Business Economics Past Paper PDF

INDEX Regular Name of the chapter Page No. Chapter 1 - Nature and Scope of Business Economics…………………………. 1.1 - 1.04 Chapter 2 - Theory of Demand and supply …………………………………………....

INDEX Regular Name of the chapter Page No. Chapter 1 - Nature and Scope of Business Economics…………………………. 1.1 - 1.04 Chapter 2 - Theory of Demand and supply …………………………………………. 2.1 – 2.16 Chapter 3 - Theory of production and cost …………………………………………. 3.1 – 3.15 Chapter 4 - Price Determination in Difference Markets ……………………… 4.1 – 4.16 Chapter 5 - Business Cycle…………………………………………………………………… 5.1 - 5.5 Chapter 6 - National Income ………………………………………………………………. 6.1 – 6.17 Chapter 7 - Public Finance ………………………………………………………………….. 7.1 – 7.20 Chapter 8 - Money Market …………………………………………………………………. 8.1 – 8.16 Chapter 9 - International Trade …………………………………………………………. 9.1 – 9. 22 Chapter 10 - Indian Economy ……………………………………………………………. 10.1 – 10.10 Chapter 11- Economist Name……………………………………………………………. 11.1 – 11.02 Chapter 12 - Formula Summary………………………………………………………… 12.1 – 12.02  Nature and Scope of business Economics Chapter 1 Nature and Scope of Business Economics 1. Economics originated from Greek work ‘'Oikonomia’. ‘Oiko’-‘House’ & ‘Nomia’,-‘Management’. 2. Till 19th century, Economics was also known as ‘Political Economy’ 3. Basic Economics problem unlimited wants, and Scarce resources. 4. Resources shall be allocated to their highest valued uses. 5. Economics is study of transformation of the scarce resources into G&S to satisfy the most important of our infinite wants 6. The book named ‘An Inquiry into the Nature and Causes of the Wealth of Nations’ (1776), by Adam Smith is considered as the first modern work of Economics. 7. Decision making - process of selecting an appropriate alternative that will provide the most efficient means of attaining a desired end, from two or more alternative courses of action’. 8. Decision making arises only if there is choice available. No alternatives no decision making- e.g.- Continue or shut down decision, New Product, Make or buy, Marketing 9. Joel Dean defined Business Economics as the use of economic analysis to make business decisions involving the best use of an organization’s scarce resources.- 10. Business Economics is referred as Managerial Economics, generally refers to the integration of economic theory with business practice. 11. Economic theories are hypothetical and simplistic in since based on simplifying assumptions. 12. Business Economics enables application of economic logic and analytical tools to bridge the gap between theory and practice. 13. Business Economics is not only valuable to business decision makers, but also useful for managers of ‘not-for-profit’ organizations 14. Difference between Micro and Macro Economics Micro Economics Macro Economics Greek work ‘Mikros’ which means ‘Small’ Greek work “Makros’ which means ‘large’ “Study of particular firm, particular household, “Macro Economics examines the Forest and individual price, wages, income, individual industries, not the Trees. Large aggregates”- particular commodities”- Prof. Boulding Prof.Mc.Connel Behavior of individual firm or industry Overall economic phenomena It is also called as ‘Price Theory’ It is also called as ‘Income Theory’ 15. The Nature of Business Economics is described as under- (a) Business Economics is a Science- Explains cause and effect relationships. (b) Business Economics is an art -application of rules and principles (c) Micro Economics based and Macro Analysis based (d) Analysis from Private Enterprises Economy viewpoint (e) Inter-Disciplinary- Integrates the tools of decision sciences such as Mathematics, Statistics and Econometrics with Economic. (f) Pragmatic Approach- Telegram – CA Aditya Sharma Foundation 1.1  Nature and Scope of business Economics 16. Normative and positive – Positive Economics or Pure economics Normative Economics It is based on facts and there is no point of It tells us about how the things should be. ambiguity or second view Descriptive in nature & It states 'what is' Prescriptive in nature & describes ‘what ought to be’. It explains cause & effect relationship and It passes value judgments /suggestions and offers there will be no value judgments/suggestions. advice. It is based on past data and can be checked Cannot be verified because it is opinion based and with data not fact based No Matter of debate Matter of Debate According to Robbins, Economics is neutral It is based on welfare economics - (Marshall &Pigou) between ends. Complete neutrality between ends is, however, neither feasible nor desirable. 17. Scope of Business Economics a. Microeconomics applied to operational or internal Issues- issues within the organization and fall within the purview and control of the management. 1. Demand Analysis 2. Demand Forecasting 3. Cost analysis 4. Theory of Capital and 5. and Uncertainty Analysis 6. Market Structure and Investment Decisions Pricing Policies 7. Resource Allocation 8. Production analysis 9. Inventory Management 10. Profit analysis b. Macroeconomics applied to environmental or external issues- issues out of preview of an organization The major macro-economic factors relate to 1) The type of economic system. 2) Stage of business cycle. 3) The general trends in national income, employment, prices, saving and investment. 4) Government’s economic policies like industrial policy, competition policy, monetary and fiscal policy, price policy, foreign trade policy and globalization policies. 5) Working of financial sector and capital market. 6) Socio-economic organizations like trade unions, producer and consumer unions and cooperatives. 7) Social and political environment. Telegram – CA Aditya Sharma Foundation 1.2  Nature and Scope of business Economics Central Economic Problems 1. All countries, without exceptions, face the problem of scarcity because their resources are limited and these resources have alternative uses. 2. If a resource has only a single use, then also the economic problem would not arise. 3. The central economic problem is further divided into four basic economic problems. a) What to produce? Which goods and in what quantities b) How to Produce? Method of production,(labour- intensive or capital – intensive) c) For whom to produce? How the G&S should be distributed among members of the society. Also shares of different people in the national product. d) What provisions (if any) are to be made for economic growth?-saving and investment 4. Understanding different types of Economies Particular Capitalist economy Socialist economy Mixed Economy Also Known as Free market economy or laissez- Karl Marx and Frederic Depends on faire economy Engels in their work ‘The both markets Communist Manifesto’ and govt. published in 1848 Most imp Private Ownership Collective Ownership/ Public Include the Feature ownership best features Other points Private property is the mainstay. of both the Profit motive is its driving force controlled How CEP are Impersonal forces of market economy and solved demand and supply or the price the market mechanism economy while What To Decided by consumers Decided by CPE excluding the produce demerits of How to Cost of production minimum. both. produce Labor or capital Intensive For Whom to Those who have buying capacity produce What provision Depends upon level of interest are to be made rate for consumer and rate of for economic return in Market for business growth? firm 5. Characteristics of each type of economy Capitalist economy Socialist economy Mixed Economy a. Right to private a. Collective Ownership of means of a. Government property production by state however, small farms, itself must run b. Freedom of enterprise workshops & trading firms which may important and c. Freedom of economic remain in private hands. selected choice b. Profit- motive and self- interest are not industries and d. Profit Motive the driving forces eliminate the e. Consumer Sovereignty c. The resources are used to achieve certain free play of f. Competition socio-economic objectives. profit motive and Telegram – CA Aditya Sharma Foundation 1.3  Nature and Scope of business Economics g. Absence of Government d. Centrally planned economy self-interest. Interference e. Absence of Consumer Choice- f. Relatively Equal Income Distribution- g. Minimum role of Price Mechanism or Market forces- h. Absence of Competition 6. Merits of each type of economy Capitalist economy Socialist economy Mixed Economy a) Self-regulating through a) Equitable distribution of a) Economic freedom and price mechanism. wealth and income existence of private property b) Rewards efficiency and b) Rapid and balanced b) Price mechanism punishes inefficiency. economic development c) Consumer sovereignty and c) Faster economic growth c) Planned Economy- freedom of choice. d) Optimum allocation of d) Minimum Wastage and d) Appropriate incentives resources optimum utislisation of e) Encourages enterprise and e) Operative efficiency. resource- risk taking. f) Lower cost of production e) Unemployment is f) Advantages of economic g) Better standard of living minimized, planning of consumers f) Absence of profit motive g) Comparatively greater h) Incentive for innovation g) Right to work and minimum economic and social equality and Technological progress. standard of living and freedom i) Right to private Property h) High Social security h) No cut throat competition j) No costs for collecting and processing of information 7. Demerits of each type of economy Capitalist economy Socialist economy Mixed Economy a) Precedence of property rights a) Inefficiency and delays, corruption, a) Excessive over human rights. red-tapism, favoritism, controls the b) Inequality and social injustice b) All material means of production are private sector. c) Wide differences in economic under the control and direction of b) Poor opportunities. state. implementation d) Does not represent the real c) Takes away right of private property. c) Undue delays needs of the society. d) No incentive for hard work e) Exploitation of labour e) Administered prices f) Consumer sovereignty is a myth f) State monopolies become g) Misallocation of resources uncontrollable h) Less of merit goods g) Consumers have no freedom of choice. i) Unplanned production. h) No importance topersonal efficiency j) Waste of productive resources and productivity. k) Formation of monopolies i) The extreme form of socialism is not l) Environmental degradation. at all practicable Telegram – CA Aditya Sharma Foundation 1.4  Consumer Behavior and Utility Analysis Chapter 2A Consumer Behaviour & Utility Analysis 1. Utility is want satisfying power of a commodity is called as utility. 2. Utility is subjective term and differs from person to person 3. Utility does not mean usefulness. 4. Utility is ethically neutral. 5. Human beings have virtually unlimited wants, Each single want is satiable (capable of being satisfied) 6. Consumer spends his income on different G&S to attain maximum satisfaction. 7. Difference Between Cardinal and Ordinal Approach Cardinal Approach Ordinal Approach Assumptions Measurable and quantifiable Utility is not quantifiable Rationale Human satisfaction can be expressed in Human Satisfaction is psychological monetary terms, phenomenon Economists Alfred Marshall Hicks and Allen CARDINAL APPROACH Refer Table for further discussion :( Table 2.1) Quantity of Oranges Total utility Marginal Utility Price Consumer’s consumed per day Surplus in Rs. 0 0 0 0 0 1 60 60 40 20 2 110 50 40 10 3 150 40 40 0 4 180 30 40 -10 5 200 20 40 -20 6 210 10 40 -30 7 210 0 40 -40 8 200 -10 40 -50 9 180 -20 40 -60 8. Total Utility- The sum total of utility derived from different units of commodity 9. Marginal Utility- Additional utility derived from additional unit of a commodity. Marginal Utility can also be defined as change in the total utility resulting from one- unit change (TUn-TU(n-1)) in consumption of commodity, per unit of time or, Change in Utility/ change in Qty. Use Code CAADITYA10 to get best discount on Unacademy subscription 2.1  Consumer Behavior and Utility Analysis 10. Assumptions under Marginal utility analysis and cardinal approach a) Cardinal Measurability of Utility- Utility is measurable and quantifiable. b) Comparability of Utility across the goods- Satisfaction derived by a person from different commodities can be compared. c) Independence of Utilities- d) Constant Marginal Utility of Money- 11. Law of diminishing Marginal utility states -as a consumer consumes more of stock, the extra satisfaction that he derives from an extra unit, declines with the increase in consumption of that item. 12. If same goods have capacity to satisfy other wants then their marginal utility would not have decreased. 13. Conclusion as per law of Diminishing marginal utility a) Total Utility increases at diminishing rate. b) Marginal Utility is Downward Sloping curve, moving from left to right c) Marginal utility is negatively sloped curve. d) Where Marginal Utility is negative, Total utility decreases. e) MU goes on decreasing & becomes negative beyond a certain point of time. 14. Assumptions and Exception to Law of Marginal utility a) Standard Units- Suitable size. b) Homogeneous units- c) Constant Income- d) Constant Taste/ fashion- Continuous consumption- e) Cardinal approach- Utility is quantifiable 15. Exceptions to Law- a) Personal Aspects- music, hobbies, etc b) Money is excluded- c) Other possessions- substitute or complimentary. 16. Significance of Law a) Law of diminishing marginal utility forms the basis of Law of demand. b) Law of diminishing marginal utility indicates consumer’s equilibrium and price. c) Law of diminishing marginal utility explains the concept of consumer surplus d) Price and MU moves together up and down. e) Marginal utility varies inversely with the supply. f) MU of the goods increases as the quantity of complementary goods increases g) MU of the goods decreases as the quantity of substitute goods with the consumer increases. Use Code CAADITYA10 to get best discount on Unacademy subscription 2.2  Consumer Behavior and Utility Analysis 17. Law of Equi- marginal utility - As per the law of Equi- marginal utility, If marginal utility of money spent on commodity X is greater than marginal utility of money spent on commodity Y, then the consumer will withdraw some money from purchase of Product Y and will spent on purchase of X, till MU of money in two cases becomes equal. 18. Maximum Satisfaction- The consumer will attain maximum satisfaction, and will be in equilibrium when MU of money spent on various goods that he buys, are equal. 19. Consumer’s Equilibrium: Consumer is in equilibrium when price of the commodity = MU. Similarly for more than two products, consumer will be in equilibrium if- MU X = MU Y = MU Z Price X Price Y Price Z 20. The consumer will attain maximum satisfaction, and will be in equilibrium when MU of money spent on various goods that he buys, are equal. 21. Consumer Surplus: What a consumer is ready to pay – what he actually pays.(refer table 2.1) a) The consumer continues to buy a commodity till MU = Price of the commodity b) For all the earlier units purchased, MU > price paid. This difference is called as consumer’s surplus 22. Limitations to Consumer surplus a) Relevant only if cardinal approach to measurement of utility is assumed. b) Consumer’s surplus cannot be measured precisely c) Consumer’s surplus derived is affected by availability of substitutes. d) In case of necessaries, consumer’s surplus is infinite e) Not applicable to prestigious items f) It is assumed that MU of the money is constant, which is unrealistic. 23. Graphical Interpretation: refer schedule above (2.1) a) Consumer is in equilibrium at 3 units, where price = MU. b) Consumer surplus is INR 20 and INR 10 at consumption level of 1 Orange and 2 oranges respectively. Use Code CAADITYA10 to get best discount on Unacademy subscription 2.3  Consumer Behavior and Utility Analysis Ordinal Approach- Hicks and Allen Approach 24. Indifference curve analysis- Assumptions a) Ordinal Approach to utility- UTILITY is not measurable in monetary terms. b) Consistency in ranking- If a consumer prefers X to Y and Y to Z , this automatically means that he must prefer X to Z. c) Rational Consumer-Ranking and preferences- d) Number of Goods- Customer prefers that combination which has more commodity in combination and tries to maximize his satisfaction. 25. Indifference curve analysis a) An Indifference curve is a curve which represents all those combination of goods which gives same satisfaction to the consumer. b) He remains indifferent among those combinations. Example: Combin- Roses Lilies Marginal Rate of ation substitution ( MRS) A 15 1 - B 11 2 4 Roses per lily C 8 3 3 Roses per lily D 6 4 2 Roses per lily E 5 5 1 Roses per lily 26. Indifference Map: a) A set of indifference curves is called as Indifference Map. b) An indifference map depicts complete picture of customer’s taste and preferences. c) The consumer is indifferent for any combination lying on same IC. d) However he prefers combination on Higher IC to combinations on lower IC, as the combinations of higher IC give more satisfaction. So IC4 > IC3>IC2>IC1. e) Farther the IC from the origin, higher is the satisfaction level. 27. Marginal rate of Substitutions a) Marginal rate of substitutions (MRS) indicates how much of one commodity is substituted for how much of another commodity. b) MRS is indicated by Slope of IC curve at a particular point. c) MRS show decreasing trend similar to concept of diminishing marginal utility. 28. Property of indifference curve a) Downward sloping to right- negatively sloped. b) Convex to the origin- due to diminishing nature of MRS. c) All point on an IC gives same satisfaction- d) Higher IC gives Higher level of satisfaction- e) Non Intersecting Use Code CAADITYA10 to get best discount on Unacademy subscription 2.4  Consumer Behavior and Utility Analysis 29. Budget line - Price line, Price opportunity line, Price- income line, Budget constraint line. a) A Budget line shows all those combinations of two goods which a consumer can buy spending his given money income on two goods at their given prices. b) Budget line is also called as Every point on Budget line represents full spending by the consumer. 30. Consumer Equilibrium under indifference curve approach a) Consumer will try to reach the highest possible IC. b) However his objective of buying higher quantity of goods is restricted by Budget line. c) Thus a consumer is in equilibrium when he derives maximum possible satisfaction from the goods, and is in no position to re- arrange his purchase of goods. 31. Assumptions under Ordinal Approach: a) The consumer has fixed money income which he has to spend wholly on 2 Goods b) Prices are constant. c) The consumer has given an indifference map which shows his scale of preferences 32. Relationship of MRS and price at equilibrium, a) At equilibrium, slope of price line is equal to slope of Indifference curve. b) Slope of the line is PX/PY. c) Slope of indifference curve indicates Marginal rate of substitution of X for Y. MRSXY=MUX/MUY. d) Hence at equilibrium MRSXY=MUX/MUY= PX/PY, alternatively, MUX/ PX = MUY/PY. Use Code CAADITYA10 to get best discount on Unacademy subscription 2.5  Demand Analysis Chapter 2B – Demand Analysis 1. Demand = Willingness (Desire) and ability (Resources/Means) + willingness to use those means 2. Demand is determined at certain, (i) Price (ii) place or (iii) time. 3. The quantity demanded is a flow. 4. Types of Demand a. Individual Demand/ Company demand- sub-system of total demand. b. Market Demand/ Industry demand. sum total demand of all individual demand c. Price Demand -Demand of consumer at various prices d. Income demand- DD at various income levels. According to this superior goods have greater demand and as the level of income lowers, inferior goods have higher demand. e. Cross demand- Demand due to availability of Substitute goods or complementary goods. f. Short run demand- refers to the demand with its immediate reaction g. Long run demand- refers to demand which exists over a long period. h. Derived demand-The demand because of the demand for some other commodity called ‘parent product’, i. Autonomous demand- Independent of the demand for other goods. j. Producer goods are used for the production of other goods - either consumer goods or producer goods themselves. k. Consumer goods are used for final consumption. Durable goods are those which can be consumed more than once. Non-durable goods are those which cannot be consumer more than once 5. Factors of Demand a. Price of the commodity: demand for a commodity is inversely related to its price. Complementary goods Inversely Related Competing goods or substitutes- Directly Related b. Income of the consumer- As the level of income rises, increase in demand of necessities is proportionally less than increase in income. As the income level increase importance of food and other non durable goods in the overall consumption basket and a rise in the importance of durable goods There are some commodities for which the quantity demanded decreases with an increase in money income beyond this level. These goods are called inferior goods.[ Also called as Giffen goods] c. Tastes and preferences of consumers- Tastes and preferences of consumers are also influence by ‘Demonstration effect’ or ‘bandwagon effect’, i.e. by seeing another person use a particular product/ commodity. Sometimes, when a product becomes common among all, some people decrease or altogether stop its consumption. This is called ‘snob effect’. Watch all free revision lectures for free on my YouTube channel “ CA ADITYA SHARMA” 2.6  Demand Analysis Highly priced goods are consumed by status seeking rich people to satisfy their need for conspicuous consumption. This is called ‘Veblen effect’ d. Population aspect- Size of the population-Directly related Composition of population: Directly if composition is in favor of demand The level of National Income and its Distribution: Even Distribution More DD, uneven distribution less Demand Consumer-credit facility and interest rates: Cheaper interest rate and larger availability of credit increases DD 6. Law of Demand (a) Other things being equal, inverse relationship between price and quantity demanded, (b) The other things which are assumed to be equal or constant are:- Prices of related commodities (complementary goods or substitute goods) Income of consumers Tastes and preferences of consumers, and Such other factors which influence demand. 7. Schedule:- 8. Features of the Demand Curve (a) Slopes downwards from left to right (b) Negatively sloped (c) May sometimes be a straight-line or sometimes a free hand curve (d) Demand curve is also called Average Revenue curve (ARC). (e) The Market Demand curve is a lateral summation of individual Demand curve. 9. Rationale of the Law of Demand a) Law of diminishing marginal utility b) Substitution effect:-When the price of a commodity falls, it becomes relatively cheaper than other commodities. c) Income effect: As a result of fall in the price of the commodity, consumer’s real income or purchasing power increases. d) Arrival of new consumer: Rise in number and rise in buying capacity e) Different uses: Watch all free revision lectures for free on my YouTube channel “ CA ADITYA SHARMA” 2.7  Demand Analysis 10. Exceptions to the Law of Demand a) Conspicuous goods: Prestige value or snob appeal or conspicuous consumption or Veblen effect or prestige goods effect. b) Giffen goods: Inferior goods , with no close substitutes easily available and which occupy a substantial place in consumer’s budget are called ‘Giffen goods’ c) 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. d) Future expectations about prices: e) Irrational consumer- f) Demand for necessaries g) Ignorant consumer: h) Speculative goods 11. Expansion and contraction in Demand VS Increase and decrease in Demand Term Meaning Effect Expansion/ Extension of Quantity demanded Increases, due to Downward movement along Demand decrease in price same Demand curve Contraction of Demand Quantity demanded decreases, due to Upward movement along same increase in price Demand curve Increase in DD Quantity demanded Increases, due to Rightward Shift of Demand change in any factor other than price Curve Decrease in DD Quantity demanded decreases, due to Leftward Shift of Demand change in any factor other than price Curve 12. Elasticity of Demand 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. the percentage change in quantity demanded divided by the percentage change in one of the variables on which demand depends 13. Factors affecting demand and name of their elasticity Factors Name of Elasticity Denoted by Price of the commodity Price Elasticity EP Income of the consumer Income Elasticity EI Price of the related product Cross Elasticity EC Availability of the substitute Substitution Elasticity ES Watch all free revision lectures for free on my YouTube channel “ CA ADITYA SHARMA” 2.8  Demand Analysis 14. Methods of calculation of Price Elasticity of Demand Methods Formula Used when Diagram Percentage 1. Responsiveness of quantity Answer will be in change or demanded of a commodity, negative denoting proportional to a change in Price Inverse relation Method 2. % change in quantity demanded divided by the % change in price, other things remaining equal Point Ep = -dq p ÷ dp q 1. change in price is Elasticity- infinitesimal (very small) Method of 2. Makes use of derivative derivative rather than finite changes in price and quantity Point EP Lower segment 1. Applicable only for Elasticity – Upper segment Straight- line Demand curve Method of touching both the axes. Graph Arc 1. EP= q1-q2 x p1+p2 1. Arc Elasticity is a measure Elasticity q1+q2 p1-p2 of average responsiveness Method 2. Large change in prices and quantities Total Outlay 1. Elasticity is calculated by analysisng the change in Total Method expenditure or Outlay of the household. 2. By this method we can only say whether the demand for a good is elastic or inelastic; we cannot find out the exact coefficient of price elasticity EP < 1 Price and Expenditure moves in same direction. ▪ Price Increase Demand is said to be less elastic, or inelastic and TR increase ▪ Price Decrease and TR decrease EP = 1 Total Expenditure remains Unchanged. Price Increase Demand is said to be unit elastic and TR unchanged Price Decrease and TR unchanged EP > 1 Price and Expenditure moves in opposite direction. Price Increase Demand is said to be elastic and TR decrease Price Decrease and TR increase Watch all free revision lectures for free on my YouTube channel “ CA ADITYA SHARMA” 2.9  Demand Analysis 15. Interpretation of Elasticity of Demand Description Numerical Interpretation Nature of Curve value Perfectly EP =0 Qty. demanded does not Vertical line inelastic changes as price changes Parallel to Y axis Inelastic or 0 MC and decrease output whenever MR < MC and the firm should continue production till 4. MR = MC and MC curve should cut to MR from below. Chapter 6 3.14  Theory Of Cost & Revenue Summary of Relationships: ▪ If TR increases, MR will be positive. TR and ▪ When TR is maximum, MR = 0. MR ▪ If TR decreases, MR will be negative. ▪ MR and AR both decline, but MR falls rapidly than AR MR and ▪ AR Curve is flatter than MR. AR ▪ MR can be zero and even negative, while AR will never cross below the X axis. ▪ At the point where MR = 0, Elasticity of Demand on AR Curve will be 1. Equilib rium Point of the Firm 1. It will be profitable for the Firm to expand its output Y whenever Marginal Revenue (MR) is greater than Marginal Cost (MC), and to keep on increasing output until MR = MC. 2. If any unit of production adds more to Revenue than to Cost, production and sale of that unit will increase profits. Similarly, if it adds more to Cost than to Revenue, it will decrease profits. 3. Profits will be maximum at the point where Additional Revenue (MR) from a unit equals its Additional Cost (MC). So, MC = MR. 4. Further, the MC Curve should cut the MR Curve from below (and not from above). This is so because, upto this point MR > MC, hence there is an incentive for further production. Beyond this point, MC > MR. 5. This position (i.e. where MC = MR, and MC cuts MR from below) is called Equilibrium position for the Firm. 6. Thus, Note: For achieving Equilibrium Position, the conditions to be satisfied are —MC = MR, and MC Curve should cut MR Curve from below, i.e. MC should have +ve slope. 7. Merely being in Equilibrium position does not mean that the Firm is making profits. The actual position of profits can be known only on the basis of AR and AC Curves Chapter 6 3.15  Chapter 4 : Price Determination in Different Markets Chapter 4 – Meaning and Types of Market A. Market basics Meaning: 1) Market is a place where Buyers and Sellers meet and bargain over a commodity for a price. 2) Also, market can be defined simply as all those buyers and sellers of a good or service who influence price. Elements of a Market: The elements of a Market are- 1) Buyers and Sellers, 2) Product or Service, 3) Bargaining for a Price, 4) Knowledge about market conditions, and 5) One Price for a Product or Service at a given time. B. Types of Market The Market Structures analysed in Economics are -- Perfect Monopoly: Monopolistic Oligopoly Monopsony- Competition Competition Many Sellers Single Seller Many Sellers A Few Sellers Single Buyer of a selling identical producing offering selling competing product or products to many differentiated differentiated products to many service. Buyers. products for products to many Buyers. many Buyers. Buyers. Other forms of the market are 1. Duopoly- Duopoly is a market situation in which there are only two Firms in the market. It is a sub—set of Oligopoly. 2. Oligopsony- Oligopsony is a market characterized by a small number of large buyers. 3. Bilateral Monopoly- 1It is a market structure in which there is only a Single Buyer and a Single Seller. Thus, it is a combination of Monopoly Market and a Monopsony Market CA Aditya Sharma 4.1  Chapter 4 : Price Determination in Different Markets Classification of Market: Markets are generally classified into- a. Product markets- markets for goods and services in which households buy the goods and services they want from firms. Product markets allocate goods to consumers, b. Factor markets- those in which firms buy the resources they need – land, labour, capital and entrepreneurship- to produce goods and services. Factor markets allocate productive resources to producers. The prices in factor markets are known as factor prices. Area Time Nature of Regulation Volume of Types of Transaction Business Competition Local market Very Short period- Spot Regulated Wholesale Perfectly Also Known as Market Market market competitive MARKET PERIOD Perishable and Market for Flower, Bulky Goods fish etc. Supply is Fixed Regional Short period Future Unregulat Retail Imperfectly Market Market ed Market Market Competitive Kolhapuri Chappal National Long Period Market Hindi books International Very long/ Secular Market Period High Value Small Bulk Alfred Marshall conceived the ‘Time’ element in markets and on the basis of this, markets are classified into Do You Know?? Difference between ‘value in use’ and ‘value in exchange’. Value in use refers to usefulness or utility i.e the attribute which a thing may have to satisfy human needs. Value in exchange or economic value is the amount of goods and services which we may obtained in the market in exchange of a particular thing. It is measured by the amount someone is willing to give up in other goods and services in order to obtain a good or service. In Economics, we are only concerned with exchange value. Considerations such as sentimental value mean little in a market economy CA Aditya Sharma 4.2  Chapter 4 : Price Determination in Different Markets C. Perfect Competition Features of Perfect Competition 1. Large number of Buyers & Sellers 2. Sellers offer Homogeneous/ identical Products 3. No individual Buyer or Seller will be in a position to influence the demand or supply in the market. 4. Firm is free to enter the market or to go out of market. 5. There is a perfect knowledge, on the part of Buyers and Sellers. 6. There are adequate facilities for the movement of goods from one center to another 7. All Firms individually are Price Takers. Because- If he lowers the price _____________________________________________________________________ _____________________________________________________________________ _______________________________ and if he increases the price _____________________________________________________________________ _____________________________________________________________________ ______________________________. 8. The goods are dealt on at a uniform price throughout the market 9. Buyers have no preference as between different Sellers 10. Sellers are indifferent as to whom they sell 11. There is perfect mobility of factors of production. Why?_________________________. 12. Perfect Competition is a MYTH How Demand Curve is determined 1. In Perfect competition there is Uniform Market Price 2. All the firms are Price Taker and same price prevails in the market. 3. Price Elasticity of Demand is infinity. 4. Hence, the Equilibrium Price determined by Market Demand and Supply forces, constitutes the Demand Curve for the Firm. This Price is also the Average Revenue (AR). 5. and Marginal Revenue (MR) for the Firm, since the price is uniform in the market. So, in Perfect Competition, D = AR = MR = Price CA Aditya Sharma 4.3  Chapter 4 : Price Determination in Different Markets Quick Recap Draw MC Draw curve demand/Average Revenue/ Marginal revenue curve Draw Draw short run Average equilibrium price cost curve curve in Market Short Run price determination, Optimum output/Equilibrium and profit Determination For achieving Equilibrium, the conditions to be satisfied are — 1. MC = MR, and 2. MC Curve should cut MR Curve from below, i.e. MC should have positive slope. For Profit determination 1. Merely being in Equilibrium position does not mean that the Firm is making profits. The actual position of profits can be known only on the basis of AR and AC Curves. 2. In the short run, a firm may earn supernormal profits, normal profits or losses depending upon its cost conditions. CA Aditya Sharma 4.4  Chapter 4 : Price Determination in Different Markets Super profits/ Economic Profits/ abnormal profits and super normal profits: When a firm earn super normal profits its Average revenue are more than average total cost or, AR > ATC. Normal profits: When the firm just meets its average total cost, it earns normal profits Normal profit is normal rate of return on capital and the remuneration for the risk bearing function of the entrepreneur. Here AR = ATC. It is also called B.E.P (Break-even-Point) means No Loss No Profit. It is called Marginal Firm. Losses: A firm may incur losses if AR < ATC. At losses the firm shall cover at least its variable cost. IF variable cost is covered Max loss will be = FC or part of it If firm is unable to meet its variable cost, it will be better for it to shut down. Shut Down point: A Firm will shut down, if AR < AVC, at a point where MC = MR (MC cutting from below). In perfect competition firm, MC curve above AVC is considered the supply curve CA Aditya Sharma 4.5  Chapter 4 : Price Determination in Different Markets Long – run Equilibrium of a firm under Perfect Competition. In the Long run the firms will be earning just NORMAL PROFITS. In the above figure industry has decided the price 'P' and firm has taken over the same price at the same time firm is earning just normal profits. In the long run, following conditions are satisfied: The Firm is called as Optimal Firm The output is produced at the minimum feasible cost or minimum LAC Consumers pay the minimum possible price which just covers Marginal cost = MC=AR=P Full utilization of plants is possible, MC = AC There is no wastage of resources. optimal allocation Firms earn only normal profits i.e. AC = AR. Firms maximize profits i.e. MC = MR, but level of profits will be normal. There are Optimum Number of firm in Industry In the long run LMC = LMR = P = LAR = LAC = SMC = SAC When LAC falls LAC> LMC and when LAC raises LMC > LAC. Long Run Equilibrium in the Industry The Industry is said to have attained long—run equilibrium when — 1. All the Firms are earning normal profits only, i.e. all the Firms are in long—run equilibrium, and 2. There is no further entry or exit of Firms to / from the market. CA Aditya Sharma 4.6  Chapter 4 : Price Determination in Different Markets Question 1: What can be the profit/ loss condition in long run in Perfect competition? Answer:_______________________________________________________________ _______________ Question 2: Why not Super- Normal profit? Answer- Super profit will attract new firms>>>> Supply will increase>>>>>>>> Market Price will fall>>>>>>> upward shift of Cost Curves>>>>>> super profit will be wiped out Question 3: Why Not Losses? Answer- Existing Firms will leave the industry >>>>>>reduction in supply>>>>>> increase in Market Price>>>>>Cost Curves may fall>>>>>>>>>loss will be recovered Relationship between AR, MR, TR and Price 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: MR= AR (e-1)/e e= elasticity Thus when i. e>1, MR is positive ii. e=1, MR = 0 iii. e AD i.e C+S > C+I Ans: The firm will not be able to sell its stock & firm will reduce the production and cut down on expenditure, as a result demand for factor of production will decrease, in case of Factor will reduce and thus spending will fall. This process will continue till equilibrium is reached. ❖ Case 2: AS Marginal Private Cost. of Negative 2) In Case of positive Externalities- Marginal Social Cost< Marginal Private Cost. Externalities Unidirectional Unidirectional Externalities Reciprocal Externalities and Occurs when Originator imposes costs or It occurs when 2 persons impose reciprocal Benefits on another (Recipient) and there is there is costs or on one another. Externalities no externality imposed by the Recipient back on the Originator. Production Production Externalities Consumption Externalities Externalities Consumption externalities initiated Production externality initiated in & in consumption which produce production which imposes an external cost/ Consumption benefit on others may be received by external costs/ benefits on others Externalities another in consumption or in production. may be received in consumption or in production. Externalities Positive externalities Negative externalities can be occur when the action of one party confers occur when the action of one party positive or benefits on another party imposes costs on another party. negative. It is socially desirable It is socially undesirable. 2. Goods Characteristics of Private goods: Private goods refer to those goods that yield utility to people. Anyone who wants to consume them must purchase them. A few examples are: food items, clothing, movie ticket, television, cars, houses etc. Properties of Private goods: 1. Property Right: 2. Rivalrous: 3. Excludable: 4. No Free riding problem: 5. Rejectable: 6. Additional resource costs 7. Efficient Allocation- 8. There is no Market Failure. Public Goods - Paul A. Samuelson who introduced the concept of ‘collective consumption good’ in his path- breaking 1954 paper ‘The Pure Theory of Public Expenditure’ is usually recognized as the first economist to develop the theory of public goods. a) Characteristics of Public Goods: 1. Collective in nature: CA Aditya Sharma Page No. 7.2 Chapter 7 Public Finance 2. No direct payment 3. Non-rival in consumption. 4. Public goods are non-excludable. 5. Public goods are characterized by indivisibility. 6. Free Riding Problem & Externalities: 7. Example: Defence, Highways, Education, Scientific Research, Law Enforcement, Lighthouse, Fire Protection, Disease Prevention, Public Sanitation etc. [Note: Public Goods are divided into Public Consumption Goods and Public Factors of Production.] Pure and Impure Public Goods sn Pure Public Goods Impure Public goods 1. A pure public good is non- There are many hybrid goods that possess some features of rivalrous and non-excludable. both public and private goods. Impure public goods are partially rivalrous or congestible.. Free Riding 1. Free riding is ‘benefiting from the actions of others without paying’. 2. Consumers can take advantage of public goods without contributing sufficiently to their production. 3. The absence of excludability in the case of public goods and the tendency of people to act in their own self-interest will lead to the problem of free riding. 4. If every individual plays the same strategy of free riding, the strategy will fail because nobody is willing to pay and therefore, nothing will be provided by the market. Then, a free ride for any one becomes impossible. 1. No public good will be provided in private markets 2. Private markets will seriously under produce public goods even though these goods provide valuable service to the society. Information failure a) Complex nature: b) Information not available quickly and cheaply: c) Ignorant Buyer/seller: d) Inaccuracy: e) Misunderstanding: Asymmetric information a) Asymmetric information occurs when there is an imbalance in information between buyer and seller i.e. when the buyer knows more than the seller or the seller knows more than the buyer can distort choices. b) This lead to Problem of Adverse Selection – wrong product selected ### ‘Lemons problem’ developed by George Akerlof in relation to the used car market. a) Second-hand cars may be good quality cars or poor quality cars defined as “lemons”. The owner of a car knows much more about its quality than anyone else & he may not disclose all the mechanical defects of the vehicle. b) Based on the probability that the car on sale is a ‘lemon’, the buyers’ willingness to pay for any particular car will be based on the ‘average quality’ of used cars. Since there is quality uncertainty, to account for this risk, the price offered for any used car is likely to be less. CA Aditya Sharma Page No. 7.3 Chapter 7 Public Finance Adverse Moral Hazard – seen in case of Insurance 1. Moral Hazard is opportunism characterized by an informed person’s taking advantage of a less- informed person through an unobserved action. 2. It arises from lack of information about someone’s future behavior. 3. Moral hazard occurs when there is distortion of incentives to take care or to exert effort when someone else bears the costs of the lack of care or effort. Role of Government Objectives of Government Interventions: 1. To control potential rise in prices. (MRTP Act) 2. To bring in welfare to the under privileged sections of the Society by ensuring equity and fairness, (Subsidy) 3. To provide Incentives to promote production / use of Resources in a socially desirable direction etc. (Organic vegetable). 4. One of the most important activities of the government is to redistribute incomes so that there is equity and fairness in the society. Argument in favor of Government Interventions: 1. The role of government improves the wellbeing of individuals and households. 2. Under production of certain goods & higher prices than would exist under conditions of competition( Generic Medicine) 3. Non-production of public goods (or collective goods) in sufficient quantities by the market. (Parks and Playground) 4. Production and Consumption of a Good or Service affects People and they cannot influence through Markets decision about how much of the Good or Service should be produced e.g. Pollution 5. Reduction or Distortion in choices available to consumers, and consequently lower welfare. (Only Private mode of Transport) 6. Equity and Fairness- to Curb Inequalities in the distribution of Income and Wealth. 7. Instabilities caused by Business cycles and fluctuations which lead to recession, inflation, etc. for prolonged periods, and cannot be corrected by Market system as such. 8. Market’s inability to rectify “Stagflation” i.e. a State of affairs in which inflation and Unemployment co-exist, 9. Market’s inability to rectify “Contagious Effect” i.e. forces of instability transmitted from one country to other countries, due to increased international interdependence Arguments against government interventions: Government intervention does not imply that Markets are replaced by Government action. Government can act only as complement rather than as a substitute to the Market System in an economy, Governments may not always be unbiased and benevolent. Individuals may use Government as a Mechanism for maximizing their self interest In certain cases, the cost incurred by Government to deal with some Market failure could be greater than the cost of Market Failure itself. Government intervention may produce fresh and more serious problems that the ones sought to be rectified. Government intervention is ineffective if it causes wastage of resources expended for the intervention Governments are likely to commit serious errors in its attempt to correct Market failure. CA Aditya Sharma Page No. 7.4 Chapter 7 Public Finance Types of Government interventions Government interference can be-  Direct as a buyer or supplier of public goods / information  Indirectly in the form of subsidies / taxes and regulation / influence to correct distortion in the market which occurs when there are deviations from the ideal perfectly competitive state. Market Power- Government control 1. Setting maximum prices that firms can charge. 2. Price regulation is most often used for natural monopolies. 3. Rate-of-return regulation. Another approach to regulation is setting price-caps. 4. Market liberalization by introducing competition in previously monopolistic sectors such as energy, telecommunication etc. 5. Controls on mergers and acquisitions if there is possible market domination 6. Price capping and price regulation 7. Profit or rate of return regulation 8. Patronage to consumer associations 9. Tough investigations into cartelization and unfair practices such as collusion and predatory pricing 10. Restrictions on monopsony power of firms 11. Reduction in import controls and 12. Nationalization Government intervention to Correct Externalities A. Direct Control: (also known as command solutions) - Direct controls prohibit specific activities that explicitly create negative externalities or require that the negative externality be limited to a certain level. Examples Include: Smoking is completely banned in many public places. Stringent rules are in place in respect of tobacco advertising, packaging and labeling etc. fix emissions standard which is the legal limit on how much pollutant a firm can emit Licensing, production quotas and mandates regarding acceptable production processes are other examples of direct intervention by governments. B. Indirect/ market-based Control: ✓ These provide economic incentives to Market Participants, to achieve the socially optimal solution. ✓ In other words, the government tries to alter the prices of goods through taxes and subsidies and thus change the behaviour of market participants. 1. Setting the price directly through a pollution tax. These taxes are named Pigouvian taxes after A.C. Pigou. 2. Setting the price indirectly through the establishment of the cap-and-trade system. a) The second approach to establishing prices indirectly is ‘tradable emissions permits’. You might have heard of ‘carbon credits’. The use of tradable permits to limit emissions is often called ‘cap and trade’. a) Marketable Licenses (called permits) to emit limited quantities of pollutants can be bought at a specified price from the Regulatory Agency, by Polluters CA Aditya Sharma Page No. 7.5 Chapter 7 Public Finance b) A high polluter has to either- i) pay monetary penalties, or ii) buy more permits both leading to increase in costs and decrease in profits. c) A low polluter can- i) avoid Monetary Penalties, and ii) sell permits and earn revenue, both making such firm profitable. i. Problems in administering an efficient pollution tax.  Difficult to Administer-  Complex-  No Genuine solution-  Failure in case of inelastic demand-  Adverse effect on employment- Government Intervention to correct externalities Positive externalities: Though positive externality is associated with external benefits, we still call it a market failure because, left to market, there will be less than optimal output. A. Direct Control:- Production & Supply a) Government enters the market directly as an Entrepreneur, to produce items whose externalities are vastly positive & pervasive. b) Examples: R&D, afforestation, Sewage Treatment, Cleaning up Rivers etc. B. Indirect control:- Subsidies: a) Subsidies given by Government reduce the Production Costs of firms. b) This leads to higher output and supply. c) Thus, such goods will be produced in higher quantities i.e. socially optimum level of output Government intervention in case of Merit Goods Meaning and Example 1. Merit Goods- a) are socially desirable, b) involve substantial positive externalities in their consumption. Need for Intervention 1. Lower Output:. 2. Equity Fairness: 3. Uncertainty in consumption: 4. Imperfect information: Government can regulate the supply of merit goods in following manner 1. Direct government provision:. 2. Regulation:. 3. Subsidies:. 4. Governments also engage in direct production of environmental quality. Government intervention in De-merit Goods Meaning and Example 1. Demerit goods are goods which are believed to be socially undesirable and involve high level of negative externalities. 2. However, it should be kept in mind that all goods with negative externalities are not essentially demerit goods; e.g. Production of steel causes pollution, but CA Aditya Sharma Page No. 7.6 Chapter 7 Public Finance steel is not a socially undesirable good. 3. More than optimal production and consumption. 4. Misallocation of society's scarce resources. 5. Consumers overvalue demerit goods because of imperfect information. ways for Intervention 1. Complete ban:. 2. Persuasion. 3. Through legislations 4. Strict regulations \. 5. Regulatory controls. 6. Imposing unusually high taxes Reason why Govt. fails to provide such measures - 1. Addiction level 2. Inelastic nature of demand. 3. Sellers can always shift the taxes to consumers without losing customers. 4. Banned goods are secretly driven underground and traded in a hidden market. Government intervention in other areas Goods Reason why certain goods are produced by government despite the fact that it can be produced by Private sector 1. Left to the markets and profit motives, these may prove dangerous to the society.. 2. In the case of such pure public goods where entry fees cannot be charged, direct provision by governments through the use of general government tax revenues is the only option. Price intervention: non-market pricing 1. Very often, there is strong political demand for governments to intervene in markets for various goods and services on grounds of fairness and equity. 2. Price floor (a minimum price buyer is required to pay). Price floor means the lowest price fixed by government for a product. The Government fixes floor price for farm products. This regulates income of the farmers. 3. Price ceiling (a maximum price seller is allowed to charge for a good or service). When prices of certain essential commodities rise extremely, government may resort to controls in the form of price ceilings for making a resource or commodity available to all at reasonable prices. 4. In the case of many crops the government has initiated the Minimum Support Price (MSP) programme as well as procurement by government agencies at the set support prices. The objective is to guarantee steady and assured incomes to farmers. In case the market price falls below the MSP, then the guaranteed MSP will prevail. Government Intervention for Incomplete Information For combating the problem of market failure due to information problems following interventions are resorted to: Government makes it mandatory to have accurate labeling and content disclosures. Mandatory disclosure of information, Regulation of advertising and setting of advertising standards to make advertising more responsible, informative and less persuasive. CA Aditya Sharma Page No. 7.7 Chapter 7 Public Finance FISCAL FUNCTIONS: AN OVERVIEW CENTRE AND STATE FINANCE 1. The governments of all nations have important economic functions even where markets constitute the basic resource allocation mechanism. 2. There are three main macroeconomic goals for any nation. a. The first is economic growth. b. The second goal is high levels of employment c. third macroeconomic goal is stable price levels. View of Economists Adam Smith Adam Smith is often described as a bold Advocate of Free Markets and Minimal Governmental Activity except in areas of- ▪ National Defense, Establishment and Maintenance of Highly beneficial Public, Maintenance of Justice, Public Works Richard Musgrave Richard Musgrave, in his classic treatise “The Theory of Public Finance” (1959) introduced the three- branch taxonomy of the role of Government functions in a Market Economy. - 1. Allocation Function (Efficiency Focus)- Aims to correct the sources of inefficiency in the Economic System 2. Distribution Function (fairness focus)- Ensures that the Distribution of Wealth and Income is fair and equitable. 3. Stabilization Function (to ensure price stability)- Covers Monetary and Fiscal Policy, ensuring Macro-economic stability, Maintenance of High Levels of Employment and Price Stability etc. The allocation and distribution functions are primarily microeconomic functions, while stabilization is a macroeconomic function. Allocation Function 1. Meaning: Optimal or efficient allocation of scarce resources means that the available resources are put to their best use and no wastages are there. 2. The private sector resource allocation is characterized by market supply and demand and price mechanism as determined by consumer sovereignty and producer profit motives. 3. The state’s allocation, on the other hand, is accomplished through the revenue and expenditure activities of governmental budgeting. 4. In its allocation role, the government acts as a complement rather than as a substitute to the market system in an economy. Reason for Government Intervention in allocation: 1. Public goods will not be produced in sufficient quantities by the market. 2. Nonexistence of markets in a variety of situations. 3. Government intervention will improve in social welfare. CA Aditya Sharma Page No. 7.8 Chapter 7 Public Finance Market failures which hold back the efficient allocation of resources 1. Imperfect competition and presence of monopoly power 2. Incomplete markets 3. Externalities Factor 4. Imperfect information 5. Inequalities in the distribution of income and wealth A variety of allocation instruments are available by which governments can influence resource allocation in the economy. 1. Government may directly produce the economic good 2. Government may influence private allocation through incentives and disincentives 3. Government may influence allocation through its competition policies, 4. Government sets legal and administrative frameworks, and Re-distribution Function 1. The distributive function of budget is related to the basic question of ‘for whom’ should an economy produce goods and services. 2. Governments can redistribute income and wealth either through the expenditure side or through the revenue side of the budget. 3. On the expenditure side, governments may provide free or subsidised education, healthcare, housing, food and basic goods etc. to deserving people. 4. On the revenue side, redistribution is done through progressive taxation. The distribution function of the government aims at- 1. Equitable Distribution ensuring increased overall social welfare 2. Well-being of those members of the society who suffer from deprivations of different types 3. Providing equality in income, wealth and opportunities 4. Providing security for people who have hardships, and 5. Ensuring that everyone enjoys a minimal standard of living. Redistribution function/ market intervention for socio- economic reasons performed by governments are: 1. Progressive taxation policies of the government 2. Proceeds from progressive taxes used for financing public services, especially those that benefit low- income households 3. Employment reservations 4. families below the poverty line are provided with monetary aid and aid in kind 5. Special schemes for backward regions and for the vulnerable sections of the population However, Redistribution measures should be accomplished with minimal efficiency costs by carefully balancing equity and efficiency objectives-comment Stabilization Function 1. Macroeconomic stability is said to exist when: a) an economy's output matches its production capacity, b) the economy's total spending matches its total output c) the economy's labour resources are fully employed, and d) Inflation is low and stable. CA Aditya Sharma Page No. 7.9 Chapter 7 Public Finance 2. Stabilization function of the government is derived from the Keynesian proposition that a market economy does not automatically generate full employment and price stability and therefore the governments should pursue deliberate stabilization policies. 3. Business cycles are natural phenomena &market mechanism is limited in its capacity to prevent it. 4. In the absence of appropriate corrective intervention it may be prolonged for longer periods. 5. The stabilization issue also becomes more complex as the increased international interdependence (”Contagion effect”). 6. Thus, The stabilization function is one of the key functions of fiscal policy and aims at eliminating macroeconomic fluctuations arising from suboptimal allocation. 7. The stabilization function is concerned with the performance of the aggregate economy in terms of: a) labour employment and capital utilization, b) overall output and income, c) general price levels, d) balance of international payments, and e) the rate of economic growth. 8. Monetary policy works through controlling the size of money supply and interest rate in the economy. 9. Fiscal policy by means of its expenditure and taxation decisions. Centre and State Finance 1) Fiscal federalism, a term introduced by Richard Musgrave, deals with the division of governmental functions and financial. 2) Musgrave argued that the federal or central government should be responsible for economic stabilization and income redistribution, and the allocation of resources should be the responsibility of the state and local governments. 3) India is a federation of 28 states and 8 union territories. 4) The constitution of India has provided for the division of powers between the central and the state governments. 5) Article 246 of the Constitution demarcates the powers of the union and the state by classifying their powers into three lists, namely union list, state list and the concurrent list. i. The union list contains items on which the union parliament alone can legislate ii. The state list has items on which the state legislative assemblies alone can legislate iii. The concurrent list, on which both the parliament and the legislative assemblies can legislate. In the event of conflicting legislation in concurrent list, the law passed by the centre prevails. 6) The central government has greater revenue raising powers. The union government can levy taxes such as tax on income, other than agricultural income, customs and export duties, excise duties on certain goods, corporation tax, tax on capital value of assets excluding agricultural land, terminal taxes, security transaction tax, central GST, union excise duty, taxes other than stamp duties etc. 7) The state governments can levy taxes on agricultural income, lands and buildings, mineral rights, electricity, vehicles, tolls, professions, collect land revenue and impose excise duties on certain items. 8) The property of the union is exempt from state taxation. The property and income of the states are not liable to be taxed by the centre. 9) Articles 268 to 281 of the constitution contain specific provisions in respect of distribution of finances among states. CA Aditya Sharma Page No. 7.10 Chapter 7 Public Finance Distribution of revenue between the union and states is based on the constitutional provisions as follows: 1) The Finance Commission is a constitutionally mandated body that is at the centre of fiscal federalism. 2) The Finance Commission helps in maintaining fiscal federalism in India by performing following functions: (a) The distribution between the union and the states of the net proceeds of taxes. (b) Determination of principles and quantum of grants-in-aid to states which are in need of such assistance. (c) To make recommendations to the President on measures needed to augment (increase) the consolidated fund of a state.  The Fifteenth Finance Commission was constituted on 27, November 2017 against the background of the abolition of Planning Commission and the introduction of the goods and services tax (GST). The commission recommended the share of states in the central taxes (vertical devolution) for the 2021-26 to be 41%, which is the same as that for 2020-21.  The criteria for distribution of central taxes among states for 2021-26 period are same as that for 2020-21. They is Income Distance i.e the distance of a state’s income from the state with the highest income. Area , Population (2011), Demographic performance (to reward efforts made by states in controlling their population), Forest and ecology, Tax and fiscal efforts: GST: - Background and facts 1. The introduction of GST, which was rolled out across the country on 1 July 2017. 2. The GST subsumes the majority of indirect taxes – excise, services tax, sales tax, octroi (entry tax). The GST has made India’s indirect tax regime unitary in nature. 3. The states levy and collect state GST (SGST) and the union levies and collects the central GST (CGST). 4. For any particular good or service or a combination of the two, the SGST and CGST rates are equal. An integrated GST (IGST) is applied on inter-state movement of goods and services and on imports and exports.. 5. During the five-year transition period, the top five GST compensation-receiving states were Maharashtra, Karnataka, Gujarat, Tamil Nadu, and Punjab. 6. As per the supreme court verdict in May 2022, the Union and state legislatures have “equal, simultaneous and unique powers “to make laws on Goods and Services Tax (GST) and the recommendations of the GST Council are not binding on them. THE PROCESS OF BUDGET MAKING: SOURCES OF REVENUE, EXPENDITURE MANAGEMENT AND MANAGEMENT OF PUBLIC DEBT 1. A Budget is a statement that presents the details of 'where the money comes from' and 'where the money goes to'. 2. The government budget is a document presented for approval and legislation by a government. 3. The budget also contains estimates of the government’s accounts for the next fiscal year called budgeted estimates. 4. Need for Government Budget: Budget is required - a) To efficiently allocate limited resources to ensure maximum social welfare. CA Aditya Sharma Page No. 7.11 Chapter 7 Public Finance b) To reallocate resources in accordance with its declared priorities. c) To ensure redistribution of Income and Wealth. d) For Reduction/ elimination of economic fluctuations to bring in stability, sustainable increase in real GDP and reduction in regional Disparities. THE PROCESS OF BUDGET MAKING 1. The budget is prepared by the Ministry of Finance in consultation with NITI Aayog and other relevant ministries. 2. Despite the fact that the union budget is presented on1st February, the process of budget preparation commences in August-September of the previous year. 3. Annual Financial statement:. 4. The budgetary procedures are - a. Preparation of the budget b. Presentation and enactment of the budget and c. Execution of the budget 5. The budget process mainly consists of two types of activities: a. The administrative process,; b. The legislative process. The budget speech of the Finance Minister is usually in two parts. The finance minister makes a detailed budget speech at the time of presenting the budget before the Lok-Sabha. A. Part A of the budget speech gives an outline of the prevailing macro economic situation of the country and the budget estimates for the next financial year B. Part B of the budget speech details the progress C. The Annual Financial Statement shows the receipts and expenditure of government in three separate parts under which government accounts are maintained, namely: a. Consolidated Fund of India b. Contingency Fund of India, and the c. Public Account. D. The expenditures of certain categories (e.g. the emoluments and allowances of the President of India and his/her office, and emoluments of Judges of supreme courts and high ranking personnel of constitutional bodies across India) are ‘charged’ on the Consolidated Fund of India and are not subject to the vote of parliament, are also indicated separately in the budget. E. By convention in an election year, the budget may be presented twice. The first one is to first to secure a Vote on Account for a few months. This is followed by the Annual financial statement for that year or the full-fledged Budget. F. The Parliament has to pass the Finance Bill within 75 days of its introduction. SOURCES OF REVENUE The broad sources of revenue are: 1. The Department of Revenue of the Ministry of Finance exercises control in respect of the revenue matters relating to direct and indirect union taxes. The department is also administering goods and services tax (GST), central sales tax, stamp duties too. CA Aditya Sharma Page No. 7.12 Chapter 7 Public Finance 2. The Department of Revenue exercises control in respect of matters relating to all the direct and indirect union taxes through two statutory boards, namely, a) the Central Board of Direct Taxes (CBDT) - Matters relating to the levy and collection of all direct taxes b) the Central Board of Indirect Taxes and Customs (CBIC). - Matters relating to the levy and collection of all indirect taxes (GST, Customs and central excise duties, service tax) 3. Government receipts are classified under two categories: a) Revenue receipts b) Capital receipts Tax revenue Non tax revenue. debt capital receipts non debt capital receipts 1. Corporation tax 1. Interest receipts, 1. Market loans for 1. Recoveries of 2. Taxes on income 2. Dividends and different purposes loans and advances 3. Wealth tax profits from public 2. Short term /Treasury 2. Miscellaneous 4. Customs duties sector enterprises bill borrowings capital receipts 5. Union excise duties and surplus 3. Securities issued (disinvestments 6. Goods and services transfers from against small savings, and others) tax including GST Reserve Bank of 4. State provident fund compensation cess India (Net) 7. Taxes on union 3. Other Non-tax 5. Net external debts territories revenues and 6. Other receipts (Net) 4. Receipts of union territories ❖ Debt capital receipts Comprise of market loans and short term borrowings by the government, borrowing from the Reserve Bank of India and loans taken from foreign governments/institutions. ❖ Non debt capital receipts include recoveries of loans advanced by the government to PSEs, state governments, foreign governments and union territories and sale proceeds of government assets, including those realized from divestment of government equity in public sector undertakings (PSUs). PUBLIC EXPENDITURE MANAGEMENT 1. The Department of Expenditure of the Ministry of Finance is the nodal department for overseeing the public financial management system. It is responsible for a. the implementation of the recommendations of the Finance Commission, b. monitoring of audit comments/observations, and preparation of central government accounts. c. Additionally, it also assists central ministries/departments in d. controlling the costs and prices of public services, e. reviewing systems and procedures to optimize outputs and outcomes of public expenditure. In Expenditure budget, the Central government expenditure is classified into six broad categories as below: A. Centre’s Expenditure: a) Establishment Expenditure of the Centre- includes establishment-related expenditure of the ministries/departments, and attached and subordinates offices. b) Central sector schemes- include those schemes which are entirely funded and implemented CA Aditya Sharma Page No. 7.13 Chapter 7 Public Finance by the central agencies under union government ministries/departments. c) Other central expenditures including those on CPSEs and Autonomous Bodies B. Centrally Sponsored Schemes and other Transfers: The transfers include a) Centrally sponsored schemes b) Finance Commission transfers and c) Other transfers to states PUBLIC DEBT MANAGEMENT 1. In emerging market and developing economies, the government is generally the largest borrower. 2. Government debt from internal and external sources contracted in the Consolidated Fund of India is defined as Public Debt. 3. Public debt management refers to the task of determining and implementing the strategy, by the fiscal and monetary authorities, the size and composition of debt, the maturity pattern, interest rates, redemption of debt etc 4. Debt management strategy is based on three broad pillars namely, low cost of borrowing, risk mitigation and market development. 5. The institutions responsible for public debt management are: a) Internal Debt Management Department (IDMD) (28 states and 2 UT) – Division of RBI b) External Debt - Department of Economic Affairs in Ministry of Finance (MOF) c) Ministry of Finance; Budget Division and Reserve Bank of India – Other liabilities such as small savings, deposits, reserve funds etc. 6. The Fiscal Responsibility and Budget Management (FRBM) was passed in 2003 to provide a legislative framework for reduction of deficit and thereby debt of the central government. The objectives of the act are: a) inter-generational equity in fiscal management, b) long run macroeconomic stability, c) better coordination between fiscal and monetary policy, and d) Transparency in fiscal operation of the government. Budget concepts (Type of budgets) surplus budget When estimated government receipts are more than the estimated government expenditure it is termed as surplus budget. deficit budget When estimated government receipts are less than the government expenditure. Balanced A balanced budget is a budget in which revenues are equal to expenditures. budget Unbalanced The budget may either be surplus or deficit. budget Capital Capital receipts are those receipts that lead to a reduction in the assets or an Receipts increase in the liabilities of the government. Revenue Revenue receipts can be defined as those receipts which neither create any Receipts liability nor cause any reduction in the assets of the government. There are two sources of revenue receipts for the government — tax revenues and non-tax revenues. Capital There are expenditures of the government which result in creation of physical CA Aditya Sharma Page No. 7.14 Chapter 7 Public Finance Expenditure or financial assets or reduction in financial liabilities. Revenue Revenue expenditure is expenditure incurred for purposes other than creation of Expenditure physical or financial assets of the central government. Revenue The revenue deficit refers to the excess of government’s revenue expenditure Deficit over revenue receipts. Revenue deficit = Revenue expenditure – Revenue receipts Budgetary Budgetary Deficit is defined as the excess of total estimated expenditure over Deficit or total estimated revenue, both revenue and capital. Overall Deficit Fiscal Deficit Fiscal deficit is the difference between the government’s total expenditure and its total receipts excluding borrowing (non-borrowed receipts). Fiscal Deficit = Revenue Deficit + (Capital Expenditure - Capital Receipts excluding borrowing) The fiscal deficit will have to be financed by borrowing. Primary Primary deficit is defined as fiscal deficit of current year minus interest Deficit payments on previous borrowings. Primary deficit = Fiscal deficit – Net Interest liabilities Finance Bill The Bill produced immediately after the presentation of the union budget detailing the Imposition, abolition, alteration or regulation of taxes proposed in the budget. Outcome The outcome budget measures budgetary allocations of schemes and its annual budget performance targets measured through output and outcome indicators. Guillotine The parliament has very limited time for examining the expenditure demands of all the ministries. Once the prescribed period for the discussion on demands for grants is over, the speaker of Lok Sabha puts all the outstanding demands for grants, whether discussed or not, to the vote of the house. This process is popularly known as 'Guillotine'. Cut Motions Motions for reduction to various demands for grants are made in the form of cut motions seeking to reduce the sums sought by government on grounds of economy or difference of opinion on matters of policy or just in order to voice a grievance. Consolidated All revenues received, loans raised and all moneys received by the government in Fund of India repayment of loans are credited to the Consolidated Fund of India All expenditures of the government are incurred from this fund. Contingency A fund placed at the disposal of the President to enable him/her to make Fund of India advances to the executive/Government to meet urgent unforeseen expenditure. Contingency fund enables the government to meet unforeseen expenditure and does not require prior legislative approval. Public Account Under provisions of Article 266(1) of the Constitution of India, public account is used in relation to all the fund flows where government is acting as a banker. Examples include Provident Funds and Small Savings. This money does not belong to government but is to be returned to the depositors. The expenditure from this fund need not be approved by the parliament.. CA Aditya Sharma Page No. 7.15 Chapter 7 Public Finance Fiscal Policy – Meaning and Objective Meaning: 1. Fiscal policy involves the use of government spending, taxation and borrowing to influence both the pattern of economic activity and level of growth of aggregate demand, output and employment. 2. Fiscal policy is in the nature of a demand-side policy. 3. An economy which is producing at full-employment level does not require government action in the form of fiscal policy. Objective of Fiscal policy: 1. Achievement and maintenance of full employment, 2. Maintenance of price stability, 3. Acceleration of the rate of economic development, and 4. Equitable distribution of income and wealth, The importance as well as order of priority of these objectives may vary from country to country and from time to time. Discretionary fiscal policy 1) Discretionary fiscal policy refers to a deliberate policy actions on the part of the government to change the levels of expenditure and taxes to influence the level of national output, employment, and prices. 2) Discretionary Policies seek to address the GDP measure [i.e. GDP = C + I + G + (X – M)], Where C = Private Consumption, I = Private Investment, G = Government spending, (X – M) = Net exports. 3) Governments can influence economic activity (GDP) by controlling G directly and influencing C, I, and (X – M) indirectly through changes in taxes, transfer payments and expenditure policies. Non- Discretionary fiscal policy 1) Non- discretionary fiscal policy or automatic stabilizers are part of the structure of the economy and are ‘built-in’ fiscal mechanism that operates automatically to reduce the expansions and contractions of the business cycle. 2) It occurs when there is changes in economic conditions cause government expenditures and taxes automatically. 3) Example: personal income tax, corporate income tax, and transfer payment. Explanation 1. Automatic Stabilizers during Recession when incomes are reduced a) Progressive tax structure b) Government expenditures & transfer payments 2. Automatic Stabilizers during Inflation/ Demand-pull inflation a) Progressive tax structure b) Government expenditures & transfer payments Four Instruments/ tools of Fiscal Policies Taxes Taxes determine the size of disposable income in the hands of the general public. Action during Inflation- Action during Recession CA Aditya Sharma Page No. 7.16 Chapter 7 Public Finance Government Government expenditures include: expenditure 1. current expenditures to meet the day to day running of the government, 2. capital expenditures which are in the form of investments made by the government in capital Equipments and infrastructure, and 3. Transfer payments i.e. pension, unemployment allowance During a recession and impact of Multiplier During Expansion/ Inflation phase- There are two concepts of public spending during depression- ‘pump priming’ and 'compensatory spending'. 1. Pump priming assumes that when private spending becomes deficient, certain volumes of public spending will help to revive the economy. 2. Compensatory spending is said to be resorted to when the government spending is carried out with the obvious intention to compensate for the deficiency in private investment. Public Debt Meaning and Types: 1. Public debt may be internal or external; 2. when the government borrows from its own people in the country, it is called internal debt. 3. When the government borrows from outside sources, the debt is called external debt. 4. Public debt takes two forms namely, market loans and small savings. 5. In the case of market loans, the government issues treasury bills and government securities. 6. The small savings represent public borrowings, which are not negotiable and are not bought and sold in the market. Action During Inflation: Action During Recession: Budget Action during Recession: Action during Inflation: Types of Fiscal There are two basic types of Fiscal- Expansionary and contractionary Expansionary Fiscal policy Contractionary Fiscal Policy When Used? Expansionary fiscal policy is designed to Designed to restrain the levels of economic stimulate the economy- activity of the economy - 1. During the contractionary phase of a 1. During an Inflationary phase. business cycle. 2. When there is anticipation of a business- 2. When there is an anticipation of a cycle expansion which is likely to induce business cycle contraction. inflation. Scenario 1. Decline / slump in overall economic 1. Increase in Aggregate Demand (i.e. activity, Demand-pull inflation) 2. Decline in Real Income (Real GDP) 2. Increase