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ECONOMIC & BUSINESS ENVIRONMENT Chapter 1 Basics of Demand and Supply and Forms of Market Competition 1 2 National Income Accounting and Related Concepts 22 3 Indian Union Budget...

ECONOMIC & BUSINESS ENVIRONMENT Chapter 1 Basics of Demand and Supply and Forms of Market Competition 1 2 National Income Accounting and Related Concepts 22 3 Indian Union Budget 39 4 Indian Financial Markets 51 5 Indian Economy 88 6 Entrepreneurship Scenario 108 7 Business Environment 120 8 Key Government Institutions 136 Lesson 1 BASICS OF DEMAND AND SUPPLY AND FORMS OF MARKET COMPETITION 1 2 Economic & Business Environment THEORY OF DEMAND AND SUPPLY Meaning of Demand Demand is an economic principle referring to a consumer's desire to purchase goods and services and willingness to pay a price for a specific good or service. Law of Demand According to the law of demand, other things being equal, if price of a commodity falls, the quantity demanded of it will rise, and if price of the commodity rises, its quantity demanded will decline. It implies that there is an inverse relationship between the price and quantity demanded of a commodity,. In other words, other things being equal, quantity demanded will be more at a lower price than at higher price. The law of demand describes the functional relationship between price and quantity demanded. Among various factors affecting demand, price of a commodity is the most critical factor. Thus, demand of a commodity is mainly determined by the price of commodity. Dx = f(Px). The law of demand may be understood from the following example: PRICE PER CAN (INR) QUANTITY DEMANDED 80 0 70 200 60 400 50 600 40 800 30 1000 20 1200 10 1400 0 1600  Economic & Business Environment 3 Source: Economics Online Thus, it may be observed that with the rise in price per can, the demand for the cans is reducing. Assumptions of the law of demand The above stated law of demand is conditional. It is based on certain conditions as given. It is therefore, always stated with the ‘other things being equal’. It relates to the change in price variable only, assuming other determinants of demand to be constant. The law of demand is thus, based on the following ceteris paribus assumptions: 1. No Change in Consumer’s Income 2. No Change in Consumer’s Preferences 3. No Change in the Fashion 4. No Change in the Price of Related Goods 5. No Expectation of Future Price Changes or Shortages 6. No Change in Size, Age Composition and Sex Ratio of the Population 7. No Change in the Range of Goods Available to the Consumers 8. No Change in the Distribution of Income and Wealth of the Community 9. No Change in Government Policy 10. No Change in Weather Conditions 4 Economic & Business Environment EXCEPTIONS TO THE LAW OF DEMAND There are few exceptional cases where the law of demand is not applicable, which may be categorised as follows: Giffen Goods : In the case of certain inferior goods called Giffen goods (named after Sir Robert Giffen), when the prices fall, quite often less quantity will be purchased than before because of the negative income effect and people’s increasing preference for a superior commodity with the rise in their real income. Examples of Giffen goods can include bread, rice, and wheat. Articles of Snob Appeal : Sometimes, certain commodities are demanded just because they happen to be expensive or prestige goods, and have a ‘snob appeal’. They satisfy the aristocratic desire to preserve exclusiveness for unique goods. Speculation : When people speculate about changes in the price of a commodity in the future, they may not act according to the law of demand at the present price, say, when people are convinced that the price of a particular commodity will rise still further, they will not contract their demand with the given price rise: on the contrary, they may purchase more for the purpose of hoarding. Consumer’s Psychological Bias or Illusion : When the consumer is wrongly biased against the quality of the commodity with the price change, he may contract this demand with a fall in price. Law of Supply Supply represents how much the market can offer. The quantity supplied refers to the amount of a good producers are willing to supply when receiving a certain price. The supply of a good or service refers to the quantities of that good or service that producers are prepared to offer for sale at a set of prices over a period of time. Supply means a schedule of possible prices and amounts that would be sold at each price. The supply is not the same concept as the stock of something in existence, for example, the stock of commodity X in Delhi means the total quantity of Commodity X in existence at a point of time; whereas, the supply of commodity X in Delhi means the quantity actually being offered for sale, in the market, over a specified period of time. The law of supply states that a firm will produce and offer to sell greater quantities of a product or service as the price of that product or service rises, other things being equal. There is direct relationship between price and quantity supplied. In this statement, change in price is the cause and change in supply is the effect. Thus, the price rise leads to increase in supply and not otherwise. It may be noted that at higher prices, there is greater incentive to the producers or firms to produce and sell more. Other things include cost of production, change of technology, prices of inputs, level of competition, size of industry, government policy and non-economic factors. Thus ‘Ceteris Paribus’ (a) With an increase in the price of a good, the producer is willing to offer more quantity in the market for sale.  Economic & Business Environment 5 (b) The quantity supplied is related to the specified time interval over which it is offered. The law of supply is the microeconomic law that states that, all other factors being equal, as the price of a good or service increases, the quantity of goods or services that suppliers offer will increase, and vice versa. The law of supply says that as the price of an item goes up, suppliers will attempt to maximize their profits by increasing the quantity offered for sale. Assumptions of Law of Supply The term “other things remaining the same” refers to the following assumptions in the law of supply: 1. No change in the state of technology. 2. No change in the price of factors of production. 3. No change in the number of firms in the market. 4. No change in the goals of the firm. 5. No change in the seller’s expectations regarding future prices. 6. No change in the tax and subsidy policy of the products. 7. No change in the price of other goods. The equilibrium price is the market price where the quantity of goods supplied is equal to the quantity of goods demanded. This is the point at which the demand and supply curves in the market intersect. Source: Study.com 6 Economic & Business Environment At equilibrium, there is no shortage or surplus unless a determinant of demand or a determinant of supply changes. If a change in the price of a good or a service creates a shortage, it means that consumers want to buy a higher quantity than the one offered by producers. In this case, demand exceeds supply and consumers are not satisfied. In contrast, if a change in the price of a product or a service creates a surplus, it means that consumers want to buy less quantity than the one offered by producers. In this case, supply exceeds demand and producers need to lower the price of the product or the service to avoid excessive inventory. Let us take an example to understand the concept. Source: My Accounting Course In the table above, the quantity demanded is equal to the quantity supplied at the price level of $60. Therefore, the price of $60 is the equilibrium price. At any other price level, there is either surplus or shortage. Specifically, for any price that is lower than $60, the quantity supplied is greater than the quantity demanded, thereby creating a surplus. For any price that is higher than $60, the quantity demanded is greater than the quantity supplied, thereby creating a shortage. ELASTICITY OF DEMAND In economics, the demand elasticity (elasticity of demand) refers to how sensitive the demand for a good is to changes in other economic variables, such as prices and consumer income. Demand elasticity is calculated as the percent change in the quantity demanded divided by a percent change in another economic variable. A higher demand elasticity for an economic variable means that consumers are more responsive to changes in this variable. “Elasticity of demand is the responsiveness of the quantity demanded of a commodity to changes in  Economic & Business Environment 7 one of the variables on which demand depends. In other words, it is the percentage change in quantity demanded divided by the percentage in one of the variables on which demand depends.” The variables on which demand can depend on are: Prices of related Price of the commodity Consumer’s income etc. commodities There are major three types of elasticity of demand, i.e. Price elasticity; Income elasticity and Cross elasticity. However, this lesson focuses only on price elasticity of demand. Price Elasticity of Demand The price elasticity of demand is the response of the quantity demanded to change in the price of a commodity. It is assumed that the consumer’s income, tastes, and prices of all other goods are steady. It is measured as a percentage change in the quantity demanded divided by the percentage change in price. Therefore, price elasticity of demand is: Percentage Change in Quantity Demanded Ep = Percentage Change in Price Change in Quantity Original Price Or, Ep = x Original Quantity Change in Price Types of Price Elasticity of Demand The extent of responsiveness of demand with change in the price is not always the same. The demand for a product can be elastic or inelastic, depending on the rate of change in the demand with respect to change in price of a product. Elastic demand is the one when the response of demand is greater with a small proportionate change in the price. On the other hand, inelastic demand is the one when there is relatively a less change in the demand with a greater change in the price. The various forms of price elasticity of demand are as under: 1. Perfectly Elastic Demand : When a small change in price of a product causes a major change in its demand, it is said to be perfectly elastic demand. In perfectly elastic demand, a small rise 8 Economic & Business Environment in price results in fall in demand to zero, while a small fall in price causes increase in demand to infinity. In such a case, the demand is perfectly elastic or ep =. Source: Economics basics 2. Perfectly Inelastic Demand : A perfectly inelastic demand is one when there is no change produced in the demand of a product with change in its price. The numerical value for perfectly inelastic demand is zero (ep=0). Source: Economics basics  Economic & Business Environment 9 3. Relatively Elastic Demand : Relatively elastic demand refers to the demand when the proportionate change produced in demand is greater than the proportionate change in price of a product. The numerical value of relatively elastic demand ranges between one to infinity (ep>1). Source: Economics help 4. Relatively Inelastic Demand: Relatively inelastic demand is one when the percentage change produced in demand is less than the percentage change in the price of a product. For example, if the price of a product increases by 30% and the demand for the product decreases only by 10%, then the demand would be called relatively inelastic. The numerical value of relatively elastic demand ranges between zero to one (ep 1) Relatively Inelastic Demand (Ep< 1 ) Unitary Elastic Demand ( Ep = 1) Factors affecting Price Elasticity of Demand 1. Price Level : The demand is generally elastic for moderately priced goods but, the demand for very costly and very cheap goods is inelastic. The rich do not bother about the prices of the goods that they buy. Very costly goods are demanded by the rich people and hence their demand is not affected much by change in prices. For example, increase in the price of Toyota car from Rs. 5,00,000 to Rs. 5,20,000 will not make any noticeable difference in its  Economic & Business Environment 11 demand. Similarly, the change in the price of very cheap goods (such as salt) will not have any effect on their demand, for their consumption which is very small and fixed. 2. Availability of Substitutes : If a good has close substitutes, the price elasticity of demand for a commodity will be very elastic as some other commodities can be used for it. A small rise in the price of such a commodity will induce consumers to switch their consumption to its substitutes. For example gas, kerosene oil, coal etc. will be used more as fuel if the price of wood increases. On the other hand, the demand of such commodities which have no close substitutes is inelastic, such as salt. 3. Necessities : If a good is a necessity, then the demand tends to be inelastic. For example, if the price for drinking water rises, then there is unlikely to be a huge drop in the quantity demanded since drinking water is a necessity. 4. Time Period : Over time, a good tends to become more elastic because consumers and businesses have more time to find alternatives or substitutes. For example, if the price of gasoline goes up, over time people will adjust for the change, i.e., they may drive less or use public transportation or form carpools. 5. Habits : The demand for addictive or habitual products is usually inelastic. This is because the consumer has no choice but no pay whatever the producer is demanding. For example, if the price for a pack of cigarettes goes up, it will likely not have any effect on demand. 6. Nature of the Commodities : The demand for necessities is inelastic and that for comforts and luxuries is elastic. This is so because certain goods which are essential will be demanded at any price, whereas goods meant for luxuries and comforts can be dispensed with easily if they appear to become costlier. 7. Various Uses : A commodity which has several uses will have an elastic demand such as milk, wood etc. On the other hand, a commodity having only one or fewer uses will have inelastic demand. The consumer finds it easier to adjust the quantity demanded of a good when it is to be used for satisfying several wants than if it is confined to a single or few uses. For this reason, a multiple-use good tends to have more elastic demand. 8. Postponing Consumption : Usually the demand for commodities, the consumption of which can be postponed, is elastic as the prices rise and are expected to fall again. For example, the demand for mp3 is elastic because its use can be postponed for some time if its price goes up, but the demand for rice and wheat is inelastic because their use cannot be postponed when their prices increase. Income Elasticity of Demand Income elasticity of demand is the degree of responsiveness of demand to the change in income. Prof. Watson defines it as : "Income elasticity of demand is the rate of change of quantity with respect to changes in the income, other determinants remaining constant." The income elasticity of demand can be measured by the following formula : Ey = Percentage change in quantity demanded/Percentage change in income Percentage change in quantity demanded = New quantity demanded (Q)/Original quantity demanded (Q) 12 Economic & Business Environment Percentage change in income = New income (Y)/original income (Y) Symbolically, Ey = Q/Q x Y/Y Income elasticity of demand, thus explains the responsiveness of demand to a change in income. Ordinarily, demand for most goods increases with increase in household's level of income. Demand for inferior goods, however, shows a negative relation to change in income. Types of Income Elasticity of Demand Income elasticity of demand can be of five different types : These are tabulated with description below: S.No. Numerical Measure of Verbal description Income elasticity of demand 1. Negative Demand for a commodity falls The trend is visible in case of inferior as income rises. goods. 2. Zero Demand for a commodity does not This is true in the case of essential change as income changes. goods. 3. Greater than zero but less than one. Demand for commodity rises in proportion to a rise in income. 4. Unity Demand for commodity rises in the same proportion as rise in income. 5. Greater than the unity Demand for commodity rises more than in proportion to rise in income. Cross Elasticity of Demand The responsiveness of demand to changes in prices of related commodities is called cross elasticity of demand. Prof. Watson defines it as, "Cross elasticity of demand is the rate of change in quantity associated with a change in the price of related goods." Thus cross elasticity of demand is the responsiveness of demand for commodity X to change in price of commodity Y and is represented as follows : Symbolically : Cross Elasticity of Demand Ec % increase in quantity demanded of A % increase in price of product B  Economic & Business Environment 13 The relationship between X and Y commodities may be substitutive as in case of tea and coffee or complementary as in the case of ball pens and refills. Main measures of cross elasticity with description are as follows : 1. Cross elasticity = Infinity (Commodity X is nearly a perfect substitute for commodity Y) 2. Cross elasticity = Zero (Commodity X and Y are not related) 3. Cross elasticity = Negative (Commodities X and Y are complementary) Thus, if Ec approaches infinity, it means that commodity X is nearly a perfect substitute for commodity Y. On the other hand, if Ec approahes Zero it would mean that the two commodities in question are not related at all. Ec shall be negative when commodity Y is complementary to commodity X. INCREASE AND DECREASE IN DEMAND AND EXPANSION AND CONTRACTION OF DEMAND Increase in Demand and Decrease in Demand Changes in demand include an increase or decrease in demand. Due to the change in the price of related goods, the income of consumers, and the preferences of consumers, etc. the demand for a product or service changes. (a) Increase in Demand : When demand changes not because of price but because of changes in other determinants of demand, it is a case of either increase or decrease in demand. “Increase in demand means more demand at same price”. Increases in demand are shown by a shift to the right in the demand curve. This could be caused by a number of factors, including a rise in income, a rise in the price of a substitute or a fall in the price of a complement. (b) Decrease in Demand: Decrease in demand means, “Less demand at same price”. Demand can 14 Economic & Business Environment decrease and cause a shift to the left of the demand curve for a number of reasons, including a fall in income, assuming a good is a normal good, a fall in the price of a substitute and a rise in the price of a complement. Expansion and Contraction of Demand When quantity demanded of a commodity increases as a result of the fall in the price, it is called extension (or expansion) in demand and when the quantity demanded decreases as a result of an increase in the price of the commodity, it is called contraction in demand. The following is the diagrammatical presentation of expansion and contraction of demand: Source: knowledgiate.com  Economic & Business Environment 15 FORMS OF MARKET COMPETITION A variety of market structures will characterize an economy. Such market structures essentially refer to the degree of competition in a market. There are other determinants of market structures such as the nature of the goods and products, the number of sellers, number of consumers, the nature of the product or service, economies of scale etc. We will discuss thefivebasic types of market structures in any economy. (1) Perfect Competition In a perfect competition market structure, there are a large number of buyers and sellers. All the sellers of the market are small sellers in competition with each other. There is no one big seller with any significant influence on the market. So, all the firms in such a market are price takers. There are certain assumptions when discussing the perfect competition. This is the reason a perfect competition market is pretty much a theoretical concept. These assumptions are as follows, The products on the market are homogeneous, i.e. they are completely identical All firms only have the motive of profit maximization There is free entry and exit from the market, i.e. there are no barriers And there is no concept of consumer preference (2) Monopolistic Competition This is a more realistic scenario that actually occurs in the real world. In monopolistic competition, there are still a large number of buyers as well as sellers. But they all do not sell homogeneous products. The products are similar but all sellers sell slightly differentiated products. Now the consumers have the preference of choosing one product over another. The sellers can also charge a marginally higher price since they may enjoy some market power. So, the sellers become the price setters to a certain extent. For example, the market for cereals is a monopolistic competition. The products are all similar but slightly differentiated in terms of taste and flavours. Another such example is toothpaste. (3) Oligopoly In an oligopoly, there are only a few firms in the market. While there is no clarity about the number of firms, 3-5 dominant firms are considered the norm. So, in the case of an oligopoly, the buyers are far greater than the sellers. The firms in this case either compete with another to collaborate together, They use their market influence to set the prices and in turn maximize their profits. So, the consumers become the price takers. In an oligopoly, there are various barriers to entry in the market, and new firms find it difficult to establish themselves. 16 Economic & Business Environment (4) Monopoly In a monopoly type of market structure, there is only one seller, so a single firm will control the entire market. It can set any price it wishes since it has all the market power. Consumers do not have any alternative and must pay the price set by the seller. Monopolies are extremely undesirable. Here the consumers loose all their power and market forces become irrelevant. However, a pure monopoly is very rare in reality. (5) Duopoly A duopoly is a kind of oligopoly: a market dominated by a small number of firms. In the case of a duopoly, a particular market or industry is dominated by just two firms (this is in contrast to the more widely-known case of the monopoly when just one company dominates). In very rare cases, this means they are the only two firms in the entire market (this almost never occurs); in practice, it usually means the two duopolistic firms have a great deal of influence, and their actions, as well as their relationship to each other, powerfully shape their industry. Duopolistic markets are imperfectly competitive, so entry barriers are typically significant for those attempting to enter the market, but there are usually still other, smaller businesses persisting alongside the two dominant firms. ELASTICITY OF SUPPLY The elasticity of supply establishes a quantitative relationship between the supply of a commodity and it’s price. Hence, we can express the numeral change in supply with the change in the price of a commodity using the concept of elasticity. Note that elasticity can also be calculated with respect to the other determinants of supply. However, the major factor controlling the supply of a commodity is its price. Therefore, we generally talk about the price elasticity of supply. The price elasticity of supply is the ratio of the percentage change in the price to the percentage change in quantity supplied of a commodity. Es = [q/q)×100] ÷ [(p/p)×100] = (q/q) ÷ (p/p) q = The change in quantity supplied q = The quantity supplied p = The change in price p = The price Types of Price Elasticity of Supply 1. Perfectly Inelastic Supply : A service or commodity has a perfectly inelastic supply if a given quantity of it can be supplied whatever might be the price. The elasticity of supply for such a service or commodity is zero. A perfectly inelastic supply curve is a straight line parallel to the Y-axis. This is representative of the fact that the supply remains the same irrespective of the price.  Economic & Business Environment 17 The supply of exclusive items, like the painting of Mona Lisa, falls into this category. Whatever might be the price on offer, there is no way we can increase its supply. (PES = 0), The Quantity Supplied doesn’t change as the price changes. Source: Intelligent Economist 2. Relatively Less-Elastic Supply : When the change in supply is relatively less when compared to the change in price, we say that the commodity has a relatively-less elastic supply. In such a case, the price elasticity of supply assumes a value less than 1. (0 < PES < 1), Quantity Supplied changes by a lower percentage than a percentage change in price. Source: Intelligent Economist 3. Relatively Greater-Elastic Supply : When the change in supply is relatively more when compared to the change in price, we say that the commodity has a relatively greater-elastic supply. In such a case, the price elasticity of supply assumes a value greater than 1. 18 Economic & Business Environment (1 < PES < 8), The Quantity Supplied changes by a larger percentage than the percentage change in price. Source: Intelligent Economist 4. Unitary Elastic Supply : For a commodity with a unit elasticity of supply, the change in quantity supplied of a commodity is exactly equal to the change in its price. In other words, the change in both price and supply of the commodity are proportionately equal to each other. To point out, the elasticity of supply in such a case is equal to one. Further, a unitary elastic supply curve passes through the origin. (PES = 1), Quantity Supplied changes by the same percentage as the change in price. Source: Intelligent Economist  Economic & Business Environment 19 5. Perfectly Elastic supply : A commodity with a perfectly elastic supply has an infinite elasticity. In such a case the supply becomes zero with even a slight fall in the price and becomes infinite with a slight rise in price. This is indicative of the fact that the suppliers of such a commodity are willing to supply any quantity of the commodity at a higher price. A perfectly elastic supply curve is a straight line parallel to the X-axis. (PES = ), Suppliers will be willing and able to supply any amount at a given price but none at a different price. Source: Intelligent Economist Factors influencing the elasticity of supply 1. Price of the Good : The supply and elasticity of supply of a good depend upon the price of the good. If the price of a good increases or decreases, the quantity supplied of it will also increase or decrease, respectively. This is the law of supply. Also the coefficient of price-elasticity of supply (ES) will depend on the price of the good. ES may be greater than, less than, or equal to one, depending on the price. 2. Probability that the Price would Change in Future : If the sellers think that the price of the good will increase (or decrease) in near future, then, at any particular price at present, they would want to decrease (or increase) their supply. In this case, the supply curve for the good would shift to the left (or to the right). 3. Conditions regarding Cost of Production : If the cost of production of a good increases (or decreases), i.e., if its cost curve shifts upwards (or downwards), then the quantity supplied of the good would decrease (or increase) at any particular price, i.e., the supply curve would shift to the left (or to the right). 4. Nature of the Good : The supply of a good depends upon the nature of the good, e.g., on the perishability and lumpiness of the good. The more the perishability or lumpiness of the good, the more would be its market localised, and, in a localised market, the supply of a good at any particular price would be relatively small. 5. Length of Time : If the price of a good rises, then by how much would supply rise, or, how large will be the price-elasticity of supply, would depend on the length of time available for the necessary adjustments (e.g., in the quantities of the factor inputs used) to complete. That is why; the elasticity of supply in the long-period market would be larger than that in the short- period market. 20 Economic & Business Environment Sample Questions 1. No change in habits, customs and income of consumers is the assumption of which law of economics? a. Law of Demand b. Law of Supply c. Laws of Production d. Law of Diminishing Marginal Utility 2. A service or commodity has a ______________, if a given quantity of it can be supplied whatever might be its price a. Relatively Less-Elastic Supply b. Unitary Elastic Supply c. Perfectly Elastic supply d. Perfectly Inelastic Supply 3. ____________________ refers to the market situation in which there is a keen competition, but neither perfect nor pure, among a group of a large number of small producers or suppliers having some degree of monopoly because of the differentiation of their products a. Perfect Competition b. Monopolistic Competition c. Duopoly d. Oligopoly 4. When demand changes not because of price but because of changes in other determinants of demand, it is a case of _________________________. a. Either Expansion or Contraction of Demand b. Either Increase or Decrease of Demand  Economic & Business Environment 21 c. Either Rise or Fall in Demand d. Either Acceleration or Deceleration in Demand 5. When quantity demanded of a commodity increases as a result of the fall in the price, it is called ___________ in demand a. Increase in Demand b. Extension in Demand c. Rise in Demand d. Acceleration in Demand *** Lesson 2 NATIONAL INCOME ACCOUNTING AND RELATED CONCEPTS 22  Economic & Business Environment 23 INTRODUCTION National income is an uncertain term which is used interchangeably with national dividend, national output and national expenditure. On this basis, national income has been defined in a number of ways. In common parlance, national income means the total value of goods and services produced annually in a country. In other words, the total amount of income accruing to a country from economic activities in a year’s time is known as national income. It includes payments made to all resources in the form of wages, interest, rent and profits. National Income or Net National Income is Gross National Income or Gross National Product less depreciation. It is to be noted that National Income includes Net Factor Income Earned from Abroad also. While computing National Income only finished or final goods are considered as factoring intermediate goods used for manufacturing would amount to double counting. It includes taxes but does not include subsidies. METHODS TO MEASURE NATIONAL INCOME There are three methods of measuring national income of a country. They yield the same result. These methods are: (1) The Product Method or Value Added Method. (2) The Income Method. (3) The Expenditure Method (1) The Product Method : The Product 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 individual 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. Goods and services are counted in gross domestic product (GDP) at their market values. The product approach defines a nation's gross product as that market value of goods and services currently produced within a nation during a one year period of time. The product approach measuring national income involves adding up the value of all the final goods and services produced in the country during the year. Here we focus on various sectors of the economy and add up all their production during the year. The main sectors whose production value is added up are: (i) agriculture (ii) manufacturing (iii) construction (iv) transport and communication (v) banking (vi) administration and defence and (vii) distribution of income. 24 Economic & Business Environment Precautions for Product Method or Value Added Method (i) Problem of double counting : When we add up the value of output of various sectors, we should be careful to avoid double counting. This pitfall can be avoided by either counting (he final value of the output or by including the extra value that each firm adds to an item. (ii) Value addition in particular year : While calculating national income, the values of goods added in the particular year in question are added up. The values which had previously been added to the stocks of raw material and goods have to be ignored. GDP thus includes only those goods, and services that are newly produced within the current period. (iii) Stock appreciation : Stock appreciation, if any, must be deducted from value added. This is necessary as there is no real increase in output. (iv) Production for self consumption : The production of goods for self consumption should be counted while measuring national income. In this method, the production of goods for self consumption should be valued at the prevailing market prices. (2) Expenditure Method : The expenditure approach measures national income as total spending on final goods and services produced within nation during a year. The expenditure approach to measuring national income is to add up all expenditures made for final goods and services at current market prices by households, firms and government during a year. Total aggregate final expenditure on final output thus is the sum of four broad categories of expenditures: (i) Consumption (ii) Investment (iii) Government and (iv) Net export. (i) Consumption expenditure (C) : Consumption expenditure is the largest component of national income. It includes expenditure on all goods and services produced and sold to the final consumer during the year. (ii) Investment expenditure (I) : Investment is the use of today's resources to expand tomorrow's production or consumption. Investment expenditure is expenditure incurred on by business firms on (a) new plants, (b) adding to the stock of inventories and (c) on newly constructed houses. (iii) Government expenditure (G) : It is the second largest component of national income. It includes all government expenditure on currently produced goods and services but excludes transfer payments while computing national income. (iv) Net exports (X - M) : Net exports are defined as total exports minus total imports. National income calculated from the expenditure side is the sum of final consumption expenditure, expenditure by business on plants, government spending and net exports.  Economic & Business Environment 25 Precautions for Expenditure Method (i) The expenditure on second hand goods should not be included as they do not contribute to the current year's production of goods. (ii) Similarly, expenditure on purchase of old shares and bonds is not included as these also do not represent expenditure on currently produced goods and services. (iii) Expenditure on transfer payments by government such as unemployment benefit, old age pensions, interest on public debt should also not be included because no productive service is rendered in exchange by recipients of these payments. (3) Income Method : Income approach is another alternative way of computing national income, This method seeks to measure national income at the phase of distribution. In the production process of an economy, the factors of production are engaged by the enterprises. They are paid money incomes for their participation in the production. The payments received by the factors and paid by the enterprises are wages, rent, interest and profit. National income thus may be defined as the sum of wages, rent, interest and profit received or occurred to the factors of production in lieu of their services in the production of goods. Briefly, national income is the sum of all income, wages, rents, interest and profit paid to the four factors of production. The four categories of payments are briefly described below: (i) Wages : It is the largest component of national income. It consists of wages and salaries along with fringe benefits and unemployment insurance. (ii) Rents : Rents are the income from properly received by households. (iii) Interest : Interest is the income private businesses pay to households who have lent the business money. (iv) Profits: Profits are normally divided into two categories (a) profits of incorporated businesses and (b) profits of unincorporated businesses (sole proprietorship, partnerships and producers cooperatives). Precautions for Income Method While estimating national income through income method, the following precautions should be undertaken. (i) Transfer payments such as gifts, donations, scholarships, indirect taxes should not be included in the estimation of national income. (ii) Illegal money earned through smuggling and gambling should not be included. (iii) Windfall gains such as prizes won, lotteries etc. is not be included in the estimation of national income. 26 Economic & Business Environment (iv) Receipts from the sale of financial assets such as shares, bonds should not be included in measuring national income as they are not related to generation of income in the current year production of goods. KEY CONCEPTS OF NATIONAL INCOME Gross Domestic Product (GDP) GDP is the total value of goods and services produced within the country during a year. This is calculated at market prices and is known as GDP at market prices. Dernberg defines GDP at market price as “the market value of the output of final goods and services produced in the domestic territory of a country during an accounting year.” There are three different ways to measure GDP: Methods of Measure GDP The Product Method The Income Method Expenditure Method (a) The Product Method : In this method, the value of all goods and services produced in different industries during the year is added up. This is also known as the value added method to GDP or GDP at factor cost by industry of origin. The following items are included in India in this: agriculture and allied services; mining; manufacturing, construction, electricity, gas and water supply; transport, communication and trade; banking and insurance, real estates and ownership of dwellings and business services; and public administration and defence and other services (or government services). In other words, it is the sum of gross value added.  Economic & Business Environment 27 (b) The Income Method : The people of a country who produce GDP during a year receive incomes from their work. Thus GDP by income method is the sum of all factor incomes: Wages and Salaries (compensation of employees) + Rent + Interest + Profit. (c) Expenditure Method : This method focuses on goods and services produced within the country during one year. GDP by expenditure method includes: 1. Consumer expenditure on services and durable and non-durable goods (C). 2. Investment in fixed capital such as residential and non-residential building, machinery, and inventories (I). 3. Government expenditure on final goods and services (G). 4. Export of goods and services produced by the people of country (X). 5. Less imports (M). That part of consumption, investment and government expenditure which is spent on imports is subtracted from GDP. Similarly, any imported component, such as raw materials, which is used in the manufacture of export goods, is also excluded. Thus GDP by expenditure method at market prices = C+ I + G + (X – M), where (X-M) is net export which can be positive or negative. GDP at Factor Cost GDP at factor cost is the sum of net value added by all producers within the country. Since the net value added gets distributed as income to the owners of factors of production, GDP is the sum of domestic factor incomes and fixed capital consumption (or depreciation). Thus GDP at Factor Cost = Net value added + Depreciation. GDP at factor cost includes: (a) Compensation of employees i.e., wages, salaries, etc. (b) Operating surplus which is the business profit of both incorporated and unincorporated firms [Operating Surplus = Gross Value Added at Factor Cost—Compensation of Employees— Depreciation]. (c) Mixed Income of Self- employed. Conceptually, GDP at factor cost and GDP at market price must be identical/This is because the factor cost (payments to factors) of producing goods must equal the final value of goods and services at market prices. However, the market value of goods and services is different from the earnings of the factors of production. 28 Economic & Business Environment In GDP at market price indirect taxes are included and subsidies by the government are excluded. Therefore, in order to arrive at GDP at factor cost, indirect taxes are subtracted and subsidies are added to GDP at market price. Thus, GDP at Factor Cost = GDP at Market Price – Indirect Taxes + Subsidies. (i) Net Domestic Product (NDP) : NDP is the value of net output of the economy during the year. Some of the country’s capital equipment wears out or becomes obsolete each year during the production process. The value of this capital consumption is some percentage of gross investment which is deducted from GDP. Thus Net Domestic Product = GDP at Factor Cost – Depreciation. (ii) Nominal and Real GDP : When GDP is measured on the basis of current price, it is called GDP at current prices or nominal GDP. On the other hand, when GDP is calculated on the basis of fixed prices in some year, it is called GDP at constant prices or real GDP. Nominal GDP is the value of goods and services produced in a year and measured in terms of rupees (money) at current (market) prices. In comparing one year with another, we are faced with the problem that the rupee is not a stable measure of purchasing power. GDP may rise a great deal in a year, not because the economy has been growing rapidly but because of rise in prices (or inflation). On the contrary, GDP may increase as a result of fall in prices in a year but actually it may be less as compared to the last year. In both 5 cases, GDP does not show the real state of the economy. To rectify the underestimation and overestimation of GDP, we need a measure that adjusts for rising and falling prices. This can be done by measuring GDP at constant prices which is called real GDP. To find out the real GDP, a base year is chosen when the general price level is normal, i.e., it is neither too high nor too low. The prices are set to 100 (or 1) in the base year. Now the general price level of the year for which real GDP is to be calculated is related to the base year on the basis of the following formula which is called the deflator index: Real GDP = GDP for the Current Year x Base Year (100) / Current Year Index GDP Deflator GDP deflator is an index of price changes of goods and services included in GDP. It is a price index which is calculated by dividing the nominal GDP in a given year by the real GDP for the same year and multiplying it by 100. Thus, Nominal (or Current Prices) GDP GDP Deflator x 100 Real (or Constant Prices) GDP  Economic & Business Environment 29 Gross National Product (GNP) GNP is the total measure of the flow of goods and services at market value resulting from current production during a year in a country, including net income from abroad. GNP includes four types of final goods and services: 1. Consumers’ goods and services to satisfy the immediate wants of the people; 2. Gross private domestic investment in capital goods consisting of fixed capital formation, residential construction and inventories of finished and unfinished goods; 3. Goods and services produced by the government; and 4. Net exports of goods and services, i.e., the difference between value of exports and imports of goods and services, known as net income from abroad. In this concept of GNP, there are certain factors that have to be taken into consideration: First, GNP is the measure of money, in which all kinds of goods and services produced in a country during one year are measured in terms of money at current prices and then added together. Second, in estimating GNP of the economy, the market price of only the final products should be taken into account. Many of the products pass through a number of stages before they are ultimately purchased by consumers. If those products were counted at every stage, they would be included many a time in the national product. Consequently, the GNP would increase too much. To avoid double counting, therefore, only the final products and not the intermediary goods should be taken into account. Third, goods and services rendered free of charge are not included in the GNP, because it is not possible to have a correct estimate of their market price. For example, the bringing up of a child by the mother, imparting instructions to his son by a teacher, recitals to his friends by a musician, etc. Fourth, the transactions which do not arise from the produce of current year or which do not contribute in any way to production are not included in the GNP. The sale and purchase of old goods, and of shares, bonds and assets of existing companies are not included in GNP because these do not make any addition to the national product, and the goods are simply transferred. Fifth, the payments received under social security, e.g., unemployment insurance allowance, old age pension, and interest on public loans are also not included in GNP, because the recipients do not provide any service in lieu of them. But the depreciation of machines, plants and other capital goods is not deducted from GNP. Sixth, the profits earned or losses incurred on account of changes in capital assets as a result of fluctuations in market prices are not included in the GNP if they are not responsible for current production or economic activity. 30 Economic & Business Environment For example, if the price of a house or a piece of land increases due to inflation, the profit earned by selling it will not be a part of GNP. But if, during the current year, a portion of a house is constructed anew, the increase in the value of the house (after subtracting the cost of the newly constructed portion) will be included in the GNP. Similarly, variations in the value of assets, that can be ascertained beforehand and are insured against flood or fire, are not included in the GNP. Last, the income earned through illegal activities is not included in the GNP. Although the goods sold in the black market are priced and fulfil the needs of the people, but as they are not useful from the social point of view, the income received from their sale and purchase is always excluded from the GNP. There are two main reasons for this. One, it is not known whether these things were produced during the current year or the preceding years. Two, many of these goods are foreign made and smuggled and hence not included in the GNP. Three Approaches to GNP After having discussed the basic constituents of GNP, it is essential to know how it is estimated. Three approaches are employed for this purpose. One, the income method to GNP; two, the expenditure method to GNP and three, the value added method to GNP. Since gross income equals gross expenditure, GNP estimated by all these methods would be the same with appropriate adjustments. 1. Income Method to GNP : The income method to GNP consists of the remuneration paid in terms of money to the factors of production annually in a country. Thus GNP is the sum total of the following items: (a) Wages and salaries : Under this head are included all forms of wages and salaries earned through productive activities by workers and entrepreneurs. It includes all sums received or deposited during a year by way of all types of contributions like overtime, commission, provident fund, insurance, etc. (b) Rents : Total rent includes the rents of land, shop, house, factory, etc. and the estimated rents of all such assets as are used by the owners themselves. (c) Interest : Under interest comes the income by way of interest received by the individual of a country from different sources. To this is added, the estimated interest on that private capital which is invested and not borrowed by the businessman in his personal business. But the interest received on governmental loans has to be excluded, because it is a mere transfer of national income. (d) Dividends : Dividends earned by the shareholders from companies are included in the GNP. (e) Undistributed corporate profits : Profits which are not distributed by companies and are retained by them are included in the GNP.  Economic & Business Environment 31 (f) Mixed incomes : These include profits of unincorporated business, self-employed persons and partnerships. They form part of GNP. (g) Direct taxes : Taxes levied on individuals, corporations and other businesses are included in the GNP. (h) Indirect taxes : The government levies a number of indirect taxes, like excise duties and sales tax. These taxes are included in the price of commodities. But revenue from these goes to the government treasury and not to the factors of production. Therefore, the income due to such taxes is added to the GNP. (i) Depreciation : Every corporation makes allowance for expenditure on wearing out and depreciation of machines, plants and other capital equipment. Since this sum also is not a part of the income received by the factors of production, it is, therefore, also included in the GNP. (j) Net income earned from abroad : This is the difference between the value of exports of goods and services and the value of imports of goods and services. If this difference is positive, it is added to the GNP and if it is negative, it is deducted from the GNP. GNP according to the Income Method = Wages and Salaries + Rents + Interest + Dividends + Undistributed Corporate Profits + Mixed Income + Direct Taxes + Indirect Taxes + Depreciation + Net Income from abroad. 2. Expenditure Method to GNP : From the expenditure view point, GNP is the sum total of expenditure incurred on goods and services during one year in a country. It includes the following items: (a) Private consumption expenditure : It includes all types of expenditure on personal consumption by the individuals of a country. It comprises expenses on durable goods like watch, bicycle, radio, etc., expenditure on single-used consumers’ goods like milk, bread, ghee, clothes, etc., as also the expenditure incurred on services of all kinds like fees for school, doctor, lawyer and transport. All these are taken as final goods. (b) Gross domestic private investment : Under this comes the expenditure incurred by private enterprise on new investment and on replacement of old capital. It includes expenditure on house construction, factory- buildings, and all types of machinery, plants and capital equipment. In particular, the increase or decrease in inventory is added to or subtracted from it. The inventory includes produced but unsold manufactured and semi-manufactured goods during the year and the stocks of raw materials, which have to be accounted for in GNP. It does not take into account the financial exchange of shares and stocks because their sale and purchase is not real investment. But depreciation is added. (c) Net foreign investment : It means the difference between exports and imports or export 32 Economic & Business Environment surplus. Every country exports to or imports from certain foreign countries. The imported goods are not produced within the country and hence cannot be included in national income, but the exported goods are manufactured within the country. Therefore, the difference of value between exports (X) and imports (M), whether positive or negative, is included in the GNP. (d) Government expenditure on goods and services : The expenditure incurred by the government on goods and services is a part of the GNP. Central, state or local governments spend a lot on their employees, police and army. To run the offices, the governments have also to spend on contingencies which include paper, pen, pencil and various types of stationery, cloth, furniture, cars, etc. It also includes the expenditure on government enterprises. But expenditure on transfer payments is not added, because these payments are not made in exchange for goods and services produced during the current year. Thus GNP according to the Expenditure Method=Private Consumption Expenditure (C) + Gross Domestic Private Investment (I) + Net Foreign Investment (X-M) + Government Expenditure on Goods and Services (G) = C+ I + (X-M) + G. 3. Value Added Method to GNP : Another method of measuring GNP is by value added. In calculating GNP, the money value of final goods and services produced at current prices during a year is taken into account. This is one of the ways to avoid double counting. But it is difficult to distinguish properly between a final product and an intermediate product. For instance, raw materials, semi-finished products, fuels and services, etc. are sold as inputs by one industry to the other. They may be final goods for one industry and intermediate for others. So, to avoid duplication, the value of intermediate products used in manufacturing final products must be subtracted from the value of total output of each industry in the economy. Thus, the difference between the value of material outputs and inputs at each stage of production is called the value added. If all such differences are added up for all industries in the economy, we arrive at the GNP by value added. GNP by value added = Gross value added + net income from abroad. GNP at Market Prices When we multiply the total output produced in one year by their market prices prevalent during that year in a country, we get the Gross National Product at market prices. Thus GNP at market prices means the gross value of final goods and services produced annually in a country plus net income from abroad. GNP at Market Prices = GDP at Market Prices + Net Income from Abroad.  Economic & Business Environment 33 GNP at Factor Cost GNP at factor cost is the sum of the money value of the income produced by and accruing to the various factors of production in one year in a country. It includes all items mentioned above under income method to GNP less indirect taxes. GNP at market prices always includes indirect taxes levied by the government on goods which raise their prices. But GNP at factor cost is the income which the factors of production receive in return for their services alone. It is the cost of production. Thus GNP at market prices is always higher than GNP at factor cost. Therefore, in order to arrive at GNP at factor cost, we deduct indirect taxes from GNP at market prices. Again, it often happens that the cost of production of a commodity to the producer is higher than a price of a similar commodity in the market. In order to protect such producers, the government helps them by granting monetary help in the form of a subsidy equal to the difference between the market price and the cost of production of the commodity. As a result, the price of the commodity to the producer is reduced and equals the market price of similar commodity. For example if the market price of rice is Rs. 3 per kg but it costs the producers in certain areas Rs. 3.50. The government gives a subsidy of 50 paisa per kg to them in order to meet their cost of production. Thus in order to arrive at GNP at factor cost, subsidies are added to GNP at market prices. GNP at Factor Cost = GNP at Market Prices – Indirect Taxes + Subsidies. Net National Product (NNP) NNP includes the value of total output of consumption goods and investment goods. But the process of production uses up a certain amount of fixed capital. Some fixed equipment wears out, its other components are damaged or destroyed, and still others are rendered obsolete through technological changes. All this process is termed depreciation or capital consumption allowance. In order to arrive at NNP, we deduct depreciation from GNP. The word ‘net’ refers to the exclusion of that part of total output which represents depreciation. So NNP = GNP—Depreciation. NNP at Market Prices Net National Product at market prices is the net value of final goods and services evaluated at market prices in the course of one year in a country. If we deduct depreciation from GNP at market prices, we get NNP at market prices. NNP at Market Prices = GNP at Market Prices—Depreciation. 34 Economic & Business Environment NNP at Factor Cost Net National Product at factor cost is the net output evaluated at factor prices. It includes income earned by factors of production through participation in the production process such as wages and salaries, rents, profits, etc. It is also called National Income. This measure differs from NNP at market prices in that indirect taxes are deducted and subsidies are added to NNP at market prices in order to arrive at NNP at factor cost. Thus NNP at Factor Cost = NNP at Market Prices – Indirect taxes+ Subsidies = GNP at Market Prices – Depreciation – Indirect taxes + Subsidies. = National Income. Normally, NNP at market prices is higher than NNP at factor cost because indirect taxes exceed government subsidies. However, NNP at market prices can be less than NNP at factor cost when government subsidies exceed indirect taxes. Domestic Income Income generated (or earned) by factors of production within the country from its own resources is called domestic income or domestic product. Domestic income includes: (i) Wages and salaries, (ii) rents, including imputed house rents, (iii) interest, (iv) dividends, (v) undistributed corporate profits, including surpluses of public undertakings, (vi) mixed incomes consisting of profits of unincorporated firms, self- employed persons, partnerships, etc., and (vii) direct taxes. Since domestic income does not include income earned from abroad, it can also be shown as: Domestic Income = National Income-Net income earned from abroad. Thus the difference between domestic income f and national income is the net income earned from abroad. If we add net income from abroad to domestic income, we get national income, i.e., National Income = Domestic Income + Net income earned from abroad. But the net national income earned from abroad may be positive or negative. If exports exceed import, net income earned from abroad is positive. In this case, national income is greater than domestic income. On the other hand, when imports exceed exports, net income earned from abroad is negative and domestic income is greater than national income. Private Income Private income is income obtained by private individuals from any source, productive or otherwise, and the retained income of corporations. It can be arrived at from NNP at Factor Cost by making certain additions and deductions. The additions include transfer payments such as pensions, unemployment allowances, sickness and  Economic & Business Environment 35 other social security benefits, gifts and remittances from abroad, windfall gains from lotteries or from horse racing, and interest on public debt. The deductions include income from government departments as well as surpluses from public undertakings, and employees’ contribution to social security schemes like provident funds, life insurance, etc. Private Income = National Income (or NNP at Factor Cost) + Transfer Payments + Interest on Public Debt — Social Security — Profits and Surpluses of Public Undertakings. Personal Income Personal income is the total income received by the individuals of a country from all sources before payment of direct taxes in one year. Personal income is never equal to the national income, because the former includes the transfer payments whereas they are not included in national income. Personal income is derived from national income by deducting undistributed corporate profits, profit taxes, and employees’ contributions to social security schemes. These three components are excluded from national income because they do reach individuals. But business and government transfer payments, and transfer payments from abroad in the form of gifts and remittances, windfall gains, and interest on public debt which are a source of income for individuals are added to national income. Personal Income = National Income – Undistributed Corporate Profits – Profit Taxes – Social Security Contribution + Transfer Payments + Interest on Public Debt. Personal income differs from private income in that it is less than the latter because it excludes undistributed corporate profits. Personal Income = Private Income – Undistributed Corporate Profits – Profit Taxes Disposable Income Disposable income or personal disposable income means the actual income which can be spent on consumption by individuals and families. The whole of the personal income cannot be spent on consumption, because it is the income that accrues before direct taxes have actually been paid. Therefore, in order to obtain disposable income, direct taxes are deducted from personal income. Thus, Disposable Income=Personal Income – Direct Taxes. But the whole of disposable income is not spent on consumption and a part of it is saved. Therefore, disposable income is divided into consumption expenditure and savings. Thus Disposable Income = Consumption Expenditure + Savings. If disposable income is to be deduced from national income, we deduct indirect taxes plus subsidies, direct taxes on personal and on business, social security payments, undistributed corporate profits or business savings from it and add transfer payments and net income from abroad to it. 36 Economic & Business Environment Disposable Income = National Income – Business Savings – Indirect Taxes + Subsidies – Direct Taxes on Persons – Direct Taxes on Business – Social Security Payments + Transfer Payments + Net Income from abroad. Real Income Real income is national income expressed in terms of a general level of prices of a particular year taken as base. National income is the value of goods and services produced as expressed in terms of money at current prices. But it does not indicate the real state of the economy. It is possible that the net national product of goods and services this year might have been less than that of the last year, but owing to an increase in prices, NNP might be higher this year. On the contrary, it is also possible that NNP might have increased but the price level might have fallen, as a result national income would appear to be less than that of the last year. In both the situations, the national income does not depict the real state of the country. To rectify such a mistake, the concept of real income has been evolved. In order to find out the real income of a country, a particular year is taken as the base year when the general price level is neither too high nor too low and the price level for that year is assumed to be 100. Now the general level of prices of the given year for which the national income (real) is to be determined is assessed in accordance with the prices of the base year. For this purpose the following formula is employed. Real NNP = NNP for the Current Year x Base Year Index (=100) / Current Year Index Per Capita Income The average income of the people of a country in a particular year is called Per Capita Income for that year. This concept also refers to the measurement of income at current prices and at constant prices. For instance, in order to find out the per capita income for 2018, at current prices, the national income of a country is divided by the population of the country in that year. National Income for 2018 Per Capita Income for 2018 = Population of 2018 Similarly, for the purpose of arriving at the Real Per Capita Income, this very formula is used. Real NationalIncome for 2018 Real Per Capita Income for 2018 = Population of 2018 This concept enables us to know the average income and the standard of living of the people. But it is not very reliable, because in every country due to unequal distribution of national income, a major portion of it goes to the richer sections of the society and thus income received by the common man is lower than the per capita income.  Economic & Business Environment 37 Sample Questions 1. ________________ means the actual income which can be spent on consumption by individuals and families. (a) Personal Disposable Income (b) Net National Income (c) Gross National Income (d) Per Capita Income 2. The formula to derive NNP at Factor Cost is: (a) NNP at Market Prices + Subsidies (b) NNP at Market Prices – Indirect taxes - Subsidies (c) NNP at Market Prices + Indirect taxes + Subsidies (d) NNP at Market Prices – Indirect taxes+ Subsidies 3. ___________ is an index of price changes of goods and services included in GDP. (a) GDP Inflator (b) GDP deflator (c) GDP accelerator (d) GDP decelerator 4. The formula to compute GDP at Factor Cost is: (a) Net value added - Depreciation (b) Net value added x Depreciation (c) Net value added + Depreciation. (d) Net value added / Depreciation 38 Economic & Business Environment 5. The formula to determine Real GDP is: (a) Nominal GDP / GDP Deflator x 100 (b) GDP of the Previous Year x Base Year (100) / Current Year Index (c) GDP of the Current Year / Current Year Index (d) GDP of the Current Year x Current Year Index *** Lesson 3 Indian Union Budget 39 40 Economic & Business Environment OVERVIEW OF INDIAN UNION BUDGET The first Indian Budget was presented by Mr James Wilson on February 18, 1869 after Indian Budget was introduced on April 7, 1860 by the East India Company. The first Budget of Independent India was presented by the then Finance Minister, Mr RK Shanmukham Chetty on November 26, 1947. Till 1955, Budget was only printed in English language. However, from 1955-56, budget started getting printed in both languages, Hindi and English. In the British Era, the Budget used to be presented at 5 PM. This practice was discontinued in the year 2001 by presenting the Budget at 11 AM. Until 2017, the ritual was to present the Budget on the last working day of the February. From last 2 years, Budget is now presented on the first working day of the February. Mr KC Neogy and Mr HN Bahuguna were the only two Finance Ministers who did not present any Indian Budget. The record of presenting maximum number of Budgets is held by Shri Morarji Desai for presenting 10 Budgets. For the first time in 92 years, Union Budget of 2017 merged the Union Budget with the Rail Budget, which was usually presented separately. KEY TERMINOLOGIES / HEADS COVERED UNDER THE BUDGET 1. Annual Financial Statement Article 112 of the Constitution requires the government to present to Parliament a statement of estimated receipts and expenditure in respect of every financial year - April 1 to March 31. This statement is the annual financial statement. The annual financial statement is usually a white 10-page document. It is divided into three parts, consolidated fund, contingency fund and public account. For each of these funds, the government has to present a statement of receipts and expenditure. 2. Consolidated Fund This is the most important of all government funds. All revenues raised by the government, money borrowed and receipts from loans given by the government flow into the consolidated fund of India. All government expenditure is made from this fund, except for exceptional items met from the Contingency Fund or the Public Account. Importantly, no money can be withdrawn from this fund without the Parliament's approval.  Economic & Business Environment 41 3. Demand For Grants Demand for Grants is the form in which estimates of expenditure from the Consolidated Fund, included in the annual financial statement and required to be voted upon in the Lok Sabha, are submitted in pursuance of Article 113 of the Constitution. The demand for grants includes provisions with respect to revenue expenditure, capital expenditure, grants to State and Union Territory governments together with loans and advances. Generally, one demand for grant is presented in respect of each ministry or department. However, for large ministries and departments, more than one demand is presented. 4. Appropriation Bill Appropriation Bill gives power to the government to withdraw funds from the Consolidated Fund of India for meeting the expenditure during the financial year. Post the discussions on Budget proposals and the Voting on Demand for Grants, the government introduces the Appropriation Bill in the Lok Sabha. It is intended to give authority to the government to withdraw from the Consolidated Fund, the amounts so voted for meeting the expenditure during the financial year. 5. Finance Bill A Finance Bill is a Money Bill as defined in Article 110 of the Constitution. The proposals of the government for levy of new taxes, modification of the existing tax structure or continuance of the existing tax structure beyond the period approved by Parliament are submitted to Parliament through this bill. The Finance Bill is accompanied by a Memorandum containing explanations of the provisions included in it. The Finance Bill can be introduced only in Lok Sabha. However, the Rajya Sabha can recommend amendments in the Bill. The bill has to be passed by the Parliament within 75 days of its introduction. 6. Contingency Fund As the name suggests, any urgent or unforeseen expenditure is met from this fund. The Rs 500-crore fund is at the disposal of the President. Any expenditure incurred from this fund requires a subsequent approval from Parliament and the amount withdrawn is returned to the fund from the consolidated fund. 7. Public Account This fund is to account for flows for those transactions where the government is merely acting as a banker. For instance, provident funds, small savings and so on. These funds do 42 Economic & Business Environment not belong to the government. They have to be paid back at some time to their rightful owners. Because of this nature of the fund, expenditure from it are not required to be approved by the Parliament. For each of these funds the government has to present a statement of receipts and expenditure. It is important to note that all money flowing into these funds is called receipts, the funds received, and not revenue. Revenue in budget context has a specific meaning. The Constitution requires that the budget has to distinguish between receipts and expenditure on revenue account from other expenditure. So all receipts in, say consolidated fund, are split into Revenue Budget (revenue account) and Capital Budget (capital account), which includes non-revenue receipts and expenditure. For understanding these budgets - Revenue and Capital - it is important to understand revenue receipts, revenue expenditure, capital receipts and capital expenditure. 8. Revenue receipt/Expenditure All receipts and expenditure that in general do not entail sale or creation of assets are included under the revenue account. On the receipts side, taxes would be the most important revenue receipt. On the expenditure side, anything that does not result in creation of assets is treated as revenue expenditure. Salaries, subsidies and interest payments are good examples of revenue expenditure. 9. Capital receipt/Expenditure All receipts and expenditure that liquidate or create an asset would in general be under capital account. For instance, if the government sells shares (disinvests) in public sector companies, like it did in the case of Maruti, it is in effect selling an asset. The receipts from the sale would go under capital account. On the other hand, if the government gives someone a loan from which it expects to receive interest, that expenditure would go under capital account. On the other hand, if the government gives someone a loan from which it expects to receive interest, that expenditure would go under the capital account. In respect of all the funds the government has to prepare a revenue budget (detailing revenue receipts and revenue expenditure) and a capital budget (capital receipts and capital expenditure). Contingency fund is clearly not that important. Public account is important in that it gives a view of select savings and how they are being used, but not that relevant from a budget perspective. The consolidated fund is the key to the budget. As mentioned in the first part, the government has to present a revenue budget (revenue account) and capital budget (capital account) for all the three funds. The revenue account of the consolidated fund is split into two parts, receipts and disbursements - simply, income and expenditure. Receipts are broadly tax revenue, non-tax revenue and grants-in-aid and contributions.  Economic & Business Environment 43 Preparing a Budget is extremely tedious and a lengthy process. It begins with the Budget Division issuing circular to all ministries, states, UTs, autonomous bodies, deparments and the defence forces, who are asked to submit expenditure estimates for the upcoming year. Extensive consultations are held between Union ministries and the Department of Expenditure of the finance ministry once the estimates have been submitted. In the meantime, the Department of Economic Affairs (DEA) and Department of Revenue meet stakeholders such as farmers, businessmen, FIIs, economists and civil society groups to take their views. Once the pre-Budget meetings are over, a final call on the tax proposals is taken by the finance minister. The proposals are discussed with the Prime Minister before the Budget is finally prepared. The Budget presentation speech comprises the following parts: Annual Financial Statement (AFS) Demand for Grants (DG) Appropriation Bill Finance Bill Macro-economic framework for the relevant financial year Medium-Term fiscal policy and a strategy statement Expenditure Profile Expenditure Budget Receipts Budget REVENUE, CAPITAL AND EXPENDITURE BUDGETS Revenue Budget The Revenue Budget records all the revenue receipts and expenditure. If the revenue expense is more than that of receipts, it indicates that there is a revenue deficit. Revenue expenditure is for the normal running of government departments and various services, interest payments on debt, subsidies, etc. Revenue receipts are divided into tax and non-tax revenue. Tax revenues are made up of taxes such as income tax, corporate tax, excise, customs and other duties that the government levies. 44 Economic & Business Environment In non-tax revenue, the government's sources are interest on loans and dividend on investments like PSUs, fees, and other receipts for services that it renders. Capital Budget The Capital Budget part of the Union Budget has accounts for capital payment and receipts of the government. Capital receipts include: (i) Loans from the public; (ii) Loans from RBI Capital receipts are loans raised by the government from the public (which are called market loans), borrowings by the government from the Reserve Bank of India and other parties through sale of treasury bills, loans received from foreign bodies and governments, and recoveries of loans granted by the Central government to state and Union Territory governments and other parties. Capital payments include expenses incurred towards building long term assets and facilities like land, buildings, machinery, etc. Expenditure Budget The expenditure budget refers to the estimated expenditure of the government during a given financial year. It shows the capital and revenue disbursements of various ministries/departments and presents it under 'Plan' and Non Plan'. Expenditure Budget provides analysis of various types of expenditure. Demand for grants of the Central government is also a part of the Expenditure Budget. MAJOR COMPONENTS OF REVENUE AND CAPITAL BUDGET Revenue Budget Government receipts which neither create asset nor reduce any liability are called Revenue Receipts. Essentially, these are current income receipts for the government from all sources. Revenue Receipts are further classified into tax revenue and non-tax revenue. Tax Revenue will include receipts from direct tax which is in the form of income tax is paid to the government. It will also include various indirect taxes like GST and Cess levied and collected by the government on various goods and services. Non-tax Revenue will include receipts from the government’s divestment process which are nothing but the proceeds from the stake sale in various public sector undertakings. Non-tax Revenue will also include the dividend income which the government receives as a shareholder of the various public sector undertakings. As the name suggests, Revenue Expenditure is also called income statement expenditure. It denotes short-term cost-related assets that are not capitalised. To put it simply, these are the maintenance  Economic & Business Environment 45 expenditure which the government makes towards the assets which it owns in order to keep them functioning. These expenditures are recurring in nature and are incurred by the government regularly. Revenue Expenditure does not create an asset for the government. For example, payment of salaries or pension as it does not create any asset. However, the amount spent on construction of Metro is not Revenue Expenditure as it leads to the creation of an asset. Revenue Expenditure also must not decrease the liability for the government. For example, repayment of borrowings is not Revenue Expenditure as it leads to a reduction in liability of the government. The difference between Revenue Receipt and Revenue Expenditure is known as Revenue Deficit. A Revenue Deficit does not denote an actual loss of revenue for the government but it only means a shortfall in revenue from what was expected by the government. Capital Budget Capital Budget is one of the two parts of the government budget. Generally, the budget is divided into revenue budget and capital budget. This classification is made by considering the items that comes under the two budget components. Capital budget is considered to be productive as it shows the investment type activities of the government. Capital Receipts Capital Budget Capital Expenditure Capital budget consists of capital receipts and payments. The capital receipts are: (1) loans raised by Government from public, called market loans, borrowings by Government from Reserve Bank and other parties through sale of Treasury Bills, loans received from foreign Governments and bodies, (2) disinvestment receipts and (3) recoveries of loans from State and Union Territory Governments and other parties. Capital expenditure consists of expenditure for acquiring of assets like land, buildings, machinery, equipment, investments in shares, etc., and loans and advances granted by Central Government to State and Union Territory Governments, Government companies, Corporations and other parties. 46 Economic & Business Environment FISCAL DEFICIT A fiscal deficit is a shortfall in a government's income compared with its spending. The government that has a fiscal deficit is spending beyond its means. A fiscal deficit is calculated as a percentage of gross domestic product (GDP), or simply as total dollars spent in excess of income. In either case, the income figure includes only taxes and other revenues and excludes money borrowed to make up the shortfall. In other words, fiscal deficit is the difference between the total income of the government (total taxes and non-debt capital receipts) and its total expenditure. A fiscal deficit situation occurs when the government’s expenditure exceeds its income. This difference is calculated both in absolute terms and also as a percentage of the Gross Domestic Product (GDP) of the country. A recurring high fiscal deficit means that the government has been spending beyond its means. The government describes fiscal deficit of India as “the excess of total disbursements from the Consolidated Fund of India, excluding repayment of the debt, over total receipts into the Fund (excluding the debt receipts) during a financial year”. The elements of the fiscal deficits are: (a) The revenue deficit, which is the difference between the government’s current or revenue expenditure and total current receipts, that is excluding borrowing. (b) Capital expenditure. In order to have a proper understanding on fiscal deficit, it is essential to have a fair idea on government’s total income and receipts. 1. Revenue Receipts Corporation Tax Income Tax Custom Duties Union Excise Duties 2. Non-tax Revenues Interest Receipts Dividends and Profits External Grants Other non-tax revenues Receipts of union territories 3. Expenditures of the government Revenue Expenditure  Economic & Business Environment 47 Capital Expenditure Interest Payments Grants-in-aid for creation of capital assets Fiscal Deficit = Total expenditure of the government (capital and revenue expenditure) – Total income of the government (Revenue receipts + recovery of loans + other receipts) If the total expenditure of the government exceeds its total revenue and non-revenue receipts in a financial year, then that gap is the fiscal deficit for the financial year. The fiscal deficit is usually mentioned as a percentage of GDP. For example, if the gap between the Centre’s expenditure and total income is Rs 5 lakh crore and the country’s GDP is Rs 200 lakh crore, the fiscal deficit is 2.5% of the GDP. COMPONENTS / VARIABLES COVERED UNDER FISCAL DEFICIT From the following exhibit, the various components covered under the fiscal deficit may be understood (INR Crore) Note: Budgeted estimates (BE) are budget allocations announced at the beginning of each financial 48 Economic & Business Environment year. Revised Estimates (RE) are estimates of projected amounts of receipts and expenditure until the end of the financial year. Actual amounts are audited accounts of expenditure and receipts in a year. The fiscal deficit for the year 2017-18 (Actuals) is calculated by deducting Total Receipts of INR 15,50,911 from the Total Expenditure of INR 21,41,973 = INR 5,91,062 Crore. It is to be noted that fiscal deficit could be financed by borrowing from Reserve Bank of India, which also known as deficit financing or money creation and market borrowing (from money market, that is mainly from banks).  Economic & Business Environment 49 Sample Questions 1. If the revenue expense is more than that of receipts, it indicates that there is a _________. (a) Primary Deficit (b) Fiscal Deficit (c) Monetary Deficit (d) Revenue Deficit 2. The _____________ records all the revenue receipts and expenditure. (a) Capital Budget (b) Cash Budget (c) Revenue Budget (d) Foreign Exchange Budget 3. Government receipts which neither create asset nor reduce any liability are called __________ (a) Revenue Receipts (b) Capital Receipts (c) Cash Receipts (d) Financial Receipts 4. Which of the following is not covered under the revenue receipts of Government of India? (a) Corporation Tax (b) Loans from RBI (c) Income Tax (d) Custom Duties 50 Economic & Business Environment 5. Payment of salaries is covered under which form of government expenditure? (a) Revenue Expenditure (b) Capital Expenditure (c) Planned Expenditure (d) Unplanned Expenditure *** Lesson 4 Indian Financial Markets 51 52 Economic & Business Environment OVERVIEW OF INDIAN FINANCIAL ECOSYSTEM The financial system of an economy is a crucial element for its economic development. It facilitates the flow of funds from the households (savers) to business organisations (investors), thereby assisting in creation of wealth for the nation. Mainly, the financial system of a country is concerned with the following: (a) Allocation and mobilisation of savings. (b) Provision of funds. (c) Facilitating the financial transactions. (d) Developing financial markets. (e) Provision of legal financial structure. (f) Provision of financial and advisory services. The important features of a financial are- (i) It plays an important role in economic development of a country. (ii) It encourages both savings and investment (iii) It links savers and investors. (iv) It assists in capital formation. (v) It facilitates expansion of financial markets. India has a diversified financial sector undergoing rapid expansion, both in terms of strong growth of existing financial services firms and new entities entering the market. The sector comprises commercial banks, insurance companies, non-banking financial companies, co-operatives, pension funds, mutual funds and other smaller financial entities. The banking regulator has allowed new entities such as payments banks to be created recently thereby adding to the types of entities operating in the sector. In other words, financial services sector consists of the capital markets, insurance sector and non- banking financial companies (NBFCs). India’s gross national savings (GDS) as a percentage of Gross Domestic Product (GDP) stood at 30.50 per cent in 2019. The total amount of Initial Public Offerings increased to Rs 84,357 crore (US$ 13,089 million) by the end of FY18. IPO’s reached to US$ 1.94 billion in FY19 (up to Feb 2019). Ultra High Net Worth Individual (UHNWI) increased to 2,697 in 2018 and the population of UHNWI has grew by 118 per cent from 2013 to 2018.  Economic & Business Environment 53 Noteworthy developments in Indian Financial Ecosystem — Rising incomes are driving the demand for financial services across income brackets. — Financial inclusion drive from RBI has expanded the target market to semi-urban and rural areas. — Investment corpus in Indian insurance sector can rise to US$ 1 trillion by 2025. — Credit, insurance and investment penetration is rising in rural areas. — HNWI (High Networth Individual) participation is growing in the wealth management segment. — Lower mutual fund penetration of 5–6 per cent reflects latent growth opportunities. — The Government of India launched India Post Payments Bank (IPPB), to provide every district with one branch which will help increase rural penetration. — India benefits from a large cross-utilisation of channels to expand reach of financial services. — Maharashtra has launched its mobile wallet facility allowing transferring of funds from other mobile wallets. Maharashtra is the first state to launch it. — As of October 2018, the Financial Inclusion Lab has selected 11 fintech innovators with an investment of US$ 9.5 million promoted by the IIM-Ahmedabad's Bharat Inclusion Initiative (BII) along with JP Morgan, Michael and Susan Dell Foundation, and the Bill and Melinda Gates Foundation. — Government has approved new banking licenses and increased the FDI limit in the insurance sector. KEY FACETS AND GROWTH OF FINANCIAL INSTITUTIONS IN INDIA The significant characteristics of Indian financial system are as under: 1. Plays a pivotal role in accelerating the rate and volume of savings through provision of different financial instruments and efficient mobilisation of savings. 2. It is playing a significant role in increasing the national output by providing funds to corporate customers to expand their business operations. 3. Safeguarding the interests of the investors by ensuring smooth financial transactions through