. Which of the following is a function of an entrepreneur?
(a) Initiating a business enterprise.
(b) Risk bearing.
(c) Innovating.
(d) All of the above.
45. In describing a given production technology, the short run is best described as lasting:
(a) up to six months from now.
(b) up to five years from now.

(c) as long as all inputs are fixed.

(d) as long as at least one input is fixed.
46. If decreasing returns to scale are present, then if all inputs are increased by 10% then:
(a) output will also decrease by 10%.
(b) output will increase by 10%.
(c) output will increase by less than 10%.
(d) output will increase by more than 10%.
47. The production function is a relationship between a given combination of inputs and:
(a) another combination that yields the same output.
(b) the highest resulting output.
(c) the increase in output generated by one-unit increase in one output.
(d) all levels of output that can be generated by those inputs.
48. If the marginal product of labour is below the average product of labour, it must be true
that:
(a) the marginal product of labour is negative.
(b) the marginal product of labour is zero.
(c) the average product of labour is falling.
(d) the average product of labour is negative.
49. The average product of labour is maximized when marginal product of labour:
(a) equals the average product of labour.
(b) equals zero.
(c) is maximized.
50. The law of variable proportions is drawn under all of the assumptions mentioned below
except the assumption that:
(a) the technology is changing.
(b) there must be some inputs whose quantity is kept fixed.
(c) we consider only physical inputs and not economically profitability in monetary terms.
(d) the technology is given and stable.
51. What is a production process?
a. technical relationship between physical inputs and physical output.
b. relationship between fixed factors of production and variable factors of production.
c. relationship between a factor of production and the utility created by it.

d. relationship between quantity of output produced and time taken to produce the
output.
52. Laws of production does not include ……
a. returns to scale.
b. law of diminishing returns to a factor
c. law of variable proportions.
d. least cost combination of factors.
53. Identify the fixed cost from the following:
a. Labour cost.
b. Electricity bill
c. Salary of watchman
d. Cost of raw materials
54. Which of the following is not an assumption of the law of variable proportions
a. Only one factor is variable.
b. Technique of production remains constant.
c. Proportion of factors of production remains same.
d. Units of variable factor are homogeneous.
a. Supply of land is perfectly elastic.
b. Fertility of land cannot change.
c. Land does not yield any result unless human efforts are employed.
d. Supply of land can be increase.
56. The production process described below exhibits
Number of Workers Output
0 0
1 23
2 40
3 50
a. constant marginal product of labour
b. diminishing marginal product of labour
c. increasing return to scale
d. increasing marginal product of labour
57. Which of the following is a variable cost in the short run?
a. rent of the factory

b. wages paid to the factory labour

c. interest payments on borrowed financial capital
d. payment on the lease for factory equipment
58. The efficient scale of production is the quantity of output that minimizes
a. average fixed cost
b. average total cost
c. average variable cost
d. marginal cost
59. If marginal cost equals average total cost,
a. average total cost is falling
b. average total cost is rising
c. average total cost is maximized
d. average total cost is minimized
60. In the long run
a. all inputs are fixed
b. all inputs are variable
c. at least one input is variable and one input is fixed
d. at most one input is variable and one input is fixed
61. Average product is defined as
a. total product divided by the total cost
b. total product divided by marginal product
c. total product divided by the variable input
d. marginal product divided by the variable input
62. The change in the total product resulting from a change in a variable input is
a. average cost
b. average product
c. marginal cost
d. marginal product
63. Marginal product, mathematically, is the slope of the
a. total product curve
b. average product curve
c. marginal product curve
d. implicit product curve

64. Suppose the first four units of a variable input generate corresponding total outputs of
200, 350, 450, 500. The marginal product of the third unit of input is:
a. 50
b. 100
c. 150
d. 200
65. The law of diminishing marginal returns indicates that marginal return
a. always diminish
b. eventually diminish
c. always diminish before increasing
d. never diminish before increasing
66. Diminishing marginal returns for the first four units of a variable input is exhibited by the
total product sequence:
a. 50,50,50,50
b. 50,110,180,260
c. 50, 100, 150, 200
d. 50, 90, 120, 140
67. If marginal product is equal to average product, then:
a. marginal product is increasing
b. marginal product is decreasing
c. average product is decreasing
d. average product is not changing
68. In the third of the three stages of production:
a. the marginal product curve has a positive slope
b. the marginal product curve lies completely below the average product curve
c. total product increases
d. marginal product is positive
69. When marginal costs are below average total costs,
(a) average fixed costs are rising
(b) average total costs are falling
(c) average total costs are rising
(d) average total costs are minimized
70. If the average cost is falling, then:
(a) Marginal cost is rising

(b) Marginal cost is falling

(c) Marginal cost is equal to average cost
(d) It is impossible to tell if marginal cost is rising or falling
71. In the long run, if a very small factory were to expand its scale of operations, it is likely
that it would initially experience
(a) an increase in pollution level
(b) diseconomies of scale
(c) economies of scale
(d) constant returns to scale
72. The difference between average total cost and average variable cost:
(a) is constant
(b) is total fixed cost
(c) gets narrow as output decreases
(d) is the average fixed cost
73. In the long-run, some firms will exit the market if the price of the good offered for sale is
less than
a. marginal revenue
b. marginal cost
c. average total cost
d. average revenue
74. The marginal cost for a firm of producing the 9th unit of output is Rs. 20. Average cost at
the same level of output is Rs. 15. Which of the following must be true?
a. marginal cost and average cost are both falling
b. marginal cost and average cost are both rising
c. marginal cost is rising and average cost is falling
d. it is impossible to tell if either of the curves are rising or falling

ANSWERS
1. a 2. a 3. d 4. b 5. b 6. b
7. c 8. a 9. d 10. c 11. c 12. a
13. b 14. c 15. a 16. b 17. d 18. d
19. a 20. b 21. a 22. d 23. a 24. c
25. c 26. a. 27. c. 28. c 29. c 30. a.
31. c 32. d 33. d 34. c 35. b 36. c
37. d 38. a 39. d 40. d 41. a 42. b
43. a 44. d 45. d 46. c 47. b 48. c
49. a 50. a 51. a 52. d 53. c 54. c
55. c 56. b 57. b 58. b 59. d 60. b
61. c 62. d 63. a 64. b 65. b 66. d
67. d 68. b 69. b 70. d 71. c 72. d
73. c 74. b

CHAPTER – 4
PRICE
DETERMINATION
IN DIFFERENT
MARKETS
Unit 1
Meaning
and
Types of Markets
PRICE DETERMINATION IN DIFFERENT MARKETS
Learning Objectives
know the meaning of market in Economics.
know various types of markets.
understand the concepts of total, average and marginal revenue.
understand behavioural principles underlying markets.
1.0 MEANING OF MARKET

Consider the following situation. You go to the local market to buy a pair of shoes. You enter
one shop which sells shoes. The shoes which you like are priced at Rs. 600. But you think that
they are not worth more than Rs. 500. You offer Rs. 500 for the shoes. But the shopkeeper is
not ready to give them at less than Rs. 550. You finally buy the shoes for Rs. 550.
This is an example of a local market. In this market some are buyers and some are sellers. The
market fixes the price at which those who want something can obtain it from those who have
it to sell.
Note that it is only exchange value which is significant here. The shopkeeper selling the shoes
may have felt that the shoes ought to have made more than Rs. 550. Considerations such as
‘sentimental value’ mean little in the market economy.
Most goods such as foodstuffs, clothing and household utensils etc., are given a definite price
by the shopkeeper. But buyers will still influence this price. If it is too high, the market will not
be cleared; if it is low, the shopkeeper’s stock will run out.
A market need not be formal or held in a particular place. Second-hand cars are often bought
and sold through newspaper advertisements. Second-hand furniture may be disposed of by a
card in the local shop window.
However, in studying the market economy it is essential to understand how price is determined.
Since this is done in the market, we can define the market simply as all those buyers and sellers
of a good or service who influence the price.
The elements of a market are :
(i) buyers and sellers;
(ii) a product or service;
(iii) bargaining for a price;
(iv) knowledge about market conditions; and
(v) one price for a product or service at a given time.
Classification of Market:
In Economics, generally the classification is made on the basis of
a. Area

b. Time
c. Nature of transaction
d. Regulation
e. Volume of business
f. Types of Competition.
On the basis of Area
On the basis of geographical area covered, markets are classified into
a. Local Markets: Generally, markets for perishable like butter, eggs, milk, vegetables, etc.,
will have local markets. Like wise, bulky articles like bricks, sand, stones, etc., will have
local markets as the transport of these over a long distance will be uneconomic.
b. Regional Markets: Semi-durable goods command a regional market.
c. National Markets: In this market durable goods and industrial items exist
d. International markets: The precious commodities like gold, silver etc. are traded in the
international market.
On the basis of Time:
Alfred Marshall conceived the ‘Time’ elements in marketing and this is classified into
a. Very short period market: It refers to that type of market in which the commodities are
perishable and supply of commodities cannot be changed at all. In a very short-period
market, the market supply is almost fixed and it cannot be increased or decreased, because
skilled labour, capital and organization are fixed. Commodities like vegetables, flower,
fish, eggs, fruits, milk, etc., which are perishable and the supply of which cannot be changed
in the very short period come under this category.
b. Short-period Market: Short period is a period which is slightly longer than the very short
period. In this period, the supply of output will be increased by increasing the employment
of variable factors to the given fixed capital equipments.
c. Long-period Market: It implies that the time available is adequate for altering the supplies
by altering even the fixed factors of production. The supply of commodities may be
increased by installing a new plant or machinery and the output adjustments can be
made accordingly.
d. Very long-period or secular period is one when secular movements are recorded in certain
factors over a period of time. The period is very long. The factors include the size of the
population, capital supply, supply of raw materials etc.
On the basis of Nature of Transactions
a. Spot Market: Spot transactions or spot markets refer to those markets where goods are
physically transacted on the spot.
b. Future Market: It is related to those transactions which involve contracts of the future
date.

On the basis of Regulation:

a. Regulated Market: In this market, transactions are statutorily regulated so as to put an
end to unfair practices. Such markets may be established for specific products or a group
of products. Eg. stock exchange
b. Unregulated Market: It is also called as free market as there are no restrictions on the
transactions.
On the basis of volume of Business
a. Wholesale Market: The wholesale market comes into existence when the commodities
are bought and sold in bulk or large quantities.
b. Retail Market: When the commodities are sold in the small quantities, it is called retail
market. This is the market for ultimate consumers.
On the basis of Competitions:
Based on the type of competition markets are classified into a. Perfectly competitive market
and b. Imperfect market. We shall study these markets in greater details in the following
paragraphs.
1.1 TYPES OF MARKET STRUCTURES

For a consumer, a market consists of those firms from which he can buy a well-defined product;
for a producer, a market consists of those buyers to whom he can sell a single well-defined
product. If a firm knows precisely the demand curve it faces, it would know its potential
revenue. If it also knows its costs, it can readily discover the profit that would be associated
with different level of output and can choose the rate that maximizes the output. But suppose
the firm knows its costs and the market demand curve for the product but does not know its
own demand curve. In other words, it does not know its own total sales. In order to find this
curve, the firm needs to answer the following questions. How many competitors are there in
the market selling similar products? If one firm changes its price, will its market share change?
If it reduces its price, will other firms follow it or not? There are so many other related questions
which will need answers.
Answers to questions of this type will be different in different circumstances. For example, if
there is only one firm in market, the whole of the market demand will be satisfied by this
particular firm. But if there are two large firms in the industry they will share the market
demand in some proportion. They will have to be very cautious of the reactions of other firm to
every decision they make. But if there are say more than 5,000 small firms in an industry, each
firm will be less worried about the reactions of other firms to its decisions because each firm
sells only a small proportion of the market. Thus, we find that the market behaviour is greatly
affected by market structure. We can conceive of more than thousand types of market structures
but we focus on a few theoretical market types which mostly cover a high proportion of cases
actually found in marketing world. These are :
Perfect Competition : Perfect competition is characterised by many sellers selling identical
products to many buyers.

Monopolistic Competition : It differs in only one respect, namely, there are many sellers offering
differentiated products to many buyers.
Monopoly : It is a situation of a single seller producing for many buyers. Its product is necessarily
extremely differentiated since there are no competing sellers producing near substitute products.
In Oligopoly : There are a few sellers selling competing products for many buyers.
Table 1 summarises the major distinguishing characteristics of these four major market forms.
Table 1 - Distinguishing features of major types of markets
Market Types
Assumption Pure Monopolistic Oligopoly Monopoly
Competition Competition
Number of sellers many many a few one
Product differentiation none slight none to substantial extreme
Price elasticity infinite large small small
of demand of a firm
Degree of control very
over price none some some considerable
Before discussing each market form in greater detail it is worthwhile to know concepts of total,
average and marginal revenues and behavioural principles which apply to all market
conditions.
1.2 CONCEPTS OF TOTAL REVENUE, AVERAGE REVENUE
AND MARGINAL REVENUE
Total Revenue : If a firm sells 100 units for Rs.10 each, what is the amount which it realises?
It realises Rs. 1,000 (100 x 10), which is nothing but total revenue for the firm. Thus we may
state that total revenue refers to the amount of money which a firm realises by selling certain
units of a commodity. Symbolically, total revenue may be expressed as
TR = P x Q
Where, TR is total revenue
P is price
Q is quantity of a commodity sold.
Average Revenue : Average revenue is the revenue earned per unit of output. It is nothing but
price of one unit of output because price is always per unit of a commodity. Symbolically,
average revenue is :
TR
AR =
Q

Where AR is average revenue

TR is the total revenue
Q is quantity of a commodity sold
PxQ
or AR =
Q
or AR = P
If, for example, a firm realises total revenue of Rs. 1,000 by the sale of 100 units. It implies that
the average revenue is Rs. 10 (1,000/100) or the firm has sold the commodity at a price of
Rs. 10 per unit.
Marginal Revenue : Marginal revenue (MR) is the change in total revenue resulting from the
sale of an additional unit of the commodity. Thus, if a seller realises Rs. 1,000 after selling 100
units and Rs. 1,200 after selling 101 units, we say marginal revenue is Rs. 200. We can say that
MR is the rate of change in total revenue resulting from the sale of an additional unit.
ΔTR
MR =
ΔQ
Where MR is marginal revenue

TR is total revenue
Q is quantity of a commodity sold
Δ is the rate of change.
For one unit change in output
MRn = TRn – TRn-1
Where TR is the total revenue when sales are at the rate of n units per period.
TRn-1 is the total revenue when sales are at the rate of n - 1 units per period.
Marginal Revenue, Average Revenue, Total Revenue and Elasticity of Demand : It is to be
noted that marginal revenue, average revenue and price elasticity of demand are uniquely
related to one another through the formula :
e−1
MR = AR x , Where e = price elasticity of demand
e
1−1
Thus if e = 1, MR = AR x = 0.
1
and if e >1, MR will be positive
and if e <1, MR will be negative

In a straight line demand curve, we know that the elasticity of the middle point is equal to one.
It follows that marginal revenue corresponding to the middle point of the demand curve (or
AR curve) will be zero.
1.3 BEHAVIOURAL PRINCIPLES

Principle 1 : A firm should not produce at all if total revenue from its product does not equal or
exceed its total variable cost.
It is a matter of common sense that a firm should produce only if it will do better by producing
than by not producing. The firm always has the option of not producing anything. If it does
not produce anything, it will have an operating loss equal to its fixed cost. Unless actual
production adds as much to revenue as it adds to cost, it will increase the loss of the firm.
Principle 2 : It will be profitable for the firm to expand output whenever marginal revenue is
greater than marginal cost, and to keep on expanding output until marginal revenue equals
marginal cost. Not only marginal cost should be equal to marginal revenue, its curve should
cut marginal revenue curve from below.
The above principle states that if any unit of production adds more to revenue than to cost,
that unit will increase profits; if it adds more to cost than to revenue, it will decrease profits.
Profits will be maximum at the point where additional revenue from a unit equals to its additional
cost.
SUMMARY
The term market is a place where buyers and sellers bargain over a commodity for a price.
There are many factors which determine the extent of a market like nature of the commodity,
size of production, extent of demand and so on.
Markets can be classified on the basis of area, volume of business, time, status of sellers, regulation
and competition. On the basis of competition a market is classified into perfect competition,
monopoly, imperfect competition and oligopoly.
The firms can operate with a complex set of objectives and under various constraints. However,
we assume that firms act as if they are maximizing their profits. With this assumption, we
study the behaviour of firms in different types of market structure.

CHAPTER – 4
PRICE
DETERMINATION
IN DIFFERENT
MARKETS
Unit 2
Determination
of Prices
Learning Objectives
At the end of this unit you will be able to understand :
how prices are generally determined.

how changes in demand and supply affect prices and quantities demanded and supplied.
2.0 INTRODUCTION
Prices of goods express their exchange value. These are also used for expressing the value of
various services rendered by different factors of production such as land, labour, capital and
organization. These values respectively are, rent, wages, interest and profit. Therefore, the
concept of price, especially the process of price determination, is of vital importance in
Economics.
It is to be noted that generally it is the interaction between demand and supply that determines
the price but sometimes Government intervenes and determines the price either fully or partially.
For example, the Government of India fixes up prices of petrol, diesel, kerosene, coal, fertilizers,
etc. which are critical inputs. It also fixes up procurement prices of wheat, rice, sugarcane, etc.
in order to protect the interests of both producers and consumers. While determining these
prices, the Government takes into account factors like cost of inputs, risks for business, nature
of the product etc.
2.1 DETERMINATION OF PRICES - A GENERAL VIEW

In an open competitive market it is the interaction between demand and supply that tends to
determine price and quantity. This can be shown by bringing together demand and supply.
Combining the tables of demand and supply (on page 33 and 66 respectively) of Chapter-2,
we have the following schedule :
Table – 2 : Determination of Price
S. No. Price Demand Supply

(Rs.) Units (Units)
1 1 60 5
2 2 35 35
3 3 20 45
4 4 15 55
5 5 10 65

When we plot the above points on a single graph with price on Y-axis and quantity demanded
and supplied on X-axis, we get a figure like this :
Fig. 1 : Determination of Equilibrium Price
It is easy to see which will be the market price of the article. It cannot be Re. 1, for at that price
there would be 60 units in demand, but only 5 units on offer. Competition among buyers
would force the price up. On the other hand, it cannot Rs. 5, for at that price there would be 65
units on offer for sale but only 10 units in demand. Competition among sellers would force the
price down. At Rs. 2, demand and supply are equal (35 units) and the market price will tend
to settle at this figure. This is equilibrium price and quantity – the point at which price and
output will tend to stay. Once this point is reached we will have stable equilibrium. It should
be noted that it would be stable only if other things were equal.
2.2 CHANGES IN DEMAND AND SUPPLY

The facts of real world, however, are such that other things (like income, tastes and preferences,
population, etc.) always change causing changes in the demand and supply. The four main
changes in demand and supply are :
(i) An increase (shift to the right) in demand;
(ii) A decrease (shift to the left) in demand;
(iii) An increase (shift to the right) in supply;
(iv) A decrease (shift to the left) in supply.
We will consider each of the above changes one by one.
(i) An increase in demand : In figure 2, the original demand curve is DD and supply curve is
SS. At equilibrium price OP, demand and supply are equal to OQ.

Now suppose the money income of the consumer increases, the demand curve will shift to
D1D1 and the supply curve will remain same. We will see that on the new demand curve
D1D1 at OP price demand increases to OQ2 while supply remains the same i.e. OQ. Since
supply is short of the demand, price will go up to OP1. With the higher price supply will
also shoot up and new equilibrium between the demand and supply will be reached. At
this equilibrium point, OP1 is price and OQ1 is the quantity which is demanded and supplied.
D1
Y D S
P1 E1
PRICE
P D1
D
O X
Q Q1 Q2
QUANTITY
Fig. 2 : Increase in Demand, causing an increase in equilibrium price and quantity
Thus, we see that as a result of an increase in demand, there is an increase in equilibrium

price, as a result of which the quantity sold and purchased also increases.
(ii) Decrease in Demand : Opposite will happen when the demand falls as a result of a fall in
income, while the supply remaining the same. The demand curve will shift to the left and
become D1D1 while the supply curve remaining as it is. With the new demand curve D1D1
at original price OP, OQ2 is demanded and OQ is supplied. As the supply exceeds demand,
price will go down and quantity demanded will go up. A new equilibrium price OP1 will
be settled in the market where demand OQ1 will be equal to supply OQ1.
Y D1 D S
P E
PRICE
P1 E1
S D
D1
O X
Q2 Q1 Q
QUANTITY
Fig. 3 : Decrease in Demand resulting in a decrease in price and quantity demanded
Thus with a decrease in demand, there is a decrease in the equilibrium price and quantity
demanded and supplied.

(iii) Increase in Supply : Let us now assume that demand does not change, but there is an
increase in supply say, because of improved technology.
Y D S S1
PRICE
P E1
P1
S
D
S1
O X
Q Q1 Q2
Fig. 4 : Increase in supply, resulting in decrease in equilibrium

price and increase in quantity supplied
The supply curve SS will shift to the right and become S1S1. At the original equilibrium
price OP, OQ is demanded and OQ2 is supplied (with new supply curve). Since the supply
is greater than the demand, the equilibrium price will go down and become OP1 at which
OQ1 will be demanded and supplied.
Thus, as a result of an increase in supply the equilibrium price will go down and the
quantity demanded will go up.
(iv) Decrease in Supply : If because of some reason, there is a decrease in the supply we will find
that equilibrium price will go up but the amount sold and purchased will go down as
shown in figure 5 :
D S1
Y S
E1
P1
P E
PRICE
S1
D
S
X
O Q2 Q1 Q
QUANTITY
Fig. 5 : Decrease in supply causing an increase in the equilibrium

price and a fall in quantity demanded

2.3 SIMULTANEOUS CHANGES IN DEMAND AND SUPPLY
Till now, we were considering the effect of change either in demand or in supply on the
equilibrium price and the quantity sold and purchased. There may be cases in which both the
supply and demand change at the same time. During a war, for example, shortage of goods
will often decrease supply while full employment causes high total wage payments which
increase demand.
We may discuss the changes in both demand and supply with the help of diagrams as follows :
S S1 D1 S1
D D1 D S
Y S Y Y
D1 S1
D
E
E1
PRICE
PRICE
P1
PRICE
E P
E E1 P E1
P D1 P1
S S D1
D1 S
D D
S1 S1
D S1
O Q Q1 X O Q Q1 X O Q Q1 X
QUANTITY QUANTITY QUANTITY
(a) (b) (c)
Fig.6 : Simultaneous Change in Demand and Supply
Fig. 6 shows simultaneous change in demand and supply and its effects on the equilibrium
price. In the figure, the original demand curve DD and the supply curve SS meet at E at which
OP is the equilibrium price OQ is the quantity bought and sold.
Fig. 6 (a), shows that increase in demand is equal to increase in supply. The new demand
curve D1D1 and S1S1 meet at E1. The new equilibrium price is equal to the old equilibrium price
(OP).
Fig. 6 (b), shows that increase in demand is more than increase in supply. Hence, the new
equilibrium price OP1 is higher than the old equilibrium price OP. Opposite will happen i.e. the
equilibrium price will go down if there is a simultaneous fall in the demand and supply and
the fall in demand is more than the fall in supply.
Fig. 6 (c), shows that supply increases in a greater proportion than demand. The new equilibrium
price will be less than the original equilibrium price. Conversely, if the fall in the supply is more
than proportionate to the fall in the demand, the equilibrium price will go up.

SUMMARY
The price of a product depends upon (i) its demand and (ii) its supply. Demand for a product
in turn depends upon utility it provides to consumers and the supply on the cost of producing
it. Equilibrium price is determined at a point where demand is equal to supply. Here, all other
things are supposed to be equal.
However, we seldom get a stable equilibrium. Conditions underlying demand and supply keep
on changing and the demand and supply curves keep on shifting giving rise to a new equilibrium
price. Supply remaining same, if demand increases, equilibrium price will move up and if
demand decreases, the equilibrium price will move down. Demand remaining same, if the
supply increases the equilibrium price will decline and vice-versa.
There can be simultaneous change in both demand and supply and the equilibrium price will
change according to the proportionate change in demand and supply.

CHAPTER – 4
PRICE
DETERMINATION
IN DIFFERENT
MARKETS
Unit 3
Price-output
Determination
Under Different
Market Forms
Learning Objectives
understand how price and quantity demanded and supplied are determined in perfect
competition, monopoly, oligopoly and monopolistic competition.
understand the conditions required to make price discrimination by monopolist successful.
understand how firms in an oligopolist market are independent.
In this unit, we shall study the determination of price and output under perfect competition,
monopoly, monopolistic competition and oligopoly. Output is supplied by individual firms on
the basis of market demand, their cost and revenue functions. However, the existence of different
forms of market structure leads to differences in demand and revenue functions of the firms.
Therefore, supplies offered at different prices by the firm would vary significantly depending
upon the market forms. We start our analysis with perfect competition.
3.0 PERFECT COMPETITION

3.0.0 Features
Suppose you go to a vegetable market and enquire about the price of potatoes from a shopkeeper.
He says potatoes are for Rs. 5 per kg. In the same way, you enquire from many shopkeepers
and you get the same answer. What do you notice? You notice the following facts :
(i) There are large number of buyers and sellers in the potatoes market.
(ii) All the shopkeepers are selling potatoes for Rs. 5.
(iii) Product homogeneity i.e. all the sellers are selling almost same quality of potatoes in the
sense that you cannot judge by seeing the potatoes from which farmer’s field do they
come from.
Such type of market is known as perfectly competitive market. In general it has the following
characteristics :
(i) There are a large number of buyers and sellers who compete among themselves and their
number is so large that no buyer or seller is in a position to influence the demand or supply
in the market.
(ii) The commodity dealt in it is homogeneous in the sense that the goods produced by different
firms are identical in nature.
(iii) Every firm is free to enter the market or to go out of it.
If the above three conditions alone are fulfilled, then it is called pure competition. The
essential feature of the pure competition is the absence of monopolistic element. The number
of producers is large, the commodity is the same and everyone has the liberty to enter the
industry. So, monopolistic combinations are not possible.
In addition to the above stated three features of pure competition, some more conditions
are attached to the perfect competition. They are:
164 COMMON
GENERAL
PROFICIENCY
ECONOMICS
TEST
(iv) There is a perfect knowledge, on the part of buyers and sellers, of the quantities of stock of
goods in the market, market conditions and the prices at which transactions of purchase
and sale are being entered into.
(v) Facilities exist for the movement of goods from one centre to another. Also buyers have no
preference as between different sellers and as between different units of commodity offered
for sale; also sellers are quite indifferent as to whom they sell.
(vi) The commodity or the goods are dealt on at a uniform price throughout the market at a
given point of time. In other words, all firms individually are price takers, they have to
accept the price determined by the market forces to total demand and total supply.
The last mentioned is a consequence of the conditions prevailing in a market operating under
conditions of perfect competition, for when there is perfect knowledge and perfect mobility, if
any seller tries to raise his price above that charged by others, he would lose his customers.
While there are few examples of perfect competition, which is regarded as a myth by many,
the grain or stock markets approach the condition of perfect competition.
3.0.1 Price determination under perfect competition
Equilibrium of the Industry : An industry in economic terminology consists of a large number
of independent firms, each having a number of factories, farms or mines under its control.
Each such unit in the industry produces a homogeneous product so that there is competition
amongst goods produced by different units called firms. When the total output of the industry
is equal to the total demand we say that the industry is in equilibrium; the price then prevailing
is equilibrium price, whereas a firm is said to be in equilibrium when it has no incentive to
expand or contract production.
As stated above under competitive conditions, the equilibrium price for a given product is
determined by the interaction of forces of demand and supply for it as is shown in figure 7.
Y
D S
PRICE
E
P
S D
O Q X
OUTPUT
Fig.7 : Equilibrium of a competitive industry
In Fig. 7, OP is the equilibrium price and OQ is the equilibrium quantity which will be sold at
that price. The equilibrium price is the price at which both the demand and supply are equal at
which no buyer goes dissatisfied who wanted to buy at that price and none of the sellers is
dissatisfied that he could not sell his goods at that price. It will be noticed that if price were to
be fixed at any other level, higher or lower, demand remaining the same, there would not be

an equilibrium in the market. Likewise, if the quantities of goods were greater or smaller than
the demand, there would not be an equilibrium.
Equilibrium of the Firm : The firm is said to be in equilibrium when it maximizes its profit. The
output which gives maximum profit to the firm is called equilibrium output. In the equilibrium
state, the firm has no incentive either to increase or decrease its output. Since it is the maximum
profit giving output which only gives no incentive to the firm to increase or decrease it, so it is
in equilibrium when it gets maximum profit.
Firms in a competitive market are price-takers. This is because there are a large number of
firms in the market who are producing identical or homogeneous products. As such these
firms cannot influence the price in their individual capacities. They have to accept the price
fixed (through interaction of total demand and total supply) by the industry as a whole.
See the following figure :
(a) Market (b) Individual Seller

Y
D
PRICE
D/AR/MR
P P
PRICE
S D
O
QUANTITY QUANTITY N M X
Fig.8 : The firm’s demand curve under perfect competition
Industry price OP is fixed through the interaction of total demand and total supply of the
industry. Firms have to accept this price as given and as such they are price-takers rather than
price-makers. They cannot increase the price OP individually because of the fear of losing
customers to other firms. They do not try to sell the product below OP because they do not
have any incentive for lowering it. They will try to sell as much as they can at price OP.
As such P-line acts as a demand curve for them. Thus the demand curve facing an individual
firm in a perfectly competitive market is horizontal one at the level of market price set by the
industry and firms have to choose that level of output which yields maximum profit. Let us
continue our example on page 126 in which demand and supply schedules for the industry
were as follows :

Table – 3 : Equilibrium price for industry
Price Demand Supply

(Rs.) (units) (units)
1 60 5
2 35 35
3 20 45
4 15 55
5 10 65
Equilibrium price for the industry thus fixed through the interaction of the demand and supply
is Rs. 2 per unit. The individual firms will accept Rs. 2 per unit as the price and sell different
quantities at this price. Let us consider the case of firm ‘X’. Firm X’s quantity sold, total revenue,
average revenue and marginal revenue are given in Table 4 :
Table – 4 : Trends of Revenue for the Firm
Price Quantity Total Average Marginal

(Rs.) Sold Revenue Revenue Revenue
2 8 16 2 2
2 10 20 2 2
2 12 24 2 2
2 14 28 2 2
2 16 32 2 2
Firm X’s price, average revenue and marginal revenue are equal to Rs. 2. Thus we see that in a
perfectly competitive market a firm’s AR = MR = price.
Conditions for equilibrium of a firm : As discussed earlier, a firm in order to attain the
equilibrium position has to satisfy two conditions :
(i) The marginal revenue should be equal to the marginal cost. i.e. MR = MC. If MR is greater
than MC, there is always an incentive for the firm to expand its production further and
gain by sale of additional units. If MR is less than MC, the firm will have to reduce output
since an additional unit adds more to cost than to revenue. Profits are maximum only at
the point where MR = MC.
(ii) The MC curve should cut MR curve from below. In other words, MC should have positive
slope.

Y MARKET (INDUSTRY) Y FIRM

D
MC
PRICE
S
E P T R AR = MR
P
D
S
O O
X
QUANTITY Q1 OUTPUT Q2 X
Fig. 9 : Equilibrium position for a firm under perfect competition
In figure 9, DD and SS are the industry demand and supply curves which equilibrate at E to
set the market price as OP. The firms of perfectly competitive industry adopt OP price as given
and considers P-Line as demand (average revenue) curve which is perfectly elastic at P. As all
the units are priced at the same level, MR is a horizontal line equal to AR line. Note that MC
curve cuts MR curve at two places T and R respectively. But at T, the MC curve is cutting MR
curve from above. T is not the point of equilibrium as the second condition is not satisfied. The
firm will benefit if it goes beyond T as the additional cost of producing additional unit is falling.
At R, the MC curve is cutting MR curve from below. Hence R is the point of equilibrium and
OQ2 is equilibrium level of output.
3.0.2 Supply curve of the firm in a competitive market : One interesting thing about the MC
curve of the firm in a perfectly competitive industry is that it depicts the firm’s supply curve.
This can be shown with the help of the following example.
Y S
Y MC
P4 = 5.00 5.00
PRICE
D4
P3 = 4.00 4.00
PRICE
D3
P2 = 3.00 AVC
3.00
D2
2.00
P1 = 2.00
D1 S
O Q1 Q2 Q3 Q4 X
O X
Q1 Q2 Q3 Q4 OUTPUT
OUTPUT
Fig. 10 : Marginal cost and supply curves for a price-taking firm

Suppose market price of a product is Rs. 2 corresponding to it we have D1 as demand curve for
the firm. At price Rs. 2, the firm supplies Q1 output because here MR=MC. If the market price
is Rs. 3, the corresponding demand curve is D2. At Rs. 3, the quantity supplied is Q2. Similarly,
we have demand curves at D3 and D4 and corresponding supplies are Q3 and Q4. The firm’s
marginal cost curve which gives the marginal cost corresponding to each level of output is
nothing but firm’s supply curve that gives the quantity the firm will supply at each price.
For prices below AVC, the firm will supply zero units because here the firm is unable to meet
even its variable cost for prices above AVC the firm will equate price and marginal cost.
When price is just meeting the AVC, the firm will break-even (Rs. 2 here). Here it is just meeting
its average variable costs and there are no profits or losses.
Thus in perfect competition the firm’s marginal cost curve above AVC has the identical shape
of the firm’s supply curve.
3.0.3 Can the the competitive firm earn profits? In the short run, a firm will attain equilibrium
position and at the same time it will earn supernormal profits, normal profits or losses depending
upon its cost conditions.
Supernormal Profits : There is a difference between normal profits and supernormal profits.
When the average revenue of a firm is just equal to its average total cost, it earns normal
profits. It is to be noted that here a normal percentage of profits for the entrepreneur for his
managerial services is already included in the cost of production. When a firm earns supernormal
profits its average revenues are more than its average total cost. Thus, in additional to normal
rate of profit, the firm earns additional profits. The following example will make the above
concepts clear :
Suppose the cost of producing 1,000 units of a product by a firm is Rs. 15,000. The entrepreneur
has invested Rs. 50,000 in the business and normal rate of return in the market is 10 per cent. Thus
the entrepreneur must earn at least Rs.5,000 (10% of 50,000) in this particular business. This Rs.
5,000 will be shown as a part of cost. Thus total cost of production is Rs. 20,000
(Rs. 15,000 + 5,000). If the firm is selling the product at Rs.20, it is earning normal profits because
AR (Rs. 20) is equal to ATC (Rs. 20). If the firm is selling the product at Rs. 22 per unit, its AR (Rs.
22) is greater than its ATC (Rs. 20) and it is earning supernormal profit at the rate of Rs. 2 per unit.
Y
MC
ATC
PRICE
E AR = MR = P
P
PROFIT
A B
O X
Q QUANTITY
Fig. 11 : Short run equilibrium : Supernormal profit of a competitive firm

The Figure 11 shows how a firm can earn supernormal profit in the short run.
The diagram shows that in order to attain equilibrium, the firm tries to equate marginal revenue
with marginal cost. MR (marginal revenue) curve is a horizontal line and MC (marginal cost)
curve is a U-shaped curve which cuts the MR curve at E. At E, MR = MC. OQ is the equilibrium
output for the firm. The firm’s profit per unit is EB (AR-ATC), AR is EQ and ATC is BQ. Total
profits are ABEP.
Normal profits : When the firm just meets its average total cost, it earns normal profits. Here
AR = ATC.
Y
MC
PRICE
ATC
E P = AR = MR
P
O X
Q OUTPUT
Fig. 12 : Short run equilibrium of a competitive firm : Normal profits
The figure shows that MR = MC at E. The equilibrium output is OQ. Since here AR=ATC or
OP = EQ, the firm is just earning normal profits.
Losses : The firm can be in an equilibrium position and still makes losses. This is the position
when the firm is minimising losses. When the firm is able to meet its variable cost and a part of
fixed cost it will try to continue production in the short run. If it recovers a part of the fixed
costs, it will be beneficial for it to continue production because fixed costs (such as costs towards
plant and machinery, building etc.) are already incurred and in such a case it will be able to
recover a part of them. But if a firm is unable to meet its average variable cost also, it will be
better for it to shut down.

Y
MC
ATC
PRICE
B
A
LOSSES
P E P = AR = MR
O X
Q OUTPUT
Fig. 13 : Short run equilibrium of a competitive firm : Losses
In figure 13, E is the equilibrium point and at this point AR = EQ and AC = BQ since BQ>EQ,
firm is earning BE per unit loss and total loss is ABEP.
3.0.4 Long Run Equilibrium of the Firm : In the long run firms are in equilibrium when they
have adjusted their plant so as to produce at the minimum point of their long run AC curve,
which is tangent to the demand curve defined by the market price. In the long run the firms
will be earning just normal profits, which are included in the AC. If they are making
supernormal profits in the short run, new firms will be attracted in the industry; this will lead
to a fall in price (a down ward shift in the individual demand curves) and an upward shift of
the cost curves due to the increase of the prices of factors as the industry expands. These
changes will continue until the AC is tangent to the demand curve. If the firms make losses in
the short run they will leave the industry in the long run. This will raise the price and costs
may fall as the industry contracts, until the remaining firms in the industry cover their total
costs inclusive of the normal rate of profit.
In Fig. 14, we show how firms adjust to their long run equilibrium position. If the price is OP,
the firm is making super-normal profits working with the plant whose cost is denoted by
SAC1. It will, therefore, have an incentive to build new capacity and it will move along its
LAC. At the same time new firms will be entering the industry attracted by the excess profits.
As the quantity supplied in the market increases, the supply curve in the market will shift to
the right and price will fall until it reaches the level of OP1 (in figure 14a) at which the firms
and the industry are in long run equilibrium.

Y FIRM
COST & REVENUE

Y INDUSTRY
LMC S
PRICE
LAC
SMC1 SAC1 D S1
P P
C SAC
SM
P1 P1
S D
S1
O X O Q Q1 X
OUTPUT
QUANTITY DEMANDED
& SUPPLIED
(a) (b)
Fig. 14 : Long run equilibrium of the firm in a perfectly competitive market
The condition for the long run equilibrium of the firm is that the marginal cost be equal to the
price and the long run average cost
i.e. LMC = LAC = P
The firm adjusts its plant size so as to produce that level of output at which the LAC is the
minimum possible. 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. Thus in the long run
we have,
SMC = LMC = SAC = LAC = P = MR
This implies that at the minimum point of the LAC the corresponding (short run) plant is
worked at its optimal capacity, so that the minima of the LAC and SAC coincide. On the other
hand, the LMC cuts the LAC at its minimum point and the SMC cuts the SAC at its minimum
point. Thus at the minimum point of the LAC the above equality is achieved.
3.0.5 Long run equilibrium of the industry : When (i) all the firms are earning normal profits
only i.e. all the firms are in equilibrium (ii) there is no further entry or exit from the market, the
industry is said to have attained long run equilibrium.

Y Y FIRM
INDUSTRY
COST/REVENUE
D S LMC
PRICE
SMC LAC
E1 SAC
P P
P = AR = MR
S D
O X O X
Q M OUTPUT
QUANTITY
Fig. 15 : Long run equilibrium of a competitive industry and its firms
Figure 15 shows that in the long-run AR = MR = LAC = LMC at E1. Since E1 is the minimum
point of LAC curve, the firm produces equilibrium output OM at the minimum (optimum)
cost. The firm producing output at optimum cost is called an optimum firm. All the firms in the
perfect competition in long run are optimum firms having optimum size and these firms charge
minimum possible price which just covers their marginal cost.
Thus in the long run, in perfect competition, the market mechanism heads to an optimal
allocation of resources. The optimality is shown by the following conditions which in the long
run equilibrium of the industry :
a. The output is produced at the minimum feasible cost.
b. Consumers pay the minimum possible price which just covers the marginal cost i.e. MC =
AR.
c. Plants are used at full capacity in the long run, so that there is no wastage of resources i.e.
MC = AC.
d. Firms earn only normal profits i.e. AC = AR.
e. Firms maximize profits (i.e. MC=MR) but the level of profits will be just normal.
In other words, in the long run,
LAR = LMR = P = LMC = LAC and there will be optimum allocation of resources.
But it should be remembered that the perfectly competitive market system is a myth. This is
because the assumptions on which this system is based are never found in the real world
market conditions.
3.1 MONOPOLY
The word ‘Monopoly’ means “alone to sell”. Thus monopoly is a situation in which there is a
single seller of a product which has no close substitute. Pure monopoly is never found in practice.
However, in public utilities such as transport, water and electricity, we generally find monopoly
form of market.

3.1.0 Features of Monopoly Market : The following are the major features of the monopoly
market :
(1) Single seller of the product : In a monopoly market there is only one firm producing or
supplying a product. This single firm constitutes the industry and as such there is no
distinction between the firm and the industry in a monopolistic market.
(2) Restrictions to Entry : In a monopolistic market, there are strong barriers to entry. The
barriers to entry could be economic, institutional, legal or artificial.
(3) No close-substitutes : The monopolist generally sells a product which has no close
substitutes. In such a case, the cross elasticity of demand for the monopolist’s product and
any other product is zero or very small. The price elasticity of demand for monopolist’s
product is also less than one. As a result, the monopolist faces a downward sloping demand
curve.
While to some extent all goods are substitutes for one other, there may be essential characteristics
in a good or group of goods which give rise to gaps in the chain of substitution. If one producer
can so exclude competition that he controls the supply of a good, he can be said to be ‘monopolist’
– a single seller.
The monopolist may use his monopolistic power in any manner in order to realize maximum
revenue. He may also adopt price discrimination.
In real life, there is seldom complete monopoly. But one producer may dominate the supply of
a good or group of goods. In public utilities, e.g. transport, water, electricity generation etc.
monopolistic markets may exist so as to reap the benefit of large scale production.
3.1.1 Monopolist’s Revenue Curves : Since the monopolist firm is assumed to be the only
producer of a particular product, its demand curve is identical with the market demand curve
for the product. The market demand curve, which exhibits the total quantity of a product that
buyers will offer to buy at each price, also shows the quantity that the monopolist will be able
to sell at every price that he sets. If we assume that the monopolist sets a single price and
supplies all buyers who wish to purchase at that price, we can easily find his average revenue
and marginal revenue curves.
Y
PRICE
MR D = AR
O X
QUANTITY
Fig. 16 : A monopolist’s demand curve and marginal revenue curve

Suppose the straight line in Fig. 16 is the market demand curve for a particular product ‘A’.
Suppose Mr. X and Co. is the single producer of the product A so that it faces the entire market
demand and hence the downward sloping demand curve.
We have tabulated selected values of price and quantity from this demand curve in Table 5 and
computed the amounts of average, total and marginal revenue corresponding to these levels.
Table – 5
Average revenue, Total revenue and Marginal revenue for a Monopolist
Quantity Average Revenue Total Revenue Marginal Revenue

sold (AR = P) (TR) (MR)
0 10.00 0
1 9.50 9.50 9.50
2 9.00 18.00 8.50
3 8.50 25.50 7.50
4 8.00 32.00 6.50
5 7.50 37.50 5.50
6 7.00 42.00 4.50
7 6.50 45.50 3.50
8 6.00 48.00 2.50
9 5.50 49.50 1.50
10 5.00 50.00 .50
11 4.50 49.50 (-).50
If the seller wishes to charge Rs. 10, he cannot sell any unit, alternatively, if he wishes to sell 10
units, his price cannot be higher than Rs. 5. Because the seller charges a single price for all units
he sells, average revenue per unit is identical with price, and thus the market demand curve is
the average revenue for the monopolist.
In perfect competition, average and marginal revenue are identical, but this is not the case in a
monopoly since the monopolist knows that if he wishes to increase his sales he will have to
reduce the price of the product. Consider the example given. If the seller wishes to sell 3 units,
he will have to reduce the price from Rs. 9 to Rs. 8.50. The third unit is sold for Rs. 8.50 only -
the price of all 3 units. This adds Rs. 8.50 to the firm’s revenue. But in order to sell the 3rd unit,
the firm had to lower its price from Rs. 9 to Rs. 8.50. It thus receives Re.50 less on each of
2 units it could have sold for Rs. 9. The marginal revenue over the interval from 2 to 3 units is
thus Rs. 7.50 only. Again if he wishes to sell 4 units, he will again reduce the price from Rs.
8.50 to 8. The marginal revenue here will be Rs. 6.50 only. Marginal revenue is less than the
price, because the firm had to lower the price in order to sell an extra unit. The relationship
between AR and MR of a monopoly firm can be stated as follows :

(i) AR and MR are both negative sloped (downward sloping) curves.

(ii) MR curve lies half-way between the AR curve and the Y axis. i.e. it cuts the horizontal line
between Y axis and AR into two equal parts.
(iii) AR cannot be zero, but MR can be zero or even negative.
3.1.2 Profit maximisation in a monopolised market Equilibrium of the monopoly firm :
Firms in a perfectly competitive market are price-takers so that they are only concerned about
determination of output. But this is not the case with a monopolist. A monopolist has to determine
not only output but also price for his product. Since, he faces a downward sloping demand
curve, if he raises price of his product his sales will go down. On the other hand, if he wants to
improve his sales volume he will have to be content with lesser price. He will try to reach that
level of output at which profits are maximum i.e. he will try to attain the equilibrium level of
output. How he attains this level can be found out as is shown below.
Short run Equilibrium
Conditions for the equilibrium : The twin conditions for equilibrium in a monopoly market
are same as discussed earlier.
(i) MC = MR
(ii) MC curve must cut MR curve from below.
Graphically, we can depict these conditions in figure 17.
Y
MC
COST & REVENUE
AR
O X
Q OUTPUT
MR
Fig. 17 : Equilibrium position of a monopolist (Short run)
The figure shows that MC curve cuts MR curve at E. That means at E, equilibrium price is OP
and equilibrium output is OQ.
In order to know whether the monopolist is making profits or losses in the short run, we need
to introduce average total cost curve. The following figure shows how the firm makes profits
in the short run.

Y
COST/REVENUE
MC AC
A
P
PROFIT
B
C
E
AR
MR
O Q OUTPUT X
Fig. 18 : Firm’s equilibrium under monopoly : maximisation of profits
Figure 18 shows that MC cuts MR at E to give equilibrium output as OQ. At OQ, price charged
is OP (we find this by extending line EQ till it touches AR or demand curve). Also at OQ, the
cost per unit is BQ. Therefore, profit per unit is AB or total profit is ABCP.
Can a monopolist incur losses? One of the misconceptions about a monopolist is that he always
makes profits. It is to be noted that nothing guarantees that a monopolist makes profits. It all
depends upon his demand and cost conditions. If he faces a very low demand for his product
and his cost conditions are such that ATC >AR, he will not be making profits but incur losses.
Figure 19 depicts this position.
Y
COST/REVENUE
SMC SAC
C A
P B
E AR
O Q OUTPUT X
MR
Fig. 19 : Equilibrium of the monopolist : Losses in the short run
In the above figure MC cuts MR at E. Here E is the point of loss minimisation. At E, equilibrium
output is OQ and equilibrium price is OP. Cost corresponding to OQ is QA. Cost per unit of
output i.e. QA is greater than revenue per unit which is BQ. Thus the monopolist incurs losses

to the extent of AB per unit or total loss is ABPC. Whether the monopolist stays in business in
the short run depends upon whether he meets his average variable cost or not. If he covers
average variable cost and at least a part of fixed cost, he will not shut down because he contributes
something towards fixed costs which are already incurred. If he is unable to meet his average
variable cost even, he will shut down.
Long Run Equilibrium : Long run is a period long enough to allow the monopolist to adjust his
plant size or use his existing plant at any level that maximizes his profit. In the absence of
competition, the monopolist need not produce at the optimal level. He can produce at sub-
optimal scale also. In other words, he need not reach the minimum of LAC curve, he can stop
at any place where his profits are maximum.
Y
MC
PRICE
ATC
A
P
PROFITS B
C
D = AR
E
O Q X
MR OUTPUT
Fig. 20 : Long run equilibrium of a monopolist
However, one thing is certain : The monopolist will not continue if he makes losses in the long
run. He will continue to make super normal profits even in the long run as entry of outside
firms is blocked.
3.1.3 Price Discrimination : Consider the following examples.
The family doctor in your neighbourhood charges a higher fees from a rich patient compared
to the fees charged from a poor patient even though both are suffering from viral fever. Why?
Electricity companies sell electricity at a cheaper rate for home consumption in rural areas
than for industrial use. Why?
The above cases are examples of price discrimination. What is price discrimination? Price
discrimination occurs when a producer sells a specific commodity or service to different buyers
at two or more different prices for reasons not associated with differences in cost.
Price discrimination is a method of pricing adopted by the monopolist in order to earn abnormal
profit. It refers to the practices of charging different prices for the different unit of the same
commodity.
Further examples :
(a) Railways separate high-value or relatively small-bulk commodities which can bear higher
freight charges from other categories of goods.

(b) Some countries dump goods at low prices in foreign markets to capture them.
(c) Some universities charge higher tuition fees from evening class students than from other
scholars.
(d) A lower subscription is charged from student readers in case of certain journals.
(e) A higher price for vegetables may be charged in posh localities inhabited by the rich than
in other localities.
Price discrimination cannot persist under perfect competition because the seller has no influence
over market determined rate. Price discrimination requires an element of monopoly so that the
seller can influence the price of his product.
Conditions for price discrimination : Price discrimination is possible only under the following
conditions :
(i) The seller should have some control over the supply of his product i.e. monopoly power in
some form is necessary (not sufficient) to discriminate price.
(ii) The seller should be able to divide his market into two or more sub-markets.
(iii) The price-elasticity of the product should be different in different markets. The monopolist
fixes up a high price for his product for those buyers whose price elasticity of demand for
the product is less than one. This implies that when the monopolist charges a higher price
from them, they do not significantly reduce their purchases in response to high price.
(iv) It should not be possible for the buyers of low-priced market to resell the product to the
buyers of high-priced market.
Thus we note that discriminating monopolist charges a higher price from the market which
has a relatively inelastic demand. The market which is highly responsive is charged less. On
the whole, the monopolist benefits from both the markets.
A numerical example will help you to understand price- discrimination more clearly.
Suppose the single monopoly price is Rs. 30 and elasticities of demand in markets A and B are
respectively 2 and 5. Then,
⎛ e -1⎞
MR in market A = AR A ⎜ ⎟
⎝ e ⎠
⎛ 2 -1⎞
= 30 ⎜ ⎟
⎝ 2 ⎠
= 15
⎛ e -1⎞
MR in market B = AR B ⎜ ⎟
⎝ e ⎠

⎛ 5 -1⎞
= 30 ⎜ ⎟
⎝ 5 ⎠
= 24
It is thus clear that marginal revenues in the two markets are different when elasticities of
demand at the single price are different. Further, we see that marginal revenue in the market
in which elasticity is high is greater than the marginal revenue in the market where elasticity is
low. Now it is profitable for the monopolist to transfer some amount of the product from
market A where elasticity is less and therefore marginal revenue is low to market B where
elasticity is high and marginal revenue is large. Thus, when the monopolist transfers one unit
from A to B, the loss in revenue (Rs. 15) will be more than compensated by gain in revenue
(Rs. 24). On the whole, the gain in revenue will be Rs. 9 (24-15) here. It is to be noted that when
some units are transferred from A to B, price in market A will rise and it will fall in B. This
means that the monopolist is now discriminating between markets A and B. Again it is to be
noted that there is a limit to which units can be transferred from A to B. Once this limit is
reached and once a point is reached when the marginal revenues in the two markets become
equal as a result of some transfer of output, it will no longer be profitable to shift more output
from market A to market B. When this point of a equality is reached, the monopolist will be
charging different prices in the two markets – a higher price in market A with lower elasticity
of demand and a lower price in market B with higher elasticity of demand.
Objectives of Price discrimination:
a. to earn maximum profit
b. to dispose of surplus stock
c. to enjoy the economies of scale
d. to capture foreign markets
e. to secure equity through pricing.
Price discrimination may take place beacause of personal, local, income, size of the purchase,
time of purchase and age of the consumers reasons.
Price discrimination may be related to the consumer surplus enjoyed by the consumers. Prof.
Pigou classified three degrees of price discrimination. Under the first degree price discrimination
the monopolist will fix a price which will take away the entire consumer’s surplus. Under the
second degree price discrimination he will take away only a part of the consumers’ surplus.
Here price varies according to the quantity sold. Larger quantities are available at lower unit
price. Under third degree price discrimination, price varies by attributes such as location or by
customer segment. Here the monopolist will divide the consumers into separate sub markets
and charge different prices in different sub-markets. E.g. Dumping.
Equilibrium under price discrimination
Under simple monopoly, a single price is charged for the whole output; but under price
discrimination the monopolist will charge different prices in different sub-markets. First of all,
therefore, the monopolist has to divide his total market into various sub-markets on the basis of

difference in elasticity of demand in them. For the sake of making our analysis simple we shall
explain the case when the total market is divided into two sub-markets.
In order to reach the equilibrium position, the discriminating monopolist has to take two
decisions: 1. how much total output should he produce; and 2. how the total output should be
distributed between the two sub-markets and what prices he should charge in the two sub-
markets.
The same marginal principle will guide his decision to produce a total output as that which
guides a perfect competitor or a simple monopolist. In other words, the discriminating
monopolist will compare the marginal revenue with the marginal cost of the output. But he
has to find out first the aggregate marginal revenue of the two sub-markets taken together and
compare this aggregate marginal revenue with marginal cost of the total output. Aggregate
marginal revenue curve is obtained by summing up laterally the marginal revenue curves of
the sub-markets.
In figure 21, MRa is the marginal revenue curve in sub-market A corresponding to the demand
curve Da. Similarly, MRb is the marginal revenue in sub-market B corresponding to the demand
curve Db. Now, the aggregate marginal revenue curve AMR, which has been shown in figure
(iii), has been derived by adding up laterally MRa and MRb. This aggregate marginal revenue
curve depicts the total amount of output that would be sold in the two sub-markets taken
together corresponding to each value of the marginal revenue. Marginal cost curve of the
monopolist is shown by the curve MC in diagram (iii).
The discriminating monopolist will maximize his profits by producing the level of output at
which marginal cost curve MC intersects the aggregate marginal revenue curve AMR. It is
manifest from diagram (iii) that profit maximizing output is OM, for only at OM aggregate
marginal revenue is equal to the marginal cost of the whole output. Thus the discriminating
monopolist will decide to produce OM level of output.
Once the total output to be produced has been determined, the next task for the discriminating
monopolist is to distribute the total output between the two sub-markets. He will distribute the
total output OM in such a way that marginal revenues in the two sub-markets are equal.
Marginal revenues in the two-sub-markets must be equal if the profits are to be maximized. If
he is so allocating the output into two markets that the marginal revenues in the two are not
equal, then it will pay him to transfer some amount from the sub-market in which the marginal
revenue is less to the sub-market in which the marginal revenue is greater. Only when the
marginal revenues in the two markets are equal, it will be unprofitable for him to shift any
amount of the good from one market to the other.
But for the discriminating monopolist to be in equilibrium it is essential not only that the marginal
revenues in the two markets should be the same but that they should also be equal to the
marginal cost of the whole output. Equality of marginal revenues in the two markets with
marginal cost of the whole output ensures that the amount sold in the two markets will together
be equal to the whole output OM which has been fixed by equalizing aggregate marginal
revenue with marginal cost. It will be seen from figure (iii) that at equilibrium output OM,
marginal cost is ME.

Now, the output OM has to be distributed in the two markets in such a way that marginal
revenue in them should be equal to the marginal cost ME of the whole output. It is clear form
the diagram (i) that OM1 must be sold in the sub-market A, because marginal revenue M1E1 at
amount OM1 is equal to marginal cost ME. Similarly, OM2 must be sold in sub-market B, since
marginal revenue M2E2 of amount OM2 is equal to the marginal cost ME of the whole output.
To conclude, demand and cost conditions being given, the discriminating monopolist will
produce total output OM and will sell amount OM1 in sub-market A and amount OM2 in sub-
market B. It should be carefully noted that the total output OM will be equal to OM1 + OM2.
Another important thing to discover is what prices will be charged in the two markets. It is
clear from the demand curve that amount OM1 of the good can be sold at price OP1 in sub-
market A. Therefore, price OP1 will be set in sub-market A. Like wise, amount OM2 can be sold
at price OP2 in sub-market B. Therefore, price OP2 will be set in sub-market B. Further, it should
be noted that price will be higher in the market A where the demand is less elastic than in
market B where the demand is more elastic. Thus, price OP1 is greater than the price OP2.
Fig. 21: Fixation of Total Output and different price in the two sub-markets by the
discriminating monopolist
3.2 IMPERFECT COMPETITION-MONOPOLISTIC COMPETITION

Consider the market for soaps and detergents. Among the well known brands on sale are Lux,
Rexona, Hamam, Dettol, Liril, Pears, Lifebuoy Plus, Dove and so many others. Is this market
an example of perfect competition? Since all the soaps are almost similar, this appears to be an
example of perfect competition. But on a close inspection we find that each seller has at least
some variation between his product and those of his competitors. For example, whereas Lux is
exhibited to be a beauty soap, Liril is more associated with freshness. And for that reason

Dettol soap is placed as antiseptic and Dove for young smooth skin. The area of product and
service differentiation gives each seller a chance to attract business to himself on some basis
other than price. This is the monopolistic part of market situation. Thus this market contains
features of both the markets discussed earlier – monopoly and perfect competition. In fact, this
type of market is more common than pure competition or pure monopoly. The industries in
monopolistic competition include clothing manufacturing and retail trade in large cities. There
are many hundreds of manufacturers of women’s dresses, and hundreds of grocery shops in
average medium sized or large city.
3.2.0 Features of Monopolistic Competition :
(i) Large number of sellers : In a monopolistically competitive market, there are a large number
of sellers who individually have a small share in the market.
(ii) Product differentiation : In a monopolistic competitive market, the products of different
sellers are differentiated on the basis of brands. These brands are generally so much
advertised that a consumer starts associating the brand with a particular manufacturer
and a type of brand loyalty is developed. Product differentiation gives rise to an element
of monopoly to the producer over the competing product. As such, the producer of an
individual brand can raise the price of his product knowing that he will not lose all the
customers to other brands because of absence of perfect substitutability. Since, however,
all the brands are close substitutes of one another, the seller will lose some of his customers
to his competitors. Thus this market is a blend of monopoly and perfect competition.
(iii) Freedom of entry or exit : New firms are free to enter into the market and existing firms
are free to quit it.
(iv) Non-price competition : In a monopolistically competitive market, sellers try to compete
on basis other than price, as for example aggressive advertising, product development,
better distribution arrangements, efficient after-sales service, and so on. A key base of
non-price competition is a deliberate policy of product differentiation. Sellers attempts to
promote their products not by cutting prices but by incurring high expenditure on publicity
and advertisement and other sale promoting techniques mentioned above. This is because
price competition may result in price – wars which may throw a few firms out of market.
3.2.1 Price-output determination under monopolistic competition : Equilibrium of a
firm : In a monopolistically competitive market since the product is differentiated between
firms, each firm does not face a perfectly elastic demand for its products. Each firm is a price
maker and is in a position to determine price of its own product. As such, the firm is faced with
a downward sloping demand curve for its product. Generally, the less differentiated the product
is from its competitors, the more elastic this curve will be.

Y
MC
PRICE
ATC
A
P
PROFITS B
C
D = AR
E
O Q X
MR OUTPUT
Fig. 22 : Short run equilibrium of a firm in monopolistic competition : Super-normal profits
The firm depicted in figure 22 has a downward sloping but flat demand curve for its product.
The firm is assumed to have U-shaped short run cost curve.
Conditions for the Equilibrium of an individual firm : The conditions for price-output
determination and equilibrium of an individual firm may be stated as follows :
(i) MC = MR
(ii) MC curve must cut MR curve from below.
Figure 22 shows that MC cuts MR curve at E. At E, the equilibrium price is OP and equilibrium
output is OQ. Since per unit cost is BQ, per unit super-normal profit (i.e. price-cost) is AB (or
PC) and total super-normal profit is APCB.
The firm may also be earning losses in the short run. This is shown in fig. 23.
The figure shows that per unit cost (AQ) is higher than price OP (or BQ) of the product of the
firm and loss per unit is AB (AQ-BQ). Total loss is ACPB.
What about long run equilibrium of the industry? If the firms in a monopolistically competitive
industry earn super-normal profits in the short run, there will be an incentive for new firms to
enter the industry. As more firms enter, profits per firm will go on decreasing as the total
demand for the product will be shared among a larger number of firms. This will happen till
all the profits are wiped away and all the firms earn only normal profits. Thus in the long run
all the firms will earn only normal profits.

Y
COST/REVENUE
SMC SAC
C A
P B
E AR
O Q OUTPUT X
MR
Fig. 23 : Short run equilibrium of a firm in Monopolistic Competition – With losses
Y
PRICE
MC
X ATC
P1
P2 R
D = AR
O Q1 Q2 X
OUTPUT
MR
Fig. 24 : The long-term equilibrium of a firm in monopolistic competition
Figure 24 shows the long run equilibrium of a firm in a monopolistically competitive market.
The average revenue curve touches the average cost curve at point X corresponding to quantity
Q1 and price P1. At equilibrium (i.e. MC = MR) profits are zero, since average revenue equals
average costs. All firms are earning zero supernormal profits or just normal profits.
In case of losses in the short run, the loss making firms will exit from the market and this will
go on till the remaining firms make normal profits only.
It is to be noted that an individual firm in the long run is in equilibrium position at a position
where it has excess capacity. That is, it is producing a lower quantity than its full capacity
level. The firm in Figure 24 could expand its output from Q1 to Q2 and reduce average costs.
But it does not do so because to do so would be to reduce average revenue even more than
average costs. It implies that firms in monopolistic competition are not of optimum size and
there exists excess capacity (Q1 Q2 in our example above) of production with each firm.

3.3 OLIGOPOLY
We have studied price and output determination under three market forms, namely, perfect
competition, monopoly and monopolistic competition. However, in the real world economies
we find that many of the industries are oligopolistic. Oligopoly is an important form of imperfect
competition. Oligopoly is often described as ‘competition among the few’. In other words,
when there are few (two to ten) sellers in a market selling homogeneous or differentiated
products, oligopoly is said to exist. Consider the example of cold drinks industry or automobile
industry. Prof. Stigler defines oligopoly as that “situation in which a firm bases its market
policy in part on the expected behavior of a few close rivals”. There are a handful firms
manufacturing cold drinks in India. Similarly there are a few members of automobile industry
in India. These industries exhibit some special features which are discussed in the following
paragraphs.
Types of Oligopoly:
Pure oligopoly or perfect oligopoly occures when the product dealt is homogeneous in nature,
e.g. Aluminum industry. Differentiated or imperfect oligopoly is based on product
differentiation, e.g. Talcum powder.
Open and closed oligopoly: In the open oligopoly new firms can enter the market and compete
with the existing firms. But in closed oligopoly entry is restricted.
Collusive and Competitive oligopoly: When few firms of the oligopolist market come to a
common understanding or act in collusion with each other in fixing price and output, it is
collusive oligopoly. When there is a lack of understanding between the firms and they compete
with each other it is called competitive oligopoly.
Partial or full oligopoly: Oligopoly is partial when the industry is dominated by one large firm
which is considered or looked upon as the leader of the group. The dominating firm will be the
price leader. In full oligopoly, the market will be conspicuous by the absence of price leadership.
Syndicated and organized oligopoly: Syndicated oligopoly refers to that situation where the
firms sell their products through a centralized syndicate. Organized oligopoly refers to the
situation where the firms organize themselves into a central association for fixing prices, output,
quotas, etc.
3.3.0 Characteristics of Oligopoly Market :
(i) Interdependence : The most important feature of oligopoly is interdependence in decision-
making of the few firms which comprise the industry. This is because when the number of
competitors is few, any change in price, output, product, by a firm will have direct effect
on the fortune of the rivals, who will then retaliate in changing their own prices, output or
advertising technique as the case may be. It is, therefore, clear that an oligopolistic firm
must consider not only the market demand for the industry product but also the reactions
of other firms in the industry to any major decision it takes.
(ii) Importance of advertising and selling costs : A direct effect of interdependence of
oligopolists is that the various firms have to employ various aggressive and defensive
marketing weapons to gain a greater share in the market or to maintain their share. For

this various firms have to incur a good deal of costs on advertising and other measures of
sales promotion. Therefore, there is a great importance of advertising and selling costs in
an oligopoly market. It is to be noted that firms in such type of market avoid price cutting
and try to compete on non-price basis because if they start under cutting one another a
type of price-war will emerge which will drive a few of them out of the market as customers
will try to buy from the seller selling at the cheapest price.
(iii) Group behaviour : The theory of oligopoly is a theory of group behaviour, not of mass or
individual behaviour and to assume profit maximising behaviour on oligopolist’s part
may not be very valid. There is no generally accepted theory of group behaviour. Do the
members of a group agree to pull together in promotion of common interest or will they
fight to promote their individual interests? Does the group possess any leader? If so, how
does he get the others to follow him? These are some of the questions that need to be
answered by the theory of group behaviour. But one thing is certain. Each oligopolist
closely watches the business behaviour of the other oligopolists in the industry and designs
his moves on the basis of some assumptions of how they behave or likely to behave.
3.3.1 Price and output decisions in an oligopolistic market : Because of interdependence an
oligopolistic firm cannot assume that its rival firms will keep their prices and quantities constant,
when it makes changes in its price and/or quantity. When an oligopolistic firm changes its
price, its rival firms will retaliate or react and change their prices which in turn would affect
the demand of the former firm. Therefore, an oligopolistic firm cannot have sure and definite
demand curve, since it keeps shifting as the rivals change their prices in reaction to the price
changes made by it. Now when an oligopolist does not know his demand curve, what price
and output he will fix cannot be ascertained by economic analysis. However, economists have
established a number of price-output models for oligopoly market depending upon the behaviour
pattern of the members of the group.
3.3.2 Kinked Demand Curve : It has been observed that in many oligopolistic industries prices
remain sticky or inflexible for a long time. They tend to change infrequently, even in the face of
declining costs. Many explanations have been given for this price rigidity under oligopoly and
the most popular explanation is kinked demand curve hypothesis given by an American
economist Sweezy. Hence this is called Sweezy’s Model.
The demand curve facing an oligopolist, according to the kinked demand curve hypothesis,
has a ‘kink’ at the level of the prevailing price. The kink is formed at the prevailing price level.
It is because the segment of the demand curve above the prevailing price level is highly elastic
and the segment of the demand curve below the prevailing price level is inelastic. A kinked
demand curve dD with a kink at point P has been shown in Fig. 25.

Y d
P
P
PRICE D
O M OUTPUT X
Fig. 25 : Kinked Demand Curve under oligopoly
The prevailing price level is MP and the firm produces and sells output OM. Now the upper
segment dP of the demand curve dD is relatively elastic and lower segment PD is relatively
inelastic. This difference in elasticities is due to the particular competitive reaction pattern
assumed by the kinky demand curve hypothesis. This assumed pattern is :
Each oligopolist believes that if he lowers the price below the prevailing level its competitors
will follow him and will accordingly lower prices, whereas if he raises the price above the
prevailing level, its competitors will not follow its increase in price.
This is because when an oligopolist lowers the price of its product its competitors will feel that
if they do not follow the price cut their customers will run away and buy from the firm which
has lowered the price. Thus in order to maintain their customers they will also lower their
prices. Thus the lower portion of the demand curve PD is price inelastic showing that very
little increase in sales can be obtained by a reduction in price by an oligopolist. On the other
hand, if a firm increases the price of its product there will a substantial reduction in its sales
because as a result of the rise in its price, its customers will withdraw from it and go to its
competitors which will welcome the new customers and will gain in sales. These happy
competitors will have therefore no motivation to match the price rise. The oligopolist who
raises its price will lose a great deal and will therefore refrain from increasing price. This
behaviour of the oligopolists explains the elastic upper portion of the demand curve dp showing
a large fall in sales if a producer raises his price.
Each oligopolist will, thus, adhere to the prevailing price seeing no gain in changing it and a
kink will be formed at the prevailing price. Thus, rigid or sticky prices are explained according
to the kinked demand curve theory.

SUMMARY
The features of the various types of market forms are summarised in the table given below :
Classification of Market Forms
Form of Market Number of Nature Price Elasticity Degree of

Structure firms of product of Demand Control over
of a firm price
(a) Perfect A large number Homogeneous Infinite None
competition of firms
(b) Monopoly One Unique product Small Very
without close Considerable
substitute
(c) Imperfect
Competition
(i) Monopolistic A large number Differentiated Large Some
Competition of firms products
(ii) Oligopoly Few Firms Homogeneous or Small Some
differentiated
product
Perfect Competition, as evident from the above table is said to prevail where there is a large
number of firms producing a homogeneous product. No individual firm is in a position to
influence the price of the product and therefore the demand curve facing it will be a horizontal
straight line at the prevailing market price. Short run equilibrium price of the firm is at a point
where MC = MR of the firm. In the short run firms may be earning supernormal profits and
some firms may be earning losses at the equilibrium price. In the long-run all the supernormal
profits or losses get wiped away with entry or exit of the firms from the industry and all the
firms earn normal profits.
Monopoly is an extreme form of imperfect competition with a single seller of a product which
has no close substitutes. As such, a monopolist has considerable control over the price of his
product. Short run equilibrium of the monopolist is at a point where MC = MR. In the long run
he may continue to have super normal profits.
Monopoly control over the product gives rise to price-discrimination (i.e. charging different
prices for the same product from different consumers).
Imperfect Competition is an important category wherein the individual firm exercises control
over the price to a smaller or larger degree depending upon the degree of imperfection present.
The first important and popular category of imperfect competition is monopolistic competition.
In this type of market, there are a large number of monopolists competing with one another.
Demand curve is highly elastic and a firm enjoys some control over the price. The other category
is that of oligopoly in which there is competition among the few firms producing homogeneous
or differentiated products. The limited number of firms ensures that each of them will have to
consider the group reaction to any action it takes.


1. In the table below what will be equilibrium market price?
Price (Rs.) Demand (tonnes per annum) Supply (tonnes per annum)
1 1000 400
2 900 500
3 800 600
4 700 700
5 600 800
6 500 900
7 400 1000
8 300 1100
(a) Rs. 2
(b) Rs. 3
(c) Rs. 4
(d) Rs. 5
2. Assume that when price is Rs. 20, quantity demanded is 9 units, and when price is Rs. 19,
quantity demanded is 10 units. Based on this information, what is the marginal revenue
resulting from an increase in output from 9 units to 10 units.
(a) Rs. 20
(b) Rs. 19
(c) Rs. 10
(d) Re. 1
3. Assume that when price is Rs.20, quantity demanded is 15 units, and when price is Rs.18,
quantity demanded is 16 units. Based on this information, what is the marginal revenue
resulting from an increase in output from 15 units to 16 units?
(a) Rs. 18
(b) Rs. 16
(c) Rs. 12
(d) Rs. 28
4. Suppose a firm is producing a level of output such that MR > MC. What should be firm do
to maximize its profits?
(a) The firm should do nothing.
(b) The firm should hire less labour.

(c) The firm should increase price.
(d) The firm should increase output.
5. Marginal Revenue is equal to :
(a) the change in price divided by the change in output.
(b) the change in quantity divided by the change in price.
(c) the change in P x Q due to a one unit change in output.
(d) price, but only if the firm is a price searcher.
6. Suppose that a sole proprietorship is earning total revenues of Rs. 1,00,000 and is incurring
explicit costs of Rs. 75,000. If the owner could work for another company for Rs. 30,000 a
year, we would conclude that :
(a) the firm is incurring an economic loss.
(b) implicit costs are Rs. 25,000.
(c) the total economic costs are Rs. 1,00,000.
(d) the individual is earning an economic profit of Rs. 25,000.
7. Which of the following is not an essential condition of pure competition?
(a) Large number of buyers and sellers
(b) Homogeneous product
(c) Freedom of entry
(d) Absence of transport cost
8. What is the shape of the demand curve faced by a firm under perfect competition?
(a) Horizontal
(b) Vertical
(c) Positively sloped
(d) Negatively sloped
9. Which is the first order condition for the profit of a firm to be maximum?
(a) AC = MR
(b) MC = MR
(c) MR = AR
(d) AC = AR
10. Which of the following is not a characteristic of a “price taker”?
(a) TR = P x Q
(b) AR = Price

(c) Negatively – sloped demand curve

(d) Marginal Revenue = Price
11. Which of the following statements is false?
(a) Economic costs include the opportunity costs of the resources owned by the firm.
(b) Accounting costs include only explicit costs.
(c) Economic profit will always be less than accounting profit if resources owned and
used by the firm have any opportunity costs.
(d) Accounting profit is equal to total revenue less implicit costs.
12. With a given supply curve, a decrease in demand causes
(a) an overall decrease in price but an increase in equilibrium quantity.
(b) an overall increase in price but a decrease in equilibrium quantity.
(c) an overall decrease in price and a decrease in equilibrium quantity.
(d) no change in overall price but a reduction in equilibrium quantity.
13. It is assumed in economic theory that
(a) decision making within the firm is usually undertaken by managers, but never by the
owners.
(b) the ultimate goal of the firm is to maximise profits, regardless of firm size or type of
business organisation.
(c) as the firm’s size increases, so do its goals.
(d) the basic decision making unit of any firm is its owners.
14. Assume that consumers’ incomes and the number of sellers in the market for good A
both decrease. Based upon this information we can conclude, with certainty, that
equilibrium :
(a) price will increase.
(b) price will decrease.
(c) quantity will increase.
(d) quantity will decrease.
15. Suppose that the supply of cameras increases due to an increase in foreign imports. Which
of the following will most likely occur?
(a) the equilibrium price of cameras will increase.
(b) the equilibrium quantity of cameras exchanged will decrease.
(c) the equilibrium price of camera film will decrease.

(d) the equilibrium quantity of camera film exchanged will increase.
16. Assume that in the market for good Z there is a simultaneous increase in demand and the
quantity supplied. The result will be :
(a) an increase in equilibrium price and quantity.
(b) a decrease in equilibrium price and quantity.
(c) an increase in equilibrium quantity and uncertain effect on equilibrium price.
(d) a decrease in equilibrium price and increase in equilibrium quantity.
17. Suppose the technology for producing personal computers improves and, at the same
time, individuals discover new uses for personal computers so that there is greater utilisation
of personal computers. Which of the following will happen to equilibrium price and
equilibrium quantity?
(a) Price will increase; quantity cannot be determined.
(b) Price will decrease; quantity cannot be determined.
(c) Quantity will increase; price cannot be determined.
(d) Quantity will decrease; price cannot be determined.
18. Which of the following is not a condition of perfect competition?
(a) A large number of firms.
(b) Perfect mobility of factors.
(c) Informative advertising to ensure that consumers have good information.
(d) Freedom of entry and exit into and out of the market.
19. Which of the following is not a characteristic of a perfectly competitive market?
(a) Large number of firms in the industry.
(b) Outputs of the firms are perfect substitutes for one another.
(c) Firms face downward-sloping demand curves.
(d) Resources are very mobile.
20. Which of the following is not a characteristic of monopolistic competition?
(a) Ease of entry into the industry.
(b) Product differentiation.
(c) A relatively large number of sellers.
(d) A homogenous product.
21. All of the following are characteristics of a monopoly except :
(a) there is a single firm.
(b) the firm is a price taker.

(c) the firm produces a unique product.

(d) the existence of some advertising.
22. Oligopolistic industries are characterized by :
(a) a few dominant firms and substantial barriers to entry.
(b) a few large firms and no entry barriers.
(c) a large number of small firms and no entry barriers.
(d) one dominant firm and low entry barriers.
23. Price-taking firms, i.e., firms that operate in a perfectly competitive market, are said to be
“small” relative to the market. Which of the following best describes this smallness?
(a) The individual firm must have fewer than 10 employees.
(b) The individual firm faces a downward-sloping demand curve.
(c) The individual firm has assets of less than Rs. 20 lakh.
(d) The individual firm is unable to affect market price through its output decisions.
24. For the price-taking firm :
(a) marginal revenue is less than price.
(b) marginal revenue is equal to price.
(c) marginal revenue is greater than price.
(d) the relationship between marginal revenue and price is indeterminate.
25. Monopolistic competition differs from perfect competition primarily because
(a) in monopolistic competition, firms can differentiate their products.
(b) in perfect competition, firms can differentiate their products.
(c) in monopolistic competition, entry into the industry is blocked.
(d) in monopolistic competition, there are relatively few barriers to entry.
26. The long-run equilibrium outcomes in monopolistic competition and perfect competition
are similar, because in both market structures
(a) the efficient output level will be produced in the long run.
(b) firms will be producing at minimum average cost.
(c) firms will only earn a normal profit.
(d) firms realise all economies of scale.
27. A monopolist is able to maximise his profits when :
(a) his output is maximum.
(b) he charges a high price.

(c) his average cost is minimum.
(d) his marginal cost is equal to marginal revenue.
28. In which form of the market structure is the degree of control over the price of its product
by a firm very large?
(a) Monopoly
(b) Imperfect Competition
(c) Oligopoly
(d) Perfect competition
29. Which is the other name that is given to the average revenue curve?
(a) Profit Curve
(b) Demand Curve
(c) Average Cost Curve
(d) Indifference Curve
30. Under which of the following forms of market structure does a firm have no control over
the price of its product?
(a) Monopoly
(b) Monopolistic competition
(c) Oligopoly
(d) Perfect competition
31. Discriminating monopoly implies that the monopolist charges different prices for his
commodity :
(a) from different groups of consumers
(b) for different uses
(c) at different places
(d) any of the above.
32. Price discrimination will be profitable only if the elasticity of demand in different market
in which the total market has been divided is :
(a) uniform
(b) different
(c) less
(d) zero
33. The Kinked demand hypothesis is designed to explain in the context of oligopoly
(a) Price and output determination

(b) Price rigidity

(c) Price leadership
(d) Collusion among rivals.
34. The firm in a perfectly competitive market is a price taker. This designation as a price taker
is based on the assumption that
(a) the firm has some, but not complete, control over its product price.
(b) there are so many buyers and sellers in the market that any individual firm cannot
affect the market.
(c) each firm produces a homogeneous product.
(d) there is easy entry into or exit from the market place.
35. Suppose that the demand curve for the XYZ Co. slopes downward and to the right. We
can conclude that
(a) the firm operates in a perfectly competitive market.
(b) the firm can sell all that it wants to at the established market price.
(c) the XYZ Co. is not a price taker in the market because it must lower price to sell
additional units of output.
(d) the XYZ Co. will not be able to maximise profits because price and revenue are subject
to change.
36. If firms in the toothpaste industry have the following market shares, which market structure
would best describe the industry?
Market share (% of market)
Toothpaste 18.7
Dentipaste 14.3
Shinibright 11.6
I can’t believe its not toothpaste 9.4
Brighter than white 8.8
Pastystuff 7.4
Others 29.8
(a) Perfect competition
(b) Monopolistic competition
(c) Oligopoly
(d) Monopoly

37. The kinked demand curve model of oligopoly assumes that
(a) response to a price increase is less than the response to a price decrease.
(b) response to a price increase is more than the response to a price decrease.
(c) elasticity of demand is constant regardless of whether price increases or decreases.
(d) elasticity of demand is perfectly elastic if price increases and perfectly inelastic if price
decreases.
38. A firm encounters its “shutdown point” when :
(a) average total cost equals price at the profit-maximising level of output.
(b) average variable cost equals price at the profit-maximising level of output.
(c) average fixed cost equals price at the profit-maximising level of output.
(d) marginal cost equals price at the profit-maximising level of output.
39. Suppose that, at the profit-maximizing level of output, a firm finds that market price is
less than average total cost, but greater than average variable cost. Which of the following
statements is correct?
(a) The firm should shutdown in order to minimise its losses.
(b) The firm should raise its price enough to cover its losses.
(c) The firm should move its resources to another industry.
(d) The firm should continue to operate in the short run in order to minimize its losses.
40. When price is less than average variable cost at the profit-maximising level of output, a
firm should :
(a) produce where marginal revenue equals marginal cost if it is operating in the short
run.
(b) produce where marginal revenue equals marginal cost if it is operating is the long
run.
(c) shutdown, since it will lose nothing in that case.
(d) shutdown, since it cannot even cover its variable costs if it stays in business.
41. A purely competitive firm’s supply schedule in the short run is determined by
(a) its average revenue.
(b) its marginal revenue.
(c) its marginal utility for money curve.
(d) its marginal cost curve.
42. One characteristic not typical of oligopolistic industry is
(a) horizontal demand curve.

(b) too much importance to non-price competition.

(c) price leadership.
(d) a small number of firms in the industry.
43. The structure of the toothpaste industry in India is best described as
(a) perfectly competitive.
(b) monopolistic.
(c) monopolistically competitive.
(d) oligopolistic.
44. The structure of the cold drink industry in India is best described as
(a) perfectly competitive.
(b) monopolistic.
(c) monopolistically competitive.
(d) oligopolistic.
(a) Even monopolistic can earn losses.
(b) Firms in a perfectly competitive market are price takers.
(c) It is always beneficial for a firm in a perfectly competitive market to discriminate
prices.
(d) Kinked demand curve is related to an oligopolistic market.
46. In perfect competition in the long run there will be no ________________ .
(a) normal profits
(b) supernormal profits.
(c) production
(d) costs.
47. When ________________________________ , we know that the firms are earning just
normal profits.
(a) AC = AR
(b) MC = MR
(c) MC = AC
(d) AR = MR
48. When ________________________________ , we know that the firms must be producing
at the minimum point of the average cost curve and so there will be productive efficiency.
(a) AC = AR

(b) MC = AC
(c) MC = MR
(d) AR = MR
49. When ______________________________ , there will be allocative efficiency meaning
thereby that the cost of the last unit is exactly equal to the price consumers are willing to
pay for it and so that the right goods are being sold to the right people at the right price.
(a) MC = MR
(b) MC = AC
(c) MC = AR
(d) AR = MR
50. Agricultural goods markets depict characteristics close to
(a) perfect competition.
(b) oligopoly.
(c) monopoly.
(d) monopolistic Competition.
51. Which of the following is not a characteristic of a competitive market?
a. There are many buyers and sellers in the market.
b. The goods offered for sales are largely the same.
c. Firms generate small but positive super normal profits in the long run.
d. Firms can freely enter or exit the market.
52. Which of the following markets would most closely satisfy the requirements for a
perfectly competitive market?
a. Electricity
b. Cable television
c. Cola
d. Milk
53. The competitive firm maximizes profit when it produces output up to the point where
a. price equals average variable cost
b. marginal revenue equals average revenue
c. marginal cost equals total revenue
d. marginal cost equals marginal revenue
54. The market for hand tools (such as hammers and screwdrivers) is dominated by
Draper, Stanley, and Craftsman. This market is best described as
a. Monopolistically competitive
b. a monopoly
c. an oligopoly
d. perfectly competitive
55. A market structure in which many firms sell products that are similar but not identical
is known as
a. monopolistic competition
b. monopoly
c. perfect competition
d. oligopoly
56. When an oligopolist individually chooses its level of production to maximize its profits, it
charges a price that is
a. more than the price charged by either monopoly or a competitive market
b. less than the price charged by either monopoly or a competitive market
c. more than the price charged by a monopoly and less than the price charged by a
competitive market
d. less then the price charged by a monopoly and more than the price charged by a
competitive market.
57. In the long-run equilibrium of a competitive market, firms operate at
a. the intersection of the marginal cost and marginal revenue
b. their efficient scale
c. zero economic profit
d. all of these answers are correct
58. Which of the following is not a characteristic of a monopolistically competitive market?
a. Free entry and exit
b. Abnormal profits in the longrun
c. Many sellers
d. Differentiated products
59. In a very short period market :
a. the supply is fixed
b. the demand is fixed
c. demand and supply are fixed
60. Time element was conceived by
a. Adam Smith
b. Alfred Marshall

c. Pigou
d. Lionel Robinson
61. Total revenue =
a. price ×quantity
b. price × income
c. income ×quantity
62. Average revenue is the revenue earned
a. per unit of input
b. per unit of output
c. different units of input
d. different units of output
63. AR can be symbolically written as:
a. MR / Q
b. price × quantity
c. TR / Q
64. AR is also known as:
a. price
b. income
c. revenue
65. Marginal revenue can be defined as the change in total revenue resulting from the:
a. purchase of an additional unit of a commodity
b. sales of an additional unit of a commodity
c. sale of subsequent units of a product
66. When e > 1 then MR is
a. zero
b. negative
c. positive
d. one
67. When e = 1 then MR is
a. positive

b. zero
c. one
d. negative
68. When e < 1 then MR is
a. negative
b. zero
c. positive
d. one
69. The term market refers to a:
a. place where buyer and seller bargain a product or service for a price
b. place where buyer does not bargain
c. place where seller does not bargain
70. In perfect competition firm is the———————-
a. price maker and not price taker
b. price taker and not price maker
c. neither price maker nor price taker
71. A Monopolist is the price
a. maker
b. taker
c. adjuster
72. Price discrimination is one of the features of —-
a. monopolistic competition
b. monopoly
c. perfect competition
d. oligopoly
73. Under monopoly, degree of control over price is:
a. none
b. some
c. very considerable

74. Generally, market for perishable like butter, eggs, milk, vegetables etc., will have
a. regional market
b. local market
c. national market
75. Durable goods and industrial items exist in
a. local market
b. regional market
c. national market
d. secular market
76. Secular period is also known as
a. very short period
b. short period
c. very long period
d. long period
77. Stock exchange market is the example for
a. unregulated market
b. regulated market
c. spot market
78. The market for the ultimate consumers is known as
a. whole sale market
b. regulated market
c. unregulated market
d. retail market
79. The condition for pure competition is
a. large number of buyer and seller, free entry and exist
b. homogenous product
c. both (a) and (b)
d. large number of buyer and seller, homogenous product, perfect knowledge about the
product

80. Pure oligopoly is based on the———————— products

a. differentiated
b. homogeneous
c. unrelated
81. In oligopoly, when the industry is dominated by one large firm which is considered as
leader of the group. This is called:
a. full oligopoly
b. collusive oligopoly
c. partial oligopoly
d. syndicated oligopoly
82. When the product are sold through a centralized body oligopoly is know as
a. organized oligopoly
b. partial oligopoly
c. competitive oligopoly
d. syndicated oligopoly
83. When the monopolist divides the consumers into separate sub markets and charges
different prices in different sub-markets it is known as
a. first degree of price discrimination
b. second degree of price discrimination
c. third degree of price discrimination
d. none of the above.
84. Under ————————— the monopolist will fix a price which will take away the
entire consumers’ surplus.
a. second degree of price discrimination
b. first degree of price discrimination
c. third degree of price discrimination
85. Price discrimination is related to
a. time
b. size of the purchase
c. income
d. any of the above

ANSWERS
1. c 2. c 3. c 4. d 5. c 6. a
7. d 8. a 9. b 10. c 11. .d 12. c
13. b 14. d 15. d 16. c 17. c 18. c
19. c 20. d 21. b 22. a 23. d 24. b
25. a 26. c 27. d 28. a 29. b 30. d
31. d 32. b 33. b 34. b 35. c 36. c
37. a 38. b 39. d 40. d 41. d 42. a
43. c 44. d 45. c 46. b 47. a 48. b
49 c 50. a 51. c. 52. d 53. d 54. c
55. a 56. d 57. d 58. b 59. a 60. b
61. a 62. b 63. c 64. a 65. b 66. c
67. b 68. a 69. a 70. b 71. a 72. b
73. c 74. b 75. c 76. c 77. b 78. d
79. c 80. b 81. c 82. d 83. c 84 b
85. d

SECTION-II
INDIAN
ECONOMIC
DEVELOPMENT
CHAPTER – 5
INDIAN
ECONOMY –
A PROFILE
Unit 1
Nature
of
Indian
Economy
INDIAN ECONOMY – A PROFILE
Learning Objectives
know about the criteria of classifying an economy as underdeveloped, developing or

developed.
understand the factors which make Indian economy as underdeveloped.
understand the factors which make Indian economy as developing.
understand how Indian economy can be classified as mixed economy.
1.0 INDIA - AN UNDEVELOPED ECONOMY

1.0.0. Features of an Underdeveloped Economy : Generally an economy is said to be
underdeveloped, if it has the following characteristics:
Agriculture is the main occupation of the people. Nearly 60 to 80 per cent of the population
is engaged in agriculture and its related activities.
Poverty is wide-spread. The ability to save of people is very low. Due to the low rate of
saving, the rate of capital formation/investment is very low.
Population grows at a high rate (about 2 per cent per annum) and the burden of dependent
population is also high.
The standard of living of people is generally low and the productivity of labour is also
considerably low.
The production techniques are backward. Investment in research and development is
quite low.
The incidence of unemployment and underemployment is quite high.
The level of human well-being measured in terms of real income, health and education is
generally low.
Income inequalities are widespread.
Apart from the above features, such economies have low participation in foreign trade,
their social life is traditional; people are generally orthodox in their outlook and they seldom
make any changes in their socio-economic relations.
1.0.1 India's case: If we analyze Indian economy we may say that it is an undeveloped
economy. This is because it has most of the characteristics mentioned above.
i) Agriculture is the main occupation of the people in India. At the time of Independence
nearly 72 per cent of the population was dependent on agriculture. At present, nearly 52
per cent population is dependent on agriculture (2008-09). There has been an increase in
the absolute number of people engaged in agricultural activities in India.

ii) In India, the incidence of poverty is very high. Every third poor person in the world is an
Indian. That means one third of the world's poor live in India. According to the latest
available data (results of the latest round of the National Sample Survey Organization
(NSSO) - 2004-05) nearly 22 per cent of the population is below poverty line. The
corresponding ratio was 36 per cent in 1993-94 and 26 per cent in 1999-2000.
iii) Over the years, Indian population has grown at a fast rate of more than 2 per cent. The
country is facing the problem of population explosion as the death rate is falling but there
is no corresponding fall in the birth rate. The dependency rate i.e. percentage of people in
non-working age group (below 15 and above 64 years of age) is nearly 40 per cent in India
as compared to developed countries where it is about 33 per cent.
iv) India's per capita income was $950 in 2007. It is low not only compared to developed
countries like USA, UK, Germany but also developing countries like China, Sri Lanka,
Indonesia etc. Because of low level of per capita, income the standard of living of people is
quite low.
v) In India, because of low per capita income and low saving rates, the gross capital formation
rates have remained considerably low. Gross domestic savings were generally below 20
per cent of GDP (at current prices) between 1950-1990. As a result, gross domestic capital
formation has also remained below 20 per cent during these years. Consequently, the rate
of economic growth has remained stuck at a relatively low level. Since 1990-91, there
have been improvements in saving and investment rates. Beginning with around 23 per
cent in 1990-91 the gross domestic savings rate reached 29.8 per cent in 2003-04 and
became 37.7 per cent in 2007-08; similarly gross domestic capital formation became 36.9 per
cent in 2006-07 and 39.1 per cent in 2007-08 starting from 26 per cent in 1990-91.
vi) Techniques of production, especially in the agriculture sector are still backward.
Productivity in agriculture as well as in industrial sector is low in India as compared to
advanced countries.
vii) The incidence of unemployment in India is quite high. The Tenth Plan aimed to create
approximately 50 million employment opportunities during the plan period. The results of the
61st NSSO round show that about 47 million persons were provided job during 2000-05. Thus,
we find that there are a large number of unemployed people in India. Not only this, the
unemployment rate over the years has increased. This will be clear from the following
table (NSSO - 55th and 61st Rounds).

Table 1 : Rate of unemployment (CDS Basis)

(in percentage)
1999-00 2004-05
Rural
Males 7.2 8.0
Females 7.0 8.7
Urban
Males 7.3 7.5
Females 9.4 11.6
Not only there is high rate of open unemployment the rate of disguised unemployment is
also very high. Disguised unemployment means apparently people are employed but their
contribution to the production is very-very low. In other words, their productivity is nil or
negative. Such type of unemployment is more common in the agricultural sector. Here,
many people work in a small farm land but their contribution is almost nil. So they are
disguisedly unemployed. The actual extent of disguised unemployment is difficult to
measure.
viii) In India, the level of human well-being is also quite low. For measuring human well-
being, generally Human Development Index (HDI) constructed by the United Nations
Development Programme (UNDP) is used. The HDI is a composite of three basic indicators
of human development - longevity, knowledge and standard of living. Longevity is
measured in terms of life expectancy at birth, knowledge in terms of education and standard
of living in terms of real GDP per capita. The HDI is a simple average of the above indices.
The UNDP finds this index for all countries and ranks them. According to the latest UNDP
Report 2008, India's relative global ranking on this index has remained at a low of 132
among 179 countries. Its HDI was 0.577 in 2004 which improved marginally to 0.609 in
2006.
ix) The distribution of income and wealth in India is not equitable. In order to measure the
inequality of income and wealth, generally Gini index is used. The Gini index measures
the extent to which distribution of income/consumption among individuals or households
within an economy deviates from a perfectly equal distribution. A Gini index of zero
represents perfect equality while an index of one represents perfect inequality. The Gini
coefficient lies between 0 and 1. According to the World Development Report - 2006, the
Gini index for India in 1999-00 (survey year) was 0.33. It increased to 0.368 in 2004 (Central
Intelligence Agency). The corresponding figure was 0.297 in 1994. Thus, over this period,
the inequalities of income and wealth have increased.

1.1 INDIA - A DEVELOPING ECONOMY
If we go through the above facts, we may rush to the conclusion that Indian economy is an
underdeveloped economy. But that is not completely true. Indian economy has over the decades
shown marked improvements. It is in fact moving fast on the path of development. The
following facts are important here:
(i) Rise in National income: India's national income i.e. Net National Product (NNP) at factor
cost was Rs. 2,04,924 crore in 1950-51 which rose to Rs. 27,64,795 crore (at constant
prices) in 2007-08. Thus, over a period of 58 years the NNP has increased by more than 12
times. On an average, the NNP has increased at a rate of a little less than 5 per cent per
annum. During the 27 years, NNP rose at a rate of more than 5.5 per cent per annum as
against 3.5 per cent per annum during the first three decades of planning. Thus, we see
that India is growing although at not so high rate of growth.
(ii) Rise in Per Capita Income: Per capita income in India was Rs. 5,708 in 1950-51 (at constant
prices). It rose Rs. 24,295 in 2008-09. Thus, over a period of 57 years, the per capita income
has increased by more than three times. On an average, the per capita income has increased
at a rate of around 2.2 per cent per annum. In fact, in the last 27 there has been a spurt in
the growth rate of per capita income. It rose at an average rate of 3.5 per annum, during
this period compared with 1.4 per cent per annum during the first 30 years of planning.
(iii) Significant changes in occupational distribution of population: By occupational structure of a
country we mean the distribution of work force in different occupations of the country.
All occupations are broadly divided into three groups.
(i) Primary Sector: Primary sector includes agriculture and other activities related with
agriculture such as animal husbandry, forestry, poultry farming etc.
(ii) Secondary sector: This includes all types of manufacturing activities including
construction etc.
(iii) Tertiary sector: This sector includes trade, transport, communication, banking and
other such services.
In general, it has been found that as an economy grows, there is a shift of labour force from
primary sector to secondary and tertiary sectors. The proportion of working population in
agriculture and allied activities falls and the proportion of working population in secondary
sector and tertiary sector rises. This happens basically because of two reasons. Firstly, as
economic development takes place income increases but demand for agricultural goods does
not increase proportionately. On the other hand, rise in incomes brings about a large increase
in demand for goods and services produced by secondary and tertiary sectors. Secondly, as an
economy develops, better techniques of production become available to the agricultural sector
which improve productivity of land and labour in this sector. The result is that there is a less
need for labour in agriculture. On the other hand, although productivity also improves in the
industrial sector, the increase in demand for industrial goods is far greater than the rise in
productivity in this sector. This necessitates engagement of more labour in this sector, hence
the shift takes place.
Occupational structure in India: The following table shows the occupational structure in
India.

Table 2: Occupational Distribution of Working Population in India
Occupation 1951 1961 1971 1981 1991 2001

Primary sector 72.1 71.8 72.1 68.7 62.7 59.3
Secondary sector 10.6 12.2 11.2 13.5 14.9 18.2
Tertiary sector 17.3 16.0 16.7 17.5 22.4 22.5
Total 100.0 100.0 100.0 100.0 100.0 100.0
During 1951, Primary sector offered work to about 72 percent of the working population,
secondary sector to 10.6 percent and tertiary sector to 17.3 percent of the working population.
In 2001 there was some change in the occupational distribution. The primary, secondary and
tertiary sectors respectively occupied 59.3 percent, 18.2 percent and 22.5 percent of the working
population.
According to the Economic Survey 2007-08, around 52.7 per cent of the working population
was engaged in primary sector, 18.8 per cent in secondary sector and 28.5 per cent in tertiary
sector in 2004-05.
Thus, over a period of five and a half decades there has been shift of work force from primary
to secondary and tertiary sectors signifying development in the economy.
(iv) Important changes in sectoral distribution of domestic product: An important indicator which
shows that India is growing is decline in the share of agricultural sector in the overall
gross domestic product. The following table shows how over a period of five and a half
decades, structural changes have taken place in India - the share of agricultural and allied
activities has fallen and shares of secondary (industrial) sector and tertiary (services) sectors
have improved in the GDP.
Table 3 : Composition of GDP
1950-51 1960-61 1970-71 1980-81 1990-91 2000-01 2007-08

Primary 56.1 47.8 42.8 36.5 29.1 26.50 17.0
Secondary 11.7 15.1 16.9 19.5 21.9 23.1 25.8
Tertiary 32.7 37.3 40.9 44.0 49.0 50.4 57.2
National Income statistics, CMIE

(v) Growing capital base of the economy: Another characteristic which hints that the economy is
growing is the development of strong industrial base in the country. At the time of
Independence, we had very few basic and capital goods industries. But after Independence,
especially in the Second Plan a high priority was given to establishing basic industries. As
a result, a large number of industries have been established during the planning period.
These include, iron and steel, heavy chemicals, nitrogenous fertilizers, heavy engineering,
machine tools, locomotives, heavy chemicals, heavy electrical equipment, petroleum
products and many more.

(vi) Improvements in social overhead capital: Social overhead capital mainly includes transport
facilities, irrigation facilities, energy, education system, health and medical facilities. When
there is an expansion in these facilities, we say that the economy is growing. In India,
since Independence, these facilities have improved a lot as can be seen from the following
points.
The railways' route length has increased by nearly 10 thousand kilometers. Indian
railways has been world's third largest rail network under a single management. In
two metro-cities - Kolkata and Delhi, Metro Rail system has been working. This system
has solved the problem of traffic congestion in these cities to a great extent.
Diesel and electrical locomotives have replaced steam engines.
The Indian road network has become one of the largest networks in the world aggregating
3.34 million kilometers.
Although the country is still facing energy crisis, there has been an impressive increase
in the installed capacity. In 2008-09, the installed electricity generating capacity was
1,49,390 MW (Mega Watt) against 2,300 MW in 1950-51. 74,700 MW in 1990-91 and
1,17,800 MW in 2000-01.
Similarly, irrigation facilities have increased raising the land under irrigation from
22.6 million hectares in 1950-51 to 87.2 million-hectares in 2006-07.
In the field of education, during the planning period, the number of primary
educational institutions has more than doubled. The number of higher secondary
educational institutions has increased by 20 times and number of colleges has increased
by around 30 times. The literacy rate has increased from 18.33 per cent in 1951 to
67.6 per cent in 2005-06.
In the field of medicine and health also, some development has taken place. The
number of doctors has increased by more than 9 times increasing from 61.800 in 1951
to around 7 lakh in 2008. The bed-population ratio is now 1.03 per 1,000 population
increasing from .32 per 1,000 in 1950-51.
(vii) Development in the banking and financial sector: Since Independence, important developments
have taken place in the banking and financial sector. Initially banks were under private
ownership. But after Independence, the process of nationalization was started. In 1949
Reserve Bank of India was nationalised and later in 1969 and 1980 many big banks
were nationalised. As a result, banks which earlier catered to very small population have
now reached at every nook and corner. Agricultural sector, small scale industries and
other sectors have been getting bank's funds on a priority basis and at concessional rates
of interest.
Thus, we can say, that although India is economically not so strong economy, but it is on
the road of development. If its present pace of development continues, in the near future
it will become an economic force to reckon with.
1.2 INDIA - A MIXED ECONOMY

In chapter one, we studied different types of economies on the basis of ownership of means of
production. In India, we observe that the following characteristics exist:
Private ownership of means of production - Agriculture and most of the industrial and services
sectors are in the private hands.

Important role of market mechanism - Market forces of demand and supply have free role in
determining prices in various markets. Government regulations and control over period
of time have reduced a lot.
Growth of monopoly houses - Over a period of time, many big business houses have come
into being and have been growing such as Tatas, Birlas, Reliance, Infosys etc.
Presence of a large public sector along with free enterprise - After Independence, the government
recognised the need to provide infrastructure for the growth of the private sector. Also, it
could not hand over strategic sectors like arms and ammunition, atomic energy, air
transport etc. to the private sector. So public sector was developed on a large scale.
Economic planning as a means of realizing overall national economic goals - Economic planning
has been an integrated part of the Indian Economy. The Planning Commission lays down
overall targets for the economy as a whole, for public sector and even for the sectors
which are in the private hands like agriculture. The government tries to achieve the laid
down targets by providing incentives to these sectors. Thus, here planning is only indicative
in nature and not compulsive.
Observing the above characteristics we conclude that Indian economy is a mixed economy.
SUMMARY
Generally an economy is said to be underdeveloped if agriculture is the main occupation of its
people, population is growing at a high rate, techniques of production are backward, incidences
of unemployment and poverty are high and there are wide-spread income-inequalities and so
on. If we observe Indian economy, we may conclude that Indian economy is undeveloped.
But, if we observe growth in national income, per-capita income, occupational structure, capital
base, social overheads etc. we may say that Indian is a developing economy. Besides, India is a
mixed economy since here the means of production are partly owned by the private sector and
partly by the public sector.

CHAPTER – 5
INDIAN
ECONOMY –
A PROFILE
Unit 2
Role of
Different Sectors
in India
Learning Objectives
understand the role played by agriculture, industry and services in the growth of Indian
economy.
understand what qualities and quantitative changes have taken place in the various
productive sectors of the economy.
understand the various problems faced by these sectors in India.
Agriculture, industry and services are the major producing sectors of an economy. In this unit,
we will study about these sectors in some detail.
2.0 AGRICULTURE
2.0.0 Role of Agriculture in India : Agriculture is a very important sector of the Indian
economy. It plays a major role in the overall development of the country as it contributes 17 of
GDP and engages around 52 per cent of the population of the country.
(i) Providing employment: Agriculture provides employment to a large number of people in
India. At the time of Independence around 72 per cent of the population was engaged in
agriculture and allied activities. As economy developed, its other sectors (industry and
services) also developed and the percentage of people working in agriculture sector came
down to around 52 per cent in 2008-09. It must however, be noted that in absolute terms
there has been a big increase in the number of people engaged in agricultural activities.
Besides, a large number of people earn their living by working in occupations dependent
on agriculture like storage, procuring, trade and transport, marketing and export of
agricultural products.
(ii) Share in national income: Agriculture contributes a large share in the country's gross
domestic product. Its share in total GDP in 1950-51 was around 55 per cent which has
come down to 17 per cent in 2008-09. This reduced share indicates that the economy and
its non-agricultural sectors are growing, nevertheless share of 17 per cent is an indicator
of the fact that India is still predominantly an agricultural economy.
(iii) Supporting industries: Agriculture has a big role in the development of industries specially
the agro-based industries such as textiles, sugar, tea, paper. There are several other industries
like handloom, weaving and other cottage industries which also depend upon inputs
from agriculture. The prosperity of these agro-based industries is directly dependent upon
the availability of inputs from the agricultural sector. The prosperity of industries depends
on agricultural prosperity from another angle also. The demand for industrial products
depends upon the income of the farmers which in turn depends upon agricultural
production.
(iv) Shares in foreign trade: The country's foreign trade especially in the export of traditional
commodities like jute, tea, tobacco and coffee depends a great deal on the supplies of the
agricultural sector. In case of crop failures the country becomes a net importer of food

grains. Therefore, the balance of trade in the country is affected a great deal by the
performance of this sector.
At the time of Independence and a number of years thereafter our export basket mainly
consisted of three agro-production-cotton textiles, jute and tea. These three accounted for
more than 50 percent of our export earnings. If we consider other agricultural commodities
like cashew, kernels, tobacco, coffee, sugar, vegetable oil etc., the total share of agriculture
in total exports was about 70 per cent. As economy developed, the share of agricultural
exports in total exports fell down. In 2007-08 agricultural exports formed about 12.2 per
cent of the national exports. In recent years, special schemes (like Special Agricultural
Product Scheme) have been started to promote exports of fruits, vegetables, flowers, dairy
products and forest products.
As far as the agro-imports are concerned they constituted just 3.1 per cent of national
imports in 2007-08. This is very meager, considering the fact that nearly one-fourth of our
total import expenditure at the time of Independence and many years thereafter was on
agro-imports (food grains, pulses, edible oil etc.). India, over a period of time has become
self-sufficient in the production of agro-products and need to import them only when
there are severe shortages resulting from unfriendly weather conditions like droughts and
floods.
(v) Supplier of food and fodder: Agriculture meets almost the entire food-needs of the people.
In India, people spend a very large proportion of their incomes on food and food products.
Thus, the cost of living of people also gets affected by agricultural prosperity. If food is
costly; the cost of living of the people also gets affected to a great deal.
Agriculture also provides fodder to sustain livestock comprising of cattle, buffaloes, sheep
and poultry etc. Their number runs in crores. These provide employment and income to
many people in the rural and hilly areas.
(vi) Savings of capital: Agriculture has low capital output ratio; in other words it requires
lesser capital per unit of output produced compared with the industries. A capital poor
economy like India can make efforts to develop this sector which along with increase in
production could increase employment opportunity in the rural areas and could help in
solving problems of urban congestion and pollution in the cities.
(vii) Contributions to Government's revenue: The government revenues also depend a great
deal on agricultural prosperity. The direct contribution of agricultural taxes to the revenues
of the centre and the states is not significant but indirectly agriculture has a considerable
influence on the revenues of the central and state governments. Particularly, when due to
agricultural droughts, the revenue suffers a set-back, government expenditure on relief,
etc., goes up a great deal leading to heavy deficit in government budgets.
(viii)Solving problems of urban congestion and brain drain: Migration from rural areas to urban
areas and metropolitan cities has created a dual problem: on the one hand, it has deprived
rural areas of skilled and educated persons and, on the other hand, it has created the
problem of urban congestion. If agriculture is on the road to prosperity and is in a position
to absorb fruitfully the growing talent in rural areas, the dual problem of urban congestion
and rural brain drain will be solved.

2.0.1 Growth of agriculture during planning period: In the following points we will learn
how agriculture sector has developed in India over the years:
I Increase in production and productivity: The following table shows how agricultural
production has progressed over the years.
Table 4 : Agriculture Production Million Tonnes
Commodity 1950-51 1991-92 2001-02 2007-08 2008-09
1. Foodgrains (m.t) 51.0 167.0 212.9 230.8 229.9
2. Pulses (m.t.) 8.4 12.0 13.4 14.8 14.2
3. Sugarcane (m.t.) 69.0 249.0 297.2 348.2 289.2
4. Oilseeds (m.t.) 5.1 18.3 20.7 29.8 28.1
5. Cotton (m. bales) 2.1 9.8 10.0 25.9 23.3
6. Jute and Mesta (m. bales) 3.5 9.2 11.7 11.2 10.3
We can see from the table that over the last 58 years, agriculture production has increased by
more than thrice. In 1950-51, food grains production was 51 million tonnes which increased to
231 million tonnes in 2007-08 (but reduced to 230 million tonnes in 2008-09).
Significant breakthrough in the production of food grains (often termed as Green Revolution)
has been made possible due to the adoption of the new agricultural strategy since 1966. This
strategy stressed upon the use of high-yielding varieties of seeds, proper irrigation facilities,
extensive use of fertilizers, pesticides and insecticides often termed as High Yielding Varieties
Programmes (HYVP). Since the adoption of this Programme, the production and productivity
of food grains especially of wheat have increased sharply. The food grains production increased
from 81 million tonnes in the Third Plan (i.e. before HYVP) to 230 million tonnes in 2008-09.
Similarly, we find the production of pulses increased from 8.4 million tonnes to 14.2 million
tonnes, of sugarcane from 69 million tonnes to 348 million tonnes in 2007-08 (but fell to 289
million tonnes in 2008-09), of oilseeds from 5.1 million tonnes to 30 million tonnes in 2007-08
(but fell to 289 million tonnes in 2008-09), of cotton from 2.1 million bales to 23 million bales,
and of Jute and Mesta from 3.5 million bales to 10.3 million bales over the period 1950-51 to
2008-09.
HYVP was restricted to five crops - wheat, rice, bajra, jawar and maize. But among these,
wheat made wide strides with production increased by more than six times from 11 million
tonnes (annual average) in the third plan to 78.5 million tonnes in 2007-08. The productivity of
wheat during the same period has increased from 827 kilograms per hectare in 1965-67 to
2806 kilograms per hectare in 2008-09. On account of this, it is often said that the green
revolution is largely wheat revolution.
The long-term annual growth of food grains output has been around 2.42 per cent during
1967-68 to 2002-03 and the per capita availability of foodgrains has improved from about 395
gm in 1951 to 443 gm in 2007.

Agricultural productivity is measured in terms of yield per hectare of land. Agricultural
productivity has increased at a rate of around 2.06 per cent per annum during 1967-2003.
There has been improvement in productivity of land in almost all commodities but it has been
more in the case of wheat and potatoes and only marginal in rest of the products. It is important
and necessary that productivity of land improves as there is hardly any scope for bringing
more land under cultivation.
II Diversified agriculture: Indian agriculture has become diversified as will be clear from
the following facts:
The share of non-crop sectors (fishery, forestry and animal husbandry) in total
agricultural output is increasing.
Area under commercial crop like sugar, cotton, oilseeds, etc. is increasing.
Within food grains, area under superior cereals (rice and wheat) is increasing and
area under the inferior cereals is declining.
III Modern agriculture: Some qualitative changes have taken place in agricultural sector
especially in India since 1966 when Green Revolution was started. These are:
The use of high-yielding varieties of seeds, chemical fertilizers, pesticides, threshing
machine is rising.
Farmers are increasingly resorting to intensive cultivation, multiple cropping, scientific
water management in some states.
There have been noticeable changes in the attitudes of farmers. They are ready to
accept new and scientific techniques of production.
Agricultural capacity has improved a lot. This has been made possible due to use of
modern techniques such as irrigation facilities, high-yielding varieties of seeds, tractors
and other modern machines.
A number of institutions have come up for marketing agricultural products for
providing agricultural credit, for purchasing and distributing of agricultural inputs
and storage etc. They have facilitated growth of agriculture.
IV. Improved agrarian system: At the time of Independence, there were three types of land
tenure systems prevailing in the country - the zamindari system, the ryotwari system and
the mahalwari system. In all these systems, the land was cultivated by tenants and they
paid rent for the use of land. Only the system of collecting rent or land revenue was
different in these land tenure systems. Whatever the system of collecting land revenue, the
tenant or the actual tiller of the land was exploited by the land owners. More than 25 per
cent of the produce was taken away by these intermediaries (zamindar etc.) in the form of
rent. These intermediaries did not work at all on the land but took away whatever surplus
above the minimum subsistence the cultivators produced. The cultivators did not show
any interest nor did they have any surplus left for modernisation of agriculture. Hence,
there was virtual stagnation in the agricultural sector.
In order to stop the exploitation of the actual tillers of the soil and to pass on the ownership
of land to them land reforms were introduced after Independence. Three measures were
contemplated to achieve these objectives:

(i) Abolition of Intermediaries

(ii) Tenancy reforms
(iii) Reorganisation of agriculture
Legislations were passed in all states to abolish zamindari system. As a result, around 173
million acres of land was acquired from the intermediaries and two crore tenants were
brought in direct contact with the state.
Under the tenancy reforms, three measures were taken (a) Regulation of rent (b) Security
of tenure and (c) Conferment of ownership rights on tenants.
Before Independence, the rent changed by the zamindars from the tenants was very high.
It ranged between 30 to 75 per cent. So after Independence, legislations were passed to fix
rents between 25-50 percent for different states. Security of tenure has also been provided
by these states by passing legislations which disallow ejectments of the tenants except in
accordance with the provisions of the law. Many States have also conferred ownership
rights on the tenants. It has been estimated that as result of laws conferring ownership
rights on tenants in various states, approximately 12.42 million tenants have acquired
ownership rights over 6.32 million hectare of land. Ceilings were also imposed on
agricultural holdings. That means limits were imposed on the amount of land which a
family could hold. Accordingly, a family could hold 18 acres of wet land or 54 acres of
unirrigated land. It has been estimated that 2.98 million hectares of land had been declared
surplus of which 2.18 million hectares has been distributed to 5.58 million beneficiaries.
In order to solve the problem of fragmentation of holdings, the land was reorganized.
Accordingly it was decided to consolidate holdings by giving to the farmer one consolidated
holding equal to the total of the land in different scattered plots under his possession.
Cooperative farming was also started but it did not succeed much.
Thus, we see that since Independence, we have a much improved agrarian system which
has resulted due to the land reforms undertaken by the government.
(V) Other developments : Apart from the above, the following developments have also taken
place:
Farmers have been getting material inputs at subsidised rates.
They are getting credit at low rates of interest.
Government is helping them in procuring their products at predetermined rates and
marketing them.
Minimum wage levels have been fixed for agricultural labourers.
Special programmes such as Integrated Rural Development Programme, Jawahar
Rozgar Yojana etc. have been started in rural areas to provide employment to the
rural people.
The National Food Security Mission (NFSM) is being implemented in identified districts
of different states. The aim is to have self sufficiency in different food crops like rice,
wheat and pulses.

The Rashtriya Krishi Vikas Yojana (RKVY) is being implemented for integrated
development of food crops. The scheme focuses on agricultural mechanisation,
improvement of soil health and productivity, development of rain fed farming systems,
improvement of agricultural marketing and pest management.
Projects like Forecasting Agricultural Output using Space, Agro-meteorology and Land-
based Observations (FASAL) and Extended Range Forecasting System (ERFS) have
been started to establish a more scientific and reliable basis for forecasting.
Special schemes have been started to improve the production of rubber, coffee, bamboo,
poultry, etc.
2.0.2 Problems of agricultural sector in India: The agricultural sector in India faces the
following problems:
(1) Slow and uneven growth:
(a) The growth of agricultural sector is not sufficient to meet the rising demands of fast
growing population. While the population is growing at a rate of around 2 percent
per annum, food grain production has increased at an annual rate of 2.42 percent.
During the first six years of new millennium starting 2001-02, this sector has grown at a
modest rate of 3 per cent per annum. The poor performance of agricultural sector resulting
mainly from deficient and uneven rainfall in the recent years has led to creating inflationary
pressure in some primary products and reduction in the potential growth of other sectors by
dampening growth. This rate is just sufficient to maintain the existing standard of
consumption of people. If we desire better standards of consumption and nutrition,
then agriculture will have to grow at a higher rate.
(b) Certain crops (like wheat) are growing at a higher rate than other crops (like maize,
jawar etc.).
(c) Low yield per unit area across almost all crops has become a regular feature of Indian
agriculture. For example, though India accounted for 21.8 per cent of global rice production,
the estimated yield per hectare in 2004-05 was one-third than that of Egypt. Similarly, in
wheat while India accounted for 12 per cent of global production, its average yield was less
than a third of the highest yield level estimated for the U.K. in 2004-05. There is a need for
a renewed focus on improving productivity.
(d) There are regional imbalances in the spread of growth. The growth has remained
confined to certain areas like Punjab, Haryana and Western Uttar Pradesh.
(e) Till very recently, the attention and resources were devoted to the development of
agricultural crops and animal husbandry, fisheries and forestry were not given much
attention.
(2) Not so modern agriculture:
(a) The HYVP was initiated on a small area of 1.89 million hectares in 1966-67 and even
in 2003-04 only 80 million hectare of land was covered by this program which is just
44 per cent of the gross cropped area. Naturally, the benefits of the new technology
have remained confined to this area only.

(b) In many areas and in a number of crops old methods of ploughing, sowing and
harvesting etc. are still used. As a result, productivity in such areas and crops is very
low.
(c) About 60 per cent net sown area is rain fed and there are no appropriate dry-farming
techniques.
(d) Only 40 per cent of the gross cropped area has irrigation facilities.The irrigation sector
requires a renewed thrust both in terms of investment as also modern management.
(3) Flaws in Land reforms:
(a) The legislation measures have not been completed in all the states.
(b) There are snags in legislation like definitions of 'personal cultivation' and 'tenants'
were inadequate, substantial area were given to zamindars for their personal
cultivation, landlords often forced their tenants to surrender the lands voluntarily,
ceiling laws were inadequate and zamindars indulged in large scale transfer of land
to their family members in order to escape these laws.
(4) Problems relating to finance:
Since agriculture is an unorganized profession dependent mainly on rains, banks and
other financial institutions are reluctant to provide finance to this sector. In fact, till a very
long period after Independence the main source of agricultural credit was the moneylender
as organized institutions insisted on collateral securities. In 1951, moneylenders accounted
for as much as 71.6 percent of rural credit. Moneylenders used to charge exorbitant rates
of interest ranging from 18 to 50 percent. They often manipulated accounts and cheated
the poor uneducated farmers. Therefore, after Independence steps were taken to free farmers
from the clutches of money lenders, the most important being the expansion of institutional
credit to agriculture. Fourteen banks were nationalised in 1969 and six banks were
nationalised in 1980 with an important objective of providing credit to the rural and other
priority sectors. In 1975, the government established Regional Rural Banks (RRBs) to
specifically meet the requirements of the farmers and villages. This was followed by the
setting of an apex bank called National Bank for Agriculture and Rural Development
(NABARD) in 1982. Cooperative credit societies were also established to finance rural
projects at lower rates of interest. As a result of all these efforts the share of moneylenders
has reduced to about 17 per cent now and that of institutional credit has increased.
Of late a number of steps have been taken to enhance credit support to farmers. These
include:
Introduction of the “Farm Credit Package” in 2004. As a result of this package the
flow of credit to the farm sector has more than tripled during 2003-04 to 2008-09.
Kisan Credit Card scheme was started in 1998 to provide adequate and timely support
for the banking system to the farmers for their cultivation needs. More than 800 lakh
credit cards have been issued till date.
Under the aegis of NABARD, the government is trying to revive short term and long
term rural credit structure.

In 2008-09, the government announced Agricultural Debt Waiver and Debt Relief
Scheme 2008. The scheme covered direct agricultural loans given to marginal and
small farmers and “other farmers”. Under the scheme, overdue loans worth Rs 50000
crore were waived and for loans worth Rs 10000 crore one time settlement relief was
provided.
A rehabilitation package for distressed farmers has also been initiated.
Although much improvement has taken place in agricultural finance, the following
problems have emerged:
Agricultural loans are concentrated in certain region and states. For example, nearly
half of the agricultural bank credit is concentrated in Southern States.
The proportion of overdue to demand has been increasing. Nearly 40 per cent of the
amount financed does not come back to the society.
The major beneficiaries of the agricultural credit have been the large and medium
farmers.
There is a lack of experienced and skilled staff in these institutions.
(5) Problems relating to warehousing and marketing:
(a) The storage facilities with the individual farmers are normally very primitive types in
the form of dug-holes and pits. As a result 10 - 15 percent of agriculture produce gets
spoiled or eaten by rats. Government agencies like Food Corporation of India provide
storage facilities but these are inadequate.
(b) There is a lack of organization among farmers so they do not get a fair price from the
purchasers who are generally well-organized.
(c) There are a number of agents between the producers (farmers) and the consumers
(buyers). They charge a heavy amount as their fees or as commission. As a result, the
farmers do not get a fair share in the total product price charged.
(d) Because of heavy indebtedness, the farmers are many times forced to sell their produces
at low prices and sometimes due to lack of proper transport facilities in the nearest
market at not so great prices.
(e) A great number of farmers live just for subsistence. Their marketable surplus is very
low or almost nil.
(f) Several malpractices exist in unorganized agricultural markets such as under
weighing, levying of a number of unauthorised fees and taxes etc.
(g) The farmers are many a times not well informed about the prevailing market conditions
including prices prevailing in the markets.
(h) Grading and standardisation are at a very low level. So often inferior quality gets
mixed up with superior one, killing the motivation of farmers to produce superior
quality products.
(i) In order to meet the needs of poor people in the country, the government runs a
network of ration shops and fair price shops which provide food grains and other

essential commodities at very low prices to consumers. But it has been seen that these
ration shops have catered to the needs of all and sundry. Despite the massive coverage
of these shops, the total requirements of food grains of all vulnerable sectors are not
met.
There is a need to develop marketing infrastructure, storage, warehousing, cold chains
and spot markets that are driven by modern technology. In this direction some steps have
been recently taken. These include:
To bring about reforms in agricultural marketing, Agricultural Produce Market
Committee (APMC) Act is being amended by various states.
To transfer agricultural technologies and information to the farming sector a number
of initiatives have been taken by the Department of Agriculture & Cooperation. These
include, setting up of Agri Clinics and Agri Business Centres (ACABC), setting up of
Kisan Call Centres and developing of Kisan Knowledge Management System (KKMS)
etc.
The National Policy for Farmers, 2007 is being adopted by the government. Major
policy provisions include provisions for assets reforms, water use efficiency, use of
technology, inputs and services, good quality seeds, disease free planting material,
credit insurance etc.
Agriculture under XI Plan : Agriculture occupies a special treatment in the XI Plan Approach
Paper. The Plan targets at doubling the growth rate in agriculture from less than 2 per cent achieved
in the X Plan to around 4 per cent in XI plan period. This requires increased investment in projects like
irrigation, water shed development in rainfed areas, rail road connectivity and rural electrification.
The Plan also focusses on removing knowledge deficit and improving technology, enhancing productinity
of farm incomes, improving marketing, evolving viable packages for individual agro climatic zones
and removing distortions in farm subsidies etc. A second green revolution is urgently needed to raise
the growth rate of agricultural GDP to 4 per cent.
2.1 INDUSTRY
2.1.0 Role of Industry in India: In any economy, industries have an important role to play. In
fact, it has been noticed that countries which are industrially well developed (example USA)
have higher per capita income than those countries where industries are not well developed
(example: India, Pakistan). The only exception to this could be the petroleum exporting countries
(like UAE) which have a higher per capita income due to abundance of petroleum products
and virtual monopoly in export of petroleum products.
In India, industrial sector plays the following roles:
i) Modernising agriculture: It modernises agriculture and improves productivity in it. It
provides agriculture with the latest tools and equipments which enhance efficiency in this
sector.
ii) Providing employment: Indian economy being labour surplus economy needs sectors which
absorb ever increasing labour-force. Industries can play an important role here. It is the
establishment of industries alone that can generate employment opportunities on an

accelerated rate. At present, industries engage only 18 per cent of the labour force of India
and there is a need to industrialise country and that too quickly.
iii) Share in the GDP: Over the years, the value-added by industrial sector in the GDP has
improved from 12 percent in 1950-51 to 25.8 per cent in 2007-08.
iv) Contribution to exports: Indian industries contribute tremendously to the export earnings
of India. In fact, manufactured goods alone contribute around two third of the export
earnings of India.
v) Raising incomes of the people: Industries generally help in raising the incomes of the
people of a country. This is possible because industries are not dependent on vagaries of
nature. By putting in more efforts, capital and improved technology industrial output and
production can be raised. In fact, in this sector, the benefits of large scale production can
be reaped. Higher industrial output results in higher income per head. In fact, in the
industrially developed countries, the GNP per capita is very high as compared to the GNP
per capita in industrially developing countries. For example, in USA GNP per capita was
$ 46,000 and in India it was just $950 in 2007.
vi) Enhancing further the economic growth: As industrialisation grows, the role of capital
goods vis-à-vis consumer goods gains strength. This helps in enhancing further the
economic growth. It helps an economy to attain self-sustaining growth.
vii) Meeting high-income demands: Beyond certain limits, the demand of the people for
agricultural products falls and for industrial products rises. Industries help in meeting
these ever-increasing demands.
viii) Strengthening the economy: Industries help strengthen the economy in a number of ways:
(a) The growth of industries producing capital goods i.e. machines, equipments etc. lets a
country to produce a number of goods in large quantities and at low cost. This gives
industrial character to the economy and strengthens its infrastructure (b) It makes possible
the production of economic infrastructure goods like railways, dams etc. which in any
case are non-importable. (c) Agriculture gets improved farm-implements, chemical fertilizers
and transport and storage facilities due to industries. (d) Dependence on foreign sources
for defense materials is a risky matter. Industrialisation helps a country to become self-
reliant in defense materials.
2.1.1 Growth of industrial sector in India: All the industries of a country can be grouped in
two major ways (i) on the basis of the size of industries and (ii) on the basis of end-use.
(i) On the basis of size of industries: On the basis of size of the industries, they can be divided
into large industries, medium industries and small industries. Large industries which largely
form the basis of the country's index of industrial production include the following
industries: (a) mining and quarrying (often referred as mining); (b) manufacturing; and
(c) electricity, gas and water supply (often referred as electricity).
(ii) On the basis of end-use: On the basis of end-use of output, industries are divided into:
(a) Basic goods industries (like minerals, fertilizers, cement, iron and steel, non-ferrous
basic metals, electricity etc.)

(b) Capital goods industries (like machinery, machine tools, rail-road equipments etc.)
(c) Intermediate goods (like chemicals, rubber, plastic, coal and petroleum products)
(d) Consumer goods - consumer durables and non durables (like man-made fibers,
beverages, watches, cosmetics, perfumes etc.).
The growth rate of industrial output over the planning period has been nearly satisfactory.
The industrial production has grown at an annual average rate of 6.2 per cent per annum over
the planning period. Consider Table 5 and 6. They show how growth has taken place in the
industrial sector since 1951.
Table: 5 : Annual Growth Rates in Index Numbers of Industrial Production
Use Based 1951 1955 1960 1966 1980 1992 1997 2002 2005 2007 2008
Classification to to to to to to to to to to to
1955 1960 1965 1980 1992 1997 2002 2003 2006 2008 2009
1. Basic Goods 4.7 12.1 10.4 5.9 7.4 6.8 4.1 4.9 6.7 7.0 2.5
2. Capital Goods 9.8 13.1 19.6 6.6 9.4 8.9 4.7 10.5 15.8 18.0 7.0
3. Intermediate Goods 7.8 6.3 6.9 4.5 4.9 8.5 5.8 3.9 2.5 9.0 -2.8
4. Consumer Goods 4.8 4.4 4.9 5.0 6.0 6.6 5.5 7.1 12.0 6.1 4.4
(a) Durables - - - 10.8 10.8 13.4 10.7 -6.3 15.3 -1.0 4.4
(b) Non-durables - - - 5.0 5.3 4.8 3.8 12.0 11.0 8.6 4.4
General Index 5.7 7.2 9.0 4.1 7.8 7.4 5.0 5.7 8.2 8.5 2.4
Table 6 : Annual Growth Rates of Industrial Production in Major Sectors of Industry

(Per cent per annum)
Base = Base = Base = 1993-94 Base = 1993-94
1980-81 1980-81
1950-51 1980-81 1993-94 2005 2006 2007 2008
to to to to to to to
1980-81 1990-91 2004-05 2006 2007 2008 2009
Mining and Quarrying 4.5 6.4 4.4 1.0 3.8 5.1 2.3
Manufacturing 5.1 6.8 9.2 9.1 11.5 9.0 2.3
Electricity, Gas and Water 9.5 8.8 5.2 5.2 7.3 6.4 2.8
2.1.2 Pattern of Industrial Development since Independence: Now in the following points
we will make a comprehensive review of the pattern of industrial development during the
planning era since 1951. The industrial development pattern on the eve of Independence was
characterized by the following elements:

(a) Lop-sided pattern of development dominated by too large and too small industrial units,
with very few medium size units. There was a high concentration of employment in small
industries and household industries (31%) and in large industries (43%).
(b) Capital employed per worker in industry was very low because of low priority given to
industry, low level of domestic demand and low per capita income.
(c) Consumer goods industries were well-established to the utter neglect of capital goods
industries like steel, machinery, heavy electrical and chemicals. The country had to largely
depend on imports for capital goods.
The progress of industrialisation during the last five and a half decades has been striking.
There has been a remarkable development of capital goods industries, substantial
diversification and broad-basing of manufactured products, phenomenal development of
small scale industries. An impressive base has been created in sophisticated and high
technology industrial sectors like electronics, machine tools, telecommunication equipment
and the like.
(1) Industrial growth experienced ups and downs during the period 1951 to 2008-09. There
was steady growth of about 8 per cent during the first three plan period viz., 1951-65.
Thereafter, a significant decline was experienced for 15 years 1965-80 when the annual
rate of industry fell down to 4.1 per cent per annum. The situation improved during 1980-
91 when the annual rate of industrial growth became 7.8 per cent. Then there was a brief
spell (1991-93) of restructuring and consequent lower growth rates. The industrial
production recorded a very low growth of 0.6 per cent during 1991-92 and a small growth
of 4 per cent during 1992-93. Since then the situation has improved a lot. The annual
average growth during 1992-2000 turns out to be 6 per cent.
The industrial growth slowed down to 5 per cent in 2000-2001. In 2001-2002, the industrial
growth rate was very low at 2.7 per cent. This happened because of lack of domestic
demand for intermediate goods, low inventory demand for capital goods, high oil prices
and existence of excess capacity and infrastructural constraints. The Tenth Plan (2002-
2007) aimed at achieving a growth rate of 10 per cent in the industrial sector.
Notwithstanding a distinct improvement in the manufacturing growth in the last three
years (9.2 per cent in 2004-2005, 9.1 per cent in 2005-2006 and 11.5 per cent in 2006-07),
overall industrial growth at an average of around 8.7 per cent per annum has remained well
short of the target.
The Eleventh Plan aims at 8.5 per cent per annum growth in the GDP. This will require
industry to grow at 10% per annum and manufacturing at 12 per cent during the Eleventh
Plan.
The industrial sector after recording robust growth during 2004-07, started showing signs
of moderation in the first half of 2007-08 although overall growth rate remained relatively
high at 8.5 per cent. The year 2008-09 has, however, been marked by a very strong
downturn in growth due to a multitude of factors, the most important being the global
financial shock that impacted the whole industrial sector. Persistent increase in the crude
oil prices during January 2006-July 2008, decline in the foreign direct investment, shrinkage
in demand for exports, decline in domestic demand and consequent decrease in profits

led to lack lustre performance of the industrial sector in 2008-09. The industrial rate of
growth tumbled down to 2.4 per cent in 2008-09 from 8.5 per cent in 2007-08.
In the period 1965-80 not only there was a deceleration in the industrial growth but the
industrial structure also witnessed the phenomenon of retrogression. In other word, the
growth of elite-oriented consumption goods such as man-made fibers, beverages, perfumes,
cosmetics, watches, clocks, etc. was considerably higher than the goods which satisfied
the needs of mass of the people such as coal, cotton, railways, etc.
Thevarious reasons behind the process of deceleration and retrogression are:
(a)Unsatisfactory performance of agriculture.
(b)Slackening of real investment especially in public sector.
(c)Slow-down in import substitution.
(d)Regulation and control over private sector in the form of industrial licensing, MRTP
Act, high taxation, price and distribution controls, foreign exchange control etc.
(e) Narrow market for industrial goods, especially in rural areas.
(2) The structure of industry has shifted in favour of basic and capital goods and intermediate
goods sector during the period of planning since 1951. The programme of industrialisation
was started on a massive scale in the Second Plan (1956-61). Based on the Mahalanobis
model, this Plan emphasized on building basic and capital goods industries so that a strong
base for development in future could be made. Three Steel Plants were set up in the public
sector at Bhilai, Rourkela and Durgapur. Public Sector made advances in machine building,
machine tools, railway locomotives, heavy electrical, ship building, fertilizers etc. In
subsequent plans and for almost four decades (1951-90), the strategy to favour basic and
capital goods and to give public sector the responsibility to develop these industries was
followed. As a result, we now have a strong industrial base in the country (see table 5).
(3) There has been a remarkable growth of consumer goods industries especially those
manufacturing elite-oriented consumer goods such as man made fibers, finer varieties of
textiles, beverages, cigarettes, motor cars, motor cycles and scooters, refrigerators, TVs,
air-conditioners, electrical goods like fans, watches and clocks, cosmetics and so on.
In first four decades after Independence, the stress was on the establishment of basic and
capital goods. Since 1991, important changes have occurred in the industrial structure.
Intermediate and consumer goods have got more importance than basic and capital goods.
As a result, the output of consumer durables goods has expanded at rapid pace especially
since 1991 (see table 5).
(4) Industrial sector has become broad-based and modernised. The role of traditional industries
like textiles has reduced and role of non-traditional industries like engineering goods,
chemical goods and electrical goods has improved tremendously. Manufacturing capabilities
over a period of time have strengthened. We now manufacture a wide array of goods like
food products, leather products, chemicals products, rubber and plastic products, metal
products, machinery, transport and equipments, paper products, wood products and so
on. The broad progress of mining, manufacturing and electricity industries can be seen in
Table 6.

(5) There has been a massive increase in the size and diversification of public sector. Before
Independence, the existence of public sector was only nominal. The post-Independence
period saw a sea change so far as the emergence of public sector was concerned. On the
eve of the First Plan, the number of central public sector units was just 5 with a total
capital of about Rs. 30 crores. In March 2008, the number of public sector industrial units
increased to 242 with a cumulative investment of about Rs. 4,55,000 crores. Several public
sector giants like ONGC, Indian Oil Corporation, Steel Authority of India, Bharat Heavy
Electricals, HMT, HAL, BEL, Cement Corporation of India, Coal India and NTPC dominate
the Indian industrial scene.
Out of 242 Central Public Sector Enterprises (CPSEs) 160 are making profits. Their net
profits stood at more than Rs 91000 crore in 2007-08. The net loss of loss making enterprises
(53) on the other hand stood at around Rs 11270 crore.
(6) So far as the private sector is concerned, the dominance of large and monopoly business
houses has increased several times. There were hardly two large business houses - Tata
and Birla in 1951 but now not only the number of big business houses has increased
enormously to about 80 (which include Reliance Group, Bajaj, Thapars, Mafatlals,
Kirloskars, Goenka, Chhabria, Shriram, Walchand, Singhania and so on) their assets have
also increased enormously during the last 50 years. Their aggregate assets amounted to
more than Rs. 10,00,000 crores in 2008 compared to just Rs. 50,000 crores in 1990-91.
(7) A remarkable expansion and sophistication took place in infrastructural facilities since
1951, in such respects as power generation, development of energy sources, railway
transport, telecommunication, roads and road transport and the like, which are basic pre-
requisites for industrial development. Large scale railway electrification and dieselisation,
extensive discovery of petroleum and gas reserves and their extraction, nationalisation of
coal mining and its development, petroleum refineries, pipelines, storage and distribution
arrangements, hydro, thermal and atomic power generation, together with manufacture
of heavy electrical equipment, electricity grids, electronic telephone exchange and micro-
wave long distance telephone facilities, cellular mobile telephone services, electronic mail
services and so on were taken up; significant strides made in these and other infrastructural
facilities have catalyzed industrial development in several ways. Industrial finance was
supported heavily by financial institutions (LIC, IDBI, ICICI for example) and commercial
banks. Port facilities for imports and exports have been substantially expanded.
(8) The country could be proud of achieving remarkable progress in the science and technology
front. Several Research laboratories were set up under the leadership of Council of Scientific
and Industrial Research. R & D facilities were installed in public and private sector units.
Technological know-how was extensively imported through foreign technical collaboration
arrangements. Science, Engineering, Management and other professional educational
institutions have been established on a large scale. An elite cadre of scientific, technical
and professional manpower has been built; India ranks high in the world in respect of
technological talent and manpower and in development of information and communication
technology, space research, nuclear technology, electronics and so on.
(9) One of the notable features of the planning era since 1951 has been the mammoth growth
of small-scale industrial units. Small-scale industrial units are those who operate with a
modest investment in fixed capital, relatively small-scale work force and which produce a

relatively small volume of output of goods/services. They differ from large-scale industries
with respect to size of capital, employment, production and management, flow of input
and outputs and so on.
The present Act - Micro, Small and Medium Enterprises Development Act, 2006 has broadly
classified the enterprises in those engaged in (i) manufacturing and (ii) providing of services.
Both categories have been further classified in Micro, small and medium based on their investment.
In manufacturing sector units with investment upto 25 lakh are called micro enterprises, units
with investment between Rs. 25 lakh and Rs. 5 crore are called small enterprises and units with
investment between Rs. 5 crore and Rs. 10 crore are called medium enterprises. In the service
sector, units with investment upto Rs. 10 lakh are called micro units and units between 10 lakh
and Rs. 2 crore are called small emterprises and units with investment between Rs. 2 crore and
Rs. 5 crore are called medium enterprises.
The number of registered and unregistered units was about 16,000 in 1950; it has gone up
to more than 128 lakh in 2006-07.
Since Independence, there has been an all-round development of small-scale and cottage
industries in India. Their performance and contribution to the growth of the industrial
economy of India has been quite remarkable. This will be clear from the following points:
(a) The growth rate of small-scale sector @ 10% per annum in terms of production has
been far faster than that of large scale sector since 1973. The production in small scale
and cottage industries increased from Rs. 13,600 crores in 1973-74 to more than
Rs. 5,85,000 crores in 2006-07. It is estimated that they contribute about 39% of the
gross value of output in the manufacturing sector.
(b) The number of registered and unregistered small-scale units which stood at 16,000
units in 1950 increased to 5.30 lakhs in 1981-82 and 128.4 lakhs in 2006-07.
(c) The small-scale sector employed nearly 312 lakhs persons in 2006-07 compared to 67
lakhs and 90 lakhs persons in 1979-80 and 1984-85 respectively. This represents about
60% of the total industrial employment. Employment in small-scale and cottage
industries is next only to that of agricultural sector.
(d) Exports from this sector increased from Rs. 852 crores in 1973-74 to Rs. 4,535 crores
in 1988-89 and further to around more than Rs. 1,50,000 crores in 2005-06. It is
estimated that this sector contributes over 40 per cent of the manufacturing exports
and 33 per cent of the total exports.
(e) Small-scale industrial units produce a very wide range of producer goods and consumer
goods items needed by the economy. They include both simple and sophisticated
engineering products, electrical, electronics, chemicals, plastics, steel, cement, textiles,
paper, matches, ready made garments and so on.
(f) Ancillary units contribute greatly and cater to the requirements of medium and large
industrial units for materials, components, consumables and so on.
(g) The traditional village and cottage industries which are generally clubbed with modern
small-scale industries provide means of living to artisans, sustain viability of countless
number of villages and towns, enrich the quality of life in society by providing fine
handicrafts and pieces of art and project the heritage of India.

(h) A large number of small-scale industries are engaged in the manufacture of consumer
goods of mass consumption, thereby making them available in plenty which serves as
a non-inflationary force.
(i) The encouragement of small-scale and cottage industries with their higher output-
capital ratio and employment-capital ratio has become a stabilizing force in the Indian
economy. The employment generating capacity per unit of capital of small and cottage
industries was found to be at least eight times greater than that of large industries
while the output generating capacity per unit of capital was three times larger than
that of large industries.
2.1.3 Problems of Industrial Development in India
(1) Failure to achieve targets: Except a few years, when targets of overall growth in the
industrial sector were achieved, in the entire period of planning, achievements have been
below targets. The average industrial growth rate during 1951 to 2007-08 has been around
6.2 per cent relative to the target of 8 per cent per annum. The following table shows how
far our targets on the industrial front have been met:
Table 7 : Growth Rate of Industrial Production
(Per cent per annum)
Five year Plan/Annual Plan Target Actual
I (1951-56) 7.0 7.3
II (1956-61) 10.5 6.6
III (1961-66) 11.0 9.0
Annual Plans (1966-69) - 2.0
IV (1969-74) 12.0 4.7
V (1974-79) 8.0 5.9
Annual Plan (1979-80) - 1.4
VI (1980-85) 8.0 5.9
VII (1985-90) 8.7 8.5
Annual Plan (1990-92) - 8.0
VIII (1992-97) 7.4 7.3
IX (1997-02) 8.2 5.2
X (2002-07) 10.0 8.7
XI (2007-12) 10.0 -
(2) Under-utilization of capacity: A large number of industries experience endemic under-

utilization of production capacity. The magnitude of under-utilisation varies from 20% to
60% in different industrial sectors, the average under-utilisation being in the region of
40% to 50%.

It is argued by some that the net output of industries in India could be easily increased by
30 to 40% without any investment in capital equipment, but by better management of
purchasing, production, manpower and marketing systems.
The factors responsible for under-utilization of capacity are said to be: (a) indiscriminate
grabbing and creation of capacities by private enterprise (b) demand short-falls (c) over-
optimistic demand projections (d) supply bottle-necks, (e) labour problems and (f) deliberate
under-utilisation to create shortages and thereby to corner more profits.
(3) Absence of world class infrastructure : The most critical barrier to growth of the industrial
sector is the absence of world class infrastructure. The short supply of transport facilities,
frequent power failures and poor condition of roads have hampered the growth of industry in
general.
(4) Increasing capital-output ratio: Another very disturbing future of industrial development
of India is the ever-rising average and incremental capital output ratio (ICOR). The latter
which was 2.95 during the first plan increased to 3.9 during the Seventh Plan and further
to around 4 during Eighth, Ninth and Tenth Plans. The increasing trend of capital output
ratios could be explained in terms of increasing capital costs of new industrial units, highly
capital intensive nature of basic and heavy units, under-utilisation of capacity,
unremunerative administered prices in respect of basic goods and services and so on.
(5) High cost industrial economy: The costs and prices of manufactured goods and services
in India are generally much higher than international costs and prices. The consuming
public is obliged to bear high burden. The high cost economy is attributed to import
substitution, government protection to indigenous industries, monopolistic tendencies in
several industrial areas, high wage rates, increasing capital intensity in industrial units,
outdated technology low productivity of labour, uneconomic size of industrial units, lack
of cost consciousness among industrial magnates and managers and so on.
(6) Inadequate employment generation: One of the most serious deficiencies of industrial
development over the decades since Independence has been its inadequate employment
generation in relation to investment made. The process of industrialisation has failed to
make a marked dent on the unemployment problem in India. Factory employment absorbed
only 2% of the labour force in 1980. There was only a marginal increase in the rate in
1980s. Employment generation through industrialisation has also been decreasing over
the decades. According to the Annual Survey of industries, there has been a decline in the
absolute number of persons engaged in the industrial sector between 1995-96 and 2004-05. Even
labour intensive manufacturing sub-sectors like leather, food products, jute and leather products
failed to generate adequate employment in the recent years. Though employment generation is
one of the major objectives of five year plans, industrialisation, especially large-scale factory
oriented industrialisation with high capital intensity has proved itself to be incapable of
generating substantial direct employment. It may provide some indirect employment in
ancillary sector and in the services sector which grow in tune with manufacturing activity.
(7) Poor performance of public sector: Though public sector has grown by leaps and bounds
over the planning period backed by massive public investment, its performance on production
and profit fronts has been generally disappointing. Though profit may not always be the
appropriate criterion for evaluating the performance of public sector industrial units, its

relevance cannot be ignored altogether. Commercial and economic efficiency is to a large
extent reflected in profit. A loss making undertaking becomes weakened in course of time. It
loses dynamism and survival capability. A large number of public sector units are 'loss leaders'
in the industrial sphere while the rate of profitability of others is low. The accumulated losses
of central public sector units stood at more than Rs. 42,000 crore in 2005-06 compared to
Rs. 83,725 crore in 2004-05.
(8) Sectoral imbalances: Planned economic and industrial development pre-supposes
coordinated and balanced development of all sectors. There should be proper fine tuning
of all sectors so that they reinforce each other. In India, industrial development on an
over-all basis suffered several set- backs because of inadequate support from agriculture
and infrastructure. Even within the industrial sector the input-output relations between
individual industries like steel and machine building, petro-chemicals and fertilizers, are
such that they have to be developed in harmony. But in real practice, several sectoral
imbalances plague the industrial economy of India.
(9) Regional imbalances: Industrial development continues to be lopsided, region-wise. Large
scale industries are concentrated in a very few states like Maharashtra, West Bengal,
Tamilnadu and Gujarat. These four States account for 44% of total factories and 48% of
productive capital. It is true that a large number of new industrial growth centers have
emerged since Independence in several States like Bihar, U.P., Punjab, A.P., Karnataka,
M.P., and Rajasthan. But these States continue to be industrially backward. The industrial
units established in these States have somehow failed to generate further industrialisation.
Also several States have not been able to attract major industrial units in spite of incentives
and facilities because of the magnetic pull of industrially advanced States. Even small
units have tended to concentrate around urban conglomerates along with large-scale units
than in backward states and small towns.
(10) Industrial sickness: Industrial sickness has become a serious problem affecting small,
medium and large units. It is a major area of concern due to its implications for the entire
economy and health of the industrial sector in particular. In March 2007, there were 1.18
lakh sick units out of which more than 96 percent were small units. Industrial sickness has
been spreading over the years. The causes of sickness are identified as financial
mismanagement, demand recession, labour unrest, working capital shortage, cost
escalations, shortage of raw materials, uneconomic size, out-dated machinery and
equipment and so on.
2.2 SERVICES
The service sector or tertiary sector of an economy involves provision of services to other business
enterprises as well as to final consumers. Service sector includes:
Business services and professional services - Accounting, Advertising, Architectural and
Engineering, Computer and related services and Legal services.
Communication services - Audio-visual services, Postal and Courier services,
Telecommunications.
Real estate and related services.

Distributive services.
Education services.
Energy services.
Environmental services.
Financial services.
Health and social services.
Tourism services.
Transport services - Air transport services, Maritime services, services auxiliary to all modes
of transport.
2.2.0. Role of service sector in India : The service sector in India is its largest sector and
accounts for increasingly significant share of GDP. This sector is growing very fast. It is playing
an important role in the development of the economy as would be clear from the following
points:
(1) Increasing share in the GDP: Over the planning period, the share of tertiary or services
sector has increased from about one third of GDP in 1950-51 to more than half in 2007-08.
In 2007-08, its share in the GDP was more than 57 per cent. Although compared to high
income industrialised economies (where value added by services generally exceeds 60 per
cent of the total output) it is not very high but considering the fact that India is still a
developing economy, this figure is appreciable.
(2) Providing employment: Service sector occupied about 17.3 per cent of working population
in 1951. In 2001, around 22.5 per cent of working population was dependent on service
sector for occupation.
(3) Providing support to other sectors: Service sector provides support to agriculture and
industries by providing a number of services in the form of financial services, transport
services, storage services, distributive services, software and communication services and
so on. No sector can perform and prosper in the absence of network of various financial
and other services.
(4) Contribution to Exports: Services exports from India comprise services such as travel,
transportation, insurance, communication, construction, financial services, software,
agency services, royalties, copyright and licence fees and management services. Services
accounted for more than 45 per cent of total exports in India (2007-08). The potential for
growth, however, continues to be large. Software and other services such as business,
technical and professional services have emerged as the major categories in India's export
of services. In 2006, India's share in world's total commercial services export was 2.7 per
cent compared to 2.3 per cent in 2005 and 0.57 per cent in 1990. Indian services exports
recorded a growth of around 29 per cent per annum during 2000-2006. The global recession
started impacting export of services and its growth came down to 28 per cent in 2006-07
and to 22 per cent in 2007-08. In the list of exporters of commercial services (2008), India
is ranked 9th.

2.2.1 Growth of service sector during planning period: The service sector now accounts for
more than half of India's GDP: 57 per cent in 2007-08. It has gained at the expense of both the
agricultural and industrial sectors through the 1990s.
Generally as an economy grows, the share of primary sector in GDP falls and shares of secondary
and tertiary sectors increase. The occupational distribution of the working force also undergoes
changes. The percentage of people engaged in primary activities particularly agriculture falls
and percentage of people engaged in secondary sector and tertiary sector rises. Except a few
cases, this has been the experience of almost all developed countries. There, the growth of
industries was accompanied by the development of tertiary activities on one hand, and the
relative decline of primary activities on the other. If we consider Indian economy we find that
though India has followed the above route, its secondary sector has failed to grow substantially.
The tertiary sector has by passed the secondary sector. The rise in the service sector's share in
GDP marks a structural shift in the Indian economy and takes it closer to the fundamentals of
a developed economy (in the developed economies, the industrial and service sectors contribute
a major share in GDP while agricultural accounts for a relatively lower share).
Some economists fear that if the service sector bypasses the industrial sector, economic growth
can be distorted. They say that service sector growth must be supported by proportionate
growth of the industrial sector, otherwise service sector growth will not be sustainable. It is
true that service sector’s contribution to GDP has sharply risen and that of industry has not
grown that fast, but it is equally true that the industrial sector has grown and grown quite
impressively through the 1990s (except in 1998-99) and in the Tenth Plan.
If we analyze growth rate in the service sector, we find that it grew by 7.54 per cent per
annum in the Eighth Plan and around 8.1 per cent per annum in the Ninth Plan.
The Government of India gave a special status to the service sector in the Export and Import
Policy (2002-07). The average growth rate of service sector during the Tenth Plan turned out to be
around 9 per cent per annum. The Eleventh Plan aims at an annual average growth rate of 9.4 per
cent for the service sector.
The growth in the services sector has been broad based. Among the sub sectors of services,
“transport, storage and communication” has been the fastest growing with growth averaging
15.3 per cent per annum during the Tenth plan. In 2007-08 and 2008-09 they grew at 15.5 per
cent rate and 9 per cent respectively.
India being a sub-continent with varied geographical, climatic, ethnic, cultural, religious and
social conditions attracts tourists worldwide. The tourism industry is growing very fast and
has the potential for growing still faster. Trade, hotels and restaurants after recording an
average growth rate of 8 per cent in 2000-07, recorded a still higher growth of 10 per cent in
2007-08. In 2008-09, however, their growth decelerated to 9 per cent.
The other notable segment of India's service sector is fast growing financial services segment.
This statement is growing very fast and is in the process of transition. Until recently, this sector
was under the government control. Now, this sector is undergoing liberal reform process
including introduction of an element of competition cutting off the barriers and allowing entry
to foreign companies.

Financial, insurance, real estate and business services recorded an average growth of 7.9 per
cent during 2000-07. During 2007-08 and 2008-09 their growth rate was to 11.7 per cent and
7.8 per cent respectively.
Community, social and personal services which grew at an average rate of 6 per cent per
annum in 2000-07, recorded a growth rate of 6.8 per cent and 13 per cent in 2007-08 and
2008-09 respectively.
India has second largest scientific and technical manpower in the world. India's consultancy
professionals possess capability to provide expertise in sophisticated areas like information
and technology, advanced financial and banking services etc. to developed countries like USA,
UK, France, West Germany and Australia. Other areas of consultancy include infrastructure,
economic and social sectors, water resource management, environment, transfer technology
etc.
India's health services, super-speciality hospitals specialising in both modern and traditional
Indian medicine systems (like Ayurveda, Unani, and Nature care) supported by state of the art
equipment, are attracting patients from across the world.
Education is another field which is not only a big segment of the services sector with the
country but also a foreign exchange earner by way of NRIs, and foreign students enrolled in
India. We also export manpower even to the western world.
Entertainment industry (including films, music, broadcast, television and live entertainment)
is another service industry which has grown very fast after Independence.
Thus services sector has maintained a steady growth pattern since last two decades. But if we
consider its share in the employment, we find that there has been a relatively slow growth of
jobs in this sector. This is primarily because of rise in labour productivity in services sectors
such as information technology that is dependent on the skilled labour. Growth in tourism and
tourism-related services such as hotels holds a large potential for employment generation.
IT enabled services, such as Business Process Outsourcing (BPO) have been growing rapidly
(60-70 per cent) in the recent past and will continue to grow. Outsourcing has changed the
image of India. Western companies are seeing India as their top destination for outsourcing
work.
Factors underlying the Services Sector Growth
The Services sector has grown at a fast rate in India due to the following reasons:
It has been noticed that income elasticity of demand for services is greater than one. Hence,
the final demand for services grows faster than the demand for goods and commodities as
income rises.
Technical and structural changes in the economy have made it more efficient to out source
certain services that were once produced with in the industry.
With the advent of the information technology revolution, it has become possible to deliver
services over long distances at a reasonable cost, thus trade in services has increased world
wide. India has been particular beneficiary of this trend. Services exports increased four
fold in the 1990s and reached US$ 90 billion in 2007-08.

Economic reforms initiated since 1991 also impacted on the performance of the services
sector. Increased demand for manufacturing industry provided synergies to the services
sector. Also, liberalisation of financial sector provided an environment for faster growth of
the financial services. Moreover, reforms in certain segments of infrastructure services
also contributed to the growth of services.
2.2.2 Problems of service sector in India: Although service sector is doing remarkably well, it
is facing lots of problems, important ones are:
(1) Achieving rapid growth of the economy and its counterparts requires a very high quality
of infrastructure. Unfortunately, our infrastructure is inadequate not only in the rural
areas but also in the urban areas. For example, power shortage and traffic congestions are
very common in Bangalore, the silicon city of India. These affect the quality of services
provided.
(2) Though service sector has been the fastest growing sector in the last dacade and has contributed
more than 50 per cent of the GDP, it provides less than 25 per cent of the total employment.
Services that have witnessed a very high growth rate e.g. business and communication services
have a low share in GDP or employment.
(3) Although economic reforms have been undertaken in all the sectors but they are inadequate.
In financial sector many controls and bottlenecks are still there. These need to be removed
if financial sector of India has to achieve the international standard.
(4) India has great potential in the tourism sector. But there is a need to create proper set up
for attracting tourists. Foreign tourists often get harassed and cheated in the hands of
babus and officialdom, touts and conmen.
(5) Etiquettes and good behaviour are the hallmark of the service sector. Indian service providers
whether they are in banks, in hotels and restaurants, in hospitals or in public administration,
they need to be trained thoroughly in public dealing, etiquettes, hospitality and manners.
(6) The airports, railways etc. in India are not clean and well organized. They need to be
revamped and reorganized.
(7) Our consular division also is not proper. It takes many days to issue visas. This hampers
the growth of tourism sector. For this, we need to have a system which entails single-
window clearance.
(8) Service trade also faces a number of problems. These include lack of set up like export
promotion councils (other than for computer software), various visible and invisible barriers
to service trade for example, visa restrictions, sector specific restrictions and preferential
market access.
(9) Unfair competition in the telecom sector and lack of, internet infrastructure, personal
computer penetration, monitoring and customer demand, mar the growth of e-commerce.
(10) Service sector cannot grow in isolation. It needs strong backing of other sectors, primary
and secondary. In India, such backing needs to be strengthened. In other words, other
sectors especially industries need to grow up if they have to provide market to the service
sector.

(11) Indian service providers (like BPOs and IT service providers) are facing stiff competition
from other countries. They need to improve their quality and reduce their costs. There are
certain political problems also like a backlash from European and North Americans
countries especially in the case of BPOs.
SUMMARY
For growth of an economy it is important that its producing sectors - agriculture, industry and
services - grow hand-in-hand. In India, agriculture sector dominates, in the sense it still provides
occupation to nearly 52 per cent of the population. Since agriculture has a pivotal role in the
Indian economy, it has been given importance throughout the planning period. A clear-cut
strategy consisting of land reforms, technological measures, administrative reforms etc. has
been carried out. But unfortunately, agricultural production and productivity have increased
just up to the point of imparting self-sufficiency in food grains and that too at a very low level
of consumption.
The industrial sector of an economy contributes to its economic development by acting as a
catalyst in the development of other sectors like agricultural, tertiary and export sectors. It
helps in raising the per capita output in the economy due to its high income elasticity and high
productivity. However, the development of industrial sector is dependent upon the development
of other sectors of the economy. The industrial sector has grown at an average rate of 6.2
percent per annum since Independence. Inspite of a number of problems like under-utilisation
of capacity, high capital-output ratio, high cost, inadequate employment generation, regional
imbalances etc., India has got a well developed industrial structure based on highly developed
infrastructure, a number of sophisticated heavy and capital goods units, a large number of
small units, besides a number of large business houses. Of the many problems faced by
industries, the problem of sickness is very prominent and chronic.
The service sector has emerges as an important sector of the Indian economy. It now contributes
more than 54 per cent of India's GDP and 45 per cent of India's exports. Of its various
components, trade, transport and communication services and financial services are growing
at a rapid pace. This sector faces a number of problems in the form of infrastructure, poor
quality, lack of adequate institutional set-up, lack of trained and hospitable service providers,
and stiff competition from other countries. These problems need to be addressed to if services
sector has to grow more rapidly in future.

CHAPTER – 5
INDIAN
ECONOMY –
A PROFILE
Unit 3
National
Income
in India
Learning Objectives
know the meaning of National income.

understand the various concepts related to National income.
understand how National income can be approached from three different ways.
know how National income and per capita income are growing in India.
INTRODUCTION
National income is the money value of all the final goods and services produced by a country
during a period of one year. National income consists of a collection of different types of goods
and services of different types. Since these goods are measured in different physical units it is
not possible to add them together. Thus we cannot state national income is so many millions of
metres of cloth, so many million litres of milk, etc. Therefore, there is no way except to reduce
them to a common measure. This common measure is money. The value of all goods and
services produced is measured in money. For example, if the value of a metre of cloth is Rs. 20
and the total cloth produced is 100 metres, then the money value of cloth is Rs. 2000. In this
way we can find out the value of other goods and services and the total value of all the goods
and services produced during one year. This gives us a single measure of the final goods and
services produced by the country in that year which is nothing but the value of national income
or national product.
3.0 BASIC CONCEPTS IN NATIONAL INCOME AND OUTPUT

(1) Gross Domestic Product (GDP) : Gross domestic product is the money value of all final
goods and services produced in the domestic territory of a country during an accounting
year. The concept of domestic territory has a special meaning in national income accounting.
Domestic territory is defined to include the following:
(i) Territory lying within the political frontiers, including territorial waters of the country.
(ii) Ships and aircrafts operated by the residents of the country between two or more countries.
(iii) Fishing vessels, oil and natural gas rigs, and floating platforms operated by the
residents of the country in the international waters or engaged in extraction in areas
in which the country has exclusive rights of exploitation.
(iv) Embassies, consulates and military establishments of the country located abroad.
(2) GDP at Constant Prices and at Current Prices : GDP can be estimated at current prices
and at constant prices. If the domestic product is estimated on the basis of the prevailing
prices it is called gross domestic product at current prices. Thus when we say that GDP of
India at current prices in 2007-08 is Rs. 43,20,892 crores, we are measuring GDP on the
basis of the prices prevailing in 2003-04. On the other hand, if GDP is measured on the

basis of some fixed prices, that is prices prevailing at a point of time or in some base year
it is known as GDP at constant prices or real gross domestic product. Thus when we say
that GDP in 2007-08 is Rs. 31,29,717 crores at 1999-00 prices, we are measuring GDP on
the basis of the prices prevailing in 1999-2000.
(3) GDP at Factor Cost and GDP at Market Price : The contribution of each producing unit to
the current flow of goods and services is known as the net value added. GDP at factor cost
is estimated as the sum of net value added by the different producing units and the
consumption of fixed capital. Since the net value added gets distributed as income to the
owners of factors of production, we can also estimate GDP as the sum of domestic factor
incomes and consumption of fixed capital. Conceptually, the value of GDP whether estimated
at market price or factor cost must be identical. This is because the final value of goods and
services (i.e. market price) must be equal to the cost involved in their production (factor
cost). However, the market value of goods and services is not the same as the earnings of the
factors of production. GDP at market price includes indirect taxes and excludes the subsidies
given by the government. Therefore, in order to arrive at GDP at factor income we must
subtract indirect taxes from and add subsidies to GDP at market price.
In brief GDPF.C = GDPM.P. - IT + S.
Where IT = Indirect Taxes
S = Subsidies
(4) Net Domestic Product : While calculating GDP no provision is made for depreciation
allowance (also called capital consumption allowance). In such a situation gross domestic
product will not reveal complete flow of goods and services through various sectors.
It is a matter of common knowledge that capital goods like machines, equipment, tools,
buildings, tractors etc., get depreciated during the process of production. After some time
these capital goods need replacement. A part of capital is therefore, set aside in the form
of depreciation allowance. When depreciation allowance is subtracted from gross domestic
product we get net domestic product.
In brief
NDP = GDP - depreciation
(5) Gross National Product (GNP) : It has already been seen that whatever is produced within
the domestic territory of a country in a year is its gross domestic product. It, however,
includes, the contribution made by non-resident producers by way of wages, rent, interest
and profits. The non-residents work in the domestic territory of some other country and
earn factor incomes. For example, Indian residents go abroad to work. Indian banks are
functioning abroad. Indians own property in foreign countries. The income of all these
people is the factor income earned from abroad. In other words, it is factor income earned
from abroad by the residents of India by rendering factor services abroad. Similarly, factor
services are rendered by non- residents within the domestic territory of India. Net factor
income from abroad is the difference between the income received from abroad for rendering
factor services and the income paid for the factor services rendered by non-residents in
the domestic territory of a country.

Gross national product is defined as the sum of the gross domestic product and net factor
incomes from abroad. Thus in order to estimate the gross national product of India we
have to add net factor income from abroad i.e., income earned by Indian residents abroad
minus income earned by non-residents in India to form the gross domestic product of
India.
In brief GNP = GDP + NFIA (where NFIA is the net factor income from abroad).
(6) Net National Product (NNP) : It can be derived by subtracting depreciation allowance
from GNP. It can also be found out by adding the net factor income from abroad to the net
domestic product. If the net factor income from abroad is positive i.e., the inflow of factor
income from abroad is more than the outflow, NNP will be more than NDP; conversely, if
net factor income from abroad is negative, NNP will be less than NDP and it would be
equal to NDP in case the net factor income from abroad is zero. Symbolically,
NNP = NDP + NFIA
(7) NNP at factor cost or National Income : NNP at factor cost is the volume of commodities
and services turned out during an accounting year, counted without duplication. It can
also be defined as the net value added at factor cost (by the residents) in an economy
during an accounting year. In terms of income earned by the factors of production, NNP
at factor cost or national income is defined as the sum of domestic factor incomes and net
factor income from abroad. If NNP figure is available at market prices we will subtract
indirect taxes and add subsidies to the figure to get NNP at factor cost or national income
of the economy.
Symbolically, NNP at FC = National Income = FID + NFIA
where FID is factor income earned in the domestic territory of a country and NFIA is the
net factor income from abroad.
There are two more concepts: Personal Income and Personal Disposal Income. Personal
income is the sum of all incomes actually received by individuals during a given year. In
order to estimate it we subtract from national income the sum total of social security
contribution and corporate income taxes and undistributed corporate profits and add
personal payments which are incomes received but not currently earned.
After the deduction of personal taxes from personal income of the individuals what is left
is called personal disposable income which is equal to consumption plus saving.
The following statements mathematically summarise the various concepts discussed above
and the relationship among them:
GNP at market price - depreciation = NNP at market price.
GNP at market price - net income from abroad = GDP at market price.
GNP at market price - net indirect taxes = GNP at factor cost.
NNP at market price - net income from abroad = NDP at market price.
NNP at market price - net indirect taxes = NNP at factor cost.
GDP at market price - net indirect taxes = GDP at factor cost.

GNP at factor cost - depreciation = NNP at factor cost.
NDP at market price - net indirect taxes = NDP at factor cost.
GDP at factor cost - depreciation = NDP at factor cost.
3.1 METHODS OF MEASURING NATIONAL INCOME

Production and sale of goods and services and the generation of income which accompanies
these activities are processes that go on continuously. Production gives rise to income; income
gives rise to demand for goods and services; and demand in turn gives rises to expenditure;
again expenditure leads to further production. The circular flow of production, income and
expenditure represents three related phases, namely, production, distribution and disposition.
These three phases enable us to look at national income in three ways - as a flow of goods and
services, as a flow of incomes or as a flow of expenditure on goods and services. To measure it
at each phase, we require different data and methods. If we want to measure it at the phase of
production, we have to find out the sum of net values added by all the producing enterprises
of the country. If we want to measure it at the phase of income distributed, we have to find out
the total income generated in the production of goods and services. Finally, if we want to
measure it at the phase of disposition, we have to know the sum of expenditures of the three
spending units in the economy, namely, government, consumer households, and producing
enterprises.
Corresponding to the three phases, there are three methods of measuring national income.
They are:
(i) Value Added Method (alternatively known as Product Method);
(ii) Income Method; and
(iii) Expenditure Method.
(i) Value Added Method: Value added method measures the contribution of each producing
enterprise in the domestic territory of the country. This method involves the following
steps:
(a) Identifying the producing enterprise and classifying them into industrial sectors
according to their activities.
(b) Estimating net value added by each producing enterprise as well as each industrial
sector and adding up the net value added by all the sectors.
All the producing enterprises are broadly classified into three main sectors namely: (1) Primary
sector which includes agriculture and allied activities; (2) Secondary sector which includes
manufacturing units and (3) Tertiary sector which include services like banking, insurance,
transport and communications, trade and professions. These sectors are further divided into
sub-sectors and each sub-sector is further divided into commodity group or service-group.
For calculating the net product of the industrial sector we need to know about gross output of
the sector, the raw materials and intermediate goods and services used by the sector and the
amount of depreciation. For an individual unit, we subtract from the value of its gross output,
the value of the raw material and intermediate goods and services used by it and, from this, we

subtract the amount of depreciation to get net product or value added by each unit. Adding
value-added by all the units in one sub-sector, we get value-added by the sub-sector. Again
adding value-added or net products of all the sub-sectors of a sector we get value-added or net
product of that sector. For the economy as a whole, we add net products contributed by each
sector to get Net Domestic Product. If the information regarding the final output and intermediate
goods is available in terms of market prices we can easily convert it in terms of factor costs by
subtracting (or adding as the case may be) net indirect taxes to it. If we add or subtract net
income from abroad we get Net National Product at factor cost which is nothing but National
Income.
Care should be taken to include the value of the following items :
(a) Own account production of fixed assets by government, enterprises and households.
(b) Production for self-consumption.
(c) Imputed rent of owner occupied houses.
Care should also be taken not to include sale of second-hand machines because they were
counted as a part of production in the year in which they were produced. However, brokerage
and commission earned by the dealers of second-hand goods are a part of production and
hence included while calculating total value-added. There is a difference of opinion among the
national income accountants regarding raw materials, intermediate goods and depreciation.
For example, a question arises whether government services are final (because they add to
satisfaction) or intermediate (because they are essential for economic activity). In India, we
treat them as final services but in Soviet Union (now called Commonwealth of Independent
States) these are treated as intermediate services. Similarly, it is very difficult to ascertain the
actual amount of depreciation because a fall in the value of capital stock depends upon many
factors which are difficult to measure.
Moreover, large areas of production activities are excluded for varying reasons. Their net
products cannot be valued either because there is no acceptable way of valuing them (which is
true in the case of services of housewives or self-services in homes or services of friends) or
because of the difficulty of securing data of the subsistence producing units particularly in
underdeveloped countries.
The product method thus gives information about the industrial origins of national income.
Additionally, net income from abroad should also be included or subtracted to get a true picture
of national income.
(ii) Income Method : Different factors of production pool their services for carrying out
production activities. These factors of production, in return, are paid for their services in
the form of factor incomes. Thus labour gets wages, land gets rent, capital gets interest
and entrepreneur gets profits. In other words, whatever is produced by a producing unit
is distributed among the factors of production for their services and aggregate of factor
incomes of all the factors of production of all the producing units form the subject matter
of calculation of national income by income method.
Only incomes earned by owners of primary factors of production are included in national
income. Transfer incomes are excluded from national income. Thus, while wages of labourers

will be included, pensions of retired workers will be excluded from national income. Labour
income includes, apart from wages and salaries, bonus, commission, employers' contribution
to provident fund and compensations in kind. Non-labour income includes dividends,
undistributed profits of corporations before taxes, interest, rent, royalties and profits of
unincorporated enterprises and of government enterprises.
However, normally, it is difficult to separate labour income from capital income because in
many instances people provide both labour and capital services. Such is the case with self-
employed people like lawyers, engineers, traders, proprietors etc. In economies where subsistence
production and small commodity production is dominant most of the incomes of people would
be of mixed type. In sectors such as agriculture, trade, transport etc. in underdeveloped countries
(including India), it is difficult to differentiate between labour element and capital element of
incomes of the people. In order to overcome this difficulty a new category of incomes, called
mixed income is introduced which includes all those incomes which are difficult to separate.
Care has to be taken to see that transfer incomes do not get included in national income. In this
context it is worthwhile to note that personal income which is income of household sector
should not be confused with national income. While personal income includes transfer
payments, national income does not. Similarly, illegal incomes, windfall gains, death duties,
gift tax and sale proceeds of second-hand goods are not included while calculating national
income.
Net income from abroad need not be added separately since the incomes received by people
include net foreign incomes as well. But if national income is calculated not from incomes
received by the people but from data regarding incomes paid out by producers then net income
from abroad would have to be added separately because incomes paid by producers would
total to domestic income. To arrive at national income, net income from abroad should be
added to domestic income.
(iii) Expenditure Method: The various sectors - household sector, business sector and
government sector either spend their incomes on consumer goods and services or save a part
of their incomes or we can say that they spend a part of their incomes on non-consumption
goods (or capital goods).
Total expenditure in an economy consists of expenditure on financial assets, on goods produced
in preceding periods, on raw materials and intermediate goods and services and on final goods
and services produced in the current period.
Expenditure on financial assets which are produced and owned within the country is excluded
but expenditure on financial assets of foreign countries is included in national expenditure.
However, only the net expenditure i.e., the difference between expenditure on foreign financial
assets by residents and expenditure on the country's financial assets by non-residents or
foreigners is incorporated. This difference is also called net foreign investment. Goods produced
in preceding years are also excluded from national income because they have been accounted
for in the national incomes of the periods when they were produced. Similarly, expenditure on
raw materials and intermediate goods and services are excluded because otherwise there would
be double counting of some of the items included in the national income. Government
expenditure on pensions, scholarships, unemployment allowance etc. should be excluded
because these are transfer payments.

Thus, only expenditure on final goods and services produced in the period for which national
income is to be measured and net foreign investment are included in the expenditure method
of calculating national income.
Expenditure on final goods and services is broadly classified into expenditure on consumer
goods and service (also called consumption expenditure) and expenditure on capital goods
(also called investment expenditure). Consumption expenditure is classified into private
consumption expenditure of the household sector and government consumption expenditure;
and investment expenditure is classified into private investment expenditure by business sector
and investment expenditure by government. To the total domestic investment we add net
foreign investment in order to arrive at national investment. Thus, the aggregates resulting
from the expenditure method measured at market prices are as follows:
Gross national expenditure = Consumption expenditure + net domestic investment + net foreign
investment + replacement expenditure (i.e., expenditure on replacement investment).
Net national expenditure = Consumption expenditure + net domestic investment + net foreign
investment.
Net domestic expenditure = Consumption expenditure + net domestic investment.
All the three methods mentioned above should ideally lead to the same figure of national
income and therefore national income of a country should be measured by these methods
separately to get a three dimensional view of the economy. This helps the government to analyse
the level of production and economic welfare in the economy, to analyse stability and growth
of the economy and to formulate appropriate economic policies of the government. Moreover,
each method provides a check on the accuracy of the other methods. However, it is easier said
than done. Because of lack of proper and reliable data it is very difficult to estimate national
income by each method separately. This is especially so in underdeveloped economies.
As a matter of fact, countries like India are unable to estimate their national income wholly by
one method. The contributions of different sectors to the total national income are estimated
by different methods. Thus, in agricultural sector net value added is estimated by the production
method, in small scale sector net value added is estimated by the income method and in
construction sector net value added is estimated by the expenditure method.
Income method may be most suitable for developed economies where people properly file their
income tax returns. With the growing facility in the use of the commodity flow method of
estimating expenditures, an increasing proportion of the national income is being estimated by
the expenditure method.
Estimation of the national income of a country is not an easy task. Appropriate and completely
reliable data for accomplishing this work is not available even in developed countries. The
following problems require particular mention:
(1) Presence of a large non-monetized sector
(2) Lack of appropriate and reliable data
(3) Problem of double counting
(4) Problem of transfer payments

(5) Difficulties in classification of working population
(6) Unreported illegal income
3.2 TRENDS IN INDIA'S NATIONAL INCOME GROWTH AND
STRUCTURE
For finding out the impact of economic planning in India a study of trends in national income
is necessary. It would be better, therefore, if the trend in national income and changes in the
structure of national product are analysed over the five and a half decades of planning.
(i) Trends in NNP : The real national income of India has increased at an annual average rate
of 4.4 per cent during the 58 years of economic planning.
There are two distinctive phases of economic growth in India since Independence: 1950-
1980 and 1980-2004. During the period 1950-51 to 1979-80, growth in GDP was 3.5 per
cent and during 1980-81 to 2003-04, growth in GDP was 5.6 per cent per annum. If we
consider the period between 2004-05 and 2007-08, GDP growth rate substantially increased
to 8.9 per cent per annum.
Colonial past, restrictive trade policy, licensing system, inward looking foreign policies,
too much stress on public sector and socialistic society, anti-market and anti-competition
attitude of the State, and vagaries of nature are some of the reasons for very poor
performance of the economy during 1950-80. In fact, since India continued to have an
average growth rate of 3.5 per cent, this rate i.e. 3.5 per cent came to be recognized as
Hindu rate of growth.
Acceleration in economic growth since 1980 was attributable to several factors.
Expansionary macro economic policies, economic reforms including trade liberalization
and deregulation of industries especially since 1991, reasonably well established social
and legal framework, well developed higher education system, improvement in
infrastructural facilities, change in attitude of national leadership, adoption of pro-market
policies, well fostered entrepreneurial skills and improvement in science and technology
etc. all led to improving the rate of growth of Indian economy.
Restructuring measures by domestic industry, overall reduction in domestic interest rates,
improved profitability, a benign investment climate amidst strong global demand and
commitment based fiscal policy have led to real GDP growth averaging 9 per cent per
annum during 2004-08.
Economic growth decelerated in 2008-09 to 6.7 per cent. The global financial crisis and
consequent economic recession in developed economies have been major factors in India’s
economic slow down. The deceleration of growth in 2008-09 was spread across almost all
the sectors.
How a country is performing can be judged in a two ways- by comparing its performance
with other countries and by comparing its performance with the targets set by it.

A comparison with a few of the developing countries is shown in the following Table:
Table 8: Real GDP Growth –Select Countries (per cent)
Country 1960s 1970s 1980s 1990s 2000-06
Brazil 5.9 8.5 3.0 1.7 3.1
China 3.0 7.4 9.8 10.0 9.5
India 4.0 2.9 5.6 5.7 7.0
Korea 8.3 8.3 7.7 6.3 5.2
Thailand 7.8 7.5 7.3 5.3 5.0
As can be seen in the Table, India’s rate of growth is improving. In fact, India now ranks
among the top ten fastest growing countries in the world along with China, Vietnam,
South Korea, Malaysia Thailand, Singapore, among others.
Plan-wise study of growth of real income in India, also indicates an encouraging fact that
although the annual rate of increase in national income was pretty low during the first
three decades of planning, it has lately risen and stood at 5.6 per cent per annum during
the eighties, around 5.7 per cent per annum during the nineties and 7 per cent during
2000-06.
During the First Plan, annual average growth rate was 3.7 per cent (at 1970-71 prices),
which increased to 4.2 per cent during the Second Plan. However, during the Third Plan,
annual average increase in national income slumped down to 2.8 per cent. This was largely
the consequence of serious drought in 1965-67, and thus the growth rate got depressed.
The depression continued in 1967-68. Only after 1967-68, the situation improved. During
the Fourth Plan, the average annual rate of growth of national income was 3.9 per cent.
The sharp upsurge in prices during 1972-73 and 1973-74 and the short falls in the
production on account of lower utilisation of capacity were the main factors responsible
for a lower growth rate during this plan. The Fifth Plan witnessed an annual economic
growth rate of 5 per cent. On the whole, the performance during the Fifth Plan was
satisfactory. During 1978-79 and 1979-80, the economy suffered a set back and the national
income fell by around 5.3 per cent. India's national income increased at a rate of 5.5 per cent
during the Sixth plan. Again, the seventh plan period witnessed 3 years of good harvest
which resulted in 5.8 per cent annual growth rate.
During the Eighth Plan, India achieved the highest ever annual average growth rate of
6.8 per cent. The spurt in economic reforms and good harvest for almost entire plan could
be mainly responsible for such a good performance of the economy. During the Ninth
plan, the annual average growth rate dipped to 5.4 per cent. This lower rate of growth
against the target of 6.5 per cent has been due to the dismal performance of the Industry.
During the five years of the Tenth Plan (2002-07), the economy registered growth rates of
3.8, 9.0, 7.8, 9 and 9.2 per cent respectively. Against the annual average target growth
rate of 8 per cent in the Tenth Plan (2002-07), achieved rate is 7.6 per cent per annum.
Encouraged with the good performance in the Tenth Plan, the Approach paper to Eleventh Plan
keeps a target of 8.5 per cent per annum growth rate.

(ii) Trends in Per Capita Income : India's per capita net national product i.e., during the last
58 years of planning has increased at a rate of 2.3 per cent per annum. This is modest
performance by all means. The rate of increase in per capita net national product was not
only conspicuously low but despite 58 years of economic planning, was still unsteady and
erratic. The per capita income increased at a modest rate of about 1.8 and 2.0 per cent
during First and Second Plans respectively.
As the Third Plan witnessed severe droughts, per capita income grew at almost zero per cent.
During the Fourth Plan, the situation improved a little bit and the per capita income grew
at a rate of 1.5 per cent per annum. The performance of the economy was satisfactory
during the Fifth Plan and the per capita income increase at a rate of 2.7 per cent per
annum. However, during 1978-79 and 1979-80, the economy suffered a set back and per
capita income fell by around 8.3 per cent during 1979-80 alone. The economy once again
witnessed years of good harvests during the sixth and seventh plans and the per capita
income recorded a growth of 3.2 and 3.6 per cent per annum respectively during these
plans. In the Eighth and Ninth plans, the per capita income witnessed a growth rate of 4.5
and 3.3 per cent per annum respectively. In the Tenth Plan, per capita income growth
accelerated to 6.1 per cent per annum.
It is to be noted that during 1950-51 to 1979-80, growth in GDP per capita per annum
was 1.4 per cent per annum. It accelerated to 3.6 per cent per annum during 1980-81 to
2004-05.
SUMMARY
We have seen that national income is nothing but money value of all the final goods and
services produced by the residents of an economy during a period of time, say one year. National
income can be measured by any of the three methods, namely product method, expenditure
method and income method. Theoretically we will get identical answers. We have also learned
various concepts in national income estimation like GNP at factor price, GNP at market price,
GDP, NNP and so on. In actual practice, there are various difficulties (conceptual and statistical)
involved in estimating national income. In India, national income is estimated by using a
combination of product and income method. India's National income has grown at an annual
average rate of around 4.4 per cent per annum since Independence. This rate is low not only
compared with other growing economies but also with regards to targets laid down. Of course,
however, there have been improvements in the growth rate of National income and per capita
income.

CHAPTER – 5
INDIAN
ECONOMY –
A PROFILE
Unit 4
Basic
Understanding of
Tax System
in India
Learning Objectives
know the meaning of Direct and Indirect Taxes.

know about merits and demerits of Direct and Indirect Taxes.
know about the taxation system prevailing in India.
4.0 MEANING OF DIRECT AND INDIRECT TAXES

Tax is the most important source of revenue of the Government. A tax is a compulsory
contribution from a person to the expenses incurred by the State in common interest of all
without reference to specific benefits conferred on any individual. Taxes are generally classified
into direct taxes and indirect taxes. Taxes which are not shifted i.e., the incidence of which
falls on persons who pay them to the Government are direct taxes. Examples of direct taxes are
income tax and wealth tax. Where the burden is shifted through a change in price, the taxes
are indirect. Examples of indirect taxes are sales tax, custom duty, excise duty etc.
4.1 MERITS AND DEMERITS OF DIRECT AND INDIRECT TAXES

Merits of Direct Taxes :
(i) They are imposed according to the ability of the person to pay. Therefore these taxes are
considered progressive.
(ii) The revenue is income elastic; because of the progressive character revenue will increase
faster than the increase in income.
(iii) These taxes create better civic consciousness because the person paying knows clearly
how much he has paid. This incidentally fulfils the objective of certainty.
(iv) They best serve the purpose of transference of income from the rich to the poor, through
provision of amenities to the poor or even direct monetary help like old age pensions.
Demerits of Direct Taxes
(i) The ability to pay is difficult to determine; only a rough idea can be formed.
(ii) Because of undeclared sources of income or evasion, the actual payment may not be strictly
according to the ability to pay. It is also sometimes said that direct taxes are taxes on the
honesty of the person.
(iii) Such taxes necessitate proper maintenance of accounts which some of the tax payers may
not be able to do.
(iv) The assessment procedure is also cumbersome requiring expert assistance of tax advisers.
The direct tax system is often very complicated.

Merits of Indirect Taxes

(i) The most important merit is convenience in assessment and a relative difficulty in evasion.
This is because they are assessed at flat rates and realised at appropriate point such as at
the factory site in the case of an excise duty on production or at point of entry in the case
of imports.
(ii) Since the tax is included in the price, the consumer may not even realise that he is paying
a tax. The amount of tax on each item is often so small as really not to hurt the tax payer.
(iii) Even these taxes may not be really regressive if they are levied on ad valorem basis or on
the basis of value. The rates may also be differential-higher for luxury articles and lower
for necessaries; the latter are sometimes fully exempt.
(iv) Such taxes are difficult to evade. Unless the producers resort to manipulation of accounts
or smuggling, it is difficult to evade the excise duty. In case of customs duties, articles are
taxed the moment they enter the country. However, it is difficult to make a similar claim
in respect of sales tax.
(v) Indirect taxes on drinks, narcotics and tobacco, serve a social purpose by discouraging
their consumption.
Demerits of Indirect Taxes:
(i) These taxes are often criticised for their regressive character. Taxes on necessaries of life
will certainly mean taxing the poor and that will mean taxing the rich and the poor alike.
(ii) Also it is contended that these taxes do not create social consciousness because they are
often not felt by tax payers.
(iii) Government is not certain about the proceeds of these taxes.
(iv) The burden of indirect taxes can be shifted forward or backward. In most of the cases, the
consumers have to bear the ultimate burden of indirect taxes.
(v) These taxes can also be evaded by such methods as smuggling, falsification of accounts
etc.
4.2 TAX STRUCTURE IN INDIA

4.2.0 Direct Taxes in India : Under this mainly income tax, wealth tax and gift tax are included.
Income Tax : Income tax is a tax on the income of an individual or an entity. Income Tax in
India was introduced in India in 1860 but was discontinued in 1873. It was reintroduced in
1886 and since then it has stayed. Since its reintroduction a number of changes have been
made in its structure, rates, exemptions and other dimensions of this system. Important types
of Income tax are Personal income tax and Corporate income tax. Though the State Governments
have power to levy a tax on agricultural income, in practice this tax has not developed as a
major source of revenue for the State Governments.
Personal income tax is levied on the income of individuals, Hindu Undivided Families,
unregistered firms and other association of people. For taxation purposes incomes from all
sources are added. Certain rebates, deductions, expenditure etc. on account of Life insurance,

medical insurance, savings in Public Provident Fund and certain notified instruments are
allowed. Whole income is divided into different slabs and it is taxed on the basis of slab into
which it falls.
Like all other countries India has a progressive income tax. That means, as income increases,
the rate of tax also increases. There was a time when the income tax rate , inclusive of surcharge
was as high as 97.75 per cent for the highest income slab. Since 1974-75, it has been brought
down(in stages) to 30 per cent in 1997-98. At present also, the marginal rate of income tax (i.e.,
tax for the highest slab) is 30 per cent. Thus the degree of the progressivity of the income tax
schedule has been considerably reduced.
Corporate Tax is levied on the incomes of registered companies and corporations. The rationale
for the corporation tax is that a joint stock company has a separate entity and thus should be
taxed separately.Untill 1960-61, corporations were taxed in a partial sense. A corporation was
required to pay income tax on behalf of its shareholders on dividends paid to them, and each
shareholder got a credit to this effect. Since 1960-61, corporations are being treated as
independent entities and shareholders are not given any credit. Though the corporates are
being taxed at a flat rate, there are provisions for various kinds of rebates and exemptions. Tax
rates are different for Indian companies and foreign companies. Certain types of companies
(e.g. export houses) are given tax exemptions and tax holidays.
Taxes on Wealth and Capital : Taxes which are levied on wealth and capital are mainly estate
duty, annual tax on wealth and gift tax. Estate duty was first introduced in India in 1953. It
was levied on the total property passing to the heirs on the death of a person. From the point
of view of proceeds, the estate duty was a minor source of revenue and it was abolished in
1985. An annual tax on wealth was introduced in 1957. It was levied on the wealth such as
land, bonds, shares etc. of the people. Certain types of properties such as agricultural land and
funds in Provident Account were exempt. Like estate duty this is also a minor source of revenue.
With effect from 1.4.1993, wealth tax has been abolished on all assets except certain specified
assets such as residential houses, farm houses, urban land, jewellery, bullion, motor car etc.
A gift tax was first introduced in 1958 and was leviable on all donations to recognised charitable
institutions, gifts to women dependents and gifts to wife. Gift tax was abolished in 1998.
Gift tax was partially reintroduced in April 2005. Gifts received from any person or persons, if
the aggregate value exceeds Rs.50000, have been made taxable under the head “Income from
other sources”. Certain exemptions have, however, been given. Now (with effect from 1.10.09)
even movable and immovable property given as gift would attract tax if its value exceeds
Rs 50000.
4.2.1 Indirect Taxes: The main indirect taxes levied in India are custom duties, excise duties,
sales tax and service tax.
Custom Duties: Custom duties are levied on exports and imports. From the point of view of
revenue, the importance of export duty is limited. Import duties are generally levied on the
basis of ad valorem which means they are determined as a percentage of the price of the
commodity. On some commodities, specific import duties i.e, per unit taxes on imports are
levied. In pre-tax reform period, India had become a country with one of the highest levels of
custom tariffs in the world. As a part of rationalisation measures carried out since 1991, the
custom duty structure has been pruned.
In the first half of 2008-09 fiscal, prices of certain commodities like crude oil, steel and food etc.
shot up world wide. This affected their domestic prices and demand. Consequently, as an
anti-inflationary measure, custom duties on many commodities were reduced.
Subsequently, in the aftermath of the impact of global financial meltdown since September
2008, there was a sharp decline in international commodity prices and some of the duty cuts
were, therefore, reversed.
But since the growth momentum of the economy was slowing down in the second half of the
2008-09, fiscal stimuli in the form of certain custom duties cut and exceptions were also given.
Excise Duties : An excise duty is levied on production and has absolutely no connection with
its actual sale. Excise duties are levied by the central Government in a number of forms. Over
the years, number of rate categories has been reduced and number of exemptions notifications
have also been brought down.
Taxation on inputs, such as raw materials, components and other intermediaries has a number
of limitations. It very often distorts the production structure, results in cascading of taxes (i.e.
compounding of tax liability) and does not allow correct assessment of the tax incidence. In
order to remove these defects, the government introduced Modified Value Added Tax
(MODVAT) in 1986-87. Value added is the difference between a firm's revenues and its
payments to other firms. It is the value difference between sales and purchased items.
MODVAT was different from VAT. VAT covers the entire value of inputs where as under
MODVAT credit was given in respect of duty paid inputs only. Under MODVAT a
manufacturer got full reimbursement of excise duty paid on the raw materials or components.
This system prevented payments of duties on earlier duties paid. However, MODVAT suffered
from many shortcomings. The most important being, the existence of a number of rates on
output and inputs leading to disputes relating to classification of both the output and inputs.
In order to combat the problem, the Budget 2000-01 introduced the Central Value-Added Tax
[CENVAT]. To attract CENVAT, there must be a process amounting to manufacture/
production and outcome should be excisable goods. The goods should be made in India to
attract CENVAT. It consists only one basic excise duty of 8 per cent and some special excise
duties. The basic rate of 8 percent is applicable to all the excisable commodities. Special excise
duty is in addition to CENVAT. It is leviable on a few mentioned goods. The basic excise paid
on excisable goods can be deducted from the excise collected on the output so that only tax on
value added is paid.
The CENVAT is simple. It will result in transparency in the system of union excise duty. The
earlier system of physically checking of goods can now be replaced by an account based systems.
Besides, it reduces cascading effect of input taxation. But the system suffers from certain
shortcomings such as existence of some cumbersome procedures, inadequate coverage of
CENVAT, scope of tax-evasion and so on.
Sales Tax : Sales tax is a tax on business transactions and thus it differs from excise duty in
certain respects. In India, many commodities are not covered by sales tax. Sales tax is more in
the case of luxury items and less or almost nil in the case of necessities. Under sales tax, the
registered trading concerns are required to pay the sales tax to the government. These registered

concerns shift the burden of sales tax to the customers. Sales tax regime suffers from many
problems, main being, cascading effect,lack of transparency, narrow base, different procedures
followed by different states and so on.
In India, sales tax was in two forms – state sales tax and central sales tax. State sale tax (i.e. tax
on transactions within a state) is being replaced by Value Added Tax in all states. Central sales
tax is inter-state sales tax. This tax is non-rebatable tax and is incongruent with the system of
VAT. Therefore, it is being phased out in stages. At present it is 2 per cent. By the financial year
2010-11, it will be completely phased out.
VAT : Value Added Tax (VAT) is a multistage sales tax with credit for taxes paid on business
purchases. One of the major benefits of VAT over sales tax is that the former is non-cascading.
One of the important components of tax reforms initiated since liberalization relate to
introducing state-level value added tax (VAT). The VAT is a multi-point destination based
system of taxation, with tax being levied on value addition at each stage of transaction in the
production/distributional chain. If for example, inputs worth Rs. 1,00,000/- are purchased
and sales are worth Rs. 2,00,000/- in a month, and input tax rate and output tax rate are 4%
and 10% respectively, then input tax credit and calculation of VAT will be as shown below:
(a) Input purchased : Rs. 1,00,000.
(b) Output sold : Rs. 2,00,000.
(c) Input tax paid : Rs. 4,000.
(d) Output tax payable : Rs. 20,000.
(e) VAT payable after
set-off input tax credit : Rs. 16,000.
[(d) - (c)]
The following are the benefits of VAT:
A set off will be given for input tax as well as tax paid on previous purchases.
Other taxes such as turnover tax, surcharge etc. will be abolished.
Overall tax burden will be rationalised.
Price will in general fall.
There will be higher revenue growth.
The zero rating of exports would increase the competitiveness of Indian exports.
There is a provision of self-assessment.
There will be more transparency.
VAT was introduced in 1999 and was implemented in April, 2005 in some states.
At present 33 states/union territories have implemented VAT. The tax revenue of the VAT
implementing states/union territories has registered a growth of more than 20 per cent per
annum since 2006-07.

Service Tax : Service tax is a form of indirect tax imposed on specified services called taxable services.
Introduced in the year 1994-95, service tax network has expanded to cover more than 100 services
over the years.
The rate of service tax was revised from 5 per cent in 2002-03 to 12 per cent in 2008-09.
However, with effect from 24.02.09 it has been reduced to 10 per cent.
4.2.2 Features of Tax Structure in India : Following are the main features of tax structure of
India :-
(i) Tax revenues (on account of the centre, state and union territories) form about 20 per cent
(2008-09) of the total national income of India. This was only 6.7 per cent in 1950-51 and
11 per cent in 1960-61. Considering the fact that India is a low income economy, the tax
burden is quite high. Among the Third World countries, India is one of the highest taxed
countries.
(ii) Over the last 57 tax revenue collected both by the Central and State governments has
increased many folds from Rs. 460 crore in 1951-52 to more than
Rs. 12,00,000 crore in 2008-09.
(iii) The ratio of direct to indirect taxes which was 40:60 in 1950-51 declined to 20:80 in 1990-
91. Thus there has been an increasing reliance on indirect taxes which is not good since
they fuel inflationary trends in the country. But since 1990-91, in wake of rationalisation,
the proportion of direct taxes has been on rise, whereas that of indirect taxes on the decline.
The share of direct taxes in the gross tax revenue (Centre and States combined) was 40 per
cent in 2008-09 while that of indirect taxes declined to 60%.
(iv) The population of the economy is more than 115 crore. But only 2.5 per cent of the
population is liable to pay income tax in India. Thus Indian tax structure relies on a very
narrow population base.
(v) The total tax revenue is highly insufficient to meet the expenditure requirements of the
economy. Over time there has been an increasing reliance to internal and external debts.
(vi) The structure of taxes in India has under gone changes. Earlier income tax and corporate
tax were important sources of the union revenue. Then excise duties became important.
Similarly, land revenues were important source of state revenue. Then sale tax became
more important. With the onset of nineties, the relative importance of different taxes has
been undergoing changes once again; the importance of personal income tax and corporate
tax has been on the rise, whereas that of customs and excise duty on the decline, although
Union excise duties continue to be the one of the largest source of tax revenue.
(vii) In India, the direct taxes are progressive, indirect taxes are differential in nature. In other
words, direct tax rates increase with increase in income and indirect tax rates are higher
for luxury items and lower for necessities.
(viii)The agriculture income is exempt from the income-tax.

4.2.3 Evaluation of the Indian tax system
Although direct taxes are progressive there is a differential rate schedule for indirect taxes. With
the increase in national income, the tax yields in general and from direct taxes in particular have
not increased at a rate high enough to show a high degree of income elasticity. Direct taxes were
2.1per cent of the GDP in 1950-51. It has increased to around 6.5 per cent in 2008-09.
Indian Tax system largely depends on urban incomes and leaves out almost completely
agricultural incomes from the purview of direct taxes. India's tax system has a much reduced
scope of manoeuvrability in the field of personal taxation. Thus, while national income rises,
with about one-fifth of it originating in the agricultural sector, the tax system is not able to tap
fully the rising income. The indirect tax system too is characterised by inelasticity.
Both the coverage and the rate schedule have been modified from time to time so that the tax
system plays a truly functional role for economic growth, stability and social justice. It is to be
noted that while the service sector accounts for more than 57 per cent of GDP, service tax
contributes just 10.4 per cent towards tax revenues and 1.2 per cent towards GDP.
In respect of canon of convenience, several, measures have been taken such as self assessment,
advance payment, deduction of tax at source, assessment on the basis of returns submitted,
etc. However, changes in tax laws in quick succession disturb long-term business decision-
making. Indirect taxes, although considered to be regressive, are quite convenient from the
collection point of view.
Simplification of tax system has also been attempted. Income tax returns have been simplified
and made handy. The Booth Lingam Committee and Chelliah Committee recommended
simplification and rationalisation of tax system in India. The proposed Direct Taxes Code also
aims at simplification of tax laws.
The cost of tax collection has increased over the years. It has increased from Rs. 543 cores in
1990-91 (Central Government) to more than 3,700 crore in 2007-08.
However, it is also noticed that the cost of tax collection for the Income Tax Department is the
lowest in the world at the rate of 60 paise for every Rs 100 collected as a tax.
Evasion and tax avoidance are reported to be very high. It has been estimated that black money
is generated at the rate of 50 per cent of the country's' GDP. Because of this, the black money
accumulation is of considerable magnitude. It is growing every year. The unaccounted funds
are invested into business through diverse means and add further to the existing funds of black
money. A part of it is squandered and wasted lavishly on social functions and on anti- social
activities. Besides, the Indian tax system is also accused of (i) discouraging employment (ii)
distorting prices (iii) and adversely affecting savings.
SUMMARY
In order to carry out its functions properly every State needs funds. An important way of
raising funds is levying taxes. Taxes could be direct and indirect. Direct taxes are taxes which
are not shifted i.e., the incidence of which falls on persons that pay them to the government.
Examples of direct taxes are income tax, wealth tax. Where the burden is shifted through a

change in price, the taxes are indirect. Examples of indirect taxes are service tax, custom duty,
excise duty, VAT etc.
A tax system could be proportional (falling on all the incomes at the same rate), regressive
(falling on higher incomes at a proportionately lower rate) or progressive rising proportionality
with rise in income. Direct taxes are progressive but indirect taxes are generally regressive in
nature. An important technique adopted for taxation in India was MODVAT i.e., Modified
Value Added Tax. Value Added Tax is the tax to be paid by all sellers of goods and services, on
the basis of value added by them. MODVAT was replaced by Central Value Added Tax
(CENVAT). Value Added Tax system has been introduced in many States since April 2005.

1. Generally an economy is considered under developed if
a. the standard of living of people is low and productivity is also considerably low.
b. agriculture is the main occupation of the people and productivity in agriculture is
quite low.
c. the production techniques are backward.
d. all of the above.
a. Agriculture occupies 10 per cent population of India.
b. Nearly 5 per cent population of India is below the poverty line.
c. The production techniques are backward.
d. None of the above.
3. Which of the statements is correct?
a. The tertiary sector contributes the maximum to the GDP.
b. India is basically a socialist economy.
c. The distribution of income and wealth is quite equitable.
4. ____________ is the apex bank for agriculture credit in India.
a. RBI
b. SIDBI
c. NABARD
d. ICICI
5. The share of agriculture in India's national income has __________ over the years.
a. remained constant.
b. decreased.

c. increased.
d. first decreased and then increased.
6. The green revolution is also known as
a. wheat revolution.
b. rice revolution.
c. maize revolution.
d. forest revolution.
7. The area under irrigation has ____________ over the years in India.
b. decreased
c. increased.
d. first increased and then decreased.
a. Under zamindari system, farmers directly paid land revenue to the state.
b. At present, income tax revenues from the agriculture sector are negligible.
c. Commercial banks are providing loans to the agriculture sector at zero interest rate.
9. Which is of the following is incorrect?
a. Special schemes have been started to promote export of agro-products.
b. India has been a big importer of food grains especially since 1990s.
c. High yielding varieties programme has resulted in improvement in production and
productivity of food grains in India.
10. Abolition of intermediaries and tenancy reforms are both parts of
a. industrial reforms in India.
b. external sector reforms in India.
c. land reforms in India.
d. banking reforms in India.
11. Agriculture sector faces the problem of
a. slow and uneven growth.
b. inadequate and incomplete land reforms.

c. inadequate finance.
12. In absolute terms, the number of people engaged in agricultural activities over the planning
period has
b. increased.
c. decreased.
d. first increased and then decreased.
13. We can say Indian agriculture has become modern since
a. there has been an increase in the use of high yielding varieties of seeds, fertilizers,
pesticides etc.
b. there has been noticeable positive change in the attitude of farmers towards new
techniques of production.
c. farmers are increasingly resorting to intensive cultivation, multiple cropping, scientific
water management
14. Which of the following has been specifically established to meet the requirements of credit
of the farmers and villagers?
a. ICICI bank.
b. Regional Rural Banks.
c. State Bank of India.
d. EXIM bank.
a. About 80 per cent of agricultural area has irrigation facilities.
b. About 60 per cent area is rain fed in India.
c. Productivity per worker in agriculture is much lower than that in industry.
d. Cropping pattern is quite skewed in India.
a. Countries which are industrially well-developed generally have higher per capita
income than countries which are not.
b. India is a capital surplus economy.
c. Agriculture sector need not depend upon industrial sector for its growth.

17. Mahalanobis model stressed upon the establishment of
a. consumer goods industries.
b. export oriented industries.
c. agro-based industries.
d. capital and basic goods industries.
18. Three steel plants in Bhilai, Rourkela and Durgapur were set up in the
a. First plan.
b. Second plan.
c. Third plan.
d. Fourth plan.
19. The industrial sector faced the process of retrogression and deceleration during
a. 1950-1965.
b. 1990-2005.
c. 1980-1995.
d. 1965-1980.
20. Which of the following has resulted in failure to achieve targets of industrial production?
a. Poor planning.
b. Power, finance and labour problems.
c. Technical complications.
d. All of the above.
a. A large number of industries face under utilization of production-capacity.
b. The incremental capital -output ratio has been falling over the planning period.
c. In terms of regions, industrial development is quite balanced.
22. About ________ per cent of the sick units in India are small units.
a. 10 per cent
b. 5 per cent
c. 30 per cent
d. 96 per cent.

23. The Tenth Plan aimed at achieving a growth rate of _______________ in the industrial
sector.
a. 5 per cent
b. 8 per cent
c. 10 per cent
d. 6 per cent
24. Oil and Natural Gas Corporation Indian Oil Corporation, Steel Authority of India, and
Bharat Heavy Electricals are all examples of
a. small scale units.
b. private sector units.
c. public sector units.
d. sick units.
25. The Indian industry faced the process of retrogression and deceleration because of
a. unsatisfactory performance of agriculture
b. slackening of real investment in public sector
c. narrow market for industrial goods, especially in rural areas.
a. The industrial pattern on the eve of Independence was quite balanced.
b. During the planning period, the structure of Indian industry has shifted in favour of
basic and capital goods and intermediate sector.
c. Most of the big industrial units in India are sick.
27. Over the planning period the share of industrial sector in the GDP of India has ___________.
a. increased
b. decreased
c. remained constant
d. remained above 50 per cent
28. The industrial sector depends on the agricultural sector because
a. the agriculture sector provides food and other products for the consumption purposes
of industrial sector.
b. the agriculture sector provides raw-materials for the development of a agro-based
industries of the economy.

c. the agricultural sector provides market for the industrial products.
29. A sick industrial unit is one
a. where most of the employees are sick.
b. which is unable to perform its normal functions and activities of production of goods
and services at a reasonable profit on a sustained basis.
c. which is unable to make profits more than 10 per cent of its capital employed.
d. which borrows money from bank for its fixed assets.
30. All of the following can cause sickness to an industrial unit except:
a. demand recession.
b. uneconomic size.
c. high productivity of labour and capital.
d. financial mismanagement.
31. The service sector in India now accounts for
a. more than 80 per cent of GDP.
b. more than 70 per cent of GDP.
c. more than 50 per cent of GDP.
d. more than 90 per cent of GDP.
32. Nearly __________ percent of working population is engaged in the service sector. [2001]
a. 23 per cent
b. 45 per cent
c. 80 per cent
d. 50 per cent
33. Service sector accounted for nearly ______________ percent of exports (2007-08).
a. 10 per cent
b. 20 per cent
c. 45 per cent
d. 80 per cent
34. India has the _____________ largest scientific and technical manpower in the world.
a. fifth
b. tenth

c. eighth
d. second
a. The service sector contributes more than half of the GDP of India.
b. The scope of attracting tourists is limited as there is hardly any place of tourist attraction
in India.
c. Generally as an economy grows first service sector grows and then agriculture and
industrial sectors grow.
36. BPO stands for
a. Bharat Petro Organisation
b. Business Process Outsourcing
c. Big Portfolio outsourcing
d. Business Partners Organisation
37. Small scale units exist in India because
a. they are labour intensive and India is a labour surplus economy.
b. they offer methods of ensuring more equitable distribution of income and wealth.
c. they facilitate the creation of a wider entrepreneurial base.
38. Which of the following is incorrect?
a. GDP at market price = GDP at factor cost plus net indirect taxes.
b. NNP at factor cost = NNP at market price minus indirect taxes.
c. GNP at market price = GDP at market price plus net factor income from abroad.
39. National income differs from net national product at market price by the amount of
a. current transfers from the rest of the world.
b. net indirect taxes.
c. national debt interest.
d. it does not differ.
40. Net national product at factor cost is
a. equal to national income.
b. less than national income.

c. more than national income.
d. sometimes less than national income and sometimes more than it.
41. Transfer payments refer to payments which are made.
a. without any exchange of goods and services.
b. to workers on transfer from one job to another.
c. as compensation to employees.
42. The net values added method of measuring national income is also known as :
a. net output method.
b. production method.
c. industry of origin method.
43. Identify the items which is not a factor payment
a. free uniform to defense personnel.
b. salaries to the members of Parliament.
c. imputed rent of an owner occupied building.
d. scholarships given to the scheduled caste students.
44. Mixed income of the self employed means
a. gross profits received by proprietors.
b. rent, interest and profit of an enterprise.
c. combined factor payments which are not distinguishable.
d. wages due to family workers.
45. Demand for final consumption arises in
a. household sector only.
b. government sector only.
c. both household and government sectors.
d. neither household nor government sector.
46. Demand for intermediate consumption arises in
a. consumer households.
b. government enterprises only.
c. corporate enterprises only.
d. all producing sectors of an economy.

47. Which of the following is an economic activity?

a. Listening to music on the radio.
b. Teaching one's own son at home.
c. Medical facilities rendered by a charitable dispensary.
d. A housewife doing household duties.
48. Net value added is equal to
a. payments accruing to factors of production.
b. compensation to employees.
c. wages plus rent plus rent.
d. value of output minus depreciation.
49. Per capita national income means
a. NNP ÷ population
b. Total capital ÷ population
c. Population ÷ NNP
50. Which of the following is correct?
a. If national income rises, per capita income must also rise
b. If population rises, per capita income must fall.
c. If national income rises, welfare of the people must rise.
51. One of the following is not the merit of direct taxes. Find it.
a. They are imposed according to the ability of the person to pay.
b. These taxes create civil consciousness.
c. The revenue is income elastic.
d. They do not require maintenance of accounts.
52. Find the tax which is direct tax among the following:
a. Personal income tax.
b. Excise duty.
c. Sales tax.
d. Service tax.

53. Among the following types of taxes, find the one which is indirect?
a. Gift tax.
b. Corporate income tax.
c. VAT.
d. Wealth tax.
a. Income tax was abolished in India in 1991.
b. Gift tax was abolished in India in 1998, but was partially reintroduced in April 2005.
c. No state has adopted VAT system of indirect taxation.
d. Estate duty was abolished in 1995.
a. Excise duty is levied on sales volume.
b. Custom duties have been drastically cut down since 1991.
c. VAT has been adopted by two-three states in India.
d. Agriculture contributes the maximum to the direct tax revenues in India.
ANSWERS
1. d 2. c 3. a 4. c 5. b 6. a
7. c 8. b 9. b 10. c 11. d 12. b
13. d 14. b 15. a 16. a 17. d 18. b
19. d 20. d 21. a 22. d 23. c 24. c
25. d 26. b 27. a 28. d 29. b 30. c
31. c 32. a 33. c 34. d 35. a 36. b
37. d 38. d 39. b 40. a 41. a 42. d
43. d 44. c 45. c 46. d 47. c 48. a
49. a 50. d 51. d 52. a 53. c 54. b
55. b

CHAPTER – 6
SELECT ASPECTS
OF INDIAN
ECONOMY
Unit 1
Population
SELECT ASPECTS OF INDIAN ECONOMY
Learning Objectives
know the meaning of population.
get familiar with demographic trends in India.
understand how big population in India is acting as a drag on its economic growth.
understand the causes of rapid population growth in India.
know the steps taken by the government to meet the challenge of high population growth.
1.0 MEANING OF POPULATION

In common parlance, population refers to the total number of people residing in a place. Thus,
population of India means the total number of people living in India. There was a time when
growth in population was considered desirable. There are still certain countries (example,
Australia), which give incentives to people to have large families and hence have big population
of the country. For them, more number of persons is desirable as
It provides work force to produce.
It provides market for the products produced.
It may promote innovative ideas.
It may promote division of labour and specialisation.
However, there are countries (example, India) for whom more number of persons is not desirable
as
There may not be adequate jobs to absorb all additional people.
They put pressure on means of subsistence.
They put pressure on social overheads (hospitals, schools, roads etc.)
They may result in increased consumption and reduced savings and hence slow down
capital formation.
They may increase dependency.
Actually, whether a big and growing population is an asset or a liability for the economy
depends upon economy to economy.
1.1 DEMOGRAPHIC TRENDS IN INDIA

Size of Population : The size of population is determined in terms of number of persons.
Considering the present boundary of India (i.e., except Pakistan and Bangladesh), the population

in 1901 was 23.84 crores and after one hundred years, in 2001 it was 102.27 crores. Thus, over
a period of 100 years, our population has more than quadrupled. In 2008-09 the population
was 115 crores. The population during various census years is given in Table 1.
Table 1 : India’s Population (1901 - 2001) (in crores)
Census Year Population

1901 23.84
1911 25.21
1921 25.13
1931 27.90
1941 31.87
1951 36.11
1961 43.92
1971 54.81
1981 68.33
1991 84.33
2001 102.70
The Table shows how population has grown in size over the 20th century. As far as the size of
India’s population is concerned India ranks second in the world after China. India has only
about 2.4 per cent of the world’s area and less than 1.2 per cent of the world’s income but
accommodates about 16.7 per cent of the world’s population. In other words, every sixth
person in the world is an Indian.
Rate of Growth : Table 2 shows the rate of growth of population in India. It shows growth rate
of population per decade and per annum.
Table 2 : Growth of population
Decade Growth Rate (Per cent)
per decade per annum
1901-1911 05.74 00.56
1911-1921 (-)00.31 -00.03
1921-1931 11.00 01.04
1931-1941 14.22 01.33
1941-1951 13.31 01.25
1951-1961 21.64 01.96
1961-1971 24.80 02.20
1971-1981 24.66 02.22
1981-1991 23.86 02.14
1991-2001 21.34 01.93

During 1901-11, the population grew by 5.74 per cent over the decade or 0.56 per cent per
annum. The next decade saw a fall in the growth rate. In fact, there was a decrease in the
population and growth rate became negative. Since 1921, population has again started
increasing. In fact, year 1921 is known as ‘Year of Great Divide’ for India’s population. The
slow or negative growth during 1901-21 was due to rapid and frequent occurrence of epidemics
like cholera, plague, influenza and famines. Since Independence, the rate has not only been
positive but crossed the 2 per cent mark. Between 1961-1991, the growth rate has remained
above 2 per cent per annum. Only in 1991-2001 decade, the growth rate has come down to
1.93 per cent per annum.
Birth rate and Death rate : Table 3 shows birth and death rates in India since Independence.
Birth rate refers to number of birth per thousand of population. Similarly, death rate refers to
number of deaths per thousand of population. We see from the table the death rate has declined
significantly from 27.4 in 1951 to 8.4 in 2001 and 7.4 in 2007 and birth rate, although has
declined but the decline is not so remarkable. Birth rate was 39.9 in 1951, it fell to 25.4 in 2001
and to 23.1 in 2007.
Table 3 : Crude Birth and Death Rate
Year Birth Rate Death Rate

1951 39.9 27.4
1961 41.7 22.8
1971 36.9 14.9
1981 33.9 12.5
1991 29.5 9.8
2001 25.4 8.4
Among all the states, Kerala has the lowest birth rate of 14.7 (2007) and Uttar Pradesh has the
highest birth rate of 29.5 (2007). Considering death rate, West Bengal has the lowest death rate
of 6.3 and Orissa has the highest death rate of 9.2 in 2007.
Density of population : Density of population refers to the number of persons per square
kilometer. The changes in the density of population have been indicated in Table 4 :
Table 4 : Density of Population
Year Density of population

1951 117
1961 142
1971 178
1981 216
1991 274
2001 324

Density of the population before Independence was less than 100. But after Independence, it
has increased rapidly from 117 in 1951 to 274 in 1991 and further to 324 in 2001. Thus the
pressure of population on land has been rising. The density of population is not the same for all
the States; while Kerala, West Bengal, Bihar and U.P. have density higher than the average
density, Andhra Pradesh, Himachal Pradesh, Gujrat, Madhya Pradesh, Maharashtra,
Karnataka, Orissa, Rajasthan, Sikkim etc. have density lower than the nation’s average. This
difference could be due to the differences in natural resources endowment, level of development
etc. West Bengal is the most densely populated state in the country with 904 persons living per sq.
km. followed by Bihar with 880.
If we consider all states and union territories of India, Delhi has the highest density of population
– with 9294 persons, followed by Chandigarh with 7903 persons living per square kilometre.
Inter-State variations in India in the density of population are also very informative about the
demographic situation in the country. For example, we have Delhi on one side with density of
more than 9000 and on the other side Arunachal Pradesh with density as low as 13 persons
per sq. km. Even we can make a guess about the level of development seeing the density of the
area. Generally, it has been noticed that areas which are industrially well developed experience
higher density vis-a-vis areas which are not. But if in an economy, agricultural sector is
dominant, better climate, rainfall and irrigation facilities exercise considerable influence on the
density of population.
Sex ratio : Sex ratio refers to the number of females per 1000 males. The following table gives
sex-ratio since Independence.
Table 5 : Sex Ratio (females per 1000 males)
Census Year Sex ratio

1951 946
1961 941
1971 930
1981 934
1991 927
2001 933
The above Table sows that sex ratio, is highly favourable to males than females. This speaks of
a very important characteristic of our society i.e., our society is male dominated. This is in
contrast to what is found in other countries of the world specially the more advanced one. Till
late, there was great tendency among people in India to get the sex of the unborn child medically
tested and get the pregnancy terminated if it was female. But now these tests have been banned.
The recent census (2001) shows that there has been a marginal increase in sex ratio. Sex ratio
was 927 in 1991. Now it is 933. That means the number of males per thousand females is on
decrease. For rural and urban India this ratio was 946 and 900 respectively in 2001.
If we analyse State-wise figures, we find the sex ratio is favourable to males in all the States
except Kerala. In Kerala, ratio of females to males in 2001 was 1058. Kerala is the State which

provides better status to women as compared to other States. A number of reasons are ascribed
for a high ratio of males to females. These are:
(i) Neglect of female child and greater care for the male child in general results in higher
mortality in the former case than the latter.
(ii) High death rate among females specially during the time of child birth and due to low
resistance power resulting from a number of deliveries without having proper diet and
rest makes the sex ratio unfavourable to females.
(iii) Under-reporting of female births.
Haryana has the lowest female sex ratio of 861 (2001) among states.
Life-expectancy at birth : Life expectancy refers to the mean expectation of life at birth. If
death rate is high and/or death occurs at an early age, life expectancy will be low and, it will
be high if death rate is low and/or death occurs at an advanced age. The following Table
shows life expectancy at birth both for males and females.
Table 6 : Life expectancy at Birth (in years)
Period Male Female Overall
average
1951 32.5 31.7 32.1
1961 41.9 40.6 41.3
1971 46.4 44.7 45.6
1981 54.1 54.7 54.4
1991 59.0 59.7 59.3
2001 62.3 65.3 63.8
Life expectancy has improved over the years. During 1901-11, life expectancy was just 23
years. It remained below 30 years till the decade 1921-30 and remained below 40 years till the
period 1941-50. However, it improved to 55 in 1981 and to 60 in 1991 and further to 63.8 in
2001. Considerable fall in the death rate is responsible for improvement in the life expectancy
at birth. This could be one of the reasons for favourable sex ratio for males.
Amongst the states, Kerala had the highest life expectancy at birth at 74 and Madhya Pradesh
had the lowest life expectancy at birth at 58 in 2006.
Life expectancy at birth in India compares badly when compared with the life expectancy at
birth in developed economies and some of the developing economies such as Sri Lanka and
Thailand. India can still improve its life expectancy by increasing moderately the expenditure
on public health and medicine.
Literacy ratio : Literacy ratio refers to number of literates as a percentage of total population.
Literacy ratio in general and among males and females is shown below :

Table 7 : Literacy Ratio
Census Year Literate persons Males Females
1951 16.7 25.0 7.9
1961 24.0 34.4 13.0
1971 29.5 39.4 18.7
1981 43.6 56.4 29.75
1991 52.21 64.1 39.3
2001 65.38 75.85 54.16
In 1951, only one-fourth of males and one-twelfth of females were literate. Thus on an average
only one-sixth of the people of the country were literate. During 1951-2001, there has been
considerable improvement in literacy. This is clear from the figures of 2001. In 2001, 76 per
cent of males and 54 of females were literate giving an overall literacy rate of 65. Compared
with other developed countries, this rate is very low. Illiteracy among 35 per cent of the
population is bound to affect the progress of family planning programme. It has been found
that literate persons are more responsive to family planning programme than illiterate ones.
Literacy is higher among urban population compared with rural population. This could be
because of better facilities of education in urban areas compared to the facilities available in
rural areas. In 2001, the proportion of literacy among males was 86 per cent in urban areas as
against 71 per cent in rural areas. Similarly 73 per cent of the females in urban areas were
literate as against about 46 per cent in rural areas.
Literacy rates are different among the States also. Kerala has the highest literacy ratio of 90.86
per cent and Bihar has the lowest literacy ratio of 47 per cent. As against about 90 per cent
literacy in Kerala, about 82 per cent in Goa, 77 per cent in Maharashtra and Himachal Pradesh, and
73 per cent in Tamil Nadu, literacy is less than 50 per cent in Bihar, and around 60 per cent in
Rajasthan and Uttar Pardesh. The differences are even greater when we compare literacy among
females in the different states.
The Eighth Plan aimed at complete eradication of illiteracy among people in the age group of
15 to 35 years by the end of the plan. Seeing the overall progress on literacy front till now, this
seems to be a difficult target. According to one estimate, it would take more than 30 years for
the Indian population to be fully literate.
1.2 CAUSES OF THE RAPID GROWTH OF POPULATION

Population generally increases because of
(i) high birth rate.
(ii) relatively lower death rate.
(iii) immigration.
India’s population has mainly increased because of high birth rate and relatively low death
rate.

Causes of high birth rate

(1) India is predominantly agrarian economy. In an agrarian economy, children are considered
assets and not burdens as they help in agricultural fields.
(2) The process of urbanisation is slow in India and it has failed to generate social forces
which force people to have small families.
(3) There is high incidence of poverty in India. Poor people tend to have large families.
(4) Marriage is both a religious and social necessity in India. Presently in India by the age of
50 only 5 out of 1,000 Indian women remained unmarried.
(5) Not only marriages are almost compulsory, they take place at quite young age in India.
(6) Most Indians on account of their religious and social superstitions desire to have more
children having no regard to their economic conditions.
(7) Joint family system in India also encourages people to have large families.
(8) Lack of education among people especially among women causes people to have irrational
attitudes and hence big families.
Causes of fall in the death rate
(1) Famines which were wide spread before Independence, have not occurred on a large
scale since Independence. Whenever droughts occurred, they have been dealt with
adequately.
(2) Cholera and small pox often resulted in epidemics before Independence. Now small pox is
completely eradicated and cholera is very much under control. Similarly there has been
decline in the incidence of malaria and tuberculosis. These have resulted in reducing the
death rate.
(3) Other factors which have reduced the death rate are: spread of education, expanded
medical facilities, improved supply of potable water, improvement in the nutritional level
and so on.
1.3 GROWTH OF POPULATION IN INDIA AND ITS EFFECTS ON

ECONOMIC DEVELOPMENT
India is passing through the phase of population explosion. Population explosion is a transitory
phase according to the theory of Demographic Transition. This theory says that every country
passes through 3 stages - In the first stage both birth rate and death rate are very high. Hence,
population remains stable. In this stage, birth rate is high because people are illiterate, poverty
is wide-spread, marriages are conducted at early age and superstitions cause people to have
big families. Death rate is high on account of malnutrition, lack of medical facilities, absence of
hygienic conditions etc.
In the second stage, birth rate comes down slightly but death rate comes down very heavily.
Death rate comes down due to improvement in medical facilities and improved standard of
living. Birth rate remains high because of social beliefs and customs do not change overnight.
This stage is also called the stage of population explosion as population increases at a very high
rate during this stage.
In the third stage, greater education causes people realise the importance of smaller families
and better standard of life. Old social customs give place to new ideas. As a result, birth rate is
low. Death rate is low because of better hygienic conditions and better medical facilities. The
net result is population grows at a very modest rate.
Now we will analyse how growth of population has affected economic growth in India.
(i) Growth of national income : National income rose by more than 12 times during 1950-51 to
2007-08, but on account of increase in population by more than 2 times, the per capita
income rose by a little more than 3.25 times only. The average annual growth during this
period was about 4.4 per cent but could effect an increase of only 2.3 per cent in per capita
income.
(ii) Food supply : The total production of foodgrains increased from 51 million tonnes in 1951
to about 231 million tonnes in 2007-08. During the same period population increased
from 361 million to 1138 million. Consequently, the per capita domestic availability of
foodgrains increased from 395 grams to 443 grams signifying a very small increase in per
capita availability. As compared to increasing demand for food, per capita availability of
food grains is insufficient. If the present trend of increase in population continues demand
for foodgrains might outgrow population unless the increase in population is contained
by vigorous family planning programmes.
Also, increase in production of foodgrains has to be brought about more and more through
increasing productivity because per capita availability of cultivable area is coming down
gradually. In 1951 it stood at 0.33 hectare per capita which came down to 0.17 hectare
per capita in recent years. A falling land-man ratio has to be compensated by increase in
productivity per acre.
(iii) Unproductive consumers : With a rapid increase in population, the ratio of children and
old persons in total population has a tendency to increase which leads to higher burden of
unproductive consumers on the total population. In India, around 63 per cent of the
population is in the age group 15-64 and 37 per cent of the population is under 15 or
above 64. An increase in the ratio of unproductive consumers places additional burden on
the resources of the family as well as the public utility services like education, health etc.
Economists have calculated the burden of dependency in terms of food, education and
health. Such dependency load is an important contributing factor to the vicious circle of
poverty and under-development in developing countries.
(iv) Problem of unemployment : With fast growing population, the labour force increases
rapidly and there is a pressure for creating jobs for the growing labour force. In absence of
insufficient number of jobs, the number of unemployed people increases.
In India, in successive plans job opportunities have been created but they have fallen short
of the required numbers and as a result the backlog of unemployed people has become
very large. It is estimated that unemployed and underemployed persons constitute nearly
10 per cent of the labour force in India. Moreover, it is projected that total labour force will
increase by 45 million in the Eleventh Plan. Jobs will have to be created for these people
plus the people in the backlog.

(v) Capital formation : It is said that a part of capital formation investment normally goes in
maintaining the existing standard of living for the additional population. For example,
with a population growth of 2 per cent an investment of around 8 per cent (with a capital
output ratio of 4 : 1) of national income would just be able to maintain the existing standard
for the additional population. Therefore, for any improvement in the standard of living,
the capital investment has to be very large. Thus, for 5 per cent rise in per capita income
the resources needed for the economic development will be 20 per cent. Thus to bring
about an increase of 5 per cent in per capita income, an investment of 28 per cent (8 per
cent for demographic investment and 20 per cent for economic investment) will be needed.
(vi) Ecological degradation: A rapid growth population in India, as in many other countries,
has somewhat upset the ecological balance. There is a gradual shrinkage of area covered
by forests as also open land. Denudation of forest means serious soil erosion and floods
with their adverse consequences on food production. Also, removal of forests has led to
unfavourable climatic changes evidenced by prolonged droughts over extensive areas.
There is also a great pressure on agricultural land leading to depletion of natural soil
fertility, increase in alkalinity and salinity of soils. A high concentration of population in
urban areas, unsupported by adequate infrastructural facilities (drinking water, sanitation,
transportation, housing etc.) is a cause of serious pollution.
1.4 GOVERNMENT MEASURES FOR SOLVING THE POPULATION

PROBLEM
Population growth is not to be left to natural, biological and other forces. Policy intervention is
needed to plan and regulate it in tune with the needs of the economy and society. Even if
economic growth rate is more than population growth rate, a developing country cannot afford
to derive satisfaction from this fact but should deliberately adopt some policy measures to slow
down the rate of population growth. In a developing country like India, the fruits of rapid
economic growth will have little impact on society if population growth is not controlled.
Much of the gains of economic growth is neutralised by rapid increase in numbers. Even inflation
which is another neutraliser of economic growth is partly a function of population growth.
Family planning which was and is a principal component of the population policy was taken
up on a modest scale with emphasis on clinical approach during the first decade of planning.
The emphasis was mainly on research in the field of demography, physiology of reproduction,
motivation and communication. Since these measures did not yield the expected results, a full
fledged department of family planning was created in 1966. Various contraceptive methods
were offered and the acceptors had the freedom to choose any of the methods offered. This has
been known as ‘cafeteria approach’. The allocation towards family planning programmes kept
on increasing from plan to plan. There was a significant shift in the strategy of the government
towards population under the Fifth Plan. A new National Population Policy replaced earlier
Population Policy of the government. It was felt that to wait for education and economic
development to bring about a drop in fertility was not a practical solution. The very increase in
population made economic development slow. Therefore, a direct assault on the problem was
made. Under the policy the marriageable age was raised to 18 years and 21 years for girls and

boys respectively, monetary incentives were offered for voluntary sterilization and family
planning was made a mass movement by involving various community groups like Zila
Parishad, Panchayat Samitis, Co-operative Societies and trade unions at the grass roots levels.
The implementation of parts of this policy during Emergency (1975-77) had disastrous
consequences since the implementers indulged in all types of high-handed practices. The result
was that the family planning programme became an object of popular fear and hatred. Learning
from the experience of Fifth Plan, in Sixth Plan and plans thereafter again the emphasis shifted
to education and economic development as a means of solving population problem.
National Population Policy, 2000
With a view to encourage two-child norm and stabilizing population by 2046 A.D. the
Government adopted the National Population Policy (NPP-2000). The following are the main
features of the NPP :
Address the unmet needs for basic reproductive and child health services, supplies and
infrastructure.
Make school education up to age 14 free and compulsory, and reduce dropouts at primary
and secondary school levels to below 20 per cent for both boys and girls.
Reduced infant mortality rate to below 30 per 1000 live births.
Reduce maternal mortality ratio to below 100 per 100,000 live births.
Achieve universal immunisation of children against all vaccine preventable diseases.
Promote delayed marriage for girls, not earlier than age 18 and preferably after 20 years
of age.
Achieve 80 per cent institutional deliveries and 100 per cent deliveries by trained persons.
Achieve universal access to information/counselling, and services for fertility regularisation
and contraception with a wide basket of choices.
Achieve 100 per cent registration of births, deaths, marriage and pregnancy.
Prevent and control communicable diseases.
Integrate Indian System of Medicine (ISM) in the provision of reproductive and child
health services, and in reaching out to households.
Promote vigorously the small family norms to achieve replacement levels of TFR (Total
Fertility Rate).
Bring about convergence in implementation of related social sector programs so that family
welfare becomes a people centred program.
Tenth plan Targets: Maternal Mortality Rate (MMR) refers to the number of maternal deaths
per 1,00,000 live births. Infant Mortality Rate refers to number of babies dying before the age
of one, per 1000 live births. As per 2007 data, Infant mortality rate in India is highest for
Madhya Pradesh (72) and lowest for Kerala (13).

The Tenth Plan targeted a reduction in Infant Mortality Rate (IMR) to 45 per 1000 by 2007 and
28 per 1000 by 2012, reduction in Maternal Mortality rate (MMR) to 2 per 1000 live births by
2007 and 1 per 1000 live births by 2012 and reduction in decadal growth rate of the population
between 2001-2011 to 16.2 per cent. Seeing the achievements so far it is unlikely that the targets set
would be timely achieved. For example, IMR is still very high at 55 (2007). Similarly, MMR is also
quite high at 2.54 (2001-04).
SUMMARY
In this Unit we have learned a very important fact that whether a growing population stimulates
growth or retards growth depends upon the size of the economy, active population of the
country, level of development and combination of all factors that determine growth. Taking
the Indian case we find that India is over populated and is instrumental in retarding growth.
While analyzing the population policy of India we find that economic and social measures
have not been given proper weightage and complete reliance has been placed on family planning
which is not very effective owing to widespread illiteracy and poverty in the economy. Even
the family planning programme is not well integrated and well planned.

CHAPTER – 6
SELECT ASPECTS
OF INDIAN
ECONOMY
Unit 2
Poverty
Learning Objectives
know the difference between absolute poverty and relative poverty.
understand how poverty is measured in India.
be familiar with the causes of poverty in India
know the government’s programmes for poverty alleviation.
Poverty is a widespread social evil in underdeveloped countries of the world, particularly in

Asia and Africa. There is no standard definition of poverty for all the countries of the world.
Some countries approach poverty in the absolute terms and some countries approach poverty
in relative terms.
2.0 ABSOLUTE POVERTY AND RELATIVE POVERTY

When poverty is taken in absolute terms and is not related to the income or consumption
expenditure distribution, it is absolute poverty.
On the other hand, when poverty is taken in relative terms and is related to the distribution of
income or consumption expenditure, it is relative poverty.
The concept of absolute poverty is relevant for the less-developed countries. To measure absolute
poverty, absolute norms for living are first laid down. These relate to some minimum standard
of living. These may be expressed or measured in terms of income/consumption expenditure.
Given this, one classifies all those as poor who fall below the standard. The number or percentage
of such poor in the country’s population gives the measure of poverty.
The concept of relative poverty is more relevant for the developed countries. According to the
relative standard, income distribution of the population in different fractile groups is estimated
and a comparison of the levels of living of the top 5 to 10 per cent with the bottom 5 to 10 per
cent of the population reflects the relative standard of poverty. Gini co-efficient are often used
for measuring poverty in relative sense.
In India we use the concept of absolute poverty for measuring poverty. For this a minimum
level of consumption standard is laid down (known poverty line) and those who fail to reach
this minimum consumption level are regarded as poor.
2.1 POVERTY IN INDIA

It is generally agreed that only those people who fail to reach a certain minimum level of
consumption standard should be regarded as poor. Different economists have defined poverty
line in different ways. The Planning Commission has adopted the definition provided by the
‘Task force on Projections of Minimum Needs and Effective Consumption Demand’ according
to which, a person is below the poverty line if his daily consumption of calories is less than
2400 in rural areas and 2100 in urban areas. On the basis of this, the monthly cut-off points
turned out to be Rs. 76 for rural areas and Rs. 88 for urban areas at 1979-80 prices.

For some times, these cut offs were used by converting them into current rupees using the
implicit price deflator of consumption in the National Accounts. This process had the
disadvantage of ignoring interstate differences in price levels as well as variations from state to
state in urban to rural price differentials. These problems were dealt with by an Expert Group
in 1993 whose recommendations for new poverty line were adopted by the Planning
Commission. These “Expert Group” poverty lines are now used in India. According to these
procedures, poverty lines are defined at the State level, separately for rural and urban
households. Each line is updated by a state specific price index, the state consumer price index
for agricultural labourer for rural lines and the state consumer price index for industrial workers
for urban lines. There is no country wide poverty line as such. The poverty ratio at all-India
level is obtained as the weighted average of the state-wise poverty ratio.
The Planning Commission has been estimating the incidence of poverty at the national level as
well as state level. For this, it uses large sample surveys on household consumer expenditure
conducted by the National Sample Survey organisation (NSSO) once in five years. As such
NSSO uses two types of recall periods – uniform recall period (URP) and mixed recall period
(MRP). While the URP uses 30-day recall/ reference period for all items of consumption, MRP
uses 365 day recall/reference period for five infrequently purchased non-food items namely,
clothing, footwear, durable goods, education and institutional medical expenses. Table 8 shows
incidence of poverty based on NSS 61st Round of consumer expenditure (2004-05).
Table 8: Incidence of Poverty (per cent)
Sl. no. Category 1993-94 2004-05

By URP Method
1. Rural 37.3 28.3
2. Urban 32.4 25.7
3. All India 36.0 27.5
By MRP Method
1999-2000 2004-05
4. Rural 27.1 21.8
5. Urban 23.6 21.7
6. All India 26.1 21.8
Source : Economic Survey 2008-09
The URP data places the poverty ratio at 28.3 per cent in rural areas, 25.7 per cent in urban
areas and 27.5 per cent for the country as a whole in 2004-05. The corresponding poverty
ratios for MRP data are 21.8 per cent for rural areas, 21.7 per cent for urban areas and 21.8 for
the country as a whole. The percentage of poor in 2004-05 estimated URP consumption
distribution of NSS 61st round of consumer expenditure data are comparable with the poverty
estimates of 1993 (50th round) which was 36 per cent for the country. The percentage of poor
in 2004-05 estimated from MRP consumption distribution of NSS 61st round of consumer

expenditure data are roughly comparable with the poverty estimates of 1999-2000 (55th round)
which was 26.1 per cent as a whole (Table 8).
It has also been calculated that for the country as a whole the per capita consumption
expenditure of 68 per cent population in 1999-00 was Rs 20 per day. This percentage reduced
to 60.5 of population in 2004-05.
While poverty rates have declined significantly, the malnutrition has remained stubbornly
high. Around 46 per cent children below 3 years of age were underweight and malnourished
in 2004-05 compared to 47 per cent in 1998-99.
The Tenth Plan had set a target of reduction in poverty ratio to 19.3 per cent by 2007 and to 11
per cent by 2012. The targets for rural and urban poverty in 2007 were 21.1 per cent and 15.1
per cent respectively.
2.2 CAUSES OF POVERTY

Economic Causes : Various causes of poverty can be classified under economic, political and
social heads. Economic backwardness or stagnation is often the characteristic of the countryside
of a developing country like India where majority of the population lives. Agriculture is the
main occupation of the rural poor and contributes 17 per cent of the GDP. Yet the income it
provides to agricultural workers is substantially below average and almost at the subsistence
level. There are a number of factors which are responsible for low income in the agricultural
sector such as small size of land holdings, inadequate irrigation facilities, lack of enough financial
resources needed for investment for ensuring development and raising productivity. Thus,
productivity in small farms is generally low resulting in very low levels of returns. The condition
of landless agricultural labourer is worse. The economic conditions of persons engaged in non-
agricultural activities in the rural sector are equally dismal.
Political and Social Causes : Political vested interests are also equally responsible for widespread
poverty in the economy. But whereas these interests can be countered by following the right
type of policies, social factors responsible for promoting poverty are more severe and are
interwoven in the web of society itself. Inhibitions and handicaps arising from caste and religion
are hard to overcome and require considerable effort by way of propaganda and education
through mass media, reorientation of education system and so on.
Other Causes : Apart from these, other factors such as family size and family composition,
poor levels of education and skills, lack of motivation and will to get out of the rut of poverty
and misery, the feudalistic system of bonded labour in some parts of the country and so on, are
also responsible for depressed standards of living among people.
2.3 GOVERNMENT PROGRAMMES FOR POVERTY ALLEVIATION

Poverty alleviation and raising the average standard of living have always been stated as the
central aims of economic planning in India. The plan strategies to achieve these aims can be
broadly divided into three phases. In the first phase, the prime emphasis was on growth. It
was expected that growth through improvement in infrastructure and heavy industries will
take care of the problem of unemployment and poverty. In the second phase, beginning with

Fifth Plan, poverty alleviation came to be adopted as an ‘explicit objective’ of economic planning.
Several specific programmes for poverty alleviation and employment generation directed
towards selected target groups were launched. In the third and final (present) phase, emphasis
shifted to ‘growth’ and ‘poverty alleviation’ as two complementary actions. The various recent
programmes for poverty alleviation are as follows. The earlier such programmes have been
streamlined and merged into these programmes.
(1) Pradhan Mantri Gram Sadak Yojana (PMGSY) : The PMGSY was launched in December,
2000 to provide road connectivity through good all weather roads to all the eligible un-
connected habitations in the rural areas by the end of the Tenth Plan. Upto March, 2009, a
total length of 2,14,281 km of road works had been completed.
(2) Indira Awas Yojana (IAY) : This is a major scheme for giving financial assistance for
construction of houses to be given to the poor living in rural areas. Up to December 2006,
about 153 lakh houses were constructed/upgraded under the scheme. During 2007-08,
around 9.4 lakh houses were constructed and during 2008-09, around 21 lakh houses
were constructed under the scheme.
(3) Swaran Jayanti Gram Swarozgar Yojana (SGSY) : This was introduced in April, 1999 as a
result of restructuring and combining the Integrated Rural Development Programme
(IRDP) and allied programmes and Million Wells Scheme (MWS). It is the only self-
employment programme for the rural poor. It aims at bringing the self employed above
the poverty line by providing them income generating assets. Upto March, 2009, about 121
lakh swarojgaries have been assisted.
(4) Sampoorna Grameen Rojgar Yojana (SGRY) : This programme was launched in 2001.
This programme aims at (i) providing wage employment in rural areas (ii) food security
and (iii) creation of durable community, social and economic assets. The earlier programmes
of the Employment Assurance Scheme (EAS) and Jawahar Gram Sammridhi Yojana
(JGSY) have been merged with this programme since April, 2002.
(5) National Rural Employment Guarantee Scheme (NREGS) : National Food for Work
Programme was launched in November, 2004 in 150 most backward districts of the country.
The objective was to intensify the generation of supplementary wage employment. The
programme was open to all rural poor who were in need of wage employment and desired
to do manual unskilled work. The National Rural Employment Guarantee Act was notified
in September, 2005 and the scheme was launched in February, 2006. The on-going
programmes of Sampoorna Grameen Rozgar Yojana (SGRY) and National Food For Work
Programme (NFFWP) were submerged in it. The objective of the Act is to enhance the
livelihood security of the people in rural areas by generating wage employment through
works that develop the infrastructure base of that area. The Act wants every State to
make a scheme for providing not less than 100 days of guaranteed employment in a financial
year to every households in the rural areas covered under the scheme and whose adult
members volunteer to do unskilled manual work subject to the conditions laid down in
the Act. During 2008-09, more than 4.47 crore households were provided employment
under the scheme. This is a significant jump over the 3.29 crore households covered under
the scheme during 2007-08.

(6) The Swarna Jayanti Shahkari Rozgar Yojana (SJSRY) : The SJSRY which came into operation
from December’97, sub-summing the earlier urban poverty alleviation programmes viz.,
Nehru Rozgar Yojana (NRY), Urban Basic Services Programmes (UBSP) and Prime
Minister’s Integrated Urban Poverty Eradication Programme (PMIUPEP). The scheme
aims to provide gainful employment to the urban unemployed or underemployed poor by
encouraging the setting up of self-employment ventures or provision of wage employment.
Under the scheme, 0.44 lakh urban poor were assisted to set up micro enterprises and
0.60 lakh urban poor were imparted skill training during 2007-08. In 2008-09, there was
a significant jump in the number of beneficiaries under the scheme as nearly 9.5 lakh
urban poor were assisted to set up micro enterprises and around 15 lakh urban poor
were imparted skill training.
SUMMARY
In India, poverty is wide spread. Nearly one-fourth of the population is below the poverty-line.
Reduction of poverty as a national objective had been mentioned in every five-year plan but
serious efforts towards it were started only in the Fifth Plan. Now, there are many poverty-
reducing employment schemes in India.

CHAPTER – 6
SELECT ASPECTS
OF INDIAN
ECONOMY
Unit 3
Unemployment
Learning Objectives
get familiar with the meaning of unemployment.
understand various types of unemployment.
understand the nature of unemployment problem in India.
know the incidence of unemployment in India.
Every sixth person in the world is an Indian and every third poor person in the world is also an
Indian. The statistics speak about the gravity of the problems of unemployment and poverty
which demand an immediate solution. It has been observed that with the increase in the number
of unemployed persons poverty expands. Keeping in view this fact, removal of unemployment
has been mentioned as one of the objectives of economic planning in all five year plans, but it
has been given serious consideration only after Fifth Plan. Till Fifth Plan, there was no serious
concern for solving the unemployment problem.
It was assumed that the gains of economic growth would percolate downwards and thus
inequalities would decline and problems of poverty and unemployment and would be
automatically solved. The growth of employment and removal of poverty were taken for granted.
The connection between economic growth and other objectives as stated above is not as simple
as it is often believed in this country. It has been observed in a number of less developed countries
that economic growth generally benefits the elite groups and, as a result, economic inequalities
grow. India’s experience is precisely the same over the period. The growing unemployment
over the years is generally attributed to this basic weakness in the approach of the Government.
3.0 MEANING AND TYPES OF UNEMPLOYMENT

Generally a person who is not gainfully employed in any productive activity is called
unemployed. Unemployment is a complex phenomenon and takes many forms. The important
forms are:
i) Voluntary unemployment : In every society, there are some people who are unwilling to
work at the prevailing wage rate and there are some people who get a continuous flow of
income from their property or other sources and need not work. All such people are
voluntarily unemployed. Voluntary employment may be a national waste of human energy,
but it is not a serious economic problem.
ii) Frictional Unemployment : Frictional unemployment is a temporary phenomenon. It may
result when some workers are temporarily out of work while changing jobs. It may also
result when the work is suspended due to strikes or lockouts. To some extent, frictional
unemployment is also caused by imperfect mobility of labour. We may also say that
frictional unemployment is due to difficulties in getting workers and vacancies together.
iii) Casual unemployment : In industries, such as construction, catering or agriculture, where
workers are employed on a day to day basis, there are chances of casual unemployment
occurring due to short- term contracts, which are terminable any time.
iv) Seasonal unemployment : There are some industries and occupations such as agriculture,

the catering trade in holiday resorts, some agro-based activities like sugar mills and rice
mills, in which production activities are seasonal in nature. So they offer employment for
only a certain period of time in a year. People engaged in such type of work or activities
may remain unemployed during the off-season. We call it seasonal unemployment.
v) Structural Unemployment : Due to structural changes in the economy, structural
unemployment may result. It is caused by a decline in demand for production in a particular
industry, and consequent disinvestment and reduction in its manpower requirement. In
fact, structural unemployment is a natural concomitant of economic progress and
innovation in a complex industrial economy of modern times.
vi) Technological unemployment : Due to the introduction of new machinery, improvement
in methods of production, labour-saving devices, etc., some workers tend to be replaced
by machines. Their unemployment is termed as technological unemployment.
vii) Cyclical unemployment : Capitalist biased, advanced countries are subject to trade cycles.
Trade cycles - especially recessionary and depressionary phases cause cyclical
unemployment in these countries. During the contraction phase of a trade cycle in an
economy, aggregate demand falls and this leads to disinvestment, decline in production
and unemployment. The solution for cyclical unemployment lies in measures for increasing
total expenditure in the economy, thereby pushing up the level of effective demand. Easy
money policy and fiscal measures such as deficit financing may help. Since cyclical phase
is temporary, cyclical unemployment remains only a short- term phenomenon.
viii) Chronic unemployment : When unemployment tends to be a long- term feature of a country
it is called chronic unemployment. Underdeveloped countries suffer from chronic
unemployment on account of the vicious circle of poverty, lack of developed resources
and their under utilisation, high population growth, backward, even primitive state of
technology, low capital formation, etc.
ix) Disguised unemployment : So far, the types of unemployment which we have discussed
above are all related to open unemployment. Apart from open unemployment we have
disguised unemployment. Disguised unemployment commonly refers to a situation of
employment with surplus manpower in which some workers have zero marginal
productivity so that their removal will not affect the volume of total output. Disguised
unemployment in the strict sense, implies underemployment of labour. To illustrate, suppose
a family farm is properly organized and four persons are working on it. If, however, two
more workers are employed on it and there is no change in output, we may say that these
two workers are disguisedly unemployed. This kind of unemployment is a common feature
of under developed economies especially of their rural sector. In short, overcrowding in
an occupation leads to disguised unemployment. It is a common phenomenon in an over
populated country.
3.1 NATURE OF THE UNEMPLOYMENT IN INDIA

Most of the unemployment in India is definitely structural, that is, the structure of the economy
is such that it does not absorb an increasing number of people coming to labour market in
search of jobs. Apart from structural unemployment there is some cyclical unemployment
which has resulted from industrial recession in urban areas. If we classify unemployment as

rural and urban unemployment we find total urban unemployment is mainly of industrial
unemployment and educated unemployment type and rural unemployment is seasonal and
disguised in nature. Industrial unemployment is the one which has resulted from failure of the
industrial sector to absorb the increasing labour force and educated unemployment results
when a large number of educated people remain unabsorbed. Seasonal unemployment,
generally, results in agricultural sector when a large number of small and marginal farmers
and labourers do not get occupied during the off-season and disguised unemployment results
when people appear to be occupied but actually they are not adding to production. This happens
because of over-population which forces people to work on a small piece of land although
their services on the land may not be required. It is estimated that over one-third of India’s
work force is disguisedly unemployed.
3.2 CAUSES OF UNEMPLOYMENT IN INDIA

The various causes responsible for widespread unemployment in India are as follows :
1. Growth without adequate employment opportunities : As economy grows usually
employment also grows. But in India, most of the time, the economic growth has been
inadequate and adequate number of jobs could not be created. In fact, for almost three
decade 1950-80, GDP growth rate was as low as 3.6 per cent per annum. Such a low rate of
growth did not push many jobs in the market. Since 1980s however, growth has accelerated
to around 5-6 per cent but job creating capacity of the economy has not improved much.
2. Growing Population : Population has increased at a very fast pace since Independence
but jobs have failed to keep pace with the population.
3. Inappropriate technology : India is a labour surplus and capital scarce economy. Under
such circumstances, labour-intensive industries should have been given preference. But
not only in industry but also in agriculture producers are increasingly substituting capital
for labour. This has hindered the growth of job opportunities.
4. Inappropriate education system : The education provided in India has not much practical
utility. The students receiving such education, even very high one, fail to get appropriate
jobs.
3.3 EXTENT OF UNEMPLOYMENT IN INDIA

The backlog of unemployment at the beginning of the FYP-1 was 3.3 million to which were
added 9.0 million new entrants during this period. The Plan provided additional employment
to 7.0 million, thus leaving a back log of 5.3 million at the beginning of the FYP-2. In the
subsequent plans, the back log has been continuously increasing, since the new jobs created
during each plan period invariably fell short of new entrants to the labour force. As per the
estimates the backlog of unemployment at the beginning of the FYP-9 was estimated to be of
the order 34-35 million. The labour force was projected to increase by about 36 million during
1997-2002. Thus, the total number of persons requiring employment would be 70 million over
the period 1997-2002. The Tenth Plan aimed at creating 50 million jobs during the plan. The
result of the 61st round of the NSSO shows that above 47 million persons were provided employment
during 2000-2005.

Before understanding the incidence of unemployment, it is better to understand the meaning
of labour force, work force and unemployment rate.
Labour force : Labour force or in other words, the economically active population refers to the
population which supplies or seeks to supply labour for production and, therefore, includes
both ‘employed’ and ‘unemployed’ persons and the labour-force participation rate (LFPR) is
defined as the number of persons in the labour force per 1000 persons.
Work-force : Work force is a part of labour force and refers to the population which is employed.
Thus work force participation rate (WPR) is defined as the number of persons/ person-days
employed per 1000 person/person days.
Unemployed rate : Unemployment rate is defined as the number of persons unemployed per
thousand persons in the labour-force.
Measurement of Unemployment: There are three main measures of employment and
unemployment.
1. Usual Status : This measure estimates the number of persons who may be said to be
chronically unemployed. This measure generally gives the lowest estimate of unemployment
especially for a poor economy because only a few can afford to remain without work over
a long period.
2. Current Weekly Status (CWS) : This estimate reduces the reference period i.e. the period
for which data is collected to one week. According to this estimate a person is said to be
employed for the week even if he is employed only for a day during that week.
3. Current Daily Status (CDS) : The reference period here is a day. It counts every half day’s
activity status of the respondent over the week. For working out the rate of unemployed
person-days the aggregated count of unemployed days during the reference weeks
constitutes the numerator and the aggregated estimate of the total number of labour force
days constitutes the denominator.
Having understood the meaning of various terms, we can now find the rate of unemployment
in India. The following table shows that the labour force participate rate, work force participation
rate and person unemployed in 2004 in India.
Table 9 : All India Labour force Participation Rate (2004) (NSSO - 60th round)
(Number of persons per thousand population)
WPR PU LFPR PU/LFPR

UPS 411 9 420 2.14
CWS 370 20 390 5.12
CDS 330 33 363 9.09
WPR = Work Force Participation Rate

PU = Persons Unemployed
LFPR = Labour Force Participation Rate

The above table shows that in the year 2004, out of 1000 persons in the population, 420 persons
were in the labour force according to UPS. Out of 420, 411 were working and 9 were
unemployed. In other words, unemployed persons as percentage of labour force were 2.14
considering UP status. Similarly according to CWS and CDS, the unemployment rates were
5.12 per cent and 9.09 per cent respectively. The extent of unemployment actually varies
considerably depending on the measure chosen. For example, the unemployment rate for the
year 2004 in India is a low 2.14% based on UPS definition but it rises to 9.09% based on the
CDS definition.(Table 9).
In order to assess the degree of unemployment in India it is relevant to compare the incidence
of unemployment with unemployment in other countries. The table below shows the
unemployment rates in selected countries :
Table 10 : Unemployment in Selected Countries (per cent)
Country 2009
India 7.2
Australia 5.8
Bangladesh 2.5
China 9.0
Indonesia 8.2
Japan 5.2
Malaysia 3.5
Pakistan 5.2
Sri Lanka 5.2
(Source : World Factbook)
If we look into the data on unemployment in India we find that the unemployment rates have
first decreased and then risen. This is clear from the following table.
Table 11 : Unemployment Rate: Alternative measures
UPS CWS CDS

1977-78 4.23 4.48 8.18
1983 2.88 4.51 9.22
1993-94 2.62 3.63 6.06
1999-00 2.78 4.41 7.31
2004-05 3.06 5.12 8.28
(Source : 61st Round of NSSO - July 2004-June 2005 and Planning Commission)
The latest round of NSSO on unemployment was conducted during July 2004 - June 2005. The 61st
round of the NSSO survey reveals a faster increase in employment during 1999-2000 to 2004-05 as
compared to 1993-94 to 1999-2000 (Table - 12). However, since labour force increased at a much
higher rate than the increase in work force (employment), unemployment (on UPS basis) was higher

at 3.06 per cent of the labour force in 2004-05 compared to 2.70 per cent in 1999-2000. Incidence of
unemployment had come down from 2.88 per cent in 1983 (38th round) to 2.62 per cent in 1993-94
(50th round)
Table 12 : Employment and Unemployment (by UPS)
1983 1993-94 1999-2000 2004-05 1983 to 1993-94 to 1999-2000

1993-94 1999-2000 to 2004-05
In million Growth in per cent per annum
Labour Force 277.34 343.56 377.88 428.37 2.06 1.60 2.54
Workforce 269.36 334.54 367.37 415.27 2.09 1.57 2.48
Number of
unemployed 7.98 9.02 10.51 13.10 - - -
As a proportion of labour force in per cent
Unemployment
rate 2.88 2.62 2.78 3.06 - - -
As per the 61the round of National Sample Survey Organisation (NSSO) (2004-05) on the
situation of employment and unemployment conducted, the following are the salient features
of the trend of unemployment rates in the country :
The unemployment rate went up between 1999-2000 to 2004-05. On the basis of current
daily status, unemployment rate for males increased from 72 per thousand persons or 7.2
per cent to 80 per thousand persons or 8 per cent in rural areas and from 73 per thousand
persons or 7.3 per cent to 75 per thousand persons or 7.5 per cent in urban areas (Table 13).
Similarly unemployment rate for females increased from 70 per thousand persons or 7 per
cent in 1999-2000 to 87 per thousand persons or 8.7 per cent in 2004-05 in rural areas and
from 94 per thousand persons or 9.4 per cent to 116 per thousand persons or 11.6 per cent
in urban areas. (Table 13).
Furthermore, unemployment rates on the basis of current daily status were much higher
than those on the basis of usual status and current weekly status.
Urban unemployment rates (CDS) were higher than rural unemployment rates for both
males and females in 1990-2000. However, in 2004-05, rural unemployment rates for males
were higher than urban employment rates.
According to the usual status, about 56 per cent of rural males and 33 per cent of the females
belonged to the labour force. The corresponding proportions in the urban areas were 57 per cent
and 18 per cent respectively.
About 42 per cent of the population in the country was usually employed. The proportion was 44
per cent in the rural and 37 per cent in the urban areas.
The daily status (employment) rates were slightly lower than the current weekly status rates,
which in turn, were slightly lower than usual status rates.

The unemployment rate according to the usual status in the rural areas was 17 and in the urban
area 45. The unemployment rates for females are found to be higher than for males and highest
among urban females.
In both the rural and urban areas, unemployment rate among the educated was higher than
among the uneducated.
Table 13: Unemployment rates for 55th round (1999-2000) and
61st round (2004-05) of the NSSO
(all India)
(in per cent)
Rural
Males Females
Round Usual CWS CDS Usual CWS CDS
55th
(1999-2000) 2.1 3.9 7.2 1.5 3.7 7.0
61st 2.1 3.8 8.0 3.1 4.2 8.7
(2004-05)
Urban
Males Females
Round Usual CWS CDS Usual CWS CDS
55th
(1999-2000) 4.8 5.6 7.3 7.1 7.3 9.4
61st 4.4 5.2 7.5 9.1 9.0 11.6
(2004-05)
The Approach Paper to the Mid-Term Appraisal (MTA) of the Tenth Plan, has repeated that
employment growth should exceed growth of labour force to reduce the backlog of
unemployment. Employment strategies advocated in the MTA include :
Special emphasis to promote public investment in rural areas for absorbing unemployed
labour force for asset creation.
Identification of reforms in the financial sector to achieve investment targets in the small
and medium enterprises (SME) sector.
Large-Scale employment creation in the construction sector, especially for the unskilled
and semi-skilled.
Necessary support to services sectors to fulfil their true growth and employment potentials
and greater focus on agro-processing and rural services.
The Approach paper to the Eleventh Plan targets generation of additional employment opportunities
in services and manufacturing, in particular, labour intensive manufacturing sectors such as food

processing, leather products, footwear and textiles and in services, sectors such as tourism and
construction and village and small scale enterprises.
Demographic Dividend
In India, 63 per cent population is in the working age group (15-64 years) and it is projected
that in 2026 this will increase to 68.4 per cent. Such a big labour force, if properly utilised can
yield high production and growth for the economy. This has come to be known as “demographic
dividend”. For actually tapping this dividend, the Eleventh plan relies upon not only ensuring
proper health care but also a major emphasis on skill development and encouragement of
labour intensive industries. The projected decline in the dependency ratio (ratio of dependents
to working age population) from 0.8 in 1991 to 0.73 in 2001 is expected to further decline
sharply to 0.59 in 2011. This is in contrast with the demographic trend in the industrialised
countries and also in China, where dependency ratio is rising. Low dependency ratio gives
India a comparative cost advantage and a progressively lower dependency ratio will result in
improving our cost competitiveness.
SUMMARY
A person who is not gainfully employed is called unemployed. In India, the problem of
unemployment has become very serious as around 9 per cent of the labour force is unemployed.
Not only there is open unemployment, disguised unemployment is also wide spread. If we
consider the nature of unemployment in India, we find that here most of the unemployment is
structural in nature. In urban areas, unemployment is mainly industrial and educational in
nature. In rural areas, it is seasonal and disguised in nature. The various causes responsible for
high incidence of unemployment in India are growing population, inappropriate technology,
faulty education system and failure of growth process in generating appropriate and adequate
jobs.

CHAPTER – 6
SELECT ASPECTS
OF INDIAN
ECONOMY
Unit 4
Infrastructural
Challenges
Learning Objectives
At the end of this unit, you will be able to:
understand how infrastructure plays an important role in the economic development of
an economy.
know the various important infrastructural services.
understand various sources of energy.
understand the various problems related to energy.
know how various means of transportation and communication in India have developed
over the years.
understand how means of transportation and communication provide an important link
between production, distribution and ultimate consumers.
understand how over the years medical services have improved but still India’s overall
health is low.
understand education system in India and the problems from which it suffers.
Infrastructure plays an important role in the economic development of an economy. It can

quicken or impede the development of an economy. In this section, we will discuss five important
infrastructural services viz. energy, transport, communication, education and health.
4.0 ENERGY
Energy is an important input for most of the production processes and consumption activities.
It plays a crucial role in the economic development. Economic growth and demand for energy
are positively co-related. A study shows a 3 per cent rise in industrial production in the world
is accompanied by a 2 per cent increase in energy consumption. A similar relation is also
observed in India.
India is both a major energy producer and consumer. India currently ranks as the world’s
seventh largest energy producer, accounting for about 2.49 per cent of the world’s total energy
production. It is also the world’s fifth largest energy consumer, accounting for about 3.45 per
cent of the world’s total energy consumption. However, it is noteworthy that India’s per capita
energy consumption is one of the lowest in the world.
In India, around 22 per cent of the population is below the poverty line and nearly 50 per cent
of the population does not have the purchasing power to enter the market for commercial
energy. This part of the population living mostly in rural areas depends upon non-commercial
traditional sources of energy such as firewood, dung cakes and agricultural wastes. At present,
nearly 27 per cent of the energy consumed is obtained from non-commercial sources or traditional
sources. The rest is commercial energy and is obtained from oil and gas, coal, hydro-electricity
and nuclear power. Production of nuclear power has started, but it is not much.
There is a distinction between primary energy resources and final energy resources. When coal
is consumed for generating electricity and electricity is consumed by industry, we call coal as
primary energy resource and electricity as the final one. Coal, petroleum products and natural
gas are both primary resources and final resources as they are consumed directly as well as
indirectly, while electricity is, by and large, the only final energy resource.

Major users of electricity are industry (38 per cent), domestic (24 per cent), agriculture (22 per
cent) and commercial establishment (9 per cent). We shall concentrate on electricity as it is the
main mover of manufacturing industry.
4.0.0 Electricity: Electricity or power is the most important source of commercial energy.
Over the planning era, the production and consumption of electricity has increased
tremendously. Our total installed capacity of generating power was around 2300 Mega Watt
(MW) in 1950-51. It increased to 74,700 MW in 1990-91, 117800 MW in 2000-01 and further to
175000 MW in 2008-09. Thus, over a period of 58 years, there has been 75 times increase in the
installed capacity. We are roughly adding 4000-5000 MW every year.
4.0.1 Sources of Electricity: There are 5 major sources of electricity (1) water (2) coal (3) oil
(4) gas and (5) radio active elements like uranium, thorium and plutonium. Electricity generated
from water is known as hydro-electricity. Electricity generated from coal, oil and gas is called
thermal electricity and electricity generated from radio-active elements is called atomic energy.
Of the present capacity, 62 per cent is in the thermal and non-conventional energy sources
other than wind 21 per cent in the hydel and wind 2.5 per cent is in the nuclear and rest is in
the other sectors. In terms of generation of power, thermal plus non conventional energy source
other than wind is contributing 73 per cent, hydel and wind around 13.5 per cent and nuclear
2.0 per cent and others are contributing 11.5 per cent.
The central government, state governments and private sector all work together in the generation
of power. The Central Government operates through National Thermal Power Corporation
(NTPC), National Hydroelectric Power Corporation (NHPC) and Nuclear Power Corporation of
India Limited (NPCIL). State governments have their State Electricity Boards (SEBs). There also
exist Central Electricity Authority and Central Electric Regulatory Commission.
4.0.2 Difficulties and Problems relating to energy
(1) Demand and Supply imbalances in commercial fuels : The demand for energy, particularly
for commercial energy, has been growing rapidly with the growth of the economy, change
in the demographic structure, rising urbanisation, social-economic development and desire
for attaining and sustaining self reliance in the economy. The supply has not increased
concurrently.
Table 14 gives the trend of primary commercial energy demand and supply between
1960-61 to 2006-07 and projected requirement for 2011-12.
Table 14
Mtoe = million tonne of oil equivalent

Source: Planning Commission, Eleventh Plan – Vol.3

We can see from the table that in 2006-07, out of the 539 mtoe of primary energy demand,
391 mtoe demand was for commercial energy and 148 mtoe was for non commercial
energy. Out of 391 mtoe demand for commercial energy, 259 mtoe was domestically
produced and 132 mtoe was imported. Non commercial energy (148 mtoe) was produced
and consumed domestically. Thus, we notice that one third of the demand for commercial
energy was met through imports.
India needs to eliminate shortage of energy and enhance the availability of commercial
energy resources if it has to sustain the projected 9 per cent growth in the Eleventh Plan.
It is projected that by the end of Eleventh plan, net imports would reduce to 20 per cent of
the total demand for commercial energy.
(2) Oil prices and inflationary pressure : Since 1973, oil prices have been rising in the
international market. During 1973-2008, the Organisation of Petroleum Exporting Countries
(OPEC) has increased the prices many folds. This has contributed to the inflationary
pressure in India. Mineral oil is presently the major source of energy for transport, industry
and agriculture. It is also used as household fuel. Therefore, rising oil prices has led to
rising general prices in India.
(3) Growing oil imports bill : Since 1973, India’s oil imports bill has increased substantially.
In 1973-74 India’s oil import bill was Rs. 1100 crore. It increased to Rs. 10,816 crore in 1990-
91 and to a record level of Rs. 3,20,000 crore in 2007-08. Petroleum, oil and lubricants (POL)
constitute around one third of our import bill. The oil import bill is also responsible to a
great extent for the existing large balance of trade gap.
(4) Transmission and distribution losses : One of the major problems faced by the power
companies are transmission and distribution (T&D) losses. The T&D losses are very high
in many of the SEB systems. These losses include substantial amount of theft of power.
National average of this loss is around 23 per cent while in many states it is more.
(5) Sick SEBs : Many SEBs have become financially sick. A large portion of these losses is
accounted for by almost free supply of power to agriculture. Besides, operational inefficiencies,
high cost structure, lower power tariffs and large overdues have made SEBs sick.
(6) Operational inefficiency : Most of the thermal power plants are operating inefficiently. Plant
load factor (PLF) measures the operational efficiency of a thermal plant. If total generating
capacity is say 600 billion kilo-watt hours (kwh) and we are producing only 300 billion kwh,
plant load factor here is 50. Plant load factor varies across the regions. It is lowest in North
Eastern region (47.5 per cent in 2008-09) and highest in Southern region (83 per cent in 2008-
09). If we consider SEBs, central sector and private sector, we find that PLF was 71 per cent
in SEBs, 84 per cent in central sector and 91 per cent in the private sector in 2008-09.
(7) Inadequate electrification : Till date, nearly 19 per cent of villages are not electrified. In
many villages, there are a very few houses which are lighted. This is sad considering the
fact that more than 60 years have passed since we got Independence and still our rural
areas are without electricity.
4.0.3 Recent steps taken to meet the above problem
(1) In order to improve production of power, Electricity Act was passed in 2003 and Electricity
Amendment Bills 2005 was passed in 2005. The focus is on improved investment in power

sector and fixing of power tariffs on the basis of competition, efficiency, economical use of
resources, commercial principles and consumers’ interests.
Certain provisions of the Electricity Act 2003 were amended in 2007 by passing of Electricity
(Amendment Act) 2007.
(2) To improve generation of power, Ministry of Power has launched the ‘Partnership in
Excellence’ programme. Under the programme, 26 thermal stations with PLF less than 60
per cent have been identified. Steps will be taken to improve their efficiency.
(3) Steps are being taken to improve and add electricity-generating capacity of the plants.
(4) Government is encouraging the use of hydel and wind energy sources which do not rely
on fossil fuels and avoid carbon emissions.
(5) Steps have been taken to turn around SEBs. These include, rationalization of tariff structure
particularly the prices charged by the SEBs from various categories of consumers, monitoring
of cost structure, optimum utilization of existing capacity.
(6) The greatest weakness in the power sector is on the distribution side. Aggregate Technical
and Commercial (AT&T) losses of most State Power Utilities (SPUs) remain high. In order
to redress the problem the Accelerated Power Development and Reforms Programme
(APDRP) was initiated in 2002-03. Although at the national level the AT&T losses have
not come down much, the losses have come down in towns where APDRP has been
implemented.
In order to reduce transmission losses, distribution reforms have been carried out. In 2002,
power sector was privatized in Delhi. The experience of privatization in Delhi has been
encouraging. For example, there the quality of power has improved, load shedding has
come down and the average response time for attending breakdowns has also come down.
(7) Government is encouraging private sector investment in power and for this it is finalizing
guidelines.
The key initiatives in this regard include permitting private sector to set up coal, gas, or
liquid based projects of any size, allowing gradual entry in distribution, encouraging foreign
equity and participation and permitting FDI in varying extent in different sub sectors of
power and giving tax incentives etc.
(8) An All India Power Grid, also called National Grid is being developed by the year 2012.
An integrated power transmission grid helps to even out supply-demand mismatches.
The existing inter-regional transmission capacity is planned to increase from its present
20750 MW to about 37,700 MW by 2012.
(9) Nine sites were identified for the development of ultra-Mega Power Plants with capacity
of 4000 MW each.
(10) Steps are being taken to provide access to electricity to all areas including villages and
hamlets. For this, ‘Rajiv Gandhi Grameen Vidhyutikaran’ programme was started in 2005.
The Scheme provides for free electricity connections to below poverty line (BPL) households.
Rural Electrification Corporations is the nodal agency for this. Under the scheme, nearly

60,000 villages have been electrified and connections to 54 lakh BPL households have
been released.
Besides the above, certain Steps have been taken to encourage conservation of energy.
These include, giving energy conservation awards to deserving industries, encouraging
use of Compact Fluorescent Lamps (CFLs) and promoting energy efficient equipments
etc. The Bureau of Energy Efficiency (BEE) has taken initiatives to promote energy efficiency.
4.1 TRANSPORTATION
Today, along with energy, transport is the basic infrastructural requirement for industrialization.
Transport provides a useful link between production centers, distribution areas and ultimate
consumers. Important means of transport are railways, roads, water transport and air transport.
4.1.0 Railways : Indian Railways, Asia’s largest and world’s third largest rail network
under a single management, has been contributing to the industrial and economic landscape
for over 150 years. There are two main segments of railways - freight and passenger. The
freight segment accounts for about 70 per cent of revenues and passengers thirty per cent of
revenues. The total route length of railways is 63.5 thousand kilometers. Out of which 17.9
thousand kilometers is electrified. During 2008-09 it carried more than 6900 million of passengers
and 832 million tonnes of freight traffic. Railways however, faces the following problems:
(1) The existing technology of both electric and diesel locomotive is very old.
(2) The railway network is smaller and inadequate vis-à-vis the requirements of the economy.
(3) The railways is facing the problem of financial crunch. The conventional methods of
increasing the net revenue, like raising of tariffs and expenditure control are inadequate
for generating the levels of investment required.
(4) Because of social responsibilities, railways is forced to operate a number of unremunerative
lines and suffer heavy losses. Often, essential goods like foodgrains, fruits and vegetables
have to be carried at a loss.
(5) Railways also suffers from over crowding and poor passenger services.
In order to meet the above challenges, railways is trying to improve resource management. Rational
price policy, increased wagon load, faster turnaround time, Public-Private Partnerships (PPPs), double
line freight corridor for efficient freight movements are some of the steps taken in recent years to
improve railway’s performance.
4.1.1 Road: The Indian road network is the one of the largest networks in the world. At the
beginning of the first plan, India had 1,57,000 kms of surfaced roads and about 2,43,000 kms
of unsurfaced road. In 2002-2003, the total road length had increased to 24,83,300 kms. Out of
which 14,20,500 kms is surfaced. Today, India has a network of 3.34 million kilometre. The
National Highways which comprise only about 2 per cent of total length of roads now encompass
a road length of 66,590 kms. and carry more than 40 per cent of the total road traffic. The rural
roads network connects around 65 per cent all weather roads. Roads occupy a crucial position in
the transportation matrix of India as they carry nearly 61 per cent of freight and 87 per cent of
passenger traffic.

Problems of road transport : Following problems are faced in the case of road transport:
(1) The road length is inadequate considering the size of the country.
(2) A number of areas, particularly interior areas and hilly tracts remain to be linked with
roads.
(3) Large tracts of rural roads are mud roads which cannot be used for plying heavy traffic.
(4) A number of urban roads are also poorly maintained. This is due to constraints of financial
resources, organizational inadequacies, procedural delays, shortage of essential materials
etc.
(5) Most of the State Road Transport Corporations are running on heavy losses. This is because
of rising cost of operations, inefficiency in operations and corruption.
In order to overcome the above problems a number of steps have been taken. These include, undertaking
the National Highways Development Project (NHDP) which involves developing Golden Quadrilateral
(Mumbai, Delhi, Chennai and Kolkata), North-South and East-West corridors, Port connectivity and
other projects, PPP in roads developments and rationalisation of taxes etc.
4.1.2 Water transport: Water transport can be divided into inland water transport and
shipping. Shipping can again be divided into coastal shipping and overseas shipping.
India has about 14500 km of navigable waterways which comprise rivers, canals, backwaters
creeks etc. About 45 million tonnes of cargo is being annually moved by inland water transport.
Over the years, the importance of this mode of transport has declined considerably due to
expansion of rail and road transport and navgational inadequacies. The government approved
the Inland Water Transport Policy which includes a number of incentives to encourage private
sector participation in inland water transport.
India has a long coastline of 7,517 kms, 12 major ports and 200 minor ports and a vast hinterland.
Coastal shipping is very energy efficient and cheapest mode of transport for carrying bulk
goods (like iron and steel, iron-ore, coal, timber etc.) over long distances. However, there had
been a sharp decline in coastal shipping operations during 1960s and 1970s. The Gross Tonnage
(GT) fell from 0.31 million in 1961 to 0.25 million in 1980. However, there was an improvement
in the coastal shipping in 2001 as coastal tonnage rose to 0.70 million GT. There was further
improvement in the ensuing year as coastal traffic increased to 116 million tonnes in 2002-03.
It is estimated that by the end of Eleventh Plan this will further increase to 220 million tonnes.
The main factors for poor growth of coastal shipping have been (1) high transportation costs
(2) port delays (3) over-aged vessels (4) lack of mechanical handling facilities (5) imbalance in
coastal traffic movement and (6) slow handling of the cargo at ports. These inflict heavy losses
on shipping companies.
Almost 95 per cent of India’s global merchandise trade is carried through the sea route. India’s
overseas shipping has improved over the planning period. The country has the largest merchant
and shipping fleet among developing countries and ranks 20th in the world in shipping tonnages.
As compared to 1.92 million Gross Tonnage (GT) at the time of Independence shipping tonnage
was 8.6 million GT at the end of March 2007. The fleet at the end of March 2007 was 787
vessels (1.19 per cent of world fleet).

Since ports are very important for coastal and overseas shipping, special efforts have been
made in the Five Years Plans for the development and modernization of existing ports and
establishment of new ports. The total traffic carried by both the major and minor ports was
723 million tonnes during 2007-08. The 12 major ports carry about three-fourth of the total
traffic, with Vishakhapatnam as the top traffic handler in each of the last seven years.
Problems faced by Indian ports : The main problem is low productivity. Major factors
contributing to this are:
Operational constraints such as frequent breakdown of cargo handling equipment due to

obsolescence.
Inadequate dredging and container handling facilities.
Inefficient and non optimal deployment of port equipment.
Lack of proper coordination in the entire chain.
Indian containers are costlier than other ports in the region for handling containers. The
additional cost burden due to use of second and third generation vessels has been estimated
at U.S. $ 250 million a year. Container delays at Indian ports cost U. S. $ 70 million a year.
4.1.3 Air transport: Air transports is the preferred mode of transport especially for long
distance travel, business travel, accessing difficult terrains and for transporting high value and
perishable commodities. In the civil aviation sector, there are three parts – operational,
infrastructural and developmental. The first is the operational. There are 11 scheduled passenger
operators and one cargo operator in the country with the combined fleet size of 407 aircrafts.
There are also 99 non scheduled airlines operators who have 241 aircraft in the inventory.
Indian Airlines and Air India were amalgamated with National Aviation Company Ltd. The
brand name ‘Air India” was however retained. The merged entity along with its subsidiary
companies, with more than 140 aircraft, would enter the list of top 30 airlines globally in terms
of fleet size.
The private sector is now playing a crucial role in the development of both airline and airport
sector. Its market share in the domestic traffic during 2006 reached 78.5 per cent from near 50
per cent share earlier. Jet airlines has emerged as the market leader with a share of 31.2 per
cent, followed by Indian Airlines (21.5) per cent, Air Deccan (18.3 per cent), Air Sahara (8.8
per cent), Kingfisher (8.7 per cent).
Regarding infrastructural facilities, Airport Authority of India manages 92 airports, including
five international airports at Delhi, Mumbai, Kolkata, Chennai and Thiruvananthapuram and
28 civil enclaves at the defense airports. Green field airports of international standards are also
constructed at Hyderabad, Bangalore and Goa. Proposals to set up green field airports with
private sector participation in Navi Mumbai, Kerala, Sikkim are also in the pipelines. An
international green field airport is already operational in Kochi.
Regarding regulatory cum developmental aspect, the Department of Civil Aviation, Government
of India, is responsible for it. International services are governed by bilateral agreements. Due
to the monopoly nature of the airports and their economic importance, efforts are being made

to set up an Independent Airport Economic Regulator for tariff setting and monitoring of
performance against standards.
Non-availability of seats has been one of the major constraints faced by international passengers.
For this, the airlines are trying to acquire more aircrafts. Government has adopted an overall
liberal approach in the matter of grant of traffic rights under bilateral agreements with various foreign
countries. Air India express has started operations on low cost pattern effective April 2005.
These initiatives have had a marked impact on airline traffic. Domestic and international traffic
grew by 21.8 per cent and 13.6 per cent respectively in the tenth plan. It is estimated that
international and domestic passengers would increase by 16 and 20 percent respectively in the
11th plan. International and domestic cargo traffic is expected to grow at the rate 12 and 10
percent respectively in the Eleventh Plan. Domestic and international cargo recorded a growth
of 12.6 per cent and 12.8 per cent respectively during the Tenth Plan.
Recent important developments in the airline and airport sector included: (i) modernization
and restructuring of Delhi and Mumbai airports launched through joint venture companies;
(ii) development of Greenfield air-ports at Bangalore and Hyderabad on a Build– Own–Operate–
Transfer basis with PPP; (iii) approval of modernization of 35 non-metro airports and 13 other
airports to world-class standards in phases; (iv) liberalization of FDI limit upto 100% through
automatic route for setting up Greenfield airports; (v) acquisition of modern and technologically
advanced aircraft for Air India (AI) Ltd, Air India Charters Ltd (AICL), and Indian Airlines
Ltd; (vi) liberalization of bilateral air services agreement in line with the contemporary
developments in international civil aviation sector; (vii) adoption of a limited Open Sky Policy
in international travel to meet the traffic demand during peak season; and (viii) adoption of
trade facilitation measures in custom procedures to facilitate speedy clearance of air cargo.
4.2 COMMUNICATION
Communication means transmission of information. For the development of industries,
commerce and trade in the country, communication is very necessary. The important means
of communications are the postal services, telephone services, tele printers, radio and television
etc. Telephone, tele-fax and e-mail have been gradually evolving and telex and telegraph are
getting out of fashion.
4.2.0 Postal services: India’s postal system dates back to 1837 and today our postal network
is the largest network in the world. Today, we have more than 1.55 lakh post offices and out of
which around 1.4 lakh are in the rural areas. On an average, one post office serves 7174
persons and 21.12 sq. km area. Postal services suffer from many weaknesses such as inadequate
number of post offices, use of outdated techniques, delays in reaching of posted material etc. A
number of steps have been taken for resolving these problems. Such as speed post, business
post, express parcel post, media post, speed post passport etc. services have been introduced.
With a view to improve the speed and volume of money order transmission, 140 VSATs (Very
Small Aperture Terminals) have been set up. They handle more than 1 million money orders a
month. To provide better services, mechanization and computerization of postal operations is
being progressively introduced. Presently more than 9600 post offices are computerized.
Automatic mail processing centers (AMPC) have been set up at Mumbai and Chennai for
faster processing of mails. Two more AMPCs are being set up in Kolkata and Delhi. E-post
services were started in 2001 in some states. Under e-bill post, customers are able to pay multiple

utility bills at post office counters. They are now being upgraded for multiple messaging to
make them useful for corporate houses. Pick up of mails from the residence of the customers
has been started all over the country. This is a major initiative to provide user-friendly services
to its vast customer base. Direct post, which comprises of un-addressed postal articles like
promotional items, has been introduced to provide the facility of direct advertising for increasing
commercial activity in the country. ‘Logistics Posts’, ‘Retail Post Services’ are other new services
which are now being provided. Post offices are also providing a number of financial products
such as saving bank and saving certificate, postal life insurance, non life insurance products,
mutual funds etc.
Besides the above, the Department of Posts has launched a pilot project “Project Arrow” with
the aim of providing fast and reliable postal services to the consumers. In addition to the above,
161 mail business centres with the state of the art technology and modern mailing tools have
been designated for collection, processing and delivery of bulk mail.
4.2.1 Telecommunications: Communications all over the world has progressed rapidly and
the most important factor accounting for increased communication has been the development
of telecommunications which include (i) the telephone service, and (ii) the telex service. At the
time of Independence, India had a total of only 321 telephone exchanges with about 8200
working connections. There were only 338 long distance public call offices and 3324 telegraph
offices. The growth of telecommunications has gained momentum after Independences and
by March 2009 India had 414 million connections (basic and mode). With the present growth,
the number of telephones is expected to reach 600 million by the end of 2012. As on March
2007, more than 5.6 lakh villages were connected using a village public telephone (VPT). Thus,
90 per cent of villages in India have been covered by the VPTs. At present, in the rural areas
more than 2 lakh public call offices (PCOs) and 113 million phones have been provided.
Although India’s telephone network is the third largest in the world, the tele density continues
to be low at about 35.65 per cent. While tele density in rural areas is 13.81 per cent, the urban
tele density shot up to 83.66 per cent in March, 2009.
A type of revolution has taken place in the field of telecommunications in recent years. A
number of value-added services like radio paging services, cellular mobile telephone service,
electronic mail, public mobile radio trunked service, voice mail, video tax, video conferencing
etc. have been started. Upto March 09, there were about 376 million subscribers of cellular
mobile telephone services. The two PSUs in the telecom sector - Bharat Sanchar Nigam Limited
(BSNL) and Mahanagar Telephone Nigam Limited (MTNL) have been losing their market shares
in fixed telephony. From 98.65 per cent share in 2001-02, their combined share declined to
85.31 per cent in December 2005. However, their share in mobile telephony has improved
from 3.98 to 21.11 per cent over the same period. Apart from this, there has been significant
growth in the internet connections and broadband subscribers. The internet connections
increased from 0.01 million in 1995 to around 35 million in March, 2009 and broadband
subscribers have increased from 0.49 lakh in December 2004 to more than 6 million in March
2009. Regulatory framework and functions are carried out by Telecom Regulatory Authority
of India (TRAI) and now the National Internet Exchange of India (NIXI) has been set up to
ensure that internet traffic originated and destined for India, is routed within India.

4.3 HEALTH
For good health, two things are essential: (1) balanced and nutritional diet and (2) medical care.
The general health standard in India is quite low. This is quite inevitable as nearly one fourth of
the population lives below the poverty line. These people do not have nutritional diet, adequate
medical care and hygienic conditions. As a result, the overall health conditions are poor in
India. It is not that nothing has been done on the health front but they are far from satisfactory.
The following table shows trends in health care in India since Independence.
Table 15 : Trends in Health Care
1951 1981 2008

Health centers 725 57,353 1,71,687
Dispensaries + Hospitals 9,209 23,555 33,855
Beds 1,17,198 5,69,495 11,75,374
Nursing personnel 18,054 1,43,887 15,72,363
Doctors (Modern) 61,800 2,68,700 around 7 lakh
Under the various plans, health development programmes have been integrated with family
welfare and nutritional programmes for vulnerable sections – children, pregnant women and
nursing women. These programmes focussed on increasing health services in rural areas,
intensification of the control of communicable diseases like small pox, malaria and leprosy,
improvement in education and training of health personnel etc. Since sixth plan there has
been a change in the whole approach towards health services. Under the new approach, the
focus is not on providing hospitals but on providing better health and medical care services to
the poor people. A community based programme on health care and medical services in rural
areas was launched. Apart from developing rural health services, the control of communicable
diseases is now being given the highest priority. Since diseases like, T.B., malaria, gastrointestinal
infections are related with unhygienic sanitation, efforts have been intensified in providing
hygienic conditions and opening new hospitals and strengthening existing hospitals especially
in rural areas. As a result of these efforts, there has been a fall in the incidence of certain
diseases like T.B, leprosy and polio. But a rise in the incidence of certain diseases like AIDS,
blindness, cancer etc. has also been noticed. These require immediate attention, care and action.
There are certain weaknesses of Indian health care which need immediate attention. These
relate to:
1. Unequal distribution of existing health institutions and manpower.
2. Mismatch between personnel and infrastructure.
3. Lack of an appropriate referral system.
4.4 EDUCATION
Education plays an important role in the overall development of a human being and a society.

Therefore, stress on imparting education has been given in our Constitution which says
education should be free for children below 14 years of age. Under the various plans, education
facilities have been expanded at all levels in India and as a result, not only the literacy rate has
risen but the percentage of children availing school education has also increased. India, now,
has the second largest education system in the world. Eighty four per cent of rural habitation in India
now have a primary school located with in a distance of 1 kilometre. The National Policy on Education
(NPE) was made in 1986 and further modified in 1992. It emphasizes 3 aspects in respect of
elementary education:
universal access and enrolment;
universal retention of children up to 14 years of age; and
a substantial improvement in the quality of education.
NPE had set a goal of expenditure on education at 6 per cent of the GDP. As against this
target, the actual expenditure of central and state governments was 3.49 percent of GDP in
2004-05.
As a result of the efforts undertaken, Gross Enrolment Ratio (GER), which shows the proportion
of children in the 6-14 years age group actually enroled in elementary schools, has increased
progressively from 32.1 in 1950-51 to 96.9 in 2006-07. With the rate of increase in GER of girls
higher than that of boys, the general gap in enrolment is declining. Drop-out rate at the primary
has declined from 39 per cent in 2001-02 to 29 in 2004-05. The main vehicle for providing
elementary education to all children is the ongoing comprehensive programme called Sarva
Shiksha Abhiyan (SSA) launched in 2001-02. It aims at having all children in school by 2005 and
universal retention by 2010. National Programme for Education of Girls at Elementary Level
(NPEGEL) is an important component of SSA. This programme concentrates on education of girl
child. Another important component of SSA is the Education Guarantee Scheme and Alternative
and Innovative Education (EGS + AIE). This is specially designed to provide access to elementary
education to children in school-less habitations and out of school children in 2004-05. Apart
from the above, Mid-day meal scheme, Kasturba Gandhi Balika Vidyalaya (KGBV), Parambhik
Shiksha Kosh (PSK) are other schemes for encouraging people for elementary education.
The achievements of SSA till December 2008 are opening of around 277000 new schools,
construction of more than 225000 school buildings, construction of more than 900000 additional
classrooms, supply of free text books to 8.40 crore children and appointment of 9.66 lakh
teachers.
Secondary education prepares students in the age group of 14-18 years for entry into higher
education and employment. There has been an impressive growth in the area of higher education
with an increase in the number of secondary and higher education school from 7416 in 1950-51 to
more than 1,68,900 in 2006-07. The corresponding increase in total student enrolment has been
from 1.5 million in 1950-51 to 39.44 million in 2006-07. Annual enrolment of women students
rose from 2.45 million in 1997-98 to 4.04 million in 2004-05 constituting 40.4 per cent of the
total annual enrolment.
University and higher education is also very important. However, it is available to a small
percentage of population in the relevant age group. Moreover, it suffers from several weaknesses,

such as increasing number of substandard institution, falling academic standards, outdated

curriculum and lack of adequate support for research.
There has been a significant growth in higher education during the academic year 2006-07.
Enrolment in various courses at higher level in 2006-07 was 11.61 million as compared to 11.34
million in the previous year. Out of these women students constituted 40.55 percent.
Technical education including management education has expanded at a spectacular rate
since Independence. At present there are more than 1200 recognised technical education
institutions at the first degree level and 1215 polytechnics at the diploma level with more than
2 lakh students each. Number of institutions offering post-graduate courses is about 150 with
an annual capacity of 10,000 students. There are seven national institutions on technology
known as Indian Institute of Technology. These provide courses in engineering and technology.
Besides these, there are 20 National Institute of Technology (NIT) consisting of 17 erstwhile Regional
Engineering colleges and 3 other engineering colleges taken over by the Central Government and a
number of other centers for specialised courses such as architecture, mining and metallurgy,
industrial engineering and forge and foundry. These include Indian Institute of Science, Indian
Institute of Science Education and Research (IISERs), National Institute of Industrial Engineering,
Indian Institute of Foreign Trade (IIFT), National Institute of Foundry and Forge Technology, Indian
School of Mines, School of Planning and Architecture and many more. There are six Indian Institutes
of Management (IIMs) which are centers of excellence in management education. Apart from
these, there are other private and government institutes which provide management education.
Not only this, there are quite a number of medical colleges imparting education in the area of medicines.
All India Institute of Medical Sciences, Delhi University College of Medical Sciences, Post Graduate
Institute of Medical Education & Research, Maharashtra University of Health Science, Sanjay Gandhi
Postgraduate Institute of Medical Science are a few of them.
Recent expansion of higher education institutions include the following: Opening of 6 new
IITs, passing of Ordinance for establishing 15 Central Universities, opening of new IIMs, setting
up of two new IISERs, setting up of two new Schools of Planning and establishing new
polytechniques etc.
For adult education, the National Literacy Mission (NLM) was launched in 1998 as a Technology
Mission. It aimed at imparting functional literacy to non-literates in the country in the age
group of 15-35 in a time-bound manner. Its objective is to attain a sustainable threshold literacy
rate of 75 per cent by 2007. The Total Literacy Campaign (TLC) has been the principal strategy
of NLM. NLM has accorded priority for the promotion of female literacy. The scheme of
continuing education is now the flagship programme of the NLM. As more and more neo-literates
emerge out of the literacy campaign, the thrust is on providing continuing and life long learning to
these people. For this purpose, a number of Continuing Education Centres (CECs) are being opened
up.
4.4.0 Problems of India’s Education system
The education system in India suffers from the following problems:
1. Unplanned expansion of higher education.

2. Inadequate number of institutions which can impart education through correspondence
or in the evening .
3. Low standard of education.
4. Large number of unemployed educated people.
5. Large-scale migration of educated people to the developed western countries.
6. Lack of infrastructure in many rural schools – absence of rooms, blackboard, teachers,
water etc.
7. Neglect of primary education.
4.4.1 Suggestions for improving the education system
1. Restrictions should be introduced on higher education. Only those who satisfy certain
conditions should be admitted to post graduate courses.
2. Education should be made job-oriented.
3. Expansion of education should be carefully planned since it is costly.
4. In rural areas emphasis should be on agriculture and vocational education.
5. Technical education should be properly planned.
6. Efforts should be made to stop brain drain i.e. highly educated people going abroad in
search of jobs.
7. The standard of education should be raised.
8. The reasons for high rate of dropout especially among girls should be found and dealt
with.
SUMMARY
Important infrastructural services are energy, transport, communication, education and health.
Energy is a vital input for most of the productive activities. In India, still half of the population
uses non-commercial sources of energy obtained from fuel wood, animal dung, biogas, crop
residue etc. Commercial energy is obtained from coal, petroleum, water, sun and wind, etc.
Demand and supply gap, operational inefficiencies, growing oil prices, T&D losses etc. are the
challenges faced by the economy vis-a-vis energy. Steps taken to meet these challenges include,
increasing capacity of plants, carrying out reforms for reducing T&D losses, turning around
SEBs, using new sources of power and so on.
Railways, roadways, water ways and airways constitute the transportation system of any
economy. Considering the size of India, these facilities are inadequate and need enhancement
and improvement.
Communications all over the world have progressed rapidly and the most important factor
behind this has been the growth of telecommunication. Radio paging, cellular mobile telephones,
electronic mail, voice mail, video-conferencing have revolutionised the world and have replaced
old means of communication such as telegram and telex. India along with the other countries
has benefited from these progresses but still it has a long way to go.

The general health of Indian people is not satisfactory. There is lack of proper balanced and
nutritious diet and medical care. Although over the years many developments have taken
place on the health front but considering the size of the population in India these are inadequate
both qualitatively and quantitatively.
Education is an important ingredient in the development of an individual and a society. In
India, education system suffers from, high percentage of dropouts, inadequate number of
educational institutions, lack of infrastructure in many rural schools, outdated co-curriculum
and so on. For improving the education system in India it is important that the above problems
are addressed adequately.

CHAPTER – 6
SELECT ASPECTS
OF INDIAN
ECONOMY
Unit 5
Inflation
Learning Objectives
understand the meaning of inflation.
know various types of inflation.
understand how prices have moved in India.
know the general causes behind inflation in India.
know the measures taken by the government to control inflation in India.
5.0 MEANING AND TYPES OF INFLATION

Inflation refers to a persistent upward movement in the general price level. It results in a
decline of the purchasing power. According to most economists inflation does not occur until
price increase averages less than 5% per year for a sustained period. Inflation can broadly be of
the following types:
(i) Demand-pull inflation : In a market there is interaction between the flow of money and
flow of goods and services. When more money chases relatively less quantity of goods and
services the excess of demand relative to supply pushes up the prices of goods and services.
Such inflation, as a result of increased money expenditure, is called demand-pull inflation.
In other words, when demand for goods and services is more than their supply, their
prices rise. Such price rise is called demand pull inflation.
(ii) Cost-push inflation : Cost push inflation refers to a situation where prices persistently rise
because of growing factor costs. Cost push inflation results when factors of production
especially wage earners try to increase their share of the total product by raising their
prices. A rise in factor prices leads to a rise in the total cost of production and consequently
a rise in the price level. This may result in an inflationary spiral. Inflation once set in
motion due to phenomenon of cost push in one industry or sector spreads throughout the
economy. For example, due to rise in wages in the steel industry, prices of steel may rise
and this will raise the prices of vehicles, machines, etc., using steel as input. The rise in
prices of vehicles may in turn raise the cost of transport and manufactured goods. The
cost of agriculture may also rise due to high prices of tractors. Ultimately, food and raw
material prices will also go up leading to higher cost of living. Higher cost of living will
further push wage rates. Cost push inflation is much more difficult to control than demand
pull inflation. This is because cost push inflation is not susceptible to direct control. Often
the demand pull inflation precedes the cost push inflation. When the former sets in, there
is an increasing demand for factors of production; the prices of these also rise, leading to
rise in general prices.
(iii) Stagflation : The combined phenomenon of demand-pull and cost-push inflation is found
in many countries, both the developed and the developing. One of these situations is in
the form of stagflation under which economic stagnation, in the form of a low rate of
growth, combines with the rise in general price level. In the developing countries, this
happens when aggregate demand increases at a fast rate due to high public expenditure

and expansion of credit money organised labour exerts its influence in raising up wages
thus combining cost-push effect with the demand pull inflation.
Such inflationary situations when unchecked by appropriate monetary and fiscal measures,
may lead to galloping or hyper-inflation leading to price increase of even 40% to 100%
every year.
Stagflation in India has been interpreted to mean that the economy is growing slowly or
stagnating (i.e. GNP is either increasing slowly or remaining constant or even declining) and
at the same time experiencing a high rate of inflation. In India during 1991, partly as a result
of large budget deficits resulting in rapid expansion in money supply and partly due to
supply shocks delivered by Gulf war in 1990-91 and sharp increase in the procurement
prices of foodgrains the high rate of inflation emerged in the economy. Along with high
inflation rate, rate of industrial and economic growth, was very low. Thus, during the period
1991-94 high inflation occurred in India while the economy was stagnating. Therefore, it is
correct to say that India was experiencing stagflation during the period.
Deflation: Deflation is a state in which the prices are falling and thus the purchasing
power of money is increasing. Deflation is just the opposite of inflation.
5.1 PRICE TRENDS IN INDIA

During the fifties, the average decadal rate of inflation was very low at 1.7 per cent.
During the sixties, the average decadal inflation edged up to 6.4 per cent. The inflationary
pressures started mounting from 1962-63, on account of the Chinese war in 1962 and
unsatisfactory supply position. The Pakistan war in 1965 and the famine conditions during
1965-67 aggravated the situation further. The maximum inflation at 13.9 per cent was recorded
for the year 1966-67.
The average inflation rate during the seventies was still higher at 9 per cent. The decade was
the most tumultuous as far as the price situation was concerned as undue hike in oil prices in
this decade, once in 1972-73 and again in 1979-80 led to overall rise in prices.
During the eighties, the decadal average inflation moved down somewhat to 8.0 per cent.
During the first half of nineties average inflation rate was around 10 per cent The years 1990
and 1991 witnessed a very high inflation rate of more than 12 per cent. The accelerated rise in
price reaching double digit during 1990-91 was mainly due to fiscal imbalances leading to
higher liquidity growth, Gulf crisis leading to the shortage of petroleum products and
consequently pushing general price index, tight position of balance of payments and supply
demand imbalances of some essential items. The next three years saw lowering of inflation
rate (to around 10 per cent) .
The growth in prices both at the wholesale level and retail level has been particularly low
between the period 1996-97 to 2003-04. It has been around 5 per cent per annum during 1996-
2001 and around 4 per cent per annum during 2001-04. Contributions to low inflation rates
during the second half of the last decade were mainly due to stable prices of manufactured
goods and also because of good monsoons resulting in only moderate price rise of primary
products. The trend was reversed in 2004-05 with pressure on prices across the group. Erratic
and delayed monsoon in 2004-05, hardening of international prices of crude oil, minerals and

related products led to high inflation rate in 2004-05. It averaged around 6.5 per cent during
this year. Crude oil prices continued rising during 2005-06 but due to monetary and fiscal
measures taken by the government the inflation was contained at 4.7 per cent during 2005-06.
The inflation rate in 2006-07 has been on a general upward trend with intermittent decreases. In
terms of wholesale Price Index (WPI) , annual point to point inflation was 6.11 per cent on January
20, 2007 compared to 4.24 per cent in the corresponding week of the previous year. However, average
inflation for the whole year remained at 5.4 per cent. Shortfall in domestic production vis-a-vis domestic
demand, hardening of international prices of primary products like wheat, pulses, edible oils, fruits,
vegetables and spices have led to higher inflation during 2006-07. The long term inflation for 2001-06
comes out to be 4.7 per cent per annum.
In 2007-08, the fiscal, monetary and administrative measures undertaken during the year
together with improved availability of wheat, pulses and edible oil started working in through
in terms of decline in inflation. The average inflation for the whole year (in terms of WPI)
comes out to be 4.7 per cent.
The fiscal year 2008-09 had been a very unusual year, marked by extremes in price movements.
The year 2008-09 recorded the highest average inflation of the decade with WPI recording a
growth of 8.4 per cent. In contrast, annual inflation as on end-March 2009 recorded the lowest
rate of 0.8 per cent.
There has been a significant variation in inflation rate in terms of WPI and the Consumer Price
Indices (CPIs). Inflation rate as per CPI for rural labour (CPI-RL) was 9.7 per cent and CPI for
industrial worker (CPI-IW) was 8 per cent as of end-March 2009. The average inflation on
CPI-RL and CPI-IW for the year was 10.2 and 9.1 per cent respectively.
It has been observed that in the first half of the fiscal year 2008-09, the inflationary pressure
was on account of the momentum in the international commodity prices and the domestic
prices of food items like cereals and pulses. However, the monetary, fiscal and administrative
measures helped in containing inflation. Later, the global meltdown in commodity prices
particularly in energy, metals and agricultural intermediates across the world led to a
corresponding decline in the domestic prices.
5.2 CAUSES OF INFLATION IN INDIA

A general price rise can take place either as a result of rise in aggregate demand or a failure of
aggregate supply or both. Increase in public expenditure, deficit financing, and rapid growth
of population can be mentioned as demand factors and erratic agricultural growth, agriculture
price policy, inadequate rise in industrial production and upward revision of administered
prices etc. can be mentioned as supply factors which have led to inflationary price rise in
India.
(i) Increase in public expenditure : Public expenditure has risen from 18.6 per cent of NNP in
1961 to 33.3 per cent in 1980-81 and further to around 35 per cent in 2007-08 (current
prices). With a rise in national income and also rapid growth of population an increase in
public expenditure is unavoidable. But the spectacular rise in the public expenditure is not
justifiable. Approximately 45 per cent of the government expenditure in India is on non-
developmental activities. No doubt, defence and maintenance of law and order are essential

for the stability of the society. At the same time, it must not be forgotten that due to their
unproductive nature, expenditure on these activities results in inflationary price rise. The
government expenditure on non-developmental activities, by putting purchasing power
into the hand of its employees, creates demand for goods and services, but it does nothing
whereby their supply could increase. Under these circumstances the general price level
shows an inevitable tendency to rise.
(ii) Deficit financing : Deficit financing means financing of budget deficits (shortages) by
borrowing from the banks or printing of more currency. The Government of India has
frequently resorted to deficit financing in order to meet its developmental expenditure. A
small dose of deficit financing is helpful in tiding over the gap between public revenue
and public expenditure and making available funds for the growth of the economy but a
large dose and that too in a period of relatively slow growth turns out to be inflationary.
This happens because by financing the deficit the government puts purchasing power in
the hands of people but it does nothing for creating real resources for the economy at least
in near future. In India from plan to plan, the recourse to deficit financing has been
increasing and the budgetary deficit during the Eighth Plan was Rs. 20000 crore but actual
deficit was very high at Rs. 29,000 crore. In the Ninth, Tenth and Eleventh Plans, the
government decided not to raise the money through deficit financing.
(iii) Erratic agricultural growth : The Indian agriculture largely depends on monsoons and
thus crop failures due to drought have been regular feature of agriculture in this country.
In the years of scarcity of foodgrains not only price of food articles increases but the general
price level also rises.
(iv) Agricultural price policy of the Government : The government has been pursuing a policy
of price support to the agriculturists. For this, it announces the price at which it would be
buying agricultural products. This ensures certain minimum price to the farmers. This
policy benefited farmers in India but this has been a major contributory factor to the
inflationary price rise in the country.
(v) Inadequate rise in industrial production : Performance of the industrial sector, particularly
in the period 1965 to 1985, has been rather disappointing. Over the 20 years period,
industrial production increased at a modest rate of 4.7% per annum. The performance of
essential consumer goods sector which includes industries like oil, food manufacturing,
textiles, weaving, apparel and footwear was particularly disappointing. Moreover, in the
ten years period from 1991-92 (except for 1995-96), the industrial sector registered slow
growth of around 6 per cent per annum. In the wake of a large expansion of the money
supply creating big demand for these goods, inadequate increase in their production pushed
up their prices.
(vi) Upward revision of administered prices : There are a number of important commodities
for which price level is administered by the government. Many of these commodities are
produced in the public sector. The government keeps on raising prices from time to time in
order to cover the losses in the public sector which often arise due to inefficiency and
unimaginative planning. This policy results in cost push inflation.
(vii) Other factors : Besides the above factors, the following have also contributed to inflationary
trends in price in India: Failure of the government to fully bring within the ambit of taxation
the increasing income of the people, large scale tax evasion and avoidance, increasing

reliance on indirect taxes, black marketing and hoarding of essential commodities, unused
capacity in industries, high capital-output ratio, shortage of essential raw materials, low
surplus from public sector undertakings, infrastructural bottleneck and rising prices of
imports.
5.3 MEASURES TO CHECK INFLATION

Since inflation is a phenomenon where money income or purchasing power is rising faster
than the real goods and services, the measures to check inflation should either be of a check on
the increase in money incomes or making available more of real goods and services. The various
measures can be studied under three main heads – monetary and fiscal measures, control over
investment and other measures.
(i) Monetary measures : Monetary measures are applied to check the supply of currency and
credit. These measures consist of quantitative measures (open market operations, statutory
reserve requirements and Bank Rate) and qualitative measures (margin requirements, moral
suasion etc.). When the Reserve Bank of India wants to control inflation it uses any one or
more of the above measures. Thus, it may sell government securities in the open market.
By issuing (i.e. by selling) government securities, the government takes away liquidity (i.e.
cash etc.) from the people. This lowers the balances with the banks; which in turn will
reduce their capacity to create credit or lend money for investment purposes. This will
reduce liquidity in the economy and bring the prices under control. Similarly, by raising
Bank Rate or statutory reserve rates the RBI controls liquidity and credit and ultimately
prices. The extent to which these will be effective will depend on the intensity of the
investment demand. The raising of the statutory reserve ratio is very widely used measure
in India but the effect of this measure also depends on the banking habits of the people.
However in those countries where banking is not fully spread and all money is not quickly
banked, the effect will be much smaller.
There are several selective measures of credit, such as variable interest rates, variable margin
requirement, ceiling on certain types of loans, minimum and maximum rates of interest
etc. There is need for selective control of credit when the rise in prices is confined to some
commodities only e.g. necessities of life.
(ii) Fiscal measures : These are the measures taken by the government with regard to taxation,
expenditure and public borrowings. Taxes determine the size of the disposable income in
the hands of the public. In the case of inflation, a proper tax policy will be to avoid tax
cuts, or to introduce some increase in the existing rates so as to reduce the purchasing
power in the hands of the people and thus reduce the pressure of demand on prices. The
fiscal tools have been extensively used as tools to control inflation in India. The progressive
income tax system, control over public expenditure, introduction of new types of taxes,
improving profits of public sector units, etc. are all meant to control inflation in the country.
(iii) Control over investment : Controlling investments is also considered necessary because,
due to the multiplier effect, the initial investment leads to large increase in income and
expenditure and the demand for both the consumer and capital goods goes up speedily.
Therefore, it is necessary that the resources of the community should be employed for
investment which does not have the effect of increasing inflation.

(iv) Other measures : These measures can be divided broadly into short term and long term
measures. Short term measures can be in regard to public distribution of scarce essential
commodities through fair price shops. There may also be control over movement of
commodities from one state to another. In India whenever shortage of basic goods has
been felt, the government has resorted to imports so that inflation may not get triggered. It
has also resorted to rationing of essential goods in times of shortages. The long term measures
will require accelerating economic growth especially of the wage goods which have a
direct bearing on the general price and the cost of living. Some restrictions on present
consumption may help in improving saving and investment which may be necessary for
accelerating the rate of economic growth in the long run.
SUMMARY
Inflation or persistent upward movement of prices results in a decline in the purchasing power
of money. A small dose of inflation at the rate of less than 5 per cent is good for the economy
because it strengthens the developmental push of the economy. But inflation at a higher rate
has bad economic and social consequences for the economy. Inflation could be caused either
because of excess of demand over supply or because of increase in the cost of production or
both. Inflation can be checked with the use of monetary measures, fiscal measures and
investment control. In India, general causes of inflation have been population explosion, poor
performance of agricultural and industrial sectors, high government expenditure, and tendency
of the people to emulate people in prosperous countries and so on. Various measures mentioned
above have been used to control inflation in India.

CHAPTER – 6
SELECT ASPECTS
OF INDIAN
ECONOMY
Unit 6
Budget and
Fiscal Deficits
in India
Learning Objectives
understand the meaning of budget deficit and fiscal deficit.
know how budget and fiscal deficits have progressed over the years.
6.0 MEANING OF BUDGET AND FISCAL DEFICITS

The Government of India, every year prepares budget which shows the expected receipts and
expenditures of the government in the coming financial year. Receipts of the government come
from taxes (both direct and indirect), profits from various financial institutions, government
commercial undertakings, interest from loans given to other governments, local bodies, etc.
and expenditure of the government are on developmental projects such as construction of
roads, railways, production of energy and non-developmental expenditure on a large number
of activities such as defence, subsidies, police, law and order, etc. If receipts are equal to
expenditure, the budget is said to be balanced one. If receipts are higher than the expenditure,
the budget is said to be surplus one and if receipts are lower than the expenditure, the budget
is said to be deficit one.
Budget deficit is thus the difference between total receipts and total expenditure (revenue plus
capital). If borrowings and other liabilities are added to the budget deficit, we get fiscal deficit.
Fiscal deficit, thus measures that part of government expenditure which is financed by
borrowings. Consider the following example to understand both the concepts:
Calculation of Budget Deficit and Fiscal Deficit
1990-91 2004-05
Rs. Rs.
(crore) (crore)
1. Revenue Receipts 54,950 3,51,200
2. Capital Receipts of which 39,010 1,63,144
(a) Loan recoveries + other receipts 5,710 12,000
(b) Borrowings & other liabilities 33,300 1,51,144
3. Total Receipts (1+2) 93,960 5,14,344
4. Revenue expenditure 73,510 1,15,982
5. Capital expenditure 31,800 67,832
6. Total expenditure (4+5) 1,05,310 5,14,344
7. Budgetary Deficit (3-6) 11,350 Nil
8. Fiscal deficit 44,650 1,51,144
[1 + 2(a) - 6 = 7 + 2(b)]

Budget deficit is Total receipt – Total expenditure

So here,
For 1990-91, Rs. 93,960 crore – Rs. 1,05,310 crore = Rs. 11,350 crore
For 2004-05, Rs. 5,14,344 crore – Rs. 5,14,344 crore = Nil
Fiscal deficit is
(a) the difference between total expenditure and total revenue receipts and capital receipts
but excluding borrowings and other liabilities. or
(b) it is the sum of budget deficit plus borrowings and other liabilities.
So here, for 1990-91, Fiscal deficit is
1st Method:
Total expenditure = Rs. 1,05,310 crore
(-) Total revenue receipts (no.1) = Rs. 54,950 crore
(-) Capital receipts [no.2(a)] = Rs. 5,710 crore
Or Rs. 1,05,310 crore – Rs. 60,660 crore
Or Rs. 44,650 crore
2nd Method:
Budget deficit (item 7) + borrowings and other liabilities (item 2(b))
= Rs. (11,350 + 33,300) crore
= Rs. 44,650 crore
For 2004-05, Fiscal deficit is
1st Method = Rs. 5,14,344 crore – Rs. [3,51,200 + 12,000] crore
= Rs. 1,51,144 crore.
2nd Method = Nil + Rs. 1,51,144 crore
= Rs. 1,51,144 crore
6.1 TRENDS IN INDIA’S BUDGET AND FISCAL DEFICITS

Budgetary deficit which shows the difference between total revenue and total expenditure
does not give a true picture of the financial health of the economy. It treats government borrowing
from the market or raising the funds from the public such as national savings schemes, post
office saving deposits, provident fund collections etc. as receipts. Originally, budget deficit was
calculated to show RBI lending to the government. In 1997, the practice of RBI lending to
government through ad hoc Treasury Bills was given up. Thus the concept lost its relevance
and now it is no longer shown in the budgetary statement. The government now taps 91 days
treasury bills from the market and shows it as part of the capital receipts under the heading
“borrowings and other liabilities”.

Fiscal deficit is a more comprehensive measure of the imbalances. It focuses on/measures the
total resource gap and as such fully reflects the impact of the fiscal operations of the indebtedness
of government. It is the measure of excess expenditure over the government’s own income.
Fiscal deficit in India have grown rapidly. In the fifteen year period of 1975-90, the fiscal deficit
of the Central Government rose alarmingly from 4.1 per cent of GDP to 7.9 per cent of GDP.
The then present fiscal malaise had been caused by unchecked growth of non planned revenue
expenditure. Non plan revenue expenditure particularly on defense, interest payments and
food and fertiliser subsidies rose sharply during 1980s. In 1991, major steps were taken to
correct the fiscal imbalances. Many expenditures were cut and controlled (e.g. subsidies). Fiscal
deficit was reduced to 4.7 per cent in 1991-92 and to 4.1 per cent in 1996-97. Since 1997-98,
fiscal deficit has again started increasing. It stood at 5.6 per cent in 2000-01. To restore fiscal
discipline, the Fiscal Responsibility and Budget Management (FRBM) Bill was introduced in
2000 and FRBM Act was passed in 2003. The Act aims at reducing gross fiscal deficit by 0.5
per cent of the GDP in each financial year (beginning on April 1, 2000). As a result of the
efforts taken, the fiscal deficit as a proportion of GDP has started declining. During 2003-04, it
was 4.5 per cent, during 2004-05 and 2005-06 it was 4.1 per cent, during 2006-07 and 2007-08
it was 3.5 per cent and 2.7 per cent respectively.
World wide financial crisis affected Indian economy also. The extraordinary situation that
emerged due to crisis had led to a sharp shrinkage in the demand for exports. Domestic demand
also shrank leading to a downturn in industry and services sectors. The situation demanded a
fiscal response. The measures taken included increase in the plan expenditure, reduction in
indirect taxes, sector specific measures for textiles, housing, infrastructure, automobiles, micro
and small sectors and exports etc. These, together with debt relief package for farmers and
outlay due to Sixth Pay Commission recommendations led to an upsurge in the fiscal deficit to
6.2% of GDP compared with 2.7% for 2007-08.
SUMMARY
Budget deficit is the difference between total receipts and total expenditure. If borrowings and
other liabilities are added to budget deficit, we get fiscal deficits. Since budget deficit does not
show the true picture of government liabilities and hence a true picture of the financial health
of the economy, the practice of showing budget deficit in the budget was given up in 1997.
Budgets now show fiscal deficits to show the overall shortfalls in the public revenues. Over the
years, fiscal deficits have grown rapidly and have become the cause of concern. To meet the
challenge, many reforms have been carried out but still the problem of high fiscal deficit remains.

CHAPTER – 6
SELECT ASPECTS
OF INDIAN
ECONOMY
Unit 7
Balance
of
Payments
Learning Objectives
understand the meaning of Balance of Payments.
know the difference between Balance of Payments and Balance of Trade.
know of the developments in Balance of Payments situation in India since Independence.
7.0 MEANING OF BALANCE OF PAYMENTS AND BALANCE OF

TRADE
The Balance of Payments (BOP) is one of the oldest and most important statistical statements
for any country. It is a systematic record of all economic transactions between the residents of
one country and the residents of the rest of the world in a year. Since we merely record all
receipts and payments in international transactions using double entry system, the balance of
payments always balance in an accounting sense.
Balance of Trade : Balance of Trade may be defined as the difference between the value of
goods sold to foreigners by the residents and firms of the home country and the value of goods
purchased by them from foreigners. If value of exports of goods is equal to the value of imports
of goods, we say that there is balance of trade equilibrium and if the latter exceeds the former,
then we say that there is balance of trade deficit. But if the former exceeds the latter, i.e., if
value of exports of goods is more than the value of imports of goods, we say there is surplus
balance of trade.
Balance of Current Account : Balance of current account is a broader concept than the balance
of trade. It includes balance of services and balance of unilateral transfers (i.e., unrequited
transfers) besides including balance of trade. Balance of services records all the services exported
and imported by a country in a year. Unlike goods which are visible and tangible, services are
invisible and are not tangible. The services transactions basically include: (i) transportation,
banking and insurance receipts and payments from and to the foreign countries, (ii) tourism,
travel services and tourist purchases of goods and services received from foreign visitors to
home country and paid out in foreign countries by home country citizens, (iii) expense of
diplomatic and military personnel from overseas as well as receipts from similar personnel
from overseas who are stationed in the home country, and (iv) interest, profits, dividends and
royalties received and paid from and to the foreigners. Balance of services is the sum of all
invisible service receipts and payments which could be zero, positive or negative. Balance of
unrequited transfers includes all gifts, donations, grants and reparation, receipts and payments
to foreign countries. All these balances, i.e., balance of trade, balance of services and balance of
unrequited transfers constitute balance of current account. It could again be positive, negative
or zero depending upon the values of these balances. It is worth noting that balance of payments
on current account covers all receipts on account of earnings (as opposed to borrowings) and
all the payments arising out of spending (as opposed to lending). This is in sharp contrast to
balance of payments on capital account.

Balance of Payment on capital account : Balance of payments on capital account includes

balances of private direct investments, private portfolio investments and government loans to
foreign governments. Balance of capital account basically deals with debts and claims of the
country in question or we say it deals with borrowings or lending of the country in question.
Balance of Payments : Overall balance of payments is the sum of balance of current account
and balance of capital account. It includes all international monetary transactions of the
reporting country vis-à-vis the rest of the world. The balance of payments must always balance
in a book-keeping sense. This is because for any surplus (or deficit) in the overall balance of
payments there must be a corresponding debit (or credit) entry in the net changes in external
reserves. In other words, if there is a surplus it adds to external reserves of the country and if
there is a deficit, it reduces down the external reserves of the country.
7.1 TRENDS IN BALANCE OF PAYMENTS OF INDIA

A country, like India, which is on the path of development generally, experiences a deficit in
balance of payments situation. This is because such a country requires imported machines,
technology and capital equipments in order to successfully launch and carry out the programme
of industrialisation. Also, since initially it has only primary goods to offer as exports, it generally
has an unfavourable balance of payments position. As pace of development picks up it has to
have ‘maintenance imports’ although it has now more sophisticated goods to offer for exports.
But the situation remains the same i.e., deficit balance of payments.
This has exactly happened in India. Over the period of planning India’s balance of payments
has generally remained unfavourable. However, deficit in balance of payments sharply increased
after the Fifth Plan. During the whole of the Fifth Plan, India experienced surplus in the balance
of payments due to a sharp increase in the export surpl.us on account of invisible remittances
(money sent by a foreign worker to his home country) From 1979-80 onwards, India started
experiencing very adverse balance of payments. This happened because growing trade deficits,
which till then were offset by net receipts could not be made good by them in spite of the fact
that the rising trends in the net receipts on account of invisibles noticed in the past few years
continued in 1980-81 to 1985-86. Apart from external assistance, India had to meet this huge
deficit in the current account through withdrawals and borrowings from IMF. It also used up
a part of its foreign exchange reserves.
The Sixth Plan characterised the balance of payments position as ‘acute’. During the Sixth
Plan, the trade deficit was 3.3 per cent of GDP and current account deficit was 1.4 per cent of
GDP. Exports performance substantially improved in the Seventh Plan with average volume
growth exceeding 7 per cent. However, the balance of payments continued to be under strain
on account of a combination of several medium and short term adverse factors. There was no
significant growth in indigenous oil production while domestic demand for petroleum products
went on rising. There was a steep rise in debt services payments. The share of net invisible
earnings in financing trade deficit declined from 63 per cent during the Sixth Plan to 29.5 per
cent during the Seventh Plan. The average current account deficit as a per cent of GDP increased
to 2.4 per cent in the Seventh Plan. The large and sustained current account deficit in the BOP
had to be financed by substantial inflow of capital in the form of loans from various sources,
commercial borrowings and inflow of funds from NRIs. In early 1990-91, the already poor
BOP position worsened because of Gulf war and further deterioration in invisible remittances.
An immediate response to the BOP crisis was introduction of several restrictions on import in
1990-91. In 1992-93, many important changes such as a new system of exchange rate
management, liberalisation of import licensing and tariff reductions were introduced. Data of
1992-93 show that there has been significant revival of imports and exports during the year
with the result that the current account deficit came down to 2.1 per cent of GDP in 1992-93.
In the year 1993-94, India saw a remarkable turnaround from a foreign exchange constrained
control regime to a more open, market driven and liberalised economy. This has been facilitated
by the structural changes in the country’s balance of payments. The trade liberalisation and a
shift to a market-determined exchange rate regime have had a significant positive impact on
the country’s balance of payments.
Exports recorded a growth of 20 per cent in dollar terms. The surplus on the invisible account
doubled. The current account deficit shrank, and the capital account was strengthened by
sharp increase in direct foreign investments and portfolio investments. Not only this, foreign
currency reserves which were just $1205 million in 1990 reached the level of $19,386 million in
1994. The balance of payments position further consolidated in 1994-95. The build up in foreign
currency reserves which reached a level of $19.6 billion at the end of January 1995, the economy
thus moved to a more stable and sustainable balance of payments position.
The balance of payments situation remained comfortable in 1995-96, 1996-97 and 1997-98. In
1998-99, despite the continuing slow down of exports and a marked deceleration in capital
flows, the BOP situation was not unmanageable. Exports during 1999-2000 showed a welcome
recovery. Similarly, imports also picked up. The current account deficit in the year 2000-01
was 0.5 per cent of GDP. It was 1.1 per cent in 1999-2000. This improvement in current account
deficit was made possible largely because of the dynamism in export performance, sustained
buoyancy in invisible receipts and subdued non-oil import demand. The BOP position remained
comfortable during 2001-02.
In the Tenth plan total exports grew at about 24 per cent per annum. This was largely due to the
impressive growth of petroleum products which grew at more than 50 per cent during the Plan.
Manufactured goods recorded an impressive growth of about 20 per cent per annum and exports
of agricultural and allied products also rose at a healthy rate of more than 16 per cent.
North America (occupying first place) continued to be an important destination of India’s
exports. During the Tenth Plan nearly 16 per cent of India’s exports went to North America.
European Union countries (27 in number) had a combined share of more than 21 per cent in
India’s exports during the Tenth Plan. The share of Asia and ASEAN countries steadily increased
during the Tenth Plan and the region accounted for nearly half of India’s exports during the
Plan.
Imports recorded a compound annual growth rate of around 30 per cent during the Tenth
Plan. The high growth was mainly due to increase in oil prices. The crude oil and petroleum
products taken together were the single most important category of imports during the Plan.
This group accounted for nearly 30 per cent of the total value of imports by India during the
Plan. The share of machinery and project goods registered a significant increase during the
plan increasing from 11.3 per cent in 2002-03 to 18 per cent in 2006-07. Asian countries remained
our main supplier of imports during the Plan. Their share increased from around 30 per cent
in 2002-03 to more than 57 per cent in 2006-07.
The merchandise trade deficit widened sharply during the Tenth Plan mainly on account of
the growing oil import bill.
We had a current account surplus for three successive years (2001-04). Buoyant invisible flows,
particularly private transfers comprising remittances, along with software services exports, have
been instrumental in creating and sustaining current account surpluses for India for the above
period. However, since 2003-04 trade deficit has widended sharply, particularly in 2004-06, because
of higher outgo on import of petroleum, oil and lubricants. As a result, current account surpluses have
once again turned into deficits inspite of the fact that invisibles flows have continued to swell. For the
years 2004-05, 2005-06 and 2006-07 the current account deficits were (-) 0.4 per cent and (-) 1.1 per
cent and (-) 1 per cent respectively.
In the Eleventh Plan exports are projected to grow at about 20 per cent per year in US dollar
terms, the imports are projected to grow at 23 per cent, current account deficit could range
between 1.2 per cent to 2 per cent and trade deficit could reach 16 per cent at the end of the
Plan.
During the first year of the Eleventh Plan, export increased by around 30 per cent, imports
increased by 35 per cent, current account balance was (-) 1.5 per cent of GDP and trade balance
was (-) 7.8 per cent of GDP.
The year 2008-09 was marked by adverse development in the external sector of the economy,
particularly during the second half of the year, reflecting the impact of global financial crisis.
Exports grew by 17.5 per cent and imports by 30.6 per cent during April - December 2008-09.
Despite higher invisible surplus, the trade deficit widened mainly because of higher growth of
imports and slower growth of exports. The current account deficit ratio to GDP reached 4.1
per cent during April-December 2008-09.
Foreign direct investment (FDI) has grown significantly on net (inward minus outward) basis.
The year to year growth (net) was 154 per cent in 2006-07 and 100 per cent in 2007-08. During
April-December 2008, net FDI remained buoyant at US $ 15.4 billion as compared to US $ 6.9
billion in April-December 2007. Considering global FDI inflows in various countries, India
ranked ninth.
Foreign exchange reserves declined from US $ 309.7 billion in 2007-08 to US $ 252 billion in
2008-09.
The United States of America continued to be the principal destination accounting for 12 per
cent of India’s total exports in 2008-09, followed by UAE(10.8 per cent), China(5.1 per cent),
Singapore (4.8 per cent), Hong Kong (3.7 per cent) and UK (3.6 per cent).
In 2008-09, Asia and ASEAN continued to be the major source of India’s imports accounting
for more than 61 per cent of total imports.
Thus, we find that there has been a significant improvement in the structure of India’s balance
of payments since the economic crisis of 1991. Comparing the pre-crisis with the post-crisis
data we find that exports grew at an annual average of 7.6 per cent during 1980 to 1992 and
at an annual average of 10 per cent 1992-93 to 2000-2001. Similarly, imports grew at 13.7 per
cent per annum during 1992-93 to 2000-2001 compared with just 8.5 per cent growth rate
during 1980-1992. Moreover, the current account deficit, as percentage of GDP has declined

from 1.9 per cent during pre-crisis period to around 1 per cent during post-crisis period and
during 2001-04 we even had surplus in the current account. Since then also, the external
sector has shown resilience despite slow down in the global economy.
SUMMARY
No country is self-sufficient today. It has to depend upon other countries for its imports and
exports. For evaluating its performance on the international front it prepares ‘Balance of Trade’
and ‘Balance of Payments’ statements. Balance of trade is the statement showing balance of
merchandise trade only. In Balance of payments we have other transactions such as capital
transactions, balance on account of service transactions, gold transactions, etc. A country could
be having a surplus in balance of trade and a deficit in balance of payments simultaneously.
While analysing India’s balance of payments situation we find that it started deteriorating
since 1979-80. This happened because growing trade deficits which till Fifth Plan were offset
by net receipts could not be made good by them in spite of the fact that the rising trend in the
net receipts continued till early 80’s. The current account deficit which was 1.3 per cent of
GDP in the Sixth Plan stood at 2.2 per cent during the Seventh Plan. This large and sustained
current account deficit had to be financed by substantial inflow of capital in the form of loans,
commercial borrowings and inflow of funds from NRIs. The Gulf crisis further deteriorated
our balance of payments position. Our reserves touched very low levels. In order to combat all
these problems and to boost exports and curb imports changes were made from time to time in
our foreign trade policy. Many schemes were started and incentives were given for improving
exports. Devaluation (reducing the value of local currency vis-a-vis other currencies) of rupee
was carried out, loan was sought from the IMF and new trade policy was announced. As a
result, we now have quite comfortable balance of payments situation.

CHAPTER – 6
SELECT ASPECTS
OF INDIAN
ECONOMY
Unit 8
External
Debt
Learning Objectives
understand the types of external assistance received by India.
know the changes that have taken place over the years in the structure of external
assistance received by India.
8.0 EXTERNAL DEBTS IN INDIA

Since no country is self-sufficient, it has to rely on other countries and international organizations
for financial assistance. This is especially true for a developing country which is on the path of
development. It needs funds for its various developmental projects. India is no exception. Ever
since Independence it has relied on other countries for external assistance. External assistance
to India has been in two forms – grants and loans. While grants do not involve any repayment
obligation, loans carry an obligation to pay interest and repay the principal. About 90 per cent
of the external assistance received by India has been in the form of loans. These loans have
been from different sources like World Bank, International Monetary Fund (IMF), International
Development Association, U.S.A., U.K., Japan, etc. A large part of the loan, especially from
multilateral and bilateral agencies has high degree of concessionability i.e., grant element of at
least 25 per cent. The share of concessional debt in total debt now is about 20 per cent. At one
time (1980-81) it was as high as 75 per cent.
India’s external debt amounted to Rs 13,470 crore at the end of March 1981. As liberal use of
borrowing has been made ever since then, the external debt stood at more than Rs 4,80,000
crore at end March 2002 and nearly 9,00,000 crore at end March 2008.
As per cent of GDP, India’s external debt was 11.7 per cent at end March 1991; it became 21
per cent at end March 2002 but reduced to 19 per cent at end March 2008. Debt service ratio
i.e. the ratio of gross debt service payments (principal and interest) to external current receipts
was as high as 35.3 in 1990-91; it declined to 13.7 per cent in 2001-02 and further to 5.4 in
2007-08.
In terms of indebtedness classification, the World Bank has categorized India as a less indebted
country since 1999. Among the top 15 debtor countries of the world, India improved its rank
from third debtor after Brazil and Mexico in 1991 to ninth in 2001 after Brazil, China, Mexico,
Russian Federation, Argentina, Indonesia, Turkey and Korea Republic and further to sixth
after Russian Federation, China, Turkey, Brazil and Poland in 2008.
It needs to be also recognized that the debt service ratio (ratio of principal and interest to total
exports) for India remains high by international standards. Besides, India’s exports of goods as
a percentage of GDP works out to be around 14 per cent. This ratio which represents the
potential capacity of the nation to service external debt, being relatively low, makes India
vulnerable to external shocks. This, therefore, underscores the need for sustaining the growth
in exports and invisibles.

SUMMARY
Like any developing economy, India has had been facing financial crunch. Therefore, it relies
on other countries and international organisations for financial assistance. Financial assistance
has been in two forms – grants and loans. Till 1980-81, the percentage of grants in total external
assistance to India had been quite high. But now, the percentage of commercial loans in total
assistance is increasing. India needs to push up its exports so its capability of repaying the
loans strengthens.

1. What is India’s rank in world population?
a. First.
b. Second.
c. Third.
d. Fourth.
2. The annual addition to India’s population is almost equal to the total population of
a. Bangladesh.
b. Australia.
c. Japan.
d. China.
3. In which state is the sex ratio most favourable to women?
a. Andhra Pradesh.
b. Uttar Pradesh.
c. Kerala.
d. Karnataka.
4. Which year is known as year of great divide for India’s population?
a. 1991.
b. 2001.
c. 1981.
d. 1921.
5. In which state/union territory is the literacy rate highest?
a. Delhi.
b. Chandigarh.
c. Karnataka.
d. Kerala.

6. India’s passing through _________ stage of demographic transition.
a. Fourth.
b. Third.
c. First.
d. Second.
7. In the theory of demographic transition in the last stage,
a. Birth rate rises, death rate rises.
b. Birth rate rises, death rate falls.
c. Birth rate falls, death rate rises.
d. Birth rate falls, death rate falls.
a. India’s population is second largest in the world.
b. India is still passing through first stage of demographic transition.
c. More people in a country always mean more economic trouble for the country.
9. India’s present population is
a. Between 50-60 crore.
b. Between 60-70 crore.
c. Between 70-80 crore.
d. Above 100 crore.
10. India accommodates nearly ______________ per cent of world’s population.
a. 10.
b. 50.
c. 17.
d. 45.
11. Over the years, birth rate in India has __________ and death rate has _____________.
a. Fallen, fallen.
b. Risen, fallen.
c. Risen, risen.
d. Fallen, risen.

12. The birth rate in India is high because of

a. Predominance of agriculture.
b. Slow urbanisation.
c. High incidence of poverty.
a. Gini coefficients are often used for measuring poverty in relative sense.
b. When poverty is related to the distribution of income or consumption expenditure, it
is absolute poverty.
c. In India, we mainly use the concept of relative poverty for measuring poverty.
14. Identify the incorrect statement.
a. The problems of poverty and unemployment are inter-related.
b. The problem of poverty has been solved in India.
c. Growing population has also contributed to the problem of poverty in India.
15. SJSRY stands for
a. Swaran Jayanti Shahari Rozgar Yojana.
b. Shahari Jeewan Sudhar Rashtriya Yojana.
c. Sampoorna Jeewan Shahari Rozgar Yojana.
16. EAS stands for
a. Easy Assistance Scheme.
b. Endless Assistance Scheme.
c. Employment Assurance Scheme.
d. Employment Assessment Scheme.
17. A situation of employment in which a person is apparently employed but his contribution
to the production is almost nil is called ________ unemployment.
a. Structural.
b. Chronic.
c. Disguised.
d. Cyclical.

18. ______________ unemployment may result when some workers are temporarily out of
work while changing job.
a. Cyclical.
b. Voluntary.
c. Frictional.
d. Seasonal.
19. According to __________________ measure, a person is said to be employed for the week
even if he is employed only for a day during the week.
a. Usual status.
b. Current weekly status.
c. Current daily status.
d. Current yearly status.
20. ___________________ measure estimates the number of persons who may be said to be
chronically unemployed.
a. Usual status.
b. Current weekly status.
c. Current daily status.
d. Current yearly status.
21. When due to introduction of new machinery, some workers tend to be replaced by machines,
their unemployment is termed as ________________.
a. Structural.
b. Technological.
c. Mechanical.
d. Seasonal.
22. Every ___________person in the world is an Indian.
a. Second.
b. Third.
c. Sixth.
d. Tenth.
23. _____________________ measure generally gives the lowest estimate of unemployment
especially for poor economy.
a. Usual status.
b. CWS.

c. CDS.
d. CMS.
24. Most of the unemployment in India is ________________.
a. Voluntary
b. Structural
c. Frictional
d. Technical
25. According to the Planning Commission, using Mixed Recall period (MRP) ______________
per cent people were below poverty line in 2004-05.
a. Rs. 26.2
b. Rs. 25.2
c. Rs. 27.8
d. Rs. 21.8
26. Work force refers to that part of:
a. Labour force which is employed.
b. Population which is unemployed.
c. Population which is forced to work.
d. Labour force which is unemployed.
27. According to the 61st NSSO survey (July 2004 - June 2005):
a. The unemployment rates went down between 1993-94 to 2004.
b. The unemployment rates went up between 1993-94 to 2004.
c. The unemployment rates remained same between 1993-94 to 2004.
28. According to the 61st NSSO survey (July 2004 - June 2005):
a. unemployment rates on the basis of current daily status were same as those on the
basis of usual status.
b. unemployment rates on the basis of current daily status were higher than those on
the basis of usual status.
c. unemployment rates on the basis of current daily status were lower than those on the
basis of usual status.

29. At present, nearly ____________ per cent of the energy consumed is obtained from non-
commercial traditional sources.
a. 45.
b. 51.
c. 27.
d. 10.
30. The highest user of commercial energy is
a. agriculture.
b. transport.
c. household.
d. industry.
31. In terms of generation of power ____________________ ‘s contribution, is the maximum.
a. hydel.
b. nuclear.
c. thermal.
d. others.
32. NTPC stands for
a. National Thermal Power Corporation.
b. National Tidal Power Corporation.
c. National Theological Power Corporation.
d. National Talent and Potential Corporation.
33. ______________________ measures the operational efficiency of a thermal plant.
a. Power load factor.
b. Power leakage factor.
c. Plant load factor.
d. Plant leakage factor.
34. According to the latest data (2008-09) PLF is lowest in
a. southern region.
b. northern region.
c. western region.
d. north eastern region.

35. Considering State Electricity Boards (SEBs) central sector and private sector, PLF is highest
in____________.
a. private sector.
b. SEBs.
c. central sector.
d. both for SEBs and private sector.
36. Electricity generated from radio active elements is called
a. thermal electricity.
b. atomic energy.
c. hydel electricity.
d. tidal energy.
a. The demand and the supply of fuel are almost equal.
b. Our import bill on account of oil has been decreasing since 1990.
c. Oil prices have been decreasing since 1973.
d. Transmission and distribution losses of power companies are very high.
a. The Indian road network is one of the longest networks in the world.
b. The rural road network connects around 65 per cent of all weather roads.
c. Most of the State Road Transport Corporations are running on profits.
d. The National highways carry more than 40 per cent of the total road traffic.
39. In terms of overseas shipping tonnage, India ranks ______________ (2007).
a. 10 th .
b. 15 th .
c. 25 th .
d. 20 th .
40. Of the major 12 ports, ____________ is the top traffic handler.
a. Paradip.
b. Cochin.
c. Vishakhapatnam.
d. Mumbai.

41. Sahara Jet and Kingfisher are examples of
a. private schools.
b. private airlines.
c. private ships.
d. private railways.
42. Our postal network is _________________ in the world.
a. the largest network.
b. fifth smallest.
c. tenth largest.
d. tenth smallest.
43. On an average, one post office in India serves ________.
a. 100 persons.
b. 1000 persons.
c. 7174 persons.
d. 5800 persons.
44. There are about __________ phones per hundred population in India.
a. 35.65.
b. 12.85.
c. 13.83.
d. 15.15.
45. Who is regulatory authority for telecom in India?
a. SEBI.
b. TRAI.
c. MTNL.
d. BSNL.
46. Over the years, the incidence of malaria (cases in million) has ________________.
a. reduced
b. increased.
c. remained the same.
d. doubled.

47. Over the years, the number of polio cases has

a. increased.
b. reduced.
c. remained the same.
d. doubled.
48. NLM stands for
a. National Leprosy Mission.
b. National Logistic Mission.
c. National Literacy Mission.
d. National Law Mission.
49. IIM stands for
a. Indian Institute of Marketing.
b. Indian Institute of Manpower planning.
c. Indian Institute of Management.
d. International Institute of Management.
50. When too much money chases too few goods, the resulting inflation is called __________.
a. deflation.
b. demand-pull inflation.
c. cost-push inflation.
d. stagflation.
51. The combined phenomenon of stagnation and inflation is called ______________.
a. demand-pull inflation.
b. cost-push inflation.
c. money inflation.
d. stagflation.
52. When prices are falling continuously, the phenomenon is called _______________.
a. inflation.
b. stagflation.
c. deflation.
d. reflation.

53. When the government tries to meet the gap of public expenditure and public revenue
through borrowing from the banking system, it is called ________________.
a. deficit financing.
b. debt financing.
c. credit financing.
54. ___________ is the difference between total receipts and total expenditure.
a. Fiscal deficit.
b. Budget deficit.
c. Revenue deficit.
d. Capital deficit.
55. If borrowings and other liabilities are added to the budget deficit we get ______________.
a. revenue deficit.
b. capital deficit.
c. primary deficit.
d. fiscal deficit.
56. FRBM Act stands for
a. Fiscal Revenue and Budget Management.
b. Foreign Revenue and Business Management.
c. Fiscal Responsibility and Budget Management.
d. Foreign Responsibility and Budget Management.
57. _______________________ is a systematic record of all the economic transactions between
one country and rest of the world.
a. Balance of trade.
b. Balance of transactions.
c. Budget.
d. Balance of payments.
58. EPCG scheme stands for
a. Export Package For Capital Goods.
b. Export Promotion Capital Goods.
c. Excise Promotion Capital Goods.
d. Excise Package For Capital Goods.

59. The share of concessional debt in total external debt of India has
a. remained the same.
b. doubled.
c. reduced.
d. increased.
60. About ________________ per cent of the external assistance has been in the form of loans.
a. 40.
b. 30.
c. 10.
d. 90.
61. Among all the states, ————— has the lowest birth rate of and ————— has the
highest birth rate.
a. Kerala, Uttar Predesh
b. West Bengal, Uttar Pradesh
c. Kerala, West Bengal
d. Kerala, Bihar
62. Considering death rate, ————— has the lowest death rate and __________ has the
highest death in 2007.
a. Kerala, Uttar Pradesh
b. West Bengal, Orissa
c. Madhya Pradesh, West Bengal
d. Kerala, Orissa
63. Which state has the lowest life expectancy at birth?
a. Kerala
b. Bihar
c. Madhya Pradesh
d. Uttar Pradesh
64. Maternal Mortality Rate is highest in ——————.
a. U.P
b. M.P.
c. Bihar
d. Kerela

65. India is the world’s —————— largest energy producer.
a. fifth
b. second
c. seventh
d. first
66. India is the world’s ————largest energy consumer.
a. second
b. seventh
c. first
d. fifth
67. Almost ——————per cent of India’s global merchandise trade is carried through the
sea route.
a. 95
b. 65
c. 80
d. 55
68. In the Tenth plan, total exports grew at about ——— per cent per annum.
a. 10
b. 15
c. 24
d. 5
69. Imports recorded a compound annual growth rate of around ————per cent during
the Tenth Plan.
a. 30
b. 20
c. 10
d. 40
70. The ——————— continued to be the principal destination of India’s total exports in
2008-09.
a. Japan
b. United States of America
c. South Korea
d.. Russia

71. In 2008-09, ——————— continued to be the major source of India’s imports.

a. Asia and ASEAN
b. EU
c. North America
d. South America
72. In terms of indebtedness classification, the World Bank has categorized India as a ———
———country since 1999.
a. highly indebted
b. less indebted
c. severely highly indebted
d. zero indebted
73. Among the top 15 debtor countries of the world, India is ranked at —————. (2008)
a. tenth
b. fifteenth
c. sixth
d. ninth
74. As per cent of GDP, India’s external debt is —— per cent. (2008)
a. 10
b. 15
c. 12
d. 19
75. India’s debt service ratio is ——————. (2007-08)
a. 11.5
b. 5.4
c. 30.5
d. 10
76. Sex ratio refers to the numbers of females per _________ males
a. 100
b. 300
c. 1000
d. Non of the above

77. Which state shows are lowest infant mortality rate in India?
a. Uttar Pradesh
b. Andhra Pradesh
c. Kerala
d. Tamil Nadu
ANSWERS
1. b 2. b 3. c 4. d 5. d 6. d
7. d 8. a 9. d 10. c 11. a 12. d
13. a 14. b 15. a 16. c 17. c 18. c
19. b 20. a 21. b 22. c 23. a 24. b
25. d 26. a 27. b 28. b 29. c 30. d
31. c 32. a 33. c 34. d 35. a 36. b
37. d 38. c 39. d 40. c 41. b 42. a
43. c 44. a 45. b 46. a 47. b 48. c
49. c 50. b 51. d 52. c 53. a 54. b
55. d 56. c 57. d 58. b 59. c 60. d
61. a 62. b 63. c 64. b 65. c 66. d
67. a 68. c 69. a 70. b 71. a 72. b
73. c 74. d 75. b 76. c 77. c

CHAPTER – 7
ECONOMIC
REFORMS
IN INDIA
Unit 1
Economic
Reforms
in India
ECONOMIC REFORMS IN INDIA
Learning Objectives
know the background behind economic reforms in India.

know the sectors in which economic reforms were carried out.
understand the reforms in the industrial sector, financial, external and fiscal sectors.
understand how reforms have fared since their introduction in India.
1.0 BACKGROUND
After Independence, India followed the policy of planned growth and for this it pursued
conservative policies. The public sector was given dominant position and was made the main
instrument of growth. The fiscal policy was framed in a way that it mobilised resources from
the private sector to finance development programme and public investment in infrastructure.
Similarly, monetary policy sought to regulate financial flows in accordance with the needs of
the industrial sector and to keep the inflation under control. Foreign trade policy was formulated
to protect domestic industry and keep trade balance in manageable limits. These conservative
policies continued for decades, but it was noticed as early as in 1980s that there was:
excess of consumption and expenditure over revenue resulting in heavy government
borrowings;
growing inefficiency in the use of resources;
over protection to industry;
mismanagement of firms and the economy;
mounting losses of public sector enterprises;
various distortions like poor technological development and shortage of foreign exchange;
and imprudent borrowings from abroad and mismanagement of foreign exchange reserves.
Realising these drawbacks, economic reforms were set in motion though on a modest scale in
1985. However, measures undertaken were ad-hoc, half-hearted and non serious. As a result,
sign of crisis began to manifest themselves in 1991. These were:
Low foreign exchange reserves: The available foreign exchange reserves were just sufficient to
finance imports of three weeks.
Burden of National Debt: National Debt constituted 60 percent of the GNP in 1991. The large
fiscal deficits in the previous five years meant that the government was borrowing increasingly
to meet the shortfall of the revenue account.
Inflation: Gulf war, hike in the administrative prices of many essential items and excess liquidity
in the economy led to very high rate of inflation in the country. The wholesale prices increased
at an annual average rate of 12 percent during the year.

The government responded to the crisis by introducing economic reforms in the country. Reforms
were introduced in all major sectors of the economy namely:
Industrial sector
Financial sector
External sector
Fiscal policy
1.1 INDUSTRIAL SECTOR

In the industrial sector, following reforms were undertaken:
Industrial licensing was abolished for all projects except for 18 industries related to strategic
and security concerns, social reasons, hazardous chemicals and over-riding environmental
reasons and items of elitist consumption. At present there are only 6 industries which
relate to health, strategic and security considerations remain under the purview of industrial
licensing.
These are:
1. Distillation and brewing of alcoholic drinks.
2. Cigars and Cigarettes of tobacco and manufactured tobacco substitutes.
3. Electronic Aerospace and Defence equipment: all types.
4. Industrial explosives including detonating fuses, safely fuses, gun powder,
nitrocellulose and matches.
5. Hazardous chemicals.
6. Drugs and Pharmaceuticals (according to modified Drug Policy issued in September,
1994 as amended in 1999).
Only 8 industries groups where security and strategic concerns pre-dominate would be
reserved exclusively for the public sector. At present, there are only 3 industries which are
reserved for the public sector. They are (i) atomic energy, (ii) the substances specified in
the schedule to the notification of the Government of India in the Department of Atomic
Energy, and (iii) rail transport. In 2001, defense production was dereserved and opened
up to private participation through licensing. A minimum capital of Rs. 100 crore would
be required by the companies seeking entry into defense production. Foreign investment
up to 26% is being allowed.
In projects where imported capital goods are required automatic clearance would be given
in the following cases:
(a) where foreign exchange availability is ensured through foreign equity. [It is no longer
necessary for automatic approval by the RBI that the amount of foreign equity should
cover the foreign exchange requirements for import of capital goods needed for the
project.]

(b) If the value of imported capital goods required is less than 25% of the total value of
plant and machinery up to maximum of Rs. 2 crore.
In locations other than cities of more than 1 million population, there would be no
requirement of obtaining industrial approvals from the Central Government except for
industries subject to compulsory licensing. Industries other than those of non-polluting
nature such as electronics, computers, software and printing would be located outside 25
km. of periphery except in prior designated industrial areas.
The mandatory convertibility clause would no longer be applicable for term loans, from
the financial institutions for new projects.
The system of phased manufacturing programmes approved on case by case basis would
not be applicable to new projects.
Existing units would be provided a new broad banding facility to enable them to produce
any article without any investment.
The exemption from licensing would apply to all subsequent expansion of existing units.
All existing schemes (the licenses registration, exempted registration, DGTD registration)
would be abolished.
Entrepreneurs would henceforth only be required to file an information memorandum on
new projects and subsequent expansions.
Foreign Investment
Approval would be given for direct foreign investment up to 51 per cent equity in high
priority industries.
To provide access to international markets, majority foreign equity holding up to 51 per
cent equity would be allowed for trading companies primarily engaged in export activities.
A special empowered board would be constituted to negotiate with a large number of
international firms.
As a consequence, a list of high priority industries (totaling 34) was prepared wherein automatic
approval would be available for direct foreign investment up to 51 per cent foreign equity. In
1999, the Government decided to place all items under the automatic route for Foreign Direct
Investment/NRI/OCB investment except for a small negative list. During the years
2000–03, 100 per cent FDI was allowed in Drugs and pharmaceuticals, hotels and tourism,
courier services, oil refining, mass rapid transport system, airports, business to business
E-commerce, special economic zones industries and certain telecom industries. Similarly, 100
per cent FDI was also allowed in internet services providers, net providing gateways (both for
satellite and submarine cables) infrastructure providing dark fiber (IP category I), electronic
mail and voice mail, advertising film sector, tea (subject to certain conditions) and for
development of township (however with prior approval). 49% FDI was allowed in banking.
Apart from this, 26% FDI has been allowed in defence production insurance, and print media.
(This is of course, subject to certain conditions).

During 2004-05, foreign investment in the banking sector was further liberalised by raising
FDI limit in private sector bank to 74 per cent under the automatic route. Similarly, there was
increase in the FDI limits in ‘Air Transport Services’ up to 49 per cent through automatic route.
Also, FDI ceiling in telecom sector in certain services was increased from 49 per cent to 74 per
cent in 2005. Besides the above, guidelines on equity cap on FDI have been revised and FDI up
to 100 percent is now permitted in many products such as distillation and brewing up of potable
alcohol, manufacture of industrial explosives, manufacture of hazardous chemicals, laying of natural
gas lines / LNG lines, etc.
FDI is prohibited in certain sectors as retail trading (except single brand product retailing),
atomic energy, lottery business, gambling and betting, business of chit fund, Nidhi companies,
trading in transferable development rights and activities/sectors not opened to private sector
investment. Except these sectors, FDI is allowed in all the sectors of the economy at varying
specified degrees either through government approval route or the automatic route of the RBI.
MRTP Act
In the pre-reform period, companies with more than defined investment in assets were required
to take prior approval of central government for establishment of new undertakings, expansion
of existing undertakings, merger, amalgamation and take over and appointment of directors
(under certain circumstances). Under the new Industrial Policy of 1991, this requirement was
abolished. Thus, with this action, the constraints imposed on growth and restructuring of
large business houses were removed.
1.2 FINANCIAL SECTOR

Financial sector reforms mainly relate to three categories as (a) banking sector reforms (b) capital
reforms (c) Insurance sector reforms. Here, we will discuss banking sector reforms only.
Banking Sector Reforms
In the pre-reform period the banking system functioned in a highly regulated environment
characterised by:
Administered interest rate structure.
Quantitative restrictions on credit flows.
High reserves requirements under Cash Reserve Ratio (CRR). [Meaning of CRR is explained
in chapter 8]
Keeping significant proportion of lendable resources for the priority sectors under Statutory
Liquidity Ratio (SLR). [Meaning of SLR is explained in chapter 8]
These restrictions resulted in inefficiency of the banks which in turn led to low or negative
profits. As a result, measures were taken to reform banks. The important ones are:
CRR was gradually lowered from its peak at 15 per cent during pre-reforms year to 4.5
per cent in June 2003 but raised to 5 per cent in 2004 further to 7.5 per cent (in stages) in
2007. In January 2009, CRR was again reduced to 5 per cent.
SLR was reduced from its peak of 38.5% during 1990-1992 to 24 per cent in November
2008.
Prime lending rates of banks for commercial credit are now entirely within the purview of
the banks and not set by the RBI. The rate of saving accounts and rates of interest on
export credit are still subject to regulations. With effect from April 2001, PLR has been
converted into a benchmark rate for banks rather than treating it as the minimum rate.
Bank Rate has been reduced from 8 per cent to 6 per cent effective from April, 2003.
Rate of interest on saving deposits of commercial banks was reduced from 4.5% in 1980’s
to 3.5% in recent years.
In 1993, RBI issued guidelines for licensing of new banks in the private sector.
Fresh guidelines for licensing new banks were issued in January, 2000. These guidelines
mainly provided for raising initial minimum capital, increasing the contribution of
promoters and keeping the NRI participation in the primary equity of a new bank to the
maximum extent of 40 per cent.
Public sector banks have been encouraged to approach the public to raise resources.
Recovery of debts due to banks and other financial institutions Act, 1993 was passed and
special recovery Tribunals were set up to facilitate quicker recovery of loans arrears.
For achieving the objective of reducing non-performing assets (NPAs) banks have been
advised to tone up their credit risk management system.
The Securitisation and Reconstruction of Financial Assets and Enforcement of Security
Interest Act was passed for assisting banks in the recovery of their loans.
A credit information bureau would be established to identify bad risks.
Derivative products such as forward rate agreement (FRAs) and interest rate swaps have
been introduced.
The RBI has emphasised transparency, diversification of ownership and strong corporate
governance practices to mitigate the fear of systemic risks in the banking sector.
A roadmap for entry of foreign banks consistent with World Trade Organisation (WTO)
has also been released by the RBI.
The Basel II framework, has been operationalised by banks since March, 2008.
The RBI has also issued detailed guidelines for the merger/amalgamation in respect of the
private sector banks in 2005.
Other measures include removing/relaxing credit restrictions for purchase of consumer
durable, enlarging the coverage of priority sector to include software, agro-processing
industries and venture capital.
The financial crisis that surfaced around August 2007 affected economies world wide. India
could not insulate itself from the adverse developments in the international financial markets.
There was extreme volatility in stock markets, exchange rates and inflation levels during a
short duration necessitating reversal of policy to deal with emergent situations. In view of the
apparent link between monetary expansion and inflation in first half of the 2008-09, the policy
stance of the RBI was oriented towards controlling monetary expansion. This was done by

raising cash reserve ratio, repo rate, reverse repo rates. In the second half of 2008-09, the
situation changed. There was liquidity crunch in the economy as there was outflow of foreign
exchange and virtual freezing of international credit. As a result, monetary stance of RBI
underwent abrupt change and it responded to the emergent situation by facilitating monetary
expansion through decreases in the Cash Reserve Ratio, repo and reverse repo rates and
statutory liquidity ratio.
1.3 EXTERNAL SECTOR

The foreign trade policy in India was made very restrictive after initiation of the programme of
industrialisation in the Second Plan. Only import of capital equipment, machinery, components,
spare parts, industrial raw material was allowed. Import of all inessential items was strictly
controlled. Import of food grains was allowed from time to time in order to meet the domestic
demand for them. This continued for the decade of sixties. In seventies few relaxations were
made. In eighties however, special arrangements were made to liberalise imports in a big way.
This was done in order to promote exports and increase competitive skills of the exports. Many
fiscal and monetary concessions were granted to exporters. Many schemes such as duty draw
back scheme, cash compensatory scheme, 100 per cent Export Oriented Units (EOUs) and
Export Processing Zones (EPZs) were started to promote exports. A number of organisations
such as The Export Promotion Council, Commodity Boards, The Federation of Indian Export
Organisations, The Trade Fair Authority, The Indian Institute of Foreign Trade etc. were geared
up to promote exports.
However, India continued to face deteriorating balance of payments situation in late 80’s and
early 90’s. In order to rectify the situation, devaluation was carried out. It was followed by
announcement of new foreign trade policy and foreign trade reforms.
Following are the major measures which have been undertaken to reform the external sector
of the country:
Exchange Rate Stabilisation: The rupee was overvalued for most of the period prior to 1991 thus
adversely affecting exports. The rupee was devalued [Devaluation means lowering the external
value of the country’s currency undertaken by the Government] twice in July, 1991 amounting
to a cumulative devaluation of about 19 per cent.
The RBI used to control the foreign exchange in accordance with the Foreign Exchange
Regulation Act, 1973, as amended periodically. With unification of exchange rates in March
1993, transactions on trade account were freed from foreign exchange controls. It was in 1994
that various types of current account transactions were liberalised from exchange control
regulations with some indicative limits. Certain capital account transactions were also freed
from exchange controls. India is moving towards fuller capital account convertibility in a phased
manner.
Foreign Investment: Foreign investment had played a very limited role in India’s economy prior
to 1991. The restrictions on equity participation in Indian industries, the technology requirements
and the then existing industrial licensing policy tended to discourage foreign direct investment
(FDI) in India. New industrial policy and subsequent policy announcements liberalised the
existing industrial policy. This led to liberalisation of FDI and foreign technology agreements.

Import Licensing: India’s foreign trade policy was quite complex till the beginning of 1990s.
There were various categories of import licenses and ways of importing. The process of
liberalisation was given a push with the announcement of EXIM Policy in 1992. The policy
allowed free trade of all items except a negative list of imports and exports. The EXIM policies
of 1997-2002, 2002-07 and 2004-09 further pruned the list of restricted consumer goods by
removing certain items. The number of import licenses has also been reduced.
Quantitative Restrictions: Quantitative Restrictions (QRs) were removed on 714 items in EXIM
Policy of 2000-01 and on remaining 715 items in EXIM Policy of 2001-02. Thus except defence
goods, environmentally hazardous goods and some other sensitive goods, gates of domestic
markets have been opened to all kinds of imported consumer goods. EXIM Policies of
1997-2002, 2002-07 and 2004-09 further pruned the list and now only very few sensitive items
are subject to QRs.
Tariff: Prior to 1991, Indian import tariff structure was among the highest in the world. India
has lowered its average applied tariff rate from 125% in 1990-91 to 41% in 1995-96 and to 10%
in 2007-08.
Export Subsidies: Direct subsidies are not provided to exporters in India. These are generally
provided indirectly through duty and tax concessions, export finance, export insurance and
guarantee and export promotion marketing assistance. Export subsidies were thought to be
important to boost exports during the period 1980-81 to 1990-91. However, they involved
considerable transaction costs, delays and corruption. Since 1991, the emphasis of the export
incentive system has considerably changed and modified. The Cash Compensatory Scheme
was abolished in July 1991. The EXIM Scrip scheme was abolished with the introduction of the
dual exchange rate scheme. A new class of value-based duty exempt import license was
introduced in which the exporter could import materials of his choice, rather than pre-defined
precise values of certain categories of import, up to the permitted foreign exchange value of
the license. A special scheme known as Export Promotion Capital Goods (EPCG) scheme
originally introduced in 1990 was liberalised in April 1992 to encourage imports of capital
goods. Finally, export income has been exempted from income taxes. EPCG scheme has been
further improved by providing additional benefits to the exporters in the EXIM Policy 2004-09.
Special Economic Zones (SEZs) : Export Processing zone model for promoting exports was not
much a successful instrument for export promotion. Therefore, a new policy called Special
Economic Zones (SEZs) Policy was announced in 2000. SEZ Act, supported by SEZ Rules,
came into effect in 2006. The main objectives of the Act are generation of additional economic
activity, promotion of exports of goods and services, promotion of investment, creation of
employment opportunities and development of infrastructure facilities. Till May 2009, as many
as 568 SEZs have been accorded formal approval and 318 SEZs have been notified. Exports
from SEZs in 2008-09 amounted to nearly Rs 100000 crore and employment generated as on
31st march 2009 was more than 387000 persons.
Foreign Exchange Reserves: The foreign exchange reserves of India consist of foreign currency
assets held by the Reserve Bank of India, gold holdings of the RBI and Special Drawing Rights
(SDRs). Foreign exchange reserves have been steadily built up from the low level of US $1.1
billion in July 1991 to above US $141.5 billion in 2004-05 and further to US $314 billion at end May
2008.

From FERA to FEMA: Due to acute shortage of foreign exchange in the country, the Government
of India had enacted the Foreign Exchange Regulation Act (FERA) in 1973. FERA remained a
nightmare for 27 years for the Indian corporate world. It, instead of facilitating external trade,
discouraged it. As a result, Foreign Exchange Management Act (FEMA) was made. FEMA sets
out its objective as “facilitating external trade and payment” and “promoting the orderly
development and maintenance of foreign exchange market in India.”
Other measures: The Foreign Trade Policy 2004-09 has identified certain thrust areas, like
agriculture, handlooms and handicrafts, gems and jewellery, leather and footwear etc. Special
schemes have been started to promote their growth. For example, ‘Vishesh Krishi Upaj Yojana’
has been started to promote agricultural exports. Similarly, to accelerate growth in exports of
services so as to create a unique ‘Served from India’ brand, the earlier Duty Free Export Credit
(DFEC) scheme has been revamped and recast into the ‘Served from India’ scheme.
In order to mitigate the effects of global recession, certain measures were taken in 2008-09.
These included, elimination/reduction of import duties on certain goods, simplification of
export licensing requirement in certain cases, withdrawing of exemptions from basic custom
duty in certain cases, continuation of duty entitlement passbook scheme till December 31st
2009, allocation of additional funds for export incentive schemes and easing of credit terms
etc.
1.4 FISCAL POLICY

Fiscal Policy means policy relating to public revenue and public expenditure and allied matters
thereof. The unsustainable levels of government expenditures, insufficient revenues combined
with poor returns on government investments led to fiscal excesses in 1980s. Fiscal reforms
were therefore undertaken to deal with the crisis. They aimed at reducing expenditure, increasing
revenues and earning positive economic returns on the investments. Following measures have
been undertaken to bring fiscal discipline in the economy.
Tax Reforms
In August 1991, the Government of India constituted a Tax Reforms Committee (TRC) to
recommend a comprehensive reform of both direct and indirect tax laws.
Income Tax Reforms: Following measures were taken to increase collection of income tax.
Historically, rates of income tax in India have been quite high, almost punitive. For example,
in 1973-94, the maximum marginal rate of individual income tax was as high as 97.7%.
This proved to be counter productive. Consequent upon the recommendations of the TRC,
the income tax slabs were reduced and the rates themselves have been scaled down.
Prior to the assessment year 1993-94, taxation of partnership firm was rather cumbersome.
For example, the method of taxation differed according to whether the firm was registered
or not under the I.T. Act. Following the recommendations of TRC, 1991, the taxation of
partnership firms was drastically modified through the Finance Act, 1992. In the recent
years tax policy relating to partnership firms has been further rationalised.
The tax rate for domestic companies has been reduced from 40 per cent in early 90’s to 30
per cent now. The tax rate on foreign companies has also been reduced from 55% to 50%

(on royality) and to 40% on other incomes. Surcharge is also payable at specified rate over and
above the specified limits.
The basic exemption limits for individuals and Hindu Undivided Families (HUFs) have
been increased.
Requirement of filing of return under the “one by six” scheme has been dispensed with.
Individuals whose incomes fall below basic exemption limit are no longer required to file
returns.
Dematerialisation of TDS certificates would be made effective from 1.4.2008.
Scheme for submission of returns through Tax Return Preparers has been introduced.
Special tax benefits have been allowed to power sector, SEZs and shipping industries.
Apart from the above many procedural simplifications and rationalisations have taken
place to improve tax compliance.
Indirect Tax Reforms: Following are the main measures with regard to indirect taxes:
Reducing the peak rate of customs duties.
Rectifying anomalies like inverted duty structure.
Rationalising excise duties with a movement towards a median CENVAT (Central Value
Added Tax).
Introduction of state-level VAT (Value-Added Tax) for achieving a non-cascading, self-
enforcing and harmonised commodity taxation regime.
Increasing productivity of expenditure by laying down monitorable performance indicators.
Introducing innovative financing mechanism like creation of a special purpose vehicle for
infrastructure projects.
The Fiscal Responsibility and Budget Management Act (FRBMA), 2003 is in place and
emphasises on revenue-led fiscal consolidation, better expenditure outcomes and
rationalisation of tax regime to remove distortions and improve competitiveness of domestic
goods and services in a globalised economic environment.
Recently further measures have been taken with respect to indirect taxes:
Replacement of the single point state sales taxes by the VAT in all the states and union
territories.
Introduction of service tax by the Centre, and a substantial expansion of its base over the
years.
Rationalisation of the CENVAT rates by reducing their multiplicity and replacing many
of the specific rates by ad valorem rates based on the maximum retail price of the products.
Plan to introduce Goods and Service Tax (GST) in the coming years. The introduction of
GST would entail a restructuring of state VAT and central excise tax. This reform measure
would facilitate greater vertical equity in fiscal federalism and reduce cascading nature of
commodity tax.

1.5 IMPACT OF ECONOMIC REFORMS ON THE INDIAN ECONOMY
The economic reform process has completed more than one and a half decades and available
evidence indicates that the Indian industry has coped extremely well with the new competitive
environment after having been sheltered in a protected economy for more than 40 years. From
an average industrial growth rate of 8 per cent in the 1980s despite the slow down in some few
years we can see the beginning of the possibility of new sustained growth of over 10 per cent.
All the areas that were subjected to the fresh winds of the competition have indeed fared well.
A great deal of re-engineering has taken place. New technologies have been imported at a
rapid pace; quality is being upgraded all around. The removal of licensing has sped up firms’
reactions, increased competition and has made growth the only protection against competition.
The removal of import licensing and lowering of the tariffs have helped exporters compete
internationally and facilitated value-added exports. There has been a considerable increase in
the investment levels, foreign investment, and reduction in the formalities to be fulfilled after
the onset of economic reforms in India.
(i) Companies, no longer, feel shy of restructuring, merging and acquisitions.
(ii) Many industries are now directing their efforts towards the world market.
(iii) An improvement in work culture has been noticed. The workers have become more
quality and cost conscious.
(iv) Many entities have graduated from being labour intensive to capital intensive.
(v) Trade unions and workers have not responded in a much hostile manner to the economic
reforms.
(vi) There has been much awareness and stress on quality and R&D.
(vii) There has been much awareness and acceptance of the role of scale economies, rapid
technological growth and increased productivity.
(viii) Corporates are going in for aggressive brand building in an increasingly competitive
market place.
These positive developments have encouraged the country to think in terms of strengthening
these reforms further and move to second generation reforms. But there are certain hurdles
which are to be cleared first. These are:
1. Failure to achieve fiscal discipline to the targetted level: Fiscal deficits are still very high
and we need to reduce them. This requires
(i) Improving tax administration to raise larger revenues.
(ii) Reducing subsides.
(iii) Downsizing of government.
(iv) Bolder privatisation.
(v) Re-prioritise plan schemes.

2. Failure to implement fully industrial deregulation: Dismantling of industrial licensing

and opening of industry to foreign investment was an important part of first generation
reforms. We have progressed a lot in this direction. But investors still face many problems
in implementing projects. Moreover, there are some areas of industrial deregulation where
further action is needed. It has been noticed that sectors which are reserved for SSI have
grown more slowly than the unreserved SSI sectors. There is a strong need for immediately
de-reserving these areas especially the ones which have a strong export potential.
3. Not fully opening the economy to trade: We should clearly identify the major tariff
anomalies and lay down a phased programme for their elimination. Besides, our anti-
dumping mechanism and procedures should also be strengthened to ensure that Indian
industry is not subjected to unfair competition.
4. Ad hoc and unplanned disinvestment: The programme of privatisation and disinvestment
has been carried out in an unplanned manner. Lack of transparency w.r.t. these
programmes has led to suspicion in the minds of public. They have begun to question the
need of economic reforms and privatisation. Therefore, it is necessary that the manner of
the disinvestment and the rationale of the specific choice should be made transparent.
5. Slow financial sector reforms : The financial sector and banking reforms need to be pushed
further.
6. Financing of infrastructure: Achieving rapid growth of the economy requires a very high
quality of infrastructure. Unfortunately, our infrastructure consisting of roads, power,
ports, telecommunications, etc. is inadequate. There are severe shortages in quantity and
equally serious deficiencies in quality. Public investment will continue to have an important
role in all these areas, but the scale of the need is such that it must be supplemented by
private investment. But they need to be given sufficient incentives for this.
In addition to the above we need to
Extend reforms to the States
Amend labour laws to bring them in line with other countries
Strengthen the legal system by scrapping outdated laws, shortening legal procedures so
that justice is done in time, bringing clarity in language of cases/rules so that they are not
subject to misinterpretation.
SUMMARY
Till mid eighties, the Indian economy was a controlled one in the sense the public sector was
given a dominant role and the private sector was regulated with the help of a number of Acts
like Industrial Development Regulation Act, Foreign Exchange Regulation Act, Monopolistic
and Restrictive Trade Practices Act and many more. These Acts and regulations strangulated
the initiative of the private sector to grow and resulted in inefficiencies, corruptions, and
mismanagement. To meet the challenge economic reforms were introduced in industrial,
financial, external and fiscal areas. As a result of these reforms, many positive changes have
taken place in India such as improved rate of growth, lesser prices, more efficiency and
competition. But failure to have fiscal discipline, ad-hocism, slow financial reforms and not
fully opening the economy still mar the progress of economic reforms.

CHAPTER – 7
ECONOMIC
REFORMS
IN INDIA
Unit 2
Liberalisation,
Privatisation
and
Disinvestment
Learning Objectives
understand the meaning of liberalisation, privatisation and disinvestment.

trace the progress of privatisation and disinvestment in India.
know about the methods of disinvestment followed in India.
2.0 MEANING OF LIBERALISATION, PRIVATISATION AND

DISINVESTMENT
Due to the inability of the Indian public sector enterprises in generating adequate resources for
sustaining the growth process and due to other weaknesses, there had been an increasing
demand for their liberalisation, privatisation and disinvestment. We shall explain the meaning
of these terms in the following paragraphs:
Liberalisation: In general, liberalisation refers to relaxation of previous government restrictions
usually in areas of social and economic policies. Thus, when government liberalises trade it
means it has removed the tariff, subsidies and other restrictions on the flow of goods and
services between countries. (Economic reforms discussed in the previous unit pertain to
liberalisation measures in India).
Privatisation: Privatisation, in general, refers to the transfer of assets or service functions from
public to private ownership or control and the opening of hitherto closed areas to private
sector entry. Privatisation can be achieved in many ways-franchising, leasing, contracting and
divesture. Of the many forms privatisation could take, divesture through equity sale is the
most significant, since ownership is transferred to public/corporate entities. Certain
preconditions should exist for privatisation to prove successful.
– Liberalisation and de-regulation of the economy is an essential pre-requisite if privatisation
is to take off and help realise higher productivity and profits.
– Capital markets should be sufficiently developed to be able to absorb the disinvested public
sector shares.
Arguments in favour of privatisation: Privatisation is favoured on the following grounds:
(i) Privatisation will help reducing the burden on exchequer which results from the public
subsidising of chronically loss making public sector units.
(ii) It will help the profit making public sector units to modernise and diversify their business.
(iii) It will help in making public sector units more competitive.
(iv) It will help in improving the quality of decision-making of managers because their decisions
will be made without any political interference.

(v) Privatisation may help in reviving sick units which have become a liability on the public
sector.
(vi) Without government financial backing, capital market and international market will force
public sector to be efficient.
Arguments against Privatisation: Privatisation is opposed on the following grounds:
(i) Privatisation will encourage growth of monopoly power in the hands of big business houses.
It will result in greater disparities in income and wealth.
(ii) Private enterprises may not show any interest in buying shares of loss-making and sick
enterprises.
(iii) Privatisation may result in lop-sided development of industries in the country. Private
entrepreneurs will not be interested in long-gestation projects, infrastructure investments
and risky projects. It may retard growth of capital good industries and other industries
where the profit margin is less.
(iv) The limited resources of the private individuals cannot meet some of the vital tasks which
alter the very character of the economy. Private individuals prefer to invest money in
trade, real estate and other services areas which allow small investments and where capital
obtains quick returns. But for changing the very structure of the economy, the investment
should go to strategic sectors of economy.
(v) The private sector may not uphold the principles of social justice and public welfare. They
may look for maximising their short run profits ignoring the needs of the economy.
(vi) Given its commitments to W.T.O., the government of India cannot avoid foreign
competition nor can it favour particular firms in the private sector. Under such
circumstances, some of our public sector giants are best bets for becoming globally
competitive firms.
(vii) It is contended that liberalisation and deregulation are very important if any firm is to
deliver higher profits. Since public sector enterprises exist in a regulatory framework, they
are not able to deliver higher productivity and profits. Had they been given unbridled
freedom to decide prices, product-mix etc. they would have behaved like private sector
and showed higher efficiency and higher returns. It is not the ownership which is important
but the competitive environment. Thus, the belief that privatisation per se leads to better
results itself is questionable.
Privatisation offers both opportunities and threats to the economy. We have to privatise in
such a manner that we make the maximum of opportunities while at the same time minimising
the threats to the economy.
Disinvestment: Disinvestment means disposal of public sector’s unit’s equity in the market or
in other words selling of a public investment to a private entrepreneur.

2.1 PRIVATISATION AND DISINVESTMENT IN INDIA

Privatisation in India generally is in the form of disinvestment of equity. In general, here
privatisation has not led to 100 per cent transfer of control from public sector to private sector
unit. Only in exceptional cases, 100 per cent privatisation has taken place (e.g. Centaur Hotel).
Following are some of the cases of privatisation in India.:
1. Lagan Jute Machinery Company Limited (LJMC).
2. Modern Food Industries Limited (MFIL).
3. Bharat Aluminicum Company Limited (BALCO).
4. CMC Limited (CMC).
5. HTL Ltd. (HTL).
6. IBP Company (IBP).
7. Videsh Sanchar Nigam Limited (VSNL).
8. India Tourism Development Corporation (ITDC).
9. Hotel Corporation of India Limited. (HCI).
10. Paradeep Phosphates Limited (PPL).
11. Jessop and Company Limited (JCL).
12. Hindustan Zinc Limited (HZL).
13. Maruti Udyog Limited (MUL).
14. Indian Petrochemical Corporation (IPCC).
15. National Thermal Power Corporation (NTPC)
2.2 METHODS OF DISINVESTMENT

In order to achieve the various objectives of disinvestment many methods of disinvestment
have been formulated and implemented. Initially, equity was offered to retail investors through
domestic public issues. This was followed by issuance of the Global Depository Receipts (GDRs)
to tap the overseas markets. Other methods included cross-holding (the government simply
selling part of its shares in one PSU to other PSUs), warehousing (government’s own financial
institutions buying government’s stake in select PSUs and holding them until any third buyer
emerged) and retaining golden share (retaining government’s stake up to 26 per cent in the
PSU to protect its interest). Of late, the government was pursuing the Strategic Sale method.
Under this method, the government sells a major portion of its stake to a strategic buyer and
also gives over the management control. Under the strategic sales method, disinvestment price
would be market based and not prefixed, PSUs shares’ sale would be under the Department of
Disinvestment and disinvestments would be delinked from the Union Budget exercise.
Later the government decided to call off the divestment of stake through strategic sale in 13
profit-making central public sector enterprises. It is considering the public offer route to sell
minority stakes in these enterprises. Disinvestment was put on hold for some times for some

political reasons. The last public sector undertaking to tap the stock market was Rural
Electrification Corporation in February 2008.
The government’s divestment programme is all set to take off again. To begin with, National
Hydroelectric Power Corporation (NHPC) would tap the capital market with their initial public
offering (IPOs) [sale of 5 per cent government equity along with issuance of fresh shares totalling
10 per cent]. State-owned Oil India Ltd, Coal India and Bharat Heavy Electricals Ltd, Rail
India Technical and Economic Services, Cochin Shipyard Limited, Telecommunications
Consultants India Limited, Manganese Core India Limited, Rashtriya Ispat Nigam and Satluj
Jal Vidyut Nigam are also in the disinvestment queue.
It is to be noted that the government, while supporting disinvestment in loss-making PSUs,
plans to retain the existing navratna companies in the public sector.
2.3 PROGRESS OF DISINVESTMENT

The disinvestment programme was started in 1991-92 but the disinvestment carried out so far
has been half-hearted. By the year end 2007-08, the Government could auction off very small
portion of its investment in the public sector, raising Rs. 51,608 crore in the process. It has been
too insignificant to affect either the structure of management or the working environment of
the PSUs. In fact, it has been pointed out that the government carried out the whole exercise of
disinvestment in a hasty, unplanned and hesitant way. It launched the programmes without
creating the conditions for its take off. It did not get public enterprises listed on the stock
exchange. Adequate efforts were not made to build up the much needed linkage between the
public enterprises and the capital market.
The procedures adopted for disinvestment have suffered from ad hocism in the absence of a
long-term policy of disinvestment. It narrowly focused only on disinvestment of shareholdings
without taking into consideration other important issues such as the initial price offers,
involvement of strategic partners, setting up of a trust, employees stock ownership and
participation, handing over the enterprises to workers’ unions/cooperatives and management
buy-outs etc.
It has been pointed out by many economists that the government has been undertaking
disinvestment of enterprises which have been earning profits – mostly they are those which
belong to the category of Navratnas or Mini-ratnas. A close perusal of the 39 PSUs which had
been chosen for disinvestment/privatisation during 1991-98 revealed that out of them only 3
PSUs viz. Hindustan Cables Ltd., Hindustan Copper Ltd. and Hindustan Photo Films
Manufacturing Co. Ltd. posted losses in 1997-98 but in all other 36 cases (e.g. BPCL, EIL,
GAIL, HMT, BEL, etc.) the divested PSUs had been earning profits. The process of disinvestment
has been referred privatisation of the profits of the profit-making enterprises and the
nationalisation of losses of the loss-making enterprises.
In most of the years, the government has failed to raise the budgeted disinvestment in the
capital market. Many reasons may be ascribed for this failure, but the most important is the
non-acceptability of the shares of PSUs in the capital market. The token privatisation to the
extent of 8-10 per cent of the share of PSUs did not enthuse the investors to buy these shares
because they could hardly exercise any control on PSUs.

Thus, during the entire disinvestment programme, the public equity has been under-priced
and thus has been sold for a fraction of what it could actually fetch. This is true for not only
enterprises which were loss-making but also the high profile companies such as Oil and Natural
Gas Corporation, Steel Authority of India, Indian Maruti Udyog Limited, VSNL and IPCL and
Oil Corporation and Shipping Corporation of India etc.
As a result, the total realisation of the government from various rounds of disinvestment has
been much below the target most of the times. This would be clear from the table given below:
Table : Disinvestment of Equity in Public Sector Enterprises (Rs. crores)
Year Target Realisation

1991-92 2,500 3,038
1992-93 2,500 1,913
1993-94 3,500 0
1994-95 4,000 4,843
1995-96 7,000 362
1996-97 5,000 380
1997-98 4,800 902
1998-99 5,000 5,371
1999-00 10,000 1,892
2000-01 10,000 1,869
2001-02 12,000 5,632
2002-03 12,000 3,342
2003-04 14,500 15,547
2004-05 4,000 2,765
2005-06 Not Fixed 1,567
2006-07 Not Fixed -
2007-08 Not Fixed 2,367
SUMMARY
Liberalisation, privatisation and disinvestment are the outcomes of the modern economic world.
Liberalisation refers to relaxation of government’s restrictions in the arena of economic and
social policies. Privatisation refers to partial or full transfer of ownership and control of PSUs
to the private sector. Disinvestment is one of the methods of privatisation. It means selling of
government share in one PSU to other PSUs or private sector or banks.In India, disinvestment
has progressed slowly. It has been carried out in a hasty, unplanned and hesitant manner. As
a result, the progress has been quite poor.

CHAPTER – 7
ECONOMIC
REFORMS
IN INDIA
Unit 3
Globalisation
Learning Objectives
understand the meaning of globalisation.

know the pros and cons of globalisation.
know the measures taken by Indian government towards globalisation.
understand how globalisation has affected the Indian economy.
3.0 MEANING OF GLOBALISATION

Globalisation means integrating the domestic economy with the world economy. It is a process
which draws countries out of their insulation and makes them join rest of the world in its
march towards a new world economic order. It involves increasing interaction among national
economic systems, more integrated financial markets, economies of trade, higher factor mobility,
free flow of technology and spread of knowledge throughout the world.
In the Indian context, it implies opening up of the economy to foreign direct investment by
providing requisites facilities, removing administrative and other constraints, allowing Indian
companies to enter into joint ventures and foreign collaborations, bringing down quantitative
and non-quantitative restrictions to trade, diluting the role of public sector and encouraging
privatisation and so on. Beginning haltingly in 1980s, globalisation got the real thrust from the
new economic policy of 1991 and it was further pushed forward by the coming up of the
World Trade Organisation (WTO). Globalisation would eventually mean being able to
manufacture in the most cost effective way anywhere in the world. It aims at integrating the
world into one global village. As a result of globalisation efforts taken by India we find all types
of goods available here. For example, Lee Cooper Shoes, Reebok-T shirts, Rayban sunglasses,
Coca-Cola and Pepsi, Armani’s shirt, INTEL’s Pentium etc. have flooded the Indian market.
3.1 CASES FOR GLOBALISATION

(1) It is argued that globalisation of under developed countries will improve the allocative
efficiency of resources, reduce the capital output ratio and increase labour productivity,
help to develop the export spheres and export culture, increase the inflow of capital and
updated technology into the country, increase the degree of competition, and give a boost
to the average growth rate of the economy.
(2) It will help to restructure the production and trade pattern in a capital-scarce, labour-
abundant economy in favour of labour-intensive goods and techniques.
(3) Foreign capital will be attracted and with its entry, updated technology will also enter the
country.
(4) With the entry of foreign competition and the removal of import tariff barriers, domestic
industry will be subject to price reducing and quality improving effects in the domestic
economy.

(5) It is believed that the main effect of integration will be felt in the industrial and related
sectors. At result cheaper and high quality consumer goods will be manufactured at home.
Besides, employment opportunities would also go up.
(6) It is also believed that the efficiency of banking and financial sectors will improve, as there
will be competition from foreign capital and foreign banks.
3.2 CASES AGAINST GLOBALISATION

(1) The globalisation process is in essence a tremendous redistribution of economic power at
the world level which will increasingly translate into a redistribution of political power.
(2) One study reveals that in the globalising world the economies of the world are ironically
moving away from one another more than coming together.
(3) With the lightening speed at which globalisation is taking place, it is increasing the pressure
on economies for structural and conceptual readjustments to a breaking point.
(4) It is becoming hard for the countries to ask their public to go through the pains and
uncertainties of structural adjustment for the sake of benefits yet to come.
(5) Globalisation is helping more the developed economies than the developing economies.
Like in India, it is argued that it is true that letting in Cokes and Pepsis have led to opening
doors for INTEL, AMD and CISCO, but the sum total of their investment has been very
less in relation to their investment abroad. None of the multinationals has set up
manufacturing plants in India or signed any technology transfer agreement with any
Indian company.
3.3 MEASURES TOWARDS GLOBALISATION

To pursue the objective of globalisation, the following measures have been taken:
(i) Convertibility of Rupee: The most important measure for integrating the economy of any
country is to make its currency fully convertible i.e., allow it to determine its own exchange
rate in the international market without any official intervention. As a first step towards
full convertibility of rupee, rupee was devalued against major currencies in 1991. This
was followed by introduction of dual exchange rate system in 1992-93 and full convertibility
of the rupee on trade account in 1993-94. India achieved full convertibility on current
account in August, 1994. Current account convertibility means freedom to buy or sell
foreign exchange for the following transactions (i) all payments due in connection with
foreign trade, other current account business, including services and normal short term
banking and credit facilities, (ii) payment due as interest on loans and as net income from
other investments (iii) payments of moderate amount of amortisation of loans or for
depreciation of direct investment and (iv) moderate remittances for family living expenses.
Certain steps towards full convertibility on capital account have also been taken like
authorised dealers have been allowed to invest abroad their unimpaired Tier1 capital,
they have been delegated powers to release exchange for opening of offices abroad, banks
fulfilling certain criteria have been permitted to import gold for resale in India. Resident

individuals and listed companies have been permitted to invest in overseas companies
listed on a recognised stock exchange (subject to certain conditions), limit on bank’s
investment from/in overseas markets has been raised, Indian companies are allowed to
access ADR/GDR markets through an automatic route, Indian companies with a proven
track record are allowed to invest up to 100% of their net worth in a foreign entity, ADs
(Authorised Dealers) are allowed to issue international credit cards, NRIs are allowed to
remit up to U.S. $1 million per calendar year out of their Non-resident ordinary accounts/
sale proceeds of assets and so on. Committee on fuller capital Account convertibility (Tarapore
Committee II) has chalked out a road map for capital account convertibility. Strong macro economic
framework, strong financial systems and prudent regulatory framework are the preconditions for
capital convertibility. A Five year time framework (2007-2011) has been given for full convertibility
on capital account.
(ii) Import liberalisation: As per the recommendation of the World Bank, free trade of all
items except negative list of imports and exports has been allowed. In addition, import
duties on a wide range of capital commodities have been drastically cut down. The peak
rate of custom duty (on non-agricultural goods) has been brought down from 150 per
cent in early 90’s to just 10 per cent in 2007-08 budget. Tariffs on imports of raw materials
and manufactured intermediates have also been reduced. In addition to the phased
reduction of import duties, India, being member of World Trade Organisation (WTO) has
since April 2001, totally removed the quantitative restrictions on foreign trade. Moreover,
as a part of the Agreement on Trade Related Intellectual Property Rights (TRIPs), the
Patents (Amendments) Act, 1999, was passed in 1999 to provide for Exclusive Marketing
Rights (EMRs).
(iii) Opening the economy to foreign capital: The government has taken a number of measures
to encourage foreign capital in India. Many facilities and incentives have been offered to
the foreign investors and Non-Resident Indians in the new economic policy. The Foreign
Direct Investment floodgates have been opened. Foreign Direct Investment up to 26%,
49%, 51%, 74% and even up to 100% has been allowed in different industries. These
include drugs and pharmaceuticals, hotels and tourism, airport, electricity generation, oil
refineries, construction and maintenance of roads, rope-ways, ports, hydro-equipment
and many more. Even defence and insurance sectors have been partially opened.
Many other measures have also been announced from time to time. For instance, foreign
companies have been allowed to use their trademarks in India and carry on any activity of a
trading, commercial or industrial nature; repatriation of profits by foreign companies has been
allowed, foreign companies (other than banking companies) wanting to borrow money or
accept deposits are now allowed to do so without taking the permission of the RBI, foreign
companies can deal in immovable property in India, restrictions on transfer of shares from one
non-resident to another non-resident have been removed, reputed Foreign Institutional Investors
(FIIs) have been allowed to invest in Indian capital market subject to certain conditions, etc.
All these initiatives are supposed to integrate the Indian economy with the world economy.

3.4 EFFECT OF GLOBALISATION ON INDIAN ECONOMY
The process of globalisation initiated in 1991 and far reaching changes in industrial and other
policies have led to considerable changes. The following achievements have been claimed
especially on the external front:
(i) India’s share in the world exports which had fallen 0.53 per cent in 1991 from 1.78 per
cent in 1950, has shown reversed trends and has improved to 1 per cent in 2005 and
further to 1.1 per cent in 2007 and 2008.
(ii) Our foreign currency reserves which had fallen to barely one billion U.S. dollars in June,
1991 rose substantially to about 310 billion U.S. dollars at March, 2008 and but declined
to U.S. $ 252 billion at end March 2009.
(iii) Exporters are responding well to sweeping reforms in exchange rate and trade policies.
This would be clear from the fact that as against a fall in the dollar value of exports by 1.5
per cent in 1991-92, export grew in the range of 18-21 per cent per annum during
1993-96. However, export growth slowed down during 1996-2002. The annual average
growth rate during this period was around 8 per cent. Since 2002-03, however, exports
have picked up once again. The average growth of export has been more than 20 per cent
per annum since 2002-03.
(iv) Exports now finance nearly 65 per cent of imports, compared to only 60 per cent in the
latter half of the eighties.
(v) The current account deficit was over 3 per cent of GDP in 1990-91. It had fallen to less
than 1 per cent in 2000-01. During 2001-04 we even had surplus in current account
ranging between 0.7-2.3 per cent of GDP. In 2004-05, 2005-06, 2006-07, 2007-08 we again
had current account deficit of (-) 0.4, (-) 1.1 per cent, (-) 1 per cent and (-) 1.5 per cent respectively.
(vi) At the time of crisis, our external debt was rising at the rate of $8 billion a year. After that
its growth has been arrested. From 1996-2006, it grew only by about $3 billion per year.
Since 2006, however its growth has picked up again.
(vii) Contrary to what many feared, the exchange rate for the rupee has remained almost
steady despite the introduction of full convertibility of rupee.
(viii) International confidence in India has been restored. This is indicated by swelling foreign
direct and portfolio investment. FDIs were just 155 million dollars in 1991. They increased
to around U.S. $ 8.9 billion dollars in 2005-06 and further to U.S. $ 23 dollars in 2006-07
and further to U.S. $ 34.4 billion in 2007-08.
(ix) Certain benefits of globalisation have accrued to the Indian consumer in the form of
larger variety of consumer goods, improved quality of goods and in some cases and
reduced prices of consumer durable.
(x) Markets have started responding to the movements abroad. A fluctuation in U.S. market
or U.K. market has started affecting Indian market. Unlike before, the SENSEX and other
stock market indices now move in line with fluctuations in similar indices in other parts
of the globe.

(xi) The rating agencies, which rate investment risks in countries for global investors, have
upgraded India’s rating.
(xii) Programmes of quality management and research and development are systematically
conducted by corporate sector.
(xiii) More and more companies are opening branch offices/subsidiaries in other countries
and making their presence felt. Asian Paints, Tatas, Sundaram Fasteners, Ranbaxy, Dr.
Reddy’s Laboratories, Infosys etc. are examples of Indian companies operating abroad.
The critics, however, point out the country’s business houses were no doubt offered
opportunities to enter foreign markets. But the superior economic and financial clout of
the multinational corporations was so great, that these opportunities could hardly be
availed of in the face of their competition. The competition was not among equal but
between the financially strong corporations and the economically weak Indian corporates.
Thus, while the multi-national corporations of Europe and the U.S. entered India in a big
way with foreign exchange resources used for investments in financial markets, a few
large Indian corporates could enter a few foreign countries and raise capital abroad at
relatively low cost.
It is also pointed out that globalisation policy is not a free lunch. Globalised economies or
outwardly oriented economies tend to perform well during a period of dynamism and high
growth in the world economy whereas they are prone to severe dislocation and collapse during
a downturn in international economic activity. On the contrary, internal oriented economies
are likely to be less damaged by the slow down in world trade.
3.5 MAIN ORGANISATIONS FOR FACILITATING GLOBALISATION

There are many international organisations which have facilitated the process of Globalisation.
We shall study three main organisations here. These are International Monetary Fund (IMF),
the World Bank and the World Trade Organisation (WTO).
3.5.0 The International Monetary Fund
The International Monetary Fund (IMF) was organised in 1946 and commenced its operation
in March, 1947. It was set up with the following main objectives:
(i) the elimination or reduction of existing exchange controls;
(ii) the establishment and maintenance of currency convertibility with stable exchange rate;
(iii) the widest extension of multilateral trade and payments.
(iv) the solving of short-term balance of payments problems faced by its member nations.
The Fund is an autonomous organisation affiliated to the UNO. Starting from the initial
membership of 31 countries at the time of inception, the Fund now has a membership of 186
countries. It is financed by the participating countries, with each country’s contribution fixed
in terms of quotas according to the relative importance of its prevailing national income and
international trade. The quotas of all the countries taken together constitute the total financial
resources of the Fund. Moreover, the contributed quota of a country determines its borrowing
rights and voting strength.

Functions of the IMF: The following are major functions of the IMF:
(i) It functions as a short-term credit institution.
(ii) It provides machinery for the orderly adjustment of exchange rates.
(iii) It is a reservoir of the currencies of all the member nations who can borrow the currency
of other nations.
(iv) It is a sort of lending institution in foreign exchange. However, it grants loans for financing
current transactions only and not capital transactions.
(v) It also provides machinery for altering sometimes the par value of currency of a member
country.
(vi) It also provides machinery for international consultations.
(vii) It monitors economic and financial developments of its members and provides policy advice aimed
at crisis preventions.
3.5.1 The World Bank
The International Bank for Reconstruction and Development (IBRD) more popularly known
as the World Bank was formed as a part of the deliberations at Bretton Woods in 1945. The
World Bank was floated in order to give loan to members’ countries, initially for the
reconstruction of their (world) war-ravaged economies, and later for the development of the
economies of the poorer member countries. The World Bank provides its member countries
(186 in numbers) long term investment loan on reasonable terms. By far the bulk of the World
Bank loans have been for financing specific projects. In recent years, it has also been engaged
in giving structural adjustment loans to the heavily indebted countries. The World Bank is an
inter-governmental institution, corporate in form, whose capital stock is entirely owned by its
member governments. The World Bank Group consists of, apart from the World Bank itself,
the International Development Association (IDA), the International Finance Corporation (IFC),
and the Multi-lateral Investment Guarantee Agency (MIGA) and the International Centre for
Settlement of Investment Disputes (ICSID).
The International Development Association (IDA) is the part of the World Bank that helps the
world’s poorest countries. Established in 1960, IDA aims to reduce poverty by providing interest-
free credits and grants for programs that boost economic growth, reduce inequalities and
improve people’s living conditions. IDA is also called soft lending arm of the World Bank since
it gives interest free loans to the poor countries.
IDA complements the World Bank’s other lending arm–the International Bank for
Reconstruction and Development (IBRD)–which serves middle-income countries with capital
investment and advisory services.
IFC provides investments and advisory services to build the private sector in developing
countries.
Created in 1988, MIGA helps encourage foreign investment in developing countries by providing
guarantees to foreign investors against loss caused by non commercial risks.
ICSID was founded in 1966. It is an autonomous body which facilitates the settlement of
disputes between foreign investors and their host countries.

Objectives of the World Bank

The World Bank works in 186 countries with the primary focus of helping the poorest people
and the poorest countries. It emphasises the need for -
Investing in the people, particularly through basic health and education.
Focusing on social development.
Protecting the environment.
Supporting and encouraging private business development.
Promoting reforms to create a stable macro-economic environment, conducive to
investment and long-term planning.
Functions of the World Bank: The main functions of the World Bank are:
(i) To help its member countries in the reconstruction and developmental of their territories
by facilitating the investment of capital for productive purposes.
(ii) To encourage private foreign investment and credit by providing guarantee of repayment
of the private investors. If private capital is not forthcoming at reasonable terms, to make
loans for productive purposes out of its own resources or funds borrowed by it.
(iii) To promote the long-term balanced growth of international trade and the maintenance of
equilibrium in balance of payments of its member countries.
3.5.2 The World Trade Organisation
As told before, it was the World Trade Organisation which gave a real push to the process of
globalisation. The World Trade Organisation (WTO) came into existence on 1st January, 1995.
The WTO is a powerful body which broadly aims at making the whole world a big village
where there is free flow of goods and services and where there are no barriers to trade. It is the
only global international organisation which deals with the rules of trade between nations. At
its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading
nations and ratified in their parliaments.
Features of WTO
The WTO is the main organ of implementing the Multilateral Trade Agreements.
The WTO is global in its membership. Its present membership is 153 countries and with
many other considering accession.
It is the forum for negotiations among its member. In this forum, the member-nations
discuss issues related to the Multilateral Trade Agreements (MTAs) and associated legal
instruments. It is also the forum for negotiations on terms of the Plurilateral Trade
Agreements (PTAs). In fact, it is the third economic pillar of world-wide dimensions along
with the IMF and the World Bank.
It has a far wider scope than its predecessor GATT, bringing into the multilateral trade
system, for the first time, trade in service, intellectual property protection and investment.
It is a full-fledged international organisation in its own right.

It administers a unified package of agreements to which all members are committed.
The decision-making under the WTO is carried out by consensus. Where a consensus is
not arrived at the issue shall be decided by voting. Each member has one vote.
The WTO has legal personality. Members shall endow it with such legal capacity, privileges
and immunities as are necessary for the exercise of its functions.
The representatives of the members and all officials of the WTO enjoy International
privileges and immunities.
Functions of WTO: The WTO has the following functions:
1. The WTO facilitates the implementation, administration and operation of world trade
agreements.
2. The WTO provides the forum for trade negotiations among its member countries.
3. The WTO handles trade disputes.
4. The WTO monitors national trade policies.
5. It provides technical assistance and training to developing countries.
6. With a view to achieving greater coherence in global economic policy making, the WTO
co-operates, as appropriate, with the IMF and IBRD and its affiliated agencies.
SUMMARY
A new thrust on international business has emerged recently although business transcending
national boundaries has always been there in the past. Of late, there has been a growing
realisation among countries of the significance of economics of markets and international
competition. India is no exception. It has also embraced globalisation. Globalisation broadly
implies free movement of goods and services and people across the countries. The global
corporations of today conduct their operations world-wide as if the whole world were a single
entity. Globalisation has thrown certain opportunities for India like it can raise capital from
the world market, it can become a premier production centre and it can attract foreign investors
etc. After globalisation, India is beginning to shed its insularity and trying to become a global
giant.
There are many international organisations which have facilitated the process of globalisation.
Chief among them are the IMF, the IBRD and the WTO.

a. The public sector was given a dominant position in the newly Independent India.
b. The foreign trade policy post Independence allowed free trade of all goods and services.
c. Monetary policy post Independence sought to keep the CRR at a very low level.

2. All of the following developments were noticed during 1991 (when economic reforms
were enforced) except one. Identify it.
a. National debt was nearly 60 per cent of the GNP of India.
b. Inflation crossed double digits.
c. Foreign reserves were maintained at a very high level.
3. Which of the following statement is correct about the New Industrial Policy, 1991?
a. It made it compulsory for the industry to obtain license for all projects.
b. It abolished licensing for all projects except 18 industries of strategic and security
importance.
c. It gave dominant position to the public sector.
4. At present only _________________ industries are reserved for the public sector.
a. 5
b. 7
c. 8
d. 3
5. At present there are only _________ industries for which licensing is compulsory.
a. 18
b. 6
c. 10
d. 9
6. At present, 100 per cent FDI is allowed in ______________ .
a. defence.
b. drugs and pharmaceuticals.
c. banks.
d. insurance.
7. In private banking ____________ per cent FDI is allowed now.
a. 100
b. 49
c. 74
d. 26

8. As a result of the New Industrial Policy, 1991:
a. prior approval of central government is required for establishing new undertakings,
and expanding the present undertaking.
b. An industry intending to have more than 100 crore of assets is required to obtain the
permission of the central government.
c. prior approval of central government for establishing new undertakings and
expanding existing undertaking is not required.
d. Two or more companies deciding to amalgamate are required to take the prior approval
of the central government.
9. Under the New Industrial policy, 1991:
a. The mandatory convertibility clause is applicable for all term loans.
b. The mandatory convertibility clause is applicable for term loans of more than 10 years.
c. The mandatory convertibility clause is applicable for term loans of less than 10 years.
d. The mandatory convertibility clause is no longer applicable.
10. As a result of the New Industrial Policy, 1991:
a. The public sector has been stripped off all its power.
b. The public sector has been given the commanding heights of the economy.
c. The public sector’s portfolio will be reviewed with greater realism. The focus will be
on strategic high tech and essential infrastructure industries.
d. The public sector’s management has been passed over to the private sector.
11. In the pre-reform period, the banking sector:
a. Functioned in a highly regulated environment.
b. Functioned in a manner detrimental to the general public.
c. Concentrated on making huge profits.
12. Which of the following is correct in relation to banks in the post-reform period?
a. Bank rate has been increased to 10 per cent.
b. CRR has been increased to 20 per cent.
c. CRR has been reduced in stages.
d. Public sector banks have been asked to raise their funds from their private resources
only.
13. Which of the following statements is correct with regard to external sector in the pre-
reform period?
a. The foreign trade policy was very liberal; it allowed import of all types of goods.

b. Import of foodgrains was strictly prohibited.

c. The balance of payments situation was quite comfortable.
14. Which of the following statements is correct with regard to external sector in the post
reform period?
a. Quantitative restrictions have been imposed on a number of tradable items.
b. Quantitative restrictions have been removed on most of the items except a few goods.
c. The tariff walls have been further raised.
d. Foreign investment is now being discouraged.
15. FERA stands for
a. Foreign Export Revaluation Act.
b. Funds Exchange Resources Act.
c. Finance and Export Regulation Association.
d. Foreign Exchange Regulation Act.
16. FEMA stands for
a. Foreign Exchange Management Act.
b. Funds Exchange Management Act.
c. Finance Enhancement Monetary Act.
d. Future Exchange Management Act.
17. As a result of the foreign trade reforms:
a. The number of import licenses has increased.
b. Only a few types of goods and services can now be exchanged freely.
c. EPCG scheme has been abolished.
d. The average tariff rates have been reduced.
18. All of the following statements except one are correct about the Foreign Trade Policy,
2004-09. Identify the incorrect statement:
a. Certain thrust areas like agriculture, handlooms, handicrafts etc. have been identified.
b. Vishesh Krishiupaj Yojana has been started.
c. ‘Served from India’ scheme has been started.
d. The entry of FDI in India has been restricted.
19. DFEC stands for
a. Direct Foreign Exchange Control.

b. Direct Finance Exchange Control.
c. Duty Free Export Credit.
d. Duty Free Exchange Credit.
20. EPCG stands for
a. Export Promotion Capital Goods.
b. Expert Programme for Credit Generation.
c. Exchange Programme for Consumer Goods.
d. Export Promotion Consumer Goods.
21. FIEO stands for
a. Foreign Import Export Organisation.
b. Federation of Import Export Organisation.
c. Forum of Indian Export Organisations.
d. Federation of Indian Export Organisations.
22. Fiscal policy means
a. Policy relating to money and banking in a country.
b. Policy relating to public revenue and public expenditure.
c. Policy relating to non-banking financial institutions.
23. The unsustainable levels of government deficits in the late 80’s can be attributed to:
a. High levels of government expenditures.
b. Insufficient revenues.
c. Poor returns on government investments.
24. CENVAT stands for
a. Common Entity Value Added Tax.
b. Corporate Entities Value Added Tax.
c. Central Value Added Tax.
25. The FRBMA stands for
a. Foreign Regulation and Budget Management Act.
b. Fiscal Responsibility and Budget Management Act.

c. Finance Regulations and Bonds Management Association.

d. Funds Reallocation and Budget Management Act.
26. The FRBMA, 2003 emphasises on:
a. Revenue-led fiscal consolidation.
b. Better expenditure outcomes.
c. Rationalisation of tax regime.
27. The economic reforms have failed to
a. Keep fiscal deficits to the targeted levels.
b. Fully implement industrial deregulation.
c. Fully open the economy to trade.
28. Under the New Industrial Policy, 1991:
a. The system of phased manufacturing programme approved on case to case basis will
not be applicable to new projects.
b. The system of phased manufacturing programme will be applicable to new projects.
c. The system of phased manufacturing programmes will be applicable to new projects
costing more than 10 crores.
29. Before financials reforms, the banking system was characterised by all of the following
except:
a. Administered interest rates structure.
b. Quantitative restrictions on credit flow.
c. High revenue requirements.
d. Keeping very less lendable resources for the priority sector.
30. WTO stands for
a. World Trade Organisation.
b. World Transport Organisation.
c. World Tariff Organisation.
d. Women Teachers Organisation.
31. _______________________ refers to relaxation of previous government restrictions.
a. Privatisation.
b. Globalisation.

c. Disinvestment.
d. Liberalisation.
32. _____________________ refers to the transfer of assets or services functions from public
to private ownership.
a. Globalisation.
b. Privatisation.
c. Disinvestment.
d. Liberalisation.
33. _______________________ refers to disposal of public sector’s units in equity in the market.
a. Globalisation.
b. Privatisation.
c. Disinvestment.
d. Liberalisation.
34. The pre-condition for privatisation to be successful requires
a. Liberalisation and de-regulation of the economy.
b. Capital markets should be sufficiently developed.
c. None of the above.
d. (a) & (b) both.
35. Which of the following statements regarding privatisation is correct?
a. Privatisation is panacea for all economic problems.
b. Privatisation always leads to attaining social and economic efficiency.
c. Privatisation may result in lopsided development of industries in the country.
36. Privatisation in India has taken place in all of the cases except
a. CMC.
b. BALCO.
c. VSNL.
a. The disinvestment programme has been successfully carried out in India.
b. Privatisation up to 100 percent has been carried out in all the PSUs in India.

c. Under strategic sale method of disinvestment, the government sells a major share to a
strategic buyer.
38. _________________________ means integrating the domestic economy with the world
economy.
a. Globalisation.
b. Privatisation.
c. Liberalisation.
d. Disinvestment.
39. Match the following:
A. WTO I Provides loans to address short-term balance of payments problems

B. RBI II Multilateral trade negotiating body.
C. IMF III Facilitating lending and borrowing for reconstruction and development
D. IBRD IV Central Bank of India
40. Which of the following pairs is not correctly matched?

a. WTO Generally forbids the use of quantitative restrictions on trade.
b. IMF Provides finance to correct disequilibrium in balance of payments.
c. RBI Promotes trade among south Asian countries.
d. IBRD Gives long term loans for development.
41. In 2009, disinvestment programme took off with the IPO of ———————.
a. NTPC
b. NHPC
c. Oil India Limited
d. Rural Electrification Corporation
42. SEZ Act came into effect in ———.
a. 2002
b. 2003
c. 2006
d. 2007

43. FDI is prohibited in all of the following except:
a. atomic energy
b. Lottery business,
c. Gambling and betting
d. Banking operations
44. FDI is allowed in all of the following except:
a. Lottery business
b. Banking operations
c. Insurance
d. Air transport services
45. Which is the soft lending arm of the World Bank?
a. IDA
b. IFC
c. MIGA
d. ICSID
ANSWERS
1. a 2. c 3. b 4. d 5. b 6. b
7. c 8. c 9. d 10. c 11. a 12. c
13. d 14. b 15. d 16. a 17. d 18. d
19. c 20. a 21. d 22. b 23. d 24. c
25. b 26. d 27. d 28. a 29. d 30. a
31. d 32. b 33. c 34. d 35. c 36. d
37. c 38. a
39.A (II)
B (IV)
C (I)
D (III)
40. c 41. b 42. c 43. d 44. a 45. a

CHAPTER – 8
MONEY AND
BANKING
Unit 1
Money
MONEY AND BANKING
Learning Objectives
know the meaning of money.

understand the functions of money.
1.0 MEANING OF MONEY

Money is an important and indispensable element of modern civilization. In ordinary usage,
what we use to pay for things is called money. To a layman, thus, in India, the rupee is the
money, in England the pound is the money while in America the dollar is the money. But to an
economist, these represent merely different units of money. Then how do we define money?
Definition of Money : It is very difficult to define money in exact sense. This is because, there
are various categories of assets which possess the attributes of money. Many things such as
clay, cowry shells, tortoise shells, cattle, slaves, rice, wool, salt, porcelain, stone, gold, iron,
brass, silver, paper and leather etc. have been used as money. Traditionally, money has been
defined on the basis of its general acceptability and its functional aspects. Thus, any thing
which performed the following three functions (i) served as medium of exchange (ii) served as
a common measure of value and (iii) served as a store of values, was termed as money. To
modern economists or empiricists, however, the crucial function of money is that it serves as a
store of value. It thus includes, not only currencies and demand deposits of banks, but also
includes a host of financial assets such as bonds, government securities, time deposits with
banks and equity shares which serve as a store of value. Some economists categorise these
financial assets as near money, distinct from pure money which refers to cash and chequable
deposits with commercial banks. The empiricists argue that whether a financial asset should
be included in money should be decided on the basis of empirical investigation of the financial
asset. To them, money is what money does. While clustering financial assets as money they
have laid down certain criteria : (i) stability of the demand function, (ii) high degree of
substitutability, and (iii) feasibility of measuring statistical variations in real economic factors
influenced by the monetary policy.
1.1 FUNCTIONS OF MONEY

In a static sense, money serves :
(i) As a medium of exchange : The fundamental role of money in an economic system is to
serve as a medium of exchange or as a means of payment.
(ii) As a unit of account : Money is a common measure or common denominator of value. The
value in exchange of all goods and services can be expressed in terms of money. In fact, it
acts as a means of calculating the relative prices of goods and services.
(iii) As standard of deferred payments : Money is a unit in terms of which debts and future
transactions can be settled. Thus loans are made and future contracts are settled in terms
of money.

(iv) As store of value : Money being a permanent abode of purchasing power holds command
over goods and services all the times-present and future. Money is a convenient means of
keeping any income which is surplus to immediate spending needs and it can be exchanged
for the required goods and services at any time. Thus it acts as a store of value.
In dynamic sense, money serves the following functions :
(v) Directs economic trends : Money directs idle resources into productive channels and there
by affects output, employment, consumption and consequently economic welfare of the
community at large.
(vi) As encouragement to division of labour : In a money economy, different people tend to
specialise in the different goods and through the marketing process, these goods are bought
and sold for the satisfaction of multiple wants. In this way, occupational specialisation
and division of labour are encouraged by the use of money.
(vii) Smoothens transformation of savings into investments : In a modern economy, savings
and investments are done by two different sets of people - households and firms. Households
save and firms invest. Households can lend their savings to firms. The mobilisation of
savings can be done through the working of various financial institutions such as banks.
Money so borrowed by the investors when used for buying raw materials, labour, factory
plant etc. becomes investment. Saved money thus can be channelised into any productive
investment.
1.2 MONEY STOCK IN INDIA

In 1979 the RBI classified money stock in India in the following four categories.
M1 = Currency with the public i.e., coins and currency notes + Demand deposits of the
public known as narrow money.
M2 = M1 + Post office saving deposits.
M3 = M1 + Time deposits of the pubic with banks called broad money.
M4 = M3 + Total post office deposits.
The basic distinction between narrow money (M1) and broad money (M3) is in the treatment of
time deposits with banks. Narrow money excludes time deposits of the public with the banking
system while broad money includes it. Not much significance is attached to M2 and M4 by the
RBI. This classification was in vogue till recently. The RBI working group has now redefined its
parameters for measuring money supply.

MONEY AND BANKING
M1 = Currency + Demand deposits + Other deposits with RBI.

M2 = M1 + Time liabilities portion of saving deposits with banks + Certificates of deposits
issued by banks + Term deposits maturing within a year excluding FCNR (B)
Deposits.
M3 = M2 + Term deposits with banks with maturity over one year + Call / term
borrowings of the banking system.
M4 has been excluded from the scheme of monetary aggregates.
SUMMARY
Money is the life line of modern civilisations. Traditionally, money served as, medium of
exchange, unit of account, store value of money and standard of deferred payment. But in the
modern economies, it carries out certain dynamic functions such as catalyst in division of
labour, director of economic trends and motivator in transformation of savings into investments.
Money stock in India is divided into narrow money and broad money. Narrow money excludes
time deposits but broad money includes it.

CHAPTER – 8
MONEY AND
BANKING
Unit 2
Commercial Banks
MONEY AND BANKING
Learning Objectives
understand the meaning of commercial banks and their role in India.

understand the functions carried out by commercial banks.
know about developments in commercial banking in India.
2.0 INTRODUCTION
A modern industrial society cannot be run by self-financing of entrepreneurs. Some institutional
assistance is necessary to mobilise the savings of the community and to make them available to
the entrepreneurs. The people, a large majority of who save in small odd lots, also want an
institution which can ensure safety of their funds together with liquidity. Banks assure this
with a further facility - that the funds can be drawn back in case of need.
From a broader social angle, banks act as a bridge between the users of capital and those who
save but cannot use the funds themselves. The idle resources of the community are thus activated
and brought to productive use.
Besides, the banking system has capacity to add to the total supply of money by means of
credit creation. The bank is a dealer in credit - its own and other people’s. It is because of the
ability to manipulate credit that banks are used extensively as a tool of monetary policy.
2.1 ROLE OF COMMERCIAL BANKS

Banks play a very useful and dynamic role in the economic life of every modern state. Their
economic importance may be viewed in the followed points :
(1) A developing economy needs a high rate of capital formation to accelerate the tempo of
economic development. But the economic development depends upon the rate of savings.
Banks offer facilities for keeping savings and thus encourage the habits of thrift in the
society.
(2) Not only do the banks encourage savings but they also mobilise savings done by several
households and make them available for production and investment to the entrepreneurs
in various sectors of the economy. Without banks these savings would have remained idle
and would not have been utilised for productive and investment purposes.
(3) Allocation of funds or economic surplus among different sectors, users or producers so as
to make maximum social return and thus to ensure optimum utilization of savings is
another important function performed by the banks. However, it may be mentioned, that
commercial banks do not always work and allocate resources in the way that maximises
production or social welfare. For example, before nationalisation in 1969, the commercial
banks in India neglected socially highly desirable sectors such as agriculture, small scale
industries and weaker sections of the society. Therefore, it was thought necessary to
nationalise them so that they should allocate resources in socially desirable directions.

(4) By encouraging savings and mobilising them from public, banks help to increase the
aggregate rate of investment in the economy. Banks not only mobilise saved funds from
the public, but they also themselves create deposits or credit which serve as money. The
new deposits are created by the banks when they lend money to the investors or other
users. These deposits are created by the banks in excess of the cash reserves they obtain
through deposits from the public. These days, the bank deposits, especially demand deposits
are as much good money as the currency issued by the government or the central bank.
This creation of credit, if it is used for productive purposes greatly enlarges production
and investment and thus promotes economic growth.
2.2 FUNCTIONS OF A BANK

The functions of a bank can be summarised as follows :
(a) Receipt of deposits : A bank receives deposits from individuals, firms, and other institutions.
Deposits constitute the main resources of a bank. Such deposits may be of different types.
Deposits which are withdrawable on demand are called demand or current deposits,
others are called time deposits. Savings deposits are those from which withdrawals are
not restricted as regards the amount and the period. Deposits withdrawable after the
expiry of an agreed period are known as fixed deposits. Interest paid by banks is different
for each kind of deposit - highest for fixed deposits and lowest or even nil for current
deposits.
(b) Lending of money : Banks lend money mainly for industrial and commercial purposes.
This lending may take the form of cash credits, overdrafts, loans and advances, or
discounting of bills of exchange. Interest charged by banks on such lending varies according
to the amount and period involved, social priority-nature of security offered, the standing
of the borrower, etc.
(c) Agency services : A bank renders various services to consumers, such as : (i) collection of
bills, promissory notes and cheques; (ii) collection of dividends, interests, premiums, etc.;
(iii) purchase and sale of shares and securities; (iv) acting as trustee or executor when so
nominated; and (v) making regular payments such as insurance premiums.
(d) General services : A modern bank performs many services of general nature to the public,
e.g. (i) issue of letters of credit, travellers cheques, bank drafts, circular notes; etc. (ii) safe
keeping of valuables in safe deposit vaults; (iii) supplying trade information and statistics;
conducting economic surveys; and (iv) preparation of feasibility studies, project reports,
etc. Banks in some foreign countries also underwrite issue of shares and make loans for
long-term purposes.

MONEY AND BANKING
2.3 COMMERCIAL BANKING IN INDIA

At the time of Independence, India had a fairly well-developed banking system with more
than 645 Banks having more than 4800 branch offices. These banks although developed but
they could not conform to social needs of the society. These banks generally catered to the
needs of industries and that too big ones. Other priority sectors like agriculture, small-scale
industries, exports etc., were almost neglected. To overcome these deficiencies, the Government
announced the nationalisation of 14 major commercial banks with effect from July, 1969. The
objectives of nationalisation were to control the heights of the economy and to meet progressively
the needs of development of the economy, in conformity with national policy and objectives.
Six more banks were nationalised in 1980. (Two banks were merged in 1993, so at present
there are 19 nationalised banks).
2.4 NATIONALISATION OF COMMERCIAL BANKS

The following factors were responsible for nationalisation of commercial banks in 1969.
(i) Private ownership of commercial banks and concentration of economic power : Until
nationalisation, all major banks were controlled by one or more business houses. These
business houses used the resources contributed by the mass of the people for their own
personal benefits. They financed those projects which ultimately enhanced their own
financial resources. Thus, private ownership of banks resulted in concentration of income
and wealth in few hands.
(ii) Urban-bias : Prior to nationalisation, commercial banks had shown no interest in
establishing offices in semi-urban and rural areas. More and more branches were opened
in cities resulting in concentration of banking facilities in urban areas. For example, out of
about 5.6 lakh villages in India, only 5000 were being served by commercial banks and
five major cities (Ahmedabad, Bombay, Calcutta, Delhi and Madras) together had one-
seventh share in the number of bank offices and about fifty percent share of bank deposits
and bank credit. This urban biased nature of commercial banks led to slow rate of growth
in the rural areas.
(iii) Neglect of agricultural sector : There was a total neglect of the agricultural sector and its
finance prior to nationalisation of banks. The banks increasingly advanced finances to
commerce and industry with the result their share in the scheduled banks advances
increased from 70 per cent in 1951 to 87 per cent in1968. Agriculture accounted for only
2.2 per cent of the total advances.
(iv) Violation of norms : Commercial banks often violated the norms and priorities laid down
in the plans and granted loans to even those industries which figured no where in the
priority list.
(v) Speculative activities : Private commercial banks earned large profits and indulged in
speculative activities. They even extended advances to hoarders and black marketers against
high rates of interest.

(vi) Neglect of priority sectors : Not only there was a complete neglect of agricultural sector,
other sectors such as export, small-scale industries etc. were also completely neglected.
In order to discipline the commercial banks so that they do not over look the national priorities,
nationalisation of banks was undertaken first in 1969 and then in 1980.
Objectives of nationalisation : Nationalisation was meant for an early realisation of the
objectives of social control which were as follows :
(i) removal of control by a few;
(ii) provision of adequate credit for agriculture and small industry and export;
(iii) giving a professional bent to management;
(iv) encouragement of a new class of entrepreneurs; and
(v) the provision of adequate training as well as terms of services for bank staff.
2.5 PROGRESS OF COMMERCIAL BANKS AFTER NATIONALISATION

After the nationalisation of banks in 1969, commercial banking operations have become an
integral part of India’s economic policy. Following development have taken place since
nationalisation in 1969 :
(i) Expansion of branches : There has been an unprecedented growth in the branch network
since nationalisation. Compared to just 8262 branch offices in 1969, the number of branch
office in 2008 has increased to 76885 indicating a greater access to banking facilities to the
common man. As a result, the population per bank office has reduced from 55,000 in 1969
to around 15,000 in 2008.
(ii) Branch opening in rural and unbanked areas : There has been a qualitative change in
branch expansion programme ever since the nationalisation of banks. Before
nationalisation, there was a clear urban bias in the operations of banks. But after
nationalisation they have started moving towards rural and less developed areas. This
will be clear from the fact that compared to just 22 per cent bank offices in rural areas in
1969, the percentage of rural branches bank improved to about 41 per cent in June, 2008.
This has helped in checking imbalances in disbursement of banking finance in India.
(iii) Deposit mobilisation : There has been a substantial rise in the rate of deposit mobilisation
since nationalisation. The aggregate deposits of commercial banks have increased from
Rs. 4,665 crore in 1969 to around Rs. 31,97,000 crore in December, 2008 forming more
than 80 per cent of the national income. Considering state-wise deposit mobilisation, we
find Maharashtra leads all other states and accounts for around one-fifth of the aggregate
deposits received by the banks. It is followed by Delhi, Uttar Pradesh, West Bengal, Tamil
Nadu, Karnataka and Andhra Pradesh. These all together account for 65 per cent of the
aggregate deposits of the banks.
(iv) Bank lending : There has been a spectacular rise in the bank lending since nationalisation
of banks in 1969. It has gone up from Rs. 3,399 crore in June, 1969 to about 23,62,000
crore in June, 2008.

MONEY AND BANKING
The bank have taken special care of the priority sectors in their lending operations. In
1969, agriculture, small scale industries and small retail trade accounted for about 15 per
cent of the commercial banks credit. This percentage has gone up to about 44 per cent in
March, 2008.
(v) Promotion of new entrepreneurship : Banks, of late, have been financing the schemes which
promote entrepreneurship. For example, they have been activity participating in schemes
such as IRDP, TRYSEM, JRY, NRY etc. Moreover, in their lending operations they now give
high priority to the relevance of the project for the economy as a whole along with genuine
business productive requirements of the borrowers.
2.6 SHORTCOMINGS OF COMMERCIAL BANKING IN INDIA

(i) Although the commercial banks have spread their wings to every corner of the country,
but considering the huge population of India, their growth in numerical terms in insufficient.
This is specially so with regard to rural areas who have just 41 per cent of the bank branches
but where more than 70 per cent of the population of the country reside.
(ii) There are regional imbalances in the coverage of bank offices. Only few states have well
developed banking facilities : Arunachal Pradesh, Jammu and Kashmir, Uttaranchal, Manipur,
Tripura on an average have lesser number of banks compared to other states. Even from
the states which are well banked like Maharashtra, West Bengal and Tamil Nadu, if big
metropolitan cities are excluded the population per bank office is larger than the average
for these states.
(iii) As a result of increasing advances and loans to unemployed and weaker sections the
commercial banks are facing the problem of bad debts, doubtful debts and over dues. This
seriously affects the process of recycling of funds by the commercial banks. Bad and doubtful
debts of scheduled commercial banks, called non-performing assets (NPAs) have swelled over a
period of time. Gross NPAs were more than Rs. 50,000 crore in 1997-98 they increased to more
than Rs. 70,000 crore in 2001-02, but of late due to stringent credit norms and improved
financial health of the economy the gross NPAs have fallen and stood at around
Rs. 51,000 crore in 2006-07. As a percentage of gross advances, they have fallen from 15 per
cent to 10.5 per cent and further to 2.5 per cent over the above period.
(iv) The quality of services rendered by commercial banks has deteriorated overtime. This has
happened because of staff indiscipline and absence of the system of accountability. There
is a problem of effective management and control especially over the branches which are
located in remote areas. This has hampered the overall efficiency of the commercial banks.
(v) The absolute profits of the banks are rising but the profitability ratio (in terms of return on
investment, return on equity) has not improved much. Six factors have been identified for
declining trends in profitability. These are (i) lower interest on Government borrowings
from banks (ii) subsidisation of credit to priority sector (iii) rapid branch expansion (iv)
locking up of funds in low-term low yielding securities resulting from directed credit
programmes of banks (v) lack of competition (vi) Increasing expenditure resulting from
over staffing and mushrooming of branches some of which are non-viable.

Concerned with the problem of declining profitability and high incidence of non performing
assets (NPA), the RBI has started fine-tuning its regulatory and supervisory mechanism.
Measures have been taken to reduce NPAs. These include, reschedulement, restructuring
at the bank level, corporate debt restructuring and recovery through Lok Adalats, civil
courts and debt recovery tribunals.
(vi) The public sector banks although entered into merchant banking and agricultural financing,
yet they lack expertise in these areas. There is a need for professional touch in these areas.
To sum up, although after nationalisation the commercial banks have played an important
role in achieving national goals of the economy yet these is a need for :-
(a) Spreading their activities to the untouched remote corners of the country.
(b) Keeping up their profitability.
(c) Looking after the growing needs of the priority sectors of the economy.
(d) Improving the performance of rural/semi-urban branches.
(e) Improving the quality of loan portfolio.
SUMMARY
A bank has many functions to perform-receipt of money lending of money, collection and
payment of bills, cheques etc. preparation of feasibility studies, project reports, issue of letters
of credit, travellers cheques and so on. Lending and borrowing functions of banks result in a
credit creation in the economy. Credit creation helps in improving money circulation without
resorting to any increase or decrease in the quantity of currency or legal tender money.
After Independence most of the banks neglected the priority sectors (agriculture, small industries,
exports etc.) and mostly financed the industrial units. In order to have social control on banks,
banks were nationalised in 1969 and 1980. After nationalisation, banks have spread their wings
all over the country. They cater to the needs of all - agriculture, industry and commerce. However,
they still have to go a long way for removing inter-regional, inter-sectoral imbalances.

CHAPTER – 8
MONEY AND
BANKING
Unit 3
The Reserve Bank

of India (RBI)
Learning Objectives
know the meaning of Central Bank.

understand the basic functions of a Central Bank.
understand how a Central Bank is different a commercial bank.
know the role and functions of Reserve Bank of India.
3.0 MEANING AND FUNCTIONS OF A CENTRAL BANK

A Central Bank is one which constitutes the apex of the monetary and banking structure of a
country and which performs, in the national economic interest, the following functions :
1. The regulation of currency in accordance with the requirements of business and the general
public.
2. The performance of general banking and agency services for the State.
3. The custody of cash reserve of the commercial banks.
4. The custody and management of the nation’s reserves of international currency.
5. The granting of accommodation, in the form of rediscounting or collateral advances to
commercial banks, bill brokers and dealers.
6. The clearance arrangements among banks; and
7. The control of credit in accordance with the needs of business with a view to carrying out
broad monetary policy adopted by the State.
The above is quite comprehensive but, in addition, central banks perform additional functions
to meet the specific requirements of the country. Broadly speaking, a central bank has three
objectives, namely monetary stability, including stability of domestic price levels, maintenance
of the international value of the nation’s currency and issue of currency.
3.1 CENTRAL BANK VS COMMERCIAL BANK

Whereas other banks are largely profit seeking institutions, the central bank is not so. Although,
it makes huge contribution to be general revenues, its objective is not to make profit. It does not
allow interest on deposits. Its profits are mainly through its dealings in Government securities
which it holds in reserve against note issue and interest on advances and loans which it grants
to State Governments and other financial institutions, including commercial banks.
The Central Bank acts as the organ of the State. The ultimate responsibility of framing and
executing economic policies is that of the State and, therefore, the Central Bank has to advance
the policies of the State. For that purpose, the Central Bank has to act in close collaboration
with the Finance Ministry and other economic ministries.

MONEY AND BANKING
Whereas other banks have largely public dealings, the Central Bank’s dealings are with
Governments, Central and State banks and other financial institutions.
Whereas other banks mobilise savings and channelise them into proper use, the Central Bank’s
role is to ensure that the other banks conduct their business with safety, security and in
pursuance of the national plan priorities and objectives of economic and social development.
3.2 ROLE OF THE RESERVE BANK OF INDIA

The Reserve Bank of India (RBI) is the Central Bank of India and occupies a pivotal position in
the Indian economy. Its role is summarised in the following points:
The RBI is the apex monetary institution of the highest authority in India. Consequently, it
plays an important role in strengthening, developing and diversifying the country’s
economic and financial structure.
It is responsible for the maintenance of economic stability and assisting the growth of the
economy.
It is India’s eminent public financial institution given the responsibility for controlling the
country’s monetary policy.
It acts as an advisor to the government in its economic and financial policies, and it also
represents the country in the international economic forums.
It also acts as a friend, philosopher and guide to commercial banks. In fact, it is responsible
for the development of an adequate and sound banking system in the country and for the
growth of organised money and capital markets.
India being a developing country, the RBI has to keep inflationary trends under control
and to see that main priority sectors like agriculture, exports and small scale industry get
credit at cheap rates.
It has also to protect the market for government securities and channelise credit in desired
directions.
3.3 FUNCTIONS OF RESERVE BANK OF INDIA

The Reserve Bank of India being the Central Bank of India performs all the central banking
functions. These are :
(i) Issue of currency : The RBI is the sole authority for the issue of currency in India other
than one rupee coins and notes and subsidiary coins, the magnitude of which is relatively
small.
(ii) Banker to the government : As a banker to the government, the RBI performs the following
functions :
(a) It transacts all the general banking business of the Central and State Governments. It
accepts money on account of these governments and makes payment on their behalf
and carries out other banking operations such as their exchange and remittances.

(b) It manages public debt and is responsible for issue of new loans. For ensuring the
successes of the loan operations it actively operates in the gilt-edged market and advises
the government on the quantum, timing and terms of new loans.
(c) It also sells Treasury Bills on behalf of the Central Government in order to wipe away
excess liquidity in the economy.
(d) The RBI also makes advances to the Central and State Governments which are
repayable within 90 days from the date of advance.
(e) The RBI also acts as an adviser to the government not only on policies concerning
banking and financial matters but also on a wider range of economic issues including
those in the field of planning and resource mobilisation. It has a special responsibility
in respect of financial policies and measures concerning new loans, agricultural finance
and legislation affecting banking and credit and international finance.
(iii) Banker’s Bank : The RBI has been vested with extensive power to control and supervise
commercial banking system under the Reserve Bank of India Act, 1934 and the Banking
Regulation Act, 1949. All the scheduled banks are required to maintain a certain minimum
of cash reserve ratio with the RBI against their demand and time liabilities. This provision
enables the RBI to control the credit position of the country.
The RBI provides financial assistance to scheduled banks and state cooperative banks in
the form of discounting of eligible bills and loans and advances against approved securities.
The RBI also conducts inspection of the commercial banks and calls for returns and other
necessary information from banks.
(iv) Custodian of Foreign Exchange Reserves : The RBI is required to maintain the external
value of the rupee. For this purpose it functions as the custodian of nation’s foreign exchange
reserves. It has to ensure that normal short-term fluctuations in trade do not affect the
exchange rate. When foreign exchange reserves are inadequate for meeting balance of
payments problem, it borrows from the IMF.
The RBI has the authority to enter into exchange transactions on its own account and on
account of government. It also administers exchange control of the country and enforces
the provisions of Foreign Exchange Management Act.
(v) Controller of Credit : Credit plays an important role in the settlement of business
transactions and affects the purchasing power of people. The social and economic
consequences of changes in the purchasing power are serious, therefore, it is necessary to
control credit. Controlling credit operations of banks is generally considered to be the
principal function of a central bank. The RBI, like any other Central Bank, possesses power
to use almost all qualitative and quantitative methods of credit controls. (For details
discussion on instruments of credit controls please refer to the topic Indian Monetary
Policy).
(vi) Promotional Functions : Apart from the traditional functions of a Central Bank, the RBI
also performs a variety of developmental and promotional functions. It is responsible for
promoting banking habits among people and mobilising savings from every corner of the
country. It has also taken up the responsibility of extending the banking system territorially

MONEY AND BANKING
and functionally. Initially, it had also taken up the responsibility for the provision of finance
for agriculture, trade and small industries. But now these functions have been handed
over to NABARD, EXIM Bank and SIDBI respectively. The Reserve Bank is responsible for
over all credit and monetary policy of the economy.
(vii) Collection and publication of Data : It has also been entrusted with the task of collection
and compilation of statistical information relating to banking and other financial sectors
of the economy.
3.4 INDIAN MONETARY POLICY

Monetary Policy is usually defined as the Central Bank’s policy pertaining to the control of the
availability, cost and use of money and credit with the help of monetary measures in order to
achieve specific goals. In the Indian context, monetary policy comprises those decisions of the
government and the Reserve Bank of India which directly influence the volume and composition
of money supply, the size and distribution of credit, the level and structure of interest rates,
and the effects of these monetary variables upon related factors such as savings and investment
and determination of output, income and price.
The broad concerns of monetary policy in India have been -
(a) to regulate monetary growth so as to maintain a reasonable degree of price stability and
(b) to ensure adequate expansion in credit to assist economic growth;
(c) to encourage the flow of credit into certain desired channels including priority and the
hitherto neglected sectors; and
(d) to introduce measures for strengthening the banking system and creating institutions for
filling credit gaps.
Monetary policy is implemented by the RBI through the instruments of credit control. Generally
two types of instruments are used to control credit.
These are (i) quantitative or general measures and (ii) qualitative or selective measures. The
quantitative measures are directed towards influencing the total volume of credit in the banking
system without special regard for the use to which it is put. Selective or qualitative instruments
of credit control, on the other hand, are directed towards the particular use of credit and not
its total volume.
I. Quantitative or General Measures : Quantitative weapons have a general effect on credit
regulation. They are used for changing the total volume of credit in the economy.
Quantitative measures consist of (a) Bank Rate Policy (b) Open Market Operations and
(c) Variable Reserve Requirements.
(a) Bank Rate Policy : It is the traditional weapon of credit control used by a Central
Bank. The Bank Rate is the rate at which the Central Bank discounts the bills of
commercial banks. When the Central Bank wishes to control credit and inflation in
the economy, it raises the Bank Rate. Increased Bank Rate increases the cost of
borrowings of the commercial banks who in turn charge a higher rate of interest from
their borrowers. This means the price of credit will increase. This will affect the profits

of the business community who will feel discouraged to borrow. As a result, the
demand for credit will go down. Decreased demand for credit will slow down
investment activities which in turn will affect production and employment .
Consequently, income in general will fall, people’s purchasing power will decrease
and aggregate demand will fall and prices will fall down. This in turn will lead to a
cumulative downward movement in the economy.
On the other hand, if the Central Bank wishes to boost production and investment
activities in the economy, it will decrease the Bank Rate. Decreasing the Bank Rate
will have a reverse effect. As regards Bank Rate in India, it was 10 percent in 1981, 12
percent in 1991, 11 per cent in 1997 which was reduced (in stages) to 6.5 per cent in
April 2001. In April 2003, it was further reduced to 6 per cent. Since then there has
been no change.
(b) Open market operations : Open market operations imply deliberate direct sales and
purchases of securities and bills in the market by the Central Bank on its own initiative
to control the volume of credit. When the Central Bank sells securities in the open
market, other things being equal, the cash reserves of the commercial banks decrease
to the extent that they purchase these securities. In effect, the credit-creating base of
commercial banks is reduced and hence credit contracts. On the other hand, open
market purchases of securities by the Central Bank lead to an expansion of credit
made possible by strengthening the cash reserves of the banks. Thus, on account of
open market operations, the quantity of money in circulation changes. This tends to
bring about changes in money rates. An increase in the supply of money through
open market operations causes a down ward movement in the interest rates, while a
decrease of money supply raises interest rates. Change in the rate of interest in turn
tends to bring about the desired adjustments in the domestic level of prices, costs,
production and trade.
(c) Variable reserve requirements : The Central Bank also uses the method of variable
reserve requirements to control credit. There are two types of reserves which the
commercial banks are generally required to maintain (i) Cash Reserve Ratio
(ii) Statutory Liquidity Ratio (SLR). Cash reserve ratio refers to that portion of total
deposits which a commercial bank has to keep with the Central Bank in the form of
cash reserves. Statutory liquidity ratio refers to that portion of total deposits which a
commercial bank has to keep with itself in the form of liquid assets viz - cash, gold or
approved government securities. By changing these ratios, the Central Bank controls
credit in the economy. If it wants to discourage credit in the economy, it increases
these ratios and if it wants to encourage credit in the economy, it decreases these
ratios. Raising of the reserve rates will reduce the surplus cash reserves of the banks
which can be offered for credit. This will tend to contract credit in the system. Reverse
will be effects of reduction in the reserve ratio requirements reflected in the expansion
of the bank credit. At present, cash reserve ratio is 5 per cent and statutory liquidity
ratio is 24 per cent for entire net demand and time liabilities of the scheduled
commercial banks. Cash Reserve Ratio (CRR) was quite low at 4.5 per cent as in
March, 2004. Due to inflationary conditions prevailing in the economy, it was hiked

MONEY AND BANKING
(in stages) to 9 per cent in August, 2008. But when situation eased it was again reduced
(in stages) to 5 per cent in January 2009.
(d) Repo Rate and Reverse Rate: In addition to these, there are tools of Repo and Reverse
Repo Rates. Repo rate is the rate at which our banks borrow rupees from RBI.
Whenever the banks have any shortage of funds they can borrow it from RBI. RBI
lends money to bankers against approved securities for meeting their day to day
requirements or to fill short term gap. A reduction in the repo rate will help banks to
get money at a cheaper rate. When the repo rate increases borrowing from RBI
becomes more expensive. At present, Repo rate is 4.75 per cent. [September, 2009]
Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money
from banks. An increase in Reverse repo rate can cause the banks to transfer more
funds to RBI due to this attractive interest rates. It can cause the money to be drawn
out of the banking system. At present Reverse Repo rate is 3.25 per cent. [September,
2009]
II Qualitative or Selective Measures : Qualitative or selective measures are generally meant
to regulate credit for specific purposes. The Central Bank generally uses the following
forms of credit control -
(a) Securing loan regulation by fixation of margin requirements : The Central Bank is
empowered to fix the margin and thereby fix the maximum amount which the
purchaser of securities may borrow against those securities. Raising of margin curbs
the borrowing capacity of the security holder. This is a very effective selective control
device to control credit in the speculative sphere without, at the same time, limiting
the availability of credit in other productive fields. This device is also useful to check
inflation in certain sensitive spots of the economy without influencing the other sectors.
(b) Consumer credit regulation : The regulation of consumer credit consists of laying
down rules regarding down payments and maximum maturities of installment credit
for the purchase of specified durable consumer goods. Raising the required down
payment limits and shortening of maximum period tend to reduce the demand for
such loans and thereby check consumer credit.
(c) Issue of directives : The Central Bank also uses directives to various commercial banks.
These directives are usually in the form of oral or written statements, appeals, or
warnings, particularly to curb individual credit structure and to restrain the aggregate
volume of loans.
(d) Rationing of credit : Rationing of credit is a selective method adopted by the Central
Bank for controlling and regulating the purpose for which credit is granted or allocated
by commercial banks.
(e) Moral suasion : Moral suasion implies persuasion and request made by the Central
Bank to the commercial banks to co-operate with the general monetary policy of the
former. The Central Bank may also persuade or request commercial banks not to
apply for further accommodation from it or not to finance speculative or non-essential
activities. Moral suasion is a psychological means of controlling credit; it is a purely
informal and milder form of selective credit control.

(f) Direct Action : The Central Bank may take direct action against the erring commercial
banks. It may refuse to rediscount their papers, and give excess credit, or it may
charge a penal rate of interest over and above the Bank Rate, for the credit demanded
beyond a prescribed limit.
By making frequent changes in monetary policy, it ensures that the monetary system
in the economy functions according to the nation’s needs and goals.
SUMMARY
At the apex of banking and monetary structure is the Central Bank of the economy. The Central
Bank performs the main functions of note issue, banker for the government, credit control,
custodian of cash reserves, lender of the last resort etc., India’s Central Bank ‘The Reserve
Bank of India’ performs all these functions. The instruments which it uses for controlling credit
in the economy are both general (in the form of bank rate, open market operations, reserve
rates) and selective (in the form of margin requirements, variable interest rates, regulation of
consumer credit and so on). Credit policy is amended from time to time to suit the needs of the
economy.

1. Money in traditional sense :
a. Serves as a medium of exchange.
b. Serves as a store of value.
c. Serves as both medium of exchange and store of value.
d. Serves neither as medium of exchange and store of value.
2. Money includes :
a. Currencies and demand deposits.
b. Bonds, government securities.
c. Equity shares.
3. Which of the following statements about money is incorrect?
a. There are many assets which carry the attribute on money.
b. Money is what money does.
c. In modern sense, money has stability, high degree of substitutability and feasibility of
measuring statistical variation.

MONEY AND BANKING
4. M1 in the money stock in India refers to :

a. Post office saving deposits.
b. Total post office deposits.
c. Currency plus demand deposits plus other deposits with RBI.
d. Time deposits with banks.
5. Narrow money refers to
a. M1
b. M2
c. M3
d. M4
6. Broad money refers to
a. M1
b. M2
c. M3
d. M4
7. The basic distinction between narrow and broad monies is the
a. Treatment of post office deposits.
b. Treatment of time deposits of banks.
c. Treatment of savings deposits of banks.
d. Treatment of currency.
8. In the present context, total money stock in India refers to
a. M1
b. M2
c. M3
d. M4
9. Which of the following statements about banks is incorrect?
a. Banks encourage saving habits among people.
b. Banks mobilise savings and make them available for production.
c. Banks help in creating credit money.

10. Banks perform the function of
a. Receiving deposits
b. Lending of money
c. Agency services
11. Commercial banks in India were nationalised in 1969 because
a. There was urban bias.
b. Agriculture sector was neglected.
c. There was concentration of economic power.
12. Nationalisation of banks aimed at all of the following except
a. Removal of control by a few.
b. Provision of credit to big industries only.
c. Provision of adequate credit for agriculture, small industry and export units.
d. Encouragement of a new class of entrepreneur.
13. Rural bank branches constitute ______ per cent of total bank branches in India.
a. 14
b. 60
c. 41
d. 82
14. Population per bank in India is
a. Around 5000
b. Around 20000
c. Around 15000
d. Around 45000
15. In terms of deposit mobilisation, _____________ leads other states.
a. U.P
b. Maharashtra
c. Kerala
d. Bihar

MONEY AND BANKING
16. In terms of lending, priority sectors constitute about _______________ of total bank lending.
a. 60
b. 80
c. 30
d. 44
17. Which is the Central Bank of India?
a. State Bank of India.
b. Punjab and National Bank.
c. Oriental Bank of Commerce.
d. Reserve Bank of India.
18. Commercial banks suffer from
a. Regional imbalances.
b. Increasing overdues.
c. Lower inefficiency.
19. Who is the official “lender of the last resort” in India?
a. SBI
b. PNB
c. RBI
d. OBC
20. _____________ refers to that portion of total deposits of a commercial bank which it has
to keep with RBI in the form of cash reserves.
a. CRR
b. SLR
c. Bank Rate
d Repo Rate
21. ___________________ refers to that portion of total deposits of a commercial bank which
it has to keep with itself in the form of liquid assets.
a. CRR
b. SLR
c. Bank Rate
d. Repo Rate

22. At present (October 2009), CRR is _______________ per cent.
a. 4
b. 4.5
c. 5
d. 5.5
23. At present, SLR is ________ per cent. (October, 2009)
a. 24
b. 30
c. 35
d. 40
24. _____________ is the official minimum rate at which the Central Bank of a country is
prepared to rediscount approved bills held by banks.
a. CRR
b. SLR
c. Bank Rate
d. Repo Rate
25. At present, Bank rate is _____________ per cent. (October, 2009)
a. 5
b. 6
c. 6.5
d. 5.5
26. In order to control credit in the country, the RBI may
a. Buy securities in the open market.
b. Sell securities in the open market.
c. Reduce CRR.
d. Reduce Bank Rate.
27. In order to encourage investment in the country, the RBI may
a. Reduce CRR.
b. Increase CRR.
c. Sell securities in the open market.
d. Increase Bank Rate.

MONEY AND BANKING
28. In order to discourage investment in the economy, the RBI may

a. Increase Bank Rate.
b. Decrease Bank Rate.
c. Buy securities in the open market.
d. Decrease CRR.
29. The effect of increase CRR will be reduced or nullified if :
a. Bank rate is reduced.
b. Securities are sold in the open market.
c. SLR is increased.
d. People do not borrow from non-banking institutions.
30. In order to control credit
a. CRR should be increased and Bank Rate should be decreased.
b. CRR should be reduced and Bank Rate should be reduced.
c. CRR should be increased and Bank Rate should be increased.
d. CRR should be reduced and Bank Rate should be increased.
31. _______________ controls affect indiscriminately all sectors of the economy.
a. Selective credit.
b. Quantitative.
c. Margin requirements.
32. During depression, it is advisable to
a. Lower Bank Rate and purchase securities in the market.
b. Increase Bank Rate and purchase securities in the open market.
c. Decrease Bank Rate and sell securities in the open market
d. Increase Bank Rate and sell securities in the open market.
a. The RBI is just like any ordinary commercial bank in India.
b. The RBI is responsible for the overall monetary policy in India.
c. Selective credit control measures affect all banks in a similar manner.
d. A high rate of interest encourages new investment.

34. ‘The lender of last resort’ means
a. The government coming to the rescue of poor farmers.
b. Central Bank coming to the rescue of other banks in times of financial crisis.
c. Commercial banks coming to the rescue of small industrial units.
35. Who is the custodian of monetary reserves in India?
a. SBI
b. SIDBI
c. NABARD
d. RBI
36. Who is called the ‘bank of issue’?
a. RBI
b. SBI
c. IDBI
d. ICICI
37. Who is the fiscal agent and adviser to government in monetary and financial matters in
India?
a. SBI
b. IDBI
c. ICICI
d. RBI
38. Who is the custodian of national reserves of international currency?
a. SBI
b. IDBI
c. RBI
d. ICICI
39. The profitability ratio of bank has declined over the years due to
a. Lower interest on government borrowings from banks.
b. Subsidisation of credit to priority sector.
c. High expenditure resulting from overstaffing and mushrooming of branches.

MONEY AND BANKING

a. Rural areas have nearly 41 per cent of bank branches but more than 70 per cent of the
population residing there.
b. Banks are evenly spread out.
c. Most of the banks have almost nil NPAs.
ANSWERS
1. c 2. d 3. d 4. c 5. a 6. c
7. b 8. c 9. d 10. d 11. d 12. b
13. c 14. c 15. b 16. d 17. d 18. d
19. c 20. a 21. b 22. c 23. a 24. c
25. b 26. b 27. a 28. a 29. a 30. c
31. b 32. a 33. b 34. b 35. d 36. a
37. d 38. c 39. d 40. a

NOTES

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GENERAL

The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

Website : www.icai.org E-mail : bosnoida@icai.org

Chapter 1 - Introduction to Micro Economics

Unit 2 : Theory of Consumer Behaviour

2.0 What is Utility? 62

Chapter 3 -Theory of Production and Cost

1.0 Meaning of Production 104

Chapter 4 - Price Determination in Different Markets

Chapter 6 - Select Aspects of Indian Economy

3.0 Meaning and Types of Unemployment 288

5.0 Meaning and Types of Inflation 312

Chapter 7 - Economic Reforms in India

1.0 Background 346

Chapter 8 - Money and Banking

1.0 Meaning of Money 382

Unit 2 : Commercial Banks

Unit 3 : The Reserve Bank of India (RBI)

know what Economics is about.

1.0 WHAT IS ECONOMICS ABOUT?

2 COMMON PROFICIENCY TEST

1.1 DEFINITIONS AND SCOPE OF ECONOMICS

1. Science of wealth. Some earlier economists defined Economics as follows :

4 COMMON PROFICIENCY TEST

6 COMMON PROFICIENCY TEST

Micro Economic Theory

Wage Rent Interest Profits

Macro Economic Theory

8 COMMON PROFICIENCY TEST

1.3 METHODS OF STUDY

10 COMMON PROFICIENCY TEST

1.4 CENTRAL ECONOMIC PROBLEMS

12 COMMON PROFICIENCY TEST

1.5 PRODUCTION POSSIBILITIES CURVE

Fig. 1 : Production Possibilities Curve

Fig. 2 : Production Possibilities Curve

14 COMMON PROFICIENCY TEST

Fig. 3 : Shift in PPC due to economic growth

1.6 HOW DIFFERENT ECONOMIES SOLVE THEIR CENTRAL

16 COMMON PROFICIENCY TEST

18 COMMON PROFICIENCY TEST

20 COMMON PROFICIENCY TEST

Merits of Mixed Economy

22 COMMON PROFICIENCY TEST

MULTIPLE CHOICE QUESTIONS

24 COMMON PROFICIENCY TEST

26 COMMON PROFICIENCY TEST

23. An economy achieves “productive efficiency” when :

(c) A movement from point F to point C.

28 COMMON PROFICIENCY TEST

(b) 8 units of consumer goods.

30 COMMON PROFICIENCY TEST

(c) agricultural goods

32 COMMON PROFICIENCY TEST

c. the decisions made by households

34 COMMON PROFICIENCY TEST

understand the meaning of demand.

1.0 MEANING OF DEMAND

1.1 WHAT DETERMINES DEMAND?

3 8 COMMON PROFICIENCY TEST

1.2 LAW OF DEMAND

4 0 COMMON PROFICIENCY TEST

Fig. 1 : Demand Curve